Forex Books

There are a number of Forex-related books that should get a mention on this blog. They may or may not be of some use to you when trading. Let's have a look at them:

Forex Made Easy : 6 Ways to Trade the Dollar
by James Dicks

This books introduces different trading tools to use when trading in Forex. It discusses a six-step process for Forex trading. There is also an in-depth discussion on techinical analysis and many different examples to illustrate the key points.

Hardcover: 256 pages
Publisher: McGraw-Hill; 1 edition (March 12, 2004)
Language: English
ISBN-10: 0071438947
ISBN-13: 978-0071438940

Forex Revolution: An Insider's Guide to the Real World of Foreign Exchange Trading
by Peter Rosenstreich

This book covers a number of different areas:

• Why Forex has become your #1 profit opportunityHow the currency markets became indispensable to the active investor
  
• Meet the players, markets, tools, portals, and platformsEverything you should know before you get started
  
• Choose the right FX investmentsUnderstand currency futures, options, swaps, and more
  
• Master both fundamental and technical trading strategiesand discover why you need to know both
  
• Gut check: What it takes to win in the Forex marketsDevelop the discipline you need to succeed

Hardcover: 304 pages
Publisher: FT Press (June 12, 2005)
Language: English
ISBN-10: 013148690X
ISBN-13: 978-0131486904

ForeX Trading for Maximum Profit: The Best Kept Secret Off Wall Street
by Raghee Horner

This book provides an in-depth look at Forex trading using the methods, analysis, and insights of the well-known author - Raghee Horner.

Horner has been trading Forex for many years and she introduces her winning tools and methods, including charting techniques, which have helped her succeed in the Forex market.

Hardcover: 216 pages
Publisher: Wiley; Har/DVD edition (December 27, 2004)
Language: English
ISBN-10: 0471710326
ISBN-13: 978-0471710325

Electronic Currency Trading for Maximum Profit: Manage Risk and Reward in the Forex and Currency Futures Markets
by Keith Long & Kurt Walter

Hardcover: 368 pages
Publisher: Prima Lifestyles (April 5, 2001)
Language: English
ISBN-10: 0761525203
ISBN-13: 978-0761525202

Day Trading the Currency Market: Technical and Fundamental Strategies To Profit from Market Swings
by Kathy Lien

Kathy Lien is a chief strategist for one of the largest online currency trading companies in the world has a very large following. This book explains how the Forex market works and discusses a variety of technical and fundamental strategies which can be used to help generate profits.

Hardcover: 256 pages
Publisher: Wiley (December 2, 2005)
Language: English
ISBN-10: 0471717533
ISBN-13: 978-0471717539

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Currency Options Explained

A "Currency/Forex option' is the right, without an obligation, to buy or sell one currency against another currency at a specified price, during a specified period.

Calls and Puts

A 'call' is the right without an obligation, to buy a currency. A 'put' is the right, without an obligation, to sell a currency.

In every foreign exchange transaction, one currency is purchased and another is sold. Consequently, every currency option is both a call and a put. An option to buy USD against JPY is both a USD call, and a JPY put.

Parties to an Option

There are two parties to an option - the buyer and seller. The buyer of the option enjoys the right to exercise the option and the right not to do so (ie to let it lapse). The seller of the option has an obligation to deal at the contracted rate if the buyer elects to exercise the option. The seller is also known as the 'writer' or 'grantor' of the option.

Option Premium

The price of the option is known as the 'option premium'. The buyer pays the premium to the seller as compensation for the risk involved in writing the option. The premium is normally paid on the spot value date from the date on which the option is contracted.

Value Terms

The 'strike price' or 'strike rate' is the exchange rate at which the option will be exercised if the buyer elects to exercise the option.

'In-the-money' (ITM) describes an option which would produce a profit if exercised (excluding consideration of the premium). 'Out-of-the-money' (OTM) describes an option which would produce a loss if exercised (excluding consideration of the premium). 'At-the-money' (ATM) describes an option which would produce neither a profit, nor a loss if exercised. The at-the-money strike price is the forward rate.

The premium will be higher if the option is in-the-money, and lower if the option is out-of-the-money.

Maturity of the Option

The 'expiration date' or 'expiry date' refers to the date on which the buyer's right to exercise ends. In practice, a specific expiry time (eg 10:00am New York time or 3:00pm Tokyo time on the expiry date) is agreed. If an option is exercised on the expiry date, the cash flows will occur on the then spot value date.

An 'American Option' refers to an option which can be exercised for spot value on an date between the contract date and the expiry date. A 'European option' refers to an option which theoretically, can only be exercised for spot value on the expiry date. In practice, writers of European options allow buyers to give notice prior to the expiry date that they will exercise the option. If a European option is 'exercised' prior to expiry date, the cash flows will occur on the spot value date following the original expiry date.

Sources of Options

Exchange-traded options are contracts traded through certain stock, futures or commodity exchanges. These contracts have strictly defined characteristics such as standard amounts, standard expiry dates and standard strike prices. Over-the-counter (OTC) options are options written by banks and other institutions but not traded through public exchanges. OTC options can be tailored to suit the exact needs of the option buyer. The currency options traded in the market are predominantly OTC options.

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Currency-Linked Note

A 'currency-linked note' is an instrument for which the yield is a function of the exchange rate. Many structures are possible. A popular one gives the investor a better-than-market yield provided the exchange rate remains within the specified range, but a lower-than-market yield if it moves outside that range.

If the 6-month USD interest rate is 5% per annum when spot USD/JPY is 110,000, an investor might be able to purchase a currency-linked note for which the yield will be 10% per annum, provided the USD remains within a range of 100.00 to 120.00 for the enture six months, but only 2% per annum if at any time the spot rate touches or moves above 120.00 or below 100.00.

The currency-linked note would normally be packaged by the bank as a single product. To construct it, the bank would merely sell two one-touch digitals. The future value of the premium received would be sufficient to lift the yield to 10% per annum provided another level is touched. The payout would be such that the yield is reduced to 2% per annum if either digital is exercised.

This sort of product appeals to many investors because their capital is guaranteed, and they are assured a minimum acceptable return, with the possibility of a yield which is much higher than otherwise available. The investor is effectively betting that the exchange rate will be less volatile than is being priced into the options.

Barrier Options

'Path-dependent options' are those whose payout depends on the path which the market price follows through the life of the option.

Standard calls and puts, as well as at-expiry digitals, are not path-dependent because their payout depends only on where the market price is at expiry compared with the strike price.

One-touch digital options are one example of path-dependent options. The most common group of path-depenedent options are known as barrier options. Other examples of path-dependent options include average rate or average strike options and look-back options.

'Barrier options' are options which can be knocked-out or which only kick-in if the market price reaches a specified level. There are vairations where the barrier applies for only a specified part of the life of the option. These are known as 'window' options. There are also options with multiple barriers.

'Knock-out options' have a zero payout if the barrier level is reached, even if the market price at expiry is better than the strike price. 'Knock-in options' have zero payout unless the option expires in-the-money (ie the market price at expiry is better than the strike price and at sometime during the life of the option the market price has reached the barrier level).

Hedging Options - Delta Hedging

What can a bank do to hedge the risk when it sells an option?

The risk the bank has is that if the exchange rate moves so that the option becomes more valuble, then if left unhedged, the seller has the potential to incur limitless losses. Suppose a trader sells a call option on the AUD at 0.8800 and the exchange rate goes to 0.9000. Under these circumstances, it is highly likely that the buyer will exercise his right to buy AUD at o.8800. In other words, it is highly likely that the trader will incur a 200-point loss.

Since a bank selling an option knows what the option will be valued at if the exchange rate moves ina certain direction, it is able to either buy or sell the currency in the spot market to hedge the risk. The process is known as 'delta hedging'.

Delta hedging sold options will inevitably incur losses. These losses are the debit side of selling an option. The credit side is that the seller receives an option premium from the buyer. The objective of the bank that sells an option is to lose less money in heding that it receives as a premium from the buyer. This will happen if the currency exhibits less volatility during the life of the option than was priced into the option. If the currency exhibits more volatility, then this will lead to losses from hedging that are larger than the amount received in the form of option premium.

It follows that a bank will sell and hedge an option when it believes that the future volatility of the currency will be less than the volatility entered into the Black-Scholes formula at the time of the sale. A bank will buy and hedge an option when it believes that the future volatility of the currency will be greater than the volatility input into the Black-Scholes formula at the time of the purchase.

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What are Currency Futures?

A 'Currency Future' is an agreement to buy or sell a standard quantity of a specified currency, at a specified price, on a specified future date.

Futures contracts are a type of forward contract, meaning they represent a pledge to make a certain transaction at a future date. Futures are distinguished from over-the-counter (OTC) forward contracts in that they contrain standardised terms; trade on a formal exchange; are regulated by overseeing agencees; are guaranteed by clearing houses; have a range of delivery dates; are settled daily.

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Terminology

Currency futures are traded in a standardised, transferable parcels called contracts. They are governed by their contract specification which details the size of each contract, when delivery is to take place and what exactly is to be delivered.

The contract unit or size specifies the amount of underlying currency to be delivered per contract. This is also known as the 'face value' of the contract.

The 'futures price' is one at which the two counterparties in a futures contract agree to transact at/on the settlement date. In terms of a currency future, this is usually a calculated arithmatic mean of a range of price quotations on the last trading day prior to settlement date. Prices are quoted in terms of USD per currency.

The 'last trading day' is the last business day prior to settlement date in the delivery month.

The 'settlement date' is the date of completion and execution of the terms of the contract - in this case the delivery of the underlying currency.

The 'delivery month' is the month during which a futures contract expires, and during which delivery may take place according to the terms of the contract. For currency futures this is usually march, June, September, and December.

A 'tick' is the smallest permitted price movement in a future contract. As each futures contract is a standardised size, the smallest price movement is known as the 'tick value'.

A currency futures contract can be 'closed' out by making an offsetting trade, or taking delivery of the underlying currency.

There are 2 parties to a currency futures contract - a buyer and a seller. The buyer of a future enters into an obligation to buy the foreign currency on a specified date. The seller of a future is under an obligation to sell the foreign currency on a future date.

The risk to the holder of the currency future is unlimited, and because of the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Loss and gains by each party on a futures contract are equal and opposite. In other words, futures trading is a 'zero-sum game'.

The clearing house acts as an intermediary in futures transactions as it guarantees the performance of each party to the transaction. In order to ensure that payment occurs, futures have a 'margin requirement' or 'clearing margin'. This margin is calculated as the difference between the current value of futures position (mark-to-market) and the position value at the time purchase/sale. This margin is calculated and settled daily with the clearning house - the form of payment/receipt into each parties account.

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Currency Swaps - How do they work?

A 'Currency Swap' is a contract which commits two counterparties to exchange, over an agreed period, two streams of interest payments in different currencies, and at the end of the period to exchange the corresponding principal amounts at an exchange rate agreed to at the start of the contract. The principal amounts are also exchanged at the prevailing spot rate on inception.

The two streams of interest payments can be fixed/fixed, fixed/floating, floating/fixed or floating/floating.

Unlike an interest rate swap, the principal and interest are usually both exchanged in full in a currency swap.

A swap is referred to as 'cross-currency' when it involves an exchange of two streams of interest payments in different currencies, where at least one stream is at a floating rate of interest.

Let's look at the Terminology:

A Currency Swap is one one where two fixed rate interest streams in different currencies are exchanged.

A 'Cross-Currency Coupon Swap' is on where a fixed rate interest stream is exchanged for a floating rate one.

A 'Cross-Currency Basis Swap' is one where two floating rate interest streams in different currencies are exchanged.

In all cases the principal is usually exchanged at inception at the prevailing spot rate and at maturity at an agreed contract rate.

There are other less commonly transacted swaps. They include 'Asset Swaps' which is a currency swap with interest streams backed by cash flows from assets, 'Differential Swaps' which is a cross-currency basis swap that does not involve any exchange of principal, and 'Circus Swaps' which is a combination of a cross currency coupon swap and a single currency coupon swap.

The counterparties to a swap transaction are commonly known as Payers and Receivers. Alternatively the terms Buyers and Sellers are used.

Floating rate interest streams are based on agreed reference rates - commonly 6 Month USD LIBOR (London Interbank Offer Rate). NB AUD floating rates are based on BBSW (Bank Bill Swap Rate).

Fixed Rate interest streams are agreed to at the start of the contract. There are two methods of quoting the fixed rates - the all-in price, or as a swap spread on a benchmark rate.

All-In Prices

A quote for one year swap may be given as 8.00% - 7.85%. This is a two-way price in which the dealer would pay a fixed rate of 7.85%, and would look to receive 8.00% fixed. The dealing spread of 15 basis points represents the dealers profit.

Swap Spreads

This is the convention of quoting the fixed rate in two parts - swap spread and a benchmark interest rate. For example, a GBP/USD cross-currency basis swap might be quoted at +10 - meaning that the swap is between US dollar LIBOR on one hand and sterling LIBOR plus +10 basis points on the other.

The Advantages and Disadvantages of Currency/Cross Currency Swaps

The advantages of currency swap transactions are:
1. They allow active currency exposure management - ie hedging translation risk.
2. They allow aceess to markets with the cheapest source of funds - comparative advantage.

The disadvantages of currency swap transactions are:
1. A default by one counter party leaves a currency exposure.
2. There are higher credit risk issues.
3. They can be expensive to terminate.

Application of Currency Swaps

Currency swaps are regularly used for hedging and arbitrage purposes.

Hedging

Currency swaps can be used as an instrument for eliminated translation risk.
Consider an Australian company that raised AUD 100,000,000 by issuing USD 62,000,000 of USD denominated 3-year bonds paying 6.0% per annum coupons semi-annually when the exchange rate was 0.6200. Each coupon payment is USD 1,860,000, and the principal nrepayment is USD 62,000,000. If the AUD/USD rate falls it will cost more AUD to purchase the USD to make the interest payments, and the principal repayment.

The company could swap from paying fixed USD into paying fixed AUD. If the USD 3-year swap rate was 6.0% per annum and the AUD 3-year swap rate was 6.5% per annum, the company could eliminate its currency risk by receiving the USD rate, and paying the AUD rate.

NB The foreign exchange conversion is done at the spot rate prevailing at the time of the swap. If the swap was done at the time of the issue of the bond when the spot rate was 0.6200, the AUD amount payable at each interest payment date would be a fixed amount of AUD 100,000,000 x 0.065/2 = AUD 3,250,000. The repayment of the USD 62,000,000 principal would be AUD 100,000,000 based on the spot rate of 0.6200.

Arbitrage

Currency swaps can also be used to arbitrage comparative advantage in different markets. Arbitrage opportunities arise because lenders require a larger 'credit premium' for borrowers with poor credit ratings raising funds in weak currencies - than for the same borrowers raising funds in strong currencies.

Consider an Australian company that can raise funds by borrowing in AUD at fixed rate of 15% or issuing Euro denominated bonds at a fixed rate of 9%. By contrast a German Company with a better credit rating can issue AUD Euro bonds at 12% or Euro bonds at 8%. See below:

For AUD Investor

Australian Borrower: 15%
German Borrower: 12%
Interest Differntial: 3%
AUD Equiv: 3%

For Euro Investor

Australian Borrower: 9%
German Borrower: 8%
Interest Differential: 1%
AUD Equiv: 1.15%

Arbitrage Opportunity = 3% - 1.15% = 1.85%

The interest differential reflects the credit premiums required for the less credit worthy borrower.

NB For a more meaningful comparison, the Euro credit premium is translated into Aud percentage points using an AUD/EUR interest conversion factor 1:1.15. The factor is dependent on the interest between the 2 currencies. It is not an exchange rate.

From the example above, it appears the Australian borrower has a comparative advantage in the Euro market, where it faces a premium of only 1.15% against a 3% mark-up in AUD. Similarly the German borrower has a relatively best market in AUD where it can obtain funds 3% below the Australian borrower's rate (15%) - whereas it can only obtain Euro at 1.15% below the Australian borrower's rate (9%).

There to take advantage of the comparative differences, the individual borrowers should raise funds in their relatively best markets, and complete the operation by transacting a currency swap with each other. The arbitrage opportunity of 1.85% is divided between the counterparties within the terms of the swap, accoring to their individual negotiating powers!

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What is 'Arbitrage'?

'Arbitrage' refers to the practice of taking advantage of inconsistent pricing to lock in risk-free profits. If two banks are quoting rates where one bank's rate is higher than the other bank's offer rate, then an arbitrage opportunity exists.

Let's look at the following example:

Bank A quotes USD 1 = JPY 120.10 (bid) and 120.15 (offer)
Bank B quotes USD 1 = JPY 120.17 (bid) and 120.20 (offer)

As Bank B's bif rate 120.17 is higher than Bank A's offer rate 120.15, it is possible to buy USD from Bank A at 120.15, and to sell them to Bank B at 120.17 for a profit of two points, without creating a net exchange position.

Once they realise that this has arisen, one or both banks will quickly trend their rates so that the arbitrage opportunity disappears.

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Market-Making

'Market-making' refers to the practice of quoting bid and offer rates to 'make a market'.

A benefit of market-making is that the price-making bank obtains more market information. Being aware of the transactions which are taking place in the market is important if the bank follows a strategy of taking positions.

It is not always desirable for banks to deal at their own prices. If rates are moving quickly in one direction because of a bias in the market, banks will be better off if they square their positions by dealing at market rates.

For example, if a bank is long USD 2,000,000 at JPY 108.10 and a very large trade deficit is announced, all market participants may expect rates to fall. Banks will tend to lower their quotes and possibly widen them as uncertainty grows. As there will be many keen sellers and possibly no keen buyers, it would be folly for a bank to wait in the vain hope of being able to sell at its offer rate. The prudent course would be to square off its position by dealing at another banks bid rate, and to trend its rates down accordingly. This will probably result in the bank taking a loss, but it is better to take a small loss now than to be caught and incur a much larger loss later.

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