Topic 5 - FX Market

Question 1

What is direct and indirect quotes, how do you read them?

Answer 1

Direct quote is local currency, indirect is the foreign currency.

AUD/USD = 1.1839 - local or indirect (point of view of AU resident)

USD/AUD = 0.8446 - foreign or direct (POV of AU resident)

Commodity/term
Or
Base/term

Question 2

Why trade FX?

Answer 2

• For international trade
• for capital movements (offshore borrowing/investing)
• hedging (to protect against unfavourable movements)
• speculation (a peral who enters into the FX market without an existing exposure to risk is speculating - to try and make a profit from movements in currencies buy cheap, sell high)
• Arbitrage - buying and selling an identical commodity, in this case $$, to take advantage of different prices in different markets. Think the apple example, you buy apples in one market for $2 and sell them in another market for $4. Eventually the market will correct itself but meanwhile you take advantage of it.

Question 3

Why borrow overseas?

Answer 3

4 reasons:

• lower interest rates
• availability of funds (Euromarkets are are very large)
• risk management - using overseas funds creates a natural hedge
• establishing a profile ( the more you do it the better credit rating you get and recognition. And exposure to more funds)

Question 4

Who are the main participants in the market?

Answer 4

• Dealers: licensed, must have $10 mill in issued capital, a dealing room, trained dealing staff, risk management and control systems. Will speculate, arbitrage, supply liquidity and service clients.

- corporations: 
Conduct transactions
Hedge
Speculate
Arbitrage

• Brokers:
  Match buyers to sellers
  Provide anonymity
  Provide advice, documentation for a fee.
• Central Banks
  Act as banker for the government
  Intervene in FX market to influence domestic market

Question 5

What is a spot rate?

Answer 5

Currency that is confirmed and settled within two working days.

Question 6

What is a TOD spot rate?

Answer 6

Today contracts
Quote rates are determined on the settlement date of the deal.if you want that currency delivered to you bank account today, it is a today deal. (Depending on time zones)

Question 7

What is a TOM spot rate?

Answer 7

Means settlement takes place tomorrow or next business day.

Question 8

What is a forward rate transaction?

Answer 8

A deal settled 3 or more days in the future.
It is not a spot rate, but is settled by the future time plus the spite rate time.
Ie: if the settlement date is agreed on the 9th April for one month, then delivery date will be one month and 2 days: 11th May.

Question 9

Calculations

Answer 9

Forward and cross rate

See page 45 of topic 3

Question 10

Name the four exchange positions?

Answer 10

1- net exchange position (total currency bought - total sold)

2- long position ( more foreign currency bought than sold)

3- short position (more foreign currency sold than bought)

4- square position ( total bought = total bought)

See blotter pg 49 of topic 3

Question 11

What is a fixed exchanged rate?

Answer 11

Similar to a pegged rate, it is where one currency is fixed to another currency usually attached to a commodity, like gold.

Question 12

What is a pegged exchange rate?

Answer 12

Similar to fixed, may be pegged against a basket of other currencies.

Trade Weighted Basket of currencies (trade weighted index), adjusted on a daily basis bust still set to TWI.

Question 13

Floating exchange rate?

Answer 13

The market determines the exchange rate.

There is a clean and dirty float, clean is purely set by the market And dirty has some government intervention. Ie: australia

Question 14

Explain the factors that determine FX value?

Answer 14

Depends on the supply an demand for AUD.

If inflation is high, then demand for AU products will decrease. Because they will become more expensive. This can be demonstrated on a graph (ER on vertical axis and quantity on horizontal)

This also means there will be. Increased imports because they become cheaper in the domestic market compared to Aussie products.

Question 15

What are the specific factors that affect exchange rates?

Answer 15

• inflation
• purchasing power of parity (the market will correct itself so prices will cost the same over the board.
• economic growth rates
• relative interest rates
• commodity prices
• international speculations and investment
• government and RBA intervention.

Question 16

What is the nature of the FX market?

Answer 16

The exchange of one currency for another.
No physical market place, just need a phone and authority to trade.
Small volumes may be handles at a shop front (travel shops).

Not used to raise funds, to exchange funds and to make profit.

Question 17

What factors determine FX value of a countries currency when it is market determined?

Answer 17

• inflation
• income growth
• interest rates
• market expectations
• Central bank & government intervention

Question 18

What is purchasing power of parity?

Answer 18

PPP is where exchange rates adjust to ensure prices of the same goods are equal in the same country.

Ie: even though prices rose quicker in the US than Australia, PPP meant that an appreciation in the dollar meant that it offset the price rise in the US. They corrected themselves.