Topic 8: FX Market

The main functions of foreign exchange (FX) markets are:

 to facilitate cross-currency payments arising from imports, exports and financing flows
 FX markets do not arrange loans
 they are needed because countries like to issue their own currencies, but they also like to trade and have
financial dealings with other countries
 to reveal the value of currencies (price discovery function)
 to allow traders to manage their FX risks

We consider the wholesale FX market

 not the retail market where you would acquire currency for an overseas trip
 this is mostly the trading of currencies between banks – that is, the Australian banks trading amongst
themselves and with overseas banks
 it is by far the largest financial market when valued by turnover

Exchange rates
 An exchange rate is the price of one currency in terms of another
 A ‘commodity currency’ priced by a ‘terms currency’
 Most commonly in terms of the USD because of its role in foreign trade
 The trade-weighted index (TWI): the weighted average value of the AUD in relation to the currencies of
Australia's trading partners

Floating Exchange Rates

 Prior to 1970, the value of currencies was fixed
 The government or central bank tied the official exchange rate to another country's currency or the price
of gold
 Since the 1970s, developed financial systems began to float their currencies (the AUD in 1983)
 where exchange rates are set by trading in FX markets based on demand/supply which means that FX
markets perform the price discovery function
 results in more short-term volatility but less large periodic adjustments
 A currency crisis is characterised by sudden unexpected movements in exchange rates
 Exchange rates are important prices within an economy, they determine the domestic value of:
 goods & services bought and sold in foreign currencies, and
 the foreign assets and liabilities of local entities
 Usually, exporters favour a low exchange rate whereas importers prefer a high exchange rate, though
businesses in general prefer a stable exchange rate
 The floating of the currency requires businesses to understand FX risk
 The depreciation of the GBP after the UK voted to leave the EU indicates that financial markets expect the
financial impact will not be favourable
 Exchange-rate quotations
 The commodity currency (currency bought/sold) is quoted first then the price is expressed in the terms currency
 Indirect quotation: showing the domestic currency as the commodity currency
 Direct quotation: showing the foreign currency as the commodity currency
 What $1 in foreign currency is worth in AUD
 All exchange rates are expressed up to 4 decimal places
 The last 2 decimal places are known as points

Exchange Rate Changes

 The first currency in the exchange rate is the currency being valued so appreciation in this currency is shown by
an increase in the exchange rate
 If AUD increases in value (appreciates), NZ falls in value (depreciates)

Bid-offer quotes and mid-point rates

 FX dealers quote bids (their buying price) and offers (their selling price)
 Dealers only mention the last two decimal places when bidding/offering

Cross rates
 The term ‘cross rates’ traditionally referred to non-USD exchange rates, such as AUD/JPY but can also mean non-
euro rates, or non-AUD rates (as published in the AFR)
 The definition of cross rates has become ambiguous
 In the EU a cross rate might mean non-euro rates
 In AU a cross rate is when there are non-AUD rates
 FX Contracts
 There is only one FX instrument: a contract to exchange an agreed amount of one currency for another
 FX contracts are agreements to exchange a specified amount of one currency for a specified amount of another,
but we distinguish between contracts according to their settlement date

Spot FX contracts
 Spot contracts are for the exchange of currencies in two days (T+2) based on the agreed spot exchange rate

 Settlement is complicated when each leg occurs in a different time zone

 Dealers store FX reserves in low-risk securities

Forward FX contracts
 Forward contracts are the exchange of currencies at any time after the spot settlement date of T + 2
 Most are arranged on a monthly basis with settlement on the monthly anniversary of the spot settlement date
 Dealers will try to match the amounts of FX bought and sold for each future date
 any net requirements are covered by holding securities in those currencies that mature on the
settlement date

Calculating forward rates

 The forward exchange rate is the spot rate adjusted for delayed settlement
 This is necessary when the interest rate is different in the two currencies
 Where the commodity country has a higher interest rate the forward rate will be lower/cheaper
 So, forward rates essentially eliminate the impact of interest rates on the exchange rates so that
spot and forward rates are comparable
 There is a historical inverse relationship between commodity prices and real interest rates
 The higher a country’s interest rate, the more likely its currency will strengthen
 Currencies surrounded by lower interest rates are more likely to weaken over the longer term
 Remember the USA use 360 day financial year
 For a 6 month forward contract it would be t = 180 days
  The amounts exchanged on the forward settlement date must have the same ratio in future value terms, so the
forward rate must offset any difference caused by interest rates

Forward points (forward margin)

 The difference between the spot rate and the forward rate
 Forward rates are quoted as forward points above or below the spot rate:
forward points = fcom/terms – scom/terms
= forward rate - spot rate
 The forward (swap) points are added to the interest rate on the loan (or reduce it if negative)
 Where the forward points a negative (forward rate < the spot rate) the currency is quoted as a forward discount
 This is where the commodity currency has the higher interest rate
 The forward points can be positive (i.e. the forward rate is more than the spot rate) meaning the currency is
quoted at a forward premium
 This is where the commodity currency has the lower interest rate

Dealers in forward contracts

 The forward rate does not expose the dealer to FX risk - it is based on the interest rates in the two currencies
 The dealer’s income comes from the spread between their forward bid and offer rates
 The dealers offer quote will be higher than the bid quote
 Dealers have many forward contracts and will ensure they have maturing securities sufficient to cover their net
settlement obligations each day
 Dealers do not set forward rates on the basis of speculation (but rather on interest rate differentials)
 Speculators profit from correctly predicting future movements in FX rates
FX swaps
 An FX swap is the combination of two FX contracts (with different settlement dates) taken simultaneously that
arrange the exchange of currencies for an agreed period
 Contract combination:
 sell FX in a spot contract
 buy FX in a forward contract
 Currencies are exchanged at an agreed rate (often the current spot rate), and arrangements made to exchange
them back at an agreed forward rate
 This offsets the interest rate on the borrowed funds
 The cost of the swap is the forward points, now called the swap points = forward ES - Spot ES
 buying price > selling price the trader who acquired the USD for the period of the FX swap pays the FX
cost
 The swap points would form part of the cost of a loan
 Buying price < selling price the FX cost would be negative meaning the trader would make a profit on
the two FX trades

Uses of FX swaps
 An FX swap is a risk-management product – it allows the exchange of currencies for a period without incurring
FX risk
 FX risk is the chance of an unexpected adverse movement in the exchange rate
 A buy/sell FX swap (the foreign currency is first bought and later sold) can hedge the FX risk of an investment in
a foreign currency
 The risk is that the foreign currency will depreciate before conversion into the domestic currency
 A sell/buy FX swap (the foreign currency is first sold and later bought) can hedge the FX risk of a foreign
currency loan
 It is the exchange of an amount of a foreign currency for the local currency for an agreed period
 The risk is that the foreign currency will appreciate before repayment

FX risk management
 The switch to floating exchange rates meant businesses had to be able to use FX risk management instruments
because they could no longer rely on the gov to maintain exchange-rate stability
 exchange rates move randomly from day-to-day
 E.g. AUD/USD fell from 0.9000 to 0.8999 the AUD cost of buying USD$10m would increase by AUD$1,235
 if the rate fell by 3 cents (to 0.8700) the cost would increase by AUD $383,142
 A FX risk exists when a business has future foreign currency obligations or receipts
FX risks
 A form of market risk that arises from unexpected adverse movements in an exchange rate
 Market participants that are exposed to risk include:
 Importers who pay for imports in a foreign currency face the risk of the AUD depreciating because this
will increase the AUD cost
 Exporters who received export income in a foreign currency are exposed to the risk of the AUD
appreciating because this reduces the AUD receipts
 Borrowers who in the future need to pay back foreign-sourced loans who need to buy foreign exchange
 A foreign loan exposes the borrower to the risk of the AUD depreciating because this increases
the amount (in AUD) to be repaid
 In the 1980s foreign loans were used to avoid high Australian interest rates then the AUD
depreciated meaning that borrowers had to pay a lot more to pay back the loan
 This happened to the Indonesian rupiah after the gov floated their currency
 Investors who have funds overseas that require future repatriation, who need to sell foreign exchange
 A foreign investment exposes the investor/lender to the risk of the domestic currency
appreciating because that reduces the AUD receipts

Hedging FX risk exposures

 Businesses will be motivated to manage or hedge their risk exposures using a forward FX contract or FX swap to
fix a future exchange rate to establish a hedged amount
R hedging removes the possibility of an unfavourable exchange rate outcome,
Q but involves giving up the possibility of a favourable exchange rate outcome
 Hedging removes the uncertainty of a future FX transaction
 The hedged amount is the future amount of the domestic currency being paid or received via the contract

Hedging with forward FX contracts

 Importers and exporters can use forward FX contracts to manage their FX risk exposures
 Say an exporter is due to receive USD20 million in 3 months’ time, that the current spot rate is AUD/USD0.9015
and the 90-day forward rate is AUD/USD0.8971
 the exporter’s risk is that the AUD appreciates
 using a forward contract allows the exporter to ‘lock-in’ proceeds of AUD22,294,059

Hedging a foreign currency loan with an FX swap

 The FX risk associated with foreign currency loans and investments can be hedged with FX swap
 Hedging with an FX swap removes the advantage of the lower rate and the effective interest cost becomes the
local interest rate

Steps to calculate a sell/buy swap

1. Calculate the proceeds of loan in commodity country by dividing foreign currency by the spot rate
2. Calculate the repayment amount using the simple interest formula = PV x (1 + r x t)
 Where PV = using the loan proceeds (in foreign currency)
 r = the interest rate (in foreign currency)
3. Calculate repayment amount in commodity currency using forward rate
= Loan repayment amount (foreign currency) / forward rate
4. Calculate the cost to borrower using the yield to maturity formula = (F/P – 1) x 365/d
 Note: the yield to maturity/cost to borrower will be the interest rate in the domestic country
Example: hedging a foreign currency loan
Suppose Westpac uses an FX swap to hedge a USD10m loan for one year at 3.5% pa, that rate AUD = 6% pa and the spot
rate is AUD/USD0.9500
 Note: By hedging the effective interest rate is the same because the FX rate is worked out using the interest rate
differential, showing that there is no benefit in borrowing money in the US market
 Hedging will cancel out any benefits of borrowing money in a lower interest country
 Borrowing overseas is still used not because they think it's cheaper, but to diversify their funding base

The Australian FX market

 The Australian FX market is defined as trading that occurs in Australia in foreign currencies
 It is wholesale & OTC
 FX dealers in Australia are organisations (mainly the major Australian banks plus the foreign banks), licensed by
ASIC to trade in FX
 We also use the term to refer to the individual traders who work for the dealer
 The RBA and representatives of the Australian FX market formed the Australian Foreign Exchange Committee
(AFXC) to oversee the market and develop the best-practice guidelines
 the large dealer organisations employ many traders (also known as dealers) who specialise in ‘making the
market’ for a particular currency pair
 Swap transactions dominate Australian FX trade (68.7%) followed by spot transactions (21.4%)

What are the main reasons for the large turnover in the Australian FX market?
 Trading in the inter-dealer market
 The time zone between the American and UK markets
Trading has two purposes:
 dealers making a market for counterparties
 The counterparties of the FX dealers in Australia are shown in the adjacent graph →
 ‘others’ includes importers, exporters and fund managers
 Inter-dealer trading where dealers trading to manage their inventory
 Inter-dealer trading in the spot AUD/USD market is around half of spot trades
 The net result of a dealer's purchases and sales is referred to as their position
 A dealer is said to be 'long' in currency if net purchases > net sales
 A dealer is said to be 'short' in a currency if net sales > net purchases

Trading and settlement arrangements

 Most FX trading is now conducted using electronic broking systems (EBSs), rather than by phone
 These are order-driven inter-dealer FX trading systems where anonymous bids and offers are accepted,
displayed and matched
 Two dominant providers of EBSs: ICAP and Reuters 3000
 Their advantages are:
 Real-time display of a centralised order book provides transparency which aids price discovery
 Arranges trades at a lower cost and narrower spreads --> greater trading volume & liquidity
 Integration of front & back office functions
 EBSs allow dealers to manage each of the deal-flow processes from pricing to settlement
 Electronic matching systems have facilitated the emergence of FX trading portals where banks provide corporate
and fund managers access to the matching system
 There has also been:
 the introduction of auto-dealing techniques
 New electronic trading venues/systems
 The rise of prime brokerage services
 Prime brokerage is a general term for investment banks that offer bundled, integrated services
to hedge funds and professional investors
 Banks also serve the FX needs of retail customers including the exchange of notes, the sale of traveller's cheques
and the transfers of funds overseas
 The bid-offer spread in the retail market is wider than in the wholesale market

Time Zone Effects

 Trading in FX occurs 24 hours but in different time zones, opening in the Pacific & Southeast Asia, then moving
to the UK & Europe and finishes the day in the USA
 This has increased the trading in our time zone:
 the Australian FX market is among the ten most active markets, along with Singapore and HK
 these markets operate when London and the US markets have closed
 About half of the trades in the Australian market are for AUD
 Note the importance of third currency (that is, non-AUD) trading from overseas counterparties wishing to trade
FX when the US and UK markets are closed
Trading in the AUD
 Most trading of AUD occurs outside of Australia
 The average daily turnover in the AUD globally in April 2019 was USD445 billion, only USD 58.8 billion of
this was traded in Australia
 AUD/USD is the fifth most traded currency pair
 Price movements in the AUD/USD tend to be larger overnight than during the Australian business day
 People like to buy the AUD for speculation purposes as investors think that the AUD is not very well correlated
with its true value in the FX market and it provides diversification as it is linked to commodity prices
 In the GFC investors sold AUD for USD so the RBA bought AUD to restore liquidity to the inter-dealer segment1

The Carry Trade

 A common speculative FX strategy is the carry trade
 The carry trade involves borrowing funds in a low interest-rate currency and investing them in securities in high
interest-rate currencies
 A carry trader hopes to benefit not only from the difference between the borrowing rate and lending rate but
also from a favourable movement in exchange rate during the investment period
 The interest differential series represents the capital accumulated by a carry trade strategy given no adjustment
to exchange rates
 There is no capital-accumulation return to a carry-trade strategy if the theory of uncovered interest-rate parity
holds true

Explaining exchange rate movements

 Exchange rates fluctuate randomly and so their movements are difficult to predict
 The explanations assume all other influences remain constant
 The forces that affect the level of exchange rates are both real and imaginary
 Unfounded rumour is just as likely to move the price of foreign exchange as is news founded in fact
 The main explanations or influences are:
 Purchasing power parity (PPP)
 Interest rate parity (IRP)
 Expected movements in interest rates
 Terms of trade
 Speculation
 Current account balance
 The RBA
Purchasing power parity (PPP)
 A long-run theory that assumes trade flows will force adjustments to exchange rates so that comparable goods
will cost the same in each country
 Assumes that exchange rates move to offset differences in inflation rates, weakening currencies with higher
inflation
 The relative purchasing power of two currencies depends on their relative inflation rates
 Movements in exchange rates are predicted by PPP by differences in inflation rates
 If a country has a lower inflation rate than another it will appreciate and vice-versa
 E.g., if inflation is 10% in Australia, and 0% in the US, PPP would predict a depreciation in the AUD
 This theory can be seen as a variation on the rule of one price where FX markets establish a single price on an
exchange rate-adjusted basis
 The Economist magazine redefined PPP as the 'Big Mac index' theory of exchange rates
 ER will adjust so that the price of a Big Mac will be the same around the globe
 Evidence does not support PPP
 The real TWI adjusts the exchange rate for inflation, and if PPP theory held over the period the real TWI
would be a straight line over time, indicating continual adjustment to inflation differences
 PPP is not a good predictor of rates, particularly in the short-term, but arguably has some validity as an influence
over long-periods

Expected Interest Rate Parity (EIRP)

 This theory says that spot exchange rates are expected to move to offset differences in interest rates to equalise
effective interest rates
 The cost of borrowing in a foreign currency at a lower interest rate would be the same as borrowing at the
higher interest rate in the domestic financial system
 So, a currency with a low interest rate will be expected to appreciate, and vice versa
 for example: rJPY + expected change in JPY/AUD = rAUD
 EIRP may or may not be relevant over long periods but within any case it is not a good predictor of shorter-term
FX movements

Expected Interest Rates

 An alternative (to EIRP) interpretation of the interest/exchange rate relationship is:
 The expectation that interest rates will increase puts upward pressure (appreciate) on the exchange
rate because international investors will move funds into the currency
 During this period the domestic currency would trade at a forward discount to the currencies
with lower interest rates
 Higher interest rates = cheaper forward rate so if interest rates are expected to rise forward
rates will lower, whereas if interest rates are expected to fall they will trade at a premium
 There have been periods when the AUD has strengthened against currencies from countries with lower interest
rates

Commodity Prices and the Terms of Trade

 A country’s terms of trade are the ratio of its export prices relative to its import prices (not the TWI)
 A relative increase in export prices (an improvement in their terms of trade) will put upward pressure on the
exchange rate (and vice versa)
  Australia experiences substantial movements in their terms of trade because of the imbalance between the
composition of the exports and imports
 Exports: Resources (or commodities), especially minerals
 Imports: Manufactured goods and services
 Australia’s terms of trade improve when there is an increase in the general level of commodity prices relative to
the price of traded goods and services
 Its usefulness as a predictor is limited given the difficulty predicting commodity prices and the terms of trade

Speculation and Risk

 The AUD is traded by speculators:
 because it is not closely correlated with other major currencies and so provides some diversification
 it tends to have a positive relationship with global commodity prices which differs from the
major currencies (USD, EUR, JPY and the GBP)
 Because some believe its movements can be predicted and so profits can be made by moving funds into
and out of the currency at the right time
 this includes the carry trade, and
 the view that the AUD is responsive to sentiment, as evidenced during the GFC

Current Account Balance

 Countries with an accumulated current account deficit (CAD) have to service that debt (over time it will
accumulate net external liabilities (external liabilities > external assets)
 if traders become concerned about the capacity of a country to service it liabilities this can trigger selling of that
currency  depreciation of currency
 Variations in CAD don't appear to influence exchange rate movements much

The RBA
 The RBA trades AUD as it doesn’t rely on the market's efficiency to always establish the currency’s true value
 They ‘focus on episodes where the exchange rate has clearly overshot’ - that is, large but infrequent
intervention achieved by trading USD/AUD rather than the previously short and frequent changes
 They buy AUD (sell USD) when they believe it is undervalued  appreciates AUD
  They sell AUD (buy USD) when they believe it is overvalued depreciates AUD
 Trading by the RBA will have an effect on the exchange rate if only through the signal it sends

Can We Forecast the AUD?

 Dealers may attempt to forecast intra-day price movements based on order flows and the market’s reaction to
news
 they don’t attempt longer-term forecasts such as a week or a year
 Dealers believe that movements over longer periods are explained by changes in fundamental factors
such as inflation and the terms of trade
 Economists who attempt forecasts over longer periods generally perform poorly
 Movements in the exchange rate are sufficiently random and volatile (similar to the EMH's random walk) to
pose considerable risk and provides motivation to hedge future transactions