Foreign Exchange and Money Markets Butterworth-Heinemann – The Securities Institute A publishing partnership About The Securities Institute Formed in 1992 with the support of the Bank of England, the London Stock Exchange, the Financial Services Authority, LIFFE and other leading financial organizations, the Securities Institute is the professional body for practitioners working in securities, investment management, corporate finance, derivatives and related businesses. Their purpose is to set and maintain professional standards through membership, qualifications, training and continuing learning and publications. The Institute promotes excellence in matters of integrity, ethics and competence. About the series Butterworth-Heinemann is pleased to be the official Publishing Partner of the Securities Institute with the development of profes- sional level books for: Brokers/Traders; Actuaries; Consultants; Asset Managers; Regulators; Central Bankers; Treasury Officials; Compli- ance Officers; Legal Departments; Corporate Treasurers; Operations Managers; Portfolio Managers; Investment Bankers; Hedge Fund Managers; Investment Managers; Analysts and Internal Auditors, in the areas of: Portfolio Management; Advanced Investment Manage- ment; Investment Management Models; Financial Analysis; Risk Analysis and Management; Capital Markets; Bonds; Gilts; Swaps; Repos; Futures; Options; Foreign Exchange; Treasury Operations. Series titles • Professional Reference Series The Bond and Money Markets: Strategy, Trading, Analysis • Global Capital Markets Series The REPO Handbook The Gilt-Edged Market Foreign Exchange and Money Markets: theory, practice and risk management IPO and Equity Offerings For more information For more information on The Securities Institute please visit: www.securities-institute.org.uk and for details of all Butterworth-Heinemann Finance titles please visit: www.bh.com/finance Foreign Exchange and Money Markets Theory, Practice and Risk Management Bob Steiner Butterworth-Heinemann An imprint of Elsevier Science Linacre House, Jordan Hill, Oxford OX2 8DP 225 Wildwood Avenue, Woburn, MA 01801-2041 A division of Reed Educational and Professional Publishing Ltd First published 2002 Copyright © 2002, Bob Steiner. All rights reserved The right of Bob Steiner to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988 No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher British Library Cataloguing in Publication Data Steiner, Bob Foreign exchange and money markets : theory, practice and risk management. – (Global aid capital market series) 1. Foreign exchange 2. Money market I. Title 332.4’5 Library of Congress Cataloguing in Publication Data A catalogue record for this book is available from the Library of Congress ISBN 0 7506 5025 7 For information on all Butterworth-Heinemann finance publications visit our website at www.bh.com/finance Typeset by Laserwords, Chennai, India Printed and bound in Great Britain Contents ABOUT THE AUTHOR xi NOTE FROM THE AUTHOR xiii Part 1 Introduction 1 1. SOME BASIC CONCEPTS 3 Currency codes 3 Hedging, speculation and arbitrage 3 Spot, forward, value dates and short dates 4 Some basic terminology 6 2. ESSENTIAL FINANCIAL ARITHMETIC 8 Percentages 8 Simple interest calculations 8 The different day/year conventions 9 Present value 13 Calculating the yield on an investment or the cost of a borrowing 14 Compounding two or more interest rates together (a strip) 16 Interpolation 17 Paying interest with different frequencies 18 Exercises 21 Part 2 Money Markets 23 3. OVERVIEW OF MONEY MARKET INSTRUMENTS 25 Introduction 25 The yield curve 26 Some more terminology 28 Money market instruments 31 4. DEPOSITS AND COUPON-BEARING INSTRUMENTS 36 Fixed deposits 36 vi Contents Taking a position 37 The price of a CD 39 Money market yield of a bond in its last coupon period 43 Breaking a fixed deposit 44 CDs paying more than one coupon 46 Exercises 48 5. DISCOUNT INSTRUMENTS 50 Discount instruments 50 Discount/true yield 52 Bond-equivalent yields for US Treasury bills 56 Effective rates and Norwegian Treasury bills 57 Exercises 58 6. FORWARD INTEREST RATES, FRAs AND INTRODUCTION TO FUTURES 60 Overview 60 Pricing a forward-forward 61 Forward rate agreement (FRA) 63 Introduction to futures 68 Futures compared with FRAs 75 The yield curve 76 Applications of FRAs and futures 77 Exercises 89 Part 3 Foreign Exchange 91 7. SPOT FOREIGN EXCHANGE 93 Introduction 93 How spot rates are quoted 94 Position-keeping 99 Reciprocal rates 101 Cross-rate calculations 101 The market environment 105 Exercises 105 8. FORWARD OUTRIGHTS AND SWAPS 107 Forward outrights 107 Forward swaps 111 Short dates 123 Forward-forwards 127 Calculation summary 131 Cross-rate calculations 133 Non-deliverable forwards (NDFs) 136 Contents vii Time options 138 Long-dated forwards 139 Synthetic agreements for forward exchange (SAFEs) 141 Summary of uses of forward FX instruments 144 Exercises 145 9. HEDGING SWAPS WITH DEPOSITS, FRAs AND FUTURES, COVERED INTEREST ARBITRAGE AND CREATING SYNTHETIC FRAs 149 Hedging FX forwards using borrowings and deposits 150 Hedging FX forward-forwards with FRAs or futures 155 Covered interest arbitrage 161 Creating an FRA in one currency from an FRA in another currency 168 Exercises 171 10. MANAGING THE SPOT RISK ON A FORWARD FX POSITION 173 Hedging a forward swap position 173 Measuring the spot risk on a forward outright position 179 Exercise 181 11. CURRENCY RELATIONSHIPS 182 Overview 182 Exchange rate regimes 183 European Monetary Union 185 Analysing currency movements 188 Part 4 Risk Management 193 12. BANK RISK MANAGEMENT 195 Overview 195 Market risk 195 Credit risk 201 Operational risk 207 Other risks 209 Value at risk (VaR) 211 Capital adequacy requirements 224 13. CORPORATE RISK MANAGEMENT 230 Analysis of risks 230 Establishing a policy 236 Forecasts, hedging decisions and targets 242 Currency exposure reporting 246 viii Contents Evaluating the success of treasury management 248 Exercises 249 ANSWERS TO EXERCISES 251 APPENDIX A. A summary of money market day/year conventions 271 APPENDIX B. A summary of calculation procedures 273 APPENDIX C. SWIFT currency codes 284 GLOSSARY 291 INDEX 323 To my wife Barbara, as always About the Author Bob Steiner is Managing Director of Markets International Ltd, an independent company specializing in training in a range of areas related to the international financial markets, treasury and banking. He has also written the best-selling Mastering Financial Calculations,andMastering Repo Markets (both published by Financial Times Prentice-Hall) and Key Market Concepts (published by Reuters and Pearson Education). Bob was previously senior consultant with HSBC, where he worked in London and New York in the dealing area as consultant to major US and European companies on treasury management. He has also been treasurer and fund manager of H P Bulmer Holdings PLC and English and American Insurance Group PLC, both active in currency and interest rate management. He has also worked in the Overseas Department of the Bank of England, and with the European Commission in Brussels. His academic background is an honours degree in mathematics from Cambridge University, followed by further studies in economics with London University. He is a member of ACI – The Financial Markets Association, and the Association of Corporate Treasurers. Bob himself spends a considerable amount of time training bankers, systems staff, corporate staff and others involved in the financial markets. In addition to general and in-house courses, he personally runs courses for all the ACI’s professional exams for dealers – the ACI Diploma, the Dealing Certificate and the Settlements Certificate – on behalf of various national ACI associations across Europe. Note from the author Although this book is called Foreign Exchange and Money Markets, the chapters on the money markets come first. This is because there are some money market ideas which it might be useful to have covered before some of the material on foreign exchange. I would be very grateful for any comments on the book, or ideas on any additional areas which readers feel could be usefully included. Bob Steiner Markets International Ltd Aylworth Naunton Cheltenham Gloucestershire GL54 3AH Markets International Ltd Training and consultancy for the international financial markets Markets International Ltd is an independent company providing training to banks and companies on financial markets and math- ematics, risk management techniques, analysis and management policy, credit analysis, technical analysis and other financial subjects. The company also provides advice to finance directors and treasurers of international companies on foreign exchange, money markets and other treasury matters. This ranges from written studies reviewing existing management policies and procedures to the development of appropriate hedging strategies. Among the subjects covered