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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
VU
Lecture # 31
Foreign Exchange & Financial Institutions
The foreign exchange (currency or forex or FX) market exists wherever one currency is
traded for another. It is by far the largest financial market in the world, and includes trading
between large banks, central banks, currency speculators, multinational corporations,
governments, and other financial markets and institutions. The average daily trade in the
global forex and related markets currently is over US$ 3 trillion. Retail traders (individuals)
are a small fraction of this market and may only participate indirectly through brokers or
banks, and are subject to forex scams.
Market size and liquidity
The foreign exchange market is unique because of
its trading volume,
·
the extreme liquidity of the market,
·
the large number of, and variety of, traders in 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)
According to the BIS, average daily turnover in traditional foreign exchange markets is
estimated at $3,210 billion. Daily averages in April for different years, in billions of US
dollars, are presented on the chart below:
This $1.88 trillion in global foreign exchange market "traditional" turnover was broken
down as follows:
$1,005 billion in spot transactions
·
$362 billion in outright forwards
·
$1,714 billion in forex swaps
·
$129 billion estimated gaps in reporting
·
In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile
Exchange and are actively traded relative to most other futures contracts. Forex futures
volume has grown rapidly in recent years, and accounts for about 7% of the total foreign
exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Average daily global turnover in traditional foreign exchange market transactions totaled
$2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New
York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover, including
non-traditional foreign exchange derivatives and products traded on exchanges, averaged
around $2.9 trillion a day. This was more than ten times the size of the combined daily
turnover on all the world's equity markets. Foreign exchange trading increased by 38%
between April 2005 and April 2006 and has more than doubled since 2001. This is largely
due to the growing importance of foreign exchange as an asset class and an increase in fund
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Management of Financial Institutions - MGT 604
VU
management assets, particularly of hedge funds and pension funds. The diverse selection of
execution venues such as internet trading platforms has also made it easier for retail traders
to trade in the foreign exchange market.
Because foreign exchange is an OTC market where brokers/dealers negotiate directly with
one another, there is no central exchange or clearing house. The biggest geographic trading
center is the UK, primarily London, which according to IFSL estimates has increased its
share of global turnover in traditional transactions from 31.3% in April 2004 to 32.4% in
April 2006. RPP
The ten most active traders account for almost 73% of trading volume, according to The
Wall Street Journal Europe, (2/9/06 p. 20). 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 price at which a bank or market maker will sell ("ask", or "offer")
and the price at which a market-maker will buy ("bid") from a wholesale customer. This
spread is minimal for actively traded pairs of currencies, usually 0­3 pips. For example, the
bid/ask quote of EUR/USD might be 1.2200/1.2203. Minimum trading size for most deals is
usually $100,000.
These spreads might not apply to retail customers at banks, which will routinely mark up
the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes or
travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more
than 3 pips wide (i.e. 0.0003). Competition has greatly increased with pip spreads shrinking
on the major pairs to as little as 1 to 2 pips.
Market participants
Unlike a stock market, where all participants have access to the same prices, the forex
market is divided into levels of access. At the top is the inter-bank market, which is made up
of the largest investment banking firms. Within the inter-bank market, spreads, which are
the difference between the bid and ask prices, are razor sharp and usually unavailable, and
not known to players outside the inner circle. As you descend the levels of access, the
difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips only for major
currencies like the Euro). This is due to volume. If a trader can guarantee large numbers of
transactions for large amounts, they can demand a smaller difference between the bid and
ask price, which is referred to as a better spread. The levels of access that make up the forex
market are determined by the size of the "line" (the amount of money with which they are
trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there
are usually smaller investment banks, followed by large multi-national corporations (which
need to hedge risk and pay employees in different countries), large hedge funds, and even
some of the retail forex market makers. According to Galati and Melvin, "Pension funds,
insurance companies, mutual funds, and other institutional investors have played an
increasingly important role in financial markets in general, and in FX markets in particular,
since the early 2000s." (2004) In addition, he notes, "Hedge funds have grown markedly
over the 2001­2004 period in terms of both number and overall size" Central banks also
participate in the forex market to align currencies to their economic needs.
Banks
The interbank market caters for both the majority of commercial turnover and large amounts
of speculative trading every day. A large bank may trade billions of dollars daily. Some of
this trading is undertaken on behalf of customers, but much is conducted by proprietary
desks, trading for the bank's own account.
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Management of Financial Institutions - MGT 604
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Until recently, foreign exchange brokers did large amounts of business, facilitating
interbank trading and matching anonymous counterparts for small fees. Today, however,
much of this business has moved on to more efficient electronic systems, such as EBS (now
owned by ICAP), Reuters Dealing 3000 Matching (D2), the Chicago Mercantile Exchange,
Dukascopy - Swiss FX Marketplace, FXMarketSpace, Bloomberg, and TradeBook(R). The
broker squawk box lets traders listen in on ongoing interbank trading and is heard in most
trading rooms, but turnover is noticeably smaller than just a few years ago.
Central banks
National central banks play an important role in the foreign exchange markets. They try to
control the money supply, inflation, and/or interest rates and often have official or unofficial
target rates for their currencies. They can use their often substantial foreign exchange
reserves to stabilize the market. Milton Friedman argued that the 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 -- that is, to trade for a profit based on their more precise information.
Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because
central banks do not go bankrupt if they make large losses, like other traders would, and
there is no convincing evidence that they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize a
currency, but aggressive intervention might be used several times each year in countries
with a dirty float currency regime. Central banks do not always achieve their objectives.
The combined resources of the market can easily overwhelm any central bank. Several
scenarios of this nature were seen in the 1992­93 Enron collapse, and in more recent times
in Southeast Asia.
Investment management firms
Investment management firms (who typically manage large accounts on behalf of customers
such as pension funds and endowments) use the foreign exchange market to facilitate
transactions in foreign securities. For example, an investment manager with an international
equity portfolio will need to buy and sell foreign currencies in the spot market in order to
pay for purchases of foreign equities. Since the forex transactions are secondary to the
actual investment decision, they are not seen as speculative or aimed at profit-maximization.
Some investment management firms also have more speculative specialist currency overlay
operations, which manage clients' currency exposures with the aim of generating profits as
well as limiting risk. Whilst the number of this type of specialist firms is quite small, many
have a large value of assets under management (AUM), and hence can generate large trades.
Hedge funds
Hedge funds, such as George Soros's Quantum fund have gained a reputation for aggressive
currency speculation since 1990. They control billions of dollars of equity and may borrow
billions more, and thus may overwhelm intervention by central banks to support almost any
currency, if the economic fundamentals are in the hedge funds' favor.
Retail forex brokers
Retail forex brokers or market makers handle a minute fraction of the total volume of the
foreign exchange market. According to CNN, one retail broker estimates retail volume at
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Management of Financial Institutions - MGT 604
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$25­50 billion daily, which is about 2% of the whole market and it has been reported by the
CFTC website that un-experienced investors may become targets of forex scams.
Trading characteristics
There is no unified or centrally cleared market for the majority of FX trades, and there is
very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency
markets, there are rather a number of interconnected marketplaces, where different currency
instruments are traded. This implies that there is not a single dollar rate but rather a number
of different rates (prices), depending on what bank or market maker is trading. In practice
the rates are often very close, otherwise they could be exploited by arbitrageurs
instantaneously. A joint venture of the Chicago Mercantile Exchange and Reuters, called
FXMarketSpace opened in 2007 and aspires to the role of a central market clearing
mechanism.
The main trading centers are in London, New York, Tokyo, and Singapore, but banks
throughout the world participate. Currency trading happens continuously throughout the
day; as the Asian trading session ends, the European session begins, followed by the North
American session and then back to the Asian session, excluding weekends.
There is little or no 'inside information' in the foreign exchange markets. Exchange rate
fluctuations are usually caused by actual monetary flows as well as by expectations of
changes in monetary flows caused by changes in GDP growth, inflation, interest rates,
budget and trade deficits or surpluses, large cross-border M&A deals and other
macroeconomic conditions. Major news is released publicly, often on scheduled dates; so
many people have access to the same news at the same time. However, the large banks have
an important advantage; they can see their customers' order flow.
Currencies are traded against one another. Each pair of currencies thus constitutes an
individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217
international three-letter code of the currency into which the price of one unit of XXX is
expressed. For instance, EUR/USD is the price of the Euro expressed in US dollars, as in 1
Euro = 1.3045 dollar. Out of convention, the first currency in the pair, the base currency,
was the stronger currency at the creation of the pair. The second currency, counter currency,
was the weaker currency at the creation of the pair.
The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive
currency correlation between XXX/YYY and XXX/ZZZ.
On the spot market, according to the BIS study, the most heavily traded products were:
EUR/USD: 28 %
·
USD/JPY: 18 %
·
GBP/USD (also called sterling or cable): 14 %
·
And the US currency was involved in 88.7% of transactions, followed by the Euro (37.2%),
the yen (20.3%), and the sterling (16.9%). Note that volume percentages should add up to
200%: 100% for all the sellers and 100% for all the buyers.
Although trading in the Euro has grown considerably since the currency's creation in
January 1999, the foreign exchange market is thus far still largely dollar-centered. For
instance, trading the Euro versus a non-European currency ZZZ will usually involve two
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Management of Financial Institutions - MGT 604
VU
trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an
established traded currency pair in the interbank spot market.
Exchange Traded Fund
Exchange-traded funds (or ETFs) are Open Ended investment companies that can be traded
at any time throughout the course of the day. Typically, ETFs try to replicate a stock market
index such as the S&P 500 (e.g. SPY), but recently they are now replicating investments in
the currency markets with the ETF increasing in value when the US Dollar weakness versus
a specific Currency, such as the Euro. Certain of these funds track the price movements of
world currencies versus the US Dollar, and increase in value directly counter to the US
Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated
investors and speculators.
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Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  7. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS:Banking Inspection Department
  8. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Debt Management
  9. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Training Programs by SBP
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  11. MAJOR DRIVERS OF FINANCIAL INDUSTRY:GLOBAL FINANCIAL SYSTEM, The World Bank
  12. INTERNATIONAL FINANCIAL INSTITUTIONS:ADB Projects in Pakistan, Paris Club
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  18. ROLE OF COMMERCIAL BANKS:Problem bank management, BANKING SECTOR REFORMS
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  21. ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday
  45. RECAP:FINANCIAL INSTITUTIONS, CENTRAL BANK,