Among non-insiders of the movie industry, FX seems to mean "effects," specifically post-production "special effects," the creation of unreality in movies through computer graphics and altering sound through the work of Foley artists and others. In truth, SFX or F/X is a more accurate descriptor.

(An excerpt from my MSc dissertation)

The Foreign Exchange (FX) market is among the most liquid in the world, with a global turnover equivalent to US$1.6 trillion. The market, by its very nature, operates 24 hours per day, with London, New York and Tokyo the centers of activity. It is of crucial importance to the major commercial banks, accounting for approximately half their profits. Banks deal on behalf of their corporate customers, who require foreign currency in which to carry out commercial activity (typically import/export businesses, or business receiving cash flows from foreign investments or subsidiaries). Several factors are combining to increase the volume of trades. Exchange rate controls have been abandoned by major governments, meaning that institutional investors such as pension funds are free to move large amounts of capital in and out of countries, converting currencies as necessary. Investors move capital sums to take advantage of favorable interest rates, whether in actuality or speculatively. As business has globalized, corporations have begun to maintain sophisticated trading operations of their own. New capital adequacy laws and increased counterparty risk in a volatile market have raised barriers to entry, leaving half the market to only 10 banks. Cash, forward contracts and swaps in the FX markets can be combined in many different ways to create new products in response to the particular needs of a customer. All these factors mean that the FX market is particularly in need of automated solutions, to reduce the risk associated with each transaction, and to lower the cost of each transaction.

The FX market has a great deal of specialist terminology associated with it. The simplest form of FX deal is the “spot trade”. This is simply a contract between two counterparties to exchange a certain amount of one currency for a certain amount of another, at the prevailing exchange rate at the time the contract was entered into. The date on which the deal is actually agreed is called the “deal date”, but the day on which the currency is delivered is called the “value date”. Generally, the value date is two days after the deal date, but the matter is complicated by differing valid trading days in different countries, for example, a national holiday in one country will mean that the currency of that country cannot be delivered. In this case, the value date is the soonest trading day that is after the normal two-day delay. Spot markets are “over the counter” (OTC) which means that counterparties contact one another directly in order to trade. Since there are only two counterparties to each deal, and an exchange or regulator does not need to approve the deal before it is written OTCs are easily customized to a particular need. A “short date” refers to a delivery date that is earlier than spot. A trader is said to be “long” when having bought more of a particular currency than sold, and “short” when having sold more than has been bought. A balanced account (or “position”) is “squared”, and results in “realized” profit (or loss). Otherwise, the profit or loss of the position is “unrealized”, and its value is the difference between the average rate of the position, and the current market rate.

Typically, an exchange will be used to source liquidity, and a request for a quote can be broadcast to all connected counterparties in order to find an interested trader, requiring a common protocol between all traders. OTC markets permit arbitrary trades, unlike exchanges where the sizes of contracts are fixed. The exchange rate delivered by services such as Reuters is merely indicative; the price at which the deal is actually struck varies as the spread is factored in, which reflects supply and demand of a currency, and the credit rating of the counterparty. This is a function of both the risk of default and competition between market makers for the transaction. Currencies are generally quoted against the US dollar; for example, USD.CHF will give the prevailing rate for exchanging US dollars for Swiss Francs. When the dollar appears first, the is a “direct quote”, when it is second it is called an “indirect quote”, and when US dollars are not present in the currency pair, this is “cross currency”. The order is important, as the currency on the left hand side of the pair is the base currency of the transaction. A quote comprises two elements, a “bid”, which is the price at which the counterparty will buy the base currency, and an “offer”, the rate at which the counterparty will sell the base currency. The difference between bid and offer is the “spread”. A “market maker” provides the liquidity of the market by buying and selling currencies to counterparties, taking profit from the spread. On the opposite side of the transaction from the market maker is the “taker”, the party who requests the quote, and who sells currency at the market maker’s buying price. A “cross currency” trade is a special case, as there may be insufficient liquidity in the market to carry out the transaction directly, as counterparties prefer to base each deal in one of the major currencies, for example US dollars, Swiss Francs or Sterling. In this case, the cross rate will have been calculated from direct or indirect quotes between either side of the currency pair, and the US dollar, bid and offer respectively. The new quote has the left hand currency of the cross as the new base, with the right hand side expressing the price in the second currency for one unit of the first.

An “FX Swap” is different from an “Interest Rate Swap”, rather than an exchange of cash flows, it means to both buy and sell a pair of base currencies, or sell and buy, at spot and a forward rate, as part of a single deal. A swap may also be between forwards of different tenors. For example, buying Sterling at spot, and selling a forward on US Dollars in the same transaction. This can be done to hedge against risk, or it can be purely speculative, in which case it would probably have different amounts on the spot and forward legs of the deal. An “outright” is a single deal for a forward date, prices at spot plus or minus the spread for the tenor, also known as the “forward points” (or “the pips” or “the margin”). These forward points are a function of the interest rate differential between the two currencies over the period (tenor) of the forward. An “FX forward” is simply a contract to deliver a quantity of a currency at a time in the future.

The market maker calculates the forward points such that it is impossible to buy into a currency offering a higher interest rate than is currently held, wait a period of time, then convert back to the original currency and realize a profit without taking a risk of adverse currency movements (speculating). This is the mechanism by which the FX market is related to the interest rate offered by the central bank for each currency, and a route by which governments are able to affect the strength of national currencies. If there is a mismatch between the spot price, the forward rate and the interest rate, there is an opportunity for “arbitrage”, which means to borrow in one currency, swap for another and realize a profit from doing so, after the cost of covering the forward exchange risk is deducted. Capital adequacy rules mean that speculation is becoming increasingly popular, since derivatives are “off balance sheet”, and the closing of positions by entering into offsetting deals means that there is no need to take delivery of inventory.

References:

  • Introduction to Global Financial Markets, Stephen Valdez, Palgrave 2000

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