125220 Topic 14: Foreign Exchange markets

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125220 Topic 14: Foreign Exchange markets
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125220 Topic 14 FX Markets
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FX Markets
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  1. Fixed Exchange Rates
    • • Value of currency determined by government or central bank. Demand & supply of currency usually not in balance under this system so government has to use reserves if demand for foreign currency is greater than supply.
    • • If there is too much pressure on overseas currency reserves, government may be forced to devalue or place severe restrictions on the movement of funds.
    • • Conversely, with supply of foreign currency exceeding demand, a reduction may be necessary if the government begins to hold too many reserves.
  2. Floating Exchange Rates
    • • Exchange rates set by market forces = markets determine FX price price discovery
    • • NZD was floated in March 1985.
    • • The FX market will remain in balance under this system in terms of all cash flows.
  3. FX Market Participants
    • FX Dealers
    • Central Banks
    • Firms conducting international trade transactions
    • Investors/borrowers in international money/capital markets
    • Arbitrageurs
  4. Market participants
    - FX Dealers
    • Organisations acting as principals in FX market
    • Institutions that quote buy(bid) and sell(offer) prices for foreign currencies
    • Institutions include commercial/investment banks, merchant banks
  5. Market participants
    - Central Banks
    Enter FX market periodically

    • Various reasons to enter include:
    • 1) acquire foreign currency to pay for govt's import purchases and to pay interest/redeem govt overseas borrowings
    • 2) Change composition of central bank's holdings of foreign currencies as part of their management of official reserve assets
    • 3) Influence exchange rate
  6. Market participants
    - Firms conducting international trade transactions
    • Country exporting G&S = often receive payment in foreign payment. Sell foreign $, buy local currency via FX market.
    • Country importing products = need to pay for goods in $ not recipient's home country. Sell local currency, buy foreign $
  7. Arbitrageurs
    • Take advantage of buy/sell price differences between markets
    • Arbitrageurs = carry out simultaneous buy/sell transactions in 2+ markets, in order to achieve risk-free profit.
  8. Arbitrageurs example
    USD1 = AUD1.35
    USD1 = SGD1.35
    AUD1 = SGD0.98
    • 1) Sell AUD1.35, get USD1
    • 2) Sell USD1, get SGD1.35
    • 3) Sell SGD1.35 = receive AUD1.3776 (SGD1.35 X 1.02)
  9. FX Markets
    - Location
    - Trading Hours
    - Activity & Volume
    • Location - global market with highly sophisticated network of telecommunication systems.
    • Trading hours - NZ/ markets open between period where US west coast markets close, before Sydney markets open
    • Activity & Volume - Midnight NZ time when NY & Europe markets trading, Global transactions = US$5.3 Trillion billion per day April 2013 with1.5 Trillion spot FX
  10. Markets Segments & Instruments traded
    • Spot market = FX contract value date is two business days from date of transaction
    • Forward transaction = FX contact value date occurs @ specific date beyond spot date
    • Futures & Currency options = deals in contracts to hedge against future changes in FX rates
    • Swaps = currency swap = technique that takes floating-rate debt servicing in one currency (coupon & principal repayments) & hedges the cost in terms of another currency.
  11. Markets Segments & Instruments traded
    - Transactions based on Counter-party April 2013
    • between dealers in banks = 39%
    • between banks and customers = 9%
    • between other FIs = 53%
  12. Settlement of FX
    • • Due to counterparty risk, where one party may default on their transaction (Herstatt risk), usually banks net their FX deals.
    • • Banks make or receive one net payment for each currency deal for each settlement date.
    • • Company owned by major banks in place a global clearing system to handle FX in real time- CLS launched in 2002
  13. FX Basics - Asking For a Quotation
    • You want to buy Swiss Francs (SF) & sell NZ Dollars (NZD), you may ask “What is SF NZD spot rate?” or Swiss franc dollar rate’
    • • Dealer will know that you are asking for spot price of SF1 in terms of NZD
    • • If you said NZD SF rate, quote will be for price of NZD1 in terms of SF.
    • • Convention in text = first currency mentioned = one whose price is being sought. Often referred to as unit of quotation or base currency.
    • • In this course textbook it is:
    • – SF/NZD means ‘the price of SF1, in terms of NZD’
    • – NZD/ USD means ‘the price of NZD1 in terms of USD
  14. Two Number Quotations (Dealers)
    • Receive two sets of numbers for written quote
    • USD/NZD 1.5044 - 1.5061
    • As USD/NZD one fifty forty four to sixty one
    • Note that decimal point is not mentioned & second number is abbreviated for 61
  15. Understanding Foreign Exchange Spot Quotes
    Wholesale versus retail quotes. Wholesale quote is:

    Quote NZD/USD
    - Bid 0.6244
    - Ask 0.6251
    • Means 1NZD in terms of USD
    • • Dealers establish two-way price so they can sell a particular currency for a higher price than they paid for it. (for retail- for customer-bid quote higher than ask)
    • • The dealer ‘buys low’ and ‘sells high’
  16. Understanding Foreign Exchange Spot Quotes
    - Bid/selling price
    • The bid price = buying price
    • Ask (offer) price = selling price
    • The difference the spread (margin) for the bank or dealer. That is
    • • the bank will buy NZD1 for USD 0.6244 (from customer’s viewpoint, the customer would give NZD1 & get USD 0.6244)
    • • the bank will sell NZD1 for USD 0.6251 (but for customer, they get NZD1 by giving USD 0.6251).
    • • Every price quotation always involves:
    • – the commodity being priced
    • – the terms that express the price
  17. Understanding Foreign Exchange Spot Quotes

    Example. 1 APPLE = $0.50
    • In any FX quote, there are two currencies involved i.e.
    1NZD = USD 0.4700
    1USD = Y97.00
    Commodity & 'terms' currency
    • • One of these will always be the 'commodity’ in the quote & the other the ‘terms’ currency.
    • • Usually the one that is expressed as 1 is the commodity currency e.g. 1 NZD, 1USD, 1 ringgit
    • • In the above, the NZD & USD are the commodity currencies being priced.
    • • The term currency is the other currency & this is the one that varies in price
  18. Understanding foreign exchange spot quotes
    • If the NZD is 1 NZD =USD 0.4600 & it moves...
    • So when the term’s currency in the quote
    • risescommodity is dearer
    • fallscommodity has fallen in value

    • In relation to example for NZD if 1NZD = USD 0.4600 and it moves...
    • 1NZD=USD0.500 = rise(apprec'n) in Kiwi
    • 1NZD=USD0.450 = fall(dep'n) in Kiwi
  19. Foreign exchange spot quotes
    Need a rule to avoid confusion
    • 1. Determine which currency is the commodity & which is the term’s currency.
    • 2. look at numbers of the term then every time the term’s price rises ⇒ the commodity has increased in value (and term’s currency has fallen) and...
    • Every time the term’s price falls ⇒ the commodity has decreased in value (and term’s currency has risen)
  20. Examples:
    $1 NZ = $0.80 Aus to $1 NZ = $0.87 Aus
    AND $1 NZ = $0.90 Aus to $1 NZ = $0.85
    • For $1 NZ = $0.80 Aus to $1 NZ = $0.87 Aus
    • - NZ dollar strengthened (risen against Aus)
    • - Aus dollar devalued (fallen against NZ)

    • For $1 NZ = $0.90 Aus to $1 NZ = $0.85
    • - then NZ dollar has devalued.
  21. Convention in the FX markets
    • • All countries quote to the USD
    • • Commonwealth countries generally use American dollar as the terms currency (indirect) e.g. 1 Aus = 1.0500 US dollars, 1 Kiwi = 0.8200 US dollars
    • • Other countries make the US dollar the commodity or base currency (direct) & express their value as term’s currency (European). e.g. 1 US dollar = 97.00 Yen in Japan, 1 US dollar = 1.2195 NZD
  22. Conventions in the FX market
    'Direct' & 'Indirect' quotes
    • Direct = USD is the base currency in an FX quotation, local currency price of 1USD. e.g. USD/$NZ = 1.2821 or NZD/USD = 0.78
    • Indirect = USD is the terms currency, other currency is base/the unit of the quotation. e.g. NZ1 = USD0.8207 (direct quote would be 1USD = 1.2185NZD
  23. Reciprocals
    • It is possible to reciprocate quotes & reverse the commodity currency to the term’s currency & vice versa.
    • Simply divide the quote into 1!
    • 1 NZD = USD 0.5000, So 1 divided by 0.5000 or 1/0.5000 1USD = NZD 2.000

    • • Useful if you want to be clear about what is happening to the term’s currency as its price moves from Rg 2.5 = 1USD moves to Rg 2.2 = 1USD
    • • With reciprocals 1Rg = 44c & 1Rg = 46 cents, you know ringgit has appreciated.
  24. Reciprocals
    - For 2-way quote
    • Transpose, Reverse quote, then Take Reciprocal,
    • Example: NZD/EUR 1.2255 1.2265
    • Reverse 1.2265 1.2255
    • Reciprocal 0.8153 0.8160
  25. Cross-rate
    e.g. 1NZD = 1.7Rg
    The exchange rate of two currencies, neither being the USD
  26. Crossing two DIRECT FX quotations
    Example 1:
    USD/EUR 0.6450-55
    USD/JPY 107.40-50
    Determine EUR/JPY
    • 1) Place currency that is to become UNIT OF THE QUOTATION first
    • a) Divide base currency offer into term's currency bid (giving bid rate)
    • b) Divide base currency bid into terms currency offer (giving offer rate)

    • For  
    • USD/EUR 0.6450-55
    • USD/JPY 107.40-50
    • Bid = 107.40/0.6450 = 166.38
    • Offer = 107.50/0.6450 = 166.67
    • Therefore: EUR/JPY is 166.38-166.67
  27. Calculating cross-rate: Direct FX quotations
    - USD/new base currency & USD/new terms currency
    • 1) USD/NBC Offer divided from USD/NTC Bid
    • 2) USD/NBC Bid divided from USD/NTC Offer

  28. Crossing/Calculating direct and indirect FX quotation:
    GBP/USD 1.9770-75
    USD/NZD 1.3760-70
    • 1) Multiply two bid rates (give bid rate)
    • 2) Multiply two offer rates (gives offer rate)

    • Bid = 1.9770 X 1.3760 = 2.7204
    • Offer = 1.9775 X 1.3770 = 2.7230
    • Therefore GBP/NZD=2.7204-30
  29. Crossing/Calculating two indirect quotes incl.
    AUD/USD 0.9262-69
    GBP/USD 1.9770-75
    Find AUD/GBP
    • 1) Place currency becoming unit of the quotation first
    • 2) Divide terms currency offer into base currency's bid (gives bid rate)
    • 3) Divide terms currency bid into base currency's offer (gives offer rate)

    • For example:
    • Bid = 0.9262/1.9775 = 0.4684
    • Offer = 0.9269/1.9770 = 0.4688
    • Therefore, AUD/GBP 0.4684-88
  30. Two direct FX quotations simple formula:
    Hint: 'T' first
    • 1) Determine Base/Terms Currency
    • 2) Bid = TB/BO
    • 3) Offer = TO/BB
  31. Two indirect FX quotations simple formula:
    Hint: 'B' first
    • 1) Determine Base/Terms currency
    • 2) Bid = BB/TO
    • 3) Offer = BO/TB
  32. Example 1: A Japanese importer needs to buy Euro against the Yen. What is the rate in Yen terms given...
    1USD = Yen 130.0 and 1USD = EUR 1.6430?
    • - Firstly, "euro against yen" means "1EUR = Yen?"
    • 1. Yen? = 1EUR (Reverse)
    • 2. EUR 1.6430 = 1USD
    • 3. 1USD = Yen 130.0
    • So 1 EUR = 130/1.643 = Yen 79.123
  33. Example 2:
    Given USD/Rg Bid=2.5000 Offer=2.5020
    NZD/USD Bid=0.6400 Offer=0.6420
    Find cross rate NZD/Rg?
    • Bid=2.5000 X 0.64000
    • Offer=2.5020 X 0.6420
  34. Forward transactions
    FX can be bought or sold for a price determined today but delivery takes place at a predetermined future date

    Conventions for quoting the outright forward rate - Need spot rate to add/subtract the forward points

    • 1. Need to line up points from last decimal point.
    • 2. To determine whether to add/subtract forward points
    • – If ascending, then add to the spot rate
    • – If descending, then subtract from spot rate
  35. Conventions for quoting the outright forward rate
    Example: Ask for spot & 1 month forward- given the Kiwi is fifty one
    thirty to forty, one -thirty- three to twenty- four
    • Spot-rate = NZD/USD 0.5130-40
    • Forward points  = other numbers (therefore, 133 and (1)24)

    • NZD/USD (spot)  0.5130-0.5140
    • and, forward       0.0132-0.0124
    • 1-mth fwd outright 0.4998-0.5016
  36. If forward points
    - falling
    - rising
    • If forward points are falling, the commodity currency is at a forward discount.
    • If forward points are rising, the commodity currency is at a forward premium.

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