International Financial Markets and Institutions COMM 377 The Currency Market organization Ali Lazrak September 2013

Why Domestic Residents Want to Hold Foreign Currencies? 2

Learning Objectives  Be familiar with the size and the scope of the foreign exchange market  Given any currency transaction, be able to predict how the foreign exchange market is going to handle it and how trades take place  Given a set of market makers currencies’ quote, be able to:  Explain what they mean (cross rates and bid/ask)  Check if the quotations are consistent and, if not, be able to implement an arbitrage strategy to profit from it. 3

Outline  Importance of the foreign exchange market  Foreign Exchange Market (FXM): Products and technicalities  Organization of FXM  Transaction costs and arbitrage 4

I. Importance of the Foreign Exchange Market (FXM)

Average Daily Turnover in Billions of US$ (BIS report April 2010) Spot Transactions Outright Forwards & Swaps Turnover: Tr 2Tr spot, 2.9Tr For/Swap

Percentage Shares of Average 2013 Daily Turnover (Total = 200) Source: Bank for International Settlements Central Bank Survey, April 2013, Graph 1,p3 Japanese yen 7

II. FXM Products and technicalities

FXM Products  Spot contract  Forward contract, or outright forward  Foreign exchange swap  Options/Futures 9

Quotation Conventions  Direct vs indirect ·Direct: HC/FC Indirect: FC/HC  American vs. European ·American: Euro and Pounds · US$/€, US$/£ ·European: all other currencies · ¥/US$ 10

Example: Converting 1 million pounds to 1.60 US$/Pound £ US$ £ 1 M = Multiply ? Divide ? 11

 If the dollar appreciates against the GBP, the GBP depreciates against the dollar Appreciation/Depreciation 12

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Cross Exchange Rates  Cross rates are exchange rates between two non-dollar currencies  Example: £/¥ Cross rates benchmark can be computed from the product or ratio of the bilateral rates against the dollarCross rates benchmark can be computed from the product or ratio of the bilateral rates against the dollar 14

Cross exchange rates US$ £ ¥ 1.60 U$/£ 120 ¥/US$ 15

A recent currency matrix 16

III. Organization of the FXM

Spot FXM Setting  A 24hours/day informal and dispersed arrangement of the larger commercial banks and a number of foreign brokers  Linked by a network (telephone, telex and SWIFT (Society for worldwide international financial telecommunications)).  Low spreads and Fast response to continuous information  Price dispersion 18

Geographic Extent of the Market 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 19

The actors Dealers (Market makers): Commercial and investment Banks typically connected through CHIPS (clearing house interbank payments system) Brokers: keep the books of market-maker’s limit orders Customers: central banks, banks customers (corporations) and investors Execute transactions through market markersExecute transactions through market markers 20

Transaction level Interbank transactions (or wholesale market): market makers Restricted access (credit quality, trading style and scale)Restricted access (credit quality, trading style and scale) Retail (or client market): central banks, banks customers (corporations) and investors 21

General Structure of the FXM Interbank mkt (C$/FC) domestic (C$) foreign (FC) Exchange-traded futures & options central bank firms investors for. firms for. central bank for. investors 22

Interbank transactions Banks trade with each other ·in response to retail orders ·to take a position for their own accounts Banks trade ·directly with other banks ·indirectly through FX brokers 23

Interbank FXM dom. bank for. bank dom. bank for. bank FX broker domestic (C$) foreign (FC) C$/FC Buy 1 mln pounds 24

Direct vs. Brokered Interbank Trades Direct dealing -Bank’s bid-ask spread confronted, fast execution -Bank’s bid-ask spread confronted, fast execution -decentralized, continuous, Open-bid, double auction market -decentralized, continuous, Open-bid, double auction market Brokered trades -Pro: Get best price of all posted buys/sells -Con: Non execution risk and brokerage fees -Quasi centralized, continuous, limit-book, single auction market 25

Retail transactions  Traditionally corporations go with commercial banks for foreign exchange transactions.  One way quotation: Interbank+Margin 26

Retail FX Market dom. bank Corp. order Buy 1 mln pounds 27

FX Market dom. bank Corp. order for. bank dom. bank for. bank FX broker Corp. order Corp. order Corp. order domestic (C$) foreign (FC) C$/FC 28

Market Turnover by Counterparty Source: Bank for International Settlements Central Bank Survey, April 2010, Table 2, p8 29 Year With reporting dealers (Interbank) 719 (58%) 1018 (53%) 1392 (42%) 1548 (39%) With other financial institutions (Asset managers: Retail) 346 (28%) 634 (33%) 1339 (40%) 1900 (48%) With non financial customers (Corporate: Retail) 174 (14%) 276 (14%) 593 (10%) 533 (13%) Total

Interbank trading is not the highest anymore! Transactions between banks and financial customers increased Trend toward automated brokerage systems (Reuter and Electronic brokerage system) FXM Trends 30

IV. Transaction costs and arbitrage

Bid-Ask Spreads Banks quote two rates for exchanging currencies:   a bid rate at which they’ll buy   a higher offer (or ask) rate at which they’ll sell   Example: US$/£ Pound ask: rate at which bank will sell Pounds Pound bid: rate at which bank will buy Pounds (and buy dollars) (and sell dollars) US$/£ US$/£ 32

US$ ¥ = ¥/US$ yen 1 bln $8.343 mln IBM wants to sell ¥ 1 bln. Citibank quotes ¥/US$. Example = ¥/US$ yen 1 bln $8.340 mln 4

Arbitrage  Arbitrageurs keep exchange rate quotations from many different banks consistent, by exploiting significant differences 34

Chase Deutsche Commerz Morgan Real time US$/€ Quotes US$/€ 35

  Assume S($/ask£) =1.4   You receive £1 in exchange of paying $1.4   Buying £ is equivalent to selling $ !   You pay $1.4 in exchange of receiving £1.   Therefore, S(£/bid$) = 1/1.4 S($/ask£) = 1 S(£/bid$) Cross Rates and Bid/Ask Spread 36

  Triangular arbitrage bounds S(€/bid£)  S(€/askUS$) * S(US$/ask£) S(€/ask£)  S(€/bidUS$) * S(US$/bid£)   Competitiveness bounds S(€/bid£)  S(US$/bid£) * S(€/bidUS$) S(€/ask£)  S(€/askUS$) * S(US$/ask£)   Maximum spread on the €/£ market is [S(US$/bid£) * S(€/bidUS$) ; S(€/askUS$) * S(US$/ask£)] Cross Rates and Bid/Ask Spread 37

Key words  Currencies turnover  Cross exchange rate  Interbank market, retail market  Direct dealing vs. brokered trades  Bid-Ask rates  Triangular arbitrage 38