Foreign exchange markets don’t operate like Wall Street does. It’s a global network of buyers and sellers exchanging currencies. Trades are executed via brokers or over-the-counter electronic networks.
“There is no centralized trading floor,” said Correy S. Jones, vice president at Wells Fargo Foreign Exchange in Denver. Jones gave a presentation at a recent Office of International Affairs seminar in Colorado Springs.
By volume (97 percent), the key players in the foreign exchange market are speculators in hedge funds and central banks. Private institutions, public banks and institutional/corporate hedgers comprise only 3 percent of annual foreign exchange market volume.
Hedging, Jones said, is a means of protecting oneself against possible volatility – gains or losses, by maintaining an offsetting position that produces gains when the underlying asset or liability position incurs losses and vice versa.
“The FX market is open 24/5. New Zealand opens around noon our time on Sunday morning, and the Wells Fargo trading desk in San Francisco is the last to close on Friday afternoon. So the market shuts down for about a day and a half, then starts over again,” Jones said.
The annual volume of the foreign exchange market is staggering – 13 times that of the world’s 10 stock markets combined – or $921.6 trillion vs. $71 trillion.
But the FX market is highly volatile because of speculation.
For instance, buyers snap up Japanese yen when they trade at 0 percent, and buy Australian dollars at 7 percent, “which works great as long as the Australian dollar doesn’t fall against the yen,” Jones said. “Regardless of whether you’re doing business in dollars or foreign currency, be prepared for volatility.”
If you’re doing business – paying or getting paid – in euros, the value of the euro can go up or down 9 percent during a three-month period. Stretched over two years, that volatility average has been 34.16 percent, during the past 15 years.
“Expectation and psychology are what’s really driving the FX market – not supply and demand,” he said.
It’s a fickle market.
“One of the primary drivers is interest rates,” Jones said.
But trade balances or deficits, for example, only affect the market “when speculators are paying attention to it.”
“Last year, people were selling U.S. dollars and buying Australian dollars because they were at a higher rate,” Jones said. “Then all of a sudden the Australian dollar got killed. Like a herd of elephants they were stampeding to sell. The Australian dollar went from about one U.S. dollar in July to 55 cents in November.”
As for economic numbers, short-term data affects the FX market, such as unemployment, or retail sales being lower than expected or the prior month’s data being downgraded.
“But one of the critical things to remember is that certain pieces of economic data come in and out of fashion,” Jones said. “Something that was viewed as negative six months ago could be considered unimportant or even positive in a few months.”
And, here’s a real-life example of the risks, rewards, terrors and thrills of doing international business and dealing with foreign currencies.
During the 1990s, Clinton Knowles, who now is chief financial officer of Mountain States Pipe & Supply, was with an international company that had borrowed $50 million from The World Bank.
Each year, the company had to repay $10 million. No problem – except the loan was denominated in 25 currencies, and World Bank wouldn’t disclose which currency the payment must be made in until one month before it was due.
Remember how volatile currencies are?
Well, the company hired Wells Fargo to do a “linear regression analysis,” comparing the volatility of currencies on the list, and the Japanese yen and the euro were less volatile than the other 23.
So, one year prior to the payment, Knowles and his company “bought forward” $10 million in yen and euros.
“We ended up having to repay in Kuwaiti dinar,” Knowles told the audience. “The yen and the euro appreciated that year, and the U.S. dollar depreciated – so we ended up earning $1.1 million on that transaction.”
But the Kuwaiti dinar also appreciated that year, so if they had not hedged by buying yen and euros, the $10 million payment would have cost them an additional $1 million.
All in a day’s work when dealing with foreign exchange markets.
Rebecca Tonn covers banking and finance for the Colorado Springs Business Journal.