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  1. 1. INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 5 The Foreign Exchange Market The Structure of the FOREX Market Where it is? Size? Types of Trades? Who are the Participants? Currencies?
  2. 2. FX Trading Floor, 1920s
  3. 3. FX Trading Floor, 2004 (London)
  4. 4. Source of Data on FX Market <ul><li>The Bank for International Settlements (BIS) conducts a Triennial Central Bank Survey of the foreign exchange markets. </li></ul><ul><ul><li>Data is collected in April, every three years. </li></ul></ul><ul><ul><ul><li>Surveys were started in April 1989. </li></ul></ul></ul><ul><ul><ul><li>The latest survey was completed in April 2004. </li></ul></ul></ul><ul><ul><ul><ul><li>52 central banks and monetary authorities participated in this survey, collecting information from approximately 1200 market participants. </li></ul></ul></ul></ul>
  5. 5. Where is the FX Market? <ul><li>Geographically, the FX (FOREX) market spans the entire globe. </li></ul><ul><li>The major FX markets (2004 data) are in: </li></ul><ul><ul><li>U.K. (London): 31.3% </li></ul></ul><ul><ul><li>U.S. (New York): 19.2% </li></ul></ul><ul><ul><li>Japan (Tokyo): 8.3% </li></ul></ul><ul><ul><li>Singapore: 5.2% </li></ul></ul><ul><ul><li>Germany: 4.9% </li></ul></ul><ul><ul><li>Hong Kong: 4.2% </li></ul></ul><ul><ul><li>Australia (Sydney): 3.4% </li></ul></ul><ul><ul><ul><li>The relative position of the four top centers has remained unchanged since 1989 </li></ul></ul></ul>
  6. 6. How are Trades Made and What is the Volume? <ul><li>It is an over-the-counter market . </li></ul><ul><ul><li>Transactions conducted by phone and computer links. </li></ul></ul><ul><ul><li>Increasing number of trades occurring through on-line (electronic) systems </li></ul></ul><ul><li>It is the world’s largest financial market, with daily volume estimates at: </li></ul><ul><ul><li>2004: $1.9 billion </li></ul></ul><ul><ul><li>2001: $1.2 billion </li></ul></ul><ul><ul><li>1998: $1.5 billion </li></ul></ul><ul><ul><ul><li>Fall from 1998 to 2001, accounted for by a consolidation in the market with the introduction of the euro during that time. </li></ul></ul></ul>
  7. 7. Location and Size of the FX Market: 89 - 01 (daily averages in April, billions of US dollars) Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives; Market Activity in April 2001,” October 2001,
  8. 8. Trading Times <ul><li>FOREX trades on a 24 hour basis (24/7): </li></ul><ul><ul><ul><li>Weekend trades can take place in Middle East. </li></ul></ul></ul><ul><li>Weekday trading begins in New Zealand Monday morning (9:00 am local time). </li></ul><ul><ul><li>Which is Sunday 5pm EST in New York; Sunday 10pm in London, and Monday 6:00 am in Japan. </li></ul></ul><ul><li>Weekday trading ends in New York Friday afternoon (4pm EST). </li></ul><ul><ul><li>Which is Friday 9pm in London, and Saturday 5:00 am in Japan. </li></ul></ul><ul><li>Globally, trading begins in New Zealand, followed by Australia, Asia, the Middle East, Europe, and North America. </li></ul>
  9. 9. 24-Hour Global Market Opens: Monday 9 am New Zealand Closes: Friday 4 pm New York Europe: LONDON Middle East North America: NEW YORK Other Asia: TOKYO
  10. 10. Trading Patterns During the Day <ul><li>Weekday trading activity is heaviest when major markets overlap. </li></ul><ul><ul><li>London (pm) and New York (am) overlap </li></ul></ul><ul><ul><li>London (am) and Tokyo (pm) overlap </li></ul></ul><ul><ul><ul><li>NOTE: New York and Tokyo do NOT overlap </li></ul></ul></ul><ul><li>Nearly two-thirds of New York activity occurs in the morning hours when London markets are open. </li></ul><ul><li>Why? </li></ul><ul><ul><li>Market participants look to liquidity to provide them with the best prices and quickest transactions. </li></ul></ul>
  11. 11. Importance of London Measuring FOREX Market Activity: Average Electronic Conversations Per Hour Greenwich Mean Time Tokyo opens Asia closing 10 AM In Tokyo Afternoon in America London closing 6 pm In NY Americas open Europe opening Lunch In Tokyo
  12. 12. Market Participants <ul><li>Six broad categories of participants operate within the FOREX market. They include: </li></ul><ul><ul><li>Commercial Banks and Investment Banks </li></ul></ul><ul><ul><ul><li>These are the market makers: </li></ul></ul></ul><ul><ul><ul><li>Major commercial banks (Citibank and Deutsche Bank ) and investment banks (Merrill Lynch) with a global presence. </li></ul></ul></ul><ul><ul><ul><ul><li>Participants profit from their bid and ask quotes (spreads). </li></ul></ul></ul></ul><ul><ul><ul><ul><li>They also trade for their own accounts! </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>See next slide for 2005 top 10. </li></ul></ul></ul></ul></ul><ul><ul><li>Foreign exchange brokers </li></ul></ul><ul><ul><ul><li>Agents who facilitate trading (in the inter-bank market and among corporates) without themselves becoming principals in the transaction. </li></ul></ul></ul><ul><ul><ul><ul><li>They do not buy or sell FX, but simply bring parties together. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>They receive a commission for doing so. </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>See: </li></ul></ul></ul></ul></ul>
  13. 13. Top 10 FX Market Makers, May 2005 <ul><li>Top 10 Currency Traders % of overall volume, by Rank, Name, and % of total FX volume </li></ul><ul><li>1 Deutsche Bank 17.0% </li></ul><ul><li>2 UBS 12.5 </li></ul><ul><li>3 Citigroup 7.5 </li></ul><ul><li>4 HSBC 6.4 </li></ul><ul><li>5 Barclays 5.9 </li></ul><ul><li>6 Merrill Lynch 5.7 </li></ul><ul><li>7 J.P. Morgan Chase 5.3 </li></ul><ul><li>8 Goldman Sachs 4.4 </li></ul><ul><li>9 ABN Amro 4.2 </li></ul><ul><li>10 Morgan Stanley 3.9 </li></ul><ul><li>Note: These ten banks accounted for 73% of FX transactions. </li></ul><ul><li>Source: Wall Street Journal (2/9/06) </li></ul>
  14. 14. Market Participants -- Continued <ul><ul><li>Business firms involved in cross border commercial transactions and hedging their FX exposures </li></ul></ul><ul><ul><ul><li>Importers, exporters, multinational firms. </li></ul></ul></ul><ul><ul><li>Financial firms conducting investment transactions </li></ul></ul><ul><ul><ul><li>Mutual funds, asset managers, non-market maker banks, and pension funds </li></ul></ul></ul><ul><ul><li>Speculators (traders) and arbitragers </li></ul></ul><ul><ul><ul><li>Hedge Funds: </li></ul></ul></ul><ul><ul><ul><ul><li>As speculators seek profit from exchange rate changes (selling short, buying long) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>As arbitragers profit from simultaneous differences in exchange rates in different markets </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>See: http:// </li></ul></ul></ul></ul></ul><ul><ul><li>Central banks and treasuries (Governments) </li></ul></ul>
  15. 15. Distribution of Participants, 2004 <ul><li>Dealers (53%): </li></ul><ul><ul><li>Other global banks (market makers). </li></ul></ul><ul><li>Other financial institutions (33%): </li></ul><ul><ul><li>Brokers, investment banks, hedge funds, pension funds </li></ul></ul><ul><li>Non-financial customers (14%): </li></ul><ul><ul><li>Importers, exporters, multinational firms </li></ul></ul>
  16. 16. Types of Transaction <ul><li>The Bank for International Settlements records three types of FX transactions: </li></ul><ul><ul><li>Spot Transactions </li></ul></ul><ul><ul><ul><li>Two (business) day purchase or sale of FX. </li></ul></ul></ul><ul><ul><li>Outright Forwards </li></ul></ul><ul><ul><ul><li>More than two business days purchase or sale of FX. </li></ul></ul></ul><ul><ul><li>Swaps </li></ul></ul><ul><ul><ul><li>Simultaneous purchase and sale of a given amount of foreign exchange for two different dates. </li></ul></ul></ul>
  17. 17. FX Swap Transactions <ul><li>The simultaneous purchase and sale of a given amount of foreign exchange for two different dates. </li></ul><ul><ul><li>Both purchase and sale are conducted with the same counterpart (i.e., the same global bank) </li></ul></ul><ul><li>The most common swap is a spot against forward </li></ul><ul><ul><li>A bank buys FX in the spot market and simultaneously sells the same amount back in the forward market </li></ul></ul><ul><ul><li>Since the swap transaction is an offset, the bank incurs NO exchange rate exposure. </li></ul></ul><ul><li>Used to provide bank clients with needed foreign exchange for a specified period of time (e.g., a short term loan). </li></ul>
  18. 18. Example of FX Swap <ul><li>Corporate approaches its bank wanting to borrow 10,000,000 euros for 90 days. </li></ul><ul><li>Bank negotiates in interbank spot market to purchase 10,000,000 euros, which in turn are lent to the corporate. </li></ul><ul><li>Bank simultaneously sells 10,000,000 euros 90 days forward (i.e., for delivery in 90 days) in the interbank market. </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>Thus, the lending bank assumes no exchange risk during the 90 day period. </li></ul>
  19. 19. Types of Transactions, 2004 and 2001 <ul><li>2004: </li></ul><ul><ul><li>Swaps: 53% </li></ul></ul><ul><ul><li>Spot: 35% </li></ul></ul><ul><ul><li>Forwards 12% </li></ul></ul><ul><li>2001: </li></ul><ul><ul><li>Swaps 55% </li></ul></ul><ul><ul><li>Spot: 33% </li></ul></ul><ul><ul><li>Forwards: 11% </li></ul></ul>
  20. 20. Currency Distribution: 1989 - 2001 (percentage shares of average daily turnover in April) Source: Bank for International Settlements , “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001,
  21. 21. BIS Survey Data: 2001
  22. 22. 2004 FX Data <ul><li>T he US dollar is involved in approximately 90% of all foreign exchange transactions, equivalent to over $1.5 trillion a day. </li></ul><ul><li>Major currency pairs are: </li></ul><ul><ul><li>EUR/USD </li></ul></ul><ul><ul><li>USD/JPY </li></ul></ul><ul><ul><li>GBP/USD </li></ul></ul>
  23. 23. Wholesale (Interbank) and Retail Markets <ul><li>The FX market is a two-tier financial market: </li></ul><ul><ul><li>Wholesale (Interbank) market </li></ul></ul><ul><ul><ul><li>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). </li></ul></ul></ul><ul><ul><ul><li>Represents about 80% of the market . </li></ul></ul></ul><ul><ul><li>Retail (client) market </li></ul></ul><ul><ul><ul><li>Transactions between banks and their retail customers (includes multinational firms, money managers, private speculators). </li></ul></ul></ul><ul><ul><ul><li>Represents about 20% of the market . </li></ul></ul></ul>
  24. 24. Spreads in the Wholesale FX Markets <ul><li>Interbank BID AND ASK PRICES WITH SPREADS </li></ul><ul><li>June 23, 2000 </li></ul><ul><li>Interbank (Wholesale) Quotes (median prices for the day) </li></ul><ul><li>Currency Bid Ask Spread (in %)* </li></ul><ul><li>Euro $0.9370 $0.9374 .043% </li></ul><ul><li>Pound $1.5136 $1.5144 .053% </li></ul><ul><li>Canada $0.6771 $0.6775 .059% </li></ul><ul><li>Mark $0.4791 $0.4793 .042% </li></ul><ul><li>Yen $0.009581 $0.009589 .084% </li></ul><ul><li>France $0.1428 $0.1429 .070% </li></ul><ul><li>Source: Oanda, Inc ( </li></ul><ul><li>*Bid/Ask Percentage Spread = Ask – Bid/Ask x 100 </li></ul>
  25. 25. Spreads in the Retail FX Markets <ul><li>BID AND ASK PRICES WITH SPREADS </li></ul><ul><li>June 23, 2000 </li></ul><ul><li>Retail Quotes (Wells Fargo) </li></ul><ul><li>Currency Bid Ask Spread (in %)* </li></ul><ul><li>Euro $0.9000 $0.9700 7.77% </li></ul><ul><li>Pound $1.4100 $1.5700 11.35% </li></ul><ul><li>Canada $0.6500 $0.7100 9.23% </li></ul><ul><li>Mark $0.4500 $0.5000 11.11% </li></ul><ul><li>Yen $0.0090 $0.0100 11.11% </li></ul><ul><li>France $0.1450 $0.1500 3.45% </li></ul><ul><li>Source: Wells Fargo Bank, Boulder, Colorado (telephone conversation) </li></ul><ul><li>*Bid/Ask Percentage Spread = Ask – Bid/Ask x 100 </li></ul>
  26. 26. Bank for International Settlements <ul><li>The Bank for International Settlements (BIS) is an international organization which aims to promote &quot;international monetary and financial cooperation and serve as a bank for central banks.&quot; </li></ul><ul><li>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. </li></ul><ul><ul><li>It began operating in Basel, Switzerland, on May 17, 1930, and is the world's oldest international financial organization . </li></ul></ul>
  27. 27. Useful BIS Web-sites <ul><li>BIS main web site: </li></ul><ul><li> </li></ul><ul><li>BIS central bank web-site: </li></ul><ul><li>The following BIS web-site has links to most of the central banks around the world! </li></ul><ul><li> </li></ul>