CH 5. FOREIGN EXCHANGE MARKETS (CURRENCY MARKETS)* Market? Place where buyers (demand) and seller (supply) of any products meet and trade. Product? Real (tangible and intangible) vs. Financial (stocks, bonds, currencies, - -)1. ORGANIZATION OF THE FOREIGN EXCHANGE (FOREX) MARKET* OTC (over-the-counter, unorganized market) (ref: exchanges areorganized markets) 1) SPOT MKT: Currencies are traded for immediate delivery. 2) FWD MKT (& FUTURES): futures and forward markets areconceptually very similar for future deliveries. They are quite different inpractice, however. 3) OPTIONS: rights to buy (Call) or to sell (Put) a specified amount offoreign currency at specified price (exercise exchange rate) at no laterthe specified date (expiration date). ref) A real life example of a call is a rain check. Ray Lewis’ contract is areal life example of a put. * PARTICIPANTS AND SIZE OF THE FOREIGN EXCHANGE MKT: currencydealers, hedgers, speculators, institutional investors including centralbanks. Daily volume easily exceeds 1 trillion dollars.2. THE SPOT MKT1) QUOTATIONS: American terms vs. European terms * BID (price to buy) –ASKED (price to sell), SPREAD (=asked price –bid), all from a dealer’s perspective. The spread is dealer’sprofit=transactions cost for others - Factors determining the size of spread: trading volume (-),trading frequency (-), exchange rate volatility (+) * CROSS-RATES 2) TRIANGULAR (CURRENCY) ARBITRAGE * Arbitrage? Profits with no risks, The arbitrage opportunity ariseswhen there is a violation of the law of one price => (two) different pricesfor the SAME product. If the market if perfect, this is not possible.a. SIMPLE ARBITRAGE: Store A $.4/TW vs. Store B $.5/TW:1) Identify High ($.5/TW) and Low2) Use the arbitrage strategy, BL SH a) Buy TWs from A using say, $1 => can get 2.5 TWs (show your work) b) Sell 2.5 TWs for $s to B => $1.25 (show your work) c) Arbitrage profit = $0.25Caveats:a) Use American terms or Prices (Do not use TW 2.5/$ vs. TW 2.0/$) b) the same currency or the product (Do not have $0.4/TW vs.$0.5/Bg)Notes: a) Can this price disparity ($0.4 vs. $0.5) be sustained? No, if the market isperfect. b) With Bid-Aked prices? i) Take average price ( (bid+asked)/2) for each locationii) Determine High and Low using the average pricesiii) BLSHiv) Check whether you have a positive arbitrage profit (yes, there is anarbitrage opportunity. Note that the arbitrage profit is smaller with the bid-asked prices as the spared is the transactions cost). If the arbitrage profit isnegative, then there is no arbitrage opportunity as no one would do BLSHknowing that (s)he would take a loss! In this case, it does not pay due totransactions costs.b. How about SF instead of TW? => Everything is practically thesame.c. Triangular Arbitrage: $ and two other products or two other foreign currencies.EG, $/£=2.809 IN NY, $/ARP=.251 IN BUENOS AIRES, AND ARP/£=11.18 IN LONDON => Complicated! We may want to simply this like the simple arbitrage example. To do that, we need to have a foreign currency like TW. There are two FCs in this example. Your choice of FC for TW is irrelevant!1) If you choose £, then you need to have $/£ in one location andanother $/£ in another location. You have immediately $/£=2.809IN NY. For another $/£, you need to use a cross rate, ($/ARP)*(ARP/£) = .251*11.18 = 2.806 in Buenos Aires and London combined.2) Now, identify H (2.809) and L.3) BL SHa) Buy £s from B & L using say, $1b) Sell £s for $s in NYNotes: 1) To do a), you need to go to Buenos Aires first since we do not have $s traded in London. In other words, you need first to buy ARPs (3.984 ARPs, show your work) in B using say, $1, then sell APRs for £s (0.3564 BPs, show your work) in London. Taking these two steps would satisfy a). 2) You can get $1.00113 c) Arbitrage profit = $0.00113. While this is so small, it could besizable if you increase the initial investment. For example, the arbitrage gain will be $1.13 million if you start with $1 billion. This is a sure profit with no risks. Why not?Aside) What if you chose ARPs? Aside) What if you have bid-asked exchange rates? HW#4: Check the triangular arbitrage possibility and determinethe arbitrage profit amount, if any, using the exchange rate quotations of10/6/2010 and initial amount of $1 million. – due 10/13/2010. Constructa diagram similar to Exh 5.8 on p.1243. THE FORWARD MARKET:EG, A US firm buys plug trays from England with payment of one millionBPs due in 90 days. The present exchange rate is So=$1.71/BP and S1could be as high as $2/BP or as low as $1.6/BP. F=$1.72/BP. ProbabilityDistribution: S1=$2/BP with 30% Probability and $1.6/BP with 70%Probability. Four alternatives to secure one million BPs.a. Buy now b. Buy later at the future spot rate (S1)c. Buy forward at Fd. Options 1) FOUR IMPORTANT POINTS: a. NOT AN INVESTMENTb. GAIN/LOSS ON THE FWD CONTRACT IS NOT DIRECTLY RELATEDTO So.c. IT's NO OPTION 2) PARTICIPANTS: ARBITRAGEURS, TRADERS, HEDGERS, AND SPECULATORS 3) QUOTATIONS - Bid/Asked Spreada. Customers are quoted the outright rate, or actual price (WSJ quotations).b. Dealers quote in terms of forward points, which are either added or subtracted from the spot rate (So) or as a premium or discount on the spot rate (the PACIFIC):Example 5.5 on p.127 about Forward Point QuotationsSo ($/BP) : $1.9712 - $1.9717F1 : 19 - 17F3: 57 – 54F6: 131 -124Note: when the second number is smaller than the first, the forward points are subtracted from the spot rates to obtain the outright forward rates at discounts. =>So ($/BP) : $1.9712 - $1.9717F1 : $1.9693 - $1.9700F3: $1.9655 - $1.9663F6: $1.9581 - $1.9593- Calculating the Forward Premium/Discount= (fwd diff/S0)*(360/contract length in days). ref) fwd diff=swap rate=F - S0.Example: So ($/yen) = 0.09220, F91 = 0.009306. The three-month forward premium is 3.69% - Exchange –Traded Currency Funds (ETF): a security created based on a portfolio of