ORGANIZATION OF THE FOREIGN EXCHANGE MARKET, THE SPOT MARKET, THE FORWARD MARKET, INTEREST RATE PARITY THEORY

1. THE FOREIGN EXCHANGE MARKET

2. I. INTRODUCTION
II. ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
III. THE SPOT MARKET
IV. THE FORWARD MARKET
V.INTEREST RATE PARITY
THEORY

3. I. INTRODUCTION
A. The Currency Market:
where money
denominated in one
currency is bought and sold
with money
denominated in another
currency.

4. B. International Trade and
Capital Transactions:
- facilitated with the ability
to transfer purchasing power
between countries

5. C. Location
1. OTC-type: no specific
location
2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide
Interbank Financial
Telecommunications

6. I . PARTICIPANTS IN THE
FOREIGN EXCHANGE MARKET
A. Participants at 2 Levels
1. Wholesale Level (95%)
- major banks
2. Retail Level
- business
customers.

7. B. Two Types of Currency
Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd
business day

8. 2. Forward Market:
- transactions take place at a
specified future date

9. C. Participants by Market
1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial
and central banks

10. 2. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators

11. II. CLEARING SYSTEMS
A. Clearing House Interbank
Payments System
(CHIPS)
- used in U.S. for electronic
fund transfers.

12. B. FedWire
- operated by the Fed
- used for domestic transfers

13. III. ELECTRONIC TRADING
A. Automated Trading
- genuine screen-based
market

14. B. Results:
1. Reduces cost of trading
2. Threatens traders’
oligopoly of information
3. Provides liquidity

15. IV. SIZE OF THE MARKET
A. Largest in the world
1995: $1.2 trillion daily

16. B. Market Centers (1995):
London =$464 billion
daily
New York= $244 billion
daily
Tokyo = $161 billion
daily

17. I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have
four different quotes:
a. spot price
b. 30-day
c. 90-day
d. 180-day

18. B. Method of Quotation
1. For interbank dollar
trades:
a. American terms
example: $.5838/dm
b. European terms
example: dm1.713/$

19. 2. For nonbank customers:
Direct quote
gives the home currency price
of one unit of foreign currency.
EXAMPLE: dm0.25/FF

20. C. Transactions Costs
1. Bid-Ask Spread
used to calculate the fee
charged by the bank
 Bid = the price at which the
bank is willing to buy
 Ask = the price it will sell
the currency

21. 4. Percent Spread Formula (PS):
100x
Ask
BidAsk
PS
−
=

22. D. Cross Rates
1. The exchange rate
between 2 non - US$
currencies.

23. 2. Calculating Cross Rates
When you want to know
what the dm/ cross rate is,
and you know
dm2/US$ and .55/US$
then dm/ = dm2/US$ ÷ .55/US$
= dm3.636/ 

24. E. Currency Arbitrage
1. If cross rates differ from
one financial center to
another, and profit
opportunities exist.

25. 2. Buy cheap in one int’l market,
sell at a higher price in
another
3. Role of Available Information

26. F.Settlement Date Value Date:
1. Date monies are due
2. 2nd Working day after date of
original transaction.

27. G. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverse
exchange rate moves.
b. Increased uncertainty
about future exchange
rate requires

28. 1.) Demand for higher risk
premium
2.) Bankers widen bid-ask
spread

29. SPOT TRANSACTIONS: An
Example
Step 1. Currency transaction:
verbal agreement, U.S.
importer specifies:
a. Account to debit (his acct)
b. Account to credit
(exporter)

30. Step 2. Bank sends importer
contract note including:
- amount of foreign
currency
- agreed exchange rate
- confirmation of Step 1.

31. Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ from
nostro account to exporter’s.
Value Date.
U.S. bank debits importer’s
account.

32. I. INTRODUCTION
A. Definition of a Forward
Contract
an agreement between a bank and a
customer to deliver a specified amount
of currency against another
currency at a specified future date
and at a fixed exchange rate.

33. 2. Purpose of a Forward:
Hedging
the act of reducing exchange
rate risk.

34. B. Forward Rate Quotations
1. Two Methods:
a. Outright Rate: quoted to
commercial customers.
b. Swap Rate: quoted in the
interbank market as a
discount or premium.

35. CALCULATING THE FORWARD PREMIUM
OR DISCOUNT
= F-S x 12 x 100
S n
where F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the
forward contract

36. C. Forward Contract Maturities
1. Contract Terms
a. 30-day
b. 90-day
c. 180-day
d. 360-day
2. Longer-term Contracts

37. I. INTRODUCTION
A. The Theory states:
the forward rate (F) differs
from the spot rate (S) at
equilibrium by an amount
equal to the interest
differential (rh - rf) between two
countries.

38. 2. The forward premium or
discount equals the interest
rate differential.
(F - S)/S = (rh - rf)
where rh = the home rate
rf = the foreign rate

39. 3. In equilibrium, returns on
currencies will be the same
i. e. No profit will be realized
and interest parity exists
which can be written
(1 + rh) = F
(1 + rf) S

40. B. Covered Interest Arbitrage
1. Conditions required:
interest rate differential does
not equal the forward
premium or discount.
2. Funds will move to a country
with a more attractive rate.

41. 3. Market pressures develop:
a. As one currency is more
demanded spot and sold
forward.
b. Inflow of fund depresses
interest rates.
c. Parity eventually
reached.

42. C. Summary:
Interest Rate Parity states:
1. Higher interest rates on a
currency offset by
forward discounts.
2. Lower interest rates are
offset by forward premiums.