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FX Trading in the Euro Era

It will be a brand new foreign exchange world come January, and dealers think it could mean more profit—at least initially.

By Margaret Elliott

There's new paradigm for foreign exchange trading on the horizon. At this point, it looks as though the foreign exchange world will break down into four major currency zones—the dollar, the yen, the euro and sterling. Beyond that, there is likely to be a slew of smaller, but suddenly more interesting, possibilities: the Australian and Canadian dollars; the Swiss franc; and the emerging markets of Asia, Europe and Latin America.

The transition to the new paradigm is already beginning as foreign exchange dealers in London seek to rearrange their trading desks. Nobody, however, is moving especially quickly. "We see an increase in volatility already and expect that between May [when the countries joining European monetary union and the guideline exchange rates are announced] and December 31 [when the local currencies cease trading], there could be some explosive foreign exchange trading,” says Christophe Chazot, head of currency options at Bankers Trust.

But Sarah Sullivan, senior manager of global foreign exchange options at HSBC Midland in London, isn't so sure. "I think for derivatives players, EMU and the coming of the euro are almost old news. What we are concentrating on is figuring out where the new activity will be. Already there is a lot of activity in what we would have considered marginal cross rates before: sterling/Australian or Canadian dollar.”

The traditional European cross rate, Deutsche mark/French franc, continues to attract interest as the news ebbs and flows over the mood of the respective populations toward the prospect of losing their home currency. The volatility in this cross rate (as expressed in one-year options) was slightly higher at year-end than during the summer, but was still typically below 1 percent, a far cry from the 2 percent to 4 percent at the beginning of the year. Deutsche mark/lira and Deutsche mark/Spanish peseta were similarly off earlier high volatilities.

One new area of convergence activity in the run-up to EMU is in swaptions involving Deutsche mark and sterling forward rates. By playing the relative volatilities in these converging currencies, it is possible to pick up yields of more than 1 percent. An example given by Jason Boyer, senior options trader at Westdeutsche Landesbank in London, is as follows: Sell the volatility of a five-year option on a five-year sterling swap and buy the volatility of a similar trade in Deutsche marks. With German swaption volatility at 11.6 percent and sterling at 12.8 percent, a trader could see a pickup of 1.2 percent. "That trade anticipates that the underlying curves will converge,” Boyer explains. The trade is not liquid, however, particularly on the sterling side, and it could move against you if the United Kingdom doesn't enter the EMU within the next few years.

Sterling may be more volatile after the euro starts trading, and that will have interesting effects on the market. "Sterling/Deutsche mark is trading as something of a proxy for euro/sterling, and since the beginning of the year, the volatility has been all over the place, particularly in short-dated options,” says Bankers Trust's Chazot. For instance, at the end of January, one-week volatility was 9.5 percent, compared with 8.5 percent the week before and 10.5 percent the week after. Longer-dated options remain less volatile. Traders suggest that the market remains bullish on sterling, expecting a trading range of £1 to 2.7 Deutsche marks–3 Deut-sche marks.

Although most foreign exchange option market observers think that there will be big redeployments of staff on currency desks this year, the moves aren't happening quite yet. "The changes remain in the planning stages. You will see more bank consolidations like Union Bank of Switzerland/SBC and ING Barings buying Banque Bruxelles Lambert in the run-up to EMU. By their very nature, mergers mean changes. Other mergers are likely and other shifts within all fixed-income and currency desks are likely,” says one trader.

But euro products are leaving the drawing boards. Banque Paribas launched euro/dollar options in January and plans to launch euro/yen and euro/Swiss franc options before too long. Although initially end-user products, Paribas hopes they will attract a following in the bank market as well.

And with swaptions on euro rates, arbitraging volatilities can't be far behind. In February, Dresdner Kleinwort Benson sold a Eur50 million euro swaption ($55 million) to Cera Investment Bank in Brussels. The deal has a strike price of 4.44 percent and cash settlement into a one-year swap in February 1999. Cera bought it as a hedge against a rise in one-year euro rates. Dresdner is hedging the trade using a basket of European rates.

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