Forex Concepts
Basic Glossary
Given - The person or party who initiates the order is called the "given" side of the order
Mid Price - This is the average value for a family of trades
Trade Date - The day the trade is created
Spot Date - A date that is two business days after the trade date
Forward Date - A projected date in the near future after the trade date
Spot Leg - The estimated value of the trade on the spot date
Forward Leg - The estimated value of the trade on the forward date
LIBOR - The reference rate for lending and borrowing money (deposits and loans) between organizations. LIBOR is used to calculate interest rates for swaps.
Spread - The difference between the bid price and the offer price
Quoting Conventions
Writing the quote
When quoting for a spot date, there are several rules to adhere to for defining a quote and there are several ways to denote this quote. Every transaction goes through USD, example: CurrencyA and CurrencyB are being exchanged. CurrencyA is converted to USD, and CurrencyB is converted to USD, and the quote is made from those values.
Why USD? Why not just convert from currency to currency? USD is used since it's the world's leading currency: it's the world's main reserve currency, valued commodities are denoted in USD (oil, gas, coffee, gold, etc.), and the US itself is still the most liquid capital market in the world. There are some more reasons but these are the easiest to highlight.
Currencies are quoted as "CurrencyA is worth X units of CurrencyB". The naming convention is that CurrencyA will be placed first in the currency pair, i.e., GBP to JPY is GBP/JPY. The first currency is sometimes referred to as the "base currency", and the bid and offer will refer to that currency.
A european quote is expressed as the value of one USD in units of the foreign currency, i.e., USD/CHF (Swiss Franc).
An american quote is expressed as the amount of dollars needed for one unit of the foreign currency, i.e., how many USD = 100 units of the foreign currency. An american quote might look like 1 USD = 110 JPY, or 1 GPB = 1.something USD.
When exchanging USD for EUR, GBP, AUD, and NZD, USD will always be the second currency. That's just the way it is.
Making the quote
One of the attributes of a currency price quote is the "spread". This is the difference between the bid (the price we're willing to pay) and the offer (the price we're willing to sell at). It sounds consistent, but the spread can change due to several factors:
- Trades in illiquid markets have wider spreads
- Very large amounts are difficult to trade and therefore will have wider spreads
- Transaction costs for processing and settling a trade will influence the spread
Credit Impact
Like all financial investments, risk is a large part of the investment equation. In forex, there's Delivery Risk and Replacement Risk.
Delivery Risk is the notion that during an exchange of currencies, the other party may not send over the money agreed upon during the exchange while we've sent over our currency. In forex trading, both sides settle simultaneously, which means that both sides pay out the exchange at the same time without either side being 100% certain that the other party has sent over their half of the exchange.
A crude example of delivery risk is that we send over our cash for some counterparty's cash, and the counterparty declares bankruptcy right after we agree on the trade, making them unable to send payment. We just lost everything because we sent over money already.
Replacement Risk is a similar risk in forex trading, but this risk is only associated with forward trades. While delivery risk focuses on "what if the other party loses all of their money (aka becomes insolvent) when we're supposed to exchange", replacement risk focuses on "what if the other party loses all of their money before we hit the forward date and trade".
Spot Trades and Forward Trades
Spot trades are those where currency is exchanged based on their trading price, which is determined by supply and demand. These trades happen quickly and in the present, taking anywhere between 1 to 2 days for settlement. These trades always result in cash.
Forward trades are more complicated; they're private agreements between two parties to buy a currency at a future date AND at a pre-determined price. Forward trades don't trade the currencies themselves and instead are contracts that represent claims to a given currency type, a price-per-unit for that type, and a future settlement date.
Forward trades can offer protection against risks in trading, because the rates, prices, terms, etc. are agreed to in advance and are set in stone; if the market goes topsy-turvy in some sector and there's a bunch of loss for some currency, or the currency under exchange has some fluctuations that somewhat ruin the profitability before the forward date, the value is retained.
Rules for spot dates
Spot trades are usually settled two business days after the trade date. Canadian dollar trades are an exception that are settled in one. The delay gives both parties enough time to initiate payments to the counterparty. If one of the two days is a legal holiday in one country but not another, the one without the holiday will get three days for the spot date.
Since most cross trades (any two currencies that are being traded where neither is USD) are settled in USD, if a trade occurs on a US holiday, most market makers will refuse to quote a spot date on that day. Saturdays are never considered valid settlement days globally.
Date edge cases
Holidays and Weekends
If a spot or forward date falls out on a holiday or a weekend, the trade still matures regardless.
Month to Month
If a trade's forward date begins at the end of a month, it will end on the third month; the clock will start ticking from the month the date began. Example: if a forward date is 3 months from April 30th, that date will be July 31st, not July 30th.
Swaps
A swap is an agreement between two parties (in this case, client and trader) where each party agrees to pay each other a sum of money as if this sum were a loan. Because these payments are structured like loans, they have interest applied to them.
An investment firm might want to engage in a swap (or several) in order to have liquid cash on hand for future investments, as they might already have cash but have it committed to other investments. Because swaps have interest applied to them, either side of a swap can either subscribe to fixed interest or variable interest.
It's common for swaps to be asymmetrical in terms of which kind of interest they choose to apply, as one side might feel that the market will perform in a way that will keep interest rates low, while the other might feel that market performance will raise rates or create too much uncertainty.
With the choice between interest rate types, swaps help mitigate risk in regards to trades/orders that revolve around volatile currencies.