Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund

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Management of Financial Institutions - MGT 604

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 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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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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$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

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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