FINS1612 SUMMARIES

Week 8
Foreign Exchange Markets The structure and
operation
FX Markets:

Comprise all financial transactions denominated in foreign currency

(currently estimated to be over USD3.5 Trillion per day)
o There are internationally adopted FX market conventions to improve
market functionality.

Facilitate exchange of value from one currency to another

1/7 Exchange Rate Regimes:

Each country or monetary union is responsible for determining their own

exchange rate regime.
o Exchange rate: Value of one currency relative to that of
another currency

Types:
o Floating exchange rate (free float) regime is where the
exchange rate is determined by supply and demand factors in the FX
markets NO CENTRAL BANK INTERVENTION
o Managed Float: Is where the exchange rate is held within a defined
band relative to other currency.
o Crawling peg: is where the exchange rate is allowed to appreciate in
controlled steps over time.
o Pegged exchange rate: is where domestic currency is locked into a
specified multiple of another currency such as the USD.

2/7 Operation of the FX Market:

It is a global market, operating 24 hours a day according to business hours

across the time zones. FX markets in each country are just places to trade
they use the same exchange rates else there would be geographic
arbitrage.

It consists of a fast and highly sophisticated global network of

telecommunications systems that provide the current buy and sell rates for
various currencies in dealing rooms located around the globe.

Involves larger FX dealers like commercial, investment and merchant banks

providing the FX function as part of their overall Treasury operations within
which they establish an FX dealing room.

3/7 FX market participants:

FX dealers and brokers:

Dealers are financial institutions, typically commercial banks and

investment banks, that quote two-way (buy and sell) prices and act as
principals in the FX market
o They are usually licensed or authorised by the central banks of the
countries in which they operate.

Brokers transact almost exclusively with FX dealers; they obtain the best
prices in global FX markets matching FX dealers buy and sell orders for a
fee. (like share brokers)

Central Banks:

Purchase foreign currency to pay for government imports, pay interest on

government debt or redeem government debt.

Change the composition of holdings of foreign currencies in managing

official reserve assets.

Influence the exchange rate.

Firms conducting international trade transactions

Exporters receive foreign currency for the sale of their goods and services.

Exporters use the FX market to sell foreign currency and buy AUD

Importers use the FX market to buy foreign currency (sell AUD) for
purchasing imports.

Investors and borrowers in the international (money and capital)

markets

Commercial bank foreign borrowings are usually converted into the home
currency
o Payments of interest and principal need to be made in the
denominated currency of the loan.

Corporations and financial institutions investing overseas need to purchase

FX in order to make investments
o Also, dividends or interest payments received from overseas
investments will be denominated in a foreign currency.

Speculators [Most FX trades]

Businesses and financial institutions may attempt to anticipate future FX

movements to make a profit though there is the risk that the exchange
rate will move in the opposite direction anticipated or move with a different
magnitude.

Arbitrage (risk free profit) transactions / Arbitrageurs [Harder with

modern tech fixing differences]

Geographic (Two dealers in different locations quote different rates on the

same currency)

Triangular (Exchange rates between 3 or more currencies are out of perfect

alignment)

4/7 Spot and Forward Transactions:

Spot transactions;
o Have maturity date two business days after the FX contract is entered
into.

Used, for example, if an AUS importer has an account in USD to

pay within the next few days.

Forward transactions;
o Have maturity date more than two days after FX contract is entered
into.

Used, for example, if an AUS importer has to pay USD liability

in two months, and covers (or hedges) against an
appreciation of the USD.

There are also TOD (today) and TOM (tomorrow) transactions.

5/7 Spot Market Quotations:

To ask for a NORMAL quotation it must be noted that the price of a

quotation is expressed in terms of another currency.
o The first currency mentioned is the price being sought (also called
base currency or the unit of quotation).
o The second currency is the terms/COUNTER/QUOTE currency

USD/AUD is the price of USD1 in terms of AUD.

A TWO WAY quotation indicates the dealers buy (bid) and sell (offer) price.
>>>Note that a dealer quoting both bid and offer prices is a price-maker.

o EUR/AUD1.6755-1.6765 (abrv = 1.6755-65) means the dealer will

buy EUR1 for AUD1.6755 and sell EUR1 for AUD1.6765.

Buy low and sell high

o The percentage spread is

the difference between the
offer price and the bid price,
relative to the bid price.

Transposing spot-quotations:
o If given the quotation above, to find the AUD/EUR quotation simply;
1) Reverse the bid and offer prices (1.6765-1.6755)
2) Take the inverse (divide both numbers into 1):
1.00/1.6765 and 1.00/1.6755
Gives AUD/EUR0.59650.5968
Hence, this dealer will BUY 1AUD for 0.5965EUR and SELL
1AUD for 0.5968EUR

Calculating cross-rates
o Since all currencies are quoted against the USD (either directly with
USD as base or indirectly where USD is the terms currency and the
other is the base).
When FX transactions occur between two currencies that are
not USD, the cross-rate needs to be calculated.
B2 S2

o Two direct FX quotations:

S1 B1

USD/EUR0.646055 AND USD/JPY107.4050

To determine the EUR/JPY cross-rate:

107.40/0.6455 = 166.38
107.50/0.6450 = 166.67

Buy2/ Sell1* = X
Sell2 / Buy1* = Y
Answer 1-2 = X-Y

EUR/JPY 166.38-67

o Indirect and direct FX quotation:

GBP/USD1.9770-75 AND USD/NZD1.3760-70 B 1B 2 S 1S 2

To determine the GBP/NZD cross-rate:

1.9770 x 1.3760 = 2.7204
1.9775 x 1.3770 = 2.7230

GBP/NZD2.7204-30

Buy1 x Buy2 = X
Sell1 x Sell2 = Y
Answer 1-2 = X-Y

B1 S1

S2 B2

o Two indirect FX quotations:

AUD/USD0.926269 AND GBP/USD1.977075

To determine the AUD/GBP cross-rate:

0.9262/1.9775 = 0.4684
0.9269/1.9770 = 0.4688

AUD/GBP0.468488

Buy1/ Sell2 = X
Sell1 / Buy2 = Y
Answer 1-2 = X-Y

6/7 Forward Market Quotations:

The forward exchange rate is the FX bid/offer rates applicable at a specified

date beyond the spot value date.

The forward exchange rate varies from the spot rate owing to the interest
rate parity
o This is the principle that exchange rates will adjust to reflect interest
rate differentials between countries.

The forward exchange rates are quoted as forward points, either above or
below the spot rate.
o Forward points represent the forward exchange rate variation to a
spot rate base.

If the forward points are rising, add them to the spot rate
(base currency is at a forward premium, interest rate of the
base currency is lower)

If the forward points are falling, subtract them from the spot
rate (base currency is at a forward discount interest rate of
the base currency is higher)

An example(1):
Given AUD/USD (spot) 0.92300.9240 And six-month forward points 0.0032
0.0027
Since the forward points are falling, ssubtract them from the spot rate to obtain
the six-month forward rate of: 0.91980.9213

An example(2):
A company approaches a FX dealer for a forward quote on the USD/CHF with a
three-month (90-day) delivery. The spot rate is USD/CHF1.1560. The dealer
needs to calculate the forward points. Assume the three-month USD interest
rate is 3.00% per annum and the three-month euroSwiss franc interest rate is
4.00% per annum:

The three-month forward rate is USD/CHF1.1589. The points are added to the
spot rate as the interest rate of the base currency is lower

Modifications to the formula:

There may be different borrowing and lending rates in the Euromarkets

where interest rates are generally taken.
o Hence a dealer will need to adjust the formula to account for the
different interest rates OR may also charge a margin for costs (or
some points) to reflect their relationship with the company and
market competition.

A Forward exchange contract: Locks in an exchange rate today for

delivery of foreign currency at a specified future date.
o FX dealers quote forward points on standard delivery dates, usually
monthly out to 12 months, of a specified amount of one currency
against another.
o As the dealer does not know what the spot rate will be on a future
date, they will carry out the FX transaction today even though
delivery will not occur until the future date;

Borrow funds in one market and purchase the foreign currency

that will be needed at a future date.

Invest the purchased foreign currency in that market until

delivery is due
The difference between the cost of borrowed funds and
the return received on the invested foreign currency will
be adjusted against the spot rate today.

Real-world complications:

Two-way FX quotations can be a problem if care is not taken when

selecting appropriate bid and offer rates in calculating forward points.

Different interest rate year conventions may involve converting a 360day basis to a 365-day basis or vice-versa

Variations in interest-compounding periods may be an issue (consider

the effective rate of interest on borrowed funds and the value of deposits)

Bid vs. Offer forward points

An example(1):
A company approaches an FX dealer for a forward quote on the USD/CHF with a
three-month (90-day) delivery. The spot rate is USD/CHF1.1555-60. The
dealer needs to calculate the forward points. Assume the three-month USD bid
and offer interest rates are 3.00% and 3.30% p.a. and the three-month
euroSwiss franc interest rates are 3.70% and 4.00% per annum, respectively.

The forward points are rising so they will be added to the spot rate. Therefore, the
three-month forward exchange rate will be USD/CHF1.1566-89

7/7 European Monetary Union and FX Markets:

16 Members of the EU (out of 27) are members of the EMU

o As the EMU gains acceptance, the size and liquidity of EMU member
equity and bond markets will increase.

The euro has become a hard currency like the USD, JPY and GBP (it is
generally accepted in international trade transactions)

Week 8 CONT
Factors that influence the Exchange Rate:
1/3 FX markets and equilibrium Exchange Rate
(floating exchange rate):

Demand for currency:

o

To purchase Australian goods and services, foreigners must buy AUD

Hence it can be seen that the Supply and Demand of AUD operates
under a supply and demand curve.

Downward sloping demand curve occurs as the devaluation

of AUD results in a greater demand by foreigners (as it is the
same as a reduction in the price of everything listed in AUD)

Upward sloping supply curve occurs as the quantity of AUD

supplied to the FX market increases as the price of the AUD
increases.

AUD appreciation causes higher AUD buying power and

hence cheaper foreign goods for AUD users hence
demand for foreign currency increases and thus the
supply of AUD does as well.

Equilibrium exchange rate is the rate at which the quantity

of AUD supplied equals the market demand for AUD and is the
rate at which demanders and suppliers are both satisfied.

2/3 Factors that influence exchange rate

movements:
Relative inflation Rates:

Inflation rates influence the price (and hence demand) of foreign goods.
o Since the demand for imported goods changes, so does the demand
for foreign currency used to buy those goods.

Purchasing Power Parity is the view of determination of

value of a currency via this method (goods), but this relies on
the law of one price which rarely holds.

For example US inflation increases relative to Australia;

o For AUS: US imports will be more expensive, decreasing demand for
these and reducing supply of AUD
o For USA: Some US demand for goods/services/assets will switch (be
substituted) for now relatively cheaper AUS items, increasing
demand for AUD to pay for them.

NET EFFECT IS AUD

APPRECIATION

Relative interest rates:

For example: If Australian Interest rates rise relative to the US:

o FOR AUS: Australian Investors and businesses are more likely to keep
their surplus funds invested in Australia, causing a decrease in the
supply of the AUD
o FOR USA: US residents and companies may redirect some of their
cash into Australian interest-bearing instruments increasing demand
for AUD

NET EFFECT IS AUD APPRECIATION

Graph for both above:

Interest Rates in Depth:

Reason for change in nominal interest rate:

This could change due to the real rate of return

OR the inflations expectations premium

If nominal interest rates rise because:

>>>Increase in the inflations expectations premium:
o Currency may not appreciate and could depreciate because of:

Effect of inflationary expectations (PPP)

Business and individuals investing cash in overseas securities

to avoid the loss in value.

Relative national income growth rates:

For example Australian Income growth rates rise relative to the

US
o Australia will therefore have increased demand for imports, increasing
the supply of the AUD causing the AUD to depreciate.

Ther
e could also
be an
increase in
foreign
investment in
Australia,
increasing
demand for
AUD and thus
appreciating
AUD to a
small extent

Exchange rate expectations:

A significant portion of turnover in the FX market is motivated by changes

in exchange rate expectations.

If AUD is expected to depreciate:

o AUD residents seek to buy
foreign currency before AUD
falls

Increases supply of AUD

on markets

o Foreign residents defer

purchases of AUD.

This reduces demand for AUD

o AUD depreciates as expected

Government / Central Bank intervention:

The policies by BOTH domestic and foreign governments can influence

the relative rate of inflation, income growth, interest rates etc.
o Expectations of all these above being altered in a certain way can
affect the elements.

Central banks: also influences the currency by;

o Intervening in international trade flows to increase exports and/or
reduce imports

Subsidies to exporters to make exports more competitive

(increase demand for AUD exports and hence AUD)

Importer intervention through Tariffs (to increase prices),

Quotas or Embargo

o Intervening in foreign investment flows (alter exchange rate by

altering flow of investment funds
between countries):

Prohibitions on the outflow of

funds from a country

Penalty taxes on residents

earning offshore income and
non-residents interest income
earned in the home country.

o Directly intervening in the FX market purchases or sales of currency

Smoothing removing volatility in the currency caused by

speculations

Exchange rate targeting RBA attempting to push equilibrium

exchange rate to a certain level

3/3 Measuring Exchange rate sensitivity to Changes in

Economic Variables:
Regression analysis can be used to assess how changes in economic
variables affect the exchange rate.