Foreign exchange market

Foreign exchange market

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  International Financial Markets: TheForeign Exchange Market An introduction to the Foreign Exchange Market and Understanding Foreign Exchange Quotes www.StudsPlanet.com
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  Definitions • International FinancialMarket: – The overall financial market in which MNCs and international investors operate. • Where they raise money, where they invest, how they make cross border payments and receive cross border receipts, how they move funds… • An important sub-set of the international financial market is the foreign exchange market. – This is the market where: • Exchange rates are determined and exchange rate exposure is managed. Additionally through this market: – international payments and international receipts are accommodated (from commercial transactions) – movements of capital are accommodated (from profit remittances and lender (investor) and borrower transactions). www.StudsPlanet.com
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  Definitions • Exchange RateRegime: – The arrangement whereby a government manages its country’s currency in relation to the rest of the world and the resulting structure through which the price (i.e., exchange rate) of that country’s currency is determined on foreign exchange markets. – There are essentially three possible structures for determining the exchange rate: • Floating Rate Regime (AKA “Independent Float”) • Managed Rate Regime (AKA “Dirty Float”) • Pegged Rate Regime www.StudsPlanet.com
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  History of ExchangeRate Regimes • For most of the past 200 years, governments and policy makers were focused on creating and facilitating a global fixed exchange rate system (i.e., one with stable exchange rates). • However, over the last 40 years, the reality has been one of a mixed exchange rate system combining unstable exchange rates (i.e., floating rate regimes and managed rate regimes) with stable rates (i.e., pegged rate regimes). • Beginning with the “classical” gold standard regime of the latter part of the 19th century we can identify there 3 distinct exchange rate regime periods: – Gold Standard: 1816 - 1914 (stable exchange rates pegged to gold) – Bretton Woods: 1945 – 1973 (stable exchange rates pegged to the U.S. dollar) – Mixed System: 1973 – the present (unstable exchange rates among major currencies of the world)www.StudsPlanet.com
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  Today’s Mixed ExchangeRate Regime • Today’s system consists of: – (Independent) Floating exchange rate regimes: • Market forces (demand and supply) determine the relative value of a currency (i.e., its exchange rate). • All of the world’s major hard currencies operate under this system. – Managed (dirty float) rate regimes: • Governments managing their currency’s value with regard to a reference currency (or market basket). • Market moves these currencies, but governments are managing the process and intervening when necessary. • However, there is no predetermined path for the exchange rate. – Pegged exchange rate regimes: • Government fixes (links) the value of its currency relative to a reference currency. • Mainly used by smaller, developing countries. www.StudsPlanet.com
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  Some Countries byExchange Rate Regime Classification (2007 IMF Data) • Floating Regimes (n = 35): – USD, JPY, EUR, GBP, CAD, AUD, NZD, CHF, ZAR, MXN, KRW, SEK, ILS • Managed Float Regimes (n = 48): – THB, SGD, INR, RUB, CZK, CNY (as of 2010) • Pegged (and Crawling Pegs*) Regimes (n = 94): – HKD (7.81:1USD), SAR (3.75: 1USD); VND* (18,932:1USD, announced August 18, 2010) – *Crawling peg: Where the currency’s peg is adjusted periodically in small amounts www.StudsPlanet.com
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  Post Bretton WoodsImplications • Since March 1973, the major currencies of the world have operated under a (an independent) floating exchange rate system. – While central banks of major countries have occasionally interviewed in support of their currencies, this intervention has become less frequent over time. • The US last intervened in 1998; Japan in 2004. • In addition, a growing number of developing countries have adopted floating rate or managed rate systems. – Thus: more and more, market forces are driving currency values. • Observations and Implications: – The move towards floating exchange rate regimes has resulted exchange rates become more volatile and less predictable. – This period has also seen market (speculative) attacks on currencies which have produced large and sudden swings in exchange rates. • British Pound: 1992; Italian Lira: 1992; Mexican Peso: 1994; Asian Currency Crisis: 1997; Russian Ruble: 1998; Brazilian Real: 1999; Turkish Lira: 2001; Argentina Peso: 2001/02; Euro: 2010. – This currency volatility complicates the management of global companies and the investment environment for global investors. • Through their exchange rate exposure. www.StudsPlanet.com
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  International Asset ReturnsAttributed to Exchange Rate Changes Percentage of Monthly Returns Explained by Monthly Currency Moves Source of Data, Findings and Conclusions • Source: State Street Bank, Global Advisors (2010). Data through November 2009 – MSCI EAFT: Morgan Stanley’s index of 21 developed equity markets in Europe, Asia Pacific, Africa and the Middle East. Excludes the U.S. and Canada. This index is the major benchmark for international equity performance (and fund managers). – BarCap: Barclays Capital Global Aggregate Index. This is a bond market index made up of investment grade (Moody’s BBB- and higher), fixed rate, corporate debt outside of the United States. • Findings and Conclusions: – Currency moves have contributed to around 60% of international bond returns. – Currency moves have contributed to around 40% of international equity returns. – “Currency risk is an inevitable by-product of investing in international assets.” www.StudsPlanet.com
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  Unhedged Versus HedgedEquity and Bond Returns, 1991-2009 Minimum and Maximum Monthly Returns for Equity and Bonds by Year Source of Data and Conclusions • Source: State Street Bank: Global Advisors (2010). Data through November 2009. • Conclusions: – The dispersion of monthly returns (i.e., the differences between the minimum and maximum monthly returns) shows that unhedged positions consistently produce larger dispersions and thus greater risk. – Hedging reduces the “upside (gain) as well as the downside risk.” www.StudsPlanet.com
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  The Foreign ExchangeMarket (April 2010) • World’s largest financial market at $4.0 trillion dollars per day in trades ($3.3 in 2007). – NYSE-Euronext stock exchange currently about $40 billion per day. • Market is a 24/5(7) over-the-counter market. – Major markets open Monday through Friday; Middle East markets also open on weekends (Saudi Arabia and Bahrain) – There is no central trading location (i.e., no central trading floor). – Trades take place through a network of computer (Reuters screens) and telephone connections all over the world. • 37% of all trades take place through banks located in the U.K. (London); 17% the U.S. (New York); 6% Japan (Tokyo). Saudi Arabia and Bahrain each 0.1%. • Most popular traded currency is the USD (86%); EUR (39%); JPY ( 19%); GBP (13%); AUD (8%); CHF (6%); CAD (5%) • Most popular traded currency pair is the USD/EUR (28%); USD/JPY (14%); USD/GBP (9%); USD/AUD (6%) www.StudsPlanet.com
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  How Does theFX Market Quote Currencies? • (1) American Terms Quote: – Expresses the exchange rate as the number of U.S. dollars and cents per one unit of a foreign currency. • For example, $1.50 per 1 British pound. • (2) European Terms Quote: – Expresses the exchange rate as the number of foreign currency units per one U.S. dollar. • For example, 85 yen per 1 U.S. dollar. • Most of the world’s currencies are quoted for trade purposes on the basis of European terms. – Exceptions include: British pound, Euro, Australian dollar and New Zealand dollar. www.StudsPlanet.com
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  Quotes are Givenby Time of Settlement • Spot Exchange Rates: – Quotes for “immediate” transactions (actually settled within 1 or 2 business days) • Forward Exchange Rates: – Quotes for specified future transactions (3 business days and longer settlement). • Forward markets are used by businesses and investors to protect (hedge) against unexpected future changes in exchange rates. –Forward rate allows businesses and investors to “lock” in an exchange rate for some future period of time. www.StudsPlanet.com
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  Role of Banksin the Foreign Exchange Market? • Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank) operate in the foreign exchange markets through: – (1) Their “external” clients” (primarily large global firms: exporters, importers, multinational firms, investment companies, hedge firms) • Acting in a broker capacity at the request of these clients. – (2) Their own banks (trading in currencies to generate profits). • Acting in a “dealer” (i.e., trading) capacity. • In meeting the needs of their clients and their own trading activities, these global banks establish the “tone” of the foreign exchange market. – This is done through their “market maker” function. www.StudsPlanet.com
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  Making the Marketin FX • The market maker function of any global bank involves two primary foreign exchange activities: • (1) A willingness of the market maker to provide the market with “on-going” (i.e., continuous) two way quotes upon request: – (1) Provide a price at which they will buy a currency – (2) Provide a price at which they will sell a currency • This function provides the market with transparency. • (2) A willingness of the market maker to actually buy and/or sell at the prices they quote: – Thus the market maker offers “firm” prices into the market. • This function provides the market with liquidity. www.StudsPlanet.com
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  Base and QuoteCurrency • Recall that a foreign exchange quote is simply the ratio of one currency to another. • Thus a “complete” market maker quote must have two ISO designations (e.g., EUR/USD; USD/JPY; USD/CNY): – The first ISO currency quoted is called the base currency. – The second ISO currency quoted is called the quote currency. • For example: EUR/USD: EUR is the base currency and USD is the quote currency. – Hint: When viewing a foreign exchange quote, assign a value of 1 to the base currency (the base currency is the first in the ISO pair). – The quotes you see refer to one unit of this base currency. • For example: EUR/USD: 1.3000 = 1 euro equals $1.3000 • For example: USD/JPY: 84.0000 = 1 US dollar equals 84 yen – Hint: If quoted exchange rates are moving up, that means that the base currency is getting stronger and the quote currency is getting weaker (reverse if the quoted rate is moving down). • For Example: EUR/USD 1.3000 EUR/USD 1.3100; Thus the euro strengthened and the dollar weakened. • For Example: USD/JPY 84.0000 USD /JPY 83.0000; thus the dollar weakened and the yen strengthened.www.StudsPlanet.com
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  Bid and AskQuotes • Recall that a market maker always provides the market with two prices, i.e., both a buy and sell quote (or price) for a currency. • For Example: EUR/USD: 1.2102/1.2106 – The first number in the quoted sequence is the market maker’s buy price for the base currency (i.e., they will buy 1 euro for $1.2102). • This price is called the market maker’s bid quote (i.e., buy price) – The second number in the quoted sequence is the market maker’s sell price for the base currency (i.e., they will sell 1 euro for $1.2106). • It is called the market maker’s ask quote (i.e., sell price) – Note: The ask quote is always higher than the ask quote. • This is the profit spread for a market maker bank.www.StudsPlanet.com
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  Complete FX Example •Assume: EUR/USD: 1.2102/1.2106 • Question: Which currency is the market maker selling and which currency is the market maker buying? • Answer: Market maker is always quoting prices at which they will buy or sell one unit of the base currency (against the quote currency). – So in the above example: • The market maker will buy euros for $1.2102 – This is the bid price for euros and this is the price that a non-market maker will get if selling euros. • The market maker will sell euros for $1.2106 – This is the ask price for euros and this is the price that a non-market maker will pay to buy euros. – Practice: Go to: http://www.fxstreet.com/ • Link to Rates and Charts then to Live Currency Rates then link to any quoted pair. Observe the bid and ask prices for this currency pair. • Make sure you understand the meaning of the quotes (bid and ask prices) and the changes in the quotes.www.StudsPlanet.com