3.1.5 Foreign Exchange Market

1. Quotes

Foreign Exchange Quotes
The most common exchange rate quotes are between USD and another currency. Other quotes (e.g., between GBP and EUR) are known as cross-currency quotes.

• The exchange rate between the U.S. dollar and the British pound, euro, Australian dollar and New Zealand dollar, the U.S. dollar is the quote currency.
• Other cases, the U.S. dollar is the base currency and the other currency is the quote currency.

Spot Quotes

• Spot exchange rates are quoteed with 4 decimal places.
  • E.g. On July 6, 2018, EURUSD was quoted as bid 1.1744 and ask 1.1746.
• The bid-ask spread faced by corporations is quite small when they trade large amounts of a currency.
• For the small currency exchanges, bid-ask spreads are much larger.

Forward Quotes
Forward exchange rates are quoted with the same base currency as spot exchange rates. They are usually shown as points that are multiplied by 1/10,000 and the added to (or subtracted from) the spot quote.

• Bid-ask spread for forward quotes being greater than the bid-ask spread for spot quotes.
• Example: EURUSD three-month forward quote with bid 90.87 and ask 82.07, the spot rate was bid 1.1744 and ask 1.1746.
  • Forward bid quote is $1.1744+0.009087=1.182487$
  • Forward ask quote is $1.1746+0.008207=1.182807$
• Example: EURUSD one-month forward quote with bid -8.29 and ask -7.67, the spot rate was bid 1.3082 and ask 1.3083.
  • Forward bid quote is $1.3082-0.000829=1.307371$
  • Forward ask quote is $1.3083-0.000767=1.307533$

Futures Quotes
The CME Group in the United States trades many different futures contracts on exchange rates between the U.S. dollar and other currencies.

• The futures are always quoted with USD.
• For example, a six-month forward quote for the UDSCAD of 1.3000 corresponds to a six-month futures quote of 0.7692(1/1.3000) USD per CAD.

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2. Types of Trade

• Spot Trade is an exchange of one currency for another that takes place immediately (or almost immediately).
• Outright Forward is an agreement to exchange currencies that will take place at a certain time in the future.
• FX(foreign exchange) Swap is a transaction that involves a currency exchange at one time and the opposite exchange at a later time.
• Currency Swap involves interest and principal in one currency being exchanged for interest and principal in another currency.

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3. Foreign Exchange Risk

Transaction Risk
The transaction risk relates to the risk associated with the exchange rate that will apply when

• a foreign currency is purchased with the domestic currency in the future to buy goods and services overseas.
• future revenues in foreign currencies are converted into the domestic currency.

Transaction risk can be hedged with outright forward transactions.

Translation Risk
Translation risk arises from the need to value foreign assets and liabilities when financial statement are produced.

• Whereas transaction risk directly affects a company’s cash flows, translation risk does not.
• However, it can have a big effect on its reported earnings.

A better way of avoiding translation risk is to finance the assets in a country with borrowings in that country.

Economic Risk
Economic risk is the risk that a company’s future cash flows will be affected by exchange rate movements.

Economic risk is more difficult to quantify than transaction or translation risk. Foreign exchange considerations might play a role in a decision to move production overseas.

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4. Interest Rate Parity

Determination of Exchange Rates
Exchange rates (like the prices of all financial assets) are ultimately determined by supply and demand, which are in turn influenced by many factors.

• Balance of Payments and Trade Flows
• Inflation(通货膨胀)
• Monetary Policy(货币政策)

Nominal and Real Interest Rates
Nominal interest rates are usually quoted in the market and indicate the return that will be earned on a currency.
Real interest rates are adjusted for inflation.

$$R_{\text{nominal}}=(1+R_{real})(1+R_{\text{Inflationrate}})-1$$
$$R_{\text{nominal}}\approx R_{\text{real}}+R_{\text{Inflationrate}}$$

Covered Interest Parity
Suppose a U.S. trader starts with 100 GBP and wants to end up with USD in T years.

There are two ways of converting 100 GBP to USD at time T. Using the GBPUSD spot exchange rates(S) and forward exchange rates(F), respectively.

• $R_{USD}$ and $R_{GBP}$ are the risk-free interest rates in USD and GBP.
• 本币当作钱，持钱赚 $R_f=R_{USD}$
• 外币当作货，持货赚 $Div=R_{GBP}$

In the absence of arbitrage opportunities
$$F=S\ast {[\frac{1+R_{USD}}{1+R_{GBP}}]}^T$$
$$F=S{e}^{(R_{USD}-R_{GBP})T}$$

In general
$$F=S(\frac{1+r_{DC}}{1+r_{FC}}{)}^T$$
$$F=S{e}^{(r_{DC}-r_{FC})T}$$

The exchange rate of FCDC or DC/FC is quoted in the spot and forward market as S and F, respectively.

• $R_{DC}$ means domestic currency rate.
• $R_{FC}$ means foreign currency rate.

Uncovered Interest Parity
Uncovered interest partity is an argument converned with exchange rates themselves and is just one of the many interacting factors that determeine how exchange rates move.
It aruges that investors should earn the same interest rate in all currencies when expected exchange rate movements are considered.