As in the Black-Scholes model for stock options and the Black model for certain interest rate options, the value of a European option on an FX rate is typically calculated by assuming that the rate follows a log-normal process.
In 1983 Garman and Kohlhagen extended the Black-Scholes model to cope with the presence of two interest rates (one for each currency). Suppose that rd is the risk-free interest rate to expiry of the domestic currency and rf is the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of domestic currency per unit of foreign currency"). Then the domestic currency value of a call option into the foreign currency is
c = S_0\exp(-r_f T)\N(d_1) - K\exp(-r_d T)\N(d_2)
The value of a put option has value
p = K\exp(-r_d T)\N(-d_2) - S_0\exp(-r_f T)\N(-d_1)
where :
d_1 = \frac{\ln(S_0/K) + (r_d - r_f + \sigma^2/2)T}{\sigma\sqrt{T}}
d_2 = d_1 - \sigma\sqrt{T}
S0 is the current spot rate
K is the strike price
N is the cumulative normal distribution function
rd is domestic risk free rate
rf is foreign risk free rate
and σ is the volatility of the FX rate.
Saturday
Hedging with FX options
Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.
Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthen against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.
If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.
Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which will:
* protect the GBP value that the firm will receive in 90 day's time (presuming the cash is received)
* cost at most the option premium (unlike a forward, which can have unlimited losses)
* yield a profit if the expected cash is not received but FX rates move in its favor
Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthen against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.
If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.
Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which will:
* protect the GBP value that the firm will receive in 90 day's time (presuming the cash is received)
* cost at most the option premium (unlike a forward, which can have unlimited losses)
* yield a profit if the expected cash is not received but FX rates move in its favor
Terms
Generally in thinking about options, one assumes that one is buying an asset: for instance, you can have a call option on oil, which allows you to buy oil at a given price. One can consider this situation more symmetrically in FX, where one exchanges: a put on GBPUSD allows one to exchange GBP for USD: it is at once a put on GBP and a call on USD.
As a vivid example: people usually consider that in a fast food restaurant, one buys hamburgers and pays in dollars, but one can instead say that the restaurant buys dollars and pays in hamburgers.
There are a number of subtleties that follow from this symmetry.
Ratio of notionals
The ratio of the notionals in an FX option is the strike, not the current spot or forward. Notably, when constructing an option strategy from FX options, one must be careful to match the foreign currency notionals, not the local currency notionals, else the foreign currencies received and delivered don't offset and one is left with residual risk.
Non-linear payoff
The payoff for a vanilla option is linear in the underlying, when one denominates the payout in a given numéraire. In the case of an FX option on a rate, one must be careful of which currency is the underlying and which in the numéraire: in the above example, an option on GBPUSD gives a USD value that is linear in GBPUSD (a move from 2.0000 to 1.9000 yields a .10 * $2,000,000 / 2.0000 = $100,000 profit), but has a non-linear GBP value in GBPUSD. Conversely, the GBP value is linear in the USDGBP rate, while the USD value is non-linear in the USDGBP rate. This is because inverting a rate has the effect of x \mapsto 1/x, which is non-linear.
Change of numéraire
the implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of x \mapsto 1/x
As a vivid example: people usually consider that in a fast food restaurant, one buys hamburgers and pays in dollars, but one can instead say that the restaurant buys dollars and pays in hamburgers.
There are a number of subtleties that follow from this symmetry.
Ratio of notionals
The ratio of the notionals in an FX option is the strike, not the current spot or forward. Notably, when constructing an option strategy from FX options, one must be careful to match the foreign currency notionals, not the local currency notionals, else the foreign currencies received and delivered don't offset and one is left with residual risk.
Non-linear payoff
The payoff for a vanilla option is linear in the underlying, when one denominates the payout in a given numéraire. In the case of an FX option on a rate, one must be careful of which currency is the underlying and which in the numéraire: in the above example, an option on GBPUSD gives a USD value that is linear in GBPUSD (a move from 2.0000 to 1.9000 yields a .10 * $2,000,000 / 2.0000 = $100,000 profit), but has a non-linear GBP value in GBPUSD. Conversely, the GBP value is linear in the USDGBP rate, while the USD value is non-linear in the USDGBP rate. This is because inverting a rate has the effect of x \mapsto 1/x, which is non-linear.
Change of numéraire
the implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of x \mapsto 1/x
Wednesday
Example
For example a GBPUSD FX option might be specified by a contract allowing the owner to sell £1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 GBPUSD or 0.5000 USDGBP and the notionals are £1,000,000 and $2,000,000 (£1,000,000 from the eyes of a USD investor, $2,000,000 from the eyes of a GBP investor).
This type of contract is both a call on dollars and a put on sterling, and is often called a GBPUSD put by market participants, as it is a put on the exchange rate; it could equally be called a USDGBP call, but isn't, as market convention is to quote the 2.0000 number (normal quote), not the 0.5000 number (inverse quote).
If the rate is lower than 2.0000 GBPUSD come December 31 (say at 1.9000 GBPUSD), meaning that the dollar is stronger and the pound is weaker, then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 USD/GBP - 1.9000 USD/GBP)*1,000,000 GBP = 100,000 USD in the process. If they immediately exchanges their profit into GBP, this amounts to 100,000/1.9000 = 52,631.58 GBP.
This type of contract is both a call on dollars and a put on sterling, and is often called a GBPUSD put by market participants, as it is a put on the exchange rate; it could equally be called a USDGBP call, but isn't, as market convention is to quote the 2.0000 number (normal quote), not the 0.5000 number (inverse quote).
If the rate is lower than 2.0000 GBPUSD come December 31 (say at 1.9000 GBPUSD), meaning that the dollar is stronger and the pound is weaker, then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 USD/GBP - 1.9000 USD/GBP)*1,000,000 GBP = 100,000 USD in the process. If they immediately exchanges their profit into GBP, this amounts to 100,000/1.9000 = 52,631.58 GBP.
Foreign exchange option
In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.
The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts: the global market for exchange-traded currency options is notionally valued by the Bank for International Settlements at $158,300 million in 2005.
The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts: the global market for exchange-traded currency options is notionally valued by the Bank for International Settlements at $158,300 million in 2005.
Spread
The quotation of a currency pair usually consists of two prices. The lower price (bid) is the price at which a market maker or a brokerage in general is willing to buy the first currency of a pair. The higher price (offer or ask) is the price at which a brokerage is willing to sell the first currency of a pair. The spread is the difference between the two prices. For example if the quotation of EUR/USD is 1.3607/1.3609, then the spread is EUR 0.0002 (or 2 pips). The more popular the pair is, the smaller the differences or spreads. Different brokerage firms have different spreads.
Cross Rates
Cross rate is a currency pair that does not include USD, such as GBP/JPY. Pairs that involve the EUR are called euro crosses, such as EUR/GBP. All other currency pairs (those that don't involve USD or EUR) are generally referred to as cross rates.
Sunday
Majors
Majors are the most liquid and widely traded currency pairs in the world. Trades involving majors make up about 90% of total Forex trading.
The Majors are: EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD and USD/CAD.
GBP/USD is the only currency pair with its own name. It is known as "Cable", which has its origins from the days when a cable under the Atlantic synchronized the GBP/USD rate between the London and New York markets. But there are also lots of abbreviations for other currency pairs such as:
AUD/USD ... "Aussie"
EUR/USD ... "Euro"
GBP/JPY ... "Geppy"
GBP/USD ... "Cable"
NZD/USD ... "Kiwi"
USD/CAD ... "Loonie"
USD/CHF ... "Swissy"
USD/JPY ... "Gopher"
USD/CAD ... "Beaver"
The Majors are: EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD and USD/CAD.
GBP/USD is the only currency pair with its own name. It is known as "Cable", which has its origins from the days when a cable under the Atlantic synchronized the GBP/USD rate between the London and New York markets. But there are also lots of abbreviations for other currency pairs such as:
AUD/USD ... "Aussie"
EUR/USD ... "Euro"
GBP/JPY ... "Geppy"
GBP/USD ... "Cable"
NZD/USD ... "Kiwi"
USD/CAD ... "Loonie"
USD/CHF ... "Swissy"
USD/JPY ... "Gopher"
USD/CAD ... "Beaver"
Currency pair
A currency pair depicts a quotation of two different currencies. The first currency in the pair is the base currency or transaction currency. The second currency in the pair is labelled quote currency, payment currency or counter currency. Such a quotation depicts how many units of the counter currency are needed to buy one unit of the base currency.
For example the quotation EUR/USD 1.2500 means that one euro is exchanged for 1.25 US dollar. If the quote moves from EUR/USD 1.2500 to EUR/USD 1.2510, the euro is getting stronger and the dollar weaker. On the other hand if the EUR/USD quote moves from 1.2500 to 1.2490 the euro is getting weaker while the dollar is getting stronger.
For example the quotation EUR/USD 1.2500 means that one euro is exchanged for 1.25 US dollar. If the quote moves from EUR/USD 1.2500 to EUR/USD 1.2510, the euro is getting stronger and the dollar weaker. On the other hand if the EUR/USD quote moves from 1.2500 to 1.2490 the euro is getting weaker while the dollar is getting stronger.
Fluctuations in exchange rates
A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).
Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the country's level of business activity, gross domestic product (GDP), and employment levels. The more people there are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.
The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency in order to force that central bank to sell their currency to keep it stable (once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit).
Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the country's level of business activity, gross domestic product (GDP), and employment levels. The more people there are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.
The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency in order to force that central bank to sell their currency to keep it stable (once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit).
Asset market model
The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as economic growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services.
The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets, particularly equities.
Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates.
The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets, particularly equities.
Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates.
Balance of payments model
This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.
Like PPP, the balance of payments model focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.
Like PPP, the balance of payments model focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.
Uncovered interest rate parity
Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates exceed Japanese interest rates then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage. The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.
UIRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency.
UIRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency.
Bilateral vs effective exchange rate
Bilateral exchange rate involves a currency pair, while effective exchange rate is weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with trade weights. a real effective exchange rate (REER) adjust NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.
Nominal and real exchange rates
* The nominal exchange rate e is the price in domestic currency of one unit of a foreign currency.
* The real exchange rate (RER) is defined as RER = e \left(\frac{P^*}{P} \right), where P is the domestic price level and P * the foreign price level. P and P * must have the same arbitrary value in some chosen base year. Hence in the base year, RER = e.
The RER is only a theoretical ideal. In practice, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. For example, if the price of a good increases 10% in the UK, and the Japanese currency simultaneously appreciates 10% against the UK currency, then the price of the good remains constant for someone in Japan. The people in the UK, however, would still have to deal with the 10% increase in domestic prices. It is also worth mentioning that government-enacted tariffs can affect the actual rate of exchange, helping to reduce price pressures. PPP appears to hold only in the long term (3–5 years) when prices eventually correct towards parity.
More recent approaches in modelling the RER employ a set of macroeconomic variables, such as relative productivity and the real interest rate differential.
N R_i = (R R_i + 1)(Expected \ inflation + 1) - 1
* The real exchange rate (RER) is defined as RER = e \left(\frac{P^*}{P} \right), where P is the domestic price level and P * the foreign price level. P and P * must have the same arbitrary value in some chosen base year. Hence in the base year, RER = e.
The RER is only a theoretical ideal. In practice, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. For example, if the price of a good increases 10% in the UK, and the Japanese currency simultaneously appreciates 10% against the UK currency, then the price of the good remains constant for someone in Japan. The people in the UK, however, would still have to deal with the 10% increase in domestic prices. It is also worth mentioning that government-enacted tariffs can affect the actual rate of exchange, helping to reduce price pressures. PPP appears to hold only in the long term (3–5 years) when prices eventually correct towards parity.
More recent approaches in modelling the RER employ a set of macroeconomic variables, such as relative productivity and the real interest rate differential.
N R_i = (R R_i + 1)(Expected \ inflation + 1) - 1
Free or pegged
If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1966, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system.
Quotations
An exchange rate quotation is given by stating the number of units of "term currency" or "price currency" that can be bought in terms of 1 unit currency (also called base currency). For example, in a quotation that says the EURUSD exchange rate is 1.3 (1.3 USD per EUR), the term currency is USD and the base currency is EUR.
There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is:
EUR - GBP - AUD - USD - *** (where *** is any other currency).
Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and *** were recently removed from this list when they joined the euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are ***), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.
Quotes using a country's home currency as the price currency (e.g., EUR 1.00 = $1.45 in the US) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., £0.4762 = $1.00 in the US) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone.
* direct quotation: 1 foreign currency unit = x home currency units
* indirect quotation: 1 home currency unit = x foreign currency units
Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.
When looking at a currency pair such as EURUSD, the first component (EUR in this case) will be called the base currency. The second is called the term currency. For example : EURUSD = 1.33866, means EUR is the base and USD the term, so 1 EUR = 1.33866 USD.
Currency pairs are often incorrectly quoted with a "/" (forward slash). In fact if the slash is inserted, the order of the currencies should be reversed. This gives the exchange rate. e.g. if EUR1 is worth USD1.35, euro is the base currency and dollar is the term currency so the exchange rate is stated EURUSD or USD/EUR. To get the exchange rate divide the USD amount by the euro amount e.g. 1.35/1.00 = 1.35
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip.") An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.3386 - GBPBEF : 58.234 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.
In 2006 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price
There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is:
EUR - GBP - AUD - USD - *** (where *** is any other currency).
Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and *** were recently removed from this list when they joined the euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are ***), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.
Quotes using a country's home currency as the price currency (e.g., EUR 1.00 = $1.45 in the US) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., £0.4762 = $1.00 in the US) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone.
* direct quotation: 1 foreign currency unit = x home currency units
* indirect quotation: 1 home currency unit = x foreign currency units
Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.
When looking at a currency pair such as EURUSD, the first component (EUR in this case) will be called the base currency. The second is called the term currency. For example : EURUSD = 1.33866, means EUR is the base and USD the term, so 1 EUR = 1.33866 USD.
Currency pairs are often incorrectly quoted with a "/" (forward slash). In fact if the slash is inserted, the order of the currencies should be reversed. This gives the exchange rate. e.g. if EUR1 is worth USD1.35, euro is the base currency and dollar is the term currency so the exchange rate is stated EURUSD or USD/EUR. To get the exchange rate divide the USD amount by the euro amount e.g. 1.35/1.00 = 1.35
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip.") An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.3386 - GBPBEF : 58.234 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.
In 2006 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price
Quotations
An exchange rate quotation is given by stating the number of units of "term currency" or "price currency" that can be bought in terms of 1 unit currency (also called base currency). For example, in a quotation that says the EURUSD exchange rate is 1.3 (1.3 USD per EUR), the term currency is USD and the base currency is EUR.
There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is:
EUR - GBP - AUD - USD - *** (where *** is any other currency).
Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and *** were recently removed from this list when they joined the euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are ***), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.
Quotes using a country's home currency as the price currency (e.g., EUR 1.00 = $1.45 in the US) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., £0.4762 = $1.00 in the US) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone.
* direct quotation: 1 foreign currency unit = x home currency units
* indirect quotation: 1 home currency unit = x foreign currency units
Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.
When looking at a currency pair such as EURUSD, the first component (EUR in this case) will be called the base currency. The second is called the term currency. For example : EURUSD = 1.33866, means EUR is the base and USD the term, so 1 EUR = 1.33866 USD.
Currency pairs are often incorrectly quoted with a "/" (forward slash). In fact if the slash is inserted, the order of the currencies should be reversed. This gives the exchange rate. e.g. if EUR1 is worth USD1.35, euro is the base currency and dollar is the term currency so the exchange rate is stated EURUSD or USD/EUR. To get the exchange rate divide the USD amount by the euro amount e.g. 1.35/1.00 = 1.35
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip.") An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.3386 - GBPBEF : 58.234 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.
In 2006 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price
There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is:
EUR - GBP - AUD - USD - *** (where *** is any other currency).
Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and *** were recently removed from this list when they joined the euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are ***), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.
Quotes using a country's home currency as the price currency (e.g., EUR 1.00 = $1.45 in the US) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., £0.4762 = $1.00 in the US) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone.
* direct quotation: 1 foreign currency unit = x home currency units
* indirect quotation: 1 home currency unit = x foreign currency units
Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.
When looking at a currency pair such as EURUSD, the first component (EUR in this case) will be called the base currency. The second is called the term currency. For example : EURUSD = 1.33866, means EUR is the base and USD the term, so 1 EUR = 1.33866 USD.
Currency pairs are often incorrectly quoted with a "/" (forward slash). In fact if the slash is inserted, the order of the currencies should be reversed. This gives the exchange rate. e.g. if EUR1 is worth USD1.35, euro is the base currency and dollar is the term currency so the exchange rate is stated EURUSD or USD/EUR. To get the exchange rate divide the USD amount by the euro amount e.g. 1.35/1.00 = 1.35
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip.") An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.3386 - GBPBEF : 58.234 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.
In 2006 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price
Saturday
Exchange rate
In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 102 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 102 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 2 trillion USD worth of currency changes hands every day.
The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
Managed currency mortgages
Managed currency mortgages can help to reduce risk exposure. A borrower can allow a specialist currency manager to manage their loan on their behalf (through a limited power of attorney), where the currency manager will switch the borrower's debt in and out of foreign currencies as they change in value against the base currency. A successful currency manager will move the borrower's debt into a currency which subsequently falls in value against the base currency. The manager can then switch the loan back into the base currency (or another weakening currency) at a better exchange rate, thereby reducing the value of the loan. A further benefit of this product is that the currency manager will try to select currencies with a lower interest rate than the base currency, and the borrower therefore can make substantial interest savings.
There are risks associated with these types of mortgages and the borrower must be prepared to accept an (often limited) increase in the value of their debt if there are adverse movements in the currency markets.
A successful currency manager may be able to use the currency markets to pay off a borrower's loan (through a combination of debt reduction and interest rate savings) within the normal lifetime of the loan, while the borrower pays on an interest only basis.
There are risks associated with these types of mortgages and the borrower must be prepared to accept an (often limited) increase in the value of their debt if there are adverse movements in the currency markets.
A successful currency manager may be able to use the currency markets to pay off a borrower's loan (through a combination of debt reduction and interest rate savings) within the normal lifetime of the loan, while the borrower pays on an interest only basis.
Foreign currency mortgage
A foreign currency mortgage is a mortgage which is repayable in a currency other than the currency of the country in which the borrower is a resident. Foreign currency mortgages can be used to finance both personal mortgages and corporate mortgages.
The interest rate charged on a Foreign currency mortgage is based on the interest rates applicable to the currency in which the mortgage is denominated and not the interest rates applicable to the borrowers own domestic currency. Therefore, a Foreign currency mortgage should only be considered when the interest rate on the foreign currency is significantly lower than the borrower can obtain on a mortgage taken out in his or her domestic currency.
Borrowers should bear in mind that ultimately they have a liability to repay the mortgage in another currency and currency exchange rates constantly change. This means that if the borrowers domestic currency was to strengthen against the currency in which the mortgage is denominated, then it would cost the borrower less in domestic currency to fully repay the mortgage. Therefore, in effect, the borrower makes a capital saving.
Conversely, if the exchange rate of borrowers domestic currency were to weaken against the currency in which the mortgage is denominated, then it would cost the borrower more in their domestic currency to repay the mortgage. Therefore, the borrower makes a capital loss.
When the value of the mortgage is large, it may be possible to reduce or limit the risk in the exchange exposure by hedging
The interest rate charged on a Foreign currency mortgage is based on the interest rates applicable to the currency in which the mortgage is denominated and not the interest rates applicable to the borrowers own domestic currency. Therefore, a Foreign currency mortgage should only be considered when the interest rate on the foreign currency is significantly lower than the borrower can obtain on a mortgage taken out in his or her domestic currency.
Borrowers should bear in mind that ultimately they have a liability to repay the mortgage in another currency and currency exchange rates constantly change. This means that if the borrowers domestic currency was to strengthen against the currency in which the mortgage is denominated, then it would cost the borrower less in domestic currency to fully repay the mortgage. Therefore, in effect, the borrower makes a capital saving.
Conversely, if the exchange rate of borrowers domestic currency were to weaken against the currency in which the mortgage is denominated, then it would cost the borrower more in their domestic currency to repay the mortgage. Therefore, the borrower makes a capital loss.
When the value of the mortgage is large, it may be possible to reduce or limit the risk in the exchange exposure by hedging
Friday
Hypothetical single "true" global currency
An alternative definition of a world or global currency refers to a hypothetical single global currency, as the proposed Terra, produced and supported by a central bank which is used for all transactions around the world, regardless of the nationality of the entities (individuals, corporations, governments, or other organisations) involved in the transaction. No such official currency currently exists for a variety of reasons, political, economic, and cultural.
There are many different variations of the idea, including a possibility that it would be administered by a global central bank or that it would be on the gold standard . Supporters often point to the euro as an example of a supranational currency successfully implemented by a union of nations with disparate languages, cultures, and economies. Alternatively, digital gold currency can be viewed as an example of how global currency can be implemented without achieving national government consensus.
A limited alternative would be a world reserve currency issued by the International Monetary Fund, as an evolution of the existing Special Drawing Rights and used as reserve assets by all national and regional central banks.
There are many different variations of the idea, including a possibility that it would be administered by a global central bank or that it would be on the gold standard . Supporters often point to the euro as an example of a supranational currency successfully implemented by a union of nations with disparate languages, cultures, and economies. Alternatively, digital gold currency can be viewed as an example of how global currency can be implemented without achieving national government consensus.
A limited alternative would be a world reserve currency issued by the International Monetary Fund, as an evolution of the existing Special Drawing Rights and used as reserve assets by all national and regional central banks.
19th - 20th centuries
Prior to and during most of the 1800s international trade was denominated in terms of currencies that represented weights of gold. Most national currencies at the time were in essence merely different ways of measuring gold weights (much as the yard and the metre both measure length and are related by a constant conversion factor). Hence some assert that gold was the world's first global currency. The emerging collapse of the international gold standard around the time of World War I had significant implications for global trade.
In the period following the Bretton Woods Conference of 1944, exchange rates around the world were pegged against the United States dollar, which could be exchanged for a fixed amount of gold. This reinforced the dominance of the US dollar a global currency.
Since the collapse of the fixed exchange rate regime and the gold standard and the institution of floating exchange rates following the Smithsonian Agreement in 1971, currencies around the world have no longer been pegged against the United States dollar. However, as the United States remained the world's preeminent economic superpower, most international transactions continued to be conducted with the United States dollar, it has remained the de facto world currency.
Only two serious challengers to the status of the United States dollar as a world currency have arisen. During the 1980s, for a while, the Japanese yen became increasingly used as an international currency, but that usage diminished with the Japanese recession in the 1990s. More recently, the euro has competed with the United States dollar in usage in international finance.
In the period following the Bretton Woods Conference of 1944, exchange rates around the world were pegged against the United States dollar, which could be exchanged for a fixed amount of gold. This reinforced the dominance of the US dollar a global currency.
Since the collapse of the fixed exchange rate regime and the gold standard and the institution of floating exchange rates following the Smithsonian Agreement in 1971, currencies around the world have no longer been pegged against the United States dollar. However, as the United States remained the world's preeminent economic superpower, most international transactions continued to be conducted with the United States dollar, it has remained the de facto world currency.
Only two serious challengers to the status of the United States dollar as a world currency have arisen. During the 1980s, for a while, the Japanese yen became increasingly used as an international currency, but that usage diminished with the Japanese recession in the 1990s. More recently, the euro has competed with the United States dollar in usage in international finance.
Spanish Dollar: 17th-19th centuries
In the 17th and 18th century, the use of silver Spanish dollars or "pieces of eight" spread from the Spanish territories in the Americas eastwards to Asia and westwards to Europe forming the first ever[citation needed] worldwide currency. Spain's political supremacy on the world stage, the importance of Spanish commercial routes across the Atlantic and the Pacific, as well as the coin's quality and purity of silver, made it become internationally accepted for over two centuries. It was legal tender in Spain's Pacific territories of Philippines, Micronesia, Guam and the Caroline Islands and later in China and other Southeast Asian countries until the mid 19th century. In the Americas it was legal tender in all of South and Central America (except Brazil) as well as in the U.S. and Canada until the mid-19th century. In Europe the Spanish dollar was legal tender in the Iberian Peninsula, in most of Italy including: Milan, the Kingdom of Naples, Sicily and Sardinia, as well as in the Franche-Comté (France), and in the Spanish Netherlands. It was also used in other European states including the Austrian Hapsburg territories.
The euro and the United States dollar
Since the mid-20th century, the de facto world currency has been the United States dollar. According to Robert Gilpin in Global Political Economy: Understanding the International Economic Order (2001): "Somewhere between 40 and 60 percent of international financial transactions are denominated in dollars. For decades the dollar has also been the world's principal reserve currency; in 1996, the dollar accounted for approximately two-thirds of the world's foreign exchange reserves" (255).
Many of the world's currencies are pegged against the dollar. Some countries, such as Ecuador, El Salvador, and Panama, have gone even further and eliminated their own currency in favor of the United States dollar. The dollar continues to dominate global currency reserves, with 64.6% held in dollars, as compared to 25.8% held in euros (see Reserve Currency).
Since 1999, the dollar's dominance has begun to be undermined by the euro, that represents a larger size economy, with the prospect of more countries adopting the euro as their national currency. The euro inherited the status of a major reserve currency from the German Mark (DM), and since then its contribution to official reserves has risen continually as banks seek to diversify their reserves and trade in the eurozone continues to expand.
Similar to the dollar, quite a few of the world's currencies are pegged against the euro. They are usually Eastern European currencies like the Estonian kroon and the Bulgarian lev, plus several west African currencies like the Cape Verdean escudo and the CFA franc. Other European countries, while not being EU members, have adopted the euro due to currency unions with member states, or by unilaterally superseding their own currencies: Andorra, Kosovo, Monaco, Montenegro, San Marino, and the Vatican City.
As of December 2006, the euro surpassed the dollar in the combined value of cash in circulation. The value of euro notes in circulation has risen to more than €610 billion, equivalent to US$800 billion at the exchange rates at the time. This results in the Euro being the currency with the highest combined value of cash in circulation in the world.
Many of the world's currencies are pegged against the dollar. Some countries, such as Ecuador, El Salvador, and Panama, have gone even further and eliminated their own currency in favor of the United States dollar. The dollar continues to dominate global currency reserves, with 64.6% held in dollars, as compared to 25.8% held in euros (see Reserve Currency).
Since 1999, the dollar's dominance has begun to be undermined by the euro, that represents a larger size economy, with the prospect of more countries adopting the euro as their national currency. The euro inherited the status of a major reserve currency from the German Mark (DM), and since then its contribution to official reserves has risen continually as banks seek to diversify their reserves and trade in the eurozone continues to expand.
Similar to the dollar, quite a few of the world's currencies are pegged against the euro. They are usually Eastern European currencies like the Estonian kroon and the Bulgarian lev, plus several west African currencies like the Cape Verdean escudo and the CFA franc. Other European countries, while not being EU members, have adopted the euro due to currency unions with member states, or by unilaterally superseding their own currencies: Andorra, Kosovo, Monaco, Montenegro, San Marino, and the Vatican City.
As of December 2006, the euro surpassed the dollar in the combined value of cash in circulation. The value of euro notes in circulation has risen to more than €610 billion, equivalent to US$800 billion at the exchange rates at the time. This results in the Euro being the currency with the highest combined value of cash in circulation in the world.
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