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Home , Foreign exchange market, Foreign exchange spot, Futures exchange

A Guide to Foreign Exchange Markets

K. Alec Chrystal

HE economies of the free world are becoming be described. This will be followed by a discussion of increasingly interdependent. U.S. now amount some of the more important activities of partici- to almost 10 percent of Gross National Product. For pants. Finally, there will be an introduction to the both Britain and Canada, the figure currently exceeds analysis of a new feature of exchange markets — cur- 25 percent. Imports are about the same size. Trade of rency options. The concern of this paper is with the this magnitude would not be possible without the structure and mechanics of foreign exchange markets, ability to buy and sell . Currencies must be not with the detemiinants of exchange rates them- bought and sold because the acceptable means of pay- selves. ment in other countries is not the U.S. dollar. As a result, importers, exporters, travel agents, tourists and many others with overseas business must change dol- THE BASICS OF FOREIGN EXCHANGE lars into foreign and/or the reverse. MARKETS

The trading of currencies takes place in foreign ex- There is an almost bewildering variety of foreign change markets whose major function is to facilitate exchange markets. Spot markets and forward markets and investment. Foreign exchange abound in a number of currencies. tn addition, there markets, however, are shrouded in mystery. One are diverse quoted for these currencies. This reason for this is that a considerable amount of foreign section attempts to bring to this seeming dis- exchange market activity does not appear to be related array. directly to the needs of international trade and invest- ment. Spot) Forward, Bid, Ask The purpose of this paper is to explain how these Virtually every major newspaper, such as the Wall 1 markets work. The basics of foreign exchange will first Street Journal or the Financial Times, prints a daily list of exchange rates. These are expressed either as the number of units of a particular currency that exchange for one U.S. dollar or as the number of U.S. K. Alec Chrystal, professor of -elect, University of dollars that exchange for one unit of a particular cur- Sheffield, England, is a visiting scholar atthe Federal Reserve of St. Louis. Leslie Bailis Koppel provided research assistance. The rency. Sometimes both are listed side by side see author wishes to thank Joseph Hernpen, Centerre Bank, St. Louis, for table Il. his advice on this paper. 1 For further discussion of foreign exchange markets in the United For major currencies, up to four different prices States, see Kubarych (1983). See also Dutey and Giddy (1978) and typically will be quoted. One is the “spot” . The McKinnon (1979). others may be ‘30 days forward,” 90 days forward,”

5 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984

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CCC CCCCCCC4 C,4/C CC C CCC FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984 and “180 days forward.” These may be expressed either in “European Terms” (such as number of $ per LI or in “American Terms” (such as number oIL per $1. (See the glossary for further explanation .1

The spot price is what you must pay to buy curren- cies for immediate delivery (two working days in the interbank market; over the counter, if you buy bank notes or travelers checks). The forward prices for each currency are what you will have to pay if you sign a contract today to buy that currency on a specific future date (30 days from now, etc.). In this market, you pay for the currency when the contract matures.

Why would anyone buy and sell foreign currency forward? There are some major advantages from hav- ing such opportunities available. For example, an ex- porter who has receipts of foreign currency due at some future date can sell those funds forward now, thereby avoiding all risks associated with subsequent adverse changes. Similarly, an importer who will have to pay for a shipment ofgoods in foreign currency in, say, three months can buy the foreign exchange forward and, again, avoid having to bear the exchange rate risk.

The exchange rates quoted in the financial press (for example, those in table 1) are not the ones individuals would get at a local bank. Unless otherwise specified, the published prices refer to those quoted by to other banks for currency deals in excess of $1 million. Even these prices will vary somewhat depending upon whether the bank buys or sells. The difference between \ii ix~ttiipIrtil tlit’ iirigr ol 51)01 V\rllZIilizi’ rates a%ail the buying and selling price is sometimes known as the able is presented ui table Z. which .sIiow% prires or bid-ask spread.” The spread partly reflects the banks’ cli’iitsrhic’iiuiiLs and St(i’liIiL4 (ILIOttLI ~~ithin a one—Iii,tir costs and profit margins in transactions; however, ma- iit’iiiitl cii) \c,\c’n)l,i’r-25 1983 I lien’ are t~~(i ii ,cii’tant jor banks make their profits more from capital gains 1 2 h)OiiitS 1(1 t’iijti(i’. I ii’,! all c’’~ec’pltlici,,c’ iii tin’ lirsi lie than from the spread. ‘‘I’ I~ir’sqtiott’cI iii the interhank 1)1 ~vhioles~iIi’.iii~ii Let tor li-ansac—tion,. in ewess ol S L niihlioit. I he .‘,ti’rling ‘rhe market for bank notes arid travelers checks is prices have a hid-ask spread ol cinI~0 I ccitt ~vhiich i’. quite separate from the interbank foreign exchange oiiI~ahlotil 0.07 percent cit the price or 57 on S 10.000 market. For smaller currency exchanges, such as an On Ifli. the ~pic’~id per dollar-s norih ~~oiks out 1cr hi’ individual going on vacation abroad might make, the abont hall that on sterling ‘54 on .410.000 spread is greater than in the interbank market. ‘Ibis

presumably reflects the larger average costs — includ- Sc.’c’oi)(l. tIt’ ~Ilces c iiciti’d I,,’ local hank,. lorsriiall. n’ 1 ing the exchange rate risks that banks face by holding ct’tzul. ti-arisat-ticins which ‘,er~eonly as a uuiclr and do in denominations too small to be sold in the riot rierev,arl\ nrpiesciit prices on actual clc’als. iii— interbank market — associated with these smaller ex- ‘. oItc’ a iiiiic1 I.ii-ger- h,icl—~tsL spi’t’.ttl I hic’se rtail changes. Asa result, individuals generally pay a higher s ,rvzccls ,.ar; tc-c,r)) Ii;,iik Ic, bank. but are i elated to ‘and 1 price for foreign exchange than those quoted in the larger than the inlethztnk iate’,. Iii sonic cases. thin newspapers.

t In practice, the spread w I va~during Inc day depending upon Notice quotes only a bank selling price at a market corrditiops Fnr example the slorl,np spread may he as lithe particular time. The Financial Times quotes the bid-ask spread and as 001 cents at ti~iesana or averages about 0.05 cents Spreads the range over the day. qenert-;yw,’i h~arger on ‘ess wioeiy traded cijrrcnc es

7 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984

4 may be of the order of4 cents orless on sterling, though channeled through brokers. If all interbank transac- the prices quoted in St. Louis involved average spreads tions at-c included, the figure rises to 59 percent. of 8 cents on sterling. The latter represents aspread of Most small banks and local offices of major banks do about 5½percent (about $530 per $10,000 transaction). not deal directly in the interbank foreign exchange ‘rhe equivalent spread for DM was 7 percent ($700 per market. Rather theytypically will have a line with $10,000 transaction). a large bank or their head office. Transactions will thus The spread on forward transactions will usually be involve an extra step (see figure IL The customer deals wider than on spot, especially for longer maturities. with a local bank, which in turn deals with a major For interbank trade, the closing spread on one and bank or head office. The interbank foreign exchange three months forward sterling on September 8, 1983, market exists between the major banks either directly was .15 cents, while the spot spread was .10 cents. This or indirectly via a broker. is shown in the top line of the Financial Times report in table 1. Of course, like the spot spread, the forward FUTURES AND MARKETS spread varies with time of day and market conditions. FOR FOREIGN EXCHANGE At times it may be as low as .02 cents. No information is available for the size of spread on the forward prices Until very recently, the interbank market was the typically offered on small transactions, since the retail only channel through which foreign exchange transac- market on forward transactions is very small. tions took place. The past decade has produced major innovations in foreign exchange trading. On May 16, 1972, the International Market (1MM) opened HOW DOES “THE” FOREIGN under the auspices of the Mercantile Ex- EXCHANGE MARKET OPERATE? change. One novel feature of the 1MM is that it provides a trading floor on which deals are struck by brokers It is generally not possible to go to a specific building face to face, rather than over telephone lines. The most and “see” the market where prices of foreign exchange significant difference between the 1MM and the inter- are determined. With few exceptions, the vast bulk of bank market, however, is that trading on the 1MM is in foreign exchange business is done over the telephone futures contracts forforeign exchange, the wpical busi- between specialist divisions of major banks. Foreign ness being contracts for delivery on the third Wednes- exchange dealers in each bank usually operate from day of March, June, September or December. Activity at one room; each dealer has several telephones and is the 1MM has expanded greatly since its opening. For surrounded by video screens and news tapes. Typical- example, during 1972, 144,336 contracts were traded; ly, each dealer specializes in one ot’ a small number of the figure for 1981 was 6,121,932. markets (such as sterling/dollar or deutschemark/dol- There is an important distinction between “forward” lar). Trades are conducted with other dealers who transactions and “futures” contracts. The former are represent banks around the world. These dealers tvpi- individual agreements between two parties, say, abank cally deal regularly with one another and are thus able and customer’. The latter’ is a contract traded on an to make firm commitments by word of mouth. organized market of a standard size and Only the head or regional offices of the larger banks date, which is resalable at the market price up to the actively deal in foreign exchange. The largest of these close of trading in the contract. These organized mar- kets are discussed more fully below. banks are known as “market makers” since they stand ready to buy or sell any of the major currencies on a While the major banks conduct foreign exchange more orless continuous basis.Unusuallylarge transac- deals in large denominations, the 1MM trading is done tions, however, will only be accommodated by market in contracts of standard size which are fairly small. maket’s on more favorable terms. In such cases, foreign Examples of the standard contracts at present are exchange brokers may be used as middlemen to find a L25,000; DM125,000; Canadian $100,000. These are taker or takers for the deal. Brokers (of which there are actually smaller today than in the early days of the four major firms and a handful of smaller ones) do not 1MM. trade on their own account, but specialize in setting up Further, unlike prices on the interbank market, price large foreign exchange transactions in return for a commission (typically 0.03 cents or less on the sterling movements in any single day are subject to specific spread). In April 1983, 56 percent of spot transactions 4 by involving banks in the were See Federal Reserve Bank of New York (1983).

8 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984

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9 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984 limits at the 1MM. For- example, for sterling futures, ling, deutschemarks, Swiss francs and yen in identical prices are not allowed to vary more than $0500 away bundles to those sold on the 1MM. In its first year, the from the previous day’s settlement price; this limit is foreign exchange business of L1FFE did not take off in a expanded if it is reached in the same direction for two big way. The majot provider of exchange rate risk cov- successive days. The limit does not apply on the last erage for business continues to be the bank network. day a contract is traded. Less than 5 percent of such cover is provided by mar- kets such as 1MM and LIFFE at present. Unlike the interbank market, parties to a foreign ex- change contract at the 1MM typically do not know each An entirely new feature of foreign exchange markets other. risk, however, is minor because con- that has arisen in the 1980s is the existence of option tracts are guaranteed by the exchange itself. To mini- markets.” The Philadelphia Exchange was the first to mize the cost of this guarantee, the exchange insists introduce foreign exchange options. ‘Fhese are in five upon “ requirements” to cover fluctuations in currencies (deutschemark, sterling, , yen the value of a contract. This means that an individual or and ). Trades are conducted in stan- firm buying a would, in effect, place a dard bundles half the size of the 1MM futures con- deposit equal to about 4 percent of the value of the tracts. The 1MM introduced an options market in Ger- 5 contract. man marks on January 24, 1984; this market trades options on futures conti-acts whereas the Philadelphia Perhaps the major limitation of the 1MM from the options are for spot currencies. point of view of importers or exporters is that contracts cover only eight currencies—those of Britain, Canada, Futures and options prices for foreign exchange are , , Japan, , France published daily in the financial press. Table 3 shows and the Netherlands — and they are specified in stan- prices for February 14, 1984, as displayed in the Wall dard sizes for particular dates. Only by chance will Street Journal on the following day. Futures prices on these conform exactly to the needs of importers and the 1MM are presented for five currencies (left-hand exporters. Large firms and financial institutions will column(. There are five contracts quoted for each cur- find the market useful, however, if they have a fairly rency: March, June, September, December and March continuous stream of payments and receipts in the 1985. For each contr’act, opening and last settlement traded foreign currencies. Although contracts have a (settle( prices, the range over the day, the change from specified standard date, they offer a fairly flexible the previous day, the range over the lifeof the contract method of avoiding exchange rate risk because they are and the number of contracts outstanding with the marketable continuously. exchange (( are listed.

A major economic advantage of the 1MM for non- Consider the March and June DM futures. March bank customers is its low transaction cost. Though the futures opened at $3653 per mark and closed at $3706 brokerage cost of a contract will vary, a ‘round trip” per’ mark; June opened at $3698 per mark and closed at (that is, one buy and one sell) costs as little as $15. This $3746 pet’ mark. Turn now to the Chicago Mercantile is only .04 percent ofthe value of a sterling contract and Exchange (1MM) futures options (center columnL less for some of the lat-ger contracts. Of course, such These are options on the futur-es contracts just dis- costs are high compared with the interbank market, cussed (see inset for explanation of options). Thus, the where the brokerage cost on DM 1 million would be line labeled “Futures” lists the settle prices of the about $6.25 (the equivalent-valued eight futures con- March and June futures as above. tracts would cost $60 in brokerage, taking $7.50 per Let us look at the call options. These are rights to buy single dealt. They are low, however, compared with those in the retail market, where the spread may in- DM futures at specified prices — the . For example, take the call option at strike price 35. This volve a cost of up to 2.5 percent or 3 percent per means that one can purchase an option to buy DM transaction. 125,000 March futures up to the March settlement date A market similat to the 1MM, the London Interna- for 5.3500 per mark. This option will cost 2.05 cents per tional Financial (LIFFE(, opened in mark, or $2,562.50, plus brokerage fees. The June op- September 1982. On LIFFE, futures are traded in ster- tion to buyJune futures DM at 5.3500 per’ mark will cost 2.46 cents pet- mat-k, or $3,075.00, plus brokerage fees.

5 A bank may also insist upon some minimum deposit to cover a , though there is no firm rule. “For a discussion of options in , see Belongia (1983).

10 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984

‘l’he March call option at strike price 5.3900 per mark on spot, options on futures. The channels through costs only 0.01 cents per mark or $12.50. These pr’ice which these markets are formed are, however, fairly differences indicate that the market expects the dollar’ straightforward (see figur-e IL The main channel is the price of the mark to exceed 5.3500, but not to rise inter1jank network, though for lar-ge interbank transac- substantially above 5.3900. tions, foreign exchange brokers may be used as middlemen. Notice that when you exercise a futures call option you buy the relevant futures contract but onE’ fulfill that futures contract at maturity. In contrast, the Phil- adelphia foreign currency options (right column( are ACTIVITIES options to buy foreign exchange (spot) itself iather than futures. So, when a call option is exercised, for- Much foreign exchange market trading does not eign curr’eticy is obtained immediately. appear to be related to the simple basic purpose of allowing businesses to buy or sell foreign cuxrency in The only difference in presentation of the currency order, say, to sell or- purchase goods overseas. It is option prices as compared with the futures options is certainly easy to see the usefulness ofthe large range of that. in the lormei-, the spot exchange r-ate is listed for foreign exchange transacrions available through the comparison rather than the futures price. ‘I’hus, on the interhank and organized markets (spot. forward, in- Philadelphia exchange, call options on March DM tures, options) to facilitate trade between nations. It is 62,500 at strike price 5.3500 per mar-k cost 1.99 cents per also clearthat there is a useful role forforeign exchange rnar’k or $1,243.75, plus brokerage. Brokerage fees here broker’s in helping to “make” the interbank rnar’ket. would be ofthe same or-der as on thc 1MM, about $16 ‘l’here are several other activities, however, iii foreign PeA- transaction round trip, per contr’act. exchange markets that are less well understood and We have seen that there are sevei-al different maikets whose relevance is less obvious to people interested in

for foreign exchange — spot, fijrward, futures, options understanding what these mat-kets accomplish.

11 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984

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Two major classes of activity will be discussed. First, tice of expressing exchange rates in American terms in the existence of a large number of foreign exchange the United States and in European terms elsewhere. markets in many locations creates opportunities to The adoption of standard practice has reduced the profit from ‘.’ Second, there is implicitly a likelihood of inconsistencies.’ Also, in recent years, market in (foreign exchange) risk bearing. Those who such opportunities for profit making have been greatly wish to avoid (at a price) may do reduced by high-speed, computerized infonnation so. Those who accept ;he risk in expectation of profits systems and the increased sophistication of the banks are known as speculators.” operating in the market. Arbitrage of a slightly different kind results from price differences in different locations. This is ‘space” arbitrage. For example, if sterling were cheaper in Lon- don than in New York, it would be profitable to buy in Triangular arbitrage is the process that ensures that London and sell in New York. Similarly, if prices in the all exchange rates are mutually consistent. IL for exam- interbank market differed from those at the 1MM, it ple, one U.S. dollar exchanges for one Canadian dollar, would be profitable to arbitrage between them. As a and one Canadian dollar- exchanges for one British result of this activity, prices in different locations will pound, then the U.S. dollar-pound exchange rate be brought broadly into line. should be one pound for one dollar. If it differs, then there is an opportunity for profit making. To see why Interest Arbitrage this is so, suppose that you could purchase two U.S. dollars with one British pound. By first buying C$1 with Interest arbitrage is slightly different in nature from U.5.51, then purchasing £1 with C$1, and finally buying triangular or space arbitrage; however, the basic motive US$2 with £1, you could double your money im- of finding and exploiting profitable opportunities still mediately. Clearly this opportunity will not last for- applies. There is no reason why interest r-ates denomi- since it involves making large profits with certainty. nated in different currencies should be equal. Interest The process of triangular arbitrage is exactly that of rates are the cost of borrowing or the return to lending finding and exploiting ptofitable opportunities in such fot a specific period of time. The relative price (ex- exchange rate inconsistencies. As a result of triangular change rate of money may change over time so that arbitrage, such inconsistencies will be eliminated the comparison of, say, a U.S. and a British rapidly. Cross rates, however, will only be roughly con- requires some allowance for expected exchange rate sistent given the bid-ask spread associated with trans- changes. Thus, it will be not at all unusual to find action costs. ‘All except U.K. and Irish exchange rates are expressed in American In the past. the possibility of making profits from terms. Futures and options contracts are expressed in European triangular arbitrage was greater as a result of the prac- terms.

13 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984 interest rates denominated in dollars and interest rates denominated in, say, pounds being somewhat differ- ent. However, real returns on assets of similar quality Arbitrage in the foreign exchange markets involves should be the same if the exchange rate r-isk is covered little or- no risk since transactions can be completed or’ hedged in the . Wet’e this not true, it rapidly. An alternative source of profit is available from would be possible to borrow in one cur-i-ency and lend ourguessing other market participants as to what fu- in another at a profit with no exchange risk. ture exchange rates will be. This is called speculation. Although any foreign exchange transaction that is not Suppose we lend one dollar for a year in the United entirely hedged forward has a speculative element, States at an interest rate of r,,~.The amount accumu- only deliberate speculation for’ profit is discussed here. lated at the end of the year per dollar lent will be I + r~, 8 Until recently, the main foreign exchange specula- (capital plus interest) - If, instead of making dollar , tors were the foreign exchange departments of banks, we converted them into pounds and lent them in the with a lesser role being played by portfolio managers of at the rate r~ k,the amount of pounds 4 other financial institutions and international corpora- we would have for each original dollar at the end of the tions. The 1MM, however, has made it much easier’ for’ year would be Sf1 + r~k(,where S is the spot exchange individuals and smaller businesses to speculate. A high rate (in pounds per dollar( at the beginning of the proportion of 1MM transactions appears to be specula- period. At the outset, it is not known if 1 + r~, dollars is 5 tive in the sense that only about 5 percent of contracts going to be worth more than 5(1 + r~k(pounds in a to ultimate delivery of foreign exchange. This year’s time because the spot exchange rate in a year’s means that most of the activity involves the buying and time is unknown. This uncertainty can be avoided by selling of a contract at d~ffcrenttimes and possibly selling the pounds forward into dollar’s. ‘[hen the rela- different prices prior to maturity. It is possible, how- tive value of the two loans would no longer depend on ever, that buying and selling of contracts before matu- what subsequently happens to the spot exchange rate. rity would arise out of a str-ate~’to reduce risk. So it is By doing this, we end up with (1 + r~,k(dollars per not possible to say that all such activity is speculative. original dollar invested. This is known as the ‘cov- ered,’ or hedged, return on pounds. Speculation is important for the efficient working of foreign exchange markets. It is a form of arbitrage that Since the covered return in our example is denomi- occurs across time rather than across space or be- nated in dollars, it can reasonably be compared with tween markets at the same time. Just as arbitrage in- the U.S. interest rate. If these returns are very different, creases the efficiency of markets by keeping prices investors will move funds where the retur-n is highest consistent, so speculation increases the efficiency of on a covered basis. This process is interest arbitrage. It forward, futures and options markets by keeping those is assumed that the assets involved are equally safe markets liquid. Those who wish to avoid foreign ex- and, because the returns are covered, all exchange risk change risk may thereby do so in a well-developed is avoided. Of course, if funds do move in large market. Without speculators~,r’iskavoidance in foreign between assets or between financial centers, then in- exchange markets would be more difficult and, in terest rates and the exchange rates (spot and forwardi many cases, impossible.” will change in predictable ways. Funds will continue to flow between countries until there is no extra profit to be made from interest arbitr-age. This will occur when Risk Reduction the returns on both dollar-- and sterling-denominated Speculation clearly involves a shifting of risk from assets are equal, that is, when one party to another. For example, if a bank buys for-

If (1+r~ ) = n+r~kL 8 This result is known as covered interest parity. It holds more or less exactly, subject only to a margin due to r~,we take, say, the three-month eurodollardeposit rate in and transaction costs, so long as the appropriate dollar’ and for rUk we take thethree-montheurosterling deposit rate in Paris, then 8 sterling interest rates are compared. (1) will hold lust about exactly. Indeed, if we took the interest rate and exchange rate quotes all from the same bank, it would be remarkable if (I) did not hold. Otherwise the bank would be offering to pay you to borrow from it and lend straight backl That is, the price of borrowing would be less than the covered return on lending. A margin between 8 Since there aremanydifferent interest rates, it obviously cannot hold borrowing and lending rates, of course, will make thiseven less likely for allot them. Where(1) does hold is if the interest rates chosenare so that in reality you would lose. 9 eurocurrency deposit rates of thesame duration. In otherwords, itfor This is not to say that all speculative activity is necessarilybeneficial.

14 FEGE~ALRESERVE BANK OF ST. ~OU~S MAROH 1984

Covered Interest Parity: An Example

11w lotion rig iflti-nst ate anti n_change -alt- hid- ask spii’ad tin tin’ loin aid tate ~\otilII lii— iIliiltatinns ale laken rum the London 1-iciniujal 1-1927 1 41)42.

I lOWS ol Si’pti9TthlT 8, 1 9M3 litHe 1-. - \o~~let us see it nf’ nouilrl do hettei- to irv,.vst in a ( losing three—month eiiilister ing deposit iw a three—mouth i,~change Hate Sj_n 3\tp~lil_ L12.1~%.~.1:iJ c-iir-tirlollai’ tte})t)sit t~lien! the (lOhlairs to he iTht9~’i’d t100 ili,llai-s pt-c- I-PUll- I 11)20 IT-- 22 discount war-i sold Ion~aitIinto stl’i log I hi’ ii’ttun F~~~- potlIlCi iirtestitt ill (or SteIIiIl!4 is 2 369 annual iilti’i’r’st iatt (II !P ti,.’ \\Iil,iiZls the iettii’n oil a eo~’eu’e.dcoin— inti’wst Rates. ltiix;stui ici~ I lilOdt)ilai - —-—-— —- clolIztide iosit is 1 -\liiiilll ( )ilei- 9’’i,. 1 Rati’ i.-49t0

2.25I - tOO ‘~ - -- 1 i12 17 — mu 1 hi, uitei-est i-aU’ on the tIli’I!t’-illIJntii i’uiIltlollzii I I11~I2 (lepllsit is a lii tie hcghei- 7 pecrent than that on an --liii is wi- could 1101 niakt’ a piulit out ol i:ovei’erl eurusteruig dV )OsIt II hit’ c—.u’harige rule rt-malns .. - - 1 - Hltt’ti’st .trInii’age l)i~spite tile tail that dollar jji - unchanged. it nould hi’ Imliet- to hold dollais, it the - - tni’t’st rates art’ higher- till! iliscotirit till ton~ai-ddot— c!\tliatIgl’ i-ate tails, the t’oi’o-.teruig deposit would - lw’s ill the lr,i’n art o1,Eiikeh 111(51115 they buy tewei hi- pr-Ierahle SIi~}lose von decide to cm ti the e~- .. _ - -- . Iornanl jiouncis Asaiesolt. till-il! us no bent-lit to ‘-hange rsk in sellicig the dollars tornarl into .-..- the opi~iation I i-an-,aclion costs toi’ iiinst 111111— piJililds. let its I lltliifltl’e liii’ i-ettii-ii to IIIJI(IIIlg Li --. - viduals ~~otitd hi, i~\cii greater 111811 those ahtj~e ar~ sic-i-hog deposit vt Itil the return ti) holiling a cloliw -- -. thi’\. noi,ild hire a lie-get- hId ask spli-ati 111,11) that tIi’posil sold lornard into step mg !asstiiliit’ig that i tiotid (ill ihi’ nitt’ihank market ‘ on stat I xviih sterling-. 1

-- cotist-i~tientI~- hi-ti’ is 10 ht’i’ielit lot tht~tvpi’aI I ‘Vu unpor;int points i iced to lit, tlai lied atjr,tit --- - - en t-stoi- from nlakmg a i-ut eI’NI ui hedged etirlirLir-— till ahote data I- i-st 11111 interest iati~sart- arinrial— -. - - ltlll\ deposit. tile rvttiiii ~tilt lit’ at least as high On a I/eli SI) the~alt, not t~hdinould actually In- eai-iit-d .- - iit’I)Osit iii tht’ t’iiiii’iit’v inn 111th tOil starl and n-ish our a three-month pei-u;d liii- ri;implc. the tiuli!— - .. -- III (‘11(1 u~i that is. ii oil ilat-li dollars aunt wish to inhiilth i-ate equivalent to au ajintiat -alt- ul 1W -- - -- — (‘11(1 ti}i ‘‘ ith dollars. niakt’ a enu-ollollar deposil - Ii pt~ier1t t~2-Is pei-~i-nt. -- - ton hate stei’luig am! ttisii to (lId IiJ) t-t-nh stel-Ictlg. ~‘econd,till’ Ii itt aid exehiangi’ rates need 501111 naki- a etiiister ing deposit ttvt;ti han, sti-ili ig arId n_pianauioul I lit- dollLo- is at a discount against stir— ttisl) to thu till ill thillai’s lilt-i-i’ IS likely to lie 19th’ or 1mg Ibis ineatm the lijinac (I ilcihlin hovs 1155 stei— miii ditiereni-v hetnei-n holding a eiuiiisit-rhing up— t hug. So tte han- to mid the tlisroiiiit onto the spo posil sold toi-nai-d into dtihliii’s In liuivirig diillais pi~-~-to r41’t the torn-aid pun- heraose till- pu-ire is spoi nOd lioldi ig a t-tirodohlar deposit. ( )l clitilse ii the iltilllIfl’l ut doilztis per iotind. not the -eu’i st’ you hold ad tilIl’rrtl!rtl (leplJSit 81111 i-tc-haiigt’ 1 \otuce also tint the llisl-IJtlrlt is tiit-asur’d iii tiiu-— i-aU’s sohisequemlv change, tin- irstilt will lie ten’ lions ol a ll’ilt 1101 ti-actions ol a (1()llai~So the dilli-it-ut

nar d lot eign i’srhange horn ai-usurullcr it 1111 cases its muumive tlu risk ul losses tile to une’tpertcll I’’ t’\pOsl.lI-c lii risk tthili till- rtcstomer reduces his I ton— rhunge I ate i-han~es ( )ne si uple wat to ito this is to ncr lhc-c-e is 111)1 .1 ti\r-d amount ot risk that ills to hi’ eflsnr-e that assets and liatiitrties dcnurni sited in each ‘shai-ed (lilt Some siraleLies niat molt i-a net ‘cdiii’ operating riurrcnrt are equal. this is kulo\t las 11181111 tool lit risk all around iui,~. loi sample 1 hank that sells sterling lounard liii 1-ristorner- ni_n sonuitanrotrslv tim sterin~ Iou’nard In general rote liriauicial inslituterns -or other this i-u-nt. the tlank is n_posed to I_eu-u e’¼1-hangi-rate liinis:. ir Ierati ig n—i tar-il-It cii rio-rent es. ttill Ii to risk. 1 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984

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Banks often use ‘swaps to close gaps in the matu- months. Once the is set up, the bank’s net profits rity structure of their assets and liabilities in a cur- are protected against subsequent changes in spot ex- r’ency. This involves the simultaneous purchase and change rates during the next six months. sale of a currency for ditferent maturity dates. In April 1983, 33 percent of U.S. banks’ foreign exchange turn- Within the limits imposed by the nature of the con- over involved swaps as compared with 63 percent spot tracts, a similar effect can be achieved by an appropri- contracts and only 4 percent outright forward ate portfolio of futuies contracts on the 1MM. Thus, a 1 contracts. ° bank would buy and sell futures contracts so as to match closely its forward commitments to customers. Suppose a bank has sold DM to a customer three In reality, banks will use a combination of methods to months forward and bought the same amount of DM reduce foreign exchange risk. from a different customer six months forward. There are two ways in which the bank could achieve zero Markets that permit banks, firms and individuals to foreign exchange risk exposure. It could either under- foreign exchange risk are essential in times of take two separate offsetting forward transactions, or it fluctuating exchange rates. This is especially impor- could set up a single swap with another bank that has tant for banks if they are to be able to provide efficient the opposite mismatch of dollar-DM flows whereby it foreign exchange services for their customers. In the teceives DM in exchange for dollars in three months absence of markets that permit foreign exchange risk and receives back dollars in exchange for DM in six hedging, the cost and uncertainty of international transactions would be greatly increased, and interna- tional specialization and trade would be greatly re- ‘°SeeFederal Reserve Bank of New York (1983). duced.

16 FEDERAL RESERVE BANK OF ST LOUIS MARCH 1984

CONCLUStON be able to reduce exchange rate risk whenever possi- ble, Some risk reduction is achieved by interbank The foreign exchange markets are complex and, for swaps, but some is also taken up by speculation Arbi- the outsider, hard to comprehend. The primacy func- trage and speculation both increase the efficiency of tion of these markets is straightforward. It is to facilitate spot and forward foreign exchange markets and have international transactions related to trade, travel or enabled foreign exchange markets to achieve a high investment. Foreign exchange markets can now level of efficiency. Without the successful operation of accommodate a large range of current and forward these markets, the obstacles to international trade and transactions - investment would be substantial and the world would Given the variability ofexchange rates, it is important be a poorer place for banks and firms operating in foreign currencies to

17 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984

REFERENCES Federal Reserve Bank of New York. “Summary of Results of US, Foreign Exchange Market Turnover Survey Conducted in April Belongia, Michael T. “ Options: A New Risk Manage- 1983” (September 8, 1983). ment Toot for Agricultural Markets,” this Review (June/July 1983), Garman, Mark B., and Steven W. Kohlhagen. “Foreign Currency pp. 5—15. Option Values,” Journal of International Money and Finance (De- Black, Fisher, and Myron Scholes. “The Pricing of Options and cember 1983), pp. 231—37. Corporate Liabilities,” Journal of Political Economy (May/June Giddy, tan H. “Foreign Exchange Options,” Journalof Futures Mar- 1973), pp. 637—54. kets (Summer 1983), pp. 143—66, Chrystal, K. Alec. “On the Theory of International Money” (paper Krugman, Paul, “Vehicle Currencies and the Structure of Intemna- presented to UK. International Economics Study Group Confer- tional Exchange,” Journal of Money, Credit and Banking (August ence, September1982, Sussex, England). Forthcoming in J. Black 1980), pp. 513-26. and C, S. Dorrance, eds., Problems of International Finance (Lon- Kubarych, Roger M. Foreign Exchange Markets in the United don: Macmillan, 1984). States. (Federal Reserve Bank of New York, 1983). Dufey, Gunter, and Ian H. Giddy. The International McKinnon, Ronald I, Money in International Exchange: The Con- (Prentice-Hall, 1978). vertible Currency System (, 1979),

18