Chapter 2 - The foreign exchange market. After reading the material in this chapter, you should be able: To describe the basic features of the foreign exchange market, to identify market participants and traded currencies, to describe the australian foreign exchange market, to describe the mechanics and technology of foreign exchange trading, to introduce some exchange rate concepts, to illustrate foreign exchange position keeping, to introduce some foreign exchange jargon.
Chapter The Foreign Exchange Market 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 Moosa 2-2 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 Moosa 2-3 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 Moosa 2-4 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 Moosa 2-5 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 Moosa 2-6 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 Moosa 2-7 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 Moosa 2-8 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 Moosa 2-9 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 Moosa 2-10 Bid and offer cross rates Sa ( x / z ) Sa ( x / y) = Sb ( y / z ) Sb ( x / z ) Sb ( x / y ) = Sa ( y / z ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-38 Cross rates matrix • For n exchange rates S(x / x ) i j S ( x / z) i S ( x / z) j Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-39 FX position keeping • 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” (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 Moosa 2-40 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 (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 Moosa 2-41 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 (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 Moosa 2-42 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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-43 An example The following is an example of FX position keeping AUD Deal Amount +10,000,000 +20,000,000 10,000,000 +25,000,000 50,000,000 AUD Balance AUD/USD Rate +10,000,000 +30,000,000 +20,000,000 +45,000,000 5,000,000 1.6525 1.6645 1.6725 1.6445 1.6500 USD Deal Amount 6,051,437 12,015,620 +5,979,073 15,202,189 +30,303,030 USD Balance 6,051,437 18,067,057 12,087,983 27,290,172 +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 Moosa 2-44 The forward exchange rate • The rate contracted today for the delivery of a currency at a specified date in the future Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-45 Forward value date • 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 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-46 Forward value date (cont) • 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 (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 Moosa 2-47 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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-48 Kinds of FX swaps • • • • Forward swaps Forward-forward swaps Overnight swaps Tom/next 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 Moosa 2-49 The forward spread F ( x / y) S ( x / y) m= × 100 × 12 N S ( x / y) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-50 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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-51 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 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2-52 ... Copyright 20 10 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2- 29 Exchange rate changes • When the exchange... Exchange rate volatility Copyright 20 10 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2- 21 Components of an. .. Copyright 20 10 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 2- 24 The bilateral spot exchange rate • The exchange