Foreign Exchange: The Structure and Operation of The FX Market

Chapter 15
Foreign exchange: the

structure and operation of
the FX market
Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 15-1

Viney & Phillips, Financial Institutions, Instruments and Markets, 9e
Learning objectives
LO 15.1 Understand the nature, size and scope of the
global FX markets and main exchange rate
regimes.
LO 15.2 Identify and discuss participants in the FX
markets.
LO 15.3 Describe the functions and operations of the FX
markets.
LO 15.4 List and explain types of FX transactions,
particularly spot and forward transactions.
(cont.)

Learning objectives
LO 15.5 Introduce conventions for quotation and
calculation of spot exchange rates.
LO 15.6 Describe the role of the forward market and
calculate forward exchange rates.
LO 15.7 Identify factors that complicate FX market prices
quotations and calculations.
LO 15.8 Recognise the important impact on FX markets
of the Economic and Monetary Union of the
European Union (EMU).

Chapter outline
15.1 Exchange rate regimes
15.2 Foreign exchange market participants
15.3 The operation of the FX market
15.4 Spot and forward transactions
15.5 Spot market quotations
15.6 Forward market quotations
15.7 Economic and Monetary Union of the EU and FX
markets

• Each country or monetary union is responsible for
determining own exchange rate regime
• Exchange rate is value of one currency relative to that of
another currency
• Major currencies like USD, GBP, JPY, EUR and AUD
adopt floating exchange rate (free float) regime
– Where exchange rate is determined by supply and demand factors
in the FX markets
(cont.)

• Other types of exchange rate regimes
– Managed float
 Exchange rate held within defined band relative to other currency
– Crawling peg
 Exchange rate allowed to appreciate in controlled steps over time
– Linked exchange rate
 Value of currency tied to value of another currency or basket of
currencies

15.2 Foreign exchange market
participants
• FX markets
– Comprise all financial transactions denominated in foreign
currency, currently estimated to be over USD5 trillion per day
– Facilitate exchange of value from one currency to another
– Internationally adopted FX market conventions to improve market
functionality
(cont.)

15.2 Foreign exchange market participants
• FX market participants can be classified as:
– FX dealers and brokers
– central banks
– firms conducting international trade transactions
– investors and borrowers in the international money markets and
capital markets
– foreign currency speculators
– arbitrageurs.

FX dealers and brokers
• FX dealers:
– are financial institutions, typically commercial banks and
investment banks, that quote two-way (i.e. buy and sell) prices and
act as principals in the FX market
– are usually licensed or authorised by the central banks of the
countries in which they operate
• FX brokers:
– transact almost exclusively with FX dealers; they obtain the best
prices in global FX markets matching FX dealers’ buy and sell
orders for a fee

Central banks
• Enter FX market to:
– purchase foreign currency to pay for government imports or pay
interest on, or redeem, government debt
– change the composition of holdings of foreign currencies in
managing official reserve assets
– influence the exchange rate

Talking markets and strategy
• Using Reserve Bank data, we’ve plotted the AUD against
the USD since 2010. What are the major features of this
time series?
1.2000
1.1000
1.0000
0.9000
0.8000
0.7000
0.6000
1 0 10 1 0 11 1 1 11 1 2 12 12 13 1 3 1 3 14 14 1 4 1 5 1 5 15 16 1 6 16 1 7 17 1 7 18 1 8 18
- 20 -20 t-20 -20 -20 t-20 -20 -20 t-20 -20 -20 t-20 -20 -20 t-20 -20 -20 t-20 -20 -20 t-20 -20 -20 t-2 0 -20 -20 t-20
b n c b n c b n c b n c b n c b n c b n c b n c b n c
-Fe -Ju 9-O -Fe -Ju 1-O -Fe -Ju 1-O -Fe -Ju 1-O -Fe -Ju 1-O -Fe -Ju 0-O -Fe -Ju 1-O -Fe -Ju 1-O -Fe -Ju 1-O
26 3 0 2 28 3 0 3 29 2 9 3 28 2 8 3 28 3 0 3 27 3 0 3 29 3 0 3 28 3 0 3 28 29 3

Firms conducting international trade
transactions
• Exporters receive foreign currency for the sale of their
goods and services
• Exporters use the FX market to sell foreign currency and
buy AUD
• Importers use the FX market to buy foreign currency (sell
AUD) for purchasing imports

Investors and borrowers in the
international money markets and
capital markets
• Commercial bank foreign borrowings are usually

converted into the home currency
– Payments of interest and principal need to be made in the
denominated currency of the loan
• Corporations and financial institutions investing overseas
– need to purchase FX in order to make investments
– dividends or interest payments received from overseas
investments will be denominated in a foreign currency

Speculative transactions
• Businesses and financial institutions may attempt to
anticipate future exchange rate movements to make a
profit
• There is a risk involved that the exchange rate will move:
– in the opposite direction to that anticipated
– in the anticipated direction but by less than expected
(cont.)

Speculative transactions
Example:
If, today:
Spot rate: USD1 = AUD0.6725
Exchange rate expected: today + n days: USD1 = AUD0.7225
Then, today:
Buy USD1 at a cost of AUD0.6725
Then, at today + n days:

Sell USD1 and obtain AUD0.7225

Talking markets and strategy
• The AUD is a fairly volatile currency, as you can see from
the chart presented before
• In 2018, the AUD fell in value against the USD throughout
the year
• This prompted the Sydney Morning Herald to run an
article entitled “Five ways to profit from a lower dollar”.
• Here are the five ways:
– Buy USD (if you think the AUD will continue to fall)
– Buy ASX-listed exporters
– Buy ASX companies with business overseas
– Buy ASX-listed ETFs
– Buy US-listed shares
• What do you think?

Arbitrage transactions
• Profit is made through FX transactions that involve no FX
risk exposure
• Types of arbitrage
– Geographic
 Where two dealers in different locations quote different rates on the
same currency
– Triangular
 When exchange rates between three or more currencies are out of
perfect alignment
(cont.)

Arbitrage transactions
Example:
Triangular arbitrage
USD1 = AUD1.3525
USD1 = SGD1.3525
AUD1 = SGD 0.9870
Arbitrage strategy
Sell AUD1.3525 and receive USD1
Sell USD1 to receive SGD1.3525
Sell SGD1.3525 to receive AUD1.3703

15.3 The operation of the FX market
• The FX market:
– is a global market, operating 24 hours a day according to business
hours across the time zones
– consists of a vast and highly sophisticated global network of
telecommunications systems that provide the current buy and sell
rates for various currencies in dealing rooms located around the
globe
– involves larger FX dealers like commercial and investment banks
providing the FX function as part of their overall Treasury
operations within which they establish an FX dealing room

• FX market instruments are typically:
– spot transactions
 have maturity date two business days after the FX contract is entered
into
• are used, for example, if an Australian importer has an account in USD to
pay within the next few days
– forward transactions
 have maturity date more than two days after FX contract is entered
into
• are used, for example, if Australian importer has to pay a USD liability in
two months, and covers or hedges against an appreciation of the USD
(cont.)

• Dealers may also provide short-dated transactions if
necessary
– ‘Tod’ value transactions—same-day settlement
– ‘Tom’ value transactions—settlement tomorrow

• Asking for a quotation
– The price of a currency is expressed in terms of another currency.
– The first currency mentioned is the price being sought (also called
base currency or the unit of quotation)
– The second is the terms currency
 Example: USD/AUD is the price of USD1 in terms of AUD
(cont.)

• Two-way quotations
– Example: Australian dollar/euro may be expressed as
EUR/AUD1.3755–1.3765
– Usually abbreviated to EUR/AUD1.3755–65
 The two numbers indicate the dealer’s buy (bid) and sell (offer) price.
 A dealer quoting both bid and offer prices is a price-maker
 The dealer will buy EUR1 for AUD1.3755
 The dealer will sell EUR1 for AUD1.3765
 Dealer ‘buys low’ and ‘sells high’
(cont.)

• Two-way quotations
 The difference between the buy and sell price is the ‘spread’,
represented in percentage terms in Equation 15.1
(cont.)

• Transposing spot quotations
– Example: Given a quotation of EUR/AUD1.3755–1.3765, the
AUD/EUR quotation can be determined by transposing the
quotation (i.e. ‘reverse and invert’)
Reverse the bid and offer prices: 1.3765–1.3755
Then take the inverse (divide both numbers into 1)

1.000 1.000
1.3765 1.3755
AUD/EUR0.7265–0.7270
(cont.)

• Calculating cross-rates
– All currencies are quoted against the USD
– There are two ways currencies can be quoted against the USD:
 direct quote—the USD is the base currency
 indirect quote—the USD is the terms currency and the other currency
is the base currency
– When FX transactions occur between two currencies, usually
where neither currency is the USD, the cross-rate needs to be
calculated
 The method of cross-rate calculation depends on whether the quote is
direct or indirect
(cont.)

Example 3: Crossing two direct FX quotations:
USD/EUR0.7250–55
USD/JPY81.40–50
To determine the EUR/JPY cross-rate:

81.40/0.7255 = 112.20
81.50/0.7250 = 112.41
EUR/JPY112.20–41
(cont.)

Example 4: Crossing a direct and indirect FX quotation:
GBP/USD1.6270–75
USD/NZD1.3292–97
To determine the GBP/NZD cross-rate:

1.6270 × 1.3292 = 2.1626
1.6275 × 1.3297 = 2.1641
GBP/NZD2.1626–41
(cont.)

Example 5: Crossing two indirect FX quotations:
AUD/USD0.7262–69
GBP/USD1.2670–75
To determine the AUD/GBP cross-rate:

0.7262/1.2675 = 0.5729
0.7269/1.2670 = 0.5737
AUD/GBP0.5729–37

• Forward points and forward exchange rates
– The forward exchange rate is the FX bid/offer rates applicable at a
specified date beyond the spot value date
– The forward exchange rate varies from the spot rate owing to
interest rate parity
 Interest rate parity is the principle that exchange rates will adjust to
reflect interest rate differentials between countries
(cont.)

– Forward exchange rates are quoted as forward points, either
above or below the spot rate
 Forward points represent the forward exchange rate variation to a spot
rate base
 If the forward points are rising, add them to the spot rate (i.e. base
currency is at a forward premium; interest rate of the base currency is
lower)
 If the forward points are falling, subtract them from the spot rate (i.e.
base currency is at a forward discount; interest rate of the base
currency is higher)
(cont.)

Example: Given AUD/USD (spot)0.7630–40 and six-month forward
points: 0.0032–0.0027
Since the forward points are falling, subtract them from the spot rate
to obtain the six-month forward rate of:
0.7598–0.7613
(cont.)

– Equation 15.2 is a generalised formula to calculate forward points
where:
is the spot rate
is the interest rate of terms currency
is the interest rate of base currency
(cont.)

Example 6: A company approaches an FX dealer for a forward quote
on the USD/CHF with a three-month (90-day) delivery. The spot rate
is USD/CHF1.1560. The dealer needs to calculate the forward points.
Assume the three-month eurodollar interest rate is 3.00% per annum
and the three-month euroswiss franc interest rate is 4.00% per annum
The three-month forward rate is USD/CHF1.1589. The points are

added to the spot rate as the interest rate of the base currency is
lower
(cont.)

– Modifications to Equation 15.2 and Example 6 required
 Different borrowing and lending rates apply in the euromarkets where
interest rates are generally taken
 An FX dealer:
• will need to adjust the formula to account for the different interest rates
• may also charge a margin for costs and perhaps some points to reflect
their relationship with the company and market competition

Forward exchange contract
• An FX contract locks in an exchange rate today for
delivery of foreign currency at a specified future date
• FX dealers quote forward points on standard delivery
dates, usually monthly out to 12 months, of a specified
amount of one currency against another
(cont.)

Forward exchange contract
• As the dealer does not know what the spot rate will be on
a future date, they will carry out the FX transaction today
even though delivery will not occur until the future date,
that is:
– borrow funds in one market and purchase the foreign currency that
will be needed at a future date
– invest the purchased foreign currency in that market until delivery
is due
– the difference between the cost of borrowed funds and the return
received on the invested foreign currency will be adjusted against
the spot rate today

Some ‘real world’ complications
• The equations and examples illustrated are simplified
and ignore complexities of the ‘real world’ financial
markets such as:
– two-way FX quotations
 care is needed in selecting appropriate bid and offer rates in
calculating forward points
– different interest rate year conventions
 converting a 360-day basis to a 365-day basis or vice versa
– variations in interest-compounding periods
 consider the effective rate of interest on borrowed funds and the
value of deposits
(cont.)

Some ‘real world’ complications
• – Borrowing and lending interest rates
 Generalised Equation 15.2 for calculating forward points can be
extended to account for borrowing and lending interest rate margins
with Equations 15.3 and 15.4
– Calculating bid and offer forward points requires the use of two
equations respectively:

Borrowing and lending interest rates
• Example 7: A company approaches an FX dealer for a
forward quote on the USD/CHF with a three-month (90-
day) delivery. The spot rate is USD/CHF1.1555–60
• The dealer needs to calculate the forward points. Assume
the three-month eurodollar bid and offer interest rates are
3.00% and 3.30% p.a. and the three-month euroswiss
franc interest rates are 3.70% and 4.00% per annum,
respectively
(cont.)

• Bid forward points
(cont.)

• Offer forward points
The forward points are rising so they will be added to the

spot rate. Therefore, the three-month forward exchange
rate will be USD/CHF1.1566–89

15.7 Economic and Monetary Union of
the EU and FX markets
• Currently, 17 members of the EU are participants in EMU
• As the EMU gains acceptance, the size and liquidity of
EMU member equity and bond markets will increase
• The euro has become a hard currency like the USD, JPY
and GBP, in that it is generally accepted in international
trade transactions
• At the time of writing, the United Kingdom is undertaking
a tumultuous ‘Brexit’ from the EU. The ramifications of this
are yet to be seen
• Students will be able to assess at least some of the
results in coming years
(cont.)

Summary
• FX market participants include companies, dealers,
central banks, investors, speculators and arbitrageurs
• FX market instruments are usually either spot or forward
transactions:
– involve the quotation of the dealer’s buy-sell prices
– cross-rates calculations are necessary between two non-USD
currencies
– forward exchange rates are quoted as forward points either above
or below the spot rate
– the euro has grown in acceptance to become a hard currency
accepted in international trade transactions


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Chapter 15

Foreign exchange: the

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• Commercial bank foreign borrowings are usually

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Then, at today + n days:

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Reverse the bid and offer prices: 1.3765–1.3755

Then take the inverse (divide both numbers into 1)

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To determine the EUR/JPY cross-rate:

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To determine the GBP/NZD cross-rate:

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To determine the AUD/GBP cross-rate:

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The three-month forward rate is USD/CHF1.1589. The points are

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The forward points are rising so they will be added to the

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