Session 3 Foreign Exchange Market: An Introduction Developed by: Dr.Prabina Rajib Associate Professor (Finance & Accounts) Vinod Gupta School of Management IIT Kharagpur, 721 302 Email: prabina@vgsom.iitkgp.ernet.in Joint Initiative IITs and IISc Funded by MHRD - 1 -
Lesson - 3 Foreign Exchange Market: An Introduction Highlight & Motivation: Happenings in the foreign exchange market (henceforth forex market) form the essence of the international finance. The foreign exchange market is not limited by any geographical boundaries. It does not have any regular market timings, operates 24 hours 7 days week 365 days a year, characterized by ever-growing trading volume, exhibits great heterogeneity among market participants with big institutional investor buying and selling million of dollars at one go to individuals buying or selling less than 100 dollar. In this module, a brief introduction to forex market, details about trading volume, Evolution of Foreign Exchange Market and Foreign Exchange System are discussed. Learning Objectives: Briefly, the following aspects would be discussed in this module. Forex trading volume Forex trading locations Details about major traded currencies Evolution of foreign exchange market and foreign exchange systems Brief introduction to currency System Joint Initiative IITs and IISc Funded by MHRD - 2 -
3.1 Introduction to Forex Market: For most of us, the focal point of understanding international finance revolves around foreign exchange market. The foreign exchange market (also known as the currency, forex, or FX) is where currency trading takes place. It is a market where banks, companies, exporters, importers, fund managers, individuals, central banks of different countries buy and sell of foreign currencies. Forex trading involves a foreign exchange transaction, defined as the simultaneous buying of one currency and selling of another currency. As forex rates are quoted in pairs, e.g. Euro/US$, US$/Japanese Yen, US$/INR, etc., a trader trading in forex sells one of the currency pair and buys the other. As the subject progresses, we will develop more understanding about which currency is bought and which currency is sold and other aspects of forex trading. The forex market is an ongoing 24-hour, 365 days year market. Trading in forex market does not necessarily involve an exchange. Hence, the trading goes on the over-thecounter market (OTC market henceforth). Major foreign currency trading centers are located in London, Tokyo, New York. As the markets remain open at different time on a given day, normally GMT is used to refer the trading hours at different locations. For example, the trading duration in Asia is from GMT.00.00 till GMT 08.00. Trading duration in London is during GMT 07:00 till GMT 15:00. Trading in USA commences during GMT 13.00 till GMT 22.00. Trading in London starts at GMT 8.00 and ends at GMT 17.00. Trading in Tokyo starts in GMT 0.00 ( midnight) and ends GMT 9.00. A video available at http://video.yahoo.com/watch/4516514/12100450 very clearly explains the relationship between GMT and forex trading hours at different location. The volume of forex trading at given point of time is correlated with the number of markets opened at that time. Presently, the FX market is one of the largest and liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, financial institutions, exporters and importers. The average daily volume in the global foreign exchange and related markets is continuously growing. The daily turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements (BIS). The Since then, the market has continued to grow. Joint Initiative IITs and IISc Funded by MHRD - 3 -
According to Euromoney's annual FX Poll, trading volumes in USA grew a further 41% between 2007 and 2008. The Bank for International Settlements undertakes triennials survey to regarding various facets of foreign exchange market. According to the last survey conducted in 2007, average daily turnover in global foreign exchange markets is estimated at $3.2 trillion. It has grown in an unprecedented 69% compared to 2004. The Bank for International Settlements is regular with the publication of these triennial surveys. The readers must check the official website for the latest survey report to get update on details discussed in this module. As the 2007 report, average daily turnover of US$3.2 trillion comes from foreign exchange spot, forward and swap transactions. US$1.005 trillion in spot transactions US$362 billion in outright forwards transactions US$1.714 trillion in foreign exchange swaps US$129 billion estimated gaps in reporting The spot market relates to immediate purchase and sale of foreign currency while in a forward transaction parties agree to buy and sell foreign currency later. In swap transactions, parties agree to swap payment and receipt of foreign currency over a specified period. These last two sentences very briefly summarize the difference between spot, forward and swap transactions. In later modules, these contracts are explained in detail. 3.2 Foreign Exchange Market, Trading Volumes : Foreign exchange market is one of the fastest growing segments in the financial world. Details given in Table 2.A extracted from the Triennial Central Bank Survey December 2007 Foreign exchange and derivatives market activity in 2000 prepared by Bank of International Settlement (BIS) indicates the growth of the forex market. The 2007 survey shows an unprecedented rise in activity in traditional foreign exchange markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an increase of 69% at current exchange rates as given in Table 3.A. Joint Initiative IITs and IISc Funded by MHRD - 4 -
Table 3.A. Global foreign exchange market turnover (*) http://www.bis.org/publ/rpfxf07t.pdf Daily averages in April, in billions ofus$ 2004 ( **) 2007 YEAR 1992 1995 1998 2001 Spot transactions 394 494 568 387 631 1,005 Outright forwards 58 97 128 131 209 362 Up to 7 days 50 65 51 92 154 Over 7 days 46 62 80 116 208 Foreign exchange swaps 324 546 734 656 954 1,714 Up to 7 days 382 528 451 700 1,329 Over 7 days 162 202 204 252 382 Estimated gaps in reporting 44 53 60 26 106 129 Total traditional turnover 820 1,190 1,490 1,200 1,900 3,210 Turnover at April 2007 exchange rates( ***) 880 1,150 1,650 1,420 1,970 3,210 1 Adjusted for local & cross-border double-counting. Due to incomplete breakdown, components do not always sum to totals. 2. Date for 2004 have been revised. 3 Non-US dollar legs of foreign currency transactions were converted from current US dollar amounts into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2007 exchange rates. Table 3.A indicates that forex swaps have grown strongest compared to the other two, i.e, spot and forward. Table 3.B indicates the percentage share of different currencies in average daily turnover during 2007. As expected, US dollar has the highest average daily turnover of 86% followed by Euro (37%) and Yen( 19%). Surprisingly the sum total of percentage of these currencies is 142%!!! The clue lies in the Table 3.B. In addition, it is heartening to see that Indian currency average daily turnover has increased from 0.3% to 0.7%. So also the Chinese Renminbi. Joint Initiative IITs and IISc Funded by MHRD - 5 -
Table 3.B:Currency distribution of reported foreign exchange market turnover(*) http://www.bis.org/publ/rpfxf07t.pdf Percentage shares of average daily turnover in April 2007 2001 2004 (**) 2007 US dollar 90.3 88.7 86.3 Euro 37.6 36.9 37 Yen 22.7 20.2 16.5 Pound sterling 13.2 16.9 15 Swiss franc 6.1 6 6.8 Australian Dollar 4.2 5.9 6.7 Canadian dollar 4.5 4.2 4.2 Swedish krona 2.6 2.3 2.8 Hong Kong dollar 2.3 1.9 2.8 Norwegian krone 1.5 1.4 2.2 New Zealand dollar 0.6 1 1.9 Mexican peso 0.9 1.1 1.3 Singapore dollar 1.1 1 1.2 Won 0.7 1.2 1.1 Rand 1 0.8 0.9 Danish krone 1.2 0.9 0.9 Rouble 0.4 0.7 0.8 Zloty 0.5 0.4 0.8 Indian rupee 0.2 0.3 0.7 Renminbi 0 0.1 0.5 New Taiwan dollar 0.3 0.4 0.4 Brazilian real 0.4 0.2 0.4 All currencies 200 200 200 Emerging market currencies (***) 16.9 15.4 19.8 (*) Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%. Adjusted for local and cross-border double-counting. (**) Data for 2004 have been revised. (***) Defined as the residual after accounting for the top eight currencies and the New Zealand dollar and the Danish krone. Table 3.C highlights foreign exchange market turnover by currency pair. Table 3.C: Reported foreign exchange market turnover by currency pair (*) http://www.bis.org/publ/rpfxf07t.pdf Joint Initiative IITs and IISc Funded by MHRD - 6 -
Daily averages in April, in billions of US dollars and per cent YEAR 2001 2004( **) 2007 Amount Amount % Share Amount % Share Amount % Share US dollar/euro 354 30 503 28 840 27 US dollar/yen 231 20 298 17 397 13 US dollar/sterling 125 11 248 14 361 12 US dollar/australian dollar 47 4 98 5 175 6 US dollar/swiss franc 57 5 78 4 143 5 US dollar/canadian dollar 50 4 71 4 115 4 US dollar/swedish krona (***) 56 2 US dollar/other 195 17 295 16 572 19 Euro/yen 30 3 51 3 70 2 Euro/sterling 24 2 43 2 64 2 Euro/Swiss franc 12 1 26 1 54 2 Euro/other 21 2 39 2 112 4 Other currency pairs 26 2 42 2 122 4 All currency pairs 1,173 100 1,794 100 3,081 100 (*) Adjusted for local and cross-border double-counting. (**)Data for 2004 have been revised. (***)The US dollar/swedish krona pair could not be separately identified before 2007 and is included in other. As usual, US dollar/euro is the most preferred currency pair followed by US dollar/yen and US dollar/pound Sterling. However, the percentage share of US dollar/euro pair is going down from 30% in 2001 to 27% in 2007. Table 3.D indicates the distribution of average daily turnover of each currency based on spot, forward and swaps transactions. For some currencies, the spot transactions is highest ( like Indian Rupees, Chinese Renmimbi, Turkish Lira etc.) while for others swap transactions have the highest percentage ( like US dollar, Australian Dollar, Swedish Krona etc.). This difference clearly indicates the degree of development of forex market in different currencies. Currencies with higher percentage of swap contract indicate the maturity of the currency market. In addition, currencies with higher percentage in spot market may be experiencing greater degree of capital control, preventing traders from these markets to enter into long-term contracts. Joint Initiative IITs and IISc Funded by MHRD - 7 -
Table 3.D Reported foreign exchange turnover by currency and instrument http://www.bis.org/publ/rpfxf07t.pdf Percentage shares of average daily turnover in April 2007 Spot Outright Foreign Exchange Forwards Swaps US dollar 29.7 10.9 59.4 Euro 36.9 12.1 51.1 Yen 40.4 12.1 47.5 Pound sterling 32.5 10 57.4 Swiss franc 42.2 10.1 47.7 Australian dollar 25.7 10 64.3 Canadian dollar 29.7 11.8 58.6 Swedish krona 20.7 10 69.3 Hong Kong dollar 18.4 7 74.6 Norwegian krone 18.4 9.7 71.9 New Zealand dollar 29.4 11.3 59.3 Mexican peso 37.4 11.7 50.9 Singapore dollar 22.5 7.9 69.6 Won 44.7 29.4 25.9 Rand 19.9 12.1 68 Danish krone 21.8 10.3 67.9 Rouble 70.7 5 24.3 Zloty 20 10.9 69.1 Indian rupee 42.6 27.5 29.8 Renminbi 61.4 31.3 7.4 New Taiwan dollar 47.1 40.6 12.3 Brazilian real 50.2 47.3 2.5 Forint 34.1 15.7 50.2 Czech koruna 23.8 20.9 55.3 Baht 18.9 13.3 67.8 Turkish lira 61.4 11.4 27.2 Philippine peso 36.9 32.5 30.5 Rupiah 43.7 39.3 17 All currencies 32.6 11.7 55.6 1 Adjusted for local and cross-border double-counting. Table 3.E shows the major countrywise average daily foreign exchange turnover. The major countries are Australia, Hong Kong, Japan, Singapore, Switzerland, United Kingdom and USA. It is to be noted here that percentage column for all countries for a given year do not add upto 100% as some country details have been deleted from the master document to arrive at this table. Table 3.E Major Countrywise Foreign Exchange Daily Average Joint Initiative IITs and IISc Funded by MHRD - 8 -
Turnover http://www.bis.org/publ/rpfxf07t.pdf 1998 2001 2004 2007 Amou % Amou % Amou % Amou % nt nt nt nt Australia 47 2.4 52 3.2 102 4.2 170 4.3 Canada 37 1.9 42 2.6 54 2.2 60 1.5 China 0 0.0 0 0.0 1 0.0 9 0.2 France 72 3.7 48 3.0 64 2.6 120 3.0 Germany 94 4.8 88 5.5 118 4.8 99 2.5 HongKong 79 4.0 67 4.1 102 4.2 175 4.4 India 2 0.1 3 0.2 7 0.3 34 0.9 Japan 136 6.9 147 9.1 199 8.2 238 6.0 Korea 4 0.2 10 0.6 20 0.8 33 0.8 Russia 7 0.4 10 0.6 30 1.2 50 1.3 Saudi Arabia 2 0.1 2 0.1 2 0.1 4 0.1 Singapore 139 7.1 101 6.2 125 5.2 231 5.8 Switzerland 82 4.2 71 4.4 79 3.3 242 6.1 United 637 32.5 504 31.2 753 31.0 1,359 34.1 Kingdom United States 351 17.9 254 15.7 461 19.2 664 16.6 Total 1,969 100 1,616 100 2,429 100 3,988 100 Table 3.E indicates that Japan s daily average foreign exchange turnover is going down while countries like Switzerland, Australia and Hong Kong are showing an increasing trend. It is also interesting to note that foreign exchange turnover percentage in United Kingdom is turnover almost double the size that of United States proving that London still enjoys status of global financial hub than New York. 3.3: Evolution of Foreign Exchange Market and Foreign Exchange System: Joint Initiative IITs and IISc Funded by MHRD - 9 -
Since time immemorial, commodity money was used during barter system. From a wide variety of commodities, gold, silver, silk and bronze became standardized commodity money. During 17 th century, countries and kingdoms started using coins as the medium of exchange. These coins had their own intrinsic value that was not related to any commodity. Normally coins were made up gold, silver or bronze. Some other unusual materials like stone and limestone and slate were also used. Can anyone imagine -- Coins were traded weighing 8800 lbs! Box 3.1 has some interesting facts about Rai stones. The content of gold, silver or bronze in a coin measured the intrinsic value of these coins, hence the exchange rate between coins was governed by the amount of gold /silver/bronze content of the coins. When an individual received/paid a coin, it meant that he was giving/receiving a certain weight of metal backed by these currencies. The value of the coins also influenced by intangibles associated these coins as mentioned in Box 2.2 By the end of 17 th century, countries started using paper money. Though paper money had its presence in China from 1050 till 1400, paper currency became accepted globally only during 17 th century. Like the coins, the paper money was also backed by gold and silver. Exchange rate between paper money was determined by the amount of gold/silver backed by respective paper money. It is worth mentioning that, different countries started introducing paper money at different point of time between 10 th and 17 th century. Joint Initiative IITs and IISc Funded by MHRD - 10 -
Box 3.1 : Rai Stones as Coins http://en.wikipedia.org/wiki/rai_stones Rai stones are large, circular stone disks carved out of limestone in the island of Yap, Micronesia. Locals have used these stones as a form of unusual currency, a "stone money." Rai stones are circular disks carved out of limestone with a large hole in the middle. The size of the stones varies widely; the largest are 3 meters (10 ft) in diameter, 0.5 meters (1.5 ft) thick and weigh 4 metric tons (8,800 lb). The extrinsic (perceived) value of a specific stone is based not only on its size and craftsmanship but also on the history of the stone. If many people - or no one at all - died when the specific stone was transported, or a famous sailor brought it in, the value of the rai stone increases. Rai stones were used in social transactions such as marriage, inheritance, political deals, sign of an alliance, ransom of the battle dead or just in exchange for food. Many of them are placed in front of meetinghouses or specific pathways. Though the ownership of a particular stone changes, the stone itself is rarely moved. The names of previous owners are passed down to the new one. According to a Economist (1999) article titled Paper Money, Sweden was the first country in Europe to introduce paper money in 1661 and other countries joined later., In 1694 the Bank of England started printing paper money used to be known as "running cash notes With increase in international trade, gold became universally accepted commodity to back issuance of paper money. This led to the emergence of gold standard. During 1870, major countries agreed to hold gold to back their currency notes. The value of any country s banknotes depended on the gold reserve held by a country and exchange rates Joint Initiative IITs and IISc Funded by MHRD - 11 -
between two currencies depended on the amount of gold backed by respective currencies. The gold standard existed until the First World War. During 1944, Bretton Woods Agreement system came into existence. The Bretton Woods Conference of 1944 established an international fixed exchange rate regime in which currencies were pegged to the US Dollar, which in turn was based on the gold standard. Bretton Woods agreement is considered as the most important economic and political accomplishment of the cold ware era. Gavin (1996) in paper titled The legends of Bretton Woods noted Bretton woods is the most revered name in international monetary history, perhaps in economic history. As part of the agreement, from 1944 till 1971, different countries permitted the exchange rates to vary within a narrow band. Central governments needed to intervene in the forex market regularly to keep the exchange rate within the band. However, this led to substantial imbalances in the forex rates i.e, some currencies became undervalued and some became overvalued. However significant changes have happened during 1971. The Smithsonian Agreement in 1971, countries were allowed to increase the band within which currency rates can fluctuate (from 1 % to 2.25%). In this agreement, the member countries i.e, Group Ten also decided to devalue US$ against most other currencies. The Smithsonian Agreement of 1973 completely abandoned the band and currencies became free float. Even though major changes were brought in 1973, but visible changes in forex market only began to emerge in 1978, when worldwide currencies were allowed to 'float' according to supply and demand. In 1992, twelve European countries joined common currency called Euro. In a floating exchange rate system, supply and demand situation influences the exchange rate. Though we see great deal of volatility in exchange rate, rarely any country has pure free floating exchange rate. Most governments through their central banks influence the exchange rate by changing their interest rates and adopting other means of control. Many-a-times exchange rate changes when governors of central banks or high ranking officials of a central bank just even casually remarks about whether their currency is under/overvalued. Joint Initiative IITs and IISc Funded by MHRD - 12 -
To sum it up, the fixed/semi-fixed vs, floating exchange rate system can be differentiated as follows: In fixed/semi-fixed exchange rate system, exchange rate is maintained at a specific level or fluctuates within a given range. In such exchange rate system, the central banks play a crucial role and regularly buy and sell foreign currency to maintain the exchange rate. Also the central banks dictate the rate of interest so that the exchange rate remains at a given value or remains within the range. This system provides great deal of advantage to exporters and importers as they are not exposed to forex risk. Fully fixed and fully floating exchange rates are at the two ends of broad spectrum of exchange rate systems prevailing in different countries. However, rarely a country will have fully fixed or fully floating exchange rate system. In a fully fixed exchange rate, there could divergence between the official rate and the currency true value. If the divergence is significant, a parallel black market starts operating where the currency s true value is reflected. Periodically, the government of the country with fixed exchange rate has to revalue or devalue the official rate. Similarly, very few countries have fully floating exchange rate system. Central banks periodically intervene in currency market to align the currency within an acceptable range. If a country s central bank aggressively intervenes to keep the exchange under control, then this is known as dirty float currency regime. In most cases, central banks interventions are more of symbolic in nature i.e., to send a message to the market participants regarding the true value of the currency. In a floating exchange rate system, the exchange rate is determined mainly through supply and demand. Hence, export-import balance, capital flows, country s fiscal deficit etc. governs the exchange rate. Fluctuating exchange rate poses significant forex risk to the exporter and importers of the country. Floating rate system led to the increase in forex trading. Initially forex trading was undertaken mostly by banks and large multinational corporations. But with the proliferation of the internet, individuals, exporters, importers, mutual funds, hedge funds are actively participating in the forex market. The spread of electronic trading platforms has led to tremendous growth as it has enabled large financial institutions to set up algorithmic trading systems and has provided trading facilities to retail investors. Multiple Choice Questions: Joint Initiative IITs and IISc Funded by MHRD - 13 -
1. The three different types of forex transactions are a) Spot, forward, swaps b) Spot, Cash, OTC c) Spot, forwards, Futures d) Spot, futures & options 2. Majority of retail forex trading happens in a) Forward Market b) Spot Market c) Futures market d) Swap market 3. The foreign exchange market is referred to as a market where one country's currency is exchanged for another currency. The currency exchange is usually made through the following methods. a) buyers and sellers of foreign exchange meet at a physical location. b) buyers and sellers of foreign exchange meet through a telephone network c) buyers and sellers of foreign exchange meet through computer communications d) A and B e) B and C 4. When domestic currency appreciates, it benefits and harms. a) Domestic exporters, domestic importer b) Domestic exporter, foreign importer c) Domestic importer foreign exporter d) Domestic importer, domestic exporter. 5. What prompted Bretton Woods Agreement? a) To set up a system that would maintain a stable exchange rate system b) To create a flexible exchange rate system. c) To stop World War II. d) Eradicate the economic difficulties brought in by World War II. Short Questions: Joint Initiative IITs and IISc Funded by MHRD - 14 -
1. Briefly explain, Why swap transactions over scores compared to spot and forward transactions for currencies of developing countries while the reverse is for developing country currencies. 2. What is dirty float and what is dirty about it? Web Exercise: 1. Read the paper titled The legend of Bretton Woods, by Gavin J.F. published in Orbis, Volume 40, Issue 2, Spring 1996, Pages 183-198 Available at http://www.sciencedirect.com. Analyse the major flaws associated with Bretton Woods Agreement. Answers to Multiple Choice Questions 1 to 5: 1.a 2. b 3. e 4.d 5. a. References: 1. Triennial Central Bank Survey December 2007: Foreign exchange and derivatives market activity in 2007.http://www.bis.org/publ/rpfxf07t.pdf 2. Gavin J.F(1996), The legend of Bretton Woods, Orbis, Volume 40, Issue 2, Spring 1996, Pages 183-198. available at http://www.sciencedirect.com Joint Initiative IITs and IISc Funded by MHRD - 15 -