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