Week 1 - Topic: Chapter 2: The Foreign Exchange Market 21 March 2021

Week 1 - Topic: Chapter 2
The Foreign Exchange Market

21 March 2021
Objectives
• To describe the FX market
• To identify participants and currencies
• To describe the Australian FX market
• To describe the mechanics and technology of
FX trading
(cont.)
Copyright  2010 McGraw-Hill Australia Pty Ltd

PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
2-2
Definition and terminologies
• The FX market is the market where
national currencies are bought and sold
against one another. Foreign exchange
consists mainly of bank deposits.

2-3
Characteristics
• It is the largest and most perfect market

• It is needed because every international
transaction requires a foreign exchange
transaction
• It is an over-the-counter (OTC) market –
international market open 24/7, buyers and
sellers contact via telecommunications

2-4
Market participants
• Foreign exchange traders buy and sell
currencies directly or indirectly
• Arbitragers exploit exchange rate anomalies;
hedgers cover open positions; speculators
take open positions

2-5
Categories of participants
• Customers
• Commercial banks
• Other financial institutions
• Brokers
• Central banks

2-6
Interbank operations
• The FX market is dominated by
interbank operations
• Participants in the interbank market are
market makers, other major dealers
and second-tier banks

2-7
Size and composition
• The size of the global FX market is measured
by the sum of daily turnover in FX centers
• A survey is coordinated by the BIS every
three years for this purpose

2-8
Daily turnover in the FX market (USD billion)
3600
3200
2800
2400
2000
1600
1200
800
400
0
1989 1992 1995 1998 2001 2004 2007
Spot Forward Total (including gaps)

2-9
Geographical distribution of FX market turnover
(%)
40
35
30
25
20
15
10
0
. . n e e a
.K .S nd pa or ng lia
nc an
y
si
U U la Ko ra us
r Ja ap st Fr
a rm
it ze ng g
Au e R
Si on G
Sw H

2-10
FX market turnover by counterparty (institutional
type)
Interbank Financial Institutions Others

2-11
FX market turnover by counterparty (locality)
Local Cross-border

2-12
Currency composition of the FX market
(by single currencies)
100
80
60
40
20
0
USD EUR JPY GBP CHF AUD CAD SEK HKD Others

2-13
Currency composition of the FX market
(by currency pairs)
30
25
20
15
10
0
USD/EUR USD/JPY USD/GBP USD/AUD USD/CHF USD/CAD USD/Other Other/Other

2-14
Traded currencies
• The US dollar is the most heavily traded
currency
• The euro and the yen are heavily traded
because of the importance of Europe and
Japan in the world economy
(cont.)

2-15
Traded currencies (cont.)
• The pound is heavily traded for historical
reasons
• Currencies that are heavily traded in certain
financial centers and lack liquidity in others:
CHF, CAD
(cont.)

2-16
Traded currencies (cont.)
• Currencies that are traded locally,
4 but internationally are traded for international
trade purposes: AUD, NZD, HKD
• Third world currencies: soft or exotic
currencies

2-17
The AUD FX market
• The market consists of the banking system
and non-bank dealers authorised by the
Reserve Bank of Australia (RBA)
• The market has grown since the flotation of
the AUD in 1983

2-18
Daily turnover in the Australian FX market (USD
billion)
200
160
120
80
40
0
1989 1992 1995 1998 2001 2004 2007

2-19
Reasons for the growth of the AUD market
• Deregulation – relaxation of capital controls
and financial innovations provided means of
foreign exchange risk management
• High interest rates in the 1980s – attracted
capital inflows
• Australia’s time zone – trading hours form a
link between New York and European trading
• Exchange rate volatility – provided
opportunities for speculation

2-20
Components of an FX transaction
• Price discovery
4 the dealer judges the exchange rate at which the
transaction can be executed.
4 Requires an assessment of the liquidity of the market and
the expectation held by others about future changes in the
exchange rate
• Decision making – dealer seeks information to support the
decision to execute the transaction via telephone or other
means of telecommunication
• Settlement - completing the transaction by making payment in
one currency and receiving payments in another
• Position keeping – dealer monitors the resulting position

2-21
FX market technology
• The telegraph
• The telephone
• The telex
• The fax
(cont.)

2-22
FX market technology (cont.)
• Screen-based information systems – carries news
and prices from other banks (Reuters Monitor,
Telerate, etc.)
• Screen-based automated dealing systems – are
networks than connect terminals.
• Automatic order matching systems – are networks of
terminals where dealers enter orders in he form of a
buying and/selling price for a given amount of
currency
• Online FX trading – internet based multi-dealer
foreign exchange services
2-23
The bilateral spot exchange rate
• The exchange rate between two currencies
for immediate delivery

2-24
Transaction dates
• The date on which the transaction is agreed
upon is called the contract date, dealing
date, done date or trade date
• The date on which currencies are exchanged
is the value date or the delivery date

2-25
A spot foreign exchange transaction
Confirmation of exchange rate and

A B
USD 500 000 (Wednesday)

amount
(Monday)
AUD 1 000 000
(Wednesday)
B’s A’s
account account

2-26
Risk of Settling FX Transaction
• Transactions in FX market take place at all hours of
the day and night.
• Cross-border, cross-time zone nature of FX
transactions poses a challenge for efficient
settlement

2-27
Two types of risk
• Herstatt Risk
4 Got its name from an historical incident involving
failure to settle transaction
4 In 1974, Bankhaus Herstatt failed to deliver US dollars
to counterparties after it was ordered into liquidation
by the German authorities.
4 Similar defaults have occurred in cases of the Bank of
Credit and Commerce International (BCCI) and
Barings Bank.
• Read: “Trust is good control is better The 1974
Herstatt Bank Crisis and its Implications for
International Regulatory Reform” on Moodle
2-28
Two types of risk
• Liquidity Risk
4 Arises from the possibility that a counterparty will
default because of an operational or system problem
that leaves it with insufficient liquidity to make
payment.
4 Particularly common in emerging markets where the
physical infrastructure may not be adequate to
accommodate transactions that are increasing in size
and number.
• Default due to insolvency or liquidity could trigger
system-wide problems.

2-29
Domino effect
• ‘Domino effect’ – the failure of one large bank may
cause a second bank to fail, in turn causing a third to
fail.

2-30
Some solutions
• Eliminate delay between two legs of transaction
(Simultaneity)
• Simultaneity
4 Refers to the delivery of currencies, requires closing
the gaps in the operating hours of the major wholesale
domestic payment systems and the development of
some sort of linked payment systems or verification of
payments to guarantee intraday ‘finality of payment’.
4 Reducing the number of and size can be achieved
through bilateral and multilateral netting systems (we’ll
see how it works in later topics),
• Reducing the number and size of payments requiring
settlement.
2-31
The delivery date
• Typically, the delivery date is two business days after
the contract date (T+2)
• In a value-today or same-day transaction the delivery
date is the same as the contract date (T+0)
• In a value-tomorrow or next-day transaction the
delivery date is one day after the contract date (T+1)
• SWIFT – electronic settlement system connecting
banks (Read article “Origins and development of
SWIFT, 1973–2009” on Moodle)
• SWIFT-society for worldwide financial
telecommunication
2-32
Exchange Clearing House (ECHO)
• Established in 1995, to supports multilateral netting
4 Problem with netting is the difficulty of making the
netted amount legally enforceable.

2-33
Continuous Linked Settlement (CLS)
• Enables member banks to settle foreign exchange
transactions through a central service provider, CLS
Bank.
• This system would eliminate settlement risk by
implementing payment-versus-payment methodology
and multilateral netting of foreign exchange
transactions.
4 payment versus payment (PvP): A mechanism which
ensures that the final transfer of a payment in one
currency occurs if – and only if – the final transfer of a
payment in another currency or currencies takes
place.
2-34
Continuous Linked Settlement (CLS)
• Using technology developed by IBM, CLS provides
market participants with same-day payments and
settlement (T+0 rather than T+2).

2-35
Operational Risk
• With the advent of Basel II Accord, emphasis is
placed more generally on operational risk, which
includes settlement risk.
• Operational Risk results from:
4 Errors and criminal activity
4 Failure of systems and procedures, etc.
• Level of operational Risk has increased due to:
4 Increasing diversity of market participants
4 Automation of execution and record keeping.

2-36

Week 1 - Topic: Chapter 2: The Foreign Exchange Market 21 March 2021

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Week 1 - Topic: Chapter 2

The Foreign Exchange Market

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

• It is the largest and most perfect market

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Spot Forward Total (including gaps)

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Interbank Financial Institutions Others

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Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Confirmation of exchange rate and

USD 500 000 (Wednesday)

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

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