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 Turnover
in the Traditional Foreign Exchange Market
Daily averages in April in billions of US dollars at April 2010 exchange rates
4500
4000
3500
3000
2500
2000
1500
1000
500
0
1998
Source: BIS
2001
2004
2007
2010
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)
40
35
30
Germany
Singapore
Japan
United Kingdom
United States
25
20
15
10
5
0
2004
Source: BIS
2007
2010
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 foreignowned institutions.
Foreign Exchange Market
• 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.
Cross (1998)
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
30
25
20
2001
2004
2007
2010
15
10
5
0
UK
US
Japan
Banking offices, not organisations.
Source: BIS
Singapore
Hong Kong
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
90
80
70
60
50
2004
2007
2010
40
30
20
10
0
US dollar
Euro
Yen
Pound
Swiss franc
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
2000
1800
1600
1400
1200
Spot
Outright Forward
Swap
1000
800
600
400
200
0
1995
Source: BIS
1998
2001
2004
2007
2010
From the Financial Times
Currency
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 twomonth 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 currency
e = spot price of the home currency in terms of
the foreign currency
f = 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.