MAGYAR NEMZETI BANK. MNB Handbooks. No. 7. November Péter Kálmán Eszter Makay Daniella Tóth. Foreign Exchange Market - PDF

MAGYAR NEMZETI BANK MNB Handbooks No. 7. November 2016 Péter Kálmán Eszter Makay Daniella Tóth Foreign Exchange Market MNB Handbooks Péter Kálmán Eszter Makay Daniella Tóth Foreign Exchange Market MAGYAR

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MAGYAR NEMZETI BANK MNB Handbooks No. 7. November 2016 Péter Kálmán Eszter Makay Daniella Tóth Foreign Exchange Market MNB Handbooks Péter Kálmán Eszter Makay Daniella Tóth Foreign Exchange Market MAGYAR NEMZETI BANK MNB Handbooks Foreign Exchange Market Written by Péter Kálmán, Eszter Makay, Daniella Tóth (Directorate Monetary Policy and Financial Market Analysis, Magyar Nemzeti Bank) This Handbook was approved for publication by Barnabás Virág, Executive Director Published by the Magyar Nemzeti Bank Publisher in charge: Eszter Hergár H-1054 Budapest, Szabadság tér 9. ISSN (Print) ISSN (Online) Contents 1 Introduction 5 2 Presentation of the foreign exchange market The significance of foreign exchange market to monetary policy Segments of the foreign exchange market based on BIS data, the HUF foreign exchange market in an international comparison 7 3 Theoretical frameworks Exchange rate theories and exchange rate regimes Foreign exchange market liquidity dimensions and transaction types 21 4 Foreign exchange market analysis in central bank practice What are the dimensions for examining the Hungarian foreign exchange market? Historic developments in the forint exchange rate and the relevant market expectations Market players and trading strategies Brief presentation of sub-markets based on the MNB s data supply 41 5 References 46 6 Annex 49 1 Introduction Foreign currency is a receivable pertaining to a specific foreign legal tender, and the exchange of foreign currencies represents the world s largest financial market (with daily turnover of USD 5.1 trillion according to the latest BIS survey 1 ). Foreign currency can be traded on the spot market or on the derivatives market for the specific currency (such as the forward market, options etc.). There is continuous trading on both the spot and derivatives markets at global financial centres 24 hours a day, five days a week. In a small, open economy, the exchange rate plays an important role in monetary policy, amongst other roles. Understanding the functioning of foreign exchange markets is also important in terms of monetary policy and financial stability, and may be the subject of even more attention during crises. This Educational Booklet endeavours to summarise the MNB s focus on foreign exchange markets, presents the characteristics of these markets, the main theories describing exchange rate developments and the tools used by the Magyar Nemzeti Bank to identify and monitor exchange rate movements. 1 Introduction 5 2 Presentation of the foreign exchange market 2.1 The significance of foreign exchange market to monetary policy The National Assembly defined the objectives of the MNB in Article 3 of Act CXXXIX of 2013 on the Magyar Nemzeti Bank. The primary objective of the MNB is to achieve and maintain price stability. Without prejudice to its primary objective, the MNB supports the maintenance of the stability of the financial intermediary system, the enhancement of its resilience and its sustainable contribution to economic growth; furthermore, the MNB supports the economic policy of the government using the instruments at its disposal. Chart 1 Schematic overview of the exchange rate channel CENTRAL BANK MONEY MARKETS COMMODITY MARKET SECTOR PRICES AGGREGATE OUTPUT AND PRICES Monetary and credit aggregates Monetary policy steps: actual and expected Market interest rates Asset prices Aggregate demand Prices of domestic goods Aggregate output Exchange rate Prices of imported goods Aggregate level of prices Source: MNB: Monetary policy in Hungary (2012) In a small, open economy such as Hungary, the exchange rate channel is one of the elements of monetary policy transmission. By changing the interest rate of Hungary s main policy instrument (the three-month deposit), the MNB also shapes market participants forint demand, and the exchange rate may shift accordingly. A potential sustained and significant depreciation of the forint may exacerbate inflationary pressure through imported inflation 6 MNB Handbooks Foreign Exchange Market and simultaneously increase the competitiveness of exports. Corporations producing for the domestic market whose products compete with imported goods (e.g. durable consumer goods) may partly adjust their prices to their competitors, resulting in an increase in the price of these domestic products. The rise in import costs may also be reflected in finished goods produced in Hungary. Changes in the exchange rate also impact aggregate demand. In the event of a high volume of foreign currency debt, depreciation of the exchange rate may hold back consumption and investment, and thus restrain demand-side inflation by increasing debtors repayment burdens. It may also have an adverse impact on the banking system s stability and consequently, on financial stability, by increasing the ratio of defaulting debtors (credit losses, capital requirement). At the same time, in the wake of the forint conversion of foreign currency loans and pillar II of the Funding for Growth Scheme (FGS), the potential impact of this channel has decreased and is now essentially limited to the remaining foreign currency loans. Hence, changes in the forint exchange rate exert a complex impact via multiple channels on the central bank s main functions, making its analysis a priority. The stable functioning and sufficient liquidity of the foreign exchange market are pivotal for the MNB, as the impacts of fundamental shocks during crises may be exacerbated if liquidity is insufficient. In addition, monetary policy measures are better able to exert an impact on liquid markets. Understanding the functioning of foreign exchange markets during crises is particularly important in order to give the central bank up-to-date information on when and how to react in the event of turmoil. In summary, inflation, stability, liquidity and real economic risks all warrant the monitoring of domestic foreign exchange markets by the MNB. 2.2 Segments of the foreign exchange market based on BIS data, the HUF foreign exchange market in an international comparison The foreign exchange market in the broader sense (including both spot and derivative transactions) is the world s largest financial market, with continuous Presentation of the foreign exchange market 7 trading across different geographic locations (London, New York, Tokyo, and Frankfurt). Daily turnover in net terms averages USD 5-6 trillion, per cent of which consists of spot transactions and the remainder of derivative transactions (forward contracts, options, currency swaps, cross-currency interest rate swaps). The foreign exchange market is an OTC (over the counter) market subject to only little regulation, so market makers execute personalised transactions. Trade between market makers (the largest global bank traders) makes up much of the turnover, while the remainder consist of client transactions. Trading between market makers may be either direct (via telephone or Reuters Dealing) or indirect (via voice broker or Reuters Spot Matching). The former is a bilateral and less transparent, while the latter is a multi-player, transparent form of trading which all participants can monitor in real time. In the 2000s, with the spread of electronic trading, emphasis shifted progressively from telephone-based transactions to transactions concluded on electronic platforms. Market volumes also increased in parallel with the rise in electronic trading. In Hungary, country-specific factors also contributed substantially to this trend: the lifting of exchange controls (2001), accession to the EU (2004) and foreign currency lending. Information on the international situation of the foreign exchange market can be obtained from dealing systems and the BIS survey published every three years. In terms of the Hungarian market, information can also be gained from the daily data supply by banks to the MNB on foreign exchange market transactions. We will address the trends in the central bank data in a separate chapter due to its significance (4.4 Brief presentation of sub-markets based on the MNB s data supply). The latest BIS report based on data from April 2016 revealed that the three currency pairs with the highest turnover remain the EUR/USD (representing a share of 23 per cent), the USD/JPY (17.7 per cent) and the USD/GBP (9.2 per cent). By comparison, the EUR/HUF currency pair accounts for 0.1% of the total market. The majority of trading is still conducted in USD on foreign exchange markets, with the currency accounting for one side of 88% of all transactions, while the euro accounts for 32% and the yen for 22%. 2 Next is the British pound (12%) and the Australian dollar (7%). On balance, the foreign exchange market is 2 The currencies comprise both sides of transactions, so total transactions amount to 200% in proportion to net turnover. 8 MNB Handbooks Foreign Exchange Market concentrated based on denomination, as well as based on geography: in terms of the location of transactions, almost half of all transactions are concentrated in the UK and the US. In addition, 77% of trading takes place in the five largest foreign exchange market centres (the UK, the US, Singapore, Hong Kong, Japan). Based on transaction type, spot transactions and FX swaps account for the lion s share of turnover. The latter is a foreign currency liquidity management tool used by international investors and a tool used for hedging banks open foreign currency positions. In terms of trading method, electronic platforms dominate trading (posting more than two thirds of spot transactions), but voice-based (telephone) transaction conclusion remains significant. 3 Chart 2 Gross daily foreign exchange market turnover by transaction type, in a breakdown by denomination (BIS, April 2016) 4,000 Billion USD 3,500 3,000 2,500 2,000 1,500 1, USD EUR JPY GBP Spot Forward FX-swap Cross-currency IRS Option Source: BIS, MNB 3 The latest source of data is the BIS report based on April 2013 data. Presentation of the foreign exchange market 9 From Hungary s perspective, countries forming a basis of comparison are also given special focus, in addition to global foreign exchange developments. These comparison groups are compiled based on the currencies traded jointly by an FX desk or based on macroeconomic developments. They deserve particular attention because, in managing their portfolios, investors trade with the regions and country groups (handling countries individually within these groupings), so any significant discrepancy from the group may trigger a change in investor sentiment. Hungary s foreign exchange market developments can be placed in an international context using these groups, which broadens the analytical framework compared to examining own development dynamics alone. In recent years, Hungary has been treated as part of the Visegrad Group less and less frequently. The forint is still handled together with the Polish zloty, the Turkish lira and the South African rand. Due to the central bank interest rate policy and low fluctuation (similar to the euro), the Czech koruna is not as good of a comparator, and neither is the Romanian leu due to the central bank s more active foreign exchange market participation. The total turnover of the forint and zloty market (where the forint or zloty constitutes one side of transactions) only accounts for a small portion of the global foreign exchange market, amounting to 1%. The different transaction types represent similar proportions in Hungary as in Poland, Turkey and South Africa, but the markets nominal value diverges significantly. The forint market is the smallest in the comparison group, at roughly half the size of the Polish market, one third of the South African market and one fourth of the Turkish market. In the emerging countries reviewed, in line with the global tendency, trading is concentrated in the United Kingdom (40-55%), while New York and Frankfurt jointly account for roughly 17-22%. Domestic transactions exhibit substantial deviation across the four countries: while approximately 9% of HUF turnover takes place in Hungary, 25% of transactions are concluded locally in South Africa. This proportion is roughly equal in Poland and Turkey, at around 13%. 10 MNB Handbooks Foreign Exchange Market Chart 3 Regional foreign exchange market transactions in an international comparison by transaction type (left panel, net) and location of conclusion (right panel, gross) (BIS, April 2016, daily turnover) Billion USD HUF PLN TRY ZAR Spot Forward FX-swap Option Billion USD HUF PLN TRY ZAR London New York Frankfurt Domestic Other Source: BIS, MNB The latest survey shows that among derivative terms, the forward transactions concluded in Hungary feature longer terms compared to both the global and the regional average, while FX swaps feature shorter maturities by international standards, which are generally continuously rolled over by market players, generating significant turnover on the FX swap market. Presentation of the foreign exchange market 11 3 Theoretical frameworks 3.1 Exchange rate theories and exchange rate regimes Identifying the determinants of exchange rate developments is a complex matter, and thus forecasting exchange rates poses a challenge for analysts despite the access to information on the fundamentals shaping them in the long run. Forecasting fundamentals involves uncertainty in and of itself, further nuancing the picture and increasing the probability of exchange rate forecasting errors. Although the exchange rate is defined in the long run by macroeconomic variables, the explanatory power of macroeconomic models is not significantly greater than the explained variance ratio of the random walk model (Meese Rogoff 1983). However, the microstructure theory is able to provide a more accurate forecast of exchange rate developments for shorter periods Macro models There are many subsets of macroeconomic models, which can be characterised mainly based on the variable or variables with the largest impact on the spot exchange rate within the model. These may include the interest rate, money supply, inflation, GDP growth, the current account and monetary and fiscal policy. There are other exchange rate approaches so that are based on the longrun equilibrium exchange rate, as well as many other parity-based theories. Due to the multitude of theories, this booklet only briefly presents the main models. In the short run, it is the interest spread that contributes to most exchange rate movements, while the balance of trade and capital flows contribute in the medium term, and the difference in inflation rates is the main explanatory variable of spot exchange rate developments in the long run. Macro models all share the assumption that market player expectations are homogenous, share the same information base and make the same assessment thereof. On this basis, a new piece of information is immediately incorporated into the exchange rate and the trading process and the traded quantities have no role in shaping the exchange rate, contrary to the microstructure theories presented later in this Booklet. 12 MNB Handbooks Foreign Exchange Market Macro models can be divided into three main groups based on market coverage: Parity-based models (PPP, CIP, UIP, UIP expanded with the risk premium) IMF models based on the long-run equilibrium exchange rate (macroeconomic balance approach, external sustainability approach, econometric approach) Other macroeconomic models (Mundell Fleming, portfolio equilibrium theory, Balassa Samuelson effect, Dornbusch overshooting model, portfolio equilibrium model) Parity-based models present specific parity correlations: In the absolute purchasing power parity (PPP) model, exchange rate levels adjust to the proportion of the purchasing power of currencies (commodity market equilibrium). According to the theory, the law of one price prevails, i.e. that a certain good have the same price in all locations, so the real exchange rate is equal to one if the theory is fulfilled. S = P P( f ), where P is the domestic price index, P(f) is the foreign price index and S is the spot exchange rate (domestic currency/unit of foreign currency). The relative purchasing power parity theory differs from this in that the change in exchange rates is caused by the relative change in price levels, in other words currencies of countries characterised by high inflation necessarily depreciate. ΔS = ΔP ΔP( f ), where Δ represents the percentage change in the above variables. The absolute PPP theory does not work in reality, and measuring it also faces technical obstacles, but the relative PPP may function in the long Theoretical frameworks 13 run (Pippenger 1993). The reasons for diverging from parity may include technological differences and diverging consumer preferences, which are not addressed by the above theories. In addition to purchasing power parity, the exchange rate theories based on different national interest rate spreads are the most widely known among partial equilibrium models. Based on covered interest rate parity (CIP), the difference between the forward and spot exchange rate must be equal to the interest rate spread of the two currencies, because any deviation from it would create an opportunity for arbitrage. In practice, this theory is used to define the forward exchange rate, however it does not work empirically for forecasting. F = S ( 1+ r) ( 1+ r f ), where F is the forward exchange rate, S is the spot exchange rate, r is the domestic interest rate level and r f is the foreign interest rate level. The uncovered interest rate parity (UIP) is based not on arbitrage-free pricing and the forward exchange rate, but on the expected future exchange rate. In a risk-free world, the interest rate of a domestic and a foreign investment with the same term differs to the amount that is compensated by the expected change in the exchange rate of the domestic currency (Delikát 2007). The nominal interest rate spread corresponds to the expected change in the exchange rate E(S 1 ) S 0. ( 1+ r) ( ) = S 0 ( ) E S 1 1+ r f However, this does not work empirically either. This is why the so-called carry trade foreign exchange market strategy can be profitable. This replaces indebtedness in a currency with low interest rate for long positions denominated in a higher interest rate currency. The party taking on the position assumes that the loss on a depreciation of the currency with the higher interest rate will be smaller than the profit gained on the interest rate spread. 14 MNB Handbooks Foreign Exchange Market In reality, investors consider numerous risks and expect a risk premium in exchange for their willingness to take risks. This supplements the uncovered interest parity with a risk factor that is the product of actual risks and the risk appetite component. The premium of a currency against other currencies thus depends on the exchange rate movements expected by investors, the size of individual risks and investors risk appetite (Delikát 2007). The IMF assesses long-run equilibrium exchange rate levels using three different approaches. The macroeconomic equilibrium approach estimates how much the exchange rate must shift to offset a country s expected current account imbalance. The external sustainability theory measures how much the exchange rate must shift to allow the level of external debt to reach a sustainable level. The econometric approach attempts to describe the exchange rate s equilibrium trajectory using numerous macro variables (trade balance, relative productivity etc.). Several of the other macroeconomic models investigate the impact of monetary and fiscal policy on the exchange rate. The Mundell Fleming model (Fleming, J.M. 1962; Mundell, R.A. 1963) examines the impact of these policies on the interest rate and through it, on the exchange rate. The model also examines the impact o
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