Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 38:  Foreign exchange markets  Basic structure  Spot and forward rates 38cis

The global foreign exchange market The foreign exchange market is the largest financial market in the world – by far. Foreign exchange is often referred to as:  Forex  FX The forex market involves the trading of one currency for another. GBP vs USD over past two years  Most currencies are allowed by their central banks to “float”  The value of one currency versus another will depend on the economic health of the issuer o Interest rates and the balance of payments are key determinants

Currencies did not always “float” Until 1971, the exchange rates of most major currencies were fixed against the US dollar, which was convertible into gold at US$35 per ounce. Governments could not devalue their currencies by more than 1%. DateGBP : USD 27 December 1945£1.00 : US$ September 1949£1.00 : US$ November 1967£1.00 : US$2.40 The Mount Washington Hotel, Bretton Woods, New Hampshire, USA  This currency system was known as the Bretton Woods Agreement, signed in July 1944  It prevented countries from devaluing their currencies to seek an unfair trade advantage

The end of Bretton Woods The US starting running large fiscal and trade deficits in the 1960s, leading to a steady flow of US dollars (and therefore gold) out of the US. By 1971, the US only had reserves of gold sufficient to cover 22% of the US dollars in issue.  It has been estimated that the true market price of gold in 1971 should have been US$103 per ounce.  Before the collapse of Bretton Woods, the French central bank was buying US dollars with French francs, and converting the US dollars into gold at US$35 per ounce. Nixon ends gold standard 15 th August 1971, President Nixon announces the end of the gold standard for the US dollar

Floating exchange rates With the end of the Bretton Woods system, most of the major currencies float against each other in value Some currencies are still fixed (or “pegged”) against another major currency  Jordan, Bahrain, Lebanon, Oman, Qatar, Saudi Arabia, UAE, Hong Kong all peg their currencies to the US dollar  Morocco, Senegal, Ivory Coast, Cameroon, New Caledonia, all peg their currencies to the euro DateGBP : USD 27 th December 1945£1.00 : US$ th September 1949£1.00 : US$ th November 1967£1.00 : US$ th November 1977£1.00 : US$ th November 1987£1.00 : US$ th November 1997£1.00 : US$ th November 2007£1.00 : US$ th November 2008£1.00 : US$ th November 2009£1.00 : US$ th November 2010£1.00 : US$1.59 Source: Bank of England Until 2005, China pegged the yuan to the US dollar, but now allows it to fluctuate within a narrow band The UK has not had a fixed exchange rate since 1972

Floating exchange rates With floating exchange rates, changes in market demand and market supply of a currency cause a change in value. In the diagram above we see the effects of a rise in the demand for sterling (perhaps caused by a rise in exports or an increase in the speculative demand for sterling). This causes an appreciation in the value of the pound.

Floating exchange rates Changes in currency supply also have an effect. In the diagram above there is an increase in currency supply (S1-S2) which puts downward pressure on the market value of the exchange rate.

Floating exchange rates

Currency trading The forex market is an over-the-counter (OTC) market, where brokers and dealers negotiate directly with each other. Individual forex traders (i.e. retail investors) are becoming increasingly important in the global forex market.

Currency trading terms Forward The transaction date is set for some date in the future. A forward transaction fixes in advance the exchange rate which will be used on that future date Future A future is a standardised version of a forward transaction, used by derivatives exchanges. A future has standard sizes and maturity dates (usually three months). Spot The spot rate is the rate quoted by a bank for the exchange of one currency for another with immediate effect. However, the trade is usually settled (i.e. paid for) two business days after the transaction date Swap A swap is the most common type of forward transaction. Two parties exchange currencies for an agreed length of time and agree to reverse the transaction at the end of that period. Swaps are not traded on exchanges. Source:

Global currency markets Currencies are now traded against each around the world, 24 hours a day Because London is in a time zone between North America and Asia, it is well placed to capture a large share of the global forex market. London is the largest forex trading centre in the world.

In September 2010, the Bank of International Settlements released its Triennial FX survey. Forex trading volume has surged over the past three years. Between April 2007 and April 2010, global foreign exchange market increased by 20% from US$3.3trn to US$4.0trn traded per day. Size of the global forex market Global foreign exchange market turnover by instrument Average daily turnover in April, in billions of US dollars (Source: BIS)

In 2001, the U.S. dollar was involved in 90% of all currency transactions and as of April 2010, this fell to 84.9%. The decline in trading of dollars has benefited the euro, which has gained 2%-points in market share since 2007 and accounts for 39% of all transactions. The Japanese yen also increased its market share by 2%-points to 19%. The share of pound sterling is around 13%, down from 15%. Structure of the global forex market Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%.

Structure of the global forex market Of the major currency pairs, trading of EUR/USD and USD/JPY have increased while trading of the GBP/USD has decreased. Outside of the UK and US, trading takes place primarily in France (7%) and Japan (3%), Singapore (3%) and Switzerland (3%). Turnover in Germany almost halved to less than 2% in April 2010 compared with The UK continues to be the most active forex trading centre in the world with a share of 46%. This is followed by the US with a share of 24%, slightly down from 2007.