Foreign Exchange Operations

David F. DeRosa is President of DeRosa Research and Trading, Inc., a firm that conducts research into derivatives pricing, macroeconomics, monetary policy, and foreign exchange. He is an adjunct associate professor of finance at the Fu Foundation School of Engineering and Applied Science at Columbia University where he teaches courses in pricing models in financial engineering. David sits on the boards of several prominent hedge fund groups. He is the author of many books including Options on Foreign Exchange (Wiley), Central Banking and Monetary Policy in Emerging-Markets Nations, and In Defense of Free Capital Markets. David received his PhD in finance and economics from the Graduate School of Business of The University of Chicago, and his BA in economics from the College of The University of Chicago. Before founding DeRosa Research, he worked on Wall Street as a foreign exchange trader, hedge fund trader, and portfolio manager.

• Preface xiAcknowledgments xvCHAPTER 1 Introduction to Foreign Exchange 1Defining Money 1Participants in the Foreign Exchange Market 2Identifying Currencies and Exchange Rates 4Quotation Conventions 5The Foreign Exchange Market 6Foreign Exchange Regimes 11Exchange Rate Controls 12The Structure of the Foreign Exchange Market 12Banks’ Identification Codes 13The Authorities 15Spot Foreign Exchange Deals 17Profit and Loss on a Simple Trade 18Value Dates 19Forward Foreign Exchange and Covered Interest Parity 20Forward Swaps 21Non-Deliverable Forwards 22Summary 22Appendix 1.1: ISO Currency Codes 23References 34CHAPTER 2 Options on Foreign Exchange 35Option Basics 35Put–Call Parity 37The Importance of Option Models 39Risk Parameters 41The Minor Greeks 44More on Delta 45Portfolios of Options 50American Exercise Models 51Volatility 52Important Option Strategies 55Option Market Making 56Non-Deliverable Options 56Barrier Options 58Binary Options 65Barrier Determination Agency 69Other Exotic Options 70More on Option-Related Risks 70Summary 72Appendix 2.1: Further Comments on Put–Call Parity 72Appendix 2.2: Black-Scholes-Merton Model 74Appendix 2.3: Barrier and Binary Options 75References 78CHAPTER 3 How Trades are Executed and Confirmed 81Spot Foreign Exchange Deals 83Forward Outright Deals 83Forward Swap Deals 85Option Trades 87How Foreign Exchange Trades are Executed 88Concentration in Market Making 89Example of an Electronic Trading Platform: FXall 92Trade Documentation Cycle 97Internal Operations and Reports for Dealers 141Summary 159Appendix 3.1: Transactions at Daily Fixings 160References 160CHAPTER 4 Foreign Exchange Settlement 161Settlement Instructions for an Individual Spot Foreign Exchange Deal 161Overview of the Settlement Process 170The Bretton Woods-Smithsonian Period 171The Herstatt Legacy 172Settlement Risk 173Netting 176How the Modern Settlement Systems Developed 181Large-Value Transfers 186Central Bank Involvement 186Correspondent Banking 187Payment Systems 187Designated-Time Net Settlement (DTNS) 189Real-Time Gross Settlement (RTGS) 189Examples of Modern Payment Systems 192CLS Bank International 203Internal Controls 208Summary 209References 209CHAPTER 5 Master Agreements 211Motivation 212The Architecture 214The FXC Master Agreement Forms 215The ISDA Master Agreement Forms 215Single Agreement 217Non-Reliance: Parties to Rely on Their Own Expertise 219Netting: Payment or Settlement Netting and Novation Netting 220Events of Default 221Termination Events 228Additional Termination Events 230Close-Out Netting 231Safe Harbors 232Early Termination 233Payments Upon Termination and Close-Out Amounts 234Close-Out Amount: 2002 ISDA 236Set-Off Provisions 241Special Features for Options: ICOM and FEOMA 241Special Features for Non-Deliverable Forwards 242Miscellaneous Issues 242More on Deeds of Adherence and Schedules 245Summary 245Appendix 5.1: IFXCO Terms 246Appendix 5.2: IFXCO Adherence Agreement 275References 281CHAPTER 6 Margin and Collateral 283Credit Agreements 283Framework for the ISDA Credit Support Deed and the FXC Collateral Annex 285Framework for the ISDA Credit Support Annexes 293Enforcement Rights of the Secured Party 294Some Additional Features Commonly Found in Credit Support Documents 296The Value-at-Risk Concept 297VaR for Spot, Forward, and Vanilla Options 298Portfolio Value-at-Risk 305Sample Customer Credit Snapshot 310Limitations of VaR 310Limitations of Collateralized Agreements 313Summary 313Appendix 6.1: The 1999 Collateral Annex to FEOMA, IFEMA, or ICOM Master Agreement 314References 337CHAPTER 7 Foreign Exchange Prime Brokerage 339Overview of FX Prime Brokerage 339Pros and Cons of FX Prime Brokerage 341Execution and Confirmation in an FX Prime Brokerage Environment 343The Legal Architecture of FX Prime Brokerage 345The FX Prime Broker and the Executing Dealer 346The Master FX Give-up Agreement 346Other Elements of the Master FX Give-up Agreement 354The FX Prime Broker and the Designated Party 359The Executing Dealer and the Designated Party 366Reverse Give-Up Relationships 366Summary 368Appendix 7.1: Master FX Give-Up Agreement 369Appendix 7.2: Compensation Agreement 384References 388About the Author 389Index 391