Topic 9 Foreign Exchange Markets Flashcards
Exchange Rate
The value of one currency relative to another
Floating Exchange rate
an exchange rate is determined by supply and demand factors in the FX market
Managed Float
an exchange rate is held within a defined band relative to another currency, limited fluctuations allowed
FX markets
markets that facilitate the buying and selling of foreign currencies
FX market participants can be classified as
- FX dealers and brokers
- Central banks
- Firms conducting international trade transactions
- Investors and borrowers in the international capital markets
- Foreign currency speculators
- Arbitrageurs
FX dealers
- institutions that quote buy (bid) and sell (offer) prices and act as pricipals in the FX market
FX dealers
Obtain the best prices in the global FX markets and match FX dealers buy and sell orders for a fee
Two-way Prices
The dealer quotes both a buy (bid) and a sell (offer) price on a currency
Why do Central Banks enter FX markets
- pay for their government’s purchase of imports.
- To change the composition of the central bank’s holdings of foreign currencies
- To influence the floating exchange rate
How can central bank influence floating exchange rate
- To increase the domestic currency value, central bank may buy some of the domestic currency and sell foreign currencies. This would decrease supply of the domestic currency and will eventually increase its value.
- To decrease the value of currency, the central bank can sell the domestic currency and buy foreign currency.
Firms conducting international trade transactions
- Exporters receive foreign currency for the sale of their goods and services.
- Exporters use the FX market to sell foreign currency and buy AUD.
- Importers use the FX market to buy foreign currency (sell AUD) for purchasing imports.
Investors and borrowers in the international capital markets
- Commercial bank foreign borrowings are usually converted into the home currency. Payment of interest and principal need to be made in the denominated currency of the loan.
- Corporations and financial institutions investing overseas
Need to purchase FX in order to make investments;
Dividends or interest payments received from overseas investments will be denominated in a foreign currency.
FX Speculators
Businesses and financial institutions may attempt to anticipate future exchange rate movements to make a profit.
2 speculative transactions positions
Long and Short
Long Position
Occurs when the underlying asset has been bought forward
e.g. a FX dealer buys foreign currency from a client and holds the currency on its own account.
Short Position
Entering into a forward contract to sell an asset that is not held at that time
e.g. a FX dealer sells foreign currency forward in the expectation that the currency will depreciate before the forward contract expires.
Arbitrage Transactions
Profit is made through FX transactions that involve no FX risk exposure
Arbitrageur
A party that simultaneously conducts buy and sell transactions in two or more markets in order to take advantage of price differentials between markets
Types of arbitrage
Geographic
Triangular
Geographic Arbitrage
where two dealers in different locations quote different rates on the same currency
eg: you find ta retailer FX dealer in Burwood offers $1.4 AUD per USD. Another retailer broker in Dandenong offers $1.41 AUD per USD
Triangular Arbitrage
occurs when exchange rates between 3 or more currencies are out of perfect alignment
2 types of FX Market Transactions
Spot and Forward
Spot transactions
Have maturity date two business days after the FX contract is entered into
e.g. used if an Australian importer has an account in USD to pay within the next few days.
Forward transactions
Have maturity date more than two days after FX contract is entered into
e.g. used if Australian importer has to pay a USD liability in 2 months, and covers or hedges against an appreciation of the USD.
Dealers may also provide short-dated transactions if necessary
‘Tod’ value transactions
‘Tom’ value transactions
‘Tod’ value transactions
same-day settlement;
‘Tom’ value transactions
settlement tomorrow
Base Currency
The first named currency in an FX quote
one unit expressed in terms of another currency
Terms Currency
The second named currency in a FX quotes;
used to express the value of the base currency
Two-way quotations
The two numbers indicate the dealer’s buy (bid) and sell (offer) price
EUR/AUD 1.6155 – 1.6165
Bid Price
Price at which dealer will buy base currency
Ask/Offer Price
Price at which dealer will sell the base currency
Spread
the points difference between bid and ask price
There are two ways currencies can be quoted against the USD
- Direct quote—USD is the base currency; i.e. USD 1 = x in FX
- Indirect quote—USD is the terms currency and the other currency is the base currency; i.e. FX 1 = quantity of USD.
Cross Rate
The exchnage rate of 2 currencies, neither being USD
The forward exchange rate
- is the FX bid/offer rates applicable at a specified date beyond the spot value date
- The forward exchange rate varies from the spot rate due to interest rate parity
Interest Rate Parity
principle that exchange rates will adjust to reflect interest rate differentials between countries.
Forward exchange rates are quoted as
forward points, either above or below the spot rate
Forward points
represent the forward exchange rate variation to a spot rate based on interest rate differentials
If the forward points are rising
then add them to the spot rate (i.e. base currency is at a forward premium; interest rate of the base currency is lower)
If the forward points are falling
then subtract them from the spot rate (i.e. base currency is at a forward discount; interest rate of the base currency is higher)
