ity is 1 dollar, or in American terms, such that the traded commodity in 1unit of foreign currency.7.3.2 Reading Foreign Exchange RatesFor example, the dollar against the Swiss franc could be quoted as 1.6703/08. But what doesthis quote actually indicate? As has been mentioned, a market maker will normally quote atwo-way price – in other words, it is obliged to make a bid and an offer for dollars against, inthis case, the Swiss franc. Market makers will always quote to their advantage and to the otherperson’s disadvantage. The left-hand side of the quote (1.6703) is the quoting person’s bid fordollars, obviously surrendering as few Swiss francs as possible. Conversely, the right-handside of the quote (1.6708) is the market maker’s offer for dollars, at which they will ask for asmany Swiss francs as possible. The difference between the rate at which someone will buy acurrency and the rate at which that person will sell is called the proﬁt (spread).For example, when a market maker quotes spot Swiss franc (against the dollar), the traderwill say:‘dollar/Swiss franc is 1.6703−1.6708’where their bid is at Sfr 1.6703/$1 and their offer is at Sfr 1.6708/$1. That is, the marker makerwill buy $1 for Sfr 1.6703, which means the client will sell $1 for Sfr 1.6703 – the client sellsat the market maker’s bid. Conversely, the market maker will sell $1 for Sfr 1.6708, whichmeans the client will buy $1 for Sfr 1.6708 – the client buys at the market maker’s offer (seeFigure 7.2)It is important to remember that in any foreign exchange transaction, each party is both buyingand selling, since it is buying one currency while selling another. One way of determining whichMarket maker
Market maker
Sell francs
Buy francs
Sell dollars
Buy dollars
Buy dollars
Sell dollars
Buy sterling
Sell sterling
1.6703
1.6708
1.4395
1.4400
Buy francs
Sell francs
Buy dollars
Sell dollars
Sell dollars
Buy dollars
Sell sterling
Buy sterling
Market user
Figure 7.2 Example of a currency transaction
Market user
44
A Foreign Exchange Primer
is the buying rate and which is the selling rate, is to remember that a market maker will buydollars for another currency at a low rate (its bid rate) and sell dollars for another currency ata high rate (its offered rate). For currencies like sterling and euro, the market maker will buysterling for dollars at the bid rate and sell sterling for dollars at the offered rate.7.3.3 Big FiguresUsually, market makers will quote only the last two numbers in the prices, for example 03/08,thus assuming the other party knows the rest of the price, which is known as the big ﬁgure,in this case 1.67. In an example of, say sterling/dollar being quoted 1.4397–1.4402, the bigﬁgure is both 1.43 and 1.44. However, in this case, the trader would say:‘97−02, around 1.44’7.3.4 SpreadAs mentioned above, by quoting a higher offer than bid, the market maker ensures that if bothsides of the quote are dealt on simultaneously, the market maker will proﬁt from the differencebetween the bid and offer. This difference is the spread and the size of the spread is affectedby various factors. The main factors are the assessment of risk, the volatility of the market, theliquidity of the currency, and the time of the day in each time zone.
7.4 DIRECT VERSUS BROKERED DEALINGWhen a dealer calls another dealer for a price, it is called direct dealing. When a dealer puts abid or offer in at a foreign exchange broker or via some Internet trading platforms, it is calledbrokered dealing. Brokered dealing is somewhat like a silent auction as the buyers and sellersare unaware of each other’s identity until the deal is done, and the bid and offer process maynot be accepted.
7.5 CROSS RATESA cross-rate is the rate of exchange between two currencies that do not involve thedomestic currency. In the international market, cross rates have come to mean ratesthat do not involve the American dollar.Most transactions are dealt in American terms. However, currencies are also dealt against eachother; for example, the Swiss franc against the Japanese yen (SFR/JPY). In these instances, itis necessary to calculate the cross rate.In order to calculate this cross rate, start with the two rates against the dollar. The objectiveis to obtain the number of Japanese yen per Swiss franc. Consider:One dollar = francs 1.6703/08One dollar = yen 121.70/75
Spot Foreign Exchange
45
Each quotation represents a bid and an offer for the currency against the dollar. The cross rateis achieved by taking opposite sides of the two prices. The rate for selling yen and buyingfrancs is achieved by using the left-hand side of the dollar/yen (bid) rate and the right-handside of the dollar/franc (offer) rate. The same logic is applied for buying yen and selling francs.Thus, the above quotations can be broken down as follows:121.70 divided by 1.6708 = 72.84121.75 divided by 1.6703 = 72.89Hence, the spot cross rate for Swiss francs against the Japanese yen is 72.84/89. The numberof places after the decimal point is determined by the convention of the quoted currency (thevariable currency). In the above example, this is the yen, since we are looking for the numberof yen per franc. It is usual to quote cross-currency exchange rates using the ‘heavier’ currencyas the base, for example the number of yen per franc.There is, of course, a variation to the rule. For currencies like the euro and sterling, it ismarket practice to multiply the respective currencies against each other. For example, considerthe following;One dollar = yen 121.70/75One pound = dollar 1.4330/35Then the sterling against yen spot cross rate calculation will be:121.70 × 1.4330 and 121.75 × 1.4335 = 174.38/53Thus it follows, that 1 pound is equal to 174.38 or 174.53 yen. This is the only way it isexpressed.
7.6 PRICE DETERMINANTSExchange rates (or prices) in the foreign exchange market are driven by the laws of supplyand demand. The supply and demand for speciﬁc currencies change, given the amount of tradeand investment being done in that currency. If there is a high demand for a currency, its valueincreases. If there is a low demand then its value decreases.However, exchange rates are not only affected by supply and demand. The exchange ratewill also be inﬂuenced by the economic, political, monetary and social factors of the countryinvolved and also by outside developments. Exchange rates can change quickly and significantly, reﬂecting the volatility in the market; and rates can also be moved by rumours andanticipated factors. Typically, currency rates can ﬂuctuate from day-to-day due to small imbalances in supply and demand, and to economic and political factors that affect the sentimentof market makers and investors.
7.7 USES FOR SPOT TRANSACTIONSClient groups, such as corporations, investors, funds and institutions, will use spot transactionsas part of their foreign exchange management programmes. Speculators will also, use thismarket because it is extremely active and liquid with roughly two-thirds of all foreign exchange
46
A Foreign Exchange PrimerDone date
Value date
Day 0
Day 1
Day 2
Dealing risk(margin)
Market risk(margin)
Delivery risk(principle)
Credit risk
Figure 7.3 The spot exchange risk
activity being traded. There can be plenty of movement (volatility) in any one day, which willenable a speculator to possibly beneﬁt from such gyrations.7.7.1 Risk considerationIt must be remembered that there are risks with spot transactions. Firstly, there is a credit risk.Like the risk a bank incurs when making a loan, a foreign exchange contract poses the riskthat the client will not perform according to the terms of the contract (i.e. will not deliver theappropriate currency on time). In a foreign exchange transaction, the market maker and theclient agree that each will deliver to the other a speciﬁed amount of a currency on a speciﬁcdate, at an agreed rate. Trading the currencies of countries that are in different time zonescompounds the risk.Secondly, there is a market/price risk. Trading in any currency has a degree of risk. Exchange rate risk is inevitable because currency values rise and fall constantly in response tomarket pressures. When engaging in a foreign exchange trade, the client’s position is openuntil it is closed or covered. While that position is open, the client is exposed to the risk ofchanges in exchange rates. A few moments can transform a potentially proﬁtable transactioninto a loss.Thirdly, there is a country risk. Some countries (and their currencies) are more risky thanothers. Country risk may be due to anything from governmental regulations and restrictionsto political situations, or the amount of foreign currency reserves the country holds. However,this risk is usually of less signiﬁcance.The spot exchange risk is shown graphically in Figure 7.3.
8Forward Contracts8.1 INTEREST RATE DIFFERENTIALSForwards work much like spots, but the value date is different from the spot date and usuallyextends further into the future, for example, six months from the commencement date. At ﬁrstsight there would seem to be no reason why the spot and the forward rate should not be thesame. However, one of the factors inﬂuencing a currency’s forward exchange rate is the levelof interest rates for that currency relative to interest rates in the other currency. There are manytheories on how a forward exchange rate can be calculated, but market participants adopt theinterest rate differential between two currencies and the current market spot rate as the basisof their calculations. The forward price is often referred to as forward points, forward pipsor swap points (pips).A forward contract (or forward outright) is a transaction executed today in whichone currency is bought or sold against another for delivery on a speciﬁed date that isnot the spot date, for example three months from the commencement date.Forward points are relative interest rate differentials expressed as units of currency,or fractions of the spot value of that currency.For example, assume that the spot and forward rates between dollars and sterling are thesame, but the interest rates in sterling are 4% per annum for a 3-month deposit, while indollars they are 2%. Investors would sell their dollars and buy sterling spot for the higher yield.They would simultaneously sell sterling and buy dollars forward for delivery at the end ofthe investment period. In this way, the investor would end up with more dollars than if theinvestment had been kept in dollars.
8.2 PERIODSMarket makers regularly trade forward contracts for periods of one, two, three, six and twelvemonths from the spot value date. A broken date or odd date forward deal is a contract withmaturity other than a normal market quote of complete months. An example would be to askfor the forward pips for 24 days.
8.3 PREMIUM OR DISCOUNTForward contract prices are determined by two main factors: the current spot price betweenthe two currencies and the interest rate prevailing in each of the two currencies. The forwardprice is calculated as the spot rate plus or minus the forward pips. To decide whether to addor subtract the forward pips, ﬁrstly determine whether the currency to be bought or sold is
48
A Foreign Exchange PrimerTable 8.1 An example of forward points for the euroand Swiss franc09.0906.4108.0408.0608.5608.5609.0009.0009.0009.00
EUR deposits3.25/3.43.26/3.413.28/3.343.31/3.373.34/3.393.36/3.423.39/3.453.45/3.513.56/3.62
o/nt/ns/n1 month2 months3 months6 months9 months12 months
EUR forwards−0.430/−0.405−0.45/−0.41−3.02/−2.97−13.95/−13.80−27.10/−26.90−40.60/−40.30−82.50/−81.50−120.05/−118.05−150.99/−147.99
Note: For explanation of o/n, t/n and s/n see Chapter 9.
trading at a premium or is trading at a discount. As all exchange rates have a ﬁxed and avariable component, if the interest rates in the variable currency are greater than those of theﬁxed currency, the variable currency is trading at a discount relative to the ﬁxed currency andforward pips are added to the spot rate to obtain the forward rate. If the interest rates in thevariable currency are less than those of the ﬁxed currency, the variable currency is trading ata premium and forward pips are subtracted from the spot rate to obtain the forward rate.There are two simple rules of thumb to decide if a currency is at a premium or a discount,and what to do with the forward points. Remember, exchange rates are quoted as units of thatcurrency, which equal 1 dollar (except for sterling, euro and a few other currencies, such asthe Australian and New Zealand dollars).If the forward points are ascending, i.e. the offer is numerically higher than the bid (20/25),that is, if the forward points rise from left to right, the currency is at a discount to the dollarand, hence, the forward points are added to the spot rate. (The major exception is sterling andthe euro, where they are at a premium to the dollar.) If the bid is numerically higher than theoffer, i.e. the points are descending (25/20), i.e. the forward points decline from left to right,the currency is at a premium to the dollar and the forward points are deducted from the spotrate. (The major exception is the quotation for the euro and sterling against the dollar, whereif the forward points decline from left to right, the points are deducted, but the dollar is at apremium to the euro and sterling.)An example of how forward rates for the euro and Swiss franc might appear on an informationscreen or brokers screen is shown in Table 8.1. Note how the forward points decline from leftto right and hence the forward points are deducted from the spot. It is common for the interestrates to be shown for the currency as well.
8.4 CALCULATIONSForward rates are not determined by where the market expects the currency to be in the future,but rather by the interest rate differential. Also, the forward exchange rate is ﬁxed at the timeof the transaction, but no accounts are credited or debited until the maturity date.The forward pips are calculated in the following way. If we assume that the spot and forwardrates between dollars and sterling are the same, say 1.4400/10, but the interest rates in sterlingare 4% per annum for a three-month deposit, while in dollars they are 2% per annum for
Forward Contracts
49
the same deposit, investors would sell their dollars and buy sterling spot for the higher yield.They would simultaneously sell sterling and buy dollars forward for delivery at the end of theinvestment period. In this way, the investors would end up with more dollars than if the moneyhad been kept in dollars. For example, if Mr Jones has $5 million to invest for three months,at 2%, the interest earned at the end of the period will be:5 000 000 × 92 × 2= $25 555.56360 × 100Thus, the total principle and interest earned at the end of the period will be $5 025 555.56($5 000 000 + $25 555.56).However, if Mr Jones buys sterling at 1.4410 and sells his dollars, he will receive£3 469 812.63, which can be invested at 4% for the same period. The interest earned at the endof the period will be:3 469 812.63 × 92 × 4= £34 983.32365 × 100Thus, the total principle and interest earned at the end of the period will be £3 504 795.95(£3 469 812.63 + £34 983.32).This can then be converted back into dollars at 1.4400, which would give an amountof $5 046 906.17 (£3 504 795.95 × 1.4400). The total gain at the end of the period will be$21 350.61 ($5 046 906.17 − $5 025 555.56).In a free market, however, the advantage of the higher sterling interest rate is usually neutralized by the lower value of sterling in the forward foreign exchange market and any yieldpick-up will be small, or non-existent.In calculating the forward points, users adopt a simple arithmetic formula which takes theinterest rate differential per annum, converts it into a differential for the required period, andexpresses the spot rate as a percentage of the differential for the period. However, it cannotbe used entirely in isolation, for it assumes knowledge of relative interest rate levels by theinterested party. It is, in essence, a variation on the old banking formula:Principle × rate × time = interestwhere the principle is the spot rate, the rate is the interest rate differential, and time is thematurity in days. Thus:Spot rate × interest rate differential × days/360= pips/points1 + (currency interest rate × days/360)In other words, the formula for dollars against currency forwards is:A × D × (B − C)(100 × E) + (C − D)which equals the number of forward points of spot currency, with 360 day basis, where:A = spot exchange rateB = currency interest rateC = dollar interest rateD = maturity in daysE = day basis
50
A Foreign Exchange Primer
It has to be noted that, in the money market, all calculations are based on the actual numberof days elapsed divided by 360, except for calculations involving sterling and some othercurrencies when 365 days are used. The formula is adjusted when the two currencies involvedhave a different day base. Also, when the value date is the last business day of a month, thecorresponding date in any future month is also the last business day. For example, if the spotvalue date were 28 February, the value date in a one-month forward transaction would be31 March. If the spot value date were 31 May, the six-month forward transaction date wouldbe 30 November. If the last day of the month is not a business day, then the value date is thenext preceding business day.8.4.1 Bids and offersJust as there is a bid and offer in the spot market, there is also a bid and offer rate in the forwardmarket. This means that the forward points for both sides of the exchange rate must be quoted.A typical example of how forward rates are quoted is:CurrencyUSD/JPYUSD/SFREUR/USD
1 month19.55/19.300.1/1.19.07/8.99
3 month62.7/61.71.7/1.929.5/27.8
8.4.2 To add or to subtractAs already mentioned, the simple rule to arrive at the forward rate is: if the forward pips declinefrom left to right, the currency is at a premium to the dollar and the forward pips are deductedfrom the spot rate. For example, if spot USD/JPY is 121.70/75, the 1-month forward price is:121.70 − 0.1955 and 121.75 − 0.1930 = 121.5045/121.557If the forward pips rise from left to right, the currency is at a discount to the dollar and theforward points are added to the spot. For example, if spot USD/SFR is 1.6703/08, the 3-monthforward price is:1.6703 + 0.00017 and 1.6708 + 0.00019 = 1.67047/1.67099The major exception is the quotation for sterling against the dollar, where if the forward pipsdecline from left to right, the pips are deducted but the dollar is at a premium to sterling.Occasionally, it is possible to have forward pips that have a negative number for one side ofthe quote and a positive number for the other. An example would be −0.7/+1.3. The rules foradding or subtracting are still the same. This type of forward pips behaviour occurs when theinterest rates of the two currencies are so close that the offer side of one crosses the bid sideof the other.
8.5 HOW ARE FORWARDS QUOTED?When a market maker quotes a forward price, the trader will say:‘3-month dollar/yen 62.7 at 61.7’
Forward ContractsMarket maker
51
Market maker
Buy + sell yen
Sell + buy yen
Buy + sell dollars
Sell + buy dollars
Sell + buy dollars
Buy + sell dollars
Sell + buy eur
Buy + sell eur
-62.7
-61.7
-9.07
-8.99
Sell + Buy yen
Buy + sell yen
Sell + buy dollars
Buy + sell dollars
Buy + Sell dollars
Sell + buy dollars
Buy + sell eur
Sell + buy eur
Market user
Market user
Figure 8.1 Examples of forward quotations
where the market maker will buy and sell jpy at −62.7pips (sell and buy dollars) and will selland buy Yen at −61.7 pips (buy and sell dollars). Of course, for currencies quoted in Americanterms, i.e. euro, the market maker will quote a 1-month forward price as:‘1-month eur/dollar 9.07 at 8.99’where the market maker will buy and sell dollars at −9.07 pips (sell and buy euros) and willsell and buy dollars at –8.99 pips (buy and sell euros). Some examples of forward quotationsare given in Figure 8.1.
8.6 FORWARD CROSS RATESForward cross rates are worked out in the same manner as for spot rates. First, calculate theforward rate from the spot rate and the forward points, then decide which currencies are beingbought and sold. Finally, decide if the rates should be divided or multiplied by one another, asappropriate. For example, by using the following forward points:
USD/JPY
USD/CHF
CHF/JPY
Spot
115.90/95
1.4382/1.4388
80.40/80.47
3-month pips
53.9–53.6
27–26
23–22
52
A Foreign Exchange Primer
CHF/JPY 3-month forward can be worked out as:3-month USD/JPY
3-month USD/CHF
3-month CHF/JPY
115.90 to 150.95
1.4409 to 1.4414
80.40 to 80.47
−53.9
−53.6
−27
115.361 to 115.414
−26
−23
1.4382 to 1.4388
−22
80.17 to 80.25
As described previously in the sections on spot pricing and calculations, the bid for spotSwiss francs against Japanese yen is derived by taking 115.90 (bid) and dividing it by 1.4414(offer), in order to reach the spot price of 80.40. Likewise, in order to obtain the offer spot
Market maker
Market maker
Sell yen
Buy yen
Sell francs
Buy francs
Buy dollars
Sell dollars
Buy dollars
Sell dollars
115.90
150.95
1.4409
1.4414
Buy yen
sell yen
Buy francs
Sell francs
Sell dollars
buy dollars
Sell dollars
Buy dollars
Market user
Market userMarket maker
Sell yen
Buy yen
Buy francs
Sell francs
80.40
80.47
Buy yen
Sell yen
Sell francs
Buy francsMarket user
Figure 8.2 Calculating forward cross rates
Forward Contracts
53
price of Swiss francs against Japanese yen, take the offer of dollar yen, 150.95 and divideit by the bid of dollar Swiss franc 1.4382, which gives 80.47. The details are presented inFigure 8.2.
8.7 USES OF FORWARDSForward contracts are a common hedging product and are used by importers, exporters, investors and borrowers. They are valuable to those with existing assets or liabilities in foreigncurrencies and to those wanting to lock in a speciﬁc future foreign exchange rate. For example,corporations that must receive or pay foreign currencies in the future because of their normalbusiness activities usually prefer to transfer the risk that the values of these currencies maychange during the intervening period. They can use the bank forward market to establish today, the exchange rate between two currencies for a value date in the future. Generally, whenPar2
Points descending:DEDUCT1
−15
−20
+
Points ascending:ADD3
+15
+
+20
−
−
earn points
paypoints
paypoints
earn points
Market maker quote: sell dollarsMarket maker quote: buy dollars1Deduct: The dollar is at a discount when it is more expensive on an interest basis than the currency. Thesedollar discounts/currency premiums are always deducted from the spot rate.2Par: Interest rates for both dollar and currency are equal.3Add: The dollar is at a premium to the currency when it is cheaper on an interest basis than the currency. Thesedollar premiums/currency discounts are always added to the spot rate.
Figure 8.3 Example of forward transactions
54
A Foreign Exchange Primer
corporations contract to pay to or receive from a bank foreign currency in the future, no moneyis exchanged until the settlement on the value date.While forwards may be used to hedge payables and receivables, corporations will also hedgeother assets and liabilities on a company’s balance sheet. The value dates of forward contractsare often constructed to match up with the expected dates of receipts for a foreign payment, orpayment of a foreign currency obligation. A forward contract can be tailored to meet a client’sspeciﬁc needs in terms of delivery dates and amount. In addition to transacting with clients,banks actively trade forward currency commitments among themselves.8.7.1 Risks involvedBecause of the time span involved in forward contracts, there can be signiﬁcant risks, just ason a spot deal. Credit risk, market/price risk and country risk are all potential problems. Infact, country risk is more signiﬁcant than spot trades as unexpected events in a foreign countryare more likely, given the longer period of exposure.
CONCLUDING REMARKSForwards provide certainty in the uncertain world of currency movements by locking in aspeciﬁc rate, and as the forward markets are quite liquid, the bid/offer spreads are low.The interest rate differential between the dollar and another currency is expressed in points,which are fractions of that currency’s exchange value against one dollar.The forward contract is shown graphically in Figure 8.3
9Short- and Long-Dated Contracts9.1 SHORT-DATED CONTRACTSA short-dated contract is a foreign exchange contract that is executed today to buyone currency for another currency at a rate agreed today with settlement less thanspot.As has been stated, most foreign exchange deals are executed for value two business daysforward, or longer. However, some participants could have a need for currency the same day,the next day or the day after spot. For some currencies, like sterling and the euro, it is possibleto trade for the same day value, but for the majority of currencies the earliest execution wouldbe tomorrow.The terminology for these differing time periods is:Value same day: overnight (o/n)Value tomorrow: tom next (t/n)SPOTValue day after: spot next (s/n)The rates quoted for value dates occurring before spot are treated in a different way to thoseoccurring after spot. The rules applying to a value date after spot is that if the forward pips gofrom high to low (20–18), they are subtracted from the spot rate and if the forward pips gofrom low to high (18–20), they are added to the spot rate. But, if the value date is before spot,the points are switched and the normal rule is then followed. The pips for ‘overnight’ and ‘tomnext’ represent only one day each. If, therefore, a rate is calculated for value today, the pipsfor ‘overnight’ and ‘tom next’ have to be added together.
9.2 INTEREST RATE DIFFERENTIALSShort dates and their equivalent rates can be more easily understood by looking at the rates overa period of time. For example, at the moment, American interest rates are higher than Japaneseinterest rates. As forward rates are calculated from interest rate differentials, the high interestrate currency will buy less of the low interest rate currency in order to offset the interest ratedifferential. Hence, the number of Japanese yen to buy one dollar will decline the further intothe future one moves. Therefore, in order to conform to the interest rate structure, the shortdates should be higher than spot.If the interest rate structure was reversed, then the exchange rates would increase in time andthe short dates would be worth less than spot. With any forward transaction, the quotation isbased on the relationship between the prevailing interest rates of the two currencies concerned.This is shown graphically in Figure 9.1.
56
A Foreign Exchange Primer
Today
123.075/14
Exchangeratesdecliningover time
o/nTomorrow
123.07/123.13
t/nSpot
123.05/10
s/nDay after spot
123.01/07
one-week swapOne week
122.995/123.06
one-month swapOne month
122.82/122.88
Figure 9.1 Interest rate differentials
9.3 LONG-DATED CONTRACTSWith any forward transaction, the quotation is based on the relationship between the prevailinginterest rates of the two currencies concerned. However, when considering forwards beyondone year, it is necessary to account for the annual interest compounding effect.
A long-dated forward is one which is dealt today to buy or sell one currency at arate agreed today with the settlement at an agreed future date, beyond one yearfrom now.
The short method for calculating a forward rate beyond one year is to use the normal formulafor calculating forward points from interest rate differentials. However, this formula has to bemodiﬁed to take into account the compounding effect of