A Foreign Exchange Primer-Shani Shamah

Disclaimer xiii
1 Introduction 1
1.1 The Foreign Exchange Market 1
1.2 Value Terms 1
1.3 Coffee Houses 1
1.4 Spot and Forward Market 2
1.5 Alternative Markets 3
Concluding Remarks 3
PART I: MARKET OVERVIEW 5
2 A Brief History of the Market 7
2.1 The Barter System 7
2.2 The Introduction of Coinage 7
2.3 The Expanding British Empire 8
2.4 The Gold Standard 8
2.5 The Bretton Woods System 9
2.6 The International Monetary Fund and The World Bank 9
2.7 The Dollar Rules OK 10
2.8 Special Drawing Rights 10
2.9 A Dollar Problem 11
2.9.1 The Smithsonian Agreement 11
2.9.2 The Snake 11
2.9.3 The Dirty Float 11
2.10 The EMS and the ERM 12
2.10.1 The European Monetary System 12
2.10.2 The Exchange Rate Mechanism 12
2.11 The European Currency Unit 12
2.12 The Maastricht Treaty 13
2.13 The Treaty of Rome 13
2.14 Economic Reform 14
2.15 A Common Monetary Policy 15
2.16 The Single Currency 15
Concluding Remarks 18
3 Market Overview 19
3.1 Global Market 19
3.2 No Physical Trading Floor 19
3.3 A ‘Perfect’ Market 20
3.4 The Main Instruments 21
3.5 The Dollar’s Role 21
3.6 Widely Traded Currency Pairs 21
Concluding Remarks 23
4 Major Participants 25
4.1 Governments 25
4.2 Banks 25
4.2.1 Central Banks 25
4.2.2 Trading Banks 27
4.2.3 Commercial Banks 27
4.2.4 Regional or Correspondent Banks 27
4.2.5 Investment and Merchant Banks 28
4.3 Brokering Houses 28
4.4 International Monetary Market 28
4.5 Money Managers 29
4.6 Corporations 29
4.7 Retail Clients 29
4.8 Others 30
4.9 Speculators 30
4.10 Trade and Financial Flows 31
5 Roles Played 33
5.1 Market Makers 33
5.2 Price Takers 33
5.3 A Number of Roles 33
Concluding Remarks 34
6 Purposes 35
6.1 Transactions 35
6.1.1 Commercial Transactions 35
6.1.2 Funding 35
6.1.3 Hedging 35
6.1.4 Portfolio Investment 36
6.1.5 Personal 36
6.2 Market Making 36
6.3 Foreign Exchange Exposure 36
6.3.1 Transaction Exposure 36
6.3.2 Translation Exposure 37
6.3.3 Economic Exposure 37
Concluding Remarks 37
PART II: FOREIGN EXCHANGE PRODUCTS 39
7 Spot Foreign Exchange 41
7.1 Spot and Reciprocal Rates 41
7.2 European and American Terms 42
7.3 Spot Transactions 42
7.3.1 Bid – Offer Spreads 42
7.3.2 Reading Foreign Exchange Rates 43
7.3.3 Big Figures 44
7.3.4 Spread 44
7.4 Direct versus Brokered Dealing 44
7.5 Cross Rates 44
7.6 Price Determinants 45
7.7 Uses for Spot Transactions 45
7.7.1 Risk Consideration 46
8 Forward Contracts 47
8.1 Interest Rate Differentials 47
8.2 Periods 47
8.3 Premium or Discount 47
8.4 Calculations 48
8.4.1 Bids and Offers 50
8.4.2 To add or to Subtract 50
8.5 How are Forwards Quoted? 50
8.6 Forward Cross Rates 51
8.7 Uses of Forwards 53
8.7.1 Risks Involved 54
Concluding Remarks 54
9 Short- and Long-Dated Contracts 55
9.1 Short-Dated Contracts 55
9.2 Interest Rate Differentials 55
9.3 Long-Dated Contracts 56
Concluding Remarks 57
10 Broken-Dated Contracts 59
10.1 Calculations 59
10.2 Outright Forwards 59
10.3 A Conversation 60
11 Non-Deliverable Forwards 63
11.1 Fixing Methodology 63
11.2 Risk Management Tool 63
11.3 Availability 64
11.4 Examples 64
11.5 Typical Risks Encountered 66
11.6 The Currencies of Emerging Markets 67
11.7 Index-Linked Deposits 68
Concluding Remarks 68
12 Foreign Exchange Swaps 71
12.1 The Value of Foreign Exchange Swaps 71
12.2 Calculations 72
12.2.1 Points of Note 73
12.3 Uses of Foreign Exchange Swaps 73
Concluding Remarks 74
13 Currency Swaps 75
13.1 Technique Involved 75
13.2 Interest Payable 76
13.3 Benefits of Currency Swaps 77
13.3.1 Flexibility 77
Concluding Remarks 77
14 Foreign Exchange Options 79
14.1 Definitions 79
14.2 Exchange vs Over-the-Counter Options 80
14.3 Application of Foreign Exchange Options 81
14.4 Alternatives to Foreign Exchange Options 84
14.5 Parties and the Risks Involved 84
14.6 Users of Foreign Exchange Options 85
14.7 Hedging versus Speculation 87
14.8 Option Theory 87
14.8.1 Delta 87
14.8.2 Gamma 88
14.8.3 Volatility 88
14.8.4 Time Decay (Theta) 89
14.8.5 American versus European 89
14.9 Pricing Theory 90
14.10 Other Considerations 91
14.10.1 Market Conventions 91
14.10.2 Premium Conversions 92
14.10.3 Settlement 93
14.10.4 Risks 93
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