Foreign Exchange Markets

In a nutshell, a foreign exchange rate is a swap of interest rates denominated in different currencies. Foreign exchange trading originated in 1971 when the gold standard collapsed under the heft of U.S. debt. From 1971 until the late 1980s, foreign exchange traded entirely among commercial banks that made deposit arrangements in different currencies. Commercial banks had exclusive access to inter-dealer networks, consisting of loose groups of third-party agents facilitating quick distribution of orders among different commercial banking clients. Investment banks, such as Goldman Sachs, had no direct access to the inter-dealer networks and transacted their foreign exchange trades through commercial banks instead.

In the early 1990s, investment banks were able to gain access to brokerdealer networks. In the late 1990s non-bank companies and non-U.S. investment banks connected directly to the inter-dealer pools. Since 2003, hedge funds and proprietary trading funds have also been granted access to the inter-dealer liquidity. Currently, spot, forward, and swap foreign exchange products trade through this decentralized and unregulated mechanism. Only foreign exchange futures and selected options contracts can be found on exchanges.

The decentralization of foreign exchange trading has had two key consequences: the absence of "one price" and the absence of volume measures.

The absence of a single coherent price at any given time is a direct consequence of decentralization. Different dealers receive different information and price their securities accordingly. The lack of one price can present substantial arbitrage opportunities at high trading frequencies. Another consequence of decentralization is that the market-wide measure of volume at any given time in foreign exchange is not available. To monitor developments in foreign exchange markets, central banks conduct financial institution surveys every three years. These surveys are then aggregated and published by the Bank for International Settlements (BIS).

BIS estimates that the total foreign exchange (FX) market in 2007 had a daily trading volume of $3 trillion. This includes the spot market and forwards, futures, options, and swaps. The spot market accounts for about 33 percent of the total daily turnover or about $1 trillion. According to BIS Triennial Surveys, the proportion of spot transactions among all FX trades has been decreasing; in 1989, spot represented 59 percent of all FX trades. In 1998, spot accounted for only 40 percent of all FX trades. Of the $2 trillion of daily FX volume that is not spot, $1.7 trillion is contributed by FX swaps.

Some FX futures and options are traded on exchanges. Table 4.4 shows daily electronic trading volumes in most common foreign exchange futures on CME.

Foreign exchange markets profitably accommodate three types of players with distinct goals: high-frequency traders, longer-term investors, and corporations. The main objective of high-frequency traders is to capture small intra-day price changes. The main objective of longer-term investors is to gain from global macro changes. Finally, the main objective of corporate currency managers is usually hedging of cross-border flows against adverse currency movements—for example, a Canadian firm selling in the United States may choose to hedge its revenue stream by purchasing puts on USD/CAD futures. The flows of the three parties can be quite distinct, as Table 4.5 illustrates.

Table 4.5 reports summary statistics for EUR/USD order flows observed by Citibank and sampled at the weekly frequency between January 1993 and July 1999: A) statistics for weekly EUR/USD order flow aggregated across Citibank's corporate, trading, and investing customers; and B) order flows from end-user segments cumulated over a week. The last four columns on the right report autocorrelations i at lag i and ^-values for the null that (i = 0). The summary statistics on the order flow data are from Evans and Lyons (2007), who define order flow as the total value of EUR/USD purchases (in USD millions) initiated against Citibank's quotes.

Daily Dollar Volume in Most Active Foreign Exchange Products on TABLE 4.4 CME Electronic Trading (Globex) on 6/12/2009 Computed as Average Price Times Total Contract Volume Reported by CME

Currency

Futures Daily Volume (in USD thousands)

Mini-Futures Daily Volume (in USD thousands)

Australian Dollar

5,389.8

N/A

British Pound

1 7,575.6

N/A

Canadian Dollar

6,988.1

N/A

Euro

32,037.9

525.3

Japanese Yen

8,371.5

396.2

New Zealand Dollar

426.5

N/A

Swiss Franc

4,180.6

Summary Statistics of Weekly EUR/USD Order Flow observed by Citibank between January 1 993 and July 1 999

Summary Statistics (Citibank weekly EUR/USD order flow 1993-1999)

Autocorrelations Lag

Mean

Maximum

Skewness or

Order Flow

Standard

Minimum

Ku rtosis

1

2

4

8

-0.043

3.722

0.105

-0.061

0.027

0.025

-0.01 5

A: Total for EUR/USD

1.234

-3.71 5

3.204

(0.287)

(0.603)

(0.643)

(0.789)

B: EUR/USD Order Flows

per Customer Type

-16.774

549.302

-0.696

-0.037

-0.04

0.028

-0.028

(i) Corporate U.S.

108.685

-529.055

9.246

(0.434)

(0.608)

(0.569)

(0.562)

(ii) Corporate Non-U.S.

-59.784

634.918

-0.005

0.072

0.089

-0.038

0.103

196.089

-692.419

3.908

(0.223)

(0.124)

(0.513)

(0.091)

-4.1 19

1710.163

0.026

-0.021

0.024

0.126

-0.009

(iii) Traders U.S.

346.296

-2024.28

8.337

(0.735)

(0.602)

(0.101)

(0.897)

1 1.187

972.106

0.392

-0.098

0.024

0.01 5

0.083

(iv) Traders Non-U.S.

183.36

-629.139

5.86

(0.072)

(0.660)

(0.747)

(0.140)

(v) Investors U.S.

19.442

535.32

-1.079

0.096

-0.024

-0.03

-0.016

146.627

-874.1 5

1 1.226

(0.085)

(0.568)

(0.536)

(0.690)

1 5.85

1881.284

0.931

0.061

0.107

-0.03

-0.014

(vi) Investors Non-U.S.

273.406

-718.895

9.253

(0.182)

(0.041)

(0.550)

(0.825)

*Skewness of order flows measures whether the flows skew toward either the positive or the negative side of their mean, and kurtosis indicates the likelihood of extremely large or small order flows. Statistical properties of skewness and kurtosis are discussed in detail in Chapter 8.

*Skewness of order flows measures whether the flows skew toward either the positive or the negative side of their mean, and kurtosis indicates the likelihood of extremely large or small order flows. Statistical properties of skewness and kurtosis are discussed in detail in Chapter 8.

Daily Dollar Volume in Most Active Equity Futures on CME Electronic TABLE 4.6 Trading (Globex) on 6/12/2009 Computed as Average Price Times Total Contract Volume Reported by CME

Instrument

Futures Daily Volume (in USD thousands)

Mini-Futures Daily Volume (in USD thousands)

S&P 500

2,331.6

N/A

Nasdaq100

172.4

N/A

E-mini

2,300,537.2

N/A

E-Mid-cap

40,820.9

N/A

E-Nasdaq

515,511.8

N/A

Nikkei

56,570.3

N/A

GSCI

211.0

N/A

MSCI EAFE

24,727.7

2,126.9

Forex Trading Manual

Forex Trading Manual

In  any  business  or  moneymaking  venture,  preparation  and foreknowledge are the keys to success.   Without this sort of insight,  the  attempt  to  make  a  profitable  financial  decision can only end in disaster and failure, regardless of your level of motivation  and  determination  or  the  amount  of  money you plan to invest.

Get My Free Ebook


Post a comment