THE FOREIGN EXCHANGE MARKET

THE FUNCTIONS OF MONEY MEDIUM OF EXCHANGE UNIT OF ACCOUNT: COMMON DENOMINATOR USED TO MEASURE THE VALUE OF GOODS AND SERVICES STORE OF VALUE. ALLOWS TO POSTPONE IN TIME VALUES EARNED AND SPENT AUTONOMOUS NATIONAL JURISDICTIONS MONEY CANNOT PERFORM THESE FUNCTIONS IN DIFFERENT COUNTRIES PURPOSE OF THE FOREIGN EXCHANGE MARKET TRANSFER OF PURCHASING POWER FROM AMONG COUNTRIES TO ALLOW INTERNATIONAL TRANSACTIONS TRADE INVESTMENT
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THE FOREIGN EXCHANGE MARKET

TWO RATES ARE QUOTED ON THE MARKET

SPOT RATES
PRICES FOR IMMEDIATE DELIVERY FORWARD RATES PRICES FOR FUTURE DELIVERY

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SIZE OF THE MARKET

IT IS THE LARGEST FINANCIAL MARKET IN THE WORLD, WITH AVERAGE DAILY TRANSACTIONS ESTIMATED TO BE IN EXCESS OF 1.5 TRILLION DOLLARS (1998) EURODOLLARS SUBSTANTIALLY CONTRIBUTED TO THE MARKET GROWTH LONDON & NEW YORK ARE THE LARGEST MARKETS, FOLLOWED BY, TOKYO, SINGAPORE, ZURICH, HONG KONG FRANKFURT AND PARIS. THE SHARE OF SPOT MARKET FELL FROM 73 TO 50 IN 1992 THANKS TO THE DEVELOPMENTS OF COMMUNICATIONS, THE MARKET IS ACTIVE 23 HOURS PER DAY

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ORGANIZATION OF THE MARKET

THE MARKET IS NOT PHYSICAL PLACE IT IS AN ELECTRONICALLY LINKED NETWORK OF BANKS, BROKERS AND DEALERS THAT BRINGS TOGETHER BUYERS AND SELLERS OF FOREIGN CURRENCIES
TRADING IS DONE BY TELEPHONE, TELEX, THE SWIFT (SOCIETY FOR WORLDWIDE INTERBANK COMMUNICATION TELECOMMUNICATIONS) AVAILABLE SINCE 1977 MOST TRANSACTIONS ARE BASED ON ORAL COMMUNICATION AND WRITTEN CONFIRMATION

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ORGANIZATION OF THE MARKET
U.S. CUSTOMER BUYS EURO WITH U. S. $ STOCKBROKERS LOCAL BANK

FOREIGN EXCHANGE BROKERS

MAJOR BANKS INTERBANK MARKET

IMM LIFFE PSE

LOCAL BANK
STOCKBROKERS ITALIAN CUSTOMER BUYS U.S $ WITH EURO

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ORGANIZATION OF THE MARKET

CUSTOMERS, LOCAL BANKS, CENTRAL BANK

CUSTOMERS BUY AND SELL FOREIGN EXCHANGE THROUGH LOCAL BANKS THESE BANKS ARE TOO SMALL TO OPERATE ON THE INTERBANK MARKET

THEY OPERATE THROUGH A CREDIT LINE WITH A LARGE BANK OR THE HOME OFFICE THE OPERATIONS OF THE CENTRAL BANK ARE SIMILAR

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ORGANIZATION OF THE MARKET
THE INTERBANK MARKET THE MARKET WHERE THE BULK OF THE TRANSACTIONS TAKE PLACE THE HEAD AND REGIONAL OFFICES OF THE MAJOR COMMERCIAL BANKS OPERATE IN THIS MARKET ON A CONTINUOUS BASIS AS DEALERS A LARGE FRACTIONS OF THE TRANSACTIONS IS CONDUCTED THROUGH THE BROKERS THESE ARE SPECIALISTS THAT OPERATE ON COMMISSIONS

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ORGANIZATION OF THE MARKET
THE CLEARING SYSTEM
A STANDARDIZED SYSTEM FOR INTERNATIONAL FUNDS TRANSFERS

IN THE US WHERE ALL TRANSACTIONS INVOLVING DOLLAR ARE CLEARED, ELECTRONIC FUNDS TRANSFER TAKE PLACE THROUGH CHIPS (CLEARING HOUSE INTERBANK PAYMENTS SYSTEM) THE SYSTEM LINKS ABOUT 150 DEPOSITORY INSTITUTIONS THAT HAVE OFFICES IN NEW YORK TRANSACTIONS ARE ENTERED INTO THE CHIPS TERMINAL AND TRANSMITTED TO THE RELEVANT INSTITUTIONS THE CLOSING OF THE CHIPS NETWORK IS AT 4.30 N.Y. TIME BANKS WITH DEBT POSITION HAVE UNTIL 5.45 P.M. TO TRANSFER THEIR DEBIT POSITION THE PROCESS IS USUALLY COMPLETED BY 6 P.M.
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ORGANIZATION OF THE MARKET

ELECTRONIC TRADING THE REUTERS AND BLOOMBERG PROVIDE A SYSTEM OF CONSTANTLY UPDATED INFORMATION THEY ALSO ENABLE DEALERS TO ENTER DIRECTLY THEIR BUY AND SELL TRANSACTIONS THE SYSTEM LEADS TO TWO MAJOR CONSEQUENCES: REDUCTION OF THE TRANSACTION COSTS AND OF THE BROKERS ROLE THE INCREASE OF LIQUIDITY AS MORE PRICES ARE FED INTO THE SYSTEM

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THE SPOT MARKET
MARKET WHERE CURRENCIES ARE NEGOTIATED FOR IMMEDIATE DELIVERY PRICES FOR THE CURRENCY EXCHANGES CAN BE IN: AMERICAN (DIRECT) TERMS: QUOTATIONS (NUMBER OF DOMESTIC CURRENCY PER UNIT OF FOREIGN CURRENCY) EUROPEAN (INDIRECT) TERMS: QUOTATIONS (NUMBER OF FOREIGN CURRENCY PER UNIT OF DOMESTIC CURRENCY)

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THE SPOT MARKET
TRANSACTION COST: THE SPREAD BANKS DO NOT CHARGE A COMMISSION ON THE TRANSACTIONS THEY PROFIT FROM THE SPREAD BETWEEN THE RATE AT WHICH THEY BUY CURRENCY (BID) SELL CURRENCY (ASK) THE SPREAD IS ALWAYS IN FAVOR OF THE BANK

FOR WIDELY TRADED CURRENCIES THE SPREAD RANGES FROM 0.05% TO 0.08%
UNLESS OTHERWISE SPECIFIED, THESE ARE THE RATES FOR THE INTERBANK TRANSACTIONS EXCEEDING 1 MILLION $

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THE FOREIGN EXCHANGE MARKET

THE SPOT MARKET

TRANSACTION COSTS: THE SPREAD: REPAYS TRADERS FOR THE COSTS THEY INCUR IN TRADING PROVIDES FOR AN EARNING ON THE CAPITAL TIED UP IN THE BUSINESS COMPENSATES FOR THE RISK BORNE CALCULATING THE PERCENTAGE SPREAD WITH THE POUND STERLING AT $1.7442 1.7543
ASK - BID 1.7453 1.7442 -------------- X 100 = ----------------------- X 100 = 0.063 ASK 1.7453

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THE FOREIGN EXCHANGE MARKET

THE SPOT MARKET

TRANSACTION COSTS: THE SPREAD:

DEALINGS ARE ALWAYS VERY QUICK AND CONCISE THE PRACTICE IS NOT TO QUOTE THE FULL RATE, BUT ONLY THE LAST TWO DIGITS OF THE DECIMAL: 42-53 THE BANK IS COMMITTED TO ITS QUOTE FOR ABOUT 20 SECONDS IN RAPIDLY EVOLVING MARKET THE BANK WANTS TO LIMIT THE CLIENTS CAPABILITY TO SHOP AROUND THE CLIENT SHOULD NOT LET THE BANK KNOW WHETHER HE WANTS TO BUY/ SELL

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THE SPOT MARKET
THE RISK THE AMOUNT OF THE SPREAD WILL DEPEND UPON MANY FACTORS: THE SHORT/LONG POSITION OF THE BANK THE MARKET EXPECTATIONS THESE IMPACT ON THE BANKS RISK BANKS ACT AS DEALERS WHEN THEY BUY, THEY ADD TO THEIR INVENTORY THEY EXPOSE THEMSELVES TO THE CURRENCY RISK WHEN THEY HAVE AN OPEN POSITION THE EXCHANGE RISK WILL REQUIRE A PREMIUM THAT IS BUILT IN THE QUOTATION A LONG POSITION IN A CURRENCY COMBINED WITH AN EXPECTATION OF THAT CURRENCY WILL LEAD TO A DECREASE IN THE ASK RATE INCREASE IN THE BID RATE
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THE SPOT MARKET

SETTLEMENT DATE THE VALUE DATE FOR SPOT TRANSACTIONS IS SET AT THE SECOND WORKING DAY AFTER THE DATE THE TRANSACTION IS CONCLUDED

ONE OR SAME DAY SETTLEMENT DATE ARE AVAILABLE EVEN IF UNUSUAL THE RATES WILL BE ADJUSTED TO REFLECT INTEREST DIFFERENTIALS

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THE FORWARD MARKET

THE MARKET WHERE OF CURRENCY WITH DEFERRED DELIVERY IS NEGOTIATED A FORWARD CONTRACT BETWEEN A BANK AND A CUSTOMER (OR ANOTHER BANK) CALLS FOR DELIVERY OF A GIVEN AMOUNT OF ONE CURRENCY AGAINST ANOTHER WITH A: PREDETERMINED FUTURE DATE EXCHANGE RATE SET AT THE TIME THE CONTRACT IS ENTERED INTO

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THE FORWARD MARKET

MARKET PARTICIPANTS

TRADERS HEDGERS ARBITRAGEURS SPECULATORS

THE FIRST THREE CATEGORIES SEEK TO REDUCE RISK BY FREEZING THE EXCHANGE RATE ON FUTURE TRADE OR FINANCIAL OPERATIONS SPECULATORS ACTIVELY EXPOSE THEMSELVES TO RISK BY BUYING / SELLING CURRENCIES

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THE FORWARD MARKET: TRADERS

AN AMERICAN IMPORTER IS SHORT IN POUNDS SINCE HE MUST PAY 1 MILLION POUNDS IN THREE MONTHS IF THE ACTUAL SPOT RATE IS $ 1.71, SETTLING THE TRANSACTION TODAY, HE WOULD HAVE TO PAY $ 1.71 MILLION THE IMPORTER IS WORRIED ABOUT A POSSIBLE APPRECIATION OF THE POUND, THAT WOULD INVOLVE A GREATER OUTFLOW OF US$ HE CAN GUARD AGAINST RISK THROUGH A FORWARD EXCHANGE HE ACQUIRES THE RIGHT RECEIVE 1 MILLION POUNDS IN THREE MONTHS AT THE EXCHANGE RATE NEGOTIATED TODAY ($ 1.72) IN 90 DAYS: THE BANK WILL GIVE THE EXPORTER 1 MILLION POUNDS THE IMPORTER WILL GIVE THE BANK $ 1.72 MILLION THE COST OF SECURITY IS $ 10.000
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THE FORWARD MARKET: TRADERS
THE RESULT OF THE FORWARD CONTRACT IS TO INSURE (AT A COST) AGAINST FUTURE FLUCTUATIONS OF THE SPOT RATE OFFSETTING OF TWO STERLING POSITIONS SHORT RESULTING FROM IMPORTS LONG RESULTING FROM THE FORWARD CONTRACT

FORWARD CONTRACT RECEIPT 1.000,000

ACCOUNT PAYABLE

1,000,000

FORWARD CONTRACT PAYMENT $ 1,282,000

IF THE CURRENT SPOT RATE IS 1 = US $ 1.72, THE COST OF INSURANCE IS 10,000 EURO

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THE FORWARD MARKET: HEDGING A PAYMENT

Payment cost ($ million)

1.75 1.74 1.73 1.72 1.71 Forward contract loss

Un-hedged cost of 1 million payment

Forward contract gain

1.70
1.69

Hedged cost of 1 million payment Forward rate

1.68 1.69 1.70

1.71 1.72 1.73 1.74 1.75 1.76

Dollar value of in 90 days

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THE FOREIGN EXCHANGE MARKET

THE FORWARD MARKET
FOREIGN EXCHANGE GAINS/LOSSES

GAINS/LOSSES RESULT FROM THE DIFFERENCE BETWEEN THE NEGOTIATED FORWARD RATE THE SPOT RATE AT MATURITY IF AT MATURITY THE SPOT RATE IS LOWER THAN $ 1.72, THERE WILL BE AN OPPORTUNITY LOSS: THE POUND COULD HAVE PURCHASED AT A LOWER RATE ON THE SPOT MARKET AT MATURITY IF THE RATE IS GREATER THAN 1.72, THERE WILL BE AN OPPORTUNITY GAIN: THE IMPORTER IS BUYING POUNDS AT LOWER RATE THAN THE ONE OF THE SPOT MARKET UPON MATURITY DIFFERENCE WITH OPTIONS: THE PARTIES ARE COMMITTED TO EXECUTE THE CONTRACT

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THE FORWARD MARKET

ARBITRAGEURS SEEK PROFITS BY EXPLOITING MARKET IMPERFECTIONS THE INTEREST RATE PARITY HEDGERS SEEK TO PROTECT FOREIGN DENOMINATED ASSETS AND LIABILITIES THAT ARE NOT REALIZED OVER THE LIFE OF THE CONTRACT HEDGING NET EQUITY SPECULATORS

SEEK PURE RISK BY EXPLOITING DEVIATIONS FROM FORWARD RATES AS UNBIASED PREDICTORS OF FUTURE SPOT RATES
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THE FORWARD MARKET

THE SPECULATION ON THE ITALIAN LIRA PRIOR TO ONE OF THE FREQUENT ITALIAN CURRENCY CRISIS THE RATES FOR THE LIRA /DM WERE AS FOLLOWS SPOT LIT 750 : DM 1 3 MONTHS FORWARD: LIT 760 : DM 1 THE SPECULATORS EXPECTED A DEPRECIATION OF THE LIRA GREATER THAT ANTICIPATED BY THE FORWARD RATE, AND PURCHASES DM AT THE RATE OF 760 THE LIRA IN FACT DEVALUED: AT MATURITY THE SPOT RATE WAS 987 THIS ENABLED THE SPECULATOR TO: PURCHASE DM AT THE FORWARD RATE OF 760 SELL DM AGAINST LIRAS AT THE RATE PF 987 REALIZE A 227 LIRAS PROFIT (987-760) FOR EACH DM SOLD
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THE FORWARD MARKET

FORWARD RATES CAN BE EXPRESSED IN TWO WAYS OUTRIGHT RATE SWAP RATE
OUTRIGHT RATES COMMERCIAL CUSTOMERS ARE USUALLY QUOTED THE ACTUAL PRICE IF THE FORWARD RATE IS ABOVE THAT OF THE SPOT, THE FOREIGN CURRENCY IS SAID TO BE AT A FORWARD PREMIUM IF IT IS BELOW THE SPOT RATE, THE FOREIGN CURRENCY IS AT A FORWARD DISCOUNT BID/ASK RATES ARE ALSO USED FOR FORWARD RATES THE THREE MONTHS BID/ASK SPREAD CAN VARY FROM 0.1 TO 1%
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THE FORWARD MARKET
SWAP RATE INDICATES IN TERMS OF POINTS (PIP) THE DISCOUNT/PREMIUM RELATIVE TO THE SPOT RATE 90 DAYS POUND IS QUOTED AT $ 1.8086 SPOT POUND IS $ 1.8220 THE BRITISH POUND IS SOLD AT A 134 POINT DISCOUNT

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THE FORWARD MARKET

THE SWAP RATE CAN BE CONVERTED IN THE OUTRIGHT RATE BY ADDING/SUBTRACTING IT TO THE SPOT RATE POINTS HAVE NO SIGN, SO THAT A RULE MUST BE USED TO DETERMINE WHEN TO ADD OR SUBTRACT A BID SMALLER THAT THE ASK INDICATES THAT THE FORWARD RATE IS AT A PREMIUM AND THE POINTS MUST BE ADDED TO THE SPOT IF THE BID EXCEEDS THE ASK, THE FORWARD RATE IS AT DISCOUNT, AND THE POINTS MUST BE SUBTRACTED FROM THE SPOT

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THE FORWARD MARKET

SWAP RATE
THE PREMIUM/DISCOUNT CAN BE USED AS AN ANNUALIZED DEVIATION FROM THE SPOT RATE
FORWARD RATE SPOT RATE SPOT RATE

360

FORWARD CONTRACT NUMBER OF DAYS

USING THE POUND/US DOLLAR INDICATED BEFORE

1.8086 1.8220 360

1.8220

90

- 0.0294 = - 2.94%

THE ANNUALIZED DEVIATION IS ESSENTIAL TO EVALUATE IF THE FORWARD RATES ARE IN LINE WITH THE EUROCURRENCIES INTERBANK MARKET
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THE FOREIGN EXCHANGE MARKET THE FORWARD MARKET

SWAP RATE

AS A GENERAL RULE THE CURRENCY WITH HIGHER INTEREST RATES SHOULD BE QUOTED AS A DISCOUNT LOWER INTEREST RATES SHOULD BE QUOTED AT A PREMIUM THE FORWARD RATE BECOMES EQUIVALENT TO A SPOT TRANSACTION INCREASED/DECREASED BY THE INTEREST RATE DIFFERENTIAL THE PREMIUM/DISCOUNT IS THE COST OF CARRY, I.E THE COST OF FREEZING CAPITAL IN A GIVEN CURRENCY IF THE YIELD IS GREATER THAT THE COST, THERE WILL BE ROOM FOR ARBITRAGE
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THE FORWARD MARKET

SPREADS ARE FUNCTION OF: BREADTH (VOLUME) OF THE MARKET RISK ASSOCIATED WITH FORWARD CONTRACTS RISK IS BASED ON THE UNCERTAINTY OF FUTURES SPOT RATES SINCE DISTANT RATES ARE LESS SECURE, DEALERS WILL COMPENSATE THEMSELVES WITH WIDER SPREADS THE GREATER UNPREDICTABILITY OF FUTURE RATES WILL ALSO REDUCE THE NUMBER OF MARKET PARTICIPANTS

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THE FORWARD MARKET

FORWARD CONTRACT MATURITIES AS FOR SPOT RATES, THE TRANSACTIONS MUST BE PERFORMED WITHIN THE SECOND WORKING DAY FOLLOWING THE MATURITY DATE MATURITIES ARE NORMALLY AVAILABLE FOR 1, 2, 3, 6, 12 MONTHS BANKS CAN ALSO TAILOR CONTRACTS FOR ODD MATURITIES TO MEET CUSTOMERS NEEDS (E.G. 77 DAYS) LONGER MATURITIES CAN BE ARRANGED FOR WIDELY TRADED CURRENCIES IN BOTH INSTANCES THE SPREAD USUALLY WIDENS THE NORMAL SPREAD RANGES FROM 0.1 TO 1%

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