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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT. Lecture 3 Topic: The Foreign Exchange Market The Structure of the Market. Loonie Hits Parity with Greenback. The Foreign Exchange Market Defined. The market where one currency is traded (exchanged) for another currency.

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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

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  1. INBU 4200INTERNATIONAL FINANCIAL MANAGEMENT Lecture 3 Topic: The Foreign Exchange Market The Structure of the Market

  2. Loonie Hits Parity with Greenback

  3. The Foreign Exchange Market Defined • The market where one currency is traded (exchanged) for another currency. • For example, purchasing pounds by selling dollars. • Or, purchasing dollars by selling euros. • FX transactions do not involve moving physical currency (exception: tourist market), but rather represent shifts in commercial bank deposits. • Commercial banks are the major institutions in this market. • They act on behalf of their customers (retail market) and for their own accounts (wholesale market).

  4. Quick Review of Market Characteristics • World’s largest financial market. • Estimated at $3.2 trillion dollars per day in trades. • NYSE-Euronext currently running about $40 billion per day. • Market is a 24/7 over-the-counter market. • There is no central trading location. • Trades take place through a network of computer and telephone connections all over the world. • Major trading center is London, England. • 34% of all trades take place through London (New York second at 17%). • Most popular traded currency is the U.S. dollar. • Accounts for 86% of all trades (euro second at 27%). • Most popular traded currency pair is the U.S. dollar/Euro. • Represents 27% of all trades (dollar yen second at 13%) • Currencies are either traded for immediate delivery (spot) or some specified future delivery (forward).

  5. FX Trading Floor, 1920s

  6. FX Trading Floor, 2004 (London)

  7. Source of Data on Foreign Exchange Market • The Bank for International Settlements (BIS) conducts a Central Bank Survey of the foreign exchange markets every three years. • First survey was done in April 1989. • The latest (7th) survey was completed in April 2007. • 54 central banks and monetary authorities participated in this recent survey, collecting information from approximately market participants (banks, brokers…) • Most of the data in this lecture comes from these BIS surveys. • See last two slides for information on the BIS

  8. What is Estimated Size of the Foreign Exchange Market? • 1973: $ 10 to 20 billion • 1989: $ 590 billion • 1992: $ 820 billion (+39%) • 1995: $1.190 trillion (+45%) • 1998: $1.490 trillion (+25%) • 2001: $1.200 trillion (-19%) • 2004: $1.880 trillion (+57%) • 2007: $3.210 trillion (+71%) • Reasons for the recent increase: • Growing role of hedge funds in the market. • Trend among institutional investors to hold internationally diversified portfolios. • Increase in technical trading (impact on spot markets).

  9. Who are the Top Dealers (Market Makers) in the Foreign Exchange Market

  10. Electronic Versus Voice Transactions • 60 percent of spot inter-dealer trading today is done on electronic platforms (2005 data). • The spot dealer-client market is less electronic, at 43 percent. • Trading platforms include: EBS, Reuters, FXConnect, FXAll, Currenex, HotSpot FXi, 360T, eSpeed, and Lava FX.

  11. Where is the Foreign Exchange Market? • Geographically, the foreign exchange market spans the entire globe, however: • The major foreign exchange markets as a percent of 2007 daily turnover (2004) are: • U.K. (London): 34.1%; $1,094 billion (31.1%) • U.S. (New York): 16.6%; $ 533 billion (19.2%) • Switzerland: 6.6% (3.3%) • Japan (Tokyo): 6.0%; (8.3%) • Singapore: 5.8% (5.2%) • Hong Kong 4.4% (4.2%) • Australia (Sydney): 4.2% (3.4%)

  12. Trading Times for the Market • Foreign exchange trades on a 24 hour basis, with major financial centers open Monday through Friday. • Weekday trading begins in Sydney, Australia, Monday morning (6:00am local time). • Which is Sunday 4pm EST in New York; Sunday 8pm in London, and Monday 5:00am in Japan. • Weekday trading ends in New York, Friday afternoon (5pm EST). • Which is Friday 10pm in London, and Saturday 6:00am in Japan. • Globally, foreign exchange trading begins Australia, moves to Asia (Tokyo, Hong Kong, and Singapore), then to the Middle East, on to Europe (Paris and London), and finally to North America (New York). • Weekend trades take place in the Middle East (e.g., in Bahrain with 360 offshore banks; 65 US banks).

  13. Europe: LONDON 7:30am – 4pm NEWYORK 5am – early afternoon Other Asia: TOKYO 7am – 7pm Middle East: Bahrain 24-Hour Global Market:Times represent normal trading hours Closes: Friday 5pm New York Opens Monday 6 am Sydney

  14. Where is Bahrain?

  15. London’s Unique Position • Due to the geographic positioning of London in relation to New York and Tokyo, London enjoys a trading day which overlaps with the other two. • Thus, London trading in the afternoon corresponds with New York trading in the morning (8 to noon). • And, London trading in the morning corresponds with Tokyo trading in the late afternoon (5 to 6pm). • However, New York (regular trading times) and Tokyo trading times do NOT overlap. • Visit: http://www.eforex-asia.com/time_zones.html

  16. Overlapping of Regions for FX Traders in New York (assuming 8 to 5 in NYC) • Times refer to EST in New York City

  17. Trading Patterns During the Day • Weekday trading activity is heaviest when the major markets overlap. As noted this would be: • London (pm) and New York (am) overlap • London (am) and Tokyo (pm) overlap • Thus, nearly two-thirds of New York foreign exchange trading activity occurs during New York morning hours (when London market is open). • Why these trading patterns? • Market participants look to the combined liquidity of two major centers to provide them with the best prices and quickest transactions.

  18. Tokyo opens Asia closing 10 AM In Tokyo Europe opening Americas open London closing Afternoon in America 6 pm In NY Lunch In Tokyo Importance of London Measuring FOREX Market Activity: Average Electronic Conversations Per Hour Greenwich Mean Time

  19. Market Participants • Five broad categories of participants operate within the foreign exchange market. They are: • Commercial Banks and Investment Banks • Major commercial banks (e.g., Citigroup and Deutsche Bank ) and investment banks (e.g., Merrill Lynch and J.P. Morgan) with a global presence. • These banks are market makers. • They profit from their bid and ask quotes (spreads). • They also trade for their own accounts. • Business firms involved in cross border commercial transactions and hedging their FX exposures • Importers, exporters, multinational firms.

  20. Market Participants -- Continued • Traders: Speculators and arbitragers • For Example: Hedge Funds: • As speculators, they seek profit from exchange rate changes (selling short, buying long) • As arbitragers, they seek profit from simultaneous differences in exchange rates in different markets • Hedge fund example: http://www.mangroupplc.com/default.cfm • Governments: Central banks and treasuries • Seeking to offset market forces • Investment firms • Mutual funds, asset managers, non-market maker banks, and pension funds • Note: The bulk of the Forex Market is between a few hundred large banks that process transactions from large companies and governments around the world.

  21. Types of Foreign Exchange Transactions • The Bank for International Settlements records three types of FX “traditional” transactions: • Spot Transactions • Contracts which call for 2 business day settlements. • Exception: North America trades of USD and CAD are 1 day. • Outright Forwards • Contracts which call for more than two business day settlements. • Swaps • Simultaneous purchase and sale of a given amount of foreign exchange for two different dates.

  22. Foreign Exchange Swap Transactions • Defined: The simultaneous purchase and sale of a given amount of foreign exchange for two different dates. • Both purchase and sale are usually conducted with the same counterpart (i.e., the same global bank) • The most common FX swap is a spot against forward • A bank buys FX in the spot market and simultaneously sells the same amount back in the forward market • Since the swap transaction is an offset, the bank incurs NO exchange rate exposure. • A swap transaction is used to provide bank clients with needed foreign exchange for a specified period of time (e.g., a short term loan).

  23. Example of FX Swap • Corporate approaches its bank wanting to borrow 10,000,000 euros for 90 days. • Bank negotiates in interbank spot market to purchase 10,000,000 euros, which in turn are lent to the corporate. • Bank simultaneously sells 10,000,000 euros 90 days forward (i.e., for delivery in 90 days) in the interbank market. • When loan matures, bank will receive the 10,000,000 euros from the corporate borrower which provides it with the euros to be delivered at that time to complete the forward agreement. • Thus, the lending bank assumes no exchange risk during the 90 day period. • The bank’s return is the interest on the loan, minus any spot/forward spread not in it’s favor.

  24. Transactions by Type of Trade, 2007, % of Total • Spot: 33% • Outright Forwards: 12% • Up to 7 days: 43% • 7 days to up to 1 year: 55% • Over 1 year: 2% • FX Swaps: 55% • Up to 7 days: 78% • 7 days to up to 1 year: 21% • Over 1 year: 1%

  25. Transactions by Type of Trade; %

  26. Which Currencies are Traded; 2004 and 2007 Data • Average daily turnover as a % share of total 20042007 • USD 88.7% 86.3% • EUR 37.2% 37.0% • JPY 20.3% 16.0% • GBP 16.8% 15.0% • CHF 6.1% 6.8% • AUD 5.5% 6.7% • CAD 4.2% 4.2% • Note: Total adds to 200% due to double counting of currencies in FX transactions.

  27. Which Currency Pairs are Traded • Average daily turnover as a % share of total 20042007 • USD/EUR 28% 27% • USD/JPY 17% 13% • USD/GBP 14% 12% • USD/AUD 5% 6% • USD/CHF 4% 5% • USD/CAD 4% 4%

  28. Wholesale (Interbank) and Retail Markets • The FX market is a two-tier financial market: • Wholesale (Interbank) market • Large transactions (>$10 million) involving 100 to 200 large “market-maker” global banks (>$400 billion) and large non-bank financial institutions (e.g., investment banks). • Represents about 80% of the market. • Retail (client) market • Transactions between banks and their retail customers (includes multinational firms, money managers, private speculators). • Represents about 20% of the market.

  29. Bank for International Settlements • The Bank for International Settlements (BIS) is an international organization which aims to promote "international monetary and financial cooperation and serve as a bank for central banks." • The BIS was originally established under the Hague agreements in January 1930 to facilitate Germany's payment of reparations following World War I, and to promote cooperation between central banks. • It began operating in Basel, Switzerland, on May 17, 1930, and is the world's oldest international financial organization.

  30. Useful BIS Web-sites BIS main web site: • http://www.bis.org/index.htm BIS central bank web-site: • The following BIS web-site has links to most of the central banks around the world! • http://www.bis.org/cbanks.htm

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