foreign exchange and precious metals en

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Foreign exchange and precious metalsMarzia Pegorer and Thomas Hirt


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All rights reserved, including foreign-language translations. All parts of this document are protected by copyright. Any use in

cases other than those permitted by law requires prior written autorisation from Compendio Bildungsmedien AG.

Copyright 2009, Compendio Bildungsmedien AG, Zurich

Blended learning material co-developed by Compendio and Crealogix

Technical coaching: CYP, Center for Young Professionals in Banking

Licences for e-learning material available from Crealogix.

www.bankingtoday.ch

www.compendio.chwww.crealogix.comwww.cyp.chwww.swissbanking.org

Foreign exchange and precious metalsMarzia Pegorer and Thomas Hirt

Technical revision: Hans Fritschi and Christian LdiEnglish version: cb service s.a. (Lausanne)

Design and layout: Mediengestaltung, Compendio Bildungsmedien AG, ZurichIllustrations: Oliver Lde, WinterthurPrinting: Edubook AG, Merenschwand

Text and educational editing: Thomas Hirt

Article number: 6639Legal deposit: 1st edition 2009Edition: N0059Language: ENCode: CYP 011


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Module Foreign exchange and precious metalsTable of contents

3BankingToday 2.0

Table of contents

Introduction 4

1 Currencies, notes and foreign exchange 61.1 What is a currency? 6

1.2 The exchange rate 8

1.3 Convertibility 12

1.4 The foreign currency account 14

Exercises 16

2 Foreign exchange trading 20

2.1 How is foreign exchange traded? 20

2.2 The role of banks in foreign exchange trading 25

2.3 How is foreign exchange trading used? 26

2.4 Types of transactions in foreign exchange trading 27

Exercises 39

3 Precious metals and coins 42

3.1 Gold and other precious metals 42

3.2 Gold trading 43

3.3 Gold investments 45

3.4 Opportunities and risks of gold 50

Exercises 52

Answers 55

Index 60


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Module Foreign exchange and precious metalsIntroduction

BankingToday 2.0

Introduction

Foreign exchange in particular (and banknotes to a much lesser extent) is of central impor-

tance in international trade.

People and companies in Switzerland regularly require foreign currency. Individuals need

to make payments in euros, for example, if they travel to Spain on holiday, or in US dollars

if they buy products from America on the Internet. Companies that import goods from

abroad also need to pay for their orders using the appropriate foreign currency.

Conversely, people from other countries require Swiss francs if they visit Switzerland as

tourists. Without Swiss francs (for them a foreign currency), they would not be able to

enjoy Switzerlands popular fondue or buy its world-famous chocolate. Foreign compa-

nies require Swiss currency if they purchase goods from Switzerland and are presented

with invoices in Swiss francs.

Whether we are dealing with foreign exchange or notes, in both cases we talk of foreign cur-

rencies. But how and where are these traded? How is the price at which you can obtain a for-

eign currency decided?

In addition to foreign currencies, this module will also examine precious metals. These are

popular (especially gold) and expensive. How and where are these precious metals traded?

What is understood by numismatics? What is a Vreneli coin?

At this point, have a look at the e-lesson entitled Introduction.

This e-lesson provides insight into the difficult conditions that apply to gold mining and dis-

cusses trends in gold prices in connection with economic and political events.

The second part deals with foreign currency trading, which nowadays is carried out on a huge

scale. You will be given a brief overview of the historical development of this market in this e-

lesson.

Length: approx. 20 minutes


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Module Foreign exchange and precious metalsIntroduction

5BankingToday 2.0

What you will learn in this module

This module is structured as follows:

Chapter 1 Currencies, notes and foreign exchange defines the terms currency,

notes and foreign exchange and explains how these are quoted. It also outlines how ex-change rates are determined and what factors have an influence. In addition, the chapter

deals with foreign currency accounts and how interest is paid on these.

Chapter 2 Foreign exchange trading is devoted to foreign exchange trading and

what transactions are involved.

Chapter 3 Precious metals and coins explains how precious metals are traded and

what opportunities are available with regard to investment and safekeeping. It also iden-

tifies the opportunities and risks associated with investing in gold.

Useful study material

To complement this lesson, the following e-media material is also available:

Introduction

This e-lesson provides insight into the difficult conditions that apply to gold mining and dis-

cusses trends in gold prices in connection with economic and political events. The second part

deals with foreign currency trading, which nowadays is carried out on a huge scale. You will be

given a brief overview of the historical development of this market in this e-lesson.

E-lesson: Foreign currency transactions

Modern foreign exchange trading is essential to the functioning of the international economy.

Discover factors that determine rates; how foreign currency transactions are carried out; and the

various types of transactions involved in professional trading.

Simulation: FOREX trading

Put yourself in the shoes of a foreign exchange trader: assess the factors and events that influ-

ence exchange rates and choose the optimum type of transaction.

E-lesson: Precious metals and coins

Discover which precious metals are most widely traded, and locate areas where they are mined

on an interactive map of the world. Learn about gold trading and the various types of invest-

ments in this metal. This e-lesson concludes with a foray into the world of numismatics.

Self Check

At this point, test your knowledge by doing the Self Check. Have you learned everything you

need to know?


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Module Foreign exchange and precious metals1 Currencies, notes and foreign exchange

BankingToday 2.0

1 Currencies, notes and foreign exchange

1.1 What is a currency?

If you want to pay for goods or services abroad, you need the money of the country in ques-

tion. Every country has a currency, which serves as the official means of payment. In Switzer-

land this is the Swiss franc (CHF), in the USA the US dollar (USD), in the United Kingdom the

British pound (GBP) and in many European countries the euro (EUR). Currencies are subdi-

vided into smaller units. The Swiss franc, for example, is divided into 100 centimes. The gov-

ernment decides how the currency is denominated. It has a coin and note-issuing privi-

lege. The Swiss National Bank (SNB), a joint-stock company under state mandate, is respon-sible for issuing of banknotes. It controls the amount of notes in circulation and the amount

of deposit money.

In the case of the euro, it is not an individual state that takes these decisions but the European

Monetary Union (EMU). In 1999 eleven states formed the EMU. The euro was initially intro-

duced as deposit money and as of 1 January 2002 has replaced the currencies of the individ-

ual states as a cash currency. It is now the official national currency in 21 countries. New

states are joining the EMU on a more or less annual basis.

To enable global trade to function, uniform and standardised currency designations are

needed. The ISO code is used for this purpose. ISO stands for International Organization for

Standardization.

Learning goals: After studying this chapter, you will be able to:

explain the terms currency, foreign exchange and notes. describe how currencies are quoted. name the main factors that influence exchange rates and use examples to describe how

changes in these factors affect the exchange rate.

explain what a foreign currency account is, on what foreign currency accounts interest is paid

and what is understood by premium and discount.

Key concepts: ask rate, base currency, bid rate, bureau de change service, coin and note-issuing

privilege, convertibility, currency, direct quotation, discount, economic conditions, EMU, exchange

rate, foreign currency account, foreign exchange, indirect quotation, interest rate level, monetary

policy, notes, political conditions, premium, speculation


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Figure 1 Important currencies with their symbol and ISO abbreviation

1.1.1 What are notes and foreign exchange?

In the case of foreign currencies we talk about notes and foreign exchange. The exchange of

money from ones own currency into a foreign currency, or vice versa, is referred to as ban-

knote and foreign exchange trading.

Notes are .cash (banknotes and coins).

Foreign exchange refers to claims on payments in foreign currencies. Claims on pay-

ments are funds that do not physically exist. The amounts owed are recorded on paper or

electronically (e.g. cheques, credit card payments, account entries, etc.). The term de-

posit money is also used.

Figure 2 Currency

Comment Banknote trading. For the purposes of international travel banks offer travellers a bureau de

change currency exchange service. As a rule, banks only trade in banknotes and do not accept for-

eign coins. Currencies that are uncommon need to be ordered in advance, provided that they are

freely tradable (see section 1.3, p. 12).

Example Peters father has returned from a business trip to Japan with a few 5,000-yen banknotes as a souvenir

for his son. Peter is delighted, especially when his father tells him that they are worth roughly 50 Swiss

francs. Peter has been saving up for some time to buy a new hi-fi system and this money is just what

he needed. The next day he heads straight to the bureau de change counter at a bank. The bank buys

the Japanese notes from Peter and pays him the equivalent value in Swiss francs.

Country Symbol ISO code Currency

Switzerland SFr. CHF 1 franc = 100 centimes

Eurozone EUR 1 euro = 100 cents

United Kingdom GBP 1 pound = 100 pence

Sweden SEK SEK 1 krona = 100 re

Japan JPY 1 yen = 100 sen

USA US$ USD 1 dollar = 100 cents

Canada kan$ CAD 1 dollar = 100 cents

Australia austr$ AUD 1 dollar = 100 cents

Foreign currencies

Notes(cash: banknotes and coins)

Foreign exchange(claims on payments)


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1.2 The exchange rate

Banks exchange currencies at the exchange rate. This expresses the price of one currency

in another currency. The rate tells us how much of a certain currency we will have to pay to

receive a certain unit of the other currency, or how much we will receive of a currency if we

sell a certain unit of the other. For example: how many CHF will we have to pay to receive a

certain unit of USD, or how many CHF will we receive if we sell a certain unit of USD?

Example

1.2.1 Exchange rate quotation

Bid rate and ask rate

The exchange rates used for trading on the foreign exchange and banknote markets are pub-

lished daily in exchange rate lists. The rates are presented from the banks perspective, with

a distinction being made between the bid and ask rate.

The bid rate is the purchase price at which the bank buys the foreign currency.

The ask rate (or offered rate) is the selling price at which the bank sells the foreign

currency.

Example Figure 3 Foreign exchange and banknote rates (in the financial press, 25th Nov 2008)

Spread

The ask rate is always higher than the bid rate. The difference between the ask and bid rate is

what the bank earns. It uses this to cover its expenses. This difference is referred to as the

spread.

The exchange rate

USD/CHF 1.1725 means: USD 1 has a value of CHF 1.1725

Foreign exchange Banknotes

1 EUR

1 GBP

1 USD

100 JPY

100 DKR

100 SEK

Bid

1.5173

1.8136

1.2020

1.2315

20.3497

14.4491

Ask

1.5565

1.8535

1.2330

1.2650

20.8770

14.8569

1 EUR

1 GBP

1 USD

100 JPY

100 DKR

100 SEK

Bid

1.5100

1.7400

1.1725

1.2250

19.80

13.85

Ask

1.5700

1.9000

1.2625

1.3250

21.55

15.50

The USD/CHFbanknote rate isstated at a bid rateof 1.1725 and anask rate of 1.2625.This means thatthe bank...

buys USD forCHF 1.1725(bid)

sells USD forCHF 1.2625(ask)


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Figure 5 Exchange rate quotation and base currency

As shown in figure 5, there are always two possible ways to quote the exchange rate for a

currency pair. Depending on the base currency, we talk of direct or indirect quotation. Both

are commonly used in practice.

Direct quotation: base currency is the foreign currency

Indirect quotation: base currency is the local currency

Figure 6 Direct and indirect quotation

Please note that the quotation depends on how you look at it. A direct quotation in Switzer-

land is seen as an indirect quotation from the country of the foreign currency.

Example In Switzerland

Direct quotation: Markus is travelling to the USA and needs US dollars. He goes to the bank andasks for the USD/CHF rate. The client advisor gives Markus the rate 1.2625. In accordance with

common practice in Switzerland, this is a direct quotation. This means that for USD 1 Markus

has to pay CHF 1.2625.

Indirect quotation: Markus would like to know how many US dollars he will receive for a Swissfranc. The advisor converts the rate to an indirect quotation and gives him the rate 0.7920. This

means that for CHF 1 Markus receives USD 0.7920. This rate is an indirect quotation.In the USA

Markus has been in the USA for a few days and would like to exchange Swiss banknotes for USD.

He goes to the bank. In accordance with common practice in the USA, the client advisor gives

him the rate as a direct quotation. This is 0.7920. This means that for CHF 1 Markus receives

USD 0.7920. This rate is a direct quotation in the USA.

Markus would like to know how many CHF he will need to pay to receive a certain amount ofUSD. The converted rate is 1.2625. To receive USD 1, Markus must pay CHF 1.2625.This rate

is an indirect quotation in the USA.

Comment In international foreign exchange trading the USD is always the base currency. This means that all cur-

rencies are related to USD 1 (exceptions are: GBP, EUR, AUD and NZD; see chapter 2, p. 20).

Exchange rate

quotation

JPY / CHF 1.3250

CHF / JPY 75.47

1.3250

75.47

JPY

CHF

CHF

JPY

1st positionBase currency

2nd positionCurrency being

used to buy base

currency

3rd positionRate = price for

a unit of the

base currency

JPY 100correspond to

CHF 1.3250

CHF 1correspondsto JPY 75.47

Indirect quotationLocal currency is base currency

Direct quotationForeign currency is base currency

Direct quotation indicates how much of thelocal currency you will have to pay for a unitof the foreign currency.

Common in, for example:

USA

Switzerland

Sweden

Japan

Indirect quotation indicates how much of theforeign currency you will have to pay for aunit of the local currency.

Common in, for example:

Countries with EUR as their currency

United Kingdom

Australia

New Zealand

Foreign currency / local currency Local currency / foreign currency


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1.2.2 How are exchange rates influenced?

Intensive foreign exchange trading creates a risk of exchange rate fluctuations. This currency

risk can result in gains or losses.

Example Ms Klin has ordered books from an American online shop. She settles the invoice for USD 280.70

using her credit card. On the day she placed the order the USD/CHF rate was 1.1510. The USD invoice

therefore corresponded to a value of CHF 323.10. Later, when Ms Klin receives her credit card state-

ment, she notices that the rate on the day the amount was debited was higher than on the day she

placed the order. The bank has debited her account with CHF 337.40, which corresponds to a rate of

approximately 1.2020.

Comment In the example a small amount is involved. However, if companies are working with large sums on a

daily basis, they are exposed to much greater risk. To eliminate this risk and simplify trade in Europe,

the euro was introduced.

Why is it that exchange rates vary so greatly? Just like all other prices, the rate of a currency

depends on supply and demand. If a currency is very much in demand, its value increases.

Conversely, the price of a currency falls if there is an excess supply of it. The following rules

therefore apply:

If there is an excess supply of a currency, rates (prices) go down.

If there is excess demand for a currency, rates (prices) go up.

Whether supply and demand are at a high or low level depends on numerous factors. The

main ones are shown in the figure below:

Figure 7 Factors that determine rates

Political conditions

Changes in political conditions can have a positive or negative influence on the confidence acountry inspires. This can lead to changes in the flows of funds between countries which

influence the exchange rate.

Example A countrys government changes. During the election campaign the party that has now beenelected was calling for redistribution measures to help less well-off members of society. Now,

however, many affluent citizens and investors are taking a rather negative view of these develop-

ments. They try to invest their assets abroad, as they are afraid, for example, that higher taxes will

be introduced. This results in an excess supply of the local currency supply increases and the

price of this currency falls.

Conditions in a country have been stable for some time. The government is pursuing a policy thatis attractive to foreign investors. More money is being invested in the country. This means that

the local currency has to be bought. Demand increases along with the price.

Exchange rate

Interest rate level

Economic conditions

Political conditions

Speculation

Monetary-policy measures


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Economic conditions

National economies are interlinked in many ways. International business relations therefore

have a substantial influence on the value of a currency.

Example A country imports many more goods than it exports and therefore has an imbalance in its balanceof payments. Due to this import surplus, the number of foreign invoices the country has to pay is

greater than the number it can issue itself. To pay these invoices it has to exchange a great deal

of local currency for foreign currency. Demand for foreign currencies increases, and therefore

prices rise. There is an excess supply of the local currency, so its value falls.

A country has a very high rate of inflation. The value of domestic currency is falling constantly.For the same amount of money citizens are able to purchase fewer and fewer goods. For this rea-

son they invest their money in strong foreign currencies. This increases the demand for foreign

currencies and the local currency loses value.

Monetary-policy measures

A countrys central bank can influence the value of its currency.

Example The central bank uses the national currency to buy foreign currencies. As a result of this intervention,

demand for foreign currencies increases and their price rises. The value of the local currency, on the

other hand, goes down and domestic products can be purchased more cheaply abroad. The country

becomes attractive to tourists, as with their strong currency they can afford more in the country

concerned.

Interest rate level

Higher interest rates abroad can encourage many savers to invest their money in foreigncountries. This increases demand for foreign currencies and their prices rise. On the other

hand, there is an excess supply of the local currency and its price drops. The same also applies

to the reverse situation, of course, where domestic interest rates are higher than those

abroad.

Speculation

Traders can play an important role in the development of currencies. They buy and sell foreign

currencies on the basis of their market expectations. In this way they try to make large gains

quickly, and their transactions influence supply and demand.

1.3 Convertibility

If a currency can be exchanged for another currency without restriction, it is fully convert-

ible. Nowadays, most of the currencies of industrial nations are fully convertible, i.e. freely

tradable.

In certain countries, on the other hand, restrictions apply to the possession, use and/or the

import and export of foreign exchange and notes. The purpose of these legal controls is gen-

erally to protect the economy of a country with an unstable currency against strong foreign

currencies.


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Example A country has an unstable and weak currency. To ensure that the currency does not become even

weaker, the state imposes restrictions on the import and export of the local currency. This means that

travellers can only take a limited amount of cash with them and that business people and investors

can only use the local currency to a limited extent for foreign transactions. Further weakening could

arise if people were to invest their assets in stable currencies. For this reason, the state instructs thecentral bank to control all foreign currency transactions.

Foreign exchange transactions are controlled to varying degrees. These controls are divided

into three groups, referred to as the three levels of convertibility.

Figure 8 Convertibility

Example Full convertibility in the eurozone: Mr Notter spends a great deal of time in France, both pri-

vately and on business. His transactions with France run to millions of euros. He can cover theseamounts at any time by exchanging Swiss francs for euros without restriction. If Mr Notter travels

to France on holiday, it is up to him how many euros he wants to take with him and how many

euros he wants to bring back to Switzerland. However, he is obliged to declare amounts of EUR

10,000 or more at customs (declare means pay duty on).

Limited convertibility of the Thai baht: Ms Albers is planning a trip to Thailand. She finds outat her bank about the conditions that apply to importing foreign currency. Tourists are permitted

to take a maximum of 2,000 baht into the country and take out a maximum of 50,000 baht. Fo-

reign currencies can be imported without restriction, but amounts valuing USD 10,000 or more

have to be declared. When you leave the country, the amount of foreign currencies you take with

you may not exceed the amount declared.

Non-convertibility of the Cuban peso: Mr Zehnder has to travel to Cuba on business. Impor-ting and exporting the Cuban peso is prohibited. This means that the Cuban peso cannot be ob-

tained at all abroad. In Cuba, tourists are not allowed to pay with USD, but must buy the conver-

tible peso, which is on par with the US dollar. The convertible peso is intended for tourists andthe Cuban peso is used by the local population. When he arrives in the country, Mr Zehnder must

declare any foreign currencies worth USD 5,000 or more at customs. When he leaves, he may

only export the amount he imported, less the amounts he has exchanged. Mr Zehnder may only

exchange the convertible peso back in Cuba. To do this must present the receipts for his ex-

change transactions.

1st level

The currencies are

fully convertible

There are no restrictions. The currency can be freely exchanged in all

cases.

Examples: CHF, EUR, USD

2

nd

levelThe currencies are

convertible to a

limited extent

Typical restrictions are: cash may only be imported or exported up to a certain amount, or

only foreigners may trade foreign exchange freely, or a different exchange rate applies to commercial transactions than to

speculative financial transactions

Examples: Indonesian rupiah, Thai baht

3rdlevel

The currencies are

not convertible

All foreign exchange and note transactions with foreign countries are

controlled.

Examples:Cuban peso and currencies of several developing countries.


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1.4 The foreign currency account

So that business people do not have to keep their foreign currency assets abroad, in a safe or

under the mattress, banks offer their clients current accounts in foreign currencies (e.g.

an EUR account, a USD account).

Clients can make deposits into/withdrawals from their foreign currency account and can

use it to make payments. However, interest is not generally paid on these accounts. Euro

accounts are an exception these usually do pay interest.

Deposits and withdrawals of banknotes into/from foreign currency accounts lead to costs for

the bank.

For transactions in the currency of the foreign currency account the bank a discount or pre-

mium to cover its costs. Premiums and discounts are indicated in percent.

If the bank accepts notes from a client for payment into a foreign currency account with

the same currency, it charges a discount. If a client asks for cash to be paid out of a foreign currency account in the same currency,

the bank charges a premium.

Example Discount: Ms Huber has GBP 3,000 that she does not wish to change into CHF. She will soon be

travelling to England again and, whats more, she expects the GBP/CHF rate to go down. She opens

a GBP account at her bank and pays her pounds into it. In accordance with applicable conditions, the

bank charges a discount of 1 % and credits the amount of GBP 2,970.

Premium: Mr Walser would like to withdraw EUR 25,000 from his euro account. The bank charges a

premium of 1%. Mr Walser withdraws EUR 25,000, but EUR 25,250 is debited from his account.

If, on the other hand, notes in a currency that differs from that of the foreign currency

account are accepted or issued, the bank does not charge any premiums or discounts. It cov-

ers its costs from the banknote rate spread.

Currency

A currency is a countrys official means of payment.

Notes are cash (banknotes and coins).

Foreign exchange refers to claims on payments in foreign currencies that are payable

abroad.

Exchange rate quotation

Exchange rates are always quoted from the banks perspective:

Bid = buy / ask = sell

The difference between the bid and ask rate is known as the spread. This is what the

bank earns.

From the clients perspective, bid and ask rates for notes are generally worse than those

for foreign exchange. This is due to the costs of transport and insurance, the risk of coun-

terfeit money, etc.


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Direct and indirect quotation

Direct quotation indicates the price of a unit of the foreign currency in the local curren-

cy: the base currency is the foreign currency (example of Switzerland: USD/CHF). Di-

rect quotation is used in Switzerland, Sweden and Japan, for example. Indirect quotation indicates the price of a unit of the local currency in the foreign cur-

rency: the base currency is the local currency (example of the United Kingdom:

GBP/CHF). This indirect quotation is used in the United Kingdom, the euro countries, Aus-

tralia and New Zealand.

Exchange rate

Variations in exchange rates occur because of factors such as: political conditions, eco-

nomic conditions, monetary-policy measures, interest rate level, speculation.

Convertibility

There are three different levels of convertibility:

Fully convertible currencies: No restrictions apply. Examples: CHF, EUR, USD.

Currencies with limited convertibility: Upwards of a certain amount, notes and for-

eign exchange can only be traded subject to controls. Examples: Indonesian rupiah, Thai

baht.

Non-convertible currencies: All foreign exchange and note transactions with other

countries are controlled. Examples: Cuban peso and currencies of several developing

countries.

Foreign currency accounts

Interest is not generally paid on foreign currency accounts (except for euro accounts).

Banks charge a premium when funds are withdrawn from an account in the same cur-

rency.

Banks charge a discount when funds are deposited in an account in the same currency.


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Exercises

Task 1 A] Ms Sommer would like to visit her daughter in Denmark. Besides travellers cheques and hercredit card she also wishes to take some cash with her on her trip. She goes to the bank to

exchange 300 Swiss francs at the exchange rate found in the table below. Calculate how many

Danish kroner Ms Sommer will receive for this.

Note down the exchange rate used and the calculation. Round off to the nearest tenth of a

krone. Do not take into account any commission charged by the bank.

B] It is Pauls birthday and his uncle has come to visit from England. As Paul has been saving

up for a moped for some time, his uncle gives him 100 British pounds in cash. Paul is over the

moon and the next day goes straight to the bank. He would like to exchange the money for

Swiss francs and deposit it into his savings account.

Calculate the amount in Swiss francs that Paul receives for his 100 British pounds. The

exchange rate can be found in the table above. You do not need to take any commission

charged by the bank into account.

Note down the exchange rate used and the calculation.

Foreign exchange and banknote rates as at 25.11.2008

Foreign exchange Banknotes

Bid Ask Bid Ask

1 EUR 1.5173 1.5565 1 EUR 1.5100 1.5700

1 GBP 1.8136 1.8535 1 GBP 1.7400 1.9000

1 USD 1.2020 1.2330 1 USD 1.1725 1.2625

100 JPY 1.2315 1.2650 100 JPY 1.2250 1.3250

100 DKR 20.3497 20.8770 100 DKR 19.80 21.55

100 SEK 14.4491 14.8569 100 SEK 13.85 15.50


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Task 2 A] Explain the meaning of the following terms using key concepts.

Currency:

Notes:

Foreign exchange:

B] Exchange rates can be quoted in different ways.

Please show how banknote rates can be quoted, using an example in each case.

State the official term for this form of quotation.

Explain the terms bid rate and ask rate.

Example 1 Switzerland

Form of quotation:

Example 2 United Kingdom

Form of quotation:

Bid rate:

Ask rate:

C] Exchange rates change as a result of supply and demand. Supply and demand are in turn

influenced by a number of factors. Write the number of the corresponding factor next to each

example and explain its impact on the currency of the country concerned.

1 2 3 4 5

Political

conditions

Economic

conditions

Monetary-policy

measures

Interest rate level Speculation

Example Factor

number

Effect

The central bank buys large amounts of the local currency

and sells foreign currencies.

Exports are very high in a country and consequently the

local currency is in high demand abroad.

Parliamentary elections are imminent in a country. Citizens

have lost confidence in the government and its policy and

are transferring their assets abroad.

Swiss foreign exchange traders are buying British pounds in

large quantities with Swiss francs. They expect the rate to

rise.

Clara has invested her assets abroad. Like many of her fel-

low citizens, she is taking advantage of the better condi-

tions on offer abroad.


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Task 3 If a currency can be exchanged for another, it is convertible. There are three levels of convert-

ibility.

List the official term for each level and explain what it means in your own words.

For each expression provide an example of a currency to which it applies.

1.

Explanation:

Example of currency:

2.

Explanation:


3.

Explanation:


Task 4 A] Ms Graf regularly trades with the USA. She has had a foreign currency account in US dollars

with her bank for some time. She occasionally also uses this account to make cash deposits or

cash withdrawals. Today, for example, she wishes to deposit USD 5,000 in cash.Please indicate whether the bank will charge a discount (1%) or a premium (1%) for this

transaction and how many USD will be credited to the foreign currency account.

B] Mr Cremer has a foreign currency account in euros. He would like to withdraw EUR 10,000

in cash for a cash purchase.

Please indicate whether the bank will charge a discount (1%) or a premium (1%) for this

transaction. Calculate how many euros will be debited from the account and how many euros

will be paid out in cash to Mr Cremer.


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Task 5 Mr Ganz visits your bank and would like to open a foreign currency account in euros. He asks

you about the conditions that apply to this account. Explain how you would advise Mr Ganz,

using short sentences.


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Module Foreign exchange and precious metals2 Foreign exchange trading

BankingToday 2.0

2 Foreign exchange trading

Unlike day-to-day banknote trading, foreign exchange trading transactions involve amounts

running into millions. When you are dealing with sums as large as this, the slightest fluctua-

tions in the exchange rate can mean the difference between substantial gains or significant

losses.

Large sums are traded on the foreign exchange markets. Here, various investors, such as

trading companies, individuals, banks and brokers interact. On these markets, they can

exchange their foreign exchange quickly and easily, manage their assets using various forms

of investment and also conclude speculative transactions.

At this point, take a look at the e-lesson entitled: currency transactions

Modern currency trading is essential to the functioning of the international economy. Discover

factors that determine rates, how foreign currency transactions are carried out, and the various

types of transactions involved in professional trading.

Length: approx. 10 minutes

2.1 How is foreign exchange traded?

Professional foreign exchange trading by banks is predominantly carried out by telephone or

using an electronic trading system such as Reuters or Bloomberg.

In this context we also talk about over-the-counter (OTC) trading. OTC transactions are not

standardised, but negotiated individually. The OTC foreign exchange market is not tied to par-

ticular trading times. Trading takes place worldwide around the clock.

What does a foreign exchange trader do?

Foreign exchange trading is extremely hectic. Exchange rates change in a matter of seconds.

In order to make gains or avoid losses, traders must always have access to the latest interna-

tional information from the fields of economics and politics and at the same time act with a

great deal of speed and accuracy.

Learning goals: After studying this chapter, you will be able to:

explain how foreign exchange trading takes place. explain how cross rates are calculated. describe various types of foreign exchange transactions.

Key concepts: arbitrage, call, cross rate, currency carry trade, derivatives, direct quotation, dis-

count, forward, forward outright, hedge, intraday transaction, limit order, long, over-the-counter

(OTC), overnight, premium, put, self-contracting party, short, spot, strike price, swap, tom/next


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In the following example, we will look at how two traders execute a foreign exchange trans-

action:

Situation: Nick works as a foreign exchange trader for XX Bank, and Daniel for ZZ Bank. They

have the following telephone conversation.

Conversation Explanation Trading practice

Daniel calls:

Hello Nick! This is

Daniel from ZZ Bank.

Id like to know the

USD/CHF rate

Daniel asks Nick for the USD/CHF rate. He does not yet say

whether he wants to buy or sell USD. If he did, Nick would

be able to state a price that would be advantageous for him-

self.

In principle, the amount to be traded is not mentioned either;

at most an idea is given of the volume involved. The higher

this is, the better the price should be.

There is no official unit of

trading.

The precise amount to be trad-ed is only mentioned once the

rate has been set.

The volume is stated for small

(< 1 million) or large

(> 5 million) amounts.

Nick answers:

Hello Daniel!..

USD/CHF is 18 (to)

23.

Nick looks at his screen and sees that the rate is around

1.2020. He then looks at his USD position and decides

whether he would prefer to buy or sell USD.

If he wants to buy, he sets the bid/ask rate slightly high-er than the current market rate.

If he wants to sell, he sets the bid/ask rate slightly lower.

Nicks decision: USD/CHF 1.2018/1.2023

During the conversation he mentions only the last twodigits, the so-calledpips, i.e. 18/23.

He assumes that the so-called big figures (1.20.) are al-ready known. The big figures are only mentioned in the

event of substantial and rapid fluctuations.

The trader who has beencalled sets a bid/askrate at

which he is prepared to trade.

He only mentions thepips.The big figures are only stated

in special situations.


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2.1.1 How is foreign exchange quoted?

Foreign exchange is traded around the clock, irrespective of national borders and national cur-

rencies. To standardise trading worldwide, trading practices (commercial customs) have been

agreed on. These include the rules of trading mentioned above and the same forms of quota-

tion.

Worldwide quotation in relation to the US dollar

In professional foreign exchange trading the USD is the base currency. This means that world-

wide, the value of any currency is related to the USD.

You therefore need to know how much of a certain currency you will have to pay to receive

a unit of USD.

Exceptions

As in the case of banknote trading, different rules also apply to the British pound, the Austral-ian and New Zealand dollars and the euro in professional foreign exchange trading.

If the USD is traded against the GBP, for example, the USD is not the base currency, but in

this case is the price. You therefore want to know how many USD you will have to pay to

receive a unit of GBP.

Daniels response:

Ill sell USD 2 million

for CHF at 1.2018.

Daniel agrees to Nicks price and sells USD 2 million at a rate

of 1.2018.

The rate set is binding. Both parties must adhere to this

price. However, this only applies to this particular conver-

sation. If Daniel hesitates, Nick may withdraw the rate and

set a new one. If the conversation ends without a deal being

reached, a new rate must be requested when the next call is

made.

Once a rate has been set it is

binding, but it must be ac-

cepted immediately or it will

lose its binding force. Non-binding rate enquiries

must be clearly signalled as

such (e.g. for information on-

ly, I estimate).

Nicks response:

Ill buy USD 2 million

for CHF at 1.2018.

Please transfer the USD

to XX Bank in New

York.

Nick confirms the transaction and specifies where he wishes

to receive the USD.

The recipient of the currencyconcerned determines where

he or she would like the for-

eign exchange to be delivered.

Daniels response:Please transfer the

CHF to the SNB in

favour of ZZ Bank.

Daniel specifies where he wishes to receive the CHF.Settlement:

With a value date of 2 bank working days. Both banks are responsible for ensuring the transfer is

made punctually.

The party delivering each cur-rency is responsible for ensur-ing the transfer is made punc-

tually and bears all the associ-

ated charges.

Conversation Explanation Trading practice


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Figure 9 Overview of worldwide quotation

Example Nick would like to sell GBP for USD. He calls a broker in London and, at the same time, uses the Reu-

ters electronic trading system to contact a bank in New York. Both parties give him the price in the

form GBP/USD (GBP 1 = USD x), irrespective of which currency is the foreign currency in their partic-

ular case. Nick will accept the best price and sell his GBP.

2.1.2 What are cross rates?

In foreign exchange trading, transactions are often executed in which currencies are

exchanged directly without first converting them into USD. In this case the currencies are

related directly to each other and we talk of cross rates.

Comment In the case of the bureau de change service at a bank the situation is different. Cross rates are not

used here. If a client in Switzerland wishes to buy British pounds with euros, the bank employee has

to make the following bookings: first of all she buys the euros and sells Swiss francs in return. She

then buys these Swiss francs back and sells British pounds to the client.

On the following pages you will find out how foreign exchange traders calculate cross rates.

To make the calculation easier to understand, we will leave bid and ask rates out of the equa-tion in this section. The following statements and calculations always refer to the average rate.

The table below contains a number of cross rates. Each of these can be presented in two dif-

ferent ways. Here it is important to identify which currency is the base currency. Lets look at

the example of the GBP/CHF rate more closely. The base currency is the one in the left-hand

column in each case.

1. If CHF is the base currency (CHF/GBP), the rate is 0.5484.

This means that CHF 1 = GBP 0.5484.

2. If GBP is the base currency (GBP/CHF), the rate is 1.8234.

This means that GBP 1 = CHF 1.8234.

Figure 10 Cross rates

In principle: direct quotation Exceptions: indirect quotation

USD/CHF

USD/JPYUSD/SEK

1.2020

97.0657.9477

1 USD = 1.2020 CHF

1 USD = 97.065 JPY1 USD = 7.9477 SEK

GBP/USD 1.5170

AUD/USD 0.6529NZD/USD 0.5476

EUR/USD 1.2925

1 GBP = 1.5170 USD

1 AUD = 0.6529 USD1 NZD = 0.5476 USD

1 EUR = 1.2925 USD

Overview of cross rates (average rates)

Base currency

USD

EUR

CHF

GBP

USD

0

1.2925

0.8319

1.5170

EUR

0.7737

0

0.6437

1.1737

CHF

1.2020

1.5536

0

1.8234

GBP

0.6592

0.8520

0.5484

0

CHF 1corresponds to

GBP 0.5484

GBP 1corresponds to

CHF 1.8234


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The calculation of cross rates in more detail

In Fig. 10 the cross rates had already been calculated. But how are these rates determined?

The calculation is performed as follows:

You need to know the USD rates for the individual currencies.

You need to know whether direct or indirect quotation applies and what this means.

From this information it is possible to derive the applicable mathematical formulae. The fol-

lowing examples show how cross rates are calculated in foreign exchange trading.

Example Cross rates in the case of direct quotation. A person wishes to exchange Canadian dollars (CAD) for

CHF. The following rates apply: USD/CHF 1.2020 and USD/CAD 1.2295. How are the cross rates cal-

culated?

Figure 11 Calculation of cross rates in the case of direct quotation

Example Cross rates in the case of indirect quotation. A person wishes to use euros to buy British pounds.

The following rates apply: EUR/USD 1.2925 and GBP/USD 1.5170. How are the cross rates calcu-

lated?

Figure 12 Calculation of cross rates in the case of indirect quotation

Example Cross rates in the case of a mix of indirect and direct quotation. A person wishes to use Swiss

francs to buy British pounds. The following rates apply: USD/CHF 1.2020 and GBP/USD 1.5170. How

are the cross rates calculated?

Figure 13 Calculation of cross rates in the case of mixed quotation

CHF/CAD = USD/CAD : USD/CHF = 1.2295 : 1.2020 = 1.0229

or

CAD/CHF = USD/CHF : USD/CAD = 1.2020 : 1.2295 = 0.9776

EUR/GBP = EUR/USD : GBP/USD = 1.2925 : 1.5170= 0.8520or

GBP/EUR = GBP/USD : EUR/USD = 1.5170 : 1.2925 = 1.1737

GBP/CHF = USD/CHF GBP/USD = 1.2020 1.5170= 1.8234

CHF/GBP = 1 : GBP/CHF = 1 : 1.8234 = 0.5484


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2.2 The role of banks in foreign exchange trading

With a little luck and skill it is possible to make substantial gains in foreign exchange trading.

For this reason, foreign exchange trading is not only used for commercial purposes. Many

speculators invest millions on the foreign exchange market every day. Banks too not only

trade on the basis of the orders they receive from their clients. In order to manage their own

foreign currency holdings, banks need to participate in the market for their own account.

2.2.1 Trading for clients

The foreign exchange department of a bank manages the exchange of one currency for

another for its corporate and retail clients. The client pays neither charges nor commission as

the built-in margin covers the banks expenses and allows a certain profit to be made. The

bank takes advantage of supply and demand trends to achieve the highest possible exchange

gains.

Example Mr Mller has received the sum of GBP 2 million from a business partner. As his company will not

need these GBP in the near future, he would like to exchange them for CHF at his bank. The GBP/CHF

rate is currently 1.8234. Mr Mller calls his foreign exchange trader and asks for a binding price for

GBP/CHF. Naturally, he does not mention that he wants to sell the GBP. The trader gives him the fol-

lowing bid/ask rates: 32/39. Mr Mller agrees and says: Ill sell GBP 2 million. or GBP 2 million to

you. This means that the deal has been concluded in a legally valid manner. The trader confirms the

transaction by repeating the details from his perspective: Ill buy GBP 2 million from you and sell CHF

to you at a rate of 1.8232. The deal is recorded in writing on a foreign exchange settlement note.

Figure 14 Foreign exchange settlement note

XYZ Bank8000 Zurich

ConfirmationSpot exchange deal

As per deal date of 25 Nov. 2008

We will buy We will sell

Account holder:

Account to be debited:

XYZ Bank, ZurichCurrent account 123-4567

Account to be credited:

XYZ Bank, ZurichCurrent account 126-4988

GBP 2,000,000

Value date 27 Nov. 2008

1.8232

Rate

CHF 3,646,400

Value date 27 Nov. 2008

Josef H. Mller, Zurich


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2.2.2 Trading for the banks own account

When banks trade for their own account they act as self-contracting parties. That is why

foreign exchange settlement notes regularly contain the phrases We will sell or We will

buy. As the bank is acting as a self-contracting party, the foreign exchange transactionalso counts as one of the banks own-account deals. Banks usually maintain their own for-

eign exchange holdings and, together with the holdings at foreign correspondent banks, this

means that they have sufficient funds to be able to execute payment orders in foreign curren-

cies.

Having its own foreign exchange positions gives the bank opportunities to make gains, but

also exposes it to corresponding risks of losses. During times of uncertainty, banks try to close

out (liquidate) their own foreign exchange positions on a daily basis by means of purchases

or sales. If a bank does not want to run any risk with regard to foreign exchange, it will only

trade with clients while simultaneously closing out the position. This means that the trader

executes a simultaneous offsetting transaction with another bank so that the bank avoids

building up its own positions.

Example A trader receives a call from a client who asks for a USD/CHF rate. The trader does not want an addi-

tional USD position on his books. Before he offers a rate to the client, he contacts another bank and

asks for the USD/CHF rate. This bank gives him the price of 1.2021/26 USD/CHF. While the other bank

holds the line, he proposes the adjusted price of 20/27 to the client. The client wishes to sell the USD

and as soon as he enters into the transaction the trader will sell on the sum that his bank has pur-

chased. All this takes place in the space of a few seconds. The trader has therefore bought USD 2

million at 1.2020 and sold them on simultaneously at 1.2021. This means he has made a gain of CHF

0.0001 per USD.

2.2.3 Central banks in foreign exchange transactions

In section 1.2.2 we mentioned that central banks can intervene in the development of

exchange rates. Central banks use professional foreign exchange trading to implement their

monetary policy. An example can be found in section 2.4.3, p. 33.

2.3 How is foreign exchange trading used?

Foreign exchange trading is by no means only used for commercial trading. Foreign exchange

investments are also used for arbitrage transactions, hedging and speculation.

The volume that is traded daily has increased markedly in recent years. Own-account deals

by banks make up the lions share of foreign exchange transactions.

Arbitrage

In the past, the exchange rates in all countries were presented using indirect quotation (as is

now the case for the British pound). This resulted in significant price differentials at all the

important financial centres. In its original sense, arbitrage meant taking advantage of

these price differentials as quickly as possible. Nowadays, however, all currencies are quoted

against the US dollar. Modern, fast communication technology has also made the originalform of arbitrage virtually impossible. Today, arbitrage is understood to mean professional


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trading between banks. These kinds of arbitrage transaction are usually closed again within

the same day of trading. Transactions that are closed out on the same day are referred to as

intraday transactions.

Example The trader buys USD 2 million from Mr Mller at 1.2020 and decides to keep this position on his books

for a while. Together with other USD purchases he builds up a position of USD 6 million. If the rate

now rises to 1.2050, he can sell the USD at a more expensive rate and realise a gain for the bank.

Hedging

The term hedging is used to describe the covering or limiting of risk. Foreign exchange trans-

actions involve currency risks, although these can be calculated and kept to a minimum with

the help of other foreign exchange transactions. In the following section we will see which

types of transactions lend themselves to hedging.

Speculation

Foreign exchange transactions are very popular speculative transactions. Speculators take

advantage of the fact that exchange rates change so quickly to realise quick gains. Thanks to

foreign exchange trading, they are able to invest their assets for a short period of time. In spite

of the major risks involved, they pursue the sole objective of using this capital to achieve sub-

stantial gains quickly.

2.4 Types of transactions in foreign exchange trading

Foreign exchange trading is extremely varied and new types of transactions are constantly

being introduced. The most important forms of transactions in foreign exchange trading are:

Figure 15 Overview of types of transactions in foreign exchange trading

2.4.1 The spot transaction

Spot transactions are conventional foreign exchange deals.

Spot transactions are concluded with a value date of + 2 bank working days. The trans-

action must therefore be settled 2 bank working days following the deal date. Both parties

have to deliver their foreign exchange on the value date of the day after tomorrow. If the

value date does not fall on a bank working day, the next bank working day is regarded as the

value date.

Types of transaction in foreign exchange trading

Spot transactionsForward outright

transactionsSwaps Currency options


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Please note the rules relating to public holidays:

If the deal date is a Thursday, the second day would fall on a Saturday. The second work-

ing day, however, is a Monday, so the transaction is settled with a value date of Monday.

If the Monday is a public holiday, though, e.g. Whit Monday, the value date falls on the

Tuesday. If the deal date is a Friday, the entire weekend has to be taken into account. The second

working day is Tuesday, so the transaction is settled with a value date of Tuesday.

Example Mr Mller calls his bank on 1 March (Wednesday) to sell his USD for CHF. He concludes the deal with

a value date of 2 working days. Consequently, Mr Mller has to make the USD available to his bank

with a value date of 3 March (Friday). On the other hand, the bank will also credit the CHF with a value

date of 3 March.

Figure 16 Spot transaction: value date of + 2 bank working days

Limit and market orders

Limit orders. Clients are unable to monitor the rate 24 hours a day in the hope that it will

reach their desired price so that they can then call their bank. Instead they can grant limit

orders. In this case clients instruct their bank, for example, to sell USD for CHF at a rate

that they have specified or, if possible, at a better one. The bank will monitor market de-

velopments and, as soon as the rate reaches the desired limit, will execute the order. As

traders too are unable to work 24 hours a day, limit orders are sent around the world. At

the end of a day, a Swiss trader will send a limit order to his colleagues at the New York

branch, who will monitor the market and, if necessary, execute the order. If the order has

still not been settled at the end of the day in New York, it will be passed on to the branch

in Japan. This process continues until the order has been settled, the order has expired or

the client withdraws it. However, there are also banks which carry out local trading 24

hours a day. In this case, traders work three 8-hour shifts.

In the case of a market order, clients do not specify a price. They instruct their bank, forexample, to sell USD for CHF at the highest possible rate at the present time. The bank

will attempt to execute the order at the best possible price. With this form of transaction

the emphasis is on the immediate execution of the deal.

SPOTdeal date

01 March

today

02 March

tomorrow

03 March

day after

04 March 31 MarchTime

SPOTsettlement

date


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2.4.2 Forward outright transactions

With forward outright foreign exchange transactions the settlement date is different

from that of spot transactions.

The duration is (almost always) longer than in the case of spot transactions and can be chosen

freely by the client. Although virtually any duration is possible, those in excess of a year are

rather uncommon. In foreign exchange trading with a commercial background it is possible

to use forward outright transactions to hedge against rate fluctuations. Forward outright

transactions are obligations, so-called unconditional deals. This means that the deal is not

dependent on certain conditions; it must be settled, completely independently of how the

exchange rate may develop.

Example Mr Huber has ordered goods with a value of USD 200,000 from his business partner. He has to pay

the invoice in 30 days. At present, the USD/CHF rate is in his favour. The risk for Mr Huber is that the

USD rate will go up by the time the invoice is due. He would then have to pay more francs for the USD

200,000, meaning that the goods would cost him more. To rule out the risk of a rise in the rate, heconcludes a forward outright transaction. This involves fixing the following contractual elements now:

the amount, currency and counter currency, period and exchange rate. Mr Huber undertakes to buy

USD 200,000 for CHF in 30 days time at a fixed rate. If, as he fears, the USD rate rises, Mr Huber will

benefit from the forward rate fixed in the past. If, however, the rate is lower in 30 days, Mr Huber is

unable to profit from the more favourable rate. Nevertheless, he still has to settle his part of the for-

ward outright transaction.

The overnight transaction is a special case. This has a shorter duration than a spot transac-

tion there is a value date of 1 day.

Example Overnight transaction: It is Monday morning. Ms Notter finds out that USD 180,000 will be paid into

her business account on Tuesday. She wants to exchange this money for CHF so that she can investit in another deal on the same day (Tuesday). She calls her bank and concludes an overnight transac-

tion. She sells USD 180,000 and in return buys CHF, with a value date of 1 day.

Figure 17 Spot and forward outright transactions

Spotdeal date

Spotsettlement

date

Forwardoutrightdeal date

Overnightdeal date

settlement date

Forward outright

settlement date is some time later than for spot

01 March

today

02 March

tomorrow

03 March

day after

tomorrow

04 March 31 MarchTime


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Currency futures

If forward outright transactions are traded on an exchange, they are referred to as futures. In

the case of futures, clients can no longer choose the durations themselves, as the details of

the deal have been laid down. Futures are therefore standard contracts that are traded on an

exchange. They can be used not only for foreign exchange, but also for shares, indices, pre-

cious metals, etc. In almost all cases an exchange of money takes place when the deal

matures rather than a physical delivery. This means that usually only the difference between

the agreed price and the current market price is exchanged.

Calculating forward rates

The price differential between the spot and forward rate depends on the interest differential

of the currencies concerned. If a USD/CHF forward outright transaction is concluded with a

duration of one month, the interest rates for borrowing and investing USD and CHF are taken

into account. The investment and borrowing are not actually carried out for each deal, but the

bank calculates the forward rate as if that were the case. The interest differential from borrow-ing and investing for one month is added to or subtracted from the spot price. The difference

is expressed in points or pips. For this reason, the difference between the spot price and for-

ward price is referred to as the premium or discount.

The following rules apply:

If the interest rate of the base currency is lower than the interest rate of the quote curren-

cy, this results in a premium.

If the interest rate of the base currency is higher than the interest rate of the quote cur-

rency, this results in a discount.

Figure 18 Forward outright foreign exchange transaction

Bank A

On deal date (today):

Mr Huber

Money market andforeign exchange

market

Bank A

On settlement date (30 days from today):

Mr Huber

Money marketand foreignexchange

market

1

5

6

2

3

4

7


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The bank concludes a 30-day forward outright transaction with Mr Huber and therefore has

to calculate the forward rate. First of all, the bank needs to determine the current interest rates

for investing and borrowing USD and CHF.

Step Explanation

Deal

1. Mr Huber and his bank conclude a forward

outright transaction.The two parties agree on the duration, amount

and forward rate

Mr Huber undertakes to buy USD 200,000 at a

fixed rate in 30 days. To offer the forward rateto Mr Huber, the bank has taken the interest dif-

ferentials of the two currencies into account.

2. Bank A concludes a USD/CHF spot transac-

tion and takes out a CHF loan.

To eliminate its own exchange risk, Bank A

buys USD for CHF in a spot transaction. To do

this, it takes out a CHF loan with a term of 30

days. Bank A has to pay interest on this CHF

loan (interest expense).

3. Bank A invests the USD for 30 days. The USD purchased from the spot transaction

are invested by the bank. It is credited with

interest on this USD investment (interest

income).

Settlement

4. The USD investment is paid back. Bank A gets back the USD 200,000, including

interest income.

5. The bank sells the USD to Mr Huber at the

rate agreed on the deal date.

With the USD from the investment Bank A can

fulfil its obligation to Mr Huber.

6. Mr Huber transfers the equivalent value in

CHF to Bank A.

Mr Huber fulfils his part of the obligation.

7. The bank pays back the CHF loan. With the CHF received from Mr Huber the bank

is able to pay back the loan due, including inter-

est.

Consideration/explanation Calculation/mathematical formula

Calculation of inter-

est expense and

interest income for

30 days.

The interest rate of

the base currency is

higher than that of

the local currency.

This means that a

discount is calcu-

lated

USD/CHF spot rate: 1.2020

Interest rate for CHF loan: 2.3%

Interest on CHF 240,400 over 30 days:

USD 200000 CHF 1.2020= CHF 240 400

= CHF 460.77

Interest rate for USD investment:

2.5%

Interest on USD 200,000 over 30

days:= USD 416.65

Amount Interest rate Days 360 100

----------------------------------------------------------------------------

CHF 240 400 2.3 30

360 100

-----------------------------------------------------------

Amount Interest rate Days 360 100

----------------------------------------------------------------------------

USD 200000 2.5 30 360 100

------------------------------------------------------------


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Digression: currency carry trades (CCTs) an investment strategy

With currency carry trades an investor takes advantage of the interest differentials of

currencies.

Lets assume that country A has lower interest rates than country B.

A client takes out a short-term loan in country A at a low rate of interest and exchanges

this amount for the currency of country B.

He then invests this sum for the longer term in country B at a higher interest rate. Here

he attempts to realise the highest possible gain in terms of the interest differential.

The short-term loan in country A is renewed until the investment in country B matures.This transaction can lead to very substantial gains. The greatest risks, however, are exchange

rate fluctuations and changes in interest rates. If exchange and interest rates remain constant,

you can only win. If, however, the exchange rate changes to the disadvantage of the investor,

he or she must expect to suffer considerable losses. Hedging against exchange rate fluctua-

tions by means of a forward outright transaction would not help. As you have learned above,

forward rates are calculated on the basis of the interest differential. A forward outright trans-

action would therefore only swallow up the expected interest income.

Example Mr Peter takes out a loan in Switzerland for CHF 100,000. Interest rates are currently very low and he

has to pay 2.3% on the loan. He sells the CHF for GBP at a rate of 1.8234 and invests the GBP

54,842.60 in the United Kingdom at an interest rate of 4.5 %. If the rate remains constant, he will earninterest income. Lets assume that the GBP/CHF rate falls to 1.8150. To be able to pay back his loan

of CHF 100,000, Mr Peter now has to obtain more GBP than he has invested, in this case 55,096.41

(interest left out of consideration). His interest income is therefore reduced by the difference in the

rate (GBP 253.81).

A) Calculation of

forward rate

CHF loan plus interest:

USD investment plus interest:

Forward rate in 30 days:

CHF 240 860.77

USD 200 416.65

The discount is therefore:= 1.2018 forward rate

forward rate spot rate = discount/premium

1.2018 1.2020 = 0.0002 = discount

B) Direct calculation

of discount

BC = base currency (here USD)

LC = local currency (here CHF)

= 0.0002

Consideration/explanation Calculation/mathematical formula

CHF amount plus interestUSD amount plus interest---------------------------------------------------------------------

240 860.77200416.65------------------------------

Spot rate (Interest rate LC (Interest rate BC) days)36000 (Interest rate BC days)

------------------------------------------------------------------------------------------------------------------------------------------------

1.2020 ( 2.3 2.5 ) 30 36 000 (2.5 30)+

-------------------------------------------------------------


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Figure 19 Currency carry trades

2.4.3 Swap

A swap is made up of two transactions, each of which has a different value date. Various

swap combinations are possible, the two main ones being:

1. Spot / forward outright combination: Here an amount of one currency is bought with a

value date of 2 days and the same amount sold again simultaneously with another value

date (or vice versa).

2. Forward outright / forward outright combination: Here an amount of one currency is

bought with a certain value date and the same amount sold again simultaneously with an-

other value date (or vice versa).

This method allows traders to swap their foreign exchange for a limited period.

Example Obtaining foreign currency

Mr Meier has to pay foreign debts amounting to USD 50,000 for his company. Unfortunately, he does

not currently have access to such an amount in USD. He does, however, have sufficient CHF to payoff the debts. And he also knows that USD payments will be received in 3 months time. By conclud-

ing a swap transaction, Mr Meier can obtain the USD he needs. He buys USD 50,000 with CHF as a

spot transaction and sells USD 50,000 for CHF with a maturity date in 3 months. He is now able to

pay the debts and, on the settlement date, pay back the USD sum with the USD income he is expect-

ing.

Example Extending forward outright transactions

Huber Ltd has been expecting an invoice in USD for a goods delivery for some time. This will need to

be paid on receipt. It has therefore made a forward purchase of USD 200,000. The forward outright

transaction matures in 2 days. Unfortunately, the goods delivery is being postponed by a month,

which means that Huber Ltd will not need to pay the USD for a month. The company now decides to

conclude a swap transaction in order to defer the forward purchase. It sells the USD 200,000 for CHFas a spot transaction and at the same time buys them back with a maturity date in one month.

LoanCHF 100,000

at 2.3 %

InvestmentGBP 54,842.60

at 4.5 %

Exchange at GBP/CHF 1.8234CHF 100,000 = GBP 54,842.60

Exchange at GBP/CHF 1.8150CHF 100,000 = GBP 55,096.41

(without interest)

Difference (loss) GBP 253.81

United KingdomSwitzerland

Swapdeal date

Swap

13 March

today

14 March

tomorrow

15 March

day aftertomorrow

Spot Forwardoutright

15 April 15 June

3 monthsTime

15 May

USD bought

CHF sold

USD sold

CHF bought


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Please note the following in this example:

The first part of the swap involves reversing the original transaction. The original transaction isclosed out (cancelled out) by means of the spot transaction.

The first part of the swap therefore creates a currency risk, as the original transaction has to beconcluded again in 30 days time at the latest. The second part of the swap, the forward outright

transaction, covers this currency risk, as it corresponds exactly to the original transaction with anew value date.

Figure 20 Swap

Swap with value date of 1 day (tom / next)

A variant of the second combination is the swap with a value date of 1 day, the so-called

tom/next swap. With a tom/next swap the first part of the transaction is settled 1 day after

the deal (i.e. tomorrow) and the second part the following day (i.e. the day after tomorrow).

The tom/next swap is a type of last-minute transaction. It is used to extend foreign

exchange transactions which mature the next day. As traders usually trade speculatively, they

do not always want to actually execute a deal on the date it matures. A tom/next transaction

allows them to comply with their delivery obligation but nevertheless retain their position.

Example On 1 March a trader purchases USD with CHF with a spot value date (usually 2 days for a spot trans-

action, i.e. 3 March). On 2 March he wants to avoid having to accept the USD on 3 March. He con-

cludes a tom/next transaction and sells the USD he will receive from the spot transaction with a value

date of 1 day (tomorrow), buying them back with a value date of 2 days (the day after tomorrow).

Huber Ltd. Bank

1. Original transaction maturesin 2 days

USD bought

CHF sold

2. Swap to close out

and extend

a) in 2 days

USD sold

CHF bought

b) in 30 days

USD bought

CHF sold

Closing out of originalforeign exchange

transaction

Forward outright

transaction with newvalue date


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Figure 21 Tom/next transaction

What are swaps used for?

Swaps can be used for a variety of purposes. They are very well suited to commercial use,

making it possible to accept or swap foreign currencies temporarily. Like forward outright

transactions, swaps are also used to hedge against exchange risks. Both transactions are

therefore also referred to as hedging transactions.

Undesired maturity dates of forward outright transactions can easily be extended or short-

ened using swaps.

The Swiss National Bank (SNB) uses swap transactions to control the money supply. If it

wants to stimulate the economy, it needs to increase the money supply. To do this, it sells

CHF to the commercial banks for USD as a spot transaction and buys these CHF back simul-

taneously as a forward outright transaction. This means that the SNB lends CHF and receives

USD in return, while the commercial banks lend USD and receive CHF. If the SNB needs to

dampen the economy, it will temporarily reduce the money supply by concluding the opposite

swap. Instruments of central banks will be studied in more detail in the Banking 2 module.

Figure 22 The use of swaps

USD bought

CHF sold

USD sold

CHF bought

USD bought

CHF sold

Spotdeal date

Spotsettlement

date

01 March

yesterday

02 March

today

03 March

tomorrow

04 March

day aftertomorrow

31 MarchTime

Tom/nextsettlement dates

Tom/nextdeal date

Swap transactionscan be used to

control the money supply

avoid exchange risks

obtain foreign currencies for a limited period

extend or shorten existing forward outright transactions


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2.4.4 Currency options

Currency options are conditional forward outright transactions. They comprise the option of

buying or selling an underlying asset at an agreed time. As option transactions are described

in more detail in the Investing 3 module, we will only provide a brief overview of them here.

Options are contracts between two parties and are traded as call or put options. Options

give you the right to buy or sell something.

Figure 23 Currency options

Currency options are options that have a currency as the underlying asset. They are very pop-

ular and are used to limit the currency risk (hedging) or to execute speculative transac-

tions.

Rights and obligations of a buyer

Buyers of a currency option purchase the right, but not the obligation, to buy or sell a certain

currency for another at a certain rate and at a certain time. Buyers are not forced to exercise

this right. They can simply allow their option to expire.

For the right conveyed by the option the buyer pays the seller a premium when the transac-

tion is concluded.

Rights and obligations of a seller (writer)

Sellers, also known as writers, receive a premium and in return for this enter into an obliga-

tion. If buyers wish to exercise their right, sellers are forced to fulfil their part of the deal. If

buyers relinquish their right, the sellers obligations lapse.

Types of currency option transaction

To make it easier to understand the text that follows, a number of industry-specific expres-

sions are explained in the table below.

Figure 24 Industry-specific expressions

Expression Meaning

Long Purchase of an option (purchase of a right)

Short Sale of an option (assumption of an obligation)

Strike or exercise price The fixed exchange rate at which the option can be exercised

(e.g. USD/CHF 1.2020).

Call option

comprises an

option to buysomething

Put option

comprises an

option to sellsomething

Options


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Call option

Long call = If a person buys a call option, he or she buys the right to purchase the

agreed currency.

Short call = If a person sells a call option, he or she sells the right to purchase the

agreed currency. This person therefore assumes the obligation to sell the agreed cur-

rency.

Put option

Long put = If a person buys a put option, he or she buys the right to sell the agreed

currency.

Short put = If a person sells a put option, he or she sells the right to sell the agreed

currency. This person therefore assumes the obligation to buy the agreed currency.

Figure 25 Option transaction

Example Mr Peter expects the USD/CHF rate to go up over the next 3 months. He buys a USD/CHF call option

at a rate of 1.2020. This means that he buys the right to purchase USD and sell CHF at a rate of 1.2020.

When the deal is concluded he pays a premium to the seller. The only thing that Mr Peter can lose is

the value of the premium. If the rate in 3 months time is lower than 1.2020, he simply allows the

option to expire. He can, after all, obtain the USD at a more favourable price on the market. If, how-

ever, the rate is higher, as he expects, he will exercise his right and purchase the USD at 1.2020. He

can then sell on the USD profitably on the foreign exchange market.

Quoting of prices

The strike price can be chosen by the buyer/seller. For exchange-traded options the

buyer/seller can choose between the strike prices quoted on the list of option prices. In the

case of OTC options, i.e. ones that are not traded on an exchange, clients can determine the

strike price themselves. Here the buyer and seller must reach agreement on a certain strike

price.

The premium that the buyer has to pay is based on the strike price. The better the hedge

offered by the strike price, the higher the premium. The price of the premium is stated in

points of the exchange rate. In the case of a USD/CHF option, the points correspond to the

Swiss centimes in the exchange rate. A premium price of 1.80 therefore means that the buyerhas to pay CHF 0.0180, or 1.80 centimes, per USD.

Call Purchase a good (in the case of foreign exchange: a currency)

Put Sell a good (in the case of foreign exchange: a currency)

OTC (over-the-counter) Options with which the strike price and expiry date can be cho-

sen freely. (These options are not traded on an exchange.)

Expression Meaning

Long USD call

Buyer

Short USD call

Seller

Buyer pays CHF (right)

Seller pays USD (obligation)

Buyer pays premium

I sell a USD/CHFcall option

at a strike price of 1.2020

I buy a USD/CHFcall option at a strike

price of 1.2020


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Example Mr Glauser will require USD 250,000 in March. He does not want to buy the USD today, but he is also

afraid that the USD/CHF rate will rise. On the list of option prices presented below Mr Glauser sees

that he could buy a call option with expiry in March at a strike price of 1.2000. The premium for this

is 4.20 centimes per USD. If he wanted to secure a lower strike price, e.g. 1.1750, he would have to

pay a higher premium, namely 5.50 centimesMr Glauser decides in favour of the strike price of 1.2000. He pays the bank the premium of CHF

10,500 (250,000 0.0420). If in March the USD/CHF rate is above 1.2000, he can exercise the option

and therefore purchase USD more cheaply. If the rate is lower, he can allow the option to expire and

his maximum loss is limited to the premium.

Distinction from an unconditional forward outright transaction: In contrast to an unconditional

forward outright transaction, Mr Glauser has the right, but not the obligation, to buy the USD at a price

of CHF 1.2000. In the case of an unconditional forward outright transaction, Mr Glauser would be

forced to buy the USD at a price of 1.2000, even if the price were below this on the maturity date. The

option is a better hedge than the forward outright transaction and, in return for this benefit, the buyer

of the option has to pay a premium.

Figure 26 Option prices

At this point, take a look at the simulation entitled FOREX trading.

Put yourself in the shoes of a foreign exchange trader: assess the factors and events that influ-

ence exchange rates and choose the optimum type of transaction.

Length: approximately 10 minutes

USD/CHF spot rate: 1.2020

Strike price 1.1750 1.2000 1.2250

--- C A L L ---

Expiry Long / Short Long / Short Long / Short

15.12.xx 3.60 / 3.80 2.00 /2.20 0.95 / 1.15

16.03.xx 5.30 / 5.50 4.00 / 4.20 2.90 / 3.10

15.06.xx 6.25 / 6.45 5.00 / 5.20 3.90 / 4.10

14.09.xx 6.85 / 7.05 5.65 / 5.85 4.60 / 4.80

--- P U T ---

Expiry

15.12.xx 0.95 / 1.15 1.85 / 2.05 3.30 / 3.50

16.03.xx 3.20 / 3.40 4.35 / 4.55 5.75 / 5.95

15.06.xx 4.60 / 4.80 5.80 / 6.00 7.15 / 7.35

14.09.xx 5.60 / 5.80 6.80 / 7.00 8.15 / 8.35


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Exercises

Task 6 Calculation of cross rates

A] A client wants to sell CHF 20,000 as a spot transaction and buy Japanese yen. What

CHF/JPY rate will the bank offer him and how will the rate be calculated? The following average

rates are available to you:

USD/CHF 1.2020

USD/JPY 97.0650

B] The client would like to sell the CHF 20,000 for yen as a forward outright transaction rather

than a spot transaction. To calculate the forward rate, the bank will take additional factors into

account. Briefly explain in your own words what these factors are and why the bank needs them

to calculate forward rates.

International trade and movements of money and capital form the basis for foreign exchange

trading. Banks work around the clock as brokers between the supply of and demand for for-

eign exchange, acting both for their clients and for their own account. No charges are made

to clients. The bank covers its expenses by means of the spread (difference between the bidand ask rate).

Currencies are quoted worldwide against the US dollar. A few important exceptions are the

GBP, AUD, NZD and EUR. If the USD is left out of the equation and currencies are related

directly to each other, this is referred to as the cross rate.

Important forms of foreign exchange transactions:

Spot transactions are concluded with a value date of 2 days.

Unconditional forward o

foreign exchange and precious metals en

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