FINS1612 Chapter Notes - Chapter finals: Crawling Peg, Floating Exchange Rate, Spot Contract
15.1 Understand the nature of global FX markets
- FX akets eist heee tasactios ae deoiated i a foeig cuec, icl it’l tade
transactions, cross-border capital transactions, speculative transactions and central bank
transactions
- An exchange rate is the value of one currency relative to another currency. Each country, or group
of countries within a monetary union, is responsible for determining the form of their exchange
rate
- Floating exchange rate is determined by factors that affect the supply and demand of currencies
within the FX market
- Countries such as China, Singapore, Malaysia and Indonesia operate a managed exchange rate
regime, whereby the exchange rate is allowed to move within a defined range relative to a
specified major currency or basket of currencies
- A crawling peg exchange rate regime allows the currency to appreciate over time, but within a
limited range determined by the government and/or central bank. A major difference between a
managed float and the crawling peg is that market participants generally agree that a currency
using the crawling peg is typically undervalued. This may in fact describe the regime used in China
- With a linked exchange rate regime, as used by HK, the exchange rate is locked into a ratio w a
nominated currency (USD or a basket of currencies)
15.2 Discuss participants in the FX markets
- Participants in the FX markets include those who have underlying commercial and financial
transactions denominated in foreign currencies. This includes importers and exporters, and those
investing or borrowing overseas in a currency other than their home currency
- There are speculators who buy and sell foreign currencies in the expectation of making profits
from favourable exchange rate movements, and there are those who arbitrage exchange rate
and/or international interest rate differentials across different it’l markets
- Central banks also enter the FX markets as buyers and sellers of foreign currency. A central bank
may enter the FX market to poide its goeet’s foeig cuec euieets o, fo tie
to time, in an attempt to influence the value of a currency in the market or to adjust its foreign
currency reserve portfolio
15.4 Outline instruments traded in FX markets
- Contracts traded in FX markets are distinguished by their maturity or delivery dates
- Spot and forward contracts are the most common contracts traded
- Spot transactions have a value date two business days from today; that is, they require delivery of
foreign currency and financial settlement two business days from contract date
- Forward contracts specify a value date more than two business days from today
15.5 Explain conventions for quotation and calculation of exchange rates and forward exchange rates,
and complicating factors
- Spot quote: first-named currency in an FX quote is called the unit of the quotation (base
currency). The base currency represents one unit of the currency. The second named currency is
known as the terms currency
- FX dealers, or price makers, quote two-way rates: the first and lower rate is the one at which the
dealer buys the base currency; the second and higher rate is the one at which the dealer sells the
base currency
- Exchange rates with less than 10 units of the terms currency are quoted to four decimal places,
and currencies with more than 10 units are quoted to only two dp
- The spread is the difference between the bid and offer rates
- A point is the final decimal place in a quote
- Transpose a quote from direct to indirect, reverse and invert
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- Cross rate between two currencies using USD- divide opposite bid and offer rates to obtain the
cross-rate
15.6 Describe the role of the forward market and calculate forward exchange rates
- The convention adopted in the quotation of forward rates is that the dealer quotes the forward
points rather than the outright forward rates
- To obtain outright rate: forward points are +/- from the spot rate
- In calculating the forward points, the dealer uses the spot rate and the differential rates of
interest of the two countries whose currencies are quoted
- When interest rates of the base-currency country are higher than interest rates in the terms
currency country, the base currency will be at a forward discount and the forward points are
subtracted from the spot rate, or vice versa (if rising forward points, added to for premium)
- Bid and offer forward points
15.7 Identify factors that complicate FX market price quotations and calculations
- Different interest rate year conventions (US used 360-day year while UK uses 365-day year)
- Two way quotations (bid and offer quotes)
- Different borrowing and lending interest rates (use effective IR)
- Effects of compounding periods
15.8 Recognise important FX impacts of the European Monetary Union
- Economic and Monetary Union has had a significant impact on the structure and operation of the
FX markets
- Seventeen foreign currencies have been replaced by a single currency, the euro
- The euro has become a hard currency for commercial and financial transactions and a major
currency traded in the FX markets
16.1 Explain how factors that affect the demand or supply for a currency, affect the determination of an
equilibrium exchange rate
- An exchange rate is the price of one currency in terms of another currency
16.2 Understand how the major factors that influence exchange rate movements operate, particularly:
Relative Inflation rates
- Of the theories advanced to explain the exchange rate, and changes in the equilibrium rate, the
purchasing power parity (PPP) theory is the longest standing
- Under PPP, a country with a higher inflation rate relative to another country can expect its
currency to depreciate
- Perhaps the most critical shortcoming of PPP is that there are variables in addition to inflation
that affect the value of a currency
- The extended learning section considers PPP calculations that apply inflation differentials
between two countries to determining the expected change in the exchange rate
Relative national income growth rates
- There is wide agreement that changes in the relative rates of growth in national incomes affect
the exchange rate
- There is disagreement, however, as to the nature of the effect
- An increase in the relative rate of growth is likely to result in an increased demand for imports,
which will result in a depreciation of the currency
- On the other hand, an increase in the growth rate may also result in an increase in foreign
investment inflows, which will cause the currency to appreciate
- Both mechanisms are likely to operate, with the balance between the two changing from time to
time
Relative interest rates
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- The interest rate differential between two countries is also important in determining the demand
for and supply of a currency in the FX market; however, the effects of a change in the interest rate
differential are ambiguous
- It is important to determine whether the change is due to a change in inflationary expectations, or
a change in the real rate of interest
- If the increase in interest rates is a result of an increase in inflation expectations, a currency
should depreciate. However, if the increase is due to a rise in the real rate of interest, then the
currency should appreciate
Exchange rate expectations
- In addition to the economic fundamentals, exchange rate expectations are important in
determining the FX value of a currency
- If the markets expect the exchange rate to depreciate, this will ultimately result in FX buy or sell
transactions that cause the depreciation; if an appreciation is expected, an appreciation typically
will be experienced
- The modelling of expectations is a particularly difficult task. Theoretically, expectations should be
formed on the basis of the expected values of economic fundamentals. However the FX market
often reacts to new information before the impact on the longer-term economic fundamentals is
fully analysed
- It may be possible to adopt a specific market indicator as a proxy for exchange rate expectations.
E.g. in Australia, the commodity price index is often used as such a proxy
Central bank or government intervention
- At times, the actions of governments or central banks are another variable that may be important
in the FX markets
- The monetary policy setting of a central bank will impact upon the demand and supply factors
that affect an exchange rate. Also a central bank or government may intervene in the FX markets
to influence directly the level of an exchange rate by intervening in international trade flows,
intervening in foreign investment flows or conducting FX transactions in the markets
- For example, in an attempt to increase the FX value of its currency, a central bank may sell foreign
currency and buy the local currency; alternatively, to reduce the value of its currency, the central
bank may buy foreign currency. Alternatively, a government may implement policies that change
tariff, quota or embargo settings relating to g&s
13.1 Describe the macroeconomic context of interest rate determination- liquidity effect, income effect,
inflation effect
- In forming a view on the future direction of interest rates, it is necessary to recognise that
changes in monetary policy settings are likely to affect the state of the economy, which in turn
affects interest rates generally
- The liquidity effect derives from monetary-policy-induced changes to interest rates, such as an
increase in interest rates due to a reduction in liquidity in the financial system
- As interest rates rise, economic activity will slow and incomes fall. This will cause interest rates to
begin to ease or fall (income effect)
- The income effect will reduce upward pressure on prices as the economy slows and there is likely
to be a reduction in the rate of inflation, thus causing interest rates to fall further (inflation effect)
- Therefore, when trying to forecast the state of an economy and future interest rates, policy
makers, economists and financial market participants consider a range of economic indicators,
such as the level of employment, productivity and housing approvals
- Indicators may be described as leading, coincident and lagging indicators of future economic
activity
13.2 Explain the loanable funds approach to interest rate determination, including supply and demand
variables for loanable funds, equilibrium and the effects of changes in variables on interest rates
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Document Summary
15. 1 understand the nature of global fx markets. Fx (cid:373)a(cid:396)kets e(cid:454)ist (cid:449)he(cid:396)e(cid:448)e(cid:396) t(cid:396)a(cid:374)sactio(cid:374)s a(cid:396)e de(cid:374)o(cid:373)i(cid:374)ated i(cid:374) a fo(cid:396)eig(cid:374) cu(cid:396)(cid:396)e(cid:374)c(cid:455), i(cid:374)cl i(cid:374)t"l t(cid:396)ade transactions, cross-border capital transactions, speculative transactions and central bank transactions. An exchange rate is the value of one currency relative to another currency. Each country, or group of countries within a monetary union, is responsible for determining the form of their exchange rate. Floating exchange rate is determined by factors that affect the supply and demand of currencies within the fx market. Countries such as china, singapore, malaysia and indonesia operate a managed exchange rate regime, whereby the exchange rate is allowed to move within a defined range relative to a specified major currency or basket of currencies. A crawling peg exchange rate regime allows the currency to appreciate over time, but within a limited range determined by the government and/or central bank.
