Trading Timing

At the time a trade is made through a broker, the trader does not know the name of the counter party. Subsequently, credit limits are checked, and it may turn out that one dealer bank must refuse a counter party name because of credit limitations. In that event, the broker will seek to arrange a name-switch i.e., look for a mutually acceptable bank to act as intermediary between the two original counter parties.

The broker should not act as principal.

Beginning in 1992, electronic brokerage systems (or automated order-matching systems) have been introduced into the OTC spot market and have gained a large share of some parts of that market.

In these systems, trading is carried out through a network of linked computer terminals among the participating users.To use the system,a trader will key an order into his terminal, indicating the amount of a currency,the price,and an instruction to buy or sell. If the order can be filled from other orders outstanding, and it is the best price available in the system from counter parties acceptable to that trader’s institution, the deal will be made.

A large order may be matched with several small orders.

If a new order cannot be matched with outstanding orders, the new order will be entered into the system, and participants in the system from other banks will have access to it. Another player may accept the order by pressing a “buy”or “sell” button and a transmit button. There are other buttons to press for withdrawing orders and other actions.

Electronic brokering systems now handle a substantial share of trading activity. These systems are especially widely used for small transactions (less than $10 million) in the spot market for the most widely traded currency pairs—but they are used increasingly for larger transactions and in markets other than spot. The introduction of these systems has resulted in greater price transparency and increased efficiency for an important segment of the market.

Quotes on these smaller transactions are fed continuously through the electronic brokering systems and are available to all participating institutions, large and small, which tends to keep broadcast spreads of major market makers very tight. At the same time electronic brokering can reduce incentives for dealers to provide two way liquidity for other market participants. With traders using quotes from electronic brokers as the basis for prices to customers and other dealers, there may be less propensity to act as market maker. Large market makers report
that they have reduced levels of first-line liquidity.

If they need to execute a trade in a single sizable amount, there may be fewer reciprocal counterparties to call on. Thus, market liquidity may be affected in various ways by electronic broking.

Proponents of electronic broking also claim there are benefits from the certainty and clarity of trade execution.For one thing there are clear audit trails, providing back offices with information enabling them to act quickly to reconcile trades or settle differences. Secondly, the electronic systems will match orders only between counter parties that have available credit lines with each other.

This avoids the problem sometimes faced by voice brokers when a dealer cannot accept a counter party he has been matched with, in which case the voice broker will need to arrange a “credit switch,” and wash the credit risk by finding an acceptable institution to act as intermediary.

Mechanics of Trading Through Brokers

Voice Brokers and Electronic Brokering System The traditional role of a broker is to act as a go between in foreign exchange deals, both within countries and across borders.Until the 1990s, all brokering in the OTC foreign exchange market was handled by what are now called live or voice brokers.

Communications with voice brokers are almost entirely via dedicated telephone lines between brokers and client banks. The broker’s activity in a particular currency is usually broadcast over open speakers in the client banks, so that everyone can hear the rates being quoted and the prices being agreed to, although not specific amounts or the names of the parties involved.

A live broker will maintain close contact with many banks, and keep well informed about the prices individual institutions will quote, as well as the depth of the market, the latest rates where business was done, and other matters. When a customer calls, the broker will give the best price available (highest bid if the customer wants to sell and lowest offer if he wants to buy) among the quotes on both sides that he or she has been given by a broad selection of other client banks.

In direct dealing, when a trader calls a market maker, the market maker quotes a twoway price and the trader accepts the bid or accepts the offer or passes. In the voice brokers market, the dealers have additional alternatives.

Thus,with a broker, a market maker can make a quote for only one side of the market rather than for both sides.Also, a trader who is asking to see a quote may have the choice, not only to hit the bid or to take (or lift) the offer, but also to join either the bid or the offer in the brokers market, or to improve either the bid or the offer then being quoted in the brokers market.

It can all happen very quickly. Several conversations can be handled simultaneously on the dealing systems, and it is possible to complete a number of deals within a few minutes. When he hears the quotes, Mike will either buy, sell, or pass—there is no negotiation of the rate between the two traders.


If Mike wants to buy $10 million at the rate of CHF 1.4590 per dollar (i.e., accept Hans’ offer price), Mike will say “Mine” or “I buy” or some similar phrase. Hans will respond by saying something like “Done I sell you ten dollars at 1.4590.” Mike might finish up with “Agreed—so long.” Each trader then completes a “ticket”with the name and amount of the base currency, whether bought or sold, the name and city of the counter party, the term currency name and amount, and other relevant information.
The two tickets, formerly written on paper but now usually produced electronically, are promptly transmitted to the two “back offices” for confirmation and payment.For the two traders, it is one more deal completed, one of 200-300 each might complete that day.But each completed deal will affect the dealer’s own limits, his bank’s currency exposure, and perhaps his approach and quotes on the next deal.


The spread between the bid and offer price in this example is 5 basis points in CHF per dollar, or about three one-hundredths of one percent of the dollar value. The size of the spread will, other things being equal, tend to be comparable among currencies on a percentage basis, but larger in absolute numbers the lower the value of the currency unit—i.e., the spread in the dollar-lira rate will tend to be wider in absolute number (of lire) than the spread in dollar-swissie, since the dollar sells for a larger absolute number of lire than of Swiss francs.

The width of the spread can also be affected by a large number of other factors the amount of liquidity in the market, the size of the transaction,the number of players,the time of day, the volatility of market conditions,the trader’s own position in that currency, and so forth. In the United States, spreads tend to be narrowest in the New York morning-Europe afternoon period, when the biggest markets are open and activity is heaviest, and widest in the late New York afternoon, when European and most large Asian markets are closed.

Market Maker

A trader can contact a market maker to ask for a two-way quote for a particular currency. Until the mid-1980s, the contact was almost always by telephone over dedicated lines connecting the major institutions with each other or by telex.
But electronic dealing systems are now commonly used computers through which traders can communicate with each other, on a bilateral, or one-to-one basis, on screens, and make and record any deals that may be agreed upon.
These electronic dealing systems now account for a very large portion of the direct dealing among dealers.

As an example of direct dealing, if trader Mike were asking market maker Hans to give quotes for buying and selling $10 million for Swiss francs, Mike could contact Hans by electronic dealing system or by telephone and ask rates on “spot dollar-swissie on ten dollars.” Hans might respond that “dollar-swissie is 1.4585-90;”or maybe “85-90 on 5,”but more likely, just “85-90,” if it can be assumed that the “big figure” (that is, 1.45) is understood and taken for granted. In any case, it means that Hans is willing to buy $10 million at the rate of CHF 1.4585 per dollar, and sell $10 million at the rate of CHF 1.4590 per dollar.
Hans will provide his quotes within a few seconds and Mike will respond within a few seconds. In a fast-moving market, unless he responds promptly in a matter of seconds the market maker cannot be held to the quote he has presented.
Also, the market maker can change or withdraw his quote at any time, provided he says “change” or “off ” before his quote has been accepted by the counterparty.

TRADING AMONG MAJOR DEALERS—DEALING DIRECTLY AND THROUGH BROKERS

Dealer institutions trade with each other in two basic ways direct dealing and through the brokers market. The mechanics of the two approaches are quite different, and both have been changed by technological advances in recent years.

Mechanics of Direct Dealing

Each of the major market makers shows a running list of its main bid and offer rates—that is, the prices at which it will buy and sell the major currencies, spot and forward and those rates are displayed to all market participants on their computer screens.

The dealer shows his prices for the base currency expressed in amounts of the terms currency.
Both dollar rates and cross-rates are shown. Although the screens are updated regularly throughout the day, the rates are only indicative to get a firm price, a trader or customer must contact the bank directly. In very active markets, quotes displayed on the screen can fail to keep up with actual market quotes.
Also, the rates on the screen are typically those available to the largest customers and major players in the interbank market for the substantial amounts that the interbank market normally trades, while other customers may be given less advantageous rates.

Trader Vs Dealing Room

A proprietary trader, on the other hand, is looking for a larger profit margin—in percentage points rather than basis points— based on a directional view about a currency, volatility, an interest rate that is about to change, a trend, or a major policy move in fact, any strategic view about an opportunity, a vulnerability, or a mispricing in a market rate.

Some dealers institutions banks and otherwise—put sizeable amounts of their own capital at risk for extended periods in
proprietary trading, and devote considerable resources to acquiring the risk analysis systems and other equipment and personnel to assist in developing and implementing such strategies.

Others are much more limited in their proprietary trading.

Forex Positions Taking

Much of the activity in trading rooms is focused on marketing services and maintaining customer relationships. Customers may include treasurers of corporations and financial institutions; managers of investment funds, pension funds, and hedge funds, and high net worth individuals. A major activity of dealer institutions is managing customer business, including giving advice, suggesting strategies and ideas, and helping to carry out transactions and approaches that a particular customer may wish to undertake.


Dealers also trade foreign exchange as part of the bank’s proprietary trading activities, where the firm’s own capital is put at risk on various strategies. Whereas market making is usually reacting or responding to other people’s requests for quotes, proprietary trading is proactive and involves taking an initiative.


Market making tends to be short-term and high volume, with traders focusing on earning a small spread from each transaction (or at least from most transactions)—with position taking limited mainly to the management of working balances and reflecting views on very short-term forces and rate movements.

THE DIFFERENT KINDS OF TRADING FUNCTIONS OF A DEALER INSTITUTION

A dealer bank or other institution is likely to be undertaking various kinds of foreign exchange trading—making markets, servicing customers, arranging proprietary transactions—and the emphasis on each will vary among institutions.

Market making is basic to foreign exchange trading in the OTC market.

The willingness of market makers to quote both bids and offers for particular currencies, to take the opposite side to either buyers or sellers of the currency, facilitates trading and contributes to liquidity and price stability, and is considered important to the smooth and effective functioning of the market. An institution may choose to serve as a market maker purely because of the profits it believes it can earn on the spreads between buying and selling prices.

But it may also see advantages in that the market-making function can broaden in an important way the range of banking services that the institution can offer to clients. In addition, it can give the market-making institution access to both market information and market liquidity that are valuable in its other activities.

Forex Equipment

The equipment and the technology are critical and expensive. For a bank with substantial trading activity, which can mean hundreds of individual traders and work stations to equip, a full renovation can cost many, many millions of dollars.

And that equipment may not last long with technology advancing rapidly, the state of the art gallops ahead, and technology becomes obsolete in a very few years.

But in a business so dependent on timing, there is a willingness to pay for something new that promises information that is distributed faster or presented more effectively, as well as for better communications, improved analytical capability, and more reliable systems with better back-up. These costs can represent a significant share of trading revenue.

TRADING ROOM SETUP

In appearance, the trading rooms of many major dealer institutions are similar in many respects.

All have rows of screens, computers, telephones, dedicated lines to customers and to brokers, electronic dealing and brokering systems, news services, analytic and informational sources, and other communications equipment.

All have various traders specializing in individual currencies and cross-currencies, in spot, forwards, swaps, and options; their specialists in offshore deposit markets and various bond markets; and their marketing groups.

There are funds managers and those responsible for proprietary transactions using the dealer’s own funds. All have their affiliated “back offices” not necessarily located nearby where separate staffs confirm transactions consummated by the traders and execute the financial payments and receipts associated with clearance and settlement.

Increasingly, there are “mid-office” personnel, checking on the validity of valuations used by the traders and other matters of risk management.

Options Combinations and Strategies

Combination of options are used among the professionals for many purposes, including taking directional views on currencies anticipating that a particular currency will move up or down as well as taking volatility views on currencies anticipating that a particular exchange rate will vary by more or by less than the market expects.

Among the options combination that are currently most widely used by traders in the OTC market are the following:

A straddle consists of one put and one call with the same expiration date, face amount, and strike price. The strike price is usually set at the forward rate or “at the money forward” (ATMF) where the delta is about 0.50.

A long straddle gains if there is higher than forecast volatility, regardless of which of the two currencies in the pair goes up and which goes down—and any potential loss is limited to the cost of the two premiums. By the same token, a short straddle gains if there is less than expected volatility, and the potential gain is limited to the premiums. Thus, a trader buys volatility by buying a straddle, and sells volatility by selling a straddle. Straddles account for the largest volume of transactions in interbank trading.

A strangle differs from a straddle in that it consists of a put and a call at different strike prices, both of which are “out of the-money,”
rather than “at-the-money.” Often the strike prices are set at 0.25 delta. It is a less aggressive position than the straddle a long strangle costs less to buy, but it requires a higher volatility (relative to market expectations of volatility) to be profitable.


A risk reversal is a directional play, rather than a volatility play. A dealer exchanges an out of themoney (OTM) put for an OTM call (or vice versa) with a counter party.
Since the OTM put and the OTM call will usually be of different values, the dealer pays or receives a premium for making the exchange. The dealer will quote the implied volatility differential at which he is prepared to a make the exchange.

“For a three-month 0.25-delta risk reversal, 0.6 at 1.4 Swiss calls over.” That means the dealer is willing to pay a net premium of 0.6 vols (above the current implied ATM volatility) to buy a 0.25-delta OTM Swiss franc call and sell a 0.25-delta OTM Swiss franc put against the dollar, and he wants to earn a net premium of 1.4 vols (above the current implied ATM premium) for the opposite transaction. The holder of a risk reversal who has sold an OTM put and bought an OTM call will gain if the call is exercised, and he will lose if the put is exercised—but unlike the holder of a long straddle or long strangle (where the maximum loss is the premium paid),on the put he has sold his potential loss is unbounded.

How Currency Options are Traded

The OTC options market has become a 24-hour market,much like the spot and forward markets, and has developed its own practices and conventions. Virtually all of the major foreign exchange dealer institutions participate as market makers and traders.

They try to stay fully abreast of developments, running global options books that they may pass from one major center to another every eight hours, moving in and out of various positions in different markets as opportunities arise. Some major dealers offer options on large numbers of currency pairs (fifty or more), and are flexible in tailoring amounts and maturities (from same day to several years ahead).

They can provide a wide array of different structures and features to meet customer wishes. A professional in the OTC interbank options market asking another professional for a quote must specify more parameters than when asking for, say, a spot quote.

The currency pair, the type of option, the strike price, the expiration date, and the face amount must be indicated. Dealers can do business with each other directly, by telephone or (increasingly) via electronic dealing system, which makes possible a two-way recorded conversation on a computer screen.

Also, they can deal through an OTC (voice) broker. Among these dealers and brokers, quotes are presented in terms of the implied volatility of the option being traded.

As in other foreign exchange markets, a market maker is expected to give both a bid the volatility at which he is prepared to buy an option of the specified features and an offer the volatility at which he is prepared to sell such an option.

For example, an interbank dealer, Jack from Bank X, might contact a market maker, Jill from Bank Z, identify himself and his institution and ask for a quote:

• w Jack: “Three month 50-delta dollar
• put/yen call on 20 dollars, please.”
• Jill: “14.50-15.”
• w Jack: “Yours at 14.50.”
• Jill: “Done. I buy European three-month
• 50-delta dollar put/yen call on 20 dollars.”

After this commitment to the trade, details (“deets”) would then be worked out and agreed upon with respect to the exact expiration date, the precise spot rate, the exact strike price, and option premium. Customarily, in trades between dealers, there would be an offsetting transaction in spot or forward trade, in the opposite direction to the option, to provide both parties with the initial delta hedge.

Note that Jack and Jill specified both currencies—“dollar put/yen call.” In foreign exchange options, since a call allowing you to buy yen for dollars at a certain price is also a put allowing you to sell dollars for yen at that price, it helps to avoid confusion if both formulations are mentioned.

Put Call Parity

“Put call parity” says that the price of a European put (or call) option can be deduced from the price of a European call (or put) option on the same currency, with the same strike price and expiration.

When the strike price is the same as the forward rate (an “at-the-money” forward), the put and the call will be equal in value.When the strike price is not the same as the forward price, the difference between the value of the put and the value of the call will equal the difference in the present values of the two currencies.


Arbitrage assures this result. If the “put call parity” relationship did not hold, it would pay to create synthetic puts or calls and gain an arbitrage profit. If, for example, an “at-the-money forward” call option were priced in the market at more than (rather than equal to) an “at-the-money forward” put option for a particular currency,a synthetic call option could be created at a cheaper price (by buying a put at the lower price and buying a forward at the market price).

Other synthetics can be produced by other combination (e.g.,buying a call and selling a forward to produce a synthetic put; buying a call and selling a put to create a synthetic long forward; or selling a call and buying a put to create a synthetic short forward).

The “put call parity” is very useful to options traders. If, for example, puts for a particular currency are being traded,but there are no market quotes for the corresponding call, traders can
deduce an approximate market price for the corresponding call.

Implied volatility is a critical factor in options pricing

In trading options in the OTC interbank market, dealers express their quotes and execute their deals in terms of implied volatility.
It is the metric, or measuring rod dealers think and trade in terms of implied volatilities and make their predictions in that framework, rather than in terms of options prices expressed in units of a currency (which can change for reasons other than volatility changes e.g., interest rates).

It is easier to compare the prices of different options, or compare changes in market prices of an option over time, by focusing on implied volatility and quoting prices in terms of volatility. (For similar reasons, traders in outright forwards deal in terms of discounts and premiums from spot, rather than in terms of actual forward exchange rates.)

Measurements Of Volatility

There are different measurements of volatility:
Historical volatility is the actual volatility, or variance, of an exchange rate that occurred during some defined past time frame. This can be used as an indication or guide to future movements in the exchange rate.

• Future volatility is the expected variance in the exchange rate over the life of the option, and must be forecast.

• Implied volatility is the variance in an exchange rate that is implied by or built into the present market price of an option—thus, it is the market’s current estimate of future movement potential as determined by supply and demand for the option in the market.

Time value is not linear

A one-year option is not valued at twice the value of a six-month option. An “at the money” option has greater time value than an “in-the-money” or “out of the money” option. Accordingly, options unlike forwards and futures have convexity; that is, the change in the value of an option for a given change in the price of the underlying asset does not remain constant.

This makes pricing options much more complex than pricing other foreign exchange instruments.
A major advance in the general theory of options pricing was introduced by Professors Black and Scholes in 1973. Their work, which was subsequently adapted for foreign exchange options, showed that under certain restrictive assumptions, the value of a European option on an underlying currency depends on six factors:

1. The spot exchange rate
2. The interest rate on the base (or underlying) currency
3. The interest rate on the terms currency
4. The strike price at which the option can be exercised
5. The time to expiration
6. The volatility of the exchange rate.

Volatility, a statistical measure of the tendency of a market price—in this case, the spot exchange rate—to vary over time, is the only one of these variables that is not known in advance, and is critically important in valuing and pricing options.

Volatility is the annualized percentage change in an exchange rate, in terms of standard deviation (which is the most widely used statistical measurement of variation about a mean). The greater the forecast volatility, the greater the expected future movement potential in the exchange rate during the life of the option—i.e., the higher the likelihood the option will move “in-the-money,” and so, the greater the value (and the cost) of the option, be it a put or a call. (With zero volatility, the option should cost nothing.)

If the one-year forward dollar-Swiss franc exchange rate is CHF 1.6000 = $1, and the volatility of a one-year European option price is forecast at 10 percent, there is implied the expectation, with a 68 percent probability, that one year hence, the exchange rate will be within CHF 1.6000 per dollar plus or minus 10 percent—that is, between CHF 1.4400 and CHF 1.7600 per dollar.

The Pricing of Currency Options

The two options markets, OTC and exchange traded, are competitors to some extent, but they also complement each other. Traders use both markets in determining the movement of prices, and are alert to any arbitrage opportunities that may develop between the two markets.
Dealers in the OTC market may buy and sell options on the organized exchanges as part of the management of their own OTC positions,hedging or laying off part of an outstanding position in an exchange market.

The Pricing of Currency Options '
It is relatively easy to determine the value of a European option at its expiration. The value of a
European option at expiration is its intrinsic value—the absolute amount by which the strike price of the option is more advantageous to the holder that the spot exchange rate.

If at expiration the strike price is more advantageous than the spot rate of the underlying, the option is “in the money”; if the difference between the strike price and the spot rate is zero, the position is “at the money”; if the strike price is less advantageous than the spot rate, the option is “out of the money.” Determining the price of an option prior to expiration, on the other hand, is much more difficult.

Before expiration, the total value of an option is based, not only on its intrinsic value (reflecting the difference between the strike price and the then current exchange rate), but also on what is called its time value, which is the additional value that the market places on the option, reflecting the time remaining to maturity, the forecast volatility of the exchange rate, and other factors.

Over The Counter Option

As a financial instrument, the option has a long history.But foreign exchange options trading first began to flourish in the 1980s, fostered by an international environment of fluctuating exchange rates, volatile markets, deregulation, and extensive financial innovation. The trading of currency options was initiated in U.S. commodity exchanges and subsequently was introduced into the over the counter market. However, options still account for only a small share of total foreign exchange trading.

An over-the-counter foreign exchange option is a bilateral contract between two parties. In contrast to the exchange traded options market (described later), in the OTC market, no clearinghouse stands between the two parties, and there is no regulatory body establishing trading rules.

Also, in contrast to the exchange traded options market, which trades in standardized contracts and amounts, for a limited number of currency pairs, and for selected maturity dates, an OTC option can be tailored to meet the special needs of an institutional investor for
particular features to satisfy its investment and hedging objectives.

But while OTC options contracts can be customized, a very large share of the OTC market consists of generic, or “plain vanilla,” options written for major currencies in standard amounts and for even dates.

OTC options are typically written for much larger amounts than exchange-traded options—an average OTC option is $30-$40 million equivalent—and a much broader range of currencies is covered. The volume of OTC options is far greater than that of exchange-traded options; indeed, the OTC market accounts for about four-fifths of the total foreign exchange options traded in the United States.

Forex Option Trading

In general, options are written either “European style,” which may be exercised only on the expiration date, or “American style,” which may be exercised at any time prior to, and including, the expiration date.
The American option is at least as valuable as the European option, since it provides the buyer with more opportunities, but is analytically more complex. American calls on the higher interest rate currency are likely to be more valuable than the equivalent European option. The bulk of trading in the OTC interbank market consists of European options, while American options are standard on some of the exchanges.

The option is one of the most basic financial instruments. All derivatives, including the various derivative financial products developed in recent years the many forms of forwards, futures, swaps, and options—are based either on forwards or on options; and forwards and options, notwithstanding their differences, are related to each other.
A forward can be created synthetically from a combination of European options: Buying a call option and selling a put option (long a call, short a put) on a currency with strike prices at the forward rate provides the same risk position as buying a forward contract on that currency.
At expiration, the payoff profiles of the forward and the synthetic forward made up of the two options would be the same: The holder would receive the same payoff whether he held the forward or the combination of two options.

OVER-THE-COUNTER FOREIGN CURRENCY OPTIONS

A foreign exchange or currency option contract gives the buyer the right, but not the obligation, to buy (or sell) a specified amount of one currency for another at a specified price on (in some cases, on or before) a specified date. Options are unique in that the right to execute will be exercised only if it is in the holder’s interest to do so.

That differs from a forward contract, in which the parties are obligated to execute the transaction on the maturity date, and it differs from a futures contract, in which the parties are obligated, in principle to transact at maturity, but that obligation easily can be and normally is bought out and liquidated before the maturity or delivery date.
A call option is the right, but not the obligation, to buy the underlying currency, and a put option is the right, but not the obligation, to sell the underlying currency.All currency option
trades involve two sides the purchase of one currency and the sale of another—so that a put to sell pounds sterling for dollars at a certain price is also a call to buy dollars for pounds sterling at that price.
The purchased currency is the call side of the trade, and the sold currency is the put side of the trade. The party who purchases the option is the holder or buyer, and the party who creates the option is the seller or writer.

The price at which the underlying currency may be bought or sold is the exercise, or strike, price. The option premium is the price of the option that the buyer pays to the writer. In exchange for paying the option premium up front, the buyer gains insurance against adverse movements in the underlying spot exchange rate while retaining the opportunity to benefit from favorable movements.

The option writer, on the other hand, is exposed to unbounded risk although the writer can (and typically does) seek to protect himself through hedging or offsetting transactions.

Purposes of Currency Swaps

The motivations for the various forms of currency swap are similar to those that generate a demand for interest rate swaps. The incentive may arise from a comparative advantage that a borrowing company has in a particular currency or capital market. It may result from a company’s desire to diversify and spread its borrowing around to different capital markets, or to shift a cash flow from foreign currencies. It may be that a company cannot gain access to a particular capital market. Or, it may reflect a move to avoid exchange controls, capital controls, or taxes. Any number of possible “market imperfections” or pricing inconsistencies provide opportunities for arbitrage.

Before currency swaps became popular,parallel loans and back-to-back loans were used by market participants to circumvent exchange controls and other impediments. Offsetting loans in two different currencies might be arranged between two parties; for example, a U.S. firm might make a dollar loan to a French firm in the United States, and the French firm would lend an equal amount to the U.S. firm or its affiliate in France. Such structures have now largely been abandoned in favor of currency swaps.

Because a currency swap, like an interest rate swap, is structurally similar to a forward, it can be seen as an exchange and re-exchange of principal plus a “portfolio of forwards”—a series of forward contracts, one covering each period of interest payment. The currency swap is part of the wave of financial derivative instruments that became popular during the 1980s and ‘90s. But currency swaps have gained only a modest share of the foreign exchange business. It has been suggested that the higher risk and related capital costs of instruments involving an exchange of principal may in part account for this result.

CURRENCY SWAPS

A currency swap is structurally different from the FX swap described above. In a typical currency swap, counter parties will:

• Exchange equal initial principal amounts of two 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, and then
• Re-exchange the principal amount at maturity at the initial spot exchange rate. Sometimes, the initial exchange of principal is omitted. Sometimes, instead of exchanging interest payments, a “difference check” is paid by one counterparty to the other to cover the net obligation.

The currency swap provides a mechanism for shifting a loan from one currency to another, or shifting the currency of an asset. It can be used, for example, to enable a company to borrow in a currency different from the currency it needs for its operations, and to receive protection from exchange rate changes with respect to the loan.

The currency swap is closely related to the interest rate swap.
There are, however, major differences in the two instruments.

An interest rate swap is an exchange of interest payment streams of differing character (e.g., fixed rate interest for floating), but in the same currency, and involves no exchange of principal. The currency swap is in concept an interest rate swap in more than one currency, and has existed since the 1960s.The interest rate swap became popular in the early 1980s; it subsequently has become an almost indispensable instrument in the financial tool box.

Forex Swaps Pricing

Pricing FX Swaps

The cost of an FX swap is determined by the interest rate differential between the two swapped currencies. Just as in the case of outright forwards, arbitrage and the principle of covered interest rate parity will operate to make the cost of an FX swap equal to the foreign exchange value of the interest rate differential between the two currencies for the period of the swap.

The cost of an FX swap is measured by swap points, or the foreign exchange equivalent of the interest rate differential between two currencies for the period. The difference between the amounts of interest that can be earned on the two currencies during the period of the swap can be calculated by formula.

The counter party who holds for the period of the swap the currency that pays the higher interest rate will pay the points, neutralizing the interest rate differential and equalizing the return on the two currencies; and the counter party who holds the currency that pays the lower interest will earn or receive the points.
At the outset, the present value of the FX swap contract is usually arranged to be zero.

The same conditions prevail with an FX swap as with an outright forward—a trader who pays the points in the forward also pays them in the FX swap; a trader who earns the points in the forward also earns them in the FX swap.

For most currencies, swap points are carried to the fourth decimal place. A dollar-swissie
swap quoted at 244-221 means that the dealer will buy the dollar forward at his spot bid rate
less 0.0244 (in Swiss francs), and sell the dollar forward at his spot offer rate less 0.0221 (in
Swiss francs), yielding an (additional) spread of 23 points (or 0.0023).

Why Forex Swaps Are Used

The popularity of Forex Swaps reflects the fact that banks and others in the dealer, or interbank, market often find it useful to shift temporarily into or out of one currency in exchange for a second currency without incurring the exchange rate risk of holding an open position or exposure in the currency that is temporarily held.

This avoids a change in currency exposure, and differs from the spot or outright forward, where the purpose is to change a currency exposure.

The use of Forex Swaps is similar to actual borrowing and lending of currencies on a collateralize basis.
Forex Swaps provide a way of using the foreign exchange markets as a funding instrument and an alternative to borrowing and lending in the Eurodollar and other offshore markets.

They are widely used by traders and other market participants for managing liquidity and shifting delivery dates, for hedging, speculation, taking positions on interest rates, and other purposes.

FX Swap Market

In the spot and outright forward markets, a fixed amount of the base currency (most often the dollar) is always traded for a variable amount of the terms currency (most often a non-dollar currency).
However, in the FX swap market, a trade for a fixed amount of either currency can be arranged.

There are two kinds of FX swaps: a buy/sell swap, which means buying the fixed, or base, currency on the near date and selling it on the far date; and a sell/buy swap, which means selling the fixed currency on the near date and buying it on the far date.
If, for example, a trader bought a fixed amount of pounds sterling spot for dollars (the exchange) and sold those pounds sterling six months forward for dollars (the re-exchange), that would be called a buy/sell sterling swap.

Forex Swaps

In the spot and outright forward markets, one currency is traded outright for another, but in the Forex swap market, one currency is swapped for another for a period of time, and then swapped back, creating an exchange and re-exchange.

An Forex swap has two separate legs settling on two different value dates, even though it is arranged as a single transaction and is recorded in the turnover statistics as a single transaction.

The two counter parties agree to exchange two currencies at a particular rate on one date (the “near date”) and to reverse payments, almost always at a different rate, on a specified subsequent date (the “far date”).
Effectively, it is a spot transaction and an outright forward transaction going in opposite directions, or else two outright forwards with different settlement dates,and going in opposite directions.
If both dates are less than one month from the deal date, it is a “short-dated swap”; if one or both dates are one month or more from the deal date, it is a “forward swap.”

The two legs of an Forex swap can, in principle, be attached to any pair of value dates. In practice, a limited number of standard maturities account for most transactions. The first leg usually occurs on the spot value date, and for about two-thirds of all Forex swaps the
second leg occurs within a week.
However, there are Forex swaps with longer maturities. Among dealers, most of these are arranged for even or straight dates e.g., one week, one month, three months but odd or broken dates are also traded for customers.

The Forex swap is a standard instrument that has long been traded in the over-the-counter market. Note that it provides for one exchange and one reexchange only, and is not a stream of payments.

The Forex swap thus differs from the interest rate swap, which provides for an exchange of a stream of interest payments in the same currency but with no exchange of principal; it also differs from the currency swap (described later), in which counterparties exchange and re-exchange principal and streams of fixed or floating interest payments in two different currencies.

Non Deliverable Forwards (NDFs)

In recent years,markets have developed for some currencies in “non-deliverable forwards.” This instrument is in concept similar to an outright forward, except that there is no physical delivery or transfer of the local currency.
Rather, the agreement calls for settlement of the net amount in dollars or other major transaction currency.
NDFs can thus be arranged offshore without the need for access to the local currency markets, and they broaden hedging opportunities against exchange rate risk in some currencies otherwise
considered unhedgeable.
Use of NDFs with respect to certain currencies in Asia and elsewhere is growing rapidly.

How Forward Rates are Quoted by Traders

Although spot rates are quoted in absolute terms say, x yen per dollar forward rates, as a matter of convenience are quoted among dealers in differentials that is, in premiums or discounts from the spot rate. The premium or discount is measured in “points,” which represent the interest rate differential between the two currencies for the period of the forward, converted into foreign exchange.
Specifically, points are the amount of foreign exchange (or basis points) that will neutralize the interest rate differential between two currencies for the applicable period. Thus, if interest rates are higher for currency A than currency B, the points will be the number of basis points to subtract from currency A’s spot exchange rate to yield a forward exchange rate that neutralizes or offsets the interest rate differential (see Box 5-2). Most forward contracts are arranged so that, at the outset, the present value of the contract is zero.

Traders in the market thus know that for any currency pair, if the base currency earns a higher interest rate than the terms currency, the base currency will trade at a forward discount,or below the spot rate; and if the base currency earns a lower interest rate than the terms currency, the base currency will trade at a forward premium, or above the spot rate.


Whichever side of the transaction the trader is on, the trader won’t gain (or lose) from both the interest rate differential and the forward premium/discount. A trader who loses on the interest rate will earn the forward premium, and viceversa.


Traders have long used rules of thumb and shortcuts for calculating whether to add or subtract the points.
Points are subtracted from the spot rate when the interest rate of the base currency is the higher one, since the base currency should trade at a forward discount; points are added when the interest rate of the base currency is the lower one, since the base currency should trade at a forward premium.Another rule of thumb is that the points must be added when the small number comes first in the quote of the differential, but subtracted when the larger number comes first.


For example,the spot CHF might be quoted at “1.5020- 30,” and the 3-month forward at “40-60” (to be added) or “60-40” (to be subtracted). Also, the spread will always grow larger when shifting from the spot quote to the forward quote. Screens now show positive and negative signs in front of points,making the process easier still.

Role of the Offshore Deposit Markets

Role of the Offshore Deposit Markets for Euro/Dollars and Other Currencies Forward contracts have existed in commodity markets for hundreds of years.

In the foreign exchange markets, forward contracts have been traded since the nineteenth century, and the concept of interest arbitrage has been understood and described in economic literature for a long time.

But it was the development of the offshore Euro currency deposit markets the markets for offshore deposits in dollars and other major currencies in the 1950s and ‘60s that facilitated and refined the process of interest rate arbitrage in practice and brought it to its present high degree of efficiency, closely linking the foreign exchange market and the money markets of the major nations, and equalizing returns through the two channels.

With large and liquid offshore deposit markets in operation, and with information transfers greatly improved and accelerated, it became much easier and quicker to detect any significant deviations from covered interest rate parity, and to take advantage of any such arbitrage
opportunities.

From the outset, deposits in these offshore markets were generally free of taxes, reserve requirements, and other government restrictions. The offshore deposit markets in London and elsewhere quickly became very convenient for, and closely attached to, the foreign exchange market.
These offshore Euro currency markets for the dollar and other major currencies were, from the outset, handled by the banks’ foreign exchange trading desks, and many of the same business practices were adopted.
These deposits trade over the telephone like foreign exchange, with a bid/offer spread, and they have similar settlement dates and other trading conventions. Many of the same counter parties participate in both markets, and credit risks are similar.
It is thus no surprise that the interest rates in the offshore deposit market in London came to be used for interest parity and arbitrage calculations and operations.
Dealers keep a very close eye on the interest rates in the London market when quoting forward rates for the major currencies in the foreign exchange market. For currencies not traded in the offshore Euro currency deposit markets in London and elsewhere, deposits in domestic money markets may provide a channel for arbitraging the forward exchange rate and interest rate
differentials.

Relationship of Forward to Spot Covered

Interest Rate Parity

The forward rate for any two currencies is a function of their spot rate and the interest rate differential between them. For major currencies, the interest rate differential is determined in the Euro currency deposit market.Under the covered interest rate parity principle, and with the opportunity of arbitrage, the forward rate will tend toward an equilibrium point at which any difference in Euro currency interest rates between the two currencies would be exactly offset, or neutralized, by a premium or discount in the forward rate.

If, for example, six-month Euro-dollar deposits pay interest of 5 percent per year, and six-month Euro-yen deposits pay interest of 3 percent per year, and if there is no premium or discount on the forward yen against the forward dollar, there would be an opportunity for “round-tripping” and an arbitrage profit with no exchange risk.

Thus, it would pay to borrow yen at 3 percent, sell the yen spot for dollars and simultaneously resell dollars forward for yen six months hence, meanwhile investing the dollars at the higher interest rate of 5 percent for the six-month period. This arbitrage opportunity would tend to drive up the forward exchange rate of the yen relative to the dollar (or force some other adjustment) until there were an equal return on the two investments after taking into account the cost of covering the forward exchange risk.

Similarly, if short-term dollar investments and short-term yen investments both paid the same interest rate, and if there were a premium on the forward yen against the forward dollar, there would once again be an opportunity for an arbitrage profit with no exchange risk, which again would tend to reduce the premium on the forward yen (or force some other adjustment) until there were an equal return on the two investments after covering the cost of the forward exchange risk.

In this state of equilibrium, or condition of covered interest rate parity, an investor (or a borrower) who operates in the forward exchange market will realize the same domestic return (or pay the same domestic cost) whether investing (borrowing) in his domestic currency or in a foreign currency, net of the costs of forward exchange rate cover. The forward exchange rate should offset, or neutralize, the interest rate differential between the two currencies.

OUTRIGHT FORWARDS

An outright forward transaction, like a spot transaction, is a straightforward single purchase/ sale of one currency for another. The only difference is that spot is settled, or delivered, on a value date no later than two business days after the deal date, while outright forward is settled on any pre-agreed date three or more business days after the deal date. Dealers use the term “outright forward” to make clear that it is a single purchase or sale on a future date, and not part of an “FX swap” (described later).

There is a specific exchange rate for each forward maturity of a currency, almost always different from the spot rate. The exchange rate at which the outright forward transaction is executed is fixed at the outset. No money necessarily changes hands until the transaction actually takes place, although dealers may require some customers to provide collateral in advance.

Outright forwards can be used for a variety of purposes—covering a known future expenditure, hedging, speculating, or any number of commercial, financial, or investment purposes.

The instrument is very flexible, and forward transactions can be tailored and customized to meet the particular needs of a customer with respect to currency, amount,and maturity date.Of course, customized forward contracts for nonstandard dates or amounts are generally more costly and less liquid, and more difficult to reverse or modify in the event of need than are standard forward contracts. Also, forward contracts for minor currencies and exotic currencies can be more difficult to arrange and more costly.

Cross Rate Trading Cross rates

Rates in which the dollar is neither the base nor the terms currency, such as “mark-yen,” in which the DEM is the base currency; and “sterling-mark,” in which the pound sterling is the base currency.


In cross trades, either currency can be made the base, although there are standard pairs mark-yen, sterling-swissie, etc.As usual, the base currency is mentioned first.


There are both derived cross rates and directly traded cross rates. Historically, cross rates were derived from the dollar rates of the two named currencies, even if the transaction was not actually channeled through the dollar.

Thus, a cross rate for sterling-yen would be derived from the sterling dollar and dollar-yen rates. That continues to be the practice for many currency pairs, as described in Box 5.1, but for other pairs, viable markets have developed and direct trading sets the cross rates, within the boundary rates established by the derived cross rate calculations.

Bid And Offer Quotes

Quotes Are in Basis Points For most currencies, bid and offer quotes are presented to the fourth decimal place—that is, to one-hundredth of one percent, or 1/10,000th of the terms currency unit, usually called a “pip.”
However, for a few currency units that are relatively small in absolute value, such as the Japanese yen and the Italian lira, quotes may be carried to two decimal places and a “pip” is 1/100 of the terms currency unit.
In any market, a “pip” or a “tick” is the smallest amount by which a price can move in that market, and in the foreign exchange market “pip” is the term commonly used.

Base Currency Traders

Bids and Offers Are for the Base Currency Traders always think in terms of how much it costs to buy or sell the base currency.
A market maker’s quotes are always presented from the market maker’s point of view,so the bid price is the amount of terms currency that the market maker will pay for a unit of the base currency; the offer price is the amount of terms currency the market maker will charge for a unit of the base currency.

A market maker asked for a quote on “dollar-swissie” might respond “1.4975-85,” indicating a bid price of CHF 1.4975 per dollar and an offer price of CHF 1.4985 per dollar. Usually the market maker will simply give the quote as “75-85,” and assume that the counterparty knows that the “big figure” is 1.49.

The bid price always is offered first (the number on the left), and is lower (a smaller amount of terms currency) than the offer price (the larger number on the right).This differential is the dealer’s spread.

Base Currency And Terms Currency

There Is a Base Currency and a Terms Currency Every foreign exchange transaction involves two currencies—and it is important to keep straight which is the base currency (or quoted, underlying, or fixed currency) and which is the terms currency (or counter currency).
A trader always buys or sells a fixed amount of the “base” currency—as noted above, most often the dollar—and adjusts the amount of the “terms” currency as the exchange rate changes.

The terms currency is thus 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.

In oral communications, the base currency is always stated first.


For example, a quotation for “dollar-yen”means the dollar is the base and the denominator, and the yen is the terms currency and the numerator; “dollar-swissie” means that the Swiss franc is the terms currency; and “sterling-dollar” (usually called “cable”) means that the dollar is the terms currency. Currency codes are also used to denote currency pairs, with the base currency usually presented first, followed by an oblique. Thus “dollar-yen” is USD/JPY; “dollar-Swissie” is USD/CHF; and “sterling-dollar” is GBP/USD.

Forex Expectations

There are still exceptions to this general rule

In particular, in all OTC markets around the world, the pound sterling continues to be quoted as the base currency against the dollar and other currencies. Thus, market makers and brokers everywhere quote the pound sterling at x dollars and cents per pound, or y DEM per pound, and so forth. The United Kingdom did not adopt a decimal currency system until 1971, and it was much easier mathematically to quote and trade in terms of variable amounts of foreign currency per pound than the other way around.

Certain currencies historically linked to the British pound—the Irish, Australian, and New Zealand currencies—are quoted in the OTC market in the same way as the pound: variable amounts of dollars and cents per unit.

The SDR and the ECU, composite currency units of the IMF and the European Monetary Union, also are quoted in dollars and cents per SDR or ECU. Similarly, it is expected that the euro will be quoted in dollars and cents per euro, at least among dealers. But all other currencies traded in the OTC market are quoted in variable amounts of foreign currency per one dollar.

How Spot Rates are Quoted

There is a Buying Price and a Selling Price In the foreign exchange market there are always two prices for every currency—one price at which sellers of that currency want to sell, and another price at which buyers want to buy.

A market maker is expected to quote simultaneously for his customers both a price at which he is willing to sell and a price at which he is willing to buy standard amounts of any currency for which he is making a market.

How Spot Rates are Quoted: Direct and Indirect Quotes, European and American Terms Exchange rate quotes, as the price of one currency in terms of another, come in two forms: a “direct” quotation is the amount of domestic currency (dollars and cents if you are in the United States) per unit of foreign currency and an “indirect” quotation is the amount of foreign currency per unit of domestic currency (per dollar if you are in the United States).

The phrase “American terms”means a direct quote from the point of view of someone located in the United States. For the dollar, that means that the rate is quoted in variable amounts of U.S. dollars and cents per one unit of foreign currency (e.g., $0.5774 per DEM1).
The phrase “European terms”means a direct quote from the point of view of someone located in Europe. For the dollar, that means variable amounts of foreign currency per one U.S. dollar (or DEM 1.7320 per $1).

In daily life,most prices are quoted “directly,” so when you go to the store you pay x dollars and y cents for one loaf (unit) of bread. For many years, all dollar exchange rates also were quoted directly. That meant dollar exchange rates were quoted in European terms in Europe, and in American terms in the United States.

However, in 1978, as the foreign exchange market was integrating into a single global market, for convenience, the practice in the U.S. market was changed—at the initiative of the brokers community—to conform to the European convention.

Thus, OTC markets in all countries now quote dollars in European terms against nearly all other currencies (amounts of foreign currency per $1). That means that the dollar is nearly always the base currency,one unit of which (one dollar) is being bought or sold for a variable amount of a foreign currency.