Chapter_2

Chapter 2

The Foreign Exchange Market

Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa

Slides prepared by Afaf Moosa

2-*

Objectives
To describe the FX marketTo identify participants and currenciesTo describe the Australian FX marketTo describe the mechanics and technology of FX trading
(cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa



2-*

Objectives (cont.)
To introduce some exchange rate conceptsTo illustrate FX position keepingTo introduce some FX jargon



2-*

Definition
The FX market is the market where national currencies are bought and sold against one another. Foreign exchange consists mainly of bank deposits.



2-*

Characteristics
It is the largest and most perfect marketIt is needed because every international transaction requires a foreign exchange transactionIt is an over-the-counter (OTC) market



2-*

Market participants
Foreign exchange traders buy and sell currencies directly or indirectlyArbitragers exploit exchange rate anomalies; hedgers cover open positions; speculators take open positions



2-*

Categories of participants
CustomersCommercial banks Other financial institutionsBrokersCentral banks



2-*

Interbank operations
The FX market is dominated by interbank operationsParticipants in the interbank market are market makers, other major dealers and second-tier banks



2-*

Size and composition
The size of the global FX market is measured by the sum of daily turnover in FX centresA survey is coordinated by the BIS every three years for this purpose



2-*

Daily turnover in the FX market (USD billion)




2-*

Geographical distribution of FX market turnover (%)




2-*

FX market turnover by counterparty (institutional type)




2-*

FX market turnover by counterparty (locality)




2-*

Currency composition of the FX market
(by single currencies)




2-*

Currency composition of the FX market
(by currency pairs)




2-*

Traded currencies
The US dollar is the most heavily traded currencyThe euro and the yen are heavily traded because of the importance of Europe and Japan in the world economy
(cont.)




2-*

Traded currencies (cont.)
The pound is heavily traded for historical reasonsCurrencies that are heavily traded in certain financial centres and lack liquidity in others: CHF, CAD
(cont.)




2-*

Traded currencies (cont.)
Currencies that are traded locally, but internationally are traded for international trade purposes: AUD, NZD, HKDThird world currencies: soft or exotic currencies



2-*
The market consists of the banking system and non-bank dealers authorised by the Reserve Bank of Australia (RBA)The market has grown since the flotation of the AUD in 1983
The AUD FX market




2-*

Daily turnover in the Australian FX market (USD billion)




2-*
DeregulationHigh interest rates in the 1980sAustralias time zoneExchange rate volatility
Reasons for the growth of the AUD market




2-*

Components of an FX transaction
Price discoveryDecision makingSettlementPosition keeping



2-*

FX market technology
The telegraphThe telephoneThe telex The fax
(cont.)




2-*

FX market technology (cont.)
Screen-based information systemsScreen-based automated dealing systemsAutomatic order matching systemsOnline FX trading



2-*

The bilateral spot exchange rate
The exchange rate between two currencies for immediate delivery



2-*

Transaction dates
The date on which the transaction is agreed upon is called the contract date, dealing date, done date or trade dateThe date on which currencies are exchanged is the value date or the delivery date



2-*

A spot foreign exchange transaction

Confirmation of exchange rate and amount

Bs

account

As

account

(Monday)

A

B

AUD 1 000 000 (Wednesday)

USD 500 000 (Wednesday)




2-*

The delivery date
Typically, the delivery date is two business days after the contract dateIn a value-today or same-day transaction the delivery date is the same as the contract dateIn a value-tomorrow or next-day transaction the delivery date is one day after the contract date



2-*
S (x /y ) is the price (in terms of x) of one unit of y :
Spot rate quotation




2-*
When the exchange rate changes from S0(x/y) to S1(x/y)
Exchange rate changes




2-*
To convert from y to x, multiply by the exchange rateTo convert from x to y, divide by the exchange rate
Currency conversion




2-*
Direct quotation refers to the domestic currency price of one unit of the foreign currencyIndirect quotation refers to the foreign currency price of the domestic currencyWhat is a direct quotation from the perspective of one country is an indirect quotation from the perspective of the other country, and vice versa
Exchange rate quotation in practice




2-*
The bid rate is the rate at which the quoting dealer is willing to buy. The offer rate is the rate at which the quoting dealer is willing to sell.The spread is
The bid and offer rates




2-*

A foreign exchange spot transaction with bid-offer spread

A

USD @ 1.8575

B

USD @ 1.8525

AUD @ 0.5398 (1/1.8525)

AUD @ 0.5384 (1/ 1.8575)




2-*

Conversion rules




2-*
A point is one-hundredth of a cent, a penny, etc.A pip is one-tenth of a pointIf the exchange rate is 1.2545-1.2585, this can be expressed as 45-85 and 1.25 is called the big number
Points and pips




2-*
A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency
Cross exchange rates




2-*

Bid and offer cross rates




2-*
For n exchange rates
Cross rates matrix




2-*
A nostro account is held by a dealer at a correspondent bankA vostro account is held by a bank on behalf of a foreign dealerThe words nostro and vostro are Latin for ours and yours
FX position keeping

(cont.)




2-*
A short position is created when a dealer borrows a currency and sells itA long position is created when a currency is bought because it is expected to appreciate
FX position keeping (cont.)

(cont.)




2-*
Position keeping is the monitoring of positions in each currencyA position is the net cumulative total of a currency holding arising from dealsA blotter is a schedule used to record the details of transactions

(cont.)




2-*
Position squaring is realising profit/loss by buying the short-position currency and selling the long-position currencyValuation is the calculation of unrealised profit/loss using the average rate




2-*

An example

The following is an example of FX position keeping


AUD Deal Amount

AUD Balance

AUD/USD Rate

USD Deal Amount

USD Balance

+10,000,000

+10,000,000

1.6525

-6,051,437

-6,051,437

+20,000,000

+30,000,000

1.6645

-12,015,620

-18,067,057

-10,000,000

+20,000,000

1.6725

+5,979,073

-12,087,983

+25,000,000

+45,000,000

1.6445

-15,202,189

-27,290,172

-50,000,000

-5,000,000

1.6500

+30,303,030

+3,012,858



2-*
The rate contracted today for the delivery of a currency at a specified date in the future
The forward exchange rate




2-*
The date on which currencies involved in a forward transaction are exchangedThe forward value date must be more than two business days after the contract date, otherwise it will be a spot transactionThe period preceding the forward value date is calculated from the spot value date
Forward value date




2-*
A short date means a maturity of one month or lessA round date means a maturity of a whole number of monthsA broken date means a maturity of less than round dates
Forward value date (cont)

(cont.)




2-*
An outright contract involves the sale or purchase of a currency for delivery more than two days into the futureA swap transaction involves a spot purchase against a matching outright sale (or vice versa)
Outright and swap forward transactions




2-*
Forward swapsForward-forward swapsOvernight swapsTom/next swaps
Kinds of FX swaps




2-*

The forward spread




2-*
If F (x /y ) > S (x /y ), then y sells at a premiumIf F (x /y ) < S (x /y ), then y sells at a discountIf F (x /y ) = S (x /y ), both currencies are flat
Premium and discount




2-*

Outright and swap rates
An outright forward rate is quoted as bid and offer ratesA swap rate is quoted in terms of the points representing the forward premium or discount
Forward rate qutoations


(

)

(

)

x

y

S

y

x

S

1

=

(

)

(

)

(

)

(

)

(

)

(

)

(

)

1

1

1

1

1

1

0

0

1

-

y

x

S

y

x

S

-

y

x

S

x

y

S

-

y

x

S

y

x

S

y

x

S

=

+

=

=

&

&

&

=

=

1

-

-

b

a

b

a

S

S

m

S

S

m

)

/

(

1

=

)

/

(

)

/

(

1

=

)

/

(

y

x

S

x

y

S

y

x

S

x

y

S

b

a

a

b

)

/

(

)

/

(

=

)

/

(

z

y

S

z

x

S

y

x

S

)

/

(

)

/

(

=

)

/

(

)

/

(

)

/

(

=

)

/

(

z

y

S

z

x

S

y

x

S

z

y

S

z

x

S

y

x

S

a

b

b

b

a

a

)

/

(

)

/

(

)

/

(

z

j

x

S

z

i

x

S

j

x

i

x

S

=

AUD Deal

Amount

AUD Balance AUD/USD Rate USD Deal

Amount

USD Balance

+10,000,000 +10,000,000 1.6525 -6,051,437 -6,051,437

+20,000,000 +30,000,000 1.6645 -12,015,620 -18,067,057

-10,000,000 +20,000,000 1.6725 +5,979,073 -12,087,983

+25,000,000 +45,000,000 1.6445 -15,202,189 -27,290,172

-50,000,000 -5,000,000 1.6500 +30,303,030 +3,012,858

N

y

x

S

y

x

S

y

x

F

m

12

100

)

/

(

)

/

(

)

/

(

=

-

Chapter_2

Documents

international finance

mcgrawhill australia

analytical approach

afaf moosa2

afaf moosacopyright

international transaction

interbank market

fx jargoncopyright