7 - Foreign Exchange Markets

Question 1

Purpose and scope of the FXM

Answer 1

• To permit the trade of one currency to another (facilitates international trade and cross-border transfers
• Channeled through the interbank market - wholesale market of major banks, brokers and dealers
• SWIFT: Society for Worldwide Interbank Financial Telecommunications: $4t per day in transactions

Question 2

Functions of the FXM: 1 - Allow participants safe transfer of purchasing power

Answer 2

-Cross-border trade of goods, service and capital, involves parties living in countries with different national currencies. Thus, transfer of PPP is necessary

Question 3

Functions of the FXM: 2 - Providing credit for international transactions

Answer 3

• Movement of goods between countries takes time, inventory in transit must be financed
• FXM provides a source of finance
• Specialised instruments such as banker’s acceptance, and letter of credit are available

Question 4

Functions of the FXM: 3 - Minimising FX risk

Answer 4

-FXM provides hedging facilities for transferring FX risks to someone else more willing to carry risks

Question 5

FXM participants: Bank and non-bank FX dealers

Answer 5

• Operate in both interbank and client markets
• Profit from buying FX currencies at a bid price and reselling at a slightly higher offer price
• They provide credit services in international transactions

Question 6

FXM participants: Individuals and firms

Answer 6

Conduct commercial or investment transactions

• Importer and exporters
• MNCs
• Tourists
• International portfolio investors

Question 7

FXM participants: Central banks and treasuries

Answer 7

• Motive is not to make a profit nor hedge risk
• Driven by a two-fold objective:
  
  • Influence the x rate that will benefit their citizens
  • Acquire or spend their country’s fx reserve

Question 8

FXM participants: FX Brokers

Answer 8

• Do not participate in trading
• Are specialists in matching the suppliers and demanders of foreign currencies
• Charge a small commission

Question 9

FXM participants: Speculators, traders, hedgers and arbitragers

Answer 9

• Profit from simultaneous exchange rate differences in different markets
• Traders and hedgers participate in the forward market to eliminate currency risks
• Speculators seek profit from the changes in exchange rates

Question 10

Spot Transactions

Answer 10

• Involve the exchange of one currency for another at an agreed rate for delivery WITHIN TWO WORKING DAYS after the deal date
• The deal date is the date on which the transaction is concluded
• The value date is the date on which the CFs occur

Question 11

Methods of quoting

Answer 11

• Direct quote in US and England: home currency price per unit of foreign currency
• Direct quote in Europe, Aus and NZ: Foreign currency price per unit of home currency

Question 12

Bid, Offer Spread

Answer 12

• In the interbank market, the spot rate is always quoted as a 2-way price with the buying price or the bid price on the left hand side and the selling (ask) price on the right hand side.
• E.g. spot US$ / A$:
• 0.7580 / 0.7860 or 0.7850 / 60
• (Bid) (offer)

Question 13

Spread

Answer 13

Difference between the bid rate and offer rate

• Less heavily traded currencies with high volatility have higher spread
• Smaller or retail transaction have relatively high spread

Question 14

Percentage Spread Formula (PS)

Answer 14

PS = {(Ask - Bid) / Ask} x 100

Question 15

Forward Transaction

Answer 15

• Requires delivery at a future date of a SPECIFIED AMOUNT of currency for another currency
• The exchange rate is established at the time of contract, but payment and delivery are not required until maturity

Question 16

Example: Forward market hedge

Answer 16

TODAY: Sign a fwd contract with FX dealer to sell 1m pounds; Transaction date three months from now, fwd rate $1.75/pound
-THREE MONTHS: deliver 1m pounds, receive $1.75m

Question 17

Calculation of forward premium/discount

Answer 17

[(F-S)/S] x [360/n]

Question 18

Swap Transaction

Answer 18

The simultaneous purchase and sale of a given amount of foreign currency for two different value dates
-E.g. Dealer buys a currency in the spot market and simultaneously sells it back to the same bank in the forward market. No unexpected foreign exchange risk

Question 19

Currency futures

Answer 19

• Transferable futures contracts that specify the price at which a currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against FX risk
• Just like a forward but standardised

Question 20

Disadvantage of forward and futures contracts

Answer 20

• Although they protect the holder against the risk of adverse movements in exchange rates, they also eliminate the possibility of gaining a windfall profit from favourable movements
• Led some banks to offer currency options

Question 21

Currency options

Answer 21

A contract from a writer (seller) that gives the right (not the obligation) to the holder (buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period

• Calls - give the owner the right to buy the currency
• Puts - give the owner the right to sell the currency

Question 22

Why use currency options?

Answer 22

1. For the firm hedging foreign exchange risk when a future event is uncertain
2. For speculators who profit from favourable exchange rate changes