The Global forex markets

1
The Global forex markets

• By
• A.V. Vedpuriswar

2
Acknowledgement

• This presentation draws heavily from BIS data and
  the Pacific Exchange Rate Service website
  maintained by Prof. Werner Antweiler of the
  University of British Columbia

3
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

4

• Players Individuals, corporate banks, central
  banks and securities firms
• More than 97 or trading is speculative
• Trading almost around the clock

5
Global forex trading

• Auckland
• Sydney
• Tokyo
• Singapore
• Frankfurt
• Zurich
• Paris
• London
• New York

6

• 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

7

• 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 on
  weekends),
• the variety of factors that affect exchange rates
• the low margins of profit compared with other
  markets of fixed income (but profits can be high
  due to very large trading volumes)
• As such, it has been referred to as the market
  closest to the ideal of perfect competition.

8

• Unlike a stock market, where all participants
  have access to the same prices, the forex market
  is divided into levels of access.
• At the top is the inter-bank market, which is
  made up of the largest investment banking firms.
• Within the inter-bank market, spreads, which are
  the difference between the bid and ask prices,
  are razor sharp and usually unavailable, and not
  known to players outside the inner circle.
• As we move to the next level of access, the
  difference between 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 difference between the bid and ask price,
  which is referred to as a better spread.

9

• The levels of access that make up the forex
  market are determined by the size of the line
  (the amount of money with which they are
  trading).
• The top-tier inter-bank market accounts for 53
  of all transactions.
• 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 forex market
  makers.
• Pension funds, insurance companies, mutual funds,
  and other institutional investors have played an
  increasingly important role in in FX markets,
  since the early 2000s.
• Hedge funds have grown markedly over the
  20012004 period in terms of both number and
  overall size.
• Central banks also participate in the forex
  market to align currencies to their economic
  needs.

10
Foreign exchange market turnover

• The April 2007 BIS data on turnover in
  traditional foreign exchange 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
  observed between 2001 and 2004.
• Even after adjusting for the valuation effects
  arising from exchange rate movements, average
  daily turnover rose by 65.

11
Growth in turnover

• Growth in turnover was broad-based across
  instruments.
• More than half of the increase in turnover can be
  accounted 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 exchange swap instruments.
• Growth in the turnover of outright forward
  contracts also picked up significantly to 74.
• In contrast, turnover in spot markets increased
  by 62, roughly unchanged from growth in turnover
  in the previous three-year period.

12
Composition of turnover by counterparty

• The composition of turnover by counterparty has
  changed substantially.
• Transactions between reporting dealers and
  non-reporting financial institutions, such as
  hedge funds, mutual funds, pension funds and
  insurance companies, more than doubled between
  April 2004 and April 2007 and contributed more
  than half of the increase in aggregate turnover.
• Factors underlying the strength of this segment
  include strong investor activity in an
  environment of financial market volatility, a
  trend shift among institutional investors with a
  longer-term investment horizon towards holding
  more internationally diversified portfolios and a
  marked increase in 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 between reporting dealers, ie
  the interbank market, fell to 43, despite growth
  in this segment being somewhat higher compared
  with the previous three-year period.

13
Currency composition of turnover

• The currency composition of turnover has become
  more diversified over the past three years.
• The share of the four largest currencies fell,
  although the US dollar/euro continued to be the
  most traded currency pair.
• The most notable increases in share were for the
  Australian and New Zealand dollars, which have
  attracted attention from investors as
  high-yielding currencies, and the 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 2007 from less than 15 in
  April 2004.

14
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 of desks.

15
OTC derivatives market turnover

• Average daily turnover in OTC foreign exchange
  and interest rate contracts went up by 74
  relative to the previous survey in 2004, to reach
  4,198 billion in April 2007.
• This corresponds to an annual compound rate of
  growth of 20, which is higher than the 14
  growth recorded since the 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.

16
OTC derivatives notional amounts

• Positions in OTC derivatives grew at an even more
  rapid pace than 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 of 33, which is higher than the
  approximately 25 average annual rate of increase
  since 1998.
• Growth accelerated in all risk categories.
• The highest rate of increase was reported in the
  credit segment of the OTC derivatives market,
  where positions expanded to 51 trillion, 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 change in
  the degree of underreporting as well as a genuine
  increase in positions.

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• Less extreme, but still high rates of growth were
  reported for the more traditional types of risk
  traded on the OTC derivatives market.
• Open positions in interest rate contracts
  increased by 119 to 389 trillion, and those in
  equity contracts by 111 to 11 trillion.
• Growth in notional amounts outstanding of OTC
  foreign exchange derivatives was less brisk at
  83, taking the volume of open positions in such
  contracts to 58 trillion.

18
OTC Derivatives Gross market values

• Notional amounts outstanding provide useful
  information on the structure of the OTC
  derivatives market.
• But we also need a measure of the riskiness of
  these positions.
• While a single comprehensive measure of risk does
  not exist, a useful concept is the cost of
  replacing all open contracts at the prevailing
  market prices.
• This measure, called gross market value,
  increased at a considerably lower rate (74) than
  notional amounts during the reporting period, to
  11 trillion at the end of June.

19
Countrys choice of exchange rates

• Openness
• Size
• Export dependence on a few commodities
• Capital A/C Convertibility
•                    

20
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.

21
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.

22
Export dependence on a few commodities

• Fixed exchange rate preferable.
• Otherwise disruptive effect on economy

23
Capital A/C Convertibility

• Heavy inflows and outflows of capital create
  considerable difficulties in  maintaining fixed
  exchange rate.
•     
•               

24
Maintaining a peg How Currency Boardsoperate.

• A currency board's foreign currency reserves must
  be sufficient to ensure that all holders of its
  notes and coins can convert them into the reserve
  currency (usually 110115).
• A currency board maintains absolute, unlimited
  convertibility between its notes and coins and
  the currency against 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 not engage in forward-exchange
  transactions.

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• A currency board has no discretionary powers to
  effect monetary policy and does not lend to the
  government. Governments cannot print money, and
  can only tax or borrow to meet their spending
  commitments.
• A currency board does not act as a lender of last
  resort to commercial banks, and does not regulate
  reserve requirements.
• A currency board does not attempt to manipulate
  interest rates by establishing a discount rate
  like a central bank.
• The peg with the foreign currency tends to keep
  interest rates and inflation very closely aligned
  to those in the country against whose currency
  the peg is fixed.

26

• 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
  against the 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 Saint Vincent and the Grenadines)

27

• 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 in fact the Danish National Bank serves as
  the lender of last resort and all bank accounts
  are denominated in Danish kroner. The Danish
  National Bank refers to the Faroese króna 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
  independence until 1979.

28
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 of
  interconnected financial markets.
• Tables now turned.
• Emerging market currencies looking strong now.  

29
Emerging scenario

• Floating exchange rates can overshoot but allow
  country to retain independence as far  
  as monetary policies are concerned .
• 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 into global capital markets.
• Fixed exchange rates- Tightly integrated into
  global capital  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
34
HK Dollar vs US Dollar
35
Yuan vs Dollar
36
Panamanian Balboas vs Dollar
37
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
41
DM vs Dollar long term trend.