Block F · Foreign exchange (FX)

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The FX market is the most liquid market in the world; for investors it is rarely a return source but almost always a risk factor; every foreign investment contains a currency position, intended or not.

72 · Spot market & quotation conventions

Definition: Spot transaction with T+2 value date; quoted as a pair of base/quote currency (EURUSD 1.10 = 1 EUR costs 1.10 USD).

Use: The basis of all FX transactions; conversion, valuation.

Opportunities: Enormous liquidity, tight spreads in majors.

Risks: Mixing up the quotation direction; exotics with wide spreads.

Typical mistake: Misattributing strength/weakness; when EURUSD rises, the dollar falls (not the euro).

73 · FX forwards & forward points

Definition: Forward transaction; forward rate = spot + forward points, which follow from the interest rate differential of the two currencies (covered interest parity).

Use: The standard instrument of currency hedging.

Opportunities: Exact hedging of amount/date.

Risks: Hedging "costs" with a negative rate differential; roll risk on extension.

Typical mistake: Assuming a USD hedge is free for EUR investors; the rate differential determines the cost, not the provider.

74 · FX swaps

Definition: Simultaneous purchase/sale at spot and reversal at forward; economically a collateralized money market loan in two currencies.

Use: Rolling hedges; short-term liquidity in foreign currency.

Opportunities: The deepest, most liquid part of the FX market.

Risks: Basis surcharges in stress phases (year-end!); operational roll processes.

Typical mistake: Setting roll dates without coordination and catching basis spikes (quarter/year-end).

75 · NDFs

Definition: Cash-settled forwards for currencies that are not freely convertible (INR, KRW, BRL etc.); no capital flow in local currency.

Use: Hedging/trading EM currency risks despite capital controls.

Opportunities: Access without an onshore setup.

Risks: Fixing risk; divergence of onshore/offshore rates; liquidity event-dependent.

Typical mistake: Equating NDF rates with onshore rates.

76 · FX options

Definition: The right to exchange at a fixed rate; the market quotes in implied volatility, structures via risk reversals/butterflies.

Use: Hedging with participation (put instead of forward); target rate strategies.

Opportunities: Asymmetry; only the premium at risk.

Risks: Premium costs; vol level timing; complexity with barriers.

Typical mistake: Labeling options as more expensive than forwards across the board; scenarios must be compared, not premiums.

77 · Currency hedging in the portfolio (hedge ratio)

Definition: The decision on what share of the foreign currency exposure is hedged (0-100%); sensible to decide separately per asset class.

Use: Risk steering; FX fluctuation often dominates the short-term return of foreign bonds; for equities a smaller effect over the long term.

Opportunities: Volatility reduction (above all fixed income).

Risks: Costs from the rate differential; forgoing currency gains; operational rolls.

Typical mistake: One hedge ratio for everything; decide bonds (hedge highly) and equities (more flexibly) separately.

78 · Carry trades

Definition: Borrowing in a low-rate currency, investing in a high-rate currency; return = rate differential minus currency loss.

Use: A systematic return source in calm markets; as an addition in currency strategies.

Opportunities: A documented carry premium over long phases.

Risks: "Up the stairs, down the elevator"; abrupt losses in risk-off phases; crowding.

Typical mistake: Planning carry income as steady; the losses come rarely but violently.

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