FX Derivatives Trader School

Giles Jewitt

• Publisher: Wiley
• Year: 2015
• ISBN:
  9781119096474
• Edition: 1
• Topic: Business
• Subtopic: Trading
• Index: Business

An essential guide to real-world derivatives trading

FX Derivatives Trader School is the definitive guide to the technical and practical knowledge required for successful foreign exchange derivatives trading. Accessible in style and comprehensive in coverage, the book guides the reader through both basic and advanced derivative pricing and risk management topics.

The basics of financial markets and trading are covered, plus practical derivatives mathematics is introduced with reference to real-world trading and risk management. Derivative contracts are covered in detail from a trader's perspective using risk profiles and pricing under different derivative models. Analysis is approached generically to enable new products to be understood by breaking the risk into fundamental building blocks. To assist with learning, the book also contains Excel practicals which will deepen understanding and help build useful skills.

The book covers of a wide variety of topics, including:

• Derivative exposures within risk management
• Volatility surface construction
• Implied volatility and correlation risk
• Practical tips for students on trading internships and junior traders
• Market analysis techniques

FX derivatives trading requires mathematical aptitude, risk management skill, and the ability to work quickly and accurately under pressure. There is a tremendous gap between option pricing formulas and the knowledge required to be a successful derivatives trader. FX Derivatives Trader School is unique in bridging that gap.

Part I
The Basics

Part I lays the foundations for understanding FX derivatives trading. Trading within a financial market, market structure, and the Black-Scholes framework are all covered from first principles. FX derivatives trading risk is then introduced with an initial focus on vanilla options since they are by far the most commonly traded contract.

Chapter 1
Introduction to Foreign Exchange

The foreign exchange (FX) market is an international marketplace for trading currencies. In FX transactions, one currency (sometimes shortened to CCY) is exchanged for another. Currencies are denoted with a three-letter code and currency pairs are written CCY1/CCY2 where the exchange rate for the currency pair is the number of CCY2 it costs to buy one CCY1. Therefore, trading EUR/USD FX involves exchanging amounts of EUR and USD. If the FX rate goes higher, CCY1 is getting relatively stronger against CCY2 since it will cost more CCY2 to buy one CCY1. If the FX rate goes lower, CCY1 is getting relatively weaker against CCY2 because one CCY1 will buy fewer CCY2.

If a currency pair has both elements from the list in Exhibit 1.1, it is described as a G10 currency pair.

Exhibit 1.1 G10 Currencies

CCY Code	Full Name	CCY Code	Full Name
AUD	Australian dollar	JPY	Japanese yen
CAD	Canadian dollar	NOK	Norwegian krone
CHF	Swiss franc	NZD	New Zealand dollar
EUR	Euro	SEK	Swedish krona
GBP	Great British pound	USD	United States dollar

The most commonly quoted FX rate is the spot rate, often just called spot. For example, if the EUR/USD spot rate is 1.3105, EUR 1,000,000 would be exchanged for USD 1,310,500. Within a spot transaction the two cash flows actually hit the bank account (settle) on the spot date, which is usually two business days after the transaction is agreed (called T+2 settlement). However, in some currency pairs, for example, USD/CAD and USD/TRY (Turkish lira), the spot date is only one day after the transaction date (called T+1 settlement).

Another set of commonly traded FX contracts are forwards, sometimes called forward outrights. Within a forward transaction the cash flows settle on some future date other than the spot date. When rates are quoted on forwards, the tenor or maturity of the contract must also be specified. For example, if the EUR/USD 1yr (one-year) forward FX rate is 1.3245, by transacting this contract in EUR10m (ten million euros) notional, each EUR will be exchanged for 1.3245 USD (i.e., EUR10m will be exchanged for USD13.245m in one year's time). In a given currency pair, the spot rate and forward rates are linked by the respective interest rates in each currency. By a no-arbitrage argument, delivery to the forward maturity must be equivalent to trading spot and putting the cash balances in each currency into “risk-free” investments until the maturity of the forward. This is explained in more detail in Chapter 5.

Differences between the spot rate and a forward rate are called swap points or forward points. For example, if EUR/USD spot is 1.3105 and the EUR/USD 1yr forward is 1.3245, the EUR/USD 1yr swap points are 0.0140. In the market, swap points are quoted as a number of pips. Pips are the smallest increment in the FX rate usually quoted for a particular currency pair. In EUR/USD, where FX rates are usually quoted to four decimal places, a pip is 0.0001. In USD/JPY, where FX rates are usually only quoted to two decimal places, a pip is 0.01. In the above example, an FX swaps trader would say that EUR/USD 1yr swap points are at 140 (“one-forty”).

Pips (sometimes called “points”) are also used to describe the magnitude of FX moves (e.g., “EUR/USD has jumped forty pips higher” if the EUR/USD spot rate moves from 1.3105 to 1.3145). Another term used to describe spot moves is figure, meaning one hundred pips (e.g., “USD/JPY has dropped a figure” if the USD/JPY spot rate moves from 101.20 to 100.20).

FX swap contracts contain two FX deals in opposite directions (one a buy, the other a sell). Most often one deal is a spot trade and the other deal is a forward trade to a specific maturity. The two trades are called the legs of the transaction and the notionals on the two legs of the FX swap are often equal in CCY1 terms (e.g., buy E...