Post on 06-May-2015
transcript
Foreign Exchange Market
Presented ByK.PRABHAKARAN
ASSISTANT PROFESSOR-FINANCERVS FACULTY OF MANAGEMENT
COIMBATORE
• A foreign exchange transaction is an agreement between a buyer and a seller that a given amount of one currency is to be delivered at a specified rate for some other currency.
• The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies.
Foreign Exchange
Foreign Exchange Definition
Forex Transacti
on
Import & Export
Inter bank Settlement
Investment Avenues Abroad
Tourism, Education,
etc
FeaturesLargest financial market
in the world with average daily turnover
of approximately $5 trillion
Dominated by large Multinational banks, Central banks, Hedge
funds & Currency Brokers
Round the clock market starting from Sydney, Tokyo,
Honk Kong, Singapore, Bahrain, London, New York.
Almost open 24hours x 5 days
The forex market is greater than the stock market. It is 75 times greater than the combined volumes at New
York Stock Exchange
Important facts about Indian Rupee
• Indian Rupee is partially convertible currency
• There is a maximum limit on conversion of Rupee• India has floating Exchange rate with active participation of RBI• INR is fast emerging as a major South East Asian Currency
Convertibility
Current Account1. Imports & Exports
2. Tourism , employment, study etc.
Capital Account1. Investments and loans
2. Strict rules & regulations
Transactions• Spot
– Immediate delivery is the basis– Standard settlement is T+2 days– USD-CAD is exception settles on T+1 day
• Forward– Contract of exchange between two parties for a future date– Any transaction settling more than T+2 days
Settlement date / Value date
•Trade date•Trade date + 1•Trade date + 2•Trade date + 3 or any later date
Term Used•Value cash•Value Tom•Spot•Forward
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The foreign exchange market is the mechanism by which participants:
– transfer purchasing power between countries;
– obtain or provide credit for international trade transactions, and
– minimize exposure to the risks of exchange rate changes.
Functions of FX Market
Participants in Forex Market
• The major participants in the foreign exchange market are central banks, like the U.S. Federal Reserve and European Central Bank, large financial institutions like commercial and investment banks, multinational corporations, and investors of varying shapes and sizes.
Participants at 2 Levels1. Wholesale Level (95%)
- major banks2. Retail Level
- business customers.
Indian Foreign Exchange Markets - Participants
• Fundamental factors• Interest rates• Inflation rate• National Income • Exchange rate policy • Central Bank interventions• Balance of Payments • Government Intervention• Technical factors• Political factors• Speculation
Factors Affecting Exchange Rates
Derivatives • A derivative is a financial instrument whose
return is derived from the return on another instrument.
• 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, forex, commodity or any other asset.
Basic Purpose Of Derivatives
• In derivatives transactions, one party’s loss is always another party’s gain
• The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance
• If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant
• Derivatives improve overall performance of the economy
Growth Drivers of Derivatives
• Increased volatility in financial markets• Increased integration of national & international financial
markets• Improvement in communication facilities & decrease in
transaction costs• Development of sophisticated risk management tools providing
better risk management strategies• Innovation in the derivatives market leading to higher returns,
reduced risk & reduced transaction cost compared with other financial markets
Ways Derivatives are Used• To hedge risks• To speculate (take a view on the future direction
of the market)• To lock in an arbitrage profit• To change the nature of a liability• To change the nature of an investment without
incurring the costs of selling one portfolio and buying another
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Actors in the Market
• There are three broad categories of market participants:
• Hedgers• Speculators• Arbitrageurs
Actors in the Market
• Hedgers Hedgers trade with an objective to minimize
the risk in trading or holding the underlying securities. Hedgers willingly bear some costs in order to achieve protection against unfavorable price changes.
Actors in the Market
• Speculators Speculators use derivatives to bet on the
future direction of the markets. They take calculated risks but the objective is to gain when the prices move as per their expectation.
Actors in the Market
• Arbitrageurs Arbitrageurs try to make risk-less profit by
simultaneously entering into transactions in two or more markets or two or more contracts.
For example, they try to benefit from difference in currency rates in two different markets. They also try to profit from taking a position in the cash market and the futures market.
Types of Derivatives
Futures: Buy or sell an asset at a date specified at the price prevailing currently.Options: Right to Buy or sell shares but not an obligation to buy or sell.
Forwards: A Contract were settlement takes place at the future date at current prevailing price on the day the agreement has been made.Swaps: Private agreements between 2 parties to exchange Currencies in the future.
Futures• Futures contracts are also agreements to buy or
sell an asset for a certain price at a future time.• futures contracts are exchange traded and are
more standardized. • They are standardized in terms of contract sizes,
trading parameters, settlement procedures and are traded on a regulated exchange.
• The contract size is fixed and is referred to as lot size.
Options
• A currency option provides the buyer with the right but not the obligation, to buy or sell a set amount of currency at an agreed exchange rate, known as the “strike price” or the “exercise price”.
• Strike price: agreed upon price for buying or selling.
• There are two basic types of options are American & European options.
• American Option American options are options contracts that can be
exercised at any time upto the expiration date. Options on individual securities available at NSE are American type of options.
• European Options European options are options that can be exercised only
on the expiration date. All index options traded at NSE are European Options.
TYPES OF OPTIONS
TYPES OF OPTIONS
• Call option: A call option gives the option buyer the right to buy an agreed amount of the specified currency at the strike price.
• Put option: A put option gives the option buyer the right to sell an agreed amount of the specified currency at the strike price.
Forward Contracts Forward contracts are agreements to exchange
currencies at an agreed rate on a specified future date. The actual settlement date is more than two working days after the deal date. Forward contracts are bilateral contracts (privately negotiated), traded outside a regulated stock exchange and suffer from counter -party risks and liquidity risks.
SwapsA swap is the exchange of one set of cash flows for another on a
future date. In simple terms Swaps means exchange of obligation in two different currencies.
Indian Company having operations in USA
US Company having operations in India
Agrees to pay $100000 over next one year
Agrees to pay 6200000 Rs over next one year
Obligation of $100000 over next one year
Obligation of Rs 6200000 over next one year
Company A Company B
Both parties having similar obligation but susceptible to exchange rate risk. These two parties will eliminate the risk by entering into a swap
Prevalent Exchange Rate 1USD= 62 Rs
Swap Transactions: Illustrations
Firm Objective Fixed interest Floating interest ratesX Fixed rate 10.75% LIBOR +0.50%Y Floating rate 10.00% LIBOR +0.25%
From the above table: Cost of borrowing → Firm Y < Firm X in both the markets. The difference is called quality spread.
Fixed marketFloating Market
10.75% - 10.00% = 0.75%LIBOR +0.50% - (LIBOR +0.25%) =0.25%
Paid to counterparty Received from counter party
Paid to Market Net Cost Savings
X
Y
LIBOR
10%
10%
LIBOR
10%
LIBOR +0.50
LIBOR
10.50%
LIBOR + 0.25% Minus LIBOR
10.75% Minus 10.50%
X
MarketMarket
Y
Fixed Rate 10.00%
LIBORLIBOR + 0.50
Fixed Rate 10%
Swap Arrangement
Types of Swaps
Currency SwapsSwapping both
principal & interest between the parties in two
different currencies
Interest Rate Swaps
Swapping only the interest
related cash flows between the parties of the
same currency
Swaptions:• Options to buy or sell a swap. Two types receiver & payer swaptions.•Receiver swaptions: received fixed and pay floating•Payer swaptions: pay fixed receive floating
Key Points of Swaps• Foreign exchange becomes necessary for import and export• SDR is the monetary unit of IMF• Dollar Index is weighted index to show the movement of dollar
against six major currencies. Euro, GBP, Yen, CHF,CAD and SKE• Floating Exchange rate is where market forces determine price.
Most countries have adopted this.• Fixed Exchange rate is where central authority fixes the rate.• Market participants are Investors, Speculators. Hedgers,
Arbitrageurs
Spreads
• Spreads involve taking advantage of the price difference between two different contracts of the same commodity.
• Spreading is considered to be one of the most conservative forms of trading in the futures market, because it is much safer than the trading of long / short futures contracts
FORWARD vs. FUTURE CONTRACT
Nature Customised Standardised Contract
Trading OTC Through Exchange only
Liquidity Less Liquid Highly Liquid
Counter Party
Risk Negligible
Settlement Delivery Offset or thro delivery
Margin No Margin System
Compulsorily needs to be paid & perform
Mark to Market
Not Marked to Market
Marked to Market on Daily basis
OTC vs ETFOver The Counter Exchange Traded Funds
Accessibility Low High
Price Transparency
Low High
Liquidity Subject to credit limits High
Agreements Customized Standard
Credit Exposure
Yes Mitigated through the clearing corporation
Settlement Physical Delivery Net Settled in INR
Underlying exposure
Required Not required
• Commodities Derivatives Ex: Gold Futures, Silver Futures, Crude oil Futures• Equity Derivatives Ex:Stock Future,Stock Options, Index Future, Index
Options• Currency Derivatives Ex:Currency Futures& Currency Options• Interest Rate Derivatives Ex: Interest Rate Futures
Categories of Derivatives Traded In India
Index Futures contracts introduced in June 2000.
Index Options introduced in June 2001.Stock Options introduced in July 2001.Commodity Futures contracts Introduced in
2003.Currency Futures introduced in August 2008.Interest rate Futures introduced in August 2009.Currency Options introduced in October 2010.
Recent Developments on Derivatives Trading in India
Major Currencies of the WorldUS Dollar
Most widely used in the world, also know as reserve currency
Vehicle currency as it is the most liquid currency
Know as greenback in forex lingo
EuroCommon currency for 16
European nationsEmerged as the most traded in recent times next to US dollar
Japanese YenThird most traded currency,
highly liquidLarge business volume between
Japan & USA in the primary reason for the popularity of YEN
British PoundOnce heavily traded has
lost to dollar after second world war
Nick named Cable
Major Currencies of the World• The most traded currency pairs in the world are called the Majors , it includes following : These
currencies follow free floating method of valuation.– Euro (EUR)– US Dollar (USD)– Japanese Yen (JPY)– Pound Sterling (GBP)– Australian Dollar (AUD)– Canadian Dollar (CAD) and the – Swiss Franc (CHF).
Market Share of Currency pairs in world market:
Currency Market Share %
EURUSD 28
USDJPY 14
GBPUSD 9
AUDUSD 6
USDCHF 4
USDCAD 5
USD/Others 18
Others/ Others 16
TOTAL 100
• US Dollar• Euro• Japanese yen• Pound
Currencies Derivatives in NSE
Product Specifications: NSE Traded Currency Futures
Category Description
Trading Hours 9:00 am to 5:00 pm
(Monday to Friday on all business days)
Contract Months 12 near calendar months
Last Trading Day Two business days prior to
last business day of the month.
Final Settlement Day
Last working day of the month
Settlement INR cash settled at RBI reference rate
Holiday Calendar Mumbai-Interbank
o Order driven market
o Revised methodology of computation and dissemination of Reference rate: Rates will be polled in a 5 minute window from 11:45 AM to 12:15 PM chosen randomly
o Expiry at 12:15PM
Features of Currency PairsUSD-INR EUR-INR GBP-INR JPY-INR
Quotation
Rate of exchange
between 1 USD and INR
(USDINR)
Rate of exchange between 1 EURO
and INR (EUR-INR)
Rate of exchange
between 1 GBP and INR (GBP-
INR)
Rate of exchange
between 100 JPY and INR
(JPY-INR)
Contract Size USD 1000 EURO 1000 GBP 1000 JPY 100000
Calendar Spread Margin
Rs. 400 for a spread of 1
month; Rs 500 for a spread
of 2 months, Rs 800 for a spread
of 3 months
Rs.700 for spreadof 1 monthRs.1000 forspread of 2
monthsRs.1500 forspread of 3
months or more
Rs.1500 forspread of 1
monthRs.1800 forspread of 2
monthsRs.2000 forspread of 3
months or more
Rs.600 for spread
of 1 monthRs.1000 forspread of 2
monthsRs.1500 forspread of 3
months or more
Product Specifications: Exchange Traded Currency Options
Category Description
Type of Option Premium Styled European Call and Put Options
Trading Hours 9:00 am to 5:00 pm
(Monday to Friday on all business days)
Permitted Lot Size One lot denotes $ 1000
Tick Size 0.25 paisa or INR 0.0025
Contracts Available Three serial monthly contracts followed by three quarterly contracts of the cycle March/June/September/December
Last Trading Day Two business days prior to last business day of the month
Final Settlement Day Last working day of the contract month (Excluding Saturdays)
Settlement INR cash settled at RBI reference rate
Holiday Calendar Mumbai-Interbank
Trading Strategies – Directional views
View: INR will depreciate against USD, caused by India’s sharply rising import bill and poor FII equity flows
Trade:USDINR 31 Dec contract : 63.50Current Spot rate (08 Nov 13): 62.70Buy 1 Dec contract : Value Rs. 63.50 (USD 1000 *63.50)Hold contract to expiry: RBI fixing rate – 64.00Economic return : Profit, Rupees 500 (64.00 – 63.50)
Long position in FuturesSpeculative long positions in currency futures market means buying futures contract without any exposure in the cash market
Illustration On 1st November 2013 mr X a currency trader expects that dollar will strengthen against the rupee in the coming months. He decides to go long and buys one December USD-INR contract at 63.50 & he wants to hold the contract till expiry. The market moves as his anticipation and the Dollar strengthens against the rupee and the RBI reference rate moves to USD-INR 65.50 on 31st December.
Date Contract Rate
!st November 2013 USD-INR December Futures
63.50
27th December 2013 USD-INR December Futures
65.50
Profit = Sell – Buy Price x lot sizeProfit = ( 63.50 – 65.50) x 1000Profit = Rs 2000
Short position in Futures Speculative short positions in currency futures market means selling futures contract without any exposure in the cash market
Illustration On 1st November 2013 mr A a currency trader expects that dollar will weaken against the rupee in the coming months. He decides to go short and sells one December USD-INR contract at 66.50 & he wants to hold the contract till expiry. The market moves as his anticipation and the Dollar depreciates against the rupee and the RBI reference rate moves to USD-INR 64.50 on 31st December. Mr A decides to square his position and makes a profit of Rs 2000 (65.50 – 63.50x 1000).
Date Contract Rate
1 st November 2013 USD-INR December Futures
66.50
27th December 2013 USD-INR December Futures
64.50
Profit = Buy – Sell Price x lot sizeProfit = ( 66.50 – 64.50) x 1000Profit = Rs 2000
Hedging means taking a long positions in futures market that is opposite to the position in the physical market in order to reduce risk associated with exchange rates. The overall portfolio of a hedger consists of the following two positions:
• Underlying Position•Hedging position which is totally opposite to underlying positions
Types of Hedge
Long HedgeUnderlying Positions : short in foreign
currency Hedging Positions: Long in Currency futures
Short HedgeUnderlying Positions : Long in foreign
currency Hedging Positions: Short in Currency
futures
Hedging using Currency Futures
ArbitrageArbitrage can potentially exist between, currency futures, OTC forwards and the non-deliverable forwards traded offshore
An arbitrage can be executed by an entity having access to any two of the above
Corporate entities with an underlying exposure, can straddle both marketsSell 1st month in currency futuresBuy 1 month forward in OTC markets
This scenario can exist when currency futures are trading higher than forwards which will also be governed by interest rate differentials and USD supply with banks
Restricted access to the OTC and NDF markets could translate to the arbitrage gap not closing
Trading
Clearing, Settlement & Risk Management
Mark to Market:• Online real time calculation• Maximum 75% of total deposit allowed to be lost• Warning given at 60%, 75% and 90% of breaching this limit• On utilizing the 75% limit member is suspendedPosition Limit:• To avoid huge built up of positions• Monitored at day end• Monitored at both client level and member level• Violation of limits used for further surveillance• CM accountable for TM violation• TM accountable for Client violationLimits:• Client level = 10 million USD or 6% of all open positions whichever is higher• Exchange disseminates warning when 3% crossed for any client• Non Bank Member = 50 Million USD or 15%• Bank Member = 100 million USD or 15%• Clearing member = no separate limits
Clearing, Settlement & Risk Management
• Clearing Corporation (CC) undertakes clearing & settlement• Acts as legal counter party to all trades• This is called NOVATION• Guarantees financial settlement
Clearing & Settlement includes:1. Clearing2. Settlement3. Risk Management
Clearing Entities:Clearing Members = TCM and PCM clear trades. For each additional TM under them they
have to bring additional depositClearing Banks = Used for Funds settlement
Each member required to open an account with Clearing Bank
Clearing and Settlement -MTM
• Daily marked to market(MTM) Settlement• Netted MTM settlement on T+1• End of day open positions MTM @ daily
settlement price(DSP)• Through clearing member’s settlement
account
FOREIGN EXCHANGE MANAGEMENT ACT-1999
• The Foreign Exchange Management Act (FEMA) was an act passed in the winter session of Parliament in 1999 which replaced Foreign Exchange Regulation Act.
• FEMA has brought a new management regime of Foreign Exchange consistent with the emerging framework of the World Trade Organisation (WTO).
BROAD STRUCTURE OF FEMA
• It mainly deals with matters pertaining to foreign exchange
• All current account transactions are free However, Central government can impose restrictions by issuing rules. S.3
• Capital accounts transactions are permitted to the extent specified by RBI regulations s.6
• RBI controls management of foreign exchange• Since it cannot directly deal with foreign exchange it
authorises” authorised persons ” to deal in foreign exchange according to RBI Regulations s.10
• RBI issues directions to such persons u/s.11• These directions are issued through AP(DIR) circulars.
Authorised Persons (Directions)
Thank You
Email Id: praba_mba2003@yahoo.co.inMobile No:9965466999