Okay.

Good morning, good afternoon, good evening, potentially everyone.

And everyone, welcome to this Felix live session on or introduction to FX products, I should say.

My name is Thomas Krause and I have the honor to guide you through this introductory session today, and very much looking forward to talking to you about the FX markets for the next 60 minutes or so.

So, what exactly are we going to cover here today? Well, we're gonna start with a very brief overview of the FX market in general.

So we're gonna talk about what FX transactions actually are, how big the market is, which products are traded, et cetera, et cetera.

And then we're gonna have a closer look at FX quotes and how to interpret them.

We are going to take an intuitive look at FX forwards and talk a little bit about where forward prices actually come from in the context of FX.

And then, you know, at the end of the session, we will discuss FX swaps and what they can be used for as well.

So let's get started with the content without further ado. And as I said, we're gonna start with thinking about what a transaction in the FX space actually is. And that is pretty straightforward. Nothing special here, that if basically the definition is that further an exchange transaction is agreement between two counterparts to purchase one currency against another, that's no surprises.

And what we have to add here, and you see this at the bottom of the slide, it is this transaction happens at a specific debt that could either be of course is spot transaction for in inverted commas, immediate delivery, either T plus 1, T plus 2, depending on the currency pair that we're trading.

That would be the immediate delivery.

But this could also, for example, be transactions that are settling at a specified point in the future that would make it a forward contract, or in particular FX traded context, sorry, the exchange traded context futures contracts. And then of course we need to agree on the price at which we are purchasing one currency against the other.

That's also, per se, nothing really special that's in line with pretty much any other financial market transaction. But this is where FX transactions do come or become often a little bit confusing when you're looking at them for the first time.

So here's an example. If someone tells you Microsoft trades at 416, it's immediately clear to most of us, even if you don't necessarily do trade in the equity markets, et cetera.

But it sort of feels intuitive that the way the price is quoted refers to the price of one Microsoft share, right? So one Microsoft share trades at $416.

It's very unlikely somebody would think, okay, that means for $1 I can get 416 Microsoft shares.

Even if you have no idea where the share price is, you probably wouldn't interpret the price quote this way.

And we're used to this from our, you know, daily shopping experiences.

You do usually see a price quoted as you know, that's what the items price is in your local currency.

Now, when we're trading for an exchange, because we're now trading basically two currencies, that means the good we're buying is a currency and the good we're paying with is also a currency that makes the quotation a little bit less obvious.

So if I tell you that Euro dollar trades at 1.0450, then it's not 100% clear anymore.

If this quote now means 1 Euro buys me $1.450 or if it's the other way around, and that means $1 gives me Euro 1.450

That of course, you know, in context, if you know roughly where the currencies are trading, you will understand that quote.

But just from hearing this pair of numbers, it's not immediately clear.

So that's where when people start looking into FX, this this potential source of confusion. Now the good news is there is a very simple rule on how to interpret these quotes. We're gonna talk about this later that you just simply have to follow, and then it just becomes a habit after a while. You need to think about this 2, 3, 4 times, and then it becomes obviously relatively straightforward to understand anyway.

So that's the definition of an FX transaction.

Let's have a look at the size of the market because if you take all those transactions together, then basically you get the FX market, right? So the FX market could be seen as the just aggregate of all FX transactions that are happening.

And here is what you might already have heard is that the FX market generally is considered to be the largest and most liquid over the counter market.

Don't confuse that with there is no, or that, that everything is still traded by phone. There's a lot of electronic trading happening in the FX space, but the vast majority of FX transactions still happens through you know, privately brand electronic trading platforms that are not regulated as exchanges per se.

Yes, there's a growing market share of, for example, FX futures, but still the vast majority of transactions that we do observe in the FX market still happens over the counter.

So it's a truly global market.

It is basically open 24 hours during the day, starting very early Monday morning in Asia, trading time hours, then sort of passing over to Europe and then sort of closing late Friday night, if you wish.

When the US markets are closing in between, you can pretty much trade any currency pair 25 hours during the day.

That doesn't mean though, that liquidity is always gonna be identical, right? So I would say if you have a large amount of Euro dollars to trade, I don't know, you might want to buy a huge amount of euros versus dollar or the other way around.

It's probably best to do that at a time of day where Europe and the US are in the office than liquidity would be expected to be highest.

But generally speaking, you can of course buy Euro dollars in Asia trading hours without disturbing the market too much.

But I would expect liquidity profile to be reaching its peak during these times when the participants that are based in the area where the currency or the or of the currencies that you wanna trade are active as well.

So size of the market, we already said it's a significant market here. What we're, what we can see here on this chart on the left hand side is a statistic that comes from the bank for international settlements.

So every three years they do their tri-annual survey of their sort of getting central bank data.

And what happens is that they analyze the daily trading volume during the months of April.

So the last data we have here is from April, 2022, and the data that was collected and analyzed showed that in April, 2022, so on any business day in that month, we traded on average about seven and a half trillion dollars worth of currency trades.

And that obviously tells you a lot about the size of the market.

And then on the right hand side, we're using the same statistic to break it down and could, which currencies are the most involved in this seven and a half trillion dollars, how much of that would fall onto US dollars, euros, et cetera. And no surprises here.

The US dollar is by far the most significant, and that is because a, the most liquid currency per traded loan is Euro dollar.

And then obviously we're trading many other currencies very actively against the dollar.

And then especially when you sort of thinking about the more exotic pairs, usually liquidity against dollars is the highest.

So dollar has a very, very central role in the FX market.

Eurodollar being the largest currency pair there is.

And in terms of volume, and now for those who are wondering why if you add the bars up here, you don't get seven and a half.

That's obviously because we're having a double counting effect because as we said, we have seven and a half trillion dollars trading volume.

But it's basically, you know, Euro dollar would count twice here in the statistic on the right hand side, one the size of Euro and then the other size for the dollar currency.

So just in case you were wondering, so the question then, of course that sometimes comes up is why is this market so big seven and a half trillion per day? That's a huge number. Why is this market so active? And I guess the answer to that really is there are so many different use cases for, for exchange transactions, and of course in this globalized world we, we live in, uh, that has gained a lot of traction over the last couple of decades, right? Simply because if you think you're buying a product from abroad that's no longer just let's put it, you know,

the company's a corporate a aspect here, but as individuals, we're now very often buying products or services, let's say it doesn't have to be a product anymore, right? We can buy services for, you know, from a company that's based in a different jurisdiction with a different currency, and that needs to be paid, right? And we're paying this maybe in Euros because they charge us in euros or in whichever your local currency is.

But you know, if that's a company that's based in, in the us they probably will transfer or, you know, exchange that amount into dollars, et cetera. So whenever you make a payment to someone in a place with a different curr or a different currency is used, then of course normally you would need to make an FX transaction of some sort, uh, in order to get this currency that you need to pay, right? So that's a simple argument here for payment facilitation. And that obviously happens day in, day out, imports, exports, and all this kind of stuff is paid usually with, um, foreign exchange transactions on the back of this.

Then of course, the, is the element of risk management, right? And we can, again, approach this from very different directions.

But if we're thinking, if we stick to global trade here because it's such a nice intuitive example, then you can see as to why FX transactions might be also done for risk management purposes. Because very often, especially in transactions between corporates payment for a good is not made immediately.

So put yourself in this sort of position that you are based in somewhere in emea, let's put it, put it like this.

And so in the Eurozone and you have just sold some, some equipment to the US and the price has been negotiated in dollars, let's say.

And so you know that you're gonna get this amount of, let's say $100 million nice round numbers, but you won't get it immediately because what you now have to do is you have to build the machine, you have to ship it over to the US and they want to check that the machine is in order, and then they want to pay you. So you give them a six month payment target, right? So they price has been agreed, you know, you're gonna get, you know, $100 million dollars in six months time, and let's say credit risk is not really of concern, that's a longstanding relationship here you have with that client.

So none of that, but you know, you can immediately see that you are taking, for an exchange exposure here, right? Because you get paid in dollars, which is not the currency that you're reporting in, that's not the currency that most of your expenses are in.

So you would like to exchange that amount of dollars that you will receive then obviously into euros, but you don't know at which exchange rate you can do this because you will get the $100 million dollars in six months time.

And then of course you can think about how to manage that risk because you can easily see if dollar were to lose value against Euro over the next six months in a significant fashion, then of course your payment in euros would be a lot worse, a lot less than you originally anticipated.

So that's a risk there. You want might want to hedge this and the FX for, for example, could be a way out. And that would be, we're gonna talk about these transactions in more detail later, but generally speaking, do you agree on the price today? Settlement happens in six months time and then you know exactly the amount of euros that you will get for your $100 million dollars in six months time.

So that's a risk management argument.

And then of course there's speculation, right? Currencies move, they strengthen, they weaken and whenever there's volatility in an asset or in the price of an asset, then of course that attracts some speculation.

So for example, you expect a dollar continuing its strengthening trend over the next couple of months, so then you against your stick with that pair here then of course could be tempting to buy some dollars against euros, right? And then hoping that this appreciation continues and that that we will, will be able to reverse that transaction at a much better price than at some point in the future.

So basically profit from expect depreciation or depreciation of currencies, and then of course diversification.

That's not necessarily directly FX link, but if you're thinking about an equity investor that is you know, heavily invested in US equities, but now is thinking to diversify a little bit out of the US into some other market.

Let's take Japan as an example, then of course, you know, there would be the desire to sell some of the US holdings and buy some Japanese stocks.

And of course, if you wanted to do this with real cash equity and in order to buy stocks on the Japanese or the on the Tokyo Stock Exchange, you of course will need Japanese yen. So the first thing that you probably should be doing is sell some dollars and then buy some yen wizard so that you have the cash in order to pay or the stock.

So a transaction in the equity space requires an underlying FX transaction here.

And all those examples, and there's of course, count as more together they explain very well why this market is so sizable.

And one thing that has already become clear is that there's various types of products that we tried. So let's have a quick look at this.

And I'm really gonna race through this because we're gonna revisit the first three, which are, and we're gonna see the stats in a minute by far the dominating ones.

But you know, let's just kind of have a look at what is generally considered to be an FX product.

First of all, there's a spot trade, right? And that's basically the transaction for immediate settlement. And I said it before, that's usually T plus 2 but maybe T plus 1 depending on the currency care, that's right, that's the immediate settlement in financial markets.

Then there's outrights, which is basically the FX term for forwards, right? And that means that we agree on the price today, but the settlement doesn't happen T plus 1 or T plus 2, it happens at a predetermined date in the future.

So that could be six months, three months, in the future, 12 months, whatever.

But the prices agreed today.

And so that's going back to our example where we had a six month payment target.

We know we're gonna get a hundred million dollars in six months time, we wanna manage the risk.

So why don't we enter into a Ford contract where we sell or agree to sell the a hundred million dollars that we get in the future to our counterparty at a pre-agreed exchange rate, and then we get a predetermined amount of Euros in six months time.

Makes perfect sense, right? That's a classic risk management transaction here.

It's just called outright or you know, instead of normal forwards, but you know, everybody will still understand forward in the FX space as well.

Okay? So those two I'd say are the ones that are really intuitive.

And then there are FX swaps. And you've gotta be a little bit careful here because on the, in the column right next to it, you see something that says XCY that basically stands for cross currency swaps. There's a nice abbreviation here so at least when you write it.

And so they are something that, you know, are easy to be confused.

So let's, let's make clear we understand the difference.

So what is an FX swap? An FX swap is basically nothing else than the combination.

And it says, so on the slide between an FX spot transaction and an FX forward trade.

And so the way they are combined is that basically the direction of the trade is opposite from FX spot to FX forward. What this means, as an example is, for example, we buy euro versus dollar in a spot transaction, and at the same time we agree to reverse this spot transaction.

I.e. we're now selling euros versus dollars six months forward, three months forward, 12 months forward, it doesn't really matter.

And both transactions happen or agreed on simultaneously.

And that's a bit strange when you look at it for the first time because you think, okay, so I'm buying one currency and I get it delivered in two days from now, and at the same time I agree to sell this currency six months later.

And I agree the price at which I'm gonna do, so, so all cash flows in this FX work will be known, right? Right? There's no question around how much will I pay today and get in six months? Everything is defined, right? So no matter where the euro dollar goes over the next six months, that has zero impact on the cash flows of this FX swap.

So what this basically means is we have taken two FX transactions, an FX spot transaction, and an FX forward transaction that in isolation both have FX exposure, right? If you go long dollar, you are benefiting from a dollar appreciation.

And that doesn't matter if this is done through spot transaction or through a forward transaction, but now in an FX, what we're combining them and we're basically taking one currency risk in the spot and then the opposite currency risk in the forward transaction.

And as a result, we're left with, well, not quite no currency risk, but hardly any exposure to a changing FX rate.

And that sounds surprising, right? Because why would I do such a transaction? Why would I trade foreign an exchange if I don't get exposure to foreign exchange? This cannot necessarily be used as a hedge, this cannot be used as a speculative tool per se.

So why bother? And that leads then often to, to the conclusion, okay, this, this is a niche product, right? This is not gonna be something that plays a significant role in the market. Well, let's have a look, right? And here, what we can see on the next slide is the trading volume.

Again, we're using BIS data, but this time we're breaking down the data according to product types, right? So we're now taking the seven and a half trillion a day and see, okay, how much of that is bot transactions? How much of that is outright forwards? How much of that is FX swaps? And FX swaps are the green bar, right? And so what you see here that consistently since the beginning of this millennium FX swaps have been the dominating, type of product.

So the funniest thing here about this data is that actually the majority of all transactions in the FX market are done with a product that doesn't really have FX exposure as a driver of, of P&L. So that I think is interesting.

And of course, you know, bit of a cliffhanger here, we're gonna talk about this later and identify, okay, why are people actually using FX swaps if it's not really for taking FX exposure? First all, let's continue going through the products here.

And we need to talk very briefly about cross currency swaps because as I said, they are somewhat similar but also different to the FX swaps, and it's just important that you are aware of these differences.

So the cross currency swap, right, is really the agreement between two counterparties to also exchange principal amounts.

I.e. enter into a swap where, you know, I will now give you a certain amount of euros, you give me a certain amount of dollars.

So it sounds a bit like an affect swap when, when we start, because we're reversing that exchange of principle at the maturity of this cross currency swap as well.

However, there's an additional component in the cross currency swap is that not only do we exchange currencies, but we're also ex exchanging interest rate payments on these two currencies.

So basically, let's say I, we enter into a transaction where I give you euros, you give me dollars, and then I pay you a US dollar interest rate over the next five years.

You pay me a Euro interest rate over the next five years, and in five years then we're reversing this transaction. So that's the difference between the FX swap and the cross currency swap.

And then of course there's all those non-linear payoff products. So there's options which differ considerably from all the products we've, we've discussed so far simply by the fact that all those four transactions that we have discussed obligations, right? Spot is obligatory in two days.

I have to deliver the currency that I sold and I get the currency that I bought.

Same for Fords in six months.

In 12 months, I have to deliver and I have to take delivery in an FX swap. It's just a combination of the two.

So both legs of an FX swap will have the obligation for both parties, same for across currency.

So options give you the right to do something, right? And that is either the right to buy a currency, the right to sell a currency and they obviously have many different variations here from the regular calls and puts to, you know, all those exotic types there.

But we're not discussing options here today in more detail, right? So we talked about this slide already.

We're coming back and we're gonna uncover the secret of why FX swaps are so large in notional. But before we go there let's build it up and we're gonna talk about the way to interpret spot quotations or any FX quotation really.

We're looking at spot first.

We're gonna spend some time on forwards, and then we're gonna discuss the FX wealth.

So here is coming back to what I said on I think the second slide is that FX quotes when you look at them for the first time might be, and you're and perfectly good company there if, if you do get confused, because that happens to a lot of people.

It's just like, how do I actually interpret this quote? I mean, Euro dollar doesn't trade at 1.0950.

you know, last time I checked yesterday it was 1.045.

But you know, it doesn't change the dynamic.

So let's just take this as an example.

Euro dollar quoted to us at 1.0950 to 1.0953.

So what do, what, what do we do with this? What, how do we read this? And here's a rule that I already sort of alluded to earlier, the currency that's named first in the pair i.e. that stands on the left hand side.

So in this case, this is the euro is basically referred to or is commonly referred to as the base currency, right? And then the other one, the one that stands on the right or that's named second, that's what we call the quoted currency.

Still doesn't really explain how we understand that quote, but basically the rule is that the price that you get quoted is effectively the price in quoted currency for one unit of base currency.

So translation of this number is then one euro gives us 1.0950 or 1.0953 depending on we're buying or selling or we're market maker, market taker, et cetera.

But, you know, let's simplify things here.

So in a way you can think about it like this, the base currency is the asset that we're buying, okay? And the quota currency is then just the price for that asset, right? So that's basically how you understand those quotes and the rule applies the left hand currency named first in the pair, that is always the base currency, and the one on the right is always the quoted currency.

Now, of course, I could quote Euro dollar as dollar euros if I wanted to, but then I would have to change the quotation because then as per the rule I just said, we would now give you the price for $1 in euros, and that would then be one over 1.0950, right? So you can of course change things around.

There's no hard and fast rule that everybody should quote Euro dollar this way, but it is the general market convention. We're gonna talk a little bit about the sort of conventions around which one which currency tends to be the base in a minute.

But, you know, if you do want for whatever reason wanna change and put dollar first, then you need to adjust the quote accordingly.

Okay? So that's how to read those numbers generally.

Then let's think a bit about some terminology that's often thrown around here in FX. You hear people talking about big figures, you hear people talking about pips points, all that kind of stuff.

So, um, all these sort of things that I just mentioned, they basically refer to different parts of the FX quote, right? And it used to be the case that currency quotes or currencies were generally quoted to five digits in total.

So as we have on the slide here, 1.0950, that's five numbers in total.

And then the rule was the first three of numbers of the quote, that is the big figure.

And then the last two are called the pips or the points.

So if you have a euro dollar example here to look at, then would basically say one point is one over 10,000 because that's how you get to the four decimal point, right? So that it's just 1.1 over 10,000.

That's not always the case for all currencies because when you look at, for example, dollar yen we have a slightly different way of quoting the price here. That's because the yen in comparison to dollar is obviously quite weak. We all know that. So the time we took the example here is basically that dollar yen pair was trading at 149.04 to 05.

Now we do see that here, if I divide by 10,000, I'm not getting to the last or to the second decimal point.

And now here, as per the rule we've discussed, the last two numbers are the points.

So if I want to get to the point, I have to not divide by one over 10,000, but one over 100, and that's becoming relevant in a minute.

So right now you might say, well, yeah, okay, Thomas, so what we'll see as to why this is important.

But generally, you know, the point I'm trying to make at this stage here is really it's not the point in some cases is one 10,000, in other cases, 1 over 100.

Now we just had a question, if I can explain the base currency again so quickly going back to that, as I said, the base currency is nothing else than effectively the asset that we're buying here, right? Or that, that, that we get quoted.

So the base currency is one that's named first in the pair.

In this case it's gonna be euroes.

And because it is a base currency, the quote basically means one euro cost you 1.0950 to 1.0953.

So if you want to buy one unit of base currency, I.e. one euros, you would have to buy were to pay $19 cents and 53 fractional cents, right? Because you are the market taker, you are buying on, you're buying the base currency, i.e. euros on the offer, you're selling the base currency, i.e.

euros on the bit.

Hopefully that clears that up. Okay? So almost there guys. So let's wrap this up here.

When with a couple of extra points on the FX spot quotation talked about the major points here, figures, points, buying and selling, interpreting the bid offer.

And that's, again, that's takes some time to get used to, right? Because now in euros, I've given, you know, the explanation, right? If you wanted to buy euros, you'd buy on the offer.

If you want to sell euros, you do that on the, on the bid as a market taker.

If you were the market maker, then of course it's the other way around.

And now then you see as to why things can easily become confusing. Because if you now have someone that's like, okay, I wanna sell dollars at which against euros, at which price do I do this? And then you have to sort of kind of think, okay, selling dollars means buying euros. Buying euros is done on the offer.

So okay, it's gonna be the 1.0953, and you know, this takes some time to get used to, to think about it in the most efficient way for you.

But as I said, that's something that almost everyone I know has struggled with at the beginning.

It doesn't take too much time to get used to this way of thinking. So, so if you go into the FX market and you are looking at this on a daily basis, very, very quickly, it becomes, uh, second nature, okay? So, then let's just quickly put some more terminology there in front of you.

And obviously when we're talking about currency moves, we are not necessarily saying, oh, you know the price of a currency has gone up, the terminology that we use it, it has strengthened or it has weakened. And I think the reason for that simply is that we're always looking at pairs, right? So we can see, okay, this currency has gone up in price against, but it's sort of like, you know, we're, we're saying instead this currency has strengthened and or has has weakened.

So very quickly to put this in context here we, we see two year chart or three year chart actually of the Euro dollar from, you know, April 21 to April 24, and we started then our observation at 1.2, give or take, right? So that meant originally one euro was, uh, giving us $1. 20, right? So one euro is the same, then $1, or $1.20.

That was the case in April, 2022, you could exchange one euro for $1.20.

Then over the next couple of months, 15 more or less you know, this line showed a clear downward trend.

And at sort of in October, 2022, we almost well we actually broke parity, right? We were trying trading below.

So now at that point, Euro dollars was trading at 0.95, which meant one Euro now only give you 95 US cents.

Now, how would you describe this move? Well, you can of course use numbers like I just did, but it's much more efficient to say, well, what has happened? Really, the Euro has weakened against the dollar, or the dollar has strengthened against the Euro from just looking at this currency pair. It's not immediately clear. What has caused that move.

All we can say is, well, look, in April, 2021, one Euro got me $1 20, and now the same Euro only gives me 95 US cents in October, 2022. That clearly means that the Euro has lost value relatively to use dollar or euro dollar has gained value relatively, uh, to Euros.

But we cannot, without further information really say, okay, is this a Euro strength weakening or is this a dollar strengthening story? Now for this, you would have to look at other currency pairs, right? You would, for example, look at how is the euro done against the pound, against the yen, against Swiss racks against, you know, many other current major currency pairs.

And if the overall trend is that Euro has weakened against most or all of them then it's relatively indicative that this whole thing is a Euro weakening story.

If you can also just look at it in, in dollar terms, right? How's the dollar done against other currencies? You can look at indices, right? So where, you know, you have currency index dollar index, which basically shows how the dollar has done against the basket of of currencies.

And if that has gone up, i.e. you know, that means the dollar has gained value against most of these basket currencies, then it's a pretty clear indication that this moves that we're showing and that we're observing here is actually a dollar strengthening story now.

But that's you know, of course important to understand why is the market moving the way it does, but just from a communication point of view, we don't need to add this.

We're just saying, okay, Euro has weakened, dollar has strengthened, or you know, as also as we can see here, there's of course market environments where, where there's a reversal of that.

I.e. if the quote goes from 0.95 to, you know, 1.1 that is then the euro has strengthened against the dollar or the dollar has weakened against the Euro.

So that's just, you know, the way to communicate about this.

Now, the rule is simple, right? Base currency is always the one that's quoted in price terms.

So one euro is X dollars.

And then I said, if you want to, $1 is X euros, you need to adjust the quote.

So the question though, how is then, okay, how does it generally work? Because I, I think it's pretty intuitive that market participants will have some sort of like uniform way to quote currencies because you just don't wanna do this arithmetics in your head and just kind of think, ah, one over that.

It's the way I understand the price.

So how do we generally quote currencies? There is of course no law in place, but there's a couple of I think, conventions in place that that one should maybe be familiar with.

And the first thing to know is that euro is always the base currency against anything, right? So it's Euro dollars, it's euro pound, it's euro yen, it's euro swissy, it's euro cap, et cetera, et cetera.

So euro is always, if the euro is involved, it's always the base currency.

The next sort of senior level, if you wish, are pounds.

And by the way, this doesn't mean anything about the importance of the currency. So I'm not indicating Europe is the most important currency in the world, but it's just sort of like a general convention, right? So then the next level are pounds or the dollars, New Zealand dollars, et cetera. They are always the base except against euros.

And then after that comes dollars, which is the base against every currency except Euro pounds or the New Zealand dollars.

And if neither of the currency pay the above is involved here, then the general rule is that we tend to use the stronger currency as the base currency so that we don't see some sort of quote like 0.00001, but instead we see, you know, a hundred something as a price quote.

That's the general sort of idea thinking process behind FX quotes.

I would suggest though that whenever you're in doubt, just go and talk to a colleague who trades that pair and, and get, you know, the real insight confirmed into how we're actually quoting this. These are just some nice to know general rules, but they might not work in any particular currency pair.

Okay? So we're in the spot market still.

So the one thing I wanted to at least introduce because it is a pretty, um, popular sort of trading strategy if you wish, in FX and involving obviously mostly spot transactions, that's a carry trade.

I'm sure you've all heard that before.

And in FX that's a very, very popular thing to do.

Now what's the idea behind this in general? Well, it says here that an FX carry trade is basically the strategy that you borrow money in a low interest rate environment and then you use those funds to invest in, a higher yield environment that normally is in a different currency, right? So as, just to give you an example here of something that was very popular for, you know a long time was for example, in, in recent years, borrow yen because yen, you know, okay, the interest rates are on the way up.

But they are still considerably or in comparison to other jurisdictions still reasonably low, especially, you know, when you're thinking about the front end.

And so you would borrow money in the yen and then you would go to, for example into, into the Mexican peso because their interest rates are significantly higher.

So I don't know exactly where they stand today, but let's say 9%, you know, so you borrow at pretty much zero and you invest your money at 9%.

That sounds like a pretty interesting deal because obviously, you know, it's quite obvious that the source of P&L here is clearly the interest rate differential.

If you basically pay nothing for the amount or uh, for the, for the money you borrowed, but you get paid 9% for the invested money, then that's a pretty interesting interest rate differential to take advantage of right now it's not risk-free though, and that's the one point that I think, you know, needs to um, be crystal clear to everybody that gets engaged into those transactions because at some point you will have to pay back the money you borrowed in yen. And the problem is that in order to be able to invest those yen that you borrowed in Mexico, you would have to do an FX transacation first.

And that is you need to sell the yen and you need to buy the Mexican peso.

That per se is of course not a problem.

You can do that and you lock in the exchange rate, it's a spot transaction.

We all kind of know what that means now and, and, and always golden, you now have Mexican peso, you buy an investment that pays you 9% and you pay zero, close to zero on your yen funding.

Now that all is is perfectly fine and now a year goes by and you're enjoying this 9% interest rate differential.

However, right? What we should not forget is our money carries invested in pesos and our debt is in in yen.

So whenever we want to unwind that Carr, we will have to sell peso for Japanese yen.

And there is the risk.

And as we don't know, obviously we never know anything of any price move with certainty where the yen Mexican peso is gonna trade or this currency trade is gonna sorry, this currency pair is going to trade, you know, whenever we want to unwind our care trade. So what we're exposed to really in this particular care trade is a strengthening of the funding currency, right? Is that happens that can quickly wipe out all the sort of accrued interest that we have enjoyed through the interest rate differential.

So that's a point to be aware of.

It's a trading strategy that, you know, potentially can reward you quite handsomely.

But the obviously thing to watch is a strengthening in the funding currency.

So it's a trade that generally is, is set up in a low volatility environment where saying, okay, things Are not gonna move around crazy. So I have this 9% Interest rate differential and if I'm not seeing a 9% strengthening of the funding currency, then I'm still Having a a net positive income.

However, if market volatility picks up because there's a risk of environment and then a lot of people need to unwind the care trades at the same time, you can easily see that the sort of significant amount of transactions going through selling peso buying yen could obviously lead to a very significant strengthening in the end, for example.

So that is something to be aware of.

Alright, and with that, now let's enter into the world of FX forwards.

Okay? So we have already defined them and again, you know, FX forwards are from a definition point of view, not really different from equity forwards from, you know, forward rate agreements in a way or, or any other sort of like transaction on any other asset prices agreed today.

And then the transaction is actually settled at a pre-agreed time in the, um, future, right? And FX forwards are fairly liquid.

They were not the most actively traded product, but still in 2022 April data it was about 1.2 trillion, notional transactions a day. So I think that we can be considered liquid and that's especially the case when you're trading sort of those nice round number periods, right? So you say one month, 2, 3, 6, 9, 12, you know, when you want a seven months, two week and four day forward, it probably isn't quite as liquid than the six months forward, but, you know, still it's not gonna, uh, cause a lot of, a lot of headache here there anyway.

So just one thing to note because I think it's, it's important when you get involved with FX the question sometimes is about around, okay, so when is the actual settlement date? So because today let's say we're trading on the 20 it is 21st of February, and so if we traded a six months forward today, would this now settle on the 21st of August or on some other date? And the answer is, it's gonna be a different date because usually the forward period starts to count from the spot date.

So today is Friday, that means we have a Monday, if I'm not mistaken, 24th and then Tuesday 25th because we have a T plus 2 settlement currency pay here. So let's stick with $0 then we would spot would be on Tuesday, which is the 25th, and then six months after that means the six months forward would not set it on the 21st of August, but on the 25th of August, assuming this is a good, business day, right? So we're starting to count the forward period from the spot that that is at least the general market standard.

That's how forward transactions and the dates, are basically determined.

Now, let's move to the forward price because how is a forward price quoted to you? And unfortunately it's not quoted as per market standard in the same way then this bot transaction.

So here what you can see is we're sticking with $0, but there's other pairs, there's cable, there's dollar yen yeah as well.

And you see here, that's a spot code, right? And you remember this, that's the one we've seen before.

And then we have obviously here one week, two week, three week, and those are the different forward periods, right? So, you know, that means how much time in the future will settlement happen? And let's just kind of take the six months point here because we're gonna do this as an example.

And you see here the bid is 90, sorry, 89.1 to 89.6, and hopefully it's immediately clear that this cannot be the actual forward rate, right? So because that would mean that the market is priced, that in six months time one euro would buy you $89, right? Where today, well when, whenever we took that example it was one euro buy you $1.09 that hopefully is immediately clear that this, this cannot be right.

Or if that was actually the price, then something would be really wrong in the market environment anyway.

It is not the price, right? So, but how do we interpret then this forward thing that we see here? And for this we have to understand that FX forwards are quoted in forward points and forward, okay? That means we're talking about the future delivery here points we heard before, right? That was sort of like the last part of the quote.

Oh, I just remembered, right? What I wanted to say and, and apologies, I'm swearing this in now, is as I started actually the right way, I said it used to be the case that FX exports were five digits. Now what you find, especially in the electronic trading space is that there's another digit.

So the quote could be 1.0950, and then let's add a three.

Now this is then basically something we call fractional points, right? So this is basically here one 10th of a point, right? And that is called sometimes a pipette, so from PIP and then the small version of that pipette.

So this whole five digits three are, you know, first three and the last two that is still kind of correct.

So the last two other points, but then we might now have in, in many currency pairs actually a more detailed way of quoting and that's no longer a point, that's the 10th of a point.

But anyway, forward points. What does that mean? We're quoting the number of points that we need to adjust the FX spot rate by in order to get to the forward rate.

Sounds unnecessary, complicated, but we're you know, there's a good reason as to why this has been decided.

But let's just go through an example.

So here what we see is we have 1.0950 because here's basically the question is what is the six months euro dollar outright forward bid? In other words, how do I interpret those 89.1? What is the actual exchange rate we're looking in with this forward contract.

So we need this spot because as I said, the 89.1 is basically the number of points we have to adjust the spot price by to get to the forward.

So we're starting with the spot price, we have the six months forward points on the bid.

So here we have the spot price, we have the forward points, and now we need to do an adjustment because it's also clear that we cannot just add 89 to 1.09. That would make the whole problem even worse.

But it's points. And now remember I told you that in the case of euro dollar, one point is 1 over 10,000 because we're talking about the four decimal point here, right? So basically to get from the spot and the forward points to the actual FX forward rate, we need to divide the six months forward points by 10,000 and then add that to the spot.

So this divided by 10,000, add that to the spot and you get the result of 1.10391.

And that would be the effective forward rate.

That means on a six months forward basis, if you agree on this, the FX rate that applies for the settlement in six months is not 1.0950, but it's 1.10391.

So far it's just mechanics, right? So we haven't talked about where these forward points are coming from.

It just, we quote forward points and that's basically something that we then, uh, have to adjust the spot rate by and there simple mechanics, it's basically depending on the quote of the currency, what's the value of one point we have to divide by 10,000.

Sometimes we also have to divide by 100.

If we're thinking about this side here dollar again, because there we said a point is basically the second decimal point, so it's one over 100.

So here the forward points would have to be divided by 100 and then added or subtracted because that's something that actually we haven't discussed yet.

Because we have, we'll just add it to the spot price, but how do we know that we have to add and not subtract? Well, in this case it's pretty clear.

That is, if the number is negative, you have to subtract.

If the number is positive, you have to add. And I think that's basically how most systems, nowadays are designed.

However, if that wasn't the case, if you have face a system where there is no plus minus then there's a trick that you can use to figure out if you have to, add or subtract.

And that is, if the left hand side points are bigger than the right hand side then you have to subtract if they are smaller than the right hand side, you have to add. So let's see if that holds, and we're looking at absolute numbers, you know, of course 89.1, 89.6 left hand smaller than right hand side.

So we need to add, if we're just kind of thinking about the absolute, now it's 426 to 425.

So that's left hand smaller sorry, larger than right hand side. That means we have to subtract. So just in case you have a face legacy tool there then you can help yourself out with that.

So that's a mechanics.

Now where do these forward points actually come from? And like any other derivative, I would suggest the starting point, well at least the delta one stuff, the, the linear ones.

The starting point is in no arbitrage principle, and we're not gonna go through this in a great amount of detail here, but just to that we have some sort of idea how this works.

No, arbitrage basically says if you have one or two or three ways or even more to achieve the exact same risk or the exact same status quo at a particular point in time, then the price of all these different alternatives must effectively be the same. Because if it wasn't, then you could buy the cheaper way and sell the more expensive way.

You're risk neutral and you have profits left and that inefficient markets shouldn't really be possible. That's a starting point, right? And this works in a decent fashion for, for, for for many products up to a certain point because market realities are somewhat different at times because there are transaction costs, there's different interest rates for funding and investing, et cetera. But as a starting point, it's a, it's a good, it's a good, concept to be aware of, right? So, how does that apply to fx? Now we could argue that, let's use a practical example.

You say, if we have an investor and they are looking to lock in the purchase price for a hundred million euros versus dollars six months forward, so they wanna buy 100 million euros and they wanna do this transaction in six months time because that's when they need them.

And, but they wanna know the price right now.

So how could they do this? Two alternatives immediately come to mind. The first one is just pick up the phone and trade an FX forward, right? So that's, uh, that's basically what we're talking about.

Just buy euros on a six months forward basis from some counterpart.

That's alternative one.

Alternative two is, well, don't do that, but you know, you can buy the euros now, right? You need them in six months, okay? Fair.

But you can still buy them right now because right now you do know where the FX spot rate is.

You know how many euros you get for a specific amount of dollars, vice versa, because that's where the FX spot rate comes in.

So you could buy the 100 million euros in the spot market right here, right now.

That means two days from now or business days from now, you get 100 million euros. You don't need them because you'd need them in six months. So as a rational human being, what are you going to do? You're gonna invest these hundred million euros over the next six months to get some interest income.

Now where you get the dollars from though, because in two days, not only do you get the euros, but you also have to deliver the dollars. And let's say you don't have the dollars, you get them in six months, right? So what do you need to do with this? You need to borrow them, and that means you borrow a certain amount of dollars and you pay interest. And that means the amount of dollars that you need to repay in six months time is larger than the amount of dollars that you get.

So basically what this all comes back to is now we can say that these two alternatives, in both cases, you will have a certain amount or you will have these 100 million dollars sorry, 100 million euros in six months time, and you know exactly how many dollars you paid for them.

That's the same risk. Well, that's the same outcome, right? That means that those two alternatives have to be the same price.

And so here the first one alternative, that was basically the Euro dollar, six months forward, right? The second alternative is again, you are getting euros and you invest them.

So that leads to a specific future value of the Euros in six months time.

And you borrow the dollars and you need to pay interest on that. That means in six months you have to repay a higher dollar amount. And the reason why dollar says at the top and euros at the bottom is simply because the currency pair is Euro versus dollars.

And remember, we wanna know the amount of dollars per Euro, so we're dividing by, uh, Euro.

So if you do the math and you use the interest rates that we've given to you here, it becomes a fairly straightforward exercise.

So it's a hundred. So if you want to buy 100 million right now in the spot market and we're just ignored bit offer now for simplicity, then you have to pay 109,500,000 dollars.

And that you pay an interest rate of five point something, over 182 days and you do get 3.75.

Well that was the interest rate level back then.

Then you can do the mass and you get to one ten three, nine, one, which was by, not by coincidence, but by design the forward rate. Now reality, as I said, is gonna be slightly different, but that goes beyond what we, what we cover today. But you generally see what drives FX forward prices because if we just put what we've just done into a formula, then this is how it looks.

You take the FX spot rate and then times 1 plus the interest of the quoted currency, which in our case is dollars.

And divided by 1 plus the base currencies interest, which is Euros.

And that will give you the FX forward rate, which now basically tells us that the only reason why FX forward and FX spot rates are different is because there often is an interest rate differential because if dollar interest rates, for example, is as now example, five in the ballpark of 5% and in euros is 3.7%, I'm just rounding here. Now, then clearly this expression here or this, this fraction is larger than one, right? And then we multiply the spot rate with something that's larger than the one. And so the FX forward rate will be higher.

It is one point 10, right? If this was a different way if it was the other way around, so we had a lower dollar rate, let's say 2% in dollars and 4% in euros, then this would be smaller than one, and then the FX spot rate would be multiplied with something below one that would make the forward rate lower.

And that of course has in some implications and where would love to talk about this.

But that goes beyond the purpose of today's session.

But you just sort of now know interest rate differentials a primary driver for those forward points.

And what's then left for us to discuss is the FX swap, where we're thinking, okay, spot plus a forward transaction.

Why would I generally do such a transaction? And I skipped this slide. It's, it's, it's I think hopefully very easy to read and understand if not, of course you know how to get in touch, let me know, happy to chat.

But what I wanted to run by you is really sort of like an application example, because that makes it then hopefully clear as to why these transactions are so popular.

And um, the fact is they are fairly important cash management tools.

So imagine you are running the treasury department of a large multinational corporation with many accounts and different currencies, and of course you wanna run your liquidity always in the right way. That means you wanna make sure you have a sufficient amount of liquidity so that when you need to make a payment, you have the money to pay.

But also you don't wanna have too much liquidity because liquidity is generally quite expensive in terms of it doesn't generate a lot of return, right? So you don't wanna have $10 billion just sitting idle on a current account and not generating any interest rate income, right? That doesn't feel right.

So, you try to manage your liquidity and you do cashflow forecasts, et cetera, et cetera.

And now let's say you are running this treasury department and your cash forecast show that over the next six months you have a significant surplus in euros.

And also over the next six months you have a shortfall in US dollars, but that's only a six months period over which this situation, is observable, right? So of course now what you could do is like, okay, I have euros that I don't need right now.

So why don't I sell them in the FX market, do a spot transaction, and I get a ton of dollars and I plug my funding hole in dollars with the euros.

That could be done. Nothing wrong with that.

The only point I would make here is that in six months you need to reverse this transaction because now you no longer have your Euro surplus and also you no longer have your dollar shortage, right? So you will then in six months do another spot transaction.

Again, nothing wrong with that.

The only problem potentially is that the currencies might have moved, right? So if you bought dollars, and what if the dollar has now weakened over the next six months and then you want to reverse this transaction, but you don't get the amount of Euros back that you need, right? So how could we approach that without taking now an FX risk here? We can simply at the time we enter into the spot transaction already agree the reversal of it, right? So that basically means we're buying the dollars that we need at spot, but because we only need them for six months, we're already agreeing to sell them back to our counterpart six months from now.

And we're investing then basically, or we're selling the euros that we don't need right now but we need them in six months.

So we're already agreeing to buy them back at the six months point as well. So what have we basically done? We have swapped a certain amount of currency temporarily from one currency into the other.

So we took our Euro surplus that we had for a limited period of time and exchanged it into dollars, but only for a limited period of six months because we only needed the dollars for six months.

And of course, now another way to address this would be, okay, just take the euros that you don't need and invest them in your bank account.

And at the other, you know, and borrow the dollars.

But you know, if you think about your own situation what's the interest that you get on your, you know, money in your, in your, in your checking account or in your current account? You know, I don't know. I can just speak for myself, but that's pretty much still zero, right? And if I borrow money I will, you know, for example, using a credit card or something, I pay a considerably higher interest rate.

Now I'm not saying for corporate it will be the exact same.

I'm just a retail unimportant retail client, so you know, won't get the best rates. But generally speaking you can see that there is gonna be some disadvantage, right? And if it was just a bit off spread, right? So the nice thing about the FX op is that the interest rates used here are sort of wholesale rates and therefore this is a very efficient way of managing liquidity across currency.

So there's other use cases as well. The previous slide talks about another one to roll the spot position, but at least I wanted to run this by you so that you have an understanding as to why the FX swap is such a significant tool, despite the fact that on the face of it doesn't really have a lot of foreign exchange exposure.

And that, ladies and gentlemen, is all I wanted to share with you here today.

I hope you found this beneficial. Thank you very much for your participation.

If you still have a question or something you know, let me know right now, use the Q&A function. Happy to chat for another couple of minutes.

Uh, if not, have a great rest of your Friday.

And, um, obviously, uh, a great weekend ahead.

Thanks once again. Hope to see you again soon and thanks for that feedback.

Appreciate it. Okay, have a great weekend guys.

And take care of yourself. Bye-bye.