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BASIC FOREIGN EXCHANGEDEFINITIONS• 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. An exception is the USD/CAD (USD–Canadian Dollars) currency pair which settles T+1.
• Forward Outright: A foreign exchange forward is a contract between two counterparties to exchange one currency for another on any day after spot.• The duration of the trade can be a few days, months or years.
Base Currency / TermsCurrency• In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency.• Eg. The expression US Dollar–Rupee, tells you that the US Dollar is being quoted in terms of the Rupee. The US Dollar is the base currency and the Rupee is the terms currency.• 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-à-vis the other currency.
CONTD…• Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency.• Eg. If US Dollar–Rupee moved from 43.00 to 43.25, the US Dollar has appreciated and the Rupee has depreciated.
SWAPS• A foreign exchange swap is a simultaneous purchase and sale, or sale and purchase, of identical amounts of one currency for another with two different value dates.• Foreign Exchange 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.
• Foreign Exchange - The exchange rate is a price - the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency.• A foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian Rupees (INR) is, broadly speaking, “foreign exchange.
Contd…• Foreign Exchange can be cash, funds available on credit cards and debit cards, travellers’ cheques, bank deposits, or other short-term claims.• Foreign currencies are usually needed for payments across national borders.• The exchange rate is a price - the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency.
Contd….• The participants in the foreign exchange market are thus a heterogeneous group.• The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years.• The exchange rate important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much more.
• The US Dollar is by far the most widely traded currency.• The market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other.• The vehicle currency used most often is the US Dollar, although very recently euro also has become an important vehicle currency.
• Thus, a trader who wants to shift funds from one currency to another, say from Indian Rupees to Philippine Pesos, will probably sell INR for US Dollars and then sell the US Dollars for Pesos.• The US Dollar took on a major vehicle currency role with the introduction of the Bretton Woods par value system, in which most nations met their IMF exchange rate obligations by buying and selling US Dollars.
• The Euro: Like the US Dollar, the Euro has a strong international presence and over the years has emerged as a premier currency, second only to the US Dollar.• The Japanese Yen : The Japanese Yen is the third most traded currency in the world. It has a much smaller international presence than the US Dollar or the Euro. The Yen is very liquid around the world, practically around the clock.
• The British Pound: Until the end of World War II, the Pound was the currency of reference. The nickname Cable is derived from the telegrams used to update the GBP/USD rates across the Atlantic. The currency is heavily traded against the Euro and the US Dollar.• The Swiss Franc : The Swiss Franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries.
Currency Derivatives inIndia• Launched on 29th August 2008 on NSE.• Launched on 7th October 2008 on MCX- SX.• Launched on 14th October 2008 on BSE.• Current Daily average turnover is Rs. 4500 crore, on each NSE & MCX-SX. ( last year the figure was only Rs. 300 crore).• July 6th 2009, was the most active day, to hit the total turnover of Rs. 11,600 crore from 24 lakh contracts.
CURRENCY FUTURES• A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price.• In other words, it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future.• For example:
TERMINOLOGY• Spot price• Future price• Contract cycle• Value date• Expiry date• Contract size• Basis• Cost of carry• Initial margin• Marking to market
INTEREST RATE PARITY AND PRICING OF CURRENCY FUTURES RINKU JAIN
Interest Rate Parity• Interest rate parity is a non-arbitrage condition• If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.
DERIVATION OF FUTURERATE FROM SPOT RATE• The price of future can be derived by following: Term : Base Formula Spot-Forward r& p Formula Continuous Compounding Formula
Term: Base Formula • Forward = Spot + Points Points =Spot 1 + terms i * days basis _1 1 + base i * days basis i = rate of interestbasis = day count basis(Most currencies use a 360-day basis, except the pound sterling and a fewothers, which use a 365-day year.)
• Long position in a currency futures contract without any exposure in the cash market is called a speculative position.• If the exchange rate strengthens Profit• If the exchange rate weakens Loss
Observation: The trader has effectively analysed the market conditionsand has taken a right call by going long on futures and thus has made again of Rs. 1,880.
SHORT POSITION IN FUTURES• Short position in a currency futures contract without any exposure in the cash market is called a speculative transaction. If the exchange rate weakens Profit If the exchange rate strengthens Loss
Observation: The trader has effectively analysed the marketconditions and has taken a right call by going short on futures andthus has made a gain of Rs. 362.50 per contract with smallinvestment (a margin of 3%, which comes to Rs. 1270.80)in a span of 6 days.
HEDGING USING CURRENCYFUTURESA hedger has an Overall Portfolio (OP)composed of (at least) 2 positions:1. Underlying position2. Hedging position with negative correlation with underlying position
Types of FX Hedgers usingFutures• Long hedge• Short hedge
The proper size of the Hedgingposition• Basic Approach: Equal hedge• Modern Approach: Optimal hedge
Long Futures Hedge Exposed to theRisk of Strengthening USD
Short Futures Hedge Exposed tothe Risk of Weakening USD
TRADING SPREADS USINGCURRENCY FUTURESSpread movement is based on following factors:• Interest Rate Differentials• Liquidity in Banking System• Monetary Policy Decisions (Repo, Reverse Repo and CRR)• Inflation
• Intra-Currency Pair Spread• Inter-Currency Pair Spread• Example
ARBITRAGE• Arbitrage means locking in a profit by simultaneously entering into transactions in two or more markets. If the relation between forward prices and futures prices differs, it gives rise to arbitrage opportunities.• Difference in the equilibrium prices determined by the demand and supply at two different markets also gives opportunities to arbitrage.
• Example – Let’s say the spot rate for USD/INR is quoted @ Rs. 44.325 and one month forward is quoted at 3 paisa premium to spot @ 44.3550 while at the same time one month currency futures is trading @ Rs.44.4625. An active arbitrager realizes that there is an arbitrage opportunity as the one month futures price is more than the one month forward price.
Clearing mechanism• It involves working out open position and obligations of CM• This position is considered for exposure and daily margin purposes• The open positions of Clearing Members (CMs) are arrived at by aggregating the open positions of all the TMs and all custodial participants clearing through him, in contracts in which they have traded.• TMs are required to identify the orders, whether its proprietary or client based
Determinant of open position of a clearing member
Settlement mechanism• Settlement of futures contract1) Mark to market settlement P/L are computed as the difference between trade price and day’s settlement price during that day which are not squared up The previous day;s settlement price and today’s settlement price if the contract is b/f Buy/sell price of the contract if it is squared up
Contd…2) Final settlement: On the last trading day of the futures contracts, after the close of trading hours, the Clearing Corporation marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash
Settlement price of a futurecontract• Daily settlement price on a trading day is the closing price of the respective futures contracts on such day• Last half an hour weighted average price of the contract• The final settlement price is the RBI reference rate for the last trading day of the futures contract• All open positions will be mark to market on the final settlement price
Risk management measures• The financial soundness• Initial margin• Open positions are MOM based• Members positions are based on• Separate settlement guarantee funds are created
Margin requirements• Initial margin• Portfolio based margin• Real time computation• Calendar spread margins• Extreme loss margin• Liquid net worth• MOM settlement
Over the counter OptionsMarket Used mainly by Multinational companies and large commercial international banks. Options are frequently written for U.S dollars against Pound Sterling, Deusche Marks, Swiss francs, Canadian Dollar, Euro,etc. Maturity ranges from 2 to 6 months. Divided into subparts: Retail Market and Wholesale Market
Limitations faced Market is relatively illiquid because of its tailor made nature Contracts are not standardized because of which there is lack of secondary market operators. Counter party risk Mispricing
Exchange-traded currencyoptions First trading commenced in 1982 by Philadelphia Stock Exchange(PHLX). In June 1987, Currency Exchange Warrants (CEW) were introduced on American Stock Exchange (AMEX) with long maturity exceeding 1 year. In February 1988, CEWs traded in AMEX had foreign currency put options with 5 years to expiration.
Basics of Currency Options Call Option: Option to buy foreign currency Sell Option: Option to sell foreign currency
Price element Exercise or Strike Price: Rate at which foreign currency can be bought and sold Premium: Which is the cost or price of the option itself Underlying or Actual Spot exchange rate: Rate in the currency market exists on exercise date.
Types American Options: Can be exercised at any time between the writing date and expiration date. European Option: Can only be exercised at the expiration date and not before this date. Mostly popular in Switzerland and Germany.
Determinants of the currency option value Changes in forward rate Changes in spot rate Time to Maturity Impact of changing volatility Changes in interest rate differential Alternative option strike price
Changes in Forward Rate(Sensitivity)• The standard foreign currency is priced around the forward rate.• It gives an idea how the future rate will move because the forward rate is determined after considering the interest rate differential of both the currencies• Forward rate also provides information to the trader to manage the position
Spot Rate Changes (Delta)• It has direct impact on the time value of the option• As long as the option has time remaining the option will posses the time value element• The sensitivity of the option premium to a small change in the spot exchange is called as delta
For Example• The change in the spot rate is $1.70 to $1.72 and also assume that option premium changes from $0.038/£ to $0.032/£ Delta=ΔPremium = 0.038-0.032= 0.60 Δspot rate 1.72-1.76
Time To Maturity(Theta)• Longer the period to maturity the greater will be the option value.• This relation is referred as Theta.• Rule of thumb is trader will normally find longer maturity options better value, giving the trader to alter an option position without suffering Time value deteriotion.
Impact of changing volatility(Lambda)• Volatility in the context of option may be defined as The standard deviation of daily percentage changes in the underlying exchange rate.• If exchange rate volatility increases then risk in option increases.• It will result in increase in option premium.
Example• Option has annual volatility of 10.5%, soDaily volatility = Annual volatility/√365. = 10.5/19.105 = 0.55%.Lambda = Δpremium Δvolatility.Thumb rule- Traders who believe volatility will fall, will sell options and buy-back for a profit after volatility falls and cause option premium to fall.
Changes in interest ratedifferentials. (Rho and Phi)• The expected change in option premium from a small change in domestic interest rate is called Rho• The expected change in option premium from a small change in Foreign interest rate is called Phi
formulaRHO = Δ Premium Δ Re interest ratePHI= Δ Premium Δ Foreign interest rateRule of thumb- A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises.
Alternative strike price andoption premiums• The most important thing in option valuation is the availability of alternative strike price In the market and finally selecting the same.• How to choose?• This is determined by exercising various strike prices and respective option premium at each strike price. The option which has more option premium will be selected and then finally a final strike price will be selected.