Foreign exchange markets are the institutional frameworks within which currencies are bought and sold by individuals, corporations, banks and governments. Trading in currencies no longer occurs in a physical marketplace or in any one country. London, New York, and Tokyo, the major international banking centers in the world, have the largest share of the market, accounting for nearly 60 percent of all transactions. The next four important centers are Singapore, Switzerland, Hong Kong, and Germany. Over half of transactions in the foreign exchange markets are cross-border, that is between parties in different countries. Trading is performed using the telephone network and electronic screens, like Reuters and Telerate. More and more, however, trading is conducted through automated dealing systems which are electronic systems that enable users to quote prices, and to deal and exchange settlement details with other users on screen , rather than by telex machine or telephone. Counterparties in foreign exchange markets d o not exchange physical coins and notes, but effectively exchange the ownership of bank deposits denominated in different currencies. In principle, a tourist who makes a physical exchange of local currency for foreign currency is also a participant in the foreign exchange market and indeed for some currencies seasonal flows of tourist spending may alter exchange rates, though in most markets rates are driven by institutional trading. Other currencies may not be officially converted except for officially approved purposes and the currency rate is then determined by a parallel market which is more indicative of market trends than official ly posted rates by the central bank or by the commercial bankers (Kamin, 1993).
According to the Bank for International Settlement’s latest triennial survey of the global foreign exchange market, around US$880 billion worth of currencies are bought and sold daily. This represents a 42 percent growth in size compared to the previous survey of 1989 and makes the foreign exchange market the world’s biggest and most liquid market. The time zone positions of major international financial markets make the foreign exchange market a 24-hour global market. Unlike the different st ock exchanges and securities markets around the world, the foreign exchange market is virtually continuously active with the same basic assets being traded in several different locations. Throughout the day, the center of trading rotates from London to New York and then to Tokyo. Less than 10 percent of the daily turnover in foreign exchange transaction is between banks and their customers in response to tangible international payments. The remaining transactions are mostly between financial institutions themselves and are driven by international financial investment and hedging activities that are stimulated by the increasing deregulation of financial markets and the relaxation of exchange controls. Trading activity in foreign exchange markets shows few abnormalities and with the exception of late Friday and weekends, day of the week distortions are minimal. Trading activity in most centers is characterized by a bimodal distribution around the lunch hour. New Yo rk, however, has a unimodal distribution of activity, peaking at the lunch hour which coincides roughly with high activity in London and Frankfurt at the end of the business day in those locations (Foster and Viswanathan, 1990).
Currencies
Although its share is a declining trend, the US dollar remains predominant in foreign exchange turnover. About 83 percent of all foreign exchange transactions involve the US dollar with main turnover between the US dollar and the deutsche mark, Japanese yen, British pound, and the Swiss franc. This small group of currencies accounts for the bulk of interbank trading. Significant amounts of trading occur in other European currencies and in the Canadian dollar, but these can be considered second-tier currencies in that they are not of worldwide interest mostly because of the limited amount of trade and financial transactions denominated in those currencies. In the third tier would be the currencies of smaller countries whose banks are active in the markets and in which there are significant local markets and some international scale trading. The Hong Kong dollar, the Singapore dollar, the Scandinavian currencies, the Saudi rial, and Kuwait dinar are such currencies. Finally, the fourth tier would consist of what are called the exotic currencies, those for which there are no active international markets and in which transactions are generally arranged on a correspondent-bank basis between banks abroad and local banks in those centers to meet the specific trade requirements of individual clients. This group includes the majority of the Latin American currencies, the African currencies, and the remaining Asian currencies. A currency needs to be fully convertible to be traded in international foreign exchange markets. If there are legal restrictions on dealings in a currency, that currency is said to be inconvertible or not fully convertible and sales or purchases can only be made through the central bank often at different rates for investment and foreign transactions.
Transactions
A spot transaction in the currency market is an agreement between two parties to deliver within two business days a fixed amount of currency in return for payment in another at an agreed upon rate of exchange. In forward transactions the delivery of the currencies, the settlement date, occurs more than two business days after the agreement. In forward contracts short maturities, primarily up to and including seven days, are dominant. There are two types of forward transactions: outright forwards and swaps. Outright forwards involve single sales or purchases of foreign currency for value more than two business days after dealing. Swaps are spot purchases against matching outright forward sales or vice versa. Swap transactions between two forward dates rather than between spot and forward dates are called “forward/forwards.” Spot transactions have the largest share in total foreign exchange transactions, accounting for just under half of the daily turnover. However, forward transactions have increased in volume faste r and now nearly match the share of spot transactions. Activity in currency futures and options, which approximately represents 6 percent of the market, accounts for the rest of the turnover.
Market Efficiency
Market efficiency is of special interest to both academics and market participants with respect to the foreign exchange markets. Modern finance theory implies that prices in the foreign exchange markets should move over time in a manner that leaves no unexploited profit opportunities for the traders. Consequently, n o foreign exchange trader should be able to develop trading rules that consistently deliver profits. This assertion seems to be supported by the traders’ performance in real life. However, published research results, so far, show evidence of ex post unexploited profit opportunities in the currency markets. Dooley and Shafer (1983) also reported that a number of filter rules beat the market even in the ex ante sense. Some authors have argued that the filter profits found in exchange markets are explicable in the light of the speculative risk involved in earning them and may perhaps not be excessive or indicative of inefficiency.
A filter rule refers to a trading strategy where a speculator aims to profit from a trend by buying a currency whenever the exchange rat e rises by a certain percentage from a trough and selling it whenever it falls by a certain percentage from a peak. If foreign exchange markets were efficient, the forward rate today would be an optimal predictor of future spot rate and by implication would be the best forecaster. The empirical evidence suggests that the forward rate is not an optimal predictor of the future spot rate, i.e. it is a biased predictor. The rejection of forward market efficiency may be attributable to the irrationality of market participants, to the existence of time-varying risk premiums, or to some combination of both of these phenomena (Cavaglia et al., 1994). Crowder (1994) is one of the examples which argues that once allowance is made for fluctuations in the risk premium, efficiency is preserved. Currently there is no consensus among the researchers on the existence of market inefficiency or on the explanations for the inefficiency.
Participants
The major participants in the foreign exchange markets are banks, central banks, multinational corporations, and foreign exchange brokers. Banks deal with each other either directly or through brokers. Banks are the most prominent institutions in terms of turnover and in the provision of market-maker services. The inter-bank market accounts for about 70 percent of transactions in the foreign exchange markets. Banks deal in the foreign exchange market for three reasons. First, banks sell and buy foreign currency against customer orders. Second, banks operate in the market in order to meet their own internal requirements for current transactions or for hedging future transactions. Finally, banks trade in currencies for profit, engaging in riskless arbitrage as well as speculative transactions. In carrying out these transactions the banks both maintain the informational efficiency of the foreign exchange market and generate the high level of liquidity that helps them to provide effective service to their commercial customers. According to the BIS survey in April 1992 in London, the top 20 banks out of 352, acting as foreign exchange market makers, account for 63 percent of total market turnover. In all international markets there is a continuing trend towards a declining number of market-making banks as a result of both mergers among banks and of the withdrawal of some smaller banks who have inadequate capital to trade at the level needed for profitability in such a highly competitive business.
Non-financial corporations use the foreign exchange market both for trade finance and to cover investment/disinvestment transactions in foreign assets. In both activities the objective of the corporation is to maximize its profits by obtaining the most advantageous price of foreign exchange possible. Although small in scale, the corporations’ involvement in foreign exchange markets extends to management of their foreign exchange exposure through derivative products and, in the case of larger corporate entities, to actively seeking profit opportunities that may exist in the market through speculative transactions.
In their role of regulating monetary policies, central banks of sovereign states are often in the position of both buying and selling foreign exchange. The objective of central banks’ involvement in the foreign exchange markets is to influence the market-determined rate of their currencies in accordance with their monetary policy. Central banks often enter into agreements with one central bank lending the other the foreign exchange needed to finance the purchase of a weak currency in the market t o maintain the value of their currencies within a mutually agreed narrow band of fluctuations. Stabilization is intended to prevent wild fluctuations and speculations in the foreign exchange market, but central banks are increasingly cautious about signaling a commitment to a fixed intervention rate. Even the Exchange Rate Mechanism (ERM) of the European Union, in which currencies were contained within narrow bands of their central rate, was unable, in spite of the committed support of all European central banks, to prevent a concerted market adjustment. In September 1992 the Bank of England lost many millions of foreign currency reserves in a short and unsuccessful defense of sterling. Both sterling and the Italian lira were on that occasion forced out of the ERM bands.
Risks
Counterparty credit risk, settlement risk, and trading risk are the three major risks that are faced by market participants in the foreign exchange markets. Credit risk relates to the possibility that a counterparty is unable to meet its obligation. Settlement risk arises when the counterparty is able and willing but fails to deliver the currency on settlement day. The settlement of a foreign exchange contract is not simultaneous; therefore, counterparties are usually not in a position to insure that they have received the countervalue before irreversibly paying away the currency amount. In the foreign exchange markets there are unequal settlement periods across countries. Different time zones may expose the party making the first payment to default by the party making the later payment. In 1974 US banks paid out dollars in the morning to a German bank, Bankhaus Herstatt, but did not receive German marks through the German payment system when German banking authorities closed at 10.30 a.m. New York time. Herstatt received the doll ars in the account of its US correspondent but did not pay out the marks. Market risk refers to the risk of adverse movements in the rate of foreign exchange. A market participant in the foreign exchange market risks loss when rates decline and it has a long position (owns the asset) or when rates rise and it has a short position (has promised to supply the asset without currently owning it).
Quotation and Transaction Costs
The exchange rate quoted for a spot transaction is called the spot rate and the rate that applies in a forward transaction is called the forward rate. If a currency is trading at a lower price against another currency on the forward market than on the spot market, it is said to be at a discount. If, however, the currency is more ex pensive forward than spot, it is said to be at a premium. What determines whether a currency trades at a premium or discount is the interest rate differential in money markets. The currency with higher/lower interest rate will sell at a discount/premium in the forward market against the currency with the lower/higher interest rate. However, some research has shown a small bias in the forward rate explained by a time-varying risk premium.
Traders in the foreign exchange markets always make two-way prices, that is they quote two figures: the rate at which they are prepared to sell a currency (offer) and the rate at which they are willing to buy a currency (bid). The difference is called the spread and represents the market maker’s profit margin. The spread is conventionally very narrow in stable currencies with a high volume of trading. Liquidity is usually extremely good for major currencies and continuous two-way quotations can be obtained. However, in unstable, infrequently traded currencies, it can become a good deal wider. It widens with uncertainty – spreads on internationally traded currencies such as British pound, US dollar, or deutsche mark will widen if the international financial markets are in turmoil. The evidence from foreign exchange markets, however, does not support an unequivocal relationship between the market liquidity and the transaction costs. Bid-ask (offer) spreads are not necessarily lowest when the liquidity is high. More trading by informed risk averse participants brings about higher costs. Bollerslev and Domowitz (1993 ) report that small traders (banks) in foreign exchange markets tend to increase both the quoted spread and market activity at the beginning and at the end of their regional trading day, because they are more sensitive with respect to their inventory positions at the close than larger banks and have less information based on retail order flow at the beginning than larger banks that operate continuously. Another factor which may effect the transaction cost in foreign exchange markets is unobservable news. News events which chang e traders’ desired inventory positions result in order imbalances, changing the relative demand and supply for the currency, with the potential of changing the spreads (Bollerslev and Domowitz, 1993).
Exchange Rate Systems
From the end of World War II until 1971 the leading industrialized countries under the hegemony of the US economy committed themselves to a fixed exchange rate system. This period in the international monetary system is known as the Bretton system and aimed to preserve a fixed exchange rate between currencies until fundamental disequilibrium appeared, at which point through devaluati on or revaluation a new fixed parity was established. The Bretton system was based on the strength of the US economy whereby the US government pledged to exchange gold for US dollars on demand at an irrevocably fixed rate (US$35 per ounce of gold). All other participating countries fixed the value of their currencies in terms of gold, but were not required to exchange their currencies into gold. Fixing the price of gold against each currency was similar to fixing the price of each currency against each other.
With the increasing competitiveness of the continental European economies and the Japanese economy against the US economy, the USA ha d become unable to meet its obligations under the Bretton system and the fixed exchange rate system gave way to the floating exchange rate system in 1973. Under the floating exchange rate system currencies are allowed to fluctuate in accordance with market forces in the foreign exchange markets. However, even in systems of floating exchang e rates where the going rate is determined by supply and demand, the central banks still feel compelled to intervene at particular stages in order to help maintain stable markets. The Group of Seven (G7) council of economic ministers has in the past attempted co-ordinated interventions in the foreign exchange markets with a view to stabilizing exchange rates. The exchange rate system that exists today for some currencies lies somewhere between fixed and freely floating. It resembles the freely floating system in that exchange rates are allowed to fluctuate on a daily basis and official boundaries do not exist. Yet it is similar to the fixed system in that governments can and sometimes do intervene to prevent their currencies from moving too much in a certain direction. This type of system is known as a managed float. Economists are not in agreement as to which of the exchange rate systems, fixed or floating, can create stability in currency markets and is a better means for adjustments to the balance of payments positions (Friedman, 1953; Dunn, 1983). A fixed exchange rate system is unlikely to work in a world where the participating countries have incompatible macroeconomic policies and the economic burden of adjustments to the exchange rates usually fall on the deficit countries. The floating exchange rate system, on the other hand, has not delivered the benefits that its advocates put forward. The exchange rate volatility during the floating rate period is severe and is not consistent with underlying economic equilibria due to the activities of short-term speculators. The European Union’s aim is not to create a fixed exchange rate system, but to create a monetary union where the exchange rate fluctuations are eliminated with adoption of a single currency by the member countries. However, to reach this goal a transitional period where a stability in exchange rates through conversion of member countries’ macroeconomic performances to a specified desirable level is n ecessary. Since the Maastricht Treaty of 1989 the European Union countries have not been successful in achieving these macroeconomic targets, thus raising serious concerns about the monetary union.
