Foreign Exchange
Market Overview
Convention and Terminology
Mechanics and Operations
Instruments
ปริทรรศน์ เหลืองอุทยั , CFA, FRM
9 August 2006
Historical Perspective
• 1880-1914 : Gold Standards
• 1918-1939 : The War Periods
• 1944-1970 : The Gold
Exchange Standard
• 1971-1973 : The Collapse of
Bretton Woods
• 1985 : The Plaza Accord
• 1997 : Floatation of Thai Baht
• 1999 : Introduction of the Euro
• 2002 : Continuous Linked
Settlement (CLS)
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Settlement
• Every trade executed has to be settled.
• Settlement risk is the risk that one side to a transaction
pays out its obligation in one time zone but the
counterparty to the transaction fails to make the
corresponding payment in a different time zone.
• A number of initiatives : FXNET, the oldest and the most
successful, provides an automated bilateral netting
solution, which is a legally binding agreement between
pairs of counterparties in which transactions are netted
continually throughout the trading day.
• Today around 20% of all FX transaction obligations are
netted via FXNET.
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Continuous Linked Settlement
• In September 2002, the CLS Bank was launched to
provide a solution called Continuous Linked Settlement.
• CLS operates by linking all of the world’s settlement
periods and indeed, truncating them, into a period of just
five hours.
• Acting in effect as a clearing hours, CLS receives
payments in but does not pay them out until the
correspondent payments are also received.
• Hence, CLS settles FX transaction on a paymentversus-payment (PVP) basis in the book of CLS Bank.
• CLS eliminates settlement risk and reduces the liquidity
needed.
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The Foreign Exchange Market
Financial Market Structure
Foreign
Exchange
Markets
Money
Markets
Capital
Markets
Derivatives
Markets
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Bond
Markets
Equity
Markets
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Basic Definition
• A Currency is a medium of exchange, coins or notes,
used to buy goods or services. Most countries have their
own currency, issued by an official agency called a
central bank or a monetary authority.
• Foreign Exchange (F/X or Forex) is the transaction that
involves the purchase of one currency against the sale
of another currency for settlement or delivery on a
specified date.
• The Exchange Rate is the
price per unit of one of the
currencies expressed in
units of the other currency.
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Foreign Exchange Markets
• A complex network of global
over-the-counter institutions
and structures
• 3 Key functions :
– Exchange of one currency
for another (transfer of
purchasing power)
– Management of exchange
rate risk (transfer of risk)
– Exchange rate
determination
• The market is geographically
dispersed.
• The U.S. dollar makes up the
highest percentage of the total
daily turnover shares.
Percentage Shares of Daily Turnover
Currency
2001
USD
90.4
EUR
37.6
JPY
22.7
GBP
13.2
CHF
6.1
CAD
4.5
AUD
4.2
SEK
2.6
HKD
2.3
SGD
1.1
Emerging Markets
5.2
Other
10.1
Source
TOTAL: Bank for International Settlements
200 (BIS)
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Market Overview
• The Foreign Exchange Market allows market
participants to exchange one currency for another. It is a
communication network linking all participants.
• Foreign exchange market is the single
largest market in the world. More
than USD 1.2 trillion is traded in
the FX market each day.
• London (38%) is the largest trading
center in the world, followed by
New York (22%), Tokyo (10%), and Singapore (9%).
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Foreign Exchange Instruments
Foreign Exchange Instruments
Foreign Exchange Instruments
FX Transactions
Spot FX
FX Derivatives
Forward FX
Forward Outright
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FX Swaps
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Foreign Exchange Transaction
• A foreign exchange transaction
is composed of spot, outright
forward, and swaps.
• Average daily turnover for all
currencies in April 1998 was
$1.4415 trillion (in 2001 was
$1.210 trillion).
• Transaction breakdown in
2001 was :
– 32 percent spot
transactions,
– 11 percent over-thecounter forwards, and
– 54 percent foreign
exchange swaps.
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Percentage Shares of Daily Turnover
Instruments
Daily Averages
(Billion of USD)
Spot Transactions
387
Outright Forwards
131
Foreign Exchange
Swaps
656
TOTAL Turnover
1,210
Source : Bank for International Settlements (BIS)
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Spot Transactions
• A spot transaction involves the exchange of one
currency for another at an agreed exchange rate to be
settled in cash in two business days between two
counterparties.
• Spot transactions account for about 32 percent of all
transactions in the foreign exchange market.
• A spot transaction is intended to transfer purchasing
power from one party to another.
ON
1M
TN
6M
1Y
Time
Today
Tom
Spot
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1M + Spot
6M + Spot
1Y + Spot
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Spot Foreign Exchange
• The normal settlement period for “spot” deals is
two working or business days.
• About one-third of all the business transacted in
the foreign exchange market is for settlement or
“value date” spot.
• For example, if the deal is done on Thursday,
then the spot date would be Monday.
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Example : Spot Quotation USD/THB
• Spot rate : USD/THB
38.600/620
• Base currency is US dollar.
• Counter currency is Thai baht.
38.600
(bid)
38.620
(offer)
Bank bids for USD against THB
Client sells USD and buys THB
Bank offers USD against THB
Client buys USD and sells THB
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Example : Spot Transaction
• A Thai company receives $100,000 and needs
to convert this money into Thai baht.
TODAY
$100,000
USA
Spot FX Deal @ 38.600
Thai
Company
SPOT
Thai
Company
$100,000
SPOT
Thai
Company
THB 3,860,000
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Bank
Bank
Bank
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Outright Forwards
• An outright forward is an over-the-counter transaction
involving the exchange of one currency at the forward
exchange rate determined today for the delivery to take
place for cash settlement in more than two business
days.
• About 11 percent of all transactions in the foreign
exchange market are forward contracts.
• A forward transaction is intended to transfer risk from
one party to another. Transferring risk is hedging that is
intended to reduce the exposure to foreign exchange
risk.
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Forward Outright
• An outright forward exchange deal is a contract to buy or
sell a given amount of currency for settlement at some
future date, at a rate of exchange which is agreed at the
time of dealing. No money changes hand until the
settlement date.
• Generally it is possible to obtain a forward rate of
exchange for up to one year for most traded currencies.
• The purpose of obtaining a forward rate of exchange is
simply to establish and fix the cost of exchange for a
known foreign currency commitment at some future
date.
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Forward F/X Rates
Forward Points = Forward Outright – Spot FX Rate
Forward Outright = Spot FX Rate +/- Forward Points
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Foreign Exchange Swaps
• A foreign exchange swap (a spot/forward swap) is a
contract to exchange currencies in principal amount only
in two business days (the short leg) and reversal of the
exchange of the same two currencies at a date in the
future (a long leg).
• An FX Swap is the combination of a spot deal with a
simultaneous forward deal.
• A FOREX swap is the portfolio of long and short
positions entered simultaneously at two different dates
prevailing in the future.
• The simultaneous purchase and sale of a specified
amount of one currency in exchange for two different
value dates.
• A swap transaction is essentially a financing at a fully
collateralized basis.
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Foreign Exchange Swaps
• Sell/Buy (S/B)
• Near Leg : Sell fixed amount of Base Currency
• Far Leg : Buy fixed amount of Base Currency
• Buy/Sell (B/S)
• Near Leg : Buy fixed amount of Base Currency
• Far Leg : Sell fixed amount of Base Currency
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Forward-Forwards
• When the short leg of the FX swap is more than two
business days, then the swap is called a forward/forward
swap.
• A forward-forward swap is a swap deal between two
forward dates rather than from spot to a forward date.
• FX forward-forwards are referred to by the beginning
and end dates of the forward period, compared with the
spot value date.
• For example, to sell USD 1 month forward and buy them
back 3 months forward. In this case, the swap is for the
2-month period between the 1-month date and the 3month date : “1v3”
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