The Foreign Exchange and Eurocurrency Markets

1
 Symbols and acronyms

Upper Case Symbols = Prices

lower case symbols = changes in a price level
Ptd (or Ptf) = price of an asset at time t in currency d (or f)
ptd (or ptf) = inflation in currency d (or f) during period t
Std/f = spot exchange rate at time t between d and f
std/f = change in the spot exchange rate during period t
Fd/f = forward exchange rate between currencies d and f
ftd/f = change in the forward rate during period t

2
 Foreign exchange (fx) markets
) Markets
» Spot market
– trade in cash today with delivery in two business days
» Forward market
– trade at a pre-specified price and on a pre-specified future date

) Volume
» volume in April 2003 averaged $2.0 trillion per day
» about 75% in the interbank market

) Operational eINRiciency
» small retail transactions can be expensive
» large interbank transactions have very low costs

3
 Major foreign exchange trading centers
(Average daily volume during April of 1989, 1992, 1995, and 1998)

700

600 1989 1992 1995 1998

500

400

300

200

100

0
London New York Tokyo

Source: Bank for International Settlements triennial survey of central banks.

4
 Rule #1
Keep track of your units.
An example: S$/INR = $.0250/INR ⇔ SINR/$ = 1/ S$/INR =INR 40/$

Dollar value of a bottle of Champagne:

Buy 1 bottle of wine PINR = INR400/btl
Spot exchange rate SINR/$ = INR40/$
How much is this in dollars?

P$ = PINR/SINR/$= (INR400/btl)/(INR4.00/$) = $10/btl

= PINRS$/INR= (INR400/btl)($.025/INR) = $10/btl

5
 Rule #2:
Always buy or sell the currency in the
denominator of a foreign exchange quote.
Example of buying low and selling high:
Buy wine at INR400/btl and sell at INR500/btl ⇒ INR100/btl Profit

Buy INRs at $.020/INR ≡ Sell $s at INR50/$

Sell INRs at $.025/INR ≡ Buy $s at INR40/$
$.005/INR Profit INR10/$ Profit

6
 Forward premiums or discounts

Percentage forward premium or discount

= (F1d/f − S0d/f ) / S0d/f

) Forward premium
» nominal value in the forward exchange market is
higher than in the spot exchange market

) Forward discount
» nominal value in the forward exchange market is
lower than in the spot exchange market

7
 An example of
forward premiums and discounts

Suppose S0$/INR = $0.020/INR and F1$/INR = $0.025/INR

Rupee forward premium
= ($.025/INR−$.020/INR)/($.020/INR) = +25%
so the Rupee is selling at a 25% forward premium.

Alternatively, S0INR/$ = INR50.00/$ ⇔ S0$/INR = $0.020/INR

F1INR/$ = INR40.00/$ ⇔ F1$/INR = $0.025/INR
Dollar forward premium
= (INR40/$−INR50/$)/(INR50/$) = −20%
so the dollar is selling at a 20% forward discount.

8
 Percentage changes in foreign exchange rates

Percentage change in the value of a foreign currency

= (S1d/f − S0d/f ) / S0d/f

An example: S0INR/$ = INR50/$ ⇔ S0$/INR = $0.020/INR

S1INR/$ = INR40/$ ⇔ S1$/INR = $0.025/INR

Percentage change in the franc = (S1$/INR−S0$/INR ) / S0$/INR

= ($0.025/INR−$0.020/INR)/($0.020/INR) = +25%

Percentage change in the dollar = (S1INR/$−S0INR/$ ) / S0INR/$

= (INR40/$−INR50/$)/(INR50/$) = −20%

9
 The interbank Eurocurrency market
Eurocurrencies are bank deposits or loans residing
outside of the country issuing the currency
» Few regulations
– No reserve requirements, interest rate regulations or caps,
withholding taxes, deposit insurance requirements, or credit
allocation regulations; less stringent disclosure requirements
» Low risk
– Relatively short maturities: Maturities of less than 5 years
– Low interest rate risk: Interest rates tied to a variable rate
base such as the London Interbank Offer Rate (LIBOR)
– Low default risk: Traded between large commercial banks,
investment banks and multinational corporations
» Highly competitive
– Daily volume of several hundred billion dollars ensures
competitive bid and offer prices

10
 Spreads in domestic and Eurocurrency
credit markets

Domestic loan rate for

commercial accounts
Eurocurrency loan Eurocurrency
rate for commercial loan rate in the
accounts interbank
market LIBOR
2%
1/2% 1/8% 1/8%
Eurocurrency LIBID
Eurocurrency deposit deposit rate in
rate for commercial the interbank
Domestic deposit rate for accounts market
commercial accounts

11
Linkages between credit & currency markets

U.S.
internal
credit market

Eurocurrencies
external credit markets
¥ £

Japanese U.K.
internal internal
credit market credit market

12
 Exposure to foreign exchange risk
(contract price INR400,000)

Expected receipt in Rupees +INR400,000 ⇔ +$10,000 at

$.025/INR
at E[S1$/INR] = $.025/INR

Actual exchange +INR400,000 ⇔ +$8,000 at

$.020/INR
S1$/INR = $.020/INR

Net loss from

original position −$2,000
∆V$/INR
Risk (or payoff) profile + slope
of underlying exposure −
$.05/IN ∆S$/INR
R
−$.05/INR

13
 Currency hedging with forwards
(contract price INR400,000)

Buy $10,000 forward +$10,000

at F1$/INR = $.025/INR
Sell INR400,000 forward −INR400,000
Market exchange of INR +$8,000
for $ at S1$/INR = $.020/INR
−INR400,000
Net gain on forward +$2,000

∆V$/INR
Risk profile
of a forward +$0.05/IN
R
contract -$0.05/INR
∆S$/INR

14
 Net currency exposure

Underlying position +INR400,000

(long INR)
+$10,000
Sell INR forward
(short INR and long dollars) −
INR40,0000
+$10,000
Net position

Net exposure ∆V$/INR

short francs long francs

∆S$/INR

15
 Example of foreign exchange trading

Market Participants
) Dealers: make a market in foreign currency (quote bid & offer prices)
) Traders: trade for their own acct

Rules of the Game - “Buy ringgits low and sell ringgits high”
) One contract ≡ Rg1,000,000,000 (Malaysian ringgits)
) Trades can be for up to 10 contracts
) Record transactions as either a ringgit purchase or sale
)Dealer quotes are good for two minutes

16
Arbitrage profit in the Malaysian ringgit market
Bank A: “$0.26602/Rg BID and $0.26612/Rg OFFER”
Bank B: “$0.26617/Rg BID and $0.26627/Rg OFFER”

Bank A Bank B
$0.26627/Rg Offer

$0.26617/Rg Bid Sell to B

$0.26612/Rg Offer Buy from A

$0.26602/Rg Bid
1. Buy Rg1 billion from Bank A at $0.26612/Rg offer price
2. Sells Rg1 billion to Bank B at its $0.26617/Rg bid price
Arbitrage Profit = ($0.00005/Rg)(Rg1 billion) = $50,000
with NO NET INVESTMENT and NO RISK.

17
 Sample foreign exchange ledger

NAME Bank of Cash, Credit, and Industry DATE October 19, 2003
Counterparty Contracts Price Total $/Rg Cumulative Rg balance
1. Penn Square BUY 1 0.22004 −$0.22004 +1
2. Citicorp BUY 3 0.22010 −$0.66030 +4
3. Bk of Tokyo SELL 2 0.22016 +$0.44032 +2
4. Bk of Tokyo SELL 4 0.22020 +$0.88080 −2
5. ...

FINAL CLOSING RATES: $.22018/Rg BID and $0.22023/Rg OFFER

Closing trade BUY 2 0.22023 −$0.44046 0

Sum of dollar transactions: +$0.00032/Rg

Times contract size x Rg1,000,000,000
Profit (loss) +$320,000

18
 Opening prices:
$0. 21945/Rg BID & $0.21950/Rg OFFER

News announcements:
) The member nations of the G7 have announced that they
are buying dollars in an effort to stabilize the dollar.
) The U.S. Federal Reserve announces that in an effort to
stimulate economic activity it is lowering the discount
rate on overnight loans to commercial banks.
) The U.S. government reports that the U.S. money supply
M1 increased by $1 billion more than expected in the
most recent quarter.

19
 The Impact of News Events
The member nations of the G7 have announced that they are
buying dollars in an effort to stabilize the dollar.

Value of the U.S. dollar

S$

P’$ D’$
P$ D$
Q$
Value of the Malaysian ringgit
SRg
PRg
DRg
P’Rg
D’Rg
QRg

The Malaysian ringgit depreciates

and the spot rate S$/Rg falls

20
 The Impact of News Events
The U.S. Federal Reserve announces that in an effort to
stimulate economic activity it is lowering the discount rate on
overnight loans to commercial banks.

This makes it easier for U.S. businesses to borrow and increases economic
activity. If this also increases U.S. inflation, then the value of the U.S.
dollar should fall. This will result in an appreciation of the ringgit against
the dollar.

Increases in the domestic discount rate usually, but not always, lead to
increases in the value of the domestic currency.

21
 The Impact of News Events
The government reports that U.S. money supply M1 increased by
$1 billion more than expected in the most recent quarter.

While this would seem to result in a larger supply of dollars and hence a
lower value for the dollar, the increase in the money supply has already
occurred and hence should be reflected in the market price of the dollar.
On the other hand, if the U.S. Federal Reserve is likely to react to this
announcement by increasing the discount rate to slow down the economy,
then the dollar may rise in anticipation of Fed policy.

If the dollar rises against the ringgit, then the ringgit will fall against the
dollar.

22