Participative Members

Presented By:
MUDASSAR HUSSAIN Adil Asad
MBC-08-01 MBC – 0 8 – 43

Muhammad Iqbal
MBC – 0 8 – 04

Najeeba Kanwal
MBC - 0 8 - 15

Muhammad Saeed
MBC – 0 8 – 26

Muhammad
Zuhair
MBC – 0 8 – 36
 PROJECT TOPIC

FOREIGN EXCHANGE MARKET

 DIVISION OF PROJECT

• Foreign Exchange Market

• Market Participants
• Trading Characteristics
• Determinants of FX rates
• Financial Instruments
• Exchange Rate
• Summary of Articles
Foreign Exchange Market

• Market is where currency trading takes place

• Involve two parties, purchasing & selling
• Started evolving during the 1970s
• Gradually switched to floating exchange rate
from fixed
• Largest and most liquid financial
• Market participants: Banks, Brokers etc
• Average daily volume US$3.2 trillion
• Volumes grew a further 41% between 2007 and
2008
• Presence of multifarious international
currencies
Market size and liquidity
its trading volumes,
the extreme liquidity of the market,
its geographical dispersion,
its long trading hours: 24 hours a day except on
weekends
the variety of factors that affect exchange rates.
the low margins of profit compared with other
markets of fixed income (but profits can be high
due to very large trading volumes)
the use of leverage
Market size and liquidity

Foreign exchange market

turnover was broken down
as follows:
• $1.005 trillion in spot
transactions.
• $362 billion in outright
forwards.
• $1.714 trillion in foreign
exchange swaps.
• $129 billion estimated
gaps in reporting.
• Largest FX markets on the basis of transactions performed

• $1.36 trillion, 34.1% of the total, trading in London

• New York accounted for 16.6%, and Tokyo accounted for
6.0%.
• Foreign exchange trading increased by 38% between April
2005 and April 2006 and has more than doubled since
2001.
• foreign exchange is an OTC market where brokers/dealers
negotiate directly with one another, there is no central
exchange or clearing house
• These large international banks continually
provide the market with both bid (buy) and
ask (sell) prices. The bid/ask spread is the
difference between the prices at which bank
buy and sell.
• Spread is less for large transactions
 Market Participants

• Foreign exchange market is divided into levels of

access
• At the top is the inter-bank market
• Spread is razor sharp difference in spread is due to
volume
• Top-tier inter-bank market accounts for 53%
• After that there are usually smaller investment
banks, followed by large multi-national
corporations
• Banks :The interbank market caters commercial
turnover and large amounts of speculative trading
every day
• billions of dollars daily
• Some on behalf of customers much is for the
bank's own account
• Commercial companies :companies seeking
foreign exchange to pay for goods or services
• trade fairly small amounts compared to banks
• Central banks :control the money supply,
inflation, and/or interest rates and often have
official or unofficial target rates for their
currencies
• use foreign exchange reserves to stabilize the
market
• best stabilization strategy would be for central
banks to buy when the exchange rate is too low,
and to sell when the rate is too high
• Rumors of central bank intervention stabilize
exchange rate

Source: World Bank (2001)

• Hedge funds as speculators: 70% to 90% of
the foreign exchange transactions are
speculative
• the currency bought or sold having no plan
to actually take delivery of the currency in
the end
• speculating on the movement of that
particular currency
• Investment management firms :manage large
accounts on behalf of customers such as pension
funds and endowments
• use the foreign exchange market to facilitate
transactions in foreign securities
• Retail foreign exchange brokers:two types of retail
brokers offering
• retail foreign exchange brokers and market makers
• Retail traders (individuals) are a small fraction of
this market
• Retail brokers, while largely controlled and
regulated by the CFTC and NFA Retail
• Other:Non-bank foreign exchange
companies offer currency exchange
• Foreign Exchange Companies:cheaper
exchange rates than the customer's bank
• Money transfer/remittance companies
perform high-volume low-value transfers
 Trading Characteristics
• no unified or centrally cleared market, a
number of interconnected marketplaces
• over-the-counter (OTC) nature
• different currencies instruments are traded
• So not a single exchange rate but different
rates (prices), depending on what bank charge
• rates are often very close, otherwise they may
be exploited by arbitrageurs
• Main trading centers are London, New York,
Tokyo, Hong Kong and Singapore
• Throughout the day Asian trading session ends,
the European session begins, followed by the
North American session
• Fluctuations in exchange rates caused by actual
monetary flows as well as expectations of changes
in GDP growth, inflation interest rates budget and
trade deficits or surpluses,
• Currencies are traded against one another
• Each pair of currencies thus constitutes an
individual product and is traditionally noted
XXX/YYY
• according to the BIS study, the most
heavily traded products
• EUR/USD: 27%
• USD/JPY: 13%
• US currency was involved in 86.3% of
transactions, the euro (37.0%), the yen
(16.5%), and sterling (15.0%)
• volume percentages is usually add up to
200%
 Determinants of FX Rates

• In fixed exchange rate regime, FX rates are

decided by its government
• International parity conditions:
purchasing power parity, interest rate parity,
Domestic Fisher effect, International Fisher
effect yet these theories falter as they are
based on challengeable assumptions as free
flow of goods.
• Balance of payments model: focuses
largely on tradable goods and services,
ignoring the increasing role of global capital
flows
• Failed to provide any explanation for
continuous appreciation of dollar during
1980s
• Asset market model: views currencies as an
important asset class for constructing investment
portfolios.
• It depends on their expectations on the future
worth of these assets
• None of the models developed so far succeed to
explain FX rates levels and volatility
• many macroeconomic factors affect the exchange
rates and in the end currency prices are a result of
dual forces of demand and supply
• Economic factors
• (a)economic policy: Economic policy comprises
government fiscal policy and monetary policy
• (b)economic conditions:
• The market usually reacts negatively and positively to the
government deficits and surplus
• Trade flow between countries illustrates the demand for
goods and services, which in turn indicates demand and
supply for a country's currency
• a currency will lose value if there is a high level of
inflation in the country or if inflation levels are
perceived to be rising .
• GDP, employment levels, retail sales, capacity
utilization and others, detail the levels of a
country's economic growth and health
• Increasing productivity in an economy should
positively influence the value of its currency.
• Political conditions: Internal, regional, and
international political conditions and events can
have a profound effect on currency markets.
• Political upheaval and instability can have a
negative impact
• Market psychology:
• Unsettling international events can lead to a
"flight to quality," with investors seeking a "safe
haven“ like Swiss franc.
• Currency markets often move in visible long-term
trends and do not have an annual growing season
like physical commodities
• "Buy the rumor, sell the fact" market truism can
apply to many currency situations
• Economic numbers itself becomes important to
market psychology and may have an immediate
impact on short-term market moves.
• Price movements in a currency pair such as
EUR/USD can form apparent patterns that
traders may attempt to use.
•
 Financial instruments

• Spot: A spot transaction is a two-day delivery

transaction
• Direct exchange” between two currencies, has the
shortest time frame, involves cash rather than a
contract
• Second largest turnover by volume after Swap.
• Forward: deal with the foreign exchange risk is to
engage in a forward transaction
• Some agreed upon future date
• Future: Foreign currency futures are exchange traded
forward transactions with standard contract sizes and
maturity dates
• Swap: two parties exchange currencies for a certain length
of time and agree to reverse the transaction at a later date
• Option: Owner has the right but not the obligation to
exchange money at a pre-agreed exchange rate on a
specified date.
• Exchange Traded Fund: open ended investment companies
that can be traded at any time throughout the course of the
day
• Speculation: Controversy about currency
speculators and their effect on currency
devaluations and national economies recurs
regularly
• Large hedge funds and other well capitalized
"position traders" are the main professional
speculators
• simply gambling that often interferes with
economic policy
 Exchange rate
• It is the value of a foreign nation’s currency
in terms of the home nation’s currency
• Spot exchange rate refers to the current
exchange rate
• Forward exchange rate refers to an
exchange rate that is quoted and traded
today but for delivery and payment on a
specific future date
• Quotations: “Term currency" (or "price currency"
or "quote currency") that can be bought in terms of
1 "unit currency" (also called "base currency")
• market convention is to use the base currency
which gives an exchange rate greater than 1.000.
• direct quotation: 1 foreign currency unit = x home
currency units
• indirect quotation: 1 home currency unit = x
foreign currency units
• Market convention from the early 1980s to 2006
was 4 decimal places, now it is incresed to 5 or 6.
• Free or pegged: exchange rate is allowed to vary
against that of other currencies and determined by
the market forces of supply and demand
• System of fixed exchange rates has provision for
the devaluation of a currency
• The nominal exchange rate e is the price in
domestic currency of one unit of a foreign
currency.
• The real exchange rate (RER) is defined as , where
P * is the foreign price level and P the domestic
price level. P and P * must have the same arbitrary
value in some chosen base year.
• The RER is only a theoretical ideal because the
model is based on purchasing power parity (PPP),
which implies a constant RER.
• Bilateral vs. effective exchange rate: Bilateral
exchange rate involves a currency pair, while
effective exchange rate is weighted average of a
basket of foreign currencies
• Uncovered interest rate parity: an appreciation or
depreciation of one currency against another currency
might be neutralized by a change in the interest rate
differential
• Balance of payments model: This model holds that a
foreign exchange rate must be at its equilibrium level - the
rate which produces a stable current account balance
• Asset market model: currencies as asset prices traded in
an efficient financial market
• Like the stock exchange, money can be made or lost on the
foreign exchange market.
• Fluctuations in exchange rates: A market based
exchange rate will change whenever the values of
either of the two component currencies change.
• more valuable whenever demand is greater than
the available supply
• Demand is either due to an increased transaction
demand for money, or an increased speculative
demand and Central bank manages the demand
and supply of currency.
• highly correlated to the country's level of
business activity
Summary of
Articles
Foreign exchange market intervention in
emerging market economies: an overview

• On 2 and 3 December 2004, the BIS hosted

a meeting of central banks from major
emerging market economies to discuss
foreign exchange market intervention.
• It is less in developed and common in
developing economies
• Several reasons of why developed
countries no longer actively intervene
• Instrument is only effective if seen as foreshadowing
interest rate or other policy adjustments
• second reason is that large-scale intervention can
undermine the stance of monetary policy
• third reason is that private financial markets have enough
capacity to absorb and manage shocks
• The reasons emerging market countries intervene is the
situations they face
• Many observers attributed the comparatively weak
appreciation of Asian currencies against a rapidly
depreciating US dollar to such intervention
• common belief that intervention altered the path of the real
exchange rates
• wide range of different objectives behind intervention
• to slow the rate of change of the exchange rate; to dampen
exchange rate volatility to supply liquidity to the forex
market; or to influence the level of foreign reserves
• Many central banks aim to limit exchange rate volatility
rather than to meet a specific target for the level of the
exchange rate
• others countered that investors need to be more aware of to
hedge their own exposures
• There is indeed some evidence that exchange rate volatility
has fallen a lot where the central bank has not intervened
• Paper by Moser-Boehm makes clear, views of central
banks also differ about transparency
• Central banks have probably improved their intervention
techniques in recent years
• devote greater resources to “reading” the market
• it is unclear whether central banks have become more
effective
• Resisting currency appreciation through large-scale
intervention creates several major challenges
 Survey of Foreign Exchange
Market Activity
• During April 1992, The survey was conducted as
part of a global survey, involving 26 countries,
which was coordinated by BIS and eleven New
Zealand banks
• The aim was to gauge the size and structure of
foreign exchange markets from the trading activity
• New Zealand foreign exchange market was US$ 4
billion representing 0.5 percent of global turn over
• UK has largest average daily turnover of US$
300.2 billion which constitute about 26.6 percent
of total turn over
• In USA, US$192.3 billion and having 17.0 percent
• Japan is on the third with US $126.3 billion
turnover.
• New Zealand is on 22nd no. US $ 4.2 billion
turnover which constitutes 0.4 percent
• US Dollar highly traded currency, involved in
over 80 percent of net turnover
• Deutsche Mark was the next nearly 40 percent of
net turnover
• Japanese Yen was 23 percent of turnover
• The gross share of activity in the US Dollar and Japanese Yen
declined by 7 percent and 3 percent respectively between 1989 and
1992
• In Uk, % of turnoveris 38% with local bank, 43% with abroad, 11%
with Financial Institutions, 6 % with customers, 2% with futures and
options
• The 49.3, 40.9, 6.6, 2.3, 0.9 percent of United kingdom of the total net
turnover is in spot, swap forward, options, futures respectively
• growth in gross turnover during 1989 to 1992 is total 53% in United
Kingdom, US and Japan preceding
• growth in United Kingdom is 19.8, 183.2 percent in spot and options
market
 The traditional brokers: what are
their chances in the forex?
• The two kinds of brokers: the traditional brokers and
Electronic brokers
• The electronic brokers can do what the traditional brokers
can do with lower costs
• The only real advantage of the traditional broker is the
gathering of information
• Many arguments are given in favor and against the
traditional brokers
• We can distinguish between two kinds of information: one
about prices quoted by dealers and another about the
market tendency
• electronic broker may stand on a superior position in the
access to the first kind of information
• The contacts between the traditional broker and its clients
occur in a more personalized way
• In a conversation, it is often possible to understand the true
motivation underlying the placement of an order
• The quality of the information improves
• the traditional broker may hint to its best clients
• But we are to find out whether this characteristic of the
traditional broker is relevant to the choice of the way
dealers trade
• Survey database show that transactions
occur through a traditional broker are a
minority about half of electronic broker by
1997
• Dealers do not value much its transmission
of superior information about the evolution
of the market
Queries?

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