Cross-currency products

A ledger which maintains all entries in the transaction currency can handle all the
pitfalls mentioned above and can give the FX exposures of the business line so long
as all the instruments are mono-currency. The exposures are simply the balances
on the profit accounts.
However, there are some products which involve more than one currency. Forward
FX trades are the simplest and the population includes currency swaps as well
as the more exotic instruments often referred to as quantos. Terminology is not
standardized in this area, but an example of such an instrument would be an option
which paid out USD1000 * max((St -S0),0) where St and S0 are the final and strike
values of a stock quoted in a currency other than USD.
Currency exposure reporting is not easy for systems with such cross-currency
instruments. If FX delta is to be calculated by the risk system performing recalculation
then the risk system must have cash balances in it (including those related to
the profit remittances discussed above) which is not often the case. Performing
recalculation on the market instruments while ignoring cash balances can give very
misleading reports of exposure resulting in mishedging. The best approach for FX
delta is therefore to have such instruments valued in component currencies, so that
the ledger will indeed show the correct exposure. FX gamma can only be obtained by
recalculation within the valuations system (the FX gamma on a cash balance is zero).
Note that not every product which pays out in a currency different from that of the
underlying is a true cross-currency instrument. For example, if the payout is (Any
function of the underlying alone) * (Spot rate on expiry) then there is no actual FX
risk for the seller, since one can execute an FX spot trade at the spot rate on expiry,
effectively on behalf of the client. This is an example where complexity is sometimes
seen where it does not exist, in what has been called ‘phantom FX’. 480