This chapter describes the foreign exchange products traded in the OTC market. It covers the three “traditional” foreign exchange instruments —spot, outright forwards, and FX swaps, which were the only instruments traded before the 1970s, and which still constitute the overwhelming share of all foreign exchange market activity.
Chapter 3 noted that the United States has both an over-the-counter market in foreign
exchange and an exchange-traded segment of the market. The OTC market is the U.S. portion of an international OTC network of major dealers—mainly but not exclusively banks—operating in financial centers around the world, trading with each other and with customers, via computers, telephones, and other means. The exchange-traded market covers trade in a limited number of foreign exchange products on the floors of organized exchanges located in Chicago, Philadelphia, and New York.
This chapter describes the foreign exchange products traded in the OTC market. It covers the three “traditional” foreign exchange instruments —spot, outright forwards, and FX swaps, which were the only instruments traded before the 1970s, and which still constitute the overwhelming share of all foreign exchange market activity. It also
covers two more recent products in which OTC trading has developed since the 1970s—currency swaps and OTC currency options. The next chapter describes currency futures
and exchange-traded currency options, which currently are traded in U.S. exchanges.
A spot transaction is a straightforward (or “outright”) exchange of one currency for another. The spot rate is the current market price, the benchmark price.
Spot transactions do not require immediate settlement, or payment “on the spot.” By
convention, the settlement date, or “value date,” is the second business day after the
“deal date” (or “trade date”) on which the transaction is agreed to by the two traders.
The two-day period provides ample time for the two parties to confirm the agreement and arrange the clearing and necessary debiting and crediting of bank accounts in various
Exceptionally, spot transactions between the Canadian dollar and U.S. dollar conventionally are settled one business day after the deal, rather than two business days later,since Canada is in the same time zone as the United States and an earlier value
date is feasible.
It is possible to trade for value dates in advance of the spot value date two days hence (“pre-spot” or “ante-spot”). Traders can trade for “value tomorrow,”with settlement one business day after the deal date (one day before spot); or even for “cash,”with settlement on the deal date (two days before spot). Such transactions are a very small part of the market, particularly same day “cash” transactions for the U.S. dollar against European or Asian currencies, given the time zone differences. Exchange rates for cash or value
tomorrow transactions are based on spot rates, but differ from spot, reflecting in part, the fact that interest rate differences between the two currencies affect the cost of earlier payment.Also, pre-spot trades are much less numerous and the market is less liquid.
A spot transaction represents a direct exchange of one currency for another, and when executed, leads to transfers through the payment systems of the two countries whose currencies are involved.In a typical spot transaction, Bank A in New York will agree on June 1 to sell $10 million for Deutsche marks to Bank B in Frankfurt at the rate of, say,
DEM 1.7320 per dollar, for value June 3. On June 3, Bank B will pay DEM 17.320 million for credit to Bank A’s account at a bank in Germany, and Bank A will pay $10 million for credit to Bank B’s account at a bank in the United States. The execution of the two payments completes the transaction.
- There is a Buying Price and a Selling
Price In the foreign exchange market there are always two prices for every currency—one price at which sellers of that currency want to sell, and another price at which buyers want to buy.A market maker is expected to quote simultaneously for his customers both a price at which he is willing to sell and a price at which he is willing to buy standard amounts of any currency for which he is making a market.
- How Spot Rates are Quoted: Direct and Indirect Quotes, European and American Terms
Exchange rate quotes, as the price of one currency in terms of another, come in two forms: a “direct” quotation is the amount of domestic currency (dollars and cents if you are in the United States) per unit of foreign currency and an “indirect” quotation is the amount of foreign currency per unit of domestic currency (per dollar if you are in the United States).
The phrase “American terms”means a direct quote from the point of view of someone located in the United States. For the dollar, that means that the rate is quoted in variable amounts of U.S. dollars and cents per one unit of foreign currency (e.g., $0.5774 per DEM1). The phrase “European terms”means a direct quote from the point of view of someone located in Europe. For the dollar, that means variable amounts of foreign currency per one U.S. dollar (or DEM 1.7320 per $1).
In daily life,most prices are quoted “directly,” so when you go to the store you pay x dollars and y cents for one loaf (unit) of bread. For many years, all dollar exchange rates also were quoted directly. That meant dollar exchange rates were quoted in European terms in Europe, and in American terms in the United States. However, in 1978, as the foreign exchange market was integrating into a single global market, for convenience, the practice in the U.S. market was changed—at the initiative of the brokers community—to conform to the European convention. Thus, OTC markets in all countries now quote dollars in European terms against nearly all other currencies (amounts of foreign
currency per $1). That means that the dollar is nearly always the base currency,one unit of which (one dollar) is being bought or sold for a variable amount of a foreign currency.
There are still exceptions to this general rule, however. In particular, in all OTC markets around the world, the pound sterling continues to be quoted as the base currency
against the dollar and other currencies. Thus, market makers and brokers everywhere quote the pound sterling at x dollars and cents per pound, or y DEM per pound, and so forth. The United Kingdom did not adopt a decimal currency system until 1971, and it was much easier mathematically to quote and trade in terms of variable amounts of foreign currency per pound than the other way around.
Certain currencies historically linked to the British pound—the Irish, Australian, and New Zealand currencies—are quoted in the OTC market in the same way as the pound: variable amounts of dollars and cents per unit. The SDR and the ECU, composite
currency units of the IMF and the European Monetary Union, also are quoted in dollars
and cents per SDR or ECU. Similarly, it is expected that the euro will be quoted in
dollars and cents per euro, at least among dealers. But all other currencies traded in the
OTC market are quoted in variable amounts of foreign currency per one dollar.
Direct and indirect quotes are reciprocals, and either can easily be determined from the other. In the United States, the financial press typically reports the quotes both ways, as shown in the excerpt from The New York Times in Figure 5-2 at the end of the chapter.
The third and fourth columns show the quotes for the previous two days in “European terms”— the foreign currency price of one dollar—which is the convention used for most exchange rates by dealers in the OTC market.
The first and second columns show the (reciprocal) quotes for the same two days in
American terms—the price in dollars and cents of one unit of each of various foreign currencies— which is the approach sometimes used by traders in dealings with commercial customers,and is also the convention used for quoting dollar exchange
rates in the exchange-traded segment of the U.S.foreign exchange market.
- There Is a Base Currency and a Terms Currency
Every foreign exchange transaction involves two currencies—and it is important to keep straight which is the base currency (or quoted, underlying, or fixed currency) and which is the terms currency (or counter currency). A trader always buys or sells a fixed amount of the “base” currency—as noted above, most often the dollar—and adjusts the amount of the “terms” currency as the exchange rate changes.
The terms currency is thus the numerator and the base currency is the enominator.When the numerator increases, the base currency is strengthening and becoming more expensive; when the numerator decreases, the base currency is weakening and becoming cheaper.
In oral communications, the base currency is always stated first. For example, a quotation for “dollar-yen”means the dollar is the base and the denominator, and the yen is the terms currency and the numerator; “dollar-swissie” means that the Swiss franc is the terms currency; and “sterling-dollar” (usually called “cable”) means that the dollar is the terms currency. Currency codes are also used to denote currency pairs, with the base currency usually presented first, followed by an oblique. Thus “dollar-yen” is USD/JPY; “dollar-Swissie” is USD/CHF; and “sterling-dollar” is GBP/USD.
- Bids and Offers Are for the Base Currency
Traders always think in terms of how much it costs to buy or sell the base currency. A market maker’s quotes are always presented from the market maker’s point of view,so the bid price is the amount of terms currency that the market maker will pay for a unit of the base currency; the offer price is the amount of terms currency the market maker will
charge for a unit of the base currency. A market maker asked for a quote on “dollar-swissie” might respond “1.4975-85,” indicating a bid price of CHF 1.4975 per dollar and an offer price of CHF 1.4985 per dollar. Usually the market maker will simply give the quote as “75-85,” and assume that the counterparty knows that the “big figure” is 1.49.
The bid price always is offered first (the number on the left), and is lower (a smaller amount of terms currency) than the offer price (the larger number on the right).This differential is the dealer’s spread.
- Quotes Are in Basis Points
For most currencies, bid and offer quotes are presented to the fourth decimal place—that is, to one-hundredth of one percent, or 1/10,000th of the terms currency unit, usually called a “pip.” However, for a few currency units that are relatively small in absolute value, such as the Japanese yen and the Italian lira, quotes may be carried to two decimal places and a “pip” is 1/100 of the terms currency unit. In any market, a “pip” or a “tick” is the smallest amount by which a price can move in that market, and in the foreign exchange market “pip” is the term commonly used.
- Cross Rate Trading
Cross rates, as noted in Chapter 3, are exchange rates in which the dollar is neither the base nor the terms currency, such as “mark-yen,” in which the DEM is the base currency; and “sterling-mark,” in which the pound sterling is the base currency. In cross trades,either currency can be made the base, although there are standard pairs—mark-yen, sterling-swissie, etc.As usual, the base currency is mentioned first.
There are both derived cross rates and directly traded cross rates. Historically, cross rates were derived from the dollar rates of the two named currencies, even if the transaction was not actually channeled through the dollar.Thus, a cross rate for
sterling-yen would be derived from the sterlingdollar and dollar-yen rates. That continues to be the practice for many currency pairs, as described in Box 5.1, but for other pairs, viable markets have developed and direct trading sets the cross rates, within the boundary rates established by the derived cross rate calculations.
During the 1980s and ‘90s, there was a very large expansion of direct cross trading,
in which the dollar was not involved either as metric or as medium of exchange. Much of
this direct cross trading activity involved the Deutsche mark. Direct trading activity
between the mark and other European currencies developed to the point where most
trading of currencies in the European Monetary System took place directly through
cross rates, and the most widely direct-traded crosses came to be used to quote rates for other, less widely traded currency pairs. By the mid-1990s, mark-yen, sterling-mark, mark-French franc (or mark-Paris), and mark-Swiss all were very actively traded pairs.
Deutsche mark cross trading with European currencies developed to the point where rates in the New York market for dollar-lira, dollar-French franc, etc., were usually calculated from the mark-lira, mark-French franc, etc., particularly during the afternoon in New York, when European markets were closed.
As direct cross currency trading between non-dollar currencies expanded, new trading
opportunities developed. Various arbitrage opportunities became possible between the
cross rate markets and the direct dollar markets. Traders had more choices than they had in a system in which the dollar was virtually always the vehicle currency.
With the launching of the euro in 1999, major structural changes in cross trading
activity can be expected. With the euro replacing a number of European currencies,
much of the earlier cross trading will no longer be required. What role the euro itself
may play as a vehicle currency remains to be seen.
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