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Financial Markets

Topic 4B: The Foreign Exchange Market

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Outline
1. Nature of the market
2. Quotation of exchange rates
3. Reasons for the forex market
4. Globalization and offshore borrowing
5. Participants
6. Types of FX transactions
7. Cross rates & trading FX
8. History of exchange rate systems
9. Determination of exchange rates

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7.Cross rates & trading FX

7.1. Cross rates
AUD/USD USD/EUR

AUD/EUR

AUD/USD x USD/EUR = AUD/EUR

(Chain Rule)

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Cross rates (cont)

• Cross rates without bid/offer spread
E.g. Find AUD/EUR, given:
AUD/USD = 0.7733

USD/EUR = 0.9286

• Cross Rate

AUD/EUR = 0.7733 x 0.9286

= 0.7181

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Cross rates (cont)

• Cross rates with bid/offer spread
E.g. Find AUD/EUR, given:
AUD/USD = 0.7733/43

USD/EUR = 0.9286/96

• Bid rate = 0.7733 x 0.9286 = 0.7181

• Offer rate = 0.7743 x 0.9296 = 0.7198

• AUD/EUR = 0.7181/97

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Examples
• AUD/USD = 1.1446/56

• CNY/USD = 6.4309/6.4641

• → AUD/EUR = ???

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7.2. Maintaining an FX trading position

Net exchange position terminology

Net exchange
position: Total Long position: More
foreign currency foreign currency
bought minus total bought than sold
sold

Short position: More Square position:

foreign currency Total bought =
sold than bought Total sold

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Maintaining an FX trading position (cont)

Using a blotter

(A$m) Position
Buy 20 +20 Up 20
Buy 10 +30 Up 30
Sell 5 +25 Up 25
Sell 15 +10 Up 10
Sell 15 -5 Down 5
Sell 10 -15 Down 15
Buy 15 0 Square

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Maintaining an FX trading position (cont)

• Suppose you do the following:

o Buy 2m AUD at AUD/EUR = 0.8620

o Sell 5m AUD at AUD/EUR = 0.8625

o Sell 3m AUD at AUD/EUR = 0.8630

o Net position = short 6m AUD (-6,000,000 AUD)

• To SQUARE THIS POSITION, you would need to buy AUD 6m (+6 mil AUD).
The rate you obtain will determine the profit or loss
AUD EUR Rates AUD/EUR
2000000 -1724000 0.862
-5000000 4312500 0.8625
-3000000 2589000 0.863
6000000 -5712000 0.862
0 5500
o Your final position is a profit of EUR 5,500.
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8. History of exchange rate

Late 1800s World War II 1944 1970 - Today

▪ International ▪ Gold Standard ▪ Every currency ▪ Exchange rate

transactions Collapse pegged to USD determined by
▪ Exchange rate – ▪ USD – gold price market forces
gold price ▪ Supply - Demand
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9. Exchange rate determination

• The exchange rate for a currency is determined by the
buying and selling decisions of those who trade in
the FX market
• Market forces will establish the level of supply and
demand
• The equilibrium exchange rate will be established by
the interaction of supply and demand
• An increase in Demand for a currency will result from:

- An increase in exports
From Rest of the
- An increase in capital inflow World

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Exchange rate determination (cont)

AUD Australian Quantity of

Value Export AUD
Demand Demanded

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Exchange rate determination (cont)

Exchange Rate AUD/USD

D
Quantity of AUD

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Exchange rate determination (cont)

• An increase in Supply of a currency will result from:
- An increase in imports
- An increase in capital outflow
From Domestic
players

Imported
Goods Quantity
AUD Imports
Price of AUD
Value
Supplied

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Exchange rate determination (cont)

Exchange Rate

S
From Domestic
players

Quantity of AUD

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Exchange rate determination (cont)

The foreign exchange market brings together the forces of
supply and demand, and establishes an equilibrium
exchange rate at which the level of supply equals the level of
demand

Exchange Rate

.70
.60
.50

D
Quantity of AUD
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Quiz #1
If Vietnam reduces tariffs on the importing of cars:

a) The price of Vietnamese-made cars will fall

b) The VND will rise in value

c) The VND will fall in value

d) The price of foreign-made cars sold in Vietnam will fall

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Quiz #2
Which of the following is likely to lead to an increase in
demand for Singapore dollars in the FX markets ?
a) An increase in demand for imports into Singapore

b) An increase in the number of tourists visiting Singapore

c) A increase in offshore investment by residents of Singapore

d) All of the above

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Determinants of the FX value of a

country’s currency
1. Economic fundamentals
a) Relative inflation rates

b) Relative economic growth rates

c) Relative interest rates

d) Commodity prices

2. Other factors
a) International speculation/investment

b) Exchange rate expectations

c) Official intervention

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1. Economic Fundamental
a) Relative inflation rates

• If Australia has higher inflation than its trading partners,

it will experience:
o Less demand for Australian exports, and therefore less
demand for AUD => D curve for AUD shifts to left

o More demand for imports, and therefore more supply of

the AUD => S curve for AUD shifts to right

o The above two effects => a fall in the value of AUD

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Relative inflation rates

Exchange S: More imports,

Rate
S1 S2
and therefore more
supply of the AUD

ER1
D: Less demand
ER2
for exports, and
therefore less
demand for AUD
D2 D1
Quantity of AUD
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Purchasing power parity (PPP)

• Goods which are cheaper in one country than another
will be bought where they are cheap, transported and
sold where they are more expensive

• Therefore, effective price of the goods will be

equalised.

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Weaknesses of PPP
Not all goods can be traded in the short run.

Goods are not homogeneous, different consumer

behaviour & income

Transport costs & trade barriers

Element of monopoly or monopsony (single buyer)

Sticky prices

Uncertainty & home bias

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b) Relative economic growth rates

The net effect of these two factors is difficult to predict in
advance
If Australia has higher economic growth than other countries
S: More imports, and
Exchange therefore more supply of
Rate the AUD
S 1 S2

D: Increase the level

ER1 of overseas
investment, and
therefore more
demand for AUD
D1 D2
Quantity of AUD
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c) Relative interest rates

• The traditional view was that an increase in
interest rates would have the following effects:
o Encourages capital inflow, increasing demand for
the AUD

o Discourages capital outflow, decreasing supply of

the AUD

• The net effect would be an appreciation of the

AUD
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Relative interest rates

If Australia experiences an increase in interest rate

Exchange
Rate S: Discourages capital
S2 S1
outflow, decreasing
supply of the AUD

ER2

ER1
D: Encourages capital
inflow, increasing
demand for the AUD
D1 D2
Quantity of AUD

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Relative interest rates (cont)

• Empirical evidence suggests high interest rates result
in depreciation
• Why? Increase in interest rate may be the result of
inflation

6%

11%
Inflation
Premium
5%

Nominal Real
Interest Interest
Rate Rate
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Relative interest rates (cont)

• If the nominal interest rate is high because the real rate
is high:
o This will lead to capital inflow and appreciation

• However, real rates are usually constant and high

nominal rates usually reflect high inflation rates:
o This will lead to a depreciation as a result of high inflation

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d) Commodity prices

Price of Australian Value of

Goods Export AUD
Value

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2. Other factors
a) International speculation and investment
Capital

Weak Strong
Economies Economies

• Positive or negative economic outlooks will result in massive

buying and selling by currency speculators, resulting in significant
variation in exchange rates
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b) Exchange rate expectations

Expectations
about future
exchange
rates can
become a
self-fulfilling
prophecy

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Exchange rate expectations

• E.g. If a currency is expected to appreciate, speculators

will buy the currency, increasing demand for the

currency, causing it to appreciate

• the opposite occurs if a currency is expected to

depreciate (they will sell that currency)

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c) Official intervention
• Exchange rates are also influenced by intervention by
central banks

• For floating exchange rates, the central bank will

intervene by “smoothing” and “testing”

• For fixed exchange rates, significant buying and

selling may be required to keep the currency at its
target value (e.g. China, Vietnam)

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