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TOPIC 5: THE FOREIGN

EXCHANGE MARKET

Aim

The aim of this topic is to explain the nature and operation of the foreign exchange market
along with the main determinants of the foreign exchange value of a currency. When a
resident of one country enters into an economic transaction with a resident from another
country, trading in the foreign exchange markets results. The topic examines the major
groups of participants and trading practices in the market, the main types of instruments
traded and, how trading in foreign exchange markets establishes the value of currencies.

Learning objectives
After working through this topic you should be able to:

1. Describe the nature of the foreign exchange market

2. Read and quote foreign exchanges prices
3. Explain why the foreign exchange markets exists
4. Outline the nature of globalisation and explain the reasons for off-shore borrowing
5. Describe the role of the major players in the market
6. Calculate the spot and forward market prices and cross rates
7. Demonstrate an ability to maintain a foreign exchange trading position.
8. Explain how the interaction of supply and demand determines the foreign exchange value
of a currency
9. Provide a brief history of the exchange rate systems adopted by Australia since the early
1970s, and outline the problems associated with the fixed exchange rates.
10. Explain how the following factors can affect the foreign exchange value of a currency:
 relative inflation rates and purchasing power parity
 relative economic growth rates
 relative interest rates
 commodity prices
 international speculation and investment
 expected movements in exchange rates
 official intervention into the foreign exchange market.
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 O B J E C T I V E 1
After working through this section, you should be able to describe the nature of the
foreign exchange market

5.1 Nature of the foreign exchange market

Foreign Exchange is simply about the exchanging of one currency for another. There is no
mystery or tricks to the exchange. If you want to buy a loaf of bread you can exchange
money for it – so too with currencies. If you want Malaysian Ringgits or Singapore Dollars
and you only have Australian dollars then you can go to a shop and literally buy Malaysian
Ringgits or Singapore dollars at a price and hand over the correct amount of Australian
dollars.

The only thing that is slightly different about buying other currencies is that the value of one
currency can be expressed in terms of another currency, and vice versa. For example, you can
walk into a shop and ask the price of a loaf of bread. The answer you get is the value of bread
in terms of dollars. You could also, in theory, walk into a shop and ask how much bread you
can get for $1. The answer you would get (half a loaf, say) is the value of a dollar in terms of
bread. Although this doesn’t often happen with bread, it happens all the time with currencies.
We will return to the various methods of quoting the value of currencies below.

There is no physical marketplace for wholesale foreign exchange – a location where large
volumes of currencies are exchanged. All you need is a phone and authority to trade and a
deal can be done. In recent year the technology has evolved, and the use of electronic broking
system has become the norm, few deals are now negotiated via the phone. The ICAP and
Reuter 300 are two of the most popular broking system. These systems centralises the order
book and match orders, enhancing efficiency and transparency of prices.

Due to time zones differences trading can take place 24 hours a day almost 7 days a week.
The market place consists of a telecommunications network and a range of information
systems which provide a mechanism for the exchange of currencies around the world.

The retail market where small volumes are handled - less than $25,000 - is often at a shop
front; at an exchange bureau, such as a bank or Thomas Cook travel shop.

5.1.1 What is Foreign Exchange?

Foreign exchange is the exchanging of one currency for another. Unlike the other markets
examined in this course, the forex market is not a capital market, in that it is not used to raise
funds. It exists to allow for the exchange of currencies. After a transaction, there is no further
obligation (e.g. debt or equity obligations) on the part of the parties to the transaction.
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5.1.2 What is a Foreign Exchange rate?

A foreign exchange rate is the price or value of one currency expressed in term of another
currency.

For example:

1 AUD = 0.8446 USD

1 USD = 1.1839 AUD

The above equations are two different ways of expressing the same exchange rate. In the first
example, the price of 1 Australian Dollar, in terms of US Dollars, is 1.1839. It would cost
US$0.8446, to buy A$1. In the second example, the price of 1 US Dollar is 1.1839 Australian
Dollars. It would cost A$1.1839 to buy US$1. This is the same rate of exchange, expressed
two different ways, because 1.1839 is the reciprocal of 0.8446.

The above exchange rate would normally be quoted in one of the following formats:

AUD/USD = 0.8446

USD/AUD = 1.1839

In each case, the exchange rate is the price of the first-named currency in terms of the second-
name currency. So the first example is the price of an Australian Dollar, in terms of US
Dollars, and the second example is the price of a US Dollar in terms of Australian Dollars.
More formally:
 Base currency – the first named currency in an FX quote that is expressed as one unit
in terms of the second currency. In the AUD/USD example the base currency is the
AUD and is expressed as 1AUD will be bought/sold for the amount of USD that will
be given in the quote.
 Terms currency – the second named currency in the quote, that is, the USD.
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Source: Thomson Reuters Eikon

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5.1.3 Further Foreign Exchange terminology

[Link] Depreciation/Appreciation/Devaluation/Revaluation

Consider again the above exchange rate. If we check the AUD/USD exchange rate the next
day, we might find that it has changed to the following:

AUD/USD = 0.8424

The price of an Australian Dollar has decreased from 0.8464 to 0.8424 US Dollars. It has
depreciated against the US Dollar. Logically, this means the US Dollar must have increased
in value, or appreciated against the Australian Dollar. We can check this by taking the
reciprocal of the above number:

USD/AUD = 1/0.8424 = 1.2136

The US Dollar has indeed increased in value, or appreciated against the Australian Dollar.

The terms Depreciation and Appreciation are used to indicate a change in the value of a
floating currency, in response to market forces. If the government decides to decrease the
value of a fixed or pegged currency, we call this a devaluation and if it decides to increase
the value of such a currency we call this a revaluation.

[Link] Direct and indirect quotation

An exchange rate which gives the value of a unit of foreign currency in terms of the local
currency is referred to as a direct quote. An exchange rate which gives the value of a unit of
local currency in terms of a foreign currency is referred to as an indirect quote. In the
examples used earlier:

AUD/USD = 0.8446

USD/AUD = 1.1839

the first quote is an indirect quote from the point of view of a resident of Australia, and
the second quote is a direct quote from the point of view of a resident of Australia.

The convention in the former members of the British Empire, such as Australia and New
Zealand, is to use indirect quotes. This is why the first of the above quotes looks more
familiar to us. The convention in most countries of the world is to use direct quotes. Foreign
exchange quotes in Malaysia and Hong Kong are usually expressed as follows:

USD/MYR = 3.0008

USD/HKD = 7.8012

[Link] Commodity and Terms currencies

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A foreign exchange quote such as AUD/USD = 0.8424 can be classified as an indirect quote
in Australia and a direct quote in the USA. However, neither classification makes sense from
the point of view of a resident of Japan. It is perhaps more useful to classify the first-named
currency as the commodity currency and the second-named currency as the term currency.
Thus, an exchange rate is the price of a unit of the commodity currency in terms of the terms
currency.

[Link] Jargon

Foreign exchange dealers have developed a short-hand jargon which they use when asking
for and giving foreign exchange quotations. In jargon speak, if the Australian/US Dollar
exchange rate is the following:

AUD/USD = 0.8424

this is described as "the Aussie is 0.8424 ". Other examples might be "the Kiwi is 7521" and
the "Cable" is 1.721. The US Dollar is known simply as the "dollar" or the “big dollar”
depending where in the world you are dealing.

In the above quote, the first 2 digits after the decimal point are known as the “big figure”.
Dealers will often assume that the person they are dealing with knows the big figure, and
might simply say that “the Aussie is at 39”. The last two digits – the “39” – are sometimes
referred to as the pips or the basis points.

5.1.4 Quotation of exchange rates

[Link] Two-way pricing

In all financial markets there will be a two-way price – a price at which the commodity can
be bought and a price at which the commodity can be sold, whether the commodity is a share,
a bank bill or currency.

Like any purchase of an asset there is a price at which you can buy and a different price at
which you can sell. Think about the price of your car or textbook. The price you paid for it
will probably not be the price which you can sell it, regardless of wear and tear. Most of the
time you will get less for selling your car than you paid to buy it. It is what as known as the
dealer’s margin or spread.

In currency markets, banks quote two-way prices and are called price makers. Banks, brokers
and financial institutions all quote a two-way price. It is part of their job and responsibility in
the market. Corporations do not quote two way prices – they are price takers. They must take
the price the bank gives them. The corporation has a choice of dealing or not dealing at that
price.
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[Link] Bid, offer and spread

There always appears some confusion over the bid and offer of a price that a bank quotes.
The bid/offer is always from the price makers’ point of view.

The bid is the first price which is the price the bank wants to buy the commodity currency
and the offer is the price the bank wants to sell the commodity currency. The difference
between the bid and the offer is often called the spread. It represents the profit the bank will
make if it can buy and sell the currency simultaneously. The bank like any trader wishes to
buy the currency lower than it will sell the currency. The foreign exchange market, unlike
many other markets, does not charge a commission. All costs are in the spread so the bank is
careful in watching the smallest movement in the market to monitor this spread.

Example of bid and offer rates in the foreign exchange market:

Spot AUD/USD
Bid Offer Spread
Quoting bank 0.8081 0.8082 1 pips
buy AUD sell AUD
sell USD buy USD
Calling bank sell AUD buy AUD
buy USD sell USD

EXAMPLES
a) A corporation might ring up a bank and ask for a price to buy $1 million USD in
exchange of AUD. The bank might answer "I will sell $1 million USD at .8081”. You
as the corporate can say "Yes that's done. I buy $1 million USD at .8081 " or "No
nothing there". Then you can ring up another bank and look for a better quote.
EXAMPLES
a) A quote from a dealer for the Aussie Euro spot rate, AUD/EUR 0.7846 - 0.7856 means:
the dealer will buy 1 AUD for 0.7846 EUR
the dealer will sell 1 AUD for 0.7856 EUR

For successful trading the rule is to buy the commodity currency cheaply or low and
selling it at a higher price.
b) When you ask a bank for their price for 1 Euro, he bank might answer "46/56". Now
what do you do? 46 and 56 are the basis points which are added to the “big figure” to
determine the actual exchange rate. The bank is assuming that you know the big figure.
Because the convention in Australia is that the AUD is the commodity currency, 46
represents the price at which the bank will buy the AUD (and hence sell Euro) and 56
represents the price at which the bank will sell AUD (and hence buy Euro).
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Once you know the convention you would say "at 46 I buy $1 USD" (which means that
the bank is selling to you 1 USD and buying AUD) or you might say “at 56 I sell $1
USD” (which means that the bank will buy 1 USD from you and sell AUD).

[Link] Calling bank and quoting bank

Corporations are not the only ones who phone banks and ask for foreign exchange quotes.
Banks can also call other banks.
 Quoting bank quotes a 2-way price
 Calling bank asks for a 2-way price
The quoting bank is the price maker and is quoting the bid/offer from their point of view. The
calling bank is the price taker who asks for the price. The price-taker trades at the most
disadvantageous price but has the advantage of deciding whether or not proceed at the price
quoted.

The table below show you the various quotes that can be obtains on the market at a specific
point in time. The quotes are posted by trading desks and brokers located around the world.
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Source: Thomson Reuters Eikon

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O B J E C T I V E 2

After working through this section, you should be able to explain why the foreign
exchange market exists

This section explains the main reasons why people, companies and government trade foreign
exchange.

5.2 Why trade Foreign Exchange?

Whenever there is an economic transaction between a resident in one country and a resident
in another, there is a need for currency exchange.
 For international trade (importing and exporting)
 For capital movements (off-shore borrowing and investing)
The world’s foreign exchange market serves to link each country’s payment system because
each country has a different legal tender.

The foreign exchange market is the place where (or rather, the mechanism by which) entities
can exchange their currencies to conduct international transactions.

5.2.1 Other reasons for trading forex

Economic units also use the market for other reasons which can be described as:
 Hedging
 Speculation
 Arbitrage

[Link] Hedging

Hedging refers to the use of various financial products (eg. derivatives such as forward
contracts, options, futures) to insure or protect an individual against unfavourable movements
in the future prices and variations in wealth. The objective is to reduce variation (ie. risk) in
financial outcomes. This often involves paying a price (ie. incurring a small reduction in the
expected return). This is consistent with the direct relationship between risk and return
discussed in Topic 1 – if there is less risk, there is often less return. Hedgers are happy to pay
this price in order to reduce risk.

For example, an exporter of goods will be paid in foreign currency in 3 months time. He
knows what the exchange rate is now, and can estimate his profit on the export deal, but he
doesn’t know what the exchange rate will be in 3 months time. He is exposed to foreign
exchange risk. He can hedge this risk by entering into a forward foreign exchange transaction
(discussed in more detail below). This involves entering into a contract now to exchange
currency at a set exchange rate in the future. He effectively locks in the rate that he will get in
3 months, and eliminates the foreign exchange risk. Because risk means variation, both
positive and negative, he also eliminates the opportunity to make a profit out of exchange rate
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movements, but exporters are usually focussed on making a profit from their exporting, rather
than foreign exchange movements, and would usually prefer certainty rather than variation.

The exporter in the above example will probably pay a small price for the elimination of risk
if he enters into the transaction with a licensed foreign exchange dealer (which he almost
certainly will). He must deal on the disadvantageous side of the dealer’s bid-ask spread, and
will receive a slightly worse exchange than the expected or average exchange rate he would
receive if he waited until he received his export income and subjected himself to foreign
exchange risk in the spot market.

[Link] Speculation

In many ways speculation can be seen as the opposite of hedging. A hedger will normally
incur a small price in return for the reduction or elimination of risk. A speculator voluntarily
takes on risk in the expectation of making a profit in the future if market conditions turn out
the way he expects. Of course, the presence of risk means that the speculator will make a loss
if market conditions turn out differently.

For example, a speculator who thinks a particular currency will appreciate in the future will
buy that currency. If the currency does appreciate, he can then “close out” his position by
selling the currency at a higher price, thus making a profit. If he thinks a currency will
depreciate in the future, he will sell that currency. (If he doesn’t have any to sell, this is
referred to as “short-selling”, incurring a negative bank balance in that currency). If the
currency does depreciate, he can close out his position by buying the currency at a lower
price, thus making a profit.

A person who enters into a forward foreign exchange transaction to reduce or eliminate the
risk of an exposed position, as in the above example in [Link] is described as a hedger. A
person who enters into a forward foreign exchange transaction without an existing exposure
to foreign exchange risk is in fact speculating. He will have to buy (or sell) the currency in
the spot market in order to perform under the forward contract. He will make a profit if he
can buy more cheaply (or sell at a higher price) in the spot market than the price at which he
deals under the forward contract.

The use of financial markets for hedging and speculation is discussed further in the topic on
Derivatives.

[Link] Arbitrage

This means making a risk-free profit by buying and selling an identical commodity in
different markets simultaneously in order to take advantage of different prices in different
markets. This can occur in almost any market and is a powerful force in ensuring that prices
for the same commodity stay very close to each other in different markets.
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EXAMPLE

Exchange rate arbitrage:

Suppose you rang two banks and received the following quotes:

Bank Location AUD/SGD Quote

Bank A Sydney 1.1050/60
Bank B Singapore 1.1065/75
Because the spreads “overlap” (the offer rate of Bank A is less than the bid rate of Bank B)
you could make an arbitrage profit by undertaking the following transactions:

Buy AUD @ 1.1060 from Bank A in Sydney

Sell AUD @ 1.1065 to Bank B in Singapore

Many others would see the same opportunity and seek to take advantage of it. The forces of
supply and demand would cause the exchange rates to adjust until there is no further arbitrage
profit to be made (or the rates would become so close that an arbitrage profit would be
insufficient to cover the transaction costs of the arbitrage transaction).

EXAMPLE

Triangular arbitrage:

Suppose you receive the following quotes on the following exchange rates:

AUD/USD 1.1050/60
USD/GBP 0.6253/65
GBP/AUD 1.5002/26
The third exchange rate is referred to as a “cross rate” because it does not involve the US
Dollar. The calculation of cross rates is discussed below. Because the above cross rate is
NOT correctly calculated based on the other 2 exchange rates, you could make an arbitrage
profit by undertaking the following transactions:

Sell AUD 1 m. for USD @ 1.1050. Proceeds = USD 1,105,000.

Sell the USD 1,105,000 for GBP @ 0.6253. Proceeds = GBP 690,956.50.

Sell the GBP 690,956 for AUD @ 1.5002. Proceeds = AUD 1,036,572.94.

This results in a profit of AUD 36,572.94. Once again, many others would also attempt to
take advantage of this arbitrage opportunity, resulting in a change to some or all of the above
rates and the elimination of the arbitrage opportunity.
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O B J E C T I V E 3

After working through this section, you should be able to explain the reasons for off-
shore borrowing and to outline the nature of globalisation.

Globalisation is defined as the international integration of economic markets including

financial markets. The globalisation of the Australian financial system has meant:
 Increasing reliance on offshore financial markets by Australian corporations seeking to
raise funds
 An increase in foreign ownership of Australian equities
 Australian managed funds have increased the proportion of funds invested overseas
 All of the top 10 largest Australian companies listed on the ASX are also listed on
overseas exchanges with BHP listed on 7 foreign exchanges
 The Australian dollar is the world fourth most frequently traded currency with over 60%
of trades occurring offshore.
 A wide range of international financial services providers have entered the Australian
market and now compete with Australian providers to offer services to local users.
The points above illustrate how the Australian financial system has become integrated into
the global financial system with substantial increases in both overseas borrowing and
overseas investment. However, offshore borrowing by Australian residents greatly exceeds
overseas investment with net overseas funding a function of the current account deficit. That
is, Australia is a net user of overseas funds.

Therefore, the rest of this section will focus on offshore borrowing, particularly by the
Australian corporate sector.

5.3.1 Reasons for borrowing overseas

There are four main reasons for raising funds offshore; lower interest rates, the availability of
funds, risk management and establishing a profile in global financial markets. These will be
examined in turn.

[Link] Lower interest rates.

One of the main determinants of the source of corporate borrowing is the cost of funds as
indicated by the interest rate. Many Australian corporations have expected to take advantage
of lower overseas rates of interest, relative to Australia, by raising funds offshore. However,
the cost of funds denominated in a foreign currency depends on both the interest rate and
movements in the exchange rate.

Many Australian economic units took out foreign currency loans in the latter half of the
1980s when Australian interest rates were relatively much higher. In particular, Swiss
currency loans were taken out at much lower interest rates than if the funds had been
borrowed domestically. However, the AUD depreciated by an unexpectedly large amount
that, in many cases, more than offset the interest rate differential. Thus, the “effective”
interest rate or cost of funds turned out to be much higher than the domestic cost of funds.
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However, despite the above, it may still be cheaper for an Australian corporate to borrow
offshore, with forward cover, as a result of:
 the Eurocurrency markets are free of domestic regulations, which tends to reduce costs,
and may provide suppliers of loanable funds with lower tax rates.
 the international markets are wholesale markets operating on narrower spreads which
provides lower borrowing rates.
 the availability of funds (see below). This is a reason for borrowing off-shore in its own
right but is also a contributing factor to the reduced cost of funds in off-shore markets.

[Link] Availability of funds

The cost of funds is not unrelated to the availability of funds and the euromarkets are very
large in comparison to Australian domestic financial markets. Thus, large scale corporate
borrowing is likely to achieve lower cost of funds and more flexible funding arrangements if
it is undertaken in international finance markets.

When an Australian corporate requires a vast quantity of funds for a large-scale investment
project, it may be necessary to borrow offshore because the funding requirements may be
beyond the capacity of Australian domestic finance markets.

[Link] Risk management

Australian corporations with international operations are likely to have offshore assets or
assets denominated in foreign currency. This exposes the firm to exchange rate risk and by
borrowing overseas, in the same currency, they are able to take out a natural hedge against
adverse currency movements.

[Link] Establishing a Profile

If an Australian corporate is intending, at some time in the future, to borrow large scale funds
in the eurobond market, it is appropriate to establish a profile and develop a well-known
presence in international markets. This can be achieved by accessing the short-term
eurocurrency markets initially and achieving recognition, and a good credit rating, as a
participant in international finance markets.
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O B J E C T I V E 4

After working through this section, you should be able to describe the role of the major
participants in the foreign exchange market

5.4 Major participants

5.4.1 Dealers

Dealers are licensed by the Australian Securities and Investments Commission (ASIC) to
deal in foreign exchange. Dealer will hold an Australian Financial Services licence. They
make a market by quoting 2-way foreign exchange rates. Dealers are usually banks, but as a
result of deregulation, corporations can also become licensed forex dealers. To become a
licensed dealer, a corporation must have:
 at least $10 million in issued capital,
 a properly equipped dealing room,
 properly trained dealing staff, and
 adequate risk management systems and controls.
Dealers will carry out the following functions and activities:
 trade on their own account to make a profit for their shareholders (speculating and
arbitraging)
 supply liquidity in the market
 service their customers.

Dealers are often broker, when is the case as broker they will offer the following services:
 match potential buyers and sellers,
 provide the service of anonymity,
 provide financial services such as financial advice, documentation of transactions, etc.
Brokers are paid fees and commissions for their services.
Some foreign exchange dealers/brokers will also trade commodity enabling their clients to
trade for instance precious metals along side currencies.

5.4.2 Corporations

Corporations (other than those who are licensed dealers) will act as price-takers as clients of
dealers. The will use the foreign exchange market and the services of dealers to:
 conduct international transactions
 hedge
 speculate
 identify and take advantage of arbitrage transactions.
The extent to which speculation is permitted is a matter of policy determined by the Board of
Directors. In some corporations, speculation is expressly forbidden. In others, intra-day
speculation is permitted but trading staff are not permitted to carry an exposed position
overnight.
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Because price-takers always take the most disadvantageous side of a foreign exchange quote,
arbitrage opportunities are rare.

5.4.3 Central banks

Central banks carry out two distinct functions in the foreign exchange market. They:
 act as the banker for the government, carrying out foreign exchange transactions on behalf
of the government whenever the governments enters into an international transactions
 intervene in the foreign exchange market to influence the value of the domestic currency
conducting International Market Operations.
Different countries have different policies in the latter area, depending on their system of
exchange rate determination. For example, central banks will have quite different roles
depending on whether the country has a fixed exchange rate of a floating exchange rate. The
central bank of Australia (the RBA) carries out the following activities in the forex market:
 monitoring the currency
 “smoothing” – buying or selling the currency as required to ensure that transitions from
one exchange rate to another are smooth and not volatile
 “testing” – buying or selling in order to force the market to re-evaluate the currency and
ensure that the value of the currency reflects economic fundamentals rather than market
sentiment.
The RBA’s policy is not to target a particular exchange rate – merely to ensure that the
currency is “correctly” valued and that there is minimal volatility.

The central bank or monetary authority of countries with a fixed exchange rate will be forced
to buy or sell the currency (sometimes in large amounts) in order to keep the currency at its
target value.
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O B J E C T I V E 5

After working through this section, you should be able to identify the various types of
foreign exchange transactions and be able to calculate spot rates, forward rates and
cross rates.

5.5 Types of FX transactions

Unlike other financial markets, which have a variety of financial instruments that are traded,
there is only one type of instrument traded in the forex market – a contract to buy or sell one
currency for another. The only thing that varies between contracts is the date on which the
exchange will occur. This section looks at different types of foreign exchange contracts, as
well as how to calculate forward exchange rates. The figure below show the volume of trade
per instruments.

Source: RBA

5.5.1 Spot rate

The most often quoted and discussed rate is known as the spot rate. This is the rate for a
currency which is settled in two business days time. This allows banks and corporations to
confirm and settle the deals in an orderly fashion. Confirmations and instructions should be
issued between parties and the settlement should proceed without a problem.

If you deal on Monday the spot date is Wednesday, if you deal on Thursday the spot date is
Monday. If there is a public holiday in the country of either participate to a transaction that
will delay the settlement date by another day.
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5.5.2 Short dates

[Link] “TOD” contracts

The exchange rate that a dealer quotes is determined on the settlement date of the deal. If you
want currency delivered to your bank account today – and that depends on time zones – then
it is a same day deal or a “tod” contract (which is short for “today”).

[Link] “TOM” contracts

You can also enter into a “tom” contract, which means that settlement takes place tomorrow
(or the next business day if there is an intervening weekend or public holiday.

The exchange rates for short-dated contracts are adjusted for the interest rate differentials
between the two countries because the deal is settled early. For example, if I am selling AUD
for USD under a TOD contract, I will be giving up some AUD interest, because I will
relinquish my AUD at least 2 days earlier than I would under a spot contract, but I will be
gaining the benefit some extra USD interest, because I will be getting my USD at least 2 days
earlier than I would under a spot contract. The actual calculation of TOD and TOM rates is
not required as part of this subject, but calculation of forward rates is discussed below.

5.5.3 Forward FX transactions

A deal that is settled three or more business days in the future is known as a forward
transaction. Because the maturity is not “spot” then the dealer must once again adjust the
price of the deal. This is determined by the interest rate differential between the two
countries.

The settlement period quoted is the period of time after the “spot” settlement date before the
forward transaction is settled. For example, if a 1-month forward contract is agreed to on 9
April 2015, the settlement date will be 11 May 2015.

Summary Table of Short Date transaction:

[Link] Quotation of forward rates

Rather than quoting the actual forward rate, dealers will quote “forward points”. These are
the number of basis points which must be added to (or subtracted from) the spot rates to
determine the outright forward rates.
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EXAMPLE

Suppose the AUD/USD spot rate is 1.1446/56, and the various forward points over the next 6
months are as follows:
1 month 14/13
2 month 29/27
3 month 43/40
6 month 84/80
In case, the forward points must be added to (or subtracted from) the spot rate to determine
the outright forward rate. For the 1-month forward points, 14 basis points must be added to
(or subtracted from) the spot bid rate of 1.1446, 13 basis points must be added to (or
subtracted from) the spot offer rate of 1.1456.

Whether the forward points should be added or subtracted depends on the relationship
between the numbers in the forward point quote. Notice that the spot is always “low-high”
ie. the bid rate is always lower than the offer rate.

The forward points could also be “low-high”, or they could be “high-low” (as in the above
example). If the forward points are “low-high”, they should be added to the spot rate. If
they are “high-low”, they should be subtracted. In the above example, the forward points
should be subtracted from the spot rate, which will result in the following outright forward
rates:
1 month 1.1432/43
2 month 1.1417/29
3 month 1.1403/16
6 month 1.1362/76
EXAMPLE

Suppose the USD/JPY spot rate is 110.25/40, and the 1-month forward point quote is 10/12.
In this case the forward quote is “low-high” and hence should be added to the spot rate. The
outright forward rate would be 110.35/52.

Another way to remember whether to add or subtract the forward points is to ensure that the
spread is wider in the forward market. This is because there is more risk, and less liquidity, in
the forward market, and the price maker will want to ensure that the spread is wider in the
forward market to ensure that it is compensated for this increased risk and reduced liquidity.
If you calculate the outright forward rates and you find that the spread has narrowed, you
have added when you should have subtracted or vice versa.

The relationship between the numbers in the forward rate quote, and hence whether the
forward points should be added to or subtracted from the spot rate (and hence whether the
commodity currency is trading at a premium or a discount in the forward market) is
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determined by the interest rate differential between the two countries concerned. This is
discussed in more detail in the following section.

[Link] Calculation of forward rates

The general formula to calculate a forward rate is:
 1  rterms t 
f comm / terms  S comm / terms  
 1  rcomm t 
f comm / terms  the forward rate for the commodity currency
S comm / terms
= the spot rate for the commodity currency
rterms = the interest rate in the terms currency for the forward period
rcomm = the interest rate in the commodity currency for the forward period
t = the time period.

Because the interest rate is expressed as an annual figure, the time period must be the number
of years. However, forward margins beyond 12 months are extremely rare, so the time period
will usually be a fraction of a year.

For example, suppose the AUD/USD spot rate is 0.8446, the interest rate in Australia is
5.50% and the interest rate in the USA is 4.75%. The 180-day forward rate for the AUD
would be:

 1  .0475(180 / 365) 
f AUD / USD .8446  
 1  .0550(180 / 365) 

= .8416

It should be noted that in the USA the 360 day convention is used while Australia uses the
365 day count. Therefore the time period (t) should be 180/360 for the USA and 180/365 for
Australia. However, for purposes of simplicity and consistency we will use the 365 day year
for all countries. (In this course, students are not expected to know which countries adopt the
360 day convention and which use the 365 day count).

The formula for calculating the forward rate illustrates that the forward rate is determined by
the spot rate adjusted for the difference in interest rates between the two countries. The
country with the higher interest rates having its forward rate trading at a discount. In the
above example, interest rates in Australia are higher than those in the USA, so the Australian
dollar will be trading at a discount in the forward market, with the outright forward rate being
0.8416. This removes an arbitrage opportunity whereby investors could borrow funds in USA
that has lower interest rates, convert the funds into AUD’s at the spot rate and invest the
proceeds in Australia at higher interest rates at higher interest rates and protect themselves
from a falling AUD by taking out forward cover.
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This does not necessarily mean that the Australian dollar is expected to depreciate in the
future. This depends on the underlying reason for high interest rates in Australia, and this will
be discussed in more detail below.

5.5.4 The FX swap

An FX swap is the simultaneous purchase of a currency in the spot market and sale of the
same currency in the forward market, or vice versa. A swap does not create a net exchange
position, but it does create mismatched cash flows. They are primarily used as a funding
mechanism or to adjust cash flow mismatches. For example, an importer or exporter with a
rolling series of foreign exchange exposures can use a series of FX swaps to hedge the risk of
each transaction.

FX swaps are very common in the foreign exchange market. Slightly more than 50% of
foreign exchange transactions consist of FX swaps. When one adds the number of outright
forward transactions (about 15%) it can be seen that forward contracts play a crucial role in
this market. When one is contemplating a swap, the underlying spot rate is irrelevant. The
only thing that is important is the difference between the spot rate and the forward rate: ie. the
forward points. This is why the forward points are quoted rather than the outright forward
rate, because it is much more useful for planning FX swaps. For this reason, forward points
are often referred to as swap points.

5.5.5 Cross rates

If there are, say, 200 different currencies in the world, there are 19,900 different possible
exchange rates. It would be impractical to quote all of these possible exchange rates. Hence
all currencies are quoted in terms of the US Dollar, and then it is possible to calculate the
exchange rate between any two currencies using the rates which are quoted in terms of the
US Dollar. The resulting exchange rate is the effective rate which would be achieved if one
currency was converted to US Dollars, and the resulting number of US Dollars was converted
to the other currency.

The resulting exchange rate is called a cross rate. A cross-rate is an exchange rate in which
neither of the currencies quoted is the US Dollar.

The easiest way to calculate a cross rate is to apply the chain rule. This involves multiplying
the exchange rates, and can be used as long as the following conditions are satisfied:
(a) The commodity currency in the desired cross rate must be the commodity currency in
the relevant USD exchange rate.
(b) The terms currency in the desired cross rate must be the terms currency in the relevant
USD exchange rate.
(c) The USD must be terms currency in one exchange rate and the commodity currency
in the other, so that it will drop out of the resulting calculation.
If the USD exchange rates are not quoted this way, one or both of them must be converted so
that they are expressed this way. This is demonstrated below.
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[Link] Cross rates without bid/offer spreads

The chain rule is very simple to apply if we don’t have to worry about bid/offer spreads. If
we wish to compute the AUD/EUR rate, given the AUD/USD rate and the USD/EUR rate in
the market. (Notice that the AUD is the commodity currency in both the desired cross rate
and the relevant USD exchange rate, and that the EUR is the terms currency in both the
desired cross rate and the relevant USD exchange rate, with the USD taking the remaining
places in the original quoted rates.) As long as this is the case, then we just multiply the
quoted rates.

EXAMPLE

AUD/USD = 1.1246

USD/CNY = 6.23

AUD/CNY = 1.1246  6.23 = 7.0132

If we were given the CNY/USD exchange rate, we would have to take the reciprocal to
determine the USD/CNY exchange rate, which is what we need to apply the chain rule. Note
that the CNY stands for the Chinese Renminbi Yuan.

[Link] Cross rates with bid/offer spreads

The calculation is slightly more complicated if we have a bid and offer price for each
exchange rate. We still need the quoted exchange rates to be in the same format as described
above. Then we perform separate calculations for the bid and offer price of the cross rate.

EXAMPLE

AUD/USD = 0.7917/56

USD/CNY = 6.20/26

As long as the exchange rates are expressed this way, the bids multiplied together will give
the bid for the cross rate, and the offers multiplied together will give the offer for the cross
rate. Thus:

AUD/CNY = 0.7917  6.20 / 0.7956  6.26 = 4.9085/ 4.9805

If one (or both) of the exchange rates we are given is not in the correct form, we need to
convert it (or them) by taking the reciprocal of both sides of the quote and reversing the
order to ensure that the offer is higher than the bid. Thus:

EUR/USD = 1.2539/49
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1 1
/
USD/EUR = 1.2549 1.2539 = 0.7969/75
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O B J E C T I V E 6

After working through this section, you should be able to demonstrate an ability to
maintain a foreign exchange trading position

5.6 Exchange position

A dealer has an open position in a commodity when the dealer stands to make a profit or loss
consequent upon a movement in the price of the commodity. This general assertion can be
applied to a foreign exchange dealer. If a dealer has bought more of a currency than he has
sold he is said to be “long” the currency. If a dealer has lent more money than he has in his
account, he is “short” the currency. We say the dealer has an FX exposure.

5.6.1 Net foreign exchange position terminology

 Net exchange position: Total foreign currency bought – total sold.
 Long position: More foreign currency bought than sold
 Short position: More foreign currency sold than bought
 Square position: Total bought = total sold
If currency dealers start from a square position, then when they are long in one currency they
should be short in another. Dealers keep account of their positions by recording the amount of
commodity currency traded in a blotter.

5.6.2 Using a blotter

The table below shows a stylised blotter, which a dealer may use to keep a record of his
trading positions.

Transaction (A$ m) Position

Buy 20 +20 Up 20
Buy 10 +30 Up 30
sell 5 +25 Up 25
sell 15 +10 Up 10
sell 15 -5 Down 5
sell 10 -15 Down 15
buy 15 0 Square
Depending on expected movements in the currency market the dealer may prefer to be short
or long the commodity currency.

5.6.3 Cash flows and T accounts

A blotter tells you of your position at any point in time. However, this doesn't tell you
whether you made a profit after all that trading. Keeping T accounts and cash flows are one
method for working this out.
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In a T account positive cash flows are set down on the left of the T and negative flows are set
down on the right of the T. In currency transactions, the origins of cash flows can be
summarised as:
 positive flows arise from (1) buying currency and (2) borrowing currency
 negative flows arise from (1) selling currency and (2) lending currency
These accounts can be done by hand or more usually by the Treasury system or spreadsheets.

These accounts can be viewed as a simple bank account and one bank account is kept for
each currency. It is possible for business to keep foreign currency bank accounts in Australia.
This can be helpful when you are dealing with a large number of small transactions in one
foreign currency in your business.

EXAMPLE

Suppose you enter into 3 transactions

1. buy 2m AUD at AUD/SGD 1.5620
2. sell 5m AUD at AUD/SGD 1.5625
3. sell 3m AUD at AUD/SGD 1.5630
Then to square this AUD position you would buy 6m AUD. The rate for this transaction
would determine whether you had made a profit or a loss. If the exchange rate when you
close out your position is AUD/SGD 1.5615, you would sell SGD 9,369,000.

AUD SGD
+2,000,000 -3,124,000
-5,000,000 +7,812,500
-3,000,000 +4,689,000
+6,000,000 -9,369,000
0 8,500
Your final position is a profit of SGD 8,500. (It stands to reason that you would have made a
profit, because the 2 transactions by which you bought AUD were at a lower exchange rate (a
lower price for the commodity currency – the AUD) than the 2 transactions by which you
sold AUD.
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O B J E C T I V E 7

After working through this section, you should be able to provide a brief history of the
exchange rate systems adopted by Australia since the early 1970s, and outline the
problems associated with pre-float regimes.

5.7 Early systems of exchange rate determination

5.7.1 The gold standard

As international transactions became more common during the late 1800s, it became
necessary to establish a stable system of exchange rate determination. This led to the
establishment of the gold standard. Each country’s exchange rate was linked to the price of
gold: ie. gold was set at a fixed price in each currency. The exchange rate between currencies
was therefore also fixed.

This system was very stable until World War I. The economic disruption caused by the war
and its after effects placed a great deal of strain on the gold standard. Various countries
attempted in various ways to reintroduce the gold standard, but by World War II the system
was close to collapse.

5.7.2 The Bretton-Woods system

In 1944, at an international monetary conference held at Bretton Woods in the United States,
a new international monetary system involving an adjustable-peg system of exchange rates
was agreed to. This system, which emphasised relatively fixed exchange rates, was managed
through the International Monetary Fund (IMF). Each country’s currency was fixed, or rather
pegged, to the US Dollar, and the US Dollar was fixed in terms of the price of gold.
Countries were able to periodically readjust their peg, revaluing or devaluing their currency
as required, in response to economic factors.

This system was quote stable for many years, but there were some fundamental problems
associated with it and these problems came to a head in the early 1970s when the system
broke down.

5.7.3 Movement to floating exchange rate systems

In August 1971 the system of pegged exchange rates was thrown into chaos when the United
States government suspended the USD convertibility into gold. With the link between the
USD and gold severed, the USD was effectively floating with its value determined by market
forces. In March 1973, the currencies of the other major economies were also floated.
Australia, however, adopted a range of different methods of determining its exchange rate
until it floated the AUD in December 1983.

In the period from 1971 - 74, the AUD was tied in value to the USD. This meant that the
AUD was effectively floating against all other currencies not tied to the USD. This was
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considered to be too restrictive to the appropriate movement of the AUD and in September
1974, the AUD was tied to trade weighted basket of currencies. In many ways, this was a
continuation of the adjustable peg system with the value of the AUD pegged to some
benchmark. In November 1976, the value of the AUD was adjusted on a daily basis but still
set in terms of the trade weighted basket of currencies (TWI traded weighted index). The
value of the AUD was still officially set but frequently adjusted in line with market forces.

Source :RBA, [Link]

In December 1983, Australia joined most of the other developed economies and adopted a
floating, market determined exchange rate. There are two types of floating exchange rate
systems – a “clean” float and a “dirty” float. A clean float occurs when the currency is
allowed to float freely in response to market forces, without any intervention by the Central
Bank. In a dirty float, the Central Bank intervenes in order to attempt to have some influence
over the value of the currency – e.g. for smoothing and testing purposes. Most countries
which have a floating exchange rate, including Australia, have a so-called dirty float.

5.7.4 Fixed and intermediate exchange rates

A number of currencies such as the Yuan have fixed value that is periodically adjusted by the
central bank. When exchange rates are not determined by market forces but officially set,
there are a number of problems that can arise. The only way to maintain the fixed rate is for
the Central Bank to continually intervene by buying and selling large quantities of the
country’s currency to increase the level of demand or supply. If the exchange rate is set at a
non-equilibrium level, resulting problems can include the following:

 A country cannot continue to buy its own currency as it will run down its holdings of
international reserves and not be able to pay for imports. Continual sales of domestic will
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result in a build-up of foreign reserves and this will mean that a country will experience a
lower standard of living than it otherwise could.

 A country will experience either an overall balance of payments surplus or deficit.

Surpluses and deficits in the balance of payments will affect a country’s volume of money
and be a potential source of monetary instability.

 Officially set exchange rates that lag behind the market can encourage speculation as
future exchange rate movements can be easy to predict. The most common non-
equilibrium fixed rate is one that is too high. The Central Bank will be forced to buy
massive amounts of domestic currency, running down its foreign reserves. Currency
speculators can often predict roughly when these reserves will run low, necessitating a
devaluation. They will sell the currency short, with the intention of buying it back cheaply
when the value of the currency falls, resulting in large profits. This short-selling places
even more downward pressure on the currency, bringing about the predicted devaluation
even sooner. In November 1976, the AUD was devalued by 17.5%, generating massive
speculative profits. One of the major causes of the recent Asian currency crisis was a
series of speculative attacks on weak currencies which the subject of artificially high
exchange rates. The Thai baht was the first such currency to be successfully attacked,
followed by others as the crisis spread from country to country.

Also see the following link to an International Monetary Fund (IMF) report on various
exchange rate regimes that are currently in place around the world:

[Link]
Exchange-Restrictions/Issues/2017/01/25/Annual-Report-on-Exchange-Arrangements-and-
Exchange-Restrictions-2016-43741
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O B J E C T I V E 8

After working through this section, you should be able to explain how the interaction of
supply and demand determines the foreign exchange value of a currency.

5.8 The equilibrium exchange rate

In previous sections of this topic we considered currency trading in the foreign exchange
market and the practices adopted by dealers in quoting two-way prices. Currency trading is
undertaken by a range of individuals, businesses and governments who all have their own
reasons for wanting to buy or sell foreign currency.

“The” foreign exchange market comprises a vast global network of physical locations linked
together by sophisticated telecommunications systems. Each currency has a large number of
buyers and sellers whose collective actions represent the demand and supply conditions in the
foreign exchange market. The prices quoted by dealers are determined by demand and supply
conditions throughout “the” market.

As with any good or service that is sold in a competitive market, the equilibrium price is
determined by the interaction of supply and demand. We will consider each of these forces in
the context of the foreign exchange market for the Australian dollar (AUD)

5.8.1 Demand for a currency

The demand for the AUD is the result of economic units selling foreign currency and buying
the AUD. An increase in demand for the AUD will result from:
 an increase in the export of Australian produced goods and services
 an increase in capital inflow (borrowing from overseas or investments from overseas)
The demand for the AUD is inversely related to the price of the AUD as a fall in price of the
AUD will lower Australian prices in world markets and increase the demand for Australian
exports. This is illustrated in the diagram below:

Exchange

D
Quantity of AUD
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5.8.2 Supply of a currency

The supply of the AUD is the result of economic units selling the AUD and buying a foreign
currency. An increase in supply of the AUD will result from:
 an increase in the import of goods and services into Australia
 an increase in capital outflow ( overseas investment/lending)
The supply of the AUD is directly related to the price of the AUD as an increase in price of
the AUD means overseas prices become relatively cheaper and increases the demand, by
Australian residents, for imported goods and services. This is illustrated in the diagram
below:

Exchange

Quantity of AUD

5.8.3 The foreign exchange market

The foreign exchange market brings together the forces of supply and demand with the
equilibrium price being the unique price (exchange rate) where the demand for the AUD
exactly equals the supply of the AUD. This is illustrated in the diagram below:
Exchange

.70
.60
.50

D
Quantity of AUD
The equilibrium price for the AUD, in terms of the USD is .60 where demand and supply
exactly equal each other.
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Any price other than the equilibrium price is not sustainable as there will either be excess
demand or supply in the market which will move the exchange rate towards equilibrium. For
example, if the AUD/USD were at .70 there would be excess supply of the AUD in foreign
exchange markets – more would be supplied at that price than would be demanded. Dealers
will reduce the price of the AUD, in terms of the USD, in order to reduce this excess supply,
and move the exchange rate back to equilibrium. If the AUD/USD were at .50 there would be
an excess demand for the AUD – more would be demanded at that price than would be
supplied. Demanders of AUD would “bid up” the price of the AUD in an attempt to satisfy
this excess demand, moving the exchange rate back to equilibrium.

Like the Loanable Funds theory of the determination of interest rates, this is a simple, but
useful theory. If a change is postulated which might change the exchange rate, with this
model it is simply a matter of determining what change, if any, will take place in the position
of the demand and supply curves shown above. This will lead to a change in the equilibrium
exchange rate, which will result from the interaction of the new demand and supply curves.
Such changes are discussed in more detail in the next section.
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O B J E C T I V E 9

After working through this section you should be able to explain the main determinants
of the foreign exchange value of a country’s currency

5.9 Determination of the foreign exchange value of a currency

The previous section established that the foreign exchange value of a currency, in a
competitive market, is determined by the interaction of supply and demand for the currency
concerned. Thus, any event that affects the value of international transactions for a particular
country has implications for the exchange rate. The main explanations for exchange rate
movements seek to identify major causes of changes in the value of a country’s international
transactions. These explanations are discussed in turn from the perspective of the AUD.

The link below introduce a video which also cites some factors influencing the rates
[Link]

5.9.1 Relative inflation rates and purchasing power parity

Assume Australia has higher inflation than the rest of the world. The effects of this will be:
 A decrease in demand for exports as Australian prices become less competitive on world
markets. There will therefore be less demand for the AUD and the demand curve will shift
to the left.
 An increase in demand for imports as overseas goods become relatively cheaper on the
Australian domestic market. There will therefore be increased supply of the AUD and the
supply curve will shift to the right.
The above two effects will result in a fall in the value of the AUD as illustrated below.

Exchange
S1 S2

ER1

ER2

D2 D1
Quantity of AUD
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What is happening is that the fall in the value of AUD (from ER1 to ER2) is reducing
Australia’s prices relative to the rest of the world and offsetting the price effect of inflation.

This view of the determination of the exchange rate assumes the maintenance of purchasing
power parity between currencies. The theory of purchasing power parity is based on the “law
of one price”. It contends that:

“Market forces will eventually force adjustments to exchange rates to provide parity of
purchasing power (ie. comparable goods cost the same) between currencies”.

The purchasing power parity theory is based on traded goods. Goods which are cheaper in
one country than another (ie. which display a violation of purchasing power parity) will be
bought where they are cheap, transported and sold where they are more expensive. Either the
prices of the goods will equalise, in response to supply and demand, or the exchange rate will
adjust because of the importing and exporting, resulting in an equalisation of the effective
price of the goods. However, not all goods are traded, and there is a time lag before changes
in the price of traded goods are passed on to non-traded goods.

A weaker form of the purchasing power parity theory is often used, which contents that
inflation rates, rather than actual prices of goods, will tend to equalise because of
interdependence between the exchange rate and inflation rates.

5.9.2 Relative economic growth rates

Assume that Australia experiences higher economic growth than its major trading partners.
Income and aggregate demand, including demand for imported goods and services, will be
growing at a faster rate. To pay for increases in imports there will be an increase in the supply
of AUD in the foreign exchange market. This is illustrated in the diagram below:

Exchange
S1 S2

ER1
ER2

D1
Quantity of AUD

The AUD has fallen from ER1 to ER2.

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However, if the higher growth involves investment projects financed through offshore
borrowing by Australian companies, the increase in capital inflow means an offsetting
increase in demand for the AUD. This is illustrated in the diagram below:
Exchange
S1

ER2
ER1

D1 D2
Quantity of AUD

Superimposing these two effects yields the following diagram.

Exchange
S1 S2

ER1

D1 D2
Quantity of AUD

In the above case, the supply effect is to reduce the price of the AUD while the demand effect
is to increase the price of AUD. The net effect will depend on the strength of each of these
separate factors and the slope (elasticity) of the demand and supply curves. It cannot easily be
determined in advance.

5.9.3 Relative interest rates

The relationship between the effect of differing interest rate movements on exchange rates
provides contrasting views which are outlined below in terms of Australia experiencing
higher interest rates than the rest of the world.

The traditional view was that the higher interest rates in Australia would encourage capital
inflow and discourage capital outflow. This would result from overseas investors placing
funds in Australia, to take advantage of the higher returns, and Australians investing a greater
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proportion of funds in the domestic financial markets. The effects of this are illustrated below
with the AUD increasing from ER1 to ER2.

The previous view does not accord with what happens in the foreign exchange market. as
empirical evidence suggests an alternative view. That is, a country experiencing higher
interest rates is also likely to be experiencing a fall in the value of its currency.

Exchange
S2 S1

ER2

ER1

D1 D2
Quantity of AUD

The explanation for the alternative view is based on inflation and the difference between real
and nominal interest rates. Nominal interest rates are the quoted observable interest rates
which include the effects of inflation. In order to determine the real interest rate – the interest
rate that actually results in an increase in purchasing power over and above the inflation rate
– it is necessary to subtract the inflation rate from the nominal rate to determine the real
interest rate. (This is an approximation which is sufficiently close for the purposes of this
analysis.)

It is assumed (it is usually a reasonable assumption) that real interest rates are constant
between countries. If this were not the case, there would be arbitrage opportunities created
and capital would quickly flow to those countries with the highest real rates, thus bringing
real rates into alignment. If real rates are constant, a country experiencing higher nominal
interest rates must also be experiencing higher inflation. As explained in Section 5.8.1, higher
inflation will result in a depreciating currency.

The interest differential also lead to carry trade where FX traders will invest in currency with
relatively higher rates.

5.9.4 Commodity prices

A commodity is essentially anything that is bought or sold. In this context, we are talking
about the commodities that Australia exports – chiefly minerals and agricultural products.
Because Australia is a large commodity exporter, the value of its exports, and hence the level
of demand for the AUD, is significantly influenced by world-wide commodity prices.
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If Australian exports become more expensive because of inflation, overseas importers of our
goods will turn to other countries, and the value of our exports will fall, along with demand
for, and the value of, the AUD. However, if our exports become more expensive because of
an increase in commodity prices, importers cannot turn to other suppliers because commodity
prices are a world-wide phenomenon. They will continue importing commodities from
Australia, and the total value of our exports, and hence demand for the AUD, and hence the
value of AUD, will all increase.

5.9.5 International speculation and investment

Notwithstanding the various theoretical causes of changes in the value of the AUD, its
change in value can be influenced by international speculation and mainly driven by
investment. When the US economy, the world’s largest, is weak capital tends to flow into
stronger economy, such as Australia.

When there is bad economic news in the US, as there has been since the early 2000’s, this
usually results in a retreat of capital from the US, and the AUD benefits as a result. Hence the
steady decline in the USD over the last 10 years, as the Australian economy becomes more
attractive for investment compared to that of the US. Severely hit by the GFC the US dollar
has recently lost such value compare to the Australian dollar that the two currencies are now
trading around parity (1 to 1).

There is no formal link, but generally non-US economies “suffer” when the US economy and
the USD are strong, and they benefit when the USD falters.

5.9.6 Exchange rate expectations

Exchange rate expectations are a major cause of actual exchange rate movements. If market
participants, including speculators, have formed expectations about future exchange rate
movements then they will take action which will have a self-fulfilling effect.

For example, if market participants expect the future value of the AUD to fall, they will sell
the AUD, increase its supply in the foreign exchange market, which will cause a fall in its
value. If they expect the value of AUD to increase, they will buy the AUD, increasing
demand for the currency and helping to bring about an appreciation.

5.9.7 Official intervention

In addition to the above factors, official (government or central bank) intervention into
foreign exchange markets can exert a significant influence on the value of that country’s
currency. In Australia, official intervention is through the activities of the Reserve Bank,
buying and selling the AUD in trade with banks and a select number of non-bank authorised
FX dealers. Since the December 1983 float of the AUD, there has been two distinct periods
of official intervention
 Dec. 1983 - mid 1986: minimum intervention (“clean float”).
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 Mid. 1986 - current: significant intervention (“dirty float”).

The reasons for Reserve Bank intervention since mid 1986 have been
 To try and understand the nature and strength of forces in the market
 To buy and sell currency to meet the needs of its clients particularly government
 offset short term instability

The Reserve Bank has stressed that its role in intervening is to “buy time” for market
participants to reassess their judgement and to provide a settling influence on the market. It is
not to target a particular exchange rate.
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TOPIC 5: SUMMARY

The foreign exchange market serves to link domestic payments systems into a global
payments system. Whenever a resident in one country has an economic transaction with a
resident in another country there is a need for currency exchange. An exchange rate is the
value of one currency in terms of another currency with the two main forms of FX transaction
being on a spot and forward basis. Forward exchange rates are determined by interest rate
differentials given that both exchange rates and interest rates are determined by expectations.

In the spot market dealers buy low, at their bid quote, and sell high, at their offer quote.

The foreign exchange market is a highly competitive market comprising a vast network of
different locations linked together by telecommunications. It is only from 1973, that the
world major currencies were floated and from December 1983 that the Australian dollar was
floated. In the competitive FX market the foreign exchange values of currencies are
determined by the demand for, and supply of, particular currencies.

There are a number of explanations of the determinants of the foreign exchange value of a
currency including relative inflation rates, relative growth rates, relative interest rates,
expectations and official intervention.