1.–2. Foreign Exchange Markets International Finance Karel Bruna.

1.–2. Foreign Exchange Markets

International Finance

Karel Bruna

Main Business Problems

• the role of bank/company in foreign exchange market

• main sources of risk to which bank/company face up

• main trends in foreign exchange markets

• effective ways how to manage foreign exchange transactions

Main Features of the Foreign Exchange Market

• place of trade concentration (geographical extent)

• trading channels

• participants (institutions)

• type of transaction

• motivation for transaction

• conventions in exchange rate quotation

Foreign Exchange Markets Geography

Reported foreign exchange market turnover structure by geographical distribution(Triennial Central Bank Survey, Foreign exchange and derivatives market activity in 2010, September 2010, BIS)

United Kingdom37%

United States18%

Others12%

Canada1%

Germany2%

Denmark2%

France3%

Australia4%

Honk Kong5%

Switzerland5%

Singapore5%

Japan6%

Reported foreign exchange market turnover structure by currency pair(Triennial Central Bank Survey, Foreign exchange and derivatives market activity in 2010, September 2010, BIS)

EUR/USD28%

USD/JPY14%

USD/GBP9%

Other26%

USD/AUD6%

EUR/CHF2%

EUR/JPY3%

USD/CHF4%

USD/CAD5%

EUR/GBP3%

The Circadian Rhythms of the FX Markets

Main Trading Channels in FX Market

Interbank Market Client Market

direct trading single-bank systemsReuters Dealing 3000 Direct Chief Dealer (Citibank)EBS Trader NatWest Global Banking & Markets

electronic brokers multi-bank systemsReuters Dealing 3000 Spot Fxall, Currenex, eSpeed,EBS Spot 360 Treasury System, Lava FX

FX Connect

e-exchange e-exchange FX MarketSpace HotSpotFX

Example of Dealer’s Conversation

From “CODE” “FULL NAME HERE” *0728GMT 030801 */7576Our Terminal: “CODE” Our Users: “FULL NAME HERE”EUR 10# 25.27

BA> I BUY# TO CONFIRM AT 1,0227 I SELL 10 MIO USD# VAL 5AUG01# MY EUR TO “FULL NAME HERE”# THANKS AND BYE

TO CONFIRM AT 1,0227 I BUY 10 MIO USDVAL 5AUG01MY USD TO “FULL NAME HERE”THANKS FOR DEAL FRDS. CHEERS

##END REMOTE#

##END#

EBS Spot Electronic Broker

HotSpot FX

Volume of Transactions Traded Online(Gtnews Online Trading Survey, 2004)

1-20%15%

21-40%9%

41-60%13%

61-80%40%

81-100%23%

Primary Benefits of E-Trading in FX Market(State Street Global Market Survey, 2005)

0

10

20

30

40

50

60

70

Fasterexecution

Convenience,efficiency,

productivity

Tight spreads Straight-through-

processing

Reduction intrade errors

Increasedliquidity

Reported foreign exchange market turnover by counterparty(Triennial Central Bank Survey, Foreign exchange and derivatives market activity in 2010, September 2010, BIS)

with reporting dealers39%

with other financial institutions

48%

with non-financial customers13%

% Share and dynamics in main segments of dealer-to-client market(2005, ClientKnowledge, 2006)

Leverage/higly active

investors38%

Client bank s37%

Corporations18%

Real money investors

7%

-80

-60

-40

-20

0

20

40

60

80

Corporations Real moneyinvestors

Leverage/higlyactive investors

Client banks

Reported global foreign exchange market turnover by transaction type(Triennial Central Bank Survey, Foreign exchange and derivatives market activity in 2010, September 2010, BIS)

Spot transactions36%

Outright forwards11%

FX swaps43%

Exchange traded futuresand options

2%Currency options5%

Currency swaps1%

Motivation for Transaction in Foreign Exchange Market

• change of purchasing power

• speculation

• hedging

• arbitrage

Exchange Rate QuotationEuropean quotation

outright quotation small figure

quoted currency

31,264 EUR/CZK

European quotationbase currency

big figure

Exchange Rate QuotationAmerican quotation

outright quotation small figure

quoted currency

0,0322 CZK/EUR

American quotation base currency

big figure

Exchange Rate QuotationEuropean vs. American quotation

1European quotation BID = --------------------------------

American quotation ASK

1

European quotation ASK = --------------------------------

American quotation BID

Exchange Rate QuotationDirect quotation

quoted currency = home currency

26,534 USD/CZK

base currency = foreign currency

Exchange Rate QuotationIndirect quotation

quoted currency = foreign currency

0,1023 CZK/USD

base currency = home currency

Exchange Rate Quotation

26,5346 26,5353 USD/CZK

26,5346/53 USD/CZK

46-53 USD/CZK

Main business problems(cross rates)

• definition of the strategy of cross rates predictions

• cross trades as the source of volatility of company’s future cash flow

• company’s management of FX risk in case of cross trades

Cross rateEuropean quotation

USD/CHFcross rate rule GBP/CHF = --------------------

USD/GBP

USD/CHFBID

GBP/CHFBID = -------------------- USD/GBPASK

USD/CHFASK

GBP/CHFASK = -------------------- USD/GBPBID

Cross rateAmerican quotation

GBP/USDcross rate rule GBP/CHF = --------------------

CHF/USD

GBP/USDBID

GBP/CHFBID = -------------------- CHF/USDASK

GBP/USDASK

GBP/CHFASK = -------------------- CHF/USDBID

Cross rateEuropean vs. American quotation

cross rate rule GBP/CHF = GBP/USD . USD/CHF

GBP/CHFBID = GBP/USDBID.USD/CHFBID

GBP/CHFASK = GBP/USDASK.USD/CHFASK

Cross rate(majors vs. cross rate majors market share in 2007)

majors cross rate majors

EUR/USD 27% EUR/JPY 2 %

USD/JPY 13 % EUR/GBP 2 %

GBP/USD 12 % EUR/CHF 2 %

Dynamics of USD/CZK cross rate (Mini case study)

14

16

18

20

22

24

26

28

30

32

34

36

38

40

42

44

01.0

1.19

99

31.0

3.19

9928

.06.

1999

24.0

9.19

99

22.1

2.19

9920

.03.

2000

19.0

6.20

00

15.0

9.20

00

14.1

2.20

0015

.03.

2001

14.0

6.20

01

12.0

9.20

0110

.12.

2001

12.0

3.20

02

11.0

6.20

0206

.09.

2002

04.1

2.20

02

06.0

3.20

0306

.06.

2003

02.0

9.20

03

01.1

2.20

0302

.03.

2004

31.0

5.20

04

27.0

8.20

04

26.1

1.20

0423

.02.

2005

24.0

5.20

05

22.0

8.20

0521

.11.

2005

16.0

2.20

06

19.0

5.20

0617

.08.

2006

14.1

1.20

06

14.0

2.20

0717

.05.

2007

15.0

8.20

07

12.1

1.20

07

12.0

2.20

0813

.05.

2008

07.0

8.20

08

04.1

1.20

0805

.02.

2009

06.0

5.20

09

04.0

8.20

09

EUR

/CZK

, USD

/CZK

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

1.5

1.6

1.7

EUR

/USD

EUR/CZK USD/CZK EUR/USD