FINS1612 W8 Lecture

8/17/2019 FINS1612 W8 Lecture

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CAPITAL MARKETS AND INSTITUTIONS

FOREIGN EXCHANGE MARKETS

Ch 15 16

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Foreign Exchange Markets

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Key things you need to know:

• What is foreign exchange (FX)?

• What affects exchange rate? And how supply / demand affect it?

• What is global FX markets?

• Who participates in the FX markets?

• What are traded in FX markets?

• How to interpret, quote, and calculate exchange rates and forward exchange rates,

and what are the complicating factors

Reference chapters are Ch15 & Ch16


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Exchange Rates

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• Each country or monetary union responsible for determining own exchange

rate regime

• Exchange rate is value of one currency relative to that of another currency

• Major currencies like USD, GBP, JPY, EUR and AUD adopt floating exchange

rate (free float) regime ie, determined by supply & demand

• Other types of exchange rate regimes include:

• Managed float - held within defined band relative to other currency ie,

Singapore, Indonesia, China

• Crawling peg - allowed to appreciate in controlled steps over time ie,

China (arguable)

• Linked exchange rate - tied to value of another currency or basket of

currencies ie, HKD


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Foreign Exchange Rate

AUD/USD = 0.7185

Above means:

- A more simplistic way to look at currency is to treat it as an item. Ie, 0.7185

AUD/USD – the price of 1 AUD (Base) in terms of USD (Terms) - which makes it

an “exchange rate”. Eg, AUD1 costs USD0.7185 to buy whereas it costs AUD1to buy AUD1.

- As an American tourist, you will use USD0.7185 to buy AUD1. Or,

- As an Aussie, you will need AUD1.39 (inverse of 0.7185) to buy USD1.

- Note this does not include fees or bid/ask, etc.

This is a “indirect” quote as AUD is the Base.

Base Currency

Terms Currency


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Supply Demand of Currency in the FX markets

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• What does a supply demand curve for foreign currency look like?


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Supply / Demand Graph

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Supply Demand of Currency in the FX markets

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• Demand for a currency (Base)

• As the price of the base currency falls, demand by foreigners increases

• Hence, downward-sloping demand curve

• Supply of a currency (Base)

• Upward-sloping supply curve occurs as the quantity of AUD supplied

increases as the price of the AUD increases

• Equilibrium exchange rate

• The rate at which the quantity of AUD supplied to the market is equal to

the demand for AUD


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What is influencing exchange rate movements?

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Main factors are:

• Relative inflation rates

• Relative national income growth rates

• Relative interest rates

• Exchange rate expectations

• Government or central bank intervention


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What is influencing exchange rate movements?

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Main factors are:

• Relative inflation rates (US higher than Aust)

• Relative national income growth rates (Aust higher than US)

• Relative interest rates (Aust higher than US)

• Exchange rate expectations (Expect AUD depreciates)

• Government or central bank intervention (how?)


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Relative inflation rate (US’ higher than ust’s)

1. US Imports expensive, less demand for

US Imports, reducing supply of AUD

2. US switches to Aust goods and demand

more AUD to pay for these items

Net effect is an appreciation of the AUD


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Relative National Income Growth Rate ( ust’shigher than US)

AUD depreciates initially and perhaps gain ground as more foreign investment

comes in

1. More income, more demand for goods

(ie, US goods), more imports, increases

supply of AUD

2. Potentially more foreign investment into

AUD which move back the AUD rate.


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Relative Interest Rate (AUD higher than USD)

1. Higher AUD interest return attracts foreign

investors, hence increase demand

2. More Aussie will keep AUD and invests locally

which may reduce import of USD goods.

Potential decrease in supply of AUD

AUD appreciates, but

expectation of AUD value will affect the likely of switching of assets from USD to

AUD ie, interest rate differentials vs. change in FX rates


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Expectation (expect AUD to decrease)

1. In anticipation of AUD fall, Aussies buys foreign

currency which increase supply of AUD

2. Foreigners defer AUD purchase which

decreases demand of AUD

AUD depreciates

S0 S1

D0

D1


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Gov’t / Central bank Intervention

• A central bank may also influence the currency by:

• Direct policy altering relative inflation rate, income growth, interest rates

• intervening in international trade flows

• intervening in foreign investment flows

• directly intervening in the FX market


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Global FX Markets

• FX markets

•

Comprise all financial transactions denominated in foreign currency,currently estimated to be over USD4.00 trillion per day

• Facilitate exchange of value from one currency to another

• FX market participants can be classified as:

•FX dealers and brokers

• central banks

• firms conducting international trade transactions

• investors and borrowers in the international money markets and capital

markets

• foreign currency speculators

• arbitrageurs


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Types of FX transactions

• FX market instruments are typically:

• Spot transactions (T+2)

• Have maturity date two business days after the FX contract is

entered into

•

Forward transactions

• Have maturity date more than two days after FX contract is entered

into

•

There are also Today (T), Tomorrow (T+1)


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Spot FX Quotations

AUD/USD = 0.7180-90

Above means:

- Price of 1AUD (base) in terms of USD (terms)

- About USD0.7185 (mid) to buy AUD1 or inverse, to buy AUD1.3918 withUSD1.00

- So, if you (Aussie) have a purchase of USD100k, you will need to have

AUD139.18k to buy enough USD to pay for it.

- Note this does not include fees or bid/ask, etc.

This is a “indirect” quote as AUD is the Base.

Direct is when USD is the Base

Base Currency

Terms Currency


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Spot FX Quotations

AUD/USD = 0.7180-90

Base Currency

Terms Currency

Bid – what dealer will buy AUD at

(your sell price)

Offer – what dealer will sell AUD at

(your buy price)

Above means:

- Dealer buy AUD1 at USD 0.7180 (where you sell AUD at)

- Dealer sell AUD1 at USD 0.7190 (where you buy AUD at)

- Difference between bid and offer is the “Spread”. In this example,

it is a 14bps spread

Remember: Bid & Offer is from the dealer perspective (Buy low / Sell high)


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Spot FX Quotations

FX Dealer:AUD/USD

0.7180-90

Going to USA(You need

USD)

Coming back

from USA

(You need

AUD)

USD1.00

Bid AUD @ 0.7180Or

1/0.7180 = AUD1.3928

Ask AUD @ 0.7190

Or1/0.7190 = AUD1.3908

USD1.00

End result: Dealer made a bid/ask spread


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Spot FX Quotations

• To transpose indirect to direct quotes:

• (i) Reverse the bid/offer and then (ii) inverse the exchange rate

• For example, AUD/USD = 0.7180-90

1. Reverse bid/offer: 0.7190-80

2. Inverse the exchange: 1 / 0.7190, 1 / 0.7180

3. USD/AUD is 1.3908 -1.3928. This is a direct quote


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Cross-Rates

• All currencies are quoted against the USD

• When FX transactions occur between two currencies, usually where neithercurrency is the USD, the cross-rate needs to be calculated

• Method of cross-rate calculation depends on whether the quote is direct

or indirect (refer details on p.509)

• Crossing a direct and indirect FX quotation:

GBP/USD1.6270-75

USD/NZD1.3292-97

To determine the GBP/NZD cross-rate:

Bid = Base Bid x Terms Bid =1.6270 x 1.3292 = 2.1626

Offer = Base Offer x Terms Offer = 1.6275 x 1.3297 = 2.1641

GBP/NZD2.1626-41


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Cross-Rates

• Crossing two direct FX quotations:

USD/EUR 0.7250 –55USD/JPY 81.40 –50

To determine the EUR/JPY cross-rate:

Bid = Terms bid ÷ Base Offer = 81.40/0.7255 = 112.20

Offer = Terms offer ÷ Base Bid = 81.50/0.7250 = 112.41

EUR/JPY 112.20-41


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Cross-Rates

Crossing two indirect FX quotations:

AUD/USD0.9262 –69GBP/USD1.6270 –75

To determine the AUD/GBP cross-rate:

Bid =Base Bid ÷ Terms Offer = 0.9262/1.6275 = 0.5691

Offer = Base offer ÷ Terms Bid = 0.9269/1.6270 = 0.5697

AUD/GBP0.5691 –97


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Forward Exchange Rate

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• What is Forward exchange rate?

• Why do we need it?

• How is it calculated?


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• Forward exchange rate is the FX bid/offer rates applicable at a specified date

beyond the spot value date

• Forward exchange rate varies from the spot rate due to interest rate parity

• Interest rate parity is the principle that exchange rates will adjust to

reflect interest rate differentials between countries

• Forward exchange rates are quoted as forward points, either above or below

the spot rate

• +ve forward points, means forward premium; interest rate of the base

currency is lower

• -ve forward points means forward discount; interest rate of the base

currency is higher)

• Eg. AUD/USD – do you think it is at a discount or premium?


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AUD / USD Forward Rate

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Say, AUD/USD (spot)

0.9630

Aust rate is 2.5% and US is 1%. So, what is the forward pts in 90 days?

Points = 0.9630 * {[(1+1%*90/360)/(1+2.5%*90/360)]-1}= -0.0036

So, to enter into a 90 days forward rate, you will get a forward discount of

36pts to the spot or. 0.9630-0.0036 = 0.9594


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http://www.fxstreet.com/rates-charts/forward-rates/?id=aud%2fusd

http://www.fxstreet.com/rates-charts/forward-rates/?id=aud/usdhttp://www.fxstreet.com/rates-charts/forward-rates/?id=aud/usd


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• The calculation explains how the dealer operates even he/she does not know

what the spot rate will be on a future date,

• They will carry out the FX transaction today even though delivery will not

occur until the future date; i.e.:

• Borrow funds in one market and purchase the foreign currency that will

be needed at a future date

• Invest the purchased foreign currency in that market until delivery is due

• The difference between the cost of borrowed funds and the return

received on the invested foreign currency will be adjusted against the

spot rate today


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Previous formula can be adjusted to reflect the difference in bid/offer.

Note the mixed use of bid/offer in the equation.


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Bid / Ask Forward Rates

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Real world example:

Company X approaches an FX dealer for a forward quote on the USD/CHF with

a three-month (90-day) delivery. The spot rate is USD/CHF1.1555-60. The

dealer needs to calculate the forward points. Assume the three-month

eurodollar bid and offer interest rates are 3.00% and 3.30% p.a. and the three-

month euroswiss franc interest rates are 3.70% and 4.00% per annum,

respectively

• The forward points are rising so they will be added to the spot rate.

Therefore, the three-month forward exchange rate will be USD/CHF1.1566-

89


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Foreign Exchange Markets

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Check on what we have learnt today

Key things you need to know:

• What is foreign exchange (FX)?

• What affects exchange rate? And how supply / demand affect it?

• What is global FX markets?

• Who participates in the FX markets?

• What are traded in FX markets?

•

How to interpret, quote, and calculate exchange rates and forward exchange rates,and what are the complicating factors

Reference chapters are Ch15 & Ch16


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Summary

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• Need to know

• How to:

• Quote spot rate (Base/Terms, direct vs. indirect, bid/offer),

• Price forward exchange rate,

•

Calculate cross-rates• The influencing factors on exchange rate and use supply / demand

curve

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FINS1612 W8 Lecture