financial market in the world.
These characteristics of the foreign exchange market – high liquidity, 24-hour trading and price fluctuation – are attractive to speculators and this explains why this market has become the largest in the world.
Currency pairs and ISO abbreviations
In the market, abbreviations are used to refer to the various currencies. These can be represented by commonly used symbols or three letter codes as set by the International Organization for Standardization (ISO). The following ISO codes are used in this book:
pound sterling (GBP)
US dollar (USD)
euro (EUR)
Swiss franc (CHF)
Japanese yen (JPY)
This group of currencies are generally referred to as the majors, based quite simply on the volumes transacted. The Australian dollar (AUD) is sometimes also included, although it normally comes under the commodity currency umbrella which includes Canada (CAD), New Zealand (NZD), South Africa (ZAR) and Norway (NOK).
In foreign exchange two currencies are always involved. The rate of exchange is the price of one currency in terms of another. For example, the relation of British pounds to US dollars will be shown as GBP/USD.
The size, scope and growth of the foreign exchange market
Market share by country
The foreign exchange market share by country can be seen in Table 3.1.
Table 3.1 – Foreign exchange market share by country in 2007 and 2010
The UK dominates foreign exchange trading, with a market share of 37% in 2010 (up from 35% in 2007). The growth in the UK becomes even more stark when compared with 1995 when its market share was 29%. The euro-zone’s market share has virtually halved since 1995 and now accounts for just 9%. The US accounted for 18% in 2010, which is broadly in line with the past ten years’ experience. The US is followed by Japan on 6%.
The other main trading centres, Singapore, Switzerland and Hong Kong, account for around 5% each with Australia accounting for 4%. A notable loser in recent years has been Japan, which has seen its share collapse from 10% in 1995, possibly reflecting a stagnant economy and banking problems.
Growth of foreign exchange trading
The pace of growth in foreign exchange trading has slowed in recent years, but the numbers are nonetheless impressive. Looking at the data in Table 3.2, the top row – Foreign exchange instruments – shows that overall turnover in the world markets in 2010 was up 18% on 2007 and over 300% since 2001. The growth was largely driven by spot transactions, which were up 48%, and by outright forwards, which increased by 31% from 2007 to 2010. These are referred to in the market as plain vanilla transactions by virtue of their simplicity.
Table 3.2 – Global foreign exchange market turnover by instrument
Source: BIS (Bank for International Settlements)
The figures show that spot trades account for 37% of transactions, which is similar to 1998 levels and up from 30% in 2007. This particular situation may be a result of the 2007-09 financial crisis, as company boardrooms might have been less inclined to use more sophisticated instruments and looked to take a more conservative approach.
The use of options fell to USD 207bn per day in April 2010, from USD 212bn in 2007, although one should not lose sight of the rapid growth in the preceding decade. The most actively traded instrument remains foreign exchange swaps, which were almost unchanged from 2007 to 2010 with daily turnover of USD 1.8trn. This reflects the critical role of swaps in the hedging process, which I shall be covering later.
Market share by currency
The currency distribution of global foreign exchange turnover shown in Table 3.3 comes as no surprise. As befits its reserve currency status, the dollar remains the most traded currency, accounting for 85% of all transactions. The euro and the yen account for 39% and 19% respectively.
Table 3.3 – Most traded currencies by market share
Emerging market (EM) currencies are still traded in relatively small size, accounting between them for less than 20% of total transaction volume. Notable within this group are India, Korea, Taiwan and China. EM is an area of expected growth for the future, especially if China adopts a flexible exchange rate system for the renminbi (CNY). In the 2010 figures USD/CNY accounted for only 0.8% of daily turnover.
Market share by currency pair
If one looks at currency pairs by market share (Table 3.4), EUR/USD dominates, accounting for 28% of market share, which is USD 1.1trn per day, up from USD 372bn in 2001. Market share has been around this level for the past ten years. The share of USD/JPY is 14%, but this appears to be on a declining trend having accounted for 19% in 1998. GBP/USD comes in at 9%, a level which has been remarkably steady over the past decade and leaves sterling as the fourth most traded currency, followed by AUD, CHF and CAD.
Table 3.4 – Most traded currency pairs by market share
Who trades foreign exchange?
The following is a list of the groups that trade foreign exchange and their main purposes in doing so.
Corporates, commodity trading accounts (CTAs)
Transactions are driven by:
payables
receivables
inter-company loans
dividends
royalties
acquisitions
divestitures.
Companies will need to record for accounting purposes the value of assets, liabilities and equity and reported income relating to overseas subsidiaries/investments. This is commonly referred to as ‘translation’ exposure. This exposure will be recorded in the financial statements as an exchange rate gain (or loss).
Portfolio fund managers
