Forex markets - International Finance

unit of measurement for exchange rates

pips: for most currencies, its .0001, for JPY its .01.

products traded in the forex market

spot, forward, and swap

spot contracts

transactions for the purchase or sale of currency for currency at today’s price for settlement within two business days

outright forward contracts

agreements to purchase or sell one currency for another set today (in terms of delivery date, price, and amount) for delivery at a future date (usually between one week and 12 months). No money changes hands when the contract is agreed although collateral may be required to minimize counterparty risk. At maturity, physical delivery of currencies will occur

Non-deliverable forwards (NDF)

similar to regular forward contracts, but do not require actual delivery. Upon maturity, settlement is made in dollars for the difference between the NDF rate and the prevailing spot rate. if spot > forward, you make a profit as you bought at forward rate and sold at a higher spot rate

Swap Contract

forward contract and spot transaction combined

reason for using forwards

if you don’t know the exchange rate in future, you can hedge against currency risk for future payables in certain currencies

reason to use spot contracts

if countries are borrowing in currencies they don’t use, you can swap to get a currency they do use. (locks exchange rate today and at several points in future (interest payments))

cross currency swaps

involves the exchange of interest and sometimes principal in one currency for the same in another. exchange principal amounts denominated in different currencies at initial prevailing exchange rate. Swapping a stream of interest payments denominated in two different currencies. Re-exchanging the principal amounts also at initial exchange rate — creates an implied exchange rate

Forex institutional framework, bringing buy and sell side together, 35% of trading

Customer asks banks for a blind quote. The bank’s forex dealer provides quotes to customers acting as the market maker. The bank hopes to be able to use existing inventory to complete transaction, but is often unable. If not enough inventory, have to ask a second bank with no commission but no guarantee that trader found best price. Could also contact a broker who finds best price and earns commission

direct trading

bank A asks bank B for a quote. no commission is paid, but no guarantee that trader will find the best price

indirect trading

banks contacting a broker who acts as matchmaker, finding the best prices and communicating them. commission is paid.

Forex institutional framework, bringing buy and sell side together, 65% of trading (electronic communication networks)

automatically match buy and sell orders, bypassing banks forex dealers. used because buy side would rather access multiple dealer portals that function as an aggregator, streaming quotes from key dealer banks that are actively routing buy side order to the most cost effective sell side providers

bid-ask spread

how participants in the forex markets make money; percentage dealer earns on volume of trades they handle. spread (%) = ask price - bid price / bid price

bid

the price at which a trader is willing to buy, quotes first

ask

the price at which a trader is willing to sell, quoted last

factors that influence bid/ask spread

liquidity, volatility, quote currency

factors that influence bid/ask spread: liquidity

Markets with higher trading volumes and more participants tend to have tighter spreads and greater liquidity. This is possible because market makers can more easily match trades, as there are more orders competing for prices

factors that influence bid/ask spread: volatility

During times of uncertainty or significant events like the outbreak of a pandemic or a central bank meeting, markets experience higher volatility and rapidly changing prices - resulting in wider spreads

factors that influence bid/ask spread: quote currency

While assets like stocks are priced in U.S. dollars, Forex pairs are priced in different currencies. The pip in a Forex pair depends on the quote currency. For most pairs, the pip is 0.0001, in the U.S. dollar-Japanese yen pair (USD/JPY), the pip is .01 yen

direct quote

the cost of one unit of foreign currency is given in units of local currency. how many units of domestic currency is equal to one unit of foreign currency. Domestic currency per foreign currency

first currency in BBB/QQQ

base currency, the currency we are pricing

second currency in BBB/QQQ

quote currency, the currency the price is in terms of

indirect quote

the cost of one unit of local currency is given in units of foreign currency. how many foreign currency equals one unit of domestic currency. Foreign currency per domestic currency

the dollar serves as the ___ currency, whether the speaker is in the US or elsewhere

base

exception to the dollar-base quote rule

when the GBP is quoted as the base currency, with the exception of the euro being the other currency

the euro should always be the ___ currency whenever it is traded, including against the US and GBP

base