<s> Foreign Exchange and Money Markets
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Foreign Exchange and Money MarketsTheory, Practice and Risk Management
Bob Steiner
Butterworth-HeinemannAn imprint of Elsevier Science Linacre House, Jordan Hill, Oxford OX2 8DP225 Wildwood Avenue, Woburn, MA 01801-2041A division of Reed Educational and Professional Publishing LtdFirst published 2002Copyright © 2002, Bob Steiner. All rights reservedThe right of Bob Steiner to be identiﬁed as the author of this workhas been asserted in accordance with the Copyright, Designs andPatents Act 1988No part of this publication may be reproduced in any material form (includingphotocopying or storing in any medium by electronic means and whetheror not transiently or incidentally to some other use of this publication) withoutthe written permission of the copyright holder except in accordance with theprovisions of the Copyright, Designs and Patents Act 1988 or under the terms ofa licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road,London, England W1T 4LP. Applications for the copyright holder’s writtenpermission to reproduce any part of this publication should be addressedto the publisher
British Library Cataloguing in Publication DataSteiner, BobForeign exchange and money markets : theory, practice andrisk management. – (Global aid capital market series)1. Foreign exchange2. Money marketI. Title332.4’5Library of Congress Cataloguing in Publication DataA catalogue record for this book is available from the Library of CongressISBN 0 7506 5025 7
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Typeset by Laserwords, Chennai, IndiaPrinted and bound in Great Britain
ContentsABOUT THE AUTHORNOTE FROM THE AUTHOR
xixiii
Part 1 Introduction
1
1. SOME BASIC CONCEPTSCurrency codesHedging, speculation and arbitrageSpot, forward, value dates and short datesSome basic terminology
33346
2. ESSENTIAL FINANCIAL ARITHMETICPercentagesSimple interest calculationsThe different day/year conventionsPresent valueCalculating the yield on an investment or the cost of aborrowingCompounding two or more interest rates together (astrip)InterpolationPaying interest with different frequenciesExercises
888913
16171821
Part 2 Money Markets
23
3. OVERVIEW OF MONEY MARKET INSTRUMENTSIntroductionThe yield curveSome more terminologyMoney market instruments
2525262831
4. DEPOSITS AND COUPON-BEARING INSTRUMENTSFixed deposits
3636
14
vi
Contents
Taking a positionThe price of a CDMoney market yield of a bond in its last coupon periodBreaking a ﬁxed depositCDs paying more than one couponExercises
373943444648
5. DISCOUNT INSTRUMENTSDiscount instrumentsDiscount/true yieldBond-equivalent yields for US Treasury billsEffective rates and Norwegian Treasury billsExercises
505052565758
6. FORWARD INTEREST RATES, FRAs ANDINTRODUCTION TO FUTURESOverviewPricing a forward-forwardForward rate agreement (FRA)Introduction to futuresFutures compared with FRAsThe yield curveApplications of FRAs and futuresExercises
606061636875767789
Part 3 Foreign Exchange
91
7. SPOT FOREIGN EXCHANGEIntroductionHow spot rates are quotedPosition-keepingReciprocal ratesCross-rate calculationsThe market environmentExercises
93939499101101105105
8. FORWARD OUTRIGHTS AND SWAPSForward outrightsForward swapsShort datesForward-forwardsCalculation summaryCross-rate calculationsNon-deliverable forwards (NDFs)
107107111123127131133136
Contents
Time optionsLong-dated forwardsSynthetic agreements for forward exchange (SAFEs)Summary of uses of forward FX instrumentsExercises9. HEDGING SWAPS WITH DEPOSITS, FRAs ANDFUTURES, COVERED INTEREST ARBITRAGE ANDCREATING SYNTHETIC FRAsHedging FX forwards using borrowings and depositsHedging FX forward-forwards with FRAs or futuresCovered interest arbitrageCreating an FRA in one currency from an FRA inanother currencyExercises
vii
138139141144145
149150155161168171
10. MANAGING THE SPOT RISK ON A FORWARD FXPOSITIONHedging a forward swap positionMeasuring the spot risk on a forward outright positionExercise
173173179181
11. CURRENCY RELATIONSHIPSOverviewExchange rate regimesEuropean Monetary UnionAnalysing currency movements
182182183185188
Part 4 Risk Management
193
12. BANK RISK MANAGEMENTOverviewMarket riskCredit riskOperational riskOther risksValue at risk (VaR)Capital adequacy requirements
195195195201207209211224
13. CORPORATE RISK MANAGEMENTAnalysis of risksEstablishing a policyForecasts, hedging decisions and targetsCurrency exposure reporting
230230236242246
viii
Contents
Evaluating the success of treasury managementExercises
248249
ANSWERS TO EXERCISES
251
APPENDIX A. A summary of money market day/yearconventionsAPPENDIX B. A summary of calculation proceduresAPPENDIX C. SWIFT currency codes
271273284
GLOSSARY
291
INDEX
323
To my wife Barbara,as always
About the AuthorBob Steiner is Managing Director of Markets International Ltd, anindependent company specializing in training in a range of areasrelated to the international ﬁnancial markets, treasury and banking.He has also written the best-selling Mastering FinancialCalculations, and Mastering Repo Markets (both published byFinancial Times Prentice-Hall) and Key Market Concepts (publishedby Reuters and Pearson Education).Bob was previously senior consultant with HSBC, where he workedin London and New York in the dealing area as consultant to majorUS and European companies on treasury management. He has alsobeen treasurer and fund manager of H P Bulmer Holdings PLCand English and American Insurance Group PLC, both active incurrency and interest rate management. He has also worked in theOverseas Department of the Bank of England, and with the EuropeanCommission in Brussels.His academic background is an honours degree in mathematicsfrom Cambridge University, followed by further studies in economicswith London University. He is a member of ACI – The FinancialMarkets Association, and the Association of Corporate Treasurers.Bob himself spends a considerable amount of time trainingbankers, systems staff, corporate staff and others involved in theﬁnancial markets. In addition to general and in-house courses, hepersonally runs courses for all the ACI’s professional exams fordealers – the ACI Diploma, the Dealing Certiﬁcate and the SettlementsCertiﬁcate – on behalf of various national ACI associations acrossEurope.
Note from theauthorAlthough this book is called Foreign Exchange and Money Markets,the chapters on the money markets come ﬁrst. This is because thereare some money market ideas which it might be useful to have coveredbefore some of the material on foreign exchange.I would be very grateful for any comments on the book, or ideas onany additional areas which readers feel could be usefully included.
Bob SteinerMarkets International LtdAylworthNauntonCheltenhamGloucestershire GL54 3AH
Markets International LtdTraining and consultancy for the international financialmarketsMarkets International Ltd is an independent company providingtraining to banks and companies on financial markets and mathematics, risk management techniques, analysis and managementpolicy, credit analysis, technical analysis and other financial subjects.The company also provides advice to finance directors andtreasurers of international companies on foreign exchange, moneymarkets and other treasury matters. This ranges from writtenstudies reviewing existing management policies and procedures tothe development of appropriate hedging strategies.Among the subjects covered in Markets International Ltd’s workshops on financial markets and banking, are:•••••••
Foreign Exchange and Interest Rate Risk ManagementFinancial MathematicsReposCorporate Exposure ManagementTechnical AnalysisAccounting for DerivativesCredit Analysis
The company also runs workshops aimed specifically at the followingexams of ACI – The Financial Markets Association:• ACI Diploma• ACI Dealing Certificate• ACI Settlements CertificateFor further information on in-house training opportunities, or publiccourses, please contact:Bob SteinerManaging DirectorMarkets International LtdAylworth, Naunton, Cheltenham, Glos GL54 3AH, UKTelephone: +44(0)1451-850055Fax:+44(0)1451-850367E-mail: Markets@FSBdial.co.uk
Part 1Introduction
This Page Intentionally Left Blank
1
Some basicconceptsCurrency codesThroughout the book, we have generally used ISO codes (also usedby the SWIFT system) to abbreviate currency names – for example,GBP for sterling, USD for US dollars and EUR for euros. You can ﬁnda list of codes in Appendix C.
Hedging, speculation andarbitrageSome activity in the ﬁnancial markets is driven by underlyingcommercial needs. Companies, banks and individuals borrow moneybecause they need to ﬁnance their activities. Conversely, investorswith surplus funds need to keep their money somewhere and wishto earn a return on it because otherwise it will dwindle in realvalue because of inﬂation. Through the mechanisms of the ﬁnancialmarkets, the investors effectively lend, directly or indirectly to theborrowers. Also, organizations involved internationally need at somepoint to convert cashﬂows from one currency to another. Otherorganizations need to buy or sell commodities because that is anessential part of their business.Beyond these activities, however, there are at least three distinctmotivations for dealing: speculation, hedging and arbitrage – although deals often contain elements of more than one category:• Speculation A trader in a bank or elsewhere will often deliberately establish a risky position where there was no risk in the ﬁrstplace, because he believes he can make a proﬁt by doing so. This
4
Foreign exchange and money markets
is speculation. For example, a trader who believes that the price ofgold is going up might buy gold, without any commercial need todo so. If the price of gold does rise as he expects, he will make aproﬁt. If it falls, he will make a loss.• Hedging In the opposite way to this, to hedge (or to cover)means to protect against the risks arising from potential marketmovements in exchange rates, interest rates or other variables.This could be a company protecting against the risk that the valueof its future income in a foreign currency is vulnerable becausethat currency might weaken soon, or a company protecting againstthe possible future increase of interest rates, which would increasethe company’s borrowing costs. Alternatively, it might be a bankdealer deciding that a speculative position he has already takenhas now become too risky and choosing to insulate the positionagainst any further market movements.• Arbitrage The third broad category involves packages of morethan one deal in different but related markets. If a dealer sees thatthe prices of two ﬁnancial instruments which should be in line arein fact not in line, he can deal in both instruments simultaneouslyin such a way as to lock in a proﬁt but take no, or little, risk. Thisis arbitrage.
Spot, forward, value dates andshort datesIn general, each type of ﬁnancial transaction has a normal time-cyclefor settlement. For example, if a dealer does a straightforward foreignexchange deal today to buy US dollars and sells euros then, undernormal circumstances, he expects that he will receive the dollars andpay the euros not today, but in two business days’ time. This delay isessentially to allow enough time for the mechanics of the cash transfers involved. In foreign exchange, this is referred to as trading forvalue spot. Each market has its own normal convention, sometimesfor settlement after a delay like this, and sometimes for settlement onthe same day as the transaction. In both the foreign exchange andinternational money markets, for example, the usual convention isspot, as just described. Money market deals in a domestic market,however – i.e. in the same currency as the market in which they takeplace (for example, a US dollar deposit in the USA) – are generallysettled on the same day as they are transacted.In many markets, it is also possible to undertake a transactionwhere the two parties agree that the settlement will be on a later
Some basic concepts
5
date than normal. This is called a forward deal. Similarly, with atransaction such as a foreign exchange spot deal or an internationalmoney market deal, it is possible to agree on settlement earlier thannormal.A futures contract is very similar in concept to a forward, butis traded on a recognized exchange, rather than between any twoparties. This gives rise to certain important mechanical differences.Both money market deposits and foreign exchange forwards arenormally quoted for certain regular dates – for example, 1, 2, 3, 6and 12 months forward. These dates are quoted over the spot date.This means that the 1-month forward rates are calculated for onecalendar month after the present spot value date. For example, iftoday is 19 April and the spot value date is 21 April, then the 1-monthforward value date will be 21 May. No adjustment in the forward valuedate is made for any weekends or public holidays between the spotdate and the forward delivery date. However, if the forward deliverydate falls on a weekend or holiday, the value date becomes the nextbusiness day.One exception to this last rule is when the spot value date is at orclose to the end of the month. Suppose that the spot value date isearlier than the last business day of the month, but the forward valuedate would fall on a non-business day. If moving the forward valuedate to the next business day would result in it falling in the nextmonth, it is instead brought back to the previous business day inorder to stay in the same calendar month. This is called the modiﬁedfollowing convention.Another exception arises if the spot value date is exactly the lastbusiness day of a month. In this case, the forward value date isthe last business day of the corresponding forward month. This isreferred to as dealing end-end.Any month that is not a regularly quoted date, for example for 4or 5 months’ maturity, is called an in-between month because it isbetween the regular dates. A forward deal may in fact be arrangedfor value on any business day (or any day which is a business day inboth currencies for foreign exchange). Dates which do not ﬁt in withcalendar month dates are called broken dates or odd dates.ExampleToday is Monday 27 October 2003.The spot value date is Wednesday 29 October 2003.The 1-month value date is Friday 28 November 2003 (modiﬁedfollowing convention because 29 November is a Saturday and
6
Foreign exchange and money markets
the next business day – Monday 1 December – is in the nextmonth).The 2-month value date is Monday 29 December.
ExampleToday is Wednesday 25 February 2004.The spot value date is Friday 27 February 2004 (which is the lastbusiness day of February because 29 February is a Sunday).The 1-month value date is Wednesday 31 March 2004 (end-endconvention).The 2-month value date is Friday 30 April 2004 (end-end convention).
Short datesValue dates earlier than 1 month are referred to as short dates. Thereare certain regular dates usually quoted, and the terminology used isthe same in the deposit market and the foreign exchange market, asfollows:Overnight:Tom-next:Spot-next:Spot-a-week:
a deposit or foreign exchange swap from todayuntil tomorrowa deposit or foreign exchange swap from tomorrowuntil the next day (spot)a deposit or foreign exchange swap from spot untilthe next daya deposit or foreign exchange swap from spot untila week later
Tomorrow means the next working day after today and next meansthe next working day following (i.e. spot).
Some basic terminology• The cash market Cash market is an expression sometimes usedfor the spot market in something as opposed to the forward market.It is also used, quite separately, for transactions where, on thesettlement date, the whole value of something will potentiallybe settled in the normal way. This is distinct from contracts fordifferences, where the cash amount to be settled is never intendedto be the full principal amount underlying the transaction; instead
Some basic concepts
7
settlement is made of only the difference between two prices orrates.• Bid, offer and spread In general, dealers who make a marketin anything (i.e. dealers whose business is to quote prices to anycreditworthy counterparty who asks) quote a two-way price. Thismeans that the dealer quotes two prices simultaneously – one atwhich he buys something or borrows money, and the other atwhich he sells something or lends money.The bid price or rate is the price at which the dealer quotingthe price is prepared to buy or borrow. The offer (or ask) price isthe price at which he is prepared to sell or lend. The differencebetween them, representing a proﬁt to the dealer, is called thespread.• Long, short and square A long position is a surplus ofpurchases over sales of a given currency or asset, or a situationwhich naturally gives rise to an organization beneﬁting from astrengthening of that currency or asset. To a money market dealer,however, a long position is a surplus of borrowings taken in overmoney lent out (which gives rise to a beneﬁt if that currencyweakens rather than strengthens).A short position is a surplus of sales over purchases of a givencurrency or asset, or a situation which naturally gives rise to anorganization beneﬁting from a weakening of that currency or asset.To a money market dealer, however, a short position is a surplusof money lent out over borrowings taken in (which gives rise to abeneﬁt if that currency strengthens rather than weakens).A square position is one in which sales exactly match purchases,or in which assets exactly match liabilities.• Eurocurrency Historically, the terms Euro and Eurocurrencyhave been used to describe any instrument which is owned outsidethe country whose currency is involved. The term does not imply‘European’. For example, a US dollar deposit made by a US resident in New York is in domestic dollars, but a dollar deposit madein Tokyo is in Eurodollars. Similarly, US dollar commercial paperissued outside the USA is Eurocommercial paper while US dollarcommercial paper issued inside the USA is domestic US commercial paper. Confusingly, this term has nothing whatever to do withthe European Monetary Union currency also called the ‘euro’.
2
EssentialﬁnancialarithmeticPercentagesWhen using interest rates, ‘4.7%’, ‘4.7/100’ and ‘0.047’ all meanexactly the same. Throughout the book, when we have used aninterest rate in a calculation, we have not multiplied it by 100. Forexample, if we do a calculation involving an interest rate of 4.7%,we generally write this in the calculation as ‘0.047’ and not ‘4.7’.Similarly, whenever we speak of ‘an interest rate’, we always mean anumber like 0.047, not a number like 4.7.When referring to interest rates, a basis point always means 0.01%(which is the same as 0.01/100 or 0.0001). Note that this is notnecessarily the same as a foreign exchange point.
Simple interest calculationsOn short-term ﬁnancial instruments, interest calculations are usuallysimple rather than compound. This means that no account is takenof interest on interest – i.e. how much interest is earned when reinvesting an interim interest payment. This is generally appropriate inthe money markets because there is usually, although not always,only one single interest payment, at maturity.Suppose that I place GBP 1 million on deposit at 5.3% for 92 days.As the 8% is generally quoted as if for a whole year rather thanfor only 92 days, the interest I expect to receive is the appropriate
Essential ﬁnancial arithmetic
9
proportion of 5.3%:GBP 1,000,000 × 0.053 ×
92= GBP 13,358.90365
The total proceeds after 92 days are therefore the return of theprincipal, plus the interest:GBP 1,000,000 + GBP 13,358.90 = GBP 1,013,358.90Note that it is possible to write this last calculation in a slightlyneater way:92GBP 1,000,000 × 1 + 0.053 ×= GBP 1,013,358.90365Simple interest earned = principal amount× interest rate ×
daysyear
Maturity proceeds = principal amountdays× 1 + interest rate ×year‘Days’ means the number of calendar days in the period, in theusual way, including the ﬁrst date but not the last date. ‘Year’means the number of days in a conventional year – see the nextsection.
The different day/yearconventionsACT/360 and ACT/365As a general rule in the money markets, the calculation of interesttakes account of the exact number of calendar days in the period inquestion, as a proportion of a year.However, the number of days in a ‘year’ is often not the usual365. Instead, it is more often 360. This is simply a convention usedin many ﬁnancial markets around the world. For example, if a bankquotes an interest rate of 5.3% per year on a deposit of USD 1 million,it does not really mean that it pays exactly 5.3% over a full calendaryear of 365 days. In fact, it pays slightly more than that, since it
10
Foreign exchange and money markets
would pay exactly 5.3% over a period of only 360 days. The interestover 365 days is therefore:365= USD 53,736.11USD 1,000,000 × 0.053 ×360Sterling deposits, on the other hand, assume that there are 365 daysin a year. In both cases, the year base remains the same – 360 or365 – regardless of whether or not a leap year is involved. Thus adeposit of GBP 1 million at 5.3% which lasts exactly one year, butincludes 29 February in its period (a total of 366 days), will actuallypay interest of slightly more than 5.3% – in fact:366= GBP 53,145.21GBP 1,000,000 × 0.053 ×365There is thus a variation between different money markets in theconventions used for the number of days assumed to be in the yearbase. The convention used for all sterling money market transactions is usually referred to as ACT/365 – i.e. the actual number ofcalendar days in the period, divided by 365. The convention usedfor all transactions in US dollars and euros is usually referred to asACT/360 – the actual number of calendar days in the period, dividedby 360.Most money markets use the ACT/360 convention. The exceptions which use ACT/365 include the international markets and thedomestic markets in the following currencies:SterlingHong Kong dollarSingapore dollarMalaysian ringgitTaiwan dollarThai bahtSouth African randand the domestic (but not international) markets in the following:Japanese yenCanadian dollarAustralian dollarNew Zealand dollarExample 1Interest is quoted on a GBP 1 million deposit at 5.3%. Thedeposit runs from 31 October 2003 to 5 March 2004. Whatis the amount of interest paid?
Essential ﬁnancial arithmetic
11
There are 126 days from 31 October to 5 March (including 29February 2004). The interest amount is therefore:126= GBP 18,295.89GBP 1,000,000 × 0.053 ×365
Example 2Interest is quoted on a USD 1 million deposit at 5.3%. Thedeposit runs from 31 October 2003 to 5 March 2004. What isthe amount of interest paid?The interest amount is:USD 1,000,000 × 0.053 ×
126= USD 18,550.00360
30/360There are some exceptions to the two conventions above. For example,Swedish Treasury bills and some other markets use a conventioncalled 30/360 (also known as 30(E)/360 or 360/360), which is alsoused in some European bond markets. In this convention, the ‘year’has 360 days and the number of days in the period is calculateddifferently from the calendar.Each month is assumed to have 30 days, regardless of what thecalendar says, so that the 31st day of any month is treated as if itwere the 30th day of that month. To calculate the number of days inany period therefore, use the following rules:• First, change any date which is 31st to 30th.• Second, multiply the difference between the months by 30.• Third, add the difference between the days.Example 3Interest is quoted on a EUR 1 million deposit at 5.3% on a30/360 basis (unusually!). The deposit runs from 31 October2003 to 5 March 2004. What is the amount of interest paid?First, change 31 October to 30 October. Second, there are5 months from October to March and 5 × 30 = 150. Third, thereare −25 days from 30th to 5th. There are therefore 125 daysfrom 31 October to 5 March on a 30/360 basis.
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Foreign exchange and money markets
The interest amount is therefore:EUR 1,000,000 × 0.053 ×
125= EUR 18,402.78360
The ACT/365 and 30/360 conventions are sometimes referred toas bond basis (because bond markets use similar conventions). TheACT/360 convention is sometimes referred to as money market basis.In Appendix A we have given a list of the conventions used in somemarkets.
Converting between the different conventionsIt is possible to convert an interest rate quoted on one basis to whatit would be if it were quoted on another basis. For example:
Interest rate on ACT/360 basis= interest rate on ACT/365 basis ×
360365
Interest rate on ACT/365 basis365360Interest rate on ACT/360 basis = interest rate on 30/360 basis= interest rate on ACT/360 basis ×
×
days in period measured on 30/360 basisdays in period measured on ACT/360 basis
Interest rate on 30/360 basis = interest rate on ACT/360 basis×
days in period measured on ACT/360 basisdays in period measured on 30/360 basis
Example 4A dealer quotes for a EUR 1 million deposit from 5 May to 31August, at 4.7% on an ACT/360 basis in the usual way. Whatwould the quote be if the customer wanted it converted to anACT/365 basis or a 30/360 basis?There are 118 actual calendar days from 5 May to 31 August.There are 115 days on a 30/360 basis.Interest rate on ACT/365 basis = 4.7% ×
365= 4.7653%360
Essential ﬁnancial arithmetic
Interest rate on 30/360 basis = 4.7% ×
13
118= 4.8226%115
Present valueAs in Example 2, if I deposit USD 1 million for 126 days at 5.3%, Ireceive interest of USD 18,550.00:126= USD 18,550.00USD 1,000,000 × 0.053 ×360The total proceeds including principal at the end of 126 days aretherefore USD 1,018,550.00. This could be written as:126USD 1,000,000 × 1 + 0.053 ×= USD 1,018,550.00360Suppose that I ask the question: ‘‘How much do I need to puton deposit now so that, after 126 days, I will receive back USD1,018,550.00?’’ Clearly, the answer is USD 1,000,000. However, howwould we have calculated the answer if we did not already know? Theanswer is the reverse of how we calculated the end proceeds above:
USD 1,018,550.00 = USD 1,000,0001261 + 0.053 ×360
The amount we have calculated is known