TRADING MODEL OF FX FORWARD & SWAP MARKET IN KOREA

The concept of Forward & Futures Market in OTC & exchange model

Foreign exchange market in Seoul has two sets of FX forward transaction via OTC and the exchange market. FX swap and FX outright forward are traded through OTC market where the brokerage services are provided by Korea Money Broker Corporation along with other FX broker firms, which include one domestic broker company and 3 offshore foreign firms. FX futures are traded through the Korea Futures Exchange. Although the terminologies of FX swap, forward, and futures are different, the main concept of the products is the same.

In Korea larger volume of forward transactions are traded in the OTC market because settlement time is diversified, the transaction process is much simpler than the exchange. In the exchange market every deal has to be done through futures companies, but in the OTC market the dealers in financial institutions can trade through brokerage firms. So the transaction fee in the OTC should be cheaper since dealings are done without futures companies as shown in the diagram 1.

Forward rate and swap point in the OTC model are calculated as below, are used in the exchange model as well.

FX Forward & Futures Rate Calculation

If KRW spot price is "S", the forward price is Forward rate (t)" for a time-horizon of "t" days (up to a year), the KRW interest rate is "r", and the USD interest rate is "r*", The equation can be made below.

Outright Forward Rate (t) = S [1 + r (t/360)] / [1 + r* (t/360)].

FX Swap Premium Calculation

Swap Forward Rate = Forward rate (t) - Spot rate

LIBOR is used for USD interest rate. 1day KRW Call rate, 3 months CD rate, and 1 year Korea T-bond interested rates are used for KRW interest rate. For the other terms, market uses its own curve rate, which takes the above rates as fundamental.

The Exchange Market

In the Korea Futures Exchange (KOFEX) established in April 1999, two currency related products; won/dollar futures and won/dollar options are listed.

The OTC(Over the Counter) Market

The OTC market consists of customers market and inter-bank market. In customers market foreign exchange banks deal with customers such as importers exporters and other individuals. In inter-bank market foreign exchange banks deal among themselves to dispose of this open positions driven from transactions with non-financial sector customers such as firms and individuals.

Trading Volume

The daily average turnover of outright-forwards in the first half of 2004 was $3.08 billion. The outright-forwards contract is a typical hedging instrument used by firms while FX swap-forwards are usually used in hedging the FX positions of banks to adjust their temporary excesses and deficiencies of funds. The daily average turnover of FX swap-forwards in the first half of 2004 was US$ 5.12 billion.

The reason why the OTC market attract more interest as in inter-bank trading

Established solely for inter-bank trade

The exchange market is open for everyone from the individual to the bank. On the contrary, the OTC market is established solely for the inter-bank market. Therefore, the OTC market should be more flexible to meet the bank's position management and speculation trading.

Trading Unit

The exchange's trading unit is $50,000, which is more suitable for the individual investor and the small corporations hedging need, however, the exchange's trading unit is not even close to the banks minimum trading volume per deal. Usually the bank's trading volume per trade is over $5 million and prefers to clear the deal with one trade. In order to trade $5 million in the exchange market, it could be done by 50 counter parties at most whereas in the OTC it could be done by one counter party.

Settlement System

The OTC market settlement system is driven by Bank of Korea, called as "BOK Wire." Every bank has its own BOK account to settle their credit with other banks. This system virtually covers every KRW transaction such as stock, bond, short-term money, FX trade, and so on. Therefore the settlement gets as simple as possible. Since the system is provided by Bank of Korea, the fee is free. On the other hand in order to settle in the exchange market, the parties have to follow the exchange settlement system which is costly, because the settlement is also required to be made through the futures company's account(shown in diagram 2).

Transaction Deposit

The exchange requires futures companies to deposit amount of USD 1,700 per trading USD 50,000. If the bank wants to sell USD 10 million through the exchange, then bank has to put deposit amount of USD 340,000. The OTC market does not require any deposit but the credit line is given one bank to another. This credit allowance decides the transaction volume limit between banks. A newly established bank that does not have any creditability in the market may not be able to trade in the OTC market, because the other banks will not allow any credit to that bank.

Trading Term and Settlement Date

The bank receives the orders from the customers with diversified hedging needs. For H[1] example, a customer wants to sell 99 days forward (3 month and 9 days) amount of USD 10 million and the date is not matching with the exchange's monthly settlement date. To hedge this amount from the exchange market, the bank has to sonsider the complicate options. On the other hand, in OTC market, such hedging needs can be met by one counter-party whom the broker firms finds out.

Conclusion

From the transaction volume chart we can see that forward trading volume in OTC is far more than that of the exchange, because OTC market is cheaper in fee, faster in trading, and more flexible in settlement time. For the individual investors and the small corporations, the exchange market might be suitable, however it is certain that the exchange market cannot fully satisfy the bank's needs. Therefore, in most countries including Korea, the FX forwards market in OTC is more active and developed than the FX futures market in the exchange.