risk-neutral means..illustrated by CIP

Background — all of my valuation procedures are subjective, like valuing a property, an oil field, a commodity …

Risk-Neutral has always been confusing, vague, abstract to me. CIP ^ UIP, based on Mark Hendricks notes has an illustration —

  • RN means .. regardless of individuals’ risk profiles … therefore objective
  • RN means .. partially [1] backed by arbitrage arguments, but often theoretical
    • [1] partially can mean 30% or 80%
    • If it’s well supported by arbitrage argument, then replication becomes theoretical foundation of RN pricing


compute FX swap bid/ask quotes from spotFX+IR quotes #eg calc

Trac Consultancy’s coursebook has an example —

USD/IDR spot = 9150 / 9160
1m USD = 2.375% / 2.5%
1m IDR = 6.125% / 6.25%

Q: USD/IDR forward outright = ? / ?

Rule 1: treat first currency (i.e. USD) as a commodity like silver. Like all currency commodities, this one has a positive carry i.e. interest.

Rule 2: Immediately, notice our silver earns lower interest than IDR, so silver is at fwd Premium, i.e. fwd price must be higher than spot.

Rule 3: in a simple zero-spread context, we know fwd price = spot * (1 + interest differential). This same formula still holds, but now we need to decide which spot bid/ask to use, which 1m-USD bid/ask to use, which 1m-IDR bid/ask to use.

Let’s say we want to compute the fwd _b_i_d_ price (rather than the ask) of the silver. The only fulfillment mechanism is — We the sell-side would borrow IDR, buy silver, lend the silver. At maturity, the total amount of silver divided by the amount of IDR would be same as my fwd bid price. In these 3 trades, we the sell-side would NOT cross the bid/ask spread even once, so we always use the favorable side of bid/ask, meaning

Use the Lower 1m-IDR
Use the Lower spot silver price
Use the Higher 1m-silver

Therefore fwd bid = 9150 [1 + (6.125%-2.5%)/12] = 9178

…… That’s the conclusion. Let’s reflect —

Rule 4: if we arrange the 4 numbers ascending – 2.375 / 2.5 / 6.125 / 6.25 then we always get interest differential between … either the middle pair (6.125-2.5) OR the outside pair (6.25-2.375). This is because the dealer always uses the favorable quote of the lend and borrow.

Rule 5: We are working out the bid side, which is always lower than ask, so the spot quote to use has to be the bid. If the spot ask were used, it could be so much higher than the other side (for an illiquid pair) that the final fwd bid price is higher than the fwd ask! In fact this echos Rule 9 below.

Rule 5b: once we acquire the silver, we always lend it at the ask (i.e. 2.5). From Rule 4, the interest differential is (6.125-2.5)

Rule 9: As a dealer/sell-side, always pick the favorable side when picking the spot, the IR on ccy1 and IR on ccy2.  If at any step you were to pick the unfavorable number, that number could be so extreme (huge bid/ask spread exists) as to make the final fwd bid Exceed the ask.

Let’s apply the rules on the fwd _a_s_k_ = 9160 [ 1+ (6.25% – 2.375%)/12 ] = 9190

Rule 1/2/3/4 same.

Apply Rule 5 – use spot ask (which is the higher quote). Once we sell silver spot, we lend the IDR sales proceeds at the higher side which is 6.25%….

cross-currency equity swap: %%intuition

Trade 1: At Time 1, CK (a hedge fund based in Japan) buys one share of GE priced at USD 10, paying JPY 1000. Eleven months later, GE is still at USD 10 which is now JPY 990. CK faces a paper loss due to FX. I will treat USD as asset currency. CK bought 10 greenbacks at 100 yen each and now each greenback is worth 99 yen only.

Trade 2: a comparable single-currency eq-swap trade

Trade 3: a comparable x-ccy swap. At Time 1, the dealer (say GS) buys and holds GE on client’s behalf.

(It is instructive to compare this to compare this to Trade 2. The only difference is the FX.)

In Trade 3, how did GS pay to acquire the share? GS received JPY 1000 from CK and used it to get [1] 10 greenbacks to pay for the stock.

Q: What (standard) solutions do GS have to eliminate its own FX risk and remain transparent to client? I think GS must pass on the FX risk to client.

I think in any x-ccy deal with a dealer bank, this FX risk is unavoidable for CK. Bank always avoids the FX risk and transfer the risk to client.

[1] GS probably bought USDJPY on the street. Who GS bought from doesn’t matter, even if that’s another GS trader. For an illiquid currency, GS may not have sufficient inventory internally. Even if GS has inventory under trader Tom, Tom may not want to Sell the inventory at the market rate at this time. Client ought to get the market rate always.

After the FX trade, GS house account is long USDJPY at price 100 and GS want USD to strengthen. If GS effectively passes on the FX risk, then CK would be long USDJPY.

I believe GS need to Sell USDJPY to CK at price 100, to effectively and completely transfer the FX risk to client. In a nutshell, GS sells 10 greenbacks to CK and CK uses the 10 greenbacks to enter an eq-swap deal with GS.

GS trade system probably executes two FX trades

  1. buy USDJPY on street
  2. sell USDJPY to CK

After that,

  • GS is square USDJPY.
  • CK is Long USDJPY at price 100. In other words, CK wants USD to strengthen.

I believe the FX rate used in this trade must be communicated to CK.

Eleven months later, GS hedge account has $0 PnL since GE hasn’t moved. GS FX account is square. In contrast, CK suffers a paper loss due to FX, since USD has weakened.

As a validation (as I instructed my son), notice that this outcome is identical to the traditional trade, where CK buys USDJPY at 100 to pay for the stock. Therefore, this deal is fair deal.

Q: Does GS make any money on the FX?
A: I don’t think so. If they do, it’s Not by design. By design, GS ought to Sell USDJPY to client at fair market price. “Fair” implies that GS could only earn bid/ask spread.

##[11] data feed to FX pricer #pre/post trade, mid/short term

(see blog on influences on FX rates)

Pricing is at heart of FX trading. It’s precisely due to the different pricing decisions of various players that speculation opportunities exist. There are pricing needs in pre/post trade, and pricing timeframes of long term or short term

For mark to market and unrealized PnL, real time market trade/quote prices are probably best, since FX is an extremely liquid and transparent market, except the NDF markets.

That’s post trade pricer. For the rest of this write-up let’s focus on pre-trade pricer of term instruments. Incoming quotes from major electronic markets are an obvious data source, but for less liquid products you need a way to independently derive a fair value, as the market might be overpriced or underpriced.

For a market maker or dealer bank responding to RFQ,
– IRS, bond data from Bloomberg
– yield spread between government bonds of the 2 countries. Prime example – 2-year Bund vs T-note
– Libor, government bond yield. See http://www.investopedia.com/articles/forex/08/forex-concepts.asp#axzz1SzK7LbkS
– Depth of market
– volume of _limit_orders_ and trades (It’s possible to detect trends and patterns)
– dealer’s own inventory of each currency
– cftc COT report. See http://www.investopedia.com/articles/forex/05/COTreport.asp#axzz1SzK7LbkS
– risk reversal data on FXCM. See http://olesiafx.com/Kathy-Lien-Day-Trading-The-Currency-Market/Fundamental-Trading-Strategy-Risk-Reversals.html

For short term trading, interest rate is the most important input to FX forward pricing — There’s a separate blog post. Other significant drivers must be selected and re-selected from the following pool of drivers periodically, since one set of drivers may work for a few days and become *obsolete*, to be replaced  by another set of drivers.
– yield spread
– T yields of 3 month, 2 year and 10 year
– Libor and ED futures
– price of oil (usually quoted in USD). Oil up, USD down.
– price of gold

For a buy-and-hold trader interested in multi-hear long term “fair value”, pricers need
– balance of trade?
– inflation forecast?
– GDP forecast?

CIP ^ UIP, based on Mark Hendricks notes

Without loss of generality, Let’s suppose the loan period is “today + 12M”.

CIP (not UIP) is enforced by arbitrage and proven by real data. UIP is kind of naive theory, inconsistent with real data.

CIP relates 4 currently observed prices including a fwd exchange rate 12M forward (something like a rate lock). See http://bigblog.tanbin.com/2012/08/fx-fwd-arbitrage-4-ba-spreads-to.html

UIP relates 3 currently observed prices + a yet-unknown price —

E[spot rate 12M later] ) / spot rate = IntRate1/IntRrate2

Above expectation is in _physical_ measure i.e. wishful thinking (IMHO). CIP replaces that expectation with the risk-neutral E*[spot rate 12M later] := fwd contract price today.

RN basically means “backing out the forward contract’s valuation using live market data”. This back-out price is enforced by CIP arbitrage.

CIP arbitrage involves 4 trades done simultaneously. UIP can also involve several trades, but one of them is executed _12_M_ later, so the execution price is unknown now and could lose money.

equivalent FX(+option) trades, succinctly

The equivalence among FX trades can be confusing to some. I feel there are only 2 common scenarios:

1) Buying usdjpy is equivalent to selling jpyusd.
2) Buying usdjpy call is equivalent to Buying jpyusd put.

However, Buying a fx option is never equivalent to Selling an fx option. The seller wants (implied) vol to drop, whereas the buyer wants it to increase.

FX vol quoting convention

? the terms “strangle” and “butterfly” seem to be used rather loosely. Not sure which is actually right. Do they mean the same thing?

On the fx vol dealer market, you get quotes in the form of RiskReversal, Strangle and ATM straddle.
An example of a RR quote is a 25 delta RR contract to convert 1 million USD to JPY. The exact sums of yens are denoted Kp25 and Kc25, and not in the quote. In this kind of confusing discussions, just treat the commodity currency (USD in this case) as a commodity like silver. When you (market-Taker) go Long any RR contract, you are Long the Call and Short the Put on that silver – Be very clear about these in your mind.
Now let’s zoom into a hypothetical RR quote. The quote says
“            On Mar 1, dealer UBS is willing to WRITE a USD call + BUY a USD put for a premium amount of x yens[1], where x will be determined at the RR volatility of 3.521% per annum. (An unrealistic fictitious vol value, because USD/JPY RR quote is usually Negative.)
The underlying Put has a strike Kp25 corresponding to a delta of -0.25. (But since you the market Taker will be Short the Put, your delta is +0.25.)
The underlying Call has a strike Kc25 corresponding to a delta of +0.25. This Call strike will be Above the Put strike.
Both the put and the call are OTM for 1 million unit of USD and expire end of May.
Optionally, the quote might mention a reference spot rate of “USD/JPY = 93.32”. This probably helps people back out the strikes Kp25 and Kc25.
That is a one-way Offer/Ask quote. For a 2-way, dealer would give 2 quotes — a bid and an ask.

[1] Note the RR instrument is denominated in yen i.e. yen is the “2nd” currency whereas dollar is the commodity like “silver”

At the time when you accept this quote, Kp25 might come out to be 88 million yens, and Kc25 might come out to be 111 million yens. The premium x might come out to be 2.5 million yens – all hypothetical figures. However, if you accept the quote an hour later, live prices would move, and Kp25, Kc25 and x would be different even if the 3.521% quote stays largely unchanged. FX volatility smile curve is known to be sticky-delta, rather than sticky-strike (stocks).

Lets see how to compute Kp25 from this quote. In the standardized RR contract, the quoted vol of 0.03521 pa is defined as the vol difference i.e. 
sigmaKc25sigmaKp25 = 0.03521 per annum
sigmaKc25 is the implied vol of the underlying call (subcontract) at strike Kc25
sigmaKp25 is the implied vol of the underlying put (subcontract) at strike Kp25
On any FX/Equity smile curve, Kp25 < Kp25, so on the graph the sigmaKc25 (implied vol on the OTM Put) is always marked on the LHS and the Call always on the RHS. For USD/JPY, smile curve looks like a stock, so LHS sigma is Higher than RHS. Therefore the RR vol is usually negative.
To determine the exact Kc25 and Kp25 values, we need to compute the 2 above-mentioned sigmas, which bring us to the Strangle and ATM quotes.
The Strangle quote says something like
“           On Mar 1, dealer UBS is willing to WRITE 2 options — a USD (i.e. silver/JPY) put + WRITE a USD (i.e. silver/JPY) call for a premium amount of x yens, where x will be determined at the volatility level of 5.1% per annum.
The put has a strike Kp25 corresponding to a delta of -0.25.
The call has a strike Kc25 corresponding to a delta of +0.25.
Both the put and the call are OTM for 1 million unit of USD (silver) and expire end of May.
The quoted vol of 0.051 pa is defined as (sigmaKc25 + sigmaKp25) / 2 – sigmaATM = 0.051 per annum
The ATM (straddle) quote says something like
“            On Mar 1, dealer UBS is willing to WRITE a USD (i.e. silver/JPY) call + WRITE a USD (i.e. silver/JPY) put for a premium amount of x yens, where x will be determined at the volatility level of 11% per annum.
The call and the put both have exactly the same strike K such that net delta = 0.0. (This K is not specified in the quote. This K makes both options ATM but K is not exactly equal to current spot rate.)
Both are ATM for 1 million unit of USD (“silver”) and expire end of May.
The quoted 11% vol is the above-mentioned sigmaATM. ATM put and call should have very similar (implied) sigmas. Their delta should both be very close to 0.50.
With these 3 quotes, it’s simple arithmetic to back out the 2 unknown sigmas – the implied vol for the underlying 25-delta OTM call and the underlying 25-delta OTM put. The RR is a portfolio of these 2 primitive instruments. The Strangle is also a combination of these 2 basic instruments. Note the 3 quotes may come from 3 dealers, so as a market taker we can mix and match the available contracts.
If we know the implied vol (sigmaKc25) of a 25-delta OTM call, and also the spot price and expiration, BS can back out the strike price Kc25. Remember there’s a one-to-one math relationship between delta values and strike values. Imagine we have a lot of (3000) call contracts with equally spaced strikes, same expiration. If we plot their Theoretical values against their strikes, we will see a smile curve. Mathematically, their delta values (not defined this way but) are numerically identical to the gradient along this smile curve. If we plot delta against strikes, we will see the one-to-one-mapping.

fwd-starting fx swap points

Q: If 9M outright fwd point is 15.2 pips, and 3M is 5 pips, what would be the fwd-starting swap point?

A (not sure now): The swap point would be 15.2 – 5 = 10.2 pips.

The fwd point for a 3Mo (our near date) is F – S = S (1 + R * 90/360)/(1 + r * 90/360) – S, which already considers the 3Mo length.

This formula shows the
* near date fwd point number is linear with (R – r).
* far date fwd point number is linear with (R – r).

However, the linear factors in these 2 cases are Different so it’s wrong (??) to subtract like 12 – 5 basis points. Swap point reflects not only the IR differential, but also the “distance” and the spot level.

The swap points are smaller when the distance is short.

Suppose you as market taker have an existing 3M fwd position and need to roll it forward. You effectively need to close the position for the original maturity and redo it at 9M. That’s 2 transactions with 2 dealers — unwise. Instead, You should go to one dealer to get a fwd-starting swap quote in bid/ask, without revealing your direction. The dealer would charge bid/ask only on the far leg, not twice on near leg and far leg.
Specifically, If there’s a bid/ask on the 3M fwd point (5 pips for eg), that doesn’t increase the swap point bid/ask spread, which would be the same bid/ask spread as the far leg fwd points.

bid side of fx swap point means@@

Q: given a pair of bid/ask quotes in fx swap point, what kind of trades are we talking about implicitly?

A: dealer is sell/Buy ccy1. The spot leg is sell ccy1. The far leg is Buy ccy1.

Note we are taking the dealer’s position, not the market-taker’s.

Note “bid” refers to the far leg, not the near leg.

Note ccy1 (not ccy2) is the asset being traded.

-ve fwd points => ccy1 weakening => ccy1 higher inflation

(As we get older we rely increasingly on intuition, less on memorizing)

Tony shared this quick intuition :
* when we see a …negative fwd point, we know ccy1 is …weakening due to … higher inflation in that country, such as AUD or BRL
* when we see a positive fwd point, we know ccy1 is strengthening due to ultra-low inflation such as EUR.

(Note the lowest inflation currency, JPY, is never a first currency…)

Remember ccy1ccy2 = 108.21 indicates the “strength of cc1”

– When we see ccy1 IR lower than ccy2, we know ccy1 will likely strengthen in the short term. You can imagine hyper-inflation in ccy2
– When we see ccy1 IR higher than ccy2, we know ccy1 will likely weaken in the short term. You can imagine hyper-inflation in ccy1

ccy swap^ IRS^ outright FX fwd

currency swap vs IRS
– Similar – exchange interest payments
– diff — Ccy swap requires a final exchange of principal. FX rate is set up front on deal date

currency swap vs outright fx fwd?
– diff — outright involves no interest payments
– similar — the far-date principal exchange has an FX rate. Rate is set on deal date
– diff — the negotiated rate is the spot rate on deal date for ccy swap, but in the outright deal, it is the fwd rate.

currency swap vs FX swap? Less comparable. Quite a confusing comparison.
– FX swap is more common more popular

ccy risk in FX swap ^ forward outright

In short, FX swap entails no currency risk because no future FX rate enters the PnL formula. Currency risk, or FX risk, refers to the uncertainty/hazard of exchange rate movement during a “holding period”, when we have an “exposure”.

For a longer explanation, let’s start with a simple spot FX transaction. As soon as we convert to or from our account currency (HKD for example), we have an open (long or short) position in some silver – I treat any other currency as a commodity. Price movement in silver causes paper gain or loss. If the notional is large, then I lose sleep, until I close the position and have everything in my home currency again.

In terms of FX risk, a forward outright is different from a spot trade only logistically. As soon as we agree on a price and execute, I take on an open position and open exposure, way before the settlement date.

(In terms of credit risk however, the outright differs substantially from the spot trade.)

The simplest no-position scenario is the fixed-fixed cross-currency swap. On near date, we exchange principals – say HKD 7m vs USD 1m. On far date, we return each other the exact same amounts, not a single cent different. In between, all the pre-agreed interest payments are exchanged too, where one interest rate can be many times higher than the other. No FX risk on the principal amount.

Finally we come to the more important instrument – FX swap. It doesn’t create any open position. On trade date counterparties agree on the two exchange rates, leaving no uncertainty or exposure to the market.

most popular/important instruments by Singapore banks

I spoke to a derivative market data vendor’s presales. Let’s just say it’s a lady named AA.

Without referring specifically to Singapore market, she said in all banks (i guess she means trading departments) FX is the bread and butter. She said FX desk is the heaviest desk. She said interest rate might be the 2nd most important instrument. Equities and commodities are not …(heavy/active?) among banks.

I feel commercial banks generally like currencies and high quality bonds in favor of equities, unrated bonds and commodities. Worldwide, Commercial banks’ lending business model is most dependent on interest rates. Singapore being an import/export trading hub, its banks have more forex exposure than US or Japanese banks. Their use of credit products is interesting.

AA later cited credit derivative as potentially the 2nd most useful Derivative market data for a typical Singapore bank. (FXVol being the #1). Actually, Most banks don’t trade a lot of credit derivatives, but they need the market data for analysis (like CVA) and risk management. She gave an example — say your bank enters a long-term OTC contract with BNP. You need to assess BNP’s default probability as part of counterparty risk. The credit derivative market data would be relevant. I think the most common is CDS

(Remember this vendor is a specialist in derivative market data.)

The FX desk of most banks make bulk of the money from FXO, not FX spot. She felt spot volume is higher but margin is as low as 0.1 pip, with competition from EBS and other electronic liquidity venues. What she didn’t say is that FXO market is less crowded.

She agreed that many products are moving to the exchanges, but OTC model is more flexible.

RiskReversal -ve bid / +ve ask

Refer to the one-way RR quote in http://bigblog.tanbin.com/2012/06/fx-vol-quoting-convention.html.

Q1: What if 25Delta risk reversal bid/ask quotes are both positive?

As in the above example, dealer (say UBS) gives an RR Ask quote of 3.521%. Let’s say we have some hacker/insider friend to peek at UBS database, and we find the call’s Ask implied-vol is 9.521% and the put’s Bid implied-vol is 6%. In other words, dealer is willing to Write the 25Delta call at an annualized implied-vol of 9% and simultaneously Buy the Put @i-vol of 6%.

Now we ask the same dealer for a bid price. Dealer is bidding 2.8%. Our friend reveals that dealer is secretly willing to Buy the call @i-vol=8.9% (Lower quote) and simultaneously Write the put @i-vol=6.1% (Higher quote).

If you compare the bid vs ask on the call, as market maker the dealer is putting out 2-way quotes to buy low sell high.

If you compare the bid vs ask on the put, as market maker the dealer is putting out 2-way quotes to buy low sell high.

In this scenario, RR bid is below RR ask but both positive.

Q2: Could an RR bid be negative while the ask positive?

Ok We are serious about Selling an RR. To get a better bid price, we ask Dealer2 (SCB) for a Bid quote. Dealer is bidding -0.2%. Our insider tells us this dealer is willing to Buy the call @i-vol=5.9% and simultaneously Write the put @i-vol=6.1%

Between these dealers, Dealer1 would be the best (highest) bid. Now Dealer1 withdraws its quote. Dealer2 is the only bid. Market best RR bid is now negative.

Q2b: When would be RR bid and ask have opposite signs?
A: I guess when the 2 currencies are almost equal in terms of downside/upside

Q3: what if best RR bid and best RR ask are both negative? I think this is the norm in some currency pairs. Suppose market is bearish on the commodity currency (1st) and bullish on the quote currency (2nd). Treating commodity currency as an asset, Sink insurance costs more than surge insurance. Put premium exceeds Call premium. RR would be negative in both bid and ask.

fxo premium as percentage of notional: mismatch

There’s an illustration in Tony’s lecture notes and also in the homework — OTM 3 month 1.10 EUR call USD put, with Spot EUR/USD = 1.07

  • Notional is USD1.1 and EUR 1.0, Not using the spot conversion rate
  • Assume the premium = USD 0.0200, paid today in USD per EUR
  • We could also say premium = 0.02/1.07 = EUR 0.0187
  • Then Pnumccy = 0.0200, or a trader might say “200 USD pips”
  • per USD notional i.e. “USD %” would be 0.0200/1.10 = 1.82%, Pnumccy% = 0.0182
  • per EUR notional i.e. “EUR %” would be 0.0187/1.0 = 1.87%, Pbaseccy% = 0.0187
  • Somehow, we got 170 EUR pips due to 0.0182/1.07 ???
  • “P” stands for premium

Observation — last line 1.87% means the premium is 1.87% of the EUR notional; the 1.82% means the same premium is 1.82% of the USD notional.

The paradox — the same premium is 1.87% of the EUR notional but only 1.82% of the USD notional !

(In general, paradoxes provide “aha” moments and great learning opportunity.)

Analysis (thin->thick->thin):

Key — the USD notional and EUR notional can have (vastly) different values before maturity.

Let’s focus on OTM (more common). Without loss of generality, let’s consider deep OTM. In such a case the EUR notional is an trivial amount and the USD notional is a king’s ransom.

Naturally, the premium as percentage of the ransom is tiny.

#1 driver of long term FX #my take

Q: what is the #1 fundamental driver of long term FX rate between 2 currencies?

Is it PPP? I don’t think so.
Is it supply/demand? Short term yes; long term … this seems less relevant
%%A: “gold” backing.

In the beginning, every pound issued by the British monarch is as good as an ounce of gold (or whatever fixed amount of gold). Therefore anyone holding a pound note can exchange it for the equivalent amount of gold.  The monarch then decided to print more pound notes. Logically, all the existing and new pounds devalue. But the country also exports and, in a world of universal gold standard, earns gold. In a more realistic world, What is earned is foreign currency.

I believe Every Singapore dollar issued is backed by some amount of “gold” which in modern context means foreign reserve in a basket of hard currencies. By the way, there’s nothing harder than gold. As the national economy expands, more goods are produced domestically so the CB could issue more SGD, but I guess the CB waits until the goods are exported[2] and foreign currency earned. Such a prudent practice helps ensure every SGD is fully backed by sufficient “gold”.

[2] incoming tourists also spend their own currency like JPY, therefore contributing to the Singapore foreign reserve. If tourists sell their JPY for SGD outside Singapore, the JPY amounts tend to flow into the global banking systems and back to Singapore banks. I think non-Singapore banks don’t want to go long or short SGD for large amounts, so they would eventually exchange with Singapore banks including Citibank, HSBC, SCB, BOC.

In general, a hard currency is more deeply *backed* by gold than a weak currency. Alternatively, the issuing central bank has other capabilities (besides gold reserve) to maintain the *strength* of her currency. This strength depends on Current Account and economic growth — the 2 fundamentals. Another factor is global competitiveness, but this is often measured by the capacity to export and compete on global markets. After all, it still seems to boil down to earning enough foreign currency to back our own currency — “gold” backing in disguise.

real/fake market-order + limit order in FX ECN

Some popular institutional ECN’s offer 3 main types of orders. Taking buy orders for example, you can place

– limit order – to buy at or below a specified price. It might match some offers immediately. All remaining amounts on the order remain in the market
– IOC – fake mkt order – buy at or below a specified price. All unfilled amount is cancelled. This is more popular than the real mkt order
– real mkt order – order without a price

some basic forex market facts

Most ECN’s support spot only. Banks don’t want to publish quotes on fwd and options because that’s proprietary.

Fwd market is bigger than futures mkt (mostly CME)

EBS min lot is 1 mio.  EBS is same nature as the ECNs but EBS pool is deeper than ECN pools. Reason — EBS is older and has more participation.

Billion-dollar deals – client would choose RFQ. These large deals are relatively rare so private negotiation is usually required.

Forex ECNs cater to banks more than buy-side

Forex ECNs compete by attracting buy-side and sell-side, but they work harder to /please/ and satisfy the sell-side — primarily banks.

In the FX business, i was told liquidity and credit ultimately depends on cash pile. All spot trades (trillions each day) must be settled in cash. Banks are the only big shots. Hedge funds can play liquidity providers but they don’t have anything close to that amount of cash. (Hedge funds ultimately need banks to support their FX trades.) I’d guess even investment banks can’t match (and have never taken the top spot). Of course, banks aggregate so much cash because of depositors.

Now, there are only a small number of mega-banks. The entire market is largely controlled by these banks (except central banks). Therefore ECNs loop them in first (as what I call “anchors”), and customers will soon follow.

Therefore, in all the bank-to-client ECNs [1], many rules are bent towards the banks — privileges of liquidity providers.  One of the privileges is the Last Look. I was told this is a protection demanded by liquidity providers. I was told LPs always need and have something like a last look. Here’s a “creative” abuse of LastLook by Barx —

  • client sees an offer of 1.117 on the Barx screen and sends a market-buy
  • Barx (backend) looks at open market and notices a temporary dip to 1.116 and anticipates a recovery so it Buys at 1.116.  Then it waits.
  • If price indeed recovers, Barx tells client “We bought for you at 1.1165”, and pockets the difference in price
  • If price /unexpectedly/ sinks further to 1.115, then Barx can tell client “we bought for you at 1.116, before prices sinks further”, so Barx doesn’t suffer any loss.
  • My own assumption — client has right to see the price history on the open market — transparency. This protects clients from large slippage in an /erratic/ market.

Another privilege is requote…

The playing field is tilted towards the liquidity providers. LPs provide an “essential service” to the (huge number of) clients, and LPs basically dictate the rules to protect themselves. However, these rules aren’t arbitrary, unfair or unreasonable. There’s no monopoly here.

In contrast, Credit bond dealers presumably have weaker stranglehold on clients. The need to convert between currencies is more basic and critical than the buy-side’s need in a credit market
* issuers have other means of borrowing, though bond issue is the most important
* bond buyers have many many investment choices.

[1] Is there any bank-to-bank network? I was told EBS was (http://www.investopedia.com/articles/forex/06/interbank.asp#axzz1ie9e5WS0), but then customers are also allowed.

another example of Forex-IR interdependency

When a government (Argentina,Greece…) is facing escalating borrowing cost …

It can devalue currency by printing lots of money (Germany in 1923)

It can default (and also devalue currency), like Argentina did around 2002

It can tighten its belt, increase taxes, reduce gov spending like welfare, increase productivity, endure increasing unemployment …

When Argentina’s new bond’s interest rate hits 700bps, why would existing bonds devalue on the secondary market? (Let’s put aside the factor of default risk.) I already discussed this on my blog, but now i feel invariably it’s related to currency depreciation. Rational Investors feel the supply of this currency has to increase and therefore devalue, because the government must print more of this currency to service debt.

But events in late 2011 are different. I’m not sure if currency is even a factor. When Italy’s new bond hits 700bps, we know the Italian government can’t print more euro as ECB is now in control. I would say the main reason for the escalating borrowing cost is default risk. Secondary bond market is unrelated to issuer’s borrowing cost, but here bond yield also increased, probably due to default risk.

One thing for sure — exchange rates, interest rates and credit risk affect each other in many ways.

FX swap: keywords #2leg

2 “legs”

opposite – the 2 legs are always opposites — HKD to CHF, then CHF to HKD but quantity will be slightly different due to interest differential.

bundle – both legs simultaneously agreed, as a bundle. Near date + far date.

spot – usually one of the 2 legs is a spot trade, but fwd-fwd FX swap is also common

repo – one way to understand the economic rationale (which is a bit convoluted) of FXSwap relies on an understanding of repo (i.e. overnight lending) assuming you find repo less convoluted than FXSwap. A borrower may need a mio USD for 24 hours and have no problem repaying. To demonstrate her repayment capability and to address lender’s concern, she pledges something as a collateral. This something could be a T-bond or some surplus JPY. Therefore, she _borrows_ USD by _buying_ USDJPY on near date, then on far date repays by selling USDJPY.

http://en.wikipedia.org/wiki/Overnight_market is a good intro to the rationale of short-term loans.

bridge-loan — is another way to understand why people need short term loans. FXSwap is similar to a short term loan.

interest calculation – Only after you grasp the rationale above, should you look into the interest implication — even the tiniest amount of math can be hard for some beginners (like me). Both currencies accrue interest between near date and far date.

quote-drive ^ order-driven markets #my take

Many practitioners classify each market into either quote-driven or order-driven.
– Futures, Listed options, listed stocks are Order-Driven.
– FX, Bonds, IRS, CDS are Quote-driven

—- In Quote-Driven markets, dealers (loosely known as “market makers”) publish quotes on
– interdealer broker systems
– 3rd-party dealer-to-client markets known as ECN’s
– their own private markets (like MLBM or CitiVelocity, or perhaps Rediplus)

Clients can also send RFQ to get customized quotes.

Here’s a key feature of the quote — at execution time, the dealer has a last look and can reject the order. Therefore the quote is an indication, not a legal promise.

FX spot/forward is Quote-driven. In some markets (such as Hotspot), non-dealers can also publish quotes, and probably can reject orders too.

Q: How about limit orders in FX spot market?
A: Remember FX spot is QD. When an ECN lets you (a retail trader) submit a limit order, the ECN will hit/lift the quotes on your behalf but still the dealer has the last look.

—- In Order-Driven markets, participants submit market orders, and “limit orders” like irreversible quotes. The exchange performs order matching [1] among market orders and limit orders. At time of execution, there’s no (easy) way for either side to reject the trade. Only the exchange can cancel trades, as they did to a lot of trades on a few special occasions.

To the exchange, there’s no dealer vs. client. If the trade happens be an individual vs GS, then GS is perhaps a dealer, perhaps a market-maker (not the same thing), or perhaps just a regular player. The exchange treats both sides as equals.

[1] Note stop market orders and stop limit orders are not part of the matching until they “activate” to become live market/limit orders.
In FX, even the executable quotes are subject to dealer’s “last look”. When a small investor Ken hits a Citi offer on an ECN, the ECN dare not book the trade right away because it can’t guarantee to Ken that Citi’s last look would pass. Ultimately, the ECN doesn’t take position.

Q: In stock exchanges (or other listed markets), dealers can’t cancel a trade. Only the exchange can. Exchange executes trades and they are final, because the exchange takes position. Why is the stock exchange so powerful? Why is the exchange able to guarantee to Ken that no matter what Citi does, Ken’s trade is confirmed?
%%A: because the exchange’s clearing fund is contributed by the big dealers
%%A: because the exchange is counterparty of every trade and takes positions. If a member bank (Citi in this case) fails to deliver, the exchange takes the loss, using the clearing fund.

%%FX IV – math

Q: Suppose you converted home currency (USD) into GBP and JPY. Avarege rate is computed as net short position in home currency (say 17,982,000 USD) divided by net long position in a foreign currency (say 10m GBP), in a single account. Same for JPY average rate, but in another account. But what if you did some cross trades between GBP and JPY? How would you compute your GBP average rate?
%%A: I would need to work out how much nett GBP was converted to JPY

IV < — Q: if a cross pair AAA/BBB can be priced using EUR, and also can be priced using USD, then what’s the algorithm to choose the correct pricing? Choose USD if it has tighter spread?
%%A: I feel it’s possible to go with EUR and publish a quote with a tri-arb loophole in it. I feel the bid quote on the cross must be the safest bid, and the offer quote on the cross must be the safest offer.

Note ECN’s don’t generate cross rates. Only market-makers (dealers) do that. Its their responsibility to check for triangular-arb loopholes.


Q772: does your system give your clients margin accounts? Do you let clients margin-trade FX options, FX futures or FX spot?
Q1802: is your system Retail-facing or Institutional-facing, an interbank trading system or prop trading?

Q: since NY traders often need to hand over the book to Tokyo traders, do they have different base currencies in their respective trader accounts?
%%A: Tokyo has a caretaker/baby-sitter trader for each NY account.  He babysits for the absent parents.

Q1234: how do you detect tri-arb (Triangular Arbitrage)? Both Outgoing quotes by your traders and incoming quotes need to checked? http://forexmentalist.com/forextrading/forex-arbitrage-trading-a-short-lived-trading-strategy/ is an introduction.
Q987: what live feeds do you use?
Q2323: typical size of your trades?
Q8792: how many cross currency pairs are actively traded on your system?
Q623: Beside the crosses, how many currency pairs are actively traded on your system?  Do these pairs always have USD as one of the 2 currencies?
Q: how many users do you support? Do they use website or WPF or swing or Quartz GUI?
Q: which ECN or interbank trading venues do you connect to?

Q: what’s the typical bid/ask spread on a non-cross currency pair?
A: 2-3 pips for top tier clients, and 20-40 pips for retail. I believe the dealer makes little if any profit on these trades, but they make more from the clients on other deals such as FX fwd, options or lending.
A: 1-2 pips for EUR/USD.

Q: is your system buy-side or sell-side?
(I believe fund managers, asset management firms are all buy-side. I guess Retail online trading websites are probably buy-side too.)

Q: typically how many percent of the trades are voice trades, and how many percent electronic?
(I know many big banks still have voice trades.)

Q: how many types of FX options are processed in your system? Barrier options, Binary options.
Q: what’s the process of FX option trading?
Q: what’s no dealing desk?
Q: what’s ledger balance?
Q: for a fx option, What’s strip? Strip leg?

A1234 (from a veteran): checking the quote frequency of crosses. for example, if EURJPY update rate is the sum of EURUSD update rate and USDJPY update rate. then that could mean one is using EURUSD and USDJPY to make market on EURJPY.
A772: I have seen real examples of retail traders using 50:1 leverage in FX spot trading, but not sure about institutional clients.
A8792 (Piroz): 5. Most of the active pairs are non-crosses.
A8792 (ZJW): 20-30 is common, and often high volume
A623 (ZJW): 200 – 300 is common in a large bank
A1802 (P): Inst sell-side system with about 700 web users.
A987 (P): Bloomberg, FXAll, Reuters
A987 (QEMS): Bloomberg

%%FX IV – processing

[L] Q: what database tables hold unrealized PnL data? I guess it’s Position table
[L] Q: how is general ledger reports generated from unrealized PnL tables?
IV <– Q: how long is a quote (in response to a RFQ) good for?
A: For an extremely competitive quote, it could be good for 1 minute only.

Q: I know derivative instruments have expiration dates, but must all CASH trades be closed sooner or later?
(Someone said you must close all your trades by converting back to your base currency, but I was told it’s possible to keep a long position in a non-base currency forever, just like you keep an IBM position forever.)

Q: after an open trade is closed, does it disappear from the Position table?
IV <– Q: is there any real time risk data presented to traders?
Q: if a trading account start out with USD 100m, and after a month becomes USD 50m + Eur 30m, how is unrealized PnL calculated?
(I think each account must choose 1 base currency. All positions are converted to it when computing unrealized PnL)

[L] Q: how is settlement done? Using some CounterPartyAccount table?

%%FX IV – IT

[L]Q: describe some multithreading challenges in your system
Q: where is the performance bottleneck of your system?
A: in the space of trade matching or “order-book”, there’s a single thread responsible for EUR/USD matching. I think this is the only thread to *removes* items from the EUR/USD order book. Allowing 2 threads to remove is probably impractical. Is this a bottleneck? I don’t know.
A: for FX options, it’s risk/PnL real time update across a large number of positions.
A: tiered pricer. See blog post.
A: Message volume and throughput. For multi-threaded processes, internal state tracking and event trigger sequences would be quite tricky.

Q: what are the functional components in your trading platform? I guess trade booking, quoting, end-of-day risk batch and PnL batch, market data gateway, connectivity to interbank trading venues i.e. FIX engine to send/receive orders and quotes?

Q: which database tables have a history table behind them and why?
(I know Trade, Quote and Position need history tables so the main table can be kept small and fast.)

[L] Q: how is tick data processed?

%%FX IV – volume stats

Q6601: how many quotes do you publish each day, and how many RFQ do you get each day?
Q3244: On a typical incoming market data feed, how many message a day?

A6601 (Pz): possibly a few thousand RFQ. There are probably fewer RequestForStreams

A3244: for a large ECN, hundreds of millions of incoming quotes a day, or 30,000 messages/sec/client, probably aggregate from liquidity providers.
A3244 (Pz): given the tiered pricer, we act on not more than 10msg/sec/currencyPair. (Presumably more are received but only this many trigger outgoing messages.)
A3244 (QEMS): Peak load was 30,000 messages per minute per client, but GUI get refreshed only 4 times ps. only few clients… 6 with GUI and 1 headless client

FX fwd arbitrage – 4 b/a spreads to OVERCOME

Look at the parity between fwd/spot FX rates and the 2 interest rates (in the 2 currencies). Basic concept looks simple, but in the real market each rate is quoted in bid and ask. 8 individual numbers involved.

We pick 4 of them to evaluate ONE arbitrage strategy (fwd rate too high) and the other 4 to evaluate another arbitrate opportunity (fwd rate too low)

Across asset classes, most pricing theories assume 0 transaction cost and 0 bid/ask spread. In this case, the bid/ask spread is often the showstopper for the arbitrageur. Similar challenge exists for many option arbitrageurs.

I think [[complete guide to capital markets]] has one page illustrating this arbitrage.

central bank rate hikes bring ccy up or down@@

Higher interest rate helps a currency short-term. Inflation (sometimes associated with increasing IR) is sure to weaken a currency. According to Wikipedia — By increasing interest rates a central bank stimulate traders to buy their currency (carry trades) as it provides a high return on investment and this would strengthen the currency against others.

I feel this might reduce inflation and increase purchasing power.When inflation is perceived to rise (easy borrowing), central banks dampen it by rate hikes (expensive to borrow).

Very roughly, Interest rate is 70% influenced by gov; FX rate is 30% influenced by gov. Central bank has 90% control on the supply of their currency (but not other currencies). FX adjustment is one of the goals of Central bank IR actions. IR actions have other serious consequences not to be ignored. In this sense, FX trading desk needs IR expertise.

The interest rate is higher on some currency because there is a probability that it will depreciate. As long as the depreciation does not materialize, the carry trade is profitable, but makes big losses when it does. High yielder currencies aren’t always safe bets.

what make EUR/USD FX bid/ask spread so tight

– Factor: large lot size. In interbank market, each deal is around 10-100 mio USD (minimum 1 mio), so a 1 pip bid/ask spread means $1k – 10k. I believe (personal opinion) the larger the volume, the tighter the spread.

– Factor: volatility. The more volatile, the wider the spread from a given liquidity provider i.e. market-maker.

– Factor: market depth. A deeper market makes it “cheaper” to unwind a losing position, thereby minimizing the market maker risk. MM can therefore take more risk and provide tighter spread.

– Factor: credit risk seems to be the most important determinant of bid/ask spread. The best spread is given to the highest credit banks. http://www.investopedia.com/articles/forex/06/interbank.asp says — “The interbank market is a credit-approved system in which banks trade based solely on the credit relationships they have established with one another. All of the banks can see the best market rates currently available; however, each bank must have a specific credit relationship with another bank in order to trade at the rates being offered. The bigger the banks, the more credit relationships they can have and the better pricing they will be able access. The same is true for clients such as retail forex brokers. The larger the retail forex broker in terms of capital available, the more favorable pricing it can get from the interbank market. If a client or even a bank is small, it is restricted to dealing with only a select number of larger banks and tends to get less favorable pricing.

credit check by forex ECNs

Each hedge fund using an FX ECN has a credit limit imposed by his backing prime broker, who is underwriting all his trades. Let’s not go into the business details, but once a HF has a 100m credit limit set up, then any of his trades will /eat/ up on this limit until there’s too little remaining.

Q: when HF sells a foreign currency position for cash (in “home currency”), will credit limit recover?
A: I think so.

From system perspective, Credit limit check is on the pre-trade critical path. If credit insufficient, then ECN won’t execute the trade. The check could take a few ms, but the entire trade takes a few milliseconds through the ECN, so this latency is significant. The check is serialized because any trade against this same HF needs to queue up for the credit limit check.

Why is execution latency so critical to ECNs and exchanges (including option exchanges)? Well, bid/ask price is the first competition among ECN’s and execution latency might well be the 2nd. Some algo shops pay a real price in terms of execution latency — They send an order, wait for the execution report then adjust their algo. In other cases, a trading house monitors execution latency across competing ECN’s.

EBS, Hotspot, Currenex, FXAll … all (Yes!) have this same credit check capability, probably because participants need it.

In exchange trading, all trades are booked under “member” name. So the prime broker (members) actually pays (or sells) from his pocket on behalf of the HF — http://bigblog.tanbin.com/2009/09/adp-broker-means.html. That’s a huge risk to the PB. Therefore credit limits needed.

Prime brokers (PB) can’t perform any pre-trade credit check on the trades executed by their clients (i.e. hedge funds). They aren’t in the pre-trade flow. The best they can do is to receive the post-trade messages in real time and analyze market risk (which they assume due to HF trades) in real time. Hedge funds themselves “don’t care” about credit limit, since it’s OtherPeople’sMoney (PB’s) lent to them. Therefore, I believe no one but ECN has the job to enforce credit checks. PB has the option to instruct an ECN to adjust the credit limit for a client intra-day, but rarely. Therefore the credit limit is *almost* static.

Something taken from an ad — Prime brokers want real-time visibility of consolidated client activity. In real-time, they can manage the credit /extended/ to clients, trading with both executing banks and ECNs. The increase in high frequency and algorithmic FX trading has made the provision of adequate controls critically important to prime brokers managing risk across clients trading on ECNs. Prime brokers now have the ability to monitor their clients’ credit risk across multiple ECNs on a real-time basis, change or close credit lines to manage risk while maximizing clients’ trading ability. With real-time integration to ECN credit and post-trade APIs, Harmony (a post-trade service) will proactively notify the Prime Broker of limit breaches and allow the prime broker to modify credit lines or terminate trading activity. By providing centralized, automated and secure ECN limit management, credit risk for all counter-parties will be significantly reduced.

commodity^IR^FX interaction illustated

When oil, crops (and gold) appreciate against USD, the objective and rational Treasury bond buyers have to discount the cash “flows” deeper [1,2]. In other words, buyers are willing to pay less for those little papers known as coupons. Sellers reluctantly follow.

Commodity (and gold) prices can also rise due to USD depreciation.

QE2 in the US but not Eurozone ==> USD depreciation against Euro and other currencies =?=> commodities appreciation ==> T yields rise. Each cause-effect in the chain reaction is “one of the factors”.

Now, magnitude of this so-called yield shift depends on how important commodities are to an economy. Is it 3% of the economy or 30% of the economy?

I feel basic commodity prices are a major contributing factor beneath the consumer price index.

[1] “Flows” are the shorthand for the multiple future cash flows of any bond, except zeros.

FX vol fitting, according to a practitioner online

— Based on http://quantdev.net/market/bootstrapping/4-buildinganfxvolsurface
The market provide fairly liquid quotes on volatility out to about 2 years for only 3 types of instruments —

ATM Straddle
Risk Reversal

The quotes are provided in terms of volatility for a specific delta. For example: a quote will be given for the volatility for a 25 delta Strangle, or a 10 delta Risk Reversal for a specific maturity. In order to construct our volatility surface we need quotes for an ATM Straddle, a 25 delta Strangle and a 25 delta Risk Reversal, and a 10 delta Strangle and a 10 delta Risk Reversal with a range of maturities.

We can imply the volatility for the specific deltas at a particular maturity by using our quotes. The 50 delta implied vol is simply the volatility of the ATM Straddle. An ATM Straddle is a call and a put with the same strike and maturity, and chosen so the delta of the straddle is zero.

The 25 delta call implied volatility is the ATM Straddle volatility + (25 delta Risk Reversal volatility / 2) + 25 delta Strangle.

On a smile curve, the x-axis would include {10delta, 25 delta, 50 delta, 25 delta, 10 delta} in symmetry. The volatility calculated for the 25Δ call (OTM) is the same as that for a 75Δ put (ITM), so for call values you go along the curve from End A to End B, and for put values you would go along the curve from End B to End A.

Based on http://quantdev.net/market/bootstrapping/4-buildinganfxvolsurface says but I doubt “Usually you would then turn the vol curve for each maturity so it is denominated in strike rather than delta, as it then becomes much easier to use in practice given that you know the strike for the option you want to price, but not the delta.

FXO sticky strike vs sticky delta

http://en.wikipedia.org/wiki/Volatility_smile#Evolution:_Sticky is brief and clear.

Heuristics show

Equity vol smile curve is typically stick-to-strike as spot moves. When we re-anchor a surface to a new spot, the curve plotted against Absolute strike looks unchanged, but curve plotted against delta would shift. I think curve plotted against relative strike would shift too. I don’t think it’s common to plot equity vol smile against delta.

FX vol smile curve is typically sticky delta. When we re-anchor a surface to a new spot rate, the curve plotted against delta would stay fairly stable.

guessing IR differential from FX fwd points

See post on the equation between forward/spot FX and IR differential.

Q2: why do you subtract in the descending case but add in the ascending case?
A2: because offer price must exceed bid price. If we were to add in the descending case, then spot bid (lower) + forward bid points (larger) might EXCEED spot offer (higher) + forward offer points(smaller)

Q1: If you see positive forward points like eur/usd 1mth = 11/12 (ascending order [1]), which currency earns higher interest for the next month?

A1: remember IR parity principle {{{ convert-deposit = deposit-convert }}}. Remember Euro is now cheaper and appreciating.

A1a: Say you start with a bunch of Euros. converting now (unfavorable) then deposit (must be favorable to compensate). So USD interest must be higher.
A1b: deposit (?) then convert (favorable). So the Eur deposit return must be lower to even up.

A1c: Say you start with a bunch of dollars. convert (economical) then deposit (must be unfavorable), so Eur deposit must be inferior
A1d: deposit (?) then convert (costly). So USD deposit return must be higher to compensate.

Conclusion — either deposit->convert or convert->deposit, the 2 legs must cancel out each other’s advantages.

Important observation — When forward points are ascending, FX rate is rising. Therefore first currency (the “silver”) appreciating. In such a context, first currency IR is lower than 2nd currency.

Intuitively, deposit->convert will even out since it’s unfavorable->favorable.

[1] If you see descending order like 12/11, then forward is lower than spot [2] i.e. First currency (the “silver”) is now expensive and depreciating. First currency IR must be higher than 2nd currency.

Intuitively, depost->convert is  favorable->unfavorable

[2] subtract points from spot bid/ask to get forward bid/ask.

1900 tiers of quotes, RFS over FIX, indicative/executable quotes #400w

One of the REAL bottlenecks in a large SELL-side FX dealer system is tiered pricer. Trigger event could be a market data change. Since such an event could trigger an avalanche of messages, the frequency of such events is not very high, probably below 10 events/second on 1 currency pair. If you have 10(or 50 or whatever) active currency pairs, then you could get 100 triggers/sec through your entire system.

Once a trigger is activated, pricer computers new bid/ask quotes for Tier 1 Gold clients. Pricer then adds a distinct spread for each tier. For an active pair like EUR/USD, there can be 1900 tiers. There can be up to 1900 (non-unique) pairs of bid/ask quotes. Typically, the “best” quotes would have a bid/ask spread of 2 to 3 pip, applicable to the best and largest clients. For a *retail* client, it could be 20 – 100 pips.

Core of the tiered pricer is a Drools rule engine.

Another module is the messaging engine using Nirvana by My-Channels. If a particular bid/ask quote applies for all (say, 20) tiers in Silver category, then pricer broadcast the quote to a topic like Quote.EURUSD.Silver. This is kind of alias for 20 different “tier” topics. For efficiency, this is probably multicast.

In the worst case, one event can trigger an avalanche of 1900 messages for one currency pair alone.

Last module is the FIX engine. Quotes often go out the door in FIX format, just as RFQ. Now there are 1900 tiers but the number of clients could be higher or lower than 1900. If there are more than 1900 clients and if all of them subscribe to our quote, then each must be sent the quote. I know a Chicago prop trading firm (Gelber?) subscribe to a lot of “bank feeds”.

The most demanding type of subscription is a RequestForStream (RFS). A typical RFS could ask for a stream of EURUSD quotes for 10 (up to 120 minutes), during which time all quotes must be delivered.

Unlike RFQ, RFS requires special approval. The bid/ask quotes in an RFS can be indicative or *executable* (similar to Firm, but see separate blot post). If a client hit an executable bid or lift an executable offer, then the trade is considered executed, though I believe cancellation is still a possibility, just like any Firm quote in bonds.

How does a dealer make sure he has enough position to honor the quote? Perhaps by setting aside reserve quantities, or by monitoring the open market.

Unlike bidwanted systems (non-negotiable quotes), it’s possible for a client to negotiate on our quote electronically, though I feel manual negotiation is more practical.

cross rate derivation illustrated

There’s confusion over the term “cross”. I believe it means the pair is not “native” to the broker/dealer you are using, so they have to synthesize 2 “native” trades. If your broker/dealer offers only USD/XXX , then a lot of non-USD currency pairs will be crosses.

If you are a big dealer bank using EBS and Reuters, then you can combine those 2 brokers’ offerings together and present a consolidated list of “native” pairs. Anything not in the list is considered a cross currency pair. Note EBS/Reuters “native” spreads are very tight. This is a defining feature of “native” pairs.

Since a cross is always synthesized using 2 pairs, transaction cost (and bid/ask spread) is higher.
In the context of “cross rate”, this term means “an exchange rate between 2 non-USD currencies”. That’s a USD cross. There are also Euro crosses — any non-Eur currency pair whose rate is computed from 2 Eur rates.

If USD/AAA has a bid/offer and USD/BBB has a bid/offer, and CCC/USD has a bid/offer. When computing the cross rates between A B and C, just remember to always take the worse prices, which are the safest prices for the market-maker.
– Offer of the cross pair is worse joining worse
– Bid of the cross pair is worse joining worse too

One principal, but many scenarios. Here’s one scenario.Given
1) USD/CHF = 0.9648/52
2) USD/JPY = 82.64/69
CHF/JPY offer must be computed as USDJPY / USDCHF, but which number by which number? Worst offer quote is the highest, so 82.69 / 0.9648 = 85.71.

Here’s the math explained in English. As a market maker who is publishing the 4 quotes of 1) and 2), at what price am i willing to convert my CHF into JPY? Well, I would convert to USD then JPY, using the safest/greediest conversion rates among my outgoing quotes. I would safely convert from CHF to USD at 0.9648, then safely convert from USD to JPY at 82.69.