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 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 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  As all currencies are quoted against the USD, it is often necessary to calculate a crossrate 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  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 the outright rate, the forward points are added to, or subtracted 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 the interest rates of the base­currency country are higher than interest rates in the  terms­currency country, then the base­currency will be at a forward discount and the  forward points are subtracted from the spot rate, or vice­versa  If the forward points are rising they are added to the spot rate and vice versa  The calculation of forward points is: 15.3 15.4 Learning objective 7: Identify factors that complicate FX market price quotations and calculations  We need to consider real­world complications which affect the calculation of  forward points and a forward exchange rate. These include:  o different interest rate year conventions; for example, the USA uses a 360­ day year while the UK uses a 365­day year  o two­way quotations (bid and offer quotes) o different borrowing and lending interest rates o the effects of compounding periods Learning objective 8: Recognise the important impact on the FX markets of the Economic and Monetary Union of the European Union (EMU)  The 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 Essay questions The following suggested answers incorporate the main points that should be recognised by a student An instructor should advise students of the depth of analysis and discussion that is required for a particular question For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion The global foreign exchange markets are enormous The Bank for International Settlements estimated in 2014 that USD5 trillion in FX transactions occurred daily Explain the role of SWIFT in the international financial markets and give some reasons for the strong ‘message traffic’ growth that SWIFT has experienced (LO 15.1)  SWIFT is a member-owned cooperative that operates an international electronic communications system for the transmission of payment orders  The very large size, geographic diversity and diverse institutional characteristics of the FX markets require a safe, secure and standardised platform for the transmission of payment orders SWIFT provides this platform  Payments orders are settled by and among the financial institutions that are party to the relevant transactions  As the international scope of financial markets has expanded and the number of participant institutions and countries has grown, the number of payment orders transmitted must be expected to increase  No doubt, however, the growth in message traffic experienced by SWIFT is also indicative of the value that financial institutions place on standardised and secure communications As we have seen, the world’s foreign exchange markets are characterised by a mixture of fixed and floating exchange rate regimes (a) Use your research skills to find out which European countries operate a fixed exchange rate regime Identify some of the economic advantages that may be associated with maintaining such a system  Interestingly, several European countries operate fixed exchange rate regimes These countries are Bosnia and Herzegovina, Bulgaria, Latvia, Denmark and Lithuania Denmark, for example, pegs its currency, the Krone or DKK, to the Euro  There may be some advantages to maintaining a fixed exchange rate These include potentially enhanced economic stability and greater certainty for international investors and customers Benefits might also derive from reduced speculation in the country’s currency (b) Discuss why China, as a major trading country, might move to adopt a floating exchange rate regime (LO 15.1)  China has maintained a pegged currency for many years Since the mid-2000s it has allowed very measured appreciation in its currency against the US dollar The reason for the tight controls is China’s fear that a sharp appreciation in its currency will make its exports more expensive and slow economic growth  Weighing against these considerations is China’s emergence as a major player in the world economy It sees a role for its currency as a ‘reserve currency’, a role traditionally played by the US dollar To achieve this goal, it is believed that the currency will have to float freely on the FX markets  There are also political considerations China has long been under pressure to allow its currency to appreciate or freely float The US has led these calls The rationale is that a stronger Chinese currency will increase the demands by Chinese consumers for Western exports Importers, exporters, investors and borrowers may all be participants in the FX markets Explain why each of these parties would be involved in FX market transactions (LO 15.2) Firms conducting international trade transactions (importers and exporters):  Businesses that export goods or services in the international markets generally receive payments in a foreign currency  Also businesses that import goods and services need to pay for those goods and services, usually in a foreign currency  The dominant currency of international trade is the USD, but other currencies, such as the GBP, JPY and the EUR, are also prominent  Typically, an exporter is likely to sell foreign currency received and buy the local currency through an FX market  Importers have to buy foreign currency in order to pay for their imports Investors and borrowers in the international financial markets:  Deregulation of the international financial markets has resulted in an enormous increase in the volume of capital flows around the world  Large corporations, financial institutions and governments raise funds in the international capital markets  Borrowers with good credit ratings are able to diversify their funding sources in the international capital markets, such as the euromarkets  A large proportion of funds borrowed in the international markets is converted in from the currency borrowed back into the home currency, using the FX market  Other corporations and financial institutions invest overseas; for example, funds managers for pension or superannuation funds will invest a proportion of their investment portfolios in international stocks and debt securities  The funds managers need to purchase FX in order to make the investments  Dividend or interest payments received by the funds managers will be denominated in a foreign currency The managers may sell on the FX markets to convert the receipts back into the home currency for distribution to fund members (a) Distinguish between speculative and arbitrage transactions in the FX market  Speculative FX transactions are motivated by the pursuit of a profit  The sheer volume of speculative transactions implies that, at times, speculators are able to move the market price of a currency  Such transactions are always accompanied by an element of risk  Arbitrage transactions are possible when price differences appear between markets  The arbitrageur is able to carry out simultaneous buy and sell transactions in two or more markets to lock-in a risk-free profit (b) The FX dealing room of a major bank has calculated that it is long in the USD, but is short in the EUR. Explain what is meant by these positions.    If the dealer is long in USD it means that it is holding surplus USD on its account, that is, the USD are in excess to its currency requirements to meet exiting FX contracts  Alternatively, the bank may be speculating on directional movements in exchange rates Therefore the bank may take a long position in USD and a short position in EUR  Long position—holding FX in expectation of a future sale  If there is an expectation that the AUD will depreciate against the USD, the bank might go long and buy the USD (sell the AUD) now If correct, a profit will be made by converting the USD back into AUD after the AUD has depreciated However, if the AUD appreciates instead, the bank will lose  Short position—entering into a forward contact to sell FX that is currently not held  If there is an expectation that the AUD will appreciate against the EUR, the bank might go short and sell forward the EUR now at an exchange rate locked in today If correct, the bank will buy the cheaper EUR on the forward delivery date and make a profit on the transaction However, if the AUD depreciates instead, the bank will lose (c) Describe arbitrage transactions using an example of a triangular arbitrage (LO 15.2)  An arbitrageur will attempt to identify markets in which pricing equilibrium is not fully reflected in the price of a financial asset For example, it may be possible to discover a cross-currency price advantage by buying and selling several foreign currencies in several FX markets at the same time  Triangular arbitrage occurs when exchange rates between three or more currencies are out of perfect alignment Again, the arbitrageur will simultaneously buy and sell a combination of currencies to take advantage of the price differences  Arbitrage profit opportunities generally not exist for long The buy/sell actions of the arbitrageurs bring the prices back into equilibrium Many developed economies operate within a floating exchange-rate regime Where a country has a floating exchange rate, identify and discuss the circumstances in which the central bank of that country might conduct transactions in the FX market (LO 15.2) The central banks of nation-states enter the FX markets periodically, for one or other of the following reasons:  to acquire foreign currency to pay for their government's purchases of imports, such as defence equipment, and to pay interest on, or to redeem, the government’s overseas borrowings  to change the composition of the central bank’s holdings of foreign currencies as part of its management of official reserve assets Official reserve assets are central bank’s holdings of foreign currencies, gold and international drawing rights  to influence the exchange rate Central bank intervention in the FX market would not exist if the value of a currency was determined purely by market forces, that is, a socalled clean-float However, central banks may, at times, be significant buyers or sellers of a currency where it considers the exchange rate is moving too rapidly, and is trading well outside rates that can be supported by economic fundamentals If the goal is to slow down an appreciation of the exchange rate, the central bank will sell its local currency In another example, if the Reserve Bank wished to support the AUD to stop it depreciating and perhaps assist it to appreciate, it would buy AUD and sell foreign currency The major commercial and investment banks locate their FX dealing rooms within their treasury operations Describe how an FX dealing room is structured and functions within a major bank (LO 15.3)  The number of dealers in an FX dealing room may range from a few FX dealers to more  than 100 dealers depending on the scale of an institution’s FX operations  Apart from the FX dealers, an institution will probably also have dealers that trade in  derivative contracts based on financial instruments and commodities, cash products and  debt securities  To facilitate FX transactions it is essential that the various dealing rooms around the  world have access to the same information at each moment in time  The information sought by FX dealing rooms is not only the current buy and sell rates for the various currencies, but also the economic, political and social news that may affect  the values of any particular currency  There are a number of global electronic networks, such as Reuters and Bloomberg, who  provide such information  In an FX dealing room, an array of computer screens link the electronic trading platforms of FX dealers  Each dealer, by keying in the codes for any other dealing room, is able to see on the  screen the indicative FX rates at which the other dealers are prepared to buy and sell  various currencies  Firm rates, at which FX dealers are prepared to transact, are obtained from each dealer’s  electronic trading platform  Deals are confirmed in writing electronically as soon as possible after the transaction.  Dealing rooms also tape­record conversations at the dealing desk for use in settling any  disputes that may arise  FX dealers have developed conventions and a language of their own. The following  sections present and explain some of the conventions and the language used in the FX  markets Outline the features of the main types of contracts that are created in the FX markets, distinguishing between short-dated, spot and forward transactions (LO 15.4)  An FX transaction is described by its value date, that is, the day that the currency is delivered and settlement is made  Spot transactions—the FX contract value date is two business days from the date of the initial order The exchange rate is determined today, but delivery occurs in two business days For example, a company places an order with an FX dealer to buy USD1 million at a rate of AUD/USD1.3032 on a Tuesday, then the dealer will deliver USD1 million on the Thursday and the company will pay AUD767 341.93 also on the Thursday  Forward transactions—the FX contract value date occurs at a specified date beyond the spot date, for example an order to sell EUR in three months Again, the exchange rate is set today that will apply at spot plus three months If today is 24 March then the 3-month forward value date will be 26 June, providing that is a business day (if not, the date will be moved forward to the next business day) 10  tod transactions—an FX contract with settlement and delivery today  tom transactions—an FX contract with settlement and delivery tomorrow ‘The FX market has a well-established set of language conventions These conventions have been developed to allow the efficient communication of market data.’ Explain and illustrate this statement by reference to the language conventions used in the spot FX markets Use an example to explain your answer (LO 15.5)  Assume the following quote AUD/USD0.9652–56  The first-named currency in the quote is the base currency or the unit of the quote, that is one AUD equals USD0.9652–56  The second named currency is the terms currency, the USD The terms currency is valued relative to the base currency  The quote is a two-way price, that is, a bid price (buy) and an offer price (sell)  The first number is the bid price—AUD/USD0.9652  The second number is the offer price—AUD/USD0.9656  The market convention is to drop common numbers between the bid/offer price  The bid/offer is from the perspective of the dealer, that is, the dealer will buy 1AUD for USD0.9652, or sell 1AUD for USD0.9656  The difference between the dealer’s bid/offer prices is the spread  The spread in the example is points (a point is the last decimal point in a quote) Using the context of the currency pair USD/JPY, explain the terms base currency, terms currency, direct quotation and indirect quotation (LO 15.5)  Base currency—the first named currency in an FX quote that is expressed as one unit in terms of the second currency In the USD/JPY example the base currency is the USD and is expressed as 1USD will be bought/sold for the amount of JPY that will be given in the quote  Terms currency—the second named currency in the quote, that is, the JPY 11  Direct quotation—when the USD is the base currency of the unit of the quotation as in the USD/JPY example  Indirect quotation—when the USD is the terms currency and the other currency is the base currency in the quotation In that case the above quote would be transposed to JPY/USD 10 An FX dealer is quoting spot USD/SGD1.2750–56 (a) explain from the perspective of the dealer what the FX quote indicates  The price maker FX dealer will buy USD1 for SGD1.2750 For the party that has entered into the FX contract with the dealer they will sell USD1 and receive SGD1.2750  Also, the dealer will sell USD1 for SGD1.2756; the customer will receive USD1 and pay the dealer SGD1.2756  The dealer will make a margin of points between its bid and offer transactions (b) transpose the quotation (LO 15.5)  The USD/SGD1.2750–56 is a direct quote; the USD is the base currency  It is possible to transpose the direct quote to an indirect quote (SGD/USD)  Rule: reverse then invert USD/SGD1.2750–1.2756 Reverse the bid/offer prices 1.2756–1.2750 take the inverse, that is, divide both numbers into SGD/USD0.7839–0.7843 11 A men’s fashion label in the UK is exporting goods to Denmark In order to ascertain the firm’s exposure to foreign exchange risk the company needs to calculate the GBP/DKK cross-rate An FX dealer quotes the following rates: USD/DKK 5.4031–37 USD/GBP 0.6063–69 Calculate the GBP/DKK cross-rate (LO 15.5)  Crossing two direct FX quotations: 12 o place the currency that is to become the unit of the quotation first o divide opposite bid and offer rates, that is: o to obtain the bid rate: divide the base currency offer into the terms currency bid o to obtain the offer rate: divide the base currency bid into the terms currency offer  Therefore, place the USD/DKK quote first: USD/DKK 5.4031–37USD/GBP 0.6063–69 To determine the GBP/DKK cross rate: 5.4031 / 0.6069 = 8.9028 5.4037 / 0.6063 = 8.9126 GBP/DKK 8.9028-9126 12 A Swiss manufacturer generates receipts in USD from its exports of chocolate to America At the same time, the company imports cocoa from Nigeria, incurring commitments in NGN (naira) Rates are quoted at: USD/NGN 162.2520-29 CHF/USD 1.1310-19 Calculate the CHF/NGN cross-rate (LO 15.5)  It is possible to use two methods to calculate this cross-rate; first transpose the CHF/USD rate to a direct USD/CHF rate and then use the two direct quote method (see question 11) Alternatively, use the direct and indirect quote method  Crossing a direct and an indirect FX quotation: o to obtain the bid rate—multiply the two bid rates o to obtain the offer rate—multiply the two offer rates  To determine the CHF/NGN cross rate: 165.2520 x 1.1310 = 183.5070 162.2529 x 1.1319 = 183.6988 CHF/NGN 183.50-69 13 13 A German importer has entered into a contract under which it will require payment in GBP in one month The company is concerned at its exposure to foreign exchange risk and decides to enter into a forward exchange contract with its bank Given the following (simplified) data, calculate the forward rate offered by the bank (LO 15.6) EUR/GBP (spot): 0.8260–67 One-month German interest rate: 4.75% p.a One-month UK interest rate: 3.25% p.a  The quote is from the perspective of the dealer relative to the base currency  The importer needs to buy GBP therefore it will sell EUR to the dealer The dealer is therefore buying EUR, so need to use the bid rate S [1 + (It x contract days/days in year)] [1 + (Ib x contract days/days in year)] where: S = spot rate Ib = interest rate of base currency It = interest rate of terms currency Therefore, based on the above data: 0.8260 [1 + (0.0325 x 30/365)] [1 + (0.0475 x 30/365)] = 0.8260 (1.00267 / 1.0039) = EUR/GBP0.8250 14 While the FX markets are a global market, variations in calculation conventions can occur When considering interest rate differentials and forward exchange rate calculations   between   currencies   such   as   the   USD   and   the   GBP,   what   important adjustments need to be taken into account?  The USA uses a 360-day year convention while the UK uses a 365-day convention  There is a need to recognise this variation in the forward exchange contract formula 14 15 The establishment of the Economic and Monetary Union has had a significant impact on the structure and operation of the global FX markets (a) Discuss the process of monetary union in Europe and the issues relevant to the FX markets that are implied in the above statement  The Maastricht treaty seeks to create economic and monetary union within Europe  As of January 2014, 28 countries are members of the European Union (EU) The newest member is Croatia Only 17 member states have adopted the euro as their nation’s currency The euro was introduced for financial transactions in January 1999  Euro notes and coins were introduced in January 2002  The euro has become a hard currency used for international trade and financial transactions  Central banks around the world support the euro by holding the euro as part of their foreign reserves  The removal of 17 currencies and the introduction of one major currency (the euro) has increased the liquidity in the FX market  The introduction of the euro has removed foreign exchange risk for trade and financial transactions denominated in euro that are carried out between member states (b) Discuss the ways in which the continued evolution of the EMU may shape FX  markets in the future  The most interesting way in which further evolution may shape markets is by the gradual establishment of a ‘United States of Europe’ in which a shared currency and shared bond markets characterise the European financial landscape.   The Euro currency and the establishment of Eurozone have made trade and finance much less   risky   across   the   region   Cross­currency   risks   have   been   eliminated   Further expansion of the EMU to include more countries that will eventually adopt the Euro may reduce the currency risks exporters and importers face when dealing with some of the smaller European economies.   However, the GFC has demonstrated that the EMU has introduced alternative sovereign debt risks and geopolitical risks that may not have been as apparent in previous decades.   The more integrated nature of financial institutions and real economies is also attended by greater risk of contagion during financial crises.  15 FINANCIAL NEWS CASE STUDY Chapter 15 introduced the foreign exchange markets and provided a good understanding of the structure and operation of the FX markets The Bank for International Settlements publishes a Triennial Survey of activity in the global FX markets This survey always makes for interesting reading One of the most interesting features of the FX markets that is revealed in each survey is the extraordinary magnitude of the volume of FX trading that takes place each day As we have mentioned in the chapter, more than $5 trillion of FX is traded each day In these trades, the US dollar is on one side of the transaction on 87 per cent of occasions The second most traded currency is the euro Most of the trading takes place at trading desks located in the United States, the United Kingdom, Singapore and Japan Global turnover of more than $5 trillion per day works out to approximately to $2000 trillion per year This figure can be contrasted with the annual value of global trade flows, which the World Trade Organisation estimates at approximately $20 trillion It is quite easy to see that much of the turnover on the FX markets has no relationship to the physical flow of goods around the world It is also plausible to conclude that much of the turnover is also unrelated to hedging the value of FX associated with the physical trade of goods The amount of turnover on the FX markets implies that there is a considerable amount of speculative activity that is somewhat detached from the underlying real economic transactions that characterise the global economy In Australia and around the world, there has been increasing participation in FX trading by small investors This has resulted in several ASIC warnings to investors as well as the imposition of sanctions and penalties on unscrupulous providers of trading platforms The warnings are summarised in the following news story from the Business Review Weekly (BRW): The Australian Securities and Investments Commission has delivered an unusually 16 stern warning to retail investors about foreign exchange trading, and detailed the reasons the odds are stacked against them On the heels of the collapse of GTL Tradeup, a Sydney forex derivatives broker that has gone into liquidation owing clients $3 million, the regulator has warned that just one of the risks faced by investors in foreign exchange is 'counterparty risk', where an issuer defaults on obligations Fretting that promoters of forex investment strategies are on the rise, ASIC has documented five reasons why most investors are not cut out for the products they offer There are significant investment risks as currency fluctuations may move against you, causing you to lose money Exchange rates are very volatile – they tend to move around a lot even within very short periods of time Markets are open 24 hours a day, six days a week (due to time zones), so you need to devote a lot of time tracking your investment Currency markets are extremely difficult to predict because so many factors affect exchange rates Even small market movements can have a big impact, because more forex trading products are highly leveraged Risk management systems, such as stop-loss orders, will only give you limited protection by capping your losses You may have to pay a premium price to guarantee your stop-loss order 'Forex trading is complex and risky Even the most skilled and experienced forex traders have difficulty predicting the movements in currencies Trading in international currencies requires a huge amount of knowledge, research and monitoring,' ASIC Commissioner Greg Tanzer says 'Like any investment, it is vitally important investors fully understand what they are getting into, and FX trading is no different Unless you fully understand what investment you are making and the risks involved with that investment, don't it.' SOURCE: Michael Bailey, 2013, 'Forex Trading: Five Reasons ASIC Says it's a Mug's Game’, Business 17 Review Weekly, October 21 DISCUSSION POINTS  The volumes, in USD terms, of transactions in the global FX markets are large compared to underlying trade flows Is there a case for the restriction of FX trading? A case could certainly be made When there is such a large volume of transactions in excess of the real underlying economic activity, a case can be made for curtailing the extent of (speculative) trading activity Financial speculation well in excess of the underlying real economic factors is a longrunning target for criticism, especially in times of crisis  Evaluate ASIC’s position regarding the suitability of FX trading for small investors ASIC effectively points out that unprofessional investors are likely to suffer losses if they attempt to trade FX This is probably true for any financial security However, there are a number of reasons, identified by ASIC, why this might be particularly the case in the FX markets The volatility of the markets, their round the clock nature and the leverage inherent in many of the products ensure that mistakes may be punished more severely  Discuss ASIC’s conclusion that the movements in the FX markets are impossible to predict because of the many factors that affect exchange rates This is probably true, though some traders would argue that technical trading rules and momentum type strategies ‘work’, particularly in the shorter term (over a matter of seconds or minutes) Over the longer term, macroeconomic factors shape the ups and downs in currencies These factors are likely to have a predictable component and an unpredictable component When this semi-predictability is combined with the level of trade, volatility and speculation that characterises the FX markets, it is possible to argue that FX markets move up and down in a manner that is impossible to predict True/False questions 18 F FX markets are open for a short period each day during which a small number of transactions are undertaken T Although Australia operates a floating exchange rate regime, the Reserve Bank has sometimes intervened in the FX markets T The Chinese government has gradually widened the range over which its currency may appreciate and depreciate relative to other currencies F There are two different types of FX dealers: those that offer to buy currencies at a particular price and those that offer to sell currencies at a particular price F Central banks not usually hold any reserves of foreign currency but simply acquire it as the need arises T A spot transaction is one in which an order to buy or sell a currency is placed today, at a price determined today, and with settlement of the transaction taking place two working days from today F A forward FX transaction is one in which the order is placed today, at a price determined at the time of the order, but with settlement of the transaction taking place before spot F If a firm were to ask a dealer for the ‘dollar euro spot’ or for the ‘euro dollar spot’, the firm will receive the same bid and offer quotes T Given USD/EUR0.7250–0.7255, the FX dealer would buy USD1 from you and give you EUR0.7250 10 T A verbal quote of ‘Euro Aussie spot is one thirty-one seventy-two–eighty’ would be written as EUR/AUD1.3172–80 11 F Given the quotation EUR/AUD1.3272–80, the transposed rate is cross-rate is AUD/EUR0.7535–30 12 T Given AUD/JPY82.50–60 and AUD/EUR0.5905–15, the EUR/JPY139.48–88 13 F Given USD/JPY76.10–15 and GBP/USD1.6350–1.6360, GBP/JPY is 46.52–46.57 14 F If an FX dealer is short a currency, they will need to sell the physical currency to settle an existing FX contract when the contract falls due 15 T If a bid price on the USD/EUR is 0.7267 and the offer price is 0.7273, the spread is points 16 T If the spot rate is AUD/USD0.9220–0.9225, and the six-month forward points are ‘58 to 63’, the six-month forward rate would be AUD/USD0.9278–0.9288 19 17 T The data in question 16 indicate that the rate of interest on six-month money is higher in the USA than it is in Australia and that the AUD is at a forward premium 18 F As a result of the sovereign debt crisis the euro has ceased to be a hard currency widely used in international trade 19 F All member states of the European Union now have the euro as their currency unit 20 T In the USA, Japan and Europe, money-market instruments are usually quoted on the basis of a 360-day year, whereas in the UK, Australia and New Zealand these rates are quoted on a 365-day year 20 ... screen the indicative FX rates at which the other dealers are prepared to buy and sell  various currencies  Firm rates, at which FX dealers are prepared to transact, are obtained from each dealer’s  electronic trading platform  Deals are confirmed in writing electronically as soon as possible after the transaction. ... of the transaction taking place before spot F If a firm were to ask a dealer for the ‘dollar euro spot’ or for the ‘euro dollar spot’, the firm will receive the same bid and offer quotes T Given... SGD/USD0.7839–0.7843 11 A men’s fashion label in the UK is exporting goods to Denmark In order to ascertain the firm’s exposure to foreign exchange risk the company needs to calculate the GBP/DKK cross-rate An