International Finance

AN INTRODUCTION TO EXCHANGE RATES$ Billion$800$700$600$500$400$300$200$100$0Unadjusted for double-countingAdjusted for double-counting$77$58$183$129$230$167$295$244$405$351$287$2541986 1989 1992 1995 1998 2001& Figure 2.1 Daily turnover in the US foreign exchange market, 1986–2001NotesDaily trading volume in the US foreign exchange market averaged $254 billion in April 2001, down 28 percent from1998. Introduction of euro, consolidation among financial institutions, increased trading through electronic brokers andshifting of trading from the United States have contributed to this decline.Source: Summary of Results of the US Foreign Exchange Market Survey Conducted in April 2001, Federal Reserve Bankof New York, 2003, p. 3.United States has the second largest foreignexchange market, followed by Japan, Singapore,and Germany. Figure 2.1 shows the size of the USforeign exchange market, indicating the recentdecline due to the introduction of the euro and thenew forms of electronic price discovery in theinterbank market made possible by new electronicforms of market making.The foreign exchange market is an informalarrangement of the larger commercial banks and anumber of foreign exchange brokers. The banks andbrokers are linked together by telephone, telex, anda satellite communications network called theSociety for Worldwide International FinancialTelecommunications (SWIFT). This computer-basedcommunications system, based inBrussels, Belgium, links banks and brokers in justabout every financial center. The banks and brokersare in almost constant contact, with activity in somefinancial center or other 24 hours a day. 4 Because of4 Indeed, in the principal centers like New York, London,Tokyo,and Toronto,largebanks maintain 24-houroperationsto keep up with developments elsewhere and continuetrading during other centers’ normal working hours.the speed of communications, significant events havevirtually instantaneous impacts everywhere in theworld despite the huge distances separating marketparticipants. This is what makes the foreign exchangemarket just as efficient as a conventional stock orcommodity market housed under a single roof.The efficiency of the foreign exchange market isrevealed in the extremely narrow spreads betweenbuying and selling prices. These spreads can besmaller than a tenth of a percent of the value of acurrency exchange, and are therefore about onefiftiethor less of the spread faced on cash by internationaltravelers. The efficiency of the market isalso manifest in the electrifying speed with whichexchange rates respond to the continuous flowof information that bombards financial markets.Participants cannot afford to miss a beat in thefrantic pulse of this dynamic, global market. Indeed,the bankers and brokers that constitute the foreignexchange market can scarcely detach themselvesfrom the video monitors that provide the latestnews and prices as fast as the information cantravel along the telephone wires and radio waves ofbusiness news wire services such as Dow JonesTelerate and Reuters.33 &