BWB3033 International Banking

TOPIC 8
BANKING ON THE
FOREIGN EXCHANGE MARKET
PART 1

© Abmalek F. Abubakar, 2005

 TOPIC OUTLINE

1. Definition and evolution

2. Spot and forward exchange rate
3. Emerging trend in FX Trading – Interest Rate
Parity, Forward and Swap, Covered Interest
Arbitrage, Currency Swap
4. Managing Risk – Hedging with FX Option

© Abmalek F. Abubakar, 2005

2
 Introduction to Foreign Exchange Market

WHAT IS FOREIGN EXCHANGE ?

The exchange of a currency of one
country for the currency of another.

FOREIGN EXCHANGE MARKET

An arena through which one is able to transfer

purchasing power from one country to another.

© Abmalek F. Abubakar, 2005

 Introduction to Foreign Exchange Market

FOREIGN EXCHANGE RATE

The price of one currency to another.

E.g. The price of 1 USD is 4.0545 MYR

The price of 1 EUR is 4.6156 MYR

© Abmalek F. Abubakar, 2005

 Introduction to Foreign Exchange Market
THE FOREIGN EXCHANGE MARKET

“The foreign exchange market is the arena

through which one is able to transfer
purchasing power, provide credit for
international trade transactions and provide
means of minimizing exposure to the risk of
exchange rate fluctuations.”

D.K. Eiteman and A.I. Stonehill

© Abmalek F. Abubakar, 2005

 Introduction to Foreign Exchange Market
Japan
Australia
HongKong
Singapore
Malaysia
9 am Msia Time

Middle East THE FX MARKETS New York

3 pm Msia Time NEVER SLEEP 9 pm Msia Time

London
3 pm Msia Time
© Abmalek F. Abubakar, 2005
BANKS AND THE FOREIGN EXCHANGE MARKET

The banks are the natural intermediary between

foreign exchange supply and demand. The main
task of a foreign exchange department is to
enable its commercial and financial customers
to convert assets held in one currency into
funds of another currency. This conversion can
take the form of a ‘spot’ transaction or a
‘forward’ operation .

© Abmalek F. Abubakar, 2005

BANKS AND THE FOREIGN EXCHANGE MARKET

Roles of banks in foreign exchange market:

1. Buying and selling currencies from

participants who use different currencies on
their business or travels.
2. Coordinating foreign exchange hedges for
bank customers.
3. Entering arbitrage transactions
4. Speculate on currency price movements for
their own account.
© Abmalek F. Abubakar, 2005
 Introduction to Foreign Exchange Market

WHY THE NEED FOR FOREIGN EXCHANGE

MARKET ?

The foreign exchange market is

inevitable because :
1. each and every country in the world has its own
national currency
2. international trade and investments and related
transactions

© Abmalek F. Abubakar, 2005

 Introduction to Foreign Exchange Market
THE NEED FOR FOREIGN EXCHANGE IN
SETTLEMENT OF IMPORT / EXPORT TRADE

IMPORTER Normally have his country’s

(Finland) currency, the FIM, to pay for
his purchase

EXPORTER Normally wants to be paid in

(Malaysia) his country’s currency, i.e.,
the MYR

© Abmalek F. Abubakar, 2005

Introduction to Foreign Exchange Market
TRADE SETTLEMENT OPTIONS

1. Using the importer’s national currency

i.e. the FIM

2. Using the exporter’s national currency

i.e. the MYR

3. Using a neutral currency

e.g. the US$

© Abmalek F. Abubakar, 2005

 Foreign Exchange
EXCHANGE RATES

FX Rates can be expressed either as

 Direct Quotation (Price Quotation)

or

 Indirect Quotation (Volume

Quotation)

© Abmalek F. Abubakar, 2005

Direct Quotation (Price Quotation)

• A rate expressed such that the foreign currency is

the commodity currency and the local currency is
the reference currency.
• Direct quotation: 1 foreign currency unit = x home
currency units

Commodity Reference
Currency Currency

In Malaysia US$ 1.00 = MYR 3.8000

In Japan US$ 1.00 = JPY 121.75

© Abmalek F. Abubakar, 2005

Indirect Quotation (Volume Quotation)
• A rate expressed such that the foreign currency
is the reference currency and the local currency
is the commodity currency.
• Indirect quotation: 1 home currency unit = x
foreign currency units
Commodity Reference
Currency Currency

In Australia AUD 1.00 = USD 0.5670

In UK GBP 1.00 = USD 1.5855

© Abmalek F. Abubakar, 2005

 How are FX rates quoted?
● Most countries use Direct Quotation
● When banks deal among each other, dealers
normally quote USD rates
● The values of the various local currencies are
expressed by indicating the price of one USD in
local currency
● E.g. USD 1.00 = MYR 3.8000
USD 1.00 = JPY 121.75
● Exception to the norm are currencies of some
former commonwealth countries which use Indirect
Quotation

© Abmalek F. Abubakar, 2005

Foreign Exchange
EXCHANGE RATES

USD as the Commodity Currency

Because USD is widely accepted,

for various reasons, as the vehicle
currency for world trade and
financial settlements, it has
assumed the role of the
Commodity Currency for almost all
international foreign exchange
dealings
© Abmalek F. Abubakar, 2005