Financial Institutions, Instruments and Markets

8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips

Chapter 15
Foreign exchange: the structure and operation of the FX market
Learning objective 1: Understand the nature, size and scope of the global FX markets and
the main exchange rate regimes used by different countries
FX markets exist wherever transactions are denominated in a foreign currency, including
international trade transactions, cross-border capital transactions, speculative transactions
and central bank transactions.
The FX markets operate through a highly sophisticated network of telecommunications
systems that link the numerous FX dealers and FX brokers located in all of the major
cities of the world.
An exchange rate is the value of one currency relative to another currency. Each country, or
group of countries within a monetary union, is responsible for determining the form of
their exchange rate.
Most major currency exchange rates are determined using a floating exchange rate regime,
including the currencies of the USA, UK, EMU, Japan, Australia and New Zealand.
A floating exchange rate is determined by factors that affect the supply and demand of
currencies within the FX market.
Countries such as China, Singapore, Malaysia and Indonesia operate a managed exchange
rate regime, whereby the exchange rate is allowed to move within a defined range relative
to a specified major currency or basket of currencies.
A crawling peg exchange rate regime allows the currency to appreciate over time, but
within a limited range determined by the government and/or central bank. A major
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difference between a managed float and the crawling peg is that market participants
generally agree that a currency using the crawling peg is typically undervalued. This may
in fact describe the regime used in China.

With a linked exchange rate regime, as used by Hong Kong, the exchange rate is locked
into a ratio with a nominated currency, such as the USD, or a basket of currencies.

Learning objective 2: Identify and discuss the major groups of participants in the FX
markets

Participants in the FX markets include those who have underlying commercial and
financial transactions denominated in foreign currencies. This includes importers and
exporters, and those investing or borrowing overseas in a currency other than their home
currency.

In addition, there are speculators who buy and sell foreign currencies in the expectation
of making profits from favourable exchange rate movements, and there are those who
arbitrage exchange rate and/or international interest rate differentials across the different
international markets.

Central banks also enter the FX markets as buyers and sellers of foreign currency. A
central bank may enter the FX market in order to provide its governments foreign
currency requirements or, from time to time, in an attempt to influence the value of a
currency in the market,ortoadjustitsforeigncurrencyreserveportfolio.

Learning objective 3: Describe the functions and operations of the FX markets

The FX markets operate somewhere around the globe 24 hours a day.

The markets are dynamic, with exchange rates changing in response to the continuous
flow of economic, political, financial and social news and information into the markets.

It is estimated that around the equivalent of USD5 trillion pass through the FX markets
each day, facilitated by FX dealing rooms that use sophisticated, technology-based
computer and communication systems.

Learning objective 4: List and explain the types of FX transactions, in particular spot and
forward transactions

The contracts that are traded in the FX markets are distinguished by their maturity or
delivery dates.
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Spot and forward contracts are the most common contracts traded.

Spot transactions have a value date that is two business days from today; that is, they
require delivery of the foreign currency and financial settlement two business days from
the contract date.

Forward contracts specify a value date more than two business days from today.

Learning objective 5: Introduce the conventions adopted for the quotation and calculation
of spot exchange rates

Because of the technology-based nature of the trade in foreign currencies, universal

conventions are adopted in the FX markets.

For example, a spot quote may be AUD/USD0.925056.

The first-named currency in an FX quote is called the unit of the quotation, or the base
currency. The base currency represents one unit of the currency.

The second-named currency is known as the terms currency.

FX dealers, or price-makers, quote two-way rates: the first and lower rate is the one at
which the dealer buys the base currency; the second and higher rate is the one at which
the dealer sells the base currency.

FX dealers will abbreviate their verbal FX quotes byremovingdecimalpointsandnot

repeatingcommonnumbers.

Exchange rates with less than 10 units of the terms currency are quoted to four decimal
places, and currencies with more than 10 units are quoted to only two decimal places.

The spread is the difference between the bid and offer rates.

A point is the final decimal place in a quote.

It is possible to derive a range of additional exchange rates on the basis of existing

published rates; for example, transposed and cross-rates can be calculated.

To transpose a quote from, say, a direct USD/AUD quote to an indirect AUD/USD quote,
the rule is to reverse the quote and then invert by dividing into 1.

As all currencies are quoted against the USD, it is often necessary to calculate a crossrate that does not incorporate the USD, for example SGD/NZD.

To calculate the cross-rate for two direct quotes, place the new base currency quote first,
followed by the second quote. Simply divide opposite bid and offer rates to obtain the
cross-rate.
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Learning objective 6: Describe the role of the forward market and calculate forward
exchange rates

The convention adopted in the quotation of forward rates is that the dealer quotes the
forward points rather than the outright forward rates.

To obtain the outright rate, the forward points are added to, or subtracted from, the spot
rate.

In calculating the forward points, the dealer uses the spot rate and the differential rates of
interest of the two countries whose currencies are quoted.

Whentheinterestratesofthebasecurrencycountryarehigherthaninterestratesinthe
termscurrencycountry,thenthebasecurrencywillbeataforwarddiscountandthe
forwardpointsaresubtractedfromthespotrate,orviceversa.

If the forward points are rising they are added to the spot rate and vice versa.

The calculation of forward points is:

Learning objective 7: Identify factors that complicate FX market price quotations and
calculations
Weneedtoconsiderrealworldcomplicationswhichaffectthecalculationof
forwardpointsandaforwardexchangerate.Theseinclude:
o differentinterestrateyearconventions;forexample,theUSAusesa360
dayyearwhiletheUKusesa365dayyear
o twowayquotations(bidandofferquotes)
o differentborrowingandlendinginterestrates
o theeffectsofcompoundingperiods.
Learning objective 8: Recognise the important impact on the FX markets of the Economic
and Monetary Union of the European Union (EMU).
4

The Economic and Monetary Union has had a significant impact on the structure and
operation of the FX markets. Seventeen foreign currencies have been replaced by a single
currency, the euro.

The euro has become a hard currency for commercial and financial transactions and a
major currency traded in the FX markets.

Essay questions
The following suggested answers incorporate the main points that should be recognised by a
student. An instructor should advise students of the depth of analysis and discussion that is
required for a particular question. For example, an undergraduate student may only be
required to briefly introduce points, explain in their own words and provide an example. On
the other hand, a post-graduate student may be required to provide much greater depth of
analysis and discussion.

1. The global foreign exchange markets are enormous. The Bank for International
Settlements estimated in 2014 that USD5 trillion in FX transactions occurred daily.
Explain the role of SWIFT in the international financial markets and give some reasons
for the strong message traffic growth that SWIFT has experienced. (LO 15.1)
SWIFT is a member-owned cooperative that operates an international electronic
communications system for the transmission of payment orders.
The very large size, geographic diversity and diverse institutional characteristics of the FX
markets require a safe, secure and standardised platform for the transmission of payment
orders. SWIFT provides this platform.
Payments orders are settled by and among the financial institutions that are party to the
relevant transactions.
As the international scope of financial markets has expanded and the number of
participant institutions and countries has grown, the number of payment orders
transmitted must be expected to increase.
No doubt, however, the growth in message traffic experienced by SWIFT is also
indicative of the value that financial institutions place on standardised and secure
communications.

2.

As we have seen, the worlds foreign exchange markets are characterised by a

mixture of fixed and floating exchange rate regimes.

(a) Use your research skills to find out which European countries operate a fixed
exchange rate regime. Identify some of the economic advantages that may be associated
with maintaining such a system.

Interestingly, several European countries operate fixed exchange rate regimes. These
countries are Bosnia and Herzegovina, Bulgaria, Latvia, Denmark and Lithuania.
Denmark, for example, pegs its currency, the Krone or DKK, to the Euro.

There may be some advantages to maintaining a fixed exchange rate. These include
potentially enhanced economic stability and greater certainty for international investors
and customers. Benefits might also derive from reduced speculation in the countrys
currency.
(b) Discuss why China, as a major trading country, might move to adopt a

floating exchange rate regime. (LO15.1)

China has maintained a pegged currency for many years. Since the mid-2000s it has
allowed very measured appreciation in its currency against the US dollar. The reason for
the tight controls is Chinas fear that a sharp appreciation in its currency will make its
exports more expensive and slow economic growth.

Weighing against these considerations is Chinas emergence as a major player in the

world economy. It sees a role for its currency as a reserve currency, a role traditionally
played by the US dollar. To achieve this goal, it is believed that the currency will have to
float freely on the FX markets.

There are also political considerations. China has long been under pressure to allow its
currency to appreciate or freely float. The US has led these calls. The rationale is that a
stronger Chinese currency will increase the demands by Chinese consumers for Western
exports.

3. Importers, exporters, investors and borrowers may all be participants in the FX

markets. Explain why each of these parties would be involved in FX market
transactions. (LO15.2)
Firms conducting international trade transactions (importers and exporters):

Businesses that export goods or services in the international markets generally receive
payments in a foreign currency
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Also businesses that import goods and services need to pay for those goods and services,
usually in a foreign currency

The dominant currency of international trade is the USD, but other currencies, such as the
GBP, JPY and the EUR, are also prominent

Typically, an exporter is likely to sell foreign currency received and buy the local
currency through an FX market

Importers have to buy foreign currency in order to pay for their imports.

Investors and borrowers in the international financial markets:

Deregulation of the international financial markets has resulted in an enormous increase

in the volume of capital flows around the world.

Large corporations, financial institutions and governments raise funds in the international
capital markets.

Borrowers with good credit ratings are able to diversify their funding sources in the
international capital markets, such as the euromarkets.

A large proportion of funds borrowed in the international markets is converted in from

the currency borrowed back into the home currency, using the FX market.

Other corporations and financial institutions invest overseas; for example, funds
managers for pension or superannuation funds will invest a proportion of their investment
portfolios in international stocks and debt securities.

The funds managers need to purchase FX in order to make the investments.

Dividend or interest payments received by the funds managers will be denominated in a

foreign currency. The managers may sell on the FX markets to convert the receipts back
into the home currency for distribution to fund members.

4. (a) Distinguish between speculative and arbitrage transactions in the FX market.

Speculative FX transactions are motivated by the pursuit of a profit

The sheer volume of speculative transactions implies that, at times, speculators are able
to move the market price of a currency

Such transactions are always accompanied by an element of risk

Arbitrage transactions are possible when price differences appear between markets

The arbitrageur is able to carry out simultaneous buy and sell transactions in two or more
markets to lock-in a risk-free profit.

(b) TheFXdealingroomofamajorbankhascalculatedthatitislongintheUSD,but
isshortintheEUR.Explainwhatismeantbythesepositions.

If the dealer is long in USD it means that it is holding surplus USD on its account, that is,
the USD are in excess to its currency requirements to meet exiting FX contracts.

Alternatively, the bank may be speculating on directional movements in exchange rates.

Therefore the bank may take a long position in USD and a short position in EUR.

Long positionholding FX in expectation of a future sale.

If there is an expectation that the AUD will depreciate against the USD, the bank might
go long and buy the USD (sell the AUD) now. If correct, a profit will be made by
converting the USD back into AUD after the AUD has depreciated. However, if the AUD
appreciates instead, the bank will lose.

Short positionentering into a forward contact to sell FX that is currently not held.

If there is an expectation that the AUD will appreciate against the EUR, the bank might
go short and sell forward the EUR now at an exchange rate locked in today. If correct, the
bank will buy the cheaper EUR on the forward delivery date and make a profit on the
transaction. However, if the AUD depreciates instead, the bank will lose.

(c) Describe arbitrage transactions using an example of a triangular arbitrage. (LO

15.2)

An arbitrageur will attempt to identify markets in which pricing equilibrium is not fully
reflected in the price of a financial asset. For example, it may be possible to discover a
cross-currency price advantage by buying and selling several foreign currencies in
several FX markets at the same time.

Triangular arbitrage occurs when exchange rates between three or more currencies are
out of perfect alignment. Again, the arbitrageur will simultaneously buy and sell a
combination of currencies to take advantage of the price differences.

Arbitrage profit opportunities generally do not exist for long. The buy/sell actions of the
arbitrageurs bring the prices back into equilibrium.

5. Many developed economies operate within a floating exchange-rate regime. Where a

country has a floating exchange rate, identify and discuss the circumstances in which
the central bank of that country might conduct transactions in the FX market. (LO
15.2)
The central banks of nation-states enter the FX markets periodically, for one or other of the
following reasons:

to acquire foreign currency to pay for their government's purchases of imports, such as
defence equipment, and to pay interest on, or to redeem, the governments overseas
borrowings.

to change the composition of the central banks holdings of foreign currencies as part of
its management of official reserve assets. Official reserve assets are central banks
holdings of foreign currencies, gold and international drawing rights

to influence the exchange rate. Central bank intervention in the FX market would not
exist if the value of a currency was determined purely by market forces, that is, a socalled clean-float. However, central banks may, at times, be significant buyers or sellers
of a currency where it considers the exchange rate is moving too rapidly, and is trading
well outside rates that can be supported by economic fundamentals. If the goal is to slow
down an appreciation of the exchange rate, the central bank will sell its local currency. In
another example, if the Reserve Bank wished to support the AUD to stop it depreciating
and perhaps assist it to appreciate, it would buy AUD and sell foreign currency.

6. The major commercial and investment banks locate their FX dealing rooms within
their treasury operations. Describe how an FX dealing room is structured and functions
within a major bank. (LO15.3)

ThenumberofdealersinanFXdealingroommayrangefromafewFXdealerstomore
than100dealersdependingonthescaleofaninstitutionsFXoperations.

ApartfromtheFXdealers,aninstitutionwillprobablyalsohavedealersthattradein
derivativecontractsbasedonfinancialinstrumentsandcommodities,cashproductsand
debtsecurities.

TofacilitateFXtransactionsitisessentialthatthevariousdealingroomsaroundthe
worldhaveaccesstothesameinformationateachmomentintime.

TheinformationsoughtbyFXdealingroomsisnotonlythecurrentbuyandsellratesfor
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thevariouscurrencies,butalsotheeconomic,politicalandsocialnewsthatmayaffect
thevaluesofanyparticularcurrency.

Thereareanumberofglobalelectronicnetworks,suchasReutersandBloomberg,who
providesuchinformation.

InanFXdealingroom,anarrayofcomputerscreenslinktheelectronictradingplatforms
ofFXdealers.

Eachdealer,bykeyinginthecodesforanyotherdealingroom,isabletoseeonthe
screentheindicativeFXratesatwhichtheotherdealersarepreparedtobuyandsell
variouscurrencies.

Firmrates,atwhichFXdealersarepreparedtotransact,areobtainedfromeachdealers
electronictradingplatform.

Dealsareconfirmedinwritingelectronicallyassoonaspossibleafterthetransaction.
Dealingroomsalsotaperecordconversationsatthedealingdeskforuseinsettlingany
disputesthatmayarise.

FXdealershavedevelopedconventionsandalanguageoftheirown.Thefollowing
sectionspresentandexplainsomeoftheconventionsandthelanguageusedintheFX
markets.

7. Outline the features of the main types of contracts that are created in the FX
markets, distinguishing between short-dated, spot and forward transactions. (LO15.4)

An FX transaction is described by its value date, that is, the day that the currency is
delivered and settlement is made.

Spot transactionsthe FX contract value date is two business days from the date of the
initial order. The exchange rate is determined today, but delivery occurs in two business
days. For example, a company places an order with an FX dealer to buy USD1 million at
a rate of AUD/USD1.3032 on a Tuesday, then the dealer will deliver USD1 million on the
Thursday and the company will pay AUD767 341.93 also on the Thursday.

Forward transactionsthe FX contract value date occurs at a specified date beyond the
spot date, for example an order to sell EUR in three months. Again, the exchange rate is
set today that will apply at spot plus three months. If today is 24 March then the 3-month
forward value date will be 26 June, providing that is a business day (if not, the date will
be moved forward to the next business day).
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tod transactionsan FX contract with settlement and delivery today.

tom transactionsan FX contract with settlement and delivery tomorrow.

8. The FX market has a well-established set of language conventions. These

conventions have been developed to allow the efficient communication of market data.
Explain and illustrate this statement by reference to the language conventions used in
the spot FX markets. Use an example to explain your answer. (LO15.5)

Assume the following quote AUD/USD0.965256

The first-named currency in the quote is the base currency or the unit
of the quote, that is one AUD equals USD0.965256

The second named currency is the terms currency, the USD. The terms
currency is valued relative to the base currency

The quote is a two-way price, that is, a bid price (buy) and an offer
price (sell)

The first number is the bid priceAUD/USD0.9652

The second number is the offer priceAUD/USD0.9656

The market convention is to drop common numbers between the

bid/offer price

The bid/offer is from the perspective of the dealer, that is, the dealer
will buy 1AUD for USD0.9652, or sell 1AUD for USD0.9656

The difference between the dealers bid/offer prices is the spread

The spread in the example is 4 points (a point is the last decimal point
in a quote).

9. Using the context of the currency pair USD/JPY, explain the terms base currency,
terms currency, direct quotation and indirect quotation. (LO15.5)

Base currencythe first named currency in an FX quote that is expressed as one unit in
terms of the second currency. In the USD/JPY example the base currency is the USD and
is expressed as 1USD will be bought/sold for the amount of JPY that will be given in the
quote.

Terms currencythe second named currency in the quote, that is, the JPY.

11

Direct quotationwhen the USD is the base currency of the unit of the quotation as in
the USD/JPY example

Indirect quotationwhen the USD is the terms currency and the other currency is the
base currency in the quotation. In that case the above quote would be transposed to
JPY/USD.

10. An FX dealer is quoting spot USD/SGD1.275056.

(a) explain from the perspective of the dealer what the FX quote indicates.

The price maker FX dealer will buy USD1 for SGD1.2750. For the party that has entered
into the FX contract with the dealer they will sell USD1 and receive SGD1.2750

Also, the dealer will sell USD1 for SGD1.2756; the customer will receive USD1 and pay
the dealer SGD1.2756

The dealer will make a margin of 6 points between its bid and offer transactions.

(b) transpose the quotation. (LO15.5)

The USD/SGD1.275056 is a direct quote; the USD is the base currency

It is possible to transpose the direct quote to an indirect quote (SGD/USD)

Rule: reverse then invert.

USD/SGD1.27501.2756
Reverse the bid/offer prices
1.27561.2750
take the inverse, that is, divide both numbers into 1
SGD/USD0.78390.7843

11. A mens fashion label in the UK is exporting goods to Denmark. In order to

ascertain the firms exposure to foreign exchange risk the company needs to calculate
the GBP/DKK cross-rate. An FX dealer quotes the following rates:
USD/DKK

5.403137

USD/GBP

0.606369

Calculate the GBP/DKK cross-rate. (LO15.5)

Crossing two direct FX quotations:

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o place the currency that is to become the unit of the quotation first
o divide opposite bid and offer rates, that is:
o to obtain the bid rate: divide the base currency offer into the terms currency bid
o to obtain the offer rate: divide the base currency bid into the terms currency offer.

Therefore, place the USD/DKK quote first:

USD/DKK

5.403137USD/GBP 0.606369

To determine the GBP/DKK cross rate:

5.4031 / 0.6069 = 8.9028
5.4037 / 0.6063 = 8.9126
GBP/DKK 8.9028-9126
12. A Swiss manufacturer generates receipts in USD from its exports of chocolate to
America. At the same time, the company imports cocoa from Nigeria, incurring
commitments in NGN (naira). Rates are quoted at:
USD/NGN

162.2520-29

CHF/USD

1.1310-19

Calculate the CHF/NGN cross-rate. (LO15.5)

It is possible to use two methods to calculate this cross-rate; first

transpose the CHF/USD rate to a direct USD/CHF rate and then use
the two direct quote method (see question 11). Alternatively, use the
direct and indirect quote method.

Crossing a direct and an indirect FX quotation:

o to obtain the bid ratemultiply the two bid rates
o to obtain the offer ratemultiply the two offer rates.

To determine the CHF/NGN cross rate:

165.2520 x 1.1310 = 183.5070
162.2529 x 1.1319 = 183.6988
CHF/NGN 183.50-69

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13. A German importer has entered into a contract under which it will require payment
in GBP in one month. The company is concerned at its exposure to foreign exchange
risk and decides to enter into a forward exchange contract with its bank. Given the
following (simplified) data, calculate the forward rate offered by the bank. (LO 15.6)
EUR/GBP (spot):

0.826067

One-month German interest rate: 4.75% p.a.

One-month UK interest rate: 3.25% p.a.

The quote is from the perspective of the dealer relative to the base currency.

The importer needs to buy GBP therefore it will sell EUR to the dealer. The dealer is
therefore buying EUR, so need to use the bid rate.

S [1 + (It x contract days/days in year)]

[1 + (Ib x contract days/days in year)]
where:

S = spot rate
Ib = interest rate of base currency
It = interest rate of terms currency

Therefore, based on the above data:

0.8260 [1 + (0.0325 x 30/365)]
[1 + (0.0475 x 30/365)]
= 0.8260 (1.00267 / 1.0039)
= EUR/GBP0.8250
14. While the FX markets are a global market, variations in calculation conventions can
occur. When considering interest rate differentials and forward exchange rate
calculations between currencies such as the USD and the GBP, what important
adjustmentsneedtobetakenintoaccount?

The USA uses a 360-day year convention while the UK uses a 365-day convention

There is a need to recognise this variation in the forward exchange contract formula.

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15. The establishment of the Economic and Monetary Union has had a significant
impact on the structure and operation of the global FX markets.
(a) Discuss the process of monetary union in Europe and the issues relevant to the FX
markets that are implied in the above statement.

The Maastricht treaty seeks to create economic and monetary union within Europe.

As of 1 January 2014, 28 countries are members of the European Union (EU). The
newest member is Croatia. Only 17 member states have adopted the euro as their nations
currency. The euro was introduced for financial transactions in January 1999.

Euro notes and coins were introduced in January 2002.

The euro has become a hard currency used for international trade and financial
transactions.

Central banks around the world support the euro by holding the euro as part of their
foreign reserves.

The removal of 17 currencies and the introduction of one major currency (the euro) has
increased the liquidity in the FX market.

The introduction of the euro has removed foreign exchange risk for trade and financial
transactions denominated in euro that are carried out between member states.

(b)DiscussthewaysinwhichthecontinuedevolutionoftheEMUmayshapeFX
marketsinthefuture.
Themostinterestingwayinwhichfurtherevolutionmayshapemarketsisbythegradual
establishmentofaUnitedStatesofEuropeinwhichasharedcurrencyandsharedbond
marketscharacterisetheEuropeanfinanciallandscape.
TheEurocurrencyandtheestablishmentofEurozonehavemadetradeandfinancemuch
less risky across the region. Crosscurrency risks have been eliminated. Further
expansionoftheEMUtoincludemorecountriesthatwilleventuallyadopttheEuromay
reducethecurrencyrisksexportersandimportersfacewhendealingwithsomeofthe
smallerEuropeaneconomies.
However,theGFChasdemonstratedthattheEMUhasintroducedalternativesovereign
debtrisksandgeopoliticalrisksthatmaynothavebeenasapparentinpreviousdecades.
Themoreintegratednatureoffinancialinstitutionsandrealeconomiesisalsoattendedby
greaterriskofcontagionduringfinancialcrises.
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FINANCIALNEWSCASESTUDY
Chapter 15 introduced the foreign exchange markets and provided a good
understanding of the structure and operation of the FX markets. The Bank for
International Settlements publishes a Triennial Survey of activity in the global FX
markets. This survey always makes for interesting reading. One of the most
interesting features of the FX markets that is revealed in each survey is the
extraordinary magnitude of the volume of FX trading that takes place each day. As we
have mentioned in the chapter, more than $5 trillion of FX is traded each day. In these
trades, the US dollar is on one side of the transaction on 87 per cent of occasions. The
second most traded currency is the euro. Most of the trading takes place at trading
desks located in the United States, the United Kingdom, Singapore and Japan.

Global turnover of more than $5 trillion per day works out to approximately to $2000
trillion per year. This figure can be contrasted with the annual value of global trade
flows, which the World Trade Organisation estimates at approximately $20 trillion. It
is quite easy to see that much of the turnover on the FX markets has no relationship to
the physical flow of goods around the world. It is also plausible to conclude that much
of the turnover is also unrelated to hedging the value of FX associated with the
physical trade of goods. The amount of turnover on the FX markets implies that there
is a considerable amount of speculative activity that is somewhat detached from the
underlying real economic transactions that characterise the global economy.

In Australia and around the world, there has been increasing participation in FX
trading by small investors. This has resulted in several ASIC warnings to investors as
well as the imposition of sanctions and penalties on unscrupulous providers of trading
platforms. The warnings are summarised in the following news story from the
Business Review Weekly (BRW):

The Australian Securities and Investments Commission has delivered an unusually

16

stern warning to retail investors about foreign exchange trading, and detailed the
reasons the odds are stacked against them. On the heels of the collapse of GTL
Tradeup, a Sydney forex derivatives broker that has gone into liquidation owing
clients $3 million, the regulator has warned that just one of the risks faced by
investors in foreign exchange is 'counterparty risk', where an issuer defaults on
obligations. Fretting that promoters of forex investment strategies are on the rise,
ASIC has documented five reasons why most investors are not cut out for the products
they offer.

1. There are significant investment risks as currency fluctuations may move

against you, causing you to lose money. Exchange rates are very volatile
they tend to move around a lot even within very short periods of time.
2. Markets are open 24 hours a day, six days a week (due to time zones), so you
need to devote a lot of time tracking your investment.
3. Currency markets are extremely difficult to predict because so many factors
affect exchange rates.
4. Even small market movements can have a big impact, because more forex
trading products are highly leveraged.
5. Risk management systems, such as stop-loss orders, will only give you limited
protection by capping your losses. You may have to pay a premium price to
guarantee your stop-loss order.

'Forex trading is complex and risky. Even the most skilled and experienced forex
traders have difficulty predicting the movements in currencies. Trading in
international currencies requires a huge amount of knowledge, research and
monitoring,' ASIC Commissioner Greg Tanzer says.

'Like any investment, it is vitally important investors fully understand what they are
getting into, and FX trading is no different. Unless you fully understand what
investment you are making and the risks involved with that investment, don't do it.'

SOURCE: Michael Bailey, 2013, 'Forex Trading: Five Reasons ASIC Says it's a Mug's Game, Business

17

Review Weekly, October 21.

DISCUSSION POINTS

The volumes, in USD terms, of transactions in the global FX markets are

large compared to underlying trade flows. Is there a case for the restriction of
FX trading?
A case could certainly be made. When there is such a large volume of
transactions in excess of the real underlying economic activity, a case can be
made for curtailing the extent of (speculative) trading activity. Financial
speculation well in excess of the underlying real economic factors is a longrunning target for criticism, especially in times of crisis.

Evaluate ASICs position regarding the suitability of FX trading for small

investors.
ASIC effectively points out that unprofessional investors are likely to suffer losses if
they attempt to trade FX. This is probably true for any financial security. However,
there are a number of reasons, identified by ASIC, why this might be particularly the
case in the FX markets. The volatility of the markets, their round the clock nature and
the leverage inherent in many of the products ensure that mistakes may be punished
more severely.

Discuss ASICs conclusion that the movements in the FX markets are impossible to
predict because of the many factors that affect exchange rates.
This is probably true, though some traders would argue that technical trading rules and
momentum type strategies work, particularly in the shorter term (over a matter of
seconds or minutes). Over the longer term, macroeconomic factors shape the ups and
downs in currencies. These factors are likely to have a predictable component and an
unpredictable component. When this semi-predictability is combined with the level of
trade, volatility and speculation that characterises the FX markets, it is possible to argue
that FX markets move up and down in a manner that is impossible to predict.

True/False questions

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1.

F FX markets are open for a short period each day during which a small number of

transactions are undertaken.

2.

T Although Australia operates a floating exchange rate regime, the Reserve Bank has

sometimes intervened in the FX markets.

3.

T The Chinese government has gradually widened the range over which its currency

may appreciate and depreciate relative to other currencies.

4.

F There are two different types of FX dealers: those that offer to buy currencies at a

particular price and those that offer to sell currencies at a particular price.
5.

F Central banks do not usually hold any reserves of foreign currency but simply

acquire it as the need arises.

6.

T A spot transaction is one in which an order to buy or sell a currency is placed today,

at a price determined today, and with settlement of the transaction taking place two working
days from today.
7.

F A forward FX transaction is one in which the order is placed today, at a price

determined at the time of the order, but with settlement of the transaction taking place before
spot.
8.

F If a firm were to ask a dealer for the dollar euro spot or for the euro dollar spot,

the firm will receive the same bid and offer quotes.
9.

T Given USD/EUR0.72500.7255, the FX dealer would buy USD1 from you and

give you EUR0.7250.

10.

T A verbal quote of Euro Aussie spot is one thirty-one seventy-twoeighty would be

written as EUR/AUD1.317280.
11.

Given

the

quotation

EUR/AUD1.327280,

the

transposed

rate

is

cross-rate

is

AUD/EUR0.753530.
12.

Given

AUD/JPY82.5060

and

AUD/EUR0.590515,

the

EUR/JPY139.4888.
13.

F Given USD/JPY76.1015 and GBP/USD1.63501.6360, GBP/JPY is 46.5246.57.

14.

F If an FX dealer is short a currency, they will need to sell the physical currency to

settle an existing FX contract when the contract falls due.

15.

T If a bid price on the USD/EUR is 0.7267 and the offer price is 0.7273, the spread is

6 points.
16.

T If the spot rate is AUD/USD0.92200.9225, and the six-month forward points are

58 to 63, the six-month forward rate would be AUD/USD0.92780.9288.

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17.

T The data in question 16 indicate that the rate of interest on six-month money is

higher in the USA than it is in Australia and that the AUD is at a forward premium.
18.

F As a result of the sovereign debt crisis the euro has ceased to be a hard currency

widely used in international trade.

19.

F All member states of the European Union now have the euro as their currency unit.

20.

T In the USA, Japan and Europe, money-market instruments are usually quoted on

the basis of a 360-day year, whereas in the UK, Australia and New Zealand these rates are
quoted on a 365-day year.

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