Slides prepared by Kaye Watson

Slides prepared by Kaye Watson
Chapter 15 Foreign Exchange Market: Participants and Mechanics Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Learning Objectives Identify participants in foreign exchange (FX) markets Describe functions and operations of FX markets Outline instruments traded in FX markets Explain conventions for quotation and calculation of exchange rates and forward exchange rates Identify participants in foreign exchange (FX) markets Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Chapter Organisation 15.1 Introduction 15.2 FX Market Participants 15.3 Operation of the FX Market 15.4 Spot and Forward Transactions 15.5 Spot Market Quotations 15.6 Forward Market Quotations 15.7 European Monetary Union 15.8 Summary Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.1 Introduction FX markets comprise all financial transactions denominated in foreign currency, currently estimated to be USD1.5 trillion per day Facilitate exchange of value from one currency to another Internationally adopted FX market conventions to improve market functionality Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.2 FX Market Participants
FX market participants can be classified as Firms conducting international trade transactions FX dealers Central banks Investors and borrowers Speculative transactions Arbitrage transactions Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Firms conducting international trade transactions
Exporters receive foreign currency for the sale of their goods and services Exporters use the FX market to sell foreign currency and buy AUD Importers use the FX market to buy foreign currency (sell AUD) to be used for purchasing imports Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

FX dealers Are financial institutions that are licensed or authorised by the central banks of the countries in which they operate Quote two-way (i.e. buy and sell) prices There are also FX brokers who transact almost exclusively with FX dealers Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Central banks Enter FX market to Purchase foreign currency to pay for imports or interest on foreign debt Change the composition of holdings of foreign currencies Influence the exchange rate Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Investors and borrowers
Commercial bank foreign borrowings are usually converted into the home currency Corporations and financial institutions investing overseas Need to purchase FX in order to make the investments Dividends or interest payments received from overseas investments will be denominated in a foreign currency Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Speculative transactions
Businesses and financial institutions may attempt to anticipate future exchange rate movements to make a profit There is a risk involved that the exchange rate will either move In the opposite direction to that anticipated In the anticipated direction but by less than expected Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Speculative transactions (cont.)
Example If, today: Spot rate: USD1= AUD1.65 Exchange rate expected today + n days: USD1= AUD1.70 Then, today: Buy USD1 at a cost of AUD1.65 Then, at today + n days: Sell USD1 and obtain AUD1.70 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Arbitrage transactions
Profit is made through FX transactions that involve no FX risk exposure Types of arbitrage Locational—where two dealers quote different rates on the same currency Triangular—occurs when exchange rates between three or more currencies are out of perfect alignment Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Arbitrage transactions (cont.)
Example: Triangular arbitrage USD1 = AUD1.65 USD1 = SGD1.65 AUD1 = SGD 0.97 Arbitrage strategy Sell AUD1.65 and receive USD1 Sell USD1 to receive SGD1.65 Sell SGD1.65 to receive AUD1.70 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.3 Operation of the FX Market
Is a global market, operating 24 hours a day according to business hours across the time zones Consists of a vast and highly sophisticated global network of telecommunications systems that provide the current buy and sell rates for various currencies in dealing rooms located around the globe Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.4 Spot and Forward Transactions
FX market instruments are typically Spot transactions Have maturity date two business days after the FX contract is entered into e.g. used 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 e.g. used if Australian importer has to pay a USD liability in 2 months Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.4 Spot and Forward Transactions (cont.)
Dealers may also provide short-dated transactions if necessary ‘Tod’ value transactions: same-day settlement ‘Tom’ value transactions: settlement tomorrow Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.5 Spot Market Quotations
Asking for a quotation The price of 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 currency is the terms currency Example: USD/AUD is the price of 1 US dollar in terms of Australian dollars Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.5 Spot Market Quotations (cont.)
Two-way quotations Example: Australian dollar/euro may be expressed as AUD/EUR1.8155–1.8165, usually abbreviated to AUD/EUR1.8155–65 The two numbers indicate the dealer’s buy and sell price The dealer will buy AUD1 for EUR1.8155 The dealer will sell AUD1 for EUR1.8165 Dealer ‘buys low’ and ‘sells high’ The difference between the buy and sell price is the ‘spread’ Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Transposing spot quotations Example: Given a quotation of AUD/EUR1.8275– the EUR/AUD quotation can be determined by transposing the quotation i.e. ‘reverse and invert’ Reverse the bid and offer prices: –1.8275 Then take the inverse (divide both numbers into 1) EUR/AUD0.5469–0.5472 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Calculating cross-rates Almost all currencies are quoted against the USD and when transactions occur between two non-USD currencies the cross-rate needs to be calculated The procedure for calculating the cross-rate varies depending on whether the USD is a Direct quote—the USD is the base currency, or Indirect quote—the USD is the terms currency and the other currency is the base currency Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Example 3:Crossing two direct FX quotations. USD/EURO 9850 – 60 USD/JPY – 50 To determine the EUR/JPY cross-rate: 118.40/ = 11550/ = EUR/JPY – 26 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Example 4:Crossing a direct and indirect FX quotation. USD/JPY – 50 GBP/USD – 80 To determine the GBP/JPY cross-rate: x = x = GBP/JPY – Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Example 5:Crossing two indirect FX quotations. AUD/USD – 70 GBP/USD – 80 To determine the AUD/GBP cross-rate: 0.5560/ = 0.5570/ = AUD/GBP – 32 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.6 Forward Market Quotations
Forward points The forward exchange rate is the FX bid/offer rates applicable at a specified date beyond the spot value date The forward exchange rate varies from the spot rate due to interest rate parity Interest rate parity is the principle that exchange rates will adjust to reflect interest rate differentials between countries Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.6 Forward Market Quotations (cont.)
Forward points (cont.) 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 the forward points are rising, then add them to the spot rate (i.e. forward premium) If the forward points are falling, then subtract them from the spot rate (i.e. forward discount) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Forward points (cont.) Example: Given AUD/USD (spot) 0.6930–0.6940 and six-month forward points: 0.0032–0.0027 Then, since the forward points are falling, subtract them from the spot rate to obtain the six-month forward rate of 0.6898–0.6913 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Forward points (cont.) Equations 15.2 and 15.3 in the textbook demonstrate how a FX dealer calculates the bid offer forward points These equations take into account Interest rates in the two countries The difference between bid and offer exchange rates i.e. spread Example 6 illustrates the application of equations 15.2 and 15.3 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Example 6: An FX dealer is to calculate the bid and offer six-month forward points for the EUR/USD and has the following information. Bid Offer Spot EUR/USD 6-month US interest rates 5.60% 5.75% 6-month euro interest rates 3.85% 4.00% Bid forward points Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Example 6 (cont.): Offer forward points Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Forward exchange contracts FX dealers quote forward points on standard delivery dates, usually monthly out to 12 months For a non-standard delivery period, a dealer will calculate the forward rate taking into account the current spot rate, domestic and foreign interest rates and days in year as indicated in equation 15.4 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Forward exchange contracts (cont.) (15.4) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Some ‘real world’ complications The equations and examples illustrated are simplified and do not take into account complexities of the ‘real world’ financial markets like Differential interest rate basis Interest withholding tax Two-way quotations Compound interest period Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.7 European Monetary Union (EMU)
Currently, 12 of the 15 members of the EU are participants in EMU As the EMU gains acceptance, the size and liquidity EMU member equity and bond markets will increase The EURO has become a hard currency like the USD in that it is generally accepted in international trade transactions Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

15.8 Summary FX market participants include companies, dealers, central banks, investors, speculators and arbitrageurs FX market instruments are usually either spot or forward transactions Which involve the quotation of the dealer’s buy-sell prices Cross-rates calculations are necessary between 2 non-USD currencies Forward exchange rates are quoted as forward points either above or below the spot rate Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

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