Exchange markets and exchange rates

Suggested Reading from Textbook

Chapter 7 (Foreign Exchange Market : Operation and Mechanics)

Exchange markets and rates

The foreign exchange market

A 24-hour market

Moves from Tokyo in the far east to Hong Kong,

Singapore, Bahrain, Frankfurt, Zurich, London,
New York and Los Angeles

No Physical, individual market place. Banks and

dealers carry out transactions

Exchange markets and rates

The foreign exchange market

Heavy use of technology

The resulting electronic infrastructure melds the

world into a global market for ideas, data and
capital, all moving virtually at the speed of light to
any part of the world

The Inter-bank foreign exchange markets are

arguably the most efficient markets in the world

Exchange markets and rates

The foreign exchange market

Today, there are more than 200,000 computer
terminals, in hundreds of trading rooms, in scores
of countries around the world, that light up to
display an unending flow of news

Less than two minutes elapse between the time a

president, a prime minister or a central banker
makes a statement and the time markets buy or sell
currency, stocks or bonds, according to their
evaluation of the policy's effect on the market

Exchange markets and rates

The foreign exchange market

The result is a continuing global referendum on a
country's economic policies, which are the final
determinant of the value of its currency

In a sense, the financial market represents a form of

economic free speech. Although many politicians
do not like what it is saying, the market presents
judgments that are generally clear-eyed and hardnosed

Exchange markets and rates

The foreign exchange market

The foreign exchange market is by far the largest
financial market in the world

Daily trading volume of close to $ 6 trillion

Question
Which are the major centres of foreign exchange
trading in the world?

Exchange markets and rates

Major centres of forex trading

New York ( 19%
Of volume)

London (41% of
Volume)

Substantial overlap
Between American and
European markets
No overlap between
American and Asian
markets
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Exchange markets and rates

Tokyo ( 6% of
Volume )

Some overlap between

European and Asian
markets
Singapore has outstripped
Tokyo by a tiny margin

Question
After peaking in 1998, daily trading volumes in
foreign exchange markets fell sharply to about a
trillion dollars in the late nineties

How would you explain this sharp fall in volumes?

Exchange markets and rates

The foreign exchange market

Volume fell largely because of the replacement of 12
European currencies with the euro .

And also the rise of electronic trading (traders entering

their buy and sell orders directly into their terminals on an
anonymous basis, and these prices are visible to all market
participants. Another trader, anywhere in the world can
execute a trade by simply pressing a button)

Question : Have you heard of high-frequency

trading?
What is it ? Why is the SEC worried about it ?
Exchange markets and rates

Question
How would you explain the following, rather
startling position? Does it bother you in terms of
how
it might affect the global financial system?

Trade accounts for less than 5% of all foreign

exchange transactions ( in other words about $ 300
billion as compared with say $ 6 trillion a day of
forex transactions )

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Exchange markets and rates

The data on the next slide might

help in forming a view on the
above question

Global Foreign Exchange Market Turnover (

Billions) ( Source : Bank for International
Settlements, database)
Transaction Type 1998 200 2004 200 201
1
7
0
Spot
568 386 631 100 148
5
8
Outright
128 130 209 362 475
forwards

Forex swaps

734 656

954

Currency
Swaps

10

21

171
4
31

Derivatives
(mainly options)

87

60

119

212

USD

201
3
204
8
680

175
9
43

222
6
54

207

447

The foreign exchange market

There could be two major reasons:

The foreign exchange market is very largely an

inter-bank market, with banks having to cover every
one of their transactions

Portfolio investments, and, to some extent,

speculation

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Exchange markets and rates

Speculation in currency markets

George Soros, Thailand, mid 1997
Current Account Deficit 8.5% of GDP
But Thai Baht pegged to the US Dollar
US Dollar began rising
Peg became difficult to maintain
Enter George Soros
Speculates heavily against THB
THB crashes
So-called East Asian crisis begins

Question
Who are the major participants in

the foreign exchange market ?

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Exchange markets and rates

Market participants
Commercial banks

Individuals

Central banks

Speculators

Arbitrageurs

Question
Why do central banks get involved in
forex markets?

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Exchange markets and rates

Question
What are the different types of

transactions in the foreign exchange

market?

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Exchange markets and rates

Types of transactions
Commercial

Arbitrage

Speculation

Intervention

Question: What is the difference between arbitrage

and speculation?

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Exchange markets and rates

Question
What are some of the major quoting

conventions in the foreign exchange

market?

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Exchange markets and rates

Rates and quoting conventions

Tomorrow (Tom) - value tomorrow or the next
trading day

Spot: value two business days after the trading

date (one business day for Canadian/US dollar
transactions)

Forwards Trade at a pre-specified price and on a

pre-specified future date ( any value date beyond
spot )

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Exchange markets and rates

Rates and quoting conventions

Direct quote: expresses the foreign currency in
local currency terms (say $ 1 = Rs. 60.00)

Indirect quote: Expresses the local currency in

foreign currency terms (say Rs 100 = $ 1.6667)

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Exchange markets and rates

Rates and quoting conventions

Cross rates (Example: If $ quotes at Rs 60 and
Pound sterling quotes at Rs 120, then we can work
out the Pound dollar rate by crossing these two
rates. We get one Pound = 120 / 60 = $2.00)

Two-way quotes (buy and sell rates) For example,

a bank might buy dollars from you at Rs 60 and sell
it at Rs. 61

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Exchange markets and rates

Question
What are the major sources of supply of foreign
exchange?

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Exchange markets and rates

Sources of supply of foreign exchange

Exporters (goods and services)

NRI deposits and remittances

FDI (foreign direct investment)

FPI (foreign portfolio investment)

Euro issues (GDRs, euro-convertibles, eurobonds)

Euro loans

Aid (bilateral, multilateral)

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Exchange markets and rates

Question
What are the major sources of demand for foreign
exchange?

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Exchange markets and rates

Sources of demand for foreign exchange

Importers (goods)

Central bank

Investors

Loan repayers

Unilateral transfers (eg. gifts)

Speculators

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Exchange markets and rates

Question
What is the US Dollar Index ?

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Exchange markets and rates

UD Dollar Index ( USDX)

Started by New York Board of Trade (NYBOT),
renamed ICE Futures US
Established in 1973 to track the Dollars
value against a basket of currencies ( major
trading partners at the time )
Began with 17 currencies, now down to 6
with euro launch
Current weights : Euro (57%), JPY ( 14%), GBP
(12%), CAD (9%), Swedish Krone (4%), CHF
(4%)
Index has traded as high as 165, but also into
the low seventies