Slide 0Slide 1Chapter OutlineFunction and Structure of the FX MarketFX Market ParticipantsCircadian Rhythms of the FX MarketCorrespondent Banking RelationshipsSlide 8Slide 9The Spot MarketSpot Rate QuotationsSlide 11The Bid-Ask SpreadSlide 14Slide 15Slide 16Currency Conversion with Bid-Ask SpreadsSample ProblemSpot FX tradingCross RatesArbitrageSlide 21Triangular ArbitrageSlide 23Spot Foreign Exchange MicrostructureThe Forward MarketSlide 27Forward Rate QuotationsSlide 29Slide 30Forward PremiumLong and Short Forward PositionsPayoff ProfilesSlide 34Slide 35Slide 36Slide 37Slide 38Forward Market HedgeForward Market Hedge: an ExampleSlide 41Slide 42Slide 43Slide 44Forward Cross Exchange RatesSlide 45Cross-Currency HedgeCurrency SymbolsSWAPSExchange Traded Currency FundsSummaryINTERNATIONALFINANCIALMANAGEMENTEUN / RESNICKFifth EditionCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/IrwinChapter Objective:This chapter serves to introduce the student to the institutional framework within which exchange rates are determined. This chapter lays the foundation for much of the discussion throughout the remainder of the text, thus it deserves your careful attention.5Chapter FiveThe Market for Foreign Exchange5-2Function and Structure of the FX MarketThe Spot MarketThe Forward MarketExchange-Traded Currency FundsFunction and Structure of the FX MarketFX Market ParticipantsCorrespondent Banking RelationshipsThe Spot MarketThe Forward MarketExchange-Traded Currency FundsFunction and Structure of the FX MarketThe Spot MarketSpot Rate QuotationsThe Bid-Ask SpreadSpot FX TradingCross Exchange Rate QuotationsTriangular ArbitrageSpot Foreign Exchange Market MicrostructureThe Forward MarketFunction and Structure of the FX MarketThe Spot MarketThe Forward MarketForward Rate QuotationsLong and Short Forward PositionsForward Cross-Exchange RatesSwap TransactionsForward PremiumExchange-Traded Currency FundsFunction and Structure of the FX MarketThe Spot MarketThe Forward MarketExchange-Traded Currency FundsChapter Outline5-3Function and Structure of the FX MarketFX Market ParticipantsCorrespondent Banking Relationships5-4FX Market Participants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)Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.5-5Circadian Rhythms of the FX Market5-6Correspondent Banking RelationshipsLarge commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market.5-7Correspondent Banking RelationshipsBank A is in London, Bank B is in New York.The current exchange rate is £1.00 = $2.00. A currency trader employed at Bank A buys £100m from a currency trader at Bank B for $200m settled using its correspondent relationship.Bank ALondonBank BNYC$200£1005-8Correspondent Banking RelationshipsInternational commercial banks communicate with one another with:SWIFT: The Society for Worldwide Interbank Financial Telecommunications.CHIPS: Clearing House Interbank Payments System ECHO E xchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions.5-9The Spot MarketSpot Rate QuotationsThe Bid-Ask SpreadSpot FX tradingCross Rates5-10Spot Rate QuotationsDirect quotationthe U.S. dollar equivalente.g. “a Japanese Yen is worth about a penny”Indirect Quotationthe price of a U.S. dollar in the foreign currencye.g. “you get 100 yen to the dollar”See exhibit 5.4 in your textbook.5-11.507219717.1=Spot Rate QuotationsCurrenciesJanuary 4, 2008U.S.-dollar foreign-exchange rates in late New York trading.--------Friday-------Country/currency in US$ per US$Euro area euro 1.4744 .67831-mos forward 1.4747 .67813-most forward 1.4744 .67826-mos forward 1.4726 .6791UK pound 1.9717 .50721-mos forward 1.9700 .50763-most forward 1.9663 .50866-mos forward 1.9593 .5104The direct quote for the pound is: £1 = $1.9717The indi rec t quote for the pound is: £.5072 = $1Note that the direct quote is the reciprocal of the indirect quote:5072.19717.1CurrenciesJanuary 4, 2008U.S.-dollar foreign-exchange rates in late New York trading.--------Friday------- --------Friday-------Country/currency in US$ per US$ Country/currency in US$ per US$Canada dollar .9984 1.0016 Euro area euro 1.4744 .67831-mos forward .9986 1.0014 1-mos forward 1.4747 .67813-most forward .9988 1.0012 3-most forward 1.4744 .67826-mos forward .9979 1.0021 6-mos forward 1.4726 .6791Japan yen .009220 108.46 UK pound 1.9717 .50721-mos forward .009250 108.11 1-mos forward 1.9700 .50763-most forward .009306 107.46 3-most forward 1.9663 .50866-mos forward .009378 106.63 6-mos forward 1.9593 .51045-12The 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.It doesn’t matter if we’re talking used cars or used currencies: the bid-ask spread is the difference between the bid and ask prices.5-130.0339% = x 100$1.4744 – $1.4739$1.4744 The Bid-Ask SpreadA dealer could offer bid price of $1.4739 per €ask price of $1.4744 per €While there are a variety of ways to quote that, the bid-ask spread represents the dealer’s expected profit.Percent Spread = × 100Ask Price – Bid Price Ask Price 5-14big figuresmall figureThe Bid-Ask SpreadA dealer pricing pounds in terms of dollars would likely quote these prices as 12–17.Anyone trading $10m knows the “big figure”.USD Bank QuotationsAmerican Terms European TermsBid Ask Bid AskPounds 1.9712 1.9717 .5072 .50735-15The Bid-Ask SpreadUSD Bank QuotationsAmerican Terms European TermsBid Ask Bid AskPounds 1.9712 1.9717 .5072 .5073Notice that the reciprocal of the S($/£) bid is the S(£/$) ask. =£1.00$1.9712£.5073$1.005-16Dealer will pay $1.9715 for 1 GBP; he is asking $1.9720.He will pay £.5071 for $1 and will charge £.5072 for $1$10,000 ×£1$1.9720= £5,071Currency Conversion with Bid-Ask SpreadsA speculator in New