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What affects exchange rate? And how supply / demand affect it?
How to interpret, quote, and calculate exchange rates and forward exchange rates,
and what are the complicating factors
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
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.
The rate at which the quantity of AUD supplied to the market is equal to
the demand for AUD
AUD depreciates initially and perhaps gain ground as more foreign investment
comes in
S1
D0
D1
AUD depreciates
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
Spot FX Quotations
Base Currency
AUD/USD = 0.7180-90
Terms Currency
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.
Spot FX Quotations
Base Currency
AUD/USD = 0.7180-90
Terms Currency
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
FX Dealer:
AUD/USD
0.7180-90
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
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
EUR/JPY 112.20-41
Cross-Rates
Crossing two indirect FX quotations:
AUD/USD0.926269
GBP/USD1.627075
AUD/GBP0.569197
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Aust rate is 2.5% and US is 1%. So, what is the forward pts in 90 days?
http://www.fxstreet.com/rates-charts/forward-rates/?id=aud%2fusd
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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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What affects exchange rate? And how supply / demand affect it?
How to interpret, quote, and calculate exchange rates and forward exchange rates,
and what are the complicating factors
31
Summary
Need to know
How to:
Calculate cross-rates
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