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

McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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

McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
¥
$
McGraw Hill / Irwin
£
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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
2001 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw
Hillfor
/ Irwin
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
2001 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw
Hillfor
/ Irwin
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%
2001 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw
Hillfor
/ Irwin
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%
2001 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw
Hillfor
/ Irwin
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 $)
500
0
100
50
0
76
McGraw
Hill / Irwin
Source:
Company
annual reports
78
80
82
84
86
88
90
92
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 12
Foreign Exchange Trading Profits
Foreign Exchange Trading Income of Selected Banks
( in millions of US$ )
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
$
McGraw
Hill / Irwin
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
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
¥
$
McGraw Hill / Irwin
£
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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).
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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€
McGraw Hill / Irwin
sell €
forward
at F
D
A manager
wishes to
own € on
July 1.
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
McGraw Hill / Irwin
The cost of each
borrowed US$.
1  i
1  i €
$,6
,6
2
2
The present
value of 1 €.
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Foreign Exchange Market
3 - 21
Products and Activities
 Synthetic forwards can be created by using a
spot contract combined with borrowing and
lending.
 By combining a spot contract with fixed-rate, nperiod borrowing and lending in the two
currencies, an n-period forward exchange
contract can be constructed.

Note that other factors may influence actual longterm forward rates.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Foreign Exchange Market
3 - 22
Products and Activities
 Synthetic securities (whether an asset or a
liability) can be constructed by combining a
security denominated in the other currency with
a forward contract of similar maturity and a
spot contract.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Foreign Exchange Market
3 - 23
Products and Activities
Construction of a Synthetic Dollar Security
currency dimension
Jan 1
US$
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€
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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

McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 26
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.

McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 28
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.

McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 29
The Foreign Exchange Market Setting
Dimensions of the Foreign Exchange Market, April 1998
(Daily Averages in billions of US dollars)
2001 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw
Hillfor
/ Irwin
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 31
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 32
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.

McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 33
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)
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 34
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
3 - 35
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.
McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.