II. FINANCAL MARKETS, TRADING PROCESSES AND INSTRUMENTS.

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 self-regulatory 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, IncorporatedChicago Board Options Exchange, IncorporatedChicago Stock Exchange, Inc.EDGA Exchange, Inc.EDGX Exchange, Inc.International Securities Exchange, LLCThe Nasdaq Stock Market LLCNational Stock Exchange, Inc.New York Stock Exchange LLCNYSE Arca, Inc.NASDAQ OMX PHLX, Inc. (formerly Philadelphia Stock Exchange)

Futures and Partially Exempt Exchanges

U.S. Futures ExchangesBoard of Trade of the City of Chicago, Inc.CBOE Futures Exchange, LLCChicago Mercantile ExchangeOne Chicago, LLCThe Island Futures Exchange, LLCNQLX LLC

Partially Exempt ExchangesArizona Stock ExchangeSWX 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 Internalized Market Maker ATS/ECN Order Executed Order Settled

U.S. Options Exchanges; Data from January 1, through July 31, 2011

Cleared Total Avg. Daily % of

Exchange Contracts Premiums Contracts Total ContractsARCA 158,529,881 $36,180,176,001 1,093,310 10.63%BATS 50,286,898 $12,952,402,034 346,806 3.37%BOX 49,788,089 $9,882,629,258 343,366 3.34%C2 10,400,904 $1,457,446,499 71,730 0.70%CBOE 316,112,979 $60,812,186,839 2,180,090 21.20%ISE 259,516,879 $45,392,864,394 1,789,772 17.40%NSDQ 69,144,416 $16,647,189,711 476,858 4.64%PHLX 367,776,704 $121,172,599,631 2,536,391 24.66%Total 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 Host

Name Country Instruments FeaturesAlpha Canada Equities Continuous

trading marketArcaEdge U.S. Equities NYSE ATSChi-X Europe U.K. European Shares Multilateral

Trading FacilityCiti Match U.S. Equities Internal Crossing

NetworkCrossfinder Global Equities Bills itself as the

world's largest dark pool; Internal

crossing network

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 14.7%NYSE Arca 13.2%Nasdaq 19.4%NASDAQ OMX BX 3.3%Broker-Dealer (Internalization) 17.5%Direct Edge 9.8%BATS 9.5%Dark Pools 7.9%Other Exchanges 3.7%Other ECNs 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)

– 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 Administration-insured 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.

• 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)– A stockholder-corporation created in 1970 by the Federal Government, also creates, insures, services and sells pass-

through 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 investor-subscribers.

• Other agencies include Fitch, A.M. Best, Duff & Phelps (now, merged into Fitch), Egan-Jones 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 Standard & Poor’ Moody’s

Least likely to default AAA AaaHigh quality AA AaMedium grade investment quality A ALow grade investment quality BBBBaaHigh grade speculative quality BB BaSpeculative B BLower grade speculative CCC CaaHighly speculative CC CaLikely bankruptcy C CAlready in default D 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 USD bill.

Year end-20101 NYSE Euronext (US) 13,3942 NASDAQ OMX (US) 3,8893 Tokyo Stock Exchange Group 3,8284 London Stock Exchange Group 3,6135 NYSE Euronext (Europe) 2,9306 Shanghai Stock Exchange 2,7167 Hong Kong Exchanges 2,7118 TMX Group (Toronto) 2,1709 Bombay SE 1,63210 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:

– 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.