chapter 2 the foreign exchange market. copyright 2010 mcgraw-hill australia pty ltd ppts t/a...
TRANSCRIPT
Chapter 2
The Foreign Exchange Market
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-3
Objectives (cont.)
• To introduce some exchange rate concepts• To illustrate FX position keeping• To introduce some FX jargon
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-4
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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-5
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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-6
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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-7
Categories of participants
• Customers• Commercial banks • Other financial institutions• Brokers• Central banks
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-8
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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-9
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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-10
Daily turnover in the FX market (USD billion)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-11
Geographical distribution of FX market turnover (%)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-12
FX market turnover by counterparty (institutional type)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-13
FX market turnover by counterparty (locality)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-14
Currency composition of the FX market (by single currencies)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-15
Currency composition of the FX market (by currency pairs)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-16
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.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-17
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.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-18
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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-19
• 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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-20
Daily turnover in the Australian FX market (USD billion)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-21
• Deregulation• High interest rates in the 1980s• Australia’s time zone• Exchange rate volatility
Reasons for the growth of the AUD market
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-22
Components of an FX transaction
• Price discovery• Decision making• Settlement• Position keeping
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-23
FX market technology
• The telegraph• The telephone• The telex • The fax
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-24
FX market technology (cont.)
• Screen-based information systems• Screen-based automated dealing systems• Automatic order matching systems• Online FX trading
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-25
The bilateral spot exchange rate
• The exchange rate between two currencies for immediate delivery
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-26
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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-27
A spot foreign exchange transaction
Confirmation of exchange rate and amount
B’saccount
A’saccount
(Monday)
A B
AU
D 1
000
000
(W
edne
sday
)
US
D 5
00 0
00 (
Wed
nesd
ay)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-28
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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-29
• S (x /y ) is the price (in terms of x) of one unit of y :
Spot rate quotation
( ) ( )xySyxS1
=
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-30
• When the exchange rate changes from S0(x/y) to S1(x/y)
11
1
1
1
1
0
0
1
-yxS
yxS-
yxSxyS
-yxS
yxSyxS
Exchange rate changes
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-31
• To convert from y to x, multiply by the exchange rate• To convert from x to y, divide by the exchange rate
Currency conversion
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-32
• 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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-33
• 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
=
=
1-
-
b
a
ba
SS
m
SSm
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-34
A foreign exchange spot transaction with bid-offer spread
A
USD @ 1.8575
B
USD @ 1.8525
AUD @ 0.5398 (1/1.8525)
AUD @ 0.5384 (1/ 1.8575)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-35
Conversion rules
)/(1
=)/(
)/(1
=)/(
yxSxyS
yxSxyS
ba
ab
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-36
• 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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-37
• A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency
Cross exchange rates
)/()/(
=)/(zySzxS
yxS
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-38
Bid and offer cross rates
)/()/(
=)/(
)/()/(
=)/(
zySzxS
yxS
zySzxS
yxS
a
bb
b
aa
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-39
• For n exchange rates
Cross rates matrix
)/(
)/()/(
zjxS
zixS
jxixS
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-40
• 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.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-41
• 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.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-42
• 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
FX position keeping (cont.)
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-43
• 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
FX position keeping (cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-44
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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-45
• The rate contracted today for the delivery of a currency at a specified date in the future
The forward exchange rate
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-46
• 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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-47
• 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
dates
Forward value date (cont)
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-48
• 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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-49
• Forward swaps• Forward-forward swaps• Overnight swaps• Tom/next swaps
Kinds of FX swaps
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-50
The forward spread
NyxSyxSyxF
m 12×100×)/(
)/()/(=
-
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-51
• 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
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-52
• 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