SIAA Foreign Exchange cheat sheet

The FX market is an over-the-counter (OTC) decentralized market with no central exchange; trading occurs via electronic platforms, phone, and interdealer brokers.

Primary participants: central banks, commercial banks (dealers), corporations, hedge funds, asset managers, retail brokers, and non-bank market makers.

The BIS Triennial Survey (2022) reported average daily FX turnover of $7.5 trillion; the US dollar was on one side of ~88% of trades.

Trading sessions: Sydney, Tokyo, London, New York; the London-New York overlap (8am-12pm ET) is the most liquid period.

Interdealer trading accounts for a large share of volume; electronic brokering systems (EBS, Reuters Matching) facilitate anonymous order matching.

Market makers quote two-way prices (bid/ask); they earn the spread and manage inventory risk.

Central banks intervene to influence exchange rates or accumulate reserves; intervention is typically sterilized to avoid affecting domestic money supply.

FX is traded 24 hours a day from Sunday 5pm ET to Friday 5pm ET, except for holidays.

Spot FX transactions settle T+2 business days for most currency pairs; USD/CAD settles T+1.

Quotation convention: base currency/quote currency (e.g., EUR/USD = 1.0850 means 1 EUR buys 1.0850 USD).

Direct quotation: domestic currency per unit of foreign currency; indirect quotation: foreign currency per unit of domestic currency.

Bid is the price at which the dealer buys the base currency; ask is the price at which the dealer sells the base currency; ask > bid.

Spread = ask - bid; expressed in pips (usually 0.0001 for most pairs, 0.01 for JPY pairs).

European terms: USD per unit of foreign currency (e.g., USD/JPY = 110.00); American terms: foreign currency per USD (e.g., EUR/USD).

Cross rates are derived by dividing or multiplying two spot rates to eliminate the USD.

Appreciation of the base currency means the exchange rate (quote currency per base) increases.

An outright forward is a single agreement to exchange a specified amount of currency at a future date and rate; it is a binding obligation.

Forward rate = spot rate × (1 + interest rate of quote currency × days/360) / (1 + interest rate of base currency × days/360) under covered interest parity.

Forward points = forward rate - spot rate; quoted in pips; positive points indicate the base currency trades at a forward premium.

Forward premium/discount: annualized forward premium = (Forward - Spot)/Spot × (360/days) × 100%.

Forwards are OTC instruments, customizable in amount and maturity, and carry counterparty credit risk.

Non-deliverable forwards (NDFs) are cash-settled in USD and used for restricted currencies (e.g., CNY, INR, BRL).

Forward contracts can be used to hedge known future foreign currency cash flows (e.g., receivables, payables).

Forward contracts have zero initial value at inception; value changes with spot rates and interest rates over time.

An FX swap combines a spot transaction and a forward transaction in opposite directions; used to roll over or fund currency positions.

FX swap cost is reflected in forward points; the party borrowing one currency and lending another pays the interest rate differential.

A currency swap (cross-currency swap) involves exchanging principal and periodic interest payments in two currencies; principal is exchanged at inception and re-exchanged at maturity.

Currency swaps are used to hedge long-term foreign currency exposure, obtain cheaper funding in foreign markets, and convert loan currency.

FX swaps are short-term (typically < 1 year) money market instruments; currency swaps are longer-term (often 2-30 years).

In a currency swap, interest payments can be fixed-for-fixed, fixed-for-floating, or floating-for-floating.

The swap rate (forward points) is determined by the interest rate differential between the two currencies.

Credit risk in a currency swap is the risk that the counterparty defaults when the swap has positive replacement value.

A currency option gives the buyer the right, but not the obligation, to buy (call) or sell (put) a currency at a specified strike price before or on expiration.

Call option on base currency: right to buy base currency at strike; put option: right to sell base currency at strike.

Option premium is affected by spot rate, strike, volatility, time to expiration, and interest rate differential (Garman-Kohlhagen model).

Delta measures change in option price for a unit change in spot; gamma measures change in delta; vega measures sensitivity to volatility; theta measures time decay.

Structured products (e.g., knock-out options, range accruals, target redemption forwards) embed exotic options and are tailored to client hedging or yield-enhancement needs.

A collar combines a purchased put and a written call (or vice versa) to reduce premium cost, often used by corporates to hedge FX risk.

A participating forward gives a client a forward rate plus a share of favorable exchange rate movements, in exchange for a premium or a cap.

Option payoff at expiration: call buyer profit = max(S - K, 0) - premium; put buyer profit = max(K - S, 0) - premium.

Covered interest rate parity (CIP): F/S = (1 + i_quote) / (1 + i_base), where F and S are forward and spot rates (quote per base) and i are interest rates for the period.

CIP ensures that hedged returns from investing in two currencies are equal; arbitrage forces the forward rate to align with the interest rate differential.

Uncovered interest rate parity (UIP): expected change in spot rate equals the interest rate differential; E(S_t) = S_0 × (1 + i_quote)/(1 + i_base).

UIP assumes risk-neutral investors and no capital controls; empirical evidence often rejects UIP (forward premium puzzle).

Forward premium for the base currency ≈ i_base - i_quote (annualized); if i_base > i_quote, base currency trades at a forward discount.

Real interest rate parity links nominal interest rates, inflation, and expected exchange rate changes (Fisher effect).

Deviations from CIP can arise from transaction costs, capital controls, counterparty risk, and liquidity constraints.

In practice, CIP is used by traders to price forwards and identify arbitrage opportunities; the forward points reflect the interest rate differential.

Cross rate = exchange rate between two currencies derived from their rates against a common third currency (usually USD).

Given A/B and B/C, then A/C = A/B × B/C; given A/B and A/C, then B/C = (A/C) / (A/B).

Triangular arbitrage exploits misalignment among three currency pairs; profit exists if the implied cross rate differs from the quoted cross rate.

Arbitrage steps: calculate implied cross rate, compare with quoted rate, execute simultaneous trades to lock in riskless profit.

Bid-ask spreads create a no-arbitrage band; cross rates must be consistent with bid and ask prices to avoid arbitrage.

Two-point arbitrage involves buying in one market and selling in another; spatial arbitrage requires fast execution and low transaction costs.

Covered interest arbitrage combines spot and forward FX transactions with borrowing/lending to exploit interest rate differentials.

Transaction costs, bid-ask spreads, and execution risk can eliminate apparent arbitrage opportunities.

Transaction exposure: risk from known foreign currency cash flows (e.g., receivables, payables, debt); hedge with forwards, futures, options, or swaps.

Translation exposure (accounting exposure): impact of exchange rate changes on consolidated financial statements of foreign subsidiaries.

Economic exposure (operating exposure): impact of exchange rate changes on future cash flows and competitiveness.

Hedging instruments: forwards lock in a rate; options provide downside protection while allowing upside participation; swaps manage timing mismatches.

Hedge ratio = size of hedge / size of exposure; a perfect hedge has a hedge ratio of 1.0.

Natural hedging: matching foreign currency revenues and costs to reduce net exposure.

Value at Risk (VaR) estimates potential loss over a given horizon and confidence level; used to measure FX risk.

Hedging policy should specify objectives, permitted instruments, counterparty limits, and monitoring procedures.

FX market conduct is governed by the FX Global Code (Global Foreign Exchange Committee), a set of principles for good practice; adherence is voluntary but widely expected.

Regulatory bodies: SEC, CFTC (US), FCA (UK), ESMA (EU), ASIC (Australia), and others; they oversee conduct, reporting, and market integrity.

Dodd-Frank Act (US) mandates central clearing and trade reporting for certain FX derivatives (swaps); spot FX is generally exempt.

EMIR (EU) requires reporting and clearing of OTC derivatives; MiFID II governs conduct and transparency in FX and CFDs.

Anti-money laundering (AML) and know-your-customer (KYC) requirements apply to FX transactions; firms must monitor for suspicious activity.

Insider trading, front-running, and market manipulation (e.g., fixing, spoofing) are prohibited; ethical standards require fair dealing and confidentiality.

Best execution obligations require firms to take reasonable steps to obtain the best possible result for clients, considering price, speed, and cost.

Recordkeeping: firms must maintain records of transactions and communications for regulatory inspection (e.g., 5-7 years).

FX settlement risk (Herstatt risk) is the risk that one party delivers currency but the counterparty fails to deliver the other currency.

CLS (Continuous Linked Settlement) is a multi-currency settlement system that provides payment-versus-payment (PVP) to eliminate settlement risk for eligible currencies.

CLS settles trades for 18 currencies; members submit trades for matching and settlement; it covers a large share of global FX volume.

Operational risk includes errors in trade capture, confirmation, settlement instructions, and technology failures.

Trade confirmation and affirmation processes (e.g., using MarkitSERV, FXall) reduce operational risk and disputes.

Nostro and vostro accounts are used for correspondent banking; nostro is our account at a foreign bank, vostro is their account at our bank.

SWIFT is the messaging network for financial transactions; MT300 series messages are used for FX confirmations.

Business continuity planning and disaster recovery are essential for FX trading and settlement operations.

Suitability requires assessing a client's investment objectives, risk tolerance, financial situation, and experience before recommending FX products.

Retail clients trading FX or CFDs must be classified and may receive risk warnings; leverage restrictions apply in some jurisdictions (e.g., ESMA 30:1 for major FX pairs).

Professional clients vs. retail clients: professional clients have fewer protections; classification must be documented and agreed.

Suitability documentation must record the client's profile, the recommendation, and the rationale for the product's suitability.

Advisory services require a suitability report; execution-only services may not require advice but still require appropriateness checks in some cases.

Conflicts of interest must be identified, disclosed, and managed; inducements (e.g., commissions) must not impair advice quality.

Periodic reviews of client suitability are required as circumstances change; documentation must be updated.

Record retention: suitability records must be kept for at least 5 years (MiFID II) or as required by local regulators.