ffirs.qxd 5/25/06 1:58 PM Page iii Foreign Exchange A Practical Guide to the FX Markets TIM WEITHERS John Wiley & Sons, Inc. ffirs.qxd 5/25/06 1:58 PM Page vi ffirs.qxd 5/25/06 1:58 PM Page i Foreign Exchange ffirs.qxd 5/25/06 1:58 PM Page ii Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and fi- nancial instrument analysis, as well as much more. 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HG3851.W44 2006 332.4'5—dc22 2005038005 Printed in the United States of America. 10987654321 ffirs.qxd 5/25/06 1:58 PM Page v Dedication: To my boys: Michael, Stephen, and Peter ffirs.qxd 5/25/06 1:58 PM Page vi ftoc.qxd 5/25/06 2:02 PM Page vii Contents Preface xi Acknowledgments xv CHAPTER 1 Trading Money 1 Introduction 1 Trading Money 2 The Roles Money Plays 3 The Major Currencies 9 Some Interesting Questions 14 Appendix: Countries, Currencies, and ISO Codes 23 CHAPTER 2 Markets, Prices, and Marketmaking 35 What Is a “Market”? 35 What Is a “Price”? 36 Buyers and Sellers 37 Marketmaking 38 Summary 46 CHAPTER 3 Interest Rates 47 What Are “Interest Rates”? 47 Inflation 48 Day Count or Day Basis 50 Compounding 51 Discounting 54 Types of Interest Rates 55 Interest Rates in the Real World 57 vii ftoc.qxd 5/25/06 2:02 PM Page viii viii CONTENTS CHAPTER 4 Brief History of Foreign Exchange 63 Historical Background 63 The FX Markets Today 71 The Regulatory Environment and Central Bank Intervention 76 Summary 80 CHAPTER 5 The Foreign Exchange Spot Market 83 The Spot Market 83 Spot FX Quoting Conventions 84 Economic Interpretation 90 Purchasing Power Parity 92 Cross Rates and Triangular Arbitrage in the Spot Market 95 The Bid–Ask Spread in Foreign Exchange 98 Timing 100 Settlement 101 Market Jargon 102 “The Best Arbitrage Around!” 102 CHAPTER 6 Foreign Exchange Forwards 105 Introduction to Forwards and Forward Pricing 105 Foreign Exchange Forwards and Forward Pricing 107 Interest Rate Parity (Covered Interest Arbitrage) 112 FX Spot–Forward Arbitrage 114 FX Forward Price Quotes and Forward Points 118 Timing 122 Off-Market Forwards 125 Foreign Exchange Forwards in the Real World 126 CHAPTER 7 Foreign Exchange Futures 129 Background 129 Futures versus Forwards 130 Foreign Exchange Futures Contract Specifications 132 Margin 133 Why Use Futures? 137 Options on FX Futures 137 Summary 138 ftoc.qxd 5/25/06 2:02 PM Page ix Contents ix CHAPTER 8 Foreign Exchange Swaps or Cross-Currency Swaps or Cross-Currency Interest Rate Swaps or . 139 Introduction 139 FX Spot-Forward Swaps 139 Cross-Currency Swaps or FX Cross-Currency Interest Rate Swaps or FX Bond Swaps 140 Summary 151 CHAPTER 9 Foreign Exchange Options 153 Option Basics 153 Equity Options 159 Put-Call Parity with Equity Options 161 In-the-Money, At-the-Money, and Out-of-the-Money 166 Theoretical Option Value and Option Risk Measures (“The Greeks”) 167 Foreign Exchange Options 170 Put-Call Parity in Foreign Exchange 172 Perspective Matters 174 FX Option Premium 177 Volatility 179 Uses and Strategies 183 Appendix: Theoretical Option Valuation 190 The Binomial Model 190 The Black–Scholes/Garman–Kohlhagen Model 198 The Garman–Kohlhagen Option Risk Measures or “Greeks” 202 CHAPTER 10 Exotic Options and Structured Products 205 What Is an Exotic Option? 205 Nonstandard Options 207 Digital or Binary Options 209 Barrier Options 212 Other Exotic Options 216 FX-Linked Notes 217 CHAPTER 11 The Economics of Exchange Rates and International Trade 219 Money versus Currency 219 Types of FX Exposures 221 Fixed versus Floating Exchange Rates 229 Implications of Monetary Policy 233 ftoc.qxd 5/25/06 2:02 PM Page x x CONTENTS Trade Deficits: A Curse or a Blessing 233 Politics and Economics 234 CHAPTER 12 Currency Crises 237 The End of Bretton Woods 238 Bankhaus Herstatt 239 The ERM Crisis of 1992 240 The Asian Crisis of 1997 241 The Russian Crisis of 1998 241 The Turkish Lira Crisis of 2001 242 The Argentinean Peso Crisis of 2002 242 Summary 244 CHAPTER 13 Technical Analysis 247 Introduction 247 What Is Technical Analysis? 249 Methods of Technical Analysis 249 Technical Analysis in Foreign Exchange 256 Technical Analysis Today 258 Summary 258 CHAPTER 14 Where Do We Go From Here? 261 CHAPTER 15 Conclusion 267 APPENDIX Precious Metals 269 Answers to the Chapter Exercises 273 Notes 287 References 301 About the Author 311 Index 313 fpref.qxd 5/25/06 2:02 PM Page xi Preface have been teaching about foreign exchange for more than a dozen years I now and thinking about money and trade for even longer. At the Univer- sity of Chicago, on my way to a Ph.D. in economics, I enrolled in the 1980s in an international trade course (“with money”—as opposed to “real” trade) with Jacob Frenkel [who, from 1991 through 2000, was governor of the Bank of Israel (i.e., Israel’s counterpart to Alan Greenspan/Ben Bernanke) and who subsequently served as president of the international division of an investment bank and then chairman and CEO of the Group of Thirty (G-30)]. The University of Chicago is proud of its role in institut- ing the “quarter system” (the summer being one of the “quarters”—that is, in establishing what most people would call the trimester system in which three 10-week sessions constitute the academic year). Mr. Frenkel distrib- uted what seemed to me like a particularly thick syllabus for a 10-week term. Chicago graduate students in the Department of Economics were re- quired to take courses in a relatively large number of different fields.