Lecture 7: The FX market Flashcards
What are the main functions of FX?
1) Facility cross- currency payments
2) Reveal the value of currency
3) Allow trades to manage their FX risks
What is an exchange rate?
A price of one currency in terms of another
What does the trade weight index (TWI) do?
Values the AUD against an index of foreign currencies weighed according to their role in trade
What is the commodity and the terms currency
Commodity (currency being bought and sold) Terms currency (what is being bought / sold) i.e. in terms of USD
What does AUD/ USD 0.9595 mean?
$1 AU= $0.9595 USD
Is the following an appreciation or depreciation of currency?
AUD/ NZD 1.3890 > AUD/ NSW 1.3990
APPRECIATION of currency
AU dollar now buys $1.3990 NZD instead of 1.3890
How are bids and offers quoted?
Buying rate (that is, in $ terms)
What does AUD/ NZD 1.1525-30 mean?
Means that the dealer is bid (willing to buy) $1AU for $1.1525NZD and offering (willing to sell) $1AU for $1.1530 NZD
What is a spot FX contract?
Exchange of currencies in two days based on the agreed spot exchange
What is a forward FX contract?
Exchange of currencies at a specified date- that is, anytime after the spot settlement date of T+2
How is the forward rate calculated?
Spot rate adjusted for delayed settlement
When will a forward trade at a premium or discount
Premium= When the terms IR is higher: premium Discount= When the terms IR is lower: discount
How are forward points calculated?
Forward rate- spot rate
When will a forward point discount or premium occur?
Forward point premium= Forward is more than the spot rate
Forward point discount= Forward is less than the spot rate
Does the forward rate expose a dealer to fx risk?
No- it is based on the INTEREST RATEWS in the two currencies.
How do dealers earn their income in the FX market?
Through the spread between their forward bid and offer rates
How do dealers cover their net obligations everyday?
Buy many and sell many forward contracts and thus have to ensure the maturing securities are sufficient to cover their net settlement obligations each day
What is an FX swap? What does it comprise of?
FX swap= combination of two FX contracts (with different settlement days)
- Currencies are exchange at agreed rate (current sport rate)
- Arrangements are made to exchange them back at an agreed forward rate
What is the cost of an FX swap?
Swap points
What is FX risk? Does it apply to swaps?
FX risk is the change of an unexpected adverse movement in the exchange rate. No- as FX swap is a risk- management product- enabling the exchange of currencies for a period of time, without incurring FX risk
When would someone engage in a buy/ sell swap, or a sell/ buy swap?
Buy/ sell swap: When purchasing an investment in a foreign country
Sell/ buy swap: When obtaining a loan in another currency
How would a sell/ buy swap when engaging in a foreign loan?
Sell/ buy swap:
1) Borrowing money: Sell USD for AUD
2) Paying back money: Sell AUD for USD
What are the FX risks faced by:
a) Importers who pay for imports in a foreign currency
b) Exporters who receive exported income in a foreign currency?
a) Risk of the AUD depreciating- having to pay more $1AU= less USD
b) Risk of the AUD appreciating- need more USD to buy $1AU
What are the FX risks faced by:
a) An Australian who has a foreign loan
b) An Australian who invests in a foreign country
a) Risk of AUD depreciating= increases the amount to repaid (need more AUD to repay $1USD)
b) Risk of AUD appreciating (need more $USD to buy $1AUD)
What is the COSTS assocaited with an FX forward or FX swap?
The forward or swap points- offsets the difference in the interest rate
What does this mean when borrowing overseas using an FX forward or swap?
The loan interest rate will be the rate of return that is achieved on the loan
What are the key features of the Australian FX market?
1) Wholesale and OTC
2) Licensed by ASIC to trade in FX
3) Two segments
- Inter-dealer and
- Dealers trading with counter parties
What system is used to settle FX transactions? What kind of a market is this
Electronic broking systems (order driven market)
What are the three main advantages of an electronic booking system?
1) Price discovery is more transparent
2) Lower cost and narrower spreads
3) Integrate front and back office functions
1) Why is the Australian FX market so large?
2) What are the two largest FX markets?
3) What is the key currency that is traded in the Australian FX market
1) So large because of time zones- when US and UK are closed- AU is open
2) UK is largest, US is second largest
3) AUD only accounts for half- other currencies are traded when US and UK markets are closed
What are the five trends that explain why market turnover has increased?
1) Speculation via the ‘carry trade’
2) Offshort borrowing
3) Offshore investing
4) Foreign trade
5) Overseas investments in AUD securities
What is the ‘carry trade’ speculation
Borrowing where interest rates are low and investing where interest rates are high- differential will lead to a very high return on investments
What are the 7 main theories for explaining exchange rate movements?
1) Purchasing power parity
2) Interest rate parity
3) Expected movements in interest rates
4) Terms of trade
5) Speculation
6) Current account baance
7) The RBA
What does the purchasing power parity theory state?
Trade flows will cause adjustments to the FX rate to ensure that all goods cost the same amount in each country
What does the expected interest rate parity theory state?
What does this theory state is AUD interest rates rise?
Spot rate movements will offset the differences between interest rates to equalise effective interest rates
e.g. if AUD interest rates rise= AUD will be expected to fall
What does the expected interest rate theory state?
States that interest rates rising will put an upward pressure on the exchange rate because international investors will move the funds into the currency
What does the terms of trade theory state?
Terms of trade= Export prices/ Import prices
- Theory states: If export prices increase (improvement to terms of trade ratio) then the currency will tend to appreciate
- THINK:
If the value goes up- we earn more– therefore more people want to invest- so naturally the FX rate will increase
What does the speculation and risk theory state?
Driven by those who predict currency movements and time currency transactions
What does the current account balance theory state?
Current account balance= Exports- Imports
If exports are greater than imports (i.e. selling more than spending) AUD will appreciate
If exports are less than imports (i.e. spending more than selling) AUD will depreciate
How does the RBA influence RX rates?
RBA trades AUD because it does not believe the market always establishes the currency’s true value- buy and sell AUD
