FIN3103B/3703B

Financial Markets

05 – Forex Market

1 Sem2 AY2020/21
The Forex Market
I. FX Exposure

II. FX Market

III. Forex Basics

IV. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

V. Determinants of Forex Rates

• Short-term
• Long-term

VI. Singapore Exchange Rate Regime

2
I. FX Exposure
• Why should investors care about exchange rates?

Source: https://dollarsandsense.sg/investing‐overseas‐high‐returns‐currency‐exchange‐rates‐impacts‐actual‐returns/. 

3 FX Exposure
• Why should managers care about exchange rates?

Source: OCBC 1H20 Results Presentation

https://www.ocbc.com/assets/pdf/quarterly-results/2020/ocbc%201h20%20ceo%20presentation.pdf
Forex Exposure
• Transaction exposure:
• Import from and export to foreign countries
• Borrow from and lend to foreign countries

• Translation exposure:
• Translating value to home country
• Example, for financial reporting

• Economic exposure:
• Long term investments and operations
• Affecting cash flows and cash flow volatility
• Difficult to hedge
• Diversification

5 FX Exposure
The Forex Market
I. FX Exposure

II. FX Market

III. Forex Basics

IV. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

V. Determinants of Forex Rates

• Short-term
• Long-term

VI. Singapore Exchange Rate Regime

6
Structure of FX market
• Over-the-counter (OTC) market
• Dealers (mostly banks) stand ready to buy and sell
• The Bank of International Settlements (BIS) surveys FX market
activity every three years since 1986. The latest Triennial Central
Bank Survey is published in 2019.

• BIS, 2019. Foreign exchange turnover in April 2019 (Triennial Central

Bank Survey). https://www.bis.org/statistics/rpfx19_fx.htm

7 FX Market
What are the most traded currencies

Source: BIS

8
Who participates in the FX market?
Source: BIS

9 FX Market
Major FX Centers
• FX trading continues to be concentrated in the largest financial
centers, with the top 5 centers, the UK, the USA, Singapore, Hong
Kong, & Japan accounting for 79% of all FX trading in 2019.

• Mainland China recorded a 87% increase from 2016 to 2019 and

climbed from the 13th place to the 8th place

10 FX Market
 Singapore FX market turnover from SFEMC

Total Monthly Volume
October 2019 April 2020
Instrument
(US$ mn) (US$ mn)
Spot transactions 1,866,638 2,611,147
Outright forwards 1,565,661 1,491,028
Foreign exchange swaps 5,789,905 5,496,517
Total foreign exchange turnover 9,222,204 9,598,692
Currency swaps 2,217,438 1,431,468
Foreign exchange options 609,226 508,443
Total foreign exchange derivatives 
2,826,664 1,939,911
turnover
Number of working days 22 21

Source: http://www.sfemc.org/statistics.html, accessed on 9 March 2021.

11 FX Market
The Forex Market
I. FX Exposure

II. FX Market

III. Forex Basics

IV. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

V. Determinants of Forex Rates

• Short-term
• Long-term

VI. Singapore Exchange Rate Regime

12
Direct Quote
• Exchange rate: The amount of one currency that can be
exchanged for a unit of another currency. That is the price of one
currency in terms of another currency.

• All quotes were taken from Bloomberg

• Direct quote: Units of local currency per unit of foreign currency

Treat “/” as a division:  1.3759 1 USD = 1.3759 SGD
• Eg. 1.3670 (SGD per USD or USD/SGD)

• If the rate increases => SGD ____________

• If the rate decreases => SGD ____________

13 Forex Basics
Bid-ask Spread
• USD/AUD = 1.3718 – 1.3728
• These are the bid and ask prices for USD in terms of AUD
• MM: market maker

1.3718 1.3728

Bid Ask 

MM buys USD, sells AUD MM sells USD, buys AUD
You sell USD, buy AUD You buy USD, sell AUD

15 Forex Basics
Cross Rates
Cross rate with bid-ask spread

Eg. USD/AUD = 1.3718 – 1.3728

USD/GBP = 0.7608 – 0.7616

Find GBP/AUD = _________ – _________

These are the bid and ask prices for GBP in terms of AUD

_________  _________ 
Bid Ask 
MM buys GBP, sells AUD MM sells GBP, buys AUD
You sell GBP, buy AUD You buy GBP, sell AUD

16 Forex Basics
 Cross Rates
Eg. USD/AUD = 1.3718 – 1.3728
USD/GBP = 0.7608 – 0.7616

_________  _________ 

Bid Ask 

MM buys GBP, sells AUD MM sells GBP, buys AUD
You sell GBP, buy AUD You buy GBP, sell AUD

How? How?
(1) You sell GBP and buy USD at the  (1) You sell AUD and buy USD at the 
ask price of USD/GBP = ________ ask price of USD/AUD = ______;
(2) You sell USD and buy AUD at the  (2) You sell USD and buy GBP at the 
bid price of USD/AUD = ________ bid price of USD/GBP = _______
GBP/AUD = ___________ GBP/AUD = ________

17 Forex Basics
Cross Rates
Cross rate with bid-ask spread

Eg. USD/AUD = 1.3718 – 1.3728

USD/GBP = 0.7608 – 0.7616

Find GBP/AUD = 1.8012 – 1.8044

These are the bid and ask prices for GBP in terms of AUD

• Shortcut to find the cross rates: Pick the 2 prices that maximize
the bid-ask spread among 4 potential prices.
• Rationale: You incur the bid-ask spread twice when crossing.

20 Forex Basics
Two-point Arbitrage
Eg. In Sydney: USD/AUD = 1.3718 – 1.3728
In New York: USD/AUD = 1.3732 – 1.3739

USD is undervalued (cheaper) in Sydney and overvalued

(more expensive) in New York
=> _____ USD in Sydney and _____ in New York

In Sydney: A$1m buy USD at _____

= US$(__________ ) = US$ 728,438.23

In New York: Buy A$ with US$ at ______

= A$(____________) = A$ 1,000,291.38

Profit = ____________

21 Forex Basics
Three-point (Triangular) Arbitrage
Eg. In Sydney: USD/AUD = 1.3718 – 1.3728
In London: USD/GBP = 0.7608 – 0.7616
In New York: GBP/AUD = 1.8052 – 1.8060

We know that the correct cross rate is 1.8012 – 1.8044

=> Price of GBP in New York is _________

=> ______ GBP in New York and ______ GBP through
Sydney and London

26 Forex Basics
Three-point (Triangular) Arbitrage
Eg. In Sydney: USD/AUD = 1.3718 – 1.3728
In London: USD/GBP = 0.7608 – 0.7616
In New York: GBP/AUD = 1.8052 – 1.8060

We know that the correct cross rate is 1.8012 – 1.8044

In Sydney: Use A$1m to ________ USD at ________

= US$(________________) = US$ 728,438.23

In London: Use USD to ________ GBP at ________

= ₤(________________) = ₤ 554,195.80

In New York: ________ GBP at ________

= A$(________________) = A$ 1,000,434.27

Profit = ________________

29 Forex Basics
Three-point (Triangular) Arbitrage
Eg. In Sydney: USD/AUD = 1.3718 – 1.3728
In London: USD/GBP = 0.7608 – 0.7616
In New York: GBP/AUD = 1.8052 – 1.8060

We know that the correct cross rate is 1.8012 – 1.8044

=> OR Price of AUD in New York is lower/higher
=> Buy/sell AUD in New York and buy/sell AUD through Sydney and
London

In New York: _________________________

= _________________________

In Sydney: _________________________
= _________________________

In London: _________________________
= _________________________

Profit = _________________________
34 Forex Basics
The Forex Market
I. FX Exposure

II. FX Market

III. Forex Basics

IV. Parity Conditions

• Purchasing Power Parity (PPP)
• Interest Rate Parity

V. Determinants of Forex Rates

• Short-term
• Long-term

VI. Singapore Exchange Rate Regime

39
1. Purchasing Power Parity (PPP)
• Law of one price: Identical product should sell at identical prices in
different countries. If violated, arbitrage will bring the price back to
parity.

• Price should reflect the exchange rate if prices are stated in

different currencies

• Different country may have different consumption pattern => use a

basket of goods => use price indices

40 Purchasing Power Parity 
Absolute and Relative PPP
• Absolute PPP:
𝑃
𝑆
𝑃
• where 𝑃 and 𝑃 are the price indices of country 1 and 2
respectively. S is Country 1’s currency per unit of Country 2’s
currency.
• E.g., 𝑆 / 𝐶𝑃𝐼 /𝐶𝑃𝐼

• Relative PPP: Changes in price level (i.e. inflation) will reflect

changes in exchange rate.
𝑆 𝑃 , /𝑃 , 1 𝜋
𝑆 𝑃 , /𝑃 , 1 𝜋
/ ,
• E.g.,
/ ,

41 Purchasing Power Parity 
The Big Mac index by the Economist
Local Big Mac 
Price in Local  Actual  PPP Implied 
Country Currency Exchange Rate Exchange Rate Valuation
Australia 6.55 1.43 1.15 -19.82
Brazil 20.90 5.34 3.66 -31.46
Britain 3.39 0.79 0.59 -25.09
Canada 6.88 1.36 1.20 -11.09
China 21.70 7.00 3.80 -45.74
Denmark 30.00 6.55 5.25 -19.78
Euro area 4.21 0.88 0.74 -16.18
Hong Kong 20.50 7.75 3.59 -53.68
Israel 17.00 3.44 2.98 -13.37
Japan 390.00 107.28 68.30 -36.33
Malaysia 9.99 4.27 1.75 -58.98
New Zealand 6.60 1.52 1.16 -23.85
Norway 52.00 9.37 9.11 -2.82
Russia 135.00 70.59 23.64 -66.51
Singapore 5.90 1.39 1.03 -25.54
South Korea 4500.00 1200.95 788.09 -34.38
Sweden 52.60 9.14 9.21 0.80
Switzerland 6.50 0.94 1.14 20.94
Taiwan 72.00 29.46 12.61 -57.19
United States 5.71 1.00 1.00 0.00
42 Purchasing Power Parity 
Absolute and Relative PPP
• Absolute PPP:
𝑃
𝑆
𝑃
where 𝑃 and 𝑃 are the price indices of country 1 and 2
respectively. S is Country 1’s currency per unit of Country 2’s
currency.

• Relative PPP: Changes in price level (i.e. inflation) will reflect

changes in exchange rate
𝑆 𝑃 , /𝑃 , 1 𝜋
𝑆 𝑃 , /𝑃 , 1 𝜋
• Higher inflation => depreciation of currencies
• Using expected inflation:
𝐸 𝑆 1 𝜋
𝐸
𝑆 1 𝜋

45 Purchasing Power Parity 
Relative PPP, US/UK, 1996 to July 2019
(Index: Jan 2009 = 100)

46 Purchasing Power Parity 
Factors that make PPP not hold up
• Taxes
• Transportation cost
• Perishability of goods
• Non-tradable goods and services

47 Purchasing Power Parity 
2. Interest Rate Parity
• Forward premium is matched by different interest rate cross
countries.
• Covered Interest Parity (CIP):
𝒇 𝟏 𝒊𝟏
𝑺 𝟏 𝒊𝟐
Note: the horizons of forward exchange rate and interest rates
should be consistent.

E.g.
𝑆 / : spot rate (USD/GBP)
𝑓 / : futures/forward rate (USD/GBP) in one year
𝑖 : US interest rate (annualized)
𝑖 : GB interest rate (annualized)
𝑓 / 1 𝑖
𝑆 / 1 𝑖

48 Interest Rate Parity
2. Interest Rate Parity
Investment 1:
a. At time t, convert 1£ to US$ at 𝑆
b. At time t, invest US$ at 𝑖 in US and earn interest
c. At time t, contact to convert (US$ + interest) to £ at 𝑓 at time t+1

Investment 2:
a. At time t, invest 1£ at 𝑖

Both investment 1 and 2 should yield the same amount at time t+1.
Investment 1 yields 1£ 1 𝑖 𝑓
Investment 2 yields 1£ 1 𝑖

Hence,
1
1£ 1 𝑖 𝑓 1£ 1 𝑖
𝑆
𝑓 1 𝑖
𝑆 1 𝑖

49 Interest Rate Parity
Covered Interest Arbitrage (CIA)
• If the parity condition is violated, arbitrage will cause the spot rate,
forward rate, and interest rates in both countries to adjust to bring
back the parity (CIP) condition. The arbitrage in this case is called
Covered Interest Arbitrage (CIA).

• E.g., If 𝑆= 0.8465, 𝑖 = 2%, 𝑖 = 4%, what should 𝑓 be in one year?

1 𝑖
𝑓 𝑆 0.8631
1 𝑖

• If 𝑓 in the market is now quoted at 0.8642, higher than the CIP

implied forward rate 0.8631.
• This means that USD in the market is more
expensive/cheaper with forward (𝑓), and thus the arbitrageur
should buy/sell USD at spot (S) and buy/sell USD with forward
(𝑓).

51 Interest Rate Parity
 Covered Interest Arbitrage (CIA)

Route A: _______________
1 m (______)
Route B: Convert _______ 
Borrow __________
at 𝑓 = _____________
PROFIT= ____________

__________ ____________

Convert to  _____(____)
________________,  Receive ___________
Invest at ________

Time t Time t+1
53 Interest Rate Parity
Covered Interest Arbitrage (CIA)
• Factors that may make the Covered Interest Arbitrage (CIA) less
than perfect, i.e. the true forward rate may vary from the
theoretical rate due to

• Bid-ask spread
• Commission
• Borrowing rate > lending rate
• Tax structure
• Forex control or restrictions

59 Interest Rate Parity
The Forex Market
I. FX Exposure

II. FX Market

III. Forex Basics

IV. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

V. Determinants of Forex Rates

• Short-term
• Long-term

VI. Singapore Exchange Rate Regime

60
Short-Term Factors
• Relative interest rates:
• Higher interest rates attract foreign capital
• Stronger demand for domestic currency
• Currency should appreciate/depreciate

• Government intervention to strengthen or weaken by buying and

selling the currencies
• Eg. To prevent domestic currency from appreciating/depreciating
• => buy domestic currency

• Political factors
• Decrease of stability => currency appreciation/depreciation

• Market expectations / sentiments

• Perception of traders

61 Determinants
Long-Term Factors
• Relative price levels
• High inflation generally => depreciation

• Trade deficit (current account deficit)

• Solutions: Trade barriers (e.g. tariffs & quotas)
• => reduce demand for import
• => increase demand for domestic goods
• =>domestic currency should appreciate (or stop
depreciating)
• Problem: retaliation!
• Long-Term solution:
• Relative productivity
• As domestic productivity rises
• => Price of domestic goods decrease
• => Demand for domestic good increase
• => Export increase
• => Domestic currency appreciates

65 Determinants
The Forex Market
I. FX Exposure

II. FX Market

III. Forex Basics

IV. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

V. Determinants of Forex Rates

• Short-term
• Long-term

VI. Singapore Exchange Rate Regime

66
VI. Singapore Exchange Rate Regime
• Two main instruments of monetary policy:
• Domestic interest rates
• Exchange rate

• 1. MAS prefers to use exchange rate instead of interest rate (due

to size of the Singapore economy and high degree of openness to
trade and capital flows)

• 2. MAS tries to guide ER in line with the fundamentals and

intervenes to keep within a specified policy band

• 3. Objectives:
• to preserve purchasing power of SGD
• to maintain confidence in currency and preserve value of
worker’s savings, especially CPF balances

67 SG ER Regime
Features of Singapore ER System
• SGD managed against basket of currencies of main trading
partners
• MAS operates a managed float for SGD
• MAS allows the SGD to float within an undisclosed target band,
against a basket of currencies of trading partners
• The ER policy band is reviewed periodically to ensure consistency
with underlying fundamentals

68 SG ER Regime
Singapore S$NEER Policy Band

• Singapore Dollar Nominal Effective Exchange Rate or S$NEER

1. Slope: the rate at which the S$ policy band appreciates
2. Width: how far the S$ can fluctuate
3. Midpoint/level: the level at which the band is centred

Source: MAS.
Straits Times Graphics.

69 SG ER Regime
MAS Monetary Policy Statement - October 2020
• In its April 2020, MAS set the rate of appreciation of the S$NEER policy
band at zero percent per annum.
• There was no change to the width of the policy band.
• The S$NEER had fallen sharply in Q1 2020. Since 30 March, it has
hovered slightly above the mid-point of the new policy band.

Source: MAS
70 SG ER Regime
MAS Monetary Policy Statement - October 2020

• MONETARY POLICY
• MAS will therefore maintain a zero percent per annum rate of
appreciation of the policy band.
• The width of the policy band and the level at which it is centred
will be unchanged.

• Source: MAS Monetary Policy Statement - October 2020

71 SG ER Regime