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					 INBU 4200

Lecture 6
Topic: The Foreign Exchange Market
FX Trading Floor, 1920s
FX Trading Floor, 2004 (London)
China’s Foreign Exchange Office; Shanghai
Source of Data on Foreign Exchange
   The Bank for International Settlements (BIS)
    conducts a Central Bank Survey of the
    foreign exchange markets every three years.
           First survey was done in April 1989.
           The latest (7th) survey was completed in April 2007.
               54 central banks and monetary authorities participated in
                this recent survey, collecting information from
                approximately market participants (banks, brokers…)
       Most of the data in this lecture comes from these
        BIS surveys.
           See last two slides for information on the BIS
What is the Foreign Exchange Market?
       It is an over-the-counter market.
         The foreign exchange market has no physical
          location and foreign exchange deals are transacted
          over telecommunication systems.
       It is the world’s largest financial market, with
        daily volume estimated at:
         1989: $ .590 trillion
         1992: $ .820 trillion (+39%)
         1995: $1.190 trillion (+45%)
         1998: $1.490 trillion (+25%)
         2001: $1.200 trillion (-19%)
         2004: $1.880 trillion (+57%)
         2007: $3.210 trillion (+71%)
FX Volume Increase from 2004 to 2007

   As noted on the previous slide, foreign
    exchange transactions rose dramatically from
    2004 to 2007, increasing 71%.
   The reasons for this increase appear to be
       Growing role of hedge funds in the market.
       Trend among institutional investors to hold
        internationally diversified portfolios.
       Increase in technical trading (impact on spot
Electronic Versus Voice Transactions

   60 percent of spot inter-
    dealer trading today is
    done on electronic
    platforms. The spot
    dealer-client market is
    less electronic, at 43
    percent (2005 data).
   Platforms include: EBS,
    Reuters, FXConnect,
    FXAll, Currenex,
    HotSpot FXi, 360T,
    eSpeed, and Lava FX.
Where is the Foreign Exchange Market?
       Geographically, the foreign exchange market
        spans the entire globe, however:
       The major foreign exchange markets as a
        percent of 2007 daily turnover (2004) are
         U.K. (London):        34.1%; $1,094 billion   (31.1%)
         U.S. (New York):      16.6%; $ 533 billion    (19.2%)
         Switzerland:           6.6%                    (3.3%)
         Japan (Tokyo):         6.0%;                  (8.3%)
         Singapore:             5.8%                   (5.2%)
         Hong Kong              4.4%                   (4.2%)
         Australia (Sydney):    4.2%                   (3.4%)
Trading Times for the Market
   Foreign exchange trades on a 24 hour basis, with major
    financial centers open Monday through Friday.
   Weekday trading begins in Sydney, Australia, Monday
    morning (6:00am local time).
       Which is Sunday 4pm EST in New York; Sunday 8pm in London, and
        Monday 5:00am in Japan.
   Weekday trading ends in New York, Friday afternoon
    (5pm EST).
       Which is Friday 10pm in London, and Saturday 6:00am in Japan.
   Globally, foreign exchange trading begins Australia,
    moves to Asia (Tokyo, Hong Kong, and Singapore), then
    to the Middle East, on to Europe (Paris and London),
    and finally to North America (New York).
       Weekend trades take place in the Middle East (e.g., in Bahrain
        with 360 offshore banks; 65 US banks).
      24-Hour Global Market:
Times represent normal trading hours
           NEW YORK 5am          LONDON
           – early afternoon   7:30am – 4pm

   Closes: Friday                                  Other Asia:
      5pm New                                      TOKYO
       York                                        7am – 7pm
                                    Middle East:

                                                    Opens Monday
                                                        6 am
Where is Bahrain?
London’s Unique Position
   Due to the geographic positioning of London
    in relation to New York and Tokyo, London
    enjoys a trading day which overlaps with the
    other two.
       Thus, London trading in the afternoon
        corresponds with New York trading in the
       And, London trading in the morning corresponds
        with Tokyo trading in the late afternoon (5 to
       However, New York (regular trading times) and
        Tokyo trading times do NOT overlap.
           Visit:
Overlapping of Regions for FX Traders in
New York (assuming 8 (or 5) to 5 in NYC)
   Times refer to EST in New York City
Trading Patterns During the Day
   Weekday trading activity is heaviest when the major
    markets overlap. As noted this would be:
       London (pm) and New York (am) overlap
       London (am) and Tokyo (pm) overlap
   Thus, nearly two-thirds of New York foreign
    exchange trading activity occurs during New York
    morning hours (when London market is open).
   Why these trading patterns?
       Market participants look to the combined liquidity of two
        major centers to provide them with the best prices and
        quickest transactions.
  Importance of London
Measuring FOREX Market Activity: Average Electronic Conversations Per





                                                                                     Greenwich Mean Time
           1   2    3   4   5   6   7   8    9    10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

       10 AM       Lunch Europe          Asia        Americas London    Afternoon      6 pm Tokyo
      In Tokyo      In   opening        closing       open    closing   in America    In NY opens
Market Participants
   Five broad categories of participants operate
    within the foreign exchange market. They are:
       Commercial Banks and Investment Banks
           Major commercial banks (e.g., Citigroup and Deutsche Bank )
            and investment banks (e.g., Merrill Lynch and J.P. Morgan)
            with a global presence.
           These banks are market makers.
               They profit from their bid and ask quotes (spreads).
               They also trade for their own accounts.
               See next slide for 2005 top 10 market maker banks.
       Business firms involved in cross border commercial
        transactions and hedging their FX exposures
           Importers, exporters, multinational firms.
Top 10 FX Market Makers, May 2005
   Top 10 Currency Traders, by Rank, Name, and % of
    total FX volume

   1 Deutsche Bank                17.0%
   2 UBS (Swiss)                  12.5
   3 Citigroup                     7.5
   4 HSBC (UK)                     6.4
   5 Barclays (UK)                 5.9
   6 Merrill Lynch                 5.7
   7 J.P. Morgan Chase             5.3
   8 Goldman Sachs                 4.4
   9 ABN Amro (Dutch)              4.2
   10 Morgan Stanley               3.9

   Note: These ten banks accounted for 73% of FX transactions.
   Source: Wall Street Journal (2/9/06)
Market Participants -- Continued
   Traders: Speculators and arbitragers
       For Example: Hedge Funds:
         As speculators, they seek profit from exchange rate changes
          (selling short, buying long)
         As arbitragers, they seek profit from simultaneous
          differences in exchange rates in different markets
         Hedge fund example:

   Governments: Central banks and treasuries
       Seeking to offset market forces
   Investment firms
       Mutual funds, asset managers, non-market maker banks, and
        pension funds
   Note: The bulk of the Forex Market is between a few
    hundred large banks that process transactions from
    large companies and governments around the world.
Types of Foreign Exchange Transactions
   The Bank for International Settlements records
    three types of FX “traditional” transactions:
       Spot Transactions
           Two (business) day purchase or sale of foreign
       Outright Forwards
           More than two business days’ purchase or sale of
            foreign exchange.
       Swaps
           Simultaneous purchase and sale of a given amount of
            foreign exchange for two different dates.
Foreign Exchange Swap Transactions
   Defined: The simultaneous purchase and sale of a given
    amount of foreign exchange for two different dates.
     Both purchase and sale are usually conducted with

       the same counterpart (i.e., the same global bank)
   The most common FX swap is a spot against forward
     A bank buys FX in the spot market and simultaneously

       sells the same amount back in the forward market
     Since the swap transaction is an offset, the bank
       incurs NO exchange rate exposure.
   A swap transaction is used to provide bank clients with
    needed foreign exchange for a specified period of time
    (e.g., a short term loan).
Example of FX Swap
   Corporate approaches its bank wanting to borrow
    10,000,000 euros for 90 days.
   Bank negotiates in interbank spot market to purchase
    10,000,000 euros, which in turn are lent to the corporate.
   Bank simultaneously sells 10,000,000 euros 90 days
    forward (i.e., for delivery in 90 days) in the interbank
       When loan matures, bank will receive the 10,000,000 euros from
        the corporate borrower which provides it with the euros to be
        delivered at that time to complete the forward agreement.
   Thus, the lending bank assumes no exchange risk
    during the 90 day period.
   The bank’s return is the interest on the loan, minus any
    spot/forward spread not in it’s favor.
Transactions by Type of Trade, 2007,
% of Total
   Spot:              33%
   Outright Forwards: 12%
       Up to 7 days:             43%
       7 days to up to 1 year:   55%
       Over 1 year:               2%
   FX Swaps:               55%
       Up to 7 days:             78%
       7 days to up to 1 year:   21%
       Over 1 year:               1%
Transactions by Type of Trade; %
Which Currencies are Traded; 2004 and
2007 Data
   Average daily turnover as a % share of total
                     2004         2007
       USD          88.7%        86.3%
       EUR          37.2%        37.0%
       JPY          20.3%        16.0%
       GBP          16.8%        15.0%
       CHF           6.1%         6.8%
       AUD           5.5%         6.7%
       CAD           4.2%         4.2%
   Note: Total adds to 200% due to double counting of
    currencies in FX transactions.
Which Currency Pairs are Traded

   Average daily turnover as a % share of total
                   2004       2007
   USD/EUR        28%        27%
   USD/JPY        17%        13%
   USD/GBP        14%        12%
   USD/AUD         5%        6%
   USD/CHF         4%        5%
   USD/CAD         4%         4%
    Wholesale (Interbank) and Retail Markets
       The FX market is a two-tier financial market:
           Wholesale (Interbank) market
             Large transactions (>$10 million) involving 100 to 200
              large “market-maker” global banks (>$400 billion) and
              large non-bank financial institutions (e.g., investment
             Represents about 80% of the market.
           Retail (client) market
             Transactions between banks and their retail customers
              (includes multinational firms, money managers, private
             Represents about 20% of the market.
Bank for International Settlements
   The Bank for International Settlements (BIS) is
    an international organization which aims to
    promote "international monetary and financial
    cooperation and serve as a bank for central
   The BIS was originally established under the
    Hague agreements in January 1930 to facilitate
    Germany's payment of reparations following
    World War I, and to promote cooperation
    between central banks.
       It began operating in Basel, Switzerland, on May 17,
        1930, and is the world's oldest international financial
Useful BIS Web-sites
BIS main web site:

BIS central bank web-site:
 The following BIS web-site has links to most
  of the central banks around the world!