An Introduction to the Foreign Exchange Markets

The foreign exchange markets are unique in many respects. In contrast to the world’s equity and bond markets, the foreign exchange markets trade 24 hours a day, seven days a week, with more than $3.0 trillion in daily turnover.

Exchange rates between countries can be either flexible or fixed (or "pegged"), or somewhere in-between. An example of a flexible rate is the Japanese yen against the U.S. dollar; an example of a pegged rate is the Chinese yuan against the U.S. dollar. In a flexible exchange rate system, foreign exchange rates are determined in markets by interaction of suppliers and demanders of a currency. A market based exchange rate will change whenever the values of either of the two component currencies change. Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for a country’s money is linked to the country's level of business activity, gross domestic product (GDP), and overall economic conditions. The central bank of a country can play a role, adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

But the value of a country’s currency can also fluctuate due to speculative demand. Speculative demand for money is much harder for a central bank to control, especially with the money supply. Central banks often revert to other measures, such as changing the country’s interest rates. Many speculative investors will buy a currency if the return (that is the interest rate) is high enough, either because they are attracted to the higher interest income or because they believe others will be.

Any exchange rate can be expressed as either the foreign currency price of ones domestic currency (e.g., to U.S. investors the value of the U.S. dollar priced in Japanese yen) or the converse, the domestic currency price of the foreign currency (e.g., the value of the yen in dollars). In Parker Global Strategies’ papers and presentations, we typically use the first approach in order to make sense of appreciation and depreciation of the U.S. dollar. For example, we would typically state the dollar-yen exchange rate (as of April 2008) as "dollar-yen is trading at 103.50," "the dollar is 103.50 yen", or "USD/JPY is at 103.50."

Size and Scope of the Foreign Exchange Markets

According to the Bank of International Settlements, average daily turnover in traditional foreign exchange markets is estimated at $3.22 trillion. This turnover was broken down as follows:

$1,010 billion in spot transactions

$362 billion in forwards

$1,714 billion in FX Swaps

$129 billion estimated gaps in reporting

$2.1 trillion was traded in exchange-traded derivatives.

As to exchange-traded derivatives, futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded today on several exchanges throughout the world. Forex futures volume now accounts for about 7% of the total foreign exchange market volume.

The daily turnover of FX is roughly ten times that of the combined daily turnover on all the world’s equity markets, and exchange trading has more than doubled since 2001. This is largely due to the growing interest in foreign exchange as an asset class and an increase in activity from investment managers, hedge fund, pension funds, and sovereign wealth funds. The growth and popularity of execution systems, known as electronic trading platforms , has also made it easier for individual and retail traders to transact in the foreign exchange markets.

According to The Wall Street Journal Europe, the 10 largest dealers in the currency markets (typically large international banks ) accounted for 73% of all transactions in FX in 2005. These dealers provide the market with both bid (buy) and ask (sell) prices. The bid-ask spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.4200/1.4203 on a retail broker. Minimum trading size for most USD-based transactions is $1,000,000 of the currency, although $500,000 and $100,000 "lots" have become common.

Investment Opportunities and Types of Trading Styles

The Opportunities: The Five Drivers of FX Returns

PGS has identified five distinct sources of returns inherent in the foreign exchange markets. Although managers can be explained by these drivers, these drivers are not necessary "styles" in themselves, although managers may often be linked predominantly to one of these drivers.

1. Trend/Momentum

2. Value

3. Carry

4. Changes in Volatility

5. Short-Term Movement

The Various Styles of FX Managers

The following are some of the more common types of currency trading styles.

Carry strategies. These strategies essentially involve the selling of currencies offering low rates of interest relative to other currencies, and buying those with relatively high inherent interest rates.

Short-term trading strategies. Implementing positions that are generally offset within five trading days, often even intra-day.

Longer-term momentum strategies. Implementing positions that are generally offset after 5-7 trading days – possibly even months.

Volatility capture strategies. The practice of taking advantage of rises and declines in volatility, in addition to exchange rates themselves, typically achieved by trading currency options. A long position in a currency option will benefit not only from a movement of price in the desired direction but also a rise in market volatility (since part of an option’s price comes from how buyers and sellers of the option perceive volatility); a short seller of a currency option, in contrast, hopes that volatility decreases so that they can capture the option premium they collected – buying it back at a much lower price or letting it expire worthless.

Macro/Discretionary strategies. These are typically medium- to longer-term strategies based on market fundamentals, and are typically, but not always, discretionary. Value strategies look at many factors, but tend to be biased either toward "value" based on measures like purchasing power parity (PPP) or as measured by the ability of a currency to attract capital (e.g. balancing a country’s equity or bond market returns against risks such as inflation, volatility, or political instability).

Why a Multi-Manager Approach

The inherent leverage in an FX manager’s program allows the manager to be applied to an underlying portfolio on an overlay basis – with the ability for the exposure to be "dialed up and down" at the investor’s choice. A multi-manager solution, rather than a single manager solution, offers more diversification and raises the odds of stable returns.

Glossary

Major currencies. The US dollar, Japanese yen, the euro, the British pound, the Swiss franc, and the Swedish krona.

Non-Major currencies. Currencies that have the liquidity aspects of the Major currencies – i.e. where liquidity is generally available 24 hours a day on a continuous basis. These include the G-10 currencies, those of the Commonwealth countries, currencies of EU countries, as well as the currencies of South Africa and Mexico.

Developing currencies. The currencies of all other countries that are not Major or Non-Major currencies but have been deemed acceptable for trading by Parker Global Strategies, the FX manager, and the FX dealers and clearers, even though the liquidity of the these currencies’ markets may be more fragmented and non-continuous.

Currency pair. The two currencies in a particular exchange rate (e.g. the USD/JPY exchange rate is a pairing of the USD and JPY). A "developing market currency pair" is one where at least one side is a Developing currency; a "major currency pair" is one where both sides are Major currencies.

Pips. The smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100^th of one percent, or one basis point.

Purchasing power parity (PPP). The idea that, in the long run, identical products and services in two different countries should cost the same, and that the exchange rate between the countries will adjust to eliminate the ability to buy something in one country for less than you can sell it in another. (Most PPP models must take into effect real world factors such as transportation, transaction, tariff and other trade barrier costs – and cannot take into effect local monopolistic or consumer psychology factors.)

The smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100th of one percent, or one basis point.