Lecture 4 The Foreign Exchange Market The Structure

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Lecture 4: The Foreign Exchange Market The Structure of the Foreign Exchange Market

Lecture 4: The Foreign Exchange Market The Structure of the Foreign Exchange Market

Where is this Financial District?

Where is this Financial District?

The Foreign Exchange Market n n Sometimes referred to as the forex or FX

The Foreign Exchange Market n n Sometimes referred to as the forex or FX market. It is the market where one currency is traded for another currency. q q n n For example, buying yen through selling dollars. Buying dollars through selling euros. The foreign exchange market is the mechanism by which one transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, moves funds cross border, and minimizes exposure (e. g. , through forward contracts) to foreign exchange risk. Commercial transactions do not involve moving physical currency, but rather represent changes in bank deposits. q For example, buying a yen deposit at a bank through selling a dollar deposit at that bank.

FX Trading Floor, 1920 s

FX Trading Floor, 1920 s

FX Trading Floor, (London)

FX Trading Floor, (London)

Participants in the FX Market n Participants in the FX market include: q q

Participants in the FX Market n Participants in the FX market include: q q q Financial institutions (Commercial banks), Organizations conducting commercial transactions (e. g. , the treasury departments of manufacturing firms, retail firms). Organizations conducting investment transactions (mutual funds), Speculators (e. g. , hedge funds) Central banks Foreign exchange brokers (who match buy and sell orders but do not carry inventory).

Participants in the FX Market n The foreign exchange market consists of two tiers:

Participants in the FX Market n The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market. q n Interbank market: The inter-bank market is composed of participants such as global commercial banks (as market makers), large non-financial corporations and central banks. This segment represents over 80% of total market. In the interbank market, about 100 -200 banks worldwide stand ready to make a market in foreign exchange (i. e. , to quote prices at which they will buy and sell currencies). q However, most of the total forex volume is transacted through about 10 banks.

Top Banks in the F. X. Market: Average Market Share, 7 year Bank Country

Top Banks in the F. X. Market: Average Market Share, 7 year Bank Country period 2004 - of 2010% Share of Years in the Top Headquarters Market 10 Deutsche Bank Germany 36% 7 UBS Switzerland 22% 7 Barclays United Kingdom 12% 7 Citi United States 6% 7 JPMorgan United States 3% 3 Goldman Sachs United States 3% 5 RBS United Kingdom 3% 6 HSBC United Kingdom 2% 7 Credit Suisse Switzerland 2% 3 Morgan Stanley United States 2% 2

The FX Market: An Overview n n World’s largest financial market with an estimated

The FX Market: An Overview n n World’s largest financial market with an estimated volume of $4. 0 trillion dollars per day in trades ($3. 3 in 2007). q NYSE-Euronext stock exchange currently about $40 billion per day. Market is a 24/5(7) over-the-counter market. q Major markets open Monday through Friday; Middle East markets also open on weekends (Saudi Arabia and Bahrain) q There is no central trading location (i. e. , no central trading floor). q Trades take place through a network of computers (e. g. , Reuters screens) and telephone connections all over the world. q Estimates of Daily Volume 1973: $ 10 to 20 billion q 1989: $ 590 billion q 1992: $ 820 billion (+39%) q 1995: $1. 190 trillion (+45%) q 1998: $1. 490 trillion (+25%) q 2001: $1. 200 trillion (-19%) q 2004: $1. 880 trillion (+57%) q 2007: $3. 210 trillion (+71%) q 2010: $4. 000 trillion (+25%) q Note: BIS April Surveys from 1989 on.

Largest 3 Foreign Exchange Centers, 1995 – 2010 (% of Total) 40 32. 6

Largest 3 Foreign Exchange Centers, 1995 – 2010 (% of Total) 40 32. 6 35 30 34. 6 32 36. 7 32 29. 3 Percent 25 20 15 16. 3 18. 3 19. 1 16. 1 United Kingdom 17. 4 17. 9 United States Japan 10. 3 10 7 9 8 5. 8 6. 2 2007 2010 5 0 1995 1998 2001 2004

Other Trading Centers, 1995 and 2010, Percent of Total Country 1995 2010 Market Singapore

Other Trading Centers, 1995 and 2010, Percent of Total Country 1995 2010 Market Singapore 6. 6 5. 3 Switzerland 5. 4 5. 2 Hong Kong 5. 6 4. 7 Australia 2. 5 3. 8 France 3. 8 3. 0 Denmark 1. 9 2. 4 Germany 4. 8 2. 1 Canada 1. 9 1. 2 Sweden 1. 2 0. 9 Korea 0. 2 (1998) 0. 9 Russia 0. 3 (1998) 0. 8

Currency Distribution in FX Market, Percent of Average Daily Currency ISO 1998 2001 2004

Currency Distribution in FX Market, Percent of Average Daily Currency ISO 1998 2001 2004 2007 2010 Turnover U. S. Dollar USD 86. 6 89. 9 88. 0 85. 6 84. 9 Euro EUR …. 37. 9 37. 4 37. 0 39. 1 Deutsche Mark DEM 30. 5 …. …. Japanese Yen JPY 21. 7 23. 5 20. 8 17. 2 19. 0 British Pound GBP 11. 0 13. 0 16. 5 14. 9 12. 9 Australian Dollar AUD 3. 0 4. 3 6. 0 6. 6 7. 6 Swiss Franc CHF 7. 1 6. 0 6. 8 6. 4 Canadian Dollar CAD 3. 5 4. 2 5. 3 Hong Kong Dollar HKD 1. 0 2. 2 1. 8 2. 7 2. 4 Swedish Krona SEK 0. 3 2. 5 2. 2 2. 7 2. 2 New Zealand Dollar NZD 0. 2 0. 6 1. 1 1. 9 1. 6 Note: Because 2 currencies are involved in each transaction, the sum of the percentage shares of individual currencies equals 200%

Other Currencies, Percent of Average Daily Turnover Currency ISO 1998 2001 2004 2007 2010

Other Currencies, Percent of Average Daily Turnover Currency ISO 1998 2001 2004 2007 2010 Korean Won KRW 0. 2 0. 8 1. 1 1. 2 1. 5 Singapore Dollar SGD 1. 1 0. 9 1. 2 1. 4 Norwegian Krone NOK 0. 2 1. 5 1. 4 2. 1 1. 3 Mexican Peso MXN 0. 5 0. 8 1. 1 1. 3 Indian Rupee INR 0. 1 0. 2 0. 3 0. 7 0. 9 Russian Rouble RUB 0. 3 0. 6 0. 7 0. 9 Polish Zloty PLN 0. 1 0. 5 0. 4 0. 8 South African Rand ZAR 0. 4 0. 9 0. 7 Brazilian Real BRL 0. 2 0. 5 0. 3 0. 4 0. 7 Chinese Yuan CNY 0. 0 0. 1 0. 5 0. 3 Thai Baht THB 0. 1 0. 2

Global Foreign Exchange Market by Currency Pair; Currency 1998 2001 2004 2007 Percent of

Global Foreign Exchange Market by Currency Pair; Currency 1998 2001 2004 2007 Percent of Total Pair 2010 USD/EUR …. 30 28 27 28 USD/DEM 20 …. …. USD/JPY 19 20 17 13 14 USD/GBP 8 10 13 12 9 USD/AUD 3 4 6 6 6 USD/CAD 3 4 4 4 5 USD/CHF 5 5 4 EUR/JPY Na 3 3 EUR/CHF Na 1 2 2 2 JPY/AUD Na <1 <1 <1 1

Currency Pair Trades by Market Center; Percent of Total for Currency U. K. U.

Currency Pair Trades by Market Center; Percent of Total for Currency U. K. U. S. Japan Center Pair 2001 2010 2004 2010 USD/EUR 33 32 12 10 USD/JPY 16 14 24 13 61 62 EUR/JPY 3 3 Na Na 7 9 USD/GBP 22 13 10 USD/CAD 3 4 9 USD/AUD 3 6 6 USD/CHF 4 4 5 EUR/GBP 4 4 EUR/CHF 2 2 Others:

Types of FX Transactions n n Most transactions in the foreign exchange market are

Types of FX Transactions n n Most transactions in the foreign exchange market are executed on a spot, forward, or swap basis: Spot: A spot transaction requires almost immediate delivery of foreign exchange. Forward: A forward transaction requires delivery at a future date of a specified amount of one currency for a specified amount of another currency. The exchange rate to prevail at the settlement date is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are normally quoted for value dates of one, two, three, six, and twelve months. Actual contracts can be arranged for other lengths. Swap: A swap transaction involves the simultaneous purchase and sale of a given amount of foreign exchange for two different dates. The most common type of swap is a spot against forward, where one buys (or sells) a currency in the spot market and simultaneously sells (or buys) the same amount back in the forward market.

Swaps Explained n n Corporations use FX swaps for cross border funding purposes. Assume

Swaps Explained n n Corporations use FX swaps for cross border funding purposes. Assume a corporation has euros in a bank in Europe and has a USD funding requirement of over the next 3 months in the United States. The firm would like to use its euros to fund this USD financing need, but incur no foreign exchange risk. Solution: q q (1) Sell the euros at the spot rate for USD. (2) Simultaneously, buy a 3 month forward contract to buy back the euros and deliver U. S. dollars.

F. X. Turnover by Type of Transaction; Amount and % of Foreign Exchange 1998

F. X. Turnover by Type of Transaction; Amount and % of Foreign Exchange 1998 2001 2004 2007 2010 Total Instrument Amount (Billions USD) Spot Transactions Outright Forwards F. X. Swaps 1, 527 1, 239 1, 934 3, 324 3, 981 568 386 631 1, 005 1, 490 128 130 209 362 475 F. X. Swaps Currency Swaps Options and others 734 656 954 1, 714 1, 765 10 7 21 31 43 Options and others Total Percent of Total 87 60 119 212 207 Spot Transactions 37. 2% 31. 2% 32. 6% 30. 2% 37. 4% Outright Forwards 8. 4% 10. 5% 10. 8% 10. 9% 11. 9% F. X. Swaps 48. 1% 53. 0% 49. 3% 51. 6% 44. 3% Currency Swaps 0. 7% 0. 6% 1. 1% 0. 9% 1. 1% Options and others 5. 7% 4. 8% 6. 2% 6. 4% 5. 2%

Trading Times for the Market n n Foreign exchange trades on a 24 hour

Trading Times for the Market n n Foreign exchange trades on a 24 hour basis, with major financial centers open Monday through Friday. Weekday trading begins in Sydney, Australia, Monday morning (6: 00 am local time). q n Weekday trading ends in New York, Friday afternoon (5 pm EST). q n n Which is Sunday 4 pm EST in New York; Sunday 8 pm in London, and Monday 5: 00 am in Japan. Which is Friday 10 pm in London, and Saturday 6: 00 am in Japan. Weekend trades take place in the Middle East (e. g. , in Bahrain with 360 offshore banks; 65 US banks). Weekday Summary: Foreign exchange trading begins Australia, moves to Asia (Tokyo, Hong Kong, and Singapore), then to the Middle East, then to Europe (Paris and London), and finally to North America (New York and the west coast).

24 -Hour Global Market: Times Represent Local Trading Hours NEW YORK 8 am –

24 -Hour Global Market: Times Represent Local Trading Hours NEW YORK 8 am – 5 pm Europe: LONDON 8 am – 5 pm Closes: Friday 5 pm New York Middle East: Bahrain Other Asia: TOKYO 8 am – 5 pm (7 am – 7 pm) Opens Monday 6 am Sydney

Normal Trading Sessions and Session Overlaps Session Key Market Local Time N. Y. EDT

Normal Trading Sessions and Session Overlaps Session Key Market Local Time N. Y. EDT GMT Overlaps Asian Tokyo (7: 00 am) 8: 00 am – 5: 00 pm (7: 00 pm) (6: 00 pm) 7: 00 pm – 4: 00 am (6: 00 am) (10: 00 pm) 11: 00 pm – 8: 00 am (10: 00 pm) Tokyo: 4: 00 pm – 5: 00 pm (7: 00 pm) with London: 7: 00 am – 8: 00 am (10: 00 am) European London 7: 00 am – 5: 00 pm 3: 00 am – 12: 00 pm 7: 00 am – 4: 00 pm London: 1: 00 pm – 5: 00 pm with New York: 8: 00 am – 12: 00 pm North America 8: 00 am – 5: 00 pm 12: 00 pm – 9: 00 pm No overlap with Tokyo and New York

London’s Unique Position n Due to the geographic positioning of London in relation to

London’s Unique Position n Due to the geographic positioning of London in relation to New York and Tokyo, London enjoys a trading day which overlaps with the other two. q q q n Thus, London trading in the afternoon corresponds with New York trading in the morning (8 to noon). And, London trading in the morning corresponds with Tokyo trading in the late afternoon (4 to 5 pm/7 pm). However, as noted, New York (regular trading times) and Tokyo trading times do NOT overlap. It isn’t surprising that the currency market is most active when the major sessions overlap.

Importance of London Measuring FOREX Market Activity: Average Electronic Conversations Per Hour Greenwich Mean

Importance of London Measuring FOREX Market Activity: Average Electronic Conversations Per Hour Greenwich Mean Time 10 AM In Tokyo Lunch Europe opening In Tokyo Asia closing Americas London open closing Afternoon in America 6 pm Tokyo In NY opens

Foreign Exchange Rates by Time of Transaction Completion n Spot Exchange Rates: q Quotes

Foreign Exchange Rates by Time of Transaction Completion n Spot Exchange Rates: q Quotes to buy or sell a certain amount of foreign currency at the current market rate, for settlement in two business days (1 day in the case of CAD/USD). n n The difference between the deal and settlement date reflects time needed confirm the agreement and to arrange the transfer of funds across various international centers. Forward Exchange Rates: q Quotes for future buy or sell transactions (3 business days and out). n n n Forward markets are used by businesses and investors to protect against unexpected future changes in exchange rates. Forward rate allows businesses and investors to “lock” in an exchange rate for some future period of time. The price (i. e. , the forward exchange rate) of a forward contract is based on the spot rate at the time the deal is booked, with an adjustment which represents the interest rate differential between the two currencies concerned.

Wall Street Journal Spot Foreign Exchange Rates, Sept. 26 2012 Country/currency In USD Per

Wall Street Journal Spot Foreign Exchange Rates, Sept. 26 2012 Country/currency In USD Per USD Wed Sept 26 Tues Sept 25 Australian dollar 1. 0371 1. 0390 0. 9642 0. 9624 UK pound 1. 6165 1. 6188 0. 6186 0. 6177 Japan yen 0. 01286 0. 01285 77. 75 77. 80 Euro-area euro 1. 2871 1. 2900 0. 7769 0. 7752 Swiss Franc 1. 0643 1. 0666 0. 9396 0. 9375 Source: http: //online. wsj. com/mdc/public/page/2_3021 -forex. html? mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms Look at the above rates and determine if a particular currency appreciated (strengthened) or depreciated (weakened) against the U. S. dollar from Thursday to Friday

Answers to Previous Slide Foreign Currency Change Country/currency In USD Wed Sept 26 In

Answers to Previous Slide Foreign Currency Change Country/currency In USD Wed Sept 26 In USD Tues Sept 25 Per USD Wed Sept 26 Per USD Tues Sept 25 Australian dollar 1. 0371 1. 0390 0. 9642 0. 9624 AUD weakened UK pound 1. 6165 1. 6188 0. 6186 0. 6177 GBP weakened Japan yen 0. 01286 0. 01285 77. 75 77. 80 JPY strengthened Euro-area euro 1. 2871 1. 2900 0. 7769 0. 7752 EUR weakened 0. 9375 CHF weakened Swiss Franc 1. 0643 1. 0666 0. 9396 Source: http: //online. wsj. com/mdc/public/page/2_3021 forex. html? mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms Look at the above rates and determine if a particular currency appreciated (strengthened) or depreciated (weakened) against the U. S. dollar from Thursday to Friday

Cross Rates n n The term cross rate generally refers to the exchange rate

Cross Rates n n The term cross rate generally refers to the exchange rate between two non-USD currencies. These rates are calculated off of each currency’s exchange rate in relations to the USD. q q Example: EUR-USD = 1. 2871 and GBP-USD = 1. 6165 Thus the GBP-EUR cross rate is = 1. 6165/1. 2871 = 1. 2559 (i. e. , GBP = 1. 2559 Euros)

Cross Rates n Assume the following rates: q q n Calculate the GBP-JPY cross

Cross Rates n Assume the following rates: q q n Calculate the GBP-JPY cross rate. q q n GBP-USD = 1. 6189 USD-JPY = 77. 6800 Convert the GBP-USD rate to European terms; 1/1. 6189 =. 6177 Then the GBP-JPY cross rate is 77. 6800/. 6177 = 125. 7588 (i. e. , 1 GBP – 125. 7588 yen) Go to Bloomberg. com to observe cross rates.

Spot Trade Date and Spot Value Date n The spot trade date is the

Spot Trade Date and Spot Value Date n The spot trade date is the date that the agreement was entered into and the spot value date is the date that the settlement will occur. q q Spot Trade Date: will establish the exchange rate. Spot Value Date will determine when funds are transferred. n Two business days from spot trade date (except for USD/CAD trades). q Weekends are not business days and if there is a holiday in one of the clearing centers, then the spot value day is extended.

Identifying Spot Trade Dates and Spot Value Dates Currency Pair Spot Friday, Sept Spot

Identifying Spot Trade Dates and Spot Value Dates Currency Pair Spot Friday, Sept Spot Trade Date 16, 2011 GBP/USD 1. 5788 CAD/USD 1. 0223 Currency Pair Spot Wednesday, Dec 24, 2008 GBP/USD 1. 4765 CAD/USD 0. 8238 Spot Value Date

Identifying Spot Trade Dates and Spot Value Dates: Currency Pair Spot Friday, Sept Spot

Identifying Spot Trade Dates and Spot Value Dates: Currency Pair Spot Friday, Sept Spot Trade Date Spot Value Date Answers 16, 2011 GBP/USD 1. 5788 Sept 16, 2011 Tuesday, Sept 20 (2 bus days) CAD/USD 1. 0223 Sept 16, 2011 Monday, Sept 19 (1 bus day) Currency Pair Spot Wednesday, Dec 24, 2008 GBP/USD 1. 4765 Dec 24, 2008 Monday, Dec 29 (2 bus days) CAD/USD 0. 8238 Dec 24, 2008 Friday, Dec 26 (1 bus day)

American and European Terms Quotes n n If you have one type of quote,

American and European Terms Quotes n n If you have one type of quote, it is easy to determine the second, as the second is simply the reciprocal of the first quote. For example: q q American terms quote for AUD = 1. 0371 Thus the European terms equivalent is simply 1/1. 0371 = 0. 9642 n Confirm this answer with the slide: Wall Street Journal Spot Foreign Exchange Rates, Sept. 26 2012

Calculating American and European Terms Quotes Country/Currency American Terms Brazilian Real 0. 5841 New

Calculating American and European Terms Quotes Country/Currency American Terms Brazilian Real 0. 5841 New Zealand Dollar European Terms 1. 2062 Solution: Calculate the reciprocal Brazilian Real New Zealand Dollar 1/0. 5841 = 1/1. 2062 = Answer

Calculating American and European Terms Quotes: Answers American European Answer Country/Currency Terms Brazilian Real

Calculating American and European Terms Quotes: Answers American European Answer Country/Currency Terms Brazilian Real Terms 0. 5841 New Zealand Dollar 1. 2062 Solution: Calculate the reciprocal Brazilian Real New Zealand Dollar 1/0. 5841 = 1. 7120 1/1. 2062 = 0. 8291

Forward Rate Quotes n Forward exchange rates are set (by market makers) at either

Forward Rate Quotes n Forward exchange rates are set (by market makers) at either a premium or discount of their spot rates. q q n If a currency’s forward rate is higher in value than its spot rate, the currency is being quoted at a forward premium. If a currency’s forward rate is lower in value than its spot rate, the currency is being quoted at a forward discount. Look at the next slide to identify a currency selling at a forward premium and at a forward discount.

Wall Street Journal Forward Foreign Exchange Rates, April 24, 2009 Country/currency In USD Friday

Wall Street Journal Forward Foreign Exchange Rates, April 24, 2009 Country/currency In USD Friday Sept 16 Thursday Sept 15 Friday Sept 16 British pound (spot) 1. 5788 1. 5800 1 -mos forward 1. 5783 1. 5795 3 -mos forward 1. 5773 1. 5785 6 -mos forward 1. 5760 1. 5772 Per USD Thursday Sept 15 Japanese Yen (spot) 76. 79 76. 70 1 -mos forward 76. 76 76. 67 3 -mos forward 76. 71 76. 60 6 -mos forward 76. 60 76. 47 Source: http: //online. wsj. com/mdc/public/page/2_3021 -forex. html? mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms

Foreign Exchange Rates, April 24, 2009: Answer Country/currency In USD Friday Sept 16 British

Foreign Exchange Rates, April 24, 2009: Answer Country/currency In USD Friday Sept 16 British pound (spot) 1. 5788 In USD Per USD Answer Thursday Sept 15 Friday Sept 16 Thursday Sept 15 1 -mos forward 1. 5783 1. 5795 Discount 3 -mos forward 1. 5773 1. 5785 Discount 6 -mos forward 1. 5760 1. 5772 Discount 1. 5800 Japanese Yen (spot) 76. 79 76. 70 1 -mos forward 76. 76 76. 67 Premium 3 -mos forward 76. 71 76. 60 Premium Source: http: //online. wsj. com/mdc/public/page/2_3021 -forex. html? mod=mdc_curr_pglnk 6 -mos forward 76. 60 76. 47 Note: In USD = American Terms and per USD = European Terms

Forward Rate Dates n n n Forward rate settlement dates are calculated off of

Forward Rate Dates n n n Forward rate settlement dates are calculated off of the spot value date (i. e. , the spot transaction settlement date). The forward settlement date is the “calendar date” (adjusting for holidays and weekends). Thus a 1 month forward with a spot value date of Wednesday September 21 st would have a settlement date on Friday October 21 st (a 31 day run). While a 1 month forward with a spot value date of Friday, September 23 rd would have a settlement date on Monday, October 24 th (a 32 day run) – because the 23 rd is a Sunday. Additionally a 1 month forward has to occur in the following month. So a Monday January 31 st would have a settlement date of Monday February 28 th (a 29 day run). q This is a similar requirement for longer forwards. q Assume: Spot Value date: Thursday 31 st March (last business day in March) q 2 months: Tuesday 31 st May (a 2 month run of 61 days) q 3 months: Thursday 30 th June (a 3 month run of 91 days)

n What is the Spot Trade Date and Spot Value (Settlement) For a spot

n What is the Spot Trade Date and Spot Value (Settlement) For a spot deal Date? GBP/USD done on Monday September 26. q q n What is the spot trade date? What is the spot value date? For a spot deal USD/CAD done on Friday September 30? q q What is the spot trade date? What is the spot value date?

Answers: What is the Spot Trade Date and Spot Value (Settlement) n Date? For

Answers: What is the Spot Trade Date and Spot Value (Settlement) n Date? For a spot deal GBP/USD done on Monday September 26. q q n What is the spot trade date? Sept 26 What is the spot value date? Sept 28 For a spot deal USD/CAD done on Friday September 30? q q What is the spot trade date? Sept 30 What is the spot value date? Oct 3

n What is the Trade Date, Spot. Value Date and Settlement Date for For

n What is the Trade Date, Spot. Value Date and Settlement Date for For a 2 month forward Forwards deal GBP/USD done on Friday September 23. q q n What is the trade date? What is the spot value date? What date will the forward be settled? What is the 2 month run? For a 2 month forward deal USD/CAD done on Friday September 30? q q What is the trade date? What is the spot value date? What date will the forward be settled? What is the 2 month run?

n Answers: What is the Trade Date, Spot Value Date and Settlement Date for

n Answers: What is the Trade Date, Spot Value Date and Settlement Date for For a 2 month forward deal Forwards GBP/USD done on Friday September 23. q q n What is the trade date? Sept 23 What is the spot value date? Sept 27 What date will the forward be settled? Nov 28 What is the 2 month run? 63 For a 2 month forward deal USD/CAD done on Friday September 30? q q What is the trade date? Sept 30 What is the spot value date? Oct 3 What date will the forward be settled? Dec 5 What is the 2 month run? 64

2011 Calendar

2011 Calendar