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Human rights law (HRL)

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LEHMAN BROTHERS

FOREIGN EXCHANGE

TRAINING MANUAL

FOREIGN EXCHANGE SPOT: INTRODUCTION CONTENTS PAGE
- AN INTRODUCTION TO FOREIGN EXCHANGE SPOT TRANSACTIONS FXSPOT:
  - INTRODUCTION
  - WJ-IAT IS AN OUTRIGHT?
  - VALUE DATES
    - CREDIT AND SETTLEMENT RISKS
  - EXCHANGE RATE QUOTATION TERMS
  - RECIPROCAL QUOTATION TERMS (RATES)
  - EXCHANGE RATE MOVEMENTS
    - SHORTCUT
  - BIDS AND OFFERS
  - THE RULE OF THE LEFT BID -RIGHT OFFER
    - CROSS RATES - ON SAME TERMS BID-OFFER FOR THE CROSS RATES OF CURRENCIES
  - EXCHANGE RATE MOVEMENT REVISITED FOR CROSSES - DIFFERENT TERMS BID-OFFER FOR CROSS RATES OF CURRENCIES ON
    - SUMMARY
    - SHORTCUTS
  - TRADING CONVENTIONS AMONG MARKET MAKERS
    - SUMMARY
  - REVIEW PROBLEMS
FOREIGN EXCHANGE FORWARDS: INTRODUCTION
- AN INTRODUCTION TO FOREIGN EXCHANGE FORWARDS FXFORWARDS:
  - INTRODUCTION
  - WJ-IAT ARE FORWARDS?
    - CALCULATING THE FORWARD RATE
  - HOW DO YOU CALCULATE FORWARD POINTS?
  - PAY AND EARN POINTS
    - SUMMARY
    - SAMPLE PROBLEMS
  - PREMIUM VS. DISCOUNT POINTS

(continued)

CONTENTS ....................................................................................................................................... PAGE

SECOND ORDER GREEKS ............................................................................................... 106

FACTORS AND THEIR EFFECTS ON OPTION VALUE ........................................ 107

EXOTIC OPTIONS ................................................................................................................ 107

TRADING CONVENTIONS .............................................................................................. 110

TRADING STRATEGIES ..................................................................................................... 111

GLOSSARY ............................................................................................................................... 123

(m)

FOREIGN EXCHANGE

SPOT

INTRODUCTION

1 WHAT IS AN OUTRIGHT?

An outright currency transaction involves two parties exchanging one currency for another. The two parties must agree on the two currencies, the amount of one currency, the settlement date, and the exchange rate. The amount of the second currency will be derived from a calculation involving the amount of the first currency and the exchange rate.

Outright rate of exchange/ spot:

Outright Transaction:

the amount of one unit of currency expressed in terms of the other.

the exchange of one currency for the other at the outright rate of exchange.

VALUE DATES

The value date is the day the two parties actually exchange the two currencies. It is impractical, in most circumstances, for the value date and the trade date to be the same. The forward value date is usually required to allow both parties time to arrange for payments which often occur in different time zones.

By market convention, foreign exchange trades settle two mutual business days (T + 2) after that trade date unless otherwise specified. This is commonly referred to as value for spot. The spot exchange rate is the benchmark price the market uses to express the underlying value of the currency. Rates for dates other than the spot are always calculated relative to the spot rate.

Listed below are the various value dates available in the market-they are all determined relative to the deal date. Assume the deal date is Monday, December 12.

Cash December 12

Value "Tomorrow Next" December 13

Spot December 14

Forward Outright December 15 or Later

Deal Date

One Mutual Business Date After Deal Date#

Two Mutual Business Days After Deal Date++

Three Business Days or More After Deal Date; Always Longer Than Spot

The Setdement Date May Not Fall on a Day That is a National Holiday in Either Country.

++ Exception: Spot for the Canadian Dollar Against the USD is One Business Day Later. Assuming Today is Monday, December 12, Spot Would be December 13.

4 ANSWERS

December 4
December 5
December 5
December 6
December 6

CREDIT AND SETTLEMENT RISKS

Foreign Exchange contracts represent a Credit Risk between Lehman and the client. The risk is equal to the replacement cost of any deal in the event that the client cannot fulfill its obligations. For spot transactions, the exposure is for only the two days between the trade date and the value date. However, for forward contracts the exposure is greater because the time between the trade date and the value date is greater. For example, if Lehman contracted to buy USD/sell EUR one year forward at 1 and the current forward rate is 1, Lehman has a gain of over 4% of the face value of the contract. If the client cannot fulfill the contract, Lehman must replace the forward at the rate currently available and, therefore, stands to lose the 4% mark-to-market gain. Since the bank reports mark-to-market gains as income, client nonperformance has bottom line implications.

Settlement Risk is another form of credit risk which can potentially be much greater. Each currency deal actually involves two settlements, since each currency settles in its home country. Since the exchange of currencies cannot be simultaneous due to time differences, each party is at risk for the time period between the two settlements. For example, assume you have sold JPY against the USD. The JPY will settle in Japan-your JPY account will be debited and the JPY delivered to the bank of the buyer-hours before your dollar account in New York is credited. Your risk is that you deliver JPY to the Japanese clearing, but the bank which owes you dollars in return for your JPY declares bankruptcy by the opening of business in NY. You have paid out the JPY but will not receive your dollars in exchange.

6

EXCHANGE RATE QUOTATION TERMS

The major currency pairs can be quoted in either European or Amen'can terms.

Those that quote in number of US dollars per one unit of another currency is American. An example of this is EUR/USD which is quoted as the number of USD per one Euro.

A currency quoted as the number of units of a specific currency per one USD is quoted in American terms. An example of this would be dollar-yen, which is quoted in yen per one USD. \X!hen rates are spoken the base currency comes first. It is imperative that you remember these conventions!

The arithmetic way to express these quotations will always have the base currency in the denominator and the rates currency in the numerator. Do not allow this representation to confuse you when actually saying the currency pairs. This is simply how they would look mathematically. Examples are USD /EUR and JPY /USD being the nomenclature for arithmetic expression of Dollars per Euro and JPY per USD, respectively. The following will illuminate this point.

Since two currencies are involved, one has to be quoted in terms of the other. \X!hen we say that the exchange rate for the yen against the dollar is 123 yen, we are valuing the dollar in terms of the yen-123 yen per dollar. The arithmetic expression tells you which currency is being quoted in terms of the yen. In the case of the USD /EUR, the EUR is being quoted in terms of the USD.

The way the two currencies are referred to verbally will usually tell you which one is the base, since the base currency is usually stated first. For example, when the two currencies involved are the US dollar and the yen, the relationship is called dollar-yen-meaning the number of yen per dollar. This tells you that the dollar is the base and that the rate will be quoted in terms of yen per dollar.

Do not let the terminology confuse you; a "dollar-yen" rate is quoted as Yen per USD.

##Also Known as the 'Loon'.

$ Sometitnes Known as the 'Fondue Franc'

QUESTIONS

In many cases, you will see only the terms account; it is assumed you know the base. For example, if you see JPY124 you know that this means 124 Yen per $1.

GBP 1: base _______ _ quoted in ____________ t,erms.
CAD 1: base _______ _ quoted in ___________ terms.
AUD 0: base _______ _ quoted in ____________ terms.
EUR 1: base _______ _ quoted in ____________ terms.

9 ANSWERS

Sterling; US terms
USD; European terms
AUD; US terms
EUR; US terms

RECIPROCAL QUOTATION TERMS (RATES)

The method of quotation can be changed from US to European terms, or vice versa, simply by calculating the reciprocal of the rate. For example, Canadian dollars are usually quoted in European terms, that is, the number of Canadian dollars per one US dollar.

CAD /USD = 1.

However, at least for Canadian banks, you sometimes see it quoted in US terms. That is, the number ofUSD per CAD.

To take the reciprocal:

1 I 1 - 0. 0 USD per 1 CAD

10 QUESTIONS

Based on the rates given below, decide which currency strengthened and which one weakened, whether it closed up or down, and your profit/loss based on the position you took at the open.

&member: When the rate increases, the base strengthens, and the terms weakens.

Sterling opens at 1 and closes at 1.

The dollar and the pound. Therefore, the Dollar closed (up/down) for the day, relative to the GBP. If you sold 1MM GBP and bought USD at the open and the reversed the trade at the close, your (profit/loss) would be _________ (currency and amount).

Dollar-yen opens at 124 and closes at 123.

The Dollar and the yen. Therefore, the Yen closed (up/ down) for the day, relative to the USD. If you sold USD 1MM at the open and reversed the position at the close, your (profit/loss) would be ______________ __

CHF /USD opens at 1 and closes at 1.

The USD and the Swiss Franc ___________ _ Therefore, the Dollar closed (up/ down) for the day, relative to the CHF. If you sold CHF 10MM at the open and bought them back at the close, your (profit/loss) would be

12 ANSWERS

The Dollar weakened and the Pound strengthened, since one Pound will buy more Dollars. The Dollar closed down for the day. You had a loss of £1,037 or $1,600.

-£1,000,000 = +$1,540,900 @ 1.

+ £998 = -$1,540 @ 1.

-£1,037 = 0

-£1,000,000@ 1 = +$1,540,

+ £1.000@ 1 = -$1.

0 - -$1,

The Dollar weakened and the Yen strengthened, since one Dollar will buy fewer Yen. The Yen closed up for the day. You had a profit of¥550,000 or $4,453.

$1,000,000 = +¥124,050,000@ 124 -$1,000,000 @ 124 - +¥124,050,

$1,004 = -¥124.050 @ 123 ...:....+.:L$1"-",0"-"0""-0,""-0"'-'00"--..>.:;:@~~--=1=23"-!."'-'0"---------=¥-=.1=23="-"0""-0,""-0~~ +$4,453 = 0 0 - +¥550,

The dollar strengthened and the Swissie weakened since one Dollar will buy more Swissie. The Dollar closed up for the day. You had a profit of CHF3,327 or $2,213.

-CHF10,000,000 = +$6,653,360@ 1 -CHF10,000,000@ 1 =+$6,653,360@ 1.

+CHF10.003 = +$6.653@ 1 +CHF10.000@ 1 =+$6.651@ 1.

+CHF3,327 = 0 0 = +$2,

In the problems above we saw the following market moves:

Dealers refer to small moves as pips. For example, in the case ofUSD/GBP, Sterling moved 16 pips whereas in the case of the USD /JPY, the market moved 55 pips. One hundred pips is a "point" or a ''big figure." Note that pips or points can be a different decimal place depending on the quoting convention of the market. In the Sterling market, one pip is 0 but in the Yen market, one pip is 0.

13 ANSWERS

Base currency gain = .31/123 * $1,000,000 = $2, Terms currency gain = .31 * $1,000,000 = JPY310,
Base currency loss = .0035/1 * $1,000,000 = ($2,328) Terms currency loss = .0035 * $1,000,000 = (CHF3,500)

15

BIDS AND OFFERS

\X!hen making a market in a currency, market-makers (traders) quote two rates:

Bid Rate at \X!hich Market Maker Will Buy the Base Currency Offer Rate at \X!hich Market Maker Will Sell the Base Currenc

The difference between the bid and the offer is called the spread.

USD/GBP = JPY/USD =

1/74, so the spread is 0 USD/GBP. 123.50/123, so the spread is 0 JPY /USD.

The market may move 10 pips, with the new quote being 1/84, but the spread remains the same under normal market conditions.

Also, note that although the spread in both markets above is 10 pips, the value of 10 pips in the USD /GBP is different from the value if the 10 pips in the JPY /USD market. However, in the market, spreads are generally comparable between currencies on a percentage basis. In general, greater uncertainty among traders is reflected in wider spreads in the market.

The size of the spread reflects:

o The liquidiry of that currency-the more liquid the currency, the narrower the spread.

o The size of the deal-the bigger the transaction, the wider the spread because the dealer is taking on more risk.

o The time of the day-spreads tend to be widest in the New York afternoon because both Europe and Asia are closed or during the Asian lunchtime.

16

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