Practitioner Guide to Forex Market-part 1

TDG Practitioner Guide

FOREX MARKET A C Reddi P Yesuthasen

in pursuit of

SIMPLICITY

THE DERIVATIVES GROUP FINANCIAL ENGINEERING and RISK MANAGEMENT

© A C Reddi 2009. All rights reserved. Printed in India. Except as permitted under Copyright Act, 1957 (as last amended by Act No. 49 of 1999), no part of this publication may be reproduced or distributed in any form or any means, without the prior written permission of the copyright holder and the publisher. Published by The Derivatives Group, 26/1 First Floor, Mangesh Street, T. Nagar, Chennai 600 017 India. Website: www.tdg.in TDG books are available at volume discount for business schools, training institutes and corporate training programs. For more information, write to the publisher or email at: [email protected] Printed by Pranam Printers & Designers, 23/24 Giri Street, West Mambalam, Chennai 600 033 India.

ISBN-13: 978-81-908834-0-5

ii

CONTENTS

Chapter 1

Forex is International Payments 1.1 Gold Standard 1.2 First Floating-rate Regime 1.3 Gold Exchange Standard 1.4 Controlled Float 1.5 Bretton Woods System 1.6 Smithsonian Agreement 1.7 Second Floating-rate Regime 1.8 Gold and Monetary System 1.9 Balance of Payment and Convertibility 1.10 Which Regime is the Best?

1 2 4 4 4 5 6 6 7 9 12

Chapter 2

Forex Basics: the Literacy 2.1 Currency Pair 2.2 Base Currency and Quoting Currency 2.3 ISO/SWIFT Codes 2.4 Hierarchy in the Currency Pair 2.5 N Currencies and N1 Currency Pairs 2.6 Numeraire Currency 2.7 Cross Rates 2.8 Quotation Styles 2.9 Two-way Quote 2.10 Abbreviated Offer Quote

13 14 14 15 17 18 18 20 20 22 24

Chapter 3

FX Settlements: Value Dates 3.1 Forex Settlement Risk 3.2 Value Dates Exceptions to Spot Value Date Rule 3.3

27 28 30 35

Chapter 4

Forex Deals: Classification and Risk 4.1 Outright 4.2 Forex swap 4.3 Exposure 4.4 Mismatch 4.5 Cash Flow Analysis 4.6 Deal Blotter, Position and Gap Statements 4.7 Limits on Position, Gap and Others Forex Swap versus Currency Swap 4.8

41 41 42 45 46 46 49 51 51

Chapter 5

Cross Rate Arithmetic 5.1 Chain Rule 5.2 Trader’s Quicker Method 5.3 Arithmetic with Two-way Quotes

55 56 58 58

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5.4 5.5 5.6

Check on Calculations Mnemonic Aid for Two-way Arithmetic Triangular Arbitrage

60 60 62

Chapter 6

Forward Exchange 6.1 Forward Exchange Arithmetic 6.2 Swap Points: Premium, Discount, Par 6.3 Arithmetic with Two-way Quotes 6.4 Nature of Swap Points 6.5 Market Conventions on Forward Exchange 6.6 Forex Prices for Short Dates 6.7 Swap Points for Broken Dates 6.8 Swap Points for Fwd-to-Fwd and Turn Periods 6.9 Long-term Forward Exchange Prices 6.10 Forward Exchange for Cross Rates 6.11 Forward Exchange: Theory versus Practice 6.12 Non-deliverable Forward (NDF)

67 68 71 73 77 78 79 81 82 83 84 88 90

Chapter 7

Forex Swaps 7.1 Forex Swap: Recap 7.2 Swap Points and Forex Swaps 7.3 Anatomy of Two-way Swap Quote 7.4 Fixing the Price for Near and Far Legs 7.5 Cash Management with Forex Swap

95 95 96 97 99 103

Chapter 8

Commercial Transactions 8.1 Features of Commercial Transactions 8.2 Classification of Commercial Transactions 8.3 Market Price and Margin 8.4 Clean Instruments/Remittances 8.5 Export Bill Transactions 8.6 Import Bill Transactions 8.7 Forward Contracts: Optional Delivery Periods 8.8 Forward Contracts: Early and Late Delivery 8.9 Forward Contracts: Cancellation 8.10 Forward Contracts: Extension/Rollover 8.11 Early and Late Payments of Purchases

107 108 108 109 110 112 113 115 117 121 123 126

Chapter 9

Trade Life Cycle and Best Practices 9.1 Organization 9.2 Process Flow 9.3 Best Practices FX Prime Brokerage 9.4

131 132 133 138 147

Chapter 10

Accounting 10.1 General Flow for Transactions 10.2 Wash Rates

155 156 160

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10.3 10.4

Position Reconciliation Mark-to-Market/Revaluation

161 162

Chapter 11

Continuous Linked Settlement 11.1 Settlement Risk in FX 11.2 Evolution of Continuous Linked Settlement 11.3 Operations 11.4 Risk Management 11.5 Liquidity Facilities 11.6 Operations Milestones

169 170 171 173 178 179 181

Chapter 12

Front Office: Trading and Hedging 12.1 FX-speak 12.2 Market Practices in Interdealer Market 12.3 Sample Deal Conversations 12.4 Trending 12.5 Trading Operations 12.6 Hedging Operations

183 183 185 188 191 192 204

Annex I

Countries, Currencies and ISO Codes

207

Annex II

Forex Market: Profile

213

Index

216

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FOREWORD

The authors have taken great pains to bring out in a lucid and clear manner the practical aspects of foreign exchange operations. All the concepts have been illustrated with practical examples that would aid students and officials to understand the way foreign exchange operations are conducted in the market and inside a dealing bank. Practices peculiar to the Indian forex market are covered, too. Mr A C Reddi was himself a forex trader with a leading bank. His rich domain knowledge is exhibited in depth with which each subject is dealt with and at the same time he has ensured that the reader gets a comprehensive view of the subject in as simple a language as possible. Mr P Yesuthasen has for many years been associated with the Financial Markets Division of the Reserve Bank of India at a time when new products were introduced in the Indian market. As a regulator, he was actively associated with the supervision of forex operations, derivatives and risk management practices in commercial banks. Both the authors have been actively involved in providing consultancy services to banks and corporate treasuries where their services are eagerly sought after. I am sure this book will go a long way in providing domain and practical knowledge to all those associated with foreign exchange business. This book is a must for all practitioners as a reference book to be kept part of the library.

R. C. ROYAPPA Formerly General Manager (Foreign Dept), State Bank of India; and Chief Executive Officer, SBI Gilts Ltd

PREFACE

From the practitioner’s perspective, the forex market has fewer books than the bond and equity markets. It is true that there are many textbooks on foreign exchange but they deal with the theory of foreign exchange and multinational finance. They do not fulfill the requirements of business and operations of a forex dealer. Ours, in 200 pages, is a modest endeavor to fill this gap. Except the first chapter, all others deal with the practice of forex. The first chapter chronicles in a dozen pages the history of exchange rates regimes over the last 150 years. Readers can safely skip this chapter: after all, “The art of reading is to skip judiciously” (Philip G Hamerton). Chapters 2 through 4 deal with the basic concepts and constitute the “literacy” of the forex. The next three chapters deal with the arithmetic: they constitute the “numeracy” of the forex. Together, these six chapters equip the reader to price and hedge any type of transaction from the customer or dealer. Chapter 8 applies the concepts and arithmetic of the previous six chapters to real-life transactions with plenty of examples and illustrations, including the early and late payments and receipts from the customers and the financing component in forex transactions. Chapter 9 deals with the trade life cycle, industry best practices and the recently emerged business of FX prime brokerage. Chapter 10 explains the accounting of various forex transactions and accounting problems in revaluation. Chapter 11 deals with the innovative forex settlement called “continuous linked settlement”, which is the world’s only cross-border multi-currency settlement system on payment-versus-payment basis with settlement finality characteristic of central bank payment systems. To our knowledge, no textbook on foreign exchange has discussed it in detail. We have spared a whole chapter to discuss in detail the concept, process and the critical operational timeline in this innovative settlement. Chapter 12 concludes the book with a detailed discussion of forex trader’s language, customs, and practices. It also discusses the general principles of speculation and hedging in forex market.

Annex I lists the countries, their currencies and their ISO codes, updated as of March 2009. Annex II summarizes the profile of global forex market from the latest Triennial Central Bank Survey 2007. Acknowledgements We have greatly benefited from discussions with our colleagues and friends in the forex market, bank and corporate treasuries and regulatory bodies. They are so many that it is quite possible that our list might miss a name or two. To manage that risk, we have chosen not to list them here and offer them our silent thanks. Being first-time authors, we are sure that the next edition will greatly improve due to readers’ feedback on omissions and commissions, which we sincerely ask you to email to us. A C Reddi

([email protected])

P Yesuthasen ([email protected])

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