Foreign Exchange

In terms of foreign exchange, currencies are always traded in pairs.
Also often referred to as currency or fx.
In the UK dollars are quoted against pounds
In the US pounds are quoted against dollars

Unlike commodities and equities - this is not a physical market
It is more like a network or framework linked by computers and phones
This market operates 24 hours a day
The FX market is an OTC market and all the following are negotiable: size, price, settlement date
An exchange rate is the price of one currency in terms of another currency.
EUR/USD = 1.239 means 1 EUR = 1.239 USD

Governments cannot annouce devaluations in advance as everyone will immediately sell their currency.
As a result they always deny it in the strongest terms and then suddenly devalue.

Foreign Exchange - Types of Risk
1) Transaction Risk (hedged using Forwards (or forward rates ??)
A german importer needs to pay for the dollar imports in 6 months which are ordered today. If the deutschemark weakens against the dollar, the imports will cost more. Most companies want to reduce this risk (hedging)

2) Translation Risk
A french company has some subsidaries overseas which report in Italian Lira. If the lira weakens against the french franc, the profits are worth less when included in the annual report

3) Economic Risk
A Dutch company sells goods to a German company. The main competitor to the Dutch company is actually a British company. If sterling weakens against the deutschemark, then the dutch firm has competetive advantage.

An exchange rate between two currencies, neither of them dollar is called cross-rate

Cable - dollar / sterling
Swissy - dollar / swiss franc
Paris - dollar / french franc
Stocky - dollar / swedish kroner
Copey - dollar / danish kroner
Dollarmark - dollar / deutschemark

London is the largest forieign exchange market
There are 4 reasons for this
1) Time zone, london can talk to Tokyo for an hour in the morning, the middle east about 11:30, New York/chicago at 1:30 and Los Angeles at 4:30
2) English is the major language in international finance
3) Traditional and historic role as a major financial centre over 500 foreign banks trading there.

The economic theory for explaining exchange rates is Purchasing Power Parity (PPP)

The theory that investors always shift assets is the basic Portfolio Balance Model.

Spot Rates are todays exchange rates with settlement (T + 2)
Forward Rates are fixed rates for a transaction at a later date
Forward rates are determined by the difference in interest rates in two currencies

Forward Rates are priced by the difference in the interest rates of the two currencies

The forward rate, being fixed, protects against the currency moving to the buyers/sellers disadvantage, but they cannot benefit if it moves in their favour. This can be achieved with currency options

In london cockney rhyming slang is used a lot - Japanese Yen is the Bill and Ben

This market is international, open 24 hours a day a, prices change constantly and huge amounts of money are traded.
Five always means five million, whether in dollars, yen or euro
Yards is billion.

Who participates in foreign exchange
importer / exporters
government spending
banks and other financial institutions

If inflation in one country is constantly higher than in another, then the expectation that the exchange rate will deterioriate in the country with the higher inflation

Base Currency

In foreign exchange markets, the base currency is the first currency in a currency pair.
The first currency in the pair is always the base currency
Example EUR/USD - Eur is the base currency
So EURUSD will give you the number of US dollars per 1 EUR

Base currency in foreign exchange can also mean the accounting currency, settled currency or domestic currency.

Term Currency

The second currency is named the quote currency, counter currency or term currency

Currency Pair Rules - Base / Term

  • If one of the currencies is the Euro, then Euro is the base (EUR / GBP, EUR / USD)

  • If one of the currencies is Sterling, then Sterling is the base (GBP / USD, GBP / JPY)

  • If one of the currencies is the Dollar, the Dollar is the base (USD / JPY, USD / CHF) (the exception is the Australian dollar which is quoted AUD / USD)

  • Everything else is arranged so the exchange rate is greater than 1

Companies use the foreign exchange market to protect themselves from exchange rate movements by hedging their FX exposure
Companies use the FX market to exchange currencies in international trade

The average daily turnover is in the trillions

Major FX Centers

UK - London - 34% (GBP)
US - New York - 17% (USD)
Japan - Tokyo - 6% (JPY)
Singapore - 6%
Switzerland - 6% (CHF, swiss franc)
Hong Kong - 5%
Australia - 4% (AUD, australian dollar)
Germany - Frankfurt - 2%

market makers - internal price is the quote to the other desks
market makers - external price is the quote to their customers/clients
brokers do not quote their own exchange rates, they just act as intermediaries for the market makers

Buying Yen / Strong Yen

USD / JPY (up)
Yen increases / appreciates
Less yen per dollar
Means 1 yen buys more dollars
Means I dollar buys less yen
good for Japanese imports
bad for Japanese exports
often indicates low interest rates

Seling Yen / Weak Yen

USD / JPY (down)
Yen decreases / depreciates
More yen per dollar
Means 1 yen buys less dollars
Means 1 dollar buys more Yen
good for Japanese exports
bad for Japanese imports
often indicates high interest rate

Asset Currency

The currency in which the security is denominated.

Local Currency

The currency is which the security is priced and typically settled.
Often the issued currency

Domestic Currency

Foreign Currency

Reserve Currency

Hard Currencies / Majors

Pound Sterling
Austrialian Dollar
New Zealand Dollar
Canadian Dollar
Swiss Franc
Japanese Yen

Soft Currencies / Minors

All other currencies, these are generally quotes against one of the major currencies.

Exchange Rates

The rate at which one currency can be exchanged for another.

This is the world of foreign exchange (fx)
Also known as foreigne exchange, forex or fx.
Specifies the value of one currency compared to another.

Some currencies are pegged to one another and others are allowed to float freely.

Whatever the exchange rates from one currency to another there must be consistency throughout
If it is possible to exchange dollars for pounds and then pounds to yen this implies a relationship between dollars and pounds.

If this relationship moves out of line it is possible to make arbitrage profits by exploiting the mispricing.

Although the fluctuation in exchange rates is unpredictable there is a link between exchange rates and the interest rates in the two countries
If the interest rate on dollars is raised while the interest rate on pounds sterling stays the same we would expect the sterling to depreciate against the dollar for while.
Central banks can use interest rates as a tool for maniuplating exchange rates but only to a degree.

The spot exchange rate (or spot rate) refers to the current exchange rate.

CLS - foreign exchange settlement system

© 2018 Better Solutions Limited. All Rights Reserved. © 2018 Better Solutions Limited