MFE 230G

Equity &

Currency Markets
Michael Melvin

Head of Currency Research

Barclays Global Investors
michael.melvin@barclaysglobal.com
415-908-7635

LECTURE 1: Section 1
Overview of the FX Market

What is foreign exchange and where is the

market?

Foreign exchange refers to bank deposits denominated in foreign

currency and banknotes

Prices are exchange rates expressed like EURUSD

EUR is base currency, USD is term currency
This is the dollar price of 1 euro, like 1.4650

Global market with 24-hour trading

No physical location, telephone and electronic trading

A decentralized dealership market

Worlds Largest Financial Market

(BIS Triennial Survey)

What is traded & where?

(BIS Triennial Survey)

London the biggest market (34%), followed by New York (17%) and Zurich, Tokyo, & Singapore (6%)
Still a USD world

Who Dominates Market Making?

Bank

(Euromoney FX Poll)
Market Share

Deutsche Bank

22%

UBS

16%

Barclays Capital

9%

Citi

7%

RBS

7%

JPMorgan

4%

HSBC

4%

Lehman Bros

4%

Goldman Sachs

3%

Morgan Stanley

3%

Bank of America

2%

Dresdner Kleinwort

2%

BNP Paribas

2%

Credit Suisse

2%

LECTURE 1: Section 2
The Case for Active Currency Management

10

Why Alpha Exists in Currency Markets:

Participants

Profit Oriented Participants

Look to profit from exchange rate changes
Currency overlay managers
Hedge funds

Liquidity Oriented Participants

Access market to fund international transactions

Tourists
Corporates financing payables & receivables or hedging
Central banks intervening, providing liquidity, or managing volatility as a policy tool
Global investors in fixed income & equities (hedging or not)

Dealers are 3rd party intermediaries between liquidity providers and liquidity
takers
If the other two parties did not trade or could trade directly, there would be no dealers
Dealers charge bid-ask spread for providing intermediation services
Dealers manage risk by passing their positions to others
Profit-oriented traders will take their positions for a price

11

Where does the alpha come from?

Liquidity-oriented pay a premium to induce profit-oriented to trade

Generates systematic returns for profit-oriented who provide liquidity

Successful profit-oriented firms:

are good forecasters
anticipate flows generated by liquidity takers
central bank policy making & associated trades
global investor trades in equity & fixed income

exploit information asymmetries & have trade execution advantages

12

Market Structure of Participants: shares of total FX

volume

13

Market Structure of Participants: Detail

Reporting dealers
Interbank, intermediary flows
Down from 1992,69% to 2007, 43%

Other financial institutions

Small non-dealer banks, mutual funds, pension funds, hedge funds,
currency overlay funds, money market funds, insurance cos, etc
Up from 1992, 13% to 2007, 40%

Non-financial customers
Corporates and governments
Steady from 1992, 18% to 2007, 17%

Total market size up from 1992, $840B to 2007, $3,081B

14

How big is the liquidity-oriented share of the

market?

Must make informed guess, as an OTC market with no marketwide

data
Lower bound: the 17% of non-financial customers
+ some fraction of the other financial institutions
DB estimates that 40% of FX turnover can be attributed to buying/selling
goods, services, or other financial assets ($1,200B a day)
implies 23% attributed to non-dealer financial customers

What about other 60% of turnover?

Includes loans, currency hedging, and speculative trades (profit oriented
traders)
DB estimates that about half of this is loan and hedging-related and half
profit-oriented speculative trading
Implies 70% of FX turnover is liquidity-oriented

Appears to be consistent opportunity for profit-oriented

15

Ancillary evidence

Chicago Mercantile Exchange data on FX futures

Non-commercial (profit-oriented speculators) earn profits over time
Commercial (liquidity-oriented hedgers) lose money on positions
Of course, commercial hedgers would not evaluate P&L in this manner

Reserve Bank of Australia study of speculators in FX futures

Non-commercial (profit-oriented speculators) earned profits on every currency
over 10-year sample period
Commercial (liquidity-oriented hedgers) lost money on every currency
Conclude that profit-oriented traders earn a risk premium for providing liquidity
and earn positive returns from superior forecasting ability

Central bank policy of leaning against the wind generates losses from FX
intervention
Creating profit opportunities for others

There are consistent opportunities for alpha in FX

Participants have different motivations for trading, different sources of
information, and different ways of processing information

16

LECTURE 1: Section 3
FX Market Microstructure

17

Market Structure

Decentralized multiple-dealership market

Market fragmented

Low trade transparency

Only parties to trade no what was traded in most transactions
Electronic platforms allow for more info than prior to 1990s
See streaming prices and can infer trade activity
No size info

Voice brokers making interbank comeback due to algo trading on Eplatforms

Banks dont want their trades to trigger algo trades

18

Participants
Dealers
Marketmakers: provide liquidity & two-way prices
Interbank & customer trades

Customers
Central bank, non-bank financial institutions, smaller banks,
corporates
Brokers
Intermediate trades
Historically just interbank, but democratization via electronic platforms
An alternative to direct dealing

Anonymity provided
19

Dealers receive info from customer orders

Order flow contains information

Big banks with big client bases have advantage over others
Infer positioning
See initial large orders that will have market impact

Private info flows between trading direct-dealing counterparties

Imagine you receive central bank intervention order

Brokered trades are visible to platform participants

See price of a completed deal, so can infer whether buy or sell

20

Transparency of Order Flow

Pre-trade vs post-trade info

Direct-dealing has no pre-trade transparency except for counterparty
interest
Dont know what others quote without checking

Price vs quantity info

Marketwide info on price only via E-broker sites
No quantity info anywhere

Public vs dealer info

In opaque market order flow not shared widely so info may be
impounded in price more slowly
Info asymmetry helps dealers manage risk of large positions

Order flow traditionally ignored in exchange rate models

Tradition of macro models, but order flow belongs more to the micro
world
21

Electronic Brokers: How Big?

22

Electronic Brokers: Who has liquidity on each

name?
120.0

100.0

80.0

60.0

40.0

20.0

EURUSD GBP USD

EURGBP

EBS

USDJ P Y

EURJ P Y

Reuters

USDCHF

Currenex

EURCHF

Hotspot

USDCAD AUDUSD

NZDUSD

Lava

23

Electronic Brokers: Transparency

24

Electronic Brokers: Liquidity

25

LECTURE 1: Section 4
Temporal Patterns of FX Trading

26

Brzeszczynski & Melvin, Explaining Trading

Volume in the Euro

The purpose of this study is to introduce several stylized facts of

the FX market
The academic purpose was to provide an early view of the pattern of
trading activity in the euro since its start.

From birds eye to microscope approach

Data frequencies used:

- weekly
- daily
- intradaily (5-minutes intervals).

The euro first appeared and began trading at the beginning of 1999
27

Explaining.. Data

The data are drawn from a major electronic brokerage platform

for currency trading (Reuters).

A record of every trade that occurred on the euro against the U.S.
dollar over the period of: January 1, 1999 - October 7, 2003.

While data exist for both the dollar value as well as number of
trades, we focus on the latter variable as an indicator of trading
activity.

The dollar value includes the effect of exchange rate changes and
such valuation effects may lead to misleading characterizations of
trading intensity.
28

Explaining.. Data

Data have been converted to standard normal variates (we

remove the mean in order to protect the vendors proprietary rights).

Holidays and weekends removed.

There is a smile pattern where trading activity was on a

downward trend until early 2002, after which trading activity started
an upward trend

29

Explaining.. More trading at launch

30

Explaining.. Determinants of activity

Galati and Melvin (BIS, 2004) provide an analysis of the BIS survey
data on global foreign exchange trading and conclude that in the
early 2000s three factors appeared to contribute to rapid growth in
foreign exchange trading:
Exchange rate trends that fostered momentum-based trading,
Interest-rate differentials that led to carry-trades
Growth of interest in currencies as an asset class alternative to equity
and fixed income

31

Explaining.. momentum

We model trends in the USD/EUR by applying the H-P filter to weekly

data to create a smoothed exchange rate series.
The Hodrick-Prescott Filter is a popular smoothing method to obtain an
estimate of the long-term trend component of a series. It is a two-sided filter
that computes the smoothed series s of series y by minimizing the variance of y
around s, subject to a penalty that constrainst the second difference of s. The
HP filter chooses s to minimize:
T

yt st
t 1

T 1

st 1 st st st 1

t 2

Where smoothness is controlled by penalty parameter

For a smoother s, choose a larger

Then the change in the log of the smoothed series is used as a

determinant of trade activity
32

Explaining.. Carry trade

In terms of trading activity, we would expect that changes in the

interest rate differential would induce more carry-related trades
the absolute value of the change in the interest differential
between the ECB marginal lending facility rate and the Federal
Reserve federal funds rate is used as an explanatory variable

33

Explaining.. currencies as an asset class

U.S. Treasury publishes data on the futures and options positions

of large foreign exchange market participants at the weekly
frequency.
These are market participants with more than $50 billion in foreign
exchange contracts on the last business day of any quarter during
the previous year.
The absolute difference of purchases minus sales of euros
against dollars is used as proxy for positioning

34

Explaining.. Weekly model

The number of trades per week were aggregated to create the dependent variable
of interest: Numtrades
Then the following equation was estimated:

Numtradest 0 1Trend t 2 Intdiff t 3 Positionst ut

Where

Trend - the change in the log of the smoothed USD/EUR exchange rate estimated via the H-P
filter;
Intdiff - the absolute change in the interest differential between the federal funds and ECB
interest rates;
Positions - the absolute value of purchases minus sales of euros against dollars by big
market participants

Variable
Constant
Trend
Intdiff
Positions
AR1
R2= 0.644
Q(10) = 13.047

Coefficient
14,405.8
1,558,603
1,496.1
0.019
0.732

P-value
(0.000)
(0.041)
(0.092)
(0.315)
(0.00)

(0.175)

35

Explaining.. Daily activity

Calendar effects
Market participants typically expect liquidity to be lower on Friday
than on other days.
This effect is due to aversion to opening positions prior to the weekend.
With two days of non-trading, any news that may occur over the weekend
cannot be met with a reaction. So position changes are not possible.
As a result, we should expect trading volume to be lower on Fridays than on
other days.

In order to examine day-of-the-week effects, a dummy variable was

created for each day of the week.
For instance, MON is a dummy variable for Monday which is equal to 1 on
Monday and zero otherwise. Similarly, the variables TUE, WED, THUR, and
FRI are created.

36

Explaining.. Daily activity

Central bank policy events

Dummy variables FED and ECB are created that equal 1 on days when the
Federal Reserve or the ECB change their target rates, respectively

The following model was estimated:

Numtradest 0 MON t 1TUEt 2WEDt 3THURt 4 FRI t

6 FEDt 7 ECB 8 Numtradest 1 ut

Variable

Coefficient

MON
-22.202
TUE
752.832
WED
20.902
THU
-20.443
FRI
-497.751
FED
-116.159
ECB
119.792
R2= 0.674
Q(10) = 6.9035 (0.228)

P-value
(0.638)
(0.000)
(0.671)
(0.681)
(0.000)
(0.202)
(0.209)
37

Explaining.. Intradaily

Determinants of Intradaily Trading Activity:

1) Time of Day

2) Stop-Loss Orders

3) Trade Persistence

38

Explaining.. Intradaily
Time of Day

Prior work on exchange rate microstructure has demonstrated that

there is a regular pattern of activity in the foreign exchange
market at the intradaily level.

We explore this pattern with a sample of 5-minute frequency

trade volume for the 2003 data in our data set, that is JanuaryOctober, 2003.

39

Explaining.. Intradaily
Intradaily Number of Trades per 5-Minute Interval for USD/EUR (standardized)
January 2003
3.5
3

Standardized Number of Trades

2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
1

11 21 31

41 51

61 71

81

91 101 111 121 131 141 151 161 171 181 191 201 211 221 231 241 251 261 271 281
Tim e Inte rval

40

Explaining.. Intradaily

There are 288 5-minute intervals each day.

The active period of trading starts around 8 a.m. London time

(interval 92) and ends around 4 p.m. London time (interval 192).

The two largest spikes occur following the period of 13:30 London
(8:30 New York) when most U.S. macro news announcements are
received and 15:00 London (10:00 New York) when many foreign
exchange options expire and trading related to unwinding delta
hedges occurs
There is also some U.S. macro news that occurs at 15:00 London
time

41

Explaining.. Intradaily

We employ two dummy variables to capture the slow period when

trading is basically flat.

Dum800 is a dummy that is set equal to 1 during the period of

midnight to 8:00 London time and equals zero otherwise.

Dum1600 is a dummy set equal to 1 during the period of 16:00 to

midnight London time and is zero otherwise.

42

Explaining.. Intradaily
Stop-Loss Orders
Recent research has attempted to link large exchange rate
changes or price cascades to the presence of stop-loss or takeprofit orders.
orders that customers place with banks that will trigger purchases or
sales of currency once the exchange rate reaches a particular level
Osler (JF, 2005; JIMF, 2003) has shown that such orders tend to cluster
at round numbers or big figures

We examine the role of crossing round numbers in our highfrequency data set on dollar/euro trades by creating a variable
Round that is set equal to 1 in any 5-minute interval in which a
round number is passed.
For the EURUSD, that would be any time the exchange rate passes
the big figure which is the exchange rate at two decimal points
like 1.25 or 1.05.
43

Explaining.. Intradaily
Trade Persistence

The data on high-frequency trade volume are highly autocorrelated.

If there is a very active market in the current 5-minute interval, there is likely
to be very active trading in the next 5-minute interval.

For this reason, we include a lagged value of trade volume as an

explanatory variable.

In addition, it is necessary to model the residuals to account for any

remaining autocorrelation and transform the errors to white noise.

We examine models for each month of our sample and fit a separate noise
model to each month.
44

Explaining.. Intradaily
We estimate the following for each month of our sample:

Tradest c 1 Round t 2 Dum800t 3 Dum1600t 4Tradest 1 t

Constant Round Dum800 Dum1600 Tradest-1
Month
January

3.036
(0.00)
February
4.371
(0.00)
March
3.382
(0.00)
April
0.640
(0.00)
May
0.668
(0.00)
June
1.519
(0.00)
July
1.550
(0.00)
August
0.742
(0.00)
September 1.306
(0.00)
October
2.658
(0.00)

2.668
(0.00)
2.136
(0.00)
0.804
(0.01)
1.452
(0.00)
1.205
(0.00)
0.725
(0.00)
1.131
(0.00)
0.569
(0.00)
0.738
(0.00)
1.911
(0.00)

-2.438
(0.00)
-3.874
(0.00)
-2.736
(0.00)
-0.190
(0.15)
-0.066
(0.00)
-0.806
(0.00)
-0.880
(0.00)
-0.274
(0.00)
-0.662
(0.00)
-1.798
(0.00)

-2.936
(0.00)
-4.278
(0.00)
-3.320
(0.00)
-0.702
(0.00)
-0.712
(0.00)
-1.570
(0.00)
-1.595
(0.00)
-0.801
(0.00)
-1.404
(0.00)
-2.701
(0.00)

0.854
(0.00)
0.815
(0.00)
0.872
(0.00)
0.962
(0.00)
0.954
(0.00)
0.923
(0.00)
0.916
(0.00)
-0.955
(0.00)
0.943
(0.00)
0.899
(0.00)

R2

Q(12)

Obs

0.668

12.93
(0.17)
11.74
(0.11)
10.11
(0.12)
13.40
(0.15)
9.148
(0.17)
7.721
(0.17)
7.051
(0.42)
6.010
(0.65)
10.420
(0.17)
2.590
(0.76)

6,718

0.660
0.721
0.704
0.713
0.708
0.677
0.695
0.679
0.719

6,144
6,528
6,720
6,720
6,528
7,008
6,528
6,720
6,720

45