Fundamentals of Financial Markets and Institutions in Australia 1st Edition Valentine Solutions Manual

Fundamentals of Financial Markets and
Institutions in Australia 1st Edition

Valentine Solutions Manual
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CHAPTER 8
The Foreign Exchange Market
Overview
The foreign exchange market is the market through which Australian dollars (AUD) can
be exchanged for foreign currencies. Official dealers in this market must be licensed by
ASIC. Licences are not restricted to banks, although the criteria to be satisfied are fairly
strict. In fact, the large banks dominate the Australian market.
Exchange rates for the Australian dollar are quoted in indirect form. That is, the
exchange rate shows the value of one AUD in terms of foreign currency. For example,
the Australian dollar/US dollar (USD) exchange rate might be written as:
AUD/USD 0.9260
which means that one Australian dollar is worth 92.60 US cents. The alternative way of
quoting an exchange rate is to use a direct quote in which the value of one unit of
foreign currency is stated in terms of the local currency. In the direct form, the above
exchange rate would be
USD/AUD 1.0799
which means that one US dollar is worth 1.0799 Australian dollars. Direct quoting is
more frequently used around the world than indirect quoting.
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442516014/Valentine et al/Fundamentals of Financial Markets & Institutions in
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8-1
There are two major types of exchange rates. The first is the spot exchange rate in
which the exchange of currencies is agreed to today but the actual physical exchange
occurs in two working days’ time.
The second is the forward exchange rate in which the physical exchange of currencies
occurs three or more working days in the future.
Foreign exchange traders quote both a buying (or bid) price and a selling (or offer) price
for Australian dollars against foreign currencies. For example, the quote could be:
AUD/USD 0.9000 – 0.9010
This trader will buy Australian dollars (sell US dollars) at 90 US cents, i.e. the bid price
is 90 US cents. The trader will sell Australian dollars (buy US dollars) at 90.10 US
cents, i.e. the offer price is 90.10 US cents.
The difference between the bid and offer price is called the spread.
Spread = Offer Price – Bid Price
In our example, the spread is 0.10 of a US cent or 10 points. A point is a unit in the
fourth decimal place of an exchange rate and, since exchange rates are usually quoted to
four decimal places, it represents the smallest change that can occur in a market
exchange rate.
Australia/1e
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The spread indicates the profit the trader will make on a round-trip transaction, i.e.
buying a parcel of AUD at the bid price and selling them at the offer price. The size of
the spread is often taken as an indicator of competitiveness and efficiency of the foreign
exchange market because it represents the resources used up in performing such a
round-trip transaction.
Exchange rates are affected by a number of variables which act through exports, imports
or capital flows. The major ones are:
Exports – state of the global economy

– competitiveness
Imports – competitiveness
– state of the Australian economy
Capital flows – interest rate differentials
– expectations about the likely future value of the AUD
Competitiveness refers to the level of Australian prices relative to those overseas
(especially in our major trading partners). One expression of this influence is the theory
of purchasing power parity which says that the depreciation of a country’s currency is
equal to its domestic inflation rate minus the rate of inflation in its trading partners. This
theory works well in the long term but has little predictive power in the short term.
The trade-weighted index (TWI) is the average value of the Australian dollar against
overseas currencies. The index is a weighted average in which the weights are based on
the importance of different overseas currencies in Australia’s trade. As at October 2007,
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the Japanese yen has the highest weight (15.49%) with the Chinese Renminbi in second
place (15.45%).
The Reserve Bank intervenes in the foreign exchange market in order to reduce the
volatility of the exchange rate. It does not currently attempt to set a particular value of
the exchange rate. This means that the current regime in the Australian foreign
exchange market is a managed float. As explained elsewhere, this arrangement gives the
Reserve Bank the freedom to set domestic interest rates.
The forward exchange rate is the rate at which a future exchange of currencies occurs. It
is normally stated as a spot exchange rate plus the number of forward points.
Forward Points = Forward Exchange Rate – Spot Exchange Rate
If the forward points are positive, we say that the Australian dollar is at a premium in
the forward market. If the forward points are negative, we say that the Australian dollar
is at a discount in the forward market.
The formula for the forward rate is:
S (1 + RO )
F=
1 + RA
Australia/1e
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Where S = the spot rate
F = the forward rate
RA = the Australian interest rate
RO = the interest rate on the other currency
This formula indicates that the forward points are determined by the interest rates in the
two countries concerned.
When funds are free to flow into and out of the two countries involved in an exchange
rate, certain parity relationships arise. The most prominent examples are:
Covered Interest Rate Parity:
1 + RO F
=
1 + RA S
This relationship says that the covered return to investing (cost of borrowing) offshore
is equal to the Australian return (cost of borrowing). This must be so or otherwise there
would be an arbitrage opportunity. For example, assume that the Australian interest rate
was higher than the covered cost of borrowing in US dollars (i.e. the cost of borrowing
US dollars and, at the same time, buying forward the US dollars necessary for the
repayment of the principal of the loan plus interest). Then we can make a riskless profit
by simultaneously:
• taking a covered US loan;

• investing the money in Australia.
Australia/1e
8-5
Uncovered Interest Rate Parity:
A similar relationship exists for uncovered investments and loans. An approximation to
this relationship is:
RA = RO + Ed
where Ed is the expected depreciation of the Australian dollar against the overseas
currency. The market expects that the Australian dollar will depreciate or appreciate just
enough against the overseas currency to offset the interest rate differential between
Australia and the overseas country. In other words, the average market expectation is
that Australian investors or borrowers will not be able to benefit by investing or
borrowing overseas.
Uncovered Share Return Parity:
We might also expect uncovered parity to apply to share returns. Thus:
SA = SO + Ed
where SA = expected return on Australian shares
SO = expected return on overseas shares
Ed = expected depreciation of the Australian dollar
against the overseas currency
The expected returns include both capital gains/losses and the dividend yield. Again,
this relationship indicates that the average market expectation is that Australian
Australia/1e
8-6
investors will not benefit from buying shares overseas. This relationship also shows
why share indices in countries free from restrictions on capital flows are highly
intercorrelated.
Globalisation refers to the growing integration of world economies. The parity
relationships just discussed indicates the high degree of financial integration created by
deregulation, but globalisation extends well beyond the financial area. It involves free
trade, unrestricted investment flows, mobile labour and the free movement of
information. Globalisation has led to many concerns, including the propagation of
economic crises and an end of cultural diversity.
A foreign exchange trading operation makes a profit from:
• the buy/sell spread in its quotes;
• position taking in which the trader takes long or short
positions in a currency in the hope that the exchange rate
will move in a favourable direction.
• arbitrage transactions which take advantage of inconsistent
pricing in different markets;
• fees earned from clients; and
• retail transactions.
Australia/1e
8-7
Foreign exchange traders face a number of risks—settlement risk, credit risk,
operational risk and market risk. A well run trading operation will have internal controls
in place to mitigate these risks.
Objectives
◼explain how exchange rates work
◼describe the instruments most commonly used in the foreign exchange market
◼analyse the factors affecting exchange rates
◼compare alternative foreign exchange regimes
◼Show how to calculate forward foreign exchange rates
◼Consider how the Reserve Bank of Australia manages the Australian foreign
exchange market
◼Describe the relationship between domestic Australian capital markets and those
overseas
◼Examine the techniques and sources of profit in foreign exchange trading
Key Concepts
An exchange rate is the price of one currency in terms of another. An indirect exchange
rate is one in which the price of the domestic currency is stated in terms of the foreign
currency. A direct exchange rate is one in which the price of a foreign currency is stated
in terms of the domestic currency.
Australia/1e
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A spot foreign exchange contract arranges an exchange of one currency for another two
days from the making of the contract. A forward foreign exchange contract arranges an
exchange of one currency in three or more days in the future. A foreign exchange swap
is a contract involving the simultaneous buying and selling of one currency for another
in the spot and forward market.
Arbitrage involves taking advantage of equivalent products being priced differently in
different parts of the market by simultaneously buying at the low price and selling at the
high price. There is no risk involved in arbitrage.
Speculation involves creating an open position (i.e. one which generates a profit or loss)
in the hope that a profit will be made.
The spread is the gap (in number of points) between a foreign exchange dealer’s bid and
offer prices.
Purchasing Power Parity (PPP) argues that the depreciation of a country’s currency will
be equal to its rate of inflation minus the rate of inflation in its trading partners.
The trade-weighted index (TWI) is the weighted average value of the Australian dollar
against other currencies. The weights used in the average are based on the importance of
the various currencies in our trade.
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The real exchange rate is an index of the purchasing power overseas of the domestic
currency.
A floating exchange rate regime is one in which the central bank does not intervene in
the foreign exchange market, allowing supply and demand for the various currencies to
determine exchange rates. In a fixed exchange rate regime, one exchange rate—a
bilateral exchange rate or the TWI—is fixed.
A sterilised intervention in the foreign exchange market involves a simultaneous
operation in the domestic market which leaves the money base and the domestic interest
rate unchanged.
Forward points are equal to the forward exchange rate minus the spot exchange rate.
Interest rate parity is a relationship between the Australian interest rate and an exchange
rate adjusted overseas interest rate. Share return parity is a similar relationship between
the Australian expected share return and the exchange rate adjusted expected return in
an overseas share market.
Globalisation is the integration of national economies and markets.
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8-10
Revision Questions
1 Define the following terms:
(a) Spot exchange rate

(b) forward exchange rate
(c) foreign exchange swap
(d) currency option
The spot exchange rate is the price at which the domestic currency can be
exchanged for a foreign currency for settlement in two working days.
A forward exchange rate is the price at which the domestic currency can be
exchanged for a foreign currency for settlement in three or more working days.
There is a forward exchange rate for each period in the future.
A foreign exchange swap involves the sale (purchase) of AUD spot and the
simultaneous purchase (sale) of the same amount in the forward market.
A currency option is an instrument which provides the right, but not the
obligation, to buy or sell one currency against another at a specified price (the
strike price) or a specified date (the expiry date).
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2 An importer of antique jewellery is required to pay GBP 500 000 to a London
antique policy in three months’ time. She takes out a forward contract for GBP
for three months’ delivery and (assuming she accepts her bank’s quote of
AUD/GBP 0.4255) agrees thereby to pay AUD to her bank in exchange for the
GBP
(a) sell; 287 750.57

(b) buy; 287 750.57
(c) sell; 1 175 088.13
(d) buy; 1 175 088.13
She would need to buy GBP. The amount she would pay on the settlement of
the contract is:
 500000 
AUD  = AUD 1175088.13
 0.4255 
The answer to the question is D.
3 An exporter wants to hedge half (50%) of his risk on a contract for the sale of
computer software to Japan. He expects to receive payment of JPY 500 million
in 180 days’ time. He takes out a forward contract for AUD with his bank in
Sydney, which quotes him a 180-day forward exchange rate of AUD/JPY 102.
He can expect to receive AUD __________ from his bank in six months’ time.
(a) buy; 51 million
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(b) sell; 25 500 000 000
(c) buy; 2 450 980.39
(d) sell; 4 901 960.78
The exporter will want to exchange JPY for AUD. Therefore, he would take out a sell contract for
 250m 
AUD  = AUD 2450980.39 Therefore, the answer is C.
 102 
4 A meat exporter in Brisbane purchases JPY7 million one month forward and
simultaneously sells JPY7 million two months’ forward. This transaction is an
example of:
(a) a spot/forward foreign exchange swap
(b) a cross-currency interest rate swap
(c) a forward/forward currency swap
(d) none of the above
The description indicates that the transaction is a forward/forward currency
(foreign exchange) swap.
5 Explain the theory of purchasing power parity (PPP). What would cause it to fail
over short periods?
Purchasing Power Parity says that the value of a country’s currency
falls by the percentage that its rate of inflation exceeds the average
of the rates of inflation in its major trading partners. This keeps the
Australia/1e
8-13
prices of domestic products in the same relationship with overseas products as
they had originally.
In the short term, other factors affect the value of the exchange rate in addition
to relative price levels. One of these is interest rate differentials. If the domestic
interest rate is high relative to overseas interest rates, a higher value of the
exchange rate can be maintained for a period. The second, and most important,
short-term influence is market sentiment, i.e. market expectations about future
movements in the exchange rate. These expectations will not necessarily be
related to relative rates of inflation. They can keep the actual exchange rate
away from the equilibrium value of the exchange rate determined by PPP for
some time.
6 What are the virtues and weaknesses of a floating exchange rate regime?
The major weakness of a floating exchange rate regime is the day-to-day
volatility of the exchange rate it involves. This volatility creates uncertainty for
participants in foreign exchange transactions. However, it should be noted:
• derivatives markets have provided a variety of tools to allow
market participants to hedge their exposures. Forward
foreign exchange contracts are the leading example; and
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8-14
• in practice, there is also uncertainty in fixed exchange rate
regimes because devaluations and revaluations often occur.
The major advantages of a floating exchange rate regime are:
• shocks originating overseas are reflected in the exchange
rate rather than in the domestic economy. That is, the
volatility of the real sector has been reduced at the cost of
increasing the volatility of the exchange rate; and
• the monetary authorities are free to pursue an independent
domestic monetary policy.
The following information applies to Questions 7 – 10.
An importer needs to borrow AUD 1 million or its equivalent for 180 days. The
bank quotes him 8% per annum (inclusive of all costs). As an alternative, the
bank suggests to the importer that it could lend him the equivalent amount in
JPY at a yield of 3% p.a. (based on a 365-day year). In addition, the bank could
sell the JPY forward at the 180-day forward exchange rate of AUD/JPY63.46.
Assume that the spot exchange rate is 65 and that the forward margin for 180
days is 1.54 points.
Australia/1e
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7 The forward margin for 180 days for AUD/JPY would be deducted, in this
example, from the spot AUD/JPY exchange rate to determine the 180-day
forward exchange rate. Why?
The Australian interest rate is higher than the Japanese interest rate. This
means that the AUD is at a discount in the forward market. That is, the forward
rate is below the spot rate.
8 What is the ‘raw’ (unadjusted) Japanese interest rate, originally quoted on a 360-
day year basis.
The 360-day Japanese interest rate is:
360
3.00  = 2.96%
365
9 On the basis of uncovered interest rate parity, what would the markets expect
the spot exchange rate for AUD/JPY to be in 180 days’ time?
Using the approximation given in the text:
180 180
Ed = 8  − 3
365 365
= 3.945 − 1.479
= 2.466
Australia/1e
8-16
That is, the exchange rate is expected to depreciate by 2.466%, i.e. go to 63.40.
More precisely:
1 + RO E ( S )
=
1 + RA S
1.01479 E (S )
i.e. =
1.039451 65
E (S ) = 63.46
Note that this is the forward exchange rate. In this simple version of the parity
relationships, without a risk premium, the forward rate is the expected future
spot rate.
9 Explain why uncovered interest rate parity tends to hold in practice.
The establishment of interest rate parity depends on the mobility of capital.
In deregulated financial sectors, capital mobility is usually very high.
Funds flows, into and out of, the economy are not subject to restrictions.
Consider covered interest rate parity. If the covered overseas interest rate (i.e.
the overseas interest rate converted into AUD by using a forward foreign
exchange contract) is not equal to the Australian interest rate, arbitrage will
take place. Assume that the Australian interest rate is below the covered
overseas interest rate. Then a risk-free profit can be obtained by borrowing in
Australia/1e
8-17
Australia and simultaneously investing overseas. This arbitrage will continue
until covered interest rate parity is established.
Uncovered interest rate parity says:
RA = RO + Ed
where RA = Australian interest rate

RO = Overseas interest rate
Ed = expected depreciation of the AUD against
the overseas currency
The right-hand side of this expression is the expected return on investing
overseas. Assume that this is higher than the Australian interest rate. Funds
will flow out of Australia to take advantage of this perceived higher overseas
return. As a result:
• Australian interests rate will rise; and/or
• the Australian dollar will depreciate, leading to a fall in Ed.
This process will continue until uncovered interest rate parity is established.
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10 Explain the concept of share return parity. Are there any factors which would
inhibit the operation of share market parity in practice?
Share return parity says:
SA = SO + Ed
where SA = expected return on Australian shares
SO = expected return on overseas shares
Ed = expected depreciation of the AUD against
the overseas currency
As with interest rate parity, this relationship will be established by capital flows.
The share return parity relationship will not be established if:
• there are controls preventing the free flow of capital; and
• overseas shares are not regarded as perfect substitutes for
Australian shares.
Also, since all the magnitudes in the relationship are expected values, market
participants will demand a risk premium to compensate for the risk that the
actual values might deviate from the expected ones. That is, the relationship is
likely to include a risk premium.
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11 How do trading operations make and lose money?
Trading operations make a profit from the spread that they earn from their role
as market makers in financial markets. The spread is the difference between the
buy and sell quotes offered by a trader. As the sell quote is higher than the buy
quote, the trader makes a profit through buying and selling. However, the
trader can also lose if the exchange rate moves unfavourably between the buy
and sell transactions.
Another way of making profit is by position-taking. This occurs when the trader
deliberately assumes a position (by either buying or selling) in anticipation of
a future exchange rate movement. Again, the trader will make a loss if the
expectation is proved wrong and the exchange rate moves unfavourably.
A third way of making money is through arbitrage. This involves buying and
selling products that are virtually the same but are priced differently. The
trader can lock in an arbitrage profit by buying the cheaper of the two and
selling the more expensive product. Arbitrage strategies carry zero risk so the
trader is not in danger of making a loss.
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Trading operations can also make money through charging of fees (for
example in exchange for providing financial advice), and servicing retail
customers (which are smaller than wholesale customers so their transactions
are more costly to execute, therefore they deal at a less favourable rate).
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True/False Questions
Answer True or False to each of the following.
1 A spot exchange contract involves the exchange of two currencies (i.e. at the
time that the deal is made).
False. Spot exchange contracts are settled after two working days.
2 In Australia, a forward contract is traded through a centralised exchange similar
to the Australian Stock Exchange or the Sydney Futures Exchange.
False. Forward foreign exchange contracts are what are called over-the-
counter contracts. They are individual contracts between a bank (or other
provider) and a customer.
3 A foreign exchange swap is the right, but not the obligation, to exchange one
currency for another by a set future time at an agreed exchange rate.
False. This is the description of a foreign currency option.
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8-22
4 Currency option holders, at the time of taking out the option, are locked in (i.e.
committed) to buying or selling currency in at least two working days’ time.
False. An option holder does not have to exercise it and the expiry date can be
any number of days in the future.
5 A foreign exchange swap is the simultaneous buying and selling of one currency
in exchange for another, for different value dates, at a price set now.
True.
6 Spot exchange contracts are useful for hedging, speculation and arbitrage.
False. Spot contracts cannot be used for hedging.
7 Globalisation can be defined as the growing interaction and integration of
national economies as a result of increasing international trade, investment and
financing opportunities and growth of real-time information flows (e.g. through
the internet, e-commerce, and enhanced worldwide communication systems).
True.
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8 The RBA does not intervene in the Australian foreign exchange market.
False. The Bank does not attempt to set the exchange rate, but it does intervene
in the foreign exchange market to smooth out fluctuations.
9 Sterilised intervention involves the RBA offsetting its operations in the foreign
exchange market through the domestic money market.
True. In a sterilised intervention, the money base and, therefore, cash interest
rates are unchanged.
10 Interest rate parity means that interest rates will be equal over time across all
countries engaged in free trade and unrestricted capital flows.
False. Only interest rates adjusted for exchange rate expectations are equated.
11 Share return parity cannot hold in practice because it fails to recognise that stock
market investment in developing countries involves higher risk than stock
market investment in more developed countries.
Australia/1e
8-24
False. If this was the case, the relationship would include a risk premium.
However, it is likely that a developing country will have capital controls in
place and these would prevent share return parity being established.
12 Capital mobility is a necessary condition for parity relationships to be satisfied.
True. Capital must be free to move to the country which appears to offer the
highest expected return.
Australia/1e
8-25

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Fundamentals of Financial Markets and

Institutions in Australia 1st Edition

The Foreign Exchange Market

strict. In fact, the large banks dominate the Australian market.

exchange rate would be

more frequently used around the world than indirect quoting.

occurs in two working days’ time.

occurs three or more working days in the future.

AUD/USD 0.9000 – 0.9010

cents, i.e. the offer price is 90.10 US cents.

Spread = Offer Price – Bid Price

exchange market because it represents the resources used up in performing such a

or capital flows. The major ones are:

Exports – state of the global economy

Competitiveness refers to the level of Australian prices relative to those overseas

the importance of different overseas currencies in Australia’s trade. As at October 2007,

Reserve Bank the freedom to set domestic interest rates.

Forward Points = Forward Exchange Rate – Spot Exchange Rate

is at a discount in the forward market.

The formula for the forward rate is:

two countries concerned.

Covered Interest Rate Parity:

• taking a covered US loan;

A similar relationship exists for uncovered investments and loans. An approximation to

this relationship is:

that Australian investors or borrowers will not be able to benefit by investing or

Uncovered Share Return Parity:

We might also expect uncovered parity to apply to share returns. Thus:

against the overseas currency

Globalisation refers to the growing integration of world economies. The parity

information. Globalisation has led to many concerns, including the propagation of

economic crises and an end of cultural diversity.

A foreign exchange trading operation makes a profit from:

• the buy/sell spread in its quotes;

• position taking in which the trader takes long or short

positions in a currency in the hope that the exchange rate

will move in a favourable direction.

• arbitrage transactions which take advantage of inconsistent

pricing in different markets;

• fees earned from clients; and

in place to mitigate these risks.

◼explain how exchange rates work

◼analyse the factors affecting exchange rates

◼compare alternative foreign exchange regimes

◼Show how to calculate forward foreign exchange rates

◼Examine the techniques and sources of profit in foreign exchange trading

in terms of the domestic currency.

in the spot and forward market.

Arbitrage involves taking advantage of equivalent products being priced differently in

high price. There is no risk involved in arbitrage.

in the hope that a profit will be made.

the various currencies in our trade.

bilateral exchange rate or the TWI—is fixed.

A sterilised intervention in the foreign exchange market involves a simultaneous

an overseas share market.

Globalisation is the integration of national economies and markets.

1 Define the following terms:

(a) Spot exchange rate

exchanged for a foreign currency for settlement in two working days.

There is a forward exchange rate for each period in the future.

simultaneous purchase (sale) of the same amount in the forward market.

strike price) or a specified date (the expiry date).

(a) sell; 287 750.57

the contract is: