The Foreign Exchange Market. Role of Foreign Exchange Markets

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1 The Foreign Exchange Market Role of the foreign exchange markets Foreign exchange (FX) basics» Terminology» Types of contracts Organization and institutional features» Actors - brokers, dealers» Segments - Interbank (wholesale), retail» Tracking a deal» Activities - Hedging, speculation, arbitrage, market making Dimensions of the FX» By location, contract type, currency of denomination Prof. Levich C , Economics of IB Chapter 16, p. 1 Role of Foreign Exchange Markets Member nations of the International Monetary Fund» 182 in 1998, up from 156 in 1991» With few exceptions, each nation issues its own national money (why?) and controls it value (why?)» Exceptions: EMU (11 nations, one money); Panama (US$); former French colonies (French franc). In commodity trade between US and Japan» US (Japanese) exporters do not usually accept yen (US$) Main roles of the FX market» Medium of exchange - facilitate trade in goods and services» Medium of exchange - facilitate purchase/sale of securities» Medium to re-denominate and manage currency risk in stock asset or liability positions Prof. Levich C , Economics of IB Chapter 16, p. 2 1

2 Foreign Exchange Contracts (1 of 2) Spot contract» An exchange of two currencies for immediate delivery» A binding commitment» Quoting conventions: Direct terms (American terms): US$/foreign currency Indirect terms (European terms): foreign currency/us$ Foreign exchange swap» Simultaneous borrowing and lending of short-term bank balances in two currencies, for example Bank A borrows $10 million from Bank B for 1-month Bank B borrows $10 million worth of from Bank A for 1-month» Used to construct forward contracts and manage risks Prof. Levich C , Economics of IB Chapter 16, p. 3 Foreign Exchange Contracts (2 of 2) Forward contract» Agreement made today for obligatory exchange at specified time in future: 1, 2, 3, 6, 12 months from today» No exchange of funds on agreement day, or at any time until settlement date» Example: On 11/15/99 buy 1,000,000 1-month forward at $1.60/ On settlement date 12/15/99 when spot pound is $1.55 Take delivery of 1,000,000, pay out $1,600,000 Cash settle, pay $50,000 to cancel obligation» Quoting conventions Outright % premium or discount relative to spot Prof. Levich C , Economics of IB Chapter 16, p. 4 2

3 FX Terminology: Appreciation and Depreciation Because every exchange rate involves two currencies» Appreciation of the US$ against Depreciation of against US$» Depreciation of the US$ against Appreciation of against US$ Examples» Change from 1.50 $/ to 1.75 $/ Appreciation of against US$» Change from 1.50 $/ to 1.25 $/ Depreciation of against US$ Exact percentage measures depend on the base rate» x% depreciation of the Mexican peso x% more pesos to buy $1 from 4 MP/$ to 8 MP/$ 100% depreciation of the peso» y% appreciation of the US$ y% fewer dollar to buy 1 peso from $0.25/MP to $0.125/MP 50% appreciation of the US$ Prof. Levich C , Economics of IB Chapter 16, p. 5 Structure of the Foreign Exchange Market The Interbank FX Market Chase Bank Deutsche Bank Broker Hong Kong Shainghai Bank Barclays Bank Credit Lyonnais Bank of Tokyo J.P. Morgan Prof. Levich C , Economics of IB Chapter 16, p. 6 3

4 Structure of the Foreign Exchange Market The Retail and Interbank FX Market General Motors General Electric Microsoft Motorola Chase Bank Deutsche Bank Broker Prof. Levich C , Economics of IB Chapter 16, p. 7 Growth in Global FX Trading Billions US$ per day 1,600 1,400 1,200 1, Prof. Levich C , Economics of IB Chapter 16, p. 8 4

5 Daily Volume of FX Trading by Location percentage market share Others 16% Australia 2% Paris 4% Frankfurt 5% Zurich 4% Hong Kong 4% London 32% Based on April 1998 BIS survey of trading in 43 countries Final estimate of global FX trading: $1.5 trillion/day Singapore 7% Tokyo 8% New York 18% Prof. Levich C , Economics of IB Chapter 16, p. 9 Daily Volume of FX Trading by Location in billions of US$ London New York Singapore Hong Kong Frankfurt Australia Tokyo Zurich Paris Others Prof. Levich C , Economics of IB Chapter 16, p. 10 5

6 Percentage Share of Trading by Currency of Denomination Source: April 1998 BIS Survey US$ DM Yen Pound French franc Swiss franc Canadian Australian ECU and dollar dollar other EMS Note: Percentage shares sum to 200% because two currencies are involved in eash transaction Others Prof. Levich C , Economics of IB Chapter 16, p. 11 Daily Volume of Trading by Contract Type 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Spot Outright Forward FX Swap Prof. Levich C , Economics of IB Chapter 16, p. 12 6

7 Table 3.7 Daily Trading Statistics for an Actual Spot DM Interbank Trading Statistics for an Actual Spot DM Interbank Direct Brokered Total Transactions Transactions Transactions Number of Transactions Value of Transactions $0.8 billion $0.4 billion $1.2 billion Median Transaction Size $3.0 million $4.0 million na Median Spread Size DM na na Note: The above figures are daily averages for a single trader in the spot DM interbank market for the period Monday, August 3, Friday, August 7, Source: Richard K. Lyons, "Tests of Microstructural Hypotheses in the Foreign Exchange Market," Journal of Financial Economics 39 (1995): Prof. Levich C , Economics of IB Chapter 16, p. 13 Net Trading Positions, August 3 - August 7, 1992 for DM/US$ Spot Trader (in US$ Millions) Monday Tuesday Wednesday Thursday Friday Transactions in Chronological Order, by Day of the Week Prof. Levich C , Economics of IB Chapter 16, p. 14 7

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