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Objectives: At the end of this Unit, you should be able to: 1. 2. 3. 4. 5. 6. explain the risk due to fluctuation of exchange rates describe the structure of foreign exchange market. explain activities in Foreign exchange market. describe different players in Foreign exchange market. explain factors affecting movement of exchange rates. describe instruments available in forex market to minimize the risk due to fluctuation of exchange rates Structure 3.1 Introduction 3.2 Overview of Foreign exchange market 3.3 Features of Foreign exchange market 3.4 Players in Foreign exchange market 3.5 Factors affecting movement of exchange rates
3.6 Forward Contract, Futures Contract, Options Contract
3.7 Summary 3.8 Key words 3.9 Self-assessment questions 3.10 Further reading 3.11 Model answers
3.1 Introduction In India any transaction which is denominated in a currency other than Rupees (home currency) is called as foreign exchange (Forex) transaction. Following to steps need to be undertaken to complete a forex transaction: 1) Transfer of funds from one country to another 2) Conversion of one currency to another Conversion of currencies takes place in Forex market. Hence Forex market can be defined as a place where different currencies are bought and sold with the intention of making profit. In Forex market in India, Banks (authorized dealers) buy and sell foreign currencies. Hence banks need to determine buying rate as well as selling rate for each foreign currency. Let us understand three important concepts in forex market: 1) A transaction whether it is of buying type or selling type is always decided from the point of view of the bank (dealer) and not from the point of view of the customer (exporter / importer) 2) Transactions in which bank receives foreign currency from the customer are of buying type and bank applies buying rate. 3) Transactions in which bank gives foreign currency to the customer are of selling type and bank applies selling rate. Hence if a bank provides quotation as follows: $ 1 = Rs. 55. 00 / 55.50, then it means that the bank is willing to buy one $ from the customer @ Rs. 55 and willing to sell $ to the customer @ Rs. 55.50. Banks undertake following transactions in foreign currencies: 1) Buying transactions a) b) c) d) Inward remittance Exports Encash Travelers cheques (T/C) Encash currency notes (C/N)
2) Selling transactions a) Outward remittance b) Imports c) Issue travelers cheques
which is beyond their control. To minimize the impact of this risk. At the time of exchange. or currency market) is a form of exchange for the global decentralized trading of international currencies. e. exporters and importers in India should be familiar with following points: i) ii) iii) iv) v) What is a Forex market Features of Forex market Players in Forex market Factors affecting movement of exchange rates Products available in forex market to minimize the risk due to fluctuation of exchange rates. and of course the media. both the opposite parties agree.d) Issue currency notes Exporters and importers in India are required to undertake transaction denominated in foreign currencies with their counterparts abroad. They affect output and employment through real exchange rates. In 1971.g. It would be hard to overstate the importance of foreign exchange markets for the world economy. it permits a business in the United States to import goods . an inter-bank market took place which in today's time we know as FOREX or FX or Foreign Exchange Market. The Foreign Exchange Market determines the relative values of different currencies. FOREX is nothing but a set of transactions or deal that involves exchange of specified currencies of any so-called nations at a decided rate as of any specified date or time. The Foreign Exchange Market assists international trade and investment by enabling currency conversion. the public. As a result they are exposed to a risk due to fluctuations of exchange rates. Fluctuations of exchange rates between the periods of 1) entering into a trade contract with the counterparty and 2) The date on which the conversion of currencies actually takes in future. when the "buy and sell" method shifted from fixed exchange rates to floating ones. the rate of one currency to another currency is determined by the deliver and demand. EBS and Reuters' dealing 3000 are two main interbank FX trading platforms. to which. They affect international capital flows through the risks and returns of different assets. FX.2 Overview of Foreign exchange market: The Foreign Exchange Market (forex. Exchange rates are justifiably a major focus for policymakers. They affect inflation through the cost of imports and commodity prices. 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. 3.
the British Pound (GBP). The advent of the euro brought a decline in the share of European trading outside of London. Hong Kong. In a typical foreign exchange transaction. some one and one-half trillion dollar worth of currencies are bought and sold. in striking contrast to the extensive regulations in most equity and bond markets. which in aggregate accounts for about one quarter of global trading. FX trading remains heavily concentrated in London. is dispersed among Tokyo. and the Middle East each account for less than 1 percent of global turnover. which captures almost one-fifth of trading London’s traditional dominance in FX grew out of the United Kingdom’s worldwide economic dominance in the nineteenth century. a party purchases some quantity of one currency by paying some quantity of another currency. Africa. It remains secure at the beginning of the twenty-first century because of its geographic location: London’s morning session overlaps with Asian trading and its afternoon session overlaps with New York trading. the Australian Dollar (AUD). and Sydney. It is the world's largest financial market in which every day. Governments have learned through experience that dealers will simply move elsewhere . Physically. The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states. After World War II. Hong Kong and Singapore now vie in importance with traditional European centres such as Switzerland and France. there have been some subtle shifts in the global distribution of currency trading. The major currencies are considered to be the U. which remained fixed as per the Bretton Woods system. It also supports direct speculation in the value of currencies. the Japanese Yen (JPY). and the carry trade. Global market in convertible currencies are traded and their conversion rates are determined. even though its income is in United States Dollars. the balance 85 percent is traded by the individual and institutional speculators. Latin America. the Swiss Franc (CHF). speculation based on the interest rate differential between two currencies. Out of this only about 15 percent is traded for goods or services. Despite the continued dominance of London and New York. There is no regulation for the traders on the kind of currencies to trade since this is an over-the-counter market The vast majority of FX trading is essentially unregulated. the Canadian Dollar (CAD) and New Zealand Dollar (NZD). Meanwhile.from the European Union member states especially Eurozone members and pay Euros. on average. Trading in the Asia-Pacific region. the Euro (EUR). which captures over one-third of global trading. The modern Foreign Exchange Market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions. when countries gradually switched to floating exchange rates from the previous exchange rate regime.S. Dollar (USD). and New York. rapid economic growth in Asia has supported a surge in trading in the Asian regional centres. Singapore.
3 Features of Forex Market Main features of foreign exchange market are listed below – 1. Since FX markets are subject to minimal regulation. to react to . In the United States. front-running of customer orders is widely considered bad practice even though it is not illegal. the way Foreign Exchange Market does. and it allows dealers to act without any time limits. The crucial part of FOREX is the stability. Their absence is not a problem due to unique features of the FX market. e. cannot even be defined in this asset class because the sale of one currency is simply the purchase of another. There is no home market for the Foreign Exchange market and hence no regulatory body to enforce rules and regulations. Though equity trading volume is a staple on the evening news.if they are regulated.S government attempted to regulate the foreign issuance of US dollar denominated bonds in the domestic market. In the absence of official sources of high-frequency data. In the 1960s. no other markets offer the potential for profit (or loss). The only comprehensive information source is the Triennial Central Bank Survey of Foreign Exchange Market Activity. though severe in most developed equity and bond markets. The International Bank of Settlements tracks trading volume. 3. a joint effort of central banks around the world coordinated every third year in April by the Bank for International Settlements (BIS). e. There is no central exchange or regulatory body for the Foreign Exchange Markets. This continuity is unique. not even the major FX dealers.g. then another currency gets stronger. Some well-known regulations in other asset markets are missing in FX markets. though they are subject to the rules and regulations of the U. Though it is strange to hear that there is always a sudden fall in a typical financial stock market but the Foreign Exchange market never falls i. if the dollar drops. bond dealers simply moved offshore when the U. This is possible since trading happens on all continents. Other practices that are illegal on most organized exchanges are discouraged in FX by market conventions and best practices. which explains the scarcity of aggregate data on FX trading.e.. they are also subject to minimal reporting requirements.S. on any given day no one knows how much was traded in FX markets – not the regulators. the stock exchanges are located in New York and they regulate themselves. for example. but it is not an enforcement body. Short-sales restrictions. most research on currency trading relies on proprietary data from banks and brokers. not the monetary authorities.. except for weekends unlike equity or commodities market which are open only for few hours. Securities and Exchange Commission. Foreign exchange market is the only market which is open 24 hours a day.g. Fortunately. As no other markets are open 24 hours a day. the FX market is sufficiently liquid that significant manipulation by any single actor is all but impossible during active trading hours for the major currencies.
any development that occurs in another place on the globe. which makes them quite unique. Fresh economic information. when it is morning time in New York. and immediately reach all over the world. thus creating equal conditions between all traders. Intense competition lowered the spreads between 4. or open a position. but trading is available around the clock. So. and other key economic indicators are published at a known time. the Forex market is totally globalized – it really doesn’t matter where you are. The aforementioned high volume and liquidity brought to high competition between trade vendors. major economic news.000 position instantly means that it will be closed with a deal with the same magnitude. except for taxes on profits. This means that traders make the majority of the Forex market’s high volume – it’s not controlled by big companies or central banks. Bloomberg. Waking up in the middle of the night to read yet another quote can be addicting. 3. Thus. something that is different from country to country. all the time. this might be very time consuming: The option to check your position at any given time during the work week leaves little time to rest. the agency enjoys the few pips of every spread in every deal. the internet. Financial news passes through television. These investment deals (or speculation) are 85% of the flow in the market. This inconceivable figure is slowly on the rise. Foreign exchange markets are more liquid than any other market because of this reason. and investment deals. 2. They open an account online. Information is available instantly. Volume of transactions which are executed in foreign exchange market is extremely huge because of many big players in foreign exchange market. For some traders who are not experienced. over the Internet. In addition. inflation reports. London. Foreign Exchange Markets are present in every country and hence geographically they are located everywhere in the world. . this high availability of data helps traders to react quickly. radio. and of course. during afternoon in London. The daily volume in the Forex market is estimated at 3 trillion dollars. and regular news affect the Forex market instantly. True. 5. Quote information is transferred electronically through multinational companies such as Reuters. As long as you have an agency. from the smallest investor to George Soros. Tokyo and New York City are major financial hubs. Most traders don’t even need a physical trading agency at their country. this means that an average $100. Hence. Anyone can trade anywhere. and many more. Remember that when you start a trading session. trading volume is highest. you can trade. you must also close it.000 billion) is divided between deals intended for payments related to import and export. As usual. such as changes in interest rate. This real time behavior (almost) totally disables the ability of anyone to gain early information. deposit money via credit card (or Paypal) and start trading with an agency that resides overseas. Sharp moves in currency pairs can be seen as the news breaks out. This astonishing number (3.
Due the vast amount of money involved. Trading agencies can offer their customers very high leverages. These spreads are much lower than spreads that we usually meet when buying foreign currency – cash money. and so much money. 6. A common deal would be of $100. Contrary to stocks. There’s a very high volume and high liquidity in the Forex market. Over the past decade microstructure research has revealed that this ―price discovery‖ process involves different categories of market participants.4 Players in Forex Market A key goal of exchange rate economics is to understand currency returns.Most traders usually use a leverage of 100.selling and buying prices. open positions can be closed at almost any market condition. Since there is high volume. the spread would be about 3 to 5 pips. and the profits of the trading agencies. it is impossible for any person or company to have a major influence on the market. a pair of currencies cannot be manipulated by a small of group of people with interests. The cost is one of the lowest in the international financial markets.000 can be sufficient for a deal of $2. or margins.000 which would demand guarantees of $1000 – not too much cash for a normal investor. Past experience shows us that even when central banks interfered with the foreign exchange market. and (b) the extent to which the agent is informed. thus creating competition. There are so many players. because mostly it is the big banks and government who are the players in foreign exchange market. and other characteristics. investment houses and brokers into the market. 5.000. The leverage ratio can sometimes surpass 200. These low spreads. that this cannot be achieved. A well traded currency like the US Dollar. such as the stock market. For major currency pairs. will usually suffer from a higher spread. Currencies came into existence because they solved the problem of the coincidence of wants with . fueled by the high competition. such as the South African Rand or the Hungarian Forint. is the cost of the deals. Euro or the Japanese Yen. something that is uncommon in other financial markets. They usually failed in achieving their goals when they put a big foot in the market. Foreign exchange market is a big player market. Exchange rates – like asset prices more generally – move in response to new information about their fundamental value. It can sometimes be lower. The original FX market participants were traders in goods and services. while less traded currencies. but it’s important to notice the agreement with the trading agency: additional costs can be imposed in such cases.000. they had success only in the short term. Each participant’s distinct role is determined by (a) whether the agent is a liquidity maker or taker. This draws many banks. draw many people into Forex trading. compared to the size of the deals. 3. will have very low spreads. Guarantees of $10. These spreads.
The profitability of foreign exchange trading is a perfect characteristic for banks to be involved.B. Some of this trading represents foreign currency conversions on behalf of customers' needs while some is carried out by the banks' proprietary trading desk for speculative purpose. Their intervention in the foreign exchange market is not to earn profit from foreign currency trading. To do so. the ECB. hedging. commercial banks and financial institutions. and arbitrage with the list of key players expanding accordingly.National central banks (such as the US Fed. Commercial Banks . They also manage the country's foreign exchange reserves that they can use in order to influence market conditions and exchange rates.Traditionally known as a savings and lending institution. The Forex over the counter market is formed by different participants – with varying needs and interests – that trade directly with each other. central banks are sometimes jokingly referred to as circus performers because of the daily balancing act that they have to perform. The Interbank Market The interbank market designates Forex transactions that occur between central banks. they also have official target rates for the currencies that they are handling. Banks are usually involved in both large quantities of speculative trading and also daily commercial turnover. Financial Institutions .I. small individual (retail) traders. They are the natural players in foreign exchange as all other participants must deal with them.) play an important role in the Forex market. These participants can be divided in two groups: the interbank market and the retail market. Foreign exchange currency trading began as an added service to deposits and loans offered by commercial banks. dealers.respect to goods. their role consists in achieving price stability and economic growth. Central banks are also responsible for stabilizing the forex market. In addition. they regulate the entire money supply in the economy by setting interest rates and reserve requirements. Their main purpose is to provide adequate trading conditions. Commercial banks provide liquidity to the Forex market due to the trading volume they handle every day. Central banks intervene in economic or financial imbalance in the foreign exchange market. investment funds. Most countries have their own currencies so international trade in goods requires trade in currencies. They do this by balancing the country's foreign exchange reserves. Because of this role. the major categories of market participants now include asset managers. R. Beyond importers and exporters. The motives for currency exchange have expanded over the centuries to include speculation. and – most recently – high-frequency traders. banks are certainly one of the major players in forex market. pension funds and brokerage companies trade foreign . The really big and well-established banks trade in the billions of dollars in foreign currencies every day.Financial institutions such as money managers. central banks. Central Banks . As principal monetary authority.
Through the Forex market. corporations and individuals / retail forex brokers and speculators. a manager of an international equity portfolio will have to engage in currency trading in order to buy and sell foreign stocks. they were not interested in foreign exchange trading. The participants of the retail market are investment firms. o Investment Firms . they convert currencies and hedge themselves against future fluctuations.They represent the companies that are engaged in import/export activities with foreign counterparts. These situations exist because there are basically no limitations to the nationalities of customers that an investment firm can attract. Macro Hedge Funds pursue trading opportunities in the Forex Market. These transactions are executed through Forex brokers who act as a mediator between the retail market and the interbank market. hedge funds. needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.currencies as part of their obligations to seek the best investment opportunities for their clients. . Sometimes. Their primary business requires them to purchase and sell foreign currencies in exchange for goods. exposing them to currency risks. investment managers with an international equity portfolio. For example.Investment management firms commonly manage huge accounts on behalf of their clients such as endowments and pension funds. o Individuals / Retail Forex Brokers . these investments require the exchange of foreign currencies so they have to facilitate these transactions through the use of the foreign exchange market.Hedge funds are private investment funds that speculate in various assets classes using leverage.Individual traders or investors trade Forex on their own capital in order to profit from speculation on future exchange rates. Initially. The Retail Market The retail market designates transactions made by smaller speculators and investors. They design and execute trades after conducting a macroeconomic analysis that reviews the challenges affecting a country and its currency. o Hedge Funds .. Due to their large amounts of liquidity and their aggressive strategies. they are a major contributor to the dynamics of Forex Market. but the trend of companies going international and tight competition amongst them made them think twice. o Corporations . Therefore.
Speculators are risk-taking investors with expertise in the market(s) in which they are trading and will usually use highly leveraged investments such as futures and options. Note that these factors are in no particular order. A single retail forex broker estimates retail volume of between 25 to 50 billion dollars each day. Speculators are a "hardy" bunch simply because they are more adept at handling and maybe even sidestepping risks that regular investors would prefer not to be involved with. o Speculators – A person. like many aspects of economics. Remember.They mainly operate through Forex platforms that offer tight spreads. Numerous factors determine exchange rates. They handle a fraction of the total volume of the entire forex market. which is critical to every free market economy in the world. but do not let that fool you. exchange rate is one of the most important determinants of a country's relative level of economic health. The following are some of the principal determinants of the exchange rate between two countries. analyzed and governmentally manipulated economic measures. . A higher exchange rate can be expected to lower the country's balance of trade. Their volume is estimated to make up 2% of the total market volume. while a lower exchange rate would increase it. Here we look at some of the major forces behind exchange rate movements. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets. These can be individuals or groups of individuals. For this reason.5 Factors affecting Movement of Exchange Rates Aside from factors such as interest rates and inflation. These are the individuals or private investors who purchase and sell foreign currencies and profit through fluctuations on their price. the relative importance of these factors is subject to much debate. exchange rates are relative. immediate execution and highly leveraged margin accounts. exchange rates are among the most watched. Before we look at these forces. who trades in currencies with a higher than average risk in return for higher than average profit potential. 3. a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. and are expressed as a comparison of the currencies of two countries. Speculators take large risks. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. especially with respect to anticipating future price movements. we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. in the hope of making quick large gains. Exchange rates play a vital role in a country's level of trade. and all are related to the trading relationship between two countries.
the country requires more foreign currency than it receives through sales of exports. and it supplies more of its own currency than foreigners demand for its products. the countries with low inflation included Japan. nations with large public deficits and debts are less attractive to foreign investors. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners. The impact of higher interest rates is mitigated. central banks exert influence over both inflation and exchange rates. Germany and Switzerland. a country with a consistently lower inflation rate exhibits a rising currency value. inflation and exchange rates are all highly correlated. Current-Account Deficits The current account is the balance of trade between a country and its trading partners. The reason? A large debt encourages inflation. lower interest rates tend to decrease exchange rates.that is. By manipulating interest rates. . During the last half of the twentieth century. Higher interest rates offer lenders in an economy a higher return relative to other countries. Differentials in Interest Rates Interest rates. while the U. interest and dividends. 2. and that it is borrowing capital from foreign sources to make up the deficit.1. 4. however. 3. and Canada achieved low inflation only later.S. While such activity stimulates the domestic economy. the debt will be serviced and ultimately paid off with cheaper real dollars in the future. Public Debt Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. Differentials in Inflation As a general rule. and changing interest rates impact inflation and currency values. as its purchasing power increases relative to other currencies. higher interest rates attract foreign capital and cause the exchange rate to rise. The opposite relationship exists for decreasing interest rates . reflecting all payments between countries for goods. and if inflation is high. and foreign assets are too expensive to generate sales for domestic interests. services. if inflation in the country is much higher than in others. Therefore. A deficit in the current account shows the country is spending more on foreign trade than it is earning. In other words. or if additional factors serve to drive the currency down. This is also usually accompanied by higher interest rates.
for example) is a crucial determinant of its exchange rate. increasing the money supply). the exchange rate will always be favourable. The fundamental factors are basic economic policies followed by the government in relation to inflation. unemployment. If the price of exports rises by a smaller rate than that of its imports. capacity utilization. the exchange rate will be . then it must increase the supply of securities for sale to foreigners. Finally. Political Stability and Economic Performance Fundamental factors include all such events that affect the basic economic and fiscal policies of the concerned government. a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. for countries facing balance of payment deficit. the country's debt rating (as determined by Moody's or Standard & Poor's. Similar for the countries which are having balance of payment surplus. these factors are found to be rather inactive unless the market attention has turned to fundamentals. thereby lowering their prices. a government may print money to pay part of a large debt. 5. This. Normally. If the price of a country's exports rises by a greater rate than that of its imports. but increasing the money supply inevitably causes inflation. Conversely. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. etc. This is a typical case for underdeveloped countries which rely on imports for development needs. Increasing terms of trade shows greater demand for the country's exports. However. in turn.In the worst case scenario. its terms of trade have favorably improved. other things remaining constant the currencies of the countries that follow the sound economic policies will always be stronger. the currency's value will decrease in relation to its trading partners. results in rising revenues from exports. Terms of Trade Trade of goods and services between countries is the major reason for the demand and supply of foreign currencies. Fundamental Factors viz. These factors normally affect the long-term exchange rates of any currency. if a government is not able to service its deficit through domestic means (selling domestic bonds. trends in import and export. On short-term basis on many occasions. the terms of trade is related to current accounts and the balance of payments. A ratio comparing export prices to import prices. in the long run exchange rates of all the currencies are linked to fundamental causes. Moreover. The current account balance (deficit or surplus) thus reflects the strength and weakness of the domestic currency. which provides increased demand for the country's currency (and an increase in the currency's value). For this reason. balance of payment position. 6.
The US Dollar is also considered a safer haven currency whenever there is a political crisis anywhere in the world. These speculators many times concentrate only on one factor affecting the exchange rate and as a result the market psychology tends to concentrate only on that factor neglecting all other factors that have equal bearing on the exchange rate movement. Swiss Franc as a refuge currency. Under these circumstances even when all other factors may indicate negative impact on the exchange rate of the currency if the one factor that the market is concentrating comes out positive the currency strengthens. started . 9. 7. can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. Political and Psychological factors Political and psychological factors are believed to have an influence on exchange rates. Speculation Speculation or the anticipation of the market participants many a times is the prime reason for exchange rate movements.g. Political turmoil. The initial positioning and final profit taking make exchange rates volatile. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Continuous and ever growing deficit in balance of payment indicates over valuation of the currency concerned and the dis-equilibrium created can be remedied through devaluation. Capital Movement The phenomenon of capital movement affecting the exchange rate has a very recent origin.adverse. Movement of these petro dollars. Many currencies have a tradition of behaving in a particular way for e. for example. Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. Those speculators anticipate the events even before the actual data is out and position themselves accordingly in order to take advantage when the actual data confirms the anticipations. The total foreign exchange turnover worldwide is many times the actual goods and services related turnover indicating the grip of speculators over the market. 8. Huge surplus of petroleum exporting countries due to sudden spurt in the oil prices could not be utilized by these countries for home consumption entirely and needed to be invested elsewhere productively.
stocks and shares. Countries which attract large capital inflows through foreign investments. 11. will witness an appreciation in its domestic currency as its demand rises. influence the demand and supply of related currencies. Stock Exchange Operations Stock exchange operations in foreign securities. with various predictions of the future government and its policies. An economy with a strong. Official intervention can smoothen an otherwise disorderly market but it is also the experience that if the authorities attempt half-heartedly to counter the market sentiments through intervention in the market. debentures. Others . Political Factors Political scenario of the country ultimately decides the strength of the country. Capital tended to move from lower yielding to higher yielding currencies and as a result the exchange rates moved. In the second quarter of 1985 the movement of exchange rates of major currencies reflected the change in the US policy in favour of co-ordinated exchange market intervention as a measure to bring down the value of dollar. Outflow of capital would mean a depreciation of domestic currency. thus influencing their exchange rate. 12.affecting the exchange rates of various currencies. In 1998. ultimately more steep and sudden exchange rate swings can occur. Stable efficient government at the centre will encourage positive development in the country. creating successful investor confidence and a good image in the international market. positive image will obviously have a strong domestic currency. 10. Intervention Exchange rates are also influenced in no small measure by expectation of changes in regulation relating to exchange markets and official intervention. 13. the Indian rupee depreciated against the dollar due to the American sanctions after India conducted the Pokharan nuclear test. International investments in the form of Foreign direct investment (FDI) and Foreign institutional investments (FII) have become the most important factors affecting the exchange rate in today’s open world economy. This is the reason why speculations rise considerably during the parliament elections.
To mitigate his uncertainty about the direction of the . with policies taking care of conflicting demands like inflation and export promotion.6 Forward Contract. the amount which the dealers can raise in various ways. A currency forward contract is binding on both the parties to the contract. end of the month considerations to cover operations for the returns that the banks have to submit the central monetary authorities etc. 3. welcoming foreign investments and avoiding an appreciation of the domestic currency. stable currency. . banks' attitude towards keeping open position during the course of a day. an Indian exporter signs a contract today to sell hardware to a French importer. Currency Forward Contracts Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future.The turnover of the market is not entirely trade related and hence the funds placed at the disposal of foreign exchange dealers by various banks. The exporter now has a known euro receivable. the Rupee value of the euro receivable will rise or fall depending on fluctuations in the exchange rate. For example. at the end of the day. all at the same time. By locking into a forward contract to sell a currency. but a complex mix of multiple factors influencing the demand and supply. Value of a currency is thus not a simple result of its demand and supply. on the eve of weekends and holidays. window dressing operations as at the end of the half year to year. the investor has in effect "locked in" the exchange rate payment amount. The terms of the contract require the importer to pay Euros in six months' time. Over the next six months. It’s a tight rope walk for any country to maintain a strong. Futures Contract.all affect the exchange rate movement of the currencies. the seller sets a future exchange rate with no upfront cost. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up. Options Contract a.
he gives up all benefits if the currency appreciates. to suit an agreed payment plan with an overseas supplier. Foreign currency forwards’ can help you budget more accurately and help you to stay in control of your finances. or the interest rate differential as it is formally known. Fixed date forwards are exactly that.g. This arrangement leaves the exporter fully protected should the currency depreciate below the contract level. However. to arrange a FX forward. as interest rates are higher in Europe than they are in the UK. . For example. It is not a prediction of where the spot FX rate is likely to be on the future date. This is a major drawback for many companies that consider this to be the true cost of a forward contract hedge. he hedges the euro receivable by locking in a forward. this aspect of a forward is an acceptable "cost". You can agree a rate of exchange on one or more specific date in the future. e. The agreed rate is locked in and you exchange using that rate over a period that can range from one week to a year. forwards are one of the least forgiving hedging instruments because they require the buyer to accurately estimate the future value of the exposure amount.exchange rate. Foreign currency forwards contracts are considered over-the-counter (OTC) because there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide. The difference between the two is the interest rate differential and in this situation the difference is charged to the client by building it into the forward exchange rate itself. the Bank is effectively borrowing euros on behalf of the client in order to convert to sterling now to secure the current exchange rate. Open Forwards can give you additional flexibility. Once the time period is fixed. the seller of a forward rate faces unlimited costs should the currency appreciate. For companies that consider this to be only an opportunity cost.. the exporter may elect to lock in the rate at which he will sell the euros and buy Rupees in six months. Foreign currency forwards contracts may have different contract sizes. For this reason. A forward rate is calculated with reference to the difference between the interest rates of the two countries involved. time periods and settlement procedures than futures contracts. in May 2011 the cost of borrowing EUR in the money market is higher than the deposit interest rate for GBP. The Bank is earning a lower rate of interest holding the sterling deposit for the next six months compared to the rate of interest we are paying to borrow euro for six months. To accomplish this. as the agreed rate can be exchanged on any date within an agreed time period. In fact. you can draw down funds of any size at any time. In the above example.
booked by an Exporter seeks to protectt his profitability from his business operations. if the foreign currency (vs INR) price depreciates as on date of cancellation as compared to the spot rate on date of booking the contract. locks an Exporter / Importer into a fixed rate of exchange. a forward currency contract suffers from the following disadvantages viz. or rules & regulations issued. A person resident in India may enter into a forward contract with an AD in India to hedge an exposure to exchange risk in respect of a transaction for which sale and/or purchase of foreign exchange is permitted under the FEMA Act. if the reverse was the case and the client was looking to convert sterling to euro for a six months forward. Conversely. The six month forward rate would therefore appear more favourable than the sterling to euro spot rate. As long as the Forward Contract is not cancelled. The interest rate differential in this situation is credited to the client by building it into the six month forward exchange rate. no upfront fees. there could a loss to the Exporter. there could be a gain for the Exporter . a Forward Currency Contract. Forward contracts are permitted only for hedging and not for speculation. where necessary. A forward contract can be booked for the following: • an inward / outward remittance for export / import transactions respectively • foreign currency loans / bonds . If a Forward Contract (Exports) is cancelled. if the foreign currency (vs INR) price appreciates as on date of cancellation as compared to the spot rate on date of booking the contract. A forward currency contract has the following advantages viz.only after RBI approval. the Exporter does not make any gains/losses on account of the fluctuations in the foreign currency versus INR (if exports is invoiced in foreign currency) If a Forward currency contract (Exports) is cancelled. has been obtained The currency of hedge and tenor will be the customers choice Maturity of the hedge should not exceed the maturity of the underlying transaction To summarise. .e. and Exporter/ Importer has to deliver the underlying currency whatever may be the Exchange Rate on date of delivery . and the contracted export takes place. However. However.This is why it currently appears that the six month forward rate for converting euro to sterling is higher (and therefore less favourable) than the rate to convert euro to sterling for value spot (two days). subject to the following conditions : There has to be a genuine underlying exposure i. we would be earning a higher rate of interest holding the euro deposit for six months than they are paying to borrow sterling for six months. forex risk due to currency fluctuation completely eliminated and profit on cancellation (depending on spot rate of the currency).
which acts as an intermediary between the two parties. the difference in the prior agreed-upon price and the daily futures price is settled daily also (variation margin). The terminology reflects the expectations of the parties—the buyer hopes or expects that the asset price is going to increase. Thus the exchange requires both parties to put up an initial amount of cash. Participants can buy or sell foreign currency at a set exchange rate on a future date. Two parties agree to buy and sell a certain currency at a given exchange rate with respect to another currency at some point in the future. A futures contract in which the underlying asset is a currency. futures) is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed today (the futures price or strike price) with delivery and payment occurring at a specified future date. and stocks). for financial futures the underlying item can be any financial instrument (also including currency. since the futures price will generally change daily.b. the delivery date. Additionally. In many cases. the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. The party agreeing to buy the underlying asset in the future. Currency Futures Contracts Currency futures started trading in 1972 at the Chicago Mercantile Exchange (CME). the "buyer" of the contract. The contracts are negotiated at a futures exchange. Currency Futures are contracts that allow participants to take a view on the movement of the exchange rate as well as hedge against currency risk. such as stock indexes and interest rates. is said to be "short". A Currency Futures contract allows market participants to trade the underlying exchange rate for a period in the future. When trading in futures contracts an investor can take one of two positions viz: Buy (Long) or Sell (Short) You are required to pay a deposit upfront (initial margin) when trading in Currency Futures. known as a good faith deposit The initial margin payment is used to eliminate . While the futures contract specifies a trade taking place in the future. the margin. while the seller hopes or expects that it will decrease in near future. A futures contract is a legally binding agreement that gives the investor the right to buy or sell an underlying currency at a fixed price on a future date. the "seller" of the contract. they can be also based on intangible assets or referenced items. the underlying asset to a futures contract may not be traditional commodities at all – that is. bonds. In finance. and the party agreeing to sell the asset in the future. a futures contract (more colloquially. The underlying instrument of a Currency Future is the exchange rate between one unit of foreign currency and the local currency. is said to be "long".
making it easier for them to plan. With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil.. livestock producers often purchase futures to cover their feed costs. as calculated by the exchange. The initial margin requirement varies between the different Currency Futures offered. where profits/losses are realized all at once at contract expiration. farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price. e. Profits/losses for a futures contract accumulate on a daily basis vs. The difference calculated from the previous day’s MTM price is either paid to the investors or paid by the investors to the clearinghouse. eliminate or control currency risk. your contract is liquidated by broker. The initial investment required to establish a futures position is called margin. etc. bet using futures contracts. in cash in the local currency. In modern (financial) markets.g. There are two participants in futures viz. every gain is exactly offset by a loss of the same amount. Buyer (seller) will gain (lose) when the settlement price rises (falls). and experts are divided on the matter. The Currency Future price is determined from the underlying market spot price to which forward points are added to deliver the final price used in the daily Mark-to-Market process. in traditional commodity markets. Every futures contract involves a buyer (long) and a seller (short). your initial margin plus interest is paid into your margin account. banks. and swing traders (swing trading). Futures trading is a "zero-sum" game. though many hybrid types and unique styles exist. Similarly. Your initial margin payment is held by the exchange and you earn daily interest on this payment. and are using futures trading to minimize. The daily profit / loss payment for each contract. Speculators and Hedgers Speculators – They have no interest in the underlying commodity / currency and purely speculate.g. At the end of each trading day contracts are Marked-to-Market (MTM). importers. The exchange calculates a closing price for each contract. day traders. e. so that they can plan on a fixed cost for feed. forward contract. Futures contracts are revalued daily depending on the daily settlement price (exrate). Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. exporters. "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap." usually 70-75% of the initial margin. Hedgers – They have a personal interest in the underlying commodity / currency.counterparty risk (the risk associated with one of the parties defaulting). If you can't make margin call. . You would also have to keep a "maintenance margin. Speculators typically fall into three categories: position traders. MNCs. When you close your position.
from a hedger to a speculator. and increased liquidity between traders with different risk and time preferences. 90% of settlements involve an actual exchange of assets. the person who is short (seller) actually delivers FX to the long (buyer).g. the short (seller) delivers the asset to the buyer (long). c. only 1% of contracts are settled with the underlying asset. Currency Options Contracts A Currency option (also FX. you get a cash settlement from your auto insurance company.where institutions and broker / dealers trade with each other over the phone to hedge their foreign currency exposure. the bank sells EUR to the importer at an agreed upon rate. With institutions dealing with transactions in the billions. currency options are now very popular amongst retail investors as electronic trading and market access is widely available. the contract is actually settled in cash continually throughout the contract. you take a short (sell) position to close out . 99% are "settled with cash" by a "reversing trade. this . However. your futures position. which closes out. Like buying insurance. FOREX option trading was initially conducted only by large institutions where fund managers." 90% of forward contracts involve an exchange of currency." Because of daily settlement. neutralizes your contract. so the importer can pay for merchandise or the bank buys Yen from the exporter at an agreed upon rate. so the exporter can convert foreign exchange into Indian Rupees In futures contracts.The social utility of futures markets is considered to be mainly in the transfer of risk. not a new car or body work. or FOREX option) is a financial product called a derivative where the value is based on an underlying instrument. e. Reversing Trade involves taking an offsetting position. neutralizes. If you are long (buy). Futures contracts are like "side bets. they were indeed traded OTC . FX options are call or put options that give the buyer the right (not the obligation) to buy (call) or sell (put) a currency pair at the agreed strike price on the stated expiration date. which in this case is a foreign currency. and you exit the market. In forward contracts.you are then selling to yourself. portfolio managers and corporate treasurers would offload risk by hedging their currency exposure in the FX option market. When currency options first came on the scene.
In addition to FOREX liquidity pools and OTC with your broker. This also means that currency options can be catered to the individual trader. FX options are more sensitive to macroeconomic factors than stock or futures options. However.makes sense. FX All and Curren X are all liquidity destinations for the FOREX market. are also influenced by company specific variables such as earnings reports. Any option agreements that you as a trader/client hold with such a company become worthless. while still affected by macro economic conditions. Without a standardized set of rules dictated by an exchange. For example. FOREX option pricing will need to consider: Underlying Price (the Spot FOREX rate) . downgrades. Many of the options traded via these firms are still considered OTC as the trader (customer) transacts directly with the broker. you have what's known as counterpart risk. the PHLX (NASDAQ) and the CME both offer currency options on currency futures. Political and/or economic factors play a large role on the view of currencies. Not all electronic trading destinations for currency options are OTC though. With a currency option. sector sentiment etc. These products will also be accessible by most retail online FX option brokers. Counterparty risk is more present in currency options than stock or futures options because there is no central clearing house to protect option traders when the dealer is unable to meet the exercise obligations. In this case the broker becomes the counter party to the currency option and hence has to bear the risk. the dividend yield represents the foreign currency's continually compounded risk-free interest rate. That is. many retail online brokerage firms as well as larger institutions provide electronic access to FOREX liquidity pools that also include the trading of currency options online. In the same way. rather than matching the order with another trader. the risk that the firm that holds the other side of the transaction goes bust. unlike stocks/futures/options. a trader can choose the strike/expiry and in rare case the expiration style of the contract that is traded with the broker. For example. In terms of market risk. Hot Spot. There are firms that provide liquidity pools for institutions to transact with one another often called Dark Pools. Like an equity option. For currency options that are OTC with your broker/dealer. FX options are generally European and hence can use a standard B&S model. especially since. currency options are also traded on exchanges. Stock options on the other hand. currency options can be priced using a standard black and scholes option model with a dividend yield. along with any financial obligation to deliver foreign currency. there is no central trading location for foreign exchange. There are two types of risk present when trading foreign exchange options: counter party risk and market risk.
where the payoff depends not on the exchange rate in effect on the day of expiration. what you have effectively done is to give away a currency option. but of course you will get less dollars per doodad. There are some other situations that could justify the use of currency options. If the euro falls against the dollar. An example might be where competitive analysis demonstrates that should a particular foreign currency fall to a certain level. If the euro rises. but these are situations that. the clever Germans will instead buy from your distributor in New Jersey whose price list they also have. And one of these is averting the costs of financial distress. Hedging can under some circumstances reduce the cost of debt: for instance when it reduces the expected costs of bankruptcy to creditors. Then both the natural exposure and the hedging instrument have payoffs that are exchange rate contingent and a currency option is exactly the right kind of hedge. or of financial distress to shareholders. By way of illustration. Anticipation of such an event could call for purchasing so-called Asian options. Where fluctuations in the firm's value can be directly attributed to exchange rate movements. or if it allows greater leverage and hence increases the tax shield afforded by debt finance. in certain well-defined situations. then producers in that country would gear up for production and would take away market share or force margins down. the Germans will buy your doodads. Are Currency Options Ever Useful? Yes. consider an American firm that sells in Germany and issues a price list in euros. Your dollar revenues are constant if the euro rises but fall if the euro drops. few companies seem to grasp. but in a more complex way than that described by conventional options. There is one kind of foreign currency cash flow for which the conventional currency option is perfectly suited: that is the rare exception where the probability of a company's foreign currency receipts or payments depends on the exchange rate. This asymmetric currency risk can be neatly hedged with a put option on Euro A variation on the above could be one where the company's profitability depends in some asymmetric fashion on a currency's value.Interest Rate = Local Currency Interest Rate Dividend Yield = Foreign Currency Interest Rate Strike Price = The cross rate at which the currency will be exchanged Expiration Date = The expiry date of the option Volatility = The expected future volatility of the exchange rate over the life of the option The forward price used for the currency option is a combination of both interest rates in each country. but on an average of rates over some period. as measured by the average spot rate over three months. Perhaps you were dumb to fix prices in both currencies. .
In such a case it would be buying insurance only against the extreme exchange rate that would put the firm into bankruptcy. They are not. Whatever happens to your "natural" positions. For these reasons. with time. A currency option is the perfect hedge only for the kind of exposure that results from the firm itself having granted an implicit currency option to another party.9 Self-assessment questions 3. Thus forwards are okay for many hedging purposes. currency options offer an imperfect hedge. The general rule about hedging tools is that specific kinds of hedging tools are suited to specific kinds of currency exposure.11 Model answers . Option-based positioning is far more complicated than outright long or short exposures. The reason is that the gain or loss from an option is a non-linear function of the currency's value. Their actions and statements suggest that many believe currency options are a good way to profit from anticipated moves in the currency. (Even this is often untrue.10 Further reading 3. 3.) But the kind of exposure for which foreign exchange options are the perfect hedge are much rarer. such as a foreign currency asset.the firm may be best off buying a out-of-the-money currency options.7 Summary 3. and that the relationship is not stable but varies with anticipated volatility. Usually. and with the level of interest rates.8 Key words 3. boring old forward contracts can do the job more effectively. you want a hedge whose value changes in precisely the opposite fashion. because the firms' natural position tends to gain or lose one-for-one with the exchange rate. because contracts are not won or lost solely because of an exchange rate change. options are not ideal speculative instruments for corporations. while plain. Frequently corporate treasurers use options to get the best of both worlds: hedging combined with a view.
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