Lecture 7: The FX market

Question 1

What are the main functions of FX?

Answer 1

1) Facility cross- currency payments
2) Reveal the value of currency
3) Allow trades to manage their FX risks

Question 2

What is an exchange rate?

Answer 2

A price of one currency in terms of another

Question 3

What does the trade weight index (TWI) do?

Answer 3

Values the AUD against an index of foreign currencies weighed according to their role in trade

Question 4

What is the commodity and the terms currency

Answer 4

Commodity (currency being bought and sold) 
Terms currency (what is being bought / sold) i.e. in terms of USD

Question 5

What does AUD/ USD 0.9595 mean?

Answer 5

$1 AU= $0.9595 USD

Question 6

Is the following an appreciation or depreciation of currency?
AUD/ NZD 1.3890 > AUD/ NSW 1.3990

Answer 6

APPRECIATION of currency

AU dollar now buys $1.3990 NZD instead of 1.3890

Question 7

How are bids and offers quoted?

Answer 7

Buying rate (that is, in $ terms)

Question 8

What does AUD/ NZD 1.1525-30 mean?

Answer 8

Means that the dealer is bid (willing to buy) $1AU for $1.1525NZD and offering (willing to sell) $1AU for $1.1530 NZD

Question 9

What is a spot FX contract?

Answer 9

Exchange of currencies in two days based on the agreed spot exchange

Question 10

What is a forward FX contract?

Answer 10

Exchange of currencies at a specified date- that is, anytime after the spot settlement date of T+2

Question 11

How is the forward rate calculated?

Answer 11

Spot rate adjusted for delayed settlement

Question 12

When will a forward trade at a premium or discount

Answer 12

Premium= When the terms IR is higher: premium 
Discount= When the terms IR is lower: discount

Question 13

How are forward points calculated?

Answer 13

Forward rate- spot rate

Question 14

When will a forward point discount or premium occur?

Answer 14

Forward point premium= Forward is more than the spot rate

Forward point discount= Forward is less than the spot rate

Question 15

Does the forward rate expose a dealer to fx risk?

Answer 15

No- it is based on the INTEREST RATEWS in the two currencies.

Question 16

How do dealers earn their income in the FX market?

Answer 16

Through the spread between their forward bid and offer rates

Question 17

How do dealers cover their net obligations everyday?

Answer 17

Buy many and sell many forward contracts and thus have to ensure the maturing securities are sufficient to cover their net settlement obligations each day

Question 18

What is an FX swap? What does it comprise of?

Answer 18

FX swap= combination of two FX contracts (with different settlement days)

• Currencies are exchange at agreed rate (current sport rate)
• Arrangements are made to exchange them back at an agreed forward rate

Question 19

What is the cost of an FX swap?

Answer 19

Swap points

Question 20

What is FX risk? Does it apply to swaps?

Answer 20

FX risk is the change of an unexpected adverse movement in the exchange rate. No- as FX swap is a risk- management product- enabling the exchange of currencies for a period of time, without incurring FX risk

Question 21

When would someone engage in a buy/ sell swap, or a sell/ buy swap?

Answer 21

Buy/ sell swap: When purchasing an investment in a foreign country
Sell/ buy swap: When obtaining a loan in another currency

Question 22

How would a sell/ buy swap when engaging in a foreign loan?

Answer 22

Sell/ buy swap:

1) Borrowing money: Sell USD for AUD
2) Paying back money: Sell AUD for USD

Question 23

What are the FX risks faced by:

a) Importers who pay for imports in a foreign currency
b) Exporters who receive exported income in a foreign currency?

Answer 23

a) Risk of the AUD depreciating- having to pay more $1AU= less USD
b) Risk of the AUD appreciating- need more USD to buy $1AU

Question 24

What are the FX risks faced by:

a) An Australian who has a foreign loan
b) An Australian who invests in a foreign country

Answer 24

a) Risk of AUD depreciating= increases the amount to repaid (need more AUD to repay $1USD)
b) Risk of AUD appreciating (need more $USD to buy $1AUD)

Question 25

What is the COSTS assocaited with an FX forward or FX swap?

Answer 25

The forward or swap points- offsets the difference in the interest rate

Question 26

What does this mean when borrowing overseas using an FX forward or swap?

Answer 26

The loan interest rate will be the rate of return that is achieved on the loan

Question 27

What are the key features of the Australian FX market?

Answer 27

1) Wholesale and OTC 2) Licensed by ASIC to trade in FX 3) Two segments - Inter-dealer and - Dealers trading with counter parties

Question 28

What system is used to settle FX transactions? What kind of a market is this

Answer 28

Electronic broking systems (order driven market)

Question 29

What are the three main advantages of an electronic booking system?

Answer 29

1) Price discovery is more transparent 2) Lower cost and narrower spreads 3) Integrate front and back office functions

Question 30

1) Why is the Australian FX market so large? 2) What are the two largest FX markets? 3) What is the key currency that is traded in the Australian FX market

Answer 30

1) So large because of time zones- when US and UK are closed- AU is open 2) UK is largest, US is second largest 3) AUD only accounts for half- other currencies are traded when US and UK markets are closed

Question 31

What are the five trends that explain why market turnover has increased?

Answer 31

1) Speculation via the 'carry trade' 2) Offshort borrowing 3) Offshore investing 4) Foreign trade 5) Overseas investments in AUD securities

Question 32

What is the 'carry trade' speculation

Answer 32

Borrowing where interest rates are low and investing where interest rates are high- differential will lead to a very high return on investments

Question 33

What are the 7 main theories for explaining exchange rate movements?

Answer 33

1) Purchasing power parity 2) Interest rate parity 3) Expected movements in interest rates 4) Terms of trade 5) Speculation 6) Current account baance 7) The RBA

Question 34

What does the purchasing power parity theory state?

Answer 34

Trade flows will cause adjustments to the FX rate to ensure that all goods cost the same amount in each country

Question 35

What does the expected interest rate parity theory state? | What does this theory state is AUD interest rates rise?

Answer 35

Spot rate movements will offset the differences between interest rates to equalise effective interest rates e.g. if AUD interest rates rise= AUD will be expected to fall

Question 36

What does the expected interest rate theory state?

Answer 36

States that interest rates rising will put an upward pressure on the exchange rate because international investors will move the funds into the currency

Question 37

What does the terms of trade theory state?

Answer 37

Terms of trade= Export prices/ Import prices - Theory states: If export prices increase (improvement to terms of trade ratio) then the currency will tend to appreciate - THINK: If the value goes up- we earn more-- therefore more people want to invest- so naturally the FX rate will increase

Question 38

What does the speculation and risk theory state?

Answer 38

Driven by those who predict currency movements and time currency transactions

Question 39

What does the current account balance theory state?

Answer 39

Current account balance= Exports- Imports If exports are greater than imports (i.e. selling more than spending) AUD will appreciate If exports are less than imports (i.e. spending more than selling) AUD will depreciate

Question 40

How does the RBA influence RX rates?

Answer 40

RBA trades AUD because it does not believe the market always establishes the currency's true value- buy and sell AUD