FOREIGN EXCHANGE MARKET

INTRODUCTION
Foreign Exchange

Foreign Exchange refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his own nations currency for money denominated in another nations currency acquires foreign exchange. The exchange rate is a price - the number of units of one nations currency that must be surrendered in order to acquire one unit of another nations currency.

INTRODUCTION

The foreign exchange market is the largest and most liquid financial market in the world. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The primary purpose of the foreign exchange market is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import European goods and pay Euros, even though the business's income is in US dollars.

INTRODUCTION

Risk Defined as the volatility of unexpected events Currency Risk Risk that the exchange rate will move in the direction

adverse

For example: If the exchange rate of the currency moves higher the exporter would gain and if the exchange rate dips, then the importer would be benefited

INTRODUCTION

What is Exchange rate? The units of one currency that a person has to pay to obtain a single unit of the other currency. Exchange rate is that rate at which one currency is converted to another currency What is Volatility? A statistical measure of the tendency of a market or security to rise or fall sharply within a period of time

INTERNATIONAL FOREX MARKET

Largest and most liquid in the world Daily turnover of $ 4 Trillion Main trading centers are : London (38%), New York (22%), Tokyo (10%) Singapore (9%) Over 85% of all FX transactions involve 7 major currencies. Market never sleeps and has its own rhythm ( 24/7 ) Starts in Sydney and ends in St. Francisco

INTERNATIONAL FOREX MARKET

Major currencies of the world

The US Dollar: The US Dollar is by far the most widely traded currency. The widespread trading of the US Dollar reflects its use as a vehicle currency in foreign exchange transactions. The Euro: Like the US Dollar, the Euro has a strong international presence & over the years has emerged as a premier currency second only to the US Dollar. The Japanese Yen: The Japanese Yen is third most traded currency in the world. The Yen is very liquid around the world, practically around the clock. The British Pound: The currency is heavily traded against the Euro and the US Dollar, but it has spotty presence against other currencies. The Swiss Franc: Although the Swiss economy is relatively small, the Swiss Franc is one of the major currencies, closely resembling the strength and quality of the Swiss economy and finance

FACTORS INFLUENCING RATE OF EXCHANGE

Inflation rates Interest rates Trade Balance ( EXIM ) Volume of international reserves with central bank Attractiveness of domestic investment environment (Stock Market) Economic Indicators Global Currency Movement RBI Reference Rate Crude Oil

Inflation Rates

If domestic inflation rate >foreign inflation rateDomestic goods are costlier than foreign goods It encourages import of foreign goods Foreign goods are cheaper More demand for foreign currencies Foreign currencies are costlier Decline in the value of domestic currencies

Interest Rates

Change in interest rates by Reserve Bank of India Interest rates change by Federal Reserve (USA) Expectation of change in interest rates

Inflows of Foreign Funds

Strong economic fundamentals attract funds into the country Political stability and clear economic direction Country specific ratings based on economic indicators

Economic Indicators

Buy sell decisions can be triggered by just a single statistic Source of statistic can be both national and international Numerous economic indicators are released every day Economic Indicators have a unique relationship in the manner in which they impact markets

RBI Interaction
A tool in the hands of the government

To meet long term economic objectives of growth and full employment. Volume of Reserves with central banks

The reserve supports or stabilizes whenever currency depreciates. Release or sell foreign exchange reserves so that demand for foreign met so further devaluation is reduced. The monetary authority can with stand only to the extend to the reserves in hand.

INDICATORS FOR DAY TRADING

USD movement against other currencies Asian Equity Markets Hang Sang, Nikkei etc. SGX Nifty $ index Indian Equity Market RBI Reference Rate JPYINR, EURINR, Korean Won Dow Jones Futures Above All the best tool available for trading is Ticker Plant

USDINR VS SENSEX

SENSEX

USD INR

USDINR VS CRUDE

TYPES OF MARKETS
Spot

market Forward market Derivatives markets : currency futures & options

FUTURES MARKET

Currency futures market is of recent origin (1972) at CME Size and maturity of contracts are standardized Transactions made with the help of brokers through the clearing house Margin deposit and daily marking to the market Hedging: to reduce risk
  

Hedge against forex exposure Hedge against equity exposure Hedge against commodity exposure

Provide a platform to retail segment of the market

FOREX TERMINOLOGIES

Base currency/ Quote currency: Base currency is the first currency in the currency pair & the second currency is called the term currency or the quote currency. Exchange rates are quoted in per unit of base currency. Bid Price/Ask Price: All Forex quotes include a two-way price, the bid and ask. The bid is always lower than the ask price. The bid is the price in which the dealer is willing to buy the base currency in exchange for the quote currency. This means the bid is the price at which you (as the trader) will sell. The ask is the price at which the dealer will sell the base currency in exchange for the quote currency. This means the ask is the price at which you will buy.

FOREX TERMINOLOGIES

Concept of Cross Rates The Indian rupee is directly quoted only to the US dollar

Now-a-days, it is also quoted directly against Euro The exchange rate between the rupee and any third currency is a derived rate It is a function of the dollar rupee rate and the exchange rate between the dollar and the third currency

FOREX CROSS RATE CALCULATION

Example I

EUR/USD

USD/INR

1 = $ 1.2650

$1 = Rs 50.27

=
1 = Rs 63.59

EUR/INR

EXCHANGE RATE MOVEMENTS

USD/INR current rate 50.27

50.27

USDINR

49.80

This would mean that US dollar has appreciated against the rupee, and that Rupee has depreciated against the dollar

Forex Terminologies
Spreads :

What is spread? Difference in price of two future contracts. A spread involves buying one futures contract in one month and simultaneously selling another futures contract of a different month. The purpose is to profit from an expected change in the relationship between the purchase price of one and the selling price of the other.

Strategy - Spreads

Spreads between different contracts within the Exchange If expressed view is Difference to move up Trader can : Sell near month in currency futures. Buy far month in currency futures. To square off both later If expressed view is Difference to move down Trader can : Buy near month in currency futures. Sell far month in currency futures To square off both later

FOREX TERMINOLOGIES
Long/Short

First, you should determine whether you want to buy or sell. If you want to buy (which actually means buy the base currency and sell the quote currency), you want the base currency to rise in value and then you would sell it back at a higher price. In trader's talk, this is called "going long" or taking a "long position". Just remember: long = buy. If you want to sell (which actually means sell the base currency and buy the quote currency), you want the base currency to fall in value and then you would buy it back at a lower price. This is called "going short" or taking a "short position". Short = sell.

FOREX TERMINOLOGIES

Concept of Value Dates

FOREX TERMINOLOGIES

Value Cash: Cash rate or the ready rate is the rate when the exchange of currencies takes place on the same day. In this case the delivery of the currencies is on the date of the deal itself Value Tomorrow: When the exchange of currencies takes place on the next working day i.e. tomorrow, the rate is called as tom rate and the Value date in this case is tomorrow or the next working day Spot: In a spot transaction the exchange of currencies takes place on after two working days from the date of the deal. The interbank rates quoted by banks are for the value spot Example: The spot date in case of Dollar/Rupee for Monday is Wednesday i.e. a deal done on Monday is settled on Wednesday and the spot date for Friday is Tuesday. In case of a holiday in USA, the spot date is the next working day Forward Outright : Forward Contract are contracts to purchase or sell currencies at a future specified date (beyond spot), at a rate negotiated at the time of entering the contract

FOREX TERMINOLOGIES

Nostro Account: Account one bank holds with a bank in a foreign country, usually in the currency of that foreign country Example: SBI (Mumbai) having an USD A/C with BoA (New York) UBI having a EURO A/C with Dresdner Bank (Frankfurt) Vostro Account: Vostro Account is a local currency account maintained by a local bank for a foreign (correspondent) bank. For the foreign bank it is a nostro account Example: JPM having Rupee A/C with SBI (Mumbai)

FOREX TERMINOLOGIES
Bid Ask
Banks selling rate

European Method (Direct)

Exchange Rate expressed in local currency in terms of per unit of Foreign Currency.

Banks buying rate

USD/INR USD/JPY

50.27 92.95

50.28 92.97

American Method (Indirect)

Exchange Rate expressed in foreign currency in terms of per unit of Local currency.

EUR/USD 1.2597 GBP/USD 1.4830 AUD/USD 0.6390 NZD/USD 0.5284

1.2599 1.4833 0.6394 0.5294

FOREX TERMINOLOGIES

Pips / Big Figures

EUR/USD 1.2650 / 55
Big Figure Pips

Here last two digits are considered as pips. For example: If Euro moves from 1.2650 to 1.2658, it is considered as euro has appreciated by 8 pips against USD The third digit is considered as big figure For example: If Euro moves from 1.2650 to 1.2750, then it is said that euro has appreciated by 1 big figure against USD

FOREX TERMINOLOGIES
Lots:

Spot Forex is traded in lots. The standard size for a lot is 100,000 units. There is also a mini lot size and that is 10,000 units. As you already know, currencies are measured in pips, which is the smallest increment of that currency. To take advantage of these tiny increments, you need to trade large amounts of a particular currency in order to see any significant profit or loss. Lets assume we will be using a 100,000 unit (standard) lot size. We will now calculate to see how it affects the pip value. USD/JPY at an exchange rate of 119.80 (.01 / 119.80) x 100,000 = $8.34 per pip

FOREX TERMINOLOGIES
Leverage

In Forex trading, a small margin deposit can control a much larger total contract value. Leverage gives the trader the ability to make nice profits, and at the same time keep risk capital to a minimum.

For example, if the leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, you broker would set aside $1,000, or the "margin". So if you have $5,000 they may allow you to trade up to $500,000 of Forex.

FOREX TERMINOLOGIES
Margin Call

In the event that money in your account falls below margin requirements (usable margin), your broker will close some or all open positions. Example : Lets say you open a regular Forex account with $2,000. You open 1 standard lot (100,000 units) of the EUR/USD, with a margin requirement of $1000. Usable Margin is the money available to open new positions or sustain trading losses. Since you started with $2,000, your usable margin is $2,000. But when you opened 1 lot, which requires a margin requirement of $1,000, your usable margin is now $1,000. If your losses exceed your usable margin of $1,000 you will get a margin call.

 

FOREX TERMINOLOGIES
Rollover

For positions open at your broker's "cut-off time" usually 5pm EST, there is a daily rollover interest rate that a trader either pays or earns, depending on your established margin and position in the market. If you do not want to earn or pay interest on your positions, simply make sure they are all closed before 5pm EST, the established end of the market day. Since every currency trade involves borrowing one currency to buy another, interest rollover charges are part of forex trading. Interest is paid on the currency that is borrowed, and earned on the one that is bought.

FOREX TERMINOLOGIES
Stop Loss

Stop Loss is used for minimization of losses caused by movement of a price in loss making direction. If a price for an instrument reaches a specified level, a position will be closed automatically. A Stop Loss order is always attached to an open position or a pending order. It is placed together with a market or a pending order. In long positions a value specified in the order is compared to an ASK price, whereas in short positions it is compared to a BID price.

FOREX TERMINOLOGIES
Take Profit

Take Profit is intended for realizing a profit when a price for a financial instrument reaches a certain level. Execution of this order results in closure of a position. This order is always attached to an open position or a pending order. It can be placed only together with a market or a pending order. In long positions a value specified in the order is compared to a BID price, whereas in short positions it is compared to an ASK price.

HEDGING

What is a Hedge?

Hedge is an investment position taken in order to protect oneself from the risk of an unfavorable price move in a currency

Why one must hedge his/her foreign currency Risk?



To mitigate exchange rate risk Fluctuations in the exchange rate of currencies give rise to exchange rate risk

As the time gap between finalizing an export/import order and receiving/making payment against it widens, the possibility of fluctuation of exchange rate rises. A hedge helps in protecting businesses from unfavorable fluctuations

HEDGING PRODUCTS

Forwards :
It is a foreign currency contract where the buyer has right as well as obligation to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period Options : It is a financial foreign currency contract giving the buyer the right, but not the obligation, to purchase or sell a specific foreign currency contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount paid for the contract is called "premium"

Futures:

A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date

FUTURES

LONG POSITION IN FUTURES Long position in a currency futures contract without any exposure in the cash market is called a speculative position.
Long position in futures for speculative purpose means buying futures contract in anticipation of strengthening of the exchange rate (which actually means buy the base currency (USD) and sell the terms currency (INR) and you want the base currency to rise in value and then you would sell it back at a higher price). If the exchange rate strengthens before the expiry of the contract then the trader makes a profit on squaring off the position, and if the exchange rate weakens then the trader makes a loss.

FUTURES

The graph above depicts the pay-off of a long position in a future contract, which does demonstrate that the payoff of a trader is a linear derivative, that is, he makes unlimited profit if the market moves as per his directional view, and if the market goes against, he has equal risk of making unlimited losses if he doesnt choose to exit out his position.

FUTURES
SHORT POSITION IN FUTURES

Short position in a currency futures contract without any exposure in the cash market is called a speculative transaction. Short position in futures for speculative purposes means selling a futures contract in anticipation of decline in the exchange rate (which actually means sell the base currency (USD) and buy the terms currency (INR) and you want the base currency to fall in value and then you would buy it back at a lower price). If the exchange rate weakens before the expiry of the contract, then the trader makes a profit on squaring off the position, and if the exchange rate strengthens then the trader makes loss.

BENEFITS OF EXCHANGE TRADED CURRENCY FUTURES

Size an advantage Instantaneous on line Mark to Market a new hedging tool Paperwork lesser document hassles Liquid more number of participants Efficient Robust settlement system Spreads Tight bid/ask spreads Transparent Price on screen and website

OPTIONS

A financial derivative that represents a contract sold by one party (option writer) to another party (option holder) Feature The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a currency or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date)

OPTION TERMINOLOGIES

Call Option: A call option gives the buyer the right to buy the underlying asset at a predetermined price. If the buyer of the call exercises his right, i.e., he decides to buy the underlying asset, then the seller of the call, viz, the banks has to oblige, i.e., it has to sell the underlying asset Put Option: A put option gives the buyer the right to sell the underlying asset at a predetermined price. If the buyer of the put option exercises his right, i.e., he decides to sell the underlying asset, then the seller of the put, viz, the bank has to oblige, i.e., it has to buy the underlying asset

OPTION TERMINOLOGIES
Call Option Put Option

Buy

Sell

Buy

Sell

Right to Buy

Obligation to Sell

Right to Sell

Obligation to Buy

OPTION TERMINOLOGIES

Strike Price: It is that pre-determined price at which buyer has right to buy (in case of call option) or sell (in case of put option) Premium: The price to be paid by the buyer of the option to acquire the right is called option premium. Option premium is payable upfront. Plain Vanilla Option: An option where the buyer of the option pays the option premium upfront in exchange for a right to do something on a specified future date is called a plain vanilla option Zero Cost Option: A packaged structure made of up two or more options, where there is no net inflow or outflow of premium

OPTION TERMINOLOGIES

European Option:
This

option could be exercised only on the due date of the contract

American Option:
This

option could be exercised at any time on or before the due date of the contract

In India, only European options are allowed by RBI

DESIRABLE FEATURES OF HEDGE PRODUCT

Minimum documentation Maximum transparency Minimum cost Maximum ease of use Minimum risk on settlement Maximum information

Indian Foreign Exchange Market

INDIAN FOREIGN EXCHANGE MARKET

Daily Turnover - US$ 60 billion in 2007 -08. 59% of the total market USDINR. USDINR volatility has seen an average increase of over 9% p.a.

MARKET PARTICIPANTS

Hedgers Importers & exporters Banks & financial institutions Foreign currency dealers Corporates with foreign currency exposure Resident Indians Money Changers Arbitrageurs: profit seeking from variations in rates in different markets Speculators: profit seeking from movements in exchange rates

Currency Exchange A Dream Start

USDINR - Contract Specification

Trading Hours Contract Size Price Quotation Tick Size Minimum Initial Margin Contracts Settlement Mechanism Last Trading Day Final Settlement Rate Final Settlement Date 9:00 AM to 5:00 PM (Monday to Friday) US$ 1,000 INR per USD INR 0.0025 1.75% on first day & 1% thereafter All months with a maturity duration of 12 months Cash Settled in Indian Rupee
2 working days prior to the last BD of the expiry month

USDINR Reference Rate Last working day of month, except Saturday.

Currency Futures
Standardized Contract. Underlying is Exchange rate. Currency futures can be cash settled or by fulfilling the respective obligation

Tick Size
A tick refers to the minimum price differential at which traders are able to enter bids and offers In case of USD-INR currency futures contract the tick size is 0.25 paisa or 0.0025 Rupee For example the USD-INR contract is trading at 47.5025 an uptick would be 47.5050 and a down tick would be 47.5000

Calculating Profit Loss on a Future Contract

Illustration : A currency trader buys a USD-INR currency futures contract at 42.2525, USD 1000 being the value of each contract. Now look at the following two scenarios In case of uptick the price moves from 42.2525 to 42.2550 In case of downtick the price moves from 42.2525 to 42.2500

Thus the trader gains 2.5 Rupees (1000x0.0025) in case of uptick and looses 2.5 rupees in case of downtick on one contract when he had bought one USD-INR contract.

IMP the value of one tick is 2.5 Rs in case of USD-INR contract.

Conclusion
Case1 If you have bought one USD-INR contract and the tick moves upward (one tick) you gain 2.5 RS and if tick moves down (one tick) you lose 2.5 Rs. Case2 If you are short (sold) on one USD-INR contract and the tick moves upward (one tick) you lose 2.5 Rs and if the tick moves down (one tick) you gain 2.5 Rs.

Profit/loss on contract= No. of Contract x Movement of ticks

COSTING
Particulars
Price Contract value ( Buy + Sell ) Brokerage Stamp duty Clearing charges Sebi fees Brokerage Service tax Total Costing

Value
48 96000 1 1.92 0.48 0.10 9.60 1.19 13.28

Remarks

1000 200 / 1CR 50 / 1CR 10 / 1CR 12.36%

Trading Cost Across Segments Type of charges exchange transaction charges cash segment futures segment 0.002% ( Rs 200 per crore ) options segment 0.05% ( Rs 5000 per crore ) on premium value commodity segment 0.0040% ( Rs 400 per crore ) currency segment

0.0035% ( Rs 350 per crore )

no charges

SEBI fees

0.0001% ( On turnover)

0.0001% ( On turnover )

0.0001% ( On turnover)

no charges

0.0001% ( On turnover)

service tax

10.3% 0.125% ( Rs 12500 per crore ) 15%-25%

10.3% 0.017%(On turnover) 15%-25%

10.3% 0.125% ( Rs 12500 per crore ) on exercised value 5%-10%

10.3%

10.3% not applicable 3%-5%

STT /CTT

not applicable

margin stamp duty

5%-15%

It is charged as per the rules of the state the client resides in