An FX Primer: Glossary of Terms

Currency instruments and terms explained.

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1169530_book_The global foreign exchange (FX or forex) market consists of six main instruments that may be combined to create other, more complex instruments.

Spot FX: A single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for cash settlement, which is typically in two business days.

Outright forwards: An agreement between two counterparties to exchange two currencies at a rate agreed on the date of the contract for cash settlement on an agreed future date which is more or less than two business days later. Non-deliverable forwards (NDFs) do not require physical delivery of a non-convertible currency; instead, the counterparty that loses on the contract simply pays the losses directly to the other counterparty.

FX futures: Similar to outright forwards, a transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) at some time in the future (more than two business days later). Unlike outright forwards, futures are exchange-traded instruments with standardized characteristics such as contract size and maturity. Four contracts are available with settlement in March, June, September and December. The biggest FX futures exchange is the Chicago Mercantile Exchange (CME), followed by the London Futures Exchange (Liffe).

Foreign exchange (FX) swaps: A single transaction with a single counterparty that involves two currency transactions – one purchase and one sale – for two different value dates. The exchange rate for both transactions is agreed at the outset. FX swaps are arranged as a single transaction with a single counterparty. Because a customer usually contracts to purchase and sell the same amount of currency at the specified rates, there is no market risk (open position) over the life of the FX swap.

Currency (or FX) options: A derivative security giving the holder the right (but not the obligation) to buy or sell a currency at an agreed exchange rate during a specified period. This category includes exotic currency options such as average rate options and barrier options. Currency options are sold in both OTC markets and on exchanges.

Currency swaps: A contract committing two counterparties to exchange streams of interest payments denominated in different currencies for an agreed period of time. They typically require an exchange of principal amounts denominated in different currencies at a pre-agreed exchange rate at inception and at maturity of the contract. Interest payments are then on a fixed, floating or zero coupon basis. In effect, a currency swap allows a borrower or lender to swap a loan (or bond) in one currency for a loan in another without incurring currency risk if the swap is held until maturity. Currency swaps are directly analogous to interest-rate swaps and do not influence exchange rate dynamics.

Other foreign exchange terms:

Algorithmic trading: Automated transactions where a computer algorithm decides the order-submission strategy. See also: High frequency trading.

Barrier options: Options that either come into existence or disappear when exchange rates cross pre-specified price levels. Barriers can be triggered by price rises or declines and reaching a barrier can either extinguish or create an option. An “up-and-out call,” for example, is a call options that disappears if the exchange rate rises above a certain level. A “down-and-in put,” by contrast, is created if the exchange rate falls to a certain level.

Bid–ask spread: The bid-ask spread is the difference between the best (lowest) price at which one can buy FX (the ask) and the best (highest) price at which one can sell it (the bid). The buy price is also called the “offer.” The bid-ask spread is a measure of transaction costs, and is often used as an indicator of market liquidity. The initiator of a trade buys at the ask (or offer) price and sells at the bid price, which should be lower. In quote-driven markets both sides of the spread are set by one dealer. In order-driven markets, the “best bid and the best offer” are likely to be set by different dealers at any point in time.

Broker: A financial intermediary who matches counterparties to a FX transaction without being a counterparty to the trade. Brokers in the interbank FX market, for example, match banks that wish to buy FX with banks that are willing to sell at a given price. Brokers provide a way for parties to trade anonymously and earn a commission on each trade. An FX broker can operate electronically (electronic broker) or by telephone (voice broker). Two electronic brokerages – EBS (Electronic Broking Service) and Thomson Reuters –dominate interbank trading in the major currencies.

Call market: A market where all parties trade at the same time when called upon such that the market clears periodically rather than continuously. During a specified time interval, traders submit orders indicating how much they are willing to buy or sell at various prices. At the end of the interval a single price is chosen at which all trades will take place. The price is chosen to maximize the amount traded and is essentially the intersection of the supply and demand curves revealed by the submitted orders.

Carry trade: A trading strategy where low-yielding currencies are sold to finance the purchase of higher-yielding currencies.

Central counterparty (CCP): An independent legal entity that interposes itself between the buyer and the seller of a security, and requires a margin deposit from both sides.

Clearing: The back-office administration process that ensures an individual trade actually takes place. The amounts and direction are confirmed by both parties and payment and settlement information is exchanged.

Counterparty credit risk: The risk that one side to an FX trade will not settle an obligation in full value, either when due or at any time thereafter. Due to the large trade sizes in FX markets, counterparty credit risk is an important issue.

Covered interest arbitrage: A form of riskless arbitrage involving the spot market, the forward market, and domestic and foreign deposits.

Dealer (or dealership) market: A market where orders for execution pass to an intermediary (known as a dealer) for execution.

Dealer (or market-maker): Intermediaries in the FX market who stand ready, during trading hours, to either buy or sell foreign exchange with customers and other FX dealers on demand. FX dealers are typically employed by a bank and they are willing to trade (ie provide liquidity) on both sides of the market at a stated price. FX dealers seek to earn profits by taking position risks in these markets and earning the bid-ask spread between their trades. FX dealers are under no formal or legal obligation to quote bid or ask prices; rather, market making is governed by reciprocity and convention. See also: FX market maker.

Delta-hedge: A trading position designed to minimize first-order price risk in a given position. That is, small price changes should change the agent’s overall position by only a minimal amount (ideally zero). A delta-hedge gets its name from an option’s “delta”, which is the first derivative (ie the change) of the option’s price with respect to the price of the underlying asset. To delta-hedge a long call (put) option position, the agent takes a short (long) position in the underlying asset equal in size to the option’s delta times the notional value of the option.

Feedback trading: The practice of trading in response to past returns. Positive-feedback trading refers to buying (selling) after positive (negative) returns. Negative-feedback trading refers to selling (buying) after positive (negative) returns.

High frequency trading (HFT): An algorithmic trading strategy that profits from incremental price movements with frequent, small trades executed in milliseconds for investment horizons of typically less than one day. See also: Algorithmic trading.

Interdealer (or interbank) market: The market where FX dealers trade exclusively with each other, either bilaterally or through brokers. Also called the “interbank market”, due to the dominance of banks as FX dealers. See quote-driven market.

Limit order: Order to buy a specified quantity up to a maximum price or sell subject to a minimum price. A limit order is only executed when it is matched with a market order or an off-setting limit order. A limit order is said to provide or supply liquidity. An expandable limit order is a limit order whose quantity can be expanded if it is crossed with a market order for a larger quantity. See also order-driven markets.

Liquidity: Characteristic of a market where transactions do not excessively move prices. It is also easy to have a trade completed quickly without a long search for counterparties (“immediacy”). Liquid markets usually have low bid–ask spreads, high volume, and (relatively) low volatility.

Long position: A long position arises when an agent owns an asset outright.

Margin account: An account that allows customers to buy securities with money borrowed from a financial intermediary. The customer’s cash deposit in the account is called the margin.

Market liquidity: A characteristic of the market where transactions have a limited impact on prices (“price impact”) and can be completed quickly (“immediacy”).

Market order: Order to buy (or sell) a specified quantity at the best available price. A market order is executed immediately and is said to remove or demand liquidity.

Multi-bank trading system: An electronic trading system that aggregates and distributes quotes from multiple FX dealers.

Order flow: The term given to the sum of buyer-initiated transactions minus seller-initiated transactions over a given period. The transaction is given a positive (negative) sign if the initiator of the transactions is buying (selling).

Order-driven markets: A market in which prices are determined by the interaction of buy and sell orders. Some participants wish to trade immediately and demand liquidity, while others post quotes where they would be willing to trade and supply liquidity. The interaction of supply and demand determines the prevailing price at any given point in time. Liquidity suppliers may place limit orders, which specify an amount the agent is willing to trade, the direction, and the worst acceptable price. A limit buy order in the euro-dollar market, for example, might specify that the agent is willing to buy up to $2 million at $1.2345 or less. These limit orders are placed into a “limit-order book,” where they remain until executed or cancelled. Agents demanding liquidity place “market” orders, which state that the agent wishes to trade a specified amount immediately at whatever price is required to fulfil the trade. Market orders are executed against limit orders in the limit order book, beginning with the best-priced limit order and, if necessary, moving to limit orders with successively less attractive prices. The foreign exchange interdealer markets for major currencies are dominated by two electronic limit-order markets, one run by EBS and the other run by Thomson Reuters. Also known as “limit-order markets.”

Price-contingent orders: Orders that instruct an FX dealer to transact a specified amount (or quantity) at market prices once a currency has traded at a pre-specified price. Two types of price-contingent orders are stop-loss orders and take-profit orders. Stop-loss orders instruct the dealer to sell (buy) if the rate falls (rises) to the trigger rate. Take-profit orders instruct the dealer to sell (buy) if the price rises (falls) to the trigger rate.

Prime brokerage: A service offered by banks that allows a client to source funding and market liquidity from a variety of executing dealers while maintaining a credit relationship, placing collateral and settling with a single entity.

Quote-driven markets: Refers to a market where FX dealers (ie market makers) post bid and ask quotes upon bilateral request. In the interbank market, these prices are on a take-it-or-leave-it basis. During trading hours the dealers commit to trade at any time but at prices they quote. The price at which they are willing to buy, the “bid,” is always no greater than – and usually lower – than the price at which they are willing to sell, the “ask.” Quote-driven markets are also known as “dealership markets” or “over-the-counter markets.”

Reporting dealer: A bank that is active in FX markets, both for its own account and to meet customer demand, and participates in the Triennial Survey.

Settlement risk: The risk that a counterparty to a transaction does not deliver payment. Settlement is the process by which funds actually change hands in the amounts and direction indicated by a trade.

Short position: A short position arises when an agent sells an asset, possibly without actually owning it. A “short position in euros” could arise if a dealer starts with zero inventory and then sells euros. The dealer could keep the short euro inventory overnight, but will typically close the position out at the end of the trading day by buying the equivalent off-setting amount of euros to cover their short position. Someone who “shorts euros in the forward market” would have entered into a forward contract to sell euros in the future.

Single-bank trading system: A proprietary electronic trading system operated by an FX dealer for the exclusive use of its customers.

Slippage: The concurrent effect of a given trade on price.

Technical Trading: Trading based on technical analysis, an approach to forecasting asset-price movements that relies exclusively on historical price movements and trading volume. Notably, technical forecasts do not rely on economic analysis but use instead charts or computer algorithms to detect patterns in the data that can be exploited profitably.

Trading volume: The value of transactions during a given time period.

Transparency: Ability of market participants to observe trade information in a timely fashion.

Triangular arbitrage: Between every three currencies A, B, and C there are three bilateral exchange rates. Triangular arbitrage is a way to make riskless profits if the A-per-B exchange rate does not equal the C-per-B exchange rate multiplied by the A-per-C exchange rate.

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