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

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Foreign exchange fundamentals

Foreign Exchange Fundamentals


Foreign exchange fundamentals

FOREIGN EXCHANGE CORE FUNDAMENTALS

AGENDA

  • Global FX Markets

  • Structure and conventions of spot markets

  • Appreciating depreciating currencies

  • Delivery timing issues

  • Using orders

  • Cash flows of both individual trade and trader's position

  • Counterparty requirements

  • Trade capture-Electronic/ Manual

  • Outright Forward Contracts

  • Client usage and intentions

  • Derivation of forward market prices

  • FX Swap market

  • Applications of FX Swaps

  • Settlement- Continuous Linked Settlement- CLS

  • Confirmations and Settlements


Foreign exchange fundamentals

FOREIGN EXCHANGE -- Exposures

  • FX Transactions derive from the combination of global activity and fluctuating exchange rates

    • Many forms of global activity:

    • + Foreign currency-denominated sales revenues

    • + Foreign currency-denominated dividends and royalties

    • + Multicurrency portfolio management

    • + Foreign currency-denominated expenses

    • + Equipment/Raw materials purchased abroad

  • + Foreign currency denominated loans/loan restructuring

  • + Foreign operations/subsidiaries

    • Growing incidence of fluctuating currencies:

    • + Asian, Latin American, and other emerging markets


Foreign exchange fundamentals

FOREIGN EXCHANGE – Managing FX Risk

  • Fueled by underlying corporate and investor needs, the global FX market is the world’s largest financial market

  • Vast majority of transactions in OTC market

  • Average daily turnover estimated at $3.2 trillion (BIS, 2007), up 71% on 2004 figures – swaps biggest increase at 82%

  • A broad mix of market participants – central banks, financial institutions, investors, multinational corporations


Foreign exchange fundamentals

FOREIGN EXCHANGE – Geographical Distribution of Turnover


Foreign exchange fundamentals

FOREIGN EXCHANGE – Currency Traded

Currency Trading Volume


Foreign exchange fundamentals

FOREIGN EXCHANGE – Major Market Participants

  • Commercial Banks

    • Provide FX dealing services for their clients

    • Manage their own FX exposures

    • Proprietary traders within banks speculate on expected long-term movements

    • Top 20 FX banks account for around 2/3 of daily turnover

  • Central Banks

    • Use the markets to stabilize exchange and interest rates

    • Supervise Commercial Bank FX operations


Foreign exchange fundamentals

FOREIGN EXCHANGE – Major Market Participants

  • Corporate and Portfolio Managers

    • International companies have transactional needs arising from their commercial activities

    • Investment institutions use the FX market to make foreign-currency investments

      • + Investing and divesting

      • + Covering or not covering FX exposure

    • Hedge Fund big ticket activity

    • Individual trading platforms

  • Brokers

    • Voice brokers virtually extinct

    • Electronic brokers provide efficiency

      • EBS

      • FXAll

      • FXConnect


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Transactions

Are you managing TIME EXPOSURE

OR FLOW EXPOSURE

OR BOTH

Do you really have an exposure

Corporate/Portfolio Manager philosophy and policy


Foreign exchange fundamentals

FOREIGN EXCHANGE – Spot Transactions

  • Definition

    • A Foreign Exchange transaction where the price is agreed today for currency delivery, normally, in two business days time.

    • Price agreed Monday-settlement Wednesday

    • Price agreed Thursday-settlement Monday

    • Bank Holidays


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Spot Rates

DEALERS

OFFER FOR

FIXED CURR.

DEALERS BID

FOR FIXED

CURRENCY

FIXED

CURRENCY

VARIABLE

/CURRENCY

1.5849

1.5850

/USD

——

GBP

0.9647

0.9650

USD

/CHF

——


Foreign exchange fundamentals

FOREIGN EXCHANGE – Some More FX Spot Rates


Foreign exchange fundamentals

FOREIGN EXCHANGE – Even More FX Spot Rates


Foreign exchange fundamentals

FOREIGN EXCHANGE – The FX Spot Transaction Procedure

Trader Order

Direct

Processing

Trading Platform

FOREX Execution

No Dealing Desk(NDD)

Straight Thru Processing(STP)

INTERBANK

Brokers Mutual funds

Hedge funds Banks

Investment corporations

Processed

For

Risk Exposure

Trader Order

Dealing Desk

Winning Trades

Losing Trades

Market maker Profit

FOREX Execution

Dealing Desk(DD)

Market Makers and Brokers

Trading Platform


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Trading

Trader A sells USD 13,280,212.48

TRADER B

TRADER A

Trader A buys EUR 10 million

Trader A sells EUR 10 million

Trader A buys USD 13,285,212.48

Profit and Loss

EUR USD

+10,000,000 -13,280,212.48

-10,000,000 +13,285,212.48

Net 0 + 5,000

BANK


Foreign exchange fundamentals

FOREIGN EXCHANGE – A FX Trade

Bank of America

Bank of America

$10 million cash payment instruction to credit Saxo Bank account at BofA

Confirmation that USD received

Saxo Bank

Copenhagen

Saxo agrees to buy $10 million against DKK at 6.1990 from Citibank

Saxo Bank

Copenhagen

Confirmation that DKK received

DKK Payment instruction

Saxo Bank

Copenhagen

Cash Dept

Saxo Bank

Copenhagen

Cash Dept

DKK 61.990 million cash payment instruction to credit Citibank London account at Citi Copenhagen


Foreign exchange fundamentals

FOREIGN EXCHANGE – Trading Parties


Foreign exchange fundamentals

FOREIGN EXCHANGE


Foreign exchange fundamentals

FOREIGN EXCHANGE


Foreign exchange fundamentals

FOREIGN EXCHANGE


Foreign exchange fundamentals

FOREIGN EXCHANGE – Best Price for the Caller

  • You are a portfolio manager and want to sell EUR 8,000,000 against USD. Three banks make two way prices. Which one do you take?

    • 1.3466-1.3468

    • 1.3465-1.3469

    • 1.3464-1.3467

  • Now you want to buy USD5,000,000 against GBP. Once again which price is best?

    • 0.6302-0.6302

    • 0.6300-0.6304

    • 0.6310-0.6306


Foreign exchange fundamentals

FOREIGN EXCHANGE – Exercises

  • Portfolio manager wants to buy GBP 1 million against USD

    • 1.5862-1.5864

    • 1.5852-1.5858

    • 1.5868-1.5866

  • Portfolio manager wants to sell USD 2 million against EUR

    • 1.3443-1.3444

    • 1.3433-1.3442

    • 1.3445-1.3448


Foreign exchange fundamentals

FOREIGN EXCHANGE – Using Orders

  • Current Spot

    • GBP/USD 1.5880-83

  • Need to buy GBP 1 million

  • Stop Loss

    • GBP/USD 1.5890

  • Take profit

    • GBP/USD 1.5868


Foreign exchange fundamentals

FOREIGN EXCHANGE – Client Trading Strategies

  • Strengthening and weakening currency

  • GBP/USD 1.5877 UDS/DKK 5.5389

  • Assuming USD interest rate remain the same

    • GBP interest rates are expected to fall

    • DKK interest rates are expected to rise

    • USD budget deficit and balance of payments increases


Foreign exchange fundamentals

FOREIGN EXCHANGE – What are the Cash Flows

  • Clients transact the following spot transactions with you. What are the cash flows delivered at spot?

  • ABC Co buys $10,500,000 against EUR at1.13590.

    • Round amounts of variable-divide for Fixed

  • Import Inc buys USD 5 million against DKK at 5.4840

    • Round amount of fixed-multiply for variable


Foreign exchange fundamentals

FOREIGN EXCHANGE – Spot Applications

  • FX spot is a cash exchange market

  • Market amounts/centralization

  • Pairing of currency exposures

    • Utilizing long position in one currency to cover short in another

  • Currency of invoices in/out

  • Currency of financing compared to currency of invoice

  • Exotic currencies


Foreign exchange fundamentals

FOREIGN EXCHANGE – Forward Outright Transactions

  • Definition

    • An FX transaction where the parties agree to exchange currencies on a future settlement date at a rate agreed today based on current spot

    • Dates available

      • Essentially any working day


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Forward Outright

GBP

USD

Exposure

T=180

TODAY

Settle at T=180

Buy GBP / Sell USD

Agree price at Today

Assume a USD based portfolio manager that has identified a GBP payable for GBP 1 million in 180 days time required to buy back some FTSE 100 equities. The manager is concerned that the GBP may appreciate against the USD during that period and therefore he wants to lock in today, based on today’s rates, an FX sale rate for USD (purchase of GBP)


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Forwards

GBP

USD

Traders Cash Flow:

T=180

TODAY

Bank cash flows with Client

Sell GBP to them and Buy USD

Bank does spot deal in interbank market to lock in today’s spot rate

Borrow USD for 180 days and use to settle spot payment

Deposit GBP for 180 days with GBP received in spot deal

Repay with USD from customer

Use funds to pay clients


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Forwards

GBP

USD

Bank cash flows to calculate OFFER points:

T=180

TODAY

Bank cash flows with Client

Sell GBP to them and Buy USD

Bank does spot deal in interbank market to lock in today’s spot rate at 1.7446

Borrow USD for 180 days

Deposit GBP for 180 days

1.60

4.32

Current Market Prices

Spot1.7441 – 1.7446

Interest Rates

GBP4.32 – 4.42%

USD1.50 – 1.60%

Interest = 2.72%


Foreign exchange fundamentals

FOREIGN EXCHANGE – Forward Rate

Offer points: 1.7468 - 1.7446 = 0.0022


Foreign exchange fundamentals

FOREIGN EXCHANGE – Another Example

Assume that the portfolio manager had a receivable of GBP 1 million in 180 days time from the sale of some UK Corporate Bonds. They want to sell the GBP forward

Exposure

T=180

TODAY

Agree price at Today

Settle at T=180


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Forwards

GBP

USD

Bank cash flows to calculate BID points:

T=180

TODAY

CUSTOMER FLOWS

Bank does spot deal in interbank market to lock in spot rate of 1.7441

Borrow GBP for 180 days

Deposit USD for 180 days

4.42

1.50

Current Market Prices

Spot1.7441 – 1.7446

Interest Rates

GBP4.32 – 4.42%

USD1.50 – 1.60%

2.92%

= COST

Interest Differential


Foreign exchange fundamentals

FOREIGN EXCHANGE – Forward Rate

Offer points: 1.7197 - 1.7441 = 0.0244


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Forwards

GBP

USD

Bank cash flows to calculate BID points:

T=180

TODAY

CUSTOMER FLOWS

Bank does spot deal in interbank market to lock in spot rate of 1.7441

Borrow GBP for 180 days

Deposit USD for 180 days

4.65

4.65

Current Market Prices

Spot1.7441 – 1.7446

Interest Rates

GBP4.55 – 4.65%

USD4.65 – 4.75%

0.00%

= COST

Interest Differential


Foreign exchange fundamentals

FOREIGN EXCHANGE – Forward Rate

Offer points: 1.7451 - 1.7441 = 0.0010


Foreign exchange fundamentals

FOREIGN EXCHANGE – Final Prices

Spot GBP/USD1.7441 – 1.7446

6 Month Points10 - 22

Outright Prices1.7451 – 1.7468

Actual Prices on the Day

Spot GBP/USD1.7441 – 1.7446

6 Month Points15.5 - 16

Outright Prices1.74465 – 1.7452


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Screen


Foreign exchange fundamentals

FOREIGN EXCHANGE – Plus or Minus Points


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Forward Points

  • If interest rates in the base/fixed currency are higher than the interest rates in the variable terms currency then:

  • Points will show high on the bid and low on the offer

  • Always deduct points in this scenario

  • Ex. GBP/USD

  • Spot: 1.8107 – 1.8112

  • 3m Points 36 – 35

  • Outright 1.8071 – 1.8077

  • If interest rates in the base/fixed currency are lower than the interest rates in the variable terms currency then:

  • Points will show low on the bid and high on the offer

  • Always add points in this scenario

  • Ex. EUR/NOK

  • Spot: 8.8859 – 8.8869

  • 3m Points 75 – 76

  • Outright 8.8934 – 8.8945


Foreign exchange fundamentals

FOREIGN EXCHANGE – Net Cost / Earnings

Given the points you may wish to know what they are worth as an interest differential

Formula:

(Earnings)


Foreign exchange fundamentals

FOREIGN EXCHANGE – FX Swaps

GBP

USD

Bank cash flows to calculate BID points:

T=180

TODAY

CUSTOMER FLOWS

Bank does spot deal in interbank market to lock in spot rate of 1.7441

Borrow GBP for 180 days

Deposit USD for 180 days

4.42

1.50

2.92

2.44

2.92

Current Market Prices

Spot1.7441 – 1.7446

Interest Rates

GBP4.55 – 4.65%

USD4.65 – 4.75%

2.92%

= COST

Interest Differential


Foreign exchange fundamentals

Thank You


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