The foreign exchange market is the world’s largest financial market by virtually any measure. It is the only truly global financial market: currencies are traded in financial centers around the world, connected by communications systems that allow nearly instantaneous transmission of price information and trade instructions. The market has grown rapidly over the last decade since cross-border capital flows have been liberalized and the regulatory constraints on institutional investments relaxed. The increased liquidity of securities markets, particularly in the industrial countries, which has resulted from privatization and from larger and more efficient markets for government debt securities, has also increased the range of foreign assets available to investors and made foreign investment easier. This expansion of cross-border capital flows has been actively promoted by governments seeking broader investor bases for their own debt and for securities issued by domestic firms. Improvements in trading and settlement practices and in technology have increased the liquidity of secondary markets for foreign exchange instruments and allowed participating financial institutions to handle larger volumes of transactions safely.
Trading in the foreign exchange markets takes place for a variety of motives. This annex discusses three aspects of foreign exchange transactions: first, the arbitrage that links the forward and spot markets; next, the use of foreign exchange markets as “synthetic money markets”; and then the use of foreign exchange instruments to hedge foreign currency risk, which covers first the basic hedging techniques typically used by individuals and investors and then the dynamic hedging strategies typically used by banks to hedge exposure associated with issuing currency options. The consequences of these various strategies for foreign exchange market behavior are also examined.
The relaxation of capital and exchange controls and the acceleration of financial innovation have clearly encouraged competition among financial institutions and improved efficiency in financial services worldwide. Increased competition has also presented financial institutions with new risks-including those associated with losses on open positions and with losses resulting from settlement failures. These risks are increased by the speed with which prices change, by the delays inherent in covering exposures and settling trades, and by the extension of credit to counterparties with non-zero bankruptcy probabilities.
The increasing sophistication of foreign exchange markets offers investors a wide range of liquid assets. In normal times, this enables participants to manage their risks and lower their costs of transacting, and is therefore conducive to a more efficient allocation of funds in the world economy. But these same features have also expanded the range of opportunities available to speculators who believe that a currency’s sudden depreciation is impending, and have increased the private sector’s ability to marshall large resources on very short notice. Of course, during a foreign exchange crisis, when most market participants become convinced—rightly or wrongly—that a large change in the exchange rate could well be in the offing, the line between speculation and hedging becomes rather blurred.
A system of fixed exchange rates, or a system of exchange rate bands like the ERM, is usually maintained through the central bank’s foreign exchange market intervention using its foreign exchange reserves. Such regimes are subject to periodic speculative attacks, however: speculators take a position against a currency if they believe that the exchange rate is likely to devalue from its current parity soon enough to compensate them for the costs of speculation; high capital mobility has lowered these costs by greatly expanding the speculators’ range of alternative means of taking positions in the foreign exchange market.1
This annex focuses on the financial aspects of the currency crisis and complements the more detailed discussion of macroeconomic developments presented elsewhere.1 The first section describes the pattern of cross-border capital flows into and out of some of the countries most affected by the recent currency crisis, elaborating on the discussion of convergence plays in Section III of the paper. The next section describes the methods by which the speculative attacks against some of the weaker currencies were launched and the tools used by central banks to try to defend their exchange rate parities. The role of the commercial banks in providing credit to those that took positions against the weak currencies is described, illustrating the mechanics of speculative attacks characterized in Annex IV. The final section examines activity in the financial markets during the crisis.
This report examines the implications of the growth and integration of international capital markets for the management of exchange rates, with particular attention to the inferences that can be drawn from the currency turmoil that shook the European Monetary System (EMS) last fall and winter.
Liberalization and reform of the financial sector have been a common theme in the industrial countries over the past decade; in some of them, liberalization gained momentum even earlier. The competitive forces unleashed by liberalization have swept away market segmentation and have greatly increased the menu of tradable financial instruments.1 Liquid markets in central and local government securities, in corporate debt, in equity, in commercial paper, in bank certificates of deposit, in asset-backed securities, and in both exchange-traded and over-the-counter derivative instruments have become a prominent feature of the financial landscape in most Group of Ten countries. By 1992, the outstanding stock of publicly traded debt and equity securities in Europe and the United States had climbed to about $24 trillion, while the notional amounts of financial derivative instruments outstanding had reached $7 trillion. Retail and institutional investors—both domestic and foreign—now have a wide choice of liquid securities.
To understand why the sales of certain ERM currencies in the summer and fall of 1992 were so huge, the story has to go back at least five years. Specifically, over 1987-91, large, cumulative inflows of capital into the higher-yielding ERM currencies occurred (see Table 4). These inflows are examined in more detail in Annex VI. One of the important factors motivating these inflows was the growing perception by international investors that the member countries of the EMS were on a continuous convergence path toward European Monetary Union (EMU), under which interest rate differentials in favor of the high-yielding ERM currencies would increasingly overestimate the actual risk of exchange rate depreciation. As one portfolio manager recalled the prevailing view, “why settle for the yield on a deutsche mark bond when you can get the higher yield on a peseta or lira bond without a compensating exchange risk?” This came to be known in major financial centers as the “convergence play.”