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Topic4B-ForeignExchange.pptxThe Foreign Exchange Market Part B
Topic 4B
BAFI 1002
FINANCIAL MARKETS
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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
More Trading Terminologies
Going “Long”: When you are buying a currency
Going “Short”: When you are selling a currency
From the Market Maker’s Point of View:
AUD/JPY
“Hit on the Left”: Bought Commodity Currency
“Hit on the Right”: Sold Commodity Currency
More Trading Terminologies
Net exchange position terminology
Net exchange position: Total foreign currency bought - total sold
Long position: More foreign curr bought than sold
Short position: More foreign curr sold than bought
Square position: Total bought = Total sold
Maintaining an FX trading position
When the Market Maker has been:
“Hit on the Left”: Bought commodity currency
To square their position, they need to sell commodity currency
“Hit on the Right”: Sold commodity currency
To square their position, they need to buy commodity currency
Maintaining an FX trading position
Why is it important to square the position?
In Long/Short Position, they have FX exposure!
What do they need to do?
Adjust their bid/offer to attract sellers/buyers
Increase both bid/offer: to attract sellers and deter buyers
Decrease both bid/offer: to attract buyers and deter sellers
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Maintaining an FX trading position
Cash flows and T accounts
Suppose you do the following:
Buy 2m AUD at AUD/EUR = 0.8620
Sell 5m AUD at AUD/EUR = 0.8625
Sell 3m AUD at AUD/EUR = 0.8630
Net position = short 6m AUD
To square this position, you would need to buy 6m AUD. The rate you obtain will determine the profit or loss.
Maintaining an FX trading position
Using a blotter
| (A$m) | Position | |
| Buy 20 | +20 | Up 20 |
| Buy 10 | +30 | Up 30 |
| Sell 5 | +25 | Up 25 |
| Sell 15 | +10 | Up 10 |
| Sell 15 | -5 | Down 5 |
| Sell 10 | -15 | Down 15 |
| Buy 15 | 0 | Square |
Maintaining an FX trading position
These cash flows can be shown as follows:
| AUD | EUR | Rates AUD/EUR |
| 2,000,000 | -1,724,000 | 0.8620 |
| -5,000,000 | 4,312,500 | 0.8625 |
| -3,000,000 | 2,589,000 | 0.8630 |
| 6,000,000 | -5,172,000 | 0.8620 |
| 0 | 5,500 |
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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
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
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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.
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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
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
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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
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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
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Could currency depreciation alone boost exports?
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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
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
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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
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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
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
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)
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