FINS1612 Chapter 15: Viney8e_IRM_ch15
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Financial Institutions, Instruments and Markets
8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips
Chapter 15
Foreign exchange: the structure and operation of the FX market
Learning objective 1: Understand the nature, size and scope of the global FX markets and
the main exchange rate regimes used by different countries
• FX markets exist wherever transactions are denominated in a foreign currency, including
international trade transactions, cross-border capital transactions, speculative transactions
and central bank transactions.
• The FX markets operate through a highly sophisticated network of telecommunications
systems that link the numerous FX dealers and FX brokers located in all of the major
cities of the world.
• 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.
• Most major currency exchange rates are determined using a floating exchange rate regime,
including the currencies of the USA, UK, EMU, Japan, Australia and New Zealand.
• A 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
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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 Hong Kong, the exchange rate is locked
into a ratio with a nominated currency, such as the USD, or a basket of currencies.
Learning objective 2: Identify and discuss the major groups of 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.
• In addition, 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 the different
international markets.
• Central banks also enter the FX markets as buyers and sellers of foreign currency. A
central bank may enter the FX market in order to provide its government’s foreign
currency requirements or, from time to time, in an attempt to influence the value of a
currency in the market, or to adjust its foreign currency reserve portfolio.
Learning objective 3: Describe the functions and operations of the FX markets
• The FX markets operate somewhere around the globe 24 hours a day.
• The markets are dynamic, with exchange rates changing in response to the continuous
flow of economic, political, financial and social news and information into the markets.
• It is estimated that around the equivalent of USD5 trillion pass through the FX markets
each day, facilitated by FX dealing rooms that use sophisticated, technology-based
computer and communication systems.
Learning objective 4: List and explain the types of FX transactions, in particular spot and
forward transactions
• The contracts that are traded in the 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 that is two business days from today; that is, they
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require delivery of the foreign currency and financial settlement two business days from
the contract date.
• Forward contracts specify a value date more than two business days from today.
Learning objective 5: Introduce the conventions adopted for the quotation and calculation
of spot exchange rates
• Because of the technology-based nature of the trade in foreign currencies, universal
conventions are adopted in the FX markets.
• For example, a spot quote may be AUD/USD0.9250–56.
• The first-named currency in an FX quote is called the unit of the quotation, or the 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.
• FX dealers will abbreviate their verbal FX quotes by removing decimal points and not
repeating common numbers.
• 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 decimal places.
• The spread is the difference between the bid and offer rates.
• A point is the final decimal place in a quote.
• It is possible to derive a range of additional exchange rates on the basis of existing
published rates; for example, transposed and cross-rates can be calculated.
• To transpose a quote from, say, a direct USD/AUD quote to an indirect AUD/USD quote,
the rule is to reverse the quote and then invert by dividing into 1.
• As all currencies are quoted against the USD, it is often necessary to calculate a cross-
rate that does not incorporate the USD, for example SGD/NZD.
• To calculate the cross-rate for two direct quotes, place the new base currency quote first,
followed by the second quote. Simply divide opposite bid and offer rates to obtain the
cross-rate.
Learning objective 6: Describe the role of the forward market and calculate forward
exchange rates
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Document Summary
Foreign exchange: the structure and operation of the fx market. A major difference between a managed float and the crawling peg is that market participants. 1 - generally agree that a currency using the crawling peg is typically undervalued. Learning objective 2: identify and discuss the major groups of 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. It is estimated that around the equivalent of usd5 trillion pass through the fx markets each day, facilitated by fx dealing rooms that use sophisticated, technology-based computer and communication systems. 2 - require delivery of the foreign currency and financial settlement two business days from the contract date: forward contracts specify a value date more than two business days from today.
