Risk Management and the Foreign Exchange Market2.1 Review of Foreign Exchange and Pricing ConventionsThe price of one currency expressed in term of another currency, or put another way, the exchange rate is the rate of one currency in terms of another.For example:AUD/USD = .6230which means that 1 Australian dollar will buy 62.30 US cents. In this example AUD is the commodity or unit currency, and USD is the terms currency. The commodity currency is written first followed by the terms currency. The two are separated by a slash and followed by the numeric rate.2.1.1 Direct quotationAn exchange rate quote where the domestic or local currency is the terms currency . ie. 1 unit of USD equals x no. of units of local currency.e.g. 1 USD = JPY 111.201 USD = EUR 1.7060The direct quotation convention is used in the USA, Japan and Europe. This has been a result of the emergence of the American dollar as the most-traded currency around the world. In practice, a direct quote means that the USD is the commodity currency in the quote.2.1.2 Indirect quotationIndirect quotation means that the foreign currency is the terms currency . The currencies of the former British empire countries (such as NZD,SGD,GBP and SGD among others are quoted as commodity currencies.For example:AUD/USD = 0.6230 - 35SGD/USD = 0.6190 - 95NZD/USD = 0.6170 - 75GBP/USD = 1.2355 - 60Some market jargon:The above rates would be described in the markets thus - "the Aussie is sixty two thirty-thirty five" and the "Kiwi is seventy - seventy five" and the "Cable" is 1.2360 . USD is known as the "Dollar" or the "Big Dollar"`, depending on the country you are working in. In practice, an indirect quote in the market usually means that the USD is the terms currency in the quote.2.1.3 Net foreign exchange positionNet exchange position Total foreign currency bought - total sold.Long position More foreign currency sold than boughtShort position More foreign currency sold than boughtSquare position Total bought = total soldIf currency dealers start from a square position, then when they are long in one currency they should be short in another. Dealers keep account of their positions by recording the cumulative amount of commodity currency traded in a special type of ledger - a 'blotter', which resembles the "T" accounts used in bookkeeping.2.1.4 Using a blotterThe figure below shows a stylised blotter, which a dealer may use to keep a record of her trading positions.
Depending on movements in the currency market the dealer may prefer to be short or long the commodity currency.2.1.5 Cash flows and T accountsA blotter tells you of your position at any point in time.You can use a blotter for your MM position as well as FX. However this doesn't tell you whether you made a profit...