30 years: Risk management & derivatives trading

In this video, Lindsey helps us understand how FX rates are quoted and how to value an FX forward. He also explains what FX options are and how the market works.

In this video, Lindsey helps us understand how FX rates are quoted and how to value an FX forward. He also explains what FX options are and how the market works.

11 mins 26 secs

Overview

FX forwards and options are trades where a currency pair is exchanged in the future, at a price agreed on today. The price that is agreed upon today is based on the spot price, adjusted for the costs and benefits of holding the underlying. The calculation of the forward price is similar to calculating the forward price on an equity option, however, the costs will be in one of the currencies and the benefits will be in the other.

Key learning objectives:

Understand how FX rates are quoted

Outline how to value an FX forward

Understand FX options

Summary#### How are FX rates quoted?

#### How do you value and FX forward?

#### What are FX options and what is the market terminology?

Let's look at one of the main currency pairs, GBP/USD, commonly known as Cable. The key thing to remember when looking at currency pairs, is that it is the currency on the left that is being bought or sold, so GBP in this case and the currency on the right is the one that the price is in terms of, in this case, USD.

If GBP/USD is currently 1.3474, and GBP was to strengthen (appreciate), this number will go up, as it requires more USD to buy one GBP.

FX forward trades are similar to spot FX trades, but rather than settling in 2 days, they settle at some point in the future.

Assume the 3-month forward price on GBP/USD is 1.3485, how has this price been determined? The cost represents the costs and benefits of holding a position in GBP/USD for 3 months. If we were to buy £1 for the spot price of $1.3474 we would then be long GBP and short USD. To hold that position for 3 months we would need to pay interest to borrow the USD and receive interest on the GBP.

Therefore, the forward price is calculated as Spot price + cost of financing USD – benefits of holding GBP. The USD costs equate to S x r-USD x t and the GBP benefits equate to 1 x r-GBP x t, which in USD terms is F x 1 x r-GBP x t.

So Forward = Spot + (S x r-USD x t) – (F x 1 x r-GBP x t) or rearranged to Spot x (1 + r-USD x t) / (1 x r-GBP x t).

Now we can price FX forwards, we can look at FX options. You can trade options on FX, exactly the same as any other option.

Take the following example:

EUR/USD spot is at 1.3474. The 3-month forward is quoted as +11 pips which gives 1.3485.

So the 3-month 1.3485 Euro call–dollar put would be at the money forward. This is just one option, to buy euros and sell dollars, even if the name sounds like it might be two options. This trade may also be known as just a Euro call.

Lindsey runs Perfordiant, an investment risk and performance consulting firm. He has worked in financial markets since 1992. Lindsey became an MD in fixed income and equities, ran a Risk function, and was on the management team of an Asset Management fintech business. Lindsey is now a Visiting Fellow at the Henley Business School, and resides on the board of CFA UK.

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