Topic 13: Foreign Exchange Markets Introduction It Is Useful to Study Foreign Exchange (FX) Markets for 3 Reasons (At Least): 1
Total Page:16
File Type:pdf, Size:1020Kb
Load more
Recommended publications
-
Arbitrage-Free Affine Models of the Forward Price of Foreign Currency
Federal Reserve Bank of New York Staff Reports Arbitrage-Free Affine Models of the Forward Price of Foreign Currency J. Benson Durham Staff Report No. 665 February 2014 Revised April 2015 This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the author and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author. Arbitrage-Free Affine Models of the Forward Price of Foreign Currency J. Benson Durham Federal Reserve Bank of New York Staff Reports, no. 665 February 2014; revised April 2015 JEL classification: G10, G12, G15 Abstract Common affine term structure models (ATSMs) suggest that bond yields include both expected short rates and term premiums, in violation of the strictest forms of the expectations hypothesis (EH). Similarly, forward foreign exchange contracts likely include not only expected depreciation but also a sizeable premium, which similarly contradicts pure interest rate parity (IRP) and complicates inferences about anticipated returns on foreign currency exposure. Closely following the underlying logic of ubiquitous term structure models in parallel, and rather than the usual econometric approach, this study derives arbitrage-free affine forward currency models (AFCMs) with closed-form expressions for both unobservable variables. Model calibration to eleven forward U.S. dollar currency pair term structures, and notably without any information from corresponding term structures, from the mid-to-late 1990s through early 2015 fits the data closely and suggests that the premium is indeed nonzero and variable, but not to the degree implied by previous econometric studies. -
Arxiv:2101.09738V2 [Q-Fin.GN] 21 Jul 2021
Currency Network Risk Mykola Babiak* Jozef Baruník** Lancaster University Management School Charles University First draft: December 2020 This draft: July 22, 2021 Abstract This paper identifies new currency risk stemming from a network of idiosyncratic option-based currency volatilities and shows how such network risk is priced in the cross-section of currency returns. A portfolio that buys net-receivers and sells net- transmitters of short-term linkages between currency volatilities generates a significant Sharpe ratio. The network strategy formed on causal connections is uncorrelated with popular benchmarks and generates a significant alpha, while network returns formed on aggregate connections, which are driven by a strong correlation component, are partially subsumed by standard factors. Long-term linkages are priced less, indicating a downward-sloping term structure of network risk. Keywords: Foreign exchange rate, network risk, idiosyncratic volatility, currency predictability, term structure JEL: G12, G15, F31 arXiv:2101.09738v2 [q-fin.GN] 21 Jul 2021 *Department of Accounting & Finance, Lancaster University Management School, LA1 4YX, UK, E-mail: [email protected]. **Institute of Economic Studies, Charles University, Opletalova 26, 110 00, Prague, CR and Institute of Information Theory and Automation, Academy of Sciences of the Czech Republic, Pod Vodarenskou Vezi 4, 18200, Prague, Czech Republic, E-mail: [email protected]. 1 1 Introduction Volatility has played a central role in economics and finance. In currency markets, a global volatility risk has been proposed by prior literature as a key driver of carry trade returns. While the global volatility risk factor is intuitively appealing, there is little evi- dence on how idiosyncratic currency volatilities relate to each other. -
Teaching the Bid-Ask Spread and Triangular Arbitrage for the Foreign Exchange Market Jeng-Hong Chen, Central State University, USA
American Journal of Business Education – Fourth Quarter 2018 Volume 11, Number 4 Teaching The Bid-Ask Spread And Triangular Arbitrage For The Foreign Exchange Market Jeng-Hong Chen, Central State University, USA ABSTRACT The foreign exchange (FX) market is an important chapter in international finance. Understanding the market microstructure is critical for learning the FX market. To assist students better understand the FX market microstructure, an instructor can use an event study with minute-by-minute quote data provided in the Excel assignment, asking students to investigate the impact of an event on the bid-ask spread and triangular arbitrage opportunities. This pedagogical paper provides two examples of making the Excel assignment for reference. Keywords: Foreign Exchange; Bid-Ask Spread; Triangular Arbitrage INTRODUCTION nderstanding the foreign exchange (FX) market is essential for learning international finance. Eun and Resnick (2015) describe the FX market’s structure, participants, and quotations. The FX market is a U decentralized or over-the-counter (OTC) market without common trading floor. The FX market is open 24 hours a day. There are several financial centers with different time zones in the world. When the trading of one currency is closed at one financial center, it continues on the other financial center with the different time zone. International banks serve as dealers who make a market by standing ready to buy or sell foreign currencies for their own accounts. The bid price represents the price a bank dealer is willing to buy for a currency and the ask price is the price a bank dealer is willing to sell for a currency. -
Foreign Exchange Training Manual
CONFIDENTIAL TREATMENT REQUESTED BY BARCLAYS SOURCE: LEHMAN LIVE LEHMAN BROTHERS FOREIGN EXCHANGE TRAINING MANUAL Confidential Treatment Requested By Lehman Brothers Holdings, Inc. LBEX-LL 3356480 CONFIDENTIAL TREATMENT REQUESTED BY BARCLAYS SOURCE: LEHMAN LIVE TABLE OF CONTENTS CONTENTS ....................................................................................................................................... PAGE FOREIGN EXCHANGE SPOT: INTRODUCTION ...................................................................... 1 FXSPOT: AN INTRODUCTION TO FOREIGN EXCHANGE SPOT TRANSACTIONS ........... 2 INTRODUCTION ...................................................................................................................... 2 WJ-IAT IS AN OUTRIGHT? ..................................................................................................... 3 VALUE DATES ........................................................................................................................... 4 CREDIT AND SETTLEMENT RISKS .................................................................................. 6 EXCHANGE RATE QUOTATION TERMS ...................................................................... 7 RECIPROCAL QUOTATION TERMS (RATES) ............................................................. 10 EXCHANGE RATE MOVEMENTS ................................................................................... 11 SHORTCUT ............................................................................................................................... -
Rethinking Forward and Spot Exchange Rates in Internationsal Trading
RETHINKING FORWARD AND SPOT EXCHANGE RATES IN INTERNATIONSAL TRADING Guan Jun Wang, Savannah State University ABSTRACT This study uses alternative testing methods to re-examines the relation between the forward exchange rate and corresponding future spot rate from both perspectives of the same currency pair traders using both direct and indirect quotations in empirical study as opposed to the conventional logarithm regression method, from one side of traders’ (often dollar sellers) perspective, using one way currency pair quotation (often direct quotation). Most of the empirical testing results in this paper indicate that the forward exchange rates are downward biased from the dollar sellers’ perspective, and upward biased from the dollar buyers’ perspective. The paper further contends that non-risk neutrality assumption may potentially explain the existence of the bias. JEL Classifications: F31, F37, C12 INTRODUCTION Any international transaction involving foreign currency exchange is risky due to economic, technical and political factors which can result in volatile exchange rates thus hamper international trading. The forward exchange contract is an effective hedging tool to lower such risk because it can lock an exchange rate for a specific amount of currency for a future date transaction and thus enables traders to calculate the exact quantity and payment of the import and export prior to the transaction date without considering the future exchange rate fluctuation. However hedging in the forward exchange market is not without cost, and the real costs are the differential between the forward rate and the future spot rate if the future spot rate turns out to be favorable to one party, and otherwise, gain will result. -
Financial Stability Effects of Foreign-Exchange Risk Migration
Financial Stability Effects of Foreign-Exchange Risk Migration∗ Puriya Abbassi Falk Br¨auning Deutsche Bundesbank Federal Reserve Bank of Boston November 7, 2019 Abstract Firms trade derivatives with banks to mitigate the adverse impact of exchange-rate fluctuations. We study how the related migration of foreign exchange (FX) risk is managed by banks and affects both credit supply and real economic variables. For iden- tification, we exploit the Brexit referendum in June 2016 as a quasi-natural experiment in combination with detailed micro-level FX derivatives data and the credit register in Germany. We show that, prior to the referendum, the corporate sector substantially increased the usage of derivatives, and banks on the other side of the trade did not fully intermediate that FX risk, but retained a large proportion of it in their own books. As a result, the depreciation of the British pound in the aftermath of the referendum poses a shock to the capital base of affected banks. We show that loss-facing banks in response cut back credit to firms, including to those without FX exposure to begin with. These results are stronger for less capitalized banks. Firms with ex-ante exposure to loss-facing banks experience a 32 percent larger reduction in credit than industry peers, and a stronger reduction in cash holdings and investment of about 8 and 2 percent, respectively. Our results show how a bank's uninsured derivatives book can take one corporation's FX risk and turn it into another corporation's financing risk. Keywords: Foreign Exchange Risk, Financial Intermediation, Risk Migration, Finan- cial Stability JEL Classification: D53, D61, F31, G15, G21, G32 ∗We thank participants at the Boston Macro-Finance Junior Meeting and the Federal Reserve System Banking Conference. -
Tsiang Article.Pdf
The Theory of Forward Exchange and Effects of Government Intervention on the Forward Exchange Market Author(s): S. C. Tsiang Reviewed work(s): Source: Staff Papers - International Monetary Fund, Vol. 7, No. 1 (Apr., 1959), pp. 75-106 Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund Stable URL: http://www.jstor.org/stable/3866124 . Accessed: 14/11/2012 22:10 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. Palgrave Macmillan Journals and International Monetary Fund are collaborating with JSTOR to digitize, preserve and extend access to Staff Papers - International Monetary Fund. http://www.jstor.org This content downloaded by the authorized user from 192.168.52.68 on Wed, 14 Nov 2012 22:10:02 PM All use subject to JSTOR Terms and Conditions The Theoryof ForwardExchange and Effectsof GovernmentIntervention on the ForwardExchange Market S.C. Tsiang* THE THEORY OF FORWARD EXCHANGE badly needs a sys- tematicreformulation. Traditionally, the emphasishas always been upon coveredinterest arbitrage, which formsthe basis of the so-called interestparity theory of forwardexchange.1 Modern economists,of course,recognize that operationsother than interestarbitrage, such as hedgingand speculation,also exert a determininginfluence upon the forwardexchange rate,2 but a systematictheory of forwardexchange whichexplains precisely how the interplayof all thesedifferent types of operationjointly determinethe forwardexchange rate and how the forwardexchange market is linked to the spot exchange market still appears to be lacking. -
SPOT MARKETS for FOREIGN CURRENCY Markets by Location and by Currency Markets by Delivery Date
Spot Markets P. Sercu, International Finance: Theory into Practice Overview Part II The Currency Market and its Satellites Spot Markets P. Sercu, International Finance: Theory into Practice Overview Chapter 3 Spot Markets for Foreign Exchange Overview Spot Markets Exchange Rates P. Sercu, HC FC International The / Convention (—ours) Finance: Theory into The FC/HC Convention Practice Bid and Ask Primary and Cross Rates Overview Inverting bid and asks Major Markets for Foreign Exchange How Exchange Markets Work Markets by Location and by Currency Markets by Delivery Date The Law Of One Price in Spot Mkts Price Differences Across Market Makers Triangular Arbitrage and the LOP PPP Exchange Rates and Real Rates PPP Exchange Rates The Real Rate or Deviation from APPP Is the RER constant? Devs from RPPP What have we learned in this chapter? Overview Spot Markets Exchange Rates P. Sercu, HC FC International The / Convention (—ours) Finance: Theory into The FC/HC Convention Practice Bid and Ask Primary and Cross Rates Overview Inverting bid and asks Major Markets for Foreign Exchange How Exchange Markets Work Markets by Location and by Currency Markets by Delivery Date The Law Of One Price in Spot Mkts Price Differences Across Market Makers Triangular Arbitrage and the LOP PPP Exchange Rates and Real Rates PPP Exchange Rates The Real Rate or Deviation from APPP Is the RER constant? Devs from RPPP What have we learned in this chapter? Overview Spot Markets Exchange Rates P. Sercu, HC FC International The / Convention (—ours) Finance: Theory into The FC/HC Convention Practice Bid and Ask Primary and Cross Rates Overview Inverting bid and asks Major Markets for Foreign Exchange How Exchange Markets Work Markets by Location and by Currency Markets by Delivery Date The Law Of One Price in Spot Mkts Price Differences Across Market Makers Triangular Arbitrage and the LOP PPP Exchange Rates and Real Rates PPP Exchange Rates The Real Rate or Deviation from APPP Is the RER constant? Devs from RPPP What have we learned in this chapter? Overview Spot Markets Exchange Rates P. -
Instructions and Guide for Carry Trade and Interest Rate Parity Lab
Instructions and Guide for Carry Trade and Interest Rate Parity Lab FINC413 Lab c 2014 Paul Laux and Huiming Zhang 1 Introduction 1.1 Overview In the lab, you will use Bloomberg to explore issues concerning carry trade and interest rate parity. You will explore: • Uncovered carry trade and uncovered interest rate parity • Covered carry trade and covered interest rate parity • Forward and forecast: expectation for FX rate A carry trade is defined as the investment strategy that borrows in a low interest rate currency and uses the funds to purchase a high interest rate currency, to take advantage of interest rate differences. Take an instance, an U.S. investor who borrows EUR at a low interest rate and invests the funds in a USD-denominated bond at a higher interest rate. Eventually the USD bond matures or is sold, and the USD proceeds are exchanged for EUR so the EUR borrowing can be repaid. If the investor also purchases/sells a for- ward contract to hedge the foreign exchange risk, this investment strategy is called a covered carry trade; if not, the investment strategy is called an uncovered carry trade. In the case of an uncovered carry trade, the investor obviously faces foreign exchange risk. If the EURUSD exchange rate increases, i.e. the currency EUR ap- preciates, the investor would need to exchange more USD into EUR to repay the debt. If the foreign exchange rate increases far enough, the investor could even lose 1 money in the carry trade. It is a good idea for you to work through the carry trade profit calculation to see this analytically. -
Is the Fx Derivatives Market Effective and Efficient in Reducing Currency Risk?
Banco Central de Chile Documentos de Trabajo Central Bank of Chile Working Papers N° 325 Agosto 2005 IS THE FX DERIVATIVES MARKET EFFECTIVE AND EFFICIENT IN REDUCING CURRENCY RISK? Esteban Jadresic Jorge Selaive La serie de Documentos de Trabajo en versión PDF puede obtenerse gratis en la dirección electrónica: http://www.bcentral.cl/esp/estpub/estudios/dtbc. Existe la posibilidad de solicitar una copia impresa con un costo de $500 si es dentro de Chile y US$12 si es para fuera de Chile. Las solicitudes se pueden hacer por fax: (56-2) 6702231 o a través de correo electrónico: [email protected]. Working Papers in PDF format can be downloaded free of charge from: http://www.bcentral.cl/eng/stdpub/studies/workingpaper. Printed versions can be ordered individually for US$12 per copy (for orders inside Chile the charge is Ch$500.) Orders can be placed by fax: (56-2) 6702231 or e-mail: [email protected]. BANCO CENTRAL DE CHILE CENTRAL BANK OF CHILE La serie Documentos de Trabajo es una publicación del Banco Central de Chile que divulga los trabajos de investigación económica realizados por profesionales de esta institución o encargados por ella a terceros. El objetivo de la serie es aportar al debate temas relevantes y presentar nuevos enfoques en el análisis de los mismos. La difusión de los Documentos de Trabajo sólo intenta facilitar el intercambio de ideas y dar a conocer investigaciones, con carácter preliminar, para su discusión y comentarios. La publicación de los Documentos de Trabajo no está sujeta a la aprobación previa de los miembros del Consejo del Banco Central de Chile. -
Triangular Arbitrage • Covered Interest Arbitrage
Chapter 7 International Arbitrage And Interest Rate Parity 6A. 1 Key Objectives To explain the conditions that will lead to various forms of currency arbitrage, along with the currency realignments that will occur in response; and To explain the concept of interest rate parity, and how parity condition prevents foreign exchange arbitrage opportunities. 6A. 2 International Arbitrage • Arbitrage can be defined as capitalizing on a discrepancy in quoted prices to make a risk-free profit. • The effect of arbitrage on demand and supply is to cause prices to realign, such that risk-free profit is no longer feasible. • International Arbitragers play a critical role in facilitating exchange rate equilibrium. They try to earn a risk-free profit whenever there is exchange rate disequilibrium. 6A. 3 International Arbitrage • As applied to foreign exchange and international money markets, international arbitrage (i.e., taking risk-free positions by buying and selling currencies simultaneously) takes three major forms: • locational arbitrage • triangular arbitrage • covered interest arbitrage 6A. 4 Locational Arbitrage • Locational arbitragers try to offset spot bid-ask exchange rate disequilibrium • Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency. Example Bank C Bid Ask Bank D Bid Ask NZ$ $.635 $.640 NZ$ $.645 $.650 Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$. 6A. 5 Triangular Arbitrage • Triangular arbitragers try to offset cross-rate disequilibrium • Triangular arbitrage is possible when a cross exchange rate (exchange rate between two foreign currencies) quoted by a bank differs from the cross rate calculated from dollar-based spot rate quotes. -
Algorithmic Trading in the Foreign Exchange Market
Rise of the Machines: Algorithmic Trading in the Foreign Exchange Market Alain Chaboud, Benjamin Chiquoine, Erik Hjalmarsson, Clara Vega Chaboud and Vega are with the Federal Reserve Board in Washington, DC; Chiquoine is with the Stanford Management Company, Stanford, CA. Hjalmarsson is with the Centre for Finance at University of Gothenburg and Queen Mary University of London. Executive Summary The use of algorithmic trading (AT), where computers monitor markets and manage the trading process at high frequency, has become common in major financial markets in recent years, beginning in the U.S. equity market in the 1990s. Since the introduction of algorithmic trading, there has been widespread interest in understanding the potential impact it may have on market dynamics, particularly recently following several trading disturbances in the equity market blamed on computer- driven trading. While some have highlighted the potential for more efficient price discovery, others have expressed concern that it may lead to higher adverse selection costs and excess volatility. In our study, we analyze the effect algorithmic (“computer”) trades and non-algorithmic (“human”) trades have on the informational efficiency of foreign exchange prices. In particular, we look at two distinct aspects of (in-)efficiency in the foreign exchange market: triangular arbitrage opportunities and “excess” volatility in high-frequency returns. We rely on a novel data set consisting of several years (September 2003 to December 2007) of minute-by-minute trading data from Electronic Broking Services (EBS) in three currency pairs: the euro-dollar, dollar-yen, and euro-yen. The data represent a large share of spot interdealer transactions across the globe in these exchange rates, with EBS widely considered to be the primary site of price discovery in these currency pairs during our sample period.