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

7

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