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FOREX MARKET

Ms. Shegorika R Lalchandani

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INTRODUCTION TO FOREXAND FOREX DERIVATIVES

The foreign exchange (currencyor forex or FX) market existswherever one currency is traded

for another. It is the largest andmost liquid financial market in theworld.

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Basic forms of Exchanging

currencies:

Outright

Swap

When two parties exchange one currency for

another the transaction is called an outright.When two parties agree to exchange and re-

exchange (in f uture) one currency foranother, it is called a swap.

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Foreign Exchange in Spot and

Future Spot: Foreign exchange spot trading is

buying one currency with a differentcurrency for immediate delivery. Thestandard settlement convention forForeign Exchange Spot trades is T+2days, i.e., two business days from thedate of trade execution.

Forward Outright: A foreign exchangeforward is a contract between twocounterparties to exchange one currency foranother on any date after spot. In thistransaction, money does not actually change

hands until some agreed upon future date.

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Base Currency / Terms

Currency: In foreign exchange markets, the base

currency is the first currency in acurrency pair.

The second currency is called as theterms currency.

Exchange rates are quoted in per unitof the base currency.

E.g. the expression Dollar Rupee,tells you that the Dollar is being quotedin terms of the Rupee. The Dollar is thebase currency and the Rupee is the

terms currency.

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Continued.. Exchange rates are constantly

changing, which means that the valueof one currency in terms of the other isconstantly in flux.

Changes in rates are expressed asstrengthening or weakening of onecurrency vis--vis the second currency.

Changes are also expressed asappreciation or depreciation of onecurrency in terms of the secondcurrency.

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Continued Whenever the base currency buys

more of the terms currency, the

base currency has strengthened /appreciated and the termscurrency has weakened /depreciated.

E.g. If Dollar Rupee moved from43.00 to 43.25. The Dollar hasappreciated and the Rupee hasdepreciated.

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Functions ofForex Market Transfer of funds from one nation & currency

to another.

Why exchange?# Import & Export of goods# Import & Export of services# Tourism

# InvestmentEg. A US commercial bank has oversupply ofpounds, then sell excess pounds, then finallya nation pays for its tourist exp. imports,investments etc.

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Participants in Forex Market: Level 1:

To

uris

ts, impor

ters, expor

ters,investors- immediate users & suppliers

of foreign currencies.

Level 2:

Commercial banks- they act as clearinghouses between users and earners, donot actually buy & sell- Retail market

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Participants in Forex Market: Level 3:

Forex

brokers-

They deal wi

thcommercial banks.

Level 4:

Na

tions cen

tral

bank

:

Act as Lender/ Buyer of last resort-Interbank market/ wholesale market

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Entities in Forex market Authorised dealers-are commercial

banks

Money changers- Buy/ sell formcustomers- deal in notes, coins andtravelers cheque.

FEDAI- Forex Dealers Association of India

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SWAPS

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What are Swaps.?

A foreign exchange swap is asimultaneous purchase and sale, or vice

versa, of identical amounts of onecurrency for another with two differentvalue dates.

The two currencies are initiallyexchanged at the Spot Rate and areexchanged back in the future at theForward Rate.

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Continued The Forward Rate is derived by

adjusting the Spot rate for the interest

rate differential of the two currenciesfor the period between the Spot and theForward date.

FX Swaps are commonly used as a wayto facilitate funding in the cases wherefunds are available in a differentcurrency than the one needed.

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DERIVATIVES.

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Derivatives means

Derivative is a product whose value is

derived from the value of one or morebasic variables, called bases (underlyingasset, index, or reference rate), in acontractual manner.

The underlying asset can be equity,foreign exchange, commodity or anyother asset.

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Regulation of Derivatives

SecuritiesC

ontracts (Regulation)Act, 1956 (SC(R)A) Regulatestrading of Derivatives in IndianSecurities Market.

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FACTORS DRIVING THE

GROWTH OF DERIVATIVES

Growth Driving Factors

IncreasedVolatility

IncreasedIntegration

Improvement inCommunication system

Innovations inDerivatives market

Development ofSophisticated

tools

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Derivatives Product

Forwards

Futures

Options

Swaps

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Explanation of various

Derivatives products: Forwards: A forward contract is a customized

contract between two entities, where

settlement takes place on a specific date inthe future at today's pre-agreed price.

Futures: A futures contract is an agreementbetween two parties to buy or sell an asset at acertain time in the future at a certain price. Futures

contracts are special types of forward contracts in thesense that they are standardized exchange tradedcontracts.

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Options: Options are of two types

- calls and puts. Calls give thebuyer the right but not theobligation to buy a given quantity

of the underlying asset, at a givenprice on or before a given futuredate. Puts give the buyer the right,but not the obligation to sell agiven quantity of the underlyingasset at a given price on or beforea given date.

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Swaps: Swaps are private agreementsbetween two parties to exchange cash flows in

the future according to a prearranged formula.They can be regarded as portfolios of forwardcontracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping

only the interest related cash flows betweenthe parties in the same currency.

Currency swaps: These entail swapping both

principal and interest between the parties, withthe cash flows in one direction being in adifferent currency than those in the oppositedirection

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PARTICIPANTS IN THE

DERIVATIVES MARKETS

Hedgers Speculators

Arbitrageurs

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CURRENCY

FUTURES

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DEFINITION OF CURRENCY

FUTURES

Currency f uture is a contract toexchange one currency for another

currency at a specified date and aspecified rate in the future. the buyerand the seller lock themselves into anexchange rate for a specific value or

delivery date. Both parties of thefutures contract must fulfill theirobligations on the settlement date.

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Settlement ofCurrency

futures Currency futures can be cash settled or

settled by delivering the respective

obligation of the seller and buyer. Allsettlements however, unlike in the caseof OTC markets, go through the

exchange.

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Calculation of Profit & Loss in

Currency Futures Currency futures are a linear product, and

calculating profits or losses on CurrencyFutures is similar to calculating profits or

losses on Index futures. In determining profits and losses in futures

trading, it is essential to know both thecontract size (the number of currency unitsbeing traded) and also what is the tick value.

A tick is the minimum trading increment orprice differential at which traders are able toenter bids and offers.

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FUTURES

TERMINOLOGY Spot price: The price at which an asset trades in the

spot market. In the case of USDINR, spot value is

T + 2.

Futures price: The price at which the futurescontract trades in the futures market.

Contract cycle: The period over which a contracttrades. The currency futures contracts on the NSE

have one-month, two-month, three-month up totwelve-month expiry cycles. Hence, NSE will have 12contracts outstanding at any given point in time.

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Continued. Value Date/FinalSettlementDate: The last

business day ofthe month will be termed the Valuedate / Final Settlement date of each contract.

Expirydate: It is the date specified in the futurescontract. This is the last day on which the contract willbe traded, atthe end of which it will cease to exist. Thelasttrading day will be two business days prior to theValue date / Final Settlement Date.

Contractsize: The amount of assetthat has to bedelivered under one contract. Also called as lot size. Inthe case ofUSDINR it is USD 1000.

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Continued. Basis: In the context of financial futures, basis can

be defined as the futures price minus the spot price.In a normal market, basis will be positive. This

reflects that futures prices normally exceed spotprices.

Cost of carry: The relationship between f uturesprices and spot prices can be summarized in terms ofwhat is known as the cost of carry. This measures (incommodity markets) the storage cost plus theinterest that is paid to finance or carrythe asset tilldelivery less the income earned on the asset. Forequity derivatives carry cost is the rate of interest.

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Types of Margins. Initial margin: The amount that must be deposited in

the margin account at the time a futures contract is firstentered into is known as initial margin.

Marking-to-market: In the futures market, at the endof each trading day, the margin account is adjusted toreflect the investor's gain or loss depending upon thefutures closing price. This is called marking-to-market.

Maintenance margin: This is somewhat lower than theinitial margin. This is set to ensure that the balance inthe margin account never becomes negative. If the

balance in the margin account falls below themaintenance margin, the investor receives a margin calland is expected to top up the margin account to theinitial margin level before trading commences on thenext day.

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The rationale for establishing

the currency futures Currency f utures enable investors to

hedge currency risks.

Increasing the cross border trade andinvestment flows.

Currency futures are expected to bring

about better price discovery and alsopossibly lower transaction costs.

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Continued.. In comparison to forwards, futures are

standardized products and helps in

elimination of counterparty credit riskand greater reach in terms of easyaccessibility to all.

currency futures could be seen as a

facilitator in promoting investment andaggregate demand in the economy,thus promoting growth.

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Advantages of futures

Advantages of

Futures

Transparencyand efficient

pricediscovery

Eliminationof

Counterparty

credit risk

Access to all

types of

market

participants

Standardized products

Transparent

trading

platform

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Limitations of Futures

Limitations

Of futures

Lack ofCustomization

High Cost

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NSES CURRENCY

DERIVATIVESSEGMENT

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PRODUCT DEFINITIONUnderlying Rate of exchange

between one USD and

INRTrading Hours

(Monday to Friday)

09:00 a.m. to

05:00 p.m.

Contract Size USD 1000

Tick Size 0.25 paise or INR0.0025

Trading Period Maximum expiration

period of 12 months

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Continued.Contract Months 12 near calendar

months

Final Settlement

date/

Valuedate

Last working day of the

month (subject toholiday calendars)

Last Trading Day Two working days prior

to Final Settlement Date

Settlement Cash settled

Final Settlement Price The reference rate fixed

by RBI 2 working days

prior to final settlement

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Features ofForex Market

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1. Location Forex market is described as OTC-as there is

no physical place oftrading.

Informal arrangements

be

tween

banks andbrokers connected to each other by

telephone and satelleite network. Wholesale segment- Is between banks. Retail customers between banks and their

customers. RBIs policy- to decentralise exchange

operations.

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2. Size ofthe market Worlds largest

Avg daily turnover in April 2004- USD 1.9 trillion.

Largest forex market is London, followed by NewYork, Tokyo, Zurich and Frankfurt.

The Rupee is involves in only 0.3% of thetransactions taking place in world forex markets.

Leading currencies of

the world are

: US Dollar,Pound-sterling, Euro, Japanese yen and Swiss

franc.

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3. 24 Hour Market The markets are situated throughout different

time zones ofthe globe in such a way that

when one market

is closingthe o

ther isbeginning its operations.

Major markets are situated in Sydney, Tokyo,Zurich, Hong Kong, Chicago and Los Angeles.

In India,the marke

tis open for

the

time

thebanks are open for their regular banking

business. No transactions take place onSaturdays.

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4. Efficiency Developments in communication have

largely contributes to the efficiency of

the market.

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5. Currencies Traded In most ofthe markets, the US dollar is

the vehicle currency, i.e. the currency

used to denominate internationaltransactions.

US dollar is involved as one of the

currencies in 87% of the transactionsfollowed by Euro (37%), Japanese yen(20%) and Pound Sterling (17%).

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Participants Corporates- They operate by placing

orders with the commercial banks. They

form the retail segment ofthe forexmarket.

Commercial Banks- Major players- work

for themselves and for their clients.

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Participants Exchange Brokers- They facilitate deals

between banks. In the absence of

exchange brokers, banks have tocontact each other for quotes.Exchange brokers ensure that the most

favourable quotation is obtained at lowcost in terms of money and time.

Central Bank

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Transactions in inter bank

markets Forex market is a market where

currencies are traded. Any trading has

two aspects: Purchase and sale.

In currencies market, the standardpractice in the market is to interpret the

transaction from the perspective of themarket maker (quoting bank) who isthe price maker.

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Transactions in inter bank

markets Two points to be kept in mind:

The transaction is always talked of fromthe quoting banks point of view,

The item referred to is the foreigncurrency.

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Types ofTransactions Spottransactions

Forward transactions

Swap

Non- deliverable forwards

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Exchange Rate Quotations:1. Direct quote:

No. of units of home currency for oneunit of foreign currency.

eg. Rs 50/ $, means that 50 rupeesare required to buy one unit of foreigncurrency/ dollar.

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Exchange Rate Quotations:2. Indirect quote:

No. of units of foreign currency required to buy

one unit of home currency. i.e. for one unit ofhome currency, how many units of foreigncurrency is required?

eg. $0.02/ Rs 1, means that 0.02 dollars are

required to buy one unit of home currency/rupees.

FF 0.1462/ Rs 1, 0.1462 French Franc perrupee.

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Exchange Rate Quotations:Spot rates for a number of currencies (in

Rupees)Country Currency Symbol Direct

quoteIndirectquote

UK PoundSterling

/ GBP 66.92

US US Dollar $ 43.30

Canada CanadianDollar

Can$ 29.10

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Rupees)

Country Currency

Symbol Directquote

Indirectquote

UK PoundSterling

/ GBP 66.92 0.0149

US US

Dollar

$ 43.30 0.0231

Canada Canadian Dollar

Can$ 29.10 0.0344

h i

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Rupees)

Country Currency

Symbol Directquote

Indirectquote

Germany

Deutschmark

DM/DEM 22.94

Euro 44.87

Netherlands

DutchGuilder

DG/$f/NLG

20.36

h Q i

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Rupees)

Country Currency

Symbol Directquote

Indirectquote

Germany

Deutschmark

DM/DEM 22.94 0.0436

Euro 44.87 0.0223

Netherlands

DutchGuilder

DG/$f/NLG

20.36 0.0491

E h R Q i

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Rupees)Country Currency Symbol Direct

quoteIndirectquote

Switzerland

Swissfranc

sFr 0.0358

France Frenchfranc

FF/ FRF 0.1462

Italy Swedishkrona

SKr 0.1931

E h R t Q t ti

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Rupees)

Country Currency

Symbol Directquote

Indirectquote

Switzerland

Swissfranc

sFr 27.97 0.0358

France French

franc

FF/ FRF 6.84 0.1462

Italy Swedishkrona

SKr 5.18 0.1931

E h R t Q t ti

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Rupees)

Country Currency

Symbol Directquote

Indirectquote

Italy Italianlira

Lira/ Lit/ITL

43.2901

Japan Japanes

e Yen

2.4994

Australia Australian dollar

AU$ 0.0360

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The

Foreign Exchange Ra

tes

Definition- An exchange rate quotationis the price of a currency stated in

terms of another.

For eg. Rs 50/ $

This means that price of one dollar is Rs

50. It is like quoting the price of a

commodity.

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The

Foreign Exchange Ra

tes

Suppose there are two nations: US andUK and the exchange rate is R.

R=2, i.e. R= 2 $/ or

R= $/ = 2

i.e. 2 dollars are required to buy onepound.

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The

Foreign Exchange Ra

tes

X axis- Quantity ofpounds

Y axis- exchangerate i.e. RR= $/

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Analysis

:

Higher exchange rate:

a) Uk gets more dollars for pound.

b) They find UK goods to be cheaper.

c) They find investing in US attractive.

Therefore, Supply of pound in USincreases.

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Analysis

:

If exchange rate becomes 3, i.e. R= 3$/ , means that now three dollars are

required to buy a pound thus, depictingDepreciation ofUS dollar.

If exchange rate becomes 1, i.e. R= 1

$/ , means that now one dollar isrequired to buy a pound thus, depictingAppreciation ofUS dollar.

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Factors that affectthe

Equili

bri

um Exchange Ra

te

1. Relative inflation rates- Eg. R= 2$ / , If inflation in US in higher than in UK, then US

goods will be costlier than that ofUK goodsand therefore, UK will export more goods toUS and US will export less goods to UK.

This means that value of Dollar has

Depreciated w.r.t. Pounds, or Value of Pounds has Appreciated w.r.t. US

dollars.

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Equili

bri

um Exchange Ra

te

2. Relative interest rates

If real interest rates ofUS are higher than

that ofUK, then the dollar is said to haveappreciated as compared to pound.

Real interest rate = Nominal interest rate -Inflation

If interest rate ofUS > int. rate ofUK(because of inflation, then wrong picture).

Therefore, real interest rate should be

considered.

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Equili

bri

um Exchange Ra

te

3. Relative economic growth rates:

Strong economic growth- attractinvestment

4. Political & Economic risk:

High risk currency- more valuable

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Numera

tor and Denomina

tor

The higher fraction is supposed to bethe numerator and the Denominator

corresponds to its lower part.Eg. EUR / USD,

EUR is the basic currency (Numerator) &

USD is the counter currency(Denominator).

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Buying and selling a c

urrency

Buy/ Long EUR/ USD, means that youwant to buy EUR and sell USD.

Sell / Short EUR/ USD, means that youwant to sell the basic currency and buy

the counter currency i.e. sell EUR andbuy USD.

Short sell

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Bid andA

sk Rates

A bank is ready to buy and sell a currency atdifferent prices.

Buy price- Bid rateSell price- Ask rate

Spread- Difference between Bid and Ask rateis called Bid- ask Spread.

It is more in retail market and less ininterbank market as there is more volume,greater liquidity and lower counterparty risk

in inter

bank

transac

tions.

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Ca

uses of spread are

:

Transaction cost

Return on capital employed

Reward / Compensation for taking risk

Mid rate- Arithmetic mean of bid andask rates i.e. when one rate ismentioned.

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Important conventions

regarding quo

tes

:

a) The bid rate always precedes the ask rate.E.g Rs/$ 45.45/ 45.50

b)

The

bid and ask ra

tes are always separa

tedeither by slash(/) or (-).

c) The quote is always from the bankers pointof view. Rs/$ 45.45/ 45.50

E.g The banker is ready to buy dollar at

45.45 and sell at 45.50. i.e. Bankers buyrate= Customers sell rate.

d) The Bid is always lower than the ask. (askrate- Bid rate = profit)

b k h

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Interbank quote vs Merchant

quo

te

Merchant quote is by bank to its retailcustomers.

Interbank quote is given by one bank toanother bank.

Since, both the parties are banks, then

whose quote will be considered. Thebank requesting the quote will is thecustomer and the other banks quote

willbe considered.

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Basis Point

(BPS) A unit that is equal to 1/100th of 1%,

and is used to denote the change in a

financial instrument. The basis point iscommonly used for calculating changesin interest rates, equity indexes andthe yield of a fixed-income security.

The relationship between percentagechanges and basis points can besummarized as follows: 1% change =100 basis points, and 0.01% = 1 basis

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Basis Point

(BPS) So, a bond whose yield increases from5% to 5.5% is said to increase by 50

basis points; or interest rates that haverisen 1% are said to have increased by100 basis points.

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Cross Ra

tes / Syn

the

tic ra

tes

When we calculate the exchange ratesbetween other currencies with the

dollar (or any other currency) as theintermediate currency.

The / rate will be calculatedthrough the / $ quote and the $/ quote.

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Cross Ra

tes

Eg. We need to calculate the Switzerlandfranc / Canadian Dollar (sFr/ Can$) rate fromgiven sFr / $ and $/ Can$ quotes.

sFr / $ :5.5971 / 5.5978

$/ Can$ : 0.7555 / 0.7562

Synthetic (sFr/ Can$)bid rate

= 5.5971 * 0.7555= (sFr / $)bid * ($/ Can$)bid

= 4.2286

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Cross Ra

tes

Eg. We need to calculate the Switzerlandfranc / Canadian Dollar (sFr/ Can$) rate fromgiven sFr / $ and $/ Can$ quotes.

sFr / $ : 5.5971 / 5.5978

$/ Can$ : 0.7555/ 0.7562

Synthetic (sFr/ Can$)ask rate

= 5.5978 * 0.7562= (sFr / $)ask * ($/ Can$)ask

= 4.2330

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Cross Ra

tes and

Chain R

ule

Rates in Mumbai market

USD 1 = Rs. 46.50

USD 1 = CHF 1.8000The rate of swiss francs can be calculated by

chain rule as follows:

? Rs =CH

F1

IfCHF 1.8000 = USD 1

USD 1 = Rs. 46.50

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Cross Ra

tes and

Chain R

ule

The rate of exchange between IndianRupee and Swiss Franc can be

calculated by dividing the product oftheright hand side by the product of theleft hand side.

46.50* 1 * 1 = Rs. 25.831.8000

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Cross Ra

tes and

Chain R

ule

Eg. Rupee/ dollar is 46.50 and Euro /dollar is 1.1568. Rupee / Euro rate can

be calculated as follows:? Rs = Eur 1

Eur 1 = USD 1.1568

USD 1 = Rs. 46.501 * 1.1568 * 46.50 = Rs. 53.7912

1 *1

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The

Foreign Exchange Marke

t

Types ofTransactions

Spot- Spot quotes- Prices in spotmarket

Forward- Forward quote- Prices inForward market

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Forward Ra

tes

IfForward > Spot = Forward premium

IfForward < Spot = Forward discount

The difference between forward rateand spot rate is known as the forwardmargin or Swap points.

i.e. Forward Spot = Margin

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Forward Ra

tes

Under direct quotation, premium isadded to the spot rate to arrive at the

spot rate. This is done for bothpurchase and sale transactions.Discount is deducted from the spot to

arrive at t

he forward rate.

Forward rate = Spot + Premium

Inte etation of Inte bank

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Interpretation of InterbankQu

ota

tions

Eg. Quotation on 25th January

Spot = USD 1= Rs. 48.4000/4200

Spot/ Feb = 2000/2100Spot/ Mar = 3500/3600

The following points should be noted:

1. The first statement is the spot rate fordollars. The quoting banks buying rate is Rs.48.4000 and selling rate is Rs. 48.4200.

Interpretation of Interbank

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ota

tions

2. The second and the third statementsare forward margins for forward

delivery during the months of Februaryand March resp.

3. The margin is expressed in points, i.e.

0.0001 of the currency. Therefore, theforward margin for Feb is 20 paise and21 paise.


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ota

tions

4.


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ota

tions

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INTEREST RATE PARITY

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INTEREST RATE PARITY

PRINCIPLE

The forward rate of any f ully convertiblecurrency is a f unction of the spot rate

and the interest rate differentialbetween the two currencies, adjustedfor time.

Method for finding forward

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Method for finding forward

rate

Forward Rate = Spot+/- Points

Points = 1 + terms i* daysbasis

1 + base i* daysbasis

1

where i = rate of interest

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21543376 Forex Market