Currency Risk summary
Contents
Chapter 6 – the foreign exchange market .............................................................................................. 1
Chapter 7 – International Parity Conditions ........................................................................................... 9
Chapter 8 – Foreign currency derivatives and swaps ........................................................................... 18
Chapter 10 – Transaction and translation exposure............................................................................. 31
Chapter 11 – Operating exposure ......................................................................................................... 44
Chapter 6 – the foreign exchange market
The foreign exchange market provides…
- The money of one country (currency) is exchanged for that of another country.
- The rate of exchange between currencies is determined.
- Foreign exchange transactions are ‘physically’ completed.
Foreign exchange = money of a foreign country (foreign currency bank balances,
banknotes).
Foreign exchange transaction = an agreement between a buyer and seller that a fixed
amount of one currency will be delivered for some other currency at a specified rate.
FOREX = forex exchange.
Main characteristics of FOREX markets:
1. The geographic extent
2. The three main functions of FOREX markets
3. The market’s participants
4. Types of transactions including spot, forward and swaps
5. The daily transaction volume
6. Methods of stating exchange rate quotations, and changes in exchange rates.
1-Geographical extent of the
foreign exchange market
The market opens in Sydney and
Tokyo, and passes the world
throughout the day where after it
closes in LA. It is open 24h, busiest
around EU lunch time because then all
3 continents are online. Closing prices
are published as the official price or
‘fixing’ for the day. Some commercial
transactions are based on this official price.
2-Functions of the FOREX markets
FOREX markets = the mechanism by which participants transfer purchasing power
between countries, obtain or provide credit for international trade transactions, and
minimize exposure to the risks of exchange rate changes. Participants can:
- Transfer purchasing power between countries (necessary for IB)
- Obtain or provide credit for international trade transactions
- Minimize exposure to exchange rate risk: it provides ‘hedging’ facilities.
3-Market Participants
The FOREX market consists of two tiers:
1
, - The interbank / wholesale market
- The client / retail market
There are five broad categories of
participants within these two tiers:
1. Bank and nonbank foreign
exchange dealers (wholesale).
Dealers in the foreign exchange
departments of large
international banks often
function as market makers.
Trading limits are important
because foreign exchange
departments of many banks
operate as profit centres, and
individual dealers are
compensated on a profit
incentive basis.
2. Individuals and firms conducting
commercial or investment
transactions (retail). Importers,
exporters, MNEs, tourists.
3. Speculators and arbitragers (retail). They operate in their own interest.
Speculators seek all their profit from exchange rate changes in one market.
Arbitragers try to profit from simultaneous exchange rate differences in multiple
markets.
4. Central banks and treasuries (wholesale). Their motive is not to earn a profit as
such, but influence the foreign exchange value of their currency so that it will
benefit their citizens.
5. Foreign exchange brokers. They are agents who facilitate trading between dealers
without themselves becoming principals in the transaction: they charge a small
commission.
CLS = Continuous Linked Settlement: this eliminates losses if either party of a foreign
exchange transaction is unable to settle with the other party. It also helps counteract
fraud. This links with…
RTGS = Real-Time Gross Settlement, in 7 major currencies.
4-Transactions in the interbank market
3 types:
- Spot transaction
- Forward transaction
2
, - Swap transaction.
Spot transactions: immediate delivery of foreign exchange.
Spot transaction in the interbank market = the purchase of foreign exchange with
delivery and payments between banks on the second following business day.
Value date = the date of settlement.
Outright forward transaction: requires delivery of foreign exchange at some future date.
It requires delivery at a future value date of a specified amount of one currency for
another. The exchange rate is set at the time of the agreement, but payment and
delivery are not required until maturity. Most of the times, forward exchange rates are
quoted for value dates of 1, 2, 3, 6 and 12 months, payments are always done on
business days.
Swap transactions: combination of spot and forward.
Swap transaction in the interbank market = simultaneous exchange of one foreign
currency for another for two different value dates (a temporarily exchange). Both
purchase and sale are done with the same counterparty.
Spot against forward = the dealer buys a currency in the spot market and at the same
time he sells the same amount back to the same bank in the forward market. This is a
single transaction with one counterparty, so the dealers does not get unexpected foreign
exchange risks.
Forward-forward swap = A forward-forward is a swap deal between two forward dates as
opposed to an outright forward that runs from a spot to a forward date. An example is to
sell USD 30 days forward and buy them back in 90 days’ time. The swap is for the 60-
day period between 30 days from deal date (now = T) and 90 days from deal date.
Interest rate parity = the difference between the buying and selling price (the same as
the interest rate differential).
Nondeliverable Forwards = NDFs =settles only in USD; the foreign currency being sold
forward or bought forward is not delivered. They are contracted offshore and are traded
internationally using standard set by the ISDA (International Swaps and Derivatives
Associations).
NDFs are used primarily for emerging market currencies, currencies that typically do not
have open spot market currency trading, liquid money markets, or quoted Eurocurrency
interest rates. NDF markets normally develop for country currencies having large cross-
border capital movements, but still being subject to convertibility restrictions.
Pricing NDFs reflects basic interest differentials and some additional premium charged by
the bank for dollar settlement.
NDFs are traded and settled outside the country of the subject currency, and therefore
are beyond the control of the country’s government.
Problem of NDFs: they are an imperfect replacement for traditional forward contract.
5-Size of the FOREX market
BIS = Bank of International Settlements
Global foreign exchange turnover is divided into three categories of currency instruments
(spot, forward, swap transactions).
The ‘big three’ dominate global trades: dollar, euro and yen.
6-Foreign exchange rates and quotations
Foreign exchange rate = the price of one currency expressed in terms of another
currency.
3
, Foreign exchange quotation = buy or sell at an announced rate.
The basic of currency trading:
If the price is $0.40/orange: the ‘price’ is $0.40, and the ‘unit’ is the orange.
Spot market quotes
The base currency to quote a currency’s value is always USD. A currency’s value is
always quoted in terms of number of units of currency to equal one USD.
Foreign currency quotations convention
Direct and indirect quotations
Direct quote = the price of a foreign currency in domestic currency units.
Indirect quote = the price of the domestic currency in foreign currency units.
…Or referring back to….
If the price is $0.40/orange: the ‘price’ is $0.40, and the ‘unit’ is the orange.
4
Contents
Chapter 6 – the foreign exchange market .............................................................................................. 1
Chapter 7 – International Parity Conditions ........................................................................................... 9
Chapter 8 – Foreign currency derivatives and swaps ........................................................................... 18
Chapter 10 – Transaction and translation exposure............................................................................. 31
Chapter 11 – Operating exposure ......................................................................................................... 44
Chapter 6 – the foreign exchange market
The foreign exchange market provides…
- The money of one country (currency) is exchanged for that of another country.
- The rate of exchange between currencies is determined.
- Foreign exchange transactions are ‘physically’ completed.
Foreign exchange = money of a foreign country (foreign currency bank balances,
banknotes).
Foreign exchange transaction = an agreement between a buyer and seller that a fixed
amount of one currency will be delivered for some other currency at a specified rate.
FOREX = forex exchange.
Main characteristics of FOREX markets:
1. The geographic extent
2. The three main functions of FOREX markets
3. The market’s participants
4. Types of transactions including spot, forward and swaps
5. The daily transaction volume
6. Methods of stating exchange rate quotations, and changes in exchange rates.
1-Geographical extent of the
foreign exchange market
The market opens in Sydney and
Tokyo, and passes the world
throughout the day where after it
closes in LA. It is open 24h, busiest
around EU lunch time because then all
3 continents are online. Closing prices
are published as the official price or
‘fixing’ for the day. Some commercial
transactions are based on this official price.
2-Functions of the FOREX markets
FOREX markets = the mechanism by which participants transfer purchasing power
between countries, obtain or provide credit for international trade transactions, and
minimize exposure to the risks of exchange rate changes. Participants can:
- Transfer purchasing power between countries (necessary for IB)
- Obtain or provide credit for international trade transactions
- Minimize exposure to exchange rate risk: it provides ‘hedging’ facilities.
3-Market Participants
The FOREX market consists of two tiers:
1
, - The interbank / wholesale market
- The client / retail market
There are five broad categories of
participants within these two tiers:
1. Bank and nonbank foreign
exchange dealers (wholesale).
Dealers in the foreign exchange
departments of large
international banks often
function as market makers.
Trading limits are important
because foreign exchange
departments of many banks
operate as profit centres, and
individual dealers are
compensated on a profit
incentive basis.
2. Individuals and firms conducting
commercial or investment
transactions (retail). Importers,
exporters, MNEs, tourists.
3. Speculators and arbitragers (retail). They operate in their own interest.
Speculators seek all their profit from exchange rate changes in one market.
Arbitragers try to profit from simultaneous exchange rate differences in multiple
markets.
4. Central banks and treasuries (wholesale). Their motive is not to earn a profit as
such, but influence the foreign exchange value of their currency so that it will
benefit their citizens.
5. Foreign exchange brokers. They are agents who facilitate trading between dealers
without themselves becoming principals in the transaction: they charge a small
commission.
CLS = Continuous Linked Settlement: this eliminates losses if either party of a foreign
exchange transaction is unable to settle with the other party. It also helps counteract
fraud. This links with…
RTGS = Real-Time Gross Settlement, in 7 major currencies.
4-Transactions in the interbank market
3 types:
- Spot transaction
- Forward transaction
2
, - Swap transaction.
Spot transactions: immediate delivery of foreign exchange.
Spot transaction in the interbank market = the purchase of foreign exchange with
delivery and payments between banks on the second following business day.
Value date = the date of settlement.
Outright forward transaction: requires delivery of foreign exchange at some future date.
It requires delivery at a future value date of a specified amount of one currency for
another. The exchange rate is set at the time of the agreement, but payment and
delivery are not required until maturity. Most of the times, forward exchange rates are
quoted for value dates of 1, 2, 3, 6 and 12 months, payments are always done on
business days.
Swap transactions: combination of spot and forward.
Swap transaction in the interbank market = simultaneous exchange of one foreign
currency for another for two different value dates (a temporarily exchange). Both
purchase and sale are done with the same counterparty.
Spot against forward = the dealer buys a currency in the spot market and at the same
time he sells the same amount back to the same bank in the forward market. This is a
single transaction with one counterparty, so the dealers does not get unexpected foreign
exchange risks.
Forward-forward swap = A forward-forward is a swap deal between two forward dates as
opposed to an outright forward that runs from a spot to a forward date. An example is to
sell USD 30 days forward and buy them back in 90 days’ time. The swap is for the 60-
day period between 30 days from deal date (now = T) and 90 days from deal date.
Interest rate parity = the difference between the buying and selling price (the same as
the interest rate differential).
Nondeliverable Forwards = NDFs =settles only in USD; the foreign currency being sold
forward or bought forward is not delivered. They are contracted offshore and are traded
internationally using standard set by the ISDA (International Swaps and Derivatives
Associations).
NDFs are used primarily for emerging market currencies, currencies that typically do not
have open spot market currency trading, liquid money markets, or quoted Eurocurrency
interest rates. NDF markets normally develop for country currencies having large cross-
border capital movements, but still being subject to convertibility restrictions.
Pricing NDFs reflects basic interest differentials and some additional premium charged by
the bank for dollar settlement.
NDFs are traded and settled outside the country of the subject currency, and therefore
are beyond the control of the country’s government.
Problem of NDFs: they are an imperfect replacement for traditional forward contract.
5-Size of the FOREX market
BIS = Bank of International Settlements
Global foreign exchange turnover is divided into three categories of currency instruments
(spot, forward, swap transactions).
The ‘big three’ dominate global trades: dollar, euro and yen.
6-Foreign exchange rates and quotations
Foreign exchange rate = the price of one currency expressed in terms of another
currency.
3
, Foreign exchange quotation = buy or sell at an announced rate.
The basic of currency trading:
If the price is $0.40/orange: the ‘price’ is $0.40, and the ‘unit’ is the orange.
Spot market quotes
The base currency to quote a currency’s value is always USD. A currency’s value is
always quoted in terms of number of units of currency to equal one USD.
Foreign currency quotations convention
Direct and indirect quotations
Direct quote = the price of a foreign currency in domestic currency units.
Indirect quote = the price of the domestic currency in foreign currency units.
…Or referring back to….
If the price is $0.40/orange: the ‘price’ is $0.40, and the ‘unit’ is the orange.
4
