International Finance:

Foreign Exchange Market Structure

Pasquale Della Corte

Imperial College London

Lecture 1

Pasquale Della Corte (Imperial) International Finance Lecture 1 1 / 54

De…nition of Exchange Rate

The exchange rate is the price of a currency in terms of another one

what is the dollar price of a pound?
how many euros a dollar is worth?
trading foreign currency is not di¤erent from trading equity

1 share of Apple $ 530 1 Euro $ 1.37

Exchange rates are relative prices and can be quoted in

1 direct terms: US dollar price of a unit of foreign currency
2 indirect terms: foreign currency price of a unit of US dollar

USD 1.3840 = EUR 1 USD 1 = JPY 83.1394

Pasquale Della Corte (Imperial) International Finance Lecture 1 2 / 54

Currency Abbreviations

In all transactions, parties use abbreviations to refer to a currency

the International Organization for Standardization (ISO) sets the
currency abbreviations
two-digit country code + a letter from the name of the currency
FX market participants, however, use their own jargon

Country Currency ISO code Nickname

Australia Australian dollar (A$) AUD Aussie
Canada Canadian dollar (C$) CAD Loonie
China Chinese renminbi (CN U) CNY
Euro Area Euro (e) EUR Fiber
Japan Japanese yen (U) JPY Ninja
New Zealand New Zealand dollar (NZ$) NZD Kiwi
United Kingdom British pound (£ ) GBP Cable
United States US dollar ($) USD

Pasquale Della Corte (Imperial) International Finance Lecture 1 3 / 54

Direct Quotation
The direct quote gives the domestic price of a unit of foreign currency
the foreign currency is the base currency
the domestic currency is the pricing (or quoting) currency.

How many units of domestic currency

per unit of foreign currency?

If the direct quote increases

the foreign currency appreciates
the domestic currency depreciates

The following quotes indicate a euro appreciation against the dollar

On 2 December 2013: 1.3550$/e
On 8 January 2014: 1.3582$/e
Pasquale Della Corte (Imperial) International Finance Lecture 1 4 / 54
Indirect Quotation
The indirect quote is the foreign price of a unit of domestic currency
the foreign currency is the pricing currency
the domestic currency is the base currency.

How many units of foreign currency

per unit of domestic currency?

If the indirect quote increases

the domestic currency appreciates
the foreign currency depreciates

The following quotes indicate a dollar appreciation against the yen

On 1 October 2013: 103.06U/$
On 8 January 2014: 104.78U/$
Pasquale Della Corte (Imperial) International Finance Lecture 1 5 / 54
Direct vs Indirect Quotation

A direct quotation from the perspective of one country is an indirect

quotation from the perspective of another.

The following exchange rate between Japan and New Zealand

64.93U /NZ $

is a direct quote for a Japanese investor but an indirect quote for a

New Zealand investor.

The direct quote is the reciprocal of the indirect quote

1
0.0154NZ $/U = .
| {z } 64.93U /NZ $
Direct Quotation for NZD | {z }
Indirect Quotation for NZD

Pasquale Della Corte (Imperial) International Finance Lecture 1 6 / 54

What is Used in Practice?
The FX markets use the following conventions:
EUR is always the base currency
GBP is base currency against all currency, except EUR,
AUD and NZD are base currencies against all currencies, except EUR
and GBP,
USD is base currency against all currencies, except the ones above,
other exceptions for some African currencies (e.g., Botswana),
to sum up: EUR=)GBP=)AUD=)NZD=)USD.

Exchange rate are typically quoted as

BBBPPP
where BBB is the base and PPP is the pricing currency, i.e.,
EURUSD, USDJPY, EURGBP, etc.
Pasquale Della Corte (Imperial) International Finance Lecture 1 7 / 54
.... and Why?
American terms (used in US)
direct quote from the perspective of someone based in the US,
units of US dollars per unit of foreign currency (0.5774$/DEM).

European terms (used in Europe)

direct quote from the point of view of someone located in Europe,
units of local currency per unit of US dollar (1.7320DEM/$).

The FX market was integrating into a single global market, and in

1978 the US brokers community changed the practice to be aligned
with the European market.

The UK adopted a decimal system only 1971. Prior to this, 1 pound

= 20 shilling, and 1 shilling = 12 pence (i.e., 240 pence for 1 pound).
So, it was easier to quote units of foreign currency per pound.
Pasquale Della Corte (Imperial) International Finance Lecture 1 8 / 54
Reuters Screen
Direct terms US perspective

Pasquale Della Corte (Imperial) International Finance Lecture 1 9 / 54

Our Notation

We will use the following notation

A/B

meaning units of currency A per unit of currency B ,

A as pricing currency (or domestic currency),
B as base currency (or foreign currency).

For instance
USD/EUR = 1.4613 or 1.4613$/e

means 1.4613 units of US dollar to buy a unit of euro

USD is the pricing currency,
EUR is the base currency.

Pasquale Della Corte (Imperial) International Finance Lecture 1 10 / 54

Direct Quotation for USD vs GBP

Pasquale Della Corte (Imperial) International Finance Lecture 1 11 / 54

Bilateral vs Cross Exchange Rate
With N currencies, we would have N (N 1) /2 exchange rates
there are roughly 180 circulating currencies in the world,
hence, we should have (180 179) /2 > 16, 000 exchange rates!
is it feasible to quote a such number of exchange rates? No!
currencies are generally quoted against USD, and often against EUR,
GBP and JPY.

If the exchange rate between A and B is not directly quoted, we can

compute the cross exchange rate as follows
USD/B
A/B =
USD/A

The cross exchange rate is de…ned as the exchange rate

between two currencies, neither of which is the US dollar.
Pasquale Della Corte (Imperial) International Finance Lecture 1 12 / 54
Cross Exchange Rate

Example
Country USD EUR GBP
Argentine Peso ARS 3.1288 4.3431 6.3431
Indian Rupee INR 40.4550 56.1556 82.0165
Singapore Dollar SGD 1.5091 2.0948 3.0595
Thai Baht THB 34.2450 47.5509 69.5328
Source: Financial Times, 14 September 2007
THB/USD 34.2450
THB/ARS = = = 10.9451
ARS/USD 3.1288

INR/USD 40.4550
INR/SGD = = = 26.8074
SGD/USD 1.5091

Pasquale Della Corte (Imperial) International Finance Lecture 1 13 / 54

Cross Exchange Rate Matrix

Given N currencies, we can determine N (N 1)/2 cross exchange rates.

ARS CAD CHF EUR GBP HKD JPY

ARS 6.1162 7.2601 8.9846 10.8457 0.8517 0.063
CAD 0.1637 1.1872 1.4692 1.7736 0.1393 0.010302
CHF 0.1379 0.8426 1.2377 1.4941 0.1173 0.008678
EUR 0.1114 0.6808 0.8081 1.2072 0.09482 0.007012
GBP 0.09231 0.564 0.6695 0.8285 0.07854 0.005809
HKD 1.1754 7.1814 8.5245 10.549 12.7346 0.07397
JPY 15.893 97.1005 115.255 142.632 172.179 13.5217

Top row =) base currencies, …rst column =) pricing currencies

0.1637 =) 1ARS = 0.1637CAD
6.1162 =) 1CAD = 6.1162ARS

Pasquale Della Corte (Imperial) International Finance Lecture 1 14 / 54

Bid-Ask Spread

Market makers quote exchange rates in terms of two numbers

the ask rate is the rate at which the dealer is willing to sell
the bid rate is the rate at which the dealer is willing to buy.

Market makers’counterparty (customer)

will buy foreign currency at the ask rate
will sell foreign currency at the bid rate.

The spread is the di¤erence between the ask and the bid rate
the spread is measured in pips
a pip is the smallest price increment in FX trading
FX rates are quoted to the fourth decimal point (JPY to the second
decimal point).
Pasquale Della Corte (Imperial) International Finance Lecture 1 15 / 54
Bid-Ask Spread

FX rate Quotes Contributor

USD/EUR 1.4611/13 Deutsche BK
USD/GBP 1.5955/57 B. Santander
JPY/USD 89.84/87 Brown Bros
Source: Reuters, 5 October 2009
the USD/EUR currency pair is trading at 1.4611 by 13
the bid for the USD/EUR is 1.4611 and the ask is 1.4613
you can buy EUR at USD 1.4613 or sell EUR at USD1.4611
spread = 1.4613 1.4611 = 0.0002 (2 pips )

the JPY/USD currency pair is trading at 89.84 by 87

the bid for the JPY/USD is 89.84 and the ask is 89.87
you can buy USD at JPY 89.87 or sell USD at USD 89.84
spread = 89.87 89.84 = 0.03 (3 pips )

Pasquale Della Corte (Imperial) International Finance Lecture 1 16 / 54

Bid-Ask Spread Determination
The market maker obtains a positive spread for trading currencies as
a compensation for three main determinants.

Cost of Dealer Services

compensation for providing liquidity
the cost of acquiring know-how
subscriptions to electronic information and trading systems (Reuters).

Adverse Selection
refers to bad results occurring because dealers and customers have
asymmetric information (access to di¤erent information)
the dealer cannot distinguish between a liquidity-motivator customer
and an insider (private information)
the dealer can widen the spread to defend himself against the adverse
selection (less willing to trade).
Pasquale Della Corte (Imperial) International Finance Lecture 1 17 / 54
Bid-Ask Spread Determination
Inventory Risk
compensation for inventory holdings (there is an opportunity cost of
holding currency)
a dealer will shift downwards and widen the spread when a positive
inventory is accumulated (getting rid of foreign currency )
a dealer will shift upwards and widen the spread when a negative
inventory is accumulated (accumulating foreign currency ).

JP Morgan has accumulated EUR in excess

16:30 GMT USD/EUR 1.4650/60

JP Morgan wants to get rid of EUR and makes more (less) convenient for any
customers to buy (sell) EUR

16:35 GMT USD/EUR 1.4610/40

Pasquale Della Corte (Imperial) International Finance Lecture 1 18 / 54

Spatial Arbitrage

Law of one price

Identical assets in di¤erent markets must have the same price
buy the underpriced and the sell the overpriced currency
riskless pro…t without any initial investment.

Equilibrium
the exchange rate A/B in two di¤erent locations

(A/B)London = (A/B)New York

if this condition is violated, arbitrage restores the equilibrium condition

via changes in the forces of supply and demand.

Spatial arbitrage arises when the same exchange rate is

quoted di¤erently in di¤erent …nancial centres

Pasquale Della Corte (Imperial) International Finance Lecture 1 19 / 54

Triangular Arbitrage

Misalignment between bilateral and cross exchange rates.

trading sequentially three currencies

trading out USD into a second currency, then trading it for a third
currency, which is in turn traded for USD.

Clockwise direction
A/C
A/B <
B /C
1 sell A and buy B
2 sell B and buy C
3 sell C and buy A.

Pasquale Della Corte (Imperial) International Finance Lecture 1 20 / 54

Triangular Arbitrage

Anti-clockwise direction
A/C
A/B >
B /C

1 sell A and buy C

2 sell C and buy B
3 sell B and buy A.

No-arbitrage condition

A/C
A/B =
B /C

Pasquale Della Corte (Imperial) International Finance Lecture 1 21 / 54

Triangular Arbitrage

Example
Exchange rates are quoted in Sydney, Auckland and Hong Kong:

HKD/AUD = 4.1548
NZD/AUD = 1.2052
HKD/NZD = 3.5825

Equilibrium condition

HKD HKD/AUD 4.1548

3.5825 = > = = 3.4474
NZD NZD/AUD 1.2052

Anti-clockwise triangular arbitrage

Pasquale Della Corte (Imperial) International Finance Lecture 1 22 / 54

Triangular Arbitrage

Example
Strategy 1: HKD =) NZD =) AUD =) HKD
1 Sell 1 HKD for NZD =) 1 = 0.2791 NZD
3.582
2 Sell 0.2791 NZD for AUD =) 0.2791 = 0.2316 AUD
1.2052
3 Sell 0.2316 AUD for HKD =) 0.2316 4.1548 = 0.9623 HKD
Loss-making sequence!!!

Strategy 1: HKD =) AUD =) NZD =) HKD

1 Sell 1 HKD for AUD =) 1 = 0.2407 AUD
4.1548
2 Sell 0.2407 AUD for NZD =) 0.2407 1.2052 = 0.2901 NZD
3 Sell 0.2901 NZD for HKD =) 0.2901 3.5825 = 1.0392 HKD
Pro…table sequence!!!

Pasquale Della Corte (Imperial) International Finance Lecture 1 23 / 54

Bid-Ask Spread Arbitrage

Equilibrium
Any two banks’quotes should overlap by at least one point

Violation (A/B)bid ask

London > (A / B)New York
ask
pro…t by buying B at (A/B)New York and selling it for (A/B)bid
London

Example
Bank A Bank B
USD/EUR 1.3925/1.3975 1.3760/1.3825

buy 1 EUR from B (at 1.3825) and resell it to A (at 1.3925)

net pro…t worth 0.01 USD for each EUR purchased

Pasquale Della Corte (Imperial) International Finance Lecture 1 24 / 54

Bid-Ask Spread Arbitrage

Violation (A/B)ask bid

London < (A / B)New York

pro…t by buying B at (A/B)ask

London and selling it for (A/B)bid
New York .

Example
Bank A Bank B
USD/EUR 1.3925/1.3975 1.4075/1.4125

buy 1 EUR from A (at 1.3975) and resell it to B (at 1.4075)

net pro…t worth 0.01 USD for each EUR purchased.

Pasquale Della Corte (Imperial) International Finance Lecture 1 25 / 54

Foreign Exchange Market
The foreign exchange market (FX or FOREX market)
is the largest and oldest …nancial market
is open 24 hours a day.

While stock and futures markets are organized exchanges, the FX

market is an over-the-counter (OTC) market
there is no central marketplace where buyers and sellers meet
London Stock Exchange but not London Foreign Exchange
buyers and sellers are linked via telephones, computers and automated
dealing systems.

Three market segments and major trading centres

Australasia (Sydney, Tokyo, Hong Kong, Singapore, and Bahrain)
Europe (Zurich, Frankfurt, Paris, and London)
North America (New York, Toronto, Chicago, and San Francisco).
Pasquale Della Corte (Imperial) International Finance Lecture 1 26 / 54
FX Market Activity
The FX market is highly decentralized and essentially unregulated
market participants may move elsewhere if they are regulated
short-sales restrictions are missing (Can we de…ne them? Selling
domestic is equivalent to buying foreign currency!)

Activity is not regular but follows the sun around the globe
periods of very heavy activity and periods of relatively light activity
most of the trading occurs when the largest number of counterparties
is available on a global basis (When would you like to sell? When you
access to the maximum number of potential buyers!).

Heavy business when Europe overlaps Asia and North-America

afternoon in Asia and morning in London, and afternoon in London
and morning in New York
little activity when Europe shuts down and Tokyo, Hong Kong, and
Singapore have not yet opened.
Pasquale Della Corte (Imperial) International Finance Lecture 1 27 / 54
FX Trading Around the Clock
F I G U R E 3 - 2

The Circadian Rhythms of the FX Market

Electronic conversations per hour (Monday-Friday, 1992-93) Avg Peak

45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300
10Am Lunch Europe Asia Lunch Americas London Afternoon New Zealand 6 Pm Tokyo
in hour coming going hour coming going in coming in Coming
Tokyo in Tokyo in out in London in out America in New York in

Note: Time (0100-2400 hours, Greenwich Mean Time)

Source: Reuters

Pasquale Della Corte (Imperial) International Finance Lecture 1 28 / 54

Market Structure and Players

Active trading started in the 1960s, and since then split into two tiers
interbank market: trades occur between dealers (typically large
international banks) directly or indirectly through brokers
retail market: trades occur between dealers and customers (corporate
…rms, asset managers, hedge funds, central banks, individual investors,
and high-frequency traders)
dealers (or market-makers) stand ready to trade with anyone needing
foreign currency
brokers match orders for a fee, they don’t take position but act as
intermediaries
customers trade currencies for international trade and investment
operations
central banks may intervene to a¤ect the level or the volatility of the
exchange rate.

Pasquale Della Corte (Imperial) International Finance Lecture 1 29 / 54

Market Structure and Players

Pasquale Della Corte (Imperial) International Finance Lecture 1 30 / 54

Top Currency Traders

Euromoney publishes in May the FX Survey: an annual study

conducted over six weeks in January and February.

Rank Name Market Share

1 Deutsche Bank 15.18%
2 Citi 14.90%
3 Barclays 10.24%
4 UBS 10.11%
5 HSBC 6.93%
6 JPMorgan 6.07%
7 Royal Bank of Scotland 5.62%
8 Credit Suisse 3.70%
9 Morgan Stanley 3.15%
10 Bank of America Merrill Lynch 3.08%
Source: EuroMoney 2013 FX Survey

Pasquale Della Corte (Imperial) International Finance Lecture 1 31 / 54

Interbank Market

The interbank market provides liquidity to dealers as they need to

o¤set foreign exchange positions arising from transactions with their
own customers. Trading occurs directly or indirectly.

Direct trading
a direct trade begins when a dealer (e.g., Barclays) contacts another
dealer (e.g., Deutsche Bank) and requests for a quote
the request contains information about the exchange rate (e.g.,
EURUSD) and the size (e.g., $10m)
the initiating dealer (Barclays) does not disclose his interest in either
buying or selling dollars at this stage
Deutsche Bank is expected to respond in few seconds by quoting the
“bid” and “ask” price
Barclays …nally decides whether to buy, sell or pass.

Pasquale Della Corte (Imperial) International Finance Lecture 1 32 / 54

An Example of Direct Trading via Reuters

#EUR 10
12 14
#URS
OK TO CONFIRM I BUY EUR 10 MIO AGAINST USD AT 1.1512
MY EUR TO STATE STREET PLS
#TO CONFIRM I SELL EUR 10 MIO AGAINST USD AT 1.1512
#MY USD TO CITI PLS
#THKS VM AND BIBI
#END REMOTE

Pasquale Della Corte (Imperial) International Finance Lecture 1 33 / 54

An Example of Direct Trading via Reuters
#EUR USD 10
The initiating dealer requests a quote for EUR against USD for
$10m. Usually you do not tell if you want to buy or sell dollars

12 14
This line shows the quoted bid and ask prices from the quoting
dealer. By convention, only the last two digits are quoted as
participants know the big …gure. The regular rate here is 1.3612 –
1.3614. The initiating dealer can buy EUR at 1.3614 and sell EUR
at 1.3612 against USD.

“URS”
A common abbreviation for “yours” meaning “I sell” (opposite
“mine” for “I buy”). Basically, the initiating dealer has decided to sell
EUR against USD at 1.3612.
Pasquale Della Corte (Imperial) International Finance Lecture 1 34 / 54
An Example of Direct Trading via Reuters

OK TO CONFIRM I BUY EUR 10 MIO AGAINST USD AT 1.3612

MY EUR TO STATE STREET PLS

The quoting dealer con…rms the deal and gives payment instructions
to receive EUR.

#TO CONFIRM I SELL EUR 10 MIO AGAINST USD AT 1.3612

#MY USD TO CITI PLS
#THKS VM AND BIBI
#END REMOTE
The initiating dealer con…rms the deal as well and gives payment
instructions to receive USD. The bank thanks for the deal; the
conversation is ended.

Pasquale Della Corte (Imperial) International Finance Lecture 1 35 / 54

Interbank Market

Dealers can also trade indirectly (and anonymously) via a broker by

placing limit orders or market orders
a limit order purchase is an instruction to buy a given amount up to
a maximum price; a limit order sale is an instruction to sell a given
quantity above a minimum price.
a market order purchase is an instruction to buy a given quantity at
the best prevailing price; a market order sale is an instruction to sell a
given quantity at the best prevailing price
agents provide liquidity through limit orders and consume liquidity
through market orders.

The set of outstanding limit orders represents the limit order book
market orders are executed against limit orders in the book
the best bid or ask prices are known as the “quotes”, and the quantity
available at the quotes is the market’s “depth”.
Pasquale Della Corte (Imperial) International Finance Lecture 1 36 / 54
Interbank Market

A broker matches market orders with limit orders

Reuters Xtra 3000 (for GBP, AUD, CAD, NOK and SEK) and EBS
(for EUR, JPY, CHF) are the dominant electronic brokerages nowadays
voice brokers remain important for less liquid currencies as the
emerging market currencies.

The dealer generally prefers to have zero inventories or imbalances

after he receives a trade from a customer, he will lay the position o¤ on
another dealer in a process called “hot potato trading”
the order imbalance (or order ‡ow) is the di¤erence between the value
of purchase and sale orders of foreign currency initiated by
counterparties against the dealer quotes
a positive (negative) order ‡ow can be thought as an excess demand
(supply) of foreign currency.

Pasquale Della Corte (Imperial) International Finance Lecture 1 37 / 54

Dealer’s Order Imbalances
6.1. THE STRUCTURE OF THE FX MARKET 277

Figure 3: Net position (in $millions) over one trading week in 1992 of a large bank
dealer in USD/DM. Source: Lyons (1995).

Pasquale Della Corte (Imperial) International Finance Lecture 1 38 / 54

Retail Market

Transactions between dealers and “customers” take place in the retail

market

leveraged investors such as hedge funds that runs speculative

strategies (carry, momentum, value and volatility)
unleveraged investors such as real-money investors, mutual funds and
pension funds that focus on hedging strategies (a 50% hedge ratio is
very common)
corporate customers support the treasury operations arising from the
core business activities such as manufacturing, shipping, mining, etc.
They typically engage in FX hedging (typically with a 40-50% hedge
ratio) but sometimes also in speculative trading (industry insiders
de…ne Porsche as an a hedge fund with a carmaker attached).
retail investors such as wealthy individuals or small institutions
trading very few currencies and holding positions for very short time
horizons, typically less than a day.
Pasquale Della Corte (Imperial) International Finance Lecture 1 39 / 54
Retail Market

Similar to the interbank market, electronic trading has become

popular in the retail market.

Electronic systems such as FX Connect, FXAll and Currenex are

popular electronic platforms linking customers with the trading desks
of banks.

These systems allow customers to request quotes from several banks

simultaneously, thereby intensifying the competition between banks.

Some banks (Deutsche Bank, Citi, Barclays, etc.) o¤er their largest
customers the ability to trade directly on the electronic brokerage
systems

Pasquale Della Corte (Imperial) International Finance Lecture 1 40 / 54

FX Market by delivery date

A spot exchange rate is the quotation for immediate exchange of

the currencies.

A forward exchange rate (or outright forward) is a rate agreed

today for the delivery of a currency at a speci…ed date in the future
forward rate higher than spot rate (quotation at a premium)
forward rate lower than spot rate (quotation at a discount)
quotes for maturities of 1,3,6,9, and 12 months are readily available
quotes beyond 1 year becoming more frequent.

A foreign exchange swap is the simultaneous sale of a currency for

spot delivery and purchase of that currency for forward delivery
generally used by dealers to manage the maturity structure of their
currency positions.
Pasquale Della Corte (Imperial) International Finance Lecture 1 41 / 54
Spot Rate

Spot transactions do not require immediate cash settlement, which is

typically made two business days (spot value date) after the deal
date.

The two-business day rule (t + 2) provides ample time for the parties
to con…rm the agreement, arrange the clearing, debit and credit the
bank accounts in various international locations.

Exceptions - settlement made one business day (t + 1) after the

deal - applies to the Canadian dollar, Mexican peso, Russian ruble,
Turkish lira, Kazakh tenge, Pakistan rupee, and Philippine peso.

Pasquale Della Corte (Imperial) International Finance Lecture 1 42 / 54

Forward Rate

The exchange of currencies in a forward contract takes place on the

forward value date. No money changes hands until the transaction
takes place but dealers/brokers may require customers to provide
collateral in advance.

A 30-day EUR/USD forward struck on Friday, November 11, 2011

spot value date is on Tuesday, November 15, 2011
forward value date is on Thursday, December 15, 2011.

If the spot value date is the last business day of the month, the
forward value date will be the last business day of the next month
(end-end rule).

Pasquale Della Corte (Imperial) International Finance Lecture 1 43 / 54

Shortest Maturities

Overnight (ON)
contract at time t; return funds at time t + 1.

Tomorrow Next (TN)

contract at time t 1; obtain funds at time t; return funds at time
t + 1.

Spot Next (SN)

contract at time t 2; obtain funds at time t; return funds at time
t +1
a deal which matures one business day past the spot date, thus, 3
business days to maturity.

Pasquale Della Corte (Imperial) International Finance Lecture 1 44 / 54

FX Market by delivery date

Example
Consider the following quotations for the USD/CHF

S (USD/CHF ) = 0.8470
F1 (USD/CHF ) = 0.8485
F3 (USD/CHF ) = 0.8517
F6 (USD/CHF ) = 0.8573

From these quotations, we can see that USD/CHF is quoted at a

premium and the premium increases up to six months.

The market expects the US dollar to depreciate relative to the Swiss

franc. It costs more dollars to buy a Swiss franc forward.

Pasquale Della Corte (Imperial) International Finance Lecture 1 45 / 54

Non-Deliverable Forwards

A non-deliverable forward (NDF) is a forward contract used to

trade/hedge a non-convertible currency against freely convertible
currency, typically USD and EUR.

Non-convertible currencies include the Argentine peso, Russian

ruble, Taiwanese dollar, Korean won, Brazilian real, Chinese yuan,
Venezuela bolivar, Indian rupee, etc.

On the settlement date, the NDF rate is settled against the spot rate
on the …xing date (two days before the delivery date of the NDF).

The reference spot rate is usually the Reuters or Bloomberg rate.

Pasquale Della Corte (Imperial) International Finance Lecture 1 46 / 54

FX Swaps
In the FX swap market, one currency is swapped for another for a
period of time, and then swapped back, creating an exchange and
re-exchange.
An FX swap has two separate legs settling on two di¤erent value
dates, even though it is arranged as a single transaction.
The two counterparties agree to exchange two currencies at a
particular rate on one date (the near date) and to reverse payments
at a di¤erent rate on a speci…ed future date (the far date).
It is a spot transaction and an outright forward transaction going in
opposite directions, or two outright forwards with di¤erent settlement
dates, and opposite directions.
The FX swap di¤ers from the currency swap in which
counterparties exchange principal and streams of …xed or ‡oating
interest payments in two di¤erent currencies.
Pasquale Della Corte (Imperial) International Finance Lecture 1 47 / 54
FX Swaps

The cost of an FX swap is measured by swap points, or the foreign

exchange equivalent of the interest rate di¤erential between two
currencies for the period.

The FX swap is a very ‡exible and convenient instrument that is used

for a variety of funding, hedging, position management, speculation,
and other purposes.

FX swaps are extremely popular among OTC interbank dealers, and

account for nearly half of daily turnover in the US OTC foreign
exchange market.

Pasquale Della Corte (Imperial) International Finance Lecture 1 48 / 54

BIS Survey
Statistics are not immediately available for an OTC market
the BIS Triennial Survey provides a comprehensive source of
information on the size and structure of the FX market BIS
worldwide cooperative e¤ort coordinated by the Bank for International
Settlements (BIS) every three years
the last survey in 2013 carried out by 53 central banks and monetary
authorities.

Global FX turnover as of April 2013

average daily turnover is $5.3 trillion
signi…cant increase in FX activity compared to 2010 (35% at current
exchange rates)
London is the most active trading centre ( 41% of total turnover),
followed by New York ( 19%), Singapore ( 6%), Tokyo ( 6%),
and Hong Kong ( 4%)
Pasquale Della Corte (Imperial) International Finance Lecture 1 49 / 54
BIS Survey

Turnover by Instruments
spot: $2.046 trillion (38%)
forwards: $680 billion (13%)
FX swaps: $2.228 trillion (42%)
FX Options: $337 billion (6%)
Currency Swaps: $54 billion (1%)

Currencies Distribution
USD has a market share of 87% of all transactions
EUR has a market share of 33% of all transactions
JPY has a market share of 23% of all transactions
GBP has a market share of 12% of all transactions
AUD has a market share of 9% of all transactions
emerging market currencies have a market share of 22% of all
transactions
Pasquale Della Corte (Imperial) International Finance Lecture 1 50 / 54
BIS Survey

Turnover by Counterparties
with reporting dealers: $2.07 trillion (39%)
with other …nancial customers: $2.81 trillion (53%)
with non-…nancial customers: $465 billion (9%).

Turnover by Execution Method

voice direct $1.474 trillion (28%)
voice indirect $785 billion (15%)
electronic direct $1.59 trillion (30%)
electronic indirect $1.37 trillion (26%).

Pasquale Della Corte (Imperial) International Finance Lecture 1 51 / 54

What is driving FX trading activity?

Momentum (buy “winners” and sell “losers”)

systematic purchase of currencies with persistent trend of appreciation
and sale of currencies with clear trend of depreciation.

Carry Trade
investors borrow in a low-interest-rate currency (the funding currency)
and invest into a high-interest-rate currency (the target currency) if the
target currency tends to appreciate against the funding currency.

Hedging
Multinational …rms tend to minimize the exposure to exchange rate
risk.

Pasquale Della Corte (Imperial) International Finance Lecture 1 52 / 54

Key Concepts

Direct and Indirect Quotations

Bilateral and Cross Exchange Rates

Arbitrage Strategies

The FX Market Activity and Market Participants

Spot and Forward Exchange Rates

The BIS Survey

Pasquale Della Corte (Imperial) International Finance Lecture 1 53 / 54

Readings

Bekaert and Hodrick, Ch. 2 & 3.

Rime, D., and A. Schrimpf (2013). “The Anatomy of the Global FX

Market through the lens of the 2013 Triennal Survey,” BIS Quaterly
Review, December 27-42.

King, M.R., C. Osler and D. Rime (2012). “Foreign Exchange Market

Structure, Players and Evolution,” in James, Marsh and Sarno (eds.),
Handbook of Exchange Rates, Wiley.

Pasquale Della Corte (Imperial) International Finance Lecture 1 54 / 54