Lecture 4 - Introduction to the FX Market

Question 1

Impact of exchange rate changes on individual firms depends on the nature of their involvement

Answer 1

Direct Involvement: their purchases/sales, financing and investments

• -> importers/exporters
• -> foreign currency denominated financing, foreign subsidiaries

Indirect Effects: impact on the suppliers, customers and competitors

Question 2

Foreign Exchange Market

Answer 2

• Where the money of one country is exchanged for that of another for…
• -> international trade
• -> foreign direct investment
• -> portfolio investment
• -> store of value
• Participants include:
• -> central banks and treasuries
• -> foreign exchange dealers
• -> retail clients

Question 3

Features of the FX Market

Answer 3

• Largest market in the world
• An OTC market
• Major centers are in London, NY, Frankfurt, Zurich, Paris
• Trades can be executed in seconds, almost a 24 hour market

Question 4

SWIFT

Answer 4

• begin in Europe in 1973 and is jointly owned by over 2,000 member banks, the system links over 10,000 financial institutions
• banks use SWIFT to send and receive messages for FX transactions, payment confirmations, documentation of international trade, transactions in securities, etc.
• -> eg SWIFT is used to confirm FX deals agreed to on the phone between traders, after which the deal can be settled int he settlement systems of the two countries

Question 5

Herstatt

Answer 5

• the risk that one leg of the transaction may not occur because of time zones, market closures,

Question 6

Continuous Linked Settlement

Answer 6

• virtually eliminated settlement risk. Under this system, each trading partner has an account with CLS BANK. CLS Bank acts as intermediary for the transaction. The parties are able to simultaneously make the trade or exchange transaction. The bank creates a 5HR window where all trading settlement process are open for all currencies.

Question 7

International Monetary System

Answer 7

• Currently, major currencies are freely floating but many currencies are not
• the IMS provides…
• -> liquidity to settle transactions
• -> adjustment mechanisms to settle imbalances between the supply and demand of currencies if the BoP is > or < 0
• -> current account and capital account combine to create a surplus or deficit, with increasing or decreasing FX reserves

Question 8

Balance of Payments

Answer 8

• asymmetry in adjustment processes often result in “crises”
• surplus countries have increasing FX reserves
• -> FX reserves are growing so there is not a lot of time pressure
• deficit countries have decreasing FX reserves

Question 9

Hard Peg

Answer 9

Extreme currency regime peg forms such as currency board or dollarization

Question 10

Soft peg

Answer 10

Fixed exchange rates where authorities maintain a set but variable band about some other currency

Question 11

Managed Float

Answer 11

Market forces of supply and demand set the exchange rate, but with occasional government intervention

Question 12

Free Floating

Answer 12

Market forces of supply and demand are allowed to set the exchange rate with no government intervention

Question 13

Emerging Market Currencies

Answer 13

Features:

• weak fiscal, financial and monetary institutions
• tendencies for commerce to allow currency substitution and the denomination of liabilities in dollars
• vulnerability to sudden stoppages of outside capital flows
• consequently, many emerging market countries choose extreme currency regimes that eliminate their own independent monetary policy including
• -> currency board fixes the value of local currency to another currency or currency basket
• -> dollarization replaces the local currency with the U.S. dollar

Question 14

Types of FX Transactions

Answer 14

Spot

Forward

Question 15

Spot

Answer 15

The market for immediate delivery

Question 16

Forward

Answer 16

for future delivery at some specified future date at an XR agreed upon
- e.g., today, agree to buy $1M US in 30 days at one month “forward” rate of 1C$ = .67US$

Question 17

Swap

Answer 17

Trade on both sides of the market for 2 different dates, that is, arrange to swap currencies for a period of time

• -> e.g. buy spot and sell forward 1 month; have the currency for days 0-30
• -> or buy 1 month forward and sell 3 months forward

Question 18

Non-Deliverable Forwards or NDFs

Answer 18

• primarily for emerging market currencies or those subject to significant exchange controls but where there are a lot of international transactions or cross-border capital movements requiring foreign exchange transactions and/or where there are a lot of speculative transactions
• NDFs possess the same characteristics and documentation requirements as traditional forward contract, except that they are settled only in U.S. dollars; the foreign currency being sold forward or bought forward is not delivered
• FX forward contract in a thinly traded or nonconvertible currency against a freely traded currency

Question 19

How do foreign exchange dealers make money?

Answer 19

On the spread between the bid and ask rates:

Bid rate - mid rate - ask rate

Question 20

Why are bid-ask spreads larger in the forward market?

Answer 20

• banks exposed to counterparty default risk for a longer time period
• -> they keep track of these exposures to other banks and may limit transactions with particular banks
• -> at the retail level they may require that the customer maintain a minimum deposit account with them, that they accept a reduction in their normal credit line, or they may require provision of some other form of collateral
• harder for the bank to manage open forward positions, which present a type of inventory risk and they may not be able to found counterparties at reasonable rates to transact with
• less liquid market, less heavily traded especially for longer term contracts

Question 21

Impact of Exchange Rate Changes on Companies

Answer 21

• cash flow impact depends on the nature of the business the firm is in
• -> exporters who invoice in foreign currency terms will receive foreign currency and benefit if it appreciates in value
• -> importers who purchase in foreign currency terms will have to pay foreign currency and benefit if it depreciates in value
• impact depends on whether the company can make adjustments to it’s purchase/sale quantities or pricing that could reduce harm or improve benefits from an exchange rate