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The Foreign Exchange Market

Foreign exchange trading refers to trading one countrys money for that of another country. The need for such trade arises because of tourism, the buying and selling of goods internationally, or investment occurring across international boundaries. The kind of money speci cally traded takes the form of bank deposits or bank transfers of deposits denominated in foreign currency. The foreign exchange market, as we usually think of it, refers to large commercial banks in

London, that trade foreign-currency-denominated deposits with each other. Actual bank notes like dollar bills are relatively unimportant insofar as they rarely physically

nancial centers, such as New York or

cross international borders. In general, only tourism or illegal activities would lead to the international movement of bank notes.

Foreign Exchange Trading Volume


The foreign exchange market is the largest nancial market in the world. In April 2010, the Bank for International Settlements (BIS) conducted a survey of trading volume around the world and found that the average amount of currency traded each business day was $3,981 billion. In 2001 the trading volume of foreign exchange was $1,239 billion. Thus, the amount of foreign exchange traded has recently grown tremendously. The U.S. dollar is by far the most important currency, and has remained so in the last decade, even with the introduction of the euro. The dollar is involved in 85 percent of all trades. Since foreign exchange trading involves pairs of currencies, it is useful to know which currency pairs dominate the market.

Table 1.1 reports the share of market activity taken by di erent currencies. The largest volume occurs in dollar/euro trading, accounting for almost 30 percent of the total. The next closest currency pair, the dollar/yen, involves roughly half as much spot trading as the dollar/euro. After these two currency pairs, the volume drops o dramatically. Thus, the currency markets are dominated by dollar trading.
Table 1.1 Top Ten Currency Pairs by Share of Foreign Exchange Trading Volume

Currency pair

Percent of total

U.S. dollar/euro U.S. dollar/Japanese yen U.S. dollar/U.K. pound

28 14 9

U.S. dollar/Australian dollar 6 U.S. dollar/Canadian Dollar U.S. dollar/Swiss franc Euro/Japanese yen Euro/U.K. pound Euro/Swiss franc U.S. dollar/Swedish krona 5 4 3 3 2 1

Source: Table created from data found in Bank for International Settlements, Triennial Central Bank Survey; Report on Global Foreign Exchange Market Activity in 2010, Basel, December, 2010.

Geographic Foreign Exchange Rate Activity


The foreign exchange market is a 24-hour market. Currencies are quoted continuously across the world. Figure 1.1 illustrates the 24-hour dimension of the foreign exchange market. We can determine the local hours of major trading activity in each location by the country bars at the top of the gure. Time is measured as Greenwich Mean Time (GMT) at the bottom of the gure. For instance, in New York 7 A.M. is 1200 GMT and 3 P.M. is 2000 GMT. Since London trading has ended by 4 P.M. London time, or 1600 GMT (11 A.M. in New York), active arbitrage involving comparisons of New York and London exchange rate quotes would end around 1600 GMT. Figure 1.1 shows that there is a small overlap between European trading and Asian trading, and there is no overlap between New York trading and Asian trading.

and Tokyo.
Table 1.2 Top Ten Foreign Exchange Markets by Trading Volume (daily averages)

Country

Total volume (billions of dollars) Percent share 37 18 6 5 5 5 4 3 2 2

United Kingdom 1,854 United States Japan Singapore Switzerland Hong Kong Australia France Denmark Germany 904 312 266 263 238 192 152 120 109

Source: Table created from data found in Bank for International Settlements, Triennial Central Bank Survey; Report on Global Foreign Exchange Market Activity in 2010, Basel, December 2010.

Figure 1.2 provides another view of the 24-hour nature of the foreign exchange market. This gure shows the average number of quotes on the Japanese yen/U.S. dollar posted to the Reuters news service screen devoted to foreign exchange. Figure 1.2 reports the hourly average number of quotes over the business week. Weekends are excluded since there is little trading outside of normal business hours. The vertical axis measures the average number of quotes per hour, and the horizontal axis shows the hours of each weekday measured in GMT. A clear pattern emerges in the gure every business day tends to look the same. Trading in the yen starts each business day in Asian markets with a little more than 20 quotes per hour being entered on the

Denmark (Danish Krone) Ecuador (US Dollar) Hong Kong (Hong Kong $) Hungary (Forint) India (Rupee) Indonesia (Rupiah) Israel (Shekel) Japan (Yen)

5.0979 1.0000 7.7713 181.0440 44.5150 8650.0000 3.4185 81.7050

971987 710715 065816 100200 000000 175195 690720 175217 800100 969007 792798 448452 624628

Norway (Norwegian Krone) 5.3196 Russia (Rouble) Sweden (Krona) Switzerland (Franc) U.K. (Pound) Euro (Euro) SDR (SDR) 27.7950 6.0988 0.8795 1.6450 1.4626 0.6214

The London foreign exchange mid-range rates above apply to trading among banks in amounts of $1 million and more, as quoted at 4 P.M. GMT by Reuters. The quotes are in foreign currency per dollar, except for the U.K. pound and the euro that are quoted as dollar per foreign currency. Source: Table is based on data from Financial Times, Currency Markets: Dollar Spot Forward against the Dollar and Dollar against Other Currencies on April 26, 2011. See: http://markets.ft.com/RESEARCH/markets

If the amount traded was less than $1 million the cost of foreign exchange would be higher. The smaller the quantity of foreign exchange purchased, the higher the price. Therefore if you travel to a foreign country the exchange rate will be much less

favorable for you as a tourist.

value to SF8.795 million. We calculated this by multiplying the total dollar value of the purchase by the Swiss franc price of a dollar price. If we need to convert Swiss francs into dollars, then we will divide the Swiss franc amount by the exchange rate, or multiply the Swiss franc amount by the reciprocal of the exchange rate. If a U.S.

In the previous example, the U.S. importer found that $10 million was equivalent in

manufacturer is exporting cars to Switzerland and receives SF12 million then we divide by the exchange rate SF12/0.8795=$13.644 million. We could also have

multiplied the SF12 by the reciprocal 1/0.8795=1.137 to reach the same amount. It will always be true that when we know the dollar price of the franc ($/SF), we can find the Swiss franc price of the dollar by taking the reciprocal 1/($/SF)=(SF/$). Note that the exchange rate quotes in the rst column in Table 1.3 are mid-range

rates. Banks buy (bid) foreign exchange at lower rates than they sell (offer), and the di erence between the selling and buying rates is called the spread. The mid-range is the average of the buying and selling rates. Table 1.3 lists the spreads for each currency in the second column. The bid/o er spread is quoted so that one can see the bid (buy) price by dropping the last three digits and replacing them with the rst number. Similarly, the offer (sell) price is found by dropping the last three digits of the mid-point quote and replacing them with the second number. For example, the Swiss franc bidoffer spread is 0.87920.8798. Thus, the bank is willing to buy dollars for Swiss francs at 0.8792, and sell dollars at 0.8798 Swiss francs. This spread of less than 1/100 of 1 percent [(0.87980.8792)/0.8792= .000068] is indicative of how small the normal spread is in the market for major traded currencies. The existing spread in any currency will vary according to the individual currency trader, the currency being traded, and the trading banks overall view of conditions in the foreign exchange market. The spread quoted will tend to increase for more thinly traded currencies (i.e., currencies that do not generate a large volume of trading) or when the bank perceives that the risks associated with trading in a currency at a particular time are rising. The large trading banks like Citibank or Deutsche Bank stand ready to make a market in a currency by o ering buy (bid) and sell (o er) rates on request. Actually, currency traders do not quote all the numbers indicated in Table 1.3. For instance, the table lists the spread on euro as 624628. In practice, this spread is quoted as $1.462428 or, in words, the U.S. dollar per euro rate is one-forty-six-twenty-four to

twenty-eight. The listener then recognizes that the bank is willing to bid $1.4624 to buy one euro and will sell euros at $1.4628. Thus far, we have discussed trading Swiss francs and Canadian dollars using the symbols SF and C$, respectively. Table 1.4 lists the commonly used symbols for

several currencies along with their international standard (ISO) code. Exchange rate quotations are generally available for all countries where currencies may be freely

traded. In the cases where free markets are not permitted, the state typically conducts all foreign exchange trading at an o cial exchange rate, regardless of current market conditions.

Table 1.4 International Currency Symbols

First, however, we should consider in more detail the nature of the foreign exchange market.

Currency Arbitrage
The foreign exchange market is a market where price information is readily available by telephone or computer network. Since currencies are homogeneous goods (a dollar is a dollar regardless of where it is traded), it is very easy to compare prices in di erent markets. Exchange rates tend to be equal worldwide. If this were not so, there would be pro t opportunities for simultaneously buying a currency in one market while selling it in another. This activity, known as arbitrage , would raise the

exchange rate in the market where it is too low, because this is the market in which you would buy, and the increased demand for the currency would result in a higher price. The market where the exchange rate is too high is one in which you sell, and this increased selling activity would result in a lower price. Arbitrage would continue until the exchange rates in di erent locales are so close that it is not worth the costs incurred to do any further buying and selling. When this situation occurs, we say that the rates are transaction costs close. Any remaining deviation between exchange rates will not cover the costs of additional arbitrage transactions, so the arbitrage activity ends. For instance, suppose the following quotes were available for the Swiss franc/U.S. dollar rate: Citibank is quoting 0.874555 Deutsche Bank in Frankfurt is quoting 0.872535 This means that Citibank will buy dollars for 0.8745 francs and will sell dollars for 0.8755 francs. Deutsche Bank will buy dollars for 0.8725 francs and will sell dollars for 0.8735 francs. This presents an arbitrage opportunity. We call this a two-point arbitrage as it involves two currencies. We could buy $10 million at Deutsche Banks o er price of 0.8735 and simultaneously sell $10 million to Citibank at their bid price of 0.8745 francs. This would earn a pro t of SF0.0010 per dollar traded, or SF10,000 would be the total arbitrage profit. If such a pro t opportunity existed the arbitrage would result in changes in the

banks changing the rates as arbitrageurs enter the market. An increase in the demand to buy dollars from Deutsche Bank would cause them to raise their o er price above 0.8735, while the increased willingness to sell dollars to Citibank at their bid price of 0.8745 francs would cause them to lower their bid. In this way, arbitrage activity

pushes the prices of di erent traders to levels where no arbitrage pro ts can be earned. Suppose the prices moved to where Citibank is quoting the Swiss franc/dollar

exchange rate at 0.874050 and Deutsche Bank is quoting 0.873040. Now there is no arbitrage profit possible. The offer price at Deutsche Bank of 0.8740 is equal to the bid price at Citibank. The di erence between the bid and o er prices of each bank is equal to the spreads of SF0.001. In the wholesale banking foreign exchange market, the bido er spread is the only transaction cost. When the quotes of two di erent banks di er by no more than the spread being quoted in the market by these banks, there is no arbitrage opportunity.

Arbitrage could involve more than two currencies. Since banks quote foreign exchange rates with respect to the dollar, one can use the dollar value of two currencies to calculate the cross rate between the two currencies. The cross rate is the implied exchange rate from the two actual quotes. For instance, if we know the dollar price of pounds ($/) and the dollar price of Swiss francs ($/SF), we can infer what the corresponding pound price of francs (/SF) would be. From now on we will explicitly write the units of our exchange rates to avoid the confusion that can easily arise. For example, $/=$1.76 is the exchange rate in terms of dollars per pound.

Suppose that in London $/=$1.76, while in New York $/SF=$1.10. The corresponding cross rate is the /SF rate. Simple algebra shows that if $/=$1.76 and $/SF=1.1, then /SF=($/SF)/($/), or 1.10/1.76=0.625. If we observe a market where one of the three exchange rates$/, $/SF, /SFis out of line with the other two, there is an arbitrage opportunity, in this case a triangular arbitrage . Triangular arbitrage, or three-point arbitrage , involves three currencies. To simplify the analysis of arbitrage involving three currencies, let us temporarily ignore the bido er spread and assume that we can either buy or sell at one price. Suppose that in Geneva, Switzerland the exchange rate is /SF=0.625, while in New York $/SF=1.100, and in London $/=$1.600.

Table 1.5 appears to have no possible arbitrage opportunity, but astute traders in the foreign exchange market would observe a discrepancy when they check the cross

their quotes in the absence of any news about exchange rate fundamentals. Evans and Lyons (2002) studied the German mark/dollar market before there was a euro and estimated that, on average, foreign exchange traders alter their quotes by .00008 for each $10 million of undesired inventory. So a trader with an undesired long mark position of $20 million would, on average, raise his quote by .00016. In addition to the inventory control e ect, there is also an asymmetric information

e ect, which causes exchange rates to change due to traders fears that they are quoting prices to someone who knows more about current market conditions than

they do. Even without news regarding the fundamentals, information is being transmitted from one trader to another through the act of trading. If Helmut posts a quote of 1.025060 and is called by Ingrid Schultz at Citibank asking to buy $5 million of euros at Helmuts o er price of 1.0260, Helmut then must wonder whether Ingrid

knows something he doesnt. Should Ingrids order to trade at Helmuts price be considered a signal that Helmuts price is too low? What superior information could Ingrid have? Every bank receives orders from nonbank customers to buy and sell currency. Perhaps Ingrid knows that her bank has just received a large order from Daimler Benz to sell dollars, and she is selling dollars (and buying euros) in advance of the price increase that will be caused by this nonbank order being lled by purchasing euros from other traders. Helmut does not know why Ingrid is buying euros at his o er price, but he protects himself from further euro sales to someone who may be better informed than he is by raising his o er price. The bid price may be left unchanged because the order was to buy his euros; in such a case the spread increases, with the higher o er price due to the possibility of trading with a better-informed counterparty. Lyons (1995) estimated that the presence of asymmetric information among traders resulted in the average change in the quoted price being .00014 per $10 million traded. At this average level, Helmut would raise his o er price by .00007 in response to Ingrids order to buy $5 million. The inventory control and asymmetric information e ects can help explain why exchange rates change throughout the day, even in the absence of news regarding the fundamental determinants of exchange rates. The act of trading generates price changes among risk-averse traders who seek to manage their inventory positions to limit their exposure to surprising exchange rate changes and limit the potential loss

Summary
1. The foreign exchange market is a global market where foreign currency deposits are traded. Trading in actual currency notes is generally limited to tourism or illegal

activities. 2. The dollar/euro currency pair dominates foreign exchange trading volume, and the

United Kingdom is the largest trading location. 3 . A spot exchange rate is the price of a currency in terms of another currency for

4. Arbitrage realizes riskless pro t from market disequilibrium by buying a currency in one market and selling it in another. Arbitrage ensures that exchange rates are

current delivery. Banks buy (bid) foreign exchange at a lower rate than they sell (offer), and the difference between the selling and buying rates is called the spread.

transaction costs close in all markets. 5 . The factors that explain why exchange rates vary so much in the short run are inventory control and asymmetric information. 6 . In the long run, economic factors (e.g., demand/supply of foreign and domestic goods) a ect the exchange rate movements. The trade ow model is useful for discussing fundamental changes in the foreign exchange rate.

Exercises
1. Suppose 1=$0.0077 in London, $1=SF2.00 in New York, and SF1= 65 in Paris. a . If you begin by holding 10,000 yen, how could you make a pro t from these exchange rates? b. Find the arbitrage profit per yen initially traded. (Ignore transaction costs.) 2. Suppose Sumitomo Bank quotes the /$ exchange rate as 110.30.40 and Nomura Bank quotes 110.40.50. Is there an arbitrage opportunity? If so, explain how you would profit from these quotes. If not, explain why not. 3. What is the cross rate implied by the following quotes? a. C$/$=1.5613, $/=1.0008 b. /$=124.84, $/=1.5720 c. SF/$= 1.4706, C$/$= 1.5613 4 . Suppose that the spot rates of the U.S. dollar, British pound, and Swedish kronor are quoted in three locations as the following:

consumer price index to measure how prices in an economy are changing. We could look at the price of shoes or the price of a loaf of bread, but such single-good prices will not necessarily re ect the general in ationary situationsome prices may be rising while others are falling.

In the foreign exchange market it is common to see a currency rising in value against one foreign money while it depreciates relative to another. As a result, exchange rate indexes are constructed to measure the average value of a currency relative to several other currencies. An exchange rate index is a weighted average of a

currencys value relative to other currencies, with the weights typically based on the importance of each currency to international trade. If we want to construct an

exchange rate index for the United States, we would include the currencies of the countries that are the major trading partners of the United States.

If half of U.S. trade was with Canada and the other half was with Mexico, then the percentage change in the trade-weighted dollar exchange rate index would be found by multiplying the percentage change in both the Canadian dollar/U.S. dollar exchange rate and the Mexican peso/U.S. dollar exchange rate by one-half and summing the result. Table 1A.1 lists two popular exchange rate indexes and their weighting schemes. The indexes listed are the Federal Reserve Boards Major Currency Index, (TWEXMMTH) and the Broad Currency Index (TWEXBMTH).
Table 1A.1 Percentage Weights Assigned to Major Currencies in Two U.S. Dollar Exchange Rate Indexes

Exchange rate indexes are commonly used analytical tools in international economics. When changes in the average value of a currency are important, bilateral

exchange rates (between only two currencies) are unsatisfactory. Neither economic theory nor practice gives a clear indication of which exchange rate index is best. In fact, for some questions there is little to di erentiate one index from another. In many cases, however, the best index to use will depend on the question addressed.

Appendix 1B The Top Foreign Exchange Dealers


Foreign exchange trading is dominated by large commercial banks with worldwide operations. The market is very competitive, since each bank tries to maintain its share of the corporate business. Euromoney magazine provides some interesting insights into this market by publishing periodic surveys of information supplied by the treasurers of the major multinational firms.

When asked to rank the factors that determined who got their foreign exchange business, the treasurers responded that the following factors were the most important: The speed with which a bank makes foreign exchange quotes was ranked third. A second-place ranking was given to competitiveness of quotes. The most important factor was the rms relationship with the bank. A bank that handles the other banking needs of a firm is also likely to receive its foreign exchange business. The signi cance of competitive quotes is indicated by the fact that treasurers often contact more than one bank to get several quotes before placing a deal. Another implication is that the market will be dominated by the big banks, because only the giants have the global activity to allow competitive quotes on a large number of currencies. Table 1B.1 gives the rankings of the Euromoney survey. According to the rankings, Deutsche Bank receives more business than any other bank. Note also that the big threeDeutsche Bank, UBS and Barclays Capitaldominate the foreign exchange market
Table 1B.1 The Top 15 Foreign Exchange Dealers with Market Share

1. Deutsche Bank (18.1%) 2. UBS (11.3%)

3. Barclays Capital (11.1%) 4. Citi (7.7%) 5. Royal Bank of Scotland (6.5%) 6. JPMorgan (6.4%) 7. HSBC (4.6%) 8. Credit Suisse (4.4%) 9. Goldman Sachs (4.3%) 10. Morgan Stanley (2.9%) 11. BNP Paribas (2.9%) 12. Bank of America Merrill Lynch (2.3%) 13. Societe Generale (2.1%) 14. Commerzbank (1.5%) 15. Standard Chartered (1.2%)
Rankings as reported in Euromoney, May 2010.

What makes Deutsche Bank the worlds best foreign exchange dealer? Many factors have kept them on top of the heap. An important factor is simply sheer size. Deutsche Bank holds the bank accounts for many corporations, giving it a natural advantage in foreign exchange trading. Foreign exchange trading has emerged as an important center for bank pro tability. Since each trade generates revenue for the bank, the volatile foreign exchange markets of recent years have often led to frenetic activity in the market with a commensurate revenue increase for the banks.

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