Transcript Chapter 3
International Financial Markets
Prices and Policies
Second Edition ©2001
Richard M. Levich
3
McGraw Hill / Irwin
Market Structure and Institutions
3-2
Overview
Importance of Foreign Exchange Market
Trading
Origins of the Market
Volume of Foreign Exchange Trading
Foreign Exchange Trading Profits
Explaining the Profitability of Foreign Exchange
Trading
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3-3
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
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3-4
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
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3-5
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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3-6
Importance of
Foreign 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
3-7
Average Daily Turnover in billions of US dollars
Notional Amounts for Derivatives
¥
2000
1800
1600
1400
1200
1000
800
600
400
200
0
$
Spot Transactions
Outright Forwards & Swaps
OTC Derivative Instruments
Traditional
Foreign Exchange
Instruments
196
£
362
900
670
1190
420
240
350
April 1989
590
1490
820
400
520
590
April 1992
April 1995
April 1998
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Hillfor
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Source:
Bank
International Settlements Central Bank Survey
1998
Currency Distribution of Global
Traditional Foreign Exchange Market Activity
3-8
Percentage Shares of Average Daily Turnover (Total = 200)
April 1998
¥
Australian
dollar 3
Canadian
dollar 4
Swiss franc 7
ECU &
other EMS
currencies 15 Other currencies
$
17
£
US dollar
87
French franc 5
Pound 11
sterling
Japanese yen 21
30 Deutsche mark
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Source:
Bank
International Settlements Central Bank Survey
1998
3-9
Geographical Distribution of Global Traditional
Foreign Exchange Market Activity
Average Daily Turnover in billions of US dollars
April 1998
¥
Others
18%
Switzerland
4%
$
Hong Kong
4%
France
4%
Germany
5%
Singapore
7%
Japan
8%
£
United
Kingdom
32%
United States
18%
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Source:
Bank
International Settlements Central Bank Survey
1998
Geographical Distribution of Global
Over-the-Counter Derivatives Market Activity
3 - 10
Average Daily Turnover of Notional Amounts in billions of US dollars
April 1998
Singapore Others
2%
12%
Canada
2%
Switzerland
3%
Germany
7%
Japan
9%
$
France
10%
¥
£
United
States
19%
United
Kingdom
36%
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Source:
Bank
International Settlements Central Bank Survey
1998
3 - 11
Foreign Exchange Trading Profits
Based on a Sample of 15 Large U.S. Commercial Banks
¥
2500
$
2000
200
Total Profit
£
(in millions of $)
1500
1000
250
150
Average Profit
(in millions of $)
500
0
100
50
0
76
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Source:
Company
annual reports
78
80
82
84
86
88
90
92
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3 - 12
Foreign Exchange Trading Profits
Foreign Exchange Trading Income of Selected Banks
( in millions of US$ )
Company
Bank of New York
Chase Manhattan
Citicorp
Credit Suisse First Boston
Deutsche Bank
Mellon Financial Corp
Morgan (J.P.) & Co.
Republic National Bank
State Street Bank
1977
NA
55
68
NA
NA
6
40
5
2
$
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Source:
Company
annual reports
¥
1987
NA
385
453
NA
NA
8
251
39
21
1997
109
790
1,486
699
1,040
118
493
98
159
£
1998
126
936
1,628
97
636
165
781
120
177
1999
137
807
1,569
897
807
173
777
141
209
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Explaining the Profitability of
3 - 13
Foreign 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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Foreign Exchange Market
3 - 14
Products 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 Market
3 - 15
Products 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 Market
3 - 16
Products and Activities
Speculation entails more than the assumption of
a risky position. It implies financial transactions
undertaken when an individual’s expectations
differ from the market’s 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 Market
3 - 17
Products 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 Market
3 - 18
Products 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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3 - 19
Foreign Exchange Market
Products and Activities
currency dimension
The Relationship between Spot and Forward Contracts
time dimension
Jan 1
borrow US$ at i$
US$ B
Jul 1
A
lend US$ at i$
buy €
spot at S
€
C
Option 2
Option 1
sell €
spot at S
buy €
forward
at F
borrow € at i€
lend € at i€
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sell €
forward
at F
D
A manager
wishes to
own € on
July 1.
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Foreign Exchange Market
3 - 20
Products and Activities
In the absence of transaction costs, taxes, or
default, the price of the two alternatives must
be identical:
The US$ cost
of each €.
Ft ,6 St
The price
of 1 € for
delivery on
July 1.
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The cost of each
borrowed US$.
1 i
1 i €
$,6
,6
2
2
The present
value of 1 €.
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Foreign Exchange Market
3 - 21
Products and Activities
Synthetic forwards can be created by using a
spot contract combined with borrowing and
lending.
By combining a spot contract with fixed-rate, nperiod borrowing and lending in the two
currencies, an n-period forward exchange
contract can be constructed.
Note that other factors may influence actual longterm forward rates.
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Foreign Exchange Market
3 - 22
Products and Activities
Synthetic securities (whether an asset or a
liability) can be constructed by combining a
security denominated in the other currency with
a forward contract of similar maturity and a
spot contract.
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Foreign Exchange Market
3 - 23
Products and Activities
Construction of a Synthetic Dollar Security
currency dimension
Jan 1
US$
B
time dimension
borrow US$ at i$
Jul 1
A
lend US$ at i$
is equivalent to
buy €
spot at S
€
sell €
spot at S
C
buy €
forward
at F
borrow € at i€
sell €
forward
at F
D
lend € at i€
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3 - 24
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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3 - 25
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 world’s largest
banks.
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3 - 27
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 multibank internet foreign exchange trading system.
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The Foreign Exchange Market Setting
Access to the brokerage system defines pricing
in the foreign exchange market:
Those with access are in the interbank (or
wholesale) market, while those without access are
in the corporate (or retail) market.
Access is based on credit quality and trading style.
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The Foreign Exchange Market Setting
Dimensions of the Foreign Exchange Market, April 1998
(Daily Averages in billions of US dollars)
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Source:
Bank
International Settlements Central Bank Survey
1998
3 - 30
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 bank’s spot trader
were earned through trades with the bank’s 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 bank’s 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.
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