Table Of Content
Foreign Exchange and Money Markets
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Foreign Exchange and Money Markets
Theory, Practice and Risk Management
Bob Steiner
Butterworth-Heinemann
AnimprintofElsevierScienceLinacreHouse,JordanHill,OxfordOX28DP
225WildwoodAvenue,Woburn,MA01801-2041
AdivisionofReedEducationalandProfessionalPublishingLtd
Firstpublished2002
Copyright©2002,BobSteiner.Allrightsreserved
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hasbeenassertedinaccordancewiththeCopyright,Designsand
PatentsAct1988
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British Library Cataloguing in Publication Data
Steiner,Bob
Foreignexchangeandmoneymarkets:theory,practiceand
riskmanagement.–(Globalaidcapitalmarketseries)
1. Foreignexchange 2. Moneymarket
I. Title
332.4’5
Library of Congress Cataloguing in Publication Data
AcataloguerecordforthisbookisavailablefromtheLibraryofCongress
ISBN0750650257
For information on all Butterworth-Heinemann finance publications
visitourwebsiteatwww.bh.com/finance
TypesetbyLaserwords,Chennai,India
PrintedandboundinGreatBritain
Contents
ABOUT THE AUTHOR xi
NOTE FROM THE AUTHOR xiii
Part 1 Introduction 1
1. SOME BASIC CONCEPTS 3
Currency codes 3
Hedging, speculation and arbitrage 3
Spot, forward, value dates and short dates 4
Some basic terminology 6
2. ESSENTIAL FINANCIAL ARITHMETIC 8
Percentages 8
Simple interest calculations 8
The different day/year conventions 9
Present value 13
Calculating the yield on an investment or the cost of a
borrowing 14
Compounding two or more interest rates together (a
strip) 16
Interpolation 17
Paying interest with different frequencies 18
Exercises 21
Part 2 Money Markets 23
3. OVERVIEW OF MONEY MARKET INSTRUMENTS 25
Introduction 25
The yield curve 26
Some more terminology 28
Money market instruments 31
4. DEPOSITS AND COUPON-BEARING INSTRUMENTS 36
Fixed deposits 36
vi Contents
Taking a position 37
The price of a CD 39
Money market yield of a bond in its last coupon period 43
Breaking a fixed deposit 44
CDs paying more than one coupon 46
Exercises 48
5. DISCOUNT INSTRUMENTS 50
Discount instruments 50
Discount/true yield 52
Bond-equivalent yields for US Treasury bills 56
Effective rates and Norwegian Treasury bills 57
Exercises 58
6. FORWARD INTEREST RATES, FRAs AND
INTRODUCTION TO FUTURES 60
Overview 60
Pricing a forward-forward 61
Forward rate agreement (FRA) 63
Introduction to futures 68
Futures compared with FRAs 75
The yield curve 76
Applications of FRAs and futures 77
Exercises 89
Part 3 Foreign Exchange 91
7. SPOT FOREIGN EXCHANGE 93
Introduction 93
How spot rates are quoted 94
Position-keeping 99
Reciprocal rates 101
Cross-rate calculations 101
The market environment 105
Exercises 105
8. FORWARD OUTRIGHTS AND SWAPS 107
Forward outrights 107
Forward swaps 111
Short dates 123
Forward-forwards 127
Calculation summary 131
Cross-rate calculations 133
Non-deliverable forwards (NDFs) 136
Contents vii
Time options 138
Long-dated forwards 139
Synthetic agreements for forward exchange (SAFEs) 141
Summary of uses of forward FX instruments 144
Exercises 145
9. HEDGING SWAPS WITH DEPOSITS, FRAs AND
FUTURES, COVERED INTEREST ARBITRAGE AND
CREATING SYNTHETIC FRAs 149
Hedging FX forwards using borrowings and deposits 150
Hedging FX forward-forwards with FRAs or futures 155
Covered interest arbitrage 161
Creating an FRA in one currency from an FRA in
another currency 168
Exercises 171
10. MANAGING THE SPOT RISK ON A FORWARD FX
POSITION 173
Hedging a forward swap position 173
Measuring the spot risk on a forward outright position 179
Exercise 181
11. CURRENCY RELATIONSHIPS 182
Overview 182
Exchange rate regimes 183
European Monetary Union 185
Analysing currency movements 188
Part 4 Risk Management 193
12. BANK RISK MANAGEMENT 195
Overview 195
Market risk 195
Credit risk 201
Operational risk 207
Other risks 209
Value at risk (VaR) 211
Capital adequacy requirements 224
13. CORPORATE RISK MANAGEMENT 230
Analysis of risks 230
Establishing a policy 236
Forecasts, hedging decisions and targets 242
Currency exposure reporting 246
viii Contents
Evaluating the success of treasury management 248
Exercises 249
ANSWERS TO EXERCISES 251
APPENDIX A. A summary of money market day/year
conventions 271
APPENDIX B. A summary of calculation procedures 273
APPENDIX C. SWIFT currency codes 284
GLOSSARY 291
INDEX 323
To my wife Barbara,
as always
