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FX Trading
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An exchange of one currency for another currency
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Dollars (USD) for Japanese Yen (JPY)
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Indirect Quote
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Currency rate 110.00
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1 USD = 110.00 JPY
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Direct Quote
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Currency rate .009091
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1 JPY = .009091 USD
Instruments used to offset risk
- Spot - buy now, pay now
- Forwards - buy now, pay later (up to 1 year). NDF (non-deliverable forwards)
- Swaps
- Options
- Alternatives
Forward Contracts
- Purchase or sale of one currency for another
- Delivery taking place on a specific future date or within a specific window
of time
- Unlike futures traded over-the-counter
- Any convertible currency
- Any maturity (typically less than a year)
- Any amount (typically with a $50,000 min)
Example
Price is based on: Current spot rate plus or minus a discount or premium for
interest rate differentials Example: One year forward sale of Japanese Yen:
Spot rate 117 Yen per US$ Interest rate differential 4.70% US interest rates
(1 yr.) 4.80% Japanese interest rates (1 yr.) 0.10% 1 Year Forward: 117 -
(117*4.70%=5.50) = 111.50
Options
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The right but not the obligation to convert one currency for another on a
specific future date.
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Difference between European and American Style is OTC and Exchange Traded
(flexibility)
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Any convertible currency
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Any strike price (typically +-5% of spot)
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Any maturity (typically below 1 year)
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Amount typically is a large amount
Example
Price is based on:
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current spot price
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strike price
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volatility factor
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The right to buy Japanese Yen at a specific rate one year out in the future.
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If the Yen weakens a conversion will be made in the open market
Options vs. Forwards
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Forward Contract
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Eliminates up and downside potential
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Good tool when company has firm commitments in the future
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Mark-to-market offset against A/R or A/P
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No initial cost
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10% risk assessment
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Option
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Eliminates "downside" but leaves "upside"
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Good tool for company involved in projects with uncertainty
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"Naked hedge" for commitments not yet recognized on the balance sheet
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1-5% premium up front a tough sale
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