CME FX Link is a CME Globex-traded basis spread, traded as a differential, between FX futures and OTC spot FX. FX Link is traded as a differential between the CME FX futures and OTC Spot FX. The spread results in a simultaneous execution of FX futures cleared by CME Clearing, and OTC spot FX, subject to OTC documentation and credit relationships.
This lesson will look at three market scenarios and how FX Link can be used in each.
Replication of an FX Swap
Assume, an asset manager has a long position in spot EUR/USD.
The asset manager intends to roll his spot position into a IMM-dated EUR/USD forward expiring one month into the future to take advantage of his market view that the euro will continue to appreciate against the U.S. dollar through the middle of May.
The asset manager has two alternatives to roll his cash position.
First, the asset manager could buy an IMM-dated FX swap on April 16; that is sell spot euro April 16 for delivery April 18 to offset the original spot euro position, while simultaneously buying a second IMM-dated EUR/USD forward that will expire Monday, May 14 for settlement Wednesday, May 16.
Alternatively, the asset manager could buy the May EUR/USD spread in FX Link on April 16; resulting in a transaction that sells spot EUR/USD April 16 for settlement April 18, while concurrently buying May EUR/USD futures that will cease trading May 14 for delivery May 16.
Offsetting the cash position with a spot transaction while concurrently buying the May EUR/USD futures to effectively roll the position forward by one month into an FX futures contract.
Either alternative will result in the one -month forward transfer of a risk positive, long position in EUR/USD, while holding the forward exposure can potentially provide certain capital and counterparty risk mitigation benefits versus the OTC FX forward.
Using FX Link to Offset an Existing FX Hedge
A bank buys spot USD/CAD on Monday, February 26 for delivery Tuesday, February 27 because Canadian dollars settle to U.S. dollars on a T-plus one business day basis.
Then, the bank hedges the resultant short CAD exposure by purchasing March CAD/USD futures that expire Tuesday, March 20th for delivery Wednesday, March 21st. Thus, creating a neutral market position, but with basis risk from February 27 settlement date to March 21st, the settlement date of the futures position.
Later that day, the bank decides to convert its hedged position from a neutral market position with basis risk into a market neutral position without basis risk.
The dealer bank has two alternatives.
First, the bank could sell CAD in the spot market and then simultaneously sell March CAD/USD futures to unwind the original hedged position. However, such an approach requires the bank to separately execute two transactions, introducing execution risk.
Alternatively, using CME FX Link, the bank could buy the March USD/CAD FX Link spread on February 26 which simultaneously sells March CAD/USD futures and sells USD/CAD OTC FX spot.
This is because CAD is an inverted pair – meaning the futures are quoted inversely to the OTC dollar/cad convention.
So, buying the spread, one needs to sell futures and sell spot simultaneously.
By using FX Link, the trader has removed the basis risk associated with the original hedge by offsetting both the original position and the hedge via a single efficient FX Link spread.
Convert FX forward from non-IMM-dated to IMM-dated
On Monday, April 2, a hedge fund seeks to rebalance its FX forward book by converting its long non-IMM-dated GBP/USD, forward position to an IMM-dated basis.
The fund currently has a non-IMM-dated GBP/USD, forward that will expire Monday, April 9 for delivery Wednesday, April 11.
The fund, however, seeks to mitigate its exposure so that its current non-IMM-dated GBP/USD forward exposure expires on an IMM-dated basis on Monday, April 16 for delivery Wednesday, April 18.
The fund has two alternatives.
First, on April 9, the fund could sell a non-IMM-dated GBP/USD forward that will offset its existing long non-IMM-dated GBP/USD forward position and then buy a second IMM-dated GBP/USD forward that expires Monday, April 16 for delivery Wednesday, April 18.
Alternatively, on April 9, the fund could buy the April 2018 GBP/USD basis spread through FX Link.
This alternative strategy combines a long March GBP/USD futures position that expires Monday, April 16 for settlement Wednesday, April 18 with a short spot GBP/USD position on Monday, April 9 for delivery on Wednesday, April 11.
Either alternative will convert the fund’s long GBP/USD forward position from a non-IMM-dated to an IMM-dated basis that results in a risk positive, long position in GBP/USD.
By using FX Link to convert the IMM-dated futures, the fund receives the netting benefits, counterparty risk mitigation and centralized liquidity associated with holding a futures position as opposed to a bilateral forward exposure.
Conclusion
We have reviewed a few scenarios where market participants could use FX Link to manage risk and positions across OTC FX spot and CME FX futures, seamlessly connecting the two markets.
CME FX Link allows you to better manage and optimize margin and credit lines across CME FX futures and OTC spot FX transactions.
