Introduction To: Foreign Exchange

Introduction to Foreign Exchange
Corporate Finance Institute®

Course Objectives
Understand the mechanics and Quote FX bid/offer rates and Differentiate between the
purposes of foreign exchange (FX) calculate cross rates different types of FX products,
their uses, and payoff structures
CorporateFinance
Institute®
Foreign Exchange Fundamentals

What Is FX
FX (Foreign Exchange) is the conversion of one currency to another.
Sell domestic currency Buy foreign currency
Exchange Rate
The price at which one

currency is converted into
Buy domestic currency Sell foreign currency
another.

What Is FX
Non-Convertible
Currency
Currency which
Floating Fixed (Pegged) Crawling Peg cannot be freely
Non-Deliverable
Exchange Rate Exchange Rate traded outside
Forwards of
(NDFs)
the nation
• Adopted by most • The central bank uses • Allows small amount • For trades in
nations open market of fluctuation within a countries without a
operations to buy/sell currency band freely convertible
its currency domestic currency
• Creates supply of • Net cash flow is

domestic currency settled in another
and helps depreciate/ convertible currency
appreciate it
Why Do We Need FX
1. Economic and 2. Trading and Speculation 3. Central Bank

Commercial Purposes and Flow of Capital Intervention
• From holiday travel to • FX markets are very deep and • Many central banks will try to
facilitating global trade liquid markets. smooth the fluctuations in
their domestic currencies.
• “Imagine if you didn’t have FX” • By definition, one can trade in
practically every currency on
the planet.
• It provides many arbitrage

opportunities to investors
and speculators.

How Does FX Trade
When? Where and How?
• Traded 6 days a week (24/6) • Over the counter (OTC)
• Market opens on Monday in Asia- • Spot transactions generally settle

Pacific region and closes in New 2 days after the trade date (“T+2”).
York on Friday.
• Exceptions are the USD/CAD pair
• The market also operates during which settles “T+1” and for AUD if
holidays. dealt early enough.

How Does FX Trade
Market Participants How Is the Market Governed

and Regulated?
• Market-makers: large investment • Largely self-regulating

banks who decide the bid/offer
• The Bank of International
spread.
Settlements (BIS) has set up a
• Brokers: service only institutional voluntary code of conduct for FX
clients and earn commissions. market participants to adhere to.
• Clients: investors and companies

that hold the currencies or
instruments.

Most Liquid Market
01
Freedom of Entry and Exit
02
Product Homogeneity
03
Perfect Market
Profit Maximization
04
Freedom of Information

Most Liquid Market
FX market is the deepest and the most liquid market in the world.
Average daily trading Very deep market – can

volume exceeds $6.6 easily absorb $1 billion
trillion USD equivalent a USD equivalent trades
day in 2019. (called a ”yard”).
Source: Bank for International Settlement. (2019). Triennial Central Bank Survey - Global foreign exchange market turnover in 2019. Retrieved from
https://www.bis.org/statistics/rpfx19_fx_annex.pdf

Market Stats – 2019
Currency distribution of OTC FX Daily Average

Currency Percentage Share
turnover: (In Billions of USD)
USD 5,824 88%
EUR 2,129 32%
JPY 1,108 17%
GBP 843 13%
AUD 446 7%
CAD 332 5%
CHF 327 5%
CNY 285 4%
*Because two currencies are involved in
each transaction, the sum of the Others 1,894 29%
percentage shares of individual currencies
Total 6,595 200%*
totals 200% instead of 100%.

Market Stats – 2019
Market Share by City
The FX markets are dominated by a handful

Rest of the world
of large banks:
(Toronto, Sydney,
Tokyo, etc.) 7 Banks cover 75% of all FX
25% London volumes
43%
38% of all volumes is between

banks
New York, Hong
Kong, Singapore
combined
32%

Market Participants
Four key segments:
1. Domestic and International 2. Central Banks (1%)

Banks (63%) • Intervening to support or suppress the
• For their own accounts or for value of its domestic currency
customers, includes market-makers and
prime brokerage
3. Corporates (7%) 4. Speculators + Investors (21%)

• Need to pay invoices or hedge their • High-net-worth individuals (HNWI),
exposure hedge funds, or proprietary trading
desks
• ”Cost-reduction strategies”
Foreign Exchange Rates

Drivers of Exchange Rates
Short Term Medium Term Long Term
• Economic news and • International trade flows • Purchasing power parity

releases (PPP)
• Balance of imports and
• Speculative flows exports • Famous example: Big Mac
Index
• Rate arbitrage/Interest • Direct foreign
Rate Differentials investments
• Technical analysis • Investment flows
• Central bank intervention

What Is an Exchange Rate
Exchange rate is the price of one currency in terms of another, also known as an FX pair.
FX that trades for T+2 (trade date plus two) settlement is called “spot”.
Example:
A trade of $1 million USD/JPY at 110.15 means that in two days’ time:
The buyer of JPY will remit The seller of JPY will remit
$1,000,000 USD. ¥110,150,000.

How Are Currencies Identified
Currency codes fall under ISO code 4217. They are three letters long and comprised of:
US D
GBP CAD THB
Country Currency
However, the convention is not consistent anymore. A few confusing ones:
IDR vs. INR Nicknames – Swissy,

(Indonesian Rupiah EUR – Euro BRL – Brazilian Real Loonie, Kiwi, Aussie,
vs. Indian Rupee) Cable, Chunnel

FX Pairs
Base Quote
Currency Currency
USD / SEK
USD / JPY
Base Quote
Currency Currency

FX Pairs
Historically, we used the stronger currency as the base currency, but there are exceptions.
Higher Priority
Euro
Pound Sterling
Australian Dollar
New Zealand Dollar

Correct Quote Incorrect Quote
United States Dollar
Canadian Dollar EUR / USD USD / EUR

Swiss Franc EUR / JPY JPY / EUR
Japanese Yen
Lower Priority

How Are FX Rates Quoted
Why is…
USD/JPY = 110.15 USD/CAD = 1.3067

Vs.
2 Decimals 4 Decimals
Market convention is to quote to 5 significant figures (”sig figs”).
Remember that the “0.” is also considered a sig fig so NZDUSD is 0.6593.

Bid/Offer Spreads
The market quotes prices using the last two digits in a price.
EUR/USD = 1.1009-14
Bid/offer spread
of 5 pips (points)
Big Figures (Big Figs) Pip (Point)
Largely ignored as Last digit in the price

market-makers assume
it is understood

Buying vs. Selling
FX is the simultaneous buying and selling of currencies.

Bank will always quote their bid/offer.
For example, if we use the EUR/USD quote of 09-14:
The bank is bidding The bank is offering

(buying) EUR for (selling) EUR for
1.1009. 1.1014.
You will get 1.1009 You will pay 1.1014

USD for each EUR USD for each EUR
you sell. you buy.

Buying vs. Selling
Market-makers show both bid and offer prices (two-ways). To avoid confusion on the direction,
traders and clients may use simple one word to deal on a trade.
A typical conversation may go:
“Where’s your market in 20

million EUR/USD (“euro- “09-14, mate.”
dollar”)?”
Client “Done, Mine. Thanks for the Market-Maker

“OK, yours in 20 million.”
trade!”

Buying vs. Selling
Indicative Quote Firm Quote
Without any commitment Generally accompanied by a

on the side of the market- size
maker
Clients view tighter bid/offer spreads as how aggressive the market-maker is in trading.
Market-makers may also reserve the tightest spreads for the best clients and who has wider
levels on multi-dealer e-trading platforms or to the brokers.

Executing FX
More spot FX trades have moved to electronic platforms for smaller ticket sizes or less profitable clients.
• In 2019, 56% of FX trading was done on electronic platforms vs. 44% voice trading.
Three broad types of electronic platforms:
1. Electronic Broker 2. Single-Dealer Platform (SDP) 3. Multi-Dealer Platform (MDP)

• Business-to-business (market- • E.g. Barclays BARX, Deutsche Bank • E.g. FX Connect, Reuters, 360T
maker to broker) Autobahn, UBS NEO
• Grant access to end clients to a
• B2C pipe from the market-maker range of prices from various
granting access directly to end- market-makers
clients

Different Groups of FX Currencies
Majors Minors Exotics or Precious Metals

Emerging
• Freely traded in the • Commodity • Remaining • Currencies were at

spot and FX currencies (CAD, currencies in the one pointed
forward markets NZD, AUD) world pegged to the value
of gold
• USD, EUR, JPY, GBP, • Scandinavian
CHF currencies (DKK, • Gold and a few
NOK, SEK) other precious
metals are often
considered part of
the FX market.

Precious Metals

Cross Rates
Cross rate is a foreign exchange market price made in two currencies not involving the US dollar.
Cross Rate Via USD
Cross currency pairs not involving Trade via USD

USD
Example: Example: Buying EUR/GBP
• EUR/GBP 1. Sell USD/EUR (short USD, long

EUR), and then
2. Buy USD/GBP (long USD,

short GBP)

Cross Rates
Triangular
Arbitrage
Cost of trading
Cost of trading
via USD or some
cross rate
other currency

Bid/Offer Spreads
Banks will quote for cross rates in the major currencies. For minor and exotic currencies, the transaction
will be done via the USD.
Currency Pair Bid Offer Spread % of Bid Price
Major/Exotic EUR/HKD 8.7914 8.8067 0.0153 0.17%
Major/Major GBP/EUR 1.1415 1.1423 0.0008 0.07%
Exotic/Exotic *MYR/KES 24.158 24.233 0.075 0.31%
*No direct quote, rate calculated via USD

Cross Rates – Example

Direct vs. Indirect Quotes
Every FX quote could potentially be a direct one or an indirect one at the same time, depending on your
perspective.
Direct Quote Indirect Quote
Base Quote Quote Base

Currency Currency Currency Currency
USD / SEK = 9.5197 SEK / USD = 0.1050
• When you get a value of X units of the • When you get a value of X units of your
quote currency for one unit of your base base currency for one unit of the quote
currency. currency (i.e. 1/direct quote).
• Base currency sits on the left-hand side • Base currency sits on the right-hand
of the pair. side of the pair.

Calculating Cross Rates – Two Indirect Quotations
An indirect quotation expresses the amount of base currency needed to buy a unit of the ONE UNIT of
the quote currency. To calculate the cross rate from two indirect quotations, the two exchange rates
must be cross divided.
Example: Spot: USD/CHF 0.9654–0.9657 Spot: USD/JPY 108.60–108.62
USD/JPY (offer) 108.62

Client can sell JPY and buy CHF at: = = 112.51
USD/CHF (bid) 0.9654
USD/JPY (bid) 108.60

Client can buy JPY and sell CHF at: =
0.9658
= 112.45
USD/CHF (offer)
Since the bank is on the other side of the price: Spot: CHF/JPY 112.45–112.51

Calculating Cross Rates – Two Direct Quotations
A direct quotation expresses the amount of quote currency needed to buy a unit of the ONE UNIT of the
base currency. To calculate the cross rate from two direct quotations, the two exchange rates must be
cross divided.
Example: Spot: GBP/USD 1.2990–1.2992 Spot: AUD/USD 0.6691–0.6692
GBP/USD (bid) 1.2990

Client can buy AUD and sell GBP at: = = 1.9411
AUD/USD (offer) 0.6692
GBP/USD (offer) 1.2992

Client can sell AUD and buy GBP at: =
0.6691
= 1.9417
AUD/USD (bid)
Since the bank is on the other side of the price: Spot: GBP/AUD 1.9411–1.9417

Calculating Cross Rates – An Indirect Quotation and A Direct Quotation
To calculate the cross rate using an indirect quote and a direct quote, the same side of each exchange rate
must be multiplied.
Example: Spot: GBP/USD 1.2990–1.2991 Spot: USD/CHF 0.9654–0.9658
Client can buy CHF and sell GBP at: GBP/USD (bid) x USD/CHF (bid) = 1.2990 x 0.9654 = 1.2541
Client can sell CHF and buy GBP at: GBP/USD (offer) x USD/CHF (offer) = 1.2991 x 0.9658 = 1.2547
Since the bank is on the other side of the price: Spot: GBP/CHF 1.2541–1.2547

Foreign Exchange Products

FX Products
Market Share by FX Products

Options
Currency Swaps 5%
2%
Spot
30%
FX Swaps
29%
Forwards
15%

FX Forwards
FX forwards are agreements made today to deliver currency at some point

in the future, hence the word “forward”. They are over-the-counter contracts
with no payment or physical exchange of funds upfront.
Trades are negotiated on No principal is exchanged FX forwards are more suited

“trade date” and settle on until the future date, known to hedging a one-time
“spot value date” (generally also as the ”delivery date”, payment rather than a
two business days from the or “forward value date”. stream of principal plus
trade date). interest payments.

FX Forwards Example
A U.S. construction company Buildco signed a JPY 500 million contract to buy elevators from Liftco, a
Japanese company. The contract will be paid in a year’s time. The USD/JPY spot rate is 110.00.
iUSD = 1.50%
USD $4.55MM $4.62MM
USD/JPY Spot USD/JPY Forward

= 110.00 =?
JPY ¥499.50MM ¥500.00MM

iJPY = 0.10%
Now t = One Year

Calculating Forward Prices
Forward price is the relationship between exchange rates and interest rates.
Forward Exchange Rate = Spot Rate + Interest Rate Differential
1 + i𝒒𝒒 ⋅ t
F=S
1 + i𝒃𝒃 ⋅ t
Where:
F = Forward rate
S = Spot rate
i𝒒𝒒 = Simple interest rate of the quote currency
i𝐛𝐛 = Simple interest rate of the base currency
t = Tenor in years (calculated according to the appropriate day count convention)

Calculating Forward Prices Example
iUSD = 1.50%
USD $4.54MM $4.61MM
1 + 0.001⋅ 1
USD/JPY Spot USD/JPY Forward F = 110.00
= 110.00 =?
1 + 0.015⋅ 1
= 108.48
JPY ¥499.50MM ¥500.00MM

iJPY = 0.10%
Now t = One Year

Quoting Forward Rates
Forward differentials, or forward points, is the difference between the spot rate and the forward rate.
Spot FX rate = 110.00

Forward points = 1.52 or 152 pips
Forward FX rate = 108.48
How to quote forward rates?
If forward points are quoted If forward points are quoted

high-low, subtract the points low-high, add the points to the
from the spot rate. spot rate.

Quoting Forward Rates Example
GBP/USD Spot Forward Points

1.3022-1.3026 11-12
Correct Quote Incorrect Quote
Spot 1.3022-1.3026 Spot 1.3022-1.3026

+ + – –
Forward point 0.0011 0.0012 Forward point 0.0011 0.0012
=
=
=
=
Forward rates 1.3033-1.3038 Forward rates 1.3011-1.3014
5 pips 3 pips

Another FX Forward Example
A client needs to sell forward USD $100 million for British pound sterling on January 3, 2021.
Dates Day Count
Transaction Date April 1, 2020 N/A Rates
Spot Value Date April 3, 2020 N/A GBP/USD Spot 1.2077-1.2079
Forward Value Date January 3, 2021 275 6-Month Forward Points 32.5-34.5
6 Months Forward October 2, 2020 182 12-Month Forward Points 37.5-40.5
12 Months Forward April 3, 2019 365

Another FX Forward Example
A client needs to sell forward USD $100 million for British pound sterling on January 3, 2021.
0.00405 – 0.00345 0.00060 0.000003

= =
365 days – 182 days 183 points/day
Buy (Bid) Sell (Offer)

1.2077 1.2079 0.000003 x (275 – 182 days) = 0.000279
32.5 34.5
37.5 40.5
GBP/USD Spot 1.2079
6-Month Forward Points 0.00345
Additional 93 Days Points + 0.000279
Forward Rate 1.211629

FX Swaps
An FX swap is an agreement to simultaneously sell one currency for another currency at an initial date, and
then swap these amounts at a later date.
Date 1 Date 2
Two “legs’; a spot transaction

and a forward transaction Company A Company A
Spot Forward
USD
EUR
USD
EUR
Rate Rate
Works when both
counterparties need the
Company B Company B
currency that the other owns

FX Swap Example
A UK client has a forward contract in place to hedge an overseas US supplier payment of USD $10 million.
However, the payment has been delayed by six months.
Current Forward Contract
UK Client
GBP
USD
Swap Dealer
Six Months
t - 2 Days Original FX Forward New Date

Expiry Date
Spot Rate: 30 Forward Points Forward Rate:
GBP/USD: 1.3030 GBP/USD: 1.3000
FX Swap

FX Swap Example
Rolling forward the position:
Current Forward Contract

FX Swap
UK Client UK Client UK Client
GBP
USD
Six Months
GBP
USD
GBP
USD
Swap Dealer Swap Dealer Swap Dealer
30 Forward
Points
USD $10MM
@ 1.3030
Original FX Forward New Payment Date

Expiry Date
New Net Position
UK Client
GBP
USD
Swap Dealer
USD $10MM
@ 1.3000

FX Swap Example
Cost of the FX swap:
Rates USD (000s) FX rate GBP (000s)
New contract $10,000 1.3000 £7,692
Less: original contract $10,000 1.3030 (£7,675)
Extra cost £17
Interest lost:
Rates GBP (000s) Interest rate Interest earned
Extra 6-months interest in UK £7,675 0.375% £29
Less: 6-months interest in US £7,675 0.875% (£67)
Interest gained (lost) (£38)
Total cost £55

Short-dated FX Swaps
Any FX swaps with settlement dates up to 1 month is known as “short-dated”.
Overnight (O/N) Tom-Next (T/N) Spot-Next (S/N) Spot-Week (S/W)
A swap today A swap A swap A swap

against tomorrow starting spot starting spot
tomorrow against the (T+2) against against a
next day the next day week later

FX Forwards and FX Swaps Recap
Forwards Swaps
• Physically settled OTC • Same as FX forwards BUT
derivative contracts
• Reverse exchange (swap) of
• Involve the exchange of two the two currencies at a later
different currencies on a date
specific future date
• The future FX rate also agreed
• Fixed rate for the exchange upon on the trade date of the
agreed upon on the trade contract
date of the contract

Cross-Currency Swaps
Process of a cross-currency swap:
a. Start b. During The Term c. Maturity

A A A
X X⋅S EUR USD EUR USD X X⋅S

(EUR) (USD) 3M Libor 3M Libor 3M Libor 3M Libor (EUR) (USD)
+ basis + basis
B B B
S: FX Spot Rate
• Two parties exchange principal in two different currencies at the FX spot rate.
• Each party uses the repayment obligation of its counterparty as collateral and pays interest on the
currency they are borrowing while receiving interest on the currency they are lending.
• Interest rates can be fixed, floating, or one party pays floating while the other pays fixed.

Different types of Coupons
The coupon can be fixed or based on a floating rate in each currency.
Currency X Currency Y
Fixed Fixed
Cross-Currency
Fixed Floating
Interest Rate Swaps
Floating Fixed
Basis Swap (or
Floating Floating Differential Swap)
LIBOR is the banks’ borrowing costs from each other over that same term in a particular currency.

Cross-Currency Basis Swap
3 Month USD LIBOR 3 Month EUR LIBOR
1.8% -0.4%
The theoretic cost of EUR/USD Currency Swap = 1.8% - (-0.4%) = 2.2%
Basis
If, due to a dollar shortage, the counterparty quotes:
-50bps
The cost of EUR/USD Currency Swap = 1.8% - (-0.4%) + 0.5% = 2.7%

Uses of Cross-Currency Swaps
Company A wishes to raise Euros to fund an expansion into Europe. The company is well-known in the US
debt markets but less well-known overseas.
• Strategy: raise finance in USD and swap into EUR to reduce funding costs
• Finance required: EUR 100MM, spot EUR/USD FX rate is 1.10
USD bond Swap
Principal USD $110MM Type Fixed-for-Fixed
Coupon USD 2% USD Principal $110MM

EUR Principal £100MM
Term 5 Years
USD Rate 2%
Price 100.00 4%
EUR Rate
USD Rate 5 Years

Uses of Cross-Currency Swaps
USD $110MM
EUR £100MM
USD $110MM
Bond Company A Swap Dealer
USD 2%
EUR 4%
USD 2%
Bond Swap
Receive USD $110MM Pay USD $110MM Receive EUR £100MM
Pay USD 2% Receive USD 2% Pay EUR 4%

Recap of Cross-Currency Swaps
• Cross-currency swaps allow two parties to swap

cash flows in one currency for cash flows into
another.
• Principal is exchanged at the start and the end of

the swap, and interest is exchanged in between.
• Interest can be either fixed or floating on each

side of the swap and is not netted off.
• Cross-currency basis swap is when interest

payments are structured to be both floating but
at different rates.

Carry Trades
Carry trades are a strategy where one borrows in a currency with lower interest rates and converts this
amount into another currency with higher rates of return and deploying it there, often with leverage.
Involves currency pairs that Invest the higher-yielding The funding currency cannot
have a large interest rate currency, making the strengthen vs. the carry
differential and borrowing, difference between their currency, otherwise the
then selling the lower- funding cost and the investors might not realize
yielding currency (funding investment returns their expected profit.
currency)

Carry Trade Example
Japan Australia
Borrowing AUD/JPY Spot: 75 Deposit

0.5% Rate
5.0% Rate
01 02 Deposit in AUD
03If the exchange rate
04 If FX rate moves
Borrow JPY ¥750MM
$10MM becomes AUD remains at 75, the against JPY (JPY
and convert to AUD
$10.5MM, while loan profit is JPY weakens against
$10MM to invest in a
for JPY ¥750MM ¥33.75MM or AUD AUD), profit increases
1-year AUD deposit.
becomes JPY $450,000. and vice versa.
753.75MM.

FX Options
An option contract is an OTC derivative which gives one party the right, but not the obligation, to buy or sell
an underlying asset at a specific price by or at a specific date.
If the party that has the right to buy or sell chooses to exercise their option, the counterparty to the
contract must deliver. The two basic options include:
Call Option
A call option is the option to

buy an underlying asset at a
VS Put Option
A put option is the option to

sell an underlying asset at a
specified price in the future. specified price in the future.

FX Options
Types of option exercise:
European American Bermudan
Exercise is only on the Exercise can be on or Exercise can be on or

expiration date. before the expiration before the expiration
date at the option of the date at certain
buyer. predetermined times.
Options can be bought and sold (i.e., you can buy or sell a call option, also known as being long or
short a call option).
The money you receive for selling an option or pay for buying an option is call the ”premium”.

Payoff Structure for Options
Moneyness refers to whether an option has intrinsic value by comparing the strike and spot prices.
Call Option Put Option

At-the-Money At-the-Money
Out-of-the- In-the- In-the- Out-of-the

Money Money Money Money
Underlying Asset Underlying Asset

Profit/Loss
Profit/Loss
K Spot Price K Spot Price
Option Premium
(OpPrem)

Call Option Profit/Loss (Pay-off) Diagrams
Here we can see the profit/loss diagrams for a long position and short position on a call option:
Long Call Position Short Call Position
$55
Profit/Loss
Profit/Loss
Profit = $5 - $1 = $4 $1 Loss = $1 - $5 = -$4

K
-$1 Underlying Asset K Underlying Asset
Spot Price Spot Price
$50 $55 $50

Put Option Profit/Loss (Pay-off) Diagrams
Here we can see the profit/loss diagrams for a long position and short position on a put option:
Long Put Position Short Put Position
$45 Loss = $1 - $5 = -$4
Profit/Loss
Profit/Loss
Profit = $5 - $1 = $4 $1
K
-$1 Underlying Asset K Underlying Asset

$45 $50 Spot Price $50 Spot Price

Option Greeks
Traders rely on models to determine the FX option premiums. There are only a few variables that determine
these premiums and each of these variables have Greeks associated with them that measures the rate of
change of the premium for each unit move of the variable.
The change of the option price with respect to the price of the underlying
δ Delta asset.
Call option: between 0 and 1 Put option: between -1 and 0
The change of an option’s delta with respect to the price of the underlying
γ Gamma
asset (second order partial derivative).
ν
The change of the value of the option with respect to the volatility of the
Vega
underlying asset.
θ Theta
The change of the value of the option with respect to the passage of time with
all else remaining the same (time decay).

FX Option Example
A UK client has a payment to make to one of its US suppliers in three months’ time. There is some uncertainty
about the size of this payment. We know that the payment will be at least USD $50MM but up to USD $66.25MM.
Obligation:
USD $50MM –
$66.25MM
Today 3 Months
GBP/USD 3-Month GBP/USD
Spot Rate: 1.3000 Forward Points: Forward Rate:1.3030
30 pips

FX Option Example
FX Forward
Obligation in 3 USD $50MM
Months
USD $50MM –
$66.25MM FX Options
USD $16.25MM
FX Options
Cost of GBP/USD FX option contract £62,500
Number of contracts $16.25MM / 1.30 / £62,500 = 200 contracts
3-Month OTM put option (strike @ 1.275) £0.0056
Put option premium £0.0056 * £12,500,000 = £70,000
Option price per contract £70,000 / 200 = £350

FX Option Example – 3 Months From Now
Scenario 1 Scenario 2
If GBP strengthens to GBP/USD of 1.40: If GBP weakens to GBP/USD of 1.20:
Do not exercise 1.275P option Exercise 1.275P option
Buy $16,250,000 at 1.40 spot -£11,607,143 Buy $16,250,000 at 1.275 -£12,745,098
Cost of the premium -£ 70,000 Cost of the premium -£ 70,000
Total cost -£11,677,143 Total cost -£12,815,098

FX Option Example – 3 Months From Now
Scenario 3 Scenario 4
If they didn’t hedge, the cost would be: If they use FX forward instead of options:
Buy $16,250,000 at 1.20 spot -£13,541,666 Buy $16,250,000 at 1.3030 -£12,471,220

forward rate
By executing the option hedge, they saved: £11,607,143
AND GBP strengthens to 1.40
(£13,541,666 – £12,815,098) = £726,568
Loss = (-£12,471,220 + £11,607,143) = £864,077

Use of FX Products in Different Hedging Situations
Certain Value Uncertain Value
• Use FX forward contracts which • Use FX options to limit

lock in a future price. downside risk if the transaction
does not occur.
• FX Swaps can be used to roll
forward the payment if delays • Unlike forward contracts,
happen. options have a premium.
• If there are interest payments • Options are very much bespoke

along the way, we use cross- and you can create more
currency FX swaps. complicated structures/payoffs.

Non-Deliverable Forwards (NDFs)
Non-deliverable forwards are used in emerging markets where markets are illiquid or inaccessible to
foreigners. NDFs differ from conventional FX markets, as no settlement occurs in the local currency.
NDF Terminology
Notional Amount Face value of the NDF in the non-deliverable currency, though this
amount will not be exchanged.
Fixing Date The date where the NDF rate will be compared with the spot rate.
Contracted NDF Rate The forward FX rate agreed upon on the transaction date.
Fixing Spot Rate The spot rate used on the fixing date.
Settlement Date The date when the difference is paid out.

Non-Deliverable Forwards (NDFs) Example
01 Company A will receive CNY ¥10 million in 1

year. The company wants to guarantee an FX
USD/CNY has
moved to 7.05
USD/CNY has
moved to 7.15
rate.
Company A receives: Company A receives:
CNY ¥10,000,000/7.05 CNY ¥10,000,000/7.15
02
= USD $1,418,439 = USD $1,398,601
Since CNY is non-convertible, Company A enters
an NDF, which guarantees a USD/CNY FX rate of FX spot rate moved in FX spot rate moved
7.10 in 1 year. Company A’s favor. against Company A.
Company A will pay: Company A will

(10,000,000/7.05) – receive:
03 In 1 year, the exchange rate has moved, which

results in one of two situations:
(10,000,000/7.10)
= USD $9,989
(10,000,000/7.15) –
(10,000,000/7.10)
= USD $9,849
Net amount =
$1,408,450 Net amount =
$1,408,450

Special Drawing Rights (SDRs)
Special drawing rights (SDRs) are a supplementary international reserve asset created by the
International Monetary Fund (“IMF”). SDRs serve as a unit of account for the IMF.
Basket of Five USD EUR CNY

Currencies JPY GBP
A currency
Not a currency that central
or a claim banks and
against the other
IMF government
agencies hold

Trading FX – Technicals
Technical analysis (“technicals” or “TA”) is defined as the study of historical price movements, primarily
using charts, for the purpose of forecasting future price trends.
• Markets are made up of • It is widely practiced in many

human decisions. markets – almost a “self-
• Emotional forces that dictate fulfilling prophecy”.
buying and selling decisions • It requires subjectivity, practice,
have repeated throughout patience, and experience.
history.

Trading FX – Fundamentals
Each currency has their own fundamental drivers and may change over time and the business cycle.
Themes may also come in and fade out of the forefront or can remain persistent.
Interest Growth Inflation/ Central

Rates Prospects Deflation Bankers’
Pressures Views

Introduction To: Foreign Exchange

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Introduction To: Foreign Exchange

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Introduction to Foreign Exchange

Corporate Finance Institute®

Corporate Finance Institute®

FX (Foreign Exchange) is the conversion of one currency to another.

Sell domestic currency Buy foreign currency

The price at which one

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• Creates supply of • Net cash flow is

1. Economic and 2. Trading and Speculation 3. Central Bank

• It provides many arbitrage

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When? Where and How?

• Traded 6 days a week (24/6) • Over the counter (OTC)

• Market opens on Monday in Asia- • Spot transactions generally settle

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Market Participants How Is the Market Governed

• Market-makers: large investment • Largely self-regulating

• Clients: investors and companies

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Corporate Finance Institute®

Average daily trading Very deep market – can

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Currency distribution of OTC FX Daily Average

EUR 2,129 32%

JPY 1,108 17%

GBP 843 13%

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Market Share by City

The FX markets are dominated by a handful

38% of all volumes is between

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Four key segments:

1. Domestic and International 2. Central Banks (1%)

3. Corporates (7%) 4. Speculators + Investors (21%)

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Short Term Medium Term Long Term

• Economic news and • International trade flows • Purchasing power parity

• Technical analysis • Investment flows

• Central bank intervention

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Corporate Finance Institute®

However, the convention is not consistent anymore. A few confusing ones:

IDR vs. INR Nicknames – Swissy,

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Corporate Finance Institute®

New Zealand Dollar

Canadian Dollar EUR / USD USD / EUR

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USD/JPY = 110.15 USD/CAD = 1.3067

Market convention is to quote to 5 significant figures (”sig figs”).

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Big Figures (Big Figs) Pip (Point)

Largely ignored as Last digit in the price

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FX is the simultaneous buying and selling of currencies.

For example, if we use the EUR/USD quote of 09-14:

The bank is bidding The bank is offering

You will get 1.1009 You will pay 1.1014

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“Where’s your market in 20

Client “Done, Mine. Thanks for the Market-Maker

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Indicative Quote Firm Quote