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Part-10

Part-10

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Part-10

FOREX

Introduction

Foreign exchange or FOREX is not traded on organized exchanges.
 

Thus the market is purely OTC It is a network of dealers which is primarily dominated by commercial banks. In India all dealers have to obtain prior approval from the RBI. Such dealers are called Authorized Dealers or ADs.

FOREX Quotes

The exchange rate for a currency is the amount of that currency that can be exchanged per unit of another currency. In other words it is the price of one currency in terms of another currency.

Two Quoting Conventions
 

Think of an asset such as a share. We usually quote the price as Rs 100 per share. We can also quote it as .10 shares for Rs 10.

However we always quote as units of currency per unit of the asset and not as units of the asset per unit of the currency.

Conventions (Cont…)

The difference in the case of FOREX is that we are quoting the price of one currency (which is also an asset), in terms of the price of another currency. Thus we can quote in terms of Rupees per Dollar or equivalently in terms of Dollars per Rupee.

Direct Quotes

If the price of the foreign currency is quoted as the number of units of the Domestic currency per unit of the Foreign currency, it is called a Direct Quote.

For example Rs 43.75 per dollar is an illustration of a direct quote.

Currency Symbols

Before we proceed let us list the internationally accepted symbols of various currencies.
       

Australian Dollar – AUD Canadian Dollar – CAD Indian Rupee – INR Japanese Yen – JPY Pound Sterling – GBP Singapore Dollar – SGD Swiss Franc – CHF US Dollar - USD

Direct Quotes (Cont…)

Consider a quote of INR 43.75 per USD. If the rate increases to INR 44.25 per USD

It implies that every dollar is worth more in terms of Rupees And we would say that the dollar has appreciated or the rupee has depreciated.

Direct Quotes (Cont…)

However if the rate were to decline to INR 43.20 per USD

Then each dollar would be worth less in terms of rupees and we would say that The dollar has depreciated or that the rupee has appreciated.

Direct Quotes (Cont…)

Thus in the case of direct quotes:

An increase in the quoted value signals an appreciating foreign currency and a depreciating domestic currency A decrease in the quoted value signals a depreciating foreign currency and an appreciating domestic currency

Indirect Quotes

We can also quote an exchange rate as the number of units of foreign currency per unit of the domestic currency. For instance if we have a quote of USD 2.25 per INR 100, it would be an indirect quote in India.

Indirect Quotes (Cont…)

If the rate were to increase to USD 2.40 per INR 100, it would imply that

The dollar has depreciated or the rupee has appreciated. Thus an increase in the value connotes a depreciating foreign currency and an appreciating home currency.

Indirect Quotes (Cont…)

If the rate were to decline to USD 2.10 per INR 100, it would imply an appreciating dollar and a depreciating rupee.

Thus a decline in the rate connotes an appreciating foreign currency and a depreciating home currency.

Confusion

It appears that an increase in the rate connotes an appreciating foreign currency if rates are quoted directly and a depreciating foreign currency if they are quoted indirectly. How do we avoid errors?

Numerator/Denominator
 

Always think in terms of numerator and denominator currencies. In a direct quote in India like INR 43.75 per USD, the rupee is the numerator currency and the dollar is the denominator currency. If the rate increases it means that the numerator currency has depreciated. Else if it decreases it means that the numerator currency has appreciated.

Numerator/Denominator (Cont…)

In the case of an indirect quote like USD 2.25 per INR 100, the dollar is the numerator currency and the rupee is the denominator currency. Once again an increase in the rate would mean that the numerator currency which is the dollar has depreciated.

Numerator/Denominator (Cont…)

On the other hand, a decline in the value would mean that the numerator currency has appreciated.

Direct or Indirect

Until 1993 banks in India were using the indirect quotation system. Subsequently they have switched to the direct method. We will use the direct method for most of our illustrations.

Purchase & Sale

Whenever we say buying or selling rates we always mean it from the dealer’s perspective. When rates are quoted there will be two rates, one for buying and the other for selling.

Purchase & Sale (Cont…)

 

Consider the Direct Quoting system. 43.25/43.70 INR/USD For the dealer purchase involves conversion of foreign exchange into rupees.

Illustration-1

BHEL has exported turbines to Libya and has received a check for 10 MM USD. When it presents it to its bank asking for the equivalent amount in rupees to be credited to its account, it constitutes a purchase transaction.

Illustration-2

An NRI from Dubai has remitted 10000 USD to his relative in Kochi. When the bank converts it to the rupee equivalent and credits the relative’s account it constitutes a purchase.

Purchase/Sales (Cont…)

Conversion of domestic currency into foreign currency by a bank will be termed as a sale of foreign exchange.

Illustration-3

Tata Steel has imported iron ore from Australia and needs to pay the party in Sydney. It therefore requests SBI to prepare a check for 50 MM AUD and debit its current account. This constitutes a sale for the bank.

Bid and Ask

For a given currency, the price at which the dealer is willing to buy the currency will obviously be lower than the price at which he is willing to sell it. So in the direct quotation system the bid will be lower than the ask. For instance, a quote for USD may read: 43.2400-43.3100.

Bid and Ask (Cont…)

However in the indirect system, the bid will be greater than the ask. For instance a quote for USD may read: 2.2200-2.1500 This means that when the AD is buying dollars he will give 100 rupees for every 2.22 dollars purchased. However when he is selling USD he will charge 100 rupees for every 2.15 dollars sold.

Arbitrage

Arbitrage in the FOREX market can arise on various counts. We have situations conforming to what are called:
   

One point arbitrage Two point arbitrage Triangular or three point arbitrage Covered interest arbitrage

One Point Arbitrage
  

ICICI bank is quoting: 43.2400-43.3100 SBI is quoting: 43.3500-43.4200 Consider the following strategy:
    

Borrow 433,100 rupees By 10000 USD from ICICI. Sell 10000 USD to SBI Receive 433,500 from SBI There is an arbitrage profit of INR 400.

One Point Arbitrage (Cont…)
  

Now consider the following quotes: ICICI: 43.2400-43.3100 SBI: 43.3000-43.3700

Clearly arbitrage is not possible. ICICI: 43.2400-43.3100 SBI: 43.1800-43.2500 Once again no arbitrage

Or:
  

One Point Arbitrage (Cont…)

So to rule out arbitrage the quotes of two banks must overlap by at least one point. What is a point, for most currencies it is 1/10000 of the domestic currency. For instance a point in India is 0.0001 rupees.

Two Point Arbitrage
    

ICICI is quoting: 27.2500-27.3500 INR/SGD DBS Singapore is quoting: 3.7000-3.7250 SGD/100 INR This is an arbitrage opportunity

Two Point Arbitrage (Cont…)
   

Consider the following strategy: Borrow 10000 SGD and sell it to ICICI. You will get 272500 INR. Sell this to DBS in Singapore in return for: 3.7000 x 2725 = 10082.50 There is an arbitrage profit of 82.50 SGD.

Why Arbitrage?

Consider ICICI’s quote of: 27.2500-27.3500 When ICICI is quoting 27.2500 for buying 1 SGD it is effectively saying that it is willing to sell 1 INR for 1/27.2500 = 0.036697 Ξ 3.6697 SGD/100INR

Why? (Cont…)

Similarly a quote of 27.3500 for selling SGD amount to a quote of: 1/27.3500 = 3.6563 SGD/100INR for buying rupees. Thus 27.2500-27.3500 INR/SGD corresponds to 3.6563-3.6697 SGD/100INR.

Why? (Cont…)

 

This does not overlap with 3.70003.7250 which is what DBS is quoting in Singapore. Hence the potential for arbitrage. Thus two-point arbitrage is nothing but the logic of one point arbitrage extended to two markets.

Triangular or Three-Point Arbitrage

To do triangular arbitrage we need three currencies. Assume that Bank Mitsubishi is offering the following rates:
 

75.2150-75.2750 JPY/AUD 150.2025-150.2925 JPY/USD 0.5220-0.5280 USD/AUD

Citibank NYC is offering:

Arbitrage Strategy

 

Borrow 752750 yen in Tokyo and buy 10000 AUD. Sell it in NYC for 5220 USD. Sell the USD in Tokyo in return for 5220 x 150.2025 = 784057.05 JPY Clearly there is an arbitrage profit of: 784057.05 – 752750 = 31307.05 JPY

Arbitrage (Cont…)

Hence the condition required to preclude arbitrage is that:
(JPY/AUD)ask ≥ (USD/AUD)bid x (JPY/USD)bid Similarly it can be shown that: (JPY/AUD)bid ≤ (USD/AUD)ask x (JPY/USD)ask The LHS in the above expressions is the natural rate for a currency. The RHS represents the synthetic rate for the currency.

   

Arbitrage (Cont…)

Thus the no arbitrage conditions may be stated as: The natural ask should be greater than or equal to the synthetic ask. The natural bid should be less than or equal to the synthetic bid.

Forward Rates

Forward trading is very common in foreign currency markets. Although futures trading is very active in certain countries, particularly in the US, the volume of trading in the forward market is much higher than in the futures market.

Forward Rates (Cont…)

The forward market is an OTC market. The majority of the participants are commercial banks.

Forward Rates (Cont…)

In the case of direct quotes, if the forward rate is greater than the spot rate then the foreign currency is said to be trading at a forward premium. However if the forward rate is less than the spot rate, then the foreign currency is said to be trading at a forward discount.

Forward Rates (Cont…)

If the forward rate is equal to the spot rate, then the currency is said to be trading flat.

Illustration-1
  

Spot: 43.2500-43.2800 INR/USD 1 M Forward: 43.2650-43.3050 Obviously the US dollar is at a forward premium.

Illustration-2:
  

Spot: 43.2500-43.2800 1 M Forward: 43.2250-43.2600 Obviously the US dollar is at a forward discount.

Illustration-3
  

Spot: 43.2500-43.2800 1 M Forward: 43.2500-43.2800 The dollar is trading flat

Forward Rates (Cont…)

In the above cases the full forward rate has been specified for both buying and selling. These are called Outright Forward Rates. However sometimes only the difference between the spot rate and the forward rate called the Forward Margin or the Swap Points will be given.

Forward Rates (Cont…)
   

Consider the following data: Spot: 43.2500-43.2800 Forward: 45/75 Obviously the forward figure represents the swap points. However we do not know whether the dollar is at a premium or at a discount.

Forward Rates (Cont…)

Thus should the swap points be added to the spot rates or should they be subtracted. The point to remember is that the spot market has the maximum liquidity. The further we go in time, the less will be the liquidity and the higher will be the spread.

Forward Rates (Cont…)

Hence when the swap points are specified as a/b where a < b, then adding the points will widen the spread. Thus a specification of a/b where a < b indicates that the foreign currency is at a forward premium and that the points should therefore be added to the spot rates.

Forward Rates (Cont…)
   

In this case the rates would be: Spot: 43.2500-43.2800 1 M Forward: 43.2545-43.2875 However what if the swap points had been specified as 75/45. In this case subtracting the swap points from the spot rates will widen the spread.

Forward Rates (Cont…)

Thus a quote of 75/45 indicates that the foreign currency is at a forward discount. The corresponding forward rates are: 43.2425-43.2755

Indirect Quotes

In the case of indirect quotes the logic will have to be reversed. In such cases the bid will be higher than the ask. Thus if the swap points are specified as a/b where a < b, then subtracting the points will widen the spread.

Indirect Quotes (Cont…)

Thus while a/b where a < b does indicate a forward premium, the points must be subtracted in order to arrive at the outright forward rates. Similarly a/b where a > b indicates a forward discount. However the points will have to be added in order to arrive at the outright forward rates.

Merchant Rates & Exchange Margins

 

Whenever a dealer buys or sells to a client he will have to interact with the Inter-bank market either prior to the deal or subsequent to it. Consider a purchase transaction. In this case after acquiring the foreign currency from the client, the dealer will have to sell it in the inter-bank market.

Merchant…(Cont…)

Had it been a sale transaction, the dealer would have had to acquire the currency in the inter-bank market prior to selling it to the client. Clearly there has to be a relation between the rates in the inter-bank market and the rates quoted by the dealer to the client, which are called merchant rates.

Merchant…(Cont…)
 

Let us take a purchase transaction. After the purchase the dealer will have to dispose off the currency in the inter-bank market. The relevant rate is therefore the bid in the inter-bank market. Thus the Base Rate for purchase transactions is the inter-bank bid.

Merchant…(Cont…)

If the dealer has to make a profit on the deal, the bid price quoted by the dealer has to be lower than the bid in the inter-bank market. Similarly in a sale transaction the dealer has to acquire the currency at the ask rate in the inter-bank market before selling it to the client.

Merchant…(Cont…)
 

The relevant base rate in this case is the ask rate in the inter-bank market. In order for the dealer to make a profit the ask rate quoted by him must be higher than the inter-bank ask rate. The profit margins applied by the dealer is known as the exchange margin.

Merchant…(Cont…)

As should be obvious, in a purchase transaction the exchange margin will be subtracted from the base rate before a buying rate is quoted to the client. In a sale transaction the exchange margin will be added to the base rate before a selling rate is quoted to the client.

Illustration-1

 

The inter-bank rates on a given day for the US dollar are: 44.2000-44.2500 An exporter has just received a draft for USD 10000 which he then presents to the bank. The bank as a matter of policy levies an exchange margin of 0.05%.

Illustration-1 (Cont…)

Given the fact that the dealer is buying his base rate is the bid of 44.2000. The rate quoted to the client will therefore be: 44.2000(1 – 0.0005) = 44.1779

Illustration-2

  

The inter-bank rates on a given day are as follows: Spot: 44.2000-44.2500 1 M Forward: 125/75 A client comes to the bank seeking to make an outward remittance of 10000 USD after one month.

Illustration-2 (Cont…)

The first step is to calculate the outright one-month forward rates. These are: 44.1875-44.2425 Since the AD is selling the relevant rate is the ask which is 44.2425. Assume that the exchange margin is 0.08%.

Illustration-2 (Cont…)

The rate that will be charged to the client will therefore be: 44.2425(1 + 0.0008) = 44.2779

Inter-bank Swap Deals

Banks regularly enter into deals with each other where they either buy spot and sell forward or vice-versa or else buy forward for one maturity and sell forward for another maturity. These are called Swap transactions and Forward to Forward Swap transactions respectively.

Swap Deals (Cont…)

Since banks routinely enter into such deals with each other they ignore the bid-ask spread implicit in the inter-bank spot quote and focus solely on the premium or discount applicable for a forward trade with the required maturity. The following examples will illustrate this.

Swap Deals…(Cont…)
   

The rates in the inter-bank market are as follows. Spot: 44.2000-44.2500 Forward: 125/75 ICICI Bank is selling spot to HDFC and buying 1M forward. The number of concern here is the discount applicable for a one month forward sale which is 75 points.

Swap Rates…(Cont…)

  

The spot rate chosen for the transaction may be any rate between the current quotes of 44.2000 and 44.2500. Assume that a rate of 44.2200 is chosen. ICICI will therefore sell spot at this rate. Since it is buying 1M forward and the dollar is at a discount, the applicable rate will be 44.2200 - .0075 = 44.2125.

Option Forwards

Sometimes while entering into a forward contract the client may not know the exact date on which he would need to buy or sell. For instance an importer is expecting a shipment which is likely to arrive between one to two months from now. However he is not sure of the precise date.

Option Forwards (Cont…)

The importer can in such cases negotiate a forward contract with the option to take delivery of the foreign currency at any time between one to two months from now. The question is how should the bank quote a rate. Should it assume that the transaction will take place one month later or should it assume that it will take place two months later.

Option Forwards (Cont…)

 

The AD will always assume that the transaction will take place at the worst possible time from his point of view. What is the worst possible situation? It would depend on:
 

Is the AD buying or selling Is the currency at a premium or at a discount

Illustration-1

Indian Rayon is importing machinery and requires dollars between two and three months from now. It wants a forward contract with an option to buy at any time between two and three months from now.

Illustration-1 (Cont…)
    

The inter-bank rates are: Spot: 45.4500-45.8525 1M Forward: 45/85 2M Forward: 70/110 3M Forward: 110/155

Illustration-1 (Cont…)

The relevant rate in this case is the selling rate since the dealer is selling. If the contract is completed after 2 months the applicable premium is 110 points. However if it is completed after three months the applicable premium will be 155 points.

Illustration-1 (Cont…)

Since a premium is being charged, the dealer will levy the higher of the two amounts. So the applicable rate for the option forward will be: 45.8525 + 0.0155 = 45.8680

Rule

In a sale transaction where a premium is applicable, charge the premium for the latest date of delivery.

Illustration-2

   

Assume that the spot rate is the same as earlier but that the dollar is trading at a discount. Spot: 45.4500-45.8525 1M: 75/35 2M: 115/75 3M: 140/95

Illustration-2 (Cont…)

If the transaction is completed after two months the applicable discount will be 75 points. Whereas if it is completed after three months, the applicable discount will be 95 points. Since the dealer is giving a discount he will give the lower of the two values. So the applicable rate will be: 45.8525 – 0.0075 = 45.8450

Rule

For a sale transaction where the foreign currency is trading at a discount, the rule is allow the discount applicable for the earliest date of delivery.

Illustration-3

  

A party has exported a consignment and will be paid in dollars at a point in time between one and two months from today. The rates in the inter-bank market are: Spot: 45.3500-45.7320 1M: 35/80 2M: 65/115

Illustration-3 (Cont…)

The relevant base rate here is the bid of 45.3500. If the transaction occurs after one month the applicable premium will be 35 points. However if it occurs after two months the applicable premium will be 65 points.

Illustration-3 (Cont…)

Since the AD is buying, he will give the lower of the two premia. So the applicable rate in this case will be: 45.3500 + 0.0035 = 45.3535

Rule

So the rule for a purchase transaction where the currency is quoting at a premium is: Offer the premium for the earliest delivery date. If the currency had been quoting at a discount, the rule would have been: Offer the discount for the latest date of delivery.

Covered Interest Arbitrage

The strategies that result in the noarbitrage condition for foreign exchange forward contracts are called Covered Interest Arbitrage strategies.

Cash and Carry

Consider the following information:
  

Spot rate: 25.2025 INR/SGD 3M Forward rate: 25.5075 INR/SGD Interest rate for 3M loan in India: 7.5% p.a. Interest rate for 3M loan in Singapore: 4.5% p.a.

Cash and Carry (Cont…)
  

Borrow 252025 INR and buy 10000 SGD. Invest it in Singapore at 4.5%. Future value = 10000(1.01125) = 10112.50 SGD At the outset go short in a forward contract to sell this amount after 3 months. Proceeds in INR = 10112.50 x 25.5075 = 257944.59

Cash and Carry (Cont…)

Amount due in India = 252025(1.01875) = 256750.46 Arbitrage profit = 257944.59 – 256750.46 = 1194.13 INR

Reverse Cash and Carry
    

Consider the following information: Spot: 25.2025 3M Forward: 25.3075 3M rate in India = 7.5% p.a. 3M rate in Singapore = 4.5% p.a.

Reverse Cash and Carry
   

Borrow 10000 dollars in Singapore. Convert it into 252025 INR. Invest it in India. Future value = 252025(1.01875) = 256750.46 Amount due in Singapore = 10000(1.01125) = 10112.50

Reverse Cash and Carry

Go long in forward contract at the outset to buy this amount. Cost = 25.3075 x (10112.50) = 255922.09 Arbitrage profit = 256750.46 – 255922.09 = 828.37 INR

Symbolic No-Arbitrage Condition
    

Spot: S INR/FCR M Period Forward: F INR/FCR Indian M-period rate = id Foreign M-period rate = if No arbitrage requires that: S(1+id) = F(1+if) So: F = S x (1+id) ______ (1+if)

Interest Rate Parity

This is called the interest rate parity condition. It can be written: F–S id - if S (1+if)

_______ = ________ ≈ id - if

Reality Check

What looks like an arbitrage opportunity in practice may not be exploitable. One reason is the presence of transactions cost. The issue is therefore can we make a profit after taking such costs into account. Secondly a country may not permit free movement of currencies across borders.

Reality Check (Cont…)
 

Thus a perceived opportunity may not be exploitable in practice. In fact even a perception that exchange controls may be imposed may preclude arbitrageurs from trying to take advantage of such opportunities. Take the case of the arbitrageur who buys and invests 10000 dollars in Singapore.

Reality Check (Cont…)

His arbitrage profit is realizable subject to the condition that he is able to repatriate the amount from Singapore after 3 months. The other key factor is the tax regulations in the two countries. The issue of relevance is the possibility of a post-tax profit.

Arbitrage with Transactions Costs
Let us introduce bid-ask spreads in the spot and forward markets, as well as differential rates for borrowing and lending Spot: Sb/Sa Forward: Fb/Fa Domestic Rates: rdb /rdl Foreign Rates: rfb /rfl

Cash and Carry

The arbitrageur will buy Singapore dollars at the spot ask rate, which is Sa. He will lend it in Singapore. The future value will be (1+rfl ) He would have gone short in a forward contract at Fb. He will get Fb(1+rfl ) when he delivers under the forward contract.

  

Cash and Carry (Cont…)
 

Amount due in India is Sa(1+rdb) Arbitrage will be ruled out if Sa(1+rdb) ≥ Fb(1+rfl) ⇒Fb ≤ Sa(1+rdb) _______ (1+rfl)

Reverse Cash and Carry
    

Borrow a Singapore dollar and buy Sb rupees. Lend it in India. Future value = Sb(1+rdl ) Go long in a forward contract at Fa. Equivalent amount in Singapore dollars at maturity = Sb(1+rdl ) _________ Fa Amount due in Singapore = (1+rfb )

Reverse Cash and Carry (Cont…)

Arbitrage is ruled out if: Sb(1+rdl ) _________ ≤ (1+rfb ) Fa ⇒ Fa ≥ Sb(1+rdl ) _______ (1+rfb )

Illustration
    

Consider the following rates: Spot: 1.5015/1.5125 USD/GBP Forward: 1.5295/1.5410 USD/GBP US rates: 5.5%/5.3% UK rates: 4.5%/4.3%

Illustration (Cont…)
    

First let us check whether cash and carry is feasible. Borrow 1.5125 USD and buy 1 pound. Invest it in the UK at 4.3% Go short in a forward contract at 1.5295. Final proceeds in dollars = 1.043x 1.5295 = 1.5952685 Amount due in dollars = 1.5125 x 1.055 = 1.5956875 Hence: NO ARBITRAGE

Illustration (Cont…)
 

  

What about reverse cash and carry. Borrow a pound and convert it into 1.5015 dollars. Invest it at 5.3%. Final proceeds = 1.053x1.5015 = 1.5810795 Go long in a forward contract to acquire: 1.5810795 _________ = 1.0260087 pounds 1.5410

Illustration (Cont…)

Amount to be paid back in UK = 1.045 Hence: NO ARBITRAGE

Futures Markets

The biggest futures exchange for foreign exchange is the International Monetary Market (IMM) at the Chicago Mercantile Exchange (CME). Currencies traded include: Australian Dollars; Canadian Dollars, Brazilian Reals; Euro; Japanese Yen; Pound Sterling; Mexican Peso; NZ Dollar; Swiss Francs Russian Rubles; South African Rands

Illustration on Hedging using Futures Contracts

Eli Lilly is scheduled to receive 25 MM Swiss Francs after 2 months. The worry is obviously that the dollar will appreciate and that since the invoice is denominated in Swiss Francs, the proceeds in dollars may be less than anticipated. Since Swiss Francs have to be sold, the company needs to go short in futures. Assume that it uses 3 month contracts.

Illustration (Cont…)
On the IMM each Swiss Francs futures contract is for 125,000 CHF.  So for 25 MM CHF 25,000,000 _____________ = 200 contracts will be 125,000 required.  The rates in the futures market are: 0.5150/0.5190

Illustration (Cont…)
 

Obviously the applicable rate is the bid of 0.5150. Assume that the rates after two months are as follows: Spot: 0.4985-0.5025 1M Futures: 0.4985-0.5025 If the company had not hedged, it would have had to sell 25 MM CHF at 0.4985 which would have yielded 12,462,500USD

Illustration (Cont…)

Since it has hedged it will receive: 25,000,000 x (0.5150 – 0.5025) = 312,500 as a profit from the futures market. The proceeds from the cash market = 12,462,500 Total proceeds = 12,775,000

Illustration (Cont…)

Effective rate: 12,775,000 __________ = 0.5110 25,000,000

Illustration-2
  

An airline in the US has ordered parts from the US worth 4MM pounds. The payment is due after one month. The worry is that the dollar will depreciate for if it does, the payment in dollars will go up. Since pounds have to be acquired the firm needs to go long in a futures contract. Assume that two month contracts are available.

Illustration-2 (Cont…)

Current rates are: Spot: 1.4025-1.4075 2M Forward: 1.4120-1.4190 Assume that the rates after one month are: Spot: 1.4150-1.4220 1M Forward: 1.4250-1.4335

Illustration-2 (Cont…)

 

If the company had not hedged it would have paid 4,000,000 x 1.4220 = 5,688,000 The effective cost if it hedges can be calculated as follows. Buy spot at 5,688,000 Profit from futures = 4,000,000(1.4250-1.4190) = 24000

Illustration-2 (Cont…)
Total payment in dollars = 5688000 - 24000 = 5664000  Effective exchange rate: 5664000 __________ = 1.4160 4000000

FOREX Options

Foreign currency options are traded on a number of exchanges.

In the U.S. the Philadelphia exchange is a major centre for such contracts.

In addition to exchange traded options, customized contracts are traded by banks and other financial institutions.

Hedging

For a party who wants to hedge a foreign currency exposure, options provide an alternative to forward contracts.

Illustration
 

An Indian exporter is expecting to be paid in pounds after a month. His worry is that the pound will depreciate and that he may receive fewer rupees than anticipated. He can hedge by buying put options on Sterling.

He can then be sure that the value of the Sterling will never be below the exercise price.

Illustration (Cont…)

Similarly, a party who is due to make a payment in Sterling at a future date will be afraid that the Sterling may appreciate. One way for it to hedge is by buying calls on Sterling.

This way it can ensure that the currency will not cost more than the exercise price.

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