Financial Institutio
Financial Institutions,
ns, Instruments and Markets
Instruments and Markets
8th edition
8th edition
Instructor's Resource Manual
Instructor's Resource Manual
Christopher Viney and Peter Phillips
Christopher Viney and Peter Phillips
Chapter 15
Chapter 15
Foreign echange! the structure and operation
Foreign echange! the structure and operation o" the F# market
o" the F# market
Learning obje
Learning objective 1:ctive 1: Understand the Understand the nature, size annature, size and scope of the d scope of the global FX markets global FX markets andand the main exchange rate regimes used b different countries
the main exchange rate regimes used b different countries
•
• FX markets exist wherever transactions are denominated in a foreign currency, includingFX markets exist wherever transactions are denominated in a foreign currency, including
international trade transactions, cross-border capital transactions, speculative transactions international trade transactions, cross-border capital transactions, speculative transactions and central bank transactions.
and central bank transactions.
•
• The FX markets operate through a highly sophisticated network of telecommunicationsThe FX markets operate through a highly sophisticated network of telecommunications
systems that link the numerous FX dealers and FX brokers located in all of the major systems that link the numerous FX dealers and FX brokers located in all of the major cities of the world.
cities of the world.
•
• n exchange rate is the n exchange rate is the value of one currency value of one currency relative to another currency. !ach country, relative to another currency. !ach country, or or
group of countries within a monetary union, is responsible for determining the form of group of countries within a monetary union, is responsible for determining the form of their exchange rate.
their exchange rate.
•
• "ost major currency exchange rates are determined using a floating exchange rate regime,"ost major currency exchange rates are determined using a floating exchange rate regime,
including the currencies
including the currencies of the of the #$, #%, !"#, &apan, #$, #%, !"#, &apan, ustralia and 'ew (ealand.ustralia and 'ew (ealand.
•
• floating exchange rate is determined by factors that floating exchange rate is determined by factors that affect the supply and demand ofaffect the supply and demand of
currencies within the FX market. currencies within the FX market.
•
• )ountries such as )hina, $ingapore, "alaysia and *ndonesia operate a managed exchange)ountries such as )hina, $ingapore, "alaysia and *ndonesia operate a managed exchange
rate regime, whereby the exchange rate is allowed to move within a defined range relative rate regime, whereby the exchange rate is allowed to move within a defined range relative to a specified major currency or basket of currencies.
to a specified major currency or basket of currencies.
•
• crawl crawling peg exchange ing peg exchange rate regime allows the currency to rate regime allows the currency to appreciate over time, butappreciate over time, but
within a limited range determined by
difference between a managed float and the
difference between a managed float and the crawling peg is that crawling peg is that market participantsmarket participants
generally agree that a currency using the crawling peg is typically undervalued. This may generally agree that a currency using the crawling peg is typically undervalued. This may in fact describe the regime used in )hina.
in fact describe the regime used in )hina.
•
• ith a linked exchange rate regime, as used by ong %ong, the exchange rate is lockedith a linked exchange rate regime, as used by ong %ong, the exchange rate is locked
into a ratio with a nominated currency, such as the #$, or a basket of currencies. into a ratio with a nominated currency, such as the #$, or a basket of currencies.
Learning obje
Learning objective !:ctive !: "dentif and disc"dentif and discuss the major guss the major groups of particroups of participants in the FXipants in the FX markets
markets
•
• /articipants in the FX markets include those who have underlying commercial and/articipants in the FX markets include those who have underlying commercial and
financial transactions denominated in foreign currencies. This includes importers and financial transactions denominated in foreign currencies. This includes importers and exporters, and those investing or borrowing overseas in a currency other than their home exporters, and those investing or borrowing overseas in a currency other than their home currency.
currency.
•
• *n addition, there are speculators who buy and sell foreign currencies in the expectation*n addition, there are speculators who buy and sell foreign currencies in the expectation
of making profits from favourable exchange rate movements, and there are those who of making profits from favourable exchange rate movements, and there are those who arbitrage exchange rate and+or international interest rate differentials across the different arbitrage exchange rate and+or international interest rate differentials across the different international markets.
international markets.
•
• )entral banks also enter the FX markets as buyers and sellers of foreign currency. )entral banks also enter the FX markets as buyers and sellers of foreign currency.
central bank may enter the FX market in order to provide its government0s foreign central bank may enter the FX market in order to provide its government0s foreign currency re1uirements or, from time to time, in an attempt to influence the value of a currency re1uirements or, from time to time, in an attempt to influence the value of a currency in the market
currency in the market, or to adjust its , or to adjust its foreign currency reserve portfolioforeign currency reserve portfolio..
Learning obje
Learning objective #:ctive #: $escribe the fun$escribe the functions and opections and operations of the FX marrations of the FX marketskets
•
• The FX markets operate somewhere around the globe 23 hours a day.The FX markets operate somewhere around the globe 23 hours a day. •
• The markets are dynamic, with exchange rates changing in response to the continuousThe markets are dynamic, with exchange rates changing in response to the continuous
flow of economic, political, financial and social news and information into the markets. flow of economic, political, financial and social news and information into the markets.
•
• *t is estimated that around the e1uivalent of #$4 trillion pass through the FX markets*t is estimated that around the e1uivalent of #$4 trillion pass through the FX markets
each day, facilitated by FX dealing rooms that use sophisticated, technology-based each day, facilitated by FX dealing rooms that use sophisticated, technology-based computer and communication systems.
computer and communication systems.
Learning obje
Learning objective %:ctive %: List and explain the List and explain the tpes of FX tratpes of FX transactions, in particnsactions, in particular spot andular spot and for&ard trans
for&ard transactionsactions
•
• The contracts that are traded in the FX markets are distinguished by their maturity orThe contracts that are traded in the FX markets are distinguished by their maturity or
delivery dates. delivery dates.
• $pot and forward contracts are the most common contracts traded.
• $pot transactions have a value date that is two business days from today5 that is, they
re1uire delivery of the foreign currency and financial settlement two business days from the contract date.
• Forward contracts specify a value date more than two business days from today.
Learning objective ': "ntroduce the conventions adopted for the (uotation and calculation of spot exchange rates
• 6ecause of the technology-based nature of the trade in foreign currencies, universal
conventions are adopted in the FX markets.
• For example, a spot 1uote may be #+#$7.824794:.
• The first-named currency in an FX 1uote is called the unit of the 1uotation, or the base
currency. The base currency represents one unit of the currency.
• The second-named currency is known as the terms currency.
• FX dealers, or price-makers, 1uote two-way rates; the first and lower rate is the one at
which the dealer buys the base currency5 the second and higher rate is the one at which the dealer sells the base currency.
• FX dealers will abbreviate their verbal FX 1uotesby removing decimal points and not
repeating common numbers.
• !xchange rates with less than <7 units of the terms currency are 1uoted to four decimal
places, and currencies with more than <7 units are 1uoted to only two decimal places.
• The spread is the difference between the bid and offer rates. • point is the final decimal place in a 1uote.
• *t is possible to derive a range of additional exchange rates on the basis of existing
published rates5 for example, transposed and cross-rates can be calculated.
• To transpose a 1uote from, say, a direct #$+# 1uote to an indirect #+#$ 1uote,
the rule is to reverse the 1uote and then invert by dividing into <.
• s all currencies are 1uoted against the #$, it is often necessary to calculate a
cross-rate that does not incorpocross-rate the #$, for example $=+'(.
• To calculate the cross-rate for two direct 1uotes, place the new base currency 1uote first,
followed by the second 1uote. $imply divide opposite bid and offer rates to obtain the cross-rate.
Learning objective ): $escribe the role of the for&ard market and calculate for&ard exchange rates
• The convention adopted in the 1uotation of forward rates is that the dealer 1uotes the
forward points rather than the outright forward rates.
• To obtain the outright rate, the forward points are added to, or subtracted from, the spot
rate.
• *n calculating the forward points, the dealer uses the spot rate and the differential rates of
interest of the two countries whose currencies are 1uoted.
• When the interest rates of the base-currency country are higher than interest rates in the
terms-currency country, then the base-currency will be at a forward discount and the forward points are subtracted from the spot rate, or vice-versa.
• *f the forward points are rising they are added to the spot rate and vice versa. • The calculation of forward points is;
Learning objective *: "dentif factors that complicate FX market price (uotations and calculations
• We need to consider real-world complications which affect the calculation of
forward points and a forward exchange rate. These include:
o different interest rate year conventions; for example, the USA uses a
360-day year while the UK uses a 365-360-day year
o two-way quotations (bid and offer quotes) o different borrowing and lending interest rates o the effects of compounding periods.
Learning objective +: ecognise the important impact on the FX markets of the -conomic and .onetar Union of the -uropean Union /-.U0
• The !conomic and "onetary #nion has had a significant impact on the structure and
operation of the FX markets. $eventeen foreign currencies have been replaced by a single currency, the euro.
• The euro has become a hard currency for commercial and financial transactions and a
major currency traded in the FX markets.
$ssay %uestions
The following suggested answers incorporate the main points that should be recognised by a student. n instructor should advise students of the depth of analysis and discussion that is re1uired for a particular 1uestion. For example, an undergraduate student may only be re1uired to briefly introduce points, explain in their own words and provide an example. >n the other hand, a post-graduate student may be re1uired to provide much greater depth of analysis and discussion.
1& he glo(al "oreign echange markets are enormous& he )ank "or International *ettlements estimated in +1- that .*/5 trillion in F# transactions occurred daily& $plain the role o" *0IF in the international "inancial markets and gie some reasons "or the strong 2message tra""ic3 gro4th that *0IF has eperienced& 67 15&1
• $*FT is a member-owned cooperative that operates an international electronic
communications system for the transmission of payment orders.
• The very large si?e, geographic diversity and diverse institutional characteristics of the FX
markets re1uire a safe, secure and standardised platform for the transmission of payment orders. $*FT provides this platform.
• /ayments orders are settled by and among the financial institutions that are party to the
relevant transactions.
• s the international scope of financial markets has expanded and the number of
participant institutions and countries has grown, the number of payment orders transmitted must be expected to increase.
• 'o doubt, however, the growth in message traffic experienced by $*FT is also
indicative of the value that financial institutions place on standardised and secure communications.
+& 9s 4e hae seen, the 4orld3s "oreign echange markets are characterised (y a miture o" "ied and "loating echange rate regimes&
a .se your research skills to "ind out 4hich $uropean countries operate a "ied echange rate regime& Identi"y some o" the economic adantages that may (e associated 4ith maintaining such a system&
• *nterestingly, several !uropean countries operate fixed exchange rate regimes. These
countries are 6osnia and er?egovina, 6ulgaria, @atvia, enmark and @ithuania. enmark, for example, pegs its currency, the %rone or %%, to the !uro.
• There may be some advantages to maintaining a fixed exchange rate. These include
potentially enhanced economic stability and greater certainty for international investors and customers. 6enefits might also derive from reduced speculation in the country0s currency.
( /iscuss 4hy China, as a ma:or trading country, might moe to adopt a "loating echange rate regime& (LO 15.1)
• )hina has maintained a pegged currency for many years. $ince the mid-2777s it has
allowed very measured appreciation in its currency against the #$ dollar. The reason for the tight controls is )hina0s fear that a sharp appreciation in its currency will make its exports more expensive and slow economic growth.
• eighing against these considerations is )hina0s emergence as a major player in the
world economy. *t sees a role for its currency as a Areserve currency0, a role traditionally played by the #$ dollar. To achieve this goal, it is believed that the currency will have to
float freely on the FX markets.
• There are also political considerations. )hina has long been under pressure to allow its
currency to appreciate or freely float. The #$ has led these calls. The rationale is that a stronger )hinese currency will increase the demands by )hinese consumers for estern exports.
;& Importers, eporters, inestors and (orro4ers may all (e participants in the F# markets& $plain 4hy each o" these parties 4ould (e inoled in F# market transactions& (LO 15.2)
Firms conducting international trade transactions Bimporters and exportersC;
• 6usinesses that export goods or services in the international markets generally receive
• lso businesses that import goods and services need to pay for those goods and services,
usually in a foreign currency
• The dominant currency of international trade is the #$, but other currencies, such as the
=6/, &/D and the !#E, are also prominent
• Typically, an exporter is likely to sell foreign currency received and buy the local
currency through an FX market
• *mporters have to buy foreign currency in order to pay for their imports.
*nvestors and borrowers in the international financial markets;
• eregulation of the international financial markets has resulted in an enormous increase
in the volume of capital flows around the world.
• @arge corporations, financial institutions and governments raise funds in the international
capital markets.
• 6orrowers with good credit ratings are able to diversify their funding sources in the
international capital markets, such as the euromarkets.
• large proportion of funds borrowed in the international markets is converted in from
the currency borrowed back into the home currency, using the FX market.
• >ther corporations and financial institutions invest overseas5 for example, funds
managers for pension or superannuation funds will invest a proportion of their investment portfolios in international stocks and debt securities.
• The funds managers need to purchase FX in order to make the investments.
• ividend or interest payments received by the funds managers will be denominated in a
foreign currency. The managers may sell on the FX markets to convert the receipts back into the home currency for distribution to fund members.
-& a /istinguish (et4een speculatie and ar(itrage transactions in the F# market&
• $peculative FX transactions are motivated by the pursuit of a profit
• The sheer volume of speculative transactions implies that, at times, speculators are able
to move the market price of a currency
• $uch transactions are always accompanied by an element of risk
• The arbitrageur is able to carry out simultaneous buy and sell transactions in two or more
markets to lock-in a risk-free profit.
( The FX dealing room of a major bank has calculated that it is long in the USD, but is short in the EUR. Explain what is meant by these positions.
• *f the dealer is long in #$ it means that it is holding surplus #$ on its account, that is,
the #$ are in excess to its currency re1uirements to meet exiting FX contracts.
• lternatively, the bank may be speculating on directional movements in exchange rates.
Therefore the bank may take a long position in #$ and a short position in !#E.
• @ong positionholding FX in expectation of a future sale.
• *f there is an expectation that the # will depreciate against the #$, the bank might
go long and buy the #$ Bsell the #C now. *f correct, a profit will be made by converting the #$ back into # after the # has depreciated. owever, if the # appreciates instead, the bank will lose.
• $hort positionentering into a forward contact to sell FX that is currently not held.
• *f there is an expectation that the # will appreciate against the !#E, the bank might
go short and sell forward the !#E now at an exchange rate locked in today. *f correct, the bank will buy the cheaper !#E on the forward delivery date and make a profit on the
transaction. owever, if the # depreciates instead, the bank will lose.
c /escri(e ar(itrage transactions using an eample o" a triangular ar(itrage& (LO 15.2)
• n arbitrageur will attempt to identify markets in which pricing e1uilibrium is not fully
reflected in the price of a financial asset. For example, it may be possible to discover a cross-currency price advantage by buying and selling several foreign currencies in several FX markets at the same time.
• Triangular arbitrage occurs when exchange rates between three or more currencies are
out of perfect alignment. gain, the arbitrageur will simultaneously buy and sell a combination of currencies to take advantage of the price differences.
• rbitrage profit opportunities generally do not exist for long. The buy+sell actions of the
5& Many deeloped economies operate 4ithin a "loating echange<rate regime& 0here a country has a "loating echange rate, identi"y and discuss the circumstances in 4hich the central (ank o" that country might conduct transactions in the F# market& 67 15&+
The central banks of nation-states enter the FX markets periodically, for one or other of the following reasons;
• to ac1uire foreign currency to pay for their governmentGs purchases of imports, such as
defence e1uipment, and to pay interest on, or to redeem, the government0s overseas borrowings.
• to change the composition of the central bank0s holdings of foreign currencies as part of
its management of official reserve assets. >fficial reserve assets are central bank0s holdings of foreign currencies, gold and international drawing rights
• to influence the exchange rate. )entral bank intervention in the FX market would not
exist if the value of a currency was determined purely by market forces, that is, a so-called clean-float. owever, central banks may, at times, be significant buyers or sellers of a currency where it considers the exchange rate is moving too rapidly, and is trading well outside rates that can be supported by economic fundamentals. *f the goal is to slow down an appreciation of the exchange rate, the central bank will sell its local currency. *n another example, if the Eeserve 6ank wished to support the # to stop it depreciating and perhaps assist it to appreciate, it would buy # and sell foreign currency.
=& he ma:or commercial and inestment (anks locate their F# dealing rooms 4ithin their treasury operations& /escri(e ho4 an F# dealing room is structured and "unctions 4ithin a ma:or (ank& (LO 15.3)
• The number of dealers in an FX dealing room may range from a few FX dealers to more
than 100 dealers depending on the scale of an institution’s FX operations.
• Apart from the FX dealers, an institution will probably also have dealers that trade in
derivative contracts based on financial instruments and commodities, cash products and debt securities.
• To facilitate FX transactions it is essential that the various dealing rooms around the
world have access to the same information at each moment in time.
the various currencies, but also the economic, political and social news that may affect the values of any particular currency.
• There are a number of global electronic networks, such as Reuters and Bloomberg, who
provide such information.
• In an FX dealing room, an array of computer screens link the electronic trading platforms
of FX dealers.
• Each dealer, by keying in the codes for any other dealing room, is able to see on the
screen the indicative FX rates at which the other dealers are prepared to buy and sell various currencies.
• Firm rates, at which FX dealers are prepared to transact, are obtained from each dealer’s
electronic trading platform.
• Deals are confirmed in writing electronically as soon as possible after the transaction.
Dealing rooms also tape-record conversations at the dealing desk for use in settling any disputes that may arise.
• FX dealers have developed conventions and a language of their own. The following
sections present and explain some of the conventions and the language used in the FX markets.
>& 7utline the "eatures o" the main types o" contracts that are created in the F# markets, distinguishing (et4een short<dated, spot and "or4ard transactions& (LO 15.4)
• n FX transaction is described by its value date, that is, the day that the currency is
delivered and settlement is made.
• $pot transactionsthe FX contract value date is two business days from the date of the
initial order. The exchange rate is determined today, but delivery occurs in two business days. For example, a company places an order with an FX dealer to buy #$< million at a rate of #+#$<.H7H2 on a Tuesday, then the dealer will deliver #$< million on the Thursday and the company will pay #I:I H3<.8H also on the Thursday.
• Forward transactionsthe FX contract value date occurs at a specified date beyond the
spot date, for example an order to sell !#E in three months. gain, the exchange rate is set today that will apply at spot plus three months. *f today is 23 "arch then the H-month forward value date will be 2: &une, providing that is a business day Bif not, the date will be moved forward to the next business dayC.
• tod transactionsan FX contract with settlement and delivery today. • tom transactionsan FX contract with settlement and delivery tomorrow.
8& 2he F# market has a 4ell<esta(lished set o" language conentions& hese conentions hae (een deeloped to allo4 the e""icient communication o" market data&3 $plain and illustrate this statement (y re"erence to the language conentions used in the spot F# markets& .se an eample to eplain your ans4er& (LO 15.5)
• ssume the following 1uote #+#$7.8:4294:
• The first-named currency in the 1uote is the base currency or the unit
of the 1uote, that is one # e1uals #$7.8:4294:
• The second named currency is the terms currency, the #$. The terms
currency is valued relative to the base currency
• The 1uote is a two-way price, that is, a bid price BbuyC and an offer
price BsellC
• The first number is the bid price#+#$7.8:42 • The second number is the offer price#+#$7.8:4:
• The market convention is to drop common numbers between the
bid+offer price
• The bid+offer is from the perspective of the dealer, that is, the dealer
will buy <# for #$7.8:42, or sell <# for #$7.8:4:
• The difference between the dealer0s bid+offer prices is the spread
• The spread in the example is 3 points Ba point is the last decimal point
in a 1uoteC.
?& .sing the contet o" the currency pair .*/@APB, eplain the terms (ase currency, terms currency, direct %uotation and indirect %uotation& (LO 15.5)
• 6ase currencythe first named currency in an FX 1uote that is expressed as one unit in
terms of the second currency. *n the #$+&/D example the base currency is the #$ and is expressed as <#$ will be bought+sold for the amount of &/D that will be given in the 1uote.
• irect 1uotationwhen the #$ is the base currency of the unit of the 1uotation as in
the #$+&/D example
• *ndirect 1uotationwhen the #$ is the terms currency and the other currency is the
base currency in the 1uotation. *n that case the above 1uote would be transposed to &/D+#$.
1& 9n F# dealer is %uoting spot .*/@*/1&+>5D5=&
a eplain "rom the perspectie o" the dealer 4hat the F# %uote indicates&
• The price maker FX dealer will buy #$< for $=<.2I47. For the party that has entered
into the FX contract with the dealer they will sell #$< and receive $=<.2I47
• lso, the dealer will sell #$< for $=<.2I4:5 the customer will receive #$< and pay
the dealer $=<.2I4:
• The dealer will make a margin of : points between its bid and offer transactions.
( transpose the %uotation& (LO 15.5)
• The #$+$=<.2I4794: is a direct 1uote5 the #$ is the base currency • *t is possible to transpose the direct 1uote to an indirect 1uote B$=+#$C • Eule; reverse then invert.
USD/SGD1.2750–1.2756
Eeverse the bid+offer prices <.2I4:9<.2I47
take the inverse, that is, divide both numbers into < $=+#$7.IJH897.IJ3H
11& 9 men3s "ashion la(el in the .E is eporting goods to /enmark& In order to ascertain the "irm3s eposure to "oreign echange risk the company needs to calculate the )P@/EE cross<rate& 9n F# dealer %uotes the "ollo4ing rates!
.*/@/EE 5&-;1D;> .*/@)P &==;D=?
Calculate the )P@/EE cross<rate& (LO 15.5)
o place the currency that is to become the unit of the 1uotation first
o divide opposite bid and offer rates, that is;
o to obtain the bid rate; divide the base currency offer into the terms currency bid
o to obtain the offer rate; divide the base currency bid into the terms currency offer.
• Therefore, place the #$+%% 1uote first;
#$+%% 4.37H<9HI#$+=6/ 7.:7:H9:8 To determine the =6/+%% cross rate;
4.37H< + 7.:7:8 K J.872J 4.37HI + 7.:7:H K J.8<2:
=6/+%% J.872J-8<2:
1+& 9 *4iss manu"acturer generates receipts in .*/ "rom its eports o" chocolate to 9merica& 9t the same time, the company imports cocoa "rom igeria, incurring commitments in naira& Rates are %uoted at!
.*/@ 1=+&+5+<+? CGF@.*/ 1&1;1<1? Calculate the CGF@ cross<rate& (LO 15.5)
• *t is possible to use two methods to calculate this cross-rate5 first
transpose the )F+#$ rate to a direct #$+)F rate and then use the two direct 1uote method Bsee 1uestion <<C. lternatively, use the direct and indirect 1uote method.
• )rossing a direct and an indirect FX 1uotation;
o to obtain the bid ratemultiply the two bid rates
o to obtain the offer ratemultiply the two offer rates.
• To determine the )F+'=' cross rate;
<:4.2427 x <.<H<7 K <JH.47I7 <:2.2428 x <.<H<8 K <JH.:8JJ
1;& 9 erman importer has entered into a contract under 4hich it 4ill re%uire payment in )P in one month& he company is concerned at its eposure to "oreign echange risk and decides to enter into a "or4ard echange contract 4ith its (ank& ien the "ollo4ing simpli"ied data, calculate the "or4ard rate o""ered (y the (ank& 67 15&=
$.R@)P spot! &8+=D=>
7ne<month erman interest rate! -&>5H p&a& 7ne<month #%interest rate! ;&+5H p&a&
• The 1uote is from the perspective of the dealer relative to the base currency.
• The importer needs to buy =6/ therefore it will sell !#E to the dealer. The dealer is
therefore buying !#E, so need to use the bid rate.
$ L< M B It x contract days+days in yearCN L< M B Ib x contract days+days in yearCN
where; $ K spot rate
*b K interest rate of base currency *t K interest rate of terms currency
Therefore, based on the above data;
7.J2:7 L< M B7.7H24 x H7+H:4CN L< M B7.73I4 x H7+H:4CN
K 7.J2:7 B<.772:I + <.77H8C K !#E+=6/7.J247
1-& 0hile the F# markets are a glo(al market, ariations in calculation conentions can occur& 0hen considering interest rate di""erentials and "or4ard echange rate calculations between currencies such as the USD and the GBP, what important adjustments need to be taken into account?
• The #$ uses a H:7-day year convention while the #% uses a H:4-day convention • There is a need to recognise this variation in the forward exchange contract formula.
15& he esta(lishment o" the $conomic and Monetary .nion has had a signi"icant impact on the structure and operation o" the glo(al F# markets&
a /iscuss the process o" monetary union in $urope and the issues releant to the F# markets that are implied in the a(oe statement&
• The "aastricht treaty seeks to create economic and monetary union within !urope.
• s of < &anuary 27<3, 2J countries are members of the !uropean #nion B!#C. The
newest member is )roatia. >nly <I member states have adopted the euro as their nation0s currency. The euro was introduced for financial transactions in &anuary <888.
• !uro notes and coins were introduced in &anuary 2772.
• The euro has become a hard currency used for international trade and financial
transactions.
• )entral banks around the world support the euro by holding the euro as part of their
foreign reserves.
• The removal of <I currencies and the introduction of one major currency Bthe euroC has
increased the li1uidity in the FX market.
• The introduction of the euro has removed foreign exchange risk for trade and financial
transactions denominated in euro that are carried out between member states.
(b) Discuss the ways in which the continued evolution of the EMU may shape FX markets in the future.
• The most interesting way in which further evolution may shape markets is by the gradual
establishment of a ‘United States of Europe’ in which a shared currency and shared bond markets characterise the European financial landscape.
• The Euro currency and the establishment of Eurozone have made trade and finance much
less risky across the region. Cross-currency risks have been eliminated. Further expansion of the EMU to include more countries that will eventually adopt the Euro may reduce the currency risks exporters and importers face when dealing with some of the smaller European economies.
• However, the GFC has demonstrated that the EMU has introduced alternative sovereign
debt risks and geopolitical risks that may not have been as apparent in previous decades.
• The more integrated nature of financial institutions and real economies is also attended by
FINANCIAL NEWS CASE STUDY
)hapter <4 introduced the foreign exchange markets and provided a good understanding of the structure and operation of the FX markets. The 6ank for *nternational $ettlements publishes a Triennial $urvey of activity in the global FX markets. This survey always makes for interesting reading. >ne of the most interesting features of the FX markets that is revealed in each survey is the extraordinary magnitude of the volume of FX trading that takes place each day. s we have mentioned in the chapter, more than O4 trillion of FX is traded each day. *n these trades, the #$ dollar is on one side of the transaction on JI per cent of occasions. The second most traded currency is the euro. "ost of the trading takes place at trading desks located in the #nited $tates, the #nited %ingdom, $ingapore and &apan.
=lobal turnover of more than O4 trillion per day works out to approximately to O2777 trillion per year. This figure can be contrasted with the annual value of global trade flows, which the orld Trade >rganisation estimates at approximately O27 trillion. *t is 1uite easy to see that much of the turnover on the FX markets has no relationship to the physical flow of goods around the world. *t is also plausible to conclude that much of the turnover is also unrelated to hedging the value of FX associated with the physical trade of goods. The amount of turnover on the FX markets implies that there
is a considerable amount of speculative activity that is somewhat detached from the underlying real economic transactions that characterise the global economy.
*n ustralia and around the world, there has been increasing participation in FX trading by small investors. This has resulted in several $*) warnings to investors as well as the imposition of sanctions and penalties on unscrupulous providers of trading platforms. The warnings are summarised in the following news story from the
Business Review Weekly B6EC;
stern warning to retail investors about foreign exchange trading and detailed the reasons the odds are stacked against them! "n the heels of the colla#se of $T% Tradeu# a Sydney forex derivatives broker that has gone into li&uidation owing clients '( million the regulator has warned that )ust one of the risks faced by investors in foreign exchange is *counter#arty risk* where an issuer defaults on obligations! +retting that #romoters of forex investment strategies are on the rise ASIC has documented five reasons why most investors are not cut out for the #roducts
they offer!
,! There are significant investment risks as currency fluctuations may move against you causing you to lose money! -xchange rates are very volatile . they tend to move around a lot even within very short #eriods of time!
/! 0arkets are o#en /1 hours a day six days a week 2due to time 3ones4 so you need to devote a lot of time tracking your investment!
(! Currency markets are extremely difficult to #redict because so many factors affect exchange rates!
1! -ven small market movements can have a big im#act because more forex trading #roducts are highly leveraged!
5! Risk management systems such as sto#6loss orders will only give you limited #rotection by ca##ing your losses! 7ou may have to #ay a #remium #rice to guarantee your sto#6loss order!
*+orex trading is com#lex and risky! -ven the most skilled and ex#erienced forex traders have difficulty #redicting the movements in currencies! Trading in international currencies re&uires a huge amount of knowledge research and monitoring* ASIC Commissioner $reg Tan3er says!
*%ike any investment it is vitally im#ortant investors fully understand what they are getting into and +8 trading is no different! 9nless you fully understand what
Review Weekly , Oc$o)er 21*
/I*C.**I7 P7I*
• he olumes, in .*/ terms, o" transactions in the glo(al F# markets are
large compared to underlying trade "lo4s& Is there a case "or the restriction o" F# trading
case could certainly be made. hen there is such a large volume of transactions in excess of the real underlying economic activity, a case can be made for curtailing the extent of BspeculativeC trading activity. Financial speculation well in excess of the underlying real economic factors is a long-running target for criticism, especially in times of crisis.
• $aluate 9*IC3s position regarding the suita(ility o" F# trading "or small
inestors&
$*) effectively points out that unprofessional investors are likely to suffer losses if they attempt to trade FX. This is probably true for any financial security. owever, there are a number of reasons, identified by $*), why this might be particularly the case in the FX markets. The volatility of the markets, their round the clock nature and the leverage inherent in many of the products ensure that mistakes may be punished more severely.
• /iscuss 9*IC3s conclusion that the moements in the F# markets are impossi(le to
predict (ecause o" the many "actors that a""ect echange rates&
This is probably true, though some traders would argue that technical trading rules and momentum type strategies Awork0, particularly in the shorter term Bover a matter of seconds or minutesC. >ver the longer term, macroeconomic factors shape the ups and downs in currencies. These factors are likely to have a predictable component and an unpredictable component. hen this semi-predictability is combined with the level of trade, volatility and speculation that characterises the FX markets, it is possible to argue that FX markets move up and down in a manner that is impossible to predict.
<. F FX markets are open for a short period each day during which a small number of transactions are undertaken.
2. lthough ustralia operates a floating exchange rate regime, the Eeserve 6ank has sometimes intervened in the FX markets.
H. The )hinese government has gradually widened the range over which its currency may appreciate and depreciate relative to other currencies.
3. F There are two different types of FX dealers; those that offer to buy currencies at a particular price and those that offer to sell currencies at a particular price.
4. F )entral banks do not usually hold any reserves of foreign currency but simply ac1uire it as the need arises.
:. spot transaction is one in which an order to buy or sell a currency is placed today, at a price determined today, and with settlement of the transaction taking place two working days from today.
I. F forward FX transaction is one in which the order is placed today, at a price determined at the time of the order, but with settlement of the transaction taking place before spot.
J. F *f a firm were to ask a dealer for the Adollar euro spot0 or for the Aeuro dollar spot0, the firm will receive the same bid and offer 1uotes.
8. =iven #$+!#E7.I24797.I244, the FX dealer would buy #$< from you and give you !#E7.I247.
<7. verbal 1uote of A!uro ussie spot is one thirty-one seventy-two9eighty0 would be written as !#E+#<.H<I29J7.
<<. F =iven the 1uotation !#E+#<.H2I29J7, the transposed rate is #+!#E7.I4H49H7.
<2. =iven #+&/DJ2.479:7 and #+!#E7.48749<4, the cross-rate is !#E+&/D<H8.3J9JJ.
<H. F=iven #$+&/DI:.<79<4 and =6/+#$<.:H479<.:H:7, =6/+&/D is 3:.4293:.4I. <3. F *f an FX dealer is short a currency, they will need to sell the physical currency to settle an existing FX contract when the contract falls due.
<4. *f a bid price on the #$+!#E is 7.I2:I and the offer price is 7.I2IH, the spread is : points.
<:. *f the spot rate is #+#$7.822797.8224, and the six-month forward points are A4J to :H0, the six-month forward rate would be #+#$7.82IJ97.82JJ.
<I. The data in 1uestion <: indicate that the rate of interest on six-month money is higher in the #$ than it is in ustralia and that the # is at a forward premium.
<J. F s a result of the sovereign debt crisis the euro has ceased to be a hard currency widely used in international trade.
<8. Fll member states of the !uropean #nion now have the euro as their currency unit. 27. *n the #$, &apan and !urope, money-market instruments are usually 1uoted on the basis of a H:7-day year, whereas in the #%, ustralia and 'ew (ealand these rates are 1uoted on a H:4-day year.
