lecture 1 – foreign exchange markets and exchange rates i

7/29/2019 Lecture 1 Foreign Exchange Markets and Exchange Rates I

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FINC3011 International Financial Management

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Lecture 1 Foreign Exchange Markets and Exchange Rates I

The Foreign Exchange Market: The market in which national currencies are bought and sold against one

another, and where exchange rates determinedo The largest and most dynamic of all financial markets Daily trading volume in the foreign exchange (FX) market is immense:

o 2010 average daily trading volume or turnover was nearly 4trillion US dollars!

The FX market is 24-hour market Trading in FX virtually never ceases Most of the trading takes place in just a handful of key currencies

o USD, Euro, Yen, British Pound, AUD, CHF, CAD A few key financial centers account for the bulk of daily trading volume in

foreign exchangeo UK (London), US (New York), Japan (Tokyo), Switzerland

Over-The-Counter Market: The FX market is an Over-The-Counter (OTC) market

o There is no one physical location or organised exchange wheretraders get together to exchange currencies

o Rather, the FX market consists of a complex international network of informal linkages between key market participantscommunicating with each other via telephone & other electronicchannels/platforms

Foreign Exchange Markets: The FX market provides the physical and institutional structure through

whicho The money of one country is exchanged for that of another countryo The rate of exchange between currencies is determinedo Foreign exchange transactions are physically completed

Foreign Exchange Transaction: An agreement between a buyer and a seller that a fixed amount of one

currency will be delivered for some other currency at a specified rate

Functions of the FOREX Market: The FOREX market is the mechanism by which participants:

o Transfer purchasing power between countries Necessary as international trade and capital transactions

normally involve parties living in countries with different national currencies

o Obtain or provide credit for international trade transactions Inventories in transit must be financed

o Minimize exposure to exchange rate risk

FOREX markets provide instruments utilized in hedgingor transferring risk to more willing parties


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Geographic Extent of the Market: Geographically, the FOREX market spans the globe with prices moving

and currencies trading every hour of every business day Major world trading starts each morning in Sydney and Tokyo Then moves west to Hong Kong and Singapore Continuing to Eu rope, London, and New York and finishing on the West

Coast of the U.S.

Measuring FOREX Market Activity: Average electronic conversions per hour

KEY FX MARKET PARTICIPANTS: The FOREX market consists of two tiers:

o The interbank or wholesale market Multiples of A$1m or equivalent in transaction size

o The client or retail market Five broad categories of participants operate within these two tiers:

o Customers or Clientso Bank and Non-Bank FX dealerso Speculators and Arbitragerso FX Brokerso Central Banks and Treasuries

Customers or Clients: Companies & individuals wishing to buy and sell FX in order to finance

foreign trade and international investment operations o E.g. Exporters, importers, tourists, immigrants, investors

Price-takers in FX market o I.e. buy/sell currencies at prices (exchange rates) determined by

the market makers in FX market

Bank and Non-Bank FX Dealers: Typically large commercial banks Market-Makers in FX Market (Price-makers)

o Market-Makers provide liquidity by quoting two-way prices forcurrencies

o Stand ready to buy and sell currencies at (bid and offer) exchangerates they quote

Deal in retail (i.e. with Customers ) and wh olesale or interbank markets Take positions; engage in FX arbitrage & speculation


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Speculators and Arbitrageurs: Seek to profit from trading in the market itself Operate for their own interest, without need or obligation to serve clients

or ensure a continuous market Speculators seek all their profit from exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates

in different markets A large proportion of speculation and arbitrage is conducted on behalf of

major banks by traders employed by those banks

FX Brokers: Agents who facilitate trading between FX dealers without themselves

becoming principals in the transaction Disseminate market information Bring together buyers & sellers with matching needs

Accepts limit orderso Limit orders: orders placed with brokers by banks to buy/sell a

certain quantity of foreign currency at a pre-specified priceo Broker puts these on its books and attempts to match purchase

orders with sell orders Do not deal or take positions in foreign exchange Receive commissions on deals that they broker in interbank FX market

Central Banks and Treasuries: Use the market to acquire or spend their country s currency reserves as

well as to influence the price at which their own currency trades Act as bankers for their governments in meeting FX requirements Sometimes intervene in FX market to:

o Smooth exchange rate fluctuationso Prevent domestic currency from appreciating or depreciating

excessively

Structure of the FX Market:


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Foreign Exchange Transactions: A Foreign exchange (FX) transaction is simply the exchange of one

currency for another currency Three general types of transactions take place in the FX market:

o Spot FX transactionso Forward FX transactions (2 types):

Outright Forwards FX swap transactions

Spot FX Transactions: A single outright transaction involving the exchange of two currencies at a

rate agreed to today (spot bilateral exchange rate) with settlement (actualdelivery of currency for currency) usually within 2 business days

o Deal date: (day on which transaction is made, t) o Value date: (day of cash settlement of transaction, t+2)

Transactions completed within 2 business dayso Exception 1: U.S. and Mexico/Canada o Exception 2: Holidays don t count in U.S. dollar transactionso Exception 3: Fridays are not business days in Middle East but

Saturdays/Sundays are so non-Middle Eastern currencies settle onFridays and Middle Eastern currencies settle on Saturday

Outright Forward FX Transactions: An agreement to exchange currencies at some future date at a price

agreed to todayo Similar to a spot FX transaction except that they are for value, i.e.

delivered for cash settlement, more than 2 business days after theconclusion of the transaction A single outright transaction involving the exchange of two currencies at a

rate agreed to today (forward exchange rate) with settlement (actualdelivery of currency for currency) more than 2 business days in the future

o E.g. Agree today to buy USD 1 million in 90 days at the forwardexchange rate of 0.9500 USD per AUD

Forward contracts come in standard maturities of 1-month, 2-months,and so on

Foreign Exchange Swaps:

A transaction involving the simultaneous purchase and sale of a givenamount of foreign exchange for two different value dateso Both purchase and sale are conducted with the same counterparty

Spot against forward foreign exchange swap:o Sale/purchase of a currency today combined with an offsetting

purchase/sale of the same currency at some future point in timeo Consists of two legs: a spot FX transaction and offsetting forward

FX transaction E.g. Day 1: Sell AUD/buy USD @ spot exchange rate (spot leg)

o Day 90: Buy AUD/sell USD @ fwd exchange rate (fwd leg)o Sell today $10m AUD (buy USD)@ spot exchange rate of $0.9500

USD and agree to buy back in 2 weeks time $10m AUD (sell USD)at the forward exchange rate of 0.9550 USD


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Forward-forward foreign exchange swaps:o Exchange of two forward contracts with different maturity dates

Electronic Trading Systems: First created in 1992 Enable automatic matching and execution of foreign exchange

transactions Reduce cost of trading by eliminating brokers and reducing the number of

transactions traders had to engage in to obtain market prices Gather and publish information on prices and quantities of currencies as

they are traded

Electronic Foreign Exchange Trading (eFX): 30% of all trading volume and 50% in spot markets Straight Through Processing (STP): forex trade takes place from

placement of order to settlement in automated fashion Three categories:o Single bank sponsored platforms (portals)o Multi-bank portals o Independent companies

Best known and most active platform is FXConnect (State Street) Another leader is Fxall (consortium of banks) Independent companies: HotSpot and Currenex Originally designed for corporate clients or institutional investors but got

a boost from hedge funds and retail aggregators

Exchange Rate: The price of one currency expressed in terms of another currency The number of units of one currency that are required to exchange for a

single unit of another currency Prices established in FX markets are the exchange rates between various

currencies

The Exchange Rate and its Quotation: Every bilateral exchange rate treats one currency as the item or

commodity which is being priced, with the other currency as the units inwhich its price is measured (terms)

E.g. For the exchange rate quote AUD=USD 1.0235, the Australian dollar isthe commodity currency and US dollar is the terms currency

In theory, the choice of commodity currency is entirely arbitraryo We could have the US dollar as commodity currency and the

Australian dollar as the terms currency USD1 = AUD 0.9770 AUD1 = USD 1.0235


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The Exchange Rate and its Quotation Formula: Let S(i/j)

o = spot price of currency j expressed in units of currency io = no. of units currency i per unit of currency j

j is the commodity currency, i is the terms currency E.g AUD = 1.0235 S(USD/AUD) = 1.0235

o Currency i is the US dollar (terms currency)o Currency j is the Australian dollar (commodity currency)

E.g. if St (USD/AUD) = 1.0235 and S t-5 (USD/AUD) = 1.0350, then

Australian dollar is said to have depreciated 1.1% against the US dollarover the 5-day period [100*(1.0235-1.0350)/(1.0350) = -1.1%]

European Quotation: Exchange rates are generally quoted with the US dollar as the commodity

currencyo I.e. number of units of foreign currency i per US dollar S(i/USD)

E.g.o S(Yen/USD) = no. of Japanese yen per US dollaro S(CAD/USD) = no. of Canadian dollars per US dollaro S(CHF/USD) = no. of Swiss Francs per US dollar

This is sometimes referred to as an exchange rate quotation inEuropean terms

American Quotation: For the British pound, Australian dollar, New Zealand dollar, Irish punt,

and the Euro, exchange rate quotations have the relevant local currencyas the commodity currency and USD as the terms currency (i.e. number of US dollars per local currency)

o E.g. S(USD/GBP) = no. of US dollars per British poundo S(USD/AUD) = no. of US dollars per Australian dollaro S(USD/NZD) = no. of US dollars per New Zealand dollaro S(USD/EUR) = no. of US dollars per Euro

This is sometimes referred to as an exchange rate quotation inAmerican terms

Direct Quotation: The exchange rate is expressed as the domestic currency price of 1 unit of

foreign currency I.e. price of the foreign currency expressed in units of domestic currency I.e. when foreign currency is the commodity currency and the terms

currency is the domestic currency

I.e. S(domestic currency/foreign currency) or S(AUD/currency i) E.g. AUD = USD 1.0235, then direct quote is: S(AUD/USD) = 0.9770 AUD


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Indirect Quotation: The exchange rate is expressed as the foreign currency price of 1 unit of

domestic currency I.e. price of the domestic currency expressed in units of foreign currency I.e. when domestic currency is the commodity currency and the terms

currency is the foreign currency I.e. S(foreign currency/domestic currency) or S(currency i/ AUD) E.g. If we have AUD = USD 1.0235, this is the indirect quote i.e.

S(USD/AUD) = 1.0235 USD

The Exchange Rate and its Quotation: In foreign exchange quotations, the units of measurement follow the usual

rules of algebra E.g. j/i = 1 (i/j) E.g. AUD/USD = 1 USD/AUD

If S(i/j) = a units of i, then S(j/i) = 1 S(i/j) = 1/a units of j I.e. If a units of currency i exchange for one unit of currency j , then it must

be the case that 1/a units of currency j must exchange for one unit of currency i

E.g. if S(USD/AUD) = USD 0.6330, then S(AUD/USD) = 1 (USD 0.6330) =AUD 1.5798

Cross Exchange Exchange Rates: Cross exchange rates are exchange rates between currencies when

neither of the 2 currencies is the US dollar

E.g. S(YEN/AUD), S(CHF/GBP), S(SF/NZD), etc. Recall that units of measurement follow the rules of algebra If we have three currencies currency i, currency j and currency z, then:


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Spot Bid and Offer Exchange Rate Quotes: In inter-bank spot FX market, when dealers provide an exchange rate

quotation, they will typically give a two - way price I.e. the buying price and the selling price of the commodity currency E.g. S(USD/AUD) = 0.6504-09

o This is the FX dealer s (price-maker s) two-way quote for the AUDin USD terms

o AUD is the commodity currency, USD is the terms currency What this quote means is that the dealer will either:

o Buy AUD in exchange for USD @ 1AUD = USD 0.6504o Sell AUD in exchange for USD @ 1 AUD = USD 0.6509

Bid price = USD 0.6504o I.e. the price at which the bank or dealer is willing to buy 1

Australian dollaro The price at which the bank is willing to buy 1 unit of thecommodity currencyo Rate at which banks will buy the base currency

Offer (Ask) price = USD 0.6509o I.e. the price at which bank is willing to sell 1 Australian dollaro It is selling price in units of the terms currencyo Rate at which banks will sell the base currency

Bid price (of the commodity currency) will always be less than Offer or ask price (of the commodity currency)

o Why? Profitable FX trading in the commodity currency dictatesbuying low/selling high

What banks make on FX transactions: 100 * (Ask Bid)/ Ask

Bid-Ask Spread: The difference between the offer or ask and bid prices of the FX quote E.g. = 0.0005 or 5 points in above example The bid/ask spread is normally larger for those currencies that are less

frequently traded The spread is also larger for retail transactions than for wholesale

transactions between banks or large corporations

Bid-Ask Percentage Spread:

Spot Bid and Offer Exchange Rate Quotes: When deali ng in foreign exchange, if you buy one currency, you also

necessarily sell the other currency and vice versa E.g. the quote on a AUD 5 million parcel of S(USD/AUD) = 0.7650 - 80

means that the dealer will: o Buy AUD 5 million @ 1 AUD =0.7650, simultaneously sell USD

3,825,000 (= 5,000,000 x 0.7650) o Sell AUD 5 million @ 1 AUD = 0.7680, simultaneously buy

USD 3,840,000 (= 5,000,000 x 0.7680)


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The Reciprocal Nature of Bid and Ask Exchange Rates:

Bid-Ask Spreads and Bank Profits: Magnitude of bid-ask spreads:

o Interbank market Within 5 pips (fourth decimal point in a currency quote) 0.05% - 0.07% for major currencies Lower for extremely liquid currencies like U.S. dollar (i.e.,

0.03% for $/ exchange rate quote) Higher for less liquid currencies

o Physical exchange 3% or more

Banks have to have inventory, which means it is not interest bearing

Banks must transact with brokers Use credit cards to exchange when in another country this

is the best possible rate for you! o Differs across the day

Bid-Ask Spreads and Bank Profits Example: Treasurer of a U.S. company purchases pounds with dollars to hedge a

British goods purchase. Directly after, he is told that they no longer needto purchase the goods. He then sells the pounds back for dollars.

Assume that the % bid-ask spread is 4 pips If the ask rate is $1.50/, the bid rate is $1.4996/ and the percentage

spread is:o [($1.50/) ($1.4996/)]/($1.4998/) = 0.03%

If the treasurer bought 1M at $1.50/, the cost would have been:o 1M * ($1.50/) = $1.5M

Selling back: 1M * ($1.4996/) - $1,499,600, or a loss of $400 on the twotransactions 0.03% of $1.5M


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Spot Market Spot Quotations: Quotes are given in pairs that reflect the bid-ask price E.g. pound sterling is quoted at $1.9719-28

o $1.9719 is the (bid) rate at which banks will buy poundso $1.9728 is the (ask) rate at which banks will sell poundso The spread equals the dealer s profit

The bid-ask spread is often quoted by the last two numbers; e.g. 19-28 Bid-ask quote expressed in American and European terms and as direct

and indirect quotes:

Bid-ask spreads are expressed as a percentage cost of transacting in theforeign exchange market as follows:

Cross Rates: Most currencies are quoted against the dollar A cross rate is the exchange rate between two non-dollar currencies

Spot Bid and Offer Cross-Rate Quotes: Example 1:

o If S(Yen/USD) = 123.00-10 and S(USD/AUD) = 0.7000-05, what isthe cross-rate quotation on the S(Yen/AUD)?

Answer:o Bid S(Yen/AUD) = bid S(USD/AUD) x bid S( Yen/USD)

= 0.7000 x 123.00 = 86.10o Offer S(Yen/AUD) = offer S(USD/AUD) x offer S(Yen/USD)

= 0.7005 x 123.10 = 86.23o S(Yen/AUD) = 86.10-23

Example 2: o If S(USD/AUD) = 0.7000-05 and S(USD/GBP) = 1.5550-60, what is

the cross-rate quotation S(GBP/AUD)? Answer:

o Bid S(GBP/AUD) = bid S(USD/AUD) offer S(USD/GBP)= 0.7000 1.5560 = 0.4499

o Offer S(GBP/AUD) = offer S(USD/AUD) bid S(USD/GBP)= 0.7005 1.5550 = 0.4505

o S(GBP/AUD) = 0.4499-05

American Terms American Terms European Terms*European Terms*

Direct in U.S.Direct in U.S.

$1.9719$1.9719- -2828

Direct outside U.S.Direct outside U.S.(1/$1.9728)(1/$1.9728)- -(1/$1.9719)(1/$1.9719)

== 0.50690.5069--7171Indirect outsideIndirect outside

U.SU.S .. Indirect in U.S.Indirect in U.S.

*Note that the bid and ask prices are reversed in quoting in European terms.

Percent Spread = Ask price Bid price

Ask price x 100


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Spot Bid and Offer Cross-Rate Quotes: Basically there are 2 simple steps in the determination of bid and offer

cross exchange rate quotations from two other bilateral bid and offerexchange rate quotes

Determine whether you have to multiply or divide the two exchange ratequotations

In determining which combination of bid and offer rates to use, recognisethat dealer will always want to have the bid price of the commoditycurrency as low as possible, and the offer price of the commoditycurrency as high as possible

Spot Market Cross Rates: E.g. Compute direct bid and ask cross rates for the pound in Zurich Direct quote for pound sterling = $1.9719-36 Direct quote for SFr = $0.8130-47

Thus, the direct quote for the pound in Zurich is SFr 2.4204-27

Triangular Currency Arbitrage: An arbitrage process involving three currencies Traders take advantage of exchange rate inconsistencies in different

money markets by buying a currency in one market and simultaneouslyselling it in another

Keeps cross-rates in line with exchange rates quoted relative to U.S. dollar Occurs when one can trade three currencies & make a profit (versus two)

o E.g. / < /$ * $/

=Bid cross rate =Bid rate for in $

Ask rate for SFr in $

$1.9719 $0.8147

= SFr2.4204

Ask cross rate =Ask rate for in $

Bid rate for SFr in $

$1.9736 $0.8130

= SFr2.4227=


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Good and Bad Triangular Arbitrage:

Triangular Arbitrage Diagram (Another Example):

Insert Exh. 2.7 here


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Triangular Currency Arbitrage: Traders take advantage of exchange rate inconsistencies in different

money markets by buying a currency in one market and simultaneouslyselling it in another

E.g. compute profit given the following exchange rates:o $/ = $1.9724 in New York o $/ = $1.3450 in Frankfurt o /= 1.4655 in London

Forward Rates and FX Swap Points: Forward exchange rate quotations are quoted in a similar manner to spot

prices A two-way bid/offer spread is quoted with the commodity currency again

being the currency referred to as being bought or sold in a transaction There are two ways of quoting forward rates

o First, is the outright forward exchange rate which is expressed asexactly as the spot exchange rate, using two numbers to represent the bid and offer forward rates

o Second, is the swap rate which quoted in terms swap points (alsoknown as forward points) of discount or premium

E.g. An FX dealer may quote the following S(USD/AUD) rates:o Spot: 0.7000-05o 3-month swap points: 40-38o (3-month forward points)

The forward price is an adjustment (represented by the swap or forwardpoints) to the spot rate to give what is known as the outright forward rate

The outright forward rate is the predetermined exchange rate at which anFX transaction is settled at a future date.

In this example, the 3-month forward S(USD/AUD) bid rate is 0.6960 (=0.7000 - 0.0040) and the corresponding offer rate is 0.6967 (= 0.7005 -0.0038)

In this example we obtain the 3-month outright forward rate bysubtracting the 3- month swap points from the bid and offer q uotes of the spot exchange rate

Adding or Subtracting Swap points? Rule:

o If the left-hand side of swap point quotation (bid) is greater thanthe right-hand side of the swap point quotation (offer), youSUBTRACT the swap points from the spot rate to obtain theoutright forward rate

New York

FrankfurtLondon

Sell $1,000,000 in Frankfurt for euros:$1,000,000/($1.3450) = 743,494

Sell euros in London for pounds: 743,494/ 1.4655 = 507,332

Sell pounds in New York for dollars: 507,332/(1/$1.9724) = $1,000,661

Profit = $661


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o If the L.H.S. of swap point quotation is less than the R.H.S. of theswap point quote, you ADD the swap points to spot rate quotation

Forward Premium: If outright forward exchange rate is greater than that spot exchange rate If F(USD/AUD) > S(USD/AUD), Australian currency is at a forward

premium If commodity currency is at a forward premiu m then terms currency

must be at a forward discount If swap bid points are greater than swap offer points, then:

o commodity currency is at forward discount o terms currency is at forward premium

If we have the following quotations swap points:3-month swap USD/AUD 40-38 (subtract swap points fromspot )3-month swap CAN/USD 15-20 (add swap points from spot )and the following spot rate quotations

S(USD/AUD) = 0.7000-05S(CAN/USD) = 1.2015-25

then we have following outright 3-month forward rates:

3-month F(USD/AUD) = 0.6960 - 0.69673-month F(CAN/USD) = 1.2030 - 1.2045

Another example: Another example:

Calculate outright forward rates from the following swap quotationsCalculate outright forward rates from the following swap quotationson the Canadian dollar (expressed in European terms):on the Canadian dollar (expressed in European terms):

ANSWER ANSWER NoteNote: we subtract the swap points from the spot rates as bid swap: we subtract the swap points from the spot rates as bid swappoints are greater than offer swap points for both maturities.points are greater than offer swap points for both maturities.

9090--day forward ($Can/USD) bid rate = 1.3890 (=1.3910day forward ($Can/USD) bid rate = 1.3890 (=1.3910- -0.0020)0.0020)9090--day forward ($Can/USD) offer rate =1.3900 (= 1.3915day forward ($Can/USD) offer rate =1.3900 (= 1.3915- -0.0015)0.0015)180180--day forward ($Can/USD) bid rate = 1.3885 (= 1.3910day forward ($Can/USD) bid rate = 1.3885 (= 1.3910- -0.0025)0.0025)180180--day forward ($Can/USD) offer rate = 1.3895 (= 1.3915day forward ($Can/USD) offer rate = 1.3895 (= 1.3915- -0.0020)0.0020)

Spot ($ Can per $US) 90-day Swap 180-day Swap1.3910-15 20-15 25-20


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Forward Discount: If outright forward exchange rate is less than that spot exchange rate If F(USD/AUD) < S(USD/AUD), Australian currency is at a forward

discount If commodity currency is at a forward discount then terms currency

must be at a forward premium If swap bid points are less than swap offer points, then:

o Commodity currency is at forward premiumo Terms currency is at forward discount

Forward Market: A forward contract between a bank and a customer calls for delivery on a

fixed future date of a specified amount of one currency against dollarpayment at a fixed exchange rate.

Negotiating a forward contract for payment of a future liability eliminates

exchange risk by locking in a known future exchange rate E.g. a U.S. company buys textiles from England, with payment of 1million due in 90 days

Implicit gains/losses on forward positions are related to the differencebetween f t and et at the forward contract s maturity

Forward Rates and FX Swap Points: What determines the forward price? The forward price will be determined by:

o the spot rateo the term or maturity of the forward contract o the respective nominal interest rates of the two currencies in the

exchange rate quotation Once we know these, we can calculate the swap or forward points and

hence the forward exchange rate Covered Interest Parity (CIP) provides the theoretical underpinning for

determination of the forward rate

e 0 = $1.97

Day 0 90

f 90 =$1.98

No exchange risk: 1,000,000 = $1,980,000

e 90 > $1.98

Exchange risk:If e 90 > f 90 , cost of payable will increase

lecture 1 – foreign exchange markets and exchange rates i

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