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IFT Notes for Level I CFA® Program

LM08 Currency Exchange Rates

Part 2


2. Market Functions

  • There are several motivations for foreign exchange transactions such as:
    • International trade: Companies buying and selling products/services across geographies.
    • Capital market transactions such as investors buying fixed assets in other countries, investing in stocks/bonds denominated in foreign currencies.
    • The growth of international tourism. Tourists buy the currency of the country they are visiting.
  • Hedging versus Speculating
  • Hedging is engaging in a transaction to mitigate foreign exchange risk.
    • For example: A Chinese food products company imports canned peaches, Maple syrup, and various types of vinegar from the United States. It makes the payment in dollars. The company can engage in a forex transaction to buy a certain amount of dollars at a specified rate. This removes the risk (uncertainty) of the U.S. dollar becoming too expensive in the future. This is an example of hedging.
    • For example: Take another example of a software services exporter in Pakistan who gets paid in dollars. But the revenues are reported in Pakistani rupee (PKR). To remove the uncertainty of how much the U.S. dollar translates into PKR, the company may engage in forex transaction to receive a certain amount of PKR for every dollar at a certain date.
  • Speculating: This means that unlike in the examples above, the person engaging in the transaction has no intention of taking delivery of the currency. They seek to profit from exchange rate changes. They were merely anticipating a movement in a certain direction (currency appreciating / depreciating) and trading on that view.
  • At times the difference between hedging and speculation is blurred.
  • Spot Transactions
  • Spot transactions involve the exchange of currencies for immediate delivery. For most currencies, this corresponds to “T+2” delivery, meaning that the exchange of currencies is settled two business days after the trade is agreed to by the two sides of the deal.
    • The exchange rate used for such transactions is called the spot exchange rate.
  • Forward Contracts
    • Forward contracts are agreements to deliver foreign exchange at a future date at an exchange rate agreed upon today. As such, they are any exchange rate transactions that occur with currency settlement longer than T+2 days.
    • In the hedging examples we saw earlier a forward contract may be used. For example, the Chinese company may enter into a contract on Jan 13, 2014 to pay $500,000 on Apr 13, 2014 at the rate of 6.21 CNY (\frac{CNY}{USD} = 6.2100)
    • Two factors are defined in each forward contract:
      • The date at which the currencies are to be exchanged.
      • The exchange rate applicable on the settlement date. This exchange rate is defined now and is called the forward exchange rate; it is different from the spot rate.
    • Forward contracts can be of any size the counterparties agree upon, however the liquidity in forward market decreases as the trade size and term to maturity increases.

3. Market Participants, Size and Composition

The forex market has a diverse range of participants. One way of classifying them is to group them based on buy side and sell side players.

Sell side:

  • Large FX trading banks such as Deutsche bank, Citigroup, UBS, and HSBC.
  • Other banks fall into the second and third tier of the FX market.

Buy side:

  • Clients who use banks to undertake FX transactions.
  • Corporate accounts: Corporations using forex transactions for cross-border trade of goods and services.
  • Real money accounts: restricted use of leverage. Investment funds managed by mutual funds, ETFs, pension funds, endowments etc.
  • Leveraged accounts: Hedge funds, high-frequency algorithmic traders.
  • Retail accounts: Individuals trading for their own accounts, tourists exchanging currency during international travel.
  • Governments.
  • Central banks: Intervene in the forex market to control their domestic exchange rate. For instance, during 2012-13, the Reserve Bank of India bought billions of U.S. dollars to strengthen the depreciating Indian rupee.
  • Sovereign wealth funds: Countries with current account surpluses like Norway, UAE, Kuwait, and China direct international capital inflows into SWFs instead of holding them as foreign exchange reserves. SWF then invests these funds internationally in natural resources, infrastructure projects and real estate to earn higher returns and exert more influence.

3.1 Market Size and Composition

Exhibit 3 in the curriculum (reproduced below) lists FX turnover by instrument.

FX Turnover by Instrument

Spot 36%
OTC forwards 12
Exchange-traded derivatives 4
Swapsa 44
OTC Optionsb 4
Total 100%
a Includes both FX and currency swaps.
b Includes what the BIS categorizes as ‘’other FX products.’’

The largest turnover is in the swaps market, followed by the spot market.

Note: You need not memorize the numbers.

Exhibit 4 in the curriculum (reproduced below) lists FX flows by counterparty. Average daily FX flow between financial clients is higher than that between the sell-side banks (interbank market).

FX Flows by Counterparty.

Interbank 39%
Financial clients 48
Non-financial clients 13

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