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.




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).
Quick Review of Market Characteristics

World’s largest financial market.

Estimated at $3.2 trillion dollars per day in trades.


Market is a 24/7 over-the-counter market.



NYSE-Euronext currently running about $40 billion per day.
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).
FX Trading Floor, 1920s
FX Trading Floor, 2004 (London)
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
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).
Who are the Top Dealers (Market
Makers) in the Foreign Exchange Market
Electronic Versus Voice Transactions



60 percent of spot interdealer 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.
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):
U.S. (New York):
Switzerland:
Japan (Tokyo):
Singapore:
Hong Kong
Australia (Sydney):
34.1%; $1,094 billion
16.6%; $ 533 billion
6.6%
6.0%;
5.8%
4.4%
4.2%
(31.1%)
(19.2%)
(3.3%)
(8.3%)
(5.2%)
(4.2%)
(3.4%)
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).


Weekday trading ends in New York, Friday afternoon
(5pm EST).


Which is Sunday 4pm EST in New York; Sunday 8pm in London, and
Monday 5:00am in Japan.
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).
24-Hour Global Market:
Times represent normal trading hours
NEW YORK 5am
– early afternoon
Europe:
LONDON
7:30am – 4pm
Closes: Friday
5pm New
York
Other Asia:
TOKYO
7am – 7pm
Middle East:
Bahrain
Opens Monday
6 am
Sydney
Where is Bahrain?
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
Overlapping of Regions for FX Traders in
New York (assuming 8 to 5 in NYC)

Times refer to EST in New York City
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.
Importance of London
Measuring FOREX Market Activity: Average Electronic Conversations Per
Hour
25,000
20,000
15,000
10,000
5,000
Greenwich Mean Time
0
1
2
10 AM
In Tokyo
3
4
5
6
Lunch Europe
opening
In
Tokyo
7
8
9
Asia
closing
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Americas London
open
closing
Afternoon
in America
6 pm Tokyo
In NY opens
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.
Market Participants -- Continued

Traders: Speculators and arbitragers


Governments: Central banks and treasuries


Seeking to offset market forces
Investment firms


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
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.
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.


Outright Forwards


Exception: North America trades of USD and CAD are 1
day.
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.
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).
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.
Transactions by Type of Trade, 2007,
% of Total


Spot:
33%
Outright Forwards: 12%




Up to 7 days:
7 days to up to 1 year:
Over 1 year:
FX Swaps:



43%
55%
2%
55%
Up to 7 days:
7 days to up to 1 year:
Over 1 year:
78%
21%
1%
Transactions by Type of Trade; %
Which Currencies are Traded; 2004 and
2007 Data

Average daily turnover as a % share of total








USD
EUR
JPY
GBP
CHF
AUD
CAD
2004
88.7%
37.2%
20.3%
16.8%
6.1%
5.5%
4.2%
2007
86.3%
37.0%
16.0%
15.0%
6.8%
6.7%
4.2%
Note: Total adds to 200% due to double counting of
currencies in FX transactions.
Which Currency Pairs are Traded







Average daily turnover as a % share of total
USD/EUR
USD/JPY
USD/GBP
USD/AUD
USD/CHF
USD/CAD
2004
28%
17%
14%
5%
4%
4%
2007
27%
13%
12%
6%
5%
4%
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.
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.
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