The Foreign Exchange Market
International Corporate Finance
P.V. Viswanath
Market Organization
 The forex market is an electronically linked
network of banks, forex brokers and dealers.
 Trading is done by phone, telex or SWIFT (Society
for Worldwide Interbank Financial
Telecommunications), an international bankcommunications network.
 The purpose of the market is to permit transfers of
purchasing power denominated in one currency to
another.
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Market Organization
 The interbank market is a wholesale market in
which major banks trade with each other.
 In the spot market, currencies trade for immediately
delivery (within 2 business days).
 In the forward market, contracts are made to buy
and sell for future delivery.
 The swap market involves packages of spot and
forward contracts.
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Participants
 Foreign Exchange Brokers – specialists in matching net
supplier and demander banks.
 Arbitrageurs – seek to earn risk-free profits by taking
advantage of differences in interest rates among countries
 Traders use forward contracts to eliminate or cover the risk
of loss on export or import orders denominated in foreign
currencies.
 Hedgers (mostly multinationals) engage in forward contracts
to protect the home currency value of various foreign
currency-denominated assets and liabilities
 Speculators expose themselves to currency risk in order to
profit from exchange rate fluctuations.
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Clearing System
 Most electronic funds transfers involving international
transactions take place through the Clearing House
Interbank Payments System (CHIPS), a computerized
network developed by the New York Clearing House
Association. Most large US banks and US branches of
foreign banks are members of CHIPS.
 At the beginning of the day, each bank puts in a security
deposit into (prefunds) its CHIPS account.
 Interbank transfers during the day are processed
electronically through CHIPS.
 At the end of the day, all CHIPS member bank balances are
netted out and their balances remitted back to them using
Fedwire.
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How Fedwire Works
 The Fedwire system is used by the Fed’s member banks to make
interbank transactions. CHIPS is a clearing system, while Fedwire is
a mechanism to accomplish any interbank transaction.
 In a typical funds transfer, an individual or a business instructs its
bank to send a funds transfer.
 The sending bank debits the sender's account and initiates a fedwire
funds transfer.
 The Federal Reserve, in turn, debits the account of the sending bank
and credits the account of the receiving bank; the Fed notifies the
receiving bank about the transfer.
 The receiving bank credits the recipient's account and notifies the
recipient of the receipt of the funds. The transfer is final when the
funds are received. Funds can be used by the recipient immediately
thereafter.
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How CHIPS Works
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Spot Quotations: Direct and Indirect
 Direct quotation – home currency price of the foreign
currency quoted. In the US, this would be equivalent to
quoting in:

American terms (no. of US$ per unit of foreign currency). e.g. on
6/2/04, $1.2216 per €. This would be an indirect quote in Europe.
 Indirect quotation – foreign currency price of the home
currency. In the US, this would be equivalent to quoting in:

European terms (no. of units of foreign currency per $). e.g. on
6/2/04, €0.8186 per $. This would be a direct quote in Europe.
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Bid-ask spread
 The bid price of a security is the price which the person
quoting (e.g. a dealer) is willing to pay for it – the price at
which anybody can sell it.
 The ask price is the price at which the dealer is willing to
sell it – the price at which anybody can buy it.
 The bid-ask spread is the difference.
 The direct (American) quote for the euro on 6/2/04 was
1.2262 -67, i.e. you could buy a € for 1.2267 (ask), but if
you wanted to sell it, you could get only $1.2262.
 The spread is 0.0005 per €.
 The percentage spread is 100(Ask-Bid)/Ask =
100(0.0005)/1.2267 = 0.04%
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Cross rates
 Most currencies are quoted against the dollar; hence it may be
necessary to work out the cross rates for currencies other than the
dollar.
 For example, the euro was quoted on 6/2/04 at 1.2208 -12 (direct),
while the yen was quoted at 109.99 -04 (indirect).
 A Japanese trader who wants to buy the euro would, implicitly be
buying the dollar for yen and then trading the dollar for euros.
 100 yen would buy $(100/110.04) or $0.9088; this could be used to
buy €0.9088/1.2212 = €0.7442
 €1 would buy $1.2208, which would buy 1.2208(109.99) = 134.28
yen; to buy 100 yen, you would need €100/134.28 = €0.7447.
 Hence the (indirect) cross quote in Japan would be €0.7442 -7.
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Currency Arbitrage
 If traders quote currencies in terms of more than one base
currency, the possibility exists that the different quotes may
be inconsistent.
 Thus, if one dealer quotes the dollar against the € and the
same or another dealer quotes € against the yen, and there is
also a dollar quote against the yen, then consistency requires
that the cross dollar-yen quote equal the direct dollar-yen
quote.
 If it doesn’t, the possibility of making money by trading
against these dealers exists, assuming that the discrepancy is
sufficiently large to outweigh the bid-ask spreads in the two
transactions.
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Currency Arbitrage
 Suppose the pound is bid at $1.5422 in New York
and the euro is offered at $0.9251 in Frankfurt and
simultaneously, the pound is quoted at €1.6650, ask,
in London.
 An arbitrageur can sell £1 for $1.5422 in New York,
buy 1.5422/0.9251 = €1.6671 with the dollars in
Frankfurt, and finally buy 1.6671/1.6650 = £
1.0012391 with the euros, in London for a profit of
0.124%.
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Currency Arbitrage
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Settlement risk
 Settlement risk is the risk that a settlement in a transfer
system does not take place as expected.
 This can happen if one party defaults on its clearing
obligations to one or more counterparties.
 Settlement risk comprises both credit and liquidity
risks. The former arises when a counterparty cannot
meet an obligation for full value on due date and
thereafter because it is insolvent.
 Liquidity risk refers to the risk that a counterparty will
not settle for full value at due date but could do so at
some unspecified time thereafter, causing the party
which did not receive its expected payment to have to
finance the shortfall at short notice.
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The Case of Bankhaus Herstatt
 On 26th June 1974 the Bundesaufsichtsamt für das
Kreditwesen withdrew the banking licence of Bankhaus
Herstatt, a small bank in Cologne active in the FX market,
and ordered it into liquidation during the banking day but
after the close of the interbank payments system in
Germany.
 Prior to the announcement of Herstatt's closure, several of its
counterparties had, through their branches or
correspondents, irrevocably paid Deutsche Mark to Herstatt
on that day through the German payments system against
anticipated receipts of US dollars later the same day in New
York in respect of maturing spot and forward transactions.
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The Case of Bankhaus Herstatt
 Upon the termination of Herstatt's business at 10.30 a.m.
New York time on 26th June (3.30 p.m. in Frankfurt),
Herstatt's New York correspondent bank suspended
outgoing US dollar payments from Herstatt's account.
 This action left Herstatt's counterparty banks exposed for
the full value of the Deutsche Mark deliveries made (credit
risk and liquidity risk).
 Moreover, banks which had entered into forward trades with
Herstatt not yet due for settlement lost money in replacing
the contracts in the market (replacement risk), and others
had deposits with Herstatt (traditional counterparty credit
risk). (Source: http://riskinstitute.ch/140960.htm)
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The BCCI case, 1991
 An institution in London was due to settle on 5th July 1991 a
dollar/sterling foreign exchange transaction into which it had
entered two days previously with BCCI SA, London.
 The sterling payment was duly made in London on 5th July.
BCCI had sent a message to its New York correspondent on 4th
July (a public holiday in the United States) to make the
corresponding US dollar payment for value on 5th July. The
payment message was delayed beyond the time of the
correspondent bank's initial release of payments (at 7 a.m.) by
the operation of a bilateral credit limit placed on BCCI's
correspondent by the recipient CHIPS member.
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The BCCI case, 1991
 The payment remained in the queue until shortly before 4
p.m. (New York time), when it was cancelled by BCCI's
correspondent, shortly after the correspondent had received
a message from BCCI's provisional liquidators in London on
the subject of the action it should take with regard to
payment instructions from BCCI London. In this way, BCCI's
counterparty lost the principal amount of the contract.
 A major Japanese bank also suffered a principal loss in
respect of a dollar/yen deal due for settlement on 5th July,
since yen had been paid to BCCI SA Tokyo that day,
through the Foreign Exchange Yen Clearing System, and
the assets of BCCI SA in New York State were frozen
before settlement of the US dollar leg of the transaction
took place.
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The BCCI case, 1991
 The UK institution's loss illustrates a particular aspect of the
difficulties which face the private sector under current
circumstances in any attempt to coordinate the timing of
payments; in this instance, the loss would almost certainly
not have occurred but for the measures in place to reduce
risk domestically within CHIPS (the bilateral credit limit).
 Moreover, the closure of BCCI by the banking supervisors
illustrates that it is generally not possible to close a bank
which is active in the foreign exchange market at a time
when all the relevant payments systems have settled all its
transactions due on a given day. In this case, the closure
required the Luxembourg Court to appoint a liquidator, an
action which under Luxembourg law can take place only
within the normal business day of the Court.
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Forward Exchange Rates
 The forward exchange rate is the rate that is contracted
today for the exchange of currencies at a specified rate in the
future.
 A contract for such a simple exchange is an outright forward
contract.
 A swap contract is a combination of a spot contract and a
forward contract



A swap-in Canadian is an agreement to buy Canadian dollars spot
and sell Canadian dollars forward.
A swap-out is the reverse.
A forward-forward involves two forward contracts of different
maturities.
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Hedging with Forwards
 The forward market can be used to hedge foreign exchange risk.
 Suppose a US company buys textiles from England with payment
of £1 m. due in 90 days. The importer is implicitly short pounds.
If the pound were to rally during the next 90 days, the importer
would lose out – he would have to pay a larger amount in dollars.
 He could go long in the forward market, i.e., buy pounds for
forward delivery in 90 days.
 Suppose he can negotiate a forward rate of $1.72 per £1. In 90
days, the bank will give him £1m. and he will give the bank
$1.72m., irrespective of how the exchange rate changes.
 Implicitly, his loss/gain in the forward market is offset by his
gain/loss in the spot market.
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Hedging with Forwards
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Forward Market Transactions
 If the actual price is quoted, it’s called an outright quote.
 In the interbank market, the forward rate is quoted as a
discount/premium from the spot. This is called the swap
rate. The difference is known as points.
 On 6/2/04, the spot GBP/USD quote was 1.8350/ 1.8355 on
Moneyline.
 The one-year forward rate was quoted as -536.25/-533.25
 This implies an outright quote of (1.8350-.053625)/ (1.8355.053325) or 1.781375/ 1.782175.
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Forward rates
On June 2, 2004, the GBP/USD spot rate was 1.8302/1.8323 and the forward
rates on www.ozforex.com.au were:
Forward Points
Period
1
Month
3
Month
12
Month
Bid
Outright Forward Rates
Ask
Period
Bid
Ask
-0.005080
-0.004890
1 Month
1.825090
1.827360
-0.015090
-0.014540
1.815090
1.817710
-0.050810
-0.050010
3 Month
12
Month
1.779370
1.782240
We can compute the implied forward discount as
(forward – spot)/spot x (360/#days).
Hence the 3-month pound bid is quoted at a discount of 3.33%, since
[(1.81509-1.8302)/ 1.8302]x(360/90) = -0.033
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