This is Not an easy chapter. I recommend you read this one at least two times.
Foreign Exchange and Eurocurrency markets
Basic outline of chapter:
Discussion of Market
Organization
Efficiency
Players
Typical transaction
Size of Market
Quotes
RULES
Types of transactions (Forward and spot)
Premiums and discounts
Intro to Hedging
Eurocurrency Market
- Largely free of regulation-no reserve requirements, no interest laws, etc.
- Very competitive markets
- Very efficient (all types of efficiency)
Ask-Price the market maker is willing to sell at.
In other words, the bid rate is the rate at which they will take deposits and the ask price (offer price) is the rate at which they will make loans.
The difference is called a spread.
As London is most active market, the London Interbank Bid Rate (LIBID) and the London Interbank Offer Rate (LIBOR).
Thus, LIBID is the rate at which banks will accept deposits from other banks, whereas the LIBOR is the rate at which the bank will loan to other banks. The difference is the interbank spread.
In the Eurocurrency markets the spreads are much smaller than in domestic US markets. For example, the spreads in US markets may be 2% (difference in loan and deposit rates). The spread for a Eurocurrency loan - deposit may be 0.5%. Why the difference?
Fewer regulations, shorter term loans, floating rates, more competition,
no reserve requirements.
Foreign Exchange Market
Spot Market--for immediate delivery (2 business days for large deals, more
for smaller deals)
Forward Market-exchange will be made at some point in the future
Roughly $2 trillion changes hands daily (based of of $1.5 trillion estimate for April 1998).
London is the most active, followed by NY and Tokyo but many others are quite close.
Players
Dealers-example commercial banks
Brokers-handle about of third of the transactions
Governments-both buyers and sellers
Corporations
Domestic Banks
Individuals
Small Businesses
Foreign Exchange Rates and Quotations
Two rules
Always keep track of currencies
Always think of buying or selling the currency in the denominator of the
quote.
Example $.5841/DM implies you are selling DM for roughly 58 cents.
In other words it would cost $584,100 for 1 million deutsche marks.
European and American Quotes for the Dollar
Generally if the dollar is involved it is in the denominator. This is called European Terms. Used except when dealing with the British pound. If the dollar in the the numerator, then it is called American Terms.
Direct and Indirect Quotes for foreign Exchange
It is more common to use indirect quotes. Indirect
Quotes state the price of the domestic currency in foreign currency terms.
For example, DM1.712/$ Bid DM1.7130/$ Ask. (you can think of this as the dollar is worth 1.71DM.) This means the bank is willing to buy dollars for DM1.712/$ and sell dollars at DM1.713/$.Direct quotes state the domestic currency price of one unit of foreign currency.The confusion typically begins. Why? Because the above transaction also implies that the sell marks at DM1.712 and buy marks at DM1.713/$.
For example:So far we have been working what would be an indirect quote to US citizens. To convert direct to indirect quote all we need to do is to take the reciprocal. Thus 1/direct quote = indirect quote. However we also have to be careful to switch sides. (a quote to buy dollars is a quote to sell DM).A quote of $0.5838/DM Bid and $0.5841/DM Ask would be a direct quote for a US citizen. (note--this means the bank is willing to buy DM at $.5838 and sell them at $.5841 for a spread of .0003). You can think of this as each DM is worth approximately 58 cents.Thus, in the above example:
1/(DM1.712/$) Bid 1/(DM1.7130/$) Ask. Thus, $.5838/DM Bid and $.5841/DM Ask. Which means the German Bank is willing to buy at $.5838/DM and sell DM at $.5841/DM. This across the top of the below table.
Bid (you are selling, dealer buying) Ask (you are buying, dealer selling) Buying or selling DM $.5838/DM $.5841/DM Buying or selling $ DM1.712/$ DM1.713/$
One way to understand this is to remember what you are you. The market maker will then take the opposite side of each trade. So if you are selling dollars, the market maker is buying dollars.
Once you determine what you are doing (buying or selling) and what you want to sell foreign exchange transactions are not that bad. But getting to that point can be quite confusing.
Example:Now if you wanted to convert back to dollars, you would have the following:
You have $100 to convert into DM. Since you have $ and want DM, you would like the quote to be in DM/$. Thus look This means you are selling dollars . Thus only look under the BID. This is in the lower two boxes below. Further you have dollars to sell, this means the dealer must buy. Therefore you end up with, $100 * 1.172DM/$= 171.20 DM.
Bid (you are selling, dealer buying) Ask (you are buying, dealer selling) Buying or selling DM $.5838/DM $.5841/DM Buying or selling $ DM1.712/$ DM1.713/$
DM171.20* ($0.5838/DM)= $99.9486
Confused yet? No? good. Now suppose the following quote:
DM1.713/$ Bid DM1.712/$ Ask.
In this quote the bid price is greater than the offer. This means the the currency in the numerator is being bought and sold. In other words, the bank is willing to sell DM1.712/$ and buy at DM1.713/$. Remember that selling DM is equivalent to buying Dollars. So the bank is willing to buy dollars at DM1.712/$ and is willing to sell dollars at DM1.713/$. This is the same as above.
Forward Premiums and Discounts
Forward Premium is when the forward market is higher than the spot market.
Forward Discount is when the forward market is higher than the spot market.Can be expressed as a basis point spread or in percentage terms.
If the spot rate of DM is $0.5839/DM and the six-month forward rate is $.5756/DM. Thus, the DM is selling at a six-month forward discount of $.0083 DM ($0.5839/DM - $.5756/DM).These premiums (or discounts) are usually quoted in annualized terms. To find the annual percentage discount us:
[(Forward rate- Spot Rate)]/Spot Rate]*the number of compounding periods per year.This only worked for the currency in the denominator.
Remember if you have a currency in the numerator, it is easy to put it in the numerator by taking the reciprocal.Exposure and Hedging
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