Chapter 2 Foreign Exchange
Unit 2
LEARNING OUTCOMES 学习效果:
At the end of this lecture, students should be able to
understand how the forex market functions and how the banks profit in forex tradings
examine the nature and operation of each traded instrument in forex market
explain how the forward exchange contract is used to cover the ex-rate risk
FOCUS AND DIFFICULTIES 知识重难点:
Focus: How do banks earn profits from foreign exchange transactions in the interbank market; distinguish the forward transaction from spot transaction; ex-rate risk;
Difficulty: examine the operation of swaps, options.
LECTURE VIDEO 授课视频:
LEARNING OUTLINE 学习大纲:
1. How the forex market functions?
a. The foreign exchange market functions at three levels:
(1) transactions bewteen commercial banks and their cumstors who are the ultimate demanders and suppliers of foreign exchange. Exporters, importers, international investors, and tourists buy and sell foreign exchange from and to commercial banks.
(2) foreign exchange tradings between domestic banks with one another through the services of foreign exchange brokers. The trading banks can turn to a broker to buy or sell foreign currency. And, brokers are paid a commission for their services by the trading banks.
A broker经纪人或经纪商 is a person who executes the trade orders on behalf of their customers, whereas a dealer坐市商或做市商 is a person who executes trades for its own account.
(3) tansactions between the trading banks and their overseas branches or foreign correspondents.
The foreign exchange tradings done with customers is called retail part of the market; while, the foreign exchange tradings between bankers form the interbank part of the forex market.
b. Retail part of the forex market:
Consider a U.S. firm that purchased one car from one Germany producer and now is making the payment for it. And the Germany producer will accept payment only in euros, 50,000 euros per car.
Then the U.S. firm contacts its US bank and requests a quotation of the exchange rate for selling $ and purchasing euro, namely 1.1 euros =1 dollar. If the rate is acceptable, the US firm instructs its bank to take the $45454.55 (=50000 euros÷1.1 euro/$) from its demand deposit (checking) account, to convert these dollars into euros, and to transfer the 50000 euros to the Germany producer.
Since the US bank holds euro demand deposits at its branch or correspondent bank in Bonn, the US bank instructs its correspondent bank in Bonn to take euros from its demand deposit account and transfer the euros to the Germany producer by transferring 50000 euros to the producer's demand deposit account.
c. Interbank Foreign Exchange Trading:
Through the electronic trading platforms such as EBS or Reuters dealing facilities, currency exchanges in the interbank market are negotiated on computer terminals; a push of a button confirms a trade.
In the interbank market, currencies are traded in amounts involving at least 1 million units of a specific foreign currency.
Banks trade currencies to earn profits for their own accounts and also provide trading services for their customers such as corporations, government agencies and wealthy private individuals.
Banks trade with customers less than 1 million currency units, called retail transactions;
Banks trade with other banks or large corporate customers more than 1 million currency units, called wholesale transactions.
d. How do banks earn profits from foreign exchange transactions in the interbank market:
(1) Banks who simultaneously purchase and sell foreign currency earn profits from a currency's bid/offer spread.
Bid rate买价- the price that a bank is willing to pay for a unit of foreign currency
Offer rate卖价- the price at which a bank is willing to sell a unit of foreign currency
Spread价差- the difference between the bid and the offer rate
At any given time, a banks' bid quote for a foreign currency will be less than its offer quote. The use of bid and offer rates allows banks to make profits on foreign exchange transactions.
(2) Banks can profit by anticipating correctly the future direction of currency movements.
Suppose Citibank expects Japanese yen to appreciate against the U.S. dollar.
Citibank will likely raise both bid and offer rates ($/yen), which encourage other traders to sell yen to Citibank and discourage other traders from buying yen from Citibank.
Thus, Citibank could stock a larger amount of yen in balances.
If the yen indeed appreciate as predicted, the Citibank can sell the yen at a higher rate in the future and earn a profit.
However, we need realize that if exchange rates move in an opposite, unexpected direction as predicted, Citibank would suffer the losses. Therefore, a bank's foreign exchange dealers are subject to position limits头寸限量--the amount of buying and selling that can be conducted in a given currency.
2. Types of Foreign Exchange Transactions
Foreign exchange transactions banks typically engaged in include spot, forwards, swaps, options and other products.
a. Spot transaction is where you can make an outright purchase or sale of a currency now as in “on the spot”, known as immediate exchange.
It means once the exchange is agreed, the delivery of currencies will generally take place in two working days. And the spot exchange rate is the price for immediate exchange and at or close to the current market rate.
b. Exchange rate risk:
For many international trade activities, payments are not made today until sometime in the future. Typically we don't know for sure how the exchange rates will be in the future to translate one currency into another.
Hence, the value of foreign currency denominated assets or debts might be affected by the unpredicted ex-rate movements in the future, which is defined as the exchange rate risk.
Spot transactions carry with the ex-rate risk. While, a forward transaction will protect the trader against unfavorable movements in the exchange rate and allow the trader to lock in the future home-currency receipt/payment in advance.
c. Forward foreign exchange contract is an agreement to exchange one currency for another on some date in the future at a price set now (the price is namely the forward exchange rate).
Different with the spot transaction, the maturity/settlement date in a forward contract could be a few months, such as 30, 90, and 180 days forward. And the price for exchanging currencies is fixed today when the contract is initially signed. Therefore, in a forward transaction, the buyer and seller are locked into a contract at a fixed price which cannot be affected by any changes in the market exchange rates.
Consider that a U.S. importer need to pay 105,000 yen of a car to the Japanese producer on Oct. 1, 60 days from now on. To guard against the possibility of the yen's appreciation in the future, the US importer can enter into a forward contract to buy 105,000 yen for 60-day delivery at today's 60-day forward rate of 106 JPY/USD. It means on the maturity date--October 1--the U.S. importer will carry out the contract by taking $991 to obtain 105000 yen for sure. No matter what the future market exchange rate is, the exchange amounts are fixed today.
d. Foreign exchange swap, the most actively trade instrument in forex market, is an agreement to exchange one currency for another today, and at a specified time in the future reverse the exchange of these two currencies with identical amounts.
Therefore, a foreign exchange swap has two legs - a spot transaction and a forward transaction - that are executed simultaneously for the same quantity, and therefore offset each other. It permits companies to meet their foreign exchange needs over a period of time.
e. Slightly differ from the foreign exchange swap, the currency swap usually involves three basic steps: initial exchange of principal amounts in two currencies, ongoing exchange of interest payments in these two currencies, the re-exchange of identical principal amounts in same currencies at maturity.
d. An option is simply an agreement between a holder(buyer) and a writer(seller) that gives the holder(buyer) the right but not the obligation, to buy or sell an underlying asset at a fixed price on or before a given date. While, writer (seller) has the obligation to fulfill a transaction.
Vocabulary associated with options:
◆ Exercising the option refers to the holder's act of buying or selling the underlying asset;
◆ Strike or exercise price refers to the fixed price in the option contract at which the holder can buy or sell the underlying asset;
◆ Expiration date refers to the maturity date of the option, after this date, the option is dead;
◆ An American option may be exercised at any time before the expiration date.
◆ A European option can only be exercised on the expiration date.
◆ Premium is the fee the writer of the options contract receives.
The holder(buyer) exercises the option only if it is a profitable thing to do so.
Call option看涨期权 gives the holder the right to buy an asset(stock, currency, etc.) at a strike price at a specified date.
Put option看跌期权 gives the holder the right to sell an asset at a strike price at a specified date.
Foreign currency/exchange options provide the holder the right to buy or sell a fixed amount of foreign currency at a prearranged price within a specified date. It is used by firms (speculators) seeking to hedge against rate risk (to make a profit).
