FX Markets
David Whitcomb, CFA
Trader, Cargill Inc
October 15th, 2010
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Agenda
• Markets Overview
• FX Instruments and Forward Pricing
• Factors Influencing FX Markets
• Corporate Hedging and Speculative Trading
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Markets Overview
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FX Market Basics
Foreign exchange market is unique due to:
• Large trading volumes
“Global foreign exchange market turnover was 20% higher in April 2010 than in
April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion.
The increase was driven by the 48% growth in turnover of spot transactions,
which represent 37% of foreign exchange market turnover. Spot turnover rose
to $1.5 trillion in April 2010 from $1.0 trillion in April 2007.”
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FX Market Basics
Foreign exchange market is unique due to:
• Extremely High Liquidity
Daily Turnover
Bid/Offer
Number of Securities
FX Market
4.0 Trillion
0.7bp
150 (40 actively traded)
Bond Market
3.0 Trillion
1-5bps
2,000,000
Equity Market
>200 Billion
15bps
20,000+?
Source: BIS 2004, 2010, Deutsche Bank
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FX Market Basics
Foreign exchange market is unique due to:
• Geographical Dispersion (London to NY to Singapore to London…)
• According to the Bank of International Settlements (BIS), Largest
geographic trading centers are: London (36.7%), US (18.0%), Japan
(6.0%), Singapore (5.0%), Switzerland (5.0%), Hong Kong (5.0%),
Australia (4.0%)
Currency
% of Trades
US Dollar
84.9%
Euro
39.1%
Japanese Yen
19.0%
Pound Sterling
12.9%
Australian Dollar
7.6%
Swiss Franc
6.4%
Canadian Dollar
5.3%
Source: BIS 2010
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FX Market Basics
Foreign exchange market is unique due to:
• Variety of Traders in the Market
• Estimated that 90% of all FX trades are speculative
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FX Market Basics
Foreign exchange market is unique due to:
• Factors that Affect Exchange Rates:
- Economic Fundamentals
- Currency Regime
- Monetary Policy
- Central Bank Intervention
- Correlation/Reaction to Other Markets
- Speculative Activity & Market Sentiment
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FX Market Basics
•
•
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Every currency has a three letter code
Typically, the first two letters refer to the country, the final letter to
the currency
FX Market Convention
• Base Currency (Primary Currency)
• The base currency is the first currency in a currency pair; the
exchange rate is always quoted per unit of the base currency
• e.g., for EUR/USD, the Euro is the base currency… if the pair is
trading at 1.30, one Euro buys 1.30 US Dollars
• Currency Hierarchy:
•
•
•
•
•
•
•
•
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Euro
British Pound (Sterling)
Australian Dollar
New Zealand Dollar
United States Dollar
Canadian Dollar
Swiss Franc
Japanese Yen
Note: Euro is the world’s dominant base
currency, all currency pairs traded against
the Euro are quote per EUR
FX Market Convention
• Some examples of quotes in currency pairs:
Bid
Ask
EUR/GBP
0.8765
0.8770
AUD/USD
0.9750
0.9755
USD/CAD
1.0204
1.0206
USD/JPY
81.04
81.06
Base
/ Secondary
Quote to sell* base Quote to buy* base
currency
currency
* From a corporate perspective, the bank/dealer sees it the other way
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FX Instruments and Forward Pricing
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FX Spot
• Spot rate is the exchange rate at which one currency is exchanged
for another for settlement as soon as possible (usually t+2)
• According to BIS, 37% of all FX transactions are spot
transactions…i.e., for customers who want the physical cash as
soon as possible
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FX Forward
• What if you want to lock in an FX rate to satisfy a future obligation?
• A forward contract in the FX market locks in the price at which an
entity can buy or sell a currency on a future date:
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•
Both parties agree on an exchange rate for a specific date in the future
•
Money does not change hands until the future maturity date
•
Length of the contract can be a couple of days, months, or years
FX Forward
Forward Pricing:
Forward price = Spot price + Forward (or swap) points
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BID
ASK
Spot: USD/CAD
1.0200
1.0202
Fwd (swap) points
[1yr fwd]
+.0123
+.0127
Forward rate
[1yr fwd]
1.0323
1.0329
FX Forward
• The forward rate is determined by the interest rate differentials between
two currencies, so no arbitrage is possible:
• One of the most important mathematical concepts in FX: understanding
the basic relationship between FX forwards and Interest Rates
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FX Forward
• Forward points are negative (the all-in forward rate is lower than the spot
rate) when interest rates in the base currency are higher than the
secondary currency…the denominator is larger
• A little counterintuitive: Why do higher interest rates make a currency
“depreciate” on the forward curve?
• This prevents speculators from investing funds in the country with higher
rates and locking in a risk-free profit
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FX Forward
• Example: USA vs Canada. Chairman Bernanke and the Fed intend to
keep US rates low (Fed Funds rate = 0.00-0.25%) while Gov Carney and
the Bank of Canada have raised rates to 1.25% over the past four
months.
• Risk-Free Rate US: 1-Year LIBOR = 0.75%
• Risk-Free Rate Canada: 1-Year CAD LIBOR = 2.00%
• Today, you can buy/sell USDCAD one-year forward at ≈1.0327
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FX Forward
October 14, 2010
Deposit USD for 12
months at rate of
0.75%
USD 10,075,000
USD 10,000,000
Spot rate
1.0200
Two paths, both end up with the
same CAD amount…no arbitrage!
Receive CAD 10,200,000
“Forward”
All-In Rate
1.0327
Receive CAD 10,404,000
Deposit CAD for 12
months at rate of
2.00%
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October 14, 2011
FX Forward
• Question: How would you arb the following? i.e., where would you
borrow/invest to extract the value from this market anomaly:
•
•
•
•
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AUDUSD spot is 0.9500
AUDUSD 1yr forward rate = spot rate = 0.9500
Risk-Free Rate US: 1-Year LIBOR = 1.00%
Risk-Free Rate Australia: 1-Year AUD LIBOR = 6.00%
FX Forward
Answer:
• You know that the forward fx rate is too high (with higher rates, AUDUSD 1yr
forward should be lower, not equal to spot…)
Day 1:
• Borrow $1,000 USD at US rate of 1.00%
• Convert the USD to AUD = $1,000 / 0.95 = AUD1,053
• Invest the AUD in an Australian risk-free investment earning 6.00% for a year
• Sell AUDUSD forward so you will have USD in a year to repay your USD loan
Day 360:
• Your AUD investment becomes 1,053 x 1.06 = AUD1,116
• When converted back to USD = AUD1,116 x 0.95 = $1,060
• Subtract the interest you owe on the USD borrow = $1,000 x 1.00% = $10.00
• You’ve made $1,060 – $1,000 – $10.00 = $50.00
• That’s $50.00 Risk Free! (ex-counterparty risk)
• Note: You earn this arbitrage today, all the rates are “locked in”
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FX Options
FX Option is a derivative where:
• The option holder has the right but not the obligation to exchange money
denominated in one currency for a second currency at a pre-agreed
exchange rate on an established date
• The option buyer may, for an agreed price (i.e. the premium), purchase
an option to buy or sell a currency at expiry date
• There are two major types of options: American and European options
• American options can be exercised at any time before expiry
• European options can only be exercised at expiry
• Call = Right to Buy, Put = Right to Sell
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FX Options
Option Pricing depends upon:
•
•
•
•
•
•
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The spot rate
The tenor of the option (time to maturity)
The volatility of the currency pair
The foreign interest rate
The domestic interest rate
The strike price, i.e., how far is the option in the money
Factors Influencing FX Markets
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Factors Affecting FX Movements
• Economic policies by central banks affect FX movements.
• The ability of a country to attract capital investments will also impact the
movement of its currency.
A strong economy
And/or
Tight monetary policy
A weak economy
And/or
Expansionary monetary
policy
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Attracts capital from overseas,
More Reserves
Current account financing is easy
The home currency appreciates
Capital flows overseas,
Fewer Reserves
Current account financing is difficult
The home currency depreciates
Factors Affecting FX Movements
Themes in FX Right Now:
• “FX Wars” and “Competitive Devaluation”
• Pronounced USD weakness as chances are high that we embark on another
Quantitative Easing (i.e., money printing) campaign in November
• China’s Resistance to Revaluation of Yuan
“This sets off a damaging dynamic…The collective impact of this behavior risks either causing
inflation and asset bubbles in emerging economies, or else depressing consumption growth and
intensifying short-term distortions in favor of exports.”
– Treasury Secretary Timothy Geithner, 10/6/10
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Corporate Trading and Speculative
Trading
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Corporate Hedging
How Do Large Corporations Use FX?
Example:
•
•
•
A large, Canadian Multinational Food Company sells Cattle in the US
The market for Cattle is US dollar based
The Canadian Company receives US dollars for its cattle sales
Cattle
US Dollars
Canadian Company
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US Customer
Corporate Hedging
The Problem:
•
•
The Canadian company faces significant FX risk
If the US$ depreciates significantly, the company’s contracts for future cattle
sales become worth significantly less in CAD$
Today that same contract for
1,000,000 US$ only worth
about 1,000,000 CAD$
1,000,000 US$ contract set in
March ‘09 worth1,300,000 CAD$
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Corporate Hedging
The Solution: Hedge
•
•
The Canadian Company knows it will receive US dollars in the future from its
US customer
The Company can hedge by selling US dollars at a forward date in exchange
for Canadian dollars
The Hedge:
US Dollars
US Dollars
Canadian Dollars
Bank
•
•
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Canadian Company
US Customer
Regardless of the appreciation/depreciation of the US dollar, the Canadian
Company will receive a contracted amount of Canadian dollars
The Canadian Company effectively receives Canadian dollars for its sales
Speculative Trading
Technical and Fundamental Trading
• Technical: Historical price movements predict future price movements
- Support/Resistance, Fibonacci, Moving Average, Channels/Trends…
• Fundamental: Economic factors determine FX valuations
- Interest Rate Parity, Purchasing Power Parity (“Big Mac Index”)…
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Speculative Trading - Fundamental
Barclays, FX Research Intraday Comment, 10/11/10:
“Last week, our economics team made two significant changes to their policy rate hike expectations.
First, our US economists now expect the Fed to announce a programme of 'incremental' asset
purchases targeting a certain amount of flow each month (around USD100bn). They do not expect
any upper limit for asset purchases but expect the length of the programme to be tied to improvement
in economic data. Second, our European economists now forecast the ECB to be on hold for 2011
(previously we expected a hike in Q211). This change in view is driven by three factors:
expectations of further QE by the Fed; further fiscal tightening announced in some countries
(France, Portugal); and the upwards pressure on the EUR as an expression of the increasingly
bearish USD sentiment. Given these changes, we have accordingly revised our EUR/USD forecasts
to 1.42, 1.39, 1.35 and 1.30 in 1, 3, 6 and 12m, respectively (previously, 1.35, 1.35, 1.33 and 1.30).”
• Note the emphasis that Barclays puts on interest rate decisions
• “further QE by the Fed” = more Treasuries purchased, driving US interest
rates lower, making US investments less attractive, USD bearish
• “further fiscal tightening” in Europe = higher Eurozone interest rates, making
EUR investments more attractive, EUR bullish
• Again: It all comes down to interest rates
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Speculative Trading - Technicals
Credit Suisse, Global Strategy Technical Analysis, 10/06/10:
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Speculative Trading - Technicals
CitiFX, Technicals, 10/11/10:
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