Thursday, July 30, 2009

FX pricer #1 short-term driver -- 2 IR of the currency pair

(See also blog on forward FX rate formula.)

For both spot dealer and forward dealer (see separate blog post), interest rates (both short and long term IR, both spot IR and forward IR) are the most important input. Unlike a buy-side (HF...) trader, a dealer typically gets a lot of RFQ during the day and must watch the live interest rates.

Beside IR, All the other inputs to FX pricing engines are probably for different purposes.

A veteran once told me "FX involve 2 interest rates; equity involves dividends. Roughly equal in complexity" but I believe eq options are more complex, involving volatility, repo (to compensate for PCP imperfections) in additional to IR + dividend.

http://en.wikipedia.org/wiki/Interest_rate_parity
 
http://www.investopedia.com/articles/basics/04/050704.asp gave 6 factors affecting FX rates. I feel interest rate is the only short term live market data.

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