The Market for Foreign Exchange

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5

Chapter Five

The Market for Foreign

Exchange

Chapter Objective:

This chapter introduces the institutional

framework within which exchange rates are

determined

determined.

It lays the foundation for much of the discussion

throughout the remainder of the text, thus it

deserves your careful attention.

5-1

Outline

z

Spot Market for Foreign Exchange

» Market characteristics » Interpreting quotes » Cross exchange rates

z

Forward Market for Foreign Exchange

» Why is it used

2

» Why is it used

» Market characteristics

(2)

The Spot Market

z

FX Market Structure

z

FX Market Structure

z

Spot Rate Quotations

z

The Bid-Ask Spread

(3)

FX Market Participants

z

The FX market is a two-tiered market:

» Interbank Market (Wholesale)

– About 100-200 banks worldwide stand ready to make a market in foreign exchange.

– Nonbank dealers account for about 40% of the market. – There are FX brokers who match buy and sell orders but

do not carry inventory and FX specialists. » Client Market (Retail)C e t a et ( eta )

z

Market participants include international

banks, their customers, nonbank

dealers, FX brokers, and central banks.

5-5

Function and Structure of the FX

Market

z

FX Market Participants

z

FX Market Participants

(4)

Correspondent Banking

Relationships

z

International commercial banks

z

International commercial banks

communicate with one another with:

» SWIFT: The Society for Worldwide

Interbank Financial Telecommunications.

» CHIPS: Clearing House Interbank

P t S t

Payments System

» ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions.

5-7

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FX Market Share: By Currencies

5-9

FX Market Trading Hours

1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8 1 9 2 0 2 1 2 2 2 3 2 4 London New York Sydney Tokyo

New York opens at 8:00 am to 5:00 pm EST Tokyo opens at 7:00 pm to 4:00 am EST Sydney opens at 5:00 pm to 2:00 am EST London opens at 3:00 am to 12:00 noon EST

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Circadian Rhythms of the FX

Market

Electronic Conversations per Hour

5000 10000 15000 20000 25000 30000 35000 40000 45000 average peak 0 5000 1:00 10 am in Tokyo 3:00 Lunch hour in Tokyo 5:00 Europe coming in 07:00 9:00 Asia going out 11:00 Lunch hour in London 1:00 Americas coming in 15:00 5:00 London going out 19:00 9:00 New Zealand coming in 11:00 6 pm in NY 5-11

Spot Market

z Transactions at the same point in time. z The market is a network

z The market is a network

z Large money center banks are wholesalers

z Major currencies: USD; Yen ; Euros; British Pounds, Swiss Francs; Australian Dollars; Canadian Dollars z Spot Rate : The price at which a foreign currency can

be bought/sold, today.

z Each spot exchange rate can be expressed in two ways:

12

ways:

» Direct quote: price of the foreign currency expressed in units of the home currency (example: 1BP = USD 2.00) » Indirect quote: price of one unit of the home currency

(7)

Currency Symbols

z

In addition to the familiar currency symbols

(e.g. £, ¥, €, $) there are three-letter codes

( g

, , , $)

for all currencies. It is a long list, but

selected codes include:

CHF Swiss francs

GBP British pound

CNY Chinese yuan

CAD Canadian dollar

JPY Japanese yen

MXN Mexican peso

5-13

FX Price Quote (September 27, 2010)

14

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Spot Foreign Exchange Quotes

z Direct Quote: U S z Indirect Quote: Currency z Direct Quote: U.S.

dollar equivalent

» Online Quotes

GBP: 1 BP = $1.5850 JPY: 1 JY = $0.0119

» Direct quote = 1 / Indirect quote

z Indirect Quote: Currency per USD

» Online Quotes

GBP: 1 USD = BP0.6309 JPY: 1 USD = JY84.285

» Indirect quote = 1 / Direct quote

15 GBP: 1 BP = 1 / 0.6309 = $1.5850

JPY: 1 JY = 1 / 84.285 = $0.0119

GBP: 1 USD = 1 / 1.5850 = BP0.6309 JPY: 1 USD = 1 / 0.0119 = JY84.285

Long-term FX Rates: USD & Yen (Direct Quote)

(9)

Long-term FX Rates: USD & Yen (Indirect Quote)

17

Long Term FX Rates: USD & Major World

Currencies

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Applying Direct and Indirect

Quotes to Convert Currency

Currency Conversion Formulas:

DQ = Direct quote

Converting USD into FC Converting FC into USD

Using DQ USD / DQ = FC FC * DQ = USD

Using IQ USD * IQ = FC FC / IQ = USD

19

DQ = Direct quote IQ = Indirect quote USD = US Dollars FC = Foreign currency

Bid and Ask Quotes and Spread

z Ask Quote (currency dealer’s selling price) z Ask Quote (currency dealer s selling price)

» $ 1.3472 / 1 Euro

z Bid Quote (currency dealer’s buying price) » $ 1.3463 / 1 Euro

z Ask price > Bid price

Bid A k Q t $1 3463 72 j t 63 73

20

z Bid-Ask Quotes: $1.3463-72 or just 63-73

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Indirect Price Quotes (Foreign Currency / USD)

S b l C Bid A k Bid A k

Direct quotes Indirect quotes

Symbol Currency Bid Ask Bid Ask

JPY Yen 0.01184 0.01189 84.10429 84.45946 EUR Euro 1.3463 1.3472 0.74230 0.74280 GBP British Pound 1.5810 1.5823 0.63200 0.63250 MXN Mexican Peso 0.07937 0.08036 12.44332 12.5997 21 Peso CHF Swiss Franc 1.01564 1.01609 0.98416 0.98460

Percentage Change: Direct Quotes

Formula: % change in DQ = 100*(DQ1– DQ0) / DQ0 DQ0 Direct quote at the beginning of the period

DQ0 = Direct quote, at the beginning of the period DQ1 = Direct quote, at the end of the period

Interpretation: Measures appreciation or depreciation of the

foreign currency, in terms of the USD. As seen from the US viewpoint

Example: On 1/1/X1 the DQ for SF was $0.50, on 1/1/X2 it

22

was $0.60, and on 1/1/X3 it was $0.57

Period Percentage Change in DQ Interpretation

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Percentage Change: Indirect Quotes

Formula: % change in IQ = 100*(IQ1 – IQ0) / IQ0 IQ0 = Indirect quote, at the beginning of the periodQ0 d ec quo e, a e beg g o e pe od

IQ1 = indirect quote, at the end of the period

Interpretation: Measures appreciation or depreciation of the

USD, in terms of the foreign currency. As seen from the foreign country’s viewpoint

Example: On 1/1/X1 the IQ for MP was 10.00, on 1/1/X2 it

was 9.00, and on 1/1/X3 it was 11.25

23

Period Percentage Change in IQ Interpretation

20X1 - 20X2 100*(9.00-10.00) / 10.00= -10.00% USD depreciated by 10% 20X2 - 20X3 100*(11.25-9.00) / 9.00= 25.00% USD appreciated by 25%

Percentage Change in Direct Quotes:

Using Indirect Quotes

% change in DQ =

**100*[100 / (100 + % h**

i IQ) 1]

**100*[100 / (100 + % change in IQ) - 1]**

Example: Suppose, on 1/1/X1 the IQ for JY was 120, and on

1/1/X2 it was 100. It means that during this period, USD

depreciated by 20% from the Japanese viewpoint. What

was the % change in the value of JY from the US viewpoint?

24

Solution: During the 20X1-X2, IQ for JY changed by – 20%

Percentage in DQ (over the same period):

100* [100 / (100 – 20) – 1] = 100* [(100/80) – 1] = + 25% During this period, JY appreciated by 25% (from US view

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Percentage Change in Indirect Quotes:

Using Direct Quotes

% change in IQ =

**100*[100 / (100 + % h**

i DQ) 1]

**100*[100 / (100 + % change in DQ) - 1]**

Example: Suppose, on 1/1/X1 the DQ for SF was $0.50, and

on 1/1/X2 it was $0.55. It means that during this period, SF

appreciated by 10% from the US viewpoint. What was the

% change in the value of USD from the Swiss viewpoint?

25

Solution: During 20X1-X2, DQ for SF changed by + 10%

Percentage in IQ (over the same period):

100* [100 / (100 + 10) – 1] = 100* [(100/110) – 1] = - 9.09% During this period, USD depreciated by 9.09% from the Swiss

viewpoint

Cross Exchange Rates Quotes

z Deriving the exchange rates between two

currencies from their respective direct quotes currencies from their respective direct quotes

» Example: Use the direct dollar quotes for SF and BP to calculate:

– how many SF per BP – how many BP per SF

» Direct dollar quotes: (SF= $ 1.0166, BP = $ 1.5850) » Cross exchange rates:

26

– The price of BP in terms of SF = (DQ of BP / DQ of SF) z (1.5850 / 1.0166) = SF 1.5591/ BP

z One BP = SF 1.5591

– The price of SF in terms of BP = (DQ of SF / DQ of BP) z (1.0166 / 1.5850) = BP 0.6414 / SF

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Cross Exchange Rates Quotes:With

Bid and Ask Quotes

z Direct dollar quotes:

» For Swiss Francs:

z Bid price: $ 1.01564 z Ask price: $ 1.01609 – Quote: $1.01564-609 » For Euro: – Bid price = $ 1.3463 – Ask Price = $1.3472 Quote: $1 3463 72 27 – Quote: $1.3463-72

z Cross exchange rates: Find the direct bid-ask quote

for Swiss Francs in terms of Euros.

LOCATIONAL ARBITRAGE

z Buy low in one location & sell high in another

l ti location

» In the FX market

– The buying price (ask price) in one bank is lower than the

selling price (bid price) of another bank

z Market adjustments which will eliminate locational arbitrage

28

g

» In the FX market:

– The ask price will rise and bid price will fall

– Till ask price (of one bank) is greater than or equal to bid

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LOCATIONAL ARBITRAGE

PROFIT

z Case 1: No z Case 2: Arbitrage z Case 1: No

Arbitrage Possible

z New York Bank Quotes » Ask $1.581 / 1 BP » Bid $1.583 / 1 BP z London Bank Quotes

z Case 2: Arbitrage Possible

z Chicago Bank Quotes » Ask $1.347 / 1 euro » Bid $1.346 / 1 euro Frankfurt Bank Quotes

29 Q » Ask $1.582 / 1 BP » Bid $1.586 / 1 BP Q » Ask $1.350 / 1 euro » Bid $1.348 / 1 euro

Triangular Arbitrage: When Implied & Actual Cross Rates are Different

1 BP = $1.50

1 SF = $0.50$ Implied cross rate: 1 BP = 1.5/0.5 = 3.0 SF

If actual cross rate: 1 BP = 3.50 SF (It is better to sell BP in return for SF)

$

If actual cross rate: 1 BP = 2.50 SF (It is better to buy BP with SF)

$

30

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Triangular Arbitrage: When Implied Cross

Rate is Less than Actual Cross Rate

1 BP = $1.50

1 SF = $0.50$ Implied cross rate: 1 BP = 1.5/0.5 = 3.0 SF If actual cross rate: 1 BP = 3.50 SF. Have $1,000

$ 1,000 $1,166.67

31

BP 666.67 _{SF 2,333.33}

666.67 X 3.5

z $ exchanged for BP

Triangular Arbitrage: When Implied Cross

Rate is Less than Actual Cross Rate

z $ exchanged for BP

» The price of BP rises against the $: ($1.50 /BP )

z BP exchanged for SF

» The price of BP falls against SF: (SF 3.50/BP )

z SF exchanged for $

» The price of SF falls against the $: ($ 0.50/SF )

Th i li d t h th t l

32

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Triangular Arbitrage: When Implied Cross

Rate is Greater than Actual Cross Rate

1 BP = $1.50

1 SF = $0.50$ Implied cross rate: 1 BP = 1.5/0.5 = 3.0 SF If actual cross rate: 1 BP = 2.50 SF. Have $1,000

$ 1,200 $1,000

33

BP 800 _{SF 2,000}

2,000 / 2.5

z $ exchanged for SF

Triangular Arbitrage: When Implied Cross

Rate is Greater than Actual Cross Rate

z $ exchanged for SF

» The price of DM rises against the $: ($0.50 /SF )

z SF exchanged for BP

» The price of BP rises against SF: (SF 2.50/BP )

z BP exchanged for $

» The price of BP falls against the $: ($ 1.50/BP )

Th i li d t h th t l

34

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Triangular Arbitrage: Eaxmple

Bank Quotations Bid Ask

D h B k £ $ $1 9712 $1 9717 Deutsche Bank £:$ $1.9712 $1.9717 Credit Lyonnais €:$ $1.4738 $1.4742 Credit Agricole £:€ €1.3310 €1.3317 “No Arbitrage” £:€ €1.3371 €1.3378

By going through Deutsche Bank and Credit Lyonnais, we y g g g y can sell pounds for €1.3371.

The arbitrage is to buy those pounds (at ask price) from Credit Agricole for €1.3317

Bid price for £ in terms of € = $1.9712

$1.4742 = €1.3371

5-35

Triangular Arbitrage

Bank Quotations Bid Ask

Deutsche Bank £:$ $1.9712 $1.9717 Credit Lyonnais €:$ $1.4738 $1.4742 Credit Agricole £:€ €1.3310 €1.3317

Start with £1m: sell £ to Deutsche Bank for $1,971,200. £10,000,000 × $1.9712

£1 00 = $1,971,200. Buy euro from Credit Lyonnais receive €1,337,132

$1,971,200 × €1.00

$1.4742 = €1,337,132. Buy £ from Credit Agricole receive £1,004,078.89

(19)

The Forward Market

z

Forward Rate Quotations

z

Forward Rate Quotations

z

Forward Premium

z

Long and Short Forward Positions

z

Motivations for using Forward contracts

» Speculation » Speculation » Hedging

5-37

Forward Currency Market

z

Market where Forward Contracts by traded

z

Forward Contracts are agreements to deliver

(or take delivery of) a specified amount of

foreign currency at a fixed future date and at

a fixed exchange rate.

z

Used by businesses and currency traders to:

38

z

Used by businesses and currency traders to:

» Hedge against currency (exchange rate) risk

(20)

Forward Exchange Rate

z

The dollar price at which a foreign

z

The dollar price at which a foreign

currency can be bought and sold at

future date. This rate is set at the time

when the contract is signed. No money

is exchanged at this time.

39

Forward Rate Quotes

z Direct Dollar Quotes from WSJ (attached): z Direct Dollar Quotes from WSJ (attached):

» Swiss Franc (FF)

– spot rate (direct quote): $0.8401

– 6-months forward rate (direct quote): $0.8492

» Japanese Yen (JY)

– spot rate (direct quote): $0.009646

40

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Using Forward Contracts

z

Two major applications of forward contracts:

z

Two major applications of forward contracts:

» Hedging » Speculation

(22)

5-43

Forward Rate Quotations

Consider these

h

t

f

Country/currency in US$ per

exchange rates: for

British pounds, the

spot exchange rate is

$1.9717 = £1.00

while the 180-day

Country/currency in US$ per US$ UK pound 1.9717 .5072 1-mos forward 1.9700 .5076 3-most forward 1.9663 .5086 6-mos forward 1.9593 .5104

Clearly market

while the 180 day

forward rate is

$1.9593 = £1.00

z

What does that

mean?

Clearly market

participants expect that

the pound will be worth

less in dollars in six

(23)

Forward Rate Quotations

z

Consider the (dollar) holding period return

of a dollar-based investor who buys £1

million at the spot exchange rate and sells

them forward:

$HPR=gain pain $1,959,300 – $1,971,700 $1,971,700 = –$12,400 $1,97,1700 = p $HPR = –0.00629 Annualized dollar HPR = –1.26% = –0.629% × 2 5-45

Forward Premium

z The interest rate differential implied by forward premium or discount

premium or discount.

z Annualized % premium (discount)

» [(Forward rate – Spot rate ) / Spot rate ] * [ 360/ Days to Maturity] * 100

z For example, suppose the € is appreciating from

S($/€) = 1.55 to F($ ) ₁₈₀₁₈₀($/€) = 1.60($ )

z The 180-day forward premium is given by:

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Long and Short Forward

Positions

z

If you have agreed to

sell anything (spot

z

If you have agreed to sell anything (spot

or forward), you are “short”.

z

If you have agreed to buy anything

(forward or spot), you are “long”.

z

If you have agreed to sell FX forward,

y

g

,

you are short.

z

If you have agreed to buy FX forward,

you are long.

5-47

Payoff Profiles

profit

If you agree to sell anything in the

0 S180($/¥)

If you agree to sell anything in the future at a set price and the spot price later falls then you gain.

F₁₈₀($/¥) = .009524

Short position (DQ)

loss

(25)

Payoff Profiles

profit

h h h

short position (IQ)

0 _S 180(¥/$) Whether the payoff profile slopes up or down depends upon whether you use the

loss

180( )

F₁₈₀(¥/$) = 105

-F₁₈₀(¥/$)

you use the direct or indirect quote: F₁₈₀(¥/$) = 105 or F₁₈₀($/¥) = .009524. 5-49

Payoff Profiles

profit short position 0 S180(¥/$) short position loss F₁₈₀(¥/$) = 105 -F₁₈₀(¥/$)

(26)

Payoff Profiles

profit short position 0 S180(¥/$) 15¥ short position loss F₁₈₀(¥/$) = 105 -F₁₈₀(¥/$) 120

If, in 180 days, S₁₈₀(¥/$) = 120, the short will make a profit by buying ¥ at S₁₈₀(¥/$) = 120 and delivering ¥ at F₁₈₀(¥/$) = 105.

5-51

Payoff Profiles

F (¥/$) short position

profit

Since this is a zero-sum game,

0 S180(¥/$)

F₁₈₀(¥/$) Since this is a zero sum game, short position

the long position payoff is the opposite of the short.

loss

F₁₈₀(¥/$) = 105

Long position

(27)

Payoff Profiles

F (¥/$) profit

The long in this forward contract agreed to BUY

0 S180(¥/$)

-F₁₈₀(¥/$) g g

¥ in 180 days at F₁₈₀(¥/$) = 105

If, in 180 days, S₁₈₀(¥/$) = 120, the long will

lose by having to buy ¥ at S₁₈₀(¥/$) = 120 and delivering ¥ at F₁₈₀(¥/$) = 105. 120 loss F₁₈₀(¥/$) = 105 Long position 120 –15¥ 5-53

Forward Market Hedge

z

If you are going to owe foreign currency

z

If you are going to owe foreign currency

in the future, agree to buy the foreign

currency now by entering into long

position in a forward contract.

z

If you are going to receive foreign

(28)

Forward Market Hedge: an

Example

You are a U S importer of British woolens

You are a U.S. importer of British woolens

and have just ordered next year’s

inventory. Payment of £100M is due in

one year.

Question: How can you fix the cash

outflow in dollars?

Answer: One way is to put yourself in a position

that delivers £100M in one year—a long

forward contract on the pound.

5-55

Forward Market Hedge: an Example

0

1

Step 1

Order Inventory; agree to pay supplier £100 in 1 year.

0

1

Step 2

Step 3

Fulfill your contractual

obligation to forward contract counterparty and buy £100 million for $195 million Step 4

Pay supplier £100 million Take a Long position in

a Forward Contract on £100 million.

million for $195 million.

(29)

Forward Market Hedge

Suppose the _{The importer will be better off}

Value of £1 in $ forward exchange rate is $1.95/£. If he does not hedge the £100m payable, in one $0 $30m p

if the pound depreciates: he still buys £100m but at an exchange rate of only $1.65/£ he saves $30 million relative to $1.95/£ $1.95/£ in one year

year his gain (loss) on the unhedged position is shown in green. $1.65/£ $2.25/£ –$30m Unhedged payable

But he will be worse off if the pound appreciates.

5-57

Forward Market Hedge

If he agrees Long

forward

If you agree to buy £100 million at a price of Value of £1 in $ to buy £100m in one year at $1.95/£ his gain (loss) on the forward are shown in $0 $30m forward million at a price of $1.95 per pound, you will make $30 million if the price of a pound reaches $2.25.

$1.95/£ $2.25/£ in one year

are shown in

blue. $1.65/£

(30)

Forward Market Hedge

The red line Long

forward Value of £1 in $ shows the payoff of the hedged payable. Note that gains on one position $0 $30 m forward Hedged payable $1.95/£ $2.25/£ in one year one position are offset by losses on the other position. $1.65/£ –$30 m Unhedged payable 5-59

Using Forward Contracts for

Hedging: Theory

z Buy Forward Contracts (take a Long Position in the FM):

» When you expect to make a payment in Foreign currency, at a y p p y g y, future date:

– You gain when the spot rate at the future date is higher than the

forward exchange rate

– You lose when the spot rate at the future date is lower than the

z Sell Forward Contracts (take a Short Position in the FM):

» When you expect to receive a payment in Foreign currency at a

60

» When you expect to receive a payment in Foreign currency, at a

future date:

– You gain when the spot rate at the future date is lower than the

– You lose when the spot rate at the future date is higher than the

(31)

Using Forward Contracts for

Speculation: Theory

z Buy Forward Contracts (take a Long Position in the FM):

» When you expect the future spot rate to be higher then the y p p g current forward rate:

– You will gain when the future spot rate is higher than the current

– You will lose when the future spot rate is lower than the current

z Sell Forward Contracts (take a Short Position in the FM):

» When you expect the future spot rate to be lower then the current

61

» When you expect the future spot rate to be lower then the current

forward rate:

– You will gain when the future spot rate is lower than the current

– You will lose when the future spot rate is higher than the current

Using Forward Contracts for

Speculation: Examples

z Today, the 6-month forward rate on SF is $0.8492

» If you expect that 6-months from today the spot rate of » If you expect that 6-months from today, the spot rate of

SF will be greater than $0.8492: – The you should BUY SF forward contracts

z If 6-months latter, the SR for SF is $0.8495:

» you make (0.8495 – 0.8492) = $0.0003 / SF (profit)

z If 6-months latter, the SR for SF is $ 0.8485:

» you make (0.8485 – 0.8492) = - $0.0007 / SF (loss)

If t th t 6 th f t d th t t f

62

» If you expect that 6-months from today, the spot rate of SF will be less than $0.8492:

– Then you should SELL SF forward contracts

» you make (0.8492 – 0.8495) = - $0.0003 / SF (loss)

(32)

Currency Conversion Problem Set #1

Please use the following quotes, to answer the questions listed below:

Currency

Quotes

Direct or Indirect ?

Swiss francs

1 SF for $0.50

Mexican pesos

10 MP for 1 USD

British pounds

0.75 BP for 1 USD

1. $3,000,000 can be converted into ______________ British pounds

2. SF 1,500,000 can be converted into ____________ USD

3. MP 600,000 can be converted into __________ Swiss francs

4a. How many SF does it take to buy 1 BP?

(33)

Currency Conversion Problem Set #2

1/1/X0

1/1/X1

BP quotes

$2.00 per BP

$2.18 per BP

SF quotes

SF 2.50 per USD

SF 2.00 per USD

JY quotes

JY100 per USD

JY 120 per USD

For the time period: 1/1/X0 - 1/1/X1, please calculate:

1. The percentage appreciation / depreciation of BP in terms of the USD

2. The percentage appreciation / depreciation of USD in terms of SF

3. The percentage appreciation / depreciation of JY from the US viewpoint

(34)

Currency Conversion Problem Set #3

Currency

Quotes on 1/1/X1

Quote on 1/1/X2

Canadian dollars

1 CD = $0.50

1 CD = $0.54

Swiss francs

SF 1.80 = 1 USD

SF 1.90 = 1 USD

Japanese yen

1 USD = JY 100

1 USD = JY 120

a. Based on the 1/1/X2 quote, convert 8,000,000 Canadian dollars into US dollars:

b. Based on the 1/1/X2 quotes, convert $25,000,000 into Swiss francs:

c. During the one-year period, what was the percentage appreciation / depreciation

of the Japanese yen from the US point of view ?

(35)

Bid-Ask Spread Problem Set #1

The following table presents bid and ask quotes for BP from currency dealers in

New York and London:

Currency Dealer in New York

London

Bid Quote for BP

$ 1. 58

$ 1.65

Ask Quote for BP

$ 1. 68

$ 1.70

1. Assume that you dealt with the New York currency dealer only. You converted

$100,000 into pounds, and immediately afterwards sold the pounds for dollars.

Estimate the dollar amount you lost in this round trip transaction.

2. Assume that you dealt with the London currency dealer only. What is the

percentage bid-ask spread for this dealer?

(36)

Cross Exchange Rates Quotes With Bid

and Ask Quotes: In-Class Exercise

• Direct dollar quotes:

–

For Swiss Francs:

• Bid-Ask Quote: $0.5205-50

–

For Canadian Dollar:

• Bid-Ask Quote: $0.8510-95

• Cross exchange rates: Find the direct bid-ask quote

(37)

EXAMPLE: FX FORWARD MARKET BASICS

Today: 1/1/XX Six Months Latter: 6/1/XX

Spot Rate for BP = $1.50

6-Month Forward Rate for BP = $1.60

Financial Obligations of Forward Contract Buyer: Pay: 1.60 x 1,000,000 = $1,600,000

Receive: BP 1,000,000

Suppose on 6/1/XX

SR = $1.63 SR = $1.58

FC BUYER / LONG POSITION HOLDER:

6-Month Forward Contract for BP 1,000,000 Current Financial Obligations: None

Then for BP 1,000,000 You have paid: $1,600,000 And it is worth: $1,630,000 Your profit/loss: $ 30,000

Then for BP 1,000,000 You have paid: $1,600,000 And it is worth: $1,580,000 Your profit/loss: - $ 20,000

Financial Obligations of Forward Contract Seller: Pay: BP 1,000,000

Receive: 1.60 x 1,000,000 = $1,600,000

Suppose on 6/1/XX

SR = $1.63 SR = $1.58

FC SELLER / SHORT POSITION HOLDER:

6-Month Forward Contract for BP 1,000,000 Current Financial Obligations: None

Then for BP 1,000,000

You have received: $1,600,000 And it is worth: $1,630,000 Your profit/loss: - $ 30,000

Then for BP 1,000,000

(38)

EXERCISE: FX FORWARD MARKET BASICS

Today: 1/1/XX Six Months Latter: 6/1/XX

Spot Rate for Euro = $1.15 6-Month Forward Rate for E = $1.20

Financial Obligations of Forward Contract Buyer: Pay:

Receive:

Suppose on 6/1/XX

E = $1.13 E = $1.25

FC BUYER / LONG POSITION HOLDER:

6-Month Forward Contract for E 5,000,000 Current Financial Obligations:

Then for E 5,000,000 You have paid: $ And it is worth: $ Your profit/loss: $

Financial Obligations of Forward Contract Seller: Pay:

Receive:

Suppose on 6/1/XX

E = $1.13 E = $1.25

FC SELLER / SHORT POSITION HOLDER:

6-Month Forward Contract for E 5,000,000 Current Financial Obligations:

Then for E 5,000,000 You have received: $ And it is worth: $ Your profit/loss: $

(39)

FX Spot / Forward Market Transactions Problem Set #1

Forward and Spot Prices Quotes for Foreign Currencies: From Wall Street Journal

Today: 01/15/XX (Wednesday) 1-month latter: 02/15/XX (Tuesday) 6-months latter: 07/15/XX (Monday)

1. Today (1/15/XX), you bought 100 million JY in the spot market from Credit Suisse First Boston (CSFB), and sold it back to CSFB one month latter: Your cash flows today, are: Your cash flows on 2/15/XX are: Your profit/loss is:

CSFB’s cash flows today, are: CSFB’s cash flows on 2/15/XX are: CSFB’s profit/loss:

2. Today (1/15/XX), you bought a one-month forward contract for 100 million JY from Credit Suisse First Boston (CSFB) :

Your cash flows today, are: Your cash flows on 2/15/XX are: Your profit/loss (in the FM) is:

(40)

FX Spot / Forward Market Transactions Problem Set #1 (Contd.)

3. Today (1/15/XX), you sold a six-month forward contract for 100 million JY to Credit Suisse First Boston (CSFB) :

CSFB’s cash flows today, are: CSFB’s cash flows on 7/15/XX are: CSFB’s profit/loss (in the FM) is:

4. Today (1/15/XX), you bought a one-month forward contract for 1 million BP from Credit Suisse First Boston (CSFB) :

CSFB’s cash flows today, are: CSFB’s cash flows on 2/15/XX are: CSFB’s profit/loss (in the FM) is:

5. Today (1/15/XX), you sold a six-month forward contract for 10 million SF to Credit Suisse First Boston (CSFB) :

Your cash flow today, is: Your cash flows on 7/15/XX is: Your profit/loss (in the FM) is:

(41)

(42)

Formula: Currency Conversion

Quotes: DQ (direct quote): The dollar price of one unit of foreign currency (FC)

IQ (indirect quote): Number of units of FC per one dollar; DQ = 1 / IQ and IQ = 1 / DQ

DQ

₀

= DQ now; DQ

₁

= DQ 1-year later; IQ

₀

= IQ now; IQ

₁

= IQ 1-year later

Calculating Percentage Change in DQ and IQ:

**% change in DQ = 100 * (DQ**

₁

- DQ

₀

) / DQ

₀

= 100*[100 / (100 + % change in IQ) - 1]

**% change in IQ = 100 * (IQ**

₁

- IQ

₀

) / IQ

₀