Foreign Exchange

A Practical Guide to the FX Markets

Tim Weithers

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118046210
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Praise for Foreign Exchange "Tim Weithers starts by telling the reader that foreign exchange is not difficult, just confusing, but Foreign Exchange: A Practical Guide to the FX Markets proves that money is much more exciting than anything it buys. This useful book is a whirlwind tour of the world's largest market, and the tour guide is an expert storyteller, inserting numerous fascinating insights and quirky facts throughout the book."
-John R. Taylor, Chairman, CEO and CIO, FX Concepts "The book reflects the author's doctorate from the University of Chicago, several years' experience as an economics professor, and, most recently, a very successful decade as an executive at a huge international bank. These fundamental ingredients are seasoned with bits of wisdom and experience. What results is a very tasty intellectual stew."
-Professor Jack Clark Francis, PhD, Professor of Economics and Finance, Bernard Baruch College "In this book, Tim Weithers clearly explains a very complicated subject. Foreign Exchange is full of jargon and conventions that make it very hard for non-professionals to gain a good understanding. Weither's book is a must for any student or professional who wants to learn the secrets of FX."
-Niels O. Nygaard, Director of Financial Mathematics, The University of Chicago "An excellent text for students and practitioners who want to become acquainted with the arcane world of the foreign exchange market."
-David DeRosa, PhD, founder, DeRosa Research and Trading, Inc., and Adjunct Professor of Finance, Yale School of Management "Tim Weithers provides a superb introduction to the arcana of foreign exchange markets. While primarily intended for practitioners, the book would be a valuable introduction for students with some knowledge of economics. The text is exceptionally clear with numeric examples and exercises that reinforce concepts. Frequent references are made to the economic theory behind the trading practices."
-John F. O'Connell, Professor of Economics, College of the Holy Cross

CHAPTER 1

Trading Money

INTRODUCTION

When many of us think of foreign exchange, what comes to mind are those little booths in the airport at which we can exchange, say, our United States Dollars for British Pounds Sterling when on our way to or from a vacation or business trip. Indeed, in some ways, there is nothing more complicated about the market for foreign exchange than that; it is all about buying and selling money.

But there are two things to note up front about foreign exchange that make it appear a bit daunting.

First, the realm of foreign exchange is rife with incomprehensible slang, confusing jargon, a proliferation of different names for the same thing, and the existence of convoluted conventions that make working in this field (unless you have already gained a facility with the rules) a real challenge. Banks and other financial institutions can’t even agree as to what this business area or “desk” should be called: FX, Currencies, Treasury Products, ForEx or Forex, Bank Notes, Exchange Rates, . . .

Second, and more fundamentally, what constitutes “foreign” depends upon where you consider “home” (e.g., whether you are from the U.S. or the U.K.). Having taught about this product for years, working for a large global bank, I know that what is “foreign” for me may very well be “domestic” for you. For that reason, I will make every attempt to avoid the use of the expressions “foreign” and “domestic” in our explanations—not so much out of my hope that this book may achieve some degree of international success, but out of my inclination to want to avoid any ambiguity (and also based on the fact that I, as an “ugly American,” would almost always revert to thinking in terms of U.S. Dollars). This will keep me honest. We see later, though, in the context of options that perspective really can and does matter!

Over the years, I have developed a mantra (which I always share with my classes):

“Foreign Exchange:
It’s not difficult;
It’s just confusing.”

I genuinely believe this. As we explore the market conventions used by the FX community, the reasons for this statement will become clear.

Furthermore, of all the complicated financial instruments about which I lecture on a daily basis, the product area, far and away, that generates the most questions (and anxiety) is foreign exchange. The interesting thing is that many of the questions asked in my classroom come from people who work in foreign exchange; in the course of doing their jobs, they often internalize mental shortcuts and rules of thumb and stop thinking about what is going on under the surface; at least one reason for this is that speed is frequently rewarded in the marketplace.

It is our intention to do four things in this book:

1. We’d like to make you familiar with the market conventions associated with foreign exchange as well as conveying an understanding of the practical mechanics required to participate in the FX markets.

2. We hope to provide you with a solid grounding in the theory and the relationships that are relevant for foreign exchange products, valuation (what some people call “pricing”), arbitrage, and trading.

3. We intend to empower you with the intuition to efficiently and expediently analyze what is transpiring in the currency markets and infer what might be the ramifications of various sorts of news.

4. And finally, we would like everyone to take away an understanding of the underlying economic phenomena that drive this fascinating maelstrom of financial activity.

TRADING MONEY

Understanding that the FX market involves exchanging one country’s currency for the currency of another country (or region), it is clearly all about trading money. Why is trading money so important? A long time ago, David Hume, a friend of Adam Smith (the founder of modern economics and champion of free markets), wrote:

Money is not, properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another. It is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy. (David Hume, Of Money (1752))

Now, if that is true (that money should not be the object of trade), then why is the foreign exchange market so large? Its magnitude (i.e., trading volume) is, surprisingly and significantly, greater than the flows required by the entire amount of global international trade. Indeed, foreign exchange constitutes the largest financial market in the world.

To answer the question of why the FX market is so big, it is worth thinking a bit about money, maybe a bit more (or at least a bit differently) than we usually do.

THE ROLES MONEY PLAYS

Economists ascribe three functions (or roles) to money. Money serves as

1. A medium of exchange.

2. A unit of account.

3. A store of value.

A Medium of Exchange

The first function is served because money, as Hume noted, is meant to facilitate trade. Prior to the emergence of money (I always thought it was interesting that “to discover” and “to invent” are the same word in Latin), people had to barter, that is, they had to trade goods for goods. This, no doubt, made transactions potentially problematic, even though barter may have been enjoyed by some wheeler-dealers at the time. Unless I had some of what you wanted, you had some of what I wanted, and we could arrive at some mutually agreeable rate of exchange, the lack of a universally acceptable product limited the extent of trade.

Over the ages, a variety of things have served in this role as money. It has been documented that, at one time, large numbers of bronze knife blades traded hands as part of lumpier transactions and, while still seemingly an instrument of barter, these are recognized as one of the first commonly accepted commodity currencies. Other non-precious metal money include sheep, shells, whale teeth, tobacco, nails, oxen, fishhooks, jewels, elephant tails, and wampum. What distinguishes these from instruments of barter is the fact that they were generally accepted in a transaction with no thought to their consumption usage, but simply as a means of payment that would later be spent again.

Some strange things have served as mediums of exchange. Perhaps one of the most unusual is the money of Yap. For centuries, inhabitants of this Micronesian island group have employed extremely large stones, known as “rai,” as currency in various transactions. Interestingly, while they occasionally change hands (in terms of ownership), they generally do not change location.

There is also a fascinating account of money that was written by a British economist (turned Royal Air Force officer) named R. A. Radford who, during World War II, was shot down, captured, and spent time in a German prisoner of war camp.¹ Within that environment, the generally accepted medium of exchange was the cigarette. Prices were quoted and transactions carried out using cigarettes as payment. As with all other forms of money, value fluctuated with demand and supply. For example, with an influx of Red Cross packages containing cigarettes, prices tended to jump, but, over time, as the supply of cigarettes was exhausted, prices (of other goods in terms of cigarettes) tended to fall—a phenomenon known as “deflation” (the opposite of the more familiar sustained aggregate price increases commonly referred to as “inflation”).

One might think that large stones and coffin nails would not be particularly relevant to the study of foreign exchange, but, as mediums of exchange, our examples all serve to highlight the central role of money in facilitating trade.

Economists have identified money, defined as a commonly accepted means of payment, as a critical factor in fostering trade, in encouraging specialization, in allowing for the division of labor, and in promoting economic development in the large—leading, quite literally, to the “wealth of nations” (a phrase which, although constituting part of the title of his revolutionary book published in 1776, was not coined by Adam Smith).²

Indeed, some people have even tried to identify or equate wealth and money, although anyone who has lived through a hyperinflation knows that the value of money can be fleeting (as experienced by generations of inhabitants of South America as well as individuals in Germany in 1923 during which it literally required a wheelbarrow of Marks to buy a loaf of bread).

In general, though, by serving as a generally acceptable (and accepted) vehicle of payment, money circumvents what economists refer to as “the double coincidence of wants,” a circumstance that makes barter a particularly inefficient mechanism of exchange.

Why is money “commonly accepted?” Good question. Why did Native Americans willingly take strung shell beads (wampum) in exchange for real products like corn and meat? One might think of the “greater fool theory” (that is, I’ll buy something for a high price today in the expectation that there is somebody out there—an even bigger fool—who will buy it from me at an even higher price in the future), but that explanation is rather naïve. In general, one accepts money as a means of payment (for one’s labor or one’s goods) in the belief that that same money can subsequently be employe...