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Trading and Capital-Markets Activities Manual

Instrument Profiles: Foreign Exchange
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)


Foreign exchange (FX) refers to the various businesses involved in the purchase and sale of currencies. This market is among the largest in the world and business is conducted 24 hours a day in most of the financial centers. The major participants are financial institutions, corporations, and investment and speculative entities such as hedge funds. Any financial institution which maintains due from bank balances, commonly known as ''nostro'' accounts, in foreign countries in the local currency can engage in foreign exchange. The volume in this market has been estimated to be the equivalent of $1 trillion a day. 


The FX market is divided into spot, forward, swap, and options segments. Each of these segments is discussed in the following subsections. 


Buying and selling FX at market rates for immediate delivery represents spot trading. Generally, spot trades in foreign currency have a ''value date'' (maturity or delivery date) of two to five business days (one day for Canada). Foreign-exchange rates that represent the current market value for the currency are known as spot rates. The risk of spot trading results from exchange-rate movements that occur while the financial institution's position in foreign currency is not balanced with regard to the currency it has bought and sold. Such unbalanced positions are referred to as net open positions. 

Net Open Positions 

A financial institution has a net open position in a foreign currency when its assets, including spot and forward/futures contracts to purchase, and its liabilities, including spot and forward/futures contracts to sell, in that currency are not equal. An excess of assets over liabilities is called a net ''long'' position, and liabilities in excess of assets are called a net ''short'' position. A long position in a foreign currency which is depreciating will result in an exchange loss relative to book value because, with each day, that position (asset) is convertible into fewer units of local currency. Similarly, a short position in a foreign currency which is appreciating represents an exchange loss relative to book value because, with each day, satisfaction of that position (liability) will cost more units of local currency. 

The net open position consists of both balance-sheet accounts and contingent liabilities. For most financial institutions, the nostro accounts represent the principal assets; however, foreign-currency loans as well as any other assets or liabilities that are denominated in foreign currency, which are sizeable in certain financial institutions, must be included. All forward/futures foreign-exchange contracts outstanding are contingents. When a contract matures, the entries are posted to a nostro account in the appropriate currency. 

Each time a financial institution enters into a spot foreign-exchange contract, its net open position is changed. For example, assume that Bank A opens its business day with a balanced net open position in pound sterling (assets plus purchased contracts equal liabilities plus sold contracts). This is often referred to as a ''flat'' position. Bank A then receives a telephone call from Bank B requesting a ''market'' in sterling. Because it is a participant in the interbank foreign-exchange trading market, Bank A is a ''market maker.'' This means it will provide Bank B with a two-sided quote consisting of its bid and offer for sterling. If a different currency was requested, European terms would be the opposite since the bid and offer would be for dollars instead of the foreign currency. In determining the market given, Bank A's trader of sterling will determine where the market is presently (from brokers and/or other financial institutions), attempt to anticipate where it is headed, and determine whether Bank B is planning to buy or sell sterling. 

Forward Transactions 

A forward transaction differs from a spot transaction in that the value date is more than two to five business days in the future. The maturity of a forward foreign-exchange contract can be a few days, months, or even years in some instances. In practice, dates that are two years or more in the future are usually referred to as the long-dated forward market or the long-term FX (LTFX) market. The exchange rate is fixed at the time the transaction is agreed on. However, nostro accounts are not debited or credited, that is, no money actually changes hands, until the maturity date of the contract. There will be a specific exchange rate for each forward maturity, and each of those rates will generally differ from today's spot exchange rate. If the forward exchange rate for a currency is higher than the current spot rate, the currency is trading at a premium for that forward maturity. If the forward rate is below the spot rate, then the currency is trading at a discount. For instance, sterling with a value date of three months is at a discount if the spot rate is $1.75 and the three-month forward rate is $1.72. 

Foreign-Exchange Swaps 

Financial institutions that are active in the foreign-exchange market find that interbank outright forward currency trading is inefficient and engage in it infrequently. Instead, for future maturities, financial institutions trade among themselves as well as with some corporate customers on the basis of a transaction known as a foreign-exchange swap. A swap transaction is a simultaneous purchase and sale of a certain amount of foreign currency for two different value dates. The key aspect is that the financial institution arranges the swap as a single transaction with a single counterparty, either another financial institution or a non-bank customer. This means that, unlike outright spot or forward transactions, a trader does not incur a net open position since the financial institution contracts both to pay and to receive the same amount of currency at specified rates. Note that a foreign exchange swap is different from a foreign currency swap, because the currency swap involves the periodic exchange of interest payments. See the discussion in section 4335.1, ''Currency Swaps.'' 

A foreign-exchange swap allows each party to use a currency for a period in exchange for another currency that is not needed during that time. Thus, the swap offers a useful investment facility for temporary idle currency balances of a corporation or a financial institution. Swaps also provide a mechanism for a financial institution to accommodate the outright forward transactions executed with customers or to bridge gaps in the maturity structure of outstanding spot and forward contracts. 

The two value dates in a swap transaction can be any two dates. But, in practice, markets exist only for a limited number of standard maturities. One of these standard types is called a spot-against-forward swap. In a spot-against-forward swap transaction, a trader buys or sells a currency for the spot value date and simultaneously sells or buys it back for a value date a week, a month, or three months later. 

Another type of transaction of particular interest to professional market-making financial institutions is called a tomorrow-next swap or a rollover. These are transactions in which the dealer buys or sells a currency for value the next business day and simultaneously sells or buys it back for value the day after. A more sophisticated type of swap is called a forward-forward in which the dealer buys or sells currency for one future date and sells or buys it back for another future date. Primarily, multinational banks specialize in transactions of this type. 


The foreign-exchange options market includes both plain vanilla and exotic transactions. See section 4330.1, ''Options,'' for a general discussion. Most options activity is plain vanilla. 


Foreign exchange is used for investment, hedging, and speculative purposes. Most banks use it to service customers and also to trade for their own account. Corporations use the FX market mainly to hedge their foreign-exchange exposure. 


Market Participants 

Sell Side 

The majority of U.S. banks restrict their foreign exchange activities to serving their customers' foreign-currency needs. The banks will simply sell the currency at a rate slightly above the market and subsequently offset the amount and maturity of the transaction through a purchase from another correspondent bank at market rates. This level of activity involves virtually no risk exposure as currency positions are covered within minutes. For these banks, a small profit is usually generated from the rate differential, but the activity is clearly designated as a service center rather than a profit center. 

Usually, the larger the financial institution, the greater the emphasis placed on foreign exchange activity. For instance, while serving the needs of corporate customers is still a priority, most regional banks also participate in the interbank market. These banks may look at the trading function as a profit center as well as a service. Such banks usually employ several experienced traders and may take positions in foreign currencies based on anticipated rate movements. These banks use their involvement in the interbank market to get information about the various markets. For most of these participants, the trading volume in the interbank market constitutes the bulk of the volume. (In some cases, the interbank volume is about 80 to 90 percent of total volume). Multinational banks assume by far the most significant role in the foreign-exchange marketplace. While still serving customer needs, these banks engage heavily in the interbank market and look to their foreign exchange trading operation for sizeable profits. These banks trade foreign exchange on a global basis through their international branch networks. 

One of the major changes in the structure of the foreign-exchange market over the past few years has been the increase in the use of electronic market-making and execution systems. In the past, most interbank dealing was done through the interbank brokers' system; however, advances in technology have made it more efficient for market participants to use electronic systems. (Among the more popular systems are Reuters and EBS (Electronic Brokering Systems).) These developments have decreased the number of errors that are common in the use of the brokers' market (for example, the use of points and error checks) and have also cut down on the costs of doing business. 

Buy Side 

The buy side consists of corporate hedgers, investors, and speculators. Corporations use this market to hedge their assets and liabilities incurred as a result of their overseas operations. Investors (for example, international mutual funds) use this market to gain exposure to markets and sometimes to hedge away the currency risk of their equity portfolios. 

Market Transparency 

Price transparency is very high. The prices for most of the markets are disseminated through various vendors such as Reuters and Telerate. 


Two methods are used to quote foreign-exchange rates. The method used depends on the currency. 

  American quote. Number of foreign-currency units per U.S. dollar (for example, 105 yen per dollar). Most currencies are quoted using this convention. 
  European quote. Number of U.S. dollars per foreign-currency unit (for example, $1.60 per British pound sterling). British and Irish pounds and Australian and New Zealand dollars are the most common currencies using this convention. 

Spot FX 

Most institutions will quote both a bid and an offer. When, for example, Bank A quotes sterling at $1.7115-25, it is saying that it will buy (bid) sterling at $1.7115 or sell (offer) sterling at $1.7125. If Bank B's interest is to buy sterling and the given quote is appealing, it will buy sterling from Bank A at $1.7125 (Bank A's offer price). Note that while Bank B may choose to buy, sell, or pass as it wishes, it must do business on the terms established by Bank A. These terms will be in Bank A's favor. As soon as Bank B announces it will purchase sterling at $1.7125, Bank A acquires a net open position (short) in sterling. Bank A must then decide whether to hold its short position (in anticipation of a decline in sterling) or cover its position. If it wishes to cover, it may call another bank and purchase the amount it sold to Bank B. However, as the calling bank, Bank A would buy its sterling from the offered side of the quote it receives and must buy it at $1.7125 or less to avoid a loss. 

Foreign-Exchange Swaps 

In foreign-exchange swap transactions, the trader is only interested in the difference between spot and forward rates-the premium or discount- rather than the outright spot and forward rates themselves. Premiums and discounts expressed in points ($0.0001 per pound sterling or DM 0.0001 per dollar) are called swap rates. If the pound spot rate is $1.8450 and the six-month forward rate is $1.8200, the dollar's six-month premium is 250 points ($0.0250). If the pound spot rate is $1.8450 and the six-month forward rate is $1.8625, the dollar's six-month discount is 175 points ($0.0175). 

Since, in a swap transaction, a trader is effectively borrowing one currency and lending the other for the period between the two value dates, the premium or discount is often evaluated in terms of percent per annum. For the examples above, the premium of 250 points is equivalent to 2.71 percent per annum, while the discount of 175 points is equivalent to 1.90 percent per annum. To calculate the percentage premium for the first case- 

  take the swap rate ($0.0250), 
  multiply by 12 months and divide by six months (a per annum basis), 
  divide by the spot rate ($1.8450), and 
  multiply by 100 (to get a percent basis). 

This formula can be expressed as- 

% per annum =        Premium or Discount  * 12     *100                
    Spot rate  *  no. of months of forward contract

Forward rates (premiums or discounts) are solely influenced by the interest-rate differentials between the two countries involved. As a result, when the differential changes, forward contracts previously booked could now be covered at either a profit or loss. For example, assume an interest-rate differential between sterling and dollars of 3 percent (with the sterling rate lower). Using this formula, with a spot rate of $1.80, the swap rate on a three-month contract would be a premium of 135 points. If that interest-rate differential increases to 4 percent (by a drop in the sterling rate or an increase in the dollar rate), the premium would increase to 180 points. Therefore, a trader who bought sterling three months forward at 135 points premium could now sell it at 180 points premium, or at a profit of 45 points (expressed as.0045). 

Thus, the dealer responsible for forward trading must be able to analyze and project dollar interest rates as well as interest rates for the currency traded. Additionally, because forward premiums or discounts are based on interest-rate differentials, they do not reflect anticipated movements in spot rates. 


Spot FX 

Banks engaged in trading in the spot market will acquire net open positions in the course of dealing with customers or other market makers. The bank must then decide whether to hold its open position (in anticipation of a move in the currency) or cover its position. If it wishes to cover, the bank may call another bank and either buy or sell the currency needed to close its open position. 

Financial institutions engaging in interbank spot trading will often have sizeable net open positions, though many for just brief periods of time. No matter how skilled the trader, each institution will have occasional losses. Knowing when to close a position and take a small loss before it becomes large is a necessary trait for a competent trader. Many financial institutions employ a ''stop-loss policy,'' whereby a net open position must be covered if losses from it reach a certain level. While a trader's forecast may ultimately prove correct within a day or week, rapid rate movements often cause a loss within an hour or even minutes. Also, access to up-to-the-minute information is vital for involvement in spot trading. Financial institutions that lack the vast informational resources of the largest multinationals may be particularly vulnerable to sudden spot rate movements. As a result, examiners should closely review financial institutions in which foreign-exchange activities consist primarily of interbank spot trading. 


Active trading financial institutions will generally have a large number of forward contracts outstanding. The portfolio of forward contracts is often called a forward book. Trading forward foreign exchange involves projecting interest-rate differentials and managing the forward book to be compatible with these projections. 

Forward positions are generally managed on a gap basis. Normally, financial institutions will segment their forward books into 15-day periods and show the net (purchased forward contracts less sold ones) balance for each period. Volumes and net positions are usually segregated into 15-day periods for only the first three months, with the remainder grouped monthly. The trader will use the forward book to manage his or her overall forward positions. 

A forward book in an actively traded currency may consist of numerous large contracts but, because of the risks in a net open position, total forward purchases will normally be approximately equal to total forward sales. What matters in reviewing a forward book is the distribution of the positions among periods. For example, if a forward book in sterling has a long net position of 3,200,000 for the first three months and is short a net 3,000,000 for the next four months, the forward book is structured anticipating a decline in dollar interest rates as compared with sterling interest rates since these sold positions could be offset (by purchase of a forward contract to negate the sold forward position) at a lower price-either through reduced premium or increased discount. See the subsection below for a discussion of the risks encountered in hedging foreign-exchange exposure. 


Exchange-Rate Risk 

Exchange-rate (market) risk is an inevitable consequence of trading in a world in which foreign-currency values move up and down in response to shifting market supply and demand. When a financial institution's dealer buys or sells a foreign currency from another financial institution or a non-bank customer, exposure from a net open position is created. Until the time that the position can be covered by selling or buying an equivalent amount of the same currency, the institution is exposed to the risk that the exchange rate might move against it. That risk exists even if the dealer immediately seeks to cover the position because, in a market in which exchange rates are constantly changing, a gap of just a few minutes can be long enough to transform a potentially profitable transaction into a loss. Since exchange-rate movements can consistently run in one direction, a position carried overnight or over a number of days entails greater risk than one carried a few minutes or hours. 

At any time, the trading function of a financial institution may have long positions in some currencies and short positions in others. These positions do not offset each other, even though, in practice, the price changes of some currencies do tend to be correlated. Traders in institutions recognize the possibility that the currencies in which they have long positions may fall in value and the currencies in which they have short positions may rise. Consequently, gross trading exposure is measured by adding the absolute value of each currency position expressed in dollars. The individual currency positions and the gross dealing exposure must be controlled to avoid unacceptable risks. 

To accomplish this, management limits the open positions dealers may take in each currency. Practices vary among financial institutions, but, at a minimum, limits are established on the magnitude of open positions which can be carried from one day to the next (overnight limits). Several institutions set separate limits on open positions dealers may take during the day. These are called ''daylight limits.'' Formal limits on gross dealing exposure also are established by some institutions, while others review gross exposure more informally. The various limits may be administered flexibly, but the authority to approve a temporary departure from a limit is typically reserved for a senior officer. 

For management and control purposes, most financial institutions distinguish between positions arising from actual foreign-exchange transactions (trading exposure) and the overall foreign-currency-translation exposure of the institution. The former includes the positions recorded by the institution's trading operations at the head office and at offices abroad. In addition to trading exposure, overall exposure incorporates all the institution's assets and liabilities denominated in foreign currencies, including loans, investments, deposits, and the capital of foreign branches. 

Maturity Gaps and Interest-Rate Risk 

Interest-rate risk arises whenever mismatches or gaps occur in the maturity structure of a financial institution's foreign-exchange forward book. Managing maturity mismatches is an exacting task for a foreign-exchange trader. 

In practice, the problem of handling mismatches is complex. Eliminating maturity gaps on a contract-by-contract basis is impossible for an active trading institution. Its foreign-exchange book may include hundreds of outstanding contracts, with some maEagle Tradersg each business day. Since the book is changing continually as new transactions are made, the maturity gap structure also changes constantly. 

While remaining alert to unusually large mismatches in maturities that call for special action, traders generally balance the net daily payments and receipts for each currency through the use of rollovers. Rollovers simplify the handling of the flow of maEagle Tradersg contracts and reduce the number of transactions needed to balance the book. Reliance on day-to-day swaps is a relatively sound procedure as long as interest-rate changes are gradual and the size and length of maturity gaps are controlled. However, it does leave the financial institution exposed to sudden changes in relative interest rates between the United States and other countries. These sudden changes influence market quotations for swap transactions and, consequently, the cost of bridging the maturity gaps in the foreign-exchange book. 

The problem of containing interest-rate risk is familiar to major money market banks. Their business often involves borrowing short-term and lending longer-term to benefit from the normal tendency of interest rates to be higher for longer maturities. But in foreign-exchange trading, it is not just the maturity pattern of interest rates for one currency that counts. In handling maturity gaps, the differential between interest rates for two currencies is decisive, making the problem more complex. 

To control interest-rate risk, senior management generally imposes limits on the magnitude of mismatches in the foreign-exchange book. Procedures vary, but separate limits are often set on a day-to-day basis for contracts maEagle Tradersg during the following week or two and for each consecutive half-monthly period for contracts maEagle Tradersg later. At the same time, management relies on officers abroad, domestic money market experts, and its economic research department to provide ongoing analysis of interest-rate trends. 

Credit and Settlement Risk 

When a financial institution books a foreign exchange contract, it faces a risk, however small, that the counterparty will not perform according to the terms of the contract. To limit credit risk, a careful evaluation of the creditworthiness of the customer is essential. Just as no financial institution can lend unlimited amounts to a single customer, no institution would want to trade unlimited amounts of foreign exchange with one counterparty. 

Credit risk arises whenever an institution's counterparty is unable or unwilling to fulfill its contractual obligations-most blatantly when a corporate customer enters bankruptcy or an institution's counterparty is declared insolvent. In any foreign-exchange transaction, each counterparty agrees to deliver a certain amount of currency to the other on a particular date. Every contract is immediately entered into the financial institution's foreign-exchange book. In balancing its trading position, a financial institution counts on that contract being carried out in accordance with the agreed-upon terms. If the contract is not liquidated, then the institution's position is unbalanced and the institution is exposed to the risk of changes in the exchange rates. To put itself in the same position it would have been in if the contract had been performed, an institution must arrange for a new transaction. The new transaction may have to be arranged at an adverse exchange rate. The trustee for a bankrupt company may perform only on contracts which are advantageous to the company and disclaim those contracts which are disadvantageous. Some dealers have attempted to forestall such arbitrary treatment through the execution of legally recognized bilateral netting agreements. Examiners should determine whether dealers have such agreements in place and whether they have a favorable legal opinion as to their effectiveness, particularly in cross-border situations. 

Another form of credit and settlement risk stems from the time-zone differences between the United States and foreign nations. Inevitably, an institution selling sterling, for instance, must pay pounds to a counterparty before it will be credited with dollars in New York. In the intervening hours, a company can go into bankruptcy or an institution can be declared insolvent. Thus, the dollars may never be credited. Settlement risk has become a major source of concern to various supervisory authorities because many institutions are not aware of the extent of the risks involved. The Bank for International Settlements (BIS) has laid out the various risks in a paper that was published in July 1996. 

Managing credit risk is the joint responsibility of the financial institution's trading department and its credit officers. A financial institution normally deals with corporations and other institutions with which it has an established relationship. Dealing limits are set for each counterparty and are adjusted in response to changes in its financial condition. In addition, most institutions set separate limits on the value of contracts that can mature on a single day with a particular customer. Some institutions, recognizing that credit risk increases as maturities lengthen, restrict dealings with certain customers to spot transactions or require compensating balances on forward transactions. An institution's procedures for evaluating credit risk and minimizing exposure are reviewed by supervisory authorities as part of the regular examination process. 


The accounting treatment for foreign-exchange contracts is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 


The credit-equivalent amount of a foreign exchange contract is calculated by summing- 

 1. the mark-to-market value (positive values only) of the contract and 
 2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are as follows. 

  Remaining Maturity                       Factor 

  One year or less                            1.00% 
  Five years or less                          5.00% 
  Greater than five years                   7.50% 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, ''Capital Adequacy.'') For institutions that apply market-risk capital standards, all foreign-exchange transactions are included in value-at-risk (VAR) calculations for market risk. 


Foreign-exchange contracts are not considered investment securities under 12 USC 24(7th). However, the use of these instruments is considered to be an activity incidental to banking, within safe and sound banking practices. 


 Das, Satyajit. Swap and Derivative Financing. Chicago: Probus Publishing, 1993. 
 Federal Financial Institutions Examination Council. Uniform Guidelines on Internal Control for Foreign Exchange in Commercial Banks. 
 The New York Foreign Exchange Committee. Reducing Foreign Exchange Settlement Risk. October 1994. 
 The New York Foreign Exchange Committee. Guidelines for Foreign Exchange Trading Activities. January 1996. 
 Schwartz, Robert J., and Clifford W. Smith, Jr., eds. The Handbook of Currency and Interest Rate Risk Management. New York Institute of Finance, 1990.

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