Understanding the
language of Foreign Currency Trading
(From “PFX Foreign Currency
Trading”)
INTRODUCTION
The financial world
consists of many specialized sectors - stocks, bonds, metals, commodities,
options, futures, swaps, derivatives, derivatives of derivatives - each with
its own dynamics and vocabulary. Even veterans of the financial battleground do
not know all investment venues or nomenclature. That's one reason why there are
so many specialized investment advisors. They know the ins and outs of their
own bailiwick, but will refer you to another specialist if you ask about an
unrelated investment.
The objective of this
book is to take one aspect of the investment world, foreign currency trading,
and make it understandable to a general audience, even someone who knows little
about the complexities of the world of finance. The subject may appear complex
on the surface, but if you take it one step at a time, with a solid grounding
in the basics, it becomes simple. Remember: Complexity is just a combination of
basics creatively arranged.
When you finish this
first chapter, you should understand the technology of foreign currency
trading. This in turn will allow you to grasp the larger concepts presented in
subsequent chapters.
BASIC CONCEPTS OF
FOREIGN EXCHANGE
Foreign exchange, often
abbreviated FX or forex, is a trade of one currency
for another at a set rate called the exchange rate. This rate, often referred
to as a price, can be the result of supply and demand for the currency in the
open, unrestricted market or, at the other extreme, a firmly fixed value
determined by an edict of a government and/or its monetary authority, usually
its central bank.
The Interbank
Market
The setting for the interbank market is not a single
location; it is virtually everywhere. It can be equated to the Internet--accessible
from seemingly infinite locations. The market could be two individuals on the
street exchanging U.S. dollars for deutschemarks, enabling a tourist to make a
phone call in
|
1. Citibank |
2. NatWest |
|
3. Merrill
Lynch |
4. Deutsche
Morgan Greenfell |
|
5. Chase
Manhattan |
6. SEC Warburg |
|
7. JP Morgan |
8. Goldman
Sachs |
|
9. HSBC
Markets/Midland |
10. BZW |
Currency Futures Market
Currency futures are a
derivative market based on the interbank cash and
forward exchange rates. Forward (and futures) exchange rates are directly Influenced by the Eurodollar rate, the short-term interest
rate of U.S. dollars held in
Forward Market
A forward market
provides the currency exchange rate for delivery in the future. Typically the interbank market enables traders to determine a forward
exchange rate 30, 60, and 90 days into the future. In forex
all spot (current cash) markets in practice are forwards, because all the spot
currency rates are quoted on a two-day settlement time frame in order to get
one currency from a counterparty to another
counterparty.
Liquidity and Price
The more accessible a
currency is to different countries, traders, and banks, the more it can be
traded. The more trading that occurs in a currency, the greater its liquidity
and therefore its efficiency. Liquidity indicates the ease with which buyers
and sellers are able to enter and exit the market. The more traders that are
buying and selling a currency, the greater the likelihood of a seller wanting
to sell at the same price a buyer is willing to pay. A very liquid market has
numerous participants buying and selling at the same prices. An extremely
liquid market is said to be deep, signifying the large number of buyers and
sellers willing to trade at any given price. The efficiency of any market is
determined by its liquidity.
Rate of exchange
Ideally, currency
exchange rates are determined by the natural forces of supply and demand in an
open market, free of the intervention by monetary authorities. Yet, to ensure
their currencies do not depreciate or appreciate excessively, intervention by a
nation's monetary authorities (central banks) does occur. The intervention of
central banks in currency exchange rates results in a "dirty float."
Rates of exchange on currencies can be truly floating, fixed, or a hybrid of
the two. Most major currencies traded in the interbank
market are floating-rate currencies. Free-floating currency rates are
determined in a free-enterprise market environment where private businesses
operate competitively with a minimum of government regulations and
intervention.
A currency's price in
relation to itself is always 1.00. One dollar can be exchanged freely for one
dollar. It can also be exchanged for other freefloating
currencies at a rate determined by the interbank
market. Non-floating-rate currencies are controlled strictly by their
respective governments and therefore are not as accessible for trade or as
efficient in their pricing.
FIGURE 1-1
Wall Street Journal,
"Currency Trading, Exchange Rates,"
Figure 1-1
( This image is being provided only as an
example. Please refer to the book for the complete images.)
Figure 1-1, from The
Wall Street Journal, shows the exchange rates around the world that will be
used throughout the book to create exchange rate examples.
SpotRate
The spot rate for a
currency is the exchange rate quoted for the closest standard settlement day.
This is the current exchange rate for a trade of one currency for another. The
spot rate, whether floating freely or fixed, reflects the external value of a
currency at the time of trade. The spot rate is also termed the cash price,
cash rate, or today's rate. Most spot interbank rates
are actually traded with two-day settlements to allow for a reasonable amount
of time to transfer the currencies for the transaction.
Cross Rate
An exchange rate is
classified as a cross rate when the home currency in the transaction is not a
party to the exchange rate traded. A common Crossrate
transaction quoted in
Forward Rate
A forward rate is the
value of a currency relative to another currency at some set time in the
future. Swiss francs valued in U.S. dollars 30 days from now will be different
from the value of Swiss francs to U.S. dollars today. Forward rates are the
exchange rates expected in the future. The forward rate settlement date is the
date in the future when one currency will be debited (withdrawn) from the
account and the other credited (deposited) into the account. Settlement dates
can be 30, 60, or 90 days into the future. The difference between the spot rate
and the forward rate is determined by interest rates, speculator expectation,
possible government intervention, supply and demand, and other factors.
Currency futures prices are very similar to forward prices except that futures
contracts are standardized in size, quote mechanism, and settlement dates, and
they are executed on a regulated exchange by open outcry.
FIGURE 1-2
Wall Street Journal,
"Key Currency Cross Rates," Wednesday, February 12, 1997 (Reprinted
by permission of The Wall Street Journal, Copyright 1997 Dow Jones & Company,
Inc. All Rights Reserved Worldwide.
Figure 1-2
( This image is being provided only as an
example. Please refer to the book for the complete images.)
Swap Rates
The swap rate is the
short-term interest rate between the sopt price and a
forward price. In dealing terms, a sap rate is expressed in terms of swap
points or forward points. The swap rate is calculated as follows:
|
Forward Points= |
|
Spot rate x difference in interest rate
of the two currencies x days until the forward |
|
|
|
Number of days for which the interest
rate applies x 100 |
|
or |
|
FP=S x (IR1 - IR2) x N |
|
|
|
YR x 100 |
Example, if:
|
S = 1.6875 DEM/USD |
|
IR1 = 1 year interest on DEM = 3.15% * |
|
IR2 = 1 year interest on USD = 5.50% * |
|
N = 90 Days |
|
YR = 360 days in a year |
|
FP = 1.6875 x (3.15 - 5.50) x 90 |
|
|
|
36,000 |
|
FP = -.00991 = 1.67759 |
|
90-Day forward = 1.6875 - .00991 -
1.67759 |
Swap points or forward
points are a quick method for dealers, arbitrageurs, pit traders, and
speculators to calculate the forward price off the cash price. Swap points are
added to the cash (spot) price in order to equal the forward price.
Market Quotations
Currencies are typically
quoted in the interbank market to many decimal places
smaller than standard currency. For example, the U.S. dollar is expressed in
dollars and cents in standard usage, but the U.S. dollar interbank
market quote accounts for thousandths of a U.S. cent. The reason is obvious:
When dealing in large transactions, a difference of one cent in price may equal
thousands of dollars in the interbank. These
thousandths of a cent are called pips.
Pips are defined as the
smallest incremental price movement in the interbank
market. Even though price movements and quotes can be less
than a pip, for most practical purposes a pip can be considered the smallest
increment. In the sometimes hectic action of the interbank
market, it is typical to hear traders quote currency exchange rates using only
a two-digit price. If the exchange rate is 1.6388, then the trader may quote
only what is called the "small figure," the last two digits; i.e.,
88. In this case the "big figure" is 63. Dealing in currencies, the
price (rate) is equal to a ratio of one currency to another currency. For
example, if $/DEM "dollar-mark" is at 1.6388, then one dollar buys
1.6388 deutschemarks. If you invert the price (meaning
"divide the price into 1"), you will get the price in terms of the
other currency. For example, the price of dollars in terms of
deutschemarks is DEM/$, or 1/1.6388 = .6102 (61.02 cents = one deutschemark).
Direct Quotations
A direct exchange-rate
quotation is always quoted in terms of the host currency; if you are in
IndirectQuotations
Indirect quotations are
the opposite of direct quotations. An example of an indirect quote in the
Standard Quotations
The interbank
market quotes all currencies except the British pound sterling as U.S.
dollar-based. Pound sterling quotes are usually currency-based in the interbank world.
Margins and Lines of
Credit
Currency transactions
are executed under various conditions based on the creditworthiness of the
counterparties. Lines of credit are the main mechanisms for executing forex transactions. Less creditworthy traders (lower than
AAA-rated) usually trade on a margined basis. Margin trading also is the
cornerstone of futures trading. The interbank market
uses margin trading for less creditworthy customers in order to maintain the
integrity of the interbank transactions. Margins are,
in effect, performance bonds. Futures exchanges have created elaborate systems
to calculate margins, taking into account the historical volatility of a
currency and the total value of the standardized futures contract. The interbank market takes its lead from the futures exchanges'
calculations and also uses margin amounts as a lever to control the volume a
customer may trade at any one time.
Currency Symbols
Figure 1-3 is a partial
list of common quote symbols used in the interbank
and futures markets (refer to Appendix for a complete list of currency symbols
or codes).
Figure 1-3 Currency
Symbols
( This image is being provided only as an
example. Please refer to the book for the complete images.)
ACCOUNT STATEMENTS - HOW
TO UNDERSTAND THEM
Customer account
statements in any field of finance can be confusing and even a little scary.
Unfortunately, forex statements are frustrating
nearly all the time. FX statements are very user-unfriendly and should be
viewed as "armed and dangerous." Each firm's statement looks
different from those of other firms depending on the back-office computer
platform used.
Most customer account
statements are never seen or reviewed by a regulatory agency and may have many
inaccuracies, so the trader's ability to accurately analyze the statements is
extremely important. There are basically three types of systems for producing
statements: proprietary systems, standardized systems, and homemade systems.
Proprietary Systems
Proprietary systems
usually have many "bells and whistles" and are customized for a major
banking institution with millions of dollars to budget for back-office systems.
They can often offer information tailored to the customers. The statements
might provide a combination of different types of accounts offered by the
institution such as futures, spot currencies, forwards, equities, and fixed
income. These statements might eliminate some confusion by showing only the
information needed by the institution's specific customers.
The flip side of the
coin is that custom-made proprietary systems may have glitches that need to be
worked out. Formulas or calculations might not have been reviewed by outside
regulators for accuracy, and the system might not have enough fail-safe backups.
In other words, any system that is created for only one institution does not
have to go through the rigors of competition that a standardized system does.
Standardized Systems
A standardized system
for producing statements is a generic one purchased "off the shelf' and
ready for any institution to use for internal or customer use. Standardized
systems for the forex industry are fairly expensive
and involve a monthly fee for support, upgrades, training, and special
requests. The companies selling standardized systems are usually put through
intensive testing and review by regulatory authorities, testing the limits and
security of the system before using it to service their customers. Standardized
systems are usually backed up and well protected from system failures.
Problems associated with
standardized systems are that they are often confusing due to extraneous
information built into a "one size fits all" system. The standardized
systems usually are very generic and therefore not as sophisticated as the customized
proprietary systems. The standardized systems also are usually somewhat clumsy
and difficult to read and understand.
Systems that have been
subject to regulatory scrutiny are likely to produce statements that will show
if a trade was improperly entered to the account and then corrected. The firm
is unable to make any change in the account without the change showing up on
the customer's statement. There is a side benefit in all the red tape of a
standard system in that the trader can sleep comfortably knowing that no one
can modify the calculations in his or her account without the modifications
being apparent.
Homemade Systems
The lowest form of
proprietary system is one home-made on a personal computer spreadsheet program.
These "customized" systems have a serious lack of controls, checks,
and balances and are ripe for abuse. Traders receiving spreadsheet-style
customer statements should be on the alert that they may be dealing with a less
than desirable counterparty. In addition, home-made systems usually do not
account for regulatory or tax reporting.
The Basic Statement
Customers should expect
to see the account name, counterparty, date, account number (if any), daily
account activity, open positions, and currency account balance summaries on the
forex statement. Figure 1-4 is a sample statement
produced from a standard statement provider. (The names and transactions are
fictitious and have no relationship to any person or corporation. Any
similarities are purely coincidental.) In this statement, the daily account
activity is divided into three sections: 1. Trades made "as of the date
indicated"; 2. Trades made "today for your account and risk";
and 3. Trades that "have been delivered" (or settled). In addition to
these there may also be a section for "trades that have been confirmed in
error and canceled."
The open positions
section of this statement (Figure 1-5) shows the "open positions,"
"currency recap for open positions:' and the "net exposure by
currency combination." The currency account balance section of the
statement (Figure 1-6) should break down any currency that has a balance,
either credit or debit. Most statements also provide a combined currency
section converting all the currency balances to one currency for ease of use.
Figure 1-7 is a copy of a combined currency summary that converts all the
previous currency balances to U.S. dollars, based on the closing currency
prices.