Lecture 1

Characteristics of FX Markets:

• Largest of all financial markets with average daily turnover of over $8.5 Trillion! Spot transactions - $2 trillion; FX swaps dominate.
  • short term instrument, buy and within a week period
  • Banks use for liquidity
• 64% of all foreign exchange transactions involves cross- border counterparties
  • counterparty, or pushed-out risk
• Only $\approx$ 6% of daily spot transactions involve non-financial customers.
• US dollar involved in one-side of 85% of all trades, a slight decline from the 2019 survey; Euro is at 31%.
• Australian $AUD is the 5th most heavily traded currency
• Loosely organised in two tiers: wholesale & retail

Characteristics of Wholesale markets

• Not an organized exchange
  • No fixed opening hours, centralized clearing mechanism, standardized contracts, etc.
  • No equivalent of a stock market or derivative market
• Extremely deep and liquid market
  • trade sizes 200-500M
• Participants in the market:
  • International banks
    • 100-200 banks willing to buy/sell foreign currency in their own account
  • Bank customers engaged in commercial and Investment transactions, BHP, QIC, e.g.
  • Non-bank dealers
  • FX brokers
  • Central banks
• Settlement of transactions – No real money changes hands
  • The role of SWIFT
  • Communication System
  • Society of Worldwide International Financial Telecommunications
    • Money often more through multiple banks before ending in the correct accounts

• chips, fedwire, target - organisations to transfer money

Exchange rate

• A foreign exchange rate is the price of one currency expressed in terms of another currency.

• A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.

  • Market makers - foreign currency dealers and brokers
  • binding quotes for a few minutes

• normally quote to four digits

• normally settles T+2

• have all the contributors at the bottom, with their bid/ask

Terminology

• Spot Rate: The exchange rate at which trades are executed immediately in the interbank market. About a third of all FX trading is done in this market.
• Value Date for a spot transaction is the date on which parties receive the funds they have purchased – e.g., in trades involving USD, settlement occurs two business days after the deal.
  • Foreign currency dealers provide two quotes: - Bid Price: Price at which the dealer is willing to buy a currency from you (i.e., client) - Ask Price: Price at which the dealer is willing to sell a currency to you (i.e., client)
• It is always the case that the Ask Price > Bid Price. The difference is the Bid-Ask spread
• The less traded and more volatile a currency, the greater is the spread.

Bid/ask prices

$$\text{USDCHF} \; \; \; .8505-0.8507*$$

USD - base currency CHF - Quote currency

$\text{USDCHF}_{bid} = 0.8505$ - the rate at which the bank will buy USD (base currency) in exchange for CHF (gives customer swiss francs)

$\text{USDCHF}_{ask} = 0.8507$ - the rate at which the bank will sell USD (base currency) for CHF (receives swiss francs from customer)

• In the wholesale market, for a currency pair, there is a base currency (the first currency in the pair), and quote currency (the second). This is what Bloomberg uses.

• Other quotations used in business include

  • Direct Quote: Home currency per unit of foreign currency (FC)
  • Indirect Quote: Foreign currency (FC) per unit of Home currency
  • American & European terms are direct and indirect quotes relative to the US dollar (USD). The quote in the previous slide is in European terms.

• Note that in all cases, the reciprocal of a direct quote is an indirect quote and vice-versa.

Example, AUDCHF

$$\text{AUDCHF} \; \; \; .5699-0.5700*$$

AUD - Base currency CHF - Quote currency If AUD is local currency, this would be an indirect quote

• Cross-rate is an exchange rate that does NOT involve the USD

• Explain the following quotes:

• $\text{AUDCHF}_{bid} = 0.5699$ the amount of AUD the bank would buy from you in exchange for 1 CHF

• $\text{AUDCHF}_{ask} = 0.5700$ the amount of AUD the bank would sell to you in exchange for 1 CHF

• Bid and Ask prices mixed with alternative quotations methods can lead to confusion. Try to remember:

  • The dealer buys the denominator (or base) currency at the BID [client buys the numerator (or quote) currency at the bid]
  • The dealer sells the denominator (base) currency at the ASK [client sells the numerator (or quote) currency at the ask]

• When all else fails, remember that the commercial client always, ALWAYS gets the worse end of the deal

Another Example

American terms (e.g. British Pound)

• Bid: Dealer buys £ for $ at the Bid, Client sells £ for $ (i.e., dealer will buy £1,000,000 for $1,274,900)
• Ask: Dealer sells £ for $ at the Ask, Client buys £ for $ (i.e., dealer will sell £1,000,000 for $1,275,000)

Inverse exchange rate

• a direct bid is the reciprocal of an indirect ask
• a direct ask is the reciprocal of an indirect bid

Bid-Ask spread

• The difference between the bid and ask prices is the bid-ask spread. It represents a “round-trip” transaction and is the cost of entering into the transaction.

$$\text{spread} = \frac{\text{Ask - Bid}}{\text{Ask}} \cdot 100$$

$$\text{spread} = \frac{\text{0.5700 - 0.5699}}{\text{0.5700}} \cdot 100$$

$$= 0.01754\% \; \; \text{or 1.75 basis points}$$

Triangular arbitrage

• Cross rates can be used to check on opportunities for intermarket arbitrage. Suppose the following exchange rates are available:

• The synthetic (manufactured) cross rate between Euros and Canadian dollars is:

$$\frac{Euro/U\$}{C/U\$} = EURO 1.5044/C\$$$

Arbitrage example

Forward contracts

• Forward transactions require delivery at a future date of a specified amount of one currency for a specified amount of another currency.
• This is a rate that is agreed upon today but settled further into the future.
• Forward contracts are traded on the inter-bank market. They can be tailored for
  • contract sizes
  • currency
  • delivery dates

Ways to quote forward rates

• There are three ways to express forward rates:
  • Via points to be added or subtracted from spot rate [known as swap points]
  • Outright quotes
  • As an annualized percentage forward premium or discount

Forward quotes: Swap rates

• Among themselves, foreign exchange traders usually quote forward rates in terms of points, also referred to as “forward points” or “swap rates”

• A point (pip) is the last digit of a quotation

  • A point (pip) is equal to 0.0001 (1/100 th of 1%) for most currencies.
  • The Japanese yen is the exception. It is quoted only to two decimal places; A point, in this case, is 1/100.

• If F > S then the currency in the denominator (base currency) is trading at a premium

  • E.g. One AUD buys more USD in the forward market than the in the spot market
  • If ascending between bid/offer forward points then forward price will be higher than the current spot price

• If F < S then the currency in the denominator (base currency) is trading at a discount*

  • E.g. One AUD buys less USD in the forward market than the in the spot market
  • If descending between bid/offer forward points then forward price will be lower than the current spot price
  • If F = S then market is relatively flat

Swap rates

• A forward quotation expressed in points is not a foreign exchange rate as such.
• Rather, it is the difference between the forward rate and the spot rate.

When the Bid Points > Ask Points, you subtract the points from the spot rate to get the outright forward quote:

If the Bid Points < Ask Points, there is a forward premium, and you add the points to the spot rate to get the outright forward quote

Forward premium/Discount

• A forward premium exists when a currency purchases more of the second currency than it does previously
  • This implies that the base currency appreciates
• A forward discount exists when a currency purchases less of the second currency than it does previously
  • This implies that the base currency depreciates

% change in exchange rates

The Australian dollar was quoted at CHF 0.9489/AUD in January 2013, while in January 2024, it was quoted at CHF 0.5701/AUD*

• At t-1 (Jan 2013): CHF 0.9489/AUD
• At t (Jan 2024): CHF 0.5701/AUD.

Thus, the appreciation/depreciation of the $, relative to the CHF from t-1 to t is: