1. Chapter 2 The Foreign Exchange Market

2. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-2 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.)

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

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

5. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-5 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

6. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-6 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

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

8. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-8 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

9. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-9 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

10. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-10 Daily turnover in the FX market (USD billion)

11. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-11 Geographical distribution of FX market turnover (%)

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

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

14. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-14 Currency composition of the FX market (by single currencies)

15. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-15 Currency composition of the FX market (by currency pairs)

16. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-16 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.)

17. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-17 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.)

18. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-18 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

19. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-19 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 The AUD FX market

20. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-20 Daily turnover in the Australian FX market (USD billion)

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

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

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

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

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

26. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-26 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

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

28. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-28 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

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

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

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

32. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-32 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 Exchange rate quotation in practice

33. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-33 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 The bid and offer rates

34. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-34 A foreign exchange spot transaction with bid- offer spread A USD @ 1.8575 B USD @ 1.8525 AUD @ 0.5398 (1/1.8525) AUD @ 0.5384 (1/ 1.8575)

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

36. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-36 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” Points and pips

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

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

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

40. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-40 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” FX position keeping (cont.)

41. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-41 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 FX position keeping (cont.) (cont.)

42. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-42 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 FX position keeping (cont.) (cont.)

43. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-43 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 FX position keeping (cont.)

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

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

46. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-46 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 Forward value date

47. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-47 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 Forward value date (cont) (cont.)

48. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-48 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) Outright and swap forward transactions

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

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

51. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-51 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 Premium and discount

52. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 2-52 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 Outright and swap rates