Lesson II: A Deeper Insight into Everyday FX Market Practice · Financial and Foreign Exchange...

InternationalFinancial and

Foreign ExchangeMarkets

Spot FX Markets

Bid/Ask Prices andQuoting Conventions

Reciprocal Rates,Cross Rates andBid/Ask Spread

Fwd FX Markets

Main Features andQuoting Conventions

Fwd Premium andDiscount

Major TradedInstruments

Terminology

To Put It intoPractice

Lesson II: A Deeper Insight into EverydayFX Market Practice

Monday 9th March, 2020



Spot FX Markets



Fwd FX Markets




Terminology


Table of Contents

Spot FX MarketsBid/Ask Prices and Quoting ConventionsReciprocal Rates, Cross Rates and Bid/Ask Spread

Fwd FX MarketsMain Features and Quoting ConventionsFwd Premium and DiscountMajor Traded Instruments

Terminology

To Put It into Practice



Spot FX Markets



Fwd FX Markets




Terminology


Getting Started

Some useful trading jargon:

I Bid: rate at which a certain market player is willing tobuy

I Ask: rate at which a certain market player is willing tosell

Watch out: Bid<Ask



Spot FX Markets



Fwd FX Markets




Terminology


The Bid/Ask Spread

Bid/Ask Spread=Ask-Bid

The bid-ask spread can be conceived as a transaction cost(step back to Lesson I)



Spot FX Markets



Fwd FX Markets




Terminology


The Bid/Ask Spread in Practice I

Apart from two notable exceptions (GBP and EUR), all theother major currencies are quoted in European terms, thatis foreign currency per USD (Lesson I).

S FUSD⇒ think of these exchange rates as the buying and

selling prices of USD



Spot FX Markets



Fwd FX Markets




Terminology


The Bid/Ask Spread in Practice II

For instance,

I S CHFbidUSD

⇒ rate at which a certain mkt player is willing to

buy USD against CHF

I S CHFaskUSD

⇒ rate at which the same mkt player

sells USD against CHF

I Watch out: S CHFbidUSD

< S CHFaskUSD



Spot FX Markets



Fwd FX Markets




Terminology


The Bid/Ask Spread in Practice III

Conversely, EUR and GBP are quoted in USD equivalent

SUSDF⇒ think of these exchange rates as the buying and

selling prices of EUR or GBP



Spot FX Markets



Fwd FX Markets




Terminology


The Bid/Ask Spread in Practice IV

For instance,

I S USDbidGBP

⇒ rate at which a certain mkt player is willing to

buy GBP against USD

I S USDaskGBP

⇒ rate at which the same mkt player

sells GBP against USD

I Watch out: S USDbidGBP

< S USDaskGBP



Spot FX Markets



Fwd FX Markets




Terminology


A Closer Focus on Everyday Mkt Practice I

I S USDbidEUR

= 1.0758⇒ the price provider is willing to

buy EUR at 1.0758 USD

I S USDaskEUR


sell EUR at 1.0759 USD



Spot FX Markets



Fwd FX Markets




Terminology


A Closer Focus on Everyday Mkt Practice II

I S JPYbidUSD


buy USD at 113.05 JPY

I S JPYaskUSD


sell USD at 113.06 JPY



Spot FX Markets



Fwd FX Markets




Terminology


Equivalent Notations I

S USDbidGBP

= S askUSDbidGBP

Rate at which the price provider is willing to buy GBPagainst (selling) USD (i.e. the buying rate for GBP andthe selling rate for USD)



Spot FX Markets



Fwd FX Markets




Terminology


Equivalent Notations II

S USDaskGBP

= S bidUSDaskGBP

Rate at which the price provider is willing to sell GBPagainst (buying) USD (i.e. the buying rate for USD andthe selling rate for GBP)



Spot FX Markets



Fwd FX Markets




Terminology


Watch Out!

Given

S USDbidGBP

and S USDaskGBP

,

what if YOU were to sell/buy GBP?

I S USDbidGBP

⇒ number of USD YOU will receive from the

bank from the sale of GBP per USD

I S USDaskGBP

⇒ the price that YOU must pay to buy GBP

from USD



Spot FX Markets



Fwd FX Markets




Terminology


Evidence on the bid-ask spread

The bid ask spread tends to:I vary throughout the day ⇒ in particular, the spread is

higher:I at the start/end of the trading day;I on Fridays (at closing), on Mondays (at opening) as

well as on the last trading day of the month;I on market holidays (for big financial centres)

I increase with the volatility of the spot rate

I decrease when more dealers are in the market⇒ thelarger the number of dealers, the thinner the spread



Spot FX Markets



Fwd FX Markets




Terminology


Reciprocal Rates and Bid/Ask Spread

When bid-ask prices are taken into account:

S iaskj

= 1S j

bidi

and

S ibidj

= 1S j

aski



Spot FX Markets



Fwd FX Markets




Terminology


Cross Rates and Triangular Arbitrages I

Suppose you were to buy GBP from EUR and assume that:

Bid AskSUSD

EUR1.102 1.105

SUSDGBP

1.5775 1.581

SGBPEUR

0.696 0.6965

In principle, you could either choose a direct transaction(you sell EUR to buy GBP) or an indirect transaction viaUSD (you first sell EUR to buy USD and then you sell USDto buy GBP)...



Spot FX Markets



Fwd FX Markets




Terminology


Indirect Transaction (via USD)

Bid AskSUSD

EUR1.102 1.105

SUSDGBP

1.5775 1.581

I Step 1:sell EUR to buy USD⇒ S USDbidEUR

I Step 2:sell USD to buy GBP⇒ S USDaskGBP

The indirect FX rate S GBPbidEUR

is thusS USD

bidEURS USD

askGBP

= 1.10201.581 =0.6970



Spot FX Markets



Fwd FX Markets




Terminology


Direct Transaction

Bid AskSGBP

EUR0.696 0.6965

In this case, you only have to sell EUR to buy GBP⇒S GBP

bidEUR= 0.696



Spot FX Markets



Fwd FX Markets




Terminology


Some Profit to Cash In...

Notice that, if you choose the indirect transaction, youwould get 0.6970 GBP. If you conversely go for the directtransaction, you would only get 0.696: are there profitopportunities? If so, how would you exploit them?



Spot FX Markets



Fwd FX Markets




Terminology


In More General Terms...

I As long as S GBPbidEUR

≥S USD

bidEURS USD

askGBP

, you are better off choosing

the direct transaction

I Conversely, if S GBPbidEUR

≤S USD

bidEURS USD

askGBP

, the indirect transaction

will offer you a better return



Spot FX Markets



Fwd FX Markets




Terminology


The Empirical EvidenceIn practice, however, triangular arbitrage opportunitiesare very unlikely to materialize.An increasing number of people will try to profit fromthe price differential and will consequently sell EUR ⇒ buyUSD ⇒ sell USD ⇒ buy GBP, thus driving EUR down andGBP up, until equilibrium is finally restored (No free lunchprinciple)

S GBPbidEUR

=S USD

bidEURS USD

askGBP



Spot FX Markets



Fwd FX Markets




Terminology


To Rust Off - Lesson I

I Spot exchange rate: FX rate that is contracted todayfor immediate delivery (generally, t+1 or t+2)

I Forward exchange rate: rate that is contracted todayfor the exchange of currencies on a specific date in thefuture (1m, 3m, 6m).



Spot FX Markets



Fwd FX Markets




Terminology


FX Fwd Markets: an Overview

Exactly like the spot market:

I No central location

I 24h trading

I Direct interbank market (decentralized, continuous,open-bid, double-auction) and indirect broker-basedmarket (quasi-centralized, continuous, limit-book,single-auction market) [Step back to Lesson I]

I Bid/Ask quotation



Spot FX Markets



Fwd FX Markets




Terminology


Adopted Notation

Forward exchange rate: rate that is contracted today forthe exchange of currencies on a specific date in the future.Fn( ij ) is the n-year forward exchange rate of currency i perunit of currency j



Spot FX Markets



Fwd FX Markets




Terminology


Quoting Conventions

Forward rates are generally quoted in terms of thecorresponding spot rate ± a suitable number of swappoints, depending on the forward maturity taken intoconsideration.Swap points will be added to (subtracted from) the spotbid-ask quotes whenever they are ascending (descending).



Spot FX Markets



Fwd FX Markets




Terminology


Quoting Conventions: an Example

Given the spot rates and the swap points below, how to findthe corresponding fwd bid-ask quotation?

Spot Bid/Ask Swap Points1.3965/1.3970 27/23

Descending swap points ⇒ to be subtractedFbid = 1.3965− .0027 = 1.3938andFask = 1.3970− .0023 = 1.3947



Spot FX Markets



Fwd FX Markets




Terminology


A Closer Mkt Insight

The bid-ask spread for forward quotations is wider astime to maturity increases: this is mostly due to market“thinness”



Spot FX Markets



Fwd FX Markets




Terminology


Fwd Premium and Discount

When it is necessary to pay more (less) for forward deliverythan for spot delivery of a currency, we say that the currencyis at a forward premium (discount).

N-year forward premium/discount=Fn

ij−S i

j

n·S ij



Spot FX Markets



Fwd FX Markets




Terminology


Fwd Premium and Discount:an Exmple

Given S JPYUSD

= 76.89 and F0.5 JPYUSD

= 76.65,

Fwd Premium/Discount=76.65−76.890.5·76.89 =0.00624

Fwd discount of the Dollar versus the Yen (or, equivalently,fwd premium of the Yen versus the Dollar)



Spot FX Markets



Fwd FX Markets




Terminology


Major Traded Instruments

I Outright fwd contract: agreement to exchangecurrencies at a pre-determined price on a future date

I FX Swap: agreement to buy and sell foreign exchangeat pre-specified exchange rates, where the buying andselling are separated in time (two major components: aspot transaction plus a forward transaction in thereverse direction). A swap-in (swap-out) EUR consistsof an agreement to buy (sell) EUR spot and to sell(buy) them forward

I Currency Swap: agreement involving two parties in theexchange of principal and interest payments on a loanin one currency for principal and interest payments inanother currency.

I Options: derivative contracts that give the buyer theopportunity to buy (call) or to sell (put) the underlyingasset at a given price sometime in the future



Spot FX Markets



Fwd FX Markets




Terminology


Some Trading Jargon



Spot FX Markets



Fwd FX Markets




Terminology


The Trading Book

I Bid Section: buying proposals, ascending prices

I Ask Section: selling proposals, descending prices

I Ranking criteria: Price priority and Time priority

I Mkt Depth: Ability to sustain large mkt orderswithout impacting the price of a security ⇒ a verylarge order will not significantly move the price of asecurity

I Mkt Width: it refers to the cost of executing atrade of a given size



Spot FX Markets



Fwd FX Markets




Terminology


No Free Lunch Principle

Free Lunch: situation where a good or a service is receivedat NO cost. In strict financial terms, No Free Lunch meansthat an investor will not be able to make large and risklessprofits on a continuous, persistent basis.



Spot FX Markets



Fwd FX Markets




Terminology


To put it into practice I

2.1: Based on the table below, answer the followingquestions:

Bid AskS USD

Currency1

1.35135 1.35227

SCurrency2USD

83.365 83.3925

I How much would you lose if you converted USD 1000into Currency1 and then back into USD?

I What is the bid-ask spread for SCurrency2USD

?

I What is the bid-ask spread for SCurrency2Currency1

?

I How much would you lose if you converted USD 1000into Currency1, then into Currency2 and finally backinto USD?



Spot FX Markets



Fwd FX Markets




Terminology


To put it into practice II2.2: Fill in the table below and answer the followingquestions:

Bid AskS CZJ

GBP42.7512 42.7983

SDKKGBP

11.3065 11.3235

S EURGBP

1.2439 1.2501

SNOKGBP

12.3363 12.3479

SDKKEUR

S EURNOK

SGBPCZJ

I Find the bid-ask spread for the S EURCZJ

quote.

I How much would you lose if you converted 1500 DKKinto GBP, then into EUR, further into NOK and finallyback into DKK?

Lesson II: A Deeper Insight into Everyday FX Market Practice · Financial and Foreign Exchange...

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Transcript of Lesson II: A Deeper Insight into Everyday FX Market Practice · Financial and Foreign Exchange...