International Finance
Iriszz
6.ForeignExchangeMarket.pptxForeign Exchange Market
International Finance
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Learning Objectives
Examine the structure of and functions performed by the foreign exchange market
Who are the participants? what is the size? what is the geography? and which currencies dominate?
Distinguish among the traditional FX market instruments: spot, forward, and foreign exchange swap transactions
Understand and apply the currency quotation methodology used by currency dealers and financial institutions
Analyze cross exchange rates and identify opportunities for inter-market arbitrage
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Structure of the Foreign Exchange Market
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Foreign Exchange
Foreign exchange means the money of a foreign country and includes:
Currency (only 5% of US dollars are in currency)
Foreign currency bank balances
Checks
Bank drafts*
Banknotes**
Foreign exchange is often abbreviated FX or Forex
A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some fixed amount of other currency at a specified date
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*A bank draft is traditionally a check drawn on a bank’s funds, AKA a cashier’s check
**In most countries of the world the issue of banknotes is handled exclusively by a single central bank or government, but in the United Kingdom seven retail banks have the right to print their own banknotes in addition to the Bank of England. The arrangements in the UK are unusual, but comparable systems are used in Hong Kong and Macao, where three and two banks respectively issue their own banknotes in addition to their respective governments
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ISO 4217
Although there are special symbols for some currencies, sometimes it is difficult to use them in e-mail, news postings or on web pages
The solution, long used by the international banking community, is the International Organization for Standardization (ISO) 4217 set of currency abbreviations
ISO 4217 (Codes for the Representation of Currencies and Funds) defines three-letter abbreviations for each world currency
The general principle used to construct these abbreviations is to take the two-letter abbreviations defined in ISO 3166 (Codes for the Representation of Names of Countries) and append the first letter of the currency name (USD for the United States Dollar)
In the case of currencies defined by supra-national entities, ISO 4217 sometimes assigns two-letter entity codes starting with "X" to use in place of country codes (XCD for the Central Caribbean Dollar)
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| Country | Currency | ISO Code | Country | Currency | ISO Code | |
| Argentina | Peso | ARS | Pakistan | Rupee | PKR | |
| Australia | Dollar | AUD | Poland | Zloty | PLZ | |
| Brazil | Real | BRL | Russia | Ruble | RUB | |
| Canada | Dollar | CAD | Saudia Arabia | Riyal | SAR | |
| China | Yuan | CNY | Singapore | Dollar | SGD | |
| Czech Rep. | Koruna | CZK | S. Korea | Won | KRW | |
| Denmark | Krone | DKK | S. Africa | Rand | ZAR | |
| Eur. Union | Euro | EUR | Sweden | Krona | SEK | |
| Hong Kong | Dollar | HKD | Switzerland | Franc | CHF | |
| Hungary | Forint | HUF | Taiwan | Dollar | TWD | |
| India | Rupee | INR | Thailand | Baht | THB | |
| Indonesia | Rupiah | IDR | Turkey | Lira | TRL | |
| Israel | Sheckel | ILS | Un. Arab Emirates | Dirham | AED | |
| Japan | Yen | JPY | United Kingdom | Pound | GBP | |
| Malaysia | Ringgit | MYR | United States | Dollar | USD | |
| Mexico | Nuevo Peso | MXN | Uruguay | Peso | UYU | |
| New Zealand | Dollar | NZD | Venezuela | Bolivar | VEF | |
| Norway | Krone | NOK | Vietnam | Dong | VND |
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Functions of the Foreign Exchange Market
The foreign exchange market provides: the institutional structure through which the money of one country is exchanged for that of another country
The determination of rates of exchange between currencies
Settlement of foreign exchange transactions
The ultimate economic purpose of the foreign exchange markets is to:
Permit the transfer of purchasing power denominated in one currency into another currency and thereby facilitate transactions
Provide credit for international trade transactions
Minimize exposure to the risks of exchange rate changes
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Time, Geography, & Major Currencies
The foreign exchange market spans the globe with prices moving and currencies trading somewhere every hour of every business day
As the next exhibits will illustrate
The ebbs and flows of currency transaction volume around the globe as the major currency trading centers open and close throughout the day
The concentration of trading volume in various financial centers
The relative importance of various currencies in the FX market
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Currency transaction volume ebbs and flows around the globe as the major currency trading centers open and close throughout the business day
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The foreign exchange market is dispersed around the globe but concentrated among a few leading financial centers
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Source: BIS Triennial Central Bank Survey December 2010
37%
18%
6%
5%
5%
5%
4%
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And concentrated in few major currencies
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Source: BIS Triennial Central Bank Survey December 2010
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The next slide shows that in 2016, there is a further significant rise in the global importance of several emerging market currencies
The renminbi became the most actively traded emerging market currency, overtaking the Mexican peso to become the world’s eighth most actively traded currency
The average daily turnover of renminbi almost doubled from $120 billion to $202 billion between April 2013 and April 2016
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A very few number of currency pairs involving the dollar and some other currency or the euro and another (non-dollar) currency comprise over 80% of all FX transactions!
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Source: Preliminary BIS Triennial Central Bank Survey September 2013
http://www.bis.org/publ/rpfxf13fxt.pdf
Year end 2013:
| Currency Pair | Percent of Market |
| USD/EUR | 24.10% |
| USD/JPY | 18.30% |
| USD/GBP | 8.80% |
| USD/AUD | 6.80% |
| USD/CAD | 3.70% |
| USD/CHF | 3.40% |
| USD/MXN | 2.40% |
| USD/CNY | 2.10% |
| USD/NZD | 1.50% |
| USD/RUB | 1.50% |
| USD/HKD | 1.30% |
| USD/SGD | 1.20% |
| EUR/JPY | 2.80% |
| EUR/GBP | 1.90% |
| EUR/CHF | 1.30% |
| Total | 81.10% |
| Currency Pair | Percent of Market |
| EUR/JPY | 2.80% |
| EUR/GBP | 1.90% |
| EUR/CHF | 1.30% |
| Total | 81.10% |
http://www.bis.org/publ/rpfx16.htm
April 2016:
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Some exchange rate pairs are given cute nicknames:
GBP/USD “Cable”
Some currencies are also give nicknames:
CHF “Swissi”
SEK “Stocki”
AUD “Aussi” or “Ozzy”
NZD “Kiwi”
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Market Size
In April 2016, the survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in foreign exchange market activity to be about $5 trillion
Based on dollar turnover, it is the largest market in the world!
Share trading in equities worldwide rose 41% to USD 114 trillion in 2015
However, annual trading in currencies is approx. $1,300 trillion (=52x5x5)
There are nearly 1,200 trading banks and as many as 10,000 traders
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The growth in the FX market has been robust!
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35% Growth
| Global OTC foreign exchange turnover | ||||||||
| Net-net basis,1 daily averages in April, in billions of US dollars | ||||||||
| Instrument | 2001 | 2004 | 2007 | 2010 | 2013 | 2016 | ||
| Foreign exchange instruments | 1,239 | 1,934 | 3,324 | 3,971 | 5,355 | 5,088 | ||
| Spot transactions | 386 | 631 | 1,005 | 1,488 | 2,046 | 1,654 | ||
| Outright forwards | 130 | 209 | 362 | 475 | 679 | 700 | ||
| Foreign exchange swaps | 656 | 954 | 1,714 | 1,759 | 2,239 | 2,383 | ||
| Currency swaps | 7 | 21 | 31 | 43 | 54 | 96 | ||
| Options and other products² | 60 | 119 | 212 | 207 | 337 | 254 | ||
| At April 2016 exchange rates | 1,381 | 1,884 | 3,123 | 3,665 | 4,915 | 5,088 |
http://www.bis.org/publ/rpfx16.htm
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Structure of the Market
The foreign exchange market is not a physical place—it is a decentralized, electronically/telephonically linked network of banks, foreign exchange dealers, and brokers
It is an over-the-counter market
This network brings together buyers and sellers of foreign exchange around the globe
The foreign exchange market consists of two tiers:
The Interbank or wholesale market (multiples of $US 1M or equivalent in transaction size)
The client or retail market (specific, smaller amounts)
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Market Participants
Five broad categories of participants operate within these two tiers:
Banks and nonbank foreign exchange dealers
Foreign exchange brokers
Firms and individuals
Speculators and arbitrageurs
Central banks and treasuries
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Bank and Nonbank Foreign Exchange Dealers
Banks and a few nonbank foreign exchange dealers operate in the Interbank market
About 20 major banks dominate this market
Approximately 80% of foreign exchange transactions are channeled through the worldwide interbank market (Bekaert and Hodrick)
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The vast majority of transactions in the Interbank market involve only 20 banks and non-bank dealers!
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Source: Bekaert and Hodrick, International Financial Management, Pearson Education Inc., 2012
| Rank | Bank/Dealer | Percent Market |
| 1 | Deutsche Bank | 18.06% |
| 2 | UBS | 11.30% |
| 3 | Barclays | 11.08% |
| 4 | Citigroup | 7.69% |
| 5 | Royal Bank of Scotland | 6.50% |
| 6 | JPMorgan Chase | 6.35% |
| 7 | HSBC | 4.55% |
| 8 | Credit Suisse | 4.44% |
| 9 | Goldman Sachs | 4.28% |
| 10 | Morgan Stanley | 2.91% |
| 11 | BNP Paribas | 2.89% |
| 12 | Bank of America | 2.27% |
| 13 | Société Générale | 2.06% |
| 14 | Commerzbank | 1.46% |
| 15 | Standard Chartered | 1.25% |
| 16 | State Street | 1.11% |
| 17 | Calyon | 0.81% |
| 18 | Nomura | 0.80% |
| 19 | SE Banken | 0.74% |
| 20 | Royal Bank of Canada | 0.71% |
| Total | 91.26% |
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| Largest Currency Dealers | |||
| Citigroup | 1 | 16.10% | |
| Deutsche Bank | 2 | 14.50% | |
| Barclays | 3 | 8.10% | |
| JPMorgan | 4 | 7.70% | |
| UBS | 5 | 7.30% | |
| Bank of America/Merrill Lynch | 6 | 6.20% | |
| HSBC | 7 | 5.40% | |
| 65.30% | |||
| Source: http://www.reuters.com/article/2015/05/27/uk-banks-forex-trading-idUKKBN0OC0P520150527 |
Dealers & the foreign exchange departments of large international banks function as market makers
Market makers stand willing at all times to buy and sell those currencies in which they specialize
They maintain an “inventory” position in those currencies
Dealers make money through differences in bid and ask rates (more below on this)
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Foreign Exchange Brokers
Recall the foreign exchange market is highly decentralized
Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction
It is a brokers business to know at any moment exactly which dealers want to buy or sell any currency.
Foreign exchange brokers act as experts in matching net supplier with net demander banks of the interbank market
For this service, they charge a commission
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Banks/Dealers use brokers:
For their speed. Brokers canvass the market looking for the best prices for their buyers and sellers reducing the economic search costs
Ability to negotiate several small trades with multiple dealers at more favorable exchange rates as compared to rates available for one large trade, and
Because they want to remain anonymous since the identity of the participants may influence short term quotes
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Firms and Individuals
Firms (such as importers, exporters and MNEs) and individuals (such as tourists) conduct commercial and investment transactions in the foreign exchange market
Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose
These participants also use the market to “hedge” foreign exchange risk that results from their use of the foreign exchange market
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First National
of Peoria
Texaco
Chevron
Fidelity
Broker
Chase
Deutche
Bank
Barclays
Citibank
General
Mills
General
Electric
First National
of Des Moines
Interbank Market
Retail Market
Individuals
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Speculators and Arbitrageurs
Speculators and arbitrageurs seek to profit from trading in the market itself, not from conducting trade or other forms of business
They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market
Speculators seek to profit from their view of exchange rate changes—bear risk!
Arbitrageurs seek to profit from simultaneous exchange rate differences in different markets—engage in riskless transactions
Spatial arbitrage occurs between segments of the foreign exchange market that are physically separated
Purchasing € in Frankfurt at 0.66 £/€ and selling € in London at 0.67 £/€
Arbitrage between the interbank forward market and the foreign exchange futures market
Triangular arbitrage in cross-rates (we’ll discuss this later)
Covered interest arbitrage (we did this)
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Central Banks and Treasuries
Central banks and treasuries may use the market to acquire or spend their country’s foreign exchange reserves to influence the price at which their own currency is traded
May support the value of their own currency because of
Policies adopted at the national level
Commitments entered into through membership in international agreements (such as the European Monetary System in the 1980s and 1990s)
Their motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will ultimately benefit their country’s citizens and businesses
As willing loss takers, central banks and treasuries differ in motive from all other market participants
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Who’s Trading?
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Innovations: Electronic Brokering Systems
Until 1992, a dealer at one bank had two ways to execute a spot transaction:
Direct dealing: a direct telephone call or telex to another dealer
Brokered dealing: a telephone call to a foreign exchange broker
In 1992 and 1993, electronic brokering systems emerged
Permit dealers to enter their live prices anonymously in the system for broadcast
Complete transactions with confirmations
By 1998, automated brokerage systems captured 75% of the brokered transactions
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The interbank FX community have two major electronic brokering systems
http://www.ebs.com/platforms/ebs-market.aspx
http://thomsonreuters.com/en/products-services/financial/hedge-funds/matching.html
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Electronic Brokering Systems
Thomson Reuters Matching
EBS Market (operated by ICAP)
Users
Banks
Process
System posts multiple quotes from dealers/ banks
Anonymous
Dealers
Innovations: Electronic Trading Systems “eFX”
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http://www.fxconnect.com/total_fx_trading.htm
eFX is also available to corporate treasurers, asset managers, hedge funds,……
Types of electronic trading systems
Single bank systems
Autobahn from Deutsche Bank
FXConnect from State Street Bank (initially)
Multi-bank/Independent systems
FXConnect from State Street Bank (now)
FXall
HotSpot
Currenex
Customers
Corporations
Institutional investors
Hedge funds
Retail aggregators such as Oanda
Process
System posts multiple quotes from dealers/ banks
Provides an ECN that displays prices and matches buy and sell orders electronically
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Source: BIS Triennial Central Bank Survey December 2010
16%
10% Other Electronic/ Dark Pools
11%
11%
51%
14%
Source: Bank of Canada Triennial Survey April 2016
38%
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http://www.fxall.com/about/our-vision-and-values
http://www.fxconnect.com/total_fx_trading.htm
Interdealer
Dealer-to-client
http://www.e-forex.net/Files/surveyreportsPDFs/Celent%20FX%20report.pdf
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Euromoney FX Survey 2015
In the press
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Foreign Exchange Dark Pools Gain Traction with KCG Hotspot Introducing Hotspot QT
HotSpot QT will bring in a non-displayed crossing venue or dark pool, assisting banking and non-banking institutions to trade large spot FX orders without exposing their books and causing big market moves.
Dark pools have been particularly attractive for banks, which have a large book of orders and aim to conceal their full exposure from other market participants. On a regular trading venue such as EBS or Thomson Reuters, the books are available for every counterpart to see, which makes it difficult to conceal one’s trading intentions
There are several banks which are running their own foreign exchange dark pools, like Deutsche Bank, UBS and Credit Suisse. Thomson Reuters owner of FXall is also running its own venture, while one of the biggest dark venues in the forex industry is owned by inter-dealer broker BGC Capital, which is wholly owned by BGC Partners Inc
In the press
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How Are Domestic Transactions Settled?
Settlement is the transfer of funds between the payer's financial institution and the payee's financial institution
Within a country, interbank payment systems settle transactions
A transfer of dollars is executed through CHIPS or Fedwire in the US
Financial institutions using Fedwire or CHIPS must operate a US branch or office for the use of the system
The Fedwire and CHIPS handle both the transmission transfer instructions and the settlement of the payments
A transfer of euros is done through TARGET2
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How Are International Transactions Settled?
Traditionally, the interbank market is a network of correspondent banking relationships
That is, large commercial banks maintain demand deposit accounts with one another
These accounts are called correspondent bank accounts
Society of Worldwide Interbank Financial Telecommunications (SWIFT) provides messaging services for a large number of international transactions
Typically, banks outside of the US communicate with their correspondent banks via SWIFT
SWIFT links more than 9,000 financial institutions in more than 200 countries
In practice, SWIFT is the primary method for international funds transfer messages
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Example: Payer’s and payee’s banks have a direct correspondent relationship:
A Miami restaurateur agrees to purchase wine from a French vineyard
The transaction is invoiced in euros for EUR 10,000
How can the restauranteur “wire” a payment?
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The Miami restaurateur contacts his bank, US Bank, which offers an exchange rate of USD1.20/EUR
US Bank debits the restaurateur’s account for USD 12,000 (= EUR 10,000 X USD1.20/EUR
US Bank instructs its correspondent bank in France, French Bank, via SWIFT, to debit its correspondent bank account EUR 10,000 and to credit the French vineyard’s bank account
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US Bank
French Bank
Instructions
SWIFT
| French Bank | |
| Assets | Liabilities & Equity |
| Account of US Bank – €10,000 | |
| Account of French Vineyard + €10,000 |
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This payment is achieved through accounting entries, a “book transfer”
Example (continued): If the US restauranteur’s bank and the French vineyard’s bank do not have a correspondent banking relationship, intermediary banks and their domestic payment systems are used
In the US, Fedwire or CHIPS transfers US dollars to/from a US intermediary with the required corresponding banking relationship
In the Eurozone, Target2 transfers euros from/to a Eurozone intermediary with the required correspondent banking relationship
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https://www.frbservices.org/files/eventseducation/pdf/international_wire_quick_ref.pdf
https://www.federalreserve.gov/paymentsystems/fedfunds_about.htm
What if the parties’ banks do not have a correspondent banking relationship?
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US Bank
French Bank
Bordeaux Bank
Euros
TARGET2
Instructions
SWIFT
Ocean Bank
USD
Fedwire
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Money doesn’t cross borders. There is no international wire—just a series of domestic transactions
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Innovations: Multilateral Netting & Payment vs. Payment
With bilateral netting, two banks agree that all trades between them on a given day will be netted against each other so that only the smaller netted amount in each currency needs to be settled
Until the early 1990s, the hundreds of thousands of daily transactions were settled through bilateral netting (or no netting—transaction by transaction)
With 1,000 trading banks there would be nearly 500,000 pairs of banks
And don’t forget multiple currencies (and multiple transactions per day for no netting)!
High transactions costs
With multilateral netting, several banks agree to settle their trades on a given day through a clearinghouse that nets all the trades among all the banks
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Example:
Goldman Sachs owes Morgan Stanley $100M
Morgan Stanley owes Goldman Sachs $60M
State Street owes Goldman Sachs $60M
Morgan Stanley owes State Street $40M
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Goldman
Morgan Stanley
State Street
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100
40
60
Total flows: 60 + 40 + 100 + 60 = 260 M
No Netting
Goldman
Morgan Stanley
State Street
100-60=40
40
60
Total flows: 60 + 40 + 40 = 140 M
Bilateral Netting
State Street
Goldman
Clearinghouse
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Total flows: 20 + 20 = 40 M
Multilateral Netting
Multilateral netting systems allow banks to clear against a central clearinghouse
The predominant clearing house is CLS Bank: 50 percent of foreign exchange trades are now settled through CLS Bank on a multilaterally netted basis
CLS went live in September 2002
Now trades 18 currencies (Settles payment instructions relating to transactions executed in the following instruments: FX spot, FX forward, FX swap, non-deliverable forwards and OTC credit derivatives )
1.5M transactions per day
Parties submit their transactions by SWIFT no later than 12 midnight (Central European Time) of the day of the transaction
The Federal Reserve Bank of New York supervises and regulates the CLS Bank
Nevertheless, over 30 percent of FX transactions still use the classic correspondent banking model (Bekaert and Hodrick)
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CLS Bank substantially reduces transaction costs because of multilateral netting
Only the balances of the netted claims and liabilities, that is, participants’ respective net positions, are transferred via the system (net funding)
For each $1T of value to settle, only $50B has to be transferred after netting!
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In addition, CLS Bank substantially reduces settlement risk (AKA Herstatt risk*)
CLS Bank simultaneously settles the payment obligations ("legs") in both currencies—on a net basis
This “payment-versus-payment” settlement model settles one payment leg of an FX transaction if and only if the corresponding payment leg in the other currency is also settled
CLS settles transactions during a common 5-hour window when the settlement systems in all currencies are open
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* What’s Herstatt risk? http://www.nasdaq.com/investing/glossary/h/herstatt-risk
http://www.nytimes.com/1983/09/01/business/2-in-herstatt-case-jailed.html
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Optional:
Specifically, after multilateral netting, members with net short (sell) positions in a currency first make a payment to CLS
Conditionally on receipt of payment from the net short parties, CLS then makes payment to members with net long (buy) positions in a currency
A ‘pay-in-failure’ occurs when, for any reason, a member fails to meet its obligations to pay, in which case CLS can return payments received
CLS reduces this liquidity risk, however, through committed standby lines of credit with major banks in each of the currencies it settles,
In case of a pay-in-failure, the transaction can nevertheless be completed (within limits)
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http://www.cls-group.com/PRODSERV/SETTLEMENT/Pages/How.aspx
http://www.bis.org/publ/qtrpdf/r_qt0809y.htm
http://www.wallstreetsystems.com/documents/CLS_and_Bilateral_Netting.pdf
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Types of Foreign Exchange Transactions
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Spot Transactions
A Spot transaction in the Interbank market is the purchase of foreign exchange with delivery and payment between banks to take place, normally, on the following second business day
The date on which the transaction is agreed to is called the dealing date
The date of settlement is referred to as the value date or settlement date
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Forwards
An Outright Forward transaction (or, more simply, Forward) requires delivery at a future date of a specified amount of one currency for a specified amount of another currency
The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity
Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced)
The date of settlement is referred to as the forward value date or the forward settlement date
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Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months
The further in future the forward settlement date, the less liquid the market and the greater the bid-ask spread (more on this later)
For example, for 90-day forward contracts the bid-ask spread is typically 15% larger than the spot market spread
Only 2.5 percent of forwards mature more than 1 year in the future
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FX Swaps
A Foreign Currency (FX) Swap transaction in the Interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different settlement dates.
Both purchase and sale are conducted with the same counterparty
Some different types of swaps are:
Spot against forward: buy/sell currency in the spot market and simultaneously sell/buy the same amount to/from the same dealer in the forward market
Forward-forward: buy/sell forward at t1 and simultaneously sell/buy forward at t2
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Why use an FX swap?
A firm may have FX receivables collected before FX payables are due and may wish to make use of the funds in domestic currency
To borrow FX short term without exposure to exchange rate risk (by a corporate treasurer or portfolio manager)
A treasurer might want to borrow dollars in the commercial paper market for 90 days but have an attractively low interest rate available in euros
The treasurer could borrow euros and then immediately sell those euros in exchange for dollars using an FX swap
Then in 90 days, the treasurer would pay the dollars back in exchange for euros in the FX swap and, then in turn, use the euros to pay off the euro borrowing
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To allow a financial institution to manage its exchange rate risk at various maturities:
Suppose that a bank has a net long position (net inflow) of euros in 90 days and a net short position (net outflow) in 180 days in the euro
The bank could hedge this position through a swap by selling euros at 90 days and buying euros at 180 days (a forward-forward swap)
Covered interest arbitrage (we did this!)
To speculate on near-term changes in interest rate differentials between currencies
As interest rate differentials change, the rate of exchange on the forward leg of the swap changes
For example, a buy-then-sell position might be reversed by a sell-then-buy position but at a lower rate of exchange on the forward leg of the second transaction
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Example: Bridgewater Associates (world’s largest hedge fund firm in 2011) enters into a swap with a dealer and buys spot EUR 1,000,000 and sells 12 month forward
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Dealer
Bridgewater
EUR 1,000,000
USD 1,155,000
Now
12 months
USD 1,143,800
EUR 1,000,000
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Discussion: Why is Bridgewater willing to accept USD 11,200 less for EUR 1,000,000 in 12 months than it paid for them spot?
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Relative Size of Foreign Exchange Transactions
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| Global OTC foreign exchange turnover | |||||||||
| Net-net basis,1 daily averages in April, in billions of US dollars | |||||||||
| Instrument | 2001 | 2004 | 2007 | 2010 | 2013 | 2016 | |||
| Foreign exchange instruments | 1,239 | 1,934 | 3,324 | 3,971 | 5,355 | 5,088 | |||
| Spot transactions | 386 | 631 | 1,005 | 1,488 | 2,046 | 1,654 | |||
| Outright forwards | 130 | 209 | 362 | 475 | 679 | 700 | |||
| Foreign exchange swaps | 656 | 954 | 1,714 | 1,759 | 2,239 | 2,383 | |||
| Currency swaps | 7 | 21 | 31 | 43 | 54 | 96 | |||
| Options and other products² | 60 | 119 | 212 | 207 | 337 | 254 | |||
| Memo: | |||||||||
| Turnover at April 2016 exchange rates3 | 1,381 | 1,884 | 3,123 | 3,665 | 4,915 | 5,088 | |||
| Exchange-traded derivatives4 | 12 | 25 | 77 | 145 | 145 | 115 | |||
| 1 Adjusted for local and cross-border inter-dealer double-counting (ie “net-net” basis). 2 The category “other FX products” covers highly leveraged transactions and/or trades whose notional amount is variable and where a decomposition into individual plain vanilla components was impractical or impossible. 3 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2016 exchange rates. 4 Sources: Euromoney Tradedata; Futures Industry Association; The Options Clearing Corporation; BIS derivatives statistics. Foreign exchange futures and options traded worldwide. |
http://www.bis.org/publ/rpfx16.htm?m=6%7C35
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Global Foreign Exchange Market Turnover by Transaction Type, 1989-2007 (daily averages in April, billions of US$)
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Quoting & Trading Currencies:
Spot Market
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Foreign Exchange Quotations
A foreign exchange rate is the price of one currency expressed in terms of another currency
A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate
Information distributors such as Reuters and Bloomberg have long provided information about market prices of currencies that are not contractually binding
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Prices for transactions in real goods and services are generally quoted as a price per unit such as dollars per gallon, dollars per ton, etc.
Unlike a transaction in real goods or services, in an FX transaction there is a transaction in two currencies: one currency is bought and another is sold
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What’s being bought or sold in an FX transaction?
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Is there an underlying unit being priced in an FX quote?
Well, sort of……..in an FX quote, a single unit of one currency is bought or sold at some price expressed as a variable number of units of a second currency
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In a quote of 100 yen per dollar, a one dollar unit is being bought or sold at a price of 100 yen
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The single unit of currency being bought or sold is called the base currency
(AKA primary currency or unit currency)
The dollar in the quote of 100 yen per dollar
The currency of which multiple units are paid or received is called the quote currency
(AKA terms currency, price currency, counter currency, or variable currency)
The yen in the quote of 100 yen per dollar
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Most foreign exchange transactions involve the US dollar
For practical reasons, professional dealers and brokers typically state foreign exchange quotations relative to the dollar in one of two ways:
The foreign currency price of one dollar—dollar is the base currency
The dollar price of one unit of foreign currency—dollar is the quote currency
72
Relative to what currency is FX quoted?
72
Most foreign currency exchange quotes in the world are stated in terms of the amount of non-US currency needed to buy one dollar
The dollar is the base currency
The non-dollar currency is the quote (terms) currency
Such quote is said to be in European terms
For example, these rates are expressed in European terms
CHF 1.60 per $
JPY 90.00 per $
73
The European-American Terms Paradigm
73
For quotes in European terms,
The quote currency (terms currency!) is a European or other non-dollar currency
The base currency is the dollar
74
74
Alternatively, for a few currencies, exchange rate quotes are stated in terms of the number of dollars needed to buy one unit of foreign currency—
The non-US currency is the base currency
The dollar is the quote (terms) currency
Such a quote is in American terms
75
75
For quotes in American terms,
The quote currency (terms currency!) is the USD—the American currency
The base currency is a non-US currency
76
76
The most important exceptions to the rule that quotes are expressed in European terms are the euro, UK pound sterling, the Australian dollar, and the New Zealand dollar. They are normally quoted in American Terms.
For example:
$ 1.15 per €
$ 1.50 per £
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77
Foreign exchange quotes are at times described as Direct or Indirect
In this pair of definitions, the home country of the currencies being discussed is critical
A direct quote is a home currency price of a unit of foreign currency.
For a South African, examples would be:
ZAR 0.1093 per JPY
ZAR 11.27 per EUR
ZAR 13.87 per GBP
78
The Direct-Indirect Terms Paradigm
A direct vs. indirect quote depends on what the speaker regards as “home” currency
78
Because they are home currency prices of a foreign currencies—just like prices of goods and services—quotes in direct terms are convenient for tourists and non-currency traders
79
79
An indirect quote is a foreign currency price of a unit of home currency.
For a French trader, examples of an indirect quote would be:
¥ 130.00 per €
£ 0.8700 per €
$ 1.1500 per €
Unlike quotes in European and American terms, the dollar need not be one of the currencies in the quote
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80
How Are Quotes Displayed by Traders?
The base currency is listed first; the quote currency is listed second; and they are separated with a slash—Opposite to what anyone who studied middle school math would suggest!
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| EUR/USD | 1.1510 |
| USD/CHF | 1.3160 |
| AUD/USD | 0.6455 |
| USD/JPY | 117.15 |
| USD/CZK | 27.323 |
81
An FX quote usually consists of 5 digits:
The last 2 digits are called pips. The rest of the quote is called the big picture
82
EUR/USD
USD/JPY
82
Foreign Exchange Bid & Ask Prices
Interbank quotations are in bid and ask pairs (ask is also referred to as offer)
A bid is the price (exchange rate) in quote currency at which a market maker will buy one unit of base currency.
An ask is the price (exchange rate) in quote currency at which a market maker will sell one unit of base currency
Dealers bid (buy) at a slightly lower price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices
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The bid is the bank/dealer’s—not the customer’s—buy price
The ask is the bank/dealer’s—not the customer’s—sell price
You might see a few different ways to display a spot quote:
Example: A dealer makes a market in the euro:
The dealer will buy 1 EUR for $1.3010 and sell 1EUR for $1.3020 making a spread of $0.0010 per euro
85
| Bid Rate | Ask Rate | |
| EUR/USD | 1.3010 | 1.3020 |
| EUR/USD | 1.3010 - 20 |
| EUR/USD | 1.3010 - 1.3020 |
85
When the dealer is buying euros, she is selling dollars. Hence,
When the dealer is selling euros, she is buying dollars. Hence,
86
The ask rate on the dollar is determined by the bid rate on the euro
The bid rate on the dollar is determined by the ask rate on the euro
86
Example: (cont.)
The exchange rates wouldn’t be displayed this way, but in explicit form:
A good confirmation of this logic is the bid is less than the ask on the dollar!
87
| Bid Rate | Ask Rate | |
| EUR/USD | 1.3010 | 1.3020 |
| USD/EUR | 1/1.3020 = 0.7680 | 1/1.3010 = 0.7686 |
87
Discussion: If you want to buy USD 10M and pay with EUR, which of the four banks below provide you the best rate?
88
| Bank | Quote EUR/USD |
| Bank A | 1.0830 - 40 |
| Bank B | 1.0850 - 60 |
| Bank C | 1.0800 - 10 |
| Bank D | 1.0790 - 00 |
Choose Bank B: EUR 9,216,589.86 = 10,000,000
88
Magnitude of bid-ask spreads
Interbank market
0.05% - 0.07% for major currencies
Lower for extremely liquid currencies like U.S. dollar (for example, 0.03% for the dollar-euro exchange rate quote)
Higher for less liquid currencies
Physical exchange
3% or more
Banks have to have inventory, which means it is not interest bearing
Banks must also typically transact with brokers
89
89
90
| Name | Bid | Ask | Net chg. | Chg. % | High | Low |
| EUR/USD Spot | 1.2918 | 1.2919 | 0.0054 | 0.42% | 1.2929 | 1.2834 |
September 18, 2014 GMT 19:30
90
Quoting & Trading Currencies
Forwards
91
91
How are Forwards Quoted?
Forward rates can be quoted in two ways:
As an "outright" quote or
With swap points (also called forward points )
The outright quote is simply a bid-ask price, same as the spot market quotes
More frequently, traders quote forward rates in terms of swap points
The swap points are the amount that needs to be added to or subtracted from the spot rate pips
92
http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=topnav_2_3051
92
Example: If the first number is smaller than the second, the swap points are added to the spot bid and ask rate pips
93
| Spot rates | USD/CAD 1.3500 - 1.3505 |
| 3 month swap points | 90 - 95 |
| Outright 3 month forward rates | USD/CAD 1.3590 - 1.3600 |
93
Example: If the first number is larger than the second, the swap points are subtracted from the spot bid and ask rate pips
The fact that the bid-ask spread is larger for the forward than for the spot quote is confirmation!
94
| Spot rates | USD/JPY 100.50 – 100.52 |
| 3 month swap points | 16 - 14 |
| Outright 3 month forward rates | USD/JPY 100.34 – 100.38 |
94
Discussion: What determines the whether points should be added or subtracted?
Points are added when the base currency is expected to appreciate
Points are subtracted when the base currency is expected to depreciate
Why are more points added/subtracted for more distant forward rates?
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Friday, September 19 2014 New York GMT 19:00
| Base/Quote | Bid | Ask | Net chg. | Chg. % | High | Low |
| EUR/USD Spot | 1.2835 | 1.2836 | -0.0087 | -0.67% | 1.2930 | 1.2831 |
| EUR/USD 01M Forward | 2.5100 | 2.7900 | 0.0250 | 0.95% | 2.8450 | 2.4250 |
| EUR/USD 02M Forward | 5.4200 | 5.9000 | -0.0200 | -0.35% | 8.5000 | 5.0000 |
| EUR/USD 03M Forward | 8.1900 | 8.6800 | 0.1300 | 1.57% | 9.0000 | 8.0000 |
| EUR/USD 04M Forward | 11.4100 | 12.0000 | +0.2700 | +2.36% | 12.2500 | 10.9300 |
| EUR/USD 05M Forward | 14.6900 | 15.5200 | 0.1850 | 1.24% | 15.7900 | 14.4900 |
| EUR/USD 06M Forward | 17.7500 | 19.2500 | +0.4400 | +2.44% | 19.5000 | 17.5000 |
| EUR/USD 12M Forward | 54.6300 | 56.3500 | +0.7350 | +1.34% | 56.5500 | 54.0000 |
| EUR/USD 02Y Forward | 217.1000 | 232.5000 | +3.1500 | +1.41% | 229.0000 | 220.0000 |
http://www.fxstreet.com/rates-charts/forward-rates/?id=eur%2fusd
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Quoting & Trading Currencies
FX Swaps
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How are FX Swaps Quoted?
Example: A dealer’s quote a 12-month EUR/USD swap looks the same as that of a 12-month forward:
This means the dealer would bid (buy) 1 euro spot for USD1.1548 and ask (sell) 1 euro spot for USD1.1552
However, for spot-against-forward FX swap transactions, the spot transaction (spot leg) typically takes place at the midrate of the bid-ask spot rates*
The 112-110 are swap points that need to be added to/subtracted from the spot mid rate to calculate the rate of exchange for the forward transaction (forward leg)
98
| Spot rates | EUR/USD 1.1548 – 1.1552 |
| 12 month swap points | 112 - 110 |
* A market maker can choose a different rate for the spot transaction so long as it is within the spot bid-ask spread. The forward rate of exchange is then calculated by adding/subtracting swap points to/from this alternative to the midpoint
http://www.financetrainer.com/fileadmin/inhalte/TOOLS_SKRIPTEN/0102_forwarde.pdf
98
Example (cont):
If the first number is smaller than the second, the base currency is expected to appreciate and the swap points are added to the spot mid rate
If the first number is larger than the second (as in this case), the base currency (euro in this case) is expected to depreciate and the swap points are subtracted from the spot mid rate
99
99
Example (cont): Here are the two FX swaps from the quote:
The swap dealer “sells and buys” 1 EUR as follows:
The swap dealer “buys and sells” 1 EUR as follows:
100
Buys 1 EUR spot for 1.1550 USD (spot mid rate)
Sells 1 EUR 12 month forward for 1.1440 USD (=1.1550 – 0.0110)
Sells 1 EUR spot for 1.1550 USD (spot mid rate)
Buys 1 EUR 12 month forward for 1.1438 USD (=1.1550 – 0.0112)
| Spot rates | EUR/USD 1.1548 – 1.1552 |
| 12 month swap points | 112 - 110 |
100
Example: Bridgewater Associates (world’s largest hedge fund firm in 2011) enters into a swap with a dealer and buys spot EUR 1,000,000 and sells 12 month forward
101
Dealer
Bridgewater
Now
12 months
EUR 1,000,000
USD 1,1550,000
USD 1,143,800
EUR 1,000,000
Dealer sells 1 EUR spot for 1.1550 USD (spot mid rate)
Dealer buys 1 EUR 12 month forward for 1.1438 USD (=1.1550 – 0.0112)
101
OPTIONAL NOTE:
In a matched principal FX swap, the base currency’s volume, in both the spot and forward transaction, is the same.
In mismatched principal swaps, forward volume equals the compounded (includes interest) spot volume
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102
Dodd-Frank and FX Swaps and Forwards
The Dodd-Frank Act put in place a comprehensive set of reforms to help build stronger, safer, and more efficient financial markets….Congress provided the Secretary of the Treasury with the authority to determine whether certain derivatives requirements, including central clearing and exchange trading, should apply to foreign exchange (FX) swaps and forwards
Treasury has issued a final determination providing that certain mandatory derivatives requirements, including central clearing and exchange trading, will not apply to FX swaps and forwards
Importantly, the final determination does not extend to other FX derivatives, such as FX options, currency swaps, and non-deliverable forwards. These other FX derivatives will be subject to mandatory clearing and exchange-trading requirements.
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103
Cross Rates & Cross-Rate Arbitrage
104
104
Cross Rates
Many currency pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency called a vehicle currency—usually the dollar as we have seen
With over 150 different currencies, making a market in each currency pair would require more than 11,175 markets! (150x149/2)
Demand to trade in most of these currency pairs is low or nonexistent
Quoting relative to a world vehicle currency is therefore efficient
105
If you know the exchange rate for each currency relative to a common vehicle currency, you know the exchange rate between any currency pair!
105
An exchange rate for a currency pair that does not include the vehicle currency (dollar) is called a Cross Rate
A cross rate is the ratio of two exchange rates (in the same terms) relative to the vehicle currency
106
Example: Suppose that you want to know how many Thai baht it requires to buy one Malaysian ringgit. You have the follow rates for the baht-dollar and ringgit-dollar markets:
USD/MYR 3.7202
USD/THB 39.370
107
USD
1 MYR
107
| Dollar | Euro | Pound | SFranc | Peso | Yen | CdnDlr | |
| Canada | 1.0961 | 1.4062 | 1.7852 | 1.1649 | 0.0830 | 0.0101 | ... |
| Japan | 109.0473 | 139.8993 | 177.6128 | 115.8931 | 8.2541 | ... | 99.4896 |
| Mexico | 13.2113 | 16.9491 | 21.5182 | 14.0407 | ... | 0.1212 | 12.0534 |
| Switzerland | 0.9409 | 1.2071 | 1.5326 | ... | 0.0712 | 0.0086 | 0.8585 |
| U.K. | 0.6140 | 0.7877 | ... | 0.6525 | 0.0465 | 0.0056 | 0.5601 |
| Euro | 0.7795 | ... | 1.2696 | 0.8284 | 0.0590 | 0.0071 | 0.7112 |
| U.S. | ... | 1.2829 | 1.6288 | 1.0628 | 0.0757 | 0.0092 | 0.9124 |
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Wall Street Journal
Key Currency Cross Rates
Friday, September 19, 2014
Snapshot of foreign exchange cross rates
108
109
Cross rates can also be used to check for opportunities for intermarket arbitrage when all the currency pairs ARE actively traded
109
Cross-Rate/Triangular Arbitrage
Example:
Suppose, the USD-JPY exchange rate is USD/JPY 111.38
And the USD-EUR exchange rate is EUR/USD 1.23
What is the implied yen-euro cross rate?
110
$
€
¥
What if ≠ JPY 137.00/EUR ???
110
Example (Cont): Now, suppose an arbitrageur sees these quoted rates:
Citibank quote: EUR/USD 1.23
Barclays quote: USD/JPY 111.38
Deutsche quote: EUR/JPY 138.00
The JPY-EUR cross rate from the Citibank USD-EUR and the Barclays JPY-USD quotes is:
Deutsche relatively overvalues the euro vs. the yen
111
≠
An arbitrage opportunity exists!!!
111
One strategy would be:
Sell euros to Deutsche and receive yen
Sell yen to Barclays and receive dollars
Sell dollars to Citi and receive euros
Per EUR, the result would be:
An arbitrage profit of 0.7318 euro cents per euro
However, the arbitrageur does not need to have euros to start with—She just needs to get them somehow and then sell them to Deutsche
112
Citibank quote: EUR/USD 1.23
Barclays quote: USD/JPY 111.38
Deutsche quote: EUR/JPY 138.00
113
Start 1M USD
End 1,007,318M USD
Profit 7,318 USD
3. Sell JPY Barclays
2. Sell EUR to Deutsche
1. Sell USD to Citibank
Citibank quote: EUR/USD 1.23
Barclays quote: USD/JPY 111.38
Deutsche quote: EUR/JPY 138.00
Strategy: Get euros and sell them to Deutsche in exchange for yen!!!
Example (Cont): Now, suppose the arbitrageur starts with 1M USD:
113
Optional: Cross Rates with Bid-Ask Rates
Example: Calculate the EUR/CHF bid and ask quotes given the quotes relative to the dollar
EUR/USD: 1.1500-10
USD/CHF: 1.4980-85
114
How do we get these rates? Think of the steps the customer would need to take if there were no cross-rate market
EUR/CHF 1.7227 - 48
114
Find EUR/CHF bid
Customer sells 1 EUR at EUR/USD bid rate for 1.1500 USD
Customer sells 1.1500 USD at USD/CHF bid rate for 1.1500 USD x 1.4980 = 1.7227 CHF
115
Sell
1.1500 USD
Receive
1.7227 CHF
Sell
1 EUR
EUR/USD: 1.1500-10
USD/CHF: 1.4980-85
Receive
1.1500 USD
EUR/USD Bid: 1.1500
USD/CHF Bid: 1.4980
115
Find EUR/CHF ask
Customer buys 1 EUR at EUR/USD ask rate for 1.1510 USD
Customer buys 1.1510 USD at USD/CHF ask rate for 1.1510 USD x 1.4985 = 1.7248 CHF
116
EUR/USD: 1.1500-10
USD/CHF: 1.4980-85
Buy
1 EUR
Sell
1.1510 USD
EUR/USD Ask: 1.1510
Sell
1.7248 CHF
Buy
1.1510 USD
USD/CHF Ask: 1.4985
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Summary
The three functions of the foreign exchange market (FOREX) are to transfer purchasing power, provide credit, and minimize foreign exchange rate risk
The FOREX is composed of two tiers: the Interbank market and the retail/client market.
Participants within these tiers include bank and nonbank foreign exchange dealers, foreign exchange brokers, individuals and firms conducting commercial and investment functions, speculators and arbitragers, and central banks and treasuries
Geographically, the FOREX market spans the globe, with prices moving and currencies traded 24 hours a day
A foreign exchange quotation is a statement of willingness to buy or sell one unit of base currency for some varying amount of quote currency
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Transactions within the FOREX market are:
Spot transactions, requiring delivery in two business days
Forward transactions, requiring settlement at some designated future date, or
FX swap transactions, requiring both a purchase of a currency at some designated date and a sale of that same currency at some designated more distant future date
Market makers buy a unit of (base) currency at the bid rate and sell a unit of (base) currency at a slightly higher ask rate to make a profit known as a spread
A cross rate is an exchange rate between two currencies, calculated from their common value relative to a third vehicle currency (dollar)
When cross rates differ from the market rate of exchange between the two currencies themselves, intermarket arbitrage may be possible
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118
Appendix: Nondeliverable Forwards (NDFs)
Nondeliverable Forwards (NDFs) are over-the-counter instruments that began to trade actively in the 1990s
NDF markets developed for emerging markets with capital controls. Most NDFs are cash settled in US dollars
The more active banks quote NDFs from between one month to one year, although some would quote up to two years upon request. NDFs are typically quoted with the USD as the reference currency, and the settlement amount is also in USD
“They are particularly suitable for clients who operate in countries with a currency that is not freely convertible, but who are allowed to repatriate money, i.e. convert funds into their home currency. NDFs make it possible to hedge the exchange-rate risk, irrespective of any restrictions arising in the country of origin (e.g. if it is not possible to hedge the currency with forwards).”
119
119
120
Credit Suisse says:
“Non-Deliverable Forwards (NDFs) are forward transactions used to hedge non-convertible currencies. Roughly speaking, NDFs can be defined as a type of non-exchange traded, non-standardized futures contract.
Under an NDF, a currency that is not freely convertible, such as the Argentinian peso, Taiwanese dollar, Korean won, etc., is specified against a freely convertible currency. This is typically the USD, but other currencies such as EUR, CHF, etc. are also possible.
The contract is for a fixed amount (of the non-convertible currency), on a specific due date, and at an agreed forward rate. At maturity, the daily rate (reference rate) is compared with the NDF rate. The difference must be paid in the convertible currency on the value date. No payment or account movement takes place in the non-convertible currency. When a non-deliverable forward transaction is agreed, the parties must also agree on a way to determine the reference rate (at maturity). This might be the daily rate fixed by the central bank in question, or an average rate published by several banks…
For Whom Are Non-Deliverable Forwards Suitable?
They are particularly suitable for clients who operate in countries with a currency that is not freely convertible, but who are allowed to repatriate money, i.e. convert funds into their home currency. NDFs make it possible to hedge the exchange-rate risk, irrespective of any restrictions arising in the country of origin (e.g. if it is not possible to hedge the currency with forwards).”
120
121
What Currencies Are Suitable for NDFs?
NDFs may be concluded in the currencies of the following countries
(list not necessarily exhaustive):
■ Argentina ■ Brazil
■ Chile ■ China
■ Guatemala ■ Indonesia
■ India ■ Columbia
■ Korea (South) ■ Malaysia
■ Philippines ■ Peru
■ Russia ■ Taiwan
■ Venezuela ■ Vietnam
121
Example: The company Müller AG receives TWD 32,600,000 in 6 months that it wishes to convert into USD. The firm will conclude a spot transaction at maturity with the central bank—at the rate that then applies
It hedges the exchange-rate risk with an NDF with a forward rate of 32.60 TWD/USD
In 6 months the spot rate is 35.00 TWD/USD, so in the spot market the firm earns less than expected (under the forward unbiasedness hypothesis)
But the bank’s payment compensates the firm for this
122
The same amount as if the spot rate now equaled the nondeliverable forward rate 6 months earlier!
122
Example (cont.): At maturity the bank pays the loss of USD 68,571.43 to the firm
If the USD/ TWD reference rate is below the forward rate at maturity—and therefore the firm earns more than if the spot rate equals the forward rate 6 months earlier—the firm pays the difference to the bank
The result is equivalent to hedging the risk with a conventional forward contract
123
123
Appendix: Dodd-Frank and FX Swaps and Forwards
(11/16/2012) The Dodd-Frank Act put in place a comprehensive set of reforms to help build stronger, safer, and more efficient financial markets….Congress provided the Secretary of the Treasury with the authority to determine whether certain derivatives requirements, including central clearing and exchange trading, should apply to foreign exchange (FX) swaps and forwards…The FX swaps and forwards market is markedly different from other derivatives markets. Existing procedures in the FX swaps and forwards market mitigate risk and help ensure stability. While central clearing requirements will strengthen the rest of the derivatives market, the potential benefit is reduced in the FX swaps and forwards market because existing practices already help limit risk and also ensure that the market functions effectively…. Given these considerations, Treasury has issued a final determination providing that certain mandatory derivatives requirements, including central clearing and exchange trading, will not apply to FX swaps and forwards. This final determination is narrowly tailored. FX swaps and forwards will remain subject to the Dodd-Frank Act’s new requirement to report trades to repositories and rigorous business conduct standards. Additionally, the Dodd-Frank Act makes it illegal to use these instruments to evade other derivatives reforms. Importantly, the final determination does not extend to other FX derivatives, such as FX options, currency swaps, and non-deliverable forwards. These other FX derivatives will be subject to mandatory clearing and exchange-trading requirements.
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124
Optional
Considering bid (deposit) and ask (loan) rates in the money market and bid and ask exchange rates in the currency market, forward rates can be calculated as follows:
125
http://www.financetrainer.com/fileadmin/inhalte/TOOLS_SKRIPTEN/0102_forwarde.pdf
125
Swap (forward) points can be similarly calculated:
Note, as only points are being calculated, the mean quote for the spot is used. The difference with the bid or ask has almost no impact
126
http://www.financetrainer.com/fileadmin/inhalte/TOOLS_SKRIPTEN/0102_forwarde.pdf
Appendix: More Examples of Clearing & Settling
127
128
129
130
131
132
Appendix: More on Bridgewater Example
Assuming (incorrectly) that there are no bid-ask spreads, Bridgewater could costlessly hedge its position:
133
------------------Now------------------------
Borrow 1.155 M USD
Pay 1.155 USD M against FX swap
Receive 1 EUR M from FX swap
Invest 1 M/(1 + iEUR) EUR
Convert 1 - 1/(1 + iEUR) M EUR to [1 - 1/(1 + iEUR)]USD and invest
---------------------12 Months-----------------
Receive 1 M EUR on Investment
Pay 1 M EUR against swap
Receive 1.1438M USD from FX swap
*Receive [1 - 1/(1 + iEUR)] x (1 + )
Repay 1.155M(1+iUSD) USD on Borrowing
0 Net Cash Flow
133
0 Net Cash Flow
*= x (1 + ) - M = x (1 + ) - M = 1.155((1 + ) – 1.1438 M
Clearly, Bridgewater might have a better use of the FX and make a positive profit!
Optional: Response to International Regulators
International regulators have encouraged the use of a compression service for non-centrally cleared OTC derivatives
This has resulted in strong market demand for a compression service for FX forwards and FX swaps
What is compression?
Compression aggregates derivatives contracts with similar risks or cash flows into fewer trades. It is a process for “tearing up” trades that allows economically redundant derivative trades to be terminated early without changing each participant’s net position
The act of compressing trades decreases notional outstanding volume, as offsetting transactions are cancelled out, or netted. This administrative process does not affect the risk profile of a portfolio, only the total notional amount
134
Portfolio compression is a post-trade risk management tool that enables counterparties to reduce the size of their outstanding portfolios without fundamentally changing their market positions
In the FX context, forwards and swaps among multiple counterparties are terminated and
Then replaced with new transactions whose combined (notional) value is less than the original combined (notional) value of the terminated trades
For example, TriOptima has collaborated with CLS to deliver the triReduce CLS Forward FX Compression Service
135
http://www.trioptima.com/uploading_images/pdf/triReduce%20CLS%20forward%20FX_A4.pdf
The diagram below illustrates how an organization’s FX forward positions can be transformed through compression service
136
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