foreign exchange market overview convention and terminology mechanics and operations instruments...

Foreign Exchange

Market OverviewConvention and TerminologyMechanics and Operations

Instruments

ปริ�ทริริศน์� เหลื�องอ�ท�ย, CFA, FRM9 August 2006

© 2006 ปริ�ทริริศน์� เหลื�องอ�ท�ย, CFA, FRM 2

Historical Perspective• 1880-1914 : Gold Standards• 1918-1939 : The War Periods• 1944-1970 : The Gold

Exchange Standard• 1971-1973 : The Collapse of

Bretton Woods• 1985 : The Plaza Accord• 1997 : Floatation of Thai Baht• 1999 : Introduction of the Euro• 2002 : Continuous Linked

Settlement (CLS)


Settlement

• Every trade executed has to be settled.• Settlement risk is the risk that one side to a transaction

pays out its obligation in one time zone but the counterparty to the transaction fails to make the corresponding payment in a different time zone.

• A number of initiatives : FXNET, the oldest and the most successful, provides an automated bilateral netting solution, which is a legally binding agreement between pairs of counterparties in which transactions are netted continually throughout the trading day.

• Today around 20% of all FX transaction obligations are netted via FXNET.


Continuous Linked Settlement• In September 2002, the CLS Bank was launched to

provide a solution called Continuous Linked Settlement.• CLS operates by linking all of the world’s settlement

periods and indeed, truncating them, into a period of just five hours.

• Acting in effect as a clearing hours, CLS receives payments in but does not pay them out until the correspondent payments are also received.

• Hence, CLS settles FX transaction on a payment-versus-payment (PVP) basis in the book of CLS Bank.

• CLS eliminates settlement risk and reduces the liquidity needed.

The Foreign Exchange Market


Financial Market Structure

EquityMarkets

BondMarkets

ForeignExchangeMarkets

DerivativesMarkets

MoneyMarkets

CapitalMarkets


Basic Definition• A Currency is a medium of exchange, coins or notes,

used to buy goods or services. Most countries have their own currency, issued by an official agency called a central bank or a monetary authority.

• Foreign Exchange (F/X or Forex) is the transaction that involves the purchase of one currency against the sale of another currency for settlement or delivery on a specified date.

• The Exchange Rate is theprice per unit of one of thecurrencies expressed inunits of the other currency.


Foreign Exchange Markets• A complex network of global

over-the-counter institutions and structures

• 3 Key functions :– Exchange of one currency

for another (transfer of purchasing power)

– Management of exchange rate risk (transfer of risk)

– Exchange rate determination

• The market is geographically dispersed.

• The U.S. dollar makes up the highest percentage of the total daily turnover shares.

Currency 2001

USD 90.4

EUR 37.6

JPY 22.7

GBP 13.2

CHF 6.1

CAD 4.5

AUD 4.2

SEK 2.6

HKD 2.3

SGD 1.1

Emerging Markets 5.2

Other 10.1

TOTAL 200

Percentage Shares of Daily Turnover

Source : Bank for International Settlements (BIS)


Market Overview

• The Foreign Exchange Market allows market participants to exchange one currency for another. It is a communication network linking all participants.

• Foreign exchange market is the single

largest market in the world. More

than USD 1.2 trillion is traded in

the FX market each day.• London (38%) is the largest trading

center in the world, followed by

New York (22%), Tokyo (10%), and Singapore (9%).

Foreign Exchange Instruments




FX Transactions

Spot FX Forward FX

Forward Outright FX Swaps

FX Derivatives


Foreign Exchange Transaction• A foreign exchange

transaction is composed of spot, outright forward, and swaps.

• Average daily turnover for all currencies in April 1998 was $1.4415 trillion (in 2001 was $1.210 trillion).

• Transaction breakdown in 2001 was :– 32 percent spot

transactions,– 11 percent over-the-

counter forwards, and– 54 percent foreign

exchange swaps.

InstrumentsDaily Averages (Billion of USD)

Spot Transactions 387

Outright Forwards 131

Foreign Exchange Swaps

656

TOTAL Turnover 1,210

Percentage Shares of Daily Turnover

Source : Bank for International Settlements (BIS)


Spot Transactions

• A spot transaction involves the exchange of one currency for another at an agreed exchange rate to be settled in cash in two business days between two counterparties.

• Spot transactions account for about 32 percent of all transactions in the foreign exchange market.

• A spot transaction is intended to transfer purchasing power from one party to another.

1M + Spot1M + SpotTodayToday SpotSpot

ONON TNTN 1M1M

6M + Spot6M + Spot 1Y + Spot1Y + Spot

6M6M 1Y1Y

TimeTime

TomTom


Spot Foreign Exchange

• The normal settlement period for “spot” deals is two working or business days.

• About one-third of all the business transacted in the foreign exchange market is for settlement or “value date” spot.

• For example, if the deal is done on Thursday, then the spot date would be Monday.


Example : Spot Quotation USD/THB• Spot rate : USD/THB 38.600/620• Base currency is US dollar.• Counter currency is Thai baht.

38.600(bid)

Bank bids for USD against THBClient sells USD and buys THB

38.620(offer)

Bank offers USD against THBClient buys USD and sells THB


Example : Spot Transaction

• A Thai company receives $100,000 and needs to convert this money into Thai baht.

USAThai

Company

$100,000Bank

Spot FX Deal @ 38.600

ThaiCompany

Bank$100,000

ThaiCompany

BankTHB 3,860,000

SPOT

SPOT

TODAY


Outright Forwards

• An outright forward is an over-the-counter transaction involving the exchange of one currency at the forward exchange rate determined today for the delivery to take place for cash settlement in more than two business days.

• About 11 percent of all transactions in the foreign exchange market are forward contracts.

• A forward transaction is intended to transfer risk from one party to another. Transferring risk is hedging that is intended to reduce the exposure to foreign exchange risk.


Forward Outright

• An outright forward exchange deal is a contract to buy or sell a given amount of currency for settlement at some future date, at a rate of exchange which is agreed at the time of dealing. No money changes hand until the settlement date.

• Generally it is possible to obtain a forward rate of exchange for up to one year for most traded currencies.

• The purpose of obtaining a forward rate of exchange is simply to establish and fix the cost of exchange for a known foreign currency commitment at some future date.


Forward Outright = Spot FX Rate +/- Forward Points

Forward F/X Rates

Forward Points = Forward Outright – Spot FX Rate


Foreign Exchange Swaps• A foreign exchange swap (a spot/forward swap) is a

contract to exchange currencies in principal amount only in two business days (the short leg) and reversal of the exchange of the same two currencies at a date in the future (a long leg).

• An FX Swap is the combination of a spot deal with a simultaneous forward deal.

• A FOREX swap is the portfolio of long and short positions entered simultaneously at two different dates prevailing in the future.

• The simultaneous purchase and sale of a specified amount of one currency in exchange for two different value dates.

• A swap transaction is essentially a financing at a fully collateralized basis.


Foreign Exchange Swaps

• Sell/Buy (S/B)• Near Leg : Sell fixed amount of Base Currency• Far Leg : Buy fixed amount of Base Currency

• Buy/Sell (B/S)• Near Leg : Buy fixed amount of Base Currency• Far Leg : Sell fixed amount of Base Currency


Forward-Forwards

• When the short leg of the FX swap is more than two business days, then the swap is called a forward/forward swap.

• A forward-forward swap is a swap deal between two forward dates rather than from spot to a forward date.

• FX forward-forwards are referred to by the beginning and end dates of the forward period, compared with the spot value date.

• For example, to sell USD 1 month forward and buy them back 3 months forward. In this case, the swap is for the 2-month period between the 1-month date and the 3-month date : “1v3”

foreign exchange market overview convention and terminology mechanics and operations instruments...

Documents