Foreign Exchange Markets Lecture 2 Notes

Characteristics of FX Markets

  • Largest financial markets globally with an average daily turnover exceeding $6.59 Trillion (as of 2019)

  • Historical turnover growth:

  • $1.8 Trillion in 2004

  • $4 Trillion in 2010

  • $5.3 Trillion in 2013

  • $5.07 Trillion in 2016

  • $6.59 Trillion in 2019

  • 62% of transactions involve cross-border counterparties

  • Only approximately 11% of daily spot transactions are between non-financial customers

  • London dominates as the largest FX market with 38% of global volume

  • The US dollar is fundamental, involved in 89% of all transactions

  • The Australian dollar was the 5th most traded currency in 2019

Structure of FX Markets

  • Not a centralized exchange

  • No fixed opening hours

  • No standardized contracts

  • Operates in two tiers:

  • Retail market: individuals buying/selling foreign exchange

  • Wholesale market: ~2,000 entities (banks, dealers, etc.)

  • Linked through SWIFT and has over 10,000 financial institutions globally

Participants in Wholesale Market

  • Key participants:

  • International banks

  • Commercial and investment clients

  • Non-bank dealers & FX brokers

  • Central banks

  • Characteristics:

  • Settlement typically does not involve actual money changing hands

  • Market is deep, liquid, and operates 24/7

Geographic Activity

  • Market mechanics dependent on global time zones:

  • Tokyo opens Asian market

  • London closes at 6 PM NY time

  • American markets open after Europe

  • Activity peaks during overlap hours

Case Study: Commonwealth Bank of Australia (CBA)

  • If CBA wants to purchase US$10 billion:

  • Can contact banks/brokers and confirm via SWIFT

  • Settlement using Reserve Bank Information and Transfer System (RITS) and CHIPS/Fedwire

  • Settlement effectiveness and timing critical to avoid liquidity risk

Settlement Risk

  • Definition: When counterparties cannot settle transactions on time, potentially leading to liquidity crises

  • High systemic risk due to interconnectedness of financial institutions

  • Examples include communication issues leading to delayed funds transfer

  • Strategies to mitigate:

  • Limit transaction volumes

  • Netting arrangements to reduce overall payment flows

Types of Foreign Exchange Activities

  • Hedging:

  • Used to manage exchange rate risks

  • Firms lock in exchange rates to stabilize costs/revenues

  • Speculation:

  • Involves betting on currency movements for profit

  • Arbitrage:

  • Exploiting price inconsistencies across different markets for risk-free gains

  • Types: spatial, triangular, covered interest arbitrage

Exchange Rates and Quotations

  • Definition: Price of one currency in terms of another

  • Spot Rate: Exchange rate for immediate execution, usually settlement occurs two days later

  • Quotations:

  • Direct Quote: Home currency per unit of foreign currency (e.g., AUD/GBP)

  • Indirect Quote: Foreign currency per unit of home currency

  • Reciprocal relations between direct and indirect quotes important for conversions

Bid-Ask Prices

  • Concept:

  • Bid: Price dealers pay to purchase currency

  • Ask: Price dealers sell currency

  • Spread: Difference between bid and ask prices represents profit margin

  • Understanding quotes is critical; e.g., quoting in American vs European terms affects interpretation

Cross Rates

  • Definition: Exchange rates determined through a third widely traded currency

  • Example: Australian dollar to Danish kroner can be derived through both being quoted against USD

  • Important for importing/exporting and international transactions

Triangular Arbitrage

  • Involves checking cross rates for arbitrage opportunities

  • Example involves converting between three different currencies to exploit rate discrepancies

Forward Contracts

  • Definition: Agreements for a future delivery of specified currency amounts

  • Can be customized in terms of size, currency type, and delivery timeline

  • Forward rates can be quoted outright, in points, or as annualized premiums/discounts

Measuring Changes in Exchange Rates

  • Percentage change in currency value can be significant for financial analysis and forecasting

  • Currency appreciation/depreciation calculations are key for evaluating market trends

  • Notably, the appreciation of one currency doesn’t equate to the depreciation of another due to compounding effects

Glossary of Terms

  • Spot Rate: Current market price of currency

  • Direct Quote: Domestic currency per unit of foreign

  • Indirect Quote: Foreign currency per unit of domestic

  • Arbitrage: Riskless profit strategy via price discrepancies

  • Forward Contract: Future currency purchase/sale agreement

  • Forward Premium/Discount: Rate differences between forward and spot market rates