L4 Foreign Exchange Market and Derivatives Flashcards
whats the Foreign Exchange Market (FOREX)
The Forex market is crucial for global economy by facilitating currency conversion, determining exchange rates, and providing risk management solutions. It facilitates international trade, investment, and tourism, and sets exchange rates, affecting costs and returns. The market offers contracts and financial instruments to manage foreign exchange exposure, ensuring stability and predictability, allowing businesses to focus on core activities.
what are its Market Characteristics
The Foreign Exchange Market is the largest and most dynamic financial market globally, characterized by its immense liquidity and speculative nature. It operates 24/7, across different time zones, and is facilitated by a network of computer and telephone connections. London is the primary trading hub, accounting for 41% of global Forex transactions. The U.S. dollar dominates, representing 87% of all trades, with the euro coming in second. Transactions can be executed for immediate or specified future delivery.
The FX Market: what are its Participants
The Foreign Exchange (FX) Market is a diverse sector with various participants. Companies and individuals exchange currencies for international trade, capital market participants for diversification, hedgers to mitigate exchange rate risk, speculators for profit, and central banks for monetary policy and stability. These participants contribute to market liquidity and price discovery, while also managing monetary policy objectives and influencing exchange rates. Their diverse roles contribute to the market’s vibrancy and depth.
The FX Market: Types of products
In the FX Market, various products cater to diverse trading needs:
- Spot Market: Involves the immediate exchange of currencies at prevailing market rates, facilitating instant transactions for immediate delivery.
- Forward Contracts: Agreements made for future currency exchange at prearranged rates, providing participants with a means to hedge against future exchange rate fluctuations.
- FX Swaps: Combining elements of spot and forward contracts, FX swaps enable the rolling over of positions in forward contracts by simultaneously executing a spot transaction and a forward contract.
- FX Options: Offer the right, but not the obligation, to enter into an FX contract at a specified exchange rate in the future, providing flexibility for participants to hedge against or speculate on future exchange rate movements.
Base and Quote Currency
All foreign currencies are assigned an International Standards Organization (ISO) abbreviation.
e.g., USD; JPY; GBP; EUR; AUD; HKD; CNY; SGD
A foreign exchange quote is the ratio of one currency to another with two ISO designations (e.g., EUR/USD or USD/JPY):
The first ISO currency is called the base currency.
The second ISO currency is called the quote currency.
A foreign exchange quote: one unit of the base currency worth how much quote currency
USD/JPY of 110.71 means USD 1= JPY 110.71
The FX Market Currency Quotations
In the FX Market, currency quotations can be categorized into direct and indirect quotes, depending on the perspective:
- Direct Currency Quote: In a direct quote, the domestic currency is the base currency, and the foreign currency is the quote currency. For example, BRL/USD=0.3134 means that one unit of the domestic currency (Brazilian real - BRL) is equivalent to 0.3134 units of the foreign currency (US dollar - USD).
- Indirect Currency Quote: Conversely, an indirect quote has the domestic currency as the quote currency and the foreign currency as the base currency. For instance, USD/BRL=3.1915 means that one unit of the foreign currency (US dollar - USD) is equal to 3.1915 units of the domestic currency (Brazilian real - BRL).
These quotes provide essential information for traders and investors, offering insights into the relative value of currencies from different perspectives.
The FX Market Currency Quotations continued
In American Currency Quotations, the exchange rate is presented as the number of U.S. dollars required to obtain one unit of foreign currency. For example, 1.4 USD/GBP signifies that 1.4 U.S. dollars are needed to purchase one British pound.
Conversely, European Currency Quotations depict the exchange rate as the number of foreign currency units needed to acquire one U.S. dollar. For instance, 106 Yen/USD indicates that 106 Japanese yen are necessary to buy one U.S. dollar.
While most currencies globally adhere to European terms for quotations, exceptions exist, notably with the British pound, Euro, and Australian dollar. However, newspapers, such as the Wall Street Journal, often provide both American and European currency quotations for broader accessibility and clarity.
what are Changes in the Exchange Rates
Changes in exchange rates are crucial indicators of currency strength or weakness:
- Appreciation (or strengthening) of a currency occurs when the currency’s spot rate increases in value against another currency. For instance, if the pounds per dollar exchange rate rises from £0.77/$1 to £0.80/$1, it means that more pounds are required to obtain one dollar. In this scenario, the pound has depreciated in value relative to the dollar, while the dollar has appreciated.
- Depreciation (or weakening) of a currency happens when the currency’s spot rate decreases in value against another currency. Conversely, if the pounds per dollar exchange rate falls from £0.80/$1 to £0.77/$1, fewer pounds are needed to acquire one dollar. Here, the pound has appreciated against the dollar, while the dollar has depreciated.
These fluctuations in exchange rates have significant implications for international trade, investment, and overall economic performance.
what are Nominal and real exchange rates
Indeed, quoted exchange rates represent nominal exchange rates, reflecting the relative value of currencies without accounting for price level differences between countries.
On the other hand, real exchange rates provide a more accurate measure by adjusting nominal exchange rates for price level differentials between countries. They reflect the actual purchasing power of currencies in international trade. The formula to calculate the real exchange rate (𝑆𝑟) is:
𝑆𝑟 = 𝑆𝐼 × (𝑃𝐼 / 𝑃𝐼*)
Here, 𝑆𝐼 represents the nominal exchange rate, 𝑃𝐼 denotes the domestic price level, and 𝑃𝐼* signifies the foreign price level. By factoring in price levels, the real exchange rate offers insights into the relative competitiveness of goods and services between countries. It helps assess whether a currency is overvalued or undervalued in terms of its purchasing power parity.
The real exchange rate index is constructed by multiplying the nominal $/£ index by the UK price index and dividing the result by the US price index.
what are Forward Rate Quotes
Forward exchange rates are set at a premium or discount of their spot rates.
If a currency’s forward rate is higher (lower) in value than its spot rate, the currency being quoted at a forward premium (discount).
Forward discount/premium=(𝐹−𝑆)/𝑆×100
The one-year dollar interest rate is 5%, sterling interest rate is 8%, and spot exchange rate GPB/USD1.60.
The one year forward exchange rate of the pound, F:
Covered interest parity: 𝐹=(0.05−0.08)*1.60/(1+0.08)=$1.5555/£1,
(𝐹−𝑆)/𝑆=(1.5555−1.60)/1.60×100=−2.78 -> an annual forward discount of 2.78%.
If the domestic interest rate is higher than the foreign interest rate, then the domestic currency will be as a forward discount by an equivalent percentage.
Forward Exchange Rate Market Participants
In the forward exchange rate market, various participants play distinct roles based on their objectives and strategies:
- Hedgers: Typically firms, hedgers utilize the forward exchange market to mitigate exchange rate risk. By entering into forward contracts, they aim to protect themselves against adverse movements in exchange rates that could impact their financial performance or cash flows. Hedgers seek to stabilize their future cash flows by locking in a predetermined exchange rate through forward contracts.
- Arbitrageurs: Mainly banks or financial institutions, arbitrageurs capitalize on discrepancies in interest rate differentials and forward exchange rates to generate riskless profits. They exploit market inefficiencies by simultaneously buying and selling currencies at favorable rates, taking advantage of any deviations from theoretical parity conditions such as covered interest rate parity.
- Speculators: Speculators engage in the forward exchange market with the primary objective of making profits from anticipated changes in exchange rates. They accept exchange rate risk with the expectation that future spot rates will deviate from the quoted forward rates. Speculators rely on their analysis of market trends, economic indicators, and geopolitical events to make informed trading decisions, aiming to profit from price movements in the foreign exchange market.
Making the Market in FX
In the Foreign Exchange Market, the market maker function of global banks encompasses two essential activities, contributing to market transparency and liquidity:
- Providing Ongoing Quotes: Market makers continuously offer two-way quotes upon request, indicating both the buying and selling prices for various currency pairs. By providing transparent and continuous pricing, market makers ensure that participants have access to real-time information about exchange rates. This transparency enables market participants to make informed decisions and facilitates efficient price discovery in the market.
- Executing Trades at Quoted Prices: Market makers not only quote prices but also stand ready to buy or sell currencies at the prices they provide. This commitment to executing trades at the quoted prices, known as firm prices, adds liquidity to the market. Market participants can confidently transact with market makers, knowing that there is a reliable source willing to fulfill their orders promptly. This liquidity ensures that transactions can be executed smoothly and at competitive prices, enhancing overall market efficiency.
By performing these crucial functions, market makers play a vital role in maintaining the integrity and efficiency of the Foreign Exchange Market, fostering transparency and liquidity for all participants.
Derivative markets for hedging
Derivative markets serve as essential tools for hedging, allowing entities to protect themselves against potential losses arising from market movements in various variables such as exchange rates and interest rates. Here’s how hedging works in practice:
- Firms: Companies often use derivative instruments to hedge against the risk of adverse movements in exchange rates. For example, a multinational firm may hedge its exposure to foreign currencies to protect the value of its future income. By establishing offsetting currency positions, the firm locks in a specific dollar value for its currency exposure, thus mitigating the risk posed by currency fluctuations.
- Dealers: Dealers in the financial markets also utilize hedging strategies to manage risks arising from speculation. If a dealer has taken on a speculative position in a particular asset, they may hedge that position to protect against potential losses. Hedging allows dealers to limit their exposure to market fluctuations and stabilize their overall portfolio.
It’s important to note that while hedging can be effective in reducing risk, it may not necessarily enhance wealth in all circumstances. In perfect capital markets or under certain parity conditions, the benefits of hedging may be limited or non-existent. However, in real-world scenarios where market imperfections exist and uncertainties prevail, hedging can play a crucial role in safeguarding against adverse market movements and preserving financial stability.
Arguments in favour of Hedging
There are several compelling arguments in favor of hedging for companies:
- Focus on Core Business: Companies can better focus on their primary operations and core competencies when they hedge against risks such as interest rate and exchange rate fluctuations. By delegating risk management to financial experts, firms can allocate resources more efficiently and devote greater attention to their main business activities.
- Limited Predictive Skills: Companies often lack the expertise or resources to accurately predict variables like interest rates and exchange rates. Hedging allows them to mitigate the uncertainties associated with these factors and avoid potential financial losses resulting from adverse market movements.
- Avoidance of Unpleasant Surprises: Hedging helps companies avoid unexpected and unfavorable events such as sudden increases in interest rates or adverse movements in exchange rates. By locking in favorable rates through hedging, firms can shield themselves from potentially harmful financial shocks.
- Tax Liability Reduction: Hedging activities can lead to a reduction in corporate tax liabilities, particularly when hedging through money market instruments. By optimizing their hedging strategies, companies can minimize tax burdens and enhance their overall financial performance.
- Lower Probability of Financial Distress: Effective hedging reduces the likelihood of a company encountering financial distress by stabilizing cash flows and mitigating the impact of market volatility. This, in turn, lowers the expected costs associated with financial distress, such as bankruptcy or restructuring expenses.
- Risk Reduction for Stakeholders: Hedging not only protects the firm’s financial health but also reduces the risk exposure for various stakeholders, including managers, employees, suppliers, and customers. By minimizing the impact of market uncertainties, hedging contributes to greater stability and resilience across the entire business ecosystem.
Arguments against Hedging
There are several arguments against hedging that are commonly cited:
- Incomplete Risk Coverage: In practice, many risks are left un-hedged because it can be challenging for companies to identify and effectively hedge against all potential risks. Factors such as transaction costs, imperfect market information, and uncertainty regarding future market conditions can complicate hedging decisions.
- Limited Impact on Shareholder Value: Some modern theories of finance argue that firms cannot significantly improve shareholder value through financial manipulations like hedging. Investors may prefer to manage corporate exchange exposure themselves rather than relying on the company’s hedging strategies.
- Competitive Disadvantage: Hedging may increase risk for a company if its competitors do not engage in similar hedging activities. This could lead to a competitive disadvantage for the hedging firm, as it may incur higher costs or miss out on potential gains compared to competitors.
- Profit Margin Fluctuations: Hedging can cause fluctuations in a firm’s profit margin, particularly if hedging practices deviate from industry norms. If the industry standard is not to hedge, a company’s hedging activities may lead to unpredictable changes in profit margins, affecting investor perceptions and market competitiveness.
- Potential for Worse Outcome: Despite its intended risk mitigation benefits, hedging can sometimes lead to a worse outcome for a company. For example, if the company experiences a loss on the hedge while simultaneously gaining on the underlying asset, explaining this situation to stakeholders can be challenging and may undermine confidence in the company’s risk management practices.
- Lack of Understanding: Hedging strategies can be complex and difficult to understand, especially for stakeholders who are not familiar with financial markets and instruments. This lack of understanding can create skepticism or resistance towards hedging initiatives, further complicating their implementation.
