Broker’s Blurb: Trading Across Borders

After explaining the importance of market participants in the forex market in our previous series, we will now look at the several financial instruments available in the market and the trading characteristics of the foreign exchange market.

Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, Euro and Russian Ruble, which make settlements on the next business day), as opposed to futures contracts which are usually of three months. This trade represents a ‘direct exchange’ between two currencies, has the shortest time frame, involves cash rather than a contract, and interest is not included in the agreed-upon transaction. Spot trading is one of the most common types of forex trading. Often, a forex broker will charge a small fee to the client to roll-over the expiring transaction into a new identical transaction for a continuum of the trade. This roll-over fee is known as the ‘swap’ fee.

Forward

In this transaction, money does not actually change hands until some agreed-upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months, or years. Usually the date is decided by both the parties. Then the forward contract is negotiated and agreed upon by both parties.

Swap

The most common type of forward transaction is the foreign exchange swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardised contracts and are not traded through an exchange. A deposit is often required in order to hold the position open until the transaction is completed.

Futures

Futures are standardised forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly of three months. Futures contracts are usually inclusive of any interest amounts. Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. Thus the currency futures contracts are similar to forward contracts in terms of their obligation, but differ from forward contracts in the way they are traded. They are commonly used by MNCs to hedge their currency positions. In addition, they are traded by speculators who hope to capitalize on their expectations of exchange rate movements.

Options

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest, and most liquid market for options of any kind in the world.

Trading Characteristics

There is no unified or centrally cleared market for the majority of trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are quite close due to arbitrage.

Due to London’s dominance in the market, a particular currency’s quoted price is usually the London market price. Some of the major trading exchanges include Electronic Broking Services (EBS) and Thomson Reuters Dealing, while selected banks also offer trading systems. A joint venture of the Chicago Mercantile Exchange and Reuters, called FXmarketspace, opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main trading centers are New York City and London, though Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate in such transactions. Currency trading happens continuously throughout the day. As the Asian trading session ends, the European session begins, followed by the North American session, and then back to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, domestic Fisher effect, international Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals, and other macro-economic conditions. Prime news is released publicly, often on scheduled dates; so many people have access to the same news at the same time. However, the larger banks have an important advantage; they can see their customers’ order flow.

Currencies are traded against one another in pairs. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), called the counter currency (or quote currency).

For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the Euro expressed in US dollars, meaning Euro 1 = USD 1.5465. The market convention is to quote most of the exchange rates against the USD with the US dollar as the base currency (e.g. USDJPY, USDCAD, and USDCHF). The exceptions are the British pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the Euro (EUR) where the USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ. On the spot market, according to the 2013 Triennial Survey, the most heavily traded bilateral currency pairs were:

• EURUSD: 24.1 per cent
• USDJPY: 18.3 per cent
• GBPUSD (also called cable): 8.8 per cent.

The USD was involved in 87 per cent of the transactions, followed by the Euro (33.4 per cent), the Yen (23.0 per cent), and Sterling Pound (11.8 per cent). The volume percentages for all individual currencies should add up to 200 per cent, as each transaction involves two currencies. Trading in the Euro has grown considerably since the currency’s creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the Euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market.

The dollar’s value erosion during 2008 has dramatically increased interest in using the Euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, and CAD have also increased. As we are well versed now with the various financial instruments, we will move on to determinants of exchange rates in the next series.

Disclaimer: The above opinion is that of the author and is for reference only.