ppt_ch02

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
`