TDG Practitioner Guide

FOREX MARKET

A C Reddi
P Yesuthasen

THE DERIVATIVES GROUP

in pursuit of
FINANCIAL ENGINEERING and RISK MANAGEMENT
SIMPLICITY
© A C Reddi 2009. All rights reserved. Printed in India. Except as permitted
under Copyright Act, 1957 (as last amended by Act No. 49 of 1999), no part of
this publication may be reproduced or distributed in any form or any means,
without the prior written permission of the copyright holder and the publisher.

Published by The Derivatives Group, 26/1 First Floor, Mangesh Street, T. Na-
gar, Chennai 600 017 India. Website: www.tdg.in

TDG books are available at volume discount for business schools, training in-
stitutes and corporate training programs. For more information, write to the
publisher or email at: contact@tdg.in

Printed by Pranam Printers & Designers, 23/24 Giri Street, West Mambalam,
Chennai 600 033 India.

ISBN-13: 978-81-908834-0-5

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 CONTENTS

Chapter 1 Forex is International Payments 1

1.1 Gold Standard 2
1.2 First Floating-rate Regime 4
1.3 Gold Exchange Standard 4
1.4 Controlled Float 4
1.5 Bretton Woods System 5
1.6 Smithsonian Agreement 6
1.7 Second Floating-rate Regime 6
1.8 Gold and Monetary System 7
1.9 Balance of Payment and Convertibility 9
1.10 Which Regime is the Best? 12

Chapter 2 Forex Basics: the Literacy 13

2.1 Currency Pair 14
2.2 Base Currency and Quoting Currency 14
2.3 ISO/SWIFT Codes 15
2.4 Hierarchy in the Currency Pair 17
2.5 N Currencies and N1 Currency Pairs 18
2.6 Numeraire Currency 18
2.7 Cross Rates 20
2.8 Quotation Styles 20
2.9 Two-way Quote 22
2.10 Abbreviated Offer Quote 24

Chapter 3 FX Settlements: Value Dates 27

3.1 Forex Settlement Risk 28
3.2 Value Dates 30
3.3 Exceptions to Spot Value Date Rule 35

Chapter 4 Forex Deals: Classification and Risk 41

4.1 Outright 41
4.2 Forex swap 42
4.3 Exposure 45
4.4 Mismatch 46
4.5 Cash Flow Analysis 46
4.6 Deal Blotter, Position and Gap Statements 49
4.7 Limits on Position, Gap and Others 51
4.8 Forex Swap versus Currency Swap 51

Chapter 5 Cross Rate Arithmetic 55

5.1 Chain Rule 56
5.2 Trader’s Quicker Method 58
5.3 Arithmetic with Two-way Quotes 58
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 5.4 Check on Calculations 60
5.5 Mnemonic Aid for Two-way Arithmetic 60
5.6 Triangular Arbitrage 62

Chapter 6 Forward Exchange 67

6.1 Forward Exchange Arithmetic 68
6.2 Swap Points: Premium, Discount, Par 71
6.3 Arithmetic with Two-way Quotes 73
6.4 Nature of Swap Points 77
6.5 Market Conventions on Forward Exchange 78
6.6 Forex Prices for Short Dates 79
6.7 Swap Points for Broken Dates 81
6.8 Swap Points for Fwd-to-Fwd and Turn Periods 82
6.9 Long-term Forward Exchange Prices 83
6.10 Forward Exchange for Cross Rates 84
6.11 Forward Exchange: Theory versus Practice 88
6.12 Non-deliverable Forward (NDF) 90

Chapter 7 Forex Swaps 95

7.1 Forex Swap: Recap 95
7.2 Swap Points and Forex Swaps 96
7.3 Anatomy of Two-way Swap Quote 97
7.4 Fixing the Price for Near and Far Legs 99
7.5 Cash Management with Forex Swap 103

Chapter 8 Commercial Transactions 107

8.1 Features of Commercial Transactions 108
8.2 Classification of Commercial Transactions 108
8.3 Market Price and Margin 109
8.4 Clean Instruments/Remittances 110
8.5 Export Bill Transactions 112
8.6 Import Bill Transactions 113
8.7 Forward Contracts: Optional Delivery Periods 115
8.8 Forward Contracts: Early and Late Delivery 117
8.9 Forward Contracts: Cancellation 121
8.10 Forward Contracts: Extension/Rollover 123
8.11 Early and Late Payments of Purchases 126

Chapter 9 Trade Life Cycle and Best Practices 131

9.1 Organization 132
9.2 Process Flow 133
9.3 Best Practices 138
9.4 FX Prime Brokerage 147

Chapter 10 Accounting 155

10.1 General Flow for Transactions 156
10.2 Wash Rates 160

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 10.3 Position Reconciliation 161
10.4 Mark-to-Market/Revaluation 162

Chapter 11 Continuous Linked Settlement 169

11.1 Settlement Risk in FX 170
11.2 Evolution of Continuous Linked Settlement 171
11.3 Operations 173
11.4 Risk Management 178
11.5 Liquidity Facilities 179
11.6 Operations Milestones 181

Chapter 12 Front Office: Trading and Hedging 183

12.1 FX-speak 183
12.2 Market Practices in Interdealer Market 185
12.3 Sample Deal Conversations 188
12.4 Trending 191
12.5 Trading Operations 192
12.6 Hedging Operations 204

Annex I Countries, Currencies and ISO Codes 207

Annex II Forex Market: Profile 213

Index 216

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 FOREWORD

The authors have taken great pains to bring out in a lucid and clear manner
the practical aspects of foreign exchange operations. All the concepts have
been illustrated with practical examples that would aid students and officials to
understand the way foreign exchange operations are conducted in the market
and inside a dealing bank. Practices peculiar to the Indian forex market are
covered, too.

Mr A C Reddi was himself a forex trader with a leading bank. His rich domain
knowledge is exhibited in depth with which each subject is dealt with and at the
same time he has ensured that the reader gets a comprehensive view of the
subject in as simple a language as possible.

Mr P Yesuthasen has for many years been associated with the Financial Mar-
kets Division of the Reserve Bank of India at a time when new products were
introduced in the Indian market. As a regulator, he was actively associated
with the supervision of forex operations, derivatives and risk management
practices in commercial banks.

Both the authors have been actively involved in providing consultancy services
to banks and corporate treasuries where their services are eagerly sought af-
ter. I am sure this book will go a long way in providing domain and practical
knowledge to all those associated with foreign exchange business. This book
is a must for all practitioners as a reference book to be kept part of the library.

R. C. ROYAPPA

Formerly General Manager (Foreign Dept), State Bank of India; and

Chief Executive Officer, SBI Gilts Ltd
 PREFACE

From the practitioner’s perspective, the forex market has fewer books than the
bond and equity markets. It is true that there are many textbooks on foreign
exchange but they deal with the theory of foreign exchange and multinational
finance. They do not fulfill the requirements of business and operations of a fo-
rex dealer. Ours, in 200 pages, is a modest endeavor to fill this gap.

Except the first chapter, all others deal with the practice of forex. The first
chapter chronicles in a dozen pages the history of exchange rates regimes
over the last 150 years. Readers can safely skip this chapter: after all, “The art
of reading is to skip judiciously” (Philip G Hamerton).

Chapters 2 through 4 deal with the basic concepts and constitute the “lite-
racy” of the forex. The next three chapters deal with the arithmetic: they consti-
tute the “numeracy” of the forex. Together, these six chapters equip the reader
to price and hedge any type of transaction from the customer or dealer.

Chapter 8 applies the concepts and arithmetic of the previous six chapters
to real-life transactions with plenty of examples and illustrations, including the
early and late payments and receipts from the customers and the financing
component in forex transactions. Chapter 9 deals with the trade life cycle, in-
dustry best practices and the recently emerged business of FX prime broker-
age. Chapter 10 explains the accounting of various forex transactions and ac-
counting problems in revaluation.

Chapter 11 deals with the innovative forex settlement called “continuous

linked settlement”, which is the world’s only cross-border multi-currency set-
tlement system on payment-versus-payment basis with settlement finality cha-
racteristic of central bank payment systems. To our knowledge, no textbook on
foreign exchange has discussed it in detail. We have spared a whole chapter
to discuss in detail the concept, process and the critical operational timeline in
this innovative settlement.

Chapter 12 concludes the book with a detailed discussion of forex trader’s

language, customs, and practices. It also discusses the general principles of
speculation and hedging in forex market.
 Annex I lists the countries, their currencies and their ISO codes, updated
as of March 2009. Annex II summarizes the profile of global forex market from
the latest Triennial Central Bank Survey 2007.

Acknowledgements

We have greatly benefited from discussions with our colleagues and friends in
the forex market, bank and corporate treasuries and regulatory bodies. They
are so many that it is quite possible that our list might miss a name or two. To
manage that risk, we have chosen not to list them here and offer them our si-
lent thanks.

Being first-time authors, we are sure that the next edition will greatly im-
prove due to readers’ feedback on omissions and commissions, which we sin-
cerely ask you to email to us.

A C Reddi (acreddi@tdg.in)

P Yesuthasen (yesuthasen@gmail.com)