Module 12 - International Foreign Exchange & FX Market PDF

Module 12 - International Foreign EX & FX Market Part A. Exchange Rates The main functions of FX market: - Facilitate Cross Country Payments: From imports, exports, financing flows. Exchanging one currency for another - FX markets do not arrange loans - Need because countries like to issue the...

Module 12 - International Foreign EX & FX Market Part A. Exchange Rates The main functions of FX market: - Facilitate Cross Country Payments: From imports, exports, financing flows. Exchanging one currency for another - FX markets do not arrange loans - Need because countries like to issue their own currencies but also like to trade and have financial dealings with other countries - Reveal value of currencies: Price discovery - Allow traders to manage their FX risks: Managing risks Any currency is traded in the foreign exchange and that’s it We consider the wholesale FX market: - Not the retail mkt where you would acquire currency for a trip - Mostly trading of currencies between banks, Aus banks trading amongst themselves and overseas banks. - Largest financial market when valued by turnover. - Wholesale clients Exchange Rate Quotations FX Mkt Standard currency codes Exchange rate is the rate at which we will exchange one currency for another USD, EUR, JPY, GBP, CHF, AUD, CAD (1st 2 #s = country, 3rd # = Currency) Exchange Rates Most commonly expressed in terms of USD due to it’s role in foreign trade The trade weighted index values the AUD against an index of foreign currencies weighted according to their role in trade with our country. - Weight them according to their role in their trade - Approx 3rd of foreign trade is with china and then japan - Provides broader measure of whether AUD is appreciating or depreciating against the currencies of its trading partners. - Weights placed on composition of AUS merchandise of goods and services trade - TWI very similarly benchmarks and follows Exchange Rates - If one currency becomes strong, it might make other currencies weaker - The movement of the TWI, shows how value of AUD changes in relation to currencies included in index in relation to their weights. - It is a wider based measure of the value of the AUD than bilateral exchange rates such as the value of the AUS relative to USD. - We don’t want to see how strong the AUD is compared to one currency we want to see how strong it is compared to a range/whole basket of currencies representative of our trading partners worldwide. Seem currencies are very infrequently traded and so have to trade in terms of USD. Approx. half of world’s trade involve USD on one half of the exchange Aus big focus on trade is CHF and JPY. More things you buy with another country, more valuable that Floating Exchange Rates currency becomes. Prior to 1970, currency values were fixed - Gov or central bank would tie official exchange rate to another country’s currency or to price of gold. - No fluctuation Now developed financial systems float their currencies (AUD changed in 1983) - Exchange rates are set by trading in FX markets. Determined purely y supply and demand. Demand increases, price decreases. - Result in more short term volatility of rates and less periodic adjustments. Exchnage rates act as prices in economy and determine domestic value of: - Goods & Services bought and sold in foreign currencies - Foreign assets and liabilities of local entities Usually exports favour low exchange rates as they receive more AUD for $1 of local currency where as importers prefer high ERs as they can buy more with $1 of local currency though businesses in general prefer stable rates. Floating currency requires businesses to understand FX Risk (Volatility of the rate) Currency Pair Assume you’re in Aus - Australia = home currency - USA = Foreign currency - Aus Dollar = Base currency= one unit - 1 AUD = 0.6812 USD - Also: AUD/USD = 0.6812 Currency on the left is always one unit and one on left is always the base or home currency. Currency on right is the quote or counter currency Indirect Quote: Quote expressed in terms of domestic currency - AUD/USD 0.6812 Direct Quote: Quote expressed in terms of foreign currency - USD/AUD 1.4680 - USD/AUD = 1/0.6812 = 1.4680 Easier to compare with home or base currency first Exchange Rate Changes An appreciation of base currency is shown y an increase in its value eg. - AUD/NZD 1.0700 increases to AUD/NZD 1.0800 (AUS DOLLAR CAN BUY MORE NZD) - Equivalent to a depreciation of the foreign country - NZD/AUD decreases to NZD/AUD 0.9259 Bid-Offer Quotes and Midpoint Rates FX Dealers quote bids (Buying Price) and offers (Selling Price) Suppose a dealer quote AUD/NZD 1.0700 (Bid) — 1.0706 (Offer) - If counterparty decides to Buy $10mill AUD, they will pay - AUD $10mill * 1.0706 = NZD $10,706,000 - To buy, they would need to buy AUD at the offer price being 1.0706 It is convenient to refer to a midpoint which is halfway between the bid and offer rates - In this case, AUD/NZD 1.0703 Example An FX Dealer provides a quote of AUD/USD 0.7320-7330. Calculate how much AUD a seller of USD 5million would receive Need to convert to USD/AUD by 1/0.7330 = 1.36425648 The seller of USD, would receive $6,821,282.4 AUD To check: 6,821,282.4*0.7330 = USD $5mil American dollar is stronger than AUD as you need more Aussie dollars to get one USD and you need less USD to receive one AUD and so you should receive more AUD than 5mil Part D. The Aus FX Market This is the FX trading conducted in Aus - Wholesale & OTC - Fx dealers in AUS (mainly large banks & foreign banks) have been licensed by ASIC to trade FX - Large dealer organisations employ many traders (aka dealers) who specialise in making the market for a currency pair - Have to be licensed by ASIC to trade in foreign exchange Global Market Share Spot Market: Where currencies are traded for immediate delivery (around 35%) Forward Market: Where contracts are made to buy or sell currencies for future delivery (around 12%) Swap Transactions: Involve a package of a spot and forward contract. [HALF TRADES IN MARKET] - DERIVATIVE SIMILAR TO OPTIONS AND FUTURES US has largest currency turnover Counterparties of FX dealer in Aus are majorly overseas banks, then local banks and others including importers, exporters & fund managers Trading has two purposes: - Dealers making a market for counterparties & dealers trading to manage their inventory Main Reasons for Importance of AUD Australia’s time zone impacts the importance FX is traded on a 24 hour basis and the Aus market (along with Singapore, HK, Jap and NZ) enables trading until the London/European and then US markets open. When the rest of the world is not trading, Aus markets are. Aus foreign exchnage market doesn’t require AUD to be used as the home or quote currency. Any currency can be traded Main reason for volume trading in AUD (majority occurs in London and US) is it tends to have a positive relationship with global commodity prices which differs from the major currencies (USE, EUR, JPY and GBP) which makes currency popular with speculators and hedgers as they can better hedge and speculate commodities form our big numbers of exports Trading & Settlement Arrangements Most FX trading is conducted using electronic brokering systems (EBSs) rather than phone These are order driven inter dealer FX trading systems where anonymous bids and offers are accepted, displayed and matched. Their advantages are: 1) Price discovery is more transparent 2) Lower cost & narrower spreads 3) Integration of front & back office functions - Front is where trading takes place & back is where administration is Time Zone Effects FX is 24 hours but trading occurs through these hours in different time zones as some markets are closed This has increases the trading in our time zone - Aus FX market is among ten most active markets along with Singapore and HK - These markets operate when London and US markets have close. Trading in Aus Market About half of Aus market trades are for AUD The next most poplar are EUR/USD, USD/JPY, NZD/USD Note importance of third currency from overseas counterparties wishing to trade in Aus F when UK & US markets are closed Part E. Explaining Exchange Rate Movements Not a single theory for predicting rates and movements but some theories are: All theories interrelated. 1) Purchasing Power Parity Long run theory that assumes trade flows (money going into foreign currency and items flowing back to AUS) will force adjustments to exchange rates so that comparable goods will cost the same in each country. - Also known as ‘Big Mac Index’ of exchange rates - Explains currency will be stronger or weaker due to a flow of trade between countries - Value of currency/exchange will increase based on higher demand for that currency - Big Mac Index: E.g. Big Mac in Aus and US cost same amount of $1, implying exchange rate should be on par at 1 for 1. Use Big Mac for sake of global awareness and identification. - Eg. Things happen in Aus (inflation) and so price of Big Mac rises and US economic conditions stay the same - The AUS burger is now worth more meaning you could make money by going to US, buying numerous Big Macs and bring them back to AUS and sell them at a profit. As everybody does this, there will be a bigger demand for US as more people are buying in USD. Supply will increase and demand will decrease for AUD as more people are selling their money to buy US. As more US is needed, USD appreciates and you will need more AUD to buy one USD, thus depreciating the AUD. - Foreign currency/other currency, will continue to appreciate until comparable goods cost the same. - Their relative purchasing power of two currencies depends on their relative inflation rates - Eg. If inflation in Aus is 7%, and 5% in US, PPP would predict a depreciation of the AUD, as people have less PPP - Big Mac in AUD * Exchange rate = USD Big Mac Price - PPP is not a good predictor of rates, especially ST, but has some validity as an influence over long periods. 2) Interest Rate Parity Theory says that exchange rates are expected to move to offset difference in interest rates to equalise effective interest rates So, a currency with a low interest rate, will be expected to appreciate and vice versa - Eg. Rjpy + expected change in JPY/AUD = raud IRP may or may not be relevant over LT but within any case, it is not a good predictor of ST FX movements Explain Two Conflicting Propositions Regarding the Influence of Interest Rates on Exchange Rates - IRP theory is the expectation that exchange rates will move to offset the differences in interest rates, overall, equalising the effective interest rate. - According to IRP, countries with relatively lower interest rates can be expected to experience an appreciation in the value of their currency - An alternative proposition however, is that an expected increase in interest rates will be accompanied by an appreciation as international investors seek greater international capital gains than what is achievable in their domestic economy/market. 3) Commodity Prices and the Terms of Trade A country’s terms of trade re the ratio of it’s export prices relative to import prices Increasing terms of trade shows greater demand for the country’s exports. This results in rising revenues from exports, as people buy more, which provides increased demand for the country’s currency and an appreciation of it’s value Explanation is particularly relevant for countries where exports differ from imports, as in Australia, because most exports are commodities but manufactured goods and services are the main imports. Explain how a country’s terms of trade re calculated and identify the main factors impacting Australia’s terms of trade - Terms of trade is the ratio of a country’s exports over import prices. - Terms of Trade = Export Price Import Prices - When more capital is leaving the country then is entering (imports>exports), then the country’s TOTAL is less than 100% - Aus major exports are mineral and agricultural commodities and these are only a small amount of our imports. Upwards movements in commodity prices improves Aus’s terms of trade, whereas downward movements mean Aus does less well from international trade. - Heavily exporting = very high terms of trade, more demand for AUD - High exports = bigger demand = stronger currency 4) Currency Account Balance Value of exports including financial transfers MINUS Value of imports including financial transfers = Current Account Balance Current Account Balance = Export Value (+FT) - Import Value (+FT) Current account balance can be in deficit or surplus, Aus tends to be surplus as we export more than we import Countries with accumulated current account deficit, have to service that debt. If traders become concerned about the capacity of a country to service it’s liabilities, this can trigger selling of that currency When the debt is paid off, the currency’s value tends to depreciate as country would need to borrow money to pay for that debt. Not important influence on AUD. 5) The RBA RBA trades AUD because it does not believe the market always establishes the currency’s true value RBA focuses on episodes where exchange rate has been clearly overshot. Thus, it is large but infrequent intervention achieved by trading USD/AUD. RBA would buy AUD and sell USD when they believe AUD is undervalued and sell AUD and buy USD if they believe AUD is overvalued. Can we Forecast the AUD? Dealers attempt to forecast intra-day price movements based on order flows and market reaction to new but do not attempt LT Forecast Economists who attempt to forecast LT generally perform poorly Movements in exchange rate are random and volatile to pose considerable risk and provides motivation to hedge future transactions ST yes it can be speculated, forecasted but LT not accurate. Encourages derivatives and risk prevention due to uncertainty LT. Workshop Notes Options give you high leverage As stock price increase, call options have high profits as the long position holders will buy at a lower price and can sell at a higher price Pay option premium + exercise price and so they would enter the contract as a long position holder of a call option, because they believe the share price will exceed the total value of this, at the option’s expiry date. BAB futures managed ST interest rate risk. LT interest rate risk is bond futures. Risk also managed through options. Part B. FX Contracts Currency Pair EG. 1 AUD = o.6812 USD - AUD/USD = 0.6812 - Currency on left is always home currency and one unit - Currency on right is the quote currency Indirect Quote: Quote expressed in terms of domestic currency - AUD/USD 0.6812 Direct Quote: Quote expressed in terms of foreign currency - USD/AUD 1.4680 FX Contracts FX contract are agreement to exchange a specified amount of one currency for a specific amount of another Contracts re distinguished based on settlement date - Spot FX Contracts - Spot contracts are for the exchange of currencies in two days (T+2) based on the agreed spot exchange rate. Y = 10 x 9 67 15 = 6 775 mil USD.. - Settlement is complicated with different tie zones - Dealers store FX reserves in low risk securities - Forward FX Contracts - Forward contracts are the exchange of currencies at any time after the spot settlement date of T+2 - Most are arranged on a monthly basis with settlement on the monthly anniversary of the spot settlement date - Dealers will try to match amounts of FX bought and sold for each future date - Any net requirements are covered by holding securities in those currencies that mature on the settlement date. Calculating Forward Exchange Rates The forward exchange rate is the spot rate adjusted for delayed settlement (Necessary when the interest rate is different in the two currencies) F is forward exchange rate S is spot exchange rate rt is the interest rate for the forward period Example: Calculate the 90-day forward exchange rate given the spot exchange rate is AUD/USD0.6725, and 90-day interest rates 300 days * am are 3% in Australia and 2% in the USA* Sbace/auste Fouse/quote = (1 + rate timeora = FAUD/USD = 0. 67251 + 0 1+0 * forward rakes currency of higher. 85(901305)). 82)* int trades as a disum = 1 6759. * AUD forward exchange rate I lower than spot exchange rate due to higher interey  Example: Calculate AUD/NZD 90 day forward rate ER if Spot ER is AUD/NZD 1.1250, the interest rate in Aus is 3.25%pa and NZ interest rate is 2.25%pa. DAVD depredes as AUS Fancel quot = Space ) 1+ = (0 325 x. int. rate is 98/365) When 1 1112 in practice Spacelquste # base/auste = , l quoted of forward 1 1772-1 1750.. = 0 5018. point - : 28 % Me orwand arency rac, hasbase un, 28bo n Remum TradeShe disc. * Forward exchange rates , higher paint ↑ ag / Ox * & Example: Calculate 1 yr forward ER between AUD and Indonesian IDR when spot ER is AUD/IDR 10,228 Aus Int rates are 2.5%pa. And Indonesian Int rates are 6.8% PA 10 , F = 225/10 365 10 , 657 Forward Point = - = F - 429 apprecingates -Tradi Pren , S 10657 BUD - 10228 point um at forward Forward Points Forward rates are quoted as forward points above or below the spot rate - Forward Points = Fbase/quote - Sbase/quote Differences in interest rates, are a major driver of Exchnage rates Carry trade: Invest money in countries with low interest rate. Can’t make a profit from this in the long term as the exchange rate has to change by appreciating or depreciating to prevent arbitrage. FX Swaps An FX swap is combination of 2 FC contracts (with different settlement dates) taken simultaneously that arrange the exchange of currencies at agreed period. Exchnage rate risk, if AUD has depreciated against USD. If it has, it will cost more AUD to reap any a loan in the foreign country being compared. If AUD depreciates in a years time, to protect, firm can enter a sell/buy FX swap where there is an agreement to sell USD now at spot rate and buy USD back in a years time at the forward rate. Example: Using FX Contract to Manage FX Risk ExposureHedging AUD trading at premium Hedging with an FX swap removes the advantage of the lower rate and the effective interest. Cost becomes the local interest rate.