A Brief Tutorial on
FX Markets - courtesy of
Foreign exchange rates
exchange rate is the parity between two currencies i.e. the amount of one
currency needed to sell (or buy) in order to buy (or sell) one unit of the
other currency. There are two ways to express such a rate. The most common
(or international way) quotes the amount of any currency that corresponds
to one U.S.Dollar. So when we see USD/DEM at 1.5000 this means that one dollar
can be exchanged for 1.5 Dmarks. Among the major currencies it is only British
sterling which is quoted the other way i.e. GBP/USD at 1.5500 means that one
pound is exchanged for 1.55 dollars. The American way of quoting rates uses
the opposite direction, that is it expresses the dollar amount that can be
exchanged for one unit of foreign currency. So when we see for example the
Dmark at 0.6625 this means that one mark can be exchanged for 0.6625 dollars
(or the same at 66 1/4 cents). The term "cross rate" is usually used to express
the parity between two nondollar currencies like DEM/SFR.
Bid and offer
Rate direction and currency direction
rates in practice are quoted as two-way rates. Thus a dollar/mark quotation
will read something like 1.5000/10. The bank or company which quotes this
rate understands that it buys marks (selling dollars) at 1.5010 and sells
marks (buying dollars at 1.5000). In other words it buys cheaper and sells
dearer a given currency in exchange for the other one. Of course, the opposite
is true for the person that asks for a quotation. The difference between the
purchase and the sale rates is called "spread". Such spreads vary in size
according to market volatility.
to keep very clear in mind the idea of market direction. First of all, in
the foreign extern market it is a mistake to say that the market is going
up or down. In the stock market one can use this expression as stocks either
go up or go down. However, in the FX market a rate as we said defines the
parity of two currencies, hence at any time one goes up , so the other goes
down. Therefore we can talk about the dollar going up or down but not about
the market doing so. Another issue that often confuses people (even traders
and bankers) is the difference between a currency moving up and its rate going
up. We have to explain this in more detail as any misunderstanding can lead
to painful surprises when trading in the real market. For simplicity reasons
let us forget for the time being the bid/offer spread. So let us suppose that
dollar/mark moves from 1.5000 to 1.5010. In this case the rate goes up whereas
the value of the mark goes down (simply because the value of the dollar goes
up). In other words one needs more marks at 1.5010 to exchange for one dollar.
Basis points or pips
exchange rate usually consists of an integer part and 4 decimal points (or
2 decimal points when expressed per 100 units like e.g. dollar/yen). Thus
the decimals are expressed either at 10th thousands or hundreds. Each such
0.0001 or 0.01 is called basis point or pip. E.g. a 50 pips change of 1.5000
is either 1.5050 or 1.4950.
Spot and forward rates
people these concepts are more easily understood as cash rates and futures.
As a matter of fact we would not like to use the term "futures" here as this
may lead to confusion with the typical futures contracts. Instead, let us
use a more descriptive approach. A spot rate is the exchange rate which is
valid for a transaction (purchase of currency A and sale of currency B) that
must be concluded within the next two working days. Thus the value date (i.e.
the day of actual delivery of currencies) of a transaction performed on a
Monday is Wednesday. For Thursday it is Monday (weekend days are not counted).
On the other hand, a forward transaction regards a deal which is concluded
today and actual effect will take place on a fixed future date In the next
paragraph we describe the relationship between a spot and a forward rate.
Interest rates, swap rates and forward rates
Many people, even in the financial sector think that a forward rate is
an expectation or forecast of a future foreign exchange movement. This is a big
mistake. Actually, a forward rate is nothing else but a mirror of the currently
prevailing spot rate, allowing for the interest rate differential between the
two currencies and the time period at the expiration of which the actual
transaction will be concluded. So the spot rate is adjusted by the so called
swap rate to give the forward rate. For the unsophisticated investor it is
enough to say that the swap rate is there to compensate the low interest
currency holder for the time period involved in a forward transaction. The best
way to explain these strange sounding terms is an example. We shall keep the
simplistic approach and will not get involved here with FX rate spreads and
interes rate spreads. Suppose person X buys $ 100,000 against Dmarks from bank B
at spot rate 1.5000 for value 30 days forward. Furthermore let us assume that
the dollar interest rate for this period is 5% and for the mark 3%. This means
that during these 30 days A will earn interest on the marks he keeps until
delivery and B will earn interest on the dollars for the same reason. The
forward rate must allow for the compensation of A so that on balance no party is
better or worse off. Investor A will receive interest in marks=
(150,000x3x30)/36,000 = 375. On the other hand bank B will receive interest in
dollars = (100,000x5x30)/36,000 = 416.67. This dollar amount calculated by
prevailing spot rate 1.5000 is equivalent to 625 marks. It is evident that bank
B has to compensate investor A through the forward rate, i.e. A will pay a lower
price for the dollars he is buying forward to equalise the difference of 250
marks. Through a formula we can reach the swap rate 0.0025 This is subtracted
from 1.5000 and the forward rate 1.4975 prevails. Indeed, the investor will
finally deliver 149,750 marks to receive 100,000 dollars.
The need for a forward market
The actual need for the existence of a foreign market is not
speculation, although as we explain in another article (see Why get involved
in the foreign exchange market) today there is no clear-cut line between
hedging and speculating. However, there are a couple of characteristic
categories of people who use the forward market in order to cover for time lags.
The first group includes exporters and importers. As receipts and payments do
not usually coincide timewise, these people buy forward the currency that they
will have to pay and sell forward the currency that they will receive. In this
way they overcome undesirable market fluctuations and take care of future cash
flows. The second group consists of people who use the forward market to
preserve the value and nature of their assets without speculating against future
trends. These operators use both the spot and forward market through swaps,
which are explained below.
transaction (not to be confused with the swap rate) is a double-leg deal,
in which one buys spot currency X selling currency Y and simultaneously sells
forward currency X buying currency Y. Let us give an example to show the rational
of such a transaction. Assume that an American investor has a future receipt
in Dmarks. In addition, assume that he thinks that German bonds are presently
a good investment. So he has dollar assets but does not hold cash in marks.
In plain words he needs marks right now and cannot wait for the future receipt
marks to come. One solution would be to sell dollars and buy marks in the
spot market. However, suppose he does not wish in a foreign exchange adventure
for he cannot forecast the exchange value of the future receipt. In this case
he sells dollars against marks spot getting his marks and buying his bonds.
Simultaneously he buys dollars forward against marks matching the value date
of the receipt. Upon expiration of the forward period, the investor cashes
the receipt, pays back the marks that he owes and gets his original dollars.
Hence he has been able to overcome the time lag problem.
FX market and Money market
issue to be discussed in this brief walk is the non-difference between two
markets that are the flip side of each other. We have already mentioned earlier
that a swap rate is basically based on interest rate differentials. We have
also explained in the previous paragraph the nature of a swap transaction.
The investor who uses marks bought in the forward market to buy German bonds
has another option. He can place his dollars on deposit and borrow from the
bank the marks he needs.Hence, he will have a dollar deposit and a mark loan.
Indeed, the interest between what he gets and what he pays is also expressed
through the swap rate Therefore, both ways lead to the same result. The only
advantage going though the foreign exchange market rather than through the
money market is simplicity i.e. usually it is faster and easier to obtain
an FX facility rather than obtaining a loan, even one based on a collaterilised