Introduction
Different countries use different exchange rates. Thus, there is
a need to exchange between them in order to carry out trade and
to buy and sell financial assets. Exchange rates are set in a variety
of ways, and countries need to hold reserves in order to enable
trade and other transactions to operate the smooth operation of
the economy. Important terms in an exchange rate context are
- Gold Standard
- Bretton Woods system (based on
gold standard, survived until 1971)
- SDRs
- US dollars - the dominating settlement
currency
- DEM (until 2001), CHF, GBP, CAD
and JPY
- EUR (from 2001) used in the European
Monetary Union
Exchange Rate Mechanisms and Quotations
There are four main mechanisms used around the world
Common currency such as the USD, EUR and CHF
Currency pegged to another currency or currency basket
Managed floating
Independent floating
Usually, exchange rates are quoted as as the number of currency
units needed to purchase one US dollar (e.g. JPY/USD or NOK/USD).
However, the pound is an exeption as we normally talk of the number
of units of foreign currency to purchase on pound sterling (USD/GBP
or JPY/GBP). The same rule applies to the euro (NOK/EUR or CAD/EUR).
In general, x/y is used to mean the number of units of x to purchase
one unit of y, where x and y are two currencies.
Price Quotations
Essentially, the foreign exchange market is a worldwide interbank
market (dealing in transaction normally above USD 1,000,000). A
bank might quote the a rate for EUR/USD transactions of 0.80000-0.80020.
The first rate is the Euro price being offered for buying dollars
(also called bid). The second rate is for selling dollars in exchange
for euros (also called ask). With no commission, the spread between
bid and ask prices is what gives the bank a return on such transactions.
Note that these pricing calculations can get quite complicated when
we are dealing with cross rates involving several problems.
The Foreign Exchange Market Today
The foreign exchange market is large and growing, with around USD
1,000,000,000,000 of transactions every day (according to the Bank
of International Settlements [BIS]). The market is operated by about
200 major financial institutions. Many transactions rely on oral
agreements, so trust in the market is vital. Traditionally, spot
transactions (transactions for immediate delivery) were the predominant
form, but in recent years forward agreements (transactions specifying
delivery at some future date) have increased more rapidly and now
account for over half of all transactions by value. Most transactions
are agreed by phone, telex, fax or over information systems on the
internet such as Reuters Dealing 2000 and EBS (Electronic Broking
System). Thus, trades can be conducted for immediate action around
the world at any time. Most trades, however, are cleared and settled
in London, Chicago or through any EUREX branch in Europe.
Forward Markets
Forward transactions are agreed today usually for delivery in 30
or 90 days. 1-month or 3-month forward exchange rates can be quoted
just as if they were spot rates discussed above. Alternatively,
they can be quoted in terms of a premium or discount on the spot
rate. For example, if the 1-month forward rate is EUR/USD = 0.80200,
and the spot rate is EUR/USD = 0.80000, then there is a dollar premum
of 0.00200 EUR/USD. The dollar is then said to be strong against
the euro. Forward premiums are often calculated and quoted as an
annualized devation from the spot rate, according to this formula:
AFP = ((Forward rate - Spot rate)
/ Spot Rate) x (12 / No of months forward) x 100%
where AFP = Annualized Forward Premium
Eurocurrency Market
The eurocurrency market is discussed further in another article
found at specialinvestor.com
The eurocurrency market started during the Cold War between the
USSR and the US - the Soviets needed to find alternative places
of depositing their dollar-accumulated profits. European banks were
judged to be safe enough, and the Eurodollar market became and instant
success. It soon extended to a market for all the major currencies.
Clearly, the the bid-ask spreads offered in this market must be
more narrow in the eurocurrency market than in the domestic market
in order to stay competitive. The euromarkets derives certain benefits,
which enables them to offer competitive spreads, such as no reserve
ratio requirements and no disclosure and strict regulatory requirements.
More on Quotations
Quotations in the market are usually in terms of an interest rate
for transactions of various durations. Hence LIBOR - the London
Interbank Offer Rate. It is important to note that quoted interest
rates are simple annualized rates. Thus a three-month interest rate
of 4% means that after three months the amount actually paid will
be 4x(3/12)%, i.e. just 1%.For purposes of these calculations, usually
assume that 1 year = 360 days, except for the pound sterling (GBP)
where 1 year = 365 days (these are just market conventions, so please
don?t ask for an explanation!). PS! Special rules might also apply
to Samurai bonds.
Exchange Rates and Interest Rate Parity
Interest rates available in two currencies must be connected to
the spot and forward exchange rates in a suitable way, otherwise
there will be opportunities for profitable arbitrage - which, in
a well functioning market, would be immediately noticed by market
participants and fully exploited. Let's assume we are dealing with
dollars (USD) and Euros (EUR), where S is the spot rate (EUR/USD)
and F is the one-year forward rate (EUR/USD). Suppose the interest
rates are r$ and r?. Then if we have USD100 million now and hold
it in dollars, after one year it will accumulate, with interest,
to: $100.(1 + r$) million. Alternatively, we can exchange for Euros
in the spot market, hold the Euros for a year, meanwhile attracting
interest at the Euro rate, then change back to dollars after a year.
The last part of the transaction can be done in two ways: (a) use
the future spot rate, i.e. the spot rate as it turns out to be in
a year?s time. But then from the present perspective, this is risky.
We don?t know what the future spot rate will be, so we have to carry
some foreign exchange risk. If we can avoid this, it is probably
better to do so. (b) use the currently quoted futures (or forward)
rate for a year ahead and commit now to change back into dollars
the Euros that we shall accumulate during the year, i.e. principal
plus interest. Adopting approach (b), our original USD100 million
becomes:
USD100 x S x (1 + r?)/F
Clearly, if the market is working
properly and arbitrage opportunities are competed away, then we
have two expressions that must be equal, i.e. 100 x (1 + r$) = 100
x S x (1 + r?)/F, or in other words: F/S = (1 + r?) / (1 + r$) This
is the condition for (covered) interest rate parity. Another way
to express this (exactly equivalent, algebraically) is in terms
of the forward premium (or discount, if negative), i.e. (F - S)/S
= (r? - r$) / (1 + r$)
