Flashcards in Currency Deck (9):
The foreign exchange (currency or forex or FX) market exists
1. one currency is traded for another.
2. largest market in the world, in terms of cash value traded,
3 includes trading between l
and other financial markets and institutions.
Spot FX deals are
delivered in two working days’ time, with settlement actually taking place in the two separate countries (even though the deal may be done in a third country).
Generally, currencies are almost always quoted against the US dollar and trades are known by shorthand codes such as:
“Cable” (Sterling – US dollar)
“Swissy” (Swiss franc – US dollar)
“Euros” (Euro – US dollar)
“Bill and Ben” (Japanese yen – US dollar).
Settlement will be on the same “working day” in both countries, but because of time zone differences, settlement will take place earlier in the Far East, followed by Europe and then in the USA. The resulting settlement risk is sometimes referred to as “Herstatt risk” following the bankruptcy of the Herstatt Bank in Germany in 1974 causing it to default on the foreign currency it owed to counterparties.
It was 4:30 pm in Germany and 10:30 am in New York on the 26th June 1974 when Herstatt's licence was withdrawn by German regulators due to a lack of income and capital to cover liabilities that were due. Unfortunately some banks had already paid Deutsche Marks (Euros now) to Herstatt during the day, believing that US dollars would be returned later the same day. When the licence was withdrawn, Herstatt stopped all its outgoing dollar payments and the banks never got their money!
Currency market quotes
Most international markets use “direct” or “normal” quotes (domestic per unit of foreign currency), but London uses “indirect” or “reciprocal” quotes (foreign per unit of domestic currency). Dealers quote in the form of a “bid – ask spread”, thus when combining quotes to calculate a “cross-rate” (where neither of the currencies is US dollars) it is important to use the correct values from the standard quotations.
Due mainly to historical precedent, FX rates are quoted in one of two formats:
1. domestic value of foreign currency unit (eg in the US, one British pound is worth US$1.5050)
2 number of foreign currency units per domestic unit (eg in the US, 107.00 yen purchases US$1).
For simplicity in their domestic markets, most international markets quote currencies using the first format. Format 1 quotes are simply the reciprocal of 2, and vice-versa. For example, $/yen 107.00 can be converted from 2 to 1 as 1/107.00=.009346.
The other main type of deal on the FX market is the forward rate, which is the guaranteed price agreed today at that the buyer will take delivery of the currency on a specific future date. For most major currencies, the most liquid forward contracts are in the 1–6 month maturities, although forward deals in some currencies are available for 3 to 5 years ahead. The market makers in the FX market are mainly the large banks.
Example of na currency forward
Company X in the UK agrees to sell aircraft parts to Company Y in the US for $9,000,000. The terms of the deal only call for payment after the goods are shipped. So, you will not receive payment for 90 days.
To secure the UK £ sterling equivalent, Company X sells dollars to Bank Z with a settlement date of 90 days in the future. If the forward exchange rate was 1.5, it would agree to swap $9,000,000 with £6,000,000 in 90 days’ time.
At maturity, Company X transfers the $9,000,000 to Bank Z’s account and its account would be credited with £6,000,000.
Pricing of currency forward contracts is
known as “Covered interest parity” (CIP) and involves the spot rate and money market interest rates in the two countries. If rd and rf are the interest rates in the domestic and foreign markets and F and S
are the forward and spot rates, then, for a one year contract: F = S ¥ (1 + rd ) (1 + rf )
In practice, outright forward rates do not usually appear on a dealer’s screens. Instead, “forward points” are quoted where forward points = F - S . Thus the “outright” forward rate is the spot rate plus forward points.
The actual forward rate quoted can be
compared with a “synthetic” forward rate calculated by looking at the cost of borrowing funds in the domestic market and switching the funds into the foreign currency on the spot market and earning foreign interest. If the actual forward rate does not equal the synthetic forward rate then a riskless arbitrage profit is available. Such arbitrage profits could be assumed to be short lived in nature, although practical complexities such as bid – ask spreads and other transaction costs may influence this.
Speculation in the forward market is based on
views about the likely movement of spot rates over the term of the forward contract.
Suppose the current (July 200X) quoted dollar sterling forward rate is F0 = 1.64 ($ £) for delivery on October 200X.
Suppose you believe the spot rate in October will be ST = 1.66($ £), ie you believe that sterling will be worth more in the cash market in
October than indicated by the current forward rate.
If your guess about ST turns out to be correct then you can make a