Nature of Exchange

8/2/2019 Nature of Exchange

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http://kalyan-city.blogspot.in/2010/09/purchasing-power-parity-ppp-theory.html

Basic Concepts II: Nature of the Foreign

Exchange MarketThe Foreign Exchange Market is an over-the-counter (OTC) market, which means that there isno central exchange and clearing house where orders are matched. With different levels ofaccess, currencies are traded in different market makers:

The Inter-bank Market - Large commercial banks trade with each other through the ElectronicBrokerage System (EBS). Banks will make their quotes available in this market only to thosebanks with which they trade. This market is not directly accessible to retail traders.

The Online Market Maker - Retail traders can access the FX market through online market

makers that trade primarily out of the US and the UK. These market makers typically have arelationship with several banks on EBS; the larger the trading volume of the market maker, themore relationships it likely has.

Market Hours

Forex is a market that trades actively as long as there are banks open in one of the majorfinancial centers of the world. This is effectively from the beginning of Monday morning inTokyo until the afternoon of Friday in New York. In terms of GMT, the trading week occursfrom Sunday night until Friday night, or roughly 5 days, 24 hours per day.

Price Reporting Trading Volume

Unlike many other markets, there is no consolidated tape in Forex, and trading prices andvolume are not reported. It is, indeed, possible for trades to occur simultaneously at differentprices between different parties in the market. Good pricing through a market maker depends onthat market maker being closely tied to the larger market. Pricing is usually relatively closebetween market makers, however, and the main difference between Forex and other markets isthat there is no data on the volume that has been traded in any given time frame or at any given
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price. Open interest and even volume on currency futures can be used as a proxy, but they are byno means perfect.

Fisher blacks optional pricing model:-

http://bradley.bradley.edu/~arr/bsm/pg04.html

FOREIGN EXCHANGE REGULATIONS IN INDIA

India has liberalized its foreign exchange controls. Rupee is freely convertible on currentaccount. Rupee is also almost fully convertible on capital account for non-residents. Profitsearned, dividends and proceeds out of the sale of investments are fully repatriable for FDI. Thereare restrictions on capital account for resident Indians for incomes earned in India.

The Reserve Bank of Indias Foreign Exchange Department administers Foreign ExchangeManagement Act 1999(FEMA). Foreign Exchange Management (transfer of securities to anyperson resident outside India) Regulation as amended from time to time regulates transfer forissue of any security by a person resident outside India.

Repatriation of investment capital and profits earned in India

(i) All foreign investments are freely repatriable, subject to sectoral policies and except for caseswhere Non Resident Indians choose to invest specifically under non-repatriable schemes.Dividends declared on foreign investments can be remitted freely through an Authorized Dealer.

(ii) Non-residents can sell shares on stock exchange without prior approval of RBI and repatriatethrough a bank the sale proceeds if they hold the shares on repatriation basis and if they havenecessary NOC/ tax clearance certificate issued by Income Tax authorities.

(iii) For sale of shares through private arrangements, Regional offices of RBI grant permissionfor recognized units of foreign equity in Indian company in terms of guidelines indicated inRegulation 10.B of Notification No. FEMA.20/2000 RB dated May 2000. The sale price ofshares on recognized units is to be determined in accordance with the guidelines prescribedunder Regulation 10B(2) of the above Notification.

(iv) Profits, dividends, etc. (which are remittances classified as current account transactions) can

be freely repatriated.

Acquisition of Immovable Property by Non-resident

A person resident outside India, who has been permitted by Reserve Bank of India to establish abranch, or office, or place of business in India (excluding a Liaison Office), has generalpermission of Reserve Bank of India to acquire immovable property in India, which is necessaryfor, or incidental to, the activity. However, in such cases a declaration, in prescribed form (IPI),
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is required to be filed with the Reserve Bank, within 90 days of the acquisition of immovableproperty.

Foreign nationals of non-Indian origin who have acquired immovable property in India with thespecific approval of the Reserve Bank of India cannot transfer such property without prior

permission from the Reserve Bank of India. Please refer to the Foreign Exchange Management(Acquisition and transfer of Immovable Property in India) Regulations 2000 (Notification No.FEMA.21/ 2000-RB dated May 3, 2000).

Acquisition of Immovable Property by NRI

An Indian citizen resident outside India (NRI) can acquire by way of purchase any immovableproperty in India other than agricultural/ plantation /farm house. He may transfer any immovableproperty other than agricultural or plantation property or farm house to a person resident outsideIndia who is a citizen of India or to a Person of Indian Origin resident outside India or a personresident in India.

Over-the-Counter Options

Normally, if an investor wants to trade or speculate in options, he or she will peruse the options

tables in the newspaper or on theirbrokers website. The variousputsand calls for a given

security will be shown for different expiration dates, going out as far as a couple of years in the

case ofLEAPs.

These types of options are listed on an exchange and trade through a clearinghouse. Don't panic -it sounds advanced but it's not. Without going into the technical details, what it effectively meansis that the performance of your option is guaranteed by the exchange itself. Each participant ischarged a fee to help cover potential default, with the odds considered remote. In other words, ifyou were to buy 10 call contracts giving you the right to buy Coca-Cola at $50.00 per sharebetween now and Friday, January 15th, 2010, you would pay $3.00 per share, or $3,000 total(each call option contract represents 100 shares so 10 contracts x 100 shares x $3.00 per share =$3,000).

If Coke were to go to $60 per share, you could exercise the call options and pocket the profitinthis case, $60.00 sale price - $53.00 cost (consisting of $50.00 for the stock and $3.00 for the

option) or $7.00 per share. Thus, a 20% rise in Coca-Colas stock resulted in a 133% gain onyour options. The option you bought had to be sold by someone, perhaps a conservative investorwho was selling covered calls as part of a buy-write transaction. They have to deliver the stock.

What happens if the other person, known as the counterparty, cant? What if they died? Wentbankrupt? Thats where the clearinghouse steps in and fulfills the contract. In essence, each ofyou was making a deal with the exchange / clearinghouse itself. Thus, there is virtually nocounterparty risk.
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Over-the-Counter Options for Customized Solutions

The only problem with listed exchange-traded options is that a suitablederivativefor an

investment strategy youve developed may not exist in standardized form. For the well-heeled

investor, this presents no problem because he or she can work with an investment bank through

their wealth manager to structure custom over-the-counter options tailored to their exact needs.

How Over-the-Counter Options Differ from Regular Stock Options

In essence, these are private party contracts written to the specifications of each side of the deal.

There are no disclosure requirements and you are limited only in your imagination as to what the

terms of the over-the-counter options are. In an extreme example, you and I could structure an

over-the-counter option that required me to deliver a set number of Troy ounces of pure 24 karat

gold based upon the number of whales spotted off the coast of Japan over the next 36 months.

Frankly, that would be a very stupid transaction, but you get the idea.

The appeal of over-the-counter options is that you can transact in private and negotiate terms. If

you can find someone who doesnt think your over-the-counter option proposal presents muchrisk to their side, you can get an absolute steal.

Counterparty Risk in Over-the-Counter Options

The problem with over-the-counter options is that they lack the protection of an exchange or

clearinghouse. You are effectively relying on the promise of the counterparty to live up to their

end of the deal. If they cant perform, you are left with a worthless promise.

This is especially dangerous if you were using the over-the-counter options to hedge yourexposure to some risky asset or security. (When this happens, its known as basis risk your

hedges fall apart and youre left exposed. That is why the world financial institutions panickedwhen Lehman Brothers failedas a huge investment bank, they were party to countless over-the-counter options that would have entered a black hole of bankruptcy court.)

This is what is referred to in financial regulatory circles as a daisy-chain risk. It only takes afew over-the-counter derivative transactions before it becomes virtually impossible to determinethe total exposure an institution would have to a given event or asset. The problem becomes evenmore complex when you realize that you may be in a position where your firm could be wipedout because one of your counterpartys had their counterparty default on them, making them

insolvent. This is why famed investorWarren Buffetthad referred to unchecked derivatives asfinancial weapons of mass destruction.
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Nature of Exchange