Fin 308 Test 1 Study Sheet

Chapter 5 FX Market:

FUNCTIONS ♣ Transfer purchasing power between countries ♣ Obtain/provide credit for international trade transactions ♣ Minimize exposure to the risks of exchange rate changes

PARTICIPANTS ♣ Bank & nonbank FX dealers ♣ Individuals and firms ♣ Speculators and arbitragers ♣ Central banks and treasuries ♣FX brokers

FX MARKET SUMMARY ♣ Global trading day - 24 hours - Dominated by London and New York ♣ Market size - Daily global net turnover in the FX market was USD 5.3 trillion in April 2013 ─ more than 12 times the global equity markets - London and New York make up roughly 60% of the FX market - Asian markets growing more rapidly than European markets ♣ Currency composition - US $ involved in 86% of currency trading - USD/EUR and USD/JPY make up 42% of trading - Big three ($, €, ¥) total roughly 92% of trading

FX TRANSACTIONS ♣ Spot (cash) market - Immediate transfer of a commodity or financial security ♣ Forward market - An agreement made today to purchase or sell a currency at a future date - Typical maturities 1, 2, 3, 6 and 12 months - All terms (the good, price, future date) are agreed today - Both buyer and seller remove price risk - Outright forward: requires delivery of the specific amount of currency - Nondeliverable forwards (NDFs): settled in cash ♣ Futures - A standardized forward contract that is traded on a commodity or security on an exchange ♣ Options - An option gives the buyer or seller the right, but not the obligation to buy or sell, a certain quantity of the underlying asset (currency) at a predetermined (strike or exercise) price on or before the expiration date ♣ Swap transactions

QUOTES ♣ A foreign exchange rate is the price of one currency expressed in terms of another currency CUR1/CUR2 ♣ CUR1 = base currency or one unit of the currency ♣ CUR2 = price currency or quote currency (??? units of the other currency) ♣ € 1.00 = $ 1.1008 ♣ 

EUROPEAN TERMS ♣ the amount of a foreign currency US $ 1.00 can buy ♣ US $ is priced in term of the foreign currency ♣ USD/CAD 1.2734 ♣ $ is base currency (1 unit) ♣ C$ is price currency (??? units) ♣ Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy US $ 1.00 ♣

AMERICAN TERMS ♣ the amount of US $ a unit of the foreign currency can buy ♣ the foreign currency is priced in term of the US $ ♣ €/$ 1.1008 ♣ 1 € = 1.1008 $ ♣ Euros, British pounds, Australia dollars, and New Zealand dollars ♣American Term = 1/European Term

DIRECT QUOTE ♣ The price of a unit of the foreign currency in home currency price (US $) ♣ A foreign exchange rate quoted as the price of the domestic currency per 1 unit of the foreign currency ♣ American terms - €/$ 1.1008 ♣ On WSJ, direct quote = In US$ or USD equivalent ♣ If you work in a bank in Dublin, the direct quote would be $/€ 0.9084

INDIRECT QUOTE ♣ The foreign currency price of one unit of home currency (US $ 1.00) ♣ The amount of foreign currency required to buy one unit of the domestic currency ♣ European terms (most currencies) o $/¥ 123.38 ♣ On WSJ, indirect quote = Per US$ or Currency per USD Indirect Quote = 1/Direct Quote

MARKET CONVENTION SUMMARY♣American:coming to USA, how much USD can you buy w/ 1 unit of foreign currency? CUR1/USD, EUR/USA1.1008♣European:Going to Europe, how many units of foreign currency can you buy with 1 USD? USD/CUR2, USD/CHF0.9451 ♣(American)Direct: direct quote on Euro, home price USD of one Euro. (European)Indirect: indirect quote on USD, how many unit (SF) of one USD.

BOOK NOTATION ♣ $ 1.1008/€ = €/$ 1.1008 ♣ Fr. 0.9541/$ = $/Fr. 0.9451 ♣ the second currency (the one at the bottom or the denominator) is always 1 unit

[pic 1]BID/ASK RATES ♣ Bid price ─ the price (exchange rate) in a currency a dealer will buy another currency ─ the price you get when selling the currency to the dealer ─ €/$ 1.2170 ♣ Ask price ─ the price (exchange rate) in a currency a dealer will sell another currency ─ the price you pay when buying the currency from the dealer ─ €/$ 1.2178 ♣ Bid-ask spread ─ dealer profit = 0.008 ♣ Mid-point quote = 1.2174

% CHANGE IN SPOT RATES ♣ Beginning spot rate = USD/MXN 10.00 - Ending spot rate = USD/MXN 11.00 - Book notation Beginning spot rate (ST) = Ps 10/$ Ending spot rate (St+1) = Ps 11/$ - $ buys 1 more Ps ─ $ appreciates against Ps –% change of $ = (𝑆t+1/St) − 1 = 11/10 − 1 = 10% - Ps buys less $ ─ Ps depreciates against $ - % change of Ps = (1/𝑆t+1 − 1/𝑆t)/ (1/𝑆t) = (0.09091 − 0.1)/ (0.1) = −9.09% - % -change of Ps = (𝑆t− 𝑆t+1)/(𝑆t+1) = (𝑆t)/(𝑆t+1)−1 = (10)/(11)−1 = −9.09%

FORWARD QUOTATIONS ♣ Forward rate specifies the exchange rate today for the future sale or purchase of foreign currency and must be honored by the parties involved.

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