TOPIC : The Foreign Exchange Market

CONTENTS

Assessment Criteria Page Number

(a) Introduction 2-3

(b) Literature Review 4-9

(c) Conclusion and Recommendations 10-11

(d) References 12-14

(a) Introduction

The foreign exchange market (Forex), or so called currency market is a market available for the

trading of one type of currency with another. Foreign exchange market works slightly differently

with stock market. Investors need some money in order to exchange with something valuable

(stocks) in the stock market. However, there will always be transactions involving two different

currencies in foreign exchange market, like USD (US Dollar) and MYR (Malaysian Ringgit).

Forex itself is a virtual marketplace which gathers all buyers and sellers of currencies all over the

world, and this explains why forex has huge volume of transactions per day.

Forex involves many participants to act in the market such as governments, central banks,

commercial banks, multinational corporations and other financial markets and institutions. There

are different purposes for each party to engage in Forex. For example, central banks attempts to

maintain value of currency in own country through acquiring and selling the foreign reserves in

the market. On the other hand, corporations involve in foreign exchange market to make

arbitrage profit from the forex transaction, as well as a mean to hedge potential foreign exchange

risk in the company. Forex is unique because of its continuous 24-hour operation per day (except

weekends and holidays), its geographical dispersion, the variety kinds of market traders, as well

as its large trading volume. Forex involves brokers or dealers negotiate directly with one another

through over-the-counter market. In addition, the forex transactions can be divided into two basic

forms, which are spot transactions and forward transactions. Spot transactions refer to

transactions which are carried out immediately. Trades which are settled on the spot, or future

transactions which cease in the current month are categorised as spot transactions (Spot Trade,

n.d.). These transactions normally explain the instantaneousness of the foreign exchange market.

The second type of transaction is forward transactions. In this transaction, trade does not settled

immediately, until some agreed upon future date. This transaction is negotiable between the

traders, and the transactions must be made on the agreed date and agreed exchange rate,

regardless of the rate determined by the market at that time.

There are three major functions brought by foreign exchange market: transfer function, credit

function and hedging function (Chand, n.d.). Forex is all about using one currency in exchange

of another currency desired. Currency resembles purchasing power of individuals (i.e.

individuals use currency to purchase goods and services). Transfer of purchasing power takes

place between two parties through several credit instruments: telegraphic transfers (TT), bank

draft (B.D.) and foreign bills. The second function of foreign exchange market is providing

credit for international trades. Specifically, foreign bill of exchange is one of the instruments

used in foreign exchange market. They normally have a maturity period of three months. They

are essential in acting as credit for international traders to possess and sell the goods, before

paying off the bill using the profit obtained. Last but not least, foreign exchange market performs

the hedging function as well. In forex context, hedging provides as a mean of reducing foreign

exchange risk as much as possible. Hedging can be done by equating assets and liabilities in

foreign currencies to reduce the losses as a result of future fluctuations in exchange rate. Traders

will enter into forward contract, which would provide protection in case of adverse changes in

exchange rate.

We have several rationales in studying foreign exchange market. Firstly, this report is to explore

several key features in the foreign exchange market. Attributes like efficiency, arbitrage,

exchange rate determination, operations and liquidity are to be pondered in this report. These

aspects should not be missed out as they are indispensable in explaining the behaviour of foreign

exchange market. Secondly, through literature review, this report is to reveal current issues

underlying in this market. Issues like operations, participants, efficiency, liquidity,

profit/arbitrage and others are to be discussed further later, before recommendations are given.

(b) Literature Review

Several features and issues are to be discussed in this section: operations, participants, efficiency,

liquidity, volatility, profit/ arbitrage opportunity, and other issues raised by researchers.

Operations

Foreign exchange market involves buying and selling of currencies. Exchange rate is determined

by price of one currency in terms of another currency. Foreign exchange market is the largest

financial market in the world. Its daily trading volume could reach up to $4.0 trillion on average

in year 2010, as compared with trades in New York Stock Exchange (NYSE) which worth $4.7

billion on average per day (Treepongkaruna et al., 2014). This implies there are many buyers and

sellers trading own currencies for desired currencies in the market. In terms of country, United

Kingdom has the largest foreign exchange market in the world, followed by United States and

Japan. This fact could show that most foreign exchange market participants are from Europe,

United States and Japan. There are three currency pairs which form up to 60% of the actively

traded currency pairs in foreign exchange market: EUR/USD, USB/JPN and GBP/USD (Tenku

Nur Shahrul Hizam YM Tengku Izham & Md. Aminul Islam, 2015). Out of all foreign exchange

instruments, foreign exchange swap takes a lion share in the market, which is 42% of

instruments traded in market.

Countries like New Zealand and Australia open the foreign exchange market earlier than other

countries, in terms of GMT1-based trading day (Treepongkaruna et al., 2012; Tenku Nur Shahrul

Hizam YM Tengku Izham & Md. Aminul Islam, 2015). The sequence then will be followed by

Japan, Asia region, Middle East, Europe region, and United States. Highest volume of trades in

global foreign exchange market may be observed within the time period between 1:00pm to

5:00pm in GMT. Most of the market makers and institutional investors in the world would

engage in foreign exchange trading during the period. Foreign exchange market itself adopts

decentralization (Treepongkaruna et al., 2014; Rosov & Foster (2014); Tenku Nur Shahrul

Hizam YM Tengku Izham & Md. Aminul Islam, 2015). There is no physical location for

1 GMT stands for Greenwich Mean Time, the mean solar time based at Greenwich, London, which is adopted as the

global time standard worldwide.

establishing foreign exchange market; it exists virtually, with buyers and sellers of currencies

connect through the platform for doing foreign exchange transactions. Traders could get

information on quotes via three channels: telephone, telex and computer screens (Reuters and

Bloomberg).

There are two categories under the foreign exchange market: retail market and interdealer market

(Rosov & Foster, 2014). Retail market includes those individual and corporate customers who

settle transactions with brokers or bank, whereas interdealer market refers to interactions

between interdealer broker and institutions for financial, and perhaps non-financial. Trades in

retail market are known as anonymous trading, as they remain unknown outside individual

banks. Retail market, is therefore, deemed opaque. This does not happen in interdealer market,

whereby quotes could be identified from other dealers and infer activities. According to

Treepongkaruna et al. (2014), interbank market constitutes 86% of the entire foreign exchange

market, whereas 14% is for the retail market.

Participants

There are five major participants identified from foreign exchange market: central banks, bank

and non-bank dealers, foreign exchange brokers, individual and corporate customers, and

speculators and arbitrageurs (Treepongkaruna et al., 2014; Tenku Nur Shahrul Hizam YM

Tengku Izham & Md. Aminul Islam, 2015; Katusiime et al., 2015).

Central banks participate in foreign exchange market to ensure the stability of their own currency

value and exchange rate. When necessary, central banks would either buy or sell the foreign

exchange reserves in the market. This is to retain the power of the currency and strength of

exchange rate. Dealers of bank and non-bank, on the other hand, are termed as market makers

in the foreign exchange market. They normally specialize in certain currencies, and buy and sell

those currencies in order to retain their inventory position in such currencies. Brokers are

responsible in providing platform for foreign exchange traders in exchange of one currency for

another currency. Individual and corporate customers involve in foreign exchange market due to

in need of foreign currencies for international trade, purchase of foreign goods and services, and

other activities which use foreign currencies as the medium of exchange. Speculators and

arbitrageurs are in view of gaining profits due to short-term exchange rate volatility. The only

feature makes arbitrageurs differentiate from speculator is the arbitrageurs may involve in two or

more different markets.

Efficiency

To date, many researchers have found that efficiency of foreign exchange market has been

enhanced (Neely et al., 2009; Ahmad et al., 2012; Lee & Sodoikhuu, 2012; Treepongkaruna et

al., 2012; Katusiime et al., 2015). Researchers suggest there are four major aspects which lead to

great efficiency in foreign exchange market nowadays: transaction costs, inflation effect,

informational flow, and unpredictability feature in foreign exchange market.

Transaction costs, which are considered during the trading of currencies, decrease the

profitability of currency trading., and eventually makes foreign exchange market become more

efficient (Lee & Sodoikhuu, 2012; Katusiime et al., 2015). Transaction cost in foreign exchange

market could be observed through combination of brokers commission and bid-ask spreads

(difference between price that buyer willing to pay and price that seller willing to sell for).

Increase in efficiency of foreign exchange market may due to lower inflation as well, as what

have been suggested by Owen & Palmer (2012). Low inflation rate (with holding other variables

constant) could imply that profit reaped from foreign exchange market decreases, due to lower

return in trading the currency in the market. Market is then to be deemed as efficient. On the

other hand, traders could make profit easily during the high inflation period (Owen & Palmer,

2012).

Efficient Market Hypothesis (EMH) is practiced in foreign exchange market, in which any

information raised would quickly incorporate into the prices and quotes. When the informational

efficiency occurs, quoted by Hallword & MacDonald (1994), which are cited by Lee &

Sodoikhuu (2012), traders of foreign exchange market could impossibly make a speculative

profit. The entire foreign exchange market would be immediately incorporated with the

information around the 24-hour trading day (Treepongkaruna et al., 2012). On top of that,

foreign exchange market follows random-walk behaviour, in which patterns in foreign exchange

market is unforeseeable. Unless there are complex and sophisticated trading strategies, otherwise

traders could hardly make profits. There are various factors surrounding foreign exchange

market: economic condition, legal requirements and restrictions, government policies and so on.

For example, Ahmad et al. (2012) found that countries in Asian region could withstand the Asian

Financial Crisis 1997 and Global Financial Crisis 2009, and remain the efficiency of foreign

exchange market in Asia. Random-walk behaviour in market well explains why returns obtained

from foreign exchange market decline over time (Neely et al., 2009).

Liquidity

Liquidity is essential in trading currencies as it views the ability of buying and selling currencies

in a vast amount and within quick pace (Chen et al., 2012). There are several types of

measurement for liquidity, which are price impact, return reversal, bid-ask spread, price

dispersion, and trading density (Chen et al., 2012; Mancini et al., 2013).

Price impact refers to the illiquidity due to the asymmetric information concealed within the

foreign exchange market. When more asymmetric information is in the market, it would prompts

more excess return for traders, which implies illiquidity of market exists (Vayanos & Wang,

2012). Return reversal views that existence of inventory risks and transaction costs lead to

liquidity of the market to be diminished. Bid-ask spread is a measure of liquidity, whereby itself

consists cost aspect of illiquidity (liquidity risk premium). Price dispersion provides a mean of

volatility in the foreign exchange market, whereby more compensation for liquidity risk is

needed by market makers when price dispersion increases. High volatility normally frightens

most traders to transact in the market further according to behavioural finance, due to the fact

that investors hate of the loss incurred in the high-volatile market, and thus implies low liquidity

in the market (Mancini et al., 2013). Trading density, on the other hand, plays essential role in

explaining the liquidity of foreign exchange market. When the trading density is considerable

enough, foreign exchange rates would be incorporated easily with much liquid information

(Chen et al., 2012). Even though the trading density is low, Chen et al. (2012) still suggest that

exchange rate determined is liquid enough as well. Mancini et al. (2013) proposes one way to

check whether such currency is prone to liquidity risk: interest rate of one country. When the

country is having higher interest rate, such countrys currency is easier to have liquidity risk, and

the vice versa is also true. Economic condition as well, decides the liquidity of currencies.

Liquidity of currencies will decrease during turbulent period (e.g. financial crisis), as most

traders would behave reservedly in currency trading (Mancini et al., 2013).

Profit/ Arbitrage

As mentioned in previous section which foreign exchange market follows random-walk

behaviour, reaping profit is in a great unpredictable state. However, researchers suggest that

foreign exchange market is still volatile enough to provide profits for the wise investors. Owen &

Palmer (2012) explain how traders could earn profit from foreign exchange market through

market inefficiency and foreign exchange volatility. Sophisticated technical analysis is a must to

outperform the market, such as momentum trading strategy when great exchange rate volatility

happens. Technical analysis could be helpful especially when foreign exchange market is in

weak-form efficiency (Quintanilla Garca et al., 2012). Several proponents of using technical

analysis to take advantage in foreign exchange market are Neely et al. (2009) and Della Corte et

al. (2011). However they have recommended different ways to gain profit in foreign exchange

market.

Several Technical Trading Rules (TTRs) have been recommended by Neely et al. (2009) for

trading in foreign exchange market. Firstly, foreign exchange portfolio should be created with

having optimal weights adhere the stock portfolio. Such weights should be less volatile than and

loosely correlated to the stock market. Secondly, foreign exchange trading strategies like channel

rules, Autoregressive Integrated Moving Average (ARIMA) and Markov model are to be

pondered. On the other hand, Della Corte et al. (2011) believe that carry trade in volatility (CTV)

strategy is a better tool to snatch profits in foreign exchange market. CTV strategy is different

form carry trade in currencies (CTC) strategy, whereby the former strategy accentuates on

returns to volatility, as the latter focuses on the returns to currency speculation. CTV strategy

considers on the transaction costs effect, which might drive the volatility in foreign exchange

market. Results in Della Corte et al. (2011) suggest that Forward Volatility Unbiased Hypothesis

(FVUH) could be overwhelmed by the CTV strategy. FVUH, which suggests the forward

implied volatility conditional on todays information is an unbiased prediction of future spot

implied volatility, is denied by the CTV strategy. CTV strategy proves that current implied

volatility may overestimate the future implied volatility. With the usage of CTV strategy, traders

could earn more profit than in FVUH.

Other Issues Raised by Researchers

Volatility in foreign exchange market might trigger the speculative attack on the market

(Katusiime et al., 2015). This fact is reflected during the Asian Financial Crisis 1997, whereby

the speculation on currencies happens as the exchange rate became unstable. This is supported

by Treepongkaruna et al. (2012), whereby such volatility might have spillover effect across the

Asian currencies. Entry costs and Tobin tax, which intend to reduce the volatility of foreign

exchange market, is rebutted by Shi & Xu (2009). Results imply the reverse effect, whereby both

aforementioned costs has no change on, or even increase the volatility of the foreign exchange

market. At the meanwhile, Consumer Sentiment Index (CSI) has influence on the currency of

one nation (Akhtar et al., 2011). This index views on how consumer generally appraises the

future economic condition, household financial situation and buying powers. CSI has

depreciating effect on the Australian Dollar, when an announcement of lower current month CSI

compared to previous CSI is made. Nevertheless, positive news of CSI does not enhance the

value of Australian Dollar.

(c) Conclusions and Recommendations

After reviewing all the journal articles provided, we have found out several issues are raised on

the foreign exchange market. Therefore, several recommendations are made which might be

helpful in enhancing the foreign exchange market.

Policymakers must always ensure that the value of their nations currency is stable and not easily

to be speculated. Heavy speculative attack towards ones currency would bring commotion over

the financial system of such nation, or may even bring up spill-over effect over other countries

within such region. This has been reflected from the incident of Asian Financial Crisis 1997,

whereby the crash in the value of Thai Baht eventually affected most countries in Asia (Ten

Years On, 2007). To prevent heavy speculations in currency market, policy makers should

frequently improve the efficiency state of the market. One of the ways suggested by Ahmad et al.

(2012) is that free-float foreign exchange regime tends to enhance the efficiency of foreign

exchange market. As compared to country adopting fixed exchange rate regime, foreign

exchange market in free-float regime tends to be more resilient to crisis. Macroeconomic

variables are the major sources to determine the exchange rate under this regime; hence it is quite

hard for traders to speculate in foreign exchange market under this regime. However, policy

makers should bear in mind that volatility under this free-float regime is higher than in the fixed

exchange regime. Reducing volatility of foreign exchange market should also be one of the

efforts of policy makers. Macroeconomic issues like high inflation rates and high unemployment

rates may be worsen due to free-float regime (Eun & Resnick, 2009). Policy makers should

review aspects like current macroeconomic conditions, stability of currency, country-specific

characteristics and others before changing to new exchange rate regime.

For traders who are eager to earn arbitrage profits from currency markets, technical analysis

might be helpful in market which has weak-form efficiency. Based on articles reviewed in

previous section, sophisticated trading tools like momentum trading strategy, carry trade

strategy, Markov model, ARIMA model can assist foreign exchange traders in reaping profits.

Due to the fact that markets under weak-form efficiency has somehow predictable exchange rate

movements, technical tools can evaluate those movements and traders can determine to which

extent they could earn, and when they should trade so that profit could be promised. However,

traders could hardly gain in markets under semi-strong and strong form of efficiency. These

markets follow random-walk behaviour, and any new information incorporates quickly into the

price and exchange rate. Therefore, traders do not normally obtain abnormal profits from these

markets. For example, pointed by Ahmad & Wong (2013), foreign exchange markets in

European region are normally too efficient enough for foreign exchange traders to earn a penny.

In short, we have reviewed several journal articles, and aspects under foreign exchange market

are to be concerned, like operations, participants, efficiency, liquidity, profit/arbitrage, as well as

other issues raised by the researchers. Furthermore, several recommendations have been made.

Hopefully this conceptual paper could provide some insight on foreign exchange market, as well

as ignite interests of researchers, policy makers, traders and other participants of the foreign

exchange market.

(d) References

Ahmad, R., Rhee, S.G., & Wong, Y.M. (2012). Foreign exchange market efficiency under recent

crises: Asia-Pacific focus. Journal of International Money and Finance, 31, 1574-1592.

Ahmad, R. & Wong Y.M. (2013). Foreign Exchange Market Efficiency under Recent Crises:

Evidence from the European Markets. Paper prepared for the submission to the European

Financial Management Association (EFMA) 2013 Annual Meeting.

Akhtar, S., Faff, R., & Oliver, B. (2011). The asymmetric impact of consumer sentiment

announcements on Australian foreign exchange rates. Australian Journal of

Management, 36(3), 387-403.

Chand, S. (n.d.). Foreign exchange market and its important functions. Retrieved January 31,

2015, from http://www.yourarticlelibrary.com/foreign-trade/foreign-exchange-market-

and-its-important-functions/26067/

Chen, S., Chien, C.C., & Chang, M.J. (2012). Order flow, bid-ask spread and trading density in

foreign exchange market. Journal of Banking & Finance, 36, 597-612.

Della Corte, P., Sarno, L., & Tsiakas, I. (2011). Spot and forward volatility in foreign exchange.

Journal of Financial Economics, 100, 496-513.

Eun, C. S., & Resnick, B. G. (2009). International financial management (5th ed.). New York:

McGraw-Hill Irwin.

Katusiime, L., Shamsuddin, A., & Agbola, F.W. (2015). Foreign exchange market efficiency and

profitability of trading rules: Evidence from a developing country. International Review

of Economics and Finance, 35, 315-322.

Lee, H.Y. & Sodoikhuu, K. (2012). Efficiency tests in foreign exchange market. International

Journal of Economics and Financial Issues, 2(2), 216-224.

Mancini, L., Ranaldo, A., & Wrampelmeyer, J. (2013). Liquidity in the foreign exchange market:

measurement, commonality, and risk premiums. The Journal of Finance, 68(5), 1805-

1841.

Neely, C.J., Weller, P.A., & Ulrich, J.M. (2009). The adaptive market hypothesis: evidence from

the foreign exchange markets. The Journal of Financial and Quantitative Analysis, 44(2),

467-488.

Owen, A.L. &Palmer, B. (2012). Macroeconomomic conditions and technical trading

profitability in foreign exchange markets. Applied Economics Letters, 19, 1107-1110.

Quintanilla Garcia, B., Tllez Gaytn, J.C., & Wolfskill, L.A. (2012). The role of technical

analysis in the foreign exchange market. Global Journal of Business Research, 6(3), 17-

22.

Rosov, S. & Foster, F.D. (2014). Measuring the information content of customer foreign

exchange orders. Australian Journal of Management, 39(2), 247-264.

Shi, K. & Xu, J. (2009). Entry cost, the Tobin tax, and noise trading in the foreign exchange

market. The Canadian Journal of Economics, 42(4), 1501-1526.

Spot Trade. (n.d.). Retrieved January 31, 2015, from

http://www.investopedia.com/terms/s/spottrade.asp

Ten years on: How Asia shrugged off its economic crisis (2007, July 4). Retrieved February 28,

2015, from: http://www.economist.com/node/9432495

Tenku Nur Shahrul Hizam YM Tengku Izham & Md. Aminul Islam (2015). Microstructure of

foreign exchange market in Malaysia. The Social Science, 10(1), 6-12.

Treepongkaruna, S., Brailsford, T., & Gray, S (2014). Explaining the bid-ask spread in the

foreign exchange market: A test for alternate models. Australian Journal of Management,

39(4), 573-591.

Treepongkaruna, S., Brooks, R., & Gray, S. (2012). Do trading hours affect volatility links in the

foreign exchange market? Australian Journal of Management, 37(1), 7-27.

Vayanos, D. & Wang, J. (2012). Liquidity and asset returns under asymmetric information and

imperfect competition. Review of Financial Studies, 25(5), 1339-1365.