US Foreign Exchange Market

INTERNATIONAL FINANCIAL MANAGEMENT ASSIGNMENT ON DEVELOPMENT OF FOREIGN EXCHANGE MARKET (U.S.)

SUBMITTED BY: P.RAMYA DEEPTI AMANPREET KAUR RISHA BANSAL ISHU PORWAL NISHA RAILAN ANUJ CHAUHAN

INTRODUCTION

In today’s world no economy is self sufficient, so there is need for exchange of goods and services amongst the different countries. So in this global village, unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries. So whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. So we can imagine that if all countries have the same currency then there is no need for foreign exchange.

The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment, by enabling currency conversion. For example, it permits a business in the United States to import goods from the United Kingdom and pay pound sterling, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of      

its huge trading volume representing the largest asset class in the world leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit and loss margins and with respect to account size.

HOW FOREIGN EXCHANGE TURNOVER HAS GROWN:

In 1998, the Federal Reserve’s most recently published survey of reporting dealers in the United States estimated that foreign exchange turnover in the U.S. market was $351 billion a day, after adjustments for double counting. That total is an increase of 43% above the estimated turnover in 1995 and more than 60 times the turnover in 1977, the first year for which roughly comparable survey data are available.

In some ways, this estimate understates the growth and the present size of the U.S. foreign exchange market. The $351 billion estimated daily turnover covered only the three traditional instruments in the “over-the-counter” (OTC)market—spot, outright forwards, and foreign exchange (FX) swaps; it did not include over-the counter currency options and currency swaps traded in the OTC market, which totaled about $32 billion a day in notional value (or face value)in 1998. Nor did it include the two products traded, not “over-the-counter,” but in organized exchanges— currency futures and exchange-traded currency options, for which the notional value of the turnover was perhaps $10 billion per day.

The global foreign exchange market also has shown phenomenal growth. In 1998, in a survey under the auspices of the Bank for International Settlements (BIS), global turnover of reporting dealers was estimated at about $1.49 trillion per day for the traditional products, plus a additional $97 billion for over-the-counter currency options and currency swaps, and a further $12 billion for currency instruments traded on the organized exchanges. In the traditional products, global foreign exchange turnover, measured in current exchange rates, increased by more than 80 percent between 1992 and 1998.

The expansion in foreign exchange turnover, in the United States and globally, reflects the continuing growth of international trade and the prodigious expansion in global finance and investment during recent years. With respect to trade, the dollar value of United States international transactions in goods and services—the sum of exports and imports— tripled between 1980 and 1995 to around 15 times its 1970 level. International trade in the global economy also has expanded at a rapid pace. World merchandise trade is now more than 2½ times its 1980 level (Figure 1-1).

FIGURE -1

FIGURE -2

But international trade cannot account for the huge increase in the U.S. foreign exchange turnover over the past twenty-five years. The enormous expansion of international capital transactions, both here and abroad, has been a dominant force. U.S. international capital inflows, including sales of U.S. bonds and equities to foreigners, acquisition of U.S. factories by foreigners, and bank deposit inflows, have averaged more than $180 billion per year since the mid-80s. Large and persistent external trade payments deficits in the United States and corresponding surpluses abroad have contributed to the growth in financing. Through much of the period since 1983, the United States has recorded trade deficits in the range of $100-$200 billion per year, while Japan and, to a lesser extent, Germany have registered substantial trade surpluses. In contrast, all three countries experienced only modest trade deficits or surpluses through the 1960s and early 1970s.

FIGURE -3

The internationalization of financial activity has increased rapidly. Cross-border bank claims are now nearly five times the level of 15 years ago; as a percentage of the combined GDP of the OECD countries, these claims have risen from about 25 percent in 1980 to about 42 percent in 1995. During that same period, crossborder securities transactions in the three largest economies—United States, Japan, and Germany—expanded from less than 10 percent of GDP to around 70 percent of GDP in Japan and to well above 100 percent of GDP in Germany and the United States (Figure 1-2). Annual issuance of international bonds has more than quadrupled during the past ten years (Figure 1-2).

Between 1988 and 1993, securities settlements through Euroclear and Cedel—the two main Euro market clearing houses— increased six-fold. All of this provided fertile ground for growth in foreign exchange trading.

CURRENT SCENARIO: The US foreign exchange market forms a substantial portion of the U.S. economy. This market is one of the most important sources of revenue for the United States government. The official currency of the United States is the U.S. dollar. According to the ISO 4217 code, the U.S. dollar is represented or symbolized as USD. It is also symbolized as $ or US$. Currently, the United States dollar is the most accepted form of foreign exchange on the global foreign exchange market, and it ranks as one of the five principal currencies of the world. Numerous countries utilize the U.S. dollar as their functional currency, a process frequently called official dollarization. The Federal Reserve Bank of the United States regulates the country's foreign exchange market. It also holds the sole authority to issue the U.S. dollar banknotes and coins. The U.S. dollar is considered to be the standard unit or medium of foreign exchange for the global foreign exchange sector because of its high volume of liquidity and global recognition. At present, the United States dollar is facing stiff competition from the Euro, andranks second after the Euro as the most important international reserve currency. The functions of the US foreign exchange market are carried out by a number of institutions:         

Commercial banks Central banks Foreign exchange dealers Retail foreign exchange brokers Commercial institutions Investment management firms Hedge fund institutions Multinational corporations or MNCs Retail foreign exchange traders New York is an important foreign exchange trading center in the United States. The leading foreign exchange brokerage firms of the world have their headquarters

located there. The United States Commodity Futures Trading Commission is responsible for regulating different foreign exchange trading firms conducting businesses in the United States. The U.S. foreign exchange market is also known as U.S. forex market and is an over-the-counter (OTC) market because the transactions are carried out with the direct involvement of forex buyers and sellers. The exchange rate of the U.S. dollar with respect to other foreign currencies is determined by the Federal Reserve. Both the Federal Reserve and the United States Treasury Department play a significant role in the U.S. foreign exchange market. The Federal Reserve Bank is primarily responsible for formulating the foreign exchange policies of the country.