In the article “FX Quotation” I wrote about quotation styles and how currencies are denoted with a letter code like CCY1 and CCY2.
The quoting conventions associated with FX market are confusing things.
However there are other points of possible confusion.
1. The most commonly traded FX market is the spot market where participants exchange one currency for another.
Making the deal on the spot market doesn’t mean “right here and right now”.
A spot transaction is settled two good business days after the deal. It is called T+2 settlement. Some currency pairs, like USD/CAD, have T+1 settlement.
However, settlement dates for CAD crosses normally take the T+2 settlement. USD/TRY has T+1 but sometimes it is even traded as T+0 (until 12:00 Istanbul time).
There are also other currency pair that have none standard settlements.
2. A “pip” is the smallest unit of the spot price, 100 pips is a “figure”.
Standard currency pairs quoted to four or five decimal places. In JPY, a pip is 0.01.
Pips sometimes called points.
First of all, let’s see a simple example:
You have euro and want to buy $1 120 000. Dollars should be settled in the next year.
What would be the forward rate if EUR deposit gives 1% and USD deposit gives 2% and the spot rate is 1.1200?
It is easy to calculate what happens next year:
1 EUR * (1+0.01) = 1.1200 USD * (1+0.02)
1.01 EUR = 1.1424 USD or simply 1 EUR next year = 1.1311 USD
We see there is no reason why the spot price should be the same as the forward price as long as there are different interest rates.
The forward price is based on the spot price and the interest cost. The forward rate is easily computed by using the formula below:
In the formula there is Day-count convention that should be taken into account if two currencies are quoted on a different day basis, say 360 and 365 respectively.
In a direct quote:
• Base currency is the first currency quoted in a currency pair. It is also known as domestic or account currency.
• Quote currency or the foreign currency is the second currency quoted in a currency pair.
In the example above, EUR/USD is a direct quote; USD/EUR is in an indirect quote.
So, to be more precise, let’s recalculate our forward rate again:
1. Now it is easy to understand that if the forward rate is lower than the spot rate, the base currency is at a discount and if the forward rate is higher than the spot rate, the base currency is at a premium.
2. Differences between the spot and a forward rate are known as swap points or forward points.
From the example, the 1-year EUR/USD swap points are 0.0112.
Traders quote forward rates in swap points.
As of 16 Jul 2015 there are swap points (taken from BBG by using function Forward points):
• USD/JPY forward rate trades at discount:
Interest rate quote currency is lower than interest rate base currency
For the 1-year USD/JPY forward the price is 123.51-1.0373 =122.4727 JPY per $1.
• EUR/USD forward rate trades at premium:
Interest rate quote currency is higher than interest rate base currency
For the 1-year EUR/USD forward the price is 1.1281+0.008763=1.13686US dollars per 1 Euro.
Swap points are easily computed by using the formula:
This is simply the same as in our previous EUR/USD example: 1.1312-1.1200=0.0112 swap points.
3. NDF (none deliverable forward transaction) is used when a currency does not have a deliverable market offshore.
Therefore the physical exchange of currencies at expiry is replaced by a net settlement transaction in a single cash payment.
NDF has the same functionality as FRA. Both instruments are none deliverable, i.e. no exchange of the notional amount and cash settled.
However, the markets are different. NDF is FX market while FRA is Interest rate/ Money Market.
4. Usually, forwards quoted for 1w, 2w, 3w, 1m up to 12m. G10 currencies terms are up to 3-5 years.
An FX Swap is simply the combination of a spot and a forward FX transaction in opposite directions.
1. FX swaps are often used as a funding source allowing utilization of funds in one currency to fund obligations denominated in another currency.
This is known as swap funding.
2. Due two simultaneous purchase and sell transactions there is only residual FX risk and interest rate risk.
Spot and forward transactions usually have the same nominal (Matched principal swaps) quoted in the base currency.
Buy and sell 1m EUR means bought 1m EUR at the Spot rate and sold 1m EUR at Forward rate.
If the nominal is the same, there is the residual FX risk which considered to be small but still exists.
In our example:
• EUR/USD spot is 1.12
• 1-year EUR/USD swap points are 112
• 1-year USD interest rate is 2%
• 1-year EUR interest rate is 1%
In order to identify residual FX risk, simple discounting of the foreign currency should be done. NPV will show whether we have residual foreign currency or not.
FX spot transaction:
• NPV (USD currency) = $1 120 000
• FX Forward: NPV (USD currency) = ((1.1200+112 point)*1m)/(1+(0.02*365/360)=1 131 200/1.02027=-$1 108 726
• Total NPV( USD exposure)= $1 120 000 -$1 108 726 = $11 274 or -10 066 EUR
Therefore, 10 066 EUR should be bought in order to neutralize the FX residual exposure.