Chapter 2 The Foreign Exchange Market Objectives • To describe the FX market. • To identify participants and currencies. • To describe the mechanics and technology of FX trading. • To introduce some exchange rate concepts. • To illustrate FX position keeping. • To describe the AUD FX market. • To introduce some FX jargon. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 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. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Characteristics • It is the largest and most perfect market. • It is needed because every international transaction requires a foreign exchange transaction. • It is an over-the-counter (OTC) market. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Market Participants • Foreign exchange traders buy and sell currencies directly or indirectly. • Arbitragers exploit exchange rate anomalies; hedgers cover open positions; and speculators take open positions. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Categories of Participants • • • • • Customers Commercial banks Other financial institutions Brokers Central banks Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Interbank Operations • The FX market is dominated by interbank operations. • Participants in the interbank market are market makers, other major dealers and second-tier banks. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Size and Composition • The size of the global FX market is measured by the sum of daily turnover in FX centres. • A survey is coordinated by the BIS every three years for this purpose. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Daily Turnover in the FX Market (USD Billion) 1600 1200 800 400 0 1989 1992 Spot 1995 Forward 1998 2001 Total (including gaps) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 The Geographical Distribution of FX Market Turnover (Per Cent) 40 35 30 25 20 15 10 5 O th er s e Fr an c A us t ra lia on g K H on g er la nd S w it z an y G er m in ga po re S Ja pa n . U .S U .K . 0 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 FX Market Turnover by Counterparty (Per Cent) (a) By institutional type Interbank Financial Institutions Others Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 FX Market Turnover by Counterparty (Per Cent) (b) By locality Local Cross-border Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 Currency Composition of FX Market Turnover (Per Cent) (a) By single currencies 100 80 60 40 20 0 USD EUR JPY GBP CHF CAD AUD SEK Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa HKD Others 13 Currency Composition of FX Market Turnover (Per Cent) (b) By currency pairs 35 30 25 20 15 10 5 0 USD/EUR USD/JPY USD/GBP USD/CHF USD/CAD USD/AUD Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa USD/Other Other/Other 14 Traded Currencies • The US dollar is the most heavily traded currency. • The euro and the yen are heavily traded because of the importance of Europe and Japan in the world economy. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 Traded Currencies (cont.) • The pound is heavily traded for historical reasons. • Currencies that are heavily traded in certain financial centres and lack liquidity in others: CHF, CAD. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 Traded Currencies (cont.) • Currencies that are traded locally, but internationally are traded for international trade purposes: AUD, NZD, HKD. • Third world currencies: soft or exotic currencies. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Components of an FX Transaction • • • • Price discovery Decision making Settlement Position keeping Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 FX Market Technology • • • • The The The The telegraph telephone telex fax Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 FX Market Technology (cont.) • • • • Screen-based information systems Screen-based automated dealing systems Automatic order matching systems Online FX trading Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 The Bilateral Spot Exchange Rate • The exchange rate between two currencies for immediate delivery. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 A Spot Foreign Exchange Transaction Confirmation of exchange rate and amount A B (Monday) B’s account Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa A’s account 22 Spot Rate Quotation • S (x /y ) is the price (in terms of x) of one unit of y : 1 S (x y ) = S ( y x) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Exchange Rate Changes • When the exchange rate changes from S0(x/y) to S1(x/y) S1 x y S x y -1 S0 x y S y x 1 -1 1 S x y Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Currency Conversion • To convert from y to x, multiply by the exchange rate. • To convert from x to y, divide by the exchange rate. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 Exchange Rate Quotation in Practice • Direct quotation refers to the domestic currency price of one unit of the foreign currency. • Indirect quotation refers to the foreign currency price of the domestic currency. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 The Bid and Offer Rates • 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 m = S a - Sb Sa m = -1 Sb Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 A Foreign Exchange Spot Transaction with Bid-Offer Spread USD @ 1.8575 USD @ 1.8525 B A AUD @ 0.5398 (1/1.8525) AUD @ 0.5384 (1/ 1.8575) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Conversion Rules 1 Sb ( y / x ) = Sa ( x / y ) 1 Sa ( y / x) = Sb ( x / y ) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 Points and Pips • A point is one-hundredth of a cent, a penny, etc. • A pip is one-tenth of a point. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 Cross Exchange Rates • A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency. S ( x / z) S ( x / y) = S ( y / z) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 Bid and Offer Cross Rates Sa ( x / z ) Sa ( x / y ) = Sb ( y / z ) Sb ( x / z ) Sb ( x / y ) = Sa ( y / z ) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 Cross Rates Matrix • For n exchange rates S ( x / z) i S(x / x ) i j S ( x / z) j Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 FX Position Keeping • A nostro account is held by a dealer at a corresponding bank. • A vostro account is held by a bank on behalf of a foreign dealer Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 34 FX Position Keeping (cont.) • A short position is created when a dealer borrows a currency and sells it. • A long position is created when a currency is bought because it is expected to appreciate. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 35 FX Position Keeping (cont.) • Position keeping is the monitoring of positions in each currency. • A position is the net cumulative total of a currency holding arising from deals. • A blotter is a schedule used to record the details of transactions. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 36 FX Position Keeping (cont.) • Position squaring is realising profit/loss by buying the short-position currency and selling the long-position currency. • Valuation is the calculation of unrealised profit/loss using the average rate. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 37 The Forward Exchange Rate • The rate contracted today for the delivery of a currency at a specified date in the future. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 38 Forward Value Date • The date on which currencies involved in a forward transaction are exchanged. • Dates may be short, round or broken. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 39 Outright and Swap Forward Transactions • An outright contract involves the sale or purchase of a currency for delivery more than two days into the future. • A swap transaction involves a spot purchase against a matching outright sale (or vice versa). Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 40 Kinds of FX Swaps • • • • Forward swaps Forward-forward swaps Overnight swaps Tom/next swaps Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 41 The Forward Spread F ( x / y) - S ( x / y) 12 m= ×100 × N S ( x / y) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 42 Premium and Discount • If F (x /y ) > S (x /y ), then y sells at a premium. • If F (x /y ) < S (x /y ), then y sells at a discount. • If F (x /y ) = S (x /y ), both currencies are flat. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 43 Outright and Swap Rates • An outright forward rate is quoted as bid and offer rates. • A swap rate is quoted in terms of the points representing the forward premium or discount. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 44 The AUD FX Market • 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. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 45 Reasons for the Growth of the AUD Market • • • • Deregulation High interest rates in the 1980s Australia’s time zone Exchange rate volatility Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 46
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