Lecture 4:The Foreign Exchange Market

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 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 • 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 commercial banks (as market makers), investment institutions, non-financial corporations and central banks. Over 80% of total market. • Participants include banks, individuals and firms conducting commercial and investment transactions, speculators and arbitragers, central banks and treasuries, foreign exchange brokers (who match buy and sell orders but do not carry inventory) and nonbank foreign exchange dealers. • Non-bank dealers (e.g., Travelex) operate in the small end of the FX market ($5 million and less) while banks operate in the larger end of the market (million dollar multiples up to $100m). • 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) – this occurs in the interbank market. • However, most of the total forex volume is transacted through about 10 banks.

7. Top Banks in the F.X. Market: Average Market Share, 7 year period 2004 - 2010

8. 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.

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

10. Other Trading Centers, 1995 and 2010, Percent of Total Market

11. Currency Distribution in FX Market, Percent of Average Daily Turnover

12. Other Currencies, Percent of Average Daily Turnover

13. Global Foreign Exchange Market by Currency Pair; Percent of Total

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

15. 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.

16. 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.

17. F.X. Turnover by Type of Transaction; Amount and % of Total

18. 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).

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

20. Normal Trading Sessions and Session Overlaps

21. 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.

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

23. 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.

24. Wall Street Journal Spot Foreign Exchange Rates, Sept. 16 2011

25. Foreign Exchange Rates, Sept. 16 2011: Answers

26. 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.

27. Identifying Spot Trade Dates and Spot Value Dates

28. Identifying Spot Trade Dates and Spot Value Dates: Answers

29. Calculating American and European Terms Quotes

30. Calculating American and European Terms Quotes: Answers

31. 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.

32. Wall Street Journal Forward Foreign Exchange Rates, April 24, 2009

33. Foreign Exchange Rates, April 24, 2009: Answer

34. 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 21st would have a settlement date on Friday October 21st (a 31 day run). • While a 1 month forward with a spot value date of Friday, September 23rd would have a settlement date on Monday, October 24th (a 32 day run) – because the 23rd is a Sunday. • Additionally a 1 month forward has to occur in the following month. So a Monday January 31st would have a settlement date of Monday February 28th (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 3month run of 91 days)

35. 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?

36. 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

37. 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?

38. 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

39. 2011 Calendar