Practitioner Guide To Forex Market-part 2

Chapter 1 Forex is International Payments There is no sphere of human influence in which it is easier to show superficial cleverness and the appearance of superior wisdom as in matters of currency and exchange. (WINSTON CHURCHILL, speech in House of Commons, 1946) As for foreign exchange, it is almost as romantic as young love, and quite as resistant to formulae ( H L MENCKEN, The Dismal Science)

Foreign exchange (shortened to forex or FX) is the consequence of the coexistence between the nationalism of currencies and the internationalism of trade. While nations zealously keep their identity with their own flags and currencies, the comparative and competitive advantages compel them to trade across borders. No country can produce all that it consumes, nor can it consume all that it produces (comparative advantage). Even if they were, it will not be effective and efficient (competitive advantage). We may say that what money does for goods and services within in a country (i.e. medium of exchange, store of value), forex does the same for dif-

Chapter 1

ferent brands of money (see Exhibit 1-1). If the world has a single currency or trade does not cross national borders, the forex disappears.

EXHIBIT

1-1: Money versus Forex

CHINA

noodles

INDIA

silk

yuan

Analects

roti

forex

Spring in a Small Town

Arthashastra

cotton

rupee

Mughal-e-Azam

Settlement of international trade requires two elements: international money and an “adjustment” mechanism to correct trade imbalances among nations. Experience shows that the first is less important and that the second has been the source of much trouble. The evolution and the timeline of international payment systems are reviewed below. 1.1. Gold Standard: 1870–1914 Under Gold Standard, central banks issued paper money and held gold (or silver or both) in reserve to back the paper money. The international payments system was built on the following features.   

Export and import of gold was freely allowed Currencies were valued in gold at a fixed rate (“mint par rate”) Convertibility of currency to gold at mint par rate was guaranteed by central banks

The mint par rates of a national currency determined its value against other currencies. For example, if mint par rates of US dollar and Indian rupee were $100 and Rs 4,000 per unit amount of gold, respectively, then dollar-rupee forex price would be: Rs 4,000 / $ 100 = Rs 40 per $. The forex price would be fixed at this level, regardless of demand-supply for the currency. If it were not, there would be an opportunity for arbitrage profit by converting currencies into gold at mint par rates, and moving gold between the two countries. In practice, the arbitrage rate level would be slightly off the mint par rate because of trans-

2

Forex as International Payments

action costs in shipping gold. Instead of one mint par rate, there was a range defined by gold export point and import point. The theory of the adjustment mechanism for trade imbalance under Gold Standard involved the chain of events, including the movement of gold among nations, shown in Exhibit 1-2.

EXHIBIT

1-2: Adjustment Mechanism under Gold Standard

TRADE DEFICIT

Gold shipped out

More imports, less exports

Lower money stock

Inflation

Deflation

Higher money stock

Gold shipped in

Less imports, more exports TRADE SURPLUS

The adjustment process was symmetrical in the sense that the country with trade surplus shared the burden of the country with trade deficit. The forex prices were fixed and stable, and the role of central bank was to freely buy and sell gold at the mint par rate. The domestic policies (e.g. economic growth, unemployment) were subordinate to external trade imbalances. In practice, the changes in price level or unemployment and the movement of gold was not to the extent warranted by the adjustment mechanism. This was due to the skillful management of international clearing by the Bank of England, which induced international capital flows in sterling pound by varying the interest rates. Interest rate rose in countries with trade deficit and fell in countries with trade surplus. The cornerstone of the Gold Standard remained the full convertibility of sterling pound to gold at ₤1 s17 d10½ a troy ounce. The

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Chapter 1

beginning of the World War I put an end to the regime of fixed and stable exchange rates under Gold Standard. 1.2. First Floating Rate Regime: 1914–1925 Except Switzerland, most countries suspended the gold convertibility for residents during 1914–1917, and the pre-war fixed exchange rates were maintained by mopping up gold and foreign securities from the residents. After the war, the currencies were allowed to float during 1918–1925 and find their realistic financial strengths. The sterling pound fell from $4.86 to $3.40. The floating rate regime was intended as an interim arrangement, and the countries were to adopt such domestic policies as would restore the prewar exchange rates and gold standard. 1.3. Gold Exchange Standard: 1925–1931 Britain restored gold standard in 1925, and the pound-dollar rate was brought to the pre-war rate of $4.86 to a pound. Over 30 other countries established gold parities or fixed the exchange rate of their currencies with sterling pound. The central banks held reserves predominantly in gold-convertible currencies (mostly sterling pound) rather than gold. This was called gold exchange standard, which did not last beyond 1931 because many countries pursued domestic policies that were unilateral and mercantilist, which did not fit in the automatic and symmetric adjustment mechanism under Gold Standard. The Great Depression of the late 1920s, too, aided the collapse of gold exchange standard. Many converted their sterling pound into gold, leading to a run on the Bank of England‟s gold reserves. 1.4. Controlled Float: 1931 – 1939 Britain suspended gold-convertibility of sterling pound in 1931. By 1933, over 30 countries went off gold standard. Germany imposed exchange controls on current account. It was a period of chaos: there was the “sterling block” of Britain and her colonies, struggling to prop up sterling; there was the “gold bloc” of Switzerland, Holland, France, Italy, Belgium, Luxembourg and Poland, struggling with their overvalued currencies; there were central European countries struggling with German recovery and rearmament; and there was the United States in

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Forex as International Payments

economic isolation and lifting itself out of the Great Depression. In general, the exchange rates were floating for the second time. Unlike the floating in 1914 – 1925, however, the floating now was controlled by national governments to protect their domestic policies. Mostly, the control meant devaluation of currencies to achieve trade competitiveness. Out of this chaos came Bretton Woods System. 1.5. Bretton Woods System: 1944 – 1971 Bretton Woods System was built on the gold-convertibility of US dollar. It was officially described as “fixed rate regime with managed flexibility” and was popularly called “adjustable peg.” The following were the features of the system.   







All currencies were pegged to US dollar at fixed rate, and the dollar was pegged to gold at $35 a troy ounce The USA guaranteed the convertibility of dollar to gold, but only to the central banks, and not to general public Forex rates must be maintained within 1% of the fixed parity with dollar, and intervention in market should occur on violation of this band Domestic economic policies (aimed at full employment) had primacy over balance-of-payment (BOP) problem. This feature was the direct opposite of the adjustment under Gold Standard. In case of BOP problem, the following two-tier approach would apply: o The problem is temporary: the country with deficit would draw from the line of credit provided by International Monetary Fund (IMF), which was set up as a part of the Bretton Woods System o Tthe problem is permanent: the country with deficit would devalue its currency in consultation with the IMF There should be no direct controls on trade account under the General Agreement on Trade and Tariffs (GATT), but the capital account transactions could be controlled

In a way, the Bretton Woods System was like Gold Standard but without the automatic adjustment mechanism because it gave domestic economic policy priority over external trade imbalances. Though there were large devaluations of some currencies (notably that of sterling pound in 1949 and 1959), the system worked well until 1965 with crisis-free economic growth. The US con-

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Chapter 1

sciously ran trade deficit to enable other countries to build up reserves in dollar, which was gold-convertible and hence “good as gold.” During the second half of the 1960s, the US suffered Vietnam War, worsened trade deficit, and inflation. To contain the inflation, dollar interest rate was hiked, which attracted further capital into the US. In a way, the US was importing goods and exporting inflation, which prompted the French President to ask: what stops America from printing dollars and buying up France? It had reached a stage where the US gold reserves were insufficient to meet the gold-convertibility of dollar. Free market price of gold went above the official price of $35 a troy ounce, and France converted their dollar reserves into gold for political (and practical) reasons. Canada abandoned the adjustable peg of Bretton Woods System and allowed its currency to float freely. And the inevitable happened: the Nixon Administration of the US suspended the goldconvertibility of US dollar, ending the Bretton Woods System. 1.6. Smithsonian Agreement: 1971 – 1973 The chaos in the aftermath of the collapse of Bretton Woods System brought the top central banks together and resulted in Smithsonian Agreement, which was a highly diluted version of the Bretton Woods System. The US President, Richard Nixon, called it “the greatest monetary agreement in history.” US dollar was devalued against gold from $35 to $38 a troy ounce, but the gold-convertibility of dollar was not restored. Other currencies (notably German deutschemark) were revalued against dollar. Currencies were allowed to move within a wider band of 2.5% from the new fixed rates against dollar. Canada continued to float its currency. The strains developed in the system as soon as it was introduced. Britain left the system in 1972, followed by others so that by March 1973, the “greatest monetary agreement” collapsed, having lived just 18 months. 1.7. Second Floating Rate Regime: From 1973 After the collapse of Smithsonian Agreement, diverse systems of forex rate regimes came in existence. A brief review of them is given below. Free Float: the forex rate is allowed to be determined by demand-supply forces in the market. The central bank did not influence the forex rate but focused on domestic monetary policy and inflation. The currencies that followed this sys-

6

Forex as International Payments

tem became the “hard currencies” and became an asset class alongside bonds and equities. Managed Float: the forex rate is allowed to be floated but controlled by the central bank. In most cases, the control meant periodic, minor and discretionary devaluation. Gliding Parity: the changes in forex rate were linked to publicly-disclosed specific economic criteria. Fixed Peg: the forex rate is pegged to the currency of the country‟s main trading partner or to a basket of currencies of trading partners. 1.8. Gold and Monetary System The link between gold and currencies is more than 2,000 years old, and is still intimate, though inexplicable. Because of this historical link, the forex department in many banks deals with buying and selling of gold, too. Gold had detractors and admirers. John Maynard Keynes, the famous English economist, mocked that it was a “barbaric relic of the past1.” Charles de Gaulle, the famous French politician, praised it thus: “has no nationality … universally accepted as unalterable fiduciary value par excellence.” Gold is unique because it is at once a commodity and monetary asset. As a commodity, it is virtually indestructible, easily recoverable and recycled, highly malleable and, of course, beautiful. As a monetary asset, it is an asset to its holder but liability of none, and hence not vulnerable to distress of and repudiation by debtor or moratorium by sovereign debtor; uncorrelated with other financial assets, providing the portfolio diversification. In times of crisis, financial assets depreciate and become illiquid. In contrast, gold rises in (or holds its) value, remains liquid, and is universally acceptable as a means of payment. Gold coins acted as money, and gold reserves backed the paper money, fully in the beginning and partly in the later years. Central to the Bretton Woods system was the fixed parity between gold and US dollar. When IMF was created under the Bretton Woods system, all members were given quotas, which consisted of 75% of national currency and 25% gold; and the members were obligated to buy or sell gold at the fixed parities. During the 1960s, the 1

Keynes comment, it must be said, was not on gold, but on the Gold Standard in international monetary system that prevailed during 1870-1914.

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central banks of the US and Western Europe formed “Gold Pool” to keep the market price of gold at around the official price of US$ 35 a troy oz. The market intervention was ineffective and central banks lost more than 12% of their gold reserves, and the Pool was abolished in 1968. The central banks decided not to intervene in the gold market but to deal only among themselves at the official parity. As a result, a two-tier market developed for gold, one for official transactions at fixed parity and the other for private transactions at marketdriven prices. The IMF planned Special Drawing Rights (SDR), a synthetic currency linked to a basket of national currencies, as a substitute for gold in its reserves. The official reserve status of gold started disappearing from 1971 when the US suspended dollar-gold convertibility at the fixed parity of US$ 35 a troy oz. In 1978, the Second Amendment to the IMF Articles barred its members from fixing their currency parities to gold, and it eliminated the obligation to buy or sell gold at the fixed parities. With this, gold was officially eliminated from the international monetary system. In 2000, Switzerland, the only country that had official minimum gold backing for currency in circulation, abolished the link between Swiss franc and gold. With that, gold ceased to have any role in domestic and international monetary systems―officially. Despite official “demonetization” of gold, central banks still held about 30,000 tons of gold as reserves in 2006, a decline from about 36,000 tons in 1980. Except Chinese central bank, which bought about 200 tons from the market since 2000, most other banks have been selling some of their gold reserves. Exhibit 1-3 shows demand-supply for gold and the total above-ground stock at 2008. There are three sources of supply (mining, recycling and central bank sales) and three sources of demand (jewellery, investment and industrial). The total above-ground stock at 2008 was about 165,000 tons, about half is held in the form of jewellery, and a less than a fifth as reserves by central banks. Today, the private holdings of gold (by way of jewellery and investments) are four times more than the official holdings. Three countries accounted for half of retail consumption in 2008: India (27%), China (12%) and USA (10%). The voracious appetite of Indian households for gold is legendary. Estimates about Indian private gold holdings vary between 10,000 and 20,000 tons (compared to 8,100 tons held by the US Treasury).

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Forex as International Payments EXHIBIT

1-3: Gold: Demand, Supply and Total (above-ground) Stock

Souce: World Gold Council, 2008 and 2009

1.9. Balance of Payment and Currency Convertibility The phrase “balance of payment” (BOP) is misleading. The word “balance” in accounting terminology refers to the amount outstanding at a point of time, but in BOP refers to the total amount over a period of time. According to International Monetary Fund, the BOP items are classified at seven levels, the first three of which are as follows.

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Chapter 1

1 1.1 1.1.1 1.1.2 1.2 1.3 2 2.1 2.1.1 2.1.2 2.2 2.2.1 2.2.2 2.2.3 2.2.4

Current Account Goods and services Goods Services Income Current transfer Capital and Financial Account Capital Account Capital transfers Non-produced non-financial assets Financial Account Direct investment Portfolio investment Other investments Reserve assets

The two accounts at the first level are current account and capital & finance account. Goods (1.1.1) are those that have physical characteristics. This definition brings electricity and gas under this head. Services (1.1.2) differ from goods in that they cannot be stored for future consumption. Income (1.2) differs from goods and services in that the latter are the output of production but the former uses the two factors of production, namely, labor and capital. (The third factor of production, land, is excluded from BOP.) The income from labor is employee compensation and that from capital is investment income by way of dividend and interest. Income from non-financial assets (e.g. royalties, license fee, rentals/charters of equipment, distribution rights, etc.) should come under Services (1.1.2) rather than Income (1.2). Current transfers (1.3) are those without quid pro quo (e.g. grants, aid, etc.). Workers‟ remittances to residents in another country will also come under this head, but remittances to own account with a bank in another country will come under Financial Account (2.2). This distinction is made because workers‟ remittances arise from labor. All items other than goods under current account are collectively called “invisibles” and the items under goods are called trade account. Capital transfers (2.1.1) include debt forgiveness/write-off and migrants‟ transfer of personal effects and financial claims from the former to the new country. Non-produced non-financial assets (2.1.2) are different from the income they produce. Copyright to a work of art is non-produced non-financial asset and its transfer should be reported under Capital transfer (2.1.1) but royalty/licensing fee from it should be reported under Services (1.1.2). Financial account (2.2) records the transactions in financial assets and liabilities. If the economy‟s savings exceed its investments, then there will be net financial outflow from it (and vice versa). In turn, financial outflow will acquire non-

10

Forex as International Payments

financial resource in the other economy. Direct investments (2.2.1) are those in which the acquirer takes an effective and lasting control. Portfolio investments (2.2.2) are those in which the acquirer‟s interest is capital gains in financial assets and are often easily shifted. Other investments (2.2.3) are residual category consisting of loans, trade credits, bank deposits, etc. Reserve assets (2.2.4) are instruments for the government to correct the payments imbalance and include monetary gold, special drawing rights (SDR) in the IMF and central bank‟s forex reserves. For all heads except those under Financial Account (2.2), transactions are recorded on gross basis: that is, debit and credit items separately. For those under Financial Account, the items are posted on a net basis, except those related to long-term loans and trade credits. The double-entry accounting should ensure that the sum of the two firstlevel accounts (current and capital & finance) should be zero. In practice, however, this is rarely the case because of discrepancy in timing, coverage, valuation, inaccurate estimation and clandestine capital flight. The balancing act is performed by introducing the item “errors and omissions.” The negative sign for this item implies overstatement of receipts and understatement of payments; and the positive sign, the opposite. Let us now examine the concept of currency convertibility, which has changed over time. Originally, it meant the convertibility of paper money to gold at the fixed mint par rate. Today, gold is officially demonetized and replaced with foreign currencies as reserves; and no fixed parties exist among major currencies. Therefore, convertibility today stands redefined as freedom to convert national currency into foreign currencies at market prices. To enable international trade, all currencies must be convertible on trade account. To conserve reserves, governments may impose trade controls, particularly for services, to limit the convertibility on trade account. Convertibility on capital account is generally restricted because capital flows are considered the source of forex rate instability. Various methods were adopted to manage capital account transactions. Belgium adopted two-tier (“dual”) forex rates, one for commercial transaction and the other for financial transactions. The UK experimented with “external” convertibility: full convertibility on capital account for non-residents but not for residents. Such distinction had been necessary because, for historical reasons, the British pound was held by non-residents as reserve currency, and restricting capital account convertibility would have resulted in loss of confidence in the British currency.

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Chapter 1

The forex regime today can be characterized by three features: forex rate mechanism, reserve asset and capital account convertibility. Exhibit 1-4 shows the different choices for each of these features.

EXHIBIT

1-4: Forex Regimes

Rate Mechanism Free Float Managed Float Gliding Peg Fixed Peg

Reserve Asset Convertible Currencies SDR Gold Mix of the above

Capital A/c Convertibility Free Regulated Dual

1.10. Which Regime is the Best? There is no definitive answer. Every regime worked well for sometime under some circumstances, and no system worked well for all times and in all circumstances. From the experience gained since 1973, we can make the following general statements. 







Adjustment mechanism is more important than the international reserve money. When the adjustment mechanism is imperfect, there will be shortage of reserve money Balance-of-payment (BOP) problem is two-sided: if a country has trade deficit, then another has trade surplus. Both countries are to shoulder the burden to correct it. However, in practice, the burden falls largely on the country with deficit. The debtor‟s problem is material and pressing while the creditor‟s problem is largely moral and persuasive. Left to itself, the BOP problem will correct itself, but causes a lot of pain. To make the correction less painful, the governments intervene, with the following policy options for the country with deficit. o Fund the deficit out of reserves. if the deficit is temporary and the country has reserves o Deflate the economy and face unemployment, if the deficit is fundamental and in current account o Devalue the currency, if the deficit is fundamental and in current account but deflation and unemployment are not acceptable o Increase the interest rate, if the deficit is in capital account o Apply exchange and trade controls (as a last resort) For countries with free convertibility on capital account, the forex rate is influenced more by capital flows than the trade in goods and services.

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Chapter 2 Forex Basics: the Literacy Success is the natural consequence of applying the basic fundamentals. ( JIM ROBIN, American motivational speaker) Once you have literacy, then you have a chance to bring in the new tools of communications. (BILL GATES , founder of Microsoft Co)

Forex is one part literacy and ninety-nine parts numeracy. The one part literacy is crucial and the foundation for the ninety-nine parts. To be qualified as a forex trade, two criteria must be satisfied. First, there must be two currencies in the trade: forex trade is always a currency pair. Second, the rate of exchange between the two currencies must be fixed. Consider the following two transactions: (1) a bank accepts a foreign currency time deposit from a customer at fixed rate of interest; and (2) a bank opens a foreign currency import letter of credit (L/C) on behalf of its importerconstituent in favor of a foreign supplier. Which of the two transactions is a forex transaction? None of them is.

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Chapter 2

The first has only one currency and therefore is a money transaction. The second transaction has two currencies― local and foreign currencies―but the rate of exchange between them is not fixed as yet. We can say that the second transaction will surely become a forex transaction in future (when the importer makes the payment), but as of today, it has not entered the forex book of the bank. 2.1. Currency Pair Every forex transaction is a currency pair, and the forex price (or exchange rate) is the price of one currency in terms of the other. Exhibit 2-1 shows three types of exchange: barter, money and forex. In barter, we exchange one goods (or services) for another. In money, we exchange goods (or services) for money. In forex, we exchange one brand of money for another brand of money. Money branded is called currency.

EXHIBIT

2-1: Three Types of Exchanges Type Barter Money Forex

Exchange goods for goods goods for money money for money

2.2. Base Currency and Quoting Currency Of the two currencies in the pair, one is called the base currency (BC) and the other, the quoting currency (QC). Base currency is the currency that is priced: it is bought and sold like a commodity (whence the name “commodity currency”) and ceases to act in the traditional role of money. Quoting currency is the currency that prices the base currency, and is thus acting in the role of money. What is quoted in the market as forex price (or exchange rate) is the price of base currency in units of quoting currency. This statement always holds in all “quotation styles” (see Section 2.8) and must be memorized. Forex Price (or Exchange Rate) = Price of BC in QC The amount of BC is fixed (usually at one unit) and the amount of QC varies as the price of base currency varies over time. Accordingly, BC and QC

14

Forex Basics: the Literacy

are also called “constant/fixed amount currency” and “variable amount currency”, respectively. 2.3. ISO/SWIFT Codes International Organization for Standardization (ISO) has given three-letter code for every currency in their ISO 4217 standard. The first two letters are the country code defined by ISO in their standard ISO 3166, and the third letter is usually, but not always, the first letter of the currency name. Exhibit 2-2 lists the ISO codes for some currencies, and the Annex I shows the complete list of world currencies and their ISO codes.

EXHIBIT

2-2: ISO Codes for Major Currencies Country United Kingdom European Union United States Switzerland Japan India China South Africa

Currency pound euro dollar franc yen rupee renminbi rand

ISO Code GBP EUR USD CHF JPY INR CNY ZAR

We can see that some codes deviate from the principles described above. Box 2-1 gives an explanation for these apparent anomalies. The ISO codes are adopted by the Society for Worldwide Interbank Financial Telecommunications (SWIFT), which is the communication and messaging network for banks the world over. Only these standard ISO/SWIFT codes, and not the special characters (e.g. $, €, ₤), must be used in any standard forex messaging. The market practice for the notation of a currency pair is to write the BC code first, followed by the QC code. For example, Currency Pair EUR/USD USD/JPY

BC EUR USD

QC USD JPY

Forex Price Price of EUR in USD Price of USD in JPY

In contrast to the above market practice, most academic text books and certain parts of OTC derivatives documentation (e.g. 2005 Barrier Option Supplement to 1998 FX and Currency Options Definitions) of International Swaps

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Chapter 2

and Derivatives Association (ISDA) adopt the opposite approach: that is, they write the QC code first, followed by the BC code. ISDA also introduced the terms “denominator currency” and “numerator currency” for BC and QC, respectively. In this book, we follow the current forex market practice of writing BC first followed by QC to represent a currency pair.

BOX 2-1:

Oddities in ISO Country/Currency Codes

United Kingdom (UK): ISO assigned GB as the country code to the United Kingdom (and reserved the code UK), which is unusual because Great Britain consists of only England, Scotland and Wales while UK consists of GB and Northern Island. European Commission (EC) and Internet Assigned Number Authority (IANA) generally adopt ISO codes, but in the case of United Kingdom, they made an exception and use “UK” instead of “GB.” Switzerland (CH): the „CH‟ is from its official Latin name of Confoederatio Helvetica („Helvetica Confederation‟). South Africa (ZA): the code of „ZA‟ is from its Dutch name of Zuid-Africa. For the currency code, the third letter is usually the first letter of the currency name. There are some exceptions to this general principle, as follows. EU’s euro (EUR): Probably because „EUE‟ is hard on the tongue. Chinese renminbi (CNY): The Chinese currency is yuan (whence the third letter Y in its currency code), but in the communist China, everything is “people‟s”: people‟s republic (as if there could be monarch‟s republic!), people‟s army, people‟s money (“renminbi”), etc. For precious metals that are traditionally associated with money, ISO‟s principle is to start the code with the letter X and take the next two letters from the chemical symbol of the metal. The chemical symbols are derived from their Latin names: aurum (AU) for gold (whence ISO code of XAU), argentums (AG) for silver (whence the ISO code of XAG). For supra-national currencies, ISO code starts with the letter X and the next two letters are taken from currency name. Thus, XDR is for Special Drawing Rights of IMF; XCD for East Caribbean dollar; XPF for CFP franc. Though euro is also a supra-national currency, it was not given this coding convention, because euro‟s price is determined by demand-supply while that of others is derived by indexing them to the price of other currencies or pegging them to another currency.

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Forex Basics: the Literacy

2.4. Hierarchy in the Currency Pair Which currency should be the BC in a currency pair? The following is the order of precedence among the major currencies: GBP, EUR, AUD, NZD, USD and other currencies. Thus, whenever GBP is involved in the currency pair, it will be the BC; whenever EUR is involved, it will be the BC unless the other currency is GBP; and so on. Accordingly, the following will be the BC-QC combinations in different currency pairs, the first of the pair being the BC. GBP/EUR, EUR/USD, AUD/NZD, NZD/USD, NZD/CHF, USD/CHF The order of precedence has nothing to with the value of the currency, which changes continuously. It is due to historical reasons and the non-metric subdivision of currencies (see Box 2-2).

BOX 2-2:

Non-metric Subdivision of Currency

The most important currency in the present times is USD, and the participants will be interested in the price of USD in other currencies rather than the other way round. In other words, USD should be the base currency. This indeed is the case except for GBP, AUD, NZD and EUR against which USD is the quoting currency. The reason for GBP was its non-metric subdivision of pound under the librae, solidi, dinarii or lsd (Latin for pounds, schillings, pennies) system. The subdivision was: ₤1 = s20 = p240. Value of less than one pound must be expressed in schillings; and value of less than a schilling, in pennies. If USD 1 = GBP 0.6250, for example, it must be expressed as 0126, which is intuitive but cumbersome. And if the price changes to GBP 0.6255, then the new price should be 0126.12. To avoid this cumbersome notation, GBP is made the base currency so that its amount is always fixed at one unit. Though the UK switched over to the metric system in the early 1970s (under which one pound is100 new pence), the market practice continued. In case of AUD and NZD, the exception was due to the colonial past. What England does, the colonies would simply copy them. The reason for EUR‟s case was that the forex market expects EUR to eventually replace USD as the international reserve currency. Ahead of such development, the market made the EUR as the base currency when it was born in 1999.

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2.5. N Currencies and N1 Currency Pairs If there are N currencies, how many pairs are possible, given that every forex transaction must have a pair of currencies? Consider the following intuitive approach. To see all possible pairs, construct a rectangle with N columns and N rows. The following exhibit shows the rectangle for five currencies: A, B, C, D and E.

A B C D E

A A/A B/A C/A D/A E/E

B A/B B/B C/B D/B E/B

C A/C B/C C/C D/C E/C

D A/D B/D C/D D/D E/D

E A/E B/E C/E D/E E/E

Each cell is a currency pair, and the total number of cells is (N  N) since it is a rectangle. The diagonal cells are the currency pairs with the same currency, which are meaningless: the price of A in A will be always unity. Since the number of cells in the diagonal will be N, which are to be excluded, the number of meaningful currency pairs will be N  (N 1). Closer look reveals that the half below the diagonal is the reciprocal of the top half. Therefore, half the currency pairs are redundant: if we know the price of A/B, we can compute the price of B/A. Accordingly, the number of meaningful currency pairs to be quoted in the market is N  (N 1) / 2. For the mathematically inclined, it is combinations, not permutations, which are: Permutations with repetition:

NN

=N

Permutations without repetitions:

N! / (N 2)!

= N  (N 1)

Combinations:

N! / [(N 2)!  2!] = N  (N 1) / 2

2

The world has about 150 currencies, which results in 11,175 currency pairs. It is impossible to deal with such a large number of currency pairs. To make the number of actual currency pairs a much smaller and manageable number, the concept of numeraire currency is introduced. 2.6. Numeraire Currency Numeraire is something that measures or prices all others. For example, we use money to price all other things. Similarly, we can designate one of the N currencies as the numeraire (“money”) to price all other currencies. This leaves

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Forex Basics: the Literacy

us only N1 other currencies, each of which is priced against the numeraire, resulting in N1 currency pairs. Which among the N currencies should be the numeraire? It depends on the market segment, and there are two distinct market segments in the forex market: interdealer and commercial. Interdealer Market (also called interbank market) In the interdealer segment of the market, the participants are banks, and the following are the features of this market.   

Both parties to the transaction are banks, who are also called dealers (whence the interdealer market) Wholesale market with large-value transactions Market is global without national boundaries

The numeraire in the interdealer market has been different in different times. Venetian ducat (the currency in The Merchant of Venice), Florentine florin, Dutch guilder, German thaler and British pound have successively served as numeraire. Today, the numeraire is US dollar. Tomorrow, it will be another, possibly the European Union‟s euro. Currency pairs not involving USD (e.g. GBP/EUR, EUR/JPY, etc) are called “cross rates”, which are not directly quoted but derived by „crossing‟ two USD-based rates (explained in the next section). Commercial Market The commercial segment of the market is that where the end users (i.e. exporters, importers) buy and sell foreign currencies against their home currency. The following are the features of the commercial market.   

Transaction is between a bank on one side and an end user on the other Retail market with small-value transactions Market is localized in each country

The numeraire in the commercial market should be the local currency of the country, because the producers and consumers will be exchanging foreign currencies against their home currency. For example, in Indian commercial market, banks quote all foreign currencies against INR (e.g. GBP/INR, EUR/INR, USD/INR), many of which are “cross rates.”

19

Chapter 2

2.7. Cross Rates Cross rates are currency pairs that do not contain the interdealer numeraire currency, which is presently USD. Examples of such rates are GBP/EUR, EUR/JPY, GBP/INR, etc. Cross rates are derived or synthesized by „crossing‟ two USD-based rates. For example, GBP/EUR cross rate is derived by „crossing‟ GBP/USD and EUR/USD forex rates, which are called underlying rates or source rates. GBP/EUR = (GBP/USD) / (EUR/USD) The crossing means division in some cases and multiplication in others, as we will explain it in the cross rate arithmetic of Chapter 5. The key difference between underlying rates and cross rates is that the price of the former is determined by demand-supply forces; and the price of the latter is determined by arbitrage arithmetic. If one of the underlying rates change in price, the cross rate must automatically change, regardless of demand-supply situation for cross rate. Such a statement may seem to defy common sense and is explained it in Chapter 5. 2.8. Quotation Styles: Direct and Indirect The first stumbling block for beginners in forex is the quotation style. Consider how the price of apple can be quoted in two different ways, as follows. 1 apple INR 100

= =

INR 10 10 apples

Each of them involves buying or selling of apple. In the first, what is quoted is the price of apple, and hence is a price quotation; and in the second, the volume of apple and hence is a volume quotation. In both quotations, the quantity on left hand side is fixed, and that on right hand side is negotiated. Price quotation is also called “direct” style of quotation because it conveys the required information (i.e. apple price) directly. The buyer and seller negotiate to “buy low and sell high” because it results in profit, which accrues in INR. Volume quotation is also called “indirect” style of quotation because the required information (i.e. apple price) is conveyed indirectly. The buyer and seller negotiate to “buy high and sell low” because it results in profit, which accrues in apples. Since the action is buying or selling of apple, the buy-highand-sell-low translates as take more and give less” of apple.

20

Forex Basics: the Literacy

Let us apply the concept of direct and indirect style of quotation to forex market. In the interdealer market, the numeraire (currently USD) is the most important currency, and the market participants are primarily interested in its price in the other currency. If the numeraire is made the base currency, then the quotation indicates the price of the numeraire in other currency: it is direct style or price quotation. If the numeraire is made the quoting currency, then the quotation indicates the volume of the numeraire per unit of the other currency: it is indirect style or volume quotation. In the commercial segment of forex market, where the numeraire is the local currency, the participants are end users of foreign currencies. They would like to know the price of foreign currency in terms of local currency. Accordingly, if the foreign currency is made the base currency, then the quotation is the price of foreign currency in local currency: it is direct style or price quotation. If the foreign currency is made the quoting currency, then the quotation is the volume of foreign currency per unit of local currency: it is indirect style or volume quotation. Exhibit 2-3 summarizes the two quotation styles in the two segments of forex market.

EXHIBIT

2-3: Direct and Indirect Quotation Styles

Direct Style Indirect Style

Interdealer Market (numeraire = USD) Numeraire = BC Numeraire = QC

Commercial Market (numeraire = local currency) Numeraire = QC Numeraire = BC

Among the major currencies, GBP, EUR, AUD and NZD are made the base currency when paired with USD in the interdealer market. Accordingly, these currency pairs are quoted in indirect style. The commercial markets in these countries, too, follow indirect style of quotation. The direct style of quotation is also called European terms of quotation because in the pre-euro European commercial markets other than UK‟s, USD is the base currency so that it becomes direct style for Europeans. The indirect style of quotation is also called American terms of quotation because USD is the quoting currency and the foreign currency is the he base currency in the US commercial market so that it becomes direct style within America but indirect style outside it. It is important to note that in all cases, what is quoted is the price of base currency in units of quoting currency. This is true in both direct and indirect styles of quotation. Forex Price (or Exchange Rate) = Price of BC in QC (always)

21

Chapter 2

The base currency amount in most cases is kept fixed at one unit. In some cases, the forex price is so low that the price needs to be quoted to more than six decimal places. In such cases, it is convenient to keep the base currency amount at 100 units (or even more) and truncate the quote to four (or fewer) decimal places. For example, consider the JPY/INR price of 0.382775 (i.e. JPY 1 = INR 0.382775) in the Indian commercial market, which follows direct style of quotation. The base currency amount is made 100 units so that the quote is truncated to four decimal places: 38.2775. 2.9. Two-way Quote In the interdealer market, the participants are dealers: that is, those who quote both buy and sell prices to others. The buy-sell price of the dealer is called the bid-offer (or bid-ask in the US market). The bid is the buy price and offer (or ask) is the sell price. We need to define the following: buy and sell for whom, for which currency, and at which side of the two-way quote. Consider the following two-way quote for EUR/USD currency pair. 1.6000 / 1.6005 Let us state the logical facts. First, what is quoted is the price of base currency in units of quoting currency units―always. Second, the dealer quoting the price (called the price maker) will buy the base currency at the lower side and sell it at the higher side of his two-way quote. The difference between the two sides, called the spread, is always to the advantage of the price maker because, by offering two-way quotes to others, he runs the risk of one-sided inventory. Third, the price at which the price maker buys (or sells) the base currency is also the price at which the other party (called the price taker) sells (or buy) the base currency. Both cannot be buyers or sellers at the same price for the same currency. Fourth, in forex trade, we exchange two currencies so that what is buy in base currency for a party is also sell in the quoting currency for the same party. Lastly, the market convention is to make the two-way quote in ascending order2: lower/bid/buy side first and followed by higher/offer/sell side. Exhibit 2-4 summarizes the anatomy of two-way forex quote.

2

This is the case for all quotes of asset prices. In interest rate market, the rate is quoted in descending order (e.g. 3.15% / 3.10%). The reason for descending quote in interest

22

Forex Basics: the Literacy EXHIBIT

2-4: Anatomy of Two-way Forex Quote PRICE MAKER BASE CURRENCY

BUYS

here

1.6000 / SELLS

here

SELLS

QUOTING CURRENCY

here

1.6005 BUYS

here

SELLS

here

1.6000 BUYS

BASE CURRENCY

here

BUYS

/

here

1.6005 SELLS

here

QUOTING CURRENCY

PRICE TAKER

The mnemonic aid to remember the above is: 1 = 1 = 1= 1. Let us explain this rule. There are two parties to the trade. Alphabetically, they are: (1) price maker; and (2) price taker. There are two actions or market sides in any transaction. Alphabetically, they are: (1) buy; and (2) sell. There are two currencies in forex transaction. Alphabetically, they are: (1) base currency; and (2) quoting currency. There are two sides to the two-way quote. Alphabetically, they are: (1) bid or left-hand side (LHS); and (2) offer or right-hand side (RHS). Join the “firsts” in the four pairs above, and we have the aide-memoire of 1=1=1=1: the 1st party (price maker) does the 1st action (buy) in the 1st currenst cy (base currency) at the 1 side (bid) of the quote. Once this combination is remembered, all other can be derived logically. For example, buying base currency is the same as selling quoting currency for the same party at the same side; buy for one party is sell for the other party in the same currency at the same side; and so on. In FX market, the action (i.e. buy, sell) may be specified in either base currency or quoting currency. For example, on EUR/USD currency pair, buying EUR is the same as selling USD for any party. When the action is stated in base currency, it is easy to follow because it is a price quotation. When the action is stated in quoting currency, it is not very easy or intuitive because it is a volume quotation. The action may be expressed in quoting currency despite it being unintuitive because the requirement is to buy or sell round amount of quoting currency (e.g. to buy an exact amount of USD 5 million on EUR/USD currency pair). Whenever the action is specified in quoting currency terms, rate market is due to the practice of trading on rate quote but settling on price quote. The inverse relationship between rate and (corresponding bond) price will convert the descending quote for rate into ascending quote for price.

23

Chapter 2

translate that in the mind‟s eye into equivalent base currency action so that it is easy to understand. For example, on EUR/USD currency pair, if you want to buy USD, consider it as selling EUR, and then identify the correct side of the two-way quote. 2.10. Abbreviated Offer Side The offer (or second or right-hand) side of the two-way quote is not quoted in full but abbreviated. Only the last two digits, which are called “small figure”, are quoted. For example, 1.6000 / 1.6005 is abbreviated to 1.6000 / 05 1.9997 / 2.0002 is abbreviated to 1.9997 / 02 The omitted part in the offer side is called the “big figure.” There is a rule that unambiguously derives the full form of second side, and the rule is: offer price will have as many decimal places as the bid price, and is the next higher numeric after the bid price with the quoted numbers as its last digits. The following procedure and examples illustrate the implementation of the rule. (1) Place the abbreviated offer price below the bid price, aligning the digits to the right Example #1 Example #2 Bid 1 . 6 0 0 0 1 . 9 9 9 7 Offer 0 5 0 2 (2) Copy down the digits from the bid price into the corresponding empty slots in the offer price Example #1 Example #2 Bid 1 . 6 0 0 0 1 . 9 9 9 7 Offer 0 5 0 2 (3) If the resulting offer price is higher than the bid price, then the derived price is the offer price (as is the case in Example #1). Otherwise, increase the right-most digit carried down from the bid price by 1 (so that the offer will be the next higher value after bid price), as is the case in Example #2. Example #1 Example #2 Bid 1 . 6 0 0 0 1 . 9 9 9 7 1 Offer 1 . 6 0 0 5 0 2 2 . 0 0 0 2

24

Forex Basics: the Literacy

Occasionally, the abbreviated offer price may contain decimal places (e.g. 40.51/1.50). In such cases, the procedure is to: (a) ignore the numbers after the decimal point; (b) place the abbreviated offer price below the bid price, aligning the digits to the right, as in step #1 above; (c) place the ignored numbers after the decimal to the right of offer price; and (d) repeating the steps #2 and #3 above. The following illustrates the procedures for 40.51/1.50, Step #1

Bid Offer

4

0

.

5

1 1

Step #2

Bid Offer

4

0

.

5

1 1

5

0

Bid Offer

4 4

1 1

5

0

Step #1

0 0

. .

5 5

Notice that the above could have been quoted as 40.5000/50 without the necessity for any decimal point in the abbreviated offer price. Matter-of-factly, the reason for quoting zeroes after decimal point (which have no numeric value) is to indicate the number of decimal places in the offer side. For example, the bid price of 40.5000 (with all zeros explicitly quoted) indicates that the offer price will have four decimal places. Key Concepts Introduced Two requirements for a forex trade: (1) presence of two currencies; (2) the rate of exchange between them is fixed. Names of two currencies in the pair: base currency (BC) and quoting currency (QC) Three-letter ISO/SWIFT code for every currency Numeraire currency is the one against which all other currencies are valued. It makes the market of N currencies complete with just N – 1 currency pairs. Two segments of forex market: interdealer and commercial. The numeraire in the former is currently the USD; and in the latter, the local currency. Two styles of quotation, direct and indirect, based on whether the numeraire is BC or QC.

25

Chapter 2

Two-way quote: two sides of the quote, two parties, two market sides and two currencies.

EXERCISES

The following are the two-way market quotes. EUR/USD USD/CHF GBP/USD

0.9998/03 0.9998/03 1.0101/10

The market is the price-maker and you are the price-taker. Answer the following. 1.

On USD/CHF, at what price the market sells USD?

2.

On EUR/USD, at what price the market buys EUR?

3.

On GBP/USD, at what price the market buys USD?

4.

On USD/CHF, at what price you can sell CHF?

5.

On USD/CHF, at what price the market sells CHF?

6.

On EUR/USD, at what price you can buy EUR?

7.

On GBP/USD, at what price the market buys GBP?

8.

On EUR/USD, at what price you can sell USD?

9.

On GBP/USD, at what price you can buy GBP?

10. On USD/CHF, at what price the market buys CHF?

26

Chapter 3 Forex Settlement: Value Dates … when the hours of operation of two payments systems do not overlap, it is technically impossible to arrange for the simultaneous settlement of both sides of a foreign exchange transaction. (Noel Report, BIS, 1993) The vast size of daily FX trading, combined with the global interdependence of FX market and payment systems participants, raises significant concerns regarding the risk … for settling FX trades. These concerns include the effects on the safety and soundness of banks, the adequacy of market liquidity, market efficiency and overall financial stability. (Allsopp Report, BIS, 1996)

What we call the settlement date in other markets is called the value date in forex market. Value date is to be distinguished from trade date: on trade date, both parties agree on trade terms (i.e. currency pair, amount, price and value date); and on value date, the two currencies are exchanged. Value date is after the trade date by few days because the trade requires processing work (e.g. confirmation, netting, etc, as explained in Chapter 9). The gap between the two dates could be one (“T+1”) or two (“T+2”) business days, where “T” stands for trade date and the numeral indicates the business days thereafter (see Exhibit 3-1).

27

Chapter 3 EXHIBIT

3-1: Trade Date and Value Date

Trade Date (T)

Value Date (T+1 or T+2) time

Negotiation of trade terms

Exchange of currencies

Settlement involves the exchange of two currencies, and is exposed to settlement risk: the possibility that one party pays his obligation while the other does not. One of the mechanisms to mitigate settlement risk is paymentversus-payment3 (PvP) style of settlement under which the two obligations are exchanged simultaneously. If one party fails, the other party withholds his obligation. 3.1. Forex Settlement Risk The unique feature of forex settlement is that it takes place at two different settlement centers that are often located in different time zones. For example, USD/JPY transaction is settled in Tokyo (for yen amount) and New York (for dollar amount), and the two centers are 13 hours apart in time zone. As a result, one party pays the yen amount and receives the equivalent value in dollar after a delay of 13 hours. Because of the time zone differences, the PvP style of settlement is impossible in forex market, unless that payment mechanism is drastically modified. The non-simultaneous settlement of the two payments in a forex trade enhances the settlement risk, leading in turn to credit risk, market risk, liquidity risk and systemic risk. Credit risk is the loss of total amount; market risk is the replacement cost of the failed trade; liquidity risk is the possibility of not secur-

3

Payment-versus-payment (PvP) in forex market is the same as delivery-versuspayment (DvP) in equity and fixed-income securities markets. The word “delivery” is used for financial security and the word “payment”, for money. The PvP/DvP reduces but does not eliminate settlement risk. Under PvP, if one party fails, the other party will withhold the payment, and thus avoids the loss of full amount (credit risk). However, the nondefaulting party will have to replace the failed transaction with a new one at the prevailing market price. The difference between the original price and the replacement price is the loss under PvP, which is called counterparty credit risk and equals market risk.

28

FX Settlements: Value Dates

ing the additional funds required in replacement; and systemic risk is the domino effect of parties failing to each other in succession. The elevated settlement risk in forex is sometimes called Herstatt Risk (see Box 3-1) or cross4 currency settlement risk .

BOX 3-1:

Bankhaus Herstatt

Bankhaus Herstatt was a Cologne-based German bank, small in size but active in FX trading. Sharp increase in oil price in 1974 led to weaker US dollar (USD), and Bankhaus Herstatt sold USD against deutschemark (DEM) in speculative trades. In the settlement of USD/DEM transaction, Bankhaus Herstatt would receive DEM in Frankfurt and pay USD in New York. German regulators discovered fraud and concealment of large trading losses by Bankhaus Herstatt. On June 26, 1974, the German authorities closed down Bankhaus Herstatt after the close of interbank payments in Frankfurt. The time was 3:30pm in Frankfurt and 10:30am in New York. On receipt of this news, Herstatt‟s dollar correspondent banks withheld the payments to be made on behalf of Herstatt Bank. As a result, Herstatt‟s counterparties lost the entire USD amount to be received in New York (credit risk); had to arrange for emergency funding to make good the loss of dollar amount from Herstatt (liquidity risk); and had to replace the original transaction with a new transaction at the prevailing market price (market risk). At least 12 counterparties faced these risks for a total amount of USD 200 million. To make matters worse, the other banks suspended payments and credit lines to the affected counterparties of Bankhaus Herstatt, unless they received confirmation that the counter-payment had already been received, leading to a gridlock in the payments system (systemic risk). It was the first time that the market participants and the regulators realized the elevated risk in FX settlements.

Given the large volume of forex market, which is currently about USD 3.2 trillion a day (see Annex II), and its impact on domestic payments systems, a 4

It was so named in the Report of the Committee on Interbank Netting Schemes (popularly called the Lamfalussy Report), Committee on Payments and Settlements Systems, Bank for International Settlements, 1990).

29

Chapter 3

single failure can result in payments gridlock or even systemic failure. Encouraged by the regulators, the forex market has invented a global payments system for forex transaction on PvP basis. It is called the continuous-linked settlement (CLS) and discussed in Chapter 11. 3.2. Value Dates All value dates in forex settlement are grouped into three: spot, forward and short. Spot date is the most common value date and defined as the second business day from trade date (but is not so simple, as we will explain shortly). Any value date after spot date is called the forward date, and any value date before the spot date is called the short date5. Exhibit 3-2 illustrates the relative position in time of the three value dates.

EXHIBIT

3-2: Value Dates: Spot, Forward and Short

Trade Date (T)

1

2 time spot

short

forward

Spot Value Date Spot value date, though commonly defined as the second business day from trade date, is not always so. The following is the procedure to determine the spot value date, depending on whether USD is one of the currencies. Case A: USD is one of the currencies in the currency pair Spot value date is the date that must be a second business day at non-dollar center and a New York business day. It need not be a second business day at New York. If New York is closed on what is a second business day at the other center, then we move to the next business day on which both non-dollar center and New York are simultaneously open. 5

In the ACI‟s The Model Code (2004), the term “short date” is used for any maturity of less than one month, but in this book we restrict it to value dates before spot date.

30

FX Settlements: Value Dates

Case B: USD is not one of the currencies in the currency pair (i.e. cross rate) Spot value date is the date that must be second business day at each settlement center and a New York business day. Though not involved in settlement, New York must be opened because the cross rates are ultimately derived by crossing two USD-based rates (see Chapter 5). Therefore, New York will be indirectly involved in settlement. If any of the settlement centers or New York is closed on such date, we move to the next business day on which all the three are open. Because of above adjustments, the spot value date may fall on third or fourth business day (or even later) after trade date. Exhibit 3-3 shows the algorithm for determining spot value date.

EXHIBIT

3-3: Algorithm for Spot Value Date Is USD one of the currencies? YES

Go to the second business day at non-USD center

Is New York open on this date? YES

NO

Go to the next business day at non-USD center

NO

Go to the second business day at each settlement center

Is New York open on this date? NO YES

Go to the next business day at each settle center

This is the Spot Value Date

Forward Value Date Any value date after spot value date is forward value date (but see the footnote on the previous page). Such dates are infinite, but are quoted only up to one

31

Chapter 3

year for most currency pairs. For hedging forex exposures beyond one year, the market practice is to use other derivatives (e.g. currency swap, currency futures, currency option) rather than currency forwards. Even up to one year, only few periods, called “standard tenors”, are quoted, which are: 1W, 1M, 2M, 3M, 4M, 5M, 6M, 7M, 8M, 9M, 10M, 11M and 1Y where W = week, M = month and Y = year. Among these standard tenors, the 1W, 1M and 3M tenors are more liquid than the others. The non-standard tenors (e.g. 45-day, 95-day, etc) are variously called broken dates or odd dates or cock dates. Prices for them are derived by interpolating from the prices for the two nearest standard tenors (see Section 6.7). It is important to note that the standard tenors are relative to spot value date, not trade date. For example, 1M forward date is 1M from the spot value date. It follows then that, to determine the forward value date, we must first determine the spot value date. The following is the procedure for determining forward value dates. 1. 2. 3.

Determine the spot value date. Check the day of the spot value date. If it is the last business day in its month, go to step #3. Otherwise, go to step #4. Go to the last business day in the forward month on which both settlement centers and New York (regardless of whether New York is involved in settlement or not) are simultaneously open. The forward month is so many calendar months after the spot month as specified by the forward period. For example, 1M value date will be in the first calendar month after spot month, 2M value date will be in the second calendar month after spot month, etc. This is called end-end rule in forex market. The same rule is called FRN convention in the ICMA6 documentation (which governs the 7 Eurobond market) and ISDA documentation (which governs the OTC derivatives market). The following example illustrates the calculation of forward value date. Example: spot value date is January 30. Let us assume that January 31 is a holiday at one of the settlement centers or New York, making January 30 the last business day in the spot month of January. The 1M value date will be in February; start at 29 (in leap year) or 28 (non-leap year). If it is holiday, move to the preceding day until you get a date in February on which both settlement centers and New York are open. For 2M value date,

6 7

International Capital Markets Association (www.icma-group.com) International Swaps and Derivatives Association (www.isda.org)

32

FX Settlements: Value Dates

start at the 31st day of March and, if it is holiday at any of the settlement centers or New York, move to the preceding day; and so on. 4.

Go to the same day of the spot value date in the forward month. The forward month is as explained in the previous step. For example, if the spot value date is January 29, then the eligible 1M value will be February 29 (in leap year) or February 28 in non-leap year; the eligible 2M value date will be March 29; and so on. Check whether the eligible value date is a business day at both settlement centers and New York. If it is, then it is the forward value date. If any of the centers is closed, then move to the next day in the same month on which both the settlement centers and New York are simultaneously open. If there is no such day in the same month, then move to the previous business day in the same month on which both settlement centers and New York are simultaneously open. In other words, the 1M value date has to be necessarily in the first month after spot month; 2M value date has to be necessarily in the second month after spot month. This is called month end rule in forex market. The same rule is called modified following day in ICMA and ISDA documentation. The following example illustrates the procedure. Example: spot value date is January 29. The 3M value date has to be necessarily in the third month after spot month, which is April. The eligible 3M value date will be April 29 (same day of spot date). If this is a business day at both settlement centers and New York, then this is the 3M value date. If any center is closed, then we move to the next day, which is April 30. If this is a business day at both settlement centers and New York, then this is the 3M value date. If any center is closed, then there is no other day in April and we move to April 28; and so on.

Exhibit 3-4 shows the algorithm for determining the forward value dates. In most developing countries and emerging economies, there maybe exchange controls, which prohibit forward transactions, particularly for non-residents. For example, Indian exchange controls freely allow forward transactions but only among residents and restrict them for non-residents. Short Dates Short dates are values dates before spot date (but see the footnote 6 on page 30), and there are only two such possible dates: trade date and the first business day after trade date.

33

Chapter 3 EXHIBIT

3-4: Algorithm for Forward Value Date Determine the spot value date ` Is it the last business day in its month for two sett. centers & NYC?

YES

NO

Go to the last business day in the forward calendar month on which both sett. centers and NYC are open

Go to the same day of spot date in the forward month Are both sett. centers and NYC are open? YES

NO end-end rule Is there next day in the same month? month-end rule

NO Go to the previous day

YES Go to the next day

This is forward value date

Settlement on trade date is called cash deal, the word “cash” being an alert to the trader that the deal affects the end-of-day cash balances on trade date. Settlement on first business day from trade is called tom, short for “tomorrow”: the word does not literally mean the next day, but refers to the next business day. Cash value dates may not be possible because of time zone differences. For example, USD/JPY trade for cash value date is possible only during Tokyo trading hours, but not in New York trading hours, because when New York opens, Tokyo is already closed. Tom value dates may not be always possible because of holidays in one of the settlement centers or New York. For example, CHF/JPY trade is contracted on January 27. Assume that January 28 and 29 are business days at Zurich and Tokyo (which are the settlement centers) and New York. The spot value date will thus be January 29 and the

34

FX Settlements: Value Dates

tom value date will be January 28. However, if New York is closed on January 28, then tom value date is not possible for this currency pair, because the next business day (January 29) will be the spot value date. To sum up: forward value date may not be possible because of exchange controls; cash value date may not be possible because of time zone differences; tom value date may not be possible because of holidays in settlement centers or New York; but spot value date is always possible, and therefore the most important value date. Day Beginning and Closing Hours The commercial segment of forex market operates only during the local banking hours: about 8-10 hours a day. A trade initiated and closed within the business hours for the same value date is considered clean square-off without mismatch in value dates. In contrast, the interdealer segment operates round the clock, and so do the margin trading companies, which provide 24-hour services to the retail traders. The round-the-clock service poses the problem of defining when does the day begin and end. For interdealer market, ACI Code of Conduct (see Chapter 12) considers 05:00 Sydney time (corresponding to 07:00 Auckland time) as opening and 17:00 New York time (corresponding to 09:00 Auckland time next day) as closing, giving 26 hours for a day! Thus, a spot trade initiated in New Zealand trading hours can be reversed in New York trading hours for the same value date, despite more than 24 hours delay. For retail speculators, most margin trading companies consider 15:00 New York time as the day‟s close, giving 24 trading hours a day. Few of them might give time up to 17:00 New York time except for NZD/USD currency pair, for which 15:00 New York time is the cut-off. 3.3. Exceptions to Spot Value Date Rules Certain currency pairs have conventions for spot value date that are different from that discussed in the previous section, and are explained below. Canadian dollar (CAD) USD/CAD currency pair, particularly in European and North American markets, settles the spot on T+1 (i.e. first business day when New York and Toronto are simultaneously open). Against other currencies, CAD spot trades will be settled on T+2 basis, as described in the previous section.

35

Chapter 3

Turkish lira (TRY) In the interdealer market, the spot date for USD/TRY is T+0 (i.e. same as trade date) if the trade is executed before 15:30 Istanbul time; and T+1 if the trade is executed thereafter. In the commercial market, the spot is T+1 with 15:00 EST as the rollover time for TRY trades against all currencies. Russian ruble (RUB) The USD/RUB pair trades spot for T+0, T+1 and T+2, but the T+1 is the most popular and hence considered the spot value date. The Reuters Dealing 3000 Spot Matching (D2) platform provides for T+0 and T+1. Certain Latin American Currencies Argentine peso (ARS), Chilean peso (CLP) and Mexican peso (MXN) require two clear business days at New York for spot value date, unlike others that do not require two business days at New York but requires that New York be open on T+2. For example, trade date is Monday and Tuesday is a holiday at New York but business day at other center; and Wednesday is a business day at both centers. For other currency pairs, Wednesday will be the spot value date though it is the first business day at New York. For these Latin American currencies, however, the spot value date will be rolled over to Thursday. Certain Middle East Currencies The Middle East observes Friday and Saturday as the weekend while the rest of the world observes Saturday and Sunday as the weekend. The following table shows the day of the week for spot value date for trades contracted on different weekdays, assuming no holiday between Monday and Thursday. Trade Date Mon Tue Wed Thu Fri Sat Sun

Spot Value Date Wed Thu Mon (of next week) Mon or Tue (see below) Cannot be a value date because of local holiday Cannot be a value date because of holiday Cannot be a value date because of New York holiday

For trades contracted on Thursday, variations exist within the region. For United Arab Emirates dirham (AED), Bahraini dinar (BHD), Egyptian pound (EGP), Kuwaiti dinar (KWD), Riyal Omani (OMR) and Qatari riyal (QAR), the

36

FX Settlements: Value Dates

spot value date for Thursday‟s trades is the following Monday because there are two business days for each currency: Friday and Monday for USD; and Sunday and Monday for the local currency. It therefore follows that Tuesday can never be the spot value date for these currencies: it will always be a broken date. Saudi riyal (SAR) and Jordanian dinar (JOD) follow a different rule for the Thursday‟s trades in that their value date is the following Tuesday. In the commercial segment of the market, some local banks follow “split settlement” with their customers: USD is settled on Friday or Monday and the local currency is settled on Sunday such that the arrangement is always to the advantage of the bank. That is, when the bank receives USD, it will be on Friday; and when bank pays it, it will be on Monday. The “split settlement” here is different from the same phrase in SWIFT and other messaging systems. In the latter, “split settlement” applies to one-to-many trade: on one side, there is a single counterparty and one large amount; and on the other side, the amount is split into smaller amounts and settled with multiple counterparties. Key Concepts Two settlement centers and time zone difference Enhanced settlement risk (“Herstatt risk”) Value dates: cash, tom, spot and forward

EXERCISES

1.

The following is the calendar with the day of the week and the calendar days in the first rows, respectively. Trade date is the first Monday (marked “TD” n the calendar). The shaded boxes represent holidays in the center indicated in the first column. For the sake of convenience, business days are numbered in italics at each center. Thus, for New York, the first business day is We 2nd, the second working day is Th 3rd, the third working day is Mo 7th, and so on. Mo TD New York London Tokyo Mumbai

Tu 1

We 2 1

1 1

1 2

Th 3 2 2

Fr 4 3 2 3

Sa 5

Su 6

Mo 7 3 4 3 4

Tu 8

4 5

We 9 4 5 5 6

Th 10 5 6 6

37

Chapter 3

Given the above calendar, what is the spot value date for the following currency pairs? A. B. C. D. E. F. 2.

USD/INR USD/JPY GBP/USD GBP/INR JPY/INR GBP/JPY

The following is another calendar. Saturday and Sunday are weekend holidays. Holidays other than weekend are indicated in each calendar month at different cities. For example, October 29 is a holiday at London and New York; and so on. October

Mo

November

December

7

14

21

28

4

11

18

25

2

9

16

23

30 31

Tu

1

8

15

22

29

5

12

19

26

3

10

17

24

We

2

9

16

23

30

6

13

20

27

4

11

18

25

Th

3

10

17

24

31

7

14

21

28

5

12

19

26

Fr

4

11

18

25

1

8

15

22

29

6

13

20

27

Sa

5

12

19

26

2

9

16

23

30

7

14

21

28

Su

6

13

20

27

3

10

17

24

8

15

22

29

Holidays 29: London, Mumbai 30: New York 31: Tokyo

Holidays 26: Mumbai 28: New York 29: London

1

Holidays 27: London, New York 31: Tokyo, Mumbai

Given the above calendar, what is the forward value date for the following currency pairs, if the spot value date is as specified against the currency pair? A. B. C. D. E. F. G. H.

USD/INR: spot is October 16. What is 1-month value date? USD/INR: spot is October 25. What is 1-month value date? USD/INR: spot is October 31. What is 1-month value date? USD/INR: spot is October 31. What is 2-month value date? USD/INR: spot is November 29. What is 1-month value date? USD/INR: spot is November 27. What is 1-month value date? USD/JPY: spot is October 31. What is 2-month value date? USD/JPY: spot is October 30. What is 2-month value date?

38

FX Settlements: Value Dates

I. J. K. L. M. N.

USD/JPY: spot is October 29. What is 2-month value date? GBP/USD: spot is October 25. What is 2-month value date? GBP/USD: spot is November 22. What is 1-month value date? GBP/INR: spot is October 15. What is 1-month value date? GBP/INR: spot is November 27. What is 1-month value date? GBP/JPY: spot is November 27. What is 1-month value date?

39

Chapter 4 Forex Deals: Classification and Risk You ask what is the use of classification, arrangement, systemization? I answer you: order and simplification are the first steps toward the mastery of a subject―the actual enemy is the unknown. (THOMAS MANN, The Magic Mountain) And the day came when the risk to remain tight in a bud was more painful than the risk it took to blossom (ANAIS NIN)

All forex deals are classified into two types: outright and FX swap; and every forex transaction is analyzed with respect to two risk parameters: exposure (also known as position) and mismatch (also known as gap). 4.1. Outright An outright transaction involves buying or selling a currency. Since the forex trade is an exchange of two currencies, it is simultaneously buying a currency and selling an equivalent amount of another currency. The following examples illustrate the outright trades.

41

Chapter 4 Deal #1

Bought EUR 1 million on EUR/USD @ 1.5665 value date spot

Deal #2

Sold JPY 500 million on USD/JPY @ 104.00 value date spot

In the trade, only one currency (“deal currency”) amount is specified. The other currency (“derived currency”) amount is derived by „crossing‟ the deal currency amount with the trade price. The trade price in all cases is the price of base currency in terms of quoting currency. In trade #1, the deal currency, EUR, is the base currency and the trade price implies that EUR 1 = USD 1.5665. The „crossing‟ here means multiplication of deal currency with trade price. In trade #2, the deal currency, JPY, is the quoting currency. There is no restriction that the deal currency should be always the base currency. If the requirement is to buy or sell a round amount of quoting currency, then the action will be specified in that currency. The trade price implies that USD 1 = JPY 104.00, so that JPY 500 million will be equivalent to 500 / 104.00 = USD 4.789272 million. The „crossing‟ here means division of deal currency amount by trade price. To sum up, the outright trade involves a bought currency and a sold currency. The amount of one of them and the price is specified. The amount of the other currency is derived by „crossing‟ the deal amount with the price. The „crossing‟ is multiplication or division, depending on whether the deal currency is base currency or quoting currency, respectively, as shown in Exhibit 4-1.

EXHIBIT

4-1: Deal Currency and Derived Currency Amount

Deal Currency = Base Currency Derived Currency Amount = Deal Currency Amount  Price Deal Currency = Quoting Currency Derived Currency amount = Deal Currency Amount / Price

4.2. Forex Swap There are two swaps with similar names: forex swap and currency swap. Until the 1980s, forex swap was simply called “swap”. In the early 1980s, another

42

Forex Deals: Classification and Risk

swap was invented, which was different from forex swap in structure and function. To make the distinction between the two, the traditional “swap” is now called forex swap and the new instrument is called currency swap. The difference between them is explained in Section 4.8. Forex swap consists of simultaneous buying and selling of same currency on the same currency pair for the same amount but for different value dates. The value dates must be necessarily different because, without such a condition, the buy and sell will square up each other, leaving no transaction in existence. The following example illustrates the FX swap. Bought EUR 1 million on EUR/USD @ price1 value date spot (near leg) Sold EUR 1 million on EUR/USD @ price2 value date 1-month (far leg)

The above are not two independent trades but two legs of the same trade. The leg that settles first is called the near leg and the other leg is called the far leg. We distinguish two kinds of forex swaps: buy-sell (B-S) and sell-buy (S-B) swaps. The market side of the near leg is always written first. Thus, in the B-S swap, the market side of the near leg is buy and that of far leg is sell; and the converse for the S-B swap. Notice that both the legs have the following features: 

Same currency pair (in the example, EUR/USD)



Same deal currency (in the example, EUR)



Same deal amount (in the example, 1 million)



Different value dates (in the example, spot and 1-month)

The only trade parameter we have not specified to be same or different is the price for two legs. We cannot impose any such restriction because the prices are market-driven. All combinations are possible: the buy price may be more than, less than or equal to the sell price. If the buy price is less than the sell price, does it mean profit? And loss, when the buy price is more than the sell price? And if they are the same, what is motive in doing such a transaction? Let us examine the cash flows from the swap transaction illustrated above. We consider that Party A has executed the above swap with Party B. For the Party A, it is a BS swap in EUR and SB swap in USD for equivalent amount; and the converse for the Party B. Exhibit 4-2 shows the cash flows between the two parties on near date and far date. Note that when we buy a currency, it will be inflow; and when we sell it, it will be an outflow.

43

Chapter 4 EXHIBIT

4-2: Cash Flows Picture of FX Swap Near Date

Far Date Time Party A

EUR

USD

EUR

USD

Party B

For a moment, ignore the USD cash flows and consider only the EUR cash flows? What is this transaction? It is obviously a money transaction in EUR with Party A as borrower and Party B as lender. Consider now only the USD cash flows and ignore the EUR cash flows. It is now a USD money transaction with Party A as lender and Party B as borrower. Consider now only the cash flows on near date, and ignore that on far date. The transaction now is a forex transaction in EUR/USD with Party A as EUR buyer/USD seller; and party B as EUR seller/USD buyer. Consider now only the cash flows on far date and ignore that on near date. The transaction is again a forex transaction in EUR/USD with Party A as EUR seller/USD buyer; and party B as EUR buyer/USD seller. Consider all flows together: it is a B-S swap in EUR (or S-B swap in USD) for Party A; and S-B swap in EUR (or B-S swap in USD) for Party B. Forex swap is thus a combination of borrowing and lending in two different currencies of equivalent amount. Exhibit 4-3 summarizes the transaction from different perspectives.

EXHIBIT

4-3: Anatomy of FX Swap

Perspective EUR cash flows USD cash flows Near date cash flows Far date cash flows Entirety

Party A EUR Borrower USD Lender EUR buyer/USD seller EUR seller/USD buyer FX swap: BS in EUR (or SB in USD)

Party B EUR Lender USD Borrower EUR seller/USD buyer EUR buyer/USD seller FX swap: SB in EUR (or BS in USD)

44

Forex Deals: Classification and Risk

We can see from the above that two money trades are combined into a single package called forex swap. The currency lent is secured by the currency borrowed or vice versa. Forex swap is similar to the repo trade in money market. Whereas repo is borrowing of money against the collateral of a financial security, forex swap is borrowing of one brand of money against the collateral of another brand of money. On the near date, the rate of exchange between the currencies is linked to the prevailing market price. On the far date, the same amounts of currencies are re-exchanged along with the two interest amounts. The two interest amounts are converted into quoted currency and clubbed with the principal amount to derive the price for far leg. This is somewhat a complex calculation and explained fully in Chapter 6. 4.3. Exposure Exposure (also known as position or exchange position) refers to price risk (or market risk) in a forex trade. What we mean by risk is the uncertainty about the future return, which could be positive or negative. The popular names for positive and negative returns are profit and loss, respectively. For example, if we buy EUR on EUR/USD, there will be either profit or loss in future, respectively, if the price rises or falls. We say we have a position or are exposed to price risk or market risk. When we buy a currency, we say we have long or overbought exposure; and when we sell it, we have short or oversold exposure. When there is no exposure, we say square. Since every forex trade involves two currencies with opposite market sides (i.e. buy one and sell the other), the exposure arises simultaneously in two currencies in a complementary way: overbought in one currency and oversold in the other for equivalent amount. If there is exposure in only one currency, it is not exposure, but profit/loss. The following trades illustrate the exposure and profit/loss. Trade #1: Bought EUR 100 on EUR/USD @ 1.5665

The deal above results in an overbought exposure for EUR 100 and oversold exposure for USD 156.65. If the rate goes up subsequently, it results in profit; and if the rate goes down, it results in loss. Let us assume that we have executed the second trade subsequently as follows. Trade #2: Sold EUR 100 on EUR/USD @ 1.5765

The second trade creates an oversold exposure for EUR 100, which will exactly offset the existing overbought exposure, leaving no exposure in EUR.

45

Chapter 4

In USD, the second trade creates overbought exposure for USD 157.65, which will eliminate the existing oversold exposure of USD 156.65, leaving a net overbought exposure of USD 1. Since exposure by definition must arise in two currencies and in a complementary way, the exposure in USD alone must be considered profit/loss from the two trades rather than exposure. If the exposure in one currency is overbought, it is inflow and thus profit; and if oversold, it is outflow and thus loss. Outright trades create new exposure, and if the new exposure is complementary to an existing exposure, they eliminate the existing exposure. Forex swap trades involve simultaneous buying and selling of same currency and same amount on the same currency pair and therefore do not create any exposure, but leave the existing exposure unchanged. 4.4. Mismatch Mismatch (also known as gap or cash position) refers to the cash balances in currencies. The cash balance in a currency can be surplus, deficit or square. Whereas the surplus requires lending and deficit requires borrowing, the square situation is the ideal state. Unlike exposure, mismatch is computed for each day at the closing, because the day is the unit period for accounting. When we buy a currency, there will be cash inflow or surplus in that currency. Similarly, when we sell it, there will be cash outflow or deficit. Since forex trade always involves buying one currency and selling another of equivalent amount, mismatch arises simultaneously in two currencies: surplus in one and deficit in another for equivalent amount. Whenever there is an exposure, it necessarily follows that there will be a mismatch. Outright trades create exposure and therefore create mismatch. Forex swaps do not create exposure but create mismatch because the buying and selling are for different value dates. The better way to understand the concepts of exposure and mismatch is by analyzing the cash flows. 4.5. Cash Flow Analysis of Trades Any financial instrument is ultimately a bundle of cash flows, and the cash flow has three attributes: occurrence, timing and amount. Each attribute is qualified as certain (i.e. known at the outset) or uncertain (i.e. not known at the outset). If the occurrence is certain, then it means that the cash flow will surely occur and not conditional on any future event. Similarly, if the timing and amount are certain, then we know at inception when it will occur and how much it will be.

46

Forex Deals: Classification and Risk

Based on the combination of three attributes, we classify cash flows into three types: fixed, floating, and contingent, as shown in Exhibit 4-4.

EXHIBIT

4-4: Types of Cash Flows

Cash Flow Type Fixed Floating Contingent

Occurrence Certain Certain Uncertain

Timing Certain Certain Certain/Uncertain

Amount Certain Uncertain Certain/Uncertain

Classification as above is the first step in any valuation. Our focus is not financial valuation but analysis of forex cash flows from the perspective of risk and profit/loss calculations. To redefine the concepts of exposure and mismatch in terms of cash flows, we will construct a cash flows table, which is a very valuable tool in financial engineering. The design of the table is such that the columns display the cash flow amount and the rows display the cash flow timing. Different columns are used for cash flows in different currencies. We illustrate the cash flow table for the following forex swap. Bought USD 100 on USD/INR @ 40.10 value date spot (near leg) Sold USD 100 on USD/INR @ 40.15 value date 3-month (far leg)

The cash flow table must have separate columns for each currency and separate rows for each value date. Exhibit 4-5 shows the cash flows for the forex swap above. The buy trade results in cash inflow (shown with positive sign) and sell trade results in cash outflow (shown with negative sign).

EXHIBIT

4-5: Cash Flows Table

Spot Total 3-month Total G Total

USD

INR

+100 +100 100 +100 0

4,010 4,010 +4,015 +4,015 +5

Remark Cash flows from near leg Day total Cash flows from far leg Day total

Note that buy-sell trades result in a pair of cash flows in the same row of different columns; and borrow-lend trades result in a pair of cash flows in the same column of different rows. We can redefine exposure and mismatch in terms of cash flows as follows: exposure is the grand total of all cash flows in

47

Chapter 4

the currency; and mismatch is the daily total of all cash flows in a currency for a value date. If the grand total of all cash flows in a currency is zero, there is no exposure; if positive, the exposure is overbought (or long); and if negative, the exposure is oversold (or short). Similarly, if the daily total of cash flows in a currency for a value date is zero, there is no mismatch; if positive, the mismatch is surplus; and if negative, the mismatch is deficit. Since the sum of cash flows at all value dates is simply the grand total of all cash flows, it follows that the sum of mismatches is the exposure. In the example above, the mismatch in USD cash flows is +100 (surplus) on spot value date and 100 on 3-month value date; and the sum of mismatches is zero or square. For INR cash flows, the mismatch is 4,010 on spot value date and +4,015 on 3-month value date; and their sum of +5, which would seem an overbought exposure but is not. By definition, exposure must arise in two currencies in a complementary way. The net cash flow in one currency alone is the profit/loss: profit if the cash flow is positive; and loss, if it is negative. In our example, there is a profit of INR 5. However, it is not the net profit. If it were, everyone in the market will do this forex swap and profit from it. Consider now the mismatch. We have surplus cash in USD from spot to 3month value dates; and deficit in INR for the same period. They are corrected by simultaneously lending USD and borrowing INR from spot to 3-month value date. The net difference in two interest amounts (USD receivable, INR payable) will exactly offset the profit of INR 5 in the FX swap. We will examine the link between forex swap and the two interest rates in Chapter 6. What remains after eliminating exposure and mismatch is the net profit/loss. Let us summarize the two concepts of exposure and mismatch. Exposure (also known as Position or Exchange Position) 

It refers to forex price risk and is of two types: long (or overbought) and short (or oversold)



It is computed as the grand total of cash flows in a currency. If the total is positive, it is long position; and if negative, short position.



It arises in two currencies in a complementary way: long in one currency and short in the other for equivalent amount. Exposure in one currency alone is gross P/L.



Exposure creates mismatch



Outright trades create new exposure or eliminate existing exposure

48

Forex Deals: Classification and Risk

Mismatch (also known as Gap or Cash Position) 

It refers to cash balances and is of two types: surplus and deficit



It is computed as the total of cash flows in a currency for a particular value date. If the total is positive, it is surplus; and if negative, deficit.



The surplus (or deficit) in a currency on a value date is accompanied by deficit (or surplus) in the same currency on another value date. In other words, surplus or deficit is for a period between the two value dates. Further, mismatch arises in two currencies in a complementary way: surplus in one currency for a period and deficit in another currency for the same period



Surplus/deficit for a period in one currency alone is not mismatch but liquidity problem; and surplus/deficit in one currency alone and on a value date alone is the net P/L.



Forex swap trades create mismatch without creating exposure

4.6. Deal Blotter, Position and Gap Statements As soon as a trade is executed by the trader, it is immediately entered into deal blotter, which records the economic details of the trade: time stamp, currency pair, deal type, market side (i.e. buy or sell), deal currency and amount, price, and value date. The blotter is maintained for each trader and for each session (which is typically a day). Exhibit 4-6 shows a specimen of deal blotter. 4-6: Deal Blotter Date: May 22, 2008 Trader: ACR (amount in millions) Time Currency Deal Market Deal Price Value Pair Type Side Amount Date

EXHIBIT

9:30:15

EURUSD

outright

Buy

EUR 5

1.5765

spot

9:30:25 9:30:55 9:31:05

USDJPY EURUSD EURUSD

outright outright outright

Sell Sell Sell

USD 5 EUR 5 EUR 3

104.39 1.5795 1.5805

spot spot spot

9:31:15 9:31:30

USDJPY EURUSD

outright outright

Buy Sell

USD 2 EUR 2

104.05 1.5785

cash spot

9:35:15 9:40:00 9:40:00

EURUSD USDJPY USDJPY

outright swap swap

Sell Sell Buy

USD 5 USD 2 USD 2

1.5742 104.16 104.11

1-mon cash spot

9:40:10 9:40:10

EURUSD EURUSD

swap swap

Sell Buy

USD 5 USD 5

1.5745 1.5738

spot 1-mon

49

Chapter 4

From the deal blotter, every trade is processed further in real-time for its effect on position and gap. Exhibit 4-7 shows the typical format of position and gap statements for the deals in Exhibit 4-6. 4-7: Position and Gap Statement Position Date: May 22, 2008 Trader: ACR (amount in millions) Time Purchase Sale Position 9:30:15 5.000000 5 OB EUR 9:30:55 5.000000 0 Square 9:31:05 3.000000 3 OS 9:31:30 2.000000 5 OS 9:35:15 3.176216 1.823784 OS 9:40:10 3.175611 1.351827 OB 9:40:10 3.177024 1.825197 OS 9:30:15 7.8825 7.8825 OS USD 9:30:25 5.0000 12.8825 OS 9:30:55 7.8975 4.9850 OS 9:31:05 4.7415 0.2435 OS 9:31:15 2.0000 1.7565 OB 9:31:30 3.1570 4.9135 OB 9:35:15 5.0000 0.0865 OS 9:40:00 2.0000 2.0865 OS 9:40:00 2.0000 0.0865 OS 9:40:10 5.0000 5.0865 OS 9:40:10 5.0000 0.0865 OS 9:30:25 521.95 521.95 OB JPY 9:31:15 208.10 313.85 OB 9:40:00 208.32 522.17 OB 9:40:00 208.22 313.95 OB Position Summary (OB = overbought; OS = oversold) EUR: 1.825197(OS); USD: 5.0865 (OS); JPY: 313.95 (OB) EXHIBIT

Gap

Date: May 22, 2008 Trader: ACR (amount in millions) Value Purchase Sale Gap spot 8.175611 10.000000 1.824389 Deficit EUR 1-mon 3.176216 3.177024 0.000808 Deficit Total 11.351837 13.177024 1.825197 cash 2.0000 2.0000 0 square USD spot 17.7960 17.8825 0.0865 Deficit 1-mon 5.0000 5.0000 0 square Total 24.7960 24.8825 0.0865 cash 208.32 208.10 0.22 surplus JPY spot 521.95 208.22 313.73 surplus Total 730.27 416.32 313.95

50

Forex Deals: Classification and Risk

Notice that, for each currency, the sum of gaps should be equal to the position. If they do not, then there is a mistake in the accounting for cash flows. 4.7. Limits on Position, Gap and Others Bank controls the forex operations by placing limits on position, gap, counterparty exposure, stop-loss, etc. Of them, the most important is that on position. The position limit has two variants: daylight limit and overnight limit. The daylight limit is the limit during the day while the overnight limit is the limit at the close of business each day. The overnight limit is also used to compute capital adequacy for trading operations under Basel II regulatory regime. The international norm for computing the position limit is the “short hand” rule, according to which the limit for capital adequacy is computed as follows. 

Segregate currencies into those with overbought and oversold positions



Translate the position into home currency equivalent



Separately sum the overbought and oversold positions



The higher of the aggregate overbought and aggregate oversold positions is considered the “net open position.”

The reason for the short hand rule is the currency diversification effect. In the forex market, in terms of price changes, it is a see-saw between US dollar and all other currencies. If dollar rises against a currency, it rises against all other; and vice versa. Most banks are now adopting advanced techniques like value-at-risk (VaR) to measure forex price risk. Basel II regulations allow VaR model to compute capital adequacy as an alternative to the short-hand rule. 4.8. Forex Swap versus Currency Swap Though sounding similar in name, they are structurally and functionally different. Forex swap is a cash management tool: currency swap is a risk management tool. Under the accounting standards of FASB 133 and IAS 39, forex swap is not a derivative but currency swap is. Forex swap, being a cash management tool, must necessarily exchange the principal amounts in two currencies. Like in money market instruments, the period of forex swap is one year or less and there is only one interest payment,

51

Chapter 4

which is merged with the principal re-exchange. The near leg is the exchange of principal and the far leg price is the re-exchange of principal and interest combined. The structure and pricing of forex swap is discussed in Chapter 7. Currency swap, being a risk management tool, need not exchange of principal amounts in two currencies. It exchanges two currency interest amounts and the forex price change during the period. It may or may not exchange principal amounts. The swap period is more than one year and can extend up to 10 – 20 years with interest payments typically at quarterly or half yearly intervals. Exhibit 4-8 summarizes the similarities and differences between two swaps.

EXHIBIT

4-8: FX Swap versus Currency Swap

Feature Purpose

FX Swap Cash management

Currency Swap Risk management

Swap period

One year or less

Principal

Always exchanged

Interest

Always exchanged and combined with principal reexchange at the end

More than one year May nor may not be exchanged Always exchanged and there will be a series of such exchanges

Key Concepts Two currencies in a trade: deal currency and derived currency, each of which can be the base currency or the quoting currency. Two types of deals: outright and forex swap. Forex swap is different from currency swap: the former is cash management tool and the latter is risk management tool. Two concepts: exposure (a.k.a. position or exchange position) and mismatch (a.k.a. gap or cash position). Two types of exposure: overbought (a.k.a. long) and oversold (a.k.a. short) Two types of mismatch: surplus and deficit

52

Forex Deals: Classification and Risk

Exposure is the grand total of all cash flows in a currency, and will arise in two currencies in a complementary way. Exposure in only one currency is the gross profit/loss Mismatch is the daily total of cash flows in a currency on a value date. The surplus or deficit runs for a period marked by two value dates. Mismatch arises in two currencies in a complementary way (i.e. surplus in one and deficit in another for the same period). Mismatch in one currency alone is funding problem; and mismatch in one currency alone and only on one value date (rather than a period) is net profit/loss.

EXERCISES

Taking into account the following deals, update the position and gap statements, in the format shown in Exhibit 4-7. Instead of deal time, use the serial number of the deal as its substitute. All amounts are indicated in millions. Note that for JPY/INR currency pair, the price is for 100 units of JPY. 1.

(USD/INR, outright): Bought USD 3 @ 40.61 value date spot

2.

(EUR/USD, outright): Sold EUR 3 @ 1.5737 value date spot

3.

(JPY/INR, outright): Bought JPY 500 @ 39.01 value date 1-mon

4.

(USD/JPY, outright): Bought USD 5 @ 104.33 value date spot

5.

(USD/INR, outright): Bought 2 @ 40.62 value date spot

6.

(EUR/USD, outright): Sold EUR 2 @ 1.5729 value date spot

7.

(GBP/INR, outright): Sold GBP 1.2 @ 80.27 value date cash

8.

(GBP/USD, outright): Bought GBP 1 @ 1.9763 value date cash

9.

(USD/INR, outright): Bought USD 2 @ 40.60 value date spot

10. (USD/JPY, swap): SB USD 5 @ 104.38/104.00 value date spot/1-mon 11. (USD/INR, swap): BS USD 5 @ 40.65/45.67 value date spot/1-mon 12. (GBP/USD, swap): SB USD 2 @ 1.9755/1.9751 value date cash/spot 13. (USD/INR, outright): Sold USD 9.7 @ 40.66 value date cash 14. (USD/INR, outright): Bought USD 10 @ 40.65 value date spot 15. (USD/INR, swap): BS USD 12 @ 40.65/40.66 value date cash/spot

53

Chapter 4

16. (EUR/USD, outright): Bought EUR 7 @ 1.5717 value date spot 17. (GBP/USD, outright): Bought GBP 0.2 @ 1.9749 value date spot 18. (EUR/USD, outright): Sold EUR 2 @ 1.5721 value date spot

54

Chapter 5 Cross Rate Arithmetic God does arithmetic. (KARL FRIEDRICH GAUSS, German mathematician) I continued to do arithmetic with my father, passing proudly through fractions and decimals. I eventually arrived at the point where so many cows ate so much grass and tanks filled with water in so many hours I found it quite enthralling. (AGATHA CHRISTIE, An Autobiography)

As stated in Chapter 2, forex is one part literacy and ninety-nine parts numeracy. Forex arithmetic, however, is simple and involves only the four operators: addition, subtraction, multiplication and division. It does not involve complex calculations like differentiation and integration, unlike option pricing. We have made a reference to cross rates in Section 2.7. They are currency pairs without the interbank numeraire currency (which is currently USD). Cross rates are not quoted directly in the market, but are derived by „crossing‟ two numeraire-based rates. The „crossing‟ means either multiplication or division, and is the subject matter of this chapter.

55

Chapter 5

5.1. Chain Rule One apple is INR 15 and one banana is INR 3. One apple is worth how many bananas? We say instantly that one apple is worth five bananas because the solution is intuitive. Let us consider similar situation. Three roses are INR 5 and seven lotuses are INR 25. One rose is worth how many lotuses? The solution does not strike immediately because it is not very intuitive. When intuition fails, we apply logic. Chain rule is that logic and the principle of cross rate arithmetic. Chain rule consists of four steps: define the cross rate in the proper format; identify the two underlying rates; arrange the underlying rates to form a chain; and multiply and divide. We will explain the four steps with the following example of EUR/INR cross rate. Define the cross rate What we mean by „definition‟ is to state the problem: one (or some other fixed quantity) unit of base currency is how many units of quoting currency. In expressing the problem, we write the base currency on the left hand side and quoting currency on the right hand side. The definition for our example is thus: EUR 1 = INR?

Identify the underlying rates The underlying rates are each currency of cross rate against the numeraire USD. The underlying rates for our example are EUR/USD and USD/INR and let their prices be EUR/USD = 1.5775

(EUR 1 = USD 1.5775)

USD/INR

(USD 1 = INR 40.31)

= 40.31

Arrange the underlying rates to form a chain Select the underlying rate containing the quoting currency of the cross rate. In our example, it is USD/INR. Arrange the price of this underlying rate in such way that INR goes to the other side of the equation, as follows. EUR 1

=

INR 40.31 =

INR ? USD 1

56

Cross Rate Arithmetic

In the first currency pair, INR is on the right hand side; and in the second, on the left hand side. It thus forms a chain. Repeat the process for the second underlying rate in such a way that USD is placed on the left hand side. EUR 1

=

INR ?

INR 40.31

=

USD 1

USD 1.5775

=

EUR 1

Multiply and divide Take the product of left hand side and divide it by the product of right hand side. It should be clear now why we formed a chain of currencies: to cancel all of them except those of the cross rate. The result of this arithmetic operation is the solution to the problem stated in the first step. Thus, for our example, (1  40.31  1.5775) / (1  1) = 63.5890 (EUR 1 = INR 63.5890)

Example #2 Let us work out one more example of JPY/INR. If the base currency JPY quantity is kept at 1, the JPY/INR value will be so low that it has to be quoted up to 6 or 8 decimal places to preserve precision. To avoid such lengthy, cumbersome quotes, the market convention for JPY/INR currency pair is to keep the base currency unit at 100 instead of 1. Define the cross rate JPY 100 = INR ?

Identify the underlying rates (and get their prices) USD/INR

= 40.31

(i.e. USD 1 = INR 40.31)

USD/JPY

= 104.28

(i.e. USD 1 = JPY 104.28)

Arrange the underlying rates to form a chain JPY 100

= INR ?

INR 40.31

= USD 1

USD 1

= JPY 104.28

57

Chapter 5

Multiply and divide (100  40.31  1) / (1  104.28) = 38.6555 (JPY 100 = INR 38.6555)

5.2. Trader’s Quicker Method Traders follow the logic quickly in their mind, as follows. The arithmetic operator for crossing the underlying rates is either multiplication or division. From the prices, guess whether the cross rate should be the highest or lowest among the three or midway between the two underlying rates. Its standing indicates the arithmetic operator. The following two examples illustrate the procedure. EUR/SAR cross rate The source rates and their prices are: EUR/USD

= 1.5775 (EUR 1 = USD 1.5775)

USD/SAR

= 3.7500 (USD 1 = SAR 3.7500)

One USD is worth SAR 3.75 and one EUR is worth more than USD. Therefore, one EUR should be worth more than SAR 3.75 and the cross rate should be the highest amount the three, which implies that we should multiply. SAR/INR cross rate The source rates and their prices are: USD/INR

= 40.31

(USD 1 = INR 40.31)

USD/SAR

= 3.7500

(USD 1 = SAR 3.7500)

One USD is worth SAR 3.75 but INR 40.31. Therefore, one SAR should be worth less than 40.31 but more than 3.75, which implies that we should divide 40.31 by 3.75. 5.3. Arithmetic with Two-way Quotes The arithmetic with one-sided quotes is simplistic and has only illustrative value. In practice, we always deal with two-way quotes, which impose the additional requirement of whether we should cross the same or opposite sides of underlying two-way quotes. Let us explain the procedure with the cross rate example of EUR/INR. The underlying rates and their two-way quotes are

58

Cross Rate Arithmetic EUR/USD

= 1.5775/79

USD/INR

= 40.3150/00

Let us first convert the abbreviated offer price to its full form, using the procedure described in Section 2.10. EUR/USD

= 1.5775/79

 1.5775 / 1.5779

USD/INR

= 40.3150/00

 40.3150 / 40.3200

Consider now the two-way quote for cross rate EUR/INR, which is to be derived from the above two underlying rates. Let this two-way quote for the cross rate be x/y. At x, the price maker buys EUR (and sells INR); and at y, he sells EUR (and buys INR). The prices are derived on the basis of hedging or covering. That is, if the price maker buys on his quote, he will immediately sell it in the market; and if sells on his quote, he will immediately buy it from the market. Therefore, we compute the bid price x on cross rate on the assumption that we sell the base currency EUR in the market on EUR/USD pair, which will be at 1.5775. When we sell EUR, we will be paid USD, which we must sell on the second pair of USD/INR, which will be at 40.3150. This exactly matches the cash flows with square position, as follows. Cross rate:

EUR/INR (bid):

We buy EUR/sell INR

@?

Underlying rate #1: EUR/USD:

We sell EUR/buy USD

@ 1.5775

Underlying rate #2: USD/INR:

We sell USD/buy INR

@ 40.3150

In case of doubt, draw the cash flows table described in Section 4.5 to ensure that the above three deals create neither position nor gap. Having identified the correct sides of the two two-way underlying quotes, we will now „cross‟ them using the chain rule or the trader‟s shortcut approach. For the offer side of the two-way cross rate, we do not have to repeat the logic again: we can simply pair the remaining sides of the underlying quotes. Thus, the two-way cross rate for our example will be EUR/INR:

(40.3150  1.5775) / (40.3200  1.5779)

= 63.5969 / 63.6209  63.5969 / 209. Notice that the offer price cannot be abbreviated to the last two digits of 09. If the last two digits alone are quoted, it will be construed as 63.6009 (see Section 2.10), which is much lower than the correct price of 63.6209.

59

Chapter 5

5.4. Check on Calculations One obvious check on the correctness of calculations is that the bid price must be lower than offer price. This is necessary but not a sufficient condition, however. The additional check is that the bid-offer spread in the cross rate must be equal to the sum of spreads in the bid-offer in two underlying rates. This must be so because the cross rate is derived from the two underlying rates and therefore combines both the spreads in its bid-offer. We cannot straightaway add the two spreads in the underlying rates because they are apples and oranges. The spread of 0.0004 on EUR/USD rate is on a base of 1.5775/79; and that of 0.0050 on USD/INR is on a base of 40.3150/00. To be comparable, they must be converted into percentages of the mid rate of bid-offer. Exhibit 5-1 shows the calculation and comparison of the spreads in underlying rates and cross rate.

EXHIBIT

5-1: Spread Comparison

Bid

Offer

Spread

Mid

Spread

EUR/USD

1.5775

1.5779

0.0004

1.5777

0.025353%

USD/INR

40.3150

40.3200

0.0050

40.3175

0.012402%

Total

0.037755%

63.608920

0.037755%

EUR/INR

63.596913

63.620928

0.024016

5.5. Mnemonic Aid for Two-way Cross Rate Arithmetic As always, there are thumb rules to do the cross rate arithmetic quickly. We can divide all scenarios into three groups, as follows. #1: Both currencies in cross rate are quoting currencies in their source rates The rule is: pair the opposite sides and divide, the numerator being the source rate containing the quoting currency of the cross rate. Example: cross rate is CHF/INR; source rates are: USD/INR and USD/CHF. The quoting currency of the cross rate is INR, and the source rate containing INR is USD/INR, which should be the numerator.

60

Cross Rate Arithmetic

Currency Pair USD/INR USD/CHF CHF/INR

Two-way Quote

Mid Rate

Spread

40.3150 / 40.3200

40.3175

0.03825%

1.0455 / 1.0459

1.0457

0.01240%

38.5458 / 38.5653

38.5555

0.05065%

Bid = 40.3150/1.0459 = 38.5458; Offer = 40.3200/1.0455 = 38.5663 #2: Both currencies in cross rate are base currencies in their source rates The rule is: pair the opposite sides and divide, the numerator being the source rate containing the base currency of the cross rate. Example: cross rate is EUR/AUD; source rates are: EUR/USD and AUD/USD. The base currency of the cross rate is EUR, and the source rate containing EUR is EUR/USD, which should be the numerator. Currency Pair

Two-way Quote

Mid Rate

Spread

EUD/USD

1.5775 / 1.5779

1.5777

0.02535%

AUD/USD

0.7859 / 0.7961

0.7860

0.02545%

EUR/AUD

2.0067 / 2.0078

2.0073

0.05080%

Bid = 1.5775/0.7961 = 2.0067; Offer = 1.5779/0.7859 = 2.0078 #3: One currency in the cross rate is base currency and the other is quoting currency in their source rates. We have two possible sub-scenarios, but the rule is same in both ―same sides and multiply―with a small variation. #3A: Base currency of cross rate is the base currency in its source rate The rule is: same sides and multiply with bids of source rates becoming the bid of cross rate; and offers of source rates becoming the offer of cross rate. Example: cross rate is EUR/INR; source rates are: EUR/USD and USD/INR. The base currency of the cross rate, EUR, is also the base currency in its source rate of EUR/USD.

61

Chapter 5

Currency Pair EUD/USD

Two-way Quote

Mid Rate

Spread

1.5775 / 1.5779

1.5777

0.02535%

USD/INR

40.3150 / 40.3200

40.3175

0.01240%

EUR/INR

63.5969 / 63.6209

63.6089

0.03775%

Bid = 1.577540.3150 = 63.5969; Offer = 1.577940.3200 = 63.6209 #3B: Base currency of cross rate is the quoting currency in its source rate The rule is: same sides and multiply, but take the reciprocal of derived rate, and reverse the bid-offer sides for the cross rate. Example: cross rate is INR/EUR; source rates are: EUR/USD and USD/INR. The base currency of the cross rate, INR, is the quoting currency in its source rate of USD/INR. Currency Pair EUD/USD

Two-way Quote

Mid Rate

Spread

1.5775 / 1.5779

1.5777

0.02535%

USD/INR

40.3150 / 40.3200

40.3175

0.01240%

EUR/INR

0.015718 / 0.015724

63.6089

0.03775%

Bid = 1 / (1.5779  40.3200) = 0.015718 Offer = 1 / (1.5775  40.3150) = 0.015724 5.6. Triangular Arbitrage The price of cross rate is derived by crossing the prices of the two underlying rates, and the demand-supply forces have no direct influence on its price. The price of cross rate will automatically change whenever one or both the underlying prices change, regardless of demand-supply situation for the cross rate. If the demand-supply forces were to directly affect the price of cross rate, there would be scope for arbitrage profit, which is impossible in efficient markets. Let us explain it with EUR/INR cross rate, for which the underlying rates are, EUR/USD: 1.5775/1.5779; USD/INR: 40.3150/40.3200

62

Cross Rate Arithmetic

Given the above prices for the underlying rates, the cross rate has to be EUR/INR bid: EUR/INR offer:

1.5775  40.3150 = 63.596 1.5779  40.3200 = 63.621

The reference bid and offer prices above impose the following restrictions on market quotes. Market bid Market offer

 

Reference offer Reference bid

If the above restrictions are violated, there would be scope for arbitrage profit, as follows. Market bid > Reference offer Market bid is overpriced: Sell at market bid on EUR/INR …and hedge it by Buy at market offer on EUR/USD Buy at market offer on USD/INR

Market offer  Reference bid Market offer is underpriced: Buy at market offer on EUR/INR …and hedge it by Sell at market bid on EUR/USD Sell at market bid on USD/INR

Arbitrage profit ensures that all the three ratestwo underlying rates and the cross rateare linked in this triangular relation, regardless of demandsupply for the cross rate. It seems a paradox and unintuitive that demandsupply forces do not influence the cross rate price. Let us state the obvious and the logical: demand-supply forces do influence the price. In case of cross rates, however, the effect is not direct but indirect through the underlying rates. Transaction costs complicate this triangular arbitrage. The source of transaction costs is the brokerage/commission. Assuming that the commission is 0.01%, it widens the bid-offer range further on each side as follows. Bid: Offer:

63.596  (1  0.0001) = 63.590 63.621  (1 + 0.0001) = 63.628

The range of 63.590/63.628 is the reference range now for arbitrage. No one arbitrages for an insignificant profit: there must be a minimum profit for arbitrage. Let us assume that the minimum arbitrage profit is 0.01%, which will further widen the range as follows. Bid: Offer:

63.590  (1  0.0001) = 63.584 63.628  (1 + 0.0001) = 63.634

63

Chapter 5

Note that to determine arbitrage profit, we must compare the opposite sides of two quotes (i.e. bid in one with the offer in another) because we will be buying on one quote and selling on the other. It is possible that market quotes may deviate to certain extent without crossing the bid-offer bounds and hence without providing arbitrage profit, as shown in Exhibit 5-2.

EXHIBIT

5-2: Bounds for Arbitrage

63.584 / 63.634 A B C

63.57/63.62 63.60/64.65 63.60/63.62

The shaded box is the reference quote determined by cross rate arithmetic. The un-shaded boxes (A, B and C) are cross rate quotes from different dealers. Notice that all the three market quotes are different from the reference quote and yet there is no arbitrage because none of them has crossed the bidoffer range. Quotes A and B are “trended” quotes: they are better on one side and worse on the other, compared to the reference quote. Quote A is trended to the “left”: its bid price is worse but offer price is better, compared to the reference quote. This quote attracts the prospective buyer. Dealer A is indicating to other dealers that he is interested in selling. Quote B is trended to the “right”: its bid price is better but offer price is worse, compared to the reference quote. This quote attracts the prospective seller. Dealer B is indicating to other dealers that he is interested in buying. Quote C is the competitive quote: it has the least bid-offer spread and, usually, has higher bid and lower offer than reference quote, attracting both buyers and sellers. Such dealers are called market-makers. In the over-thecounter (OTC) market, market makers are the first port-of-call for all other dealers. They are able to provide competitive quotes by actively managing the inventory and by continuously quoting prices to others. By entering and exiting quickly, the manage the price risk and profit from the bid-offer spread.

64

Cross Rate Arithmetic

To sum up, there will be different market quotes at any point of time from different dealers for a cross rate, many of which may deviate from reference quote and yet without crossing the bid-offer bounds. The rule to determine the possibility of arbitrage is to select the quote with the highest bid and that with the lowest offer and find their difference (highest bid)  (lowest offer). If the above difference is positive and greater than the transaction cost, then there exists arbitrage by buying at the offer and selling at the bid. Key Concepts Introduced Chain rule: the basis of cross rate arithmetic Check on calculations: spread comparison between underlying rates and cross rate after converting them into percentages of mid rate. Triangular arbitrage and bounds on arbitrage

EXERCISES

The following are the two-way quotes for various source rates. Currency Pair EUR/USD GBP/USD USD/JPY USD/CHF AUD/USD NZD/USD USD/INR

Market Quote 1.5329/32 1.9398/05 101.98/03 0.9978/81 0.7843/47 0.5246/48 39.9950/50

From the above, compute the cross rates shown in the table below. Round off the cross rates to the decimal places indicated against each currency pair. In rounding off, round down the bid price, and round up the offer price. For example, if the decimal place to be rounded is 0.0025 and the derived rate is 39.3937/39.4158, then the rounded off cross rate should be 39.3925/39.4175. Abbreviate the offer price according to the procedure described in Section 2.10. For example, if the quote is 39.3925/39.4075, then it is abbreviated to 39.3925/175.

65

Chapter 5

Currency Pair EUR/JPY GBP/JPY CHF/JPY NZD/CHF AUD/NZD EUR/INR GBP/INR CHF/INR INR/JPY AUD/INR NZD/INR

Round-off Place 0.01 0.01 0.01 0.0001 0.0001 0.005 0.01 0.005 0.001 0.0025 0.0025

66

Chapter 6 Forward Exchange Current forward rate is the expected future spot rate. ( UNBIASED FUTURE SPOT PRICE theory) Current forward rate is determined by the current interest rates for the two currencies. (COVERED INTEREST PARITY condition)

The first statement above is based on expectations about the future and therefore speculative. The second is enforced by arbitrage (except under certain conditions) and therefore practical. Forward exchange is the link between the spot forex market and the money market for two currencies. According to the legend (see Box 6-1), forward exchange was invented in the 12th century Europe. However, the forward exchange market in its today‟s character developed only after the World War I in Vienna. Further development took place in Eurocurrency centers of London and Luxembourg during 1960-70.

67

Chapter 6

BOX 6-1: History

of Forward Exchange

According to the legend, it was the Italian moneychangers in the Plains of Lomth

bardy that invented the forward exchange during the 12 century. In those days, there would be weekly cross-border trade fairs where merchants from different city-states would bring their goods and trade in them. Before they buy foreign goods, they would go to Italian moneychangers to exchange currencies. On one occasion, the moneychanger advised a merchant that franc was costly because of good demand for French wine. Expecting that demand would still be higher next week (and therefore a costlier franc), the merchant would buy next week‟s requirement of franc in advance. The moneychanger advised him that it was not necessary to buy in advance and that they could enter into a contract on franc for delivery one week forward at a price agreed in advance. That was the first forward exchange contract. Paul Einzig writes in his book, A History of Foreign Exchange (University of Wales Press, 1996), that the earliest known forward contract was made in 1156 in which 115 Genoese pounds were borrowed to be paid after one month in 460 bezants. This is not strictly a forward contract but a loan combined with a forward contract.

6.1. Forward Exchange Arithmetic Money has time-value, which is called the “rent” or interest on money. Forex transaction has two brands of money, and their interest rates jointly determine the time-value of forex price. This is the basis of forward exchange. Let us explain this with the following example. EUR/USD spot price is 1.5000: that is, EUR 1 = USD 1.5000 for delivery on spot value date. The interest rate for EUR is 3% and that for USD, 2%. If EUR and USD are to be exchanged after one year instead of on spot, then the rate of exchange should be such that the spot amount must be increased by 3% for EUR and by 2% for USD. The future amount of EUR 1 growing at 3% will be EUR 1.03; and that of USD 1.5000 growing at 2% will be USD 1.5300. Therefore, the rate of exchange between the two currencies contracted today for delivery after one year should be EUR 1.03 = USD 1.5300. Since the forex price is expressed as the number of quoting currency units per one unit of base currency, the one-year forward exchange is: 1.5300 / 1.03 = 1.4854.

68

Forward Exchange

6-1: Forward Exchange Arithmetic

EXHIBIT

Now

One year 3%

EUR 1

time

EUR 1.03

=

= 2%

USD 1.50

USD 1.53 or EUR 1 = USD 1.53 /1.03 = USD 1.4854

The two interest rates for the currencies together with the spot price determined the forward exchange price. This is called covered interest parity (CIP) or interest rate parity (IRP). In the example above, if the forward exchange price is other than 1.4854, there will be arbitrage profit as follows. If the forward exchange price is more than 1.4854 (say, 1.4900), EUR is overpriced in the forward, and can be arbitraged for risk-free profit by executing the following trades simultaneously. 1. 2. 3. 4.

Sell EUR 1.03 for forward delivery @ 1.4900 Buy EUR 1.00 for spot delivery @ 1.5000 Lend EUR 1.00 for spot to one year @ 3% Borrow USD 1.50 for spot to one year @ 2%

Note that the amount of EUR sale in the forward must be equal to its timevalue. The above four actions create neither position nor gap, as shown by the cash flows table below. Value Date Spot Gap One year Gap Position

EUR

USD

+1.00

1.5000

1.00 0

+1.5000 0

+1.03

1.5300

1.03 0

+1.5347 +0.0047

0

+0.0047

Remark Cash flows from trade #2 Cash flows from trades #3 and #4 Total of day‟s cash flows Cash flows from trades #3 and #4 Cash flows from trade #1 Total of day‟s cash flows Grand total of all cash flows

There is neither gap (i.e. total of day‟s cash flows) nor position (i.e. grand total of all cash flows) in either currency. Therefore, as discussed in Section

69

Chapter 6

4.5, the net cash flow of USD 0.0047 is the net profit, resulting from the arbitrage. Two points needs attention here. First, the amount of arbitrage profit will be slightly more than the difference between the arbitrage-free price and the actual price. In our example, A. Arbitrage-free price: 1.53 / 1.03 B. Market price C. Difference (B  A) D. Arbitrage profit

1.48543689 1.49 0.00456311 0.0047

The reason for the discrepancy is the time-value of money. The forex price is expressed in the units of quoting currency for one unit of base currencyalways. To arbitrage the price differences, however, we do not always buy or sell one unit of base currency. In our example above, we bought EUR 1.00 for spot but sold EUR 1.03 for forward. The forward amount is more than the spot amount by 3% because of the time-value of EUR. Therefore, the arbitrage-profit will be higher by 3% on the difference between the two prices. 0.00456311  1.03 = 0.0047

Second, if the quantity of EUR forward sale is only EUR 1.00, there will be a net cash flow of +0.0300 in EUR and 0.04 in USD. This is a position (long EUR/short SD) and does not ensure profit if the EUR weakens substantially against USD during the period. Similarly, if the market price of one-year forward is less than 1.4854, there will be an opportunity for arbitrage profit by executing the following trades. 1. 2. 3. 4.

Buy the underpriced EUR for forward delivery Sell EUR for spot delivery Borrow EUR Lend USD

This is called covered interest arbitrage (CIA), which is the practical face of the covered interest parity (CIP). As long as there are no restrictions on credit and capital flows, the interest arbitrage will be fully covered, and the forward exchange price will reflect the difference in two interest rates, rather than expectations about the future spot price. When there are controls on credit and capital flows, however, the interest arbitrage will not be fully covered, and the forward price may reflect expectations about the future spot rate. We will revisit the topic in Section 6.11.

70

Forward Exchange

6.2. Swap Points: Premium, Discount and Par The difference between spot and forward forex prices is called forward differential, swap differential or swap points. Swap Points = Forward Price  Spot Price. If the swap points are positive, the forward price is higher than spot price: the base currency is costly or at premium relative to spot. If the swap points are negative, the forward price is lower than spot price: the base currency is cheaper or at discount relative to spot. If the swap points are zero, the forward and spot prices are the same: they are said to be at par. In commodity markets, the premium, discount and par are called, respectively, contango, backwardation, and par. Indian stock market of old days had its own terms for these conditions (see Box 6-2). BOX 6-2:

Premium, Discount and Par in Indian Stock Market

The innovative and enterprising skills of Gujarati and Marwari traders in trading and trade finance date back to hundreds of years. According to Mr Bhupen Dalal, India‟s first merchant banker, traders in the Indian stock market of old days used the terms seedhi badla for premium; ulta (or undha) badla for discount; and bhav-e-bhav for par.

The “premium” and “discount” are used with respect to base currency and they relative to the spot price. Given the reciprocal relationship between base currency and quoting currency, it follows that, if the base currency is in premium in the forward, the quoting currency will be at discount, and vice versa. For example, we can transform EUR/USD into USD/EUR by taking the reciprocal of the former for spot and forward prices as follows. Currency Pair EUR/USD USD/EUR

Remark

Spot Price

Forward Price

1.5000

1.48543689

EUR at discount

0.66666667

0.67320262

USD at premium

We can see that the USD price (in terms of EUR) is costlier or at premium in the forward relative to spot price. Two points need attention in forward exchange arithmetic.

71

Chapter 6

First, the currency with higher interest will be at discount to the currency with lower interest rate, and vice versa. It may seem somewhat paradoxical at first but is quite logical. Look at it this way: currency with higher interest rate will have larger growth than the currency with lower interest rate. Since the forward price already commits to exchange these growths, we exchange the larger amount in high interest currency for the smaller amount in low interest currency; and the difference between the two amounts is the premium on the currency with lower interest rate or discount on the currency with higher interest rate. Second, since the premium/discount arises from the difference in two interest rates, one may expect that the premium/discount in percentage terms should be equal to the difference in two interest rates; and that the premium (%) on once currency should be equal to discount (%) on the other. However, the three are equal only approximately. The following table compares the discount (%) on EUR, premium (%) on USD and the difference in the interest rates of EUR and USD. Discount on EUR Premium on USD Diff. in interest rates

(1.48543689  1.5000) / 1.5000 =

0.97087379%

(0. 0.67320262  0.6667) / 0.6667 =

+0.98039216%

3%  2% =

+1%

The three measures are slightly different from each other, despite they being in the same units of percentage per annum, and the differences are not due to rounding off. The difference between premium (%) and discount (%) is similar to that between yield and discount in interest rate arithmetic. Yield has the interest paid in arrears (ex post), but discount has the interest paid in advance (ex ante). As for comparing premium/discount (%) with the difference in interest rates, the latter should be expressed in relative, not absolute, terms because the difference is a rate per unit time. The following is thus the correct way of comparing them. 



Premium/discount in one currency should be computed as a percentage of spot price while the discount/premium on the other should be computed as a percentage of forward price Difference in interest rates should be a relative measure: (1+ quoting currency interest rate) / (1 + base currency interest rate)  1 Discount on EUR Premium on USD Diff. in interest rates

(1.48543689  1.5000) / 1.5000 = 0.97087% (0.67320262  0.66666667) / 0.67320262 = 0.97087% (1.02 /1.03)  1 = 0.97087%

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Forward Exchange

The above adjustments must to be considered when comparing premium/discount (%) of different currencies. In general, for comparison in arbitrage calcualtions, when the deal currency is base currency, compute the premium/discount as a percentage of spot price; and when it is quoting currency, compute the premium/discount as a percentage of forward price. 6.3. Forward Exchange Arithmetic with Two-way Quotes Let us work out the forward exchange arithmetic with two-way quotes with the following two-way market quotes for spot forex price and two interest rates. Price/Rate EUR/USD spot EUR interest rate USD interest rate

Quote 1.4998 / 1.5002 2.96875 / 3.03125 1.96875 / 2.03125

Our objective is to derive the two-way one-year forward price of EUR/USD currency pair, x/y, where x is the quoter‟s buying price of base currency (and the selling price of quoting currency) and y is the quoter‟s selling price of base currency (and buying price of quoting currency). As explained in Section 5.2, the derivation of any price is based on hedge. You buy on your quote and sell it immediately in the market. In other words, when you quote a price to someone, your buying and selling prices for a currency are the market‟s buying and selling prices, respectively, too. On the other hand, when you go to the market as a price taker/asker, you will be buying at the market‟s selling price; and selling at the market‟s buying price. Let us derive the bid side of the forward price. We buy the base currency (EUR) on the bid of our quote for forward delivery and hedge it immediately by: 1.

2. 3.

Sell EUR for spot delivery at market‟s buying price of 1.4998 (this eliminates the position created by the original trade, but creates gap because of different value dates) Borrow EUR from spot to 1-year at the market‟s lending rate of 3.03125% Lend USD from spot to 1-year at the market‟s borrowing rate of 1.96875%

With Trades #2 and #3 eliminating the gap, we are square in position and gap. As explained in the previous section, the sale amount of EUR in trade #1 should be equal to the 1-year future value (which is, 1  1.03125 = 1.03125) to eliminate the position completely. Exhibit 6-2 depicts the sides to match in deriving the two-way quote for forward exchange.

73

Chapter 6 EXHIBIT 6-2:

Derivation of Two-way Forward Exchange Quote Spot forex price:

bid / offer

Quoting currency (QC) interest rate:

bid / offer

Base currency (BC) interest rate:

bid / offer

Forward forex price:

bid / offer

Note that we “cross” the side for base currency interest rate because we will be always borrowing one currency and lending the other in the hedging operations. In the calculations above, we assumed that the forward period is always one year. In practice, however, we deal with prices for periods other than one year. In such cases, the period also enters into the calculations. The 8 period is called basis . Basis is expressed as a fraction of two parts: numerator and denominator. The numerator specifies the procedure to count the number of days in the period; and the denominator specifies the number of days in a full year. Though there are more than 16 types of basis, only two types are used in money and forex market, which are as follows. Actual / 360 The “actual” indicates that we should count the actual number of days in the numerator; and the “360” indicates that we should use 360 in the denominator for both leap and non-leap year. This is used in money market of US and continental Europe, and therefore also called “money market basis.” Actual / 365 (now renamed as Actual / 365 Fixed) For the numerator, we count the actual number of days in the period; and for the denominator, the constant of 365 for both leap and non-leap years. This is used in the money market of GBP and most Asia-Pacific currencies except IDR.

8

It is properly called day count basis but is simply referred to as basis by traders. In the ISDA documentation for OTC derivatives, it is called day count fraction. The „basis‟ here is different from the „basis‟ in futures market, where it refers to the difference between spot price and futures price.

74

Forward Exchange

Incorporating the basis in the forward exchange arithmetic, we can now develop formulas, as follows.

𝐹bid = 𝑆bid

QC 1 + 𝑅bid × 𝑏𝑎𝑠𝑖𝑠 QC BC 1 + 𝑅offer × 𝑏𝑎𝑠𝑖𝑠 BC

𝐹offer = 𝑆offer

QC 1 + 𝑅offer × 𝑏𝑎𝑠𝑖𝑠 QC BC 1 + 𝑅bid × 𝑏𝑎𝑠𝑖𝑠 BC

where F: S: R: BC (in superscript): QC (in superscript):

Forward price Spot price Interest rate Base currency Quoting currency

The product of interest rate and basis gives the interest amount for the period, which, when added to unity, indicates the growth factor: how much one unit of currency has grown up to in the period. We can see from the equations above that if the quoting currency interest rate is higher than that of base currency, the fraction in the square brackets will be higher than unity, which makes the forward price higher (“premium”) than the spot price. If the quoting currency interest rate is lower than that of base currency, the fraction will be less than unity, which makes the forward price lower (“discount”) than the spot price. If the interest rate is the same for both currencies, the fraction will be unity, and the forward price will be the same (“par”) as the spot price. We can also rearrange the equations above to solve for swap points directly from spot price and two interest rates. Instead of „bid‟ and „offer‟ for the two-way swap quote, we designate the two sides of swap quote as left hand side (LHS) and right hand side (RHS), respectively. QC

swapLHS = Sbid

1 + R bid × 𝑏𝑎𝑠𝑖𝑠 QC − 1 BC 1 + RBC offer × 𝑏𝑎𝑠𝑖𝑠 QC

swapRHS = Soffer

1 + R offer × 𝑏𝑎𝑠𝑖𝑠 QC − 1 BC 1 + RBC bid × 𝑏𝑎𝑠𝑖𝑠

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Chapter 6

We can also rearrange the equations above to solve for interest rate from the swap points and spot price, as follows. RQC bid = QC

R offer =

swapLHS + Sbid Sbid swapRHS + Soffer Soffer

RBC bid =

Soffer swapRHS + Soffer

RBC offer =

Sbid swapLHS + Sbid

BC 1 + RBC − 1 offer × basis

basisQC

BC 1 + RBC − 1 bid × basis

basisQC

QC 1 + RQC − 1 offer × basis

basisBC

QC 1 + RQC − 1 bid × basis

basisBC

The interest rates derived as above are called the implied interest rates, which are “free” interest rates prevailing in Eurocurrency market. The “eurocurrency” (one word) is different from “euro currency” (two words). The latter is the lawful currency of European Union while the former is any currency that is outside the control of its central bank. Dollar outside the control of Federal Reserve is Eurodollar; pound outside the control of Bank of England is Europound; and so on. Such currency markets are also called Eurodollar market, offshore currency market and International Banking Facilities (IBF). Eurocurrency market developed first for USD and in Europe (whence the name Eurodollar) and subsequently for other currencies (whence Eurocurrency). In later years, such business was increasingly booked through offshore centers like Cayman Islands, Isle of Man, etc. (whence the name offshore currency market). Deregulation in recent years pulled back some of that business back to on-shore centers, particularly New York, where it is now called IBF. Because there are no regulations and reserve requirements, the interest rates in Eurocurrency market reflect the “free” interest rates. The spread in the bid-offer of forward price will be much higher than that in spot price. The reason is that all the three spreads in the components―spot price, BC interest rate and QC interest rate―add up in the forward price. We will illustrate it with the market quotes given at the beginning of Section 6.3 and using the formula in the previous section. To illustrate the incorporation of basis in calculations, we assume the spot value date is May 22 and 6-month value date is November 24; and the basis is actual/365 for EUR and actual /360 for USD. Accordingly, the basis is for EUR is 186/365 and for USD, 186/360.

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Forward Exchange

Spot Swap Forward (spot + swap)

Bid

Offer

Spread

1.4998

1.5002

0.0004

0.0078

0.0068

0.0010

1.4920

1.4934

0.0014

Note that we can directly add the spot and swap spreads because both are expressed in the same units: quoting currency units per unit base currency. 6.4. Nature of Swap Points Spot forex price is the price of an asset and can never be zero or negative. Interest rate is the time-value of money and can never be negative. Swap points are neither the price of n asset nor the time-value of money. The derivation of swap points consists of the following steps: for each of the two currencies, convert interest rate into interest amount for the given period; translate the base currency interest amount into equivalent quoting currency amount so that the two interest amounts are now in the same units; find the difference between the two interest amounts; and express the difference per unit of base currency. This difference can be positive, negative or zero and is the difference between prices of non-spot value date and spot value date. In general, both sides of the two-way swap quote have the same sign (e.g. +0.0010/+0.0012 or 0.0012/0.0010). The sign indicates whether the swap points are to be added to or deducted from the spot price. When the interest rates are the same for both currencies, the swap points should be zero. However, transaction costs and bid-offer spreads will make the swap points deviate from zero on either side: negative LHS and positive RHS (e.g.0.0001 / +0.0001). Note that the quote can never be positive LHS and negative RHS, which is irrational as shown below. The following table computes the forward price from spot and swap, assuming that swap quote can be +/ and /+.

Spot Swap Forward

Case #1 (+/)

Case #2 (/+)

1.5000 / 1.5005

1.5000 / 1.5005

+0.0010 / 0.0012

0.0010 / +0.0012

1.5010 / 1.4993

1.4990 / 1.5017

The forward price in case #1 is irrational: its bid is higher than offer. If such a quote were to exist in the market, everyone will simultaneously buy and sell on it for arbitrage profit. The forward price in case #2, on the other hand, is ra-

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Chapter 6

tional and practical. Another way to look at the quotes is to consider the spread in swap quote. The spread is negative in case #1 at 0.0022, which is irrational, while that in case #2 is positive and rational, as follows. 0.0012 (+0.0010) = 0.0022 +0.0012 (0.0010) = +0.0022. To sum up, if the two-way swap quote has different signs for each sides, then the only possible structure is /+. In such quotes, the spread is against the price taker (or asker) in both sides (which is discussed in Section 7.4). We may note that any bid-offer quote will be always in ascending order in its numerical value (e.g. +10/+11, 10/+11, 11/10, etc.). 6.5. Market Conventions on Forward Exchange There are three market conventions on quotes for forward exchange. The first convention is to quote the forex price only for spot value date. For all other value dates, the swap points are quoted, For example, Spot Spot / 1M Spot / 3M Spot / 6M

1.5000/10 +0.0010/+0.0011 +0.0025/+0.0027 +0.0049/+0.0053

The price for non-spot value date is derived by algebraically adding the spot price and swap points. Non-spot price = Spot price + Swap points The reason for quoting swap points rather than outright price for non-spot value dates is the spot price volatility. The spot price, being determined by demand-supply forces, continually changes, and can change as much as 0.10.5% in a minute and 0.51% in an hour. In contrast, interest rates are not as volatile: changes are about 0.1 percentage points during the entire day. Further, changes in interest rates are annualized and when, converted into changes per day, are insignificant. Since swap points are determined by the difference in two interest rates, they tend to be fairly constant during the day. It is therefore convenient to compute the swap points once in a day and use them throughout. Whenever you are asked to quote a price for a non-spot value date, quote the swap point (available off-the-shelf) and the on-going spot price. It will be much faster and convenient.

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Forward Exchange

The second convention is that the swap points are quoted as whole numbers though they are decimal fractions. For example, the swap point of 0.0010 may be quoted simply as 10. In such cases, we convert the whole number into decimal fraction (or mixed number) by the convention that swap points have as many decimal places as spot price. Thus, to convert whole number into decimal fraction, we divide the former by 10N where N is the number of decimal places in the spot price. The following shows the conversion of quoted swap points to their correct numerical value. Spot price 0.5775 1.2575 12.375 37.75 110

Swap (quote) 10.5 10 10 10 10

Divisor 4 10 104 103 102 100

Swap (value) 0.00105 0.0010 0.010 0.10 10

The third convention is about the sign of the two-way swap quote. If both sides of the quote have the same sign, then the sign is dropped. If the two sides have different signs (of which only the case of /+ is possible), then the signs are explicitly quoted. For example, +10/+11 11/10 11/+10

is quoted as is quoted as is quoted as

10/11 11/10 11/+10

If the signs are dropped, we must assign the signs by following the rule that any two-way quote must be in ascending order. Thus, the unsigned swap quote of 11/10 can be only 11/10 (ascending order) and not +11/+10 (descending order). Similarly, 10/11 can be only +10/+11 and not 10/11. An aide memoire for assigning signs to the unsigned two-way swap quote is “AA-DD” rule: Add Ascending order, Deduct Descending order. Even if you misplace the sequence of arithmetic operation and order (“Ascending order Add, Descending order Deduct”), the rule does not fail you! 6.6. Forex Prices for Short Dates The prices for the two short dates, cash and tom (see section 3.2 and the footnote 6 on page 30), are derived from spot price and swap points, but in a manner opposite to that for forward dates. For forward outright price, we add the swap side to the same side of the spot; and for short date outright prices,

79

Chapter 6

we deduct the swap side from the opposite side of spot. Exhibit 6-3 shows the pairing of swap and spot two-way quotes to derive the non-spot price.

EXHIBIT

6-3: Outright Prices for Short and Forward Dates FORWARD

SHORT

Spot

A / B

A / B

Swap

X / Y

X / Y

(A + X) / (B + Y)

(A  Y) / (B  X)

Derived

Note that swap points have their own sign. If the swap points are quoted without sign, we must assign the sign to swap quote by using AA-DD rule. The reason for the reversal of arithmetic operator and reversal of matching sides is as follows. The swap points are always quoted forward in time: cash to tom (C/T), tom to spot (T/S), cash to spot (C/S), spot to 1M (S/1M), etc. The derivation of non-spot outright price (from spot price and swap points) is not always forward in time. For forward dates, we move forward from spot date, like swap points. Therefore, we pair the same sides and add them. For short dates, we move backward from spot date. This is summarized in Exhibit 6-4.

EXHIBIT

6-4: Derivation of Non-spot Outright Prices

Cash

Tom

Spot

1M. Time

swap

non-spot outright

C/T

T/S

S/1M

T

1M

C

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Forward Exchange

6.7. Swap Points for Broken dates As explained in section 3.2, only the “standard” forward value dates are quoted in the market, which correspond to the “standard” tenors in the money market. They are ON, 1W, 1M, 2M, 3M, 4M, 5M, 6M, 7M, 8M, 9M, 10M, 11M and 1Y. Even among these standard tenors, not all of them are liquid: only the 1W, 1M, 3M and 6M tenors are liquid. The value date not belonging to the standard tenors is called broken date, odd date or cock date. The swap points for broken dates are derived through linear interpolation from two standard tenors such that one is immediately before the broken date (“near date”) and other is immediately after the broken date (“far date”). For example, the swap points for 45-day forward are derived by interpolating from the swap points for 1M and 2M. Linear interpolation involves connecting the near date and far date by a straight line and finding the place corresponding to broken date on that straight line. The formula-face of this technique is as follows. 𝑆2 = 𝑆1 +

𝑆3 − 𝑆1 𝑁3 − 𝑁1

𝑁2 − 𝑁1

where S1 = S2 = S3 = N1 = N2 = N3 =

swap points for near date swap points for broken date swap points for far date number of days from spot to near date number of days from spot to broken date number of days from spot to far date

The expression in square brackets gives the swap point per day during the period from near date to far date. The expression in parentheses is the number of days between the broken date and the near date. The product of the two expressions gives the swap points for the period between the broken date and the near date, which is then added to that for near date so that the final number is the swap points from the spot date to the broke date. In the interpolation, we match the same sides of the two swap quotes. That is, we find the difference between the LHS of far date and the LHS of near date, and between the RHS of far date and the RHS of near date. The following example illustrates the derivation of swap points for the broken date. The dates in parentheses are the value dates.

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Chapter 6

Spot (Apr 21) Swap for S/1M (May 22) Swap for S/3M (Jul 25)

1.5000/1.5005 15/16 38/40

Using the above inputs, we will derive the swap points for S/2M whose value date is Jun 23. The number of days between spot and far date (N3) is 95; that between spot and near date (N1) is 31; and that between spot and broken date (N2) is 64. The quote for swap points for the broken date is: LHS RHS Swap for S/2M

15 + [(38  15) / (95  31)]  (64  31) = 26.86 16 + [(40  16) / (95  31)]  (64  31) = 28.38 26 / 29 (LHS rounded down; RHS rounded up)

6.8. Swap Points for Forward-to-Forward and ‘Turn’ Periods Forward-to-forward period starts on a forward date (“near date”) and ends on a still later date (“far date”). Examples of such periods are 1M/3M, 3M/6M, etc. Swap points for forward-to-forward periods are derived from two spot-based swap points: spot to near date and spot to far date. If the near date and forward dates are broken dates, then they must be derived first using the procedure in the previous section before forward-to-forward swap points are derived. The following is the formula to derive them, and Exhibit 6-5 depicts the mechanism behind the formula. LHS: RHS:

EXHIBIT

LHS of far date  RHS of near date RHS of far date  LHS of near date

6-5: Forward-to-Forward Swap Points

Swap: Spot / M-date

A

/

B

(near date)

Swap: Spot / N-date

C

/

D

(far date)

Swap: M-date / N-date

(C  B) / (D  A)

We are pairing the opposite sides of two spot-based swap quotes because in hedging the forward-to-forward swap, we need to execute opposite actions

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Forward Exchange

(buy-sell swap for one period and sell-buy swap for the other), which will be at opposite sides of swap quote (explained in the next chapter. The following example illustrates the calculation of swap points for forward period. S / 1M S / 2M 1M / 2M

10 / 12 25 / 28 (25  12) / (28  10) = 13 / 18

The spread in the forward-to-forward swap quote should be equal to the sum of spreads in the two component swap quotes. In the example above, the spread is 2 for near date and 3 for far date. Accordingly, the spread in the forward-to-forward quote should be 5, which is the case indeed. The money market equivalent of forward-to-forward swap is called forward rate agreement (FRA): interest rate on a loan/deposit that commences on a future date and runs until another future date. ‘Turn’ Periods The “turn” periods are the overnight period between two calendar months or two calendar years: last day of a month to the first day of next month or last day of a year to the first day of next year. For certain currencies, such periods are special because the interest rate tends to be very high for this period due to regulatory or window-dressing reasons. Accordingly, premium on the currency for usual periods turns into discount for the turn period. In the mid1980s, the interest rate for CHF used to be very high for monthly turn and low for other periods. As a result, CHF would be in premium for other periods (because of low interest rate) but in steep discount for the monthly turn (because of high interest rate). Swap points for turn periods should never be derived from interpolation but should always be obtained from forward interest rates. The deregulation of markets and the move towards transparency have made such Jekyll-and-Hyde phenomenon disappear in most cases. 6.9. Long-term Forward Exchange Prices Forward exchange market does not go beyond one year for most currencies. The preferred instruments to manage currency risk for tenors beyond one year are other derivatives (currency swap, currency futures and currency options). For few currencies, however, forward market exists beyond one year and up to two years.

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Chapter 6

While the arithmetic continues to be the same for tenors beyond one year, the principle of compounding enters into the calculations. The bond market convention is to pay interest semi-annually. Incorporating this semi-annual compounding to meet the hedge requirements, we need to use the exponent operator instead of multiplication between interest rate (R) and basis. In other words, the following replacement should be made in the formulas. basis  N

(1 + R  basis) should be replaced with (1 + R / N)

where N is the compounding frequency in a year. Let us illustrate the calculation of bid-offer for 2Y forward contract on GBP/USD currency pair, giving the following inputs. Spot 2Y interest rate for GBP 2Y interest rate for USD

1.2995 / 1.3000 2.975 / 3.100 1.975 / 2.100

We will assume that the spot and 2Y value dates are, respectively, May 22, 2008 and May 25, 2010; and the compounding frequency and day count basis are annual and actual/365 for GBP and semi-annual and actual/360 for USD. Number of days Basis for GBP Basis for USD 2Y bid

1.2595  [(1 + 0.01975 / 2)

2Y offer

1.3000  [(1 + 0.021 / 2)

733 / 365 733 / 360 2.036111  2

733 = 2.008219 = 2.036111 2.008219

/ (1 + 0.031) = 1.2721 (rounded down)

2.036111  2

2.008219

/ (1 + 0.02975) = 1.2790 (rounded up)

Note that the spread between forward bid-offer has increased considerably. This is because there is a spread of 0.125% in each interest rate, together constituting 0.25%, which for two years, doubles to 0.5%. And there is spread in spot and the effect of compounding and day count basis. 6.10. Forward Exchange for Cross Rates Chapter 5 dealt with the spot arithmetic for cross rates. With the rules defined there and using the rules developed in this chapter, we will extend the arithmetic to forward prices and swap points. The following is the procedure.

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Forward Exchange

1.

2.

3.

4. 5.

6.

Identify the two underlying rates for the required cross rate. For example, if the cross rate is EUR/INR, then the two underlying rates are EUR/USD and USD/INR. For each underlying rate, get the spot price and swap points for the required forward period as inputs. If the required forward period is a broken date, derive the broken date swap points for each underlying rate, using the procedure described in Section 6.7. Ensure that the forward value dates for each underlying rate is the same as that for cross rate. If not, using the broken date procedure in Section 6.7, derive the swap points for the underlying rates. Derive the forward outright price for each underlying rate, using the procedure described in section 6.5 (or Section 6.6 for short dates). Compute the forward (or short date) outright price for the cross rate by crossing the two outright rates of underlying rates derived in the previous step, using the rules described in Section 5.5. To derive the swap points for cross rate, deduct the spot cross rate from the forward outright cross rate.

Let us illustrate the above procedure for JPY/INR cross rate, separately for cash value date (short date) and 2M forward value date, using the following market inputs. For simplicity, we will assume that the value dates match for all the three currency pairs.

Spot C/S swap S/1M swap S/3M swap

USD/JPY

USD/INR

98.75 / 98.80

50.78 / 50.79

4/3

1.5 / 2.5

50 / 48

15 / 16

136 / 130

37 / 40

Note that the swap points above are quoted as whole numbers and without sign. Using the market conventions defined in Section 6.5, we need to divide 2 the swap points by 10 (because the spot is quoted up to two decimal places) to convert them into their correct decimal fraction. Further, the sign for swap points is minus for USD/JPY (because the two-way quote is in descending order) and plus for USD/INR (because the two-way quote is in ascending order). Cash value date The cash outright rates are derived by deducting the swap points from the spot price, pairing the opposite sides (see Section 6.6), as shown below.

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Chapter 6

USD/JPY

USD/INR

Spot price

98.75 / 98.80

50.78 / 50.79

C/S swap

0.04 / 0.03

+0.015 / +0.025

Cash price

98.78 / 98.84

50.755 / 50.775

To check that calculations are correct, ensure that the spread in the cash outright price is equal to the sum of spreads in the spot and swap. Our calculations conform to it. The next step is to compute the cross rate by crossing the two underlying rates, using the rules of Section 5.5. Our example is a case of “both currencies in the cross rate are quoting currencies in their source rates.” The rule for this case is to divide the USD/INR rate by USD/JPY rate, by pairing the opposite sides. JPY/INR cash bid JPY/INR cash offer

= 50.755 / 98.84

= 0.513507

= 50.775 / 98.78

= 0.514021

The market convention for JPY/INR rate is to keep the base currency amount at 100 units instead of one unit. Applying the convention and rounding down the bid and rounding up the offer to two decimal places, the JPY/INR cross rate for cash value date is 51.35 / 51.41. To determine the swap points, we need to compute the cross rate for spot and then deduct the cash price from the spot price. The spot for cross rate is, for 100 units of JPY, is (with bid rounded down and offer rounded up): JPY/INR spot bid JPY/INR spot offer

= (50.78 / 98.80)  100

= 51.39

= (50.79 / 98.75)  100

= 51.44

The swap points for C/S are derived by reversing the calculations in the box above. Swap LHS Swap RHS

= Spot offer  Cash offer = Spot bid  Cash bid

= 51.44  51.41

= +0.03

= 51.39  51.35

= +0.04

Using the market conventions of dropping the sign and quoting the whole numbers, we write that C/S swap for JPY/INR is 3/4.

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Forward Exchange

2M forward value date The inputs do not contain the 2M swap points, and therefore we need derive the swap points for the broken period. Assuming that the 2M value date is exactly half way between 1M and 3M values dates, the swap points for 2M are:

USD/JPY USD/INR

LHS

RHS

50 + (136  50) / 2 = 93

48 + (130  48) / 2 = 89

15 + (37  15) / 2 = 26

16 + (40  16) / 2 = 28

Using the market conventions on signs (i.e. AA-DD rule) and decimal places, the correct numerical value of swap points are:

S/2M swap

USD/JPY

USD/INR

0.93 / 0.89

+0.26 / +0.28

The 2M forward outright price from spot price and swap points are:

USD/JPY

USD/INR

Spot price

98.75 / 98.80

50.78 / 50.79

C/S swap

0.93 / 0.89

+0.26 / +0.28

Cash price

97.82 / 97.91

51.04 / 51.07

Check the correctness of calculations by ensuring that the spread in forward price is equal to the sum of spreads in spot price and swap points. The next step is to perform the cross rate arithmetic, as earlier.

JPY/INR

Bid

Offer

(51.04 / 97.91)  100 = 52.12

(51.07 / 97.82)  100 = 52.21

The swap points are derived by deducting the spot price from the forward price, using the same sides.

S/2M

Bid

Offer

52.12  51.39 = +0.73

52.21  51.44 = +0.77

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Using the market convention of dropping the sign and quoting the whole numbers, the swap points for S/2M period are 73/77. 6.11. Forward Exchange: Theory versus Practice Let us now discuss various propositions that relate spot price, forward price, interest rate and inflation rate. There are four such propositions: covered interest parity, international Fisher effect, purchasing power parity and unbiased future spot price. In all the equations below, the period is assumed to be one year. Covered Interest Parity (CIP) Also called interest rate parity (IRP), it links the interest rates (R), spot price (S) and forward price (F) in the following relation. 𝐹=𝑆

1 + 𝑅QC 1 + 𝑅BC

where the subscripts QC and BC indicate the quoting currency and base currency, respectively. The equation says that the forward price is determined by spot price and two interest rates. CIP is the most important because it has no assumptions about future and is solely based on current market inputs. In other words, if it is violated, there will be scope for arbitrage profit, as explained in Section 6.1. This practical face of CIP is called covered interest arbitrage (CIA), which is the basis of all arithmetic in the previous chapter. CIP holds even if the causality is reversed between interest rates and forward price. For example, during the ERM crisis of the early 1990s, GBP was under severe bear attack by speculators, who short-sold GBP in spot and funded it by borrowing GBP in the Eurocurrency market. The falling price of GBP (cause) resulted in its rising interest rate (effect). The short-term interest rates rose as high as 50% pa, but the CIP held. When there are controls to restrict the movement of capital between different countries (or where the Eurocurrency market is not liquid), CIP may not hold, and the forward price will be determined by expectations about future spot price. This condition is called uncovered interest parity (UIP), and was observed during ASEAN currency crisis in the late 1990s. Fisher Equation (FE) and International Fisher Effect (IFE) Fisher equation relates the nominal interest rate (R), inflation rate () and real interest rate () within a country as follows.

88

Forward Exchange

1+𝑅 = 1+E 𝛼

× 1+𝛽

where E is the expectation operator. Fisher equation postulates that the nominal interest rate (i.e. current rate prevailing in the market) is determined by the expected future inflation rate. If the capital flows are freely allowed, arbitrage ensures that the real rates will be the same in every country, which in turn supposes that the nominal rates will adjust to reflect the expected inflation. The international version of Fisher equation, the IFE, postulates the following. E 𝑆𝑇 = 𝑆

1 + 𝑅QC 1 + 𝑅BC

The equation states that the expected future spot price is determined by the current interest rates: currency with lower rate will appreciate and that with higher rate will depreciate. Unlike CIP, IFE does not provide scope for arbitrage profit on its violation because it deals with expectations, which differ among market participants and change over time. The action based on expectations is speculation, not arbitrage, which does not guarantee profit. Purchasing Power Parity (PPP) There are two versions of PPP, and the relevant version to our topic is the relative PPP (RPPP), which postulates that expected future inflation rates () will determine the future spot price (ST): currency with higher inflation rate will depreciate because of the loss of purchasing power; and that with lower inflation rate will appreciate because of gain in its purchasing power. E 𝑆𝑇 = 𝑆

1 + E 𝛼QC 1 + E 𝛼BC

Like IFE, PPP deals with expectations and therefore provides for only speculation, not arbitrage, if it is violated in the market. Unbiased Future Spot Price (UFSP) Theory Unbiased future spot price (UFSP) theory links the current forward price and the expected future spot price. It postulates that the current forward price is the unbiased estimate of future spot price. The “unbiased” here means that it holds on an average but may overshoot and undershoot on occasions. The action based on averages rather than specifics is speculative, not arbitrage.

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Exhibit 6-6 puts together all the relations between prices and rates. The boxes in the first column represent the current state of the world. The shaded boxes are the current market prices and rates and the un-shaded boxes are the expectations about future. The second column represents the future state of the world, which is an expectation. To generate arbitrage profit, the action must be based on shaded boxes.

EXHIBIT

6-6: Parities between Prices and Rates

CURRENT

FUTURE

Time Expectation of future inflation

RPPP

FE Current nominal interest rates

IFE

Future spot price

CIP Current forward Price

UFSP

6.12. Non-deliverable Forward (NDF) In some emerging market economies, there are restrictions on foreigners from freely dealing in the local currencies. In particular, foreigners are not allowed to sell the local currency for forward delivery because such deals are considered speculative and destabilizing. Non-deliverable forward (NDF) was the response to such controls and developed in offshore centers of Singapore and Hong Kong for certain currencies of Asia and Latin America to provide hedging and speculative opportunities for foreigners in these currencies. NDF differs from conventional forward in two features. First, the trade is between two parties resident outside the country of the NDF currency and

90

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booked in an offshore center. Second, settlement must bypass the NDF currency, and involves cash settlement method (explained below) and in a convertible currency. There are two settlement methods for derivatives: physical and cash. In the former, the two currencies are separately settled in their respective settlement centers. In the latter, settlement involves only one currency and the settlement amount is the change in value between trade date and settlement date. Let us illustrate them with the USD/INR example in which Party A has bought USD 100 @ 50.25 from Party B. In physical settlement, Party A would receive USD 100 and pay INR 5,025 on the settlement date. In cash settlement, the trade price is compared with the prevailing market price at the time of settlement (“settlement price”), and their difference is settled. The party to whom the difference is negative will pay it to the other. Thus, if the settlement price is 51.75, the difference is INR 1.50 per unit of USD or INR 150 for the trade, which is positive for Party A and negative for Party B. Accordingly, the latter pays it to the former. Exhibit 6-7 illustrates the physical and cash settlement.

EXHIBIT

6-7: Physical and Cash Settlement PHYSICAL SETTLEMENT

USD

A

CASH SETTLEMENT

100

INR 5,025

INR 150

B

A

B

To sum up, physical settlement settles the value, involving two flows in opposite direction; and cash settlement settles the change in value, involving only one flow, representing the profit/loss on the trade. If the deal currency is base currency, the settlement amount will be in quoting currency; and if the deal currency is quoting currency, it will be in base currency. Cash settlement is invented to eliminate the settlement risk for one party and greatly reduce it for the other. In the example above, with physical settlement, the settlement risk is USD 100 for Party A and INR 5,025 for Party B; and with cash settlement, the settlement risk is eliminated for Party B and reduced to INR 150 for Party A.

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NDF is a forward with compulsory cash settlement, but has one more additional settlement feature, which is to translate the settlement amount (i.e. change in value) to another currency (“settlement currency”) in which it is settled. All NDF currencies are quoted against USD and in direct style of quotation: USD is the base currency and NDF currency is the quoting currency. Since USD is fully convertible on capital account, the change in value is converted into equivalent USD amount and settled in New York. In the above example, the change in value is INR 150, which is converted into equivalent USD at the prevailing price of 51.75. INR 125 / 51.75 = USD 2.42, which is the settlement amount for the NDF trade. The controls on capital movement between two money markets impose uncovered interest parity in both on-shore forward and NDF. The forward price is determined by expectations about the future spot price (ST). In the on-shore forward market, residents are allowed covered interest arbitrage to a limited extent, particularly for the transactions backed by international trade and commerce, because of which there can be substantial difference between the price of onshore forward and NDF markets. Some analysts use the CIP formula to price the NDF with the quoting currency interest rate as the implied offshore interest rate (I). 𝐹=𝑆

1 + 𝐼QC 1 + 𝑅BC

However, this is incorrect. The “implied interest rate” implies that one can borrow or lend the currency at the rate implied. We can borrow or lend only through forex swap and not through forward contract. In Eurocurrency market, one can trade both money and forex trades (including forex swaps) with physical delivery and therefore “implied interest rate” is actionable. The NDF market is not a Eurocurrency market: it trades only the non-deliverable products, and therefore the interest rate implied in this market is not actionable. Summary of Key Concepts Money market is the link between spot and forward exchange (covered interest parity/arbitrage) Swap points are the difference in two interest rates, expressed as units of quoting currency per unit of base currency. Swap points can be positive (pre-

92

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mium), negative (discount) or zero (par). The interest rates relevant to the forward exchange are the “free” or unregulated rates, typically prevailing in Eurocurrency market. All forex prices for other than spot value dates are quoted as a combination of spot price and swap points. For forward value dates, we derive the price by adding the swap points to the same side of two-way spot quote. For short dates, we derive the price by deducting the swap points from the opposite side of two-way spot price. Swap points for broken dates and forward-to-forward periods are derived from two-spot based swap quotes. Swap points for „turn‟ periods are derived from forward interest rates. Parities between prices and rates: CIP, IFE, PPP and UFSP Non-deliverable forward (NDF) and uncovered interest parity

EXERCISES

The following are the market quotes for spot and swap for different currency pairs.

Spot C/S S/1M S/3M S/6M

EUR/USD

AUD/USD

USD/JPY

USD/CHF

1.2595/00

0.7364/68

99.97/02

1.1235/42

1/0.5

1/0.5

2.5/2.0

1/+1

12/11

13/12

30/29

5/4

31/29

32/30

85/83

13/12

55/52

58/56

165/160

25/23

Convert the swap points into their proper numerical values with signs. Assume the following values dates: Spot = Mar 10; 1M = Apr 13; 2M = May 10; 3M = Jun 14; 4M = Jul 11; 5M = Aug 10; and 6M = Sep 12. Assume further that the value date for a period is the same for all currency pairs. Work out the solutions for the following. 1. 2.

What is the cash outright bid-offer for all the four underlying currency pairs? What is the tom outright bid-offer for all the four underlying currency pairs?

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3. 4. 5. 6. 7.

What is the cash outright bid-offer for the following cross rates: EUR/AUD, EUR/JPY, AUD/CHF and CHF/JPY? What is the S/5M swap quote (bid and offer) for all the four underlying currency pairs? What is the S/2M swap quote (bid and offer) for the four cross rates in question #3? What is the 48-day swap quote all the four underlying currency pairs? Assuming that the 3M USD interest rate is 1.950/2.075%, what are the 3M implied interest rates (bid and offer) for EUR, AUD, JPY and CHF?

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Chapter 7 Forex Swaps In the global forex market, the turnover of FX swaps greatly exceeds spot transactions: $1.7 trillion versus $1.0 trillion a day in April 2007. (Triennial Central Bank Survey 2007, BANK FOR INTERNATIONAL SETTLEMENTS) [In Asian markets] … one indication of the importance of FX swap market as a source of interbank funding is the use of swap-implied rates as the reference rate for interest rate swap contracts instead of interbank rate fixings as used in USD, EUR and JPY. (Working Paper No 252, May 2008, BANK FOR INTERNATIONAL SETTLEMENTS )

In developed markets, the money market establishes the swap points and forex swap, as explained in the previous chapter. In emerging market economies, the cause-and-effect is reversed: the forex swap acts as a substitute for money market, and is used for local currency funding and to establish (implied) interest rate benchmarks for the local currency. 7.1. Forex Swap: Recap Let us recap the main points about forex swaps from Section 4.2. Forex swap is simultaneous borrowing in one currency and lending in another of equivalent amounts for a given period, and the two money trades are combined into a fo-

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rex swap (see Exhibit 4-3). The transaction is structured as simultaneous buy and sell of a currency for two different value dates against another currency. The trade that is settled first is called the near leg and the other trade as far leg. The buy (in near leg)-sell (in far leg) corresponds to borrowing and the sell-buy corresponds to lending. The near leg corresponds to the exchange of principals and the rate of exchange is linked to the market price relevant to the near leg value date. The far leg corresponds to the re-exchange of principals and exchange of interest amounts in base currency and quoting currency. The former is converted into quoting currency and then netted with the interest amount in quoting currency. The net interest amount is expressed as quoting currency units per unit base currency, and is called the swap points. The price for the far leg is the sum of near leg price (representing the principal rate of exchange) and swap points (representing the net interest amount exchange). 7.2. Swap Points and Forex Swaps Swap points are sometimes erroneously referred to as the swap “price” or “rate”. As explained in Section 6.4, swap point are not a price (a la spot price) or a rate (a la interest rate). It is the difference between two interest amounts and can be positive, negative or zero. Swap points are used in practice for two distinct purposes. First, they are used in conjunction with spot price to derive the non-spot outright price, as discussed in the previous chapter. In these operations, the action is to buy or sell and the sides of swap and spot two-way quotes must be correctly matched. In other words, the spread in the derived outright price will be equal to the sum of spreads in the swap and spot quotes. Second, swap points are used in cash and liquidity management. In these operations, we do not buy or sell, but do buy-sell (i.e. borrowing) or sell-buy (i.e. lending). Though we still need the spot price to determine the equivalent amounts of two currencies, the spread in spot quote should not matter because we are not buying or selling. Forex swap is simultaneous borrowing and lending in two currencies, and therefore only the spread in the bid-offer of interest rates, which is captured in the swap quote, alone should matter. Accordingly, we select an appropriate side of swap quote (depending on whether we are borrowing or lending) and then match it with any side (i.e. bid, offer or mid) of spot quote without incorporating the spread in spot quote. This will be discussed further and illustrated in Section 7.4 of this chapter.

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FX Swaps

7.3. Anatomy of Two-way Swap Quote The two actions or market sides of the swap quote are borrowing, which is structured as buy-sell (B-S); and lending, which is structured as sell-buy (S-B). The questions that arise with two-way swap quote are: which side is for buysell and sell-buy, in which currency, and for which party? Let us consider two logical facts. The first is to determine whether the interest rate difference is in our favor or against us. When we B-S a currency with lower interest rate, it implies that: we borrow the currency with lower interest rate and lend the currency with higher interest rate; and that the interest rate difference, which is captured as swap points, is in our favor: we “receive” it. When we B-S a currency with higher interest rate, it implies that: we borrow the currency with higher interest rate and lend the currency with lower interest rate; and that the interest rate difference, which is captured as swap points, is against us: we “pay” it. Similarly, when we S-B a currency with lower interest rate, the swap points are against us (we “pay” it); and when we S-B a currency with higher interest rate, the swap points are in our favor (we “receive” it). We may note that the swap points we receive or pay in a swap is not profit and loss, respectively, but the net gain and cost in borrowing and lending. Swap does not create position but it does create gap in cash flows. The gain/cost in swap will be offset when the gap is eliminated through borrowing/lending. The second logical fact is that the bid-offer spread in any two-way quote is always to the advantage of the quoter (i.e. price maker) and against the asker (i.e. price taker). It follows that when the quoter receives the swap points, the he will receive the higher of the two sides; and when he pays, he will pay the lower of the two sides. For the asker, the opposite is true: when he pays, he pays the higher; and when he receives, he receives the lower. The two logical points guide us to identify which side is for which swap type (B-S or S-B) for which party (quoter or asker). Consider the swap quote of 10/11 for USD/INR. We know that USD‟s interest rate is lower than INR‟s. If we do B-S swap in USD, then we borrow USD (paying lower interest rate) and

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lend INR (receiving higher interest rate); and we should receive the swap points to reflect the interest rate advantage. If we are the quoter, we should receive 11 (the higher); and if we are the asker, 10 (the lesser). Similarly, if we do S-B swap in USD, we should pay the swap points and pay 10 as the quoter but pay 11 as the asker. Thus, if we know which currency has higher interest rate, then we can determine which side of the swap quote is for B-S or S-B for a given party and in a given currency. But how do we know which currency has higher interest arte? The structure of the swap quote itself indicates the relative levels of two currencies. There are two currencies in a forex trade, which are, alphabetically, base currency (BC) and quoting currency (QC). There are two sides to the twoway quote, which are, alphabetically, left-hand side (LHS) and right-hand side (RHS). Associate the first side of swap quote with the first currency, and the second side with the second currency. If the first side (i.e. LHS) of the quote is higher, then the first currency (i.e. BC) has the higher interest rate, and vice versa.

BC

QC

BC

10 / 11 LHS

RHS

QC has higher rate

QC

11 / 10 LHS

RHS

BC has higher rate

The thumb rule works only when the swap points are quoted without the signs or when both the sides have the same sign. In the latter case, we drop the signs and consider the absolute values of swap quote. If the swap quote has different signs (of which only the /+ case is possible, as explained in Section 6.4), the rule above does not work. Let us formulate an aide memoire that works in all cases, and it is 1 = 1 = 1= 1. The following is the explanation of the 1=1=1=1 rule. Two currencies in a pair. Alphabetically, they are: Two parties to a trade. Alphabetically, they are: Two types of FX swaps. Alphabetically, they are: Two sides to a quote. Alphabetically, they are:

(1) BC (1) Asker (1) B-S (1) LHS

(2) QC (2) Quoter (2) S-B (2) RHS

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FX Swaps

Associate all the first sides (1 = 1 = 1 = 1): on the 1st currency, the 1st party does the 1st swap type on the 1st side of the swap quote. From this, all other operations can be worked out. For example, what is B-S for one party is the SB for the other party in the same currency at the same side of the quote; what is B-S in BC is also the S-B in QC for the same party at the same side; and so on. (Note that similar rule in Sec. 2.9 has different names and should not be mixed up with the rule here). Exhibit 7-1 illustrates the 1=1=1=1 rule.

EXHIBIT

7-1: Who does what and in which currency and at which side? BASE CURRENCY

(1)

QUOTING CURRENCY

ASKER (1) B-S

(1) (1=1=1=1)

ASKER

S-B

S-B

10 / 11 S-B

B-S

QUOTER BASE CURRENCY

B-S

10 / 11 (2=2=2=2) S-B (2) QUOTER (2) QUOTING CURRENCY (2) B-S

The top left-hand corner corresponds to the 1=1=1=1 rule, and its opposite diagonal corresponds to the equivalent 2=2=2=2 rule. 7.4. Fixing the Prices for Near and Far Legs The previous section explained the structure of two-way swap quote and which swap type can be executed at a given side of the quote. The next step is to transform the given swap points into trade prices for the two legs of swap. The near leg represents the exchange of principal and therefore its price must be that relevant to its value date. For example, if the near leg is for delivery spot, then spot price will be the price for near leg; if it is for delivery cash, it will be the cash price; and so on. The far leg represents the re-exchange of principal (which must be at the same rate of exchange as in near leg) and the net interest amount (which is the swap points). Therefore, the price for far leg should be the algebraic sum of the price for near leg and the swap points. Note that the swap points have their own sign, and if the swap points are quoted without sign, then we must assign the signs, using the AA-DD rule (Add As-

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cending order, Deduct Descending order), as explained in Section 6-5. Let us illustrate the transformation of swap points into trade prices with the following market quotes for EUR/USD. Spot C/S swap S/1M swap S/3M swap EXAMPLE #1:

1.2500 / 1.2505 1/+1 4/5 11 / 12

Asker does B-S swap in EUR for S/1M

At what difference: 4 (because of 1=1=1=1 rule) Paid or received: The spread is against the asker: he will receive the lesser and pay the higher. Since 4 is the lesser side of the quote, asker receives it. Price for the near leg: Near leg is for spot, and the spot price is applied. Which side of the spot price? It does not matter, as explained in Section 7.2. We can take either bid or offer or mid price. Note that we are not buying or selling, but only borrowing and lending, for which the asker has already paid the spread in the swap quote (by way of receiving the lesser amount in this example). We can select either 1.2500 or 1.2505 or some value between them. Generally, it is so chosen that the far leg price is a round number, as explained below. Price for the far leg: it is the algebraic sum of near leg price and swap points. Before we sum them, we must convert the swap points in to their proper numerical value and assign signs (as explained in Section 6.5). Since the spot price is quoted up to four decimal places, the swap quote of 4/5 has the numerical value of 0.0004/0.0005. Since it is in ascending order, it has to be added or has a positive sign (i.e. +0.0004). If the near leg price is 1.2500, then far leg price will be 1.2504; if the near leg price is 1.2505, the far leg price will be 1.2509; if the near leg price is 1.2501, the far leg price will be 1.2505; and so on. The last pair of prices (1.2501 and 1.2505) is likely to be chosen because it results in a round number for the far leg price. We can now formally record the forex swap trade as follows (from the asker‟s perspective), assuming that the deal amount is EUR 100. Near leg: Far leg:

Bought EUR 100 @ 1.2501 against USD value spot Sold EUR 100 @ 1.2505 against USD value 1M

In the swap above, the sell price is higher than buy price by 0.0004, resulting in gain. This, of course, is the swap points at which we did the B-S swap.

100

FX Swaps EXAMPLE #2:

Quoter does S-B swap in USD for C/S

Note that the swap points are quoted with signs because the two sides have different signs. At what difference: +1 (because of 2=2=2=2 rule) Paid or received: Whenever the swap quote has /+ signs, the quoter “receives” and the asker “pays” on either side. Accordingly, the quoter received the difference of +1. Price for the near leg: Near leg is for delivery cash, for which there is no market quote. The cash outright price has to be derived from spot and C/S swap quotes, using the procedure described in Section 6.6: deduct the swap from spot, pairing the opposite sides. This gives us the cash outright price of 1.2499/1.2506. The spread in cash outright quote must be equal to the sum of spreads in spot and swap quotes, which is the case indeed. We can now choose either 1.2499 or 1.2506 or a value between them as the price for near leg. We will choose 1.2499 (so that the far leg price would be a round number, as shown below). Price for the far leg: We must convert the swap points in to their proper numerical value, which is +0.0001. We need not assign the sign because it is already given in the market quote. The far leg price is the algebraic sum of near leg price and swap point, which is 1.2499 + 0.0001 = 1.2500. We can now formally record the forex swap trade as follows (from the quoter‟s perspective), with the deal amount of EUR 100. Near leg: Far leg:

Sold USD 100 @ 1.2499 against USD value cash Bought USD 100 @ 1.2500 against USD value spot

The deal currency is quoting currency in this example and „bought high and sold low‟ (or took more and gave less USD per unit EUR). This is a profit of USD 0.0001 per EUR, which corresponds to the “receiving” of 1 in swap. Note that in the above example, if the quoter does B-S swap in USD (which is S-B swap in EUR), it would be at the difference of 1, which the quoter will receive and the asker will pay (because in +/ quote the quoter receives and the asker pays on both sides). The parties are likely to choose the price of 1.2501 for near leg so that the far leg price would be a round number of 1.2500. Another point to be noted is that, if the signs are dropped from swap quote (e.g. 1 / 2), then assign the signs using the AA-DD rule.

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Chapter 7 EXAMPLE #3:

Asker does B-S swap in EUR for 1M/3M

The swap period is forward-to-forward, which is not quoted in the market. It has to be derived from the two spot-based quotes of S/1M and S.3M, using the procedure described in Section 6.8. Let us first convert the S/1M and S/3M swap points into their proper numerical value and assign them the signs. Given that spot is quoted up to four decimal places and swap points are in ascending order, the signed numerical value of swap points for S/1M and S/3M are: S/1M S/3M

+0.0004 / +0.0005 +0.0011 / +0.0012

The swap points for 1M/3M forward-to-forward points are computed as: LHS S/3M LHS  S/1M RHS

/ /

RHS S/3M RHS  S/1M LHS

= 0.0011  0.0005

/

= 0.0012  0.0004

= +0.0006

/

= +0.0008

The reason for pairing the opposite sides is to eliminate the gap in cash flows. Consider that we want to do B-S swap for 1M/3M period. This is engineered by doing two spot-based swaps of opposite types. For the longer period (S/3M), the swap type has to be the same as that for the required forwardto-forward swap (B-S in our example); and for the short period (S/1M), it has to be the opposite swap type (S-B in our example). S/3M swap S/1M swap

Near leg Far leg Near leg Far leg

Bought EUR 1 @ 1.2500 value spot on EUR/USD Sold EUR 1 @ 1.2511 value 3M on EUR/USD Sold EUR 1 @ 1.2500 value spot on EUR/USD Bought EUR 1 @ 1.2505 value 1M on EUR/USD

The two swaps will create a gap that exactly matches the desired forwardto-forward swap. This is illustrated by the following cash flows table. Value Date Spot

EUR +1 1

Gap 1M

USD 1.2500 +1.2500 0

+1

0 1.2505

Remark S/3M swap – Near leg S/1M swap – Near leg No gap S/1M swap – Far leg

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FX Swaps

Gap

+1 1

3M Gap

1

1.2505 +1.2511 +1.2511

EUR surplus/USD deficit S/3M swap – Far leg EUR deficit/USD surplus

We can now logically proceed as earlier. At what difference: +0.0006 (because of 1=1=1=1 rule, which can be also seen from the cash flows table as the difference between the USD cash flows at 1M and 3M) Paid or received: Asker receives the lesser side and pays the higher side. Since the difference of 6 is the lesser, the asker receives it. It is also confirmed by the cash flows table: the net cash flow in USD is inflow at +0.0006. Price for the near leg: Near leg is for delivery 1M, for which we have no market quote. It has to be derived by adding S/1M swap to spot and pairing the same sides (see Exhibit 6.3). This gives us the 1M outright price of 1.2504/1.2511. The spread in 1M outright quote must be equal to the sum of spreads in spot and swap quotes, which is the case indeed. We can now choose either 1.2504 or 1.2511 or a value between them as the price for near leg. We will choose 1.2504 so that the far leg price will be a round number. Price for the far leg: The far leg price is the algebraic sum of near leg price and swap point, which is 1.2504 + 0.0006 = 1.2510. Note that the cash flow table above has taken the prices of 1.2505 and 1.2511, which is also acceptable. The condition is that the difference between the prices of two legs should be +0.0006, which is the contracted swap points. We can now formally record the swap trade as follows (from the asker‟s perspective), with the deal amount at EUR 1. Near leg: Far leg:

Bought EUR 1 @ 1.2504 (or 1.2505) against USD value 1M Sold EUR 1 @ 1.2510 (or 1.2511) against USD value 3M

7.5. Cash Management with Forex Swaps Forex swap, being simultaneous borrowing and lending in two currencies, is a cash management tool. It is the forex-equivalent of repo in money market. The working cash balances for forex operations are held in what is called nostro account (see Box 7-1) with another bank (“nostro agent” or “correspondent bank”) in the country of the currency. How do we fund the nostro account

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with working balances? There are three ways: buy the foreign currency with local currency, borrow the foreign currency and do a B-S swap in foreign currency against the local currency. The first is dangerous, the second is possible but not efficient, and the third is the practical and efficient solution. Buying the foreign currency for funding nostro account is ruled out because it creates long/overbought position, exposing us to currency risk. Borrowing the foreign currency does not create position and therefore acceptable, but the problems is the availability of credit lines. The fact that we can borrow from only those with whom we have the credit line restricts the counterparties from whom we can borrow. There is also narrow scope for rate negotiation since interest rates are counterparty-specific, unlike asset prices, which are uniform for all market participants. Forex swap is a collateralized borrowing and therefore can be executed with every market participant on finer terms. BOX 7-1:

Nostro, Vostro and Loro Accounts

Nostro is Italian for “our” and therefore nostro account is simply “our” account maintained with the nostro agent. When you refer to this account in correspondence with the nostro agent, you say nostro account (and not “our nostro” account, which is tautological). When the nostro agent replies, he would refer to the account as vostro (Italian for “your”) account. When the same nostro agent also maintains a local currency account with you in a reciprocal relationship, there could be potential confusion: your account with him is nostro for you and vostro for him; and his account with you is vostro for you and nostro for him. The loro (Italian for “their”) account is a third party‟s account with the nostro agent. You will use it when referring to a third party‟s account with the nostro agent. Why Italian words? Like forex money-changing (see Box 6-1), the modern banking institutions were established by Italians in the city-states of Genoa, Venice and Florence during the fifteenth century.

Consider now the “float” (i.e. temporary surplus funds) in the nostro account. We have three alternatives to use the float funds: sell the currency, lend the currency or S-B swap the currency. The first creates position and therefore is risky; the second creates credit risk and therefore we will be selective about the borrower; and the third creates neither price risk nor credit risk.

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Forex swaps are required to support most commercial transactions. For example, bills under import letter of credit (L/C) will be debited to the nostro account before they are retired by the importer-customer. Until the retirement of the bill, the nostro debit has to be funded through B-S swap in the currency of nostro account. Similarly, foreign currency bills discounted by the bank are paid prior to or later than the expected due date. In all such cases, forex swap becomes handy to adjust the gap in cash flows. We will examine those cases with examples in the next chapter. Key Concepts Introduced Forex swap is simultaneous borrowing and lending in two currencies: it is the forex equivalent of repo in money market. Forex swap is a cash management tool, not a risk management tool. The actions or market sides of forex swap are buy-sell (B-S) and sell-buy (SB), which correspond to borrowing and lending, respectively. Since every forex trade has two currencies in a complementary way, the B-S in one currency is also S-B in the other for equivalent amount. The difference in the price of near leg and far leg is the swap points, which represents the net interest amount payable or receivable in the swap. This difference is expressed in the same style as forex price: amount of quoting currency per unit of base currency. An aide memoire for operations on two-way swap quote is “1=1=1=1.”

EXERCISES

The following are the market quotes for spot price and swap points.

Spot C/S S/1M S/3M S/6M

EUR/USD

AUD/USD

USD/JPY

USD/CHF

1.2595/00

0.7364/68

99.97/02

1.1235/42

1/0.5

1/0.5

2.5/2.0

1/+1

12/11

13/12

30/29

5/4

31/29

32/30

85/83

13/12

55/52

58/56

165/160

25/23

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1.

In the following trades, specify: (1) the swap points for the trade; (2) whether the swap points are “paid” or “received”; and (3) the prices for the near leg and far leg of swap. Note that “You” = Asker and “Market” = Quoter in the following questions. A. B. C. D. E. F. G. H. I. J. K. L. M. N. O. P. Q. R.

2.

EUR/USD: S-B swap in EUR for C/S period EUR/USD: B-S swap in EUR for S/3M period EUR/USD: B-S swap in EUR for 1M/3M period EUR/USD: S-B swap in USD for 2M/6M period AUD/USD: S-B swap in USD for S/6M period AUD/USD: B-S swap in AUD for C/S period AUD/USD: S-B swap in AUD for 2M/6M period USD/JPY: S-B swap in JPY for S/6M period USD/JPY: B-S swap in USD for C/S period USD/JPY: B-S swap in JPY for 3M/6M period USD/JPY: S-B swap in USD for 2M/4M period USD/JPY: S-B swap in JPY for S/45 days period USD/CHF: B-S swap in CHF for C/S period USD/CHF: S-B swap in CHF for C/S period USD/CHF: S-B swap in USD for C/S period USD/CHF: B-S swap in USD for C/S period USD/CHF: B-S swap in CHF for 2M/3M period USD/CHF: B-S swap in USD for 1M/3M period

Using the underlying rates given before, compute the two-way quote for swap points for the following cross rates and for the following periods. EUR/AUD

EUR/JPY

AUD/JPY

CHF/JPY

C/S S/1M S/3M S/6M

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Chapter 8 Commercial Transactions Investment banking business will increase its focus on client and flow trading businesses… and exit certain proprietary and principal trading activities. (Credit Suisse, press release, December 4, 2008, Zurich) Deutsche Bank said…it planned to scale back proprietary trading, while investing more in “flow” trading…Other banks have weighed or started cuts in proprietary trading, including J P Morgan Chase & Co, the largest US bank by market value, which is shutting a stand-alone global proprietary trading desk. (Bloomberg, December 12, 2008, New York)

Forex trades in a bank are accounted in two separate books: proprietary (“prop”) trading and commercial transactions. Proprietary trading is euphemism for speculation in which bank maintains a position, which results in profit or loss. For these transactions, bank does not need a customer: it deals with another dealer in the market. Customer transactions are those initiated with customers. The bank is not exposed to market risk on these transactions, but rather earns margin or spread or both. If the products are highly standardized, common place and offthe-shelf (“commoditized”) and the market is competitive, the margins are thin

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and the bid-offer spread is the primary source of profits. Such customer transactions are called flow trading in which the customer is evolved from client to counterparty. In fixed-income securities (and institutional equities), where the market is very competitive because of the presence of investment banks and brokers in addition to commercial banks, much of the customer business is flow trading. If the products are customized or the market is not very competitive, banks earn margin in addition to bid-offer spread. Such transactions are called commercial or merchant transactions. At the present stage, much of the customer business in the OTC forex market is commercial, with the flow trading restricted to interdealer business between active and inactive dealers. Proprietary (“prop”) trading was the fashion in Sales & Trading units of big banks during the 2000s until the subprime crisis blew it up in 2008. Bitten by the excessive greed and reckless risk-taking, most banks are now re-focusing on customer transactions, as evidenced by the quotations at the beginning of this chapter. 8.1. Features of Commercial Transactions Commercial transactions differ from interdealer transactions in three features: transaction type, currency pair and deal currency. First, commercials transactions are predominantly outright trades and usually smaller and odd amounts and for broken dates, driven by the underlying import/export requirement. Forex swaps, in most countries, are not allowed with customers but restricted to interdealer business. Second, the currency pair in most commercial transactions is a foreign currency against the local currency. Except in the US, such currency pairs are “cross rates” in the interdealer market and derived by crossing two underlying rates (see Chapter 5). Third, deal currency in most commercial transactions is foreign currency regardless of whether the currency pair is in direct or indirect style of quotation. 8.2. Classification of Transactions All commercial transactions are classified at first level into purchase and sale, the words being understood from the bank‟s perspective and usually with reference to the foreign currency. Thus, in a “purchase” transaction, the bank buys the foreign currency from the customer against the local currency. Purchase and sale transactions are further classified into clean and bill transactions. Clean transactions are those that do not require handling of trade

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documents. The customer and the bank simply exchange foreign currency and local currency with little paperwork. Of course, the transaction must be permissible under the exchange controls. Examples of such transactions are remittances and other permissible current account transactions. Bill transactions, on the other hand, are related to exports and imports and involve scrutiny of trade documents (e.g. bill of lading, invoice, etc) by the bank. Bill transactions may be under letter of credit (L/C) or outside it. Some transactions also involve financing by the bank. In purchase transactions, the financing is in local currency: bank pays local currency before it receives the equivalent foreign currency. In sale transactions, the financing is involved only in those under L/C: bank pays foreign currency before it receives the equivalent local currency. Exhibit 8-1 summarizes the transaction types.

EXHIBIT

8-1: Types of Commercial Transactions 1.

2.

Purchase 1.1. Clean 1.2. Bill Sale 2.1. Clean 2.2. Bill

Besides the above, there are purchase and sale of bank notes and travelers checks, which are handled more by money-changers than by banks. In all transactions, banks load margin in the transaction price. In those that involve financing by the bank, the interest is separately charged, independent of the exchange margin. 8.3. Market Price and Margin The prices for commercial transactions are quoted based on hedge (or “cover”) in the market. If the bank buys foreign currency from the customer, it sells it in the market at the market‟s bid price. Similarly, to sell foreign currency to the customer, the bank buys it from the market at the market‟s offer price. Once the relevant side of bid-offer in market price is determined, the exchange margin is loaded on to the market price. Whether the margin is to be added to or

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deducted from the market price will depend on whether it is purchase or sale; and whether the price is in direct or indirect style of quotation. For this purpose, the quotation style is determined as follows, based on whether the deal currency is base currency (BC) or quoting currency (QC). Deal currency is BC: Deal currency is QC:

Direct style Indirect style

Note that the currency pair in commercial transactions is foreign currency (FC) versus local currency (LC). The deal currency will always be FC regardless of whether it is BC or QC. To make profit, the bank must “buy low, sell high” in direct style; and “buy high, sell low” in indirect style. This principle guides as whether the margin is to be added to the market price or deducted from it, as shown below. Note that we have used left-hand side (LHS) and right-hand side (RHS) for bid and offer, respectively. The reason is that the bid and offer are always with respect to the BC, but the deal currency, which is the foreign currency (FC) in commercial transactions, may be BC or QC.

Market Price Margin loading Purchase from customer (and sale in market) Sale to customer (and purchase from market)

Direct Style (FC/LC) (FC = BC) LHS / RHS “buy low, sell high” LHS  Margin

Indirect Style (LC/FC) (FC = QC) LHS / RHS “buy high, sell low” RHS + Margin

RHS + Margin

LHS  Margin

8.4. Clean Instruments/Remittances Clean transactions are purchases and sales on current account without trade documentation. Of course, the bank must ensure that the transaction is permissible under the exchange regulations and that other statutory requirements (e.g. anti-money laundering) are satisfied. In these transactions, the settlement in local currency takes place immediately (i.e. it corresponds to cash value date). For settlement in foreign currency: for sales, the bank will remit the foreign currency on the same day by wire transfer; and for purchases, the bank must have already have received the foreign currency its nostro account. Such transactions are called “TT” (for telegraphic transfer) buying and selling in India because the foreign currency settlement is traditionally through wire transfer.

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Since the settlement corresponds to cash value date, we must load the margin on cash outright price rather than spot price. The following example illustrates the calculation of market price and the loading of margin. We will assume that the margin is 0.0010 unit of quoting currency and the deal currency is the foreign currency (FC).

Spot price Swap: C/S Cash price Purchase Sale

Direct Style (FC/LC)

Indirect Style (LC/FC)

1.2500 / 1.2505

1.2500 / 1.2505

0.0001 / 0.0002

0.0002 / 0.0001

1.2498 / 1.2504

1.2501 / 1.2507

1.2498  0.0010 = 1.2488

1.2507 + 0.0010 = 1.2517

1.2504 + 0.0010 = 1.2514

1.2501  0.0010 = 1.2491

For some purchases, the customer may present to the bank a negotiable instrument (e.g. check, draft, etc) payable in the foreign country. In such cases, there will be no prior credit in the nostro account, and the transaction cannot be treated as TT buying. There are two ways to process such transactions. First, the bank may send the instrument on collection basis to its nostro agent, who will present it in the local clearing. After the proceeds are realized, the nostro agent will credit the amount to the nostro account under advice to the bank. The bank will then put through the transaction as TT buying, paying the local currency to the customer at the market rates prevailing on that date. Second, the bank may at its discretion discount9 the instrument and settle the local currency immediately with the customer, send the instrument to nostro agent and wait until the foreign currency amount is cleared and credited to its nostro account. In this transaction, the bank is parting away with local currency amount before it receives the equivalent foreign currency amount. Effectively, the bank has lent the local currency amount to the customer, for which interest would be charged separately upfront. The bank will assume a transit time, which varies from country to country, and is about a week, for which interest would be charged. Since the foreign currency would be paid after the transit time (of a week), the forex price to the transaction should be 1W forward price. The following USD/INR example illustrates the transaction price and in9

In banking, the term purchase or demand purchase is used for financing “sight” instrument (i.e. instrument payable at sight or on demand after presenting it); and the term discount is used for “usance” or time instrument (i.e. instrument payable after a specified period from the date of presentation). Since we have used the word “purchase” in the first-level classification of commercial transaction, we will use the word discount for financing of both sight and usance bills to avoid the confusion whether the “purchase” is related to the market side of the transaction or financing of sight bill.

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terest amount for discounting of clean instrument for USD 10,000. We will assume a margin of 0.15 units of quoting currency; transit time of one week; and INR interest rate of 10% pa USD/INR spot price Swap: S/1W 1W forward outright price Transaction price with margin Interest for one week

50.48 / 50.49 1 / 2 (to be converted into decimal form) 50.49 / 50.51 (“same sides, AA-DD”) 50.49  0.15 = 50.34 10,000  50.34  10%  7 / 365 = 965

If the instrument is paid on or before seven days, the loan to the customer will be self-liquidating and the transaction ends. If the instrument is paid after seven days, the bank will recover additional interest for the excess period beyond seven days (and there may be swap charges, too, as explained in Section 8.11). If the instrument is returned unpaid, the bank will make a clean sale to the customer (and recover local currency amount), which will offset the earlier clean purchase. 8.5. Export Bill (in Foreign Currency) Transactions Export bill transactions are purchases for the bank. As explained in footnote 9, the “purchase” here is with respect to the market side of the transaction and not related to the financing by the bank. The export bill may be under L/C or outside it; and it may be a sight bill (i.e. payable immediately after presenting it) or usance/time bill (i.e. payable after a specified period from the date of presentation/invoice, etc.). For bills under L/C confirmed by the bank, the bank will scrutinize the documents and, if they are in conformity with the L/C terms, the bank will put through the transaction on the same day for sight bills and on the due date for usance bills. The bank gets the reimbursement of foreign currency from the L/C opening bank and pays the equivalent local currency amount at that day‟s price for cash value date. For scrutinizing documents, the bank will charge commission and recover all out-of-pocket expenses. For bills outside L/C, the bank may either send the bill on collection basis or discount it. In case of collection, there will be no forex transaction between the bank and the exportercustomer until the nostro agent confirms the realization of the bill and credits the proceeds to the nostro account, when it would be put through as purchase at that day‟s price for cash value date. The bank will also charge commission and out-of-pocket expenses. In case of discounting, there is a financing component under which bank will lend the local currency to the customer. The

112

Commercial Transactions

bank computes the expected or notional due date (NDD) after considering the transit time and grace period applicable to the country of the foreign currency. For certain usance bills, the payment date (PD) is fixed and known in advance (e.g. 90 days after from the date of bill of lading/invoice, etc). The bank will apply the forward price applicable to the NDD/PD, and pay the local currency equivalent at this price on the date of negotiation. The following example illustrates the calculations for discounting of 90-day (after sight) export bill for USD 10,000 negotiated on May 22. We will assume that transit period is seven days; grace period is three days; margin is INR 0.15 per USD; INR interest for discounting is 9% pa; commission is 0.10% on the bill amount; and handling charges are INR 500. (a) time to NDD (usance+transit+grace) (b) NDD: date after (a) days from May 22 (c) USD/INR spot (May 24) (d) Swap: S/3M (Aug 24) (e) Swap: S/6M (Nov 27) (f) Swap for broken date (Aug 30) (g) Outright price for broken date (h) Transaction price after margin (i) INR proceeds of the bill (j) Interest cost for 100 days @ 9% (k) Commission @ 0.10% of (i) (l) Out-of-pocket expenses (m) INR payable to exporter (ijkl)

100 days Aug 30 50.38 / 50.39 30 / 32 53 / 56 31 / 34 50.69 / 50.73 50.69  0.15 = 50.54 10,000  50.54 = 505,400 505,400  9%  100/365 = 12,462 505 500 491,933

Note that the interest amount is recovered upfront. In other words, the interest rate is the bank discount rate and not the interest yield. If the bill is paid on NDD, the loan to the customer will be self-liquidating and the transaction ends. If the instrument is paid after or before NDD, the bank will recover additional interest for the excess period or refund the excess interest charged earlier, as the case may be; and additionally pay or receive swap charges, as explained in Section 8.11. If the instrument is returned unpaid, the bank will make a clean sale to the customer, which will offset the earlier purchase. 8.6. Import Bill (in Foreign Currency) Transactions Import bills are sale transactions to the bank. Like export bills, import bills may be under L/C or outside it; and may be sight bills or usance/time bills. Bills out-

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side L/C are collection bills. The bank will merely advise the importer-customer of the bill. If the importer retires the bill, the bank will put through the transaction on cash value date basis and wire-transfer the foreign currency amount. If the importer does not retire the bill, the bank will send back the documents to the foreign correspondent. For bills under L/C, the debit to nostro account precedes the receipt of documents. After the bank receives the documents from the foreign correspondent, it will forward them to the importer for payment after grace period (which is 10 days in India). When the importer retires the bill, the bank will put through the transaction at that day‟s price for the cash value date. Note that the financing between the date of debit in nostro account and the date of retirement by importer is in foreign currency. The bank would usually fund the debit by a B-S swap in the foreign currency against the local currency. The swap cost or gain is passed on to the customer. Alternatively, the bank may fund the debit by borrowing the foreign currency, and add the foreign currency interest amount to the import bill amount. The following example illustrates the calculation for sight import bill under L/C for USD 10,000. We will assume that margin is INR 0.15 per USD; commission is 0.10% on the bill amount; and handling charges are INR 500. Date of debit to nostro account Date documents are received Date of payment by importer Market rates on May 22 Spot (May 25) Swap: C/S Swap: S/1M (Jun 25) Swap: C/Jun 03 (12 days) Market rates on Jun 03 Spot Swap: C/S Cash outright

May 22 May 27 Jun 03 50.38 / 50.39 1/2 15 / 16 6/7 50.27 / 50.28 1/2 50.25 / 50.27

The swap cost/gain is calculated on the assumption that the debit is funded through a B-S swap on the date of debit and for up to date of retirement. Of course, the latter will not be known as on the date of debit to nostro account. This is a simplifying assumption and in practice the nostro account could have been funded for any period. In the B-S swap from May 22 to Jun 03, we would be receiving a different of 0.06 per USD, which will be passed on to the customer. On the date of retirement, we will be buying USD in the market for cash

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value date at a price of 50.27 and selling to the customer at 50.42 after loading the margin of 0.15. The final INR amount recovered from the customer will be as follows. (a) Transaction amount @ 50.42 (b) Commission at 0.10% of (a) (c) Out-of-pocket expenses (d) Swap gain deducted (e) Net amount (a + b + c  d)

504,200 504 500 600 504,604

8.7. Forward Contracts: Optional Delivery Period The calculation of forward exchange rates in interdealer market is discussed in Chapter 6. For the customer forward exchange transactions, the additional element is the loading of margins, which is discussed in Section 8.3 of this chapter. We will not discuss these any further except a variation called forward with optional delivery period. For most commercial transactions, the date of negotiation is not known in advance because of uncertainty and delay in processing and shipment. Only a period, rather than an exact date, is known for negotiation of documents. To manage such uncertainty about the date of negotiation, customers prefer the forward contract that can be delivered on any day during a specified period to the forward contract with fixed date delivery. Such contracts are called forwards with optional delivery period. For example, in the forward contract with delivery period of May 15-31, the customer can deliver the forward contract on any day between May 15 and May 31. Similarly, a forward contract whose deth livery period is the fourth week can be delivered on any day between 24 and the last day of its month; that with delivery period of third week can be delivered on any day between 16th and 23rd day of its month; and so on. Note that the word “optional” here is not related to another derivative contract called option. In the option contract, the option is whether to deliver, but in the forward with optional delivery period, the option is when to deliver, and it must be delivered. Secondly, in the forward with optional delivery period, the choice is with the customer, regardless of whether the customer is buyer or seller of foreign currency. In option contrast, the choice is with the option buyer, who may be customer or bank. The word “buyer” in option contract is with respect to the choice, and not with respect to the foreign currency.

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In pricing the forward with optional delivery period, bank will load the swap points in a in a manner that is unfavorable to the customer. To wit, calculate the price for the first day and the last day of the delivery period, and the unfavorable of them will be the transaction price. This is justified because the customer has the choice of delivery date, which the bank cannot control. In hedge, bank will cover the transaction to the date for which the price is quoted. The following USD/INR example of 2M forward in USD against INR with optional st th delivery between 31 day and 60 day illustrates the calculation of price.

Spot price Swap: S/1M Swap: S/2M 1M forward outright 2M forward outright

Case #1

Case #2

50.30 / 50.31

50.30 / 50.31

15 / 16

16 / 15

28 / 30

30 / 28

50.45 / 50.47

50.14 / 50.16

50.58 / 50.61

50.00 / 50.03

The forward price is at premium in Case #1 and discount in Case #2. We will calculate the price separately for forward purchase and sale. Forward purchase contract (FPC): bank buys USD from the customer and sells it at the market bid price in hedge. Case #1: the prices are 50.45 and 50.58 and the former is the worse to the customer and therefore the transaction price. Bank hedges it to the value date of 50.45, which is 1M or the first day of optional delivery period. Case #2: the prices are 50.14 and 50.00 and the latter is the worse to the customer and therefore the transaction price. Bank hedges it to the value date of 50.00, which is 2M or the last day of optional delivery period. Forward sale contract (FSC): bank buys USD at the market‟s offer in hedge and sells to the customer. Case #1: the prices are 50.47 and 50.61 and the latter is the worse to the customer and therefore the transaction price. Bank hedges it to the value date of 50.61, which is 2M or the last day of optional delivery period. Case #2: the prices are 50.16 and 50.03 and the former is the worse to the customer and therefore the transaction price. Bank hedges it to the value date of 50.03, which is 1M or the first day of optional delivery period.

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What happens if the customer delivers it on a date other than the date of hedge? If the customer delivers on the date of hedge, the bank does not lose; and if the customer delivers it on a date other than the hedge date, the bank gains. The discrepancy between the delivery date and hedge date creates gap, not position, which is corrected through a forex swap. The following table shows the gaps in cash flows due to the customer delivery date and hedge date being at the extreme ends of delivery period. The plus sign is cash inflow (i.e. customer delivery in FPC, bank‟s purchase in market) and the negative sign is cash outflow (i.e. customer delivery in FSC and bank‟s sale in market).

FPC FSC

Case #1 Case #2 Case #1 Case #2

Delivery on last day, hedge for first day Delivery on first day, hedge for last day Delivery on first day, hedge for last day Delivery on last day, hedge for first day

1M  +  +

2M +  + 

To eliminate the gap, bank will execute forex swap as follows, depending on the case, and in all cases, the swap will be result in gain to the bank, which is the additional profit for the bank. FPC FSC

Case #1 (premium) Case #2 (discount) Case #1 (premium) Case #2 (discount)

B-S S-B B-S S-B

gain gain gain gain

It must be noted, however, that the always-gain-for-the-bank scenario will be true only if there is no reversal from premium to discount or vice versa between the original booking date and the first day of the delivery period. Such reversal is unlikely in the short term. To sum up, if the customer delivers on hedge date, the bank does not lose; and if the customer delivers on a date different from the hedge date, the bank gains. What is “either gain or no loss” situation for the bank is “either loss or no gain” to the customer. The customer should avoid this skew against him by always opting for fixed-date forward and then request for early or late delivery (described in the next section) to manage uncertainty in delivery date. 8.8. Forward Contracts: Early and Late Delivery To manage the uncertainty in delivery date, customer can request the bank to advance or postpone the delivery of fixed-date forward contracts. Early deli-

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very can be affected on any day before maturity date, but the late delivery can be affected after maturity date only during a limited period of say, one week, after which the bank may unilaterally cancel the overdue contract. Early or late delivery does not create position but creates only gap and funds inflow/outflow. The gap is adjusted through a swap, and the funds inflow/outflow is adjusted by lending/borrowing. The cost or gain on both accounts, swap and financing, is to the customer‟s account. The following example illustrates the early delivery of forward purchase contract (FPC) and forward sale contract (FSC), each for USD 1,000,000 against INR on USD/INR currency pair. The contract prices for FPC and FSC are 50.45 and 50.52, respectively, and their maturity date is Jun 14. The customer requests for early delivery on May 15 on which the market prices are as follows. Spot (May 18) Swap: C/S Swap : S/1M (Jun 18)

50.74 / 50.75 3/4 30 / 32

Early Delivery of FPC The bank would have hedged the FPC by selling USD against INR for delivery June 14. Ignoring the margin, the hedge price will be the same as that of the FPC (i.e. 50.45). If the early delivery is affected on May 15, the following will be the cash flows. Date May 15 Gap Jun 14 Gap Position

USD

INR

+1,000,000

50,450,000

+1,000,000

50,450,000

+1,000,000

50,450,000

1,000,000

+50,450,000

1,000,000

+50,450,000

0

0

Remark FPC early delivery (from Jun 14) Subtotal of daily cash flows FPC, now advanced to May 15 Hedge transaction Subtotal of daily cash flows Grand total of all cash flows

We can see that early delivery creates only gap, not position by shifting the cash flow of FPC from Jun 14 to May 15. The gap is surplus in USD and deficit in INR between May 15 and June 14, which must be eliminated by executing S-B swap in USD against INR. The swap points for the broker period of May 15 to Jun 14 will be 29/33 (see Section 6.7). The S-B swap in USD will be at the difference of 33, which is a cost (see Section 7.3). Assuming that the prices for the near leg and far leg are, say, 50.72 and 51.05, respectively (see Section 7.4), the cash flows will now be as follows.

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Date May 15 Gap Jun 14

USD

INR

+1,000,000

50,450,000

1,000,000

+50,720,000

0

+270,000

1,000,000

+50,450,000

+1,000,000

51,050,000

0

600,000

0

330,000

Gap Position

Remark FPC Early delivery (from Jun 14) Near leg of S-B swap Subtotal of daily cash flows Hedge transaction Far leg of S-B swap Subtotal of daily cash flows Grand total of all cash flows

The surplus of INR 270,000 on May 15 is not a gap. Recall from Section 4.5 that gap must arise in two currencies in the same period but in a complementary way; and that gap in one currency alone is a funding problem. In put example, the S-B swap in USD managed the gap arising from early delivery of FPC but also resulted in funds inflow in INR from May 15 to June 14. In general, funds inflow/outflow results because of change in spot price between the booking date and the early delivery date; and the period of inflow/outflow will be between the early delivery date and the original maturity date. The difference between the inflow on one date and outflow on the other (corresponding to the position in INR for the example above) is the swap gain/cost. Thus, the early delivery of forward contract has two sources of gain/cost:  

swap gain/cost, arising from the swap required to manage the gap interest gain/cost on funds inflow/outflow, arising from changes in spot price between the booking date and early delivery date

Both of that are to the customer‟s account. The following table shows the swap gain/cost and interest gain/cost for our example, assuming that the interest is 7.5% pa for the 30-day period between May 15 and June 14. Swap cost: (0.33  1,000,000) Interest gain: (270,000  7.5%  30 / 365) Total (receivable from customer)

330,000 1,664 328,336

Early Delivery of FSC For the early delivery of forward sale contract (FSC), applying similar procedure, we will find that the bank has to execute a B-S swap in USD for the period from May 15 to Jun 14. The swap will be executed at 29, which is gain and let the prices for near leg and far leg be 50.71 and 51.00, respectively). The

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swap results in a funds outflow, which requires borrowing. The following table shows cash flows for early delivery of forward sale contract. Date May 15 Gap Jun 14

USD

INR

1,000,000

+50,520,000

+1,000,000

50,710,000

0

190,000

+1,000,000

50,520,000

1,000,000

+51,000,000

0

+480,000

0

+290,000

Gap Position

Remark FSC Early delivery Near leg of B-S swap Subtotal of daily cash flows Hedge transaction Far leg of B-S swap Subtotal of daily cash flows Grand total of all cash flows

The INR deficit on May 15 represents the funds outflow of INR 190,000, which requires funding until Jun 14. The difference between the gaps of May 15 and Jun 14 represents the swap gain, which is INR 290,000. Assuming that the interest rate for funding is 7.5% for 30 days, the interest cost is INR 1,171. The net amount for early delivery of FSC payable to the customer is: 290,000  1,171 = 288,829.

Late delivery of FPC and FSC is similar to the early delivery. It has gain/cost from two channels: swap gain/cost and interest gain/cost on funds inflow/outflow. Readers may work out the examples given in the exercises at the end of this chapter. To sum up, swap gain/cost will depend on whether the base currency is in premium or discount; and interest gain/cost will depend on whether the base currency has appreciated or depreciated. Exhibit 8-2 summarizes the swap type to be executed, whether the swap points will be cost or gain, and whether the interest on funds flow will be cost or gain for early delivery (ED) and late delivery (LD) of FPC and FSC.

EXHIBIT

8-2: Status of Swap and Interest Cost/Gain on ED/LD

Contract

ED/LD

FPC

ED LD ED LD

FSC

Swap type S-B B-S B-S S-B

Swap cost/gain Prem. Disc. cost gain gain cost gain cost cost gain

Interest cost/gain Rises Falls gain cost cost gain cost gain gain cost

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Commercial Transactions

The table above is based on the assumption that the deal currency is base currency. If the deal currency is quoting currency, translate it into equivalent base currency action (e.g. FPC in quoting currency is equivalent to FSC in base currency) and then read the table. 8.9. Forward Contracts: Cancellation Forward contract can be cancelled anytime on or before its maturity. It can be also cancelled after maturity, but within a limited period of, say, one week, after which the bank will unilaterally cancel the overdue forward contract. Cancellation is affected by entering into an offsetting contract: purchase is nullified by a sale, and vice versa. The difference between the prices of original and offsetting deals is the exchange gain/loss to the customer. If the contract is cancelled after maturity, there would be a gap, which needs to corrected by a swap, resulting in swap gain/cost and interest gain/cost to the customer (as explained in the previous section), which are in addition to the exchange gain/cost. The following example of FPC on USD/INR currency pair for USD 1,000,000 at 50.48 due on Jun 14 is used to illustrate cancellation. We will consider the two cases of cancellation: request for cancellation is on May 22 (early cancellation) and on Jun 21 (late cancellation). As always, drawing up the table of cash flows and examining the effect of cancellation on position and gap will guide us on what action is required. Early Cancellation The bank would have hedged the FPC by selling USD against INR for delivery June 14. Ignoring the margin, the hedge price will be the same as that of the FPC (i.e. 50.48). Cancellation implies that the customer transaction no longer exists, resulting in short/oversold position in USD. Date Jun 14 Position

USD +1 1

Before INR 50.48 +50.48 0 0

USD +1 1

After INR 50.48 +50.48 1 +50.48

Remark Cancellation Hedge

Bank eliminates the oversold position in USD created by cancellation by buying USD for value Jun 14. The purchase transaction is executed on the cancellation date of May 22, the prices on which are as follows.

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Spot (May 24) Swap: S/1M (June 25) Swap: S/Jun 14 (broken date) Outright price for Jun 14

50.78 / 50.79 15 / 16 9 / 11 50.87 / 50.90

Bank will buy USD at the market offer price of 50.90, which eliminates the position, and leaves an exchange loss of: 50.48  50.90 = 0.42 per USD or INR 420,000 for the deal amount, which is recovered from the customer. The bank may charge margin on cancellation, too, but there will be no other charges on account of swap and interest on funds flow. Late Cancellation The request for cancellation came on Jun 21, which is after maturity date of Jun 14. On Jun 14, because of non-delivery by customer, there will be a gap in cash flows, which is corrected by entering into B-S swap for C/1W. Therefore, we need to know the swap differences and spot price on June 14, which are: Spot (Jun 16) Swap: C/S Swap: S/1W (Jun 23) Swap: C/Jun 14 (broken date) Cash outright price

50.70 / 50.71 2/3 7/8 7/8 50.67 / 50.69

The B-S swap is executed at the difference of 7, which is gain; and the prices for the near leg and far are, say, 50.68 and 50.75, respectively. The cash flows will now be as follows. Date Jun 14

Gap Jun 21 Gap Position

USD

INR

+1

50.48

+1

50.68

1

+50.48

0

0.20

+1

50.48

1

+50.75

0 0

+0.27 +0.07

Remark Non-delivery of FPC Near leg of B-S swap Original hedge Subtotal of daily cash flows Expected delivery of FPC Far leg of B-S swap Subtotal of daily cash flows Grand total of all cash flows

The deficit of INR 0.20 per USD on Jun 14 is the funds outflow. Interest has to calculated, say, at 9% pa, for seven days (between Jun 14 and Jun 21) on a total INR amount of 200,000, which works out to be INR 345. The difference

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Commercial Transactions

between the net cash flow on Jun 14 and Jun 21 corresponds to the swap gain of INR 0.07 per USD or INR 70,000 for the deal amount. Since the customer is not giving delivery but cancelling the contract on Jun 21, bank will have to buy USD on June 21 for cash value date. The market prices on Jun 21 are: Spot (Jun 23) Swap: C/S Cash outright price

50.60 / 50.61 2/3 50.57 / 50.59

Bank will buy USD at the market‟s offer price of 50.59, and the difference between this price and the FPC price of 50.48 is the exchange gain/loss for the customer. In this example, it is a loss of INR 0.11 per USD or INR 110,000 for the deal amount. The total charges to the customer account are: Swap gain Interest cost on funds outlay Exchange loss Total

70,000 345 110,000 40,345

One question that arises is whether we should swap the overdue forward contract exactly for 1W. If depends on the bank‟s policy. The bank may decide to swap the overdue contracts uniformly for 1W and then cancel it or swap the overdue contracts on overnight basis until 1W after maturity. In the latter, if the customer requests for cancellation before 1W, the overnight rollover is discontinued. In the former, the bank will enter into another offsetting swap for the period between the date of request from the customer and the date of the far leg of the earlier swap. For example, bank did S-B swap from maturity date to 1W, and the costumer cancels it on the third day after maturity. The bank will then execute a B-S swap for the period from the third day to seventh day to close the gaps. As we will discuss in Chapter 12, the bank may not actually execute any swap because such gaps are absorbed by day-to-day cash management in nostro accounts. Nevertheless, for the purpose of computing charges on cancellation (or early/late delivery), the required transactions are considered. 8.10. Forward Contracts: Extension/Rollover The maturity of a forward contract can be extended, and it is called extension or rollover. As discussed in Chapter 6, the forward market exists only up to 6M or 1Y. If the customer wants a long-term forward exchange (LTFX), he has to book for 6M or 1Y and then roll it over every 6M or 1Y.

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There are two practices for LTFX: roll it over at original (or historical) price, which is called historical price rollover (HPR); and cancel the old contract and rebook a new contract. We will illustrate both of them with the following example of FPC in USD on USD/INR currency pair booked at the price of 50.50 and maturity of May 22. Ignoring the margins, bank would have hedged it by selling USD at 50.50 for value May 22. The customer wants to roll over the FPC by another 6M to Nov 22. We assume that the customer requests the rollover two days before the maturity so that the spot value date on the date of request corresponds to the maturity date of the FPC. The impact on the cash flows because of rollover will be as follows. Date May 22 Gap Nov 22 Gap Position

USD

INR

+1

50.50

1

+50.50

1

+50.50

+1

50.50

+1

50.50

0

0

Remark FPC rolled over to Nov 22 Original hedge Subtotal of daily cash flows Rolled over FPC (from May 22) Subtotal of daily cash flows Grand total of all cash flows

We can see that the rollover does not create position but creates only a gap, which is deficit in USD between May 22 and Nov 22. The bank eliminates the gap with a B-S swap in USD for the period from May 22 to Nov 22. The following are the market prices on the date of request for rollover. Spot (May 22) Swap: S/6M (Nov 22)

50.25 / 50.26 72 / 75

The B-S swap in USD will be at a gain of 72, and the prices for the near leg and far leg are, say, 50.25 and 50.97. The new cash flows after the swap are: Date May 22 Gap Nov 22 Gap Position

USD

INR

1

+50.50

+1

50.25

0

+0.25

+1

50.50

1

+50.97

0

+0.47

0

+0.72

Remark Original hedge Near leg of B-S swap Subtotal of daily cash flows Rolled over FPC (from May 22) Near leg of B-S swap Subtotal of daily cash flows Grand total of all cash flows

The net cash flow in INR on May 22 is the funds inflow because of changes in forex price between the contract date and the rollover date. Interest on this

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Commercial Transactions

inflow has to be calculated for 184 days (from May 22 to Nov 22). Assuming that the FPC amount is USD 1 million and the interest rate is 9% pa, the interest gain on inflow is INR 11,342. The net position of INR 0.72 is not a position but the swap gain. On the FPC amount of USD 1 million, the total swap gain is INR 720,000. Both the interest gain and swap gain are settled with the customer (in this example, paid to the customer) and the FPC will be carried in the books at the original (or historical) price of 50.50. This is called historical price rollover (HPR). We can see that the calculations are identical to that late delivery of forward (see Section 8.8), and we can use Exhibit 8-2 to quickly determine whether the swap points and interest will be gain or cost. As an alternative to the above, another method of rollover is to cancel the old contract and rebook a new contract at the current market rate. For our example, it involves the execution of following trades by the bank. 1. 2.

Buy USD value May 22 @ 50.26 (this is to replace the old FPC) Sell USD value Nov 22 @ 50.97 (this is the new FPC)

However, such a practice is unfair to the customer because it loads two spreads against him: spread in spot price and spread in swap points. Because the customer does both transactions simultaneously, the bank will not be executing two outright transactions in the hedge, but executing one B-S swap in USD at a gain of 72 with the prices for near leg and far leg of, say, 50.25 and 50.97. With this swap, the cash flows will now be as follows. Date May 22 Gap Nov 22 Gap Position

USD

INR

1

+50.50

+1

50.25

0

+0.25

1

+50.97

+1

50.97

+1

50.50

0

0

Remark Original hedge Near leg of B-S swap Subtotal of daily cash flows Far leg of B-S swap New FPC Subtotal of daily cash flows Grand total of all cash flows

The near leg of B-S swap at 50.25 is offset with the original FPC at 50.50, and the difference in their prices is the exchange gain/loss, which is settled with the customer. The far leg of swap at 50.97 is the hedge for the new FPC with the customer. The cancel-and-rebook rollover is economically the same as HPR but differs in the timing of cash flows. In the HPR method, swap gain/cost and inter-

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est cost/gain on funds inflow/outflow are settled, and the contract is rolled over at the historical price. The charges here are similar to those in early/later delivery of forward contracts. In the cancel-and-rebook method, both the swap gain/cost and interest gain/cost are replaced with exchange gain/cost, similar to the procedure in cancellation of forward contract; and the new contract is carried forward at the current forward price. Though the cancel-and-rebook method involves a swap, the swap gain/cost is split into two components. The first component is treated as exchange gain/cost and settled in cash with the customer. The second component is incorporated into the price of new forward contract. In the example above, of the total swap gain of 0.72, an amount of 0.25 is settled in cash as exchange gain, and the balance of 0.47 is adjusted in the new FPC at 50.97, which is better to the customer by 0.47 compared to the old FPC price of 50.50. The proportion of the amount split into exchange gain/cost will depend on the change in spot price between the date of original booking and the date of rollover. The following summarizes the differences between the two methods of rollover.

New contract price Interest gain/cost Swap gain/cost

HPR Historical old price Settled in cash Fully settled in cash

Cancel and Rebook Current forward price No such concept Part amount settled in cash and the balance loaded in the new contract price

The current market practice is to prefer the cancel-and-rebook method to the HPR method because it brings the outstanding forward contracts closer to the current market prices. 8.11. Early and Late Payment of Discounted Purchases Export bills discounted by the bank may be paid earlier or later than the due date. Such incidents will create gaps in the cash flows, which are adjusted through swap, similar to that in early and late delivery of forward contracts (see Section 8.8). In other words, there would be swap gain/cost and interest gain/cost on funds inflow/outflow. Besides these two gains/costs, there will be an additional interest gain/cost due to the financing component. Let us illustrate the early payment of discounted export bill on USD/INR currency pair with the following details: bill for USD 1 million at 50.70 with due date of May 22 and discounted at 7.5% pa. The bill was realized on Apr 22, creating a gap in the cash flows, as shown below.

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Commercial Transactions

Date Apr 22 Gap May 22 Gap Position

USD

INR

+1

50.70

+1

50.70

+1

50.70

1

+50.70

1

+50.70

0

0

Remark Early payment of bill due on May 22 Subtotal of daily cash flows Export bill due but paid early on Apr 22 Original hedge Subtotal of daily cash flows Grand total of all cash flows

The gap USD surplus from Apr 22 to May 22, and is to be adjusted through S-B swap in USD for the same period. The market prices on Apr 22 are: Spot (Apr 24) Swap: C/S Swap; S/1M (May 24) Swap: C/May 22 (broken period) Cash outright price

50.18 / 50.19 2/3 30 / 31 30 / 31 50.15 / 50.17

The S-B swap will be executed at 31, which is cost, and the prices for near and far legs of the swap are, say, 50.16 and 50.47. The cash flows will now be: Date Apr 22 Gap May 22 Gap Position

USD

INR

+1

50.70

1

+50.16

0

0.54

+1

50.47

1

+50.70

0

+0.23

0

0.31

Remark Early payment of bill due on May 22 Near leg of S-B swap Subtotal of daily cash flows Far leg of S-B swap Original hedge Subtotal of daily cash flows Grand total of all cash flows

The deficit of INR 0.54 on Apr 22 is funds outflow on which interest is to be computed at, say, 9% for 30 days (from Apr 22 to May 22). The oversold position of INR 0.31 is not the position but the swap cost. The third item is the refund of interest charged earlier at 7.5% for the period from Apr 22 to May 22. Interest cost on funds outflow: (0.54  1,000,000  9%  30/365) Swap cost: (0.311,000,000) Interest refund: (50.70  1,000,000  7.5%  30 / 365) Total (payable by customer)

3,995 310,000 +312,534 1,461

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For the late payment of discounted export bills, there will be similar charges for: (1) swap gain/cost; (2) interest gain/cost on funds inflow/outflow; and (3) additional interest cost to be charged from notional due date to the date of payment. We will leave this as an exercise to the readers. Key Concepts The currency pair in most commercial transactions is foreign currency against local currency. Most transactions are outright type, of small and odd amount and for broken dates. Commercials transactions are classified into bank‟s Purchase and Sale at the first level; and Clean and Bill at the second level. Purchases may have financing element under which the bank lends local currency funds to the customer. For financing component, interest is separately charged, which is in addition to the exchange margin. Bank will freely permit early delivery, late delivery, cancellation and extension of forward contracts. In all such cases, the bank will examine the impact of such action on gap and position. Bank will execute the appropriate outright or swap transaction to eliminate position and gap. Drawing the table of cash flows will guide as to which transaction is to be executed. In all cases, the gain/cost of adjusting the position and gap will be to the customer‟s account.

EXERCISES

The following are the market quotes for spot price and swap points.

Spot C/S S/1M S/3M S/6M

EUR/USD

AUD/USD

USD/JPY

USD/CHF

USD/INR

1.2595/00

0.7364/68

99.97/02

1.1235/42

50.01/02

1/0.5

1/0.5

2.5/2.0

1/+1

par/1

12/11

13/12

30/29

5/4

13/14

31/29

32/30

85/83

13/12

30/32

55/52

58/56

165/160

25/23

55/52

To answer the following questions, some cross rates and outright prices for broken dates may have to be calculated from the above underlying rates. Assume that 1M = 30 days; 3M = 90 days and 6M = 90 days from spot value date, which is two days from today; and the interest rate is 9% pa for calculations of interest amount on funds inflow/outflow.

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Commercial Transactions

1. 2. 3. 4. 5. 6.

7. 8. 9.

10. 11. 12.

13. 14. 15. 16. 17.

USD/INR: Outward remittance (i.e. TT selling) in USD for cash value date; load a margin of 0.05. EUR/INR: Inward remittance (i.e. TT buying) in EUR for cash value date; load a margin of 0.07. USD/CHF: Outward remittance in CHF for cash value date; load margin of 0.0025. AUD/USD: inward remittance in USD for spot value date; load margin of 0.0010. USD/JPY: Forward purchase contract in JPY for 45 days forward; load margin of 0.25. USD/INR: Forward sale contract in USD with optional delivery period between 1M and 2M; load margin of 0.15, and indicate the hedge date. CHF/INR: Forward sale contract in CHF for 1M value date; load margin of 0.20. AUD/INR: Forward sale contract in AUD with 1M value date with optional delivery period in the fourth week, and indicate the hedge date. USD/JPY: Forward purchase contract in JPY with 1M value date with th optional period from 15 day to the maturity date; load a margin of 0.10, and indicate the hedge date. USD/INR: Cancellation of forward purchase contract in USD at 50.15 due in 15 days; indicate all the charges payable and receivable USD/CHF: Cancellation of forward sale contract in CHF at 45.25 due in 10 days; indicate all the charges payable and receivable AUD/USD: Cancellation of forward purchase contract in USD at 0.7545 due in 60 days; indicate all the charges payable and receivable USD/INR: Early delivery of forward purchase contract in USD at 50.43 due in 10 days; indicate all the charges payable and receivable USD/CHF: Early delivery of forward sale contract in CHF at 1.1545 due in 20 days; indicate all the charges payable and receivable EUR/USD: Late delivery of forward sale contract in EUR at 1.2825 by 1W; indicate all the charges payable and receivable USD/JPY: Late delivery of forward purchase contract in JPY at 102.35 by two days; indicate all the charges payable and receivable USD/INR: extension of forward purchase contract in USD (due in two days) for 6M; indicate charges payable/receivable under historical price rollover method and cancel-and-rebook method.

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18. EUR/INR: extension of forward purchase contract in EUR (due today) for 6M; indicate charges payable/receivable under historical price rollover method and cancel-and-rebook method. 19. USD/INR: Late delivery of forward purchase contract in USD at 50.55 by 1W; indicate all the charges payable and receivable 20. EUR/INR: late delivery of forward sale contract in EUR at 63.19 by 1W; indicate all the charges payable and receivable 21. USD/INR: late payment of export bill @ 50.70 and discounted at 7.5% by 30 days; indicate all the charges payable and receivable

130

Chapter 9 Trade Life Cycle and Best Practices Trade processing , like love-making, has three stages: pre-trade, trade and post-trade. And the excitement level in each stage is similar in both processes (a Process Manager in a Bengaluru BPO firm) …best practices are intended as goals, not binding rules…Given the differences in the size of the firms, it may be helpful to underscore that firms are not bound to integrate all of the recommended practices, but should use them as a benchmark for examining their existing practices. (Management of Operational Risk in Foreign Exchange, THE FOREIGN EXCHANGE COMMITTEE, 2004)

Information technology and straight-through-processing (STP) industry divide the trade life cycle into pre-trade, trade and post-trade stages. From business perspective, however, there are many stages and processes in the trade life cycle, and they differ from market to market. Best practices, on the other hand, differ from organization to organization even in the same market. This chapter will examine the forex trade process for interdealer business and a new business service called “FX prime brokerage”; and the best practices for both.

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Chapter 9

9.1. Organization Forex business is traditionally organized into two units: Sales & Trading and Operations. The current practice is to organize it into three units: front office, mid office and back office. Front Office The traditional Sales & Trading unit is now the front office. It is the risk management and sales unit. Risk management consists of taking risk (also called speculation), eliminating risk (also called hedging), insuring against risk (called risk insurance) and minimizing risk (through diversification). Depending on the nature of business they deal with, the front office staff is further categorized as follows. 

 



Proprietary (“prop”) traders: they execute trades on bank‟s own account with other dealers in the market. There will be profit if the speculation is successful; and loss, otherwise. Flow traders: they execute trades in commoditized products with institutional customers. The bid-offer spread is the profit in this business. Sales traders: they execute customized and structured products with corporate customers. The commission and margin are the profit in this business. Arbitrage (“arb”) traders: they look for risk-free profit opportunities across markets and products.

For engineering new products, there may be a separate “quant” team to assist the front office, but usually such product engineering is a cross-market function. In a word, the front office is the profit center of business. Mid Office Mid office is carved out from the traditional operations and credit staff. Its functions are risk measurement (but not management, which belongs to the front office) and performance evaluation. Both market risk and counterparty credit risk are handled by the mid office. It is the mid office that set the counterparty exposure limits. Performance evaluation consists of measurement in riskadjusted return (RAR) terms, attribution and benchmarking. Mid office may also handle other operations such as documentation, confirmation, P/L calculations, etc, but there is no uniformity in the industry. An independent and skilled mid office implies strong internal controls, which is the main defense against fraudulent trading and internal frauds.

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Trade Life Cycle and Best Practices

Back Office Back office is the traditional Operations unit. It handles much of the post-trade processing (e.g. confirmation, settlement, reconciliation, etc.). 9.2. Process Flow The process for interdealer business in forex market can be divided into different stages, as shown in Exhibit 9-1.

EXHIBIT

9-1: FX Trade Process Flow

Accounting & Financial Control

0

1

2

3

4

5

Investigations & Repairs Exceptions, Escalations Senior Management 0 = Pre-trade preparation 1 = Trade execution & capture 2 = Confirmation 3 = Netting 4 = Settlement 5 = Nostro reconciliation

Pre-trade Preparation Pre-trade preparation (also called “client on-boarding”) is a one-time process that establishes the business relationship with the counterparty. The parties will assess each other‟s technical sophistication and credit worthiness, and agree on operational practices and procedures. The general and legal terms of relationship are documented in a “master agreement”: an agreement that governs all future transactions between the parties. Such master agreement

133

Chapter 9

enables the parties to exchange a brief confirmation for each trade that contains only the economic terms of the trade without legal and relationship terms. For forex trades, there are several master agreements, as follows.     

International Currency Options Market (ICOM) master agreement International Foreign Exchange Master Agreement (IFEMA) Foreign Exchange and Options Master Agreement (FEOMA) International Foreign Exchange and Currency Options (IFXCO) master agreement International Swaps and Derivatives Association (ISDA) master agreement

ICOM was developed in 1992 and covered only forex option trades. IFEMA followed suit in 1993 and covered only spot and forward forex trades. In 1995, they were combined into a single agreement under FEOMA to cover spot, forward and option trades in forex. All of them were revised and updated in 1997 after a review of the legal enforceability of its provisions. For derivative trades in other markets (e.g. interest rate, equity, commodity, etc), ISDA developed its own master agreement in 1992, which covered options and non-deliverable forward (NDF) in forex market. The three industry associationsThe Forex Committee (FXC), ISDA and Emerging Market Traders Association (EMTA)jointly published standardized procedures and practices under “1998 FX and Currency Options Definitions”, which greatly simplified the drafting of trade confirmation. IFEMA and ISDA master agreement have gained acceptance in the market with the former for spot and forward forex trades and the latter for forex options and forex NDF. The subsequent market events (e.g. ASEAN currency crisis, collapse of LTCM and Peregrine, etc) led to the revision of ISDA master agreement in 2002. The FXC followed suit and consolidated the three forex master agreement into a simpler one under IFEXCO (pronounced “eye-fexcoh”) master agreement, which relies on the 1998 FX and Currency Options definitions. Trade Execution and Capture Trade is executed by the front office through different means: phone, voice broker, electronic order-matching or negotiated dealing systems (e.g. Reuters Dealing 3000, EBS) and Internet-based systems. The last may be proprietary or multi-dealer platforms. A popular proprietary platform is Deutsche Bank‟s

134

Trade Life Cycle and Best Practices www.autobahnfx.com for flow business and www.dbfx.com for retail speculators. The popular multi-dealer platforms are www.fxall.com and www.currenex.com.

After the trade execution, trade data (see Box 9-1) is captured in the front office systems. For trades executed on electronic or Internet-based systems, trade data flow automatically into front-office system. For trades executed over phone or through voice brokers, the trader inputs the trade data into the frontoffice system or records them in a deal ticket and passes it to the back office, which will input the trade data to the system. The front office system updates the position, gap and limits in real time and sends the trade data to other systems (risk, operations, etc.). The operations system will supplement the trade data with static data (see Box 9-1) required for further processing.

BOX 9-1:

Trade Data, Static Data, Market Data and Reference Data

Trade data is the data that is unique to each trade and therefore must be captured at trade level. Examples of such data are the counterparty and economic terms (e.g. price, amount and value date). Static data is the data that is unique to the counterparty and remains the same for all trades with the same counterparty. Since it does not change from trade to trade, it is not captured at trade level but stored separately and subsequently blended (“trade enrichment”) with the trade data during processing. Examples of such data are counterparty‟s settlement instructions, address, contact details, etc. Market data is the data that is unique to a business day and remains the same for all trades with all counterparts for that particular day. Examples of such data are official closing prices, interest rate fixings, etc. Reference data as a concept has emerged in recent years from the straight-through-processing (STP) industry. It is the data that remains the same for all trades, with all counterparties, and for all dates. Examples of such data are security identifiers (e.g. ISIN, CUSIP), SWIFT codes for currencies and banks, holidays at business centers, corporate actions in equity and fixed-income securities, etc. There has been an industry initiative to standardize such data to enable straight-through-processing (STP).

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Confirmation Trade confirmation establishes the legal basis for the trade and supplements the master agreement. For spot, forward and forex swap trades, the confirmation is simple and the process is automated. For trades executed in secured electronic and Internetbased dealing platforms, the parties may chose, on a bilateral basis, to replace the confirmation with electronic affirmation facility offered by these platforms. Under this facility, the back office may review and validate the trade data (“affirm”) after checking the details with those in the internal system. For NDF, exotic options and structured products (which are usually under ISDA master agreement), confirmation is quite complicated and is a subprocess within the documentation process. The confirmation may take up to a week or more, and the parties usually confirm the important details over phone before the formal confirmation. Netting There are different forms of netting and the form relevant here is payments netting (also called settlement netting), under which, all the payments and receipts from multiple trades due on the same day in the same currency and with the same counterparty are netted into a single amount. For example, we have USD 10 million payments and USD 12 million receipts with the same counterparty due on the same day. The two amounts are netted into a single amount of USD 2 million, which is settled (in this case we will receive from the counterparty). The settlement of USD 2 million will legally discharge both the parties from their obligation of making payment for USD 10 and USD 12 million. Netting must have legal sanction in the jurisdictions and is bilaterally negotiated. The master agreements (e.g. ISDA, IFEMA) contain provisions to automatically sanction bilateral netting. Netting is a tool to mitigate settlement risk as well as operational risk and costs. The scope of netting is extended to multiple parties (“multilateral netting”) in most payment and clearing systems for securities and cash. In many countries, there are special local clearing with multilateral netting for USD (e.g. FXCLEAR in India), which nets all USD payments locally into a single amount for each party, which is settled in New York clearing. The prestigious continuous-linked settlement (CLS) in forex also implements multilateral netting.

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Settlement Settlement is the process of paying to and receiving from the counterparty the foreign currency amounts through the nostro accounts maintained with the correspondent banks. If one of the currencies is a local currency, it is settled in the local clearing. The correspondent bank is advised of both payment instructions and expected receipts. Payment instructions are sent through SWIFT and must contain SWIFT address and account number of the counterparty‟s correspondent bank. Depending on the time zone of the payment center, payment instructions may have to be sent a day in advance. For example, banks in Europe and North America must send settlement instructions one day in advance for the Far East currencies. The differences in time zones will make the payment-versus-payment method of settlement impossible with conventional practices and technology. The delay between the payments in two currencies magnifies the settlement risk to Herstatt risk (see Section 3.1). The continuous-linked settlement (CLS) is a solution to mitigate the Herstatt risk and is discussed in Chapter 11. Nostro Reconciliation Nostro reconciliation is the last stage in the trade life cycle. Accounting entries will be passed (discussed in the next chapter) in internal records at different stages in the trade life cycle. Reconciliation consists of matching the entries in the internal records with those in the nostro account. Entries in the internal records record what should occur, and those in nostro account record what has occurred. If both of them match, then the trade has retired in the correct manner. Exceptions, Investigations, Repairs and Escalations Whenever the processing of a trade deviates from the established procedure, it is called exception, which is documented, investigated and the problem repaired or resolved. Such exceptions must be reported to the management, which is called escalation, on which there would be a policy. All exceptions have cost, impact profitability and elevate the operational risk. Therefore, they are comprehensively reviewed every quarter or year as to their causes and impact, leading to improvement through business process reengineering.

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9.3. Best Practices for Interdealer Business The Forex Committee (FXC) is an industry association sponsored by the Federal Reserve Bank of New York. It has issued a checklist of best practices in 1996, which was expanded and revised in 200410. There are 60 best practices in the 2004 edition, associated with every stage in the trade life cycle, as shown in the table below. Best Practices # 15 6  12 13  24 25  28 29  35 36  39 40  44 45  47 48  60

Stage in Trade Life Cycle Pre-trade preparation Trade execution and capture Confirmation Netting Settlement Nostro reconciliation Accounting & financial control FX Options and NDF General

1. Know your customer (KYC) This is the first line of defense and, at a minimum, should consist of the identity, business profile and reputation of the customer. In many countries, there are additional requirements under anti-money laundering laws. 2. Determine the documentation requirements and execute it prior to trading Master agreement, standard settlement instructions (SSI) and authorized signatory list must have been arranged prior to trading relationship. If trading should precede documentation for genuine reasons, there should be policy on such cases, which must be communicated to all staff in front office, mid office, back office, legal, compliance and audit departments. Electronic trading will require additional documentation for user identification and security issues. 3. Use master netting agreements Both payments netting and close-out netting should be incorporated, the former to mitigate settlement risk and the latter, to mitigate counterparty 10

Management of Operational Risk in Foreign Exchange, The Foreign Exchange Committee, 2004. See their website: www.newyorkfed.org/fxc

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credit risk. Such provisions must be incorporated in the master agreement, and the bank must ensure they are legally enforceable in the jurisdictions. 4. Agree on trading and operational practices Establish practices for the type of products and key operational practices (e.g. timeline for confirmation/affirmation, use of SSI, etc.) 5. Agree on documentation for special arrangements Third party payments (i.e. payment to an account other than the counterparty‟s) and prime brokerage (see Section 9.4) requires special documentation. 6. Record all trades, external and internal, as soon as they are executed It ensures that the real-time updates on position, gap and counterparty limits are available to the front office and mid office. Internal trades (i.e. those with own offices) have the same impact on risk, except for counterparty credit risk. 7. Use straight-through-processing When there are different systems for front office, mid office and back office, information flow between them should be automatic. It ensures that the data are accurate and timely and operations are less prone to error. Integrated applications should be preferred to piecemeal applications. 8. Monitor in real time the counterparty exposure limits and usage globally Real-time globally aggregated counterparty credit limits and usage must be made available to the front office and mid office. 9. Use standard settlement instructions (SSI) SSIs speed up the confirmation, enable straight-through-processing, and allow for formatted and readable SWIFT message. Changes in SSI must have a minimum of two weeks notice. 10. SSI is the responsibility of the back office Maintenance of SSI is back office function. When SSIs are not in place (e.g. for non-bank customers), the front office may record settlement in-

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structions in the deal ticket. Such non-standard settlement instructions must be checked by back office during confirmation stage. 11. Review amendments to trade data Amendment must be in a controlled manner, involving both the front office and the back office, regardless of who initiates the amendment. Bank must have written procedures on segregation of duties in amendments. This is a key control mechanism. All amendments must be reported to the management as exceptions. Amendments to forex swap after the near leg is settled requires extra caution since it will impact the P/L already booked. 12. Monitor off-market and deep in-the-money option trades Historical price rollover (see Section 8.10) and trades with off-market prices may require special confirmations, which will make a reference to the current market price. Sale of deep in-the-money options, too, requires careful monitoring. Though there may be genuine reasons for such transactions, they can be misused to exploit weakness in revaluation and accounting systems of the counterparty. Banks must have written policies to ensure appropriate level of review to guard against potential legal and reputational risks. 13. Confirm or affirm trades in a timely manner Trade should be confirmed within two hours after execution and in no event later than the end of the day for both external and internal trades. Exceptions to this rule must be documented and approved by compliance and management staff. Counterparties must either send out their own confirmation to the other or sign and return (“affirm”) the incoming confirmation. Merely receiving the counterparty‟s confirmation does not constitute the completion of confirmation stage. 14. Diligence in confirmation through non-secure means When unauthenticated electronic message is received, there should be a callback procedure to an authorized person, and the conversation should be on recorded telephone line. 15. Diligence in confirmation of structured trades Such confirmations are manually prepared and sent by non-secure media. Where ever possible, they should be drafted in standard templates of ISDA

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or EMTA. The confirmation must include non-standard price sources, disruption events, and the identity and role of “Calculation Agent.” 16. Diligence in confirmation through phone It should be done over recorded lines and between authorized persons, and followed by a written confirmation or callback procedure. 17. Establish controls for trades executed through electronic platforms Replace the traditional confirmation with validation against electronic front office system only under the following conditions: (1) trade data flows straight from front-office system to back-office system; (2) controls must exist that the flow of data is not changed and that data is not deleted; and (3) trade details are sufficient to validate the trade terms. 18. Verify expected settlement instructions The confirmation must include own settlement instructions and counterparty‟s. On receipt of confirmation, the settlement instructions must be matched with those on internal records. 19. Confirm all netted transactions All transaction in the netting set should be individually confirmed to avoid offsetting errors of including the wrong trade and excluding the right trade. 20. Confirm all internal transactions Internal transactions are not immune to errors and have the same impact on risk, except for credit risk. All standard procedures applicable to external transactions must apply to internal transactions, too. 21. Confirm all block trades and split allocations Block trade must be confirmed within two hours; and allocations for split, within four hours, and in no event later than the end of the day. 22. Review all third party advices Review of Reuters logs, EBS tickets, voice broker advices are not the primary method of confirmation but only for review, and such trades should be confirmed with the counterparty bilaterally.

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23. Automate confirmation matching process Automation will speed up confirmation, reduce operational risk and enable higher business volumes. The process should be controlled by establishing an automated confirmation tracking and follow-up system. 24. Establish exception processing and escalation procedures For unconfirmed and disputed trades, clear procedures must be established, and the control should never be left to the front office. 25. Use on-line settlement netting systems Correct calculation of net amounts improves cash management. 26. Confirm bilateral net amounts Third-party electronic payment & clearing systems (e.g. FXCLEAR in India) will inform both parties of the final amount. If such systems are not used, then the final net amount must be bilaterally confirmed. 27. Employ timely cut-offs for netting Trades that miss the deadline for netting must be settled on gross basis, and such cases should be incorporated in credit exposure systems to accurately compute the settlement risk and the counterparty credit risks. 28. Establish consistency between practice and documentation Credit exposure systems should not consider netting unless documentation supports netting. 29. Use real-time nostro balance projections To improve cash management, project real-time nostro balances after considering cancellations and amendments. 30. Send electronic messages to nostro agent for expected receipts Nostro agent should be given not only instructions for payments but also informed of expected receipts. It will help nostro agent identify the unmatched amounts early and correct the misdirected payments. However, some nostro agents may not be equipped with processing expected receipts.

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31. Use automated cancellation and amendment procedures Automated real-time communication system with nostro agent for cancellation and amendments of payment instructions will achieve the latest possible cut-off times for changes. 32. Implement timely payment cutoffs Bank should achieve the latest cutoff times for cancelation and amendments of payment instructions to the nostro agent; and the earliest possible time for the confirmation of final receipts. 33. Report payment failures to mid office Counterparty credit exposure limits must factor in the payment failures. 34. Understand the settlement process and settlement exposure Knowledge of when the payment instruction becomes irrevocable and the payment confirmation reached finality are essential for senior managers and operations staff. In forex trades, settlement risk is equal to the full amount of purchased currency amount and lasts from the time of payment instruction to the sold currency can no longer be canceled until the currency purchased is received with finality. 35. Prepare for crisis situation outside your organization Knowledge of each nostro agent‟s contingency operations and the alternative settlement procedure is essential for operations staff. 36. Perform timely nostro reconciliation It should be completed no later than the following settlement date. 37. Automate nostro reconciliation Electronic reconciliation ensures timely identification of differences. Escalation procedure for un-reconciled trades should be in place. 38. Identify non-receipt of funds from counterparties Policy on escalating such cases to the specified parties should be in place. Policy should also cover prioritizing cases, based on counterparty credit

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rating, payment amount, and frequency of failures. The counterparty should be checked against the internal watch list of counterparties. 39. Establish operational standards for nostro account users The nostro accounts are managed by the forex department, but also used by other business groups (e.g. fixed-income, equity, etc). Policy on funding the account (i.e. individual or group funding) must be in place. 40. Conduct daily general ledger reconciliation Daily reconciliation between back office system and front office system on one hand, and between back office system and general ledge on the other should be practiced. 41. Conduct daily position and P/L reconciliation Position reconciliation ensures that all trades executed by the front office have been correctly processed by the back office, along with the amendments. Discrepancy in P/L can imply differences in position or market data. Banks that use single integrated system should ensure that the market data source is properly controlled. 42. Conduct daily position valuation Position valuation should be done independently, preferably by the mid office. Quality of market data should be checked, particularly for less liquid products. For option products, the correct “volatility surface” must be used. 43. Review off-market trade prices Institute a procedure that provides for a review of such cases. 44. Use straight through processing for prices Electronic links from price sources to the position valuation systems ensures speedy and efficient valuation, and eliminates data entry errors. 45. Establish clear policy and procedure for the exercise of options Exercise notification to the counterparty should be through an independent electronic system, and designed to auto-exercise in-the-money options. Exercising staff should be independent of front office and back office. If the

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option processing is by a separate system, the forex trades resulting from option exercise should flow automatically to the back office system. 46. Obtain appropriate fixings for exotic and structured trades They should be obtained by the back office independent of the front office. 47. Closely monitor the option premium settlements Premium settlement reduces the chances of out-trades. 48. Segregate the duties The reporting line for the back office should be independent of that for the front office, mid office, financial accounting and audit. For key areas, the segregation must be implemented within the back office functions. Good practices include: (a) segregation between trade execution and confirmation/settlement; (b) segregation between posting and reconciliation access to the general ledger; and (c) separate database functions between the front office and the back office. 49. Ensure that staff understands business and operational role Everyone should understand the entire process flow, and “front-to-back” training should be encouraged. 50. Understand operational risks Understanding operational risk will lead to improved process flow and improved technology. 51. Identify procedures for introducing new products, new customer types, and new trading strategies They introduce new risks and new processes. All stafffront office, back office, mid office, credit, legal, compliance and technologyshould be involved when they are introduced. 52. Ensure proper model sign-off and implementation For quantitative trading models, the model validation and input & output reporting should be independent of the front office.

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53. Control system access Function-specific user access “profiles” are recommended. External user control for Internet-based systems should be as robust as internal user access controls. 54. Establish strong independent audit/risk control group Bank should implement policies and procedures that enable employees to raise concern anonymously. 55. Use internal and external operational performance measures Operational performance reporting should contain quantifiable metrics. Service Level Agreements (SLA) should be exchanged when outsourcing operations, which should clearly define, measure and report on the operational performance. 56. Ensure that service outsourcing conforms to industry standards and best practices Controls should be in place to monitor vendors in order to ensure that internal standards are met. 57. Implement globally consistent processing standards When there are multiple processing centers at different locations, they may use different systems or technology, but the standards and procedures (e.g. valuation) should be consistent. 58. Maintain records of deal execution and confirmation The length of time for keeping the records depends on the type of business and is also subject to local regulations. 59. Maintain procedure for retaining transaction records It should be based on tax, regulatory and legal requirements of the jurisdiction. 60. Develop and test contingency plans The plan should cover long-term and short-term incapacitation of trading, operations, system failure, communication failure between systems, and

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the failure of internal or external dependency. Emergency crisis teams and back-up sites should be established. During a disaster, the bank should inform all the counterparties about processing problems and provide them with the contact particulars of emergency crisis team. 9.4. FX Prime Brokerage Forex prime brokerage is a specialized service involving three parties: client, executing dealer and prime broker. The client executes the trade directly with executing dealer (also called “spoke bank” or “give-up bank”) in the name of prime broker. When informed of the trade, the prime broker accepts the trade by becoming counterparty to the trade and settles it directly with the executing dealer. At the same time, the prime broker enters into an offsetting contract with the client. Exhibit 9-2 shows the flows between the three parties.

EXHIBIT

9-2: Prime Brokerage

Client

trade

execution

Prime Broker

Executing Dealer

trade

Effectively, the client benefits from the market liquidity of executing with multiple executing dealers, but maintains a single counterparty relationship and settlement with the prime broker. Prime brokerage emerged during the early 1990s and gained momentum with standardized procedures and practices in the late 1990s. The clients are typically hedge funds, commodity trading advisors (CTA), asset management companies, pension funds and smaller banks. The prime brokers are large commercial banks (e.g. Deutsche Bank, UBS, etc.) and bulge bracket investment banks (e.g. Goldman Sachs, Morgan Stanley). For enabling the client to trade in the name of the prime broker, the latter will hold collateral from the former to secure the credit exposure in the trades. The client typically will have many sub-accounts, and the bulk trade (or block trade) with the executing

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dealer has to be split and allocated to the sub-accounts. As a value added service, the prime broker manages the split and allocation of block trade. Over time, some prime brokers have become a “one-stop shop” for many other services such as administration of client sub-accounts and reporting, cash management, mid office and valuation, etc. In recent years, driven by technology, prime brokers started offering trade execution via electronic communication networks. These platforms provide automated program trading facility by providing access to tradable prices via two-way message interface between the client‟s front office system and the forex market. In this electronic prime-broker model, there is an element of anonymity to the client because the executing dealer sees the name of prime broker and not the client. Process Flow The trade process in prime brokerage can be divided into the following stages, and are shown in Exhibit 9-3.

EXHIBIT

9-3: Process Flow in Prime Broker Trade

Client

 trade order & execution

Executing Broker

 notification  give-up  allocation

 confirmation Prime Broker

1. 2.

3. 4.

Client executes the trade with the executing dealer and informs (“notification”) the prime broker about the execution and allocation of block trade. Executing dealer informs the prime broker of the execution, which is called “give up.” The prime broker than “matches” it with the notification and either accepts or rejects the give-up, depending on matching status. If the give-up matches with notification, the prime broker confirms (“confirmation”) the trade to executing dealer and becomes the counterparty. Primer broker splits the block trade and allocates it to the sub-account and informs the client. This is called “allocation.”

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Documentation The industry has come out with a standard documentation to establish the legal relationships among the three parties in the form of two separate bilateral agreements: prime brokerage agreement and give-up agreement. Prime brokerage agreement is between client and prime broker. It sanctions that the client can execute the trade with executing dealers approved by the prime broker and that the prime broker becomes a counterparty to the executing brokers. The agreement specifies the allowable products and their maximum tenor; and the limits on position and settlement amount. The limits may be specified in the agreement or communicated subsequently and periodically by the prime broker. The collateral required to be maintained with the primer broker by the client, the key operational procedures, and the fees payable to the prime broker are also documented. Give-up agreement is between prime broker and executing dealer. It is executed as a master agreement and is supplemented with a “give-up agreement notice” for each client of the prime broker. The notice will identify the client and specify the permissible products, tenors and limits on them. The Foreign Exchange Committee (FXC) has published a Master Give-Up Agreement, which may be supplemented with another agreement called Compensation Agreement, which shall be between the executing dealer and the client. The Compensation Agreement is an additional protection for the executing dealer when the prime broker refuses to accept the trade. Value Proposition Prime brokerage offers benefits and opportunities for all the three parties. For the client, the benefits are market liquidity and price advantage from multiple executing dealers while maintaining a single counterparty and credit relationship with the prime broker. There is also optimization of resources by outsourcing much of back office and mid office work to the prime broker. For the prime broker, the benefit is non-fund fee income while securing the credit exposure with the client through sufficient collateral. It contributes to the strengthening of client relationship and establishing new clients. For the executing broker, the benefit is expanding trading relationships and increased execution volumes by transacting with less credit-worthy counterparties without enhanced credit risk or credit enhancement requirements.

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Best Practices The Foreign Exchange Committee (FXC) has brought out 22 best practices for prime brokerage, which are consistent with the recommendations of Counterparty Risk Management Group II (CRMG II) report. The following is the summary of best practices. 1.

Prime broker should update the give-up line as soon as the trade is accepted, and the updated utilization of limit should be made available to the executing dealers. 2. Prime broker should establish real-time credit exposure system to monitor open positions against the limit and the pending give-up trades. 3. Prime broker should establish procedure for credit limit breaches and document approval of limit exceptions. Persistent credit limit exceptions should prompt a review and possible adjustment to client limits. 4. Executing dealer should have tools to monitor open positions and limits against the pending trades. 5. Prime brokerage agreement and the master FX give-up agreement must clearly specify the following: transaction types, their tenors, credit limits, and the procedure to compute the credit limit. 6. All the three parties must have sufficient internal controls to monitor the transaction types, tenors and credit limits. 7. All the three parties should have processes to send and receive give-up notices, and the contact details of appropriate persons in a give-up relationship. 8. The client and the executing dealer should notify the details of trade execution within the time specified in the relevant agreement. 9. To the extent possible, the client and the executing dealer should use the electronic messaging system to the prime broker‟s electronic matching system. 10. Prime broker should notify the executing dealer and the client of the rejected trades that were not authorized within the time stipulated in the relevant agreement. 11. Prime broker should confirm the trade to the executing dealer only after matching the details with the notification from the client. Structured trades should be matched for all trade details. 12. Confirmation should be completed within two hours of execution and no later than the end of the day. Escalation procedures should be in place to resolve the discrepancies.

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13. Prime brokerage and give-up agreements should specify the party responsible for determination and notification of certain post-trade events in structured options (e.g. barrier breach, etc.). 14. Prime brokerage agreement should specify whether the primer broker will assume the basis risk arising from post-trade events in structured options or “pass through” it to the client. 15. The staff of prime broker and executing dealer should have been properly trained to handle post-trade events in structured options. 16. On the trades rejected by the prime broker because the details of the client and the executing dealer do not match, the dispute resolution should be between the client and the executing dealer. 17. Prime broker should inform the client and, if the give-up agreement so provides, the executing dealer of the details of mismatch. 18. Except in case of default, the client has the right of confidentiality in their identity, order and strategy. The client‟s confidentiality requirements must be assessed by the primer broker at the outset. In the absence of such agreement, the prime broker should assume that the client requires confidentiality. 19. Prime broker should establish control access to its systems regarding client give-up trades and positions. 20. Primer broker staff in client service and operations should understand the confidentiality requirements for each client. 21. Primer broker should perform due diligence, including anti-money laundering review, with respect to the client. 22. Prime broker should investigate complaints from executing dealers about the client‟s illegal or unethical practices. While there is no legal obligation, the prime broker should ascertain whether such activities impose legal and regulatory obligations for the prime broker.

Key Concepts Organization of forex business: front office (earlier called sales and trading), mid office, back office (also called operations). Front office: prop trader, flow trader, corporate sales trader, arbitrage trader Stages in trade life cycle: pre-trade preparation (one-time activity), trade execution & capture, confirmation, netting, settlement and nostro reconciliation; and accounting and financial control at different stages.

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Exceptions, investigation, repairs and escalation FX prime brokerage: client – prime broker – executing dealer Trade life cycle in prime brokerage: trade execution and notification (from client by client); give-up (by executing dealer); matching and confirmation or mismatch and rejection (by prime broker); allocation (by prime broker). Best practices: 60 best practices for interdealer business; and 22 best practices for prime brokerage business.

EXERCISES

Comment on the following practices as to whether they constitute the best practices or desirable for efficient operations. 1.

2.

3.

4.

5.

6.

7.

Bank has newly established a relationship with an important institutional client. The documentation and master agreement processes are being prepared but the client wants to put through a trade immediately. Can the trade the executed without documentation? There is a bottleneck in confirmation process. The operations manager has decided to skip the confirmation for internal trades (i.e. those with own offices) and take up confirmations with external counterparties. Is this practice acceptable? Justify the answer. The P/L calculations are performed independently by mid office and front office and they are reconciled daily. The market data is input by the front office since they are more knowledgeable about the market prices. Front office amends the trade data such that the amendment is beneficial to the bank. Though the front office has not informed the back office, the latter has noticed it, but since the amendment was beneficial, it was not captured as an exception and escalated to the management. The daily high-low range for EUR/USD was 1.25 – 1.27. Front office has executed four trades: (a) Bought EUR @ 1.23; and (b) Bought EUR @ 1.28; (c) Sold EUR @ 1.24; and (d) Sold EUR @ 1.29. Which of them requires investigation? Front office recorded the settlement instructions in the deal ticket that are different from those in static data (i.e. SSI). Should the confirmation contain the settlement instructions in the deal ticket or SSI from static data? The counterparty has neither sent the confirmation nor affirmed our confirmation, and the settlement is due tomorrow. The back office called up

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the counterparty over phone and confirmed the particulars. Is this acceptable? 8. A forex swap trade has been amended after the near leg has been settled. What are the earlier reports that were wrong because of this amendment? 9. Between its own business continuity plan (BCP) and its nostro agent‟s, which is more important for the back office staff to study? 10. In the settlements, there are three purchases totaling to USD 15 million and two sales totaling to USD 12 million. After payments netting, an amount of USD 3 million is receivable. In the pre-settlement confirmation, will you confirm USD 3 million or USD 12 million or USD 15 million? 11. In a trade mediated by a broker, the trade data in broker advice match with that in the deal ticket. The counterparty has neither confirmed not affirmed the trade. Since the broker advice matches with our confirmation, no further confirmation was followed up with the counterparty. 12. What are the potential problems if the same person is allowed to post the entries and reconcile them?

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Chapter 10 Accounting It [true and fair view] was the most inviolate of the four golden principles of accounting (and the only one not beginning with the letter C: the other three being continuity, consistency and conservatism). ( TIM HINDLE, Guide to Management Ideas and Gurus) So controversial has accounting become that even John McCain [the Republican candidate for the American presidency], a man not known for his interest in balance sheets, has an opinion (The Economist, Sep 18, 2008)

Forex accounting has different perspectives, and this chapter deals with only one of them. It is not about the following.   

Accounting from the perspective of corporate treasurer Accounting for translation gain/loss of foreign investments in home currency, which is dealt by FASB 52 (US) and IAS 21 (EU) standards Special accounting for derivatives, which is dealt by FASB 133 (US), IAS 39 (EU) or AS 30 (India) standards.

It is about accounting for forex trades for their actual cash flows in the books of a forex dealer conducting interdealer and commercial transactions.

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10.1. General Flow for Transactions The forex trade starts in the position and ends in the nostro account; and is laid to rest when its entry in Nostro A/c entry is reconciled with its complement in the Mirror A/c. Before reaching its final destination in nostro account, it may be held in suspense accounts or as an off-balance-sheet item. Collection Register Trades for which the rate of exchange between the two currencies is not fixed as yet will not be entered in the position. Examples of such trades are foreigncurrency denominated collection items (e.g. clean instruments, export bills, import bills). Collection items are recorded as memo items in a register (“Collection Register”) and held there until they are realized and their conversion into local currency is fixed with the customer. Collection register is maintained currency-wise and separately for purchases (e.g. clean instruments, export bills) and sales (e.g. imports). The following is the sample format. Currency: USD Market Side: Purchase Item: Export Bill S No Date Details (drawer, Collection Realization Balance drawee, etc) Amount Amount

The “amount” in Collection Register is the foreign currency amount, and there will be no equivalent local currency amount because the rate of exchange is not yet fixed. When the bill is received for collection, it is posted under “Collection” column and added to the Balance; and when it is realized, it is posted under “Realization” and deducted from the Balance. Therefore, the amount under “Balance” column indicates the outstanding amount under collection at a point of time. Position All trades for which the rate of exchange between the two currencies is fixed will enter the position, and it marks the beginning of its accounting life cycle. The purpose of the position is to indicate the extent of price risk that the bank is exposed to at any point of time. This is the reason why the trade is first recorded in the position. Position is maintained currency-wise and independently by front office and back office.

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Front office maintains the position in “Dealer‟s Pad” (see Section 4.6), which contains the skeletal details (e.g. amount in thousands or millions, etc.). Back office maintains the position with complete trade details. Besides the two actual currencies involved in the trade, the home currency equivalent amount is also recorded. For example, consider the following EUR/USD trade in the books of an Indian bank whose home currency is INR. In the EUR/USD trade, the bank has purchased EUR 1 million at the price of 1.5000. The deal amounts are EUR 1 million (overbought/OB) and USD 1.5 million (oversold/OS). The position would be recorded in EUR and USD as follows. Currency: EUR Description Trade Ref 00000

Purchase

Currency: USD Description Trade Ref 00000

Purchase

Sale

1,000,000

Position 1,000,000 (OB)

Sale

Position

1,500,000

1,500,000 (OS)

Though INR is not involved in the trade, the equivalent INR amount must be recorded for each of them because the assets and liabilities are to be accounted in the home currency. The equivalent home currency is derived by employing “wash rate”, which is discussed in the next section. From the position, the trade is posted into the various accounts, depending on the nature of the trade. If both currency amounts in the trade are settled on the same day as the trade date, the trade is posted into the mirror A/c, which is a general ledger account. If one currency amount is settled immediately and the other is settled on a future date, it implies that there is a financing component in the transaction, and therefore it is posted in a suspense account. If both currency amounts are to be settled on a future date, it is posted in offbalance-sheet item. Suspense Account Suspense account is used to record and store trades in which one currency amount is settled and the other currency amount is yet to be settled. All trades in which there is a financing (“discounting”) by banks falls under this category, as explained Chapter 8 (see Section 8.5 and footnote 9). Typically, such transactions are foreign clean instruments and foreign currency export bills discounted by the bank. In these transactions, the bank has paid the home currency amount but will receive the foreign currency equivalent on a future

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date. After the foreign currency amount is realized, the item is reversed in this account and released to the mirror A/c. The suspense accounts may be designated as Foreign Clean Instruments Discounted A/c and Export Bills Discounted A/c. The account is maintained currency-wise in the following format, with amount recorded in both foreign currency (FC) and home currency (HC). Date

Details

Discounted FC HC

Realized FC HC

Balance FC HC

Note that all the items in suspense accounts are purchase transactions for the bank. Off-balance-sheet items All forex trades for which the rate of exchange between the two currencies is fixed but will be settled on a future trade will be recorded as off-balance-sheet items. All forward contracts belong to this category. They are maintained currency-wise and separately for forward purchase contracts (FPC) and forward sale contracts (FSC) in the following format, with amounts recorded in both foreign currency (FC) and home currency (HC). Date

Details FC

Booked HC

Delivered FC HC

Balance FC HC

When the contract is booked, the amount is added to the Balance. On delivery of the contract, the item is deducted from the Balance and released to the mirror A/c. If the forward contract is cancelled, the amount is deducted from the Balance, but not released into the mirror A/c. The charges payable/receivable on cancellation (see Section 8.9) are credited/debited to a general ledger account and brought into the P/L account on the balance sheet date. Similarly, all charges on extension/rollover, early delivery and late delivery are credited or debited to the same general ledger account. The amount outstanding in FPC and FSC accounts on the balance sheet date are disclosed in the Notes to the Accounts. Other General Ledger Accounts Single-currency items like brokerage payable, interest (in home currency) payable and receivable on settlement fails are accounted in separate general ledger accounts, and their balance is brought into the P/L account on the bal-

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ance sheet date. Interest payable/receivable in foreign currency for settlement fails are first recorded in the Position and then released into the Mirror A/c. Mirror Account Mirror A/c (also called “ledger A/c”) is the ultimate destination for all forex trades. It is called “mirror” because it mirrors the entries in the nostro A/c: debits in Mirror A/c will correspond to the credit in Nostro A/c, and vice versa. Purchase transactions (i.e. those in which the bank buys foreign currency) will be credits and sale transactions will be debits in the Nostro A/c. Therefore, to mirror these entries, purchases will be released into the Mirror A/c as debits and sales as credits. Mirror A/c will be maintained for each Nostro A/c and each entry in it will have both foreign currency and home currency amount. In contrast, Nostro A/c will show only the foreign currency amount. The prudent principle in releasing entries into Mirror A/c is that there must be a prior credit in Nostro A/c before the corresponding debit is raised in Mirror A/c; and credit must be released into Mirror A/c before the corresponding debit takes place in Nostro A/c. Exhibit 10-1 shows the accounting flow for trades.

EXHIBIT

10-1: Accounting Flow

Position Purchases

Discounted purchases

Suspense A/c

FPC A/c

FSC A/c

Sales On delivery

On payment

Dr Cr

Dr

Mirror A/c

Dr

Cr

Cr Dr

Cr

Nostro A/c

Cr

Dr

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10.2. Wash Rates Forex trades not involving home currency11 must still be accounted in home currency in the books. The home currency equivalent is derived by employing the “wash rate” for the trade, which is in addition to the actual trade price/rate. Consider the EUR/USD trade example referred to in the previous section. The bank, whose home currency is INR, has bought EUR 1 million at 1.5000. The wash rate that is to be applied to this trade is the market price of BC/QC currency pair prevailing at the time of the trade, where BC is the base currency of the trade (in our example, EUR) and QC is the home currency of the bank (in our example, INR). Assuming that the prevailing EUR/INR market price is 75, the INR-equivalent of the trade is INR 75 million, which is posted in the Mirror accounts of both EUR and USD, as follows. EUR Mirror A/c EUR Cr

Dr

Balance

Dr

(1,000,000)

75,000,000

USD Cr

Balance

Dr

1,500,000

1,500,000

1,000,000

INR Cr

Balance (75,000,000)

USD Mirror A/c Dr

INR Cr

Balance

75,000,000

75,000,000

When the trade is squared up by an offsetting trade subsequently, the wash rate for the closing trade may be the same as that for the opening trade or the market price of EUR/INR prevailing at the time of the closing trade. The former is preferred because it reflects the actual profit/loss amount. Assuming that in the closing trade, the bank has sold EUR 1 million at 1.5100, the profit from the trade is: (1.5100  1.5000)  1,000,000 = USD 10,000. The market price of EUR/INR prevailing at the time of closing trade is, say, 75.50. Consider now the impact of different wash rates for the closing trade on the accounting entries in the Mirror accounts. The first pair of tables below applies the same wash rate (i.e. 75.00) as that for the opening trade while the second pair of tables applies the wash rate of 75.50. 11

Currency pairs in which both currencies are foreign currencies are called “switch” trades by Foreign Exchange Dealers Association of India (FEDAI), a self-regulatory organization in India.

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EUR Mirror A/c (wash rate of 75.00 for both trades) EUR Dr Cr Balance Dr 1,000,000 1,000,000

(1,000,000) 0

1,510,000

1,500,000 10,000

Balance

75,000,000

(75,000,000) 0

75,000,000

USD Mirror A/c (wash rate of 75.00 for both trades) USD Dr Cr Balance Dr 1,500,000

INR Cr

INR Cr 75,000,000

75,000,000

Balance 75,000,000 0

The balance is zero in EUR and INR and debit (i.e. asset) of 10,000 in USD, which corresponds to the actual profit. Instead, if we use different wash rate of 75.00 for opening trade and 75.50 for the closing trade, the accounting entries will be as follows. EUR Mirror A/c (wash rate of 75.00 and 75.50) EUR Dr Cr Balance Dr 1,000,000 1,000,000

(1,000,000) 0

1,510,000

1,500,000 10,000

Balance

75,500,000

(75,000,000) 500,000

75,000,000

USD Mirror A/c (wash rate of 75.00 and 75.50) USD Dr Cr Balance Dr 1,500,000

INR Cr

INR Cr 75,000,000

75,500,000

Balance 75,000,000 (500,000)

The zero balance in EUR and the debit/profit of 10,000 in USD are correct, as earlier. The INR equivalent in EUR is a loss of 500,000 and that in USD is a profit of 500,000, both of which, though offsetting, are fictitious. Thus, when we use different wash rates, the currency-wise profit/loss will have fictitious but offsetting entries. In such cases we should consider only the aggregate profit/loss across all currencies and not the currency-wise profit/loss. 10.3. Position Reconciliation Every forex trade is first booked in position on trade date and finally recorded in Mirror A/c on settlement date. After trade date, pending settlement, they are parked in suspense accounts or as off-balance sheet items. Therefore, the sum of balance in suspense accounts, off-balance-sheet items and Mirror A/c must be equal to the balance in position, for each currency.

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Suspense account is only for purchase transactions and only those purchases that the bank has financed. Since only purchase transactions are accounted here, the balance will always be overbought/debit in this account. There may be different subsidiary accounts for operational convenience and control. For example, separate suspense accounts for clean instruments, export sight bills, export usance bills, etc. Off-balance-sheet items are forward trades, which are accounted separately for purchases and sales. The balance in forward purchase contract (FPC) A/c will be always overbought/debit and that in forward sale contract (FSC) account will be always oversold/credit. There may be subsidiary accounts under FPC/FSC, such as FPC-interdealer A/c, FPC-commercial A/c, etc. Mirror A/c balance may be in debit or credit, depending on how many items have reached the Mirror A/c and how many are held in suspense accounts or as off-balance-sheet items. If the following relation is satisfied for the outstanding amounts in each account, then the accounting flows are correct. Position = Suspense A/c + FPC A/c + FSC A/c + Mirror A/c. The above check is called position reconciliation and made at the close of every day by the back office. 10.4. Mark-to-market/Revaluation Whereas the trading book is generally marked to the market at daily intervals, the entire forex book (i.e. trading and commercial books) is marked to the market at monthly or weekly intervals. This exercise is called “revaluation” and is meant for assessing the profit/loss in the operations. The accounting entries for profit/loss, however, are passed at longer intervals of quarter or year. The mark-to-market/revaluation exercise involves liquidating the foreign currency balances in mirror, suspense, FPC and FSC accounts at the prevailing market price. The difference between the liquidation value and book value (in home currency) is the realized profit/loss. The appropriate market price is the price relevant to the maturity of the trade. Mirror A/c represents the settled transactions and therefore the appropriate rate is the spot rate. The outstanding trades in suspense, FPC and FSC accounts are forward trades with different maturity dates; and liquidated at forward prices relevant to their maturity. Traditionally, forward trades are bucketed into maturity buckets (of weeks, months, etc), and one price is used for all trades in the same bucket. In India,

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Foreign Exchange Dealers Association of India (FEDAI) recommends calendar month as the unit for maturity buckets and the market price for end-of-themonth as the revaluation price. Such a procedure greatly distorts the profit/loss because the trade maturing on first of the month and the last of the month are liquidated at the same price. The profit margins in most commercial transactions is about 0.02 – 0.1%, and the difference in the market price between the first and last day of the month can be 0.3%. Forex swaps for the “turn” periods (see Section 6.8) will be similarly distorted. Reducing the bucket width to shorter interval (e.g. week) and using the market price for the middle-of-thebucket period will lessen such distortions. Of course, the better solution is to take the appropriate market rate for each trade separately, which is possible in the current environment of high automation. Many software applications implementing value-at-risk (VaR) follow such an approach. Another source of distortion in profit/loss during revaluation is that the profit/loss from mirror A/c (“ready profit/loss”) is realized and crystallized; and the profit/loss from the forward maturity buckets (“forward profit/loss”) is realized but not crystallized. This poses a problem: should be consider only the ready P/L and ignore the forward P/L? Should we consider both? There are different market practices, as follows.   

consider only the ready P/L and ignore the forward P/L consider both ready and forward P/L consider ready P/L, provide for forward loss and ignore forward profit

The first is wrong; the second is right; and the third is conservative. Let us illustrate them with the following example. On May 22, a bank in India has started its forex business and the first trade is a funding swap to keep working balance in USD nostro account. The swap is B-S in USD against INR for the period from May 22 to June 30, as follows. Buy USD 1m @ 50.00 against INR value date May 22 Sell USD 1m @ 50.39 against INR value date Jun 30

(near leg) (far leg)

The swap was at a gain of INR 0.39 per USD or INR 390,000 for the deal amount. There is no position and hence there will be neither profit nor loss from subsequent changes in USD/INR price. Consider now the revaluation at the end of May, when the mid market prices are: Spot Forward outright for Jun 30

49.50 49.79

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The near leg is already settled and therefore will be in the mirror A/c. The far leg will be outstanding in Forward Sale Contract (FSC) A/c. Assuming that the maturity buckets are months, the following will be the balance, book value and liquidation value of mirror A/c and FSC A/c. A/c Mirror A/c FSC A/c Total

USD (1,000,000) 1,000,000 0

INR

Liquidation Price Amount

(50,000,000) 50,390,000 390,000

49.50 49.79

49,500,000 (49,790,000)

P/L (500,000) 600,000 100,000

We know for sure that the funding swap resulted in a gain of INR 390,000 (which is the difference in INR amounts in Mirror A/c and FSC A/c). Of course, this is not the net P/L because the interest cost on INR funds outlay in the swap is not considered. We will ignore the funding cost in INR and focus only on profit/loss from the sole forex swap trade. In any case, there is no position in USD and therefore the subsequent changes in USD/INR should not result in any profit or loss. On the revaluation date, because of splitting the two legs of swap into two maturity buckets and revaluing them separately, we have overbought/debit position in Mirror A/c and oversold/credit position in FSC A/c due on the last day of June. The overbought position is liquidated at the market price of 49.50, which results in a ready loss of INR 0.5m (INR received in liquidation is less than the book value). The oversold position is covered at the market price of 49.79, resulting in a forward profit of INR 0.6m (covering required lesser INR than the book value). Consider now the three different P/L methods and their P/L amounts. Book only ready P/L Book both ready and forward P/L Book ready P/L, provide for loss but ignore profit in forward

0.5m (loss) 0.1m (profit) 0.5m (loss)

As stated earlier, the first method is wrong; the second is right; and the third is conservative. We know for sure that there cannot be any loss and there is no loss because there is no position. The revaluation splits the position into multiple units (e.g. Mirror A/c, suspense A/c, etc), which results in gain on one date and a compensating loss on another. The second method is right because it incorporates the offsetting gain and loss on different value dates. But why does the profit of INR 0.1 million in this method differs from the actual swap gain of INR 0.39 million? The latter is the

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realized gain and will crystallize if we continue with the trade until the settlement of the far leg on Jun 30. However, if we liquidate the bank on the revaluation date, the realized gain will not be fully crystallized because we need to execute a reversing S-B swap from May 31 to Jun 30 in liquidation. In the reversing swap, we will be paying a swap loss of INR 0.29 per USD (i.e. the difference between the prices for May 31 and June 30) or INR 0.29 million for the deal amount. Offsetting this with the earlier gain of INR 0.39 million, the realized and crystallized gain will be INR 0.1 million. Thus, the sum of ready and forward P/L represents the realized and crystallized P/L as of revaluation date. The third method is conservative, and better than the first method but not a true and fair view. It is better than the first method because in certain cases, it is closer to the true and fair view. To illustrate it, consider the market prices of 50.50 and 50.79 for spot and June 30, respectively, and use them for revaluation of our earlier examples. It results in the following P/L. A/c Mirror A/c FSC A/c Total

USD (1,000,000) 1,000,000 0

INR

Liquidation Price Amount

(50,000,000) 50,390,000 390,000

50.50 50.79

50,500,000 (50,790,000)

P/L 500,000 (400,000) 100,000

The first method results in a fictitious profit of INR 0.5m while the second and third methods result in the correct profit of INR 0.1m. As the quotation at the beginning of the chapter says, the true and fair view is the most inviolate of the four principles of accounting (continuity, consistency, conservatism, and true and fair). Therefore, the second method should be preferred to the first and third methods. Let us end this chapter by summarizing the three sources of distortion on revaluation profit/loss. 1.

Currency-wise profit/loss is not meaningful because the use of wash rates (and their subsequent price changes) can create fictitious profit in one currency and a compensating loss in another. Therefore, only the aggregate profit/loss over all currencies will give the true view.

2.

Within a currency, the ready and forward profit/loss is not meaningful because of splitting the position across various maturity dates. The changes in spot price can create fictitious profit in one maturity and a compensating loss in another. Therefore, only the aggregate profit/loss over all maturity dates will give the true view.

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3.

For the purpose of revaluation, the ideal solution is to value each trade at the market price relevant to its maturity. If this is not feasible, then positions must be classified into narrow maturity buckets (say, weeks) and the revaluation price must be the price relevant to the middle of the bucket period. Wider maturity buckets (e.g. months) and using the end-of-the-period revaluation price for each bucket can greatly distort the profit/loss, and such distortion can be more than the profit margins loaded in the commercial transactions.

Key Concepts Position and Mirror A/c are the beginning and end of the trade accounting. All trades contracted are recorded in the Position on trade date; and all trades settled are recorded in the Mirror A/c on settlement date. Pending settlement, the trades are parked in suspense account for financed trades and as offbalance-sheet items for forward trades. The sum of balances in suspense account, off-balance-sheet items and Mirror A/c must be equal to the balance in Position. This check is called position reconciliation. Wash rates are used for trades not involving home currency to determine the home currency equivalent of the trade. Currency-wise and maturity-wise profit/loss are not reliable. Only the aggregate sum of profit/loss at all maturity dates and over all currencies will give a true and fair view of profit/loss.

EXERCISES

1.

In the Mirror A/c (and also other accounts), the balance of foreign currency and its home currency equivalent should be on the same accounting side: both of them are debits or both of them are credits. This is because the home currency amount merely indicates the equivalent of foreign currency. If the foreign currency amount is an asset, so must be the home currency equivalent, and vice versa. However, in one particular case, it is found that the GBP Mirror A/c is showing debit for GBP amount and credit for home currency equivalent; and EUR Mirror A/c is showing credit for EUR amount and debit for home currency equivalent. Is such a situation possible?

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2.

On May 22, the bank has commenced the forex business and executed the following transactions. a.

USD/INR: Bought USD 1m @ 50.00 value date cash. This is the first leg of funding swap. b. USD/INR: Sold USD1m @ 50.22 value date Jun 30. This is the second leg of funding swap. c. EUR/USD: Bought EUR 1m @ 1.2576 value date spot. This is the originating proprietary trading transaction. d. GBP/USD: Sold USD 5m @ 1.6575 value spot. This is the originating proprietary trading transaction. e. USD/INR: Bought USD 504,279 @ 50.04 value date Jun 14. This is a commercial transaction of export bill discounted. f. USD/INR: Sold USD 500,000 @ 50.01 value date spot. This is a hedge transaction for (e) to eliminate position. g. JPY/INR: Sold JPY 500m @ 50.59 (quoted as INR per 100 JPY) value date Jun 30. This is a commercial forward sale contract with a customer. h. USD/JPY: Bought JPY 500m @ 99.72 value date spot. This is a hedge transaction for (g) to eliminate position partially. i. USD/INR: Bought USD 5m @ 49.98 value date spot. This is a hedge transaction for (g) to eliminate the residual position after (h). j. EUR/USD: Sold EUR 1m @ 1.2591 value date spot. This is the reversing proprietary trading transaction, which squares up the (c). k. GBP/USD: Bought USD 5m @ 1.6571 value date spot. This is the reversing proprietary trading transaction, which squares up the (d). l. USD/INR: Bought USD 0.5m @ 50.00 value date spot. This is the first leg of hedging swap for (e) to eliminate gap. m. USD/INR: Sold USD 0.5m @ 50.06 value date Jun 14. This is the second leg of hedging swap for (e) to eliminate gap. n. USD/INR: Sold USD 5m @ 50.01 value date spot. This is the first leg of hedging swap for (g) to eliminate gap partially. o. USD/INR: Bought USD 5m @ 50.24 value date Jun 30. This is the second leg of hedging swap for (g) to eliminate gap partially. p. USD/JPY: Sold JPY 500m @ 99.78 value date spot. This is the first leg of hedging swap for (g) to eliminate gap fully. q. USD/JPY: Bought JPY 500m @ 99.38 value date Jun 30. This is the second leg of hedging swap for (g) to eliminate gap fully.

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Based on the above transactions, answer the following. i. ii.

iii.

What is the Position in USD, EUR, GBP, JPY and INR? Post the entries in suspense A/c (in this case Export Bills Discounted A/c) , off-balance-sheet items (FPC A/c, FSC A/c) and Mirror A/c for each currency. Revalue the books as of May 31, assuming the following market prices (use monthly maturity buckets and use the end-of-bucket period price for revaluation). Spot USD/INR EUR/USD GBP/USD USD/JPY Outright for Jun 30 USD/INR EUR/USD GBP/USD USD/JPY

50.25 1.2765 1.6790 103.05 50.40 1.2761 1.6780 102.75

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Chapter 11 Continuous Linked Settlement CLS settlement is the only means by which settlement risk can be eliminated with finality using a unique combination of payment versus payment in central bank funds, multilateral payment netting and a standard legal framework, supported by a robust and resilient infrastructure. (from the home page of CLS Group website, http://www.cls-group.com ) Share of various methods in FX settlements: CLS, 55%; traditional correspondent banking, 32%; bilateral netting, 8%; and others, 5 %. (Progress in Reducing Foreign Exchange Settlement Risk, May 2008, CPSS, Bank for International Settlement)

Continuous linked settlement today is the only global payment system that operates on payment versus payment (PvP) basis for cross-border settlements in 17 currencies. It combines the best elements from different domains: mission critical technology, straight-through-processing, multilateral netting, real-time settlement and settlement finality. The elevated settlement risk in forex (“Herstatt risk”) is introduced in Section 3.1. The forex settlements were disrupted by the failures of Bank Herstatt (1974), Drexel Burnham Lambert (1989), Bank for Credit and Commerce International (1991) and Barings Bank (1995). The Committee on Payments and Settlements Systems (CPSS) of Bank for International Settlements (BIS) has

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been regularly examining the safety and efficiency of payment systems, which resulted in various reports: Angell Report (1989), Lamfalussy Report (1990), Noel Report (1993) and Allsopp Report (1996). 11.1. Settlement Risk in Forex Allsopp Report focused specially on the settlement risk in forex transactions. It provided, for the first time, a measure for settlement exposure and linked it to the five categories of settlement status, as follows. Status Revocable (R) Irrevocable (I)

Uncertain (U)

Fail (F) Settled (S)

Description Payment instruction for sold currency is not issued or, if issued, cancellable Cancellation of payment instruction for sold currency is not possible; and the payment from the counterparty for bought currency is not yet due Payment from the counterparty for bought currency is due but no information about the finality of its receipt Payment of bought currency is not received from counterparty Payment of bought currency is received with finality

Exposure None Bought currency amount

Bought currency amount Bought currency amount None

Exhibit 11-1 shows the timeline for various settlement statuses of the trade. The “payment” is for the sold currency amount and the “receipt” is for the bought currency amount.

EXHIBIT

11-1: Timeline and Duration of Settlement Status for Trade

Trade Date

Deadline for cancellation of payment instruction

R

I

Receipt of amount due

U

Identify final or failed receipt

F or S

The duration of each status depends on the currency pair and the market side (i.e. bought or sold). The following table shows the average duration (in hours) for the three most actively traded currencies against USD.

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Continuous Linked Settlement

Currency EUR GBP JPY

USD sold I U 9 13 9 15 5 20

USD bought I U 22 8 24 8 33 8

Source: Progress in Reducing FX Settlement Risk, BIS, May 2008

In reality, there are more risks to settlement, namely, counterparty credit risk, liquidity risk and systemic risk. Counterparty credit risk (formerly called pre-settlement risk) arises during the Status R period (i.e. between the trade date and the time the payment instruction for sold currency becomes irrevocable). It arises because, if the counterparty fails during this period, we need to replace the original contract with a new contract at the prevailing market price. The difference between the prevailing market price and the original contract price is the replacement cost and the size of counterparty credit risk. When the settlement status is F, we need to arrange for additional funding, which is the liquidity risk. If the settlement fails are widespread, there is a possibility that the entire settlement process might come to halt because of domino effect, which is the systemic risk. Allsopp Report recommended a three-pronged strategy to reduce settlement risk in forex: (1) action by individual banks to improve their risk controls and operational practices; (2) action by industry groups to adopt risk-reducing settlement services such as multi-currency and multilateral netting; and (3) action by central banks to induce the industry pursuing the required strategies by improving the national payments systems. 11.2. Evolution of Continuous Linked Settlement The industry responded with various initiatives. FXNET, Valuenet and SWIFT Accord pursued bilateral netting arrangements under standardized agreements (e.g. IFEMA). Exchange Clearing House (ECHO) and Multinet pursued multilateral netting. In 1997, a group of 20 banks (“G20”) from eight countries formed the company, CLS Services Ltd (CLSS), to provide PvP services by means of “continuous linked settlement”. The “continuous” means that the settlement runs continuously in the specified time-window until all the currency time zones are covered; and the “linked” means that the payment made for sold currency is linked to the payment to be received for bought currency. Either both of them are settled or none of them is settled. Continuous linked settlement is different from trade guarantee. In the

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latter, the settlement is guaranteed; in the former, the principal amount is guaranteed, but not the settlement. If the settlement fails, the non-defaulting party will not lose the principal but has to replace the trade at the prevailing market price, which is subject to the loss of replacement cost. The jurisdiction for incorporating CLSS was narrowed to US or UK, based on the enforceability of settlement finality and security interest. The concern about the possibility of the Office of Foreign Asset Control (OFAC) in the US blocking the foreign banks‟ funds with CLSS for political reasons led to the UK as the choice for incorporating CLSS. To implement PvP settlement, CLSS must maintain accounts with central banks to access the real-time gross settlement (RTGS) system for each currency. In many countries, banking status is required to maintain accounts with the central bank. Therefore, CLSS formed two subsidiaries in 1999: CLS Bank International (CLSB), which is incorporated in New York as a special purpose multi-currency bank subject to the regulatory oversight by the Federal Reserve; and CLS Operations in the UK to provide operational support and IT infrastructure. For tax reasons, there was a corporate restructuring in 2000 under which a new holding company, CLS Group Holdings AG, was incorporated in Switzerland, which was regulated by the Federal Reserve as a bank holding company. CLSS became a shell company and its name changed to CLS UK Holdings Ltd, which operated through two subsidiaries: CLS Bank International, a special purpose bank in the US; and CLS Services Ltd (formerly CLS Operations Ltd), in the UK to provide operational support. Exhibit 11-2 shows the corporate structure.

EXHIBIT

11-2: CLS Corporate Structure

CLS Group Holdings (Switzerland)

CLS UK Holdings (UK) (shell company)

CLS Bank Intl. (US)

CLS Services (UK)

The acronym “CLS” is a registered trademark and may be used only with CLS Bank International (CLSB) or CLS Services (CLSS) Ltd. The phrase “continuous linked settlement” is not a registered trade mark, however.

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11.3. Operations After time and cost overruns of 25 months and 130%, respectively, CLSB started operations in September 2002 with seven currencies, which were increased to 17 currencies over time, as follows. Sep 2002 Sep 2003 Dec 2004 May 2008

AUD, CAD, CHF, EUR, GBP, JPY and USD DKK, NOK, SEK and SGD HKD, KRW, NZD and ZAR ILS and MXN

Currently, six instruments are settled in each CLS currency: FX spot, FX forward, FX swap, FX option premium and exercise, non-deliverable forward (NDF) and credit derivatives. The first three involve settlement in two currencies on PvP basis. The last three involve payment in a single currency, which does not require PvP requirement, but CLSB provides value-added services (e.g. automated confirmation/exercise notice) in the instruments. In each of the CLS currencies, CLSB makes and receives payment with its members in the RTGS system through its accounts with central banks. CLSB has two types of members: settlement member and user member. Settlement Members: they maintain a single multi-currency account with CLSB and assume responsibility for settlement risk and providing liquidity. For this reason, only large financial institutions can be settlement members, and CLSB has prescribed certain qualifying criteria. User Members: they maintain a single multi-currency account with a settlement member, but can submit settlement instructions directly to CLSB, which are settled by the settlement member with CLSB. User member does not assume responsibility for settlement risk or liquidity support. Both settlement member and user member must be shareholders of CLS Group, but the converse is not true. As at the end of March 2009, there are 70 shareholders but only 60 members. Members access the CLSB systems through SWIFTNet InterAct, which is an automated and interactive messaging system of SWIFT. There are two more parties in the CLS operations: third parties and nostro agent. Third parties are users of the CLS, but not its members. They settle transactions through either user members or settlement members. As of March 2009, there are 4,686 third parties, consisting of 411 banks and 4,275 investment funds. Nostro agents are neither users nor members of the CLS: they are facilitators. Since CLSB makes and receives payments only through RTGS systems, settlement members, too, must have access to them.

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If they do not have direct access to RTGS systems, then a nostro agent will establish the connectivity between the CLSB and settlement members. In general, most settlement members have direct access to the RTGS system. Exhibit 11-3 shows the relations between various parties.

EXHIBIT

11-3: Linkages in CLSB Operations

CLS Bank

Central Bank RTGS

Settlement Member

Nostro Agent

Third Party

Payment instruction and settlement

User Member

Third Party

Payment instruction only

Submission of Settlement Instructions Settlement instructions are submitted by settlement members and user members to CLSS via SWIFTNet. They can be submitted as soon as the trade is executed and up to 06:30 CET on value date. However, the best practice is not to submit the instruction after 00:00 CET on value date. In other words, cash value date trades are settled outside the CLS system. Matching After comparing the settlement instructions from both the parties, CLSS will assign the following trade status, which is made available to the members in real time. Status REJECTED INVALID SUSPENDED UNMATCHED MATCHED

Description Possible duplication Not a CLS currency or a business day Trade does not pass risk management tests Settlement instruction not received from counterparty Eligible for settlement

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Matched instructions can be cancelled or modified up to 00:30 CET on value date unilaterally and up to 06:30 CET on value date bilaterally. Settlement and Funding CLSS makes a distinction between settlement and funding. Settlement refers to the book entries in the settlement member‟s account with CLSB and is on gross basis. Funding is the pay-in in central bank RTGS funds and is on net basis. The following example illustrates the settlement and funding for three transactions in EUR/USD as follows. (Sale = Debit; Purchase = Credit). SETTLEMENT

(in the settlement member‟s account with CLSB)

EUR USD Debit Credit Debit Credit 100 125 200 245 150 185 Total 250 200 245 310 Settlement member pays EUR 250 and receives EUR 200; and pays USD 245 and receives USD 310. It is on gross basis. FUNDING

(between CLSB and settlement member in RTGS funds)

EUR USD Debit Credit Debit Credit 50 65 Settlement member pays EUR 50 and receives USD 65. It is on net basis. The multi-lateral netting before pay-in results in, on an average, the reduction of 95% in funding and 99.75% in the number of transactions, which improves liquidity management and lowers transaction costs. The following is the timeline for various activities, which are summarized in Exhibit 11-4. 00:00 CET: Initial pay-in schedule (IPIS) after multilateral netting is issued; this is also the deadline for unilateral cancellation or amendment. 06:30 CET: Revised pay-in schedule (RPIS); this is also the deadline for bilateral cancellation or amendment. 07:0012:00 CET: This is the five-hour settlement cycle time window, during which settlement will be completed in the first two hours while the funding takes place continuously.

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09:00 CET: Settlement completion target time (SCTT) 10:00 CET: Funding completion target time for Asia-Pacific currencies (FCTT1) 12:00 CET: Funding completion target time for other currencies (FCTT2)

EXHIBIT

11-4: Timeline for CLS Process

00:00

06:30

07:00

09:00

10:00

IPIS

RPIS

start

SCTT FCTT1

12:00

Time (CET)

FCTT2

settlement and funding time

The funding takes place in the CLSB‟s accounts with various central banks, whose RTGS systems and their operating hours are as follows. Country & Currency RTGS Local Time CET Switzerland CHF SIC 17:00a – 15:00 17:00a – 15:00 New Zealand NZD ESAS 09:00 – 08:30b 23:00a – 22:00 Canada CAS LVTS 06:00 – 18:00 00:00 – 12:00 Mexico MXN SPEI 08:30 – 17:00 01:00 – 12:30 Australia AUD RITS 09:15 – 18:30 01:15 – 10:30 Japan JPY BOJ-NET 09:00 – 19:00 02:00 – 12:00 S Korea KRW BOK-Wire 09:30 – 17:00 02:30 – 10:00 Hong Kong HKD CHATS 09:00 – 17:30 03:00 – 11:30 US USD Fedwire 21:00a – 18:00 03:00 – 02:00b Singapore SGD MEPS+ 09:00 – 19:00 03:00 – 13:00 Norway NOK NBO 05:40 – 16:30 05:40 – 16:30 Denmark DKK KRONOS 07:00 – 15:30 07:00 – 15:30 EU EUR TARGET 07:00 – 17:00 07:00 – 17:00 UK GBP CHAPS 06:00 – 16:00 07:00 – 17:00 Sweden SEK K-RIX 07:00 – 17:00 07:00 – 17:00 S Africa ZAR SAMOS 07:00 – 16:00 07:00 – 16:00 Israel ILS ZAHAV 07:00 – 14:15 07:00 – 14:15 a One day before value date (V1); bOne day after value date (V+1) (Source: Progress in Reducing Foreign Exchange Settlement Risk, BIS, May 2008) The 07:00–12:00 CET time window is chosen because the RTGS systems of 17 currencies are simultaneously open during this period (see Exhibit 11-5).

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Funding for Asia-Pacific currencies (AUD, HKD, JPY, KRW, NZD and SGD) occurs during the three-hour period of 07:00 – 10:00 CET during which their RTGS systems are open. For other currencies, funding continues in the full five-hour period of 07:00 – 12:00 CET. Processing Queue Before the pay-in schedule is issued, settlement instructions are filtered based on certain risk management criteria (discussed in the next section). Since the funding takes place continuously, a large payment amount in the early stages may block all other payments and result in a total pay-in failure. To prevent such a situation, large amounts are split into smaller amounts to facilitate early pay-ins. After the pay-in occurs in the RTGS funds, CLSB completes the corresponding pay-out to the settlement member or its nostro agent. The unsettled trades at 12:00 CET are removed from the queue, and the counterparties will decide whether to settle them in CLS on the next day or settle it outside CLS on the same day. 11.4. Risk Management Each trade in the processing queue is subjected to three risk management tests: positive adjusted balance, short position limit and aggregate short position limit. Only after passing these tests, the payment instruction is processed. Positive Adjusted Balance CLSB converts the balances in all currencies, both long and short, in the settlement member‟s account into USD-equivalent at the prevailing market prices (supplied by Reuters) and add them up. The aggregate USD-equivalent is the positive adjustment balance. Before converting them into USD-equivalent, the balances are subjected to haircut, which reduces the long balances and increases the short balances. The haircut is usually set at the price change over 6-day period at four standard deviations. For a payment instruction to be processed, positive adjusted balance must be greater than zero. Short Position Limit CLSB assigns a currency-wise short position limit for each settlement member and reviews it periodically. This is a liquidity facility, which enables the settlement to occur even if the CLSB has not received the other currency amount. Note that the short position limit does not create any credit risk to the CLSB because the positive adjusted balance (the first test) is greater than zero.

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Aggregate Short Position Limit It is a limit on the settlement member‟s total short positions in all currencies. Like positive adjusted balance, it is computed in USD-equivalent after applying the haircuts. The limit is reviewed from time to time. The following example illustrates the aggregate short position limit and positive adjusted balance, assuming that the settlement member has the following positions in its accounts with the CLSB. All the amounts are in USD equivalent and after adjusting for haircuts. Currency EUR GBP JPY Total

Dr/Short 125

Cr/Long 250

100 225

250

The aggregate short position is USD 225 and the adjusted positive balance is USD 25, which is the difference between total positions and total long positions. For a payment instruction to be processed, the following tests must be passed: (1) positive adjusted balance must be greater than zero, which is the case indeed; (2) short position of USD 125 in EUR and USD 100 in JPY must be less than the limits set for each currency; and (3) aggregate short position of USD 225 must be less than the limit specified for this test. 11.5. Liquidity Facilities The pay-in in CLS is extremely time critical and differs substantially from other payment systems. For Asia-Pacific currencies, domestic clearing is completed before CLS clearing begins; for European currencies, domestic clearing and CLS clearing are roughly coterminous; and for North American currencies, CLS clearing is completed before domestic clearing starts. The time difference between CLS and domestic clearings has significant impact on liquidity management. For example, for Asia-Pacific currencies, a bank expecting a large receipt in CLS will build up a large debit position in domestic clearing. Similarly, for North American currencies, making a large pay-in in CLS is exposed to cost and credit risk because the covering funds are received later in the domestic clearing. Consider a bank that executed an overnight sell-buy forex swap in EUR against USD, and invested the overnight USD funds in USD money market. In the settlement of far leg, the bank will pay

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USD in CLS before it receives the covering funds in CHIPS. To improve the liquidity management and to ensure successful completion of pay-in in CLS, there are three tools: inside/outside (I/O) swap, top-up and contingency swap (TUCS) and liquidity providers. Inside/Outside (I/O) Swap Consider the situation in which Bank A has a large short position in EUR and a large long position in USD; and Bank B has a complementary position of large long position in EUR and large short position in USD. Both of them can enter into the following intra-day swap. Bank A buys EUR (and sells USD) from Bank B value cash Bank A sells EUR (and buys USD) to Bank B value cash

(“inside leg”) (“outside leg”)

The first leg is called inside leg because it is settled within CLS; and the second leg is called outside leg because it is settled outside CLS and in the domestic clearing of the two currencies. The inside leg ensures that the pay-in for EUR is completed early. Though I/O swap enables a smooth pay-in in CLS despite large short position for a member, it introduces to one party (in the above example, to Bank B) the Herstatt risk, which defeats the very purpose of CLS. The introduction of Herstatt risk here is considered tolerable in view of significant improvement in the liquidity of CLS pay-in. After the initial pay-in schedule is issued at 00:00 CET, CLSS will identify the potential I/O swaps between various members and publish them by 00:30 CET. The I/O swap advice from CLSS is subject to the counterparty limits that the members have established for each other, maximum trade size for each currency, etc. The members interested in executing the I/O swaps must bilaterally negotiate and confirm the I/O swap to the CLS. The inside leg must be matched by 03:30 CET so that it can be incorporated in the final pay-in schedule at 06:00 CET. Overall, I/O swaps have not been popular. Top-up Contingency Swap (TUCS) Some settlement members privately formed a group to execute I/O swaps on a bilateral basis. However, the process is highly manual and hence lost its relevance. Liquidity Providers If a settlement member‟s short position in a currency is extended and continuing, it does not create credit risk to the CLSB because there is an equivalent

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long position in another currency (under the first test). However, the CLSB cannot make the pay-out in the short currency in the circumstances. To enable CLSB complete the pay-out, there is a liquidity facility committed by certain settlement members (“liquidity providers”) for each currency. Under this facility, CLSB enters into an overnight forex swap with liquidity providers, Under the swap, CLSB receives funds in the short currency (with which it completes the pay-out) and pays funds in long currency (which would otherwise have been credited to the failing settlement member‟s account). On the next day, one of the following will take place. First, the failing member makes good the short currency funds, which settles the second leg of swap. Second, if the failing member does not make good the short currency, CLSB will enter into an outright transaction to complete the second leg of forex swap. The hair cut built into the failing member‟s long position should be adequate to withstand the price changes overnight. If the outright transaction is not possible (because of lack of quotes), the overnight forex swap is rolled over for a maximum of four business days, after which CLSB computes the loss and allocates it pro rata to those settlement members that had traded with the failing member such that the loss to a member is capped at the bilateral net amount with the failing member. In the unlikely event of CLSB not able to raise enough funds to cover the short fall amount, there will be general loss allocation to all surviving members. The general loss allocation is subject to a cap of USD 30 million. 11.6. Operations Milestones Despite the initial cost and time overruns, CLS made significant progress after it commenced operations in September 2002. The following are the milestones in its operations. Date Feb 2003 Jan 2004 Dec 2004 Sep 2005 May 2006 Jun 2006 Dec 2006 Jun 2007 Sep 2007 Nov 2007 Mar 2008 Sep 2008

Milestone Daily value of settlements exceed USD 1 trillion Daily value of settlements exceed USD 2 trillion Daily value of settlements exceed USD 3 trillion Daily value of settlements exceed USD 4 trillion Daily payment instructions exceed 0.5 million Daily value of settlements exceed USD 5 trillion Daily value of settlements exceed USD 6 trillion Daily value of settlements exceed USD 7 trillion Daily value of settlements exceed USD 8 trillion Daily payment instructions exceed 1 million Daily value of settlements exceed USD 10 trillion Daily payment instructions exceed 1.5 million

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On the negative side, there were just two jarring notes. The first occurred within first six months of operations. On March 25, 2003, database programming errors by IBM resulted in 30% of the settlements being wrongly rejected. The CLSS staff was slow to respond, and the RTGS systems of Asia-Pacific currencies had to be extended to complete the settlement. The second problem occurred on May 27, 2003, just two months after the first problem. Due to errors by the CLSS staff, pay-out occurred before pay-in! However, the problem was solved immediately.

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Chapter 12 Front Office: Trading and Hedging Currency trading is unnecessary, unproductive and totally immoral. It should be stopped. It should be made illegal. We don‟t need currency trading. ( MOHAMAD MAHATHIR,

Prime Minister of Malaysia, at a meeting of IMF in Hong Kong

on September 20, 1997. The context was the sharp fall of Malaysian ringgit in FX market. ) Hedging is the tai chi of trading. ( JIM KHAROUF, Futures, October 1996)

Trading (also called speculation) is taking risk, which results in either profit or loss. Hedging is eliminating risk, which results in neither profit nor loss. Together, they constitute the main activity of front office. 12.1. FX-speak FX traders have their own lingo which, like airline pilot‟s language, is precise with a vocabulary of about two dozen words. The deal conversation takes hardly about 5-10 seconds. Exhibit 12-1 lists alphabetically the commonly used words and phrases and their meaning.

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12-1: FX Trader’s Lingo

BIO

CABLE

CBL CH CHANGE CHECK CHK CHOICE

COPEY FIGURE LEVEL

LVL MINE MIO MY RISK

OFF OZZY SMALL STOCKY TINY URS VALUE YARD YOURS

Billion, which is always the American billion (i.e. a thousand millions) and not a British billion (i.e. a million millions). The British use the word milliard for American billion, but it is no longer in use. It is also called YARD (q.v.) GBP/USD. It is so called because the London closing price of this rate used to be sent to New York by cable; and the New York traders, would ask: “Has the cable arrived?”, “What is the cable (price)”? Short for CABLE (q.v.) Short for CHANGE (q.v.) Said by the by the price quoter/maker and means that the price quoted earlier has changed and does not hold now. Another way of saying CHANGE (q.v.) Short for CHECK (q.v.) Used after the price (“1.2555 choice”) by the price quoter/maker and means that the price asker/taker can buy or sell at the same price. In other words, the bid-offer spread is zero. Nickname Danish krone (DKK) Pronunciation for “00” (e.g. “figure five” for 00/05) Used after the price (“1.2525/30 level”) by the price quoter/maker and means that the price is for indication only and not for dealing. Short for LEVEL (q.v.) Said by the price asker/taker and means “I bought” (base currency in outright) or “I received” (swap points in FX swap) Short for million Said by the asker/price-taker and means that the quoter hold the price for a while and any change in price during the holding period will be at the risk of asker. If the asker wants to deal, he would check the latest price by saying “How now?” Typically used when the asker is executing a matching trade with another simultaneously. Another way of saying CHANGE (q.v.) Nickname for Australian dollar (AUD) Trade amount will be about USD 0.25 MIO equivalent Nickname for Swedish krona (SEK) Trade amount will be about USD 0.1 MIO equivalent Short for YOURS (q.v.) Short for value date American billion. From the last syllable of the equivalent but archaic British word “milliard”. It is also called BIO (q.v.) Said by the price asker/taker and means “you bought” (base currency in outright) or “you received” (swap points in FX swap)

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12.2. Market Practices in Interdealer Market The market has some uniform global practices defined by ACI12 Model Code of Conduct. In addition, the local chapter of ACI or the local regulator may have recommended additional practices applicable to the local market. And most important, there are certain informal rules, unwritten yet powerful, among dealers, which govern the dealing practices. The following are some of them. Price Quotes A dealer is not bound to quote a price when asked for quotation. He may indicate his lack of interest by replying “not in the market.” Price quoter/maker should usually quote both bid and offer except in exceptional circumstances. During market closing hours, for illiquid currency pairs or in volatile price conditions, the price quoter/maker may request the price asker/taker to disclose the market side (i.e. buy or sell) and the deal amount. The asker need not disclose them and approach another price quoter. All price quotes are firm and tradable for “standard” amount (explained below) unless indicated otherwise. If the price is for indication only, the quoter should indicate so (e.g. “1.2525/30 level”, “1.2525/30 for info only”). Price quoter/maker should not engage in “spoofing”: quoting an off-market price and withdrawing it immediately with a view to misguiding others about the current market level or conditions. The price quoted must be traded (“hit”) immediately by the price asker saying “mine”, “yours” or “thanks, nothing”. If the asker requires the price to be held for few seconds more, he should say “my risk” and when he decides to hit the price, he should say “how now?” or “are you there?”. The price quoter/maker may give a new price or indicate that the old price is good for dealing. If the asker does not say “my risk”, the quoter himself may say “your risk”, indicating that the price is held at the asker‟s risk and the asker should ask for the price 12

ACI is the abbreviation for the Paris-based Association Cambiste International. Originally, it was an informal club of forex traders with the motto “Once a dealer, always a dealer” and an old style telephone receiver as its logo, and was popularly known as “Forex Club” in tune with its informal style. It has national chapters in most countries under the name “Forex Association”. In the later years, ACI extended its scope to money market and money derivatives (which was wholly unnecessary), became formal (and even academic) in its functioning, and renamed itself as “ACI The Financial Markets Association.” Their website is www.aciforex.com.

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again. For swap quotations, the quoter may indicate the price is good for a specified period (e.g. “25/26 good for an hour”) because the swap points are not volatile like spot price. Price asker/taker is not bound to trade on the price given to him. He may ask for price and not deal; he may ask for price for the second time and not deal; and so on ad infinitum. However, ad infinitum should not be ad nauseam. There should be no reason to ask the price for the third time. Asking for the second time is acceptable because the first price may have been “trended” (see Section 12.4), which was against the asker. If the price quoter/maker gives the choice price (which will be naturally within the bid-offer range of market price), the price asker/taker is not bound to trade, but courtesy demand that he should. Similarly, if the price asker/taker requests for a second quote with a narrow spread and the price quoter/maker obliges, the price asker/taker is not bound to deal on the second quote, but courtesy demands that he should. Deal Amounts All prices quoted are for standard (“market lot”) amounts. How much is a market lot depends on the business center and the currency pair, and is informally set by the traders in each local market. The following is an indicative list. Business center Tokyo London New York India

Currency Pair USD/JPY Others active pairs Top five currency pairs Top five currency pairs USD/INR (spot) USD/INR (FX swap) Other active pairs (spot)

Market Lot USD 1 – 3 MIO USD 1 – 2 MIO USD 1 – 5 MIO USD 1 – 3 MIO USD 0.5 – 1 MIO USD 0.5 – 2 MIO USD 0.5 – 2 MIO

If the amount is other than the market amount, the price asker/taker must indicate it in advance (e.g. “cable for small please?”, “spot yen for tiny please”, euro for ten please?”). In the last request, the word “ten” means ten million. All quantity indicators are assumed to be in millions. If the asker has not specified his non-standard amount in advance, the price quoter/maker has the right to reject the deal concluded. When non-standard amount is indicated in advance, the price quoter is not bound to quote the price or he may insist on knowing the market side (i.e. buy or sell) of the price asker. When the price quoter asks for the market side of the asker, the asker may refuse to divulge it and approach another price quoter for the price.

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Position Parking Position parking is the dangerous practice of transferring a position to another dealer with a commitment to reverse it next day at the same price. Such practice is used to hide the excessive trading beyond the sanctioned limit by the party parking the position. Position parking is prohibited. Value Dates Since the procedure to determine value dates differs for currency pairs and business centers, it is desirable that the parties clearly specify the value date in terms of month and date rather than generic terms like “spot”, “tom”, etc. Further, it is desirable that the month is spelt rather than specified by a numeral since different conventions are prevalent (e.g. DD/MM, MM/DD). Brokers Advances in information technology are replacing services of voice brokers, who may be a thing of the past very soon in the inter-dealer market. Some of the practices with respect to the inter-dealer brokers are as follows. Broker must not disclose the name of the principal until the deal is concluded. Broker must not quote firm price to a principal unless the broker has received it firm from another principal; and the broker should not maintain any position on his own, even for a very short period. For spot trades, the broker must give the name of the counterparty to each principal on conclusion of trade. Position parking is prohibited. For forex swap trades, the broker may fix different principals for near leg and far leg, which should be accepted by the principal, unless it is agreed in advance that the principal should be the same for both legs of the swap. Management of “stuffing”: stuffing is the exceptional situation when the broker is hit on the quote by the asker-principal while the quoter-principal withdraws it, both occurring simultaneously. As a result, the broker is stuck on one side: he is said to be “stuffed.” In such cases, the asker-principal may use his discretion to relieve the broker from the trade (provided the broker explains the situation immediately and satisfactorily) or hold the broker to the trade. In the latter case, the broker will have to conclude another trade immediately with another principal at the next available price. The asker-principal should not insist on the original price but accept the replacement price, and collect the difference be-

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tween them from the broker. All cases of stuffing must be informed immediately to the managements of broker and the principal. Points-parking is an undesirable activity and associated with stuffing. Instead of settling the price difference on the stuck deal, the broker maintains a running account with the principal for parking the price difference (“points”) on stuck deals to be offset over a period of time. Points-parking is prohibited. Ethics Difficulty arises when ethics are incorporated in the code of conduct. Two facts need to be recognized. First, ethics are practiced out of personal conviction and cannot be enforcedalways. Second, what is ethical and what is not differs from culture to culture. Some of the ethics incorporated in the code of conduct are as follows. “Management should watch for signs of the abuse of drugs including alcohol and abused substances.” (Note the exclusion of tobacco. By the way, no annual meeting of ACI is complete without liberal dose of alcoholic drinks, as do the meetings of local chapters.) “Gifts and entertainment should not be excessive or frequent.” “Entertainment should neither be offered nor attended when it is underwritten but not attended by the host.” (The drink and dinner at ACI conferences are hosted by different sponsors. Neither the host is visible nor the attendees look for him.) “Gambling and betting among market participants should be discouraged.” (Note that they are not prohibited but discouraged. And what is the difference between gambling, betting and trading?) “Dealing for personal account is allowed but the management should ensure safeguards against insider trading and front running.” (Safeguards against front running are certainly required. Insider trading may be relevant in equity market, but its applicability in forex market is doubtful.) 12.3. Sample Deal Conversations Few sample conversations are shown in this section. They illustrate the trader‟s language, vocabulary and the market practices. In the specimens below, “A” is the asker of price and “Q” is the quoter of price.

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Conversation #1 Script A: Hi, IOB, chn, spot euro pls?

Q: Hi, there, 1.25 35/39 A: At 39, we buy two euro

Q: Agreed. Val Jan 25 A: Tks n bye

Remark Asker identifies himself as Indian Overseas Bank, Chennai (“IOB, chn”) and asks for EUR/USD spot price. Quoter gives the price At 1.2539, the asker buys two million euro (“two euro”). All amounts are understood to be in millions Quoter confirms that spot value date (“val”) is Jan 25. Closing line

Conversation #2 Script A: Hi, IOB, chn, spot cbl for small pls?

Q: 55/57 A: At 57, we sell 0.25 MIO dlr

Q: Tks. I buy dlr 0.25 MIO at 1.4557 val Jan 25. TGIF

Remark Asker identifies himself, asks for GBP/USD (“cbl”) spot price and indicating that the amount will be about USD 0.25 MIO (“small”) Quoter gives the price; only small figure is quoted and the big figure is omitted At the 57, asker can buy GBP or sell USD. Since the deal currency is USD (“dlr”), the asker must explicitly specify it Quoter confirms all the details and exclaims “thank God it‟s Friday” (TGIF)

Conversation #3 (very precise, brief and terse) Script A: yen pls?

Q: 98/03 A: At 98, five

Q: Agreed A: At 103.98, v sell USD 5 MIO val Jan 25. Done n confirmed

Remark USD/JPY price: unless otherwise specified, the other currency is always USD, Value date is always spot unless otherwise specified Only small figure is quoted Asker sold 5 MIO USD. The deal currency is base currency unless otherwise specified. At 98, asker can only sell USD Quoter confirms the trade Asker confirms the full details of the trade

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Conversation #4 (with a broker, who is the asker, A, in the following) Script A: spot rupee, Sir? Q: 50.00/01 A: Tks, ntg. I deal 0000/50

Q: Mine one A: You bought from ABC dlr one @ 50.0050 value Jan 25 A: Some good selling coming, big fig now 99 Q: How you deal? A: 49.99/50.00 sry wide sprd

Q: Tks, ntg. I deal parity

A: Ticcy, my risk

A: R U there at 99/00 Q: SS A: Urs half at 49.99. XYZ sold. Val 25/1 A: can give u another half at 9950 Q: Show me firm A: I sell half at 9950 firm Q: Taken A: ABC sold at 49.9950. Val Jan 25. Done n cnfmd. Lvl now is 99/00. Q: Tks, no interest there

Remark Broker asking for USD/INR spot price Bank gives the price Broker offers his own price with a narrow spread and his offer (at 50.0050) is better than the bank‟s offer of 50.01 Bank bought USD 1 MIO at 50.0050 Broker provides the seller‟s name and gives the other details Broker supplying info on market, and indicating that the big figure (“big fig”) now is 49.99 (“99”). Bank asks for a dealing price Broker is quoting the full price for both bid and offer because he does not risk any misunderstanding on the big figure. He is apologetic that the spread is wide now compared to his earlier quote Quoter shows no interest on the broker‟s quote, and says that his price is the same, too (“parity”) Broker requests the bank to hold the price for a while (“ticcy”) and he will assume the risk of price change for the delay (“my risk”) Broker asking whether the dealing price is still 49.99/50.00 (“99/00”) Bank confirms (“SS”) it is Brokers sell USD 0.5 MIO (“half”) on behalf of XYZ to the Quoter. Price and value date confirmed. Broker indicates he can sell (“give”) USD 0.5 MIO more at 49.9950. It is an indication and not a firm quote Bank asks the broker to give firm quote Broker confirms that he sells at 9950 Bank buys(“taken”) USD 0.5 MIO at 49.9950 Broker confirms the deal with other details, and indicates that the current price if 49.99/50.00 for information only (“lvl”). Bank indicates no interest at that level

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12.4. Trending From the sample conversations in the previous section, readers may have noticed that there will be different two-way quotes from different dealers prevail at the same time, Yet, they do not provide any arbitrage profit opportunity because they do not cross the bid-offer spread. Such quotes are called “trended” quotes, which provide valuable information about the price quoter‟s intention. Suppose that the current market price is 1.2550 /55. You are a dealer in the market and your intention is to buy the base currency. You have two alternatives: first, go another dealer in the market and buy at his offer price, which is 1.2555; and second, make your own quote and place it in the market so that you can buy at your bid price. In the second case, your quote must be different from the current market quote: it should be a “trended” quote. How different should it be, should it be higher or lower than the current market price? One might think that since the intention is to buy and since buying at lower price is better, the quote should be trended lower (or “left”) to, say, 1.2549/54. This is incorrect and reflects greed, and greed is dangerous. Consider what happens if your quote is 1.2549/54. It is attractive to the buyer, not seller: you sell at 1.2554 and the market sells at 1.2555. Therefore, if you quote this price, you attract a buyer and sell to him, which is the opposite of what you want to do. Since you have sold on this quote, you must immediately cover by buying at the market‟s offer price of 1.2555, making a loss of one „pip.‟ And your original intention of buying remains unfulfilled. Consider now the trending in the opposite way: higher (or “right”) to, say, 1.2551/56. Compared to the market price of 1.2550/55, it is attractive to the seller: you buy at 1.2551 and the market buys at 1.2550. Therefore, you attract the seller and buys from him at your bid price of 1.2551. You have done what you intended (i.e. to buy) in this correctly trended price, but to whom the trending benefit, counterparty or yourself? The answer is both. That the counterparty benefited by selling at a higher price is obvious. Your benefit in the trending is not as obvious. You have two ways of buying: go to the market and buy at 1.2555; or correctly trend the price and buy at 1.2551. The latter is better than the former. In other words, Consider now another unlikely but possible situation. You have trended correctly to 1.2551/56, but the counterparty foolishly bought from you at 1.2556. You ended up selling at 1.2556 instead of buying at 1.2551. To cover the sale, you immediately buy from the market at 1.2555 and it results in profit of one pip!

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To sump up, if you trend with benefit to you alone, your trending is wrong, you attract the wrong party and you make a small loss in reversing the unwanted trade. If you trend with befit to the counterparty, your trending is right, you attract the right party and the trending benefits you, too; and if you are hit on the wrong side of the correctly trended quote, you make a small profit in reversing the unwanted trade. 12.5. Trading Operations Money, bond, equity and forex markets constitute the four underlying markets or asset classes. Trading in forex market is different from that in the other three. The table below shows the stylized facts on risk/return profile of the four asset classes, with the following instruments as the proxies for each. Money: Bond: Equity: Forex:

three-month Treasury bill or certificate of deposit five-year sovereign or AAA-rated corporate bond large-cap index stock reserve currencies (EUR, GBP, JPY, CHF) against USD

Money Bond Daily returna 0 0 – 1% Weekly returna 0 – 0.10% 0 – 2% Annual returna 1 – 5% 3 – 12% Of which: Yield/Dividend 1 – 5% 2 – 6% Capital gain/loss 0 0 – 6% b Risk 0 0 – 10% Leverage in cash None None c market (usually) Transaction cost 0.1% 0.1% a Could be positive or negative b Standard deviation (“volatility”) of returns c Ratio of investment value to owned funds

Equity 0 – 10% 2 – 30% 10 – 70%

Forex 0 – 0.5% 1 – 2% 4 – 15%

0.1 – 0.5% 10 – 70% 10 – 70% 2

2 – 5% 2 – 10% 4 – 12% 10 – 50

0.25%

0.01%

Money and bond markets are used for fixed return investment with buyand-hold strategy. If they are held until maturity, there would be no capital gain/loss and therefore no risk. It is true that the instrument may change its value during its life because of changes in interest rate, resulting in capital gain/loss. However, such capital gain/loss will disappear at maturity because of the “pull-to-par” effect in the price of money and bond instruments. Further, there is no leverage in these markets: you do not borrow and invest, but invest only to the extent of own funds. We must note here that we are discussing the underlying markets (i.e. cash or spot) and not derivative markets. In derivative

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markets, leverage is available for all four asset classes. Matter-of-factly, leverage is one of the qualifying features for derivatives. Equity and forex markets, on the other hand, provide capital gain/loss (which is the source of risk) and leverage. The extent of capital gain/loss and leverage is different in each market. Before examining the differences and their implications for trading, let us look at the nature of price changes in equity and forex markets shown in Exhibit 12-2.

EXHIBIT

12-2: Daily Prices Changes in Forex and Equity Markets

Price change

FOREX market

EQUITY

market

7%

5%

3%

1% Time

Each vertical bar represents the daily range of price change. We can conclude the following stylized facts from the exhibit. 

In forex market, the price changes regularly but only by about 0.5% a day, and the trend is immediately reversed substantially within 34 days, because of which the net change over a week is only about 12% and over a year about 415%. In equity market, on the other hand, the price moves in jerks, and the trend is persisting, because of which the weekly change is almost equal to the sum of daily changes.



The price changes are smooth in forex market but have “gaps” (shown as circles in the exhibit) in equity market. The “gap” is the break between the ranges of price changes over consecutive days.

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Let us explain the reason for these differences. Because the daily price changes are very small, forex market provides leverage of up to 1050 times. This, coupled with the very low transaction costs and 24-hour trading, results in smaller holding periods (of few hours to few days) and quick turnaround, which results in immediate and substantial trend reversal within a week. In other words, forex trading is short-term levered speculation. The equity market, in contrast, has lower leverage, higher transaction cost, large price changes alternating with negligible changes, and persistent trend. This forces the strategy to be buy-and-hold for long term with little or no leverage. As for price “gaps”, the price changes because of the arrival of new information and news. Since the forex market is open 24 hours days, it translates the news instantly as it happens into price changes, resulting in small and continuous changes at the same rate as the news arrival. The equity market works only for 8–10 hours a day and when it opens next day, it translates the accumulated news over the last 14–16 hours into price action in one shot, resulting in sudden and large changes at market opening, leading to price “gaps.” Levered Speculation and Stop-loss Limit Levered speculation requires adherence to the stop-loss limit: to exit the trade at a pre-defined level of loss if the market moves against. The stop-loss limit is a form of insurance against ruin. Consider a trade with 10 times leverage. If the market moves against as by 10%, it results in loss of entire investment amount, leading to ruin. To prevent such a contingency, we keep a stop-loss limit of, say 2%, so that the first loss still leaves enough money to play another four trades. Let us now compare the two strategies: buy-and-hold without leverage and levered speculation with stop-loss limit. They are implemented on an asset whose current market price is 100 and the outlook is bullish. Immediately after we buy the asset, the market price falls to 95, which is quite common because of short-term noise and countertrend in the price changes. In the buy-and-hold strategy, we ignore the short-term countertrend and continue to hold on to the trade. In fact, some investors average the holding price by buying more at lower price, which is called dollar cost averaging (DCA) and popular in mutual fund industry. In the second strategy (10 times leverage, 2% stop-loss), the price dip forces us to exit with a loss. Immediately thereafter, the price rallies to 110. The first strategy would result in a profit of 10% while the second had already exited at a loss of 20%. It is obvious that, in buy-and-hold strategy, we need to be right on the trend to make profit; but in the levered speculation with stop-loss, we need to be right on the trend as well as on the market timing.

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The success depends, not on where the price reached, but the path it took to reach there. Economists call this as the “path dependence” of the strategy. One might think that it is the stop-loss that exposes us to the problem of market timing and that the removal of stop-loss will ensure profit if we are right on the trend. This is downright wrong. Loss on account of market timing will only weaken the trader but makes him survive another day to fight. Removing stop-loss, on the other hand, is like removing the protective armor: it results in total ruin. This brings us to the topic of “money management”. Money Management The “money management” here is different from cash (or liquidity) management in finance. Money management, as applied to gambling, deals with selecting the right game of chance and the right amount of money to be staked on each play of the game selected. Let us review the probability math for the games of chance. In particular, we need to define and establish the relation between probability, odds, payoff, payoff odds, expectation and edge. Probability (p) of an outcome is the ratio of the number of times the outcome can occur to the total number of all outcomes; and its value will be between 0 and 1. Odds (o) of an outcome are the ratio of the probability of its occurrence to the probability of it not occurring. p o

= (chances for an outcome / total number of outcomes) = (probability of an outcome / probability of it not occurring)

For example, in a 52-card deck, there are four aces. The probability of picking up an ace is 4/52 or 1/13 (“1 in 13”); and the odds for it, 4/48 or 1/12 (“1 to 12”). The odds are more commonly expressed as “against” rather than “for”. Thus, if the odds for are 1-to-12, it is the same as the odds against of 12-to-1. Since the total of probability of occurrence and non-occurrence is unity, the following is the relationship between the probability and the odds. o = p / (1  p) p = o / (1 + o) and (1  p) = 1 / (1 + o) Payoff is the amount won or lost in a game of chance, and the mathematical expectation (or simply the expectation) of the game is the weighted average of profit and loss amounts, the weights being their probabilities. Thus, if

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the profit is x with a probability of p and the loss is y with a probability of (1p), then the expectation is: expectation = (x  p) + (y  (1p)) Expectation holds only on an average over a large number of plays. For example, consider the coin toss game that pays one unit on head and loses one unit on tail. Since the chance of each outcome is even (i.e. p = 0.5), the expectation is zero. However, on a single outcome, there is either profit or loss of one unit. If we play it many times, then the average payoff will be zero. It is more convenient to express the profit amount relative to the loss amount because the loss is the amount of investment. The ratio of profit-toloss will indicate how much an unit of investment has grown. Expressed in this fashion, it is called payoff odds (b). Thus, if the game pays profit of 3 units and loss of 2 units, the payoff odds (for) are 3-to-2. If the expectation is computed with payoff odds (b), it is called “edge” (E), which is also called “advantage.” E

= (b  p)  (1p) = (b + 1)p  1

With payoff expressed as payoff odds, the edge now represents the proportional return on investment (where investment is the loss amount, of course). Consider now the following five games of chance. #1 Profit (x) Loss (y) Prob. of x (p) Prob. of y (1p) Payoff odds (b) Edge (E)

1 1 0.5 0.5 1 0

#2 2 3 0.50 0.50 0.67 0.1667

#3 3 2 0.50 0.50 1.50 0.25

#4 9 16 0.80 0.20 0.5625 0.25

#5 21 4 0.20 0.40 5.25 0.25

Game #1 has zero edge (“fair bet”): you cannot make profit in this game and therefore should not play it. Game #2 has negative edge (“bad bet”): you will lose playing this game and therefore should not play it. Games #3 through #5 have positive edge (“good bet”): you win in these games and may play them. The positive edge corresponds to some valuable information that you know and others do not. We may note that if the market were efficient, the positive edge disappears by adjusting either the probabilities or the payoff odds. Recall that the edge is the return on investment and that investment is loss amount. Thus, in Game #2, the player will lose 16.67% of 3; in Game #3, the player will gain 25% of 2; in Game #4, the gain will be 25% of 16; and so on.

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We must note that the edge works only on an average over many plays of the game, and does not hold for a single play. For example, if we play the Game #1 five times, it is possible that we may win all the five times, but the 5 probability of that will be very small at: 0.5 = 0.03125 (or 3.125%). Let us define the following. N

= Total number of plays

A

= Total amount staked or invested over N number of plays (also called “action”) and is computed as (N  y)

TE

= Total expectation over N number of plays, which is computed as (A  y)

TP

= Total actual payoff over N number of plays

We can make the following conclusions from the statistical theory: 

To be significant, N should be at least 20. In other words, we must play the game at least 20 times.



The deviation of total actual payoff (TP) from the total expectation (TE) will be within y N (square root of N) of TE for 68% of the cases; and within 2y N of TE for 96% of the cases. For example, if we play Game #2 for 100 times, then N = 100; N = 10; A = (100  3) = 300; TE = (300  0.1667) = 50. The actual total payoff (TP) will have the follo wing range. 50  (3  10) 50  (2  3  10)



= 80 to 20 = 110 to +10

in 68% of the cases in 96% of the cases

The absolute size of the deviation, N, increases with N but tends towards zero as a proportion of A, which implies that the difference between TE and TP becomes larger with N but the fraction TE/A will tends to be the same as the fraction TP/A.

Thus, playing a positive sum game does not guarantee profit if the game is played for just few times. We need to play at least 20 times for the edge to be statistically meaningful. The next question is which of the three good bets do we play? We can play any of them, and the question should be how much of the capital should be staked in each play of the game. If we stake the entire capital, the ruin is guaranteed, regardless of the probability and the payoff. To illustrate the point, consider the Game #5, in

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which the edge is 0.25 (or 25%) and the game is played five times. The probability of winning all the five is 0.255 = 0.000977 (or 0.0977%) and the probability of just one loss is 1  0.255 = 0.9990 (or 99.9%). Since we are betting the entire stake, the probability of ruin is 99.9% over the five games. As we increase the number of games, the probability of a single loss becomes almost a certainty. Staking too little of the capital, on the other hand, will make the probability of ruin close to zero, but also makes the return on investment so ridiculously small that we would be better off investing the capital in fixed-income securities rather than speculate in a game of chance. The optimal amount to be staked on each play was derived by a mathematician, J L Kelly, and is expressed as a fraction of the capital available at any point of time. It is called Kelly’s fraction (f*) and is given by f* = [(b + 1)p  1] / b The numerator is the edge and the denominator is the payoff odds. For this reason, Kelly‟s fraction is often defined as “edge / odds” where the odds should be understood as payoff odds and not probability odds. For even bets (i.e. those in which profit and loss amounts are the same so that b = 1), the Kelly‟s fraction is simplified to: f* = 2p  1. Kelly‟s fraction should be computed only when the edge is positive. Since the stake amount is fraction of the available capital, the probability of ruin is close to zero, and the probability of losing x% of capital is 100  x. Thus, the chance of losing 10% of initial capital is 90% and that of losing 90% is 10%. The differences in probability and payoffs are factored into the fraction. For the Games #3 through #5, the Kelly‟s fraction is:

Payoff odds (b) Probability of profit (p) Kelly‟s fraction: [(b + 1)p  1] / b

Game #3 1.5 0.5 16.7%

Game #4 0.5625 0.8 44.4%

Game #5 5.25 0.2 4.8%

Notice that Game #5 has high payoff odds and yet Kelly‟s fraction has allocated the least fraction of the capital because the probability of profit is low at 0.2. Similarly, Kelly‟s fraction has allocated higher fraction of capital on Game #4 despite low payoff odds because it has higher probability of profit at 0.8. Kelly‟s fraction has another desirable property: it maximizes the growth rate of initial capital in the long term, and takes the least amount of time to reach a

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given level of growth, compared to any other strategy. One problem with the fractional amount is that the breakeven in the number of plays does not guarantee the breakeven in the payoff. For example, given that f* = 1%, b = 1 and N = 100, we lose in 50 plays and gain in the other 50, starting with a capital of 100. The capital at the end of 100 plays will be: 100  (1 + f*)50  (1  f*)50 = 99.50. which is less than the starting capital despite breakeven in the number of profitable and losing plays. Staking the flat amount on every play would ensure that breakeven in the number of plays is the breakeven in the payoff, too, for games with the payoff odds of 1. Another problem with the Kelly‟s fraction is that it holds true only when the probabilities and the payoff amounts are constant over time. This may indeed be the case in the games of chance, but not in financial markets. For this reason, many traders prefer “half Kelly” (i.e. staking only 50% of f*) to “full Kelly” for the bet size. Kelly strategy is the opposite of another strategy called “martingale,” which doubles the stake on every loss and exits the game on the first win. The profit after the single win will be equal to the stake on the first play. For example, in coin toss game with even payoff, start with 1 unit and continue to bet on the same outcome. If you lose on the first play, double the stake to 2 units and bet on the same outcome; if you lose again, double the stake to 4 and bet on the same outcome; and so on. The chance of win is very high as the number of plays is increased. If you win on the third play, the profit is 4 units, the cumulative loss until the second game is 3 units, and the net profit is 1 unit; if you win on the eleventh play, the profit is 1,024 units, the cumulative loss until the tenth game is 1,023 units, and the net profit is 1 unit; and so on. The martingale strategy is the recipe for sure ruin for two reasons. First, the amount of capital required as we play more number of games becomes impossibly high, forcing the trader to quit the game with loss before the win occurs. Second, there is usually a limit placed on the stake amount. If, for example, the maximum stake is 1,000 units, and you win on the eleventh play, the profit is 1,000 units, the cumulative loss until the tenth game is 1,023 units, and the net loss is 23 units. Trading Plan We have discussed the two important elements of trading: path dependence in levered speculation and money management techniques. Let us now formulate a “trading plan”, which is a set of management principles rather than specific technical tools for trading. The following are the elements of the trading plan.

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1.

Decide on the style of trading

In forex market, depending on the holding period, traders can be classified into different styles: market-maker (also called scalper, jobber or flow trader), day trader, position trader and fund manager. The following is their profile. Trader Style Market-maker Day trader Position trader Fund manager

Trading Aim Order flow Price range Price trend Value

Holding Period Few seconds Few hours Few days Few quarters

Profit Source Bid-offer spread Range move Trend move Fundamentals

Trading the value requires the study of economic fundamentals. As we discussed earlier, forex market is not suitable for long-term investment because fixed-income securities and equity markets provide better risk/return opportunities. There are only two purposes for which the value is traded in forex market. First, an asset manager might assume currency risk not for its own sake but as an add-on to equity risk when investing in foreign equity. Second, hedge funds trade the “carry trades” in forex market: buy the high-yield currency and sell the low-yield currency if the fundamentals do not suggest appreciation of sold currency so that the net interest difference during the carry period is the profit. This is a levered long-term speculation and not practiced outside hedge fund industry. Day trading and position trading have short holding period of few hours to few days. Since the economic fundamentals do not change in this time span, these traders rely on technical factors (e.g. charts, cycles, oscillators, etc.), which are form-and-pattern analysis rather than cause-and-effect analysis. Market-makers have a very short holding period of few seconds. In such a time span, neither fundamentals not technicals change, and there is just random flow of orders into the market from other traders. It is this order flow that the market-maker trades, with quick entry and exit and endeavoring to benefit from their bid-offer spread. For most traders in forex, market-making and funds management is out of reach; and the day trading and position trading are the only available trading styles. Position traders may hold the position for more than a day and yet they do not have to outlay cash for trade value because the cash settlement method (see Section 6.12) allows settlement of profit/loss rather than trade value. Even if the position is held beyond the value dates, full cash outlay is not required because the settlement can be funded by overnight forex swap. This is called “rollover spot” or “contracts for difference.”

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2.

Develop and rely on a trading system or rule for entry

The trader must develop and follow a system or rule to enter the market. The advantage of having such a system or rule is that we can determine whether the success is due to skill or luck. The rule can be as simple as relying on a particular analyst‟s recommendation, key reversal day (i.e. a day that has higher high and lower low compared to the previous day‟s and either a higher or lower close), higher/lower close for three consecutive days, etc. It can be a complex system, too, such as Elliot‟s wave theory or a system combining trend and oscillators. Backtesting the system or rule will give valuable information (e.g. percentage of profitable and losing trades, average profit/loss per trade, etc), which is essential for money management. 3.

Allocate and bring in the entire risk capital

Allocate and bring in upfront the entire risk capital (also known as “equity”) for trading. How much risk capital should you allocate will depend on your wealth. As a thumb rule, you should not allocate more than 10% of your financial resources in trading. It is also important that the risk capital should not be too little: it should be large enough to cover 35 consecutive losses and still leave something to trade further. Undercapitalization is one of the main reasons for unsuccessful trading. If the required minimum risk capital is more than 10% of your resources, then you will be better off not trading rather than trade with low capital with plans to arrange for more capital in future. Such plans rarely work and reflect greed and hopethe two things that tend to be excessive and are the causes of ruin. 4.

Follow Kelly strategy

Do not bet the entire risk capital on a single trade, but bet the Kelly‟s fractional amount. Kelly‟s strategy lowers the probability of ruin and maximizes the growth of capital. Between them, the former is more important than the latter, and therefore the stake on each trade should be ideally less than full Kelly. Trading is after all gambling in which survival is more important than success. 5.

Use stop-loss limit

For leveraged speculation, the stop-loss limit is the protective armor for the trader and insurance against large losses. Novice traders are told that there are only three rules in trading. The first is important and it is “cut your losses.”

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The second is more important and it is “cut your losses.” The third is the most important and it is “cut your losses.” Never follow the martingale strategy. Even if you are extraordinarily lucky, it will surely cost you money, time and peace of mind. 6.

Average the profit, not the loss, through pyramiding.

After you enter the trade and the market is moving in your favor and half-way to the target level, it is time to increase the position size, but the size of second position should be less than that of the first, typically about 50% of the size of the first position. This is called pyramiding and should be accompanied by the trailing stop-loss. Let us illustrate this with an example. The current EUR/USD spot price is 1.2500 and you are bullish on EUR with a price target of 1.2550 in the next 6–8 hours. You enter the trade by buying EUR 1 MIO at 1.2500 with stop-loss at 1.2475. The price rallies to 1.2525, and you increase the position size. How much should you buy now? Consider three cases: increase the position by 50% (which is called pyramiding), by 100% and by 200%. In all cases, you should move the stop-loss limit to 1.2510 in order to lock the favorable move in the price so far, which is called trailing stop-loss. The following table shows the position size, the holding price, profit if the target is hit without stop-loss limit being hit, and the profit/loss if the stop-loss limit is hit before the target.

Position size (EUR) Holding price (USD per EUR) Target hit – P/L (USD) Stop hit – P/L (USD)

Case #1 1,500,000 1.2508 6,250 250

Case #2 2,000,000 1.2513 7,500 (500)

Case #3 3,000,000 1.2517 10,000 (2,000)

If the price rallies to hit the target without hitting the stop-limit, then Case #3 performs the best. However, if the market turns against and the stop is hit, Case #1 stills results in a profit but the other two cases result in loss. Thus, pyramiding ensures that the part of initial profit is locked in when the market moves against the trader and therefore should be preferred to the other two. On the other hand, if the market moves against the trader immediately after the entry, the position size should not be increased. Averaging the loss is similar to martingale strategy, which is ruinous. The dollar cost averaging (DCA) prevalent in mutual fund industry works only in unlevered long-term investment on trend, which is not exposed to path-dependence. In levered short-term

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speculation such as forex trading, path-dependence makes the loss-averaging dangerous. 7.

Draw from equity regularly

The trader must periodically draw from the accumulated balance in the trading account (which is called the “equity”) and invest it in risk-free securities (e.g. Treasury bill, bank deposits) rather than re-invest in the equity. It is true that compounded growth will become the dominant factor for success in the long term. However, it works only when the return is certain and guaranteed. Trading is a game of chance with uncertainty about return: part of the profit made in it must be taken out and allowed to grow with certainty elsewhere. 8.

Review the trading system or rule regularly for changes in risk profile.

Since financial markets change their risk/return profile over time, a trading system or rule will not work for ever. We need to review its features (e.g. ratio of profitable to losing trades, size of average profit/loss per trade, etc) periodically and identify the best among the good bets, and recalibrate money management tools (e.g. Kelly‟s fraction). 9.

Take a regular break from trading.

Speculation is habit-forming: the more you do it, the more you are addicted to it. Taking a break regularly and spending time on other activities will improve the efficacy of speculation. When are the times one should not speculate? Walter Bagehot (pronounced “baj-uh t”), the famous editor of The Economist, said: All people are most credulous when they are most happy13. And Shakespeare had Romeo say: Tempt not a desperate man. So, these are the times then, one should not speculate: when one is most happy and when one is desperate. 10. Take responsibility Pat yourself for the profit, and blame yourself (not the market) for the loss. Losses are natural and the greatest teachers. The earlier they happen, the better will be the learning. The trader that does not report losses is either a liar or not a real trader.

13

Walter Bagehot, Lombard Street – A Description of the Money Market

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12.6. Hedging Operations For flow traders and corporate sales traders, hedging the trade executed with the counterparty or customer is important and crucial. For them, the source of profit is bid-offer spread and margins rather than maintaining a position against the market. Every trade creates position and gap. As explained in Section 6.5, position creates price risk, is more volatile and therefore must be removed immediately, on trade by trade basis, by executing an outright trade. Gap, in contrast, does not create price risk but creates funding and liquidity disturbances, is less volatile than position, and can be managed with delay. In practice, hedging is not perfect because some features in commercial transactions. First, commercial transactions are for small and odd amounts (e.g. EUR 13,546, GBP 495,765, etc) while the interdealer market trades in standard market lots (e.g. GBP 500,000). Second, commercial transactions have odd tenors (e.g. 47 days, 98 days, etc) while the interdealer market trades for standard tenor (spot, 1M, 3M, etc). To manage the divergence between commercial transaction features and interdealer market practices, the following are the general practices in hedging the commercial transactions. 1.

If the commercial transaction size is closer to market lot, hedge it immediately in the spot market with an outright trade for the nearest market lot. This eliminates the position but retains the gap, which can be managed later.

2.

If the commercial transaction size too small to be hedged, then it will have to be taken into position but kept open. Either it will be offset by the continuous flow of such small transactions from other customers or absorbed into the running open position maintained by the trader. In general, traders maintain a running position appropriate to the market outlook and business mix, which will take care of such transactions. For example, if the business mix of the bank is more sales than purchases in a currency and the market outlook for the next 1-2 weeks is bullish for the currency, the trader will maintain open overnight/long position in that currency to take care of the small transactions in the pipeline.

3.

Gaps are not immediately covered, even if they are of marketable lots and for standard tenors. They are consolidated and aggregated for the day during which some of them may offset each other. At the end of the day, the gaps that are marketable lots are covered to the nearest standard te-

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nors. The gaps that are not market lots and of standard tenors are absorbed in the running gaps maintained for keeping working cash balances, float funds, etc. 4.

Gaps are managed usually with forex swaps or by borrowing/lending in money market. The latter is often called money market hedge, which is somewhat erroneous because “hedging” means elimination of price risk by an outright trade while borrowing/lending (or its equivalent forex swap) does not hedge price risk but manage cash and liquidity. If the interest parity is fully covered, it does not matter whether the gap is managed through forex swap or money market. If the parity is not fully covered, then one of them is preferred to the other. Even when the parity is fully covered, money market route may be preferred to forex swap in some cases because the money market division of the bank has a borrowing requirement in a currency while the forex division has S-B swap requirement in it. In such cases, internally adjusting the cash position will save bid-offer spread and other transaction costs in the market.

The following example commercial transaction is used to illustrates the hedging practices. GBP/INR: Sold GBP 494,545.69 @ 75.05 value date 45 days forward

The trade is hedged immediately for position by executing the following two outright transactions for spot value date. GBP/USD: Bought GBP 500,000 @ 1.5000 value date spot (Hedge trade #1) USD/INR: Bought USD 750,000 @ 49.98 value date spot (Hedge trade #2)

Notice the minor discrepancy in the transaction and hedge amounts, which cannot be avoided. As a result of the above two hedge trades, the position is eliminated, as shown in the cash flows table below, and therefore the subsequent price changes do not affect the profitability.

Date Spot GAP 45 day fwd. GAP Position

GBP +500 +500 495 495 +5

USD 750 +750 0 0 0

INR 37,485 37,485 +37,150 +37,150 335

(amounts in „000) Remark Hedge #1 Hedge #1 Daily sum of cash flows Customer‟s Daily sum of cash flows Sum of all cash flows

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Ignoring the residual position of GBP +5 and INR 335 (which is absorbed in the running position of the bank), the position is square. The gap (surplus in GBP and deficit in INR) is eliminated through either forex swap or money market operations, but managing gap is not as pressing and immediate as that of position. The forex swap will be on GBP/INR, which is a cross rate and usually not quoted in the market. Accordingly, two forex swaps will have to be executed, separately on GBP/USD and USD/INR, as follows. GBP/USD: Sell-Buy GBP 500,000 value date spot against 45D fwd @ 1.5002 against 1.4992, respectively (swap #1) USD/INR: Sell-Buy USD 750,000 value date spot against 45D fwd @ 49.95 against 50.03, respectively (swap #2)

The cash flows after the two forex swaps will eliminate the gap. Date Spot

GAP 45 day fwd.

GAP Position

GBP +500 500

0 495 +500 +5 +5

USD 750 +750 750 +750 0 750 +750 0 0

INR

+37,485 37,485 0 +37,150 37,523 373 373

Remark Hedge #1 Near leg of swap #1 Near leg of swap #2 Hedge #1 Daily sum of cash flows Customer‟s Far leg of swap #1 Far leg of swap #2 Daily sum of cash flows Sum of all cash flows

Typically, the swap trades are executed towards the end of the day or cutoff time for the currency pair. Notice that the swap may not be for the exact value date, if the commercial transaction is for odd-tenor. For example, if the tenor is 96 days, it may be hedged in the market for the nearest standard tenor of 3M. Because of discrepancy in the amount and tenor between the commercial and hedge transactions, the profit/loss on commercial transactions should not be computed from the cash flow amounts in the table above, but should be computed from the trade prices. For the above example, to hedge the customer trade, we bought GBP against USD in the spot at 1.5000 and “received” 0.0010 (“ten pips”) in the swap. The forward price is thus 1.4990. And we bought USD against USD in the spot at 49.98 and “paid” 0.08 (“eight paise”) in the swap. The forward price is thus 49.90. Crossing these two underlying rates, the GBP/INR forward price is: 1.4990  49.90 = 74.80. Against this, we sold GBP against INR to the customer at 75.05, giving a profit of INR 0.25 per GBP or INR 123,636 for the deal amount of GBP 494,545.69.

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Annex I: Countries, Currencies and ISO Codes Country Afghanistan Albania Algeria American Samoa Andorra Angola Anguilla Antigua and Barbuda Argentina Armenia Aruba Australia Austria Azerbaijan Bahamas Bahrain Bangladesh Barbados Belarus Belgium Belize Benin Bermuda Bhutan Bolivia Bolivia Bosnia and Herzegovina Botswana Brazil Brunei Darussalam Bulgaria Burkina Faso Burundi Cambodia Cameroon Canada Cape Verde Cayman Islands

Currency Afghani Lek Algerian Dinar US Dollar Euro Kwanza East Caribbean Dollar East Caribbean Dollar Argentine Peso Armenian Dram Aruban Guilder Australian Dollar Euro Azerbaijanian Manat Bahamian Dollar Bahraini Dinar Taka Barbados Dollar Belarussian Ruble Euro Belize Dollar CFA Franc BCEAO Bermudian Dollar Ngultrum Boliviano Mvdol Convertible Marks Pula Brazilian Real Brunei Dollar Bulgarian Lev CFA Franc BCEAO Burundi Franc Riel CFA Franc BEAC Canadian Dollar Cape Verde Escudo Cayman Islands Dollar

ISO Code AFN ALL DZD USD EUR AOA XCD XCD ARS AMD AWG AUD EUR AZN BSD BHD BDT BBD BYR EUR BZD XOF BMD BTN BOB BOV BAM BWP BRL BND BGN XOF BIF KHR XAF CAD CVE KYD

207

Annex I Country Central African Republic Chad Chile Chile China Colombia Colombia Comoros Congo (Rep.) Congo (Democratic Rep.) Costa Rica Côte D'Ivoire Croatia Cuba Cuba Cyprus Czech Republic Denmark Djibouti Dominica Dominican Republic Ecuador Egypt El Salvador Equatorial Guinea Eritrea Estonia Ethiopia Falkland Islands Faroe Islands Fiji Finland France French Guiana French Polynesia Gabon Gambia Georgia Germany Ghana Gibraltar

Currency CFA Franc BEAC CFA Franc BEAC Chilean Peso Unidades de foment Yuan Renminbi Colombian Peso Unidad de Valor Real Comoro Franc CFA Franc BEAC Congolese Franc Costa Rican Colon CFA Franc BCEAO Croatian Kuna Cuban Peso Peso Convertible Euro Czech Koruna Danish Krone Djibouti Franc East Caribbean Dollar Dominican Peso US Dollar Egyptian Pound El Salvador Colon CFA Franc BEAC Nakfa Kroon Ethiopian Birr Falkland Islands Pound Danish Krone Fiji Dollar Euro Euro Euro CFP Franc CFA Franc BEAC Dalasi Lari Euro Cedi Gibraltar Pound

ISO Code XAF XAF CLP CLF CNY COP COU KMF XAF CDF CRC XOF HRK CUP CUC EUR CZK DKK DJF XCD DOP USD EGP SVC XAF ERN EEK ETB FKP DKK FJD EUR EUR EUR XPF XAF GMD GEL EUR GHS GIP

208

Currencies and ISO Codes Country Greece Greenland Grenada Guadeloupe Guam Guatemala Guinea Guinea-Bissau Guyana Haiti Holy See (Vatican) Honduras Hong Kong Hungary Iceland India Indonesia Iran Iraq Ireland Israel Italy Jamaica Japan Jordan Kazakhstan Kenya Korea, North Korea, South Kuwait Kyrgyzstan Lao Latvia Lebanon Lesotho Liberia Libya Liechtenstein Lithuania Luxembourg

Currency Euro Danish Krone East Caribbean Dollar Euro US Dollar Quetzal Guinea Franc CFA Franc BCEAO Guyana Dollar Gourde Euro Lempira Hong Kong Dollar Forint Iceland Krona Indian Rupee Rupiah Iranian Rial Iraqi Dinar Euro New Israeli Sheqel Euro Jamaican Dollar Yen Jordanian Dinar Tenge Kenyan Shilling North Korean Won Won Kuwaiti Dinar Som Kip Latvian Lats Lebanese Pound Loti Liberian Dollar Libyan Dinar Swiss Franc Lithuanian Litas Euro

ISO Code EUR DKK XCD EUR USD GTQ GNF XOF GYD HTG EUR HNL HKD HUF ISK INR IDR IRR IQD EUR ILS EUR JMD JPY JOD KZT KES KPW KRW KWD KGS LAK LVL LBP LSL LRD LYD CHF LTL EUR

209

Annex I Country Macao Macedonia Madagascar Malawi Malaysia Maldives Mali Malta Marshall Islands Martinique Mauritania Mauritius Mayotte Mexico Mexico Moldova Monaco Mongolia Montenegro Montserrat Morocco Mozambique Myanmar Namibia Nauru Nepal Netherlands Netherlands Antilles New Caledonia New Zealand Nicaragua Niger Nigeria Norway Oman Pakistan Panama Papua New Guinea Paraguay Peru Philippines

Currency Pataca Denar Malagasy Ariary Kwacha Malaysian Ringgit Rufiyaa CFA Franc BCEAO Euro US Dollar Euro Ouguiya Mauritius Rupee Euro Mexican Peso Mexican Unidad de Inversion Moldovan Leu Euro Tugrik Euro East Caribbean Dollar Moroccan Dirham Metical Kyat Namibia Dollar Australian Dollar Nepalese Rupee Euro Netherlands Antillian Guilder CFP Franc New Zealand Dollar Cordoba Oro CFA Franc BCEAO Naira Norwegian Krone Rial Omani Pakistan Rupee Balboa Kina Guarani Nuevo Sol Philippine Peso

ISO Code MOP MKD MGA MWK MYR MVR XOF EUR USD EUR MRO MUR EUR MXN MXV MDL EUR MNT EUR XCD MAD MZN MMK NAD AUD NPR EUR ANG XPF NZD NIO XOF NGN NOK OMR PKR PAB PGK PYG PEN PHP

210

Currencies and ISO Codes Country Poland Portugal Puerto Rico Qatar Romania Russian Federation Rwanda St Helena St Kitts and Nevis St Lucia St Martin St Pierre and Miquelon St Vincent and the Grenadines Samoa San Marino São Tome And Principe Saudi Arabia Senegal Serbia Seychelles Sierra Leone Singapore Slovakia Slovenia Solomon Islands Somalia South Africa Spain Sri Lanka Sudan Suriname Swaziland Sweden Switzerland Syria Taiwan Tajikistan Tanzania Thailand Timor-Leste

Currency Zloty Euro US Dollar Qatari Rial New Leu Russian Ruble Rwanda Franc Saint Helena Pound East Caribbean Dollar East Caribbean Dollar Euro Euro East Caribbean Dollar Tala Euro Dobra Saudi Riyal CFA Franc BCEAO Serbian Dinar Seychelles Rupee Leone Singapore Dollar Euro Euro Solomon Islands Dollar Somali Shilling Rand Euro Sri Lanka Rupee Sudanese Pound Surinam Dollar Lilangeni Swedish Krona Swiss Franc Syrian Pound New Taiwan Dollar Somoni Tanzanian Shilling Baht US Dollar

ISO Code PLN EUR USD QAR RON RUB RWF SHP XCD XCD EUR EUR XCD WST EUR STD SAR XOF RSD SCR SLL SGD EUR EUR SBD SOS ZAR EUR LKR SDG SRD SZL SEK CHF SYP TWD TJS TZS THB USD

211

Annex I Country Togo Tokelau Tonga Trinidad and Tobago Tunisia Turkey Turkmenistan Turks and Caicos Islands Tuvalu Uganda Ukraine United Arab Emirates United Kingdom

Currency CFA Franc BCEAO New Zealand Dollar Pa'anga Trinidad and Tobago Dollar Tunisian Dinar Turkish Lira Manat US Dollar Australian Dollar Uganda Shilling Hryvnia UAE Dirham Pound Sterling

ISO Code XOF NZD TOP TTD TND TRY TMT USD AUD UGX UAH AED GBP

United States Uruguay Uruguay Uzbekistan Vanuatu Venezuela Viet Nam Virgin Islands (British) Virgin Islands (U.S.) Wallis And Futuna Western Sahara Yemen Zambia Zimbabwe

US Dollar Peso Uruguayo Peso en Unidades Indexadas Uzbekistan Sum Vatu Bolivar Fuerte Dong US Dollar US Dollar CFP Franc Moroccan Dirham Yemeni Rial Zambian Kwacha Zimbabwe Dollar

USD UYU UYI UZS VUV VEF VND USD USD XPF MAD YER ZMK ZWL

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Annex II: Forex Market: Profile Bank for International Settlements (BIS)14, the Basel-based banking think-tank, conducts a comprehensive market survey every three years under the Triennial Central Bank Survey. The latest survey was conducted in April 2007, involving 1,260 market participants in 54 countries. The following are the highlights from the April 2007 survey. Market Size and Product Share The average daily turnover in April 2007 was USD 3.21 trillion, an increase of 71% from the previous survey in April 2004. It is 24 times more than international trade flows and 17 times more than trade and capital flows. Among the products, forex swaps account for the major share of 54%, followed by spot (31%) and forward (11%). The table below shows the total daily turnover (in USD billion) and the percentage share of different products in the latest three surveys. Product Spot Forward Forex swap Gaps Total

2001 Amount % 387 32 131 11 656 55 26 2 1,200 100

2004 Amount % 621 33 208 11 944 50 107 6 1,880 100

2007 Amount % 1,005 31 362 11 1,714 54 129 4 3,210 100

Business Centers London continues to maintain its dominance in forex market (as it does in others), accounting for a third of the global turnover. The table below shows the top five business centers and their percentage share in forex turnover. Business Center London New York Zurich Tokyo Singapore

14

2001 31 16 4 9 5

2004 31 19 3 8 5

2007 34 17 6 6 6

www.bis.org

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Annex II

Counterparty Types Globalization has no impact on forex market in terms of increased cross-border turnover, which continues to be steady at about 60% of the total turnover since 2001. Possibly, the forex market had already been globalized by 2001. Among the counterparty types, the share of non-bank financial institutions (e.g. hedge funds, pension funds) and non-financial counterparties has been rising. The table shows the percentage share of business with dealers, non-bank financial institutions and non-financial counterparties. Counterparty Dealer Non-bank financial Non-financial

2001 59 28 13

2004 53 33 14

2007 43 40 17

The spread of electronic trading platforms has created new opportunities and boosted turnover outside interdealer business. For the institutional investors, they have opened up algorithmic trading. For the retail traders, the Internet-based platforms provided new opportunity for day traders with high leverage, low transaction costs and 24-hour trading facility. Business Concentration Consolidation in banking industry led to decreased share of interdealer business in the total turnover. It also led to increased concentration of business. The table below shows the number of banks accounting for 75% of forex turnover. Country UK US Japan Switzerland Singapore

2001 17 13 17 6 18

2004 16 11 11 5 11

2007 12 10 9 3 11

Currency Composition USD-based currency pairs continue to dominate the trading, accounting for 90% of the total turnover. Their share fell only marginally from 91% in 2001 to 87% in 2007. The European Union‟s euro did not replace the US dollar as the interbank numeraire to any significant effect. The table below shows the percentage share of top five currency pairs in the total turnover.

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Forex Market Profile

Currency Pair EUR/USD USD/JPY GBP/USD AUD/USD USD/CHF

2001 30 20 11 4 5

2004 28 17 14 5 4

2007 27 13 12 6 5

The share of emerging market currencies in the total turnover has gone up by 3% from 16.9% in 2001 to 19.8% in 2007, reflecting their growing economic strengths. Note: Data on currency swap and currency options are not included in the above because they are considered as a part of “OTC derivatives market” rather than the traditional forex market.

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INDEX

A AA-DD rule · See aide memoire abbreviated offer side · 24 accounting · 159; collection register · 160; four principles · 169; mirror account · 163; off-balance-sheet items · 162; other GL accounts · 162; position · 160; position reconciliation · 166; profit/loss distortion · 169; revaluation · 166; suspense account · 161; wash rate · 164 ACI Code of Conduct · 35, 189 action · 200 adjusted peg · 5 advantage · 199 affirmation · See tade life cycle aggregate short position limit · 183 aide memoire: AA-DD rule · 80; twoway swap quote · 100 Allsopp Report · 174 American terms · See quotation style Angell Report · 174 arbitrage trading · 136

B back office · 137 backwardation · 71 bad bet · 199 balance of payment · 9; capital & finance account · 10; capital transfers · 10; current account · 10; current transfers · 10; errors

and omissions · 11; goods · 10; invisibles · 10; services · 10 base currency · 14 basis · 74 best practices · See trade life cycle bid-offer · See two-way quote big figure · 24 bill transactions · See commercial transactions Bretton Woods system · 5 broken date · 32 brokers · 191 buy-sell swap · See forex swap

C cancel-and-rebook rollover · See commercial transactions cancellation · See commercial transactions capital & finance account · See balance of payment carry trades · 202 cash flow: contingent · 47; fixed · 47; floating · 47 cash flow table · 46 cash management · See forex swap cash position · 46 cash settlement · See settlement cash value date · See value date chain rule · See cross rate arithmetic check on calculations · See cross rate arithmetic choice price · 190 clean transactions · See commercial transactions client on-boarding · 137 cock date · 32

217

Index

collection transactions · See commercial transactions commercial market · See forex market commercial transactions · 112; bill transactions · 113; cancel-andrebook rollover · 129; cancellation · 125; classification · 113; clean transactions · 113; collection · 115; discounting · 115; early and late payment of exports · 130; early delivery · 122; extension · 127; features · 112; financing · 115; historical price rollover · 128; import bill · 118; late delivery · 122; margin · 114; optional delivery period · 119 commodity currency · 14 comparative advantage · 1 competitive advantage · 1 confirmation · See trade life cycle contango · 71 continuous linked settlement · 173; aggregate short position limit · 183; continuous · 175; linked · 175; liquidity facilities · 183; liquidity providers · 185; matching · 178; nostro agent · 177; operations · 177; positive adjustment balance · 182; processing queue · 182; risk management tests · 182; settlement and funding · 179; settlement member · 177; short position limit · 182; third parties · 177; timeline for operations · 180; user members · 177; versus trade guarantee · 175 contracts for difference · 203 controlled float · 4 correspondent bank · 106 counterparty credit risk · 175

covered interest arbitrage · 70, 89 covered interest parity · 69, 89 cross rate arithmetic: chain rule · 56; triangular arbitrage · 62; twoway quotes · 58 cross rates · 20, 55 cross-currency settlement risk · See forex settlement crossing · 42, 55 currency convertibility · 11; capital account · 11; external convertibility · 11; trade account · 11 currency pair hierarchy · 17 current account · See balance of payment customer transactions · 111

D day beginning · 35 day closing · 35 daylight limit · See limit deal blotter · 49 deal conversations · 192 deal currency · 42 deficit · See gap derived currency · 42 direct style quotation · See quotation style discount · See forward exchange dollar cost averaging · 197

E early delivery · See commercial transactions early payment of export bill · See commercial transactions

218

Index

edge · 199; negative · 199; positive · 199; zero · 199 end-end rule · See value date equity · 204, 205 escalations · 141 ethics · 192 Eurocurrency · 76 European terms · See quotation style exceptions · 141 exchange position · 45 exchange rate regimes: fixed peg · 7; free float · 6; gliding parity · 7; managed float · 7 exposure · 45 extension · See commercial transactions

F fair bet · 199 far leg · See forex swap FEOMA · 138 fixed amount currency · 15 fixed peg · See exchange rate regimes floating rate regime: first (19141925) · 4; second (from 1973) · 6 flow traders · 136 flow trading · 112 forex market: commercial market · 19; interbank market · 19 forex settlement · 28; credit risk · 28; cross-currency settlement risk · 29; Herstatt risk · 29; liquidity risk · 28; market risk · 28; systemic risk · 29; time zone differences · 28 forex swap: buy-sell · 43; cash management · 98, 106; definition · 42; far leg · 43; near leg · 43; repo ·

45; sell-buy · 43; structure · 45; types · 43; versus currency swap · 51 forex swap quote · 99; aide memoire · 100; interest rate indicator · 100; near and far leg price fixing · 101 forex trade: barter · 14; currency pair · 14; qualifications · 13 forward differential · 71 forward exchange: arithmetic · 68; covered interest arbitrage · 70; cross rates · 85; discount · 71; history · 67; link with money market · 67; long-term · 84; market conventions · 78; nondeliverable forward · 92; par · 71; premium · 71; theory versus practice · 89; two-way quotes · 73 forward value date · See value date forward-to-forward periods · 83 free float · See exchange rate regime FRN convention · See value date front office · 136

G gap · 46; cash flows definition · 48; deficit · 46; surplus · 46 give-up bank · 151 gliding parity · See exchange rate regimes gold: demand-supply · 8; demonetization · 8; monetary system · 7; official reserve · 8 gold exchange standard · 4 gold point · 3 gold standard · 2 good bet · 199

219

Index

H half Kelly · 201 hedging operations · 206 Herstatt risk · 173, See forex settlement historical price rollover · See commercial transactions

I ICOM · 138 IFEMA · 138 IFEXCO · 138 implied interest rates · 76 import bill · See commercial transactions indirect style quotation · See quotation style inside/outside (I/O) swap · 184 interdealer market · See forex market interest rate parity · 69, 89 International Banking Facilities · 76 international Fisher effect · 90 investigations · 141 invisibles · See balance of payment ISDA · 138 ISO codes · 15

K Kelly‟s fraction · 201

L

ledger account · 163 leverage · 195 limit: daylight limit · 51; overnight limit · 51 limits · 51 liquidity facilities · 183 liquidity providers · 185; milestones · 185 liquidity risk · 175

M managed float · See exchange rate regimes margin · See commercial transactions market data · 139 market lot · 190 market practices · 189; brokers · 191; choice price · 190; ethics · 192; market lot · 190; points parking · 192; position parking · 191; spoofing · 189; stuffing · 191 martingale · 201 matching · 178 merchant transactions · 112 mid office · 136 mirror account · See accounting mismatch · 46 mnemonic aid: cross rate arithmetic · 60; outright price · 23 modified following day convention · See value date monetary system · See gold money management · 198 money market hedge · 208 month end rule · See value date multilateral netting · 140

Lamfalussy Report · 174 late delivery · See commercial transactions

220

Index

N near leg · See forex swap netting · See trade life cycle Noel Report · 174 non-deliverable forward · 92 nostro account · 106 nostro agent · 106, 177 nostro reconciliation · See trade life cycle numeraire currency · 18

O odd date · 32 odds · 198 off-balance-sheet items · See accounting offshore market · 76 operations unit · 136 optional delivery period · 119 outright · 41 overbought · See position overnight limit · See limit oversold · See position

P par · See forward exchange path dependence · 197 payments netting · 140 payment-versus-payment · 28 payoff · 198 payoff odds · 199 physical settlement · See settlement points parking · 192 position · 45, 160; cash flows definition · 48; daylight limit · 51; overbought · 45; oversold · 45

position parking · 191 position reconciliation · 166 positive adjustment balance · 182 premium · See forward exchange pre-settlement risk · 175 pre-trade preparation · See trade life cycle price gaps · 196 price maker · 22 price quotation · See quotation style price quotes · 189 price taker · 22 prime brokerage · 151; allocation · 152; best practices · 154; documentation · 152; process flow · 152 probability · 198 probability of ruin · 200 process flow · See trade life cycle profit/loss distortion · 169 proprietary trading · 111, 136 purchasing power parity · 90 pyramiding · 204

Q quant team · 136 quotation style: American terms · 21; direct style · 20; European terms · 21; indirect style · 20; price quotation · 20; volume quotation · 20 quoting currency · 14

R reference data · 139 repairs · 141 repo · See forex swap

221

Index

revaluation · See accounting risk capital · 203 risk management tests · 182 rollover spot · 203

S sales & trading unit · 136 sales trading · 136 sell-buy swap · See forex swap settlement · See trade life cycle; cash settlement · 92; physical settlement · 92 settlement and funding · 179 settlement member · 177 settlement netting · 140 settlement risk · 28 settlement status · 174 short dates · See value date short position limit · 182 small figure · 24 Smithsonian Agreement · 6 source rates · See underlying rates split settlement · See value date spoke bank · 151 spoofing · 189 spot value date · See value date static data · 139 stop-loss limit · 197, 204 stuffing · 191 surplus · See gap suspense account · See accounting swap differential · 71 swap points · 71, 77, 98, See forward exchange; broken date · 82; forward-to-forward periods · 83; short dates · 80; turn periods · 84 SWIFT codes · 15 systemic risk · 175

T third parties · 177 time zone differences · See forex settlement tom value date · See value date top-up contingency swap (TUCS) · 184 trade data · 139 trade date · 27 trade execution and capture · See trade life cycle trade life cycle · 135; affirmation · 140, 144; best practices · 142; confirmation · 140; netting · 140; nostro reconciliation · 141; pretrade preparation · 137; process flow · 137; settlement · 141; trade execution and capture · 138 trader styles · 202 trader‟s shortcut method · See cross rate arithmetic traders' lingo · 187 trading operations · 195 trading plan · 202 trended quote · 64, 191 triangular arbitrage · 62 turn periods · 84 two-way quote · 22; bid-offer · 22; mnemonic aid · 23

U unbiased future spot price · 91 underlying rates · 20 user members · 177

222

Index

V value date · 27; cash value date · 34; end-end rule · 32; exceptions to spot value date rule · 35; forward value date · 31; FRN convention · 32; Latin American currencies · 36; Middle East currencies · 36; modified following day convention · 33; month end rule · 33; short dates · 33; split settlement · 37;

spot value date · 30; tom value date · 34 value-at-risk (VaR) · 51 variable amount currency · 15 volume quotation · See quotation style

W wash rate · See accounting

223