Introduc)ontoFXMarketsSpotMarkets

AkshatShankar,CFA,FRM

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OutlineMarketConven,ons

•  Base&QuotedCurrencies•  Direct&IndirectCode•  CrossRates•  BigFigure&Pips

Par,cipants

ElectronicCommunica,onNetwork

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Spotmarket–wherecurrenciesaretradedforimmediatedelivery.

Forwardmarket–wherecontractsaremadetobuyorsellcurrenciesforfuturedelivery

Swaptransac1ons–involveaseriesofforwardcontracts.

Op1ons-involvepayoffsrelatedtospotvalue.

FXMarkets

SpotMarket ForwardMarket SwapMarket Op,onMarket

FXMarket

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SpotMarket•  Spotmarketrepresentsthedirectexchangeofcurrencies.

•  SpotratesarequotedasoneunitoftheBasecurrencyagainstanumberofunitsoftheQuoteCurrency.

•  ActualcurrencytransferhappensaNer2daysoftrade.(T+2).

GBP

USD

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CurrencyValueo  TheCurrencyPairistherela,vevalueofacurrencyunit

againsttheunitofanothercurrency

51258.1=USDGBP USDGBP 51258.11 =

BuysGBPusingUSD

BuysGBPUSD

SellsUSDGBP

BuysUSDusingGBP

SellsGBPUSD

BuysUSDGBP

GBP

USD

BaseandQuoteCurrencies

BaseCurrency

Currencies

QuoteCurrency

Onewhichisbeingusedtoquotethe‘price’.Oneforwhichthe‘price’isbeingquoted.

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USDINR=551USD=55INR

BaseandQuoteCurrencies

BaseCurrency

Currencies

QuoteCurrency

Onewhichisbeingusedtoquotethe‘price’.Oneforwhichthe‘price’isbeingquoted.

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INRUSD=0.0181INR=0.018USD

DirectandIndirectQuotes

o  Onewantstobuybanana.Whichofthetwoseems‘Direct’?

1Banana=0.5INR.

2Banana=1INR

o  Interestedtofindthepriceofsomethingintermsofourowno  Whatisthepriceof1Banana(DirectQuote)o  HowmanyBananain1INR(IndirectQuote)

DirectandIndirectQuotes

o  Wearealwaysinterestedtofindthepriceofsomethingintermsofourowncurrency.SoforanIndian

o  Whatisthepriceof1EurointermsofINR(DirectQuote)o  HowmanyEuroin1INR(IndirectQuote)o  DirectQuota1onisthepricewhentheQuoteCurrencyis

yourowncurrency.

o  ForanIndianbuyingPound,whichseems‘Direct’?

1GBP=90INR.

1INR=1/90GBP

DirectandIndirectQuotes

o  DirectQuota,on:Aforeigncurrencyquotedintermsofdomes,ccurrencyo  Example:

o  1EUR=1.3387USD(forAmericans)o  1USD=0.7470USD(forEuropeans)

o  IndirectQuota,on:Domes,ccurrencyquotedintermsofforeigncurrencyo  Example:

o  1EUR=1.3387USD(forEuropeans)o  1USD=0.7470USD(forAmericans)

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CrossRates

Onecanbuy1orangewith2bananas.

Onecanbuy1appleusing3oranges.

Howmanybananasarerequiredtobuy1apple?

Orange/Banana=2

Apple/Orange=3

Apple/Banana=(Apple/Orange)*(Orange/Banana)

=3*2=6

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CrossRates:TriangularArbitrage

o  CrossRateisthevalueofacurrency-pairderivedfromathirdcurrency-pair.

o  Arbitrageopportuni,esexistifanobservedrateinanothermarketisnotconsistentwithacross-rate(ignoringtransac,oncosts).

o  ThiskindofArbitrageiscalledTriangularArbitrage.o  Profitopportuni,esarelikelytobearbitragedawayquickly.o  Soforthemostpart,CrossRatesareconsistentwith

observedrates.

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CrossRates:TriangularArbitrageExample

GBP/USD=1.7936

GBP/PLN=6.5492

USD/PLN=3.7826

Thecross-rateforUSD/PLNis:

6.5492/1.7936=3.6514(Z/$)

Hence,anarbitrageopportunityexists.

USDGBPPLNGBP

PLNUSD

=

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Pip(PercentageinPoint)o  Thesmallestpricechangethatagivenexchangeratecan

make.o  Sincemostmajorcurrencypairsarepricedtofourdecimal

places,thesmallestchangeisthatofthelastdecimalpoint.o  Formostpairsthisistheequivalentto0.0001(basispoint).

o  EURUSD,GBPUSDo  Thesmallestmoveinacurrencydoesnotalwaysneedtobe

equaltoonebasispoint.o  USDJPY

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BigFigure

o  Currenciesarenotveryvola,lesointhemarketonlylasttwodigitsareprominentlydisplayed.

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OutlineMarketConven,ons

•  Base&QuotedCurrencies•  Direct&IndirectCode•  CrossRates•  BigFigure&Pips

Par,cipants

ElectronicCommunica,onNetwork

Brokero  Brokerisanintermediarywhohelpstheclientinthetransac,on.

Hasalicensetobuyandsellsecuri,esonaclient'sbehalf.

Its great that you two have agreed to

do the transaction. I would charge just a small commission for

making you meet!

Dealero  Dealerisanintermediarywhoiswillingtobuyorsellsecuri,esfor

theirownaccount.Itoffloadstheportoliobyfindingasuitablereversecustomer.

DealerPlease buy

apples from me at $1.1 per

kg.

Please sell apples to me at $1.2 per

kg.

Hedger

I need to export mangoes in 2 months. But I fear that Dollar

would fall by then.

o  Hedgerusescurrencyderiva,vestoreduceriskthatitmayfacefrompoten,almovementsintheprice.

Don’t worry. Let’s buy a derivative on Dollar. You can

lock in a price of Dollars today for a later date.

Speculator

I would get Rs 1 crore if USDINR hits 61 by today. I pity at those who think this would not happen!

o  Speculatorsareessen,allygamblerswhotakeaposi,oninmarketbyeitherbeungthatpriceofassetwillgoup,orbybeungthatitwillgodown.

Arbitrageur

I think I can make sure shot $100 if I long

USDINR, long JPYUSD and short JPYINR.

o  Arbitrageurlocksinarisklessprofitbysimultaneouslyenteringintotransac,onsintwoormoremarkets.

CentralBanko  CentralBankisresponsibleforthemonetarypolicyofacountry

andmaytradetoreducethevola,lityofacurrency.

Our currency is rising these days

which would hurt our exports. We should start selling it to

decrease the price.

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OutlineMarketConven,ons

•  Base&QuotedCurrencies•  Direct&IndirectCode•  CrossRates•  BigFigure&Pips

Par,cipants

ElectronicCommunica,onNetwork

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ElectronicCommunica,onNetwork(ECN)

o  ECNsarebrokersthatuseelectronicnetworkstoconnectclientswithotherpar,cipantslikeInterbankMarket.

o  Tradersarechargedwithfixedcommissionforeverytrade.o  Brokersdoesnottradeagainstyoubutsimplytransfersyour

requesttoothermarketpar,cipants.

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ECNAdvantages ECNbrokersgatherpricesfrommul,plesourcessuchasbanks,marketmakersandothertraderswhoareconnectedtotheECN.

ECNprovideanonymoustradingwithfasterexecu,onspeed.

InterbankMarket

Trader1 Trader2

ECN1 ECN2

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ECNExample:FXCM