Back Matter

Appendix I. Developments in Global FX Swap Activity

FX swap activity in advanced countries and major financial centers has dominated global activity in the instrument. By April 2007, the United Kingdom—the global center for FX—had recorded the biggest turnover by far, averaging almost $900 billion daily; the United States was the next largest, at almost $240 billion (Figure A.1). Among advanced countries, the FX swap market in Slovenia has been the least active, with an average daily turnover of only $60 million. The turnover has varied significantly among emerging market countries, with daily averages ranging from $32 million in Brazil to $15 billion in Russia in April 2007 (Figure A.2).

Figure A.1.
Figure A.1.

Advanced Countries and Major Financial Centers: FX Swaps Turnover, 2007

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.Note: Amounts are the daily average in April 2007.
Figure A.2.
Figure A.2.

Key Emerging Market Countries: FX Swaps Turnover, 2007

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.Note: Amounts are the daily average in April 2007.

That said, the share of emerging market currencies in FX activity has increased. These currencies were used in almost 20 percent of all transactions in 2007, compared to about 15 percent in 2004 (BIS, 2007). The instruments used to trade different currencies have also varied. FX spot and forward transactions have tended to be dominated by emerging market currencies (Figures A.3 and A.4). Separately, FX swaps have been popular instruments for the currencies of major financial centers, such as Hong Kong and Singapore; in countries where the banking sectors have had a greater reliance on market funding, such as Australia, New Zealand; as well as in important host banking countries, namely, Denmark, Sweden (Figure A.5).

Figure A.3.
Figure A.3.

FX Spot Turnover by Currency, 2007

(Percentage shares of average daily turnover)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.Note: Data are for April 2007.
Figure A.4.
Figure A.4.

FX Forwards Turnover by Currency, 2007

(Percentage shares of average daily turnover)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.Note: Data are for April 2007.
Figure A.5.
Figure A.5.

FX Swaps Turnover by Currency, 2007

(Percentage shares of average daily turnover)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.Note: Data are for April 2007.

Positions in forwards and FX swaps grew exponentially over the 2004–07 period. Outstanding notional amounts increased by 78 percent, compared to 26 percent in the preceding 3-year period (Figure A.6). The expansion was largely driven by non-financial customers, whose outstanding positions more than doubled during this time, compared to a 33 percent rise between 2001 and 2004 (Figure A.7). However, gross market value increased at a much slower 45 percent over the 2004–07 period, following three previous periods of declines (Figure A.8).26 These increases were predominantly driven by transactions between reporting dealers and other parties (Figure A.9).

Figure A.6.
Figure A.6.

Notional Amounts Outstanding of OTC Foreign Exchange Derivatives, by Instrument

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.
Figure A.7.
Figure A.7.

Notional Amounts Outstanding of Forwards and FX Swaps, by Counterparty

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.
Figure A.8.
Figure A.8.

Gross Market Values of OTC Foreign Exchange Derivatives, by Instrument

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.
Figure A.9.
Figure A.9.

Gross Market Values of Forwards and FX Swaps, by Counterparty

(In billions of U.S. dollars)

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Source: Bank for International Settlements.

However, more recent data show that the financial crisis took a toll on activity in the FX swap market, with positions in FX derivatives falling sharply in H2 200827 Among the countries comprising the G-10 and Switzerland, notional amounts outstanding in forwards and FX swaps fell by 33 percent, followed by a slight uptick of 9 percent in H1 2009. The average daily volume in FX swaps at U.S.-based market participants fell by 27 percent in April 2009 compared to a year ago. On a counterparty basis, the average daily volume between surveyed U.S. participants with non-financial customers fell by almost 58 percent over the April 2008–09 period. At the same time, activity by maturity also fell across the board. Consistent with the trend observed in the United States, the turnover in FX swaps in the United Kingdom fell by almost 29 percent during the April 2008 to 2009 period. Activity between surveyed institutions and non-financial institutions fell the most, by 41 percent; activity with all other financial institutions declined by 28 percent during this time.

Overall, market concentration in OTC FX derivatives has increased over time. The Herfindahl index, which measures concentration, shows that the increase in market shares of individual reporting institutions have been more marked in the forwards, FX swaps and currency swaps markets, compared to their shares in the options market (Figure A.10).

Figure A.10.
Figure A.10.

G-10 and Switzerland: Herfindahl Indices for All OTC Foreign Exchange Derivatives Contracts top 1/

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

1/ The Herfindahl index is defined as the sum of the squares of the market shares of each individual institution; it ranges from 0 to 10,000. The more concentrated the market, the higher the measure.Source: Bank for International Settlements.

Appendix II. How FX Swaps Affect the Capital Adequacy Ratio

A bank’s transactions in FX swaps could affect its capital adequacy ratio (CAR), the ratio which defines the capacity of the bank to meet its liabilities and absorb risks to its exposures. It is the central feature of the Basel Capital Accord, and is an analytical construct in which regulatory capital is the numerator and risk-weighted assets (RWA) is the denominator:

(A.1)CAR=Regulatory CapitalRWA.

The minimum ratio of regulatory capital to RWA is set at 8 percent. The core regulatory capital element, also known as Tier I capital, should be at least 4 percent. These ratios are considered the minimum necessary to achieve the objective of securing over time soundly-based and consistent capital ratios for all international banks.28

A bank’s regulatory capital consists of its Tier I and Tier II capital. Tier I capital consists of common shareholders’ equity, retained earnings and non-cumulative preferred stock. Tier II capital consists of undisclosed reserves, revaluation reserves, general loan loss provisions, hybrid debt equity instruments and subordinated term debt.

(A.2)Regulatory Capital=Tier I Capital+Tier II Capital.

Separately, a bank’s total RWA comprise three elements. They are: market risk, operational risk and credit risk. RWA are calculated by multiplying the capital requirements for market and operational risks by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8 percent) and adding the resulting amount to the sum of the RWA for credit risk:

(A.3)RWA=Capital RequirementsMarket Risk+Operational Risk×12.5+RiskWeighted[Credit Risk].

Thus, (A.4) can be derived from (A.1), (A.2) and (A.3):

CAR=Tier I+Tier II CapitalCapital Requirements[Market Risk+Operational Risk]×12.5RiskWeighted[Credit Risk],

where the denominator includes both on- and off-balance sheet RWA. Thus, FX swaps could impact a bank’s CAR to the extent that they change the capital requirements for market risk and credit risk in the denominator in (A.4), and Tier I capital through retained earnings from any impact on the profit and loss.

Appendix III. Calculation of the Credit Risk Charge for FX Swaps29

The focus on on-balance sheet items in the past meant that an increasingly important component of the credit risk of the banking system, namely its exposure to derivatives, was largely being overlooked. FX swaps are classified under “other derivatives” among the five broad categories of off-balance sheet items.30 These instruments are typically given “special” treatment because of the complexity of their exposures.

Under the Basel Accords, derivative contracts require adjustments prior to their assignment to the appropriate asset class. These include interest rate, equity, commodity and exchange rate linked contracts. A three-step process is required to derive the proper amount to be allocated to the appropriate asset class. In the case of FX swaps, the following steps would be applied:

1. Determine the credit exposure, also known as the credit equivalent, of the FX swap contract which is equivalent to the notional for a loan. This figure is calculated as the sum of the current, net replacement value (NRV) of the contract—i.e., its marked-to-market value—plus an add-on component that is supposed to capture future or potential exposures:

(A.5)Credit exposure=NRV+Addon.

The add-on factor is computed as follows:

Addon=Notional × Credit conversion factor × (0.4+0.6 × NGR),

where NGR is the net-to-gross ratio or the ratio of current net market value to gross market value, which is always between zero and one.31

The credit conversion factor would depend on the tenor (maturity) and type of contract. It approximates the maximum credit exposure that depends on the volatility of the risk factor and maturity. Since volatility is typically highest for commodities, followed by equity, and then currencies, the credit conversion factor is greater for swap contracts for these instruments than for, say, fixed income instruments; the credit conversion factor also increases with maturity (Table A.1). The relevant credit conversion factors for FX swaps across maturities are presented in the second column of Table A.1.

Table A.1.

Credit Conversion Factors for Potential Credit Exposure

(In percent of notional)

article image
Source: BCBS (1995).

2. Determine whether an exception applies. The first exception places a maximum 50 percent risk weighting on the credit exposure of a contract. The second exception provides for the exclusion of derivatives contracts traded in exchanges from the risk-based ratio calculation. The former holds for off-balance sheet items such as FX swaps.

3. Calculate the risk-weighted asset (RWA). The calculation of RWA for the credit risk component in an FX swap is effected by applying counterparty-specific risk weights (RW) to the derived credit exposure in equation (A.5):

(A.6)RWA(FX Swaps)=RWi×50%×Credit Exposurei.

4. Calculate the credit risk charge (CRC). Banks must hold at least 8 percent of their RWA, as defined in (A.6), to cover their CRC:

CRC(FX Swaps)=8%×RWA(FX Swaps)=8%×(RWi×50%×Credit Exposurei).

Appendix IV. Assumptions of FX Spot and Swap Rates

All numerical examples in this paper use the assumed FX spot and swap rates presented in Table A.2.

Table A.2.

Assumptions: FX Spot and Swap Rates

(In domestic currency per unit of FX)

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Appendix V. Closing a Net Open FX Position on the Balance Sheet Using FX Swaps

The following example demonstrates how FX swaps could be used to close net open FX positions on bank balance sheets. Assume that a local bank (domestic bank or local affiliate of foreign bank) has more domestic currency (“DC”) liabilities on its balance sheet than domestic currency assets. The bank would thus have exactly the opposite position with the FX-denominated items—it has more FX denominated assets than liabilities. In other words, the bank has a long FX position on its balance sheet (Figure A.11).32 Specifically, assume that the bank has FX100 million in assets, and no FX liabilities; the spot rate the time of transaction is DC1.05 per unit of FX; the 12-month swap rate is DC1.10 per unit of FX.

Figure A.11.
Figure A.11.

Initial Position of Balance Sheet

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

In order to avoid having a net open FX position, the bank could create a synthetic forward hedge by entering into the following transactions:

1. Convert excess domestic currency liquidity to FX via an FX swap transaction (lend domestic currency and borrow FX). Assume that the bank enters into a 12-month contract to swap DC105 million for FX100 million at the near date, i.e., at a rate of DC1.05 per unit of FX, and to swap FX100 million back at a rate of DC1.10 per unit of FX, i.e., for DC110 million, at the far date. The transaction would be recorded as follows:33

article image

As a consequence of the first leg of this swap transaction, the bank now has a domestic currency-denominated asset, i.e., domestic currency is receivable in the future, and an FX-denominated liability. i.e., FX is payable in the future (Figure A.12).

Figure A.12.
Figure A.12.

Position of Balance Sheet Following FX Swap Transaction

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

2. Sell FX in the spot market in exchange for domestic currency to close the open FX exposure. The bank sells FX100 million on the spot market for DC105 million to close the net open FX position. The transaction would be recorded as follows (Figure A.13):

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Figure A.13.
Figure A.13.

Position of Balance Sheet Following Sale of FX on the Spot Market

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

3. At this point, any depreciation (appreciation) in the domestic currency spot exchange should have no net impact on the amount of the FX assets and liabilities on the balance sheet. Assume that the spot exchange rate moves to DC1.40 per unit of FX at the maturity of the swap contract. The change would be recorded as follows, with movements in the spot rate having the same impact on both the asset and liability sides of the balance sheet, and on profit and loss (Figure A.14):

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In other words, there would be no net impact on the balance sheet, as the bank has a closed position (Figure A.4):

Figure A.14.
Figure A.14.

Position of Balance Sheet Following Depreciation of Domestic Currency

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

4. Upon the maturity of the FX swap contract, purchase FX in the spot market to repay FX to the counterparty and receive domestic currency from the counterparty:

The FX is purchased at the spot exchange rate of DC1.40 per unit of FX:

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The return to the open FX position means that the bank would have to seek to roll over the swap contract in order to once again close its position (Figure A.15):

Figure A.15.
Figure A.15.

Position of Balance Sheet Following Settlement of Swap Contract with Purchase of FX in Spot Market

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

5. Alternatively, if the FX Receivables mature at the same time as the swap contract, the receipts could be used to repay the contract:

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The outcome would be to remove the FX asset from the balance sheet, so that only domestic currency positions remain (Figure A.16):

Figure A.16.
Figure A.16.

Position of Balance Sheet Following Settlement of Swap Contract with Maturing Assets

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

6. Note that the balance sheet position in Figure A.6 is essentially a replication of an outright forward contract. In other words, it is a “synthetic forward” position. In the case of an outright forward transaction, the bank would undertake to pay out FX100 at the maturity of the contract in exchange for domestic currency at the agreed upon forward rate of DC1.10 per unit of FX (Figure A.17):

article image
Figure A.17.
Figure A.17.

Position of Balance Sheet Following Forward Transaction

Citation: IMF Working Papers 2010, 055; 10.5089/9781451963533.001.A999

Appendix VI. An Illustration of How Margin Calls on FX Swaps are Calculated

Assume that a bank enters into an FX swap transaction with a counterparty to exchange domestic currency for FX. The transaction takes place at time t0, the maturity of the contract is 12 months, i.e., at time t12:

The bank agrees to provide DC105 million in exchange for FX100 million at time t0;

It agrees to repay FX100 million and receive DC110 million at time t12, i.e., at the swap rate of DC1.10 per unit of FX.

Based on an assessment of the credit risks of both parties, the margin threshold is set at DC5 million for the bank, and FX7 million for the counterparty.

The positions are marked-to-market at the end of every month. In other words, a valuation is conducted at the end of each month to determine the both parties’ positions (receivable or payable).

Depending on the position established, the bank may call for collateral from the counterparty to protect its position, or the counterparty may call on the bank to protect the counterparty’s position.

Assume that in the intervening 12 months (Table A.3):

  1. The domestic currency swap rate initially appreciates against the FX, relative to the contracted swap rate, between t0 and t3 so that the bank’s position is “in the money” and the counterparty’s is “out of the money.” In other words, it would have cost the counterparty more FX to purchase DC110 million in order to repay the bank.

  2. At t2, the swap rate moves to DC1.00 per unit of FX. The amount by which the counterparty is out of the money exceeds the agreed upon margin threshold for the counterparty of FX7 million, by FX3 million. This represents the margin call that the bank would make on the counterparty.34

  3. At t3, the swap rate moves to DC0.98 per unit of FX. At this point, the amount by which the counterparty is out of the money exceeds the agreed upon margin threshold for the counterparty of FX7 million, by a total of FX5.2 million. The bank, having already made a margin call of FX3 million on the counterparty at t2, makes another margin call of FX2.2 million.

  4. At t4, the domestic currency swap rate begins to depreciate against the FX, to 1.03 DC per unit of FX, albeit still stronger than the contracted swap rate. The counterparty is still out of the money by 6.8 million FX, but by less than its margin threshold of 7 million FX. At that point, the bank repays the counterparty the total margin it had previously called, of 5.2 million FX.

  5. At t6, the extent of the depreciation in the domestic currency swap rate to DC1.15 per unit of FX results in the bank being out-of-the-money by DC5 million. Since this amount is equivalent to the agreed up margin threshold for the bank, there is no margin call.

  6. At t7, however, the depreciation of the domestic currency swap rate to DC1.19 per unit of FX puts the bank in a position of being DC9 million out-of-the-money, DC4 million more than the margin threshold. The counterparty would make a margin call of DC4 million.

  7. At t8, the swap rate weakens further, to DC1.25 per unit of FX, i.e., the bank is out of the money by DC15 million, and a margin call of an additional DC11 million is made by the counterparty.

  8. By t12, at the maturity of the contract, the swap rate moves to DC1.45 per unit of FX. The bank is out of the money by a total of DC35 million, and margin calls totaling DC30 million (DC35 million less the margin threshold of DC5 million) would have been paid to the counterparty.

  9. At this point, if the bank fulfils its swap contract and repays the counterparty FX100 million in exchange for DC110 million, counterparty risk is extinguished. The total margin called of DC30 million and held by the counterparty in an escrow account is returned to the bank.

Table A.3.

Example: Calculation of Margin Calls on FX Swaps

(In millions of domestic currency units)

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Source: Authors’ calculations.

The difference between standard accounting requirements and the establishment of valuation lies in the objectives of the two. Accounting entries are for financial reporting purposes—they simply note or disclose the position on the balance sheet. In contrast, establishing valuation at any one point other than as part of the financial cycle is normally done for efficiency/trading or for credit collateral purposes. It should be noted that in a situation where the bank may not have sufficient liquidity to meet the margin calls before the contract expires, its liquidity problem may well become a solvency problem.

Appendix VII. Recording of FX Swaps in the Balance of Payments and the International Investment Position

The Balance of Payments (“BoP”) records transactions between residents and non-residents. An FX swap is recorded in the Balance of Payments and the International Investment Position (“IIP”) if it is a contract between residents and non-residents. The treatment of the transactions is consistent across the BoP and the IIP, but the IIP also records valuation changes at given reference dates during the lifetime of the FX swap contract.

Balance of Payments

The creation of an FX swap contract does not generally involve a transaction in financial derivatives in the financial account, although the underlying flows of currencies should be recorded as transactions in the BoP. At the inception of the contract, there is a spot exchange of currencies and a simultaneous commitment by the counterparties to transact amounts in the future at agreed-upon prices. Hence, risk exposures of equal value are usually being exchanged. Any initial exchange of currencies is a transaction that is recorded, at the exchange rate agreed upon by the counterparties, in the “other investment” category of the financial account. Any commissions or fees paid, for instance to banks, brokers and dealers, are classified as payments for services in the current account, and should be deducted from the value of the financial derivative.

Over the contract period, only transactions related to margin payments and sales in secondary markets should be recorded in the BoP (Box A.1).35 Any change in the value of an FX swap due to exchange rate movements during the contract period is generally treated as holding gains or losses, which is not recorded as a transaction in the BoP. Transactions may be recorded over the contract period only in the following cases:

  • Margin payments and receipts. A margin payment is recorded as a reduction in financial derivative liabilities only if it is non-repayable; the receipt of non-repayable margin is recorded as a reduction in financial derivative, probably currency and deposits).36

  • Secondary market transactions. Sales of FX swap contracts in secondary markets, whether on exchanges or over-the-counter, are valued at market prices and recorded in the financial account as a transaction in financial derivatives.

The settlement of an FX swap contract generally gives rise to transactions that are recorded in the financial account. At the time of settlement, the difference between the values (which are measures in the unit of account and at the prevailing exchange rate) of the currencies exchanged are allocated to a transaction in a financial derivative. In other words, if the value of the currency received exceeds that of the currency paid, a reduction in a financial derivative asset―a credit―is recorded. The contra-debit entry is an increase in another assets (in many cases currency and deposits under the other investment category) classified in the financial account. When the value of the currency received is less than that of the currency paid, the opposite applies. That is, a reduction in a financial derivative liability―a debit―is recorded. The contra-credit entry is an increase in another liabilities (again in many cases currency and deposits under the other investment category) classified in the financial account.

International Investment Position

The IIP of a country represents the assets and liabilities of a country vis-à-vis the outside world at a reference date. In the IIP, FX swaps are valued at current market prices on appropriate reference dates (Box A.2). It is recommended that data on gross assets and gross liabilities be compiled by summing, respectively, the values of all individual contracts in asset positions and the values of all individual contracts in liability positions. Any variation in a position can generally be attributed to transactions and valuations changes:

  • Transactions. The recording of a transaction related to an FX swap in the IIP is consistent with that of the financial accounts of the BoP.

  • Valuations, reflecting price and exchange rate changes. Changes in valuations that do not give rise to a transaction should still be accounted for in the IIP if they reflect variations in market value. For example, a fluctuation in exchange rates during the period between the inception of the contract and the settlement date, will give rise to a different market value of an FX swap, hence a valuation adjustment in the IIP.

Therefore, at any reference date over the contract period of the FX swap, in addition to recording the transactions recorded in the BoP, valuation changes due to exchange rate changes should be recorded in the IIP.

Recording an FX Swap Transaction in the Balance of Payments

Assume that a domestic bank swaps DC105 for FX100, with the swap to be reversed 12 months later at the forward price of DC110 to FX100.

At the inception of the FX swap, the following transactions in FX would be recorded in the financial account of the BoP:

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After 12 months, at the settlement of the FX swap contract, the domestic currency has depreciated to DC140 against the foreign currency and more domestic currency will be needed to pay the FX liability, compared to the forward price set at the initiation of the contract. The actual depreciation of the domestic currency is not explicitly shown as that the BoP is recorded in FX. However, it can be deduced that the amount of FX21 (=DC30/1.40) represents the equivalent loss in domestic currency that the bank is incurring as a result of the depreciation in the domestic currency, while the balance of FX79 (DC110/1.40) is the equivalent amount that the bank would have had to pay in domestic currency, if the domestic currency had not depreciated.

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Recording an FX Swap in the International Investment Position

Assume the same example as in Box A.1. A domestic bank swaps DC105 in exchange for FX100, with the swap to be reversed 12 months later at the forward price of DC110 to FX100. At the initiation of the contract there is a spot sale/purchase of currencies reflected in the IIP but no changes in financial derivatives:

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Assume now that after six months, at end-March, the domestic currency has depreciated to 112 against the foreign currency. Due to valuation changes, the IIP has changed:

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After 12 months, when the FX swap matures, the domestic currency has depreciated to DC140 against the foreign currency and more domestic currency will be needed to pay the FX liability, compared to the forward price set at the initiation of the contract:

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  • Stone, Mark R., Christopher W. Walker and Yosuke Yasui, 2009, “From Lombard Street to Avenida Paulista: Foreign Exchange Liquidity Easing in Brazil in Response to the Global Shock of 2008–09,” IMF Working Paper No. 09/259 (Washington: International Monetary Fund).

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  • The Foreign Exchange Joint Standing Committee, 2009a, “Results of the Semi-Annual FX Turnover Survey in October 2008” (London, January).

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  • The Foreign Exchange Joint Standing Committee, 2009b, “Results of the Semi-Annual FX Turnover Survey, April 2009” (London, July).

1

The authors would like to thank Roberto Benelli, Martin Čihák, Antonio Galicia-Escotto, Patrick Iman, Cheng Hoon Lim, Donal McGettigan, Jason Mitchell and Mark Stone for their invaluable comments. Any remaining mistakes are the responsibility of the authors.

2

See Baba and Packer (2009) for a detailed discussion on the shortage in U.S. dollar funding and the illiquidity in FX swap markets during the crisis.

3

Baba, Packer and Nagano (2008) show that the increasingly one-sided order flow during the recent crisis, which was concentrated on U.S. dollar borrowing, resulted in the shift away from covered interest parity conditions for the euro, sterling and yen vis-à-vis the U.S. dollar. Coffey, Hrung, Nguyen, and Sarkar (2009) show that the premium international institutions paid for U.S. dollar funding became persistently large and positive during the crisis, as these institutions struggled to obtain funds.

5

FX swaps and spots represent the largest transactions traded in international FX markets. FX transactions are estimated at around $4 trillion daily, with the top 10 currency traders accounting for nearly 80 percent of the total volume (www.forexrobotguides.com).

6

Details of the most recent triennial survey are presented in BIS (2007).

7

“Reporting dealers” are defined as those institutions that have participated in the BIS triennial and semiannual surveys. They refer to financial institutions that actively participate in local and global FX and derivatives markets, namely, large commercial and investment banks and securities houses that participate in the inter-dealer market; and have active businesses with large customers, such as corporates, governments and non-reporting financial institutions. “Other financial institutions” cover the institutions that are not classified as reporting dealers. The comprise all other financial institutions such as smaller commercial banks, hedge funds, pension funds, insurance companies etc.

8

See BIS (2009) for an over view of FX swaps activity in the G-10 countries plus Switzerland. Surveys in the United States are done annually by The Foreign Exchange Committee (FXC), while that in the United Kingdom is conducted semi-annually by the Foreign Exchange Joint Standing Committee (FXJSC). These surveys are not comparable to the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, given the differences in the reporting methods. The latest survey results were released in January 2009.

9

Gross market values, which measure the cost of replacing all existing contracts, represent a better measure of market risk than notional amounts.

10

ISDA creates industry standards for derivatives and provides legal definitions of terms used in contracts. The ISDA Master Agreement, a bilateral framework agreement, contains general terms and conditions (such as provisions relating to payment netting, tax gross-up, basic covenants, events of default and termination) but does not, by itself, include details of any specific derivatives transactions the parties may enter into. It cannot be amended, except for adding in the names of the parties. However, it also has a separately produced Schedule in which the parties are required to select certain options and may modify sections of the Agreement. Details of individual derivatives transactions are included in Confirmations entered into by the parties to the Agreement; each Confirmation relates to a specific transaction and sets out the agreed commercial terms of that transaction. The Agreement and all the Confirmations entered into under it form a single agreement. The Agreement also provides for the mitigation of credit risk by parties to the contract, by requiring the counterparty which is “outof-the-money’ to post collateral (usually cash, government securities or highly rated bonds) amounting to that which would be payable by that counterparty were all the outstanding transactions under the relevant Agreement to be terminated. This is typically included as a credit support annex. Collateral other than cash is usually discounted for risk, i.e., the party posting collateral would have to do so in excess of the potential settlement amount.

11

See Appendix II for a derivation of the capital adequacy ratio and the potential impact of FX swaps.

12

See Appendix III for details on the calculation of capital charges for credit risk associated with FX swaps.

13

Under Basel II, there are three approaches to determining the credit risk weights. They are: (i) the Standardized Approach, which is an extension of Basel I, but with finer classification of categories for credit risk, based on external credit ratings; the 50 percent risk weight cap on derivatives is also removed; (ii) the Foundation International Ratings-Based Approach, where banks estimated the probability of default and supervisors supply other inputs; and (iii) the Advanced Internal Ratings-Based Approach, where banks can supply both the estimated probability of default and other inputs as well. Basel II also takes into account credit risk mitigation techniques, such as collateralization, third-party guarantees, credit derivatives, and netting.

15

Net open short or long currency positions can lead to sizeable losses when exchange rates are volatile, and capital thus needs to be held to cover such open positions.

16

See Appendix IV for assumptions of FX spot and swap rates used in all numerical examples presented in this paper; and Appendix V for an accounting example of how FX swaps could be applied to close a net open FX position.

17

See Appendix VI for an illustration of how margin calls on an FX swap contract could occur.

18

IAS 39.9 defines a derivative as a financial instrument that derives its value from an underlying price or index. Derivatives could be divided into three main categories: (i) forward (futures) contract; (ii) swap; and (iii) option.

19

IAS 39 defines fair value as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

20

Exceptions occur when the assessment of fair value and tradable value (e.g., off-market trades) are different.

21

The calculation of the FX-swap implied interest rates and its spread vis-à-vis the lending rate is based on the methodology laid out in the technical appendix of Coffey, Hrung, Nguyen and Sarkar (2009).

22

Appendix VII describes how FX swap transactions affect a country’s BoP.

23

See, for instance, Rosenberg and Tirpák (2008) and Box 2.2 in IMF (2009).

24

Stone, Walker and Yasui (2009) examine the effectiveness of the foreign exchange liquidity providing measures of the Banco Central do Brasil in response to market stresses during the financial crisis.

25

See the report by the Committee on the Global Financial System (CGFS) on central bank actions to address pressures in funding markets and the results of those actions (CGFS, 2008).

26

Notional amounts outstanding provide information on the structure of the market, but do not measure the riskiness of these positions as they do not reflect the immediate exposure. A more useful measure in this regard may be gross market value, which shows the cost of replacing all open contracts at the prevailing market prices.

27

See BIS (2009) for an over view of FX swaps activity in the G-10 countries plus Switzerland. Surveys in the United States are done annually by The Foreign Exchange Committee (FXC), while that in the United Kingdom is conducted semi-annually by the Foreign Exchange Joint Standing Committee (FXJSC). The latest survey results were released in January 2009. Although similar in nature, these surveys are not comparable to the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, given the differences in the reporting methods.

29

A detailed discussion on the calculation of credit risk charges is presented in Jorion (2009) and Berger (2008).

30

The other categories are: (i) instruments that substitute for loans (e.g., guarantees, bankers’ acceptances, and standby letters of credit); (ii) transaction-related contingencies (e.g., performance bonds or commercial letters of credit); (iii) short-term, self-liquidating trade-related liabilities (e.g., documentary credits collateralized by the underlying shipments); and (iv) commitments with maturity greater than a year (such as credit lines), and not-issuance facilities.

31

The NGR reduces the capital requirements for contracts for which there are legally valid netting agreements; otherwise, the NGR could be equal to one. Where NGR = 0, that is, all contracts fully net out, the multiplier for the add-on factor would be equal to a minimum 0.4, to provide a cushion against potential movements in the NGR, which could change over time.

32

In the balance sheet examples presented in this appendix, all FX items are denoted in domestic currency equivalents

33

Debit entries are denoted “DR;” credit entries are denoted “CR.”

34

The amount would typically be discounted by the market-determined interest rate over the relevant time period, to arrive at the net present value. For the purpose of this example, and to keep the calculations simple, we assume that the effect of discounting is negligible.

35

Under the fifth and sixth editions of the Balance of Payments Manual, FX swap transactions are recorded as forward contracts under financial derivatives, which is a component of the financial account (IMF, 1993; 2010).

36

A non-repayable margin is a transaction in a derivative paid to reduce a financial liability created under a derivative. The entity that pays non-repayable margin no longer retains ownership of the margin nor has the right to the risks and rewards of ownership, such as the receipt of income or exposure to holding gains and losses. Repayable margins consist of deposits or other collateral deposited to protect a counterparty against default risk, but which remain under the ownership of the unit that placed the margin. Although its use may be restricted, a margin is classified as repayable if the depositor retains the risks and rewards of ownership, such as the receipt of income or exposure to holding gains and losses. At settlement, repayable margins, or the amounts of repayable margins in excess of any liability owed on the derivative, are returned to the depositor. Arrangements for margining can be complex, and procedures differ among countries.

FX Swaps: Implications for Financial and Economic Stability
Author: Ms. Li L Ong and Ms. Bergljot B Barkbu
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    Advanced Countries and Major Financial Centers: FX Swaps Turnover, 2007

    (In billions of U.S. dollars)

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    Key Emerging Market Countries: FX Swaps Turnover, 2007

    (In billions of U.S. dollars)

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    FX Spot Turnover by Currency, 2007

    (Percentage shares of average daily turnover)

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    FX Forwards Turnover by Currency, 2007

    (Percentage shares of average daily turnover)

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    FX Swaps Turnover by Currency, 2007

    (Percentage shares of average daily turnover)

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    Notional Amounts Outstanding of OTC Foreign Exchange Derivatives, by Instrument

    (In billions of U.S. dollars)

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    Notional Amounts Outstanding of Forwards and FX Swaps, by Counterparty

    (In billions of U.S. dollars)

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    Gross Market Values of OTC Foreign Exchange Derivatives, by Instrument

    (In billions of U.S. dollars)

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    Gross Market Values of Forwards and FX Swaps, by Counterparty

    (In billions of U.S. dollars)

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    G-10 and Switzerland: Herfindahl Indices for All OTC Foreign Exchange Derivatives Contracts top 1/

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    Initial Position of Balance Sheet

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    Position of Balance Sheet Following FX Swap Transaction

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    Position of Balance Sheet Following Sale of FX on the Spot Market

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    Position of Balance Sheet Following Depreciation of Domestic Currency

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    Position of Balance Sheet Following Settlement of Swap Contract with Purchase of FX in Spot Market

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    Position of Balance Sheet Following Settlement of Swap Contract with Maturing Assets

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    Position of Balance Sheet Following Forward Transaction