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FX Summary for Finance and IT Professionals

Manoj Kochhar

 

Objective:

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 ?

 

The FX market consists of the following products:

 

FX Cash Products (traded OTC):

  • Spot FX
  • Outright Forwards
  • FX Swaps
  • Currency Swaps
  • Currency Options

 

FX Listed Derivative Products (traded on exchanges):

  • Currency Options
  • Currency Futures

 

 

 

FX Markets

 

FX 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 electronically.

 

 

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:

 

 

Symbols

Description

EURUSD

Euro-US Dollar pair

USDYEN

US Dollar-Japanese Yen pair

GBPUSD

British Pound-US Dollar pair aka Cable

USDCHF

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.

 

The 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.

 

As stated earlier, traders always buy or or sells a fixed amount of the base currency.

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.

 

For 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.

 

 

 

Instrument Details

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 them.

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.

 

Currency Swaps

In a typical currency swap, counterparties will:

a.      Exchange equal initial principle amounts of 2 currencies at the spot exchange rate.

b.      Exchange a stream of fixed or floating interest rate payments in their swapped currencies for the agreed period of the swap.

c.      Re-exchange the 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.

Currency swaps 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"



Copyright Manoj Kochhar, all rights reserved