A Foreign Exchange Primer Shani Shamah Published 2003 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): [email protected] Visit our Home Page on www.wileyeurope.com or www.wiley.com Copyright C Shani Shamah All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms 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 W1T 4LP, UK, without the permission in writing of the Publisher. 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Other Wiley Editorial Offices John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data Shamah, Shani. A foreign exchange primer / Shani Shamah. p. cm.—(Wiley finance series) Includes index. ISBN 0-470-85162-7 (cased : alk. paper) 1. Foreign exchange futures. 2. Foreign exchange market. I. Title. II. Series. HG3853 .S53 2003 332.45—dc21 2002191093 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0-470-85162-7 Typeset in 10/12pt Times by TechBooks, New Delhi, India Printed and bound in Great Britain by Antony Rowe, Chippenham, Wiltshire This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production. Contents Disclaimer xiii 1 Introduction 1 1.1 The Foreign Exchange Market 1 1.2 Value Terms 1 1.3 Coffee Houses 1 1.4 Spot and Forward Market 2 1.5 Alternative Markets 3 Concluding Remarks 3 PART I: MARKET OVERVIEW 5 2 A Brief History of the Market 7 2.1 The Barter System 7 2.2 The Introduction of Coinage 7 2.3 The Expanding British Empire 8 2.4 The Gold Standard 8 2.5 The Bretton Woods System 9 2.6 The International Monetary Fund and The World Bank 9 2.7 The Dollar Rules OK 10 2.8 Special Drawing Rights 10 2.9 A Dollar Problem 11 2.9.1 The Smithsonian Agreement 11 2.9.2 The Snake 11 2.9.3 The Dirty Float 11 2.10 The EMS and the ERM 12 2.10.1 The European Monetary System 12 2.10.2 The Exchange Rate Mechanism 12 2.11 The European Currency Unit 12 2.12 The Maastricht Treaty 13 2.13 The Treaty of Rome 13 2.14 Economic Reform 14 vi Contents 2.15 A Common Monetary Policy 15 2.16 The Single Currency 15 Concluding Remarks 18 3 Market Overview 19 3.1 Global Market 19 3.2 No Physical Trading Floor 19 3.3 A ‘Perfect’ Market 20 3.4 The Main Instruments 21 3.5 The Dollar’s Role 21 3.6 Widely Traded Currency Pairs 21 Concluding Remarks 23 4 Major Participants 25 4.1 Governments 25 4.2 Banks 25 4.2.1 Central Banks 25 4.2.2 Trading Banks 27 4.2.3 Commercial Banks 27 4.2.4 Regional or Correspondent Banks 27 4.2.5 Investment and Merchant Banks 28 4.3 Brokering Houses 28 4.4 International Monetary Market 28 4.5 Money Managers 29 4.6 Corporations 29 4.7 Retail Clients 29 4.8 Others 30 4.9 Speculators 30 4.10 Trade and Financial Flows 31 5 Roles Played 33 5.1 Market Makers 33 5.2 Price Takers 33 5.3 A Number of Roles 33 Concluding Remarks 34 6 Purposes 35 6.1 Transactions 35 6.1.1 Commercial Transactions 35 6.1.2 Funding 35 6.1.3 Hedging 35 6.1.4 Portfolio Investment 36 6.1.5 Personal 36 6.2 Market Making 36 6.3 Foreign Exchange Exposure 36 6.3.1 Transaction Exposure 36 Contents vii 6.3.2 Translation Exposure 37 6.3.3 Economic Exposure 37 Concluding Remarks 37 PART II: FOREIGN EXCHANGE PRODUCTS 39 7 Spot Foreign Exchange 41 7.1 Spot and Reciprocal Rates 41 7.2 European and American Terms 42 7.3 Spot Transactions 42 7.3.1 Bid – Offer Spreads 42 7.3.2 Reading Foreign Exchange Rates 43 7.3.3 Big Figures 44 7.3.4 Spread 44 7.4 Direct versus Brokered Dealing 44 7.5 Cross Rates 44 7.6 Price Determinants 45 7.7 Uses for Spot Transactions 45 7.7.1 Risk Consideration 46 8 Forward Contracts 47 8.1 Interest Rate Differentials 47 8.2 Periods 47 8.3 Premium or Discount 47 8.4 Calculations 48 8.4.1 Bids and Offers 50 8.4.2 To add or to Subtract 50 8.5 How are Forwards Quoted? 50 8.6 Forward Cross Rates 51 8.7 Uses of Forwards 53 8.7.1 Risks Involved 54 Concluding Remarks 54 9 Short- and Long-Dated Contracts 55 9.1 Short-Dated Contracts 55 9.2 Interest Rate Differentials 55 9.3 Long-Dated Contracts 56 Concluding Remarks 57 10 Broken-Dated Contracts 59 10.1 Calculations 59 10.2 Outright Forwards 59 10.3 A Conversation 60 Glossary of Terms for Chapters 7 to 10 61 viii Contents 11 Non-Deliverable Forwards 63 11.1 Fixing Methodology 63 11.2 Risk Management Tool 63 11.3 Availability 64 11.4 Examples 64 11.5 Typical Risks Encountered 66 11.6TheCurrenciesofEmergingMarkets67 11.7 Index-Linked Deposits 68 Concluding Remarks 68 12 Foreign Exchange Swaps 71 12.1 The Value of Foreign Exchange Swaps 71 12.2 Calculations 72 12.2.1 Points of Note 73 12.3 Uses of Foreign Exchange Swaps 73 Concluding Remarks 74 13 Currency Swaps 75 13.1 Technique Involved 75 13.2 Interest Payable 76 13.3 Benefits of Currency Swaps 77 13.3.1 Flexibility 77 Concluding Remarks 77 14 Foreign Exchange Options 79 14.1 Definitions 79 14.2 Exchange vs Over-the-Counter Options 80 14.3 Application of Foreign Exchange Options 81 14.4 Alternatives to Foreign Exchange Options 84 14.5 Parties and the Risks Involved 84 14.6 Users of Foreign Exchange Options 85 14.7 Hedging versus Speculation 87 14.8 Option Theory 87 14.8.1 Delta 87 14.8.2 Gamma 88 14.8.3 Volatility 88 14.8.4 Time Decay (Theta) 89 14.8.5 American versus European 89 14.9 Pricing Theory 90 14.10 Other Considerations 91 14.10.1 Market Conventions 91 14.10.2 Premium Conversions 92 14.10.3 Settlement 93 14.10.4 Risks 93 Concluding Remarks 93 Contents ix 15 Picturing Profit and Loss of Options 95 15.1 Long Call 95 15.2 Short Call 96 15.3 Long Put 97 15.4 Short Put 97 15.5 Long Straddle 98 15.6 Short Straddle 99 15.7 Long Strangle 100 15.8 Short Strangle 100 15.9 Bull Spread 101 15.10 Bear Spread 102 15.11 Long Butterfly 102 15.12 Short Butterfly 103 15.13 Long Condor 104 15.14 Short Condor 105 15.15 Call Ratio Spread 105 15.16 Put Ratio Spread 106 15.17 Barriers 107 Glossary of Terms for Chapters 14 and 15 109 16 Foreign Exchange Futures 113 16.1 Two-Sided Risk 113 16.2 Exchange Members 114 16.3 Clearing Corporation 114 16.3.1 Major Exchanges 114 16.4 Quoting Currency Futures 115 16.5 Ticks and Delivery Months 115 16.6 Contract Specifications 115 Concluding Remarks 116 17 Exchange for Physical 117 17.1 Examples 117 17.1.1 Example 1 117 17.1.2 Example 2 117 17.2 Point of the Exercise 118 Concluding Remarks 118 PART III: ESSENTIAL KNOWLEDGE 119 18 Foreign Exchange Dealing Rooms 121 18.1 Composition of a Dealing Room 121 18.1.1 Spot Dealers 121 18.1.2 Forward Dealers 121 18.1.3 Money-market Dealers 121 x Contents 18.1.4 Treasury Product Dealers 121 18.1.5 Corporate Dealers 122 18.1.6 Research Personnel 123 18.1.7 Position Clerks 123 18.2 Back Office 123 19 Managing the Relationship with an Institution 125 19.1 Role of the Adviser 125 19.2 Client–Adviser Relationship 127 19.3 Marketing Process 127 20 Foreign Exchange Dealings 129 20.1 Asking for a Quote 129 20.2 Examples 129 20.2.1 Example 1 129 20.2.2 Example 2 130 20.3 A Matter of Seconds 131 20.4 Information Needed 131 20.5 Forward Asking 131 Concluding Remarks 131 21 Foreign Exchange Market Orders 133 21.1 Market Orders 133 21.2 At Best Orders 133 21.3 Stop Orders 133 21.4 Discretionary Price Order 134 Concluding Remarks 134 Glossary of Terms for Chapter 21 135 22 Electronic Foreign Exchange Trading 137 22.1 Days Gone By 137 22.2 The Environment Today 137 22.3 Internet Revolution 138 22.3.1 Internet Trading Platforms 138 22.4 What Else to Expect? 139 Concluding Remarks 139 23 Margin Trading 141 23.1 Understand How Margin Works 141 23.2 Simple Example 142 23.3 Recognize the Risks 142 23.4 General Margin Rules 142 23.5 Margin Calls in Volatile Markets 142 Concluding Remarks 143 Contents xi PART IV: FUNDAMENTALS AND TECHNICAL ANALYSIS 145 24 Fundamental versus Technical Approaches 147 24.1 Fundamental Approach 147 24.1.1 Subjective Interpretation 148 24.2 Technical Approach 149 Concluding Remarks 149 25 Fundamental Analysis 151 25.1 Purchasing Power Parity 151 25.2 Interest Rate Parity 151 25.3 Balance of Payments Model 151 25.4 Asset Market Model 152 25.5 Economic Influences on the Market 152 25.5.1 Consumer