Introduction To Foreign Exchange

1
Introduction To Foreign Exchange

• Saeed Amen

2
Introduction

• We present a brief introduction to the foreign
  exchange market
• What are the major currencies?
• How are they quoted?
• What is relative liquidity of different currency
  pairs?
• Brief description on how FX options are quoted.

3
Foreign Exchange Market

• Volume 3.5tr
• FX spot - 1tr
• Buying currency for immediate delivery
  settlement usually T1
• Outright FX forwards - 350mm
• Buying currency for future delivery for example
  1M delivery
• FX swaps - 1.7tr (FX spot FX forward)
• Buying (selling) spot and selling (buying)
  forward date
• Common usage is to roll spot positions overnight
  through tom/next contract
• FX options - 200bn
• Calls, put, straddles, strangles (buy OTM call
  and put) risk reversals (buy OTM call sell put)
  most common vanillas
• More exotic instruments barrier options, one
  touches, volatility swaps, correlation swaps etc.
• Centres
• UK 34 - open during both Asian (morning) and
  American timezones (afternoon)
• US 17
• Singapore 6
• Switzerland 6
• Japan 6
• Source BIS 2007 Wikipedia

4
Major Currencies

• Double counting given FX transactions involve two
  currencies base/terms quote
• G10 (official name and trading name)
• EUR (37) - euro, GBP (15) sterling/British
  pound, AUD (6.7) Australian dollar - Aussie,
  NZD (1.9) New Zealand dollar - Kiwi, USD
  (86.3) US dollar - dollar, CAD (4.2)
  Canadian dollar cad (loonie), CHF (6.8)
  Swiss franc - Swiss, NOK (2.2) Norwegian krone
  - Nokkie, SEK (2.8) Swedish krona - Stokkie,
  JPY (16.5) Japanese yen
• Written in quotation order
• Eg. EUR always first, JPY always last
• Correct quotations EUR/GBP, AUD/NZD, CHF/JPY etc.
• Generally USD crosses traded more (except
  EUR/scandis)
• EUR/USD (27), USD/JPY (13), GBP/USD (12),
  AUD/USD (6), USD/CHF (5), USD/CAD (4), USD/SEK
  (2), USD/other (19)
• EUR/JPY (2), EUR/GBP (2), EUR/CHF (4),
  EUR/other (4)
• Other crosses (4) eg. AUD/NZD, NOK/SEK
• Can trade any cross indirectly if direct
  equivalent not traded eg. CHF/SEK EUR/CHF and
  EUR/SEK

5
Emerging Market Currencies

• Double counting given FX transactions involve two
  currencies
• Usually traded against USD (except CEE)
• Most Asian and Latam currencies are traded as NDF
  non-deliverable forwards settled in USD
• Many currencies in EM are pegged or are managed
  currencies that trade within a band that central
  bank supports
• Common trading name also given
• Latam
• MXN Mex (1.3), BRL (0.4) - Brazil, CLP -
  Chile, COP - cop
• EMEA
• CEE PLN (0.8) - Poland, CZK - Czech, HUF huf
  traded mostly EUR/CEE
• ZAR rand (0.9), RUB - rouble (0.8), TRY -
  Turkey, ILS - shekel, ISK (against EUR very
  illiquid now)
• Asia
• HKD (2.8) Hong Kong, KRW (1.1) - Korea, INR
  (0.7) - India, CNY (0.5) - China, TWD (0.4)
  - Taiwan, SGD - sing, MYR - Malaysia, IDR -
  Indonesia

6
Terminology

• Investors can trade FX leveraged
• E.g put on a margin of 10mm USD to cover losses
  and trade 20mm USD notional
• Greater leverage is more risky
• Long/short
• Going long EUR/USD
• Borrow USD which is sold, and used to buy EUR
• Due to arbitrageurs cross rates consistent at
  nearly all time levels (eg. EUR/JPY EUR/USD
  rate USD/JPY)
• aaa/bbb 1 / aaa/bbb
• aaa/bbb aaa/ccc ccc/bbb

7
Liquidity

• Liquidity concentrated during London hours
• Most liquidity between 12 16 LDN (London and NY
  open)
• Dependent on local markets (eg. Scandis illiquid
  during Asian time, similarly EM Asian currencies
  illiquid during NY time)
• Illiquidity reduces sizes that can be traded and
  increases spreads
• Major USD crosses such as EUR/USD are liquid all
  the time
• Market opens approx 2200 LDN Sunday evening in
  Sydney and continues trading till 5pm NY on
  Friday evening
• Amount that can be executed depends on time of
  day and currency cross
• 100mm USD in EUR/USD is not big amount, but in
  USD/NOK it is a big amount
• Recent market turmoil has reduced liquidity

8
Who trades FX markets?

• Not everyone is an FX speculator
• Corporations repatriating profits
• Investors buying assets in foreign countries
• Foreign equities and bonds, businesses
• Tourists visiting other countries
• Governments
• Central banks
• Intervening in market to strengthen/weaken
  currency
• Mostly EM countries
• However, some G10 countries have intervened in
  the past
• Recently Russia has intervened to try and support
  RUB (sell USD reserves and buying RUB)
• UK unsuccessfully tried to defend GBP in 1992
• Also diversify currency reserves
• Speculators trying to predict future exchange
  rate (also help liquidity)
• Hedge funds
• Retail investors
• Banks

9
Market Makers

• Market makers provide liquidity
• Commercial and investment banks DB, UBS,
  Barcap, Citi, RBS, JPMorgan, HSBC, LEH/NOM, GS,
  MS (order of liquidity)
• FX mostly traded over-the-counter
• Some futures are traded on exchanges (eg. at CME)
• G10 FX spot bid/ask spreads are very small in
  most liquid crosses
• EUR/USD 1 or 2 pips
• G10 FX spot is high volume, low margin business
  (compared to many other assets)
• In EM, volumes are lower, hence spreads are wider
  given that it is more difficult to hedge out risk
• High liquidity is an attraction for investors
• Interbank FX brokers
• Interbank electronic platforms EBS Reuters

10
What influences exchange rates?

• Fundamental factors
• Interest rates
• Higher interest rates attract overseas capital
• Carry trade investors taking advantage of carry
  differential between two currencies
• Economic situation
• Current account
• GDP
• Inflation
• Unemployment
• Raft of other economic indicators surveys, new
  auto sales etc.
• Terms of Trade Effects
• State of the market
• Investor sentiment during periods of poor
  investor sentiment (like now) people are not
  prepared to take as much risks, hits currencies
  that are considered risky like Turkish Lira

11
What influences exchange rates?

• Technical factors
• Momentum (trend following) and mean reversion
  (range trading)
• Positioning in currencies
• Charting areas of resistance, support etc.
• Market will focus on different aspects at
  different times, sometimes totally ignoring
  factors. Need to adapt to changes in the market.
• Each trader has a different take some look at
  fundamentals, others at technical factors, but
  most at a mixture of both. There is no right
  way to view the market.

12
FX Options

• Traders typically quote implied vols for
  different tenors (ON, 1W, 1M etc.)
• ATM implied vol what strike ATM is depends on
  the currency pair and tenor!
• 10d and 25d risk reversals give the skewness of
  the smile call put OTM
• RR 25d IV(25d call) IV(25d put) roughly
• 10d and 25d strangles gives the curvature of
  the smile call put OTM
• SM 25d (IV(25d call) IV(25d put))/2 - ATM
• Can create a vol surface from these quotes to
  price any strike tenor options
• Calculate option price using a model like
  Black-Scholes
• Rationale is that spot is very volatile, where as
  vols are not, so dont need to keep updating
  prices
• Smile is not sticky, moves with spot
• NOT like in equities where a price is quoted by
  traders and we back out implied vol from price
• Terminology
• USD/JPY call USD call / JPY put NOT USD put /
  JPY call
• Clearly a big subject!
• Peter Carr has good presentation that introduces
  FX options http//www.samsi.info/200506/fmse/worki
  nggroup/lp/Presentations/Carr2.pdf