Week 4 - Foreign Exchange Market Flashcards
what is the foreign exchange market ?
The foreign exchange market is where various national currencies are bought and sold.
what is this called USD/JPY = 133.83?
USD/JPY = 133.83
This is a currency pair quote. The currency on the left is the base currency, while the currency on the right is called the quote or counter currency.
Base currency (USD) is always equal to one unit (in this case, 1$)
what are the two main types of Currency Markets?
1) Spot Market (transaction) includes the immediate transactions
The delivery of the underlying currencies usually occurs within two working days.
Settlement takes place in two separate countries, even though the deal may be done in a third country.
If trade is with a London bank, the funds are not transferred to London but to the accounts of the two parties in the settlement countries.
2) Forward Market includes forward transactions that involve exchanges at some future date, completed at the forward rate
It is an Over-The-Counter (OTC) marketplace in which currency forward contracts (and other financial instruments/derivatives) are traded.
what is the Foreign Exchange (FOREX 0r FX) Market?
Foreign Exchange (FOREX 0r FX) Market is Largest and most attractive financial market with trillion(s) of dollars changing hands daily.
what is the Spot FX rate?
Spot FX rate = actual foreign exchange rate at that point in time.
what are the major Forex Market Players?
Forex Market Players
Commercial banks
Customers of commercial
and central banks
Brokers
Arbitrageurs
Traders
Hedgers
Speculators
when a deal is done in the spot value hwo many days does it take?
When a deal is done in the spot market;
Delivery is in two working days’ time spot value date.
e.g., a deal done on Wednesday will be settled on Friday.
e.g., a deal done on Thursday will be settled on Monday.
what is a direct quote?
Direct quote (DQ) is domestic per unit of foreign.
A rate that is quoted in fixed units of foreign currency in variable amounts of the domestic currency.
Asks what amount of domestic currency is needed to buy one unit of the foreign currency.
In a direct quote, the domestic currency is the quote currency.
e.g., 0.92 USD/EUR a direct quote for people with Euro as domestic.
What is an Indirect quote?
Indirect quote (IQ) is foreign per unit of domestic:
A rate that is quoted in fixed units of domestic currency in variable amounts of the foreign currency.
Asks what amount of foreign currency is needed to buy one unit of the domestic currency
Or, what amount of foreign currency is received when selling one unit of the domestic currency).
The domestic currency is the base currency and the foreign is the quoted.
e.g., 0.92 USD/EUR an indirect quote for U.S. people.
what is the ‘bid’ and ‘ask’ price?
Dealers trade the base currency in round amounts and make money from the bid-ask spread.
The difference between the buying price and selling price of a currency
‘bid’ price is the buy price
‘ask’ or ‘offer’ price is the sell price
What is the three b’s ruile?
The market makers Buys the Base currency at the Bid price, which is the low figure
what are the Risks involved in investing in a foreign country with a different currency?
Risks/Costs
Transaction costs: Transaction costs of trading options in the US as a UK resident are higher than for a US citizen
Taxes: Taxed in both countries
Political risk: May be expropriated by the overseas government. Could introduce factors to make investments less attractive
Exchange rate risk
Not only affects investors but companies engaged in international trade – Balance of Payments (BoP)
Two forms
Transaction risk – risk of invoicing in foreign currency
Translation risk – risk to balance sheet of having assets and liabilities denominated in foreign currency
What influences exchange rates?
Two major factors are:
Interest Rates:
Higher interest rates attract foreign investors → increases demand for the currency → stronger exchange rate
Inflation Rates:
Higher inflation reduces purchasing power and investor confidence → lowers demand for the currency → weaker exchange rate
what is the balance of payments?
The Balance of Payments is the record of all the country’s transactions with the rest of the world over a given period
e.g., Current Account Deficits
Current Account Deficits indicate that a country’s imports are higher than its exports. Therefore, a rising current account deficit is associated with an increase in the supply of the country’s currency in the Foreign Exchange Markets.
What are cross rates?
cross rate are the currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in
Example
If an exchange rate between the Euro and the Japanese Yen was quoted in an American newspaper, this would be considered a cross rate in this context, because neither the euro or the yen is the standard currency of the U.S.
However, if the exchange rate between the Euro and the U.S. dollar were quoted in that same newspaper, it would not be considered a cross rate because the quote involves the U.S. official currency.
Depends on the way the two currencies are quoted against the USD.
What is the Forward Rate?
Forward rate is The guaranteed price agreed today at which the buyer will take delivery of the currency on a specific future date.
what is the forward rate used for?
Forward rate Its use eliminates risk from possible future changes in the spot exchange rate as the forward rate is agreed today, even though the transaction takes place in the future.
what is the Covered Interest Parity (CIP) ?
Covered Interest Parity (CIP) is the pricing formula for the forward exchange rate that is based on the assumption that no arbitrage opportunities arise due to interest rate differential between two countries.
Whta is Uncovered Interest Parity ?
Similar to CIP, but UIP involves “risk arbitrage”.
Example of John, who wants to invest his £100.
But, instead of using a forward contract, he makes a forecast as to what he thinks the spot rate will be in one year’s time.
He is now a speculator, since he does not know what the exchange rate will be in one year, so investing in the U.S. involves exchange-rate risk.
UIP, however, assumes that he ignores the exchange rate risk, he is risk neutral, and is only concerned with the forecast return from the U.S. investment.
UIP asks
“What is the relationship between the spot rate and interest rates in the two countries and the forecast spot rate that will make the investor indifferent to investing in either country?”
what is Purchasing Power Parity (PPP) ?
Over the long run, the price of identical items sold in two countries should be the same (when expressed in a common currency)
An iPad in London should cost the same as an iPad in Dublin (also holds within countries, e.g., from Newcastle to Southampton)
If goods are perfect substitutes for foreign goods and there are no transaction costs, then arbitrageurs will act to ensure that the price is equalised in a common currency.
PPP holds better in the long run than in the short run (Ardeni and Lubian 1991).
What is Purchasing Power Parity (PPP) equation?
𝑺_𝑷𝑷𝑷= 𝑷_𝟏/𝑷_𝟐
Example
Iphone 14 Pro Max in Germany is €1.299 (P1)
Iphone 14 Pro Max in the UK is £1,199 (P2)
If PPP holds, then the exchange rate between Euro and GBP should be:
𝑺_𝑷𝑷𝑷=𝑃_1/𝑃_2 =1199/1299=0.923 (EUR/GBP)
The actual EUR/GBP is 0.88 therefore PPP does not hold.
What are some explanations of the poor performance of ppp?
the poor performance of PPP is caused by:
The level of prices in two countries may not be equal due to transport costs, taxes, duties etc., and there may be a fixed gap between the prices.
PPP implies that the inflation rates and the change in the exchange rate in the two countries will be related.
Example
If Inflation in the U.K. is 6% and in the U.S. is 4%. To preserve UK price competitiveness, the sterling post rate will have to depreciate by 2% over the coming year.
2% higher sterling prices at the end of the year would make U.K. goods expensive for the U.S. citizens if the exchange rate remained unchanged.
But, if $ appreciates by 2%, goods would be equivalent.
If a country’s long-term inflation > others, could be a signal of future currency depreciation
Imperfect competition
Competition standards and rules are different in different countries, so multinational firms can price-discriminate.
