FOREX MARKET

INTRODUCTION TO FOREX AND FOREX DERIVATIVES

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is the largest and most liquid financial market in the world.

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 reexchange (in future) one currency for another, it is called a swap.

Foreign Exchange in Spot and Future

Spot: Foreign exchange spot trading is buying one currency with a different currency for immediate delivery. The standard settlement convention for Foreign Exchange Spot trades is T+2 days, i.e., two business days from the date of trade execution. Forward Outright: A foreign exchange forward is a contract between two counterparties to exchange one currency for another on any date after spot. In this transaction, money does not actually change hands until some agreed upon future date.

Base Currency / Terms Currency:

In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. E.g. the expression Dollar Rupee, tells you that the Dollar is being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms currency.

Continued..

Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis--vis the second currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency.

Functions of Forex Market

Transfer of funds from one nation & currency to another. Why exchange? # Import & Export of goods # Import & Export of services # Tourism # Investment Eg. A US commercial bank has oversupply of pounds, then sell excess pounds, then finally a nation pays for its tourist exp. imports, investments etc.

Participants in Forex Market:

Level 1: Tourists, importers, exporters, investors- immediate users & suppliers of foreign currencies. Level 2: Commercial banks- they act as clearing houses between users and earners, do not actually buy & sell- Retail market

Participants in Forex Market:

Level 3: Forex brokers- They deal with commercial banks. Level 4: Nations central bank: Act as Lender/ Buyer of last resortInterbank market/ wholesale market

Entities in Forex market

Authorised dealers-are commercial banks Money changers- Buy/ sell form customers- deal in notes, coins and travelers cheque.

FEDAI- Forex Dealers Association of India

SWAPS

What are Swaps.?

A foreign exchange swap is a simultaneous purchase and sale, or vice versa, of identical amounts of one currency for another with two different value dates. The two currencies are initially exchanged at the Spot Rate and are exchanged back in the future at the Forward Rate.

Continued

The Forward Rate is derived by adjusting the Spot rate for the interest rate differential of the two currencies for the period between the Spot and the Forward date. FX Swaps are commonly used as a way to facilitate funding in the cases where funds are available in a different currency than the one needed.

DERIVATIVES.

Derivatives means

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner.
The underlying asset can be equity, foreign exchange, commodity or any other asset.

FACTORS DRIVING THE GROWTH OF DERIVATIVES

Growth Driving Factors

Increased Volatility Increased Integration

Derivatives market

Development of Sophisticated Innovations in tools

Improvement in Communication system

Derivatives Product

Forwards Futures Options Swaps

Explanation of various Derivatives products:

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that they are standardized exchange traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction

CURRENCY FUTURES

DEFINITION OF CURRENCY FUTURES

Currency future is a contract to exchange one currency for another currency at a specified date and a specified rate in the future The buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date

Settlement of Currency futures

Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer All settlements however, unlike in the case of OTC markets, go through the exchange.

Calculation of Profit & Loss in Currency Futures

Currency futures are a linear product, and calculating profits or losses on Currency Futures is similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what is the tick value. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers.

FUTURES TERMINOLOGY

spot market. In the case of USD INR, spot value is T + 2. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The currency futures contracts on the NSE have one-month, two-month, three-month up to twelve-month expiry cycles. Hence, NSE will have 12 contracts outstanding at any given point in time.

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

Continued.

Value Date/Final Settlement Date: The last

business day of the month will be termed the Value date / Final Settlement date of each contract. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the Value date / Final Settlement Date. Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. In the case of USDINR it is USD 1000.

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 spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures (in commodity markets) the storage cost plus the interest that is paid to finance or carry the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest.

Types of Margins.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

Advantages of futures
Advantages of Futures
Transparency and efficient price discovery Elimination of Counterparty credit risk

Transparent trading Standardized platform Access to all products types of market participants

Limitations of Futures
Limitations Of futures

Lack of Customization

High Cost

Features of Forex Market

1. Location

Forex market is described as OTC-as there is no physical place of trading. Informal arrangements between banks and brokers 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.

2. Size of the market

Worlds largest Avg daily turnover in April 2004- USD 1.9 trillion. Largest forex market is London, followed by New York, Tokyo, Zurich and Frankfurt. The Rupee is involves in only 0.3% of the transactions taking place in world forex markets. Leading currencies of the world are: US Dollar, Pound-sterling, Euro, Japanese yen and Swiss franc.

3. 24 Hour Market

The markets are situated throughout different time zones of the globe in such a way that when one market is closing the other is beginning its operations. Major markets are situated in Sydney, Tokyo, Zurich, Hong Kong, Chicago and Los Angeles. In India, the market is open for the time the banks are open for their regular banking business. No transactions take place on Saturdays.

4. Efficiency

Developments in communication have largely contributes to the efficiency of the market.

5. Currencies Traded

In most of the markets, the US dollar is the vehicle currency, i.e. the currency used to denominate international transactions. US dollar is involved as one of the currencies in 87% of the transactions followed by Euro (37%), Japanese yen (20%) and Pound Sterling (17%).

Participants

Corporates- They operate by placing orders with the commercial banks. They form the retail segment of the forex market. Commercial Banks- Major players- work for themselves and for their clients.

Participants

Exchange Brokers- They facilitate deals between banks. In the absence of exchange brokers, banks have to contact each other for quotes. Exchange brokers ensure that the most favourable quotation is obtained at low cost in terms of money and time. Central Bank

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 standard practice in the market is to interpret the transaction from the perspective of the market maker (quoting bank) who is the price maker.

Transactions in inter bank markets

Two points to be kept in mind:

The transaction is always talked of from the quoting banks point of view, The item referred to is the foreign currency.

Transactions in inter bank markets

Foreign Exchange Transaction Sale

Purchase
Quoting Bank

Quoting Bank

Acquires Foreign currency

Parts with Home currency

Acquires Home currency

Parts with Foreign currency

Sale and Purchase Transactions

Types of Transactions

Spot transactions Forward transactions Swap Non- deliverable forwards

Quotations in inter bank markets

Two way quotation: It means that the rate quoted by the bank (market Maker) will indicate two prices, one at which it is willing to buy the foreign currency, and the other is at which it is willing to sell it. For ex: USD 1 = Rs. 46.1525/1650 or 1525/1650. Here, the buying rate is also called bid rate and the selling rate is called ask rate / offer rate.

Exchange Rate Quotations:

1.

Direct quote: No. of units of home currency for one unit of foreign currency. eg. Rs 50/ $, means that 50 rupees are required to buy one unit of foreign currency/ dollar.

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 of home currency, how many units of foreign currency 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 per rupee.

The Foreign Exchange Rates

Definition- An exchange rate quotation is 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.

The Foreign Exchange Rates

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

R=2, i.e. R= 2 $/ or R= $/ = 2 i.e. 2 dollars are required to buy one pound.

The Foreign Exchange Rates

X axis- Quantity of pounds Y axis- exchange rate i.e. R R= $/

Analysis:
Lower exchange rate: a) fewer dollars will be required to purchase one pound. b) It will be cheaper for US to import funds from UK. c) Better for us to invest in UK. Therefore, Demand for pound increases.

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 increases.

in US

Analysis:

If exchange rate becomes 3, i.e. R= 3 $/ , means that now three dollars are required to buy a pound thus, depicting Depreciation of US dollar. If exchange rate becomes 1, i.e. R= 1 $/ , means that now one dollar is required to buy a pound thus, depicting Appreciation of US dollar.

Factors that affect the Equilibrium Exchange Rate

1. Relative inflation rates- Eg. R= 2$ / , If inflation in US in higher than in UK, then US goods will be costlier than that of UK goods and therefore, UK will export more goods to US 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.

Factors that affect the Equilibrium Exchange Rate

2. Relative interest rates If real interest rates of US are higher than that of UK, then the dollar is said to have appreciated as compared to pound. Real interest rate = Nominal interest rate Inflation If interest rate of US > int. rate of UK (because of inflation, then wrong picture). Therefore, real interest rate should be considered.

Factors that affect the Equilibrium Exchange Rate

3. Relative economic growth rates: Strong economic growth- attract investment 4. Political & Economic risk: High risk currency- more valuable

Numerator and Denominator

The higher fraction is supposed to be the numerator and the Denominator corresponds to its lower part. Eg. EUR / USD, EUR is the basic currency (Numerator) & USD is the counter currency (Denominator).

Buying and selling a currency

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

Sell / Short EUR/ USD, means that you want to sell the basic currency and buy the counter currency i.e. sell EUR and buy USD.
Short sell

Bid and Ask Rates

A bank is ready to buy and sell a currency at different prices. Buy price- Bid rate Sell price- Ask rate Spread- Difference between Bid and Ask rate is called Bid- ask Spread. It is more in retail market and less in interbank market as there is more volume, greater liquidity and lower counterparty risk in interbank transactions.

Causes of spread are:

Transaction cost Return on capital employed Reward / Compensation for taking risk Mid rate- Arithmetic mean of bid and ask rates i.e. when one rate is mentioned.

Important conventions regarding quotes:

a) The bid rate always precedes the ask rate. E.g Rs/$ 45.45 / 45.50 b) The bid and ask rates are always separated either by slash(/) or (-). c) The quote is always from the bankers point of 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 buy rate= Customers sell rate. d) The Bid is always lower than the ask. (ask rate- Bid rate = profit)

Interbank quote vs Merchant quote

Merchant quote is by bank to its retail customers. Interbank quote is given by one bank to another bank. Since, both the parties are banks, then whose quote will be considered. The bank requesting the quote will is the customer and the other banks quote will be considered.

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 is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security. The relationship between percentage changes and basis points can be summarized as follows: 1% change = 100 basis points, and 0.01% = 1 basis

Basis Point (BPS)

So, a bond whose yield increases from 5% to 5.5% is said to increase by 50 basis points; or interest rates that have risen 1% are said to have increased by 100 basis points.

Cross Rates / Synthetic rates

When we calculate the exchange rates between other currencies with the dollar (or any other currency) as the intermediate currency. The / rate will be calculated through the / $ quote and the $/ quote.

Thank You