1.8 Asset Classes- Foreign Exchange Flashcards
Which two types of transaction conducted on the FX market?
There are two types of transaction conducted on the FX market:
- Spot transactions are immediate currency deals that are settled within two working days.
- Forward transactions involve currency deals that are agreed for a future date at a rate of exchange
fixed now.
What is FX?
The foreign exchange (‘forex’ or ‘FX’) market is the collective way of describing all the transactions in which one currency is exchanged for another, anywhere in the world. There is no physical exchange for the currency market in London; it is purely over-the-counter (OTC) and dominated by the banks.
What purpose does the FX market hold?
The users of the FX market fall into two broad camps.
First, FX transactions are driven by international trade. If a Japanese company sells goods to a US customer, they might invoice the transaction in US dollars. These dollars will need to be exchanged for Japanese yen by the Japanese company and this is the FX transaction. The Japanese company may not be expecting to receive the dollars for a month after submission of the invoice. This gives them two choices:
- They can wait until they receive the dollars and then execute a spot transaction.
- They can enter into a forward transaction to sell the dollars for yen in a month’s time. This will provide them with certainty as to the amount of yen they will receive and assist in their budgeting
efforts.
The second reason for FX transactions is speculation. If an investor feels that the US dollar is likely to weaken against the euro, he can buy euros in either the spot or forward market to profit if he is right.
Trading of foreign currencies is always done in pairs. These are currency pairs when one currency is bought and the other is sold, and the prices at which these take place make up the exchange rate. When the exchange rate is being quoted, the name of the currency is abbreviated to a three-character reference; so, for example, sterling is abbreviated to GBP.
What are the most commonly quoted currency pairs?
The most commonly quoted currency pairs are:
• US dollar and Japanese yen (USD/JPY);
• Euro and US dollar (EUR/USD);
• US dollar and Swiss franc (USD/CHF);
• British pound and US dollar (GBP/USD).
When currencies are quoted, the first currency is the base currency and the second is the counter or quote currency. The base currency is always equal to one unit of that currency, in other words, one pound, one dollar or one euro. For example, at the time of writing, the EUR:USD exchange rate is 1:1.3693 which means that €1 is worth $1.3693.
When currency pairs are quoted, a market maker or foreign exchange trader will quote a bid and an ask price. Staying with the example of the EUR/USD, the quote might be 1.3692/94. So if you want to buy e100,000 then you will need to pay the higher of the two prices and deliver $136,940; if you want to sell e100,000 then you get the lower of the two prices and receive $136,920.
Explain the cross rate the foreign currency…
Generally, exchange rates around the world are quoted against the US dollar. A cross rate is any foreign currency rate that does not include the US dollar, eg, GBP/JPY is a cross rate. Obviously a cross rate will be of particular interest to companies doing international business between the constituent countries, eg, a UK company selling goods or services to Japanese consumers, and receiving payment in yen.
Bid-Offer Spread
A typical sterling/dollar spot quote might look something like this:
GBP/USD spot rate 1.8055–1.8145
• Buyer’s rate: £1 buys $1.8055.
• Seller’s rate: $1.8145 buys £1.
The buyer’s rate and seller’s rate refer to buying and selling dollars respectively. The difference between the buyer’s and seller’s rates is generally referred to as the bid-offer spread. It enables the bank offering the deals to make money.
How much will an investor get if the above spot rate is applied? If the investor wants to sell $50,000 for pounds sterling, he will get £27,556. This is based on the seller’s rate of $1.8145:£1.
The forward market is almost exactly the same as the spot market, except that currency deals are agreed for a future date, but at a rate of exchange fixed now. These rates of exchange are not directly quoted. Instead, quotes on the forward market state how much must be added to, or subtracted from, the present spot rate.
pm (notation)
For example, the three month GBP/USD quote might be:
spot $1.8055–$1.8145 three-month forward
1.00–0.97c pm
pm stands for premium. It is used when the dollar is going to be more expensive relative to sterling in the future. It is deducted from the quoted spot rate in order to arrive at the forward rate. £1 will buy fewer dollars in three months’ time and, if you have dollars in three months’ time, the bank will sell you more sterling per dollar than they will now. The premium is quoted in cents, unlike the spot rate, which is quoted in dollars. So 1.00 pm is a premium of 1 cent or 0.01 dollars. And 0.97 pm is a premium of 0.97 cents or 0.0097 dollars.
The three-month forward quote is, therefore: $1.7955–$1.8048.
dis (notation)
Alternatively the three-month forward rate might exhibit a discount, rather than a premium, for example:
spot 1.8055–1.8145 three-month forward
0.79–0.82c dis
dis stands for discount. The discount is used when the dollar is going to be cheaper relative to sterling in the future. It needs to be added to the quoted spot rate to arrive at the forward rate. £1 will buy more dollars in three months’ time and, if you have dollars in three months’ time, the bank will sell you less sterling per dollar than they will now.
The three-month forward quote is therefore:
three-month forward $1.8134–$1.8227
The logic is that the forward rate will always exhibit a wider spread than the spot rate.
Interest Rate Parity
The concept of interest rate parity in determining the exchange rate between currencies arises from one of the cornerstone ideas in financial theory, which is that of rational pricing and the notion of arbitrage.
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be ‘arbitraged away’.
Arbitrage is the practice of taking advantage of a pricing anomaly between securities that are trading in two (or possibly more) markets. One market can be the physical or underlying market; the other can often be a derivative market.
When a mismatch or anomaly can be exploited (ie, after transaction costs, storage costs, transport costs and dividends), the arbitrageur ‘locks in’ a risk-free profit. In general terms, arbitrage ensures that the law of one price will prevail.
Interest rate parity results from recognising a possible arbitrage condition and arbitraging it away.
Consider the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the investment period. Under the assumption of arbitrage, the returns available should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency.
If the returns are different, investors could theoretically arbitrage and make risk-free returns.
Interest rate parity says that the spot and future prices for currency trades incorporate any interest rate differentials between the two currencies.
Interest Parity in Forward Exchange Contracts
A forward exchange contract is an agreement between two parties to either buy or sell foreign currency at a fixed exchange rate for settlement at a future date. The forward exchange rate is the exchange rate set today even though the transaction will not settle until some agreed point in the future, such as in three months’ time.
The relationship between the spot exchange rate and forward exchange rate for two currencies is simply given by the differential between their respective nominal interest rates over the term being considered. The relationship is purely mathematical and has nothing to do with market expectations.
The idea behind this relationship is embodied in the principle of interest rate parity and is expressed as follows:
Forward rate for GBP/USD = £ Spot rate x [( 1+US $ Short-term interest rate) / (1+UK £ Short-term interest rate)]
It is important to realise that the forward rate calculated under the notion of arbitrage and interest rate parity is not a forecast of what the rate of exchange will actually be in three months. The actual rate will vary according to all of the factors which influence exchange rates in the forex market. The three-month forward rate in this example is simply a mathematically derived rate resulting from the interest rate differentials prevailing between the two currencies being exchanged.
Factors Affecting Foreign Exchange (FX) Rates
Historically, exchange rates were fixed as part of the 1944 Bretton Woods agreement and not subject to market forces. Resetting or changing these exchange rates took place, as it did in the UK in the 1960s, by a formal devaluation whereby the rates which had been set in 1944 were modified. The UK government undertook a devaluation of the pound against the dollar from £1= $2.80 to £1= $2.40 in 1968.
The era of fixed exchange rates came to an end during the 1970s, largely as a result of a currency crisis for the USD and the end of the official convertibility of currencies into gold, which was abandoned in August 1971. There have been attempts by governments to reintroduce managed exchange rates but these efforts have essentially failed, and the current regime of freely floating exchange rates is now accepted as the only feasible way for the FX market to function effectively.
There are exceptions to floating currencies; for example, some Middle Eastern countries, such as Saudi Arabia and the UAE, peg their currencies to the US dollar.
Questions regarding the determination of the FX rates by the markets comes down to several related issues concerning the demand and supply for individual currencies, monetary and interest rate policy, issues relating to purchasing power parity, and speculation.
Purchasing power parity (PPP) Theory
In the short term, it appears that the primary factors affecting the manner in which market participants decide on the appropriate exchange rates are those of supply and demand and, to a greater or lesser extent, market sentiment.
Purchasing power parity (PPP) theory concerns the rate to which exchange rates should tend to move over the long term. PPP theory predicts that amounts of different currencies (at current exchange rates) should have equal purchasing power.
PPP has some plausibility over the long term and gives an underlying theme to the FX markets. If one economy consistently has an inflation rate in excess of its competitors, then its currency will deteriorate against its trading partners.
Factors Affecting the Demand for Sterling
• Foreigners need sterling to pay for exports of UK goods to overseas markets.
• Overseas investors want to invest capital in the UK.
• Speculation – if sterling is expected to increase relative to one or more other currencies, speculators
will buy sterling.
• Currency rate management activities of central banks including the BoE.
• Demand will be downward-sloping with respect to price – less demand for exports and less interest
from foreign investors as sterling advances relative to other currencies.
Factors Affecting the Supply of Sterling
• When UK importers purchase foreign currencies to pay for imported goods arriving in the UK they are increasing the supply of sterling into the markets.
• UK residents wishing to invest in overseas assets will have to sell sterling to buy foreign currency.
• Speculation – if sterling is expected to decrease relative to one or more other currencies speculators
will sell sterling.
• The BoE may sell the domestic currency to purchase additional foreign currency reserves in order to
influence the exchange rate as part of macro-economic policy.
• Supply will be upward-sloping with respect to price.
FX Market Volume
The volume of transactions has been estimated by the Bank for International Settlements (BIS) at approximately $4 trillion in nominal amounts traded daily. Just as with derivatives, the nominal amount traded is somewhat misleading since the speculative activity in FX is focused on the amount that is traded at the margin. In other words, if one places an order to sell $1 million to purchase £600,000, but only holds the position for a few hours (minutes), there is a sense in which the nominal amounts are not really exchanged, but, just as in the case of a swap or contract of difference (CFD), it is the marginal difference which is really being traded or at risk.
