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Foreign Exchange Fundamentals

Foreign Exchange Fundamentals . FOREIGN EXCHANGE CORE FUNDAMENTALS. AGENDA. Global FX Markets Structure and conventions of spot markets Appreciating depreciating currencies Delivery timing issues Using orders Cash flows of both individual trade and trader's position

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Foreign Exchange Fundamentals

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  1. Foreign Exchange Fundamentals

  2. FOREIGN EXCHANGE CORE FUNDAMENTALS AGENDA Global FX Markets Structure and conventions of spot markets Appreciating depreciating currencies Delivery timing issues Using orders Cash flows of both individual trade and trader's position Counterparty requirements Trade capture-Electronic/ Manual Outright Forward Contracts Client usage and intentions Derivation of forward market prices FX Swap market Applications of FX Swaps Settlement- Continuous Linked Settlement- CLS Confirmations and Settlements
  3. FOREIGN EXCHANGE -- Exposures FX Transactions derive from the combination of global activity and fluctuating exchange rates Many forms of global activity: + Foreign currency-denominated sales revenues + Foreign currency-denominated dividends and royalties + Multicurrency portfolio management + Foreign currency-denominated expenses + Equipment/Raw materials purchased abroad + Foreign currency denominated loans/loan restructuring + Foreign operations/subsidiaries Growing incidence of fluctuating currencies: + Asian, Latin American, and other emerging markets
  4. FOREIGN EXCHANGE – Managing FX Risk Fueled by underlying corporate and investor needs, the global FX market is the world’s largest financial market Vast majority of transactions in OTC market Average daily turnover estimated at $3.2 trillion (BIS, 2007), up 71% on 2004 figures – swaps biggest increase at 82% A broad mix of market participants – central banks, financial institutions, investors, multinational corporations
  5. FOREIGN EXCHANGE – Geographical Distribution of Turnover
  6. FOREIGN EXCHANGE – Currency Traded Currency Trading Volume
  7. FOREIGN EXCHANGE – Major Market Participants Commercial Banks Provide FX dealing services for their clients Manage their own FX exposures Proprietary traders within banks speculate on expected long-term movements Top 20 FX banks account for around 2/3 of daily turnover Central Banks Use the markets to stabilize exchange and interest rates Supervise Commercial Bank FX operations
  8. FOREIGN EXCHANGE – Major Market Participants Corporate and Portfolio Managers International companies have transactional needs arising from their commercial activities Investment institutions use the FX market to make foreign-currency investments + Investing and divesting + Covering or not covering FX exposure Hedge Fund big ticket activity Individual trading platforms Brokers Voice brokers virtually extinct Electronic brokers provide efficiency EBS FXAll FXConnect
  9. FOREIGN EXCHANGE – FX Transactions Are you managing TIME EXPOSURE OR FLOW EXPOSURE OR BOTH Do you really have an exposure Corporate/Portfolio Manager philosophy and policy
  10. FOREIGN EXCHANGE – Spot Transactions Definition A Foreign Exchange transaction where the price is agreed today for currency delivery, normally, in two business days time. Price agreed Monday-settlement Wednesday Price agreed Thursday-settlement Monday Bank Holidays
  11. FOREIGN EXCHANGE – FX Spot Rates DEALERS OFFER FOR FIXED CURR. DEALERS BID FOR FIXED CURRENCY FIXED CURRENCY VARIABLE /CURRENCY 1.5849 1.5850 /USD —— GBP 0.9647 0.9650 USD /CHF ——
  12. FOREIGN EXCHANGE – Some More FX Spot Rates
  13. FOREIGN EXCHANGE – Even More FX Spot Rates
  14. FOREIGN EXCHANGE – The FX Spot Transaction Procedure Trader Order Direct Processing Trading Platform FOREX Execution No Dealing Desk(NDD) Straight Thru Processing(STP) INTERBANK Brokers Mutual funds Hedge funds Banks Investment corporations Processed For Risk Exposure Trader Order Dealing Desk Winning Trades Losing Trades Market maker Profit FOREX Execution Dealing Desk(DD) Market Makers and Brokers Trading Platform
  15. FOREIGN EXCHANGE – FX Trading Trader A sells USD 13,280,212.48 TRADER B TRADER A Trader A buys EUR 10 million Trader A sells EUR 10 million Trader A buys USD 13,285,212.48 Profit and Loss EUR USD +10,000,000 -13,280,212.48 -10,000,000 +13,285,212.48 Net 0 + 5,000 BANK
  16. FOREIGN EXCHANGE – A FX Trade Bank of America Bank of America $10 million cash payment instruction to credit Saxo Bank account at BofA Confirmation that USD received Saxo Bank Copenhagen Saxo agrees to buy $10 million against DKK at 6.1990 from Citibank Saxo Bank Copenhagen Confirmation that DKK received DKK Payment instruction Saxo Bank Copenhagen Cash Dept Saxo Bank Copenhagen Cash Dept DKK 61.990 million cash payment instruction to credit Citibank London account at Citi Copenhagen
  17. FOREIGN EXCHANGE – Trading Parties
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  21. FOREIGN EXCHANGE – Best Price for the Caller You are a portfolio manager and want to sell EUR 8,000,000 against USD. Three banks make two way prices. Which one do you take? 1.3466-1.3468 1.3465-1.3469 1.3464-1.3467 Now you want to buy USD5,000,000 against GBP. Once again which price is best? 0.6302-0.6302 0.6300-0.6304 0.6310-0.6306
  22. FOREIGN EXCHANGE – Exercises Portfolio manager wants to buy GBP 1 million against USD 1.5862-1.5864 1.5852-1.5858 1.5868-1.5866 Portfolio manager wants to sell USD 2 million against EUR 1.3443-1.3444 1.3433-1.3442 1.3445-1.3448
  23. FOREIGN EXCHANGE – Using Orders Current Spot GBP/USD 1.5880-83 Need to buy GBP 1 million Stop Loss GBP/USD 1.5890 Take profit GBP/USD 1.5868
  24. FOREIGN EXCHANGE – Client Trading Strategies Strengthening and weakening currency GBP/USD 1.5877 UDS/DKK 5.5389 Assuming USD interest rate remain the same GBP interest rates are expected to fall DKK interest rates are expected to rise USD budget deficit and balance of payments increases
  25. FOREIGN EXCHANGE – What are the Cash Flows Clients transact the following spot transactions with you. What are the cash flows delivered at spot? ABC Co buys $10,500,000 against EUR at1.13590. Round amounts of variable-divide for Fixed Import Inc buys USD 5 million against DKK at 5.4840 Round amount of fixed-multiply for variable
  26. FOREIGN EXCHANGE – Spot Applications FX spot is a cash exchange market Market amounts/centralization Pairing of currency exposures Utilizing long position in one currency to cover short in another Currency of invoices in/out Currency of financing compared to currency of invoice Exotic currencies
  27. FOREIGN EXCHANGE – Forward Outright Transactions Definition An FX transaction where the parties agree to exchange currencies on a future settlement date at a rate agreed today based on current spot Dates available Essentially any working day
  28. FOREIGN EXCHANGE – FX Forward Outright GBP USD Exposure T=180 TODAY Settle at T=180 Buy GBP / Sell USD Agree price at Today Assume a USD based portfolio manager that has identified a GBP payable for GBP 1 million in 180 days time required to buy back some FTSE 100 equities. The manager is concerned that the GBP may appreciate against the USD during that period and therefore he wants to lock in today, based on today’s rates, an FX sale rate for USD (purchase of GBP)
  29. FOREIGN EXCHANGE – FX Forwards GBP USD Traders Cash Flow: T=180 TODAY Bank cash flows with Client Sell GBP to them and Buy USD Bank does spot deal in interbank market to lock in today’s spot rate Borrow USD for 180 days and use to settle spot payment Deposit GBP for 180 days with GBP received in spot deal Repay with USD from customer Use funds to pay clients
  30. FOREIGN EXCHANGE – FX Forwards GBP USD Bank cash flows to calculate OFFER points: T=180 TODAY Bank cash flows with Client Sell GBP to them and Buy USD Bank does spot deal in interbank market to lock in today’s spot rate at 1.7446 Borrow USD for 180 days Deposit GBP for 180 days 1.60 4.32 Current Market Prices Spot 1.7441 – 1.7446 Interest Rates GBP 4.32 – 4.42% USD 1.50 – 1.60% Interest = 2.72%
  31. FOREIGN EXCHANGE – Forward Rate Offer points: 1.7468 - 1.7446 = 0.0022
  32. FOREIGN EXCHANGE – Another Example Assume that the portfolio manager had a receivable of GBP 1 million in 180 days time from the sale of some UK Corporate Bonds. They want to sell the GBP forward Exposure T=180 TODAY Agree price at Today Settle at T=180
  33. FOREIGN EXCHANGE – FX Forwards GBP USD Bank cash flows to calculate BID points: T=180 TODAY CUSTOMER FLOWS Bank does spot deal in interbank market to lock in spot rate of 1.7441 Borrow GBP for 180 days Deposit USD for 180 days 4.42 1.50 Current Market Prices Spot 1.7441 – 1.7446 Interest Rates GBP 4.32 – 4.42% USD 1.50 – 1.60% 2.92% = COST Interest Differential
  34. FOREIGN EXCHANGE – Forward Rate Offer points: 1.7197 - 1.7441 = 0.0244
  35. FOREIGN EXCHANGE – FX Forwards GBP USD Bank cash flows to calculate BID points: T=180 TODAY CUSTOMER FLOWS Bank does spot deal in interbank market to lock in spot rate of 1.7441 Borrow GBP for 180 days Deposit USD for 180 days 4.65 4.65 Current Market Prices Spot 1.7441 – 1.7446 Interest Rates GBP 4.55 – 4.65% USD 4.65 – 4.75% 0.00% = COST Interest Differential
  36. FOREIGN EXCHANGE – Forward Rate Offer points: 1.7451 - 1.7441 = 0.0010
  37. FOREIGN EXCHANGE – Final Prices Spot GBP/USD 1.7441 – 1.7446 6 Month Points 10 - 22 Outright Prices 1.7451 – 1.7468 Actual Prices on the Day Spot GBP/USD 1.7441 – 1.7446 6 Month Points 15.5 - 16 Outright Prices 1.74465 – 1.7452
  38. FOREIGN EXCHANGE – FX Screen
  39. FOREIGN EXCHANGE – Plus or Minus Points
  40. FOREIGN EXCHANGE – FX Forward Points If interest rates in the base/fixed currency are higher than the interest rates in the variable terms currency then: Points will show high on the bid and low on the offer Always deduct points in this scenario Ex. GBP/USD Spot: 1.8107 – 1.8112 3m Points 36 – 35 Outright 1.8071 – 1.8077 If interest rates in the base/fixed currency are lower than the interest rates in the variable terms currency then: Points will show low on the bid and high on the offer Always add points in this scenario Ex. EUR/NOK Spot: 8.8859 – 8.8869 3m Points 75 – 76 Outright 8.8934 – 8.8945
  41. FOREIGN EXCHANGE – Net Cost / Earnings Given the points you may wish to know what they are worth as an interest differential Formula: (Earnings)
  42. FOREIGN EXCHANGE – FX Swaps GBP USD Bank cash flows to calculate BID points: T=180 TODAY CUSTOMER FLOWS Bank does spot deal in interbank market to lock in spot rate of 1.7441 Borrow GBP for 180 days Deposit USD for 180 days 4.42 1.50 2.92 2.44 2.92 Current Market Prices Spot 1.7441 – 1.7446 Interest Rates GBP 4.55 – 4.65% USD 4.65 – 4.75% 2.92% = COST Interest Differential
  43. Thank You
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