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Introduction to FX Trading
In order to gain a complete understanding of what foreign exchange trading is all about, it is useful to examine the reasons that lead to its emergence.
The Early Days
Originally, our ancestors conducted trading of goods against other goods. This system of bartering was, of course, quite inefficient and required lengthy negotiation and searching to be able to strike a deal. Eventually forms of metal like bronze, silver and gold came to be used in standardized sizes and later grades (purity) to facilitate the exchange of merchandise. The basis for these mediums of exchange was acceptance by the general public and practical variables like durability and storage. Eventually during the late middle ages, a variety of paper IOU started gaining popularity as an exchange medium.
The obvious advantage of carrying around ‘precious’ paper versus carrying around bags of precious metal was slowly recognized through the ages.
The Coming of Paper
Eventually stable governments adopted paper currency and backed the value of the paper with gold reserves. This came to be known as the gold standard. The Bretton Woods accord in July 1944 fixed the dollar to US$35 per ounce and other currencies to the dollar. In 1971, President Nixon suspended the convertibility to gold and let the US dollar ‘float’ against other currencies.
The Size of the International FX Market
Since then the foreign exchange market has developed into the largest market in the world with a total daily turnover of about 1.5 to 2.5 trillion USD.
World Currencies
There are over 150 currencies worldwide. Most countries have their own currency while others have chosen to adopt another country’s currency. They are all represented by unique symbols: JMD, USD, GBP, Euro, CAD, Rupee, Peso, etc. From our standpoint, all the currencies outside of J$ and USD are known as “Third Currencies”.
Main FX Markets
The breadth, depth, and liquidity of the market are truly impressive. It has been estimated that the world’s most active exchange rates like EUR/USD and USD/JPY can change up to 18,000 times during a single day.
The 24-Hour Cycle
Somewhere on the planet, financial centers are open for business, and banks and other institutions are trading the dollar and other currencies, every hour of the day and night, aside from possible minor gaps on holidays and weekends. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade.
Market Share of Major Players
In 1998 a survey under the auspices of the Bank for International Settlements (BIS), global turnover of reporting dealers was estimated at about US$1.49 trillion per day. In comparison, currency futures turnover was estimated at US$12 billion. By 2004, average daily forex turnover reached a staggering US1.9 trillion per day.
Among the various financial centers around the world, the largest amount of foreign exchange trading takes place in the United Kingdom; even though that nation’s currency (the British Pound) is less widely traded in the market than others.
The United Kingdom accounts for about 32 percent of the global total; the United States ranks a distant second with about 19 percent, and Japan is third with 8 percent.
RESOURCES
Related Article (FOREX Turnover 2001)
Related Article (FOREX Turnover 2004)
View More Information on FOREX Turnover
What is FX Trading?
FX Trading is defined as exchanging one currency for another using a predetermined rate of exchange. The rate can either be market determined or fixed.
The FX Trader
The typical FX Trader is very numerate, well qualified, and a special “breed”. In order to be successful, he works long hours and is relentless in his watch of the markets using specialized gadgets that keeps him on top of world and country economic trends. He is a very good understanding of all markets and how they affect each other.
FX Trader’s Tools
Day trading is a mentally and psychologically challenging activity and is by no means meant for everyone. Additionally, trading successfully is by no means a simple matter. It requires time, market understanding, and a large amount of self-restraint.
In executing any trade the following ingredients are necessary:
• Authority
• A clear objective
• Information
• Decisiveness
• Ability to deliver
The Concept of FX Trading from a Bank’s Perspective
The bank assumes that any unit of currency bought does not belong to the bank but is available for resale. As such, any positive trading balance is treated as a liability or credit balance. When the bank trades for its own account, then any unit of currency bought is an asset or “debit” balance for the bank.
The FX Market
The different players in the market include the Central Bank, Commercial Banks, Merchant Banks, Cambios, Brokerages, non-financial entities such as Hotels, Manufacturing and Export companies, and individuals. Players will access the market for speculative or transactionary purposes.
Financial and Non-Financial Entities
The Central Bank The Central Bank or Forex Regulatory Body regulates the FX market and intervenes at various points through authorized FX Dealers (Commercial and Merchant Banks) and Cambios to smooth demand and supply issues.
Commercial Banks
Forex trading houses and Commercial Banks on the other hand trade FX with a wide range of legitimate market players. They are typically large gatherers of FX through their extensive distribution networks.
Merchant Banks
Merchant Banks operate in the market in a similar fashion to Commercial Banks but are usually constrained by the size of their distribution network.
Cambios
Cambios and Bureau de Change are typically much smaller players than Commercial and Merchant Banks. They typically operate out of authorized traffic hubs such as Airports.
Non-Financial Entities
Non-financial entities range from very large players such as multinationals to much smaller individual players. These entities can legitimately trade FX through financial intermediaries that have been authorized to trade FX by Forex Regulatory Boards.
See Chapter 1 of FX and Money Markets by Heinz Riehl and Rita M. Rodriguez for a description of players in the FX Market.
Foreign Exchange and Money Markets: Managing Foreign and Domestic Currency Operations
What Determines FX Rates?
• Interest Rates
• Inflation Rates
• Income Levels
• Government Controls
• Expectations
• Interaction of Factors
These are described in more detail in Chapter 2 and Chapter 6 of FX and Money Markets by Heinz Riehl and Rita Rodriguez
Currency Codes
Throughout these notes, we have not been consistent, but ISO codes (also used by the SWIFT system) are generally used to abbreviate currency names.
Quoting Currency Exchange Rates
The US Dollar/Japanese Yen exchange rate is written as USD/JPY if it refers to the number of yen equal to 1 US dollar and JPY/USD if it refers to the number of US dollars equal to 1 yen. The currency code written on the left is the “base” currency; there is always 1 of the base unit. The currency code written on the right is the “variable” currency (or “counter” currency or “quoted” currency). The number of units of this currency equal to 1 of the base currency varies according to the exchange rate. Although some people do use the precisely opposite convention, the one we use here is the more common. The important point to remember is to be consistent.
Types of Trading
Spot
Spot trading is defined as exchanging one currency for another at an agreed rate for same day delivery. This is typical in the local market. Internationally, spot delivery can be up to two days and is referenced T+2. This is common for currencies that trade in different time zones e.g. CND/GBP.
Reasons for T + 2
T + 2 allows time for the necessary paperwork and cash transfers to be arranged. Normally, therefore, if a spot deal is contracted on Monday, Tuesday or Wednesday, delivery will be two days after (i.e. Wednesday, Thursday or Friday, respectively). If a spot deal is contracted on a Thursday or Friday, the delivery date is on Monday or Tuesday respectively, as neither Saturday nor Sunday are working days in the major markets.
Exceptions to the Rule
There are, however, some exceptions. For example, a price for USD/CAD without qualification generally implies delivery on the next working day after the dealing day.
A “spot” price (valued for two working days after the dealing day, as usual) can generally be requested as an alternative. USD/HKD is also often traded for value the next working day (a “U” price). Another problem arises in trading Middle East currencies where the relevant markets are closed Friday but open on Saturday. A USD/SAR spot deal on Wednesday would need to have a split settlement date: the USD would be settled on Friday, but the SAR on Saturday.
Dealing on Public Holidays
If the spot date falls on a public holiday in one or both of the centers of the two currencies involved, the next working day is taken as the value date. For example, if a spot GBP/USD deal is transacted on Thursday, 31 August, it would normally be for value Monday, 4 September. However, if this date is a holiday in the UK or USA all spot transactions on Thursday, 31 August are for value on Tuesday, 5 September. If the intervening day (between today and spot) is a holiday in one only of the two centers, the spot value date is usually also delayed by one day.
Spread
The spread is usually quoted in units called “pips”. All currencies (except the yen) are quoted to four (4) decimal places so one pip is 0.0001. The yen is quoted two decimal places. Therefore, one pip would be 0.01
Forwards
A Forward is exchanging one currency for another at a fixed rate for settlement at an agreed future date. Forwards can be for periods of up to a year in the future. This can be done or agreed with any two counter parties.
See Chapter 3 of FX and Money Markets by Heinz Riehl and Rita M. Rodriguez for more information on Spot and Forward value dates. Forwards are discussed further in Chapter 8, Page 174.
RULES FOR FORWARD EXCHANGE RATE
1. The currency with higher interest rates (= the currency at a “discount”) is worth less in the future.
2. The currency with lower interest rates (= the currency at a “premium”) is worth more in the future.
Futures
Similar to forwards but traded in standard blocks on an exchange. This product is only available in the more developed markets. Unlike Forwards, you do not need counterparty as the transaction can be done with the exchange.
Cross Rates
A cross rate is one exchange rate expressed in terms of another using a third currency as base, e.g.
If we know: US$1.40 = £1
And that: US$1.00 =JA$45.50
Then we can deduce: JA$1 = £63.70; the GBP cross rate expressed in JA$
See Chapter 2, Page 34 and Chapter 4, Page 87 of FX and Money Markets by Heinz Riehl and Rita M. Rodriguez.
Arbitrage
The opportunity for arbitrage exists when there are imperfections within or between markets. In the Jamaican context, the consistently higher interest rate paid on Jamaican currency compared to that paid on USD presents a good opportunity for arbitraging.
The idea is that one can borrow USD at 10% p.a. for e.g. convert to JMD at the going rate and invest at 20% pa in a JMD instrument. This arrangement yields a gross spread of 10% p.a. providing the exchange rate between the JMD and the USD remains stable.
In order to guard against the movement in the exchange rate a covered interest arbitrage can be done. The additional element here is a hedge arrangement where a forward purchase of USD is done at rate to preserve much of the 1 0% p.a. yield.
Another example is currency arbitrage whereby one can purchase GBP in Jamaica at a rate say, JA$63.70 (using the example from cross rates), convert the GBP in U.S. markets and end up purchasing JMD/USD below JA$45.20 (assuming that this was the current market rate).
See Chapter 8 of FX and Money Markets by Heinz Riehl and Rita M. Rodriguez.
Back Office Monitoring of FX Trades
The Trader’s “Blotter”
A Trader’s Blotter is used to record all the details of an FX trade whether that trade is confirmed or not. It records the date, the amount, the bid or offer rate, counter-party, contact, etc. the Blotter while very tedious to maintain because of the hectic nature of FX trading, acts as a very useful control tool for management.
Position Accounts
The balance in any currency is tracked by a position account. A purchase increases the credit balance while a sale results in a decrease. The position account tracks the effective day of the trade, the amount traded, the rate of exchange, the other currency equivalent and the realized and unrealized profit positions.Long and Short Positions
A long position means there is excess FX for sale while a short position means the FX position has been oversold. This translates to a credit and a debit respectively on the position account.
Base Accounts
A Base Account is the local or carrying currency equivalent of the other currency being traded. Carrying currency is used when a decision is taken to hold positions in another currency other than the local currency.
Revaluation
Settling FX Trades
FX trades can be settled via:
• Wire Transfer
• Cheque (Company cheque or Certified Item)
• Cash
• Other (Money Orders, Travelers Cheques etc)
The method of settlement is dependent upon the client involved.
Internal and External Documentation Required
• Contract Note
• Receipt
• Formal Instructions from Clients for example client authorizing bank/FX Dealer to cut check to third party.
• Typed Wire Instructions
Accounting for FX Deals
Accounts
The typical accounts set up to facilitate FX Trading are:
• Base Accounts
• Position Accounts
• Bank/Cash Accounts
• Settlement Accounts
• Incoming Wire Accounts
• Realized and Un-realized Profit Accounts
Accounting Entries
Purchase:
DR Bank/Cash (Foreign Currency)
CR Position
DR Base A/c
CR Bank/Cash (JMD)
Sale:
DR Position
CR Bank/ Cash (Foreign Currency)
DR Bank/Cash (J$)
CR Base A/c
Cross Trades — Purchase of US$ / Sale of Euro:
DR Incoming Wired Funds USD
CR US$ Position
DR Euro Position
CR Euro Settlements
DR US$ Base
CR Euro Base
Profit Entries:
DR Base A/c.
CR Trading Profit
Profit Calculation
The accurate and timely calculation profit on FX Trading activities is very important both to the Trader and management alike.
Example
Deal 1: Bank buys USD 1,000,000 against CHF at 1 .4830 Deal 2: Bank sells USD 1,000,000 against CHF at 1.4855
INFLOWS OUTFLOWS
Deal 1: USD 1,000,000 CHF 1,483,000
Deal 2: CHF 1,485,500 USD 1,000,000
Net result: CHF 2,500
Realized and Unrealized Profit
When X amount of currency is bought and the same amount sold the result is either a realized loss or gain. The result of a revaluation on a long or short position is an unrealized profit or loss.
Realized Trading Profits
The profit (realized) per trade is simple to calculate:
SP-BP*Vol Traded = Trading Profit
NB. The SP-BP is known as the spread on the transaction
Un-realized Trading Profit/Loss
This is determined by multiplying either the weighted average selling rate in the system or the mid-rate (WASP-WABP)/2 by the position balance remaining at the end of the trading period.
WASP - Weighted Average Selling Price
WABP - Weighted Average Buying Price
Overall FX Profits
The overall profit made from FX Trading is the realized profit plus the un-realized trading profit.
The topics above are discussed detail in Chapter 6 and Chapter13 of FX and Money Markets by Heinz Riehl and Rita M. Rodriguez.FX Systems
Forex Computer Software Systems
Internal Systems
Most banks use internally developed FX trading systems to track FX Trading activities and positions. Systems range from coded programmes to simple spreadsheets (in lesser developed markets).
External Systems
These are FX trading systems provided by companies like Bloomberg. They are PC/Mac-Based or web-based and are more used to facilitate International/third-currency trading.
Reporting Systems
Some banks may also utilise a third system, whether internally or externally developed, to assist with management/regulatory reporting of Forex deals.
Hybrid Systems
Technology has come such a far way that many banks have merged internal and external systems in a fully integrated system designed to perform all the technology-based support for Forex trading.
Internal Workflows
Purchase
Trader→Manager FX→ Ops (FX Admin)→Ops (Cashier) (Ck Cutting)→Ops (FX Admin)→Client
Sale
Trader→ Manager→ Ops (FX Admin)→ Ops (Cashier) (Ck Cutting)→Ops (FX Admin)→Bank/Cash Account
Key:
FX - Foreign Exchange
Ops - Operations
Admin - Administration
CK - Check
NB: The flow represents the flow of the transaction from the time is generated by the Forex Trader to the time it is delivered to the client are funds are added to the bank account.
Regulation of FX Markets
In International markets because of the liquidity of the market, exchange controls are virtually non-existent and the regulation of Forex deals is quite different from that which obtains in lesser markets. Trading is essentially between institutional players and the internal trading guidelines of these institutions act largely as a self regulatory mechanism.
Anti-Money Laundering Issues
In recent times Money Laundering has become a very important concern for Regulators all around the world. The act focuses on the "Know Your Customer Rule" which puts the onus on market players to have intimate knowledge of the people they trade with.
Risk Management
Risks
There are many risks inherent in FX Trading. These include:
Credit
Credit risk is the risk of loss due to a the ono-settlement for funds due from the counter-party to a transaction.
Sovereign
Sovereign risk exists as countries reserve the right to control the supply of its currency. In actuality, at any time a country may just decide to close its FX window.
FX Rate Risk
Rate risk occurs when there is the potential for the exchange rate to move beyond the point at which conversion was effected.
Liquidity
Liquidity risk occurs where there is willingness and ability to pay but the supply of foreign exchange is channeled or cannot be sourced.
Controls
FX Trading Limits
A very useful tool in managing some, of if not all the risks involved in FX Trading is the setting of various FX Trading Limits. These include:
• Trader’s Volume Limits - the Trader is only able to trade up a certain level without approval
• Trader’s Position Limits - the Trader can be long or short up to a specified level
• Daytime Limits - the Trader can only be long or short up to a specified limit during trading hours
• Overnight Limits - the Trader can be long or short up to a specified limit after trading hours
Line of Credit
To reduce credit risk where the counter-party is not in a position to settle on the delivery date a line of credit can be very useful. This can be established against resources held with the company so that in the event of default the said resources can be liquidated and used to settle the FX transaction.
Exposure Limits
Exposure limits can be useful in controlling sovereign risk. This takes the form of a stated amount that a Trader can be exposed to the currency of any one country.
Hedging
Hedging is a technique used to manage FX rate risk. Hedging techniques include forward, futures and swap arrangements. In essence hedging allows the locking in of a particular rate of exchange to guard against any movement in the rate at which the initial transaction was effected.
See Chapters 1 2 and 14 of FX and Money Markets by Heinz Riehl and Rita M. Rodriguez for more on exchange risks and how risks can be controlled.
Internal and External Reporting
Internal Reporting
The internal management reporting requirements for FX trading includes hourly, daily and monthly position reports on Trading volumes, Position balances and Trading Limits. The reports are prepared by the FX Trader and checked by an Operations/Compliance/Forex Administration Manager or other assigned personnel.
External Reporting
In International Markets, Forex deals are captured electronically as they happen and update internal reporting systems instantaneously. Similarly the net impact of these trades are accounted for as they happen and reports and trends of various kinds (rate movements, volumes traded, weekly and daily movements, etc) are made available via live feeds to external market players.
RESOURCE LINKS
Anti Money Laundering Regulations
Foreign Exchange and Money Markets: Managing Foreign and Domestic Currency Operations