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International Financial
Markets and Banking
L ESACRHNOI N
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Juliane Thamm

SW 3.07, Ext.: 3889, [email protected]

Office hours: see myplace for details and/or email for an appointment
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S T R AT H C LY D E B U S I N E S S S C H O O L

Lecture 6
Foreign Exchange and
Derivatives Markets

© Juliane Thamm – University of Strathclyde

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S T R AT H C LY D E B U S I N E S S S C H O O L

Foreign Exchange Markets

© Juliane Thamm – University of Strathclyde

 Image on next slide: Foreign exchange
X market turnover by currency and currency
pairs, Graph 1 from BIS Triennial Central

Foreign Exchange Markets

S T R AT H C LY D E B U S I N E S S S C H O O L

Bank Survey 2019, p.5

https://www.bis.org/statistics/rpfx19_fx.pdf

London is a major centre for FX trading (it is the world’s biggest FX trading hub with over a third of
global turnover)

Spot transactions accounted for $2 trillion per day in April 2019 a 20% rise from 2016, the turnover
of FX swaps rose further, reaching $3.2 trillion per day in April 2019*
UK remains the single largest centre of FX activity with 43% of global turnover in April 2019*

The most heavily traded currency pair remains euro/dollar, which accounted for 32% of total
turnover.*

Foreign exchange market participants include:

Companies trading overseas
Investors investing overseas
Speculators speculating
Central banks trying to influence exchange rates

* 2019 BIS Triennial Central Bank Survey https://www.bis.org/statistics/rpfx19_fx.htm (new 2022 survey results are due to be published in December 2022)

© Juliane Thamm – University of Strathclyde

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FX trading
S T R AT H C LY D E B U S I N E S S S C H O O L

Trading is carried out in numerous locations

Some of the trades are on regulated exchanges but most are not
Most trading occurs when both the European and New York markets are
open
Most banks carry out proprietary trading
When a non-bank organisation needs an FX deal it mostly trades with a
bank
Exchange trading tends to deal in standard amounts and maturities.

© Juliane Thamm – University of Strathclyde

X Image on next slide: FX market turnover
by instrument, Graph 2 from BIS Triennial

FX Markets
Central Bank Survey 2019, p.6
S T R AT H C LY D E B U S I N E S S S C H O O L

https://www.bis.org/statistics/rpfx19_fx.pdf

The FX market is a dealer (or “quote-driven”) market where banks act as market
makers, posting prices at which they will buy or sell currencies

“Spot” transactions are those to be settled within 2 days

These account for 30% of market volume

“Forward” transactions are for settlement at a set date in the future (2 days+)
Forward markets account for the remaining 70%
Forwards are often used in hedging transactions
Forwards are priced using interest rate differentials – covered interest parity
© Juliane Thamm – University of Strathclyde
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Exchange Rates
S T R AT H C LY D E B U S I N E S S S C H O O L

An exchange rate is the price of one currency (the base currency) expressed
in terms of another (the secondary, counter or quote currency)
If the exchange rate between the US dollar and the pound is US$1.60 = £1.00
this means that £1.00 will cost US$1.60
US$1.00 will cost 62.50 pence
The standardised forms of expression are
US$/£ : 1.60 or US$1.60/£ or USD1.60/£
Exchange rates are expressed in terms of the number of units of the first
currency per single unit of the second currency
A pip is one ten-thousandth of one unit of currency

© Juliane Thamm – University of Strathclyde

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Example
S T R AT H C LY D E B U S I N E S S S C H O O L

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Forward Pricing
S T R AT H C LY D E B U S I N E S S S C H O O L

Sterling / Euro exchange rate today is 1.463

Sterling one year interest rate is 4.55%

Euro one year interest rate is 2.38%

The one year forward exchange rate must reflect the interest rate differential:

1.463 / [1+(4.55%-2.38%)] = 1.432

Otherwise an arbitrage opportunity exists

If the one year forward rate is 1.450, what is the arbitrage opportunity?
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Settlement
S T R AT H C LY D E B U S I N E S S S C H O O L

Herstatt risk

Continuous Linked Settlement (CLS)

- began operating in 2002
- the world’s largest multicurrency cash settlement service to
mitigate FX settlement risk for its 62 settlement members and their
clients globally
- uses the payment versus payment (PvP) operating model to
ensure that all currencies settle from 07.00-09.00 CET; if a trade is
not matched, it is returned to its originator
- only the net value of trades is settled

Images on next slide:

top: https://ctmfile.com/assets/ugc/images/FXM_CLS_p_v._p_RTGS.png
bottom: https://ctmfile.com/assets/ugc/images/FXM_CLS_timeline.png
© Juliane Thamm – University of Strathclyde
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Cross exchange rates

S T R AT H C LY D E B U S I N E S S S C H O O L

The Philippines peso and the United Arab Emirates dirham would see little
trade
The traditional way of dealing with this was to exchange the dirhams into one
of the major currencies, usually the US dollar, and then to exchange the
dollars for pesos
A cross-rate is the exchange rate of two currencies that are normally
expressed in terms of a third currency, usually the US dollar.

© Juliane Thamm – University of Strathclyde

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Dealing with FX risk

S T R AT H C LY D E B U S I N E S S S C H O O L

Transaction risk

The risk that transactions already entered into, or for which the firm is likely to have a
commitment in a foreign currency, will have a variable value in the home currency because of
exchange-rate movements

Translation risk

Translation risk arises because financial data denominated in one currency are then expressed
in terms of another currency. Between two accounting dates the figures can be affected by
exchange-rate movements, greatly distorting comparability

Economic risk

A company’s economic value may decline as a result of FX movements causing a loss in

competitive strength

© Juliane Thamm – University of Strathclyde

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S T R AT H C LY D E B U S I N E S S S C H O O L

Derivatives Markets

© Juliane Thamm – University of Strathclyde

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Derivative Markets
S T R AT H C LY D E B U S I N E S S S C H O O L

A derivative is an instrument whose price is derived from some underlying security

It follows that derivative markets are very closely linked to the equity, bond, money and
FX markets we have already discussed

The main uses of derivatives:

Hedging – offsetting risks you already have
Speculation – taking on more risk in hope of profit
Arbitrage - exploit price differences on the same instrument or similar assets

Derivatives often get a bad press

“Financial weapons of mass destruction” Warren Buffet

© Juliane Thamm – University of Strathclyde

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Image on next slide: Global OTC derivatives market Graphic D.2

Derivatives
S T R AT H C LY D E B U S I N E S S S C H O O L

page A14: https://www.bis.org/publ/qtrpdf/r_qt1909_charts.pdf

A variety of derivatives exist:

Forwards
Futures
Options (call/put/US/European)
Swaps
…?

…on many underlying instruments:

Equity indices (e.g. FTSE 100)
Individual shares
Bonds and bond indices
Interest rates
Exchange rates
…?
© Juliane Thamm – University of Strathclyde
X Image on next slide Over-the-Counter: Image (top half):
https://financegraphics.files.wordpress.com/2012/05/12advangage-
gfc-1-popup.jpg

Trading Derivatives
S T R AT H C LY D E B U S I N E S S S C H O O L

Some derivatives are traded on a recognised exchange (LIFFE, CBOT):

Standard contracts
Usually liquid
Limited credit risk
Examples, futures / exchange traded options

Others trade ‘over the counter’ with banks:

Tailored to user’s needs
Dependent on issuing bank for liquidity
Exposed to the credit risk of the bank
Examples, forwards / swaps / exotic options
© Juliane Thamm – University of Strathclyde
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Trading Derivatives
S T R AT H C LY D E B U S I N E S S S C H O O L

Derivative exchanges tend to be order-driven markets

Until a few years ago, ETDs were traded by ‘open outcry’ in trading ‘pits’ - proponents
argue that open outcry markets have superior liquidity in times of stress

However, most ETDs now trade on electronic systems

Derivatives exchanges provide a ‘clearing’ service – acting as a central counterparty

for all trades. Positions are “marked to market” and margin is required to cover losses

Trades can be closed out by taking an equal and opposite position with any other
trader – you do not need to go back to the trader you dealt with initially (c.f. OTC
derivatives)

Next slide: OTC v Exchange traded derivatives: Image http://www.bis.org/publ/qtrpdf/r_qt1609/images/ch02-gb1.jpg

© Juliane Thamm – University of Strathclyde
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Central Clearing
S T R AT H C LY D E B U S I N E S S S C H O O L

Counterparty Counterparty
CCP
A B

Each party in the transaction enters into a contract with the central counterparty, so
each party does not take on the risk of the other defaulting
Currently, all exchange-traded and some OTC-traded derivatives contracts are
centrally cleared. However, pending legislation central clearing will be required for
most standardised OTC derivatives contracts.
Examples: LCH.Clearnet, CME, Eurex and IntercontinentalExchange (ICE)

© Juliane Thamm – University of Strathclyde

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Trading Derivatives
S T R AT H C LY D E B U S I N E S S S C H O O L

If a derivative is mispriced relative to its underlying asset, an arbitrage opportunity

will occur
Arbitrage is defined as the opportunity to make a (near) riskless profit

Futures price = spot price + interest cost – dividends

Professional traders in investment banks constantly monitor the market for

arbitrage opportunities
As a result, arbitrage opportunities are few and far between and do no1919t last
for long if they do occur

© Juliane Thamm – University of Strathclyde

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Forwards
S T R AT H C LY D E B U S I N E S S S C H O O L

A forward contract is an agreement between two parties to undertake an

exchange at an agreed future date at a price agreed now

tailor-made, over-the counter instruments

risk of default
available for long-term maturities

Example:
Forward rate agreements (FRAs) - Agreements about the future level of
interest rates. The rate of interest at some point in the future is compared with
the level agreed when the FRA was established and compensation is paid by
one party to the other based on the difference

© Juliane Thamm – University of Strathclyde

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Futures
S T R AT H C LY D E B U S I N E S S S C H O O L

Agreements between two parties to undertake a transaction at an agreed price

on a specified future date
Exchange-based instruments traded on a regulated exchange
Clearing house becomes the formal counterparty to every transaction
Unable to back away

Examples:
equity index futures (such as FTSE100 future)
single stock futures
interest rate futures

© Juliane Thamm – University of Strathclyde

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Buying and selling futures

S T R AT H C LY D E B U S I N E S S S C H O O L

Deal through a registered broker (a futures commission merchant)

Trades conducted over a computer system (e.g on Liffe: LIFFE CONNECTTM)
Price limit or at-the-market order
Prices are set by competing market makers
Real-time market prices are available on the Internet
(https://www.theice.com/liffe )

Trading costs include brokerage commissions, market maker’s spread, taxes

and fees imposed by the exchange.

© Juliane Thamm – University of Strathclyde

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Marking to market and margins

S T R AT H C LY D E B U S I N E S S S C H O O L

The clearing house being the formal counterparty for every buyer or
seller has enormous potential for credit risk
To protect itself the clearing house operates a margining system by
which the futures buyer or seller has to provide, usually in cash, an
initial margin
0.1–15 per cent of the value of the underlying
Not a ‘down payment’
Daily marking to market
Variation margin

© Juliane Thamm – University of Strathclyde

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Margins Illustration
S T R AT H C LY D E B U S I N E S S S C H O O L

Imagine a buyer and seller of a future on Monday with an underlying value of £50,000
are each required to provide an initial margin of 10 per cent, or £5,000 assumed that
counterparties have to keep all of the initial margin permanently as a buffer.

© Juliane Thamm – University of Strathclyde

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Settlement
S T R AT H C LY D E B U S I N E S S S C H O O L

Physical delivery
Majority are closed out before the expiry
Reverse their trade
Cash settlement

© Juliane Thamm – University of Strathclyde

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Options
S T R AT H C LY D E B U S I N E S S S C H O O L

An option is a contract giving one party the right, but not the obligation, to buy
or sell a financial instrument, commodity or some other underlying asset at a
given price, at or before a specified date
Options may be allowed to lapse
Options can also be traded
Examples:

Index Options
Options on whole share indices for example, Standard & Poor’s 500 (US),
FTSE 100 (UK), CAC 40 (France), XETRA Dax (Germany)

Cash settled
© Juliane Thamm – University of Strathclyde
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Share options
S T R AT H C LY D E B U S I N E S S S C H O O L

A share call option gives the purchaser a right, but not the obligation, to buy a fixed
number of shares at a specified price at some time in the future – a share put option
gives the purchaser the right to sell a fixed number of shares at a specified price in the
future
In the case of traded options on NYSE Liffe, one option contract relates to a quantity of
1,000 shares
seller of the option, who receives the premium, is referred to as the writer
American-style options / European-style options
Exercise price
Time value -arises because of the potential for the market price of the underlying to
change in a way that creates intrinsic value. The intrinsic value of an option is the
payoff that would be received if the underlying were at its current level when the option
expires
In the- money option / Out-of-the-money option
© Juliane Thamm – University of Strathclyde
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comparison of options, futures, forwards and

S T R AT H C LY D E B U S I N E S S S C H O O L

forward rate agreements

© Juliane Thamm – University of Strathclyde

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comparison of options, futures, forwards and

S T R AT H C LY D E B U S I N E S S S C H O O L

forward rate agreements (cont.)

© Juliane Thamm – University of Strathclyde

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Other derivatives
S T R AT H C LY D E B U S I N E S S S C H O O L

Caps, floors, collars, swaps

Contracts for difference (CFD)
Credit default swaps (CDS)

© Juliane Thamm – University of Strathclyde

 X Derivative Contracts Traded on Regulated Exchanges Source: WFE/IOMA 2021
(millions of contracts) Derivatives Market Survey
S T R AT H C LY D E B U S I N E S S S C H O O L

(and previous versions)

2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 https://www.world-
Single Stock Options 10,204 7,039 4,285 4,452 3,485 3,328 3,522 3,841 4,074 3,990 exchanges.org/storage/app/m
Single Stock Futures 4,818 3,388 1,690 1,455 1,138 848 999 987 947 1,024 edia/2021%20Annual%20Deri
Stock Index Options 16,315 9,019 6,174 4,355 3,186 2,765 3,748 3,154 2,780 3,637 vatives%20Report.pdf
Stock Index Futures 7,785 6,536 4,008 3,379 2,386 2,552 2,769 2,370 2,333 2,243
ETF Options 4,600 3,070 1,723 1,889 1,611 1,671 1,558 1,495 1,482 1,375
ETF Futures 17.5 0.9 1.2 2.1 1.9 2 1 1 0 0
Total Equity 39,123 25,982 16,157 13,641 10,196 11,167 12,596 11,849 11,617 12,270

STIR Options 268 268 509 545 520 374 341 356 348 379
STIR Futures 740 630 1,721 1,754 1,566 1,390 1,339 1,382 1,437 1,224
LTIR Options 292 238 339 330 263 207 227 204 211 171
LTIR Futures 1,933 1,722 1,951 1,950 1,645 1,475 1,361 1,326 1,335 1,161
Total Interest Rate 4,558 3,982 4,520 4,579 3,994 3,446 3,267 3,268 3,330 2,934

Currency Options 1,533 859 1,333 1,155 814 650 467 225 403 288
Currency Futures 3,063 2,959 2,406 2,518 1,949 2,199 2,118 1,656 2,081 2,143
Total Currency 4,597 3,818 3,739 3,673 2,763 2,850 2,585 1,881 2,485 2,431

Commodity Options 450 331 263 280 261 255 237 223 224 192
Commodity Futures 9,891 8,968 6,675 5,640 5,624 6,621 4,086 3,203 3,776 3,051
Total Commodity 10,341 9,299 6,938 5,921 5,884 6,876 4,323 3,427 4,001 3,243

Other Options - 9 139 182 197 158 158 194 188 116
Other Futures 1 31 101 192 236 462 496 221 180 121
Total “Other” 1 40 240 374 433 620 655 428 469 339

38 Grand Total 63,236 46,192 33,318 30,078 24,884 24,958 23,428 20,864 21,902 21,217
© Juliane Thamm – University of Strathclyde
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New developments
S T R AT H C LY D E B U S I N E S S S C H O O L

•regulators are trying to move more derivatives trading into the open, by
shifting OTC derivatives trades onto exchanges or electronic platforms
as agreed on by G20 leaders in 2009
•e.g. the Dodd-Frank act in the U.S. requires most OTC derivatives to
be traded on a so-called Swap Execution Facility (SEF)*, and the EU’s
MiFID II legislation will see liquid OTC derivatives move onto a similar
platform called an Organised Trading Facility (OTF)

* Commodity Futures Trading Commission (CFTC) is responsible for writing rules that will regulate the over-the-counter derivatives marketplace

© Juliane Thamm – University of Strathclyde

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S T R AT H C LY D E B U S I N E S S S C H O O L

Regulators believe OTFs and SEFs will transform the derivatives

market, making it more transparent, boosting liquidity and reducing
transaction costs.

Critics argue that there is nothing to stop firms from trading

electronically at the moment, or from requesting quotes from multiple
dealers. Transparency can be enforced by other means, they say, from
mandatory reporting to the use of data repositories that record details of
trades. If the market fragments and liquidity is spread across multiple
venues, the costs would be high.
© Juliane Thamm – University of Strathclyde
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Further information (optional)

S T R AT H C LY D E B U S I N E S S S C H O O L

- BoE The foreign exchange and over-the-counter interest rate

derivatives market in the United Kingdom https://www.bankofengland.co.uk/-
/media/boe/files/quarterly-bulletin/2016/foreign-exchange-and-over-the-counter-interest-rate-derivatives-market-in-the-uk-
2016-q4.pdf?la=en&hash=A0F11116D86E7FFCD9C25E531128DC7A784A2ECF

- The Global Derivatives Market - An Introduction (Deutsche Börse Group

White Paper April 2008) http://www.math.nyu.edu/faculty/avellane/global_derivatives_market.pdf
- Markets in Financial Instruments Directive and new Regulation (MiFID
II/MiFIR) http://www2.deloitte.com/content/dam/Deloitte/es/Documents/servicios-financieros/Deloitte-ES-mifid-II-
Servicios-Financieros.pdf

© Juliane Thamm – University of Strathclyde

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next steps
Please review the lecture 6 material and complete the week 6 required
reading, then attempt to answer the workshop 6 questions.
Prepare for the class test!
Try self-assessment quiz 6 and don’t forget about the Survey home work
and check out podcase 3.
Next Tuesday’s lecture (wk7) will be our Monday lecture 7.
Keep e-mailing topic suggestions for future Tuesdays.

… and attend tomorrow’s session!

© Juliane Thamm – University of Strathclyde
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further help:

Come to any office hours – these are drop-in sessions, no appointment

needed! All details are on the AG991 myplace page.

Send any questions you may have by e-mail.

If you wish to see me outside of office hours, please e-mail to make

arrangements.
© Juliane Thamm – University of Strathclyde
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