Practitioner Guide To Forex Market-Part 2

Chapter 1
Forex is International Payments

There is no sphere of human influence in which it is easier to show superficial
cleverness and the appearance of superior wisdom as in matters of currency
and exchange. (WINSTON CHURCHILL, speech in House of Commons, 1946)
As for foreign exchange, it is almost as romantic as young love, and quite as

resistant to formulae ( H L MENCKEN, The Dismal Science)
Foreign exchange (shortened to forex or FX) is the consequence of the coexis-

tence between the nationalism of currencies and the internationalism of trade.
While nations zealously keep their identity with their own flags and curren-
cies, the comparative and competitive advantages compel them to trade
across borders. No country can produce all that it consumes, nor can it con-
sume all that it produces (comparative advantage). Even if they were, it will not
be effective and efficient (competitive advantage).
We may say that what money does for goods and services within in a
country (i.e. medium of exchange, store of value), forex does the same for dif-
Chapter 1
ferent brands of money (see Exhibit 1-1). If the world has a single currency or
trade does not cross national borders, the forex disappears.
EXHIBIT 1-1: Money versus Forex
CHINA INDIA
noodles silk roti cotton
yuan forex rupee
Analects Spring in a Small Town Arthashastra Mughal-e-Azam
Settlement of international trade requires two elements: international mon-

ey and an “adjustment” mechanism to correct trade imbalances among na-
tions. Experience shows that the first is less important and that the second has
been the source of much trouble. The evolution and the timeline of internation-
al payment systems are reviewed below.
1.1. Gold Standard: 1870–1914
Under Gold Standard, central banks issued paper money and held gold (or sil-
ver or both) in reserve to back the paper money. The international payments
system was built on the following features.
 Export and import of gold was freely allowed

 Currencies were valued in gold at a fixed rate (“mint par rate”)
 Convertibility of currency to gold at mint par rate was guaranteed by
central banks
The mint par rates of a national currency determined its value against other
currencies. For example, if mint par rates of US dollar and Indian rupee were
$100 and Rs 4,000 per unit amount of gold, respectively, then dollar-rupee fo-
rex price would be: Rs 4,000 / $ 100 = Rs 40 per $. The forex price would be
fixed at this level, regardless of demand-supply for the currency. If it were not,
there would be an opportunity for arbitrage profit by converting currencies into
gold at mint par rates, and moving gold between the two countries. In practice,
the arbitrage rate level would be slightly off the mint par rate because of trans-
2
Forex as International Payments
action costs in shipping gold. Instead of one mint par rate, there was a range
defined by gold export point and import point.
The theory of the adjustment mechanism for trade imbalance under Gold
Standard involved the chain of events, including the movement of gold among
nations, shown in Exhibit 1-2.
EXHIBIT 1-2: Adjustment Mechanism under Gold Standard
TRADE DEFICIT
More imports, less exports Gold shipped out
Inflation Lower money stock
Higher money stock Deflation
Gold shipped in Less imports, more exports
TRADE SURPLUS
The adjustment process was symmetrical in the sense that the country with
trade surplus shared the burden of the country with trade deficit. The forex
prices were fixed and stable, and the role of central bank was to freely buy and
sell gold at the mint par rate. The domestic policies (e.g. economic growth, un-
employment) were subordinate to external trade imbalances.
In practice, the changes in price level or unemployment and the movement

of gold was not to the extent warranted by the adjustment mechanism. This
was due to the skillful management of international clearing by the Bank of
England, which induced international capital flows in sterling pound by varying
the interest rates. Interest rate rose in countries with trade deficit and fell in
countries with trade surplus. The cornerstone of the Gold Standard remained
the full convertibility of sterling pound to gold at ₤1 s17 d10½ a troy ounce. The
3
Chapter 1
beginning of the World War I put an end to the regime of fixed and stable ex-
change rates under Gold Standard.
1.2. First Floating Rate Regime: 1914–1925
Except Switzerland, most countries suspended the gold convertibility for resi-
dents during 1914–1917, and the pre-war fixed exchange rates were main-
tained by mopping up gold and foreign securities from the residents.
After the war, the currencies were allowed to float during 1918–1925 and
find their realistic financial strengths. The sterling pound fell from $4.86 to
$3.40. The floating rate regime was intended as an interim arrangement, and
the countries were to adopt such domestic policies as would restore the pre-
war exchange rates and gold standard.
1.3. Gold Exchange Standard: 1925–1931
Britain restored gold standard in 1925, and the pound-dollar rate was brought
to the pre-war rate of $4.86 to a pound. Over 30 other countries established
gold parities or fixed the exchange rate of their currencies with sterling pound.
The central banks held reserves predominantly in gold-convertible currencies
(mostly sterling pound) rather than gold. This was called gold exchange stan-
dard, which did not last beyond 1931 because many countries pursued domes-
tic policies that were unilateral and mercantilist, which did not fit in the auto-
matic and symmetric adjustment mechanism under Gold Standard. The Great
Depression of the late 1920s, too, aided the collapse of gold exchange stan-
dard. Many converted their sterling pound into gold, leading to a run on the
Bank of England‟s gold reserves.
1.4. Controlled Float: 1931 – 1939
Britain suspended gold-convertibility of sterling pound in 1931. By 1933, over

30 countries went off gold standard. Germany imposed exchange controls on
current account.
It was a period of chaos: there was the “sterling block” of Britain and her
colonies, struggling to prop up sterling; there was the “gold bloc” of Switzer-
land, Holland, France, Italy, Belgium, Luxembourg and Poland, struggling with
their overvalued currencies; there were central European countries struggling
with German recovery and rearmament; and there was the United States in
4
economic isolation and lifting itself out of the Great Depression. In general, the
exchange rates were floating for the second time.
Unlike the floating in 1914 – 1925, however, the floating now was con-
trolled by national governments to protect their domestic policies. Mostly, the
control meant devaluation of currencies to achieve trade competitiveness. Out
of this chaos came Bretton Woods System.
1.5. Bretton Woods System: 1944 – 1971
Bretton Woods System was built on the gold-convertibility of US dollar. It was

officially described as “fixed rate regime with managed flexibility” and was po-
pularly called “adjustable peg.” The following were the features of the system.
 All currencies were pegged to US dollar at fixed rate, and the dollar
was pegged to gold at $35 a troy ounce
 The USA guaranteed the convertibility of dollar to gold, but only to the
central banks, and not to general public
 Forex rates must be maintained within 1% of the fixed parity with
dollar, and intervention in market should occur on violation of this
band
 Domestic economic policies (aimed at full employment) had primacy
over balance-of-payment (BOP) problem. This feature was the direct
opposite of the adjustment under Gold Standard.
 In case of BOP problem, the following two-tier approach would apply:
o The problem is temporary: the country with deficit would
draw from the line of credit provided by International Mone-
tary Fund (IMF), which was set up as a part of the Bretton
Woods System
o Tthe problem is permanent: the country with deficit would
devalue its currency in consultation with the IMF
 There should be no direct controls on trade account under the Gen-
eral Agreement on Trade and Tariffs (GATT), but the capital account
transactions could be controlled
In a way, the Bretton Woods System was like Gold Standard but without
the automatic adjustment mechanism because it gave domestic economic pol-
icy priority over external trade imbalances. Though there were large devalua-
tions of some currencies (notably that of sterling pound in 1949 and 1959), the
system worked well until 1965 with crisis-free economic growth. The US con-
5
Chapter 1
sciously ran trade deficit to enable other countries to build up reserves in dol-
lar, which was gold-convertible and hence “good as gold.”
During the second half of the 1960s, the US suffered Vietnam War, wor-
sened trade deficit, and inflation. To contain the inflation, dollar interest rate
was hiked, which attracted further capital into the US. In a way, the US was
importing goods and exporting inflation, which prompted the French President
to ask: what stops America from printing dollars and buying up France?
It had reached a stage where the US gold reserves were insufficient to

meet the gold-convertibility of dollar. Free market price of gold went above the
official price of $35 a troy ounce, and France converted their dollar reserves in-
to gold for political (and practical) reasons. Canada abandoned the adjustable
peg of Bretton Woods System and allowed its currency to float freely. And the
inevitable happened: the Nixon Administration of the US suspended the gold-
convertibility of US dollar, ending the Bretton Woods System.
1.6. Smithsonian Agreement: 1971 – 1973
The chaos in the aftermath of the collapse of Bretton Woods System brought
the top central banks together and resulted in Smithsonian Agreement, which
was a highly diluted version of the Bretton Woods System. The US President,
Richard Nixon, called it “the greatest monetary agreement in history.”
US dollar was devalued against gold from $35 to $38 a troy ounce, but the
gold-convertibility of dollar was not restored. Other currencies (notably German
deutschemark) were revalued against dollar. Currencies were allowed to move
within a wider band of 2.5% from the new fixed rates against dollar. Canada
continued to float its currency. The strains developed in the system as soon as
it was introduced. Britain left the system in 1972, followed by others so that by
March 1973, the “greatest monetary agreement” collapsed, having lived just 18
months.
1.7. Second Floating Rate Regime: From 1973
After the collapse of Smithsonian Agreement, diverse systems of forex rate

regimes came in existence. A brief review of them is given below.
Free Float: the forex rate is allowed to be determined by demand-supply forces

in the market. The central bank did not influence the forex rate but focused on
domestic monetary policy and inflation. The currencies that followed this sys-
6
tem became the “hard currencies” and became an asset class alongside
bonds and equities.
Managed Float: the forex rate is allowed to be floated but controlled by the
central bank. In most cases, the control meant periodic, minor and discretio-
nary devaluation.
Gliding Parity: the changes in forex rate were linked to publicly-disclosed spe-
cific economic criteria.
Fixed Peg: the forex rate is pegged to the currency of the country‟s main trad-
ing partner or to a basket of currencies of trading partners.
1.8. Gold and Monetary System
The link between gold and currencies is more than 2,000 years old, and is still
intimate, though inexplicable. Because of this historical link, the forex depart-
ment in many banks deals with buying and selling of gold, too.
Gold had detractors and admirers. John Maynard Keynes, the famous Eng-
lish economist, mocked that it was a “barbaric relic of the past1.” Charles de
Gaulle, the famous French politician, praised it thus: “has no nationality … un-
iversally accepted as unalterable fiduciary value par excellence.”
Gold is unique because it is at once a commodity and monetary asset. As a

commodity, it is virtually indestructible, easily recoverable and recycled, highly
malleable and, of course, beautiful. As a monetary asset, it is an asset to its
holder but liability of none, and hence not vulnerable to distress of and repud-
iation by debtor or moratorium by sovereign debtor; uncorrelated with other fi-
nancial assets, providing the portfolio diversification. In times of crisis, financial
assets depreciate and become illiquid. In contrast, gold rises in (or holds its)
value, remains liquid, and is universally acceptable as a means of payment.
Gold coins acted as money, and gold reserves backed the paper money,
fully in the beginning and partly in the later years. Central to the Bretton Woods
system was the fixed parity between gold and US dollar. When IMF was
created under the Bretton Woods system, all members were given quotas,
which consisted of 75% of national currency and 25% gold; and the members
were obligated to buy or sell gold at the fixed parities. During the 1960s, the
1
Keynes comment, it must be said, was not on gold, but on the Gold Standard in inter-
national monetary system that prevailed during 1870-1914.
7
Chapter 1
central banks of the US and Western Europe formed “Gold Pool” to keep the
market price of gold at around the official price of US$ 35 a troy oz. The mar-
ket intervention was ineffective and central banks lost more than 12% of their
gold reserves, and the Pool was abolished in 1968. The central banks decided
not to intervene in the gold market but to deal only among themselves at the
official parity. As a result, a two-tier market developed for gold, one for official
transactions at fixed parity and the other for private transactions at market-
driven prices. The IMF planned Special Drawing Rights (SDR), a synthetic cur-
rency linked to a basket of national currencies, as a substitute for gold in its re-
serves.
The official reserve status of gold started disappearing from 1971 when the
US suspended dollar-gold convertibility at the fixed parity of US$ 35 a troy oz.
In 1978, the Second Amendment to the IMF Articles barred its members from
fixing their currency parities to gold, and it eliminated the obligation to buy or
sell gold at the fixed parities. With this, gold was officially eliminated from the
international monetary system. In 2000, Switzerland, the only country that had
official minimum gold backing for currency in circulation, abolished the link be-
tween Swiss franc and gold. With that, gold ceased to have any role in domes-
tic and international monetary systems―officially.
Despite official “demonetization” of gold, central banks still held about

30,000 tons of gold as reserves in 2006, a decline from about 36,000 tons in
1980. Except Chinese central bank, which bought about 200 tons from the
market since 2000, most other banks have been selling some of their gold re-
serves.
Exhibit 1-3 shows demand-supply for gold and the total above-ground
stock at 2008. There are three sources of supply (mining, recycling and central
bank sales) and three sources of demand (jewellery, investment and industri-
al). The total above-ground stock at 2008 was about 165,000 tons, about half
is held in the form of jewellery, and a less than a fifth as reserves by central
banks. Today, the private holdings of gold (by way of jewellery and invest-
ments) are four times more than the official holdings.
Three countries accounted for half of retail consumption in 2008: India

(27%), China (12%) and USA (10%). The voracious appetite of Indian house-
holds for gold is legendary. Estimates about Indian private gold holdings vary
between 10,000 and 20,000 tons (compared to 8,100 tons held by the US
Treasury).
8
EXHIBIT 1-3: Gold: Demand, Supply and Total (above-ground) Stock
Souce: World Gold Council, 2008 and 2009
1.9. Balance of Payment and Currency Convertibility
The phrase “balance of payment” (BOP) is misleading. The word “balance” in

accounting terminology refers to the amount outstanding at a point of time, but
in BOP refers to the total amount over a period of time. According to Interna-
tional Monetary Fund, the BOP items are classified at seven levels, the first
three of which are as follows.
9
Chapter 1
1 Current Account
1.1 Goods and services
1.1.1 Goods
1.1.2 Services
1.2 Income
1.3 Current transfer
2 Capital and Financial Account
2.1 Capital Account
2.1.1 Capital transfers
2.1.2 Non-produced non-financial assets
2.2 Financial Account
2.2.1 Direct investment
2.2.2 Portfolio investment
2.2.3 Other investments
2.2.4 Reserve assets
The two accounts at the first level are current account and capital & finance
account. Goods (1.1.1) are those that have physical characteristics. This defi-
nition brings electricity and gas under this head. Services (1.1.2) differ from
goods in that they cannot be stored for future consumption. Income (1.2) dif-
fers from goods and services in that the latter are the output of production but
the former uses the two factors of production, namely, labor and capital. (The
third factor of production, land, is excluded from BOP.) The income from labor
is employee compensation and that from capital is investment income by way
of dividend and interest. Income from non-financial assets (e.g. royalties, li-
cense fee, rentals/charters of equipment, distribution rights, etc.) should come
under Services (1.1.2) rather than Income (1.2). Current transfers (1.3) are
those without quid pro quo (e.g. grants, aid, etc.). Workers‟ remittances to resi-
dents in another country will also come under this head, but remittances to
own account with a bank in another country will come under Financial Account
(2.2). This distinction is made because workers‟ remittances arise from labor.
All items other than goods under current account are collectively called “invi-
sibles” and the items under goods are called trade account.
Capital transfers (2.1.1) include debt forgiveness/write-off and migrants‟

transfer of personal effects and financial claims from the former to the new
country. Non-produced non-financial assets (2.1.2) are different from the in-
come they produce. Copyright to a work of art is non-produced non-financial
asset and its transfer should be reported under Capital transfer (2.1.1) but
royalty/licensing fee from it should be reported under Services (1.1.2). Finan-
cial account (2.2) records the transactions in financial assets and liabilities. If
the economy‟s savings exceed its investments, then there will be net financial
outflow from it (and vice versa). In turn, financial outflow will acquire non-
10
financial resource in the other economy. Direct investments (2.2.1) are those in
which the acquirer takes an effective and lasting control. Portfolio investments
(2.2.2) are those in which the acquirer‟s interest is capital gains in financial as-
sets and are often easily shifted. Other investments (2.2.3) are residual cate-
gory consisting of loans, trade credits, bank deposits, etc. Reserve assets
(2.2.4) are instruments for the government to correct the payments imbalance
and include monetary gold, special drawing rights (SDR) in the IMF and central
bank‟s forex reserves.
For all heads except those under Financial Account (2.2), transactions are
recorded on gross basis: that is, debit and credit items separately. For those
under Financial Account, the items are posted on a net basis, except those re-
lated to long-term loans and trade credits.
The double-entry accounting should ensure that the sum of the two first-
level accounts (current and capital & finance) should be zero. In practice, how-
ever, this is rarely the case because of discrepancy in timing, coverage, valua-
tion, inaccurate estimation and clandestine capital flight. The balancing act is
performed by introducing the item “errors and omissions.” The negative sign
for this item implies overstatement of receipts and understatement of pay-
ments; and the positive sign, the opposite.
Let us now examine the concept of currency convertibility, which has

changed over time. Originally, it meant the convertibility of paper money to
gold at the fixed mint par rate. Today, gold is officially demonetized and re-
placed with foreign currencies as reserves; and no fixed parties exist among
major currencies. Therefore, convertibility today stands redefined as freedom
to convert national currency into foreign currencies at market prices.
To enable international trade, all currencies must be convertible on trade

account. To conserve reserves, governments may impose trade controls, par-
ticularly for services, to limit the convertibility on trade account. Convertibility
on capital account is generally restricted because capital flows are considered
the source of forex rate instability. Various methods were adopted to manage
capital account transactions. Belgium adopted two-tier (“dual”) forex rates, one
for commercial transaction and the other for financial transactions. The UK ex-
perimented with “external” convertibility: full convertibility on capital account
for non-residents but not for residents. Such distinction had been necessary
because, for historical reasons, the British pound was held by non-residents as
reserve currency, and restricting capital account convertibility would have re-
sulted in loss of confidence in the British currency.
11
Chapter 1
The forex regime today can be characterized by three features: forex rate
mechanism, reserve asset and capital account convertibility. Exhibit 1-4 shows
the different choices for each of these features.
EXHIBIT 1-4: Forex Regimes
Rate Mechanism Reserve Asset Capital A/c Convertibility

Free Float Convertible Currencies Free
Managed Float SDR Regulated
Gliding Peg Gold Dual
Fixed Peg Mix of the above
1.10. Which Regime is the Best?
There is no definitive answer. Every regime worked well for sometime under
some circumstances, and no system worked well for all times and in all cir-
cumstances. From the experience gained since 1973, we can make the follow-
ing general statements.
 Adjustment mechanism is more important than the international reserve

money. When the adjustment mechanism is imperfect, there will be short-
age of reserve money
 Balance-of-payment (BOP) problem is two-sided: if a country has trade def-
icit, then another has trade surplus. Both countries are to shoulder the bur-
den to correct it. However, in practice, the burden falls largely on the coun-
try with deficit. The debtor‟s problem is material and pressing while the
creditor‟s problem is largely moral and persuasive.
 Left to itself, the BOP problem will correct itself, but causes a lot of pain. To
make the correction less painful, the governments intervene, with the fol-
lowing policy options for the country with deficit.
o Fund the deficit out of reserves. if the deficit is temporary and the
country has reserves
o Deflate the economy and face unemployment, if the deficit is fun-
damental and in current account
o Devalue the currency, if the deficit is fundamental and in current
account but deflation and unemployment are not acceptable
o Increase the interest rate, if the deficit is in capital account
o Apply exchange and trade controls (as a last resort)
 For countries with free convertibility on capital account, the forex rate is in-
fluenced more by capital flows than the trade in goods and services.
12
Chapter 2
Forex Basics: the Literacy
Success is the natural consequence of applying the basic fundamentals. ( JIM
ROBIN, American motivational speaker)
Once you have literacy, then you have a chance to bring in the new tools of
communications. (BILL GATES , founder of Microsoft Co)
Forex is one part literacy and ninety-nine parts numeracy. The one part literacy
is crucial and the foundation for the ninety-nine parts.
To be qualified as a forex trade, two criteria must be satisfied. First, there

must be two currencies in the trade: forex trade is always a currency pair.
Second, the rate of exchange between the two currencies must be fixed.
Consider the following two transactions: (1) a bank accepts a foreign cur-
rency time deposit from a customer at fixed rate of interest; and (2) a bank
opens a foreign currency import letter of credit (L/C) on behalf of its importer-
constituent in favor of a foreign supplier. Which of the two transactions is a fo-
rex transaction? None of them is.
13
Chapter 2
The first has only one currency and therefore is a money transaction. The
second transaction has two currencies― local and foreign currencies―but the
rate of exchange between them is not fixed as yet. We can say that the second
transaction will surely become a forex transaction in future (when the importer
makes the payment), but as of today, it has not entered the forex book of the
bank.
2.1. Currency Pair
Every forex transaction is a currency pair, and the forex price (or exchange
rate) is the price of one currency in terms of the other.
Exhibit 2-1 shows three types of exchange: barter, money and forex. In
barter, we exchange one goods (or services) for another. In money, we ex-
change goods (or services) for money. In forex, we exchange one brand of
money for another brand of money. Money branded is called currency.
EXHIBIT 2-1: Three Types of Exchanges
Type Exchange
Barter goods for goods
Money goods for money
Forex money for money
2.2. Base Currency and Quoting Currency
Of the two currencies in the pair, one is called the base currency (BC) and the
other, the quoting currency (QC).
Base currency is the currency that is priced: it is bought and sold like a
commodity (whence the name “commodity currency”) and ceases to act in the
traditional role of money. Quoting currency is the currency that prices the base
currency, and is thus acting in the role of money. What is quoted in the market
as forex price (or exchange rate) is the price of base currency in units of quot-
ing currency. This statement always holds in all “quotation styles” (see Section
2.8) and must be memorized.
Forex Price (or Exchange Rate) = Price of BC in QC
The amount of BC is fixed (usually at one unit) and the amount of QC va-
ries as the price of base currency varies over time. Accordingly, BC and QC
14
are also called “constant/fixed amount currency” and “variable amount curren-
cy”, respectively.
2.3. ISO/SWIFT Codes
International Organization for Standardization (ISO) has given three-letter code

for every currency in their ISO 4217 standard. The first two letters are the
country code defined by ISO in their standard ISO 3166, and the third letter is
usually, but not always, the first letter of the currency name. Exhibit 2-2 lists
the ISO codes for some currencies, and the Annex I shows the complete list of
world currencies and their ISO codes.
EXHIBIT 2-2: ISO Codes for Major Currencies
Country Currency ISO Code

United Kingdom pound GBP
European Union euro EUR
United States dollar USD
Switzerland franc CHF
Japan yen JPY
India rupee INR
China renminbi CNY
South Africa rand ZAR
We can see that some codes deviate from the principles described above.
Box 2-1 gives an explanation for these apparent anomalies. The ISO codes
are adopted by the Society for Worldwide Interbank Financial Telecommunica-
tions (SWIFT), which is the communication and messaging network for banks
the world over. Only these standard ISO/SWIFT codes, and not the special
characters (e.g. $, €, ₤), must be used in any standard forex messaging.
The market practice for the notation of a currency pair is to write the BC
code first, followed by the QC code. For example,
Currency Pair BC QC Forex Price

EUR/USD EUR USD Price of EUR in USD
USD/JPY USD JPY Price of USD in JPY
In contrast to the above market practice, most academic text books and
certain parts of OTC derivatives documentation (e.g. 2005 Barrier Option Sup-
plement to 1998 FX and Currency Options Definitions) of International Swaps
15
Chapter 2
and Derivatives Association (ISDA) adopt the opposite approach: that is, they
write the QC code first, followed by the BC code. ISDA also introduced the
terms “denominator currency” and “numerator currency” for BC and QC, re-
spectively. In this book, we follow the current forex market practice of writing
BC first followed by QC to represent a currency pair.
BOX 2-1: Oddities in ISO Country/Currency Codes
United Kingdom (UK): ISO assigned GB as the country code to the United King-
dom (and reserved the code UK), which is unusual because Great Britain consists of
only England, Scotland and Wales while UK consists of GB and Northern Island. Eu-
ropean Commission (EC) and Internet Assigned Number Authority (IANA) generally
adopt ISO codes, but in the case of United Kingdom, they made an exception and
use “UK” instead of “GB.”
Switzerland (CH): the „CH‟ is from its official Latin name of Confoederatio Helvetica
(„Helvetica Confederation‟).
South Africa (ZA): the code of „ZA‟ is from its Dutch name of Zuid-Africa.
For the currency code, the third letter is usually the first letter of the currency
name. There are some exceptions to this general principle, as follows.
EU’s euro (EUR): Probably because „EUE‟ is hard on the tongue.
Chinese renminbi (CNY): The Chinese currency is yuan (whence the third letter Y
in its currency code), but in the communist China, everything is “people‟s”: people‟s
republic (as if there could be monarch‟s republic!), people‟s army, people‟s money
(“renminbi”), etc.
For precious metals that are traditionally associated with money, ISO‟s principle
is to start the code with the letter X and take the next two letters from the chemical
symbol of the metal. The chemical symbols are derived from their Latin names: au-
rum (AU) for gold (whence ISO code of XAU), argentums (AG) for silver (whence
the ISO code of XAG).
For supra-national currencies, ISO code starts with the letter X and the next two
letters are taken from currency name. Thus, XDR is for Special Drawing Rights of
IMF; XCD for East Caribbean dollar; XPF for CFP franc. Though euro is also a su-
pra-national currency, it was not given this coding convention, because euro‟s price
is determined by demand-supply while that of others is derived by indexing them to
the price of other currencies or pegging them to another currency.
16
2.4. Hierarchy in the Currency Pair
Which currency should be the BC in a currency pair? The following is the order
of precedence among the major currencies: GBP, EUR, AUD, NZD, USD and
other currencies. Thus, whenever GBP is involved in the currency pair, it will
be the BC; whenever EUR is involved, it will be the BC unless the other cur-
rency is GBP; and so on. Accordingly, the following will be the BC-QC combi-
nations in different currency pairs, the first of the pair being the BC.
GBP/EUR, EUR/USD, AUD/NZD, NZD/USD, NZD/CHF, USD/CHF

The order of precedence has nothing to with the value of the currency,
which changes continuously. It is due to historical reasons and the non-metric
subdivision of currencies (see Box 2-2).
BOX 2-2: Non-metric Subdivision of Currency
The most important currency in the present times is USD, and the participants will
be interested in the price of USD in other currencies rather than the other way
round. In other words, USD should be the base currency. This indeed is the case
except for GBP, AUD, NZD and EUR against which USD is the quoting currency.
The reason for GBP was its non-metric subdivision of pound under the librae,
solidi, dinarii or lsd (Latin for pounds, schillings, pennies) system. The subdivision
was: ₤1 = s20 = p240. Value of less than one pound must be expressed in schil-
lings; and value of less than a schilling, in pennies. If USD 1 = GBP 0.6250, for
example, it must be expressed as 0126, which is intuitive but cumbersome. And
if the price changes to GBP 0.6255, then the new price should be 0126.12. To
avoid this cumbersome notation, GBP is made the base currency so that its
amount is always fixed at one unit. Though the UK switched over to the metric
system in the early 1970s (under which one pound is100 new pence), the market
practice continued.
In case of AUD and NZD, the exception was due to the colonial past. What
England does, the colonies would simply copy them. The reason for EUR‟s case
was that the forex market expects EUR to eventually replace USD as the interna-
tional reserve currency. Ahead of such development, the market made the EUR
as the base currency when it was born in 1999.
17
Chapter 2
2.5. N Currencies and N1 Currency Pairs
If there are N currencies, how many pairs are possible, given that every forex
transaction must have a pair of currencies?
Consider the following intuitive approach. To see all possible pairs, con-
struct a rectangle with N columns and N rows. The following exhibit shows the
rectangle for five currencies: A, B, C, D and E.
A B C D E
A A/A A/B A/C A/D A/E
B B/A B/B B/C B/D B/E
C C/A C/B C/C C/D C/E
D D/A D/B D/C D/D D/E
E E/E E/B E/C E/D E/E
Each cell is a currency pair, and the total number of cells is (N  N) since it
is a rectangle. The diagonal cells are the currency pairs with the same curren-
cy, which are meaningless: the price of A in A will be always unity. Since the
number of cells in the diagonal will be N, which are to be excluded, the number
of meaningful currency pairs will be N  (N 1). Closer look reveals that the
half below the diagonal is the reciprocal of the top half. Therefore, half the cur-
rency pairs are redundant: if we know the price of A/B, we can compute the
price of B/A. Accordingly, the number of meaningful currency pairs to be
quoted in the market is N  (N 1) / 2. For the mathematically inclined, it is
combinations, not permutations, which are:
NN
2
Permutations with repetition: =N
Permutations without repetitions: N! / (N 2)! = N  (N 1)
Combinations: N! / [(N 2)!  2!] = N  (N 1) / 2
The world has about 150 currencies, which results in 11,175 currency
pairs. It is impossible to deal with such a large number of currency pairs. To
make the number of actual currency pairs a much smaller and manageable
number, the concept of numeraire currency is introduced.
2.6. Numeraire Currency
Numeraire is something that measures or prices all others. For example, we

use money to price all other things. Similarly, we can designate one of the N
currencies as the numeraire (“money”) to price all other currencies. This leaves
18
us only N1 other currencies, each of which is priced against the numeraire,
resulting in N1 currency pairs. Which among the N currencies should be the
numeraire? It depends on the market segment, and there are two distinct mar-
ket segments in the forex market: interdealer and commercial.
Interdealer Market (also called interbank market)
In the interdealer segment of the market, the participants are banks, and the
following are the features of this market.
 Both parties to the transaction are banks, who are also called dealers
(whence the interdealer market)
 Wholesale market with large-value transactions
 Market is global without national boundaries
The numeraire in the interdealer market has been different in different

times. Venetian ducat (the currency in The Merchant of Venice), Florentine flo-
rin, Dutch guilder, German thaler and British pound have successively served
as numeraire. Today, the numeraire is US dollar. Tomorrow, it will be another,
possibly the European Union‟s euro. Currency pairs not involving USD (e.g.
GBP/EUR, EUR/JPY, etc) are called “cross rates”, which are not directly
quoted but derived by „crossing‟ two USD-based rates (explained in the next
section).
Commercial Market
The commercial segment of the market is that where the end users (i.e. expor-
ters, importers) buy and sell foreign currencies against their home currency.
The following are the features of the commercial market.
 Transaction is between a bank on one side and an end user on the

other
 Retail market with small-value transactions
 Market is localized in each country
The numeraire in the commercial market should be the local currency of

the country, because the producers and consumers will be exchanging foreign
currencies against their home currency. For example, in Indian commercial
market, banks quote all foreign currencies against INR (e.g. GBP/INR,
EUR/INR, USD/INR), many of which are “cross rates.”
19
Chapter 2
2.7. Cross Rates
Cross rates are currency pairs that do not contain the interdealer numeraire
currency, which is presently USD. Examples of such rates are GBP/EUR,
EUR/JPY, GBP/INR, etc. Cross rates are derived or synthesized by „crossing‟
two USD-based rates. For example, GBP/EUR cross rate is derived by „cross-
ing‟ GBP/USD and EUR/USD forex rates, which are called underlying rates or
source rates.
GBP/EUR = (GBP/USD) / (EUR/USD)
The crossing means division in some cases and multiplication in others, as

we will explain it in the cross rate arithmetic of Chapter 5.
The key difference between underlying rates and cross rates is that the
price of the former is determined by demand-supply forces; and the price of
the latter is determined by arbitrage arithmetic. If one of the underlying rates
change in price, the cross rate must automatically change, regardless of de-
mand-supply situation for cross rate. Such a statement may seem to defy
common sense and is explained it in Chapter 5.
2.8. Quotation Styles: Direct and Indirect
The first stumbling block for beginners in forex is the quotation style. Consider
how the price of apple can be quoted in two different ways, as follows.
1 apple = INR 10
INR 100 = 10 apples
Each of them involves buying or selling of apple. In the first, what is quoted
is the price of apple, and hence is a price quotation; and in the second, the vo-
lume of apple and hence is a volume quotation. In both quotations, the quantity
on left hand side is fixed, and that on right hand side is negotiated.
Price quotation is also called “direct” style of quotation because it conveys

the required information (i.e. apple price) directly. The buyer and seller nego-
tiate to “buy low and sell high” because it results in profit, which accrues in
INR. Volume quotation is also called “indirect” style of quotation because the
required information (i.e. apple price) is conveyed indirectly. The buyer and
seller negotiate to “buy high and sell low” because it results in profit, which ac-
crues in apples. Since the action is buying or selling of apple, the buy-high-
and-sell-low translates as take more and give less” of apple.
20
Let us apply the concept of direct and indirect style of quotation to forex
market. In the interdealer market, the numeraire (currently USD) is the most
important currency, and the market participants are primarily interested in its
price in the other currency. If the numeraire is made the base currency, then
the quotation indicates the price of the numeraire in other currency: it is direct
style or price quotation. If the numeraire is made the quoting currency, then the
quotation indicates the volume of the numeraire per unit of the other currency:
it is indirect style or volume quotation. In the commercial segment of forex
market, where the numeraire is the local currency, the participants are end us-
ers of foreign currencies. They would like to know the price of foreign currency
in terms of local currency. Accordingly, if the foreign currency is made the base
currency, then the quotation is the price of foreign currency in local currency: it
is direct style or price quotation. If the foreign currency is made the quoting
currency, then the quotation is the volume of foreign currency per unit of local
currency: it is indirect style or volume quotation. Exhibit 2-3 summarizes the
two quotation styles in the two segments of forex market.
EXHIBIT 2-3: Direct and Indirect Quotation Styles
Interdealer Market Commercial Market

(numeraire = USD) (numeraire = local currency)
Direct Style Numeraire = BC Numeraire = QC
Indirect Style Numeraire = QC Numeraire = BC
Among the major currencies, GBP, EUR, AUD and NZD are made the
base currency when paired with USD in the interdealer market. Accordingly,
these currency pairs are quoted in indirect style. The commercial markets in
these countries, too, follow indirect style of quotation. The direct style of quota-
tion is also called European terms of quotation because in the pre-euro Euro-
pean commercial markets other than UK‟s, USD is the base currency so that it
becomes direct style for Europeans. The indirect style of quotation is also
called American terms of quotation because USD is the quoting currency and
the foreign currency is the he base currency in the US commercial market so
that it becomes direct style within America but indirect style outside it.
It is important to note that in all cases, what is quoted is the price of base
currency in units of quoting currency. This is true in both direct and indirect
styles of quotation.
Forex Price (or Exchange Rate) = Price of BC in QC (always)
21
Chapter 2
The base currency amount in most cases is kept fixed at one unit. In some
cases, the forex price is so low that the price needs to be quoted to more than
six decimal places. In such cases, it is convenient to keep the base currency
amount at 100 units (or even more) and truncate the quote to four (or fewer)
decimal places. For example, consider the JPY/INR price of
0.382775 (i.e. JPY 1 = INR 0.382775)
in the Indian commercial market, which follows direct style of quotation. The
base currency amount is made 100 units so that the quote is truncated to four
decimal places: 38.2775.
2.9. Two-way Quote
In the interdealer market, the participants are dealers: that is, those who quote
both buy and sell prices to others. The buy-sell price of the dealer is called the
bid-offer (or bid-ask in the US market). The bid is the buy price and offer (or
ask) is the sell price.
We need to define the following: buy and sell for whom, for which currency,
and at which side of the two-way quote. Consider the following two-way quote
for EUR/USD currency pair.
1.6000 / 1.6005
Let us state the logical facts. First, what is quoted is the price of base cur-
rency in units of quoting currency units―always. Second, the dealer quoting
the price (called the price maker) will buy the base currency at the lower side
and sell it at the higher side of his two-way quote. The difference between the
two sides, called the spread, is always to the advantage of the price maker be-
cause, by offering two-way quotes to others, he runs the risk of one-sided in-
ventory. Third, the price at which the price maker buys (or sells) the base cur-
rency is also the price at which the other party (called the price taker) sells (or
buy) the base currency. Both cannot be buyers or sellers at the same price for
the same currency. Fourth, in forex trade, we exchange two currencies so that
what is buy in base currency for a party is also sell in the quoting currency for
the same party. Lastly, the market convention is to make the two-way quote in
ascending order2: lower/bid/buy side first and followed by higher/offer/sell side.
Exhibit 2-4 summarizes the anatomy of two-way forex quote.
2
This is the case for all quotes of asset prices. In interest rate market, the rate is quoted
in descending order (e.g. 3.15% / 3.10%). The reason for descending quote in interest
22
EXHIBIT 2-4: Anatomy of Two-way Forex Quote
PRICE MAKER
BASE CURRENCY QUOTING CURRENCY
BUYS here SELLS here SELLS here BUYS here
1.6000 / 1.6005 1.6000 / 1.6005
SELLS here BUYS here BUYS here SELLS here
BASE CURRENCY QUOTING CURRENCY
PRICE TAKER
The mnemonic aid to remember the above is: 1 = 1 = 1= 1. Let us explain

this rule. There are two parties to the trade. Alphabetically, they are: (1) price
maker; and (2) price taker. There are two actions or market sides in any trans-
action. Alphabetically, they are: (1) buy; and (2) sell. There are two currencies
in forex transaction. Alphabetically, they are: (1) base currency; and (2) quot-
ing currency. There are two sides to the two-way quote. Alphabetically, they
are: (1) bid or left-hand side (LHS); and (2) offer or right-hand side (RHS).
Join the “firsts” in the four pairs above, and we have the aide-memoire of
1=1=1=1: the 1st party (price maker) does the 1st action (buy) in the 1st curren-
st
cy (base currency) at the 1 side (bid) of the quote. Once this combination is
remembered, all other can be derived logically. For example, buying base cur-
rency is the same as selling quoting currency for the same party at the same
side; buy for one party is sell for the other party in the same currency at the
same side; and so on.
In FX market, the action (i.e. buy, sell) may be specified in either base cur-
rency or quoting currency. For example, on EUR/USD currency pair, buying
EUR is the same as selling USD for any party. When the action is stated in
base currency, it is easy to follow because it is a price quotation. When the ac-
tion is stated in quoting currency, it is not very easy or intuitive because it is a
volume quotation. The action may be expressed in quoting currency despite it
being unintuitive because the requirement is to buy or sell round amount of
quoting currency (e.g. to buy an exact amount of USD 5 million on EUR/USD
currency pair). Whenever the action is specified in quoting currency terms,
rate market is due to the practice of trading on rate quote but settling on price quote. The
inverse relationship between rate and (corresponding bond) price will convert the des-
cending quote for rate into ascending quote for price.
23
Chapter 2
translate that in the mind‟s eye into equivalent base currency action so that it is
easy to understand. For example, on EUR/USD currency pair, if you want to
buy USD, consider it as selling EUR, and then identify the correct side of the
two-way quote.
2.10. Abbreviated Offer Side
The offer (or second or right-hand) side of the two-way quote is not quoted in
full but abbreviated. Only the last two digits, which are called “small figure”, are
quoted. For example,
1.6000 / 1.6005 is abbreviated to 1.6000 / 05

1.9997 / 2.0002 is abbreviated to 1.9997 / 02
The omitted part in the offer side is called the “big figure.” There is a rule
that unambiguously derives the full form of second side, and the rule is: offer
price will have as many decimal places as the bid price, and is the next higher
numeric after the bid price with the quoted numbers as its last digits. The fol-
lowing procedure and examples illustrate the implementation of the rule.
(1) Place the abbreviated offer price below the bid price, aligning the digits to
the right
Example #1 Example #2
Bid 1 . 6 0 0 0 1 . 9 9 9 7
Offer 0 5 0 2
(2) Copy down the digits from the bid price into the corresponding empty slots
in the offer price
Bid 1 . 6 0 0 0 1 . 9 9 9 7
Offer 0 5 0 2
(3) If the resulting offer price is higher than the bid price, then the derived
price is the offer price (as is the case in Example #1). Otherwise, increase
the right-most digit carried down from the bid price by 1 (so that the offer
will be the next higher value after bid price), as is the case in Example #2.
Bid 1 . 6 0 0 0 1 . 9 9 9 7
1
Offer 1 . 6 0 0 5 0 2
2 . 0 0 0 2
24
Occasionally, the abbreviated offer price may contain decimal places (e.g.
40.51/1.50). In such cases, the procedure is to: (a) ignore the numbers after
the decimal point; (b) place the abbreviated offer price below the bid price,
aligning the digits to the right, as in step #1 above; (c) place the ignored num-
bers after the decimal to the right of offer price; and (d) repeating the steps #2
and #3 above. The following illustrates the procedures for 40.51/1.50,
Step #1 Bid 4 0 . 5 1
Offer 1
Step #2 Bid 4 0 . 5 1
Offer 1 5 0
Step #1 Bid 4 0 . 5 1
Offer 4 0 . 5 1 5 0
Notice that the above could have been quoted as 40.5000/50 without the
necessity for any decimal point in the abbreviated offer price. Matter-of-factly,
the reason for quoting zeroes after decimal point (which have no numeric val-
ue) is to indicate the number of decimal places in the offer side. For example,
the bid price of 40.5000 (with all zeros explicitly quoted) indicates that the offer
price will have four decimal places.
Key Concepts Introduced
Two requirements for a forex trade: (1) presence of two currencies; (2) the rate
of exchange between them is fixed.
Names of two currencies in the pair: base currency (BC) and quoting currency
(QC)
Three-letter ISO/SWIFT code for every currency
Numeraire currency is the one against which all other currencies are valued. It
makes the market of N currencies complete with just N – 1 currency pairs.
Two segments of forex market: interdealer and commercial. The numeraire in

the former is currently the USD; and in the latter, the local currency.
Two styles of quotation, direct and indirect, based on whether the numeraire is
BC or QC.
25
Chapter 2
Two-way quote: two sides of the quote, two parties, two market sides and two
currencies.
EXERCISES
The following are the two-way market quotes.
EUR/USD 0.9998/03
USD/CHF 0.9998/03
GBP/USD 1.0101/10
The market is the price-maker and you are the price-taker. Answer the follow-
ing.
1. On USD/CHF, at what price the market sells USD?

2. On EUR/USD, at what price the market buys EUR?
3. On GBP/USD, at what price the market buys USD?
4. On USD/CHF, at what price you can sell CHF?
5. On USD/CHF, at what price the market sells CHF?
6. On EUR/USD, at what price you can buy EUR?
7. On GBP/USD, at what price the market buys GBP?
8. On EUR/USD, at what price you can sell USD?
9. On GBP/USD, at what price you can buy GBP?
10. On USD/CHF, at what price the market buys CHF?
26
Chapter 3
Forex Settlement: Value Dates
… when the hours of operation of two payments systems do not overlap, it is
technically impossible to arrange for the simultaneous settlement of both sides
of a foreign exchange transaction. (Noel Report, BIS, 1993)
The vast size of daily FX trading, combined with the global interdependence of
FX market and payment systems participants, raises significant concerns re-
garding the risk … for settling FX trades. These concerns include the effects
on the safety and soundness of banks, the adequacy of market liquidity, mar-
ket efficiency and overall financial stability. (Allsopp Report, BIS, 1996)
What we call the settlement date in other markets is called the value date in fo-
rex market. Value date is to be distinguished from trade date: on trade date,
both parties agree on trade terms (i.e. currency pair, amount, price and value
date); and on value date, the two currencies are exchanged.
Value date is after the trade date by few days because the trade requires
processing work (e.g. confirmation, netting, etc, as explained in Chapter 9).
The gap between the two dates could be one (“T+1”) or two (“T+2”) business
days, where “T” stands for trade date and the numeral indicates the business
days thereafter (see Exhibit 3-1).
27
Chapter 3
EXHIBIT 3-1: Trade Date and Value Date
Trade Date (T) Value Date (T+1 or T+2)

time
Negotiation of Exchange of
trade terms currencies
Settlement involves the exchange of two currencies, and is exposed to set-

tlement risk: the possibility that one party pays his obligation while the other
does not. One of the mechanisms to mitigate settlement risk is payment-
versus-payment3 (PvP) style of settlement under which the two obligations are
exchanged simultaneously. If one party fails, the other party withholds his obli-
gation.
3.1. Forex Settlement Risk
The unique feature of forex settlement is that it takes place at two different set-
tlement centers that are often located in different time zones. For example,
USD/JPY transaction is settled in Tokyo (for yen amount) and New York (for
dollar amount), and the two centers are 13 hours apart in time zone. As a re-
sult, one party pays the yen amount and receives the equivalent value in dollar
after a delay of 13 hours.
Because of the time zone differences, the PvP style of settlement is im-
possible in forex market, unless that payment mechanism is drastically mod-
ified. The non-simultaneous settlement of the two payments in a forex trade
enhances the settlement risk, leading in turn to credit risk, market risk, liquidity
risk and systemic risk. Credit risk is the loss of total amount; market risk is the
replacement cost of the failed trade; liquidity risk is the possibility of not secur-
3
Payment-versus-payment (PvP) in forex market is the same as delivery-versus-
payment (DvP) in equity and fixed-income securities markets. The word “delivery” is
used for financial security and the word “payment”, for money. The PvP/DvP reduces but
does not eliminate settlement risk. Under PvP, if one party fails, the other party will with-
hold the payment, and thus avoids the loss of full amount (credit risk). However, the non-
defaulting party will have to replace the failed transaction with a new one at the prevail-
ing market price. The difference between the original price and the replacement price is
the loss under PvP, which is called counterparty credit risk and equals market risk.
28
FX Settlements: Value Dates
ing the additional funds required in replacement; and systemic risk is the do-
mino effect of parties failing to each other in succession. The elevated settle-
ment risk in forex is sometimes called Herstatt Risk (see Box 3-1) or cross-
4
currency settlement risk .
BOX 3-1: Bankhaus Herstatt
Bankhaus Herstatt was a Cologne-based German bank, small in size but active in
FX trading. Sharp increase in oil price in 1974 led to weaker US dollar (USD), and
Bankhaus Herstatt sold USD against deutschemark (DEM) in speculative trades. In
the settlement of USD/DEM transaction, Bankhaus Herstatt would receive DEM in
Frankfurt and pay USD in New York.
German regulators discovered fraud and concealment of large trading losses by

Bankhaus Herstatt. On June 26, 1974, the German authorities closed down Bank-
haus Herstatt after the close of interbank payments in Frankfurt. The time was
3:30pm in Frankfurt and 10:30am in New York. On receipt of this news, Herstatt‟s
dollar correspondent banks withheld the payments to be made on behalf of Herstatt
Bank.
As a result, Herstatt‟s counterparties lost the entire USD amount to be received

in New York (credit risk); had to arrange for emergency funding to make good the
loss of dollar amount from Herstatt (liquidity risk); and had to replace the original
transaction with a new transaction at the prevailing market price (market risk). At
least 12 counterparties faced these risks for a total amount of USD 200 million. To
make matters worse, the other banks suspended payments and credit lines to the
affected counterparties of Bankhaus Herstatt, unless they received confirmation that
the counter-payment had already been received, leading to a gridlock in the pay-
ments system (systemic risk).
It was the first time that the market participants and the regulators realized the
elevated risk in FX settlements.
Given the large volume of forex market, which is currently about USD 3.2
trillion a day (see Annex II), and its impact on domestic payments systems, a
4
It was so named in the Report of the Committee on Interbank Netting Schemes (popu-
larly called the Lamfalussy Report), Committee on Payments and Settlements Systems,
Bank for International Settlements, 1990).
29
Chapter 3
single failure can result in payments gridlock or even systemic failure. Encour-
aged by the regulators, the forex market has invented a global payments sys-
tem for forex transaction on PvP basis. It is called the continuous-linked set-
tlement (CLS) and discussed in Chapter 11.
3.2. Value Dates
All value dates in forex settlement are grouped into three: spot, forward and
short. Spot date is the most common value date and defined as the second
business day from trade date (but is not so simple, as we will explain shortly).
Any value date after spot date is called the forward date, and any value date
before the spot date is called the short date5. Exhibit 3-2 illustrates the relative
position in time of the three value dates.
EXHIBIT 3-2: Value Dates: Spot, Forward and Short
Trade Date (T) 1 2

time
spot
short forward
Spot Value Date
Spot value date, though commonly defined as the second business day from
trade date, is not always so. The following is the procedure to determine the
spot value date, depending on whether USD is one of the currencies.
Case A: USD is one of the currencies in the currency pair
Spot value date is the date that must be a second business day at non-dollar
center and a New York business day. It need not be a second business day at
New York. If New York is closed on what is a second business day at the other
center, then we move to the next business day on which both non-dollar center
and New York are simultaneously open.
5
In the ACI‟s The Model Code (2004), the term “short date” is used for any maturity of
less than one month, but in this book we restrict it to value dates before spot date.
30
Case B: USD is not one of the currencies in the currency pair (i.e. cross rate)
Spot value date is the date that must be second business day at each settle-
ment center and a New York business day. Though not involved in settlement,
New York must be opened because the cross rates are ultimately derived by
crossing two USD-based rates (see Chapter 5). Therefore, New York will be
indirectly involved in settlement. If any of the settlement centers or New York is
closed on such date, we move to the next business day on which all the three
are open.
Because of above adjustments, the spot value date may fall on third or
fourth business day (or even later) after trade date. Exhibit 3-3 shows the algo-
rithm for determining spot value date.
EXHIBIT 3-3: Algorithm for Spot Value Date
Is USD one of the currencies?

YES NO
Go to the second business day at Go to the second business day at

non-USD center each settlement center
Is New York open on this date? Is New York open on this date?
YES NO NO YES
Go to the next business Go to the next business

day at non-USD center day at each settle center
This is the Spot Value Date
Forward Value Date
Any value date after spot value date is forward value date (but see the footnote
on the previous page). Such dates are infinite, but are quoted only up to one
31
Chapter 3
year for most currency pairs. For hedging forex exposures beyond one year,
the market practice is to use other derivatives (e.g. currency swap, currency fu-
tures, currency option) rather than currency forwards. Even up to one year,
only few periods, called “standard tenors”, are quoted, which are:
1W, 1M, 2M, 3M, 4M, 5M, 6M, 7M, 8M, 9M, 10M, 11M and 1Y
where W = week, M = month and Y = year. Among these standard tenors, the
1W, 1M and 3M tenors are more liquid than the others. The non-standard te-
nors (e.g. 45-day, 95-day, etc) are variously called broken dates or odd dates
or cock dates. Prices for them are derived by interpolating from the prices for
the two nearest standard tenors (see Section 6.7). It is important to note that
the standard tenors are relative to spot value date, not trade date. For exam-
ple, 1M forward date is 1M from the spot value date. It follows then that, to de-
termine the forward value date, we must first determine the spot value date.
The following is the procedure for determining forward value dates.
1. Determine the spot value date.

2. Check the day of the spot value date. If it is the last business day in its
month, go to step #3. Otherwise, go to step #4.
3. Go to the last business day in the forward month on which both settlement
centers and New York (regardless of whether New York is involved in set-
tlement or not) are simultaneously open. The forward month is so many
calendar months after the spot month as specified by the forward period.
For example, 1M value date will be in the first calendar month after spot
month, 2M value date will be in the second calendar month after spot
month, etc. This is called end-end rule in forex market. The same rule is
called FRN convention in the ICMA6 documentation (which governs the
7
Eurobond market) and ISDA documentation (which governs the OTC de-
rivatives market). The following example illustrates the calculation of for-
ward value date.
Example: spot value date is January 30. Let us assume that January 31 is
a holiday at one of the settlement centers or New York, making January
30 the last business day in the spot month of January. The 1M value date
will be in February; start at 29 (in leap year) or 28 (non-leap year). If it is
holiday, move to the preceding day until you get a date in February on
which both settlement centers and New York are open. For 2M value date,
6
International Capital Markets Association (www.icma-group.com)
7
International Swaps and Derivatives Association (www.isda.org)
32
start at the 31st day of March and, if it is holiday at any of the settlement
centers or New York, move to the preceding day; and so on.
4. Go to the same day of the spot value date in the forward month. The for-
ward month is as explained in the previous step. For example, if the spot
value date is January 29, then the eligible 1M value will be February 29 (in
leap year) or February 28 in non-leap year; the eligible 2M value date will
be March 29; and so on. Check whether the eligible value date is a busi-
ness day at both settlement centers and New York. If it is, then it is the
forward value date. If any of the centers is closed, then move to the next
day in the same month on which both the settlement centers and New
York are simultaneously open. If there is no such day in the same month,
then move to the previous business day in the same month on which both
settlement centers and New York are simultaneously open. In other
words, the 1M value date has to be necessarily in the first month after
spot month; 2M value date has to be necessarily in the second month af-
ter spot month. This is called month end rule in forex market. The same
rule is called modified following day in ICMA and ISDA documentation.
The following example illustrates the procedure.
Example: spot value date is January 29. The 3M value date has to be
necessarily in the third month after spot month, which is April. The eligible
3M value date will be April 29 (same day of spot date). If this is a business
day at both settlement centers and New York, then this is the 3M value
date. If any center is closed, then we move to the next day, which is April
30. If this is a business day at both settlement centers and New York, then
this is the 3M value date. If any center is closed, then there is no other day
in April and we move to April 28; and so on.
Exhibit 3-4 shows the algorithm for determining the forward value dates. In
most developing countries and emerging economies, there maybe exchange
controls, which prohibit forward transactions, particularly for non-residents. For
example, Indian exchange controls freely allow forward transactions but only
among residents and restrict them for non-residents.
Short Dates
Short dates are values dates before spot date (but see the footnote 6 on page
30), and there are only two such possible dates: trade date and the first busi-
ness day after trade date.
33
Chapter 3
EXHIBIT 3-4: Algorithm for Forward Value Date
Determine the spot value date
`
Is it the last business day in its month for two sett. centers & NYC?
YES NO
Go to the last business day in Go to the same day of spot

the forward calendar month date in the forward month
on which both sett. centers
and NYC are open
Are both sett. centers and
NYC are open?
NO YES
end-end rule
Is there next day in
the same month?
month-end rule NO YES
Go to the pre- Go to the

vious day next day
This is forward value date
Settlement on trade date is called cash deal, the word “cash” being an
alert to the trader that the deal affects the end-of-day cash balances on trade
date. Settlement on first business day from trade is called tom, short for “to-
morrow”: the word does not literally mean the next day, but refers to the next
business day. Cash value dates may not be possible because of time zone dif-
ferences. For example, USD/JPY trade for cash value date is possible only
during Tokyo trading hours, but not in New York trading hours, because when
New York opens, Tokyo is already closed. Tom value dates may not be always
possible because of holidays in one of the settlement centers or New York. For
example, CHF/JPY trade is contracted on January 27. Assume that January
28 and 29 are business days at Zurich and Tokyo (which are the settlement
centers) and New York. The spot value date will thus be January 29 and the
34
tom value date will be January 28. However, if New York is closed on January
28, then tom value date is not possible for this currency pair, because the next
business day (January 29) will be the spot value date.
To sum up: forward value date may not be possible because of exchange
controls; cash value date may not be possible because of time zone differenc-
es; tom value date may not be possible because of holidays in settlement cen-
ters or New York; but spot value date is always possible, and therefore the
most important value date.
Day Beginning and Closing Hours
The commercial segment of forex market operates only during the local bank-
ing hours: about 8-10 hours a day. A trade initiated and closed within the busi-
ness hours for the same value date is considered clean square-off without
mismatch in value dates. In contrast, the interdealer segment operates round
the clock, and so do the margin trading companies, which provide 24-hour ser-
vices to the retail traders. The round-the-clock service poses the problem of
defining when does the day begin and end.
For interdealer market, ACI Code of Conduct (see Chapter 12) considers
05:00 Sydney time (corresponding to 07:00 Auckland time) as opening and
17:00 New York time (corresponding to 09:00 Auckland time next day) as clos-
ing, giving 26 hours for a day! Thus, a spot trade initiated in New Zealand trad-
ing hours can be reversed in New York trading hours for the same value date,
despite more than 24 hours delay. For retail speculators, most margin trading
companies consider 15:00 New York time as the day‟s close, giving 24 trading
hours a day. Few of them might give time up to 17:00 New York time except
for NZD/USD currency pair, for which 15:00 New York time is the cut-off.
3.3. Exceptions to Spot Value Date Rules
Certain currency pairs have conventions for spot value date that are different
from that discussed in the previous section, and are explained below.
Canadian dollar (CAD)
USD/CAD currency pair, particularly in European and North American markets,

settles the spot on T+1 (i.e. first business day when New York and Toronto are
simultaneously open). Against other currencies, CAD spot trades will be set-
tled on T+2 basis, as described in the previous section.
35
Chapter 3
Turkish lira (TRY)
In the interdealer market, the spot date for USD/TRY is T+0 (i.e. same as trade
date) if the trade is executed before 15:30 Istanbul time; and T+1 if the trade is
executed thereafter. In the commercial market, the spot is T+1 with 15:00 EST
as the rollover time for TRY trades against all currencies.
Russian ruble (RUB)
The USD/RUB pair trades spot for T+0, T+1 and T+2, but the T+1 is the most
popular and hence considered the spot value date. The Reuters Dealing 3000
Spot Matching (D2) platform provides for T+0 and T+1.
Certain Latin American Currencies
Argentine peso (ARS), Chilean peso (CLP) and Mexican peso (MXN) require
two clear business days at New York for spot value date, unlike others that do
not require two business days at New York but requires that New York be
open on T+2. For example, trade date is Monday and Tuesday is a holiday at
New York but business day at other center; and Wednesday is a business day
at both centers. For other currency pairs, Wednesday will be the spot value
date though it is the first business day at New York. For these Latin American
currencies, however, the spot value date will be rolled over to Thursday.
Certain Middle East Currencies
The Middle East observes Friday and Saturday as the weekend while the rest
of the world observes Saturday and Sunday as the weekend. The following ta-
ble shows the day of the week for spot value date for trades contracted on dif-
ferent weekdays, assuming no holiday between Monday and Thursday.
Trade Date Spot Value Date

Mon Wed
Tue Thu
Wed Mon (of next week)
Thu Mon or Tue (see below)
Fri Cannot be a value date because of local holiday
Sat Cannot be a value date because of holiday
Sun Cannot be a value date because of New York holiday
For trades contracted on Thursday, variations exist within the region. For
United Arab Emirates dirham (AED), Bahraini dinar (BHD), Egyptian pound
(EGP), Kuwaiti dinar (KWD), Riyal Omani (OMR) and Qatari riyal (QAR), the
36
spot value date for Thursday‟s trades is the following Monday because there
are two business days for each currency: Friday and Monday for USD; and
Sunday and Monday for the local currency. It therefore follows that Tuesday
can never be the spot value date for these currencies: it will always be a bro-
ken date. Saudi riyal (SAR) and Jordanian dinar (JOD) follow a different rule
for the Thursday‟s trades in that their value date is the following Tuesday.
In the commercial segment of the market, some local banks follow “split
settlement” with their customers: USD is settled on Friday or Monday and the
local currency is settled on Sunday such that the arrangement is always to the
advantage of the bank. That is, when the bank receives USD, it will be on Fri-
day; and when bank pays it, it will be on Monday. The “split settlement” here is
different from the same phrase in SWIFT and other messaging systems. In the
latter, “split settlement” applies to one-to-many trade: on one side, there is a
single counterparty and one large amount; and on the other side, the amount
is split into smaller amounts and settled with multiple counterparties.
Key Concepts
Two settlement centers and time zone difference
Enhanced settlement risk (“Herstatt risk”)
Value dates: cash, tom, spot and forward
EXERCISES
1. The following is the calendar with the day of the week and the calendar
days in the first rows, respectively. Trade date is the first Monday (marked
“TD” n the calendar). The shaded boxes represent holidays in the center
indicated in the first column. For the sake of convenience, business days
are numbered in italics at each center. Thus, for New York, the first busi-
ness day is We 2nd, the second working day is Th 3rd, the third working
day is Mo 7th, and so on.
Mo Tu We Th Fr Sa Su Mo Tu We Th
TD 1 2 3 4 5 6 7 8 9 10
New York 1 2 3 4 5
London 1 2 3 4 5 6
Tokyo 1 2 3 4 5 6
Mumbai 1 2 3 4 5 6
37
Chapter 3
Given the above calendar, what is the spot value date for the following
currency pairs?
A. USD/INR
B. USD/JPY
C. GBP/USD
D. GBP/INR
E. JPY/INR
F. GBP/JPY
2. The following is another calendar. Saturday and Sunday are weekend hol-
idays. Holidays other than weekend are indicated in each calendar month
at different cities. For example, October 29 is a holiday at London and
New York; and so on.
October November December

Mo 7 14 21 28 4 11 18 25 2 9 16 23 30
Tu 1 8 15 22 29 5 12 19 26 3 10 17 24 31
We 2 9 16 23 30 6 13 20 27 4 11 18 25
Th 3 10 17 24 31 7 14 21 28 5 12 19 26
Fr 4 11 18 25 1 8 15 22 29 6 13 20 27
Sa 5 12 19 26 2 9 16 23 30 7 14 21 28
Su 6 13 20 27 3 10 17 24 1 8 15 22 29
Holidays Holidays Holidays
29: London, Mumbai 26: Mumbai 27: London, New York
30: New York 28: New York 31: Tokyo, Mumbai
31: Tokyo 29: London
Given the above calendar, what is the forward value date for the follow-
ing currency pairs, if the spot value date is as specified against the cur-
rency pair?
A. USD/INR: spot is October 16. What is 1-month value date?

B. USD/INR: spot is October 25. What is 1-month value date?
C. USD/INR: spot is October 31. What is 1-month value date?
D. USD/INR: spot is October 31. What is 2-month value date?
E. USD/INR: spot is November 29. What is 1-month value date?
F. USD/INR: spot is November 27. What is 1-month value date?
G. USD/JPY: spot is October 31. What is 2-month value date?
H. USD/JPY: spot is October 30. What is 2-month value date?
38
I. USD/JPY: spot is October 29. What is 2-month value date?

J. GBP/USD: spot is October 25. What is 2-month value date?
K. GBP/USD: spot is November 22. What is 1-month value date?
L. GBP/INR: spot is October 15. What is 1-month value date?
M. GBP/INR: spot is November 27. What is 1-month value date?
N. GBP/JPY: spot is November 27. What is 1-month value date?
39
Chapter 4
Forex Deals: Classification and Risk
You ask what is the use of classification, arrangement, systemization? I an-
swer you: order and simplification are the first steps toward the mastery of a
subject―the actual enemy is the unknown. (THOMAS MANN, The Magic Moun-
tain)
And the day came when the risk to remain tight in a bud was more painful than
the risk it took to blossom (ANAIS NIN)
All forex deals are classified into two types: outright and FX swap; and every
forex transaction is analyzed with respect to two risk parameters: exposure (al-
so known as position) and mismatch (also known as gap).
4.1. Outright
An outright transaction involves buying or selling a currency. Since the forex

trade is an exchange of two currencies, it is simultaneously buying a currency
and selling an equivalent amount of another currency. The following examples
illustrate the outright trades.
41
Chapter 4
Deal #1 Bought EUR 1 million on EUR/USD @ 1.5665 value date spot

Deal #2 Sold JPY 500 million on USD/JPY @ 104.00 value date spot
In the trade, only one currency (“deal currency”) amount is specified. The
other currency (“derived currency”) amount is derived by „crossing‟ the deal
currency amount with the trade price. The trade price in all cases is the price of
base currency in terms of quoting currency.
In trade #1, the deal currency, EUR, is the base currency and the trade
price implies that EUR 1 = USD 1.5665. The „crossing‟ here means multiplica-
tion of deal currency with trade price. In trade #2, the deal currency, JPY, is
the quoting currency. There is no restriction that the deal currency should be
always the base currency. If the requirement is to buy or sell a round amount
of quoting currency, then the action will be specified in that currency. The trade
price implies that USD 1 = JPY 104.00, so that JPY 500 million will be equiva-
lent to 500 / 104.00 = USD 4.789272 million. The „crossing‟ here means divi-
sion of deal currency amount by trade price.
To sum up, the outright trade involves a bought currency and a sold cur-
rency. The amount of one of them and the price is specified. The amount of
the other currency is derived by „crossing‟ the deal amount with the price. The
„crossing‟ is multiplication or division, depending on whether the deal currency
is base currency or quoting currency, respectively, as shown in Exhibit 4-1.
EXHIBIT 4-1: Deal Currency and Derived Currency Amount
Deal Currency = Base Currency
Derived Currency Amount = Deal Currency Amount  Price
Deal Currency = Quoting Currency
Derived Currency amount = Deal Currency Amount / Price
4.2. Forex Swap
There are two swaps with similar names: forex swap and currency swap. Until
the 1980s, forex swap was simply called “swap”. In the early 1980s, another
42
swap was invented, which was different from forex swap in structure and func-
tion. To make the distinction between the two, the traditional “swap” is now
called forex swap and the new instrument is called currency swap. The differ-
ence between them is explained in Section 4.8.
Forex swap consists of simultaneous buying and selling of same currency

on the same currency pair for the same amount but for different value dates.
The value dates must be necessarily different because, without such a condi-
tion, the buy and sell will square up each other, leaving no transaction in exis-
tence. The following example illustrates the FX swap.
Bought EUR 1 million on EUR/USD @ price1 value date spot (near leg)
Sold EUR 1 million on EUR/USD @ price2 value date 1-month (far leg)
The above are not two independent trades but two legs of the same trade.
The leg that settles first is called the near leg and the other leg is called the far
leg. We distinguish two kinds of forex swaps: buy-sell (B-S) and sell-buy (S-B)
swaps. The market side of the near leg is always written first. Thus, in the B-S
swap, the market side of the near leg is buy and that of far leg is sell; and the
converse for the S-B swap. Notice that both the legs have the following fea-
tures:
 Same currency pair (in the example, EUR/USD)
 Same deal currency (in the example, EUR)
 Same deal amount (in the example, 1 million)
 Different value dates (in the example, spot and 1-month)
The only trade parameter we have not specified to be same or different is

the price for two legs. We cannot impose any such restriction because the
prices are market-driven. All combinations are possible: the buy price may be
more than, less than or equal to the sell price. If the buy price is less than the
sell price, does it mean profit? And loss, when the buy price is more than the
sell price? And if they are the same, what is motive in doing such a transac-
tion? Let us examine the cash flows from the swap transaction illustrated
above. We consider that Party A has executed the above swap with Party B.
For the Party A, it is a BS swap in EUR and SB swap in USD for equivalent
amount; and the converse for the Party B. Exhibit 4-2 shows the cash flows
between the two parties on near date and far date. Note that when we buy a
currency, it will be inflow; and when we sell it, it will be an outflow.
43
Chapter 4
EXHIBIT 4-2: Cash Flows Picture of FX Swap
Near Date Far Date

Time
Party A
EUR USD EUR USD
Party B
For a moment, ignore the USD cash flows and consider only the EUR cash
flows? What is this transaction? It is obviously a money transaction in EUR
with Party A as borrower and Party B as lender. Consider now only the USD
cash flows and ignore the EUR cash flows. It is now a USD money transaction
with Party A as lender and Party B as borrower. Consider now only the cash
flows on near date, and ignore that on far date. The transaction now is a forex
transaction in EUR/USD with Party A as EUR buyer/USD seller; and party B as
EUR seller/USD buyer. Consider now only the cash flows on far date and ig-
nore that on near date. The transaction is again a forex transaction in
EUR/USD with Party A as EUR seller/USD buyer; and party B as EUR buy-
er/USD seller.
Consider all flows together: it is a B-S swap in EUR (or S-B swap in USD)
for Party A; and S-B swap in EUR (or B-S swap in USD) for Party B. Forex
swap is thus a combination of borrowing and lending in two different currencies
of equivalent amount. Exhibit 4-3 summarizes the transaction from different
perspectives.
EXHIBIT 4-3: Anatomy of FX Swap
Perspective Party A Party B

EUR cash flows EUR Borrower EUR Lender
USD cash flows USD Lender USD Borrower
Near date cash flows EUR buyer/USD seller EUR seller/USD buyer
Far date cash flows EUR seller/USD buyer EUR buyer/USD seller
Entirety FX swap: BS in EUR FX swap: SB in EUR
(or SB in USD) (or BS in USD)
44
We can see from the above that two money trades are combined into a
single package called forex swap. The currency lent is secured by the currency
borrowed or vice versa. Forex swap is similar to the repo trade in money mar-
ket. Whereas repo is borrowing of money against the collateral of a financial
security, forex swap is borrowing of one brand of money against the collateral
of another brand of money. On the near date, the rate of exchange between
the currencies is linked to the prevailing market price. On the far date, the
same amounts of currencies are re-exchanged along with the two interest
amounts. The two interest amounts are converted into quoted currency and
clubbed with the principal amount to derive the price for far leg. This is some-
what a complex calculation and explained fully in Chapter 6.
4.3. Exposure
Exposure (also known as position or exchange position) refers to price risk (or
market risk) in a forex trade. What we mean by risk is the uncertainty about the
future return, which could be positive or negative. The popular names for posi-
tive and negative returns are profit and loss, respectively.
For example, if we buy EUR on EUR/USD, there will be either profit or loss
in future, respectively, if the price rises or falls. We say we have a position or
are exposed to price risk or market risk. When we buy a currency, we say we
have long or overbought exposure; and when we sell it, we have short or over-
sold exposure. When there is no exposure, we say square. Since every forex
trade involves two currencies with opposite market sides (i.e. buy one and sell
the other), the exposure arises simultaneously in two currencies in a comple-
mentary way: overbought in one currency and oversold in the other for equiva-
lent amount. If there is exposure in only one currency, it is not exposure, but
profit/loss. The following trades illustrate the exposure and profit/loss.
Trade #1: Bought EUR 100 on EUR/USD @ 1.5665
The deal above results in an overbought exposure for EUR 100 and over-
sold exposure for USD 156.65. If the rate goes up subsequently, it results in
profit; and if the rate goes down, it results in loss. Let us assume that we have
executed the second trade subsequently as follows.
Trade #2: Sold EUR 100 on EUR/USD @ 1.5765
The second trade creates an oversold exposure for EUR 100, which will
exactly offset the existing overbought exposure, leaving no exposure in EUR.
45
Chapter 4
In USD, the second trade creates overbought exposure for USD 157.65, which
will eliminate the existing oversold exposure of USD 156.65, leaving a net
overbought exposure of USD 1. Since exposure by definition must arise in two
currencies and in a complementary way, the exposure in USD alone must be
considered profit/loss from the two trades rather than exposure. If the expo-
sure in one currency is overbought, it is inflow and thus profit; and if oversold,
it is outflow and thus loss.
Outright trades create new exposure, and if the new exposure is comple-
mentary to an existing exposure, they eliminate the existing exposure. Forex
swap trades involve simultaneous buying and selling of same currency and
same amount on the same currency pair and therefore do not create any ex-
posure, but leave the existing exposure unchanged.
4.4. Mismatch
Mismatch (also known as gap or cash position) refers to the cash balances in
currencies. The cash balance in a currency can be surplus, deficit or square.
Whereas the surplus requires lending and deficit requires borrowing, the
square situation is the ideal state. Unlike exposure, mismatch is computed for
each day at the closing, because the day is the unit period for accounting.
When we buy a currency, there will be cash inflow or surplus in that cur-
rency. Similarly, when we sell it, there will be cash outflow or deficit. Since fo-
rex trade always involves buying one currency and selling another of equiva-
lent amount, mismatch arises simultaneously in two currencies: surplus in one
and deficit in another for equivalent amount. Whenever there is an exposure, it
necessarily follows that there will be a mismatch. Outright trades create expo-
sure and therefore create mismatch. Forex swaps do not create exposure but
create mismatch because the buying and selling are for different value dates.
The better way to understand the concepts of exposure and mismatch is by
analyzing the cash flows.
4.5. Cash Flow Analysis of Trades
Any financial instrument is ultimately a bundle of cash flows, and the cash flow
has three attributes: occurrence, timing and amount. Each attribute is qualified
as certain (i.e. known at the outset) or uncertain (i.e. not known at the outset).
If the occurrence is certain, then it means that the cash flow will surely occur
and not conditional on any future event. Similarly, if the timing and amount are
certain, then we know at inception when it will occur and how much it will be.
46
Based on the combination of three attributes, we classify cash flows into three
types: fixed, floating, and contingent, as shown in Exhibit 4-4.
EXHIBIT 4-4: Types of Cash Flows
Cash Flow Type Occurrence Timing Amount

Fixed Certain Certain Certain
Floating Certain Certain Uncertain
Contingent Uncertain Certain/Uncertain Certain/Uncertain
Classification as above is the first step in any valuation. Our focus is not fi-
nancial valuation but analysis of forex cash flows from the perspective of risk
and profit/loss calculations. To redefine the concepts of exposure and mis-
match in terms of cash flows, we will construct a cash flows table, which is a
very valuable tool in financial engineering. The design of the table is such that
the columns display the cash flow amount and the rows display the cash flow
timing. Different columns are used for cash flows in different currencies. We il-
lustrate the cash flow table for the following forex swap.
Bought USD 100 on USD/INR @ 40.10 value date spot (near leg)
Sold USD 100 on USD/INR @ 40.15 value date 3-month (far leg)
The cash flow table must have separate columns for each currency and
separate rows for each value date. Exhibit 4-5 shows the cash flows for the fo-
rex swap above. The buy trade results in cash inflow (shown with positive sign)
and sell trade results in cash outflow (shown with negative sign).
EXHIBIT 4-5: Cash Flows Table
USD INR Remark

Spot +100 4,010 Cash flows from near leg
Total +100 4,010 Day total
3-month 100 +4,015 Cash flows from far leg
Total +100 +4,015 Day total
G Total 0 +5
Note that buy-sell trades result in a pair of cash flows in the same row of
different columns; and borrow-lend trades result in a pair of cash flows in the
same column of different rows. We can redefine exposure and mismatch in
terms of cash flows as follows: exposure is the grand total of all cash flows in
47
Chapter 4
the currency; and mismatch is the daily total of all cash flows in a currency for
a value date.
If the grand total of all cash flows in a currency is zero, there is no expo-
sure; if positive, the exposure is overbought (or long); and if negative, the ex-
posure is oversold (or short). Similarly, if the daily total of cash flows in a cur-
rency for a value date is zero, there is no mismatch; if positive, the mismatch is
surplus; and if negative, the mismatch is deficit. Since the sum of cash flows at
all value dates is simply the grand total of all cash flows, it follows that the sum
of mismatches is the exposure.
In the example above, the mismatch in USD cash flows is +100 (surplus)
on spot value date and 100 on 3-month value date; and the sum of mis-
matches is zero or square. For INR cash flows, the mismatch is 4,010 on spot
value date and +4,015 on 3-month value date; and their sum of +5, which
would seem an overbought exposure but is not. By definition, exposure must
arise in two currencies in a complementary way. The net cash flow in one cur-
rency alone is the profit/loss: profit if the cash flow is positive; and loss, if it is
negative. In our example, there is a profit of INR 5. However, it is not the net
profit. If it were, everyone in the market will do this forex swap and profit from
it. Consider now the mismatch. We have surplus cash in USD from spot to 3-
month value dates; and deficit in INR for the same period. They are corrected
by simultaneously lending USD and borrowing INR from spot to 3-month value
date. The net difference in two interest amounts (USD receivable, INR paya-
ble) will exactly offset the profit of INR 5 in the FX swap. We will examine the
link between forex swap and the two interest rates in Chapter 6. What remains
after eliminating exposure and mismatch is the net profit/loss. Let us summar-
ize the two concepts of exposure and mismatch.
Exposure (also known as Position or Exchange Position)
 It refers to forex price risk and is of two types: long (or overbought)
and short (or oversold)
 It is computed as the grand total of cash flows in a currency. If the to-
tal is positive, it is long position; and if negative, short position.
 It arises in two currencies in a complementary way: long in one cur-
rency and short in the other for equivalent amount. Exposure in one
currency alone is gross P/L.
 Exposure creates mismatch
 Outright trades create new exposure or eliminate existing exposure
48
Mismatch (also known as Gap or Cash Position)
 It refers to cash balances and is of two types: surplus and deficit

 It is computed as the total of cash flows in a currency for a particular
value date. If the total is positive, it is surplus; and if negative, deficit.
 The surplus (or deficit) in a currency on a value date is accompanied
by deficit (or surplus) in the same currency on another value date. In
other words, surplus or deficit is for a period between the two value
dates. Further, mismatch arises in two currencies in a complementary
way: surplus in one currency for a period and deficit in another cur-
rency for the same period
 Surplus/deficit for a period in one currency alone is not mismatch but
liquidity problem; and surplus/deficit in one currency alone and on a
value date alone is the net P/L.
 Forex swap trades create mismatch without creating exposure
4.6. Deal Blotter, Position and Gap Statements
As soon as a trade is executed by the trader, it is immediately entered into

deal blotter, which records the economic details of the trade: time stamp, cur-
rency pair, deal type, market side (i.e. buy or sell), deal currency and amount,
price, and value date. The blotter is maintained for each trader and for each
session (which is typically a day). Exhibit 4-6 shows a specimen of deal blotter.
EXHIBIT4-6: Deal Blotter

Date: May 22, 2008 Trader: ACR (amount in millions)
Time Currency Deal Market Deal Price Value
Pair Type Side Amount Date
9:30:15 EURUSD outright Buy EUR 5 1.5765 spot
9:30:25 USDJPY outright Sell USD 5 104.39 spot
9:30:55 EURUSD outright Sell EUR 5 1.5795 spot
9:31:15 USDJPY outright Buy USD 2 104.05 cash
9:35:15 EURUSD outright Sell USD 5 1.5742 1-mon
9:40:00 USDJPY swap Sell USD 2 104.16 cash
9:40:00 USDJPY swap Buy USD 2 104.11 spot
9:40:10 EURUSD swap Sell USD 5 1.5745 spot
9:40:10 EURUSD swap Buy USD 5 1.5738 1-mon
49
Chapter 4
From the deal blotter, every trade is processed further in real-time for its ef-
fect on position and gap. Exhibit 4-7 shows the typical format of position and
gap statements for the deals in Exhibit 4-6.
EXHIBIT4-7: Position and Gap Statement

Position Date: May 22, 2008 Trader: ACR (amount in millions)
Time Purchase Sale Position
9:30:15 5.000000 5 OB
EUR 9:30:55 5.000000 0 Square
9:31:05 3.000000 3 OS
9:31:30 2.000000 5 OS
9:35:15 3.176216 1.823784 OS
9:40:10 3.175611 1.351827 OB
9:40:10 3.177024 1.825197 OS
9:30:15 7.8825 7.8825 OS
USD 9:30:25 5.0000 12.8825 OS
9:30:55 7.8975 4.9850 OS
9:31:05 4.7415 0.2435 OS
9:31:15 2.0000 1.7565 OB
9:31:30 3.1570 4.9135 OB
9:35:15 5.0000 0.0865 OS
9:40:00 2.0000 2.0865 OS
9:40:00 2.0000 0.0865 OS
9:40:10 5.0000 5.0865 OS
9:40:10 5.0000 0.0865 OS
9:30:25 521.95 521.95 OB
JPY 9:31:15 208.10 313.85 OB
9:40:00 208.32 522.17 OB
9:40:00 208.22 313.95 OB
Position Summary (OB = overbought; OS = oversold)
EUR: 1.825197(OS); USD: 5.0865 (OS); JPY: 313.95 (OB)
Gap Date: May 22, 2008 Trader: ACR (amount in millions)

Value Purchase Sale Gap
spot 8.175611 10.000000 1.824389 Deficit
EUR 1-mon 3.176216 3.177024 0.000808 Deficit
Total 11.351837 13.177024 1.825197
cash 2.0000 2.0000 0 square
USD spot 17.7960 17.8825 0.0865 Deficit
1-mon 5.0000 5.0000 0 square
Total 24.7960 24.8825 0.0865
cash 208.32 208.10 0.22 surplus
JPY spot 521.95 208.22 313.73 surplus
Total 730.27 416.32 313.95
50
Notice that, for each currency, the sum of gaps should be equal to the posi-
tion. If they do not, then there is a mistake in the accounting for cash flows.
4.7. Limits on Position, Gap and Others
Bank controls the forex operations by placing limits on position, gap, counter-
party exposure, stop-loss, etc. Of them, the most important is that on position.
The position limit has two variants: daylight limit and overnight limit. The
daylight limit is the limit during the day while the overnight limit is the limit at
the close of business each day. The overnight limit is also used to compute
capital adequacy for trading operations under Basel II regulatory regime. The
international norm for computing the position limit is the “short hand” rule, ac-
cording to which the limit for capital adequacy is computed as follows.
 Segregate currencies into those with overbought and oversold posi-

tions
 Translate the position into home currency equivalent
 Separately sum the overbought and oversold positions
 The higher of the aggregate overbought and aggregate oversold posi-
tions is considered the “net open position.”
The reason for the short hand rule is the currency diversification effect. In
the forex market, in terms of price changes, it is a see-saw between US dollar
and all other currencies. If dollar rises against a currency, it rises against all
other; and vice versa. Most banks are now adopting advanced techniques like
value-at-risk (VaR) to measure forex price risk. Basel II regulations allow VaR
model to compute capital adequacy as an alternative to the short-hand rule.
4.8. Forex Swap versus Currency Swap
Though sounding similar in name, they are structurally and functionally differ-
ent. Forex swap is a cash management tool: currency swap is a risk manage-
ment tool. Under the accounting standards of FASB 133 and IAS 39, forex
swap is not a derivative but currency swap is.
Forex swap, being a cash management tool, must necessarily exchange

the principal amounts in two currencies. Like in money market instruments, the
period of forex swap is one year or less and there is only one interest payment,
51
Chapter 4
which is merged with the principal re-exchange. The near leg is the exchange
of principal and the far leg price is the re-exchange of principal and interest
combined. The structure and pricing of forex swap is discussed in Chapter 7.
Currency swap, being a risk management tool, need not exchange of prin-
cipal amounts in two currencies. It exchanges two currency interest amounts
and the forex price change during the period. It may or may not exchange
principal amounts. The swap period is more than one year and can extend up
to 10 – 20 years with interest payments typically at quarterly or half yearly in-
tervals. Exhibit 4-8 summarizes the similarities and differences between two
swaps.
EXHIBIT 4-8: FX Swap versus Currency Swap
Feature FX Swap Currency Swap

Purpose Cash management Risk management
Swap period One year or less More than one year
May nor may not be ex-
Principal Always exchanged
changed
Always exchanged and Always exchanged and
Interest combined with principal re- there will be a series of
exchange at the end such exchanges
Key Concepts
Two currencies in a trade: deal currency and derived currency, each of which
can be the base currency or the quoting currency.
Two types of deals: outright and forex swap. Forex swap is different from cur-
rency swap: the former is cash management tool and the latter is risk man-
agement tool.
Two concepts: exposure (a.k.a. position or exchange position) and mismatch

(a.k.a. gap or cash position).
Two types of exposure: overbought (a.k.a. long) and oversold (a.k.a. short)
Two types of mismatch: surplus and deficit
52
Exposure is the grand total of all cash flows in a currency, and will arise in two
currencies in a complementary way. Exposure in only one currency is the
gross profit/loss
Mismatch is the daily total of cash flows in a currency on a value date. The
surplus or deficit runs for a period marked by two value dates. Mismatch arises
in two currencies in a complementary way (i.e. surplus in one and deficit in
another for the same period). Mismatch in one currency alone is funding prob-
lem; and mismatch in one currency alone and only on one value date (rather
than a period) is net profit/loss.
EXERCISES
Taking into account the following deals, update the position and gap state-
ments, in the format shown in Exhibit 4-7. Instead of deal time, use the serial
number of the deal as its substitute. All amounts are indicated in millions. Note
that for JPY/INR currency pair, the price is for 100 units of JPY.
1. (USD/INR, outright): Bought USD 3 @ 40.61 value date spot

2. (EUR/USD, outright): Sold EUR 3 @ 1.5737 value date spot
3. (JPY/INR, outright): Bought JPY 500 @ 39.01 value date 1-mon
4. (USD/JPY, outright): Bought USD 5 @ 104.33 value date spot
5. (USD/INR, outright): Bought 2 @ 40.62 value date spot
7. (GBP/INR, outright): Sold GBP 1.2 @ 80.27 value date cash
8. (GBP/USD, outright): Bought GBP 1 @ 1.9763 value date cash
10. (USD/JPY, swap): SB USD 5 @ 104.38/104.00 value date spot/1-mon
11. (USD/INR, swap): BS USD 5 @ 40.65/45.67 value date spot/1-mon
12. (GBP/USD, swap): SB USD 2 @ 1.9755/1.9751 value date cash/spot
13. (USD/INR, outright): Sold USD 9.7 @ 40.66 value date cash
15. (USD/INR, swap): BS USD 12 @ 40.65/40.66 value date cash/spot
53
Chapter 4
16. (EUR/USD, outright): Bought EUR 7 @ 1.5717 value date spot

17. (GBP/USD, outright): Bought GBP 0.2 @ 1.9749 value date spot
54
Chapter 5
Cross Rate Arithmetic
God does arithmetic. (KARL FRIEDRICH GAUSS, German mathematician)
I continued to do arithmetic with my father, passing proudly through fractions

and decimals. I eventually arrived at the point where so many cows ate so
much grass and tanks filled with water in so many hours I found it quite enth-
ralling. (AGATHA CHRISTIE, An Autobiography)
As stated in Chapter 2, forex is one part literacy and ninety-nine parts numera-
cy. Forex arithmetic, however, is simple and involves only the four operators:
addition, subtraction, multiplication and division. It does not involve complex
calculations like differentiation and integration, unlike option pricing.
We have made a reference to cross rates in Section 2.7. They are currency
pairs without the interbank numeraire currency (which is currently USD). Cross
rates are not quoted directly in the market, but are derived by „crossing‟ two
numeraire-based rates. The „crossing‟ means either multiplication or division,
and is the subject matter of this chapter.
55
Chapter 5
5.1. Chain Rule
One apple is INR 15 and one banana is INR 3. One apple is worth how many
bananas? We say instantly that one apple is worth five bananas because the
solution is intuitive. Let us consider similar situation. Three roses are INR 5
and seven lotuses are INR 25. One rose is worth how many lotuses? The solu-
tion does not strike immediately because it is not very intuitive. When intuition
fails, we apply logic. Chain rule is that logic and the principle of cross rate
arithmetic.
Chain rule consists of four steps: define the cross rate in the proper format;
identify the two underlying rates; arrange the underlying rates to form a chain;
and multiply and divide. We will explain the four steps with the following exam-
ple of EUR/INR cross rate.
Define the cross rate
What we mean by „definition‟ is to state the problem: one (or some other fixed
quantity) unit of base currency is how many units of quoting currency. In ex-
pressing the problem, we write the base currency on the left hand side and
quoting currency on the right hand side. The definition for our example is thus:
EUR 1 = INR?
Identify the underlying rates
The underlying rates are each currency of cross rate against the numeraire
USD. The underlying rates for our example are EUR/USD and USD/INR and
let their prices be
EUR/USD = 1.5775 (EUR 1 = USD 1.5775)

USD/INR = 40.31 (USD 1 = INR 40.31)
Arrange the underlying rates to form a chain
Select the underlying rate containing the quoting currency of the cross rate. In
our example, it is USD/INR. Arrange the price of this underlying rate in such
way that INR goes to the other side of the equation, as follows.
EUR 1 = INR ?
INR 40.31 = USD 1
56
In the first currency pair, INR is on the right hand side; and in the second,
on the left hand side. It thus forms a chain. Repeat the process for the second
underlying rate in such a way that USD is placed on the left hand side.
EUR 1 = INR ?
INR 40.31 = USD 1
USD 1.5775 = EUR 1
Multiply and divide
Take the product of left hand side and divide it by the product of right hand
side. It should be clear now why we formed a chain of currencies: to cancel all
of them except those of the cross rate. The result of this arithmetic operation is
the solution to the problem stated in the first step. Thus, for our example,
(1  40.31  1.5775) / (1  1) = 63.5890 (EUR 1 = INR 63.5890)
Example #2
Let us work out one more example of JPY/INR. If the base currency JPY quan-
tity is kept at 1, the JPY/INR value will be so low that it has to be quoted up to
6 or 8 decimal places to preserve precision. To avoid such lengthy, cumber-
some quotes, the market convention for JPY/INR currency pair is to keep the
base currency unit at 100 instead of 1.
Define the cross rate
JPY 100 = INR ?
Identify the underlying rates (and get their prices)
USD/INR = 40.31 (i.e. USD 1 = INR 40.31)

USD/JPY = 104.28 (i.e. USD 1 = JPY 104.28)
Arrange the underlying rates to form a chain
JPY 100 = INR ?
INR 40.31 = USD 1
USD 1 = JPY 104.28

57
Chapter 5
Multiply and divide
(100  40.31  1) / (1  104.28) = 38.6555 (JPY 100 = INR 38.6555)
5.2. Trader’s Quicker Method
Traders follow the logic quickly in their mind, as follows. The arithmetic opera-
tor for crossing the underlying rates is either multiplication or division. From the
prices, guess whether the cross rate should be the highest or lowest among
the three or midway between the two underlying rates. Its standing indicates
the arithmetic operator. The following two examples illustrate the procedure.
EUR/SAR cross rate
The source rates and their prices are:
EUR/USD = 1.5775 (EUR 1 = USD 1.5775)
USD/SAR = 3.7500 (USD 1 = SAR 3.7500)
One USD is worth SAR 3.75 and one EUR is worth more than USD. There-
fore, one EUR should be worth more than SAR 3.75 and the cross rate should
be the highest amount the three, which implies that we should multiply.
SAR/INR cross rate
The source rates and their prices are:
USD/INR = 40.31 (USD 1 = INR 40.31)

USD/SAR = 3.7500 (USD 1 = SAR 3.7500)
One USD is worth SAR 3.75 but INR 40.31. Therefore, one SAR should be
worth less than 40.31 but more than 3.75, which implies that we should divide
40.31 by 3.75.
5.3. Arithmetic with Two-way Quotes
The arithmetic with one-sided quotes is simplistic and has only illustrative val-
ue. In practice, we always deal with two-way quotes, which impose the addi-
tional requirement of whether we should cross the same or opposite sides of
underlying two-way quotes. Let us explain the procedure with the cross rate
example of EUR/INR. The underlying rates and their two-way quotes are
58
EUR/USD = 1.5775/79
USD/INR = 40.3150/00
Let us first convert the abbreviated offer price to its full form, using the pro-
cedure described in Section 2.10.
EUR/USD = 1.5775/79  1.5775 / 1.5779
USD/INR = 40.3150/00  40.3150 / 40.3200
Consider now the two-way quote for cross rate EUR/INR, which is to be de-
rived from the above two underlying rates. Let this two-way quote for the cross
rate be x/y. At x, the price maker buys EUR (and sells INR); and at y, he sells
EUR (and buys INR). The prices are derived on the basis of hedging or cover-
ing. That is, if the price maker buys on his quote, he will immediately sell it in
the market; and if sells on his quote, he will immediately buy it from the market.
Therefore, we compute the bid price x on cross rate on the assumption that we
sell the base currency EUR in the market on EUR/USD pair, which will be at
1.5775. When we sell EUR, we will be paid USD, which we must sell on the
second pair of USD/INR, which will be at 40.3150. This exactly matches the
cash flows with square position, as follows.
Cross rate: EUR/INR (bid): We buy EUR/sell INR @?

Underlying rate #1: EUR/USD: We sell EUR/buy USD @ 1.5775
Underlying rate #2: USD/INR: We sell USD/buy INR @ 40.3150
In case of doubt, draw the cash flows table described in Section 4.5 to en-
sure that the above three deals create neither position nor gap. Having identi-
fied the correct sides of the two two-way underlying quotes, we will now „cross‟
them using the chain rule or the trader‟s shortcut approach. For the offer side
of the two-way cross rate, we do not have to repeat the logic again: we can
simply pair the remaining sides of the underlying quotes. Thus, the two-way
cross rate for our example will be
EUR/INR: (40.3150  1.5775) / (40.3200  1.5779)
= 63.5969 / 63.6209  63.5969 / 209.
Notice that the offer price cannot be abbreviated to the last two digits of 09.
If the last two digits alone are quoted, it will be construed as 63.6009 (see Sec-
tion 2.10), which is much lower than the correct price of 63.6209.
59
Chapter 5
5.4. Check on Calculations
One obvious check on the correctness of calculations is that the bid price must
be lower than offer price. This is necessary but not a sufficient condition, how-
ever. The additional check is that the bid-offer spread in the cross rate must be
equal to the sum of spreads in the bid-offer in two underlying rates. This must
be so because the cross rate is derived from the two underlying rates and
therefore combines both the spreads in its bid-offer.
We cannot straightaway add the two spreads in the underlying rates be-
cause they are apples and oranges. The spread of 0.0004 on EUR/USD rate is
on a base of 1.5775/79; and that of 0.0050 on USD/INR is on a base of
40.3150/00. To be comparable, they must be converted into percentages of
the mid rate of bid-offer. Exhibit 5-1 shows the calculation and comparison of
the spreads in underlying rates and cross rate.
EXHIBIT 5-1: Spread Comparison
Bid Offer Spread Mid Spread

EUR/USD 1.5775 1.5779 0.0004 1.5777 0.025353%
USD/INR 40.3150 40.3200 0.0050 40.3175 0.012402%
Total 0.037755%
EUR/INR 63.596913 63.620928 0.024016 63.608920 0.037755%
5.5. Mnemonic Aid for Two-way Cross Rate Arithmetic
As always, there are thumb rules to do the cross rate arithmetic quickly. We
can divide all scenarios into three groups, as follows.
#1: Both currencies in cross rate are quoting currencies in their source rates
The rule is: pair the opposite sides and divide, the numerator being the source
rate containing the quoting currency of the cross rate.
Example: cross rate is CHF/INR; source rates are: USD/INR and USD/CHF.
The quoting currency of the cross rate is INR, and the source rate containing
INR is USD/INR, which should be the numerator.
60
Currency Pair Two-way Quote Mid Rate Spread

USD/INR 40.3150 / 40.3200 40.3175 0.03825%
USD/CHF 1.0455 / 1.0459 1.0457 0.01240%
CHF/INR 38.5458 / 38.5653 38.5555 0.05065%
Bid = 40.3150/1.0459 = 38.5458; Offer = 40.3200/1.0455 = 38.5663
#2: Both currencies in cross rate are base currencies in their source rates
The rule is: pair the opposite sides and divide, the numerator being the source
rate containing the base currency of the cross rate.
Example: cross rate is EUR/AUD; source rates are: EUR/USD and AUD/USD.
The base currency of the cross rate is EUR, and the source rate containing
EUR is EUR/USD, which should be the numerator.

EUD/USD 1.5775 / 1.5779 1.5777 0.02535%
AUD/USD 0.7859 / 0.7961 0.7860 0.02545%
EUR/AUD 2.0067 / 2.0078 2.0073 0.05080%
Bid = 1.5775/0.7961 = 2.0067; Offer = 1.5779/0.7859 = 2.0078
#3: One currency in the cross rate is base currency and the other is quoting
currency in their source rates. We have two possible sub-scenarios, but the
rule is same in both ―same sides and multiply―with a small variation.
#3A: Base currency of cross rate is the base currency in its source rate
The rule is: same sides and multiply with bids of source rates becoming the bid
of cross rate; and offers of source rates becoming the offer of cross rate.
Example: cross rate is EUR/INR; source rates are: EUR/USD and USD/INR.
The base currency of the cross rate, EUR, is also the base currency in its
source rate of EUR/USD.
61
Chapter 5

EUD/USD 1.5775 / 1.5779 1.5777 0.02535%
USD/INR 40.3150 / 40.3200 40.3175 0.01240%
EUR/INR 63.5969 / 63.6209 63.6089 0.03775%
Bid = 1.577540.3150 = 63.5969; Offer = 1.577940.3200 = 63.6209
#3B: Base currency of cross rate is the quoting currency in its source rate
The rule is: same sides and multiply, but take the reciprocal of derived rate,
and reverse the bid-offer sides for the cross rate.
Example: cross rate is INR/EUR; source rates are: EUR/USD and USD/INR.
The base currency of the cross rate, INR, is the quoting currency in its source
rate of USD/INR.

EUD/USD 1.5775 / 1.5779 1.5777 0.02535%
USD/INR 40.3150 / 40.3200 40.3175 0.01240%
EUR/INR 0.015718 / 0.015724 63.6089 0.03775%
Bid = 1 / (1.5779  40.3200) = 0.015718

Offer = 1 / (1.5775  40.3150) = 0.015724
5.6. Triangular Arbitrage
The price of cross rate is derived by crossing the prices of the two underlying
rates, and the demand-supply forces have no direct influence on its price. The
price of cross rate will automatically change whenever one or both the underly-
ing prices change, regardless of demand-supply situation for the cross rate. If
the demand-supply forces were to directly affect the price of cross rate, there
would be scope for arbitrage profit, which is impossible in efficient markets. Let
us explain it with EUR/INR cross rate, for which the underlying rates are,
EUR/USD: 1.5775/1.5779; USD/INR: 40.3150/40.3200
62
Given the above prices for the underlying rates, the cross rate has to be
EUR/INR bid: 1.5775  40.3150 = 63.596

EUR/INR offer: 1.5779  40.3200 = 63.621
The reference bid and offer prices above impose the following restrictions
on market quotes.
Market bid  Reference offer

Market offer  Reference bid
If the above restrictions are violated, there would be scope for arbitrage
profit, as follows.
Market bid > Reference offer Market offer  Reference bid

Market bid is overpriced: Market offer is underpriced:
Sell at market bid on EUR/INR Buy at market offer on EUR/INR
…and hedge it by …and hedge it by
Buy at market offer on EUR/USD Sell at market bid on EUR/USD
Buy at market offer on USD/INR Sell at market bid on USD/INR
Arbitrage profit ensures that all the three ratestwo underlying rates and
the cross rateare linked in this triangular relation, regardless of demand-
supply for the cross rate. It seems a paradox and unintuitive that demand-
supply forces do not influence the cross rate price. Let us state the obvious
and the logical: demand-supply forces do influence the price. In case of cross
rates, however, the effect is not direct but indirect through the underlying rates.
Transaction costs complicate this triangular arbitrage. The source of trans-

action costs is the brokerage/commission. Assuming that the commission is
0.01%, it widens the bid-offer range further on each side as follows.
Bid: 63.596  (1  0.0001) = 63.590

Offer: 63.621  (1 + 0.0001) = 63.628
The range of 63.590/63.628 is the reference range now for arbitrage. No

one arbitrages for an insignificant profit: there must be a minimum profit for ar-
bitrage. Let us assume that the minimum arbitrage profit is 0.01%, which will
further widen the range as follows.
Bid: 63.590  (1  0.0001) = 63.584

Offer: 63.628  (1 + 0.0001) = 63.634
63
Chapter 5
Note that to determine arbitrage profit, we must compare the opposite

sides of two quotes (i.e. bid in one with the offer in another) because we will be
buying on one quote and selling on the other. It is possible that market quotes
may deviate to certain extent without crossing the bid-offer bounds and hence
without providing arbitrage profit, as shown in Exhibit 5-2.
EXHIBIT 5-2: Bounds for Arbitrage
63.584 / 63.634
A 63.57/63.62
B 63.60/64.65
C 63.60/63.62
The shaded box is the reference quote determined by cross rate arithmetic.
The un-shaded boxes (A, B and C) are cross rate quotes from different deal-
ers. Notice that all the three market quotes are different from the reference
quote and yet there is no arbitrage because none of them has crossed the bid-
offer range. Quotes A and B are “trended” quotes: they are better on one side
and worse on the other, compared to the reference quote. Quote A is trended
to the “left”: its bid price is worse but offer price is better, compared to the ref-
erence quote. This quote attracts the prospective buyer. Dealer A is indicating
to other dealers that he is interested in selling.
Quote B is trended to the “right”: its bid price is better but offer price is
worse, compared to the reference quote. This quote attracts the prospective
seller. Dealer B is indicating to other dealers that he is interested in buying.
Quote C is the competitive quote: it has the least bid-offer spread and,
usually, has higher bid and lower offer than reference quote, attracting both
buyers and sellers. Such dealers are called market-makers. In the over-the-
counter (OTC) market, market makers are the first port-of-call for all other
dealers. They are able to provide competitive quotes by actively managing the
inventory and by continuously quoting prices to others. By entering and exiting
quickly, the manage the price risk and profit from the bid-offer spread.
64
To sum up, there will be different market quotes at any point of time from
different dealers for a cross rate, many of which may deviate from reference
quote and yet without crossing the bid-offer bounds. The rule to determine the
possibility of arbitrage is to select the quote with the highest bid and that with
the lowest offer and find their difference
(highest bid)  (lowest offer).
If the above difference is positive and greater than the transaction cost,
then there exists arbitrage by buying at the offer and selling at the bid.
Chain rule: the basis of cross rate arithmetic
Check on calculations: spread comparison between underlying rates and cross

rate after converting them into percentages of mid rate.
Triangular arbitrage and bounds on arbitrage
EXERCISES
The following are the two-way quotes for various source rates.
Currency Pair Market Quote

EUR/USD 1.5329/32
GBP/USD 1.9398/05
USD/JPY 101.98/03
USD/CHF 0.9978/81
AUD/USD 0.7843/47
NZD/USD 0.5246/48
USD/INR 39.9950/50
From the above, compute the cross rates shown in the table below. Round off
the cross rates to the decimal places indicated against each currency pair. In
rounding off, round down the bid price, and round up the offer price. For ex-
ample, if the decimal place to be rounded is 0.0025 and the derived rate is
39.3937/39.4158, then the rounded off cross rate should be 39.3925/39.4175.
Abbreviate the offer price according to the procedure described in Section
2.10. For example, if the quote is 39.3925/39.4075, then it is abbreviated to
39.3925/175.
65
Chapter 5
Currency Pair Round-off Place

EUR/JPY 0.01
GBP/JPY 0.01
CHF/JPY 0.01
NZD/CHF 0.0001
AUD/NZD 0.0001
EUR/INR 0.005
GBP/INR 0.01
CHF/INR 0.005
INR/JPY 0.001
AUD/INR 0.0025
NZD/INR 0.0025
66
Chapter 6
Forward Exchange
Current forward rate is the expected future spot rate. ( UNBIASED FUTURE SPOT
PRICE theory)
Current forward rate is determined by the current interest rates for the two cur-
rencies. (COVERED INTEREST PARITY condition)
The first statement above is based on expectations about the future and there-
fore speculative. The second is enforced by arbitrage (except under certain
conditions) and therefore practical.
Forward exchange is the link between the spot forex market and the money
market for two currencies. According to the legend (see Box 6-1), forward ex-
change was invented in the 12th century Europe. However, the forward ex-
change market in its today‟s character developed only after the World War I in
Vienna. Further development took place in Eurocurrency centers of London
and Luxembourg during 1960-70.
67
Chapter 6
BOX 6-1: History of Forward Exchange
According to the legend, it was the Italian moneychangers in the Plains of Lom-
th
bardy that invented the forward exchange during the 12 century. In those days,
there would be weekly cross-border trade fairs where merchants from different
city-states would bring their goods and trade in them. Before they buy foreign
goods, they would go to Italian moneychangers to exchange currencies.
On one occasion, the moneychanger advised a merchant that franc was costly
because of good demand for French wine. Expecting that demand would still be
higher next week (and therefore a costlier franc), the merchant would buy next
week‟s requirement of franc in advance. The moneychanger advised him that it
was not necessary to buy in advance and that they could enter into a contract on
franc for delivery one week forward at a price agreed in advance. That was the
first forward exchange contract.
Paul Einzig writes in his book, A History of Foreign Exchange (University of

Wales Press, 1996), that the earliest known forward contract was made in 1156
in which 115 Genoese pounds were borrowed to be paid after one month in 460
bezants. This is not strictly a forward contract but a loan combined with a forward
contract.
6.1. Forward Exchange Arithmetic
Money has time-value, which is called the “rent” or interest on money. Forex
transaction has two brands of money, and their interest rates jointly determine
the time-value of forex price. This is the basis of forward exchange. Let us ex-
plain this with the following example.
EUR/USD spot price is 1.5000: that is, EUR 1 = USD 1.5000 for delivery on
spot value date. The interest rate for EUR is 3% and that for USD, 2%. If EUR
and USD are to be exchanged after one year instead of on spot, then the rate
of exchange should be such that the spot amount must be increased by 3% for
EUR and by 2% for USD. The future amount of EUR 1 growing at 3% will be
EUR 1.03; and that of USD 1.5000 growing at 2% will be USD 1.5300. There-
fore, the rate of exchange between the two currencies contracted today for de-
livery after one year should be EUR 1.03 = USD 1.5300. Since the forex price
is expressed as the number of quoting currency units per one unit of base cur-
rency, the one-year forward exchange is: 1.5300 / 1.03 = 1.4854.
68
Forward Exchange
EXHIBIT 6-1: Forward Exchange Arithmetic
Now One year

time
3%
EUR 1 EUR 1.03
= =
2%
USD 1.50 USD 1.53
or EUR 1 = USD 1.53 /1.03
= USD 1.4854
The two interest rates for the currencies together with the spot price deter-
mined the forward exchange price. This is called covered interest parity (CIP)
or interest rate parity (IRP). In the example above, if the forward exchange
price is other than 1.4854, there will be arbitrage profit as follows. If the for-
ward exchange price is more than 1.4854 (say, 1.4900), EUR is overpriced in
the forward, and can be arbitraged for risk-free profit by executing the following
trades simultaneously.
1. Sell EUR 1.03 for forward delivery @ 1.4900

2. Buy EUR 1.00 for spot delivery @ 1.5000
3. Lend EUR 1.00 for spot to one year @ 3%
4. Borrow USD 1.50 for spot to one year @ 2%
Note that the amount of EUR sale in the forward must be equal to its time-
value. The above four actions create neither position nor gap, as shown by the
cash flows table below.
Value Date EUR USD Remark

Spot +1.00 1.5000 Cash flows from trade #2
1.00 +1.5000 Cash flows from trades #3 and #4
Gap 0 0 Total of day‟s cash flows
One year +1.03 1.5300 Cash flows from trades #3 and #4
1.03 +1.5347 Cash flows from trade #1
Gap 0 +0.0047 Total of day‟s cash flows
Position 0 +0.0047 Grand total of all cash flows
There is neither gap (i.e. total of day‟s cash flows) nor position (i.e. grand
total of all cash flows) in either currency. Therefore, as discussed in Section
69
Chapter 6
4.5, the net cash flow of USD 0.0047 is the net profit, resulting from the arbi-
trage. Two points needs attention here.
First, the amount of arbitrage profit will be slightly more than the difference
between the arbitrage-free price and the actual price. In our example,
A. Arbitrage-free price: 1.53 / 1.03 1.48543689

B. Market price 1.49
C. Difference (B  A) 0.00456311
D. Arbitrage profit 0.0047
The reason for the discrepancy is the time-value of money. The forex price
is expressed in the units of quoting currency for one unit of base curren-
cyalways. To arbitrage the price differences, however, we do not always buy
or sell one unit of base currency. In our example above, we bought EUR 1.00
for spot but sold EUR 1.03 for forward. The forward amount is more than the
spot amount by 3% because of the time-value of EUR. Therefore, the arbi-
trage-profit will be higher by 3% on the difference between the two prices.
0.00456311  1.03 = 0.0047
Second, if the quantity of EUR forward sale is only EUR 1.00, there will be
a net cash flow of +0.0300 in EUR and 0.04 in USD. This is a position (long
EUR/short SD) and does not ensure profit if the EUR weakens substantially
against USD during the period.
Similarly, if the market price of one-year forward is less than 1.4854, there
will be an opportunity for arbitrage profit by executing the following trades.
1. Buy the underpriced EUR for forward delivery

2. Sell EUR for spot delivery
3. Borrow EUR
4. Lend USD
This is called covered interest arbitrage (CIA), which is the practical face of
the covered interest parity (CIP). As long as there are no restrictions on credit
and capital flows, the interest arbitrage will be fully covered, and the forward
exchange price will reflect the difference in two interest rates, rather than ex-
pectations about the future spot price. When there are controls on credit and
capital flows, however, the interest arbitrage will not be fully covered, and the
forward price may reflect expectations about the future spot rate. We will revisit
the topic in Section 6.11.
70
Forward Exchange
6.2. Swap Points: Premium, Discount and Par
The difference between spot and forward forex prices is called forward diffe-
rential, swap differential or swap points.
Swap Points = Forward Price  Spot Price.
If the swap points are positive, the forward price is higher than spot price:
the base currency is costly or at premium relative to spot. If the swap points
are negative, the forward price is lower than spot price: the base currency is
cheaper or at discount relative to spot. If the swap points are zero, the forward
and spot prices are the same: they are said to be at par. In commodity mar-
kets, the premium, discount and par are called, respectively, contango, back-
wardation, and par. Indian stock market of old days had its own terms for these
conditions (see Box 6-2).
BOX 6-2: Premium, Discount and Par in Indian Stock Market
The innovative and enterprising skills of Gujarati and Marwari traders in trading and
trade finance date back to hundreds of years.
According to Mr Bhupen Dalal, India‟s first merchant banker, traders in the Indian
stock market of old days used the terms seedhi badla for premium; ulta (or undha)
badla for discount; and bhav-e-bhav for par.
The “premium” and “discount” are used with respect to base currency and
they relative to the spot price. Given the reciprocal relationship between base
currency and quoting currency, it follows that, if the base currency is in pre-
mium in the forward, the quoting currency will be at discount, and vice versa.
For example, we can transform EUR/USD into USD/EUR by taking the reci-
procal of the former for spot and forward prices as follows.
Currency Pair Spot Price Forward Price Remark

EUR/USD 1.5000 1.48543689 EUR at discount
USD/EUR 0.66666667 0.67320262 USD at premium
We can see that the USD price (in terms of EUR) is costlier or at premium
in the forward relative to spot price. Two points need attention in forward ex-
change arithmetic.
71
Chapter 6
First, the currency with higher interest will be at discount to the currency
with lower interest rate, and vice versa. It may seem somewhat paradoxical at
first but is quite logical. Look at it this way: currency with higher interest rate
will have larger growth than the currency with lower interest rate. Since the
forward price already commits to exchange these growths, we exchange the
larger amount in high interest currency for the smaller amount in low interest
currency; and the difference between the two amounts is the premium on the
currency with lower interest rate or discount on the currency with higher inter-
est rate.
Second, since the premium/discount arises from the difference in two inter-
est rates, one may expect that the premium/discount in percentage terms
should be equal to the difference in two interest rates; and that the premium
(%) on once currency should be equal to discount (%) on the other. However,
the three are equal only approximately. The following table compares the dis-
count (%) on EUR, premium (%) on USD and the difference in the interest
rates of EUR and USD.
Discount on EUR (1.48543689  1.5000) / 1.5000 = 0.97087379%

Premium on USD (0. 0.67320262  0.6667) / 0.6667 = +0.98039216%
Diff. in interest rates 3%  2% = +1%
The three measures are slightly different from each other, despite they be-
ing in the same units of percentage per annum, and the differences are not
due to rounding off. The difference between premium (%) and discount (%) is
similar to that between yield and discount in interest rate arithmetic. Yield has
the interest paid in arrears (ex post), but discount has the interest paid in ad-
vance (ex ante). As for comparing premium/discount (%) with the difference in
interest rates, the latter should be expressed in relative, not absolute, terms
because the difference is a rate per unit time. The following is thus the correct
way of comparing them.
 Premium/discount in one currency should be computed as a percentage

of spot price while the discount/premium on the other should be computed
as a percentage of forward price
 Difference in interest rates should be a relative measure: (1+ quoting cur-
rency interest rate) / (1 + base currency interest rate)  1
Discount on EUR (1.48543689  1.5000) / 1.5000 = 0.97087%

Premium on USD (0.67320262  0.66666667) / 0.67320262 = 0.97087%
Diff. in interest rates (1.02 /1.03)  1 = 0.97087%
72
Forward Exchange
The above adjustments must to be considered when comparing pre-

mium/discount (%) of different currencies. In general, for comparison in arbi-
trage calcualtions, when the deal currency is base currency, compute the pre-
mium/discount as a percentage of spot price; and when it is quoting currency,
compute the premium/discount as a percentage of forward price.
6.3. Forward Exchange Arithmetic with Two-way Quotes
Let us work out the forward exchange arithmetic with two-way quotes with the
following two-way market quotes for spot forex price and two interest rates.
Price/Rate Quote
EUR/USD spot 1.4998 / 1.5002
EUR interest rate 2.96875 / 3.03125
USD interest rate 1.96875 / 2.03125
Our objective is to derive the two-way one-year forward price of EUR/USD

currency pair, x/y, where x is the quoter‟s buying price of base currency (and
the selling price of quoting currency) and y is the quoter‟s selling price of base
currency (and buying price of quoting currency). As explained in Section 5.2,
the derivation of any price is based on hedge. You buy on your quote and sell
it immediately in the market. In other words, when you quote a price to some-
one, your buying and selling prices for a currency are the market‟s buying and
selling prices, respectively, too. On the other hand, when you go to the market
as a price taker/asker, you will be buying at the market‟s selling price; and sell-
ing at the market‟s buying price.
Let us derive the bid side of the forward price. We buy the base currency
(EUR) on the bid of our quote for forward delivery and hedge it immediately by:
1. Sell EUR for spot delivery at market‟s buying price of 1.4998 (this elimi-
nates the position created by the original trade, but creates gap because
of different value dates)
2. Borrow EUR from spot to 1-year at the market‟s lending rate of 3.03125%
3. Lend USD from spot to 1-year at the market‟s borrowing rate of 1.96875%
With Trades #2 and #3 eliminating the gap, we are square in position and
gap. As explained in the previous section, the sale amount of EUR in trade #1
should be equal to the 1-year future value (which is, 1  1.03125 = 1.03125) to
eliminate the position completely. Exhibit 6-2 depicts the sides to match in de-
riving the two-way quote for forward exchange.
73
Chapter 6
EXHIBIT 6-2: Derivation of Two-way Forward Exchange Quote
Spot forex price: bid / offer
Quoting currency (QC) interest rate: bid / offer
Base currency (BC) interest rate: bid / offer
Forward forex price: bid / offer
Note that we “cross” the side for base currency interest rate because we
will be always borrowing one currency and lending the other in the hedging
operations. In the calculations above, we assumed that the forward period is
always one year. In practice, however, we deal with prices for periods other
than one year. In such cases, the period also enters into the calculations. The
8
period is called basis . Basis is expressed as a fraction of two parts: numerator
and denominator. The numerator specifies the procedure to count the number
of days in the period; and the denominator specifies the number of days in a
full year. Though there are more than 16 types of basis, only two types are
used in money and forex market, which are as follows.
Actual / 360
The “actual” indicates that we should count the actual number of days in the
numerator; and the “360” indicates that we should use 360 in the denominator
for both leap and non-leap year. This is used in money market of US and con-
tinental Europe, and therefore also called “money market basis.”
Actual / 365 (now renamed as Actual / 365 Fixed)
For the numerator, we count the actual number of days in the period; and for
the denominator, the constant of 365 for both leap and non-leap years. This is
used in the money market of GBP and most Asia-Pacific currencies except
IDR.
8
It is properly called day count basis but is simply referred to as basis by traders. In the
ISDA documentation for OTC derivatives, it is called day count fraction. The „basis‟ here
is different from the „basis‟ in futures market, where it refers to the difference between
spot price and futures price.
74
Forward Exchange
Incorporating the basis in the forward exchange arithmetic, we can now

develop formulas, as follows.
QC
1 + 𝑅bid × 𝑏𝑎𝑠𝑖𝑠 QC
𝐹bid = 𝑆bid BC
1 + 𝑅offer × 𝑏𝑎𝑠𝑖𝑠 BC
QC
1 + 𝑅offer × 𝑏𝑎𝑠𝑖𝑠 QC
𝐹offer = 𝑆offer BC
1 + 𝑅bid × 𝑏𝑎𝑠𝑖𝑠 BC
where
F: Forward price
S: Spot price
R: Interest rate
BC (in superscript): Base currency
QC (in superscript): Quoting currency
The product of interest rate and basis gives the interest amount for the pe-
riod, which, when added to unity, indicates the growth factor: how much one
unit of currency has grown up to in the period.
We can see from the equations above that if the quoting currency interest
rate is higher than that of base currency, the fraction in the square brackets will
be higher than unity, which makes the forward price higher (“premium”) than
the spot price. If the quoting currency interest rate is lower than that of base
currency, the fraction will be less than unity, which makes the forward price
lower (“discount”) than the spot price. If the interest rate is the same for both
currencies, the fraction will be unity, and the forward price will be the same
(“par”) as the spot price. We can also rearrange the equations above to solve
for swap points directly from spot price and two interest rates. Instead of „bid‟
and „offer‟ for the two-way swap quote, we designate the two sides of swap
quote as left hand side (LHS) and right hand side (RHS), respectively.
QC
1 + R bid × 𝑏𝑎𝑠𝑖𝑠 QC
swapLHS = Sbid − 1
1 + RBC
offer × 𝑏𝑎𝑠𝑖𝑠
BC
QC
1 + R offer × 𝑏𝑎𝑠𝑖𝑠 QC
swapRHS = Soffer − 1
1 + RBCbid × 𝑏𝑎𝑠𝑖𝑠
BC
75
Chapter 6
We can also rearrange the equations above to solve for interest rate from
the swap points and spot price, as follows.
swapLHS + Sbid
RQC
bid = 1 + RBC
offer × basis
BC
− 1 basisQC
Sbid
QC swapRHS + Soffer
R offer = 1 + RBC
bid × basis
BC
− 1 basisQC
Soffer
Soffer
RBC
bid = 1 + RQC
offer × basis
QC
− 1 basisBC
swapRHS + Soffer
Sbid
RBC
offer = 1 + RQC
bid × basis
QC
− 1 basisBC
swapLHS + Sbid
The interest rates derived as above are called the implied interest rates,
which are “free” interest rates prevailing in Eurocurrency market. The “eurocur-
rency” (one word) is different from “euro currency” (two words). The latter is the
lawful currency of European Union while the former is any currency that is out-
side the control of its central bank. Dollar outside the control of Federal Re-
serve is Eurodollar; pound outside the control of Bank of England is Euro-
pound; and so on. Such currency markets are also called Eurodollar market,
offshore currency market and International Banking Facilities (IBF). Eurocur-
rency market developed first for USD and in Europe (whence the name Euro-
dollar) and subsequently for other currencies (whence Eurocurrency). In later
years, such business was increasingly booked through offshore centers like
Cayman Islands, Isle of Man, etc. (whence the name offshore currency mar-
ket). Deregulation in recent years pulled back some of that business back to
on-shore centers, particularly New York, where it is now called IBF. Because
there are no regulations and reserve requirements, the interest rates in Euro-
currency market reflect the “free” interest rates.
The spread in the bid-offer of forward price will be much higher than that in
spot price. The reason is that all the three spreads in the components―spot
price, BC interest rate and QC interest rate―add up in the forward price. We
will illustrate it with the market quotes given at the beginning of Section 6.3 and
using the formula in the previous section. To illustrate the incorporation of ba-
sis in calculations, we assume the spot value date is May 22 and 6-month val-
ue date is November 24; and the basis is actual/365 for EUR and actual /360
for USD. Accordingly, the basis is for EUR is 186/365 and for USD, 186/360.
76
Forward Exchange
Bid Offer Spread

Spot 1.4998 1.5002 0.0004
Swap 0.0078 0.0068 0.0010
Forward (spot + swap) 1.4920 1.4934 0.0014
Note that we can directly add the spot and swap spreads because both are
expressed in the same units: quoting currency units per unit base currency.
6.4. Nature of Swap Points
Spot forex price is the price of an asset and can never be zero or negative. In-
terest rate is the time-value of money and can never be negative. Swap points
are neither the price of n asset nor the time-value of money.
The derivation of swap points consists of the following steps: for each of
the two currencies, convert interest rate into interest amount for the given pe-
riod; translate the base currency interest amount into equivalent quoting cur-
rency amount so that the two interest amounts are now in the same units; find
the difference between the two interest amounts; and express the difference
per unit of base currency. This difference can be positive, negative or zero and
is the difference between prices of non-spot value date and spot value date.
In general, both sides of the two-way swap quote have the same sign (e.g.
+0.0010/+0.0012 or 0.0012/0.0010). The sign indicates whether the swap
points are to be added to or deducted from the spot price. When the interest
rates are the same for both currencies, the swap points should be zero. How-
ever, transaction costs and bid-offer spreads will make the swap points deviate
from zero on either side: negative LHS and positive RHS (e.g.0.0001 /
+0.0001). Note that the quote can never be positive LHS and negative RHS,
which is irrational as shown below. The following table computes the forward
price from spot and swap, assuming that swap quote can be +/ and /+.
Case #1 (+/) Case #2 (/+)

Spot 1.5000 / 1.5005 1.5000 / 1.5005
Swap +0.0010 / 0.0012 0.0010 / +0.0012
Forward 1.5010 / 1.4993 1.4990 / 1.5017
The forward price in case #1 is irrational: its bid is higher than offer. If such
a quote were to exist in the market, everyone will simultaneously buy and sell
on it for arbitrage profit. The forward price in case #2, on the other hand, is ra-
77
Chapter 6
tional and practical. Another way to look at the quotes is to consider the spread
in swap quote. The spread is negative in case #1 at 0.0022, which is irration-
al, while that in case #2 is positive and rational, as follows.
0.0012 (+0.0010) = 0.0022

+0.0012 (0.0010) = +0.0022.
To sum up, if the two-way swap quote has different signs for each sides,
then the only possible structure is /+. In such quotes, the spread is against
the price taker (or asker) in both sides (which is discussed in Section 7.4). We
may note that any bid-offer quote will be always in ascending order in its nu-
merical value (e.g. +10/+11, 10/+11, 11/10, etc.).
6.5. Market Conventions on Forward Exchange
There are three market conventions on quotes for forward exchange. The first
convention is to quote the forex price only for spot value date. For all other
value dates, the swap points are quoted, For example,
Spot 1.5000/10
Spot / 1M +0.0010/+0.0011
Spot / 3M +0.0025/+0.0027
Spot / 6M +0.0049/+0.0053
The price for non-spot value date is derived by algebraically adding the
spot price and swap points.
Non-spot price = Spot price + Swap points
The reason for quoting swap points rather than outright price for non-spot
value dates is the spot price volatility. The spot price, being determined by
demand-supply forces, continually changes, and can change as much as
0.10.5% in a minute and 0.51% in an hour. In contrast, interest rates are not
as volatile: changes are about 0.1 percentage points during the entire day.
Further, changes in interest rates are annualized and when, converted into
changes per day, are insignificant. Since swap points are determined by the
difference in two interest rates, they tend to be fairly constant during the day. It
is therefore convenient to compute the swap points once in a day and use
them throughout. Whenever you are asked to quote a price for a non-spot val-
ue date, quote the swap point (available off-the-shelf) and the on-going spot
price. It will be much faster and convenient.
78
Forward Exchange
The second convention is that the swap points are quoted as whole num-
bers though they are decimal fractions. For example, the swap point of 0.0010
may be quoted simply as 10. In such cases, we convert the whole number into
decimal fraction (or mixed number) by the convention that swap points have as
many decimal places as spot price. Thus, to convert whole number into decim-
al fraction, we divide the former by 10N where N is the number of decimal plac-
es in the spot price. The following shows the conversion of quoted swap points
to their correct numerical value.
Spot price Swap (quote) Divisor Swap (value)

4
0.5775 10.5 10 0.00105
1.2575 10 104 0.0010
12.375 10 103 0.010
37.75 10 102 0.10
110 10 100 10
The third convention is about the sign of the two-way swap quote. If both
sides of the quote have the same sign, then the sign is dropped. If the two
sides have different signs (of which only the case of /+ is possible), then the
signs are explicitly quoted. For example,
+10/+11 is quoted as 10/11

11/10 is quoted as 11/10
11/+10 is quoted as 11/+10
If the signs are dropped, we must assign the signs by following the rule that
any two-way quote must be in ascending order. Thus, the unsigned swap
quote of 11/10 can be only 11/10 (ascending order) and not +11/+10 (des-
cending order). Similarly, 10/11 can be only +10/+11 and not 10/11. An aide
memoire for assigning signs to the unsigned two-way swap quote is “AA-DD”
rule: Add Ascending order, Deduct Descending order. Even if you misplace the
sequence of arithmetic operation and order (“Ascending order Add, Descend-
ing order Deduct”), the rule does not fail you!
6.6. Forex Prices for Short Dates
The prices for the two short dates, cash and tom (see section 3.2 and the foot-
note 6 on page 30), are derived from spot price and swap points, but in a
manner opposite to that for forward dates. For forward outright price, we add
the swap side to the same side of the spot; and for short date outright prices,
79
Chapter 6
we deduct the swap side from the opposite side of spot. Exhibit 6-3 shows the
pairing of swap and spot two-way quotes to derive the non-spot price.
EXHIBIT 6-3: Outright Prices for Short and Forward Dates
FORWARD SHORT
Spot A / B A / B
Swap X / Y X / Y
Derived (A + X) / (B + Y) (A  Y) / (B  X)
Note that swap points have their own sign. If the swap points are quoted
without sign, we must assign the sign to swap quote by using AA-DD rule.
The reason for the reversal of arithmetic operator and reversal of matching
sides is as follows. The swap points are always quoted forward in time: cash to
tom (C/T), tom to spot (T/S), cash to spot (C/S), spot to 1M (S/1M), etc. The
derivation of non-spot outright price (from spot price and swap points) is not
always forward in time. For forward dates, we move forward from spot date,
like swap points. Therefore, we pair the same sides and add them. For short
dates, we move backward from spot date. This is summarized in Exhibit 6-4.
EXHIBIT 6-4: Derivation of Non-spot Outright Prices
Cash Tom Spot 1M.

Time
C/T T/S S/1M

swap
T 1M
non-spot
outright C
80
Forward Exchange
6.7. Swap Points for Broken dates
As explained in section 3.2, only the “standard” forward value dates are quoted
in the market, which correspond to the “standard” tenors in the money market.
They are ON, 1W, 1M, 2M, 3M, 4M, 5M, 6M, 7M, 8M, 9M, 10M, 11M and 1Y.
Even among these standard tenors, not all of them are liquid: only the 1W, 1M,
3M and 6M tenors are liquid.
The value date not belonging to the standard tenors is called broken date,
odd date or cock date. The swap points for broken dates are derived through
linear interpolation from two standard tenors such that one is immediately be-
fore the broken date (“near date”) and other is immediately after the broken
date (“far date”). For example, the swap points for 45-day forward are derived
by interpolating from the swap points for 1M and 2M. Linear interpolation in-
volves connecting the near date and far date by a straight line and finding the
place corresponding to broken date on that straight line. The formula-face of
this technique is as follows.
𝑆3 − 𝑆1
𝑆2 = 𝑆1 + 𝑁2 − 𝑁1
𝑁3 − 𝑁1
where
S1 = swap points for near date

S2 = swap points for broken date
S3 = swap points for far date
N1 = number of days from spot to near date
N2 = number of days from spot to broken date
N3 = number of days from spot to far date
The expression in square brackets gives the swap point per day during the
period from near date to far date. The expression in parentheses is the number
of days between the broken date and the near date. The product of the two
expressions gives the swap points for the period between the broken date and
the near date, which is then added to that for near date so that the final num-
ber is the swap points from the spot date to the broke date. In the interpolation,
we match the same sides of the two swap quotes. That is, we find the differ-
ence between the LHS of far date and the LHS of near date, and between the
RHS of far date and the RHS of near date. The following example illustrates
the derivation of swap points for the broken date. The dates in parentheses are
the value dates.
81
Chapter 6
Spot (Apr 21) 1.5000/1.5005

Swap for S/1M (May 22) 15/16
Swap for S/3M (Jul 25) 38/40
Using the above inputs, we will derive the swap points for S/2M whose val-
ue date is Jun 23. The number of days between spot and far date (N3) is 95;
that between spot and near date (N1) is 31; and that between spot and broken
date (N2) is 64. The quote for swap points for the broken date is:
LHS 15 + [(38  15) / (95  31)]  (64  31) = 26.86

RHS 16 + [(40  16) / (95  31)]  (64  31) = 28.38
Swap for S/2M 26 / 29 (LHS rounded down; RHS rounded up)
6.8. Swap Points for Forward-to-Forward and ‘Turn’ Periods
Forward-to-forward period starts on a forward date (“near date”) and ends on a

still later date (“far date”). Examples of such periods are 1M/3M, 3M/6M, etc.
Swap points for forward-to-forward periods are derived from two spot-based
swap points: spot to near date and spot to far date. If the near date and for-
ward dates are broken dates, then they must be derived first using the proce-
dure in the previous section before forward-to-forward swap points are derived.
The following is the formula to derive them, and Exhibit 6-5 depicts the me-
chanism behind the formula.
LHS: LHS of far date  RHS of near date

RHS: RHS of far date  LHS of near date
EXHIBIT 6-5: Forward-to-Forward Swap Points
Swap: Spot / M-date A / B (near date)
Swap: Spot / N-date C / D (far date)
Swap: M-date / N-date (C  B) / (D  A)
We are pairing the opposite sides of two spot-based swap quotes because
in hedging the forward-to-forward swap, we need to execute opposite actions
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Forward Exchange
(buy-sell swap for one period and sell-buy swap for the other), which will be at
opposite sides of swap quote (explained in the next chapter. The following ex-
ample illustrates the calculation of swap points for forward period.
S / 1M 10 / 12
S / 2M 25 / 28
1M / 2M (25  12) / (28  10) = 13 / 18
The spread in the forward-to-forward swap quote should be equal to the

sum of spreads in the two component swap quotes. In the example above, the
spread is 2 for near date and 3 for far date. Accordingly, the spread in the for-
ward-to-forward quote should be 5, which is the case indeed. The money mar-
ket equivalent of forward-to-forward swap is called forward rate agreement
(FRA): interest rate on a loan/deposit that commences on a future date and
runs until another future date.
‘Turn’ Periods
The “turn” periods are the overnight period between two calendar months or
two calendar years: last day of a month to the first day of next month or last
day of a year to the first day of next year. For certain currencies, such periods
are special because the interest rate tends to be very high for this period due
to regulatory or window-dressing reasons. Accordingly, premium on the cur-
rency for usual periods turns into discount for the turn period. In the mid-
1980s, the interest rate for CHF used to be very high for monthly turn and low
for other periods. As a result, CHF would be in premium for other periods (be-
cause of low interest rate) but in steep discount for the monthly turn (because
of high interest rate). Swap points for turn periods should never be derived
from interpolation but should always be obtained from forward interest rates.
The deregulation of markets and the move towards transparency have made
such Jekyll-and-Hyde phenomenon disappear in most cases.
6.9. Long-term Forward Exchange Prices
Forward exchange market does not go beyond one year for most currencies.
The preferred instruments to manage currency risk for tenors beyond one year
are other derivatives (currency swap, currency futures and currency options).
For few currencies, however, forward market exists beyond one year and up to
two years.
83
Chapter 6
While the arithmetic continues to be the same for tenors beyond one year,
the principle of compounding enters into the calculations. The bond market
convention is to pay interest semi-annually. Incorporating this semi-annual
compounding to meet the hedge requirements, we need to use the exponent
operator instead of multiplication between interest rate (R) and basis. In other
words, the following replacement should be made in the formulas.
basis  N
(1 + R  basis) should be replaced with (1 + R / N)
where N is the compounding frequency in a year. Let us illustrate the calcula-

tion of bid-offer for 2Y forward contract on GBP/USD currency pair, giving the
following inputs.
Spot 1.2995 / 1.3000

2Y interest rate for GBP 2.975 / 3.100
2Y interest rate for USD 1.975 / 2.100
We will assume that the spot and 2Y value dates are, respectively, May 22,
2008 and May 25, 2010; and the compounding frequency and day count basis
are annual and actual/365 for GBP and semi-annual and actual/360 for USD.
Number of days 733

Basis for GBP 733 / 365 = 2.008219
Basis for USD 733 / 360 = 2.036111
2Y bid 2.036111  2 2.008219
1.2595  [(1 + 0.01975 / 2) / (1 + 0.031)
= 1.2721 (rounded down)
2Y offer 2.036111  2 2.008219
1.3000  [(1 + 0.021 / 2) / (1 + 0.02975)
= 1.2790 (rounded up)
Note that the spread between forward bid-offer has increased considerably.
This is because there is a spread of 0.125% in each interest rate, together
constituting 0.25%, which for two years, doubles to 0.5%. And there is spread
in spot and the effect of compounding and day count basis.
6.10. Forward Exchange for Cross Rates
Chapter 5 dealt with the spot arithmetic for cross rates. With the rules defined
there and using the rules developed in this chapter, we will extend the arith-
metic to forward prices and swap points. The following is the procedure.
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Forward Exchange
1. Identify the two underlying rates for the required cross rate. For ex-
ample, if the cross rate is EUR/INR, then the two underlying rates are
EUR/USD and USD/INR.
2. For each underlying rate, get the spot price and swap points for the
required forward period as inputs. If the required forward period is a
broken date, derive the broken date swap points for each underlying
rate, using the procedure described in Section 6.7.
3. Ensure that the forward value dates for each underlying rate is the
same as that for cross rate. If not, using the broken date procedure in
Section 6.7, derive the swap points for the underlying rates.
4. Derive the forward outright price for each underlying rate, using the
procedure described in section 6.5 (or Section 6.6 for short dates).
5. Compute the forward (or short date) outright price for the cross rate
by crossing the two outright rates of underlying rates derived in the
previous step, using the rules described in Section 5.5.
6. To derive the swap points for cross rate, deduct the spot cross rate
from the forward outright cross rate.
Let us illustrate the above procedure for JPY/INR cross rate, separately for
cash value date (short date) and 2M forward value date, using the following
market inputs. For simplicity, we will assume that the value dates match for all
the three currency pairs.
USD/JPY USD/INR
Spot 98.75 / 98.80 50.78 / 50.79
C/S swap 4/3 1.5 / 2.5
S/1M swap 50 / 48 15 / 16
S/3M swap 136 / 130 37 / 40
Note that the swap points above are quoted as whole numbers and without
sign. Using the market conventions defined in Section 6.5, we need to divide
2
the swap points by 10 (because the spot is quoted up to two decimal places)
to convert them into their correct decimal fraction. Further, the sign for swap
points is minus for USD/JPY (because the two-way quote is in descending or-
der) and plus for USD/INR (because the two-way quote is in ascending order).
Cash value date
The cash outright rates are derived by deducting the swap points from the spot
price, pairing the opposite sides (see Section 6.6), as shown below.
85
Chapter 6
USD/JPY USD/INR
Spot price 98.75 / 98.80 50.78 / 50.79
C/S swap 0.04 / 0.03 +0.015 / +0.025
Cash price 98.78 / 98.84 50.755 / 50.775
To check that calculations are correct, ensure that the spread in the cash
outright price is equal to the sum of spreads in the spot and swap. Our calcula-
tions conform to it. The next step is to compute the cross rate by crossing the
two underlying rates, using the rules of Section 5.5. Our example is a case of
“both currencies in the cross rate are quoting currencies in their source rates.”
The rule for this case is to divide the USD/INR rate by USD/JPY rate, by pair-
ing the opposite sides.
JPY/INR cash bid = 50.755 / 98.84 = 0.513507

JPY/INR cash offer = 50.775 / 98.78 = 0.514021
The market convention for JPY/INR rate is to keep the base currency
amount at 100 units instead of one unit. Applying the convention and rounding
down the bid and rounding up the offer to two decimal places, the JPY/INR
cross rate for cash value date is 51.35 / 51.41. To determine the swap points,
we need to compute the cross rate for spot and then deduct the cash price
from the spot price. The spot for cross rate is, for 100 units of JPY, is (with bid
rounded down and offer rounded up):
JPY/INR spot bid = (50.78 / 98.80)  100 = 51.39

JPY/INR spot offer = (50.79 / 98.75)  100 = 51.44
The swap points for C/S are derived by reversing the calculations in the
box above.
Swap LHS = Spot offer  Cash offer = 51.44  51.41 = +0.03

Swap RHS = Spot bid  Cash bid = 51.39  51.35 = +0.04
Using the market conventions of dropping the sign and quoting the whole
numbers, we write that C/S swap for JPY/INR is 3/4.
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Forward Exchange
2M forward value date
The inputs do not contain the 2M swap points, and therefore we need derive
the swap points for the broken period. Assuming that the 2M value date is ex-
actly half way between 1M and 3M values dates, the swap points for 2M are:
LHS RHS
USD/JPY 50 + (136  50) / 2 = 93 48 + (130  48) / 2 = 89
USD/INR 15 + (37  15) / 2 = 26 16 + (40  16) / 2 = 28
Using the market conventions on signs (i.e. AA-DD rule) and decimal plac-
es, the correct numerical value of swap points are:
USD/JPY USD/INR
S/2M swap 0.93 / 0.89 +0.26 / +0.28
The 2M forward outright price from spot price and swap points are:
USD/JPY USD/INR
Spot price 98.75 / 98.80 50.78 / 50.79
C/S swap 0.93 / 0.89 +0.26 / +0.28
Cash price 97.82 / 97.91 51.04 / 51.07
Check the correctness of calculations by ensuring that the spread in for-

ward price is equal to the sum of spreads in spot price and swap points. The
next step is to perform the cross rate arithmetic, as earlier.
Bid Offer
JPY/INR (51.04 / 97.91)  100 = 52.12 (51.07 / 97.82)  100 = 52.21
The swap points are derived by deducting the spot price from the forward
price, using the same sides.
Bid Offer
S/2M 52.12  51.39 = +0.73 52.21  51.44 = +0.77
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Chapter 6
Using the market convention of dropping the sign and quoting the whole
numbers, the swap points for S/2M period are 73/77.
6.11. Forward Exchange: Theory versus Practice
Let us now discuss various propositions that relate spot price, forward price, in-
terest rate and inflation rate. There are four such propositions: covered interest
parity, international Fisher effect, purchasing power parity and unbiased future
spot price. In all the equations below, the period is assumed to be one year.
Covered Interest Parity (CIP)
Also called interest rate parity (IRP), it links the interest rates (R), spot price (S)
and forward price (F) in the following relation.
1 + 𝑅QC
𝐹=𝑆
1 + 𝑅BC
where the subscripts QC and BC indicate the quoting currency and base cur-
rency, respectively. The equation says that the forward price is determined by
spot price and two interest rates. CIP is the most important because it has no
assumptions about future and is solely based on current market inputs. In oth-
er words, if it is violated, there will be scope for arbitrage profit, as explained in
Section 6.1. This practical face of CIP is called covered interest arbitrage
(CIA), which is the basis of all arithmetic in the previous chapter.
CIP holds even if the causality is reversed between interest rates and for-
ward price. For example, during the ERM crisis of the early 1990s, GBP was
under severe bear attack by speculators, who short-sold GBP in spot and
funded it by borrowing GBP in the Eurocurrency market. The falling price of
GBP (cause) resulted in its rising interest rate (effect). The short-term interest
rates rose as high as 50% pa, but the CIP held. When there are controls to re-
strict the movement of capital between different countries (or where the Euro-
currency market is not liquid), CIP may not hold, and the forward price will be
determined by expectations about future spot price. This condition is called
uncovered interest parity (UIP), and was observed during ASEAN currency cri-
sis in the late 1990s.
Fisher Equation (FE) and International Fisher Effect (IFE)
Fisher equation relates the nominal interest rate (R), inflation rate () and real
interest rate () within a country as follows.
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Forward Exchange
1+𝑅 = 1+E 𝛼 × 1+𝛽
where E is the expectation operator. Fisher equation postulates that the no-
minal interest rate (i.e. current rate prevailing in the market) is determined by
the expected future inflation rate. If the capital flows are freely allowed, arbi-
trage ensures that the real rates will be the same in every country, which in
turn supposes that the nominal rates will adjust to reflect the expected inflation.
The international version of Fisher equation, the IFE, postulates the following.
1 + 𝑅QC
E 𝑆𝑇 = 𝑆
1 + 𝑅BC
The equation states that the expected future spot price is determined by
the current interest rates: currency with lower rate will appreciate and that with
higher rate will depreciate. Unlike CIP, IFE does not provide scope for arbi-
trage profit on its violation because it deals with expectations, which differ
among market participants and change over time. The action based on expec-
tations is speculation, not arbitrage, which does not guarantee profit.
Purchasing Power Parity (PPP)
There are two versions of PPP, and the relevant version to our topic is the
relative PPP (RPPP), which postulates that expected future inflation rates ()
will determine the future spot price (ST): currency with higher inflation rate will
depreciate because of the loss of purchasing power; and that with lower infla-
tion rate will appreciate because of gain in its purchasing power.
1 + E 𝛼QC
E 𝑆𝑇 = 𝑆
1 + E 𝛼BC
Like IFE, PPP deals with expectations and therefore provides for only
speculation, not arbitrage, if it is violated in the market.
Unbiased Future Spot Price (UFSP) Theory
Unbiased future spot price (UFSP) theory links the current forward price and
the expected future spot price. It postulates that the current forward price is the
unbiased estimate of future spot price. The “unbiased” here means that it holds
on an average but may overshoot and undershoot on occasions. The action
based on averages rather than specifics is speculative, not arbitrage.
89
Chapter 6
Exhibit 6-6 puts together all the relations between prices and rates. The
boxes in the first column represent the current state of the world. The shaded
boxes are the current market prices and rates and the un-shaded boxes are
the expectations about future. The second column represents the future state
of the world, which is an expectation. To generate arbitrage profit, the action
must be based on shaded boxes.
EXHIBIT 6-6: Parities between Prices and Rates
CURRENT FUTURE
Time
Expectation of
future inflation
RPPP
FE
Current nomin- IFE Future spot

al interest rates price
CIP
Current forward UFSP

Price
6.12. Non-deliverable Forward (NDF)
In some emerging market economies, there are restrictions on foreigners from

freely dealing in the local currencies. In particular, foreigners are not allowed to
sell the local currency for forward delivery because such deals are considered
speculative and destabilizing. Non-deliverable forward (NDF) was the re-
sponse to such controls and developed in offshore centers of Singapore and
Hong Kong for certain currencies of Asia and Latin America to provide hedging
and speculative opportunities for foreigners in these currencies.
NDF differs from conventional forward in two features. First, the trade is be-
tween two parties resident outside the country of the NDF currency and
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Forward Exchange
booked in an offshore center. Second, settlement must bypass the NDF cur-
rency, and involves cash settlement method (explained below) and in a con-
vertible currency.
There are two settlement methods for derivatives: physical and cash. In the
former, the two currencies are separately settled in their respective settlement
centers. In the latter, settlement involves only one currency and the settlement
amount is the change in value between trade date and settlement date. Let us
illustrate them with the USD/INR example in which Party A has bought USD
100 @ 50.25 from Party B. In physical settlement, Party A would receive USD
100 and pay INR 5,025 on the settlement date. In cash settlement, the trade
price is compared with the prevailing market price at the time of settlement
(“settlement price”), and their difference is settled. The party to whom the dif-
ference is negative will pay it to the other. Thus, if the settlement price is
51.75, the difference is INR 1.50 per unit of USD or INR 150 for the trade,
which is positive for Party A and negative for Party B. Accordingly, the latter
pays it to the former. Exhibit 6-7 illustrates the physical and cash settlement.
EXHIBIT 6-7: Physical and Cash Settlement
PHYSICAL SETTLEMENT CASH SETTLEMENT
USD 100 INR 150

A B A B
INR 5,025
To sum up, physical settlement settles the value, involving two flows in op-
posite direction; and cash settlement settles the change in value, involving only
one flow, representing the profit/loss on the trade. If the deal currency is base
currency, the settlement amount will be in quoting currency; and if the deal cur-
rency is quoting currency, it will be in base currency.
Cash settlement is invented to eliminate the settlement risk for one party
and greatly reduce it for the other. In the example above, with physical settle-
ment, the settlement risk is USD 100 for Party A and INR 5,025 for Party B;
and with cash settlement, the settlement risk is eliminated for Party B and re-
duced to INR 150 for Party A.
91
Chapter 6
NDF is a forward with compulsory cash settlement, but has one more addi-
tional settlement feature, which is to translate the settlement amount (i.e.
change in value) to another currency (“settlement currency”) in which it is set-
tled. All NDF currencies are quoted against USD and in direct style of quota-
tion: USD is the base currency and NDF currency is the quoting currency.
Since USD is fully convertible on capital account, the change in value is con-
verted into equivalent USD amount and settled in New York. In the above ex-
ample, the change in value is INR 150, which is converted into equivalent USD
at the prevailing price of 51.75.
INR 125 / 51.75 = USD 2.42,
which is the settlement amount for the NDF trade.
The controls on capital movement between two money markets impose

uncovered interest parity in both on-shore forward and NDF. The forward price
is determined by expectations about the future spot price (ST). In the on-shore
forward market, residents are allowed covered interest arbitrage to a limited
extent, particularly for the transactions backed by international trade and
commerce, because of which there can be substantial difference between the
price of onshore forward and NDF markets. Some analysts use the CIP formu-
la to price the NDF with the quoting currency interest rate as the implied off-
shore interest rate (I).
1 + 𝐼QC
𝐹=𝑆
1 + 𝑅BC
However, this is incorrect. The “implied interest rate” implies that one can
borrow or lend the currency at the rate implied. We can borrow or lend only
through forex swap and not through forward contract. In Eurocurrency market,
one can trade both money and forex trades (including forex swaps) with physi-
cal delivery and therefore “implied interest rate” is actionable. The NDF market
is not a Eurocurrency market: it trades only the non-deliverable products, and
therefore the interest rate implied in this market is not actionable.
Summary of Key Concepts
Money market is the link between spot and forward exchange (covered interest
parity/arbitrage)
Swap points are the difference in two interest rates, expressed as units of
quoting currency per unit of base currency. Swap points can be positive (pre-
92
Forward Exchange
mium), negative (discount) or zero (par). The interest rates relevant to the for-
ward exchange are the “free” or unregulated rates, typically prevailing in Euro-
currency market.
All forex prices for other than spot value dates are quoted as a combination of
spot price and swap points. For forward value dates, we derive the price by
adding the swap points to the same side of two-way spot quote. For short
dates, we derive the price by deducting the swap points from the opposite side
of two-way spot price.
Swap points for broken dates and forward-to-forward periods are derived from
two-spot based swap quotes. Swap points for „turn‟ periods are derived from
forward interest rates.
Parities between prices and rates: CIP, IFE, PPP and UFSP
Non-deliverable forward (NDF) and uncovered interest parity
EXERCISES
The following are the market quotes for spot and swap for different currency
pairs.
EUR/USD AUD/USD USD/JPY USD/CHF

Spot 1.2595/00 0.7364/68 99.97/02 1.1235/42
C/S 1/0.5 1/0.5 2.5/2.0 1/+1
S/1M 12/11 13/12 30/29 5/4
S/3M 31/29 32/30 85/83 13/12
S/6M 55/52 58/56 165/160 25/23
Convert the swap points into their proper numerical values with signs. As-
sume the following values dates: Spot = Mar 10; 1M = Apr 13; 2M = May 10;
3M = Jun 14; 4M = Jul 11; 5M = Aug 10; and 6M = Sep 12. Assume further
that the value date for a period is the same for all currency pairs. Work out the
solutions for the following.
1. What is the cash outright bid-offer for all the four underlying currency
pairs?
2. What is the tom outright bid-offer for all the four underlying currency
pairs?
93
Chapter 6
3. What is the cash outright bid-offer for the following cross rates:
EUR/AUD, EUR/JPY, AUD/CHF and CHF/JPY?
4. What is the S/5M swap quote (bid and offer) for all the four underlying
currency pairs?
5. What is the S/2M swap quote (bid and offer) for the four cross rates in
question #3?
6. What is the 48-day swap quote all the four underlying currency pairs?
7. Assuming that the 3M USD interest rate is 1.950/2.075%, what are
the 3M implied interest rates (bid and offer) for EUR, AUD, JPY and
CHF?
94
Chapter 7
Forex Swaps
In the global forex market, the turnover of FX swaps greatly exceeds spot
transactions: $1.7 trillion versus $1.0 trillion a day in April 2007. (Triennial
Central Bank Survey 2007, BANK FOR INTERNATIONAL SETTLEMENTS)
[In Asian markets] … one indication of the importance of FX swap market as a

source of interbank funding is the use of swap-implied rates as the reference
rate for interest rate swap contracts instead of interbank rate fixings as used in
USD, EUR and JPY. (Working Paper No 252, May 2008, BANK FOR INTERNA-
TIONAL SETTLEMENTS )
In developed markets, the money market establishes the swap points and fo-
rex swap, as explained in the previous chapter. In emerging market econo-
mies, the cause-and-effect is reversed: the forex swap acts as a substitute for
money market, and is used for local currency funding and to establish (implied)
interest rate benchmarks for the local currency.
7.1. Forex Swap: Recap
Let us recap the main points about forex swaps from Section 4.2. Forex swap
is simultaneous borrowing in one currency and lending in another of equivalent
amounts for a given period, and the two money trades are combined into a fo-
95
Chapter 7
rex swap (see Exhibit 4-3). The transaction is structured as simultaneous buy
and sell of a currency for two different value dates against another currency.
The trade that is settled first is called the near leg and the other trade as far
leg. The buy (in near leg)-sell (in far leg) corresponds to borrowing and the
sell-buy corresponds to lending.
The near leg corresponds to the exchange of principals and the rate of ex-
change is linked to the market price relevant to the near leg value date. The far
leg corresponds to the re-exchange of principals and exchange of interest
amounts in base currency and quoting currency. The former is converted into
quoting currency and then netted with the interest amount in quoting currency.
The net interest amount is expressed as quoting currency units per unit base
currency, and is called the swap points. The price for the far leg is the sum of
near leg price (representing the principal rate of exchange) and swap points
(representing the net interest amount exchange).
7.2. Swap Points and Forex Swaps
Swap points are sometimes erroneously referred to as the swap “price” or

“rate”. As explained in Section 6.4, swap point are not a price (a la spot price)
or a rate (a la interest rate). It is the difference between two interest amounts
and can be positive, negative or zero. Swap points are used in practice for two
distinct purposes.
First, they are used in conjunction with spot price to derive the non-spot
outright price, as discussed in the previous chapter. In these operations, the
action is to buy or sell and the sides of swap and spot two-way quotes must be
correctly matched. In other words, the spread in the derived outright price will
be equal to the sum of spreads in the swap and spot quotes.
Second, swap points are used in cash and liquidity management. In these
operations, we do not buy or sell, but do buy-sell (i.e. borrowing) or sell-buy
(i.e. lending). Though we still need the spot price to determine the equivalent
amounts of two currencies, the spread in spot quote should not matter be-
cause we are not buying or selling. Forex swap is simultaneous borrowing and
lending in two currencies, and therefore only the spread in the bid-offer of in-
terest rates, which is captured in the swap quote, alone should matter. Accor-
dingly, we select an appropriate side of swap quote (depending on whether we
are borrowing or lending) and then match it with any side (i.e. bid, offer or mid)
of spot quote without incorporating the spread in spot quote. This will be dis-
cussed further and illustrated in Section 7.4 of this chapter.
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FX Swaps
7.3. Anatomy of Two-way Swap Quote
The two actions or market sides of the swap quote are borrowing, which is
structured as buy-sell (B-S); and lending, which is structured as sell-buy (S-B).
The questions that arise with two-way swap quote are: which side is for buy-
sell and sell-buy, in which currency, and for which party? Let us consider two
logical facts. The first is to determine whether the interest rate difference is in
our favor or against us.
When we B-S a currency with lower interest rate, it implies that:

we borrow the currency with lower interest rate and lend the
currency with higher interest rate; and that
the interest rate difference, which is captured as swap points, is
in our favor: we “receive” it.
When we B-S a currency with higher interest rate, it implies that:
we borrow the currency with higher interest rate and lend the
currency with lower interest rate; and that
the interest rate difference, which is captured as swap points, is
against us: we “pay” it.
Similarly, when we S-B a currency with lower interest rate, the swap points
are against us (we “pay” it); and when we S-B a currency with higher interest
rate, the swap points are in our favor (we “receive” it). We may note that the
swap points we receive or pay in a swap is not profit and loss, respectively, but
the net gain and cost in borrowing and lending. Swap does not create position
but it does create gap in cash flows. The gain/cost in swap will be offset when
the gap is eliminated through borrowing/lending.
The second logical fact is that the bid-offer spread in any two-way quote is
always to the advantage of the quoter (i.e. price maker) and against the asker
(i.e. price taker). It follows that when the quoter receives the swap points, the
he will receive the higher of the two sides; and when he pays, he will pay the
lower of the two sides. For the asker, the opposite is true: when he pays, he
pays the higher; and when he receives, he receives the lower.
The two logical points guide us to identify which side is for which swap type
(B-S or S-B) for which party (quoter or asker). Consider the swap quote of
10/11 for USD/INR. We know that USD‟s interest rate is lower than INR‟s. If we
do B-S swap in USD, then we borrow USD (paying lower interest rate) and
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Chapter 7
lend INR (receiving higher interest rate); and we should receive the swap
points to reflect the interest rate advantage. If we are the quoter, we should re-
ceive 11 (the higher); and if we are the asker, 10 (the lesser). Similarly, if we
do S-B swap in USD, we should pay the swap points and pay 10 as the quoter
but pay 11 as the asker.
Thus, if we know which currency has higher interest rate, then we can de-
termine which side of the swap quote is for B-S or S-B for a given party and in
a given currency. But how do we know which currency has higher interest
arte? The structure of the swap quote itself indicates the relative levels of two
currencies. There are two currencies in a forex trade, which are, alphabetically,
base currency (BC) and quoting currency (QC). There are two sides to the two-
way quote, which are, alphabetically, left-hand side (LHS) and right-hand side
(RHS). Associate the first side of swap quote with the first currency, and the
second side with the second currency. If the first side (i.e. LHS) of the quote is
higher, then the first currency (i.e. BC) has the higher interest rate, and vice
versa.
BC QC BC QC
10 / 11 11 / 10
LHS RHS LHS RHS

QC has higher rate BC has higher rate
The thumb rule works only when the swap points are quoted without the
signs or when both the sides have the same sign. In the latter case, we drop
the signs and consider the absolute values of swap quote. If the swap quote
has different signs (of which only the /+ case is possible, as explained in Sec-
tion 6.4), the rule above does not work. Let us formulate an aide memoire that
works in all cases, and it is
1 = 1 = 1= 1.
The following is the explanation of the 1=1=1=1 rule.
Two currencies in a pair. Alphabetically, they are: (1) BC (2) QC

Two parties to a trade. Alphabetically, they are: (1) Asker (2) Quoter
Two types of FX swaps. Alphabetically, they are: (1) B-S (2) S-B
Two sides to a quote. Alphabetically, they are: (1) LHS (2) RHS
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FX Swaps
Associate all the first sides (1 = 1 = 1 = 1): on the 1st currency, the 1st party
does the 1st swap type on the 1st side of the swap quote. From this, all other
operations can be worked out. For example, what is B-S for one party is the S-
B for the other party in the same currency at the same side of the quote; what
is B-S in BC is also the S-B in QC for the same party at the same side; and so
on. (Note that similar rule in Sec. 2.9 has different names and should not be
mixed up with the rule here). Exhibit 7-1 illustrates the 1=1=1=1 rule.
EXHIBIT 7-1: Who does what and in which currency and at which side?
BASE CURRENCY (1) QUOTING CURRENCY

ASKER (1) ASKER
B-S(1) S-B S-B B-S
(1=1=1=1)
10 / 11 10 / 11
(2=2=2=2)
S-B B-S B-S S-B (2)
QUOTER QUOTER (2)
BASE CURRENCY QUOTING CURRENCY (2)
The top left-hand corner corresponds to the 1=1=1=1 rule, and its opposite
diagonal corresponds to the equivalent 2=2=2=2 rule.
7.4. Fixing the Prices for Near and Far Legs
The previous section explained the structure of two-way swap quote and which
swap type can be executed at a given side of the quote. The next step is to
transform the given swap points into trade prices for the two legs of swap.
The near leg represents the exchange of principal and therefore its price
must be that relevant to its value date. For example, if the near leg is for deli-
very spot, then spot price will be the price for near leg; if it is for delivery cash,
it will be the cash price; and so on. The far leg represents the re-exchange of
principal (which must be at the same rate of exchange as in near leg) and the
net interest amount (which is the swap points). Therefore, the price for far leg
should be the algebraic sum of the price for near leg and the swap points. Note
that the swap points have their own sign, and if the swap points are quoted
without sign, then we must assign the signs, using the AA-DD rule (Add As-
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Chapter 7
cending order, Deduct Descending order), as explained in Section 6-5. Let us

illustrate the transformation of swap points into trade prices with the following
market quotes for EUR/USD.
Spot 1.2500 / 1.2505

C/S swap 1/+1
S/1M swap 4/5
S/3M swap 11 / 12
EXAMPLE #1: Asker does B-S swap in EUR for S/1M
At what difference: 4 (because of 1=1=1=1 rule)
Paid or received: The spread is against the asker: he will receive the lesser
and pay the higher. Since 4 is the lesser side of the quote, asker receives it.
Price for the near leg: Near leg is for spot, and the spot price is applied. Which
side of the spot price? It does not matter, as explained in Section 7.2. We can
take either bid or offer or mid price. Note that we are not buying or selling, but
only borrowing and lending, for which the asker has already paid the spread in
the swap quote (by way of receiving the lesser amount in this example). We
can select either 1.2500 or 1.2505 or some value between them. Generally, it
is so chosen that the far leg price is a round number, as explained below.
Price for the far leg: it is the algebraic sum of near leg price and swap points.
Before we sum them, we must convert the swap points in to their proper nu-
merical value and assign signs (as explained in Section 6.5). Since the spot
price is quoted up to four decimal places, the swap quote of 4/5 has the nu-
merical value of 0.0004/0.0005. Since it is in ascending order, it has to be
added or has a positive sign (i.e. +0.0004). If the near leg price is 1.2500, then
far leg price will be 1.2504; if the near leg price is 1.2505, the far leg price will
be 1.2509; if the near leg price is 1.2501, the far leg price will be 1.2505; and
so on. The last pair of prices (1.2501 and 1.2505) is likely to be chosen be-
cause it results in a round number for the far leg price. We can now formally
record the forex swap trade as follows (from the asker‟s perspective), assum-
ing that the deal amount is EUR 100.
Near leg: Bought EUR 100 @ 1.2501 against USD value spot
Far leg: Sold EUR 100 @ 1.2505 against USD value 1M
In the swap above, the sell price is higher than buy price by 0.0004, result-
ing in gain. This, of course, is the swap points at which we did the B-S swap.
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FX Swaps
EXAMPLE #2: Quoter does S-B swap in USD for C/S
Note that the swap points are quoted with signs because the two sides have
different signs.
At what difference: +1 (because of 2=2=2=2 rule)
Paid or received: Whenever the swap quote has /+ signs, the quoter “rece-
ives” and the asker “pays” on either side. Accordingly, the quoter received the
difference of +1.
Price for the near leg: Near leg is for delivery cash, for which there is no mar-
ket quote. The cash outright price has to be derived from spot and C/S swap
quotes, using the procedure described in Section 6.6: deduct the swap from
spot, pairing the opposite sides. This gives us the cash outright price of
1.2499/1.2506. The spread in cash outright quote must be equal to the sum of
spreads in spot and swap quotes, which is the case indeed. We can now
choose either 1.2499 or 1.2506 or a value between them as the price for near
leg. We will choose 1.2499 (so that the far leg price would be a round number,
as shown below).
Price for the far leg: We must convert the swap points in to their proper numer-
ical value, which is +0.0001. We need not assign the sign because it is already
given in the market quote. The far leg price is the algebraic sum of near leg
price and swap point, which is 1.2499 + 0.0001 = 1.2500. We can now formally
record the forex swap trade as follows (from the quoter‟s perspective), with the
deal amount of EUR 100.
Near leg: Sold USD 100 @ 1.2499 against USD value cash
Far leg: Bought USD 100 @ 1.2500 against USD value spot
The deal currency is quoting currency in this example and „bought high and
sold low‟ (or took more and gave less USD per unit EUR). This is a profit of
USD 0.0001 per EUR, which corresponds to the “receiving” of 1 in swap.
Note that in the above example, if the quoter does B-S swap in USD (which
is S-B swap in EUR), it would be at the difference of 1, which the quoter will
receive and the asker will pay (because in +/ quote the quoter receives and
the asker pays on both sides). The parties are likely to choose the price of
1.2501 for near leg so that the far leg price would be a round number of
1.2500. Another point to be noted is that, if the signs are dropped from swap
quote (e.g. 1 / 2), then assign the signs using the AA-DD rule.
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Chapter 7
EXAMPLE #3: Asker does B-S swap in EUR for 1M/3M
The swap period is forward-to-forward, which is not quoted in the market. It

has to be derived from the two spot-based quotes of S/1M and S.3M, using the
procedure described in Section 6.8.
Let us first convert the S/1M and S/3M swap points into their proper numer-
ical value and assign them the signs. Given that spot is quoted up to four de-
cimal places and swap points are in ascending order, the signed numerical
value of swap points for S/1M and S/3M are:
S/1M +0.0004 / +0.0005

S/3M +0.0011 / +0.0012
The swap points for 1M/3M forward-to-forward points are computed as:
LHS / RHS
S/3M LHS  S/1M RHS / S/3M RHS  S/1M LHS
= 0.0011  0.0005 / = 0.0012  0.0004
= +0.0006 / = +0.0008
The reason for pairing the opposite sides is to eliminate the gap in cash
flows. Consider that we want to do B-S swap for 1M/3M period. This is engi-
neered by doing two spot-based swaps of opposite types. For the longer pe-
riod (S/3M), the swap type has to be the same as that for the required forward-
to-forward swap (B-S in our example); and for the short period (S/1M), it has to
be the opposite swap type (S-B in our example).
S/3M Near leg Bought EUR 1 @ 1.2500 value spot on EUR/USD

swap Far leg Sold EUR 1 @ 1.2511 value 3M on EUR/USD
S/1M Near leg Sold EUR 1 @ 1.2500 value spot on EUR/USD
swap Far leg Bought EUR 1 @ 1.2505 value 1M on EUR/USD
The two swaps will create a gap that exactly matches the desired forward-
to-forward swap. This is illustrated by the following cash flows table.
Value Date EUR USD Remark

Spot +1 1.2500 S/3M swap – Near leg
1 +1.2500 S/1M swap – Near leg
Gap 0 0 No gap
1M +1 1.2505 S/1M swap – Far leg
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FX Swaps
Gap +1 1.2505 EUR surplus/USD deficit

3M 1 +1.2511 S/3M swap – Far leg
Gap 1 +1.2511 EUR deficit/USD surplus
We can now logically proceed as earlier.
At what difference: +0.0006 (because of 1=1=1=1 rule, which can be also seen
from the cash flows table as the difference between the USD cash flows at 1M
and 3M)
Paid or received: Asker receives the lesser side and pays the higher side.
Since the difference of 6 is the lesser, the asker receives it. It is also confirmed
by the cash flows table: the net cash flow in USD is inflow at +0.0006.
Price for the near leg: Near leg is for delivery 1M, for which we have no market
quote. It has to be derived by adding S/1M swap to spot and pairing the same
sides (see Exhibit 6.3). This gives us the 1M outright price of 1.2504/1.2511.
The spread in 1M outright quote must be equal to the sum of spreads in spot
and swap quotes, which is the case indeed. We can now choose either 1.2504
or 1.2511 or a value between them as the price for near leg. We will choose
1.2504 so that the far leg price will be a round number.
Price for the far leg: The far leg price is the algebraic sum of near leg price and
swap point, which is 1.2504 + 0.0006 = 1.2510. Note that the cash flow table
above has taken the prices of 1.2505 and 1.2511, which is also acceptable.
The condition is that the difference between the prices of two legs should be
+0.0006, which is the contracted swap points. We can now formally record the
swap trade as follows (from the asker‟s perspective), with the deal amount at
EUR 1.
Near leg: Bought EUR 1 @ 1.2504 (or 1.2505) against USD value 1M
Far leg: Sold EUR 1 @ 1.2510 (or 1.2511) against USD value 3M
7.5. Cash Management with Forex Swaps
Forex swap, being simultaneous borrowing and lending in two currencies, is a

cash management tool. It is the forex-equivalent of repo in money market.
The working cash balances for forex operations are held in what is called
nostro account (see Box 7-1) with another bank (“nostro agent” or “correspon-
dent bank”) in the country of the currency. How do we fund the nostro account
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Chapter 7
with working balances? There are three ways: buy the foreign currency with
local currency, borrow the foreign currency and do a B-S swap in foreign cur-
rency against the local currency. The first is dangerous, the second is possible
but not efficient, and the third is the practical and efficient solution.
Buying the foreign currency for funding nostro account is ruled out because
it creates long/overbought position, exposing us to currency risk. Borrowing the
foreign currency does not create position and therefore acceptable, but the
problems is the availability of credit lines. The fact that we can borrow from on-
ly those with whom we have the credit line restricts the counterparties from
whom we can borrow. There is also narrow scope for rate negotiation since in-
terest rates are counterparty-specific, unlike asset prices, which are uniform for
all market participants. Forex swap is a collateralized borrowing and therefore
can be executed with every market participant on finer terms.
BOX 7-1: Nostro, Vostro and Loro Accounts
Nostro is Italian for “our” and therefore nostro account is simply “our” ac-
count maintained with the nostro agent. When you refer to this account in
correspondence with the nostro agent, you say nostro account (and not
“our nostro” account, which is tautological). When the nostro agent rep-
lies, he would refer to the account as vostro (Italian for “your”) account.
When the same nostro agent also maintains a local currency account
with you in a reciprocal relationship, there could be potential confusion:
your account with him is nostro for you and vostro for him; and his account
with you is vostro for you and nostro for him.
The loro (Italian for “their”) account is a third party‟s account with the
nostro agent. You will use it when referring to a third party‟s account with
the nostro agent.
Why Italian words? Like forex money-changing (see Box 6-1), the
modern banking institutions were established by Italians in the city-states
of Genoa, Venice and Florence during the fifteenth century.
Consider now the “float” (i.e. temporary surplus funds) in the nostro ac-
count. We have three alternatives to use the float funds: sell the currency, lend
the currency or S-B swap the currency. The first creates position and therefore
is risky; the second creates credit risk and therefore we will be selective about
the borrower; and the third creates neither price risk nor credit risk.
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FX Swaps
Forex swaps are required to support most commercial transactions. For

example, bills under import letter of credit (L/C) will be debited to the nostro
account before they are retired by the importer-customer. Until the retirement
of the bill, the nostro debit has to be funded through B-S swap in the currency
of nostro account. Similarly, foreign currency bills discounted by the bank are
paid prior to or later than the expected due date. In all such cases, forex swap
becomes handy to adjust the gap in cash flows. We will examine those cases
with examples in the next chapter.
Forex swap is simultaneous borrowing and lending in two currencies: it is the

forex equivalent of repo in money market.
Forex swap is a cash management tool, not a risk management tool.
The actions or market sides of forex swap are buy-sell (B-S) and sell-buy (S-
B), which correspond to borrowing and lending, respectively. Since every forex
trade has two currencies in a complementary way, the B-S in one currency is
also S-B in the other for equivalent amount.
The difference in the price of near leg and far leg is the swap points, which
represents the net interest amount payable or receivable in the swap. This dif-
ference is expressed in the same style as forex price: amount of quoting cur-
rency per unit of base currency.
An aide memoire for operations on two-way swap quote is “1=1=1=1.”
EXERCISES
The following are the market quotes for spot price and swap points.
EUR/USD AUD/USD USD/JPY USD/CHF

Spot 1.2595/00 0.7364/68 99.97/02 1.1235/42
C/S 1/0.5 1/0.5 2.5/2.0 1/+1
S/1M 12/11 13/12 30/29 5/4
S/3M 31/29 32/30 85/83 13/12
S/6M 55/52 58/56 165/160 25/23
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Chapter 7
1. In the following trades, specify: (1) the swap points for the trade; (2)
whether the swap points are “paid” or “received”; and (3) the prices for the
near leg and far leg of swap. Note that “You” = Asker and “Market” = Quo-
ter in the following questions.
A. EUR/USD: S-B swap in EUR for C/S period

B. EUR/USD: B-S swap in EUR for S/3M period
C. EUR/USD: B-S swap in EUR for 1M/3M period
D. EUR/USD: S-B swap in USD for 2M/6M period
E. AUD/USD: S-B swap in USD for S/6M period
F. AUD/USD: B-S swap in AUD for C/S period
G. AUD/USD: S-B swap in AUD for 2M/6M period
H. USD/JPY: S-B swap in JPY for S/6M period
I. USD/JPY: B-S swap in USD for C/S period
J. USD/JPY: B-S swap in JPY for 3M/6M period
K. USD/JPY: S-B swap in USD for 2M/4M period
L. USD/JPY: S-B swap in JPY for S/45 days period
M. USD/CHF: B-S swap in CHF for C/S period
N. USD/CHF: S-B swap in CHF for C/S period
O. USD/CHF: S-B swap in USD for C/S period
P. USD/CHF: B-S swap in USD for C/S period
Q. USD/CHF: B-S swap in CHF for 2M/3M period
R. USD/CHF: B-S swap in USD for 1M/3M period
2. Using the underlying rates given before, compute the two-way quote for
swap points for the following cross rates and for the following periods.
EUR/AUD EUR/JPY AUD/JPY CHF/JPY

C/S
S/1M
S/3M
S/6M
106
Chapter 8
Commercial Transactions
Investment banking business will increase its focus on client and flow trading
businesses… and exit certain proprietary and principal trading activities. (Cre-
dit Suisse, press release, December 4, 2008, Zurich)
Deutsche Bank said…it planned to scale back proprietary trading, while invest-
ing more in “flow” trading…Other banks have weighed or started cuts in pro-
prietary trading, including J P Morgan Chase & Co, the largest US bank by
market value, which is shutting a stand-alone global proprietary trading desk.
(Bloomberg, December 12, 2008, New York)
Forex trades in a bank are accounted in two separate books: proprietary

(“prop”) trading and commercial transactions. Proprietary trading is euphemism
for speculation in which bank maintains a position, which results in profit or
loss. For these transactions, bank does not need a customer: it deals with
another dealer in the market.
Customer transactions are those initiated with customers. The bank is not
exposed to market risk on these transactions, but rather earns margin or
spread or both. If the products are highly standardized, common place and off-
the-shelf (“commoditized”) and the market is competitive, the margins are thin
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Chapter 8
and the bid-offer spread is the primary source of profits. Such customer trans-
actions are called flow trading in which the customer is evolved from client to
counterparty. In fixed-income securities (and institutional equities), where the
market is very competitive because of the presence of investment banks and
brokers in addition to commercial banks, much of the customer business is
flow trading. If the products are customized or the market is not very competi-
tive, banks earn margin in addition to bid-offer spread. Such transactions are
called commercial or merchant transactions. At the present stage, much of the
customer business in the OTC forex market is commercial, with the flow trad-
ing restricted to interdealer business between active and inactive dealers.
Proprietary (“prop”) trading was the fashion in Sales & Trading units of big
banks during the 2000s until the subprime crisis blew it up in 2008. Bitten by
the excessive greed and reckless risk-taking, most banks are now re-focusing
on customer transactions, as evidenced by the quotations at the beginning of
this chapter.
8.1. Features of Commercial Transactions
Commercial transactions differ from interdealer transactions in three features:

transaction type, currency pair and deal currency.
First, commercials transactions are predominantly outright trades and

usually smaller and odd amounts and for broken dates, driven by the underly-
ing import/export requirement. Forex swaps, in most countries, are not allowed
with customers but restricted to interdealer business. Second, the currency
pair in most commercial transactions is a foreign currency against the local
currency. Except in the US, such currency pairs are “cross rates” in the inter-
dealer market and derived by crossing two underlying rates (see Chapter 5).
Third, deal currency in most commercial transactions is foreign currency re-
gardless of whether the currency pair is in direct or indirect style of quotation.
8.2. Classification of Transactions
All commercial transactions are classified at first level into purchase and sale,
the words being understood from the bank‟s perspective and usually with ref-
erence to the foreign currency. Thus, in a “purchase” transaction, the bank
buys the foreign currency from the customer against the local currency.
Purchase and sale transactions are further classified into clean and bill
transactions. Clean transactions are those that do not require handling of trade
108
documents. The customer and the bank simply exchange foreign currency and
local currency with little paperwork. Of course, the transaction must be per-
missible under the exchange controls. Examples of such transactions are re-
mittances and other permissible current account transactions. Bill transactions,
on the other hand, are related to exports and imports and involve scrutiny of
trade documents (e.g. bill of lading, invoice, etc) by the bank. Bill transactions
may be under letter of credit (L/C) or outside it.
Some transactions also involve financing by the bank. In purchase transac-

tions, the financing is in local currency: bank pays local currency before it rece-
ives the equivalent foreign currency. In sale transactions, the financing is in-
volved only in those under L/C: bank pays foreign currency before it receives
the equivalent local currency. Exhibit 8-1 summarizes the transaction types.
EXHIBIT 8-1: Types of Commercial Transactions
1. Purchase
1.1. Clean
1.2. Bill
2. Sale
2.1. Clean
2.2. Bill
Besides the above, there are purchase and sale of bank notes and travel-
ers checks, which are handled more by money-changers than by banks.
In all transactions, banks load margin in the transaction price. In those that
involve financing by the bank, the interest is separately charged, independent
of the exchange margin.
8.3. Market Price and Margin
The prices for commercial transactions are quoted based on hedge (or “cover”)
in the market. If the bank buys foreign currency from the customer, it sells it in
the market at the market‟s bid price. Similarly, to sell foreign currency to the
customer, the bank buys it from the market at the market‟s offer price. Once
the relevant side of bid-offer in market price is determined, the exchange mar-
gin is loaded on to the market price. Whether the margin is to be added to or
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Chapter 8
deducted from the market price will depend on whether it is purchase or sale;
and whether the price is in direct or indirect style of quotation. For this pur-
pose, the quotation style is determined as follows, based on whether the deal
currency is base currency (BC) or quoting currency (QC).
Deal currency is BC: Direct style

Deal currency is QC: Indirect style
Note that the currency pair in commercial transactions is foreign currency

(FC) versus local currency (LC). The deal currency will always be FC regard-
less of whether it is BC or QC. To make profit, the bank must “buy low, sell
high” in direct style; and “buy high, sell low” in indirect style. This principle
guides as whether the margin is to be added to the market price or deducted
from it, as shown below. Note that we have used left-hand side (LHS) and
right-hand side (RHS) for bid and offer, respectively. The reason is that the bid
and offer are always with respect to the BC, but the deal currency, which is the
foreign currency (FC) in commercial transactions, may be BC or QC.
Direct Style (FC/LC) Indirect Style (LC/FC)

(FC = BC) (FC = QC)
Market Price LHS / RHS LHS / RHS
Margin loading “buy low, sell high” “buy high, sell low”
Purchase from custom- LHS  Margin RHS + Margin
er (and sale in market)
Sale to customer (and RHS + Margin LHS  Margin
purchase from market)
8.4. Clean Instruments/Remittances
Clean transactions are purchases and sales on current account without trade
documentation. Of course, the bank must ensure that the transaction is per-
missible under the exchange regulations and that other statutory requirements
(e.g. anti-money laundering) are satisfied. In these transactions, the settle-
ment in local currency takes place immediately (i.e. it corresponds to cash val-
ue date). For settlement in foreign currency: for sales, the bank will remit the
foreign currency on the same day by wire transfer; and for purchases, the bank
must have already have received the foreign currency its nostro account. Such
transactions are called “TT” (for telegraphic transfer) buying and selling in India
because the foreign currency settlement is traditionally through wire transfer.
110
Since the settlement corresponds to cash value date, we must load the
margin on cash outright price rather than spot price. The following example il-
lustrates the calculation of market price and the loading of margin. We will as-
sume that the margin is 0.0010 unit of quoting currency and the deal currency
is the foreign currency (FC).
Direct Style (FC/LC) Indirect Style (LC/FC)

Spot price 1.2500 / 1.2505 1.2500 / 1.2505
Swap: C/S 0.0001 / 0.0002 0.0002 / 0.0001
Cash price 1.2498 / 1.2504 1.2501 / 1.2507
Purchase 1.2498  0.0010 = 1.2488 1.2507 + 0.0010 = 1.2517
Sale 1.2504 + 0.0010 = 1.2514 1.2501  0.0010 = 1.2491
For some purchases, the customer may present to the bank a negotiable
instrument (e.g. check, draft, etc) payable in the foreign country. In such cas-
es, there will be no prior credit in the nostro account, and the transaction can-
not be treated as TT buying. There are two ways to process such transactions.
First, the bank may send the instrument on collection basis to its nostro agent,
who will present it in the local clearing. After the proceeds are realized, the no-
stro agent will credit the amount to the nostro account under advice to the
bank. The bank will then put through the transaction as TT buying, paying the
local currency to the customer at the market rates prevailing on that date.
Second, the bank may at its discretion discount9 the instrument and settle
the local currency immediately with the customer, send the instrument to no-
stro agent and wait until the foreign currency amount is cleared and credited to
its nostro account. In this transaction, the bank is parting away with local cur-
rency amount before it receives the equivalent foreign currency amount. Effec-
tively, the bank has lent the local currency amount to the customer, for which
interest would be charged separately upfront. The bank will assume a transit
time, which varies from country to country, and is about a week, for which in-
terest would be charged. Since the foreign currency would be paid after the
transit time (of a week), the forex price to the transaction should be 1W forward
price. The following USD/INR example illustrates the transaction price and in-
9
In banking, the term purchase or demand purchase is used for financing “sight” instru-
ment (i.e. instrument payable at sight or on demand after presenting it); and the term
discount is used for “usance” or time instrument (i.e. instrument payable after a specified
period from the date of presentation). Since we have used the word “purchase” in the
first-level classification of commercial transaction, we will use the word discount for fi-
nancing of both sight and usance bills to avoid the confusion whether the “purchase” is
related to the market side of the transaction or financing of sight bill.
111
Chapter 8
terest amount for discounting of clean instrument for USD 10,000. We will as-
sume a margin of 0.15 units of quoting currency; transit time of one week; and
INR interest rate of 10% pa
USD/INR spot price 50.48 / 50.49

Swap: S/1W 1 / 2 (to be converted into decimal form)
1W forward outright price 50.49 / 50.51 (“same sides, AA-DD”)
Transaction price with margin 50.49  0.15 = 50.34
Interest for one week 10,000  50.34  10%  7 / 365 = 965
If the instrument is paid on or before seven days, the loan to the customer
will be self-liquidating and the transaction ends. If the instrument is paid after
seven days, the bank will recover additional interest for the excess period
beyond seven days (and there may be swap charges, too, as explained in
Section 8.11). If the instrument is returned unpaid, the bank will make a clean
sale to the customer (and recover local currency amount), which will offset the
earlier clean purchase.
8.5. Export Bill (in Foreign Currency) Transactions
Export bill transactions are purchases for the bank. As explained in footnote 9,
the “purchase” here is with respect to the market side of the transaction and
not related to the financing by the bank. The export bill may be under L/C or
outside it; and it may be a sight bill (i.e. payable immediately after presenting
it) or usance/time bill (i.e. payable after a specified period from the date of
presentation/invoice, etc.).
For bills under L/C confirmed by the bank, the bank will scrutinize the doc-
uments and, if they are in conformity with the L/C terms, the bank will put
through the transaction on the same day for sight bills and on the due date for
usance bills. The bank gets the reimbursement of foreign currency from the
L/C opening bank and pays the equivalent local currency amount at that day‟s
price for cash value date. For scrutinizing documents, the bank will charge
commission and recover all out-of-pocket expenses. For bills outside L/C, the
bank may either send the bill on collection basis or discount it. In case of col-
lection, there will be no forex transaction between the bank and the exporter-
customer until the nostro agent confirms the realization of the bill and credits
the proceeds to the nostro account, when it would be put through as purchase
at that day‟s price for cash value date. The bank will also charge commission
and out-of-pocket expenses. In case of discounting, there is a financing com-
ponent under which bank will lend the local currency to the customer. The
112
bank computes the expected or notional due date (NDD) after considering the
transit time and grace period applicable to the country of the foreign currency.
For certain usance bills, the payment date (PD) is fixed and known in advance
(e.g. 90 days after from the date of bill of lading/invoice, etc). The bank will ap-
ply the forward price applicable to the NDD/PD, and pay the local currency
equivalent at this price on the date of negotiation.
The following example illustrates the calculations for discounting of 90-day

(after sight) export bill for USD 10,000 negotiated on May 22. We will assume
that transit period is seven days; grace period is three days; margin is INR
0.15 per USD; INR interest for discounting is 9% pa; commission is 0.10% on
the bill amount; and handling charges are INR 500.
(a) time to NDD (usance+transit+grace) 100 days

(b) NDD: date after (a) days from May 22 Aug 30
(c) USD/INR spot (May 24) 50.38 / 50.39
(d) Swap: S/3M (Aug 24) 30 / 32
(e) Swap: S/6M (Nov 27) 53 / 56
(f) Swap for broken date (Aug 30) 31 / 34
(g) Outright price for broken date 50.69 / 50.73
(h) Transaction price after margin 50.69  0.15 = 50.54
(i) INR proceeds of the bill 10,000  50.54 = 505,400
(j) Interest cost for 100 days @ 9% 505,400  9%  100/365 = 12,462
(k) Commission @ 0.10% of (i) 505
(l) Out-of-pocket expenses 500
(m) INR payable to exporter (ijkl) 491,933
Note that the interest amount is recovered upfront. In other words, the in-
terest rate is the bank discount rate and not the interest yield. If the bill is paid
on NDD, the loan to the customer will be self-liquidating and the transaction
ends. If the instrument is paid after or before NDD, the bank will recover addi-
tional interest for the excess period or refund the excess interest charged ear-
lier, as the case may be; and additionally pay or receive swap charges, as ex-
plained in Section 8.11. If the instrument is returned unpaid, the bank will make
a clean sale to the customer, which will offset the earlier purchase.
8.6. Import Bill (in Foreign Currency) Transactions
Import bills are sale transactions to the bank. Like export bills, import bills may
be under L/C or outside it; and may be sight bills or usance/time bills. Bills out-
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side L/C are collection bills. The bank will merely advise the importer-customer
of the bill. If the importer retires the bill, the bank will put through the transac-
tion on cash value date basis and wire-transfer the foreign currency amount. If
the importer does not retire the bill, the bank will send back the documents to
the foreign correspondent.
For bills under L/C, the debit to nostro account precedes the receipt of
documents. After the bank receives the documents from the foreign corres-
pondent, it will forward them to the importer for payment after grace period
(which is 10 days in India). When the importer retires the bill, the bank will put
through the transaction at that day‟s price for the cash value date. Note that
the financing between the date of debit in nostro account and the date of re-
tirement by importer is in foreign currency. The bank would usually fund the
debit by a B-S swap in the foreign currency against the local currency. The
swap cost or gain is passed on to the customer. Alternatively, the bank may
fund the debit by borrowing the foreign currency, and add the foreign currency
interest amount to the import bill amount. The following example illustrates the
calculation for sight import bill under L/C for USD 10,000. We will assume that
margin is INR 0.15 per USD; commission is 0.10% on the bill amount; and
handling charges are INR 500.
Date of debit to nostro account May 22

Date documents are received May 27
Date of payment by importer Jun 03
Market rates on May 22
Spot (May 25) 50.38 / 50.39
Swap: C/S 1/2
Swap: S/1M (Jun 25) 15 / 16
Swap: C/Jun 03 (12 days) 6/7
Market rates on Jun 03
Spot 50.27 / 50.28
Swap: C/S 1/2
Cash outright 50.25 / 50.27
The swap cost/gain is calculated on the assumption that the debit is funded
through a B-S swap on the date of debit and for up to date of retirement. Of
course, the latter will not be known as on the date of debit to nostro account.
This is a simplifying assumption and in practice the nostro account could have
been funded for any period. In the B-S swap from May 22 to Jun 03, we would
be receiving a different of 0.06 per USD, which will be passed on to the cus-
tomer. On the date of retirement, we will be buying USD in the market for cash
114
value date at a price of 50.27 and selling to the customer at 50.42 after loading
the margin of 0.15. The final INR amount recovered from the customer will be
as follows.
(a) Transaction amount @ 50.42 504,200

(b) Commission at 0.10% of (a) 504
(c) Out-of-pocket expenses 500
(d) Swap gain deducted 600
(e) Net amount (a + b + c  d) 504,604
8.7. Forward Contracts: Optional Delivery Period
The calculation of forward exchange rates in interdealer market is discussed in

Chapter 6. For the customer forward exchange transactions, the additional
element is the loading of margins, which is discussed in Section 8.3 of this
chapter. We will not discuss these any further except a variation called forward
with optional delivery period.
For most commercial transactions, the date of negotiation is not known in

advance because of uncertainty and delay in processing and shipment. Only a
period, rather than an exact date, is known for negotiation of documents. To
manage such uncertainty about the date of negotiation, customers prefer the
forward contract that can be delivered on any day during a specified period to
the forward contract with fixed date delivery. Such contracts are called for-
wards with optional delivery period. For example, in the forward contract with
delivery period of May 15-31, the customer can deliver the forward contract on
any day between May 15 and May 31. Similarly, a forward contract whose de-
th
livery period is the fourth week can be delivered on any day between 24 and
the last day of its month; that with delivery period of third week can be deli-
vered on any day between 16th and 23rd day of its month; and so on. Note that
the word “optional” here is not related to another derivative contract called op-
tion. In the option contract, the option is whether to deliver, but in the forward
with optional delivery period, the option is when to deliver, and it must be deli-
vered. Secondly, in the forward with optional delivery period, the choice is with
the customer, regardless of whether the customer is buyer or seller of foreign
currency. In option contrast, the choice is with the option buyer, who may be
customer or bank. The word “buyer” in option contract is with respect to the
choice, and not with respect to the foreign currency.
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Chapter 8
In pricing the forward with optional delivery period, bank will load the swap
points in a in a manner that is unfavorable to the customer. To wit, calculate
the price for the first day and the last day of the delivery period, and the unfa-
vorable of them will be the transaction price. This is justified because the cus-
tomer has the choice of delivery date, which the bank cannot control. In hedge,
bank will cover the transaction to the date for which the price is quoted. The
following USD/INR example of 2M forward in USD against INR with optional
st th
delivery between 31 day and 60 day illustrates the calculation of price.
Case #1 Case #2
Spot price 50.30 / 50.31 50.30 / 50.31
Swap: S/1M 15 / 16 16 / 15
Swap: S/2M 28 / 30 30 / 28
1M forward outright 50.45 / 50.47 50.14 / 50.16
2M forward outright 50.58 / 50.61 50.00 / 50.03
The forward price is at premium in Case #1 and discount in Case #2. We

will calculate the price separately for forward purchase and sale.
Forward purchase contract (FPC): bank buys USD from the customer and sells
it at the market bid price in hedge.
Case #1: the prices are 50.45 and 50.58 and the former is the worse to the
customer and therefore the transaction price. Bank hedges it to the value
date of 50.45, which is 1M or the first day of optional delivery period.
Case #2: the prices are 50.14 and 50.00 and the latter is the worse to the
date of 50.00, which is 2M or the last day of optional delivery period.
Forward sale contract (FSC): bank buys USD at the market‟s offer in hedge
and sells to the customer.
Case #1: the prices are 50.47 and 50.61 and the latter is the worse to the
date of 50.61, which is 2M or the last day of optional delivery period.
Case #2: the prices are 50.16 and 50.03 and the former is the worse to the
date of 50.03, which is 1M or the first day of optional delivery period.
116
What happens if the customer delivers it on a date other than the date of
hedge? If the customer delivers on the date of hedge, the bank does not lose;
and if the customer delivers it on a date other than the hedge date, the bank
gains. The discrepancy between the delivery date and hedge date creates
gap, not position, which is corrected through a forex swap. The following table
shows the gaps in cash flows due to the customer delivery date and hedge
date being at the extreme ends of delivery period. The plus sign is cash inflow
(i.e. customer delivery in FPC, bank‟s purchase in market) and the negative
sign is cash outflow (i.e. customer delivery in FSC and bank‟s sale in market).
1M 2M
Case #1 Delivery on last day, hedge for first day  +
FPC
Case #2 Delivery on first day, hedge for last day + 
Case #1 Delivery on first day, hedge for last day  +
FSC
Case #2 Delivery on last day, hedge for first day + 
To eliminate the gap, bank will execute forex swap as follows, depending
on the case, and in all cases, the swap will be result in gain to the bank, which
is the additional profit for the bank.
FPC Case #1 (premium) B-S gain

Case #2 (discount) S-B gain
FSC Case #1 (premium) B-S gain
Case #2 (discount) S-B gain
It must be noted, however, that the always-gain-for-the-bank scenario will

be true only if there is no reversal from premium to discount or vice versa be-
tween the original booking date and the first day of the delivery period. Such
reversal is unlikely in the short term.
To sum up, if the customer delivers on hedge date, the bank does not lose;
and if the customer delivers on a date different from the hedge date, the bank
gains. What is “either gain or no loss” situation for the bank is “either loss or no
gain” to the customer. The customer should avoid this skew against him by al-
ways opting for fixed-date forward and then request for early or late delivery
(described in the next section) to manage uncertainty in delivery date.
8.8. Forward Contracts: Early and Late Delivery
To manage the uncertainty in delivery date, customer can request the bank to
advance or postpone the delivery of fixed-date forward contracts. Early deli-
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Chapter 8
very can be affected on any day before maturity date, but the late delivery can
be affected after maturity date only during a limited period of say, one week,
after which the bank may unilaterally cancel the overdue contract.
Early or late delivery does not create position but creates only gap and
funds inflow/outflow. The gap is adjusted through a swap, and the funds in-
flow/outflow is adjusted by lending/borrowing. The cost or gain on both ac-
counts, swap and financing, is to the customer‟s account. The following exam-
ple illustrates the early delivery of forward purchase contract (FPC) and for-
ward sale contract (FSC), each for USD 1,000,000 against INR on USD/INR
currency pair. The contract prices for FPC and FSC are 50.45 and 50.52, re-
spectively, and their maturity date is Jun 14. The customer requests for early
delivery on May 15 on which the market prices are as follows.
Spot (May 18) 50.74 / 50.75

Swap: C/S 3/4
Swap : S/1M (Jun 18) 30 / 32
Early Delivery of FPC
The bank would have hedged the FPC by selling USD against INR for delivery
June 14. Ignoring the margin, the hedge price will be the same as that of the
FPC (i.e. 50.45). If the early delivery is affected on May 15, the following will be
the cash flows.
Date USD INR Remark

May 15 +1,000,000 50,450,000 FPC early delivery (from Jun 14)
Gap +1,000,000 50,450,000 Subtotal of daily cash flows
Jun 14 +1,000,000 50,450,000 FPC, now advanced to May 15
1,000,000 +50,450,000 Hedge transaction
Gap 1,000,000 +50,450,000 Subtotal of daily cash flows
Position 0 0 Grand total of all cash flows
We can see that early delivery creates only gap, not position by shifting the
cash flow of FPC from Jun 14 to May 15. The gap is surplus in USD and deficit
in INR between May 15 and June 14, which must be eliminated by executing
S-B swap in USD against INR. The swap points for the broker period of May
15 to Jun 14 will be 29/33 (see Section 6.7). The S-B swap in USD will be at
the difference of 33, which is a cost (see Section 7.3). Assuming that the pric-
es for the near leg and far leg are, say, 50.72 and 51.05, respectively (see
Section 7.4), the cash flows will now be as follows.
118
Date USD INR Remark

May 15 +1,000,000 50,450,000 FPC Early delivery (from Jun 14)
1,000,000 +50,720,000 Near leg of S-B swap
Gap 0 +270,000 Subtotal of daily cash flows
Jun 14 1,000,000 +50,450,000 Hedge transaction
+1,000,000 51,050,000 Far leg of S-B swap
Gap 0 600,000 Subtotal of daily cash flows
Position 0 330,000 Grand total of all cash flows
The surplus of INR 270,000 on May 15 is not a gap. Recall from Section
4.5 that gap must arise in two currencies in the same period but in a comple-
mentary way; and that gap in one currency alone is a funding problem. In put
example, the S-B swap in USD managed the gap arising from early delivery of
FPC but also resulted in funds inflow in INR from May 15 to June 14.
In general, funds inflow/outflow results because of change in spot price be-

tween the booking date and the early delivery date; and the period of in-
flow/outflow will be between the early delivery date and the original maturity
date. The difference between the inflow on one date and outflow on the other
(corresponding to the position in INR for the example above) is the swap
gain/cost. Thus, the early delivery of forward contract has two sources of
gain/cost:
 swap gain/cost, arising from the swap required to manage the gap
 interest gain/cost on funds inflow/outflow, arising from changes in spot
price between the booking date and early delivery date
Both of that are to the customer‟s account. The following table shows the
swap gain/cost and interest gain/cost for our example, assuming that the inter-
est is 7.5% pa for the 30-day period between May 15 and June 14.
Swap cost: (0.33  1,000,000) 330,000

Interest gain: (270,000  7.5%  30 / 365) 1,664
Total (receivable from customer) 328,336
Early Delivery of FSC
For the early delivery of forward sale contract (FSC), applying similar proce-
dure, we will find that the bank has to execute a B-S swap in USD for the pe-
riod from May 15 to Jun 14. The swap will be executed at 29, which is gain and
let the prices for near leg and far leg be 50.71 and 51.00, respectively). The
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Chapter 8
swap results in a funds outflow, which requires borrowing. The following table
shows cash flows for early delivery of forward sale contract.
Date USD INR Remark

May 15 1,000,000 +50,520,000 FSC Early delivery
+1,000,000 50,710,000 Near leg of B-S swap
Gap 0 190,000 Subtotal of daily cash flows
Jun 14 +1,000,000 50,520,000 Hedge transaction
1,000,000 +51,000,000 Far leg of B-S swap
Gap 0 +480,000 Subtotal of daily cash flows
Position 0 +290,000 Grand total of all cash flows
The INR deficit on May 15 represents the funds outflow of INR 190,000,
which requires funding until Jun 14. The difference between the gaps of May
15 and Jun 14 represents the swap gain, which is INR 290,000. Assuming that
the interest rate for funding is 7.5% for 30 days, the interest cost is INR 1,171.
The net amount for early delivery of FSC payable to the customer is:
290,000  1,171 = 288,829.
Late delivery of FPC and FSC is similar to the early delivery. It has
gain/cost from two channels: swap gain/cost and interest gain/cost on funds in-
flow/outflow. Readers may work out the examples given in the exercises at the
end of this chapter.
To sum up, swap gain/cost will depend on whether the base currency is in
premium or discount; and interest gain/cost will depend on whether the base
currency has appreciated or depreciated. Exhibit 8-2 summarizes the swap
type to be executed, whether the swap points will be cost or gain, and whether
the interest on funds flow will be cost or gain for early delivery (ED) and late
delivery (LD) of FPC and FSC.
EXHIBIT 8-2: Status of Swap and Interest Cost/Gain on ED/LD
Contract ED/LD Swap Swap cost/gain Interest cost/gain

type Prem. Disc. Rises Falls
FPC ED S-B cost gain gain cost
LD B-S gain cost cost gain
FSC ED B-S gain cost cost gain
LD S-B cost gain gain cost
120
The table above is based on the assumption that the deal currency is base
currency. If the deal currency is quoting currency, translate it into equivalent
base currency action (e.g. FPC in quoting currency is equivalent to FSC in
base currency) and then read the table.
8.9. Forward Contracts: Cancellation
Forward contract can be cancelled anytime on or before its maturity. It can be

also cancelled after maturity, but within a limited period of, say, one week, after
which the bank will unilaterally cancel the overdue forward contract.
Cancellation is affected by entering into an offsetting contract: purchase is

nullified by a sale, and vice versa. The difference between the prices of original
and offsetting deals is the exchange gain/loss to the customer. If the contract
is cancelled after maturity, there would be a gap, which needs to corrected by
a swap, resulting in swap gain/cost and interest gain/cost to the customer (as
explained in the previous section), which are in addition to the exchange
gain/cost. The following example of FPC on USD/INR currency pair for USD
1,000,000 at 50.48 due on Jun 14 is used to illustrate cancellation. We will
consider the two cases of cancellation: request for cancellation is on May 22
(early cancellation) and on Jun 21 (late cancellation). As always, drawing up
the table of cash flows and examining the effect of cancellation on position and
gap will guide us on what action is required.
Early Cancellation
The bank would have hedged the FPC by selling USD against INR for delivery
June 14. Ignoring the margin, the hedge price will be the same as that of the
FPC (i.e. 50.48). Cancellation implies that the customer transaction no longer
exists, resulting in short/oversold position in USD.
Date Before After Remark

USD INR USD INR
Jun 14 +1 50.48 +1 50.48 Cancellation
1 +50.48 1 +50.48 Hedge
Position 0 0 1 +50.48
Bank eliminates the oversold position in USD created by cancellation by

buying USD for value Jun 14. The purchase transaction is executed on the
cancellation date of May 22, the prices on which are as follows.
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Chapter 8
Spot (May 24) 50.78 / 50.79

Swap: S/1M (June 25) 15 / 16
Swap: S/Jun 14 (broken date) 9 / 11
Outright price for Jun 14 50.87 / 50.90
Bank will buy USD at the market offer price of 50.90, which eliminates the
position, and leaves an exchange loss of: 50.48  50.90 = 0.42 per USD or
INR 420,000 for the deal amount, which is recovered from the customer. The
bank may charge margin on cancellation, too, but there will be no other
charges on account of swap and interest on funds flow.
Late Cancellation
The request for cancellation came on Jun 21, which is after maturity date of
Jun 14. On Jun 14, because of non-delivery by customer, there will be a gap in
cash flows, which is corrected by entering into B-S swap for C/1W. Therefore,
we need to know the swap differences and spot price on June 14, which are:
Spot (Jun 16) 50.70 / 50.71

Swap: C/S 2/3
Swap: S/1W (Jun 23) 7/8
Swap: C/Jun 14 (broken date) 7/8
Cash outright price 50.67 / 50.69
The B-S swap is executed at the difference of 7, which is gain; and the
prices for the near leg and far are, say, 50.68 and 50.75, respectively. The
cash flows will now be as follows.
Date USD INR Remark

Jun 14 +1 50.48 Non-delivery of FPC
+1 50.68 Near leg of B-S swap
1 +50.48 Original hedge
Gap 0 0.20 Subtotal of daily cash flows
Jun 21 +1 50.48 Expected delivery of FPC
1 +50.75 Far leg of B-S swap
Gap 0 +0.27 Subtotal of daily cash flows
The deficit of INR 0.20 per USD on Jun 14 is the funds outflow. Interest has
to calculated, say, at 9% pa, for seven days (between Jun 14 and Jun 21) on a
total INR amount of 200,000, which works out to be INR 345. The difference
122
between the net cash flow on Jun 14 and Jun 21 corresponds to the swap gain
of INR 0.07 per USD or INR 70,000 for the deal amount. Since the customer is
not giving delivery but cancelling the contract on Jun 21, bank will have to buy
USD on June 21 for cash value date. The market prices on Jun 21 are:
Spot (Jun 23) 50.60 / 50.61

Swap: C/S 2/3
Bank will buy USD at the market‟s offer price of 50.59, and the difference
between this price and the FPC price of 50.48 is the exchange gain/loss for the
customer. In this example, it is a loss of INR 0.11 per USD or INR 110,000 for
the deal amount. The total charges to the customer account are:
Swap gain 70,000

Interest cost on funds outlay 345
Exchange loss 110,000
Total 40,345
One question that arises is whether we should swap the overdue forward
contract exactly for 1W. If depends on the bank‟s policy. The bank may decide
to swap the overdue contracts uniformly for 1W and then cancel it or swap the
overdue contracts on overnight basis until 1W after maturity. In the latter, if the
customer requests for cancellation before 1W, the overnight rollover is discon-
tinued. In the former, the bank will enter into another offsetting swap for the pe-
riod between the date of request from the customer and the date of the far leg
of the earlier swap. For example, bank did S-B swap from maturity date to 1W,
and the costumer cancels it on the third day after maturity. The bank will then
execute a B-S swap for the period from the third day to seventh day to close
the gaps. As we will discuss in Chapter 12, the bank may not actually execute
any swap because such gaps are absorbed by day-to-day cash management
in nostro accounts. Nevertheless, for the purpose of computing charges on
cancellation (or early/late delivery), the required transactions are considered.
8.10. Forward Contracts: Extension/Rollover
The maturity of a forward contract can be extended, and it is called extension

or rollover. As discussed in Chapter 6, the forward market exists only up to 6M
or 1Y. If the customer wants a long-term forward exchange (LTFX), he has to
book for 6M or 1Y and then roll it over every 6M or 1Y.
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Chapter 8
There are two practices for LTFX: roll it over at original (or historical) price,
which is called historical price rollover (HPR); and cancel the old contract and
rebook a new contract. We will illustrate both of them with the following exam-
ple of FPC in USD on USD/INR currency pair booked at the price of 50.50 and
maturity of May 22. Ignoring the margins, bank would have hedged it by selling
USD at 50.50 for value May 22. The customer wants to roll over the FPC by
another 6M to Nov 22. We assume that the customer requests the rollover two
days before the maturity so that the spot value date on the date of request cor-
responds to the maturity date of the FPC. The impact on the cash flows be-
cause of rollover will be as follows.
Date USD INR Remark

May 22 +1 50.50 FPC rolled over to Nov 22
Gap 1 +50.50 Subtotal of daily cash flows
Nov 22 +1 50.50 Rolled over FPC (from May 22)
Gap +1 50.50 Subtotal of daily cash flows
We can see that the rollover does not create position but creates only a
gap, which is deficit in USD between May 22 and Nov 22. The bank eliminates
the gap with a B-S swap in USD for the period from May 22 to Nov 22. The fol-
lowing are the market prices on the date of request for rollover.
Spot (May 22) 50.25 / 50.26

Swap: S/6M (Nov 22) 72 / 75
The B-S swap in USD will be at a gain of 72, and the prices for the near leg
and far leg are, say, 50.25 and 50.97. The new cash flows after the swap are:
Date USD INR Remark

May 22 1 +50.50 Original hedge
Nov 22 +1 50.50 Rolled over FPC (from May 22)
1 +50.97 Near leg of B-S swap
The net cash flow in INR on May 22 is the funds inflow because of changes
in forex price between the contract date and the rollover date. Interest on this
124
inflow has to be calculated for 184 days (from May 22 to Nov 22). Assuming
that the FPC amount is USD 1 million and the interest rate is 9% pa, the inter-
est gain on inflow is INR 11,342. The net position of INR 0.72 is not a position
but the swap gain. On the FPC amount of USD 1 million, the total swap gain is
INR 720,000. Both the interest gain and swap gain are settled with the cus-
tomer (in this example, paid to the customer) and the FPC will be carried in the
books at the original (or historical) price of 50.50. This is called historical price
rollover (HPR). We can see that the calculations are identical to that late deli-
very of forward (see Section 8.8), and we can use Exhibit 8-2 to quickly deter-
mine whether the swap points and interest will be gain or cost.
As an alternative to the above, another method of rollover is to cancel the

old contract and rebook a new contract at the current market rate. For our ex-
ample, it involves the execution of following trades by the bank.
1. Buy USD value May 22 @ 50.26 (this is to replace the old FPC)
2. Sell USD value Nov 22 @ 50.97 (this is the new FPC)
However, such a practice is unfair to the customer because it loads two

spreads against him: spread in spot price and spread in swap points. Because
the customer does both transactions simultaneously, the bank will not be ex-
ecuting two outright transactions in the hedge, but executing one B-S swap in
USD at a gain of 72 with the prices for near leg and far leg of, say, 50.25 and
50.97. With this swap, the cash flows will now be as follows.
Date USD INR Remark

May 22 1 +50.50 Original hedge
Nov 22 1 +50.97 Far leg of B-S swap
+1 50.97 New FPC
The near leg of B-S swap at 50.25 is offset with the original FPC at 50.50,
and the difference in their prices is the exchange gain/loss, which is settled
with the customer. The far leg of swap at 50.97 is the hedge for the new FPC
with the customer.
The cancel-and-rebook rollover is economically the same as HPR but dif-

fers in the timing of cash flows. In the HPR method, swap gain/cost and inter-
125
Chapter 8
est cost/gain on funds inflow/outflow are settled, and the contract is rolled over
at the historical price. The charges here are similar to those in early/later deli-
very of forward contracts. In the cancel-and-rebook method, both the swap
gain/cost and interest gain/cost are replaced with exchange gain/cost, similar
to the procedure in cancellation of forward contract; and the new contract is
carried forward at the current forward price. Though the cancel-and-rebook
method involves a swap, the swap gain/cost is split into two components. The
first component is treated as exchange gain/cost and settled in cash with the
customer. The second component is incorporated into the price of new forward
contract. In the example above, of the total swap gain of 0.72, an amount of
0.25 is settled in cash as exchange gain, and the balance of 0.47 is adjusted in
the new FPC at 50.97, which is better to the customer by 0.47 compared to the
old FPC price of 50.50. The proportion of the amount split into exchange
gain/cost will depend on the change in spot price between the date of original
booking and the date of rollover. The following summarizes the differences be-
tween the two methods of rollover.
HPR Cancel and Rebook

New contract price Historical old price Current forward price
Interest gain/cost Settled in cash No such concept
Swap gain/cost Fully settled in cash Part amount settled in cash
and the balance loaded in
the new contract price
The current market practice is to prefer the cancel-and-rebook method to

the HPR method because it brings the outstanding forward contracts closer to
the current market prices.
8.11. Early and Late Payment of Discounted Purchases
Export bills discounted by the bank may be paid earlier or later than the due
date. Such incidents will create gaps in the cash flows, which are adjusted
through swap, similar to that in early and late delivery of forward contracts (see
Section 8.8). In other words, there would be swap gain/cost and interest
gain/cost on funds inflow/outflow. Besides these two gains/costs, there will be
an additional interest gain/cost due to the financing component.
Let us illustrate the early payment of discounted export bill on USD/INR

currency pair with the following details: bill for USD 1 million at 50.70 with due
date of May 22 and discounted at 7.5% pa. The bill was realized on Apr 22,
creating a gap in the cash flows, as shown below.
126
Date USD INR Remark

Apr 22 +1 50.70 Early payment of bill due on May 22
May 22 +1 50.70 Export bill due but paid early on Apr 22
Gap 1 +50.70 Subtotal of daily cash flows
The gap USD surplus from Apr 22 to May 22, and is to be adjusted through
S-B swap in USD for the same period. The market prices on Apr 22 are:
Spot (Apr 24) 50.18 / 50.19

Swap: C/S 2/3
Swap; S/1M (May 24) 30 / 31
Swap: C/May 22 (broken period) 30 / 31
The S-B swap will be executed at 31, which is cost, and the prices for near
and far legs of the swap are, say, 50.16 and 50.47. The cash flows will now be:
Date USD INR Remark

Apr 22 +1 50.70 Early payment of bill due on May 22
1 +50.16 Near leg of S-B swap
Gap 0 0.54 Subtotal of daily cash flows
May 22 +1 50.47 Far leg of S-B swap
Position 0 0.31 Grand total of all cash flows
The deficit of INR 0.54 on Apr 22 is funds outflow on which interest is to be

computed at, say, 9% for 30 days (from Apr 22 to May 22). The oversold posi-
tion of INR 0.31 is not the position but the swap cost. The third item is the re-
fund of interest charged earlier at 7.5% for the period from Apr 22 to May 22.
Interest cost on funds outflow: (0.54  1,000,000  9%  30/365) 3,995

Swap cost: (0.311,000,000) 310,000
Interest refund: (50.70  1,000,000  7.5%  30 / 365) +312,534
Total (payable by customer) 1,461
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Chapter 8
For the late payment of discounted export bills, there will be similar charges
for: (1) swap gain/cost; (2) interest gain/cost on funds inflow/outflow; and (3)
additional interest cost to be charged from notional due date to the date of
payment. We will leave this as an exercise to the readers.
Key Concepts
The currency pair in most commercial transactions is foreign currency against

local currency. Most transactions are outright type, of small and odd amount
and for broken dates.
Commercials transactions are classified into bank‟s Purchase and Sale at the
first level; and Clean and Bill at the second level. Purchases may have financ-
ing element under which the bank lends local currency funds to the customer.
For financing component, interest is separately charged, which is in addition to
the exchange margin.
Bank will freely permit early delivery, late delivery, cancellation and extension
of forward contracts. In all such cases, the bank will examine the impact of
such action on gap and position. Bank will execute the appropriate outright or
swap transaction to eliminate position and gap. Drawing the table of cash flows
will guide as to which transaction is to be executed. In all cases, the gain/cost
of adjusting the position and gap will be to the customer‟s account.
EXERCISES
The following are the market quotes for spot price and swap points.
EUR/USD AUD/USD USD/JPY USD/CHF USD/INR

Spot 1.2595/00 0.7364/68 99.97/02 1.1235/42 50.01/02
C/S 1/0.5 1/0.5 2.5/2.0 1/+1 par/1
S/1M 12/11 13/12 30/29 5/4 13/14
S/3M 31/29 32/30 85/83 13/12 30/32
S/6M 55/52 58/56 165/160 25/23 55/52
To answer the following questions, some cross rates and outright prices for
broken dates may have to be calculated from the above underlying rates. As-
sume that 1M = 30 days; 3M = 90 days and 6M = 90 days from spot value
date, which is two days from today; and the interest rate is 9% pa for calcula-
tions of interest amount on funds inflow/outflow.
128
1. USD/INR: Outward remittance (i.e. TT selling) in USD for cash value

date; load a margin of 0.05.
2. EUR/INR: Inward remittance (i.e. TT buying) in EUR for cash value
date; load a margin of 0.07.
3. USD/CHF: Outward remittance in CHF for cash value date; load mar-
gin of 0.0025.
4. AUD/USD: inward remittance in USD for spot value date; load margin
of 0.0010.
5. USD/JPY: Forward purchase contract in JPY for 45 days forward;
load margin of 0.25.
6. USD/INR: Forward sale contract in USD with optional delivery period
between 1M and 2M; load margin of 0.15, and indicate the hedge
date.
7. CHF/INR: Forward sale contract in CHF for 1M value date; load mar-
gin of 0.20.
8. AUD/INR: Forward sale contract in AUD with 1M value date with op-
tional delivery period in the fourth week, and indicate the hedge date.
9. USD/JPY: Forward purchase contract in JPY with 1M value date with
th
optional period from 15 day to the maturity date; load a margin of
0.10, and indicate the hedge date.
10. USD/INR: Cancellation of forward purchase contract in USD at 50.15
due in 15 days; indicate all the charges payable and receivable
11. USD/CHF: Cancellation of forward sale contract in CHF at 45.25 due
in 10 days; indicate all the charges payable and receivable
12. AUD/USD: Cancellation of forward purchase contract in USD at
0.7545 due in 60 days; indicate all the charges payable and receiva-
ble
13. USD/INR: Early delivery of forward purchase contract in USD at 50.43
14. USD/CHF: Early delivery of forward sale contract in CHF at 1.1545
15. EUR/USD: Late delivery of forward sale contract in EUR at 1.2825 by
1W; indicate all the charges payable and receivable
16. USD/JPY: Late delivery of forward purchase contract in JPY at
102.35 by two days; indicate all the charges payable and receivable
17. USD/INR: extension of forward purchase contract in USD (due in two
days) for 6M; indicate charges payable/receivable under historical
price rollover method and cancel-and-rebook method.
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Chapter 8
18. EUR/INR: extension of forward purchase contract in EUR (due today)

for 6M; indicate charges payable/receivable under historical price rol-
lover method and cancel-and-rebook method.
19. USD/INR: Late delivery of forward purchase contract in USD at 50.55
by 1W; indicate all the charges payable and receivable
20. EUR/INR: late delivery of forward sale contract in EUR at 63.19 by
1W; indicate all the charges payable and receivable
21. USD/INR: late payment of export bill @ 50.70 and discounted at 7.5%
by 30 days; indicate all the charges payable and receivable
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Chapter 9
Trade Life Cycle and Best Practices
Trade processing , like love-making, has three stages: pre-trade, trade and
post-trade. And the excitement level in each stage is similar in both processes
(a Process Manager in a Bengaluru BPO firm)
…best practices are intended as goals, not binding rules…Given the differ-
ences in the size of the firms, it may be helpful to underscore that firms are not
bound to integrate all of the recommended practices, but should use them as a
benchmark for examining their existing practices. (Management of Operational
Risk in Foreign Exchange, THE FOREIGN EXCHANGE COMMITTEE, 2004)
Information technology and straight-through-processing (STP) industry divide

the trade life cycle into pre-trade, trade and post-trade stages. From business
perspective, however, there are many stages and processes in the trade life
cycle, and they differ from market to market. Best practices, on the other hand,
differ from organization to organization even in the same market.
This chapter will examine the forex trade process for interdealer business
and a new business service called “FX prime brokerage”; and the best practic-
es for both.
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Chapter 9
9.1. Organization
Forex business is traditionally organized into two units: Sales & Trading and
Operations. The current practice is to organize it into three units: front office,
mid office and back office.
Front Office
The traditional Sales & Trading unit is now the front office. It is the risk man-
agement and sales unit. Risk management consists of taking risk (also called
speculation), eliminating risk (also called hedging), insuring against risk (called
risk insurance) and minimizing risk (through diversification). Depending on the
nature of business they deal with, the front office staff is further categorized as
follows.
 Proprietary (“prop”) traders: they execute trades on bank‟s own ac-

count with other dealers in the market. There will be profit if the specu-
lation is successful; and loss, otherwise.
 Flow traders: they execute trades in commoditized products with insti-
tutional customers. The bid-offer spread is the profit in this business.
 Sales traders: they execute customized and structured products with
corporate customers. The commission and margin are the profit in this
business.
 Arbitrage (“arb”) traders: they look for risk-free profit opportunities
across markets and products.
For engineering new products, there may be a separate “quant” team to

assist the front office, but usually such product engineering is a cross-market
function. In a word, the front office is the profit center of business.
Mid Office
Mid office is carved out from the traditional operations and credit staff. Its func-
tions are risk measurement (but not management, which belongs to the front
office) and performance evaluation. Both market risk and counterparty credit
risk are handled by the mid office. It is the mid office that set the counterparty
exposure limits. Performance evaluation consists of measurement in risk-
adjusted return (RAR) terms, attribution and benchmarking. Mid office may al-
so handle other operations such as documentation, confirmation, P/L calcula-
tions, etc, but there is no uniformity in the industry. An independent and skilled
mid office implies strong internal controls, which is the main defense against
fraudulent trading and internal frauds.
132
Back Office
Back office is the traditional Operations unit. It handles much of the post-trade
processing (e.g. confirmation, settlement, reconciliation, etc.).
9.2. Process Flow
The process for interdealer business in forex market can be divided into differ-
ent stages, as shown in Exhibit 9-1.
EXHIBIT 9-1: FX Trade Process Flow
Accounting & Financial Control
0 1 2 3 4 5
Investigations & Repairs
Exceptions, Escalations
Senior Management
0 = Pre-trade preparation
1 = Trade execution & capture
2 = Confirmation
3 = Netting
4 = Settlement
5 = Nostro reconciliation
Pre-trade Preparation
Pre-trade preparation (also called “client on-boarding”) is a one-time process

that establishes the business relationship with the counterparty. The parties
will assess each other‟s technical sophistication and credit worthiness, and
agree on operational practices and procedures. The general and legal terms of
relationship are documented in a “master agreement”: an agreement that go-
verns all future transactions between the parties. Such master agreement
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Chapter 9
enables the parties to exchange a brief confirmation for each trade that con-
tains only the economic terms of the trade without legal and relationship terms.
For forex trades, there are several master agreements, as follows.
 International Currency Options Market (ICOM) master agreement

 International Foreign Exchange Master Agreement (IFEMA)
 Foreign Exchange and Options Master Agreement (FEOMA)
 International Foreign Exchange and Currency Options (IFXCO) mas-
ter agreement
 International Swaps and Derivatives Association (ISDA) master
agreement
ICOM was developed in 1992 and covered only forex option trades. IFEMA
followed suit in 1993 and covered only spot and forward forex trades. In 1995,
they were combined into a single agreement under FEOMA to cover spot, for-
ward and option trades in forex. All of them were revised and updated in 1997
after a review of the legal enforceability of its provisions.
For derivative trades in other markets (e.g. interest rate, equity, commodity,
etc), ISDA developed its own master agreement in 1992, which covered op-
tions and non-deliverable forward (NDF) in forex market. The three industry
associationsThe Forex Committee (FXC), ISDA and Emerging Market Trad-
ers Association (EMTA)jointly published standardized procedures and prac-
tices under “1998 FX and Currency Options Definitions”, which greatly simpli-
fied the drafting of trade confirmation.
IFEMA and ISDA master agreement have gained acceptance in the market
with the former for spot and forward forex trades and the latter for forex options
and forex NDF. The subsequent market events (e.g. ASEAN currency crisis,
collapse of LTCM and Peregrine, etc) led to the revision of ISDA master
agreement in 2002. The FXC followed suit and consolidated the three forex
master agreement into a simpler one under IFEXCO (pronounced “eye-fex-
coh”) master agreement, which relies on the 1998 FX and Currency Options
definitions.
Trade Execution and Capture
Trade is executed by the front office through different means: phone, voice
broker, electronic order-matching or negotiated dealing systems (e.g. Reuters
Dealing 3000, EBS) and Internet-based systems. The last may be proprietary
or multi-dealer platforms. A popular proprietary platform is Deutsche Bank‟s
134
www.autobahnfx.com for flow business and www.dbfx.com for retail speculators.

The popular multi-dealer platforms are www.fxall.com and www.currenex.com.
After the trade execution, trade data (see Box 9-1) is captured in the front
office systems. For trades executed on electronic or Internet-based systems,
trade data flow automatically into front-office system. For trades executed over
phone or through voice brokers, the trader inputs the trade data into the front-
office system or records them in a deal ticket and passes it to the back office,
which will input the trade data to the system. The front office system updates
the position, gap and limits in real time and sends the trade data to other sys-
tems (risk, operations, etc.). The operations system will supplement the trade
data with static data (see Box 9-1) required for further processing.
BOX 9-1: Trade Data, Static Data, Market Data and Reference Data
Trade data is the data that is unique to each trade and therefore must be
captured at trade level. Examples of such data are the counterparty and
economic terms (e.g. price, amount and value date).
Static data is the data that is unique to the counterparty and remains the
same for all trades with the same counterparty. Since it does not change
from trade to trade, it is not captured at trade level but stored separately
and subsequently blended (“trade enrichment”) with the trade data dur-
ing processing. Examples of such data are counterparty‟s settlement in-
structions, address, contact details, etc.
Market data is the data that is unique to a business day and remains the
same for all trades with all counterparts for that particular day. Examples
of such data are official closing prices, interest rate fixings, etc.
Reference data as a concept has emerged in recent years from the

straight-through-processing (STP) industry. It is the data that remains the
same for all trades, with all counterparties, and for all dates. Examples of
such data are security identifiers (e.g. ISIN, CUSIP), SWIFT codes for
currencies and banks, holidays at business centers, corporate actions in
equity and fixed-income securities, etc. There has been an industry in-
itiative to standardize such data to enable straight-through-processing
(STP).
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Chapter 9
Confirmation
Trade confirmation establishes the legal basis for the trade and supplements
the master agreement.
For spot, forward and forex swap trades, the confirmation is simple and the
process is automated. For trades executed in secured electronic and Internet-
based dealing platforms, the parties may chose, on a bilateral basis, to replace
the confirmation with electronic affirmation facility offered by these platforms.
Under this facility, the back office may review and validate the trade data (“af-
firm”) after checking the details with those in the internal system.
For NDF, exotic options and structured products (which are usually under
ISDA master agreement), confirmation is quite complicated and is a sub-
process within the documentation process. The confirmation may take up to a
week or more, and the parties usually confirm the important details over phone
before the formal confirmation.
Netting
There are different forms of netting and the form relevant here is payments
netting (also called settlement netting), under which, all the payments and re-
ceipts from multiple trades due on the same day in the same currency and with
the same counterparty are netted into a single amount.
For example, we have USD 10 million payments and USD 12 million re-
ceipts with the same counterparty due on the same day. The two amounts are
netted into a single amount of USD 2 million, which is settled (in this case we
will receive from the counterparty). The settlement of USD 2 million will legally
discharge both the parties from their obligation of making payment for USD 10
and USD 12 million. Netting must have legal sanction in the jurisdictions and is
bilaterally negotiated. The master agreements (e.g. ISDA, IFEMA) contain pro-
visions to automatically sanction bilateral netting. Netting is a tool to mitigate
settlement risk as well as operational risk and costs.
The scope of netting is extended to multiple parties (“multilateral netting”) in

most payment and clearing systems for securities and cash. In many countries,
there are special local clearing with multilateral netting for USD (e.g. FXCLEAR
in India), which nets all USD payments locally into a single amount for each
party, which is settled in New York clearing. The prestigious continuous-linked
settlement (CLS) in forex also implements multilateral netting.
136
Settlement
Settlement is the process of paying to and receiving from the counterparty the
foreign currency amounts through the nostro accounts maintained with the cor-
respondent banks. If one of the currencies is a local currency, it is settled in
the local clearing.
The correspondent bank is advised of both payment instructions and ex-

pected receipts. Payment instructions are sent through SWIFT and must con-
tain SWIFT address and account number of the counterparty‟s correspondent
bank. Depending on the time zone of the payment center, payment instructions
may have to be sent a day in advance. For example, banks in Europe and
North America must send settlement instructions one day in advance for the
Far East currencies.
The differences in time zones will make the payment-versus-payment me-

thod of settlement impossible with conventional practices and technology. The
delay between the payments in two currencies magnifies the settlement risk to
Herstatt risk (see Section 3.1). The continuous-linked settlement (CLS) is a so-
lution to mitigate the Herstatt risk and is discussed in Chapter 11.
Nostro Reconciliation
Nostro reconciliation is the last stage in the trade life cycle. Accounting entries
will be passed (discussed in the next chapter) in internal records at different
stages in the trade life cycle. Reconciliation consists of matching the entries in
the internal records with those in the nostro account. Entries in the internal
records record what should occur, and those in nostro account record what
has occurred. If both of them match, then the trade has retired in the correct
manner.
Exceptions, Investigations, Repairs and Escalations
Whenever the processing of a trade deviates from the established procedure,

it is called exception, which is documented, investigated and the problem re-
paired or resolved. Such exceptions must be reported to the management,
which is called escalation, on which there would be a policy.
All exceptions have cost, impact profitability and elevate the operational
risk. Therefore, they are comprehensively reviewed every quarter or year as to
their causes and impact, leading to improvement through business process re-
engineering.
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Chapter 9
9.3. Best Practices for Interdealer Business
The Forex Committee (FXC) is an industry association sponsored by the Fed-

eral Reserve Bank of New York. It has issued a checklist of best practices in
1996, which was expanded and revised in 200410. There are 60 best practices
in the 2004 edition, associated with every stage in the trade life cycle, as
shown in the table below.
Best Practices # Stage in Trade Life Cycle

15 Pre-trade preparation
6  12 Trade execution and capture
13  24 Confirmation
25  28 Netting
29  35 Settlement
36  39 Nostro reconciliation
40  44 Accounting & financial control
45  47 FX Options and NDF
48  60 General
1. Know your customer (KYC)
This is the first line of defense and, at a minimum, should consist of the
identity, business profile and reputation of the customer. In many countries,
there are additional requirements under anti-money laundering laws.
2. Determine the documentation requirements and execute it prior to trading
Master agreement, standard settlement instructions (SSI) and authorized

signatory list must have been arranged prior to trading relationship. If trad-
ing should precede documentation for genuine reasons, there should be
policy on such cases, which must be communicated to all staff in front of-
fice, mid office, back office, legal, compliance and audit departments. Elec-
tronic trading will require additional documentation for user identification
and security issues.
3. Use master netting agreements
Both payments netting and close-out netting should be incorporated, the

former to mitigate settlement risk and the latter, to mitigate counterparty
10
Management of Operational Risk in Foreign Exchange, The Foreign Exchange Com-
mittee, 2004. See their website: www.newyorkfed.org/fxc
138
credit risk. Such provisions must be incorporated in the master agreement,

and the bank must ensure they are legally enforceable in the jurisdictions.
4. Agree on trading and operational practices
Establish practices for the type of products and key operational practices
(e.g. timeline for confirmation/affirmation, use of SSI, etc.)
5. Agree on documentation for special arrangements
Third party payments (i.e. payment to an account other than the counter-
party‟s) and prime brokerage (see Section 9.4) requires special documen-
tation.
6. Record all trades, external and internal, as soon as they are executed
It ensures that the real-time updates on position, gap and counterparty lim-
its are available to the front office and mid office. Internal trades (i.e. those
with own offices) have the same impact on risk, except for counterparty
credit risk.
7. Use straight-through-processing
When there are different systems for front office, mid office and back office,
information flow between them should be automatic. It ensures that the da-
ta are accurate and timely and operations are less prone to error. Inte-
grated applications should be preferred to piecemeal applications.
8. Monitor in real time the counterparty exposure limits and usage globally
Real-time globally aggregated counterparty credit limits and usage must be

made available to the front office and mid office.
9. Use standard settlement instructions (SSI)
SSIs speed up the confirmation, enable straight-through-processing, and

allow for formatted and readable SWIFT message. Changes in SSI must
have a minimum of two weeks notice.
10. SSI is the responsibility of the back office
Maintenance of SSI is back office function. When SSIs are not in place
(e.g. for non-bank customers), the front office may record settlement in-
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Chapter 9
structions in the deal ticket. Such non-standard settlement instructions

must be checked by back office during confirmation stage.
11. Review amendments to trade data
Amendment must be in a controlled manner, involving both the front office

and the back office, regardless of who initiates the amendment. Bank must
have written procedures on segregation of duties in amendments. This is a
key control mechanism. All amendments must be reported to the manage-
ment as exceptions. Amendments to forex swap after the near leg is settled
requires extra caution since it will impact the P/L already booked.
12. Monitor off-market and deep in-the-money option trades
Historical price rollover (see Section 8.10) and trades with off-market prices
may require special confirmations, which will make a reference to the cur-
rent market price. Sale of deep in-the-money options, too, requires careful
monitoring. Though there may be genuine reasons for such transactions,
they can be misused to exploit weakness in revaluation and accounting
systems of the counterparty. Banks must have written policies to ensure
appropriate level of review to guard against potential legal and reputational
risks.
13. Confirm or affirm trades in a timely manner
Trade should be confirmed within two hours after execution and in no event
later than the end of the day for both external and internal trades. Excep-
tions to this rule must be documented and approved by compliance and
management staff. Counterparties must either send out their own confir-
mation to the other or sign and return (“affirm”) the incoming confirmation.
Merely receiving the counterparty‟s confirmation does not constitute the
completion of confirmation stage.
14. Diligence in confirmation through non-secure means
When unauthenticated electronic message is received, there should be a

callback procedure to an authorized person, and the conversation should
be on recorded telephone line.
15. Diligence in confirmation of structured trades
Such confirmations are manually prepared and sent by non-secure media.

Where ever possible, they should be drafted in standard templates of ISDA
140
or EMTA. The confirmation must include non-standard price sources, dis-

ruption events, and the identity and role of “Calculation Agent.”
16. Diligence in confirmation through phone
It should be done over recorded lines and between authorized persons,

and followed by a written confirmation or callback procedure.
17. Establish controls for trades executed through electronic platforms
Replace the traditional confirmation with validation against electronic front

office system only under the following conditions: (1) trade data flows
straight from front-office system to back-office system; (2) controls must ex-
ist that the flow of data is not changed and that data is not deleted; and (3)
trade details are sufficient to validate the trade terms.
18. Verify expected settlement instructions
The confirmation must include own settlement instructions and counterpar-

ty‟s. On receipt of confirmation, the settlement instructions must be
matched with those on internal records.
19. Confirm all netted transactions
All transaction in the netting set should be individually confirmed to avoid

offsetting errors of including the wrong trade and excluding the right trade.
20. Confirm all internal transactions
Internal transactions are not immune to errors and have the same impact
on risk, except for credit risk. All standard procedures applicable to external
transactions must apply to internal transactions, too.
21. Confirm all block trades and split allocations
Block trade must be confirmed within two hours; and allocations for split,
within four hours, and in no event later than the end of the day.
22. Review all third party advices
Review of Reuters logs, EBS tickets, voice broker advices are not the pri-
mary method of confirmation but only for review, and such trades should be
confirmed with the counterparty bilaterally.
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Chapter 9
23. Automate confirmation matching process
Automation will speed up confirmation, reduce operational risk and enable

higher business volumes. The process should be controlled by establishing
an automated confirmation tracking and follow-up system.
24. Establish exception processing and escalation procedures
For unconfirmed and disputed trades, clear procedures must be estab-

lished, and the control should never be left to the front office.
25. Use on-line settlement netting systems
Correct calculation of net amounts improves cash management.
26. Confirm bilateral net amounts
Third-party electronic payment & clearing systems (e.g. FXCLEAR in India)

will inform both parties of the final amount. If such systems are not used,
then the final net amount must be bilaterally confirmed.
27. Employ timely cut-offs for netting
Trades that miss the deadline for netting must be settled on gross basis,
and such cases should be incorporated in credit exposure systems to accu-
rately compute the settlement risk and the counterparty credit risks.
28. Establish consistency between practice and documentation
Credit exposure systems should not consider netting unless documentation

supports netting.
29. Use real-time nostro balance projections
To improve cash management, project real-time nostro balances after con-

sidering cancellations and amendments.
30. Send electronic messages to nostro agent for expected receipts
Nostro agent should be given not only instructions for payments but also in-
formed of expected receipts. It will help nostro agent identify the un-
matched amounts early and correct the misdirected payments. However,
some nostro agents may not be equipped with processing expected re-
ceipts.
142
31. Use automated cancellation and amendment procedures
Automated real-time communication system with nostro agent for cancella-

tion and amendments of payment instructions will achieve the latest possi-
ble cut-off times for changes.
32. Implement timely payment cutoffs
Bank should achieve the latest cutoff times for cancelation and amend-
ments of payment instructions to the nostro agent; and the earliest possible
time for the confirmation of final receipts.
33. Report payment failures to mid office
Counterparty credit exposure limits must factor in the payment failures.
34. Understand the settlement process and settlement exposure
Knowledge of when the payment instruction becomes irrevocable and the

payment confirmation reached finality are essential for senior managers
and operations staff. In forex trades, settlement risk is equal to the full
amount of purchased currency amount and lasts from the time of payment
instruction to the sold currency can no longer be canceled until the curren-
cy purchased is received with finality.
35. Prepare for crisis situation outside your organization
Knowledge of each nostro agent‟s contingency operations and the alterna-

tive settlement procedure is essential for operations staff.
36. Perform timely nostro reconciliation
It should be completed no later than the following settlement date.
37. Automate nostro reconciliation
Electronic reconciliation ensures timely identification of differences. Escala-

tion procedure for un-reconciled trades should be in place.
38. Identify non-receipt of funds from counterparties
Policy on escalating such cases to the specified parties should be in place.

Policy should also cover prioritizing cases, based on counterparty credit
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Chapter 9
rating, payment amount, and frequency of failures. The counterparty should

be checked against the internal watch list of counterparties.
39. Establish operational standards for nostro account users
The nostro accounts are managed by the forex department, but also used
by other business groups (e.g. fixed-income, equity, etc). Policy on funding
the account (i.e. individual or group funding) must be in place.
40. Conduct daily general ledger reconciliation
Daily reconciliation between back office system and front office system on
one hand, and between back office system and general ledge on the other
should be practiced.
41. Conduct daily position and P/L reconciliation
Position reconciliation ensures that all trades executed by the front office
have been correctly processed by the back office, along with the amend-
ments. Discrepancy in P/L can imply differences in position or market data.
Banks that use single integrated system should ensure that the market da-
ta source is properly controlled.
42. Conduct daily position valuation
Position valuation should be done independently, preferably by the mid of-

fice. Quality of market data should be checked, particularly for less liquid
products. For option products, the correct “volatility surface” must be used.
43. Review off-market trade prices
Institute a procedure that provides for a review of such cases.
44. Use straight through processing for prices
Electronic links from price sources to the position valuation systems en-
sures speedy and efficient valuation, and eliminates data entry errors.
45. Establish clear policy and procedure for the exercise of options
Exercise notification to the counterparty should be through an independent

electronic system, and designed to auto-exercise in-the-money options.
Exercising staff should be independent of front office and back office. If the
144
option processing is by a separate system, the forex trades resulting from

option exercise should flow automatically to the back office system.
46. Obtain appropriate fixings for exotic and structured trades
They should be obtained by the back office independent of the front office.
47. Closely monitor the option premium settlements
Premium settlement reduces the chances of out-trades.
48. Segregate the duties
The reporting line for the back office should be independent of that for the
front office, mid office, financial accounting and audit. For key areas, the
segregation must be implemented within the back office functions. Good
practices include: (a) segregation between trade execution and confirma-
tion/settlement; (b) segregation between posting and reconciliation access
to the general ledger; and (c) separate database functions between the
front office and the back office.
49. Ensure that staff understands business and operational role
Everyone should understand the entire process flow, and “front-to-back”

training should be encouraged.
50. Understand operational risks
Understanding operational risk will lead to improved process flow and im-
proved technology.
51. Identify procedures for introducing new products, new customer types, and
new trading strategies
They introduce new risks and new processes. All stafffront office, back
office, mid office, credit, legal, compliance and technologyshould be in-
volved when they are introduced.
52. Ensure proper model sign-off and implementation
For quantitative trading models, the model validation and input & output re-
porting should be independent of the front office.
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Chapter 9
53. Control system access
Function-specific user access “profiles” are recommended. External user

control for Internet-based systems should be as robust as internal user
access controls.
54. Establish strong independent audit/risk control group
Bank should implement policies and procedures that enable employees to

raise concern anonymously.
55. Use internal and external operational performance measures
Operational performance reporting should contain quantifiable metrics.

Service Level Agreements (SLA) should be exchanged when outsourcing
operations, which should clearly define, measure and report on the opera-
tional performance.
56. Ensure that service outsourcing conforms to industry standards and best
practices
Controls should be in place to monitor vendors in order to ensure that in-

ternal standards are met.
57. Implement globally consistent processing standards
When there are multiple processing centers at different locations, they may
use different systems or technology, but the standards and procedures
(e.g. valuation) should be consistent.
58. Maintain records of deal execution and confirmation
The length of time for keeping the records depends on the type of business
and is also subject to local regulations.
59. Maintain procedure for retaining transaction records
It should be based on tax, regulatory and legal requirements of the jurisdic-

tion.
60. Develop and test contingency plans
The plan should cover long-term and short-term incapacitation of trading,

operations, system failure, communication failure between systems, and
146
the failure of internal or external dependency. Emergency crisis teams and

back-up sites should be established. During a disaster, the bank should in-
form all the counterparties about processing problems and provide them
with the contact particulars of emergency crisis team.
9.4. FX Prime Brokerage
Forex prime brokerage is a specialized service involving three parties: client,

executing dealer and prime broker. The client executes the trade directly with
executing dealer (also called “spoke bank” or “give-up bank”) in the name of
prime broker. When informed of the trade, the prime broker accepts the trade
by becoming counterparty to the trade and settles it directly with the executing
dealer. At the same time, the prime broker enters into an offsetting contract
with the client. Exhibit 9-2 shows the flows between the three parties.
EXHIBIT 9-2: Prime Brokerage
execution
Client Executing
Dealer
trade trade
Prime Broker
Effectively, the client benefits from the market liquidity of executing with
multiple executing dealers, but maintains a single counterparty relationship
and settlement with the prime broker.
Prime brokerage emerged during the early 1990s and gained momentum
with standardized procedures and practices in the late 1990s. The clients are
typically hedge funds, commodity trading advisors (CTA), asset management
companies, pension funds and smaller banks. The prime brokers are large
commercial banks (e.g. Deutsche Bank, UBS, etc.) and bulge bracket invest-
ment banks (e.g. Goldman Sachs, Morgan Stanley). For enabling the client to
trade in the name of the prime broker, the latter will hold collateral from the
former to secure the credit exposure in the trades. The client typically will have
many sub-accounts, and the bulk trade (or block trade) with the executing
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Chapter 9
dealer has to be split and allocated to the sub-accounts. As a value added ser-
vice, the prime broker manages the split and allocation of block trade. Over
time, some prime brokers have become a “one-stop shop” for many other ser-
vices such as administration of client sub-accounts and reporting, cash man-
agement, mid office and valuation, etc. In recent years, driven by technology,
prime brokers started offering trade execution via electronic communication
networks. These platforms provide automated program trading facility by pro-
viding access to tradable prices via two-way message interface between the
client‟s front office system and the forex market. In this electronic prime-broker
model, there is an element of anonymity to the client because the executing
dealer sees the name of prime broker and not the client.
Process Flow
The trade process in prime brokerage can be divided into the following stages,
and are shown in Exhibit 9-3.
EXHIBIT 9-3: Process Flow in Prime Broker Trade
Client
 trade order & execution Executing
Broker
 notification
 give-up
 allocation
 confirmation
Prime Broker
1. Client executes the trade with the executing dealer and informs (“notifica-
tion”) the prime broker about the execution and allocation of block trade.
2. Executing dealer informs the prime broker of the execution, which is called
“give up.” The prime broker than “matches” it with the notification and ei-
ther accepts or rejects the give-up, depending on matching status.
3. If the give-up matches with notification, the prime broker confirms (“con-
firmation”) the trade to executing dealer and becomes the counterparty.
4. Primer broker splits the block trade and allocates it to the sub-account and
informs the client. This is called “allocation.”
148
Documentation
The industry has come out with a standard documentation to establish the le-
gal relationships among the three parties in the form of two separate bilateral
agreements: prime brokerage agreement and give-up agreement.
Prime brokerage agreement is between client and prime broker. It sanc-

tions that the client can execute the trade with executing dealers approved by
the prime broker and that the prime broker becomes a counterparty to the ex-
ecuting brokers. The agreement specifies the allowable products and their
maximum tenor; and the limits on position and settlement amount. The limits
may be specified in the agreement or communicated subsequently and period-
ically by the prime broker. The collateral required to be maintained with the
primer broker by the client, the key operational procedures, and the fees paya-
ble to the prime broker are also documented.
Give-up agreement is between prime broker and executing dealer. It is ex-

ecuted as a master agreement and is supplemented with a “give-up agreement
notice” for each client of the prime broker. The notice will identify the client and
specify the permissible products, tenors and limits on them. The Foreign Ex-
change Committee (FXC) has published a Master Give-Up Agreement, which
may be supplemented with another agreement called Compensation Agree-
ment, which shall be between the executing dealer and the client. The Com-
pensation Agreement is an additional protection for the executing dealer when
the prime broker refuses to accept the trade.
Value Proposition
Prime brokerage offers benefits and opportunities for all the three parties. For
the client, the benefits are market liquidity and price advantage from multiple
executing dealers while maintaining a single counterparty and credit relation-
ship with the prime broker. There is also optimization of resources by outsourc-
ing much of back office and mid office work to the prime broker.
For the prime broker, the benefit is non-fund fee income while securing the
credit exposure with the client through sufficient collateral. It contributes to the
strengthening of client relationship and establishing new clients.
For the executing broker, the benefit is expanding trading relationships and
increased execution volumes by transacting with less credit-worthy counterpar-
ties without enhanced credit risk or credit enhancement requirements.
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Best Practices
The Foreign Exchange Committee (FXC) has brought out 22 best practices for
prime brokerage, which are consistent with the recommendations of Counter-
party Risk Management Group II (CRMG II) report. The following is the sum-
mary of best practices.
1. Prime broker should update the give-up line as soon as the trade is ac-
cepted, and the updated utilization of limit should be made available to the
executing dealers.
2. Prime broker should establish real-time credit exposure system to monitor
open positions against the limit and the pending give-up trades.
3. Prime broker should establish procedure for credit limit breaches and doc-
ument approval of limit exceptions. Persistent credit limit exceptions
should prompt a review and possible adjustment to client limits.
4. Executing dealer should have tools to monitor open positions and limits
against the pending trades.
5. Prime brokerage agreement and the master FX give-up agreement must
clearly specify the following: transaction types, their tenors, credit limits,
and the procedure to compute the credit limit.
6. All the three parties must have sufficient internal controls to monitor the
transaction types, tenors and credit limits.
7. All the three parties should have processes to send and receive give-up
notices, and the contact details of appropriate persons in a give-up rela-
tionship.
8. The client and the executing dealer should notify the details of trade ex-
ecution within the time specified in the relevant agreement.
9. To the extent possible, the client and the executing dealer should use the
electronic messaging system to the prime broker‟s electronic matching
system.
10. Prime broker should notify the executing dealer and the client of the re-
jected trades that were not authorized within the time stipulated in the re-
levant agreement.
11. Prime broker should confirm the trade to the executing dealer only after
matching the details with the notification from the client. Structured trades
should be matched for all trade details.
12. Confirmation should be completed within two hours of execution and no
later than the end of the day. Escalation procedures should be in place to
resolve the discrepancies.
150
13. Prime brokerage and give-up agreements should specify the party re-
sponsible for determination and notification of certain post-trade events in
structured options (e.g. barrier breach, etc.).
14. Prime brokerage agreement should specify whether the primer broker will
assume the basis risk arising from post-trade events in structured options
or “pass through” it to the client.
15. The staff of prime broker and executing dealer should have been properly
trained to handle post-trade events in structured options.
16. On the trades rejected by the prime broker because the details of the
client and the executing dealer do not match, the dispute resolution should
be between the client and the executing dealer.
17. Prime broker should inform the client and, if the give-up agreement so
provides, the executing dealer of the details of mismatch.
18. Except in case of default, the client has the right of confidentiality in their
identity, order and strategy. The client‟s confidentiality requirements must
be assessed by the primer broker at the outset. In the absence of such
agreement, the prime broker should assume that the client requires confi-
dentiality.
19. Prime broker should establish control access to its systems regarding
client give-up trades and positions.
20. Primer broker staff in client service and operations should understand the
confidentiality requirements for each client.
21. Primer broker should perform due diligence, including anti-money launder-
ing review, with respect to the client.
22. Prime broker should investigate complaints from executing dealers about
the client‟s illegal or unethical practices. While there is no legal obligation,
the prime broker should ascertain whether such activities impose legal
and regulatory obligations for the prime broker.
Key Concepts
Organization of forex business: front office (earlier called sales and trading),
mid office, back office (also called operations).
Front office: prop trader, flow trader, corporate sales trader, arbitrage trader
Stages in trade life cycle: pre-trade preparation (one-time activity), trade ex-
ecution & capture, confirmation, netting, settlement and nostro reconciliation;
and accounting and financial control at different stages.
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Chapter 9
Exceptions, investigation, repairs and escalation
FX prime brokerage: client – prime broker – executing dealer
Trade life cycle in prime brokerage: trade execution and notification (from
client by client); give-up (by executing dealer); matching and confirmation or
mismatch and rejection (by prime broker); allocation (by prime broker).
Best practices: 60 best practices for interdealer business; and 22 best practic-
es for prime brokerage business.
EXERCISES
Comment on the following practices as to whether they constitute the best

practices or desirable for efficient operations.
1. Bank has newly established a relationship with an important institutional

client. The documentation and master agreement processes are being
prepared but the client wants to put through a trade immediately. Can the
trade the executed without documentation?
2. There is a bottleneck in confirmation process. The operations manager
has decided to skip the confirmation for internal trades (i.e. those with own
offices) and take up confirmations with external counterparties. Is this
practice acceptable? Justify the answer.
3. The P/L calculations are performed independently by mid office and front
office and they are reconciled daily. The market data is input by the front
office since they are more knowledgeable about the market prices.
4. Front office amends the trade data such that the amendment is beneficial
to the bank. Though the front office has not informed the back office, the
latter has noticed it, but since the amendment was beneficial, it was not
captured as an exception and escalated to the management.
5. The daily high-low range for EUR/USD was 1.25 – 1.27. Front office has
executed four trades: (a) Bought EUR @ 1.23; and (b) Bought EUR @
1.28; (c) Sold EUR @ 1.24; and (d) Sold EUR @ 1.29. Which of them re-
quires investigation?
6. Front office recorded the settlement instructions in the deal ticket that are
different from those in static data (i.e. SSI). Should the confirmation con-
tain the settlement instructions in the deal ticket or SSI from static data?
7. The counterparty has neither sent the confirmation nor affirmed our con-
firmation, and the settlement is due tomorrow. The back office called up
152
the counterparty over phone and confirmed the particulars. Is this accept-
able?
8. A forex swap trade has been amended after the near leg has been settled.
What are the earlier reports that were wrong because of this amendment?
9. Between its own business continuity plan (BCP) and its nostro agent‟s,
which is more important for the back office staff to study?
10. In the settlements, there are three purchases totaling to USD 15 million
and two sales totaling to USD 12 million. After payments netting, an
amount of USD 3 million is receivable. In the pre-settlement confirmation,
will you confirm USD 3 million or USD 12 million or USD 15 million?
11. In a trade mediated by a broker, the trade data in broker advice match
with that in the deal ticket. The counterparty has neither confirmed not af-
firmed the trade. Since the broker advice matches with our confirmation,
no further confirmation was followed up with the counterparty.
12. What are the potential problems if the same person is allowed to post the
entries and reconcile them?
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Chapter 10
Accounting
It [true and fair view] was the most inviolate of the four golden principles of ac-
counting (and the only one not beginning with the letter C: the other three be-
ing continuity, consistency and conservatism). ( TIM HINDLE, Guide to Manage-
ment Ideas and Gurus)
So controversial has accounting become that even John McCain [the Republi-
can candidate for the American presidency], a man not known for his interest
in balance sheets, has an opinion (The Economist, Sep 18, 2008)
Forex accounting has different perspectives, and this chapter deals with only
one of them. It is not about the following.
 Accounting from the perspective of corporate treasurer

 Accounting for translation gain/loss of foreign investments in home
currency, which is dealt by FASB 52 (US) and IAS 21 (EU) standards
 Special accounting for derivatives, which is dealt by FASB 133 (US),
IAS 39 (EU) or AS 30 (India) standards.
It is about accounting for forex trades for their actual cash flows in the
books of a forex dealer conducting interdealer and commercial transactions.
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Chapter 10
10.1. General Flow for Transactions
The forex trade starts in the position and ends in the nostro account; and is
laid to rest when its entry in Nostro A/c entry is reconciled with its complement
in the Mirror A/c. Before reaching its final destination in nostro account, it may
be held in suspense accounts or as an off-balance-sheet item.
Collection Register
Trades for which the rate of exchange between the two currencies is not fixed
as yet will not be entered in the position. Examples of such trades are foreign-
currency denominated collection items (e.g. clean instruments, export bills, im-
port bills). Collection items are recorded as memo items in a register (“Collec-
tion Register”) and held there until they are realized and their conversion into
local currency is fixed with the customer.
Collection register is maintained currency-wise and separately for purchas-

es (e.g. clean instruments, export bills) and sales (e.g. imports). The following
is the sample format.
Currency: USD Market Side: Purchase Item: Export Bill

S No Date Details (drawer, Collection Realization Balance
drawee, etc) Amount Amount
The “amount” in Collection Register is the foreign currency amount, and

there will be no equivalent local currency amount because the rate of ex-
change is not yet fixed. When the bill is received for collection, it is posted un-
der “Collection” column and added to the Balance; and when it is realized, it is
posted under “Realization” and deducted from the Balance. Therefore, the
amount under “Balance” column indicates the outstanding amount under col-
lection at a point of time.
Position
All trades for which the rate of exchange between the two currencies is fixed
will enter the position, and it marks the beginning of its accounting life cycle.
The purpose of the position is to indicate the extent of price risk that the bank
is exposed to at any point of time. This is the reason why the trade is first rec-
orded in the position. Position is maintained currency-wise and independently
by front office and back office.
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Accounting
Front office maintains the position in “Dealer‟s Pad” (see Section 4.6),
which contains the skeletal details (e.g. amount in thousands or millions, etc.).
Back office maintains the position with complete trade details. Besides the two
actual currencies involved in the trade, the home currency equivalent amount
is also recorded. For example, consider the following EUR/USD trade in the
books of an Indian bank whose home currency is INR. In the EUR/USD trade,
the bank has purchased EUR 1 million at the price of 1.5000. The deal
amounts are EUR 1 million (overbought/OB) and USD 1.5 million (over-
sold/OS). The position would be recorded in EUR and USD as follows.
Currency: EUR
Description Purchase Sale Position
Trade Ref 00000 1,000,000 1,000,000 (OB)
Currency: USD
Description Purchase Sale Position
Trade Ref 00000 1,500,000 1,500,000 (OS)
Though INR is not involved in the trade, the equivalent INR amount must
be recorded for each of them because the assets and liabilities are to be ac-
counted in the home currency. The equivalent home currency is derived by
employing “wash rate”, which is discussed in the next section.
From the position, the trade is posted into the various accounts, depending
on the nature of the trade. If both currency amounts in the trade are settled on
the same day as the trade date, the trade is posted into the mirror A/c, which is
a general ledger account. If one currency amount is settled immediately and
the other is settled on a future date, it implies that there is a financing compo-
nent in the transaction, and therefore it is posted in a suspense account. If
both currency amounts are to be settled on a future date, it is posted in off-
balance-sheet item.
Suspense Account
Suspense account is used to record and store trades in which one currency
amount is settled and the other currency amount is yet to be settled. All trades
in which there is a financing (“discounting”) by banks falls under this category,
as explained Chapter 8 (see Section 8.5 and footnote 9). Typically, such
transactions are foreign clean instruments and foreign currency export bills
discounted by the bank. In these transactions, the bank has paid the home
currency amount but will receive the foreign currency equivalent on a future
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Chapter 10
date. After the foreign currency amount is realized, the item is reversed in this
account and released to the mirror A/c. The suspense accounts may be desig-
nated as Foreign Clean Instruments Discounted A/c and Export Bills Dis-
counted A/c. The account is maintained currency-wise in the following format,
with amount recorded in both foreign currency (FC) and home currency (HC).
Date Details Discounted Realized Balance

FC HC FC HC FC HC
Note that all the items in suspense accounts are purchase transactions for
the bank.
Off-balance-sheet items
All forex trades for which the rate of exchange between the two currencies is
fixed but will be settled on a future trade will be recorded as off-balance-sheet
items. All forward contracts belong to this category. They are maintained cur-
rency-wise and separately for forward purchase contracts (FPC) and forward
sale contracts (FSC) in the following format, with amounts recorded in both
foreign currency (FC) and home currency (HC).
Date Details Booked Delivered Balance

FC HC FC HC FC HC
When the contract is booked, the amount is added to the Balance. On deli-
very of the contract, the item is deducted from the Balance and released to the
mirror A/c. If the forward contract is cancelled, the amount is deducted from the
Balance, but not released into the mirror A/c. The charges payable/receivable
on cancellation (see Section 8.9) are credited/debited to a general ledger ac-
count and brought into the P/L account on the balance sheet date. Similarly, all
charges on extension/rollover, early delivery and late delivery are credited or
debited to the same general ledger account.
The amount outstanding in FPC and FSC accounts on the balance sheet
date are disclosed in the Notes to the Accounts.
Other General Ledger Accounts
Single-currency items like brokerage payable, interest (in home currency) pay-
able and receivable on settlement fails are accounted in separate general
ledger accounts, and their balance is brought into the P/L account on the bal-
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Accounting
ance sheet date. Interest payable/receivable in foreign currency for settlement

fails are first recorded in the Position and then released into the Mirror A/c.
Mirror Account
Mirror A/c (also called “ledger A/c”) is the ultimate destination for all forex
trades. It is called “mirror” because it mirrors the entries in the nostro A/c: de-
bits in Mirror A/c will correspond to the credit in Nostro A/c, and vice versa.
Purchase transactions (i.e. those in which the bank buys foreign currency)
will be credits and sale transactions will be debits in the Nostro A/c. Therefore,
to mirror these entries, purchases will be released into the Mirror A/c as debits
and sales as credits. Mirror A/c will be maintained for each Nostro A/c and
each entry in it will have both foreign currency and home currency amount. In
contrast, Nostro A/c will show only the foreign currency amount.
The prudent principle in releasing entries into Mirror A/c is that there must
be a prior credit in Nostro A/c before the corresponding debit is raised in Mirror
A/c; and credit must be released into Mirror A/c before the corresponding debit
takes place in Nostro A/c. Exhibit 10-1 shows the accounting flow for trades.
EXHIBIT 10-1: Accounting Flow
Position
Purchases Discounted purchases
Suspense A/c FPC A/c FSC A/c

Sales
On payment On delivery
Dr Cr Dr Mirror A/c Dr Cr
Cr Dr Cr Nostro A/c Cr Dr
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Chapter 10
10.2. Wash Rates
Forex trades not involving home currency11 must still be accounted in home
currency in the books. The home currency equivalent is derived by employing
the “wash rate” for the trade, which is in addition to the actual trade price/rate.
Consider the EUR/USD trade example referred to in the previous section.

The bank, whose home currency is INR, has bought EUR 1 million at 1.5000.
The wash rate that is to be applied to this trade is the market price of BC/QC
currency pair prevailing at the time of the trade, where BC is the base currency
of the trade (in our example, EUR) and QC is the home currency of the bank
(in our example, INR). Assuming that the prevailing EUR/INR market price is
75, the INR-equivalent of the trade is INR 75 million, which is posted in the Mir-
ror accounts of both EUR and USD, as follows.
EUR Mirror A/c

EUR INR
Dr Cr Balance Dr Cr Balance
1,000,000 (1,000,000) 75,000,000 (75,000,000)
USD Mirror A/c

USD INR
1,500,000 1,500,000 75,000,000 75,000,000
When the trade is squared up by an offsetting trade subsequently, the

wash rate for the closing trade may be the same as that for the opening trade
or the market price of EUR/INR prevailing at the time of the closing trade. The
former is preferred because it reflects the actual profit/loss amount. Assuming
that in the closing trade, the bank has sold EUR 1 million at 1.5100, the profit
from the trade is:
(1.5100  1.5000)  1,000,000 = USD 10,000.
The market price of EUR/INR prevailing at the time of closing trade is, say,
75.50. Consider now the impact of different wash rates for the closing trade on
the accounting entries in the Mirror accounts. The first pair of tables below ap-
plies the same wash rate (i.e. 75.00) as that for the opening trade while the
second pair of tables applies the wash rate of 75.50.
11
Currency pairs in which both currencies are foreign currencies are called “switch”
trades by Foreign Exchange Dealers Association of India (FEDAI), a self-regulatory or-
ganization in India.
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Accounting
EUR Mirror A/c (wash rate of 75.00 for both trades)

EUR INR
1,000,000 (1,000,000) 75,000,000 (75,000,000)
1,000,000 0 75,000,000 0
USD Mirror A/c (wash rate of 75.00 for both trades)

USD INR
1,500,000 1,500,000 75,000,000 75,000,000
1,510,000 10,000 75,000,000 0
The balance is zero in EUR and INR and debit (i.e. asset) of 10,000 in
USD, which corresponds to the actual profit. Instead, if we use different wash
rate of 75.00 for opening trade and 75.50 for the closing trade, the accounting
entries will be as follows.
EUR Mirror A/c (wash rate of 75.00 and 75.50)

EUR INR
1,000,000 (1,000,000) 75,000,000 (75,000,000)
1,000,000 0 75,500,000 500,000
USD Mirror A/c (wash rate of 75.00 and 75.50)

USD INR
1,500,000 1,500,000 75,000,000 75,000,000
1,510,000 10,000 75,500,000 (500,000)
The zero balance in EUR and the debit/profit of 10,000 in USD are correct,
as earlier. The INR equivalent in EUR is a loss of 500,000 and that in USD is a
profit of 500,000, both of which, though offsetting, are fictitious. Thus, when we
use different wash rates, the currency-wise profit/loss will have fictitious but
offsetting entries. In such cases we should consider only the aggregate prof-
it/loss across all currencies and not the currency-wise profit/loss.
10.3. Position Reconciliation
Every forex trade is first booked in position on trade date and finally recorded
in Mirror A/c on settlement date. After trade date, pending settlement, they are
parked in suspense accounts or as off-balance sheet items. Therefore, the
sum of balance in suspense accounts, off-balance-sheet items and Mirror A/c
must be equal to the balance in position, for each currency.
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Suspense account is only for purchase transactions and only those pur-
chases that the bank has financed. Since only purchase transactions are ac-
counted here, the balance will always be overbought/debit in this account.
There may be different subsidiary accounts for operational convenience and
control. For example, separate suspense accounts for clean instruments, ex-
port sight bills, export usance bills, etc.
Off-balance-sheet items are forward trades, which are accounted separate-

ly for purchases and sales. The balance in forward purchase contract (FPC)
A/c will be always overbought/debit and that in forward sale contract (FSC) ac-
count will be always oversold/credit. There may be subsidiary accounts under
FPC/FSC, such as FPC-interdealer A/c, FPC-commercial A/c, etc.
Mirror A/c balance may be in debit or credit, depending on how many items
have reached the Mirror A/c and how many are held in suspense accounts or
as off-balance-sheet items. If the following relation is satisfied for the outstand-
ing amounts in each account, then the accounting flows are correct.
Position = Suspense A/c + FPC A/c + FSC A/c + Mirror A/c.
The above check is called position reconciliation and made at the close of
every day by the back office.
10.4. Mark-to-market/Revaluation
Whereas the trading book is generally marked to the market at daily intervals,
the entire forex book (i.e. trading and commercial books) is marked to the mar-
ket at monthly or weekly intervals. This exercise is called “revaluation” and is
meant for assessing the profit/loss in the operations. The accounting entries
for profit/loss, however, are passed at longer intervals of quarter or year.
The mark-to-market/revaluation exercise involves liquidating the foreign

currency balances in mirror, suspense, FPC and FSC accounts at the prevail-
ing market price. The difference between the liquidation value and book value
(in home currency) is the realized profit/loss. The appropriate market price is
the price relevant to the maturity of the trade. Mirror A/c represents the settled
transactions and therefore the appropriate rate is the spot rate. The outstand-
ing trades in suspense, FPC and FSC accounts are forward trades with differ-
ent maturity dates; and liquidated at forward prices relevant to their maturity.
Traditionally, forward trades are bucketed into maturity buckets (of weeks,
months, etc), and one price is used for all trades in the same bucket. In India,
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Accounting
Foreign Exchange Dealers Association of India (FEDAI) recommends calendar

month as the unit for maturity buckets and the market price for end-of-the-
month as the revaluation price. Such a procedure greatly distorts the profit/loss
because the trade maturing on first of the month and the last of the month are
liquidated at the same price. The profit margins in most commercial transac-
tions is about 0.02 – 0.1%, and the difference in the market price between the
first and last day of the month can be 0.3%. Forex swaps for the “turn” periods
(see Section 6.8) will be similarly distorted. Reducing the bucket width to
shorter interval (e.g. week) and using the market price for the middle-of-the-
bucket period will lessen such distortions. Of course, the better solution is to
take the appropriate market rate for each trade separately, which is possible in
the current environment of high automation. Many software applications im-
plementing value-at-risk (VaR) follow such an approach.
Another source of distortion in profit/loss during revaluation is that the prof-

it/loss from mirror A/c (“ready profit/loss”) is realized and crystallized; and the
profit/loss from the forward maturity buckets (“forward profit/loss”) is realized
but not crystallized. This poses a problem: should be consider only the ready
P/L and ignore the forward P/L? Should we consider both? There are different
market practices, as follows.
 consider only the ready P/L and ignore the forward P/L
 consider both ready and forward P/L
 consider ready P/L, provide for forward loss and ignore forward profit
The first is wrong; the second is right; and the third is conservative. Let us
illustrate them with the following example.
On May 22, a bank in India has started its forex business and the first trade
is a funding swap to keep working balance in USD nostro account. The swap
is B-S in USD against INR for the period from May 22 to June 30, as follows.
Buy USD 1m @ 50.00 against INR value date May 22 (near leg)
Sell USD 1m @ 50.39 against INR value date Jun 30 (far leg)
The swap was at a gain of INR 0.39 per USD or INR 390,000 for the deal
amount. There is no position and hence there will be neither profit nor loss
from subsequent changes in USD/INR price. Consider now the revaluation at
the end of May, when the mid market prices are:
Spot 49.50
Forward outright for Jun 30 49.79
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Chapter 10
The near leg is already settled and therefore will be in the mirror A/c. The
far leg will be outstanding in Forward Sale Contract (FSC) A/c. Assuming that
the maturity buckets are months, the following will be the balance, book value
and liquidation value of mirror A/c and FSC A/c.
A/c USD INR Liquidation P/L

Price Amount
Mirror A/c (1,000,000) (50,000,000) 49.50 49,500,000 (500,000)
FSC A/c 1,000,000 50,390,000 49.79 (49,790,000) 600,000
Total 0 390,000 100,000
We know for sure that the funding swap resulted in a gain of INR 390,000
(which is the difference in INR amounts in Mirror A/c and FSC A/c). Of course,
this is not the net P/L because the interest cost on INR funds outlay in the
swap is not considered. We will ignore the funding cost in INR and focus only
on profit/loss from the sole forex swap trade. In any case, there is no position
in USD and therefore the subsequent changes in USD/INR should not result in
any profit or loss.
On the revaluation date, because of splitting the two legs of swap into two
maturity buckets and revaluing them separately, we have overbought/debit po-
sition in Mirror A/c and oversold/credit position in FSC A/c due on the last day
of June. The overbought position is liquidated at the market price of 49.50,
which results in a ready loss of INR 0.5m (INR received in liquidation is less
than the book value). The oversold position is covered at the market price of
49.79, resulting in a forward profit of INR 0.6m (covering required lesser INR
than the book value). Consider now the three different P/L methods and their
P/L amounts.
Book only ready P/L 0.5m (loss)

Book both ready and forward P/L 0.1m (profit)
Book ready P/L, provide for loss but ignore profit in forward 0.5m (loss)
As stated earlier, the first method is wrong; the second is right; and the
third is conservative. We know for sure that there cannot be any loss and there
is no loss because there is no position. The revaluation splits the position into
multiple units (e.g. Mirror A/c, suspense A/c, etc), which results in gain on one
date and a compensating loss on another.
The second method is right because it incorporates the offsetting gain and
loss on different value dates. But why does the profit of INR 0.1 million in this
method differs from the actual swap gain of INR 0.39 million? The latter is the
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Accounting
realized gain and will crystallize if we continue with the trade until the settle-
ment of the far leg on Jun 30. However, if we liquidate the bank on the revalua-
tion date, the realized gain will not be fully crystallized because we need to ex-
ecute a reversing S-B swap from May 31 to Jun 30 in liquidation. In the revers-
ing swap, we will be paying a swap loss of INR 0.29 per USD (i.e. the differ-
ence between the prices for May 31 and June 30) or INR 0.29 million for the
deal amount. Offsetting this with the earlier gain of INR 0.39 million, the rea-
lized and crystallized gain will be INR 0.1 million. Thus, the sum of ready and
forward P/L represents the realized and crystallized P/L as of revaluation date.
The third method is conservative, and better than the first method but not a
true and fair view. It is better than the first method because in certain cases, it
is closer to the true and fair view. To illustrate it, consider the market prices of
50.50 and 50.79 for spot and June 30, respectively, and use them for revalua-
tion of our earlier examples. It results in the following P/L.
A/c USD INR Liquidation P/L

Price Amount
Mirror A/c (1,000,000) (50,000,000) 50.50 50,500,000 500,000
FSC A/c 1,000,000 50,390,000 50.79 (50,790,000) (400,000)
Total 0 390,000 100,000
The first method results in a fictitious profit of INR 0.5m while the second
and third methods result in the correct profit of INR 0.1m.
As the quotation at the beginning of the chapter says, the true and fair view
is the most inviolate of the four principles of accounting (continuity, consisten-
cy, conservatism, and true and fair). Therefore, the second method should be
preferred to the first and third methods. Let us end this chapter by summariz-
ing the three sources of distortion on revaluation profit/loss.
1. Currency-wise profit/loss is not meaningful because the use of wash rates

(and their subsequent price changes) can create fictitious profit in one cur-
rency and a compensating loss in another. Therefore, only the aggregate
profit/loss over all currencies will give the true view.
2. Within a currency, the ready and forward profit/loss is not meaningful be-
cause of splitting the position across various maturity dates. The changes
in spot price can create fictitious profit in one maturity and a compensating
loss in another. Therefore, only the aggregate profit/loss over all maturity
dates will give the true view.
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Chapter 10
3. For the purpose of revaluation, the ideal solution is to value each

trade at the market price relevant to its maturity. If this is not feasible,
then positions must be classified into narrow maturity buckets (say,
weeks) and the revaluation price must be the price relevant to the
middle of the bucket period. Wider maturity buckets (e.g. months) and
using the end-of-the-period revaluation price for each bucket can
greatly distort the profit/loss, and such distortion can be more than the
profit margins loaded in the commercial transactions.
Key Concepts
Position and Mirror A/c are the beginning and end of the trade accounting.
All trades contracted are recorded in the Position on trade date; and all trades
settled are recorded in the Mirror A/c on settlement date. Pending settlement,
the trades are parked in suspense account for financed trades and as off-
balance-sheet items for forward trades.
The sum of balances in suspense account, off-balance-sheet items and Mirror

A/c must be equal to the balance in Position. This check is called position re-
conciliation.
Wash rates are used for trades not involving home currency to determine the
home currency equivalent of the trade.
Currency-wise and maturity-wise profit/loss are not reliable. Only the aggre-
gate sum of profit/loss at all maturity dates and over all currencies will give a
true and fair view of profit/loss.
EXERCISES
1. In the Mirror A/c (and also other accounts), the balance of foreign currency
and its home currency equivalent should be on the same accounting side:
both of them are debits or both of them are credits. This is because the
home currency amount merely indicates the equivalent of foreign curren-
cy. If the foreign currency amount is an asset, so must be the home cur-
rency equivalent, and vice versa. However, in one particular case, it is
found that the GBP Mirror A/c is showing debit for GBP amount and credit
for home currency equivalent; and EUR Mirror A/c is showing credit for
EUR amount and debit for home currency equivalent. Is such a situation
possible?
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Accounting
2. On May 22, the bank has commenced the forex business and executed
the following transactions.
a. USD/INR: Bought USD 1m @ 50.00 value date cash. This is the

first leg of funding swap.
b. USD/INR: Sold USD1m @ 50.22 value date Jun 30. This is the
second leg of funding swap.
c. EUR/USD: Bought EUR 1m @ 1.2576 value date spot. This is
the originating proprietary trading transaction.
d. GBP/USD: Sold USD 5m @ 1.6575 value spot. This is the origi-
nating proprietary trading transaction.
e. USD/INR: Bought USD 504,279 @ 50.04 value date Jun 14. This
is a commercial transaction of export bill discounted.
f. USD/INR: Sold USD 500,000 @ 50.01 value date spot. This is a
hedge transaction for (e) to eliminate position.
g. JPY/INR: Sold JPY 500m @ 50.59 (quoted as INR per 100 JPY)
value date Jun 30. This is a commercial forward sale contract
with a customer.
h. USD/JPY: Bought JPY 500m @ 99.72 value date spot. This is a
hedge transaction for (g) to eliminate position partially.
i. USD/INR: Bought USD 5m @ 49.98 value date spot. This is a
hedge transaction for (g) to eliminate the residual position after
(h).
j. EUR/USD: Sold EUR 1m @ 1.2591 value date spot. This is the
reversing proprietary trading transaction, which squares up the
(c).
k. GBP/USD: Bought USD 5m @ 1.6571 value date spot. This is
the reversing proprietary trading transaction, which squares up
the (d).
l. USD/INR: Bought USD 0.5m @ 50.00 value date spot. This is the
first leg of hedging swap for (e) to eliminate gap.
m. USD/INR: Sold USD 0.5m @ 50.06 value date Jun 14. This is the
second leg of hedging swap for (e) to eliminate gap.
n. USD/INR: Sold USD 5m @ 50.01 value date spot. This is the first
leg of hedging swap for (g) to eliminate gap partially.
o. USD/INR: Bought USD 5m @ 50.24 value date Jun 30. This is
the second leg of hedging swap for (g) to eliminate gap partially.
p. USD/JPY: Sold JPY 500m @ 99.78 value date spot. This is the
first leg of hedging swap for (g) to eliminate gap fully.
q. USD/JPY: Bought JPY 500m @ 99.38 value date Jun 30. This is
the second leg of hedging swap for (g) to eliminate gap fully.
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Based on the above transactions, answer the following.
i. What is the Position in USD, EUR, GBP, JPY and INR?

ii. Post the entries in suspense A/c (in this case Export Bills
Discounted A/c) , off-balance-sheet items (FPC A/c, FSC
A/c) and Mirror A/c for each currency.
iii. Revalue the books as of May 31, assuming the following
market prices (use monthly maturity buckets and use the
end-of-bucket period price for revaluation).
Spot
USD/INR 50.25
EUR/USD 1.2765
GBP/USD 1.6790
USD/JPY 103.05
Outright for Jun 30
USD/INR 50.40
EUR/USD 1.2761
GBP/USD 1.6780
USD/JPY 102.75
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Chapter 11
Continuous Linked Settlement
CLS settlement is the only means by which settlement risk can be eliminated
with finality using a unique combination of payment versus payment in central
bank funds, multilateral payment netting and a standard legal framework, sup-
ported by a robust and resilient infrastructure. (from the home page of CLS
Group website, http://www.cls-group.com )
Share of various methods in FX settlements: CLS, 55%; traditional correspon-

dent banking, 32%; bilateral netting, 8%; and others, 5 %. (Progress in Reduc-
ing Foreign Exchange Settlement Risk, May 2008, CPSS, Bank for Interna-
tional Settlement)
Continuous linked settlement today is the only global payment system that op-
erates on payment versus payment (PvP) basis for cross-border settlements in
17 currencies. It combines the best elements from different domains: mission
critical technology, straight-through-processing, multilateral netting, real-time
settlement and settlement finality.
The elevated settlement risk in forex (“Herstatt risk”) is introduced in Sec-

tion 3.1. The forex settlements were disrupted by the failures of Bank Herstatt
(1974), Drexel Burnham Lambert (1989), Bank for Credit and Commerce Inter-
national (1991) and Barings Bank (1995). The Committee on Payments and
Settlements Systems (CPSS) of Bank for International Settlements (BIS) has
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Chapter 11
been regularly examining the safety and efficiency of payment systems, which
resulted in various reports: Angell Report (1989), Lamfalussy Report (1990),
Noel Report (1993) and Allsopp Report (1996).
11.1. Settlement Risk in Forex
Allsopp Report focused specially on the settlement risk in forex transactions. It

provided, for the first time, a measure for settlement exposure and linked it to
the five categories of settlement status, as follows.
Status Description Exposure

Revocable (R) Payment instruction for sold currency None
is not issued or, if issued, cancellable
Irrevocable (I) Cancellation of payment instruction Bought currency
for sold currency is not possible; and amount
the payment from the counterparty for
bought currency is not yet due
Uncertain (U) Payment from the counterparty for Bought currency
bought currency is due but no infor- amount
mation about the finality of its receipt
Fail (F) Payment of bought currency is not Bought currency
received from counterparty amount
Settled (S) Payment of bought currency is re- None
ceived with finality
Exhibit 11-1 shows the timeline for various settlement statuses of the trade.
The “payment” is for the sold currency amount and the “receipt” is for the
bought currency amount.
EXHIBIT 11-1: Timeline and Duration of Settlement Status for Trade
Trade Deadline for cancellation of Receipt of amount Identify final or

Date payment instruction due failed receipt
R I U F or S
The duration of each status depends on the currency pair and the market
side (i.e. bought or sold). The following table shows the average duration (in
hours) for the three most actively traded currencies against USD.
170
Currency USD sold USD bought

I U I U
EUR 9 13 22 8
GBP 9 15 24 8
JPY 5 20 33 8
Source: Progress in Reducing FX Settlement Risk, BIS, May 2008
In reality, there are more risks to settlement, namely, counterparty credit

risk, liquidity risk and systemic risk. Counterparty credit risk (formerly called
pre-settlement risk) arises during the Status R period (i.e. between the trade
date and the time the payment instruction for sold currency becomes irrevoca-
ble). It arises because, if the counterparty fails during this period, we need to
replace the original contract with a new contract at the prevailing market price.
The difference between the prevailing market price and the original contract
price is the replacement cost and the size of counterparty credit risk. When the
settlement status is F, we need to arrange for additional funding, which is the
liquidity risk. If the settlement fails are widespread, there is a possibility that the
entire settlement process might come to halt because of domino effect, which
is the systemic risk.
Allsopp Report recommended a three-pronged strategy to reduce settle-

ment risk in forex: (1) action by individual banks to improve their risk controls
and operational practices; (2) action by industry groups to adopt risk-reducing
settlement services such as multi-currency and multilateral netting; and (3) ac-
tion by central banks to induce the industry pursuing the required strategies by
improving the national payments systems.
11.2. Evolution of Continuous Linked Settlement
The industry responded with various initiatives. FXNET, Valuenet and SWIFT
Accord pursued bilateral netting arrangements under standardized agreements
(e.g. IFEMA). Exchange Clearing House (ECHO) and Multinet pursued multila-
teral netting. In 1997, a group of 20 banks (“G20”) from eight countries formed
the company, CLS Services Ltd (CLSS), to provide PvP services by means of
“continuous linked settlement”.
The “continuous” means that the settlement runs continuously in the speci-
fied time-window until all the currency time zones are covered; and the “linked”
means that the payment made for sold currency is linked to the payment to be
received for bought currency. Either both of them are settled or none of them is
settled. Continuous linked settlement is different from trade guarantee. In the
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Chapter 11
latter, the settlement is guaranteed; in the former, the principal amount is

guaranteed, but not the settlement. If the settlement fails, the non-defaulting
party will not lose the principal but has to replace the trade at the prevailing
market price, which is subject to the loss of replacement cost.
The jurisdiction for incorporating CLSS was narrowed to US or UK, based

on the enforceability of settlement finality and security interest. The concern
about the possibility of the Office of Foreign Asset Control (OFAC) in the US
blocking the foreign banks‟ funds with CLSS for political reasons led to the UK
as the choice for incorporating CLSS. To implement PvP settlement, CLSS
must maintain accounts with central banks to access the real-time gross set-
tlement (RTGS) system for each currency. In many countries, banking status is
required to maintain accounts with the central bank. Therefore, CLSS formed
two subsidiaries in 1999: CLS Bank International (CLSB), which is incorpo-
rated in New York as a special purpose multi-currency bank subject to the reg-
ulatory oversight by the Federal Reserve; and CLS Operations in the UK to
provide operational support and IT infrastructure. For tax reasons, there was a
corporate restructuring in 2000 under which a new holding company, CLS
Group Holdings AG, was incorporated in Switzerland, which was regulated by
the Federal Reserve as a bank holding company. CLSS became a shell com-
pany and its name changed to CLS UK Holdings Ltd, which operated through
two subsidiaries: CLS Bank International, a special purpose bank in the US;
and CLS Services Ltd (formerly CLS Operations Ltd), in the UK to provide op-
erational support. Exhibit 11-2 shows the corporate structure.
EXHIBIT 11-2: CLS Corporate Structure
CLS Group Holdings (Switzerland)
CLS UK Holdings (UK) (shell company)
CLS Bank Intl. (US) CLS Services (UK)
The acronym “CLS” is a registered trademark and may be used only with
CLS Bank International (CLSB) or CLS Services (CLSS) Ltd. The phrase “con-
tinuous linked settlement” is not a registered trade mark, however.
172
11.3. Operations
After time and cost overruns of 25 months and 130%, respectively, CLSB
started operations in September 2002 with seven currencies, which were in-
creased to 17 currencies over time, as follows.
Sep 2002 AUD, CAD, CHF, EUR, GBP, JPY and USD
Sep 2003 DKK, NOK, SEK and SGD
Dec 2004 HKD, KRW, NZD and ZAR
May 2008 ILS and MXN
Currently, six instruments are settled in each CLS currency: FX spot, FX

forward, FX swap, FX option premium and exercise, non-deliverable forward
(NDF) and credit derivatives. The first three involve settlement in two curren-
cies on PvP basis. The last three involve payment in a single currency, which
does not require PvP requirement, but CLSB provides value-added services
(e.g. automated confirmation/exercise notice) in the instruments. In each of the
CLS currencies, CLSB makes and receives payment with its members in the
RTGS system through its accounts with central banks. CLSB has two types of
members: settlement member and user member.
Settlement Members: they maintain a single multi-currency account with CLSB

and assume responsibility for settlement risk and providing liquidity. For this
reason, only large financial institutions can be settlement members, and CLSB
has prescribed certain qualifying criteria.
User Members: they maintain a single multi-currency account with a settlement

member, but can submit settlement instructions directly to CLSB, which are
settled by the settlement member with CLSB. User member does not assume
responsibility for settlement risk or liquidity support.
Both settlement member and user member must be shareholders of CLS

Group, but the converse is not true. As at the end of March 2009, there are 70
shareholders but only 60 members. Members access the CLSB systems
through SWIFTNet InterAct, which is an automated and interactive messaging
system of SWIFT. There are two more parties in the CLS operations: third par-
ties and nostro agent. Third parties are users of the CLS, but not its members.
They settle transactions through either user members or settlement members.
As of March 2009, there are 4,686 third parties, consisting of 411 banks and
4,275 investment funds. Nostro agents are neither users nor members of the
CLS: they are facilitators. Since CLSB makes and receives payments only
through RTGS systems, settlement members, too, must have access to them.
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Chapter 11
If they do not have direct access to RTGS systems, then a nostro agent will es-
tablish the connectivity between the CLSB and settlement members. In gener-
al, most settlement members have direct access to the RTGS system. Exhibit
11-3 shows the relations between various parties.
EXHIBIT 11-3: Linkages in CLSB Operations
CLS Bank
Central
Bank
RTGS
Settlement Member User Member
Nostro Agent Third Party Third Party
Payment instruction Payment instruction

and settlement only
Submission of Settlement Instructions
Settlement instructions are submitted by settlement members and user mem-

bers to CLSS via SWIFTNet. They can be submitted as soon as the trade is
executed and up to 06:30 CET on value date. However, the best practice is not
to submit the instruction after 00:00 CET on value date. In other words, cash
value date trades are settled outside the CLS system.
Matching
After comparing the settlement instructions from both the parties, CLSS will
assign the following trade status, which is made available to the members in
real time.
Status Description
REJECTED Possible duplication
INVALID Not a CLS currency or a business day
SUSPENDED Trade does not pass risk management tests
UNMATCHED Settlement instruction not received from counterparty
MATCHED Eligible for settlement
174
Matched instructions can be cancelled or modified up to 00:30 CET on val-

ue date unilaterally and up to 06:30 CET on value date bilaterally.
Settlement and Funding
CLSS makes a distinction between settlement and funding. Settlement refers

to the book entries in the settlement member‟s account with CLSB and is on
gross basis. Funding is the pay-in in central bank RTGS funds and is on net
basis. The following example illustrates the settlement and funding for three
transactions in EUR/USD as follows. (Sale = Debit; Purchase = Credit).
SETTLEMENT (in the settlement member‟s account with CLSB)
EUR USD
Debit Credit Debit Credit
100 125
200 245
150 185
Total 250 200 245 310
Settlement member pays EUR 250 and receives EUR 200; and pays USD
245 and receives USD 310. It is on gross basis.
FUNDING (between CLSB and settlement member in RTGS funds)
EUR USD
Debit Credit Debit Credit
50 65
Settlement member pays EUR 50 and receives USD 65. It is on net basis.
The multi-lateral netting before pay-in results in, on an average, the reduc-
tion of 95% in funding and 99.75% in the number of transactions, which im-
proves liquidity management and lowers transaction costs. The following is the
timeline for various activities, which are summarized in Exhibit 11-4.
00:00 CET: Initial pay-in schedule (IPIS) after multilateral netting is issued; this
is also the deadline for unilateral cancellation or amendment.
06:30 CET: Revised pay-in schedule (RPIS); this is also the deadline for bila-
teral cancellation or amendment.
07:0012:00 CET: This is the five-hour settlement cycle time window, during
which settlement will be completed in the first two hours while the funding
takes place continuously.
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Chapter 11
09:00 CET: Settlement completion target time (SCTT)
10:00 CET: Funding completion target time for Asia-Pacific currencies (FCTT1)
12:00 CET: Funding completion target time for other currencies (FCTT2)
EXHIBIT 11-4: Timeline for CLS Process
00:00 06:30 07:00 09:00 10:00 12:00 Time (CET)
IPIS RPIS start SCTT FCTT1 FCTT2
settlement and funding time
The funding takes place in the CLSB‟s accounts with various central banks,
whose RTGS systems and their operating hours are as follows.
Country & Currency RTGS Local Time CET

Switzerland CHF SIC 17:00a – 15:00 17:00a – 15:00
New Zealand NZD ESAS 09:00 – 08:30b 23:00a – 22:00
Canada CAS LVTS 06:00 – 18:00 00:00 – 12:00
Mexico MXN SPEI 08:30 – 17:00 01:00 – 12:30
Australia AUD RITS 09:15 – 18:30 01:15 – 10:30
Japan JPY BOJ-NET 09:00 – 19:00 02:00 – 12:00
S Korea KRW BOK-Wire 09:30 – 17:00 02:30 – 10:00
Hong Kong HKD CHATS 09:00 – 17:30 03:00 – 11:30
US USD Fedwire 21:00a – 18:00 03:00 – 02:00b
Singapore SGD MEPS+ 09:00 – 19:00 03:00 – 13:00
Norway NOK NBO 05:40 – 16:30 05:40 – 16:30
Denmark DKK KRONOS 07:00 – 15:30 07:00 – 15:30
EU EUR TARGET 07:00 – 17:00 07:00 – 17:00
UK GBP CHAPS 06:00 – 16:00 07:00 – 17:00
Sweden SEK K-RIX 07:00 – 17:00 07:00 – 17:00
S Africa ZAR SAMOS 07:00 – 16:00 07:00 – 16:00
Israel ILS ZAHAV 07:00 – 14:15 07:00 – 14:15
a
One day before value date (V1); bOne day after value date (V+1) (Source:
Progress in Reducing Foreign Exchange Settlement Risk, BIS, May 2008)
The 07:00–12:00 CET time window is chosen because the RTGS systems
of 17 currencies are simultaneously open during this period (see Exhibit 11-5).
176
177
Chapter 11
Funding for Asia-Pacific currencies (AUD, HKD, JPY, KRW, NZD and
SGD) occurs during the three-hour period of 07:00 – 10:00 CET during which
their RTGS systems are open. For other currencies, funding continues in the
full five-hour period of 07:00 – 12:00 CET.
Processing Queue
Before the pay-in schedule is issued, settlement instructions are filtered based
on certain risk management criteria (discussed in the next section). Since the
funding takes place continuously, a large payment amount in the early stages
may block all other payments and result in a total pay-in failure. To prevent
such a situation, large amounts are split into smaller amounts to facilitate early
pay-ins. After the pay-in occurs in the RTGS funds, CLSB completes the cor-
responding pay-out to the settlement member or its nostro agent. The unset-
tled trades at 12:00 CET are removed from the queue, and the counterparties
will decide whether to settle them in CLS on the next day or settle it outside
CLS on the same day.
11.4. Risk Management
Each trade in the processing queue is subjected to three risk management

tests: positive adjusted balance, short position limit and aggregate short posi-
tion limit. Only after passing these tests, the payment instruction is processed.
Positive Adjusted Balance
CLSB converts the balances in all currencies, both long and short, in the set-
tlement member‟s account into USD-equivalent at the prevailing market prices
(supplied by Reuters) and add them up. The aggregate USD-equivalent is the
positive adjustment balance. Before converting them into USD-equivalent, the
balances are subjected to haircut, which reduces the long balances and in-
creases the short balances. The haircut is usually set at the price change over
6-day period at four standard deviations. For a payment instruction to be
processed, positive adjusted balance must be greater than zero.
Short Position Limit
CLSB assigns a currency-wise short position limit for each settlement member
and reviews it periodically. This is a liquidity facility, which enables the settle-
ment to occur even if the CLSB has not received the other currency amount.
Note that the short position limit does not create any credit risk to the CLSB
because the positive adjusted balance (the first test) is greater than zero.
178
Aggregate Short Position Limit
It is a limit on the settlement member‟s total short positions in all currencies.

Like positive adjusted balance, it is computed in USD-equivalent after applying
the haircuts. The limit is reviewed from time to time.
The following example illustrates the aggregate short position limit and pos-
itive adjusted balance, assuming that the settlement member has the following
positions in its accounts with the CLSB. All the amounts are in USD equivalent
and after adjusting for haircuts.
Currency Dr/Short Cr/Long

EUR 125
GBP 250
JPY 100
Total 225 250
The aggregate short position is USD 225 and the adjusted positive balance
is USD 25, which is the difference between total positions and total long posi-
tions. For a payment instruction to be processed, the following tests must be
passed: (1) positive adjusted balance must be greater than zero, which is the
case indeed; (2) short position of USD 125 in EUR and USD 100 in JPY must
be less than the limits set for each currency; and (3) aggregate short position
of USD 225 must be less than the limit specified for this test.
11.5. Liquidity Facilities
The pay-in in CLS is extremely time critical and differs substantially from other
payment systems. For Asia-Pacific currencies, domestic clearing is completed
before CLS clearing begins; for European currencies, domestic clearing and
CLS clearing are roughly coterminous; and for North American currencies,
CLS clearing is completed before domestic clearing starts.
The time difference between CLS and domestic clearings has significant
impact on liquidity management. For example, for Asia-Pacific currencies, a
bank expecting a large receipt in CLS will build up a large debit position in do-
mestic clearing. Similarly, for North American currencies, making a large pay-in
in CLS is exposed to cost and credit risk because the covering funds are re-
ceived later in the domestic clearing. Consider a bank that executed an over-
night sell-buy forex swap in EUR against USD, and invested the overnight
USD funds in USD money market. In the settlement of far leg, the bank will pay
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Chapter 11
USD in CLS before it receives the covering funds in CHIPS. To improve the li-
quidity management and to ensure successful completion of pay-in in CLS,
there are three tools: inside/outside (I/O) swap, top-up and contingency swap
(TUCS) and liquidity providers.
Inside/Outside (I/O) Swap
Consider the situation in which Bank A has a large short position in EUR and a
large long position in USD; and Bank B has a complementary position of large
long position in EUR and large short position in USD. Both of them can enter
into the following intra-day swap.
Bank A buys EUR (and sells USD) from Bank B value cash (“inside leg”)
Bank A sells EUR (and buys USD) to Bank B value cash (“outside leg”)
The first leg is called inside leg because it is settled within CLS; and the
second leg is called outside leg because it is settled outside CLS and in the
domestic clearing of the two currencies. The inside leg ensures that the pay-in
for EUR is completed early. Though I/O swap enables a smooth pay-in in CLS
despite large short position for a member, it introduces to one party (in the
above example, to Bank B) the Herstatt risk, which defeats the very purpose of
CLS. The introduction of Herstatt risk here is considered tolerable in view of
significant improvement in the liquidity of CLS pay-in.
After the initial pay-in schedule is issued at 00:00 CET, CLSS will identify
the potential I/O swaps between various members and publish them by 00:30
CET. The I/O swap advice from CLSS is subject to the counterparty limits that
the members have established for each other, maximum trade size for each
currency, etc. The members interested in executing the I/O swaps must bilate-
rally negotiate and confirm the I/O swap to the CLS. The inside leg must be
matched by 03:30 CET so that it can be incorporated in the final pay-in sche-
dule at 06:00 CET. Overall, I/O swaps have not been popular.
Top-up Contingency Swap (TUCS)
Some settlement members privately formed a group to execute I/O swaps on a

bilateral basis. However, the process is highly manual and hence lost its relev-
ance.
Liquidity Providers
If a settlement member‟s short position in a currency is extended and continu-

ing, it does not create credit risk to the CLSB because there is an equivalent
180
long position in another currency (under the first test). However, the CLSB
cannot make the pay-out in the short currency in the circumstances.
To enable CLSB complete the pay-out, there is a liquidity facility committed

by certain settlement members (“liquidity providers”) for each currency. Under
this facility, CLSB enters into an overnight forex swap with liquidity providers,
Under the swap, CLSB receives funds in the short currency (with which it com-
pletes the pay-out) and pays funds in long currency (which would otherwise
have been credited to the failing settlement member‟s account). On the next
day, one of the following will take place. First, the failing member makes good
the short currency funds, which settles the second leg of swap. Second, if the
failing member does not make good the short currency, CLSB will enter into an
outright transaction to complete the second leg of forex swap. The hair cut built
into the failing member‟s long position should be adequate to withstand the
price changes overnight. If the outright transaction is not possible (because of
lack of quotes), the overnight forex swap is rolled over for a maximum of four
business days, after which CLSB computes the loss and allocates it pro rata to
those settlement members that had traded with the failing member such that
the loss to a member is capped at the bilateral net amount with the failing
member. In the unlikely event of CLSB not able to raise enough funds to cover
the short fall amount, there will be general loss allocation to all surviving mem-
bers. The general loss allocation is subject to a cap of USD 30 million.
11.6. Operations Milestones
Despite the initial cost and time overruns, CLS made significant progress after
it commenced operations in September 2002. The following are the milestones
in its operations.
Date Milestone
Feb 2003 Daily value of settlements exceed USD 1 trillion
Jan 2004 Daily value of settlements exceed USD 2 trillion
Dec 2004 Daily value of settlements exceed USD 3 trillion
Sep 2005 Daily value of settlements exceed USD 4 trillion
May 2006 Daily payment instructions exceed 0.5 million
Jun 2006 Daily value of settlements exceed USD 5 trillion
Dec 2006 Daily value of settlements exceed USD 6 trillion
Jun 2007 Daily value of settlements exceed USD 7 trillion
Sep 2007 Daily value of settlements exceed USD 8 trillion
Nov 2007 Daily payment instructions exceed 1 million
Mar 2008 Daily value of settlements exceed USD 10 trillion
Sep 2008 Daily payment instructions exceed 1.5 million
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Chapter 11
On the negative side, there were just two jarring notes. The first occurred
within first six months of operations. On March 25, 2003, database program-
ming errors by IBM resulted in 30% of the settlements being wrongly rejected.
The CLSS staff was slow to respond, and the RTGS systems of Asia-Pacific
currencies had to be extended to complete the settlement.
The second problem occurred on May 27, 2003, just two months after the
first problem. Due to errors by the CLSS staff, pay-out occurred before pay-in!
However, the problem was solved immediately.
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Chapter 12
Front Office: Trading and Hedging
Currency trading is unnecessary, unproductive and totally immoral. It should
be stopped. It should be made illegal. We don‟t need currency trading. ( MOHA-
MAD MAHATHIR, Prime Minister of Malaysia, at a meeting of IMF in Hong Kong
on September 20, 1997. The context was the sharp fall of Malaysian ringgit in
FX market. )
Hedging is the tai chi of trading. ( JIM KHAROUF, Futures, October 1996)
Trading (also called speculation) is taking risk, which results in either profit or
loss. Hedging is eliminating risk, which results in neither profit nor loss. To-
gether, they constitute the main activity of front office.
12.1. FX-speak
FX traders have their own lingo which, like airline pilot‟s language, is precise
with a vocabulary of about two dozen words. The deal conversation takes
hardly about 5-10 seconds. Exhibit 12-1 lists alphabetically the commonly used
words and phrases and their meaning.
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Chapter 12
EXHIBIT 12-1: FX Trader’s Lingo
BIO Billion, which is always the American billion (i.e. a thousand

millions) and not a British billion (i.e. a million millions). The
British use the word milliard for American billion, but it is no
longer in use. It is also called YARD (q.v.)
CABLE GBP/USD. It is so called because the London closing price of
this rate used to be sent to New York by cable; and the New
York traders, would ask: “Has the cable arrived?”, “What is
the cable (price)”?
CBL Short for CABLE (q.v.)
CH Short for CHANGE (q.v.)
CHANGE Said by the by the price quoter/maker and means that the
price quoted earlier has changed and does not hold now.
CHECK Another way of saying CHANGE (q.v.)
CHK Short for CHECK (q.v.)
CHOICE Used after the price (“1.2555 choice”) by the price quo-
ter/maker and means that the price asker/taker can buy or sell
at the same price. In other words, the bid-offer spread is zero.
COPEY Nickname Danish krone (DKK)
FIGURE Pronunciation for “00” (e.g. “figure five” for 00/05)
LEVEL Used after the price (“1.2525/30 level”) by the price quo-
ter/maker and means that the price is for indication only and
not for dealing.
LVL Short for LEVEL (q.v.)
MINE Said by the price asker/taker and means “I bought” (base cur-
rency in outright) or “I received” (swap points in FX swap)
MIO Short for million
MY RISK Said by the asker/price-taker and means that the quoter hold
the price for a while and any change in price during the hold-
ing period will be at the risk of asker. If the asker wants to
deal, he would check the latest price by saying “How now?”
Typically used when the asker is executing a matching trade
with another simultaneously.
OFF Another way of saying CHANGE (q.v.)
OZZY Nickname for Australian dollar (AUD)
SMALL Trade amount will be about USD 0.25 MIO equivalent
STOCKY Nickname for Swedish krona (SEK)
TINY Trade amount will be about USD 0.1 MIO equivalent
URS Short for YOURS (q.v.)
VALUE Short for value date
YARD American billion. From the last syllable of the equivalent but
archaic British word “milliard”. It is also called BIO (q.v.)
YOURS Said by the price asker/taker and means “you bought” (base
currency in outright) or “you received” (swap points in FX
swap)
184
12.2. Market Practices in Interdealer Market
The market has some uniform global practices defined by ACI12 Model Code of
Conduct. In addition, the local chapter of ACI or the local regulator may have
recommended additional practices applicable to the local market. And most
important, there are certain informal rules, unwritten yet powerful, among deal-
ers, which govern the dealing practices. The following are some of them.
Price Quotes
A dealer is not bound to quote a price when asked for quotation. He may indi-
cate his lack of interest by replying “not in the market.”
Price quoter/maker should usually quote both bid and offer except in excep-
tional circumstances. During market closing hours, for illiquid currency pairs or
in volatile price conditions, the price quoter/maker may request the price ask-
er/taker to disclose the market side (i.e. buy or sell) and the deal amount. The
asker need not disclose them and approach another price quoter.
All price quotes are firm and tradable for “standard” amount (explained below)
unless indicated otherwise. If the price is for indication only, the quoter should
indicate so (e.g. “1.2525/30 level”, “1.2525/30 for info only”).
Price quoter/maker should not engage in “spoofing”: quoting an off-market

price and withdrawing it immediately with a view to misguiding others about the
current market level or conditions.
The price quoted must be traded (“hit”) immediately by the price asker saying
“mine”, “yours” or “thanks, nothing”. If the asker requires the price to be held
for few seconds more, he should say “my risk” and when he decides to hit the
price, he should say “how now?” or “are you there?”. The price quoter/maker
may give a new price or indicate that the old price is good for dealing. If the
asker does not say “my risk”, the quoter himself may say “your risk”, indicating
that the price is held at the asker‟s risk and the asker should ask for the price
12
ACI is the abbreviation for the Paris-based Association Cambiste International. Origi-
nally, it was an informal club of forex traders with the motto “Once a dealer, always a
dealer” and an old style telephone receiver as its logo, and was popularly known as
“Forex Club” in tune with its informal style. It has national chapters in most countries un-
der the name “Forex Association”. In the later years, ACI extended its scope to money
market and money derivatives (which was wholly unnecessary), became formal (and
even academic) in its functioning, and renamed itself as “ACI The Financial Markets As-
sociation.” Their website is www.aciforex.com.
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Chapter 12
again. For swap quotations, the quoter may indicate the price is good for a
specified period (e.g. “25/26 good for an hour”) because the swap points are
not volatile like spot price.
Price asker/taker is not bound to trade on the price given to him. He may ask
for price and not deal; he may ask for price for the second time and not deal;
and so on ad infinitum. However, ad infinitum should not be ad nauseam.
There should be no reason to ask the price for the third time. Asking for the
second time is acceptable because the first price may have been “trended”
(see Section 12.4), which was against the asker.
If the price quoter/maker gives the choice price (which will be naturally within
the bid-offer range of market price), the price asker/taker is not bound to trade,
but courtesy demand that he should. Similarly, if the price asker/taker requests
for a second quote with a narrow spread and the price quoter/maker obliges,
the price asker/taker is not bound to deal on the second quote, but courtesy
demands that he should.
Deal Amounts
All prices quoted are for standard (“market lot”) amounts. How much is a mar-
ket lot depends on the business center and the currency pair, and is informally
set by the traders in each local market. The following is an indicative list.
Business center Currency Pair Market Lot

USD/JPY USD 1 – 3 MIO
Tokyo
Others active pairs USD 1 – 2 MIO
London Top five currency pairs USD 1 – 5 MIO
New York Top five currency pairs USD 1 – 3 MIO
USD/INR (spot) USD 0.5 – 1 MIO
India USD/INR (FX swap) USD 0.5 – 2 MIO
Other active pairs (spot) USD 0.5 – 2 MIO
If the amount is other than the market amount, the price asker/taker must indi-
cate it in advance (e.g. “cable for small please?”, “spot yen for tiny please”, eu-
ro for ten please?”). In the last request, the word “ten” means ten million. All
quantity indicators are assumed to be in millions. If the asker has not specified
his non-standard amount in advance, the price quoter/maker has the right to
reject the deal concluded. When non-standard amount is indicated in advance,
the price quoter is not bound to quote the price or he may insist on knowing
the market side (i.e. buy or sell) of the price asker. When the price quoter asks
for the market side of the asker, the asker may refuse to divulge it and ap-
proach another price quoter for the price.
186
Position Parking
Position parking is the dangerous practice of transferring a position to another

dealer with a commitment to reverse it next day at the same price. Such prac-
tice is used to hide the excessive trading beyond the sanctioned limit by the
party parking the position. Position parking is prohibited.
Value Dates
Since the procedure to determine value dates differs for currency pairs and
business centers, it is desirable that the parties clearly specify the value date
in terms of month and date rather than generic terms like “spot”, “tom”, etc.
Further, it is desirable that the month is spelt rather than specified by a numer-
al since different conventions are prevalent (e.g. DD/MM, MM/DD).
Brokers
Advances in information technology are replacing services of voice brokers,

who may be a thing of the past very soon in the inter-dealer market. Some of
the practices with respect to the inter-dealer brokers are as follows.
Broker must not disclose the name of the principal until the deal is concluded.
Broker must not quote firm price to a principal unless the broker has received it
firm from another principal; and the broker should not maintain any position on
his own, even for a very short period. For spot trades, the broker must give the
name of the counterparty to each principal on conclusion of trade. Position
parking is prohibited.
For forex swap trades, the broker may fix different principals for near leg and
far leg, which should be accepted by the principal, unless it is agreed in ad-
vance that the principal should be the same for both legs of the swap.
Management of “stuffing”: stuffing is the exceptional situation when the broker

is hit on the quote by the asker-principal while the quoter-principal withdraws it,
both occurring simultaneously. As a result, the broker is stuck on one side: he
is said to be “stuffed.” In such cases, the asker-principal may use his discretion
to relieve the broker from the trade (provided the broker explains the situation
immediately and satisfactorily) or hold the broker to the trade. In the latter
case, the broker will have to conclude another trade immediately with another
principal at the next available price. The asker-principal should not insist on the
original price but accept the replacement price, and collect the difference be-
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Chapter 12
tween them from the broker. All cases of stuffing must be informed immediate-
ly to the managements of broker and the principal.
Points-parking is an undesirable activity and associated with stuffing. Instead

of settling the price difference on the stuck deal, the broker maintains a run-
ning account with the principal for parking the price difference (“points”) on
stuck deals to be offset over a period of time. Points-parking is prohibited.
Ethics
Difficulty arises when ethics are incorporated in the code of conduct. Two facts
need to be recognized. First, ethics are practiced out of personal conviction
and cannot be enforcedalways. Second, what is ethical and what is not dif-
fers from culture to culture. Some of the ethics incorporated in the code of
conduct are as follows.
“Management should watch for signs of the abuse of drugs including alcohol
and abused substances.” (Note the exclusion of tobacco. By the way, no an-
nual meeting of ACI is complete without liberal dose of alcoholic drinks, as do
the meetings of local chapters.)
“Gifts and entertainment should not be excessive or frequent.”
“Entertainment should neither be offered nor attended when it is underwritten

but not attended by the host.” (The drink and dinner at ACI conferences are
hosted by different sponsors. Neither the host is visible nor the attendees look
for him.)
“Gambling and betting among market participants should be discouraged.”

(Note that they are not prohibited but discouraged. And what is the difference
between gambling, betting and trading?)
“Dealing for personal account is allowed but the management should ensure
safeguards against insider trading and front running.” (Safeguards against
front running are certainly required. Insider trading may be relevant in equity
market, but its applicability in forex market is doubtful.)
12.3. Sample Deal Conversations
Few sample conversations are shown in this section. They illustrate the trad-
er‟s language, vocabulary and the market practices. In the specimens below,
“A” is the asker of price and “Q” is the quoter of price.
188
Conversation #1
Script Remark
A: Hi, IOB, chn, spot euro pls? Asker identifies himself as Indian Over-
seas Bank, Chennai (“IOB, chn”) and
asks for EUR/USD spot price.
Q: Hi, there, 1.25 35/39 Quoter gives the price
A: At 39, we buy two euro At 1.2539, the asker buys two million eu-
ro (“two euro”). All amounts are unders-
tood to be in millions
Q: Agreed. Val Jan 25 Quoter confirms that spot value date
(“val”) is Jan 25.
A: Tks n bye Closing line
Conversation #2
Script Remark
A: Hi, IOB, chn, spot cbl for Asker identifies himself, asks for
small pls? GBP/USD (“cbl”) spot price and indicat-
ing that the amount will be about USD
0.25 MIO (“small”)
Q: 55/57 Quoter gives the price; only small figure
is quoted and the big figure is omitted
A: At 57, we sell 0.25 MIO dlr At the 57, asker can buy GBP or sell
USD. Since the deal currency is USD
(“dlr”), the asker must explicitly specify it
Q: Tks. I buy dlr 0.25 MIO at Quoter confirms all the details and ex-
1.4557 val Jan 25. TGIF claims “thank God it‟s Friday” (TGIF)
Conversation #3 (very precise, brief and terse)
Script Remark
A: yen pls? USD/JPY price: unless otherwise speci-
fied, the other currency is always USD,
Value date is always spot unless other-
wise specified
Q: 98/03 Only small figure is quoted
A: At 98, five Asker sold 5 MIO USD. The deal cur-
rency is base currency unless otherwise
specified. At 98, asker can only sell USD
Q: Agreed Quoter confirms the trade
A: At 103.98, v sell USD 5 MIO Asker confirms the full details of the
val Jan 25. Done n confirmed trade
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Chapter 12
Conversation #4 (with a broker, who is the asker, A, in the following)
Script Remark
A: spot rupee, Sir? Broker asking for USD/INR spot price
Q: 50.00/01 Bank gives the price
A: Tks, ntg. I deal 0000/50 Broker offers his own price with a nar-
row spread and his offer (at 50.0050) is
better than the bank‟s offer of 50.01
Q: Mine one Bank bought USD 1 MIO at 50.0050
A: You bought from ABC dlr Broker provides the seller‟s name and
one @ 50.0050 value Jan 25 gives the other details
A: Some good selling coming, Broker supplying info on market, and in-
big fig now 99 dicating that the big figure (“big fig”) now
is 49.99 (“99”).
Q: How you deal? Bank asks for a dealing price
A: 49.99/50.00 sry wide sprd Broker is quoting the full price for both
bid and offer because he does not risk
any misunderstanding on the big figure.
He is apologetic that the spread is wide
now compared to his earlier quote
Q: Tks, ntg. I deal parity Quoter shows no interest on the broker‟s
quote, and says that his price is the
same, too (“parity”)
A: Ticcy, my risk Broker requests the bank to hold the
price for a while (“ticcy”) and he will as-
sume the risk of price change for the de-
lay (“my risk”)
A: R U there at 99/00 Broker asking whether the dealing price
is still 49.99/50.00 (“99/00”)
Q: SS Bank confirms (“SS”) it is
A: Urs half at 49.99. XYZ sold. Brokers sell USD 0.5 MIO (“half”) on be-
Val 25/1 half of XYZ to the Quoter. Price and val-
ue date confirmed.
A: can give u another half at Broker indicates he can sell (“give”)
9950 USD 0.5 MIO more at 49.9950. It is an
indication and not a firm quote
Q: Show me firm Bank asks the broker to give firm quote
A: I sell half at 9950 firm Broker confirms that he sells at 9950
Q: Taken Bank buys(“taken”) USD 0.5 MIO at
49.9950
A: ABC sold at 49.9950. Val Broker confirms the deal with other de-
Jan 25. Done n cnfmd. Lvl now tails, and indicates that the current price
is 99/00. if 49.99/50.00 for information only (“lvl”).
Q: Tks, no interest there Bank indicates no interest at that level
190
12.4. Trending
From the sample conversations in the previous section, readers may have no-
ticed that there will be different two-way quotes from different dealers prevail at
the same time, Yet, they do not provide any arbitrage profit opportunity be-
cause they do not cross the bid-offer spread. Such quotes are called “trended”
quotes, which provide valuable information about the price quoter‟s intention.
Suppose that the current market price is 1.2550 /55. You are a dealer in
the market and your intention is to buy the base currency. You have two alter-
natives: first, go another dealer in the market and buy at his offer price, which
is 1.2555; and second, make your own quote and place it in the market so that
you can buy at your bid price. In the second case, your quote must be different
from the current market quote: it should be a “trended” quote. How different
should it be, should it be higher or lower than the current market price?
One might think that since the intention is to buy and since buying at lower
price is better, the quote should be trended lower (or “left”) to, say, 1.2549/54.
This is incorrect and reflects greed, and greed is dangerous. Consider what
happens if your quote is 1.2549/54. It is attractive to the buyer, not seller: you
sell at 1.2554 and the market sells at 1.2555. Therefore, if you quote this price,
you attract a buyer and sell to him, which is the opposite of what you want to
do. Since you have sold on this quote, you must immediately cover by buying
at the market‟s offer price of 1.2555, making a loss of one „pip.‟ And your origi-
nal intention of buying remains unfulfilled.
Consider now the trending in the opposite way: higher (or “right”) to, say,
1.2551/56. Compared to the market price of 1.2550/55, it is attractive to the
seller: you buy at 1.2551 and the market buys at 1.2550. Therefore, you attract
the seller and buys from him at your bid price of 1.2551. You have done what
you intended (i.e. to buy) in this correctly trended price, but to whom the trend-
ing benefit, counterparty or yourself? The answer is both. That the counterpar-
ty benefited by selling at a higher price is obvious. Your benefit in the trending
is not as obvious. You have two ways of buying: go to the market and buy at
1.2555; or correctly trend the price and buy at 1.2551. The latter is better than
the former. In other words, Consider now another unlikely but possible situa-
tion. You have trended correctly to 1.2551/56, but the counterparty foolishly
bought from you at 1.2556. You ended up selling at 1.2556 instead of buying
at 1.2551. To cover the sale, you immediately buy from the market at 1.2555
and it results in profit of one pip!
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Chapter 12
To sump up, if you trend with benefit to you alone, your trending is wrong,
you attract the wrong party and you make a small loss in reversing the un-
wanted trade. If you trend with befit to the counterparty, your trending is right,
you attract the right party and the trending benefits you, too; and if you are hit
on the wrong side of the correctly trended quote, you make a small profit in re-
versing the unwanted trade.
12.5. Trading Operations
Money, bond, equity and forex markets constitute the four underlying markets
or asset classes. Trading in forex market is different from that in the other
three. The table below shows the stylized facts on risk/return profile of the four
asset classes, with the following instruments as the proxies for each.
Money: three-month Treasury bill or certificate of deposit

Bond: five-year sovereign or AAA-rated corporate bond
Equity: large-cap index stock
Forex: reserve currencies (EUR, GBP, JPY, CHF) against USD
Money Bond Equity Forex

Daily returna 0 0 – 1% 0 – 10% 0 – 0.5%
Weekly returna 0 – 0.10% 0 – 2% 2 – 30% 1 – 2%
Annual returna 1 – 5% 3 – 12% 10 – 70% 4 – 15%
Of which:
Yield/Dividend 1 – 5% 2 – 6% 0.1 – 0.5% 2 – 5%
Capital gain/loss 0 0 – 6% 10 – 70% 2 – 10%
b
Risk 0 0 – 10% 10 – 70% 4 – 12%
Leverage in cash None None 2 10 – 50
c
market (usually)
Transaction cost 0.1% 0.1% 0.25% 0.01%
a
Could be positive or negative
b
Standard deviation (“volatility”) of returns
c
Ratio of investment value to owned funds
Money and bond markets are used for fixed return investment with buy-
and-hold strategy. If they are held until maturity, there would be no capital
gain/loss and therefore no risk. It is true that the instrument may change its
value during its life because of changes in interest rate, resulting in capital
gain/loss. However, such capital gain/loss will disappear at maturity because
of the “pull-to-par” effect in the price of money and bond instruments. Further,
there is no leverage in these markets: you do not borrow and invest, but invest
only to the extent of own funds. We must note here that we are discussing the
underlying markets (i.e. cash or spot) and not derivative markets. In derivative
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markets, leverage is available for all four asset classes. Matter-of-factly, leve-
rage is one of the qualifying features for derivatives.
Equity and forex markets, on the other hand, provide capital gain/loss
(which is the source of risk) and leverage. The extent of capital gain/loss and
leverage is different in each market. Before examining the differences and their
implications for trading, let us look at the nature of price changes in equity and
forex markets shown in Exhibit 12-2.
EXHIBIT 12-2: Daily Prices Changes in Forex and Equity Markets
Price FOREX market EQUITY market

change
7%
5%
3%
1%
Time
Each vertical bar represents the daily range of price change. We can con-
clude the following stylized facts from the exhibit.
 In forex market, the price changes regularly but only by about 0.5% a
day, and the trend is immediately reversed substantially within 34
days, because of which the net change over a week is only about
12% and over a year about 415%. In equity market, on the other
hand, the price moves in jerks, and the trend is persisting, because of
which the weekly change is almost equal to the sum of daily changes.
 The price changes are smooth in forex market but have “gaps” (shown
as circles in the exhibit) in equity market. The “gap” is the break be-
tween the ranges of price changes over consecutive days.
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Let us explain the reason for these differences. Because the daily price
changes are very small, forex market provides leverage of up to 1050 times.
This, coupled with the very low transaction costs and 24-hour trading, results
in smaller holding periods (of few hours to few days) and quick turnaround,
which results in immediate and substantial trend reversal within a week. In
other words, forex trading is short-term levered speculation. The equity market,
in contrast, has lower leverage, higher transaction cost, large price changes al-
ternating with negligible changes, and persistent trend. This forces the strategy
to be buy-and-hold for long term with little or no leverage. As for price “gaps”,
the price changes because of the arrival of new information and news. Since
the forex market is open 24 hours days, it translates the news instantly as it
happens into price changes, resulting in small and continuous changes at the
same rate as the news arrival. The equity market works only for 8–10 hours a
day and when it opens next day, it translates the accumulated news over the
last 14–16 hours into price action in one shot, resulting in sudden and large
changes at market opening, leading to price “gaps.”
Levered Speculation and Stop-loss Limit
Levered speculation requires adherence to the stop-loss limit: to exit the trade
at a pre-defined level of loss if the market moves against. The stop-loss limit is
a form of insurance against ruin.
Consider a trade with 10 times leverage. If the market moves against as by

10%, it results in loss of entire investment amount, leading to ruin. To prevent
such a contingency, we keep a stop-loss limit of, say 2%, so that the first loss
still leaves enough money to play another four trades.
Let us now compare the two strategies: buy-and-hold without leverage and
levered speculation with stop-loss limit. They are implemented on an asset
whose current market price is 100 and the outlook is bullish. Immediately after
we buy the asset, the market price falls to 95, which is quite common because
of short-term noise and countertrend in the price changes. In the buy-and-hold
strategy, we ignore the short-term countertrend and continue to hold on to the
trade. In fact, some investors average the holding price by buying more at low-
er price, which is called dollar cost averaging (DCA) and popular in mutual
fund industry. In the second strategy (10 times leverage, 2% stop-loss), the
price dip forces us to exit with a loss. Immediately thereafter, the price rallies to
110. The first strategy would result in a profit of 10% while the second had al-
ready exited at a loss of 20%. It is obvious that, in buy-and-hold strategy, we
need to be right on the trend to make profit; but in the levered speculation with
stop-loss, we need to be right on the trend as well as on the market timing.
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The success depends, not on where the price reached, but the path it took to
reach there. Economists call this as the “path dependence” of the strategy.
One might think that it is the stop-loss that exposes us to the problem of
market timing and that the removal of stop-loss will ensure profit if we are right
on the trend. This is downright wrong. Loss on account of market timing will
only weaken the trader but makes him survive another day to fight. Removing
stop-loss, on the other hand, is like removing the protective armor: it results in
total ruin. This brings us to the topic of “money management”.
Money Management
The “money management” here is different from cash (or liquidity) manage-
ment in finance. Money management, as applied to gambling, deals with se-
lecting the right game of chance and the right amount of money to be staked
on each play of the game selected.
Let us review the probability math for the games of chance. In particular,
we need to define and establish the relation between probability, odds, payoff,
payoff odds, expectation and edge.
Probability (p) of an outcome is the ratio of the number of times the out-
come can occur to the total number of all outcomes; and its value will be be-
tween 0 and 1. Odds (o) of an outcome are the ratio of the probability of its oc-
currence to the probability of it not occurring.
p = (chances for an outcome / total number of outcomes)

o = (probability of an outcome / probability of it not occurring)
For example, in a 52-card deck, there are four aces. The probability of pick-
ing up an ace is 4/52 or 1/13 (“1 in 13”); and the odds for it, 4/48 or 1/12 (“1 to
12”). The odds are more commonly expressed as “against” rather than “for”.
Thus, if the odds for are 1-to-12, it is the same as the odds against of 12-to-1.
Since the total of probability of occurrence and non-occurrence is unity, the fol-
lowing is the relationship between the probability and the odds.
o = p / (1  p)
p = o / (1 + o) and (1  p) = 1 / (1 + o)
Payoff is the amount won or lost in a game of chance, and the mathemati-
cal expectation (or simply the expectation) of the game is the weighted aver-
age of profit and loss amounts, the weights being their probabilities. Thus, if
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the profit is x with a probability of p and the loss is y with a probability of (1p),
then the expectation is:
expectation = (x  p) + (y  (1p))
Expectation holds only on an average over a large number of plays. For

example, consider the coin toss game that pays one unit on head and loses
one unit on tail. Since the chance of each outcome is even (i.e. p = 0.5), the
expectation is zero. However, on a single outcome, there is either profit or loss
of one unit. If we play it many times, then the average payoff will be zero.
It is more convenient to express the profit amount relative to the loss

amount because the loss is the amount of investment. The ratio of profit-to-
loss will indicate how much an unit of investment has grown. Expressed in this
fashion, it is called payoff odds (b). Thus, if the game pays profit of 3 units and
loss of 2 units, the payoff odds (for) are 3-to-2. If the expectation is computed
with payoff odds (b), it is called “edge” (E), which is also called “advantage.”
E = (b  p)  (1p)
= (b + 1)p  1
With payoff expressed as payoff odds, the edge now represents the pro-
portional return on investment (where investment is the loss amount, of
course). Consider now the following five games of chance.
#1 #2 #3 #4 #5
Profit (x) 1 2 3 9 21
Loss (y) 1 3 2 16 4
Prob. of x (p) 0.5 0.50 0.50 0.80 0.20
Prob. of y (1p) 0.5 0.50 0.50 0.20 0.40
Payoff odds (b) 1 0.67 1.50 0.5625 5.25
Edge (E) 0 0.1667 0.25 0.25 0.25
Game #1 has zero edge (“fair bet”): you cannot make profit in this game
and therefore should not play it. Game #2 has negative edge (“bad bet”): you
will lose playing this game and therefore should not play it. Games #3 through
#5 have positive edge (“good bet”): you win in these games and may play
them. The positive edge corresponds to some valuable information that you
know and others do not. We may note that if the market were efficient, the pos-
itive edge disappears by adjusting either the probabilities or the payoff odds.
Recall that the edge is the return on investment and that investment is loss
amount. Thus, in Game #2, the player will lose 16.67% of 3; in Game #3, the
player will gain 25% of 2; in Game #4, the gain will be 25% of 16; and so on.
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We must note that the edge works only on an average over many plays of
the game, and does not hold for a single play. For example, if we play the
Game #1 five times, it is possible that we may win all the five times, but the
5
probability of that will be very small at: 0.5 = 0.03125 (or 3.125%). Let us de-
fine the following.
N = Total number of plays

A = Total amount staked or invested over N number of plays (al-
so called “action”) and is computed as (N  y)
TE = Total expectation over N number of plays, which is computed
as (A  y)
TP = Total actual payoff over N number of plays
We can make the following conclusions from the statistical theory:
 To be significant, N should be at least 20. In other words, we must

play the game at least 20 times.
 The deviation of total actual payoff (TP) from the total expectation
(TE) will be within y N (square root of N) of TE for 68% of the cas-
es; and within 2y N of TE for 96% of the cases. For example, if we
play Game #2 for 100 times, then N = 100; N = 10; A = (100  3) =
300; TE = (300  0.1667) = 50. The actual total payoff (TP) will
have the follo wing range.
50  (3  10) = 80 to 20 in 68% of the cases

50  (2  3  10) = 110 to +10 in 96% of the cases
 The absolute size of the deviation, N, increases with N but tends to-
wards zero as a proportion of A, which implies that the difference be-
tween TE and TP becomes larger with N but the fraction TE/A will
tends to be the same as the fraction TP/A.
Thus, playing a positive sum game does not guarantee profit if the game is
played for just few times. We need to play at least 20 times for the edge to be
statistically meaningful. The next question is which of the three good bets do
we play? We can play any of them, and the question should be how much of
the capital should be staked in each play of the game.
If we stake the entire capital, the ruin is guaranteed, regardless of the

probability and the payoff. To illustrate the point, consider the Game #5, in
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which the edge is 0.25 (or 25%) and the game is played five times. The proba-
bility of winning all the five is 0.255 = 0.000977 (or 0.0977%) and the probabili-
ty of just one loss is 1  0.255 = 0.9990 (or 99.9%). Since we are betting the
entire stake, the probability of ruin is 99.9% over the five games. As we in-
crease the number of games, the probability of a single loss becomes almost a
certainty. Staking too little of the capital, on the other hand, will make the prob-
ability of ruin close to zero, but also makes the return on investment so ridicu-
lously small that we would be better off investing the capital in fixed-income
securities rather than speculate in a game of chance. The optimal amount to
be staked on each play was derived by a mathematician, J L Kelly, and is ex-
pressed as a fraction of the capital available at any point of time. It is called
Kelly’s fraction (f*) and is given by
f* = [(b + 1)p  1] / b
The numerator is the edge and the denominator is the payoff odds. For this
reason, Kelly‟s fraction is often defined as “edge / odds” where the odds
should be understood as payoff odds and not probability odds. For even bets
(i.e. those in which profit and loss amounts are the same so that b = 1), the
Kelly‟s fraction is simplified to:
f* = 2p  1.
Kelly‟s fraction should be computed only when the edge is positive. Since
the stake amount is fraction of the available capital, the probability of ruin is
close to zero, and the probability of losing x% of capital is 100  x. Thus, the
chance of losing 10% of initial capital is 90% and that of losing 90% is 10%.
The differences in probability and payoffs are factored into the fraction. For the
Games #3 through #5, the Kelly‟s fraction is:
Game #3 Game #4 Game #5

Payoff odds (b) 1.5 0.5625 5.25
Probability of profit (p) 0.5 0.8 0.2
Kelly‟s fraction: [(b + 1)p  1] / b 16.7% 44.4% 4.8%
Notice that Game #5 has high payoff odds and yet Kelly‟s fraction has al-
located the least fraction of the capital because the probability of profit is low at
0.2. Similarly, Kelly‟s fraction has allocated higher fraction of capital on Game
#4 despite low payoff odds because it has higher probability of profit at 0.8.
Kelly‟s fraction has another desirable property: it maximizes the growth rate
of initial capital in the long term, and takes the least amount of time to reach a
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given level of growth, compared to any other strategy. One problem with the
fractional amount is that the breakeven in the number of plays does not guar-
antee the breakeven in the payoff. For example, given that f* = 1%, b = 1 and
N = 100, we lose in 50 plays and gain in the other 50, starting with a capital of
100. The capital at the end of 100 plays will be:
100  (1 + f*)50  (1  f*)50 = 99.50.
which is less than the starting capital despite breakeven in the number of prof-
itable and losing plays. Staking the flat amount on every play would ensure
that breakeven in the number of plays is the breakeven in the payoff, too, for
games with the payoff odds of 1. Another problem with the Kelly‟s fraction is
that it holds true only when the probabilities and the payoff amounts are con-
stant over time. This may indeed be the case in the games of chance, but not
in financial markets. For this reason, many traders prefer “half Kelly” (i.e. stak-
ing only 50% of f*) to “full Kelly” for the bet size.
Kelly strategy is the opposite of another strategy called “martingale,” which

doubles the stake on every loss and exits the game on the first win. The profit
after the single win will be equal to the stake on the first play. For example, in
coin toss game with even payoff, start with 1 unit and continue to bet on the
same outcome. If you lose on the first play, double the stake to 2 units and bet
on the same outcome; if you lose again, double the stake to 4 and bet on the
same outcome; and so on. The chance of win is very high as the number of
plays is increased. If you win on the third play, the profit is 4 units, the cumula-
tive loss until the second game is 3 units, and the net profit is 1 unit; if you win
on the eleventh play, the profit is 1,024 units, the cumulative loss until the tenth
game is 1,023 units, and the net profit is 1 unit; and so on. The martingale
strategy is the recipe for sure ruin for two reasons. First, the amount of capital
required as we play more number of games becomes impossibly high, forcing
the trader to quit the game with loss before the win occurs. Second, there is
usually a limit placed on the stake amount. If, for example, the maximum stake
is 1,000 units, and you win on the eleventh play, the profit is 1,000 units, the
cumulative loss until the tenth game is 1,023 units, and the net loss is 23 units.
Trading Plan
We have discussed the two important elements of trading: path dependence in

levered speculation and money management techniques. Let us now formulate
a “trading plan”, which is a set of management principles rather than specific
technical tools for trading. The following are the elements of the trading plan.
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1. Decide on the style of trading
In forex market, depending on the holding period, traders can be classified into
different styles: market-maker (also called scalper, jobber or flow trader), day
trader, position trader and fund manager. The following is their profile.
Trader Style Trading Aim Holding Period Profit Source

Market-maker Order flow Few seconds Bid-offer spread
Day trader Price range Few hours Range move
Position trader Price trend Few days Trend move
Fund manager Value Few quarters Fundamentals
Trading the value requires the study of economic fundamentals. As we dis-

cussed earlier, forex market is not suitable for long-term investment because
fixed-income securities and equity markets provide better risk/return opportuni-
ties. There are only two purposes for which the value is traded in forex market.
First, an asset manager might assume currency risk not for its own sake but as
an add-on to equity risk when investing in foreign equity. Second, hedge funds
trade the “carry trades” in forex market: buy the high-yield currency and sell the
low-yield currency if the fundamentals do not suggest appreciation of sold cur-
rency so that the net interest difference during the carry period is the profit.
This is a levered long-term speculation and not practiced outside hedge fund
industry.
Day trading and position trading have short holding period of few hours to
few days. Since the economic fundamentals do not change in this time span,
these traders rely on technical factors (e.g. charts, cycles, oscillators, etc.),
which are form-and-pattern analysis rather than cause-and-effect analysis.
Market-makers have a very short holding period of few seconds. In such a time
span, neither fundamentals not technicals change, and there is just random
flow of orders into the market from other traders. It is this order flow that the
market-maker trades, with quick entry and exit and endeavoring to benefit from
their bid-offer spread.
For most traders in forex, market-making and funds management is out of

reach; and the day trading and position trading are the only available trading
styles. Position traders may hold the position for more than a day and yet they
do not have to outlay cash for trade value because the cash settlement me-
thod (see Section 6.12) allows settlement of profit/loss rather than trade value.
Even if the position is held beyond the value dates, full cash outlay is not re-
quired because the settlement can be funded by overnight forex swap. This is
called “rollover spot” or “contracts for difference.”
200
2. Develop and rely on a trading system or rule for entry
The trader must develop and follow a system or rule to enter the market. The
advantage of having such a system or rule is that we can determine whether
the success is due to skill or luck. The rule can be as simple as relying on a
particular analyst‟s recommendation, key reversal day (i.e. a day that has
higher high and lower low compared to the previous day‟s and either a higher
or lower close), higher/lower close for three consecutive days, etc. It can be a
complex system, too, such as Elliot‟s wave theory or a system combining trend
and oscillators.
Backtesting the system or rule will give valuable information (e.g. percen-
tage of profitable and losing trades, average profit/loss per trade, etc), which is
essential for money management.
3. Allocate and bring in the entire risk capital
Allocate and bring in upfront the entire risk capital (also known as “equity”) for
trading. How much risk capital should you allocate will depend on your wealth.
As a thumb rule, you should not allocate more than 10% of your financial re-
sources in trading. It is also important that the risk capital should not be too lit-
tle: it should be large enough to cover 35 consecutive losses and still leave
something to trade further. Undercapitalization is one of the main reasons for
unsuccessful trading. If the required minimum risk capital is more than 10% of
your resources, then you will be better off not trading rather than trade with low
capital with plans to arrange for more capital in future. Such plans rarely work
and reflect greed and hopethe two things that tend to be excessive and are
the causes of ruin.
4. Follow Kelly strategy
Do not bet the entire risk capital on a single trade, but bet the Kelly‟s fractional
amount. Kelly‟s strategy lowers the probability of ruin and maximizes the
growth of capital. Between them, the former is more important than the latter,
and therefore the stake on each trade should be ideally less than full Kelly.
Trading is after all gambling in which survival is more important than success.
5. Use stop-loss limit
For leveraged speculation, the stop-loss limit is the protective armor for the
trader and insurance against large losses. Novice traders are told that there
are only three rules in trading. The first is important and it is “cut your losses.”
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The second is more important and it is “cut your losses.” The third is the most
important and it is “cut your losses.”
Never follow the martingale strategy. Even if you are extraordinarily lucky, it
will surely cost you money, time and peace of mind.
6. Average the profit, not the loss, through pyramiding.
After you enter the trade and the market is moving in your favor and half-way
to the target level, it is time to increase the position size, but the size of second
position should be less than that of the first, typically about 50% of the size of
the first position. This is called pyramiding and should be accompanied by the
trailing stop-loss. Let us illustrate this with an example.
The current EUR/USD spot price is 1.2500 and you are bullish on EUR with
a price target of 1.2550 in the next 6–8 hours. You enter the trade by buying
EUR 1 MIO at 1.2500 with stop-loss at 1.2475. The price rallies to 1.2525, and
you increase the position size. How much should you buy now? Consider three
cases: increase the position by 50% (which is called pyramiding), by 100% and
by 200%. In all cases, you should move the stop-loss limit to 1.2510 in order to
lock the favorable move in the price so far, which is called trailing stop-loss.
The following table shows the position size, the holding price, profit if the target
is hit without stop-loss limit being hit, and the profit/loss if the stop-loss limit is
hit before the target.
Case #1 Case #2 Case #3

Position size (EUR) 1,500,000 2,000,000 3,000,000
Holding price (USD per EUR) 1.2508 1.2513 1.2517
Target hit – P/L (USD) 6,250 7,500 10,000
Stop hit – P/L (USD) 250 (500) (2,000)
If the price rallies to hit the target without hitting the stop-limit, then Case #3
performs the best. However, if the market turns against and the stop is hit,
Case #1 stills results in a profit but the other two cases result in loss. Thus, py-
ramiding ensures that the part of initial profit is locked in when the market
moves against the trader and therefore should be preferred to the other two.
On the other hand, if the market moves against the trader immediately after
the entry, the position size should not be increased. Averaging the loss is simi-
lar to martingale strategy, which is ruinous. The dollar cost averaging (DCA)
prevalent in mutual fund industry works only in unlevered long-term investment
on trend, which is not exposed to path-dependence. In levered short-term
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speculation such as forex trading, path-dependence makes the loss-averaging

dangerous.
7. Draw from equity regularly
The trader must periodically draw from the accumulated balance in the trading
account (which is called the “equity”) and invest it in risk-free securities (e.g.
Treasury bill, bank deposits) rather than re-invest in the equity. It is true that
compounded growth will become the dominant factor for success in the long
term. However, it works only when the return is certain and guaranteed. Trad-
ing is a game of chance with uncertainty about return: part of the profit made in
it must be taken out and allowed to grow with certainty elsewhere.
8. Review the trading system or rule regularly for changes in risk profile.
Since financial markets change their risk/return profile over time, a trading sys-
tem or rule will not work for ever. We need to review its features (e.g. ratio of
profitable to losing trades, size of average profit/loss per trade, etc) periodically
and identify the best among the good bets, and recalibrate money manage-
ment tools (e.g. Kelly‟s fraction).
9. Take a regular break from trading.
Speculation is habit-forming: the more you do it, the more you are addicted to
it. Taking a break regularly and spending time on other activities will improve
the efficacy of speculation. When are the times one should not speculate?
Walter Bagehot (pronounced “baj-uh t”), the famous editor of The Econo-
mist, said: All people are most credulous when they are most happy13. And
Shakespeare had Romeo say: Tempt not a desperate man. So, these are the
times then, one should not speculate: when one is most happy and when one
is desperate.
10. Take responsibility
Pat yourself for the profit, and blame yourself (not the market) for the loss.
Losses are natural and the greatest teachers. The earlier they happen, the bet-
ter will be the learning. The trader that does not report losses is either a liar or
not a real trader.
13
Walter Bagehot, Lombard Street – A Description of the Money Market
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12.6. Hedging Operations
For flow traders and corporate sales traders, hedging the trade executed with
the counterparty or customer is important and crucial. For them, the source of
profit is bid-offer spread and margins rather than maintaining a position against
the market.
Every trade creates position and gap. As explained in Section 6.5, position
creates price risk, is more volatile and therefore must be removed immediately,
on trade by trade basis, by executing an outright trade. Gap, in contrast, does
not create price risk but creates funding and liquidity disturbances, is less vola-
tile than position, and can be managed with delay. In practice, hedging is not
perfect because some features in commercial transactions.
First, commercial transactions are for small and odd amounts (e.g. EUR
13,546, GBP 495,765, etc) while the interdealer market trades in standard
market lots (e.g. GBP 500,000). Second, commercial transactions have odd
tenors (e.g. 47 days, 98 days, etc) while the interdealer market trades for stan-
dard tenor (spot, 1M, 3M, etc). To manage the divergence between commer-
cial transaction features and interdealer market practices, the following are the
general practices in hedging the commercial transactions.
1. If the commercial transaction size is closer to market lot, hedge it imme-

diately in the spot market with an outright trade for the nearest market lot.
This eliminates the position but retains the gap, which can be managed
later.
2. If the commercial transaction size too small to be hedged, then it will have
to be taken into position but kept open. Either it will be offset by the conti-
nuous flow of such small transactions from other customers or absorbed
into the running open position maintained by the trader. In general, traders
maintain a running position appropriate to the market outlook and busi-
ness mix, which will take care of such transactions. For example, if the
business mix of the bank is more sales than purchases in a currency and
the market outlook for the next 1-2 weeks is bullish for the currency, the
trader will maintain open overnight/long position in that currency to take
care of the small transactions in the pipeline.
3. Gaps are not immediately covered, even if they are of marketable lots and
for standard tenors. They are consolidated and aggregated for the day
during which some of them may offset each other. At the end of the day,
the gaps that are marketable lots are covered to the nearest standard te-
204
nors. The gaps that are not market lots and of standard tenors are ab-
sorbed in the running gaps maintained for keeping working cash balances,
float funds, etc.
4. Gaps are managed usually with forex swaps or by borrowing/lending in

money market. The latter is often called money market hedge, which is
somewhat erroneous because “hedging” means elimination of price risk by
an outright trade while borrowing/lending (or its equivalent forex swap)
does not hedge price risk but manage cash and liquidity. If the interest
parity is fully covered, it does not matter whether the gap is managed
through forex swap or money market. If the parity is not fully covered, then
one of them is preferred to the other. Even when the parity is fully cov-
ered, money market route may be preferred to forex swap in some cases
because the money market division of the bank has a borrowing require-
ment in a currency while the forex division has S-B swap requirement in it.
In such cases, internally adjusting the cash position will save bid-offer
spread and other transaction costs in the market.
The following example commercial transaction is used to illustrates the

hedging practices.
GBP/INR: Sold GBP 494,545.69 @ 75.05 value date 45 days forward
The trade is hedged immediately for position by executing the following two
outright transactions for spot value date.
GBP/USD: Bought GBP 500,000 @ 1.5000 value date spot (Hedge trade #1)
USD/INR: Bought USD 750,000 @ 49.98 value date spot (Hedge trade #2)
Notice the minor discrepancy in the transaction and hedge amounts, which
cannot be avoided. As a result of the above two hedge trades, the position is
eliminated, as shown in the cash flows table below, and therefore the subse-
quent price changes do not affect the profitability.
(amounts in „000)
Date GBP USD INR Remark
Spot +500 750 Hedge #1
+750 37,485 Hedge #1
GAP +500 0 37,485 Daily sum of cash flows
45 day fwd. 495 +37,150 Customer‟s
GAP 495 0 +37,150 Daily sum of cash flows
Position +5 0 335 Sum of all cash flows
205
Chapter 12
Ignoring the residual position of GBP +5 and INR 335 (which is absorbed
in the running position of the bank), the position is square. The gap (surplus in
GBP and deficit in INR) is eliminated through either forex swap or money mar-
ket operations, but managing gap is not as pressing and immediate as that of
position. The forex swap will be on GBP/INR, which is a cross rate and usually
not quoted in the market. Accordingly, two forex swaps will have to be ex-
ecuted, separately on GBP/USD and USD/INR, as follows.
GBP/USD: Sell-Buy GBP 500,000 value date spot against 45D fwd @ 1.5002
against 1.4992, respectively (swap #1)
USD/INR: Sell-Buy USD 750,000 value date spot against 45D fwd @ 49.95
against 50.03, respectively (swap #2)
The cash flows after the two forex swaps will eliminate the gap.
Date GBP USD INR Remark

Spot +500 750 Hedge #1
500 +750 Near leg of swap #1
750 +37,485 Near leg of swap #2
+750 37,485 Hedge #1
GAP 0 0 0 Daily sum of cash flows
45 day fwd. 495 +37,150 Customer‟s
+500 750 Far leg of swap #1
+750 37,523 Far leg of swap #2
GAP +5 0 373 Daily sum of cash flows
Position +5 0 373 Sum of all cash flows
Typically, the swap trades are executed towards the end of the day or cut-
off time for the currency pair. Notice that the swap may not be for the exact
value date, if the commercial transaction is for odd-tenor. For example, if the
tenor is 96 days, it may be hedged in the market for the nearest standard tenor
of 3M. Because of discrepancy in the amount and tenor between the commer-
cial and hedge transactions, the profit/loss on commercial transactions should
not be computed from the cash flow amounts in the table above, but should be
computed from the trade prices. For the above example, to hedge the custom-
er trade, we bought GBP against USD in the spot at 1.5000 and “received”
0.0010 (“ten pips”) in the swap. The forward price is thus 1.4990. And we
bought USD against USD in the spot at 49.98 and “paid” 0.08 (“eight paise”) in
the swap. The forward price is thus 49.90. Crossing these two underlying
rates, the GBP/INR forward price is: 1.4990  49.90 = 74.80. Against this, we
sold GBP against INR to the customer at 75.05, giving a profit of INR 0.25 per
GBP or INR 123,636 for the deal amount of GBP 494,545.69.
206
Annex I: Countries, Currencies and ISO Codes

Afghanistan Afghani AFN
Albania Lek ALL
Algeria Algerian Dinar DZD
American Samoa US Dollar USD
Andorra Euro EUR
Angola Kwanza AOA
Anguilla East Caribbean Dollar XCD
Antigua and Barbuda East Caribbean Dollar XCD
Argentina Argentine Peso ARS
Armenia Armenian Dram AMD
Aruba Aruban Guilder AWG
Australia Australian Dollar AUD
Austria Euro EUR
Azerbaijan Azerbaijanian Manat AZN
Bahamas Bahamian Dollar BSD
Bahrain Bahraini Dinar BHD
Bangladesh Taka BDT
Barbados Barbados Dollar BBD
Belarus Belarussian Ruble BYR
Belgium Euro EUR
Belize Belize Dollar BZD
Benin CFA Franc BCEAO XOF
Bermuda Bermudian Dollar BMD
Bhutan Ngultrum BTN
Bolivia Boliviano BOB
Bolivia Mvdol BOV
Bosnia and Herzegovina Convertible Marks BAM
Botswana Pula BWP
Brazil Brazilian Real BRL
Brunei Darussalam Brunei Dollar BND
Bulgaria Bulgarian Lev BGN
Burkina Faso CFA Franc BCEAO XOF
Burundi Burundi Franc BIF
Cambodia Riel KHR
Cameroon CFA Franc BEAC XAF
Canada Canadian Dollar CAD
Cape Verde Cape Verde Escudo CVE
Cayman Islands Cayman Islands Dollar KYD
207
Annex I

Central African Republic CFA Franc BEAC XAF
Chad CFA Franc BEAC XAF
Chile Chilean Peso CLP
Chile Unidades de foment CLF
China Yuan Renminbi CNY
Colombia Colombian Peso COP
Colombia Unidad de Valor Real COU
Comoros Comoro Franc KMF
Congo (Rep.) CFA Franc BEAC XAF
Congo (Democratic Rep.) Congolese Franc CDF
Costa Rica Costa Rican Colon CRC
Côte D'Ivoire CFA Franc BCEAO XOF
Croatia Croatian Kuna HRK
Cuba Cuban Peso CUP
Cuba Peso Convertible CUC
Cyprus Euro EUR
Czech Republic Czech Koruna CZK
Denmark Danish Krone DKK
Djibouti Djibouti Franc DJF
Dominica East Caribbean Dollar XCD
Dominican Republic Dominican Peso DOP
Ecuador US Dollar USD
Egypt Egyptian Pound EGP
El Salvador El Salvador Colon SVC
Equatorial Guinea CFA Franc BEAC XAF
Eritrea Nakfa ERN
Estonia Kroon EEK
Ethiopia Ethiopian Birr ETB
Falkland Islands Falkland Islands Pound FKP
Faroe Islands Danish Krone DKK
Fiji Fiji Dollar FJD
Finland Euro EUR
France Euro EUR
French Guiana Euro EUR
French Polynesia CFP Franc XPF
Gabon CFA Franc BEAC XAF
Gambia Dalasi GMD
Georgia Lari GEL
Germany Euro EUR
Ghana Cedi GHS
Gibraltar Gibraltar Pound GIP
208
Currencies and ISO Codes

Greece Euro EUR
Greenland Danish Krone DKK
Grenada East Caribbean Dollar XCD
Guadeloupe Euro EUR
Guam US Dollar USD
Guatemala Quetzal GTQ
Guinea Guinea Franc GNF
Guinea-Bissau CFA Franc BCEAO XOF
Guyana Guyana Dollar GYD
Haiti Gourde HTG
Holy See (Vatican) Euro EUR
Honduras Lempira HNL
Hong Kong Hong Kong Dollar HKD
Hungary Forint HUF
Iceland Iceland Krona ISK
India Indian Rupee INR
Indonesia Rupiah IDR
Iran Iranian Rial IRR
Iraq Iraqi Dinar IQD
Ireland Euro EUR
Israel New Israeli Sheqel ILS
Italy Euro EUR
Jamaica Jamaican Dollar JMD
Japan Yen JPY
Jordan Jordanian Dinar JOD
Kazakhstan Tenge KZT
Kenya Kenyan Shilling KES
Korea, North North Korean Won KPW
Korea, South Won KRW
Kuwait Kuwaiti Dinar KWD
Kyrgyzstan Som KGS
Lao Kip LAK
Latvia Latvian Lats LVL
Lebanon Lebanese Pound LBP
Lesotho Loti LSL
Liberia Liberian Dollar LRD
Libya Libyan Dinar LYD
Liechtenstein Swiss Franc CHF
Lithuania Lithuanian Litas LTL
Luxembourg Euro EUR
209
Annex I

Macao Pataca MOP
Macedonia Denar MKD
Madagascar Malagasy Ariary MGA
Malawi Kwacha MWK
Malaysia Malaysian Ringgit MYR
Maldives Rufiyaa MVR
Mali CFA Franc BCEAO XOF
Malta Euro EUR
Marshall Islands US Dollar USD
Martinique Euro EUR
Mauritania Ouguiya MRO
Mauritius Mauritius Rupee MUR
Mayotte Euro EUR
Mexico Mexican Peso MXN
Mexico Mexican Unidad de Inversion MXV
Moldova Moldovan Leu MDL
Monaco Euro EUR
Mongolia Tugrik MNT
Montenegro Euro EUR
Montserrat East Caribbean Dollar XCD
Morocco Moroccan Dirham MAD
Mozambique Metical MZN
Myanmar Kyat MMK
Namibia Namibia Dollar NAD
Nauru Australian Dollar AUD
Nepal Nepalese Rupee NPR
Netherlands Euro EUR
Netherlands Antilles Netherlands Antillian Guilder ANG
New Caledonia CFP Franc XPF
New Zealand New Zealand Dollar NZD
Nicaragua Cordoba Oro NIO
Niger CFA Franc BCEAO XOF
Nigeria Naira NGN
Norway Norwegian Krone NOK
Oman Rial Omani OMR
Pakistan Pakistan Rupee PKR
Panama Balboa PAB
Papua New Guinea Kina PGK
Paraguay Guarani PYG
Peru Nuevo Sol PEN
Philippines Philippine Peso PHP
210
Currencies and ISO Codes

Poland Zloty PLN
Portugal Euro EUR
Puerto Rico US Dollar USD
Qatar Qatari Rial QAR
Romania New Leu RON
Russian Federation Russian Ruble RUB
Rwanda Rwanda Franc RWF
St Helena Saint Helena Pound SHP
St Kitts and Nevis East Caribbean Dollar XCD
St Lucia East Caribbean Dollar XCD
St Martin Euro EUR
St Pierre and Miquelon Euro EUR
St Vincent and the Grenadines East Caribbean Dollar XCD
Samoa Tala WST
San Marino Euro EUR
São Tome And Principe Dobra STD
Saudi Arabia Saudi Riyal SAR
Senegal CFA Franc BCEAO XOF
Serbia Serbian Dinar RSD
Seychelles Seychelles Rupee SCR
Sierra Leone Leone SLL
Singapore Singapore Dollar SGD
Slovakia Euro EUR
Slovenia Euro EUR
Solomon Islands Solomon Islands Dollar SBD
Somalia Somali Shilling SOS
South Africa Rand ZAR
Spain Euro EUR
Sri Lanka Sri Lanka Rupee LKR
Sudan Sudanese Pound SDG
Suriname Surinam Dollar SRD
Swaziland Lilangeni SZL
Sweden Swedish Krona SEK
Switzerland Swiss Franc CHF
Syria Syrian Pound SYP
Taiwan New Taiwan Dollar TWD
Tajikistan Somoni TJS
Tanzania Tanzanian Shilling TZS
Thailand Baht THB
Timor-Leste US Dollar USD
211
Annex I

Togo CFA Franc BCEAO XOF
Tokelau New Zealand Dollar NZD
Tonga Pa'anga TOP
Trinidad and Tobago Trinidad and Tobago Dollar TTD
Tunisia Tunisian Dinar TND
Turkey Turkish Lira TRY
Turkmenistan Manat TMT
Turks and Caicos Islands US Dollar USD
Tuvalu Australian Dollar AUD
Uganda Uganda Shilling UGX
Ukraine Hryvnia UAH
United Arab Emirates UAE Dirham AED
United Kingdom Pound Sterling GBP
United States US Dollar USD
Uruguay Peso Uruguayo UYU
Uruguay Peso en Unidades Indexadas UYI
Uzbekistan Uzbekistan Sum UZS
Vanuatu Vatu VUV
Venezuela Bolivar Fuerte VEF
Viet Nam Dong VND
Virgin Islands (British) US Dollar USD
Virgin Islands (U.S.) US Dollar USD
Wallis And Futuna CFP Franc XPF
Western Sahara Moroccan Dirham MAD
Yemen Yemeni Rial YER
Zambia Zambian Kwacha ZMK
Zimbabwe Zimbabwe Dollar ZWL
212
Annex II: Forex Market: Profile
Bank for International Settlements (BIS)14, the Basel-based banking think-tank,

conducts a comprehensive market survey every three years under the Trienni-
al Central Bank Survey. The latest survey was conducted in April 2007, involv-
ing 1,260 market participants in 54 countries. The following are the highlights
from the April 2007 survey.
Market Size and Product Share
The average daily turnover in April 2007 was USD 3.21 trillion, an increase of
71% from the previous survey in April 2004. It is 24 times more than interna-
tional trade flows and 17 times more than trade and capital flows.
Among the products, forex swaps account for the major share of 54%, fol-
lowed by spot (31%) and forward (11%). The table below shows the total daily
turnover (in USD billion) and the percentage share of different products in the
latest three surveys.
Product 2001 2004 2007

Amount % Amount % Amount %
Spot 387 32 621 33 1,005 31
Forward 131 11 208 11 362 11
Forex swap 656 55 944 50 1,714 54
Gaps 26 2 107 6 129 4
Total 1,200 100 1,880 100 3,210 100
Business Centers
London continues to maintain its dominance in forex market (as it does in oth-
ers), accounting for a third of the global turnover. The table below shows the
top five business centers and their percentage share in forex turnover.
Business Center 2001 2004 2007

London 31 31 34
New York 16 19 17
Zurich 4 3 6
Tokyo 9 8 6
Singapore 5 5 6
14
www.bis.org
213
Annex II
Counterparty Types
Globalization has no impact on forex market in terms of increased cross-border

turnover, which continues to be steady at about 60% of the total turnover since
2001. Possibly, the forex market had already been globalized by 2001. Among
the counterparty types, the share of non-bank financial institutions (e.g. hedge
funds, pension funds) and non-financial counterparties has been rising. The
table shows the percentage share of business with dealers, non-bank financial
institutions and non-financial counterparties.
Counterparty 2001 2004 2007

Dealer 59 53 43
Non-bank financial 28 33 40
Non-financial 13 14 17
The spread of electronic trading platforms has created new opportunities

and boosted turnover outside interdealer business. For the institutional inves-
tors, they have opened up algorithmic trading. For the retail traders, the Inter-
net-based platforms provided new opportunity for day traders with high leve-
rage, low transaction costs and 24-hour trading facility.
Business Concentration
Consolidation in banking industry led to decreased share of interdealer busi-

ness in the total turnover. It also led to increased concentration of business.
The table below shows the number of banks accounting for 75% of forex turn-
over.
Country 2001 2004 2007

UK 17 16 12
US 13 11 10
Japan 17 11 9
Switzerland 6 5 3
Singapore 18 11 11
Currency Composition
USD-based currency pairs continue to dominate the trading, accounting for

90% of the total turnover. Their share fell only marginally from 91% in 2001 to
87% in 2007. The European Union‟s euro did not replace the US dollar as the
interbank numeraire to any significant effect. The table below shows the per-
centage share of top five currency pairs in the total turnover.
214
Forex Market Profile
Currency Pair 2001 2004 2007

EUR/USD 30 28 27
USD/JPY 20 17 13
GBP/USD 11 14 12
AUD/USD 4 5 6
USD/CHF 5 4 5
The share of emerging market currencies in the total turnover has gone up
by 3% from 16.9% in 2001 to 19.8% in 2007, reflecting their growing economic
strengths.
Note: Data on currency swap and currency options are not included in the
above because they are considered as a part of “OTC derivatives market” ra-
ther than the traditional forex market.
215
INDEX
and omissions · 11; goods · 10;

A invisibles · 10; services · 10
base currency · 14
AA-DD rule · See aide memoire basis · 74
abbreviated offer side · 24 best practices · See trade life cycle
accounting · 159; collection register · bid-offer · See two-way quote
160; four principles · 169; mirror big figure · 24
account · 163; off-balance-sheet bill transactions · See commercial
items · 162; other GL accounts · transactions
162; position · 160; position Bretton Woods system · 5
reconciliation · 166; profit/loss broken date · 32
distortion · 169; revaluation · 166; brokers · 191
suspense account · 161; wash rate buy-sell swap · See forex swap
· 164
ACI Code of Conduct · 35, 189
action · 200 C
adjusted peg · 5
advantage · 199 cancel-and-rebook rollover · See
affirmation · See tade life cycle commercial transactions
aggregate short position limit · 183 cancellation · See commercial
aide memoire: AA-DD rule · 80; two- transactions
way swap quote · 100 capital & finance account · See
Allsopp Report · 174 balance of payment
American terms · See quotation carry trades · 202
style cash flow: contingent · 47; fixed · 47;
Angell Report · 174 floating · 47
arbitrage trading · 136 cash flow table · 46
cash management · See forex swap
cash position · 46
B cash settlement · See settlement
cash value date · See value date
back office · 137 chain rule · See cross rate arithmetic
backwardation · 71 check on calculations · See cross
bad bet · 199 rate arithmetic
balance of payment · 9; capital & choice price · 190
finance account · 10; capital clean transactions · See commercial
transfers · 10; current account · transactions
10; current transfers · 10; errors client on-boarding · 137
cock date · 32
217
Index
collection transactions · See covered interest arbitrage · 70, 89

commercial transactions covered interest parity · 69, 89
commercial market · See forex cross rate arithmetic: chain rule ·
market 56; triangular arbitrage · 62; two-
commercial transactions · 112; bill way quotes · 58
transactions · 113; cancel-and- cross rates · 20, 55
rebook rollover · 129; cancellation cross-currency settlement risk · See
· 125; classification · 113; clean forex settlement
transactions · 113; collection · 115; crossing · 42, 55
discounting · 115; early and late currency convertibility · 11; capital
payment of exports · 130; early account · 11; external
delivery · 122; extension · 127; convertibility · 11; trade account ·
features · 112; financing · 115; 11
historical price rollover · 128; currency pair hierarchy · 17
import bill · 118; late delivery · current account · See balance of
122; margin · 114; optional payment
delivery period · 119 customer transactions · 111
commodity currency · 14
comparative advantage · 1
competitive advantage · 1
D
confirmation · See trade life cycle
day beginning · 35
contango · 71
day closing · 35
continuous linked settlement · 173;
daylight limit · See limit
aggregate short position limit ·
183; continuous · 175; linked · 175; deal blotter · 49
liquidity facilities · 183; liquidity deal conversations · 192
providers · 185; matching · 178; deal currency · 42
nostro agent · 177; operations · deficit · See gap
derived currency · 42
177; positive adjustment balance ·
direct style quotation · See
182; processing queue · 182; risk
quotation style
management tests · 182;
discount · See forward exchange
settlement and funding · 179;
dollar cost averaging · 197
settlement member · 177; short
position limit · 182; third parties ·
177; timeline for operations · 180; E
user members · 177; versus trade
guarantee · 175 early delivery · See commercial
contracts for difference · 203 transactions
controlled float · 4 early payment of export bill · See
correspondent bank · 106 commercial transactions
counterparty credit risk · 175
218
Index
edge · 199; negative · 199; positive · 45; sell-buy · 43; structure · 45;
199; zero · 199 types · 43; versus currency swap ·
end-end rule · See value date 51
equity · 204, 205 forex swap quote · 99; aide memoire
escalations · 141 · 100; interest rate indicator · 100;
ethics · 192 near and far leg price fixing · 101
Eurocurrency · 76 forex trade: barter · 14; currency pair
European terms · See quotation · 14; qualifications · 13
style forward differential · 71
exceptions · 141 forward exchange: arithmetic · 68;
exchange position · 45 covered interest arbitrage · 70;
exchange rate regimes: fixed peg · cross rates · 85; discount · 71;
7; free float · 6; gliding parity · 7; history · 67; link with money
managed float · 7 market · 67; long-term · 84;
exposure · 45 market conventions · 78; non-
extension · See commercial deliverable forward · 92; par · 71;
transactions premium · 71; theory versus
practice · 89; two-way quotes · 73
forward value date · See value date
F forward-to-forward periods · 83
free float · See exchange rate regime
fair bet · 199
FRN convention · See value date
far leg · See forex swap
front office · 136
FEOMA · 138
fixed amount currency · 15
fixed peg · See exchange rate G
regimes
floating rate regime: first (1914- gap · 46; cash flows definition · 48;
1925) · 4; second (from 1973) · 6 deficit · 46; surplus · 46
flow traders · 136 give-up bank · 151
flow trading · 112 gliding parity · See exchange rate
forex market: commercial market · regimes
19; interbank market · 19 gold: demand-supply · 8;
forex settlement · 28; credit risk · 28; demonetization · 8; monetary
cross-currency settlement risk · 29; system · 7; official reserve · 8
Herstatt risk · 29; liquidity risk · 28; gold exchange standard · 4
market risk · 28; systemic risk · 29; gold point · 3
time zone differences · 28 gold standard · 2
forex swap: buy-sell · 43; cash good bet · 199
management · 98, 106; definition ·
42; far leg · 43; near leg · 43; repo ·
219
Index
H ledger account · 163

leverage · 195
half Kelly · 201 limit: daylight limit · 51; overnight
hedging operations · 206 limit · 51
Herstatt risk · 173, See forex limits · 51
settlement liquidity facilities · 183
historical price rollover · See liquidity providers · 185; milestones ·
commercial transactions 185
liquidity risk · 175
I
M
ICOM · 138
IFEMA · 138 managed float · See exchange rate
IFEXCO · 138 regimes
implied interest rates · 76 margin · See commercial transactions
import bill · See commercial market data · 139
transactions market lot · 190
indirect style quotation · See market practices · 189; brokers ·
quotation style 191; choice price · 190; ethics ·
inside/outside (I/O) swap · 184 192; market lot · 190; points
interdealer market · See forex parking · 192; position parking ·
market 191; spoofing · 189; stuffing · 191
interest rate parity · 69, 89 martingale · 201
International Banking Facilities · 76 matching · 178
international Fisher effect · 90 merchant transactions · 112
investigations · 141 mid office · 136
invisibles · See balance of payment mirror account · See accounting
ISDA · 138 mismatch · 46
ISO codes · 15 mnemonic aid: cross rate arithmetic
· 60; outright price · 23
modified following day convention ·
K See value date
monetary system · See gold
Kelly‟s fraction · 201 money management · 198
money market hedge · 208
month end rule · See value date
L
multilateral netting · 140
Lamfalussy Report · 174
late delivery · See commercial
transactions
220
Index
N position parking · 191

position reconciliation · 166
near leg · See forex swap positive adjustment balance · 182
netting · See trade life cycle premium · See forward exchange
Noel Report · 174 pre-settlement risk · 175
non-deliverable forward · 92 pre-trade preparation · See trade life
nostro account · 106 cycle
nostro agent · 106, 177 price gaps · 196
nostro reconciliation · See trade life price maker · 22
cycle price quotation · See quotation style
numeraire currency · 18 price quotes · 189
price taker · 22
prime brokerage · 151; allocation ·
O 152; best practices · 154;
documentation · 152; process flow
odd date · 32 · 152
odds · 198 probability · 198
off-balance-sheet items · See probability of ruin · 200
accounting process flow · See trade life cycle
offshore market · 76 profit/loss distortion · 169
operations unit · 136 proprietary trading · 111, 136
optional delivery period · 119 purchasing power parity · 90
outright · 41 pyramiding · 204
overbought · See position
overnight limit · See limit
oversold · See position Q
quant team · 136
P quotation style: American terms · 21;
direct style · 20; European terms ·
par · See forward exchange 21; indirect style · 20; price
path dependence · 197 quotation · 20; volume quotation ·
payments netting · 140 20
payment-versus-payment · 28 quoting currency · 14
payoff · 198
payoff odds · 199
physical settlement · See settlement R
points parking · 192
position · 45, 160; cash flows reference data · 139
definition · 48; daylight limit · 51; repairs · 141
overbought · 45; oversold · 45 repo · See forex swap
221
Index
revaluation · See accounting T

risk capital · 203
risk management tests · 182 third parties · 177
rollover spot · 203 time zone differences · See forex
settlement
tom value date · See value date
top-up contingency swap (TUCS) ·
S 184
trade data · 139
sales & trading unit · 136
trade date · 27
sales trading · 136
trade execution and capture · See
sell-buy swap · See forex swap
trade life cycle
settlement · See trade life cycle; cash
trade life cycle · 135; affirmation ·
settlement · 92; physical
140, 144; best practices · 142;
settlement · 92
confirmation · 140; netting · 140;
settlement and funding · 179
nostro reconciliation · 141; pre-
settlement member · 177
trade preparation · 137; process
settlement netting · 140
flow · 137; settlement · 141; trade
settlement risk · 28
execution and capture · 138
settlement status · 174
trader styles · 202
short dates · See value date
trader‟s shortcut method · See cross
short position limit · 182
rate arithmetic
small figure · 24
traders' lingo · 187
Smithsonian Agreement · 6
trading operations · 195
source rates · See underlying rates
trading plan · 202
split settlement · See value date
trended quote · 64, 191
spoke bank · 151
triangular arbitrage · 62
spoofing · 189
turn periods · 84
spot value date · See value date
two-way quote · 22; bid-offer · 22;
static data · 139
mnemonic aid · 23
stop-loss limit · 197, 204
stuffing · 191
surplus · See gap U
suspense account · See accounting
swap differential · 71 unbiased future spot price · 91
swap points · 71, 77, 98, See forward underlying rates · 20
exchange; broken date · 82; user members · 177
forward-to-forward periods · 83;
short dates · 80; turn periods · 84
SWIFT codes · 15
systemic risk · 175
222
Index
V spot value date · 30; tom value

date · 34
value date · 27; cash value date · 34; value-at-risk (VaR) · 51
end-end rule · 32; exceptions to variable amount currency · 15
spot value date rule · 35; forward volume quotation · See quotation
value date · 31; FRN convention · style
32; Latin American currencies · 36;
Middle East currencies · 36;
modified following day convention
W
· 33; month end rule · 33; short
wash rate · See accounting
dates · 33; split settlement · 37;
223

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Chapter 1

Forex is International Payments

As for foreign exchange, it is almost as romantic as young love, and quite as

Foreign exchange (shortened to forex or FX) is the consequence of the coexis-

EXHIBIT 1-1: Money versus Forex

noodles silk roti cotton

yuan forex rupee

Analects Spring in a Small Town Arthashastra Mughal-e-Azam

Settlement of international trade requires two elements: international mon-

1.1. Gold Standard: 1870–1914

 Export and import of gold was freely allowed

EXHIBIT 1-2: Adjustment Mechanism under Gold Standard

More imports, less exports Gold shipped out

Inflation Lower money stock

Higher money stock Deflation

Gold shipped in Less imports, more exports

In practice, the changes in price level or unemployment and the movement

1.2. First Floating Rate Regime: 1914–1925

1.3. Gold Exchange Standard: 1925–1931

1.4. Controlled Float: 1931 – 1939

Britain suspended gold-convertibility of sterling pound in 1931. By 1933, over

1.5. Bretton Woods System: 1944 – 1971

Bretton Woods System was built on the gold-convertibility of US dollar. It was

It had reached a stage where the US gold reserves were insufficient to

1.6. Smithsonian Agreement: 1971 – 1973

1.7. Second Floating Rate Regime: From 1973

After the collapse of Smithsonian Agreement, diverse systems of forex rate

Free Float: the forex rate is allowed to be determined by demand-supply forces

1.8. Gold and Monetary System

Gold is unique because it is at once a commodity and monetary asset. As a

Despite official “demonetization” of gold, central banks still held about

Three countries accounted for half of retail consumption in 2008: India

EXHIBIT 1-3: Gold: Demand, Supply and Total (above-ground) Stock

Souce: World Gold Council, 2008 and 2009

1.9. Balance of Payment and Currency Convertibility

The phrase “balance of payment” (BOP) is misleading. The word “balance” in

Capital transfers (2.1.1) include debt forgiveness/write-off and migrants‟

Let us now examine the concept of currency convertibility, which has

To enable international trade, all currencies must be convertible on trade

EXHIBIT 1-4: Forex Regimes

Rate Mechanism Reserve Asset Capital A/c Convertibility

1.10. Which Regime is the Best?

 Adjustment mechanism is more important than the international reserve

To be qualified as a forex trade, two criteria must be satisfied. First, there

2.1. Currency Pair

EXHIBIT 2-1: Three Types of Exchanges

2.2. Base Currency and Quoting Currency

Forex Price (or Exchange Rate) = Price of BC in QC

2.3. ISO/SWIFT Codes

International Organization for Standardization (ISO) has given three-letter code

EXHIBIT 2-2: ISO Codes for Major Currencies

Country Currency ISO Code

Currency Pair BC QC Forex Price

BOX 2-1: Oddities in ISO Country/Currency Codes

EU’s euro (EUR): Probably because „EUE‟ is hard on the tongue.

2.4. Hierarchy in the Currency Pair

GBP/EUR, EUR/USD, AUD/NZD, NZD/USD, NZD/CHF, USD/CHF

BOX 2-2: Non-metric Subdivision of Currency

2.5. N Currencies and N1 Currency Pairs

2.6. Numeraire Currency

Numeraire is something that measures or prices all others. For example, we

Interdealer Market (also called interbank market)

The numeraire in the interdealer market has been different in different