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.
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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.
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PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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.
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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.
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Categories of Participants
•
•
•
•
•
Customers
Commercial banks
Other financial institutions
Brokers
Central banks
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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.
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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.
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8
Daily Turnover in the FX Market
(USD Billion)
1600
1200
800
400
0
1989
1992
Spot
1995
Forward
1998
2001
Total (including gaps)
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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
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10
FX Market Turnover by
Counterparty (Per Cent)
(a) By institutional type
Interbank
Financial Institutions
Others
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FX Market Turnover by
Counterparty (Per Cent)
(b) By locality
Local
Cross-border
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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
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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
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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.
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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.
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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.
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Components of an FX Transaction
•
•
•
•
Price discovery
Decision making
Settlement
Position keeping
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FX Market Technology
•
•
•
•
The
The
The
The
telegraph
telephone
telex
fax
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FX Market Technology (cont.)
•
•
•
•
Screen-based information systems
Screen-based automated dealing systems
Automatic order matching systems
Online FX trading
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The Bilateral Spot Exchange Rate
• The exchange rate between two currencies
for immediate delivery.
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21
A Spot Foreign Exchange
Transaction
Confirmation of exchange rate and amount
A
B
(Monday)
B’s
account
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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)
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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 
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Currency Conversion
• To convert from y to x, multiply by the
exchange rate.
• To convert from x to y, divide by the
exchange rate.
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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.
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PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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
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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)
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Conversion Rules
1
Sb ( y / x ) =
Sa ( x / y )
1
Sa ( y / x) =
Sb ( x / y )
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Points and Pips
• A point is one-hundredth of a cent, a
penny, etc.
• A pip is one-tenth of a point.
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PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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)
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Bid and Offer Cross Rates
Sa ( x / z )
Sa ( x / y ) =
Sb ( y / z )
Sb ( x / z )
Sb ( x / y ) =
Sa ( y / z )
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Cross Rates Matrix
• For n exchange rates
S ( x / z)
i
S(x / x ) 
i j
S ( x / z)
j
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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
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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.
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PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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.
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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.
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The Forward Exchange Rate
• The rate contracted today for the delivery
of a currency at a specified date in the
future.
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Forward Value Date
• The date on which currencies involved in a
forward transaction are exchanged.
• Dates may be short, round or broken.
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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).
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PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Kinds of FX Swaps
•
•
•
•
Forward swaps
Forward-forward swaps
Overnight swaps
Tom/next swaps
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41
The Forward Spread
F ( x / y) - S ( x / y)
12
m=
×100 ×
N
S ( x / y)
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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.
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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.
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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.
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PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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
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46