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12

2.2.1 Structure of the Foreign Exchange Spot Market

The usual description of the FX markets made by international organizations such as the Bank for International Settlements (1999) or the International Monetary Fund (1993) emphasizes the presence of different geographical markets and different types of agents. However, these structural characteristics are not apparent from the inspection of daily or weekly data and their implications were seldom considered in theoretical modeling.

The FX market consists of two dominating parts, the FX spot and the FX forward market, and a smaller but growing market of FX derivatives. In 1992, both the FX spot and forward markets had a market share of roughly 50% each. In 1998, the FX forward market was moderately larger than the FX spot market, by a ratio 60:40% (Bank for International Settlements, 1999). However, the FX spot rates are used not only in the FX spot market but also for outright FX forward transactions, as explained in Section 2.3.2.

Nowadays, a growing segment of the FX spot transactions goes through automated, electronic order-matching systems,5 such as the Electronic Broking Services (EBS) and Reuters Dealing 2000. These markets deliver good high-frequency data with transaction prices and volumes. These transaction data have become available to researchers to a limited amount.6 Results based on these data are discussed in a few places in this book.

Aside from this electronic trading, the over-the-counter FX spot market is a direct market between banks (and brokers). The bid and ask offers of major financial institutions are conveyed to customers screens by large data suppliers such as Reuters, Bloomberg, and Bridge (formerly Telerate and Knight Ridder) with as little time delay as possible and the deals are negotiated over the telephone. Many researchers have investigated data in various forms from this interbank market; there is no alternative way to obtain large FX samples, especially historical samples extending to the 1980s and early 1990s.

The bid-ask prices from the over-the-counter FX spot market are called quoted prices or quotes as opposed to transaction prices. One full tick contains the time stamp, a bid and an ask price and often some information on the origin of the tick (bank code, city, etc.). Transaction prices or volumes are not available, but some additional information such as financial news in text form is available from other pages of the data vendors.

The data suppliers offer a rather easy access to market data nowadays. The real-time data for a financial instrument can be obtained from Reuters, for instance, through the Reuters Instrument Code (RIC). The FX rate EUR-USD, for instance,7 has the RIC "EUR=," the FX rate USD-JPY has the RIC "JPY-" Rates

5 In April 1998, the share of deals going through such systems was "almost one quarter" in the United Kingdom, "almost one third" in the United States, and 36% in Japan, (Bank for International Settlements, 1999).

6 Lyons (1995, 1996a,b); Goodhart et al. (1995), and Goodhart and Payne (1996) could obtain a few days of such data.

7 For the currencies, we use the standard abbreviations of the International Organization for Standardization (ISO, code 4217).



TABLE 2.1 The traditional FXFX page of Reuters.

On this traditional page, the first column gives the time in GMT (for example, for the first line, "07:27"), the second column gives the name of a traded currency ("DEM" for USD-DEM), the third column the name of the bank subsidiary that publishes the quote as a mnemonic ("RABO"), the fourth column the name of the bank ("Rabobank"), the fifth column the location of the bank as a mnemonic ("UTR" for Utrecht), the sixth column gives the bid price with five digits (" 1.6290") and the two last digits of the ask price ("00" which means 1.6300), the seventh column repeats the currency ("DEM"), and the last two columns give the highest ("1.6365") and the lowest ("1.6270") quoted prices of the day.

0727

PAGE

NAME * REUTER SPOT RATES

HI*EUR0*L0 FXFX

0727

RABO

RABOBANK

1.6290/00

1.6365

1.6270

0727

MNBX

MOSCOW

1.5237/42

1.5245

1.5207

0727

UBZA

1.3655/65

1.3730

1.3630

0727

IBJX

I.B.J

102.78/83

103.02

102.70

0727

BUEX

UE CIC

5.5620/30

5.5835

5.5582

0726

RABO

RABOBANK

1.8233/38

1.8309

1.8220

0727

BCIX

B.C.I.

1592.00/3.00

1596.00

1591.25

0727

NWNT

NATWEST

1.1807/12

1.1820

1.1774

XAU SBZG 387.10/387.60 * ED3 4.43/ 4.56 * FED PREB * GOVA 30Y XAG SBCM 5.52/ 5.53 * US30Y YTM 7.39 * 4.31- 4.31 * 86.14-15

between two currencies other than the U.S. Dollar (USD) are called cross rates (see Section 2.2.2) and have both currencies in the RIC (e.g. "EURJPY=" for the rate EUR-JPY). There are also RICs serving as "tables of contents," called tiles. These contain information on other RICS. Once a real-time feed for a financial instrument is established, the data are transmitted in data records, each representing a tick. A data record contains several variables such as bid and ask prices and some side information. This data organization is used for all financial data, not just for FX.

Once the instrument codes and the variables of the data records are known, data collection is a straightforward operation. However, many results of this book arc based on historical data collected at a time when data extraction was technically difficult. The traditional data feeds of the early 1990s and before were oriented to human users looking at full pages of information, such as the FXFX page of Reuters. Table 2.1 shows a snapshot of this traditional FXFX page. A quoted price of 1.6290/00 for the USD-DEM rate expresses the willingness of the market maker to buy USD at 1.6290 DEM and sell USD at 1.6300 DEM. Telerate also had a page-based feed at that time. Rather than using todays instrument codes, the data collector had to extract the desired information from full pages and from the many real-time updating messages associated to these pages. This implied a delicate text parsing task and also controlling for unexpected changes in the page layout. A large part of the data used in the studies of this book has been extracted and collected in this tedious way.



The FX market has no business-hour limitations. Any market maker can submit new bid-ask prices; many larger institutions have branches worldwide so that trading is continuous. Nevertheless, the bid-ask prices do emanate from particular banks in particular locations and the deals are entered into dealers books in particular institutions. Although the FX market is virtually global through its electronic linkages, its activity pattern can be divided into three continental components, each with its typical group of time zones: East Asia, Europe, and America with Tokyo, London and New York as major trading centers8 (Goodhart and Demos, 1990).

Except for some major currencies against the USD, currencies tend to be traded more specifically in their own geographical markets. Major currencies are USD, EUR (until 1998: DEM), JPY, GBP, and CHF. Both the global and local characteristics of the FX markets are reflected by the statistical properties of the data.

Actual trading prices and volumes are not known from the over-the-counter spot market. However, reputation considerations prevent market makers from quoting prices at which they would actually not be willing to trade. Therefore, real transaction prices tend to be contained within the quoted bid-ask spread (Petersen and Fialkowski, 1994). This is also shown by a comparison to simultaneous transaction prices of electronic dealing systems (where the bid-ask spread is narrower).

The growing volume of FX transactions has been increasingly made up of short-term, intraday transactions and results from the interaction of traders with different time-horizons, risk-profiles, or regulatory constraints. Nonfinancial corporations, institutional investors (mutual funds, pension funds, insurance companies), and hedge funds9 have shifted their FX activities from long-term (buy and hold) investment to short-term (profit-making) transactions. This movement is both enabled and enhanced by the development of real-time information systems and the decrease of transaction costs following the liberalization of cross-border financial flows. This flow of short and long-term transactions initiated by nonfinancial institutions on the retail market is the origin of an even larger-by a factor of four to five times-flow of intradaily transactions between the dealers (the 50 largest banks and a few securities houses) on the wholesale market. These dealers, who are usually not allowed to take overnight positions, transact with each other to reduce the risk arising from their accumulated currency positions (Lyons, 1996a).

8 In typical historical samples, the data contributors of "East Asia" are located in Australia, Hong Kong, India, Indonesia, Japan, South Korea, Malaysia, New Zealand, and Singapore. "Europe" covers Austria, Bahrain, Belgium, Germany, Denmark, Finland, France, Great Britain, Greece, Ireland, Italy, Israel, Jordan, Kuwait, Luxembourg, the Netherlands, Norway, Saudi Arabia, South Africa, Spain, Sweden, Switzerland, Turkey, and United Arab Emirates. "America" comprises Argentina, Canada, Mexico, and the United States.

9 The high leverage and unregulated aspects of hedge funds distinguish their investors from other institutional investors.



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