Chapter 15: Foreign Exchange (FX)

Markets

FX markets allow for financial transactions dominated in a foreign

currency
Facilitate the exchange of value from one currency to another and
allows market participants to buy/sell foreign currencies
There is a demand to buy/sell foreign currency due to:
Financial flow from international trade in goods and services
(imports and exports)
Cross-border capital transactions involving the
investment/borrowing of funds (borrowing and investing)
Speculative transactions which profit from favourable
movements in future exchange rates (buying and selling
currency)
Central bank transactions within the FX

15.1 Exchange rate regime

Each country, or monetary union, is responsible for determining own

exchange rate regime
o i.e. method by which the exchange rate is calculated
Exchange rate is the value of one currency relative to another
currency
Major currencies such as the USD, JPY, AUD, GBP (UK pound
sterling), EUR (Economic and Monetary Union of the European Union
euro) adopt a floating exchange rate regime

Exchange Rate Regime

Floating exchange rate
USD, JPY, AUD, EUR, GBP

Managed float

Description
Determined by supply and
demand factors
If demand for a currency
increases in the FX markets,
then currency will appreciate
relative to other currencies
Not directly controlled by the
govt or central bank
Although, CB may enter FX
markets to influence the
exchange rate by
buying/selling currency to
slow down movement of
exchange rate (should it
rapidly fluctuate)

Allow currency to move

China, Singapore, Malaysia,

Indonesia

Crawling Peg
China (arguable)

Linked (or fixed) exchange

rate
Hong Kong

within a defined range

relative to another major
currency (e.g. USD, or REM)
Exchange rate may adjust
such that it does not
adversely impact economic
objectives of the country
Limited fluctuations allowed
May be used to maintain
competitive trade equilibrium
Managed float where
exchange rate is allowed to
appreciate in controlled steps
over time set by the govt
Currency is generally
undervalued
Currency is directly linked to
another currency
E.g. Honk Kong Dollar (HKD)
linked to USD
HK authorities have pegged
HKD exchange between 7.75
to 7.85 HKD to the USD
That is, value of pegged
currency is tied to value of
another currency or basket of
currencies
Exchange rate is locked into
a ratio with the nominated
currency

15.2 Foreign Exchange Market Participants

FX market participants may be categorised as:

Foreign exchange deals and brokers
Central banks
Firms conducting international trade transactions
Investors/borrowers in the international money markets and
capital markets
Foreign currency speculators
Arbitrageurs

FX Market
Participants

Description

Foreign exchange
Dealers

FX Brokers

Central Banks

Firms conducting
international trade
transactions

Investors/borrower
s in international
money markets
and capital
markets

Institutions who quote bid(buy) or offer(sell) prices

and act as principals in the FX market
Organisations acting as principals in FX market
Main dealers are commercial banks, investment
banks, and merchant banks
FX dealers require authority to deal from prudential
supervisor
Dealers quote two-way prices i.e. prices at which
they are prepared to buy and sell in foreign currencies
Dealers are indifferent between buy/sell transactions
as they make profit on the spread between the two
prices
Transactions are exclusively with FX dealers, and not
with the public
Brokers seek out best exchange rates in global FX
markets and match FX dealers bid and offer orders for
a fee/brokerage
Acquire foreign currency for government expenditure
e.g. imports, defence equipment, pay interest, or to
redeem govt overseas borrowing
Conduct international transactions on behalf of the
govt
Manage official reserve assets by changing the
constituents of CB holdings of foreign currencies
E.g. CB may want to increase REM holdings, and
would fund purchase by reducing EUR holdings
To influence floating exchange rate
Clean Float: Exchange rate determined without
the intervention of CB
Dirty Float: CB regularly intervenes in FX
market to influence FX rate
International exporters often receive payments in
foreign currency
Similarly, importers from international markets pay for
g&s in foreign currency
E.g. borrow foreign currency from international FX
market to be converted into domestic currency to fund
liability management
E.g. purchase FX for overseas investments

Speculative
transactions

Arbitrageurs

Enter in futures positon to generate profits

Take on risks that hedgers often avoid
A speculative transaction:
A speculator buys a BAB futures and sells
Treasury bond futures
Therefore, will only gain if bills contract price
increase (b/c has to sell in future) OR bond
contract price decreases (b/c have to buy in
future)
NB: yield and price are inverse
Expect bills yield to decrease and bond yield to
increase
Simultaneous FX transactions that involve no risk
exposure to take advantage of price differentials
between markets

15.4 Spot and Forward transactions

Common currency contracts bought/sold on the FX markets are

those with a maturity date i.e. value date
Value date is the FX contract date where delivery of a currency and
financial settlement occurs
Spot transactions: 2 business days after entering into
contract
Forward transactions: more than 2 working days after
entering into contract
Tod value transactions: FX contract with settlement and delivery
today
Tom value transactions: FX contract with settlement and delivery
tomorrow
The one-month forward date will be the spot delivery date + 1
month
Short-dated FX transactions may be tod or tom

Spot Transaction
2 business days after
entering contract

Forward Transaction
Settlement more than 2
working days after entering
contract
Contract can be obtained for
any future date
Standard dates are usually
one or more months hence
Settlement occurs at the
spot date + month
o E.g. today is Monday

13th August
o Spot value(delivery)
date would be
Wednesday 15th August
(i.e. 2 business days
after entering contract)
o The one-month forward
value date is 15th
September
o The two-month forward
value date is 15th
October, and so on

Currency contracts examples

How does a spot transaction arise?
E.g. Importer must pay USD account within next few days
Importer must purchase required USD via FX dealer and would nominated a
US bank account for the USD to be credited
Importer also nominates account from which local currency is to be debited
in order for financial settlement to the FX dealer for the transaction
Spot contract for USD would be entered into today at an exchange rate
determined today with settlement occurring in 2 business days
How does a forward transaction arise?
Importer must pay foreign currency to exported in 2 months
Importer may be concerned that foreign currency will appreciate during the
period and will thus enter into a forward contract to hedge the risk
Contract to buy EUR is entered into today
Price of EUR is determined today and locked in
Value date i.e. when local currency Is paid and EUR received at a
future date, is specified today
Value day

Today

Today + 1

Today + 2

Today + 3
and beyond

Transaction

Tod

Tom

Spot

Forward

15.5 Spot Market Quotations

The first currency mentioned is being sought i.e. the base currency
or the unit of quotation (the price of one unit of currency that is
being quoted)
One unit expressed in terms of another currency
The terms currency is the second term and used to express value
of the base currency
E.g. USD/EUR = price of USD1 relative to EUR
Suppose an importing firm asks for the Euro/Aussie spot rate (Price
of EUR1 in terms of AUD)
Firm will receive two sets of numbers:
EUR/AUD 1.3755-1.3765
Euro/Aussie spot rate is one thirty-seven fifty-fivesixty-five
The two numbers are the prices the price-maker FX dealer will buy
and sell 1 unit of the quotation i.e. a dealer that quotes both bid and
offer prices
the price-maker dealer will buy EUR1 for AUD1.3755
the price-taker will sell EUR1 and receive AUD1.3755
Alternatively;
The price-maker will sell EUR1 for AUD1.3665
The price-taker will buy EUR1 and pay the dealer AUD1.3765
Buy price is known as the bid price; price dealer will buy the unit
of quotation (base currency)
Sell is offer price or ask price; price dealer will sell unit of
quotation (base currency)
The difference between the bid and offer price is the spread which
Is represented in percentage difference:

Percentage spread=

offer pricebid price

x 100
bid price

Spread: the points difference between bid and offer price

Point: the final decimal place in an FX quotation
o E.g. AUD/GBP 0.6250-53 has a spread of three points

Transposing spot quotations

Transpose indirect quotes to direct quotes

o E.g. we want to find the value of AUD/EUR but are given an
EUR/AUD quote
Reverse and then invert (divide both numbers into 1)
Direct quote: USD is the base currency e.g. USD/AUD
Indirect quote: currency other than USD is the base currency e.g.
EUR/USD

Cross-rate: exchange rate of two currencies, neither being the USD

Common figures are not repeated in a quote
o Quotes with fewer than 10 units of terms currency is quoted to
4 d.p
o Quotes with more than 10 units of terms currency is quoted to
2 d.p

15.6 Forward market quotations

Foreign currencies bought/sold at a price determined today but

delivery at a future specified date (beyond spot date)

Terms
Forward exchange
rate

Definition
The FX bid/offer rates applied at a specified date
that is beyond the spot delivery date

Interest rate
parity

Concept that exchange rates adjust to reflect the

different interest rates between countries

Forward points

Forward exchange rate variation to a spit rate based

on interest rate differentials (if increase add to
spot rate; if decrease minus from spot rate)

Forward Discount

Forward Premium

Forward exchange rate is less than the spot rate i.e.

interest rates in the base (first) currency ae higher
than the terms currency
E.g. AUD/USD decreases in the future thus the
forward rate is less than the spot rate
Base currency (AUD) is at a forward discount
Indicates that AUD interest rates are higher
than USD interest rates
Forward exchange rate is higher than the spot rate
Indicates that base currency interest rates are less
than terms-currency country

Additional notes from test bank

Daily turnover of FX markets is estimated to be nearly USD 2000 billion

There is no central trading location or floor for the FX

Speed and efficiency of FX markets are attributed by a vast global network of
sophisticated telecommunications system
Commercial banks act as FX dealers and are not to be confused with central banks
(who are participants of the FX)
FX dealers: quote two-way prices
o Require authority to deal from a prudential supervisor
FX brokers: exclusively transact with dealers only
o Match buy/sell orders from various dealing rooms
o Provide anonymity to clients until transaction is carried out
FX dealers pay a fee/brokerage for the service provided by brokers
Clean float: CB does not intervene in FX markets
Dirty float: CB regularly intervenes in the FX market
Speculative FX transactions may move the market price of a currency due to the
sheer volumes being traded

Chapter 16: Foreign Exchange: factors

that influence the exchange rate

Exchange rate is the value of one currency relative to another

Past information is reflected in the floating exchange rate (supply
and demand factors) and new information will impact it

Demand for currency

Supply for currency

Equilibrium exchange rate

The curve is download sloping

The cheaper the local currency, the
greater the demand for currency by
the rest of the world
There is a demand for currencies to
purchase goods, services, and
financial assets denominated in a
foreign price
As a currency depreciates, its
goods and services become
cheaper and thus more will be
demanded increase the quantity
of local currency demanded in the
FX
Supply of local currency in the FX
occurs when we buy foreign
currency
When local currency price
increases, the relative price of
foreign currencies decrease, thus
the demand for foreign g&s
increase supply of local currency
in the FX increases
Exchange rate at point where
demand and supply curves
intersect

In a floating exchange regime, the exchange rate is determined by

the demand for and supply of a currency
Lower exchange rates will decrease the competitiveness of a
countrys export (because cheaper for foreigners to buy)
o Attracting buyers of local currency
As local currency appreciates, relative cost of foreign currencies falls
thus making exports more attractive
o Attracts sellers of local currency (i.e. buyers of foreign
currency)

16.2 Factors that influence exchange rate movements

Main factors that influenced exchange rate movements:

1) Relative inflation rates
2) Relative national income growth rates
3) Relative interest rates
4) Exchange rate expectations

5) Central bank or government intervention

Government central bank intervention central bank may also
influence currency by:
o Direct policy altering relative inflation rate, income growth,
interest rates
o Intervening in international trade flows
o Intervening in foreign investment flows
o Directly intervening in the FX market

Chapter 13: Interest Rate Determination and

Forecasting

RBA maintains overnight inter-bank cash rate at a specified rate

influence desired economic performance outcomes over the longer
term
Country CB responsible for implementing monetary policy by
influencing interest rates to maintain inflation within a defined band
or range in order to achieve desired economic outcomes
Inflationary target for Aus is 2-3% over the economic/business cycle
Main monetary policy used by banks are open market operations
to maintain the inter-bank overnight cash rate at a specific interest
rate
Cash rate changes will flow onto other interest rates which
eventually results in changes in economic activity

13.1 The macroeconomic context of interest rates

Central banks may increase interest rates (i.e. tighten monetary policy) if
there is:

Inflation above target range

Excessive GDP growth
Deficit in Current Account (in balance of payments1)
Credit and debt growth levels rapid
Unsustainable prices in major sectors e.g. property and mining
sector
Currency under excessive downward pressure in FX markets

When banks tighten monetary policy:

Slow spending in the interest-sensitive areas of the economy (e.g.

investments )
Slows down and weakens the position of suppliers, therefore the
rate of suppliers increasing prices will fall
Prices decrease
As price decrease, inflation rate will decline
Also, balances out economys production and spending thus reduces
demand for imports which eventually improves the balance of
payments
An increase of ST rates will attract foreign investment increase in
demand for local currency currency appreciation

1 Balance of payments are a record of a countrys transaction with the rest of the
world

o Foreigners borrow money from their home country at a lower

rate which yields higher returns in foreign investments
o Lower interest rates are unattractive to foreign investors
As spending slows and there is more of a balance between the economys
production and spending levels, the demand for imported goods and
services from overseas should decrease, bringing about an improvement
in the balance of payments. Finally, by increasing short-term interest
rates, it is likely that there will be an increase in the flow of investment
funds into the country, and as a result there will be an increase in the
demand for the local currency in the FX market. The price of the currency
would be bid up and would appreciate

Tightening monetary policy reduces money supply and liquidity in

the financial system
Income effect: Reduced levels of spending lower income in all
sectors
Employment growth declines, demands for g&s eases, and tax
revenue decreases
Demand for loans also fall due to the slowing economic activity
easing interest rates
Slower pace of the economy will ease inflation rates and allow
interest rates to ease as well inflation effect

Open market operations

CB implements monetary policy through open market operations

Three main strategies
1) Direct buying/selling of govt securities
2) Repurchase agreements
3) Foreign currency swaps
These transactions affect money supply and liquidity

Liquidity effect

Effect on money
supply and
system liquidity
of a CBs open
market
operations

Income effect

If interest rates
rise, economic
activity slows and
income will fall
thus easing rates
It is the flow oneffect from the
liquidity impact

Inflation effect

As economy slows,
upward pressure
on price will ease
thus allowing
interest rates to
fall

Economic indicators: data that provides an insight into possible

future economic growth
Business cycle peak and trough

Leading Indicators economic variables that change before

there is a change in the business cycle
o Useful for anticipating changes
Housing loan approvals

Coincident indicators variables that change at the same time

as a business cycle change
o Provide same time tracking of economic activity level
o E.g. these indicators increase as growth rate of economy
increases
Non-farm payroll data and industrial production

Lagging indicators variables that change after a business

cycle change
o Useful in confirming that an increase, or decrease, in
economic growth has taken place
Unemployment rate data

Reflection

If inflation rate is forecast to exceed above a specific range, the CB

will increase interest rates; tighten monetary policy
Monetary policy changes have three effects over time:
1) Liquidity effect
Changes in funds that are available for lending
2) Income effect
Changes in economic activity and thus, future income
levels
3) Inflation effect
Eventual impact on inflation of the liquidity and income
effects

The initial liquidity effect on interest rates is offset by the opposite

effects of income and inflation effects
As liquidity pushes up interest rates (by decreasing money supply/
how?), the income and inflation effects will cause interest rates to
decline

Market participants monitor the economic indicators to gain an

insight into the growth of the economy and the future direction of
monetary policy
Published economic data may be leading, lagging, or coincidence

13.2 The loanable funds approach to interest rate

determination

LF is an approach to explaining and forecasting interest rates

Interest rate is determined by supply and demand for loanable funds
Loanable Funds are funds available for lending within the
financial system
Demand for LF will decrease as I.R rise and vice versa

Demand for loanable funds

Business Sector

Demand for loanable funds

Government Sector

Finance short-term working capital

and longer-term capital investment
The lower the rate of interest, the
more debt funds demanded

Finance annual budget capital and

recurrent expenditures
Fund budget deficits

Fund daily liquidity shortfalls that will

occur intra-year liquidity

Public sector borrowing

requirement: required borrowing of
government and their
instrumentalities

Borrowing of the government

sector are independent to the
rate of interest

Increases or decreases in government

borrowing results in a shift of the Gcurve

Should the total government

borrowing requirement be negative

due to budget surplus, the G curve

would disappear and the surplus
represented as savings in the S curve

Demand of both sectors are combined to give the total demand for loanable
funds denoted G + B

Supply of loanable funds

Three principal sources:

Savings of household sector
Changes in money supply
Dishoarding

Sources of funds
Savings of household
sector

Description

Upward sloping

As interest rates increase, people will save a larger

proportion of their incomes

Changes in money
supply

Dishoarding

The total amount of money in the economy i.e.

circulating money and deposits

Changes in money supply are represented by a parallel

shift in the SHH curve

If money supply increase, the SHH curve STR and vice

versa.

Changes in money supply will NOT change the slope of

the curve. It only shifts it out/inwards depending on
whether change is positive or negative

Changes to money supply may occur through banks

buying/selling CGS
Situation where normal cash holdings are reduced and
invested into financial instruments

A proportion of savings comprises of hoarded currency

Currency that is hoarded will not be available for

lending unless deposited or invested

Increased interest rates provide an incentive for

hoarders to deposit and invest funds to acquire the
increased yield

Therefore, as interest rates increase, more funds are

made available

As rates fall, there is less incentive to invest cash

holdings and hoarding will take place reduction in
loanable funds

There is a problem with the LF approach

Final equilibrium interest rates cannot be determined because the S
and D curve not independent to each other i.e. they are
interdependent
Changes in supply cause changes to demand for funds
As shown in Page 432,
o At a given interest rate, dishoarding will occur and the supply
curve will adjust upwards (i.e. steeper slope)

o The increase in money supply and dishoarding results in lower

interest rates (observe graph) and thus business demand for
funds (B) will increase shift the demand curve to the right
o However, (G) will decrease b/c higher levels of national
income and production = more tax recipients and less funding
on unemployment benefits = lower budget deficit = lower
borrowing requirement

13.2.4 Loanable fundsan expected increase in the

level of economic activity

Business sectors are first to respond to the expectation of increased

economic activity
Increase demand for funds to finance investments to exploit
anticipated increase in demand for goods and services
Increased B shifts demand graph to the right thus increasing interest
rates (akin to income effect)
Why?
o Businesses looking to invest borrow funds from the banks or
issue securities
o As supply of securities increases, their prices will decrease
and yields will increase
Supply of securities is basically supply of debt i.e.
decreases money supply thus increase interest rates
o These lower prices and higher interest rates (yields) will
induce dishoarding
Increased business investments increased economic activity
relieves upward pressure on interest rates as well as improve
government deficit

Reflection points
13.3
The
term

LF approach accounts for factors that influence demand and

supply for loanable funds (funds available for lending in the
financial system)

Demand curve comprises of government and business sector.

Government borrowing is unaffected by interest rates, whereas
business sector demand will fall as interest rates rise

Supply curve comprises of savings, changes in money supply,

dishoarding
Savings are from HH
Changes in money supply are from CB open market
operations
Dishoarding relates to cash funds held outside the financial
system

Equilibrium interest rate is where the S and D intersect

Expected increase in economic activity initial result of

increased business demand for loanable funds (companies want
to take advantage of anticipated increase in demand due to
increasing economic activity upward pressure on interest rates
initial changes may either increase rates further or relieve
pressure on interest rate rises

Anticipation of rising inflation rates increase in interest

rates

structure of interest rates

Yield: total rate of return on an investment

Yield curve illustrates term structure of interest rates for a
specific security at that point in time
Yield curves come in different shapes determined by market
expectations with respect to future interest rates

Normal/Positive yield curve

Inverse/Negative yield curve

Humped yield curve

LT interest rates are higher

than ST rates curve slopes
upwards
ST rates > LT rates curve
slopes downwards
Shape of yield curve changes
over time from being a
normal yield curve to an
inverse yield curve

Term structure is important as rate changes affect borrowing costs

and investment returns
Three major theories to understand slope and shape of yield curve:
o Expectations theory
o The segmented markets theory
o Liquidity premium theory

13.3.1 The expectations theory

Current ST interest rates and expectations about future ST interest

rates are used to explain shape of yield curve
LT interest rates = average of ST rates and expected future ST rates
Expectations theory based on the following assumptions:
o Large volumes of investors hold homogenous expectations of
future value of ST interest rates
o No transaction costs
o No obstacles to changing market rates
o Investor objective is to maximise expected return
o All bonds are perfect substitutes for each other
o And investors are indifferent between holding long-term and
short-term maturity instruments
Hence, for the inverse yield curve, future ST rates are expected to
be lower than current ST rates
Normal yield curve future ST rates expected to be higher than
current ST rates
Humped yield curve expect ST rates to initially rise and then fall

13.3.2 The segmented markets theory

Rejects two assumptions of the expectations theory in that:

o All bonds are perfect substitutes for each other
o And investors are indifferent between holding long-term and
short-term maturity instruments
It is the relative demand and supply of securities at various
maturity ranges that determine yields
E.g. when CB sells ST securities, price of bonds will decrease (b/c
increased supply) and their yields would increase (bond price and
interest/ yield rates inverse relationship) thus
o Short end of yield curve would lift inverse yield curve
Disturbances will occur in securities with ST maturity but will not be
felt in LT end

13.3.3 The expectation approach vs. segmented

markets approach

Segmented approach does not account for arbitrage

Also, unable to explain monetary policy effects and shape of yield

curve
Segmented markets accounts only for risk managers and ignores
speculators and motivations of other participants

13.3.4. Liquidity premium theory

Investors prefer short-term securities and thus require a

compensation to invest for longer periods
Lenders are less exposed to default risk over the short-term
o Default-risk: risk that borrower may not meet financial
commitments
Thus, lenders are willing to accept lower yields on ST investments
for greater liquidity and reduced risk exposures
Thus, investors require compensation as an incentive to invest for
longer periods
There are greater risks associated to LT securities liquidity
premium
Manipulate the pure expectations theory to include the premium
which is the higher yield received for the increased risk of investing
for a longer period
The longer the term to maturity, the higher the premium
Expectations yield curve observed yield curve b/c of liquidity
premium
Premium cannot flip an inverse yield curve during tight monetary
policy
o Instead, it reduces the steepness

13.4 The risk structure of interest rates

Government bonds tend to have zero default risk and serves as a

benchmark rate for comparing other securities
o The risk-free of return
Securities issued by other borrows involve default risk may not
meet financial commitments

o Thus, lender may demand a higher return rate when lending

to the said borrowers to offset the higher risk

Expectations theory LT rates will be the average of expected future ST

rates
Thus, normal yield curve indicates expectation that future ST rates will rise,
whereas inverse shows that future ST rates will fall
Segmented markets theory rejects two expectation theory assumptions
All bonds are perfect substitutes
Investors are indifferent about holding ST or LT securities
Thus, yield curve is influence by S and D factors
Liquidity premium investors prefer ST securities and thus require higher
yields to invest in LT securities
Liquidity premium increase steepness of yield curve
LT yields will be higher
Every borrower has a perceived level of risk
The yield curve reflects the risk premium applied to that issuer by
the borrower
Government bond yields are risk-free rates
All borrowers pay a premium above the risk-free rate
This is known as the risk structure of interest rates

Chapter 19: Futures Contracts and

Forward Rate Agreements

Derivatives are used to manage financial risk and commodity

risks
Derivative prices are based on the underlying asset (commodity or
financial instrument) available in the physical market
Lock in prices today that apply at a later specified date
Contracts are standardised exchange-traded contracts formal
futures exchange
Forward Rate Agreements are OTC derivatives where its terms
and conditions can be negotiated with the provider

19.1 Hedging using futures contracts

Futures contracts are legally binding agreements between two

parties to buy/sell a specified commodity or financial instrument at
a specified date in the future at a price determined today
A hedge manages exposure to price risk by locking in a price today
that applies in the future e.g. locking in a future interest rate
Hedge strategy
Conduct initial transaction in futures market today that
corresponds with what you intend to do in the physical market
at a later date

Close out the open futures position by buying/selling an

opposite contract at maturity
Profits/losses made in the futures transaction is offset against
the physical market transaction

19.2 Main features of a futures transaction

Exchange-traded contract
o Standardised financial contract traded on a formal exchange
Tend to offer contracts based on underlying assets available
in the country
o E.g. the ASX Trade24 offers Commonwealth Treasure bond
futures and the Eurex offers German government bond
contracts
Price quotations on futures may differ
o The US and Euro-market bonds are quoted on basis of clean
price which is the present value of the bond less accrued
interest, whereas AUS bonds are based on yield-to-maturity

19.2.1 Orders and agreement to trade

An order normally specifies the following

o Buy or Sell order
o Type (e.g. 10-year Treasury bond)
o Delivery month/ value date/ expiration date
o Price restrictions that may apply
Market order buy or sell at current market price
Limit order buy or sell at specified price within a
certain time
o Time limit
Clearing House: records transactions conducted on an exchange
and facilitates value settlement and transfer
Novation: process whereby one party to a contract is replaced with
another part
Whilst contracts to buy/sell were made between the two companies,
in effect, the ASX becomes the other party to each contract

19.2.2 Margin Requirements

Long position: when underlying asset has been brought forward

(i.e. currently own it)
o An agreement to buy a futures contract
Short position: entering into a forward contract to sell an asset
that is not held at the time
o Agreement to sell futures contract
When entering into a contract, parties must pay an initial margin
into the clearing house to cover for adverse price movements in
futures contracts and default risk

o Ranges between 2-10% and change accordingly to the price

volatility of underlying asset in the futures contract
Marked-to-market: periodic repricing of existing contracts to
reflect current market valuations
o ASX reprices daily

19.2.3 Closing out of a contract

Able to close open positions by entering into a contract that is

opposite and identical to the initial futures contract transaction
before maturity date
Read process at page 607

19.2.4 Contract delivery

Futures market participants are either trying to hedge risk or

generate profits
They do not actually want to deliver/receive physical goods within
the contract
Thus, future contracts are closed out before the delivery/maturity
date
Standard delivery settled by physical delivery of specified asset
Cash settlement

19.3 Futures market instruments

Futures contracts develop in markets where the underlying asset is

freely traded, easily standardised, experiences price volatility, and
readily available or cash settlement possible
Contracts vary between international FX; are based on local
commodities and financial instruments
Commodities: gold, wool, frozen orange juice
Financial instruments: bonds, discount securities, currencies,
shares, and share indices

19.4 Futures market participants

Participan
ts
Hedgers

Description

Manage price risk to changes in interest rates, exchange rates,

and share prices
o Take the opposite position to the underlying transaction
Borrower concerned about rising interest rates and may sell
futures contract to hedge the risk exposure

Speculat
ors

Traders

Arbitrag
eurs

Make profits by purposely taking risk. May construct a:

o Straddle buy/sell contracts with different delivery dates
to benefit from price variances
o Spread position buy/sell related or same value-date
contracts to benefit from price variances
Speculators take up risks that hedgers avoid and generally
constitute a large volume of the trading market
Enter the market with an expectation that market price will move
in a direction favourable to them

Traders, similar to speculators, they buy/sell short-term

contracts (intra-day) in large volumes to exploit small price
changes
o Add depth and liquidity to the market
o Narrows bid/off spread
Orders are made on their own account (i.e. use own funds) or for
clients
Simultaneously buy/sell transactions in two or more markets to
exploit price differentials between markets
Make profit at no risk

Hedging Rule:

Conduct a transaction in the futures market today that

corresponds with the transaction to be carried out in the
physical market at a later date

Hedging the cost of funds (borrowing funds)

Physical or Fixed Interest Market
Today

Futures market
Today

Expects to borrow an X amount of money in 3

months. The current interest rate is R but is
forecast to rise

Sell one bond (essentially borrowing funds). Price

it using discount formula

In three months
Issue bond with face value of X at a yield of Y.
Discount.

In three months
Company buys an identical bonds contract to
close out on their futures position

A funds manager wishes to buy bonds in three months time

conduct a corresponding future transaction today

Physical or Fixed Interest Market

Today
Expects to buy bonds in 3 months

Futures market
Today
Buys the bonds

In three months
Company buys the bonds

In three months
Company sells the bonds to close out on their
futures position

Effective cost of borrowing = net cost of funds divided by

total amount of funds
Total amount of funds = discounted value + futures profit
Net cost of funds = Discount amount LESS futures contract
profit

Hedging the cost of foreign currency

Spot Market
Today
Importer buys goods @ USD85,000 and agrees to
pay USD in 3 months. Spot AUD/USD 0.9500
In three months
Spot AUD/USD 0.9190. Importer pays
USD85000 at a cost of AUD92491.83.

Futures market
Today
Sell one futures contract at AUD/USD 0.9400

In three months
Close out by buying one identical contract

With a borrowing hedge; sell relevant futures contracts today and

close out its position by buying an identical futures contract
Profits/losses will be offset by the net cost of borrowing
FX risk can be hedged by buying/selling futures contract in the
required foreign currency
Share portfolio risk can be hedged by buying/selling future contracts
based on listed companies, or share-market indices

19.6 Risks associated with futures contract hedging

strategy

Perfect hedge may not be possible

When dollar value of risk is not perfectly matched by the
standardised dollar value risk of exposure
Greater risks arise from price movements in the physical market
that do not perfectly match with price movements in the futures
market i.e. difference between the price in the physical and futures
market
o Difference in prices is known as basis risk
o Initial basis risk vs. final basis risk
Cross-commodity risk arises due to limited range of futures
contracts on commodities or instruments
o Use a selection of futures contracts whose price movements
are highly correlated with the price of the asset to be hedged
Standard contract size not possible to perfectly match the
physical asset exposure to futures market exposure as the contract
sizes are standardised and cannot be adjusted to meet
Margin Payments initial margin deposit to ASX clearing house is
required and further cash will be required should prices move
adversely (marked-to-market margin calls)
o Opportunity cost associated with the margin requirements

19.7 Describe, illustrate, and calculate the use of a

Forward Rate Agreement (FRA) for hedging interest rate
risk

FRAs are OTC

Do not have standard contract sizes, delivery dates, and no margin
calls
Lock in an interest rate at a specified date, based on a specified
notional principal amount
Although, FRA does not facilitate borrowing/investing of funds, but it
used as a risk management tool
At commencement, FRA specifies the fixed FRA agreed rate applied
on either three-month money or six-month money at a future
date
Agreed rate is compared to nominated reference rate to discern the
compensation amount payable on the settlement date
o Reference rates may be LIBOR, USCP, BBSW
At settlement, one party to the FRA compensates the other for any
interest rate movements between agreed rate and reference rate
In a borrowing hedge, the FRA writer compensates the buyer should
the reference rate exceed the agreed rate

o Compensation offsets current higher cost of borrowing in the

physical debt market
Compensation amounts are calculated via discount formula

Additional notes from test bank

Futures are highly standardised but the quoting conventions differ between exchanges
Also, contracts traded between exchanges differ because exchanges trade future
contracts based on the securities issued/traded in that country
o Types of contracts traded between exchanges differ b/c differing underlying
assets
o E.g. Sydney Futures Exchange (SFE) trades Commonwealth Treasury bonds
futures, Eurex offers Euro-Bund contracts
Quoting conventions also differ
o Australia markets bonds based on YTM
o US bonds based on clean price (PVbond less accrued interest)
Hedger enter position where any changes in physical market price is offset by P/L
generated in the futures market
Futures contracts are usually not delivered; and most traders close out their position
by entering into an opposite position of the identical contract
Characteristics of the Sydney Futures Exchange (SFE):
o Formerly open outcry
o Trading occurs via electronic system which matches buy/sell orders
o Clearing-house enforces payments of margins
o Bond futures contracts are quoted in terms of YTM, not price
Process?
o Brokers pass orders to dealers who enter their orders into the SFE electronic
trading which automatically matches the orders
For the SFE, if the price of a contract changes, only the party who has incurred a loss
will be required to top up the initial margin
When parties enter into a contract, they do not have to pay the full price, but rather the
initial margin (which is held by the clearing-house) and change dependent upon the
volatility of the underlying stock price
o It will cover up the potential loss amount
When initial margin is not sufficient to cover contract, company is required to top up
their margins with the clearing house maintenance margin call
o Ensures that parties don't default on their contracts should the price move
against them
Novation facilitates ease of entry/exit from the market
o Clearing-house (ASX) contracts with the opposite parties so that open
positions remain unaltered by transactions
For settlement, treasury Commonwealth bond contracts and SFE/SPI200 are not
physically deliverable! can only be cash settlement

Although, BAB can be physically delivered in the form of a physical BAB or bank
Negotiable Certificates of deposit or their electronic equivalent
All futures contracts must be settled (they do not simply expire)
Those who engage in futures do so to manage risk or generate profits and do not
actually wish for physical delivery
o Thus, majority of futures are closed out before delivery date
Basic hedging rule:

Hedger should carry out the same transaction in the futures

market today that is to be carried out later in the physical market

BABs, options on BABs, and Treasury bonds can be used to manage interest rate risks
The share price index is used only to manage risk in fluctuations in the equity
market (not interest rates)
Examples of hedging:
o A borrower can lock in the cost of borrowing by selling futures
contracts in order to protect against the risk of rising interest
rates.
o An investor can lock in the yield on an investment, and protect
against the effects of falling interest rates, by buying futures
contracts.
o An importer with FX payables, or a company having to make
interest payments to foreign lenders, can lock in the price of
the required foreign currency by buying FX futures (selling
AUD futures).
o A portfolio manager who anticipates a decline in the share
market can sell sharemarket index futures contracts to protect
the value of the portfolio.
o An investor who expects to buy shares at some time in the
future, but who also expects the share market to rise before
buying the shares, can obtain protection by buying specific
company share futures contracts now.
Speculators provide information on the expected future direction of
the price of physical market commodities forecast future price
trends
Arbitrageurs bring about price changes until contracts are brought
intro equilibrium
o Simultaneously buying/selling orders across markets to
generate risk-free profit
When conducting calculations:

Account for standard futures contract sizes!

Basis risk is the difference b/w physical price and futures price of
same underlying asset
If entering into a position with no expiration, basis risk will occur and
introduces a degree of uncertainty when it comes to hedging
Initial basis risk: pricing differences at commencement of hedging
strategy vs. final basis risk
Cross-commodity hedging futures contract based on one asset
to hedge risk exposure associated with a different asset
o Why? b/c futures exchange offers limited no. of futures
contracts based on limited range of assets
o Cross-commodity hedging uses a future where its price is
highly correlated with the price of the other asset
Forwards
o No margin deposits, no formal markets, and risk involved
o FRAs are not standardized and can be altered to meet needs
of parties involved

Forwards
Advantages:
OTC contract, not standardized like futures contract. Flexible in
terms of contract period and amount.
No margin requirements, unlike futures
Disadvantages:
Risk of settlement b/c no clearing house
There is no formal market (unlike futures) not easy to close out
on FRA position

Forwards lock in interest rates to be applied at a specified future

date based on notional principal amount (INTEREST only agreement)
o there is no exchange of principal
contract is settled when one party compensates the other a
monetary value of the difference between FRA agreed and
settlement rate
When futures closed out well before expiry basis risk is
present

Chapter 20: Options

Futures allow hedgers to lock in a price to manage risk exposure

which protects against adverse risk
However, such methods do not allow exploitation if price
movements benefit the hedger
Option contracts allow hedgers to cover for adverse risk exposure,
but still take advantage of any possible upside in price movements
Option contracts:
o May be private contracts between two parties
o Exchange traded contracts have largely replaced OTC options
o OTC and exchange traded options are both important

o Commercial banks and investment banks are major providers

in OTC option contracts
o Those available in Aus. are share options, warrants, low
exercise price options, and options on futures contracts
(trading warrants have grown rapidly)

Terms
Option
Contract

Definitions

The right, not the obligation, to buy/sell a commodity or

security at a predetermined exercise price
The option buyer pays the option writer a premium
Option premium payment is made by the contract buyer
at the commencement of the contract
Specified price in the options contract at which the option
buyer can buy/sell

Exercise Price
or Strike Price

Physical Market

Market where commodities or financial instruments are

issued/traded

European
options

Options that can be exercised on the specified date

American
options

Options that can be exercised at any time up to the

expiration date

The maximum profit obtained by the writer of the call (i.e. party who
sold call contract) is limited to the premium
However, the loss potential for the writer is unlimited
o It is expected that (e.g. call) writers would close out negative
position by taking on a risk management strategy e.g.
Buying an opposite contract
Maintaining a covered position by buying and holding
the actual shares in the physical market before the stock
price exceeded the exercise price

Covered Call

Call option writer buys a call

option in the same asset but
with a lower exercise price