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The market of foreign exchange, image, ◦ decrease with dealer competition.…
The market of foreign exchange
Function and Structure of the FX Market
FX Market Participants
International banks
provide
the core
“make a market”
buy foreign currency
sell foreign currency
for their own account
serve
retail clients
the bank customers
Nonbank dealers
large nonbank financial institutions
investment banks
mutual funds
pension funds
hedge funds
size and frequency
make it cost effective
own dealing rooms
trade directly
the interbank market
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new technologies
enabled nonbank market participants
gain ground in the FX market
Bank customers
MNCs
money managers
private speculators
FX brokers
match dealer orders
buy and sell currencies
a fee
have knowledge
the quotes
offered by
dealers in the market
Central bank
intervened
the foreign exchange market
an attempt
influence the price
its currency against
a major trading partner
a country
“fixes”
“pegs” its currency against
Intervention
the process
using foreign currency reserves
buy one’s own currency
decrease its supply
increase its value
the foreign exchange market
selling one’s own currency
foreign currency
increase its supply
lower its price
worldwide linkage
bank currency traders
nonbank dealers
FX brokers
The structure of the foreign exchange market
an outgrowth
the primary functions of a commercial banker
assist clients
the conduct of international commerce.
Example
a corporate client desiring
import merchandise
from abroad
would need
a source of foreign exchange
if
the import
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Three major market segments
Australasia
Europe
North America.
two-tier market
the wholesale or interbank market
the retail or client market
Correspondent Banking
Relationships
The interbank market
a network
correspondent banking relationships,
large commercial banks
maintaining
demand deposit accounts with one another
called correspondent banking accounts
The Society for Worldwide Interbank Financial Telecommunication (SWIFT)
allows international commercial banks
communicate instructions
a private nonprofit message
transfer system
used by more than 11,000 financial institutions
more than 200 countries
territories around the world
The Clearing House (CHIPS)
processes an average of $1.5 trillion
payments each day
The Spot Market
Spot Rate Quotations
Spot rate currency quotations can be stated in direct or indirect terms.
(1) Direct quotation
referring to the price of one unit of a foreign currency in terms of the domestic currency.
the U.S. dollar equivalent
◦ e.g. “a Japanese Yen is worth about a penny”
◦ the price of a U.S. dollar in the foreign currency
◦ e.g. “you get 100 yen to the dollar”
(2) Indirect Quotation
the price of one domestic currency in terms of a
foreign currency.
Cross-Exchange Rate Quotations
A cross-exchange rate is an exchange rate between a currency pair where neither
currency is the U.S. dollar.
Calculate
The Bid-Ask Spread
❖ The bid price is the price a dealer is willing to pay you for something.
❖ The ask price is the amount the dealer wants you to pay for the thing.
❖ The bid-ask spread is the difference between the bid and ask prices.
❖ The bid-ask spread represents the dealer’s expected profit.
Spot FX Trading
❖ In the interbank market, the standard size trade is about U.S. $10 million.
❖ A bank trading room is a noisy, active place.
❖ The stakes are high.
❖ The “long term” is about 10 minutes.
The Cross-Rate Trading Desk
In dealer jargon, a nondollar trade such as this is referred to as a currency against currency
trade.
Triangular Arbitrage
Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency
then trading it for a third currency, which is in turn traded for $
Purpose
Earn profit
Direct exchange rate
the cross-exchange rate.
Spot Foreign Exchange Market Microstructure
Market Microstructure refers to the mechanics of how a marketplace operates..
Bid-Ask spreads in the spot FX market:
◦ increase with FX exchange rate volatility and
The Forward market
Forward Rate Quotations
FN (j/k)
price of one unit of currency k in terms of currency j for delivery in N months.
N equaling 1 denotes a one-month maturity based on a 360-day banker’s year.
N equaling 3 denotes a three-month maturity.
direct or indirect with one being the
reciprocal of the other.
Ex: the European term quotes are the reciprocals of the corresponding American term quotations.
an unbiased predictor of the expected spot exchange rate N months into the future.
Long and Short Forward Positions
Buy (take a long position) or sell (take a short position) foreign exchange forward.
customers can contract with their international bank to buy or sell a specific sum of freely traded FX
interbank traders can establish a
long or short position
dealing with a trader from a competing bank.
Forward Premium
useful for comparing against the interest rate differential between two countries.
can be calculated using American or European term quotations
Forward Cross-Exchange Rates
calculated in an analogous manner to spot crossrates.
Non-Deliverable Forward Contracts
A non-deliverable forward contract is settled in cash
Difference between
Spot exchange on the maturity date
the NDF rate times the notional
Swap Transactions
the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of approximately an equal amount of the foreign currency.
provide a means for the bank to
mitigate the currency exposure in a forward trade.
An outright forward transaction
forward transaction is an uncovered speculative position in a currency, even though it
might be part of a currency hedge to the bank customer on the other side of the transaction.
Exchange-Traded currency funds
Exchange-traded fund (ETF) is a portfolio of financial assets .
Shares representing fractional ownership of the fund trade on an organized exchange
Growth
2019
March
Assets invested in the global ETF industry reached $5.4 trillion
April
NAV of all nine currency trusts stood close to $1
billion
2005
CurrencyShares Euro Trust.
For institutional and retail investors
Desire to take a position in a financial asset that
will track the performance of the euro with respect to the U.S. dollar.
Individual shares are denominated in the U.S. dollar and trade on the New York Stock Exchange.
net asset value (NAV) of one share at any point in time will reflect the spot dollar value of 100 euros plus accumulated interest minus expenses.
Created eight additional currency trusts
April 2018
CurrencyShares ETF product line
was transitioned to Invesco.
Created representing investment
example: a number of stock market indices.
Allow small investors to invest in portfolios of financial assets that they would find difficult individually.
◦ decrease with dealer competition.
