Lecture 3 • Chapter 5. The Market for Foreign Exchange – Function and Structure of the FX Market • FX Markets and Participants • Correspondent Banking Relationships

– The Spot Market • • • •

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Spot Rate Quotations The Bid-Ask Spread Cross Exchange Rate Quotations Triangular Arbitrage

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Circadian Rhythms of the FX Market

The benefit of around the clock trading is the absence of overnight gap risk

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The Three Forex Trading Sessions

GMT am (Eastern Time) 12 1 2 3 4 5

6 7 8 London

pm (Eastern Time) 9 10 11 12 1 2 3 4 5

6

7

8

9 10 11

New York Sydney

Tokyo Bus418 Fall 2016

Sydney Tokyo 3

Top 10 Geographic Trading Centers in Forex

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Forex Market Turnover, 1989-2010

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Market Participants • The Forex market is an over-the-counter or broker-dealer market • The FOREX market consists of two tiers: – the interbank or wholesale market – the client or retail market

• Five broad categories of participants operate within these two tiers – (Bank and non-bank) foreign exchange dealers – Foreign exchange brokers – Individuals and firms conducting commercial or investment transactions – Speculators and arbitragers – Central banks and treasuries Bus418 Fall 2016

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Bank and Non-bank Dealers • Dealers on behalf of large international banks often act as market makers, often willing to stand in and buy or sell these currencies without having a counterparty with which to unload the “inventory”. – This provides liquidity to the market

• They profit from buying currencies at a bid price and then reselling them at an offer or ask price • Competition among dealers narrows the spread between the bid and offer rate contributing to the market’s efficiency Bus418 Fall 2016

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The Top 20 Forex Dealers

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Foreign Exchange Brokers • A firm or bank acts as a broker (or agent) when it executes orders on behalf of clients (vs. a dealer who trades on its own account and makes the market)

• STP (Straight Through Processing) brokers –

send orders directly from clients to the liquidity providers

• ECN (Electronic Communications Network) brokers –

provide a marketplace for market makers, banks, and traders by matching trades between them might have their order filled by external liquidity providers, or have the trade matched internally by the bid or offer of another trader

– •

ECNs consolidate price quotations from many market participants; Tighter bidask spreads than STP, even 0 spread if filled internally. –

•

But check the depth of the market (liquidity, order volume) within the ECN

It is an anonymous trading environment (the trades are done externally in the name of your ECN broker, thereby providing you with complete anonymity.)

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Individuals and Firms Conducting Commercial/Investment Transactions • Importers, exporters, portfolio investors, MNCs, tourists and others use the FOREX market for their commercial or investment transactions – For example, a firm importing goods or equipment will need foreign currency

• Some of these participants use the market to hedge their foreign exchange rate risk

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Speculators and Arbitragers • Speculators and arbitragers seek to profit from trading in the market itself – They operate for their own interest (proprietary trading), without the need or obligation to serve clients or ensure a continuous market

• Speculators seek all their profit from future exchange rate changes • Arbitragers try to profit from simultaneous differences in exchange rates in different markets • A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks

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Central Banks and Treasuries • Central banks and treasuries use the market to acquire or spend their country’s currency reserves. – They do not trade to profit but to influence the country’s exchange rate, such as a pegged rate.

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Correspondent Banking Relationships • Large commercial banks maintain demand deposit accounts with one another. – A foreign bank acts like an agent of a domestic bank abroad. – For example, a Canadian bank’s client needs to make a payment to someone abroad. The payment deposited into the foreign payee’s account abroad comes from the Canadian bank’s deposit account held at the correspondent foreign bank abroad. – Benefit: A domestic bank can offer foreign currency services to clients and does not need to have branches abroad or trade in the Forex market if its clients do an international transaction in a foreign currency.

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Example. Correspondent Banking A Canadian client comes to TD and wants to pay £100m to a firm in UK. The exchange rate is C$2/£1. TD has a correspondent deposit account with Barclays in UK. TD receives either C$200m or £100m in Canada. Barclays sends £100m to the UK payee firm from TD’s account at Barclays in UK. • •

Neither $ not £ transferred from their “home currency” countries. TD’s deposit account in Barclays is TD’s assets and Barclays’ liabilities. Assets $ deposit at TD

Barclays

Liabilities

$400m TD’s deposit £200m £100m

Other Assets £600m Other L&E £500m

£600m

Total Assets £700m

£700m

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Total L&E

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Correspondent Banking Relationships

• Bank Barclays is in London, and Bank TD is in Toronto. • The current exchange rate is £1.00 = C$2.00. • A currency trader employed at Barclays buys £100m from a currency trader at TD for C$200m, settled using its correspondent relationship.

Barclays London Bus418 Fall 2016

$200 £100

TD Toronto 16

Correspondent Banking Relationships Barclays buys £100m from TD for $200m TD Barclays $200 Toronto

£100

London •

Neither $ not £ transferred from their “home currency” countries.

•

TD has both $ and £ deposit accounts in Barclays. Note: these deposit accounts are TD’s assets and Barclays’ liabilities. Assets

Barclays

Liabilities

£ deposit at TD

£300m TD’s deposit $1,000m £400m $1,200m

$ deposit at TD

$800m TD’s deposit £200m

$600m Other Assets £600m Other L&E

£100m £600m

Total Assets £1,300m Total L&E £1,300m

Assets

TD

Liabilities

£100m

B’s Deposit £300m £400m B’s Deposit $800m $600m

$800m

Other L&E $800m

Total Assets $2,200m

Total L&E $2,200m

$ deposit at B $1000m $1200m £ deposit at B £200m Other Assets

You can check your work: make sure that £1,300m = $1,200x(£1/$2) +£100 + £600

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Modern Settlement Systems • Cross-currency settlement (or Herstatt) risk • The risk that a financial institution may not deliver the currency on one side of a completed transaction •

Bankhaus Herstatt in 1974: after receiving DMs, it went bankrupt when it had to send $ to US correspondent banks

• How this risk is addressed

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•

Bank of International Settlements (BIS) has studied this and encouraged the voluntary restriction of transaction amounts to limit this form of risk

•

Simultaneity of both transactions. CLS Bank (CLS: Continuous Linked Settlement), owned by 71 of the world’s largest financial groups, acts as a global clearing house in 17 currencies. It nets mutual payments between banks. 50% of of foreign exchange trades are now settled through CLS bank, but over 30% of transactions still use the classic correspondent banking model. 18

Netting Arrangements

Without netting the transaction amounts, Total flows = 30+20+50+30=130 million Bus418 Fall 2016

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Netting Arrangements

CLS estimates that for each $1 trillion of value settled, only $50 billion has to be Bus418 Fall 2016 transferred between counterparties.

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Spot Rate Quotations • Exchange rate quotes – Direct – quoting the FX rate with domestic currency first • E.g., in Canada, CAD1.09 / USD, 1.09 C$ for 1 US$. • Here, USD is the base currency (in the denominator)

– Indirect – quoting foreign currency first • E.g., in Canada, USD0.91/ CAD. • From the U.S. perspective, this is a direct quote.

• How to remember? - Direct quotes can be viewed as more natural for domestic investors: they are just prices of goods (units of foreign currencies).

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Spot Rate Quote Notation • The spot rate for currency j in terms of i is s(i/j). • Currency j is called the base currency – it is priced in units of currency i. The base currency is the one in the denominator. • Example: USD is the base in CAD1.09 / USD.

• Direct and indirect are inverse: Direct = 1/Indirect •

𝑠 𝑖 𝑗 =

1 𝑆(𝑗 𝑖)

• e.g., USD/CA𝐷 = • 0.91 =

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1 𝐶𝐴𝐷/𝑈𝑆𝐷

1 1.09

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Vehicle currencies and currency cross-rates • Vehicle currency – a currency that is actively used in many international financial transactions around the world – Used because transaction costs of making markets in certain currencies are too high for dealers – U.S. Dollar is the primary vehicle currency (89% of all transactions)

• A cross-rate: where both currencies are not expressed in U.S. dollars •

Using US$ as the vehicle currency for a cross-rate: 𝑠 𝑖 𝑗 = 𝑠(𝑖 $) × 𝑠($ 𝑗) •

To buy j with i, you need to buy $ with i, then use $ to buy j.

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Currency Cross-rates xe.com

June 2014

September 2016

𝑠 𝑖 𝑗 = 𝑠(𝑖 $) × 𝑠($ 𝑗) Check a cross-rate: CAD/EUR = CAD/USD * USD/EUR = 1.32080*1.11742 = 1.47589 This means there is no arbitrage opportunity in trading these currency pairs. Bus418 Fall 2016

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Forex Market Turnover by Currency Pair

The Majors: EUR/USD = "Euro" USD/JPY = "Dollar Yen" GBP/USD = "Cable" or "Sterling" USD/CHF = "Swissy" USD/CAD = "Dollar Canada" AUD/USD = "Aussie Dollar" Bus418 Fall 2016

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Spot Rate Quotes (Cont’d) • USD is the base currency (denominator) in most currency pairs. • The exceptions are many Commonwealth currencies (because they were not on the decimal system until the 1970s), such as British pound, Australian dollar and New Zealand dollar, and the euro. In these currencies, USD is the numerator, quote currency.

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Base Currency in Quotes • The conventional ranking, where a currency closer to the top is the base currency for a currency lower in the list. 1. 2. 3. 4. 5. 6. 7. 8.

Euro Pound sterling Australian dollar New Zealand dollar United States dollar Canadian dollar Swiss franc Japanese yen

• Examples. – EUR and GBP pair is quoted as 0.59 pounds per euro – GBP and USD pair is quoted as US$1.69 per GBP – CAD and USD pair is quoted as CAD 1.09 / USD Bus418 Fall 2016

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American and European Quotes • If the USD is in the numerator, it is an American quote. – ($1.69/GBP)

• If the USD is in the denominator, it is a European quote. – (GBP0.59/$)

• If USD is not involved, the quote does not have a special name. • American&European is not the same as Direct&Indirect.

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The Bid-Ask Spread • A dealer could offer: – A bid price of $1.3090 per €. – An ask price of $1.3092 per €. – The spread is $0.0002, or 2 pips (“percentage in point”). • While there are a variety of ways to quote the above, the bidask spread represents the dealer’s expected profit.

Percent Spread = 0.0153% = Bus418 Fall 2016

Ask Price – Bid Price Ask Price $1.3092– $1.3090 $1.3092

× 100% x 100% 31

The Bid-Ask Spread

A dealer pricing pounds in terms of dollars would likely quote these prices as 00–05. Experienced traders know the “big figure” preceding these decimal places.

USD Bank Quotations

American Terms

European Terms

Bid

Ask

Bid

Ask

Pounds

1.5400

1.5405

.6491

.6494

The easiest way to keep bid and ask prices straight is to take the position of the retail customer and anticipate getting the “worst” price every time. You’d have to sell at 1.54 and buy at 1.5405. Bus418 Fall 2016

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The Bid-Ask Spread Bank Quotations of US dollar in pounds American Terms($/£)

Pounds

Bid

Ask

Bid

Ask

1.5400

1.5405

.6491

.6494

Notice that the reciprocal of the S($/£) bid is the S(£/$) ask. £.6494 $1.00

=

European Terms (£/$)

£1.00 $1.5400

Dealer

$1,540 £1,000

Customer

Sells pounds for USD to dealer: direct bid

Dealer

$1,000 £649.40

Customer

Buy USD for pounds from dealer: indirect ask Bus418 Fall 2016

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Currency Conversion with Bid-Ask Spreads • A speculator in New York wants to take a $10,000 position in the pound. • After his trade, what will be his position? Bid

S($/£) S(£/$)

Ask

1.5400 – 05

Dealer will pay $1.5400 for 1 GBP; he is asking $1.5405.

.6491– 94

Dealer will pay £.6491 for $1 and will charge £.6494 for $1

The speculator pays

$10,000 ×

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£0.6491 $1.00

= £6,491

$10,000 ×

£1 $1.5405

= £6,491 34

Sample Problem • A businessman has just completed transactions in Italy and England. He is now holding €250,000 and £500,000 and wants to convert to U.S. dollars. • His currency dealer provides this quotation: GBP/USD 0.6488 – 93 USD/EUR 1.4739 – 44 • What are his proceeds from conversion?

He sells €250,000 at the dealer’s bid price: €250,000 x He sells £500,000 at the dealer’s ask price: £500,000 x Bus418 Fall 2016

$1.4739 €1.00 $1.00 £.6493

=$368,475 =$770,060.06 $1,138,535.06 35

Magnitude of bid-ask spreads • Interbank market – Within 5 pips – 0.05% - 0.07% for major currencies • Lower for extremely liquid currencies like U.S. dollar (i.e., 0.03% for $/€ exchange rate quote) • Higher for less liquid currencies

• Physical exchange – 3% or more • Banks have to have FX cash inventory, which does not earn interest • Banks must transact with brokers VBCE: bid ask spread USD 1.3066 1.3279 1.63% CNY 0.1873 0.2002 6.89% AUD 0.9771 1.0206 4.45%

– Use credit cards to exchange when in another country – this is the best possible rate for you. However, most credit cards charge 2%-3% foreign transaction fee Bus418 Fall 2016

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Cross Rates without bid-ask spreads

• Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00) and that S($/£) = 2.00 (i.e., £1.00 = $2.00). • What must the €/£ cross rate be? $1.50 £1.00 £0.75 × = €1.00 $2.00 €1.00 €1.00 = £0.75

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Cross Rates with Bid-Ask Spreads: Bid USD Quotations Pounds Euros €/£

American Terms

European Terms

Bid

Ask

Bid

Ask

1.5400

1.5405

.6491

.6494

1.3087 €1.1763

1.3092

.7638

.7641 £0.8501

To find the €/£ cross bid rate, consider a retail customer who starts with £1 and wants €: he sells £ for $, and buys €:

£1 ×

$1.5400 €1.00 = €1.1763 × £1.00 $1.3092

1 €1.1763/£

He has effectively sold £ at a €/£ bid price of €1.1763/£.

£1 sell £ at bid Bus418 Fall 2016

$1.5400 buy € at ask

€1.1763 39 5-39

Cross Rates with Bid-Ask Spreads: Ask USD Quotations

American Terms

European Terms

Bid

Ask

Bid

Ask

Pounds

1.5400

1.5405

.6491

.6494

Euros

1.3087

1.3092

.7638

.7641

€/£

€1.1763

€1.1771

£0.8495

£0.8501

To find the €/£ cross ask rate, consider a retail customer who starts with €1 and wants £. He sells € for $, and buys £: $1.3087 £1.00 1 = £0.8495 €1/£0.8495 = €1.1771/£ €1 × × €1.00 $1.5405 He has effectively bought £ at a €/£ ask price of €1.1771/£.

€1 Bus418 Fall 2016

sell € at bid

$1.3087

buy £ at ask

£0.8495 40

Cross Rates with Bid-Ask Spreads Bank Quotations

direct American Terms

indirect European Terms

Bid

Ask

Bid

Ask

£:$

$1.5400

$1.5405

£.6491

£.6494

€:$

$1.3087

$1.3092

€.7638

€.7641

€/£

€1.1763

€1.1771

£0.8495

£0.8501

Recall that the reciprocal of the S(£/€) bid is the S(€/£) ask.

€1.1763

£1.00

=

€1.00

£0.8501

Bid-ask quote would be €/£: 1.1763-71 If a customer buys £ with €, he would pay at a €/£ ask price of €1.1771/£ Bus418 Fall 2016

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Triangular arbitrage • Triangular arbitrage - an arbitrage opportunity involving three currencies. – Occurs when one can trade three currencies and make a profit. – “Triangular”: three currencies rather than two. • Keeps cross-rates in line with exchange rates quoted relative to the U.S. dollar. • For example, cross-rates are not consistent with one another if €/£ < €/$ * $/£. • What is the opportunity here? • GBP is too cheap in euros. Buy GBP with EUR. Then sell these GBP for $ and use $ to buy EUR. Bus418 Fall 2016

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Triangular arbitrage

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Example: Triangular arbitrage Suppose David Sylvian, a trader at the foreign exchange desk of Goldman Sachs in London, observes the following exchange rates of the euro relative to the pound and the dollar, and the dollar relative to the pound: EUR1.1555/GBP or GBP0.86543/EUR EUR0.76388/USD or USD1.3091/EUR USD1.5386/GBP or GBP0.64994/USD Determine the arbitrage profits when David starts with EUR10,000,000 and buys GBP. (note: the question suggests moving clockwise in the triangle.) Solution. Step 1. The revenue in pounds of selling EUR10,000,000 at the direct cross-rate would be EUR10,000,000 * (GBP0.86543/EUR) = GBP8,654,300 Step 2. Because the exchange rate of dollars per pound is ($1.5386/GBP), David would be able to sell GBP8,654,300 for dollars to get GBP8,654,300 * ($1.5386/GBP) = $13,315,506 Step 3. Then, because the exchange rate of euros per dollar is EUR0.76388/$, he would sell the $13,315,506 for euros to get $13,315,506 * (EUR0.76388/$) = EUR10,171,449 The profit is EUR10,171,449 - EUR10,000,000 = EUR171,449 Bus418 Fall 2016

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Example: Triangular arbitrage (Cont’d)

The correct cross-rate of EUR/GBP using the dollar as an intermediary currency should be ($1.5386/GBP) * (EUR0.76388/$) = EUR1.1753/GBP, rather than EUR1.1555/GBP Bus418 Fall 2016

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Triangular arbitrage • Note that to make the profit all three trades had to be done simultaneously. – Because this is not possible, there is some risk that the prices change. – As traders buy GBP and sell EUR, the demand and supply will increase the relative price of GBP. At the same time, the other two rates in $ change. • We did not have to start with EUR to make an arbitrage profit. What we need is to determine the direction we are moving (clockwise or counter-clockwise) and go through all the three corners of the triangle.

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Triangular Arbitrage with Bid-Ask Spreads Returning to our bid-ask cross-currency example. Suppose we observe banks posting the following exchange rates:

Bank Quotations

Bid

Ask

Deutsche Bank $:£

$1.5400

$1.5405

Credit Lyonnais $:€

$1.3087

$1.3092

Credit Agricole €/£

€1.1758

€1.1760

“No Arbitrage” €/£

€1.1763

€1.1771

As we have calculated the “no arbitrage” €/£ cross bid and ask rates, we can see that there is an arbitrage opportunity: Credit Agricole’s ask is too low (less than no-arbitrage bid!), while its bid is fine. Bus418 Fall 2016

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Triangular Arbitrage with Bid-Ask Spreads Bank Quotations

Bid

Ask

Deutsche Bank $:£

$1.5400

$1.5405

Credit Lyonnais $:€

$1.3087

$1.3092

Credit Agricole €/£

€1.1758

€1.1760

“No Arbitrage” €/£

€1.1763

€1.1771

1. Since GBP are too cheap at Credit Agricole, the arbitrage is to buy 1 GBP there, for €1.1760. 2. Then, by going through Deutsche Bank and Credit Lyonnais, we can sell the 1 pound for €1.1763. £1 ×

$1.5400 £1.00

€1.00 × $1.3092 = €1.1763

The profit is 3 pips, or 0.0003/1.1760*100%=0.025%. Bus418 Fall 2016

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Forex Trader Lot Type

Amount Controlled

Initial Margin

Value per Pip

Standard

$100,000

$2,000

$10

Mini

$10,000

$200

$1

Micro

$1,000

$20

$0.1

Large leverage: 50:1. For example, $2,000 controls $100,000. Beginners should start with micro lots. Example. A slow day on May 20, 60 pips change. With a $2000 starting margin, a standard lot would produce a profit or loss of .0060*$100,000=$600.

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