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

2. Where is this Financial District?

3. The Foreign Exchange Market Sometimes referred to as the forex or FX market. It is the market where one currency is traded for another currency.  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.  For example, buying a yen deposit at a bank through selling a dollar deposit at that bank.

4. FX Trading Floor, 1920s

5. FX Trading Floor, (London)

6. Participants in the FX Market Participants in the FX market include:  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).

7. Participants in the FX Market The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market.  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).  However, most of the total forex volume is transacted through about 10 banks.

8. Top Banks in the F.X. Market: Average Market Share, 7 year period 2004 - 2010 BankCountry of Headquarters % Share of Market Years in the Top 10 Deutsche BankGermany36%7 UBSSwitzerland22%7 BarclaysUnited Kingdom12%7 CitiUnited States 6%7 JPMorganUnited States 3%3 Goldman SachsUnited States 3%5 RBSUnited Kingdom 3%6 HSBCUnited Kingdom 2%7 Credit SuisseSwitzerland 2%3 Morgan StanleyUnited States 2%2

9. The FX Market: An Overview World’s largest financial market with an estimated volume of $4.0 trillion dollars per day in trades ($3.3 in 2007).  NYSE-Euronext stock exchange currently about $40 billion per day. Market is a 24/5(7) over-the-counter market.  Major markets open Monday through Friday; Middle East markets also open on weekends (Saudi Arabia and Bahrain)  There is no central trading location (i.e., no central trading floor).  Trades take place through a network of computers (e.g., Reuters screens) and telephone connections all over the world.  Estimates of Daily Volume  1973: $ 10 to 20 billion  1989: $ 590 billion  1992: $ 820 billion (+39%)  1995: $1.190 trillion (+45%)  1998: $1.490 trillion (+25%)  2001: $1.200 trillion (-19%)  2004: $1.880 trillion (+57%)  2007: $3.210 trillion (+71%)  2010: $4.000 trillion (+25%) Note: BIS April Surveys from1989 on.

10. Largest 3 Foreign Exchange Centers, 1995 – 2010 (% of Total)

11. Other Trading Centers, 1995 and 2010, Percent of Total Market Country19952010 Singapore6.65.3 Switzerland5.45.2 Hong Kong5.64.7 Australia2.53.8 France3.83.0 Denmark1.92.4 Germany4.82.1 Canada1.91.2 Sweden1.20.9 Korea0.2 (1998)0.9 Russia0.3 (1998)0.8

12. Currency Distribution in FX Market, Percent of Average Daily Turnover CurrencyISO19982001200420072010 U.S. DollarUSD86.689.988.085.684.9 EuroEUR….37.937.437.039.1 Deutsche MarkDEM30.5…. Japanese YenJPY21.723.520.817.219.0 British PoundGBP11.013.016.514.912.9 Australian DollarAUD 3.0 4.3 6.0 6.6 7.6 Swiss FrancCHF 7.1 6.0 6.8 6.4 Canadian DollarCAD 3.5 4.5 4.2 5.3 Hong Kong DollarHKD 1.0 2.2 1.8 2.7 2.4 Swedish KronaSEK 0.3 2.5 2.2 2.7 2.2 New Zealand DollarNZD 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%

13. Other Currencies, Percent of Average Daily Turnover CurrencyISO19982001200420072010 Korean WonKRW0.20.81.11.21.5 Singapore DollarSGD1.1 0.91.21.4 Norwegian KroneNOK0.21.51.42.11.3 Mexican PesoMXN0.50.81.11.3 Indian RupeeINR0.10.20.30.70.9 Russian RoubleRUB0.3 0.60.70.9 Polish ZlotyPLN0.10.50.40.8 South African RandZAR0.40.90.70.90.7 Brazilian RealBRL0.20.50.30.40.7 Chinese YuanCNY0.0 0.10.50.3 Thai BahtTHB0.10.2

14. Global Foreign Exchange Market by Currency Pair; Percent of Total Currency Pair 19982001200420072010 USD/EUR….30282728 USD/DEM20…. USD/JPY1920171314 USD/GBP 8 101312 9 USD/AUD 3 4 6 6 6 USD/CAD 3 4 4 4 5 USD/CHF 5 5 4 5 4 EUR/JPYNa 3 3 3 3 EUR/CHFNa 1 2 2 2 JPY/AUDNa<1 1

15. Currency Pair Trades by Market Center; Percent of Total for Center Currency Pair U.K. 2001 U.K. 2010 U.S. 2001 U.S. 2010 Japan 2004 Japan 2010 USD/EUR333233321210 USD/JPY161424136162 EUR/JPY 3 3Na 7 9 Others: USD/GBP221310 USD/CAD 3 4 9 USD/AUD 3 6 6 USD/CHF 4 4 5 EUR/GBP 4 4 EUR/CHF 2 2

16. Types of FX Transactions 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.

17. Swaps Explained 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:  (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.

18. F.X. Turnover by Type of Transaction; Amount and % of Total Foreign Exchange Instrument 19982001200420072010 Spot Transactions Outright Forwards F.X. Swaps Currency Swaps Options and others Total Foreign Exchange Instrument 19982001200420072010 Spot Transactions Outright Forwards F.X. Swaps Currency Swaps Options and others Total Foreign Exchange Instrument 19982001200420072010 Amount (Billions USD)1,5271,2391,9343,3243,981 Spot Transactions 568 386 6311,0051,490 Outright Forwards 128 130 209 362 475 F.X. Swaps 734 656 954 1,7141,765 Currency Swaps 10 7 21 31 43 Options and others 87 60 119 212 207 Percent of Total Spot Transactions37.2%31.2%32.6%30.2%37.4% Outright Forwards 8.4%10.5%10.8%10.9%11.9% F.X. Swaps48.1%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%

19. Trading Times for the Market Foreign exchange trades on a 24 hour basis, with major financial centers open Monday through Friday. Weekday trading begins in Sydney, Australia, Monday morning (6:00am local time).  Which is Sunday 4pm EST in New York; Sunday 8pm in London, and Monday 5:00am in Japan. Weekday trading ends in New York, Friday afternoon (5pm EST).  Which is Friday 10pm in London, and Saturday 6:00am 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).

20. 24-Hour Global Market: Times Represent Local Trading Hours Europe: LONDON 8am – 5pm Middle East: Bahrain NEW YORK 8am – 5pm Other Asia: TOKYO 8am – 5pm (7am – 7pm) Opens Monday 6am Sydney Closes: Friday 5pm New York

21. Normal Trading Sessions and Session Overlaps SessionKey Market Local TimeN. Y. EDTGMTOverlaps AsianTokyo(7:00am) 8:00am – 5:00pm (7:00pm) (6:00pm) 7:00pm – 4:00am (6:00am) (10:00pm) 11:00pm – 8:00am (10:00pm) Tokyo: 4:00pm – 5:00pm (7:00pm) with London: 7:00am – 8:00am (10:00am) EuropeanLondon7:00am – 5:00pm 3:00am – 12:00pm 7:00am – 4:00pm London: 1:00pm – 5:00pm with New York: 8:00am – 12:00pm North America New York 8:00am – 5:00pm 12:00pm – 9:00pm No overlap with Tokyo and New York

22. London’s Unique Position 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.  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 5pm/7pm).  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.

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

24. Foreign Exchange Rates by Time of Transaction Completion Spot Exchange Rates:  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). 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:  Quotes for future buy or sell transactions (3 business days and out). 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.

25. Wall Street Journal Spot Foreign Exchange Rates, Sept. 26 2012 Country/currencyIn USD Per USD Wed Sept 26Tues Sept 25Wed Sept 26Tues Sept 25 Australian dollar1.03711.03900.96420.9624 UK pound1.61651.61880.61860.6177 Japan yen0.012860.0128577.7577.80 Euro-area euro1.28711.29000.77690.7752 Swiss Franc1.06431.06660.93960.9375 Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnkhttp://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

26. Answers to Previous Slide Foreign Currency Change Country/currencyIn USD Per USD Wed Sept 26 Tues Sept 25 Wed Sept 26 Tues Sept 25 Australian dollar1.03711.03900.96420.9624AUD weakened UK pound1.61651.61880.61860.6177GBP weakened Japan yen0.012860.0128577.7577.80JPY strengthened Euro-area euro1.28711.29000.77690.7752EUR weakened Swiss Franc1.06431.06660.93960.9375CHF weakened Source: http://online.wsj.com/mdc/public/page/2_3021- forex.html?mod=mdc_curr_pglnkhttp://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

27. Cross Rates 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.  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)

28. Cross Rates Assume the following rates:  GBP-USD = 1.6189  USD-JPY = 77.6800 Calculate the GBP-JPY cross rate.  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.

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

30. Identifying Spot Trade Dates and Spot Value Dates Currency PairSpot Friday, Sept 16, 2011 Spot Trade DateSpot Value Date GBP/USD1.5788 CAD/USD1.0223 Currency PairSpot Wednesday, Dec 24, 2008 GBP/USD1.4765 CAD/USD0.8238

31. Identifying Spot Trade Dates and Spot Value Dates: Answers Currency PairSpot Friday, Sept 16, 2011 Spot Trade DateSpot Value Date GBP/USD1.5788Sept 16, 2011Tuesday, Sept 20 (2 bus days) CAD/USD1.0223Sept 16, 2011Monday, Sept 19 (1 bus day) Currency PairSpot Wednesday, Dec 24, 2008 GBP/USD1.4765Dec 24, 2008Monday, Dec 29 (2 bus days) CAD/USD0.8238Dec 24, 2008Friday, Dec 26 (1 bus day)

32. American and European Terms Quotes 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:  American terms quote for AUD = 1.0371  Thus the European terms equivalent is simply 1/1.0371 = 0.9642 Confirm this answer with the slide: Wall Street Journal Spot Foreign Exchange Rates, Sept. 26 2012

33. Calculating American and European Terms Quotes Country/CurrencyAmerican Terms European Terms Answer Brazilian Real0.5841 New Zealand Dollar1.2062 Solution: Calculate the reciprocal Brazilian Real1/0.5841 = New Zealand Dollar1/1.2062 =

34. Calculating American and European Terms Quotes: Answers Country/CurrencyAmerican Terms European Terms Answer Brazilian Real0.5841 New Zealand Dollar1.2062 Solution: Calculate the reciprocal Brazilian Real1/0.5841 =1.7120 New Zealand Dollar1/1.2062 =0.8291

35. Forward Rate Quotes Forward exchange rates are set (by market makers) at either a premium or discount of their spot rates.  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.

36. Wall Street Journal Forward Foreign Exchange Rates, April 24, 2009 Country/currencyIn USD Per USD Friday Sept 16Thursday Sept 15Friday Sept 16Thursday Sept 15 British pound (spot)1.57881.5800 1-mos forward1.57831.5795 3-mos forward1.57731.5785 6-mos forward1.57601.5772 Japanese Yen (spot)76.7976.70 1-mos forward76.7676.67 3-mos forward76.7176.60 6-mos forward76.6076.47 Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnkhttp://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms

37. Foreign Exchange Rates, April 24, 2009: Answer Country/currencyIn USD Per USD Answer Friday Sept 16 Thursday Sept 15Friday Sept 16 Thursday Sept 15 British pound (spot)1.57881.5800 1-mos forward1.57831.5795Discount 3-mos forward1.57731.5785Discount 6-mos forward1.57601.5772Discount Japanese Yen (spot)76.7976.70 1-mos forward76.7676.67Premium 3-mos forward76.7176.60Premium 6-mos forward76.6076.47 Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnkhttp://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms

38. Forward Rate Dates 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).  This is a similar requirement for longer forwards.  Assume: Spot Value date: Thursday 31st March (last business day in March)  2 months: Tuesday 31st May (a 2 month run of 61 days)  3 months: Thursday 30th June (a 3 month run of 91 days)

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

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

41. What is the Trade Date, SpotValue Date and Settlement Date for Forwards For a 2 month forward deal GBP/USD done on Friday September 23.  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?  What is the trade date?  What is the spot value date?  What date will the forward be settled?  What is the 2 month run?

42. Answers: What is the Trade Date, Spot Value Date and Settlement Date for Forwards For a 2 month forward deal GBP/USD done on Friday September 23.  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?  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

43. 2011 Calendar