financial market report
rockshan19977
Topic-4Foreignexchange.pptx
Topic 4
FINANCIAL MARKETS The Foreign Exchange Market
3/21/2021
1
What’s next
Mid-semester test (10%)
MCQ (Topics 1 to 3)
When: Week 5
Market View Presentation (20%)
Individually develop a view on a currency pair
FX Report (20%)
When: Week 10, Friday…..
2
RMIT University
Overview: Foreign Exchange Market
3
Nature of forex market
History of forex
Spot rates
Determinants of exchange rates
FX market participants
Why trade foreign exchange
Foreign exchange market facts
One of the largest financial markets in the world
$4.0 trillion average daily turnover, equivalent to:
More than 12 times the average daily turnover of global equity markets
The US & UK markets account for over 50% of daily turnover
Major markets: London, New York, Tokyo
Source: BIS and http://www.goforex.net/forex-market-snapshot.htm
Nature of the foreign exchange market
A market which allows for the exchange of one currency for another
No physical market place
24/7 trading
Primarily a wholesale market
(interbank)
The trading volume is around $1.4 trillion each day.
They say that some cities never sleep. Same can be said about the foreign exchange market.
- Based on AEST, forex market hours are Sydney, 7:00am – 4:00pm AEST; at 9:00am the Tokyo market comes online and before it closes, the London market comes online at 5:00pm; New York opens at 10:00pm and closes at 7:00am when the Sydney Forex market opens again.
- Most of the trading takes place when UK and US trading hours overlap.
3/21/2021
5
History of exchange rate systems
Early systems of exchange rate determination
The Gold Standard (1879 to 1934): Currency value based on country gold reserve.
gold was set at a fixed price
exchange rates were also fixed
FIXED exchange system
The Bretton Woods system (1944 to 1970’s):
U.S. dollar fixed at $35 per ounce of gold,
all other currencies value based on gold and US dollar reserve.
PEGGED exchange system
3/21/2021
6
History of exchange rate systems
Problems with fixed exchange system:
A country will run down its international reserves if it has to keep buying its own currency
Balance of payment deficits or surplus will affect a country’s currency reserves and affect monetary stability
Vulnerability to speculative attacks:
when the fixed rate is too high, central bank forced to buy back domestic currency.
The economic conditions of the pegging country must closely match those of the reserve country.
3/21/2021
7
Forex terminology
Direct quote
The value of a unit of foreign currency in terms of domestic currency
Eg. USD/AUD = 1.1839
Indirect quote
The value of a unit of domestic currency in terms of foreign currency
Eg. AUD/USD =0.8447
Price quote: the price of foreign currency, in terms of domestic currency
Quantity quote: the quantity of foreign currency for one unit of domestic currency
3/21/2021
8
Forex terminology
Commodity currency
The exchange rate is a value of the commodity currency also called base currency
Terms currency
The value of the commodity currency is expressed “in terms of” the terms currency
AUD/USD = 0.8447
Base/Commodity currency
Term currency
Forex terminology
Terms to indicate change in values in exchange rates: one currency increased or decreased against another currency
Floating currencies: Depreciation vs Appreciation
Fixed/pegged currencies: Devaluation vs Revaluation
AUD/USD = 0.8447 0.8443
USD/AUD = 1.1839 1.1844
= 1/0.8447
= 1/0.8443
Quotation of exchange rates
Two-way pricing
The bid is the rate at which the price maker will buy the commodity currency
The offer is the rate at which the price maker will sell the commodity currency
The bid is always less than the offer
The spread is the difference between the bid and offer rates
The price-maker gets to choose the best side of the quote, and makes a profit from the spread
The price-taker takes the worst side of the quote
Quotation of exchange rates
Two-way pricing
The bid is the rate at which the price maker will buy the commodity currency
The offer is the rate at which the price maker will sell the commodity currency
The bid is always less than the offer
The spread is the difference between the bid and offer rates
The price-maker gets to choose the best side of the quote, and makes a profit from the spread
The price-taker takes the worst side of the quote
| Spot AUD/CHF | |||
| Bid | Offer | Spread | |
| Quoting bank | 0.8436 | 0.8446 | 10 pips |
| buy AUD | sell AUD | ||
| sell CHF | buy CHF | ||
| Calling bank | sell AUD | buy AUD | |
| buy CHF | sell CHF |
Foreign exchange market participants
Dealers
Corporations
Brokers
Central bank
Source: BIS Triennial Survey 2010
Dealers
Licensed by the Australian Securities and Investments Commission to deal in FX
To become a licensed dealer:
At least $10mil issued capital
Properly equipped dealing room
Properly trained dealing staff
Adequate risk management systems and control
Dealers
Usually banks, but corporations can become licensed dealers
Trade on their own account to make profits by speculating and arbitraging
Providing liquidity in the market
Service their customers
Corporations
Corporations (that are not dealers) act as price-takers in the market
Conduct international transactions
Hedge
Speculate (Depends on policy)
Arbitrage (Opportunities are rare)
Brokers
Match potential buyers and sellers
Allow for anonymity
Provide financial services
Paid fees and commissions
Central banks
Conduct FX transactions on behalf of the government – International Market Operations
Intervene in the FX market by:
Monitoring the currency
“Smoothing” to reduce volatility
“Testing” the market to ensure that the currency is accurately priced
Other Foreign exchange market participants
FX market participants can be classified as:
firms conducting international trade transactions
investors and borrowers in the international money markets and capital markets
foreign currency speculators
arbitrageurs.
19
Why trade foreign exchange
International transactions
International trade (importing/exporting)
International capital movements (borrowing/investing)
Hedging
Speculation
Arbitrage
Hedging
Exposure to risk of unpredictable and/or unfavourable movements in exchange rates.
Using financial products to reduce risk, of adverse rate fluctuations.
This may result in a reduction in the expected return
E.g: An importer or exporter can use forward foreign exchange contracts to lock in future exchange rates, for when the transaction will be settled.
Speculation
Voluntarily taking on risk with the expectation of earning a profit
Eg: If a speculator expects a currency to appreciate, he will “go long” - buy the currency
If a speculator expects a currency to depreciate, he will “go short” - sell the currency
Example of Brexit.
3/21/2021
22
Arbitrage
Simultaneously buying and selling an identical commodity in different markets to obtain a risk-free profit
e.g. Exchange rate arbitrage AUD/USD
Bank A 0.8050/60
Bank B 0.8065/75
offer rate of Bank A < bid rate at Bank B the spreads overlap
Arbitrage profit possible
Buy AUD @ 0.8060 from Bank A
Sell AUD @ 0.8065 to Bank B
AUD
USD GBP
Triangular Arbitrage
| AUD/USD | 1.1050/60 |
| USD/GBP | 0.6253/65 |
| GBP/AUD | 1.5002/26 |
AUD 1,000,000 = USD 1,105,000
USD 1,105,000 =
GBP 690,956 @ 0.6253
GBP 690,956@ 1.5002=
AUD 1,036,573
3/21/2021
24
Triangular Arbitrage
Cross rate can be used to check on opportunities for inter-market arbitrage.
Triangular arbitrage is the process of converting one currency to another, converting it again to a third currency and, finally, converting it back to the original currency within a short time span.
This opportunity for riskless profit arises when the currency's exchange rates do not exactly match up.
3/21/2021
25
Spot and forward transactions
FX market instruments are typically:
spot transactions
have maturity date two business days after the FX contract is entered into
are used, for example, if an Australian importer has an account in USD to pay within the next few days
forward transactions
have maturity date more than two days after FX contract is entered into
are used, for example, if Australian importer has to pay a USD liability in two months, and covers or hedges against an appreciation of the USD
(cont.)
26
Spot market quotations
Asking for a quotation
The price of a currency is expressed in terms of another currency.
The first currency mentioned is the price being sought (also called base currency or the unit of quotation)
The second is the terms currency
Example: USD/AUD is the price of USD1 in terms of AUD
(cont.)
27
Spot market quotations
Two-way quotations
Example: Australian dollar/euro may be expressed as EUR/AUD1.3755–1.3765
Usually abbreviated to EUR/AUD1.3755–65
The two numbers indicate the dealer’s buy (bid) and sell (offer) price.
A dealer quoting both bid and offer prices is a price-maker
The dealer will buy EUR1 for AUD1.3755
The dealer will sell EUR1 for AUD1.3765
Dealer ‘buys low’ and ‘sells high’
(cont.)
28
Spot market quotations
Two-way quotations
The difference between the buy and sell price is the ‘spread’, represented in percentage terms in Equation 15.1
(cont.)
29
Spot market quotations
Transposing spot quotations
Example: Given a quotation of EUR/AUD1.3755–1.3765, the AUD/EUR quotation can be determined by transposing the quotation (i.e. ‘reverse and invert’)
Reverse the bid and offer prices: 1.3765–1.3755
Then take the inverse (divide both numbers into 1)
1.000 1.000
1.3765 1.3755
AUD/EUR0.7265–0.7270
(cont.)
30
Types of FX transactions
There is only one type of instrument traded in the FX market - a contract to buy and sell currency
The only difference is the delay before the exchange takes place
Spot transactions
Short-dated transactions
Forward transactions
Exchange rate determination
The exchange rate for a currency is determined by the buying and selling decisions of those who trade in the FX market
Market forces will establish the level of supply and demand
The equilibrium exchange rate will be established by the interaction of supply and demand
Exchange rate determination
Demand for a currency will result from:
An increase in exports
An increase in capital inflow
Supply of a currency will result from:
An increase in imports
An increase in capital outflow
From Rest of the World
From Domestic players
3/21/2021
33
Exchange rate determination
Exchange Rate
Quantity of AUD
S
D
The level of supply is directly related to the value of the currency
The level of demand is inversely related to the value of the currency
Exchange rate determination
The foreign exchange market brings together the forces of supply and demand, and establishes an equilibrium exchange rate at which the level of supply equals the level of demand
Exchange rate determination
Exchange Rate
Quantity of AUD
S
D
.60
.70
.50
Equilibrium rate
Excess Demand
Excess Supply
At a higher exchange rate, such as 0.70, there will be an excess supply of the AUD
At a lower exchange rate, such as 0.50, there will be an excess demand for the AUD
Determinants of the FX value of a country’s currency
Economic fundamentals
Relative inflation rates
Commodity prices
Relative economic growth rates
Relative interest rates
Other factors
International speculation/investment
Exchange rate expectations
Official intervention
G
S
P
Y
I
3/21/2021
37
Relative inflation rates
If Australia has higher inflation than its trading partners, it will experience:
Less demand for exports, and therefore less demand for AUD
More demand for imports, and therefore more supply of the AUD
Relative inflation rates
Exchange Rate
Quantity of AUD
S1
D1
ER1
ER2
D2
S2
D: Less demand for exports, and therefore less demand for AUD
S: More imports, and therefore more supply of the AUD
Q1
Purchasing power parity
This parity relationship is based on the “law of one price”
It predicts that identical commodities will sell at the same price in different currencies, after adjustment for exchange rates
Has been tested empirically (eg. the “Big Mac ” index)
PPP doesn’t hold in the short run, because not all goods are traded
However, adjustments to exchange rates because of inflation will tend to equalise prices and inflation in the long run
http://www.economist.com/content/big-mac-index
3/21/2021
40
41
RMIT University
Could currency depreciation alone boost exports?
If so, then “Made in Russia” labels would be common!
Russian Rubles are undervalued by 69%
In LR: exchange rates would adjust such that identical goods in two diff countries have the same price if expressed in the same currency
42
RMIT University
Commodity prices
Australia is a major exporter of commodities (eg. minerals and agricultural products)
An increase in commodity prices will increase the value of Australian exports, resulting in an appreciation
Trading partners cannot switch suppliers because commodity prices are constant world-wide
3/21/2021
43
Commodity prices
Relative economic growth rates
One effect of higher levels of economic growth is an increased demand for imports
This will increase the supply of the AUD, and shift the supply curve to the right
Another effect could be to increase the level of overseas borrowing (to finance increased investment)
This will increase the demand for the AUD, and shift the demand curve to the right
Relative economic growth rates
Exchange Rate
Quantity of AUD
S1
D2
ER1
D1
S2
S: More imports, and therefore more supply of the AUD
D: Increase the level of overseas investments, and therefore more demand for AUD
Q1
Q2
Relative economic growth rates
The net effect of these two factors is difficult to predict in advance
Relative interest rates
The traditional view was that an increase in interest rates would have the following effects:
Encourages capital inflow, increasing demand for the AUD
Discourages capital outflow, decreasing supply of the AUD
The net effect would be an appreciation of the AUD
Relative interest rates
Exchange Rate
Quantity of AUD
S2
D2
ER2
ER1
D1
S1
D: Encourages capital inflow, increasing demand for the AUD
S: Discourages capital outflow, decreasing supply of the AUD
Q1
Relative interest rates
Empirical evidence suggests high interest rates result in depreciation
Why? Increase in interest rate may be the result of inflation
It is important to distinguish between:
Nominal interest rate - the observable rate which includes the effect of inflation
Real interest rate - the underlying rate, which is received over and above the inflation rate
3/21/2021
50
Relative interest rates
If the nominal interest rate is high because the real rate is high:
This will lead to capital inflow and appreciation
However, real rates are usually constant and high nominal rates usually reflect high inflation rates:
This will lead to a depreciation as a result of high inflation (see above)
This can be linked to carry trade
International speculation and investment
Capital tends to flow into strong economies and out of those with weaker economies
Positive or negative economic outlooks will result in massive buying and selling by currency speculators, resulting in significant variation in exchange rates
Exchange rate expectations
Expectations about future exchange rates can become a self-fulfilling prophecy
Eg. If a currency is expected to appreciate, speculators will buy the currency, increasing demand for the currency, causing it to appreciate
The opposite occurs if a currency is expected to depreciate
Official intervention
Exchange rates are also influenced by intervention by central banks
For floating exchange rates, the central bank will intervene by “smoothing” and “testing” (Australia “Dirty float”)
For fixed exchange rates, significant buying and selling may be required to keep the currency at its target value (e.g China)
THE END
RMIT University©
55
