International Financial Markets

1
International Financial Markets
Market Structure and Institutions
2 ?
2
Overview

• Importance of Foreign Exchange Market Trading
• Origins of the Market
• Volume of Foreign Exchange Trading (e.g. spot /
  market is about 150 billion per day)
• Foreign Exchange Trading Profits
• Explaining the Profitability of Foreign Exchange
  Trading

3
Overview

• Foreign Exchange Market Products and Activities
• Spot and Forward Contracts
• Foreign Exchange Swaps
• Types of Trading Activities Speculation and
  Arbitrage
• The Relationship between Spot and Forward
  Contracts

4
Overview

• The Foreign Exchange Market Setting
• Comparing the Foreign Exchange Market with Other
  Markets
• Tracking Foreign Exchange Transactions
• The Interbank Market - Classic Connections and
  Recent Innovations
• Corporate Foreign Exchange Trading - The Classic
  Relationship and Recent Innovations
• Counterparties and Concentration in the Foreign
  Exchange Market

5
Overview

• Policy Matters - Private Enterprises
• A Close-Up View on Foreign Exchange Trading
• Controls over Foreign Exchange Trading
• Valuing Foreign Exchange Trading Profits
• Policy Matters - Public Policymakers

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Importance ofForeign Exchange Market Trading

• Origins of the Market
• International trade - No single currency is
  particularly efficient as a medium of exchange.
• International investment - Foreign assets are an
  alternative store of value. They may also serve
  to offset certain financial risks. Some of their
  features may not be available domestically too.
• Speculation - The aim is purely to earn higher
  returns.

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The Global Foreign Exchange and Over-the-Counter
Derivatives Markets
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Currency Distribution of GlobalTraditional
Foreign Exchange Market Activity
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Geographical Distribution of Global Traditional
Foreign Exchange Market Activity
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Geographical Distribution of GlobalOver-the-Count
er Derivatives Market Activity
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Foreign Exchange Trading Profits
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Foreign Exchange Trading Profits
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Explaining the Profitability ofForeign Exchange
Trading

• If foreign exchange trading is a zero-sum game,
  how can it be profitable to all banks?
• The data is for one-year intervals, suggesting
  that longer-run profits exceed short-term losses.
• Only speculative profits ought to conform to the
  predictions of a zero-sum game. Service charges
  should be excluded.
• Central banks have at times incurred substantial
  losses due to their market interventions.

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Background

• The roles of money
• Unit of account (what currency to use in
  invoicing, pricing)
• Store of value (saving, portfolio, inflation,
  exchange rate change) and also store of
  liquidity You can readily exchange it for goods
  or other assets, thereby facilitating economic
  transactions.
• The value of money depends on its purchasing
  power. The lower the expected inflation, the
  more money people will demand. Exchange rate
  reflects the relative demands for two moneys.
  (Shapiro, p.88)
• Medium of exchange (effect payment for exchange)

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Background

• What is a currency?
• liabilities of governments (legal tender), or,
  sometimes, banks. Not direct claims on real
  assets! (e.g., stocks are claims to real
  returns generated in the production of goods and
  services).
• What is an exchange rate?
• the price of one currency in terms of another

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Background

• spot exchange rate governing on-the-spot
  trading (spot transaction a currency is traded
  for immediate delivery and payment is made within
  two business days of the contract entry date)
• forward exchange rate value at some date
  further than two days (forward transaction a
  currency is traded on a future date e.g. 30,
  90, 180-days into the future at a forward rate
  agreed on today)

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Foreign Exchange MarketProducts and Activities

• A spot contract is a binding commitment for an
  exchange of funds, with normal settlement and
  delivery of bank balances following in two
  business days (one day in the case of North
  American currencies).
• A forward contract, or outright forward, is an
  agreement made today for an obligatory exchange
  of funds at some specified time in the future
  (typically 1,2,3,6,12 months).

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Foreign Exchange MarketProducts and Activities

• Forward contracts typically involve a bank and a
  corporate counterparty and are used by
  corporations to manage their exposures to foreign
  exchange risk.
• A foreign exchange swap is the simultaneous sale
  of a currency for spot delivery and purchase of
  that currency for forward delivery.
• Foreign exchange swaps can be used by dealers to
  manage the maturity structure of their currency
  positions.

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Foreign Exchange MarketProducts and Activities

• Why do swaps exist? Example.
• A multinational company has just received 1
  million from sales and knows it will have to pay
  those dollars to a BC supplier in three months.
• Meanwhile, the company would like to invest in
  the 1 million in British pounds.
• A three-month swap of dollars into British pounds
  may result in lower brokers fees than the two
  separate transactions of selling for spot British
  pounds and selling the British pounds for dollars
  on the forward market.

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Foreign Exchange MarketProducts and Activities

• Exchange rate quotations
• Assuming the U.S. is the domestic currency
  (d.c.) and the British pound () is the foreign
  currency (f.c.), then 
• American terms 's per unit of f.c 2.00/
• European terms units of f.c. per 0.50/
• Direct quote units of d.c. per f.c. 2.00/
• Indirect quote units of f.c. per d.c. 0.50/

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Foreign Exchange MarketProducts and Activities

• In currency futures and options markets, currency
  prices are quoted in American terms, that is,
  dollars per unit of another currency .6435/DM,
  1.536/.
• The Wall Street Journal and the Financial Times
  publishes exchange rates (both spot and forward)
  for the previous business day.The Wall Street
  Journal carries cross rates for major currencies
  in the foreign exchange section.
• Swap rates can be found on the Reuters screen.

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Foreign Exchange MarketProducts and Activities

• Bid/ask spread
• Bid price the price at which a marketmaker is
  willing to buy a currency
• Ask price the price at which a marketmaker is
  willing to sell a currency
• The difference between the two prices is referred
  to as the bid/ask or bid/offer spread, which is
  often expressed in percentage terms
• Percent spread(ask price bid price) / ask
  price x 100
• Suppose 1.7019-36
• Percent spread(1.7036 1.7019) / 1.7036
  0.1 

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Foreign Exchange MarketProducts and Activities

• Speculation entails more than the assumption of a
  risky position. It implies financial transactions
  undertaken when an individuals expectations
  differ from the markets expectation.
• Arbitrage is the simultaneous, or nearly
  simultaneous, purchase of securities in one
  market for sale in another market with the
  expectation of a risk-free profit.

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Foreign Exchange MarketProducts and Activities

• Spatial arbitrage suggests arbitrage between
  segments of the foreign exchange market that are
  physically separated.
• Ignoring transaction costs, the prices for any
  three currencies A, B, C must be consistent
• A A ? B
• C B C
• If the above relation does not hold, then profit
  opportunities will be available based on
  triangular arbitrage.

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Foreign Exchange MarketProducts and Activities

• Cross rates and arbitrage
• A cross rate is usually constructed from the
  individual exchange rates of the currencies with
  respect to the U.S. dollar.
• Exchange rates on September 17, 1997 (source The
  Wall Street Journal, Sep. 18, 1996)
• British pound (in U.S. dollars)
  1.5561gt1.5561/
• Canadian dollar (in U.S. dollars)
  0.7293gt0.7293/C
• Swiss franc (per U.S. dollar) 1.2445gtSF1.2445/
• Japanese yen (per U.S. dollar) 110.36gt110.36/
• German mark (per U.S. dollar) 1.5142gt DM1.5142/

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Foreign Exchange MarketProducts and Activities

• What is the exchange rate between the British
  pound and the Canadian dollar?
• Canadian dollars per British pound
• (1.5561/)?(0.7293/C)(1.5561/)x(C/0.7293)
  (C/)x(1.5561/ 0.7293)C2.1136/
• What's the exchange rate between the British
  pound and the Japanese yen?
• Japanese yen per British pound
• (1.5561/)x(110.3/)(110.36 x 1.5561)/

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Foreign Exchange MarketProducts and Activities

• If the cross rate is inconsistent with exchange
  rates between the two currencies and the dollar,
  an arbitrage opportunity exists.
• Given (1) New York 1.9809 /
• (2) Frankfurt 0.6251 / DM
• (3) London DM3.1650 /
• Is there an arbitrage opportunity?
• Key calculate the exchange rate between DM and
  using the two direct quotes
• Objective Find out how much DM you have to pay
  for one

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Foreign Exchange MarketProducts and Activities

• Customer start with DM
•   1. Sell DM for in Frankfurt 0.6251 per DM
• 2. Sell for in New York 1.9809 per
• How much DM have you spent on buying one ?
•   1.9809 / 0.6251 DM3.168932971 per
• Compare with the price for in London DM3.1650
  per
• gtprice of in London is lower than the rate
  implied in the other two markets.
• gtCustomer should buy with DM in London and
  sell it elsewhere.

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Foreign Exchange MarketProducts and Activities

• Cross rates with bid/ask spread
• Rule the trader would choose the most
  advantageous price with each transaction (so you,
  as a customer, will take the unfavorable of the
  two prices in each transaction)
• Two transactions involved.
• Example
• Given 1.7019-36 per , 0.6250-67 per DM
• What is the direct quote for in Frankfurt?

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Foreign Exchange MarketProducts and Activities

• In Frankfurt, DM is the home currency. Direct
  quote Number of DM per pound
• The bid rate trader's buying price of pound
  (customer sells for DM)
• 1. A customer sells for (or the trader buys
  with ) at the buying price
• 1.7019 per (the bid price for )
• 2. Then the customer sells for DM (or the
  trader sell DM for ) at
• 0.6267/DM (the ask price for DM)
• gt 1.7019/ / 0.6267/DM DM2.7157/

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Foreign Exchange MarketProducts and Activities

• The ask rate trader's selling price of BP
  (Customer buy BP with DM)
•  1.Customer starts with DM, sells DM for
  (trader buy DM) at
•   0.6250 per DM (the bid price for DM)
•  2.The customer sells for BP (trader sells BP)
  at
•   1.7036 per BP (the ask price for BP)
•  gt 1.7036/ / 0.6250/DM DM2.7258/
•   So the bid/ask price for in terms of DM is
  DM2.7157-7258/.
•  

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Foreign Exchange MarketProducts and Activities

• Forward market
• Quoted in two ways
• Outright rate Actual price (see Wall Street
  Journal quotations), for commercial customers.
• Swap rate forward discount or forward premium
  points.

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Foreign Exchange MarketProducts and Activities

• Examples
• Spot yen sold at 0.006879
• 90-day forward at 0.006902
• The swap rate for the 90-day forward yen is
  quoted at a 23-point premium (yen in unit of 100)
  
• Spot BP sold at 1.7015
• 90-day forward at 1.6745
• Swap rate 270 point-discount

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Foreign Exchange MarketProducts and Activities

• The swap rate is calculated as the difference
  between the forward rate and the spot rate
•   F(t,T) - S(t) 1.6745 - 1.7015-0.0270
• gt 270 point-discount
•   The underlying currency is the British pound
  which is priced in . When the F(t,T) - S(t) gt 0
  , the underlying currency is at a forward
  premium when lt 0, the currency is at a forward
  discount. In the example above, the forward rate
  (1.6745) is smaller than the spot rate
  (1.7015), so the difference is negative
  (-0.0270). There is at a forward discount, and
  swap is represented as 270 point-discount.

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Foreign Exchange MarketProducts and Activities

• Swap rates with bid/ask spread
• Spot rate DM2.4273/90 spread 0.0017
• Swap rate 30/20 large/smallgt subtract
• forward DM2.4243/70 spread 0.0027
• Spot rate DM2.5005/10 spread 0.0005
• Swap rate 100/95 large/smallgt subtract
• forward DM2.4905/15 spread 0.0010
• Spot rate DM2.5005/10 spread 0.0005
• Swap rate 95/100 small/largegt add
• forward DM2.5100/110 spread 0.0010

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Foreign Exchange MarketProducts and Activities

• Covered interest arbitrage describes capital
  flows that seek risk-free profits based on
  differences between the forward exchange premium
  and the relative rate of interest in domestic and
  foreign currency.

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Foreign Exchange MarketProducts and Activities

• Forward premium (Discount)
• For direct quotes (domestic currency (dc) /
  foreign currency(fc), say /)

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Foreign Exchange MarketProducts and Activities

• Example
• Exchange rates (source The Wall Street Journal,
  September 18, 1996)
• German mark spot .6604/DM
• 30-day forward .6618
• 90-day forward .6645
• 180-day forward .6690
•  
• The 180-day forward premium for DM
• (.6690 - .6604) / .6604 x 100 1.3022 ()

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Foreign Exchange MarketProducts and Activities

• Suppose you need DM in 180 days (to pay for
  imports, to repay DM debt, or to make DM
  investment). Should you buy DM in the spot
  market (pay now) or buy DM in the forward market
  (sign contract now but pay 180 days later)? Of
  course, there is another choice Do nothing today
  and buy DM in the spot market 180 days later.
  God knows how much you are going to pay then?
  You may pay .50 per DM or .75 per DM -- the key
  point is that you face uncertainty -- foreign
  exchange rate risk!

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Foreign Exchange MarketProducts and Activities

• If you buy DM in the forward market (That's
  hedging with forward), you will have to pay
  1.3022 more than you do now in the spot market.
  Should you buy DM in the spot market then?
• If you buy DM in the spot market, you tie up your
  funds gt opportunity cost give up U.S. dollar
  interest rate income. But if you put the DM you
  just bought in DM deposit for 180 days (you will
  not need the DM until 180 days later anyway), you
  will earn DM interest (this is called money
  market hedging).

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Foreign Exchange MarketProducts and Activities

• To decide whether to buy foreign exchange in the
  spot market or in the forward market, one should
  not only consider forward premium, but also the
  interest rates involved.
• Suppose
• i 12 (annualized gt i for 180 days 6)
• iDM 8 (annualized gt iDM for 180 days 4)
•  

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Foreign Exchange MarketProducts and Activities

• Comparing costs in 180 days (future values) of
  buying ONE DM in the spot and forward markets
•  
• Cost of buying forward F/DM .6690
•  
• Cost of buying spot
• S/DM(1 i)/(1 iDM).6604 (1 .06)/(1
  .04).6731
• gt It actually cost you more to buy DM in the
  spot market.

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Foreign Exchange MarketProducts and Activities
The Relationship between Spot and Forward
Contracts
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Foreign Exchange MarketProducts and Activities

• In the absence of transaction costs, taxes, or
  default, the price of the two alternatives must
  be identical

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The Foreign Exchange Market Setting

• The foreign exchange market is a dispersed,
  broker-dealer market, and hence lacks
  transparency.
• Trading takes place 24 hours per day around the
  world, and the transactions can be customized.
• Dealers can trade in a number of ways
• direct telephone contact with a dealer at another
  bank (direct dealing)
• telephone contact with a voice broker
• electronic direct trading and broking systems

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The Foreign Exchange Market Setting

• There is a trend toward automated brokerage
  systems.
• Reuters Dealing 2000-2 was introduced in 1992,
  MINEX in 1993, and Electronic Brokering Service
  in 1993.
• MINEX and EBS later merged to form the EBS
  Partnership.
• By 1998, electronic brokers had captured 75 of
  all brokered transactions in the United States.
• In 1998, 23.6 of U.S. foreign exchange
  transactions are handled by brokers.

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The Foreign Exchange Market Setting

• Another innovation is the development of private
  systems for clearing and settlement.
• A multilateral netting system with banks clearing
  against a central clearinghouse substantially
  reduce transaction costs and liquidity risks.
• The leading multilateral netting firm is FXNET,
  owned by a consortium of 14 of the worlds
  largest banks.

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The Foreign Exchange Market Setting

• Traditionally, corporations conduct their foreign
  exchange transactions through commercial banks.
  Large corporations that trade frequently may also
  use automated trading systems.
• Various companies are now developing business
  plans that bring a web-based auction
  environment to corporate foreign exchange.
• In April 2000, Currenex launched the first
  multi-bank internet foreign exchange trading
  system.

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The Foreign Exchange Market Setting
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The Foreign Exchange Market Setting

• In the UK, transactions by brokers fell from 35
  in 1995 to 27 in 1998.
• Traditional voice brokers contributed 16 (down
  from 30 in 1995) while electronic brokers
  handled 11 (up from 5 in 1995).
• In the UK, US, and Japan, spot trading accounts
  for most of electronic brokers volumes.

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The Foreign Exchange Market Setting

• A survey by the Euromoney magazine found that
  non-commercial banks have gained leading
  positions in the market.
• There is also a trend toward increased
  concentration of business among fewer dealers.

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Policy Matters - Private Enterprises

• Various studies indicate that
• The position of an interbank spot trader usually
  returns close to zero at the end of each day.
• The majority of the profits of a banks spot
  trader were earned through trades with the banks
  retail customers rather than through interbank
  dealing or speculation.
• The bid-ask spread tends to be wider at the start
  and at the end of the trading day.

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Policy Matters - Private Enterprises

• Managers have always been concerned about the
  risks of foreign exchange trading.
• exchange rate risk
• interest rate risk
• credit risk - rate risk, delivery risk
• Various control measures are used to contain
  these risks.
• value-at-risk (VAR)

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Policy Matters - Private Enterprises

• Perhaps because of the uncertainties in trading,
  many investors are unwilling to place a high
  value on that portion of a banks profits that
  are derived from trading.

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Policy Matters - Public Policymakers

• The design of clearing and settlement systems for
  foreign exchange, domestic bank deposits, and
  traded securities is receiving greater attention
  from public policymakers.
• Settlement exposures can last several days.
• Prohibitions and quantitative restrictions on
  securities may not be reliable policy
  instruments.
• Using synthetic instruments, it is relatively
  easy to overcome such restrictions.