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3.3 THE FOREIGN EXCHANGE MARKET
deposit rate is less than LIBID, so the Eurocurrency market pays more interest on deposits and accepts less interest on loans than on comparable transactions in domestic credit markets.
To make a profit, banks purchase funds at low rates and lend them out at higher rates. For example, a bank might pay 1.5 percent per year on the savings account of a depositor and lend these funds out to a small business at 2.5 percent per year.
The 1 percent spread is the source of the bank’s profit. For large loans to corporate customers in the external Eurocurrency market, the bank might charge 2.25 percent.
For large deposits (greater than $1 million) in the external Eurocurrency market, the bank might be willing to pay 1.75 percent. In this case, the bank’s spread falls to 0.5 percent (2.25−1.75). Corporate customers with large enough borrowing needs and good enough credit to be able to borrow in this market often find they can improve on the rates they would face in their domestic credit market.
Interest rates extended to corporate borrowers depend on the borrower’s cred- itworthiness and the size of the loan. Interest rates on large loans to AAA-rated corporate borrowers typically are made at a minimum of 15 to 25 basis points (0.15 percent to 0.25 percent) over LIBOR. Larger spreads are charged on smaller loans and on loans to customers with lower credit quality.
Interest rate spreads often are quoted in basis points,where one basis point is 1/100thof 1 percent (or, sometimes, 1/100thof one cent).
1 percent is equal to 100 basis points.
A bank might quote borrowing and lending rates of 1.9375 percent and 2.0625 percent on a large transaction with another bank in the Eurocurrency market. At these rates, the bank’s bid-ask spread is 0.125 percent, or 12.5 basis points. The bank can afford to quote such a small bid-ask spread for large transactions with a reputable counterparty. Larger spreads would be quoted for smaller amounts, for longer maturities, with banks of lower credit quality, and in volatile market conditions.
Clearing and Settlement for International Transactions
Transfers between international financial institutions are cleared and settled through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) (www.swift.com). SWIFT is an industry-owned cooperative with thousands of members from the commercial banking, asset management, securities, and insurance industries. SWIFT ensures low-cost, secure transmission of electronic messages between member institutions.
MARKET UPDATE Value-at-Risk
Most international banks assess credit risk using a method calledvalue-at-risk (VaR) that estimates potential losses with a certain level of confidence and over a certain time horizon due to adverse price movements in an underlying asset. For example, a bank might estimate that there is a 5 percent probability of losing more than 20 percent of a loan portfolio’s value over the next year.
Today, internationally active banks commonly report VaR estimates in their financial reports in response to calls for increased disclosures of banks’ risk exposures. There is evidence that these disclosures are indeed informative in that they predict subsequent variability in banks’ revenues.1
VaR is often criticized because applications based on the normal distribution underestimate the probability of extreme negative events and fail to account for correlated default; that is, the tendency of asset prices to fall in unison. Such events can have a disproportionate impact on economic life and the viability of the international financial system. Indeed, a major point of emphasis in Basel III is to foster the use of risk assessment tools that recognize the existence of correlated defaults. To this end, many contemporary applications of VaR eschew the normality assumption for models that incorporate fat tails and higher-than-normal co-movements in the tails of the return distribution.
exchange market is largely an interbank market that deals in spot and forward currency transactions.
■ In thespot market,trades are made for immediate delivery.
■ In the forward market, trades are made for future delivery according to an agreed-upon delivery date, exchange rate, and amount. The forward currency market can be further categorized into outright forwards and currency swaps.
■ Outright forwardsare transactions involving a single delivery date.
■ Currency swapsinvolve multiple future delivery dates and are similar in form and function to portfolios of outright currency forward contracts.
Most interbank transactions are settled through CLS Group Holdings AG (CLS stands for continuous linked settlement), with each counterparty receiving one currency and delivering the other. Forward and swap transactions are settled on the agreed-upon delivery date or dates.
The foreign exchange market is at the heart of international trade and finance, because it permits the transfer of purchasing power from one currency to another — either today or in the future. When used in combination with the Eurocurrency mar- ket, spot and forward FX markets allow investors to move capital toward productive uses regardless of the timing of investment or currency of denomination.
The most important function of the foreign exchange market is to provide a means to defend or hedge against exposures to currency risks. Foreign exchange risk or currency risk is the risk of unexpected changes in exchange rates. The Multinational Corporation (MNC) is exposed to currency risk if unexpected changes
in FX rates affect the value of the firm’s assets or liabilities. Hedging can reduce the adverse consequences of currency risk by creating currency exposures that offset the MNC’s underlying exposures.
FX risk is the risk of unexpected change in an FX rate.
The foreign exchange market also allows speculators to bet on changes in cur- rency values. Currency speculation by international banks and hedge funds ensures that FX rates represent a consensus of market participants and provides additional liquidity to the FX markets.
Foreign Exchange Transaction Volume
TheBank for International Settlements(www.bis.org) surveys central banks in April of every third year regarding wholesale foreign exchange activities conducted by that country’s residents. Central banks from 53 countries reported foreign exchange transactions in the April 2010 survey.
Figure 3.3 displays the results of the last several surveys. FX transactions averaged nearly $4 trillion per day during April 2010. In comparison, gross domestic product around the world was about $62 trillion during 2010. About 37 percent of FX transactions were in the spot market, 12 percent in outright forwards, and 45 percent in foreign exchange or currency swaps.
Daily volume fell from $1.5 trillion in the 1998 BIS survey to $1.2 trillion in 2001. A small part of this decrease was attributable to the introduction of the euro ( ) in 1999. The euro replaced the national currencies of Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain in 1999 as a step toward European monetary union (Emu).
With the elimination of cross-currency trading within these countries, average daily
0 1000 2000 3000 4000
1989 1992 1995 1998 2001 2004 2007 2010
U.S.$ billions
Spot transactions Outright forwards FX & currency swaps Other (e.g., FX options)
FIGURE 3.3 Global Foreign Exchange Turnover.
Source:Bank for International Settlements Triennial Central Bank Survey, April 2010 (www.bis.org).
¥ 19%
£ 13%
A$ 8%
SFr 6%
C$ 5%
Other 25%
U$ 85%
€ 39%
FIGURE 3.4 Foreign Exchange Turnover by Currency.
Source:BIS Triennial Survey, April 2010 (www.bis.org). Percentages sum to 200 percent.
Symbols represent Japanese yen (¥), U.K. pound (£), Swiss franc (SFr), Australian (A$), Canadian (C$), and U.S. dollars ($), and euros ( ).
volume fell from $332 billion in the 1998 survey to $234 billion in 2001 within the Eurozone.
As shown in Figure 3.4, the U.S. dollar was involved in 84.9 percent of all FX transactions, followed by the euro (39.1 percent), Japanese yen (19.0 percent), British pound (12.9 percent), Australian dollar (7.6 percent), Swiss franc (6.4 percent), and Canadian dollar (5.3 percent). The next most actively traded currencies were the Hong Kong dollar (2.4 percent), Swedish krona (2.2 percent), New Zealand dollar (1.6 percent), Korean won (1.5 percent), Singapore dollar (1.4 percent), Norwegian krone (1.3 percent), and Mexican peso (1.3 percent). These percentages sum to 200 percent rather than 100 percent because two currencies are involved in each transaction.
Figure 3.5 displays the geographic distribution of volume in the five most active markets. London dominated trading with average daily volume of $1,854 billion during April 2010. The next highest volume of trade is in the United States, with average daily volume of $904 billion. Banks in Eurozone countries have a prominent place in the FX market with volume of $477 billion, despite losing trade in currencies within the Eurozone after the 1999 introduction of the euro. Japan’s FX volume has rebounded in recent years after languishing during the 1990s because of a lingering recession. Switzerland maintained its 2007 gains with 2010 volume of $263 billion.
Japan’s daily volume of $312 billion was only slightly more than the $266 billion volume in Singapore, which actively trades a wider range of currencies than is traded in Tokyo. Active markets also are conducted in Hong Kong, Zurich, Frankfurt, Paris, and other regional centers.
Foreign Exchange Market Participants
Commercial banks serve as dealers or market makers in the foreign exchange market by quoting bidand offer (or ask)prices,earning their profit by buying at
0 500 1,000 1,500 2,000
UK US Eurozone Switzerland Japan
1989 1992 1995 1998 2001 2004 2007 2010
FIGURE 3.5 Major Foreign Exchange Trading Centers (Average daily volume in billions of U.S. dollars during April).
Source:Bank for International Settlements Triennial Central Bank Survey (www.bis.org).
Totals are adjusted for local double-counting, but not cross-border double-counting.
their bid price and selling at a slightly higher offer price.Bid-ask spreads(ask price minus bid price) depend on the size of the transaction, the liquidity and volatility of the currencies, and — for forward transactions — the creditworthiness of the counter- party. Spreads are often as low as a few basis points for large transactions between major banks in the active interbank currency market. Most customers settle the full amount on forward contracts, whereas others choose to settle only the gain or loss.
When a bank buys one currency, it simultaneously sells another currency. A bank has a long position in a particular currency when it has purchased that currency in the spot or forward market. Conversely, a bank is in a short position when it has sold that currency. By aggregating all of its expected future transactions at each forward date, the bank can identify its net position in each currency. In this way, banks can identify and manage their exposures to currency risks.
Whereas dealers take a position, foreign exchangebrokersserve as matchmakers and do not put their own money at risk. Brokers monitor the quotes of major international banks through computerized quotation systems such as Reuters, and can quickly identify the banks offering the best rates. A major player, such as a central bank or a large commercial bank, can conceal its identity, and sometimes its intentions, through the use of a broker. For example, if the U.K. Chancellor of the Exchequer wants to dispose of an accumulated position in euros without signaling its activity to the market, it can use a broker to maintain anonymity.
Banks serve as dealers in an active FX market.
More than 85 percent of all FX transactions are conducted through commercial banks, credit card companies, or other financial institutions. The remaining business is with retail customers, including governments, businesses, smaller commercial customers, and individuals.
Efficiency of the Foreign Exchange Market
Operational Efficiency The interbank wholesale market is the world’s most operationally efficient market, with very low percentage costs for large transactions between major banks. Although the interbank market is operationally efficient, percentage fees on retail transactions can be large. Tourists face bid-ask spreads of 2 to 10 percent at international airports. Fees charged by local vendors outside of airports can be even higher. For example, a tourist might find that a shopkeeper in a resort location is more than happy to accept a nonlocal currency. However, unless she does a quick calculation, she might not notice the 20 percent surcharge hidden in the foreign currency price of a loaf of bread.
Operational efficiency refers to the influence of market frictions.
One way to reduce these charges is to use an ATM card from your local bank.
Most ATM cards have access to your local financial account through one or more international communications networks. A range of fees may apply to international cash withdrawals depending on the policies of your financial institution, but are often around 2 percent of the transaction amount. Fees charged by credit card providers such asVisaandMasterCardvary, but are typically about 3 percent plus applicable finance charges. Check the fees charged on your ATM and credit cards before you travel abroad. Credit card usage may not be advisable when traveling in countries with high rates of credit card fraud, such as Nigeria.
In all countries, you should keep an eye on your card during each transaction and get it back as quickly as possible to avoid losing your credit card information.
You also should routinely save your ATM and credit card receipts and reconcile them with your billing statements.
Informational Efficiency
Informational efficiency refers to whether prices reflect value.
Through their dealing and trading activities, international commercial banks ensure that currency values represent a consensus of informed opinions and thus promote the informational efficiency of the currency market. The international banks also provide a forum in which market participants can speculate on the direction of changes in currency values. Currency speculators take positions and seek to profit by anticipating the direction of future changes in currency values. Speculation is widely blamed by government officials for contributing to volatility and serving as a destabilizing influence in financial markets. Nevertheless, speculative activity by informed, profit-seeking participants promotes the informational efficiency of financial markets and ensures that prices reflect a consensus estimate of the value of the underlying instruments.
APPLICATION The notation used in Multinational Finance
UPPERCASE SYMBOLS ARE USED FOR PRICES Lowercase symbols are used for changes in a price
■ Pdt =price of an asset in currency d at time t
■ pd=inflation rate (i.e., change in the consumer price index) in currency d
■ id =nominal interest rate in currency d
■ d
=real (or inflation-adjusted) interest rate in currency d
■ Sdt/f =spot exchange rate between currencies d and f at time t
■ sd/ft =change in the spot rate between currencies d and f during period t
■ Fd/ft =forward exchange rate between currencies d and f for exchange at time t
■ ftd/f=change in the forward rate between currencies d and f during period t Note: Time subscripts are dropped when it is unambiguous to do so.
Allocational Efficiency Because of its operational and informational efficiency, the interbank market in major currencies is the most allocationally efficient market in the world. Markets for less liquid currencies are less efficient in their allocation of capital. Fixed exchange rate systems also are less efficient, because governments intentionally disrupt the flow of capital in the pursuit of their policy objectives.