Chap A

International Financial Management P G Apte P.G.Apte International Financial Management

1

CURRENCY MARKETS •The foreign exchange market is the market in which currencies are bought and sold against each other. •The interbank foreign exchange market is an overthe-counter (OTC) market. Daily turnover about $1.5 trillion. Average transaction is about USD 4 million •The participants in the wholesale market are commercial banks, investment institutions, corporations and central banks. Currency brokers act as middlemen between dealers •A small number of currencies account for bulk of turnover: USD, GBP, EUR, CHF, CAD, JPY, DEM, AUD P.G.Apte International Financial Management

2

CURRENCY MARKETS •Among the participants, primary price makers or professional dealers make a two-way market to each other and to their clients •Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market-making banks •Corporations usually are price takers. However, some nonbank, non-financial companies do act as market makers. •Large money centre banks deal in a large number of currencies. Smaller banks have a restricted range.

P.G.Apte International Financial Management

3

CURRENCY MARKETS Geographically, the markets span all the time zones from New Zealand to the West coast of the United States. When it is 3.00 p.m. in Tokyo it is 2.00 p.m. in Hong Kong. When it is 3.00 p.m. in Hong Kong it is 1.00 p.m. in Singapore. At 3.00 p.m. in Singapore it is 12.00 noon in Bahrain. When it is 3.00 p.m. in Bahrain it is noon in Frankfurt and Zurich and 11.00 a.m. in London. 3.00 p.m. in London is 10.00 a.m. in New York. By the time New York is starting to wind down at 3.00 p.m., it is noon in Los Angeles. By the time it is 3.00 p.m. in Los Angeles it is 9.00 a.m. of the next day in Sydney. The gap between New York closing and Tokyo opening is about 21/2 hours. Thus the market functions 24 hours. Of all these centres, London, Tokyo and New York are the big ones accounting for about 50% volume. P.G.Apte International Financial Management

4

Foreign Exchange Interbank (I/B) Desk of Bank A Corporate Desk of Bank A or I/B Desk of Bank B I/B Desk of Bank A I/B Desk of Bank C P.G.Apte International Financial Management

5

Corporate Foreign Exchange (CorpFx) Desk of Bank A Corporate Client of Bank A CorpFx Desk of Bank A I/B Desk of Bank A P.G.Apte International Financial Management

6

Dealings of Corporate Foreign Exchange (CorpFx) Desk of Bank A CorpFx Desk of Bank A

Export / Import Desk of Bank A Client of Bank A

P.G.Apte International Financial Management

Outward / Inward Remittance Desk of Bank A 7

CURRENCY MARKETS • Spot Markets : Value date 2 business days from transaction date. If bank holiday in either settlement centre, push to next business day. •Outright Forwards : Value date 3 days and beyond. •Standard forward dates : 1,2,3,6,9,12 months. Spot value date plus required calendar months. •Swaps : A spot plus a forward or two forwards. Buy USD spot vs. EUR, sell USD 3 month forward vs.EUR. Sell USD 1 month forward, buy USD 3 month forward vs. GBP.

P.G.Apte International Financial Management

8

CURRENCY MARKETS • A spot GBP/USD deal on Friday Dec 8 : Value date Tuesday Dec 11 •If Dec 11 holiday in NY/London, value date 12 Dec. •A 2-month forward deal USD/CHF on Monday Dec 11: Value date Feb 13 2001. If holiday in NY/Zurich, Feb 14. •A 2-month forward USD/JPY on Dec 26. Value date Feb 28. If holiday Tokyo/NY, push forward? NO. Pushing forward must not carry to next calendar month. Push back to Feb 27. • Spot deals in some currency pairs such as US dollarCanadian dollar settled in one business day

P.G.Apte International Financial Management

9

CURRENCY MARKETS ACI QUOTATION CONVENTIONS SPOT RATE QUOTATIONS:

• Base Currency/Quoted Currency

Bid Rate/Offer Rate

•USD/CHF : USD base, CHF quoted •GBP/USD : GBP base, USD quoted •Most currencies quoted with USD as base. Exceptions are EUR, GBP, AUD, NZD •Quotation given as no. of units of quoted currency per unit of base currency, bid rate/offer rate. •Bid rate applies to market maker buying base currency. Offer rate applies to market maker selling base currency. P.G.Apte International Financial Management

10

CURRENCY MARKETS • Currency Codes : All currencies have a 3-letter code used by SWIFT for all interbank transactions. DEM : Deutsche Mark NLG : Dutch Guilder FRF : French Franc ESP : Spanish Peseta USD : US Dollar

CHF : Swiss Franc BEF : Belgian Franc DKK : Danish Kroner ITL : Italian Lira AUD : Australian Dollar CAD : Canadian Dollar JPY : Japanese Yen GBP : British Pound IEP : Irish Pound (punt) INR : Indian Rupee SAR : Saudi Riyal EUR : Euro P.G.Apte International Financial Management

11

CURRENCY MARKETS SPOT QUOTES : EXAMPLES USD/CHF SPOT: 1.4575/1.4580 Bid

Offer

Bank will buy 1 USD and give CHF 1.4575 Bank will sell 1 USD and want to be paid CHF 1.4580. Shortened to 1.4575/80 or even 75/80 between dealers. “1.45” is the “big figure” P.G.Apte International Financial Management

12

CURRENCY MARKETS SPOT QUOTES : EXAMPLES Interpret these quotes : GBP/USD : 1.5665/70 USD/DEM : 1.9995/05 GBP/EUR : 1.2545/50 USD/INR : 46.7585/46.7685 USD/JPY : 110.25/35 •Most currencies quoted upto six significant figures. Last two figures known as “points” or “pips”. GBP/USD the bid-offer spread is 10 pips. Smaller currencies quoted to 2 decimals. P.G.Apte International Financial Management

13

CURRENCY MARKETS • Quotations in European Terms: Units of a currency per US dollar. Example : USD/INR : 46.7560/7675 • Quotations in American Terms : US dollars per unit of a currency. Example : GBP/USD : 1.5060/65 • Direct Quotations: Units of “home” currency per unit of “foreign” currency. Example : USD/INR above, a direct quote in India. • Reciprocal or Indirect Quotations: Units of “foreign” currency per unit of “home currency”. Example: USD/GBP : 0.6638/0.6640, an indirect quote in UK. P.G.Apte International Financial Management

14

CURRENCY MARKETS Interbank Arbitrage : Suppose banks A and B are quoting : A B GBP/USD : 1.4550/1.4560 1.4538/1.4548 --------- Bank A bid ask ---------- Bank B bid ask Buy GBP from bank B, sell to bank A. Prices will move. A B GBP/USD : 1.4550/1.4560 1.4548/1.4558 --------- Bank A ---------- Bank B No arbitrage. Quotes must “overlap”. P.G.Apte International Financial Management

15

INVERSE QUOTES AND 2-POINT ARBITRAGE USD/CHF : 1.4955/1.4962 A bank in Zurich CHF/USD : 0.6695/0.6699 A bank in NY Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich sell in New York. $(1,000,000/1.4955) i.e. $6,68,700 needed to acquire the Swiss francs. $(0.6695 × 1000000) i.e. $6,69,500, obtained on selling, a riskless profit of $800. Zurich USD/CHF quotes imply certain CHF/USD quotes: Implied (CHF/USD)bid = 1/(USD/CHF)ask Implied (CHF/USD)ask = 1/(USD/CHF)bid P.G.Apte International Financial Management

16

INVERSE QUOTES AND 2-POINT ARBITRAGE To prevent arbitrage, the New York bank's (CHF/USD) quotes must overlap the (CHF/USD) quotes implied by the Swiss bank's quotes. The latter work out to 0.6684/0.6687. A quote such as 0.6686/0.6689 will not lead to arbitrage though it may lead to a one-way market for the banks. The rates actually found in the markets will obey the above relations to a very close approximation. GBP/USD: 1.5465/70 USD/INR: 46.7550/46.7650 GBP/EUR: 1.3035/45

P.G.Apte International Financial Management

USD/GBP ? (100)INR/USD ? EUR/GBP?

17

Cross-Rates and Three-Point Arbitrage A New York bank is currently offering these quotes : USD/JPY : 110.25/111.10 USD/AUD : 1.6520/1.6530 At the same time, a bank in Sydney is quoting : AUD/JPY : 68.30/69.00 Is there an arbitrage opportunity? Consider this sequence of transactions: Sell yen against US dollars and the US dollars against Australian dollars both in New York and finally sell the AUD for yen in Sydney. This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C; Finally sell C buy A. P.G.Apte International Financial Management

18

Cross-Rates and Three-Point Arbitrage The calculations are :(N: NY S: Sydney) 1 JPY in NY gets USD [1/(USD/JPY)ask(N) ] = USD (1/111.10) Sell USD [1/(USD/JPY)ask(N) ] in NY to get AUD {[1/ (USD/JPY)ask(N) ](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520) Sell AUD {[1/(USD/JPY)ask(N) ](USD/AUD)bid(N) } in Sydney to get JPY{[1/(USD/JPY)ask(N) ](USD/AUD)bid(N) (AUD/JPY bid(S) } = JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156 P.G.Apte International Financial Management

19

EUR Locking Rates EUR Locking Rates EUR/ATS= EUR/BEF= EUR/DEM= EUR/ESP= EUR/FIM= EUR/FRF= EUR/IEP= EUR/ITL= EUR/LUF= EUR/NLG= EUR/PTE=

13.760300 40.339900 1.955830 166.386000 5.945730 6.559570 0.787564 1936.270000 40.339900 2.203710 200.482000

P.G.Apte International Financial Management

20

INTERBANK SPOT DEALING •Monday September 21 10.45 am BANK A: "Bank A calling. DLR-FRF 25 please. •BANK B: "Forty -Fiftytwo” (Bank B is specifying a two-way price. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 4.1540/4.1552.) •BANK A: “Mine” (Bank A dealer finds bank B’s price acceptable and wishes to buy USD 25 million. She conveys this by saying “mine”)

P.G.Apte International Financial Management

21

SPOT DEALING (Contd.) •BANK B: OK. I sell you USD 25 million against FRF at 4.1552 value 23 September. BNP Paris for my FRF. •BANK A: CITIBANK NYK for my dollars. Thanks & Bye. • Deal is consummated. Back office staff will retrieve details, exchange confirmatory faxes/telexes and arrange settlement. •Spot deals account for about 60 % of total turnover. •Dealers work within limits assigned by management •Counterparty must be acceptable credit. P.G.Apte International Financial Management

22

FORWARD AND SWAP QUOTES • Forward outrights can be given like spot quotes. • USD/CHF 3-months 1.5655/65 bid/ask •More commonly given as a spot quote plus a pair of swap points USD/CHF Spot : 1.6525/35 1 month : 15/10 2 months : 25/18 3 months : 35/25 GBP/USD Spot : 1.4925/35 1 month : 12/15 2 months : 20/25 3 months : 28/35

P.G.Apte International Financial Management

23

FORWARD AND SWAP QUOTES • To find outrights : Spot quote ± Swap Points • Each swap point is 0.0001 ( or 0.01) •When to add, when to subtract? •Take USD/CHF Spot : 1.6525/35

1 month : 15/10

•If you add : 1 month outright : 1.6540/45 • If you subtract 1 month outrights : 1.6510/1.6525 •Which is correct? •Two “rules” : 1 Ask > Bid 2 Bid-Ask spread must widen as you go farther into future P.G.Apte International Financial Management

24

FORWARD AND SWAP QUOTES • Using rule 2, 1.6540/1.6545 is wrong. 1.6510/25 is correct. • Now take GBP/USD Spot 1.4925/35

2 months : 20/25

• If add, 2 month outrights 1.4945/1.4960, if subtract 1.4905/1.4910. The latter is correct. •Mechanical rule : If swap points are Big/Small, subtract, base currency at forward discount, quoted currency at premium. If swap points Small/Big, add. Quoted currency at discount, base currency at premium.

P.G.Apte International Financial Management

25

FORWARD AND SWAP QUOTES • A quote like : USD/SEK Spot 8.4565/70 3 month : 10/20 •Bank will do either swap: (1) Buy USD spot, sell USD 3 months forward agnst SEK. The forward rate would be 20 points above the spot rate. (2) Sell USD spot, buy 3 months forward, forward rate 10 points above spot. In a swap, amount of one currency - usually the base currencykept same in the spot and the forward leg. Buy USD 1m spot, sell USD 1m forward. Amount of SEK will be different. P.G.Apte International Financial Management

26

INTERBANK FORWARD DEALING DEC 4 2000 BANK A : "Bank A calling. Three-month yen-dollar please.” BANK B : "Thirty two; twenty five." BANK A : "Fifteen dollars yours at thirty two". BANK B : "OK. Let's use a spot of 120.50 which is for value December 6; I buy at 120.18 for value March 6."

P.G.Apte International Financial Management

27

OPTION FORWARDS •Delivery date to be chosen by the contract buyer within a specified interval. •A 3 month forward with delivery option over 3rd month •A 6 month forward with delivery option over last three months. •Banks extract maximum premium or give least discount •GBP/USD spot : 1.4565/70 2 Mth. 15/10 3 Mth 22/17 •Customer wants to buy USD, 3 mths forward, option over 3rd month. USD at premium at 2 mths, greater premium at 3 mths. Bank will charge 3 mths premium. P.G.Apte International Financial Management

28

OPTION FORWARDS •If customer wanted to sell USD, bank would give only 2 months premium. •USD/CHF Spot 1.6570/75 3 Mths 15/20 (1) Customer wants to buy USD 3 mths forward option period from spot to 3 months. Rates? (2) Customer wants to buy CHF. Rates? •In the Indian market, length of option period cannot exceed one month.

P.G.Apte International Financial Management

29

FORWARD QUOTES INR1F= INR= INRON= INRTN= INRDECM= INRJANM= INRFEBM= INRMARM= INRAPRM= INRMAYM= INRJUNM= INRJULM= INRAUGM= INRSEPM= INROCTM= INRNOVM= P.G.Apte International Financial Management

Bid 46.4425 0.25 0.75 5.00 20.75 34.50 51.00 67.25 83.50 98.50 116.50 133.50 150.50 167.50 184.00

Ask 46.4625 0.50 1.00 6.00 21.75 35.50 52.00 68.25 84.50 99.50 117.50 134.50 152.00 169.00 185.50 30

BROKEN DATES • Standard forward are whole months. Banks will do any number of days forward - 63 days, 135 days etc. These are “broken date” or “odd date” forwards. •Interpolate between two whole month dates. OK if the gap between the two dates is not too long and no special technical factors are at work. •USD/INR spot 46.95/96 1 month 10/12 2 mths 20/27 •Customer wants to buy USD 43 days forward. •15 paise premium from 1 mth to 2 mths. Suppose 30 days in 2nd month. 0.5 paisa per day, 6 paise for 12 days. Rate would be 46.96+0.12+0.06 = 47.14 P.G.Apte International Financial Management

31

SHORT DATES • Delivery same day- cash •Delivery next day - Tomorrow or “Tom”. •Markets quote overnight O/N, tomorrow/next T/N and Spot/Next S/N swaps. These are used to compute rates for short date transactions. •Reverse swap points and follow add/subtract rule. •USD/DEM Spot 1.9545/50

T/N : 5/3

3/5

•Outright for tom : 1.9548/50

P.G.Apte International Financial Management

32

FOREX AND MONEY MARKETS • Annualised %Premium/Discount, T-year forward = [(Forward-Spot)/(Spot)] × (1/T) × 100 •Use mid rates for quick calculations. •Annualised forward margin = Interest rate differential True for fully convertible currencies with no capital controls. • Currency with higher interest rate will be at discount. •3-month Euro LIBOR : 8% p.a. 3-month USD LIBOR : 6% •USD will be at a 3-month forward premium of 2% p.a.

P.G.Apte International Financial Management

33

FOREX AND MONEY MARKETS This relation between interest rate differential and spot-forward margin is known as Covered Interest Parity. It holds for freely convertible currencies with no capital controls. It is a result of investors arbitraging between money markets in different currencies in search of highest return. Holds with Euromarket interest rates. It is not a causal relation but an equilibrium relationship. It will be analysed in detail in the next chapter P.G.Apte International Financial Management

34

FORWARD-FORWARDS AND RELATED PRODUCTS • Buy USD 1 month sell 3 months vs.GBP. A 1-3 swap. •Related products are FSAs, ERAs and FXAs •Third currency forwards in the Indian market. •Forward contracts can be cancelled. Settlement payments depend upon current forward rates. •Forward contracts tie up credit limits and attract capital adequacy norms. FSAs, ERAs and FXAs are innovations to get around these problems. Analysed in next chapter

P.G.Apte International Financial Management

35