Topic 8 - Foreign Exchange Market Structure & Operations (Part 1)

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This article is a topic within the subject Capital Markets and Institutions.

Contents

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 516-545.

Exchange Rate Regimes And Foreign Exchanges (FX’s) Global Nature

[1] The Foreign Exchange (FX) markets trade currencies of the majority of nation states. The market is open 24 hours a day & trades $4 trillion/day. Each country or monetary union is responsible for determining their exchange rate regime. An exchange rate is the value of 1 currency relative to that of another currency.

  • Floating Exchange (Free Float) Regime - the exchange rate is determined by the forces of supply & demand
    • Adopted by the major currencies (USD, GBP, JPY, EUR, and AUD), a central bank can intervene to slow movements
  • Managed Floatexchange rate is held within a defined band relative to another currency (limited fluctuations allowed)
  • Crawling Pegexchange rate is allowed to appreciate in controlled steps over time
  • Pegged Exchange Ratevalue of the pegged currency is tied to the value of another currency or basket of currencies.

Foreign Exchange Market Participants

[2]

  • FX Dealersfirms that act as principals in the FX markets (price makers) & quote 2 way prices (bid/offer) on currencies
    • Financial institutions (investment/merchant/commercial banks) that have authority from a prudential supervisor
  • FX Brokersobtain (seek out) the best prices (rates) in global FX markets & match FX dealers buy/sell orders for a fee
    • Transact almost exclusively with FX dealers & not with the public. Anonymity is given until the transaction is carried out
    • Price takers
  • Central Banksintervene for the following reasons
    • Acquire foreign currency to pay for government purchases of imports & repay foreign borrowings/interest
    • Change the composition of CB’s holdings of foreign currency as part of its management of official reserve assets
      • Holdings of foreign currencies, gold & international drawing rights
    • Influence the exchange rate – dirtying the float
  • Firms Conducting International Trade Transactions – exporting & importing
    • Exporters need to convert foreign currency received to AUD (usually from USD contracts)
    • Importers need to convert AUD to foreign currency to pay for imports
  • Investors & Borrowers in the International Money & Capital Markets
    • Borrowed funds are converted into the home currency & will be converted back upon repayments
    • Firms/Investors need to purchase the currency of the market they are investing in e.g. USD for NYSE
      • Return received is denominated in foreign currency - need to exchange it for their own currency
  • FX Speculatorsanticipate future exchange rate movements, motivated by the pursuit of profit, e.g. hedge funds
    • Accompanied by an element of risk
      • Exchange rate moves in the opposite direction to that anticipated
      • Exchange rates moves in the anticipated direction but by less than expected
  • Arbitrageurspossible when differences occur between buy/sell prices in markets
    • Carries out simultaneous buy/sell transactions in 2 or more markets to achieve a risk free profit’
    • Geographic – 2 dealers in different locations quote different rates on the same currency
    • Triangular – when 3 or more currency exchange rate are out of perfect alignment

FINS161281.jpg

The Operation Of The Foreign Exchange Market

[3] The FX market is a global market operating 24 hours a day. It consists of a vast, highly sophisticated global network of telecommunication systems that provide current buy/sell rates for various currencies in dealing rooms located around the globe. It comprises all financial transactions denominated in foreign currency. FX is usually part of a banks treasury operation (dealing room).

Spot And Forward Transactions

[4] FINS161282.jpg

The Value Date (delivery or maturity date) refers to the FX contract date at which delivery of a currency & financial settlement occur. Spot transactions have a maturity date 2 days after the contract is entered into, whilst forward transactions have value date in excess of 2 days. If it’s the 13th Aug, the spot delivery date is the 15th & the 1 month forwards delivery date is Sept 15th.

Spot Market Quotations

[5]

Asking For A Quotations

The price of a currency must be expressed in terms of another currency. The 1st currency is the ‘base currency’ (unit of quotation or price being sought) & the 2nd is the ‘terms currency’. USD/AUD (USD – Base, AUD – Terms, this is the price of 1 USD in terms of AUD).

2 Way Quotations

EUR/AUD 1.6755-65. The lower number is the dealers buy (bid) price & the higher number is the dealers sell (offer) price.[6]

FINS161283.jpg

Transposing Quotations

EUR/AUD 1.6755-65

  1. Reverse the bid & offer prices - EUR/AUD 1.6765-55
  2. Invert - AUD/EURO 0.5965-68[7]

Originally, the dealer would give (sell) 1.6755 AUD to buy 1 EURO. Thus 1.6755 AUD is the ‘offer’ for 1 EUR. Hence, if the dealer was to buy AUD (AUD/EUR) the offer is 0.5968 EUR for 1 AUD. Originally, the dealer would sell 1 EUR to get (buy) 1.6765 AUD. Thus 1.6765 AUD is what the dealer gets (buys) for 1 EURO. The dealer bids 1.6765 for 1 EURO which is AUD/EUR 0.5965.

To put it simply, the original bid refers to the rate at which the dealer would buy the base currency and sell the terms currency. Thus the original bid is the offer rate when the original terms currency is transposed to become the base currency.

Calculating Cross Rates

All currencies are quoted against the USD. Direct quotes are when the USD is the base currency & indirect quotes are when the USD is the terms currency. When FX transactions take place between 2 currencies, with neither being USD, a cross rate is calculated. E.g. can calculate EUR/JPY with EUR/USD & JPY/USD

Crossing 2 Direct Foreign Exchange Quotations

[8]

Book Method

Crossing 2 Direct FX Quotations:

  1. Place the currency that is to become the unit of quotation 1st
  2. Divide opposite bid & offer rates
    1. Dividing the base currency offer into the terms currency bid = bid rate
    2. Divide base currency bid into terms currency offer = offer rate
Personal Method

Transpose one of the direct quotations (whilst aligning the correct base currency to what is required) to get a direct and an indirect quotation. Then you can simply multiply bid with bid and offer with offer. This can be seen in the below example.[9]

FINS161284.jpg

Crossing A Direct And Indirect Quotations

Multiple bid with bid and offer with offer. [10] FINS161285.jpg

Crossing 2 Indirect Foreign Exchange Quotations

Book Method
  1. Place the currency that is to become the unit of quotation 1st
  2. Divide opposite bid & offer rates
    1. Divide the terms currency offer rate into the base currency bid rate = bid rate
    2. Divide the terms currency bid rate into the base currency offer rate = offer rate
Personal Method

Transpose one of the indirect quotations (the exact one depends on the question - you must make sure the base currency is first). Then multiply bid with bid and offer with offer. This can be seen in the below example. [11]

FINS161286.jpg

Forward Market Quotations

[12] Foreign currencies may be bought/sold at a price determined today, but with delivery occurring at a specific date beyond spot.

Forward Points And Forward Exchange Rates

The forward exchange rate varies from the spot rate owing to interest rate parity. Interest rate parity is the 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 base.

  • If forward points are rising, add them to the spot rate
    • The base currency is at a forward premium as its interest rate is lower
  • If forward points are falling, deduct them from the spot rate
    • The base currency is at a forward discount as its interest rate is higher

This following 2 examples demonstrate the knowledge required for this course.[13]

FINS161287.jpg

Forward Exchange Rate Contracts

Forward exchange rate contracts lock in an exchange rate today for delivery at a specified future date. FX dealers quote forward points on standard delivery dates, (usually monthly, out to 12 months) of a specified amount of currency against another. In the previous example, the dealer buys 1 million USD (invests at 3% p.a. = 1,007,500) by borrowing CHF 1,156,000 (cost 4% p.a. = 1,167,560). The forward exchange rate is 1,167,560 / 1,007,500 = 1.1589 (29 points).

Forward Market Complications

2 Way Quotations

FX quotes show what the buyer will pay for the base currency & the rate at which they will sell. Dealers must be careful in selecting appropriate bid/offer rates for forward points, cross rates, transposing etc.

Different Interest Rate Year Conventions

Dealers need to convert interest rates based on 360 days to 365 (or vice versa).

Borrowing And Lending Interest Rates

FX dealers need to recognise borrowing & lending interest rate margins.

FINS161288.jpg [14]

Compound Interest Rates

The effective value of deposits & cost of borrowings should be calculated by using the effective rate of interest.

End

This is the end of this topic. Click here to go back to the main subject page for Capital Markets and Institutions.

References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 517-519
  2. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 520-523
  3. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 523-524
  4. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 525-526
  5. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 526-531
  6. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  7. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  8. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  9. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  10. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  11. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  12. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 531-535
  13. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  14. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
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