2. FOREX Market Participants The FOREX market is a two-tiered market: The FOREX market is a two-tiered market: Interbank Market (Wholesale)Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in Foreign exchange. About 700 banks worldwide stand ready to make a market in Foreign exchange. Nonbank dealers account for about 20% of the market. Nonbank dealers account for about 20% of the market. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail)Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks. Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

3. London is Most Active FX Market

4. Daily Trading Volumes by Hour

5. Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. International commercial banks communicate with one another with: International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications.SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments SystemCHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.

6. Correspondent Banking

7. FX Turnover

8. Spot Rate Quotations Direct quotation Direct quotation the U.S. dollar equivalentthe U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny”e.g. “a Japanese Yen is worth about a penny” Indirect Quotation Indirect Quotation the price of a U.S. dollar in the foreign currencythe price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar”e.g. “you get 100 yen to the dollar”

9. Spot Rate Quotations The direct quote for British pound is: £1 = $1.5627 Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso) 0.33090.32923.02213.0377 Australia (Dollar) 0.59060.59341.69321.6852 Brazil (Real) 0.29390.28793.40253.4734 Britain (Pound) 1.56271.5660.63990.6386 1 Month Forward 1.55961.56290.64120.6398 3 Months Forward 1.55351.55680.64370.6423 6 Months Forward 1.54451.54770.64750.6461 Canada (Dollar) 0.66920.67511.49431.4813 1 Month Forward 0.66810.67411.49681.4835 3 Months Forward 0.66580.67171.5021.4888 6 Months Forward 0.6620.66781.51061.4975

10. Spot Rate Quotations The indirect quote for British pound is: £.6399 = $1 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry

11. Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote: 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry

12. The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The bid price is the price a dealer is willing to pay you for something. The ask price is the amount the dealer wants you to pay for the thing. The ask price is the amount the dealer wants you to pay for the thing. The bid-ask spread is the difference between the bid and ask prices. The bid-ask spread is the difference between the bid and ask prices.

13. Spot FX trading In the interbank market, the standard size trade is about U.S. $10 million. In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. A bank trading room is a noisy, active place. The stakes are high. The stakes are high. The “long term” is about 10 minutes. The “long term” is about 10 minutes.

14. Cross Rates Suppose that S($/€) =.50 Suppose that S($/€) =.50 i.e. $1 = 2 € i.e. $1 = 2 € and that S(¥/€) = 50 and that S(¥/€) = 50 i.e. €1 = ¥50 i.e. €1 = ¥50 What must the $/¥ cross rate be? What must the $/¥ cross rate be?

15. Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

16. Triangular Arbitrage $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money? Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars. ¥ £

17. Triangular Arbitrage $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. ¥ £ 1 2 3 $

18. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250

19. Spot Foreign Exchange Microstructure Market Microstructure refers to the mechanics of how a marketplace operates. Market Microstructure refers to the mechanics of how a marketplace operates. Bid-Ask spreads in the spot FX market: Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility andincrease with FX exchange rate volatility and decrease with dealer competition.decrease with dealer competition. Private information is an important determinant of spot exchange rates. Private information is an important determinant of spot exchange rates.

20. The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out- of-stock textbook, then you have entered into a forward contract. If you have ever had to order an out- of-stock textbook, then you have entered into a forward contract.

21. Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available. Longer-term swaps are available.

22. Forward Rate Quotations Consider the example from above: Consider the example from above: for British pound, the spot rate is $1.5627 = £1.00 While the 180-day forward rate is $1.5445 = £1.00 What’s up with that? What’s up with that?

23. Spot Rate Quotations Clearly the market participants expect that the pound will be worth less in dollars in six months. 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry

24. Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to sell forex forward, you are short. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long. If you have agreed to buy forex forward, you are long.

25. Payoff Profiles 0 S 180 ($/¥) F 180 ($/¥) =.009524 Short positionloss profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. If you agree to sell anything in the future at a set price and the spot price later rises then you lose.

26. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) profit Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote: F 180 (¥/$) = 105 or F 180 ($/¥) =.009524. short position

27. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F 180 (¥/$) = 105 profit short position

28. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) 120 If, in 180 days, S 180 (¥/$) = 120, the short will make a profit by buying ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 15¥ profit short position

29. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position-F 180 (¥/$) F 180 (¥/$) short position profit Since this is a zero-sum game, the long position payoff is the opposite of the short.

30. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position -F 180 (¥/$) profit The long in this forward contract agreed to BUY ¥ in 180 days at F 180 (¥/$) = 105 If, in 180 days, S 180 (¥/$) = 120, the long will lose by having to buy ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 120 –15¥

31. SWAPS A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent. Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

32. Forward Premium It’s just the interest rate differential implied by forward premium or discount. It’s just the interest rate differential implied by forward premium or discount. For example, suppose the € is appreciating from S($/€) =.5235 to F 180 ($/€) =.5307 For example, suppose the € is appreciating from S($/€) =.5235 to F 180 ($/€) =.5307 The forward premium is given by: The forward premium is given by: