Block F · Foreign exchange (FX)
‹ NadirAlpha financial markets handbook: overview
Independent NadirAlpha working reference. Product and feature names mentioned are trademarks of their respective owners. No investment advice.
The FX market is the most liquid market in the world; for investors it is rarely a return source but almost always a risk factor; every foreign investment contains a currency position, intended or not.
72 · Spot market & quotation conventions
Spot transaction with T+2 value date; quoted as a pair of base/quote currency (EURUSD 1.10 = 1 EUR costs 1.10 USD).
The basis of all FX transactions; conversion, valuation.
Enormous liquidity, tight spreads in majors.
Mixing up the quotation direction; exotics with wide spreads.
Misattributing strength/weakness; when EURUSD rises, the dollar falls (not the euro).
73 · FX forwards & forward points
Forward transaction; forward rate = spot + forward points, which follow from the interest rate differential of the two currencies (covered interest parity).
The standard instrument of currency hedging.
Exact hedging of amount/date.
Hedging "costs" with a negative rate differential; roll risk on extension.
Assuming a USD hedge is free for EUR investors; the rate differential determines the cost, not the provider.
77 · Currency hedging in the portfolio · 74 · FX swaps
74 · FX swaps
Simultaneous purchase/sale at spot and reversal at forward; economically a collateralized money market loan in two currencies.
Rolling hedges; short-term liquidity in foreign currency.
The deepest, most liquid part of the FX market.
Basis surcharges in stress phases (year-end!); operational roll processes.
Setting roll dates without coordination and catching basis spikes (quarter/year-end).
75 · NDFs
Cash-settled forwards for currencies that are not freely convertible (INR, KRW, BRL etc.); no capital flow in local currency.
Hedging/trading EM currency risks despite capital controls.
Access without an onshore setup.
Fixing risk; divergence of onshore/offshore rates; liquidity event-dependent.
Equating NDF rates with onshore rates.
76 · FX options
The right to exchange at a fixed rate; the market quotes in implied volatility, structures via risk reversals/butterflies.
Hedging with participation (put instead of forward); target rate strategies.
Asymmetry; only the premium at risk.
Premium costs; vol level timing; complexity with barriers.
Labeling options as more expensive than forwards across the board; scenarios must be compared, not premiums.
77 · Currency hedging in the portfolio (hedge ratio)
The decision on what share of the foreign currency exposure is hedged (0-100%); sensible to decide separately per asset class.
Risk steering; FX fluctuation often dominates the short-term return of foreign bonds; for equities a smaller effect over the long term.
Volatility reduction (above all fixed income).
Costs from the rate differential; forgoing currency gains; operational rolls.
One hedge ratio for everything; decide bonds (hedge highly) and equities (more flexibly) separately.
157 · Currency risk in the portfolio · 73 · FX forwards & forward points
78 · Carry trades
Borrowing in a low-rate currency, investing in a high-rate currency; return = rate differential minus currency loss.
A systematic return source in calm markets; as an addition in currency strategies.
A documented carry premium over long phases.
"Up the stairs, down the elevator"; abrupt losses in risk-off phases; crowding.
Planning carry income as steady; the losses come rarely but violently.
73 · FX forwards & forward points · 90 · Policy rates & rate decisions