chapter 2 The Foreign Exchange Market The forcign exchange market is larger, in terms of trading volume, than any INTRODUCTION other market, financial or otherwise. In fat, it dwarfs all ofthe other markeo. Every transaction involving international trade or investment must go through the forcign exchange market, since there transactions involve the exchange of currencies. This chapter provides a general overview ofthe institutional aspects af the foreign exchange market and exchange rate concepts. The objectives of ths chapter are: OBJECTIV To describe the basic features of the foreign exchange market. To idemify market participants and traded currencies. To introduce some exchange rate concepts. To describe the Australian foreign exchange market To introduce some foreign exchange jargon. 25 Scanned with |\CamScannerThe Foreign Puchange Market 2.1 Definition and Characteristics yee marker isthe marher in which wold agains one another, This mathet * market and not the “foreign cutrency rmodity’ that is traded on the market is mote appropriately called “fore The foreign exch ly a mall part of wha be exchange’ than “foreign currency’: the latter i traded. Forcign exchange consists mainly of bank depenits denominated i Sill, the term “foreign currency’ will be used interchange ably with the term ‘foreign exchange’. ‘The forcign exchange market is characterised by being the largest and most petfoct of all markets. It is the largest in terms of trading volume (turnover), which currently stands at over one wil US dollars a day.’ Ie the most perfect market because it possesses the requirements for marker perfection: a large number of buyers and sellers, homogenous products, free flow of information, and the absence of barriers to entry.’ Its importance stems from it function of determining a crucial macroeconomic variable, the exchange rate, which affects to a considerable extent the performance of economics and businesses. This market is needed because every international cconomic transaction needs a foreign exchange transaction, Unfortunately. however, its function of exchange rate determination is not very well under- stood in the sense that economists are yet 0 come up with a theory of exchange rate determination that appears empirically valid. ‘The foreign exchange market is an over-the-counter (OTC) market, as participants rarely mect and actual currency is rarely seen.’ Ie is an OTC an international market that is open around the clock. The market consists of a vast worldwide network of buyers and sellers of currencies operating from approximately ewelve major centres and tens of minor ones. This poi further elaboration, Because major foreign exchange centres fall i time zones, any point in time around the clock must fall within the bus hhouts of atleast one centre. This point is illustrated by Table 2.1 which lists the official working hours (in GMT) in major financial centres. It can be seen that the twenty-four hours are almost covered by these centres, starting with Far Eastern centres (Sydney, Tokyo and Hong Kong), passing through the "Im April 1995 che Bank for International Sertements super a survey of frcgn exchange markets in twenty-six which revealed tha che daily tumover in the markets surveyed was USD1190 billion. For detail, see the 1996 Annual Reor of the Bank for International Setements 2 The foreign exchange marke is made up ofa vast numb of panicipans, The products traded on the farcign ‘exchange matket are currencies: no matter whete you buy your dlls or pounds they ate alway the same, ‘There is no restriction on aces to information, and insider tading is much Ks important than, for example, in stock market. Finally. anyone can paricipate inthe market co rade currencies. » Financial matkes ean be one of two kinds: organised exchanges and OTC markets. In an organised (like a sock exchange) the market has a physi location where buyers and sellers can mec. Brokers markets act on the floor of the exchangs, and this i why they are called floor brokers. Thete is, on Ino physical location for OTC markets. fend, buyers, sellers and brokers contact each other via means of | communication (telephone, fa, e-mail et) +The most important cettes, in terms of ramover, ae London, New York and Tokyo. INTERNATIONAL FINANCE Scanned with |CamScannerod Le Middle East (Wahrain), across Burope (Vrankfor ond) de passing through the US centres, ending. ap with Sen Franc TABLE 2.1: Wa foreign exchange centres Contre time (GMT) Cling time (OM 0100 O70 0100 om Hong Kong, 0200 1000 Singapore 0300 1130 Bahrain 0530 1030 Frankfurt 0730 1530 Londo 0830 1630 New York 1300 2000 Chicago. 1400 2100 San Francisco 1530 300 2.2 Market Participants Market participants are foreign exchange traders, the agents who, ditcctly or indirectly, buy and sell currencies. ‘These clases of participants enter the market as arbitragers, hedgers and speculators. Arbitragers seek to make riskless profit by exploiting exchange rate anomalies. Hedgers hate tisk (jie. they are risk-averse) and so they enter the matket to cover an open position to avoid risk.* Speculators, on the other hand, bear risk deliberately by taking decisions involving open positions to make profit if their expectations ate correct. We will come across and elaborate on these concepts later, but for the time being we concentrate on the institutional classification of market participants. There are five broad categories of participants in the foreign exchange market: customers, commercial banks, other financial institutions, brokers, and central banks, Customers include individuals and companies utilising the services of commercial banks to buy and sell foreign exchange in order 0 finance international trade and investment operations. ‘Thus, customers clude, inter alia, exporters, importers, tourists, immigrants, and investors? Customers are price-takers in the forcign exchange market, which means that 5 This is why the fist task ofa forign exchange dealer on artval at work in the motning.is 10 find out what hopped wile he she ws sep avernight. Some kak and ancl instuions may fr ths son operate cling room of install the necesary hardware (Reuters scren, et) in their deales’ homes. Otbers ray delegate the tak co foreign afliates or subsidiaries in ative time zones. * An open postion arises, for example, when an imponer has to meet a frcign curtency payment which is due some time in the future. This postion can be covered, for example, by buying the foreign cutency forwatd * Exporters sll the foreign currencies they obtain by selling their products abroad. Importers buy the f currencies they need 0 pay forthe foreign goods they buy. Tourists going abroad buy foreign currencies whi those (orcign tourists) coming from abroad buy the domestic eutreny to pay for cei living expenses while they are on holiday. Immigrants buy foreign curcncis when they transfer funds to relatives in thee home counties. Finally investors buy and sll cuecncies as part of their acquisition and disposi of asets INTERNATIONAL FINANCE Scanned with |\CamScannerThe Foreign Exchange Market they buy currencies at the prices (Le. exchange rates) determined by: enarke makers mak Lange commercial b er8) bey he mathet (he, they are pice nanding teady to buy and sell e rencies at the (bid and offer) exchange eaves n the retail sace they declare, acting via theit ‘commercial hanks deal with customer, the wholesale side they dea! in the her banks, Commerce ‘banks participate in the foreign exchange market mainly as speculators, trying to make short-term profit by getting exposed to foreign exchange risk.’ They cxccute this function via the ‘dealing desk’ or ‘dealing room’ which houses a group of dealers who may specialise in the trading of a particular currency, group of currencies oF a panicular type of transaction? Other financial institutions (such as investment banks and mutual funds) and large companies may deal direaly by conducting thet forcign exchange operations themselves and not though banks, Commercial banks, other financial institu large companies deal with each other in cwo ways. The direct way is to telephone another dealer diteetly, of to contact him or her via an electronic dealing system. Otherwise, dealing can be carried out indirectly via a broker, thus preserving anonymity. ‘The function of a broker is to spread market information and to bring together buyers and sellers with matching needs. Brokers differ from dealers in that they do not take positions themselves, but obtain their ‘living’ by charging commission fees. Major brokerage houses are global in natu servicing the interbank market around the clock. lly, central banks participate in the foreign exchange market because they act as bankers for their governments and also because they run the ‘exchange rate and monetary policies. All of these functions require market participation. For example, under a system of managed floating, central banks often intervene in the foreign exchange market by buying and selling. currencies, with the objective of ‘smoothing out’ exchange rate movements or 10 prevent the domestic currency from appreciating oF depreciating excessively.” ‘The orcgn exchange markt is dominated by interbank operations, the buying and selling of currencies among banks. The Bank of England’s 1995 survey of the foreign exchange market in London (which was part of the Bank for International Settlements’ global survey) reveals the dominance of inter- bank transactions in both spot and forward trading. This is demonstrated in ‘Table 2.2 by curreney traded. retbank ot the wholesale market, ie. with ns and * Commercial hanks aim a making poi ia speculation when they defor tet own accouns. They also make rote from customer y using the bidofe spread (ce sction 2.4 * Onc of dhe mont important component ofa ding rom the Reuters Monitor, which dplys exchange rates anu ec incl variable ay wells inancal and clean nes rom all around the wold. The provider of this servic, ewes, few fiom a snull Eaopen company wing courier pgzons in 1850 10 a workdwide compre information ser. The Rewters Monitor was lunchal in 1973 follwing the shift to floating xchange rats. In 1981 the Reuters Monite Dealing Sytem was lunchel. Snir servies are offered by Telente For mote deus om cental hank intervention, sce Chapter 4 INTERNATIONAL FINANCE Scanned with |CamScannerTABLE 2.2: Distribution of spot operations in the London foreign ex Other financial Interbank non USD/DEM #43 " 44 SDIPY 81.0 44 SDIGRP, 83.7 104 USDICHE 71.9 237 JSDIAUD 125 CAD 3 78 90 USD/FRE 7 339 73 USDATL 222 68 Source: Thomas (1995). 2.3 Traded Currencies “The size of the (global) forcign exchange market is measured by the sum of daily turnover in foreign exchange centres around the world. The three largest foreign exchange centres are London, New York and Tokyo, A survey of foreign exchange markets by the Bank for International Settlements in April 1995 revealed that London had consolidated its position as the world’s leading forcign exchange centre with a daily tumover of USD464 billion, 60 per cent higher than the USD290 figure recorded in April 1992. This amounts to 30 per cent of the global turnover. New York and Tokyo recorded USD244 billion (16 per cent) and USD161 billion (10 per cent) respective The following analysis is based on the figures revealed by the Bank of England’s survey of the London foreign exchange market. These figures are summarised in Table 2.3 with comparable figures from the surveys of 1992 and 1989." It is important to note that the percentage shares do not add up to 100 because of the bilateral nature of trading, For example, the 80.6 per cent share of the US dollar in 1995 contains the USD/DEM trading, which accounts for 21.1 per cent. The latter is also included in the 29.4 per cent share of the DEM. TABLE 2.3: Percentage shares of total trading in London Currency 1995 1992 1989 US dollar 80.6 717 89.0 Japanese yen 16.0 23.9 31.0 German mark 294 35.8 27.0 UK pound 19.2 147 170 Other currenci 72 9.0 5.0 Nore: Figures are adjusted for double counting of domestic interbank business. «+ Includes ransactions in the European currency unit (ECU). © For more dena, see Thomas (1995). INTERNATIONAL FINANCE Scanned with |\CamScanner20 The Foreign Exchange Market Traded currencies may be classified inte the follow 1. ‘The US dollar is the most heavily traded currency for the following awone (i) the US fi wnanly seal as a means of settling inte hers are very lange: (i) it ig predomi national transactions; (iti) it ie major component of international reserves: and (iv) it is the most widely the retail level internationally.” Ald hh the importance of the dollar has declined on all counts, i still accounts for amore than 80 per cent of daily turnover The mark and yen ate heavily traded because of the eco and trade importance of Getmany and Japan. However, the trading of the yen does not reflect the relative size of the Jap role Japan plays in international trade, In 1995, accounted for 29.4 per cent and 16 per cent of daily wmover respec- tively. These ate examples of hand’ cuttencies, strong and well-supported thy reserves and, therefore, easy to convert into other currencies, The pound is still heavily: traded despite the decline of the United Kingdom as a major economic power, This may reflect the historical importance of the UK eurreney, which played a more important role in. the international monetary system under the gold standard than the dollar played ander the Bretton Woods system. In 1995 the pound accounted for 19.2 per cent of total trading, up fiom 14.7 per cent in 192, Ay Currencies that at cotlers, ‘These include the curren lands, Hay an Canad, 5, Currencies that ate heavily traded locally, while internationally they are tradal for the purpose of financing exports and imports. These include the currencies of Australia, New Zealand, Hong Kong, Spain, Belgium, Austria, Norway, Sweten, Denmark and Finland, orld currencies that ate traded almost entirely on a local basi ee sometimes called ‘sof’ or “evotic? currencies to indicate that accepted cutteney ¢ economy oF the ye mark and yen Incavily trade! in eettain centres but lack liquidity: jay es of Switzerland, nee, the Nether- These they are not widely traded! or used as common settlement curren 2.4 The Spot "The fimetion ofa market is the determination of the price of the commodity 9437 in which it is traded. The commodity that is taded on the foreign exchange B marker fs foreign cachang various currencies, For simplicity, we will just call them currencies, s denominated in currencies and bank depo ther 194, the author filed nisctaty eo pera some officials at the Australians Ema’ to accept Australian dollars stent a US do Some of the tra cute 1 Os the French Oa visit wo Hanoi in Nowe {purchase of some snall items from the einbay. The offical ‘on payee is have nighnan Australian + use by forsign exchange traders, For examples th dollar is la the pound i Cable the New Zealand dllar is Atri, and the INTERNATIONAL FINANCE Scanned with |\CamScannerThe Bilateral Spot Exchange Rare A foreign exchange caurrency and sella ‘ypically (but a foreign currency, The price currency in teen called 4 bilatcral exchange rate, because tw curtencies are involved in the tranaacrion. Confusion may arise because the exchange rate is the price of one hind of money in terms of another kind of money When the exchange of currencies takes place immediately, the underlying ‘operation is called a spot transaction, and so we define the spot exchange rare as the rate applicable to transactions involving immediate exchange of the currencies. The word ‘immediate’ means different things. When you use the services of a money changer at Melbourne Airport to exchange some Austra lian dollars for Hong Kong dollars because you ate going on a tip to Hor Kong, you obtain the Hong Kong dollars that you have bought immediately, ‘meaning at once. This is also called a cash transaction. However, in interbank transactions, the exchange of currencies does not take place at once, but rather in two business days." When a transaction berween wo hank dealers is concluded today, each bank will in two business days credit the other's account with the prescribed currency and amount agrced upon. This is still regarded as an immediate delivery, and so the underlying exchange rate is a spor exchange rate." If the delivery takes place some time in the Future, then the underlying operation is a forward transaction, “There are variations, however. When the delivery date is thece days away, the transaction is described as ‘spot/next’. If, on the other hand, the settle- ment takes place the following day, the transaction is ‘tom’ which is short for ‘tomorrow’, Another variety is a ‘tom/next’ transaction. An example of such 2 transaction is when a trader sells the US dollar and buys the Australian dollar today for settlement tomorrow, while atthe same time buying back the US dollar and selling the Australian dollar for settlement next da The delivery of currencies does not necessarily require the flow of a draft ‘or a cheque, Settlement of interbank transactions normally takes place electronic settlement system such as SWIFT, the Society for Worldwide Financial Telecommunication. SWIFT, which began operations in 1977, connects over three thousand commercial and investment banks in over sixty ‘countries. Spot Rate Quotations ‘The spot exchange rate is the price of one currency in terms of another for immediate delivery. The commodity that is traded is a currency, but the price is expressed in terms of another currency. Thus, the exchange rate between ‘wo currencies, and y, can be expressed as xy, that is, the number of units "A busines day is a day on which banks and other fotcign exchange market panicipants ate open for busines. "Yo dates are involved in such a transaction, The fis, called the contact date, is the date on which the texnsction is concluded at the exchange rte prevailing on the same date. The second, which fills ewo business days later, is called the delivery of value date. The exchange rate preiling in the market may actualy change bbenscen the eo dates but, io matter sehat happens. the exchange of the currencies takes place a the exchange dd. fate agreed upon when the transaction i INTERNATIONALam The Foreign Exchange Market of x per one unit of x J, the number of wri Obviounly, the two rm are related because aay xiye yix at if /y tives, then this wold What is important indicate an appreciation of y and a depreciation because a larger number indicates worth more than before in terms of units of x. “Thus, we refer to the rise and fall of exchange rates but the appreciation and depreciation of currencies.” When x/y changes between two po time from (x/y)y to (x/y), then the percentage rate of appreciation or depreciation (the percentage change in y or j) is given by FEW / (x/ o> 1 (2.2) Currency x will change in the opposite direction but not necessarily by the same percentage. It can be shown in general that the percentage change in currency a, &, is related to the percentage change in currency y, js by the following equation: j/4+5) (2.3) ill be equal and of opposite sign only n mathematical terms, if j= 0, then «in which means that the rates of change if the exchange rate changes slightly. 14j=1 and x=} (Example 2.1). What is Used in Practice? Obviously, it can be confusing if two foreign exchange dealers trying to conclude a transaction to exchange two currencies express the exchange rate differently from each other. In other markets, are expressed as the number of units of money per one unit (which could be a dozen, a kilo, a portion, etc. of the commodity. So, we say that the price of a pot of beer is AUD2. We never say that the price of one Australian dollar is half a pot of beer. In the foreign exchange market, the underlying commodity is foreign exchange or foreign currency. So, it makes a lot of sense to express the exchange rate as the domestic currency price of one unit of the foreign currency. This is called a direct quotation of the spot exchange rate (domestic/forcign or d/f)2" It is also called normal or price quotation 1 When the exchange rate is expressed as x/y, currency y is equivalent to the “traded commod "When a currency appreciates since its lit quote, it is described as being ‘firmer’. Otherwi Currencies, therefore, firm and ease. ™ In equation (2.2) the percentage change in y (j) is calculated as a decimal (eg, 0.05). To convert the decimal into a percentage it has to be multiplied by 100 (and hence we obtain 5 per cent. It is normal in finance to fefer to the percentage change (the percentage rate of change or simply the rate of change), while carrying, out the calculations on decimals. tis invariably the ease that equations like (2.2) produce the rate of change measured asa decimal, Likewise, the percentage change in y is substituted into equation (2,3) 28a decimal, This convention is used throughout this book. 1 This mathematical oddity is known 25 Siegel's paradox. % The number representing the exchange rate quoted in ditect quot is arate at which a trader is prepared to deal. An indicative quot dealer is prepared to det an approximation to the rate at which the INTERNATIONAL FINANCE Scanned with |CamScannerThe Forage PRSENTENIG Toveepresing The Wise wna Rates lateral Pachange ‘On 2 December 1996 the USD/AUD exchange rate was 0.8191. Bh 29 January 1997 this rate had fallen to 0.7673. Wh change in the exchange rate imply for the individual curr Solution This fallin the exchange rate implies a deprecation of the Australian dollar, The percentage change in the exchange rate is given by equation (2.2): 0.7673 _ oai91 ~0.0632 oF ~6.32% ‘The corresponding percentage appreciation of the US dollar can be calculated directly by using equation (2.3), which gives: (-0.0632) 70,0639, 7020675 oF 6.75% Alternatively, the appreciation of the US dollar can be calculated from changes in the AUD/USD rate which is calculated from equation (2.1) as the reciprocal of the USD/AUD rate, ic. i USD/AUD It follows that the AUD/USD exchange rate rose from 1.2209 to 1.3033. Thus, the US dollar appreciated by 6.75 per cent. AUDIUSD = because it gives the domestic currency price of one unit of the foreign currency. When the direct quotation is used, a higher level of the exchange rate implies appreciation of the foreign currency and depreciation of the domestic currency. The reciprocal of this exchange rate (foreign/domestic or Fld) gives the value of one unit of the domestic currency in terms of the forcign currency. called indirect or reciprocal quotation. It may also be called quantity (or volume) quotation because it gives the quantity of forcign curreney that can be obtained in exchange. for one unit of the domestic currency. ‘We must bear in mind that the words ‘domestic’ and ‘foreign’ are relative, What is domestic relative to one country is foreign relative 10 another. Thus, a direct quotation from the perspective of one country is an indirect quotation from the perspective of another. For example, if the ‘exchange rate between the Australian and New Zealand currencies is expressed as AUDINZD, then this is a direct quotation from an Australian perspective but it is an indirect quotation from a New Zealand perspective, The opposite is valid if the exchange rate is expressed as NZD/AUD (Example 2.2). So, what do bank dealers use and how are exchange rates reported in INTERNATIONAL Fi Lechongy Marker Scanned with |\CamScannerThe Foreign Exchange Market ‘Quotations singe Po rect and Indirect E 0.8963. talian and On 2 Deo What are thy New Zealand perspectives? Solution This exchange tate represents direct qu perspective, meaning that one New Zealand dollar (the foreign rency) is worth 89.63 Australian cents. From a New Zealand perspective, the direct quotation is her 1996 the AUD/NZD exchange tate Jirect and indirect quotations from the Au om an Australian given by RUDINZD * Dav63 = 1157 NZDIAUD = ‘This means that one Australian dollar (the foreign currency from the New Zealand perspective) is worth one dollar and 11,57 cents New Zealand, The indirect quotation from an Australian perspective NZDIAUD = 1.1157, while from a New Zealand perspective it is AUDINZD = 0.8963. Thus, the direct quotation for Australia is equivalent to the indirect quotation for New Zealand, and vice versa. practice? Normally, by using direct quotation, When European banks deal with American banks the exchange rates are expressed as the number of units of the European currency per one unit of the US dollar, hence we have DEM/USD, CHE/USD, FRE/USD and so on. This is direct quotation from a European perspective. To avoid confusion, American banks quote exchange rates in a similar manner, which is indirect quotation from an American perspective. However, when American banks deal amongst themselves, they resort to using direct quotation, USD/DEM, USD/CHF, USD/FRF, etc. There are some exceptions to this rule, however. The most notable ion is the pound, whose exchange rate against the US dollar is quoted 2" There is a historical reason for this anomaly, Before 25 February 1971, the pound was not a decimal currency as it is now (equal to 100 pence), Instead, each pound was equal t0 20 shillings and each shilling was equal to 12 old pennies. It would have been rather awkward to express the exchange rate as GBP/USD. For example, an exchange rate of 1.60 USD/GBP would have been equal to 12 shillings and 6 pennies? Another scory is that expressing the pound exchange rate in this way makes the Brits cies he old “seing bloc’ are quved in a simi ishion. These includ, inter ali, the Australian the New Zealand dll, and the Irish pus USDIGBH = 1.60, 1 follows that GBIYUSD = 0.625, This means thatthe US dollar is equal to 62.5 new UK pence. Given that exch oil shilling was equivalent 10 5 new pence. this means that the US dollar is equal 10 125 shillings. Given aso that each shilling, was equal to 12 old pennies, it follows that the US dollar would be equal to 12 shillings and 6 old pennies. » Other « doll INTERNATIONAL FINANCE Scanned with |CamScannerfeel better as it is a reflection of the pound, as the most important fore The Australian dollat exchange tater ate shoo tion.” For example, the exchange rates on 29 Janusry 19°77 as the Australian newspaper were the following: 0. guinea the | 121.97 against the yen, 1.6515 spainst the enark, snd 04753 spine dhe pound, These rates obviously represent the price of ome Awsralian dollar oy terms of other currencies, and 10 they must represent the tates express a USD/AUD, JPY/AUD, DEM/AUD and GBP/AUD respectively. The divect quotations are the reciprocals of these rates. Hence, the values of these exchange rates expressed in direct quotations are AUD/USD = 1.3033, AUD/JPY = 0.0082, AUD/DEM = 0.6055 and AUD/GBP = 2.1039. In this book, both ways of expressing the Australian dollar exchange rates are wed ‘The objective is not, of course, to create confusion, but rather to teach and train students to be flexible enough to deal with exchange rates no matter hhow they are expressed. The following question may arise: What, for example, is the USDIGBP rate from an Australian perspective? Obviously, we cannot call it direct or indirect quotation because neither of the two curtencies is the Australian domestic currency. In this case, it may be appropriate to use the expressions “American terms’ and ‘European terms’ to describe the exchange tate ‘expressed as US dollar per other currency and other currency per US dollar respectively, Hence, the USDIGBP exchange rate is expressed in American terms while the GBP/USD exchange rate is expressed in European terms. But ceven with this system, some situations cannot be covered. For example, what do we call che AUD/DEM exchange rate from a New Zealand perspective? ‘We may in this case use a more flexible system and call the AUDIDE: “Australian terms’, and so on. potted io ik The Bid and Offer Rates When dealers exchange two currencies they quote exchange rates in terms of ‘two numbers, the so-called ‘two-way quote’ or “two-way rate’. For example, a dealer may quote an exchange rate of the Australian dollar against the US dollar (AUD/USD) as 1.3230-1.3240. The first number is the bid rate, the rate at which the dealer (who quotes this rate) is willing to buy the US dollar. “The second number is the offer (or ask) rate, the rate at which this dealer is willing to sell the US dollar. The bid rate is higher than the offer rate by an amount called the spread or the margin, m. Thus, the spread is measured as the difference berween the offer and bid rates as represented by the equation m=(x/y),—(/y)y (2.4) where the subscripts a and & denote the offer and bid rates respectively. The spread is much higher in the retail business than in the interbank business because of the higher costs associated with small retail transactions. You may 2 “This isthe ease with the rates reported by the press. However, dealers use dizect quotation when they negotiate deal. INTERNATIONAL FINANCE Scanned with |\CamScannerThe Foreign Exchange Market have noticed that the bid-offer spreads reported by newspapers ate signifi- cantly narrower than thote advertised by money changers at Melbourne Airport. 7 Now that we have distinguished between the bid and offer rates, we rrvst be very careful when we convert exchange tates from direct into indirect ‘quotations. In general, the following relationships hold: 1 OM, (2.5) 1 /x),= 2.6) Oy, ‘ which means that the bid rate measured in direct quotation is the reciprocal of the offer rate measured in indirect quotation and vice versa. In order to avoid confusion, the following points must be borne in mind, assuming two dealers, A and B, or you may want to call A a dealer and Ba ‘customer. First, dealer A’s bid rate is dealer B's offer rate, and vice versa. Thus, if B agrees to A's bid rate of 1.3230, then B will sell the US dollar and buy the Australian dollar at 1.3230. Second, A's bid rate for the US dollar (1.3230) is his or her offer rate for the Australian dollar, and this is exactly what equations (2.5) and (2.6) mean Thus, if A is willing to buy the US dollar at 1.3230, this also means that he or she is willing to sell the Australian dollar at the same rate. This rate is also known as the ‘left-hand side’27 The average of the bid and offer rates is called the mid-rate, which is given by &/)=3[e/+e/p,] 27) which is normally the rate reported by the media. In the above example, the mid-rate is 1.3235. Now, we come to the definition of a ‘point’ in exchange rate quotations. All major currencies are decimal in the sense that the unit is divided into 100 parts. Thus, a dollar is 100 cents, a pound is 100 pence, a mark is 100 pfennigs and a franc is 100 centimes. A hundredth (1/100) of a cent, a pence, a pfennig or a centime is called one basis point, or simply one point.” Thus, the spread of A in the above example is 0.0010 o ten points (1.3240 minus % If there is selling pressure on the Australian dollar at 1.3230, the currency is said to be ‘trading on the lefr-hand. 2 IFA iscommined to buying the US dollar at 1.3230, this ate is lle a frm bid. Similay i isa fim offer to has emerged Because dealers quote bid rates which are lower than the offer rates. ‘Castomers ‘ge screwed’ hecause dey buy a the higher offer rate and sell ar the lower bid ate, Dealers, however, may ‘shade their rate for good customers, meaning charge a ower spread. ® Aleratively the rate x which A is willing to sell the US dollur and buy the Australian dollar is called the right-hand side. % Therefore, a point is als 1/10 O00:h of a dolls, a pound, « mark oF a Fane. Ie is however, 1/100th of a yen and an Traian lira, Notice that a point has diferent valucs depending on the undelying currencies and how the exchange rates are expressed. The value of one point when the exchange rate is expressed as USD/AUD is 1/100ch af one US cnt. When the acange refs pee as AUD/USD, on poi scl vo 1/10Dkh of one Australian cent INTERNATIONAL FINANCE Scanned with |\CamScanner1.3230). Because the spread is small, the offer ere as the number of points only (the lst tw decirna! 1,3230-40, Alo, duri move slightly, normally by: more convenient to quote both the bid and offer rates in terme of p ‘Le, 30-40. This is a shorthand quotation which lewer rnumber'.” Finally ote an exchange rate a8 means that the dealer is quoting a bid rate of 1.3230 and an offer rate of 1.3240 applicable only to round amounts of USD5 million (Example 2.3) [EESNEEEID 4 Spot Foreign Exchange Deal The following is a hypothetical telephone conversation between two Australian bank dealers, A and B, assuming that they use direct quotation (Australian dolla/forcign currency). The conversation takes place on 12 February. Bank A calling, Price on US dollar please. Thiry-forry on five. A: Five yours at chiny. B: Confirming 1 buy five million US dollars at 1.3230, sell six million six hundred and fifteen thousand Australian dollars, value date February 14, “The conversation isso bref because things move very quickly in the forcign exchange market. Dealer A identifis the calling bank and asks for a quote on the US dollar against the Australian dollar, Dealer B responds by quoting a bid rate of 1.3230 and an offer rate of 1.3240, Dealer A likes the bid rate of dealer B and accepts to sell USDS million at this rate. Dealer B confirms the transaction, stating, the relevant rate and the amount of Australian dollars equivalent 10 USDS million at thac rate, as well asthe delivery date, On that date, 14 February, Bank B will be credited with USDS million and Bank ith AUDG.615 million. Exchange rates for major currencies, with the exception of the Japanese yen and the Italian lira, are usually quoted to four decimal places in the interbank market. This is because the fourth decimal place is a point, Someximes a fifth decimal place is used and is called a pip. ‘The Japanese and Tralian currencies are quoted to two decimal places because they have small par values, Whether four, five or two decimal places are used depends on the monetary significance involved, that is, the value of the point or the pip in a transaction (Example 2.4). The Farrage Vochuongy Starker The big number (or figure) is the number which completes the exchange rate when added to the dealer's shorthand quotation. The big number in our example is 1.3200, INTERNATIONAL FINANCE ” Scanned with |\CamScannerThe Foreign Exchange Market [EET The ote Spread On 29 January 1997 the (indirect quotation) bid-« rates of the Australian dollar as reported by the Ausra Review were as follows: fer exchange jan Financial USD/AUD 0.7639-0,7689 DEM/AUD 1,2495-1,2713 GBPYAUD, 0.4696-0.4760 “The spreads (in points and as a percentage of the bid rate) and the rmid-rates are: Exchange Rate Points Per cent Mid-rate USD/AUD 50 0.66 0.7664 DEM/AUD 218 1.75 1.2604 GBP/AUD 64 1.36 0.4728 A lower spread in the case of the US dollar may indicate more liquid trading than in the case of the other two currencies. The direct quotation rates and the associated spreads are as shown below. Exchange Rate Value Points Per cent Mid-rate AUD /USD 1,3006-1.3091 85 0.65 1.3049 AUDIDEM. 0.7866-0.8003 1371.74 0.7935 AUD/GBP 2.1008-2.1295 287 -1.37,2.1152 Interbank dealing on ewo-way rates is carried out on the basis of the principle of reciprocity. When dealer A asks dealer B for a price, B may respond, in an ascending order of ‘generosity’ by: (i) not quoting a two-way rate; (ii) quoting a two-way rate with a wide spread; and (ii) quoting a ‘two-way rate with a narrow spread bue only for small amounts. Dealer B will get a similar response at another time when he or she asks dealer A for a quote. The situation is different when dealer A acts on behalf of a client who wants to buy a currency that is not actively traded. Dealer A does not seek a vo-way rate from B because A does not want £0 reciprocate in this currency. In this case, dealer B treats dealer A as a customer, in which case the former is not faced with uncertainty about whether the rate is for selling or buying. The situation may also arise when a dealer makes a mistake in quoting rates, that i, when there is a misquote. In this case, market etiquette suggests thae the calling dealer asks the quoting dealer to double-check the quote. If the quoting dealer decides to stand by the quote, the deal will go even if there is a misquote. Cross Exchange Rates A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency. Thus, if x, y, and z are three currencies, then INTERNATIONAL FINANCE Scanned with |CamScannerThe Foray In practice, « is the US dollar because exchange tates are normally expereed in terms of the US dollar, Thus, the cross exchange tate enay be defend an exchange rate between two currencies, neither of whic Analogously, cross trading is defined as the excha acither of which is the US dollar, This kind of trading is eas widespread, seed is normally: more expensive, particularly if it involves currencies that are mot hrcavily traded. This is because this kind of trading involves two transactions rather than one. In direct trading, x is exchanged for y in one transaction. In cross trading, if a direct deal is unavailable, x is exchanged for ¢ and 2 is exchanged for y. Two transactions are more costly because they involve brokerage fees and the bid-offer spreads. A bid-offer cross exchange rate may be calculated by assuming that rwo transactions take place, Let us assume that the bid-offer spreads for the x2 and y/z exchange rates are measured as a percentage, m, of the bid rates ‘Thus, we have 2),= (1+ m\(v/2), a) +m)y/2), (2.10) Assume that a customer wants to convert x into y via z. This deal involves the following two transactions: 1. Buying 2 and selling x at the rate (x/2), t0 obtain 1/ (x/2), units of 2, Buying y and sell of y This means thatz yg 2 at the rate (y/z), to obtain (7/2), / (x/2), units 41) This is because one unit of x will eventually be converted into (y/2)g/ («/2), units of y. Hence, the exchange rate berween x and y is the reciprocal of (y/2),/ (8/2) oF (x/2),/ (7/2). Since the customer is buying y, the underlying exchange rate must be the offer rate, ie. (x/y),. ‘Assume now that the customer wants to convert y into x via 2. This deal involves the following two transactions: 1. Buyir 2. Buying x and selling = atthe rate (x/2)y to obtain (x /2),/ (y/2), units of, This means that: 26 OW”, Te can be demonstrated that cross trading is more expensive by showing that ic involves a larger bid-offer spread. By di (2.11) by equation 2.12), we obtain (ly)= 2.12) ig £and selling y ar the rate (y/2), to obtain 1/ (y/2), units of z. INTERNATIONAL FINANCE ”40 The Forcign Exchange Market (/)),_ /2),072), an (iy OLY) . iy substituting equations (2.9) and (2.10) into (2.13) we obtain (x/y),_ 4 mG Se), 7 (em)? 414) Gm W078) which implies that (2.15) (x/y), = (14m)? (x/y)y “This means that the bid-offer spread for the x/y exchange rate is greater than for the rates measured against z (Example 2.5). If the spreads are different, say mand my, then (x/y),= (+m YL + mL yy (2.16) TERE) Cross Exchange Rates and Cross Trading On 29 January 1997, the bid-offer exchange rates of the Australian dollar a the Danish kroner and the Hong Kong dollar as reported by the Australian Financial Review were as follows DKK/AUD ——4.7545~4.8381 HKD/AUD _5.8785-5.9809 ‘The percentage bid-offer spreads for the evo rates are almost equal for the (wo exchange rates, being 1.76 per cent and 1.74 per cent respectively. Thus (DKK/AUD), _ 4.7545 Ori 07850) (OKKIHKD).= GiepyauD), 7 5.9809 = 0795 DKK/AUD: ¢ a 4.8381 _ 9 59539 (DKK/HKD), = (HKD/AUD), 5-8785 The spread on the cross exchange rate (0.8230 = 100% (55535 - :) = 3.52% also be calculated from equation (2.16). In this case, m, = 0.0176 |. Hence, the spread on the cross exchange rate can be calculated as “The spread « and m 100 x [(1 +m, + m,) = 1] = 100 x (1.0176 x 1.0174~ 1) = 3.53%. A customer who wants to obtain HKD1000 by selling DKK at the cross rate will pay DKK823.00. If, on the other hand, he or she wants to obrain DKK1000 by D, this will cost HKD 1257.86. INTERNATIONAL FINANCE Scanned with |\CamScannerVomvage Vahonge Mites “ Crowe trading may ah Ve vottesponal berween tH cuttencies ency, With ete domestic ‘The Austalian Financial Review and other finsnc ‘of cross tates, This is prepared for ® tates exprenad in direct quotation apsinwt &. These exc 1 £/ xy. In genctal, the cross exchange tate x,/x, can be calcutared a nge tates may be written ase / The matrix of cross rates, therefore, appears as in Table 24. It symmetrical mattix with diagonal elements equal to unity because they represent the exchange rates between each currency and itself. The half matrix below the diagonal reports the reciprocals of the exchange rates above the diagonal, TABLE 2.4: Cross exchange rates for m currencies x yOO% eee % 1 ox/sy xl [ey sae ayy Som 1 ly als tlk, x ols, yl 1 hy ily xls, ley xy als, t i i i boob bo a ' Sas al : shawn! A question that may arise here isthe following: Which exchange rate is used in practice: x,/,0F 3/4? Asa rule of thumb, the exchange rate between x; and is expressed as x, /x, when x has a larger par value, so that the exchange rate has a value greater than one, ‘Thus, itis preferable (but not necessarily what i followed in practice) to express the exchange rate between the Japanese yen and the German mark as JPY/DEM, not as DEM/PY. To use the information provided in Example 2.6, instead of dealing, with an awkward number representing the DEM/JPY rate (0.0135) its preferable to use the number 78.84 as representing the JPY/DEM. rate, Similarly, it is This is also known as trading in died currencies. INTERNATIONAL FINANCEa The Foreign Exchange Market preferable to expres the exchange tate between the pound and the yer’ JPYIGBP and not as ¢ 256.57 for the JPVIGHP GBPIPY rate, [ENTER The Cross Exchange Rates M Construct a cross exchange rates matrix on the b information P/]PY. Again, it may be preferable to use the number ate tath thet 0.0089 representing, the of the following, AUDIJPY 0.0082 AUD/DEM 0.6055 AUDIGBP 2.1039 Solution We could construct a cross exchange rates matrix which does not contain the Australian dollar, This matrix will have the form py DEM GaP gry 1 JPYIDEM —JPY/GBP DEM —DEM/JPY 1 DEM/GBP GBP GBP/JPY__ GBP/DEM 1 By using equations (2.17) and (2.18) where z is the Austra dollar, we can replace the symbols by numbers to give the matrix yy DEM GBP spy 1 73.84 256.57 DEM 0.0135 1 3.4747 GP 0.0039 2878 1 2.5 The Forward Exchange Rate ‘The forward exchange rate is a rate contracted today for the delivery of a currency at a specified date in the future. This dace in the future must be more than two business days away, otherwise the underlying transaction will be a spor transaction. If the delivery takes place one week after the transaction, has been concluded, then the underlying rate is a one-week forward rate. Typically, forward contracts have maturities extending up to one year, maturities of one month, two months, etc. If the maturity is, for example, six and a half weeks, this is called a broken or an odd date, However, forward contracts of maturities longer than one year can also be found." Forward transactions are of two types: outright forward contracts and 1A special kind of forward contact is ealled a break forward contract. This contract can be terminated at a predetermined date, thus providing protection against adverse exchange rate movements. It may also be called orwatd with optional exit’, abbreviated as FOX. INTERNATIONAL FINANCE Scanned with |CamScannerswape. An outright forward eanuns tovders iw « urrency for delivery 1 doy 27). The we in 0 opt swaps, on the oth sles 2 epeit puarcbunse np ). Kor exsenyde, a emg ‘ ) some time in the furare st an ¢ remy bonere f the ope determined now, When the revers used, Sometimes, forw selling with both offic [EEE The Mechanics of Spot-Forward Swaps On the basis of the following spot and forward AUD/USD exchange tates, illustrate the mechanics of a spot-forward swap when a dealer sells USDI million spot and buys it three months forward. Show that net cash flows are unaffected by the change in the spot rate. is om adjacent dys, the term ‘tallewer d swaps ate used, These involve buying and Spot 1.3000-1.3090 ‘Three-month forward 3015-1.3110 Solution ‘The cash flows involved in this operation are usD AUD Present 000 000 +1300 000 Future +1000 000 =1311 000 Net 0 11.000 ‘The net outflow in Australian dollars arises because of the discount con this currency. If the spor rate changes to 1.3090 ~ 1.3180, the three-month forward rate becomes 1.3105 — 1.3200. The cash flows will in this ease be usb AUD Present 1000 000 +1 309 000. Future +1000 000 -1 320.000 Net 0 =11 000 Obviously, the net cash flows are unaffected by the change in the spot rate. Forward transactions currently dominate spot transactions. The 1995 survey by the Bank for International Settlements shows thar out of a total figure of USD1190 billion for daily turnover, USD520 billion (or 44 per cent) takes the form of spot transactions, while outright forwards and swaps account for 8 per cent and 48 per cent respectively. In the London foreign exchange market, 60 per cent of the daily turnover takes the form of forward transactions (both outright and swap). While rading in US dollars against INTERNATIONAL FINANCE Scanned with |CamScannerThe Forcign Exchange Market the pound accounts for 12.2 pet cent of total turnerer, BS per cent take ve form of forward transactions. ‘The same sary goes for trading i) U% dalere against the yen and the Australian dollar (11.3 pet cent aut of Hii per covet for the yen and 1.2 pet cent out of 17 pet the Australian Aether) Convenely, trading, in US dolla againet the amark dhirwe + berger spot trading (forward trading accounts fur 9.7 pet cent cut of a tanta 211 per cent), Moreaver, swap dominate outright forward comtences, hve share of swaps out of forward trading of the US dollar againut the enark, yew pound and Australian dollar ie 87.5 pee cent, 90 per cent, 95 per cent xd 934 per cent respectively. In the trading, of the peninid apainee the Auerratinrs dollar, swaps account for GO per cent of total forward trading,” ‘Table 2.5 provides an idea of the maturity structure of forward tration tions as revealed by the Bank of England's 1995 survey of the foreign exchange market in London. Obviously, shorter maturities of one week ot fevs dominate, while longer maturities of over one year ate very tate, TABLE 2.5: The maturity structure (in days) of forward contracts Currency combination = NS7 7 Stx/y) Premium Discount Flx/y)< Stx/y) Discount Premium Par (fat) Par (flat) [LREEEZ TY Calculating the Forward Spread Calculate the forward spread in per cent per annum for the follow ing forward exchange rates. Exchange Rate Spot Forward Maturity (month) AUDIUSD 1.3200 1.3500 3 GBP/AUD 0.4700 0.4500 6 Solution For the AUD/USD exchange tate, che USD is selling ata premium, ‘The premium is calculated as Bey 100 x42 = 9.09% For the GBP/AUD exchange rate, the AUD is selling ara discount. “The forward spread is calculated as 0.45 0.47 Forward Rate Quotations ‘There are ewo ways for quoting forward rates. The first is the outright rate which is expressed exactly as the spor rate, using two numbers to represent the bid and offer rates. The second is the swap rate which is quoted in terms of the points of discount/premium, ie. the spread. When the forward rate is expressed asa swap rate, the number of points corresponding to the bid and offer rates are given for a particular maturity. Converting a swap rate into a bid-offer outright rate is simple. If the swap forward rate x/y for a particular maturity measured in terms of points is expressed as cyt, where the subscripts b and a refer to the bid and offer INTERNATIONAL FINANCE Scanned with |\CamScannerThe Fovvtgn Vavhange Marbes nuda Geororwed omnes, Fy wn Vhnartome wd eben Aallown Wary 4p. thn 9 a6 willing wt teen hy PATE REAL) TADS A019) 4 5, A000, 1 1 gs Mellow thet Pte ye The ph Phe rout that the tid 4 re wf and fler forwenrl ta Imnpiving what y is selling at x premium. Hon the onhver Yost 1 y 1 ealing at» discount, The outright forward rxvee A by wubiracting che number of pointe from eve SOLES the Obviownly, nuns toe Newer then the than the cotreupon implies urespronding var rates, Hence FOL S069) = 6 110.000 22 FAT) S019) = 6,710 000 (25) 64> 6g it follows that F079) E009). al result that the bid sate is lower than the offer rate. ind offer forward rates ate lower spot tates, implying, thar y is selling, at a diser suillolvain However, it is than the correspond (Example 2.9), EE Suppose that we ate given the following, spot and swap AUD/USD exchange rat Determine, for each maturity, the currency selling at a premium or a discon Calculate the outright bid and offer forward rates, Spot 1,3000-90 One month 5-10 ‘Three months 15-20 at it and Swap Forws Six months 25-20 Solution “The US dollar is selling at a premium (the Austealian dolar is selling at a discount) for the maturities of one and three months because ¢,<¢y For the maturity of six months the US dolla is selling at a discount because ¢) > ¢,. The following out bid and offer rates are calculated Kate Bid Offer Spot 1.3000 13090 One month 1.3005 1.3100 “Vhice months 1.3015 13110 Six months ‘The following, can be noticed: (i) in all cases the bid rate is lower than the offer rate; and (ii) except for the maturity of six months the forward rate is higher than the spot rate, implying, that de US dollar is selling, at a premium, INTERNATIONAL FINANCE Scanned with |CamScannerhe Vomege Vachiongy Mote “ The hid-ofler spread cn « forww the contract lengshens, The reason fe dn smnaller turnover, and hence it becomes difficw v0 ofa ge interbank forward market, The dl ward contracts makes them rishi th yah 4 comernct immediately after quoting the forward rate." Example 2.10 illeuraves how a forward forcign exchange deal is conducted [EXTEND 4 Forward Foreign fs ‘The following isa hypothetical telephone conversation berween #0 Australian bank dealers, A and B, assuming the we of quotation. The conversation takes place on 12 February. increases as the dey of ofhetting longes-snanariey fae The arises from uncerta 1 the price of an ofherting forw fe Deal A: Bank A calli B: Fificen, twenty. ‘As One US yous at fificen, Br OK, done, Let's use a spor of 1.3000 which i February. My purchase will beat 1.3015 for value 14 May, ‘Thice-month US dollar please for value 14 Dealer A identifies the calling bank and asks for a quote on the US. dollar against the Australian dollar three-month forward. Dealer 8 responds by quoting a swap bid rate of 15 points and an offer rate of 20 points, Dealer A likes the bid rate of dealer B and accepts to sell USD1 million at an outright forward rate equal to the spot rate plus 15 points, Dealer B confirms the tansaction, stating the televant spot rate and the value date 2.6 The Australian Dollar Foreign Exchange Market ‘The core of the Australian forcign exchange market consis of the banking, system and the non-bank dealers authorised by the Reserve Bank of Australia (RBA). The Australian foreign exchange market is highly integrated with the global foreign exchange market This integration is indicated by the fact tat about 40 per cent of foreign exchange transactions are conducted with foreign counterparties, most importantly foreign ban ‘The foreign exchange controls on the Australian dollar were lifted ancl the curreney was allowed to float on 9 December 1983. ‘The floating of the dollar was one of the frst steps towards the deregulation of Australian financial markets, Since then the Australian dollar has become one of the most actively traded currencies, having been regarded as an ‘exotic’ curtency earlier. In 1983 daily turnover of the Australian dollar was AUD2 billion, By 10 mans elated 1 pt fate eypexte to eval th y oF the fran INTERNATIONAL FINANCE Scanned with |CamScannerThe Fervign Buchange Market 1995 daily narnower had AUIS billion (LISTERS % Lrillion) of which 42 5 the Australian dollar This thet the ninth berger ond the n dollar the ninth most traded currency in the world helt n foreign exchange involves thee Australian, Anrpely trading, of major the US dollat, with the mark, yen and pound accounting for about 42. prer of voral trading, the U6 sn exchangy of the HENCiE® aparroer ‘Table 2.7 reports the percentage distribution of traded currency pairs be the Reserve Bank surveys of 1989, 1992 and 1995, More than half of hse ovet takes the form of forward swaps (USD20.6 billion), with forward transactions valued at USDI.3 billion and spot « at USDI7G billion, An indication of the extent of intep Australian foreign exchange market with the global market is thar m half of the daily turnover (USD206 billion) results from transac sv counterparties, The remaining portion is divided almost equally heaven transactions with customers (USDI billion) and with other bank dealers (USDS billion), Trading involving the Australian dollar is twice as large as the volume in overseas foreign exchange markets. daily: ion of the ons with Currency composition of turnover in the Australian foreign, ‘exchange market (per cent) TANLE 2.7: Currency combination 1989 192 1995 USD/AUD 55.2 40.3 42.0 USD/DEM 147 207 27 USD/JPY 93 178 13.3, USD/GBP. 80 86 7.0 USDINZD 22 13 3.2 USD/CHF 5.1 25 2.6 ‘Total (USD billio 29.0 39.5 Sourve: Reserve Bank of A 1995, pp. 46-7. “There are several reasons for the impressive growth of the Australian forcign exchange market: 1. Deregulation provided vast opportunites for foreign investment, ‘This is because with no capital conttols, direct investment can take place more readily, and because the resulting financial innovation provided the means of curreney risk management. . Australia’s above-average level of real interest rates generated massive capital flows into the country from the mid-1980s onwards, . Australia’s time zone contributed significantly to market growth, Austra Tian trading hours form a link between New York and early European ing “The high level of volatility in the Australian dollar exchange rates in. the initial years of the floae provided opportunities for speculation, % Soe Campbell (1998), INTERNATIONAL FINANCE Scanned with |CamScanner