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CHAPTER 8 The Foreign Exchange Market

Overview The foreign exchange market is the market through which Australian dollars (AUD) can be exchanged for foreign currencies. Official dealers in this market must be licensed by ASIC. Licences are not restricted to banks, although the criteria to be satisfied are fairly strict. In fact, the large banks dominate the Australian market.

Exchange rates for the Australian dollar are quoted in indirect form. That is, the exchange rate shows the value of one AUD in terms of foreign currency. For example, the Australian dollar/US dollar (USD) exchange rate might be written as: AUD/USD 0.9260 which means that one Australian dollar is worth 92.60 US cents. The alternative way of quoting an exchange rate is to use a direct quote in which the value of one unit of foreign currency is stated in terms of the local currency. In the direct form, the above exchange rate would be USD/AUD 1.0799 which means that one US dollar is worth 1.0799 Australian dollars. Direct quoting is more frequently used around the world than indirect quoting.

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There are two major types of exchange rates. The first is the spot exchange rate in which the exchange of currencies is agreed to today but the actual physical exchange occurs in two working days’ time.

The second is the forward exchange rate in which the physical exchange of currencies occurs three or more working days in the future.

Foreign exchange traders quote both a buying (or bid) price and a selling (or offer) price for Australian dollars against foreign currencies. For example, the quote could be: AUD/USD 0.9000 – 0.9010 This trader will buy Australian dollars (sell US dollars) at 90 US cents, i.e. the bid price is 90 US cents. The trader will sell Australian dollars (buy US dollars) at 90.10 US cents, i.e. the offer price is 90.10 US cents.

The difference between the bid and offer price is called the spread.

Spread = Offer Price – Bid Price

In our example, the spread is 0.10 of a US cent or 10 points. A point is a unit in the fourth decimal place of an exchange rate and, since exchange rates are usually quoted to four decimal places, it represents the smallest change that can occur in a market exchange rate.

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The spread indicates the profit the trader will make on a round-trip transaction, i.e. buying a parcel of AUD at the bid price and selling them at the offer price. The size of the spread is often taken as an indicator of competitiveness and efficiency of the foreign exchange market because it represents the resources used up in performing such a round-trip transaction.

Exchange rates are affected by a number of variables which act through exports, imports or capital flows. The major ones are: Exports

– state of the global economy – competitiveness

Imports

– competitiveness – state of the Australian economy

Capital flows – interest rate differentials – expectations about the likely future value of the AUD

Competitiveness refers to the level of Australian prices relative to those overseas (especially in our major trading partners). One expression of this influence is the theory of purchasing power parity which says that the depreciation of a country’s currency is equal to its domestic inflation rate minus the rate of inflation in its trading partners. This theory works well in the long term but has little predictive power in the short term.

The trade-weighted index (TWI) is the average value of the Australian dollar against overseas currencies. The index is a weighted average in which the weights are based on the importance of different overseas currencies in Australia’s trade. As at October 2007, Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442516014/Valentine et al/Fundamentals of Financial Markets & Institutions in Australia/1e 8-3

the Japanese yen has the highest weight (15.49%) with the Chinese Renminbi in second place (15.45%).

The Reserve Bank intervenes in the foreign exchange market in order to reduce the volatility of the exchange rate. It does not currently attempt to set a particular value of the exchange rate. This means that the current regime in the Australian foreign exchange market is a managed float. As explained elsewhere, this arrangement gives the Reserve Bank the freedom to set domestic interest rates.

The forward exchange rate is the rate at which a future exchange of currencies occurs. It is normally stated as a spot exchange rate plus the number of forward points.

Forward Points = Forward Exchange Rate – Spot Exchange Rate

If the forward points are positive, we say that the Australian dollar is at a premium in the forward market. If the forward points are negative, we say that the Australian dollar is at a discount in the forward market.

The formula for the forward rate is:

F

S 1  RO  1  RA

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Where S F

= the spot rate = the forward rate

RA = the Australian interest rate RO = the interest rate on the other currency

This formula indicates that the forward points are determined by the interest rates in the two countries concerned.

When funds are free to flow into and out of the two countries involved in an exchange rate, certain parity relationships arise. The most prominent examples are:

Covered Interest Rate Parity: 1  RO F  1  RA S

This relationship says that the covered return to investing (cost of borrowing) offshore is equal to the Australian return (cost of borrowing). This must be so or otherwise there would be an arbitrage opportunity. For example, assume that the Australian interest rate was higher than the covered cost of borrowing in US dollars (i.e. the cost of borrowing US dollars and, at the same time, buying forward the US dollars necessary for the repayment of the principal of the loan plus interest). Then we can make a riskless profit by simultaneously: 

taking a covered US loan;



investing the money in Australia.

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Uncovered Interest Rate Parity:

A similar relationship exists for uncovered investments and loans. An approximation to this relationship is: RA = RO + Ed where Ed is the expected depreciation of the Australian dollar against the overseas currency. The market expects that the Australian dollar will depreciate or appreciate just enough against the overseas currency to offset the interest rate differential between Australia and the overseas country. In other words, the average market expectation is that Australian investors or borrowers will not be able to benefit by investing or borrowing overseas.

Uncovered Share Return Parity:

We might also expect uncovered parity to apply to share returns. Thus:

where

SA

= SO + Ed

SA

= expected return on Australian shares

SO

= expected return on overseas shares

Ed = expected depreciation of the Australian dollar against the overseas currency

The expected returns include both capital gains/losses and the dividend yield. Again, this relationship indicates that the average market expectation is that Australian investors will not benefit from buying shares overseas. This relationship also shows Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442516014/Valentine et al/Fundamentals of Financial Markets & Institutions in Australia/1e 8-6

why share indices in countries free from restrictions on capital flows are highly intercorrelated.

Globalisation refers to the growing integration of world economies. The parity relationships just discussed indicates the high degree of financial integration created by deregulation, but globalisation extends well beyond the financial area. It involves free trade, unrestricted investment flows, mobile labour and the free movement of information. Globalisation has led to many concerns, including the propagation of economic crises and an end of cultural diversity.

A foreign exchange trading operation makes a profit from: 

the buy/sell spread in its quotes;



position taking in which the trader takes long or short positions in a currency in the hope that the exchange rate will move in a favourable direction.



arbitrage transactions which take advantage of inconsistent pricing in different markets;



fees earned from clients; and



retail transactions.

Foreign exchange traders face a number of risks—settlement risk, credit risk, operational risk and market risk. A well run trading operation will have internal controls in place to mitigate these risks.

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Objectives  explain how exchange rates work  describe the instruments most commonly used in the foreign exchange market  analyse the factors affecting exchange rates  compare alternative foreign exchange regimes  Show how to calculate forward foreign exchange rates  Consider how the Reserve Bank of Australia manages the Australian foreign exchange market  Describe the relationship between domestic Australian capital markets and those overseas  Examine the techniques and sources of profit in foreign exchange trading

Key Concepts An exchange rate is the price of one currency in terms of another. An indirect exchange rate is one in which the price of the domestic currency is stated in terms of the foreign currency. A direct exchange rate is one in which the price of a foreign currency is stated in terms of the domestic currency.

A spot foreign exchange contract arranges an exchange of one currency for another two days from the making of the contract. A forward foreign exchange contract arranges an exchange of one currency in three or more days in the future. A foreign exchange swap Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442516014/Valentine et al/Fundamentals of Financial Markets & Institutions in Australia/1e 8-8

is a contract involving the simultaneous buying and selling of one currency for another in the spot and forward market.

Arbitrage involves taking advantage of equivalent products being priced differently in different parts of the market by simultaneously buying at the low price and selling at the high price. There is no risk involved in arbitrage.

Speculation involves creating an open position (i.e. one which generates a profit or loss) in the hope that a profit will be made.

The spread is the gap (in number of points) between a foreign exchange dealer’s bid and offer prices.

Purchasing Power Parity (PPP) argues that the depreciation of a country’s currency will be equal to its rate of inflation minus the rate of inflation in its trading partners.

The trade-weighted index (TWI) is the weighted average value of the Australian dollar against other currencies. The weights used in the average are based on the importance of the various currencies in our trade. The real exchange rate is an index of the purchasing power overseas of the domestic currency.

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A floating exchange rate regime is one in which the central bank does not intervene in the foreign exchange market, allowing supply and demand for the various currencies to determine exchange rates. In a fixed exchange rate regime, one exchange rate—a bilateral exchange rate or the TWI—is fixed.

A sterilised intervention in the foreign exchange market involves a simultaneous operation in the domestic market which leaves the money base and the domestic interest rate unchanged.

Forward points are equal to the forward exchange rate minus the spot exchange rate.

Interest rate parity is a relationship between the Australian interest rate and an exchange rate adjusted overseas interest rate. Share return parity is a similar relationship between the Australian expected share return and the exchange rate adjusted expected return in an overseas share market.

Globalisation is the integration of national economies and markets.

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Revision Questions

1

Define the following terms: (a) (b) (c) (d)

Spot exchange rate forward exchange rate foreign exchange swap currency option

The spot exchange rate is the price at which the domestic currency can be exchanged for a foreign currency for settlement in two working days.

A forward exchange rate is the price at which the domestic currency can be exchanged for a foreign currency for settlement in three or more

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Australia/1e 8-11

working days. There is a forward exchange rate for each period in the future.

A foreign exchange swap involves the sale (purchase) of AUD spot and the simultaneous purchase (sale) of the same amount in the forward market.

A currency option is an instrument which provides the right, but not the obligation, to buy or sell one currency against another at a specified price (the strike price) or a specified date (the expiry date).

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Australia/1e 8-12

2

An importer of antique jewellery is required to pay GBP 500 000 to a London antique policy in three months’ time. She takes out a forward contract for GBP for three months’ delivery and (assuming she accepts her bank’s quote of AUD/GBP 0.4255) agrees thereby to pay AUD to her bank in exchange for the GBP (a) (b) (c) (d)

sell; 287 750.57 buy; 287 750.57 sell; 1 175 088.13 buy; 1 175 088.13

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She would need to buy GBP. The amount she would pay on the settlement of the contract is:  500000  AUD   AUD 1175088 .13  0.4255 

The answer to the question is D.

3 An exporter wants to hedge half (50%) of his risk on a contract for the sale of computer software to Japan. He expects to receive payment of JPY 500 million in 180 days’ time. He takes out a forward contract for AUD with his bank in Sydney, which quotes him a 180-day forward exchange rate of AUD/JPY 102. He can expect to receive AUD __________ from his bank in six months’ time. (a) buy; 51 million (b) sell; 25 500 000 000 of Pearson Australia Group Pty Ltd) – Copyright © 2011 Pearson Australia (a division 9781442516014/Valentine et al/Fundamentals of Financial Markets & Institutions in (c) buy; 2 450 980.39 Australia/1e 8-14 (d) sell; 4 901 960.78

The exporter will want to exchange JPY for AUD. Therefore, he would take out a sell contract for JPY (buy contract for AUD). The settlement amount is:  250 m  AUD    AUD 2450980.39  102 

Therefore, the answer is C.

4

A meat exporter in Brisbane purchases JPY7 million one month forward and simultaneously sells JPY7 million two months’ forward. This transaction is an example of: (a) a spot/forward foreign exchange swap (b) a cross-currency interest rate swap (c) a forward/forward currency swap (d) none of the above

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The description indicates that the transaction is a forward/forward currency (foreign exchange) swap.

5

Explain the theory of purchasing power parity (PPP). What would cause it to fail over short periods?

Purchasing Power Parity says that the value of a country’s currency falls by the percentage that its rate of inflation exceeds the average of the rates of inflation in its major trading partners. This keeps the prices of domestic products in the same relationship with overseas products as they had originally.

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In the short term, other factors affect the value of the exchange rate in addition to relative price levels. One of these is interest rate differentials. If the domestic interest rate is high relative to overseas interest rates, a higher value of the exchange rate can be maintained for a period. The second, and most important, short-term influence is market sentiment, i.e. market expectations about future movements in the exchange rate. These expectations will not necessarily be related to relative rates of inflation. They can keep the actual exchange rate away from the equilibrium value of the exchange rate determined by PPP for some time.

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6

What are the virtues and weaknesses of a floating exchange rate regime?

The major weakness of a floating exchange rate regime is the day-to-day volatility of the exchange rate it involves. This volatility creates uncertainty for participants in foreign exchange transactions. However, it should be noted:  derivatives markets have provided a variety of tools to allow market participants to hedge their exposures. Forward foreign exchange contracts are the leading example; and  in practice, there is also uncertainty in fixed exchange rate regimes because Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442516014/Valentine et al/Fundamentals of Financial Markets & Institutions in Australia/1e 8-18

devaluations and revaluations often occur.

The major advantages of a floating exchange rate regime are: 

shocks originating overseas are reflected in the exchange rate rather than in the domestic economy. That is, the volatility of the real sector has been reduced at the cost of increasing the volatility of the exchange rate;...