5. FX Mathematics and Applications

Question 1

What are Counter rates & it’s corresponding transaction size? Why won’t it majorly affect banks overall FX gain/loss for the day?

Answer 1

• FX rates which are used for OTC transactions during normal banking hours.
• rates are set in the morning & won’t be revised (unless there are major movements) during the day.
• rates are applicable for small transactions (usually less than MYR50,000), such as:
  • Sale and purchase of bank drafts
  • Outward and inward remittances
  • Small import and export bills
• FX transactions small, hence minimal impact on banks’ gain/loss for the day.

Question 2

Why do counter rates have big spread?

Answer 2

Since the rates are applicable for the whole day, the bank would normally quote a big spread between the buying & selling rates.

Question 3

What are the procedure for setting the rates?

Answer 3

• Determine the spot rates in the morning.
• Calculate the cross rates for the various currencies based on the spot rates.
• Add on the margins for the telegraphic transfers (‘TT’) buying & selling rates.
• Determine on demand (OD) buying rate by deducting swap points (to account for interest rates charged for the transit period & after adjusting for value today swap points) from the TT buying rate.
• Monitor movement of spot rates & make necessary adjustment to counter rates

Question 4

What is forward FX rate valuation for?

Answer 4

to hedge forward currency exposure risks

Question 5

Why do some customers value tomorrow and today their FX contracts?

Answer 5

to hedge their immediate exposure risks

Question 6

Why is optional delivery contract much more flexible than fixed delivery contracts & why do banks prefer the latter? Why optional delivery cost more?

Answer 6

1. fixed delivery contract:
   - customer only can use the contract on the contracted biz day/upon maturity of the contracted forward fixed delivery period.
   - allows bank to determine the exact day the customer will utilize the contract amount & enabled to square-off the fixed delivery contract in the interbank forward market.
2. optional delivery contract
   - customer can utilize the contract on any biz day/days within the contracted forward optional period.
   - bank can’t determine which day the customer will use the contract amount
   - common for customer to utilize the contract in smaller sums — cause extra costs & work for the bank — more pricy
   - banks quote the worst rate for such contracts.

Question 7

What would traders always attempt to do?

Answer 7

• buy (long) lower than what he sells (short)
• sell (short) higher than what he buys (long)

Question 8

What are the types of dealing strategies?

Answer 8

1. jobber/scalper
   - eg: jobber observes a strong short term support level, suggesting an immediate strengthening of the USD against MYR — promptly buy 10m USD/MYR at 4.4015.
2. positioner
   - study markets, look at charts, read news & decide whether to go long/short
   - relies on less trading volume, but goes for bigger profit margins.
   - can carry position overnight but risky — market can move either way & the open position is exposed to any economic event overnight — protect by using ‘stop-loss’ & ‘take-profit’ strategies.
3. structural trader
   - longer trading periods, usually more than 1 month, may incorporate chart analysis, recognize setups & formulate trading strategy.
   - trader will hold on to the structural position hoping to generate higher profit.

Question 9

What are stop-loss & take profit strategies? & of the 2 strategies, which one is a must?

Answer 9

• ‘Stop-loss’ strategies: aimed at limiting loss — buy a particular currency at no more/sell at no less than the specified FX rate
• ‘take profit’ strategies: buy a particular currency at no less/sell at no more than the specified FX rate — limits FX trading profit.
• Of the 2 strategies, ‘stop-loss’ is a must as it limits losses

Question 10

Why stop loss strategies may not work well in reality?

Answer 10

actual execution may likely involve price slippage whereby the stop loss order is filled at a rate worse than the stop loss order level because of high volatility or low liquidity.

Question 11

‘here is a spot EUR/USD order for you one-cancels-the-other order (OCO). We are buyers of 10 EUR at 1.1840 (take profit) or at 1.1925 (stop loss). The order is good until cancelled (GTC). Thanks, have a nice day.’
What is OCO?

Answer 11

• if one of the orders is executed, the other order is automatically cancelled
• eg: If Euro fails to reach both the order levels, the bank will continue to observe the order the next day until the order is filled/cancelled by the trader.