The foreign exchange (FX or FOREX) market is the market where exchange rates are determined. Exchange rates are the mechanisms by which world currencies are
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I.1 CHAPTER I FOREIGN EXCHANGE MARKETS The international business context requires trading and investing in assets denominated in different currencies. Foreign assets and liabilities add a new dimension to the risk profile of a firm or an investor’s portfolio: foreign exchange risk. This ch apter has two goals. First, this chapter introduces the terminology used in foreign exchange markets. Second, this chapter presents the instruments used in currency markets. I. Introduction to the Foreign Exchange Market 1.A An Exchange Rate is Just a Price The foreign exchange (FX or FORE X) market is the market where exchange rates are determined. Exchange rates are the mechanis ms by which world currencies are tied together in the global marketplace, providing the price of on e currency in terms of another. An exchange rate is a price, specifi cally the relative price of two currencies. For example, the U.S. dollar/Mexican peso exchange rate is the price of a peso expressed in U.S. dollars. On March 23, 2015, this exchange rate wa s USD 1.0945 per EUR, or , in market notation, 1.0945 USD/EUR. The Price of Milk and the Price of Foreign Currency An exchange rate is another price in the economy. Let™s compare an exchange rate to the price of milk. Suppose that the price of a gallon of milk is USD 2.50, or 2.50 USD/milk, using the above exchange rate market notation. When we price milk, the denominator refers to one unit of the good that it is being bought Œa gallon of milk. When we pr ice exchange rates, the denominator re fers specifically to one unit of a currency. Therefore, think of the currency in the denominator as the currency you are buying. The exchange rate is just a price, but it is an important one: S t plays a very important role in the economy since it dire ctly influences impor ts, exports, & cross- border investments. It has an indirect effect on other economic variables, such as the domestic price level, P d, and real wages. For example: when S t increases, foreign imports become more expensive in USD. Then, the domestic price level P d increases and, thus, real wages decrease (through a reduction in purchasing power). Also, when S t increases, USD-denominat ed goods and assets ar e more affordable to foreigners. Foreigners buy more go ods and assets in the U.S. (export s, real estate, bonds, companies, etc.). These factors drive 1.A.1 Equilibrium Exchange Rate s and Foreign Exchange Risk
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I.2 Like in any other market, demand and supply dete rmine the price of a currency. At any point in time, in a given country, the exchange rate is determined by the intera ction of the demand for foreign currency and the corresponding supply of foreign currency. Thus, the exchange rate is an equilibrium price (StE) determined by supply and demand considerations , as shown by Exhibit I.1. Exhibit I.1 Demand and Supply determine th e price of foreign currency (S tE). St Supply of FC (S) StE Demand of FC (D) Quantity of FC What are the determinants of currency supply and demand in the foreign exchange market? The supply of foreign currency derives from foreign re sidents purchasing domestic goods and services Œi.e. domestic export–, foreign investors purchasing domestic assets, and foreign tourists traveling to the domestic country. These foreign residents n eed domestic currency to pay for their domestic purchases. Thus, the foreign resi dents buy the domestic currency w ith foreign currency in the foreign exchange market. Similarly, the dema nd for foreign currency derives from domestic residents purchasing foreign goods and services Œi.e. domestic imports–, domestic investors purchasing foreign assets, and domes tic tourists traveling abroad. Over time, the many variables that affect foreign trade, international investments and international tourism will change, forcing exch ange rates to adjust to new eq uilibrium levels . For example, suppose interest rates in the domestic country increase, ceteris paribus , relative to interest rates in the foreign country. The domestic demand for fo reign bonds will decrease, reducing the demand for foreign currency in the foreign exchange rate. The foreign demand for domestic bonds will increase, increasing the supply of foreign currency in the foreign exchange rate. As a result of these movements of the supply and the demand curves in the foreign exchange market, the price of the foreign currency in terms of dome stic currency will decrease. Exhib it I.2 shows the effect of these changes in the equilibrium exchange rate.
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I.3 Exhibit I.2 The Effect of an Increase in Domestic Interest Rates relative to Foreign Interest Rates. St S S™ S0E S1E D D™ Quantity of FC Changes in exchange rates are usually measured by percentage changes or returns. The currency return from time t to T, s t,T , is given by: st,T = (S T/St) – 1, where St represents the exchange rate in terms of number of units of domestic currency for one unit of the foreign currency (the spot rate). Risk arises every time actual outcomes can differ from expected outcomes. Assets and liabilities are exposed to financial price risk when their actual values may di ffer from expected values. In foreign exchange markets, we are in the presence of foreign exchange risk (currency risk ) when the actual exchange rate is different from the expect ed exchange rate. That is, if there is foreign exchange risk, s t,T cannot be predicted perfectly at time t. In statistical terms, we can think of s t,T as a random variable. II. Currency Markets 2.A Organization The foreign exchange market is the generic term for the worldwide ins titutions that exist to exchange or trade the currencies of different count ries. It is loosely organized in two tiers: the retail tier and the wholesale tier . The retail tier is where the small agents buy and sell foreign exchange. The wholesale tier is an informal, ge ographically dispersed, ne twork of about 2,000 banks and currency brokerage firm s that deal with each other an d with large corporations. The foreign exchange market is open 24 hours a day, split over three time zones. Foreign exchange trading begins each day in Sydney , and moves around the world as th e business day begins in each financial center, first to Tokyo , London and New York. Computer screens, around the world, continuously show exchange rate prices. A trader enters a price for the USD/CHF exchange rate on her machine, and can then receive messages from anywhere in th e world from people willing to
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I.4 meet that price. It does not matter to her whether the counterparties are sitting in London, Singapore, or, in theory, Buenos Aires. The foreig n exchange market has no physical venue where traders meet to deal in currencies. When the fi nancial press and economic textbooks talk about the foreign exchange market they refer to the wholes ale tier. In this chapter we will follow this convention. Currency markets are the largest of all financial markets in the worl d. A typical transaction in USD is about 10 million (“ten dollars,” in dealer slang). In the last triennial survey conducted by the Bank of International Settlements (BIS) in Apr il 2019, it was estimated that the average daily volume of trading on the foreign exchange market -spot, forward, and swap- was close to USD 6.6 trillion Œa 29% increase, compared to April 20 13, see Exhibit I.1 below. The daily average volume is about ten times the daily volume of all the world™s equity markets and sixty times the U.S. daily GDP. The exchange ma rket’s daily turnover is also equal to 40% of the combined reserves of all central banks of IMF member states. In April 2019, the major markets were London, with 43% of the daily volume, New York (17%), Singapore (7%), Hong Kong (8%), and Tokyo (6%). Zu rich, Frankfurt, Paris, and Amsterdam are small players. The top traded currency was the USD, which was involved in 88% of transactions. It was followed by the EUR (30%), and the JPY (16%)). The USD/EUR was by far the most traded currency pair in 2019 and captured 23% of globa l turnover, followed by USD/JPY with 18% and USD/GBP with 9%. Trading in local currencies in emerging markets captured about 23% of foreign exchange activity in 2019. Given the international nature of the market, the majority (57%) of all foreign exchange transactions involves cross-border counterparties. This highlights one of the main concerns in the foreign exchange market: counterparty risk. A good settlement and clearing system is clearly needed. 2.A.1 Settlement of transactions At the wholesale tier, no real money changes hands. There are no messengers flying around the world with bags full of cash. All transactions are done electronically using an international clearing system. SWIFT (Society for Wo rldwide Interbank Financial Telecommunication). operates the primary clearing system for international transact ions. The headquarters of SWIFT is located in Brussels, Belgium. SWIFT has global routing co mputers located in Brussels, Amsterdam, and Culpeper, Virginia, USA. The electronic transfer system works in a very simple way. Two banks involved in a foreign currency transaction will si mply transfer bank deposits through SWIFT to settle a transaction. Example I.1 : Suppose Banco del Suquía, one of the largest Argentine private banks , sells Swiss francs (CHF) to Malayan Banking Berhard, th e biggest Malayan private bank, for Japanese yens (JPY). A transfer of bank deposits will settle this tr ansaction. Banco del Suquía will turn over to Malayan Banking Berhard a CHF deposit at a bank in Switzerla nd, while Malayan Banking Berhard wi ll turn over to Banco del Suquía a JPY deposit at a bank in Japan. Th e SWIFT messaging system will handle confirmation of trade details and payment instructions to the banks in Switzerland and Japan. Banco del Suquía will have a bank account in
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I.5 Japan, in which it holds JPY, and Malayan Banking Be rhard will have a bank acc ount in Switzerland, in which it holds CHF. ¶ The foreign accounts used to settle international pa yments can be held by foreign branches of the same bank, or in an account with a correspondent bank. A correspondent bank relationship is established when two banks maintain a corresponde nt bank account with one another. The majority of the large banks in the world ha ve a correspondent relationship w ith other banks in all the major financial centers in which they do not have their own banking opera tion. For example, a large bank in Tokyo will have a correspondent bank account in a Malayan bank, and the Malayan bank will maintain one with the T okyo bank. The correspondent accounts are also called nostro accounts , or due from accounts . They work like current (checking) accounts. The foreign exchange market is largely an unregulated market. Only exchange-traded derivative contracts are subject to formal regulation. The U. S. banks participating in the spot market are supervised by the Federal Reserv e System and must report their foreign exchange position on a periodic basis. 2.A.2 Activities Speculation is the activity that leaves a currency position open to the risks of currency movements. Speculators take a position to “spe culate” the direction of exchange rates. A specula tor takes on a foreign exchange position on the expectation of a favorable currency rate change. That is, a speculator does not take any other position to re duce or cover the risk of this open position. Hedging is a way to transfer part of the foreign exchange risk inherent in all transactions, such as an export or an import, which involves two currencie s. That is, by contrast to speculation, hedging is the activity of covering an open position. A he dger makes a transaction in the foreign exchange market to cover the currency risk of another position. Arbitrage refers to the process by which banks, firms or individuals attempt to make a risk-profit by taking advantage of discrepancies among prices prevailing simultaneously in different markets. The simplest form of arbitrage in the foreign exchange market is spatial arbitrage, which takes advantage of the geographically dispersed nature of the market. For example, a spatial arbitrageur will attempt to buy GBP at 1.61 USD/GBP in London and sell GBP at 1.615 USD/GBP in New York. Triangular arbitrage takes advantage of pricing mistakes between three currencies. As we will see below, cross-rates are determined by triangular arbitrage. Covered interest arbitrage takes advantage of a misalignment of spot and forward rates, and domestic and fo reign interest rates. 2.A.3 Players and Dealing in Foreign Exchange Markets The players in the foreign exchange markets ar e speculators, corporations, commercial banks, currency brokers, and central banks. Corporations enter into the market primarily as hedgers; however, corporations might also spec ulate. Central banks tend to be speculators, that is, they enter into the market without covering their positions. Commercial banks and currency brokers primarily
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I.6 act as intermediaries, however, at different times, they might be also speculators, arbitrageurs, and hedgers. All the parties in the foreign exchange market communicate through traders or dealers. Commercial banks account for the largest propor tion of total trading volume. In 2019, the BIS reported that over 90% of all foreign exchange tr ading was either interbank (39%) or with other financial institutions incl uding hedge funds, mutual funds, inve stment houses and securities firms (53%). Only 9% of the trading was done between banks and non-financial customers, for example big corporations. The high volume of interbank trading is partially explained by the geographically dispersed nature of the market an d the price discovering process. 2.A.3.i Dealers, Market Makers and Brokers A dealer’s main responsibility is to make money without compromising the re putation of his or her employer. To this end, they take positions, that is, buy and sell securities using their employer’s capital. At the end of the day, a dealer should have the book squa red Œi.e., all positions closed. Many dealers act as market makers . Therefore, they are obliged to provide bids and offers to both competitors and clients upon request. That is, any in terested parties can ask market makers for a two-way quote, a bid and an ask quote. Once given, the quote is bi nding, that is, the market maker will buy foreign exchange at the bi d quote and sell at th e ask quote. The difference between the bid and the ask is the spread. Market makers make a profit from the bid-ask spread. Bid-ask spreads are close to .03%, which ar e significantly lower than spreads in any other financial market with the exception of the Treasury bill market. The arithmetic average of the bid rate and the ask rate is called the mid rate . Market makers profit from the high volume in the foreign exchange market. Another channel for dealing is through a broker. For example, a Bertoni Bank dealer contacts a broker offering to buy, say, JPY 500 million. The broker provides two prices: a bid and an ask, without revealing the name of the counterparty. If Bertoni Bank accepts the ask, then the broker will reveal the name of the coun terparty so the electronic settleme nt of the transaction can be performed. If the broker cannot provide immediatel y a price, the broker will shop around and see if there are any sellers for this volume. Brokers make a profit from a fixed commission paid by both parties. Instead of going to a broker, Bertoni Bank can contact another bank and try to purchase directly from the other bank. This transaction is an interbank or direct dealing transaction. Direct dealing saves the commission charged by the broker . Direct dealing also reveals information about the position of other parties. Discovering other dealers’ prices help dealers to determine the position of the market and then establish their prices. A study by Richard Lyons, published in the Journa l of Financial Economics, in 1995, analyzes the transactions of an interbank spot trader ove r a five-day period. This trader completed 267 transactions per day, that is, one transaction every 67 seconds. The average daily volume traded by this trader was USD 1.2 billion. The majority of the transactions were direct deals; however, this trader tended to use brokers for larger than av erage transactions. In this study, Richard Lyons reports that the median spread between the bi d and ask prices was DEM .0003, which represented less than 0.02 percent of the spot rate.
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I.8 know it. The last two digits are referred as the small figure. Thus, it is clear for traders the meaning of a telephone quote of “97-98.” The difference between the bid and the ask is called the bid-ask spreads. Spreads are very thin in the FX market. For actively tr aded pairs, usually no more 3 pips Œi.e., 0.0003. Example I.2 : A bid/ask quote of EUR/USD: 1.2397/1.2398 (spread: one pip ). See screenshot from electronic trading platform EBS below: Take the EUR/USD quote. The first number in black, 1.23 , represents the fibig figurefl Œi.e., the first digits of the quote. The big numbers in yellow, within the green/bl ue squares, represent the last digits of the quote to form 1.2397-1.2398. The number in black by the ask (fi offerfl) 98 (11) represents an irregular amount (say USD 11 million); if no number is by the bid/ask quot e, then the fiusualfl amount is in play (say, USD 10 million, usually set by the exchange and may differ by currency). These irregular amounts have a better price quote than the regular amounts. The best regular quotes are on the sides 97 & 99. ¶ In 2016, the BIS estimate d that the daily volume of spot cont racts was USD 1.652 trillion (33% of total turnover). Again, the majority of the spot tr ading is done between financial institutions. Only 19% of the daily spot transactions involved non- financial customers. The high volume of interbank trading is partially explained by the geographically dispersed nature of the market. Dealers trade with one another to take and lay off risks, and to discover transaction prices. Discovering other dealers’ prices help dealers to determine the positi on of the market and then establish their prices. 2.B.1.i Direct and Indirect Quotations An exchange of currencies involves two currencies, either of which may arbitrarily be thought as the currency being bought. That is, either curre ncy may be placed in the denominator of an exchange rate quotation. When exchange rates ar e quoted in terms of th e number of units of domestic currency per unit of foreign currency, the quote is referred to as direct quotation . On the other hand, when exchange rates are quoted in te rms of the number of foreign currency units per
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I.9 unit of domestic currency, the quote is referred to as indirect quotation . The indirect quotation is the reciprocal of the corresponding direct quotation. Most currencies are quoted in terms of units of currency that one USD will buy. This quote is called “European” quote. Exceptions are the “Anglo Saxon” currenc ies (British Pound (GBP), Irish punt (IEP), Australian dollar (AUD), the New Zeal and dollar (NZD)), and th e EUR. This second type of quote is also called “American quote.” Example I.3 : Quotations. (A) Indirect quotation: JPY/USD (European quote). Suppose a U.S. tourist wish es to buy JPY at Los Angeles Internat ional Airport. A quote of JPY 110.34- 111.09 means the dealer is willing to buy one USD for JPY 110.34 ( bid) and sell one USD for JPY 111.09 (ask). For each USD that the dealer buys and sells, she makes a profit of JPY .75. (B) Direct quotation: US D/JPY (American quote). If the dealer at Los Angeles International Airport us es direct quotations, the bid-ask quote will be USD .009002-.009063 per one JPY. ¶ It is easy to generate indirect quotes from direct quotes. And vicev ersa. As Example I.3 illustrates: S(direct)bid = 1/S(indirect) ask, S(direct)ask = 1/S(indirect) bid. The discussion about exchange rate movements sometimes is confusing because some comments refer to direct quotations while other comments refe r to indirect quotations. Direct quotations are the usual way prices are quoted in an economy. For example, a gallon of milk is quoted in terms of units of the domestic currency. Thus, unless stated otherwise, we will use direct quotations. That is, the domestic currency will always be in the numerator while the fo reign currency will always be in the denominator. In the foreign exchange market, banks act as market makers. They realize their profits from the bid-ask spread. Market makers will try to pass th e exposure from one transac tion to another client. For example, a bank that buys JPY from a client will try to cover its exposure by selling JPY to another client. Sometimes, a bank that expects the JPY to appreciate over the next hours may decide to speculate, that is, wait before selling JPY to another client. During the day, bank dealers manage their exposure in a way that is consistent with their short-term view on each currency. Toward the end of the da y, bank dealers will try to square the banks’ position. A dealer who accumulates too large an inventory of JPY could induce clients to buy them by slightly lowering the price. Thus, because quoted prices reflect inve ntory positions, it is advisable to check with several banks before deciding to enter into a transaction. 2.B.1.ii Cross-rates The direct/indirect quote system is related to the domestic currency. The European/American quote system involves the USD. But if a Malayan trader calls a Hong Kong bank and asks for the JPY/CHF quote, the Hong Kong bank will quote a rate that does not fit under either quote system. The Hong Kong bank will quote a cross rate . Most currencies are quoted against the USD, so that
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I.10 cross-rates are calculated from USD quotations. For example, the JPY/GBP is calculated using the USD/JPY and USD/GBP rates. This usually implies a larger bid-ask spread on cross exchange rates. The cross-rates are calculated in such a wa y that arbitrageurs cannot take advantage of the quoted prices. Otherwise, triangular arbitrage stra tegies would be possible and banks would soon notice imbalances in their buy/sell orders. Example I.4 : Suppose Housemann Bank gives the following quotes: S t = .0104-.0108 USD/JPY, and S t= 1.5670-1.5675 USD/GBP. Housemann Bank wants to calculate the JPY/GBP cross-rate s. The JPY/GBP bid rate is the price at which Housemann Bank is willing to buy GBP against JPY, i.e., the number of JPY units it is willing to pay for one GBP. This transaction (buy GBP-sell JPY) is equivalent to selling JPY to buy one USD -at Housemann’s bid rate of (1/.0108) JPY/US D- and then reselling that USD to buy GBP -at Housemann’s bid rate of 1.5670 USD/GBP. Fo rmally, the transaction is as follows: Sbid,JPY/GBP = Sbid,JPY/USD x Sbid,USD/GBP = [(1/.0108) JPY/USD]x[(1.5670) USD/GBP] = 145.0926 JPY/GBP. That is, Housemann Bank will never set th e JPY/GBP bid rate below 145.0926 JPY/GBP. Using a similar argument, Housemann Bank will set the ask JPY/GB P rate (sell GBP-buy JPY) using the following formula: Sask,JPY/GBP = Sask,JPY/USD xSask,USD/GBP = [(1/.0104) JPY/USD]x[(1.5675) USD/GBP] = 150.7211 JPY/GBP.¶ Example I.5 : A Triangular Arbitrage Opportunity Consider, again, Example I.4. Suppose, now, that a Housemann Bank trader observes the following exchange rate quote: S ask,JPY/GBP = 143.00 JPY/GBP. We can see that the JPY is overvalued in terms of GBP, since it is below the arbitrage-free bid rate of 145.0926 JPY/GBP. Th e trader automatically starts a triangular arbitrage strategy: (1) Borrow USD 1 M (2) Sell USD 1,000,000 at the rate .0108 USD/ JPY. Then, the trader buys JPY 92,592,592.59. (3) Sell JPY 92,592,592.59 at the rate of 143.00 JPY/GBP. The trader buys GBP 647,500.65. (4) Sell GBP 647,500.65 at the rate 1.5670 US D/GBP. The trader buys USD 1,014,633.51. (5) Return USD loan, keep profits. The triangle: JPY Sell JPY at Sell USD at St = 143 JPY/USD S t = .0108 JPY/GBP GBP USD Sell GBP at S t = 1.5760 USD/GBP This operation makes a profit of USD 14,633.51 (or 1. 46% per USD borrowed). The Housemann trader will try to repeat this operation as many times as possible. After several ope rations, banks will adjusts the quotes to eliminate arbitrage. Note: For the strategy (1)-(5) to be considered arbi trage, steps (1)-(5) should be done simultaneously. ¶ 2.B.2 The Forward Market
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I.11 Forward currency markets have a very old hist ory. In the medieval Eu ropean fairs, traders routinely wrote forward currency cont racts. A forward transaction is si mple. It is similar to a spot transaction, but the settlement da te is deferred much further into the future. No cash moves on either side until that settlement date. That is , the forward currency mark et involves contracting today for the future purchase or sale of fore ign currency. Forward currency transactions are indicated on dealing room screen s for intervals of one , two, three and twelve month se ttlements. Most bankers today quote rates up to ten years fo rward for the most traded currencies. Forward contracts are tailor-made to meet the needs of bank customers. Ther efore, if one customer wants a 63-day forward contract a bank will offer it. No nstandard contracts, however, can be more expensive. Forward quotes are given by “forward points.” The points corresponding to a 180-day forward GBP might be quoted as .0100-.0108. These points can also be quoted as 8-100. The first number represents the points to be added to the second number to form the ask small figure, while the second number represents the small figure to be added to the bid’s big figure. These points are added from the spot bid-ask spread to obtain the forward price if the first number in the forward point “pair” is smaller than th e second number. The forward point s are subtracted from the spot bid-ask spread to obtain the forward price, if th e first number is higher than the second number. The combination of the forward poi nts and the spot bid-ask rate is called the “outright price.” Example I.6 : Suppose S t=1.5670-1.5677 USD/GBP. We want to calculate the outright price. (A) Addition The 180-days forward points are .0100-.0108 (8-100), then F t,180 = 1.5770-1.5785 USD/GBP. (B) Subtraction The 180-days forward points are .0072-.0068 (68-4), then F t,180 = 1.5602-1.5605 USD/GBP. ¶ Forward contracts allow firms and investors to tran sfer the risk inherent in every international transaction. Suppose a U.S. i nvestor holds British bonds wort h GBP 1,000,000. This investor believes the GBP will depreciate against the USD, in the next 90 days. This U.S. investor can buy a 90-day GBP forward contract to transfer the currency risk of her British bond position. A forward transaction can be cl assified into two classes: outright and swap. An outright forward transaction is an uncovered speculative position in a currency, even though it might be part of a currency hedge to the other side of the transactio n. A foreign exchange swap transaction helps to reduce the exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange agains t a forward purchase (or sale) of approximately an equal amount of the foreign currency. In 2016, the daily volume of outr ight forward contract s amounted to USD 700 billion, or 14% of the total volume of the foreign exchange market. Unlike the spot market, 35% of transactions involved a non-financial customer . These non-financial customers typically use forward contracts to manage currency risk. Forward contracts tend to have very short maturities: 40% of the contracts had a maturity of up to 7 days. Less than 5% of the forward cont racts had a maturity of over one year.
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