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FOREIGN EXCHANGE MARKETS OVERVIEW
Mustafa Onur Caglayan, Ph.D. Assistant Professor of Finance Özyeğin University
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The FX Market Overview Definition: The FX Market:
A foreign exchange transaction – or FX – transaction involves the purchase of one currency against the sale of another currency for settlement or delivery on a specified date. The rate of exchange – or exchange rate – is the price per unit of one currency expressed in units of another currency. The FX Market: The Foreign Exchange Market is the most liquid, the largest, and one of the most influential markets in the world. It is a 24-hour global market and participants can trade from midnight (12:00 am) Sunday Turkey time to midnight (12:00 am) Friday Turkey time. The daily transaction volume is close to $2 trillion dollars, making it far bigger than the combined total volume of all of the world’s stock exchanges. 1
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The FX Market Overview FX Market Characteristics:
Fairly easy to enter: with the advent of electronic trading platforms, self-directed investors and smaller financial firms now have access to the same liquidity as larger market participants. Extremely liquid: liquidity refers to the ease with which a trade can be executed without causing a significant movement in the price. The FX Market is an over-the-counter (OTC) market. There are no fixed contract sizes or fixed settlement dates as in futures exchanges. No physical market place. But there is always at least one money centre open for business at anytime somewhere in the world. Main FX trading centres include Sydney, Singapore, Tokyo, London, Frankfurt, and New York. 2
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The FX Market Overview FX Market Participants:
Central Banks: by using their stock of currency reserves, central banks can directly intervene in the FX markets to smooth out fluctuations. They can also have an indirect impact in FX markets by changing policy interest rates through money market operations. Commercial Banks: by acting as market makers, and continuously altering their bid and ask prices, they try to balance the supply and demand for each currency within their own books, hopefully for a profit. Market Information Vendors: The large number of market makers make it difficult for the FX trader in deciding which of the major dealing banks is quoting the best rate of exchange. Market Information Vendors, such as Reuters, Bloomberg, Telerate, collect all quotes from major dealing banks and provide this information to market users in one single computer screen in a timely fashion. The rates shown by the vendors are “indication” rates. 3
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The FX Market Overview FX Market Participants (continued):
Interbank Brokers: they relay prices received from major dealing banks via a telecommunications network to other banks and some large market users. The prices they quote are “live” prices, not “indication” prices. They basically broadcast to all their clients the highest rate paid by banks buying the currency (the bid rate) and the lowest rate asked by banks selling the currency (the offer rate). Brokers operate on a commission based on the size of a trade. Corporations and Institutions: Companies use FX markets to manage their cash flows. They primarily use FX markets to cover or “hedge” their foreign currency exposures. Institutional investors, which manage very large domestic and international financial assets, use FX markets to structure their portfolios across a range of currencies. Changes in patterns of portfolio flows can result in significant market trends and banks that can detect these changes early enough can end up with large profits in FX markets. 4
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The FX Market Overview FX Market Participants (continued):
Hedge Funds: a.k.a. speculators… using various techniques, and leverage, they try to exploit market inefficiencies in FX by taking large positions. Leverage enables an FX trader to trade an amount which is much larger than the capital amount. For example with 4:1 leverage, a trader with $25k capital, can trade up to $100k. A zero-sum game? If someone profits in FX markets, there must be someone else who incurred losses. Overall, the FX markets is a zero-sum game. Looking at various players in the FX arena, commercial banks and to some extent hedge funds are the net gainers compared to central banks and corporations as these two institutions do not aim to make profit in FX markets. 5
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The FX Market Overview Why trade FX?
Liquidity: because of large number of buyers and sellers with different objectives, FX orders are generally filled with no slippage problem. 24-hour trading: because the markets are always open, traders can react to market, economic, and political news right away, locking in profits or cutting losses. Leverage: a trader can take a position in a currency more than the capital amount. But this is a double-edged sword. You can lose money equally as fast as you make it. Lower transaction costs: liquidity in FX markets makes the bid-ask spread very small. Under normal market conditions the spread is no more than 5 pips. No restrictions on trading: Trade in both rising and falling markets; through long and short positions traders can take a view on any currency pair and may have access to an economy where there are restrictions on short-selling stocks. 6
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The FX Market Overview Foreign Exchange Quoting Conventions:
All currencies have a three letter code: USD, EUR, JPY, GBP, CHF, AUD, CAD, NZD, NOK, SEK, etc... When trading currencies, the trading pairs are quoted next to each other separated by a slash. ex: EUR/JPY, AUD/NZD, USD/BRL, USD/TRL, etc… When quoting FX pairs, in contrast to academic/mathematical representation, the first currency on the left is always the base currency. And the second currency on the right is the term currency. The number next to the quotation indicates how many units of the term currency would 1 unit of the base currency could buy (ex: USD/JPY 98.70; EUR/USD ). Just like in other markets, when trading you see two prices for each FX pair (ex: GBP/USD – ). The market maker buys the base currency at the rate shown on the left hand side (BID price); and sells the base currency at the rate shown on the right hand side (ASK price). 7
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The FX Market Overview Foreign Exchange Quoting Conventions:
If as a market user you are quoted two rates, the higher rate is the amount you will have to pay (ASK price), and the lower rate is the amount you will receive (BID price) for the base currency. The ASK price is always greater than the BID price. The market maker’s bid/offer spread is the difference between the rate at which the base currency is bought and the rate at which it is sold. The spread represents the risk of pricing the exchange of two currencies at a given moment in time. The greater the risk, the wider the spread. The time between the trade date and settlement date also have a direct impact on the size of the spread. 8
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The Determinants of Exchange Rates
Fundamental Factors: Interest rates The balance of payments (current account balance) Economic growth and capacity utilization Reported economic data vs. expectations Events: Central Bank policy meetings and central banker comments G-7 Finance Minister’s meetings FX Interventions by central banks Elections Natural disasters (hurricanes, earthquakes, etc…) 9
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The Determinants of Exchange Rates
Flows and positioning: Equity flows: Flows generated from equity transactions between two countries Bond flows: Flows generated from bond transactions between two countries Speculative positioning data: (IMM data reported every Friday on a weekly basis provide net long/short positions held by speculators) Technical Factors: Psychological “resistance” and “support” levels in currency pairs Recurring patterns in price charts such as “head and shoulders”, “double bottoms” 10
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Alternative FX Trading Strategies
Discretionary Trading: Developing a view on a currency or a country by looking at various factors and taking a position in the FX markets either through a spot or forward transaction. Quantitative Trading Models: Developing a systematic quantitative/algorithmic model where certain indicators (such as interest rates, portfolio flows, economic data releases, etc… ) are used as an input to generate trading signals on currencies and trades are executed entirely based on the signals received from the model. Technical Trading: Identifying support and resistance levels and trading FX within these boundaries or detecting the formation of a momentum in the price and trading FX based on price momentum. 11
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