The case for turn impact-adjusted FX forward curves

1. Improved market pricing during turn-dates is needed due to the lack of transparency in FX forwards.
2. Best practice for accurately pricing FX forwards can vary depending on the type of market event.
3. There are factors to consider when adjusting FX forwards pricing for ‘turn event impact’.

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We aim to make the case for ‘turn impact-adjusted FX forward curves’ and how they can help improve market pricing where there is a lack of transparency. We will do this by looking at the breadth of data, analytics and liquidity available to LSEG FX. In so doing, we will consider best practice approaches to improving market pricing, set out key factors to consider and provide an overview of how we set out to solve this challenge.

We are often consulted by liquidity consumers looking to “improve their Forward FX pricing”, which comes as a surprise given the abundance of data available to market participants from a myriad of sources, be these banks, venues or data vendors.

There is a common theme around this challenge along the lines of, “We need access to improved market pricing for FX Forwards. Standard tenors are fairly accurate, however, when we look at trading broken date tenors (e.g., end of month), the rate from our calculator is more often quite different to the rates being quoted by our liquidity providers.”

Ultimately, Market Transparency is at the crux of this challenge. Transparency is driven by electronic markets and most electronic trading occurs on a bilateral (non-transparent) basis. As one large Pension Fund manager put it, “We all want access to the IP and transparency built into the curves of the largest liquidity providers but can only get access when we ask for a price.”

The larger liquidity providers, with the largest flows, will have an edge when determining the shape & skew of the forward curve. Other institutions may need to engage the market iteratively, testing supply/ demand to build their curve daily, which is both time-consuming & costly. Credit is another consideration, with every liquidity provider having their skew, therefore in the absence of competitive streaming pricing for special date tenors, the market needs a credit-agnostic view.

This blog looks at best-practice approaches to improving the accuracy of Forward FX Pricing, particularly for non-standard turn-dates, using the breadth of data, analytics and liquidity available within LSEG FX. 

Two broad market events are most likely to dislocate the FX Forwards curve include:

• Demand-driven funding squeezes. Increased end-of-month, quarter or year corporate funding requirements (e.g., to cover monthly salary/procurement payments), Quarterly IMM date futures contract rollovers, end-of-year balance sheet ‘dressing’ activities, etc.
• Central Bank Monetary policy implementation. Interest rate setting to address inflationary or recessionary pressures.

Both these events will alter the relationship between the relative interest rates for each currency in any given pair for a specified time period during which the forward curve will need to be adjusted to accommodate the change in the interest rate differentials for the two currencies in the pair.

LSEG FX Venues provides on average in excess of $460BN of FX liquidity to the market on a daily basis across Spot, FX Forwards, NDFs & FX Options. This forms the basis of the observations laid out in this introspective, as well as serving as a guide for best practice in improving the accuracy of pricing non-standard tenor FX Forwards.

We observed that ‘turn impact-adjusted’ FX Forward trades varied by between 1 – 15 pips from the equivalent interpolated rate for the same settlement date (interpolated using standard tenors with no turn date adjustment). The size of the difference depended on currency pair, as well as the turn, with end-of-year turns demonstrating the greatest difference.

We observe a concentration of volume trading on turn dates (end of month, but particularly end of year as well as IMM dates). 51% of all FX Forward trades on the venue are “broken-dated”, and 20% of Volume is traded on average during the Turn periods, all of which require accurate data & analytics to price.

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• Demand-driven turn-dates. We observe that the demand for liquidity generally manifests characteristics in line with normal market conditions in the period leading up to monthly turns. This is followed by a surge in demand resulting in a liquidity squeeze that can occur at month/ quarter or year-end, evidenced by a spike in the fwd fwd rate during the turn period. Following the event, normal demand resumes, with the interest rate differential stabilising back to normal.
• Central Bank Rate Decisions. Impact from a Central Bank rate decision will continue following the event but have little impact before the rate decision event due to the relationship between the CB rate and the currency pair interest rate differential before and after the rate change.

There are several approaches to improving accuracy and ‘pricing in’ the impact of these events:

1. Analytically adjust the turn-period FX Forward price taking into account the change in the interest rate differential by modelling either:
   1. The turn date forward-forward for the temporary funding squeeze that occurs during the turn period (e.g., during Month-end or IMM dates).
   2. The ‘OIS implied forward (interest) rate’ impact from an expected Central Bank rate change.
      
2. Calibrate your FX Forward curve using live market pricing or historical market data for turn-period value dates. A key requirement is access to either a considerable pool of trades for calibrating your curve or a platform streaming forwards FX prices for these special dates.

The LSEG FX ‘Turn-date Impact-adjusted FX Forward Curves’ provide a comprehensive Forward FX term-structure complementing the standard monthly tenors with the special turn dates that adjust the FX curves during these events.