FOREX for Dummies
A simple explanation of FOREX instruments
I had always been fascinated by terms like derivatives, swaps, options and all those other esoteric sexy sounding words usually reserved to the super elite and immensely intelligent. I was also somewhat embarrassed to be a financier with an economics degree and very little idea about what most of these words actually meant. I was also sure that while most of the black suit brigade at Soul Bar on a Friday night were happy to throw these terms around indiscriminately, very few of us had any idea what we are actually talking about.
Recently, however, I took on some funding lines in Euro (EUR) and had a real reason to dig further into the world of foreign exchange.
I was approached by Adrian Lodge at Kiwibank who assessed my needs and assigned me my own foreign exchange dealer, Mike Shirley. With all of my preconceptions about foreign currency dealers I was expecting to meet a slick, fast talking trader with a bad attitude and a cocaine addiction. I was pleasantly surprised to find Mike to be a pleasant, down to earth chap who was more than happy to assist me in my understanding of foreign exchange markets.
My first step was to borrow EUR and convert them to New Zealand dollars (NZD) at the prevailing spot rate.
The spot market
The spot market is a real market containing buyers and sellers of currency. Currencies are traded on a day two days following the quote date and the expected demand of particular currencies are reflected in their rates. You should bear this in mind if trading foreign currency because some traders load the value of currency by 2% or more. There are a number of foreign currency houses out there, or you can deal directly with your bank, so be sure to shop around. The rates and level of service you receive while partially dictated by volume, are a reflection of the quality of the provider.
While I had never used Kiwibank before they were a full 1.5% lower than the second-lowest rate I was able to obtain, and they provided a level of service I found to be extra-ordinary for someone who was new to the game.
All I then needed to do was to lock in the value of EUR for all future interest payments. The two methods I considered (and there a many more) were forward contracts and foreign currency options.
A forward contract is an agreement to lock the purchase or sale of a particular currency at the current exchange rate at a future date. For instance if I borrowed Euro at 60 cents, I could enter into a contract to purchase EUR at today’s rate (or very close to it as will be explained) and repay that amount in the future.
This is the basics of how it works for the customer though the mechanics behind this a far more interesting as will be demonstrated by this example.
If I wanted to buy EUR in three months’ time, Kiwibank would borrow NZD today and convert it to EUR at the prevailing spot rate, then invest the EUR for the same period. In three months’ time Kiwibank would receive the invested EUR and repay the foreign currency loan, while I honoured the contract and repaid the NZD loan.
As there is no certainty that I would actually honour the loan, Kiwibank would usually require a deposit of up to 10% of the amount contracted to be held in their account. This would cover them for any losses should they be required to make good on the contract if I reneged.
As the interest rates in the two currencies may not be the same, any shortfall or gain will be reflected in the forward rate. The contemporaneous borrowing in one currency and investing in another currency removes the need to match buyers and sellers as in the spot market. This is important as the market for currencies at longer dated terms may be illiquid and impossible to match off on an exchange.
Foreign currency options
Forward contracts are for the risk averse, they lock in a set rate and while they require a deposit, they do not in general require a premium.
With the Eurozone balanced on the precipice of disaster many would not have bothered to hedge against upward movements of the EUR against the NZD. They would have been happy to take the punt be happy to enjoy the profits if the EUR fell against the NZD. While this was tempting, it would also have been a little reckless.
The solution then was a foreign currency option that would give me the right to purchase EUR at a date in the future but not the obligation to. For instance I could buy the right to buy EUR at 60 cents in three months’ time, but if the NZD was higher at that date, I would not be required to and could take the profit. Furthermore, with an option you can not only specify the amount and date that you wish to purchase EUR at, but the rate.
With an option, as opposed to a forward contract, the bank takes a position and charges a risk or insurance premium based on rate selected (strike rate) and date of the contract. The higher the 'strike rate' or the longer the futures date of the contract, the higher the value of the premium.
There are many other very clever types of foreign currency instruments that can be used for the slightly more exciting risk seeker, but the two middle of the road methods discussed should suit most. Both of these instruments are designed for the user to eliminate risk completely by paying a premium and allowing the banks to take a position in the market.
Many thanks to the team at Kiwibank for helping me with this.
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