Basic FX Instruments

Demetri Papacostas and Francesco Tonin

There are two broad intertwining paths in any asset class: the core, or underlying instrument, and the derivative path. By definition, the derivative is a derivation of the underlying, so it cannot exist without the core. With that in mind, this chapter will build some foundations in core FX so we can later move onto the derivative part.

Four related instruments will be discussed:

• • FX spot market;
• • forward market;
• • non-deliverable forward (NDF) market; and
• • cross-currency swap as it relates to the cross-currency basis.

It can be argued that the forward market is nothing more than spot for delayed delivery, that an NDF is an artificial, virtual forward and that a cross-currency swap is a series of forwards. Why examine them separately? The reason is that there are many differences in application and effectiveness that make them very interesting and critical to understand, especially if we want to advance to more complex derivatives. To get some context, we begin with the desks on a typical bank trading floor that trades and sells these products.

Although we will be looking at the mechanics of the market, it is critical