Fund managers seeking to manage their currency exposures can pursue one or more

Fund managers seeking to manage their currency

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Fund managers seeking to manage their currency exposures can pursue one or more strategies: trade over-the-counter (OTC) market currency forwards and options, exchange-traded futures and options on futures, or hire the services of an overlay manager. Overlay managers are essentially specialist currency trading firms that will actively manage a currency hedge mandate, and in addition, attempt to generate a positive excess return. These firms too rely on currency futures, forwards and options contracts. Exchange-Traded Currency Futures Exchange-traded currency products offer at least three major advantages vis-à- vis the inter-bank over-the-counter (OTC) market: (1) price transparency and efficiency, (2) elimination of counterparty credit risk, and (3) accessibility for all types of market participants.
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Price Transparency and Efficiency Futures and options exchanges bring together in one place divergent categories of buyers and sellers to determine foreign exchange prices. This efficient price discovery process is further enhanced by transparent trading arrangements. Whether the trading venue is open outcry or electronic, the prices for exchange- traded foreign currency products are disseminated worldwide via major quote vendors such as Reuters, Bloomberg, and others. Electronic trading on computerized trading systems (e.g., GLOBEX ® at Chicago Mercantile Exchange (CME) Inc.) takes place on a nearly 24-hour basis. Elimination of Counterparty Credit Risk Exchange-traded currency contracts have the exchange clearing house as the counterparty to every trade. For example, the CME Clearing House is the buyer to every seller and the seller to every buyer of all its currency products. Market participants then need not evaluate the credit worthiness of multiple counterparties. The CME Clearing House is their counterparty. All clearing members of the CME Clearing House stand behind trades at the exchange. Importantly, there has never been a single default in the 104-year history of the exchange. The OTC inter-bank market operates on the basis of credit limits for every potential counterparty. BIS requires banks to maintain adequate levels of capital to cover forward-maturity currency transaction risk. These requirements are waived for foreign exchange transactions booked on exchanges, where performance bonds are required and daily mark to market of open positions is done. Accessible to All Market Participants The advent of financial futures began in the early 1970’s because some inventive and persistent commodity traders at Chicago Mercantile Exchange did not have access to the inter-bank foreign exchange markets when they believed significant moves were about to take place in currency prices. They established the International Monetary Market (now a division of CME), which launched trading in seven currency futures contracts on May 16, 1972—creating the world’s first financial futures. No longer was the arena of foreign exchange trading limited to large commercial banks and their big corporate customers. Individuals, small and medium-sized banks and corporations, investment funds and governments can buy and sell currencies for future delivery or cash settlement.
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  • Fall '16
  • Foreign exchange market, United States dollar, fund manager

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