Module 7 – The foreign exchange market 1

Module 7 – The foreign exchange market

Introduction
The Australian foreign exchange market has grown strongly since deregulation and the
floating of the Aussie dollar in the early 1980s. This market is strategically located, being
open after the New York market closes and before the major Asian markets open. Thus, since
the mid 1980s, the Australian foreign exchange market has been amongst the top ten in terms
of turnover.

Learning objectives
On completion of this module students will be:

● able to explain the various theories about the determinants of exchange rates
● aware of the structure of the market
● able to interpret, calculate and use various forms of exchange rates
● aware of some of the issues of concern in foreign exchange dealings.

Resources

Text
Mishkin, FS & Eakins, SG 2012, Financial markets and institutions, 7th edn, Pearson
Education Limited, Edinburgh Gate, England (chapters 15 & 16).

Note: This material is contained in module 7 of your custom publication: FIN8202 Financial
markets and instruments.

7.1 Market structure

The foreign exchange market is the wholesale, over-the-counter, market where currencies are
traded. The participants in this market are the following:

● Dealers – mainly banks

● Clients – companies, government enterprises and financial institutions
● Brokers

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● Information providers, e.g. Reuters and Telerate

● Central banks – the RBA.

7.2 Interpretation and calculation of exchange rates

In this section, we are concerned with the interpretation of an exchange rate quotation, how to
transpose rates, calculation of cross-rates, and calculation of forward market rates. You are
expected to be familiar with the processes noted in this section, but you may find the other
information in these pages of interest.

7.2.1 Interpretation of exchange rates

The price of any commodity or service is quoted in terms of a particular currency. Thus, the
price of a textbook may be quoted in terms of Australian dollars, e.g. $70. Currency prices
are quoted the same way. The commodity or commodity currency is stated first and the
price is stated second in another currency or terms currency. Accordingly, the USD/AUD
rate is the price of USD in terms of AUD. USD here sometimes called unit currency,
because one unit of USD involved.

When two prices are given by a dealer, the first price is a ‘buy’ price, and the second is a
‘sell’ price (for the dealer). The difference is the ‘spread’ and the spread will increase in
uncertain markets or with small transactions. In interpreting foreign exchange questions,
make sure you analyse each transaction carefully. For example, if an Australian exporter has
US dollars to sell and has a quote of AUD/USD 0.7850 – 70 (buy .7850: sell .7870), the
foreign exchange dealer will use the sell (0.7870) part of the quote, because the Australian
exporter wants to buy Aussie dollars and the dealer will sell them to him.

To complicate the issue further, Australian media usually quote the market prices from the
customers’ point of view. Check to see if the larger number is first or second. The larger
number is the sell price, as dealers are in business to make a profit from their trading.

Note that a distinction is made between direct and indirect quotes:

● direct quote – x units of the home currency equal one unit of the overseas currency.
● indirect quote – one unit of the home currency equals x units of the overseas currency.

Australia, and most former British colonies, use the indirect quote i.e. the quote is written as
AUD/foreign currency.

7.2.2 Transposing rates

To reverse a quotation so that the price is that of the terms currency given in the other
currency of the original quotation, the rule is ‘reverse then inverse’. For example,
USD/AUD 1.3450 – 1.3520 becomes .7396 – .7435

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7.2.3 Cross-rates
The most actively traded currencies are usually traded bilaterally, or with direct quotations.
However, the US Dollar is almost an international currency and probably all currencies are
quoted somewhere in terms of USD. Where there is no direct bilateral quote, a cross rate may
be calculated for any two currencies quoted in USD terms.

For example, if DEM/JPY is required, and quotes are available:

USD/JPY 149.50 – 150.40

USD/DEM 1.5650 – 1.5660

DEM is to be unit currency – divide 149.50 by 1.5660 to get the buy price of 95.47 yen
divide 150.40 by 1.5650 to get the sell price of 96.10 yen.

The quotation is thus DEM/JPY 95.47 – 96.10.

7.2.4 Forward market prices

Forward market quotes, where a price is quoted now for delivery of the currency at a future
time, are given in terms of spot and forward points:

e.g. AUD/USD.7900 – .7910, 200, 210 (200, 210 are forward points)

Forward points are added or subtracted depending on whether their values (comparing the
two) are rising or falling:

e.g. 200, 210 are rising, so add sequentially to the spot quote to give .8100–.8120. This is
forward premium market. The opposite is a forward discount market.

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

Where S = the spot rate

F = the forward rate
RA = the Australian interest rate
RO = the interest rate on the other currency

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This formula indicates that the forward points are determined by the interest rates in the two
countries concerned.

Forward points reflect comparative interest rates in the two countries for the maturity period
(otherwise arbitrageurs could profit by borrowing in one country, investing in securities in
another, repaying later and make a profit, purely because of the currency quotes being out of
alignment).

Exercise 1
To ensure that you understand the foreign exchange calculations discussed here,
attempt the following questions:

1. Change the following indirect quote on the Australian dollar to a direct

quote:

AUD/UK£ 0.4032

2. Express the exchange rate quotation AUD/CHF 1.4450 with the Swiss franc
as the commodity (or unit) currency.

3. Express the exchange rate quotation EUR/AUD 1.7828 with the AUD as the
commodity (or unit) currency.

4. If you have $300 Australian, how many euros if the exchange rate is
AUD/EUR 0.5609?

5. If you have €300, how many AUD could you get given the exchange rate in
(4)?

6. Express the exchange rate quotation AUD/CHF 0.8437–8546 with the Swiss
franc as the commodity currency.

7. Express the exchange rate quotation EUR/AUD 1.7869–1.7932 with the

AUD as the commodity currency.

8. If you have $400 Australian, how many CHF could you get given the
following exchange rate AUD/CHF 0.8437–8546?

9. If you have 400 Swiss francs, how many AUD could you get given the
following exchange rate AUD/CHF 0.8437–8546?

10. If you have 1000 euros, how many Australian dollars could you get given
the following exchange rate EUR/AUD 1.7869–1.7932?

11. AUD/UK£ spot 0.4016–32

3 month forward points 12–8
6 month forward points 7–15

Given the quotes above, calculate the outright 3 and 6 month forward rates.
Is AUD trading at a forward premium or discount at 3 and 6 months?

12. AUD/USD spot 0.6530–52

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3 month forward points 4–9

6 month forward points 6–13

Given the quotes above, calculate the outright 3 and 6 month forward rates.
Is AUD trading at a forward premium or discount at 3 and 6 months?

7.3 Managing foreign exchange risk

A firm with transactions denominated in foreign currencies is exposed to foreign exchange
risk. In particular, we may distinguish:

● Transaction exposure – risk that changes in exchange rates will affect the firm’s future
cash flow.
● Translation exposure – impact of exchange rate changes on the financial statements.

The firm may hedge against FX risk by concluding a forward exchange contract. This fixes
‘today’ exchange rates applicable to foreign currency receivable or payable at a future date.
There are also various ‘internal’ hedging techniques which the firm may use.

7.4 Theories of foreign exchange rate determination

Various theories have been put forward which seek to explain the determination of exchange
rates. Factors considered to play a part include:

● inflation rates
● interest rates
● commodity prices
● random adjustments
● government intervention
● expectations.

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:

1. 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

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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.

2. 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.

Self assessment 1
Questions 9, 11, 14 & 15; Quantitative problem 1, 2, 5, 10 & 15 from Mishkin &
Eakins, chapter 15.

Answers are in the solutions manual.

Additional self-assessment
Weekly tutorial worksheet – see USQStudyDesk.

Conclusion
This module covered the working of the foreign exchange market and explained the
determinants of exchange rates.

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Feedback to exercise 7.1

1. AUD/UK£ 0.4032, so 1 / 0.4032 = 2.480159 and UK£/AUD = 2.4802
2. AUD/CHF 1.4450, so 1 / 1.4450 = 0.692042 and CHF/AUD = 0.6920
3. EUR/AUD 1.7828, so 1 / 1.7828 = 0.5609 and AUD/EUR = 0.5609
4. AUD/EUR 0.5609, so 300 × .5609 = €168.27. As a rough check on your answer it is a
good idea to ask yourself if you should have more euros than dollars – the answer is no.
For each dollar, you will only get 0.5609 euros, so your euro amount after conversion has
to be lower than the number of dollars you had to start with.
5. AUD/EUR 0.5609, so 300 / 0.5609 = $534.86. Again using our rough check, if we start
with euros, we should end up with more dollars. For each euro we should get nearly twice
as many dollars after conversion.
6. AUD/CHF 0.8437–8546
1 / 0.8437 = 1.185255 inverse of bid
and 1 / 0.8546 = 1.170138 inverse of offer

We write the quote as CHF/AUD 1.1701–1.1853.

7. EUR/AUD 1.7869–1.7932
1 / 1.7869 = 0.559628 inverse of bid
and 1 / 0.559628 = 0.557662 inverse of offer

We write the quote as AUD/EUR 0.5577–0.5596.

8. AUD/CHF 0.8437–8546
If you have AUD, the dealer will buy AUD from you, so we use the bid rate.
AUD 400 × 0.8437 = CHF 337.48

9. AUD/CHF 0.8437–8546
If you have Swiss Francs, the dealer will sell AUD to you, so we use the offer rate.
CHF 400 / 0.8546 = AUD 468.06

10. EUR/AUD 1.7869–1.7932

If you have euros, the dealer will buy euros from you, so we use the bid rate.
EUR 1 000 × 1.7869 = AUD $1 786.90

11. The 3 month forward points shown above are descending (12 > 8). We need to subtract
the points to the spot as follows:
AUD/£ spot 0.4016 0.4032
3 month forward points 12 8
3 month outright forward rate 0.4004 0.4024

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The 3 month outright forward rate is AUD/£ 0.4004–24. Comparing this rate to the spot
rate tells us that the AUD will be worth less in terms of UK pounds. Therefore, the AUD
is at a forward discount.
The 6 month forward points are ascending (7 < 15) so we add them to the spot quote:
AUD/£ spot 0.4016 0.4032
6 month forward points 7 15
6 month outright forward rate 0.4023 0.4047

The 6 month outright forward rate is AUD/£ 0.4023–47. Comparing this rate to the spot
rate tells us that the AUD will be worth more in terms of pounds. We can say that the
AUD is at a forward premium or that the UK pound is at a forward discount.
12.
AUD/USD spot 0.6530 – 52
3 month forward points 4–9
6 month forward points 6–13

The 3 month forward points shown above are ascending (4<9). We need to add the points
to the spot as follows:
AUD/USD spot 0.6530 0.6552
3 month forward points 4 9
3 month outright forward rate 0.6534 0.6561

The 3 month outright forward rate is AUD/USD 0.6534–61. Comparing this rate to the
spot rate tells us that the AUD will be worth more in terms of USD. Therefore, the AUD
is at a forward premium.
The 6 month forward points are ascending (6<13) so we add them to the spot quote
AUD/USD spot 0.6530 0.6552
6 month forward points 6 13
6 month outright forward rate 0.6536 0.6565

The 6 month outright forward rate is AUD/USD 0.6536–65. Comparing this rate to the
spot rate tells us that the AUD will be worth more in terms of USD. We can say that the
AUD is at a forward premium or that the USD is at a forward discount.

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