IS 356 IT for Financial Services Foreign Exchange Trading December 24,

December 24, 2015© Paul Tallon2/18 Background  According to the Bank for International Settlements (BIS), the foreign exchange markets trade approx $1.2 trillion per day − more than a month of combined NYSE and NASDAQ trades  $8 trillion of foreign exchange trading is online (Greenwich Associates )… that’s only about 2%  Characteristics: − digital good − no central clearinghouse (trading and clearing are in sync) − no physical trading floor − little regulation (central banks often get involved to stop outflows) − 24-hour global trading

December 24, 2015© Paul Tallon3/18 The Foreign Exchange Market  Minimizes foreign exchange risk (unpredictable rate swings)  There are different ways to trade currencies − Spot exchange rates: the day’s rate offered by a dealer/bank − Forward exchange rates: – Agreed in advance rates to buy/sell a currency on a future date – Usually quoted 30, 90, 120 days in advance  Arbitrage: buying low and selling high … given slightly different exchange rate quotes in one location vs. another (e.g., London vs. Tokyo)

December 24, 2015© Paul Tallon4/18 Spot Market Characteristics  It is the oldest and largest financial market in the world: − Has no central trading floor where buyers and sellers meet. − Is open twenty-four hours a day, except for short gaps on weekends. − The spot market is a market for immediate delivery.  Primarily an inter-bank or sell-side market, which is the trading of foreign-currency-denominated deposits between large banks. − Global banks account for about two-thirds of the market volume, while foreign exchange brokers and dealers account for approximately 20 percent.

December 24, 2015© Paul Tallon5/18 A Foreign Exchange Transaction  Toshiba Japan receives a dollar denominated payment from Best Buy, which they present to their local Fuji Bank.  To exchange the dollar payment for the yen equivalent, Fuji Bank may contact another bank, such as Citigroup, or contact a FX broker. buy Yen, sell $

December 24, 2015© Paul Tallon6/18 Arbitrage: Consistency of Rates  Arbitrage is the simultaneous buying and selling to profit (as opposed to speculation).  You can arbitrage around either spot or future rates but either way, you need to move very fast  The ability of market participants to arbitrage guarantees that cross rates will be, in general, consistent.  If a cross rate is not consistent, the actions of currency traders (arbitrage) will bring the respective currencies into line very quickly.

December 24, 2015© Paul Tallon7/18 Spatial Arbitrage  Spatial Arbitrage refers to buying a currency in one market and selling it in another  Price differences at a point in time arise from spatial or geographically dispersed markets − USD/EUR rate quoted in Paris: $ = €1.00 − EUR/USD rate quoted in NY: €0.77=$1 but according to the rate posted in Paris, the real rate should be € (or 1 ÷ 1.29) − NY trader buys €1 in Paris for $1.29 and sells €1 in New York for $1.2987(makes $ or % profit)  Due to the low-cost rapid-information nature of the foreign exchange market, these price differences are arbitraged quickly and the rates return to equilibrium

December 24, 2015© Paul Tallon8/18 Triangular Arbitrage  Triangular arbitrage involves a third currency  Arbitrage opportunities exist if an observed rate in another market is not consistent with a cross-rate  The US dollar is trading for ($/£) and the South African Rand for (R/£) in London, while the Rand is trading for (R/$) in New York.  The cross-rate in London is: / = (R/$)  Hence, an arbitrage opportunity exists.  How do you take advantage of it?

December 24, 2015© Paul Tallon9/18 Example Continued  A trader sells £1 for $ in London.  The $ would purchase R in New York.  The R purchases £ in London. This is a profit of £ or 3.59 percent profit on a round trip transaction. Sell £ in London Purchase R in New York Purchase £ in London profit

December 24, 2015© Paul Tallon10/18 Market Structure Source: Gallaugher & Melville (2004), CACM 47(8)

December 24, 2015© Paul Tallon11/18 Issues  Phone trading is still an important part of the market. This often paperless approach helped John Rusnak of AllFirst to hide $691M in currency trading losses  Buy-side banks later developed proprietary systems that directly linked to clients. These systems did not support multiple counterparties which was a problem for trader seeking price competition.  This situation led to eFX portals − Single-bank sponsored (State St. – FX Connect) − Independents – Currenex − Bank consortia – FXall, Atriax (closed: Chase, Citibank & DB)

December 24, 2015© Paul Tallon12/18 Source: Gallaugher & Melville (2004), CACM 47(8) Technology Innovation

December 24, 2015© Paul Tallon13/18 Currenex To buy €1, it will cost you $ Roundtrip Example: $ = €1; €1 = ¥137.95; ¥ = $ (no clear arbitrage opportunity; there is only a tiny difference) Bought by State Street in January 2007

December 24, 2015© Paul Tallon14/18 Trading (just like equities)

December 24, 2015© Paul Tallon15/18 Up to 200:1 leverage No fees or commissions

December 24, 2015© Paul Tallon16/18

December 24, 2015© Paul Tallon17/18

December 24, 2015© Paul Tallon18/18 For Next Class…  Read – There will be a 60-minute exam next class