is 356 it for financial services foreign exchange trading december 24, 2015 pptallon/is356.htm

IS 356IS 356IT for Financial ServicesIT for Financial Services

Foreign Exchange Trading

April 21, 2023

http://www.evergreen.loyola.edu/~pptallon/is356.htm

April 21, 2023© Paul Tallon 2/18

BackgroundBackground According to the Bank for International Settlements

(BIS), the foreign exchange markets trade approx $1.2 trillion per day

− more than a month of combined NYSE and NASDAQ trades $8 trillion of foreign exchange trading is online

(Greenwich Associates )… that’s only about 2%

Characteristics: − digital good− no central clearinghouse (trading and clearing are in sync)− no physical trading floor− little regulation (central banks often get involved to stop outflows)− 24-hour global trading


The Foreign Exchange The Foreign Exchange MarketMarket

Minimizes foreign exchange risk (unpredictable rate swings)

There are different ways to trade currencies− Spot exchange rates: the day’s rate offered by a dealer/bank− Forward exchange rates:

– Agreed in advance rates to buy/sell a currency on a future date– Usually quoted 30, 90, 120 days in advance

Arbitrage: buying low and selling high … given slightly different exchange rate quotes in one location vs. another (e.g., London vs. Tokyo)


Spot Market Spot Market CharacteristicsCharacteristics

It is the oldest and largest financial market in the world:− Has no central trading floor where buyers and sellers meet.− Is open twenty-four hours a day, except for short gaps on

weekends.− The spot market is a market for immediate delivery.

Primarily an inter-bank or sell-side market, which is the trading of foreign-currency-denominated deposits between large banks.

− Global banks account for about two-thirds of the market volume, while foreign exchange brokers and dealers account for approximately 20 percent.


A Foreign Exchange A Foreign Exchange Transaction Transaction

Toshiba Japan receives a dollar denominated payment from Best Buy, which they present to their local Fuji Bank.

To exchange the dollar payment for the yen equivalent, Fuji Bank may contact another bank, such as Citigroup, or contact a FX broker.

buy Yen, sell $


Arbitrage: Consistency of Arbitrage: Consistency of RatesRates Arbitrage is the simultaneous buying and selling to

profit (as opposed to speculation). You can arbitrage around either spot or future rates but

either way, you need to move very fast The ability of market participants to arbitrage

guarantees that cross rates will be, in general, consistent.

If a cross rate is not consistent, the actions of currency traders (arbitrage) will bring the respective currencies into line very quickly.


Spatial ArbitrageSpatial Arbitrage Spatial Arbitrage refers to buying a currency in one

market and selling it in another Price differences at a point in time arise from spatial or

geographically dispersed markets− USD/EUR rate quoted in Paris: $1.2900 = €1.00− EUR/USD rate quoted in NY: €0.77=$1 but according to the

rate posted in Paris, the real rate should be €0.77519 (or 1 ÷ 1.29)

− NY trader buys €1 in Paris for $1.29 and sells €1 in New York for $1.2987(makes $0.0087 or 0.6744% profit)

Due to the low-cost rapid-information nature of the foreign exchange market, these price differences are arbitraged quickly and the rates return to equilibrium


Triangular ArbitrageTriangular Arbitrage Triangular arbitrage involves a third currency Arbitrage opportunities exist if an observed rate in

another market is not consistent with a cross-rate The US dollar is trading for 1.7936 ($/£) and the South

African Rand for 6.5492 (R/£) in London, while the Rand is trading for 3.7826 (R/$) in New York.

The cross-rate in London is:6.5492/1.7936 = 3.6514 (R/$)

Hence, an arbitrage opportunity exists. How do you take advantage of it?


Example ContinuedExample Continued A trader sells £1 for $1.7936 in London. The $1.7936 would purchase R6.7845 in New York. The R6.7845 purchases £1.0359 in London. This is a

profit of £0.0359 or 3.59 percent profit on a round trip transaction.

Sell £ in London

Purchase R in New YorkPurchase £ in London

1.

2.3.

profit


Market StructureMarket Structure

Source: Gallaugher & Melville (2004), CACM 47(8)


IssuesIssues Phone trading is still an important part of the market.

This often paperless approach helped John Rusnak of AllFirst to hide $691M in currency trading losses

Buy-side banks later developed proprietary systems that directly linked to clients. These systems did not support multiple counterparties which was a problem for trader seeking price competition.

This situation led to eFX portals− Single-bank sponsored (State St. – FX Connect)− Independents – Currenex− Bank consortia – FXall, Atriax (closed: Chase, Citibank & DB)


Source: Gallaugher & Melville (2004), CACM 47(8)

Technology InnovationTechnology Innovation


CurrenexCurrenexTo buy €1, it will cost you $1.2934

Roundtrip Example:$1.2934 = €1; €1 = ¥137.95; ¥137.95 = $1.2932

(no clear arbitrage opportunity;there is only a tiny difference)

Bought by State Street in January 2007


Trading (just like equities)Trading (just like equities)


Up to 200:1 leverage

No fees or commissions


For Next Class…For Next Class… Read

– There will be a 60-minute exam next class

is 356 it for financial services foreign exchange trading december 24, 2015 pptallon/is356.htm

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