FIN3703A

Financial Markets
05: Forex Market

Dr. YUE Ling

1 Sem1 AY2022/23
 FIN3703A

The Forex Market

I. FX Introduction
• FX market overview
• Quotes and Cross rates

II. Determinants of Forex Rates

• Short-term
• Long-term

III. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

IV. Singapore Exchange Rate Regime

2
 FX market overview

Structure of FX market
• Over-the-counter (OTC) market
• decentralized and distributed, with no real central location
• electronic marketplace
• dealers (mostly banks) stand ready to buy and sell

• Major FX centers:
• FX trading continues to be concentrated in the largest
financial centers.
• In April 2019, sales desks in five countries – the United
Kingdom, the United States, Hong Kong SAR, Singapore and
Japan – facilitated 79% of all foreign exchange trading.
• Mainland China recorded a 87% increase from 2016 to 2019
and climbed from the 13th place to the 8th place.

3
 FX market overview

Singapore FX market turnover from SFEMC

know the top 3 product. dont need to know all the product
• Total Monthly Volume
October 2021 April 2022
Instrument
(US$ mn) (US$ mn)
Spot transactions 3,488,518 4,828,209
Outright forwards 2,862,444 2,829,263
Foreign exchange swaps 9,217,975 9,085,895
Total foreign exchange turnover 15,568,937 16,743,367
Currency swaps 123,465 130,994
Foreign exchange options 997,881 1,299,929
Total foreign exchange derivatives
1,121,346 1,430,923
turnover
Number of working days 21 20

Source: https://www.sfemc.org/statistics.html, accessed on 29 Sep 2022.

5
 FX market overview

Top 10 global market share (FX overall volume)

• Deutsche Bank take the top volume ranking

• Slight increases to the combined market share of top 5 and top 10
to 44% (2021 - 39%) and 66% (2021 - 64%) respectively

Source: Euromoney FX Survey 2022.

6
 FX market overview

Who participates in the FX market?

Source: BIS 2019

7
 FX market overview

What are the most traded currencies

Source: BIS 2019

8
 FX market overview

FX market survey
• 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.
• 2022 Triennial Central Bank Survey: final results will be
published in December 2022.
(https://www.bis.org/press/p220330.htm)

• Industry surveys:
• Euromoney FX Survey
• Asiamoney FX Survey

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 FIN3703A

The Forex Market

I. FX Introduction
• FX market overview
• Quotes and Cross rates

II. Determinants of Forex Rates

• Short-term
• Long-term

III. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

IV. Singapore Exchange Rate Regime

10
 Quotes and Cross rates

FX 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.

• Convention: 1 𝑈𝑈𝑈𝑈𝑈𝑈
Treat “/” as a division: = 1.3759 1 USD = 1.3759 SGD
1 𝑆𝑆𝑆𝑆𝑆𝑆

• USD/SGD = 1.3759 <=> 1 USD = 1.3759 SGD

• If the rate increases => SGD ____________
depreciate

• If the rate decreases => SGD ____________

appreciate

• SGD/USD = 0.7268 <=> 1 SGD = 0.7268 USD

base currency
quote currency

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 Quotes and Cross rates

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

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 Quotes and Cross rates

Cross Rates
Cross rate with bid-ask spread

Eg. USD/AUD = 1.3718 – 1.3728

USD/GBP = 0.7608 – 0.7616
1.3718/0.7616= 1.8012

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.

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 Quotes and Cross rates

Cross Rates
Eg. USD/AUD = 1.3718 – 1.3728
GBP/AUD
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 = ________
0.7616
ask price of USD/AUD = ______;
0.7608

(2) You sell USD and buy AUD at the (2) You sell USD and buy GBP at the
bid price of USD/AUD = ________
1.3718 bid price of USD/GBP = _______
1.3728

 GBP/AUD = ___________
1.8012  GBP/AUD = ________
1.8044

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 Quotes and Cross rates

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
=> _____
buy
USD in Sydney and _____
sell USD in New York

In Sydney: A$1m buy USD at _____

1.3728

= US$(__________
1m/1.3728
) = US$ 728,438.23

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

1.3732

= A$(____________)
728438.23*1.3732 = A$ 1,000,291.38

Profit = ____________
291.38(0.029138%)/ 2.9basis point

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 FIN3703A

The Forex Market

I. FX Introduction
• FX market overview
• Quotes and Cross rates

II. Determinants of Forex Rates

• Short-term
• Long-term

III. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

IV. Singapore Exchange Rate Regime

24
 Determinants of FX rates

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

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 Determinants of FX rates

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

26
 Determinants of FX rates

Short-Term Factors
• Political factors
• Decrease of stability => currency appreciation/depreciation

• Market expectations / sentiments

• Perception of traders

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 Determinants of FX rates

Long-Term Factors
• Relative price levels
• High inflation generally => appreciation/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/depreciate
• Problem: retaliation!

31
 Determinants of FX rates

US Dollar Index (DXY)

• The US Dollar Index a measure of the value of the U.S. dollar relative to a
basket of foreign currencies: Euro, Swiss franc, Japanese yen, Canadian
dollar, British pound, and Swedish krona.
• The index was established shortly after the Bretton Woods Agreement
dissolved in 1973 with a base of 100 is now maintained by ICE.

us decide to give 20% i/r Source: Yahoo Finance, accessed

everyone floods their money on 30 Sep 2022.
in, other countries suffer
because outflow of money

asia financial crisis, flock to usa

i/r going up,
invest in usd

33
 Determinants of FX rates

US current-account balance

Source: https://fred.stlouisfed.org/series/IEABC, accessed on 30 Sep 2022.

35
 FIN3703A

US: Current account balance / GDP vs. DXY ppl buy usd because its a
reserve currency, hence
currency dont fall

Source: Refinitiv, accessed on 1 Oct 2022. Current account balance as a percentage of GDP as at Q2 2022, US Dollar Index data as at 30 Sep 2022.

36
 Determinants of FX rates

Long-Term Factors
Trade deficit (current account deficit)
• Long-Term solution:
• Relative productivity
• As domestic productivity rises
• => Price of domestic goods decrease
• => Demand for domestic good increase
• => Export increase
• => Domestic currency appreciates/depreciates

39
 FIN3703A

The Forex Market

I. FX Introduction
• FX market overview
• Quotes and Cross rates

II. Determinants of Forex Rates

• Short-term
• Long-term

III. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

IV. Singapore Exchange Rate Regime

41
 Purchasing Power Parity

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

42
 Purchasing Power Parity

Absolute PPP
• Absolute PPP:
𝑃𝑃1 1300
𝑆𝑆2/1 =
𝑃𝑃2
currency = 1.3
1000

• Notation:
• S2/1 is the spot rate, country 1’s currency per unit of
country 2’s currency.
• 𝑃𝑃1 and 𝑃𝑃2 are the price indices of country 1 and 2
respectively.

• E.g., 𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝑆𝑆𝑆𝑆𝑆𝑆 = 𝐶𝐶𝐶𝐶𝐼𝐼𝑆𝑆𝑆𝑆𝑆𝑆 /𝐶𝐶𝐶𝐶𝐼𝐼𝑈𝑈𝑈𝑈𝑈𝑈

43
 Purchasing Power Parity

The Big Mac index by the Economist

Local Big Mac Price Actual Exchange PPP Implied
Country in Local Currency Rate Exchange Rate Valuation
Australia 6.7 1.4484 1.3010 -10.18%
Brazil 22.9 5.3918 4.4466 -17.53%
Britain 3.69 0.8311 0.7165 -13.79%
Canada 6.77 1.2892 1.3146 1.97%
Switzerland 6.5 0.9685 1.2621 30.33%
China 24 6.7474 4.6602 -30.93%
Euro area 4.65 0.9758 0.9029 -7.47%
Hong Kong 21 7.8500 4.0777 -48.05%
Indonesia 35000 14977.5000 6796.1165 -54.62%
India 191 79.9513 37.0874 -53.61%
Israel 17 3.4375 3.3010 -3.97%
Japan 390 137.8650 75.7282 -45.07%
South Korea 4600 1313.4500 893.2039 -32.00%
Malaysia 10.9 4.4500 2.1165 -52.44%
Norway 62 9.8977 12.0388 21.63%
Poland 16.68 4.6485 3.2388 -30.32%
Singapore 5.9 1.3914 1.1456 -17.66%
Sweden 57 10.1979 11.0680 8.53%
Taiwan 75 29.9075 14.5631 -51.31%
United States 5.15 1.0000 1.0000 0.00%
44 Source: The Economist, accessed on 30 Sep 2022.
 Purchasing Power Parity

The Big Mac index by the Economist – Calculation

• Big Mac in the US: 5.15 USD

• Big Mac in Singapore: 5.9 SGD

• PPP implied exchange rate:

• 5.15 USD = 5.9 SGD
• USD/SGD = ______________
5.9/5.15 = 1.14563

• Actual exchange rate: USD/SGD = 1.3914

• According to PPP, SGD is undervalued against USD.

• __________________
(1.14563/1.3914) -1 = - 17.66%

45
 Purchasing Power Parity

47 Source: The Economist, accessed on 30 Sep 2022.

 Purchasing Power Parity

Relative PPP
• Relative PPP:
• Changes in price level (i.e. inflation) will reflect changes in
exchange rate.
𝑆𝑆2/1,𝑡𝑡 𝑃𝑃1,𝑡𝑡 /𝑃𝑃1,𝑡𝑡−1 1 + 𝜋𝜋1
= =
𝑆𝑆2/1,𝑡𝑡−1 𝑃𝑃2,𝑡𝑡 /𝑃𝑃2,𝑡𝑡−1 1 + 𝜋𝜋2

𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝑆𝑆𝑆𝑆𝑆𝑆,𝑡𝑡 1+𝜋𝜋𝑆𝑆𝑆𝑆𝑆𝑆
• E.g., =
𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝑆𝑆𝑆𝑆𝑆𝑆,𝑡𝑡−1 1+𝜋𝜋𝑈𝑈𝑈𝑈𝑈𝑈

• Higher inflation => depreciation of currencies

• Using expected inflation:

𝐸𝐸 𝑆𝑆2/1,𝑡𝑡+1 1 + 𝜋𝜋1
= 𝐸𝐸
𝑆𝑆2/1,𝑡𝑡 1 + 𝜋𝜋2

48
 Purchasing Power Parity

Relative PPP, US/UK, 1996 to July 2019 check with prof why go down

(Index: Jan 2009 = 100)

and up

49
 Purchasing Power Parity

Factors that make PPP not hold up

• Taxes
• Transportation cost
• Perishability of goods cant keep fresh fish last long, so fresh salmon in norway is cheap than sg
• Non-tradable goods and services goods- Real estate/cant be moved
services - medical treatment, some countries specialise in brain,
others in heart.
services - tourism

50
 Interest Rate Parity

2. Interest Rate Parity

• Covered Interest Parity (CIP): Forward premium is matched by
different interest rate cross countries.

𝑓𝑓2/1 1 + 𝑖𝑖1
=
𝑆𝑆2/1 1 + 𝑖𝑖2

• Notation:
• 𝑆𝑆2/1 is the spot exchange rate, price of a currency for
immediate delivery at time t
• 𝑓𝑓2/1 is the forward exchange rate, price of a currency for
delivery in the future (e.g. 30 days, 60 days, 1 year, etc)
• 𝑖𝑖1 is the interest rate in country 1
• 𝑖𝑖2 is the interest rate in country 2

• Important note: the horizons of forward exchange rate and interest

rates should be consistent.

51
 Interest Rate Parity

CIP: example
• Covered Interest Parity (CIP):
𝑓𝑓2/1 1 + 𝑖𝑖1
=
𝑆𝑆2/1 1 + 𝑖𝑖2

• E.g.
• 𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 : spot rate (USD/GBP)
• 𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 : futures/forward rate (USD/GBP) in one year
• 𝑖𝑖𝑈𝑈𝑈𝑈 : US interest rate (annualized)
• 𝑖𝑖𝐺𝐺𝐺𝐺 : GB interest rate (annualized)
𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 1 + 𝑖𝑖𝐺𝐺𝐺𝐺
=
𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 1 + 𝑖𝑖𝑈𝑈𝑈𝑈

52
 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 𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 = 0.8465, 𝑖𝑖𝑈𝑈𝑈𝑈 = 2%, 𝑖𝑖𝐺𝐺𝐺𝐺 = 4%, what should

𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 be in one year?
(1 + 𝑖𝑖𝐺𝐺𝐺𝐺 )
𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 = 𝑆𝑆 = 0.8631
(1 + 𝑖𝑖𝑈𝑈𝑈𝑈 ) 𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺

• That is, the CIP implied 𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 is 0.8631.

53
 Interest Rate Parity

CIA (continued)
• The CIP implied 𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 is 0.8631.

• If 𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 in the market is now quoted at 0.8642, what would an

arbitrageur do?

• This means that USD in the market is more expensive/cheaper

with forward (𝑓𝑓) than with spot (S).
• Thus, the arbitrageur should buy/sell USD at spot (S) and buy/sell
USD with the forward market quote (𝑓𝑓).

54
 Interest Rate Parity

Covered Interest Arbitrage (CIA)

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

__________ Buy/Sell USD Buy/Sell USD ____________

with 𝑆𝑆 with market 𝑓𝑓

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

Time t Time t+1

56
 Interest Rate Parity

CIP derivation: no arbitrage

• Investment 1:
• a. At time t, invest 1£ at 𝑖𝑖_𝐺𝐺𝐵𝐵  1£ × (1 + 𝑖𝑖𝐺𝐺𝐺𝐺 )

• Investment 2:
• a. At time t, convert 1£ to US$ at 𝑆𝑆  1£/𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺
• b. At time t, invest US$ at 𝑖𝑖_𝑈𝑈𝑆𝑆 in US and earn interest 
1£/𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 × 1 + 𝑖𝑖𝑈𝑈𝑈𝑈
• c. At time t, contact to convert (US$ + interest) to £ at 𝑓𝑓 at time
t+1 1£/𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 × 1 + 𝑖𝑖𝑈𝑈𝑈𝑈 × 𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺

• The two investment strategies should yield the same amount at

time t+1. Hence:
• 1£ × 1 + 𝑖𝑖𝐺𝐺𝐺𝐺 = 1£/𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 × 1 + 𝑖𝑖𝑈𝑈𝑈𝑈 × 𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺
𝑓𝑓𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 (1+𝑖𝑖𝐺𝐺𝐺𝐺 )
• =
𝑆𝑆𝑈𝑈𝑈𝑈𝑈𝑈/𝐺𝐺𝐺𝐺𝐺𝐺 (1+𝑖𝑖𝑈𝑈𝑈𝑈 )

64
 Interest Rate Parity

Factors affecting CIA profit

• 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

65
 FIN3703A

The Forex Market

I. FX Introduction
• FX market overview
• Quotes and Cross rates

II. Determinants of Forex Rates

• Short-term
• Long-term

III. Parity Conditions

• Purchasing Power Parity
• Interest Rate Parity

IV. Singapore Exchange Rate Regime

66
 SG ER Regime

Singapore Exchange Rate Regime

• Two main instruments of monetary policy:
• Domestic interest rates
• Exchange rate (ER)

• 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)

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

intervenes to keep within a specified policy band

• 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

Source: MAS

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: July 2022

• In October 2021, MAS slightly increased the rate of appreciation of the
S$NEER policy band. Over the last three months, the S$NEER has
broadly appreciated within the upper half of the policy band.
• MAS will re-centre the mid-point of the S$NEER policy band up to its
prevailing level.
• There will be no change to the slope and width of the band.

Source: MAS

70