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Finance > Lecture 7: The FX market > Flashcards

Lecture 7: The FX market Flashcards

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1
Q

What are the main functions of FX?

A

1) Facility cross- currency payments
2) Reveal the value of currency
3) Allow trades to manage their FX risks

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2
Q

What is an exchange rate?

A

A price of one currency in terms of another

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3
Q

What does the trade weight index (TWI) do?

A

Values the AUD against an index of foreign currencies weighed according to their role in trade

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4
Q

What is the commodity and the terms currency

A 
Commodity (currency being bought and sold) 
Terms currency (what is being bought / sold) i.e. in terms of USD
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5
Q

What does AUD/ USD 0.9595 mean?

A

$1 AU= $0.9595 USD

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6
Q

Is the following an appreciation or depreciation of currency?
AUD/ NZD 1.3890 > AUD/ NSW 1.3990

A

APPRECIATION of currency

AU dollar now buys $1.3990 NZD instead of 1.3890

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7
Q

How are bids and offers quoted?

A

Buying rate (that is, in $ terms)

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8
Q

What does AUD/ NZD 1.1525-30 mean?

A

Means that the dealer is bid (willing to buy) $1AU for $1.1525NZD and offering (willing to sell) $1AU for $1.1530 NZD

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9
Q

What is a spot FX contract?

A

Exchange of currencies in two days based on the agreed spot exchange

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10
Q

What is a forward FX contract?

A

Exchange of currencies at a specified date- that is, anytime after the spot settlement date of T+2

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11
Q

How is the forward rate calculated?

A

Spot rate adjusted for delayed settlement

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12
Q

When will a forward trade at a premium or discount

A 
Premium= When the terms IR is higher: premium 
Discount= When the terms IR is lower: discount
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13
Q

How are forward points calculated?

A

Forward rate- spot rate

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14
Q

When will a forward point discount or premium occur?

A

Forward point premium= Forward is more than the spot rate

Forward point discount= Forward is less than the spot rate

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15
Q

Does the forward rate expose a dealer to fx risk?

A

No- it is based on the INTEREST RATEWS in the two currencies.

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16
Q

How do dealers earn their income in the FX market?

A

Through the spread between their forward bid and offer rates

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17
Q

How do dealers cover their net obligations everyday?

A

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

18
Q

What is an FX swap? What does it comprise of?

A

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
19
Q

What is the cost of an FX swap?

A

Swap points

20
Q

What is FX risk? Does it apply to swaps?

A

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

21
Q

When would someone engage in a buy/ sell swap, or a sell/ buy swap?

A

Buy/ sell swap: When purchasing an investment in a foreign country
Sell/ buy swap: When obtaining a loan in another currency

22
Q

How would a sell/ buy swap when engaging in a foreign loan?

A

Sell/ buy swap:

1) Borrowing money: Sell USD for AUD
2) Paying back money: Sell AUD for USD

23
Q

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

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

24
Q

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

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)

25
Q

What is the COSTS assocaited with an FX forward or FX swap?

A

The forward or swap points- offsets the difference in the interest rate

26
Q

What does this mean when borrowing overseas using an FX forward or swap?

A

The loan interest rate will be the rate of return that is achieved on the loan

27
Q

What are the key features of the Australian FX market?

A

1) Wholesale and OTC
2) Licensed by ASIC to trade in FX
3) Two segments
- Inter-dealer and
- Dealers trading with counter parties

28
Q

What system is used to settle FX transactions? What kind of a market is this

A

Electronic broking systems (order driven market)

29
Q

What are the three main advantages of an electronic booking system?

A

1) Price discovery is more transparent
2) Lower cost and narrower spreads
3) Integrate front and back office functions

30
Q

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

A

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

31
Q

What are the five trends that explain why market turnover has increased?

A

1) Speculation via the ‘carry trade’
2) Offshort borrowing
3) Offshore investing
4) Foreign trade
5) Overseas investments in AUD securities

32
Q

What is the ‘carry trade’ speculation

A

Borrowing where interest rates are low and investing where interest rates are high- differential will lead to a very high return on investments

33
Q

What are the 7 main theories for explaining exchange rate movements?

A

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

34
Q

What does the purchasing power parity theory state?

A

Trade flows will cause adjustments to the FX rate to ensure that all goods cost the same amount in each country

35
Q

What does the expected interest rate parity theory state?

What does this theory state is AUD interest rates rise?

A

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

36
Q

What does the expected interest rate theory state?

A

States that interest rates rising will put an upward pressure on the exchange rate because international investors will move the funds into the currency

37
Q

What does the terms of trade theory state?

A

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

38
Q

What does the speculation and risk theory state?

A

Driven by those who predict currency movements and time currency transactions

39
Q

What does the current account balance theory state?

A

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

40
Q

How does the RBA influence RX rates?

A

RBA trades AUD because it does not believe the market always establishes the currency’s true value- buy and sell AUD

Finance (10 decks)

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