37%
57%
1%
5%
1
2
3
4
Figure 1.2. Market share of US spot trading (in %% of the volume): 1 – forwards and swaps; 2 – options; 3 - futures; 4 –
spots.
A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given
currency against receipt of a specified amount of another currency from a counterparty, based on an agreed
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9
exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed next business day. The two-day spot delivery for currencies was developed long before technological breakthroughs in information processing. This time period was necessary to
check out all transactions' details among counterparties. Although technologically feasible, the
contemporary markets did not find it necessary to reduce the time to make payments. Human errors still occur and they need to be fixed before delivery.
By the entering into a contract on the spot market a bank serving a trader tells the latter the
quota – an evaluation of the currency traded against the U.S. dollar or an other currency. A quota consists from two figures (for example, USD/JPY = 133.27/133.32 or, which is the same, USD/JPY
= 133.27/32). The first from these figures (the left part) is called the bid – price (that is a price at which the trader sells), the second (the right part) is called the ask - price (the price at which the trader buys the currency). The difference between asks and bid is called the spread. The spread, as any currency price alteration, is being measured in points ( pips).
In terms of volume, currencies around the world are traded mostly against the U.S. dollar, because
the U.S. dollar is the currency of reference. The other major currencies are the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Other currencies with significant spot market shares are the Canadian dollar and the Australian dollar. In addition, a significant share of trading takes place in the currencies crosses, a non-dollar instrument whereby foreign currencies are quoted against other foreign currencies, such as euro against Japanese yen.
The spot market is characterized by high liquidity and high volatility. Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. For instance, in an active global trading day (24 hours), the euro/dollar exchange rate may change its value 18,000 times "flying"
100-200 pips in a matter of seconds if the market gets wind of a significant event. On the other hand, the exchange rate may remain quite static for extended periods of time, even in excess of an hour, when one market is almost finished trading and waiting for the next market to take over. For example, there is a technical trading gap between around 4:30 PM and 6 PM EDT. In the New York market, the majority of
transactions occur between 8 AM and 12 PM, when the New York and European markets overlap. The
activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support. (See Figure 1.3) Overnight trading is limited, as very few banks have overnight desks.
Most of the banks send their overnight orders to branches or other banks that operate in the active time zones.
The reasons of the spot-market popularity, in addition to the fast liquidity-taking place thanks to the volatility, belongs also the short time of a contract execution. Therefore the credit risk is on that market restricted. The profit and loss can be either realized or unrealized. The realized P&L is a certain amount of money netted when a position is closed. The unrealized P&L consists of an uncertain amount of money that an outstanding position would roughly generate if it were closed at the current rate. The unrealized P&L changes continuously in tandem with the exchange rate.
Forward Market. On the forward Forex are used two tools: forward outright deals and exchange deals or swaps. A swap deal is a combination of a spot deal and a forward outright deal.
According to figures published by the Bank for the International Settlements, the percentage share
of the forward market was 57 percent in 1998. (See Figure 1.2). Translated into U.S. dollars, out of an estimated daily gross turnover of US$1.49 trillion, the total forward market represents US$900 billion. In the forward market there is no norm with regard to the settlement dates, which range from 3 days to 3
years. Volume in currency swaps longer than one year tends to be light but, technically, there is no
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10
29%
5%
66%
1
2
3
Figure 1.3. Diagram of the trade activity (in %% of the volume) of US Forex in time distribution: 1 – from 12 pm till 4 pm, 2
– from 4 pm till 8 pm, 3 – from 8 am till 12 pm.
impediment to making these deals. Any date past the spot date and within the above range may be a
forward settlement, provided that it is a valid business day for both currencies. The forward markets are decentralized markets, with players around the world entering into a variety of deals either on a one-on-one basis or through brokers.
The forward price consists of two significant parts: the spot exchange rate and the forward spread.
The spot rate is the main building block. The forward spread is also known as the f orward points or the forward pips. The forward spread is necessary for adjusting the spot rate for specific settlement dates different from the spot date. It holds, then, that the maturity date is another determining factor of the forward price.
Futures Market. Currency futures are specific types of forward outright deals. Because they are derived from the spot price, they are derivative instruments. (See Figure 1.2). They are specific with regard to the expiration date and the size of the trade amount. Whereas, generally, forward outright deals—those that mature past the spot delivery date—will mature on any valid date in the two countries whose currencies are being traded, standardized amounts of foreign currency futures mature only on the third Wednesday of March, June, September, and December.
The following characteristics of currency futures that make them attractive. They are open to all
market participants, individuals included. It is a central market, just as efficient as the cash market, and whereas the cash market is a very decentralized market, futures trading takes place under one roof. It eliminates the credit risk because the Chicago Mercantile Exchange Clearinghouse acts as the buyer
for every seller, and vice versa. In turn, the Clearinghouse minimizes its own exposure by requiring traders who maintain a nonprofitable position to post margins equal in size to their losses. Although the futures and spot markets trade closely together, certain divergences between the two occur, generating arbitraging opportunities. Gaps, volume, and open interest are significant technical analysis tools (See Chapter 4) solely available in the futures market.
Because of these benefits, currency futures trading volume has steadily attracted a large variety
of players.
Because futures are forward outright contracts and the forward prices are generally slow movers, the
elimination of the forward spreads will transform the futures contracts into spot contracts.
For traders outside the exchange, the prices are available from on-line monitors. The most popular
pages are found on Bridge, Telerate, Reuters, and Bloomberg. Telerate presents the currency futures on
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11
composite pages, while Reuters and Bloomberg display currency futures on individual pages shows the convergence between the futures and spot prices.
Options Market. A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency; and gives the
seller, or writer, the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option.
More factors affect the option price relative to the prices of other foreign currency instruments. Unlike spot or forwards, both high and low volatility may generate a profit in the options market. For some, options are a cheaper vehicle for currency trading. For others, options mean added security and exact stop-loss order execution.
Currency options constitute the fastest-growing segment of the foreign exchange market. As of April 1998, options represented 5 percent of the foreign exchange market. (See Figure 1.4). The biggest options trading center is the United States, followed by the United Kingdom and Japan. Options prices are based on, or derived from, the cash instruments. Often, however, traders have misconceptions regarding both the difficulty and simplicity of using options. There are also misconceptions regarding the capabilities of options.
Trading an option on currency futures will entitle the buyer to the right, but not the obligation,
to take physical possession of the currency future. Unlike the currency futures, buying currency
options does not require an initiation margin. The option premium, or price, paid by the buyer to the seller, or writer, reflects the buyer's total risk.
However, upon taking physical possession of the currency future by exercising the option, a trader
will have to deposit a margin.
19%
81%
1
2
Figure 1.4. Market share of the currency options (in %% of the volume): 1 - OTC; 2 – organized exchanges.
The currency price is the central building block, as all the other factors are compared and analyzed
against it. It is the currency price behavior that both generate the need for options and impacts on the profitability of options.
2. Kinds of major currencies and exchange systems