.71204−0.01597−0.01991−3.67052−0.03673−0.82100−0.00570
RHS−0.003810.00175−0.87448−0.00801−0.01009−1.84550−0.01819−0.40400−0.00260
−0.003860.00169−0.88523−0.00818−0.01017−1.86239−0.01845−0.40900−0.00270
−0.002650.00115−0.60261−0.00547−0.00688−1.25850−0.01229−0.27500−0.00170
−0.007120.00367−1.69061−0.01563−0.01981−3.64396−0.03630−0.81100−0.00550
RHS
6m Fwd
LHS
3m Fwd
RHS
2m Fwd
USD/EUR1.04781.0483 −0.00148 −0.00146 −0.00269GBP/EUR0.65040.65080.000590.000620.00111JPY/EUR 124.4263 124.5380 −0.33294 −0.32802 −0.61067CHF/EUR1.45631.4570 −0.00303 −0.00295 −0.00561USD/GBP1.61091.6111 −0.00377 −0.00374 −0.00692JPY/GBP 191.2944 191.3987 −0.68876 −0.68220 −1.26926CHF/GBP2.23792.2403 −0.00673 −0.00661 −0.01250JPY/USD 118.7500 118.8000 −0.15000 −0.14800 −0.27900CHF/USD1.38921.3905 −0.00093 −0.00088 −0.00180
Currencypair
Table 3.1 WM/Reuters London close exchange rates 6 Jan 2003
RHS−0.011800.00793−3.25718−0.02822−0.03700−7.21324−0.06939−1.79000−0.01140
LHS−0.012100.00760−3.30114−0.02976−0.03730−7.26185−0.07149−1.80000−0.01250
12m Fwd
28
Currency Overlay
The market in forward contracts is so well developed, and so liquid, that the bid/offer spreadsthat market-makers are able to charge are extremely small.Table 3.1 is an example of quotes given on a day in January 2003 (6/1/03) for nine majorexchange rates. I have used WM/Reuters rates, as these are representative of the average ofquotes of several major market-makers. The quotes are expressed as LHS/RHS, where LHS isthe offer price of the ﬁrst named currency. As an example, for the ﬁrst named currency pair,USD/EUR, the spot price of 1.0478 USD per EUR is the price at which the quoting bank willsell the customer USD for EUR (i.e. the customer buying USD with EUR). The swap pricesare similarly quoted (see Box 3.2). So as an example, the 1-month LHS quote of −0.00148(or −14.8 FX points – an FX point being 1/10 000th of the exchange rate integer) is thedifference from the spot rate, expressed in exchange rate terms, at which the bank will sell thecustomer USD vs. EUR for 1-month maturity, and simultaneously buy EUR vs. USD spot.The spot will be agreed between the bank and the customer, and will be the currency marketrate, but the exact rate agreed is not material since if it beneﬁts one party for one ‘leg’ of thetransaction, it will equally disadvantage them on the other leg.In this example, the following cash ﬂows would be committed to if a customer rolled a longposition in USD (vs. EUR) one month forward. It assumes the customer took the bank’s LHS1-month swap price, and agreed the spot at the LHS quote, for $10m. The cash ﬂows are forthe customer; for the bank they would be the exact reverse:DateSpot (= +2 working days)One-month(=spot date + 1 month)
USD
Rate
EUR
−10 000 000.00
1.04780
9 543 806.07
10 000 000.00
1.04632 (= 1.0478 − 0.00148)
−9 557 305.60
The USD is at a premium in the forward market because it costs more euros to buy dollarsforward than it does spot. This reﬂects the fact that, on this date, USD interest rates at onemonth were lower than euro interest rates.We can turn the Table 3.1 into a ‘spreads’ table, in which we record only the differencebetween the LHS and RHS quotes. Table 3.2 shows this in FX points (1/10 000th of theTable 3.2 Table of WM/Reuters FX bid/offer spreads (in FX points = 1/10 000thof integer)Forward spreadsCurrency pair
Spot spread
1m
2m
3m
6m
12m
USD/EURGBP/EURJPY/EURCHF/EURUSD/GBPJPY/GBPCHF/GBPJPY/USDCHF/USD
5.04.01117.0∗7.02.01043.0∗24.0500.0∗13.0
0.20.349.20.80.365.61.220.00.5
0.40.480.61.40.4107.62.140.01.0
0.50.6107.51.70.8168.92.650.01.0
1.01.1214.33.41.0265.64.3100.02.0
3.03.3439.615.43.0486.121.0100.011.0
∗ Note: It is a convention in the FX market that JPY-based quotes’ FX points are 1/100th of anFX integer, not 1/10 000th. However, I have expressed them here as 1/10 000th for consistency.
Currency Hedging
29
integer, which would be recognised by a currency dealer), and Table 3.3 shows this in basispoints (bp), which express all spreads in 1/100th of percentage point terms (i.e. 100 bp =1%). Note that I have added two additional rows at the bottom, the unweighted average of theTable 3.3 Table of WM/Reuters FX bid/offer spreads (in basis points = 1/100thof 1%)Forward spreadsCurrency pairUSD/EURGBP/EURJPY/EURCHF/EURUSD/GBPJPY/GBPCHF/GBPJPY/USDCHF/USDUnweighted averagesAverage outright spreads
Spot spread
1m
2m
3m
6m
12m
4.776.158.974.811.245.4510.724.219.356.196.19
0.190.460.400.550.190.340.540.170.360.356.54
0.380.610.650.960.250.560.940.340.720.606.79
0.480.920.861.170.500.881.160.420.720.796.98
0.951.691.722.330.621.391.920.841.441.437.62
2.865.073.5310.57∗1.862.549.380.847.914.2510.44
∗ This value omitted in the averages, for consistency with Table 3.4.
spreads (in bp) and the unweighted average of the outrights. Outrights are the spot spread plusthe relevant forward swap spread added together. The outright is the deal required to open orclose a forward hedging contract.It is notable that the spreads across all the currencies vary widely. WM/Reuters have aparticular methodology for calculating some cross rates which may exaggerate the spreads(CHF/GBP being one example), but this would not apply to, for example, CHF/USD, whichalso apparently has wide spreads. For many currencies, there is a sharp widening of spreadsbetween 6m and 12m. As we will see below, this is not reﬂected in the prices actually obtainedin live dealing.How do these quoted rates compare to rates actually dealt? These are, after all, just oneday’s snapshot rates. Spreads can vary according to market conditions, competitive pressure,and the nature of the customer. In trying to answer this question, I will call upon proprietaryBox 3.3
Bid/offer spreads
The currency market enjoys transparent pricing, no commissions, taxes or levies. Its pricingtransparency has been one of its strengths, and the competitive pressure of other jurisdictionshas prevented governments from successfully imposing taxes and levies. Where these havebeen imposed, trading has moved to other, more accommodating, jurisdictions.The form that the pricing of transactions in the currency market takes is bid/offer spreads.These are expressed by market-makers as the simultaneous issue of two prices at whichthey will deal – a price to buy the currency (bid) and a price to sell the currency (offer). Ofcourse with currency rates, there are two currencies involved, not one, so a convention hasgrown up as follows.
30
Currency Overlay
If a spot currency rate for currencies A and B is expressed as A/B (i.e. the number ofunits of A to buy B), A is the numerator and B is the denominator. Suppose A is $ and B is£; the bid and offer quotes might be 1.4363/65. This means that the bank will buy (the bid)sterling (the denominator) from the customer at 1.4363, and sell (the offer) sterling to thecustomer at 1.4365. The ﬁrst quoted number is always the lower one, and it is called the‘left-hand side’ (LHS) of the quote. The other side is the RHS.In market slang, this quote would be expressed as 63/65 on ‘big ﬁgure’ 3, i.e. the 1.40is assumed, the 3 cents is the ‘big ﬁgure’ and the quote is in ‘FX points’ (1/10 000th) ofa dollar. All FX market quotes are in FX points, and the rules above (LHS always a lowernumber than RHS) always apply. Market convention quotes some low value currencies (e.g.yen) with FX points equal to 1/100th of a yen rather than 1/10 000th. See also Box 3.2.data from the currency overlay ﬁrm that I chair – Record Currency Management. This ﬁrmhas collected bid/offer spread data from four years’ history of dealing (1999–2002), and theresults are shown in Table 3.4. The table is calculated from 6230 actual deals with an averagesize of some $10m each (i.e. total volume in this survey c. $60 bn). The ﬁgures shown are thebid/offer spreads – i.e. the cost of two deals, buying and selling. The cost of one deal is halfthe spread cost. To ensure wide coverage, we have categorised into the relevant month dealswhere the actual maturity date falls within 15 days of the exact maturity date. The table is laidout in an identical fashion to the previous tables.Table 3.4 Table of actual FX dealing spreads spot and forward (in basis points =1/100th of 1%)Forward spreadsCurrency pairUSD/EURGBP/EURJPY/EURCHF/EURUSD/GBPJPY/GBPCHF/GBPJPY/USDCHF/USDUnweighted averagesAverage outright spreads
Spot spread
1m
2m
3m
6m
12m
2.733.193.101.432.504.373.332.872.262.872.87
0.230.560.620.600.220.460.640.420.400.463.33
0.420.780.940.800.330.900.790.530.590.683.54
0.520.831.091.010.390.931.100.620.760.813.67
0.871.642.311.890.751.782.301.051.301.544.41
1.634.063.57*2.203.805.002.472.972.865.72
∗ Insufﬁcient number of deals for reliable average.
Finally, we can record the proportion of the quoted FX spread actually paid in long-termdaily experience. Table 3.5 shows, for each table cell, the percentage of actual spread toquoted spread. For example, for USD/EUR spot = 57% = 2.73/4.77. The averages and outrights are the ratio of the averages in the source tables, not the averages of the percentagetable.In summary, the quoted bid/offer spot spreads from this WM/Reuters London close snapshotare (with the exception of USD/GBP) signiﬁcantly wider than the prices achievable in practice.The spot spreads are by far the largest component of the outright spread for an outright forward
Currency Hedging
31
Table 3.5 Table of proportion of quoted spread actually paidForward spreadsCurrency pairUSD/EURGBP/EURJPY/EURCHF/EURUSD/GBPJPY/GBPCHF/GBPJPY/USDCHF/USDUnweighted averagesAverage outright spreads
Spot spread
1m
2m
3m
6m
12m
57%52%35%30%201%80%31%68%24%46%46%
123%120%156%109%119%135%120%251%112%130%51%
110%128%145%83%135%160%84%158%81%112%52%
108%90%126%86%79%105%95%148%106%102%53%
91%97%134%81%121%128%120%125%90%108%58%
57%80%101%118%150%53%294%38%67%55%
contract, and so this effect dominates the outright spreads, which range from 46% to 58% ofthe quoted outright spreads.The story for swap spreads is quite different. With the exception of 12m maturity, swapspreads achieved are slightly wider than the swap spreads quoted. However, the absolute sizeof the spreads is very small, so the impact on overall costs is very small.3.1.2.3 SensitivityForward contracts are a ‘straight line’ hedge – that is, if the principal value of the contractsequals the asset value, then it will fully eliminate foreign currency risks.Both the example and some of the caveats from Section 3.1.1 apply to forward contracts.However, forward contracts are very cheap and easy to adjust in size, they are ideal for hedginga changing asset value. They are also easy to value (using the forward currency market to markthem to market), and their change in value is dominated by the movements in the spot marketrather than changing interest rate differentials.3.1.3 Currency swaps3.1.3.1 NatureCurrency swaps (to be distinguished from FX swaps, which are the shifting of maturities in theFX market) are long-term contracts which have developed out of the needs of the internationalbond market, and the need of companies and their corporate treasuries to easily hedge bondsthat they issue in foreign currencies.A currency swap is a contract between two parties (say customer and bank), in which theparties agree to exchange regular (quarterly, twice-yearly or yearly) payments in differentcurrencies, and then one ﬁnal, much larger, exchange at maturity. The purpose of currencyswap is to convert the payment (or receipt) stream from a bond from one currency into another.As an example, Table 3.6 shows the payments for a USD/GBP swap for a sterling-based issuer,who has issued a USD ﬁxed rate bond, but wishes to have only sterling ﬁxed rate liabilities.(10-Year $100m bond; annual interest payments; ﬁxed rate; bullet repayment; dollar coupon= 5% p.a.; sterling 10-year ﬁxed rate market (for this issuer) = 7% p.a. All payments andreceipts are from the perspective of the customer.)
−100.00
−7.00−7.00−7.00−7.00−7.00−7.00−7.00−7.00−7.00−7.00−7.00
012345678910
Repayment ofprincipal ($m)
Coupon paymentsunder bond ($m)
Years fromissue
C
B
A
Table 3.6 Payments for a USD/GBP swap
7.007.007.007.007.007.007.007.007.007.007.00
Swap annualreceipts ($m)
D
100.00
−5.00−5.00−5.00−5.00−5.00−5.00−5.00−5.00−5.00−5.00−5.00−71.43
Swap ﬁnalpayment (£m)
G
Total net swap payments (£m)
Swap ﬁnalreceipt ($m)
F
Swap annualpayments (£m)
E
1.40001.36001.61501.50501.53001.71001.81001.75001.74001.55001.6200
USD/GBP spotexchange rate
H
−16.17
–0.15−0.67−0.35−0.42−0.91−1.13−1.00−0.98−0.48−10.38
INet swapreceipts/payments (£m)
Currency Hedging
33
The mechanics of the swap is generally that the swap counterparties will make the dollarleg of the payments direct to the bondholders, and the customer will then only ‘see’ sterlingpayments. They will look for all the world like a sterling 7% ﬁxed rate bond. However, swappayments can be netted (at the then current exchange rate), and just the sterling amount paid toor from the customer (column I). This is uncommon in currency swaps, but almost universalin another branch of the swap world – interest rate swaps.A currency swap is the economic equivalent of an issue of a bond in one currency, and theinvestment of the proceeds in another. The astute reader will have noticed that a currency swapis like a series of forward contracts at increasing maturities, and one large forward contract atﬁnal maturity. However, whereas individually traded forward contracts would be conducted atthe forward rates relating to the maturity, the currency swap exchange rates are all conductedat the spot exchange rate at initiation. The mechanics of the interest rate differential is accountedfor by means of outgoing annual swap payments being higher or lower than annual receiptsby the interest rate differential.Why is this very specialised type of currency hedge relevant in currency overlay? The answeris that a currency swap, or its equivalent, is the only instrument capable of hedging a ﬁxed rateforeign currency bond into a domestic currency ﬁxed rate bond. Short-term currency hedgeswill not allow a pension fund or insurance company to match the domestic long-bond yieldcurve with long-dated foreign bonds. Short-term hedges will eliminate the spot (and short-termforward) exchange rate risk, but leave the investor with an unwanted foreign currency yieldcurve and not give the investor the desired domestic yield curve. A currency swap can do this.However, the use of swaps in this area is rare. All the hedged benchmarks for internationalﬁxed income use 1-month rolling currency hedges, and short-term currency hedges remainoverwhelmingly the currency hedge of choice for ﬁxed income.3.1.3.2 CostsCurrency swaps are a relatively restricted market, although they will be offered by the investment banking market in volume to interested customers. Bid/offer spreads, expressed in basispoints of yield, are around 5–10 bp for ‘straight dates’ (i.e. exactly 10 years), plain vanillacontracts, collateralised and liquid currencies. While 5–10 bp may look similar to the costsof outright forward contracts (see above), 10 basis points of yield is 81 bp of NPV at a 4%discount rate. That is, if a customer wished to reverse a currency swap the day after he hadinitiated it, it would cost him 0.81% of the principal in bid/offer spreads.Closing currency swaps, particularly where the original counterparty to the swap is asked toquote, is often more expensive than nominal spread quotes would imply. The ‘odd’ maturitydate is a much less liquid market, and the original counterparty has a credit advantage overa new counterparty – the former is eliminating a credit risk, while the latter is taking a newrisk on.Finally, swap contracts are ‘credit-intensive’. Unless a swap is collateralised (i.e. assets areregularly posted to cover losses either way), the counterparty will demand a signiﬁcant creditpremium, which will emerge in a wider bid/offer spread.3.1.3.3 SensitivityA currency swap is another ‘straight line’ instrument as far as currency exchange rates areconcerned. However, it can give convexity in its interest rate sensitivity, to counter the same
34
Currency Overlay
convexity in bond valuation. This means that the marginal change in value of the swap as thedomestic interest rate falls, rises as the domestic interest rate tends towards zero.3.1.4 Currency futures3.1.4.1 NatureA currency futures contract is an irrevocable contract to buy or sell one currency for anotherat a ﬁxed price, on a ﬁxed date in the future. Currency futures contracts are almost identicalto forward contracts in their economic effect, but are traded in standardised amounts, forstandardised and ﬁxed maturity dates on a formal futures exchange (see Box 3.4). Currencyfutures are widely used by retail ‘investors’ (in reality ‘traders’ rather than ‘investors’).Box 3.4
Futures
Futures markets exist in a very wide variety of commodity, ﬁnancial and money markets, including the currency market. Futures contracts are always issued by an organised exchange,and have certain common characteristics that set them apart from forward contracts:
r A futures contract is an agreement to buy (long contract) or sell (short contract) a ﬁxed
amount of a commodity, ﬁnancial index or other market at a ﬁxed price on a ﬁxed datein the future.r Futures are priced in public (at the exchange) and are available to anybody able to payan initial cash deposit.r A futures contract can be a ‘contract for difference’ or contract for delivery. A contractfor delivery means that the holder of the long contract will be tendered the commodityin question at expiry of the contract. A ‘contract for difference’ means that the holder ofthe long contract will be paid/have to pay an amount of money equal to the differencebetween the contract rate and the ofﬁcial ‘settlement’ rate on the closing day of thecontract.r Futures contracts do not require any assessment of credit by either buyer or seller. Eachfutures contract is contracted with the issuing exchange, and the exchange requires a cash‘margin’ from each participant sufﬁcient to cover their marked-to-market liability to theexchange. If the contract become worth less (or negative) because of market movements,the exchange will ask for more cash (variation margin), and failing that will force theclosure of the contract.Although the exchange is the counterparty to all futures contracts, the fundamental principleof futures markets is that the exchange ‘holds the ring’ for independent traders, who contractdeals with each other in the open outcry ‘ﬂoor’ of the exchanges. The exchanges’ tradingsystems ensure that there are always exactly the same amount of long contracts outstandingas short contracts.Users of futures contracts, whether retail or wholesale, are obliged to use a broker to executethe transaction on their behalf. The broker will be a clearing member of the exchange, whichmeans that they can deal directly with the futures exchange, and represent the counterpartywhich the exchange looks to for margining. Futures brokers will make their money in threeways: through commissions charged to the client, through differential interest rates paid andreceived on margin accounts, and through acting as proprietary market-makers in the futures
Currency Hedging
35
market. The futures market needs proprietary market-makers, just as the interbank currencymarket needs price-givers. They act as the lubrication of the system, taking short-term currency risk for a fee (the bid/offer spread). Bid/offer spreads in the currency market are highlydependent on activity in the particular market, and on the direction of sentiment (i.e. desiredtrades) on the ﬂoor. Currency futures markets are the most ‘anchored’ of any of the futuresmarkets, because the massive interbank market is an exact match for hedging. This means thatprices on futures exchanges never stray far from interbank prices.Futures markets’ margining systems allow anyone, with or without a credit status, to accessthe currency market. Margining works as follows.3.1.4.2 MarginingTo establish an initial futures position, a customer must ﬁrst appoint a futures broker withwhom he will transact the futures contracts. The broker will either be a clearing member ofthe futures exchange, or a customer of a clearing member. The smaller, or very ‘retail’ brokersmay not be clearing members, but this will mean that they will have a higher cost base inthe transaction ‘chain’. We will assume for the purpose of this description, however, that thebroker is a clearing member.The customer will be required by the broker to deposit an amount of cash (an ‘initial margin’)with the broker to be able to undertake the ﬁrst trade. This margin is calculated as a percentageof the face value of the contracts – typically 10%, although this can vary widely depending onthe market conditions at the time, the market in which the customer is going to transact, and therequirements of the exchange. This initial margin is paid over to the exchange by the broker.The arrangements for interest on margins varies. The broker may be paid interest by theexchange at something below market interest rates; most brokers will not pay interest on marginbalances, but it is common for brokers (and sometimes the exchange) to accept interest-bearinginstruments (say Treasury bills) as margin.For retail investors, all that is required is an initial cash payment, and further cash payments ifthe contract loses money. Failure to pay the further cash payments results in automatic closureof the contract by the exchange, preserving the credit integrity of the contract (i.e. ensuring thatthe commitment is fulﬁlled in full). Futures contracts are generally cheap to deal by normalretail standards, although for large sizes, the combination of brokerage charge, bid/offer spreadand margin interest arrangements will make futures not cost-effective. To my knowledge, nocurrency overlay manager of institutional accounts uses currency futures markets to any greatextent – the interbank alternative is just too attractive.Table 3.7 shows the futures exchanges that offer currency futures contracts, and the broadspeciﬁcation of the contracts.3.1.4.3 CostsIt is not easy to generalise on the transaction costs of futures contracts – it depends on thecharging structure of the broker, and the contracts which are being dealt. In currency futures,total transaction costs are almost invariably higher than the underlying cash (i.e. interbank)market. Bid/offer ‘spreads’ in futures, while not formally necessary, will in practice exist, andwill be wider than interbank spreads. ‘Spreads’ in futures are a particular concept on which itis worth elaborating.When a futures contract trades, it does so at one price. If a customer – buyer of a contract, anda customer – seller of the same contract, happen to wish to execute their trades simultaneously,
JPY
EURZAR
AUDAUS, GBP, CAD, JPY, CHF
4
15m
50
20100
5050–100
12m12m412 quarterly maturities& 2 near-monthmatur