Topic 9 Foreign Exchange Markets Flashcards Preview

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Flashcards in Topic 9 Foreign Exchange Markets Deck (41)
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Exchange Rate

The value of one currency relative to another


Floating Exchange rate

an exchange rate is determined by supply and demand factors in the FX market


Managed Float

an exchange rate is held within a defined band relative to another currency, limited fluctuations allowed


FX markets

markets that facilitate the buying and selling of foreign currencies


FX market participants can be classified as

- FX dealers and brokers
- Central banks
- Firms conducting international trade transactions
- Investors and borrowers in the international capital markets
- Foreign currency speculators
- Arbitrageurs


FX dealers

- institutions that quote buy (bid) and sell (offer) prices and act as pricipals in the FX market


FX dealers

Obtain the best prices in the global FX markets and match FX dealers buy and sell orders for a fee


Two-way Prices

The dealer quotes both a buy (bid) and a sell (offer) price on a currency


Why do Central Banks enter FX markets

- pay for their government’s purchase of imports.
- To change the composition of the central bank’s holdings of foreign currencies
- To influence the floating exchange rate


How can central bank influence floating exchange rate

- To increase the domestic currency value, central bank may buy some of the domestic currency and sell foreign currencies. This would decrease supply of the domestic currency and will eventually increase its value.
- To decrease the value of currency, the central bank can sell the domestic currency and buy foreign currency.


Firms conducting international trade transactions

- Exporters receive foreign currency for the sale of their goods and services.

- Exporters use the FX market to sell foreign currency and buy AUD.

- Importers use the FX market to buy foreign currency (sell AUD) for purchasing imports.


Investors and borrowers in the international capital markets

- Commercial bank foreign borrowings are usually converted into the home currency. Payment of interest and principal need to be made in the denominated currency of the loan.

- Corporations and financial institutions investing overseas
Need to purchase FX in order to make investments;
Dividends or interest payments received from overseas investments will be denominated in a foreign currency.


FX Speculators

Businesses and financial institutions may attempt to anticipate future exchange rate movements to make a profit.


2 speculative transactions positions

Long and Short


Long Position

Occurs when the underlying asset has been bought forward
e.g. a FX dealer buys foreign currency from a client and holds the currency on its own account.


Short Position

Entering into a forward contract to sell an asset that is not held at that time
e.g. a FX dealer sells foreign currency forward in the expectation that the currency will depreciate before the forward contract expires.


Arbitrage Transactions

Profit is made through FX transactions that involve no FX risk exposure



A party that simultaneously conducts buy and sell transactions in two or more markets in order to take advantage of price differentials between markets


Types of arbitrage



Geographic Arbitrage

where two dealers in different locations quote different rates on the same currency
eg: you find ta retailer FX dealer in Burwood offers $1.4 AUD per USD. Another retailer broker in Dandenong offers $1.41 AUD per USD


Triangular Arbitrage

occurs when exchange rates between 3 or more currencies are out of perfect alignment


2 types of FX Market Transactions

Spot and Forward


Spot transactions

Have maturity date two business days after the FX contract is entered into
e.g. used if an Australian importer has an account in USD to pay within the next few days.


Forward transactions

Have maturity date more than two days after FX contract is entered into
e.g. used if Australian importer has to pay a USD liability in 2 months, and covers or hedges against an appreciation of the USD.


Dealers may also provide short-dated transactions if necessary

‘Tod’ value transactions
‘Tom’ value transactions


‘Tod’ value transactions

same-day settlement;


‘Tom’ value transactions

settlement tomorrow


Base Currency

The first named currency in an FX quote
one unit expressed in terms of another currency


Terms Currency

The second named currency in a FX quotes;
used to express the value of the base currency


Two-way quotations

The two numbers indicate the dealer’s buy (bid) and sell (offer) price

EUR/AUD 1.6155 – 1.6165