Margin and Collateral
Financing Foreign Exchange Trading
Foreign exchange dealers have several related functions. The most obvious of these is standing ready to make prices on currencies and options in response to requests for quotations by clients and other dealers. Another dimension is a credit function. Dealers are in the business of extending credit and receiving collateral from their clients to facilitate trading. A large part of the activity in the foreign exchange market is trading on margin.
Dealers allow customers to take positions solely to trade. For example, a hedge fund that buys $100 million of dollar/yen is hoping the dollar will appreciate against the yen. Ultimately, it plans to trade out of the position. Said another way, receiving $100 million and delivering some-odd 10 billion yen are not part of its strategy.
This chapter describes how credit and collateral can be used to support foreign exchange trading. I review the prominent contractual agreements that form the legal basis for trading on margin. Next I discuss how dealers measure their exposure to the risk of carrying client positions and present a summary of value-at-risk concepts. Next I advance to the role of posted collateral. Finally, I discuss the duties of the dealers to act in good faith with respect to their clients who trade on margin.
There are four credit support documents that are designed for integration into the Master Agreement frameworks that ISDA and the FXC ...