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TDG Practitioner Guide

FOREX MARKET
A C Reddi P Yesuthasen

in pursuit of

THE DERIVATIVES GROUP
FINANCIAL ENGINEERING and RISK MANAGEMENT

SIMPLICITY

ISBN-13: 978-81-908834-0-5 ii . All rights reserved. without the prior written permission of the copyright holder and the publisher.in TDG books are available at volume discount for business schools. Chennai 600 033 India. 26/1 First Floor. 23/24 Giri Street.in Printed by Pranam Printers & Designers. Except as permitted under Copyright Act. T. For more information. Printed in India. 1957 (as last amended by Act No. 49 of 1999).tdg. write to the publisher or email at: contact@tdg.© A C Reddi 2009. West Mambalam. Published by The Derivatives Group. Mangesh Street. Chennai 600 017 India. Website: www. Nagar. training institutes and corporate training programs. no part of this publication may be reproduced or distributed in any form or any means.

1 Gold Standard 1.1 Forex Settlement Risk 3.9 Balance of Payment and Convertibility 1.3 Arithmetic with Two-way Quotes 1 2 4 4 4 5 6 6 7 9 12 13 14 14 15 17 18 18 20 20 22 24 27 28 30 35 41 41 42 45 46 46 49 51 51 55 56 58 58 Chapter 2 Chapter 3 Chapter 4 Chapter 5 iii .7 Second Floating-rate Regime 1.7 Cross Rates 2.4 Mismatch 4. Gap and Others Forex Swap versus Currency Swap 4.5 N Currencies and N1 Currency Pairs 2.8 Gold and Monetary System 1.2 Trader’s Quicker Method 5.1 Chain Rule 5.2 Forex swap 4.4 Hierarchy in the Currency Pair 2.5 Bretton Woods System 1.10 Abbreviated Offer Quote FX Settlements: Value Dates 3.7 Limits on Position.6 Numeraire Currency 2.6 Smithsonian Agreement 1.2 Base Currency and Quoting Currency 2.6 Deal Blotter.CONTENTS Chapter 1 Forex is International Payments 1. Position and Gap Statements 4.8 Quotation Styles 2.3 Forex Deals: Classification and Risk 4.9 Two-way Quote 2.1 Currency Pair 2.10 Which Regime is the Best? Forex Basics: the Literacy 2.1 Outright 4.2 Value Dates Exceptions to Spot Value Date Rule 3.4 Controlled Float 1.3 ISO/SWIFT Codes 2.3 Exposure 4.2 First Floating-rate Regime 1.8 Cross Rate Arithmetic 5.3 Gold Exchange Standard 1.5 Cash Flow Analysis 4.

10 Forward Exchange for Cross Rates 6.6 Import Bill Transactions 8.4 5.3 Market Price and Margin 8.8 Swap Points for Fwd-to-Fwd and Turn Periods 6.5 5.1 Forward Exchange Arithmetic 6.2 Swap Points and Forex Swaps 7.7 Forward Contracts: Optional Delivery Periods 8. Discount. Par 6.5 Export Bill Transactions 8.2 Swap Points: Premium.3 Arithmetic with Two-way Quotes 6.3 Anatomy of Two-way Swap Quote 7.11 Early and Late Payments of Purchases Trade Life Cycle and Best Practices 9.4 Fixing the Price for Near and Far Legs 7.11 Forward Exchange: Theory versus Practice 6.12 Non-deliverable Forward (NDF) Forex Swaps 7.5 Market Conventions on Forward Exchange 6.4 Clean Instruments/Remittances 8.1 Forex Swap: Recap 7.6 Forex Prices for Short Dates 6.5 Cash Management with Forex Swap Commercial Transactions 8.2 Classification of Commercial Transactions 8.5.1 Features of Commercial Transactions 8.8 Forward Contracts: Early and Late Delivery 8.3 Best Practices FX Prime Brokerage 9.10 Forward Contracts: Extension/Rollover 8.2 Wash Rates Chapter 7 Chapter 8 Chapter 9 Chapter 10 iv .4 Accounting 10.7 Swap Points for Broken Dates 6.2 Process Flow 9.9 Forward Contracts: Cancellation 8.9 Long-term Forward Exchange Prices 6.1 Organization 9.4 Nature of Swap Points 6.6 Chapter 6 Check on Calculations Mnemonic Aid for Two-way Arithmetic Triangular Arbitrage 60 60 62 67 68 71 73 77 78 79 81 82 83 84 88 90 95 95 96 97 99 103 107 108 108 109 110 112 113 115 117 121 123 126 131 132 133 138 147 155 156 160 Forward Exchange 6.1 General Flow for Transactions 10.

1 FX-speak 12.5 Liquidity Facilities 11.10.1 Settlement Risk in FX 11.3 Sample Deal Conversations 12.2 Evolution of Continuous Linked Settlement 11.6 Operations Milestones Front Office: Trading and Hedging 12.3 10.5 Trading Operations 12.4 Chapter 11 Position Reconciliation Mark-to-Market/Revaluation 161 162 169 170 171 173 178 179 181 183 183 185 188 191 192 204 207 213 216 Continuous Linked Settlement 11. Currencies and ISO Codes Forex Market: Profile Index Chapter 12 Annex I Annex II v .2 Market Practices in Interdealer Market 12.3 Operations 11.4 Risk Management 11.6 Hedging Operations Countries.4 Trending 12.

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R. I am sure this book will go a long way in providing domain and practical knowledge to all those associated with foreign exchange business. His rich domain knowledge is exhibited in depth with which each subject is dealt with and at the same time he has ensured that the reader gets a comprehensive view of the subject in as simple a language as possible. too. This book is a must for all practitioners as a reference book to be kept part of the library. Both the authors have been actively involved in providing consultancy services to banks and corporate treasuries where their services are eagerly sought after. derivatives and risk management practices in commercial banks.FOREWORD The authors have taken great pains to bring out in a lucid and clear manner the practical aspects of foreign exchange operations. Mr A C Reddi was himself a forex trader with a leading bank. and Chief Executive Officer. ROYAPPA Formerly General Manager (Foreign Dept). C. Practices peculiar to the Indian forex market are covered. Mr P Yesuthasen has for many years been associated with the Financial Markets Division of the Reserve Bank of India at a time when new products were introduced in the Indian market. All the concepts have been illustrated with practical examples that would aid students and officials to understand the way foreign exchange operations are conducted in the market and inside a dealing bank. he was actively associated with the supervision of forex operations. As a regulator. State Bank of India. SBI Gilts Ltd .

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Chapter 12 concludes the book with a detailed discussion of forex trader’s language. “The art of reading is to skip judiciously” (Philip G Hamerton). which is the world’s only cross-border multi-currency settlement system on payment-versus-payment basis with settlement finality characteristic of central bank payment systems. Chapter 9 deals with the trade life cycle. Chapters 2 through 4 deal with the basic concepts and constitute the “literacy” of the forex. The first chapter chronicles in a dozen pages the history of exchange rates regimes over the last 150 years. Chapter 11 deals with the innovative forex settlement called “continuous linked settlement”. Ours. Readers can safely skip this chapter: after all. customs. Together. process and the critical operational timeline in this innovative settlement. To our knowledge. Except the first chapter. the forex market has fewer books than the bond and equity markets. industry best practices and the recently emerged business of FX prime brokerage. and practices. It also discusses the general principles of speculation and hedging in forex market. all others deal with the practice of forex.PREFACE From the practitioner’s perspective. is a modest endeavor to fill this gap. these six chapters equip the reader to price and hedge any type of transaction from the customer or dealer. Chapter 8 applies the concepts and arithmetic of the previous six chapters to real-life transactions with plenty of examples and illustrations. The next three chapters deal with the arithmetic: they constitute the “numeracy” of the forex. We have spared a whole chapter to discuss in detail the concept. including the early and late payments and receipts from the customers and the financing component in forex transactions. Chapter 10 explains the accounting of various forex transactions and accounting problems in revaluation. They do not fulfill the requirements of business and operations of a forex dealer. . It is true that there are many textbooks on foreign exchange but they deal with the theory of foreign exchange and multinational finance. no textbook on foreign exchange has discussed it in detail. in 200 pages.

They are so many that it is quite possible that our list might miss a name or two. bank and corporate treasuries and regulatory bodies. A C Reddi (acreddi@tdg.com) x . we have chosen not to list them here and offer them our silent thanks.in) P Yesuthasen (yesuthasen@gmail. Acknowledgements We have greatly benefited from discussions with our colleagues and friends in the forex market. their currencies and their ISO codes.Annex I lists the countries. Being first-time authors. Annex II summarizes the profile of global forex market from the latest Triennial Central Bank Survey 2007. updated as of March 2009. To manage that risk. which we sincerely ask you to email to us. we are sure that the next edition will greatly improve due to readers’ feedback on omissions and commissions.

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