Unique Source of Forex

Foreign Exchange Dealers

The market is made up of 2000 foreign exchange dealers. These are mostly commercial banks and investment banks. They trade with customers and with each other.
They are linked through telephones, computers and other electronic means.
There are about 100 – 200 market-making banks that account for the bulk of the trading.
The dealers don’t trade physical currency; they trade bank accounts denominated in different currencies.

by Stock Specialist ~ Saturday, October 31, 2009 0 comments

London is the largest market

London’s size as a financial centre is partially due to its historical importance and it relative lack of regulation.
London benefits from its proximity to major Eurocurrency markets.
London benefits from its time zone: London’s morning overlaps with late trading in the Far East and London’s afternoon overlaps with New York.
Most of the trading in London is done by foreign-owned institutions.

by Stock Specialist ~ Friday, October 30, 2009 0 comments

It is a 24-hour market

The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore.
A few hours later, trading begins in Bahrain.
Late in the Tokyo day, markets open in Europe.
In the early afternoon in Europe, markets open in the United States.
In the mid to late afternoon in New York, markets open in the Asia-Pacific area.
Most of the activity takes place when European markets are open.

by Stock Specialist ~ Thursday, October 29, 2009 0 comments

Reasons for the Changes

The fall in 2001 was due to: the introduction of the euro, consolidation in the banking sector, mergers in the corporate sector.
The recent rise is more difficult to explain in terms of fundamentals.

by Stock Specialist ~ Wednesday, October 28, 2009 0 comments

From a 1998 publication by the NY Fed:

Individual trades of $200 – 500 million are not uncommon.
Quoted prices change as often as 20 times a minute.
It is estimated that the world’s most active exchange rates can change 18,000 times a day.

by Stock Specialist ~ Tuesday, October 27, 2009 0 comments

The Foreign Exchange Market

The foreign exchange market is by far the largest and most liquid financial market in the world.
It is many times larger than the next largest market: the US government securities market.
Despite its size and importance of the foreign exchange market, it is largely unregulated. No international organization supervises it; no international institution sets rules.

by Stock Specialist ~ Monday, October 26, 2009 0 comments

Theory #4: Expectations theory of forward rates

Main idea:
The forward rate equals expected spot exchange rate

With risk, the forward rate may not equal the spot rate

If Group 1 predominates, then E(s€/$) < f€/$
If Group 2 predominates, then E(s€/$) > f€/$

by Stock Specialist ~ Sunday, October 25, 2009 0 comments

Example of capital market equilibrium

Fisher condition in U.S. and France:
(1 + r$(Real)) = (1 + r$) / (1 + i$)
(1 + r€(Real)) = (1 + r€) / (1 + i€)

If real rates are equal, then the Fisher condition implies:

The difference in interest rates is equal to the expected difference in inflation rates

by Stock Specialist ~ Saturday, October 24, 2009 0 comments

Theory #3: The Fisher condition

Main idea: Market forces tend to allocate resources to their most productive uses

So all countries should have equal real rates of interest

Relation between real and nominal interest rates:

(1 + rNominal) = (1 + rReal)(1 + i )

(1 + rReal) = (1 + rNominal) / (1 + i )

by Stock Specialist ~ Friday, October 23, 2009 0 comments

Evidence on interest rate parity

Does interest rate parity hold?
Which way will funds flow?
How will this affect exchange rates?

Evidence on interest rate parity

Generally, it holds
Why would interest rate parity hold better than PPP?
Lower transactions costs in moving currencies than real goods
Financial markets are more efficient than real goods markets

by Stock Specialist ~ Thursday, October 22, 2009 0 comments

Interest rate parity

Main idea: Either strategy gets you the 100,000€ when you need it.
This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates

by Stock Specialist ~ Wednesday, October 21, 2009 0 comments

Example of a forward market transaction

Suppose you will need 100,000€ in one year

Through a forward contract, you can commit to lock in the exchange rate

f$/€ : forward rate of exchange
Currently, f$/€ = 1.19854 Þ 1 € buys $1.19854
Þ 1 $ buys 0.83435 €

At this forward rate, you need to provide $119,854 in 12 months.

by Stock Specialist ~ Tuesday, October 20, 2009 0 comments

Theory #2: Interest rate parity

Main idea: There is no fundamental advantage to borrowing or lending in one currency over another

This establishes a relation between interest rates, spot exchange rates, and forward exchange rates

Forward market: Transaction occurs at some point in future
BUY: Agree to purchase the underlying currency at a predetermined exchange rate at a specific time in the future
SELL: Agree to deliver the underlying currency at a predetermined exchange rate at a specific time in the future

by Stock Specialist ~ Monday, October 19, 2009 0 comments

What is the evidence?

The Law of One Price frequently does not hold.
Absolute PPP does not hold, at least in the short run.
See The Economist’s Big McCurrencies
The data largely are consistent with Relative PPP, at least over longer periods.

by Stock Specialist ~ Sunday, October 18, 2009 0 comments

Relative PPP

Absolute PPP:

For PPP to hold in one year:

P€ (1 + i€) = E(s€/$) · P$ (1 + i$),

or: P€ (1 + i€) = s€/$ [E(s€/$)/s€/$ )] · P$ (1 + i$)

Using absolute PPP to cancel terms and rearranging:

Relative PPP:
Relative PPP
Main idea – The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates:

by Stock Specialist ~ Saturday, October 17, 2009 0 comments

Absolute PPP

If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:
May 21 : s€/$ = P€ / PUS
= 1235.75 € / $1482.07 = 0.8338 €/$

May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$

by Stock Specialist ~ Friday, October 16, 2009 0 comments

Absolute PPP

Extension of law of one price to a basket of goods
Absolute PPP examines price levels
Apply the law of one price to a basket of goods with price P€ and PUS (use upper-case P for the price of the basket):

where P€ = Si (wFR,i · p€,i )
PUS = Si (wUS,i · pUS,i )

by Stock Specialist ~ Thursday, October 15, 2009 0 comments

The Law of One Price

Example:
Price of wheat in France per bushel (p€) = 3.45 €
Price of wheat in U.S. per bushel (p$) = $4.15
S€/$ = 0.83215 (s$/€ = 1.2017)

Dollar equivalent price
of wheat in France = s$/€ x p€
= 1.2017 $/€ x 3.45 € = $4.15

Þ When law of one price does not hold, supply and demand forces help restore the equality

by Stock Specialist ~ Wednesday, October 14, 2009 0 comments

Theory #1: Purchasing power parity

The Law of One Price

A commodity will have the same price in terms of common currency in every country
In the absence of frictions (e.g. shipping costs, tariffs,..)

Example
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P$
S€/$ = spot exchange rate

by Stock Specialist ~ Saturday, October 10, 2009 0 comments

The Foreign Exchange Market - Four theories

Theory #1: Purchasing power parity

Theory #2: Interest rate parity

Theory #3: The Fisher condition

Theory #4: Expectations theory of forward rates

by Stock Specialist ~ Thursday, October 8, 2009 0 comments

The Foreign Exchange Market - Definitions

r$ : dollar rate of interest (r¥, rHK$,…)
i$ : expected dollar inflation rate
f€/$ : forward rate of exchange
s€/$ : spot rate of exchange
“Indirect quote”:
s€/$ = 0.83215 Þ 1 $ buys 0.83215 €
“Direct quote”:
s$/€ = 1.2017 Þ 1 € buys $1.2017

by Stock Specialist ~ Wednesday, October 7, 2009 0 comments

The Foreign Exchange Market...

Some basic questions

Why aren’t FX rates all equal to one?

Why do FX rates change over time?

Why don’t all FX rates change in the same
direction?

What drives forward rates – the rates at
which you can trade currencies at some future
date?

by Stock Specialist ~ Monday, October 5, 2009 0 comments

The Foreign Exchange Market

Some currency rates as of May 21, 2004:

Per U.S. dollar:
Brazil (Real) 3.1939
Mexico (Peso) 11.5754
Japan (Yen) 112.2839
Indonesia (Rupiah) 89066
South Africa (Rand) 6.7295
United Kingdom (Pound) 0.5593

by Stock Specialist ~ Sunday, October 4, 2009 0 comments

Foreign Exchange Markets

The foreign exchange (FX) market

Basic questions and definitions

Four theories

- Purchasing Power Parity

- Interest Rate Parity

- Fisher condition for capital market equilibrium

- Expectations theory of forward rates

by Stock Specialist ~ Thursday, October 1, 2009 2 comments

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