Position Keeping

Net Cash Flow Position

There is said to be a 'position' if circumstances are such that a change in a rate will create a profit or loss. If cash inflows and cash outflows are unequal or have mismatched value dates, there is a 'net cash flow position'. Seperate net cash flow positions apply for each value date.

Net cash flow position = cash inflow - cash outflow

A positive net cash flow position reflects an excess of cash inflow, over cash outflow, on the relevant value date. The surplus cash will be available for investment. If interest rates rise the return will be higher. If interest rates fall, the return will be lower.

A negative net cash flow position reflects an excess of cash outflow overcash inflow on the relevant value date. Assuming there are no idle balances, the account will become overdrawn. The shortfall of cash will require funding. If interest rates rise it will become more expensive to fund the account. If interest rates fall it will become less expensive to fund the account.

A negative net cash flow position also implies a 'liquidity position'. There is a risk that there will be insufficient funds available for borrowing, in which case the account must remain overdrawn. Being overdrawn may involve financial and non-financial penalties.

If cash inflow equals cash outflow on a particular value date, then the net cash flow position is zero. This is referred to as a 'square cash flow position'. Changes in interest rates will have no net impact on profits or losses.

Net Exchange Position

Buying and selling foreign currencies creates exposure to changes in exchange rates. Buying a foreign currency creates an asset. The position is said to be 'long' the foreign currency. If the foreign currency appreciates there will be an exchange gain. If the currency depreciates there will be an exchange loss.

Selling a foreign currency creates a liability. The position is said to be 'short' the foreign currency. If the foreign currency depreciates there will be an exchange gain. If the foreign currency appreciates there will be an exchange loss.

The excess amount of a foreign currency which has been purchased over the amount of the same foreign currency which has been sold is described as the 'net exchange position'. There is a seperate net exchange position for each foreign currency.

Net exchange position = foreign currency purchased - foreign currency sold

Being long a currency implies having a net exchange position which is positive. Provided the exchange rate is quoted with the foreign currency as the base currency, a rise in the exchange rate will yield an exchange gain and a fall in the exchange rate will result in an exchange loss.

Being short a currency implies having a net exchange position which is negative. Provided the foreign currency is the base currency, a rise in the exchange rate will result in an exchange loss, and a fall in the exchange rate will cause an exchange gain.

If the amount of foreign currency purchased equals the amount of that currency that has been sold, then the net exchange position will be zero. This is referred to as a 'square exchange position'. Changes in exchange rates will have no impact on profit or loss.

A net exchange position is created or removed at the time the purchase or sale of foreign currency is contracted, not at the time when the related cash flows occur. For example, if a spot contract is entered into today to purchase USD 1 million against JPY at a rate of USD 1 = 120.50, the buyer immediately becomes long USD and short JPY regardless of the fact that he or she will not receive the USD or pay away the JPY until two business days hence. Similarly, forward purchases or sales of foreign currency immediately create, or remove a net exchange position.

Distinction between Net Exchange Position and Net Cash Flow Position

It is important to appreciate the disctinction between a net exchangte position, and a net cash flow position. Money market transactions create net cash flow positions, but do not create net exchange positions. Only buying buying or selling a currency can create a net exchange position - merely borrowing or lending a foreign currency does not.

Borrowing CHF for three months will cause a positive cash flow of swiss francs now and a negative cash flow of CHF in three months time, but no exposure to the exchange rate. Unless the CHF are sold (which create a net exchange position), they will be available to repay the loan on maturity and so exchange rate changes will have no effect on profit or loss.

Foreign exchange transactions create both net cash flows positions and net exchange positions. Mismatched cash flows may be offset by either money market transactions or foreign exchange transactions. However, net exchange positions can only be offset by foreign exchange transactions.

Understanding the Dates

Spot Value Date

The date on which a transaction is contracted is known as the 'contract date' or 'trade date'. The dates on which the cash flows occur are known as 'value dates'.

In international transactions, two business days are usually allowed between the contract date and the value date. This allows time for payments to be made to accounts in banks and other countries which may be in different time zones. 'Spot value' refers to a payment which will be made two business days from the contract date. If there is a holiday in either or both countries in which the cash flows are to occur, the spot date moves forward to the next eligible date.

A 'spot transaction' is done for value two business days from the contract date. As this is the recognised standard form of quotation, any deviation from this requires an adjustment.

Forward Value Date

If the cash flows associated with a transaction are to occur on a date or dates further into the future than spot, these are said to have 'forward value'. It is common for transactions to mature some round number of months after spot. For example, if GBP 1 million is purchased for value three months from spot, the GBP will be received three months from the spot date. If that date is a weekend or public holiday, the repayment will occur on the next available business date unless that would require going beyond month-end in which case the forward value date would be the first available business day prior to month end.

Short Dates

On occasions it is necessary for transactions to mature and the cash flows to occur prior to spot value. By definition there are only two eligible business days before spot value: today (tod) and tomorrow (tom). These are known as 'short dates'. Transactions with cash flows which occur on the same day as the contract date are known as 'value today' transactions. Similarly, transactions with cash flows which occur on the business day following the contract date are described as 'value tomorrow'. Most foreign exchange transactions are done for spot value.

Bid and Offer Rates

Banks typically quote bid and offer exchange rates. The 'bid rate' is the rate at which the price-maker is willing to buy the currency being priced. The 'offer rate' is the rate at which the price-maker is willing to sell the currency being priced.

For example, if a bank quotes AUD/USD as 0.5150/0.5155, its bid rate is 0.5150, and its offer rate is 0.5155. The difference between the bid rate and the offer rate (0.0005 in this example) is known as the 'bid-offer spread'.

The price-maker is willing to buy AUD at 0.5150 and is willing to sell AUD at 0.5155.

If a price-taker wishes to deal, it will have to deal at a price maker's rate. If the price-taker wishes to buy AUD from the price-maker, it will have to buy them at 0.5155. On the other hand, if the price-taker wishes to sell AUD to the price-maker - it will have to sell them at 0.5150.

If a price-maker is able to find people to buy at its offer rate and other people to sell the same amount at its bid rate, it would make a profit equal to the bid-offer spread. In practice this coincidence rarely occurs. Price-makers attempt to make money by moving their bid and offer rates up and down.

The offer price is the price at which the price maker is prepared to sell the base currency.

Two-way prices are quoted with the bid first, followed by the offer.

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The Role of Banks & Brokers

Banks: Price-Maker/Price-Taker

In any transaction there are two parties - a 'price-maker' and a 'price-taker'. The price-maker quotes the price. The price-taker decides whether or not to deal at that price. In foreign exchange transactions each party buys one currency, and sells the other currency.

The role of price-maker is always performed by a bank. When banks deal directly with one another, banks also perform the role of price-taker. This is known as the 'interbank market'. Corporates, fund managers, retail customers and the Reserve Bank all participate as price-makers (although some companies act in this capacity as internal bankers to their subsidiaries). In a bank-to-bank transaction, the bank initiating contact is the price-taker, and the bank being contacted (which quotes the price) is the price-maker.

Consider the following example of an exchange of AUD for USD:

Party A Party B

Buys AUD <---> Sells AUD

Sells USD <---> Buys USD

The two parties perform different roles. One acts as a price-maker whilst the other is the price-taker.

NB: The interbank market consists of commercial banks and, to a lessor degree, financial institutions such as merchant banks and investment banks, accounts for about 90% of foreign exchange turnover globally.

Role of Brokers

Brokers facilitate the coming together of buyers and sellers by collecting prices from a variety of banks. The broker selects the highest bid rate, and the lowest offer rate, and combines them to establish the best two-way price available to calling banks. For example, if banks quote different prices as shown below, then broker price would be USD 1 = JPY 120.11/120.14. Calling banks find it easier and quicker to call the broker than to call all of the banks seperately.

Brokers charge a fee for their service known as 'brokerage'. The fees are negotiated by management and vary with the product. Discounts are provided based on volume of turnover.

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Broking Exchange Rate


USD 1 = JPY

Bid Offer
Bank A 120.09 120.14
Bank B 120.10 120.15
Bank C 120.11 120.16

Broker price 120.11 120.14

In recent years electronic dealing has become the dominant means of communication between interbank dealers. Dealing systems such as Reuters 3000 enable dealers to quote and transact with each other electronically rather than by telephone or facsimile. Similarly, electronic broking systems, such as EBS, have become a very popular alternative to voice brokers. Electronic dealing systems have the advantage that there is a printable record of completed deals, and deal capture into the back office can occur automatically. This reduces the risk of error, saves time and labour costs.

Foreign Exchange Rates & Systems

Fixed Exchange Rate System

A fixed exchange rate is one where the foreign exchange rate is artificially pegged to a reference standard, ie the gold price or a trade weighted basket of currencies. The benefit of a fixed exchange rate system is that people know exactly what the exchange rate will be. The disadvantage is that holding exchange rates at fixed levels can require a lot of intervention through foreign exchange and/or money markets. This can create distortions in the economy and may reach a point where an adjustment (usually a de-valuation) is unavoidable. When these occur they are typically large devaluations which have a major impact.

Floating Exchange Rate System

A floating exchange rate system is one where the foreign exchange rate varies with supply and demand for the currency. The benefit of floating exchange rates is that the market is allowed to determine its own level. The disadvantage is that the market may set exchange rates at levels not considered desirable.

Evolution of the Foreign Exchange Rate System in Australia

The British pound was used as legal tender in Australia until 1931 when the Australian pound came into existence. The Australian pound was fixed to the pound sterling at a rate of 1.25 pound equaling GBP 1. In 1966, Australia introduced decimal currency with the Australian dollar replacing the Australian pound as Australia's currency with AUD 2 = 1 Australian pound.

Under the gold standard, exchange rates were fixed to the price of gold. A British pound was originally one pound weight of gold. Under the Bretton Woods system, which operated from 1947 until it broke down in 1971, the value of the US dollar was fixed as equal to 1 oz of gold. Other currencies were given 'parity' against the USD. 1 Australian pound was set at USD 3.224. Central banks held reserves to keep their exchange rate fixed at the parity level. Very occasionally the paritities were changed. For example, in 1949 the Australian pound (in line with sterling) was devalued by 30% against gold, and the USD to 1 Australian pound = USD 2.224. In 1967, the pound sterling was devalued by 14.3% - but the AUD did not follow.

The Bretton Woods system ended in late 1971 and the major currencies returned to a floating rate mechanism. It was decided that the AUD would be linked to the USD, rather than the pound. Adjustments to the AUD/USD rate were made in December 1972, February 1973 and September 1973. In September 1974 the link with the USD was broken and replaced with a link to a trade weighted basket of currencies. In November 1976 the AUD was devalued by 17.5% against the trade-weighted basket and it was decided to make frequent small adjustment rather than occasional large changes.

Each morning the Reserve Bank (RBA) posted a mid-rate for the day based on the closing New York exchange rates, and the then secret trade-weighted index. Until December 1984, when a large number of foreign owned banks were given authority to trade in foreign exchange in Australia - only the major trading banks were permitted to deal in deliverable foreign exchange. Exchange controls existed that restricted dealing in foreign currencies to importers and exporters with documentary evidence of international trade. An unofficial market known as the 'hedge market' developed in which non-deliverable forward contracts were traded. The forward prices in the hedge market were based on the day's mid-rate and reflected supply and demand.

The Australian dollar was floated and exchange controls were lifted on 11 December 1983. The RBA mid-rate was replaced with a daily published rate known as the 'hedge settlement rate', (HSR). The HSR was (and still is) determined by calculating the average spot rate at 9.45am Sydney time of ten banks, after excluding outriders. The hedge market no longer operates, but the HSR is still used as the basis of settlement of a number of derivative contracts.

From 1979, most European currencies joined the European Rate Mechanism (ERM), which was known as 'the snake'. Under this arrangement, exchange rates between participating currencies were kept within a band of 2.5% of each other, but the ERM was free to move against other currencies, particularly the USD. As with the Bretton Woods system, realignments were made from time-to-time.

OTC and Licensed Markets

OTC transactions are all financial products not traded on a licensed exchange or market. Consistent with this distinction, OTC financial transactions are also known as off-exchange transactions. In Australia, there are two principal licensed financial markets: the Sydney Futures Exchange (SFE), and the Australian Stock Exhchange (ASX) - the SFE was purchased by the ASX. Generally, any financial products that are traded outside the SFE or ASX are therefore termed OTC financial transactions.

A principal difference between OTC and exchange traded products is the flexible nature of the OTC product. They can be tailored specifically to the client's needs in terms of product structure, settlement terms and dealing method (ie an OTC product is a privately negotiated bilateral transaction). In contrast, exchange-traded products are subject to fixed terms and conditions which are determined by the exchange, and sometimes require the approval of the responsible Minister.

In the case of exchange-traded products, deals are normally with the exchange or clearing house as a principal and are subject to binding rules and procedures. The facility of the exchange is offered on the condition of adherence to the Business Rules of the exchange. The products traded on exchanges are usually in a standard format with little or no scope for variations to accommodate specific client circumstances, except of course, price.

Exchange-traded products are distinguished by constant contract terms (fungibility), which allows for novation of contracts with a central clearning house. Novation allows for credit risk management to be transferred from the principal to the clearning house. Exchange-traded products are cleared and settled by the exchange; OTC products are cleared and settled by the individual participants. Clearing Houses manage market risk largely through margin calls, where as OTC participants manage market risk individually.

Transaction costs can be surprisingly high for OTC transactions. Results of OTC research showed that average costs for cash, securities and foreign exchange transactions were in the region of $160 to $380 per transaction. More involved transactions such as swaps and interest rate options, were in the region of $2,500 per deal. In contrast, exchange-traded futures showed an average cost per deal of around $350.

OTC products tend to have standardised contracts, as a starting point, with numerous variations to suit the end-users particular needs (eg. bank bills drawn to suit a client's cash flow or foreign exchange rate forwards matched to a client's date of receipt).

OTC products are responsible for a large number of bilateral transactions. Since this bilateral method of operation in OTC financial products is usually not automated, or on a regulated third party exchange, is relied heavily on the orderly self-regulated behaviour of its participants.

Over time, participants have developed commonly accepted procedures for transacting, documenting and settling OTC transactions that have resulted in an efficient and secure trading environment.

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Market Intermediation

Market intermediaries can be considered to be 'facilitators' of financial transactions, acting between buyers and sellers, and investors and borrowers. This can be done as a principal - lending and borrowing off their own balance sheet, or as a broker matching participants without taking a principal position. Market intermediaries traditionally use their influence or position to bring together investors and those in need of funding, and matching those in need of foreign currencies and those with surplus foreign currency. Intermediaries earn income for providing such 'matching' and/or risk spreading, or carrying services. This matching can involve the pooling of many small buy or sell positions then, matching these with the opposite position for a fee or a margin.

It is this concept of pooling or 'matching' that distinguishes an intermediary from an end-user. Because of a diverse range of financial markets product types, many of which are not attractive or simply not available to some end-users, the financial intermediary is able to offer a 'package solution' that is far more attractive, or affordable.

It is important to note that as a consequence of this 'matching' activity, financial intermediaries provide OTC products with liquidity, ie the presence of a large number of buyers and sellers of products.

The intermediation process produces several other advantages for end-users and the financial system. They include:

1. Risk Bearing

The financial intermediary may accept a number of financial risks when dealing with end-users, including:

• The risk that lenders will want to retrieve their money after it has already been loaned to borrowers, or that borrowers will want to repay early before it is due to be repaid to the intermediary's lenders
• The risk that the loans made to borrowers may not be repaid, that payments under derivative contracts are not made or that currencies are not delivered as required in foreign exchange transactions
• The risk that interest rates will move unfavourably, rendering transactions unprofitable
• The risk that exchange rates will move unfavourably rendering transactions unprofitable
• The risk that price relativities between products will move unfavourably rendering hedging arrangements ineffective and unprofitable

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2. Economies of Management Costs

By managing transactions in sheer volumes, intermediaries can achieve economies of scale. Administrative and other costs associated with evaluating potential investments can be spread over a large number of transactions, thereby reducing unit costs.

The result of Stage 1 of the OTC Benchmarking Project showed that there are significant economies of scale in otc operations. Total operating costs per deal drop consistently as firm size increase.

Financial intermediation may also provide economies of scope with the provision of 'one-stop shopping' for clients. This reduces the search costs of the participants in the financial services sector.

3. Liquidity Management Allowing Mismatch of Transactions

Intermediaries match the imbalance between the financial requirements of various end-users. Seldom do clients' needs match in terms of credit risk, maturity dates, interest rate, liquidity, or currency risk. By pooling transactions, intermediaries are able to accommodate this mismatch.

4. Rational Allocation of Financial Resources

Financial intermediaries allocate capital against the risks which are taken. The cost of that capital is reflected in the prices to the end-users, normally in an internally consistant risk management framework. This process goes a long way towards ensuring that scarce resources are properly priced, thereby assisting the financial system in the efficient allocation of those resources across the competing needs.

5. Allocation Economies

Facilitating large volume lending and borrowing transactions that are beyond the resources of individual participants.

Primary and Secondary Trading

All financial transactions, including OTC financial products have 'primary' or 'secondary' trading. This distinction indicates whether the transaction relates to an instrument which is new or not. Secondary trading refers to trades which are subsequent to the initial issue to the market, or issuance. All transactions which are originated by bilateral negotiation between two counterparts, and which do not produce a tradable interest (or property), are considered initial issuance or primary trades. Examples include foreign exchange or derivatives transactions.

Primary trading is where financial products are issued for the first time by the issuer. Sometimes these transactions are referred to as capital market transactions. An example of a primary trading transaction would be where the Commonwealth Treasury raised funds by issuing bonds, or treasury notes. These transactions also include securities issued directly to underwriters, who in turn on-sell the securities to end investors. Market capitalisation is the current value of all primary issuance at a date.

Secondary Trading is the term used to describe the situation where products are on-sold or traded between participants after the initial issuance. Secondary trading may occur many times over, and the seller may have absolutely no relationship with the original borrower of the funds, or with the primary issue itself.

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Products and Transactions - An Australian Perspective

Financial transactions provide participants with the opportunity to manage financial risk using products that are tailored to meet their specific requirments. Financial markets products are available over the full spectrum of financial risks, from interest rates and foreign exchange, to equities and commodities. Similarly, the users of financial markets products are quite diverse. They range from clients for whom these products are one of many inputs to their operation (eg car manufacturer, oil production etc.), to sophisticated trading organisations (eg commodity traders, electricity generators etc.).

The growth of financial markets trading has been substantial over the past two decades. In the main this has been due to increased deregulation of the financial services coupled with the improvements in technology.

These developments have led to an improved understanding of financial risk as well as an improved ability to deal with it. This surge in the number of transactions has led the participants to institute their own self-regulatory policies, in addition to those imposed by the government.

Functions of Markets

Markets are operating environments in which goods and services can be bought and sold. The operation of a financial market involves borrowing (buying) and lending (selling).

Bringing buyers/sellers, and lenders/borrowers to a central market place provides:

• Price discovery
• Liquidity
• The ability to offset risk
• Efficient resource allocation

For OTC financial products, the market venue is not a single facility. It is a network of relationships and communication links. For exchange-traded financial products, the market venue is a physical or electronic exchange facility, typically with Business Rules that define the relationships and products.

Financial markets products afford participants the opportunity to structure transactions to satisfy specific requirements, at reasonable prices. Financial markets products also act as a conduit for efficient allocation of financial risks. This risk allocation is fundamental to both the stability of the financial system, and to the economy as a whole.

Evolution of Financial Markets Products and Services

Financial markets products evolved as end-users needs to tailor their financial products increased. They came into prominence during the 1980s. In Australia, this coincided with the deregulation of the financial system, and with the entry of new foreign banks.

Prior to 1980, OTC products in Australia were largely limited to trading in bank bills, cash and some forms of foreign exchange. Bills were drawn to meet borrowers' exact cash flow requirements, in terms of both value and date. These bank bills were soon being sold to investors. Since those early days, the turnover in OTC products has grown exponentially.

Concurrently, exchange traded products have developed rapidly. The Sydney futures exchange has developed from a largely commodity-based exchange to a major provider of interest rate derivatives. Similarly, Australian Stock Exchange Futures has responded to demand by offering equity and electricity derivatives. This increase in the turnover and diversity of financial markets products and services has been driven by both supply-side and demand-side factors. Demand for products has increased for a number of reasons, including:

• Technical advances enabling users to better analyse and understand their financial risk
• Recognition of financial risk as a discrete element of business, flowing from the inflationary environment of the 70s and 80s, and from the lower levels of government intervention
• Globalisation flowing from improvements in communication, computing and transport
• Legislative imposition of mandatory superannuation

From a supply side, growth has been driven by both improvements in technology and by increased participation . The factors that led to this were:

• Growth in the number and diversity of non-bank financial organisations
• A move away from government ownership of financial institutions and other assets
• Technical advances in recording, processing and disseminating information
• More effective and secure means of communication

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