Week 10: Foreign Exchange

Question 1

What are the main functions of foreign exchange (FX) markets?

Answer 1

The main functions of foreign exchange (FX) markets are:

i. to facilitate cross-currency payments arising from imports, exports and financing flows - FX markets do not arrange loans
ii. to reveal the value of currencies
iii. To allow traders to manage their FX risks

We consider the wholesale FX market
–it is by far the largest financial market when valued by turnover

Question 2

What is an exchange rate?

Answer 2

An exchange rate is the price of one currency in terms of another.

Question 3

Traded weighted index.

Answer 3

The trade-weighted index (TWI) values the AUD against an index of foreign currencies weighted according to their role in trade.

Question 4

Why are FX markets needed?

Answer 4

FX markets are needed because countries like to issue their own currencies but they also like to trade and have financial dealings with other countries.

Question 5

What is a floating exchange rate?

Answer 5

An exchange rate which is set by trading in FX markets rather than being fixed officially.

It results in more short-term volatility but less large periodic adjustments (unlike fixed exchange rates).

Question 6

Importance of exchange rates.

Answer 6

Exchange rates are important prices within an economy – they determine the domestic value of:
–goods & services bought and sold in foreign currencies, and
–the foreign assets and liabilities of local entities

Usually, exporters favour a low exchange rate whereas importers prefer a high exchange rate, though businesses in general prefer a stable exchange rate.

The floating of the currency requires businesses to understand FX risk

Question 7

FX market participants.

Answer 7

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

Question 8

Exchange rate quotes (quotations).

Answer 8

The commodity currency (the currency being bought and sold) is quoted first. It is priced in the terms currency.

Commodity is left and terms is right.

Quotes can be direct and indirect - this depends on where you are, not who you are.

Question 9

What is a direct quote?

Answer 9

Domestic currency per unit of foreign currency

Foreign currency is the commodity (left) currency and domestic currency is the terms (right) currency.

−AUD/USD = 0.9595 is direct quote in New York, USA
−USD/CAD = 1.2510 is direct quote in Vancouver, Canada

Question 10

What is an indirect quote?

Answer 10

Foreign currency per unit of domestic currency.

Domestic currency is the commodity (left) currency and foreign currency is the terms (right) currency.

−AUD/USD = 0.9595 is indirect quote in Sydney, Australia
−USD/CAD = 1.2510 is indirect quote in New York, USA

Question 11

Interpreting exchange rates.

Answer 11

An appreciation of the commodity currency is shown by an increase in its value, eg.:

AUD/NZD1.3890 → AUD/NZD1.3990
–an appreciation of the AUD against the NZD

–this is equivalent to a depreciation of the NZD:
NZD/AUD 0.7199 → NZD/AUD 0.7148

Question 12

Bid-offer quotes and mid-point rates.

Answer 12

FX dealers quote bids (their buying rate) and offers (their selling rate).

Suppose a dealer quotes AUD/NZD 1.1525-30
(There is a bid of 1.1525 and an offer of 1.1530).

If the counterparty decides to buy AUD10million they will pay
AUD10,000,000 x 1.1530 = NZD11,530,000

A mid-point is half-way between the bid and offer rates.

Question 13

Cross-rates.

Answer 13

The term ‘cross rates’ traditionally referred to non-USD exchange rates, such as AUD/JPY but can also mean non-euro rates, or non-AUD rates (as published in the AFR)

They can be calculated from the related exchange rates:
Eg. Find SGP/GBP given USD/GBP = 0.5873 and SGP/USD = 0.8004

SGP/GBP = SGD/USD x USD/GBP (USDs cancel each other out)
= 0.8004 x 0.5873 = 0.4701

Question 14

FX contracts.

Answer 14

FX contracts are contracts to exchange an agreed amount of one currency for an agreed amount of another.
–but we distinguish between contracts according to their settlement date.

Types include spot and forward contracts.

Question 15

Spot FX contracts.

Answer 15

•Spot contracts are for the exchange of currencies in two days (T+2) based on the agreed spot exchange rate

Monday - Deal is made to sell AUD10m at AUD/USD0.9548
Wednesday - The seller supplies AUD10m and receives USD9.548m

• Settlement is complicated when each leg occurs in a different time zone
• Dealers store FX reserves in low risk securities

Question 16

Forward FX contracts.

Answer 16

Forward contracts are the exchange of currencies at a future specified date – that is, anytime after the spot settlement date of T+ 2.

•Most are arranged on a monthly basis with settlement on the monthly anniversary of the spot settlement date
•Dealers will try to match the amounts of FX bought and sold for each future date
–any net requirements are covered by holding securities in those currencies that mature on the future settlement date

Question 17

Time zone effects.

Answer 17

Trading in FX occurs 24 hours but in different time zones.

This has increased the trading in our time zone:
. The Australian FX market is among the ten most active markets, along with Singapore and Hong Kong
. These markets operate when London and the US markets have closed

Question 18

Explaining exchange rate movements.

Answer 18

Exchange rates move randomly and their movements are difficult to predict.

The main explanations or influences are:
. The RBA
. Current account balance 
. Speculation
. Terms of trade
. Expected movements in interest rates
. Interest rate parity (IRP)
. Purchasing power parity (PPP)

Question 19

Purchasing Power Parity.

Answer 19

A long-run theory that assumes trade flows will force adjustments to exchange rates so that comparable goods will cost the same in each country.

The relative purchasing power of two currencies depends on their relative inflation rates, e.g.:
if inflation is 10% in Australia, and 0% in the US, PPP would predict a depreciation in the AUD
⬆️AUD prices x ⬇️AUD/USD = USD prices

However PPP has not held for many years

Question 20

Expected Interest Rate Parity (EIRP).

Answer 20

The expectation that spot rate movements will offset differences between interest rates to equalise effective interest rates.

A currency with a low interest rate will be expected to depreciate, and vice versa, eg.:
rJPY + expected change in JPY/AUD = rAUD

EIRP explains why interest rate differences can be sustained and is consistent with PPP and the international Fisher effect
–but it is not a good predictor of FX movements

Question 21

Expected interest rates.

Answer 21

An alternative (to EIRP) interpretation of the interest/exchange rate relationship is:

The expectation that interest rates will increase puts upward pressure on the exchange rate because international investors will move funds into the currency.

There have been periods when the AUD has strengthened against currencies from countries with lower interest rates.

Question 22

Terms of trade.

Answer 22

A country’s terms of trade are the ratio of its export prices relative to its import prices.

If a country experiences a relative increase in export prices (an improvement in their terms of trade), the currency will tend to appreciate (and vice versa).

This explanation is particularly relevant for countries where exports differ from imports, as in Australia, because most exports are commodities but manufactured goods and services are the main imports.

The relationship between the value of the AUD and commodity prices has been quite close.

Question 23

Speculation and risk.

Answer 23

The AUD is traded by speculators:
i.because it is not closely correlated with other major currencies and so provides some diversification benefits, or
ii.who try to predict currency movements and time currency transactions
–this includes the carry trade, and
–the view that the AUD is responsive to sentiment, as evidenced during the GFC

Question 24

Current account balance.

Answer 24

Value of exports including financial transfers - value of imports including financial transfers = current account balance.
•Countries with an accumulated current account deficit have to service that debt
–if traders become concerned about the capacity of a country to service it liabilities this can trigger selling of that currency
•Not an important influence on the AUD

Question 25

The RBA.

Answer 25

The RBA trades AUD because it does not believe the market always establishes the currency’s true value.

They ‘focus on episodes where the exchange rate has clearly overshot’ - mostly to counter balance cyclical movements in the AUD
. that is, large but infrequent intervention achieved by trading USD/AUD
. they buy AUD (sell USD) when they believe the AUD is undervalued and sell AUD (buy USD) when they believe it is overvalued

Question 26

Can we forecast the Australian dollar?

Answer 26

•Dealers may attempt to forecast intra-day price movements based on order flows and the market’s reaction to news
–they don’t attempt longer term forecasts

• Economists who attempt forecasts over longer periods generally perform poorly
• Movements in the exchange rate are sufficiently random and volatile to pose considerable risk and provides motivation to hedge future transactions