II. FINANCAL MARKETS,
TRADING PROCESSES AND
INSTRUMENTS
A. Exchanges and Floor Markets
•The Securities and Exchange Act of 1934 defined an exchange to be:
any organization, association, or group of persons, whether incorporated
or unincorporated, which constitutes, maintains, or provides a market place
or facilities for bringing together purchasers and sellers of securities or for
otherwise performing with respect to securities the functions commonly
performed by a stock exchange as that term is generally understood, and
includes the market place and the market facilities maintained by such
exchange.
•An exchange is a physical or virtual meeting place drawing together
brokers, dealers and traders to facilitate the buying and selling of
securities.
•Exchanges include the floor-based markets as well as many virtual
meeting sites and screen-based systems provided by Electronic
Communications Networks (ECNs).
Exchange Functions
• Exchanges are intended to provide for orderly, liquid
and continuous markets for the securities they trade.
• A continuous market provides for transactions that can
be executed at any time for a price that might be
expected to differ little from the prior transaction price
for the same security.
• In addition, exchanges traditionally serve as selfregulatory organizations (SROs) for their members,
regulating and policing their behavior with respect to a
variety of rules and requirements.
NYSE Euronext
• NYSE Euronext, the world’s largest exchange and
its first global exchange, lists over 8,000 issues
(excluding European structured products) from 55
countries on six equities exchanges and six
derivatives exchanges in six countries.
• NYSE Euronext was launched on April 4, 2007,
the result of a merger between the New York
Stock Exchange Group and Euronext, NV.
NYSE Family Tree
U.S. Stock and Options Exchanges
NYSE Amex LLC (formerly the American Stock Exchange)
BATS Exchange, Inc.
BATS Y-Exchange, Inc.
NASDAQ OMX BX, Inc. (formerly the Boston Stock Exchange)
C2 Options Exchange, Incorporated
Chicago Board Options Exchange, Incorporated
Chicago Stock Exchange, Inc.
EDGA Exchange, Inc.
EDGX Exchange, Inc.
International Securities Exchange, LLC
The Nasdaq Stock Market LLC
National Stock Exchange, Inc.
New York Stock Exchange LLC
NYSE Arca, Inc.
NASDAQ OMX PHLX, Inc. (formerly Philadelphia Stock Exchange)
Futures and Partially Exempt
Exchanges
U.S. Futures Exchanges
Board of Trade of the City of Chicago, Inc.
CBOE Futures Exchange, LLC
Chicago Mercantile Exchange
One Chicago, LLC
The Island Futures Exchange, LLC
NQLX LLC
Partially Exempt Exchanges
Arizona Stock Exchange
SWX Europe Limited (f/k/a Virt-x)
Early Exchanges
• Precursors to modern stock exchanges might have existed in Egypt as early as
the 11th century, where it is believed that Jewish and Islamic brokers traded a
variety of credit-related instruments.
• 13th century Bruges (Belgium) commodity traders assembled in the van der
Beurse family home (and inn), ultimately becoming the “Brugse Beurse.”
• The Amsterdam Stock Exchange opened in the early 17th century, trading
shares of the Dutch East India Company. The exchange continues to operate
as a unit of Euronext, and as the world's longest continuously operated
exchange.
• Several older exchanges began in coffee houses and taverns, where brokers
and dealers would meet to trade securities.
• The first securities exchange to operate in the United States was in
Philadelphia.
• The New York Stock Exchange began operations outdoors after the 1792
signing of the “Buttonwood Agreement.”
• Exchanges often operated outdoors so that brokers could call out their orders
from their office windows to the street where transactions actually took place.
• The American Stock Exchange, known as the New York Curb Exchange until
1953, did not move indoors until 1921.
Traditional NYSE Structure
• Until 2006, the NYSE was a hybrid corporation/partnership whose
members faced unlimited liability.
• Only members who owned or leased seats had trading privileges and
there were four types of members:
– House Broker: Executed orders on behalf of clients submitting orders
through brokerage firms. This and other broker roles have been taken
over by "Trading Floor Brokers."
– Independent Broker: Also called a two-dollar broker, executed orders
on behalf of commission brokers when activity was high. This type of
distinct membership no longer exists.
– Floor Trader: Executed orders on their own trading accounts. The
NYSE has created the "Supplemental Liquidity Provider" role, which is
intended to enhance market liquidity by allowing for proprietary
trading.
– Specialist: Responsible for maintaining a continuous, liquid, orderly
market for the securities in which he specializes. The specialist has
been replaced by the Designated Market Maker (DMM).
• Now, under its new structure, one can join the 1366 members by
purchasing a license that permits the member to trade for one year.
Securities Order Routing Process
Access: PC, Phone, Wireless Communication Device, etc.
Order
Confirmation
Brokerage Firm
Confirmation
Exchange
Market Maker
Order Executed
Order Settled
Internalized
ATS/ECN
U.S. Options Exchanges; Data from
January 1, through July 31, 2011
Exchange
ARCA
BATS
BOX
C2
CBOE
ISE
NSDQ
PHLX
Total
Cleared
Total
Avg. Daily % of
Contracts
Premiums Contracts Total Contracts
158,529,881 $36,180,176,001 1,093,310 10.63%
50,286,898 $12,952,402,034 346,806
3.37%
49,788,089
$9,882,629,258 343,366
3.34%
10,400,904
$1,457,446,499
71,730
0.70%
316,112,979 $60,812,186,839 2,180,090 21.20%
259,516,879 $45,392,864,394 1,789,772 17.40%
69,144,416 $16,647,189,711 476,858
4.64%
367,776,704 $121,172,599,631 2,536,391 24.66%
1,491,204,897 $340,633,377,303 10,284,172 100.00%
B. Over the Counter Markets and
Alternative Trading Systems
• The over the counter markets have
traditionally been defined as the non-exchange
markets.
• An alternative trading system (ATS) might be
loosely defined as a securities trading venue
that is not registered with the S.E.C. as an
exchange.
ATS Types
• Electronic Communication Networks (ECNs),
which are virtual meeting places and screen-based
systems for trading securities.
• Dark Pools and "Crossing Networks," where
quotations for share blocks are matched
anonymously. Participants in crossing markets
enjoy reduced transactions costs and anonymity
but often must wait for counterparty orders to
accumulate before transactions can be executed.
• Internalization Crossing
• Voice-Brokered Third-Party Matching.
Sample ATS List
Name
Host
Country
Instruments
Features
Alpha
Canada
Equities
ArcaEdge
Chi-X Europe
U.S.
U.K.
Equities
European Shares
Continuous
trading market
NYSE ATS
Multilateral
Trading Facility
Internal Crossing
Network
Bills itself as the
world's largest
dark pool; Internal
crossing network
Citi Match
U.S.
Crossfinder Global
Equities
Equities
ATS Definition
• Alternative trading system means any organization,
association, person, group of persons, or system:
1. That constitutes, maintains, or provides a market place or
facilities for bringing together purchasers and sellers of
securities or for otherwise performing with respect to securities
the functions commonly performed by a stock exchange within
the meaning of Rule 3b-16 under the Securities Exchange Act of
1934; and
2. That does not:
i. Set rules governing the conduct of subscribers other than the conduct of
such subscribers' trading on such organization, association, person, group
of persons, or system; or
ii. Discipline subscribers other than by exclusion from trading.
• What the ATS does not do is what distinguishes it from an
exchange.
Equity Trading Centers Volume 2009
NYSE
NYSE Arca
Nasdaq
NASDAQ OMX BX
Broker-Dealer (Internalization)
Direct Edge
BATS
Dark Pools
Other Exchanges
Other ECNs
14.7%
13.2%
19.4%
3.3%
17.5%
9.8%
9.5%
7.9%
3.7%
1.0%
Electronic versus Open Outcry
• Bakos et al. [2000, opened a series of accounts at various full-service,
discount and electronic securities brokers.
• Their commissions for 100-share lots averaged $7.50 for electronic
brokers and $47 for full-service voice brokers.
• They found that full-service brokers were more likely to route orders to
the principle exchanges than electronic brokers and that such orders
were more likely to be improved.
• However, for smaller orders, these price improvement advantages are
more than offset by the higher brokerage commissions. Hence,
specialists and market makers on exchanges were able to provide better
order executions while brokers using electronic markets charged
smaller commissions.
• It appeared that smaller investors fared better with discount electronic
brokers while larger transactions resulted in better after-commission
executions on the principle exchanges.
D. Crossing Networks and Upstairs Markets
•
•
•
•
•
•
•
•
•
Slippage, associated with large transactions, occurs when an order forces prices against
the trader.
Crossing networks are alternative trading systems that match buyers and sellers with
agreed-upon quantities.
Crossing networks do not publicly display quotations, thereby enabling participants
anonymity.
Trades are priced by reference to prices obtained from other market. The crossing
network then matches buy and sell orders at prices obtained from more traditional
markets such as the NYSE.
This crossing procedure enables institutional traders to execute without exposing orders
to competitors.
The crossing network, by having prices determined elsewhere, also prevents the price
impact or pressure typically associated with auctions of large blocks of shares.
Because crossing networks do not reveal prices or client identities, and that they
represent non-displayed liquidity, they are sometimes referred to as dark pools of
liquidity.
MidPoint Match and Nasdaq Crossing provide traders with opportunities to match orders
anonymously at known benchmark (e.g., the mid-point of the spread) or closing or other
prices several times a day.
The Securities and Exchange Commission [1998] defines crossing networks as ‘‘systems
that allow participants to enter unpriced orders to buy and sell securities. Orders are
crossed at a specified time at a price derived from another market.’’
Internalization
• Internalization occurs when brokers execute their own client buy orders
against their own client sell orders, representing both sides of a trade and
without routing them to central markets.
• Internalization allows brokers to easily execute transactions at a lower
cost.
• However, internalization
– may inhibit the broker’s ability to properly represent the client as the
client’s agent
– results in fewer transactions being executed in the central market, which
increases market fragmentation and reduces transparency and potential price
competition.
– can lead to reduced liquidity and increased price volatility in the central
market.
– can lead to violations of price and time priority.
– the transaction might be more susceptible to manipulation or may not be
executed at the best possible prices.
• Internalization of customer orders is not possible for options markets
transactions due to exchange rules.
E. Quotation, Inter-market and
Clearing Systems
• Consolidated Tape (CTA): High-speed electronic system maintained
by SIAC for reporting transaction prices and volumes for securities
on all U.S. exchanges and markets.
• Consolidated Quotations System (CQS): Provides traders with price
quotes through SIAC from the various exchanges and FINRA and
calculates the NBBO. The CQS does not time delay as the
Consolidated Tape can during periods of heavy volume.
• Intermarket Trading System (ITS): Displays quotes in different
markets and links markets for trade executions to facilitate investors’
access to the best quotes. This system might be considered to be the
centerpiece of the National Market System.
• Securities Investors Protection Corporation (SIPC): analogous to
FDIC in that it insures investors' account for up to $500,000 in
securities and $100,000 in cash, but only when the investor’s
brokerage firm fails. Thus, this coverage is very limited.
Clearing and Settlement
•
The general clearing process involves two primary tasks: trade comparison (matching
of trades) and settlement (delivery of securities or book entry).
– Clearing refers to activities resulting in the settlement of claims of financial institutions
against other financial institutions.
– The operations department of a financial institution, often referred to as the institution’s back
office, is responsible for handling or overseeing the clearing and settlement processes.
– A clearing firm is authorized by a clearing house to manage trade comparisons and other
back office operations.
– Leading clearing firms include Pershing, LLC, JPMorgan Clearing Corp. and National
Financial Services, LLC.
– A clearing house clears transactions for a market such as the NYSE. A clearing house
facilitates the trade settlement between two clearing firms and seeks to ensure that the
clearing firms honor their trade settlement obligations. The clearing house will typically
guarantee the obligations of its member firms.
– The clearing house steps into a transaction to be settled by its members and assumes the
settlement obligations of both counterparties to the transaction, in effect becoming the
counterparty to both sides of every transaction, a process known as novation. Thus, the
clearinghouse, acting as a central counterparty, acts as the counterparty for each party to
every transaction, and assumes all credit risk.
Clearing
•
•
In the United States, the National Securities Clearing Corporation (NSCC, a
division of the Depository Trust and Clearing Corporation) is the major clearing
agent for equity markets.
Its primary facility for clearing is the Securities Industry Automated Corporation
(SIAC).
Clearing Process
•
Confirmation is the first step of the clearing process.
– Buyers and sellers record trade details.
– Brokers and dealers receive confirmations that the trade has been executed and pass on details
to clients.
– The typical confirmation document received by the client reports the stock's name and CUSIP
number (the security’s 9-character alpha-numeric identifier issued by the Committee on
Uniform Security Identification Procedures), the number of units traded, the security price, the
broker commission and other fees, along with trade and settlement dates.
•
Trade comparison is the second step in the clearing process.
– Comparison matches counterparties in transactions.
– Trades are compared and are said to be cleared when the counterparties’ records are identical.
– Out-trades in futures markets or DK’s (Don’t Knows) in other markets, which are trade reports
with discrepancies.
•
•
Netting is the simplification process used by clearing firms, which is the process of
adding all of an institution’s purchases of each security, adding the sales of each
security, deducting sells from buys to determine the net change in holdings of that
security for the institution and computing the net cash flows associated with all
transactions.
The NSCC uses an automated system through the Securities Industry Automation
Corporation (SIAC) to “net down” or reduce the number of trading obligations that
require financial settlement. At the end of the netting process, the NSCC delivers to
each brokerage firm settlement instructions.
Settlement Details
•
•
Trade settlement occurs when buyers receive securities and sellers receive payment.
The Depository Trust & Clearing Corporation (DTCC), holds stock certificates of
member firms, registering them in member names.
– As of year-end 2006, the DTCC was holding over 5.5 million stock certificates worth over $36
trillion and had processed over 8.5 billion transactions during the year.
– The DTCC settled more than $1.48 quadrillion in securities transactions in 2009, including
equities, fixed income instruments, mutual funds, insurance products, etc.
•
•
•
•
•
•
Equity securities are held in street name, meaning that securities are held in the
names of brokers, who, in turn, maintain their own records of ownership in client
accounts.
Settlement of a trade is completed when the DTCC transfers the ownership of the
shares from the selling firm to the buying firm in its automated book-entry
recordkeeping system and transfers money between firms with net credits and net
debits.
Federal law requires that settlement occur within three days after the transaction.
The DTCC provides clearing services at low cost, averaging approximately
$.0000066 per share.
In the 1960s, clearing involved the physical transfer of paper securities and checks.
The Depository Trust Corporation (DTC) was set up in 1973 to mechanize the
clearing business for the major stock exchanges.
G. Fixed Income Securities and
Money Markets
• Types of debt securities include:
– Bonds
– Notes
– Mortgage-backed instruments
– Treasury instruments
• Many of the fixed income securities with
shorter terms to maturity are considered to be
money market instruments.
U.S. Treasury Securities and Markets
•
•
•
The United States Treasury is the largest issuer of debt securities in the world.
In 2010, the U.S. Treasury (technically, the Fed) auctioned $8.4 trillion in Treasury
instruments.
Treasury issues are fully backed by the full faith and credit of the U.S. government,
which has substantial resources due to its ability to tax citizens, create money and borrow
more. Thus, these securities are generally expected to have the lowest default risk and
should generally be safer than the safest of corporate bonds or short-term notes.
– Treasury Bills typically mature in less than one year (13, 26 or 52 weeks). These issues are sold as
pure discount debt securities, meaning that their purchasers receive no explicit interest payments.
– Strips are issued through the U.S. Treasury’s Separate Trading of Registered Interest and Principle
Securities (STRIPS) program. Strips are portfolios of single payment instruments sold by the Treasury
in blocks with varying maturities.
– Treasury Notes (T-Notes) have maturities ranging from one to ten years and make semi-annual interest
payments.
– Treasury Bonds (T-Bonds) typically range in maturity from ten to thirty years and make semi-annual
interest payments. These T-Bonds are frequently callable, meaning that the Treasury maintains an
option to repurchase them from investors at a stated price.
•
More than half the marketable Treasury debt outstanding as of 2000 was in the form of
notes, while bills and bonds each represented about 20 percent.
Agency Issues
•
•
The U.S. Federal Government sponsors agencies that enable it to make funds available for policy-related
functions.
The Federal National Mortgage Association (FNMA or Fannie Mae)
–
–
–
–
–
–
–
–
•
The Government National Mortgage Association (GNMA or Ginnie Mae)
–
–
–
–
•
Established 1968 as a “spin off” of FNMA, is a corporation owned by the U.S. Federal Government.
GNMA guarantees mortgage-backed securities for the FHA, VA and other agency mortgage issues.
Many mortgages issued by these agencies are targeted towards particular groups such as families in lower-income
brackets or veterans, and experience relatively high default rates.
The mortgages issued by these agencies are full faith and credit instruments.
The Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
–
–
–
•
Created in 1938 to expand the flow of money to housing markets during the Great Depression, spur investment into
real estate, improve employment to help enable people to purchase homes.
Functions of Fannie Mae are to purchase, hold, and sell FHA-insured (and, after World War II, VA Administrationinsured loans) mortgage loans originated by private lenders.
Privatized in 1968, FNMA had shares traded on the New York Stock Exchange and other security holders as well.
FNMA was taken over by the Federal Government during the Financial Crisis of 2008.
The firm received a bail-out package from the Federal Government to support it until 2012.
FNMA facilitates capital acquisition in the mortgage industry through the creation of mortgage-backed securities.
These portfolios of mortgage-backed securities are also called pass- through securities.
FNMA can obtain money directly from the U.S. Treasury should it need to do so.
A stockholder-corporation created in 1970 by the Federal Government, also creates, insures, services and sells passthrough securities related to single family and multi-family residential mortgages.
Freddie Mac’s creation was essentially to provide competition in the secondary mortgage market to the virtual
monopoly enjoyed by Fannie Mae.
Freddie Mac was also placed in conservatorship by the Federal Government during the Financial Crisis of 2008-09.
The Student Loan Marketing Association (SLMA or Sallie Mae) creates, insures and sells pass-through
securities related to student loans.
Municipal Securities and Markets
• U.S. federal taxation code permits investors in municipal
instruments to omit from their taxable income any interest
payments received on most G.O. municipals.
• Several types of municipal issues are offered by state and local
governments.
– General Obligation Bonds are full faith and credit bonds.
– Limited Obligation Bonds provide backing only by specific claims.
• Many municipals are rated for default risk by agencies such as
Fitch.
• Some municipal issues are insured by private insurance
institutions.
– Insurance enables issuers to offer bonds with reduced interest rates.
– Among the larger insurers of municipal bonds are the Ambac
Financial Group, MBIA, the Financial Guaranty Insurance Company
(FGIC) and the Financial Security Assurance, Inc. (FSA).
– Collectively, these insurers are often known as "the Big Four."
Financial Institution Instruments
• Federal Funds markets depository institutions to borrow from one another to
meet Federal Reserve requirements.
– Excess reserves of one bank are loaned to other banks for satisfaction of reserve
requirements.
– The rate at which these loans are extended is referred to as the Federal Funds Rate.
• The Negotiable Certificates of Deposit (a type of Jumbo C.D.) is a tradable
depository institution C.D. with a denomination or balance exceeding $100,000.
• The amounts by which jumbo C.D.s exceed $250,000 are not FDIC insured.
• Negotiable CDs are often purchased by H.N.W. individual investors, financial
institutions, corporate treasuries and by Money Market Mutual Funds, which are
created by banks and investment institutions for the purpose of pooling together
depositor or investor funds.
• Banker's Acceptances are originated when a bank accepts responsibility for
assuming some financial responsibility on behalf of a client. Because the bank is
likely to be a good credit risk, acceptances are usually marketable.
• Repurchase Agreements (Repos) are issued by financial institutions
acknowledging the sale of assets and a subsequent agreement to re-purchase at a
higher price in the near term. This agreement is essentially the same as a
collateralized short-term loan.
Corporate Issues
•
•
•
Corporations are also important issuers of debt securities.
Commercial paper:.issued by large, well-known, credit-worthy firms needing to borrow
for short periods of time
Corporate bonds: normally issued with longer terms to maturity
– Callable bonds may be called, meaning that the issuing institution has the right to pay off the callable
bond before its maturity date. The callable bond typically has a call date and a call price.
– Convertible bonds can be convertible by bondholders into equity or other securities.
– Sinking fund provisions provide additional safety for bondholders by placing money into a fund that
will be accumulated to ensure full satisfaction of the firm’s obligation.
•
•
•
•
•
•
•
The terms of the bond will be specified in a contract known as a bond indenture.
Debentures are not backed by collateral.
Serial bonds are issued in series with staggered maturity dates.
Floating rate bonds have coupon rates that rise and fall with market interest rates; reverse
floaters have coupon rates that move in the opposite direction of market interest rates.
Indexed bonds have coupon rates that are tied to the price level of a particular commodity
like oil or some other value like the inflation rate.
Catastrophe bonds make payments that depend on whether some disaster occurs.
These catastrophe bonds provide a sort of insurance for issuers against the occurrence of
the disaster.
Corporate Bond Markets
• The predecessor to the New York Stock Exchange was
established in 1792 as a venue for trading bonds.
• While over 1000 bonds trade on "NYSE Bonds," the
largest centralized corporate bond market in the U.S.,
the majority of trades for corporate bonds occur in the
over-the-counter markets.
• FINRA TRACE (Trade Reporting and Compliance
Engine) provides corporate bond trading data to the
public as all FINRA member broker/dealers are
required to report OTC corporate bond transactions
data to TRACE.
Credit Ratings and Credit Agencies
•
•
•
•
Corporations pay credit rating agencies such as Standard & Poor’s and Moody’s to rate the
risk of their issues, though a few credit agencies still receive revenues from investorsubscribers.
Other agencies include Fitch, A.M. Best, Duff & Phelps (now, merged into Fitch), EganJones and Dun & Bradstreet.
Bonds without ratings assigned by these agencies are difficult to sell; in fact, many
institutions face restrictions on purchasing unrated or low-rated bonds.
International and federal government regulatory agencies including the SEC and the Fed
sanction these agencies, and constrain or limit banks and other institutions investment in
low-rated instruments.
– Basel II guidelines allow for "External Credit Assessment Institutions" ratings for assessing bank risk.
– The S.E.C. allows investment banks and broker-dealers to use credit ratings from “NRSROs”
– FDIC can prohibit banks from purchasing bonds with ratings below investment grade (BBB or higher).
•
While ratings in the past have been almost universally accepted, there have been problems:
– Many rating agencies are paid by the firms that issue debt instruments, creating potential conflicts of
interest.
– Rating services have provided consulting services to issuing firms, advising them on strategies to
improve their ratings. However, such services have been restricted by Dodd-Frank legislation.
– Credit agencies have been accused of strong-arming clients and potential clients. For example, Moody's
published an "unsolicited" rating of Hannover Re, a German re-insurance firm. It sent a letter indicating
that "it looked forward to the day Hannover would be willing to pay" (Klein [2004]). Hannover
management refused payment. Moody's continued to rate Hannover debt. Moody's cut Hannover ratings
to junk, despite high ratings given by other agencies.
– Agencies are often too slow in responding to dramatic shifts in market conditions and traders are often
much faster at responding to such shifts. For example, Enron bonds were rated triple-A by both major
agencies until only a few days before the company filed for bankruptcy protection.
Standard & Poor’s and Moody’s
Corporate Bond Ratings
Description
Least likely to default
High quality
Medium grade investment quality
Low grade investment quality
High grade speculative quality
Speculative
Lower grade speculative
Highly speculative
Likely bankruptcy
Already in default
Standard & Poor’
AAA
AA
A
BBB
BB
B
CCC
CC
C
D
Moody’s
Aaa
Aa
A
Baa
Ba
B
Caa
Ca
C
D
Eurocurrency Instruments and Markets
•
•
Eurodollars are freely convertible dollar-denominated time deposits outside the United States.
Eurodollar markets began after World War II when practically all currencies other than the U.S.
dollar were perceived as unstable.
–
–
–
–
–
–
•
•
•
•
•
•
•
Most foreign trade between countries was denominated in U.S. dollars
The Soviet Union and Eastern European institutions were concerned that their dollars held in U.S. banks
might be attached by U.S. residents in litigation with these countries
Thus, they dealt not with actual U.S. dollars, but merely denominated their debits and credits with dollars
Monies owed to them were simply offset by monies that they owed.
In a sense, they dealt with "fake" euro-dollars, but since their trading partners did also, and their accounts
tended to "zero out" over time, this did not create significant problems.
During the 1960s and 1970s, these markets thrived due to regulations imposed by the U.S. government such
as Regulation Q (interest ceilings), Regulation M (reserve requirements), the Interest Equalization Tax
imposed beginning in 1963 to tax interest payments on foreign debt sold in the U.S. and restrictions placed on
the use of domestic dollars outside the U.S.
More generally, eurocurrencies are loans or deposits denominated in currencies other than that of the
country where the loan or deposit is created. Roughly 65% of eurocurrency loans are denominated in
dollars.
Eurocredits (e.g., Eurodollar Credits) are bank loans. They are attractive due to very low interest rate
spreads made possible by the large size of the loans and the lack of reserve, FDIC and other
requirements.
Euro-Commercial paper are short-term (less than six months) notes issued by large, credit-worthy
institutions.
Euro-Medium Term Notes (EMTN's), unlike Eurobonds, are usually issued in installments.
Eurobonds are generally underwritten, bearer bonds. Eurobonds often have call and sinking fund
provisions as well as other features found in bonds publicly traded in American markets.
Euro-Medium Term Notes (EMTN's) are interest-bearing instruments usually issued in installments.
It is important to note that eurodollars and eurocurrencies are not euro, the currency used in the EU.
H. Markets around the World
Exchange
1
2
3
4
5
6
7
8
9
10
USD bill.
Year end-2010
NYSE Euronext (US)
13,394
NASDAQ OMX (US)
3,889
Tokyo Stock Exchange Group
3,828
London Stock Exchange Group
3,613
NYSE Euronext (Europe)
2,930
Shanghai Stock Exchange
2,716
Hong Kong Exchanges
2,711
TMX Group (Toronto)
2,170
Bombay SE
1,632
National Stock Exchange India
1,597
Table 6: Major Exchanges of the World
I. Currency Exchange and Markets
• Exchange rates denote the number of units of one
currency that must be given up for one unit of a second
currency.
• Foreign exchange rates are determined by supply and
demand conditions. A variety of factors will affect these
supply and demand conditions, including:
– Governmental policies
– Supply and demand conditions for commodities in the two
countries
– Income levels in the two countries
– Interest rates in the two countries
– The perceived risk of engaging in trade with the two
countries
Cross Rates
• Cross rates refer to the price of a currency in terms of the price
of any other currency.
• The price of the Swiss franc in terms of dollars is given by
Table 7 to be $.80205. The price of a U.S. dollar in terms of
the UK pound is £.5256. These two rates imply that the price
of a Swiss franc in terms of the UK pound is $.80205  £.5256
= .42156.
US $
Ca $
Euro
UK £
Japan ¥
Swiss Fr
US $
1
1.1317
0.7803
0.5256
118.27
1.2468
Ca $
0.88363
1
0.68949
0.46443
104.50649
1.10171
Euro
1.28156
1.45034
1
0.67359
151.56991
1.59785
UK £
1.90259
2.15316
1.48459
1
225.019
2.37215
Japan ¥
0.00846
0.00957
0.0066
0.00444
1
0.01054
Swiss Fr
0.80205
0.90768
0.62584
0.42156
94.85884
1
Exchange Risks
• Rate risk: Exchange rates may change in directions opposite to
those anticipated by participants.
• Credit risk: the other party to the contract may default by not
delivering the currency specified in the contract. In many instances,
an intermediary such as a large reputable commercial bank may act
to ensure that one or both contracting parties will honor their
agreements. Dealer reputation is key.
• Liquidity risk: The market participant may have difficulty obtaining
the currency he must deliver; he may be "stuck" with a currency that
will be difficult to sell. Again, a number of intermediaries may
improve liquidity by trading and making markets for various
currencies.
• Trading system risk: The trading platform, ECN, exchange and other
communication systems are all subject to malfunction or failure.
Currency Trading
• Professional currency traders participate in inter-bank and inter-dealer markets
as well as exchange markets for a variety of types of contracts on currencies.
• The most important currency trading centers are located in:
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–
–
–
London, with about 37% of total volume
New York, 18%
Tokyo, 6%
Frankfurt, Zurich, Hong Kong and Singapore with somewhat less
• Note that the dispersion of markets implies that forex markets operate around the
clock.
• Transactions can be executed between any two counterparties that agree to trade
via the telephone or electronic network or trade through an exchange. To a large
extent, currency trading is decentralized.
• Dealers can post or advertise their exchange rates bids and offers using an
information or distribution network, such as Reuters and ICAP.
• Many OTC trades proceed through a three-step process similar to the following:
– A trader communicates by phone or electronically the currency pair and the amount
he would like to trade with a given counterpart in trade.
– The counterparty responds with both a bid and an ask quotation.
– The trader responds to the bid and ask quotations by either buying, selling or passing
on both.
– The transaction is executed if the trader agrees to buy or sell.