Transcript Chapter 3
International Financial Markets Prices and Policies Second Edition ©2001 Richard M. Levich 3 McGraw Hill / Irwin Market Structure and Institutions 3-2 Overview Importance of Foreign Exchange Market Trading Origins of the Market Volume of Foreign Exchange Trading Foreign Exchange Trading Profits Explaining the Profitability of Foreign Exchange Trading McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-3 Overview Foreign Exchange Market Products and Activities Spot and Forward Contracts Foreign Exchange Swaps Types of Trading Activities: Speculation and Arbitrage The Relationship between Spot and Forward Contracts McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-4 Overview The Foreign Exchange Market Setting Comparing the Foreign Exchange Market with Other Markets Tracking Foreign Exchange Transactions • The Interbank Market - Classic Connections and Recent Innovations • Corporate Foreign Exchange Trading - The Classic Relationship and Recent Innovations Counterparties and Concentration in the Foreign Exchange Market McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-5 Overview Policy Matters - Private Enterprises A Close-Up View on Foreign Exchange Trading Controls over Foreign Exchange Trading Valuing Foreign Exchange Trading Profits Policy Matters - Public Policymakers McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-6 Importance of Foreign Exchange Market Trading Origins of the Market International trade - No single currency is particularly efficient as a medium of exchange. International investment - Foreign assets are an alternative store of value. They may also serve to offset certain financial risks. Some of their features may not be available domestically too. Speculation - The aim is purely to earn higher returns. ¥ $ McGraw Hill / Irwin £ 2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Global Foreign Exchange and Over-the-Counter Derivatives Markets 3-7 Average Daily Turnover in billions of US dollars Notional Amounts for Derivatives ¥ 2000 1800 1600 1400 1200 1000 800 600 400 200 0 $ Spot Transactions Outright Forwards & Swaps OTC Derivative Instruments Traditional Foreign Exchange Instruments 196 £ 362 900 670 1190 420 240 350 April 1989 590 1490 820 400 520 590 April 1992 April 1995 April 1998 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hillfor / Irwin Source: Bank International Settlements Central Bank Survey 1998 Currency Distribution of Global Traditional Foreign Exchange Market Activity 3-8 Percentage Shares of Average Daily Turnover (Total = 200) April 1998 ¥ Australian dollar 3 Canadian dollar 4 Swiss franc 7 ECU & other EMS currencies 15 Other currencies $ 17 £ US dollar 87 French franc 5 Pound 11 sterling Japanese yen 21 30 Deutsche mark 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hillfor / Irwin Source: Bank International Settlements Central Bank Survey 1998 3-9 Geographical Distribution of Global Traditional Foreign Exchange Market Activity Average Daily Turnover in billions of US dollars April 1998 ¥ Others 18% Switzerland 4% $ Hong Kong 4% France 4% Germany 5% Singapore 7% Japan 8% £ United Kingdom 32% United States 18% 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hillfor / Irwin Source: Bank International Settlements Central Bank Survey 1998 Geographical Distribution of Global Over-the-Counter Derivatives Market Activity 3 - 10 Average Daily Turnover of Notional Amounts in billions of US dollars April 1998 Singapore Others 2% 12% Canada 2% Switzerland 3% Germany 7% Japan 9% $ France 10% ¥ £ United States 19% United Kingdom 36% 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hillfor / Irwin Source: Bank International Settlements Central Bank Survey 1998 3 - 11 Foreign Exchange Trading Profits Based on a Sample of 15 Large U.S. Commercial Banks ¥ 2500 $ 2000 200 Total Profit £ (in millions of $) 1500 1000 250 150 Average Profit (in millions of $) 500 0 100 50 0 76 McGraw Hill / Irwin Source: Company annual reports 78 80 82 84 86 88 90 92 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 12 Foreign Exchange Trading Profits Foreign Exchange Trading Income of Selected Banks ( in millions of US$ ) Company Bank of New York Chase Manhattan Citicorp Credit Suisse First Boston Deutsche Bank Mellon Financial Corp Morgan (J.P.) & Co. Republic National Bank State Street Bank 1977 NA 55 68 NA NA 6 40 5 2 $ McGraw Hill / Irwin Source: Company annual reports ¥ 1987 NA 385 453 NA NA 8 251 39 21 1997 109 790 1,486 699 1,040 118 493 98 159 £ 1998 126 936 1,628 97 636 165 781 120 177 1999 137 807 1,569 897 807 173 777 141 209 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Explaining the Profitability of 3 - 13 Foreign Exchange Trading If foreign exchange trading is a zero-sum game, how can it be profitable to all banks? The data is for one-year intervals, suggesting that longer-run profits exceed short-term losses. Only speculative profits ought to conform to the predictions of a zero-sum game. Service charges should be excluded. Central banks have at times incurred substantial losses due to their market interventions. ¥ $ McGraw Hill / Irwin £ 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 14 Products and Activities A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months). McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 15 Products and Activities Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk. A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery. Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 16 Products and Activities Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation. Arbitrage is the simultaneous, or nearly simultaneous, purchase of securities in one market for sale in another market with the expectation of a risk-free profit. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 17 Products and Activities Spatial arbitrage suggests arbitrage between segments of the foreign exchange market that are physically separated. Ignoring transaction costs, the prices for any three currencies A, B, & C must be consistent: A = A B C B C If the above relation does not hold, then profit opportunities will be available based on triangular arbitrage. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 18 Products and Activities Covered interest arbitrage describes capital flows that seek risk-free profits based on differences between the forward exchange premium and the relative rate of interest in domestic and foreign currency. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 19 Foreign Exchange Market Products and Activities currency dimension The Relationship between Spot and Forward Contracts time dimension Jan 1 borrow US$ at i$ US$ B Jul 1 A lend US$ at i$ buy € spot at S € C Option 2 Option 1 sell € spot at S buy € forward at F borrow € at i€ lend € at i€ McGraw Hill / Irwin sell € forward at F D A manager wishes to own € on July 1. 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 20 Products and Activities In the absence of transaction costs, taxes, or default, the price of the two alternatives must be identical: The US$ cost of each €. Ft ,6 St The price of 1 € for delivery on July 1. McGraw Hill / Irwin The cost of each borrowed US$. 1 i 1 i € $,6 ,6 2 2 The present value of 1 €. 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 21 Products and Activities Synthetic forwards can be created by using a spot contract combined with borrowing and lending. By combining a spot contract with fixed-rate, nperiod borrowing and lending in the two currencies, an n-period forward exchange contract can be constructed. Note that other factors may influence actual longterm forward rates. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 22 Products and Activities Synthetic securities (whether an asset or a liability) can be constructed by combining a security denominated in the other currency with a forward contract of similar maturity and a spot contract. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Foreign Exchange Market 3 - 23 Products and Activities Construction of a Synthetic Dollar Security currency dimension Jan 1 US$ B time dimension borrow US$ at i$ Jul 1 A lend US$ at i$ is equivalent to buy € spot at S € sell € spot at S C buy € forward at F borrow € at i€ sell € forward at F D lend € at i€ McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 24 The Foreign Exchange Market Setting The foreign exchange market is a dispersed, broker-dealer market, and hence lacks transparency. Trading takes place 24 hours per day around the world, and the transactions can be customized. Dealers can trade in a number of ways: direct telephone contact with a dealer at another bank (direct dealing) telephone contact with a voice broker electronic direct trading and broking systems McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 25 The Foreign Exchange Market Setting There is a trend toward automated brokerage systems. Reuters Dealing 2000-2 was introduced in 1992, MINEX in 1993, and Electronic Brokering Service in 1993. MINEX and EBS later merged to form the EBS Partnership. By 1998, electronic brokers had captured 75% of all brokered transactions in the United States. In 1998, 23.6% of U.S. foreign exchange transactions are handled by brokers. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 26 The Foreign Exchange Market Setting Another innovation is the development of private systems for clearing and settlement. A multilateral netting system with banks clearing against a central clearinghouse substantially reduce transaction costs and liquidity risks. The leading multilateral netting firm is FXNET, owned by a consortium of 14 of the world’s largest banks. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 27 The Foreign Exchange Market Setting Traditionally, corporations conduct their foreign exchange transactions through commercial banks. Large corporations that trade frequently may also use automated trading systems. Various companies are now developing business plans that bring a web-based “auction environment” to corporate foreign exchange. In April 2000, Currenex launched the first multibank internet foreign exchange trading system. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 28 The Foreign Exchange Market Setting Access to the brokerage system defines pricing in the foreign exchange market: Those with access are in the interbank (or wholesale) market, while those without access are in the corporate (or retail) market. Access is based on credit quality and trading style. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 29 The Foreign Exchange Market Setting Dimensions of the Foreign Exchange Market, April 1998 (Daily Averages in billions of US dollars) 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hillfor / Irwin Source: Bank International Settlements Central Bank Survey 1998 3 - 30 The Foreign Exchange Market Setting In the UK, transactions by brokers fell from 35% in 1995 to 27% in 1998. Traditional voice brokers contributed 16% (down from 30% in 1995) while electronic brokers handled 11% (up from 5% in 1995). In the UK, US, and Japan, spot trading accounts for most of electronic brokers’ volumes. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 31 The Foreign Exchange Market Setting A survey by the Euromoney magazine found that non-commercial banks have gained leading positions in the market. There is also a trend toward increased concentration of business among fewer dealers. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 32 Policy Matters - Private Enterprises Various studies indicate that: The position of an interbank spot trader usually returns close to zero at the end of each day. The majority of the profits of a bank’s spot trader were earned through trades with the bank’s retail customers rather than through interbank dealing or speculation. The bid-ask spread tends to be wider at the start and at the end of the trading day. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 33 Policy Matters - Private Enterprises Managers have always been concerned about the risks of foreign exchange trading. exchange rate risk interest rate risk credit risk - rate risk, delivery risk Various control measures are used to contain these risks. value-at-risk (VAR) McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 34 Policy Matters - Private Enterprises Perhaps because of the uncertainties in trading, many investors are unwilling to place a high value on that portion of a bank’s profits that are derived from trading. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 35 Policy Matters - Public Policymakers The design of clearing and settlement systems for foreign exchange, domestic bank deposits, and traded securities is receiving greater attention from public policymakers. Settlement exposures can last several days. Prohibitions and quantitative restrictions on securities may not be reliable policy instruments. Using synthetic instruments, it is relatively easy to overcome such restrictions. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.