Malaysian Futures Market
Assignment 1Read the article “Open Your Market and Say “Ahh” , “Contagion Indicators” for an Ailing Global Economy.
http://www.rand.org/content/dam/rand/pubs/corporate_pubs/2007/RAND_CP22-1999-01.pdf
Write a critical review 2-3 page long addressing the following issues:.
- Identified the explanations for the financial crises affecting simultaneously few countries
- Identified and explain four models of financial contagion and their prospects for prediction and prevention
- Explain differences between financial crises in Argentina, South Africa and Southeast Asia
All written assignments and responses should follow APA rules for attributing sources.
Assignment 2 Discuss the advantages and disadvantages of futures contracts. Name two established exchanges where you would likely find future contracts traded.
Post your work by Sunday, September 23, 2012 to the Discussion Area. Comment on two other postings by the end of the module. Your work should be 3-5 paragraphs long.
All written assignments and responses should follow APA rules for attributing sources
CHAPTER 7 The Foreign Exchange Market
The Spaniards coming into the West Indies had many commodities of the country which they needed, brought unto them by the inhabitants, to who when they offered them money, goodly pieces of gold coin, the Indians, taking the money, would put it into their mouths, and spit it out to the Spaniards again, signifying that they could not eat it, or make use of it, and therefore would not part with their commodities for money, unless they had such other commodities as would serve their use.
Edward Leigh (1671)
Learning Objectives
• To describe the organization of the foreign exchange market and distinguish between the spot and forward markets
• To distinguish between different methods of foreign exchange quotation and convert from one method of quotation to another
• To read and explain foreign currency quotations as they appear in the Wall Street Journal
• To identify profitable currency arbitrage opportunities and calculate the profits associated with these arbitrage opportunities
• To describe the mechanics of spot currency transactions
• To explain how forward contracts can be used to reduce currency risk
• To list the major users of forward contracts and describe their motives
• To calculate forward premiums and discounts
Key Terms
American terms
arbitrageurs
bid-ask spread
Clearing House Interbank Payments System (CHIPS)
contract note
cross rate
currency arbitrage
direct quotation
electronic trading
European terms
exchange risk
fed funds
FedWire
foreign exchange brokers
foreign exchange market
foreign exchange quotes
forward contract
forward discount
forward market
forward premium
forward price
hedgers
Herstatt risk
indirect quotation
interbank market
liquidity
long
no-arbitrage condition
nostro account
outright rate
position sheet
settlement risk
short
Society for Worldwide Interbank Financial
Telecommunications
speculators
spot market
spot price
swap
swap rate
traders
triangular currency
arbitrage
value date
The volume of international transactions has grown enormously over the past 60 years. Exports of goods and services by the United States now total more than 10% of gross domestic product. For both Canada and Great Britain, this figure exceeds 25%. Imports are about the same size. Similarly, annual capital flows involving hundreds of billions of dollars occur between the United States and other nations. International trade and investment of this magnitude would not be possible without the ability to buy and sell foreign currencies. Currencies must be bought and sold because the U.S. dollar is not the acceptable means of payment in most other countries. Investors, tourists, exporters, and importers must exchange dollars for foreign currencies, and vice versa.
The trading of currencies takes place in foreign exchange markets whose primary function is to facilitate international trade and investment. Knowledge of the operation and mechanics of these markets, therefore, is important for any fundamental understanding of international financial management. This chapter provides this information. It discusses the organization of the most important foreign exchange market—the interbank market—including the spot market, the market in which currencies are traded for immediate delivery, and the forward market, in which currencies are traded for future delivery. Chapter 8 examines the currency futures and options markets.
7.1 Organization of The Foreign Exchange Market
If there were a single international currency, there would be no need for a foreign exchange market. As it is, in any international transaction, at least one party is dealing in a foreign currency. The purpose of the foreign exchange market is to permit transfers of purchasing power denominated in one currency to another—that is, to trade one currency for another currency. For example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells machine tools to a Japanese company for yen. Ultimately, however, the U.S. company will likely be interested in receiving dollars, whereas the Japanese exporter will want yen. Similarly, an American investor in Swiss-franc-denominated bonds must convert dollars into francs, and Swiss purchasers of U.S. Treasury bills require dollars to complete these transactions. It would be inconvenient, to say the least, for individual buyers and sellers of foreign exchange to seek out one another, so a foreign exchange market has developed to act as an intermediary.
Most currency transactions are channeled through the worldwide interbank market, the wholesale market in which major banks trade with one another. This market, which accounts for about 95% of foreign exchange transactions, is normally referred to as the foreign exchange market. It is dominated by about 20 major banks. In the spot market, currencies are traded for immediate delivery, which is actually within two business days after the transaction has been concluded. In the forward market, contracts are made to buy or sell currencies for future delivery Spot transactions account for about 33% of the market, with forward transactions accounting for another 12%. The remaining 55% of the market consists of swap transactions, which involve a package of a spot and a forward contract.1
The foreign exchange market is not a physical place; rather, it is an electronically linked network of banks, foreign exchange brokers, and dealers whose function is to bring together buyers and sellers of foreign exchange. The foreign exchange market is not confined to any one country but is dispersed throughout the leading financial centers of the world: London, New York, Paris, Zurich, Amsterdam, Tokyo, Hong Kong, Toronto, Frankfurt, Milan, and other cities.
Trading has historically been done by telephone, telex, or the SWIFT system. SWIFT (Society for Worldwide Interbank Financial Telecommunications), an international bank-communications network, electronically links all brokers and traders. The SWIFT network connects more than 7,000 banks and broker-dealers in 192 countries and processes more than five million transactions a day, representing about $5 trillion in payments. Its mission is to transmit standard forms quickly to allow its member banks to process data automatically by computer. All types of customer and bank transfers are transmitted, as well as foreign exchange deals, bank account statements, and administrative messages. To use SWIFT, the corporate client must deal with domestic banks that are subscribers and with foreign banks that are highly automated. Like many other proprietary data networks, SWIFT is facing growing competition from Internet-based systems that allow both banks and nonfinancial companies to connect to a secure payments network.
Foreign exchange traders in each bank usually operate out of a separate foreign exchange trading room. Each trader has several telephones and is surrounded by terminals displaying up-to-the-minute information. It is a hectic existence, and many traders burn out by age 35. Most transactions are based on verbal communications; written confirmation occurs later. Hence, an informal code of moral conduct has evolved over time in which the foreign exchange dealers’ word is their bond. Today, however, much of the telephone-based trading has been replaced by electronic brokering.
Although one might think that most foreign exchange trading is derived from export and import activities, this turns out not to be the case. In fact, trade in goods and services accounts for less than 5% of foreign exchange trading. More than 95% of foreign exchange trading relates to cross-border purchases and sales of assets, that is, to international capital flows.
Currency trading takes place 24 hours a day, but the volume varies depending on the number of potential counterparties available. Exhibit 7.1 indicates how participation levels in the global foreign exchange market vary by tracking electronic trading conversations per hour.
The Participants
The major participants in the foreign exchange market are the large commercial banks; foreign exchange brokers in the interbank market; commercial customers, primarily multinational corporations; and central banks, which intervene in the market from time to time to smooth exchange rate fluctuations or to maintain target exchange rates. Central bank intervention involving buying or selling in the market is often indistinguishable from the foreign exchange dealings of commercial banks or of other private participants.
Exhibit 7.1 The Circadian Rhythms of the Foreign Exchange Market
Note: Time (0100-2400) hours, Greenwich Mean Time.
Source: Reuters Chart appears in Sam Y. Cross. “All About … the Foreign Exchange Market in the United States,” Federal Reserve Bank of New York, www.ny.frb.org/pihome/addpub.
Only the head offices or regional offices of the major commercial and investment banks are actually market makers—that is, they actively deal in foreign exchange for their own accounts. These banks stand ready to buy or sell any of the major currencies on a more or less continuous basis. Exhibit 7.2 lists some of the major financial institutions that are market makers and their estimated market shares.
A large fraction of the interbank transactions in the United States is conducted through foreign exchange brokers, specialists in matching net supplier and demander banks. These brokers receive a small commission on all trades (traditionally, 1/32 of 1% in the U.S. market, which translates into $312.50 on a $1 million trade). Some brokers tend to specialize in certain currencies, but they all handle major currencies such as the pound sterling, Canadian dollar, euro, Swiss franc, and yen. Brokers supply information (at which rates various banks will buy or sell a currency); they provide anonymity to the participants until a rate is agreed to (because knowing the identity of the other party may give dealers an insight into whether that party needs or has a surplus of a particular currency); and they help banks minimize their contacts with other traders (one call to a broker may substitute for half a dozen calls to traders at other banks). As in the stock market, the role of human brokers has declined as electronic brokers have significantly increased their share of the foreign exchange business.
Exhibit 7.2 Leading Foreign Exchange Traders in 2007
Source: EuroMoney Magazine. FX poll 2007: Winners and Losers in 2007.
Commercial and central bank customers buy and sell foreign exchange through their banks. However, most small banks and local offices of major banks do not deal directly in the interbank market. Rather, they typically will have a credit line with a large bank or with their home office. Thus, transactions with local banks will involve an extra step. The customer deals with a local bank that in turn deals with its head office or a major bank. The various linkages between banks and their customers are depicted in Exhibit 7.3. Note that the diagram includes linkages with currency futures and options markets, which we will examine in the next chapter.
The major participants in the forward market can be categorized as arbitrageurs, traders, hedgers, and speculators. Arbitrageurs seek to earn risk-free profits by taking advantage of differences in interest rates among countries. They use forward contracts to eliminate the exchange risk involved in transferring their funds from one nation to another.
Traders use forward contracts to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currencies. More generally, a forward-covering transaction is related to a specific payment or receipt expected at a specified point in time.
Hedgers, mostly multinational firms, engage in forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities on their balance sheets that are not to be realized over the life of the contracts.
Arbitrageurs, traders, and hedgers seek to reduce (or eliminate, if possible) their exchange risks by “locking in” the exchange rate on future trade or financial operations.
In contrast to these three types of forward market participants, speculators actively expose themselves to currency risk by buying or selling currencies forward in order to profit from exchange rate fluctuations. Their degree of participation does not depend on their business transactions in other currencies; instead, it is based on prevailing forward rates and their expectations for spot exchange rates in the future.
Exhibit 7.3 Structure of Foreign Exchange Markets
Note: The International Money Market (IMM) Chicago trades foreign exchange futures and euro futures options. The London International Financial Futures Exchange (LIFFE) trades foreign exchange futures. The Philadelphia Stock Exchange (PSE) trades foreign currency options.
Source: Federal Reserve Bank of St. Louis, Review, March 1984, p. 9, revised.
The Clearing System.
Technology has standardized and sped up the international transfers of funds, which is at the heart of clearing, or settling, foreign exchange transactions. In the United States, where all foreign exchange transactions involving dollars are cleared, electronic funds transfers take place through the Clearing House Interbank Payments System (CHIPS). CHIPS is a computerized network developed by the New York Clearing House Association for transfer of international dollar payments, currently linking 46 major depository institutions that have offices or affiliates in New York City. Currently, CHIPS handles more than 360,000 interbank transfers daily valued at more than $2 trillion. The transfers represent more than 95% of all interbank transfers relating to international dollar payments.
The New York Fed (Federal Reserve Bank) has established a settlement account for member banks into which debit settlement payments are sent and from which credit settlement payments are disbursed. Transfers between member banks are netted out and settled at the close of each business day by sending or receiving FedWire transfers of fed funds through the settlement account. Fed funds are deposits held by member banks at Federal Reserve branches.
The FedWire system is operated by the Federal Reserve and is used for domestic money transfers. FedWire allows almost instant movement of balances between institutions that have accounts at the Federal Reserve Banks. A transfer takes place when an order to pay is transmitted from an originating office to a Federal Reserve Bank. The account of the paying bank is charged, and the receiving bank’s account is credited with fed funds.
To illustrate the workings of CHIPS, suppose Mizuho Corporate Bank has sold U.S.$15 million to Citibank in return for ¥1.5 billion to be paid in Tokyo. In order for Mizuho to complete its end of the transaction, it must transfer $15 million to Citibank. To do this, Mizuho enters the transaction into its CHIPS terminal, providing the identifying codes for the sending and receiving banks. The message—the equivalent of an electronic check—is then stored in the CHIPS central computer.
As soon as Mizuho approves and releases the “stored” transaction, the message is transmitted from the CHIPS computer to Citibank. The CHIPS computer also makes a permanent record of the transaction and makes appropriate debits and credits in the CHIPS accounts of Mizuho Corporate Bank and Citibank, as both banks are members of CHIPS. Immediately after the closing of the CHIPS network at 4:30 p.m. (eastern time), the CHIPS computer produces a settlement report showing the net debit or credit position of each member bank.
Member banks with debit positions have until 5:45 P.M. (eastern time) to transfer their debit amounts through FedWire to the CHIPS settlement account on the books of the New York Fed. The Clearing House then transfers those fed funds via FedWire out of the settlement account to those member banks with net creditor positions. The process usually is completed by 6:00 P.M. (eastern time).
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