Anne Sibert

Lecture 2: The Foreign Exchange Market

Autumn 2013

The Foreign Exchange Market

• The foreign exchange market is by far the largest and most liquid financial market in the world.

• It is many times larger than the next largest market: the US government securities market.

• Despite its size and importance of the foreign exchange market, it is largely unregulated. No international organization supervises it; no international institution sets rules.

From a 1998 publication by the NY Fed:

• Individual trades of $200 – 500 million are not uncommon.

• Quoted prices change as often as 20 times a minute.

• It is estimated that the world’s most active exchange rates can change 18,000 times a day.

Global Foreign Exchange Market Turnoverin the Traditional Foreign Exchange Market

Daily averages in April in billions of US dollars at April 2010 exchange rates

0

500

1000

1500

2000

2500

3000

3500

4000

4500

1998 2001 2004 2007 2010

Source: BIS

This is just the turnover in the over-the-counter (OTC) traditional foreign exchange market: the market for foreign exchange spot, forward and swap transactions.

It does not include other OTC derivatives.

It does not include trading in foreign currency futures and options on organised exchanges.

But, these are relatively small.

Reasons for the Changes

• The fall in 2001 was due to: the introduction of the euro, consolidation in the banking sector, mergers in the corporate sector.

• The recent rise is more difficult to explain in terms of fundamentals.

• Perhaps some of the rise is due to innovations in electronic trading that allow high-volume high-frequency trading.

It is a 24-hour market

• The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore.

• A few hours later, trading begins in Bahrain.• Late in the Tokyo day, markets open in

Europe.• In the early afternoon in Europe, markets

open in the United States.• In the mid to late afternoon in New York,

markets open in the Asia-Pacific area.• Most of the activity takes place when

European markets are open.

Geographic Distribution of Turnover

(in percent)

0

5

10

15

20

25

30

35

40

2004 2007 2010

Germany

SingaporeJapan

United Kingdom

United States

Source: BIS

London is the largest market

• London’s size as a financial centre is partially due to its historical importance and it relative lack of regulation.

• London benefits from its proximity to major Eurocurrency markets.

• London benefits from its time zone: London’s morning overlaps with late trading in the Far East and London’s afternoon overlaps with New York.

• Most of the trading in London is done by foreign-owned institutions.

Cross (1998)

• In the late 1990s about 100 – 200 market making banks where half of most transactions. These were mostly commercial banks and investment banks. They trade with customers and with each other. They were mainly linked through telephones.

• The old telephone system is gradually moving to electronic trading and 30 percent of all transactions are done online. This allows other financial institutions to trade with each other.

Foreign Exchange Market

Electronic Trading

• Electronic trading offers anonymity, transparency (all prices are shown) and lower costs.

• Electronic trading platforms are offered by individual banks, groups of banks and by independent companies.

Market Makers

• A market maker for a currency is a dealer who regularly quotes the rates at which he is willing to buy and to sell that currency.

• During normal hours, he creates a two-sided market for its customers. He is willing (within reason) to both buy and sell at the rates he quotes.

• He makes a profit from the spread; that is the difference between the selling and buying rates.

By Type of Reporting Bank’s Counterparty

(percent)

Other Participants

• Interbank trading no longer dominates the market. In 2010 only 39 percent of reporting dealers’ transactions were with other dealers.

• Other financial institutions: mutual funds, pension funds, hedge funds, central banks and smaller banks have become much more important. In 2010 48 percent of reporting dealers’ transactions were with “other” financial institutions.

Number of Banks Accounting for 75 Percent of the Turnover

0

5

10

15

20

25

30

UK US Japan Singapore Hong Kong

2001

2004

2007

2010

Banking offices, not organisations. Source: BIS

Top Dealers(in terms of trading volume)

Central Banks

• Central Banks intervene in the foreign exchange market to influence the value of their currency.

• Many central banks serve as the primary banker for their government and for other public enterprises.

• Some central banks (for example, the Federal Reserve Bank of New York) act as agent for other central banks.

• Some central banks actively manage their foreign exchange reserves.

Currency Distribution of Forex Turnover

0

10

20

30

40

50

60

70

80

90

US dollar Euro Yen Pound Swiss franc

2004

2007

2010

Because there are two currencies in each transactions, the sum of all percentage shares is 200. Source: BIS

The dollar is the most important currency

• Many central banks hold the bulk of their reserves in the form of dollars; many central banks conduct much of their intervention in dollars; many international transactions are done using dollars; many contracts are invoiced in dollars.

• The dollar is the major “vehicle” currency: if a dealer wants to trade Swiss francs for Mexican pesos, he will probably trade the francs for dollars and the dollars for pesos.

• Only 10% of all transactions involve the euro vs. a currency other than the dollar.

Use as a unit of account

• About 95 percent of US exports and 85 percent of US imports are priced in dollars.

• About a third of Euro Area exports and 40 percent of Euro Area imports are priced in dollars.

Types of Transactions Daily averages in April in billions of US dollars

0

200

400

600

800

1000

1200

1400

1600

1800

2000

1995 1998 2001 2004 2007 2010

SpotOutright Forward

Swap

Source: BIS

From the Financial TimesCurrency

Australia (A$) 0.9826

United Kingdom (£) 1.5774

one-month 1.5769

three-month 1.5760

one-year 1.5726

Euro (euro) 1.3796

one-month 1.3791

three-month 1.3786

one-year 1.3778

How to read this

• These are rates taken at an instant in time from one source: 4:00 pm from Reuters.

• Currencies other than the pound and euro are quoted in currency units per dollar; the pound and the euro are quoted in dollar per pound or euro.

• For some important currencies we also get the one-month, three-month and one-year forward rates

Def. An exchange rate is the price of one currency in terms

of another.• A complication is that there are two ways to

express any exchange rate.

• Direct quote: the number of units of home currency necessary to buy one unit of foreign currency - the home currency price of foreign currency

• Indirect quote: the number of units of foreign currency necessary to buy one unit of home currency - the foreign currency price of home currency

The base currency

• Suppose the exchange rate is expressed as e units of currency B = 1 unit of currency A (That is, e is the price of currency A in terms of currency B)

• Currency A is called the base currency. By convention, the euro is the usual base currency against other currencies: the EUR/USD exchange rate is 1.3796. (Note EUR/USD does not mean euros per dollar or euros/dollar)

• The pound is the usual base currency against all other currencies than the euro.

Triangular Arbitrage

• Opportunities for triangular arbitrage arise when direct quotations (exchange rates in terms of the dollar - this is another sense of this word) and cross-rate quotations (two other currencies against each other) allow for profit making.

• This entails using one currency to buy a second, a second currency to buy a third, and a third currency to buy the first.

Example of Triangular Arbitrage

• Suppose the pound is quoted at 1.6000 dollars per pound.

• Suppose that the euro is quoted at 1.4000 dollars per euro

• Suppose that the pound is quoted at 1.0000 pounds per euro.

• Trade 1 euro for 1 pound. Trade 1 pound for 1.6000. Trade 1.6000 dollars for 1.6000/1.4000 = 1.1429 euros: a profit.

To find what the cross rate must be:

• Suppose the pound is quoted at 1.6000 dollars per pound.

• Suppose that the euro is quoted at 1.4000 dollars per euro

• Then pounds / euro = (pounds /dollar) x (dollars/euro) = (dollars / euro) / (dollars / pound) = 1.4000 / 1.6000 = .8750.

Another example:

• The Sri Lankan rupee is trading at 108.415 rupees per dollar.

• The Malaysian ringgit is trading at 3.50580 ringgits per dollar.

• The cross rate is rupees / ringgit = (rupees/$) / (ringgits/$) = 108.415/3.50580 = 30.9245.

Learn how to compute cross rates

• Suppose you are given exchange rates for currencies A and B in terms of currency C and that you are told to find the price of currency B in terms of currency A (or equivalently, units of currency A / currency B).

• First, find the exchange rates for A and B in the form: units of A / units of C and units of B / units of C.

• Then: units of A / units B = (units of A/units of C) / (units of B/units of C)

The Spread• Foreign exchange dealers quote two rates: the rate at which

they will buy the currency and the rate at which they will sell the currency.

• Example: A newspaper may report that the Swiss franc had a central rate of 1.5024 francs /$ and a bid/offer spread of 020 – 028.

• This means that the two exchange rates were 1.5020 and 1.5028. The dealer would buy dollars (sell Swiss francs) for 1.5020 Swiss francs per dollar. He would sell dollars (buy Swiss francs) for 1.5028 Swiss francs per dollar.

• When expressed as units of currency per dollar, the smaller rate is the bid rate: the rate at which the dealer will buy (bid for) dollars. The higher rate is the offer rate: the rate at which the dealer will sell (offer) dollars.

• In the wholesale market (as opposed to the money changers on Tottenham Court Road), the spread is very small. In normal times the spread on the dollar / euro exchange rate is under a pip: 1.3400 – 1.3401 if we are talking about a big transaction between two major banks.

We can find cross rates with spreads

• In European form: The Swiss franc is 1.5020 – 1.5088 and the Swedish krona is 10.0025 – 10.0075. Find the kronar/franc cross rates.

• The dealer will buy 1 Swiss franc for 1/1.5088 dollars. He will buy 1/1.5020 dollars for 10.0025/1.5088 = 6.6294 kronar. So, he will buy 1 Swiss franc for 6.6294 kronar.

• The dealer will sell one Swiss franc for 1/1.5020 dollars. He will sell 1/1.5020 dollars for 10.0075/1.5020 =6.6628 kronar.

• The kronar/franc cross rates are 6.6294 – 6.6628.

Types of Contracts

• Spot contracts -- a price and quantity are agreed upon. The two currencies are typically exchanged two business days later.

• Forward contracts -- a fixed price contract made today for delivery of a certain amount of a currency at a specified future date. The specified date is the settlement date and the agreed price is the forward rate. More precisely, the two currencies are exchanged on an agreed upon date which is a certain number of days or months after the spot date. Thus, a three-month forward contract is conventionally settled in three months plus two days. Typically, no money changes hands at the time the contract is written

Example of a Forward Contract

Frank Dollar, the foreign exchange manager at the Big American Automobile Company was informed that the BAAC is importing parts from Japan at a cost of 600 million yen, to be paid upon delivery in two months time. To protect the BAAC from exchange rate fluctuations, Frank Dollar arranged to purchase 600 million yen forward from Mega Bank. The two-month forward price was 120.00 yen/dollar. In two months and two days, Dollar paid 5 million dollars and received 600 million yen.

The Timing of the Contract

• At time zero: All of the details of the contract were worked out

• At time zero plus two months and two days: The exchange is carried out.

Eurocurrency Markets

• Eurocurrency refers to deposits in a commercial bank which are denominated in a currency other than the currency issued by the country the bank is resident in. For example, a bank deposit denominated in dollars in a bank located in London is a Eurodollar deposit. It does not matter whether the bank is Barclays or an American bank.

Historical Background• The Eurodollar market arose in the 1950s. The Soviet Union

had large amounts of dollars from their oil sales. They did not want to hold them in the United States because of fears that the US would freeze them.

• They found European banks that would accept their dollars as deposits. It is said that one was a French bank with the cable address eurobank, hence the name. Thus, there arose a large pool of dollars outside the United States and outside the control of US authorities.

• In 1958 the British government introduced a restrictions on capital flows. British banks tried to get around these regulations by issuing loans dollar loans.

• Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the late 1980s onwards, US companies began to borrow and hold money offshore. British banks found it attractive to make loans in dollars.

• London is the most important centre.

Covered Interest Arbitrage

i = one-year interest rate on (Eurocurrency ) deposits denominated i* = one-year interest rate on (Eurocurrency) deposits denominated in the foreign currencye = spot price of the home currency in terms of the foreign currencyf = one-year forward price of the home currency in terms of the foreign currency

An investor has two options

• He can take one unit of the local currency and deposit it in an account denominated in the local currency.

• At the end of the year, he will have 1 + i units of the home currency.

He can take one unit of the home currency and

simultaneously:• buy e units of the foreign currency and deposit

it in an account denominated in the foreign currency. This will cause him to have (1 + i*)e units of foreign currency at the end of the year.

• enter into a forward contract to sell (1 + i*)e units of the foreign currency at the end of the year at a forward rate f.

• At the end of the year, his account will be worth (1 + i*)e units of foreign currency; he will carry out the forward transaction and end up with (1 + i*)e/f units of the home currency.

There will be arbitrage possibilities unless the two investment activities

yield the same amount of foreign currency:

•Thus, we must have: (1 + i*) / (1 + i ) = f /e.

•This relationship is called uncovered interest parity

Example

• Suppose that pound trades at 1.6000 dollars per pound the one-year US interest rate is 1.00 percent and the one-year UK interest rate is 2.00 percent.

• If you invest one pound you end up with 1.0200 pounds at the end of the year. Or, you can trade the pound for 1.6000 dollars, invest them at 1.00 percent and get 1.6000 x 1.0100 = 1.6160 dollars at the end of the year. If you entered into a one-year forward contract at the start of the year you could sell these dollars for 1.6160 / f pounds.

• So, it must be true that 1.0200 = 1.6160 / f and thus, f = 1.6160 / 1.0200 = 1.5804.