Introduction To Foreign Exchange
Saeed Amen
Introduction
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We present a brief introduction to the foreign exchange market
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What are the major currencies?
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How are they quoted?
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What is relative liquidity of different currency pairs?
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Brief description on how FX options are quoted.
Foreign Exchange Market
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Volume $3.5tr
 FX spot - $1tr
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Outright FX forwards - $350mm
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Calls, put, straddles, strangles (buy OTM call and put) risk reversals (buy OTM call & sell put) most common
vanillas
More exotic instruments – barrier options, one touches, volatility swaps, correlation swaps etc.
Centres
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UK 34% - open during both Asian (morning) and American timezones (afternoon)
US 17%
Singapore 6%
Switzerland 6%
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Japan 6%
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Buying (selling) spot and selling (buying) forward date
Common usage is to roll spot positions overnight through tom/next contract
FX options - $200bn
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Buying currency for future delivery – for example 1M delivery
FX swaps - $1.7tr (FX spot + FX forward)
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Buying currency for immediate delivery – settlement usually T+1
Source BIS 2007 & Wikipedia
Major Currencies
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Double counting given FX transactions involve two currencies – base/terms quote
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G10 (official name and “trading” name)
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EUR (37%) - euro, GBP (15%) – sterling/British pound, AUD (6.7%) – Australian dollar Aussie, NZD (1.9%) – New Zealand dollar - Kiwi, USD (86.3%) – US dollar - dollar, CAD
(4.2%) – Canadian dollar – cad (loonie), CHF (6.8%) – Swiss franc - Swiss, NOK (2.2%) –
Norwegian krone - Nokkie, SEK (2.8%) – Swedish krona - Stokkie, JPY (16.5%) Japanese
yen
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Written in quotation order
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Eg. EUR always first, JPY always last
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Correct quotations EUR/GBP, AUD/NZD, CHF/JPY etc.
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Generally USD crosses traded more (except EUR/scandis)
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EUR/USD (27%), USD/JPY (13%), GBP/USD (12%), AUD/USD (6%), USD/CHF (5%),
USD/CAD (4%), USD/SEK (2%), USD/other (19%)
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EUR/JPY (2%), EUR/GBP (2%), EUR/CHF (4%), EUR/other (4%)
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Other crosses (4%) – eg. AUD/NZD, NOK/SEK
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Can trade any cross indirectly if direct equivalent not traded eg. CHF/SEK = EUR/CHF and
EUR/SEK
Emerging Market Currencies
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Double counting given FX transactions involve two currencies
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Usually traded against USD (except CEE)
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Most Asian and Latam currencies are traded as NDF – non-deliverable forwards settled in
USD
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Many currencies in EM are pegged or are managed currencies that trade within a band that
central bank supports
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Common “trading” name also given
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Latam
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MXN – Mex (1.3%), BRL* (0.4%) - Brazil, CLP* - Chile, COP* - cop
EMEA
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CEE – PLN (0.8%) - Poland, CZK - Czech, HUF – huf traded mostly EUR/CEE
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ZAR – rand (0.9%), RUB* - rouble (0.8%), TRY - Turkey, ILS - shekel, ISK (against EUR –
very illiquid now)
Asia
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HKD (2.8%) – Hong Kong, KRW* (1.1%) - Korea, INR* (0.7%) - India, CNY* (0.5%) China, TWD* (0.4%) - Taiwan, SGD - sing, MYR* - Malaysia, IDR* - Indonesia
Terminology
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Investors can trade FX leveraged
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E.g put on a margin of $10mm USD to cover losses and trade $20mm USD notional
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Greater leverage is more risky
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Long/short
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Going long EUR/USD
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Borrow USD which is sold, and used to buy EUR
Due to arbitrageurs cross rates consistent at nearly all time levels (eg. EUR/JPY = EUR/USD
rate * USD/JPY)
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aaa/bbb = 1 / aaa/bbb
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aaa/bbb = aaa/ccc * ccc/bbb
Liquidity
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Liquidity concentrated during London hours
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Most liquidity between 12 – 16 LDN (London and NY open)
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Dependent on local markets (eg. Scandis illiquid during Asian time, similarly EM Asian
currencies illiquid during NY time)
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Illiquidity reduces sizes that can be traded and increases spreads
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Major USD crosses such as EUR/USD are liquid all the time
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Market opens approx 2200 LDN Sunday evening in Sydney and continues trading till 5pm NY
on Friday evening
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Amount that can be executed depends on time of day and currency cross
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$100mm USD in EUR/USD is not big amount, but in USD/NOK it is a big amount
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Recent market turmoil has reduced liquidity
Who trades FX markets?
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Not everyone is an FX speculator
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Corporations repatriating profits
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Investors buying assets in foreign countries
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Foreign equities and bonds, businesses
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Tourists visiting other countries
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Governments
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Central banks
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Intervening in market to strengthen/weaken currency
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Mostly EM countries
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However, some G10 countries have intervened in the past
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Recently Russia has intervened to try and support RUB (sell USD reserves and buying RUB)
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UK unsuccessfully tried to defend GBP in 1992
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Also diversify currency reserves
Speculators trying to predict future exchange rate (also help liquidity)
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Hedge funds
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Retail investors
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Banks
Market Makers
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Market makers provide liquidity
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Commercial and investment banks – DB, UBS, Barcap, Citi, RBS, JPMorgan, HSBC, LEH/NOM, GS, MS (order of
liquidity)
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FX mostly traded over-the-counter
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Some futures are traded on exchanges (eg. at CME)
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G10 FX spot bid/ask spreads are very small in most liquid crosses
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EUR/USD 1 or 2 pips
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G10 FX spot is high volume, low margin business (compared to many other assets)
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In EM, volumes are lower, hence spreads are wider given that it is more difficult to hedge out
risk
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High liquidity is an attraction for investors
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Interbank FX brokers
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Interbank electronic platforms – EBS & Reuters
What influences exchange rates?
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Fundamental factors
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Interest rates
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Higher interest rates attract overseas capital
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Carry trade – investors taking advantage of carry differential between two currencies
Economic situation
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Current account
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GDP
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Inflation
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Unemployment
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Raft of other economic indicators – surveys, new auto sales etc.
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Terms of Trade Effects
State of the market
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Investor sentiment – during periods of poor investor sentiment (like now) people are
not prepared to take as much risks, hits currencies that are considered risky like
Turkish Lira
What influences exchange rates?
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Technical factors
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Momentum (trend following) and mean reversion (range trading)
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Positioning in currencies
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Charting – areas of resistance, support etc.
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Market will focus on different aspects at different times, sometimes totally ignoring factors.
Need to adapt to changes in the market.
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Each trader has a different take – some look at fundamentals, others at technical factors, but
most at a mixture of both. There is no “right” way to view the market.
FX Options
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Traders typically quote implied vols for different tenors (ON, 1W, 1M etc.)
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ATM implied vol – what strike ATM is depends on the currency pair and tenor!
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10d and 25d risk reversals – give the skewness of the smile – call & put OTM
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RR 25d = IV(25d call) – IV(25d put) – roughly
10d and 25d strangles – gives the curvature of the smile – call & put OTM
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SM 25d = (IV(25d call) + IV(25d put))/2 - ATM
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Can create a vol surface from these quotes to price any strike & tenor options
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Calculate option price using a model like Black-Scholes
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Rationale is that spot is very volatile, where as vols are not, so don’t need to keep updating prices
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Smile is not sticky, moves with spot
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NOT like in equities where a price is quoted by traders and we back out implied vol from
price
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Terminology
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USD/JPY call = USD call / JPY put NOT USD put / JPY call
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Clearly a big subject!
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Peter Carr has good presentation that introduces FX options
http://www.samsi.info/200506/fmse/workinggroup/lp/Presentations/Carr2.pdf