financial markets - 2500 words
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Topic4A-Foreignexchange2019.pptxThe Foreign Exchange Market Part A
Topic 5
BAFI 1002
FINANCIAL MARKETS
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What’s next
Mid-semester test (20%)
MCQs (Topics 1 to 3 )
When: Week 5, During your tutorial
Market View Presentation (20%)
Individually develop a view on a currency pair
When: Week 7, Friday…..
FX Report (20%)
FX Dealing sessions
When: Week 10, Friday…..
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Overview: Foreign Exchange Market
Nature of forex market
Foreign exchange rates
Spot & forward rates
Cross Rates & trading positions
Why trade foreign exchange
History of forex
Determinants of exchange rates
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.
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Overview: Foreign Exchange Market
Nature of forex market
Foreign exchange rates
Spot & forward rates
Cross Rates & trading positions
Why trade foreign exchange
History of forex
Determinants of exchange rates
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
Forex terminology
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
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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
Forex terminology
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 |
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Overview: Foreign Exchange Market
Nature of forex market
Foreign exchange rates
Spot & forward rates
Cross Rates & trading positions
Why trade foreign exchange
History of forex
Determinants of exchange rates
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.
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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
Arbitrage
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
GBP 690,956 =
AUD 1,036,573
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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.
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Cross rates
A cross rate is an exchange rate that does not involve the USD eg. AUD/CHF
Sometimes quotes are not available, to calculate these quotes you need to use USD quotes:
AUD/CHF =? AUD/USD = 0.8446
USD/CHF = 0.8222
For this use the chain rule, which involves multiplying the two USD exchange rates
AUD/CHF = AUD/USD x USD/CHF
= 0.8446 x 0.8222
= 0.6944
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Cross rates
Cross rates without bid/offer spread
Example: Find AUD/EUR, given: AUD/USD = 0.8446
USD/EUR = 0.7975
AUD/EUR = AUD/USD x USD/EUR
= 0.8446 x 0.7975 = 0.6736
Cross rates
Cross rates with bid/offer spread
Example: Find AUD/EUR, given: AUD/USD = 0.8446/56
USD/EUR = 0.7975/85
Bid rate = 0.8446 x 0.7975 = 0.6736
Offer rate = 0.8456 x 0.7985 = 0.6752
AUD/EUR = 0.6736/52
Cross rates
The chain rule will only work if the USD exchange rates are in the following format:
Find CurrA/CurrB, given: CurrA/USD and USD/CurrB
Where CurrA/USD x USD/CurrB = CurrA/CurrB
Eg. AUD/USD x USD/CHF = AUD/CHF
If the quotes are not in this order, they must be converted so that they are
Alternatively: S(x/y) = S(x/z) / S(y/z)
Cross rates
You do not have CurrA/USD and USD/CurrB
To convert an exchange rate to the desired format, you take the reciprocal of both sides and reverse them
Example, USD/EUR = 1.2539/49
We need it to be EUR/USD:
Use “Old” Offer 1/1.2549 = 0.7969 = New Bid
Use “Old” Bid 1/1.2539 = 0.7975 = New Offer
EUR/USD = 0.7969/75
Cross-rate Calculation
The calculation depends on the quote style
USD/EUR 0.8130-40
USD/JPY 110.40-50
EUR/JPY
= 110.40/0.8140 -110.50/0.8130
AUD/USD 0.7560-70
GBP/USD 1.8270-80
AUD/GBP 0.7560/1.8280- 0.7570/1.8270
EUR/USD*USD/JPY
AUD/USD*USD/GBP
Triangular Arbitrage
Suppose we observe these exchange rates posted by different banks:
$
£
€
HSBC S(£/$)=1.55
National
S(£/€)=1.50
Barclays
S(€/$) = 1.06
First, calculate any implied cross rate to see if an arbitrage exists.
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Triangular Arbitrage
$
£
€
HSBC
S(£/$)=1.55
National
S(£/€)=1.50
Barclays
S(€/$) = 1.06
The implied S(£/€) cross rate:
£/$1.55
€/$1.06
= £ /€ 1.4623
National has posted a quote of S(£/€)=1.50
so there is an arbitrage opportunity.
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Triangular Arbitrage
$
£
€
HSBC
S(£/$)=1.55
National
S(£/€)=1.50
Barclays
S(€/$) = 1.06
1. Sell our $ for £,
2. Sell our £ for €,
3. Sell those € for $.
So, how can we make money?
Buy £ @ $1.55; sell @ €1.50
Then trade Euro for your preferred currency.
1
2
3
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Triangular Arbitrage
$
£
€
HSBC
S(£/$)=1.55
National
S(£/€)=1.50
Barclays
S(€/$) = 1.06
1
2
3
Sell $1,000,000 for £:
£645,161
Sell £645,161 for € :
€967,742
Sell € 967,742 for $:
$1,025,806
Profit = $1,025,806 - $1,000,000
= $ 25,806
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Triangular Arbitrage
Here we have to go “clockwise” to make money - but it doesn’t matter where we start.
The inter-market arbitrage can continue until exchange rate equilibrium is re-established.
This is, until the calculated cross rate equals the actual equation, less a margin for transaction costs.
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Triangular Arbitrage
What is the easiest method of measuring arbitrage opportunity?
In the case of three point arbitrage, x, y, z, the no-arbitrage condition maybe written as: S(x/y) S(y/z) S(z/x)= 1
If there are more than 3 currencies involved, it can be rewritten as:
S(x1/x2) S(x2/x3) S(x3/x4)S(x4/x1)= 1
S(x/y) S(y/z) S(z/x)= 1 this means that S(x/y) S(y/z) =S(x/z)
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Triangular Arbitrage
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Another Example
Suppose that the following exchange rates are quoted in Sydney, Auckland and Hong Kong: Determine the triangular arbitrage profit that is possible if you have HKD 1,000,000.
S(AUD/HKD) = 4.1548
S(AUD/NZD) = 1.2052
S(NZD/HKD) = 3.5825
(a) $39,190 profit
(b) $33,460 profit
(c) No profit is possible
(d) $39,190 loss
Triangular Arbitrage
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Another Example
Approach 1: sell HKD for NZD, NZD for AUD,then AUD for HKD.
Approach 2: sell HKD for AUD, AUD for NZD, then NZD for HKD.
Players in the forex market
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
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Overview: Foreign Exchange Market
Nature of forex market
Foreign exchange rates
Spot & forward rates
Cross Rates & trading positions
Why trade foreign exchange
History of forex
Determinants of exchange rates
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
Spot transactions
The most often quoted rate
The exchange will take place 2 business days after the deal is done
Transactions weekends or public holidays will delay the settlement date
Short-dated transactions
TOD contracts
The exchange will occur “today” (the day on which the deal is done)
TOM contracts
The exchange will occur “tomorrow” (the next business day)
The spot rate is adjusted to reflect interest rate differentials
Forward transactions
The exchange will take place 3 or more business days in the future
The most common settlement periods are 30 - 180 days
The settlement period is the period beyond the spot settlement date
Eg: 1 month forward contract will be settled in 1 month & 2 days
Short-dated transactions
Summary Table
Quotation of forward rates
Rather than quote outright forward rates, dealers will quote “forward points” - the number of basis points to be added to or subtracted from the spot rate
Eg: 1 month 14/13
2 month 29/27
3 month 43/40
6 month 84/80
14 basis points must be added to (or subtracted from) the spot bid rate, and 13 points must be added to (or subtracted from) the offer rate
Quotation of forward rates
The spot rate is always “low-high”
If the forward points are “low-high”, they must be added to the spot rate
If the forward points are “high-low”, they must be subtracted
** The spread may be wider in the forward market (due to increased risks and reduced liquidity)
L.Li - International Finance
Quotation of forward rates
Suppose that the spot and forward rates for the (GBP/AUD) were:
Spot 2.7586 – 2.7593
| Forward points | Forward rates | |
| 1-month | 10-15 | 2.7596 - 2.7608 |
| 3-month | 15-7 | 2.7571 - 2.7586 |
| 6-month | 30-35 | 2.7616 – 2.7628 |
| 9-month | 25-18 | 2.7561 – 2.7575 |
Calculation of forward rates
Calculation of forward rates
Example: Calculate 180 day forward margin, Given Spot AUD/USD = 0.8446
Aust. interest rate = 5.50%
US interest rate = 4.75%
= .8416
Calculation of forward rates
If rcomm> rterm the commodity currency will sell at a discount in the forward market.
If rcomm< rterm the commodity currency will sell at a premium in the forward market.
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Calculation of forward rates
In the USA the 360 day year convention is used and therefore t is really 180/360 for the USA and 180/365 for AUS. However, for simplicity and consistency we have used a 365 day year for both countries.
Calculation of forward rates
The establishment of a forward premium or discount is based on arbitrage between spot rates, forward rates and interest rates.
The forward rate does NOT necessarily predict what the spot rate will be in the future
Calculation of forward rates
Calculate 120 day forward margin, given:
Spot AUD/EUR = 0.7895
BBSW interest rate = 4.50%
EURIBOR interest rate = 2.75%
THE END
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