Lecture 4: The Foreign Exchange Market

The Structure of the Foreign Exchange Market

Where is this Financial District?

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.

FX Trading Floor, 1920s

FX Trading Floor, (London)

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).

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.

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

Headquarters% Share of Market

Years in the Top 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 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 billion1992: $ 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.

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

Other Trading Centers, 1995 and 2010, Percent of Total MarketCountry 1995 2010

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 TurnoverCurrency ISO 1998 2001 2004 2007 2010

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 6.0 6.8 6.4

Canadian Dollar CAD 3.5 4.5 4.2 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 1.6Note: 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 TurnoverCurrency ISO 1998 2001 2004 2007 2010

Korean Won KRW 0.2 0.8 1.1 1.2 1.5

Singapore Dollar SGD 1.1 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 1.3

Indian Rupee INR 0.1 0.2 0.3 0.7 0.9

Russian Rouble RUB 0.3 0.3 0.6 0.7 0.9

Polish Zloty PLN 0.1 0.5 0.4 0.8 0.8

South African Rand ZAR 0.4 0.9 0.7 0.9 0.7

Brazilian Real BRL 0.2 0.5 0.3 0.4 0.7

Chinese Yuan CNY 0.0 0.0 0.1 0.5 0.3

Thai Baht THB 0.1 0.2 0.2 0.2 0.2

Global Foreign Exchange Market by Currency Pair; Percent of TotalCurrency Pair

1998 2001 2004 2007 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 5 4

EUR/JPY Na 3 3 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 CenterCurrency Pair

U.K. 2001

U.K.2010

U.S.2001

U.S.2010

Japan2004

Japan2010

USD/EUR 33 32 33 32 12 10

USD/JPY 16 14 24 13 61 62

EUR/JPY 3 3 Na Na 7 9

Others:

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

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.

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.

F.X. Turnover by Type of Transaction; Amount and % of TotalForeign Exchange Instrument

1998 2001 2004 2007 2010

Spot Transactions

Outright Forwards

F.X. Swaps

Currency Swaps

Options and others

Total

Foreign Exchange Instrument

1998 2001 2004 2007 2010

Spot Transactions

Outright Forwards

F.X. Swaps

Currency Swaps

Options and others

Total

Foreign Exchange Instrument

1998 2001 2004 2007 2010

Amount (Billions USD) 1,527 1,239 1,934 3,324 3,981

Spot Transactions 568 386 631 1,005 1,490

Outright Forwards 128 130 209 362 475

F.X. Swaps 734 656 954 1,714 1,765

Currency Swaps 10 7 21 31 43

Options and others 87 60 119 212 207

Percent of Total

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 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).

24-Hour Global Market: Times Represent Local Trading Hours Europe:

LONDON8am – 5pm

Middle East:Bahrain

NEW YORK 8am – 5pm

Other Asia:TOKYO8am – 5pm (7am – 7pm)

Opens Monday 6am

Sydney

Closes: Friday 5pm New

York

Normal Trading Sessions and Session OverlapsSession Key

MarketLocal Time N. Y. EDT GMT Overlaps

Asian Tokyo (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)

European London 7:00am – 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

8:00am – 5:00pm

12:00pm – 9:00pm

No overlap with Tokyo and New York

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.

Importance of London

0

5,000

10,000

15,000

20,000

25,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Measuring FOREX Market Activity: Average Electronic Conversations Per Hour

Greenwich Mean Time

Tokyoopens

Asiaclosing

10 AMIn Tokyo

Afternoonin America

Londonclosing

6 pmIn NY

Americasopen

Europeopening

LunchIn

Tokyo

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.

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

Wed Sept 26 Tues Sept 25 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 0.9375Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk

Note: In USD = American Terms and per USD = European TermsLook 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 SlideForeign Currency Change

Country/currency In USD In USD Per USD Per USD

Wed Sept 26

Tues Sept 25

Wed Sept 26

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

Swiss Franc 1.0643 1.0666 0.9396 0.9375 CHF weakenedSource: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk

Note: In USD = American Terms and per USD = European TermsLook 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 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)

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.

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.

Identifying Spot Trade Dates and Spot Value DatesCurrency Pair Spot Friday,

Sept 16, 2011Spot Trade Date Spot Value Date

GBP/USD 1.5788

CAD/USD 1.0223

Currency Pair Spot Wednesday, Dec 24, 2008

GBP/USD 1.4765

CAD/USD 0.8238

Identifying Spot Trade Dates and Spot Value Dates: AnswersCurrency Pair Spot Friday,

Sept 16, 2011Spot Trade Date Spot Value Date

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 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

Calculating American and European Terms QuotesCountry/Currency American

TermsEuropean Terms

Answer

Brazilian Real 0.5841

New Zealand Dollar 1.2062

Solution: Calculate the reciprocal

Brazilian Real 1/0.5841 =

New Zealand Dollar 1/1.2062 =

Calculating American and European Terms Quotes: AnswersCountry/Currency American

TermsEuropean Terms

Answer

Brazilian Real 0.5841

New Zealand Dollar 1.2062

Solution: Calculate the reciprocal

Brazilian Real 1/0.5841 = 1.7120

New Zealand Dollar 1/1.2062 = 0.8291

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.

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

Friday Sept 16 Thursday Sept 15 Friday Sept 16 Thursday Sept 15

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

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_pglnkNote: In USD = American Terms and per USD = European Terms

Foreign Exchange Rates, April 24, 2009: Answer

Country/currency In USD In USD Per USD Per USD Answer

Friday Sept 16

Thursday Sept 15 Friday Sept 16

Thursday Sept 15

British pound (spot) 1.5788 1.5800

1-mos forward 1.5783 1.5795 Discount

3-mos forward 1.5773 1.5785 Discount

6-mos forward 1.5760 1.5772 Discount

Japanese Yen (spot) 76.79 76.70

1-mos forward 76.76 76.67 Premium

3-mos forward 76.71 76.60 Premium

6-mos forward 76.60 76.47Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnkNote: In USD = American Terms and per USD = European Terms

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 3 month run of 91 days)

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?

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

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?

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

2011 Calendar