Liquidity provision in the overnight foreign exchange market

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from 1.1994 to 6.2002) was 1.6% compared with 0.5% for the exchange rate. 11 The maximum daily return in the stock market was 11.9% compared with 1.9% in the foreign exchange market. Given this kind of volatility, timing is extremely important. It is much more important to time correctly the investment in the stock market, than to wait for the appropriate exchange rate. Hence, it seems reasonable that they are push customers. Trading in stock markets would not affect the exchange rate if currency positions are hedged. It is well known that investors in stock markets do not usually hedge currency risk. 12 Two possible reasons are that currency risk is small compared to overall risk, and that it may be difficult to hedge currency risk when future cash flows are uncertain. Non-Financial customers, on the other hand, probably trade currency either to conduct current account trading, or to make foreign direct investments. For these kinds of transactions, the minute-to-minute considerations play a less important role in investment timing. In contrast to many asset prices, most prices for goods only change slowly. In this case, the FX part may be very important. For Non-Financial customers, the exchange rate may be viewed as an option, i.e., the customer can wait to make the transaction until the exchange rate becomes “sufficiently” attractive. For instance, if the dollar appreciates against the euro, US goods, like airplanes from Boeing, will become relatively more expensive compared to European goods, like Airbus. If the USD/EURrate is 1.40, most airline companies will choose to buy new airplanes from Boeing, hence buying dollars. However, if the dollar appreciates to 1.00 it is likely that many airline companies will exercise their option and rather buy from Airbus, and hence buy euros and sell dollars. 11 The stock exchange is measured by the log of the MSCI index for Sweden, and the exchange rate as the log of the SEK/EUR. 12 In less volatile asset markets, we often see that currency risk is hedged. 28
Assume that Financial customers buy dollars because they want to buy US assets. They are “pushing” the market, and the dollar will appreciate. The dollar will appreciate such that Non-Financial customers find it attractive to sell the dollars. They are pull customers. A stronger dollar makes it attractive for Non-Financial customers to sell dollars, and buy euros, because European goods become relatively less expensive. A natural question to ask is whether a particular group is systematically making profits or losses. An implication of the above argument is that financial customers may be willing to pay a premium in the foreign exchange market in order to buy assets denominated in foreign currencies. Since Financial customers are willing to pay a premium, this means that Non-Financial customers can sell at high prices and buy at low prices. Non-Financial customers behave as profit takers. Non-Financial customers buy and sell at prices that suit them, that is, at prices at which they choose to exercise their option. They do not have to perceive themselves as liquidity providers to perform this role. 6 Conclusion The provision of liquidity is important for well-functioning asset markets. Still, the liquidity of the foreign exchange market, perhaps the most important financial market, is a black box. We know that market makers provide liquidity in the intraday market when exchange rates are floating. This paper addresses the issue of who provides liquidity overnight in the foreign exchange market. To this end we use a unique data set from the Swedish foreign exchange market which covers the trading of several distinct groups over a long time span, from the beginning of 1993 to the summer of 2002. The distinct groups we analyze are: (i) Market making banks; (ii) Financial customers; (iii) Non-Financial customers; and (iv) 29
Page 1 and 2: Discussion Papers No. 391, Septembe
Page 3 and 4: 1 Introduction The provision of liq
Page 5 and 6: positive correlation between net pu
Page 7 and 8: demand for a currency and the value
Page 9 and 10: atically fill the role of overnight
Page 11 and 12: dealers will adjust their prices. W
Page 13 and 14: In the traditional portfolio balanc
Page 15 and 16: ency when the bond returns in Swede
Page 17 and 18: 11.0 10.5 10.0 9.5 9.0 8.5 8.0 1994
Page 19 and 20: as non-stationary in order to get t
Page 21 and 22: of customers is weakly exogenous to
Page 23 and 24: horizon to 0.71% per SEK 10 billion
Page 25 and 26: .012 .004 .008 .000 .004 -.004 .000
Page 27 and 28: Table 5: Flows, returns and short r
Page 29: clude that Non-Financial customers
Page 33 and 34: the steady-state long run. The perm
Page 35 and 36: Carlson, J. A. and C. L. Osler (200
Page 37 and 38: Recent publications in the series D

Liquidity provision in the overnight foreign exchange market

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