Money represents purchasing power (JS Mill: "There is nothing more insignificant than money"), but usually only in one country.  ¥, £, or € have no purchasing power in U.S.  Exchanging one currency for another takes place in the FX market (converting purchasing power from one currency into another).

FX is world's largest financial market in world.  $1.2T/day vs. $5T/year for all publicly traded stock in U.S. ($20B/day in US stocks vs. $1200B/day in FX).  FX market trading has decreased in recent years.  Reason??

FX traded 24/7/365.  Three major areas: Australasia (Sydney, Tokyo, Hong Kong, Singapore), Europe (London, Paris, Amsterdam, Frankfurt) and N. America (NY, Montreal, Toronto, SF, Chicago, LA, etc.)  Due to time zone differences, trading takes place 24 hours/day, see Exhibit 4.2 on page 76 (Electronic trades per hour).

Most trading rooms operate 9-12 hour days.  Trading volume is high when the N. America and Europe markets overlap (early in the day in U.S.) and late in the day in Asia when the European market is opening. 
 

Two largest trading centers: 33% of daily trading volume in London/UK ($504B daily), and 17% in U.S. ($254B daily), see Exhibit 4.1, p. 75, and see the NY Fed article here: http://www.newyorkfed.org/education/fx/foreign.html  
 

FX actually covers spot currency markets, forward currency markets, currency options, currency swaps, currency futures, foreign trade financing and credit arrangement, etc.  This chapter covers spot and forward markets only.

 

FUNCTION AND STRUCTURE OF FX MKT.

FX markets are part of Commercial Banking activities, assisting corporate clients/MNCs to conduct international commerce.  Banks provide the service of buying/selling foreign currency for commercial customers, e.g. importers who are buying foreign products and need to buy foreign currency with $, or exporters who are receiving foreign currency and need to sell foreign currency for $.  

FX is an OTC (over-the-counter) market, like NASDAQ.  How does OTC differ from non-OTC??

FX OTC: Int'l. network of bank currency traders, nonbank dealers, FX brokers, linked by computers, phone lines, telex machines, automated quotation systems, etc.  The communication system of FX dealers is extremely advanced, sophisticated and reliable. 
 

FX MARKET PARTICIPANTS

Two levels: Wholesale (Interbank, 87% of trading volume) and Retail (Client market, 13% of market).  Why so much wholesale?  Much wholesale trading is speculative trading (trying to correctly judge the direction of currency values) or arbitrage trading (exploiting ex-rate discrepancies between dealers).  Currency trading is a profit center for large banks.

1. INTL BANKS and BANK CUSTOMERS.  100-200 large commercial banks worldwide provide the core of the FX market and actively participate, and "make a market" in FX, trading FX on behalf of bank customers (MNCs, money managers, exporters, importers, private traders).

2. NONBANK DEALERS.  Wholesale currency traders who are NOT commercial banks, e.g. Investment banks (Solomon Smith Barney, M-L, JP Morgan, Goldman Sachs, etc.), who establish their own trading centers to trade directly in the FX market, and account for 28% of the interbank (wholesale) volume.

3. FX BROKERS.  Brokers/intermediaries who track quotes offered by many dealers in the global market, and then match buyers and sellers for a fee (bid/ask spread), and "make a market," without taking a position themselves (no currency inventory).  More and more trading (50-70%) now takes place through automated electronic trading systems, making the role of FX brokers unnecessary.  This trend will continue as electronic trading becomes more advanced.

4. CENTRAL BANKS.  If a country has a fixed ex-rate (Argentina until recently, Hong Kong, Belize), or a pegged rate (China), the central bank (or currency board) has to make regular interventions to support the fixed/pegged ex-rate.

Example: China, pegged rate is Y8.28/$.  If the ex-rate goes toward 8.4 (8.2), Yuan is depreciating (appreciating), central bank must buy (sell) Yuan to strengthen/appreciate (weaken/depreciate) the Yuan.  Buying (selling) pressure will increase (decrease) the value of the currency.

Even under floating rates, central banks may intervene in FX market, to influence the domestic (or foreign trading partner's) currency for policy goals.

Example:  In mid-80s, dollar was strong, US manufacturers complained to Reagan admin.  Why?  Solution?

Japan tries to keep the US $ strong.  Why?
 

CORRESPONDENT BANKING RELATIONSHIPS  

Wholesale interbank FX trading among commercial banks, who maintain demand deposits (corresponding banking accounts) with each other, creating a wholesale banking network.

See example 4.1, page 77.  U.S. importer buying merchandise from a Dutch exporter invoiced in Euros at an agreed upon price of €512,100.  Correspondent banking systems handles the currency trading.  Importer contacts U.S. bank to get an ex-rate quote to buy  €512,100 @ €1.0242/$ (Note: ex-rates typically quoted to 4 decimal places), or $500,000.  Funds get transferred between U.S. Bank and its correspondent bank in Europe (EZ Bank), where the Dutch Exporter has an account.  Thus, the US Importer and Dutch Exporter handle the currency transfer through their respective banks, who have a correspondent banking relationship.    
 

The transfer of funds internationally is facilitated by int'l clearinghouse services like SWIFT (Society for Worldwide Interbank Financial Telecommunications), CHIPS (Clearing House Interbank Payments System, part of the FRS) and ECHO (Exchange Clearing House Limited).  SWIFT and CHIPS also provide check-clearing services, account transfers, wire transfers, etc.  ECHO is exclusively for FX.

FX SPOT MARKET

Cash (or spot) market for currency, involves immediate delivery (within one or two days), represents 33% of total FX market, see p. 79.  Spot rates (S) can be quoted two ways.  Ex-rate is just a ratio of two currencies, can be expressed two ways: S = $/£, or S = £/$.  (1/x key on calculator).

When the dollar is on the top of the ratio, S = $ / £, or S($/£) = $1.5272/£  this is called:
a. Direct quote (priced in dollars)
b. U.S. $ Equivalent
c. American terms

When the dollar is on the bottom of the ratio S = £ / $ or S(£/$)  = £0.6548/$, this is called:
a. Indirect Quote
b. European terms
c. Currency PER US $

Spot rates are reported both ways.  See WSJ quotes on p. 80 and handout.

Most currencies are priced and traded against the $ (90% world currency market involves the dollar on one side of transaction), See Exhibit 4.5 on p. 81.

General rule: All currencies are generally quoted in European terms, Indirect quote, e.g., ¥118/$, Mex Pesos 9.8130 / $, EXCEPT British pound (£) and former British colonies (Australia, NZ and Ireland), which are quoted in American terms, Direct, e.g. $1.5272/ £.  Reason: pre-1971, British pound and currencies based on the £ were NON-decimal, so it was more convenient to report Spot Rate as $/ £, a practice that continues until today.  When Euro was introduced, it was decided it would also be quoted as a direct quote, $1.1139/€.  HINT: Always pay close attention to how currency is quoted, direct or indirect!

S($/£) or S(£/$).  Reciprocal of one another.

S = $1.5272 / £

S = 1/1.5578 =  £0.6548 / $.
 

Calculator: Use 1/x key (HP: 1/x is on the Divide key)

 

BID-ASK SPREAD

Bid/Ask Spread provides a commission/brokerage fee for currency traders/brokers.  The FX currency trader/bank will BUY FX for inventory at the BID price and SELL FX at the ASK price.  BID price is always LOWER than the ASK price.  Dealers buys low, sells high.

Example: S(BID) =  £0.6548 / $
               S(ASK) = £0.6550 / $

Dealer will pay £0.6548 for a $, and sell the $ for £0.6550, spread is the profit margin (£0.6421 - £0.6419 = £0.0002).  Most wholesale, standard-size transactions are for $10m or more, so the spread generates profits even though it is very low, ($10m x £0.0002/$ = £2000 profit, or about $3000).  Retail bid-ask spreads are higher, more profitable than wholesale spreads, to cover the fixed cost of a transaction that applies to even small currency trades.

Currency trading rooms are set up so that individual traders specialize in one currency and trade it against the $:  ¥, €, £, SF, etc.  There is also a "cross-rate" desk for trades NOT involving the $, e.g., ¥ / €.  Traders might make 400 trades per day.  See story "Young Traders Run Currency Markets" on pages 84-85.
 

CROSS EX-RATES

Cross Ex-Rate is an ex-rate that does NOT involve $, e.g. €/£.  See cross currency rates on page 86.

Example:  S(€/£) = S($/£) / S($/€)  =   S($/£) x  S(€/$), so S =  €/£

(The $s cancel, leaving €/£).

From Exhibit 4.4: S($/£) = 1.5272 and S($/€) = .9764

So S($/£) = 1.5272 / .9764 =  €1.5641/£. 

      S($/€)

For 9 currencies there would be (9 x 8)/2 = 36 cross currency rates.  

(Explain Triangle Cross-Products in Table, ¥100, $0.843 per ¥100)
 

CROSS-RATE TRADING

To simplify trading, most trades goes through the $, even for a nondollar "currency against currency" trade, e.g. trading £s for SF.  Trade: £s for $s, $s for SFs instead of £s directly for SFs.  Reason: Assume there are 9 major currencies including $.  There are 8 trading desks, each quoting a rate using US $.  If each 9 currencies were also traded against each other, there would have to be 36 trading desks [((N-1) x N) / 2] instead of 8 to have all combinations of two currencies, or traders would have to deal in more than one currency, which would be too complicated and complex.

Cross trades (currency against currency) are handled at a special cross-rate desk, going  through the dollar ex-rate for each currency.
 

TRIANGULAR ARBITRAGE

Exploiting FX discrepancies using 3 currencies, to make riskless profits.

Example: $1 to £,  £ to €, and € back to $.  Supposed you start with a $1, end up with $1.01.

$/£  x  £/€  x  €/$ should = 1

1.529 x .639 x 1.024 ≈ 1.000

When it does not equal 1, there is Triangular Arbitrage.

Example: 1.529 x .639 x 1.0337  = 1.01

$1 turns into $1.01, $1m turns into $1.01m = $10,000 profit.  Reason: $ is overvalued to the € ($1 should buy only €1.024, but actually buys €1.0337, about 1% overvalued).

Example 4.3 , page 87 and Exhibit 4.8 on p. 89.  $5m into €5.12m (@ €1.024/$) into £3.286m (@£0.6418/€) into $5,017,139 (@$1.5267/£) for a $17,139 Arbitrage Profit (no risk, no investment). 
 
Arbitrage profits from triangular arbitrage would typically be: a) small, b) infrequent and c) temporary.  "Picking up dimes with a bulldozer."  Efficient market hypothesis.  Law of One Price. Price Equalization Principle.  

FORWARD MARKET

Contract settled today for future delivery/receipt of FX.  Agree today on P (ex-rate) and Q, future settlement in 1, 3, 6, 9, 12 months, 2, 5, 10 years, etc..  Forward rates are available for most major currencies at most maturities.
 
Compared to the spot rate, FX is usually trading at either a Forward Discount (currency is expected to depreciate) or Forward Premium (currency is expected to appreciate).

See Handout.  Which FX are selling at discount/premium??

Notation in Book:    S($/SF) = Spot rate
                              F₁($/SF), F₃($/SF), F₆($/SF) are 1, 3, and 6 month forward rates.

Page 90.    S($/SF) = .6653
                 F₁($/SF) = .6660 

                  F₃($/SF) = .6670

                      F₆($/SF) = .6684 (% CHG = .466% x 2 = .932% annual)

SF is selling at a forward premium of about 1% (annual), dollar is selling at forward discount of about 1% per year.  SF is expected to appreciate, dollar is expected to depreciate, and those expectations are already being priced in the forward market.   

Calculation of Forward Premium/Discount in %:
S($/SF) = .6653
F₆($/SF) = .6684

FORWARD PREMIUM/DISCOUNT: [(F - S) / S] x 100

%CHG = [(.6684 - .6653) / .6653] x 100 = .466% x 2 = .932%

HP 10B: .6653 / INPUT / .6684 / Yellow Key / % (.466 in Display x 2 = .932%)

Two groups of participants for Forward/Futures Markets:

1. Hedgers - Investors/companies who are exposed to currency risk.  Allows MNCs to control and manage revenues and payments

2. Speculators - Pure speculative position on currency rates, gambling on ex-rates.  Go long if you expect future S > F₆, go short if you expect future S < F₆.  

Example of Speculative Forward Position, page 91.

F₃($/SF) = $.6670 but S₃ will probably not be exactly $.6670, but you can lock in now to buy or sell at $.6670/SF.  If you think S₃ will be > $.6670, you go LONG, buy SF forward, and lock in at .6670, expecting S >$.6670 in 3 months.  Hopefully, you buy at F₃ = $.6670 (guaranteed) and sell at S > $.6670 in 3 months, make profit of (S₃ - $.6670).

If you think S₃ < $.6670, you go SHORT, sell SF forward, lock in to sell at $.6670, if S₃ < $.6670, you can buy at < $.6670 and sell at $.6670, and make money.

See payoff diagram, page 91.

Example 4.4, page 91.  SF trader thinks that the S₃ < F₃ $.6670, so takes a SHORT position, sells SF5,000,000 forward in 3 months against the $, based on belief that the SF will appreciate less than expected, dollar will depreciate less than expected.  If S₃ < F₃ $.6670, trader will make money.  If S₃ = $.6600, trader can buy SF at $.6600 and sell SF at $.6670, make money ($.6670 - $.6600 = $.0070/SF x SF5,000,000 = $35,000 profit).

If trader is wrong and S₃ > F₃, then they lose money.  If S₃ = $.6700 then they have to buy at $.6700 and sell at $.6670 for a loss of -$.0030 per SF, x SF5,000,000 = -$15,000.
 
Point: a) Hedgers are using the forward ex-rate markets to manage, control or eliminate currency risk, because they have some personal or business interest in the outcome of currency movements.  Forward markets are like insurance markets for the hedgers, e.g., importers, exporters, foreign investors, etc. 

b) Speculators are using the forward ex-rate markets to take pure speculative positions on currency changes, pure gambling, with no business interest in currency changes.