1. The Foreign Exchange Market
Chapter 2
The Foreign Exchange Market

2. Slides prepared by Afaf Moosa
Objectives
To describe the FX market.
To identify participants and currencies.
To describe the mechanics and technology of FX trading.
To introduce some exchange rate concepts.
To illustrate FX position keeping.
To describe the AUD FX market.
To introduce some FX jargon.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Definition
The FX market is the market where national currencies are bought and sold against one another. Foreign exchange consists mainly of bank deposits.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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.
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Market Participants
Foreign exchange traders buy and sell currencies directly or indirectly.
Arbitragers exploit exchange rate anomalies; hedgers cover open positions; and speculators take open positions.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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6. Categories of Participants
Customers
Commercial banks
Other financial institutions
Brokers
Central banks
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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9. Daily Turnover in the FX Market (USD Billion)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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10. The Geographical Distribution of FX Market Turnover (Per Cent)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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11. FX Market Turnover by Counterparty (Per Cent)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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12. FX Market Turnover by Counterparty (Per Cent)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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13. Currency Composition of FX Market Turnover (Per Cent)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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14. Currency Composition of FX Market Turnover (Per Cent)
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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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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16. 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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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17. 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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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18. Components of an FX Transaction
Price discovery
Decision making
Settlement
Position keeping
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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FX Market Technology
The telegraph
The telephone
The telex
The fax
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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20. FX Market Technology (cont.)
Screen-based information systems
Screen-based automated dealing systems
Automatic order matching systems
Online FX trading
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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21. The Bilateral Spot Exchange Rate
The exchange rate between two currencies for immediate delivery.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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22. A Spot Foreign Exchange Transaction
Confirmation of exchange rate and amount
B’s
account
A’s
(Monday) A B
AUD (Wednesday)
USD (Wednesday)
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Spot Rate Quotation
S (x /y ) is the price (in terms of x) of one unit of y :
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Exchange Rate Changes
When the exchange rate changes from S0(x/y) to S1(x/y)
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Currency Conversion
To convert from y to x, multiply by the exchange rate.
To convert from x to y, divide by the exchange rate.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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26. Exchange Rate Quotation in Practice
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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Bid and Offer Rates
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
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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28. A Foreign Exchange Spot Transaction with Bid-Offer Spread B
(1/1.8525)
(1/ )
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Conversion Rules
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Points and Pips
A point is one-hundredth of a cent, a penny, etc.
A pip is one-tenth of a point.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Cross Exchange Rates
A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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32. Bid and Offer Cross Rates
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Cross Rates Matrix
For n exchange rates
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FX Position Keeping
A nostro account is held by a dealer at a corresponding bank.
A vostro account is held by a bank on behalf of a foreign dealer
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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35. FX Position Keeping (cont.)
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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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36. FX Position Keeping (cont.)
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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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37. FX Position Keeping (cont.)
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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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38. The Forward Exchange Rate
The rate contracted today for the delivery of a currency at a specified date in the future.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Forward Value Date
The date on which currencies involved in a forward transaction are exchanged.
Dates may be short, round or broken.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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40. Outright and Swap Forward Transactions
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).
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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Kinds of FX Swaps
Forward swaps
Forward-forward swaps
Overnight swaps
Tom/next swaps
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The Forward Spread
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Premium and Discount
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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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44. Outright and Swap Rates
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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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The AUD FX Market
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.
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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46. Reasons for the Growth of the AUD Market
Deregulation
High interest rates in the 1980s
Australia’s time zone
Exchange rate volatility
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
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