Chapter Eighteen

Markets and Risk Aspects of Each Market

IN THIS CHAPTER WE COVER some of the key markets—foreign exchange (FX) markets, fixed income and money markets, equity markets and commodity markets—and the dynamics associated with each of them. We also cover some of the key economic data and indicators that emanate from governments and their broad impact on domestic markets and factors. This will set up our discussion for risk management solutions in Chapter 21.

WORLD OF MARKETS

The world of markets is divided into five main asset or risk classes, as shown in Figure 18.1.

FIGURE 18.1 World of Markets

Each market has its own characteristics and dynamics, and we explore these in the rest of the chapter.

Foreign Exchange Markets

As long as international trade has been around, the need to denominate or value goods and services has been present. In ancient times, coinage and currencies were popular in different forms, but challenges arose when looking to trade across borders.

The barter system, where goods or services would be exchanged in good value for each other, became a common practice. Over time, gold came to be accepted as a universal method of exchange.

The Bretton Woods conference in the aftermath of World War II set in place the mechanics of currencies and conversion. A few hiccups later, the global foreign exchange (FX) market as we know today took shape and form, to aid the flow of money across borders and hence facilitate transactions in both the trade (or current) accounts and capital accounts.

Today’s global FX market is a round-the-clock, primarily over-the-counter (OTC) market that determines the relative value of two currencies, denoted as a currency pair. The FX market is the largest in the world in terms of liquidity (estimated at around USD 4 trillion per day) and works across these types:

• Cash. Exchange OTC at banks, automated teller machines, exchange centers, and so on.
• Spot. The most extensive market in terms of volume. Spot settlement usually refers to the settlement two working days (T+2) from the date of the transaction.
• Forward. A combination of exchange rates and interest rates across time, the settlement rate for an exchange beyond two days, fixed today.
• FX swaps. A transaction to take advantage of the forward points only, where the spot is bought/sold and correspondingly sold/bought forward.
• Currency swaps. Exchanges of cash flows over time across two currencies.
• Options. One example is the right to buy/sell a currency at a particular price on a particular date.

A currency itself is denoted by a three-letter code as per the International Standards Organization (ISO) 4217 standard, made up of the two-letter ISO 3166–1 country code followed by an initial of the currency itself.

Hence, the United States (country code: US) dollar is USD, the Japanese (country code: JP) yen in JPY, and the Indian (country code: IN) rupee is INR.

Appendix B contains a list of global currencies.

A currency pair, which denotes the exchange of currency from one to the other (and hence the term foreign exchange), is denoted generally with a six-letter format, with the first currency being the commodity currency, one unit of which is measured in “terms” of the terms currency (the second currency of the pair).

Hence, USDJPY is the representation of 1 USD in terms of the JPY, while EURUSD is the value of 1 EUR in terms of the USD.

With the exception of EUR, GBP, AUD, and NZD, most currencies in the world trade against the United States with the U.S. dollar as the commodity currency.

Movement of Money

When money moves across borders, it changes form and has to be exchanged from one currency to another—this is the basis of FX. When money moves over time, the rate at which it gains value can be represented by interest, while the rate at which it loses value can be represented by inflation (see Figure 18.2). When money moves across borders over time, the forward market, explained more in detail later in the book, evolves.

FIGURE 18.2 Linkages Between the World of Money Markets and Foreign Exchange

We articulate the key differences between over-the-counter transactions and those done on an exchange in the following note.

Underlying Assets or Market Factors

Currencies can be categorised into:

• Free float. G7+ currencies float freely based on demand supply and expectation.
• Managed float. The central bank allows the market to move on its own but also sets parameters for the currency to trade within (see “Intervention”). Some countries, such as China, set upper and lower bands beyond which the currency cannot trade.
• Fixed or pegged. The currency is pegged to a large trading partner, such as the USD.

Currencies can also be categorised by convertibility, or the ease and flexibility with which they can be bought and sold (traded) in local or global markets

• Fully convertible. In this case, all transactions (on the current and capital accounts) can be executed without any prior approval from the central bank.
• Partially convertible. The central bank imposes restrictions on the type of transactions for which no prior approval need be taken for currency conversion and the type of transactions that need to be pre-approved. In most cases, speculative purchases or sales are not allowed and an underlying genuine trade or capital-related transaction is mandated for currency dealings.

Intervention

When central banks are of the opinion that their currency has appreciated or depreciated beyond a point that is good for the economic, financial, or political conditions of the country, or if the market moves have been very rapid, they could choose to enter the market and buy or sell the currency to stem the flow. This is generally not a common event, but the central bank’s intervention usually signals the regulator’s intent and potential comfort levels to markets and traders in particular, who then understand the outer limits of immediate currency moves.

Participants

The FX market has many participants (see Figure 18.3) that are driven primarily by the OTC transactions between banks. Various exchanges and agents offer convertibility to the end-user space and themselves depend on the global market to manage and settle their own positions.

FIGURE 18.3 FX Market Participants

Fixed Income and Money Markets

Fixed income and money markets have been categorised together because they constitute the majority of debt or interest rate–related markets.

Money markets are shorter term (usually under one year) markets that involve liquid sources of funding, such as:

• Repurchase agreements (repos)
• Interbank lending
• Commercial paper
• Fed funds or overnight borrowing
• Bills
• Working capital borrowings

Table 18.1 shows some of the key terminologies across FX and money markets.

TABLE 18.1 Terminologies Across FX and Money Markets

The term fixed income markets refers to any type of investment that is not equity of a tenor usually of over a year, which creates an obligation from the borrower (or “issuer”) to make payments on a fixed schedule to a lender (or “investor”). The number of payments, or the amount of payments, may be variable. Examples of fixed income transactions are:

• Bonds
• Medium-term notes (MTNs)
• Structured notes and bonds
• Credit markets including credit derivatives
• Derivative markets, such as interest rate options and swaps

Participants

Figure 18.4 depicts the key participants in fixed income and money markets.

FIGURE 18.4 Key Participants in Fixed Income and Money Markets

Investors can include funds, banks, individuals, corporations and institutions in a country and overseas. Each investor has a specific risk profile and would take on the tenor, rating characteristics, and profile of the investor and investment that suits its risk profile.

In the context of risk management, derivatives also form a core requirement for the investor and issuer base; issuers use them to protect against risk and investors use them to assume a specific kind of risk for improved or targeted returns.

Commodity Markets

In commodity markets, trading ownership of physical and paper transactions, usually in the future, take place. Commodities may be defined as uniform items of value and large volume that are in demand by users and are produced, mined, or sold by different entities.

Well-established physical commodities actively trade on exchanges or OTC. Hence, these can be physically delivered and generally stored for a reasonable period of time. Commodities can also trade as paper contracts, where settlement of physical goods does not happen at maturity; instead, a financial equivalent settlement happens at maturity.

Firms use commodity markets to hedge against exposures that they may have or as alternative investments and long-term hedges against currency depreciation and inflation. Commodity prices move similarly to the equities of commodity producers but generally do not have a steep correlation with equity or bond markets.

Futures and options are traded on many exchanges, such as the Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), London Metals Exchange (LME), and the Intercontinental Exchange (ICE), as well as OTC.

Commodities markets are largely categorised into these themes (Figure 18.5):

FIGURE 18.5 Commodity Markets

• Energy. Comprised of oil and gas (such as crude oil [WTI Intermediate, Brent, Dubai crude, etc.] and gasoil), other petrochemicals, and hard energy, such as coal
• Metals. Comprised of precious metals (such as gold and silver) and base metals (such as nickel and aluminum)
• Agricultural or Softs. Comprised of agricultural commodities, such as soybean, coffee, cocoa, sugar, wheat, and cotton
• Animal. Comprised of standard high-volume livestock or foods, such as pork bellies
• Transportation. Comprised of freight-related quotes and products
• Environment. Comprised of carbon-related credits and derivatives, weather-related products, and so on
• Exotics. Other commodities or new classes not mentioned above

Equity Markets

We have covered equity capital from an issuer’s perspective earlier in Chapter 13. Equities are traded on an exchange for listed companies and OTC for private ones. From the perspective of a corporate, direct equity risk arises for three reasons:

Equity markets are some of the most commonly followed markets around the world and act as a barometer for market sentiment on a country’s economy as a whole.

MOVEMENT OF MARKETS

Many factors cause markets to move. The fundamental factor is the buying (and demand) or selling (and supply) of most players in a market, or the expectation of demand and supply.

Some of these factors are economic data indicators and market events.

Economic Data Indicators

Economic data indicators are measures of the strength of an economy or a region that provide insight into the actual well-being of that country or region. Governments, through their economic offices, central banks, or other authorities, usually publish some of the important indicators. Many independent agencies publish survey results of their own, and industry uses some of the credible surveys. For example, agencies such as Thomson Reuters poll economists and market experts on their own estimates of these numbers prior to the formal release of these indicators. These expectations hence get factored in along with traders’ own views on the market to determine price of an asset or a group of assets.

When the number actually gets published, the variance from the expected number as well as the improvement or deterioration from earlier indicators merge with the current mood and expectation to drive markets up or down.

Figure 18.6 shows some of the drivers of markets.

FIGURE 18.6 Drivers of Short- and Long-Term Market Moves

Table 18.2 provides a general overview on market reactions to positive or higher economic indicator numbers.

TABLE 18.2 Movement of Markets with Data Releases

Market Events

The interlinkages across global markets nowadays has increased dependence on external environments. Hence market events, such as liquidity freezes, fear, regulatory or other incidents, can have an effect on other markets and countries.

SUMMARY

We introduced debt and equity markets in Part Three. In this chapter we focused on the markets from the point of view of risk management and also some drivers of markets and their moves. Thus, we have laid the foundation to explore risk management in more detail in the coming chapters.