Foreign Exchange Market Lecture Notes PDF

THE FOREIGN EXCHANGE MARKET TOPIC 5 CHAPTER 5 OUTLINE  What is a FX Market  Primary functions of a FX Market  The 24-hour Market  Participants of the FX Market  FX Quotations  Cross Rates (FX Market Arbitrage)  Evolution of the Global FX Market  Transactions on the FX Market WHAT...

THE FOREIGN EXCHANGE MARKET TOPIC 5 CHAPTER 5 OUTLINE  What is a FX Market  Primary functions of a FX Market  The 24-hour Market  Participants of the FX Market  FX Quotations  Cross Rates (FX Market Arbitrage)  Evolution of the Global FX Market  Transactions on the FX Market WHAT IS AN FX MARKET  FOREIGN EXCHANGE MARKET – physical/virtual institutional structure through which the currency of one country can be exchanged for that of another country.  - it is a mileu in which currencies are exchanged  - it is the world’s largest financial market – by volume of trading  -e.g. of USA tourist in Botswana  - therein the price of currencies relative to other currencies are determined – “ERs” are determined by the forces of demand and supply on this market  -came post 1973???  - FX – money of another country – incl bank notes/bank balances/cheques/bank drafts PRIMARY FUNCTIONS OF THE FX MARKET  Integral in supporting the commercial integration/trades between residents/nationals of different countries  FX mkt is the backbone/pillar of international trade  The functions are:  1. Transfer of value/funds and purchasing power from one currency to another  - FX mkt converts the currency of one country to allow buyers in such country to purchase the goods from another country  -imagine int’l transactions between two persons resident in diff countries: t/action can only be invoiced/denominated in ONE currency – “usually” the sellor’s currency……….one of the parties must access the FX mkt to consummate/complete the transaction  - E.g. a Botswana importer of RSA goods OR Botswana MNC setting up subsidiary in RSA OR Botswana resident opening a US$ FCA  - PRIMARY FUNCTIONS OF THE FX MARKET  2. Source of Credit for Inventory/Goods in Transit  - the manufacture and movement/shipping of goods to a buyer takes time and therefore money (w/cap)  - traders/manufacturers are able to finance goods in transit by getting a Letter of Credit from the Buyer’s Bank so that they can get a loan in their own country to manufacture and get the goods to the shipping port.  - bankers acceptances and LCs  traded/issued by FX Mkt participants  - LC – contractual agmt by a foreign buyer’s bank to pay the supplier when goods are shipped – facilitates international trade by protecting both parties to the int’l trade transaction  - B Acc – an instrument issued by a bank promising to pay a PRIMARY FUNCTIONS OF THE FX MARKET  3. Provides Hedging facilities against Foreign Exchange Risk  - hedging  this is whereby foreign exchange risk is transferred from one entity to another (usually a FX mkt participant –e.g. Bank), via a contract  - these hedging contracts are traded/sold on the FX mkt  - some examples of hedging instruments traded on the FX market are spot money (e.g. FCA); futures contr ; options contr and; swap contr  - these hedge against FX risk FX MARKET STRUCTURE – THE TRADING PERIOD/DAY  -two issues about the FX mkt structure and operations  - a.FX mkt is a global phenomenon – somewhere around the world currency price formation happens, and currencies are traded/exchanged every hour of the day all year round  - b. 24/7/365 Mkt - this market never sleeps  - old financial centres (NY/London - 2000) vs new/emerging trading centres (Far East- HK/Sing/Tokyo – China?) THE FX MKT TRADING DAY THE FX MKT TRADING DAY (ANOTHER VERSION) FX MARKET STRUCTURE –THE TRADING PERIOD/DAY  - major international banks opened trading offices in some major trading jurisdictions (mnc) allows them to trade currency 24 hours   Barclays, Std Cht, etc   own acc trading (proprietary trading) vs trading on behalf of customers  - incr trading DEPTH (suppl & demand) and LIQUIDITY of major currencies - overlap of trading activity of major FX trading cities  - who are the key participants/players on the FX market? PARTICIPANTS OF THE FX MARKET  - they can be divided into two broad categories/groups, viz;  1. Liquidity seekers - they trade currency to facilitate international commercial trade and investment; ensuring that international trade parties have forex/liquidity to pay-for/settle their transactions – non proprietary traders  2. Profit seekers – they trade currencies to essentially make profits from future movements in ERs ; they are arbitragers/speculators  - made possible by the phenomenal growth in the volumes and values of FOREX trading ; also incr geog spread of the FX trading mkt/environment  - they are the "marginal investors" on the forex market ; keen researchers/seekers of information about future ER FX MARKET PARTICIPANTS DIAGRAM PARTICIPANTS OF THE FX MARKET  1. BANK and NON-BANK DEALERS  - bank and nonbank traders/dealers buy and sell forex to profit from the difference between the buy and sell rates for forex  - often done by big banks : smaller-medium banks just trade to close positions for their liquidity seeking customers  ; also some Bureau de Changes …. same as smaller/meduim Banks  - dealers in forex depts of big int’l banks make the market, by buying and selling currencies in which they specialize, on banks own a/c.  - facilitate the liquidity seekers by ensuring the availability of currencies needed to consummate int’l trade and investment transactions  -the keen competition among these dealers/traders, narrows the bid/ask spreads; making the forex markets to be “pricing efficient”  - profitable for many large banks – 20-30% of their net income/profit  - the banks’ traders also earn a commission on the profit made by banks   Profit seekers PARTICIPANTS OF THE FX MARKET  2. Commercial and Investment Transactors  - these transact/enter the foreign exchange market out of necessity, to settle the international trade and investment transactions they have embarked on.  - incl – importers; exporters; int’l portfolio investors; MNCs; tourists, etc  - they also use the forex mkt to hedge forex risk  - Liquidity seekers PARTICIPANTS  OF THE FX MARKET 3. Speculators and Arbitragers  - they seek profits from trading currencies on the FX market for their own interest  - they do not attempt to “make the market” or “serve clients”  - Speculators – seek profit through ER differences in the same market – very short period purchases and sales (intra-hour)  - Arbitragers – seek profits by trading “simultaneously” on ER differences in different FX markets (also intra-hour) PARTICIPANTS OF THE FX MARKET  4. Foreign Exchange Brokers  - they facilitate trading between dealers for a commission  - they do not take positions in the trades – they just maintain a database of dealers/traders, and connect the buyers and sellers of currencies  - usually specialize in brokering particular currency dealers – e.g. Broker1 caters for GBP/USD; HKD/CNY; USD/CNY, …… Broker 2 etc  - Profit seekers PARTICIPANTS OF THE FX MARKET  5. Central Banks and National Treasuries  - two reasons for transacting;  1. To acquire or spend the country’s forex reserves  2. To adjust the price at which their currency is traded on the market – i.e. they use the forex mkt for foreign exchange intervention  - done in line with national best-interest / policy or to satisfy “exch rate currency agmts” entered into with other countries  - thus, in pursuit of above, these participants should be willing to take losses  -Liq vs Profit Seekers???? CLASS (FOREIGN) EXCHANGE RATES AND QUOTATIONS  1. BACKGROUND  -FX RATE – the price of one currency expressed in terms of another currency  -FX Quote – a stmt of willingness to buy or sell currency at an announced rate  - quotes work in same fashion as everyday pricing of commodities  - e.g. price of an apple is P1.20 ; unit is an apple and the price is P1.20 EXCHANGE RATES AND QUOTATIONS  2. CURRENCY SYMBOLS  - primarily 2 kinds of symbols;  - a. Traditional symbols – P; R; $; £; €; ¥  -mainly used in retail fx market  -b. ISO Codes – BWP; ZAR; USD; GBP; EUR; JPY  - Int’l Org for Stdization – ISO4217:2015  - all electronic wholesale global (FX) mkt places use ISO Codes  - SEE END OF TEXTBOOK FOR LISTING OF ISO & TRAD CODES EXCHANGE RATES AND QUOTATIONS  3. EXCHANGE RATES QUOTES  -basic and enduring forex quotes  - forex quotes -- always in “currency pairs”  -- CURR1and CURR2 -- CURR1 / CURR2  - CURR 1 – “base or unit” currency – 1 unit  -CURR 2 – “price or quote” currency – no of units of CURR 2 needed to buy one unit of CURR1 EXCHANGE RATES AND QUOTATIONS  3.1 European vs American Terms Quotes  a. European Terms Quotes  -on wholesale global int’l forex mkts, majority of currency quotes are “per unit $” – forex participants will then convert to required currency using the cross-rates  - e.g. Motswana wants to use BWP to buy ZAR  - the quote is USD/ZAR = 16.0000  - most currencies are quoted per USD on the wholesale global mkt  - USD is the most convertible and traded currency EXCHANGE RATES AND QUOTATIONS  b. American Terms Quotes  -currency on wholesale global mkts is also quoted using the EUR or GBP as the base currency - Motswana wants to use BWP to buy ZAR  Quote is = GBP / ZAR = 18.0000 OR EUR / ZAR = 17.0000  REASONS?  a. - traditionally London was global financial hub,  b. - EUR became eurozone currency, thus residents of diff countries needed to convert their local currencies into EUR ; unit currency was EUR and price currency was residents’ local currencies--- and EUR became a greatly traded currency after 1999.  - also used to quote forex futures and options  - exhibit 5.9 -- CLASS EXCHANGE RATES AND QUOTATIONS  3.2 DIRECT VS INDIRECT QUOTES  - mostly used in retail fx mkts  a. Direct Quote  - price of a foreign currency unit in domestic currency units  - e.g in a Bots bank, the quote for Rands would be; ZAR / BWP = 0.7692  b. Indirect Quote  - price of a domestic currency unit in foreign currency units  - e.g in a Bots bank, the quote for Rands would be; BWP / ZAR = 1.3000  -P1 = R1.3000  - the direct quote is inverse of the indirect quote, and vice versa  Direct Quote = 1/Indirect Quote = 0.7692 EXCHANGE RATES  4. BID and ASK RATES AND QUOTATIONS  Bid price – price in one currency at which a dealer will buy another currency  Ask price – the price in one currency at which the dealer will sell the currency  -note – dealers buy at one price and sell at a higher price/rate  - “bid-ask spread” – higher for illiquid currencies (longer safe keeping before disposal!)  - in a Bots bank using the indirect quote; EXCHANGE  5. CROSS RATES RATES AND QUOTATIONS  - since many currencies are very inactively traded on the global fx (wholesale) markets, their values/rates are thus determined in relation to an actively traded currency, e.g. USD/EUR/GBP/JPY  - E.g. a Botswana importer needs Zambian Kwacha ; both are commonly quoted against the USD, but not directly against each other.  - USD / BWP = 13.1579 …….USD / ZMW=15.6250……..use link currency as the base currency  - thus BWP / ZMK = (ZMK = 1 USD ÷ BWP = 1 USD) = 15.6250 ÷ 13.1579 = ZMK1.1875  - ind qu – base currency is dom currency  - note – reciprocal will give the rate of 1ZMK to BWP (pricing unit)  - dir qu – base currency if foreign currency  - USE – to find exch rate twixt two inactively traded currencies using their individual exch rates with an actively traded “link” currency” EVOLUTION OF THE FX MARKET PLACE  -two distinct era’s in the evolution of the global forex mkt are identifiable;  A. “cable trading era” (1973 – 1987)  -used telephones to seek quotations from a single counterparty  - recording of transactions was manual  - took a “long” time/days to fully settle the transaction – settlement risk  B. “computer era” (1987 – date)  -use computer networks and the “www” to seek quotations, trade, record transactions, and settle transactions  - greater transparency as quotes can be viewed simultaneously by large numbers of participants  - “instantaneous settlement of transactions – thus “eliminating” counterparty settlement risk  - PROB – cyber risk EVOLUTION OF THE FX MARKET PLACE TYPES OF FOREIGN EXCHANGE MARKET TRANSACTIONS  - 3 kinds of forex transactions take place on the interbank global forex mkt  -these transactions are settled via electronic interbank settlement systems  - e.g. CHIPS –Clearing House Interbank Payments System --- for settlement of USD transactions  - the future delivery date defines the type of forex transaction  - Value / Settlement Date – the date on which forex deals are settled between the interbank forex dealers  - range between 2 days and some years TYPES OF FOREIGN EXCHANGE  1. SPOT FOREIGN EXCHANGE TRANSACTIONS MARKET  TRANSACTIONS DEF – forex t/actions basically involving the “immediate” exchange of currencies at the current (spot) exchange rate  - these in the interbank market involve the purchase/sale of foreign currency (at current exchange rate – spot rate) with delivery and payment between the two banks being 2 business days after the transaction date  - the value date on such market is usually 2 business days after transaction date  -E.g. A USA bank contracts to sell GBP10mio to a London bank, in return for USD on 2nd June 2024. The exchange rate is GBP/USD=1.8000  - value date is thus on 4th June 2024 TYPES OF FOREIGN EXCHANGE MARKET TRANSACTIONS  2. OUTRIGHT FORWARD FOREIGN EXCHANGE TRANSACTIONS  DEF – exchange of currencies at a currently specified future exchange rate (forward rate), with the currencies being actually exchanged at a specified future date  - these in the interbank market involve the purchase/sale of foreign currency with delivery and payment between the banks being traditionally between 1 - 12 months after the transaction date  -E.g. a 3 mtn forward contract entered into on 2 nd June 2024, will be for a value date 2 working days after the 3 mtn anniversary --- 4th Sept 2024  -futures contract transactions - follow the same trading principles as the outright forward transactions, including in terms of value date determination TYPES OF FOREIGN EXCHANGE MARKET TRANSACTIONS  3. SWAP TRANSACTIONS  DEF - a swap transaction is the simultaneous purchase and sale of a given amount of a particular foreign currency for two different value dates, with the same counterparty  - e.g. the purchase is delivered spot and the sale is a forward delivery  -there are many kinds of swap transactions,;  a. Spot against Forward – a dealer buys a foreign currency in the spot market and immediately sells it (same amount) in the forward markets, using the same counterparty  - diff is the value dates of the two transactions  b. Forward-Forward Swaps - a dealer buys a foreign currency in the forward market and immediately sells it (same amount) in another forward market, using the same counterparty – (speculator vs arbitrager???????) TYPES OF FOREIGN EXCHANGE MARKET TRANSACTIONS  c. Nondeliverable Forward Contracts – these are swap contracts where the currency being bought and sold forward is not delivered, but the transaction is settled in USD on the value dates.  - the forex being bought and sold is never delivered  - CROSS RATES COME TO PLAY!!!!!  - they have the same characteristics and documentation as forward contracts.  -used for currencies whose countries have significant exchange controls – e.g. emerging market currencies ; e.g. Renminbi in the mid-2000’s  - nowadays @70% of the NDF transactions are “speculative trades”  USES OF FX MKTS BY MNC’S International companies use the foreign exchange market to: 1. Convert the currency of one country into the currency of another. - MNCs need to pay for imports in foreign currency and exchange foreign currency receipts for local currency the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies. - they must pay a foreign company for its products or services in its country’s currency. -they must convert income received from abroad into their local currency they have spare cash that they wish to invest for short terms in foreign currency money markets. - mainly SPOT MARKET TRANSACTIONS (very rarely will MNCs get involved in currency speculation (the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates)) USES OF FX MKTS BY MNC’S  2. Hedge against foreign exchange risk  -helps coys to mitigate/eliminate the adverse consequences of unpredictable changes in exchange rates  - buy or sell currencies forward depending expectation of exchange rates  - e.g. class  3. Get foreign currency loans  DEF/HOW - where the buyer in an international trade transaction purchases a letter of credit or bankers’ acceptance from a forex market participant in favour of the sellor, and thus the sellor can use this to approach their own bank to obtain a working capital loan to produce the goods and release them to port for shipping SUMMARY THANK YOU