Topic 7 - FE Markets 2015 FV
description
Transcript of Topic 7 - FE Markets 2015 FV
Foreign Exchange Foreign Exchange Markets Markets
TOPIC 7
MAF306 International Finance and Investments
Foreign Exchange MarketsForeign Exchange Markets
Objectives
to describe how the foreign exchange (FX) market is organized
understand it’s 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 Is this where you might like to be??to be??
3
An international holiday?......What role do FX markets play?
Why do we need FE Markets?
Transfer of purchasing power across nationsFacilitate 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)
4
The Foreign Exchange Market
its trading volumes - As of April 2014, average daily turnover in the FX
market exceeded US$5 trillion!!the extreme liquidity of the marketthe large number of, and variety of, traders in the marketits geographical dispersionthe 24-hour-a-day trading – no fixed opening/closing timestransactions 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
What makes Foreign Exchange Markets Unique?
Foreign Exchange Markets Foreign Exchange Markets
6
Most traded currencies,Size (per day) and 24-hour trading
7
Global foreign exchange daily turnover(measured in billions of USD, BIS Dec 2007, see Figure 7.4B, p 263
for updated figure)
Location?The FX market spans the globe in 2012
The Foreign Exchange Market
8
FX turnover: Top currencies
9
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
The Foreign Exchange Market
Bank and foreign exchange dealersCentral banksIndividuals and companies conducting commercial and investment transactions Speculators and arbitrageursHedgersCentral banks and treasuries
11
Participants in the FE Market
Two Types of Currency MarketsSpot 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
Organisation of the Foreign Exchange Market
Spot QuotationsSources
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 Spot 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 OrA$1 buys US$1.40
14
The Foreign Exchange Market
In the currency market convention all currencies are quoted in the following manner:-
1 unit of a currency = x units of another currency
Example: 1 unit of US$ = 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.
Foreign Exchange Rates and Foreign Exchange Rates and QuotationsQuotations
15
16
Depreciation/Depreciation/AppreciationAppreciation
Currency is appreciating against another currency……when 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 CHF
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.”
Foreign Exchange Rates and Foreign Exchange Rates and QuotationsQuotations
17
FX quotation conventionsFX quotation conventions
American TermsUSD 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 TermsForeign currency price of one USDFor example ¥108.10/US$1An Indirect quote in the USA Direct quote outside the US (e.g. in Japan)
Most interbank quotations around the world are stated in European termsExceptions to this include EUR, GBP, AUD, NZD
Direct/indirect quotes for foreign Direct/indirect quotes for foreign currencycurrency
Direct quotes place the domestic (home) currency (always) in the numerator and the foreign currency in the denominator (d/f);
e.g. €0.0090/¥ for a resident of Europe OR AUD0.917/USD for a resident of Australia
Indirect quotes place the domestic currency in the denominator and the foreign currency in the numerator (f/d);
e.g. ¥110.95/€ for a resident of Europe OR USD1.09/AUD for a resident of Australia
Direct quote and indirect quote are reciprocals
18
20
Reciprocal Reciprocal RatesRates
The reciprocal rate is the inverse/reciprocal of a conventional quote.
Examples:1 US$ = SGD 1.7650Reciprocal rate is: 1 SGD = US$ 1/1.7650 = US$ 0.5666
1 AU$ = US$ 0.7850Reciprocal rate is:1 US$ = AU$ 1.2739
21
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.
22
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.
Transactions CostsBid-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 currencyPercent Spread Formula
23
The Spot Market
100xAsk
BidAskPS
24
BID and ASK (or buy and BID and ASK (or buy and sell)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$1 as follows
0.7850/0.7860 or
(BID) (ASK or Sell)
0.7850-60 (BID)- (ASK)
What does this mean (see next slide)?
25
BID and ASK…cont• The interbank dealer (also called price maker) is
prepared to buy Australian dollar against US dollars at a price of 1 AU$ 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 explanation1. 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$7860 (receive more)
• In the buy transaction, the dealer wants to give/pay less
• In the sell transaction, the dealer wants to receive more
26
FE FE SpreadSpread
The spread = difference between the bid rate and the offer rate.
In the above US$/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
Why is the interbank market spread is narrow than the retail market? (Answer: see the topic: International financial markets)
27
Multiple Choice Time! No Multiple Choice Time! No 11
From the viewpoint of a British investor, which of the following would be a direct quote in the foreign exchange market?
(a) SF2.40/£(b) $1.50/£(c) £0.55/€(d) $0.90/€ Ans C
Multiple Choice Question Time! Multiple Choice Question Time! No 2No 2
Assume that a bank's bid rate on Japanese yen is $.0041 and its ask rate is $.0043. Its bid‑ask percentage spread is:a. about 4.99%.b. about 4.88%.c. about 4.65%.d. about 4.43%.
28
ANSWER: C SOLUTION: Bid‑ask percentage spread = ($.0043 ‑ $.0041)/$.0043 = 4.65%
29
Multiple Choice Time! No 3Multiple 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 termsAns d
30
““Market Makers” in FX Market Makers” in FX MarketsMarkets
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
31
Market Spreads in Spot Market Market Spreads in Spot Market (Buy-Sell Spread)(Buy-Sell Spread)Buy-sell or Bid-ask spread using direct
quotes Supply (Market Makers)
Demand (Market Makers)
A$/US$
Qty of US$
Supply (Public)
Demand (Public)
So
Sbuy
A$1.300
SSell
A$1.316S
P
R
E
A
D
A$1.316/US$ = US$0.76/AU$
A$1.300/US$ = US$0.77/AU$
32
Market Spreads in Spot Market Market Spreads in Spot Market (Buy-Sell Spread)(Buy-Sell Spread)
Assume initially the public demand and supply functions in the spot market are Dp and Sp
If public’s “bid” and “ask” tenders could be revealed to each other Equilibrium at “So” would occur
Dmm (market marker’s Demand curve) - dealers willingness to purchase US$ (with $A) from the public
Smm – (market maker’s supply curve) – dealers willingness to sell US$ (for $A) to the public
33
Market Spreads in Spot Market Market Spreads in Spot Market (Buy-Sell Spread)(Buy-Sell Spread)
Intersection of Dmm with Sp determines the exchange rate at which US$ 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 dealer’s 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 premiumbankers widen bid-ask spread
ExerciseExercise 1 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
31
ExerciseExercise 1 1Bank of Tokyo (the market maker) quotes the following rates for: JPY/US$1 = 81.55/81.58
If you are a buyer/seller of JPY, what is the rate you choose if you wish to buy/sell JPY?
(Hint: Reverse and invert to get buy/sell rates for Yen (see p 265-266)…so 1/81.58 (0.01225 US cents/1 Yen) becomes buy rate for Yen and 1/81.55 becomes sell rate (0.01226 US cents /1 Yen)
BoT Buyer of Yen = 0.01225 US centsBoT Sell Yen = 0.01226 US cents
If you are a buyer/seller of US$, what is the rate you choose if you wish to buy/sell US$?
Buyer of US$ = 81.55 yen to buy US$1Sell US$ = 81.58 yen received for each US$ sold
* Note: Bank always buys low/sells high
31
Cross ratesCross rates• Monday, September 10, 2012, listed the yen–dollar and euro–dollar rates as ¥78.56 and €0.7802, respectively. Suppose you want to know the euro–yen 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 euro–dollar exchange rate by the yen–dollar exchange rate, the dollars cancel and you get the euro– yen exchange rate: 36
Cross Ratesthe 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/ €
37
The Spot Market
GBP EUR GBP USD GBPx
USD USD USD EUR EUR
The Spot MarketThe 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$1.7999/£
= £.6667/ €
38
USD USD USD GBP GBPx
EUR GBP EUR USD EUR
The rates given are as follows:
US$/AU$1 = 0.7250CHF/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 FrancQ: What is the cross rate for A$ in terms of CHF?
Q: What is the cross rate for CHF in terms of AU$?
Cross Cross RRateate Exercise 2 Exercise 2
36
Given 1 AU$ = 0.7250 US$ and its reciprocal rate: 1
US$ = 1.3793 AU$
and 1 US$ = 1.4610 CHF (Swiss Franc)
Therefore, Using American terms (or direct quotes)……
USD USD
USD x
GBP GBP EUR GBP EUR USD EUR
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$1)Q: What is the cross rate for CHF in terms of AU$?
Ans.: 1 CHF = 1.3793/1.4610 = 0.9441 AU$ (i.e., A$/CHF1, which is the reciprocal rate of CHF/A$1).
Cross rateCross rate Exercise 2 Exercise 2
36
Cross Rate Cross Rate ExerciseExercise 3 3
What is the cross rate for € in terms of SGD?
Hint: Need to get US$ in denominator for both! Hence take reciprocal…
37
• Given SGD/US$1 1.2835
US$/€ 1 1.2165
Cross Rate Cross Rate ExerciseExercise 3 3
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 =0.8220Then use European terms…
•€ = 1.2835/0.8220 = SGD$1.5614
37
• Given SGD/US$1 1.2835
US$/€ 1 1.2165
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
The Spot MarketThe Spot Market
44
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
The Spot MarketThe Spot MarketTriangular currency arbitrage
Note: transaction (2) has an error, it should be divided:
A$1 000 000/1.8410= £543 183
45
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 premiumA currency’s 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)
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
1 0
0
360* *100
f e
e n
Calculating the Percentage Forward Premium or Discount on foreign currency (Indirect formula)
where f1’ = the 1-period forward rate (indirect quote)
e0’ = the current spot rate (indirect quote)
n = the number of days in the forward contract
49
The Forward Market
' '0 1
'1
360* *100
e f
f n
50
The Forward MarketThe Forward MarketCalculating the Forward Premium or Discount….using S for e0, and F for f1
Direct = F-S x 12 x 100 S n
where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the
forward contract
Indirect = S-F x 12 x 100 F n
50
Percentage Forward Percentage Forward Premium/DiscountsPremium/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/DiscountsIndirect 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 Indirect Quotes and % Forward Premium/DiscountPremium/Discount
SFr is selling at a forward discount relative to AUDAUD is selling at a forward premium relative to SFrUsing indirect formula, the forward premium/discount of SFr is calculated as:
Therefore, SFr is selling at a forward discount of 2.84%
53
' '0 1
'1
360* *100
1.7126 1.7373 360* *100
1.7373 1802.84%
e f
f n
Direct Quotes and % Forward Premium/DiscountDirect 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:
Again, SFr is selling at a forward discount of 2.84%
54
1 0
0
360* *100
0.5756 0.5839 360* *100
0.5839 1802.84%
f e
e n
Multiple Choice Time! No 4Multiple 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 priceb. sale pricec. A or Bd. none of the above
55
ANSWER: C
Multiple Choice Time! No 5Multiple Choice Time! No 5
The spot and 180‑day 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 solutionMultiple Choice Time 5 solution1. 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
3. Answer (d)
57
1 0
0
360* *100
1.3402 1.3310 360* *100
1.3310 1801.38%
f e
e n