1. Lecture 4:The Foreign Exchange Market
The Structure of the Foreign Exchange Market

2. Where is this Financial District?

3. 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 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.

4. FX Trading Floor, 1920s

5. FX Trading Floor, (London)

6. 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 commercial banks (as market makers), investment institutions, non-financial corporations and central banks. Over 80% of total market.
Participants include banks, individuals and firms conducting commercial and investment transactions, speculators and arbitragers, central banks and treasuries, foreign exchange brokers (who match buy and sell orders but do not carry inventory) and nonbank foreign exchange dealers.
Non-bank dealers (e.g., Travelex) operate in the small end of the FX market ($5 million and less) while banks operate in the larger end of the market (million dollar multiples up to $100m).
About banks worldwide stand ready to make a market in foreign exchange (i.e., to quote prices at which they will buy and sell currencies) – this occurs in the interbank market.
However, most of the total forex volume is transacted through about 10 banks.

7. Top Banks in the F.X. Market: Average Market Share, 7 year period 2004 - 2010
Country of Headquarters
% Share of Market
Years in the Top 10
Deutsche Bank
Germany
36% 7
UBS
Switzerland
22%
Barclays
United Kingdom
12%
Citi
United States 6%
JPMorgan 3% 3
Goldman Sachs 5
RBS 6
HSBC 2%
Credit Suisse
Morgan Stanley 2

8. 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: $ billion
1992: $ 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.

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

10. Other Trading Centers, 1995 and 2010, Percent of Total Market
Country
1995
2010
Singapore
6.6
5.3
Switzerland
5.4
5.2
Hong Kong
5.6
4.7
Australia
2.5
3.8
France
3.0
Denmark
1.9
2.4
Germany
4.8
2.1
Canada
1.2
Sweden
0.9
Korea
0.2 (1998)
Russia
0.3 (1998)
0.8

11. Currency Distribution in FX Market, Percent of Average Daily Turnover
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
6.8
6.4
Canadian Dollar
CAD
3.5
4.5
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
New Zealand Dollar
NZD
0.2
0.6
1.1
1.9
1.6
Note: Because 2 currencies are involved in each transaction, the sum of the percentage shares of individual currencies equals 200%

12. Other Currencies, Percent of Average Daily Turnover
Currency
ISO
1998
2001
2004
2007
2010
Korean Won
KRW
0.2
0.8
1.1
1.2
1.5
Singapore Dollar
SGD
0.9
1.4
Norwegian Krone
NOK
2.1
1.3
Mexican Peso
MXN
0.5
Indian Rupee
INR
0.1
0.3
0.7
Russian Rouble
RUB
0.6
Polish Zloty
PLN
0.4
South African Rand
ZAR
Brazilian Real
BRL
Chinese Yuan
CNY
0.0
Thai Baht
THB

13. Global Foreign Exchange Market by Currency Pair; Percent of Total
1998
2001
2004
2007
2010
USD/EUR …. 30 28 27
USD/DEM 20
USD/JPY 19 17 13 14
USD/GBP 8 10 12 9
USD/AUD 3 4 6
USD/CAD 5
USD/CHF
EUR/JPY Na
EUR/CHF 1 2
JPY/AUD
<1

14. Currency Pair Trades by Market Center; Percent of Total for Center
U.K. 2001
U.K.
2010
U.S.
2001
Japan
2004
USD/EUR 33 32 12 10
USD/JPY 16 14 24 13 61 62
EUR/JPY 3 Na 7 9
Others:
USD/GBP 22
USD/CAD 4
USD/AUD 6
USD/CHF 5
EUR/GBP
EUR/CHF 2

15. 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.

16. 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.

17. F.X. Turnover by Type of Transaction; Amount and % of 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
37.2%
31.2%
32.6%
30.2%
37.4%
8.4%
10.5%
10.8%
10.9%
11.9%
48.1%
53.0%
49.3%
51.6%
44.3%
0.7%
0.6%
1.1%
0.9%
5.7%
4.8%
6.2%
6.4%
5.2%
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
Spot Transactions
Outright Forwards
F.X. Swaps
Currency Swaps
Options and others
Total

18. 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).

19. 24-Hour Global Market: Times Represent Local Trading Hours
Europe:
LONDON
8am – 5pm
NEW YORK 8am
– 5pm
Closes: Friday
5pm New York
Other Asia:
TOKYO
8am – 5pm
(7am – 7pm)
Middle East:
Bahrain
Opens Monday
6am
Sydney

20. Normal Trading Sessions and Session Overlaps
Key Market
Local 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
12:00pm – 9:00pm
No overlap with Tokyo and New York

21. 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.

22. Importance of London
Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
Greenwich Mean Time
Tokyo
opens
Asia
closing
10 AM
In Tokyo
Afternoon
in America
London
6 pm
In NY
Americas
open
Europe
opening
Lunch In

23. 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.

24. Wall Street Journal Spot Foreign Exchange Rates, Sept. 16 2011
Country/currency
In USD
Per USD
Friday Sept 16
Thursday Sept 15
Friday Sept 16
Australian dollar
1.0363
1.0329
0.9650
0.9682
UK pound
1.5788
1.5800
0.6334
0.6329
Japan yen
76.79
76.70
Euro-area euro
1.3798
1.3876
0.7248
0.7207
S. Africa rand
0.1339
0.1352
7.4705
7.3959
Source:
Note: In USD = American Terms and per USD = European Terms
Look at the above rates and determine if a particular currency appreciated (strengthened) or depreciated (weakened) against the U.S. dollar from Thursday to Friday

25. Foreign Exchange Rates, Sept. 16 2011: Answers
Foreign currency change
Country/currency
In USD
Per USD
Fri Sept 16
Thur Sept 15
Thur to Friday
Australian dollar
1.0363
1.0329
0.9650
0.9682
Strengthened
UK pound
1.5788
1.5800
0.6334
0.6329
Weakened
Japan yen
76.79
76.70
Euro-area euro
1.3798
1.3876
0.7248
0.7207
S. Africa rand
0.1339
0.1352
7.4705
7.3959
Source:
Note: In USD = American Terms and per USD = European Terms
Look at the above rates and determine if a particular currency appreciated (strengthened) or depreciated (weakened) against the U.S. dollar from Thursday to Friday

26. 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.

27. Identifying Spot Trade Dates and Spot Value Dates
Currency Pair
Spot Friday, Sept 16, 2011
Spot Trade Date
Spot Value Date
GBP/USD
1.5788
CAD/USD
1.0223
Spot Wednesday, Dec 24, 2008
1.4765
0.8238

28. Identifying Spot Trade Dates and Spot Value Dates: Answers
Currency Pair
Spot Friday, Sept 16, 2011
Spot Trade Date
Spot Value Date
GBP/USD
1.5788
Sept 16, 2011
Tuesday, Sept 20 (2 bus days)
CAD/USD
1.0223
Monday, Sept 19
(1 bus day)
Spot Wednesday, Dec 24, 2008
1.4765
Dec 24, 2008
Monday, Dec 29 (2 bus days)
0.8238
Friday, Dec 26

29. Calculating American and European Terms Quotes
Country/Currency
American Terms
European Terms
Answer
Brazilian Real
0.5841
New Zealand Dollar
1.2062
Solution: Calculate the reciprocal
1/ =
1/ =

30. Calculating American and European Terms Quotes: Answers
Country/Currency
American Terms
European Terms
Answer
Brazilian Real
0.5841
New Zealand Dollar
1.2062
Solution: Calculate the reciprocal
1/ =
1.7120
1/ =
0.8291

31. 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.

32. Wall Street Journal Forward Foreign Exchange Rates, April 24, 2009
Country/currency
In USD
Per USD
Friday Sept 16
Thursday Sept 15
Friday Sept 16
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
76.76
76.67
76.71
76.60
76.47
Source:
Note: In USD = American Terms and per USD = European Terms

33. Foreign Exchange Rates, April 24, 2009: Answer
Country/currency
In USD
Per USD
Answer
Friday Sept 16
Thursday Sept 15
Friday Sept 16
British pound (spot)
1.5788
1.5800
1-mos forward
1.5783
1.5795
Discount
3-mos forward
1.5773
1.5785
6-mos forward
1.5760
1.5772
Japanese Yen (spot)
76.79
76.70
76.76
76.67
Premium
76.71
76.60
76.47
Source:
Note: In USD = American Terms and per USD = European Terms

34. 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)

35. 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?

36. 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

37. 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?

38. 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

39. 2011 Calendar