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CAPITAL MARKETS AND INSTITUTIONS

FOREIGN EXCHANGE MARKETS


Ch 15 & 16

Foreign Exchange Markets


Key things you need to know:

What is foreign exchange (FX)?

What affects exchange rate? And how supply / demand affect it?

What is global FX markets?

Who participates in the FX markets?

What are traded in FX markets?

How to interpret, quote, and calculate exchange rates and forward exchange rates,
and what are the complicating factors

Reference chapters are Ch15 & Ch16

Exchange Rates
Each country or monetary union responsible for determining own exchange
rate regime
Exchange rate is value of one currency relative to that of another currency
Major currencies like USD, GBP, JPY, EUR and AUD adopt floating exchange
rate (free float) regime ie, determined by supply & demand
Other types of exchange rate regimes include:
Managed float - held within defined band relative to other currency ie,
Singapore, Indonesia, China
Crawling peg - allowed to appreciate in controlled steps over time ie,
China (arguable)
Linked exchange rate - tied to value of another currency or basket of
currencies ie, HKD

Foreign Exchange Rate


Base Currency

AUD/USD = 0.7185
This is a indirect quote as AUD is the Base.
Terms Currency
Above means:
- A more simplistic way to look at currency is to treat it as an item. Ie, 0.7185
AUD/USD the price of 1 AUD (Base) in terms of USD (Terms) - which makes it
an exchange rate. Eg, AUD1 costs USD0.7185 to buy whereas it costs AUD1
to buy AUD1.
- As an American tourist, you will use USD0.7185 to buy AUD1. Or,
- As an Aussie, you will need AUD1.39 (inverse of 0.7185) to buy USD1.
- Note this does not include fees or bid/ask, etc.

Supply & Demand of Currency in the FX markets


What does a supply demand curve for foreign currency look like?

Supply / Demand Graph

Supply & Demand of Currency in the FX markets


Demand for a currency (Base)
As the price of the base currency falls, demand by foreigners increases

Hence, downward-sloping demand curve

Supply of a currency (Base)


Upward-sloping supply curve occurs as the quantity of AUD supplied
increases as the price of the AUD increases

Equilibrium exchange rate

The rate at which the quantity of AUD supplied to the market is equal to
the demand for AUD

What is influencing exchange rate movements?

Main factors are:

Relative inflation rates


Relative national income growth rates
Relative interest rates
Exchange rate expectations
Government or central bank intervention

What is influencing exchange rate movements?

Main factors are:

Relative inflation rates (US higher than Aust)


Relative national income growth rates (Aust higher than US)
Relative interest rates (Aust higher than US)
Exchange rate expectations (Expect AUD depreciates)
Government or central bank intervention (how?)

Relative inflation rate (US higher than Austs)

1. US Imports expensive, less demand for


US Imports, reducing supply of AUD

2. US switches to Aust goods and demand


more AUD to pay for these items

Net effect is an appreciation of the AUD

Relative National Income Growth Rate (Austs higher than US)

1. More income, more demand for goods


(ie, US goods), more imports, increases
supply of AUD

2. Potentially more foreign investment into


AUD which move back the AUD rate.

AUD depreciates initially and perhaps gain ground as more foreign investment
comes in

Relative Interest Rate (AUD higher than USD)

1. Higher AUD interest return attracts foreign


investors, hence increase demand

2. More Aussie will keep AUD and invests locally


which may reduce import of USD goods.
Potential decrease in supply of AUD

AUD appreciates, but


expectation of AUD value will affect the likely of switching of assets from USD to
AUD ie, interest rate differentials vs. change in FX rates

Expectation (expect AUD to decrease)


S0

S1

1. In anticipation of AUD fall, Aussies buys foreign


currency which increase supply of AUD

2. Foreigners defer AUD purchase which


decreases demand of AUD

D0
D1

AUD depreciates

Govt / Central bank Intervention


A central bank may also influence the currency by:
Direct policy altering relative inflation rate, income growth, interest rates
intervening in international trade flows

intervening in foreign investment flows


directly intervening in the FX market

Global FX Markets
FX markets
Comprise all financial transactions denominated in foreign currency,
currently estimated to be over USD4.00 trillion per day
Facilitate exchange of value from one currency to another
FX market participants can be classified as:
FX dealers and brokers
central banks
firms conducting international trade transactions
investors and borrowers in the international money markets and capital
markets
foreign currency speculators
arbitrageurs

Types of FX transactions
FX market instruments are typically:
Spot transactions (T+2)
Have maturity date two business days after the FX contract is
entered into

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

There are also Today (T), Tomorrow (T+1)

Spot FX Quotations
Base Currency

AUD/USD = 0.7180-90

Terms Currency

This is a indirect quote as AUD is the Base.


Direct is when USD is the Base

Above means:
- Price of 1AUD (base) in terms of USD (terms)
- About USD0.7185 (mid) to buy AUD1 or inverse, to buy AUD1.3918 with
USD1.00
- So, if you (Aussie) have a purchase of USD100k, you will need to have
AUD139.18k to buy enough USD to pay for it.

- Note this does not include fees or bid/ask, etc.

Spot FX Quotations
Base Currency

Bid what dealer will buy AUD at


(your sell price)

AUD/USD = 0.7180-90

Terms Currency

Offer what dealer will sell AUD at


(your buy price)

Above means:
- Dealer buy AUD1 at USD 0.7180 (where you sell AUD at)
- Dealer sell AUD1 at USD 0.7190 (where you buy AUD at)
- Difference between bid and offer is the Spread. In this example,
it is a 14bps spread

Remember: Bid & Offer is from the dealer perspective (Buy low / Sell high)

Spot FX Quotations

Going to USA
(You need
USD)

USD1.00

Bid AUD @ 0.7180


Or
1/0.7180 = AUD1.3928

FX Dealer:
AUD/USD
0.7180-90

Ask AUD @ 0.7190


Or
1/0.7190 = AUD1.3908

End result: Dealer made a bid/ask spread

USD1.00

Coming back
from USA
(You need
AUD)

Spot FX Quotations
To transpose indirect to direct quotes:
(i) Reverse the bid/offer and then (ii) inverse the exchange rate
For example, AUD/USD = 0.7180-90
1. Reverse bid/offer: 0.7190-80

2. Inverse the exchange: 1 / 0.7190, 1 / 0.7180


3. USD/AUD is 1.3908 -1.3928. This is a direct quote

Cross-Rates
All currencies are quoted against the USD
When FX transactions occur between two currencies, usually where neither
currency is the USD, the cross-rate needs to be calculated
Method of cross-rate calculation depends on whether the quote is direct
or indirect (refer details on p.509)
Crossing a direct and indirect FX quotation:

GBP/USD1.6270-75
USD/NZD1.3292-97
To determine the GBP/NZD cross-rate:
Bid = Base Bid x Terms Bid =1.6270 x 1.3292 = 2.1626
Offer = Base Offer x Terms Offer = 1.6275 x 1.3297 = 2.1641
GBP/NZD2.1626-41

Cross-Rates
Crossing two direct FX quotations:
USD/EUR 0.725055
USD/JPY 81.4050

To determine the EUR/JPY cross-rate:


Bid = Terms bid Base Offer = 81.40/0.7255 = 112.20
Offer = Terms offer Base Bid = 81.50/0.7250 = 112.41

EUR/JPY 112.20-41

Cross-Rates
Crossing two indirect FX quotations:
AUD/USD0.926269
GBP/USD1.627075

To determine the AUD/GBP cross-rate:


Bid =Base Bid Terms Offer = 0.9262/1.6275 = 0.5691
Offer = Base offer Terms Bid = 0.9269/1.6270 = 0.5697

AUD/GBP0.569197

Forward Exchange Rate

What is Forward exchange rate?

Why do we need it?


How is it calculated?

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Forward Exchange Rate


Forward exchange rate is the FX bid/offer rates applicable at a specified date
beyond the spot value date
Forward exchange rate varies from the spot rate due to interest rate parity
Interest rate parity is the principle that exchange rates will adjust to
reflect interest rate differentials between countries
Forward exchange rates are quoted as forward points, either above or below
the spot rate
+ve forward points, means forward premium; interest rate of the base
currency is lower
-ve forward points means forward discount; interest rate of the base
currency is higher)
Eg. AUD/USD do you think it is at a discount or premium?

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AUD / USD Forward Rate


Say, AUD/USD (spot)
0.9630

Aust rate is 2.5% and US is 1%. So, what is the forward pts in 90 days?

Points = 0.9630 * {[(1+1%*90/360)/(1+2.5%*90/360)]-1}


= -0.0036
So, to enter into a 90 days forward rate, you will get a forward discount of
36pts to the spot or. 0.9630-0.0036 = 0.9594
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AUD / USD Forward Rate

http://www.fxstreet.com/rates-charts/forward-rates/?id=aud%2fusd

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Forward Exchange Rate


The calculation explains how the dealer operates even he/she 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; i.e.:
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

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AUD / USD Forward Rate


Previous formula can be adjusted to reflect the difference in bid/offer.

Note the mixed use of bid/offer in the equation.

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Bid / Ask Forward Rates


Real world example:
Company X 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
eurodollar bid and offer interest rates are 3.00% and 3.30% p.a. and the threemonth 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/CHF1.156689
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Foreign Exchange Markets


Check on what we have learnt today
Key things you need to know:

What is foreign exchange (FX)?

What affects exchange rate? And how supply / demand affect it?

What is global FX markets?

Who participates in the FX markets?

What are traded in FX markets?

How to interpret, quote, and calculate exchange rates and forward exchange rates,
and what are the complicating factors

Reference chapters are Ch15 & Ch16

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Summary

Need to know

How to:

Quote spot rate (Base/Terms, direct vs. indirect, bid/offer),

Price forward exchange rate,

Calculate cross-rates

The influencing factors on exchange rate and use supply / demand


curve

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