Types of foreign exchange trading

Foreign exchange operations
Foreign exchange trading operations will be explained
with the aid of the next diagram. The type of operation
selected depends on the date set for delivery of
the currency. As a general rule, four types of operations
are used: spot transactions, forward transactions,
swaps and futures.
Spot transactions are the basic type of foreign
exchange operation. Under spot agreements, both
parties fulfil their obligations two working days after
conclusion of the trade. In the old days, the two-day
period between conclusion and execution of the
agreement was required for completion of the accompanying
paperwork. Although this no longer applies
in the same way, the traditional system has been
retained. In principle, spot transactions can also be
concluded for execution on the next working day or
even for the same day. However, in such cases, slightly
modified prices are used instead of the normal spot
prices. The premium/discount to the spot price
depends on the interest rate for the currencies concerned.
Before we turn to transactions covering more
than two working days, let us take a closer look at
how spot transactions work. The various stages to
the settlement of a spot transaction will be illustrated
by means of an example. Let’s assume that a further
decline in US inflation has been announced on the
previous day. A low inflation effects generally a
higher valuation of the underlying currency. Let us
assume that yesterday’s closing rate for the USD/CHF
was 1.3810/1.3820, while New York closed at
1.3855/1.3865 and the exchange rate in the Far East
is currently 1.3860/1.3870. If a bank in, for example,
Frankfurt asks for a quote, the trader will quote a
slightly higher price, for example 1.3865/1.3875. If
no transaction is concluded, it may be assumed that
the bank considered the exchange rate quoted to
be correct. Accordingly the trader will not modify it.
This is what traders call “par” or “parity.”
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6. Types of foreign exchange trading
Spot transactions
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Instead of quoting the full exchange rate, professional
traders merely give the last two decimal places,
e.g. 65/75, because they know what the other figures
are. By quoting a bid/ask spread, the bank undertakes
to buy or sell a certain amount of the currency concerned
at the prices quoted. It is not normally evident
from the enquiry whether the counterparty wishes to
buy or sell. There are no fixed rules on the sums for
PIPS
Forward
Beyond spot
Foreign exchange
operations
Overnight – tomorrow/next
Before the spot date
(tomo rrow/day after tomorrow)
Spot
Two working
days previously
Outright
Purchase/sale on a
specific date
Swap
Currency swap on two different dates
Spot
Today
overnight
23.2. 24.2. 25.2. 26.2. 27.2.
Tomorrow Day after
tomorrow
Two days after
tomorrow
Later
Spot purchase
Forward sale
Spot sale
Forward purchase
Prior to spot Beyond spot
tomorrow/next spot/next
(today/tomorrow)
which quotes are given, but it is standard practice
for major banks to quote each other bid/ask spreads
for at least USD 10 million or the equivalent. The
Frankfurt bank in our example does not take any
action on a spread of 1.3865/75.
A contract for delivery of currencies more than two
working days later is known as a forward transaction.
Such transactions are concluded at forward rates, not
at spot rates. Forward rates reflect the time for which
the agreement runs. Theoretically, the forward rate
for a currency can be identical to the spot rate, but in
practice it is almost always higher (premium) or lower
(discount). Forward transactions are used for a variety
of purposes. They are most commonly used to hedge
trading risks and the risks arising from financial
transactions.
Forward operations cannot be set apart from currency
swaps, which are a mixture of spot and forward
transactions. To prevent confusion between these
two types of forward transaction, traders use the
term “outright” transactions for simple forward rate
transactions that are not part of a swap operation.
Forward rates are not quoted directly. Professional
traders work with the difference between spot and
forward prices expressed in decimals. In other words,
they work on the basis of premiums and discounts.
Another term for this difference is the “swap rate,”
although as the term suggests, it strictly applies to
swap operations.
The term “outright” is used to show that the quote
refers to the forward rate rather than the swap rate,
i.e. the corresponding premium or discount. The
table below shows how spot rates and swap rates are
shown on the screens. Swap rates are always expressed
as decimal places in the currency concerned in
relation to the USD. On 5 August 1996, the rates
were as follows:
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Forward transactions
Forward rates:
premiums and discounts
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The forward rate is obtained by adding the premium
to the spot rate or deducting the discount. Even
when swap rates are quoted without a plus or minus
sign, traders would see immediately that the GBP is
trading at a discount to the USD. How?
The answer is easy. Regardless of whether they are
looking at spot or forward operations, the bid price
(purchase price) is always lower than the asked price
(selling price). Moreover, the spread has to be wider
for forward rates than for spot rates.
Where the currency is trading at a discount, the figures
on the bid side are higher than those on the ask
side, and vice versa when the currency is trading at a
premium.
Example:
GBP/USD spot rate 1.6604 1.6614
– discount (3 months) –33 –30
= FORWARD RATE 1.6571 1.6584
The spread is 10 pips between the spot rates but
13 pips between the forward rates.
Similarly, a 3-month forward rate of 52.9/53.2 for the
EUR against the USD indicates a premium.
EUR/USD spot rate 1.1575 1.1590
+ premium (3 months) 50 53
= FORWARD RATE 1.1625 1.1643
GBP/USD EUR/USD USD/CHF
Spot 1.6604 1.6614 1.1575 1.1590 1.3820 1.3830
1 month 14 12 17 18 43 42
2 months 24 22 33 35 87 85
3 months 33 30 50 53 130 127
6 months 53 50 109 112 249 246
12 months 66 62 230 235 481 476

The spread is 15 pips between the spot rates but
18 pips between the forward rates.
Interest rates for the currencies concerned determine
whether currency forwards are traded at a premium
or a discount. At the same time, interest rates determine
the extent of the difference between spot and
forward rates. However, it is the interest spread between
the two currencies on the international money
markets that is important, not the interest rate in
each currency. This is due to the fact that when a bank
enters into a forward transaction, it has open positions.
International trade creates an ongoing demand for
currency forwards, which are used to hedge currency
risks. For example, a Swiss importer may purchase
goods from Germany that are invoiced in EUR, payable
within 90 days. To eliminate exposure to the risk
of a rise in the EUR in the meantime and provide a
sound basis on which to set his prices, the importer
buys the EUR required to pay the invoice in an
“outright” transaction for delivery in three months.
Conversely, if a Swiss exporter knows that he will
receive a payment in EUR in three months’ time, he
can eliminate the exchange risk by entering a
3-month outright deal to sell EUR. Failure to undertake
these forward operations would be tantamount
to speculating on a fall in the EUR in the first example
and a rise in the EUR in the second example. Foreign
currency holdings that have to be hedged can also
be generated by a wide range of non-commercial
transactions:
– investment in securities, money market investments,
loans to foreign subsidiaries, direct investment,
etc. undertaken in foreign currencies represent
foreign currency assets. The exchange risk
can be eliminated by selling the currencies concerned
forward.
– raising loans on foreign capital markets in foreign
currencies generates foreign currency liabilities.
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The associated exchange risk can be hedged by
forward purchase transactions for the currency in
question.
Forward transactions can also be used to hedge risks
when the underlying business is medium- or longterm.
For many currencies, it is difficult to conclude
forward transactions for more than twelve months.
However, by renewing 12-month contracts regularly
when they expire, long-term transactions can be
hedged. Naturally, hedging costs are only known for
the first period. However, the fact that the hedging
costs for the ensuing period are uncertain is not
necessarily a reason to refrain from hedging. In many
instances, the customer is interested in relative
hedging costs (i.e. the costs in per cent p.a.) rather
than in absolute costs. Let’s take the example of a
Swiss exporter who will receive payment for his
goods in USD in six months’ time. When he asks his
bank for the spot and six-month forward rates for
USD/CHF, he is given the following information:
Spot USD/CHF 1.3820 1.3830
Discount 6 months 249 246
Discount 12 months 481 476
The customer will not tell the bank whether he is interested
in buying or selling so the bank quotes both
bid and asked prices.
The exporter then knows that he can sell USD in return
for CHF for delivery in six months’ time at a discount
of 249 points. Deducting the discount from
the spot price of 1.3820 gives a forward rate of
1.3571. However, for the purpose of his calculations,
the exporter wants to know the discount (i.e. the
hedging costs) in percent p.a. He thus converts the
discount for the period concerned into a discount for
the full year and looks at it in relation to the spot price.
(0.0249 x 2 x 100) = 3.60%
1.3820
If the customer had sold USD for CHF for delivery in
twelve months time, the forward rate would have
been 1.3339 (1.3820 minus 481 points) and thus
lower than the forward rate for three months. Accordingly,
the hedging costs would have been lower i.e.:

(0.0481x 1 x 100)
1.3820
= 3.48%

In the same way as a premium or discount expressed
in absolute terms can be expressed in per cent p.a.,
the same calculation can be performed in the opposite
direction. If the hedging costs are 3.60% p.a., the
absolute discount can be calculated using the following
formula:

[(spot rate) x (hedging costs in % p.a.) x (term of the transaction in months)]
[100 x no. of months in year]

(1.3820 x 3.60 x 6)
100 x 12
= CHF 0.0249

(Discount – 6-months)
Most “outright” transactions between banks and
their customers are for broken periods (odd dates).
These are non-standard periods falling between the
standard periods for forward contracts (1, 2, 3, 6 and
12 months). Banks normally endeavour to close out
forward positions entered into through customer
business by entering into counter-transactions for the
same period. However, counter-transactions cannot
always be entered into even though the bank may
feel that it has an obligation to enter into the contract
with its customer. For both long maturities and
for currencies outside the standard range, it is comparatively
difficult to find a counterparty for countertransactions.
The method used to calculate the pips (swap rate) for
broken periods is illustrated in the example given
below. For the purposes of the calculation, the difference
between the two closest trading dates for for-
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(0.0481x 1 x 100)
1.3820
(1.3820 x 3.60 x 6)
100 x 12
[(spot rate) x (hedging costs in % p.a.) x (term of the transaction in months)]
[100 x no. of months in year]
“Broken dates” forward
transactions
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ward contracts is divided by the number of days between
the two dates. The result is then multiplied by
the number of days between the broken date and
the later forward date. The result of this is subtracted
from the swap rate for the later date.
The swap rate on Monday 25 April is to be calculated
on 3 March.
1-month swap rate 101 pips
2-month swap rate 203 pips
Value date for spot
transactions on 3 March = 7 March
1-month value date = 7 April
2-month value date = 9 May
25 April – 9 May = 14 days
203 2-month swap rate
–101 1-month swap rate
102 = 3,4 pips per day
(approximation)
14 x 3.4 = 48 pips for 14 days (approximation)
203
– 48
155 = arithmetic swap rate
on 3 March for delivery on 25 April
Money market transactions, specifically those geared
to short-term capital exports, are often coupled with
swap transactions. If the outflow of capital involves
investment in another currency and this investment
has to be hedged, a swap transaction is required.
As we have seen, a swap is a combination of a spot
purchase and a simultaneous forward sale (or vice
versa) in a given currency.
It should be noted that the method used to calculate
the costs of swap transactions is not the same as the
method used for “outright” transactions. This is
Swap transactions
because the amount invested in the spot price is hedged
and the sum involved in the forward transaction is
paid back (capital plus interest). If the forward rate is
below the spot rate (i.e. if it is trading at a discount),
the swap costs are slightly higher in percentage
terms. In the past this was taken into account by
using the forward rate instead of the spot rate.
However, the sharp increase in interest spreads in the
1980s meant that the rates calculated were increasingly
unsatisfactory. Deviations of up to 0.5% were
observed. Consequently, a somewhat more complicated
formula is now used to calculate the exact costs,
although approximations are often sufficient in individual
cases. The two methods give the following results:

Old method:
Swap costs =
New calculation:
Swap costs =
The difference between the two methods lies in
the fact that in the second method in addition to the
capital interest rates are hedged.
Another detail relating to the calculation of swap
costs should be noted. Since it makes little difference
to the calculation whether the bid or offer price is
used, a rate between the two is generally used,
giving a relatively “round” end-result. Long-term
funds are generally invested abroad for two reasons:
– either because the domestic money market does
not offer suitable investment opportunities
– or because investment in other countries and
currencies generates a higher return, even after
hedging.
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0.0034 x 100 x 360
[0.6740 x 90]
swap x 100 x 360
spot x maturity
= = 2.02%
(0.0034 x 5.42 x 90) + (0.0034 x 100 x 360)
0.6740 x 90
= 2.03%
(swap x deposit rate x maturity) + (swap x 100 x 360)
spot x maturity

This is an appropriate place to point out that – contrary
to popular opinion – exchange rate hedging
does not necessarily involve costs. “Weak” currencies
are normally hedged against “stronger” currencies by
entering into forward rate agreements for the
“weak” currency. Many people believe that “weak”
currencies are currencies trading at a “discount.” In
such cases, hedging does entail costs. However, it has
often been the case that the apparently “weak” currency
has strengthened while the currency that was
assumed to be “stronger” (trading at a premium) has
weakened. Here are two examples to illustrate this:
between February and October 1982 the GBP dropped
from USD 1.82 to USD 1.61 although it traded at a
premium throughout this period. Between February
and September 1984 the dollar rose from DEM 2.70
to DEM 3.10, regardless of the fact that it consistently
traded at a discount. In these specific cases, it
would have been advisable to hedge sterling and the
DEM against the dollar (in other words to buy dollars
at a forward rate). This would have avoided exchange
losses and even generated a “hedging gain.” Recent
years have shown that exchange rates often move
contrary to expectations. Outright transactions can
just as easily generate high losses as high gains.
Not only does this affect investors – be they private
persons, companies or banks – it also affects banks
in their function as counterparties.
Now let us return to the question of how forward
rates are determined. It is hardly surprising to find
that the forward rate for a currency alters in parallel
with changes in the spot rate. However, it is interesting
to establish why the difference between spot
and forward rates varies, and when and why discounts
and premiums expand and contract.
Let us start by looking at the swap rate as this expresses
an important relationship: In a free market
such as the Euromarket, the swap rate tends to correspond
to the interest spread between two currencies.
For example, if a 3-month Eurodollar investment yields
Factors determining
forward rates
6% p.a. and a 3-month Eurofranc investment yields
2.5% p.a., the swap rate will be around 3.5% p.a. In
other words the dollar will trade at a discount of
3.5% p.a. to the franc or, putting it the other way
round, the franc will trade at a premium of 3.5% p.a.
against the dollar.
The constant interrelationship between swap rates and
interest rates is evident. Assuming that dollar investments
yield 6% p.a. and that the dollar’s discount
against the franc is just 1% p.a., the net yield would
be 5% p.a. Under these conditions, hardly anyone
would remain in francs at 3.5%. Large sums would be
shifted into dollars – bought at the spot rate and sold
at the forward rate, thus increasing the discount.
Moreover, the interest rate on dollars would decline
and the interest on francs would rise. This process of
adjustment would thus quickly even out the difference
between the interest spread and the swap rate.
As we have seen, the swap rate tends to be in line
with the interest spread on the Euromarket, but
which rate determines the other? So what determines
the demand and supply of currencies at forward
rates?
In normal times, in other words, when the markets
are not overshadowed by currency turmoil or political
upheaval, most forward transactions are generated
by the money market and, to a lesser extent, commercial
transactions. The level of interest payable on
the various currencies in the Euromarket determines
the swap rates. In turn, interest rates on the Euromarket
reflect the corresponding domestic interest
rates, provided these are not artificially depressed or
inflated. Domestic interest rates are often influenced
by official institutions and can thus differ from the
rates on the Euromarket. In such cases, monetary and
economic conditions in the country are reflected
accurately in the Euromarket rates but not in domestic
interest rates.
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For example, if Euroland cuts its discount rate to stimulate
the economy while US monetary policy remains
unchanged, money market rates will decline in Euroland
and – unless it significantly restricts the flow of
capital -the short-term EUR rates on the Euromarket
will also decline. Accordingly, the dollar’s discount
against the EUR will rise to adjust to the wider
interest spread between the Eurodollar and the EUR.
Under normal circumstances, the swap rates depend
on the level of interest rates but the situation is different
when a currency suddenly comes under pressure
for economic or political reasons. In such cases,
outright sales of these currencies will surge suddenly,
thus increasing their discount substantially. The interest
rates for these currencies on the Euromarket and
thus to some extent on their domestic markets will
rise to take account of the higher discount.