A Practical Guide to the FX Markets

TIM WEITHERS

John Wiley & Sons, Inc.

ForeignExchange

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ForeignExchange

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A Practical Guide to the FX Markets

TIM WEITHERS

John Wiley & Sons, Inc.

ForeignExchange

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Copyright 2006 by Tim Weithers. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United StatesCopyright Act, without either the prior written permission of the Publisher, or authorizationthrough payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc.,222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should beaddressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street,Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online athttp://www.wiley.com/go/permissions.

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The views expressed herein are those of the author and do not necessarily reflect the views,statements, positions, analysis, research, or products of UBS AG or its affiliates such as UBSInvestment Bank and/or UBS Global Wealth Management & Business Banking (UBS). UBS is not responsible for and does not endorse or sponsor the views, statements, positions,or analysis of the author.

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Library of Congress Cataloging-in-Publication Data:

Weithers, Timothy M. (Timothy Martin), 1956Foreign exchange : a practical guide to the FX markets / Tim Weithers.

p. cm.(Wiley finance series)Includes bibliographical references and index.ISBN-13: 978-0-471-73203-7 (cloth)ISBN-10: 0-471-73203-6 (cloth)1. Foreign exchange market. 2. International finance. I. Title. II.

Series.HG3851.W44 2006332.4'5dc22

2005038005

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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www.wiley.com

Dedication:

To my boys: Michael, Stephen, and Peter

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Contents

Preface xi

Acknowledgments xv

CHAPTER 1Trading Money 1

Introduction 1Trading Money 2The Roles Money Plays 3The Major Currencies 9Some Interesting Questions 14

Appendix: Countries, Currencies, and ISO Codes 23

CHAPTER 2Markets, Prices, and Marketmaking 35

What Is a Market? 35What Is a Price? 36Buyers and Sellers 37Marketmaking 38Summary 46

CHAPTER 3Interest Rates 47

What Are Interest Rates? 47Inflation 48Day Count or Day Basis 50Compounding 51Discounting 54Types of Interest Rates 55Interest Rates in the Real World 57

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CHAPTER 4Brief History of Foreign Exchange 63

Historical Background 63The FX Markets Today 71The Regulatory Environment and Central Bank Intervention 76Summary 80

CHAPTER 5The Foreign Exchange Spot Market 83

The Spot Market 83Spot FX Quoting Conventions 84Economic Interpretation 90Purchasing Power Parity 92Cross Rates and Triangular Arbitrage in the Spot Market 95The BidAsk Spread in Foreign Exchange 98Timing 100Settlement 101Market Jargon 102The Best Arbitrage Around! 102

CHAPTER 6Foreign Exchange Forwards 105

Introduction to Forwards and Forward Pricing 105Foreign Exchange Forwards and Forward Pricing 107Interest Rate Parity (Covered Interest Arbitrage) 112FX SpotForward Arbitrage 114FX Forward Price Quotes and Forward Points 118Timing 122Off-Market Forwards 125Foreign Exchange Forwards in the Real World 126

CHAPTER 7Foreign Exchange Futures 129

Background 129Futures versus Forwards 130Foreign Exchange Futures Contract Specifications 132Margin 133Why Use Futures? 137Options on FX Futures 137Summary 138

viii CONTENTS

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CHAPTER 8Foreign Exchange Swaps or Cross-Currency Swaps or Cross-Currency Interest Rate Swaps or . . . 139

Introduction 139FX Spot-Forward Swaps 139Cross-Currency Swaps or FX Cross-Currency Interest Rate

Swaps or FX Bond Swaps 140Summary 151

CHAPTER 9Foreign Exchange Options 153

Option Basics 153Equity Options 159Put-Call Parity with Equity Options 161In-the-Money, At-the-Money, and Out-of-the-Money 166Theoretical Option Value and Option Risk Measures

(The Greeks) 167Foreign Exchange Options 170Put-Call Parity in Foreign Exchange 172Perspective Matters 174FX Option Premium 177Volatility 179Uses and Strategies 183

Appendix: Theoretical Option Valuation 190The Binomial Model 190The BlackScholes/GarmanKohlhagen Model 198The GarmanKohlhagen Option Risk Measures or Greeks 202

CHAPTER 10Exotic Options and Structured Products 205

What Is an Exotic Option? 205Nonstandard Options 207Digital or Binary Options 209Barrier Options 212Other Exotic Options 216FX-Linked Notes 217

CHAPTER 11The Economics of Exchange Rates and International Trade 219

Money versus Currency 219Types of FX Exposures 221Fixed versus Floating Exchange Rates 229Implications of Monetary Policy 233

Contents ix

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Trade Deficits: A Curse or a Blessing 233Politics and Economics 234

CHAPTER 12Currency Crises 237

The End of Bretton Woods 238Bankhaus Herstatt 239The ERM Crisis of 1992 240The Asian Crisis of 1997 241The Russian Crisis of 1998 241The Turkish Lira Crisis of 2001 242The Argentinean Peso Crisis of 2002 242Summary 244

CHAPTER 13Technical Analysis 247

Introduction 247What Is Technical Analysis? 249Methods of Technical Analysis 249Technical Analysis in Foreign Exchange 256Technical Analysis Today 258Summary 258

CHAPTER 14Where Do We Go From Here? 261

CHAPTER 15Conclusion 267

APPENDIXPrecious Metals 269

Answers to the Chapter Exercises 273

Notes 287

References 301

About the Author 311

Index 313

x CONTENTS

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Preface

I have been teaching about foreign exchange for more than a dozen yearsnow and thinking about money and trade for even longer. At the Univer-sity of Chicago, on my way to a Ph.D. in economics, I enrolled in the 1980sin an international trade course (with moneyas opposed to realtrade) with Jacob Frenkel [who, from 1991 through 2000, was governorof the Bank of Israel (i.e., Israels counterpart to Alan Greenspan/BenBernanke) and who subsequently served as president of the internationaldivision of an investment bank and then chairman and CEO of the Groupof Thirty (G-30)]. The University of Chicago is proud of its role in institut-ing the quarter system (the summer being one of the quartersthat is,in establishing what most people would call the trimester system in whichthree 10-week sessions constitute the academic year). Mr. Frenkel distrib-uted what seemed to me like a particularly thick syllabus for a 10-weekterm. Chicago graduate students in the Department of Economics were re-quired to take courses in a relatively large number of different fields. Inter-national trade was not one of my areas of specialization, so I stopped byMr. Frenkels office to ask if he could tell me which were the more impor-tant papers. His succinct response: Zey are oll important! While I wasreading the material, some of the journal articles seemed to refer to the ex-change rate as, say, Dollars per Pound, while others appeared to take theexchange rate to indicate Pounds per Dollar; it was truly confusing! Thiswas my first exposure to the ambiguity and frustration associated with for-eign exchange.

Engaging in that fascinating phenomenon that I believe psychologistsrefer to as the continuing cycle of child abuse, I went on to teach eco-nomics at Fordham University for several years. After my wife and I hadour third son, I joined an amazing little partnership called OConnor andAssociates, a proprietary option trading firm based in Chicago that hadits own in-house Education Department (of which I was the third full-time instructor). Many businesses refer to internal development pro-grams as training; one of my colleagues was always quick to point out, You train animals; you educate people. While the name of thisbusiness has changed repeatedly over the years (OConnor and Associ-ates, LLP; SBC/OC; Swiss Bank Corporation (SBC), SBC Warburg; SBC

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Warburg Dillon Read; Warburg Dillon Read; UBS Warburg; and UBS)and while my title has changed (though slightly less often), I am stillteaching (and still enjoy teaching) for the Bank. Up until a few yearsago, with rare exception, the only people whom our group, now calledFinancial Markets Education, taught were internal employees; more re-cently, we have opened many of our more popular classes to UBSs topclients. We have both invited them into our regularly scheduled coursesand, on occasion, taught dedicated seminars for them. Foreign Exchangehas been, and continues to be, one of our best attended and most de-manded courses.

In addition, starting back in the Fall of 1997, the University ofChicago began offering a financial engineering graduate degree, organizedby the Department of Mathematics, through its Masters of Science in Fi-nancial Mathematics. At that time, Niels Nygaard, the director of the pro-gram, sought teaching assistance from what he referred to as thepractitioner community. I have taught Foreign Exchange, among otherthings, every year since the start of that program (with friends and formercolleagues, Al Kanzler and Jeff Krause).

This book is a synthesis of what I teach at UBS, what I teach at theUniversity of Chicago, and also what I find interesting about foreign ex-change (FX) that may not have made its way into either of the two afore-mentioned forums. I have assumed no prior exposure to foreign exchange(which, obviously, depending on the reader, may be grossly inaccurate); be-cause I start from the basics, though, its my belief that this book is self-contained. More importantly, I would like to think that this book ispractical, insightful, and useful for anyone who is, or who will be, workingin the area of foreign exchange.

The organization of the book is as follows:Chapter 1 describes what I believe foreign exchange is all about in very

general terms, identifies the most important currencies, and provides (in anAppendix) a relatively exhaustive listing of the names for, and standardizedabbreviations of, money from around the globe.

Chapter 2, for those who have not worked in the financial commu-nity, is a brief exposition on prices and markets that might differ slightlyfrom what you may have heard in a college economics or finance course,but an understanding of these concepts is essential, and will set the stagefor what follows.

Chapter 3 serves as an introduction to interest rates. The phenomenonof interest, through which money tends to multiply, distinguishes foreignexchange from many of the traditional asset classes. Compounding con-ventions, day count, discounting, and examples of actual market rates areall discussed here.

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Chapter 4 gives some historical perspective and color on the evolu-tion and development of the foreign exchange markets. Moreover, it con-tains some information about the current state of the FX markets (as oflate 2005).

In Chapter 5 we introduce the FX spot market. Everything in foreignexchange revolves around spot. If you understand the following statement:I buy 10 bucks, Dollar-Swiss, at the offer of one-twenty-fivethe figure,you may skip to Chapter 6.

Chapter 6 presents FX forwardsin as intuitive a fashion as I havebeen able to devise over the years. FX forward valuation and forwardpoints, while they could be viewed as being somewhat mechanical, are thesource of a great deal of confusion, and this chapter is an attempt to elimi-nate any obfuscation and to empower the reader with some solid intuitionregarding the pricing of these useful and frequently traded instruments.

FX futures, although not terribly significant as a fraction of FX tradingvolume, can be a source of market information (in a world dominated bynontransparent, over-the-counter transactions) and are covered in Chapter 7.

The subject of Chapter 8, Cross-Currency Interest Rate Swaps, is re-ally a funding or interest rate topic; these instruments are most easily ex-plained after our discussion of FX forwards (really being nothing morethan bundlings of FX forwards into single contracts). They are very im-portant for the world of international debt issuance.

Options follow in Chapter 9 [in which we start by comparing and con-trasting the way most people understand and talk about options (that is,from the equity point of view) versus their foreign exchange counterparts].There is always the question of where to start and where to end with op-tions; terminology, graphical representations, option spreads, theoreticalvaluation, option risk measures (or the Greeks), and strategies all de-serve treatment. We save the more formal, quantitative modeling issues foran Appendix.

In FX, exotic (or non-standard) options are really not all that ex-otictrading more, and more liquidly, in this product area than in anyother. In this sense, they constitute an important component of the FXmarkets. Even if one does not trade FX exotic options, everyone dealingwith foreign exchange should still have an understanding of, and apprecia-tion for, what these instruments are all about because, as Chapter 10 at-tempts to point out, they can have a significant impact on the movementand behavior of the FX spot market.

Once we have laid out the spectrum of products found within theworld of foreign exchange, we circle back and talk about exchange rateswithin their larger economic context in Chapter 11. This includes a discus-sion of the pros and cons of fixed versus flexible exchange rate systems or

Preface xiii

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