Ch 9 Global Foreign Exchange Markets PDF

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Ch 9 Global Foreign Exchange Markets - Foreign exchange is short term claims (cash, c/d cards, checks, bank deposits) o Exchange rate is the price of the currency - Bank for International Settlements (BIS): controlled by 60 member banks, divides the market into 3 categories: reporting dealers, other financial institutions, and nonfinancial institutions. o Reporting dealers: money center banks, active in foreign exchange and derivative markets, influence price setting and are the market makers o Other financial institutions: smaller banks, IB, hedge funds, western union, etc. - How dealers can trade foreign exchange o Directly with customers o Through voice brokers (can also do low touch with eTrading) o Electronic brokerage system o Directly through interbank - Foreign exchange major segments: o Over the counter (OTC) commercial and investment banks o Securities exchange - Global OTC Foreign-Exchange Instruments o Spot transactions: exchange of currency for delivery 2 business days later o Outright forward transactions: future date (more than 2 days) o FX swap (dominant): swapping currency on one date then swapping back o Currency Swap: involves the exchange of principal and interest payments o Option: the right, but not the obligation to trade foreign currency in the future o Future contracts: agreement to buy or sell a particular currency on a specific date in a standardized contract - Global Foreign exchange: currency distribution adds up to 200% - US is the most important currency on the foreign exchange market, a (euro, yen, and pound) yuan is growing importance o Why the dollar is so widely traded  Investment currency in many capital markets  reserve currency held by many central banks  transaction currency in many international commodity markets  invoice currency in many contracts  intervention currency employed by monetary authorities in market operations to influence their own exchange rates  part of the top 4 of 7 pairs and the top 2 are dollar/euro and dollar/yen  biggest market of foreign exchange is London, then New York, Tokyo, and Singapore o closest to major capital markets, location and time zone when lunch time asai is closing, New York is opening

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times of greatest foreign exchange activity are when Tokyo and London are both open (2hours), then when NY & London are open (8am-12) cross rate: exchange rate between two currencies other than the dollar

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The spot market: for foreign exchange transactions that occur within 2 business days

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o Bid (buy)- offer(sell) rate = dealer profit margin (Spread) o American terms (direct quote): the number of dollars per unit of foreign currency o European terms (indirect quote) : the number of units of foreign currency per dollar o Base currency (denominator), term currency (numerator)  USD/JPY or USDJPY=X : dollar is the base currency and yen is the term currency (number of yen per 1 dollar)  The European terms is the reciprocal so once you find the American terms do it 1/currency per one dollar o Spot rates: selling rates for interbank transactions of $1 million and more  Retail transactions (between banks and companies or individuals) provide fewer foreign currency units per dollar -

The forward market: transactions where seller extends credit to the buyer for a period longer than 2 days (euro, yen, franc, and pound most widely traded due to market liquidity) o Forward rate: rate quoted for transactions that call for delivery after 2 business days o Foreign exchange traders can provide forward rates for most countries, the more exotic the currency, the more difficult it is to get a forward quote farther in the future o Forward discount or forward premium: difference in spot and forward  US trading perspective (dollars per francs): if forward rate for Swiss franc is greater than they spot rate they get more dollars in the future, trading at a premium  Premium/Discount = spot rate – forward rate X 12 Forward rate. m/o forward o Usually cheaper than the option, but cant walk away from contract, less flexible

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Options: the right, but not the obligation, to buy or sell a foreign currency within a certain time period o Strike price: rate of currency per other currency o Charged a fee. More it benefits the company the higher the fee  The fee: the premium

o On day set to expire can compare the strike price with the spot rate choose whichever is less -

Futures: a contract specifies an exchange rate in advance of the actual exchange currency, less flexible than forward. Specific amount and maturity date o Traded on an exchange not OTC. Work with exchange brokers

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Top Exchanges for trading foreign exchange: mostly options and futures, are traded on the commodities exchange o OTC market, companies work directly with their banks to enter into forward and options contracts o Commodities exchange: buyers and sellers enter into contracts with each other without going through banks  3 best known: CME Group, NASDAQ QMX, and NYSE:ICE (intercontinental Exchange) Cash flow aspects of imports and exports o Commercial bill of exchange (draft): one party (drawer) directs another party (the drawee) to make a payment  Protect the buyer and seller  Sight draft: paid immediately  Time draft: payment made later o Letter of credit (L/C): not able to may payment on agreed time, irrevocable, currency needs to be specified o Confirmed letter of credit: exporter has the guarantee of an additional bank

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Other financial flows o Speculation: buying or selling of a commodity (foreign currency), that has an element of risk and a change of great profit. o Arbitrage: purchase of foreign currency on one market for immediate resale on another market o Interest arbitrage: investing in debt instruments (bonds) in foreign exchange to earn profit due to interest rate differentials

Case: Do Yuan to Buy some Renminbi? - Yuan joins reserve currencies known as SDRs (Special Drawing rights) o Chinas increasing dominance in the global economy and its moves in recent years to liberalize financial markets - China export more to US because low manufacturing wages - Many believed the yuan was undervalued and the governments should free the currency to seek a market level - 2005 delinked yuan peg to the US in favor of currency basket  rate rose - Exchange rate managed by SAFE State Administration of Foreign Exchange

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o Closely linked to PBOC o Establishing new foreign exchange trading guidelines as well as for managing foreign exchange reserves. Global financial crisis  yuan pegged against the U.S. dollar from 2008 -2010 Banks and companies issued bonds and securities in yuan  circulation of yuan outside of china grew ICAP PLC and Thomson Reuters began trading yuan on their electronic trading platforms o Use of electronic platforms increased transparency and traffic Fixed exchange rates set by Safe will be more important rate PCOB devalued the yuan again in 2015 to rekindle economic growth  giving market more freedom in setting rates  many companies paid off debt or switched currencies in fear of devaluation Yuan more accepted by banks than consumers As china moves closer to being a global currency, it will achieve greater control over global decision that used to be made by global reserve currencies To be accepted as a global currency, will need legal, political, and institutional reforms to inspire confidence in foreign investors...