Foreign Exchange Market

 The FE market performs an international clearing function by bringing two parties wishing to trade currencies at agreeable exchange rates.

The FE market takes place between dealers and brokers in financial centers around the world. During the hours of business common to different time zones, they rapidly exchange shorthand messages expressing their bids for different currencies.

To make a profit on FE maneuvers, a trader or broker has to make quick decisions correctly. Foreign exchange traders lead an exciting and hectic life, and the pressure often shortens many careers.

The fastest possible communications are used. Before the trans-Atlantic cable was laid in 1865 by Cyrus West Field (after many failed attempts), somebody wanting to exchange dollars for pounds often had to wait the time required for a roundtrip voyage to clear up the transaction. Modern telephone links have reduced the transaction costs on foreign exchange to near zero for large transactions.

 The daily volume of business dealt with on the foreign exchange markets in 1998 was estimated to be over $2.5 trillion dollars. In 2010, the daily volume was about $4 trillion.

The London market is the largest (about 36%), followed by New York (18%) and Tokyo (6%).

USD accounts for 85%, Euro 40%, Yen 19%.

(Daily volume on New York Stock Exchanges is about $20 billion) Today (2011) it may be about $5 trillion dollars. The daily volume of the foreign exchange market in North America in October 2005 was about $440 billion.

The Foreign Exchange market expanded considerably since President Nixon closed the gold window and currencies were left afloat vis-á-vis other currencies and speculators could profit from their transactions.

(ii) The emergence of Yen as a major currency, and

(iii) new Euro, in addition to the Dollar beside many other currencies, and the frequent fluctuations in relative value of these currencies provide a great opportunity to generate substantial profits.

(iv) RMB: Chinese Renminbi is convertible on current account, but not on capital account. When it becomes fully convertible, which is not likely to occur until 2020 or later, it will fundamentally affect the foreign exchange market due to its sheer volume.

The London market is the largest (about 36%), followed by New York (18%) and Tokyo (6%). volume in 2010 = $4 trillion per day.

Before the single currency euro was launched in 2002, the composition of foreign currency transactions in the New York market in 1985 was as follows: Mark 32%, Pound 23%, Canada $ 12%, Yen 10%, Swiss Franc 10%, others 13%.

The introduction of euro in 2002 dramatically changed the composition of these foreign currencies as most of European currencies were no longer circulated. The foreign exchange markets were handling over $450 billion per day through New York, London and Frankfurt. (most market economies have less GNP). Today it is estimated to be more than $5T a day.

The exchange rate is the domestic price of a foreign currency. The FE quotations list selling price in dollars or foreign currency per dollar.

The selling price refers to the price at which a large customer could have bought the currency from the dealers. The buying price at which one could have sold foreign currency to the dealers is normally 0.1% below the selling price, which represents the commission of FE dealers or banks. This is called interbank trading as it occurs usually between foreign exchange dealers in different banks in major financial centers. Obviously, the "retail" rates for corporate customers are less favorable than the "wholesale" rates.

(ii) Transactions agreed on Monday will result in payments on Wednesday. Those agreed on Thursday will be available on Monday. Canadian/US dollar business is cleared in one day (because Toronto and New York are in the same time zone).

(iii) Some New York banks maintain 2 shifts (one arriving at office at 3 am when London and Frankfurt are open). Large New York banks also have branches in Tokyo, Frankfurt, and London. Thus, they are in contact with all financial centers 24 hours.

(iv) When a FE dealer or broker quotes a price on the telephone, he can be held to it for only a few seconds (It used to be up to 1 minute). Dealers may quote different prices to different customers. Prices change throughout the day. Bluffing/counterbluffing for a large sum of FE. For average customers, it does not pay to get more than one quote.

 Bank notes

 Buying and selling rates for bank notes may be listed. Prices do not change throughout the day. Selling price for BN may be higher/lower than the selling price for Cable transfers. The spread is much larger than 0.1% for cable transfers, and may go up to 5-10%.

forward rates are for currency to be delivered 30, 90 or 180 days later at the known price on a given day. Forward rates are available for major international currencies.

Currency futures markets were established by Chicago Mercantille exchange in 1972. Futures prices are for contracts applicable to a specific calendar dates (Third Wednesday of June, September, December and March).  

They are importers/exporters of goods, services and financial assets (stocks/bonds).

They are most numerous.

They buy and sell FE for transaction purposes.

These do not usually trade currencies one another because it is difficult to match double coincidence of wants. Instead they go to a commercial bank for the transactions.

(i) FE Dealers are large commercial banks, which buy and sell FE. Specifically, they are the international departments of large commercial banks in the financial centers of the world: London, New York, Tokyo, Zurich, Frankfurt, Paris, Singapore, Hong Kong, Toronto.

In New York City, there are about 100 such banks.

(ii) Large banks outside the center also participate through their affiliates.

(iii) Small regional banks do not directly participate in the FE market. But to meet their customers' FE need, they deal with correspondant banks. Almost 14,000 commercial banks maintain corresponent relationship with FE dealers.

(iv) FE dealers typically maintain a trading room equipped with telephones and telex machines. They ususally communicate directly with the trading rooms of banks in other centers. They go through a broker when dealing with other banks in the same center. They are exposed to FE risks. 

(i) Central banks participate (a) to facilitate Treasury's transactions, and (b) to prevent or effect a change in the value of their currency.

(ii) in the US, Federal Reserve Bank of NY acts as agent for the entire Federal Reserve System and the Treasury Department.

(iii) it usually tries to conceal its intervention. It may requres an obscure bank in Midwest to place an order in the New York market.

(iv) Sometimes it publicizes its buying intent.

World Poker Championship: Cards are shown only to the viewers. Apparently, viewers cannot convey any message to the players. The winner's prize is over $2 million.

With sharp minds, the players can incorporate all the information on the displayed cards and calculate the probability of a desired card. In the case of poker, there are only 52 possible cards. Accordingly, bright individuals can compute the probabilities of winning of his own and competing players. These probabilities of winning are almost instantaneously computed for TV viewers.

Since so many things can possibly affect the probability that a currency will rise against another, computer programs or formulas for the price of a given stock or currency to rise cannot be devised. Some investment companies will claim they have developed a certain formula or program to buy and sell currencies (or stocks), but they are doomed. If a particular method brings profits to the investor, more people will invest money into that formula, thereby driving the prices of currencies/stocks downward and raising the prices of those they are selling, eventually eliminating profits.

Instead of relying on a fixed formula, currency dealers can incorporate all the available information about the currency markets and other news on world events which affect currency values.

 Ronnie Schlaefer

(speculator)

13 rich investors, around the world 50% profit rate in 1984.

management fee = fixed.
performance fee = 20- 25% once a year.
made many mistakes of missing the moment to sell mark, but breaks even at the end of the day

Hill finds out that Russians (Moscow) are buying £ with mark, jumps on the bandwagon by buying £, thereby raising the price a little and then sells it later.

Hill bought and sold 750 million £ and profited π = $160,000 (£91,400) that day. (one day's interest at 1% is £20547). The rate of return is about 8% per year.

U: = you, pls = please

Barclay: 8 dealers, made $150 million profit, 1984
($.5 million a day) Today, their profits from foreign exchange transactions would be over $1 million a day.

Salary = $40,000 + 3% commission.

When selling a large amount of FE, people notice it and price falls. To avoid it, William Wong requests the assistance of other dealers and sell £ simultaneously.

At the end of the day, he bought and sold 120 million £, with profit = $30,000 (£17,142), which is equivalent to one day's interest on the principal at 5.2 % per year.

Any foreign exchange delaer can engage in exchange arbitrage.

Exchange arbitrage involes the simultaneous purchase and sale of a currency in different foreign exchange markets. Thus, arbitragers take a closed position. (No risk)

Arbitrage becomes profitable whenever the price of a currency in one market differs from that in another market.

Suppose the pound quoted in NY is $1.75, but pound quoted in London is $1.78. Then an arbitrager in NY and his partner in London can take the following steps:

(a) buy 10 M pounds in NY: cost = $17.5 M

(b) sell 10 M pounds in London: revenue = $17.8 M

(c) profit = $300,000 less the cost of telephone, cable transfer. The supply of pound shrinks in NY, increases in London.

when to sell?

sell FE if ES^t+1 < S^t.

if F⁹⁰ > ES⁹⁰ (when spot rate is expected to fall), then sell forward pound,

if F⁹⁰ < ES⁹⁰ (when spot rate is expected to rise), then buy forward pound.

President Nixon once tried to punish these specualtors by dumping gold, effectively raising the official price of gold, but eventually he gave up. On August 15, 1971, President Nixon announced:

In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation's currency is based on the strength of that nation's economy-and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators.

I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets,except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.

How George Soros made over $1 billion

"the Man who broke the Bank of England"

Suppose pound is weak at $2.00 per pound, and that the equilibrium rate is $1.50.

Borrow 1 billion pounds (weak currency) for 3 months at the annual interest rate of 4% per year.

Convert 1 billion pounds to USD (strong currency) = $1 × 2.00 = $2 billion. Buy US securities at the same rate. If there is no loss in interest rate (when interest rates are equal), then don't bother with it.

Since pound is weak, sooner or later pound will be devaluated to its equilibrium level, $1.50.

Pay off loan in weak currency. When the pound falls to $1.50, buy back pounds to pay off the loan.

Revenue is $2 billion/$1.50 = £1.333 billion. Cost = £1 billion.

Profit from speculation is £333,333,333 (or (1/3) × 1.5 = $.5 billion dollars)

The forward exchange market resembles the futures markets found in organized commodity markets, such as wheat and coffee. The primary function of forward market is to afford protection against the risk of fluctuations in exchange rates.

(i) under flexible exchange rate system and if there are significant exchange variations,

(ii) under fixed exchange rate system, if there is a strong possibility of devaluation/revaluation,

(i) it cannot function when exchange control is imposed.

(ii) it cannot function during periods of hyperinflation.

 It is John Maynard Keynes' theory of how forward rates are determined.

When short term interests are higher in one market than in another, investors will be motivated to shift funds between markets, say New York and London.

Investors borrow (or buy) a low interest currency and lend the same amount in a high interest currency. This is called carry trade. There is roughly a 5% difference in the interest rates between Japan and the US. To make profits from differeing interest rates, investors must convert, for example, dollars (a low interest currency) into pound sterling (a high interest currency) for investment in London. However, they would be exposed to an exchange risk. If the exchange rate is stable, the investors gain the interest differential, (i - i*), by shifting funds from New York to London.

          If pound appreciates during the investment period, the foreign investors will reap additional gain in the change in the exchange rate. However, if pound depreciates, they will experience an exchange loss. The exchange loss may partially or more than offset the gain in the interest income.

          To avoid this exchange loss, dollar investors want cover against the exchange loss by selling pound forward. The amount of forward pound to sell is equal to the purchase of spot pound plus the interest earned in London. This practice is called interest arbitrage. Interest arbitrage links the two national money markets and the forward market.

$1M(1 + .02) = $1.02M

(2) Invest in London

£_t=0 = $1M/spot = $1M/1.5 = £666,667.

If S_t=90 = S_t=0, then investing overseas is better ($10,000 more return).

If S_t=90 = 1.65 (£ rose 10%), then

$10,000 (interest gain) + $103,000 (appreciation of £) = $113,000 (foreign investment is definitely better).

If S_t=90 = 1.35 (£ fell 10%), then

$10,000 (interest gain) - $103,000 (depreciation of £) = - $93,000.

Most investors would rather avoid this exchange risk.

(i) If F = $1.47, then

S_t=90 = 686.667 x 1.47 < 1.02 million. You are worse off.

Even if i* > i, do not invest in the UK. (That is, taking the foreign exchange risk is cheaper)

(ii) If F = $1.53, then

S_t=90 = 686.667 x 1.53 >1.02 million. You are better off.

Invest in the UK. (In this case, forward transactions are profitable and eliminate the foreign exchange risk.)

(1) A(1 + i)

i = i₉₀ = annual interest rate ÷ 4.

However, the subscript 90 is suppressed (too cumbersome)

(2) A(1 + i*)(F/S)

F = price of one pound sterlilng for delivery 90 days hence

S = price of one pound sterling in the spot market

(3) A(1 + i) = A (1 + i*)(F/S).

Solve for F.

(4) F = S(1 + i)/(1 + i*).

Since i and i* are small fractions, this is approximately equal to:

F = S(1 + i - i*), or

i - i* = (F - S)/S.

That is, if the domestic interest rate is higher, the forward pound must be sold at a premium. Specifically, the domestic interest advantage (i - i*) must be equal to %premium on the forward pound when the forward rate is at its parity.

For example, if the domestic interest is 1% above the foreign interest rate, forward pound must be higher than the spot rate by the same proportion to prevent capital flows.

 If i - i* > (F - S)/S, then K* inflow occurs.

(Domestic investors have no incentive to invest abroad, but foreign investors will invest in America)

If i - i* < (F - S)/S, then K outflow occurs. (Foreign investors will stay put, but domestic investors will move funds abroad)

If i - i* = (F - S)/S, then no capital flow.

Federal Reserve Bulletin publishes CAM, e, i, i*. CAM are very nearly zero.

Problems of IRP Theory

Keynes' theory does not take into account differing investment risks between the two countries.

(1) Interest rates in developing and transition economies are generally higher, due to higher risks.

(2) Inflation rates also differ between countries. It is not the nominal payoffs, but real interest rates. Thus, different inflation rates will affect investment decisions.