Forex Basics

Discussions about trading the Forex markets.
Sir G
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Forex Basics

Post by Sir G » Thu Apr 17, 2003 8:39 pm

What are the basics to Forex? What makes them different then the IMM contracts?

Thanks. Sir G
Last edited by Sir G on Tue Apr 22, 2003 10:41 am, edited 1 time in total.

damian
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Post by damian » Thu Apr 17, 2003 10:30 pm

Interesting points about physical FX, not necessarily pros or cons:

- very liquid if you have the right broker. Certainly very, very liquid at the interbank level.
- no contract maturities
- no true end of day. This always confuses me.
- can be margin traded.... you can select the leverage to a certain degree.
- unless you are a bank, there really isn't any 'one market'. There is no exchange. I sell you two apples for 1 banana. We have just set a price in the apple/banana market.
- when you buy USDJPY, where do you get your JPY from? You have to borrow it.
- all sorts of X rates are possible, thus if you trade on country fundamentals, you can get great spread exposure (and FX trade is a spread).
- USDJPY is quoted correctly, IMM contracts quote it incorrectly (back to front relative to the physical). Same for CHF (SF).
- more flexible than futures regarding position size (depends on your broker)
- always liquid, 24hrs per day
- often strongly correlated eg if you thought the USD was going to weaken, you could sell USDJPY, USDCAD or buy AUDUSD, EURUSD. Which one wouuld you choose? Can you choose all of them if they have very different volatility characteristics?
- it may seem (very) insulting to say this, but I always found that it helped to think in the following terms when looking at a currency price: The currency on the left is the commodity, the currency on the right is the money. APPLES/USD = 0.5, ie, 1 unit of apples cost USD0.5. USD/JPY = 119 ie 1 unit of the commodity USD costs 119 Yen. AUD/USD = 0.6145 ie, 1 unit of the commodity AUD costs USD0.6145. Sorry if that was insulting, as I said I found it helpful to think that way when I first began throwing around different currency terms in my head at high speed.
- the FX market is the biggest by transaction value in the world. Huge.
- I do not use physical FX for trading, but I do earn Yen and need it in a different currency, so I sometimes end up using a chart to get a feel whether I should sell Yen today or wait.
- never try to borrow in a low interest rate currency and sell into a high interest rate currency and then place a deposit. A lot of people still try to do this.
- in terms of pricing, there is no reall difference between IMM contracts and FX. The derivative and physical move together, except futures settle value today and FX usually settles t+3. Plus the futures are futures, ie delivery in March, June etc. Any difference between futures price/implied physical vale and the spot market is removed very very very quickly by arbitrage traders with big computers. I sit next to a group of equity index arbitrage traders and it is amazing to see them "work".
- a conventional FX price is not the price for settlement today, it is a bery short dated forward price (3 days). If you trade with an FX broker and settle value today, your closing price will be different to that of the price you see on Bloomberg or Reuters or the news that night. The magnitude of the difference is a function of the 3 day interest rate differential between the two currencies.

I hope these random thoughts were at least interesting.

cheers

ps - I think this is going to be a great forum. Quite exciting.

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Post by Moodaeng » Mon Apr 21, 2003 4:57 am

Damian,
it may seem (very) insulting to say this, but I always found that it helped to think in the following terms when looking at a currency price: The currency on the left is the commodity, the currency on the right is the money.
I use the same and it makes things easier
- never try to borrow in a low interest rate currency and sell into a high interest rate currency and then place a deposit. A lot of people still try to do this.
I don't agree with you on this one. JPMorgan did a historical study of this "carry trade". They took a basket of 11 currencies (17 before the Euro) : AUD, CAD, DEK, EUR, JPY, SEK, GBP, USD, CHF, NZD, NOK. Each month, they look at the 1 month deposit rate in each currency and they go long the N highest yielding currencies vs short the N lowest yielding ones. Starting in 1988 until 1999, their strategy yielded the following results :
N : Sharpe Ratio

1 : 0.46
2 : 0.77
3 : 0.92
4 : 0.92
5 : 0.96
6 : 0.93
7 : 0.79

I would not recommend this strategy for emerging markets, but I believe it is a useful tool for developped currencies.

Guest

Post by Guest » Mon Apr 21, 2003 5:52 am

moodaeng,
I think the JPM study is a little different from what I was talking about. Are you saying that they just sell low yield ccy and buy high yield ccy? If so they obviously had to borrow the low yield and lend the high yield (which is what I recommended against). If they did then how did they hedge their FX risk? If this is a carry trade then they do not want FX risk. On the other hand, they could have funded the trade by using the FX Swap market which would also have hedged the FX risk so they would have had no ccy risk, but would have also negated any profit that they made in the interest rate differential as the swap price (and implied forward FX price) is determined by calculating that price which removes the ability to take profit from the interest rate differential. This is equilibrium and when the forwards move out of line they are arbed back into place. I used to do this myself, but was no expert (probably why I am no longer doing it :wink: ).

Either way, neither strategy is available to the retail level participant with retail credit rating (I doubt anyone here can borrow at 1 month libor).

Happy to discuss :D

damian

Guest

Post by Guest » Mon Apr 21, 2003 5:54 am

whoops, the above was from me, but I had not logged in, hence the 'guest' name tag.

sorry.

damian
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Post by damian » Mon Apr 21, 2003 5:55 am

I did it again. :oops: :oops: :oops:

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Post by Moodaeng » Mon Apr 21, 2003 9:25 am

Hi Damian,

When I use the term carry trade, I mean borrowing in a low yielding currency, selling it short to buy a high yielding currency that you lend. So you take the FX Risk. In financial theory, this strategy should not yield profit in the long term - the interest rate differntial should be compensated by capital loss - but as the study showed, it works in practice. This "anomaly" is also called the "forward rate bias" and is well documented in the litterature.

A retail participant can apply this strategy at interest rates slightly worse than market deposit rates (oanda.com). But it is still very porfitable.

PS : I have no affiliation to OANDA, other platforms may give the same service.

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Post by damian » Mon Apr 21, 2003 10:09 am

hi,

Without knowing more about the strategy that JPM tested I can't really comment much.

However, I am certainly surprised that this trade works over the long run. Yet again I must state that I am far from an expert, but I am not sure if it can be called a carry trade if you leave the FX risk open. One thing worth noting: if you simply traded a ccy pair, you MUST borrow or lend at least one of the legs. From a 0% margin perspective (ie, you have no starting capital in any currency), you must borrow one leg AND lend the other. This is a typical spot FX transaction, not a carry trade.

Certainly this strategy (or one similar, I can't state for sure) has been advocated by a lot of retail level bank advisors in the past, many of whom helped clients achieve huge capital loss on the FX movement portion of the deal.

Assume you borrow JPY1 at Ji, sell JPY/buy AUD at X1 and lend AUD1 at Ai. Where Ai and Ji are the respective JPY and AUD offer and bid rates for 6 month tenor. At the end of 6 months you have to repay the JPY and owe JPY2. You have now a balance in Australia of AUD2. The current FX rate is X2. Sell AUD2/buy JPY3. You owe EUR2 and have JPY3 available for repayment. Is JPY3 enough? That will depend on the value of X2. I do not mean to sound smart, but there is a very good reason why all of us are not doing this day in, day out. It seems liek a good deal as even at expensive rates lets assume we can access unsecured JPY loans at 1%, yet can earn 4.75% on our AUD.

I will have to set aside some time to look at the levels provided by the mentioned site. However I do observe that they have a negative bid in JPY interest rates. This is not so unusual, most wholesale names pay negative yen depo rates for overnight deposits. But it is a fair way from market. Their offer is also very expensive at 0.135%. Interbank offer rates are at approx 0.002% (actually, they are even lower, some times 0.0005%). again, this observation is not intended to be critical of anything you have written (or anything that oanda.com offers).

Please do not feel I am trying to throw your idea back at you. I am enjoying scratching this theory out of my fading memory. I may also have made a glaring omission that would validate the whole strategy.

cheers
damian

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Post by Moodaeng » Mon Apr 21, 2003 4:02 pm

Damian,
I am far from an expert, but I am not sure if it can be called a carry trade if you leave the FX risk open.
Yes it can.
Read first : http://www.investopedia.com/terms/c/cur ... ytrade.asp
And then take look at the first JY1 graph at : http://www.speculative-investor.com/new ... 11201.html
And last, if you want to know why the Yen gapped in Oct 98, read : http://www.pkarchive.org/crises/tiger.html

Assume you borrow JPY1 at Ji, sell JPY/buy AUD at X1 and lend AUD1 at Ai. Where Ai and Ji are the respective JPY and AUD offer and bid rates for 6 month tenor. At the end of 6 months you have to repay the JPY and owe JPY2. You have now a balance in Australia of AUD2. The current FX rate is X2. Sell AUD2/buy JPY3. You owe EUR2 and have JPY3 available for repayment. Is JPY3 enough? That will depend on the value of X2. I do not mean to sound smart, but there is a very good reason why all of us are not doing this day in, day out. It seems liek a good deal as even at expensive rates lets assume we can access unsecured JPY loans at 1%, yet can earn 4.75% on our AUD.
You make things more complicated that they are. Just buy the high yielding currency, sell short the low yielding one on a spot FX transaction. Since you trade on margin, you will HAVE TO borrow your short and lend your long.
Please do not feel I am trying to throw your idea back at you
No pb Damian. THis is not my idea anyway. Many prop traders/hedge funds use some version of it (see Tiger). And by the way, my intention is not to convince anyone, just to share a simple, robust strategy that hasn't worked too bad the past.

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Post by John D. » Mon Apr 21, 2003 7:41 pm

Thanks for the Links, Moodaeng. I thought I'd landed on another planet.

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Post by damian » Mon Apr 21, 2003 7:48 pm

Hmmm,
You make things more complicated that they are. Just buy the high yielding currency, sell short the low yielding one on a spot FX transaction. Since you trade on margin, you will HAVE TO borrow your short and lend your long.
Then all you are saying is trade spot FX, and base you decision to buy AUDUSD on the relative interest rates. This is not carry, this is standard FX trading. You are long AUDUSD. Just because it was relative interest rates that influenced your decision to buy AUDUSD does not make it a carry trade.

From investopedia.com
By borrowing in a foreign country with low interest rates and investing in the domestic market, investors are almost able to secure a riskless return - except for the uncertainty of exchange rates
!!!A riskless return (except for the uncertainty of exchange rates). Unless you hedge that risk, all you have is a directional FX position. Nothing more, nothing less.

Large funds do trade FX on heavy margin. But they are betting on the direction of FX rates. Soros (Robertson) in MYR, THB and as you point out, in JPY. They were betting on FX direction..... and they lost in EUR and JPY.

Soros Fund Management, which made over one billion pounds profit when it “broke the Bank of England” in the 1992 devaluation of the British currency, is also lost billions in speculating that the euro would rise against the dollar, and that the Japanese yen would fall. The opposite occurred with the US dollar, in particular, remaining strong against the euro. Some time in the late 1990's, these guys shut down. I admit, tech stocks didn't help their cause.

If street level investors enter the FX market thinking they can borrow a cheap ccy and sell for an expensive ccy (in terms of interest rates) and have a near riskless return, they are going to lose buckets, UNLESS, they enter the trade as nothing more than a directional FX position with an exit plan and position sizing in place. Sure, they can enjoy the small benefit of earning the interest rate differential, but it doesn't take much of an FX rate move to wipe out that differential.... unless you manage the position as an outright long/short ccy pair trade.

:D damian.

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Post by damian » Mon Apr 21, 2003 8:09 pm

I should add that this residual FX risk (ie teh FX risk of a basic directional spot positio, long AUDUSD) can be hedged using IMM contracts. But the fair value forward price of a currency (the futures price) is calculated by taking into account the interest rate differential in the ccy pair. At times, futures trade away from fair value. At this time you can borrow a low interest rate ccy and do the FX spot txn, invest the other high interest rate ccy and be hedged, leaving the mispricing in the futures market (ie deviation from calculated fair value) as the risk free profit. This is arbitrage and unless you have access to interbank depo markets yields and ultra fast execution + massive volume, you can't trade this strategy and make money.

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Post by Moodaeng » Tue Apr 22, 2003 3:54 am

This is not carry, this is standard FX trading.
Of course this is standard FX trading.
But looking at a basket of 10 currencies and buying the high yld one vs selling the low yld one is called a carry trade. I call it a carry trade, the Street calls it a carry trade. I suggest you type : "yen carry trade" in google and see what comes out.
But you may have a different definition of carry trade and it's perfectly fine.

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Post by damian » Tue Apr 22, 2003 4:57 am

I did the search, I found the following after reading for 20 seconds. Sounds a lot like what I was saying. By this definition, every spot FX transaction is a carry trade, unless it is funded in the FX swap market. It is just another name for being short JPY and long USD spot. If you read all my posts again you will realise that the main thrust of what I was saying was that this 'carry trade' is a bad idea unless you treat it as an outrightright FX spot directional trade (which is all it is), and at the retail market level it is a bad idea unless you first recognise the capital risk in the trade. Thanks for the advice from "the street". Good luck with the easy money carry strategy. Many thanks for the discussion on this point.

http://www.speculative-investor.com/new ... 11201.html
"In our view, the Yen's relentless slide has less to do with economic fundamentals and more to do with the 'Yen carry trade' (borrow Yen at an interest rate near zero, exchange the Yen for Dollars and invest the proceeds in higher-yielding US Government debt). A trader who does the 'Yen carry' is short the Yen, long the Dollar and hoping to pocket the interest rate differential between the US and Japan plus a profit on a decline in the Yen's exchange value. The main risk associated with this trade is that the Yen will strengthen against the Dollar by more than the interest rate differential between the US and Japan."

ps - I spent 6 years on a STIR (short term interest rate) trading desk at a bank doing all sorts of FX swap/FX spot/depo market structures packaged up as one trade. In the context of the above quote, what would you call it if you were very bearish USDJPY and sold rather than bought USDJPY?

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Post by Moodaeng » Tue Apr 22, 2003 7:13 am

Sounds a lot like what I was saying
So I misunderstood what you were saying.
Good luck with the easy money carry strategy.
Did I say it was an easy money strategy?
In the context of the above quote, what would you call it if you were very bearish USDJPY and sold rather than bought USDJPY?
I usually sell when I'm bearish and buy when I'm bullish.

Damian, I've followed your messages in Chuck Lebeau's forum for a long time and have learned a great deal from your informative posts. Let's be constructive about this "carry strategy", OK?

In my first message, I said:
. JPMorgan did a historical study of this "carry trade". They took a basket of 11 currencies (17 before the Euro) : AUD, CAD, DEK, EUR, JPY, SEK, GBP, USD, CHF, NZD, NOK. Each month, they look at the 1 month deposit rate in each currency and they go long the N highest yielding currencies vs short the N lowest yielding ones.
One feature of this strategy can be applied to other markets. It is what I call "basket trading". Instead of timing time-series, you can look at a basket of securities, rank them and buy the "best" to sell the "worse". JPM ranked currencies according to interest rates. You can rank stocks according to PE ratios, relative strength... has anyone any experience with it?

rs

Post by rs » Tue Apr 22, 2003 4:27 pm

Damian,

You mention in an earlier post that Soros Fund management closed up shop. I don't think that is true, they are still trading today. I believe a couple of the heavyweight managers there left like Roditi but the firm still exists. Although, they did take heavy losses in the 1990s due to tech stocks and the other bets you mentioned.

rs

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Post by damian » Tue Apr 22, 2003 8:43 pm

Moodaeng,
we did get a little less constructive towards the end there, at least I say that I did. At the very start I should have clarified my stance, that being as an FX Basics thread, I suggested not doing the borrow/lend thing. I should have been more clearer when you questioned this by saying that as as a trade idea, it can work, but if beginners take this strategy on its own with no consideration for the true risk of the trade (FX volatility) they can, and have, lose lots of money. Every spot FX directional trade a retail trader does will be to some degree of leverage a carry or negative carry trade, which is why I do not attach the label at all. The reason I cheekily called it an easy money strategy was because I was still reeling from the proposition placed by one of the original web pages taht we were refering to. The one where the strategy was defined as 'nearly risk free'. The fact is, it is not at all so. In fact, the more you leverage to get meat from teh yield differential, the greater will be the actual spot FX risk on the position. You never disputed this though.

Anyhow, on other matters. The Soros fund closure statement. I typed too fast. He is still around but a few of his funds (Tiger) shut, or so I understand.

The current AUDJPY move is a good example of the benefit of trading where there is also +ve carry, I suppose. It started to trend in perhaps mid Jan, consolidated late Feb/March and has just started on its way again to the upside. If you traded this according to a basic trend following system you would be long AUD/short JPY. Borrowing JPY at <1% and lending AUD at a good spread. The interest rate carry could be used to offset some of the loss in the initial risk of the trade. However if you were stopped out in a short period of time, you would not have accumulated much interest rate income.

Did you know that ING in Australia offer a 24 hour call account that pays 4.75% This is higher than the central bank overnight target rate!!! ie, it is more than the biggest bank in Australia earns on its overnight deposits at the central bank (or any other bank). If you could manage to get your long AUD into an account like that (rather than at the broker account)... it could be interesting. In fact, 4.75% on your at call funds is higher than the inter-bank 6 month rate!!

Now there is another topic, does anyone trade the curve shape (eg spread t-notes and Treasuries). I suppose that is another topic.

cheers
damian

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Post by Jimmy » Wed Apr 30, 2003 8:01 pm

Damian,

In your first post on this thread on 4/17, you stated:
- can be margin traded.... you can select the leverage to a certain degree.
Excuse the ignorant question, but will you please elaborate on this for me? I'm not sure exaclty what this means. If you feel up to it, an example would be really helpful :lol:.

Also, do you have any recommendations on historical data providers for the forex markets?

Cheers,
Jimmy

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Post by damian » Wed Apr 30, 2003 8:33 pm

hi Jimmy,

I do not actually trade spot FX. If I did I would use Bloomberg data, or perhaps Reuters (but that is because I have it on my system at work).

Someone who actually uses one of these online FX services could answer far better than I, however here is a brief response. Leverage (in one sense) = the amount of cash you parted with relative to the value of an asset. Some FX brokers will let you control huge leverage where you put down very small marging relative to the amount of FX you bought/sold.

Like in futures, you have a $4000 initial margin on a contract that allows you to have economic exposure to 1000 barrels of oil. This economic exposure in the physical world would cost a lot more than $3000 (or what ever the margin is). Some brokers of FX will let you choose what level of leverage you are happy with. The thing is, you can also do this with futures by deciding to have $50,000 spare cash at the broker for ever contract of oil that you buy. If you use fixed fractional position sizing you will end up with this type of reduced futures leverage by default.

Jester

FX forwards

Post by Jester » Wed May 28, 2003 9:21 pm

Lets not forget that the NPV of all FX forwards should be equal to zero, and when liquidity is high, they are. So if the NPV = 0 then there is no borrow/lend arb .... Right?
Although arbs do exist (in theory) in emerging market currencies, if you could trade onshore funds. But that's a different story.

Jester
:P

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