Forex

19 September 2012
Foreign Exchange
The foreign exchange market ---------------------------------------------------- 3
Spot exchange rates ---------------------------------------------------------------- 6
How spot rates are quoted ---------------------------------------------------- 7
Reciprocal rates ------------------------------------------------------------------ 9
Some terminology-------------------------------------------------------------- 10
Profit and loss ------------------------------------------------------------------- 11
Position-keeping---------------------------------------------------------------- 13
Dealing and broking --------------------------------------------------------------- 16
Market-making ------------------------------------------------------------------ 16
Broking ---------------------------------------------------------------------------- 17
Electronic trading and broking ---------------------------------------------- 18
Dealing terminology --------------------------------------------------------------- 19
Cross-rates -------------------------------------------------------------------------- 21
Forward exchange rates --------------------------------------------------------- 26
Forward outrights -------------------------------------------------------------- 26
Forward swaps ----------------------------------------------------------------- 30
Discounts and premiums----------------------------------------------------- 33
A forward swap position---------------------------------------------------------- 37
Historic rate rollovers ------------------------------------------------------------- 46
Cross-rate forwards --------------------------------------------------------------- 49
Outrights -------------------------------------------------------------------------- 49
Swaps ----------------------------------------------------------------------------- 50
Short dates -------------------------------------------------------------------------- 53
Summary of calculation methods ---------------------------------------------- 58
Hedging a forward with deposits----------------------------------------------- 60
Disadvantages ------------------------------------------------------------------ 62
Covered interest arbitrage ------------------------------------------------------- 63
Summary of uses of forward FX instruments ------------------------------ 68
Hedging --------------------------------------------------------------------------- 68
Speculation ---------------------------------------------------------------------- 68
Arbitrage -------------------------------------------------------------------------- 68
Precious metals -------------------------------------------------------------------- 69
Pricing ----------------------------------------------------------------------------- 69
Physical delivery v book-entry ---------------------------------------------- 70
The gold fix ---------------------------------------------------------------------- 70
Borrowing gold and forward transactions ------------------------------- 71
Revision exercises----------------------------------------------------------------- 74
Answers ------------------------------------------------------------------------------ 86
All material in this training documentation is copyright of Markets International Ltd, Aylworth,
Naunton, Cheltenham, Glos GL54 3AH, United Kingdom. No reproduction, in whole or part, by
any means, is permitted without express permission in writing from Markets International Ltd.
2 Foreign Exchange - Part 1
19 September 2012
© Markets International Ltd. ACI Dealing Certificate

Foreign Exchange - Part 1 3
19 September 2012
The foreign exchange market
Throughout this chapter, we have generally used ISO codes (also

used by the SWIFT system) to abbreviate currency names. For the
Dealing Certificate exam, you should recognise the codes for the
currencies of the following countries, affiliated to the ACI:
ACI Dealing Certificate © Markets International Ltd

4 Foreign Exchange - Part 1
19 September 2012
Country Currency Code Country Currency Code

Argentina Peso ARS Macao Pataca MOP
Australia Dollar AUD Macedonia Denar MKD
Austria Euro EUR Malaysia Ringgitt MYR
Bahamas Dollar BSD Malta Euro EUR
Bahrain Dinar BHD Mauritius Rupee MUR
Belgium Euro EUR Mexico Peso Nuevo MXN
Bermuda Dollar BMD Monaco Euro EUR
Brazil Real BRL Mongolia Tugrik MNT
Bulgaria Lev BGN Netherlands Euro EUR
Canada Dollar CAD New Zealand Dollar NZD
China Renmimbi yuan CNY Nigeria Naira NGN
Croatia Kuna HRK Norway Krone NOK
Cyprus Euro EUR Pakistan Rupee PKR
Czech Republic Koruna CZK Panama Balboa PAB
Denmark Krone DKK Philippines Peso PHP
Egypt Pound EGP Poland Zloty PLN
Finland Euro EUR Portugal Euro EUR
France Euro EUR Romania Leu ROL
Georgia Lari GEL Russia Ruble RUB
Germany Euro EUR Singapore Dollar SGD
Great Britain & Pound GBP Serbia Dinar RSD
Channel Islands Slovakia Euro EUR
Greece Euro EUR Slovenia Euro EUR
Hong Kong Dollar HKD South Africa Rand ZAR
Hungary Forint HUF Spain Euro EUR
Iceland Krona ISK Sri Lanka Rupee LKR
India Rupee INR Sweden Krona SEK
Indonesia Rupiah IDR Switzerland Franc CHF
Irish Republic Euro EUR Tanzania Shilling TZS
Israel Shekel ILS Thailand Baht THB
Italy Euro EUR Tunisia Dinar TND
Japan Yen JPY United Arab Dirham AED
Jordan Dinar JOD Emirates
Kenya Shilling KES USA US dollar USD
Korea (South) Won KRW Zambia Kwacha ZMK
Kuwait Dinar KWD
Lebanon Pound LBP
Luxembourg Euro EUR

Foreign Exchange 5
19 September 2012
Base currency and variable currency

A convention has also been used that for example, the exchange rate
between USD and JPY is written as 'USD/JPY' if it refers to the
number of JPY equal to 1 USD and 'JPY/USD' if it refers to the
number of USD equal to 1 JPY. The currency code written on the left
is the 'base' currency; there is always 1 of the base unit. The
currency code written on the right is the 'variable' currency (or
'counter' currency or 'quoted' currency); the number of units of this
currency equal to 1 of the base currency varies according to the
exchange rate. Although some people do use the precisely opposite
convention, the one we use here is the more common one and is the
convention used in the ACI exam.
Key point
We always write the base currency on the left.

NOK/SGD, for example, means the number of SGD per NOK
Example 1
The CHF/DKK exchange rate is 4.1235. If I buy CHF 1 million
against DKK, how many DKK do I pay? The number 4.1235 means
the number of DKK per CHF. I therefore pay DKK 4,123,500:
1,000,000 x 4.1235 = 4,123, 500
If instead I buy DKK 1 million, how many CHF do I pay? In this case,
it is CHF 242,512.43:
1,000,000 ÷ 4.1235 = 242,512.43

6 Foreign Exchange
19 September 2012
Spot exchange rates
The basic transaction in the foreign exchange market is a ‘spot’ deal.

As we discussed in the ‘Money Markets’ chapter, a 'spot' transaction
is an outright purchase or sale of one currency for another currency,
for delivery two working days after the dealing date (the date on
which the contract is made). This allows time for the necessary
paperwork and cash transfers to be arranged.
Key point
‘Spot’ is value two working days after trade date
There are however some exceptions. For example, a price for

USD/CAD without qualification generally implies delivery on the next
working day after the dealing day. This is referred to as 'funds'. A
'spot' price (value two working days after the dealing day, as usual)
can generally be requested as an alternative.
Key point
USD/CAD is usually traded for value next day (‘funds’)
Another problem arises in trading Middle East currencies where the

relevant markets are closed on Friday but open on Saturday or
Sunday. A USD/AED spot deal on Wednesday would need to have a
split settlement date: the USD would be settled on Friday, but the
AED on Saturday.
If the spot date falls on a public holiday in one or both of the centres
of the two currencies involved, the following working day is taken as
the spot value date. If the intervening day (between today and spot)
is a holiday in one of the two centres, the spot value date is often also
delayed by one day.
Example 2
If a spot GBP/USD deal is transacted on Thursday 31 August, it
would normally be for value Monday 4 September. If this date is a
holiday in the UK however, it would normally be for value Tuesday 5
September.

Foreign Exchange 7
19 September 2012
How spot rates are quoted

When quoting against the EUR, it is the practice in the interbank
market to quote most currencies in terms a varying number of units of
currency per 1 EUR. In other words, the EUR is, by convention,
always the base currency if it is one of the two currencies involved.
Similarly, apart from the EUR, it is the interbank convention to quote
all currencies against GBP using GBP as the base currency. Apart
from the EUR and GBP, currencies quoted against the AUD and NZD
use the AUD and NZD as the base. Again, apart from the EUR, GBP,
AUD and NZD, all rates against the USD are always quoted interbank
with the USD as the base currency.
Next in this ‘hierarchy’ probably comes the CHF, which in most (but
not all) markets is quoted as the base currency against anything other
than the EUR, GBP, AUD, NZD and USD.
In the currency futures markets, as opposed to the interbank market,

quotations against the USD usually have USD as the variable
currency.
Although dealing is possible between any two convertible currencies

- for example, NZD against EUR or CHF against JPY - the
interbank market has historically quoted mostly against USD, so
reducing the number of individual rates that needed to be quoted.
The exchange rate between any two non-USD currencies could then
be calculated from the rate for each currency against USD. A rate
between any two currencies, neither of which is the USD, has
historically been known as a ‘cross-rate’. Nowadays, the term ‘cross-
rate is also used more widely to mean any exchange rate calculated
from two other rates - so, for example, a GBP/SEK rate could be
calculated by combining a EUR/GBP rate and a EUR/SEK rate.
Key point
A ‘cross-rate’ is an exchange rate calculated by combining two

other rates (historically, a non-USD rate calculated by
combining two USD-based rates).

8 Foreign Exchange
19 September 2012
The non-USD rates (for example EUR/GBP, EUR/JPY, EUR/CHF)

have increasingly been traded between banks in addition to the USD-
based rates. This sometimes reflects the importance of the
relationship between the pair of currencies. The economic
relationship between CHF and EUR, for example, is closer than the
relationship between CHF and USD. It is therefore more true
nowadays to say that the USD/CHF exchange rate is a function of the
EUR/USD rate and the EUR/CHF rate, rather than that the EUR/CHF
rate is a function of the EUR/USD rate and the USD/CHF rate. The
principle of calculating cross-rates remains the same however.
As in other markets, a bank normally quotes a two-way price,

whereby it indicates at what level it is prepared to buy the base
currency against the variable currency (the 'bid' for the base currency
- a cheaper rate), and at what level it is prepared to sell the base
currency against the variable currency (the 'offer' of the base currency
- a more expensive rate).
Example 3
If a bank is prepared to buy USD for 1.4375 Swiss francs, and sell
USD for 1.4385 Swiss francs, the USD/CHF rate would be quoted as:
1.4375 / 1.4385.
The quoting bank buys the base currency (in this case USD) on the
left and sells the base currency on the right. If the bank quotes such
a rate to a company or other counterparty, the counterparty would sell
the base currency on the left, and buy the base currency on the right
- the opposite of how the bank itself sees the deal.
In the money market, the order of quotation is not important and it

does differ between markets. From a quotation of either '5.80% /
5.85%' or '5.85% / 5.80%', it is always clear to the customer that the
higher rate is the offered rate and the lower rate is the bid rate. In
foreign exchange however, the market-maker's bid for the base
currency (the lower number in a spot price) is always on the left. This
is particularly important in forward prices.

Foreign Exchange 9
19 September 2012
The difference between the two sides of the quotation is known as the
'spread'. Historically, a two-way price in a cross-rate would have a
wider spread than a two-way price in a USD-based rate, because the
cross-rate constructed from the USD-based rates would combine
both the spreads. Now however, the spread in say a EUR/CHF price
might typically be proportionally narrower than a USD/CHF spread,
because it is more the EUR/CHF price that is 'driving' the market, as
noted above, rather than the USD/CHF price.
Key point
The ’bid’ is the price on the left, at which the quoting bank buys
the base currency.
The ‘offer’ is the price on the right, at which the quoting bank
sells the base currency.
The ‘spread’ is the difference between the bid and the offer.
In some markets, there is a convention to adjust exchange rates to a

number which that market considers more ‘user-friendly’. For
example, if the CHF/DKK exchange rate is 4.5278, it would be quoted
in the London market as ‘4.5278’ but might be quoted in the
Copenhagen market as ‘452.78’ - i.e. as the number of DKK equal to
100 CHF rather than 1 CHF. Similarly, a JPY/CHF rate of 0.014385
might be quoted in some markets as ‘1.4385’.
Exercises
1 The SGD/NOK exchange rate is quoted as 2.9584. Does this
exchange rate express the number of Norwegian kroner equal
to 1 Singapore dollar, or the number of Singapore dollars equal
to one Norwegian krone?
See ‘Answers’ at the end of this chapter
Reciprocal rates
Any quotation with a particular currency as the base currency can be
converted into the equivalent quotation with that currency as the
variable currency by taking its reciprocal.

10 Foreign Exchange
19 September 2012
Example 4
A USD/CHF quotation of 1.4375 / 1.4385 can be converted to a
CHF/USD quotation of (1 -: 1.4375) / (1 -: 1.4385). However, this
would still be quoted with a smaller number on the left, so that the two
sides of the quotation are reversed: 0.6952 / 0.6957. In either case,
the bank buys the base currency against the variable currency on the
left, and sells the base currency against the variable currency on the
right.
Exercises
2 The SEK/NOK exchange rate is 1.0523 / 28. What is the
reciprocal rate?
Some terminology
1
Rates are typically quoted to 100
th of a cent etc. (known as a 'point' or
a 'pip'). For example the USD/CHF rate would usually be quoted to
four decimal places as '1.4375 / 1.4385'. This depends on the size of
the number however and in the case of USD/JPY for example, the
convention is to use 2 decimal places. In a USD/JPY quote of
'105.05 / 105.15' for example, '15 points' means 0.15 JPY. In both
cases, one point is thus one unit of the last decimal place quoted.
Example 5
When trading USD/CHF in an amount of USD 1 million, the value of
one point is CHF 100. In other words, CHF 100 is the size of the
profit or loss made on the deal if the exchange rate moves one point:
1,000,000 x CHF 0.0001 = CHF 100
‘The points’ quoted generally mean the final two digits of the number.
All the digits before these last two digits are known as the ‘big figure’.
As the big figure does not change in the short term, dealers generally
do not quote it when dealing in the interbank market. In the example
above (1.4375 / 1.4385) the quotation would therefore be given as
simply as the points: '75 / 85'. However when dealers are quoting a
rate to a corporate client they will often mention the big figure also. In
this case, the quotation would be '1.4375 / 85'. One big figure means
100 points, so that if the rate moves from 1.4375 to 1.4475, it is said
to have moved by one big figure.

Foreign Exchange 11
19 September 2012
Key point
A ‘point’ is one unit of the last decimal place in the exchange

rate.
Exchange rates are typically quoted in ‘points’ or ‘pips’, usually
the last two decimal places.
The ‘big figure’ is the first part of the exchange rate, excluding
the points.
A change in the rate of ‘one big figure’ generally means a
change of ‘100 points’.
A ‘long’ position is a surplus of purchases over sales of a given

currency - i.e., a position which benefits from a strengthening of that
currency. Similarly, a ‘short’ position is a surplus of sales over
purchases of a given currency, which benefits from a weakening of
that currency. A ‘square’ position is one which is neither long nor
short - i.e. one in which the sales and purchases are equal.
A ‘yard’ of a currency is an American billion units of that currency (i.e.

1,000,000,000 units).
‘Cable’ is a nickname for the GBP/USD exchange rate.
If one party asks another for a two-way price and then chooses to
deal on the bid side of the price, he is said to ‘hit’ the bid. If he
chooses to deal on the offer side of the price, he is said to ‘lift’ the
offer.
Occasionally a dealer will narrow the bid / offer spread to zero - i.e.
he will quote a single price and the party asking for the price can
choose whether he will buy or sell at that price. This is known as a
‘choice’ price.
Profit and loss

To earn profit from dealing, the bank's objective is clearly to sell the
base currency at the highest rate it can against the variable currency
and buy the base currency at the lowest rate.

12 Foreign Exchange
19 September 2012
Example 6
Deal 1: Bank buys USD 1,000,000 against CHF at 1.4830
Deal 2: Bank sells USD 1,000,000 against CHF at 1.4855
Cashflows
USD CHF
Deal 1: + USD 1,000,000 - CHF 1,483,000
Deal 2: - USD 1,000,000 + CHF 1,485,500
Net result: + CHF 2,500
The value of a single point depends on the number of decimal places

in the exchange rate.
Example 7
I buy USD 1 million against CHF when spot USD/CHF is 1.5835.
Later in the day, I close my position by selling USD 1 million again
when spot USD/CHF is 1.5836. I thus have a profit of 1 point.
Cashflows
USD CHF
Deal 1: + USD 1,000,000 - CHF 1,583,500
Deal 2: - USD 1,000,000 + CHF 1,583,600
Net result: + CHF 100
Therefore the value of 1 point in USD/CHF, on a deal of USD 1

million, is CHF 100.
Example 8
I buy USD 1 million against JPY when spot USD/JPY is 118.35. Later
in the day, I close my position by selling USD 1 million again when
spot USD/JPY is 118.36. I thus have a profit of 1 point.
Cashflows
USD JPY
Deal 1: + USD 1,000,000 - JPY 118,350,000
Deal 2: - USD 1,000,000 + JPY 118,360,000
Net result: + JPY 10,000
Therefore the value of 1 point in USD/JPY, on a deal of USD 1

million, is JPY 10.000.

Foreign Exchange 13
19 September 2012
Dealers generally operate on the basis of small percentage profits but

large turnover. These rates will be good for large, round amounts.
For very large amounts, or for smaller amounts, a bank would
normally quote a wider spread. The amount for which a quotation is
'good' (that is, a valid quote on which the dealer will deal) will vary
with the currency concerned and market conditions.
Quoting a rate
When a dealer is asked for a quote, and he particularly wishes to buy
or sell himself, he will tend to adjust the price he is quoting, slightly up
or down from the prevailing market rate, in order to try to achieve his
desired result. For example if I wish to buy, then I might raise my bid
slightly. Then if the counterparty asking me for a price is a seller, he
will be attracted by my bid price rather than anyone else’s and sell to
me (which is what I want). At the same time, I might also raise my
offer slightly, because I do not wish him to lift my offer, because I do
not wish to sell. The result is that both my bid and my offer might be
slightly higher than the rates being quoted generally in the market.
Position-keeping
At any time, a dealer needs to know what is his position resulting from
the net of all the deals he has undertaken during the day so far. He
also needs to know what is the average exchange rate of this net
position, so that he can compare it with the current market rate to see
whether or not the position is profitable. At the end of the day, he
might not close out the position, but will in that case need to ‘mark to
market’ the position - i.e. calculate the unrealised profit or loss on
the position so far. This is achieved by calculating what the profit or
loss would be if he did in fact close out the position out at the current
rate (i.e. the end-of-day closing market rate).

14 Foreign Exchange
19 September 2012
Example 9
You undertake three spot deals in USD/CHF as follows.
Sell USD 4 million at 1.6723

Buy USD 1 million at 1.6732
Buy USD 5 million at 1.6729
The market closes at 1.6730.
What is your position? What is the average rate of this position?

What is your net profit or loss?
USD CHF
- 4,000,000 at 1.6723: + 6,689,200
+ 1,000,000 at 1.6732: - 1,673,200
+ 5,000,000 at 1.6729: - 8,364,500
Position: + 2,000,000 - 3,348,500
3 ,348 ,500
Average rate: = 1.67425
2 ,000 ,000
- 2,000,000 at 1.6730: + 3,346,000

Loss: - 2,500
The position is therefore long USD 2 million. The average rate is

1.67425. The loss is CHF 2,500. This loss could be expressed in
USD by converting it into USD at the spot rate, or in any other
currency by converting it at the appropriate spot rate.
Exercise
3 You are short EUR/CHF and need to square your position. On
which of the following prices quoted to you will you deal?
a. 1.5920 / 30
b. 1.5915 / 25
c. 1.5925 / 35
d. 1.5922 / 28

Foreign Exchange 15
19 September 2012
4 You are a dealer with a short position in USD against EUR. A

counterparty calls you for a price in EUR/USD. The market is
currently 0.9503 / 08. Which of the following prices might you
quote if you now wish to reduce the size of your position?
a. 0.9502 / 07
b. 0.9503 / 08
c. 0.9504 / 09
5 If the spot AUD/USD exchange rate is quoted as 0.5413, what

is the value of 1 ‘point’ on a deal of 1 million of the base
currency? If the spot USD/JPY exchange rate is quoted as
107.13, what is the cash value of 1 ‘point’ on a deal of 1 million
of the base currency?
6 Spot EUR/CHF is quoted to as 1.5318 / 23. You buy CHF

3,000,000. How many EUR do you sell?
7 You buy USD 10 million against CAD at 1.3785 and sell USD
10 million at 1.3779. What is your profit or loss in CAD?
8 You are a dealer. A customer asks you for a CHF/USD price.

You quote him 0.6330 / 38 and he buys CHF 5 million from you.
You want to cover this position in the market and therefore deal
on a price of USD/CHF 1.5783 / 88 quoted to you by another
bank, for exactly the same amount of CHF 5 million. What profit
or loss in USD have you made?
9 You sell EUR 5 million against USD at 0.9320, you buy EUR 2
million at 0.9325, you buy EUR 4 million at 0.9330 and you sell
EUR 3 million at 0.9327. The market closes at 0.9328 and the
closing rate for GBP/USD is 1.4730. At the end of the day,
what is your EUR/USD position? What is the average rate of
this position? What is your total net profit or loss in GBP?

16 Foreign Exchange
19 September 2012
Dealing and broking
Market-making
In any market, a market-maker is a dealer who sets out to ‘make a
market’ in some instrument or commodity - that is, he will quote a
two-way price in it, if asked to do so by someone else who wants to
buy or sell (or borrow or lend). In some markets, market-makers are
officially designated as such by the relevant authorities and are
obliged to make two-way prices at all times. This is not the case in
the foreign exchange markets. A dealer who considers himself a
market-maker in, say, GBP/USD, will try to quote a two-way
GBP/USD price all the time, but he might occasionally choose not to
quote or to quote only a bid or only an offer. As well as giving quotes,
a market-maker also asks other banks for quotes.
The market-maker seeks to make a profit from the bid/offer spread

that he quotes. If he quotes the same two-way price to two different
customers, and each customer deals for the same amount but on a
different side of the price, the market-maker profits by the spread. In
practice of course, customers will not be paired tidily like this but, over
time, the market maker nevertheless hopes to earn a profit in this way
on average.
By providing prices to the market, the market-maker hopes that many

counterparties will deal with him, thereby providing him in return with
information on who is buying and who is selling. These information
flows help the market-maker to decide on the likely direction of the
market, which in turn helps him in his position-taking. Being ready to
quote prices also helps the bank in maintaining its relationships
generally with its counterparties.
The risk of course is that the market moves against him after a
customer has dealt. The market-maker could remove that risk by
always covering his own resulting position immediately. However, if
he did that, he would make no profit because he would be dealing at
a similar price with another bank. Also, it might not be possible for
the market-maker to cover the position quickly enough, before the
market has moved against him, so that he actually makes a loss,
rather then just breaks even.

Foreign Exchange 17
19 September 2012
It might also be the case that the position given to the market-maker
by the customer is one which the market-make likes, so that he seeks
to make profit by running the position for a time. The risk here of
course, as always with a speculative position, is that the market-
maker might be wrong in his view of the market.
Note that in all this, the ‘customer’ might himself also be a bank, and
possibly a market-maker. He is considered the customer here
because he is the one asking for the price, rather than the one
quoting it. He is the ‘price-taker’, rather than the ‘price-maker’. This
party, which deals at another bank’s price, is known as the
‘aggressor’.
Broking
A deal is undertaken between two counterparties. Each counterparty
then has a position and is known as a ‘principal’ in the transaction. It
is possible that the deal is arranged through a third party agent,
known as a ‘broker’. In the foreign exchange and money markets, a
broker is a ‘name-passing’ broker. This means that he is never a
principal himself in the chain of transactions, but only passes the
names of the two counterparties (the principals) to each other. The
function of a broker is to aid the process of price discovery in the
market, to disseminate these prices, and to match buyers with sellers.
Market-makers keep the broker aware of their bid/offer prices. When

a customer calls the broker, he will select the best bid currently given
to him by a market-maker, and also the best offer currently given to
him by a market-maker, and pass this resulting bid/offer to the
customer. If the customer deals on one side or the other, the broker
immediately tells whichever market-maker gave him that price. That
market-maker has now dealt with the customer. The broker is only
acting as a go-between in this - at no point in the process is he
acting as principal himself. In return for this service, the dealing
parties pays the broker a commission (‘brokerage’) for each deal
transacted.
Until the deal has been finalised, the broker maintains confidentiality.
He does not pass the name of either party to the other until he is
satisfied that they intend to deal, subject to each having a sufficient
credit line for the other.

18 Foreign Exchange
19 September 2012
In some markets other than those we are discussing here (for

example in the futures markets), the term ‘broker’ applies to someone
who does take a position as principal, at least for a short time.
Electronic trading and broking

We have so far been implying that the market-maker, the broker and
the customer are all speaking to each other, probably by telephone.
The broker in such a situation is known as a ’voice-broker’.
Increasingly however, dealing and broking is carried out

electronically. An electronic broker, such as EBS, is a computer
system into which market-makers feed prices. The system
disseminates the best bid and offer prices to users in the same way
that a voice-broker does. Counterparties who have access to the
system are able to deal on these prices. The identity of each of the
counterparties is not revealed to the other until the deal is done. The
system requires information regarding the credit lines that each of the
participants has for each of the others.
With voice brokers, in both FX and deposit transactions, it is typical

for each party to pay brokerage to the broker, at a rate which has
been negotiated individually for all such business between that bank
and the broker. With Reuters and EBS, it is only the aggressor who
pays the brokerage.
An automated trading system (ATS) is similarly an electronic system

through which dealers can communicate with each other, as an
alternative to dealing over the telephone. This is often a dedicated
system belonging to a particular bank, for dealing with its own
customers. An on-line trading system such as FXall is an ATS
allowing end-users the ability to deal via the internet with any of a
group of participating banks.

Foreign Exchange 19
19 September 2012
Dealing terminology
The following remarks all relate to the spot foreign exchange market.
We have included a similar section at the end of the Money Markets
chapter. Where the terminology is the same in the two areas, we
have repeated it.
In all the following situations, the ‘customer’ is the party initiating the
conversation - i.e. the party asking the other party to quote a price for
a foreign exchange deal. This customer might be another bank, or a
corporate or other organisation. The two parties might be dealing via
a broker.
• Unless otherwise specified, there is a general understanding

in the market that the parties are discussing buying and selling
the base currency (rather then the variable currency) and that
amounts are in millions. For example, “I buy five” would mean
“I buy 5 million of the base currency and sell an amount of the
variable currency in exchange”.
• If the quoting dealer says “I bid …” or “I pay …”, he means

that he would like to buy the base currency at a certain price.
• If the quoting dealer says “I offer at …”, he means that he

would like to sell the base currency at a certain price
• If the quoting dealer says “Either way”, “Choice” or “Your

choice”, he means that he is quoting the same price for both
bid and offer.
• “Firm” or “Firm price” means that the price quoted is valid and
can be traded on.
• “For indication”, “Indication”, “For information” or “For level”

however means that the quote given is only indicative and
should be confirmed before a trade is proposed.
• If the broker says that a quote is “under reference”, he means

that the rate quoted might no longer be valid and must be
confirmed before any trades can be agreed.

20 Foreign Exchange
19 September 2012
• If the quoting dealer says “Your risk”, he is warning the other

party (the broker or the customer) that the price may have to
be re-quoted.
• If the broker or the customer says “My risk”, he is

acknowledging that the price may have to be re-quoted.
• If the quoting dealer says “Off”, he is cancelling any existing

bids or offers he has quoted, with immediate effect.
• If the quoting dealer says “Checking”, he means that he is

checking that he has a credit line available for the customer
before he can agree the deal.
• If the customer or the broker says “Mine” or “I buy” or “I take”,

this means that he accepts the other party’s quote and wishes
to buy the base currency at the offered rate for the amount
proposed. For example if one dealer wishes to buy USD 5
million from another who is quoting him a USD/CHF price, he
will say "5 mine"; this means "I wish to buy from you 5 million
of the base currency and sell the other currency, at your
offered price". Similarly, if he wishes to sell USD 5 million, he
will say "5 yours", meaning "I wish to sell you 5 million of the
base currency and buy the other currency, at your bid price".
Key point
“5 mine” said by the price-taker means he wishes to buy 5

million units of the base currency.
“5 yours” means he wishes to sell 5 million units of the base
currency.
• If the customer or the broker says “Yours” or “I sell” or “I give”,

this means that he accepts the quote and wishes to sell the
base currency at the bid rate for the amount proposed.
• Similarly, “Given” means that a deal has been proposed and

agreed at the bid price quoted, and “Taken” means that a deal
has been proposed and agreed at the offered price quoted.
• “Done” means that the deal is agreed as proposed.

Foreign Exchange 21
19 September 2012
Cross-rates
As mentioned earlier, if the EUR is involved in an exchange rate, it is

generally the base currency. Apart from that, if GBP, the AUD, NZD
or USD are involved, they would generally be base currency. In other
cases, there is not a universal convention for which way round to
quote a cross-rate - that is, which is the base currency and which
the variable currency. If a rate between CHF and NOK is requested
'in NOK terms' for example, this would generally mean that NOK is
the base and CHF the variable.
Example 10
Suppose that we need to quote to a counterparty a spot rate between
the Canadian dollar and the Singapore dollar, and that our bank does
not have a CAD/SGD trading book. The rate must therefore be
constructed from the prices quoted by our bank's USD/CAD dealer
and our bank's USD/SGD dealer as follows:
Spot USD/CAD: 1.4874 / 1.4879
Spot USD/SGD: 1.6782 / 1.6792
Consider first the left side of the final CAD/SGD price we are
constructing. This is the price at which our bank will buy CAD (the
base currency) and sell SGD. We must therefore ask: at which price
(1.4874 or 1.4879) does our USD/CAD dealer buy CAD against USD,
and at which price (1.6782 or 1.6792) does our USD/SGD dealer sell
SGD against USD? The answers are 1.4879 (on the right) and
1.6782 (on the left) respectively. Effectively, by dealing at these
prices, our bank is both selling USD (against CAD) and buying USD
(against SGD) simultaneously, with a net zero effect in USD. If we
now consider the right side of the final CAD/SGD price we are
constructing, this will come from selling CAD against USD (on the left
at 1.4874) and buying SGD against USD (on the right at 1.6792).
Finally, since each 1 USD is worth 1.48 CAD and also 1.67 SGD, the
CAD/SGD exchange rate must be the ratio between these two:
1.6782 ÷ 1.4879 = 1.1279
is how the bank sells SGD and buys CAD
1.6792 ÷ 1.4874 = 1.1289
is how the bank buys SGD and sells CAD
Therefore the spot CAD/SGD rate is: 1.1279 / 1.1289

22 Foreign Exchange
19 September 2012
In summary therefore, to calculate a spot rate from two other rates

which share the same base currency (in our example this was USD),
divide opposite sides of the exchange rates. Following the same
logic shows that to calculate a spot rate from two other rates which
share the same variable currency (also USD in the following
example), we again need to divide opposite sides of the exchange
rates:
Example 11
Spot EUR/USD: 1.2166 / 1.2171
Spot AUD/USD: 0.6834 / 0.6839
The EUR/USD dealer buys EUR and sells USD at 1.2166 (on the
left). The AUD/USD dealer sells AUD and buys USD at 0.6839 (on
the right). Therefore:
1.2166 ÷ 0.6839 = 1.7789
is how the bank buys EUR and sells AUD
Similarly:
1.2171 ÷ 0.6834 = 1.7809
is how the bank sells EUR and buys AUD
Therefore the spot EUR/AUD rate is: 1.7789 / 1.7809
Finally, to calculate a rate from two rates where the common currency
is the base currency in one quotation but the variable currency in the
other, following the same logic through again shows that we multiply
the same sides of the exchange rates:

Foreign Exchange 23
19 September 2012
Example 12
Spot EUR/USD: 1.2166 / 1.2171
Spot USD/SGD: 1.6782 / 1.6792
The EUR/USD dealer buys EUR and sells USD at 1.2166 (on the
left). The USD/SGD dealer buys USD and sells SGD at 1.6782 (on
the left). Also, since each 1 EUR is worth 1.21 USD, and each of
these USD is worth 1.67 SGD, the EUR/SGD exchange rate must be
the product of these two numbers.
Therefore:
1.2166 x 1.6782 = 2.0417
is how the bank buys EUR and sells SGD
Similarly:
1.2171 x 1.6792 = 2.0438
is how the bank sells EUR and buys SGD
Therefore the spot EUR/SGD rate is: 2.0417 / 2.0438
Calculation Summary
To calculate an exchange rate from two other rates:
from two rates with the same base currency or the same
variable currency:
divide opposite sides of the exchange rates
from two rates where the base currency in one is the same as
the variable currency in the other:
multiply the same sides of the exchange rates
The examples above all construct cross-rates from exchange rates

involving the USD (which is often the case). The same approach
applies when constructing other rates: considering the way in which
each of the two separate dealers will deal to create the rate, gives the
construction:

24 Foreign Exchange
19 September 2012
Example 13
Spot EUR/GBP 0.7374 / 0.7379
Spot GBP/CHF 2.1702 / 2.1707
Spot GBP/JPY 192.70 / 193.00
(i) To construct spot CHF/JPY:

192.70 ÷ 2.1707 = 88.77
is how the bank buys CHF and sells JPY
193.00 ÷ 2.1702 = 88.93
is how the bank sells CHF and buys JPY
Therefore the spot CHF/JPY rate is: 88.77 / 88.93
(ii) To construct the spot JPY/CHF:

2.1702 ÷ 193.00 = 0.011245
is how the bank buys JPY and sells CHF
2.1707 ÷ 192.70 = 0.011265
is how the bank sells JPY and buys CHF
Therefore the spot JPY/CHF rate is 0.011245 / 0.011265
(iii) To construct spot EUR/CHF:

0.7374 x 2.1702 = 1.6003
is how the bank buys EUR and sells CHF
0.7379 x 2.1707 = 1.6018
is how the bank sells EUR and buys CHF
Therefore the spot EUR/CHF rate is: 1.6003 / 1.6018
(iv) To construct spot CHF/EUR, take the reciprocal of the EUR/CHF:

1 ÷ (0.7379 x 2.1707) = 0.6243
is how the bank buys CHF and sells EUR
1 ÷ (0.7374 x 2.1702) = 0.6249
is how the bank sells CHF and buys EUR
Therefore the spot CHF/EUR rate is 0.6243 / 0.6249

Foreign Exchange 25
19 September 2012
The construction of one exchange rate from two others in this way
can be seen as follows:
Calculation Summary
Given two exchange rates A/B and A/C, the cross-rates are:
B/C = A/C ÷ A/B

and B/C = B/A ÷ C/A
Given two exchange rates B/A and A/C, the cross-rates are:
B/C = B/A x A/C

and B/C = 1 ÷ C/B = 1 ÷ (C/A x A/B)
When dividing, use opposite sides.

When multiplying, use the same sides.
Exercise
10 You are a dealer and a counterparty asks you for you price in
EUR/USD. You quote “0.9503 / 08” and the counterparty
replies “5 yours”. What have you sold or bought, how much,
and at what rate?
11 Current spot rates are as follows:
USD/CHF 1.5384/89
USD/SGD 2.3895/05
EUR/USD 0.9678/83
AUD/USD 0.5438/43
a. What is the two-way price for CHF/SGD? On which side of

this price would the customer sell SGD?
b. What is the two-way price for EUR/AUD? On which side of
this price would the customer buy EUR?
c. What is the two-way price for EUR/CHF? On which side of
this price would the customer buy CHF?
d. What is the two-way price for CHF/AUD? On which side of
this price would the customer sell CHF?

26 Foreign Exchange
19 September 2012
Forward exchange rates
Forward outrights
Although 'spot' is settled two days in the future, it is not considered in
the foreign exchange market as 'future' or 'forward', but as the
baseline from which all other dates (earlier or later) are considered.
A 'forward outright' is an outright purchase or sale of one currency in

exchange for another currency for settlement on a fixed date in the
future other than the spot value date. Rates are quoted in a similar
way to those in the spot market, with the quoting bank buying the
base currency 'low' (on the left side) and selling it 'high' (on the right
side). In some emerging markets, forward outrights are non-
deliverable and are settled in cash against the spot rate at maturity as
a contract for differences (see later).
Example 14
The spot EUR/USD rate is 1.2166 / 1.2171, but the rate for value one
month after the spot value date is 1.2186 / 1.2193.
The 'spread' (the difference between the bank's buying price and the
bank's selling price) is wider in the forward quotation than in the spot
quotation. Also, in this example, the EUR is worth more in the future
than at the spot date. EUR 1 buys USD 1.2186 in one month's time
as opposed to 1.2166 at present. In a different example, the EUR
might be worth less in the future than at the spot date.
The forward outright rate can be seen both as the market's

assessment of where the spot rate will be in the future and as a
reflection of current interest rates in the two currencies concerned.
Consider for example the following 'round trip' transactions, all

undertaken simultaneously:
(i) Borrow USD for 3 months starting from spot value date.
(ii) Sell USD and buy EUR for value spot.
(iii) Deposit the purchased EUR for 3 months starting from spot
value date.
(iv) Sell forward now the EUR principal and interest which mature
in 3 months' time, into USD.

Foreign Exchange 27
19 September 2012
In general, the market will adjust the forward price for (iv) so that
these simultaneous transactions generate neither a profit nor a loss.
This is the theory of ‘interest rate parity’. When the four rates
involved are not in line (USD interest rate, EUR/USD spot rate, EUR
interest rate and EUR/USD forward rate), there is in fact opportunity
for arbitrage - making a profit by round-tripping. That is, either the
transactions as shown above will produce a profit or exactly the
reverse transactions (borrow EUR, sell EUR spot, deposit USD and
sell USD forward) will produce a profit. The supply and demand
effect of this arbitrage activity is such as to move the rates back into
line. If in fact this results in a forward rate which is out of line with the
market's 'average' view, supply and demand pressure will tend to
move the spot rate or the interest rates until this is no longer the case.
In more detail, the transactions might be as follows:
(i) Borrow USD 100

The principal and interest payment at maturity will be:
  days  
USD 100 ×  1 +  variable currency interest rate × 
  360  
(ii) Sell USD 100 for EUR at spot rate to give EUR (100 -: spot)
(iii) Invest EUR (100 :- spot).

The principal and interest returned at maturity will be:
  days  
EUR (100 ÷ spot ) × 1 +  base currency interest rate × 
  360  
(iv) Sell forward this last amount at the forward exchange rate to
give:
  days  
USD (100 ÷ spot ) × 1 +  base currency interest rate × 
  360  
× forward outright
The supply and demand effect of’ arbitrage’ activity (i.e. round-
tripping deliberately, to make a profit out of the fact that the rates are
not all in line with each other) will tend to make the amount in (iv) the
same amount as that in (i), so that:

28 Foreign Exchange
19 September 2012
(1 + (var iable currency interest rate × )) days

forward outright = spot ×
(1 + (base currency interest rate × )
360
days
360
Calculation Summary
Interest rate parity
forward outright =
(1 + (var iable currency int erest rate × ))

days
year
spot ×
(1 + (base currency interest rate × ))
days
year
You will need this formula for the exam. On the ACI formula
sheets provided in the exam, it appears as follows. Check
now that you can find it and understand how to use it.
interest rate quoted currency x day count

1+
annual basis quoted currency
forward rate = spot rate
interest rate base currency x day count
1+
annual basisbase currency
Notice that the length of the year may be 360 or 365, and might be
different for the two currencies.
Example 15
31-day USD interest rate: 5%
31-day EUR interest rate: 3%
Spot EUR/USD rate: 1.2168
= 1.2168 ×
(1 + (0.05 × 360
31 ))
(1 + (0.03 × 360 )) = 1.2189

Then forward outright 31

Foreign Exchange 29
19 September 2012
In theory, to calculate the right-hand side of the outright price (where

the bank sells EUR to the customer against USD for outright value
one month forward as in the above example), one could use:
• the right-hand side of the spot price (the offer)
• the offered interest rate for USD and
• the bid interest rate for EUR.
One could then use the bid price for the spot, the bid interest rate for
USD and the offered interest rate for EUR to determine the other side
of the outright price. For the purpose of the ACI exam, this would be
expected.
Note however, that this generally produces a rather large spread. It

would be more realistic to use middle prices throughout, to calculate a
middle price for the outright, and then to spread the two-way outright
price around this middle price. In practice, a dealer does not
recalculate outright prices continually in any case, but takes them
from the market just as the spot dealer takes spot prices.
Example 16
31-day USD interest rate: 4.9 / 5.0%
31-day EUR interest rate: 3.0 / 3.1%
Spot EUR/USD rate: 1.2158 / 68
Using the offered interest rate for USD and the bid interest rate for
EUR:
forward outright = 1.2168 ×

(1 + (0.05 × 360
31 ))
(1 + (0.03 × 360
31
)) = 1.2189
Using the bid interest rate for USD and the offered interest rate for
EUR:
(1 + (0.049 × 360
31
))
forward outright = 1.2158 × = 1.2177
(1 + (0.031 × 360 ))
31
The outright price is therefore 1.2177 / 1.2189.

30 Foreign Exchange
19 September 2012
Forward swaps
Although forward outrights are an important instrument, trading banks
do not in practice deal between themselves in forward outrights, but
rather in forward 'swaps', where a forward swap is the difference
between the spot and the forward outright. The reason for not
dealing in outrights will become clear later. The forward outright rate
can therefore be seen as a combination of the current spot rate and
the forward swap rate (which may be positive or negative) added
together.
Key point
forward outright = spot + forward swap
Example 17
Spot EUR/USD: 1.2166 / 1.2171
Forward swap: 0.0145 / 0.0150
Forward outright = spot + swap
In this case: 1.2166 + 0.0145 = 1.2311

1.2171 + 0.0150 = 1.2321
Therefore the forward outright is 1.2311 / 1.2321
Putting this the other way round, it is equally true that:
Key point
forward swap = forward outright - spot
Example 18
Spot EUR/USD: 1.2166 / 1.2171
Forward outright: 1.2311 / 1.2321
forward swap = forward outright - spot
In this case: 1.2311 - 1.2166 = 0.0145

1.2321 - 1.2171 = 0.0150
Therefore the forward swap is 0.0145 / 0.0150

Foreign Exchange 31
19 September 2012
In the previous section, we saw that:

(1 + (var iable currency int erest rate × )) days
year
forward outright = spot ×
(1 + (base currency interest rate × )) days
year
Since we know that:

forward swap = forward outright - spot,
it follows that:
Calculation Summary
forward swap =
spot ×
((var iable currency int erest rate × ) − (base currency interest rate × ))
days days
(1 + (base currency interest rate × ))

year year
days
year
You might find this formula useful. It is not on the ACI

formula sheets provided in the exam, so remember it!
As before, the length of each year may be 360 or 365 days.
Swap prices are generally quoted so that the last digit of the price
coincides with the same decimal place as the last digit of the spot
price. For example, if the spot price is quoted to four decimal places
(1.2166) and the swap price is "20 points", this means "0.0020".
If the year basis is the same for the two currencies and the number of
days is sufficiently small (so that the denominator in the swap points
formula is close to 1), the following approximation holds:
Calculation Summary
Approximation
days
forward swap ≈ spot × interest rate differential ×
year

32 Foreign Exchange
19 September 2012
Example 19
31-day USD interest rate: 5%
31-day EUR interest rate: 3%
forward swap = 1.2168 ×

(( 31 ) − (0.03 × 31 ))
0.05 × 360 360
(1 + (0.03 × 360 ))
31
= 0.0021 or + 21 points
Approximate swap = 1.2168 × (+ 0.02 ) × (

31
) = +21 points
360
The following example shows that the approximation is generally not

accurate enough for longer periods. It also becomes less accurate as
the base currency interest rate increases.
Example 20
1-year USD interest rate: 5%
1-year EUR interest rate: 3%
((0.05 × 365 ) − (0.03 × 365 ))

Forward swap = 1.2168 × 360 360
(1 + (0.03 × 365
360
))
= + 0.0239 or + 239 points
Approximate swap = 1.2168 × (+ 0.02 ) ×

365
= +247 points
360
Exercises
12 What is the theoretical 6-month outright price for EUR/USD,
based on the following rates? The 6-month period is 181 days.
EUR/USD spot: 1.2120

EUR 6-month interest rate: 3.20%
USD 6-month interest rate: 4.70%
13 What is the theoretical two-way 3-month swap price for

USD/CHF, based on the following borrowing and lending rates?
The 3-month period is 92 days.
USD/CHF spot: 1.7120 / 26,

USD 3-month interest rate: 5.10 / 5.20%
CHF 3-month interest rate: 2.70 / 2.80%

Foreign Exchange 33
19 September 2012
14 The Eurosterling interest rate for one year (a period of exactly

365 days) is 5.9 / 6.0%. The EuroSwiss franc interest rate for
the same period is 3.0 / 3.1%. The spot rate today is GBP/CHF
2.1580 / 90. What is the theoretical two-sided GBP/CHF
forward outright price for one year forward?
Discounts and premiums

It can be seen from the formulas given above that when the base
currency interest rate is lower than the variable currency rate, the
forward outright exchange rate is always greater than the spot rate.
That is, the base currency is worth more forward units of the variable
currency forward than it is spot. This can be seen as compensating
for the lower interest rate: if I deposit money in the base currency
rather than the variable currency, I will receive less interest.
However, if I sell forward the maturing deposit amount, the forward
exchange rate is correspondingly better. In this case, the base
currency is said to be at a 'premium' to the variable currency, and the
forward swap price must be positive.
The reverse also follows. In general, given two currencies, the

currency with the higher interest rate is at a 'discount' (worth fewer
units of the other currency forward than spot) and the currency with
the lower interest rate is at a 'premium' (worth more units of the other
currency forward than spot). When the variable currency is at a
premium to the base currency, the forward swap points are negative;
when the variable currency is at a discount to the base currency, the
forward swap points are positive.
When the swap points are positive, and the forward dealer applies a
bid/offer spread to make a two-way swap price, the left price is
smaller than the right price as usual. When the swap points are
negative, he must similarly quote a "more negative" number on the
left and a "more positive" number on the right in order to make a
profit. However, the minus sign " - " is generally not shown. The
result is that the larger number appears to be on the left. As a result,
whenever the swap price appears larger on the left than the right, it is
in fact negative, and must be subtracted from the spot rate rather
than added.

34 Foreign Exchange
19 September 2012
Key point
The currency with the higher interest rate is worth less forward
than spot in terms of the other currency and is said to be at a
forward ‘discount’. If it is the base currency, the forward points
are negative and appear to be quoted ‘high’ to ‘low’.
The currency with the lower interest rate is worth more forward
than spot in terms of the other currency and is said to be at a
forward ‘premium’. If it is the base currency, the forward points
are positive and are quoted ‘low’ to ‘high’.
Example 21
German interest rate: 3%
US interest rate: 5%
EUR is at a premium to USD
USD is at a discount to EUR
Forward swap points are positive
Example 22
The EUR is at a premium to the USD, and the swap rate is quoted as
20 / 22.
Spot EUR/USD: 1.2166 / 71

1-month swap 20 / 22
1-month outright: 1.2186 / 1.2193
The spot EUR will purchase USD 1.2166; the forward EUR will
purchase USD 1.2186. The EUR is therefore worth more in the
future, and is thus at a forward premium.
Example 23
Spot EUR/JPY: 144.25 / 144.30
1-month swap: 2.30 / 2.20
1-month outright: 141.95 / 142.10
The spot EUR will purchase JPY 144.25; the forward EUR will
purchase JPY 141.95. The EUR is therefore worth less in the future
and is thus at a forward discount.

Foreign Exchange 35
19 September 2012
If a forward swap price includes the word 'par' it means that the spot
rate and the forward outright rate are the same: 'par' in this case
represents zero. 'A/P' is 'around par', meaning that the left-hand side
of the swap must be subtracted from spot and the right-hand side
added. This happens when the two interest rates are the same or
very similar.
Example 24
Spot USD/CAD: 1.4695 / 00
1-year swap: 6/ 4 A/P
Forward outright: 1.4689 / 1.4704
This is often written -6 / +4, which means the same as 6 / 4 A/P but
indicates more clearly how the outrights are calculated.
Beware!
Terminology
It is important to be careful about the terminology regarding
premiums and discounts. The clearest terminology for example
is to say that "the EUR is at a premium to the USD" or that "the
USD is at a discount to the EUR "; there is then no ambiguity. If
however a dealer says that "the EUR/USD is at a discount",
then what he means depends on where he is! In the UK market,
he generally means that the variable currency, USD, is at a
discount and that the swap points are to be added to the spot.
Similarly, if he says that "the GBP/JPY is at a premium", he
means that the variable currency, JPY, is at a premium and that
the points are to be subtracted from the spot. In other countries
however, he would mean the opposite.
Covering an outright position

When a trading bank quotes a forward outright price to a customer, it
has constructed the price from a spot price (which represents the FX
element of the price) and a forward swap price (which represents the
interest rate differential). Of these two, it is the spot price which is the
more volatile. If the customer deals on the price quoted, and the
bank wishes to cover the position by undertaking a spot deal and a
forward swap deal with other banks, it is therefore the spot which
must be covered urgently.

36 Foreign Exchange
19 September 2012
Quoting a forward outright

Typically, when a corporate customer asks for a forward outright, the
bank quotes simply the outright rate. If the customer asking for a
forward outright price is another bank however, the bank quoting will
often give the two component parts of the price - the forward swap
points and the spot.
Exercises
15 Given the following rates, what would be the two-way quote for
a 1-month USD/CHF forward outright?
USD/CHF spot: 1.7410 / 20

l month: 123 / 126
a. 1.7536 / 1.7543
b. 1.7284 / 1.7297
c. 1.7287 / 1.7294
d. 1.7533 / 1.7546
16 A client wishes to sell USD against GBP 3 months forward. The

spot rate is 1.4340 / 1.4350 and the forward points are 72 / 68.
At what outright rate will the client deal?
a. 1.4282
b. 1.4268
c. 1.4412
d. 1.4418
17 USD and EUR 3-month rates are the same. The USD yield
curve is more negative than the EUR curve.
a. The 1-month EUR/USD forward points are negative.

b. The 1-month EUR/USD forward points are positive.
c. The 1-month EUR/USD forward points are at par.
d. There is not enough information to tell.
18 The swap points for 3 months (92 days) are -173 and the swap
points for 4 months (124 days) are -221. Assuming straight-line
interpolation, what are the points for 98 days?

Foreign Exchange 37
19 September 2012
A forward swap position
In order to see why a bank trades in forward swaps rather than

forward outrights, consider how the following swap and outright rates
change as the spot rate and interest rates move:
spot EUR USD 31-day 31-day

rate interest interest forward forward
rate rate outright swap
1.2168 3.0% 5.0% 1.2189 + 0.0021
1.2268 3.0% 5.0% 1.2289 + 0.0021
1.2268 3.5% 5.0% 1.2284 + 0.0016
A movement of 100 points in the exchange rate from 1.2168 to

1.2268 has not affected the forward swap price (to 4 decimal places).
A change in the interest rate differential from 2.0% to 1.5% however
has changed it significantly. Essentially, a forward swap is an interest
rate instrument rather than a currency instrument; when banks take
forward positions, they are taking an interest rate view rather than a
currency view. If bank dealers traded outrights, they would be
combining two related but different markets in one deal, which is less
satisfactory.
Key point
A forward FX swap price represents the interest rate differential

between the two currencies.
The table above suggests that the forward rate is unaffected by a

change in the spot rate. In fact, it is affected, but only to a relatively
small extent. The effect can be significant, however, with a large
change in the spot rate, and the effect is more significant for longer-
dated forwards than for shorter-dated ones, and also when the
interest rate differential between the currencies is greater.
The forward swap deal itself is an exchange of one currency for

another currency on one date, to be reversed on a given future date.
Thus for example when the bank sells EUR outright to a counterparty,
it may be seen as doing the following:

38 Foreign Exchange
19 September 2012
spot deal: Bank's spot dealer sells EUR spot
forward swap deal:

.
{ Bank's forward dealer buys EUR spot
Bank's forward dealer sells EUR forward
net effect: Bank sells EUR forward outright
Therefore on a EUR/USD 1-month forward swap quote of 20 / 22, the

bank quoting the price does the following:
20 / 22
sells EUR spot buys EUR spot
buys EUR forward sells EUR forward
A forward foreign exchange swap is therefore a temporary purchase

or sale of one currency against another. An equivalent effect could
be achieved by borrowing one currency for a given period, while
lending the other currency for the same period. This is an extremely
important relationship and is why the swap rate formula reflects the
interest rate differential (generally based on Eurocurrency interest
rates rather than domestic interest rates) between the two currencies,
converted into foreign exchange terms.
Although only one single price is dealt (the swap price), the
transaction has two separate settlements:
(i) a settlement on the spot value date

(ii) a settlement on the forward value date
The dealer always ‘buys and sells’ (meaning that he buys for value on
the near date, spot and simultaneously agrees to sell again for value
on the far date) or he ‘sells and buys’ (the reverse).
Key point
A forward swap deal always involves settlements on two dates:

it is always a ‘buy and sell’ or a ‘sell and buy’.
We can see that an FX swap is approximately equivalent to a

borrowing plus a lending, as follows. Firstly, the cashflows have the
same pattern:

Foreign Exchange 39
19 September 2012
cashflows from FX swap to ‘buy and sell’ USD against CHF:

spot forward
‘buy and sell’ USD: USD inflow USD outflow
‘sell and buy’ CHF: CHF outflow CHF inflow
cashflows from borrowing USD and lending CHF:

spot forward
borrow USD: USD inflow USD outflow
lend CHF: CHF outflow CHF inflow
Secondly, we know that the swap price is derived mathematically

from the borrowing and lending interest rates. So we would expect
the two sets of transactions to be equivalent.
Key point
Very important!
An FX swap to ‘buy and sell’ the base currency is equivalent to
borrowing the base currency and lending the variable currency.
And vice versa
Terminology
If a forward dealer is ‘long’, he has ‘bought and sold’ the base
currency against the variable currency. This is equivalent to
It is therefore equivalent to a money-market dealer being ‘long’
of the base currency by borrowing it, so the terminology is
consistent.
If a forward dealer is ‘short’, he has ‘sold and bought’ the base

currency against the variable currency.
However, this terminology is not used consistently worldwide.

Some dealers will use ‘long’ and ‘short’ in the opposite sense
from the one explained here!

40 Foreign Exchange
19 September 2012
If a forward dealer has bought and sold EUR (in that order) as a
speculative position, what interest rate view has he taken? He has
effectively borrowed EUR and lent USD for the period. The answer is
therefore the same as the answer to the question ‘why would the
dealer borrow EUR and/or lend USD?’ He probably expects EUR
interest rates to rise (so that he can re-lend them at a higher rate)
and/or USD rates to fall (so that he can re-borrow them at a lower
rate). In fact the important point is that the interest differential should
move in the EUR's favour. For example, even if EUR interest rates
fall rather than rise, the dealer will still make a profit as long as USD
rates fall even further.
When a bank quotes a swap rate, it quotes in a similar manner to a

spot rate. The bank buys the base currency forward on the left, and
sells the base currency forward on the right. It is very important to
remember this; it is true for the swaps we are looking at here, and
also for short-date swaps and forward-forwards as we see later.
Key point
Very important!
A spot dealer quoting a price buys the base currency on the left
and sells the base currency on the right.
A forward dealer quoting a price ‘sells and buys’ the base

currency on the left and ‘buys and sells’ the base currency on
the right.

Foreign Exchange 41
19 September 2012
Example 25
A dealer quotes a EUR/GBP 6-month swap to a customer as 189 /
187. The customer deals at 189. What has the customer done?
The deal is done at the left side of the price. Therefore the dealer
‘sells and buys’ the base currency (EUR in this case). Therefore the
customer must be ‘buying and selling’ the base currency.
Thus the customer buys EUR and sells GBP for value on the near
date (spot) and sells EUR and buys GBP for value on the far date (6
months). The difference between the settlement rates used for the
two settlements will be -189 points.
There is no net outright position taken, and the spot dealer's spread
will not be involved, but some benchmark spot rate will nevertheless
be needed in order to arrive at the settlement rates. As the swap is a
representation of the interest rate differential between the two
currencies quoted, as long as the 'near' and 'far' settlement rates
preserve this differential, it does not generally make a large difference
which exact spot rate is used as a base for adding or subtracting the
swap points. The rate - often a middle rate - must however
normally be a current rate and is generally suggested by the dealer
quoting the swap.

42 Foreign Exchange
19 September 2012
Example 26
Spot EUR/USD: 1.2166 / 1.2171
31-day USD interest rate: 5.0%
31-day EUR interest rate: 3.0%
31-day forward swap: 20 / 22
Our bank's dealer expects EUR interest rates to rise. He therefore

asks another bank for its price, which is quoted as 20 / 22. Our
dealer buys and sells EUR 10 million at a swap price of 20 (that is, +
0.0020). The spot rate is set at 1.2168 and the forward rate at
1.2188. The cashflows are therefore:
spot 31 days forward

buy EUR 10,000,000 sell EUR 10,000,000
sell USD 12,168,000 buy USD 12,188,000
Immediately after dealing, EUR rates in fact fall rather than rise, but
USD rates also fall, as follows:
Spot EUR/USD: 1.2166 / 1.2171

31-day USD interest rate: 4.5%
31-day EUR interest rate: 2.75%
Our dealer now asks another counterparty for a price, is quoted 17 /

19, and deals to close out his position. Thus he now sells and buys
EUR at a swap price of 19 (that is, + 0.0019). The spot rate is set at
1.2168 again and the forward rate at 1.2187. The new cashflows are:
spot 31 days forward

sell EUR 10,000,000 buy EUR 10,000,000
buy USD 12,168,000 sell USD 12,187,000
The net result is a profit of USD 1,000, 31 days forward. The dealer
has made a profit because the interest differential between EUR and
USD has narrowed from 2.0% to 1.75%, even though it did not
narrow in the way he expected.

Foreign Exchange 43
19 September 2012
In general:
Key point
A forward dealer expecting the interest rate differential to move

in favour of the base currency (for example, base currency
interest rates rise or variable currency interest rates fall) will
'buy and sell' the base currency. This is equivalent to borrowing
the base currency and depositing in the variable currency.
And vice versa
Valuation of a forward position

In the example above, we valued the result of two swaps, where the
second swap neatly offset the first. In practice, a dealer will have
many swaps on his book, resulting in many cashflows in different
currencies on different dates. The entire book can be valued by
calculating the present value of each cashflow separately and then
adding up all the present values - some positive and some negative
- to calculate an NPV. As discussed in the ‘Financial Arithmetic’
chapter, a present value is the ‘worth’ of a future cashflow, so the
NPV of a series of cashflows represents the true value of that series
of cashflows.
Terminology again
If the interest rate differential between the two currencies widens (i.e.
the interest difference becomes larger) then the forward swap points
will also become larger in absolute terms - i.e. a positive number will
become more positive, and a negative number will become more
negative. Because of this, the terminology ‘wider’ is used for larger or
swap points.
Suppose for example that the current swap points are ’78 / 76’ (which
means ‘-78 / -76’). If the interest differential becomes wider (i.e. the
two interest rates move further apart), then the swap points might
move, for example, to ’81 / 79’ (which means ‘-81 / -79’). The points
would be said to have ‘widened’. This means that the points have
become larger in absolute terms, and has nothing to do with the
bid/offer spread. Similarly, if the points are said to ‘narrow’, this
means that they become smaller in absolute terms - positive points
become less positive, or negative points become less negative.

44 Foreign Exchange
19 September 2012
Key point
Terminology
If positive swap points become more positive, or negative points
become more negative, they are said to ‘widen’. If positive
swap points become less positive, or negative points become
less negative, they are said to ‘narrow’.
Exercises
19 You wish to take a particular speculative position and ask a
bank for a 3-month USD/CHF swap price. It is quoted to you as
127 / 122 and you deal at 127. What is your expectation for
market movements?
20 EUR/USD forward swaps are as follows. What can you say

about the EUR and USD yield curves?
6 months: 10 / 5
12 months: 5 / 10
21 The NOK/SEK 3-month forward points move from 20 / 35 to 35 /

20. If the spot rate has not changed and Norwegian interest
rates have not changed, this might suggest that:
a. Swedish interest rates have fallen.

b. Swedish interest rates have risen.
c. Swedish interest rates have remained the same but the
market expects rates to rise in 3 months’ time.
d. Swedish interest rates have remained the same but the
market expects rates to fall in 3 months’ time.
22 Spot USD/CHF is 1.7150. The 3-month swap is quoted as 124

/ 120. A customer buys and sells CHF. What settlement rates
are set on the deal?
a. Spot: 1.7150, 3 months: 1.7274

b. Spot: 1.7150, 3 months: 1.7220
c. Spot: 1.7150, 3 months: 1.7026
d. Spot: 1.7150, 3 months: 1.7030

Foreign Exchange 45
19 September 2012
23 The 3-month USD/CHF swap is quoted to you as 45 / 55. You

buy and sell CHF. Later in the day, the 3-month swap is quoted
to you as 65 / 75 and you close your position. Ignoring spot
rate movements and NPV, have you made a profit or a loss?
24 What would be the impact of a decrease in CHF interest rates

on the profitability of a short forward outright position in
USD/CHF?
a. Positive
b. Negative
c. It depends on what happens to USD interest rates
d. None

46 Foreign Exchange
19 September 2012
Historic rate rollovers
We have mentioned above that the settlement rates (spot and

forward) for a forward swap deal must generally be based on a
current market spot rate. This is because deals at non-current rates
might result in concealment of a profit or loss, in fraud, in tax evasion
or in ‘hidden’ unauthorised lending to the counterparty. For example,
if a customer has taken a speculative position which has made a loss,
a historic rate rollover enables it to roll the loss over to a later date
rather than realise it immediately.
Many central banks therefore require that banks under their

supervision use only current rates, except with the prior express
permission of senior management of both counterparties, and with
proper controls in place, with clear audit trails, for the monitoring and
reporting of such transactions.
The following example illustrates why a corporate customer might

wish to use a historic rate rather than a current rate, and the effect.
Example 27
In June, a German company sells EUR 10 million forward outright for
value 15 August against USD, at a forward outright rate of 1.1250.
This deal is done to cover the cost the company expects to pay for
US imports. On 13 August, the company realises that it will not need
to pay the USD until a month later. It therefore rolls over the foreign
exchange cover by using a forward swap - buying EUR spot and
selling one month forward.
On 13 August, the exchange rates are as follows:

spot EUR/USD: 1.2166 / 71
The company therefore buys and sells EUR at 1.2168 (spot) and
1.2168 + 0.0020 = 1.2188 (forward).
The company's cashflows will then be:

Foreign Exchange 47
19 September 2012
15 August 15 September
sell EUR 1,000,000
buy USD 1,125,000
buy EUR 1,000,000 sell EUR 1,000,000
sell USD 1,216.800 buy USD 1,218,800
Net: sell EUR 1,000,000
sell USD 91,800 buy USD 1,218,800
The overall net result is that the company sells EUR 1 million against
USD 1,127,000 (= USD 1,218,800 - USD 91,800) - an all-in rate of
1.1270 which is effectively the original rate dealt of 1.1250 adjusted
by the swap price of 20 points.
The company might however have a cashflow problem on 15 August,

because there is a cash outflow of USD 91,800. The company might
therefore prefer to request the bank to base the swap on the 'historic'
rate of 1.1250 - dealing instead at 1.1250 spot and 1.1270 forward.
The cashflows would then be:
15 August 15 September
sell EUR 1,000,000
buy USD 1,125,000
buy EUR 1,000,000 sell EUR 1,000,000
sell USD 1,125,000 buy USD 1,127,000
Net: sell EUR 1,000,000
buy USD 1,127,000
The overall net result is the same as before, but there is no cashflow
problem. Underlying this arrangement however is an effective loan
from the bank to the company of USD 91,800 for 31 days. If the bank
is, exceptionally, prepared to base the swap on a historic rate, it
needs to charge the company interest on this hidden loan. This
interest would normally be incorporated into a less favourable swap
price.
Also, as stated in the Model Code, any such arrangement should be

agreed and fully documented by the senior management of both bank
and customer.

48 Foreign Exchange
19 September 2012
In the example above, the company rolls over the FX cover by ‘buying
and selling’ EUR against USD. It could equally well have moved the
cover earlier rather than later. Suppose that in July, the company
realises that it needs the USD immediately in July instead of in
August. It could again use a swap to adjust the effective date of the
cover. In this case, it would need to ‘sell and buy’ EUR against USD
- selling EUR spot and buying one month forward.
Terminology
When the forward settlement rate in a swap is better for me than the
spot settlement rate, the forward points are said to be ‘in my favour’.
If I am selling on the forward date (i.e. I am ‘buying and selling’), this
means that the forward points are positive; if I am buying on the
forward date (i.e. I am ‘selling and buying’), this means that the
forward points are negative. Conversely, when the forward
settlement rate is worse for me than the spot settlement rate, the
forward points are said to be ‘against me’.

Foreign Exchange 49
19 September 2012
Cross-rate forwards
Outrights
A forward cross-rate is calculated in a similar way to a spot cross-
rate. To calculate a forward outright cross-rate from two exchange
rates with the same base currency (e.g. USD), divide opposite sides
of the individual forward outright rates:
Example 28
Spot USD/SGD: 1.6782 / 92
6-month swap: 90/ 95
6-month outright: 1.6872 / 1.6887

6-month outright: 1.4719 / 1.4729
Therefore 6-month CAD/SGD is:
1. 6872
= 1.1455 : how the quoting bank buys CAD, sells SGD
1. 4729
1. 6887
= 1.1473 : how the quoting bank sells CAD, buys SGD
1. 4719
The forward outright cross-rate is therefore 1.1455 / 1.1473
To calculate a forward outright cross-rate from two exchange rates

with the same variable currency, again divide opposite sides of the
forward rates. Similarly, to calculate a forward outright cross-rate
from two rates where the common currency is the base for one but
the variable for the other, multiply the same sides.

50 Foreign Exchange
19 September 2012
Example 29
1-month swap: 14 / 9
1-month outright: 1.2152 / 1.2162
Spot AUD/USD: 0.6834 / 39

1-month outright: 0.6774 / 0.6784
Therefore 1-month EUR/AUD is:

1. 2152
= 1.7913 : how the quoting bank buys EUR, sells AUD
0 .6784
1. 2162
= 1.7954 : how the quoting bank sells EUR, buys AUD
0 .6774
The forward outright cross-rate is therefore 1.7913 / 1.7954
Example 30
Spot EUR/USD: 1.2166 / 1.2171
1-month outright: 1.2152 / 1.2162

6-month outright: 1.6872 / 1.6887
Therefore 1-month EUR/SGD is:

1.2152 x 1.6872 = 2.0503: how the bank buys EUR and sells SGD
1.2162 x 1.6887 = 2.0538: how the bank sells EUR and buys SGD
The forward outright cross-rate is therefore: 2.0503 / 2.0538
Swaps
To calculate cross-rate forward swaps, the process above must be
taken a step further:
(i) calculate the spot cross-rate
(ii) calculate the two individual forward outrights
(iii) from (ii) calculate the forward outright cross-rate
(iv) from (i) and (iii) calculate the cross-rate swap

Foreign Exchange 51
19 September 2012
Example 31
Using the same details as in earlier examples, the CAD/SGD cross-
rate swap can be calculated as follows:


From an earlier example,

the forward outright rate is: 1.1455 / 1.1473
From an earlier example,
the spot rate is: 1.1279 / 1.1289
Therefore the forward swap is (outright - spot): 0.0176 / 0.0184
That is, 176 / 184
Exercises
25
Spot 3-month
forward swap
USD/CHF 1.5140 / 45 29 / 32
USD/NOK 7.1020 / 40 246 / 259
GBP/USD 1.6490 / 00 268 / 265
Based on the prices above:
a. What is the two-way price for CHF/NOK spot? Which side

does the customer buy NOK?
b. What is the two-way price for GBP/NOK spot? Which
side does the customer sell GBP?
c. What is the two-way price for USD/NOK 3-month forward
outright?
d. What is the two-way price for GBP/USD 3-month forward
outright?
e. What is the two-way price for GBP/NOK 3-month forward
outright? Which of the two currencies has higher interest
rates?
f. What is the two-way price for CHF/NOK 3-month forward
outright? Which of the two currencies has higher interest
rates?
g. What is the two-way price for CHF/NOK 3-month forward
swap?

52 Foreign Exchange
19 September 2012

Foreign Exchange 53
19 September 2012
Short dates
As in the money markets, value dates earlier than 1 month, but not
spot, are referred to as 'short dates', with certain 'regular' dates
usually quoted, as follows (with their usual abbreviations shown in
brackets):
'Overnight' a foreign exchange swap from today until

(O/N): 'tomorrow'
'Tom-next’ a foreign exchange swap from 'tomorrow' to the
(T/N): 'next' day (spot)
'Spot-next' a foreign exchange swap from spot until the 'next'
(S/N): day
'Spot-a-week' a foreign exchange swap from spot until a week
(S/W): later
'Tomorrow' means 'the next business day after today' and 'next'
means 'the next business day following'.
Outright deals as opposed to swaps, are referred to for example as

'value today', 'value tomorrow', 'value spot-next', and 'value a week
over spot'.
In considering swaps and outrights for short dates later than the spot
date, exactly the same rules apply as in calculating longer dates.
However confusion can arise in considering the prices for dates
earlier than spot - that is, value today and 'tomorrow'. The rules are
still the same in that the bank buys the base currency on the far date
on the left and sells the base currency on the far date on the right. In
other words, the bank always 'sells and buys' (in that order) the base
currency on the left and 'buys and sells' the base currency on the
right - regardless of whether it is before or after spot. The confusion
can arise because the spot value date - effectively the baseline date
for calculation of the outright rate - is the near date when calculating
most forward prices. For value today and tomorrow however, the
spot date becomes the far date and the outright date is the near date.

54 Foreign Exchange
19 September 2012
Key point
Very important!
A forward dealer quoting a price always ‘sells and buys’ the

base currency on the left and ‘buys and sells’ the base currency
on the right. This is still the same, with swaps before spot.
Because short dates refer to short time periods, the swap prices are
often very small, and expressed as fractions of one point, or decimals
of one point, as in the following example
Example 32

Overnight swap: 1 / ¾
Tom-next swap: ½ / ¼
1-week swap: 7 / 5
(i) Suppose a customer wishes to buy USD for outright value one
week after spot. The bank spot dealer sells USD for value spot on
the left at 1.2505. The bank forward dealer sells USD for value on
the 'far' date ( = one week after spot) also on the left at a swap
difference of 7 points. Therefore the bank sells USD outright one
week after spot at 1.2505 - 0.0007 = 1.2498. The other side of the
one week outright price is 1.2510 - 0.0005 = 1.2505.
(ii) Suppose the customer wishes to buy USD for outright value
tomorrow. This is equivalent to buying USD for value spot and, at the
time, undertaking a swap to buy USD for value tomorrow and sell
USD back for value spot.

Foreign Exchange 55
19 September 2012
Again, the bank spot dealer buys EUR for value spot on the left at
1.2505. However the bank forward dealer sells EUR for value on the
'far' date ( = spot this time) on the right at a swap difference of ¼
point. Furthermore (because USD interest rates are lower than EUR
rates) the EUR is at a discount to the USD: the 'bigger number' ½ is
on the left. The EUR is therefore worth less on the 'far' date and
more on the 'near' date. The swap difference is therefore added to
the spot rate to give an outright value tomorrow price of 1.2505 + ¼ =
1.250525. The other side of the value tomorrow outright price is
1.2510 + ½ =1.25105.
A simple rule to remember for the calculation of dates earlier than

spot is 'reverse the swap points and proceed exactly as for a forward
later than spot'. In the above example, this would mean reversing ' ½
/ ¼ ' to ' ¼ / ½'. The outright value tomorrow price is then (1.2505 +
¼) / (1.2510 + ½), obtained by adding the swap points to the spot rate
because the 'bigger' swap number is now on the right. However it is
important always to remember to make this reversal in your
head only! Never actually quote the price in reverse!
'Overnight' prices are the only regular swap prices not involving the
spot value date. To calculate an outright value today price, it is
therefore necessary to combine the 'overnight' price with the 'tom-
next' price:
(iii) Suppose the customer wishes to buy USD for outright value
today. This is equivalent to three separate transactions: buying USD
for value spot, undertaking a swap to buy USD for value tomorrow
and sell USD back for value spot ('tom-next') and undertaking another
swap to buy USD for value today and sell USD back for value
tomorrow ('overnight'). The price is therefore 1.2505 + ¼ + ¾ =
1.2506.
The 'rules' can be thought of in terms of premiums and discounts,

which apply in the same way as in forwards after spot. The swaps in
the previous example show a EUR discount because USD interest
rates are lower than EUR interest rates. Consequently, if the
customer buys USD value today and not value spot, he will receive
the currency with the lower interest rate two days early. The extra
point which he receives from the bank reflects this.

56 Foreign Exchange
19 September 2012
Deals cannot always be done for value today. For example, when
London and European markets are open, the Japanese banks have
already closed their books for today, so deals in JPY can only be
done for value tomorrow. Similarly in London, most European
currencies can only be dealt early in the morning for value today,
because of the time difference and the mechanical difficulties of
ensuring good value. Even the market for value 'tomorrow' generally
closes during the morning.
Tom-next deals are used frequently to roll over a bank’s spot position.
Suppose for example that on Monday, a spot dealer is long of USD
10 million and that, when he goes home at the end of Monday, he
chooses to leave this position unchanged. The position at that point
is value Wednesday. When he returns to his desk on Tuesday
morning, the position is still value Wednesday, but spot is now value
Thursday. He must therefore convert his position back to a spot
position by ‘selling and buying’ USD 10 million tom-next.
Some further examples follow.
Example 33
USD/CHF spot rate: 1.5103 / 13
O/N: ¼/ ½
T/N: ¼/ ½
S/N: ¼/ ½
The bank's customers can make purchases and sales as follows:
Value S/N: Outright purchase of CHF and sale of USD:

1.5103 + 0.000025 = 1.510325
Outright sale of CHF and purchase of USD:

1.5113 + 0.00005 = 1.51135
Value tomorrow: Outright purchase of CHF and sale of USD:

1.5103 - 0.00005 = 1.51025

1.5113 - 0.000025 = 1.511275

Foreign Exchange 57
19 September 2012
Value today: Outright purchase of CHF and sale of USD:

1.5103 - 0.0001 = 1.5102

1.5113 - 0.00005 = 1.51125
In the following exercise, note that if a swap price is quoted as ‘2.3’,

this means ‘2.3 points’. The ‘2’ is therefore in the same decimal place
as a point would normally be, and the ‘3’ is one decimal place further
to the right. In this case, therefore, the swap price of ‘2.3’ means
‘0.00023’
Exercise
26
Spot O/N T/N S/W 1 month

USD/NOK 7.1020 / 40 2.0 / 2.5 2.3 / 2.9 18 / 20
EUR/USD 1.2490 / 00 10.6 / 10.1 3.5 / 3.3 23 / 22 96 / 94
a. What is the two-way price for USD/NOK forward outright

value one week after spot?
b. What is the two-way price for USD/NOK forward outright
value tomorrow?
c. What is the two-way price for USD/NOK forward outright
value today? Which side does the customer buy NOK?
d. What is the two-way price for EUR/USD forward outright
value today? Which side does the customer buy EUR?

58 Foreign Exchange
19 September 2012
Summary of calculation methods
It may be helpful to collect together here various 'rules' which apply to

calculating forwards:
Key point
(i) The currency with higher interest rates ( = the currency at a

'discount') is worth less in the future.
The currency with lower interest rates ( = the currency at a

'premium') is worth more in the future.
(ii) The bank quoting the price buys the base currency / sells
the variable currency on the far date on the left.
The bank quoting the price sells the base currency / buys
the variable currency on the far date on the right.
For outright forwards later than spot:

(iii) The left swap price is added to (or subtracted from) the left
spot price.
The right swap price is added to (or subtracted from) the

right spot price.
(iv) If the swap price is larger on the right than the left, add it to
the spot price.
If the swap price is larger on the left than the right, subtract
it from the spot price.
For outright deals earlier than spot:

(v) Calculate as if the swap price were reversed and then
follow (iii) and (iv).

Foreign Exchange 59
19 September 2012
In general:
(vi) Of the two prices available, the customer gets the worse
one. Thus if the swap price is 3 / 2 and the customer knows
that the points are 'in his favour' (the outright will be better than
the spot), the price will be 2. If he knows that the points are
'against him' (the outright will be worse than the spot), the price
will be 3.
(vii) The effect of combining the swap points with the spot price
will always be to widen the spread, never to narrow it.

60 Foreign Exchange
19 September 2012
Hedging a forward with deposits
The link between interest rates and forward swaps allows dealers and
end-users of the market to take advantage of opportunities in different
markets, in two ways.
Firstly, it enables a dealer with a forward swap position to hedge this

position by using money market borrowings and deposits, if it turns
out to be cheaper or easier to do so.
Key point
An FX swap to ‘buy and sell’ the base currency is equivalent to

The swap can therefore be hedged by lending the base
currency and borrowing the variable currency.
And vice versa
Secondly, it enables a borrower or investor to borrow or invest in a

different currency from that in which he originally intended to deal,
and then to convert this transaction to the intended currency by using
a swap. Again, he would do so if the result were a better all-in rate,
or if it were easier to arrange. This is known as ‘covered interest
arbitrage’ - see later.
These two strategies are in fact essentially the same idea, viewed
from different angles; both depend on the fact that an FX swap is
broadly equivalent to a borrowing plus a deposit.

Foreign Exchange 61
19 September 2012
Example 34
A dealer buys and sells USD against JPY, spot against 3 months. He
hedges the position by lending USD for 3 months and borrowing JPY
for 3 months.
The cashflows from the deal and the cover are therefore as follows:
spot 3 months
original deal: + USD - USD
- JPY + JPY
lend USD: - USD + USD

borrow JPY: + JPY - JPY
The cashflows will not net to zero exactly, but the differences are
relatively small.
Key point
Hedging an FX swap with deposits leaves a small residual FX

risk, which could be covered by spot or outright deals.
The method just described can be extended from hedging a swap to

hedging an outright. We know that an outright position is equivalent
to a swap position plus a spot position. Therefore, hedging an
outright is equivalent to hedging a swap plus hedging a spot position.
Therefore, for example:
Key point
An FX outright to buy the base currency can be hedged by a

spot sale of the base currency, combined with borrowing the
base currency and lending the variable currency.
And vice versa

62 Foreign Exchange
19 September 2012
Disadvantages
Although forwards can effectively be hedged through the deposit
market in this way, there are some advantages of using swaps rather
than the deposit market.
First, using the deposit market leaves a small residual risk, as

discussed above.
Second, the transaction costs are generally higher, because it

probably involves lending out one currency at another bank’s bid rate
and borrowing the other currency at another bank’s offer rate. The
bid/offer spread in the swap market is generally much less
disadvantageous.
Third, using the deposit market creates extra credit risk. If we use a
swap and the swap counterparty goes bankrupt during the life of the
swap, the swap will not be consummated. Our loss on that deal is
restricted to the mark-to-market profit we have on that swap with that
counterparty. However, if we use the deposit market and the
counterparty to whom we have lent one of the two currencies goes
bankrupt during the life of the loan, we lose the entire principal
amount of the deal.
Example 35
A dealer sells USD against JPY, 3 months outright. He hedges the
position by lending USD for 3 months and borrowing JPY for 3
months, and also buying USD spot against JPY.
Exercise
27 You are a dealer and a customer has just sold you GBP 5
million against EUR for value 3 months forward outright. Which
of the following are possible ways of hedging your risk, either
mostly or completely? (possibly none, or more than one
answer)
a. Buy EUR against GBP for value 3 months forward outright.

b. Buy EUR spot, and also buy and sell EUR against GBP in a
3-month swap.
c. Borrow GBP for 3 months, lend EUR for 3 months and sell
GBP spot.

Foreign Exchange 63
19 September 2012
Covered interest arbitrage
As mentioned in the last section, the link between interest rates and
forward swaps also allows banks and others to take advantage of
different borrowing and lending opportunities in different markets.
This can be seen in either of two ways.
Suppose that a bank needs to fund itself in currency A but can borrow
relatively cheaply in currency B; it can choose deliberately to borrow
currency B and use a forward FX swap to convert the borrowing to
currency A. The reason for doing this would be if the resulting all-in
cost of borrowing were slightly less than the cost of borrowing
currency A directly. Taking advantage of such a strategy is known as
'covered interest arbitrage'. The cost of borrowing via this strategy
will be approximately the same as borrowing currency A directly, but
possibly slightly cheaper. If it is not cheaper, then of course the bank
would not use this strategy and would instead borrow currency A in
the straightforward way.
We can see that the cashflows of borrowing via covered interest

arbitrage have the same pattern as the cashflows of a straightforward
borrowing, as follows:
cashflows from covered interest arbitrage

(borrow CHF, and ‘sell and buy’ CHF against USD):
spot forward
borrow CHF: CHF inflow CHF outflow
‘sell and buy’ CHF: CHF outflow CHF inflow
‘buy and sell’ USD: USD inflow USD outflow
net flows: USD inflow USD outflow
cashflows from borrowing USD:

spot forward
borrow USD: USD inflow USD outflow
We also know that the swap price is derived mathematically from

borrowing and lending interest rates. So we would expect the two
sets of transactions to be equivalent.

64 Foreign Exchange
19 September 2012
Even if it does not need to borrow, a bank can still borrow in the
second currency, use a forward swap to convert the borrowing to the
first currency and then make a deposit directly in the first currency;
the reason for doing this would be that a profit can be locked in
because the swap price is slightly out of line with the interest rates.
Note that the following examples show detailed calculations of what

we are discussing here. In the Dealing Certificate exam, you must
understand the structure of the strategy, but will not be asked to
calculate the resulting synthetic interest rate.
Example 36
USD/CHF spot: 1.4810 / 1.4820
3-month swap: 116 / 111
USD 3-month interest rates: 7.43% / 7.56%
CHF 3-month interest rates: 4.50% / 4.62%
Suppose that the 3-month period is 92 days and the bank needs to
produce (i.e. borrow) CHF 10 million. It deals on rates quoted to it as
above by another bank.
(a) Bank borrows USD 6,749,915.63 for 92 days from spot at 7.56%.
(b) At the end of 92 days, bank repays principal plus interest:

principal USD 6,749,915.63
plus interest USD 6 ,749 , 915 . 63 × 0 .0756 × 360
92
= USD 6,880,324.00
(c) Bank 'sells and buys' USD against CHF at a swap price of 111,
based on a spot of 1.4815:
Bank sells USD 6,749,915.63 / buys CHF 10,000,000.00

spot at 1.4815
Bank buys USD 6,880,324.00 / sells CHF 10,116,828.41
3 months forward at 1.4704
The net USD flows balance to zero.

The effective cost of borrowing is therefore interest of CHF
116,828.41 on a principal sum of CHF 10,000,000 for 92 days:
116 ,828.41 360
× = 4.57%
10 ,000 ,000 92

Foreign Exchange 65
19 September 2012
The net effect is thus a CHF 10 million borrowing at 4.57%. This is 5

basis points cheaper than the 4.62% at which the bank could borrow
directly.
If the bank is in fact not looking for funds, but is able to deposit CHF
at higher than 4.57%, it can instead 'round trip', locking in a profit.
Key point
A borrowing (or lending) in one currency can be created by

borrowing (or lending) a second currency plus an FX swap to
‘buy and sell’ (or ‘sell and buy’) the first currency against the
second currency.
Two points to notice in the example above are:
(i) The example assumes that we are not the bank

quoting the price; we are taking another bank's rates to borrow at
7.56% and swap at 111 points. This is normally the case, as it is our
idea, so we must seek prices from someone else in order to carry out
the idea.
(ii) When a swap is dealt, the amount of the deal (e.g. USD
6,749,915.63) is usually the same at both ends of the deal, spot and
forward. In the example above, the amounts are mismatched, with
USD 6,880,324.00 at the far end in order to match the cashflows
exactly with the underlying flows arising from the borrowing. It is
generally acceptable in the market to use mismatched amounts in this
way as long as the mismatch is not great.
The following example shows how covered interest arbitrage can be

used in the same way by an investor, rather than a depositor.
Example 37
An investor has SEK 5 million to invest for 6 months (183 days). He
can either invest directly in SEK at 5.3%, or invest in EUR at 4.5%
and swap them to SEK. The following exchange rates are quoted to
him:

66 Foreign Exchange
19 September 2012
EUR/SEK spot: 11.2360 / 70

6 months: 523 / 524
Investing via EUR would be as follows.
Sell SEK 5 million and buy EUR, value spot.

Invest the EUR for 6 months at 4.5%.
Sell forward the maturing EUR deposit amount back into SEK.
The swap involves buying and selling the EUR, at +523 points. If we
use 11.2365 as the spot rate, the settlement rates are 11.2365 (spot)
and 11.2888 (6 months).
The amount of the EUR deposit is:

5 ,000 ,000
= 444 ,978.42
11.2365
The maturing amount of the deposit is then:

183
int erest = 444 ,978.42 × 0.045 × = 10 ,178.88
360
principal + int erest = 444 ,978.42 + 10 ,178.88 = 455 ,157.30
The cashflows are as follows:

spot 6 months
EUR deposit: - EUR 444,978.42 + EUR 455,157.30
swap: + EUR 444,978.42 - EUR 455,157.30

- SEK 5,000,000.00 + SEK 5,138,179.73
net cashflows: - SEK 5,000,000.00 + SEK 5,138,179.73
The net result is effectively a 6-month deposit of SEK 5,000,000 with

total proceeds of SEK 5,138,179.73 - i.e. effective interest received
of SEK 138,179.73.
This interest earned is for a period of 183 days. It can be expressed

as an interest rate per annum of 5.46%:
138 ,179.73 360

× = 0.0544 = 5.44%
5 ,000 ,000 183

Foreign Exchange 67
19 September 2012
This yield of 5.44% is higher than the 5.3% quoted for SEK. It is
therefore worthwhile to create a synthetic SEK deposit via EUR in this
way.
Exercises
28 An investor has USD 15 million to invest for three months. He
has a choice between two possible investments, both at LIBID -
either a USD deposit, or a EUR deposit which could be hedged
back into USD (covered interest arbitrage). If he invests via
EUR, what transactions does he do, which way round, and at
what rates and prices?

3-month swap: 132 / 128
3-month EUR: 8.415 / 8.515%
3-month USD: 4 1/8 / 4 1/4%
29 I wish to borrow EUR 3 million for one week from spot. I borrow
via USD at 4.5%, using covered interest arbitrage. The
following exchange rates are quoted to me:
EUR/USD spot: 0.9129

1 week: 1.1 / 0.9
a. I ‘buy and sell’ EUR at -1.1 points.

b. I ‘buy and sell’ USD at -1.1 points.
c. I ‘buy and sell’ EUR at -0.9 points.
d. I ‘buy and sell’ USD at -0.9 points.

68 Foreign Exchange
19 September 2012
Summary of uses of forward FX instruments
Hedging
A company which expects to pay or receive foreign currency at a
future date can lock in the exchange rate for doing this with a forward
outright. If the currency requirement is earlier than spot then,
depending on the currency and provided the deal is done early
enough, the company can deal for outright value today or tomorrow.
If a company has already transacted a forward deal but wishes to

delay settlement because the commercial requirement has not arisen
as early as originally anticipated, it can roll the maturing deal forward
with a swap. If the requirement is earlier than expected, it can roll it
nearer with a swap the other way round.
A bank dealer can use forwards to hedge his existing positions. A

trading bank which needs to provide an outright for a customer will
construct it from a spot and a swap. However, a dealer in a small
bank covering a customer position might himself ask another bank,
more active in foreign exchange, for a forward outright price.
Speculation
A dealer wishing to take a strategic (i.e. medium-term) speculative
position in a currency, might use a forward outright, rather than a spot
deal which would continually require rolling over with swaps.
Forward swaps are essentially interest rate instruments. A dealer

wishing to speculate on the interest rate differential between two
currencies will ‘buy and sell’ or ‘sell and buy’.
Arbitrage
The relationship between interest rates and swap prices allows for the
possibility of arbitrage.

Foreign Exchange 69
19 September 2012
Precious metals
The term ‘precious metals’ covers gold, silver, palladium, platinum,

and the other ‘platinum’ group metals (rhodium, ruthenium, iridium
and osmium). ‘Bullion’ means precious metals traded in bulk form,
(for example, gold bars, gold ingots or gold plate, rather than gold
coins).
Metal ISO Code

Gold XAU
Silver XAG
Platinum XPT
Palladium XPD
Pricing
Prices for the four metals above are quoted and traded as the price in
USD for one ounce of the metal - strictly, a ‘troy’ ounce (rather than
a normal ounce used for weighing, which is an ‘avoirdupois’ ounce).
As with all prices, a dealer quotes a two-way price - the ‘bid’ is the
price in USD that he is willing to pay to buy one ounce of metal, and
his ‘offer’ is the price in USD that he is willing to receive if he sells one
ounce of metal. The abbreviation for ‘ounce’ is ‘oz’.
London good delivery (LGD)

The principal centre for trading gold is the London market, dominated
by the London Bullion Market, which is operated by the London
Bullion Market Association (LBMA). The second centre for trading
physical gold is Zurich.
The LBMA sets down standards for gold bars that can be accepted
for ‘London good delivery’ (LGD). A good delivery bar for London
should weigh between 350 and 430 ounces (gold content), of at least
99.5% purity. Although the price is quoted in dollars per ounce, all
trades must take place in terms of so many gold bars, because
physical delivery must take place in whole multiples of gold bars. The
standard amount for a spot price quotation in the market is ten 400-
ounce bars, or 4,000 ounces of gold.

70 Foreign Exchange
19 September 2012
Example 38
You ask for a gold price and receive a quote of 403.80 / 404.10. You
wish to sell 20,000 ozs of gold, so you hit the quoting dealer’s bid of
403.80. the amount you pay is USD 8,076,000
USD 403.80 x 20,000 = USD 8,076,000
As with foreign exchange, there is a spot market and a forward

market in precious metals. The spot market is for value two days
after trade date, as with foreign exchange.
Delivery in London (known as ‘loco’ London) is the international

benchmark for quoting prices. Non-standard contracts - either in a
location other than London or in a form other than a good delivery bar
- can be priced by taking into account the extra costs involved in
shipping to London or in converting the form into a good delivery bar.
Physical delivery v book-entry

‘Delivery’ of gold can mean either physical delivery or ‘book entry’.
With physical delivery, the purchaser of the gold has an ‘allocated
account’, meaning that a specific gold bar is delivered to a specific
location and allocated to his account. With book entry, the purchaser
of the gold has an ‘unallocated account’. This confirms his ownership
of a certain number of ounces of gold, but does not associate this
holding with any specific physical gold bars. Most gold trading is by
book entry, which avoids the transaction costs and security risks of
moving the actual metal.
The gold fix

The gold fix is a process of arriving at a reference price for gold in the
market, which takes place twice each day in London at 10:30 am and
3:00 pm. The five members of the fix commence the fix with a trying
price. This trying price is passed to the members’ dealing rooms,
which are in contact with market participants, who declare how much
gold they wish to buy or sell at that price. If the net result of all this is
more demand than supply, the price is adjusted upwards and if
demand is less than supply, the price is adjusted downwards. The
process is repeated until balance is achieved, at which point the price
is fixed.

Foreign Exchange 71
19 September 2012
The gold fix provides a reference price analogous to LIBOR as a

fixing for interest rates. Some market users use the fix as a price at
which they wish to transact – for example, by leaving an order with a
dealer to buy or sell at whatever the fix turns out to be.
Borrowing gold and forward transactions

We know from repos, that someone wishing to go short of a bond can
do so by selling the bond and then borrowing it in order to be able to
deliver to the counterparty. He will then benefit if the bond price falls
because he can buy the bond back cheaper in order to return it to the
lender.
Gold borrowing is analogous. A gold mining company for example,

might wish to sell its future production and at the same time finance
that production. It can do this by selling gold spot for cash. In order
to deliver the gold now, it can borrow the gold. It then repays the gold
in the future, out of its own future production. The interest rate for
borrowing the gold is called the gold ‘lease rate’. It is expressed in
gold, with a year basis of 360 days. For example, if I borrow 100
ounces of gold for 180 days at a gold lease rate of 1.25%, then at the
end of 180 days when I return the 100 ounces of gold, I also owe
interest of 0.625 ounces of gold:
100 ounces x 180/360 x 1.25% = 0.625 ounces
In practice however, the interest is paid in USD, converted from gold

using a gold price agreed at the start of the loan. Suppose for
example that this agreed price is USD 1,257.50. The interest due
would then be:
0.625 ounces x USD 1,257.50 per oz = USD 785.94
Central banks, which are big holders of gold, are the major lenders of
gold. The level of the gold lease rate is determined by the supply and
demand in the gold borrowing market.

72 Foreign Exchange
19 September 2012
Forward transactions in gold.

We have seen how a forward foreign exchange rate is derived from
the spot exchange rate and the interest rates for the two currencies
involved. In exactly the same way, a forward gold price is derived
from the spot gold price and the two interest rates - in other words,
the interest rate for cash (i.e. US dollars) and the interest rate for gold
(i.e. the gold lease rate).
Again analogously to foreign exchange, if the lease rate is lower than

the USD interest rate, then the forward gold price is higher than the
spot price. In this case, the difference between the spot price and the
forward price is known as the ‘contango’.
If the lease rate is higher than the USD interest rate, then the forward
gold price is lower than the spot price. In this case, the difference
between the spot price and the forward price is known as the
‘backwardation’.
A forward swap in foreign exchange is a spot purchase of one

currency against another, combined with a simultaneous agreement
to sell the same currency back again for a forward date. In the same
way, a gold swap transaction is a spot purchase or sale of gold
combined with a simultaneous agreement to reverse the transaction
for a forward date.
The gold forward offered rate (‘GOFO’) is the difference between the
dollar interest rate and the gold lease rate on which the swap price is
based. It is quoted as the rate at which dealers lend gold against
USD - i.e. borrow USD and, at the same time, lend gold. As in an
FX swap, this is economically equivalent to a swap to ‘sell and buy’
gold against USD.
In the FX market, we know that the forward swap therefore

represents the difference between the two currencies interest rates.
Earlier in this chapter, we gave an exact formula and an approximate
formula for deriving the swap points from this interest rate difference.
In the gold market, the swap points are treated as being exactly
equivalent to the interest rate difference. Rather than quote gold
outright prices or swaps therefore, the market quotes and trades on
this interest rate difference - i.e. GOFO - and then converts this to
the swap using the approximate formula.

Foreign Exchange 73
19 September 2012
Key point
GOFO - the benchmark for fixing a gold swap - is the rate at

which dealers lend gold against USD.

74 Foreign Exchange
19 September 2012
Revision exercises
30 Which of the following is the ISO code for the Indonesian

rupiah?
a. IDR
b. INR
c. ISR
d. INS
31 You have been called up for a cable quote, which you give at
1.9555 / 65. Your counterparty says “5 mine”. What have you
done?
a. Bought USD 5 million at 1.9555

b. Sold USD 5 million at 1.9555
c. Bought GBP 5 million at 1.9565
d. Sold GBP 5 million at 1.9565
32 If you make a quote of 1.6020 / 25 in cable and the caller

“gives you 2”, what deal has been done?
a. He has sold you USD 2,000,000 at 1.6025

b. He has sold you USD 2,000,000 at 1.6020
c. He has sold you GBP 2,000,000 at 1.6020
d. He has sold you GBP 2,000,000 at 1.6025
33 Four banks offer a customer a two-way price on the AUD

against USD. From which bank will he buy AUD?
a. .7705/12
b. .7705/10
c. .7710/15
d. .7707/15
34 A ‘yard’ refers to:
a. Ten million.
b. One hundred million.
c. One billion.
d. One trillion.

Foreign Exchange 75
19 September 2012
35 You need to buy USD against JPY. You receive the following
quotes. Which is the best?
a. 101.85 / 90
b. 101.88 / 93
c. 101.84 / 89
d. 101.89 / 94
36 Spot GBP/AUD is quoted to as 2.4534 / 37. You sell AUD

7,000,000. How many GBP do you buy?
37 You have a position, long of USD against GBP. The market

has moved your way and is being quoted 1.6085 / 95. Another
bank calls you for a cable price and you wish to close your
position. Which of these prices would you quote?
a. 1.6085 / 95
b. 1.6080 / 90
c. 1.6088 / 98
d. 1.6083 / 93
38 The EUR/GBP exchange rate is 0.6527 / 0.6535. What is the

reciprocal rate?
a. 0.6535 / 0.6527
b. 1.5321 / 1.5302
c. 1.5302 / 1.5321
d. 0.6527 / 1.5302
39 You buy SEK 50 million against NOK at NOK/SEK 1.0523 and

sell SEK 50 million against NOK at 1.0515. At the end of the
day your revaluation rates are USD/SEK 9.8532 and NOK/SEK
1.0507. What is your profit or loss in USD?
40 Value spot, you sell DKK to a customer against CHF at

CHF/DKK 3.4280. Another bank then quotes you 0.2915 / 16.
You cover your position using this quote. What is your result?
a. A profit.
b. A loss.
c. Break even.
d. Not sufficient information to say.

76 Foreign Exchange
19 September 2012
41 You need to sell JPY against CHF. Of the following four

different quotes that you are given to do this, on which one will
you deal?
a. CHF/JPY 79.25
b. JPY/CHF 1.2617
c. CHF/JPY 79.27
d. JPY/CHF 1.2614
42 You buy USD 6 million against CHF at 1.7345, you sell USD 2
million at 1.7350, you sell USD 3 million at 1.7338 and you buy
USD 1 million at 1.7335. The market closes at 1.7342 and the
closing rate for CHF/SEK is 5.5875. At the end of the day, what
is your USD/CHF position? What is the average rate of this
position? What is your total net profit or loss in SEK?
43 Which of the following is traditionally correct regarding an FX

deal?
a. A broker must pass the name of the customer to the market-

maker before quoting a price to the customer.
b. A broker must pass the name of the market-maker to the
customer before quoting a price to the customer.
c. A broker must not pass the name of the customer to the
market-maker after concluding a deal.
d. A broker must not pass the name of the market-maker to the
customer before quoting a price to the customer.

Foreign Exchange 77
19 September 2012
44 Given the following, what is the two-sided rate for GBP/NZD?
GBP/USD spot: 1.4537 / 47

NZD/USD spot: 0.3456 / 59
45 Given the following, what is the two-sided rate for GBP/SEK?

USD/SEK spot: 9.2312 / 22
46 Given the following, what is the two-sided rate for CHF/SEK?

USD/SEK spot: 9.2312 / 22
47 What is the theoretical 3-month outright price for GBP/CHF,

based on the following rates? The 3-month period is 91 days.
GBP/CHF spot: 2.1638

GBP 3-month interest rate: 5.20%
CHF 3-month interest rate: 2.70%
48 What are the theoretical 6-month (181 days) USD/CAD forward

points, given the following?
USD/CAD spot: 1.1625 / 30

USD 6 months: 8 5/8 / 8 ½%
CAD 6 months: 13 ½ / 13 3/8%
a. 266 / 280
b. 280 / 266
c. 135 / 142
d. 142 / 135
49 You are given the following rates. Assume a 3-month period of

91 days.

USD 3 months: 4.0625 / 3.9375%
GBP 3 months: 9.9375 / 9.8750%
a. Calculate the theoretical two-way 3-month swap points for

GBP/USD.
b. If you have ‘bought and sold’ GBP, what movement are you
expecting in interest rates?

78 Foreign Exchange
19 September 2012
50 Given the following rates, what would be the two-way quote for
a 1-month USD/CHF forward outright?

l month: 58 / 57
a. 1.6468 / 1.6477
b. 1.6467 / 1.6468
c. 1.6352 / 1.6363
d. 1.6353 / 1.6362
51 A customer buys CHF from your bank against NZD in a 3-

month forward outright. He asks to have the rate quoted to him
as CHF/NZD. What should you do first to hedge the FX risk?
a. Sell CHF spot.

b. Sell and buy NZD.
c. Sell and buy CHF.
d. Buy CHF spot.
52 A client wishes to sell GBP against USD 3 months forward. The

spot rate is 1.8340 / 1.8350 and the forward points are 192 /
188. At what outright rate will the client deal?
a. 1.8532
b. 1.8148
c. 1.8162
d. 1.8158
53 A client wishes to sell USD against GBP 3 months forward. The

spot rate is 1.4340 / 1.4350 and the forward points are 5 / 3
around par. At what outright rate will the client deal?
a. 1.4335
b. 1.4345
c. 1.4347
d. 1.4353
54 Forward points represent:
a. The amount of money by which you change the value of a

currency against the base.
b. The interest rate differential between two currencies.
c. The time/value ratio of one currency against another.
d. The future value of a currency.

Foreign Exchange 79
19 September 2012
55 Which of these events could lead to an arbitrage opportunity?
a. A movement in interest rates.

b. A movement in forward points.
c. Either of these.
d. Neither of these.
56 What are the theoretical 3-month (90 days) forward points for
USD/CHF, given the following?

USD 3 months: 8 9/16 / 8 7/16%
CHF 3 months: 8.125 / 8.000%
a. 25 / 15
b. 23 / 13
c. 13 / 23
d. 15 / 25
57 The 3-month EUR/NOK swap is quoted to you as 123 / 118.

You sell and buy NOK. Later in the day, the 3-month swap is
quoted to you as 113 / 108 and you close your position.
Ignoring spot rate movements and NPV, have you made a profit
or a loss?
58 The swap points for 6 months (182 days) are -214 and the swap
points for 7 months (213 days) are -197. Assuming straight-line
interpolation, what are the points for 203 days?
59 If the forward points for one month USD/CHF are quoted as 60 /

55, how is the CHF being quoted ?
a. At a discount.
b. At par.
c. At a premium.
d. Either side of par.
60 At what price can a customer sell JPY against USD 3 months

forward outright, given the following?
USD/JPY spot: 129.50 / 60

3-months: 8 / 11
a. 129.71
b. 129.68
c. 129.42
d. 129.49

80 Foreign Exchange
19 September 2012
61 If the 3-month AUD/SGD forward points change from 169 / 179

to 120 / 130, what does this imply?
a. A rise in AUD rates.

b. A fall in AUD rates.
c. A rise in SGD rates.
d. Insufficient information to decide.
62 If the forward points for a given period are quoted from high to
low (i.e. decreasing) this means that:
a. The base currency has a higher interest rate than the

quoted currency.
b. The quoted currency has a higher interest rate than the
base currency.
c. Both base and quoted currencies have the same interest
rate.
d. Interest rates are not relevant.
63 Which of the following are true? (possibly none, or more than

one answer)
a. If the 6-month USD/CHF forward swap points change from

125 / 120 to 135 / 130, USD interest rates might have fallen.
b. If the 3-month forward swap points are greater on the left
than the right, then the variable currency has a higher
interest rate than the base currency.
c. The 2-month GBP/USD swap points are 67 / 72. If USD
interest rates then rise but nothing else changes, the swap
points will get bigger.
d. If the 1-month forward points for AUD/CAD are 123 / 118,
the Canadian dollar is at a forward discount against the
Australian dollar.
64 If you ‘sell and buy’ GBP/CHF, what do you do?
a. Sell GBP spot and buy CHF forward.

b. Buy CHF spot and sell GBP forward.
c. Sell CHF spot and buy CHF forward.
d. Buy CHF spot and buy GBP forward.
65 What would be the impact of a decrease in AUD interest rates

on the profitability of a long forward outright position in
AUD/SEK, assuming that the spot rate does not change?
a. Positive.
b. Negative.
c. It depends on what happens to SEK interest rates.
d. None.

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19 September 2012
66 Which one of the following should you do to benefit from a fall in

CHF interest rates relative to USD rates?
a. Sell and buy USD/CHF spot against 1 month.

b. Sell USD forward outright against CHF.
c. Buy and sell USD/CHF spot against 12 months.
d. Buy USD forward outright against CHF.
67 The 3-month EUR/CHF swap is quoted as 123 / 119. Interest

rates in Switzerland fall slightly and EUR rates are unchanged.
Of the following rates, what would you expect the 3-month
EUR/CHF swap to become?
a. 128 / 124
b. 120 / 114
c. 115 / 119
d. 163 / 159
68 Given the following rates, at what rate can a customer buy NOK
against CHF 3 months forward outright?
USD/NOK: 6.0000 / 05 USD/CHF: 1.8680 / 85

3 month 45 / 40 270 / 265
a. 3.2567
b. 3.2549
c. 2.2554
d. 3.2572
69 EUR/CHF 30-day forward points are - 65 and 90-day points are

- 25. This means:
a. CHF interest rates are higher than EUR interest rates

b. EUR interest rates are higher than CHF interest rates
c. The CHF yield curve is negative and the EUR yield curve is
positive.
d. The CHF yield curve is positive and the EUR yield curve is
negative.
70 Given the following rates, at what rate is a market-maker willing

to buy CHF against GBP 3 months forward, if he is quoting the
price?
GBP/USD 1.4900 / 05 USD/CHF 1.6680 / 85

3 month 40 / 45 270 / 265
a. 2.4517
b. 2.4531
c. 2.4533
d. 2.4548

82 Foreign Exchange
19 September 2012
71 Given the following prices:
USD/CAD spot: 1.5671 / 77 6-month swap 30 / 33

USD/SEK spot: 10.3458 / 68 6-month swap 70 / 67
a. What is the two-way 6-month forward outright price for

CAD/SEK and at what price can a customer sell Canadian
dollars?
b. What is the two-way 6-month swap price for CAD/SEK, and
at what price can a customer sell and buy CAD?
72 Which of the following statements is correct about rolling over a

foreign exchange deal using a historic exchange rate?
a. It is illegal.
b. It is permitted under certain circumstances.
c. It is encouraged because it simplifies accounting.
d. It is discouraged because such deals can help to highlight
FX losses.
73 As an FX trader wishing to roll forward yesterday's spot

position, which you left open overnight, into spot, you will have
to do:
a. An outright transaction value tomorrow.

b. An outright transaction value today.
c. An overnight swap.
d. A tom/next swap.
74 Your client has asked for a GBP/CHF quote for same-day

value. You should give him the following rate:
a. Spot adjusted by the tom-next points.

b. Spot adjusted by the overnight points.
c. Spot adjusted by the overnight and the tom/next points.
d. It is impossible to deal GBP/CHF for same day value.
75 A customer asks to buy GBP against USD for value tomorrow.

What do you quote, based on the following rates?
Spot 1.5800 / 05
T/N 1.40 / 1.10
S/N 0.50 / 0.40
a. 1.58064
b. 1.58039
c. 1.58011
d. 1.58061

Foreign Exchange 83
19 September 2012
76 A customer asks to buy GBP against USD for value today. You
have the following rates. What do you quote?
Spot: 1.5800 / 05
T/N: 1.40 / 1.10
O/N: 0.50 / 0.40
77 Spot EUR/CHF is 1.6735 and the O/N swap is 1.2 / 1.0. Which
one of the following statements is correct?
a. The EUR yield curve must be less positive (or more

negative) than the CHF yield curve.
b. The CHF O/N interest rate is lower than the EUR O/N rate.
c. The CHF yield curve must be less positive (or more
negative) than the EUR yield curve.
d. The CHF O/N interest rate is higher than the EUR O/N rate.
78 Your customer wishes to sell EUR value tomorrow against CHF.

EUR/CHF spot is quoted to you as 1.7835 / 40 and T/N is
quoted to you as par / 1. What rate do you quote to your
customer in order to break even against the rates quoted to
you?
a. 1.7834
b. 1.7836
c. 1.7832
d. 1.7828
79 Cable is 1.5538/43, the swap is par (i.e. zero) for O/N (3 days),
and the USD O/N interest rate is 3.17%. What is the GBP O/N
interest rate?
80 A customer has just sold you NZD against USD 3 months

forward outright. Which of the following could effectively cover
your position?
a. Buy USD spot against NZD, and ‘sell and buy’ USD against
NZD in an FX swap.
b. Buy USD against NZD 3-month forward outright.
c. Buy USD spot against NZD, borrow NZD for 3 months and
lend USD for 3 months.
d. All of the above.
81 Arbitrage, in a treasury context, can mean:
a. Using one market to improve your position in another.

b. Trading in periods longer than one year.
c. Speculating in one currency against another.
d. Dealing in the spot markets.

84 Foreign Exchange
19 September 2012
82 You want to borrow CHF via covered interest arbitrage for 6

months. Given the following, what transactions do you do,
which way round, and at what rates and prices?
6-month USD 6.25 / 6.22%

USD/CHF spot 1.3640 / 50
USD/CHF 6-month forward 107 / 105
83 An investor client has CAD 10 million to invest for 3 months.

Your bank has available an investment to sell him, which is
denominated in EUR which would yield the offer rate plus 5 bp.
Using this, construct a CAD investment for your client: - what
transactions are done, which way round, and at what rates and
prices?
EUR/CAD spot: 1.9780 / 90

3 months: 112 / 108
EUR 3 months: 7.875 / 7.75%
CAD 3 months: 5.56 / 5.44%
84 Given the following rates for GBP/USD:
Spot: 1.4253 / 58
O/N: 1.80 / 1.30
T/N: 2.10 / 1.60
S/N: 2.20 / 1.70
3 months: 183 / 178
a. At what rate can a customer buy GBP for outright value the
day after spot?
b. At what rate can a customer sell USD for outright value
tomorrow?
c. At what rate can a customer sell GBP for outright value
today?
85 You are quoted the following forward USD/CHF prices. What

conclusions can you draw about the relationship between the
USD and the CHF yield curves?
1 week 0.5 / 0.8

1 month 1.5 / 2.5
2 months 1.7 / 2.7
3 months 2/3
6 months 16 / 14
9 months 33 / 30
1 year 50 / 45

Foreign Exchange 85
19 September 2012
86 The internationally traded gold price is quoted in terms of:
a. USD per troy ounce.

b. USD per gramme.
c. USD per kilogramme.
d. USD per tonne.
87 Which of the following is the ISO code for palladium?
a. XPL
b. XPD
c. XPM
d. XLM
88 At what times does the London Gold fix take place?
a. 10:00 am and 3:00 pm

b. 10:30 am and 3:30 pm
c. 10:00 am and 3:30 pm
d. 10:30 am and 3:00 pm
89 Backwardation in the context of the gold forward price implies

that:
a. The gold lease rate is higher than the USD interest rate.
b. The gold lease rate is lower than the USD interest rate.
c. The gold spot price is lower than the gold forward price.
d. The gold lease rate is lower than the gold forward price.
90 You ask for a gold price and receive a quote of 387.35 / 387.65.
You wish to buy 40,000 ozs of gold. How much do you pay?

86 Foreign Exchange
19 September 2012
Answers
1 The number of Norwegian kroner equal to 1 Singapore dollar.
2 0.9498/03
3 b
4 a
5 For AUD/USD, one point on a deal of AUD 1 million is worth

USD 100. For USD/JPY, one point on a deal of USD 1 million
is worth JPY 10,000.
6 EUR 1,958,480.22
7 Loss of CAD 6,000
8 Profit USD 1,034.47
9 The position is short EUR 2 million. The average rate is

0.93055. The loss is GBP 3,054.99
10 You have bought EUR 5 million, at 0.9503.
11
a. 1.5527/39. The customer sells SGD on the right at 1.5539
b. 1.7781/06. The customer buys EUR on the right at 1.7806
c. 1.4889/01. The customer buys CHF on the left at 1.4889
d. 1.1939/53. The customer sells CHF on the left at 1.1939
12 1.2210
13 108 / 99
14 2.0978 / 2.1028
15 d
16 a
17 b
18 -182
19 You are expecting the interest rate difference to widen - for

example, USD interest rates to rise more than CHF rates or
CHF rates to fall more than USD rates.
20 The yield curves cross

Foreign Exchange 87
19 September 2012
21 a
22 d
23 A profit.
24 c
25
a. 4.6893 / 4.6922, customer buys NOK at 4.6893
b. 11.7112 / 11.7216, customer sells GBP at 11.7112
c. 7.1266 / 7.1299
d. 1.6222 / 1.6235
e. 11.5608 / 11.5754, GBP interest rates are higher than NOK
rates
f. 4.6957 / 4.7003, NOK interest rates are higher than CHF rates
g. 64 / 81
26
a. 7.1038 / 7.1060
b. 7.10171 / 7.10377
c. 7.10146 / 7.10357, customer buys NOK value today at 7.10146
d. 1.25034 / 1.25141, customer buys EUR value today at 1.25141
27 a and c
28 He invests EUR at 8.415% and he ‘buys and sells’ EUR at -132

points.
29 a
30 a
31 d
32 c
33 b
34 c
35 c
36 GBP 2,852,834.50
37 c
38 c
39 Profit of USD 3,854.90

88 Foreign Exchange
19 September 2012
40 a
41 a
42 The position is long USD 2 million. The average rate is

1.73455. The loss is SEK 3,911.25
43 d
44 4.2027 / 92
45 13.4194 / 13.4301
46 5.2608 / 44
47 2.1507
48 a
49
a. 3-month swap price: 265 / 257
b. You expect interest differential to widen
50 c
51 d
52 b
53 d
54 b
55 c
56 b
57 A loss
58 -202.5
59 c
60 a
61 d
62 a
63 a and c are true.

Foreign Exchange 89
19 September 2012
64 d
65 c
66 c
67 a
68 b
69 b
70 d
71
a. CAD/SEK 6-month outright is 6.5810 / 56
The customer can sell CAD at 6.5810
b. CAD/SEK 6-month swap is 183 / 169
The customer can sell and buy CAD at -169 points.
72 b
73 d
74 c
75 a
76 1.58069
77 b
78 a
79 3.21%
80 d
81 a
82 You borrow USD at 6.25% and you ‘sell and buy’ USD at -105
points.
83 The cash is invested in EUR at 7.925% and converted to a CAD

investment by ‘buying and selling’ EUR at -112 points.
84
a. 1.42563
b. 1.42601
c. 1.42559
85 They cross between 3 and 6 months.

90 Foreign Exchange
19 September 2012
86 a
87 b
88 d
89 a
90 USD 15,506,000

Forex

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19 September 2012

© Markets International Ltd. ACI Dealing Certificate

The foreign exchange market

Throughout this chapter, we have generally used ISO codes (also

ACI Dealing Certificate © Markets International Ltd

Country Currency Code Country Currency Code

© Markets International Ltd. ACI Dealing Certificate

Base currency and variable currency

We always write the base currency on the left.

1,000,000 x 4.1235 = 4,123, 500

1,000,000 ÷ 4.1235 = 242,512.43

ACI Dealing Certificate © Markets International Ltd

Spot exchange rates

The basic transaction in the foreign exchange market is a ‘spot’ deal.

‘Spot’ is value two working days after trade date

There are however some exceptions. For example, a price for

USD/CAD is usually traded for value next day (‘funds’)

Another problem arises in trading Middle East currencies where the

© Markets International Ltd. ACI Dealing Certificate

How spot rates are quoted

In the currency futures markets, as opposed to the interbank market,

Although dealing is possible between any two convertible currencies

A ‘cross-rate’ is an exchange rate calculated by combining two

ACI Dealing Certificate © Markets International Ltd

The non-USD rates (for example EUR/GBP, EUR/JPY, EUR/CHF)

As in other markets, a bank normally quotes a two-way price,

In the money market, the order of quotation is not important and it

© Markets International Ltd. ACI Dealing Certificate

In some markets, there is a convention to adjust exchange rates to a

See ‘Answers’ at the end of this chapter

ACI Dealing Certificate © Markets International Ltd

See ‘Answers’ at the end of this chapter

1,000,000 x CHF 0.0001 = CHF 100

© Markets International Ltd. ACI Dealing Certificate

A ‘point’ is one unit of the last decimal place in the exchange

A ‘long’ position is a surplus of purchases over sales of a given

A ‘yard’ of a currency is an American billion units of that currency (i.e.

‘Cable’ is a nickname for the GBP/USD exchange rate.

Profit and loss

ACI Dealing Certificate © Markets International Ltd

The value of a single point depends on the number of decimal places

Therefore the value of 1 point in USD/CHF, on a deal of USD 1

Therefore the value of 1 point in USD/JPY, on a deal of USD 1

© Markets International Ltd. ACI Dealing Certificate

Dealers generally operate on the basis of small percentage profits but

ACI Dealing Certificate © Markets International Ltd

Sell USD 4 million at 1.6723

The market closes at 1.6730.

What is your position? What is the average rate of this position?

- 2,000,000 at 1.6730: + 3,346,000

The position is therefore long USD 2 million. The average rate is

© Markets International Ltd. ACI Dealing Certificate

4 You are a dealer with a short position in USD against EUR. A

5 If the spot AUD/USD exchange rate is quoted as 0.5413, what

6 Spot EUR/CHF is quoted to as 1.5318 / 23. You buy CHF

8 You are a dealer. A customer asks you for a CHF/USD price.

See ‘Answers’ at the end of this chapter

ACI Dealing Certificate © Markets International Ltd

Dealing and broking

The market-maker seeks to make a profit from the bid/offer spread

By providing prices to the market, the market-maker hopes that many

© Markets International Ltd. ACI Dealing Certificate

Market-makers keep the broker aware of their bid/offer prices. When

ACI Dealing Certificate © Markets International Ltd