Foreign Exchange Market: An Introduction

3.1 Introduction to Forex Market:

For most of us, the focal point of understanding international finance revolves around foreign exchange market. The foreign exchange market (also known as the currency, forex, or FX) is where currency trading takes place. It is a market where banks, companies, exporters, importers, fund managers, individuals, central banks of different countries buy and sell of foreign currencies.

Forex trading involves a foreign exchange transaction, defined as the simultaneous buying of one currency and selling of another currency. As forex rates are quoted in pairs, e.g. Euro/US$, US$/Japanese Yen, US$/INR, etc., a trader trading in forex sells one of the currency pair and buys the other.

As the subject progresses, we will develop more understanding about which currency is bought and which currency is sold and other aspects of forex trading.

The forex market is an ongoing 24-hour, 365 days year market. Trading in forex market does not necessarily involve an exchange. Hence, the trading goes on the over-the-counter market (OTC market henceforth). Major foreign currency trading centers are located in London, Tokyo, New York. As the markets remain open at different time on a given day, normally GMT is used to refer the trading hours at different locations. For example, the trading duration in Asia is from GMT.00.00 till GMT 08.00. Trading duration in London is during GMT 07:00 till GMT 15:00. Trading in USA commences during GMT 13.00 till GMT 22.00. Trading in London starts at GMT 8.00 and ends at GMT 17.00. Trading in Tokyo starts in GMT 0.00 ( midnight) and ends GMT 9.00.

A video available at http://video.yahoo.com/watch/4516514/12100450 very clearly explains the relationship between GMT and forex trading hours at different location. The volume of forex trading at given point of time is correlated with the number of markets opened at that time.

Presently, the FX market is one of the largest and liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, financial institutions, exporters and importers. The average daily volume in the global foreign exchange and related markets is continuously growing. The daily turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements (BIS). The Since then, the market has continued to grow.

According to Euromoney's annual FX Poll, trading volumes in USA grew a further 41% between 2007 and 2008.

The Bank for International Settlements undertakes triennials survey to regarding various facets of foreign exchange market. According to the last survey conducted in 2007, average daily turnover in global foreign exchange markets is estimated at $3.2 trillion. It has grown in an unprecedented 69% compared to 2004. The Bank for International Settlements is regular with the publication of these triennial surveys. The readers must check the official website for the latest survey report to get update on details discussed in this module.

As the 2007 report, average daily turnover of US$3.2 trillion comes from foreign exchange spot, forward and swap transactions.

•                     US$1.005 trillion in spot transactions

•                     US$362 billion in outright forwards transactions

•                     US$1.714 trillion in foreign exchange swaps

•                     US$129 billion estimated gaps in reporting

The spot market relates to immediate purchase and sale of foreign currency while in a forward transaction parties agree to buy and sell foreign currency later. In swap transactions, parties agree to swap payment and receipt of foreign currency over a specified period. These last two sentences very briefly summarize the difference between spot, forward and swap transactions. In later modules , these contracts are explained in detail.

3.2     Foreign Exchange Market, Trading Volumes :

Foreign exchange market is one of the fastest growing segments in the financial world. Details given in Table 2.A extracted from the “Triennial Central Bank Survey December 2007 Foreign exchange and derivatives market activity in 2000” prepared by Bank of International Settlement (BIS) indicates the growth of the forex market.

The 2007 survey shows an unprecedented rise in activity in traditional foreign exchange markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an increase of 69% at current exchange rates as given in Table 3.A.

Table 3.A. Global foreign exchange market turnover (*)

http://www.bis.org/publ/rpfxf07t.pdf

Daily averages in April, in billions
ofUS$					2004
YEAR	1992	1995	1998	2001	( **)	2007
Spot transactions	394	494	568	387	631	1,005
Outright forwards	58	97	128	131	209	362
Up to 7 days	…	50	65	51	92	154
Over 7 days	…	46	62	80	116	208
Foreign exchange swaps	324	546	734	656	954	1,714
Up to 7 days	…	382	528	451	700	1,329
Over 7 days	…	162	202	204	252	382
Estimated gaps in reporting	44	53	60	26	106	129
Total “traditional” turnover	820	1,190	1,490	1,200	1,900	3,210
Turnover  at  April  2007  exchange
rates( ***)	880	1,150	1,650	1,420	1,970	3,210

1 Adjusted for local & cross-border double-counting. Due to incomplete

breakdown, components do not always sum to totals. 2. Date for 2004 have been revised.

3 Non-US dollar legs of foreign currency transactions were converted from current

US

dollar amounts into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2007 exchange rates.

  

Table 3.A indicates that forex swaps have grown strongest compared to the other two, i.e, spot and forward.

Table 3.B indicates the percentage share of different currencies in average daily turnover during 2007. As expected, US dollar has the highest average daily turnover of 86% followed by Euro (37%) and Yen( 19%). Surprisingly the sum total of percentage of these currencies is 142% !!! The clue lies in the Table 3.B.

In addition, it is heartening to see that Indian currency average daily turnover has increased from 0.3% to 0.7%. So also the Chinese Renminbi.

Table 3.B:Currency distribution of reported foreign exchange market turnover(*)

http://www.bis.org/publ/rpfxf07t.pdf

Percentage shares of average daily turnover in April 2007		2004
	2001	(**)	2007
US dollar	90.3	88.7	86.3
Euro	37.6	36.9	37
Yen	22.7	20.2	16.5
Pound sterling	13.2	16.9	15
Swiss franc	6.1	6	6.8
Australian Dollar	4.2	5.9	6.7
Canadian dollar	4.5	4.2	4.2
Swedish krona	2.6	2.3	2.8
Hong Kong dollar	2.3	1.9	2.8
Norwegian krone	1.5	1.4	2.2
New Zealand dollar	0.6	1	1.9
Mexican peso	0.9	1.1	1.3
Singapore dollar	1.1	1	1.2
Won	0.7	1.2	1.1
Rand	1	0.8	0.9
Danish krone	1.2	0.9	0.9
Rouble	0.4	0.7	0.8
Zloty	0.5	0.4	0.8
Indian rupee	0.2	0.3	0.7
Renminbi	0	0.1	0.5
New Taiwan dollar	0.3	0.4	0.4
Brazilian real	0.4	0.2	0.4
All currencies	200	200	200
Emerging market currencies (***)	16.9	15.4	19.8

(*) Because two currencies are involved in each transaction, the sum of the percentage

shares of individual currencies totals 200% instead of 100%. Adjusted for local and cross-border double-counting. (**) Data for 2004 have been revised.

(***) Defined as the residual after accounting

for the top eight currencies and the New Zealand dollar and the Danish krone.

Table 3.C highlights foreign exchange market turnover by currency pair.

Table 3.C: Reported foreign exchange market turnover by currency pair (*) http://www.bis.org/publ/rpfxf07t.pdf

  

Daily averages in April, in billions of US dollars and per cent
YEAR	2001	%	2004( **)	%	2007
Amount	Amount	Share	Amount	Share	Amount	% Share
US dollar/euro	354	30	503	28	840	27
US dollar/yen	231	20	298	17	397	13
US dollar/sterling	125	11	248	14	361	12
US dollar/Australian dollar	47	4	98	5	175	6
US dollar/Swiss franc	57	5	78	4	143	5
US dollar/Canadian dollar	50	4	71	4	115	4
US  dollar/Swedish  krona
(***)	…	…	…	…	56	2
US dollar/other	195	17	295	16	572	19
Euro/yen	30	3	51	3	70	2
Euro/sterling	24	2	43	2	64	2
Euro/Swiss franc	12	1	26	1	54	2
Euro/other	21	2	39	2	112	4
Other currency pairs	26	2	42	2	122	4
All currency pairs	1,173	100	1,794	100	3,081	100

(*) Adjusted for local and cross-border double-counting. (**)Data for 2004 have been revised.

(***)The US dollar/Swedish krona pair could not be separately identified before 2007

and is included in “other”.

As usual, US dollar/Euro is the most preferred currency pair followed by US dollar/Yen and US dollar/Pound Sterling. However, the percentage share of US dollar/Euro pair is going down – from 30% in 2001 to 27% in 2007.

Table 3.D indicates the distribution of average daily turnover of each currency based on spot, forward and swaps transactions. For some currencies, the spot transactions is highest ( like Indian Rupees, Chinese Renmimbi, Turkish Lira etc.) while for others swap transactions have the highest percentage ( like US dollar, Australian Dollar, Swedish Krona etc.).

This difference clearly indicates the degree of development of forex market in different currencies. Currencies with higher percentage of swap contract indicate the maturity of the currency market. In addition, currencies with higher percentage in spot market may be experiencing greater degree of capital control, preventing traders from these markets to enter into long-term contracts.

Table 3.D Reported foreign exchange turnover by currency and instrument

http://www.bis.org/publ/rpfxf07t.pdf

Percentage shares of average daily turnover in April 2007
	Spot	Outright	Foreign Exchange
		Forwards	Swaps
US dollar	29.7	10.9	59.4
Euro	36.9	12.1	51.1
Yen	40.4	12.1	47.5
Pound sterling	32.5	10	57.4
Swiss franc	42.2	10.1	47.7
Australian dollar	25.7	10	64.3
Canadian dollar	29.7	11.8	58.6
Swedish krona	20.7	10	69.3
Hong Kong dollar	18.4	7	74.6
Norwegian krone	18.4	9.7	71.9
New Zealand dollar	29.4	11.3	59.3
Mexican peso	37.4	11.7	50.9
Singapore dollar	22.5	7.9	69.6
Won	44.7	29.4	25.9
Rand	19.9	12.1	68
Danish krone	21.8	10.3	67.9
Rouble	70.7	5	24.3
Zloty	20	10.9	69.1
Indian rupee	42.6	27.5	29.8
Renminbi	61.4	31.3	7.4
New Taiwan dollar	47.1	40.6	12.3
Brazilian real	50.2	47.3	2.5
Forint	34.1	15.7	50.2
Czech koruna	23.8	20.9	55.3
Baht	18.9	13.3	67.8
Turkish lira	61.4	11.4	27.2
Philippine peso	36.9	32.5	30.5
Rupiah	43.7	39.3	17
All currencies	32.6	11.7	55.6

1 Adjusted for local and cross-border double-counting.

Table 3.E shows the major countrywise average daily foreign exchange turnover. The major countries are Australia, Hong Kong, Japan, Singapore, Switzerland, United Kingdom and USA. It is to be noted here that percentage column for all countries for a given year do not add upto 100% as some country details have been deleted from the master document to arrive at this table.

Table 3.E Major Countrywise Foreign Exchange Daily Average

Turnover

http://www.bis.org/publ/rpfxf07t.pdf

	1998		2001		2004		2007
	Amou	%	Amou	%	Amou	%	Amou	%
	nt		nt		nt		nt
Australia	47	2.4	52	3.2	102	4.2	170	4.3
Canada	37	1.9	42	2.6	54	2.2	60	1.5
China	0	0.0	0	0.0	1	0.0	9	0.2
France	72	3.7	48	3.0	64	2.6	120	3.0
Germany	94	4.8	88	5.5	118	4.8	99	2.5
HongKong	79	4.0	67	4.1	102	4.2	175	4.4
India	2	0.1	3	0.2	7	0.3	34	0.9
Japan	136	6.9	147	9.1	199	8.2	238	6.0
Korea	4	0.2	10	0.6	20	0.8	33	0.8
Russia	7	0.4	10	0.6	30	1.2	50	1.3
Saudi Arabia	2	0.1	2	0.1	2	0.1	4	0.1
Singapore	139	7.1	101	6.2	125	5.2	231	5.8
Switzerland	82	4.2	71	4.4	79	3.3	242	6.1
United	637	32.5	504	31.2	753	31.0	1,359	34.1
Kingdom
United States	351	17.9	254	15.7	461	19.2	664	16.6
Total	1,969	100	1,616	100	2,429	100	3,988	100

Table 3.E indicates that Japan’s daily average foreign exchange turnover is going down while countries like Switzerland, Australia and Hong Kong are showing an increasing trend. It is also interesting to note that foreign exchange turnover percentage in United Kingdom is turnover almost double the size that of United States—proving that London still enjoys status of global financial hub than New York.

  

 3.3: Evolution of Foreign Exchange Market and Foreign

Exchange System:

Since time immemorial, commodity money was used during barter system. From a wide variety of commodities, gold, silver, silk and bronze became standardized commodity money. During 17^th century, countries and kingdoms started using coins as the medium of exchange. These coins had their own intrinsic value that was not related to any commodity.

Normally coins were made up gold, silver or bronze. Some other unusual materials like stone and limestone and slate were also used. Can anyone imagine -- Coins were traded weighing 8800 lbs! Box 3.1 has some interesting facts about Rai stones. The content of gold, silver or bronze in a coin measured the intrinsic value of these coins, hence the exchange rate between coins was governed by the amount of gold /silver/bronze content of the coins. When an individual received/paid a coin, it meant that he was giving/receiving a certain weight of metal backed by these currencies. The value of the coins also influenced by intangibles associated these coins as mentioned in Box 2.2

By the end of 17^th century, countries started using paper money. Though paper money had its presence in China from 1050 till 1400, paper currency became accepted globally only during 17^th century. Like the coins, the paper money was also backed by gold and silver. Exchange rate between paper money was determined by the amount of gold/silver backed by respective paper money. It is worth mentioning that, different countries started introducing paper money at different point of time between 10^th and 17^th century.

Box 3.1 : Rai Stones as Coins

http://en.wikipedia.org/wiki/Rai_stones

Rai stones are large, circular stone disks carved out of limestone in the island of Yap, Micronesia. Locals have used these stones as a form of unusual currency, a "stone money." Rai stones are circular disks carved out of limestone with a large hole in the middle. The size of the stones varies widely; the largest are 3 meters (10 ft) in diameter, 0.5 meters (1.5 ft) thick and weigh 4 metric tons (8,800 lb). The extrinsic (perceived) value of a specific stone is based not only on its size and craftsmanship but also on the history of the stone. If many people - or no one at all - died when the specific stone was transported, or a famous sailor brought it in, the value of the rai stone increases.

Rai stones were used in social transactions such as marriage, inheritance, political deals, sign of an alliance, ransom of the battle dead or just in exchange for food. Many of them are placed in front of meetinghouses or specific pathways. Though the ownership of a particular stone changes, the stone itself is rarely moved. The names of previous owners are passed down to the new one.

According to a Economist (1999) article titled “Paper Money”, Sweden was the first country in Europe to introduce paper money in 1661 and other countries joined later.,

In 1694 the Bank of England started printing paper money used to be known as "running cash notes”

With increase in international trade, gold became universally accepted commodity to back issuance of paper money. This led to the emergence of gold standard. During 1870, major countries agreed to hold gold to back their currency notes. The value of any country’s banknotes depended on the gold reserve held by a country and exchange rates

between two currencies depended on the amount of gold backed by respective currencies. The gold standard existed until the First World War.

During 1944, Bretton Woods Agreement system came into existence. The Bretton

Woods Conference of 1944 established an international fixed exchange rate regime in which currencies were pegged to the US Dollar, which in turn was based on the gold standard. Bretton Woods agreement is considered as the most important economic and political accomplishment of the cold ware era. Gavin (1996) in paper titled “The legends of Bretton Woods” noted “Bretton woods is the most revered name in international monetary history, perhaps in economic history”. As part of the agreement, from 1944 till 1971 , different countries permitted the exchange rates to vary within a narrow band. Central governments needed to intervene in the forex market regularly to keep the exchange rate within the band. However, this led to substantial imbalances in the forex rates i.e, some currencies became undervalued and some became overvalued. However significant changes have happened during 1971.

The Smithsonian Agreement in 1971, countries were allowed to increase the band within which currency rates can fluctuate (from 1 % to 2.25%). In this agreement, the member countries i.e, Group Ten also decided to devalue US$ against most other currencies. The Smithsonian Agreement of 1973 completely abandoned the band and currencies became “free float”.

Even though major changes were brought in 1973, but visible changes in forex market only began to emerge in 1978, when worldwide currencies were allowed to 'float' according to supply and demand. In 1992, twelve European countries joined common currency called Euro.

In a “floating exchange rate system”, supply and demand situation influences the exchange rate. Though we see great deal of volatility in exchange rate, rarely any country has pure free floating exchange rate. Most governments through their central banks influence the exchange rate by changing their interest rates and adopting other means of control. Many-a-times exchange rate changes when governors of central banks or high ranking officials of a central bank just even casually remarks about whether their currency is under/overvalued.

To sum it up, the fixed/semi-fixed vs, floating exchange rate system can be differentiated as follows:

In fixed/semi-fixed exchange rate system, exchange rate is maintained at a specific level or fluctuates within a given range. In such exchange rate system, the central banks play a crucial role and regularly buy and sell foreign currency to maintain the exchange rate. Also the central banks dictate the rate of interest so that the exchange rate remains at a given value or remains within the range. This system provides great deal of advantage to exporters and importers as they are not exposed to forex risk.

Fully fixed and fully floating exchange rates are at the two ends of broad spectrum of exchange rate systems prevailing in different countries. However, rarely a country will have fully fixed or fully floating exchange rate system.

In a fully fixed exchange rate, there could divergence between the official rate and the currency true value. If the divergence is significant, a parallel “black market” starts operating where the currency’s true value is reflected. Periodically, the government of the country with fixed exchange rate has to revalue or devalue the official rate. Similarly, very few countries have fully floating exchange rate system. Central banks periodically intervene in currency market to align the currency within an acceptable range. If a country’s central bank aggressively intervenes to keep the exchange under control, then this is known as “dirty float” currency regime. In most cases, central banks interventions are more of symbolic in nature i.e., to send a message to the market participants regarding the true value of the currency.

In a floating exchange rate system, the exchange rate is determined mainly through supply and demand. Hence, export-import balance, capital flows, country’s fiscal deficit etc. governs the exchange rate. Fluctuating exchange rate poses significant forex risk to the exporter and importers of the country.

Floating rate system led to the increase in forex trading. Initially forex trading was undertaken mostly by banks and large multinational corporations. But with the proliferation of the internet, individuals, exporters, importers, mutual funds, hedge funds are actively participating in the forex market. The spread of electronic trading platforms has led to tremendous growth as it has enabled large financial institutions to set up algorithmic trading systems and has provided trading facilities to retail investors.