Discussion 8 Foreign Exchange Activity

292 Part 2 Securities Markets

spot price of pounds in dollar terms to more than $1.60/£1. In addition, the FI could sell

more pounds forward (the proceeds of these pound loans) for dollars, driving the forward

rate to below $1.55/£1. The outcome would widen the dollar forward–spot exchange rate

difference on pounds, making forward hedged pounds investments less attractive than

before. This process would continue until the U.S. cost of FI funds just equals the forward

hedged return on British loans—that is, the FI could make no further profits by borrow-

ing in U.S. dollars and making forward contract–hedged investments in U.K. loans (see

also the discussion below on the interest rate parity theorem). Futures and options foreign

exchange contracts, as well as foreign exchange swaps, are other derivative securities that

may be used to hedge foreign exchange risk. We discuss and illustrate the use of these

contracts in Chapter 23.

Role of Financial Institutions in Foreign Exchange Transactions

Foreign exchange market transactions, like corporate bond and money market transactions,

are conducted among dealers mainly over the counter (OTC) using telecommunication and

computer networks. Foreign exchange traders are generally located in one large trading

room at a bank or other FI where they have access to foreign exchange data and telecom-

munications equipment. Traders generally specialize in just a few currencies.

A major structural change in foreign exchange trading has been the growing share

of electronic brokerage in the interbank markets at the expense of direct dealing (and

telecommunication). The transnational nature of the electronic exchange of funds makes

secure, Internet-based trading an ideal platform. Online trading portals—terminals where

currency transactions are being executed—are a low-cost way of conducting spot and

forward foreign exchange transactions. In the 2000s, some 85 to 95 percent of interbank

trading in major currencies was conducted by using electronic brokerage. This compares

to 50 percent in 1998 and 20 to 30 percent in 1995. Two companies, Thomson Reuters

and ICAP’s EBS, currently dominate the market for the provision of electronic trading

platforms, software, and FX quotation systems. Electronic brokers automatically provide

traders with the best prices available to them. In contrast, traders using traditional methods

typically needed to contact several dealers to obtain market price information.

Since 1982, when Singapore opened its FX market, foreign exchange markets have

operated 24 hours a day. When the New York market closes, trading operations in San

Francisco are still open; when trading in San Francisco closes, the Hong Kong and Singapore

markets open; when Tokyo and Singapore close, the Frankfurt market opens; an hour later,

the London market opens; and before these markets close, the New York market reopens.

The nation’s largest commercial banks are major players in foreign currency trading and

dealing, with large money center banks such as Citigroup and J. P. Morgan Chase also tak-

ing significant positions in foreign currency assets and liabilities. Smaller banks maintain

lines of credit with these large banks for foreign exchange transactions. Table 9–3 lists the

top foreign currency traders as of May 2013.

LG 9-6

Rank Name Market Share

1 Deutsche Bank 15.18%

2 Citigroup 14.90

3 Barclays Capital 10.24

4 UBS AG 10.11

5 HSBC 6.93

6 J. P. Morgan Chase 6.07

7 Royal Bank of Scotland 5.62

8 Credit Suisse 3.70

9 Morgan Stanley 3.15

10 Bank of America Merrill Lynch 3.08

TABLE 9–3 Top Currency Traders by Percent of Overall Volume

sau61663_ch09_277-303.indd 292sau61663_ch09_277-303.indd 292 29/05/14 7:53 PM29/05/14 7:53 PM

Final PDF to printer

Chapter 9 Foreign Exchange Markets 293

Item 1993 1996 1999 2002 2004 2007 2010 2013 †

Banks’ liabilities $78,259 $103,383 $88,537 $80,543 $ 68,189 $279,559 $167,408 $218,109

Banks’ claims (assets) 62,017 66,018 67,365 71,724 129,544 170,113 341,739 344,361

Claims of banks’ domestic customers * 12,854 10,978 20,826 35,923 32,056 74,693 82,123 46,537

TABLE 9–4 Liabilities to and Claims on Foreigners Reported by Banks in the United States, Payable in Foreign Currencies (millions of dollars, end of period)

Note: Data on claims exclude foreign currencies held by U.S. monetary authorities.

*Assets owned by customers of the reporting bank located in the United States that represents claims on foreigners held by reporting banks for the accounts of the

domestic customers.

† As of March.

Source: Treasury Bulletin, various issues. www.ustreas.gov

Table 9–4 lists the outstanding dollar value of U.S. banks’ foreign assets and liabilities

for the period 1993 to March 2013. The March 2013 figure for foreign assets is $344.4

billion, with foreign liabilities of $218.1 billion. Both foreign currency liabilities and

assets were growing during the mid-1990s and then fell in the late 1990s and early 2000s.

The financial crises in Asia and Russia in 1997 and 1998 and in Argentina in the early

2000s are likely reasons for the decrease in foreign assets and liabilities during this period.

After this period, growth accelerated rapidly as the world economy recovered. While the

growth of liabilities to and asset claims on foreigners slowed during the financial crisis,

levels remained stable as U.S. FIs were seen as some of the safest FIs during the crisis.

Further, in many of the reported years (e.g., 2002 and 2007), U.S. banks had more liabili-

ties to than claims (assets) on foreigners. Thus, if the dollar depreciated relative to foreign

currencies, more dollars (converted into foreign currencies) would be needed to pay off the

liabilities and U.S. banks would experience a loss due to foreign exchange risk. However,

the reverse was true in many of the most recent years (e.g., 2010 and 2013); that is, as the

dollar depreciated relative to foreign currencies, U.S. banks experienced a gain from their

foreign exchange exposures.

Table  9–5 gives the categories of foreign currency positions (or investments) of

all U.S. banks in five major currencies in March 2013. Columns 1 and 2 of Table 9–5

refer to the assets and liabilities denominated in foreign currencies that are held in

the portfolios of U.S. banks. Columns 3 and 4 refer to foreign currency trading activi-

ties (the spot and forward foreign exchange contracts bought—a long position—and

sold—a short position—in each major currency). Foreign currency trading dominates

direct portfolio investments. Even though the aggregate trading positions appear very

large—for example, U.S. banks bought 482,065 billion Japanese yen—their overall or

net exposure positions can be relatively small (e.g., the net position in Japanese yen was

¥1,012 billion.).

(1)

Assets (2)

Liabilities (3)

FX Bought * (4)

FX Sold* (5)

Net Position †

Canadian dollars (millions of C$) 185,186 178,028 925,318 924,456 8,020

Japanese yen (billions of ¥) 89,089 83,569 482,065 486,573 1,012

Swiss francs (millions of Sf) 138,088 91,145 912,266 932,898 26,311

British pounds (millions of £) 637,455 542,575 1,840,457 1,823,772 111,565

Euros (millions of €) 2,098,727 1,986,910 6,112,034 6,003,050 220,801

TABLE 9–5 Monthly U.S. Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, 2013 (in currency of denomination)

*Includes spot, future, and forward contracts.

† Net position  =  Assets  -  Liabilities  +  FX bought  -  FX sold

Source: Treasury Bulletin, June 2013, pp. 87–97. www.ustreas.gov

sau61663_ch09_277-303.indd 293sau61663_ch09_277-303.indd 293 29/05/14 7:53 PM29/05/14 7:53 PM

Final PDF to printer

294 Part 2 Securities Markets

A financial institution’s overall net foreign exchange (FX) exposure in any given cur-

rency can be measured by its net book or position exposure, which is measured in column 5

of Table 9–5 as:

Net exposure i =  (FX assets i   −  FX liabilities i )  +  (FX bought i   −  FX sold i )

=  Net foreign assets i + Net FX bought i

=  Net position i

where

i   =   i th country’s currency

Clearly, a financial institution could match its foreign currency assets to its liabilities in

a given currency and match buys and sells in its trading book in that foreign currency to

reduce its foreign exchange net exposure to zero and thus avoid foreign exchange risk.

It could also offset an imbalance in its foreign asset–liability portfolio by an opposing imbal-

ance in its trading book so that its net exposure position in that currency would also be zero. Notice in Table  9–5 that U.S. banks carried a positive net exposure position in all

currencies in March 2013. A positive net exposure position implies that a U.S. financial institution is overall net long in a currency (i.e., the financial institution has purchased more foreign currency than it has sold). The institution will profit if the foreign currency

appreciates in value against the U.S. dollar, but it also faces the risk that the foreign cur-

rency will fall in value against the U.S. dollar, the domestic currency. A negative net expo- sure position implies that a U.S. financial institution is net short (i.e., the financial institution has sold more foreign currency than it has purchased) in a foreign currency. The

institution will profit if the foreign currency depreciates in value against the U.S. dollar, but

it faces the risk that the foreign currency will rise in value against the dollar. Thus, failure

to maintain a fully balanced position in any given currency exposes a U.S. financial institu-

tion to fluctuations in the exchange rate of that currency against the dollar. Indeed, the

greater the volatility of foreign exchange rates given any net exposure position, the greater

the fluctuations in value of a financial institution’s foreign exchange portfolio (see also

Chapter 19, where we discuss market risk). An FI’s net position in a currency may not be

com p letely under its own control. For example, even though an FI may feel that a particular

currency will fall in value relative to the U.S. dollar, it may hold a positive net exposure in

that currency because of many previous business loans issued to customers in that country.

Thus, it is important that the FI manager recognize the potential for future foreign exchange

losses and undertake hedging or risk management strategies like those described above (in

Example 9–4) when making medium- and long-term decisions in nondomestic currencies.

We have given the foreign exchange exposures for U.S. banks only, but most large

nonbank financial institutions also have some foreign exchange exposure either through

asset-liability holdings or currency trading. The absolute sizes of these exposures are

smaller than for major U.S. money center banks. The reasons for this are threefold: smaller

asset sizes, prudent person concerns, 8 and regulations.

9 Table 9–6 shows international ver-

sus U.S.–based assets held by private pension funds from 1989 to 2013.

net exposure

A financial institution’s overall

foreign exchange exposure in

any given currency.

net long (short) in a currency

A position of holding more

(fewer) assets than liabilities in

a given currency.

8. Prudent person concerns, which require financial institutions to adhere to investment and lending policies, stan- dards, and procedures that a reasonable and prudent person would apply with respect to a portfolio of investments and

loans to avoid undue risk of loss and obtain a reasonable return, are especially important for pension funds.

9. For example, New York State restricts foreign asset holdings of New York–based life insurance companies to less

than 10 percent of their assets.

1989 1994 1999 2004 2007 2010 2013

Total assets $1,631.8 $2,436.2 $4,593.8 $4,922.8 $6,108.2 $6,143.1 $6,820.7

Foreign assets 137.8 227.1 341.9 267.8 447.2 443.4 339.7

U.S.–based assets 1,494.0 2,209.1 4, 251.9 4,6 55.0 5,661.0 5, 669.7 6,481.0

TABLE 9–6 Foreign versus U.S.–Based Assets Held by Private Pension Funds (in billions of U.S. dollars)

Source: Board of Governors of the Federal Reserve, Flow of Funds Accounts, various issues. www.federalreserve.gov

sau61663_ch09_277-303.indd 294sau61663_ch09_277-303.indd 294 29/05/14 7:53 PM29/05/14 7:53 PM

Final PDF to printer

Chapter 9 Foreign Exchange Markets 295

A financial institution’s position in the foreign exchange markets generally reflects

four trading activities:

1. The purchase and sale of foreign currencies to allow customers to partake in and com- plete international commercial trade transactions.

2. The purchase and sale of foreign currencies to allow customers (or the financial institu- tion itself) to take positions in foreign real and financial investments.

3. The purchase and sale of foreign currencies for hedging purposes to offset customer (or financial institution) exposure in any given currency.

4. The purchase and sale of foreign currencies for speculative purposes through forecast- ing or anticipating future movements in foreign exchange rates.

In the first two activities, the financial institution normally acts as an agent on behalf of its customers for a fee but does not assume the foreign exchange risk itself. J. P. Morgan

Chase is a dominant supplier of foreign exchange trading to retail customers in the

United States. As of December 31, 2012, the aggregate value of J. P. Morgan Chase’s

notional or principal amounts of foreign exchange contracts totaled $8.7 trillion. In the

third activity, the financial institution acts defensively as a hedger to reduce foreign

exchange exposure. For example, it may take a short (sell) position in the foreign

exchange of a country to offset a long (buy) position in the foreign exchange of that

same country. Thus, foreign exchange risk exposure essentially relates to open (or spec- ulative) positions taken by the FI, the fourth activity. A financial institution usu- ally creates open positions by taking an unhedged position in a foreign currency

in its foreign exchange trading with other financial institutions. The Federal

Reserve estimates that 200 financial institutions are active market makers in for-

eign currencies in the U.S. foreign exchange market, with about 25 commercial

and investment banks making a market in the five most important currencies.

Financial institutions can make speculative trades directly with other financial

institutions or arrange them through specialist foreign exchange brokers. The

Federal Reserve Bank of New York estimates that approximately 45 percent of

speculative or open position trades are accomplished through specialized brokers

who receive a fee for arranging trades between financial institutions. Speculative

trades can be instituted through a variety of foreign exchange instruments. Spot

currency trades are the most common, with financial institutions seeking to make

a profit on the difference between buy and sell prices (i.e., movements in the

purchase and sale prices over time). However, financial institutions can also take

speculative positions in foreign exchange forward contracts, futures, and options

(see Chapter 10).

open position

An unhedged position in a

particular currency.

D O Y O U U N D E R S T A N D :

3. What the difference is between a

spot and forward foreign exchange

market transaction?

4. The two ways in which an FI

manager can hedge foreign

exchange risk?

5. What the advantages are for an FI

that hedges foreign exchange risk

with forward contracts (as opposed

to hedging this risk on the balance

sheet)?

6. What the four major foreign

exchange trading activities are that

financial institutions perform?

INTERACTION OF INTEREST RATES, INFLATION, AND EXCHANGE RATES

As global financial markets and financial institutions and their customers have become

increasingly interlinked, so have interest rates, inflation, and foreign exchange rates. For

example, higher domestic interest rates may attract foreign financial investment and

impact the value of the domestic currency. In this section, we look at the effect that infla-

tion (or the change in the price level of a given set of goods and services, defined earlier,

in Chapter 2, as the variable IP ) in one country has on its foreign currency exchange rates—purchasing power parity (PPP). We also examine the links between domestic and

foreign interest rates and spot and forward foreign exchange rates—interest rate

parity (IRP).

Recall from Chapter 2 that the relationship among nominal interest rates, real inter-

est rates, and expected inflation is often referred to as the Fisher effect, named for the economist Irving Fisher, who identified these relationships early in the last century. The

Fisher effect theorizes that nominal interest rates observed in financial markets must (1)

compensate investors for any reduced purchasing power due to inflationary price changes

LG 9-7

sau61663_ch09_277-303.indd 295sau61663_ch09_277-303.indd 295 29/05/14 7:53 PM29/05/14 7:53 PM

Final PDF to printer