By Lokeshwar Das Ashwath Ram Ramesh Siddanth Ruba Balan Sai Sreekar.

CONTENTS AND PURPOSE

1. 2. 3. 4. 5. Definition and Organization of the Foreign Exchange Markets Foreign Exchange Market Functions Foreign Exchange Market Participants Types of Foreign Exchange Market Transactions Quotations of Currencies on Foreign Exchange Markets

purpose:
enhance theoretical knowledge from the first two chapters with practical issues of foreign exchange markets functioning principles for the analysis of the international business finance problems

1. Definition and Organization of the Foreign Exchange Markets

foreign exchange markets are markets on which individuals, firms and banks buy and sell foreign currencies:
foreign exchange trading occurs with the help of the telecommunication net between buyers and sellers of foreign exchange that are located all over the world can actually talk about a single international foreign exchange market for every single currency foreign exchange trading takes place at least in some of the world financial centers in every moment
interbank-markets client markets

2. Foreign Exchange Market Functions Clearing of Currencies and Provision of Credit

Clearing of currencies:
service of exchanging one currency for another

Provision of Credit:
trader that bought a certain good from the manufacturer, needs time to sell this good to the final customer and to pay the manufacturer with the money he received from the customer

Foreign Exchange Market and Insurance Against Foreign Exchange Risk

hedging:
activities with which the foreign exchange market participants avoid exchange rate risk or activities with which they are closing their open foreign exchange position closed foreign exchange position:

open foreign exchange position:

size of the assets in a certain currency is equal to the size of the liabilities in the same currency full insurance against exchange rate risk with respect to this currency long: net assets in a certain currency short: net liabilities in a certain currency

in the spot or forward foreign exchange market standardized forward contracts and options

Foreign Exchange Markets and Conscious Foreign Exchange Risk Acceptance

activities in which economic agents consciously open their foreign exchange positions long or short hoping to get profits in all foreign exchange market segments

3. Foreign Exchange Market Participants Economic Agents and Types of Activities on Foreign Exchange Markets
Client buys $ with

Local bank

Bro kers

Main banks interbank market

Purchases and sales of big mu ltinational companies

Local bank

Client buys with $

Economic Agents and Types of Activities on Foreign Exchange Markets

bank clients (individuals, firms, non-banking financial institutions):
all those groups of legal and physical persons that need foreign currency in doing their commercial or investment business

commercial banks:
the most important group of foreign exchange market participants they buy and sell foreign currencies for their clients and trade for themselves

Economic Agents and Types of Activities on Foreign Exchange Markets

brokers:
agents that connects dealers interested in buying and selling foreign exchange, but does not become an active client in the transaction they provide their client, the bank, with the information about the exchange rates at which banks are willing to buy or sell a particular currency

central banks:
foreign exchange market interventions are meant to influence the exchange rate of the domestic currency in a way that is beneficial for the domestic economy and, consequently, for the country it does not necessarily have a profit, it can also have a loss

Economic Agents and Motivation for the Foreign Exchange Market Participation
arbitragers:
they want to earn a profit without taking any kind of risk (usually commercial banks):
try to profit from simultaneous exchange rate differences in different markets making use of the interest rate differences that exist in national financial markets of two countries along with transactions on spot and forward foreign exchange market at the same time (covered interest parity)

Economic Agents and Motivation for the Foreign Exchange Market Participation
hedgers and speculators:
hedgers do not want to take risk while participating in the market, they want to insure themselves against the exchange rate changes speculators think they know what the future exchange rate of a particular currency will be, and they are willing to accept exchange rate risk with the goal of making profit every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transaction

4. Types of Foreign Exchange Market Transactions Spot Foreign Exchange Transactions

almost immediate delivery of foreign exchange

Outright Forward Transactions

buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity forward exchange rates:
1, 3, 6, 9 months, one year

Swap Transactions
simultaneous purchase and sale of a given amount of foreign exchange for two different value dates:
spot against forward swaps:

b a *d c
a annual swap rate (%), b premium/discount during the time of the currency swap, c spot exchange rate, and d - 1/part of the year, for which the currency swap is agreed upon (if the contract is valid for a three-month period, then this is one quarter of a year)

forward-forward swaps

Futures
basic characteristics of futures:
the amount of the currency that is being traded type of currency quotation contract expiration last day of trading with the contract settlement day margin requirements

information about futures trading futures usage:

arbitrage between outright forward contract and futures rarely used as an insurance instrument (rigidity!)

 similarities and differences between outright forward contract and futures:

both need to be executed unconditionally they are usually established for at most one year
Characteristic Size of the contracts Location and trade activity Futures standardized for a given currency at the stock exchange or at a given location; actively traded in an organized market standardized, but at most a year yes insurance explicitly required ( marg in requirements); high security of doing business with the instrument regulated with the stock exchange rules Outright Forward Contract depends on the individual needs of the client with the provision of agents, connected among each other with the help of telecommun ications; not traded in an organized market depends on the individual needs of the client , but not more than a year yes insurance not required exp licitly (imp licit insurance are affiliat ions of two partners up till now); lower security than futures regulation not exp licit ly determined

Duration of the contract Contract has to be executed Insurance and Security of doing Business with the Instrument Trade regulation

Options
basic characteristics of options:
financial instrument that gives the buyer the right, but not the obligation, to buy or sell a standardized amount of a foreign currency, that is traded, at a fixed price at a particular time, or until a particular time in the future call option and put option American and European options at-the-money in-the-money three different prices:
exercise/strike price cost, price or value of the option underlying or actual spot exchange rate out-of-money

Options
types of options trading:
in organized markets:
standardized contracts with given strike prices, standardized durations (1, 3, 6, 9, 12 months) and expirations only certain currencies, contract amounts are standardized

over-the-counter trading:
expiration date, strike price and contract amount depend on the individual needs of the client counterparty risk! retail and interbank market

information about options trading

Options

Usage of options:
when the economic agent expects that the exchange rate trend of a particular currency could change drastically when the economic agent does not know for sure that a certain foreign exchange flow will occur in the future advantages:
fixed option costs options do not need to be executed

Profit/ loss

A. Buyer of a call option

Profit/ loss

C. Buyer of a put option

Unlimited profit Limited loss

Unlimited profit Limited loss

Profit/ loss

B. Seller of a call option

Profit/ loss

D. Seller of a put option

Limited profit Unlimited loss Unlimited loss

Limited profit

5. Quotations of Currencies on Foreign Exchange Markets

quotation of a currency tells us at what price is a financial mediator willing to buy or sell a certain currency

Currency Quotations in Spot Foreign Exchange Markets

European and American quotation direct and indirect quotation (which currency is regarded as a domestic/basis currency)
s st s0 * 100 s0 s s0 st * 100 st

Currency Quotations in Spot Foreign Exchange Markets

American quotation European quotation

Definition: Definition: number of units of $ needed to buy a unit of number of units of a foreign currency needed a foreign currency to buy $1 Direct quotation in the USA: Direct quotation outside the USA: number of units of a domestic currency ($) number of units of a domestic currency needed to buy a unit of foreign currency needed to buy a unit of a foreign currency ($) Indirect quotation outside the USA: number of units of a foreign currency ($) needed to buy a unit of a domestic currency Indirect quotation in the USA : number of units of a foreign currency needed to buy a unit of a domestic currency ($)

Currency Quotations in Spot Foreign Exchange Markets

bid price and offer/sell price quotation:
bid price is the exchange rate at which a bank is willing to buy another currency offer/sell price is the exchange rate at which the same bank is willing to sell the currency in question

transaction costs:
banks usually do not charge provision difference between the bid and offer/sell price represents the banks profit and is called a margin or spread
offer/sell price - bid price offer/sell price

margin

Currency Quotations in Spot Foreign Exchange Markets

cross exchange rate:
can be calculated with the help of the relationship of two currencies with a third currency

triangular currency arbitrage:

it enables profit earning because of inconsistency between currency quotations in different financial centers buying a particular currency in one financial center and selling it in another financial center

Currency Quotations in Forward Foreign Exchange Markets

outright quotation tokovna quotation, forward premium/discount:
forward discount:
when a currency is worth less (is cheaper relative to another currency) in the forward foreign exchange market than in the spot foreign exchange market

forward premium:
when a currency is worth more (is more expensive relative to another currency) in the forward foreign exchange rate market than in the spot foreign exchange market

annual forward premium and discount

f USD

f s 360 * *100 s n

f USD

s f 360 * *100 f n

Publishing the Currency Quotations in the Leading World Financial Newspapers

Financial Times Wall Street Journal