FINC3011 International Financial Management

Lecture 1 Foreign Exchange Markets and Exchange Rates I

The Foreign Exchange Market: The market in which national currencies are bought and sold against one another, and where exchange rates determined o The largest and most dynamic of all financial markets Daily trading volume in the foreign exchange (FX) market is immense: o 2010 average daily trading volume or turnover was nearly 4 trillion US dollars! The FX market is 24-hour market Trading in FX virtually never ceases Most of the trading takes place in just a handful of key currencies o USD, Euro, Yen, British Pound, AUD, CHF, CAD A few key financial centers account for the bulk of daily trading volume in foreign exchange o UK (London), US (New York), Japan (Tokyo), Switzerland Over-The-Counter Market: The FX market is an Over-The-Counter (OTC) market o There is no one physical location or organised exchange where traders get together to exchange currencies o Rather, the FX market consists of a complex international network of informal linkages between key market participants communicating with each other via telephone & other electronic channels/platforms Foreign Exchange Markets: The FX market provides the physical and institutional structure through which o The money of one country is exchanged for that of another country o The rate of exchange between currencies is determined o Foreign exchange transactions are physically completed Foreign Exchange Transaction: An agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate Functions of the FOREX Market: The FOREX market is the mechanism by which participants: o Transfer purchasing power between countries Necessary as international trade and capital transactions normally involve parties living in countries with different national currencies o Obtain or provide credit for international trade transactions Inventories in transit must be financed o Minimize exposure to exchange rate risk FOREX markets provide instruments utilized in hedging or transferring risk to more willing parties

FINC3011 International Financial Management Geographic Extent of the Market: Geographically, the FOREX market spans the globe with prices moving and currencies trading every hour of every business day Major world trading starts each morning in Sydney and Tokyo Geographic of the Market Then moves west to Hong Extent Kong and Singapore Continuing Europe, London, New York and finishing on the West Measuring to FOREX Market Activity:and Average Electronic Conversions per Hour Coast of the U.S.

Measuring FOREX Market Activity: Average electronic conversions per hour KEY FX MARKET PARTICIPANTS: The FOREX market consists of two tiers: o The interbank or wholesale market Multiples of A$1m or equivalent in transaction size o The client or retail market Five broad categories of participants operate within these two tiers: o Customers or Clients o Bank and Non-Bank FX dealers o Speculators and Arbitragers o FX Brokers o Central Banks and Treasuries Customers or Clients: Companies & individuals wishing to buy and sell FX in order to finance foreign trade and international investment operations o E.g. Exporters, importers, tourists, immigrants, investors Price-takers in FX market o I.e. buy/sell currencies at prices (exchange rates) determined by the market makers in FX market Bank and Non-Bank FX Dealers: Typically large commercial banks Market-Makers in FX Market (Price-makers) o Market-Makers provide liquidity by quoting two-way prices for currencies o Stand ready to buy and sell currencies at (bid and offer) exchange rates they quote Deal in retail (i.e. with Customers) and wholesale or interbank markets Take positions; engage in FX arbitrage & speculation 2

FINC3011 International Financial Management Speculators and Arbitrageurs: Seek to profit from trading in the market itself Operate for their own interest, without need or obligation to serve clients or ensure a continuous market Speculators seek all their profit from exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates in different markets A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks FX Brokers: Agents who facilitate trading between FX dealers without themselves becoming principals in the transaction Disseminate market information Bring together buyers & sellers with matching needs Accepts limit orders o Limit orders: orders placed with brokers by banks to buy/sell a certain quantity of foreign currency at a pre-specified price o Broker puts these on its books and attempts to match purchase orders with sell orders Do not deal or take positions in foreign exchange Receive commissions on deals that they broker in interbank FX market Central Banks and Treasuries: Use the market to acquire or spend their countrys currency reserves as well as to influence the price at which their own currency trades Act as bankers for their governments in meeting FX requirements Sometimes intervene in FX market to: o Smooth exchange rate fluctuations o Prevent domestic currency from appreciating or depreciating excessively Structure of the FX Market:
cities:

ucture of the Foreign Exchange Market

s/day

ket nsactions 13.4%

48%

e $1M

FINC3011 International Financial Management Foreign Exchange Transactions: A Foreign exchange (FX) transaction is simply the exchange of one currency for another currency Three general types of transactions take place in the FX market: o Spot FX transactions o Forward FX transactions (2 types): Outright Forwards FX swap transactions Spot FX Transactions: A single outright transaction involving the exchange of two currencies at a rate agreed to today (spot bilateral exchange rate) with settlement (actual delivery of currency for currency) usually within 2 business days o Deal date: (day on which transaction is made, t) o Value date: (day of cash settlement of transaction, t+2) Transactions completed within 2 business days o Exception 1: U.S. and Mexico/Canada o Exception 2: Holidays dont count in U.S. dollar transactions o Exception 3: Fridays are not business days in Middle East but Saturdays/Sundays are so non-Middle Eastern currencies settle on Fridays and Middle Eastern currencies settle on Saturday Outright Forward FX Transactions: An agreement to exchange currencies at some future date at a price agreed to today o Similar to a spot FX transaction except that they are for value, i.e. delivered for cash settlement, more than 2 business days after the conclusion of the transaction A single outright transaction involving the exchange of two currencies at a rate agreed to today (forward exchange rate) with settlement (actual delivery of currency for currency) more than 2 business days in the future o E.g. Agree today to buy USD 1 million in 90 days at the forward exchange rate of 0.9500 USD per AUD Forward contracts come in standard maturities of 1-month, 2-months, and so on Foreign Exchange Swaps: A transaction involving the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates o Both purchase and sale are conducted with the same counterparty Spot against forward foreign exchange swap: o Sale/purchase of a currency today combined with an offsetting purchase/sale of the same currency at some future point in time o Consists of two legs: a spot FX transaction and offsetting forward FX transaction E.g. Day 1: Sell AUD/buy USD @ spot exchange rate (spot leg) o Day 90: Buy AUD/sell USD @ fwd exchange rate (fwd leg) o Sell today $10m AUD (buy USD)@ spot exchange rate of $0.9500 USD and agree to buy back in 2 weeks time $10m AUD (sell USD) at the forward exchange rate of 0.9550 USD 4

FINC3011 International Financial Management Forward-forward foreign exchange swaps: o Exchange of two forward contracts with different maturity dates

Electronic Trading Systems: First created in 1992 Enable automatic matching and execution of foreign exchange transactions Reduce cost of trading by eliminating brokers and reducing the number of transactions traders had to engage in to obtain market prices Gather and publish information on prices and quantities of currencies as they are traded Electronic Foreign Exchange Trading (eFX): 30% of all trading volume and 50% in spot markets Straight Through Processing (STP): forex trade takes place from placement of order to settlement in automated fashion Three categories: o Single bank sponsored platforms (portals) o Multi-bank portals o Independent companies Best known and most active platform is FXConnect (State Street) Another leader is Fxall (consortium of banks) Independent companies: HotSpot and Currenex Originally designed for corporate clients or institutional investors but got a boost from hedge funds and retail aggregators Exchange Rate: The price of one currency expressed in terms of another currency The number of units of one currency that are required to exchange for a single unit of another currency Prices established in FX markets are the exchange rates between various currencies The Exchange Rate and its Quotation: Every bilateral exchange rate treats one currency as the item or commodity which is being priced, with the other currency as the units in which its price is measured (terms) E.g. For the exchange rate quote AUD=USD 1.0235, the Australian dollar is the commodity currency and US dollar is the terms currency In theory, the choice of commodity currency is entirely arbitrary o We could have the US dollar as commodity currency and the Australian dollar as the terms currency USD1 = AUD 0.9770 AUD1 = USD 1.0235

FINC3011 International Financial Management The Exchange Rate and its Quotation Formula: Let S(i/j) o = spot price of currency j expressed in units of currency i o = no. of units currency i per unit of currency j j is the commodity currency, i is the terms currency E.g AUD = 1.0235 S(USD/AUD) = 1.0235 o Currency i is the US dollar (terms currency) o Currency j is the Australian dollar (commodity currency)

E.g. if St (USD/AUD) = 1.0235 and St-5(USD/AUD) = 1.0350, then Australian dollar is said to have depreciated 1.1% against the US dollar over the 5-day period [100*(1.0235-1.0350)/(1.0350) = -1.1%]

European Quotation: Exchange rates are generally quoted with the US dollar as the commodity currency o I.e. number of units of foreign currency i per US dollar S(i/USD) E.g. o S(Yen/USD) = no. of Japanese yen per US dollar o S(CAD/USD) = no. of Canadian dollars per US dollar o S(CHF/USD) = no. of Swiss Francs per US dollar This is sometimes referred to as an exchange rate quotation in European terms American Quotation: For the British pound, Australian dollar, New Zealand dollar, Irish punt, and the Euro, exchange rate quotations have the relevant local currency as the commodity currency and USD as the terms currency (i.e. number of US dollars per local currency) o E.g. S(USD/GBP) = no. of US dollars per British pound o S(USD/AUD) = no. of US dollars per Australian dollar o S(USD/NZD) = no. of US dollars per New Zealand dollar o S(USD/EUR) = no. of US dollars per Euro This is sometimes referred to as an exchange rate quotation in American terms Direct Quotation: The exchange rate is expressed as the domestic currency price of 1 unit of foreign currency I.e. price of the foreign currency expressed in units of domestic currency I.e. when foreign currency is the commodity currency and the terms currency is the domestic currency I.e. S(domestic currency/foreign currency) or S(AUD/currency i) E.g. AUD = USD 1.0235, then direct quote is: S(AUD/USD) = 0.9770 AUD

FINC3011 International Financial Management Indirect Quotation: The exchange rate is expressed as the foreign currency price of 1 unit of domestic currency I.e. price of the domestic currency expressed in units of foreign currency I.e. when domestic currency is the commodity currency and the terms currency is the foreign currency I.e. S(foreign currency/domestic currency) or S(currency i/ AUD) E.g. If we have AUD = USD 1.0235, this is the indirect quote i.e. S(USD/AUD) = 1.0235 USD The Exchange Rate and its Quotation: In foreign exchange quotations, the units of measurement follow the usual rules of algebra E.g. j/i = 1 (i/j) E.g. AUD/USD = 1 USD/AUD If S(i/j) = a units of i, then S(j/i) = 1 S(i/j) = 1/a units of j I.e. If a units of currency i exchange for one unit of currency j, then it must be the case that 1/a units of currency j must exchange for one unit of currency i E.g. if S(USD/AUD) = USD 0.6330, then S(AUD/USD) = 1 (USD 0.6330) = AUD 1.5798 Cross Exchange Exchange Rates: Cross exchange rates are exchange rates between currencies when neither of the 2 currencies is the US dollar E.g. S(YEN/AUD), S(CHF/GBP), S(SF/NZD), etc. Recall that units of measurement follow the rules of algebra If we have three currencies currency i, currency j and currency z, then:

FINC3011 International Financial Management Spot Bid and Offer Exchange Rate Quotes: In inter-bank spot FX market, when dealers provide an exchange rate quotation, they will typically give a two- way price I.e. the buying price and the selling price of the commodity currency E.g. S(USD/AUD) = 0.6504-09 o This is the FX dealers (price-makers) two-way quote for the AUD in USD terms o AUD is the commodity currency, USD is the terms currency What this quote means is that the dealer will either: o Buy AUD in exchange for USD @ 1AUD = USD 0.6504 o Sell AUD in exchange for USD @ 1 AUD = USD 0.6509 Bid price = USD 0.6504 o I.e. the price at which the bank or dealer is willing to buy 1 Australian dollar o The price at which the bank is willing to buy 1 unit of the commodity currency o Rate at which banks will buy the base currency Offer (Ask) price = USD 0.6509 o I.e. the price at which bank is willing to sell 1 Australian dollar o It is selling price in units of the terms currency o Rate at which banks will sell the base currency Bid price (of the commodity currency) will always be less than Offer or ask price (of the commodity currency) o Why? Profitable FX trading in the commodity currency dictates buying low/selling high What banks make on FX transactions: 100 * (Ask Bid)/ Ask

Bid-Ask Spread: The difference between the offer or ask and bid prices of the FX quote E.g. = 0.0005 or 5 points in above example The bid/ask spread is normally larger for those currencies that are less frequently traded The spread is also larger for retail transactions than for wholesale transactions between banks or large corporations Bid-Ask Percentage Spread:

Spot Bid and Offer Exchange Rate Quotes: When dealing in foreign exchange, if you buy one currency, you also necessarily sell the other currency and vice versa E.g. the quote on a AUD 5 million parcel of S(USD/AUD) = 0.7650 - 80 means that the dealer will: o Buy AUD 5 million @ 1 AUD =0.7650, simultaneously sell USD 3,825,000 (= 5,000,000 x 0.7650) o Sell AUD 5 million @ 1 AUD = 0.7680, simultaneously buy USD 3,840,000 (= 5,000,000 x 0.7680) 8

The Reciprocal Nature of Bid and Ask Exchange Rates

The Reciprocal Nature of Bid and Ask Exchange Rates:

FINC3011 International Financial Management

Bid-Ask Spreads and Bank Profits: Magnitude of bid-ask spreads: o Interbank market Within 5 pips (fourth decimal point in a currency quote) 0.05% - 0.07% for major currencies Lower for extremely liquid currencies like U.S. dollar (i.e., 0.03% for $/ exchange rate quote) Higher for less liquid currencies o Physical exchange 3% or more Banks have to have inventory, which means it is not interest bearing Banks must transact with brokers Use credit cards to exchange when in another country this is the best possible rate for you! o Differs across the day Bid-Ask Spreads and Bank Profits Example: Treasurer of a U.S. company purchases pounds with dollars to hedge a British goods purchase. Directly after, he is told that they no longer need to purchase the goods. He then sells the pounds back for dollars. Assume that the % bid-ask spread is 4 pips If the ask rate is $1.50/, the bid rate is $1.4996/ and the percentage spread is: o [($1.50/) ($1.4996/)]/($1.4998/) = 0.03% If the treasurer bought 1M at $1.50/, the cost would have been: o 1M * ($1.50/) = $1.5M Selling back: 1M * ($1.4996/) - $1,499,600, or a loss of $400 on the two transactions 0.03% of $1.5M 9

Spot Quotations, continued

Quotes are given in pairs that reflect the bidbid-ask price.
FINC3011 International Financial Management E.g., pound sterling is quoted at $1.9719$1.9719 -28. Spot Market Spot Quotations: $1.9728 is the (ask) rate at which banks will sell pounds Quotes are given in pairs that reflect the bid-ask price E.g. pound sterling is quoted at $1.9719-28 The spread equalse the dal e r s profit o $1.9719 is the (bid) rate at which banks will buy pounds o $1.9728 is the (ask)is rate at which banks pounds The bid-ask bidspread often quoted by will the sell last two numbers; o The spread equals the dealer s profit e.g., 1919-28. The bid-ask spread is often quoted by the last two numbers; e.g. 19-28 BidBid -ask quote expressed in American and European terms and as Bid-ask quote expressed in American and European terms and as direct direct and quotes: indirect quotes: and indirect

$1.9719 is the (bid) rate at which banks will buy pounds

Spot Market (3)

$1.9719$1.9719 -28

Spot quotations, continued Direct in U.S. Direct outside U.S.

Indirect outside

American Terms

European Terms*
(1/$1.9728)-(1/$1.9719) (1/$1.9728)=0.5069 0.5069-71

BidBid-ask spreads are expressed a percentage cost of Indirect as in U.S. U.S. transacting the foreign as follows: *Note in that the bid and ask prices areexchange reversed in quoting inmarket European terms.
Bid-ask spreads are expressed as a percentage cost of transacting in the foreign exchange market as follows:

Percent Spread =

Ask price Bid price x 100 Ask price

Cross rates

Cross Rates: Most currencies are quoted against the dollar A cross rate is the exchange rate between two non-dollar currencies Spot Bid and Offer Cross-Rate Quotes:

Most currencies are quoted against the dollar. Example 1: A cross rate is the exchange rate between two nonnon-dollar currencies
o If S(Yen/USD) = 123.00-10 and S(USD/AUD) = 0.7000-05, what is the cross-rate quotation on the S(Yen/AUD)? Answer: o Bid S(Yen/AUD) = bid S(USD/AUD) x bid S( Yen/USD) = 0.7000 x 123.00 = 86.10 o Offer S(Yen/AUD) = offer S(USD/AUD) x offer S(Yen/USD) = 0.7005 x 123.10 = 86.23 o S(Yen/AUD) = 86.10-23

Example 2: o If S(USD/AUD) = 0.7000-05 and S(USD/GBP) = 1.5550-60, what is the cross-rate quotation S(GBP/AUD)? Answer: o Bid S(GBP/AUD) = bid S(USD/AUD) offer S(USD/GBP) = 0.7000 1.5560 = 0.4499 o Offer S(GBP/AUD) = offer S(USD/AUD) bid S(USD/GBP) = 0.7005 1.5550 = 0.4505 o S(GBP/AUD) = 0.4499-05 10

FINC3011 International Financial Management Spot Bid and Offer Cross-Rate Quotes: Basically there are 2 simple steps in the determination of bid and offer cross exchange rate quotations from two other bilateral bid and offer exchange rate quotes Determine whether you have to multiply or divide the two exchange rate quotations Spot Market of bid Cross rates In determining which combination and offer rates to use, recognise that dealer will always want to have the bid price of the commodity currency as low as possible, and the offer price of the commodity Cross rates, continued currency as high as possible Example: Compute direct bid and ask cross rates for the pound in Zurich Spot Market Cross Rates: E.g. direct and ask cross for the Compute Direct quote forbid pound sterling =rates $1.9719 $1.9719-36pound in Zurich Direct quote for pound sterling = $1.9719-36 Direct quote for= SFr = $0.8130$0.8130-47 Direct quote for SFr $0.8130-47
Bid cross rate = Bid rate for in $ Ask rate for SFr in $ = $1.9719 $0.8147 = SFr2.4204

Ask cross rate =

Ask rate for in $ Bid rate for SFr in $

$1.9736 $0.8130

= SFr2.4227

Thus, the direct quote for the pound in Zurich is SFr 2.4204-27 Thus, the direct quote for the pound in Zurich is SFr2.4204SFr2.4204-27. Triangular Currency Arbitrage: An arbitrage process involving three currencies Traders take advantage of exchange rate inconsistencies in different money markets by buying a currency in one market and simultaneously selling it in another Keeps cross-rates in line with exchange rates quoted relative to U.S. dollar Triangular Arbitrage Diagram Occurs when one can trade three currencies & make a profit (versus two) o E.g. / < /$ * $/

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GoodGood and Bad Triangular Arbitrages and Bad Triangular Arbitrage:

FINC3011 International Financial Management

Triangular Arbitrage Diagram (another example)

Triangular Arbitrage Diagram (Another Example):

Insert Exh. 2.7 here

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Spot Market
Currency arbitrage
FINC3011 International Financial Management

Triangular Currency Arbitrage: rate inconsistencies in different money markets by buying a currency Tradersin take advantage of exchange rate inconsistencies different one market and simultaneously selling it inin another. money markets by buying a currency in one market and simultaneously E.g., compute profit given the following exchange rates selling it in another E.g. compute profit following exchange rates: $/ = $1.9724 ingiven New the York o $/ = $1.9724 in New York $/ $1.3450 in Frankfurt o =$/ = $1.3450 in Frankfurt / 1.4655 in London o= /= 1.4655 in London
New York

Triangular currency arbitrage traders take advantage of exchange

Sell pounds in New York for dollars: 507,332/(1/$1.9724) = $1,000,661 Profit = $661 London

Sell $1,000,000 in Frankfurt for euros: $1,000,000/($1.3450) = 743,494

Frankfurt Sell euros in London for pounds: 743,494/1.4655 = 507,332

Forward Rates and FX Swap Points: Forward exchange rate quotations are quoted in a similar manner to spot prices A two-way bid/offer spread is quoted with the commodity currency again being the currency referred to as being bought or sold in a transaction There are two ways of quoting forward rates o First, is the outright forward exchange rate which is expressed as exactly as the spot exchange rate, using two numbers to represent the bid and offer forward rates o Second, is the swap rate which quoted in terms swap points (also known as forward points) of discount or premium E.g. An FX dealer may quote the following S(USD/AUD) rates: o Spot: 0.7000-05 o 3-month swap points: 40-38 o (3-month forward points) The forward price is an adjustment (represented by the swap or forward points) to the spot rate to give what is known as the outright forward rate The outright forward rate is the predetermined exchange rate at which an FX transaction is settled at a future date. In this example, the 3-month forward S(USD/AUD) bid rate is 0.6960 (= 0.7000 - 0.0040) and the corresponding offer rate is 0.6967 (= 0.7005 0.0038) In this example we obtain the 3-month outright forward rate by subtracting the 3-month swap points from the bid and offer quotes of the spot exchange rate Adding or Subtracting Swap points? Rule: o If the left-hand side of swap point quotation (bid) is greater than the right-hand side of the swap point quotation (offer), you SUBTRACT the swap points from the spot rate to obtain the outright forward rate 13

Forward Rates and FX Swap points

FINC3011 International Financial Management

If we have the following quotations swap points: 3-month swap USD/AUD 40-38 (subtract swap points from
spot)

o If the L.H.S. of swap point quotation is less than the R.H.S. of the swap point quote, you ADD the swap points to spot rate quotation

3-month swap CAN/USD 15-20 (add swap points from spot) and the following spot rate quotations S(USD/AUD) = 0.7000-05 S(CAN/USD) = 1.2015-25 then we have following outright 3-month forward rates: 3-month F(USD/AUD) = 0.6960 - 0.6967 3-month F(CAN/USD) = 1.2030 - 1.2045 Forward Rates and FX Swap
Another example:
Calculate outright forward rates from the following swap quotations on the Canadian dollar (expressed in European terms):

Rates

Spot ($ Can per $US) 1.3910-15

90-day Swap 20-15

180-day Swap 25-20

ANSWER Note: Note : we subtract the swap points from the spot rates as bid swap points are greater than offer swap points for both maturities. 9090 -day forward ($Can/USD) bid rate = 1.3890 (=1.3910(=1.3910-0.0020) 9090 -day forward ($Can/USD) offer rate =1.3900 (= 1.39151.3915-0.0015) 180180 -day forward ($Can/USD) bid rate = 1.3885 (= 1.39101.3910-0.0025) 180180 -day forward ($Can/USD) offer rate = 1.3895 (= 1.39151.3915-0.0020)
Forward Premium: If outright forward exchange rate is greater than that spot exchange rate If F(USD/AUD) > S(USD/AUD), Australian currency is at a forward premium If commodity currency is at a forward premium then terms currency must be at a forward discount If swap bid points are greater than swap offer points, then: o commodity currency is at forward discount o terms currency is at forward premium

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FINC3011 International Financial Management Forward Discount: If outright forward exchange rate is less than that spot exchange rate If F(USD/AUD) < S(USD/AUD), Australian currency is at a forward discount If commodity currency is at a forward discount then terms currency must be at a forward premium Forward Market If swap bid points are less than swap offer points, then: o Commodity currency is at forward premium o Terms currency is at forward discount A forward contract between a bank and a customer calls for Forward Market: currency against dollar payment ata a fixed exchange rate. A forward contract between a bank and customer calls for delivery on a fixed future date of a specified amount of one currency against dollar Negotiating a forward contract for payment of a future liability payment at a fixed exchange rate. eliminates exchange risk by locking in a known future exchange rate. Negotiating a forward contract for payment of a future liability eliminates risk by locking a known future exchange rate payment of E.g., exchange a U.S. company buys in textiles from England, with E.g. a U.S. company buys textiles from England, with payment of 1 1 million due in 90 days. million due in 90 days
Day 0 e0 = $1.97 e90 > $1.98 Exchange risk: If e90 > f90, cost of payable will increase 90 f90 = $1.98 No exchange risk: 1,000,000 = $1,980,000

delivery on a fixed future date of a specified amount of one

Implicit gains/losses on forward are related to the between ft and et at the forward positions contracts maturity difference between ft and e ht at te forward contracts maturity. h

Implicit gains/losses on forward positions are related to the difference

Forward Rates and FX Swap Points: What determines the forward price? The forward price will be determined by: o the spot rate o the term or maturity of the forward contract o the respective nominal interest rates of the two currencies in the exchange rate quotation Once we know these, we can calculate the swap or forward points and hence the forward exchange rate Covered Interest Parity (CIP) provides the theoretical underpinning for determination of the forward rate

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