Foreign Exchange Activity PDF

Trust and Treasury Management Unit II: Foreign Exchange Activity of the Treasury Department Ms. Lourdes Francesca Revadillo, MBA Weeks 5-9  Flow of Discussion I. Foreign Exchange Market Overview II. Fore...

Trust and Treasury Management Unit II: Foreign Exchange Activity of the Treasury Department Ms. Lourdes Francesca Revadillo, MBA Weeks 5-9  Flow of Discussion I. Foreign Exchange Market Overview II. Foreign Exchange Market and Transaction Convention Foreign Exchange Contract Commodity vs. Terms currency Quotation System Parties Explicit vs. Implied Quote Price Quote and Pip Price Decimal Convention Foreign Exchange Jargons  Flow of Discussion II. Foreign Exchange Market and Transaction Convention Cash Flow, Profits or Losses Currency Appreciation and Depreciation Trading Position Commercial Pricing Trade vs. Settlement Date Cross Rates  Foreign Exchange Money denominated in the currency of another nation or group of nations Buying and selling of foreign currency  Foreign Exchange Exchange Rate The price of one currency in terms of another currency The number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency  Foreign Exchange Transaction International Currency Codes (ISO 4217) US Dollar USD Australian Dollar AUD Euro EUR Singapore Dollar SGD Japanese Yen JPY Philippine Peso PHP Pound Sterling GBP Indonesian Rupiah IDR Swiss Franc CHF Thailand Baht THB Canadian Dollar CAD Hong Kong Dollar HKD Malaysian Ringgit MYR Indian Rupee INR Source: IBAN. (n.d.) List of currency codes by country (ISO 4217). https://www.iban.com/currency-codes  Foreign Exchange Transaction Currency Nicknames USD – “the Greenback”, “buck” EUR – “the common currency”, “fiber” GBP – “cable”, “pound sterling” AUD – “aussie”, “aussie battler” NZD – “kiwi”, “flightless bird” CAD – “loonie” CHF – “swissie” o Confoederatio Helvetica - Latin for Swiss Confederation Common safe-havens – USD, CHF, JPY  Foreign Exchange Transaction Common Safe-haven currencies Safe-haven currency – a currency that investors believe is stable enough to keep its value compared to other currencies in times of economic uncertainty, inflation, and other forms of crisis. Gold – has always been viewed as a store of value; essentially a currency that cannot be manipulated by the interest rate policies of any government and has traditionally been used as a hedge against inflation.  Foreign Exchange Transaction Safe-havens currencies USD – increased demand for U.S. Treasuries during times of financial turmoil and crisis drives up demand for the U.S. Dollar CHF – historically, considered a safe-haven currency with virtually zero inflation and part of the core value of the Swiss Franc is backed up by gold (more than 25%) JPY – Japan’s government debt is largely owned by domestic investors, which makes Japan less at risk of capital flight when economic political shocks cause confidence to collapse  Foreign Exchange Market The market in which a currency of one country is exchanged for the currency of another country Foreign exchange trading (forex trading, FX trading, or currency trading) refers to buying and selling currencies in the foreign exchange market – to make a profit or use as an end-user The world’s largest financial market where trillions are traded daily.  Foreign Exchange Market The currency market is open 24 hours a day, 5 days a week, with all major currencies traded in all major financial centers Most important world trading centers located in London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris, and Sydney.  Foreign Exchange Market Philippine FX Market Floating exchange rate system Managed by the Bangko Sentral ng Pilipinas (with its aim of Price Stability) US Dollar against Philippine Peso: o Banks traded FX using an electronic trading platform – Philippine Dealing and Exchange Corp. (PDEx) through Reuters or Bloomberg dealing, OTC, or via brokers o Monday to Friday 9 am - 12 noon, 2 pm – 4 pm o FX Summary: Bankers Association of the Philippines  Foreign Exchange Market Market Participants Banks and Other Financial Institutions o The interbank market o Take on a huge amount of FX transactions each day for both their clients and themselves o You could say that the interbank market is THE foreign exchange market o Examples: UBS, Barclays Capital, Deutsche Bank, and Citigroup  Foreign Exchange Market Market Participants Large Commercial Companies o Take part in the FX market for the purpose of doing business o Example: Apple must first exchange its USD for JPY when purchasing electronic parts from Japan for their products.  Foreign Exchange Market Market Participants Speculators (includes retail traders) o Individuals who trade FX through online FX trading platforms (e.g., OANDA, FXCM, Interactive Brokers, eToro)  Foreign Exchange Market Market Participants Governments and Central Banks o Primary function is to provide the nation’s money supply and consequently maintain price stability o May have: - Official exchange rate target (fixed rate or peg) – USD/CNY - Unofficial exchange rate target (managed float) – EUR/CHF - No exchange rate target (free float) – USD/PHP FX Market Conventions  What is a Foreign Exchange Contract? A bilateral agreement to buy or sell one currency against another at an agreed price at a specific value date. Bilateral agreement 2 parties to buy or sell 2 cash flows one currency against another 2 currencies at an agreed price 2-way quote at a specific value date 2 dates  What is a Foreign Exchange Contract? A bilateral agreement to buy or sell one currency against another at an agreed price at a specific value date. Bilateral agreement 2 parties to buy or sell 2 cash flows one currency against another 2 currencies at an agreed price 2-way quote at a specific value date 2 dates  Foreign Exchange Market Conventions Currencies involved in an FX Contract FX Rates Translation Spot EUR/USD 1 EUR = USD 1.0780 Spot USD/JPY 1 USD = JPY 112.30  Foreign Exchange Market Conventions USD/PHP 56.80 First currency: Commodity Currency Oblique (/): Against not Per Second currency: Term Currency Amount: Price of Commodity Currency Verbal jargon: USDPHP is “Dollar Peso” not “Peso Dollar” Foreign Exchange Market Conventions USD/PHP 56.80 Commodity Term Currency Currency 1 unit of the Commodity Currency = X units of the Term Currency  Foreign Exchange Market Conventions Commodity vs. Term Currency TERM CURRENCY The currency used as a reference for pricing in an FX transaction or to express the price of the commodity Also called price currency/quote currency USD/PHP 56.250 56.750 COMMODITY CURRENCY The currency being priced in an FX transaction The currency being bought or sold Also called base currency What is implied in an FX rate? USD/PHP 56.80 USD PHP 1 USD can be exchanged for 56.80 PHP If you buy USD, you pay PHP; if you sell USD, you receive PHP  Foreign Exchange Market Conventions Quotation System Commodity Term Currency Currency Price Quotation Foreign Currency Local Currency Volume Quotation Local Currency Foreign Currency The two systems (price and volume quotation) express the same thing but from different perspectives In general, currencies are traded using Price Quotation except K-A-P-E (Kiwi, Aussie, Pound, and Euro)  Foreign Exchange Market Conventions Quotation System Price Quotation (also known as Direct Quotation) o Cost of one unit of foreign currency is given in units of local currency; or o Fixed amount of foreign currency quoted against a variable amount of local currency Volume Quotation (also known as Indirect Quotation) o Cost of one unit of local currency is given in units of foreign currency; or o Fixed amount of local currency quoted against a variable amount of foreign currency  What is a Foreign Exchange Contract? A bilateral agreement to buy or sell one currency against another at an agreed price at a specific value date. Bilateral agreement 2 parties to buy or sell 2 cash flows one currency against another 2 currencies at an agreed price 2-way quote at a specific value date 2 dates Who are involved in an FX transaction? Spot USD/PHP What’s Spot 56.25 – 56.75 USD/PHP, please? USD PHP Quoting Party Calling Party (Market Maker) (Price Taker) Bid and Offer refer to the COMMODITY Currency Price Taker has to deal at the price of the Market Maker  Foreign Exchange Market Conventions Explicit and Implied FX Quote Quoting Bank Calling Bank willing to can Buy Commodity Sell Commodity BID Currency Currency USD/PHP 56.25 implicitly selling implicitly buying Term Currency Term Currency Sell Commodity Buy Commodity OFFER Currency Currency USD/PHP 56.75 implicitly buying implicitly selling Term Currency Term Currency  Foreign Exchange Market Conventions Explicit and Implied FX Quote QP (MM) USD/PHP 56.25 CP (PT) Buy USD $100 Sell USD Sell PHP P5,625 Buy PHP QP (MM) USD/PHP 56.75 CP (PT) Sell USD $100 Buy USD Buy PHP P5,675 Sell PHP  Foreign Exchange Market Conventions Explicit and Implied FX Quote USD/JPY 147.29 147.31 BID OFFER The price the quoting party is willing The price the quoting party is willing to buy the commodity currency; the to sell the commodity currency; the price the calling party can sell the price the calling party can buy the commodity currency commodity currency  Foreign Exchange Market Conventions Explicit and Implied FX Quote USD/JPY 147.29 147.31 Willing to Buy USD Willing to Sell USD (Market Maker) (Market Maker) Can Sell USD Can Buy USD (Price Taker) (Price Taker) Spread 2 pips (JPY)  Foreign Exchange Market Conventions Price Quote 41.905-925 Big figure or “big fig”: 41.9 Small figure: 05-25 Bid-offer spread or “spread”: 2 centavos / 20 pips  Foreign Exchange Market Conventions Pip Percentage in Point Last significant digit in a quote Depends on how a currency pair is quoted Smallest price change that a given foreign exchange rate can make  Foreign Exchange Market Conventions Pip EUR/USD 1.0707 0.0001 = 1 pip USD/JPY 147.70 0.01 = 1 pip USD/PHP 56.640 0.001 = 1 pip [EUR/USD] How would you express 2 pips? 1.0709 [USD/JPY] How would you express 10 pips? 147.80 [USD/PHP] How would you express 300 pips? 56.940  Foreign Exchange Market Conventions Price Decimal Convention Usually, forex rates are quoted up to 4 decimal places o EUR/USD 1.0703, USD/HKD 7.8398 If price is above 20, usually 3 decimal places o USD/PHP 56.640, USD/TWD 32.068 If price is above 70, usually 2 decimal places o USD/JPY 147.76, USD/KRW 1,333.09 Foreign Exchange Jargons PURCHASE SELL BUY SELL BID ASK LONG SHORT MINE YOURS PAY OFFER TAKEN GIVEN BILI BATO  Exercise #1 USD/PHP 56.35 56.85 Transaction Quoting Party Calling Party Buy USD Buy PHP Sell USD Sell PHP USD/PHP rates from BPI as of September 9, 2023  Exercise #1 Willing to Buy USD Willing to Sell USD (Market Maker) USD/PHP (Market Maker) Can Sell USD Can Buy USD (Price Taker) 56.35 56.85 (Price Taker) Transaction Quoting Party Calling Party Buy USD 56.35 56.85 Buy PHP (Sell USD) 56.85 56.35 Sell USD 56.85 56.35 Sell PHP (Buy USD) 56.35 56.85 USD/PHP rates from BPI as of September 9, 2023  Exercise #2 GBP/USD 1.2535 1.2538 Transaction Quoting Party Calling Party Buy USD Sell USD Buy GBP Sell GBP GBP/USD rates from Investing.com as of September 11, 2023  Exercise #2 Willing to Buy GBP Willing to Sell GBP (Market Maker) GBP/USD (Market Maker) Can Sell GBP Can Buy GBP (Price Taker) 1.2535 1.2538 (Price Taker) Transaction Quoting Party Calling Party Buy USD (Sell GBP) 1.2538 1.2535 Sell USD (Buy GBP) 1.2535 1.2538 Buy GBP 1.2535 1.2538 Sell GBP 1.2538 1.2535 GBP/USD rates from Investing.com as of September 11, 2023  References BAP-Ateneo Treasury Certification Program Brandl, M.W. (2021). Money, banking, financial markets & institutions (2nd ed.). Cengage Learning Trust and Treasury Management Unit II: Foreign Exchange Activity of the Treasury Department Ms. Lourdes Francesca Revadillo, MBA Weeks 5-9  Flow of Discussion I. Foreign Exchange Market Overview II. Foreign Exchange Market and Transaction Convention Foreign Exchange Contract Commodity vs. Terms currency Quotation System Parties Explicit vs. Implied Quote Price Quote and Pip Price Decimal Convention Foreign Exchange Jargons  Flow of Discussion II. Foreign Exchange Market and Transaction Convention Cash Flow, Profits or Losses Currency Appreciation and Depreciation Trading Position Commercial Pricing Trade vs. Settlement Date Cross Rates  What is a Foreign Exchange Contract? A bilateral agreement to buy or sell one currency against another at an agreed price at a specific value date. Bilateral agreement 2 parties to buy or sell 2 cash flows one currency against another 2 currencies at an agreed price 2-way quote at a specific value date 2 dates  Elements of an FX Cash Flow Cash Flow Currency Direction Currency bought Inflow Currency sold Outflow How are FX Profits or Losses Computed? FX Profits or Losses (P/L) are generated by buying and selling the commodity currency at different exchange rates Calculated by maintaining the commodity currency constant and determining the difference in the terms currency FX P/L is expressed in terms currency and can be converted to commodity currency by applying the current rate How are FX Profits or Losses Computed? Assuming you entered into the following FX Transactions: 1. Bought USD 1MM @ USD/CHF 0.9120 2. Sold USD 1MM @ USD/CHF 0.9130 How much is your FX P/L? FX Blotter Currency Pair: USD/CHF Foreign Currency Rate Terms Currency Equivalent +USD 1,000,000.00 0.9120 - CHF 912,000.00 -USD 1,000,000.00 0.9130 +CHF 913,000.00 FX Profit + CHF 1,000.00 How are FX Profits or Losses Computed? Assuming you entered into the following FX Transactions: 1. Sold CAD 1MM @ CAD/PHP 42.3680 2. Bought CAD 1MM @ CAD/PHP 42.3730 How much is your FX P/L? FX Blotter Currency Pair: CAD/PHP Foreign Currency Rate Terms Currency Equivalent - CAD 1,000,000.00 42.3680 +PHP 42,368,000.00 +CAD 1,000,000.00 42.3730 - PHP 42,373,000.00 FX Loss - PHP 5,000.00  When is a Currency Appreciating or Depreciating? Commodity Currency appreciation (worth more units of Term Currency) Price Rise USD/PHP 56.90 Original Price USD/PHP 56.80 Price Fall USD/PHP 56.65 Commodity Currency depreciation (worth less units of Term Currency)  When is a Currency Appreciating or Depreciating? Commodity Currency Terms Currency Appreciation Depreciation Price More expensive to avail the Worth more units of Increase Term currency Commodity currency; you can buy less commodity currency Depreciation Appreciation Price Less expensive to avail the Worth less units of Decrease Term currency Commodity currency; you can buy more commodity currency  Currency Pair: USD/PHP Is the USD appreciating Is the PHP appreciating or depreciating? or depreciating?  FX Trading Treasury makes money on trading by taking advantage of the movements in FX rates. A long USD position means you are buying USD against another currency, with the expectation or view that the rate will eventually rise. A short USD position means you are selling USD against another currency, with the expectation or view that the rate will fall. Treasury makes FX trading income by taking views or positions accordingly.  FX Trading If the Treasury’s view is that the PHP will strengthen in the long run, it will take a short USD position (sell USD against PHP). Treasury sells USD 10 MM against PHP at 43.60 - USD 10,000,000.00 +PHP 436,000,000.00 If true enough, PHP strengthens and USD/PHP falls to 43.40, the Treasury will make 20 centavos income for every dollar position when it buys USD at 43.40. Treasury buys USD 10 MM against PHP at 43.40 - PHP 434,000,000.00 +USD 10,000,000.00 Profit = 2,000,000.00 (PHP 436 MM – 434 MM)  FX Trading Assuming you expect GBP/JPY to depreciate from the current level. What two transactions will you enter versus USD to establish your intended position? Expectation: Commodity currency will depreciate o Short GBP, Long JPY Transaction to enter versus USD o Sell GBP/USD (Buy USD/GBP) and Buy JPY/USD (Sell USD/JPY)  How is the Net FX Position Determined? Total FX Purchases > Total FX Sales = Overbought (O/B) Total FX Purchases < Total FX Sales = Oversold (O/S) Computed regardless of maturity date; recognized at transaction date Outstanding FX Contracts (Contingent accounts) include: o Value Tom o Value Spot o Value Forward  What is a Foreign Exchange Contract? A bilateral agreement to buy or sell one currency against another at an agreed price at a specific value date. Bilateral agreement 2 parties to buy or sell 2 cash flows one currency against another 2 currencies at an agreed price 2-way quote at a specific value date 2 dates How Does a Bank Quote Competitive FX? Acts as an intermediary between corporate client and market; buys or sells on behalf of the client Assumes original risk positions of the corporate client o Treasury will act as broker/dealer on behalf of the client Accesses market to: o Determine break-even pricing o Cover risk/s How Does a Bank Quote Competitive FX? The Bank buys (sells) USD/PHP The Bank sells (buys) USD/PHP from Corporate (client) to the interbank market Price Taker Market Maker Price Taker Market Maker Photos from Corporate Finance Institute and flaticon.com  What is FX Commercial Pricing? Market rate USD/PHP 56.68-56.71 Assuming the Bank buys USD with a spread from Corporate: What price will the Bank quote to its Corporate client? If the Bank wants to have an additional 2-centavo spread, will it add or deduct from the break-even price? Break-even (Market’s Bid) 56.68 Deduct: desired spread 0.02 Final Buying Rate 56.66 Quoted to Corporate Client  What is FX Commercial Pricing? Market rate EUR/PHP 60.67-60.69 Assuming the Bank sells EUR with a spread to Corporate: What price will the Bank quote to its Corporate client? If the Bank wants to have an additional 3-centavo spread, will it add or deduct from the break-even price? Break-even (Market’s Offer) 60.69 Add: desired spread 0.03 Final Selling Rate 60.72 Quoted to Corporate Client  What is a Foreign Exchange Contract? A bilateral agreement to buy or sell one currency against another at an agreed price at a specific value date. Bilateral agreement 2 parties to buy or sell 2 cash flows one currency against another 2 currencies at an agreed price 2-way quote at a specific value date 2 dates  Trade Date vs. Value Date Trade Date The date that the counterparties commit to the transaction or enter into the transaction Value Date (Settlement Date) The date when currencies are settled (exchange of values) o “tod” – for value today; same-day transaction o “tom” – for value tomorrow; T+1 o “spot” – for value two (2) business days from the transaction date; T+2 o Forward – any date beyond spot value date (e.g., 3 mos.) o Swap – usually a pair of spot and an opposite-side forward transaction Cross Rates  Cross Rate Exchange rate of one currency against another derived through a third currency Cross Currency Pair Typically, currency pairs involve the USD Currency pairs not involving the USD are called “cross currency pairs” or “crosses.”  Cross Rate JPY/PHP = ? EUR/PHP = ? USD/JPY 147.8500 EUR/USD 1.0657 USD/PHP 56.8150 USD/PHP 56.8150 FX rates from Bloomberg as of September 15, 2023  Cross Rate Methodology 1. Start with Terms Currency 2. Start 2nd equation with currency ending 1st equation 3. Start 3rd equation with currency ending 2nd equation 4. Plug in currency values 5. Divide RHS by LHS  Cross Rate Methodology JPY/PHP = ? 1. Start with Terms Currency 2. Start 2nd equation with currency ending 1st equation 3. Start 3rd equation with currency ending 2nd equation USD/JPY 147.8500 4. Plug in currency values 5. Divide RHS by LHS USD/PHP 56.8150 LHS RHS ? PHP 1 JPY 147.8500 JPY 1 USD 1 USD 56.8150 PHP ? x 147.8500 x 1 1 x 1 x 56.8150  Cross Rate JPY/PHP = ? EUR/PHP = ? USD/JPY 147.8500 EUR/USD 1.0657 USD/PHP 56.8150 USD/PHP 56.8150 1 × 1 × 56.8150 𝐽𝑃𝑌/𝑃𝐻𝑃 = ?× 147.8500 × 1 𝑱𝑷𝒀/𝑷𝑯𝑷 = 𝟎. 𝟑𝟖𝟒𝟑 FX rates from Bloomberg as of September 15, 2023  Cross Rate Methodology EUR/PHP = ? 1. Start with Terms Currency 2. Start 2nd equation with currency ending 1st equation 3. Start 3rd equation with currency ending 2nd equation EUR/USD 1.0657 4. Plug in currency values 5. Divide RHS by LHS USD/PHP 56.8150 LHS RHS ? PHP 1 EUR 1 EUR 1.0657 USD 1 USD 56.8150 PHP ?x1x1 1 x 1.0657 x 56.8150  Cross Rate JPY/PHP = ? EUR/PHP = ? USD/JPY 147.8500 EUR/USD 1.0657 USD/PHP 56.8150 USD/PHP 56.8150 1 × 1 × 56.8150 1 × 1.0657 × 56.8150 𝐽𝑃𝑌/𝑃𝐻𝑃 = 𝐸𝑈𝑅/𝑃𝐻𝑃 = ?× 1 × 1 ?× 147.8500 × 1 𝑱𝑷𝒀/𝑷𝑯𝑷 = 𝟎. 𝟑𝟖𝟒𝟑 𝑬𝑼𝑹/𝑷𝑯𝑷 = 𝟔𝟎. 𝟓𝟒𝟕𝟕 FX rates from Bloomberg as of September 15, 2023  Cross Rate: Implied Offer/Bid Price Scenario: A currency trader is bullish on the CHF/JPY cross. What two FX deals will he transact versus the USD to create the desired cross position based on the following: Bid Offer USD/JPY 106.64 106.66 USD/CHF 0.9879 0.9881 What is the implied offer for CHF/JPY?  Cross Rate: Implied Offer/Bid Price 1. Given the market expectation, determine what will be the position/s. Are you going to long or short the currencies? Expectation: Bullish on the CHF/JPY (expecting price to go up) o Long CHF o Short JPY Why do opposite transactions? To align with the currency pairs provided in the table Transactions to enter versus USD o Buy CHF → Buy CHF/USD → Sell USD/CHF o Sell JPY → Sell JPY/USD → Buy USD/JPY  Cross Rate: Implied Offer/Bid Price 2. After determining the position, what price are you going to get – Bid or Offer? Sell USD/CHF o CP to sell → look at bid price → USD/CHF 0.9879 Buy USD/JPY o CP to buy → look at offer price → USD/JPY 106.66  Cross Rate: Implied Offer/Bid Price 3. Now, solve for the implied offer for CHF/JPY. LHS RHS ? JPY 1 CHF 0.9879 CHF 1 USD 1 USD 106.66 JPY 0.9879 106.66 106.66 𝐶𝐻𝐹/𝐽𝑃𝑌 = 0.9879 𝑪𝑯𝑭/𝑱𝑷𝒀 = 𝟏𝟎𝟕. 𝟗𝟔𝟔𝟒  References BAP-Ateneo Treasury Certification Program Brandl, M.W. (2021). Money, banking, financial markets & institutions (2nd ed.). Cengage Learning.