THE FOREIGN EXCHANGE

MARKET

TOPIC 2

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 Foreign Exchange Markets
Facilitates international trade and financial
transactions
It is an over-the-counter market
No centralized meeting place and no fixed and
closing time
Dealers located in the major commercial and
investment banks around the world
Participants communicate using computer
terminals, telephones, and other
telecommunication facilities, e.g. Society for
World Inter-bank Financial Telecommunications
(SWIFT).
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 The spot market
The spot market is the market for immediate
exchange of currencies.
The rate of exchange in this market is the spot
rate (or the cash exchange rate)
In practice, delivery and payment occur two
days following the conclusion of the deal
The local forex bureau market is an example
of a spot market.

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The forward Market

In the forward market, currencies are bought and

sold now for future delivery
Payment is made upon delivery, but the exchange
rate is agreed upon at the time of contract
Date of delivery is called the value date
Forward rate is therefore the exchange rate for a
currency to be delivered at a future date
Forward rates usually quoted for 30, 90, 180, 270,
and 360 days.

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The forward Market (contd)
The forward market enables an MNC
to lock in the exchange rate at which
it will buy or sell a certain quantity of
currency on a specified future date.
Hundreds of banks facilitate foreign
exchange transactions, though the
top 20 handle about 50% of the
transactions.

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 SYMBOLS AND ACRONYMS
Std/f = spot exchange rate between currencies d
(domestic) and
f (foreign) at time t
Ftd/f = forward exchange rate between the
domestic and
foreign currencies priced at time 0 and for
delivery at time t (sometimes denoted F0,td/f)
Futtd/f = Price in domestic currency of a futures
contract on f
foreign currency priced at time 0 and for
delivery at time t (sometimes denoted Fut0,td/f)
Calltd/f = value of call option on foreign currency f at
time t
Puttd/f = Value of a put option on foreign currency f
at time t 6
 What is Exchange Rate?
Amount of one currency needed to exchange for
one unit of another currency
Measures the price of one currency in terms of
another currency
The exchange rate can be quoted in any direction

E.g. the exchange rate between the cedi and the

US dollar may be quoted either as:
1.cedis needed to purchase one US dollar, i.e. the cedi
price of the dollar; e.g. GH4.00/$
2.number of US dollars necessary to purchase one cedi
or
the dollar price of the cedi, e.g. $0.25/cedi.

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Exchange Rate Quotation
Conventions
direct or indirect quotation.
direct quotation expresses the number of local
currency required to buy a unit of foreign
currency. E.g. GHS4.00/$ in Ghana
indirect quote expresses number of units of a
foreign currency exchanging for one unit of a
local currency. E.g. $0.25/GHS
UK uses indirect quotation. Many countries use
direct quotation.

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 Conversion

1
Direct quote
indirect quote

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Appreciation and Depreciation

Appreciation is the strengthening of a

currency
Depreciation is the weakening of a
currency.

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Cross Rate

The calculation of foreign exchange

rate from two separate quotes that
contain a common currency.

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 Arbitrage
Purchase of currency in one market
for immediate resale in another
market to exploit price discrepancies
between the two markets to make a
risk free profit
No investment required because the
purchase of currency is financed with
the sale of the other currency.
This is done by an arbitrageur.
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 Arbitrage (contd)
Comparing Quotes From Different Traders
New York Frankfurt
$1.24/ 0.82/$
Expressing quotes in same currency $/, we have
New York Frankfurt
$1.24/ $1.22/
Differences in quotes makes it possible for market
participants to make profit by buying from one trader and
selling the same currency to another trader
Difference in quotation leads to arbitrage.

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Relationship Between Forward and
Spot Rates
The relationship between the spot
and the forward exchange rates at
anytime is quantified
This is done by expressing it in the
form of percentage per annum
premium or discount of the forward
rate over the spot rate.

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 Forward Premium or
Discount
The foreign currency is at a forward
discount against a given currency
when the forward price of the foreign
currency is quoted lower than its
spot price. The opposite holds for the
forward premium.
Example
Spot $1.4615/
1 month forward $1.4600/.
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 Quantifying Forward Premium or
Discount

Forward spot 12 x 100

x
spot No of months forward

Forward discount/premium of

(1.4600 1.4615) x12 x 100

1.4615 x 1
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 Quantifying Forward Premium or
Discount
=-1.2316% p.a.

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 Major dealers in the FX
Market
1. Commercial Banks
. Banks are main participants in foreign exchange market
. At the retail level they deal with
Corporations
Exporters
importers
. At the wholesale level they maintain an inter-bank foreign
exchange market.
2. Businesses
-international trade
-foreign direct investment.
3. Central Banks
- frequently intervene in the market to maintain the spot rates of
their currencies within a desired range.

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 Eurocurrency Market
U.S. dollar deposits placed in banks
in Europe and other continents are
called Eurodollars.
In the 1960s and 70s, the Eurodollar
market, or what is now referred to as
the Eurocurrency market, grew to
accommodate increasing
international business and to bypass
stricter U.S. regulations on banks in
the U.S. 19
Composition of the Eurocurrency
Market
Eurocurrency market composed of
several large banks (Eurobanks)
They accept deposits and provide
loans in various currencies
Transactions represent large deposits
and loans (equivalent of $1million or
more)
Such large transactions reduce
operating expenses of a bank.
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Composition of the Eurocurrency
Market (contd)
Deposits or loans from Eurobank
described with Euro prefix
Thus a deposit of Japanese yen is a
Euroyen deposit
A loan in Swiss francs by a Eurobank
is Euro-Swiss franc loan
Interest rate on Eurocurrency reflect
that currencys rate in the home
country.
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 Eurocurrency Market
Although the Eurocurrency market
focuses on large-volume transactions,
there are times when no single bank is
willing to lend the needed amount.
A syndicate of Eurobanks may then be
composed to underwrite the loans.
Front-end management and
commitment fees are usually charged
for such syndicated Eurocurrency loans.

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 Eurocurrency Market
The recent standardization of regulations
around the world has promoted the
globalization of the banking industry.
In particular, the Single European Act has
opened up the European banking industry.
The 1988 Basel Accord signed by G-10
central banks outlined common capital
standards, such as the structure of risk
weights, for their banking industries.

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 Eurocredit Market
Loans of one year or longer are
extended by Eurobanks to MNCs or
government agencies in the
Eurocredit market. These loans are
known as Eurocredit loans.
Because of asset liability
mismatch, Eurobanks commonly use
floating rates
LIBOR used as base rate.
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 Eurobond Market
There are two types of international
bonds.
Foreign Bonds or Parallel Bonds are
bonds denominated in the currency
of the country where they are placed
but issued by borrowers foreign to
the country.
Eurobonds are bonds issued in
multiple countries, but denominated
in a single currency, usually the
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 TRIANGULAR ARBITRAGE
Action to capitalize on a discrepancy where the
quoted cross exchange rate is not equal to the
rate that should exist at equilibrium.
Assume the euro and Japanese yen are both
quoted versus the US dollar,
They appear as 0.7332/USD and 115.915/USD.
If the YEN/EURO cross rate is needed, it is simply
a matter of division:
115.915/0.7332 = 158.0947/

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Triangular arbitrage (contd)
The YEN/EURO cross rate of 158.0947 is the
third leg of the triangle.
This must be true if the first two exchange
rates are known.
If one of the exchange rates changes due to
market forces, the others must adjust for the
three exchange rates again to align.
If they are out of alignment, it would be
possible to make a profit simply by
exchanging one currency for a second, the
second for a third, and the third back to the
first.
This is known as TRIANGULAR ARBITRAGE27
 Arbitrages
Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage

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