Chapter 4
Foreign Exchange Traders
What Does a Foreign Exchange Trader Do?
The Foreign Exchange Trader’s Role
A foreign exchange (FX) trader, or dealer, buys and sells currencies in the foreign exchange markets. He may specialise in one of the major currency pairs, for example dollar/mark or dollar/yen, or trade several of the less active ones.
Size of the FX Market The Foreign exchange market is one of the largest markets in terms of turnover. It is essentially a 24-hour global market which never really closes. Typically, $1 trillion a day is traded in this market. In this market, $5m dollars is a small deal since deals can be as large as $100m or more. Traders in major currencies may perform up to 1000 deals per day. Individual traders have been known to make their banks 10 million in one day.
What motivates traders? Traders are motivated purely by profit which they earn from their bid/ask spread. They buy (that is, take long positions in) currencies that they think will rise in value and sell (that is, take short positions in) currencies they think will fall in value. Foreign exchange traders look for mispriced currencies in the market so that they can benefit from long positions in undervalued currencies and short positions in overvalued ones. They assess a currency’s prospects using a number of sources. These include currency rate trends from inter-day and intra-day charts, interest rate policy, news of major political developments, economic announcements and the outlook of its domicile country. They also keep a look out for relevant developments in related markets such as the debt markets, equities and commodities, as these might also affect exchange rates.
How much can a trader risk? Unless appropriate controls are put in place, an FX trader can expose the bank to quite large currency or counterparty risks. The dealing room manager sets a daylight limit on the size of the position, or quantity of currency, that a trader can hold. Traders cannot ordinarily trade beyond their limits and must notify the dealing room manager if they make a loss in excess of the loss reporting limit that has been set.
Specialisms Within the Foreign Exchange Market
Different types of foreign exchange transaction exist; traders tend to specialise in one particular type of transaction. Traders may however trade a number of currency pairs.
Spot trader A spot trader conducts spot deals. A spot deal is an agreement to exchange one currency for another, settled over a standard period of trade (spot), usually two business days. By convention, one of the currencies in a spot deal is the US dollar. When this is not the case the deal is a cross rate deal, although settlement is still spot. A spot deal always involves a single outright exchange of principal and in the majority of cases leads to transfers through the payments system of the countries in which the currencies are issued.
As all the spot trader’s deals are settled spot, delivery dates do not have to be matched and as a result turnover and liquidity are high and the markets can be volatile. In April 1992, about 47% of the foreign exchange market was in spot activity.
Forward trader A forward trader conducts two types of forward deals: outright and swap. In April 1992, forward deals amounted to 46% of foreign exchange turnover. A forward outright deal is similar to a spot deal, but is settled on a date other than spot. Outright deals represent somewhat less that 15% of the total forwards market and about 7% of total foreign exchange turnover. An outright rate is quoted in the same way as spot. A forward swap consists of two separate parts. Two counterparties agree to exchange two currencies at a particular rate on one date called the near date, and to reverse the transaction, generally at a different rate, at a future date called the far date. For most swaps, the near date is normally spot but a number of forward/forward transactions exist, where the near date is not spot. Forward swaps make up somewhat more than 85% of the forwards market, which represents about 39% of the foreign exchange turnover, and are heavily concentrated on the US dollar. A forward swap is quoted as a margin. This is the difference between the exchange rates for the near date and far date and there are conventions governing how the subtraction is done using the two bid/ask exchange rates. Nearly two thirds of all forward transactions have a maturity of seven days or less. Only around 1% of forward deals have maturities greater than 1 year.
Derivatives trading Derivatives trading is relatively new, with 6% of turnover in April 1992, yet is the fastest growing sector of foreign exchange. FX derivatives include futures and options. Strictly speaking, a currency forward or swap is also a derivative, as its value depends on time to maturity, spot and deposit rates. Currency Futures are contracts which specify delivery of a particular currency at a given rate on a date more than two days hence. They differ from forwards in that they are standardised contracts tradable through an exchange clearing house.
Currency Options give the purchaser the right, but not the obligation, to buy or sell a certain amount of currency in the future at a predetermined rate. They are traded on an exchange or over the counter (OTC). Around 80% of currency activity is OTC where a whole range of customised products (exotic options) have evolve
Currencies Traded
The US dollar is the predominant counter-currency in foreign exchange trading and it appears in over 80% of all transactions. Other major currencies, for which there is an active cross-market, are the German mark representing 38%, and the Japanese yen representing 24% of all transactions.
Europe In Europe in general, and London in particular, the most heavily traded currency is the dollar against the mark ($/DM). Other heavily traded currencies include: + sterling against the dollar ( /$) and mark ( /DM) + dollar against Swiss franc ($/CHF) and yen ($/ ) + mark against yen (DM/ ) + all European Monetary System (EMS) currencies.
Asia In Asia, and Tokyo in particular, the most heavily traded currency is the dollar against the yen ($/ ). Other important currencies are: + Australian dollar (A$) + New Zealand dollar (NZ$) + Hong Kong dollar (HK$)
+ Singapore dollar (SG$) + Thai Baht (THB).
Americas In the Americas the vast majority of foreign exchange trading is performed in the USA and Canada, and the majority of that in New York.
The emphasis is on the major currencies: + mark (DM) + sterling( ) + Swiss franc (CHF) + yen ( ) + Canadian dollar (CA$). Periods when the New York markets trade are especially important. This is because the release of US economic indicators is carefully tracked and the US Federal Reserve (the “Fed”) is the most influential central bank. What the Chairman of the Fed says about the state of the financial market has the power to move all markets
Typical Employers
Most foreign exchange traders are employed by international banks such as Barclays or Citibank.
Locations London has the largest share of foreign exchange dealing, about 27% of trading activity. All the world’s large banks have branches or subsidiaries there. Dealing is carried out in any convertible currency.
Other major dealing centres are the United States (mainly New York) with 17% of turnover, and Japan (Tokyo) with 11%. Singapore, Switzerland and Hong Kong are also important centres, and dealing takes place in many other cities worldwide. Modern technology even allows dealing to be performed from home. A trader in London may phone his or her New York or Tokyo branch in the late evening to take, or get out of, a currency position.
Characteristics of Foreign Exchange Traders
Demographics
As of 1995, there were approximately 15,000 foreign exchange traders worldwide. London is the largest centre, employing about 3,800 traders. However this number has declined slightly in recent years partly as a result of new trading methods and company mergers and acquisitions.
In London, the majority of traders are in their mid 20s to mid. Very few are over the age of 50. There are few female traders working in London.
Educational background Although some banks currently recruit graduates only, approximately half the FX traders in London dealing rooms are estimated to have a degree. Often the degree is not in a financial subject.
Typical skills Traders have to be quick-thinking and able to prioritise information. They need to be able to assimilate new market information and relate this to their current or potential position. Information arrives from all sides in many different forms. Experienced traders can pick up what is most relevant to them and what represents potential trading opportunities.
Work experience Some traders work their way up from the bottom. A school leaver could begin in the Back Office checking deal details, then move to the trading floor to assist traders as a position keeper or dealer’s assistant. The aspiring trader might then be allowed to deal small amounts in quiet currencies and gradually take on more responsibility and risk. A graduate might begin working in the dealing room as a dealer’s assistant and progress from there.
Work performance targets Many traders are required to achieve appropriate profit targets. This is the main mechanism for determining salary. Traders need to sustain consistently high performance to retain their jobs and to progress within their company.
High staff turnover Employers tend to be unsympathetic to traders who do not achieve required levels of performance.