FOREX MARKET

Ms. Shegorika R Lalchandani

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 re-
exchange (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-à-vis the second currency.
 Changes are also expressed as
appreciation or depreciation of one
currency in terms of the second
currency.
Continued……
 Whenever the base currency buys
more of the terms currency, the
base currency has strengthened /
appreciated and the terms
currency has weakened /
depreciated.
 E.g. If Dollar – Rupee moved from
43.00 to 43.25. The Dollar has
appreciated and the Rupee has
depreciated.
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:
Nation’s central bank:
Act as Lender/ Buyer of last resort-
Interbank 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.
Regulation of Derivatives

 Securities Contracts (Regulation)

Act, 1956 (SC(R)A) Regulates
trading of Derivatives in Indian
Securities Market.
 FACTORS DRIVING THE
GROWTH OF DERIVATIVES

Growth Driving Factors

Increased Development of
Volatility Sophisticated
Increased Innovations in tools
Integration Derivatives market

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
PARTICIPANTS IN THE
DERIVATIVES MARKETS

 Hedgers
 Speculators
 Arbitrageurs
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 price: The price at which an asset trades in
the spot market. In the case of USDINR, 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.
 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.
The rationale for establishing
the currency futures
 Currency futures enable investors to
hedge currency risks.
 Increasing the cross border trade and
investment flows.
 Currency futures are expected to bring
about better price discovery and also
possibly lower transaction costs.
Continued…..
 In comparison to forwards, futures are
standardized products and helps in
elimination of counterparty credit risk
and greater reach in terms of easy
accessibility to all.
 currency futures could be seen as a
facilitator in promoting investment and
aggregate demand in the economy,
thus promoting growth.
 Advantages of futures

Advantages of
Futures

Transparent
Transparency
trading
and efficient
Elimination Standardize platform
price
of Access to all d products
discovery
Counterparty types of
credit risk market
participants
Limitations of Futures

Limitations
Of futures

Lack of High Cost

Customization
NSE’S CURRENCY
DERIVATIVES
SEGMENT
PRODUCT DEFINITION
Underlying Rate of exchange
between one USD and
INR
Trading Hours 09:00 a.m. to
(Monday to Friday) 05:00 p.m.
Contract Size USD 1000

Tick Size 0.25 paise or INR

0.0025
Trading Period Maximum expiration
period of 12 months
 Continued….
Contract Months 12 near calendar
months
Final Settlement Last working day of the
date/ month (subject to
Value date holiday calendars)
Last Trading Day Two working days prior
to Final Settlement Date
Settlement Cash settled
Final Settlement Price The reference rate fixed
by RBI 2 working days
prior to final settlement
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.
 RBI’s policy- to decentralise exchange
operations.
2. Size of the market
 World’s 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 bank’s 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 Acquires Parts with

Parts with
Foreign Home Foreign
Home
currency currency currency
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.
 Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country Currency Symbol Direct Indirect
quote quote
UK Pound £/ GBP 66.92
Sterling
US US Dollar $ 43.30

Canada Canadian Can$ 29.10

Dollar
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currenc Symbol Direct Indirect

y quote quote
UK Pound £/ GBP 66.92 0.0149
Sterling

US US $ 43.30 0.0231
Dollar

Canada Canadia Can$ 29.10 0.0344

n Dollar
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currenc Symbol Direct Indirect

y quote quote
German Deutsch DM/DEM 22.94
y mark

Euro € 44.87

Netherla Dutch DG/$f/ 20.36

nds Guilder NLG
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currenc Symbol Direct Indirect

y quote quote
German Deutsch DM/DEM 22.94 0.0436
y mark

Euro € 44.87 0.0223

Netherla Dutch DG/$f/ 20.36 0.0491

nds Guilder NLG
 Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country Currency Symbol Direct Indirect
quote quote
Switzerla Swiss sFr 0.0358
nd franc

France French FF/ FRF 0.1462

franc

Italy Swedish SKr 0.1931

krona
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currenc Symbol Direct Indirect

y quote quote
Switzerl Swiss sFr 27.97 0.0358
and franc

France French FF/ FRF 6.84 0.1462

franc

Italy Swedish SKr 5.18 0.1931

krona
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currenc Symbol Direct Indirect

y quote quote
Italy Italian Lira/ Lit/ 43.2901
lira ITL

Japan Japanes ¥ 2.4994

e Yen

Australia Australia AU$ 0.0360

n dollar
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currenc Symbol Direct Indirect

y quote quote
Italy Italian Lira/ 0.0231 43.2901
lira Lit /ITL

Japan Japanes ¥ 0.4001 2.4994

e Yen

Australia Australia AU$ 27.76 0.0360

n dollar
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 in US

increases.
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 banker’s 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. Banker’s buy rate=
Customer’s 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 bank’s 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 point.
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 $/ £
quote.
Cross Rates
 Eg. We need to calculate the Switzerland
franc / Canadian Dollar (sFr/ Can$) rate from
given sFr / $ and $/ Can$ quotes.
sFr / $ : 5.5971 / 5.5978
$/ Can$ : 0.7555 / 0.7562
 Synthetic (sFr/ Can$)bid rate
= 5.5971 * 0.7555
= (sFr / $)bid * ($/ Can$)bid
= 4.2286
Cross Rates
 Eg. We need to calculate the Switzerland
franc / Canadian Dollar (sFr/ Can$) rate from
given sFr / $ and $/ Can$ quotes.
sFr / $ : 5.5971 / 5.5978
$/ Can$ : 0.7555 / 0.7562
 Synthetic (sFr/ Can$)ask rate
= 5.5978 * 0.7562
= (sFr / $)ask * ($/ Can$)ask
= 4.2330
Cross Rates and Chain Rule
 Rates in Mumbai market
USD 1 = Rs. 46.50
USD 1 = CHF 1.8000
The rate of swiss francs can be calculated by
“chain rule” as follows:
? Rs = CHF 1
If CHF 1.8000 = USD 1
USD 1 = Rs. 46.50
Cross Rates and Chain Rule
 The rate of exchange between Indian
Rupee and Swiss Franc can be
calculated by dividing the product of the
right hand side by the product of the
left hand side.
46.50* 1 * 1 = Rs. 25.83
1.8000
Cross Rates and Chain Rule
 Eg. Rupee/ dollar is 46.50 and Euro /
dollar is 1.1568. Rupee / Euro rate can
be calculated as follows:
? Rs = Eur 1
Eur 1 = USD 1.1568
USD 1 = Rs. 46.50
1 * 1.1568 * 46.50 = Rs. 53.7912
1 *1
The Foreign Exchange Market
Types of Transactions

 Spot- Spot quotes- Prices in spot

market

 Forward- Forward quote- Prices in

Forward market
Forward Rates
 If Forward > Spot = Forward premium
 If Forward < Spot = Forward discount
 The difference between forward rate
and spot rate is known as the ‘forward
margin’ or ‘Swap points’.
 i.e. Forward – Spot = Margin
Forward Rates
 Under direct quotation, premium is
added to the spot rate to arrive at the
spot rate. This is done for both
purchase and sale transactions.
Discount is deducted from the spot to
arrive at the forward rate.
 Forward rate = Spot + Premium
Interpretation of Interbank
Quotations
 Eg. Quotation on 25th January
Spot = USD 1= Rs. 48.4000/4200
Spot/ Feb = 2000/2100
Spot/ Mar = 3500/3600
The following points should be noted:
1. The first statement is the spot rate for
dollars. The quoting bank’s buying rate is Rs.
48.4000 and selling rate is Rs. 48.4200.
Interpretation of Interbank
Quotations
2. The second and the third statements
are forward margins for forward
delivery during the months of February
and March resp.
3. The margin is expressed in points, i.e.
0.0001 of the currency. Therefore, the
forward margin for Feb is 20 paise and
21 paise.
Interpretation of Interbank
Quotations
4.
Interpretation of Interbank
Quotations
INTEREST RATE PARITY
PRINCIPLE
 The forward rate of any fully convertible
currency is a function of the spot rate
and the interest rate differential
between the two currencies, adjusted
for time.
Method for finding forward
rate
Forward Rate = Spot +/- Points

1 + terms i* days
Points = basis
1
1 + base i* days
basis

where i = rate of interest