Chapter 15

Financial Institutions, Institutions, Instruments and Markets 8th edition Instructor's Resource Manual

Christopher Viney and Peter Phillips

Chapter 15 Foreign echange! the structure and operation o" the F# market

 Learning objective objective 1: Understand the nature, size and and scope of the global FX markets and the main exchange rate regimes used b different countries •

FX markets exist wherever transactions are denominated in a foreign currency, including international trade transactions, cross-border capital transactions, speculative transactions and central bank transactions.

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The FX markets operate through a highly sophisticated network of telecommunications systems that link the numerous FX dealers and FX brokers located in all of the major cities of the world.

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n exchange rate is the value of one currency relative to another currency. !ach country, or  group of countries within a monetary union, is responsible for determining the form of their exchange rate.

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"ost major currency exchange rates are determined using a floating exchange rate regime, including the currencies of the #$, #%, !"#, &apan, ustralia ustralia and 'ew (ealand.

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 floating exchange rate is determined by factors that affect the supply and demand of currencies within the FX market.

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)ountries such as )hina, $ingapore, "alaysia and *ndonesia operate a managed exchange rate regime, whereby the exchange rate is allowed to move within a defined range relative to a specified major currency or basket of currencies.

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 crawling crawling peg exchange rate regime allows the currency to appreciate over time, but within a limited range determined by the government and+or central bank.  major

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difference between a managed float and the crawling peg is that market participants generally agree that a currency using the crawling peg is typically undervalued. This may in fact describe the regime used in )hina. •

ith a linked exchange rate regime, as used by ong %ong, the exchange rate is locked into a ratio with a nominated currency, such as the #$, or a basket of currencies.

 Learning objective objective !: "dentif and discuss discuss the major groups groups of participants participants in the FX markets •

/articipants in the FX markets include those who have underlying commercial and financial transactions denominated in foreign currencies. This includes importers and exporters, and those investing or borrowing overseas in a currency other than their home currency.

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*n addition, there are speculators who buy and sell foreign currencies in the expectation of making profits from favourable exchange rate movements, and there are those who arbitrage exchange rate and+or international interest rate differentials across the different international markets.

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)entral banks also enter the FX markets as buyers and sellers of foreign currency.  central bank may enter the FX market in order to provide its government0s foreign currency re1uirements or, from time to time, in an attempt to influence the value of a currency in the market, or to adjust its foreign currency reserve portfolio.

 Learning objective objective #: $escribe the functions functions and operations operations of the FX markets markets •

The FX markets operate somewhere around the globe 23 hours a day.

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The markets are dynamic, with exchange rates changing in response to the continuous flow of economic, political, financial and social news and information into the markets.

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*t is estimated that around the e1uivalent of #$4 trillion pass through the FX markets each day, facilitated by FX dealing rooms that use sophisticated, technology-based computer and communication systems.

 Learning objective objective %: List and explain the tpes of FX transactions, transactions, in particular particular spot and  for&ard transactions transactions •

The contracts that are traded in the FX markets are distinguished by their maturity or delivery dates. 2

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$pot and forward contracts are the most common contracts traded.

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$pot transactions have a value date that is two business days from today5 that is, they re1uire delivery of the foreign currency and financial settlement two business days from the contract date.

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Forward contracts specify a value date more than two business days from today.

 Learning objective ': "ntroduce the conventions adopted for the (uotation and calculation of spot exchange rates •

6ecause of the technology-based nature of the trade in foreign currencies, universal conventions are adopted in the FX markets.

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For example, a spot 1uote may be #+#$7.824794:.

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The first-named currency in an FX 1uote is called the unit of the 1uotation, or the base currency. The base currency represents one unit of the currency.

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The second-named currency is known as the terms currency.

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FX dealers, or price-makers, 1uote two-way rates; the first and lower rate is the one at which the dealer buys the base currency5 the second and higher rate is the one at which the dealer sells the base currency.

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FX dealers will abbreviate their verbal FX 1uotes by removing decimal points and not repeating common numbers.

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!xchange rates with less than & 7utline the "eatures o" the main types o" contracts that are created in the F# markets, distinguishing (et4een short