the global forex markets

8/6/2019 The Global Forex Markets

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Acknowledgement This presentation draws heavily from BIS data and the

Pacific Exchange Rate Service website maintained by Prof.

Werner Antweilerof the University of British Columbia


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Introduction International Trade - Barter

Bond issues to finance infrastructure projects in

developing countries (19th century)

Gold Standard (1879 - 1934)

Bretton Woods (1944 - 1971)

1960s: Decline of U.S Economy

1971: Devaluation of Dollar

Managed / Dirty float

America, Germany first to free capital flows

Britain, 1979, Japan, 1980 (mostly)

France, Italy remove restrictions in 1990

Currency Board in Hongkong, Argentina- Dollarisation?

Creeping peg in Brazil


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Players : Individuals, corporate banks, central banks

and securities firms

More than 97 % or trading is speculative Trading almost around the clock


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Global forex trading Auckland

Sydney

Tokyo Singapore

Frankfurt

Zurich

Paris

London

New York


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Peak trading during European waking hours

New York most active when Europe is open

During afternoon, New York becomes more volatile Worst time to trade - after New York closes but Sydney has

not opened


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The foreign exchange market is unique because of its trading volumes,

the extreme liquidity of the market,

the large number of, and variety of, traders in the market,

its geographical dispersion,

its long trading hours: 24 hours a day (except onweekends),

the variety of factors that affect exchange rates

the low margins of profit compared with other markets offixed income (but profits can be high due to very largetrading volumes)

As such, it has been referred to as the market closest tothe ideal of perfect competition.


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Unlike a stock market, where all participants have accessto the same prices, the forex market is divided into levels ofaccess.

At the top is the inter-bank market, which is made up of thelargest investment banking firms.

Within the inter-bank market, spreads, which are thedifference between the bid and ask prices, are razor sharp

and usually unavailable, and not known to players outsidethe inner circle.

As we move to the next level of access, the differencebetween the bid and ask prices widens .

This is due to volume. If a trader can guarantee large numbers of transactions for

large amounts, they can demand a smaller differencebetween the bid and ask price, which is referred to as a

better spread.


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The levels of access that make up the forex market aredetermined by the size of the line (the amount of moneywith which they are trading).

The top-tier inter-bank market accounts for 53% of alltransactions.

After that there are usually smaller investment banks,followed by large multi-national corporations (which need

to hedge risk and pay employees in different countries),large hedge funds, and even some of the retail forexmarket makers.

Pension funds, insurance companies, mutual funds, and

other institutional investors have played an increasinglyimportant role in in FX markets, since the early 2000s.

Hedge funds have grown markedly over the 20012004period in terms of both number and overall size.

Central banks also participate in the forex market to aligncurrencies to their economic needs.


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Foreign exchange market turnover

The April 2007 BIS data on turnover in traditional foreignexchange markets highlight several important features of

the evolution of these markets. First, average daily turnover has grown by an

unprecedented 71% since April 2004, to $3.2 trillion.

This increase was much stronger than the one observedbetween 2001 and 2004.

Even after adjusting for the valuation effects arising fromexchange rate movements, average daily turnover rose by65%.


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Growth in turnover

Growth in turnover was broad-based across instruments.

More than half of the increase in turnover can beaccounted for by the growth in foreign exchange swaps,which rose 82% compared with 44% over the previous

three-year period. Changes in hedging activity may have been one factor

underlying the increasing importance of foreign exchangeswap instruments.

Growth in the turnover of outright forward contracts alsopicked up significantly to 74%.

In contrast, turnover in spot markets increased by 62%,roughly unchanged from growth in turnover in the previousthree-year period.


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Composition of turnover by counterparty The composition of turnover by counterparty has changed substantially.

Transactions between reporting dealers and non-reporting financialinstitutions, such as hedge funds, mutual funds, pension funds andinsurance companies, more than doubled between April 2004 and April2007 and contributed more than half of the increase in aggregateturnover.

Factors underlying the strength of this segment include strong investoractivity in an environment of financial market volatility, a trend shift amonginstitutional investors with a longer-term investment horizon towardsholding more internationally diversified portfolios and a marked increasein the levels of technical trading.

Turnover between reporting dealers and non-financial customers also

more than doubled.

Consequently, the share of turnover resulting from transactions betweenreporting dealers, ie the interbank market, fell to 43%, despite growth inthis segment being somewhat higher compared with the previous three-year period.


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Currency composition of turnover

The currency composition of turnover has become morediversified over the past three years.

The share of the four largest currencies fell, although theUS dollar/euro continued to be the most traded currencypair.

The most notable increases in share were for theAustralian and New Zealand dollars, which have attractedattention from investors as high-yielding currencies, andthe Hong Kong dollar, which has benefited from being

associated with the economic expansion of China. More broadly, the share of emerging market currencies in

total turnover has increased, to almost 20% in April 2007from less than 15% in April 2004.


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Geographical distribution The geographical distribution of foreign exchange trading

did not change significantly.

Among countries with major financial centres, Singapore,Switzerland and the United Kingdom gained market share,while the shares of Japan and the United States dropped.

In some cases, changing shares reflected the relocation ofdesks.


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OTC derivatives market turnover

Average daily turnover in OTC foreign exchange andinterest rate contracts went up by 74% relative to theprevious survey in 2004, to reach $4,198 billion in April2007.

This corresponds to an annual compound rate of growth of

20%, which is higher than the 14% growth recorded sincethe derivatives part of triennial survey was started in 1995.

Activity in foreign exchange derivatives rose by 79%,slightly above the rate of increase reported for the spot

market (62%). More moderate growth was recorded in the interest rate

segment, where turnover went up by 64%.


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OTC derivatives notional amounts

Positions in OTC derivatives grew at an even more rapid pacethan turnover. Notional amounts outstanding went up by 135% to$516 trillion at the end of June 2007.

This corresponds to an annualised compound rate of growth of33%, which is higher than the approximately 25% averageannual rate of increase since 1998.

Growth accelerated in all risk categories.

The highest rate of increase was reported in the credit segmentof the OTC derivatives market, where positions expanded to $51trillion, from under $5 trillion in the 2004 survey.

Notional amounts outstanding of commodity derivatives rose

more than sixfold to $8 trillion, although this may reflect a changein the degree of underreporting as well as a genuine increase inpositions.


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Less extreme, but still high rates of growth were reportedfor the more traditional types of risk traded on the OTCderivatives market.

Open positions in interest rate contracts increased by119% to $389 trillion, and those in equity contracts by111% to $11 trillion.

Growth in notional amounts outstanding of OTC foreignexchange derivatives was less brisk at 83%, taking thevolume of open positions in such contracts to $58 trillion.


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OTC Derivatives : Gross market values

Notional amounts outstanding provide useful informationon the structure of the OTC derivatives market.

But we also need a measure of the riskiness of thesepositions.

While a single comprehensive measure of risk does notexist, a useful concept is the cost of replacing all opencontracts at the prevailing market prices.

This measure, called gross market value, increased at a

considerably lower rate (74%) than notional amountsduring the reporting period, to $11 trillion at the end ofJune.


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Countrys choice of exchange rates Openness

Size

Export dependence on a few commodities

Capital A/C Convertibility


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Openness Relatively closed economies may find it difficult to correct

external imbalances using domestic policies.

They would prefer flexible exchange rates. On the other hand, open economies would prefer fixed

exchange rates.


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Size Small countries tend to prefer fixed exchange rates.

Economic policy can be tailored to meet the needs of the

economy as a whole. In a diversified large economy, flexible rates are

preferable.


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Export dependence on a few

commodities

Fixed exchange rate preferable.

Otherwise disruptive effect on economy


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Capital A/C Convertibility

Heavy inflows and outflows of capital create considerable

difficulties in maintaining fixed exchange rate.


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Maintaining a peg : How Currency Boardsoperate.

A currency board's foreign currency reserves must besufficient to ensure that all holders of its notes and coinscan convert them into the reserve currency (usually 110115%).

A currency board maintains absolute, unlimitedconvertibility between its notes and coins and the currencyagainst which they are pegged, at a fixed rate of exchange,with no restrictions on current-account or capital-account

transactions. A currency board only earns profit from interest on

reserves (less the expense of note-issuing), and does notengage in forward-exchange transactions.


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A currency board has no discretionary powers to effectmonetary policy and does not lend to the government.Governments cannot print money, and can only tax orborrow to meet their spending commitments.

A currency board does not act as a lender of last resort tocommercial banks, and does not regulate reserverequirements.

A currency board does not attempt to manipulate interestrates by establishing a discount rate like a central bank.

The peg with the foreign currency tends to keep interestrates and inflation very closely aligned to those in thecountry against whose currency the peg is fixed.


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Examples of currencies with a currency board against

the euro

Bulgarian lev

Estonian kroon

Bosnian mark (Konvertibilna marka)

Lithuanian litas

Examples of currencies with a currency board againstthe U.S. dollar

Hong Kong dollar

Bermudian dollar

Cayman Islands dollar Djiboutian franc

East Caribbean dollar(Antigua and Barbuda, Dominica,Grenada, Saint Kitts and Nevis, Saint Lucia, and SaintVincent and the Grenadines)


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Examples of currencies with a currency board against

the pound sterling

Falkland Islands pound

Gibraltar pound

Saint Helena pound

Examples of currency boards against other currencies

Brunei dollar, against the Singapore dollar

Macanese pataca, against the Hong Kong dollar

The Faeroe Islands have a de jure currency board, but infact the Danish National Bank serves as the lender of lastresort and all bank accounts are denominated in Danish

kroner. The Danish National Bank refers to the Faroesekrna as a "special version" of the Danish krone.

Examples of currencies that have historically had a

currency board

Irish pound, pegged against pound sterling from


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Global financial architecture

1994- Mexican Peso crisis

1997- Asian currency crisis

1998- Brazil/Russia

Weak financial systems Poor supervision and regulation

Too much short term borrowing

False security of stable exchange rates

Once crisis struck, contagion effects because ofinterconnected financial markets.

Tables now turned.

Emerging market currencies looking strong now.


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Emerging scenario Floating exchange rates can overshoot but allow country to

retain independence as far as monetary policies areconcerned .

This freedom is however more limited than it looks prima facie.

For example, Indian interest rates cannot be set completely

independent of the Fed. Fixed rates mean subservience to monetary policies of another

country.

Emerging scenario- Two groups of countries

Flexible exchange rates , relatively low level of integration intoglobal capital markets.

Fixed exchange rates- Tightly integrated into globalcapital markets, foreign ownership.


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Dollar vs Euro


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Dollar vs Sterling


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Dollar vs Yen


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Dollar vs Rupee


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HK Dollar vs US Dollar


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Yuan vs Dollar


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Panamanian Balboas vs Dollar


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SF vs Dollar


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HK Dollar vs US Dollar : long term trend


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Indian Rupee vs Dollar : long term trend


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Yen vs Dollar long term trend


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DM vs Dollar long term trend.

the global forex markets

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