The Foreign Exchange Market
F Role of the foreign exchange markets
F Foreign exchange (FX) basics
» Terminology
» Types of contracts
F Organization and institutional features
» Actors - brokers, dealers
» Segments - Interbank (wholesale), retail
» Tracking a deal
» Activities - Hedging, speculation, arbitrage, market making
F Dimensions of the FX
» By location, contract type, currency of denomination
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 1
Role of Foreign Exchange Markets
F 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$);
former French colonies (French franc).
F In commodity trade between US and Japan
» US (Japanese) exporters do not usually accept yen (US$)
F 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
C45.0001, Economics of IB
Chapter 16, p. 2
1
Foreign Exchange Contracts (1 of 2)
F Spot contract
» An exchange of two currencies for “immediate delivery”
» A binding commitment
» Quoting conventions:
u Direct terms (American terms): US$/foreign currency
u Indirect terms (European terms): foreign currency/US$
F Foreign exchange swap
» Simultaneous borrowing and lending of short-term bank
balances in two currencies, for example
u Bank A borrows $10 million from Bank B for 1-month
u Bank B borrows $10 million worth of £ from Bank A for 1-month
» Used to “construct” forward contracts and manage risks
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 3
Foreign Exchange Contracts (2 of 2)
F 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:
u On 11/15/99 buy £1,000,000 1-month forward at $1.60/ £
u 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 $50,000 to cancel obligation
» Quoting conventions
u Outright
u % premium or discount relative to spot
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 4
2
FX Terminology: Appreciation and Depreciation
F Because every exchange rate involves two currencies
» Appreciation of the US$ against £ ⇔ Depreciation of £ against US$
» Depreciation of the US$ against £ ⇔ Appreciation of £ against US$
F Examples
» Change from 1.50 $/£ to 1.75 $/£ ⇒ Appreciation of £ against US$
» Change from 1.50 $/£ to 1.25 $/£ ⇒ Depreciation of £ against US$
F Exact percentage measures depend on the base rate
» x% depreciation of the Mexican peso ⇒ x% more pesos to buy $1
u from 4 MP/$ to 8 MP/$ ⇒ 100% depreciation of the peso
» y% appreciation of the US$ ⇒ y% fewer dollar to buy 1 peso
u from $0.25/MP to $0.125/MP ⇒ 50% appreciation of the US$
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 5
Structure of the Foreign Exchange Market
The Interbank FX Market
Chase Bank
Dealer
Deutsche Bank
Dealer
Broker
Barclays
Bank
Prof. Levich
Hong Kong
Shainghai Bank
J.P. Morgan
Credit
Lyonnais
Bank of
Tokyo
C45.0001, Economics of IB
Chapter 16, p. 6
3
Structure of the Foreign Exchange Market
The Retail and Interbank FX Market
General
Motors
General
Electric
Microsoft
Chase Bank
Dealer
Motorola
Deutsche Bank
Dealer
Broker
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 7
Growth in Global FX Trading
1,600
1500
Billions US$ per day
1,400
1190
1,200
1,000
820
800
600
590
400
200
0
1989
Prof. Levich
1992
C45.0001, Economics of IB
1995
1998
Chapter 16, p. 8
4
Daily Volume of FX Trading by Location
percentage market share
Others
16%
London
32%
Australia
2%
Based on April 1998 BIS
survey of trading in 43
countries
Paris
4%
Frankfurt
5%
Final estimate of global FX
trading:
Zurich
4%
Hong Kong
4%
$1.5 trillion/day
Singapore
7%
New York
18%
Tokyo
8%
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 9
Daily Volume of FX Trading by Location
in billions of US$
637
351
321
149
139
79
72
rs
he
Ot
a
ali
str
Au
C45.0001, Economics of IB
47
ris
Pa
rt
kfu
an
Fr
h
ric
Zu
ng
Ko
ng
Ho
e
or
ap
ng
Si
rk
Yo
o
ky
To
w
Ne
on
nd
Lo
Prof. Levich
94
82
Chapter 16, p. 10
5
Percentage Share of Trading by Currency of Denomination
Source: April 1998 BIS Survey
100
90
80
70
60
50
40
30
20
10
0
US$
DM
Yen
Pound
French franc Swiss franc
Canadian
dollar
Australian
dollar
ECU and
other EMS
Others
Note: Percentage shares sum to 200% because two currencies are involved in eash transaction
Prof. Levich
C45.0001, 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%
1989
1992
Spot
Prof. Levich
1995
Outright Forward
1998
FX Swap
C45.0001, Economics of IB
Chapter 16, p. 12
6
Table 3.7
Daily Trading Statistics
for an Actual Spot DM
Interbank Dealer
Trading Statistics for an Actual Spot DM Interbank Dealer
Direct
Transactions
Brokered
Transactions
Total
Transactions
Number of Transactions
190
77
267
Value of Transactions
$0.8 billion
$0.4 billion
$1.2 billion
Median Transaction Size
$3.0 million
$4.0 million
na
Median Spread Size
DM 0.0003
na
na
Note: The above figures are daily averages for a single trader in the spot DM interbank
market for the period Monday, August 3, 1992 - Friday, August 7, 1992.
Source:
Richard K. Lyons, "Tests of Microstructural Hypotheses in the Foreign
Exchange Market," Journal of Financial Economics 39 (1995): 321-351.
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 13
Net Trading Positions, August 3 - August 7, 1992
for DM/US$ Spot Trader (in US$ Millions)
50
30
10
-10
-30
Monday
Tuesday
Wednesday
Thursday
Friday
-50
Transactions in Chronological Order, by Day of the Week
Prof. Levich
C45.0001, Economics of IB
Chapter 16, p. 14
7