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PKMC M3 > 1. Introduction to FX Market > Flashcards

1. Introduction to FX Market Flashcards

1
Q

What is FX market & when does it exist?

A

market whereby buyers and sellers transact in convertible currencies. There is no single unified foreign exchange market. The market exists wherever one currency is traded for another

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2
Q

What is the largest & most liquid market?

A

The FX market

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3
Q

What is a FX transaction?

A

FX transaction is an exchange of a specific amount of one currency for another currency at an agreed rate and date.

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4
Q

When are foreign currencies required?

A

When making payments across national borders and international trade (import/export)

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5
Q

What is FX rate?

A

price of the nation’s currency in terms of another currency, i.e., the number of units of the domestic currency needed to buy one unit of another nation’s currency

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6
Q

When is foreign exchange needed?

A
  1. Social need
  2. organization trading internationally
  3. speculative reasons, hope to profit from favourable currency movements.
    - 85-90% of the daily global turnover is due to speculation.
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7
Q

What are the feature of FX Market?

A

• no physical/centralized marketplace for FX transactions — not traded on exchanges, traded on OTC market.
• an electronic market; funds are transferred between buyers & sellers via SWIFT (Society for Worldwide Interbank Financial Telecommunication).
• FX market made up of dealers & brokers located various locations, transact via international dealing systems.
• advances in telecommunication + access to real-time market information = FX market have almost total price transparency.
• heart of the market is the dealing rooms
• informal market — buyers & sellers transact with/without having to meet/know each other.
• open 24 hours — from 10 p.m. GMT on Sunday (8 a.m. Sydney) until 10 p.m. GMT on Friday (5 p.m. New York).

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8
Q

How are the participants in the FX market classifies & who are they?

A

classified in terms of the level of access:
1. At the top is the interbank market, which has largest commercial + investment banks+large central banks — individual trades of USD100m-USD500m — account for majority of the daily forex transactions.

  1. After that, smaller investment + commercial banks, large hedge funds, large multi-national corporations, smaller central banks, non-bank financial + related institutions (pension funds, insurance companies and mutual funds) — trades of USD3m-USD50m.
  2. At the lower are corporations, retail forex market makers & individuals — trades below USD5m.
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9
Q

Why does investment and commercial banks engage in FX trading? & how do they provide liquidity & market depth for FX market?

A
  1. speculative trades (trading for bank’s own account)
  2. trading for customers.

By actively quoting 2-way prices (bid & offer prices), banks provide the liquidity and market depth

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10
Q

Why do corporations buy & sell currencies?

A
  1. to meet their foreign currency payables & receivables + investment purposes.
  2. larger multinational & supranational international corporations also speculate (aka take position)
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11
Q

Why do Insurance companies, pension funds, finance companies, international bodies and local statutory authorities do FX trading?

A

for trade and investment purposes

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12
Q

Why do individuals do FX trading?

A

For investment & leveraging purposes

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13
Q

Why do central banks participate in and intervene FX market?

A
  1. Participate to manage the reserves of their own countries
  2. Intervene to support currencies/reduce excessive market volatilities.
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14
Q

How do money brokers participate in the FX market?

A
  1. Money brokers are the only passive participants in the market — act as a ‘financial middlemen’ by providing ‘running’ currency prices — matching deals between buyers and sellers — commercial banks.
  2. earn a commission — brokerage — for every deal matched.
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15
Q

What contributed to the enormous daily FX volume?

A
  1. global deregulation of financial markets
  2. increased market volatilities
  3. vast range of OTC &exchange-traded derivative products such as currency futures, FX options and swaps.
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16
Q

why currency interventions fail sometimes?

A

Due to the enormous daily trading volume

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17
Q

What are the factor affecting FX rates?

A
  1. Supply & demand
  2. Market Forces — Fundamental & Technical
  3. Economic, political & technical Factors
  4. Government and Central Bank’s Policies
  5. Market Psychology and Sentiments
  6. International Events
  7. Market Speculation and Hedging
  8. Market information
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18
Q

How does demand & supply affect FX exchange rate?

A

For example, if the demand for US Dollars is more than the supply of Dollars against the Yen, the buying activity of Dollar buyers would cause the Dollar to appreciate against the Yen.

This Dollar buying will continue until an ‘equilibrium’ level is reached where the demand for Dollars equates to the supply. At this point, the newly established USD/JPY exchange rate will hold for a while until new market forces cause it to move again.

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19
Q

How does market forces affect FX rates?

A

Fundamentally, the market will try to ascertain the range at which it should be traded given the fundamentals between the two countries. However, other short-term and medium-term factors such as market rumours and sudden news of political and international events must be considered.

technical analysis impacted FX rates — caused traders to ‘skew’ the market in certain ‘self-prophesized’ directions.

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20
Q

How does economic factors affect FX rates?

A

These economic factors influence dealers who decide the value of a currency.

The main economic factors are as follows:
• The pace of economic activities — GDP
• inflation rate — CPI & PPI
• money supply, monetary growth rates & policies, nominal & real interest rate
• External trade performances — trade balances.
• Other economic indicators are the employment rate, leading indicators, retail and
auto sales, consumer credit, industrial production and capacity utilization levels.

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21
Q

How does the government and central bank’s policies affect FX rates?

A

It influences the economic outlook for the country & consequently, the perceived value of its currency. The main policies are as follows:
• Both fiscal and monetary policies.
• Size of a country’s budget deficit/surplus and external debt.
• Size of a country’s current account deficit/surplus.
• Taxation policies.
• Central bank’s statements and actions.

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22
Q

How does Market Psychology and Sentiments affect FX Rates?

A

It affects the currency ‘confidence’ factor:
• In an economic upturn, the market tends to be positive on the country’s interest and exchange rates. This positive sentiment will cause the currency to stay strong and market will tend to focus on the positive news (and ignore the negative news).
• A falling/sharply depressed stock/bond market could trigger a loss of confidence and subsequently a negative sentiment for the country’s currency — causing the market to sell on every piece of negative news.

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23
Q

How does political factors affect FX rates?

A

These factors include political uncertainties such as elections, wars, scandals, possible coups and change in leadership. For example, the start of the Gulf War in 1990 caused the US Dollar to strengthen sharply against major currencies in the foreign exchange market as the market sought after the greenback as a haven currency. The end of the conflict saw the US unit falling against other currencies.

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24
Q

How does technical factors also affect foreign exchange rates?

A

Seasonal demand and year-end factors affect currencies to the extent that they may be bought or sold. For example, US Dollar usually rise against certain currencies during the year end, while some European currencies are more in demand during the European summer period.

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25
Q

How does international events affect FX rates?

A

• The 1985 Plaza Accord of the industrialized countries to bring down the overvalued Dollar, which caused it to fall sharply in the foreign exchange markets.
• The 1987 Louvre Accord which set informal target zones between major currencies.
• The rescheduling of the international debts of Third World countries in the early 1980s, actions and recommendations of various international bodies like the Bank for International Settlements (‘BIS’), International Monetary Fund (‘IMF’) and the World Bank.

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26
Q

What is Market Speculation and Hedging & how does it affect FX rates?

A
  1. FX market speculation — buying/selling/holding currencies to make a profit from favourable fluctuations in exchange rates.
  2. FX hedging — managing the degree of risk that may be present when engaging in foreign currency investment strategy by minimizing the FX exposure from unfavorable exchange rates movement.
  3. Eg:
    • In September 1992, heavy market speculation against the British Pound caused the Pound to fall sharply and its subsequent ejection from the European Monetary System.
    • Expectation of a lower USD/JPY (due to a massive Japanese trade surplus with the US) in early 1995 caused the USD/JPY to fall to a historical low of 79.75. The USD fall was further aggravated by hedging of USD proceeds by Japanese exporters and other international corporations.
    • On 24 June 2016, the United Kingdom Brexit Referendum voted for Britain’s withdrawal from the European Union. Heavy market speculation against the British Pound caused the GBP/ USD to fall sharply from a high of 1.5018 to a low of 1.3229.
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27
Q

How does market information (including rumours & hearsay) affects FX rates & what does a responsive dealer do?

A

Sudden news/rumours like ‘US attacks Iraq’ or ‘Coup by Russian military hard-liners’ would cause the market to immediately buy or sell the US Dollar. A responsive dealer would be one who capitalizes on such market information to make a quick profit by ‘scalping’ the market.

28
Q

What are the 2 main areas of FX Desk?

A

• Interbank Desk
• Corporate Desk

29
Q

What does interbank desk do?

A
  • engages in ‘market making’ and ‘speculative’ trading activity
  • trades mostly with other banks (hence the name ‘interbank’ trader),
  1. Market making
    - provide immediacy services by providing market liquidity and supporting price discovery by absorbing temporary supply and demand imbalances.
    - generate profits from the bid and offer spread or provide good prices to its customers.
    - quoting of interbank prices by interbank dealer
  2. proprietary traders
    - execute ‘stop loss’ or ‘take profit’ orders.
    - participate in FX intervention activities of the Central Bank.
30
Q

What does corporate desk/dealers do?

A
  • marketing services and maintaining customer relationships.
  • prices quoted to the customers are interbank prices + spread.
  • spread depends on the amount, market volatility, frequency of trade etc
  • handles interest of the bank’s corporate customers — don’t take currency positions — ‘matches’ customer trade — makes profit with no FX price exposure.
31
Q

What are the 3 main types of interbank traders & their characteristics?

A
  1. Jobber/scalper
    - short-term traders who move in and out of the market to reap small profits.
    - cannot expect to make a profit on every deal.
    - performance is judged by the profits generated over a period of time.
  2. Positioner
    - has a longer-term view of the market.
    - does not move quickly in and out of the market
    - ‘positions’ himself with a view — may be an ‘inter-day’ or ‘intra-day’ trader/may or may not be allowed to carry overnight positions.
    - techniques — study markets, look at charts, read news & decide whether to go ‘long or short’ in the market
    - relies on less trading volume, but goes for bigger profit margins.
  3. Structural trader (aka strategic traders)
    - takes long- term or ‘structural’ positions.
    - sizeable position — highly risky — profits/losses can be substantial.
    - done by more experienced traders — Senior Traders, Chief Dealers, Treasury Managers and Treasurers.
    - Due to busy work schedules, don’t ‘sit behind the desk’ to trade — hence take longer term positions
32
Q

What is the difference between interbank & corporate dealers in terms of knowledge of products?

A
  • Corporate dealers are ‘financial specialists’ — need to possess a wider knowledge of products and always have to keep in touch with the latest market products and developments.
  • interbank dealer only specializes in a few treasury products which he regularly trades in.
33
Q

When is open FX positions revalued & what are the objectives & how is it done?

A
  • open FX positions must be revalued at day-end.
  • objective: to determine the overall profit/loss status of all existing forex open positions as compared to prevailing market rates.
  • done by selecting the market rates at a particular time at day-end (eg: market rates at 6pm) & marking these rates against the cost of all the net open positions.
34
Q

Example of day-end FX revaluation

A

Assuming that at day-end, the USD/MYR is 4.2945 – 49.
- the bank will revalue the long 12m USD/MYR position against the market bid rate of 4.2945.
- the position is being revalued using the bid rate because if the trader is to liquidate his long position, he will have to sell at the bid rate.
- Hence, the revaluation profit is RM66k ([4.2945 – 4.2890] × USD12m).
- profit is a ‘revaluation profit’/‘book profit’ — will not be realized until the trader liquidates the position (aka sell off the 12m USD/MYR at 4.2945).

35
Q

What rates are used to reevaluate FX open positions?

A
  1. ‘market rate’ revaluation approach
    - revalue ‘long’ positions against the market bid rates.
    - revalue ‘short’ positions against the market offer rates.
    - more conservative — use the worst rate to revalue.
  2. ‘mid-rate’ approach
    - more popular approach
    - FX positions are revalued using the day-end mid-rates.
36
Q

Why is FX market terminology important?

A
  • communicate specific meanings of standard practices — avoid unnecessary disputes and mistakes
  • Once a FX contract is entered = legally binding
37
Q

What is FX regimes?

A

the way a country manages its currency with respect to foreign currencies & FX market.

38
Q

How are exchange rate systems classified?

A

classified according to the degree to which the rates are controlled by gov, which includes:
1. Fixed
2. Freely floating
3. Managed Float
4. Crawling Peg and Bands

39
Q

Define fixed exchange rate, its benefits & disadvantages.

A
  • rate determined by the central bank — held constant/allowed to fluctuate within very narrow bands.
  • eg: Bretton Woods Era (1944–1971), the Smithsonian Agreement (1971) and HKD originally fixed at 7.80 per USD in 1983.
  • benefits:
    1. provide greater certainty for importers and exporters
    2. allow gov to maintain low inflation — gov can revalue/devalue its currency depending on economic conditions.
  • cons: may be vulnerable to the economic conditions of another country as the exchange rate cannot fluctuate to reflect the underlying economic fundamentals between countries whereby the country may be forced to devalue its currency instead of by choice.
40
Q

Define the floating rate system.

A
  • rates are determined by market forces without gov intervention.
  • most common exchange rate regime.
  • eg: major currencies, Dollar, Euro, Yen, and the Pound
  • Pros:
    • country is more protected from the economic challenges of other countries
    • central bank interventions not required
    • gov not constrained by the need to maintain exchange rates when setting new policies
    • less capital flow restrictions giving rise to an efficient market
  • but companies and traders would need to manage their currency exposure due to exchange rate fluctuations.
41
Q

Define managed float aka dirty float.

A
  • central bank monitors currency & intervenes to influence the exchange rate.
  • still allow market forces to determine its value, but sets a certain band within which they must allow their currency to fluctuate.
  • FX intervention is carried out to keep rates from deviating too far from the target band/value — allows gov to promote economic stability by keeping currency volatility low
42
Q

Define Crawling Peg and Bands and when will it be used

A
  • pegged to foreign currency/band/value — fixed/periodically adjusted
  • Pegged floats can be:
    1. Crawling pegs — central bank specifies the parity value for its currency & permit variation within a specified band.
    2. Crawling bands — rate is allowed to fluctuate in a band around a central value, which is adjusted periodically.
  • gov will announce the new rate, often following economic indicators — ensure country’s export remains competitive.
  • Currency pegs are often used to stabilize a country’s currency which has come under attack or due to an economic crisis.
43
Q

What is dollarisation?

A

Some countries may replace their country currency with another country currency, for example, ‘dollarization’ i.e., where the local currency is replaced with the United States Dollar. Ecuador implemented dollarization in the year 2000.

44
Q

What is the impossible trinity?

A

This trilemma observes that it is impossible for a country to have a fixed foreign exchange rate, free capital movement (without capital controls) and an independent monetary policy.

45
Q

Define the types of dealing modes and their characteristics.

A
  1. Direct dealing
    - dealers use electronic dealing systems to communicate w/ each other, make and record any agreed upon deals.
    - bank/market maker shows a running list of the prices at which it will buy & sell the major currencies + rates are displayed to market on their computer screens (computers are connected via a series of networks, like Thomson Reuters and Bloomberg).
    - prices on the screens are updated regularly but the rates are only indicative.
    - To get a firm/dealing price, must contact the bank directly.
  2. Indirect dealing
    - Brokers act as a go-between
    - trader will key orders into computer terminal, indicating the amount of a currency + price + sell or buy order.
    - If order can be filled from other orders outstanding, deal will be made.
    - Electronic brokering systems are mainly used for small transactions in the spot market for widely traded currency — greater price transparency & dealing efficiency.
46
Q

What are the types of forex transaction?

A
  1. Interbank deals
    - FX transactions between banks done at very competitive market rates and on a ‘clean’ basis — without collateral.
    - Once executed, no cancellations of deals.
  2. Non-interbank deals
    - FX transactions between banks & non-bank institutions/bank’s customers
    - deals done at prevailing market rates/prevailing market rates + spread.
    - deals could be on a ‘clean’ basis/collateralised.
    - Customers can cancel deals for valid reasons, subject to compensation for any forex loss or gain.
47
Q

What are the details required for forex deals?

A

• name of counterparty and centre
• currencies and amount transacted
• exchange rate
• value date
• fund flow instructions
• other relevant details: dealing ticket number, transaction date, time stamp, proper authorization, other special remarks, conditions, etc.

48
Q

Describe the types of FX contracts.

A
  1. Immediate FX Contracts
    - today FX Contracts
    - Spot FX Contracts
    - Tomorrow FX Contracts
  2. Forward FX Contracts
    - Forward Fixed Delivery Contracts
    - Forward Optional Delivery Contracts
    - Forward Multiple Optional Delivery Contracts
  • Forward FX Contracts can be for standard fixed value dates (eg: 1 month, 3 months, 6 months) or odd-dated value dates (eg: 15 days, 28 days, 100 days, etc.).
49
Q

What is spot FX contract?

A
  • purchases/sales of currencies done at an exchange rate established at the time of the deal, but with the payment (delivery) of the currencies taking place two business days (T+2) from the transaction date.

Eg: Today is Monday, 10 July 2017.
- Bank ABC buys USD/MYR3m at 4.2920 for value spot 12 July 2017 from Bank XYZ.

50
Q

What is the market convention for FX transaction?

A

exchange rates for most currencies are quoted for value spot — delivery in two business days (T+2)

51
Q

What is tomorrow FX contracts?

A
  • delivery one business day from the transaction date (T+1)
  • by market convention quoted for value tomorrow — Canadian Dollar.
  • other T+1 currencies: USD/PHP, USD/TRY (Turkish lira) and USD/RUB (Russian Ruble)

Eg: Today is Monday, 10 July 2017.
HSBC Bank sells USD/CAD10,000,000 at 1.2750 for value 11 July 2017 from SCB Bank.

52
Q

What is today FX contracts?

A
  • delivery the same day as the transaction date.
  • normally for urgent foreign currency payments/requirements — cover overdrawn foreign currency account — often face time constraints with tight cut-off time.
53
Q

What is forward FX contract?

A
  • legal and binding agreement — 1 counterparty agrees to deliver a specified amount of 1 currency in exchange for another specified amount of another currency to be delivered at specific future date.
  • exchange rate fixed on the transaction date.
  • quotes from 1 week to 2 to 3 years
  • But normally quoted for 1 month to 1 year.
54
Q

Why are FX contracts beyond 1 year becomes less attractive?

A

market becomes thin/illiquid as transaction volume decreases — quoted prices become unattractive and more costly for the hedger.

55
Q

What are forward FX contracts?

A
  • ‘fixed-dated delivery’ contracts — both counterparties agree on a specific future date to exchange their currency obligations.

Eg: : Today is Monday, 10 July 2017.
Spot date is 12 July 2017.
Citibank buys 2m USD/MYR at 4.2979 for value 14 August 2017 from Maybank (assuming spot is 4.2920 plus 0.0059 one-month swap points).

56
Q

What are the different types of Forward Fixed Delivery dates?

A
  1. Standard forwards
    - have specific delivery dates that coincide with the money market fixed date maturities — 1 month, 2 months and 1 year.
  2. Odd-dated forwards
    - delivery dates that don’t coincide with the money market dates — 1.5 months or 100 days forward contract.
57
Q

What is Forward Optional Delivery FX Contracts (aka ‘outright optional delivery’ contract)?

A
  • ‘fixed-period’ contracts but specific forward value date is not finalised
  • customer given ‘optional’ period to decide on the delivery date (so long as it is a business day and within the optional delivery period).
  • can be from between 1 week to 1/3 months in the future.
  • solve timing and irregular cashflow problems
  • but cannot fully hedge the FX exposure risks.

Eg: Today is Monday, 10 July 2017. Spot date is 12 July 2017.
XYZ Sdn Bhd buys 3m USD/MYR at 4.3035 within the optional delivery period for value 14 August 2017 to 12 September 2017 (assuming spot is 4.2920 plus 0.0115 two months swap points).

58
Q

Why Forward Optional Delivery FX Contracts need Board of Directors’ approval?

A

Given the optionality of such contracts, some banks may classify this type of contract as derivatives product which require new product approval from BOD

59
Q

What is the similarity between forward fixed and an optional delivery contract?

A

both the counterparties must ‘take up’ the full amount contracted and at the rate contracted.

60
Q

Why is Forward multiple optional delivery FX contracts are not practiced in the market?

A

not possible to manage the risks.

61
Q

Bretton Woods Era from 1944–1971 features an adjustably pegged foreign exchange market rate system with exchange rates pegged to gold. The inability of the fixed exchange rate system to cope with those turbulent years finally led to the most fundamental change in the international payment mechanism i.e., the evolution of floating exchange rates.

A

During the 1950s, the United States began running an almost continuous deficit in its balance of payments and this became a cause of considerable official concern and anxiety. At that time, the deficit was averaging USD2.5 billion annually, which led to a depletion of the gold stock and other official reserves of the United States.

currencies would be free to fluctuate against one another, whereby the ‘right’ exchange rates between currencies would be determined by the forces of supply and demand or according to economic fundamentals. In short, there was now a need to manage currency risks.

62
Q

What is Quantitative easing?

A
  • central bank monetary policy in which a central bank purchases securities to lower interest rates & increase the money supply.
  • increases money supply by providing financial institutions with liquidity to promote lending — doesn’t involve the printing of new banknotes.
  • to stimulate a sluggish economy when typical expansionary open market operations have failed.
63
Q

What are the potential of Negative interest rates?

A

It can weaken a nation’s currency — exports become cheaper which may boost exports while imports become more expensive.
- may complement with other central banks’ easing measures such as quantitative easing, in order to tackle persistently below-target inflation.

64
Q

All members of the ACI are to adhere to the The Model Code + rules of local jurisdiction. The Model Code has now been replaced by the FX Global Code in 2017.

What’s the goal of FX global code?

A
  • to ensure the professional conduct in the trading of FX and financial products in the global market.
  • taken as a globally accepted minimum standard.
  • The scope of the Code is wide, includes the OTC FX markets & instruments traded by the banks’ Treasury Division. Some of the areas covered under the Model Code are:
    • business hours
    • personal conduct issues
    • payments and confirmations
    • disputes, differences, and mediations
    • authorization and documentation
    • brokers and brokerage
    • dealing practices
    • general risk management principles
    • dealing with corporate and commercial clients
    • market terminology
65
Q

The Malaysian Ringgit was formerly known as the Malayan Dollar (M$). In the early days, the Malayan Dollar was linked to the Pound Sterling,

A
66
Q

Bank Negara Malaysia (BNM) introduced the Foreign Exchange Notices (FE Notices) which set out transactions that are allowed by BNM which otherwise are prohibited under section 214(2) read together with Schedule 14 of the FSA 2013 as well as section 225(2) read together with Schedule 14 of the IFSA 2013.

A

Forex transactions for non-banks are limited to trade-related transactions and other transactions permitted by BNM. All forex transactions for trade-related transactions or other non-trade related transactions are to be undertaken only with licensed onshore banks (LOB) or approved merchant banks in Malaysia.

Forex dealers are required to abide by the Code of Conduct for Malaysia Wholesale Financial Markets + guidelines issued by BNM. Forex dealers are required to be members of the Financial Markets Association Malaysia (FMAM) and pass the examination for Pasaran Kewangan Malaysia Certificate (PKMC) before they can be confirmed as dealers.

67
Q

What is the main difference between an ‘intra-day’ and an ‘inter-day’ trader?

A

An ‘inter-day’ trader is allowed to carry overnight positions whereas an ‘intra-day’ trader must close-out all open positions at the end of day.

PKMC M3 (7 decks)

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