6. Foreign Exchange and Derivatives Trading Flashcards
How does the volume of foreign exchange trading compare with that required to finance trade and capital flows?
Foreign exchange market trading is over 50 times the size of underlying trade flows.
$6.6 trillion per day of FX trading. 49% foreign exchange swaps, 30% spot transactions, 15% outright forwards.
43% FX trades booked in London, 17% in US (mostly NY).
What things contribute to foreign exchange trading volume?
- Foreign exchange risk management (hedging)
- The opportunities for trading profits (speculation and arbitrage)
- The role played by this financial trading in foreign exchange price discovery
- Financing purchases of goods and services (small percentage of overall volume)
What is transaction risk?
The adverse effect that foreign exchange rate fluctuations can have on a completed transaction prior to settlement. The exposure to uncertainty factors that may impact the expected return from a deal or transaction.
Example: Company X in UK makes a deal with Company Y in US to pay it $100,000 in 6 months for some goods. The current spot exchange rate for $100,000 is £60,000. The transaction risk is that in 6 months, the spot exchange rate for $100,000 might change to something >£60,000 (Company X may need to pay more £ in future than it would now).
Foreign exchange forward (outright forward)?
An agreement between two parties to exchange a specified amount of currencies for a predetermined rate (forward rate) at a future date.
Define the terms spot transaction & spot rate
A spot transaction is the immediate exchange of currencies at the current market rate (spot rate).
What is an options contract?
A financial agreement that grants the buyer the right, but not the obligation, to buy or sell a particular asset (e.g., a stock or currency (FX)) at a preset price within a given period.
What is arbitrage?
Arbitrage means taking advantage of discrepancies in an asset’s price between different markets in order to make a risk-free profit. This is done by simultaneously buying an asset in one market and selling it in another if there is a price difference. Arbitrage opportunities never yield large scale permanent profits.
This is because in highly efficient markets, price discrepancies are usually small and exist only for very short periods because the process of arbitrage itself corrects the pricing inefficiency.
Thus, any such price discrepancy quickly disappears as traders take advantage of the arbitrage opportunity. Therefore, a consequence of arbitrage is prices across markets aligning and supporting price discovery across markets.
What is the relationship between spot and forward exchange rates?
Covered interest parity (CIP) is a theoretical financial condition that describes their relationship.
The differential between the forward exchange rate and the spot exchange rate is equal to the interest rate differential between the two countries.
This condition states that arbitrage is not possible but in reality, departures from this relationship exist. Any departure from this relationship large enough to overcome the costs of trading is an arbitrage profit opportunity.
What is speculative trading (speculation)?
Speculation is taking a risky financial position in a market with the expectation of benefiting from future price movements (with potential returns sufficiently large to compensate for the risk). Speculators typically seek to profit from anticipated changes in the price of an asset (e.g., stocks, commodities, currencies) over a short or medium-term horizon, often without a long-term commitment to the asset itself.
What is a hedge fund?
An investment fund open only to wealthy or professional investors, in which the investment managers hold a large share of equity and the fund seeks to profit from temporary discrepancies or predictable movements in market prices. Hedge funds make considerable use of derivative markets in order to increase their leverage and hence profitability and also to isolate and protect themselves against risks where they do not believe they have potential to make money. Hedge funds do take risks, but aim to be clever, choosing carefully what risks to take, and hedging other risks (e.g., through long-short strategies). Hedge funds attract finance from wealthy investors; high management fees; flat management structure. The managers of hedge funds also have a substantial stake, they might own one third of the fund. They also get a share of investor returns (not the fixed fee given to mutual fund managers).
- Incentives encourage profitable risk-taking
- Can earn 30% plus returns on capital
What is insider trading?
A form of market abuse when an individual, for example an employee or manager in a firm trades on the basis of inside information not in the public domain.
Insider trading is illegal and if discovered and prosecuted can be subject to substantial fines or even imprisonment. However, there is evidence – from market prices moving before announcements are made – that regulation does not completely prevent insider trading.
What is front running?
The practice of the market abuse of entering into a trade to capitalize on non-public knowledge of a large transaction that will be executed later that will influence the price of the underlying security.
What is market manipulation? What are some examples?
Manipulating market activity to benefit from creating a false price. Conduct designed to deceive investors by controlling or artificially affecting the price of securities.
- A market corner: Acquiring enough shares of a particular security type, such as those of a firm in a niche industry, or to hold a significant commodity position to be able to manipulate its price. The term implies that the market has been backed into a corner, and there is nowhere for the market to move to find other sellers and buyers.
- Wash trading: Buying and selling a security for the express purpose of feeding misleading information to the market.
- Spoofing: Placing a very large order on a limited order book with no intention to execute the order.
