Foreign Exchange. 19 September 2012

Transcription

1 Foreign Exchange The foreign exchange market Spot exchange rates How spot rates are quoted Reciprocal rates Some terminology Profit and loss Position-keeping Dealing and broking Market-making Broking Electronic trading and broking Dealing terminology Cross-rates Forward exchange rates Forward outrights Forward swaps Discounts and premiums A forward swap position Historic rate rollovers Cross-rate forwards Outrights Swaps Short dates Summary of calculation methods Hedging a forward with deposits Disadvantages Covered interest arbitrage Summary of uses of forward FX instruments Hedging Speculation Arbitrage Precious metals Pricing Physical delivery v book-entry The gold fix Borrowing gold and forward transactions Revision exercises Answers All material in this training documentation is copyright of Markets International Ltd, Aylworth, Naunton, Cheltenham, Glos GL54 3AH, United Kingdom. No reproduction, in whole or part, by any means, is permitted without express permission in writing from Markets International Ltd.

2 2 Foreign Exchange - Part 1 Markets International Ltd. ACI Dealing Certificate

3 The foreign exchange market Foreign Exchange - Part 1 3 Throughout this chapter, we have generally used ISO codes (also used by the SWIFT system) to abbreviate currency names. For the Dealing Certificate exam, you should recognise the codes for the currencies of the following countries, affiliated to the ACI: ACI Dealing Certificate Markets International Ltd

4 4 Foreign Exchange - Part 1 Country Currency Code Argentina Peso ARS Australia Dollar AUD Austria Euro EUR Bahamas Dollar BSD Bahrain Dinar BHD Belgium Euro EUR Bermuda Dollar BMD Brazil Real BRL Bulgaria Lev BGN Canada Dollar CAD China Renmimbi yuan CNY Croatia Kuna HRK Cyprus Euro EUR Czech Republic Koruna CZK Denmark Krone DKK Egypt Pound EGP Finland Euro EUR France Euro EUR Georgia Lari GEL Germany Euro EUR Great Britain & Pound GBP Channel Islands Greece Euro EUR Hong Kong Dollar HKD Hungary Forint HUF Iceland Krona ISK India Rupee INR Indonesia Rupiah IDR Irish Republic Euro EUR Israel Shekel ILS Italy Euro EUR Japan Yen JPY Jordan Dinar JOD Kenya Shilling KES Korea (South) Won KRW Kuwait Dinar KWD Lebanon Pound LBP Luxembourg Euro EUR Country Currency Code Macao Pataca MOP Macedonia Denar MKD Malaysia Ringgitt MYR Malta Euro EUR Mauritius Rupee MUR Mexico Peso Nuevo MXN Monaco Euro EUR Mongolia Tugrik MNT Netherlands Euro EUR New Zealand Dollar NZD Nigeria Naira NGN Norway Krone NOK Pakistan Rupee PKR Panama Balboa PAB Philippines Peso PHP Poland Zloty PLN Portugal Euro EUR Romania Leu ROL Russia Ruble RUB Singapore Dollar SGD Serbia Dinar RSD Slovakia Euro EUR Slovenia Euro EUR South Africa Rand ZAR Spain Euro EUR Sri Lanka Rupee LKR Sweden Krona SEK Switzerland Franc CHF Tanzania Shilling TZS Thailand Baht THB Tunisia Dinar TND United Arab Dirham AED Emirates USA US dollar USD Zambia Kwacha ZMK Markets International Ltd. ACI Dealing Certificate

5 Foreign Exchange 5 Base currency and variable currency A convention has also been used that for example, the exchange rate between USD and JPY is written as 'USD/JPY' if it refers to the number of JPY equal to 1 USD and 'JPY/USD' if it refers to the number of USD equal to 1 JPY. The currency code written on the left is the 'base' currency; there is always 1 of the base unit. The currency code written on the right is the 'variable' currency (or 'counter' currency or 'quoted' currency); the number of units of this currency equal to 1 of the base currency varies according to the exchange rate. Although some people do use the precisely opposite convention, the one we use here is the more common one and is the convention used in the ACI exam. Key point We always write the base currency on the left. NOK/SGD, for example, means the number of SGD per NOK Example 1 The CHF/DKK exchange rate is If I buy CHF 1 million against DKK, how many DKK do I pay? The number means the number of DKK per CHF. I therefore pay DKK 4,123,500: 1,000,000 x = 4,123, 500 If instead I buy DKK 1 million, how many CHF do I pay? In this case, it is CHF 242,512.43: 1,000, = 242, ACI Dealing Certificate Markets International Ltd

6 6 Foreign Exchange Spot exchange rates The basic transaction in the foreign exchange market is a spot deal. As we discussed in the Money Markets chapter, a 'spot' transaction is an outright purchase or sale of one currency for another currency, for delivery two working days after the dealing date (the date on which the contract is made). This allows time for the necessary paperwork and cash transfers to be arranged. Key point Spot is value two working days after trade date There are however some exceptions. For example, a price for USD/CAD without qualification generally implies delivery on the next working day after the dealing day. This is referred to as 'funds'. A 'spot' price (value two working days after the dealing day, as usual) can generally be requested as an alternative. Key point USD/CAD is usually traded for value next day ( funds ) Another problem arises in trading Middle East currencies where the relevant markets are closed on Friday but open on Saturday or Sunday. A USD/AED spot deal on Wednesday would need to have a split settlement date: the USD would be settled on Friday, but the AED on Saturday. If the spot date falls on a public holiday in one or both of the centres of the two currencies involved, the following working day is taken as the spot value date. If the intervening day (between today and spot) is a holiday in one of the two centres, the spot value date is often also delayed by one day. Example 2 If a spot GBP/USD deal is transacted on Thursday 31 August, it would normally be for value Monday 4 September. If this date is a holiday in the UK however, it would normally be for value Tuesday 5 September. Markets International Ltd. ACI Dealing Certificate

7 Foreign Exchange 7 How spot rates are quoted When quoting against the EUR, it is the practice in the interbank market to quote most currencies in terms a varying number of units of currency per 1 EUR. In other words, the EUR is, by convention, always the base currency if it is one of the two currencies involved. Similarly, apart from the EUR, it is the interbank convention to quote all currencies against GBP using GBP as the base currency. Apart from the EUR and GBP, currencies quoted against the AUD and NZD use the AUD and NZD as the base. Again, apart from the EUR, GBP, AUD and NZD, all rates against the USD are always quoted interbank with the USD as the base currency. Next in this hierarchy probably comes the CHF, which in most (but not all) markets is quoted as the base currency against anything other than the EUR, GBP, AUD, NZD and USD. In the currency futures markets, as opposed to the interbank market, quotations against the USD usually have USD as the variable currency. Although dealing is possible between any two convertible currencies - for example, NZD against EUR or CHF against JPY - the interbank market has historically quoted mostly against USD, so reducing the number of individual rates that needed to be quoted. The exchange rate between any two non-usd currencies could then be calculated from the rate for each currency against USD. A rate between any two currencies, neither of which is the USD, has historically been known as a cross-rate. Nowadays, the term crossrate is also used more widely to mean any exchange rate calculated from two other rates - so, for example, a GBP/SEK rate could be calculated by combining a EUR/GBP rate and a EUR/SEK rate. Key point A cross-rate is an exchange rate calculated by combining two other rates (historically, a non-usd rate calculated by combining two USD-based rates). ACI Dealing Certificate Markets International Ltd

8 8 Foreign Exchange The non-usd rates (for example EUR/GBP, EUR/JPY, EUR/CHF) have increasingly been traded between banks in addition to the USDbased rates. This sometimes reflects the importance of the relationship between the pair of currencies. The economic relationship between CHF and EUR, for example, is closer than the relationship between CHF and USD. It is therefore more true nowadays to say that the USD/CHF exchange rate is a function of the EUR/USD rate and the EUR/CHF rate, rather than that the EUR/CHF rate is a function of the EUR/USD rate and the USD/CHF rate. The principle of calculating cross-rates remains the same however. As in other markets, a bank normally quotes a two-way price, whereby it indicates at what level it is prepared to buy the base currency against the variable currency (the 'bid' for the base currency - a cheaper rate), and at what level it is prepared to sell the base currency against the variable currency (the 'offer' of the base currency - a more expensive rate). Example 3 If a bank is prepared to buy USD for Swiss francs, and sell USD for Swiss francs, the USD/CHF rate would be quoted as: / The quoting bank buys the base currency (in this case USD) on the left and sells the base currency on the right. If the bank quotes such a rate to a company or other counterparty, the counterparty would sell the base currency on the left, and buy the base currency on the right - the opposite of how the bank itself sees the deal. In the money market, the order of quotation is not important and it does differ between markets. From a quotation of either '5.80% / 5.85%' or '5.85% / 5.80%', it is always clear to the customer that the higher rate is the offered rate and the lower rate is the bid rate. In foreign exchange however, the market-maker's bid for the base currency (the lower number in a spot price) is always on the left. This is particularly important in forward prices. Markets International Ltd. ACI Dealing Certificate

9 Foreign Exchange 9 The difference between the two sides of the quotation is known as the 'spread'. Historically, a two-way price in a cross-rate would have a wider spread than a two-way price in a USD-based rate, because the cross-rate constructed from the USD-based rates would combine both the spreads. Now however, the spread in say a EUR/CHF price might typically be proportionally narrower than a USD/CHF spread, because it is more the EUR/CHF price that is 'driving' the market, as noted above, rather than the USD/CHF price. Key point The bid is the price on the left, at which the quoting bank buys the base currency. The offer is the price on the right, at which the quoting bank sells the base currency. The spread is the difference between the bid and the offer. In some markets, there is a convention to adjust exchange rates to a number which that market considers more user-friendly. For example, if the CHF/DKK exchange rate is , it would be quoted in the London market as but might be quoted in the Copenhagen market as i.e. as the number of DKK equal to 100 CHF rather than 1 CHF. Similarly, a JPY/CHF rate of might be quoted in some markets as Exercises 1 The SGD/NOK exchange rate is quoted as Does this exchange rate express the number of Norwegian kroner equal to 1 Singapore dollar, or the number of Singapore dollars equal to one Norwegian krone? See Answers at the end of this chapter Reciprocal rates Any quotation with a particular currency as the base currency can be converted into the equivalent quotation with that currency as the variable currency by taking its reciprocal. ACI Dealing Certificate Markets International Ltd

10 10 Foreign Exchange Example 4 A USD/CHF quotation of / can be converted to a CHF/USD quotation of (1 : ) / (1 : ). However, this would still be quoted with a smaller number on the left, so that the two sides of the quotation are reversed: / In either case, the bank buys the base currency against the variable currency on the left, and sells the base currency against the variable currency on the right. Exercises 2 The SEK/NOK exchange rate is / 28. What is the reciprocal rate? See Answers at the end of this chapter Some terminology Rates are typically quoted to 1 th of a cent etc. (known as a 'point' or 100 a 'pip'). For example the USD/CHF rate would usually be quoted to four decimal places as ' / '. This depends on the size of the number however and in the case of USD/JPY for example, the convention is to use 2 decimal places. In a USD/JPY quote of ' / ' for example, '15 points' means 0.15 JPY. In both cases, one point is thus one unit of the last decimal place quoted. Example 5 When trading USD/CHF in an amount of USD 1 million, the value of one point is CHF 100. In other words, CHF 100 is the size of the profit or loss made on the deal if the exchange rate moves one point: 1,000,000 x CHF = CHF 100 The points quoted generally mean the final two digits of the number. All the digits before these last two digits are known as the big figure. As the big figure does not change in the short term, dealers generally do not quote it when dealing in the interbank market. In the example above ( / ) the quotation would therefore be given as simply as the points: '75 / 85'. However when dealers are quoting a rate to a corporate client they will often mention the big figure also. In this case, the quotation would be ' / 85'. One big figure means 100 points, so that if the rate moves from to , it is said to have moved by one big figure. Markets International Ltd. ACI Dealing Certificate

11 Foreign Exchange 11 Key point A point is one unit of the last decimal place in the exchange rate. Exchange rates are typically quoted in points or pips, usually the last two decimal places. The big figure is the first part of the exchange rate, excluding the points. A change in the rate of one big figure generally means a change of 100 points. A long position is a surplus of purchases over sales of a given currency - i.e., a position which benefits from a strengthening of that currency. Similarly, a short position is a surplus of sales over purchases of a given currency, which benefits from a weakening of that currency. A square position is one which is neither long nor short - i.e. one in which the sales and purchases are equal. A yard of a currency is an American billion units of that currency (i.e. 1,000,000,000 units). Cable is a nickname for the GBP/USD exchange rate. If one party asks another for a two-way price and then chooses to deal on the bid side of the price, he is said to hit the bid. If he chooses to deal on the offer side of the price, he is said to lift the offer. Occasionally a dealer will narrow the bid / offer spread to zero - i.e. he will quote a single price and the party asking for the price can choose whether he will buy or sell at that price. This is known as a choice price. Profit and loss To earn profit from dealing, the bank's objective is clearly to sell the base currency at the highest rate it can against the variable currency and buy the base currency at the lowest rate. ACI Dealing Certificate Markets International Ltd

12 12 Foreign Exchange Example 6 Deal 1: Bank buys USD 1,000,000 against CHF at Deal 2: Bank sells USD 1,000,000 against CHF at Cashflows USD CHF Deal 1: + USD 1,000,000 - CHF 1,483,000 Deal 2: - USD 1,000,000 + CHF 1,485,500 Net result: + CHF 2,500 The value of a single point depends on the number of decimal places in the exchange rate. Example 7 I buy USD 1 million against CHF when spot USD/CHF is Later in the day, I close my position by selling USD 1 million again when spot USD/CHF is I thus have a profit of 1 point. Cashflows USD CHF Deal 1: + USD 1,000,000 - CHF 1,583,500 Deal 2: - USD 1,000,000 + CHF 1,583,600 Net result: + CHF 100 Therefore the value of 1 point in USD/CHF, on a deal of USD 1 million, is CHF 100. Example 8 I buy USD 1 million against JPY when spot USD/JPY is Later in the day, I close my position by selling USD 1 million again when spot USD/JPY is I thus have a profit of 1 point. Cashflows USD JPY Deal 1: + USD 1,000,000 - JPY 118,350,000 Deal 2: - USD 1,000,000 + JPY 118,360,000 Net result: + JPY 10,000 Therefore the value of 1 point in USD/JPY, on a deal of USD 1 million, is JPY Markets International Ltd. ACI Dealing Certificate

13 Foreign Exchange 13 Dealers generally operate on the basis of small percentage profits but large turnover. These rates will be good for large, round amounts. For very large amounts, or for smaller amounts, a bank would normally quote a wider spread. The amount for which a quotation is 'good' (that is, a valid quote on which the dealer will deal) will vary with the currency concerned and market conditions. Quoting a rate When a dealer is asked for a quote, and he particularly wishes to buy or sell himself, he will tend to adjust the price he is quoting, slightly up or down from the prevailing market rate, in order to try to achieve his desired result. For example if I wish to buy, then I might raise my bid slightly. Then if the counterparty asking me for a price is a seller, he will be attracted by my bid price rather than anyone else s and sell to me (which is what I want). At the same time, I might also raise my offer slightly, because I do not wish him to lift my offer, because I do not wish to sell. The result is that both my bid and my offer might be slightly higher than the rates being quoted generally in the market. Position-keeping At any time, a dealer needs to know what is his position resulting from the net of all the deals he has undertaken during the day so far. He also needs to know what is the average exchange rate of this net position, so that he can compare it with the current market rate to see whether or not the position is profitable. At the end of the day, he might not close out the position, but will in that case need to mark to market the position - i.e. calculate the unrealised profit or loss on the position so far. This is achieved by calculating what the profit or loss would be if he did in fact close out the position out at the current rate (i.e. the end-of-day closing market rate). ACI Dealing Certificate Markets International Ltd

14 14 Foreign Exchange Example 9 You undertake three spot deals in USD/CHF as follows. Sell USD 4 million at Buy USD 1 million at Buy USD 5 million at The market closes at What is your position? What is the average rate of this position? What is your net profit or loss? USD CHF - 4,000,000 at : + 6,689, ,000,000 at : - 1,673, ,000,000 at : - 8,364,500 Position: + 2,000,000-3,348,500 Average rate: 3,348,500 = ,000,000-2,000,000 at : + 3,346,000 Loss: - 2,500 The position is therefore long USD 2 million. The average rate is The loss is CHF 2,500. This loss could be expressed in USD by converting it into USD at the spot rate, or in any other currency by converting it at the appropriate spot rate. Exercise 3 You are short EUR/CHF and need to square your position. On which of the following prices quoted to you will you deal? a / 30 b / 25 c / 35 d / 28 Markets International Ltd. ACI Dealing Certificate

15 Foreign Exchange 15 4 You are a dealer with a short position in USD against EUR. A counterparty calls you for a price in EUR/USD. The market is currently / 08. Which of the following prices might you quote if you now wish to reduce the size of your position? a / 07 b / 08 c / 09 5 If the spot AUD/USD exchange rate is quoted as , what is the value of 1 point on a deal of 1 million of the base currency? If the spot USD/JPY exchange rate is quoted as , what is the cash value of 1 point on a deal of 1 million of the base currency? 6 Spot EUR/CHF is quoted to as / 23. You buy CHF 3,000,000. How many EUR do you sell? 7 You buy USD 10 million against CAD at and sell USD 10 million at What is your profit or loss in CAD? 8 You are a dealer. A customer asks you for a CHF/USD price. You quote him / 38 and he buys CHF 5 million from you. You want to cover this position in the market and therefore deal on a price of USD/CHF / 88 quoted to you by another bank, for exactly the same amount of CHF 5 million. What profit or loss in USD have you made? 9 You sell EUR 5 million against USD at , you buy EUR 2 million at , you buy EUR 4 million at and you sell EUR 3 million at The market closes at and the closing rate for GBP/USD is At the end of the day, what is your EUR/USD position? What is the average rate of this position? What is your total net profit or loss in GBP? See Answers at the end of this chapter ACI Dealing Certificate Markets International Ltd

16 16 Foreign Exchange Dealing and broking Market-making In any market, a market-maker is a dealer who sets out to make a market in some instrument or commodity - that is, he will quote a two-way price in it, if asked to do so by someone else who wants to buy or sell (or borrow or lend). In some markets, market-makers are officially designated as such by the relevant authorities and are obliged to make two-way prices at all times. This is not the case in the foreign exchange markets. A dealer who considers himself a market-maker in, say, GBP/USD, will try to quote a two-way GBP/USD price all the time, but he might occasionally choose not to quote or to quote only a bid or only an offer. As well as giving quotes, a market-maker also asks other banks for quotes. The market-maker seeks to make a profit from the bid/offer spread that he quotes. If he quotes the same two-way price to two different customers, and each customer deals for the same amount but on a different side of the price, the market-maker profits by the spread. In practice of course, customers will not be paired tidily like this but, over time, the market maker nevertheless hopes to earn a profit in this way on average. By providing prices to the market, the market-maker hopes that many counterparties will deal with him, thereby providing him in return with information on who is buying and who is selling. These information flows help the market-maker to decide on the likely direction of the market, which in turn helps him in his position-taking. Being ready to quote prices also helps the bank in maintaining its relationships generally with its counterparties. The risk of course is that the market moves against him after a customer has dealt. The market-maker could remove that risk by always covering his own resulting position immediately. However, if he did that, he would make no profit because he would be dealing at a similar price with another bank. Also, it might not be possible for the market-maker to cover the position quickly enough, before the market has moved against him, so that he actually makes a loss, rather then just breaks even. Markets International Ltd. ACI Dealing Certificate

17 Foreign Exchange 17 It might also be the case that the position given to the market-maker by the customer is one which the market-make likes, so that he seeks to make profit by running the position for a time. The risk here of course, as always with a speculative position, is that the marketmaker might be wrong in his view of the market. Note that in all this, the customer might himself also be a bank, and possibly a market-maker. He is considered the customer here because he is the one asking for the price, rather than the one quoting it. He is the price-taker, rather than the price-maker. This party, which deals at another bank s price, is known as the aggressor. Broking A deal is undertaken between two counterparties. Each counterparty then has a position and is known as a principal in the transaction. It is possible that the deal is arranged through a third party agent, known as a broker. In the foreign exchange and money markets, a broker is a name-passing broker. This means that he is never a principal himself in the chain of transactions, but only passes the names of the two counterparties (the principals) to each other. The function of a broker is to aid the process of price discovery in the market, to disseminate these prices, and to match buyers with sellers. Market-makers keep the broker aware of their bid/offer prices. When a customer calls the broker, he will select the best bid currently given to him by a market-maker, and also the best offer currently given to him by a market-maker, and pass this resulting bid/offer to the customer. If the customer deals on one side or the other, the broker immediately tells whichever market-maker gave him that price. That market-maker has now dealt with the customer. The broker is only acting as a go-between in this - at no point in the process is he acting as principal himself. In return for this service, the dealing parties pays the broker a commission ( brokerage ) for each deal transacted. Until the deal has been finalised, the broker maintains confidentiality. He does not pass the name of either party to the other until he is satisfied that they intend to deal, subject to each having a sufficient credit line for the other. ACI Dealing Certificate Markets International Ltd

18 18 Foreign Exchange In some markets other than those we are discussing here (for example in the futures markets), the term broker applies to someone who does take a position as principal, at least for a short time. Electronic trading and broking We have so far been implying that the market-maker, the broker and the customer are all speaking to each other, probably by telephone. The broker in such a situation is known as a voice-broker. Increasingly however, dealing and broking is carried out electronically. An electronic broker, such as EBS, is a computer system into which market-makers feed prices. The system disseminates the best bid and offer prices to users in the same way that a voice-broker does. Counterparties who have access to the system are able to deal on these prices. The identity of each of the counterparties is not revealed to the other until the deal is done. The system requires information regarding the credit lines that each of the participants has for each of the others. With voice brokers, in both FX and deposit transactions, it is typical for each party to pay brokerage to the broker, at a rate which has been negotiated individually for all such business between that bank and the broker. With Reuters and EBS, it is only the aggressor who pays the brokerage. An automated trading system (ATS) is similarly an electronic system through which dealers can communicate with each other, as an alternative to dealing over the telephone. This is often a dedicated system belonging to a particular bank, for dealing with its own customers. An on-line trading system such as FXall is an ATS allowing end-users the ability to deal via the internet with any of a group of participating banks. Markets International Ltd. ACI Dealing Certificate

19 Foreign Exchange 19 Dealing terminology The following remarks all relate to the spot foreign exchange market. We have included a similar section at the end of the Money Markets chapter. Where the terminology is the same in the two areas, we have repeated it. In all the following situations, the customer is the party initiating the conversation - i.e. the party asking the other party to quote a price for a foreign exchange deal. This customer might be another bank, or a corporate or other organisation. The two parties might be dealing via a broker. Unless otherwise specified, there is a general understanding in the market that the parties are discussing buying and selling the base currency (rather then the variable currency) and that amounts are in millions. For example, I buy five would mean I buy 5 million of the base currency and sell an amount of the variable currency in exchange. If the quoting dealer says I bid or I pay, he means that he would like to buy the base currency at a certain price. If the quoting dealer says I offer at, he means that he would like to sell the base currency at a certain price If the quoting dealer says Either way, Choice or Your choice, he means that he is quoting the same price for both bid and offer. Firm or Firm price means that the price quoted is valid and can be traded on. For indication, Indication, For information or For level however means that the quote given is only indicative and should be confirmed before a trade is proposed. If the broker says that a quote is under reference, he means that the rate quoted might no longer be valid and must be confirmed before any trades can be agreed. ACI Dealing Certificate Markets International Ltd

20 20 Foreign Exchange If the quoting dealer says Your risk, he is warning the other party (the broker or the customer) that the price may have to be re-quoted. If the broker or the customer says My risk, he is acknowledging that the price may have to be re-quoted. If the quoting dealer says Off, he is cancelling any existing bids or offers he has quoted, with immediate effect. If the quoting dealer says Checking, he means that he is checking that he has a credit line available for the customer before he can agree the deal. If the customer or the broker says Mine or I buy or I take, this means that he accepts the other party s quote and wishes to buy the base currency at the offered rate for the amount proposed. For example if one dealer wishes to buy USD 5 million from another who is quoting him a USD/CHF price, he will say "5 mine"; this means "I wish to buy from you 5 million of the base currency and sell the other currency, at your offered price". Similarly, if he wishes to sell USD 5 million, he will say "5 yours", meaning "I wish to sell you 5 million of the base currency and buy the other currency, at your bid price". Key point 5 mine said by the price-taker means he wishes to buy 5 million units of the base currency. 5 yours means he wishes to sell 5 million units of the base currency. If the customer or the broker says Yours or I sell or I give, this means that he accepts the quote and wishes to sell the base currency at the bid rate for the amount proposed. Similarly, Given means that a deal has been proposed and agreed at the bid price quoted, and Taken means that a deal has been proposed and agreed at the offered price quoted. Done means that the deal is agreed as proposed. Markets International Ltd. ACI Dealing Certificate

21 Foreign Exchange 21 Cross-rates As mentioned earlier, if the EUR is involved in an exchange rate, it is generally the base currency. Apart from that, if GBP, the AUD, NZD or USD are involved, they would generally be base currency. In other cases, there is not a universal convention for which way round to quote a cross-rate - that is, which is the base currency and which the variable currency. If a rate between CHF and NOK is requested 'in NOK terms' for example, this would generally mean that NOK is the base and CHF the variable. Example 10 Suppose that we need to quote to a counterparty a spot rate between the Canadian dollar and the Singapore dollar, and that our bank does not have a CAD/SGD trading book. The rate must therefore be constructed from the prices quoted by our bank's USD/CAD dealer and our bank's USD/SGD dealer as follows: Spot USD/CAD: / Spot USD/SGD: / Consider first the left side of the final CAD/SGD price we are constructing. This is the price at which our bank will buy CAD (the base currency) and sell SGD. We must therefore ask: at which price ( or ) does our USD/CAD dealer buy CAD against USD, and at which price ( or ) does our USD/SGD dealer sell SGD against USD? The answers are (on the right) and (on the left) respectively. Effectively, by dealing at these prices, our bank is both selling USD (against CAD) and buying USD (against SGD) simultaneously, with a net zero effect in USD. If we now consider the right side of the final CAD/SGD price we are constructing, this will come from selling CAD against USD (on the left at ) and buying SGD against USD (on the right at ). Finally, since each 1 USD is worth 1.48 CAD and also 1.67 SGD, the CAD/SGD exchange rate must be the ratio between these two: = is how the bank sells SGD and buys CAD = is how the bank buys SGD and sells CAD Therefore the spot CAD/SGD rate is: / ACI Dealing Certificate Markets International Ltd

22 22 Foreign Exchange In summary therefore, to calculate a spot rate from two other rates which share the same base currency (in our example this was USD), divide opposite sides of the exchange rates. Following the same logic shows that to calculate a spot rate from two other rates which share the same variable currency (also USD in the following example), we again need to divide opposite sides of the exchange rates: Example 11 Spot EUR/USD: / Spot AUD/USD: / The EUR/USD dealer buys EUR and sells USD at (on the left). The AUD/USD dealer sells AUD and buys USD at (on the right). Therefore: = is how the bank buys EUR and sells AUD Similarly: = is how the bank sells EUR and buys AUD Therefore the spot EUR/AUD rate is: / Finally, to calculate a rate from two rates where the common currency is the base currency in one quotation but the variable currency in the other, following the same logic through again shows that we multiply the same sides of the exchange rates: Markets International Ltd. ACI Dealing Certificate

23 Foreign Exchange 23 Example 12 Spot EUR/USD: / Spot USD/SGD: / The EUR/USD dealer buys EUR and sells USD at (on the left). The USD/SGD dealer buys USD and sells SGD at (on the left). Also, since each 1 EUR is worth 1.21 USD, and each of these USD is worth 1.67 SGD, the EUR/SGD exchange rate must be the product of these two numbers. Therefore: x = is how the bank buys EUR and sells SGD Similarly: x = is how the bank sells EUR and buys SGD Therefore the spot EUR/SGD rate is: / Calculation Summary To calculate an exchange rate from two other rates: from two rates with the same base currency or the same variable currency: divide opposite sides of the exchange rates from two rates where the base currency in one is the same as the variable currency in the other: multiply the same sides of the exchange rates The examples above all construct cross-rates from exchange rates involving the USD (which is often the case). The same approach applies when constructing other rates: considering the way in which each of the two separate dealers will deal to create the rate, gives the construction: ACI Dealing Certificate Markets International Ltd

24 24 Foreign Exchange Example 13 Spot EUR/GBP / Spot GBP/CHF / Spot GBP/JPY / (i) To construct spot CHF/JPY: = is how the bank buys CHF and sells JPY = is how the bank sells CHF and buys JPY Therefore the spot CHF/JPY rate is: / (ii) To construct the spot JPY/CHF: = is how the bank buys JPY and sells CHF = is how the bank sells JPY and buys CHF Therefore the spot JPY/CHF rate is / (iii) To construct spot EUR/CHF: x = is how the bank buys EUR and sells CHF x = is how the bank sells EUR and buys CHF Therefore the spot EUR/CHF rate is: / (iv) To construct spot CHF/EUR, take the reciprocal of the EUR/CHF: 1 ( x ) = is how the bank buys CHF and sells EUR 1 ( x ) = is how the bank sells CHF and buys EUR Therefore the spot CHF/EUR rate is / Markets International Ltd. ACI Dealing Certificate

25 Foreign Exchange 25 The construction of one exchange rate from two others in this way can be seen as follows: Calculation Summary Given two exchange rates A/B and A/C, the cross-rates are: B/C = A/C A/B and B/C = B/A C/A Given two exchange rates B/A and A/C, the cross-rates are: B/C = B/A x A/C and B/C = 1 C/B = 1 (C/A x A/B) When dividing, use opposite sides. When multiplying, use the same sides. Exercise 10 You are a dealer and a counterparty asks you for you price in EUR/USD. You quote / 08 and the counterparty replies 5 yours. What have you sold or bought, how much, and at what rate? 11 Current spot rates are as follows: USD/CHF /89 USD/SGD /05 EUR/USD /83 AUD/USD /43 a. What is the two-way price for CHF/SGD? On which side of this price would the customer sell SGD? b. What is the two-way price for EUR/AUD? On which side of this price would the customer buy EUR? c. What is the two-way price for EUR/CHF? On which side of this price would the customer buy CHF? d. What is the two-way price for CHF/AUD? On which side of this price would the customer sell CHF? See Answers at the end of this chapter ACI Dealing Certificate Markets International Ltd

26 26 Foreign Exchange Forward exchange rates Forward outrights Although 'spot' is settled two days in the future, it is not considered in the foreign exchange market as 'future' or 'forward', but as the baseline from which all other dates (earlier or later) are considered. A 'forward outright' is an outright purchase or sale of one currency in exchange for another currency for settlement on a fixed date in the future other than the spot value date. Rates are quoted in a similar way to those in the spot market, with the quoting bank buying the base currency 'low' (on the left side) and selling it 'high' (on the right side). In some emerging markets, forward outrights are nondeliverable and are settled in cash against the spot rate at maturity as a contract for differences (see later). Example 14 The spot EUR/USD rate is / , but the rate for value one month after the spot value date is / The 'spread' (the difference between the bank's buying price and the bank's selling price) is wider in the forward quotation than in the spot quotation. Also, in this example, the EUR is worth more in the future than at the spot date. EUR 1 buys USD in one month's time as opposed to at present. In a different example, the EUR might be worth less in the future than at the spot date. The forward outright rate can be seen both as the market's assessment of where the spot rate will be in the future and as a reflection of current interest rates in the two currencies concerned. Consider for example the following 'round trip' transactions, all undertaken simultaneously: (i) (ii) (iii) (iv) Borrow USD for 3 months starting from spot value date. Sell USD and buy EUR for value spot. Deposit the purchased EUR for 3 months starting from spot value date. Sell forward now the EUR principal and interest which mature in 3 months' time, into USD. Markets International Ltd. ACI Dealing Certificate

27 Foreign Exchange 27 In general, the market will adjust the forward price for (iv) so that these simultaneous transactions generate neither a profit nor a loss. This is the theory of interest rate parity. When the four rates involved are not in line (USD interest rate, EUR/USD spot rate, EUR interest rate and EUR/USD forward rate), there is in fact opportunity for arbitrage - making a profit by round-tripping. That is, either the transactions as shown above will produce a profit or exactly the reverse transactions (borrow EUR, sell EUR spot, deposit USD and sell USD forward) will produce a profit. The supply and demand effect of this arbitrage activity is such as to move the rates back into line. If in fact this results in a forward rate which is out of line with the market's 'average' view, supply and demand pressure will tend to move the spot rate or the interest rates until this is no longer the case. In more detail, the transactions might be as follows: (i) Borrow USD 100 The principal and interest payment at maturity will be: days USD variable currency interest rate 360 (ii) Sell USD 100 for EUR at spot rate to give EUR (100 :- spot) (iii) Invest EUR (100 :- spot). The principal and interest returned at maturity will be: days EUR ( ) 100 spot 1+ base currency interest rate 360 (iv) Sell forward this last amount at the forward exchange rate to give: days USD ( 100 spot) 1+ base currency interest rate 360 forward outright The supply and demand effect of arbitrage activity (i.e. roundtripping deliberately, to make a profit out of the fact that the rates are not all in line with each other) will tend to make the amount in (iv) the same amount as that in (i), so that: ACI Dealing Certificate Markets International Ltd

28 28 Foreign Exchange forward outright = spot days ( 1+ ( var iable currency interest rate ) 360 days ( 1+ ( base currency interest rate ) 360 Calculation Summary Interest rate parity spot forward outright = days ( 1+ ( var iable currency int erest rate ) year days ( 1+ ( base currency interest rate ) year You will need this formula for the exam. On the ACI formula sheets provided in the exam, it appears as follows. Check now that you can find it and understand how to use it. 1+ interest rate quoted currency annual basis forward rate = spot rate interest rate 1+ annual basis base currency quoted currency x day count base currency x day count Notice that the length of the year may be 360 or 365, and might be different for the two currencies. Example day USD interest rate: 5% 31-day EUR interest rate: 3% Spot EUR/USD rate: Then forward outright = ( ( ) ( ( 0.03 ) 360 = Markets International Ltd. ACI Dealing Certificate

29 Foreign Exchange 29 In theory, to calculate the right-hand side of the outright price (where the bank sells EUR to the customer against USD for outright value one month forward as in the above example), one could use: the right-hand side of the spot price (the offer) the offered interest rate for USD and the bid interest rate for EUR. One could then use the bid price for the spot, the bid interest rate for USD and the offered interest rate for EUR to determine the other side of the outright price. For the purpose of the ACI exam, this would be expected. Note however, that this generally produces a rather large spread. It would be more realistic to use middle prices throughout, to calculate a middle price for the outright, and then to spread the two-way outright price around this middle price. In practice, a dealer does not recalculate outright prices continually in any case, but takes them from the market just as the spot dealer takes spot prices. Example day USD interest rate: 4.9 / 5.0% 31-day EUR interest rate: 3.0 / 3.1% Spot EUR/USD rate: / 68 Using the offered interest rate for USD and the bid interest rate for EUR: 1 + forward outright = ( ( ) ( ( 0.03 ) 360 = Using the bid interest rate for USD and the offered interest rate for EUR: forward outright = ( 1 + ( ) ( 1 + ( ) 360 = The outright price is therefore / ACI Dealing Certificate Markets International Ltd

30 30 Foreign Exchange Forward swaps Although forward outrights are an important instrument, trading banks do not in practice deal between themselves in forward outrights, but rather in forward 'swaps', where a forward swap is the difference between the spot and the forward outright. The reason for not dealing in outrights will become clear later. The forward outright rate can therefore be seen as a combination of the current spot rate and the forward swap rate (which may be positive or negative) added together. Key point forward outright = spot + forward swap Example 17 Spot EUR/USD: / Forward swap: / Forward outright = spot + swap In this case: = = Therefore the forward outright is / Putting this the other way round, it is equally true that: Key point forward swap = forward outright - spot Example 18 Spot EUR/USD: / Forward outright: / forward swap = forward outright - spot In this case: = = Therefore the forward swap is / Markets International Ltd. ACI Dealing Certificate

31 Foreign Exchange 31 In the previous section, we saw that: forward outright = spot days ( 1+ ( var iable currency int erest rate ) year days ( 1+ ( base currency interest rate ) year Since we know that: forward swap = forward outright - spot, it follows that: Calculation Summary forward swap = spot days days ( var iable currency int erest rate ) ( base currency interest rate ) year year days ( 1 + ( base currency interest rate ) year You might find this formula useful. It is not on the ACI formula sheets provided in the exam, so remember it! As before, the length of each year may be 360 or 365 days. Swap prices are generally quoted so that the last digit of the price coincides with the same decimal place as the last digit of the spot price. For example, if the spot price is quoted to four decimal places (1.2166) and the swap price is "20 points", this means "0.0020". If the year basis is the same for the two currencies and the number of days is sufficiently small (so that the denominator in the swap points formula is close to 1), the following approximation holds: Calculation Summary Approximation forward swap spot interest rate differential days year ACI Dealing Certificate Markets International Ltd

32 32 Foreign Exchange Example day USD interest rate: 5% 31-day EUR interest rate: 3% Spot EUR/USD rate: forward swap = = or + 21 points ( ) ( ) ( 1 + ( 0.03 ) Approximate swap = ( ) ( ) = + 21 points The following example shows that the approximation is generally not accurate enough for longer periods. It also becomes less accurate as the base currency interest rate increases. Example 20 1-year USD interest rate: 5% 1-year EUR interest rate: 3% Spot EUR/USD rate: Forward swap = = or points ( ) ( ) ( 1 + ( 0.03 ) Approximate swap = ( ) = +247 points Exercises What is the theoretical 6-month outright price for EUR/USD, based on the following rates? The 6-month period is 181 days. EUR/USD spot: EUR 6-month interest rate: 3.20% USD 6-month interest rate: 4.70% 13 What is the theoretical two-way 3-month swap price for USD/CHF, based on the following borrowing and lending rates? The 3-month period is 92 days. USD/CHF spot: / 26, USD 3-month interest rate: 5.10 / 5.20% CHF 3-month interest rate: 2.70 / 2.80% Markets International Ltd. ACI Dealing Certificate

33 Foreign Exchange The Eurosterling interest rate for one year (a period of exactly 365 days) is 5.9 / 6.0%. The EuroSwiss franc interest rate for the same period is 3.0 / 3.1%. The spot rate today is GBP/CHF / 90. What is the theoretical two-sided GBP/CHF forward outright price for one year forward? See Answers at the end of this chapter Discounts and premiums It can be seen from the formulas given above that when the base currency interest rate is lower than the variable currency rate, the forward outright exchange rate is always greater than the spot rate. That is, the base currency is worth more forward units of the variable currency forward than it is spot. This can be seen as compensating for the lower interest rate: if I deposit money in the base currency rather than the variable currency, I will receive less interest. However, if I sell forward the maturing deposit amount, the forward exchange rate is correspondingly better. In this case, the base currency is said to be at a 'premium' to the variable currency, and the forward swap price must be positive. The reverse also follows. In general, given two currencies, the currency with the higher interest rate is at a 'discount' (worth fewer units of the other currency forward than spot) and the currency with the lower interest rate is at a 'premium' (worth more units of the other currency forward than spot). When the variable currency is at a premium to the base currency, the forward swap points are negative; when the variable currency is at a discount to the base currency, the forward swap points are positive. When the swap points are positive, and the forward dealer applies a bid/offer spread to make a two-way swap price, the left price is smaller than the right price as usual. When the swap points are negative, he must similarly quote a "more negative" number on the left and a "more positive" number on the right in order to make a profit. However, the minus sign " - " is generally not shown. The result is that the larger number appears to be on the left. As a result, whenever the swap price appears larger on the left than the right, it is in fact negative, and must be subtracted from the spot rate rather than added. ACI Dealing Certificate Markets International Ltd