Forex

Participative Members Presented By: MUDASSAR HUSSAIN MBC-08-01 Muhammad Iqbal MBC – 0 8 – 04 Najeeba Kanwal MBC - 0 8 - 15 Muhammad Saeed MBC – 0 8 – 26 Muhammad Zuhair MBC – 0 8 – 36

Adil Asad MBC – 0 8 – 43

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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