Forward Market

The forward currency market consists of two instruments: forward

outright deals and swaps. A swap deal is unusual among the rest of the

foreign exchange instruments in the fact that it consists of two deals, or legs.

All the other transactions consist of single deals. In its original form, a swap

deal is a combination of a spot deal and a forward outright deal.

Generally, this market includes only cash transactions. Therefore,

currency futures contracts, although a special breed of forward outright

transactions, are analyzed separately.

According to figures published by the Bank for International

Settlements, the percentage share of the forward market was 57 percent in

1998 (See Figure 3.1). 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 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. In contrast, the currency futures market is a centralized

market, in which all the deals are executed on trading floors provided by

different exchanges. 

Whereas in the futures market only a handful of foreign currencies may

be traded in multiples of standardized amounts, the forward markets are

open to any currencies in any amount. 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 price is derived from the spot

price by adjusting the spot price with the forward spread, so it follows that

both forward outright and swap deals are derivative instruments. The forward

spread is also known as the forward 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. Just as in the case of the spot

market, the left side of the quote is the bid side, and the right side is the offer

side.



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Currency Options

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.

Currency options are unique trading instruments, equally fit for

speculation and hedging. Options allow for a comprehensive customization of

each individual strategy, a quality of vital importance for the sophisticated

investor. 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 3.1) 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. Therefore, an

option is a derivative instrument. Options are usually mentioned vis-a-vis

insurance

and hedging strategies. Often, however, traders have

misconceptions regarding both the difficulty and simplicity of using options.

There are also misconceptions regarding the capabilities of options. 

In the currency markets, options are available on either cash or futures.

It follows, then, that they are traded either over-the-counter (OTC) or on the

centralized futures markets.

The majority of currency options, around 81 percent, are traded over-

the-counter. (See Figure 3.3) The over-the-counter market is similar to the

spot or swap market. 

Corporations may call banks and banks will trade with each other either

directly or in the brokers' market. This type of dealing allows for maximum

flexibility: any amount, any currency, any odd expiration date, any time. The

currency amounts may be even or odd. The amounts may be quoted in either

U.S. dollars or foreign currencies.

Any currency may be traded as an option, not only the ones available as

futures contracts. Therefore, traders may quote on any exotic currency, as

required, including any cross currencies.

81%

19%

1

2

Figure 3.3. Distribution of the options trading between over-the-counter (OTC) and the

organized exchange market: 1 – the share of OTC; 2 – the share of organized exchanges.

The expiration date may be quoted anywhere from several hours to

several years, although the bulk of dates are concentrated around the even

dates—one week, one month, two months, and so on. The cash market never

closes, so options may be traded literally around the clock.

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.

Seven major factors have an impact on the option price:

1. Price of the currency.

2. Strike (exercise) price.

3. Volatility of the currency.

4. Expiration date.

5. Interest rate differential.

6. Call or put.

7. American or European option style. 

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 generates the need for options and impacts on the profitability of

options.

The impact of the currency price on the option premium is measured by

delta, the first of the Greek letters used to describe aspects of the theoretical

pricing models in this discussion of factors determining the option price.

Delta

Delta, or commonly A, is the first derivative of the option-pricing model

Delta may be viewed in three respects:

• as the change of the currency option price relative to a change in

the currency price. For instance, an option with a delta of 0.5 is

expected to move at one half the rate of change of the currency price.

Therefore, if the price of a currency goes up 10 percent, then the price

of an option on that particular currency is expected to rise by 5 percent.

• as the hedge ratio between the option contracts and the currency

futures contracts necessary to establish a neutral hedge. Therefore, an

option with a delta of 0.5 will need two option contracts for each of the

currency futures contracts.

• as the theoretical or equivalent share position. In this case, delta is

the number of currency futures contracts by which a call buyer is long

or a put buyer is short. If we use the same example of the delta of 5,

then the buyer of the put option is short half a currency futures

contract. 

Traders may be unable to secure prices in the spot, forward outright, or

futures market, temporarily leaving the position delta unhedged. In order to

avoid the high cost of hedging and the risk of unusually high volatility, traders

may hedge their original options positions with other options. This method of

risk neutralization is called gamma or vega hedging.

Gamma

Gamma (?) is also known as the curvature of the option. It is the

second derivative of the option-pricing model and is the rate of change of an

option's delta, or the sensitivity of the delta. For instance, an option with delta

= 0.5 and gamma = 0.05 is expected to have a delta = 0.55 if the currency

rises by 1 point, or a delta = 0.45 if the currency decreases by 1 point.

Gamma ranges between 0 percent and 100 percent. The higher the gamma,

the higher the sensitivity of the delta. It may therefore be useful to think of

gamma as the acceleration of the option relative to the movement of the

currency.

Vega

Vega gauges volatility impact on the option premium. Vega (<;) is the

sensitivity of the theoretical value of an option to a change in volatility. For

instance, a vega of 0.2 will generate a 0.2 percent increase in the premium

for each percentage increase in the volatility estimate, and a 0.2 percent

decrease in the premium for each percentage decrease in the volatility

estimate.

The option is traded for a predetermined period of time, and when this

time expires, there is a delivery date known as the expiration date. A buyer

who intends to exercise the option must inform the writer on or before

expiration. The buyer's failure to inform the writer about exercising the option

frees the writer of any legal obligation. An option cannot be exercised past

the expiration date.

Theta

Theta (T), also known as time decay, occurs as the very slow or

nonexistent movement of the currency triggers losses in the option's

theoretical value.

For instance, a theta of 0.02 will generate a loss of 0.02 in the premium

for each day that the currency price is flat. Intrinsic value is not affected by

time, but extrinsic value is. Time decay accelerates as the option approaches

expiration, since the number of possible outcomes is continuously reduced as

the time passes.

Time has its maximum impact on at-the-money options and its

minimum effect on in-the-money options. Time's effect on out-of-the-money

options occurs somewhere within that range.

Bid-offer spreads in the market may make it too expensive to sell the

option and trade forward out rights.

If the option shifts deeply into the money, the interest rate differential

gained by early exercise may exceed the value of the option.

If the option amount is small or the expiration is close and the option

value only consists of the intrinsic value, it may be better to use the early

exercise.

Due to the complexity of its determining factors, option pricing is

difficult. In the absence of option pricing models, option trading is nothing but

inefficient gambling. 

The one idea to make option pricing is that the option of buying the

domestic currency with a foreign currency at a certain price x is equivalent to

the option of selling the foreign currency with the domestic currency at the

same price x. Therefore, the call option in the domestic currency becomes the

put option in the other, and vice versa.





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Kinds of Exchange Systems

Trading with Brokers

Foreign exchange brokers, unlike equity brokers, do not take positions for

themselves; they only service banks. Their roles are:

• bringing together buyers and sellers in the market;

• optimizing the price they show to their customers;

• quickly, accurately, and faithfully executing the traders' orders.

The majority of the foreign exchange brokers execute business via phone.

The phone lines between brokers and banks are dedicated, or direct, and are

usually in-stalled free of charge by the broker. A foreign exchange brokerage

firm has direct lines to banks around the world. Most foreign exchange is

executed through an open box system—a microphone in front of the broker that

continuously transmits everything he or she says on the direct phone lines to the

speaker boxes in the banks. This way, all banks can hear all the deals being

executed. Because of the open box system used by brokers, a trader is able to

hear all prices quoted; whether the bid was hit or the offer taken; and the

following price. What the trader will not be able to hear is the amounts of

particular bids and offers and the names of the banks showing the prices. Prices

are anonymous the anonymity of the banks that are trading in the market ensures

the market's efficiency, as all banks have a fair chance to trade.

Brokers charge a commission that is paid equally by the buyer and the

seller. The fees are negotiated on an individual basis by the bank and the

brokerage firm.  

Brokers show their customers the prices made by other customers either

two-way (bid and offer) prices or one way (bid or offer) prices from his or her

customers. Traders show different prices because they "read" the market

differently; they have different expectations and different interests. A broker who

has more than one price on one or both sides will automatically optimize the

price. In other words, the broker will always show the highest bid and the

lowest offer. Therefore, the market has access to the narrowest spread possible.

Fundamental and technical analyses are used for forecasting the future direction

of the currency. A trader might test the market by hitting a bid for a small

amount to see if there is any reaction. 

Brokers cannot be forced into taking a principal's role if the name switch

takes longer than anticipated.

Another advantage of the brokers' market is that brokers might provide a

broader selection of banks to their customers. Some European and Asian banks

have overnight desks so their orders are usually placed with brokers who can deal

with the American banks, adding to the liquidity of the market.

Direct Dealing

Direct dealing is based on trading reciprocity. A market maker—the bank

making or quoting a price—expects the bank that is calling to reciprocate with

respect to making a price when called upon. Direct dealing provides more trading

discretion, as compared to dealing in the brokers' market. Sometimes traders take

advantage of this characteristic. 

Direct dealing used to be conducted mostly on the phone. Dealing errors

were difficult to prove and even more difficult to settle. In order to increase

dealing safety, most banks tapped the phone lines on which trading was

conducted. This measure was helpful in recording all the transaction details and

enabling the dealers to allocate the responsibility for errors fairly. But tape

recorders were unable to prevent trading errors. Direct dealing was forever

changed in the mid - 1980s, by the introduction of dealing systems.

Dealing Systems

Dealing systems are on-line computers that link the contributing banks

around the world on a one-on-one basis. The performance of dealing systems is

characterized by speed, reliability, and safety. Accessing a bank through a dealing

system is much faster than making a phone call. Dealing systems are

continuously being improved in order to offer maximum support to the dealer's

main function: trading. The software is very reliable in picking up the big figure of

the exchange rates and the standard value dates. In addition, it is extremely

precise and fast in contacting other parties, switching among conversations, and

accessing the database. The trader is in continuous visual contact with the

information exchanged on the monitor. It is easier to see than hear this

information, especially when switching among conversations.

Most banks use a combination of brokers and direct dealing systems. Both

approaches reach the same banks, but not the same parties, because

corporations, for instance, cannot deal in the brokers' market. Traders develop

personal relationships with both brokers and traders in the markets, but select

their trading medium based on price quality, not on personal feelings. The market

share between dealing systems and brokers fluctuates based on market

conditions. Fast market conditions are beneficial to dealing systems, whereas

regular market conditions are more beneficial to brokers.

Matching Systems

Unlike dealing systems, on which trading is not anonymous and is

conducted on a one-on-one basis, matching systems are anonymous and

individual traders deal against the rest of the market, similar to dealing in the

brokers' market. However, unlike the brokers' market, there are no individuals

to bring the prices to the market, and liquidity may be limited at times. Matching

systems are well-suited for trading smaller amounts as well. 

The dealing systems characteristics of speed, reliability, and safety are

replicated in the matching systems. In addition, credit lines are automatically 

managed by the systems. Traders input the total credit line for each counter

party. When the credit line has been reached, the system automatically disallows

dealing with the particular party by displaying credit restrictions, or shows the

trader only the price made by banks that have open lines of credit. As soon as

the credit line is restored, the system allows the bank to deal again. In the

interbank market, traders deal directly with dealing systems, matching systems,

and brokers in a complementary fashion.  






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Major Currencies

The U.S. Dollar

The United States dollar is the world's main currency. All currencies are

generally quoted in U.S. dollar terms. Under conditions of international economic

and political unrest, the U.S. dollar is the main safe-haven currency which was

proven particularly well during the Southeast Asian crisis of 1997-1998. 

The U.S. dollar became the leading currency toward the end of the

Second World War and was at the center of the Bretton Woods Accord, as the

other currencies were virtually pegged against it. The introduction of the euro in

1999 reduced the dollar's importance only marginally.

The major currencies traded against the U.S. dollar are the euro,

Japanese yen, British pound, and Swiss franc.

The Euro

The euro was designed to become the premier currency in trading by

simply being quoted in American terms. Like the U.S. dollar, the euro has a

strong international presence stemming from members of the European

Monetary Union. The currency remains plagued by unequal growth, high

unemployment, and government resistance to structural changes. The pair was

also weighed in 1999 and 2000 by outflows from foreign investors, particularly

Japanese, who were forced to liquidate their losing investments in euro-

denominated assets. Moreover, European money managers rebalanced their

portfolios and reduced their euro exposure as their needs for hedging currency

risk in Europe declined.

The Japanese Yen

The Japanese yen is the third most traded currency in the world; it has a

much smaller international presence than the U.S. dollar or the euro. The yen is

very liquid around the world, practically around the clock. The natural demand to

trade the yen concentrated mostly among the Japanese keiretsu, the economic

and financial conglomerates. 

The yen is much more sensitive to the fortunes of the Nikkei index, the

Japanese stock market, and the real estate market. The attempt of the Bank of

Japan to deflate the double bubble in these two markets had a negative effect

on the Japanese yen, although the impact was short-lived

The British Pound

Until the end of World War II, the pound was the currency of reference. Its

nickname, cable, is derived from the telex machine, which was used to trade it

in its heyday. The currency is heavily traded against the euro and the U.S.

dollar, but has a spotty presence against other currencies. The two-year bout

with the Exchange Rate Mechanism, between 1990 and 1992, had a soothing

effect on the British pound, as it generally had to follow the deutsche mark's

fluctuations, but the crisis conditions that precipitated the pound's withdrawal from

the ERM had a psychological effect on the currency.

Prior to the introduction of the euro, both the pound benefited from any

doubts about the currency convergence. After the introduction of the euro, Bank

of England is attempting to bring the high U.K. rates closer to the lower rates in

the euro zone. The pound could join the euro in the early 2000s, provided that

the U.K. referendum is positive.

The Swiss Franc

The Swiss franc is the only currency of a major European country that

belongs neither to the European Monetary Union nor to the G-7 countries.

Although the Swiss economy is relatively small, the Swiss franc is one of the

four major currencies, closely resembling the strength and quality of the Swiss

economy and finance. Switzerland has a very close economic relationship with

Germany, and thus to the euro zone. Therefore, in terms of political uncertainty

in the East, the Swiss franc is favored generally over the euro. 

Typically, it is believed that the Swiss franc is a stable currency.

Actually, from a foreign exchange point of view, the Swiss franc closely

resembles the patterns of the euro, but lacks its liquidity. As the demand for it

exceeds supply, the Swiss franc can be more volatile than the euro.

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