Foreign Exchange

Markets
TOPIC 7
MAF306 International Finance
and Investments

Foreign Exchange Markets

Objectives
to describe how the foreign exchange (FX) market is organized
understand its role, importance & participants
to examine the distinction between spot and forward exchange
rates
to understand FX quotations and conventions
to calculate forward premiums and discounts
To consider FX arbitrage
READING
Shapiro Ch 7

Is this where you might like to

be??

An international holiday?......What role do FX markets play?

3

The Foreign Exchange Market

Why do we need FE Markets?
Transfer of purchasing power across nations
Facilitate I/N trade .ie buy stuff!
Determine ER (ie D & S in the market see
lecture 2 for factors that influence ER)
Facilitate FE stability (central bank intervention
see lecture 2)
Facilitate FE risk management (see lecture 9 & 10)
Give assistance or foreign aid (eg. Third world
countries, nations affected by natural disasters)

What makes Foreign Exchange Markets

Unique?
its trading volumes
- As of April 2014, average daily turnover in the FX market
exceeded US$5 trillion!!

the extreme liquidity of the market

the large number of, and variety of, traders in the
market
its geographical dispersion
the 24-hour-a-day trading no fixed
opening/closing times
transactions are done via telephones, computer
dealing systems, or through brokers, there is no
physical transfer of one currency for another
currency electronic book-keeping
5

Foreign Exchange Markets

Most traded currencies,
Size (per day) and 24-hour
trading

Global foreign exchange daily turnover

(measured in billions of USD, BIS Dec 2007, see Figure 7.4B, p 263 for
updated figure)

The Foreign Exchange Market

Location?
The FX market spans the globe in 2012

FX turnover: Top currencies

The Foreign Exchange Market

Location?
The FX market spans the globe
- London accounts for > 40% of the daily trading (2015)
- New York: 17.9%
- Tokyo: 5.4%

Historically, most trades by phone, telex, or SWIFT

(SWIFT: Society for Worldwide Interbank Financial
Telecommunications)

More recently, electronic trading

- Increases liquidity
- Reduces trading cost
- Makes information more accessible

10

Participants in the FE Market

Bank and foreign exchange dealers
Central banks
Individuals and companies conducting commercial and
investment transactions
Speculators and arbitrageurs
Hedgers
Central banks and treasuries

11

Organisation of the Foreign Exchange

Market

Two Types of Currency Markets

Spot Market:

immediate transaction cash market

settled on the 2nd business day after the
date of transaction

Forward Market:

transactions at a pre-specified price take

place on a specified future date

12

The Spot Market

Spot Quotations
Sources

all major newspapers

major currencies have four different quotes:
spot price
30-day forward price
90-day forward price
180-day forward price

13

The Foreign Exchange Market

The Foreign Currency Market
where money denominated in one currency is
bought and sold with money denominated in
another currency
EG. US$1 buys A$0.71
Or
A$1 buys US$1.40

14

Foreign Exchange Rates and

Quotations
In the currency market convention all

currencies are quoted in the following manner:1 unit of a currency = x units of another
currency
Example: 1 unit of US$ = JPY122.65
This quotation means that it costs JPY122.65
to buy one US$ or if one wishes to convert 1
US$ into JPY one would receive JPY122.65.
15

Depreciation/Appreciatio
n

Currency is appreciating against another

currencywhen that the currency is now worth
more in terms of the other currency.
For example:
Before
Now

1 US$ = 1.4680 CHF

1 US$ = 1.4710 CHF

The US$ is appreciating against CHF

because it costs 1.4710 CHF to buy 1 US$
now which is more than before by 0.0030
1
CHF
6

Foreign Exchange Rates and

Quotations

Foreign exchange quotes either direct or

indirect.
In this pair of definitions, the home or base
country of the currencies being discussed is
critical.
A direct quote is a home currency price of a
unit of foreign currency. (1 FC=x units DC)
An indirect quote is a foreign currency price
of a unit of home currency. (1 DC=x units FC)
The form of the quote depends on what the
speaker regard as home.
17

FX quotation conventions
American Terms
USD price per unit of
foreign currency
for example, USD
1.09/AUD1
A Direct quote in the US
An Indirect quote
outside the U.S. (e.g. in
Australia)

European Terms

Foreign currency price of

one USD
For example 108.10/US$1
An Indirect quote in the US
A Direct quote outside the
US (e.g. in Japan)

Most interbank quotations

around the world are stated in
European terms
Exceptions to this include
EUR, GBP, AUD, NZD

Direct/indirect quotes for foreign

currency
Direct quotes place the domestic (home) currency (always)
in the numerator and the foreign currency in the
denominator (d/f);
e.g. 0.0090/ for a resident of Europe OR
AUD0.917/USD for a resident of Australia
Indirect quotes place the domestic currency in the
denominator and the foreign currency in the numerator
(f/d);
e.g. 110.95/ for a resident of Europe OR
USD1.09/AUD for a resident of Australia
Direct quote and indirect quote are reciprocals
18

Reciprocal Rates
The reciprocal rate is the inverse/reciprocal of
a conventional quote.
Examples:
1 US$ = SGD 1.7650
Reciprocal rate is:

1 SGD = US$ 1/1.7650 = US$ 0.5666

1 AU$ = US$ 0.7850
Reciprocal rate is:
1 US$ = AU$ 1.2739
20

Commodity and Term Currency

Quoted currency - commodity currency or
base currency
expressed in terms of a number of units of
the other currency.
The other currency is know as the term
currency.

21

Commodity and Term Currency

Example:

(a) 1 AU$ = US$ 0.7850

(b) 1 US$ = SGD 1.7725

In (a) the commodity currency is the Australian
dollar. One Australian dollar is expressed as
0.7850 units of US dollars and the US$ is the
term currency.
In (b) US$ is the commodity currency and SGD
is the term currency.
22

The Spot Market

Transactions Costs
Bid-Ask Spread
used to calculate the fee charged by
the bank
bid = the price at which the bank/FE
dealer is willing to buy
ask = the price it will sell the currency
Percent Spread Formula

Ask Bid
PS
x100
Ask
23

BID and ASK (or buy and

sell)

Spot rate is always quoted as a 2-way price

-

Buying price or the bid price on the left

hand side

ASK/selling price or the offer price on

the right hand side.
Example: the dealer quotes spot US$/AU$1
as follows
0.7850/0.7860

or

0.7850-60 (BID)(ASK)

(BID)
(ASK or
Sell)
What does this mean (see next
slide)?

24

BID and ASKcont

The interbank dealer (also called price maker) is prepared

to buy Australian dollar against US dollars at a price of 1
AU$ to 0.7850 US$ (bid price, i.e., buy cheap)

he is prepared to sell the Australian dollars against the US

dollars at the price of 1 AU$ to 0.7860 US$ (offer price,
i.e., sell high).

Further explanation
1. For bid/buy transaction: buy AU$10,000 (i.e., pay/sell
US$) = 10000 x 0.785 = US$7850 (pay less)
2. For offer/sell transaction: sell AU$10,000 (i.e.,
receive/buy US$) = 10000 x 0.786 = US$7860 (receive
more)
In the buy transaction, the dealer wants to give/pay less
In the sell transaction, the dealer wants to receive more
25

FE Spread
The spread = difference between the bid rate
and the offer rate.
In the above US$/A$1 price, the spread is 10
points or 10 pips i.e 0.7860 - 0.7850 = 0.0010
or 10 pips
A pip/point refers to one unit in the final
decimal place to which a given exchange rate
is conventionally quoted.
In the above example, the spread is = 10000 x
(0.7860 0.7850) = US$10
26
Why is the interbank market spread is narrow
than the retail market? (Answer: see the
topic: International financial markets)

Multiple Choice Time! No 1

From the viewpoint of a British investor, which of
the following would be a direct quote in the foreign
exchange market?

(a)
(b)
(c)
(d)

SF2.40/
$1.50/
0.55/
$0.90/

Ans C

27

Multiple Choice Question Time! No 2

Assume that a bank's bid rate on Japanese
yen is $.0041 and its ask rate is $.0043.
Its bidask percentage spread is:
a. about 4.99%.
b. about 4.88%.
c. about 4.65%.
d. about 4.43%.
ANSWER: C
SOLUTION: Bidask percentage spread = ($.0043 $.0041)/
$.0043 = 4.65%

28

Multiple Choice Time! No 3

Most foreign exchange transactions are through the
U.S. dollar. If the transaction is expressed as the
foreign currency per dollar this is known as
_____________ whereas ___________ are
expressed as dollars per foreign unit.
(a) European terms; indirect
(b) American terms; direct
(c) American terms; European terms
(d) European terms; American terms
Ans d

29

Market Makers in FX Markets

Brokers/banks stand willing to trade both ways

at their buy/bid and sell/ask rate to make profit
Creates an efficient market

transaction costs of search for prices and

counterparts
Provides immediacy service at fee - the market
spread

30

Market Spreads in Spot Market

(Buy-Sell
Spread)
Buy-sell or Bid-ask
spread using direct
quotes

A$/US$

Supply (Market Makers)

SSell
S

Supply (Public)

A$1.316

So

R
E
A
D

Demand (Public)

Sbuy
A$1.300

Demand (Market Makers)

Qty of US$

A$1.316/US$ = US$0.76/AU$
A$1.300/US$ = US$0.77/AU$

31

Market Spreads in Spot Market

(Buy-Sell Spread)
Assume initially the public demand and
functions in the spot market are Dp and Sp

supply

If publics bid and ask tenders could be revealed to

each other Equilibrium at So would occur
Dmm (market markers Demand curve) - dealers
willingness to purchase US$ (with $A) from the public
Smm (market makers supply curve) dealers
willingness to sell US$ (for $A) to the public

32

Market Spreads in Spot Market

(Buy-Sell Spread)

Intersection of Dmm with Sp determines the exchange rate at which US$

are bought from the public, i.e. Sbuy
Intersection of Dp with Smm determines the exchange rate at which US$
are sold to the public, i.e. Ssell
Difference between buy and sell rates = buy-sell spread or market spread
dealers profits
Bid-ask Spread
% Spread = (Ask price Bid price)/Ask price x 100
Ask price is ALWAYS higher !

Increased uncertainty about future exchange rate requires:

demand for higher risk premium
bankers widen bid-ask spread

33

Exercise 1
Bank of Tokyo (the market maker) quotes the
following rates for: JPY/US$1 = 81.55/81.58
If you are a buyer/seller of JPY, what is the rate you
choose if you wish to buy/sell JPY?
If you are a buyer/seller of US$, what is the rate you
choose if you wish to buy/sell US$?

* Note: Bank always buys low/sells high

3
1

Exercise 1
Bank of Tokyo (the market maker) quotes the following
rates for: JPY/US$1 = 81.55/81.58
If you are a buyer/seller of JPY, what is the rate you
choose if you wish to buy/sell JPY?
(Hint: Reverse and invert to get buy/sell rates for Yen (see
p 265-266)so 1/81.58 (0.01225 US cents/1 Yen) becomes
buy rate for Yen and 1/81.55 becomes sell rate (0.01226 US
cents /1 Yen)
BoT Buyer of Yen = 0.01225 US cents
BoT Sell Yen = 0.01226 US cents
If you are a buyer/seller of US$, what is the rate you
choose if you wish to buy/sell US$?
Buyer of US$ = 81.55 yen to buy US$1
Sell US$ = 81.58 yen received for each US$ sold

* Note: Bank always buys low/sells high

3
1

Cross rates
Monday, September 10, 2012, listed the
yendollar and eurodollar rates as 78.56
and 0.7802, respectively. Suppose you
want to know the euroyen exchange rate,
how do you get this rate? i.e.

Because the dollar is the common currency

here, cancel it. Think in terms of the
currencies involved: When you divide the
eurodollar exchange rate by the yen
dollar exchange rate, the dollars cancel
and you get the euro yen exchange rate:
36

The Spot Market

Cross Rates
the exchange rate between 2 non-US$ currencies

Calculating Cross Rates (European terms)

Suppose you want to calculate the / cross rate:

You know .5556/US$ and .8334/US$
then:
/ rate = .5556/US$ .8334/US$
= .6667/
GBP EUR GBP USD
GBP

USD USD
USD EUR
EUR
37

The Spot Market

Calculating Cross Rates (American terms)
Again you want to calculate the / cross rate:

You know US$1.7999/ and US$1.1999/

then:
/ rate = US$1.1999/ US$1.7999/
= .6667/

USD USD
USD GBP
GBP

EUR GBP
EUR USD
EUR

38

Cross Rate Exercise 2

The rates given are as follows:
US$/AU$1 = 0.7250
CHF/US$1 = 1.4610
What rate is not given?
The cross rate for A$ in terms of CHF ie CHF/A$1
Given

1 AU$ = 0.7250 US$ and its reciprocal rate: 1

US$ = 1.3793 AU$

and
1 US$ = 1.4610 CHF
CHF = Swiss Franc
Q:
What is the cross rate for A$ in terms of CHF?
Q:

3
6

What is the cross rate for CHF in terms of AU$?

Given

Cross rate Exercise 2

1 AU$ = 0.7250 US$ and its reciprocal rate: 1

US$ = 1.3793 AU$

and

1 US$ = 1.4610 CHF (Swiss Franc)

Therefore,
USD

USD

Using American terms (or direct quotes)

USD

GBP

GBP EUR

GBP

EUR

USD

Q: What is the cross rate for A$ in terms of CHF?

1 AU$ = 1.4610/1.3793 = 1.0592 CHF (i.e.,
CHF/A$1)
Q: What is the cross rate for CHF in terms of AU$?
3
6

Ans.: 1 CHF = 1.3793/1.4610 = 0.9441 AU$ (i.e., A$/CHF1,

which is the reciprocal rate of CHF/A$1).

EUR

Cross Rate Exercise 3

Given

SGD/US$1

1.2835

US$/ 1

1.2165

What is the cross rate for in terms of SGD?

Hint: Need to get US$ in denominator for both!
Hence take reciprocal

3
7

Cross Rate Exercise 3

Given

SGD/US$1

1.2835

US$/ 1

1.2165

What is the cross rate for in terms of SGD?

Hint: Need to get US$ in denominator for both!
Hence take reciprocal
/US$1
=1/1.2165 =0.8220
Then use European terms
= 1.2835/0.8220 = SGD$1.5614

3
7

The Spot Market

Currency Arbitrage
if cross rates differ from one financial
centre to another, then profit
opportunities exist
buy cheap in one I/N market, sell at a
higher price in another
the critical role of available information

43

The Spot Market

Currency arbitrage: An example

The different euro/pound rates mean that there

is an arbitrage advantage of buying currency in one
market and selling it for a higher rate in another
44

The Spot Market

Triangular currency arbitrage

Note: transaction (2) has an error, it should be divided:

A$1 000 000/1.8410= 543 183

45

The Forward Market

Definition of a Forward Contract:
- an agreement between two parties for the
delivery, on a specified future date, of a specified
amount of currency against another
currency at
a fixed exchange rate

Use of a Forward:
- Hedging: reducing/eliminating exchange rate risk
for existing FX position
- Speculation: taking open positions in the FX
market
46

The Forward Market

Forward premium
A currencys value in the forward exchange market is
higher than in the spot exchange market

Forward discount
A currency value in the forward exchange market is lower
than in the spot exchange market
Quoted in the interbank market as a discount or premium
to the spot rate

47

The Forward Market

Calculating the Percentage Forward Premium
or Discount on foreign currency (Direct
formula Eq 7.1, Shapiro p274)

f1 e0 360
*
*100
e0
n
where

f1 = the 1-period forward rate (F)

e0 = the current spot rate (S)
n = the number of days in the forward
contract
48

The Forward Market

Calculating the Percentage Forward Premium
or Discount on foreign currency (Indirect
formula)

e f 360
*
*100
'
f1
n
'
0

'
1

where f1 = the 1-period forward rate (indirect quote)

e 0 =

the current spot rate (indirect quote)

n=
the number of days in the forward
contract
49

The Forward Market

Calculating the Forward Premium or
Discount.using S for e0, and F for f1
Direct =
S

where
S=
n=
contract

F-S x 12 x 100
n

F=
the forward rate of exchange
the spot rate of exchange
the number of months in the
forward

Indirect = S-F x 12 x 100

F
n
50

Percentage Forward
Premium/Discounts
Allows % comparison of annualised premium and discounts
in the forward market with i/r differentials (will utilise
with IRP, topic 8)
Note:
both
formulas
calculate
the
forward
premium/discount of the foreign currency relative to the
domestic currency.
Regardless of using direct or indirect quotes, the
calculation of the premium should be the same, provided
that the currency quote is consistent with the formula
used, i.e., direct quote use direct formula, indirect quote
use indirect formula.
What if you are given indirect quote and direct formula?

51

Indirect Quotes % Forward Premium/Discounts

An

example, assume the following indirect

quotes (i.e. AUD is the home currency)

Spot rate e0 = SFr1.7126/AUD

Forward rate f1 = SFr 1.7373/AUD
Forward contract number of days
= 180 (6 months)

52

Indirect Quotes and % Forward Premium/Discount

SFr is selling at a forward discount relative to AUD
AUD is selling at a forward premium relative to SFr
Using indirect formula, the forward premium/discount of SFr is calculated as:

e0' f1' 360

*
*100
'
f1
n
1.7126 1.7373 360
Therefore, SFr
of 2.84%
is selling at a forward*discount*100
1.7373
180
2.84%

53

Direct Quotes and % Forward Premium/Discount

In order to use the DIRECT formula
Convert indirect quotes to direct quotes:
Spot rate e0 = 1/1.7126= AUD0.5839/SFr
Forward rate f1= 1/1.7373=AUD 0.5756/SFr
Using direct formula, the forward premium/discount of SFr
is calculated as:

f1 e0 360
*
*100
e0
n
0.5756 0.5839 360

*
*100
0.5839
180
2.84%
Again, SFr is selling at a forward discount of 2.84%
54

Multiple Choice Time! No 4

A forward contract can be used to
lock in the __________ of a
specified currency for a future
point in time.
a. purchase price
b. sale price
c. A or B
d. none of the above
ANSWER: C
55

Multiple Choice Time! No 5

The spot and 180day forward rates for the
euro are $1.3310 and $1.3402, respectively.
The Euro is said to be selling at a forward
(answer rounded up)
a. discount of 6.9%
b. premium of 6.9%
c. discount of 1.4%
d. premium of 1.4%

56

Multiple Choice Time 5 solution

1. We want to know the forward premium/discount of the Euro,
therefore treat Euro as the foreign currency and the
exchange rates as direct quotes:
e0 = $1.3310/EUR and f1 = $1.3402/EUR
2. Use direct formula

f1 e0 360
*
*100
e0
n
1.3402 1.3310 360
*
*100
1.3310
180
1.38%

3. Answer (d)

57