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EFB201 Financial Markets > Foreign Exchange Markets > Flashcards

Foreign Exchange Markets Flashcards

1
Q

What are financial institutions?

A

Major borrowers in the international markets, indicating that banks prefer to raise funds using debt markets rather than rely on their deposit base

This is known as liability management. The average cost of borrowing from overseas is slightly less than borrowing in the domestic market

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2
Q

What contributed to the growth in international debt markets?

A

Deregulation of financial systems and the process of globalisation has encouraged growth in international debt markets and increased their importance as a source of funds

The progressive removal of official controls on foreign borrowing and floating of many foreign exchange rates over the late 1970s and 1980s also contributed

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3
Q

Why are investors and borrowers attracted to international debt markets?

A

They are deeper and more liquid than domestic markets

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4
Q

Who can access international debt markets?

A

Under normal market conditioners, borrowers with a strong reputation and very good credit ratings, accessed from most major financial centres

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5
Q

What are foreign exchange markets?

A
  • Trade 24/7

Exist wherever financial transactions are conducted in foreign currencies:

  • Financial flows associated with international trade in goods and services
  • Capital flows involving investment and borrowing of funds
  • Speculative transactions to profit from changing exchange rates
  • Central bank intervention within the FX markets
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6
Q

What is the exchange rat regime?

A

An exchange rate is the value of one country relative to another currency

Major currencies: USD, GBP, Yen, AUD (all adopt a floating exchange rate regime or a free float)

A floating exchange rate regime exists when the exchange rate for the currency of a country is allowed to move as factors of supply and demand change

Under this regime a central bank would only buy and sell the local currency to prevent a significant appreciation or depreciation away from its true value

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7
Q

What is managed float?

A

Under managed float the exchange rate is allowed to move within a define range, or band, relative to a major currency (USD) or a group of currencies

Exchange rate movements are allowed as long as they do not adversely affect the country’s economic objectives

Countries that use this: Singapore, Malaysia and Indonesia

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8
Q

What is pegged exchange rate?

A

Under a pegged exchange regime the value of a currency is fixed to the value of another currency or basket of currencies. Hong Kong uses a pegged exchange rate.

Stronger economies are more likely to have a floating exchange rate regime

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9
Q

What is a crawling peg exchange rate?

A

A crawling peg exchange rate regime is where an exchange rate is allowed to change in controlled steps. China uses a crawling peg.

It is generally accepted that crawling pegs are used on undervalued currencies.

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10
Q

Who are the 5 participants in the FX?

A
  1. Foreign exchange dealers and brokers
  2. Central banks
  3. Firms conducting international trade transactions
  4. Investors and borrowers in the international money markets and capital markets
  5. Foreign currency speculators
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11
Q

Who are foreign exchange dealers and brokers?

A
  • Must be authorised to deal
  • They are price makers and so quote both their buy and sell prices (two-way price). They profit from the difference between the two
  • An FX broker provides the service of seeking the best exchange rate from dealers for a client, in return for a fee
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12
Q

Who are central banks?

A
  • Central banks trade in FX markets for several reasons:
    > To obtain foreign currencies to pay for imports purchased by the government or make interest and face value payments on overseas borrowings by the government
    > To change the composition of the central bank’s holdings of foreign currencies
    > To slow down a rapid appreciation or depreciation of the exchange rate
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13
Q

Who are firms conducting international trade transactions?

A
  • Trading in FX markets is undertaken by exporters who receive foreign currency income and importers who must make foreign currency payments
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14
Q

Who are investors and borrowers in the international money markets and capital markets?

A
  • Investors, such as fund managers, need to purchase foreign currencies to invest overseas
  • Financial institutions, corporations and governments with good credit ratings can borrow in the international money and capital markets. A large portion of the borrowed funds will be converted to the home currency of the borrower
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15
Q

Who are foreign currency speculators?

A
  • Most of the volume of currency that moves through FX markets is for speculative FX transactions
  • Speculative transactions are undertaken to make a profit from exchange rate movements
  • The large volume of speculative transactions indicates that speculators are able to change the price of a currency, although the transactions are accompanied by a high level of risk
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16
Q

What are the operations of the FX markets?

A

Typically, at any point in time the price of each currency will be identical regardless of geographical location of the FX

Otherwise, arbitrage profits could be made

The larger the FX dealers, including commercial and investment banks, have an FX dealing room as part of their treasury operations

17
Q

What are the most common transactions in the FX markets?

A
  1. Spot transactions where delivery of the currency is made two business days after the transaction occurs. The convention of two business days is a carryover from when there were less sophisticated communication and settlement systems between FX trading centres.
  2. Forward transactions where delivery of the currency is mad emore than two business days after the transaction occurs.

Dealers also undertake transactions that have same-day settlement (known as today or tod value transactions) or settlement tomorrow (known as tomorrow or tom value transactions)
The convention in the ordering of the two currencies in a quote is that the first currency mentioned is the one whose price is being sought.
This currency is called the base currency or unit of the quotation since it is the price of one unit of the currency being quote
The second currency is called the terms currency as it expresses the value of the base currency/
e.g. USD/EUR means the price of one USD in terms of EUR
e.g. EUR/AUD 1.6755-1.6765
The buy price is referred to as the bid price and sell price is referred to as the offer or ask price
The spread is the difference between the dealer’s bid and offer quotes

18
Q

Quotes

A

A direct quote is where the USD is the unit of quotation (base currency)
An indirect quote is where the USD is the terms currency

19
Q

How to calculate cross-rate

A
  1. Place the currency that is to become the base currency first.
  2. Calculate the bid rate by dividing the base currency offer into the terms currency bid
  3. Calculate the offer rate by dividing the base currency bid into the terms currency offer

EUR/JPY using the following direct FX quotations:
USD/EUR 0.6450-0.6555
USD/JPY 107.40-107.50

Bid EUR/JPY 107.40/0.6455=166.38
Offer EUR/JPY 107.50/0.6450=166.67

20
Q

What are forward market quotations?

A

The quotation of prices in the forward market is different from the practice in the spot market

The market convention is to quote the spot exchange rate and forward points for the forward exchange rate

The forward exchange rate can be obtained by adding or subtracting the points to or from the spot quote

The points are added when the base currency is at a forward premium and deducted when it is at a forward discount

A forward discount is when the forward exchange rate is less than the spot rate. A forward premium is when the forward exchange rate is higher than the spot rate.

21
Q

What are the factors affecting exchange rates?

A
  1. Relative inflation rates
  2. Relative national income growth rates
  3. Relative interest rates
  4. Exchange rate expectations
  5. Central bank of government intervention
22
Q

What are relative inflation rates?

A
  • The purchasing parity theory argues that any national currency should have equal purchasing power in its own country, or in any foreign country once the currency is exchanged into the foreign currency at the prevailing exchange rate
  • So if inflation increases in the US relative to Australia, US demand for the relatively cheaper Australian goods and services will increase
  • This will increase the demand for the AUD and lead to an appreciation of the AUD
23
Q

What are relative national income growth rates?

A
  • If there is a change in the relative national income growth rates, exchange rates will be affected due to changes in the demand for imports and exports
  • For example, assume there is a substantial increase in the rate of national income growth in Australia relative to the US
  • Australia’s demand for US imports will increase, which will increase the supply of AUD and lead to a depreciation in the AUD
24
Q

What are the relative interest rates?

A
  • A relative increase in foreign interest rates, or a relative reduction in local interest rates, would result in a depreciation of the local currency. Similarly, a relative reduction in foreign interest rates, or relative increase in local rates, would result in an appreciation of the local currency
  • So if US interest rates increase relative to Australian interest rates, Australian investors and corporations would prefer to keep their surplus funds in US investments. This would see an increase in the supply of AUD and lead to a depreciation in the AUD
25
Q

What are exchange rate expectations?

A
  • Expectations of how an exchange rate will move can influence where investors place their funds as well as speculative trading
  • For example if the AUD is expected to depreciate then investors might move their funds offshore and speculators might sell AUD to profit from the depreciation
  • These actions will increase the supply of the AUD and cause the AUD to actually depreciate
26
Q

What are central bank of government intervention?

A
  • Any government policy that alters the relative rate of inflation, relative income, or relative interest rates will have an impact on the exchange rate. Any expectation by the market that government policy will change in the near future will also affect the value of the currency
  • A government or central bank may also seek to influence the currency by intervening:
    > In international trade flows (tariff, quota, embargos)
    > In foreign investment flows (prohibitions on capital flows)
    > Directly in FX markets (FX smoothing to stabilise the market)
27
Q

What are the euromarkets?

A

A global financial market where financial instruments are written in a currency other than the currency of the country in which the instrument is issued

Domestic bonds are issued in a country by a local borrower and denominated in the currency of that country

Foreign bonds are issued in a country by a foreign borrower and denominated in the currency of that country

Eurobonds are issues in a country by a local or foreign borrower and denominated in a foreign currency

28
Q

What are the categories of euromarkets?

A
  1. Eurocurrency markets
  2. Euronote markets
  3. Eurobond markets
29
Q

What are eurocurrency markets?

A

Intermediated bank finance, such as eurocurrency deposits and eurocurrency loans, is available in these markets. For example, a USD deposit account with a bank in the UK is a eurocurrency deposit

30
Q

What are euronote markets?

A

Short-term direct finance, such as euronote issuance facilities and eurocommercial paper, is available in these markets

31
Q

What are eurobond markets?

A

Medium-to-long term direct finance, such as eurobonds and euro floating rate not, is available in these markets

32
Q

What is the fundamental reason for the ongoing growth of euromarkets?

A

Interest rates on investments in these markets are generally higher than interest rates offered on domestic investments. At the same time, interest rates charged on euromarket loans are generally less than interest rates on domestic notes

This is because the costs of undertaking business in euromarkets is lower as euromarkets only deal in wholesale transactions, which are exposed to foreign exchange risk

This risk exposure can be reduced by implementing certain trading strategies or creating natural hedges where foreign currency cash inflows and outflows are matched

33
Q

What is the international parity relationship equation?

A

1+If/1+Id=F/S=E(S)/S=1+INFf/1+INFd

If=foreign interest rate
Id=domestic interest rate
F=forward exchange rate
S=spot exchange rate
E(S)=expected future spot rate
INFf=foreign inflation rate
INFd-domestic inflation rate
Components:
1. Interest Rate Parity
1+If/1+Id=F/S
2. Uncovered Interest Rate Parity
1+If/1+Id=E(S)/S
3. Unbiased Forward Rates
F/S=E(S)/S
4. Purchasing Power Parity
E(S)/S=1+INFf/1+INFd
34
Q

EXAMPLE: International Parity Relationship

A 
1. Interest Rate Parity
AUD=0.90USD
iAU=5.7%
iUS=4.8%
What is the one year forward rate?
F=0.90*1.048/1.057=0.8923 USD
AUD is at a forward discount
  1. Uncovered Interest Rate Parity
    AUD=0.35GBP
    iA=5.7%
    iGB=7.2%
    What is the spot rate expected in one quarter?
    E(S)=0.35*(1.072^0.25)/(1.057^0.25)=0.3512GBP
    AUD is expected to appreciate
  2. Unbiased Forward Rates
    The expected future spot rate will be equal to the forward rate
4. Purchasing Power Parity
AUD=80Yen
infA=3%pa
infJ=5%pa
What is the spot rate expected in one year?
E(S)=80*1.05/1.03=81.55Yen
AUD is expected to appreciate

EFB201 Financial Markets (4 decks)

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