FX Markets David Whitcomb, CFA Trader, Cargill Inc October 15 th,

Agenda Markets Overview FX Instruments and Forward Pricing Factors Influencing FX Markets Corporate Hedging and Speculative Trading 2

Markets Overview 3

FX Market Basics Foreign exchange market is unique due to: Large trading volumes 4 “Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007.”

FX Market Basics Foreign exchange market is unique due to: Extremely High Liquidity 5 Daily TurnoverBid/OfferNumber of Securities FX Market4.0 Trillion0.7bp150 (40 actively traded) Bond Market3.0 Trillion1-5bps2,000,000 Equity Market>200 Billion15bps20,000+? Source: BIS 2004, 2010, Deutsche Bank

FX Market Basics Foreign exchange market is unique due to: Geographical Dispersion (London to NY to Singapore to London…) According to the Bank of International Settlements (BIS), Largest geographic trading centers are: London (36.7%), US (18.0%), Japan (6.0%), Singapore (5.0%), Switzerland (5.0%), Hong Kong (5.0%), Australia (4.0%) 6 Currency% of Trades US Dollar84.9% Euro39.1% Japanese Yen19.0% Pound Sterling12.9% Australian Dollar7.6% Swiss Franc6.4% Canadian Dollar5.3% Source: BIS 2010

FX Market Basics Foreign exchange market is unique due to: Variety of Traders in the Market Estimated that 90% of all FX trades are speculative 7

FX Market Basics Foreign exchange market is unique due to: Factors that Affect Exchange Rates: - Economic Fundamentals - Currency Regime - Monetary Policy - Central Bank Intervention - Correlation/Reaction to Other Markets - Speculative Activity & Market Sentiment 8

FX Market Basics Every currency has a three letter code Typically, the first two letters refer to the country, the final letter to the currency 9

FX Market Convention Base Currency (Primary Currency) The base currency is the first currency in a currency pair; the exchange rate is always quoted per unit of the base currency e.g., for EUR/USD, the Euro is the base currency… if the pair is trading at 1.30, one Euro buys 1.30 US Dollars Currency Hierarchy: Euro British Pound (Sterling) Australian Dollar New Zealand Dollar United States Dollar Canadian Dollar Swiss Franc Japanese Yen 10 Note: Euro is the world’s dominant base currency, all currency pairs traded against the Euro are quote per EUR

FX Market Convention Some examples of quotes in currency pairs: * From a corporate perspective, the bank/dealer sees it the other way Base / Secondary BidAsk EUR/GBP AUD/USD USD/CAD USD/JPY Quote to sell* base currency Quote to buy* base currency 11

FX Instruments and Forward Pricing 12

FX Spot Spot rate is the exchange rate at which one currency is exchanged for another for settlement as soon as possible (usually t+2) According to BIS, 37% of all FX transactions are spot transactions…i.e., for customers who want the physical cash as soon as possible 13

FX Forward What if you want to lock in an FX rate to satisfy a future obligation? A forward contract in the FX market locks in the price at which an entity can buy or sell a currency on a future date: Both parties agree on an exchange rate for a specific date in the future Money does not change hands until the future maturity date Length of the contract can be a couple of days, months, or years 14

FX Forward 15 Forward Pricing: Forward price = Spot price + Forward (or swap) points BIDASK Spot: USD/CAD Fwd (swap) points [1yr fwd] Forward rate [1yr fwd]

FX Forward 16 The forward rate is determined by the interest rate differentials between two currencies, so no arbitrage is possible: One of the most important mathematical concepts in FX: understanding the basic relationship between FX forwards and Interest Rates

FX Forward 17 Forward points are negative (the all-in forward rate is lower than the spot rate) when interest rates in the base currency are higher than the secondary currency…the denominator is larger A little counterintuitive: Why do higher interest rates make a currency “depreciate” on the forward curve? This prevents speculators from investing funds in the country with higher rates and locking in a risk-free profit

FX Forward 18 Example: USA vs Canada. Chairman Bernanke and the Fed intend to keep US rates low (Fed Funds rate = %) while Gov Carney and the Bank of Canada have raised rates to 1.25% over the past four months. Risk-Free Rate US: 1-Year LIBOR = 0.75% Risk-Free Rate Canada: 1-Year CAD LIBOR = 2.00% Today, you can buy/sell USDCAD one-year forward at ≈1.0327

FX Forward 19 October 14, 2010 USD 10,000,000 Spot rate Receive CAD 10,200,000 Deposit CAD for 12 months at rate of 2.00% Receive CAD 10,404,000 “Forward” All-In Rate October 14, 2011 USD 10,075,000 Deposit USD for 12 months at rate of 0.75% Two paths, both end up with the same CAD amount…no arbitrage!

FX Forward 20 Question: How would you arb the following? i.e., where would you borrow/invest to extract the value from this market anomaly: AUDUSD spot is AUDUSD 1yr forward rate = spot rate = Risk-Free Rate US: 1-Year LIBOR = 1.00% Risk-Free Rate Australia: 1-Year AUD LIBOR = 6.00%

FX Forward 21 Answer: You know that the forward fx rate is too high (with higher rates, AUDUSD 1yr forward should be lower, not equal to spot…) Day 1: Borrow $1,000 USD at US rate of 1.00% Convert the USD to AUD = $1,000 / 0.95 = AUD1,053 Invest the AUD in an Australian risk-free investment earning 6.00% for a year Sell AUDUSD forward so you will have USD in a year to repay your USD loan Day 360: Your AUD investment becomes 1,053 x 1.06 = AUD1,116 When converted back to USD = AUD1,116 x 0.95 = $1,060 Subtract the interest you owe on the USD borrow = $1,000 x 1.00% = $10.00 You’ve made $1,060 – $1,000 – $10.00 = $50.00 That’s $50.00 Risk Free! (ex-counterparty risk) Note: You earn this arbitrage today, all the rates are “locked in”

FX Options FX Option is a derivative where: The option holder has the right but not the obligation to exchange money denominated in one currency for a second currency at a pre-agreed exchange rate on an established date The option buyer may, for an agreed price (i.e. the premium), purchase an option to buy or sell a currency at expiry date There are two major types of options: American and European options American options can be exercised at any time before expiry European options can only be exercised at expiry Call = Right to Buy, Put = Right to Sell 22

FX Options Option Pricing depends upon: The spot rate The tenor of the option (time to maturity) The volatility of the currency pair The foreign interest rate The domestic interest rate The strike price, i.e., how far is the option in the money 23

Factors Influencing FX Markets 24

Factors Affecting FX Movements Economic policies by central banks affect FX movements. The ability of a country to attract capital investments will also impact the movement of its currency. A strong economy And/or Tight monetary policy A weak economy And/or Expansionary monetary policy Attracts capital from overseas, More Reserves Current account financing is easy The home currency appreciates Capital flows overseas, Fewer Reserves Current account financing is difficult The home currency depreciates 25

Factors Affecting FX Movements Themes in FX Right Now: “FX Wars” and “Competitive Devaluation” Pronounced USD weakness as chances are high that we embark on another Quantitative Easing (i.e., money printing) campaign in November China’s Resistance to Revaluation of Yuan “This sets off a damaging dynamic…The collective impact of this behavior risks either causing inflation and asset bubbles in emerging economies, or else depressing consumption growth and intensifying short-term distortions in favor of exports.” – Treasury Secretary Timothy Geithner, 10/6/10 26

Corporate Trading and Speculative Trading 27

Corporate Hedging 28 How Do Large Corporations Use FX? Example: A large, Canadian Multinational Food Company sells Cattle in the US The market for Cattle is US dollar based The Canadian Company receives US dollars for its cattle sales Cattle US Dollars US Customer Canadian Company

Corporate Hedging 29 The Problem: The Canadian company faces significant FX risk If the US$ depreciates significantly, the company’s contracts for future cattle sales become worth significantly less in CAD$ Today that same contract for 1,000,000 US$ only worth about 1,000,000 CAD$ 1,000,000 US$ contract set in March ‘09 worth1,300,000 CAD$

Corporate Hedging 30 The Solution: Hedge The Canadian Company knows it will receive US dollars in the future from its US customer The Company can hedge by selling US dollars at a forward date in exchange for Canadian dollars Regardless of the appreciation/depreciation of the US dollar, the Canadian Company will receive a contracted amount of Canadian dollars The Canadian Company effectively receives Canadian dollars for its sales US Dollars Canadian Company US Customer The Hedge: US Dollars Bank Canadian Dollars

Speculative Trading 31 Technical and Fundamental Trading Technical: Historical price movements predict future price movements - Support/Resistance, Fibonacci, Moving Average, Channels/Trends… Fundamental: Economic factors determine FX valuations - Interest Rate Parity, Purchasing Power Parity (“Big Mac Index”)…

Speculative Trading - Fundamental 32 Barclays, FX Research Intraday Comment, 10/11/10: “Last week, our economics team made two significant changes to their policy rate hike expectations. First, our US economists now expect the Fed to announce a programme of 'incremental' asset purchases targeting a certain amount of flow each month (around USD100bn). They do not expect any upper limit for asset purchases but expect the length of the programme to be tied to improvement in economic data. Second, our European economists now forecast the ECB to be on hold for 2011 (previously we expected a hike in Q211). This change in view is driven by three factors: expectations of further QE by the Fed; further fiscal tightening announced in some countries (France, Portugal); and the upwards pressure on the EUR as an expression of the increasingly bearish USD sentiment. Given these changes, we have accordingly revised our EUR/USD forecasts to 1.42, 1.39, 1.35 and 1.30 in 1, 3, 6 and 12m, respectively (previously, 1.35, 1.35, 1.33 and 1.30).” Note the emphasis that Barclays puts on interest rate decisions “further QE by the Fed” = more Treasuries purchased, driving US interest rates lower, making US investments less attractive, USD bearish “further fiscal tightening” in Europe = higher Eurozone interest rates, making EUR investments more attractive, EUR bullish Again: It all comes down to interest rates

Speculative Trading - Technicals 33 Credit Suisse, Global Strategy Technical Analysis, 10/06/10:

Speculative Trading - Technicals 34 CitiFX, Technicals, 10/11/10: