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Transcript of Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a...
![Page 1: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/1.jpg)
Chapter 2
The Foreign Exchange Market
![Page 2: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/2.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-2
Objectives
• To describe the FX market• To identify participants and currencies• To describe the Australian FX market• To describe the mechanics and technology of FX
trading
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-3
Objectives (cont.)
• To introduce some exchange rate concepts• To illustrate FX position keeping• To introduce some FX jargon
![Page 4: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/4.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-4
Definition
• The FX market is the market where national currencies are bought and sold against one another. Foreign exchange consists mainly of bank deposits.
![Page 5: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/5.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-5
Characteristics
• It is the largest and most perfect market• It is needed because every international transaction
requires a foreign exchange transaction• It is an over-the-counter (OTC) market
![Page 6: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/6.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-6
Market participants
• Foreign exchange traders buy and sell currencies directly or indirectly
• Arbitragers exploit exchange rate anomalies; hedgers cover open positions; speculators take open positions
![Page 7: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/7.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-7
Categories of participants
• Customers• Commercial banks • Other financial institutions• Brokers• Central banks
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-8
Interbank operations
• The FX market is dominated by interbank operations• Participants in the interbank market are market
makers, other major dealers and second-tier banks
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-9
Size and composition
• The size of the global FX market is measured by the sum of daily turnover in FX centres
• A survey is coordinated by the BIS every three years for this purpose
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-10
Daily turnover in the FX market (USD billion)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-11
Geographical distribution of FX market turnover (%)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-12
FX market turnover by counterparty (institutional type)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-13
FX market turnover by counterparty (locality)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-14
Currency composition of the FX market (by single currencies)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-15
Currency composition of the FX market (by currency pairs)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-16
Traded currencies
• The US dollar is the most heavily traded currency• The euro and the yen are heavily traded because of
the importance of Europe and Japan in the world economy
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-17
Traded currencies (cont.)
• The pound is heavily traded for historical reasons• Currencies that are heavily traded in certain financial
centres and lack liquidity in others: CHF, CAD
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-18
Traded currencies (cont.)
• Currencies that are traded locally, but internationally are traded for international trade purposes: AUD, NZD, HKD
• Third world currencies: soft or exotic currencies
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-19
• The market consists of the banking system and non-bank dealers authorised by the Reserve Bank of Australia (RBA)
• The market has grown since the flotation of the AUD in 1983
The AUD FX market
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-20
Daily turnover in the Australian FX market (USD billion)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-21
• Deregulation• High interest rates in the 1980s• Australia’s time zone• Exchange rate volatility
Reasons for the growth of the AUD market
![Page 22: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/22.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-22
Components of an FX transaction
• Price discovery• Decision making• Settlement• Position keeping
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-23
FX market technology
• The telegraph• The telephone• The telex • The fax
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-24
FX market technology (cont.)
• Screen-based information systems• Screen-based automated dealing systems• Automatic order matching systems• Online FX trading
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-25
The bilateral spot exchange rate
• The exchange rate between two currencies for immediate delivery
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-26
Transaction dates
• The date on which the transaction is agreed upon is called the contract date, dealing date, done date or trade date
• The date on which currencies are exchanged is the value date or the delivery date
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-27
A spot foreign exchange transaction
Confirmation of exchange rate and amount
B’saccount
A’saccount
(Monday)
A B
AU
D 1
000
000
(W
edne
sday
)
US
D 5
00 0
00 (
Wed
nesd
ay)
![Page 28: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/28.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-28
The delivery date
• Typically, the delivery date is two business days after the contract date
• In a value-today or same-day transaction the delivery date is the same as the contract date
• In a value-tomorrow or next-day transaction the delivery date is one day after the contract date
![Page 29: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/29.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-29
• S (x /y ) is the price (in terms of x) of one unit of y :
Spot rate quotation
( ) ( )xySyxS1
=
![Page 30: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/30.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-30
• When the exchange rate changes from S0(x/y) to S1(x/y)
11
1
1
1
1
0
0
1
-yxS
yxS-
yxSxyS
-yxS
yxSyxS
Exchange rate changes
![Page 31: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/31.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-31
• To convert from y to x, multiply by the exchange rate• To convert from x to y, divide by the exchange rate
Currency conversion
![Page 32: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/32.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-32
• Direct quotation refers to the domestic currency price of one unit of the foreign currency
• Indirect quotation refers to the foreign currency price of the domestic currency
• What is a direct quotation from the perspective of one country is an indirect quotation from the perspective of the other country, and vice versa
Exchange rate quotation in practice
![Page 33: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/33.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-33
• The bid rate is the rate at which the quoting dealer is willing to buy. The offer rate is the rate at which the quoting dealer is willing to sell.
• The spread is
The bid and offer rates
=
=
1-
-
b
a
ba
SS
m
SSm
![Page 34: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/34.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-34
A foreign exchange spot transaction with bid-offer spread
A
USD @ 1.8575
B
USD @ 1.8525
AUD @ 0.5398 (1/1.8525)
AUD @ 0.5384 (1/ 1.8575)
![Page 35: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/35.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-35
Conversion rules
)/(1
=)/(
)/(1
=)/(
yxSxyS
yxSxyS
ba
ab
![Page 36: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/36.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-36
• A point is one-hundredth of a cent, a penny, etc.• A pip is one-tenth of a point• If the exchange rate is 1.2545-1.2585, this can be
expressed as 45-85 and 1.25 is called the “big number”
Points and pips
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-37
• A cross exchange rate is the exchange rate between two currencies derived from their exchange rates against another currency
Cross exchange rates
)/()/(
=)/(zySzxS
yxS
![Page 38: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/38.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-38
Bid and offer cross rates
)/()/(
=)/(
)/()/(
=)/(
zySzxS
yxS
zySzxS
yxS
a
bb
b
aa
![Page 39: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/39.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-39
• For n exchange rates
Cross rates matrix
)/(
)/()/(
zjxS
zixS
jxixS
![Page 40: Chapter 2 The Foreign Exchange Market. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad.](https://reader035.fdocuments.in/reader035/viewer/2022081508/5697c0231a28abf838cd437e/html5/thumbnails/40.jpg)
Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-40
• A nostro account is held by a dealer at a correspondent bank
• A vostro account is held by a bank on behalf of a foreign dealer
• The words “nostro” and “vostro” are Latin for “ours” and “yours”
FX position keeping
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-41
• A short position is created when a dealer borrows a currency and sells it
• A long position is created when a currency is bought because it is expected to appreciate
FX position keeping (cont.)
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• Position keeping is the monitoring of positions in each currency
• A position is the net cumulative total of a currency holding arising from deals
• A blotter is a schedule used to record the details of transactions
FX position keeping (cont.)
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• Position squaring is realising profit/loss by buying the short-position currency and selling the long-position currency
• Valuation is the calculation of unrealised profit/loss using the average rate
FX position keeping (cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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An example
The following is an example of FX position keeping
AUD Deal Amount
AUD Balance AUD/USD Rate USD Deal Amount
USD Balance
+10,000,000 +10,000,000 1.6525 -6,051,437 -6,051,437 +20,000,000 +30,000,000 1.6645 -12,015,620 -18,067,057 -10,000,000 +20,000,000 1.6725 +5,979,073 -12,087,983 +25,000,000 +45,000,000 1.6445 -15,202,189 -27,290,172 -50,000,000 -5,000,000 1.6500 +30,303,030 +3,012,858
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• The rate contracted today for the delivery of a currency at a specified date in the future
The forward exchange rate
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• The date on which currencies involved in a forward transaction are exchanged
• The forward value date must be more than two business days after the contract date, otherwise it will be a spot transaction
• The period preceding the forward value date is calculated from the spot value date
Forward value date
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• A short date means a maturity of one month or less• A round date means a maturity of a whole number of
months• A broken date means a maturity of less than round
dates
Forward value date (cont)
(cont.)
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• An outright contract involves the sale or purchase of a currency for delivery more than two days into the future
• A swap transaction involves a spot purchase against a matching outright sale (or vice versa)
Outright and swap forward transactions
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• Forward swaps• Forward-forward swaps• Overnight swaps• Tom/next swaps
Kinds of FX swaps
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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The forward spread
NyxSyxSyxF
m 12×100×)/(
)/()/(=
-
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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• If F (x /y ) > S (x /y ), then y sells at a premium• If F (x /y ) < S (x /y ), then y sells at a discount• If F (x /y ) = S (x /y ), both currencies are flat
Premium and discount
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa2-52
• An outright forward rate is quoted as bid and offer rates
• A swap rate is quoted in terms of the points representing the forward premium or discount
Outright and swap rates