International Financial Markets:
The Foreign Exchange Market
An introduction to the Foreign
Exchange Market and Understanding
Foreign Exchange Quotes
Definitions
• International Financial Market:
– The overall financial market in which MNCs and
international investors operate.
• Where they raise money, where they invest, how they make
cross border payments and receive cross border receipts,
how they move funds…
• An important sub-set of the international
financial market is the foreign exchange market.
– This is the market where:
• Exchange rates are determined and exchange rate exposure
is managed. Additionally through this market:
– international payments and international receipts are
accommodated (from commercial transactions)
– movements of capital are accommodated (from profit
remittances and lender (investor) and borrower transactions).
Definitions
• Exchange Rate Regime:
– The arrangement whereby a government manages its
country’s currency in relation to the rest of the world
and the resulting structure through which the price
(i.e., exchange rate) of that country’s currency is
determined on foreign exchange markets.
– There are essentially three possible structures for
determining the exchange rate:
• Floating Rate Regime (AKA “Independent Float”)
• Managed Rate Regime (AKA “Dirty Float”)
• Pegged Rate Regime
History of Exchange Rate Regimes
• For most of the past 200 years, governments and policy
makers were focused on creating and facilitating a global
fixed exchange rate system (i.e., one with stable exchange
rates).
• However, over the last 40 years, the reality has been one of
a mixed exchange rate system combining unstable
exchange rates (i.e., floating rate regimes and managed
rate regimes) with stable rates (i.e., pegged rate regimes).
• Beginning with the “classical” gold standard regime of the
latter part of the 19th century we can identify there 3
distinct exchange rate regime periods:
– Gold Standard: 1816 - 1914 (stable exchange rates pegged to
gold)
– Bretton Woods: 1945 – 1973 (stable exchange rates pegged to
the U.S. dollar)
– Mixed System: 1973 – the present (unstable exchange rates
among major currencies of the world)
Today’s Mixed Exchange Rate Regime
• Today’s system consists of:
– (Independent) Floating exchange rate regimes:
• Market forces (demand and supply) determine the relative value
of a currency (i.e., its exchange rate).
• All of the world’s major hard currencies operate under this system.
– Managed (dirty float) rate regimes:
• Governments managing their currency’s value with regard to a
reference currency (or market basket).
• Market moves these currencies, but governments are managing
the process and intervening when necessary.
• However, there is no predetermined path for the exchange rate.
– Pegged exchange rate regimes:
• Government fixes (links) the value of its currency relative to a
reference currency.
• Mainly used by smaller, developing countries.
Some Countries by Exchange Rate
Regime Classification (2007 IMF Data)
• Floating Regimes (n = 35):
– USD, JPY, EUR, GBP, CAD, AUD, NZD, CHF, ZAR, MXN,
KRW, SEK, ILS
• Managed Float Regimes (n = 48):
– THB, SGD, INR, RUB, CZK, CNY (as of 2010)
• Pegged (and Crawling Pegs*) Regimes (n = 94):
– HKD (7.81:1USD), SAR (3.75: 1USD); VND*
(18,932:1USD, announced August 18, 2010)
– *Crawling peg: Where the currency’s peg is adjusted
periodically in small amounts
Post Bretton Woods Implications
• Since March 1973, the major currencies of the world have
operated under a (an independent) floating exchange rate
system.
– While central banks of major countries have occasionally interviewed
in support of their currencies, this intervention has become less
frequent over time.
• The US last intervened in 1998; Japan in 2004.
• In addition, a growing number of developing countries have
adopted floating rate or managed rate systems.
– Thus: more and more, market forces are driving currency values.
• Observations and Implications:
– The move towards floating exchange rate regimes has resulted
exchange rates become more volatile and less predictable.
– This period has also seen market (speculative) attacks on currencies
which have produced large and sudden swings in exchange rates.
• British Pound: 1992; Italian Lira: 1992; Mexican Peso: 1994; Asian Currency
Crisis: 1997; Russian Ruble: 1998; Brazilian Real: 1999; Turkish Lira: 2001;
Argentina Peso: 2001/02; Euro: 2010.
– This currency volatility complicates the management of global
companies and the investment environment for global investors.
• Through their exchange rate exposure.
International Asset Returns Attributed to
Exchange Rate Changes
Percentage of Monthly Returns
Explained by Monthly Currency
Moves
Source of Data, Findings and
Conclusions
•
•
Source: State Street Bank, Global Advisors (2010).
Data through November 2009
– MSCI EAFT: Morgan Stanley’s index of 21
developed equity markets in Europe, Asia
Pacific, Africa and the Middle East. Excludes the
U.S. and Canada. This index is the major
benchmark for international equity
performance (and fund managers).
– BarCap: Barclays Capital Global Aggregate
Index. This is a bond market index made up of
investment grade (Moody’s BBB- and higher),
fixed rate, corporate debt outside of the United
States.
Findings and Conclusions:
– Currency moves have contributed to around
60% of international bond returns.
– Currency moves have contributed to around
40% of international equity returns.
– “Currency risk is an inevitable by-product of
investing in international assets.”
Unhedged Versus Hedged Equity and
Bond Returns, 1991-2009
Minimum and Maximum Monthly
Returns for Equity and Bonds by Year
Source of Data and Conclusions
• Source: State Street Bank:
Global Advisors (2010). Data
through November 2009.
• Conclusions:
– The dispersion of monthly
returns (i.e., the differences
between the minimum and
maximum monthly returns)
shows that unhedged positions
consistently produce larger
dispersions and thus greater
risk.
– Hedging reduces the “upside
(gain) as well as the downside
risk.”
The Foreign Exchange Market (April 2010)
• World’s largest financial market at $4.0 trillion dollars per
day in trades ($3.3 in 2007).
– NYSE-Euronext stock exchange currently about $40 billion per day.
• Market is a 24/5(7) over-the-counter market.
– Major markets open Monday through Friday; Middle East markets
also open on weekends (Saudi Arabia and Bahrain)
– There is no central trading location (i.e., no central trading floor).
– Trades take place through a network of computer (Reuters screens)
and telephone connections all over the world.
• 37% of all trades take place through banks located in the
U.K. (London); 17% the U.S. (New York); 6% Japan (Tokyo).
Saudi Arabia and Bahrain each 0.1%.
• Most popular traded currency is the USD (86%); EUR (39%);
JPY ( 19%); GBP (13%); AUD (8%); CHF (6%); CAD (5%)
• Most popular traded currency pair is the USD/EUR (28%);
USD/JPY (14%); USD/GBP (9%); USD/AUD (6%)
How Does the FX Market Quote Currencies?
• (1) American Terms Quote:
– Expresses the exchange rate as the number of U.S.
dollars and cents per one unit of a foreign
currency.
• For example, $1.50 per 1 British pound.
• (2) European Terms Quote:
– Expresses the exchange rate as the number of
foreign currency units per one U.S. dollar.
• For example, 85 yen per 1 U.S. dollar.
• Most of the world’s currencies are quoted for trade
purposes on the basis of European terms.
– Exceptions include: British pound, Euro, Australian
dollar and New Zealand dollar.
Quotes are Given by Time of Settlement
• Spot Exchange Rates:
– Quotes for “immediate” transactions (actually
settled within 1 or 2 business days)
• Forward Exchange Rates:
– Quotes for specified future transactions (3
business days and longer settlement).
• Forward markets are used by businesses and
investors to protect (hedge) against unexpected
future changes in exchange rates.
–Forward rate allows businesses and
investors to “lock” in an exchange rate for
some future period of time.
Role of Banks in the Foreign Exchange Market?
• Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank)
operate in the foreign exchange markets through:
– (1) Their “external” clients” (primarily large global firms:
exporters, importers, multinational firms, investment
companies, hedge firms)
• Acting in a broker capacity at the request of these
clients.
– (2) Their own banks (trading in currencies to generate
profits).
• Acting in a “dealer” (i.e., trading) capacity.
• In meeting the needs of their clients and their own trading
activities, these global banks establish the “tone” of the
foreign exchange market.
– This is done through their “market maker” function.
Making the Market in FX
• The market maker function of any global bank involves two
primary foreign exchange activities:
• (1) A willingness of the market maker to provide the market
with “on-going” (i.e., continuous) two way quotes upon
request:
– (1) Provide a price at which they will buy a currency
– (2) Provide a price at which they will sell a currency
• This function provides the market with transparency.
• (2) A willingness of the market maker to actually buy and/or
sell at the prices they quote:
– Thus the market maker offers “firm” prices into the
market.
• This function provides the market with liquidity.
Base and Quote Currency
• Recall that a foreign exchange quote is simply the ratio of one
currency to another.
• Thus a “complete” market maker quote must have two ISO
designations (e.g., EUR/USD; USD/JPY; USD/CNY):
– The first ISO currency quoted is called the base currency.
– The second ISO currency quoted is called the quote currency.
• For example: EUR/USD: EUR is the base currency and USD is the quote currency.
– Hint: When viewing a foreign exchange quote, assign a value of 1 to the
base currency (the base currency is the first in the ISO pair).
– The quotes you see refer to one unit of this base currency.
• For example: EUR/USD: 1.3000 = 1 euro equals $1.3000
• For example: USD/JPY: 84.0000 = 1 US dollar equals 84 yen
– Hint: If quoted exchange rates are moving up, that means that the base
currency is getting stronger and the quote currency is getting weaker
(reverse if the quoted rate is moving down).
• For Example: EUR/USD 1.3000 EUR/USD 1.3100; Thus the euro strengthened
and the dollar weakened.
• For Example: USD/JPY 84.0000 USD /JPY 83.0000; thus the dollar weakened
and the yen strengthened.
Bid and Ask Quotes
• Recall that a market maker always provides the
market with two prices, i.e., both a buy and sell quote
(or price) for a currency.
• For Example: EUR/USD: 1.2102/1.2106
– The first number in the quoted sequence is the market
maker’s buy price for the base currency (i.e., they will buy 1
euro for $1.2102).
• This price is called the market maker’s bid quote (i.e., buy price)
– The second number in the quoted sequence is the market
maker’s sell price for the base currency (i.e., they will sell 1
euro for $1.2106).
• It is called the market maker’s ask quote (i.e., sell price)
– Note: The ask quote is always higher than the ask quote.
• This is the profit spread for a market maker bank.
Complete FX Example
• Assume: EUR/USD: 1.2102/1.2106
• Question: Which currency is the market maker selling and
which currency is the market maker buying?
• Answer: Market maker is always quoting prices at which they
will buy or sell one unit of the base currency (against the
quote currency).
– So in the above example:
• The market maker will buy euros for $1.2102
– This is the bid price for euros and this is the price that a non-market
maker will get if selling euros.
• The market maker will sell euros for $1.2106
– This is the ask price for euros and this is the price that a non-market
maker will pay to buy euros.
– Practice: Go to: http://www.fxstreet.com/
• Link to Rates and Charts then to Live Currency Rates then link to
any quoted pair. Observe the bid and ask prices for this currency
pair.
• Make sure you understand the meaning of the quotes (bid and ask
prices) and the changes in the quotes.