FINS3616 Lecture Notes - Lecture 2: Interbank Foreign Exchange Market, Fedwire, Foreign Exchange Market
Week 1 – Globalisation and Multinational Corporations
Foreign Exchange Market
Foreign exchange dealers – commercial banks, investment banks
1. Market makers – make it easier for buyers and sellers to come together
Brokerage firms – iterediaries, ot arket akers do’t put ow oey at risk
Liquidity – ease with which one can sell an asset AT ITS FAIR VALUE
1. Highly liquid assets have low transaction costs
Other participants in the forex market – central banks, multinational corporations
Why is Forex a competitive market?
1. No product differentiation
2. A lot of players (top 4 account for over 40%, top 20 over 90%)
3. No signs of any clear leader in this market
Exchange rate – price of one currency in terms of another
1. Direct: quoting domestic currency first (in numerator)
2. Indirect: quoting foreign currency first (in numerator)
Rules:
1. Keep track of units (keep on same side)
2. Think of buying or selling the asset in the denominator
Vehicle currency – currency actively used in many international financial transactions
around the world
• Used due to transaction costs of making markets in certain currencies being too high
• US$ primary vehicle currency (89% of all transactions)
Cross-rate – trading currency in NY market where both currencies are not expressed in
US$
• Trend toward cross-rate transactions
• Cross exchange rate equilibrium: Y / A$ = (Y / $) * ($ / A$)
Or (Y / $) * ($ / A$) * (A$ / Y) = 1
Triangular Arbitrage
• Arbitrage process involving three currencies
• Keeps cross-rates in line with exchange rates quoted relative to a third currency
• If equilibrium equation is < 1, one exchange rate must rise
Currency in denominator is too low relative to currency in numerator
Buy each currency in the denominator with currency in numerator
• If equilibrium equation is > 1, one exchange rate must fall
Currency in denominator is too high relative to currency in numerator
Sell each currency in denominator with currency in numerator
Bid-Ask Spread
• Bid – rate at which banks will buy the base currency
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