Introduction To Foreign Exchange

Saeed Amen
Introduction
 We present a brief introduction to the foreign exchange market
 What are the major currencies?
 How are they quoted?
 What is relative liquidity of different currency pairs?
 Brief description on how FX options are quoted.
Foreign Exchange Market
 Volume $3.5tr
 FX spot - $1tr
 Buying currency for immediate delivery – settlement usually T+1
 Outright FX forwards - $350mm
 Buying currency for future delivery – for example 1M delivery
 FX swaps - $1.7tr (FX spot + FX forward)
 Buying (selling) spot and selling (buying) forward date
 Common usage is to roll spot positions overnight through tom/next contract
 FX options - $200bn
 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
 UK 34% - open during both Asian (morning) and American timezones (afternoon)
 US 17%
 Singapore 6%
 Switzerland 6%
 Japan 6%
 Source BIS 2007 & Wikipedia
Major Currencies
 Double counting given FX transactions involve two currencies – base/terms quote
 G10 (official name and “trading” name)
 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
 Written in quotation order
 Eg. EUR always first, JPY always last
 Correct quotations EUR/GBP, AUD/NZD, CHF/JPY etc.
 Generally USD crosses traded more (except EUR/scandis)
 EUR/USD (27%), USD/JPY (13%), GBP/USD (12%), AUD/USD (6%), USD/CHF (5%),
USD/CAD (4%), USD/SEK (2%), USD/other (19%)
 EUR/JPY (2%), EUR/GBP (2%), EUR/CHF (4%), EUR/other (4%)
 Other crosses (4%) – eg. AUD/NZD, NOK/SEK
 Can trade any cross indirectly if direct equivalent not traded eg. CHF/SEK = EUR/CHF and
EUR/SEK
Emerging Market Currencies
 Double counting given FX transactions involve two currencies
 Usually traded against USD (except CEE)
 Most Asian and Latam currencies are traded as NDF – non-deliverable forwards settled in USD
 Many currencies in EM are pegged or are managed currencies that trade within a band that
central bank supports
 Common “trading” name also given
 Latam
 MXN – Mex (1.3%), BRL* (0.4%) - Brazil, CLP* - Chile, COP* - cop
 EMEA
 CEE – PLN (0.8%) - Poland, CZK - Czech, HUF – huf traded mostly EUR/CEE
 ZAR – rand (0.9%), RUB* - rouble (0.8%), TRY - Turkey, ILS - shekel, ISK (against EUR
– very illiquid now)
 Asia
 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
 Investors can trade FX leveraged
 E.g put on a margin of $10mm USD to cover losses and trade $20mm USD notional
 Greater leverage is more risky
 Long/short
 Going long EUR/USD
 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)
 aaa/bbb = 1 / aaa/bbb
 aaa/bbb = aaa/ccc * ccc/bbb
Liquidity
 Liquidity concentrated during London hours
 Most liquidity between 12 – 16 LDN (London and NY open)
 Dependent on local markets (eg. Scandis illiquid during Asian time, similarly EM Asian
currencies illiquid during NY time)
 Illiquidity reduces sizes that can be traded and increases spreads
 Major USD crosses such as EUR/USD are liquid all the time
 Market opens approx 2200 LDN Sunday evening in Sydney and continues trading till 5pm NY
on Friday evening
 Amount that can be executed depends on time of day and currency cross
 $100mm USD in EUR/USD is not big amount, but in USD/NOK it is a big amount
 Recent market turmoil has reduced liquidity
Who trades FX markets?
 Not everyone is an FX speculator
 Corporations repatriating profits
 Investors buying assets in foreign countries
 Foreign equities and bonds, businesses
 Tourists visiting other countries
 Governments
 Central banks
 Intervening in market to strengthen/weaken currency
 Mostly EM countries
 However, some G10 countries have intervened in the past
 Recently Russia has intervened to try and support RUB (sell USD reserves and buying RUB)
 UK unsuccessfully tried to defend GBP in 1992
 Also diversify currency reserves
 Speculators trying to predict future exchange rate (also help liquidity)
 Hedge funds
 Retail investors
 Banks
Market Makers
 Market makers provide liquidity
 Commercial and investment banks – DB, UBS, Barcap, Citi, RBS, JPMorgan, HSBC, LEH/NOM, GS, MS
(order of liquidity)
 FX mostly traded over-the-counter
 Some futures are traded on exchanges (eg. at CME)
 G10 FX spot bid/ask spreads are very small in most liquid crosses
 EUR/USD 1 or 2 pips

 G10 FX spot is high volume, low margin business (compared to many other assets)
 In EM, volumes are lower, hence spreads are wider given that it is more difficult to hedge out
risk
 High liquidity is an attraction for investors
 Interbank FX brokers
 Interbank electronic platforms – EBS & Reuters
What influences exchange rates?
 Fundamental factors
 Interest rates
 Higher interest rates attract overseas capital
 Carry trade – investors taking advantage of carry differential between two currencies
 Economic situation
 Current account
 GDP
 Inflation
 Unemployment
 Raft of other economic indicators – surveys, new auto sales etc.
 Terms of Trade Effects
 State of the market
 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?
 Technical factors
 Momentum (trend following) and mean reversion (range trading)
 Positioning in currencies
 Charting – areas of resistance, support etc.
 Market will focus on different aspects at different times, sometimes totally ignoring factors.
Need to adapt to changes in the market.
 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
 Traders typically quote implied vols for different tenors (ON, 1W, 1M etc.)
 ATM implied vol – what strike ATM is depends on the currency pair and tenor!
 10d and 25d risk reversals – give the skewness of the smile – call & put OTM
 RR 25d = IV(25d call) – IV(25d put) – roughly
 10d and 25d strangles – gives the curvature of the smile – call & put OTM
 SM 25d = (IV(25d call) + IV(25d put))/2 - ATM
 Can create a vol surface from these quotes to price any strike & tenor options
 Calculate option price using a model like Black-Scholes
 Rationale is that spot is very volatile, where as vols are not, so don’t need to keep updating prices
 Smile is not sticky, moves with spot
 NOT like in equities where a price is quoted by traders and we back out implied vol from price
 Terminology
 USD/JPY call = USD call / JPY put NOT USD put / JPY call
 Clearly a big subject!
 Peter Carr has good presentation that introduces FX options
http://www.samsi.info/200506/fmse/workinggroup/lp/Presentations/Carr2.pdf