Eurocurrency, Forex, EMS, Derivatives, and Options
Eurocurrency and the Eurodollar
A Eurocurrency is a claim (e.g., time deposit) in that currency held by a nonresident of the currency’s country of origin. Since the Eurodollar is the major Eurocurrency, it is a U.S. dollar claim arising from a dollar‑denominated deposit, note, or bond held by a nonresident of the United States.
The LIBOR (London Interbank Offer Rate) fixing is the base rate in the Eurocurrency market. (Offer Rate = Ask Rate) It represents the average rate at which leading multinational banks in London are willing to lend to each other.
The rate at which major banks in London are willing to borrow funds from each other (tipo tomador), as opposed to lend to each other, is the London Interbank Bid Rate or LIBID. The spread between LIBOR and LIBID represents the “bid-ask spread” or “bid-offer spread” for Eurodollars. The bid rate (LIBID) is the lower of the two rates.
Foreign Exchange (Forex) Market
The FX or forex market exists because of trade between countries with different currencies. That is, exporters prefer not to hold foreign currencies; they want to be paid in their national currency.
Direct Quote = Home currency/Foreign currency
(Number of units of the home currency per unit of the foreign currency)
Indirect Quote = Foreign currency/Home currency
(Number of units of the foreign currency per unit of the home currency)
Their relationship: Direct quote = 1/Indirect Quote
Foreign Market
Bid Price – Price (low) at which the bank (or a dealer) buys (offers to buy) a foreign currency.
Offer Price (Ask Price) – Price (high) at which the bank (or a dealer) sells (offers to sell) a foreign currency.
The Spread between both prices is the profit margin for the bank (for the dealer).
Spot Market: Transactions for immediate execution.
Forward Market: Transactions in which the purchase price of a certain amount of a currency is agreed today for a future date.
A foreign currency is said to have a “forward premium” when its direct forward quote is higher than its direct spot quote. It has a “forward discount” in the opposite case.
The European Monetary System (EMS) and the Euro
Created in 1979 to establish monetary stability in Europe and to promote economic and political unification for the European Union.
ECB: A third important development coming out of the EMU (European Monetary Union) was the establishment of the European Central Bank (ECB). Its primary task is to control inflation through the supply of money and credit for the EMU countries, which have rendered their monetary sovereignty to the ECB.
Derivatives and Interest-Rate Derivatives
Derivatives are contracts whose cash flows (payments), up to the contract “maturity date”, “value date” or “expiration date”, are based on or derived from the price or value of the underlying (el subyacente), and are generated at agreed “performance dates” (settlement dates).
The underlying can be a commodity (oil, gold, coffee, sugar,…), a financial instrument (financial asset), a currency, a stock-market index, an interest rate, etc.
Four basic kinds of derivatives: forwards, futures, swaps, and options.
Interest Rate Derivatives: Off-Balance sheet interest-rate derivatives that banks and managers use for hedging or trading.
Forwards
Forwards are contracts between two parties agreeing that at a certain time in the future (settlement date, maturity date, value date) one party (the seller) will deliver a pre-agreed quantity of the underlying (or its cash equivalent in the case of cash-settled contracts or non-deliverable underlyings) and the other party (the buyer) will pay a pre-agreed amount of money for it.
Forwards are traded on OTC markets, tend to be custom-tailored to the needs of both parties, and cannot be sold to a third party as a general rule.
Forward Rate Agreement (FRA)
A FRA is a forward contract based on a notional amount N, an underlying interest rate and a specified future maturity date (settlement date, value date).
- The “buyer” of a FRA makes sure that, on the FRA settlement date (value date, maturity date), he will be able to borrow the notional amount N ($, €, Y,..) at the contract rate. The buyer hedges against the risk of rising interest rates.
- The “seller” of a FRA makes sure that, if on the FRA settlement date he makes a deposit of (he lends) an amount N ($, €, Y,..), he will be able to get a return equal to the contract rate. The seller hedges against the risk of falling interest rates.
- A FRA will come into force even if you finally do not borrow or do not make a deposit. So speculators may also use FRAs.
- In a FRA the counterparty is typically a Bank.
Futures
Futures are standardized forwards which are traded on organized exchanges. The exchange ensures that default on either side of the contract does not take place by means of margin calls that demand investors to deposit additional money or securities so that the “margin account” maintains the minimum maintenance margin.
Open positions in forwards or futures can be:
- Long position (buying position) – A position that benefits from increases of the price or value of the underlying beyond Pc.
To buy a forward, a future, is to take a buying position.
- Short position (selling position) – A position that benefits from decreases of the price or value of the underlying beyond Pc.
To sell a forward, a future, is to take a selling position.
Short Selling
Short selling is the selling of stock shares that the seller doesn’t own. This can be done when the seller is anticipating a decrease in share price.
When you short sell a stock your broker will lend it to you. The shares are sold and the proceeds are credited to your margin account set up with the broker. If the price of the stock drops in the market you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price and you lose money.
Margin accounts are subject to restrictions imposed by brokers, and have a minimum maintenance margin as a guarantee. Margin calls occur when market price rises and brokers demand the short seller to deposit additional money so that the margin account is brought up to higher minimum maintenance margins calculated by the broker.
Options
Call Option (a “Cap”): Gives the “Holder” (the buyer of the option) the right – but not the obligation – to buy the underlying (“exercise the option”) at a specific price or value (strike ‘per unit’ price or value) with an agreed volume (unit notional value), at a specified future date (European style options) or up to a specified future date (American style options). The specified future date is called maturity date or expiration date.
Put Option (a “Floor”): Gives the “Holder” (the buyer of the option) the right – but not the obligation – to sell the underlying (“exercise the option”) at a specific price or value (strike ‘per unit’ price or value) with an agreed volume (unit notional value), at a specified future date (European style options) or up to a specified future date (American style options). The specified future date is called maturity date or expiration date.
The buyer of a call option is said to take a long position on that option, and will benefit from increases in price or value of the underlying beyond Pc.
The buyer of a put option is said to take a long position on that option, and will benefit from decreases in price or value of the underlying beyond Pc.
Option Premium is the premium (fee) that the buyer pays to the seller of the option (is the price of the option at that moment). If the buyer decides not to exercise the option (let it to expire), he simply loses the premium paid for the option.
Options can be OTC traded (generally custom-made) or Exchange traded (generally standardized, known as “Listed Options”).
The ability to easily close an open options position by executing an offsetting contrary operation (with the same strike price and expiration) in the market is one of the main advantages of standardized options.
Time value of an option at a given moment is the value attributed to the possibility that the option will increase its value during the remaining time before expiration.