TheMarketforForeignExchangeChapterFiveCopyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.OverviewMoneyrepresentspurchasingpowerMarketforforeignexchangeisthelargestfinancialmarketintheworldbyvirtuallyanystandardForeignexchange(FX)marketencompassestheconversionofpurchasingpowerfromonecurrencyintoanother,bankdepositsofforeigncurrency,theextensionofcreditdenominatedinaforeigncurrency,foreigntradefinancing,tradinginforeigncurrencyoptionsandfuturescontracts,andcurrencyswaps5-2Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.FunctionandStructureofFXMarketFunctionofFXmarketistoassistclientsintheconductofinternationalcommerceServicethatcommercialbanksprovidetotheirclientsSpotandforwardFXmarketsareOTCmarkets,meaningtradingdoesnottakeplaceinacentralmarketplacewherebuyersandsellerscongregateMajormarketsegmentsAustralasia:Sydney,Tokyo,HongKong,Singapore,andBahrainEurope:Zurich,Frankfurt,Paris,Brussels,Amsterdam,andLondonNorthAmerica:NewYork,Montreal,Toronto,Chicago,SanFrancisco,andLosAngeles5-3Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.FXMarketParticipantsFXmarketisatwo-tiermarketInterbank(wholesale)marketAbout100-200banksworldwidestandreadyto“makeamarket”inforeignexchangeNonbankdealersaccountforabout40%ofthemarketThereareFXbrokerswhomatchbuyandsellordersbutdonotcarryinventoryandFXspecialistsClient(retail)marketMarketparticipantsincludeinternationalbanks,theircustomers,nonbankdealers,FXbrokers,andcentralbanks5-4Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.SharesofReportedGlobalForeignExchangeTurnoverbyCountry

5-5Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.AverageElectronicForeignExchangeConversationsperHour(Monday–Friday,2001)

5-6Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.CorrespondentBankingRelationshipsInterbankmarketMadeupofanetworkofcorrespondentbankingrelationships,withlargecommercialbanksmaintainingdemanddepositaccounts(i.e.,correspondentbankingaccounts)withoneanotherCorrespondentbankaccountnetworkfacilitatestheefficientfunctioningoftheFXmarket5-7Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.CorrespondentBankingCommunicationsInternationalcommercialbankscommunicatewithoneanotherusing:SWIFT:SocietyforWorldwideInterbankFinancialTelecommunications.CHIPS:ClearingHouseInterbankPaymentsSystemECHO:ExchangeClearingHouseLimitedFirstglobalclearinghouseforsettlinginterbankFXtransactions5-8Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.SpotMarketSpotmarketinvolvesalmostimmediatepurchaseorsaleofforeignexchangeOnecanbuy(takealongposition)orsell(takeashortposition)foreignexchangeCashsettlementisusuallymadeintwobusinessdaysafterthetransactionfortradesbetweentheU.S.dollarandanon-NorthAmericancurrency5-9Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.SpotRateQuotationsSpotratecurrencyquotationscanbestatedindirectorindirecttermsDirectquotationsrefertothepriceofoneunitofaforeigncurrencyintermsofthedomesticcurrencyIndirectquotationisthepriceofonedomesticcurrencyintermsofaforeigncurrency5-10Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.AverageDailyForeignExchangeTurnoverbyInstrumentandCounterpartyCopyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.5-11ExchangeRatesCopyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.5-12SpotRateQuotations(Continued)MostcurrenciesarequotedinEuropeanterms,meaningtheU.S.dollarispricedintermsoftheforeigncurrency(anindirectquotefromtheU.S.perspective)AmericantermsareadirectquotefromtheU.S.perspectiveCross-exchangerateisanexchangeratebetweenacurrencypairwhereneithercurrencyistheU.S.dollar5-13Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.TheBid-AskSpreadInterbankFXtradersbuycurrencyforinventoryatthebidpriceandsellfrominventoryatthehigherofferoraskpriceAverageofthebidandaskratesarecalledmid-ratesBid-askspreadallowsdealerstoearnaprofit5-14Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.SpotFXTradingIntheinterbankmarket,thestandardsizetradeisabout$10millionSpotquotationsaregoodforonlyafewsecondsbeforebeingwithdrawnBid-askquotesarenormallyfourdecimalplaces(e.g.,$1.3153)$1.31isknownasthebidquotebigfigureandassumedtobeknownbyalltradersLasttwodigits(.53)isthesmallfigure5-15Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.Cross-RateTradingDeskCurrencyagainstcurrencytradeiswhenacustomerwantstotradeoutanondollarcurrencyforanothernondollarcurrencyForexample,acustomerwantstotradeoutofBritishpoundsintoSwissfrancsTypicallyhandledbythebanksellingBritishpoundsforU..SdollarsandthensellingU.S.dollarsforSwissfrancsHandledatthecross-ratedeskofthebank5-16Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.CalculatingCross-ExchangeRateBid-AskSpread5-17Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.Cross-RateForeignExchangeTransactions5-18Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.TriangularArbitrageTriangulararbitrageistheprocessoftradingoutoftheU.S.dollarintoasecondcurrency,thentradingitforathirdcurrency,whichinturnistradedforU.S.dollarsPurposeistoearnanarbitrageprofitviatradingfromthesecondtothethirdcurrencywhenthedirectcross-exchangeratebetweenthetwoisnotinalignmentwiththeimpliedcross-exchangerateArbitrageisazero-risk,zero-investmentstrategyfromwhichaprofitisguaranteed5-19Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.SpotForeignExchangeMarketMicrostructureMarketmicrostructurereferstothebasicmechanicsofhowamarketplaceoperatesStudieshaveshown:Bid-askspreadsinthespotFXmarketincreasedwithFXexchangeratevolatilityanddecreasedwithdealercompetition$1bofnetdollarpurchasesincreasethedeutschemarkpriceofadollarby0.5percentBid-askspreadshaveaprolongedUshapeandarenarrowestwhenLondonandNYareopen,whiletradingvolumeandexchangeratevolatilityarebothM-shapedwithpeaksatLondonopenandtheNYopen5-20Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.TheForwardMarketForwardmarketinvolvescontractingtodayforthefuturepurchaseorsaleofFXNomoneychangeshandsuponenteringthecontracttodayMaybeusedtohedgeFXexposureortospeculateinFXmarketForwardpriceisusuallyhigher(atapremium)orlower(atadiscount)thanspotpriceBankquotesformaturitiesof1,3,6,9,and12monthsarereadilyavailable5-21Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ForwardRateQuotationsForwardmarketinvolvescontractingtodayforthefuturepurchaseorsaleofFXFN(j/k)isthenotationusedtorefertothepriceofoneunitofcurrencykintermsofcurrencyjfordeliveryinNmonthsFnotationisusedtodenoteaforwardexchangerateLikespotquotes,forwardquotesareeitherdirectorindirectwithonebeingthereciprocaloftheother5-22Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ForwardRateQuotations(Continued)AmericantermSwissfrancforwardquotationsS($/SFr)=1.0018F1($/SFr)=1.0047F3($/SFr)=1.0104F6($/SFr)=1.0193EuropeantermforwardquotationsarethereciprocaloftheAmericantermquotesS(SFr/$)=0.9982F1(SFr/$)=0.9953F3(SFr/$)=0.9897F6(SFr/$)=0.98115-23Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.Exampleofreciprocalcalculations:1/1.0018=0.99821/0.9928=1.0018ForwardPremiumCommontoexpressthepremiumordiscountofaforwardrateasanannualizedpercentagedeviationfromthespotrateForwardpremium(ordiscount)isusefulforcomparingagainsttheinterestratedifferentialbetweentwocountriesForwardpremiumordiscountcanbecalculatedusingAmericanorEuropeantermquotations5-24Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ForwardCross-ExchangeRates5-25Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.Non-DeliverableForwardContractsDuetogovernment-institutedcapitalcontrols,currenciesofsomeemergingmarketcountriesarenotfreelytradedNotpossibletoobtainthesecurrenciesoffshoreinthespotmarkettosettleaforwardpositionFormanyofthesecurrencies,tradinginnon-deliverableforward(NDF)contractsexistsNDFcontracts,unlikeadeliverableforward(DF),issettledincashatthedifferencebetweenthespotexchangeonthematuritydateofthecontractandtheNDFratetimesthenotionalamountofthecontract5-26Copyrigh