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International Financial Management P G Apte

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  1. CHAPTER - 7 Foreign Exchange Markets International Financial Management P G Apte

  2. …a peculiar currency of your own So much of barbarism, however, still remains in the transactions of most civilized nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbors, a peculiar currency of their own. John Stuart Mill, 1894

  3. CURRENCY MARKETS • The foreign exchange market is the market in which currencies are bought and sold against each other. • The inter-bank foreign exchange market is an over-the-counter (OTC) market. London is the largest centre followed by New York/Tokyo. 20-25 other smaller centres. Average transaction size is about USD 5 million • The participants in the wholesale market are commercial banks, investment institutions, corporations and central banks. Currency brokers act as middlemen between dealers • A small number of currencies account for bulk of turnover:USD, EUR, GBP, CHF, JPY, CAD, AUD

  4. Size Of the Global Forex Market • Largest market in the world • $3.99 trillion average daily turnover in 2007, which is equivalent to more than 10 times the average daily turnover of global equity markets. May reach $5 trillion in 2010. • More than 35 times the average daily turnover of the NYSE • In 2007, $500 a day for every man, woman, and child on earth • Annual turnover more than 10 times world GDP • Trade related transactions account for about 15% of the turnover; the rest are related to capital flows. • 80% of the transactions are estimated to be for speculative purposes and the rest for commercial purposes

  5. FOREX MARKET TURNOVER (NET) DAILY AVERAGE, APRIL 2007 (US$ BILLION) TOTAL 3988 SPOT 1305 OUTRIGHT FORWARDS 433 SWAPS 2250 US$ vs. OTHERS 2660.262 EURO vs. OTHERS 1139.406 JPY vs. OTHERS 509.731 GBP vs. OTHERS 460.779 CHF vs. OTHERS 208.790

  6. 2007 BIS SURVEY – FOREX MARKET. • Average daily FX turnover $3.99 trillion USD. • Increased by more than 2.7 time since 2001. • 67% Forwards and Swaps. • 33% Spot transactions. • Less than 10% delivered. • USD involved in 89% of trades – almost $1.7 trillion daily.

  7. The forex market has not escaped the impact of global deleveraging and the failure of Lehman Brothers in 2008. • Central banks from around the world have released their semi-annual foreign exchange surveys and based upon all of the reports, forex trading volume decreased significantly between April 2008 and April 2009. • The lack of participation may explain why the major currency pairs have been stuck in a range since the beginning of May. In New York for example, forex spot trading volume fell to the lowest level in more than 3 years. • London remains the most active forex trading center followed by NY and Tokyo. The EUR/USD is still the most actively traded currency pair by far.

  8. Geographic Distribution of Turnover(in percent) Source: BIS

  9. The BIS data in its triennial survey is incomplete. • The global turnover maybe around 6% higher than reported. • Turnover in Asian currencies (excluding Japanese Yen) is under-reported to a higher extent – maybe as much as 15%. In some Asian currencies like Chinese Yuan this is much higher. • Turnover on account of trade-related transactions is a larger fraction of total turnover for Asian currencies than for developed country currencies. • Although growing fast, the share of Asian currencies (excluding Yen) in the global turnover is only about 7.5%. Australian dollar alone has a 6.6% share. Japanese Yen has 17.5%. • Asian currencies have a larger share of inter-dealer activity in the total turnover compared to global average.

  10. The turnover of Asian currencies is low relative to the volume of trade in goods and services compared to the global average. Thus for most Asian currencies activity in the markets is driven largely by trade. • Due to controls on capital flows, transactions with financial customers form a low share of total turnover for most Asian currencies. The exceptions are SGD and HKD. • For most Asian currencies, over 90% of the turnover is against the US dollar. • Again due to capital controls, the share of non-residents in the total turnover is quite small.

  11. CURRENCY MARKETS • Among the participants, primary price makers or professional dealersmake a two-way market to each other and to their clients • Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market-making banks • Corporations usually are price takers. However, some non-bank, non-financial companies do act as market makers. • Large money centre banks deal in a large number of currencies. Smaller banks have a restricted range.

  12. It is a 24-hour market • The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore. • A few hours later, trading begins in Bahrain. • Late in the Tokyo day, markets open in Europe. • In the early afternoon in Europe, markets open in the United States. • In the mid to late afternoon in New York, markets open in the Asia-Pacific area. • Most of the activity takes place when European markets are open.

  13. CURRENCY MARKETS Geographically, the markets span all the time zones from Auckland, New Zealand to Los Angeles, United States. 3.00 pm in Tokyo 2.00 pm in Hong Kong. 3.00 pm in Hong Kong 1.00 pm in Singapore. 3.00 pm in Singapore 12.00 noon in Bahrain. 3.00 pm in Bahrain 12.00 noon in Frankfurt and Zurich and 11.00 am in London. 3.00 pm in London 10.00 am in New York. 3.00 pm in New York Noon in Los Angeles. 3.00 p.m. in Los Angeles 9.00 a.m. of the next day in Sydney. London, Tokyo and New York account for about 50% volume.

  14. Tokyo opens Asia closing 10 AM In Tokyo Lunch In Tokyo Americas open London closing Afternoon in America 6 pm In NY Europe opening Geographic Extent of the Market Measuring FOREX Market Activity: Average Electronic Conversations Per Hour

  15. How Volatile is the Market? The dollar’s value changes 18,000 times during an average trading day —that’s once every 4.8 seconds In 2005 : – The daily trading range was as much as 1–2% – The average monthly difference between high and low was 3–5% Volatility isalways part of the market behaviour Annual currency volatility is typically 10–20% (or more)

  16. Inter-bank Dealing Corporate Desk of Bank A or I/B Desk of Bank B I/B Desk of Bank A I/B Desk of Bank C

  17. Corporate Foreign Exchange (CorpFx) Desk of Bank A Corporate Client of Bank A CorpFx Desk of Bank A I/B Desk of Bank B I/B Desk of Bank A

  18. Dealings of Corporate Foreign Exchange (CorpFx) Desk of Bank A CorpFx Desk of Bank A Export / Import Desk of Bank A Client of Bank A Outward / Inward Remittance Desk of Bank A

  19. Foreign Exchange Brokers • Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction • For this service they charge a small commission • They maintain instant access to hundreds of dealers worldwide via open lines and at times may maintain such lines with several banks, with separate lines for differing currencies, spot and forward rates

  20. Currency Distribution of Forex Turnover Because two currencies are involved in each transaction the percentages sum to 200. Source: BIS

  21. DAILY TURNOVER IN INDIAN MARKET

  22. CURRENCY MARKETS • Spot Markets : Value date two business days from transaction date. If bank holiday in either settlement centre, push to next business day. • Outright Forwards : Value date three business days and beyond. • Standard forward dates : 1, 2, 3, 6, 9, 12 months. Spot value date plus required calendar months. If holiday, push forward to next eligible business day; but pushing forward must not carry you to next calendar month; then push back • Swaps : A spot plus a forward or two forwards. Buy USD spot vs. INR, sell USD 3 month forward vs.INR. Sell USD 1 month forward, buy USD 3 month forward vs. GBP.

  23. Top 10 Currency Traders % of Overall Volume, May 2009 RankNameMarket Share 1                    Deutsche Bank                                  20.96% 2                    UBS AG                                        14.58% 3                   Barclays Capital                               10.45% 4              Royal Bank of Scotland                  8.19% 5                      Citi                                          7.32% 6                  JPMorgan                                        5.43% 7                HSBC                                            4.09% 8                 Goldman Sachs                                 3.35% 9                   Credit Suisse                                     3.05% 10               BNP Paribas                                      2.26%

  24. The monthly turnover in the inter-bank segment of the foreign exchange market in India increased from US $405 billion in March 2006 to US $533 billion in March 2007 and that in the merchant segment from US $141 billion to US $192 billion. As of now the average daily turnover is estimated to be around $35 billion. Bulk of this is in the Mumbai market. Other centres are Delhi, Kolkata and Chennai.

  25. CNY: CHINESE YUAN KRW: KOREAN WON TWD: TAIWAN DOLLAR INR: INDIAN RUPEE PHP: PHILIPPINES PESO THB: THAI BAHT IDR: INDONESIAN RUPIAH MYR: MALAYSIAN RINGITT SGD: SINGAPORE DOLLAR HKD: HONGKONG DOLLAR

  26. CURRENCY MARKETS • A spot GBP/USD deal on Friday December 12: Value date Tuesday December 16 • If December 16 holiday in NY/London, value date December 17. • Suppose the deal is between a French and a German bank and December 16 is holiday in Paris but not London or NY. Push forward? • A 2-month forward deal USD/CHF on Monday Dec 22: Value date Feb 24. If holiday in NY/Zurich, Aug 17. • A 3-month forward USD/JPY on Nov 26, 2008. Value date Feb 28, 2009. If holiday in Tokyo/NY, push forward? NO. Pushing forward must not carry into next calendar month. Push back to Feb 27, 2009. Could have pushed forward in a leap year – February 29. • Spot deals in some currency pairs in the same time zone such as US dollar-Canadian dollar, US dollar- Mexican peso settled in one business day

  27. CURRENCY MARKETS • ACI QUOTATION CONVENTIONS • SPOT RATE QUOTATIONS: • Base Currency/Quoted Currency Bid Rate/Offer Rate • USD/CHF : USD base, CHF quoted • GBP/USD : GBP base, USD quoted • Most currencies quoted with USD as base. Exceptions are EUR, GBP, AUD, NZD, CAD • Quotation given as no. of units of quoted currency per unit of base currency, bid rate/offer rate. • Bid rate applies to market-maker buying base currency. Offer rate applies to market-maker selling base currency.

  28. CURRENCY MARKETS • Currency Codes : All currencies have a 3-letter code used by SWIFT (Society for Worldwide Inter-bank Financial Telecommunications) for all inter-bank transactions. • USD : US Dollar AUD : Australian Dollar • CAD : Canadian Dollar JPY : Japanese Yen • GBP : British Pound INR : Indian Rupee • SAR : Saudi Riyal EUR : Euro • SEK : Swedish Kroner DKK : Danish Kroner • CHF : Swiss Franc SGD : Singapore Dollar • KRW : Korean Won THB : Thai Baht • European Currencies which have become history: • DEM : Deutschemark FRF : French Franc NLG :Dutch Guilder • ITL : Italian Lira ESP : Spanish Peseta PTE : Portugese Escudo • BEF : Belgian Franc LUF : Luxembourg Franc • IEP : Irish Pound FIM : Finnish Markka • ATS : Austrian Schilling GRD : Greek Drachma

  29. CURRENCY MARKETS SPOT QUOTES : EXAMPLES USD/CHF SPOT: 1.2075/1.2080 Bid Offer (Ask) Bank will buy 1 USD and give CHF 1.2075 Bank will sell 1 USD and want to be paid CHF 1.2080. Shortened to 1.2075/80 or even 75/80 between dealers. “1.20” is the “big figure”

  30. CURRENCY MARKETS • SPOT QUOTES : EXAMPLES • Interpret these quotes : • GBP/USD : 1.5218/25 EUR/USD : 1.2525/30 • GBP/EUR : 1.2150/55 USD/INR : 49.1850/49.2075 • USD/JPY : 98.3550/55 • Most currencies quoted uptosix significant figures. Last two figures known as “points” or “pips”. A pip is 0.0001. In the GBP/USD quote the bid-offer spread is 8 pips. Smaller currencies such as JPY and INR are quoted to 2 decimals in merchant segments. Here a pip is 0.01

  31. CURRENCY MARKETS • Quotations in European Terms: Units of a currency per US dollar. Example : USD/INR : 48.5560/675 • Quotations in American Terms : US dollars per unit of a currency. Example : GBP/USD : 1.6650/55 • Direct Quotations: Units of “home” currency per unit of “foreign” currency. Example : USD/INR above, a direct quote in India. • Reciprocal or Indirect Quotations: Units of “foreign” currency per unit of “home currency”. Example: • USD/GBP : 0.5085/0.5090, an indirect quote in US. • GBP/USD : 1.6650/55, an indirect quote in UK

  32. INTERBANK SPOT DEALING • Friday December 25, 10.45 am • BANK A : "Bank A calling. Dollar-Swissy 25 please.” • (Bank A is specifying the size of the deal because it is much larger than the market lot) • BANK B : "Forty -Fortyfive” • (Bank B is specifying a two-way price. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 1.1540/1.1545. The quote is valid for 3-5 minutes.) • BANK A : “Mine” • (Bank A dealer finds bank B’s price acceptable and wishes to buy USD 25 million. She conveys this by saying “mine”; if she wanted to sell USD she would say “yours”)

  33. SPOT DEALING (Contd.) • BANK B : OK. I sell you USD 25 million against CHF at 1.1545, value 29 December. UBS Geneva for my CHF. • BANK A : CITIBANK NYK for my dollars. Thanks & Bye. • Deal is consummated. Back office staff will retrieve details, exchange confirmatory faxes/telexes and arrange settlement. • Spot deals (including those in swaps) account for about • 60 % of total turnover. • Dealers work within limits assigned by management • Counter-party must be acceptable credit.

  34. CURRENCY MARKETS Inter-bank Arbitrage : Suppose banks A and B are quoting : A B GBP/USD : 1.6550/1.6560 1.6338/1.6348 ---------Bank A Bid Ask ----------Bank B Bid Ask Buy GBP from bank B, sell to bank A. Prices will move. A B GBP/USD : 1.6652/1.6662 1.6648/1.6658 --------- Bank A ---------- Bank B No arbitrage. Quotes must “overlap”.

  35. INVERSE QUOTES AND TWO-POINT ARBITRAGE USD/CHF : 1.2955/1.2962 A bank in Zurich CHF/USD : 0.7728/0.7735 A bank in NY Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich sell in New York. $(1,000,000/1.2955) i.e. $771902.74 needed to acquire the Swiss francs. $(0.7728  1000000) i.e. $772800, obtained on selling, a riskless profit of $897. Zurich USD/CHF quotes imply certain CHF/USD quotes: Implied (CHF/USD)bid = 1/(USD/CHF)ask Implied (CHF/USD)ask = 1/(USD/CHF)bid

  36. INVERSE QUOTES AND TWO-POINT ARBITRAGE USD/CHF : 1.2955/1.2962 implies CHF/USD :0.7715/0.7719. Any quote which does not overlap this would lead to arbitrage. For example CHF/USD : 0.7728/0.7735 allows arbitrage. A quote such as 0.7718/0.7723 will not lead to arbitrage though it may lead to a one-way market for the banks. The rates actually found in the markets will obey the above relations to a very close approximation. GBP/USD: 1.6015/20 USD/GBP ? USD/INR: 48.7550/48.7650 INR/USD ? GBP/EUR: 1.2735/45 EUR/GBP?

  37. CROSS-RATES AND THREE-POINT ARBITRAGE A New York bank is currently offering these quotes : USD/JPY : 110.25/111.10 USD/AUD : 1.6520/1.6530 At the same time, a bank in Sydney is quoting : AUD/JPY : 68.30/69.00 Is there an arbitrage opportunity? Consider this sequence of transactions: Sell yen against US dollars and the US dollars against Australian dollars both in New York and finally sell the AUD for yen in Sydney. This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C; Finally sell C buy A.

  38. CROSS-RATES AND THREE-POINT ARBITRAGE The calculations are :(N: NY S: Sydney) 1 JPY in NY gets USD [1/(USD/JPY)ask(N)] = USD (1/111.10) Sell USD [1/(USD/JPY)ask(N)] in NY to get AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520) Sell AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } in Sydney to get JPY{[1/(USD/JPY)ask(N)](USD/AUD)bid(N)(AUD/JPYbid(S) } = JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156 A riskless gain of JPY 0.0156 per yen you started with.

  39. CROSS-RATES AND THREE-POINT ARBITRAGE Synthetic Rates must overlap observed market rates Synthetic (C/A)bid = (C/B)bid (B/A)bid Synthetic (C/A)ask = (C/B)ask (B/A)ask e.g. USD/INR: 44.7550/44.7725 USD/CHF: 1.2765/70 Synthetic (CHF/INR)bid = (CHF/USD)bid  (USD/INR)bid = [1/(USD/CHF)ask]  (USD/INR)bid = (1/1.2770)(44.7550) = 35.0470 Synthetic (CHF/INR)ask = (CHF/USD)ask  (USD/INR)ask = [1/(USD/CHF)bid]  (USD/INR)ask = (1/1.2765)(44.7725) = 35.0744 ----------------- 35.0470 35.0744 ---------------- --------------- Acceptable --------------- ------------- not acceptable

  40. Foreign Exchange Rates &Quotations • Intermarket Arbitrage • Cross rates can be used to check on opportunities for intermarket arbitrage • Example: Assume the following exchange rates are quoted Citibank $1.2223/€ Barclays Bank $1.8410/£ Dresdner Bank €1.5100/£

  41. 3-Point ARBITRAGE…. Citibank New York Start with $1,000,000 End with $1,002,538 • Sell $1,000,000 to Barclays • Bank at $1.8410/£ (6) Receive $1,002,538 Dresdner Bank Barclays Bank, London • Sell €820,206 to Citibank • at $1.2223/€ (2) Receive £543,183 (4) Receive €820,206 • Sell £543,183 to Dresdner Bank • at €1.5100/£

  42. Foreign Exchange Rates & Quotations • Intermarket Arbitrage • The cross rate between Citibank and Barclays is • ($1.8410/₤) • ---------------- = €1.5062/ ₤ • ($1.2223/€) • This cross rate is not the same as Dresdner’s rate quote of €1.5100/£ • Therefore, an opportunity exists for risk-less profit or arbitrage