financial market report

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
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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.
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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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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

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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.

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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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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

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