Lecture 5 The FX market. Haakon O. Solheim

Transcription

1 Lecture 5 The FX market Haakon O. Solheim Norwegian School of Management April 30, 2002

2 Tobin tax A Tobin tax is a proposed tax on on all transactions in the foreign exchange market. Intention: to reduce excess volatility caused by low costs of transaction. Will it work? Yes and no. Hinder currency crises? If the cost is high relative to expected gains a tax will reduce the probability of crises. However, the tax necessary must probably be high. And there are possible problems, see example below. A tax would make the markets less liquid. It is not perfectly clear how that will effect the price process. However, short term volatility might fall. 1

3 It has been argued that for a Tobin tax to be effective it must be implemented in all territories if only a tiny bit of land is excluded one could move all FX transactions there to avoid the tax. However, a tax that covers the OECD countries will probably still have a substantial effect. The real problem is financial derivatives. It is possible to speculate in the FX-market without being in the FX-market one can create financial derivatives that reflect the risk in the FX market.

4 Hold Trader 1 Sell Hold 0,0 0,2 Trader 2 Sell 2,0 1/2,1/2 Hold Trader 1 Sell Hold 0,0 0,1 Trader 2 Sell 1,0-1/2,-1/2 2

5 Attack when fundamentals are weak. Committed reserves=6. In first case cost of speculation is set to -1. In second case cost of speculation is set to -2. In the first case we have one Nash equilibrium, in the lower, right corner. In the second case we have two Nash equilibria, in the upper right and lower left corner. This creates the possibility of a more unstable situation. 3

6 Spot market: transactions made today that shall be completed within two days, i.e. formal delivery of the currency will take place in two days. Outright forward: transaction that contract delivery of the currency at some point in the future. Option: The right to buy (or sell) an asset at a predetermined value. Swap: Bundles two FX transactions that go in opposing directions. Usual to combine a spot transaction and an outright forward. 4

7 All exchange rates are quoted as two prices a bid and an ask. On the Reuters screen you will see quotes of the type: USD/EUR will be the price where the bank is willing to buy EUR. This is the bid price for EUR will be the price where the bank is willing to sell EUR. This is the ask price for EUR. The seller asks USD to give you one EUR. The spread is measured in basis points. One basis point is one point in the fourth decimal of the quote. In the above example the spread is two basis points. 5

8 Triangular arbitrage Assume that we have HKD/USD 7.70 (HKD-Hong Kong Dollar) ZAR/USD 11.9 (ZAR-South African Rand) What is the HKD/ZAR rate? HKD/U SD ZAR/USD = = HKD/ZAR. (1) Suppose not. Suppose e.g. that HKD/ZAR=0.75. This means that we can make a profit by arbitrage. How? Sell one ZAR and get 0.75 HKD. Sell 0.75 HKD and get USD. Sell USD and get ZAR you have made a profit of 16 per cent! 6

9 1. Invest 1 USD at the US 1 year interest rate of i. In one year you will have USD (1+i). 2. Convert 1 USD to GBP at the spot rate ɛ today. This gives you a total of GBP=U SD/ɛ. Invest this at the UK 1 year interest rate of i. In one year you will have the equivalent of (USD/ɛ) (1 + i ). Converted to USD at current forward rate you have (USD/ɛ) (1 + i ) F. These two transactions are equivalent. This is a swap transaction there is no currency risk. It follows that we must have F ɛ = (1 + i) (1 + i ). (2) 7

10 Assets are traded in three different types of markets: 1. Auction market. Customers submit orders. These can either be market orders buy or sell at the current market price, or limit orders buy or sell at a in the contract predetermined price. There will be no dealers in this market, only a system for organising the stream of orders. 2. Single-dealer market. 3. Multiple dealer market. 8

11 The FX-market: a decentralised multiple dealer market. There exists no exchange and no common screen for all quotes. This means that trading will be partly fragmented it is not possible to observe the price in all simultaneous transactions. Note that there are two types of traders that are active in the FX-market: 1. brokers, and 2. dealers. 9

12 Dealer Will offer two-way prices (both bid and ask). Three ways of trading: trading with customers trading through brokers direct inter-dealer trading Direct trade between dealers will be conducted over a computer system, like Reuters D2000-1, or over the telephone. One dealer will contact another, and ask for a price quote. These quotes are considered to be binding. 10

13 A market maker is a dealer that is supposed to always give a quote. A single dealer will mostly specialise in only one currency cross. Most dealers close their positions over night.

14 Figure 3 provides an example of a D conversation when a trade takes place. A conversation starts by a dealer contacting another dealer. The contacting dealer usually asks for bid and ask quotes for a certain amount, for instance USD one million. 4 When seeing the quotes, the contacting dealer states whether he wants to buy or sell. Sometimes he asks for better quotes, or end the conversation without trading. However, most conversations result in a trade (70%). All D transactions in the data set take place at quoted bids or asks. Figure 3: D conversation From CODE FULL NAME HERE *0728GMT????98 */7576 Our Terminal: CODE Our user: FULL NAME HERE DEM 1 # BA> I BUY # TO CONFIRM AT 1,8147 I SELL 1 MIO USD # VAL??(+2)??98 # MY DEM TO FULL NAME HERE # THANKS AND BYE TO CONFIRM AT 1,8147 I BUY 1 MIO USD VAL??(+2)??98 MY USD TO FULL NAME HERE THANKS FOR DEAL FRDS. CHEERS # # END REMOTE # ^ ## TKT EDIT OF CNV 7576 BY CODE 0728GMT????98 ^ STATUS CONFIRMED ^ ##ENDED AT 07:27 GMT# ( 293 CHARS) An example of a D conversation when a trade takes place. The first word means that the call came From another dealer. There are information regarding the institution code and the name of the counterpart, and the time (Greenwich Mean), the date, and the number assigned to the communication. DEM 1 means that this is a request for a spot DEM/USD quote for up to USD 1 million, since it is implicitly understood that it is DEM against USD. At line 4, we find the quoted bid and ask price. Only the last two digits of the four decimals are quoted. In this case, the bid quote is and the ask quote is When confirming the transaction, the communication record provides the first three digits. In this case, the calling dealer buys USD 1 million at the price The record confirms the exact price and quantity. The transaction price always equals the bid or the ask. There is also information regarding the settlement bank. My DEM to Settlement bank identifies the settlement bank of our bank, while My USD to Settlement bank identifies the settlement bank of the other bank. It is usual to end a conversation with standard phrases, such as thanks and bye, thanks for deals friends. Source: Bjønnes and Rime, Electronic broker systems Electronic broker systems fill the same functions as voice-brokers, but are more efficient. A bank dealer with access to one of the electronic broker systems can enter his buy and/or sell price into the system as a market maker. D and EBS show only the highest bid and the lowest ask, thereby minimizing the spread. These will normally be entered by different banks, but the identity of the inputting bank is not shown. The total quantity entered for trade on these quotes is also shown. This means that when more than one bank input the same best bid (ask) price, the quantity shown is the sum of that offered 11 by these banks. This quantity is shown as integers of USD one million, and in some bilateral cases DEM one million. When the quantity is at least ten million, R is entered on the D screen. EBS shows two set of bid and ask quotes, for amounts up to ten million USD or DEM, and for amounts of at least ten millions. This information is optional on 4

15 A broker is a pure matchmaker. Dealers will submit limit orders to the broker. The broker will post these orders on a screen. One such system is the the Reuters D The broker system: traders can observe the quotes available in the market on one screen. it is not revealed who has posted the quote. This is first revealed after the trade has been completed. dealers only post small limit orders on the screen. no commitment to trade over the broker system can be spells of low liquidity. 13

16 Dealer inventory Figure 2: Dealer Inventory USD USD Mon Tue Wed Thu Fri -4 Mon Tue Wed Thu Fri a) Dealer 1: DEM/USD Market Maker b) Dealer 2: DEM/USD "Nintendo-dealer" DEM USD Mon Tue Wed Thu Fri -15 Mon Tue Wed Thu Fri c) Dealer 3: NOK/DEM Market Maker d) Dealer 4: DEM/USD The evolution of dealers inventory over the week. Dealer 1 (panel a), 2 (panel b) and 4s (panel d) inventory are in USD million, while Dealer 3s inventory is in DEM million. The horizontal axis is in transaction -time. Vertical lines indicate end of day. The numbers are in USD million. Source: Bjønnes and Rime, 2001

17 Customer dealer Spread: 3-7 basis points Brokered interdealer Spread: 2-3 basis points Direct interdealer Spread: 2 points Why use a broker? 1. Do not have access to direct market 2. Do not have to reveal identity before trade is completed 3. Access to a larger market Source: Lyons,

18 Three characteristics of the FX market: 1. A very high volume, 2. high intra-dealer volume, and 3. low transparency. FX-market is different from other multiple dealer asset markets. The daily volume in the FX spot market in April 1998 was 600 billion USD, of which about 2/3 is supposed to have been intradealer trade. As a comparison, the daily volume in the New York Stock Exchange in this period was 30 billion USD, and average daily world trade in goods and services was about 15 billion USD. 15

19 The hot-potato-hypothesis Assume that a dealer gets an order from a customer. However, the dealer wants to keep his inventory as close to zero as possible. the dealer makes a trade with another dealer New dealer with excess inventory. He keeps a little, and trade the rest. And so on. Every customer trade gets multiplied when we look at the FX-market as a whole. Why do dealers conduct such trading? They could try to seek a better match for their orders, thereby reducing the number of rounds before the currency risk is spread thin enough to satisfy the market. The willingness to trade might be explained through the low transparency in these markets. The only way dealers can obtain information about the flows in the market is by trading themselves. 16

20 Table 2 Reported foreign exchange market turnover by instrument, counterparty and maturity 1 Daily averages in April, in billions of US dollars Instrument/counterparty Spot With reporting dealers With other financial institutions With non-financial customers Outright forwards With reporting dealers With other financial institutions With non-financial customers Up to 7 days Over 7 days and up to 1 year Over 1 year Foreign exchange swaps With reporting dealers With other financial institutions With non-financial customers Up to 7 days Over 7 days and up to 1 year Over 1 year Total ,137 1,430 1,173 With reporting dealers With other financial institutions With non-financial customers Local Cross-border Adjusted for local and cross-border double-counting. 2 Revised. Source: BIS,

21 Table 1 Global foreign exchange market turnover 1 Daily averages in April, in billions of US dollars Instrument Spot transactions Outright forwards Foreign exchange swaps Estimated gaps in reporting Total traditional turnover ,190 1,490 1,210 Memorandum item: Turnover at April 2001 exchange rates ,400 1,210 1 Adjusted for local and cross-border double-counting. 2 Revised. 3 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2001 exchange rates. Source: BIS, 2001

22 Factors that the determine the international use of a currency is size of the economy, importance in international trade, size, depth, liquidity, and openness of domestic financial markets, convertibility of currency, and macroeconomic policies. Policies fostering low inflation (i.e. a stable value of money) are especially important. 20

23 R EVIEW The Table roles 1 of international money Functions of an International Currency Sector Function Private Official Unit of account Invoice Exchange rate peg Store of value Financial assets Reserves Medium of exchange Vehicle/substitution Intervention reserves in this currency and (ii) as a medium of exchange if it is used for intervening in currency markets. The three functions of an international currency reinforce each other. For example, the use of a currency for invoicing trade and holding financial assets increases the likelihood that the currency will be used as a vehicle currency. In the official sector, if a country pegs its exchange rate to another currency, it is likely to hold reserves in that currency and conduct its interventions in exchange markets in that currency. In addition, the use of an international currency by one sector reinforces its use by the other sector. For example, using a currency as an exchange rate peg facilitates the use of that Korean economy, U.S. exports comprise a much larger share of world exports. Clearly the dominance of the U.S. economy and the decline of the U.K. economy in the twentieth century were related to the rise of the dollar and the decline of the pound as international currencies. Likewise, the growth of the German and Japanese economies in the last several decades of the twentieth century prompted the use of their currencies in international markets. As a result, the overwhelming dominance the dollar held in international markets in the 1950s and 1960s diminished. Table 2 compares the relative size of the U.S., euro-area, and Japanese economies. The U.S. economy is the largest in the world, accounting for about

24 Table 3 Currency distribution of reported global foreign exchange market turnover 1 Percentage shares of average daily turnover in April Currency US dollar Euro Deutsche mark French franc ECU and other EMS currencies Japanese yen Pound sterling Swiss franc Canadian dollar Australian dollar Swedish krona Hong Kong dollar Norwegian krone Danish krone Singapore dollar South African rand Mexican peso Korean won New Zealand dollar Polish zloty Brazilian real Russian rouble Taiwan dollar Chilean peso Czech koruna Indian rupee Thai baht Malaysian ringgit Saudi riyal Other currencies All currencies Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%. The figures relate to reported net-net turnover, ie they are adjusted for both local and cross-border double-counting, except for 1989 data, which are available only on a gross-gross basis. 2 Revised. 3 Data for April 1989 exclude domestic trading involving the Deutsche mark in Germany. 4 For , the data cover local home currency trading only. 22 6/13

25 FEDERAL RESERVE BANK OF ST. LOUIS Factors Table 2 that determine the international use of a currency Comparison of United States, Euro-Area, and Japanese Economies in 1999 United States Euro area Japan Share of world GDP (%) Share of world exports (%) Financial markets ($ billions) 40, , ,888.5 Bank assets ($ billions) 7, , ,662.5 Domestic debt securities outstanding ($ billions) 15, , ,444.9 Stock market capitalization ($ billions) 17, , ,781.4 NOTE: GDP is based on purchasing power parity equivalents. World exports excludes intra-euro-area trade. SOURCE: GDP: IMF, World Economic Outlook, October Exports: IMF, Direction of Trade Statistics Quarterly, September Bank assets: European Central Bank, Monthly Bulletin; Board of Governors of the Federal Reserve System, Flow of Funds Accounts; IMF, International Financial Statistics. Debt securities: Bank for International Settlements, Quarterly Review of International Banking and Financial Market Developments. Stock market: Eurostat. exchange a currency for other currencies limits its global use. At the end of World War II almost every country, with the exception of the United States, restricted the convertibility of its currency. This inconvertibility persisted for the first decade after the war. The convertibility of the U.S. dollar prompted its use as the currency in which international trade was conducted. Macroeconomic policies also play an important role in determining whether a country s currency will be used internationally. These policies this currency; (ii) if this currency is used to facilitate the exchange of other currencies; and (iii) if this currency is used as a substitute currency. Invoice Currency The dollar is the main currency that functions as a unit of account for private international transactions. Although data on the currency of invoice in international trade are limited, the available data confirm the dominance of the dollar. In 1995 the U.S. dollar was used as the invoice currency for more

26 Table 4 Reported foreign exchange turnover by currency pairs 1 Daily averages in April, in billions of US dollars and percentages Currency pair Amount % share Amount % share Amount % share Amount % share USD/EUR USD/DEM USD/FRF USD/XEU USD/OthEMS USD/JPY USD/GBP USD/CHF USD/CAD USD/AUD USD/Oth EUR/JPY EUR/GBP EUR/CHF EUR/Oth DEM/JPY DEM/GBP DEM/CHF DEM/FRF DEM/XEU DEM/OthEMS DEM/Oth OthEMS/OthEMS Other currency pairs All currency pairs , , , Adjusted for local and cross-border double-counting. 2 Revised. 3 The data cover local home currency trading only. 23

27 Invoice currency: Between industrialised countries: price the good in the currency of the exporter. Between industrialised countries and developing countries: price the good in the currency of the industrialised country or in USD. Between developing countries: most likely price the good in USD. Importance of invoice currency: Is it important which currency is used as an invoice currency? Would it reduce risk if a commodity is priced in the national currency? 24

28 R EVIEW Table 3 Trade Invoiced in Major Currencies Percent of world exports Internationalization ratio Currency U.S. dollar Japanese yen Deutsche mark French franc British pound Italian lira Netherlands guilder Euro NA NA NOTE: Euro-4 is the share of the four euro-area currencies listed in the table. No data were available for the other euro-area currencies. World exports includes intra-euro-area trade. The internationalization ratio is the ratio of the share of world exports denominated in a currency to the share of the issuing country in world exports. SOURCE: Bekx (1998, Table 3, p. 8). tries use that currency to invoice some (or all) of their exports. 6 What determines the currency of invoice in world trade? A number of studies including those by Grassman (1973), Page (1981), and Black (1990) revealed the following patterns. Trade in manufactured goods among the industrial economies is most often priced in the currency of the exporter. If the exporter s currency is not used, then the importer s currency is the most frequent choice. Only rarely is a third country s currency used. Trade between industrial and developing countries is generally priced in the currency of the industrial country or that of a third country. Trade between developing countries is often priced in the currency of a third country. When a third country s currency is used for invoicing trade, the U.S. dollar is the most likely choice. Trade in primary commodities is almost always invoiced in U.S. dollars because these products are predominantly priced in dollars on international exchanges. According to Hartmann (1996), two factors that explain these patterns are transaction costs and acceptability. The lower the cost of buying and selling a currency in the foreign exchange market, the more likely is its use for invoicing trade. In the lower its transaction costs; the lower its transaction costs, the more likely it is to be accepted. Related factors that explain these patterns are convertibility and the expected stability of the currency. As noted above, the use of the dollar as an invoice currency was prompted by the lack of convertibility of most other currencies in the 1950s. The limited use of developing countries currencies in world trade arose in part because many of these countries restricted (and some continue to restrict) the convertibility of their currencies. Black (1990) showed that the share of a country s exports denominated in its domestic currency declines the greater is the expected depreciation of its currency. Thus, the currencies of countries with high inflation are seldom used in international trade. The mere creation of the euro as a currency should provide ample incentive for its use as an invoice currency. Replacing the currencies of 12 countries with a single currency reduces the 25 transaction costs involved in currency exchanges. Although only a small number of firms within the euro area have already switched to invoicing in euros, the advent of euro notes and coins, along 6 An internationalization ratio greater than or equal to 1.0 does not

29 FEDERAL RESERVE BANK OF ST. LOUIS Table 6 International Debt Securities by Currency of Issue (Percent) Amounts outstanding Share of new issues Currency Total securities U.S. dollar Japanese yen Swiss franc Euro area* Other E.U Pound sterling Bonds and notes U.S. dollar Japanese yen Swiss franc Euro area* Other E.U Pound sterling Money Market U.S. dollar Japanese yen Swiss franc Euro area* Other E.U Pound sterling *Euro area includes the currencies of the 11 original members of the euro area and currency composites, such as the ecu. Other E.U. includes the currencies of Denmark, Sweden, and the United Kingdom. SOURCE: Bank for International Settlements, Quarterly Review of International Banking and Financial Market Developments, March the 1950s. By the 1970s, however, the currency denomination of bond issues had become more diversified, as shown in Table 5. Nevertheless, the U.S. dollar has remained the most popular currency choice for issuing bonds in international markets, as shown in Table 6. 9 By the 1960s the euro legacy currencies, taken together as a group, had become the second most widely used currency in international bond markets, a status that continues today. The Japanese yen was not used at all until the 1970s, and its share of new issues lags far below that of the dollar or euro. The use of the Swiss franc in international bond markets, which rivaled the Deutsche mark in the 1970s, declined precipitously in the 1990s. 10 In international money markets as well, the dollar is the currency of choice, but again its dominance has declined, as noted in Table 6. The increased use of the euro legacy currencies in these markets during the 1990s is particularly noteworthy. In 1993 these currencies accounted for 8.5 percent of the outstanding debt in international money markets. By 1998 this share had increased to 19.2 percent. 9 The data in Tables 5 and 6 rely on different sources and hence may not be directly comparable Some policymakers in Switzerland were concerned that the creation of the euro might result in a sharp rise in demand for assets denominated in Swiss francs. See Laxton and Prasad (1997) for an analysis of this argument. SEPTEMBER/OCTOBER

30 The oil price in NOK and USD from 1998 to Indexed values, index=100 in January 1, /01/98 10/08/98 7/15/99 4/20/00 1/25/01 OILNOKI OILUSDI

31 Figure 2 US seignorage revenue Seignorage Revenues from Foreign Holdings of U.S. Dollars Billions of 1996 $ to lag be Foreign ble, secu value of against t existenc the euro If th substitu ECB will revenue demand euro and Emerson age reve a year fo THE O INTER Exchan 30