FX Summary for Finance and IT
This is a short summary paper on the FX market.
What is Foreign Exchange
Foreign Exchange (also known as FX, Forex) is the
simultaneous buying of one currency and selling of another. FX is the
largest trading market in the world with a turnover estimated at $1.9
trillion daily by the Bank for International Settlements.
What Instruments Make Up The FX Market ?
FX market consists of the following products:
FX Cash Products (traded OTC):
FX Listed Derivative Products (traded on exchanges):
is a true 24-hour market with trading beginning on a Sunday 10pm in Sydney and moving around the globe as the business day
begins in each financial centre first to Tokyo, London, and New
York. London is
the world’s predominant FX centre followed by New York.
In common with
most asset classes, FX is being brought into the worlds of electronic and
multi-asset trading platforms. Most
FX trading is conducted OTC in the inter-bank market via telephone or
What Are The Main Currencies Traded ?
Currencies are never traded in
isolation but always as a “cross” between pairs of currencies
(aka a currency pair). The four major currency pairs traded are:
Euro-US Dollar pair
US Dollar-Japanese Yen pair
British Pound-US Dollar pair aka Cable
Dollar-Swiss Franc pair
Note that the order i.e. USDYEN is a
market convention it does not imply that you are trading dollar’s for
yen’s or vice-versa. The dollar-yen exchange rate is expressed in yen
per dollar. Hence, an increase in this rate indicates an increase in the
value of the dollar versus the yen. In contrast, the euro-dollar exchange
rate is expressed in dollars per euro. Thus an increase in this rate
indicates a decline in the value of the dollar versus the euro.
Trading Spot Currency
A trader always buys or sells a fixed
amount of the base currency (aka quoted, underlying
or fixed currency), and adjusts the
amount of the terms currency (aka counter currency) as the rate changes. The
terms currency is the numerator and the base currency is the denominator.
When the numerator increases, the base currency is strengthening and
becoming more expensive; when the numerator decreases, the base currency is
weakening and becoming cheaper.
base currency is always quoted first. E.g. USDYEN means the dollar is the
base and the denominator and the yen is the terms currency and the
numerator. GBPUSD means that sterling is the base currency and dollars is
the terms currency.
stated earlier, traders always buy or or sells a fixed amount of the base
The price or rate quoted is the
amount of the terms currency required to purchase one unit of the base
currency. For example: if EUR/USD has an ask price of 1.2178, then you can
buy one Euro for 1.2178 dollars. A
EUR/USD bid-ask spread of 1.2170/1.2178 means that you can sell one Euro
for $1.2170 and buy one Euro for $1.2178.
most currencies, bid-ask quotes are to 4 decimal places of the term
currencies units. Each .0001
movement in the price is called a pip.
The Japanese yen and the Italian lire are quoted to 2 decimal places and a
pip is for each .01 movement in the price. A pip
is the terminology used in the FX markets. Other markets use the term tick.
Spot Transactions are single transactions that involve the exchange
of two currencies at a rate agreed to on the date of the contract for value
or delivery within two business days (U.S. dollar-Canadian dollar
transactions delivered within one day).
Outright Forwards involving the exchange of two currencies at a
rate agreed to on the date of the contract for value or delivery at some
time in the future (more than one business day for USD-CAD transactions or
more than two business days for all other transactions). This category also
includes forward foreign exchange agreement transactions (FXA),
non-deliverable forwards (NDFs), and other forward contracts for
differences. The agreed upon maturity can range from a few days to month or
even (less common) a few years. The forward rate for any two currencies is
a function of their spot rate and the interest rate differential between
Foreign Exchange Swaps involve the exchange of two currencies on
a specific date at a rate agreed to at the time of the conclusion of the
contract, and a reverse exchange of the same two currencies at a date
further in the future at a rate agreed to at the time of the contract. For
measurement purposes, only the long leg of the swap is reported so that
each transaction is recorded only once. If both value dates are less than a
month from the trade-date than it is called a short-dated swap else if one
or both legs are one month or more from the trade-date it is called a
forward swap. There is no stream of payments.
In a typical currency swap, counterparties will:
Exchange equal initial
principle amounts of 2 currencies at the spot exchange rate.
Exchange a stream of
fixed or floating interest rate payments in their swapped currencies for the
agreed period of the swap.
principle amount at maturity at the initial spot rate.
Variations include not exchanging the
initial principle and netting interest rate payments so that only one
counterparty makes net a payment.
come in various forms. One variant is the fixed-for-fixed
currency swap, in which the interest rates on the periodic interest
payments of the two currencies are fixed at the outset for the life of the
swap. Another variant is the fixed-for-floating
swap, also called cross-currency swap,
or currency coupon swap, in which
the interest rate in one currency is floating (e.g. based on LIBOR) and the
interest rate in the other is fixed. It is also possible to arrange floating-for floating currency swaps, in which
both interest rates are floating.
Currency Options are contracts that give the right or the
obligation to buy or sell a currency with another currency at a specified
exchange rate during a specified time period or on a specified date. This
category also includes exotic foreign exchange options such as average rate
options and barrier options. An OTC currency option is a bilateral contract
between two parties. An exchange traded currency option is a contract
between each party and a clearing house that guarantees delivery. In
addition, OTC options can be tailored to meet requirements whilst an
exchange traded contract is standardized. Around 80% of all currency
options are traded OTC.
Currency Futures are contracts that give the obligation to buy or
sell a currency with another currency at a
specified exchange rate during a specified time period or on a specified
date. When entering into a foreign exchange futures
contract, no one is actually buying or selling anything—the
participants are agreeing to buy or sell currencies on pre-agreed
terms at a specified future date if the contract is allowed to reach
maturity, which it rarely does. The actual counter-party is the clearing
house which guarantees contract execution.
Jack Welch: "Shun
the incremental and go for the leap"