Foreign exchange market

1. Foreign Exchange Market

2. 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 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

3. The Currency Market Where money denominated in one currency is bought and sold with money denominated in another currency. International Trade and Capital Transactions: facilitated with the ability to transfer purchasing power between countries.

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

5. Participants in the foreign exchange market Participants at 2 Levels 1. Wholesale Level (95%) - major banks 2. Retail Level (business customers) Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2 nd business day 2. Forward Market: - transactions take place at a specified future date

6. Participants by Market Spot Market commercial banks Brokers customers of commercial and central banks Forward Market a. arbitrageurs b. traders c. hedgers d. speculators

7. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers. B. FedWire - operated by the Fed - used for domestic transfers

8. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market B. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity

9. 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

10. Foreign Exchange Market and Insurance Against Foreign Exchange Risk 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 : 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

11. Foreign Exchange Market and Insurance Against Foreign Exchange Risk open foreign exchange position : 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

12. 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

13. 3. Foreign Exchange Market Participants Economic Agents and Types of Activities on Foreign Exchange Markets

14. 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

15. 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 Economic Agents and Types of Activities on Foreign Exchange Markets

16. 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 Types of Activities on Foreign Exchange Markets

17. 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)

18. 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

19. 4. Size and Structure of Foreign Exchange Market Transactions the biggest share of all financial markets in the world

20. 5. 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

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

22. Hedging the act of reducing exchange rate risk Forward Rate Quotations Two Methods: Outright Rate: quoted to commercial customers. Swap Rate: quoted in the interbank market as a discount or premium.

23. Futures positions Futures are similar to forwards First, futures positions require a margin deposit to be posted and maintained daily . If a loss is taken on the contract, the amount is debited from the margin account after the close of trading. In other words, these futures are cash settled and no underlying instruments or principals are exchanged . Secondly, all contract specifications such as expiration time, face amount, and margins are determined by the exchange instead of by the individual trading parties.

24. 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 (rigid ity !)

25. similarities and differences between outright forward contract and futures : both need to be executed unconditionally they are usually established for at most one year

26. Options Options are a way of buying or selling a currency at a certain point in the future . An option is a contract which specifies the price at which an amount of currency can be bought at a date in the future called the expiration date. Unlike forwards and futures, the owner of an option does not have to go through with the transaction if he or she does not wish to do so.

27. Types of options The buyer of a call has the right but not the obligation to buy the underlying asset at the strike price on or before a specified date in the future. However , the seller has a potential obligation to sell the underlying asset at the strike price on or before a specified date in the future if the holder of the option exercises his or her right. The buyer of a put has the right but not the obligation to sell the underlying asset at the strike price on or before a specified date in the future . On the other hand, the seller of a put has a potential obligation to buy the underlying asset at the strike price on or before a specified date in the future if the holder of the option exercises his/her right.

28. 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 three different prices : exercise/strike price cost, price or value of the option underlying or actual spot exchange rate

29. 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

30. 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 Options

31. 6. 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 )

32. 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.