The FOREX market

Publié le par Claire Zanuso

Overview

The Foreign Exchange Market, also known as FOREX or FX market, is the largest of all financial markets. In 2007, the average daily volume of transactions on this market was equivalent to $3200 billion (BIS, 2007), three times the volume of all futures and global equity markets combined. The main purpose of this article is to introduce the FOREX and outline how it is used in the management of foreign exchange risk, as exchange rate movements affect present as well as future cash flows of a company.


 

FOREX daily turnover between 1995 and 2009

forex1

Source: IFSL (2009)

Daily FOREX turnover fell between 1998 and 2001 essentially due to the introduction of the euro. Between April 2005 and 2008, foreign exchange turnover nearly doubled, boosted by increasing participation by hedge funds as well as the proliferation of electronic trading platforms. The decline in trading volume during the year 2009 can be explained by the economic recession and by a fall in activity by international investors, in particular hedge funds, in relation to the financial crisis.

 


Unlike the stock market trading, the FOREX market is not conducted by a central exchange. The FX market is an inter-bank market, which is thought of as an over the counter (OTC) market. The foreign exchange market knows no borders: there is one global foreign exchange market. In 2007, the major trading places are: London (34,1% of total average transactions in April), New York (16,6%), Geneva (6,1%), Tokyo (6,0%), Singapore (5,8%), Hong Kong (4,4%), Sydney (4,2%) and Paris (3%), making FOREX a 24-hour market, from Sunday evening to Friday evening. 

 

It is possible to treat more than 170 pairs of different currencies, but “majors” currencies are the U.S. dollar (USD), the Euro (EUR), Japanese yen (JPY), Pound Sterling (GBP), Swiss franc (CHF), the Australian dollar (AUD), the Canadian dollar (CAD). Others currencies, less traded on the FX market, are called “minors”, “emerging” and even “exotic” currencies.

 

 

forex tab

Source: BIS, 2007

Note: every transaction requires a pair of different currencies, thus total is 200%.

 


The most important pairs are: EUR/USD (27% of total transactions in April 2007), USD/JPY (13%), and GBP/USD (12%). EUR/GBP or EUR/JPY represent both only about 2% of total transactions for the same period.

 

Six categories of market participants

It is possible to distinguish between six categories of market participants on this market, depending on their objectives, their aversion to risk and their time horizons.

 

Central Banks manage their foreign exchange reserves and Treasury bills. Transactions of Central Banks account for about 5% to 10% of total volumes in FX market. Considering the size of FOREX in comparison to their currency reserves, the central banks' influence on exchange rates is limited. Intervention usually happens when a nation’s currency expeirence excessive downward or upward pressure from market players. According to the large volume of the FX market, it is not so easy for a Central Bank to stabilize its currency. Central Banks equipped with substantial foreign currency reserves are those that command the most respect in FX interventions.


Commercial banks are historical actors in FX market. They are usually the final speaker of other market participants and seek to profit from the “market making”. It is a highly concentrated market, the first three banks account for more than 45% of trading in May 2009, and the first ten banks gather a 80% market share (Euromoney FX survey, 2009).


There are different types of brokers on the FOREX. They are the guarantors of the successful organization of market liquidity.


Multinational corporations involved in the FX market in order to pay a foreign supplier, to repatriate profits made in other currencies or to hedge the currency risk. Some large multinational companies also speculate on the FOREX. Their transactions represent 30% of total transactions.


Institutional investors manage international bond and stock portfolios, seek to hedge their exposure and make bets on gains on the FOREX.


Individual investors transactions represent 5% of total transactions on the FX market. The advent of Internet and trading platforms make foreign exchange market more easily accessible. 

 

 

Spot, futures and derivatives markets

 

The FOREX has several compartments. On the spot market, trades are settled “immediately”, in practice this means within two banking days. On the forward and market, one negotiates today the exchange of two currencies, but for a later delivery date. Finally, additional derivatives markets are made of powerful tools (like options of all kinds) that can be used to manage the risks associated with production, trade and finance.



forex2 

Source: BIS survey (2007)

 


Who carries the transaction risk?

Speculating and hedging are the two ways in which FX derivatives are used. ‘Hedgers’ are exposed to currency risk in the course of their ordinary activities and seek to cover their positions as creditors or debtors. In contrast, speculators believe they can take a position exposed to currency risk to realize a profit. In reality, market participants may adopt a mix of these two attitudes.

 

Let’s take a closer look at hedging strategies. A major goal is to neutralize the effect of currency fluctuations on sales revenue. Foreign exchange transaction exposure exits when companies have financial obligations due to be settled in foreign currencies. It occurs in all foreign trading, when there is a time delay between the sale of goods and the receipt of the payments. The company exposed to transaction risk can either run the risk of exchange-rate movements or can take steps to protect its future cash flows from this fluctuation.

 

Once a firm has decided to hedge a particular currency risk, there are various methods to consider. They can be grouped as internal and external hedging techniques. Internal techniques do not operate through the FOREX. Therefore they avoid the associated costs, but this does not mean they are costless. On the contrary, external techniques use financial markets to hedge foreign currency movements. To choose an appropriate external hedging tool, is important to consider the cost and the flexibility of the hedge, the currency to be hedged, the risk management of the firm, the size and probability of the exposure.

 

External hedging techniques

 

Forward markets

The idea of a forward exchange contract is that one party agrees to deliver a specified amount of a currency to another at a specified exchange rate fixed today (forward rate) and at a specified future date, called the delivery date (or settlement date).

 

A company takes a position in the FOREX by buying a forward contract, thus the firm is said to be in a long position. In a short position, the investor sells a forward contract. Most forward contracts have a maturity of less than 2 years. The size of the spread (ie. the difference between tspot rate and the forward rate) for a given currency increases with the maturity. This technique becomes less attractive for managing long dated foreign currency exposure, and its main problem is the fixed delivery date.

 

For example:

European company has to pay $200 000 in one month to an American supplier .

The forward rate is €1 = $1,4255 and the spot rate is €1 = $1,4295.

If the EU company entered into a forward contract to buy dollars, the amount the company would have to pay at the settlement date would be: 200000/1,4255 = 140 310,65 euros.

Alternatively, the company could choose not to manage the risk and to be therefore exposed to the fluctuations of the USD/EUR during one month. If the forward rate is the best estimate of the future spot rate, then the amount to be paid would be the same as above, but it is rare case.

 

Options forward exchange contract

It is different from a currency option contract. An option forward exchange contract offers same advantages as the previous forward contract except that there is a choice of dates on which the user can exercise the contract. If transaction dates are unknown, this technique offers more flexibility, but at a higher cost.

 

Futures

Financial futures in foreign exchange rates are contracts to buy or sell an amount of foreign currency at a future date, they can be sold before their delivery date. The FX futures trading contract specifies a buying price, a settlement date and a quantity. A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange. A company would sell currency futures to hedge receivables in foreign currency, and buy one to hedge foreign currency payments, if obviously the foreign currency is the underlying currency of the futures.

 

Options

Options give the right to buy (‘call’) or sell (‘put’) a specific amount of currency at a specific price on a specific date. Whereas a forward or future contains the contractual obligation to deliver at the agreed time and forward rate, an option offers a choice. But, as opposed to a forward contract, a foreign exchange option has an explicit fee, which is similar to a premium paid for an insurance policy. The level of premium to be paid to banks for the option depends on various factors: the ‘strike price’, the maturity of the option, the volatility of the spot rate, interest-rate differentials, liquidity in the market and anticipations.

The ‘strike price’ could be:

‘at the money’: it means is equal to spot rate or forward rate

‘in the money’: the agreed price is more favourable to the client than is currently available, the premium would be higher

‘out of the money’: the agreed price is less favourable to the client than is currently available, the premium would be lower.

 

Currency swaps

A currency swap is a foreign exchange agreement between buyer and seller to exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. Foreign currency swap can be negotiated for various types of maturity. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate. The parties end up with their original currencies. Unlike interest-rate swaps, there is an exchange of principal at the beginning and at the end of the contract.

 

Conclusion

The foreign exchange market is unique because of the following features: considerable trading volumes, the very high level of liquidity, the large number and variety of actors, geographical dispersion, long trading hours and the variety of factors that affect exchange rates. A key assumption in the concept of foreign exchange risk is that exchange rate changes are not predictable, and that this is determined by how efficient the markets for foreign exchange are. In general, companies use internal hedging techniques to reduce exposure before applying external tools.


Important considerations in the selection of an appropriate external hedging technique would be the cost and flexibility of the hedge, the firm’s attitude to risk, the currency to be hedged and the size and certainty of the exposure. Currency swaps and futures are more useful for medium to long-term hedging, forward contracts and currency options are generally used to manage a foreign currency exposure until one year.

 


Sources:

Bank for International Settlements: Triennial Central Bank survey of foreign exchange and derivatives market activity in 2007

http://www.bis.org/publ/rpfxf07t.htm

Cambiste.info : website about trading Forex

http://www.cambiste.info/sdmpage/market/orga30.php

P.M. Collier et S. Agyei-Ampomah, From Management Accounting: Risk and Control Strategy, Chap 14: Foreign exchange, risk management, 2006

www.download-it.org/learning-resources.php

B. Döhring, Hedging and invoicing strategies to reduce exchange rate exposure: a euro-area perspective, Economic Papers 299 for European Commission, January 2008

European Central Bank : Euro foreign exchange reference rates

www.ecb.int/stats/exchange/eurofxref/html/index.en.html

Financial Times Markets data: currency performance and currency cross rates

http://markets.ft.com/markets/currencies.asp?segid=70113

International Financial Services London, Foreign exchange, September 2009

www.ifsl.org.uk

Commenter cet article

Ricky John 22/03/2016 04:46

A very interesting post to read.A well presented article in graphical form. about foreign exchange market. Good work.Keep it up.

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