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Chapter 2. The Foreign Exchange Market. Learning Objectives. Summarize the fundamental underpinnings of the foreign exchange market. Explain the distinctions between various measures of the exchange rate.

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Chapter 2


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    1. Chapter 2 The Foreign Exchange Market www.themegallery.com

    2. Learning Objectives Summarize the fundamental underpinnings of the foreign exchange market. Explain the distinctions between various measures of the exchange rate. Differentiate the roles of hedging, arbitrage, and speculation in foreign exchange markets. Describe the links between the current spot rate and contracts to buy or sell foreign exchange in the future.

    3. Foreign Exchange Market • A market where “foreign exchanges” are bought and sold against one another. • Foreign exchanges include foreign currencies and interbank deposits denominated in various currencies. • FX rates determine the price of each (domestic) currency in terms of other (foreign) currencies.

    4. The Function and Structure of the FX Market Introduction FX markets comprise all financial transactions denominated in foreign currency; Facilitate exchange of value from one currency to another; Internationally adopted FX market conventions to improve market functionality.

    5. The Function and Structure of the FX Market Transfer of purchasing power due to international trade and capital transactions; Provide financial services to support international trade; Provide hedging facilities for managing foreign exchange risk.

    6. The Function and Structure of the FX Market The FX market is extremely competitive, worldwide in scope and the trading of currencies is unrestricted (due to the abolition of capital control). FX is needed because every international transaction requires a foreign exchange transaction. Largest and most perfect market. It is an over-the-counter (OTC) market as participants rarely meet and actual currencies are rarely delivered physically.

    7. Participants in the FX market Four board categories can be summarized: Banks and foreign exchange dealers: Operate in interbank and client market Market makers Individuals and firms: Individual, commercial or investment transactions hedging exchange rate risk

    8. Participants in the FX market Include those who buy and sell foreign exchanges directly or indirectly. Arbitragers exploit exchange rate anomalies in an attempt to reap profits Buy at a low price and sell at a high price Hedgers enter the market to cover open positions They protect against possible exchange rate risk Speculators take open positions They deliberately bear the risk to make a profit Banks play a very important role in the market.

    9. Participants in the FX market Central banks and treasuries acts as bankers for their government. Use the market to acquire or spend their country’s foreign reserves to influence the exchange rate. Profitability is not the priority here.

    10. FX Market Participants The FX market is a two-tiered market: Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in foreign exchange. Nonbank dealers account for about 20% of the market. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

    11. BIS: Triennial Central Bank Survey (April 2010) • Size: Average daily turnover of USD 4.0 trillion • Activity: Cross-border transactions represent 65% of trading activity while local transactions account for 35%. • FX market turnover: UK 36.7%; United States 18%; • Japan 6%; Singapore 5%; Switzerland 5%; Hong Kong SAR 5%; and Australia 4%. • Currency: USD 85%; Euro 39%; Yen19%; GBP 13% • Currency pairs: USD/EUR 28%; USD/JPY 14%; USD/GBP 9%

    12. Global foreign exchange market turnover by instrument Average daily turnover in April, in billions of US dollars

    13. Currency distribution of global foreign exchange market turnover Percentage shares of average daily turnover in April 2010

    14. Global foreign exchange market turnover by currency pair Daily averages in April, in billions of US dollars and percentages

    15. Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market.

    16. Correspondent Banking Relationships Bank A is in London, Bank B is in New York. The current exchange rate is £1.00 = $2.00. A currency trader employed at Bank A buys £100m from a currency trader at Bank B for $200m settled using its correspondent relationship. $200m £100m Bank A London Bank B NYC

    17. Correspondent Banking Relationships $200m £100m $600m $600m £400m $1200m $1,200m £400m £100m £100m Bank A London Bank B NYC Assets Liabilities Assets Liabilities £ deposit at B £300m B’s Deposit $1,000m $ deposit at A $1000m A’s Deposit £300m £ deposit at A £200m A’s Deposit $800m $ deposit at B $800m B’s Deposit £200m Other Assets £600m Other L&E £600m Other Assets $800m Other L&E $800m Total Assets £1,300m Total L&E £1,300m Total Assets $2,200m Total L&E $2,200m

    18. The Foreign Exchange Rate and the Market for Foreign Exchange • Foreign exchange rate: the price of one currency in terms of another. • e.g., US$/€ or €/US$

    19. The foreign exchange rate is determined by the interaction of demand for and supply of foreign exchange. • The foreign exchange market is the worldwide network of markets and institutions that exchange currencies

    20. The Market for Foreign Exchange S€ $/€ Initially, Qeq euros are traded, and the equilibrium price is eeq. eeq D€ Qeq Euros (€)

    21. The Market for Foreign Exchange S€ $/€ An increase in U.S. demand for euros causes an appreciation of the euro. e'eq eeq D'€ D€ Qeq Q'eq Euros (€)

    22. The Market for Foreign Exchange S€ S'€ $/€ An increase in the supply of euros causes a depreciation of the euro. eeq e'eq D€ Qeq Q'eq Euros (€)

    23. The Market for Foreign Exchange: Demand wishing to buy goods and services from or send gifts or payments to another country. wishing to purchase financial assets in another country. Foreign exchange is demanded by those wishing to profit from exchange rate changes (speculation). wishing to minimize risk from exchange rate changes (hedging).

    24. The Market for Foreign Exchange: Supply selling goods and services to or receiving gifts or payments from another country. in other countries who wish to purchase financial assets in the home country. Foreign exchange is suppliedby those wishing to profit from exchange rate changes (speculation). wishing to minimize risk from exchange rate changes (hedging).

    25. The Market for Foreign Exchange: Supply The total supply and demand for foreign exchange includes two components. The other is related to financial flows, including speculation and hedging. One is related to current account transaction.

    26. The Market for Foreign Exchange SG&S $/€ STotal The total equilibrium exchange rate will only be the same as the one for G&S if the current account is exactly in balance. eeq DG&S DTotal Qeq Euros (€)

    27. Transactions in the foreign exchange Market • The spot market involves almost the immediate purchase or sale of foreign exchange. • have maturity date two business days after the FX contract is entered into • Cash transaction e.g. exchange of AUD100 for US$ at a moneychanger. The Spot Market

    28. The Spot Transactions • A Spot transaction in the foreign exchange market is the purchase of foreign exchange, with delivery and payment is normally on the second following business day. • The date of settlement is referred to as the value date. • value date has three types: Value Spot/VAL SP; Value Tomorrow/VAL TOM; Value Today/VAL TOD.

    29. Spot transaction • Procedure of Spot transaction • Inquiry When a bank needs to transact foreign exchange with other banks, trader should firstly inquire to other banks by telephones, telex • Quotation quotation is the linchpin segment of forex, because it relates to whether the forex could be bought or sold. • Making a deal when quotation banks report the price, enquiry banks should give the reply whether to buy or sell, and the quantity. • Confirmation If the reply is “OK, Done”, The two parties also should confirm the sort of currencies, exchange rate, quantity, value date and settlement methods etc. • Delivery

    30. Spot transaction example Bank A:HI BANK OF A CALLING SPOT GBP AGAINST USD PLS Bank B:65/95 Bank A:MINE USD3 Bank B:OK DONE WE SELL USD3AGAINST GBP AT 1.6765 VALUE 16/2/06 GBP TO BKL BK FOR OUR A/C 123456 Bank A:USD TO KKY BK FOR OUR A/C 654321

    31. Spot Rate Quotations Like the price of any commodity, the exchange rate is an expression of the value of one unit of a currency (the commodity) in terms of another currency (the unit of account). S(x/y) is the price (in terms of x) of one unit of y

    32. Spot Rate Quotations • Direct quotationrefers to the domestic currency price of one unit of the foreign currency (normal or price quotation) (AUD/USD = 1.25). • Indirect quotationrefers to the foreign currency price of one unit of the domestic currency (quantity or volume quotation) (USD/AUD = 0.80). • A quote that is direct to one country is indirect to another.

    33. Currency Conversion • To convert from y to x, multiply by the exchange rate. • To convert from x to y, divide by the exchange rate. • Examples – given S(USD/AUD) = 0.80 + To convert AUD100 into USD, we get: AUD100 * 0.80 = USD80 + To convert USD100 into AUD, we get USD100/0.80 = AUD125

    34. Exchange Rate Changes When the exchange rate changes between 2 points in time fromS0(x/y) to S1(x/y), the % change in the exchange rate (change in the value of y) is measured as: To express as a percentage, we then multiply by 100

    35. Example (direct quotations) Suppose that the exchange rate between the Australian dollar and British pound stands at S(AUD/GBP) = 3.57, and then falls to S(AUD/GBP) = 3.52. As such, S0(AUD/GBP) = 3.57 and S1(AUD/GBP) = 3.52, implying that the AUD has appreciated We can calculate the percentage depreciation in the British pound as

    36. Example (indirect quotations) Suppose that the exchange rate between the Australian dollar and British pound stands at S(GBP/AUD) = 0.2801, and then rises to S(GBP/AUD) = 0.2840. Again, it implies that the AUD has appreciated We can calculate the percentage appreciation in the AUD as

    37. The Bid-Ask (offer) Spread • When dealers attempt to strike a deal, they quote exchange rates in terms of two numbers, known as the two-way quote. • The bid rate is the rate at which the quoting dealer is willing to buy. • The ask rate is the rate at which the quoting dealer is willing to sell.

    38. The Bid-Ask Spread A dealer could offer bid price of $1.25 per € ask price of $1.26 per € While there are a variety of ways to quote that, The bid-ask spread represents the dealer’s expected profit.

    39. The Bid-Ask Spread A dealer would likely quote these prices as 72-77. It is presumed that anyone trading $10m already knows the “big figure”. big figure small figure Bid Ask S(£/$) 1.9072 1.9077 S($/£) .5242 .5243

    40. Points and Pips Exchange rate quotations are measured in points and pips A point is one-hundredth of a cent (or a penny) 0.01/100 = 0.0001 (i.e. the fourth decimal place) In the previous example, the spread is 0.0003, or 3 points The bid and ask rates may be quoted as the number of points only (the last 2 decimals) In the previous example, 1.2078-81. A pip is one-tenth of a point 0.0001/10 = 0.00001 (i.e. the fifth decimal place).

    41. How the media report exchange rates In its issue of the 17 March 2009, The Age reported the following exchange rates provided by the Westpac Banking Corporation on 16 March 2009: buy sell USD 0.6649 0.6451 EURO 0.5179 0.4987 Yen 65.71 63.10

    42. How the media report exchange rates • This is very confusing. Maybe the officer was drunk when he made the decision. • But why the bid rates are higher than the offer rates? • Surely a market maker such as Westpac wants to buy low and sell high.

    43. How the media report exchange rates • The clarify this, we have to determine how the exchanges rates are expressed and to which currency the words “buy” and “sell” refer. • The exchange rates are obviously expressed as the price of one Australia Dollar, but the “buy” and “sell” rates refer to the other currency, and this is the source of confusion. • Thus, the 0.6649/0.6451 means that Westpac is willing to buy the USD at the reciprocal of 0.6649 and sell it at the reciprocal of 0.6451.

    44. How the media report exchange rates The confusion would certainly disappear if the exchange rates were expressed as S(X/AUD), which gives the following: buy sell USD 1.5309 1.5501 EURO 1.9308 2.0052 Yen 0.0152 0.0158 Represent the buying and selling rates of one unit of the foreign currency in terms of the Australian dollar. Now the bid rates are lower than the offer rate

    45. How the media report exchange rates • Alternatively, the exchanges can be left as they appear in the first table, provided that the words “buy” and “sell” are switched around. • It will be useful if it said “sell/buy (AUD)”, so that there is non confusion about the rates representing the prices of one Australian dollar. • buy sell USD 0.6649 0.6451 EURO 0.5179 0.4987 Yen 65.71 63.10

    46. Cross Exchange Rates A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency. In practice, z is normally the US dollar, and x, and y involve currencies that are not heavily traded.

    47. Cross-rate Calculation The calculation depends on the quote style USD/EUR 0.8130-40 USD/JPY 110.40-50 EUR/JPY 110.40/0.8140 -110.50/0.8130 AUD/USD 0.8560-70 GBP/USD 1.8270-80 AUD/GBP 0.8560/1.8280-0.8570/1.8270

    48. exercise USD/JPY=120.10/120.30 USD/HKD=7.7820/7.7840 AUD/USD=0.7350/0.7360 NZD/USD=0.6030/0.6040 USD/HKD=7.7820/7.7830 GBP/USD=1.6910/1.6920

    49. Transactions in the foreign exchange Market • An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. • The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. • Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months. • Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)

    50. Forward transaction and Quotes • Forward rates are typically quoted in terms of points. • A forward quotation which is expressed in points is not a foreign exchange rate as such. • Rather, it is the difference between the forward rate and the spot rate.