FX Market Mechanics and Participants

Chapter 2
The Foreign Exchange Market

Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
2-2
Objectives
• To describe the FX market
• To identify participants and currencies
• To describe the Australian FX market
• To describe the mechanics and technology of FX
trading
(cont.)

2-3
Objectives (cont.)
• To introduce some exchange rate concepts
• To illustrate FX position keeping
• To introduce some FX jargon

2-4
Definition
• The FX market is the market where national
currencies are bought and sold against one another.
Foreign Exchange market consists mainly of bank
deposits.

2-5
Characteristics
• It is the largest and most perfect market
• It is needed because every international transaction
requires a foreign exchange transaction
• It is an over-the-counter (OTC) market

2-6
Market participants
• Foreign exchange traders buy and sell currencies
directly or indirectly
• Arbitragers exploit exchange rate anomalies;
hedgers cover open positions; speculators take open
positions

2-7
Categories of participants
• Customers
• Commercial banks
• Other financial institutions
• Brokers
• Central banks

2-8
Interbank operations
• The FX market is dominated by interbank operations
• Participants in the interbank market are market
makers, other major dealers and second-tier banks

2-9
Size and composition
• The size of the global FX market is measured by the
sum of daily turnover in FX centres
• A survey is coordinated by the BIS every three years
for this purpose

2-10
Daily turnover in the FX market (USD billion)
0
400
800
1200
1600
2000
2400
2800
3200
3600
1989 1992 1995 1998 2001 2004 2007
Spot Forward Total (including gaps)

2-11
Geographical distribution of FX market
turnover (%)
0
5
10
15
20
25
30
35
40

2-12
FX market turnover by counterparty
(institutional type)
Interbank Financial Institutions Others

2-13
FX market turnover by counterparty (locality)
Local Cross-border

2-14
Currency composition of the FX market
(by single currencies)
0
20
40
60
80
100
USD EUR JPY GBP CHF AUD CAD SEK HKD Others

2-15
Currency composition of the FX market
(by currency pairs)
0
5
10
15
20
25
30
USD/EUR USD/JPY USD/GBP USD/AUD USD/CHF USD/CAD USD/Other Other/Other

2-16
Traded currencies
• The US dollar is the most heavily traded currency
• The euro and the yen are heavily traded because of
the importance of Europe and Japan in the world
economy
(cont.)

2-17
Traded currencies (cont.)
• The pound is heavily traded for historical reasons
• Currencies that are heavily traded in certain financial
centres and lack liquidity in others: CHF, CAD
(cont.)

2-18
Traded currencies (cont.)
• Currencies that are traded locally, but internationally
are traded for international trade purposes: AUD,
NZD, HKD
• Third world currencies: soft or exotic currencies

2-19
• The market consists of the banking system and
non-bank dealers authorised by the Reserve Bank of
Australia (RBA)
• The market has grown since the flotation of the AUD
in 1983
The AUD FX market

2-20
Daily turnover in the Australian FX market
(USD billion)
0
40
80
120
160
200
1989 1992 1995 1998 2001 2004 2007

2-21
• Deregulation
• High interest rates in the 1980s
• Australia’s time zone
• Exchange rate volatility
Reasons for the growth of the AUD market

2-22
Components of an FX transaction
• Price discovery
• Decision making
• Settlement
• Position keeping

2-23
FX market technology
• The telegraph
• The telephone
• The telex
• The fax
(cont.)

2-24
FX market technology (cont.)
• Screen-based information systems
• Screen-based automated dealing systems
• Automatic order matching systems
• Online FX trading

2-25
The bilateral spot exchange rate
• The exchange rate between two currencies for
immediate delivery

2-26
Transaction dates
• The date on which the transaction is agreed upon is
called the contract date, dealing date, done date or
trade date
• The date on which currencies are exchanged is the
value date or the delivery date

2-27
A spot foreign exchange transaction
Confirmation of exchange rate and amount
B’s
account
A’s
account
(Monday)
A B

2-28
The delivery date
• Typically, the delivery date is two business days after
the contract date
• In a value-today or same-day transaction the
delivery date is the same as the contract date
• In a value-tomorrow or next-day transaction the
delivery date is one day after the contract date

2-29
• S (x /y ) is the price (in terms of x) of one unit of y :
Spot rate quotation
( )
( )
x
y
S
y
x
S
1
=

2-30
• When the exchange rate changes from S0(x/y) to
S1(x/y)
   
 
 
 
 
 
1
1
1
1
1
1
0
0
1
-
y
x
S
y
x
S
-
y
x
S
x
y
S
-
y
x
S
y
x
S
y
x
S







Exchange rate changes

2-31
• To convert from y to x, multiply by the exchange rate
• To convert from x to y, divide by the exchange rate
Currency conversion

2-32
• Direct quotation refers to the domestic currency price
of one unit of the foreign currency
• Indirect quotation refers to the foreign currency price
of the domestic currency
• What is a direct quotation from the perspective of
one country is an indirect quotation from the
perspective of the other country, and vice versa
Exchange rate quotation in practice

2-33
• The bid rate is the rate at which the quoting dealer is
willing to buy. The offer rate is the rate at which the
quoting dealer is willing to sell.
• The spread is
The bid and offer rates
=
=
1
-
-
b
a
b
a
S
S
m
S
S
m

2-34
A foreign exchange spot transaction with bid-
offer spread
A
USD @ 1.8575
B
USD @ 1.8525
AUD @ 0.5398 (1/1.8525)
AUD @ 0.5384 (1/ 1.8575)

2-35
Conversion rules
)
/
(
1
=
)
/
(
)
/
(
1
=
)
/
(
y
x
S
x
y
S
y
x
S
x
y
S
b
a
a
b

2-36
• A point is one-hundredth of a cent, a penny, etc.
• A pip is one-tenth of a point
• If the exchange rate is 1.2545-1.2585, this can be
expressed as 45-85 and 1.25 is called the “big
number”
Points and pips

2-37
• A cross exchange rate is the exchange rate between
two currencies derived from their exchange rates
against another currency
Cross exchange rates
)
/
(
)
/
(
=
)
/
(
z
y
S
z
x
S
y
x
S

2-38
Bid and offer cross rates
)
/
(
)
/
(
=
)
/
(
)
/
(
)
/
(
=
)
/
(
z
y
S
z
x
S
y
x
S
z
y
S
z
x
S
y
x
S
a
b
b
b
a
a

2-39
• For n exchange rates
Cross rates matrix
)
/
(
)
/
(
)
/
(
z
j
x
S
z
i
x
S
j
x
i
x
S 

2-40
• A nostro account is held by a dealer at a
correspondent bank
• A vostro account is held by a bank on behalf of a
foreign dealer
• The words “nostro” and “vostro” are Latin for “ours”
and “yours”
FX position keeping
(cont.)

2-41
• A short position is created when a dealer borrows a
currency and sells it
• A long position is created when a currency is bought
because it is expected to appreciate
FX position keeping (cont.)
(cont.)

2-42
• Position keeping is the monitoring of positions in
each currency
• A position is the net cumulative total of a currency
holding arising from deals
• A blotter is a schedule used to record the details of
transactions
(cont.)

2-43
• Position squaring is realising profit/loss by buying the
short-position currency and selling the long-position
currency
• Valuation is the calculation of unrealised profit/loss
using the average rate

2-44
An example
The following is an example of FX position keeping
AUD Deal
Amount
AUD Balance AUD/USD Rate USD Deal
Amount
USD Balance
+10,000,000 +10,000,000 1.6525 -6,051,437 -6,051,437
+20,000,000 +30,000,000 1.6645 -12,015,620 -18,067,057
-10,000,000 +20,000,000 1.6725 +5,979,073 -12,087,983
+25,000,000 +45,000,000 1.6445 -15,202,189 -27,290,172
-50,000,000 -5,000,000 1.6500 +30,303,030 +3,012,858

2-45
• The rate contracted today for the delivery of a
currency at a specified date in the future
The forward exchange rate

2-46
• The date on which currencies involved in a forward
transaction are exchanged
• The forward value date must be more than two
business days after the contract date, otherwise it
will be a spot transaction
• The period preceding the forward value date is
calculated from the spot value date
Forward value date

2-47
• A short date means a maturity of one month or less
• A round date means a maturity of a whole number of
months
• A broken date means a maturity of less than round
dates
Forward value date (cont)
(cont.)

2-48
• An outright contract involves the sale or purchase of
a currency for delivery more than two days into the
future
• A swap transaction involves a spot purchase against
a matching outright sale (or vice versa)
Outright and swap forward transactions

2-49
• Forward swaps
• Forward-forward swaps
• Overnight swaps
• Tom/next swaps
Kinds of FX swaps

2-50
The forward spread
N
y
x
S
y
x
S
y
x
F
m 12
×
100
×
)
/
(
)
/
(
)
/
(
=
-

2-51
• If F (x /y ) > S (x /y ), then y sells at a premium
• If F (x /y ) < S (x /y ), then y sells at a discount
• If F (x /y ) = S (x /y ), both currencies are flat
Premium and discount

2-52
• An outright forward rate is quoted as bid and offer
rates
• A swap rate is quoted in terms of the points
representing the forward premium or discount
Outright and swap rates

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