foreign exch. market
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| What is the foreign exchange market | a place where currencies are traded, money denominated in one currency bought and sold with money denominated in another currency
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| method of quotation | system of direct quotation, gives the home currency price (numerator) of one unit of foreign currency EX: $1.81/£
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| cross rates | the exchange rate between two non-US currencies
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| currency arbitrage | 1. if cross rates differ from one financial center to another, the profit opportunity exists
2. buy cheap in one international market, sell at a higher price in another
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| triangular currency arbitrage | 1. starting investment (home currency)
2. sell investment in one country
3. sell first exchange in another country
4. resell final exchange in home country
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| transaction costs | 1. banks don't charge commission on currency transactions
2. they profit from the spread between buying and selling rates on both spot and forward transactions
3. quotes are given in pairs, first the buy (bid) price and second the sell (ask) rate
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| Bid-ask spread | used to calculate the fee charged by the bank
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| bid | the price at which the bank is willing to buy
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| ask | the price it will sell the currency (offer price)
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| percent spread formula | PS= Ask-Bid/Ask x 100
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| wholesale level | (95%) Interbank market; wholesale market in which major banks trade with one another (20 major banks)
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| retail level | business customers
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| financial derivative are | contracts that derive their value from underlying:
assets: such as stock, bond, or currency
reference rate: such as a 90-day treasury bill rate
index: such as the S&P 500 stock index
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| Forward market participants, Arbitrageurs | seek risk free profit by taking advantage of differences in interest rates among countries
use forward contracts to eliminate exchange risk involved from transferring their funds from one nation to another
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| Forward market participants, Traders | also use forward contracts to eliminate risk of loss on export or import orders that are denominated in foreign currencies
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| Forward market participants, speculators | actively expose themselves to currency risk by buying or selling currencies forward in order to profit from exchange rate fluctuations
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| Forward contract | an agreement between a bank and a customer to deliver on 3 things:
1. a specified amount of currency against another currency
2. at a specified future date and,
3. at a fixed exchange rate
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| purpose of a forward is | hedging, which is the act of reducing exchange rate risk
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| calculating forward premium/discount | =forward-spot/spot x360/n x100
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