(An excerpt from my MSc dissertation)
The Foreign Exchange (FX) market is among the most liquid in the world, with a
global turnover equivalent to US$1.6 trillion. The market, by its very
nature, operates 24 hours per day, with London, New York and Tokyo the centers of
activity. It is of crucial importance to the major commercial banks, accounting for
approximately half their profits. Banks deal on behalf of their
corporate customers, who require foreign currency in which to carry out commercial
activity (typically import/export businesses, or business receiving cash flows from
foreign investments or subsidiaries). Several factors are combining to increase the
volume of trades. Exchange rate controls have been abandoned by major
governments, meaning that institutional investors such as pension funds are free to
move large amounts of capital in and out of countries, converting currencies as
necessary. Investors move capital sums to take advantage of favorable interest rates,
whether in actuality or speculatively. As business has globalized, corporations have
begun to maintain sophisticated trading operations of their own. New capital
adequacy laws and increased counterparty risk in a volatile market have raised
barriers to entry, leaving half the market to only 10 banks. Cash, forward contracts
and swaps in the FX markets can be combined in many different ways to create new
products in response to the particular needs of a customer. All these factors mean
that the FX market is particularly in need of automated solutions, to reduce the risk
associated with each transaction, and to lower the cost of each transaction.
The FX market has a great deal of specialist terminology associated with it. The
simplest form of FX deal is the “spot trade”. This is simply a contract between two
counterparties to exchange a certain amount of one currency for a certain amount of
another, at the prevailing exchange rate at the time the contract was entered into.
The date on which the deal is actually agreed is called the “deal date”, but the day on
which the currency is delivered is called the “value date”. Generally, the value date
is two days after the deal date, but the matter is complicated by differing valid
trading days in different countries, for example, a national holiday in one country
will mean that the currency of that country cannot be delivered. In this case, the
value date is the soonest trading day that is after the normal two-day delay. Spot
markets are “over the counter” (OTC) which means that counterparties contact one
another directly in order to trade. Since there are only two counterparties to each
deal, and an exchange or regulator does not need to approve the deal before it is
written OTCs are easily customized to a particular need. A “short date” refers to a
delivery date that is earlier than spot. A trader is said to be “long” when having
bought more of a particular currency than sold, and “short” when having sold more
than has been bought. A balanced account (or “position”) is “squared”, and results in
“realized” profit (or loss). Otherwise, the profit or loss of the position is
“unrealized”, and its value is the difference between the average rate of the position,
and the current market rate.
Typically, an exchange will be used to source liquidity, and a request for a quote can
be broadcast to all connected counterparties in order to find an interested trader,
requiring a common protocol between all traders. OTC markets permit arbitrary
trades, unlike exchanges where the sizes of contracts are fixed. The exchange rate
delivered by services such as Reuters is merely indicative; the price at which the
deal is actually struck varies as the spread is factored in, which reflects supply and
demand of a currency, and the credit rating of the counterparty. This is a function of
both the risk of default and competition between market makers for the transaction.
Currencies are generally quoted against the US dollar; for example, USD.CHF will
give the prevailing rate for exchanging US dollars for Swiss Francs. When the dollar
appears first, the is a “direct quote”, when it is second it is called an “indirect quote”,
and when US dollars are not present in the currency pair, this is “cross currency”.
The order is important, as the currency on the left hand side of the pair is the base
currency of the transaction. A quote comprises two elements, a “bid”, which is the
price at which the counterparty will buy the base currency, and an “offer”, the rate at
which the counterparty will sell the base currency. The difference between bid and
offer is the “spread”. A “market maker” provides the liquidity of the market by
buying and selling currencies to counterparties, taking profit from the spread. On the
opposite side of the transaction from the market maker is the “taker”, the party who
requests the quote, and who sells currency at the market maker’s buying price.
A “cross currency” trade is a special case, as there may be insufficient liquidity in
the market to carry out the transaction directly, as counterparties prefer to base each
deal in one of the major currencies, for example US dollars, Swiss Francs or Sterling. In this case, the cross rate will have been calculated from direct or indirect
quotes between either side of the currency pair, and the US dollar, bid and offer
respectively. The new quote has the left hand currency of the cross as the new base,
with the right hand side expressing the price in the second currency for one unit of
the first.
An “FX Swap” is different from an “Interest Rate Swap”, rather than an exchange of
cash flows, it means to both buy and sell a pair of base currencies, or sell and buy, at
spot and a forward rate, as part of a single deal. A swap may also be between
forwards of different tenors. For example, buying Sterling at spot, and selling a
forward on US Dollars in the same transaction. This can be done to hedge against
risk, or it can be purely speculative, in which case it would probably have different
amounts on the spot and forward legs of the deal. An “outright” is a single deal for a
forward date, prices at spot plus or minus the spread for the tenor, also known as the
“forward points” (or “the pips” or “the margin”). These forward points are a
function of the interest rate differential between the two currencies over the period
(tenor) of the forward. An “FX forward” is simply a contract to deliver a quantity of
a currency at a time in the future.
The market maker calculates the forward points such that it is impossible to buy into
a currency offering a higher interest rate than is currently held, wait a period of time,
then convert back to the original currency and realize a profit without taking a risk
of adverse currency movements (speculating). This is the mechanism by which the
FX market is related to the interest rate offered by the central bank for each
currency, and a route by which governments are able to affect the strength of
national currencies. If there is a mismatch between the spot price, the forward rate
and the interest rate, there is an opportunity for “arbitrage”, which means to borrow
in one currency, swap for another and realize a profit from doing so, after the cost of
covering the forward exchange risk is deducted. Capital adequacy rules mean that
speculation is becoming increasingly popular, since derivatives are “off balance
sheet”, and the closing of positions by entering into offsetting deals means that there
is no need to take delivery of inventory.
References:
- Introduction to Global Financial Markets, Stephen Valdez, Palgrave 2000