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Chapter 2 The Foreign Exchange Market Chapter 2 The Foreign Exchange Market

Objectives • • To describe the FX market To identify participants and currencies To Objectives • • To describe the FX market To identify participants and currencies To describe the Australian FX market To describe the mechanics and technology of FX trading (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -2

Objectives (cont. ) • To introduce some exchange rate concepts • To illustrate FX Objectives (cont. ) • To introduce some exchange rate concepts • To illustrate FX position keeping • To introduce some FX jargon Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -3

Definition • The FX market is the market where national currencies are bought and Definition • The FX market is the market where national currencies are bought and sold against one another. Foreign exchange consists mainly of bank deposits. Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -4

Characteristics • It is the largest and most perfect market • It is needed Characteristics • It is the largest and most perfect market • It is needed because every international transaction requires a foreign exchange transaction • It is an over-the-counter (OTC) market Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -5

Market participants • Foreign exchange traders buy and sell currencies directly or indirectly • Market participants • Foreign exchange traders buy and sell currencies directly or indirectly • Arbitragers exploit exchange rate anomalies; hedgers cover open positions; speculators take open positions Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -6

Categories of participants • • • Customers Commercial banks Other financial institutions Brokers Central Categories of participants • • • Customers Commercial banks Other financial institutions Brokers Central banks Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -7

Interbank operations • The FX market is dominated by interbank operations • Participants in Interbank operations • The FX market is dominated by interbank operations • Participants in the interbank market are market makers, other major dealers and second-tier banks Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -8

Size and composition • The size of the global FX market is measured by Size and composition • The size of the global FX market is measured by the sum of daily turnover in FX centres • A survey is coordinated by the BIS every three years for this purpose Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -9

Daily turnover in the FX market (USD billion) 3600 3200 2800 2400 2000 1600 Daily turnover in the FX market (USD billion) 3600 3200 2800 2400 2000 1600 1200 800 400 0 1989 1992 1995 Spot Forward 1998 2001 2004 2007 Total (including gaps) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -10

Geographical distribution of FX market turnover (%) 40 35 30 25 20 15 10 Geographical distribution of FX market turnover (%) 40 35 30 25 20 15 10 5 a si us R G er m an y ce Fr an lia ra st Au ng Ko g H on or e ng ap Ja pa n Si Sw itz er la nd . . S U U . K . 0 Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -11

FX market turnover by counterparty (institutional type) Interbank Financial Institutions Others Copyright 2010 Mc. FX market turnover by counterparty (institutional type) Interbank Financial Institutions Others Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -12

FX market turnover by counterparty (locality) Local Cross-border Copyright 2010 Mc. Graw-Hill Australia Pty FX market turnover by counterparty (locality) Local Cross-border Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -13

Currency composition of the FX market (by single currencies) 100 80 60 40 20 Currency composition of the FX market (by single currencies) 100 80 60 40 20 0 USD EUR JPY GBP CHF AUD CAD SEK HKD Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa Others 2 -14

Currency composition of the FX market (by currency pairs) 30 25 20 15 10 Currency composition of the FX market (by currency pairs) 30 25 20 15 10 5 0 USD/EUR USD/JPY USD/GBP USD/AUD USD/CHF USD/CAD USD/Other/Other Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -15

Traded currencies • The US dollar is the most heavily traded currency • The Traded currencies • The US dollar is the most heavily traded currency • The euro and the yen are heavily traded because of the importance of Europe and Japan in the world economy (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -16

Traded currencies (cont. ) • The pound is heavily traded for historical reasons • Traded currencies (cont. ) • The pound is heavily traded for historical reasons • Currencies that are heavily traded in certain financial centres and lack liquidity in others: CHF, CAD (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -17

Traded currencies (cont. ) • Currencies that are traded locally, but internationally are traded Traded currencies (cont. ) • Currencies that are traded locally, but internationally are traded for international trade purposes: AUD, NZD, HKD • Third world currencies: soft or exotic currencies Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -18

The AUD FX market • The market consists of the banking system and non The AUD FX market • The market consists of the banking system and non -bank dealers authorised by the Reserve Bank of Australia (RBA) • The market has grown since the flotation of the AUD in 1983 Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -19

Daily turnover in the Australian FX market (USD billion) 200 160 120 80 40 Daily turnover in the Australian FX market (USD billion) 200 160 120 80 40 0 1989 1992 1995 1998 2001 2004 Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2007 2 -20

Reasons for the growth of the AUD market • • Deregulation High interest rates Reasons for the growth of the AUD market • • Deregulation High interest rates in the 1980 s Australia’s time zone Exchange rate volatility Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -21

Components of an FX transaction • • Price discovery Decision making Settlement Position keeping Components of an FX transaction • • Price discovery Decision making Settlement Position keeping Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -22

FX market technology • • The telegraph The telephone The telex The fax (cont. FX market technology • • The telegraph The telephone The telex The fax (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -23

FX market technology (cont. ) • • Screen-based information systems Screen-based automated dealing systems FX market technology (cont. ) • • Screen-based information systems Screen-based automated dealing systems Automatic order matching systems Online FX trading Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -24

The bilateral spot exchange rate • The exchange rate between two currencies for immediate The bilateral spot exchange rate • The exchange rate between two currencies for immediate delivery Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -25

Transaction dates • The date on which the transaction is agreed upon is called Transaction dates • The date on which the transaction is agreed upon is called the contract date, dealing date, done date or trade date • The date on which currencies are exchanged is the value date or the delivery date Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -26

A spot foreign exchange transaction Confirmation of exchange rate and amount A B AUD A spot foreign exchange transaction Confirmation of exchange rate and amount A B AUD 1 000 (Wednesday) USD 500 000 (Wednesday) (Monday) B’s account A’s account Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -27

The delivery date • Typically, the delivery date is two business days after the The delivery date • Typically, the delivery date is two business days after the contract date • In a value-today or same-day transaction the delivery date is the same as the contract date • In a value-tomorrow or next-day transaction the delivery date is one day after the contract date Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -28

Spot rate quotation • S (x /y ) is the price (in terms of Spot rate quotation • S (x /y ) is the price (in terms of x) of one unit of y : Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -29

Exchange rate changes • When the exchange rate changes from S 0(x/y) to S Exchange rate changes • When the exchange rate changes from S 0(x/y) to S 1(x/y) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -30

Currency conversion • To convert from y to x, multiply by the exchange rate Currency conversion • To convert from y to x, multiply by the exchange rate • To convert from x to y, divide by the exchange rate Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -31

Exchange rate quotation in practice • Direct quotation refers to the domestic currency price Exchange rate quotation in practice • Direct quotation refers to the domestic currency price of one unit of the foreign currency • Indirect quotation refers to the foreign currency price of the domestic currency • What is a direct quotation from the perspective of one country is an indirect quotation from the perspective of the other country, and vice versa Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -32

The bid and offer rates • The bid rate is the rate at which The bid and offer rates • The bid rate is the rate at which the quoting dealer is willing to buy. The offer rate is the rate at which the quoting dealer is willing to sell. • The spread is Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -33

A foreign exchange spot transaction with bid-offer spread USD @ 1. 8575 USD @ A foreign exchange spot transaction with bid-offer spread USD @ 1. 8575 USD @ 1. 8525 B A AUD @ 0. 5398 (1/1. 8525) AUD @ 0. 5384 (1/ 1. 8575) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -34

Conversion rules Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Conversion rules Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -35

Points and pips • A point is one-hundredth of a cent, a penny, etc. Points and pips • A point is one-hundredth of a cent, a penny, etc. • A pip is one-tenth of a point • If the exchange rate is 1. 2545 -1. 2585, this can be expressed as 45 -85 and 1. 25 is called the “big number” Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -36

Cross exchange rates • A cross exchange rate is the exchange rate between two Cross exchange rates • A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -37

Bid and offer cross rates Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Bid and offer cross rates Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -38

Cross rates matrix • For n exchange rates Copyright 2010 Mc. Graw-Hill Australia Pty Cross rates matrix • For n exchange rates Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -39

FX position keeping • A nostro account is held by a dealer at a FX position keeping • A nostro account is held by a dealer at a correspondent bank • A vostro account is held by a bank on behalf of a foreign dealer • The words “nostro” and “vostro” are Latin for “ours” and “yours” (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -40

FX position keeping (cont. ) • A short position is created when a dealer FX position keeping (cont. ) • A short position is created when a dealer borrows a currency and sells it • A long position is created when a currency is bought because it is expected to appreciate (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -41

FX position keeping (cont. ) • Position keeping is the monitoring of positions in FX position keeping (cont. ) • Position keeping is the monitoring of positions in each currency • A position is the net cumulative total of a currency holding arising from deals • A blotter is a schedule used to record the details of transactions (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -42

FX position keeping (cont. ) • Position squaring is realising profit/loss by buying the FX position keeping (cont. ) • Position squaring is realising profit/loss by buying the short-position currency and selling the long-position currency • Valuation is the calculation of unrealised profit/loss using the average rate Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -43

An example The following is an example of FX position keeping Copyright 2010 Mc. An example The following is an example of FX position keeping Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -44

The forward exchange rate • The rate contracted today for the delivery of a The forward exchange rate • The rate contracted today for the delivery of a currency at a specified date in the future Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -45

Forward value date • The date on which currencies involved in a forward transaction Forward value date • The date on which currencies involved in a forward transaction are exchanged • The forward value date must be more than two business days after the contract date, otherwise it will be a spot transaction • The period preceding the forward value date is calculated from the spot value date Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -46

Forward value date (cont) • A short date means a maturity of one month Forward value date (cont) • A short date means a maturity of one month or less • A round date means a maturity of a whole number of months • A broken date means a maturity of less than round dates (cont. ) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -47

Outright and swap forward transactions • An outright contract involves the sale or purchase Outright and swap forward transactions • An outright contract involves the sale or purchase of a currency for delivery more than two days into the future • A swap transaction involves a spot purchase against a matching outright sale (or vice versa) Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -48

Kinds of FX swaps • • Forward swaps Forward-forward swaps Overnight swaps Tom/next swaps Kinds of FX swaps • • Forward swaps Forward-forward swaps Overnight swaps Tom/next swaps Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -49

The forward spread Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: The forward spread Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -50

Premium and discount • If F (x /y ) > S (x /y ), Premium and discount • If F (x /y ) > S (x /y ), then y sells at a premium • If F (x /y ) < S (x /y ), then y sells at a discount • If F (x /y ) = S (x /y ), both currencies are flat Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -51

Outright and swap rates • An outright forward rate is quoted as bid and Outright and swap rates • An outright forward rate is quoted as bid and offer rates • A swap rate is quoted in terms of the points representing the forward premium or discount Copyright 2010 Mc. Graw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3 e by Imad A. Moosa Slides prepared by Afaf Moosa 2 -52