chapter 2 the foreign exchange market. copyright 2010 mcgraw-hill australia pty ltd ppts t/a...

Chapter 2

The Foreign Exchange Market

Slides prepared by Afaf Moosa2-2

Objectives

• To describe the FX market• To identify participants and currencies• To describe the Australian FX market• To describe the mechanics and technology of FX

trading

(cont.)

Objectives (cont.)

• To introduce some exchange rate concepts• To illustrate FX position keeping• To introduce some FX jargon

Definition

• The FX market is the market where national currencies are bought and sold against one another. Foreign exchange consists mainly of bank deposits.

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

Market participants

• Foreign exchange traders buy and sell currencies directly or indirectly

• Arbitragers exploit exchange rate anomalies; hedgers cover open positions; speculators take open positions

Categories of participants

• Customers• Commercial banks • Other financial institutions• Brokers• Central banks

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

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

Daily turnover in the FX market (USD billion)

Geographical distribution of FX market turnover (%)

FX market turnover by counterparty (institutional type)

FX market turnover by counterparty (locality)

Currency composition of the FX market (by single currencies)

Currency composition of the FX market (by currency pairs)

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

(cont.)

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

(cont.)

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

• 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

The AUD FX market

Daily turnover in the Australian FX market (USD billion)

• Deregulation• High interest rates in the 1980s• Australia’s time zone• Exchange rate volatility

Reasons for the growth of the AUD market

Components of an FX transaction

• Price discovery• Decision making• Settlement• Position keeping

FX market technology

• The telegraph• The telephone• The telex • The fax

(cont.)

FX market technology (cont.)

• Screen-based information systems• Screen-based automated dealing systems• Automatic order matching systems• Online FX trading

The bilateral spot exchange rate

• The exchange rate between two currencies for immediate delivery

Transaction dates

• The date on which the transaction is agreed upon is called the contract date, dealing date, done date or trade date

• The date on which currencies are exchanged is the value date or the delivery date

A spot foreign exchange transaction

Confirmation of exchange rate and amount

B’saccount

A’saccount

(Monday)

The delivery date

• Typically, the delivery date is two business days after the contract date

• In a value-today or same-day transaction the delivery date is the same as the contract date

• In a value-tomorrow or next-day transaction the delivery date is one day after the contract date

• S (x /y ) is the price (in terms of x) of one unit of y :

Spot rate quotation

( ) ( )xySyxS1

• When the exchange rate changes from S0(x/y) to S1(x/y)

yxSxyS

yxSyxS

Exchange rate changes

• To convert from y to x, multiply by the exchange rate• To convert from x to y, divide by the exchange rate

Currency conversion

• 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

• What is a direct quotation from the perspective of one country is an indirect quotation from the perspective of the other country, and vice versa

Exchange rate quotation in practice

• 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

The bid and offer rates

A foreign exchange spot transaction with bid-offer spread

USD @ 1.8575

USD @ 1.8525

AUD @ 0.5398 (1/1.8525)

AUD @ 0.5384 (1/ 1.8575)

Conversion rules

yxSxyS

• A point is one-hundredth of a cent, a penny, etc.• A pip is one-tenth of a point• If the exchange rate is 1.2545-1.2585, this can be

expressed as 45-85 and 1.25 is called the “big number”

Points and pips

• A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency

Cross exchange rates

)/()/(

=)/(zySzxS

Bid and offer cross rates

)/()/(

zySzxS

• For n exchange rates

Cross rates matrix

)/()/(

• A nostro account is held by a dealer at a correspondent bank

• A vostro account is held by a bank on behalf of a foreign dealer

• The words “nostro” and “vostro” are Latin for “ours” and “yours”

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

FX position keeping (cont.)

(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

(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

An example

The following is an example of FX position keeping

AUD Deal Amount

AUD Balance AUD/USD Rate USD Deal Amount

USD Balance

+10,000,000 +10,000,000 1.6525 -6,051,437 -6,051,437 +20,000,000 +30,000,000 1.6645 -12,015,620 -18,067,057 -10,000,000 +20,000,000 1.6725 +5,979,073 -12,087,983 +25,000,000 +45,000,000 1.6445 -15,202,189 -27,290,172 -50,000,000 -5,000,000 1.6500 +30,303,030 +3,012,858

• The rate contracted today for the delivery of a currency at a specified date in the future

The forward exchange rate

• The date on which currencies involved in a forward transaction are exchanged

• The forward value date must be more than two business days after the contract date, otherwise it will be a spot transaction

• The period preceding the forward value date is calculated from the spot value date

Forward value date

• A short date means a maturity of one month or less• A round date means a maturity of a whole number of

months• A broken date means a maturity of less than round

Forward value date (cont)

(cont.)

• 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)

Outright and swap forward transactions

• Forward swaps• Forward-forward swaps• Overnight swaps• Tom/next swaps

Kinds of FX swaps

The forward spread

NyxSyxSyxF

m 12×100×)/(

)/()/(=

• 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

Premium and discount

• 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

Outright and swap rates

chapter 2 the foreign exchange market. copyright 2010 mcgraw-hill australia pty ltd ppts t/a...

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