Currency Derivative

Forex market
Currency Derivative: Business Perspective Page 1

1.1 WHAT IS FOREX MARKET?
The international currency market Forex is a special kind of the world financial market.
Trader’s purpose on the Forex is to get profit as the result of foreign currencies purchase and
sale. The exchange rates of all currencies being in the market turnover are permanently changing
under the action of the demand and supply alteration. The latter is a strong subject to the
influence of any important for the human society event in the sphere of economy, politics and
nature. Consequently current prices of foreign currencies, evaluated for instance in US dollars,
fluctuate towards its higher and lower meanings.
Using these fluctuations in accordance with a known principle “buy cheaper – sell
higher” traders obtain gains. Forex is different in compare to all other sectors of the world
financial system thanks to his heightened sensibility to a large and continuously changing
number of factors, accessibility to all individual and corporative traders, exclusively high trade
turnover which creates an ensured liquidity of traded currencies and the round – the clock
business hours which enable traders to deal after normal hours or during national holidays in
their country finding markets abroad open. Just as on any other market the trading on Forex,
along with an exclusively high potential profitability, is essentially risk - bearing one. It is
possible to gain a success on it only after a certain training including a familiarization with the
structure and kinds of Forex, the principles of currencies price formation, the factors affecting
prices alterations and trading risks levels, sources of the information necessary to account all
those factors, techniques of the analysis and prediction of the market movements as well as with
the trading tools and rules.
Foreign exchange market is an over the counter market in which currencies of different
countries are bought and sold against each other. Foreign Exchange is nothing but claims of the
residents of a country to foreign currency payable abroad. It is a method of converting one
country's currency into another. So long as there is a cross border flow of funds, the need for
such conversion/exchange continues to arise.

Forex markets are quite decentralized. Participants like market makers, brokers, corporate
and individual customers are physically separated from each other. They communicate with each
other via, telephone, telex, computer network, etc. It is the commercial banks that offer such
conversion facility through their dealing rooms. Today, it is a giant market.
1.2 Trade systems on Forex
Trading with brokers. Foreign exchange brokers, unlike equity brokers, do not take
positions for themselves; they only service banks. Their roles are to bring together buyers and
sellers in the market, to optimize the price they show to their customers and quickly, accurately,
and faithfully executing the traders' orders. The majority of the foreign exchange brokers execute
business via phone using an open box system — a microphone in front of the broker that
continuously transmits everything he or she says on the direct phone lines to the speaker boxes in
the banks.
This way, all banks can hear all the deals being executed. Because of the open box
system used by brokers, a trader is able to hear all prices quoted; whether the bid was hit or the
offer taken; and the following price. What the trader will not be able to hear is the amounts of
particular bids and offers and the names of the banks showing the prices. Prices are anonymous.
The anonymity of the banks that are trading in the market ensures the market's efficiency, as all
banks have a fair chance to trade. Sometimes brokers charge a commission that is paid equally
by the buyer and the seller. The fees are negotiated on an individual basis by the bank and the
brokerage firm. Brokers show their customers the prices made by other customers, either two-
way (bid and offer) prices or one way (bid or offer) prices from his or her customers. Traders
show different prices because they "read" the market differently; they have different expectations
and different interests. A broker who has more than one price on one or both sides will
automatically optimize the price. In other words, the broker will always show the highest bid and
the lowest offer. Therefore, the market has access to an optimal spread possible. Fundamental
and technical analyses are used for forecasting the future direction of the currency. A trader
might test the market by hitting a bid for a small amount to see if there is any reaction. Another
advantage of the brokers' market is that brokers might provide a broader selection of banks to

their customers. Some European and Asian banks have overnight desks so their orders are
usually placed with brokers who can deal with the American banks, adding to the liquidity of the
market.
Direct Dealing. Direct dealing is based on trading reciprocity. A market maker—the
bank making or quoting a price — expects the bank that is calling to reciprocate with respect to
making a price when called upon. Direct dealing provides more trading discretion, as compared
to dealing in the brokers' market. Sometimes traders take advantage of this characteristic. Direct
dealing used to be conducted mostly on the phone. Phone dealing was error-prone and slow.
Dealing errors were difficult to prove and even more difficult to settle. Direct dealing was
forever changed in the mid-1980s, by the introduction of dealing systems. Dealing systems are
on-line computers that link the contributing banks around the world on a one-on-one basis. The
performance of dealing systems is characterized by speed, reliability, and safety. Dealing
systems are continuously being improved in order to offer maximum support to the dealer's main
function: trading. The software is rather reliable in picking up the big figure of the exchange
rates and the standard value dates. In addition, it is extremely precise and fast in contacting other
parties, switching among conversations, and accessing the database. The trader is in continuous
visual contact with the information exchanged on the monitor. It is easier to see than hear this
information, especially when switching among conversations. Most banks use a combination of
brokers and direct dealing systems. Both approaches reach the same banks, but not the same
parties, because corporations, for instance, cannot deal in the brokers' market. Traders develop
personal relationships with both brokers and traders in the markets, but select their trading
medium based on price quality, not on personal feelings. The market share between dealing
systems and brokers fluctuates based on market conditions. Fast market conditions are beneficial
to dealing systems, whereas regular market conditions are more beneficial to brokers.
Matching Systems. Unlike dealing systems, on which trading is not anonymous and is
conducted on a one-on-one basis, matching systems are anonymous and individual traders deal
against the rest of the market, similar to dealing in the brokers' market. However, unlike the
brokers' market, there are no individuals to bring the prices to the market, and liquidity may be
limited at times. Matching systems are well-suited for trading smaller amounts as well. The
dealing systems' characteristics of speed, reliability, and safety are replicated in the matching

systems. In addition, credit lines are automatically managed by the systems. Traders input the
total credit line for each counterparty. When the credit line has been reached, the system
automatically disallows dealing with the particular party by displaying credit restrictions, or
shows the trader only the price made by banks that have open lines of credit. As soon as the
credit line is restored, the system allows the bank to deal again. In the inter-bank market, traders
deal directly with dealing systems, matching systems, and brokers in a complementary fashion.
Trading Forex works remarkably easy. But you have to make your own trading system.
A trading system is created by generating signals, setting up a decision making

procedure, and incorporating risk management into the system. A trading system is supposed to
be objective and mechanical. The analyst combines a set of objective trading rules (usually in a
formula or algorithm). As a general rule, good technical analysis indicators are the building
blocks of good trading systems. However, as previously mentioned, even good technical analysis
indicators can lose their validity when combined in a trading system. Therefore, it is important to
not only back-test your system but to also forward-test your system in real time.
1.3 Pitfalls of Trading Systems
Trading systems are supposed to be objective and mechanical. They take the intuition
out of trading. Buy when the system tells you to and sell when the system tells you to. The
problem is that there are not a lot of good trading systems out there. However, some are created
for certain institutions to take advantage of arbitrage opportunities, or tricky derivative strategies.
They are not at all suitable for the average trader.
Traders tend to lose objectivity when using technical analysis indicators. The trader is not
able to remain objective and the subjectivity of using the indicator overwhelms him.
Traders have a tendency to test their trading systems and technical analysis indicators on
an insufficient amount of data. Analysts need to test trading systems and technical analysis
indicators on a wide array of data in different types of trading markets.

Additionally, many traders and analysts don't forward test their trading systems and
technical analysis indicators in real time. They rush to trade based on insufficient back-testing
and forward-testing. Thus, they are trading on not a sound, valid basis. Many traders fail to
incorporate sound risk management techniques in their trading systems. Additionally, many
traders fail to incorporate stop loss orders with their initial orders when using technical analysis
indicators only.
Traders also tend to over-optimize their trading systems. They start asking the what-if
question and back-test the trading system with different parameters. They are always trying to
trade with the parameters which generate the highest amount of wins. However, in real time
these over-optimized systems rarely perform well. Another trap traders fall into is to use too
many technical analysis indicators. Find the few that work consistently well for you and go with
them.
There are basically two types of Forex trading systems, mechanical and discretionary
systems. The trading signals that come out of mechanical systems are mainly based off technical
analysis applied in a systematic way. On the other hand, discretionary systems use experience,
intuition or judgment on entries and exits.

We will first analyze the advantages and disadvantages of each system.
Advantages Disadvantages
Mechanical systems
This kind of system can be

Most traders back test Forex trading systems incorrectly.
automated and back tested
In order to produce accurate results you need tick data.
efficiently.
The Forex market is always changing.
It has very rigid rules.

The Forex market (and all markets) has a random component.
Either, there is a trade or there
isn’t.
The market conditions may look similar, but they are never the same.
Mechanical traders are less

A system that worked successfully the past year doesn’t
susceptible to emotions than
necessary mean it will work this year.
discretionary traders.
Discretionary systems
Discretionary systems are easily

adaptable to new market
They cannot be back tested or automated, since there is
conditions
always a thought decision to be made.
.
Trading decisions are based on
It takes time to develop the experience required to trade
experience.
successfully and track trades in a discretionary way.
Traders learn to see which trading

At early stages this can be dangerous.
signals have higher probability of
success.

1.4 FOREX CURRENCIES
There are 7 most traded currencies in forex market.
Currencies are traded in dollar amounts called "lots". One lot is equal to $1,000, which
controls $100,000 in currency. This is what is known as the "margin". You can control $100,000
worth of currency for only 1,000 dollars. This is what is called "High Leverage".
Currencies are always traded in pairs in the FOREX.
Here are some of the common symbols used in the Forex:
 USD - The US Dollar

 EUR - The currency of the European Union "EURO"
 GBP - The British Pound
 JPN - The Japanese Yen
 CHF - The Swiss Franc
 AUD - The Australian Dollar
 CAD - The Canadian Dollar
A currency can never be traded by itself. So you can not ever trade a EUR by itself. You
always need to compare one currency with another currency to make a trade possible.
The Euro is the dominant base currency against all other global currencies. Thus,
currencies paired with the EUR will always be identified with the EUR acronym first in the
sequence. The British Pound is next in the hierarchy of currency name domination and usually
USD after that. (Aside from the EUR and GBP, the only case where the USD is not the base
currency of a pair is with the Australian & New Zealand dollars).
Every foreign exchange transaction is an exchange between two currencies, each

denoted by a unique three-letter code. Currency pairings are expressed as two codes usually
separated by a division symbol (e.g. GBP/USD), the first representing the “base currency” and
the other the “secondary currency”. The base currency is the one that you are buying or selling.

The exchange rate is the price of one currency in terms of another. For example
GBP/USD = 1.5545 denotes that one unit of sterling (the base currency) can be exchanged for
1.5545 US dollars (the secondary currency).
Pairings with the US dollar are known as the “majors”. The “big four” majors are:
 EUR/USD: euro/US dollar

 GBP/USD: sterling/US dollar (known as “cable”)
 USD/JPY: US dollar /Japanese yen
 USD/CHF: US dollar/Swiss franc
Pairings of non-U.S. Dollar currencies from the aforementioned major pairings are known as
crosses.
EUR/GBP EUR/JPY GBP/CAD GBP/CHF AUD/CAD CHF/JPY
EUR/CHF EUR/AUD GBP/JPY AUD/JPY AUD/NZD CHF/NZD
Exotic pairings involve currencies not included in the eight major currencies. There are
hundreds of currencies around the world, most of which are not easily traded on the open market.
There are a few exotics some speculators will venture into; however, the spreads on these
currencies tend to be very wide and the degree of risk makes them generally unattractive to most
traders.

The seven categories of Forex currencies:
Top currency
This rarified rank is reserved only for the most esteemed of international currencies -
those whose use dominates for most if not all types of cross-border purposes and whose
popularity is more or less universal, not limited to any particular geographic region. During the
era of territorial money, just two currencies could truly be said to have qualified for this exalted
status: Britain's pound sterling before World War I and the U.S. dollar after World War II.
Patrician currency
Just below the top rank we find currencies whose use for various cross-border purposes,
while substantial, is something less than dominant and/or whose popularity, while widespread, is
something less than universal. Obviously included in this category today would be the euro, as
natural successor to the DM; most observers would still also include the yen, despite some recent
loss of popularity. Both are patricians among the world's currencies.
Elite currency
In this category belong currencies of sufficient attractiveness to qualify for some degree
of international use but of insufficient weight to carry much direct influence beyond their own
national frontiers. Here we find the more peripheral of the international currencies, a list that
today would include inter alia Britain's pound (no longer a Top Currency or even Patrician
Currency), the Swiss franc, and the Australian dollar.
Plebian currency
One step further down from the elite category are Plebian Currencies - more modest
monies of very limited international use. Here we find the currencies of the smaller industrial
states, such as Norway or Sweden, along with some middle-income emerging-market economies
(e.g., Israel, South Korea, and Taiwan) and the wealthier oil-exporters (e.g., Kuwait, Saudi
Arabia, and the United Arab Emirates).

Internally, Plebian Currencies retain a more or less exclusive claim to all the traditional
functions of money, but externally they carry little weight (like the plebs, or common folk, of
ancient Rome). They tend to attract little cross-border use except perhaps for a certain amount of
trade invoicing.
Permeated currency
Included in this category are monies whose competitiveness is effectively compromised

even at home, through currency substitution. Although nominal monetary sovereignty continues
to reside with the issuing government, foreign currency supersedes the domestic alternative as a
store of value, accentuating the local money's degree of inferiority.
Permeated Currencies confront what amounts to a competitive invasion from abroad.

Judging from available evidence, it appears that the range of Permeated Currencies today is in
fact quite broad, encompassing perhaps a majority of the economies of the developing world,
particularly in Latin America, the former Soviet bloc, and Southeast Asia.
Quasi-currency
One step further down are currencies that are superseded not only as a store of value but,
to a significant extent, as a unit of account and medium of exchange, as well. Quasi-Currencies
are monies that retain nominal sovereignty but are largely rejected in practice for most purposes.
Their domain is more juridical than empirical. Available evidence suggests that some
approximation of this intensified degree of inferiority has indeed been reached in a number of
fragile economies around the globe, including the likes of Azerbaijan, Bolivia, Cambodia, Laos,
and Peru.
Pseudo-currency
Finally, we come to the bottom rank of the pyramid, where currencies exist in name only
- Pseudo-Currencies. The most obvious examples of Pseudo-Currencies are token monies like
the Panamanian balboa, found in countries where a stronger foreign currency such as the dollar is
the preferred legal tender.

1.5 FOREX MARKET ADVANTAGES
There are many benefits and advantages to trading Forex. Here are just a few reasons
why so many people are choosing this market as a profitable business opportunity:
1. Powerful forex leverage
In Forex trading, a small margin deposit can control a much larger total contract value.
Leverage gives the trader the ability to make extraordinary profits and at the same time keep risk
capital to a minimum.
2. Liquidity
Because the Forex Market is so large, it is also extremely liquid. This means that with a
click of a mouse you can instantaneously buy and sell at will. You are never 'stuck' in a trade.
You can even set the online trading platform to automatically close your position at your desired
profit level (limit order), and/or close a trade if a trade is going against you (stop order).
3. Forex trading online is instant.
The FX market is fast. Orders are executed, filled and confirmed usually within 1-2
seconds. Since this is all done electronically with no humans involved, there is little to slow it
down!
4. Zero forex commissions
Because you access the market directly through electronic online forex trading you pay
zero commissions or exchange fees.
5. Limited risk
Your risk is strictly limited. You can never lose more than you have in your forex
account. This means you can never have a negative equity balance. You can also define and limit
your risk with stop-loss orders, which are guaranteed by stocks on all forex orders up to $1
million in size.

6. Guaranteed prices and Instantaneous Fills
You get instantaneous execution and total price certainty on all orders up to $1 million in
size. This allows you to trade forex with confidence off real-time, two-way quotes. And this
price guarantee applies to stop-loss and limit orders as well.
7. 24-hour market
Forex is a 24-hour-a-day market that literally follows the sun around the world, from the
U.S. to Australia and New Zealand to Hong Kong, the Far East, Europe and then back again to
the U.S. The huge number and diversity of forex investors involved make it difficult even for
governments to control the direction of the forex market. The unmatched liquidity, and around-
the-clock global activity make forex the ideal market to trade.
8. Free 'demo' accounts, news, charts and analysis
Most Online Forex firms offer free 'Demo' accounts to practice trading, along with
breaking Forex news and charting services. These are very valuable resources for traders who
would like to hone their trading skills with 'virtual' money before opening a live trading account.
9. 'Mini' trading
One might think that getting started as a currency trader would cost a lot of money. The
fact is, it doesn't. Some Forex firms now offer 'mini' trading accounts with a minimum account
deposit of only $200 with no commission trading. This makes Forex much more accessible to the
average individual, without large, start-up capital.

1.6 PARTICIPANTS IN FOREIGN EXCHANGE MARKET
The main players in foreign exchange market are as follows:
1. CUSTOMERS
The customers who are engaged in foreign trade participate in foreign exchange market by
availing of the services of banks. Exporters require converting the dollars in to rupee and
importers’ require converting rupee in to the dollars, as they have to pay in dollars for the
goods/services they have imported.
2. COMMERCIAL BANKS
They are most active players in the forex market. Commercial bank dealing with international
transaction offer services for conversion of one currency in to another. They have wide network
of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to
the importers of goods. As every time the foreign exchange bought or oversold position. The
balance amount is sold or bought from the market.
3. CENTRAL BANK
In all countries Central bank have been charged with the responsibility of maintaining the
external value of the domestic currency. Generally this is achieved by the intervention of the
bank.
4. EXCHANGE BROKERS
Forex brokers play very important role in the foreign exchange market. However the extent to
which services of foreign brokers are utilized depends on the tradition and practice prevailing at
a particular forex market center. In India as per FEDAI guideline the Ads are free to deal directly
among themselves without going through brokers. The brokers are not among to allowed to deal
in their own account allover the world and also in India.

5. OVERSEAS FOREX MARKET
Today the daily global turnover is estimated to be more than US$ 1.5 trillion a day. The
international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading
in world forex market is constituted of financial transaction and speculation. As we know that the
forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens,
thereafter India, followed by Bahrain, Frankfurt, paris, London, new york, Sydney, and back to
Tokyo.
6. SPECULATORS
The speculators are the major players in the forex market.
Bank dealing are the major pseculators in the forex market with a view to make profit on account
of favorable movement in exchange rate, take position i.e. if they feel that rate of particular
current go up in short term. They buy that currency and sell it as soon as they are able to make
quick profit.
 Corporation’s particularly multinational corporation and transnational corporation having
business operation beyond their national frontiers and on account of their cash flows being large
and in multi currencies get in to foreign exchange exposures. With a view to make advantage of
exchange rate movement in their favor they either delay covering exposures or do not cover until
cash flow materialize.
Individual like share dealing also undertake the activity of buying and selling of foreign
exchange for booking short term profits. They also buy foreign currency stocks, bonds and other
assets without covering the foreign exchange exposure risk. This also result in speculations

1.7 Risk Management in Forex
Trading foreign currencies is a challenging and potentially profitable opportunity for

educated and experienced investors. However, before deciding to participate in the Forex market,
you should carefully consider your investment objectives, level of experience and risk appetite.
Most importantly, do not invest money you cannot afford to lose.
There is considerable exposure to risk in any foreign exchange transaction. Any

transaction involving currencies involves risks including, but not limited to, the potential for
changing political and/or economic conditions that may substantially affect the price or liquidity
of a currency. Moreover, the leveraged nature of FX trading means that any market movement
will have an effect on your deposited funds proportionally equal to the leverage factor. This may
work against you as well as for you. The possibility exists that you could sustain a total loss of
initial margin funds and be required to deposit additional funds to maintain your position. If you
fail to meet any margin call within the time prescribed, your position will be liquidated and you
will be responsible for any resulting losses. Investors may lower their exposure to risk by
employing risk-reducing strategies such as 'stop-loss' or 'limit' orders.
There are also risks associated with utilizing an internet-based deal execution software
application including, but not limited, to the failure of hardware and software and
communications difficulties.
The Forex Market is the largest and most liquid financial market in the world. Since
macroeconomic forces are one of the main drivers of the value of currencies in the global
economy, currencies tend to have the most identifiable trend patterns. Therefore, the Forex
market is a very attractive market for active traders, and presumably where they should be the
most successful. However, success has been limited mainly for the following reasons:
Many traders come with false expectations of the profit potential, and lack the discipline
required for trading. Short term trading is not an amateur's game and is not the way most people
will achieve quick riches. Simply because Forex trading may seem exotic or less familiar then
traditional markets (i.e. equities, futures, etc.), it does not mean that the rules of finance and
simple logic are suspended. One cannot hope to make extraordinary gains without taking

extraordinary risks, and that means suffering inconsistent trading performance that often leads to
large losses. Trading currencies is not easy, and many traders with years of experience still incur
periodic losses. One must realize that trading takes time to master and there are absolutely no
short cuts to this process.
The most enticing aspect of trading Forex is the high degree of leverage used. Leverage
seems very attractive to those who are expecting to turn small amounts of money into large
amounts in a short period of time. However, leverage is a double-edged sword. Just because one
lot ($10,000) of currency only requires $100 as a minimum margin deposit, it does not mean that
a trader with $1,000 in his account should be easily able to trade 10 lots. One lot is $10,000 and
should be treated as a $100,000 investment and not the $1000 put up as margin. Most traders
analyze the charts correctly and place sensible trades, yet they tend to over leverage themselves
(get in with a position that is too big for their portfolio), and as a consequence, often end up
forced to exit a position at the wrong time.
For example, if your account value is $10,000 and you place a trade for 1 lot, you are in
effect, leveraging yourself 10 to 1, which is a very significant level of leverage. Most
professional money managers will leverage no more then 3 or 4 times. Trading in small
increments with protective stops on your positions will allow one the opportunity to be
successful in Forex trading.
Currency Trade Profit/Loss Calculation Example
The current bid/ask price for USD/CHF is 1.6322/1.6327, meaning you can buy $1 US
for 1.6327 Swiss Francs or sell $1 US for 1.6322.
Suppose you decide that the US Dollar (USD) is undervalued against the Swiss Franc
(CHF). To execute this strategy, you would buy Dollars (simultaneously selling Francs), and
then wait for the exchange rate to rise.
So you make the trade: purchasing US$100,000 and selling 163,270 Francs. (Remember,
at 1% margin, your initial margin deposit would be $1,000.)

As you expected, USD/CHF rises to 1.6435/40. You can now sell $1 US for 1.6435
Francs or buy $1 US for 1.6440 Francs.
Since you're long dollars (and are short francs), you must now sell dollars and buy back
the francs to realize any profit.
You sell US$100,000 at the current USD/CHF rate of 1.6435, and receive 164,350 CHF.
Since you originally sold (paid) 163,270 CHF, your profit is 1080 CHF.
To calculate your P&L in terms of US dollars, simply divide 1080 by the current
USD/CHF rate of 1.6435. Total profit = US $657.13
1.8 FOREX SPREADS
One of the main forex terms is forex spread. As with other financial commodities, there
is a buying (“offer” or “ask”) and a selling (“bid”) exchange rate. The difference is known as the
“bid-offer spread” or “the spread”.
The forex spread is written in a particular format. For example, GBP/USD = 1.5545/50
means that the bid price of GBP is 1.5545 USD and the offer price is 1.5550 USD. The spread in
this case is 5 points.
Every purchase of the base currency implies a sale of the secondary currency. Likewise,
sale of the base currency implies the simultaneous purchase of the secondary currency. For
example, when I sell GBP/USD, I am selling GBP and buying USD. Similarly, when I buy GBP
I am simultaneously selling USD.
We can express this equivalence by inverting the GBP/USD exchange rate and rotating
the bid and offer reciprocals to derive the USD/GBP rate. For example, if GBP/USD = 1.5545/50
then
USD/GBP = 1/1.5550 (bid)/(1/1.5545 (offer) = 0.6431/33

The basic unit of trading for private investors is known as a “lot” which represents
100,000 units of the base currency. Some brokers permit trading in mini-lots.
• The purchase of a single lot of GBP/USD at 1.5852 implies 100,000 GBP bought at 158,520
USD.
• The sale of a single lot of GBP/USD at 1.5847 entails the sale of 100,000 for 158,470 USD.
The spot forex trading spread is how brokers make their money. Wider spreads will
result in a higher asking price and a lower bid price. The end result is that you have to pay more
when you buy and get less when you sell, which makes it more difficult to realize a profit.
Brokers generally don't earn the full spread, especially when they hedge client positions.
The spread helps to compensate for the market maker for taking on risk from the time it starts a
client trade to when the broker's net exposure is hedged (which could possibly be at a different
price).
Spot forex trading spreads are important because they affect the return on your trading
strategy in a big way. As a trader, your sole interest is buying low and selling high (like futures
and commodities trading). Wider spreads means buying higher and having to sell lower. A half-
pip lower spread doesn't necessarily sound like much, but it can easily mean the difference
between a profitable trading strategy and one that isn't profitable.
Spread Terminology - "Pip"
The term used in currency market to represent the smallest incremental move an
exchange rate can make. Depending on context normally one basis point (0.0001 in the case
of EUR/USD, GBP/USD, USD/CHF and 0.01 in the case of USD/JPY). }
The tighter the spread is the better things are going to be for you. However tight spreads
are only meaningful when they are paired up with good execution. Quality of execution will
decide whether you actually receive tight spreads. A good example of this is when your screen
shows a tight spread, but your trade is filled a few pips to your disadvantage or is mysteriously
rejected.

Spread policies change a great deal from broker to broker, and the policies are often
difficult to see through. This certainly makes comparing brokers much more difficult. Some
brokers actually offer fixed spreads that are guaranteed to remain the same regardless of market
liquidity. But since fixed spreads are traditionally higher than average variable spreads, you are
paying an insurance premium during most of the trading day so that you can get protection from
short-term volatility.
Other brokers offer traders variable spreads depending on market liquidity. Spreads are
tighter when there is good market liquidity but they will widen as liquidity dries up. When it
comes to choosing between fixed and variable rates, the choice depends on your individual
trading pattern. If you trade primarily on news announcements that you hear, you may be better
off with fixed spreads. But only if quality of execution is good.
Some brokers have different spreads for different clients based on their accounts. For
example; those clients that have larger accounts or those who make larger trades may receive
tighter spreads, while the clients that are referred by an introducing broker might receive wider
spreads in order to cover the costs of the referral. Some offer the same spreads to everyone.
Problems can come up when you are trying to learn about a company's spread policy
because this information, along with information on trade execution and order-book depth is
rather difficult to get. Because of this, many traders get caught up in all of the promises they
hear, and take a broker's words at face value. This can be dangerous. The only real way to find
out is to try out various brokers or talk to those who have.
In summary, the spread is the difference between the price that you can sell currency at
(Bid) and the price you can buy currency at (Ask). The spread on majors is usually 5 pips under
normal market conditions.
A pip is the smallest unit by which a cross price quote changes. When trading forex you
will often hear that there is a 5-pip spread when you trade the majors. This spread is revealed
when you compare the bid and the ask price, for example EURUSD is quoted at a bid price of
0.9875 and an ask price of 0.9880. The difference is USD 0.0005, which is equal to 5 "pips".

On a contract or position, the value of a pip can easily be calculated. You know that the
EURUSD is quoted with four decimals, so all you have to do is the cancel-out the four zeros on
the amount you trade and you will have one pip. Thus, on a EURUSD 100,000 contract, one pip
is USD 10. On a USDJPY 100,000 contract, one pip is equal to 1000 yen, because USDJPY is
quoted with only two decimals.
1.9 Determinants of Exchange Rates
Introduction:
On the most fundamental level, exchange rates are market-clearing prices that equilibrate
supplies and demands in foreign exchange markets. Obviously, it is the supply of, and the
demand for, foreign currency that would determine at any time the rate of exchange of a
country’s currency just as the market price of commodities is determined by the forces of
demand and supply. Managers of multi national enterprises, international portfolio investors,
importers and exporters, and government officials are very much interested in knowing the
determinants of exchange rates. An important question to be answered is whether change in
exchange rates predictable?
Unfortunately, there is no general theory of exchange rate determination. Instead, there are
economic theories called parity conditions that attempt to explain long-run exchange rate
determinants. Numerous other variables appear to explain short and medium-run exchange rate
determinants. A major problem is that the same set of determinants does not explain rates for all
countries at all times, or even for the same country at all times.

Potential Foreign Exchange Rate Determinants
Source: Adapted from text book ‘Multinational Business Finance’, by David K.Eiteman, Arthur
I.Stonehill, Michael H Moffett, Pearson Education Speculation contributed greatly to the
emerging market crises. Some characteristics of speculation were hot money flows into and out
of currencies, securities, real estate, and commodities. Cross border foreign direct investment and
international\ portfolio investment into the emerging markets are on the rise in recent times.
Political risks have been much reduced in recent years, as capital markets became less segmented
from each other and more liquid. Cash flows motivated by any and all of the potential exchange
rate determinants eventually show up in the balance of payments (BOP). The BOP provides a
means to account for these cash flows in a standardized and systematic manner. The BOP
increases the transparency of the whole international monetary environment and enables
decision-makers to make more rational policy choices.

Balance of Payments Approach
The International Monetary Fund defines the BOP as a statistical statement that systematically
summarizes, for a specific time period, the economic transactions of an economy with the rest of
the world. BOP data measures economic transactions include exports and imports of goods and
services, income flows, capital flows, and gifts and similar “one-sided” transfer payments. The
net of all these transactions is matched by a change in the country’s international monetary
reserves. The significance of a deficit or surplus in the BOP has changed since the advent of
floating exchange rates. Traditionally, BOP measures were used as evidence of pressure on a
country’s foreign exchange rate. This pressure led to governmental transactions that were
compensatory in nature, forced on he government by its need to settle the deficit or face
devaluation.
Exchange Rate Impacts:

The relationship between the BOP and exchange rates can be illustrated by use of a simplified
equation that summarizes BOP data:
BOP = (X-M) + (CI-CO) + (FI-FO) +FXB

Where: X is exports of goods and services,
M is imports of goods and services,
(X-M) is known as Current Account Balance
CI is capital outflows,
CO is capital outflows,
(CI-CO) is known as Capital Account Balance
FI is financial inflows,
FO is financial outflows,
(FI-FO) is known as Financial Account Balance
FXB is official monetary reserves such as foreign exchange and gold
The effect of an imbalance in the BOP of a country works somewhat differently depending on
whether that country has fixed exchange rates, floating exchange rates, or a managed exchange
rate system.

a) Fixed Exchange Rate Countries.
Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP
near zero. If the sum of the current and capital accounts does not approximate zero, the
government is expected to intervence in the foreign exchange market by buying or selling
official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a
surplus demand for the domestic currency exists in the world. To preserve the fixed exchange
rate, the government must then intervence in the foreign exchange market and sells domestic
currency for foreign currencies or gold so as to bring the BOP back near zero. It the sum of the
current and capital accounts is negative, an exchange supply of the domestic currency exists in
world markets. Then the government must intervene by buying the domestic currency with its
reserves of foreign currencies and gold. It is obviously important for a government to maintain
significant foreign exchange reserve balances to allow it to intervene effectively. If the country
runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and
will be forced to devalue. For fixed exchange rate countries, then, business managers use
balance-of-payments statistics to help forecast devaluation or revaluation of the official exchange
rate. Normally a change in fixed exchange rates is technically called “devaluation” or
“revaluation,” while a change in floating exchange rates is called either “depreciation” or
“appreciation”.
b) Floating Exchange Rate Countries. Under a floating exchange rate system, the government
of a county has no responsibility to peg the foreign exchange rate. The fact that the current and
capital account balances do not sum to zero will automatically (in theory) alter the exchange rate
in the direction necessary to obtain a BOP near zero. For example, a country running a sizable
current account deficit with the capital and financial accounts balance of zero will have a net
BOP deficit.
An excess supply of the domestic currency will appear on world markets. As is the case with all
goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus,
the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate
markets do not always follow this theory, particularly in the short-to-intermediate term.

c) Managed Floats. Although still relying on market conditions for day-to-day exchange rate
determination, countries operating with managed floats often find it necessary to take actions to
maintain their desired exchange rate values. They therefore seek to alter the market’s valuation
of a specific exchange rate by influencing the motivations of market activity, rather than through
direct intervention in the foreign exchange markets.
The primary action taken by such governments is to change relative interest rates, thus
influencing the economic fundamentals of exchange rate determination. A change in domestic
interest rates is an attempt to alter capital account balance, especially the short-term portfolio
component of these capital flows, in order to restore an imbalance caused by the deficit in
current account. The power of interest rate changes on international capital and exchange rate
movements can be substantial. A country with a managed float that wishes to defend its currency
may choose to raise domestic interest rates to attract additional capital from abroad. This will
alter market forces and create additional market demand for domestic currency.
In this process, the government signals exchange market participants that it intends to take
measures to preserve the currency’s value within certain ranges. The process also raises the cost
of local borrowing for businesses, however, and so the policy is seldom without domestic critics.
For managed-float countries, business managers use BOP trends to help forecast changes in the
government policies on domestic interest rates.

Parity Conditions
There are many potential exchange rate determinants. Economists have traditionally isolated
several of these determinants and theorized how they are linked with one another and with spot
and forward exchange rates. These linkages are called parity conditions. They are useful in
explaining and forecasting the long-run trend in an exchange rate.
1. Prices and Exchange Rates:

If the identical product or service can be sold in two different markets, and no restrictions exist
on the sale or transportation costs of moving the product between markets, the product’s price
should be the same in both markets. This is called the law of one price. A primary principle of
competitive markets is that prices will equalize across markets if frictions or costs of moving the
products or services between markets do not exist. If the two markets are in two different
countries, the product’s price may be stated in different currency terms, but the price of the
product should still be the same. Comparison of prices would only require a conversion from one
currency to the other.
2. Purchasing Power Parity and the Law of One Price:

If the law of one price were true for all goods and services, the purchasing power parity
exchange rate could be found from any individual set of prices. By comparing the prices of
identical products denominated in different currencies, we could determine the “real” or PPP
exchange rate which should exist if markets were efficient. The hamburger standard, as it has
been christened by The Economist, is a prime example of this law of one price. Assuming that
the Big Mac, food item sold by McDonalds is indeed identical in all countries, it serves as one
means of identifying whether currencies are currently trading at market rates that are close to the
exchange rate implied by Big Macs in local currencies. A less extreme form of this principle
would say that, in relatively efficient markets, the price of a basket of goods would be the same
in each market. This is the absolute version of the theory of purchasing power parity. Absolute
PPP state that the spot exchange rate is determined by the relative prices of similar baskets of
goods.

3. Relative Purchasing Power Parity:
If the assumptions of the absolute version of PPP theory are relaxed a bit more, we observe what
is termed relative purchasing power parity. This more general idea is that PPP is not particularly
helpful in determining what the spot rate is today, but that the relative change in prices between
two countries over a period of time determines the change in the exchange rate over that period.
More specifically, if the spot exchange rate between two countries starts in equilibrium, any
change in the differential rate of inflation between them tends to be offset over the long run by an
equal but opposite change in the spot exchange rate.
4. Exchange Rate Indices: Real and Nominal:

Any single country in the current global market trades with numerous partners. This requires
tracking and evaluating its individual currency value against all other currency values in order to
determine relative purchasing power, that is, whether it is “overvalued” or “undervalued” in
terms of PPP. One of the primary methods of dealing with this problem is the calculation of
exchange rate indices. These indices are formed by trade-weighting the bilateral exchange rates
between the home country and its trading partners. The nominal effective exchange rate index
calculates, on a weighted average basis, the value of the subject currency at different points in
time. It does not really indicate anything about the “true value” of the currency, or anything
related to PPP. The nominal index simply calculates how the currency value relates to some
arbitrarily chosen base period. The real effective exchange rate index indicates how the weighted
average purchasing power of the currency has changed relative to some arbitrarily selected base
period.

5. Interest Rates and Exchange Rates
In this section we see how interest rates are linked to exchange rates.
1. The Fisher Effect:

The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each
country are equal to the required real rate of return plus compensation for expected inflation.
2. The International Fisher Effect:

The relationship between the percentage change in the spot exchange rate over time and the
differential between comparable interest rates in different national capital markets is known as
the international Fisher effect. Fisher-open as it is often termed, states that the spot exchange rate
should change in an amount equal to but in the opposite direction of the difference in interest
rates between two countries. Empirical tests lend some support to the relationship postulated by
the international
Fisher effect, although considerable sort-run deviations occur. However, a more serious criticism
has been posed by recent studies that suggest the existence of a foreign exchange risk premium
for major currencies. Also, speculation in uncovered interest arbitrage, such as “carry trade”,
creates distortions in currency markets. Thus the expected change in exchange rates might be
consistently more than the difference in interest rates.
3. Interest Rate Parity:

The theory of interest rate parity (IRP) provides the linkages between the foreign exchange
markets and the international money markets. The theory states that the difference in the national
interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to,
the forward rate discount or premium for the foreign currency, except for transaction costs.
4. Covered Interest Arbitrage:

The spot and forward exchange markets are not, however, constantly in the state of equilibrium
described by interest rate parity. When the market is not in equilibrium, the potential for

“riskless” or arbitrage profit exists. The arbitrager who recognizes such an imbalance will move
to take advantage of the disequilibrium by investing in whichever currency offers the higher
return on a covered basis. This is called covered interest arbitrage (CIA).
5. Forward Rate as an Unbiased Predictor of the Future Spot Rate:

Some forecasters believe that for the major floating currencies, foreign exchange markets are
“efficient” and forward exchange rates are unbiased predictors of future spot exchange rates.
Intuitively this means that the distribution of possible actual spot rates in the future is centered on
the forward rate. The forward exchange rate’s being an unbiased predictor does not, however,
mean that the future spot rate will actually be equal to what the forward rate predicts. Unbiased
prediction simply means that the forward rate will, on average, overestimate and underestimate
the actual future spot rate in equal frequency and degree. The forward rate may, in fact, never
actually equal the future spot rate.
6. The Asset Market Approach

Along with the BOP approach to long-term foreign exchange rate determination, there is an
alternative approach to exchange rate forecasting called the asset market approach. The asset
approach to forecasting suggests that whether foreigners are willing to hold claims in monetary
form depends partly on relative real interest rates and partly on a country’s outlook for economic
growth and profitability. For example, during the period 1981-1985 the US dollar strengthened
despite growing current account deficits. This strength was due partly to relatively high real
interest rates in the US. Another factor, however, was the heavy inflow of foreign capital into the
US stock market and real estate, motivated by good long-run prospects for growth and
profitability in the US.
7. Technical Analysis
Technical analysts traditionally referred to as chartists focus on price and volume data to
determine past trends that are expected to continue into the future. The single most important
element of time series analysis is that future exchange rates are based on the current exchange
rate. Exchange rate movements, like equity price movements, can be subdivided into periods: (I)
day-to-day movement that is seemingly random; (2) short-term movements extending from

several days to trends lasting several months; (3) long-term movements, which are characterized
by up and down long-term trends.The longer the time horizon of the forecast, the more
inaccurate the forecast is likely to be. Whereas forecasting for the long-run must depend on
economic fundamentals of exchange rate determination, many of the forecast needs of the firm
are short-to medium-term in their time horizon and can be addressed with less theoretical
approaches. Time series techniques infer no theory or causality but simply predict future values
from the recent past. Forecasters freely mix fundamental and technical analysis, presumably
because in forecasting, getting close is all that counts.

1.10 Factors Determining Spot Exchange Rates
The most vital factor in foreign exchange is the determination of spot exchange rate. It is on this,
all other activities revolve. We know that forward margin is determined by adding premium or
subtraction discount with reference to spot rate. The spot exchange rate is not determined by a
single factor. It is the combination of several factors which act either concurrently or
independently in determining the spot rate. Let us discuss about these factors.
Balance of Payments
A study of International Trade and Consequent Balance of Payments between countries will
determine the value of the currencies concerned. We know that in international trade exports
from a country, both visible and invisible represent the supply side of foreign exchange. On the
contrary, imports into a country, both visible and invisible create demand for foreign exchange.
Let us illustrate with an example. Suppose India is making lot of exports to USA (both visible
and also invisible). The Indian exporters have to receive ‘Rupee’ payment from USA and the
importing merchants in USA would be offering lot of US dollars in exchange for rupees for
payment to Indian merchants. Thus, there will be lot of supply of US dollars from the point of
view of India and lost of demand for Indian rupees from the point of view of USA. Thus exports
represent supply of Dollar demanding Rupees. When there is lot of supply of dollar, demanding
rupees, the value of Rupee will automatically go up. On the other hand, if India imports more,
we have to pay Dollars to USA merchants. This means, we will offer lot of Rupees, demanding
Dollars. In that case, the value of Dollar will go up comparative to Rupees. In other words Put if
differently, the exporters would offer foreign currencies in the exchange market, they have
acquired, and demand local currency in exchange. Similarly, importers would offer local
currency in exchange for foreign currency.
When a country is continuously importing more than what it exports to the other country, in the
long run, the demand for the currency of the country importing would be lesser than its supply.
This is an indication that the Balance of Payments of the country with reference to the other
country is continuously at deficit. This will lead to decline of the value of the currency in relation

to the other country. On the other hand if the balance of payments of a country is continuously at
surplus, it is an indication that the demand for the currency in the market is higher than its supply
and therefore the currency gains more value. Thus the value of the currency depends on balance
of payment position.
Inflation in the Economy

Another important factor that would have serious effect on the value of currencies and the
exchange rate is the level of inflation in the country. More inflation means increase in domestic
prices of commodities. When commodities are priced at a higher level, exports would dwindle,
as the price would not be competitive in the international market, and foreigners would not
demand the commodities at a higher price. The decrease in the export, in the long run, would
reduce the demand for the currency of the country and the external value of the currency would
decline. Thus, if the country is under the grip of more inflation, the value of the currency will be
low in the exchange market. It should be understood in this context, that the value of the
currencies concerned will depend on comparative inflationary rate in the two countries.
Suppose the inflation in India is 20% and in USA also it 20%, the rate between dollar and rupee
will remain the same. If inflation in India is higher than USA, the rupee will depreciate in value
relative to dollar. Almost all countries of the world will be experiencing ‘inflation’ to a greater or
lesser degree. The inflation is a very vital factor in deciding the value of the currency.
Interest Rates
The difference in interest rate between countries has great influence in the short term movement
of capital between countries. If the interest rate in country ‘A’ increases, that country would
attract short term of founds from other countries. This will create demand for the currency of the
country having higher rate of interest.
Ultimately, this will lead to increase in its exchange value. Raising the interest rate may also be
adopted by a country deliberately to attract foreign investments to easen tight money conditions.
This will increase the value of the currency. This is also an attempt to reduce the outflow of the
country’s currency. But, this process may not sustain for long, if the other country also adopt

similar measures of increasing the rate of interest. If country ‘B’ also increases the interest rate
like that of country ‘A’, there will be no change in the exchange rate and the effect of country
‘A’ will be nullified
Money Supply
Money supply is also another factor affecting the rate of exchange between countries. As
increased money supply will cause inflationary conditions in the economy and thereby affect the
exchange rate via increase in price of exportable commodities. An increase in money supply
should have scope for increasing production of goods in the economy. In other words, the
increase in money supply should go hand-in-hand with increase in the production of goods in the
economy.
Otherwise, the increased money supply will be utilized in the purchase of foreign commodities
and also making foreign investments. Thus the supply of the currency in the foreign market
increases and the value declines. The downward pressure on the external value of the currency
will in its turn increase the cost of imports and finally it adds to inflation in the economy.
Increase in National Income

Increase in national income of a country indicates an increase in the income of the residents of
the country. This increase will naturally, create demand for goods in the country. If there is
under-utilised productive capacity in the economy, this demand will lead to increase in
production of goods. This will also lead to more export of goods. In some cases, this adjustment
process will take a very long time; and in some other cases there will not be increased production
at all. In such cases where the production does not increase in sympathy with income rise, it may
lead to increased imports and also increased supply of the currency of the country in the foreign
exchange market. This result is similar to that of inflation, i.e., decline in the value of the
currency. Thus, increase in the national income may lead to increase in investment or in
consumption and accordingly, it will have its effect on the exchange rate. Here also, this concept
of increased national income is related to relative increase in national income between two
countries and not the absolute increase in national income.

Discoveries of New Resources
A country in its progress of economic development, may also discover new resources which are
very vital for the economy. These resources are called ‘Key Resources’ or ‘Basic Resources’
which would abundantly help the economy in the production of new goods and services and also
in reducing the cost of production of existing goods and services. A country may discover Oil
resources which are very vital for economic development.
Capital Movements
Bright and congenial climate in a country combined with political stability will encourage
portfolio investments in that country. In such cases, there will be very high demand for the
currencies of those countries for purposes of movements. This higher demand will result in the
increase of exchange rate of those currencies.
On the other hand, poor economic outlook, instantly, repatriation of investments etc. will result
in the decreased demand for the currencies of those countries and as a result the exchange rate of
those currencies will fall.
Speculation and Psychological Factors

The speculation may take the form of bull, i.e., purchasing heavily expecting a rise in price; or it
may take the form of bear, i.e., selling heavily expecting a fall in price. It may also take the form
of leads and lags, i.e., changing the time of settlement of debts with a view to getting advantage
of the change in exchange rates. Arbitrage operations are also undertaken by the speculations to
take advantage of difference in two markets. This will cause movements in exchange rates in
both markets till a level is reached.
Finally, political stability of the country is of very vital factor. Investors will not be interested in
countries which are ravaged with frequent wars or political rebellion. Frequent election, frequent
change of government, frequent changes of policies of the government, lack of political will on
the part of government etc., will detract the investors, and the currency of the country may not
enjoy high value

1.11 Overview of Indian economy
The economy of India is the twelfth largest economy in the world by nominal value and
the fourth largest by purchasing power parity (PPP). In the 1990s, following economic reform
from the socialist-inspired economy of post-independence India, the country began to experience
rapid economic growth, as markets opened for international competition and investment. In the
21st century, India is an emerging economic power with vast human and natural resources, and a
huge knowledge base. Economists predict that by 2020, India will be among the leading
economies of the world.
India was under social democratic-based policies from 1947 to 1991. The economy was
characterised by extensive regulation, protectionism, and public ownership, leading to pervasive
corruption and slow growth. Since 1991, continuing economic liberalisation has moved the
economy towards a market-based system. A revival of economic reforms and better economic
policy in 2000s accelerated India's economic growth rate. By 2008, India had established itself as
the world's second-fastest growing major economy. However, the year 2009 saw a significant
slowdown in India's official GDP growth rate to 6.1 as well as the return of a large projected
fiscal deficit of 10.3% of GDP which would be among the highest in the world.
India's large service industry accounts for 62.6% of the country's GDP while the industrial and
agricultural sector contribute 20% and 17.5% respectively. Agriculture is the predominant
occupation in India, accounting for about 52% of employment. The service sector makes up a
further34%,and industrialsector around14%.
Major industries include telecommunications, textiles, chemicals, food processing, steel,

transportation equipment, cement, mining, petroleum, machinery, information technology
enabled services and software.
India's per capita income (nominal) is $1032, ranked 139th in the world, while its per capita
(PPP) of US$2,932 is ranked 128th. Previously a closed economy, India's trade has grown
fast. India currently accounts for 1.5% of World trade as of 2009 according to the WTO. Despite
robust economic growth, India continues to face many major problems. The recent economic
development has widened the economic inequality across the country. Despite sustained high
economic growth rate, approximately 80% of its population lives on less than $2 a day (PPP).

Demographic data and statistics:
Population: 1,179,053,046
Growth rate: 1.548%
Birth rate: 22.22 births/1,000 population
Death rate: 6.4 deaths/1,000 population
Life expectancy: 69.89 years
male: 67.46 years
female: 72.61 years
Fertility rate: 2.72 children born/woman
Infant mortality rate: {{{infant mortality}}}
Age structure:
0-14 years: 31.1% (male 190,075,426/female 172,799,553)
15-64 years: 63.6% (male 381,446,079/female 359,802,209)
65-over: 5.3% (male 29,364,920/female 32,591,030) (2009 est.)
Gender ratio:
At birth: 1.12 male(s)/female
Under 15: 1.10 male(s)/female
15-64 years: 1.06 male(s)/female
65-over: 0.90 male(s)/female
Interpretation:
India’s population is growing year to year which shows tremendous growth indicator for India
.Even Indian economy’s young population account for nearly 70% which also indicates great
future of Indian economy. As male v/s female ratio is also improving which helps in making
economy equivalent as earlier Indian economy was dominated by male. In India Life expectancy
very well compared to other countries. In European countries life expectancy is biggest issue
because of that there’s economy is stagnant. So we can conclude that there will be assonating
future of India.

Indian economy’s indicators
2006 2007 2008 2009 2010
Annual 733,601.07 908,057.36 967,743.25 980,725.06 1,039,894.00
Disposable
Income (US$
million)
Consumer 501,477.25 617,942.52 658,790.84 704,029.47 764,390.05
Expenditure
(US$ million)
Population 52,128.16 53,626.68 55,132.74 56,656.42 58,215.24
Aged 65+:
January 1st
('000)
GDP 2,783,397.37 3,120,021.14 3,341,338.61 3,630,359.36 3,924,782.88
Measured at
Purchasing
Power Parity
(million
international
$)
Real GDP 9.80 9.36 7.41 5.60 7.70
Growth (%
growth)
Population 376.62 382.17 387.66 393.11 398.51
Density
(people per sq
km)
Inflation (% 6.17 6.39 8.32 10.83 8.41
growth)

Annual Gross 754,849.44 946,420.51 1,012,168.00 1,024,791.56 1,083,677.00
Income (US$
million)
Interpretation:
Increase in annual income which shows economy is growing and its growing from 733,601.7 to
1,039,894.00 means there is around 3 % growth .consumer expenditure which is also increasing.
this one indicator is biggest indicator for forecasting any economy. Gdp growth is down warding
as there was a great depression started from 2008 but now its almost got over and this year gdp
growth is showing good recovery from 5.6 to 7.7. so overall we can say that Indian economy is
growing and have potential to become super power in world.
_________________________
Source: www. World Economic Factbook.com

1.12 Foreign exchange market in India
During the early 1990s, india embarked on a series of structural reforms in the foreign exchange
market. The exchange rate regime that was earlier pegged was partially floated in march 1992
and fully floated in march 1993. The unification of the rupee and was an important step in the
progress towards total current account convertibility, which was achieved in august 1994.
Although liberalization helped the Indian forex market in various ways, it led to extensive
fluctuation of exchange rate. This issue has attracted a great deal of concern from policy maker
and investor. While some flexibility in foreign exchange markets and exchange rate
determination is desirable, excessive volatility can have an adverse impact on price discovery,
export performance, sustainability of current account balance, and balance sheets. In the context
of upgrading Indian foreign exchange market to international standards, a well developed foreign
exchange derivative market is imperative.
With a view to enable entities to mange volatility in the currency market, RBI on April 20 2007
issued comprehensive guidelines on the usage of foreign currency forwards, swaps and option in
the OTC market. At the same time, RBI also set up an internal working group to explore the
advantages of introducing currency futures. The report of the internal working Group of RBI
submitted in April 2008, recommended the introduction of exchange traded currency futures.
Subsequently, RBI and SEBI jointly constituted a standing technical committee to analyze the
currency forward and future market around the world and lay down the guidelines to introduce
exchange traded currency future in the Indian market. The committee submitted its report on
May 2008 further RBI and SEBI also issued circulars in this regards on august 2008
Currently India is a USD 34 billion OTC market where all major currencies like USD EURO
YEN POUND SWISS FRANC etc, are traded. With the help of electronic trading and efficient
risk management systems exchange traded currency futures will bring in more transparency and
efficiency in price discovery, eliminate counterparty credit risk, provide transparent trading
platform. Banks are also allowed to become members of this segment on the exchange, thereby
providing them with a new opportunity.

1.13 Perspective on the Indian Forex market
The Indian forex market is made up of banks authorized to deal in foreign exchange,
known as Authorized Dealers (ADs), foreign exchange brokers, money changers and customers -
both resident and non-resident, who are exposed to currency risk. It is predominantly a
transaction-based market with the existence of underlying forex exposure generally being an
essential requirement for market users.
The Indian forex market has grown manifold over the last several years. Average daily
total turnover has increased from US$3.67 billion in 1996-97 to US$9.71 billion in 2003-04.
The normal spot market quote has a spread of 0.50 to 1 paise while swap quotes are available at
1 to 2 paise spread. The derivatives market activity has shown tremendous growth as well,
especially after the MIFOR (Mumbai Inter-bank Forward Offered Rate) swap curve evolved in
2000.
Many policy initiatives have been taken to develop the forex market. ADs have been
permitted to have larger open position and aggregate gap limits, linked to their capital. They
have been given permission to borrow overseas up to 25 per cent of their Tier-I capital and
invest up to limits approved by their respective Boards. Cash reserve requirements have been
exempted on inter-bank borrowings.
Exporters and importers are, in general, permitted to freely cancel and rebook forward
contracts booked in respect of their foreign currency exposures, except in respect of forward
contracts booked to cover import and non-trade payments falling due beyond one year. They
have also been permitted to book forward contracts on the basis of past performance (without
production of underlying documents evidencing transactions at the time of booking the
contract). Corporates have been permitted increasing access to foreign currency funds. General
permission has been given to ADs for approving External Commercial Borrowings of their
customers up to a limit of US $ 500 million; appropriate restrictions have been placed on the
end-use of such funds. While exchange earners in select categories such as Export Oriented
Units (EOU) are permitted to retain 100 per cent of their export earnings, others are permitted to

retain 50 per cent of their forex receipts in EEFC accounts. Residents may also enter into
forward contracts with ADs in respect of transactions denominated in foreign currency but
settled in Indian rupee. They can hedge the exchange risk arising out of overseas direct
investments in equity and loan. Residents engaged in export/import trade, are permitted to hedge
the attendant commodity price risk in international commodity exchanges/ markets using
exchange traded as well as OTC contracts.
Non-residents are permitted to hedge the currency risk arising on account of their
investments in India. However, once cancelled, these contracts cannot be rebooked for the same
exposure.
Enabling Environment for Reforms in the Forex Market:
In order to embark upon further deregulation of the foreign exchange market, including
relaxation of capital controls, an enabling environment is needed for the reforms to proceed on a
sustainable basis. It is in this context that liberalization of various sectors has to proceed in
tandem to derive synergies of the reforms encompassing multiple sectors.
Sound macroeconomic policies and a competitive domestic sector improve the capacity of the
economy to absorb higher capital inflows and provide cushion against unexpected shocks. Some
of the parameters recommended by the Tarapore Committee on Capital Account Convertibility
such as reduction in the combined fiscal deficit, inflation between 3 and 5 percent and further
reduction in the gross NPAs of the banking sector are required to be achieved for creating an
enabling environment for further liberalization in the forex markets.

Currency Derivative

2.1 Launch of currency futures contracts on 29th August, 2008
India’s financial market has been increasingly integrating with rest of the world through
increased trade and finance activity, as noted above, giving rise to a need to permit further
hedging instruments, other that OTC products, to manage exchange risk like currency futures.
With electronic trading and efficient risk management systems, exchange traded currency futures
were expected to benefit the universe of participants including corporate and individual
investors. The RBI Committee on Fuller Capital Account Convertibility recommended that
currency futures may be introduced subject to risks being contained through proper trading
mechanism, structure of contracts and regulatory environment.
Accordingly, Reserve Bank of India in the Annual Policy Statement for the Year 2007-08
proposed to set up a Working Group on Currency Futures to study the international experience
and suggest a suitable framework to operationalise the proposal, in line with the current legal and
regulatory framework. This Group submitted its report in April, 2008. Following this, RBI and
Securities and Exchange Board of India (SEBI) jointly constituted a Standing Technical
Committee to interalia evolve norms and oversee implementation of Exchange Traded Currency
Derivatives.
Derivatives Market ISMR
This report laid down the framework for the launch of Exchange Traded Currency Futures in
terms of the eligibility norms for existing and new Exchanges and their Clearing
Corporations/Houses, eligibility criteria for members of such Exchanges/Clearing
Corporations/Houses, product design, risk management measures, surveillance mechanism and
other related issues.
The Regulatory framework for currency futures trading in the country, as laid down by the
regulators, provide that persons resident in India are permitted to participate in the currency
futures market in India subject to directions contained in the Currency Futures (Reserve Bank)
Directions, 2008, which have come into force with effect from August 6, 2008.

Standardized currency futures have the following features:
a. USD INR, EUR INR, JPY INR and GDP INR contracts are allowed to be traded.
b. The size of each contract is - USD 1000, EUR 1000, GDP 1000 and JPY 1,00,000.
c. The contracts shall be quoted and settled in Indian Rupees.
d. The maturity of the contracts shall not exceed 12 months.
e. The settlement price shall be the Reserve Bank’s Reference Rate on the last trading day.
The membership of the currency futures market of a recognised stock exchange has been
mandated to be separate from the membership of the equity derivative segment or the cash
segment. Banks authorized by the Reserve Bank of India under section 10 of the Foreign
Exchange Management Act, 1999 as ‘AD Category - I bank’ are permitted to become trading
and clearing members of the currency futures market of the recognized stock exchanges, on their
own account and on behalf of their clients, subject to fulfi lling certain minimum prudential
requirements pertaining to net worth, non-performing assets etc.
NSE was the fi rst exchange to have received an in-principle approval from SEBI for setting up
currency derivative segment. The exchange lunched its currency futures trading platform on 29th
August, 2008. While BSE commenced trading in currency futures on 1st October, 2008, Multi-
Commodity Exchange of India (MCX) started trading in this product on 7th October, 2008

NSE (NATIONAL STOCK EXCHANGE)
NSE was incorporated in 1992 and was given recognition as a stock exchange in April 1993. It
started operations in June 1994, with trading on the Wholesale Debt Market Segment.
Subsequently it launched the Capital Market Segment in November 1994 as a trading platform
for equities and the Futures and Options Segment in June 2000 for various derivative
instruments.
NSE has been able to take the stock market to the doorsteps of the investors. The
technology has been harnessed to deliver the services to the investors across the country at the
cheapest possible cost. It provides a nation-wide, screen-based, automated trading system, with a
high degree of transparency and equal access to investors irrespective of geographical location.
The high level of information dissemination through on-line system has helped in integrating
retail investors on a nation-wide basis. The standards set by the exchange in terms of market
practices, Products, technology and service standards have become industry benchmarks and are
being replicated by other market participants. Within a very short span of time, NSE has been
able to achieve all the objectives for which it was set up. It has been playing a leading role as a
change agent in transforming the Indian Capital Markets to its present form. The Indian Capital
Markets are a far cry from what they used to be a decade ago in terms of market practices,
infrastructure, technology, risk management, learing and settlement and investor service.

Multi Commodity Exchange is popularly known as MCX. It deals with round about 100
commodities. MCX is an independent commodity exchange in India. It was established in 2003
in Mumbai. MCX of India Limited is a new order exchange with a mandate for setting up a
nationwide, online multi-commodity, Market place, offering unlimited opportunities to
commodities market participants. As a true neutral market, MCX has taken many initiatives for
users.
Features:
• The exchange's competitor is National Commodity & Derivatives Exchange Ltd. popularly
known as NCDEX
• With a growing share of 72%, MCX continues to be India's No. 1 commodity exchange
• Globally, MCX ranks no. 1 in silver, no. 2 in natural gas, no. 3 in crude oil and gold in futures
trading
• The average daily turnover of MCX is about US$ 2.2 billion)
• MCX now reaches out to about 500 cities in India with the help of about 10,000 trading
terminals
Key Shareholders:
Financial Technologies (I) Ltd., State Bank of India and it's associates, National
Bank for Agriculture and Rural Development (NABARD), National Stock Exchange of India
Ltd. (NSE), Fid Fund (Mauritius) Ltd. - an affiliate of Fidelity International, Corporation Bank,
Union Bank of India, Canara Bank, Bank of India, Bank of Baroda , HDFC Bank and SBI Life
Insurance Co. Ltd., ICICI ventures, IL&FS, Meryll Lynch

2.2 Introduction to currency derivative
Each country has its own currency through which both national and international transaction are
performed. All the international business transaction involve an exchange of one currency for
another. The price of one currency in terms of other currency is known as exchange rate
The foreign exchange market of a country provide the mechanism of exchanging different
currencies with one and another, and thus, Facilitating transfer of purchasing power from one
country to another.
With the multiple growths of international trade and fiancé all over the world, trading in foreign
currencies has grown tremendously over the past several decades. Since the exchange rates are
continuously changing so the firms are exposed to the risk of exchange rate movements. As a
result the assets or liability or cash flows of firm which are denominated in foreign currencies
undergo a change in value over a period of time due to variation in exchange rates.
This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk.
Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed
countries, the currency risk has become substantial for many business firms.
As a result, these firms are increasingly turning to various risk hedging product like foreign
currency futures, foreign currency forwards foreign currency options and foreign currency
swaps.

History of currency derivative
Currency futures were first created at the Chicago mercantile exchange in 1972. The contracts
were created under the guidance and leadership of Leo Melamed. CME chairman Emerilus. The
FX contract capitalized on the U.S. abandonment the Bretton woods agreement, which had fired
world exchange rates to a gold standard after World War II. The abandonment of the bretton
woods agreement resulted in currency values being allowed to float, increasing the risk of doing
business. By creating another type of market in which future could be traded, CME currency
futures extended the reach of risk management beyond commodities, which were the main
derivative contracts traded at CME until then. The endorsement of Nobel-prize-winning
economist Milton friedman.
Today, CME offer 41 individual FX futures and 31 option contract on 19 currencies, all of which
trade electronically on the exchange’s CME Globex platform. It is the largest regulated
marketplace for FX trading. Traders of CME FX futures are a diverse group that includes
multinational corporations, hedge funds, commercial banks, investment banks financial manger
commodity trading advisors (CTAs) proprietary trading firms, currency overlay managers and
individual investors. They trade in order to transact business hedge against unfavourable changes
in currency rates or to speculate on rate fluctuations.

2.3 Utility of currency derivative
Currency based derivative are used by exporters invoicing receivables in foreign currency,
willing to protect their earning from the foreign currency depreciation by locking the currency
conversion rate at high level. Their use by importers hedging foreign currency payables is
effective when the payment currency is expected at appreciate and the importers would like to
guarantee a lower conversion rate. Investors in foreign currency denominated securities would
like to secure strong earning by obtaining the right to sell foreign currency at a high conversion
rate thus defending their revenue from the foreign currency depreciation. Multinational
companies use currency derivatives being engaged in direct investment overseas. They want to
guarantee the rate of purchasing foreign currency for various payments related to the installation
of foreign branch or subsidiary or to joint ventures with a foreign partner
A high degree of volatility of exchange rates creates a fertile ground for foreign exchange
speculators. Their objective is to guarantee a high selling rate of foreign currency by obtaining a
derivative contract while hoping to buy the currency at a low rate in the future. Alternatively
they may wish to obtain a foreign currency forward buying contract expecting to sell the
appreciating currency at a high future rate in either case they are exposed to the risk of currency
fluctuations in the futures betting on the pattern of the spot exchange rate adjustment consistent
with their initial expectations.
The most commonly used instrument among the currency derivative are currency forward
contracts. These are large notional value selling or buying contracts obtained by exporters,
importers, investor and speculators from banks with denomination normally exceeding 2 million
USD. The contracts guarantee the future conversion rate between two currencies and can be
obtained for any customized amount and any date in the future. They normally do not require a
security deposit since their purchasers are mostly large business firm and investment institutions
although the banks may require compensating deposit balances or line if credit. Their transaction
costs are set by spread between banks buy and sell prices.

Exporter invoicing receivables in foreign currency are the most frequent used of these contracts.
They are willing to protect themselves from the currency depreciation by locking in the future
currency conversion rate at high level. A similar foreign currency forward selling contract is
obtained by investors in foreign currency denominated bonds who want to take advantage of
higher foreign that domestic interest rates on government or corporate bonds and the foreign
currency forward financial investment. Investment in foreign securities induced by higher
foreign interest rate and accompanied by the forward selling of the foreign currency income is
called a covered interest arbitrage.
Source:-recent development in international currency derivative market by Mr. orlowski)

2.4 Need for the exchange traded currency futures
With a view to enable entities to manage volatility in the currency market, RBI on april 2007
issued comprehensive guidelines on the usage of foreign currency forwards,swaps and option in
the OTC market. At the same time, RBI also set up internal working group to explore the
advantages of introducing currency futures. The report of the internal working group of RBI
submitted in april 2008 recommended the introduction of exchange traded currency futures.
Exchange traded futures as compared to OTC forwards serve the same economic purpose, yet
differ in fundamental ways. An individual entering into a forward contract agreed to transact at a
forward price on a future date. On the maturity date, the obligation of the individual equals the
forward price at which the contract was executed. Except on the maturity date, no money
changes hands. On the other hand, a daily basis , since the profit or losses in the futures market
are collected/paid on a daily basis, the scope for building up of mark to market losses in the
books of various participant gets limited.
The counterparty risk in a futures contract is further eliminated by the presence of a clearing
corporation, which by assuming counterparty guarantee eliminates credit risk. Further, in an
exchange traded scenario where the market lot is fixed at a much lesser size than the OTC
market, equitable opportunity is provided to all classes of investors whether large or small to
participate in the futures market. The transaction on an exchange are executed on the price time
priority ensuring that the best price is available to all categories of market participants
irrespective of their size. Other advantages of an exchange traded market would be greater
transparency efficiency and accessibility.
Futures markets were designed to solve the product that exists in forward market. A futures
contract is an agreement between two parties to buy or sell asset at a certain time in the future at
certain price. But unlike forward contract the futures contract are standardized and exchange
traded. To facilitate liquidity in the futures contract the exchange specifies certain standard
features of the contract. A futures contract is standardized contract with standard underlying
instrument a standard quantity and quality of the underlying instrument that can be delivered,

and a standard timing of such settlement. A futures contract may be offset prior to maturity by
entering into an equal and opposite transaction.
The standardized items in a futures contract are:

 Quantity of the underlying
 Quality of the underlying
 The date and the month of delivery
 The unit of price quotation and minimum price change
 Location of settlement
The rationale for introducing currency futures in the Indian context has been outlined in the
report of the internal working group on currency futures as follows.
The rationale for establishing the currency futures market is manifold, both resident and non
resident purchase domestic currency assets. If the exchange rate remains unchanged from the
time of purchase of the asset to its sale, no gain and losses are made out of currency exposures.
But if domestic currency depreciates against the foreign currency the exposure would result in
gain for resident purchasing foreign assets and loss for nonresident purchasing domestic assets.
In this backdrop, unpredicted movement in exchange rate exposes investors to currency risks.
Currency futures enable them to hedge this risk. Nominal exchange rates are often random walks
with or without drift, while real exchange rates over long run are mean reverting. As such it is
possible that over a long run the incentive to hedge currency risk may not be large. However
financial planning horizon is much smaller than the long run which is typically inter-generational
in the context of exchange rates. As such there is a strong need to hedge currency risk and this
need has grown manifold with fast growth in cross border trade and investment flows. The
argument for hedging currency risks appear to be natural in the case of assets and applies equally
to trade in goods and service, which result in come flow with leads and lags and get converted
into different currencies at the market rates. Empirically, changes in exchanges rate are found to
have very low correlation with foreign equity and bond return. This in theory should lower
portfolio risk. Therefore sometimes argument is advanced against the need for hedging currency
risk. but there is strong empirical evidence to suggest that hedging reduces the volatility of

returns and indeed considering the episodic nature of currency returns there strong arguments to
use instrument to hedge currency risks
Market Design for Currency Derivatives

Currency derivatives have been launched on the NSE in August, 2008. The market design,
including the risk management framework for this new product is summarized below:
Eligibility criteria
The following entities are eligible to apply for membership subject to the regulatory norms and
provisions of SEBI and
As provided in the Rules, Regulations, Byelaws and Circulars of the Exchange –
a. Individuals;
b. Partnership Firms registered under the Indian Partnership Act, 1932;
c. Corporations, Companies or Institutions or subsidiaries of such Corporations, Companies or
Institutions set up for providing financial services;
d. Such other person as may be permitted under the Securities Contracts (Regulation) Rules 1957
Professional Clearing Member (PCM)

The following persons are eligible to become PCMs of NSCCL for Currency Futures Derivatives
provided they fulfill the prescribed criteria:
a. SEBI Registered Custodians; and

b. Banks recognized by NSEIL/NSCCL for issuance of bank guarantees
Banks authorized by the Reserve Bank of India under section 10 of the Foreign Exchange
Management Act, 1999 as
‘AD Category - I bank’ are permitted to become trading and clearing members of the currency
futures market of the recognized stock exchanges, on their own account and on behalf of their
clients, subject to fulfilling the following minimum prudential requirements:

a. Minimum net worth of Rs. 500 crores.
b. Minimum CRAR of 10 per cent.
c. Net NPA should not exceed 3 per cent.
d. Made net profit for last 3 years.
The AD Category - I banks which fulfill the prudential requirements are required to lay down
detailed guidelines with the approval of their Boards for trading and clearing of currency futures
contracts and management of risks.
AD Category - I banks which do not meet the above minimum prudential requirements and AD
Category - I banks which are Urban Co-operative banks or State Co-operative banks can
participate in the currency futures market only as clients, subject to approval therefore from the
respective regulatory Departments of the Reserve Bank.
Other applicable eligibility criteria
a. Where the applicant is a partnership firm/corporate entity, the applicant shall identify a
Dominant Promoter Group as per the norms of the Exchange at the time of making the
application. Any change in the shareholding of the company including that of the said Dominant
Promoter Group or their shareholding interest shall be effected only with the prior permission of
NSEIL/SEBI.
b. The applicant has to ensure that at any point of time they would ensure that at least
individual/one partner/one designated director/compliance officer would have a valid NCFM
certification as per the requirements of the Exchange. The above norm would be a continued
admittance norm for membership of the Exchange.
c. An applicant must be in a position to pay the membership and other fees, deposits etc, as
applicable at the time of admission within three months of intimation to him of admission as a
Trading Member or as per the time schedule specified by the Exchange.

d. The trading members and sales persons in the currency futures market must have passed a
certification program me which is considered adequate by SEBI. The approved users and sales
personnel of the trading member should have passed the certification program me.
e. To begin with, FIIs and NRIs would not be permitted to participate in currency futures market.
f. Strict enforcement of “Know your customer” rule is required. Therefore every client shall be
registered with the member. The members are also required to make their clients aware of the
risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and
obtain a copy of the same duly signed by the client. The members shall enter into a member
constituent agreement as stipulated.
g. The Exchange may specify such standards for investor service and infrastructure with regard
to any category of applicants as it may deem necessary, from time to time.
Position limits
Client Level Position Limit: The client level position limit as prescribed in the Report of the RBI-
SEBI Standing Technical Committee shall be applicable where the gross open position of the
client across all contracts exceeds 6% of the total open interest or 5 million USD, whichever is
higher.
The client level gross open position would be computed on the basis of PAN across all members.
Trading Member Level Position Limit: The trading member position limit shall be higher of 15%
of the total open interest or 25 million USD. However, the position limit for a Trading Member,
which is a bank, shall be higher of 15% of the total open interest or 100 million USD.
Margins
Initial Margins: Initial margin shall be payable on all open positions of Clearing Members, up to
client level, and shall be payable upfront by Clearing Members in accordance with the margin
computation mechanism and/ or system as may be adopted by the Clearing Corporation from
time to time. Initial Margin shall include SPAN margins, futures final settlement margin and

such other additional margins, that may be specified by the Clearing Corporation from time to
time.
Calendar Spread Margins: A currency futures position in one expiry month which is hedged by
an offsetting position in a different expiry month would be treated as a calendar spread. The
calendar spread margin shall be Rs. 250/- per contract for all months of spread. The benefit for a
calendar spread would continue till expiry of the near month contract.
Minimum Margins: The minimum margin percentage shall be 1.75% on the first day of currency
futures trading and 1 % thereafter which shall be scaled up by look ahead period as may be
specified by the Clearing Corporation from time to time.
Futures Final Settlement Margin: Futures Final Settlement Margin shall be levied at the clearing
member level in respect of the final settlement amount due. The final settlement margins shall be
levied from the last trading day of the contract till the completion of pay-in towards the Final
Settlement.
Extreme Loss margins: Clearing members shall be subject to extreme loss margins in addition to
initial margins. The applicable extreme loss margin shall be 1% on the mark to market value of
the gross open positions or as may be specified by the relevant authority from time to time.

2.5 DERIVATIVE MARKET OF FOREX CURRENCIES
The following Forex types will be reviewed in this part:
 Currency futures
 Currency forwards
 Currency swaps
 Currency options
Derivatives play an important and useful role in the economy, but they also pose several
dangers to the stability of financial markets and the overall economy. Derivatives are often
employed for the useful purpose of hedging and risk management, and this role becomes more
important as financial markets grow more volatile. Derivatives are also used to commit fraud and
to manipulate markets.
Derivatives are powerful tools that can be used to hedge the risks normally associated
with production, commerce and finance. Derivatives facilitate risk management by allowing a
person to reduce his exposure to certain kinds of risk by transferring those risks to another person
that is more willing and able to bear such risks.
Today, derivatives are traded in most parts of the world, and the size of these markets is
enormous. Data for 2002 by the Bank of International Settlements puts the amount of
outstanding derivatives in excess of $151 trillion and the trading volume on organized
derivatives exchanges at $694 trillion. By comparison, the IMF’s figure for worldwide output, or
GDP, is $32.1 trillion.
A derivative is a financial contract whose value is linked to the price of an underlying

commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative
refers to how the price of these contracts is derived from the price the underlying item. Typical
examples of derivatives include futures, forwards, swaps and options, and these can be combined
with traditional securities and loans in order to create structured securities which are also known
as hybrid instruments.

Warren Buffet says: “Derivatives are financial weapons of mass destruction, carrying
dangers that, while now latent, are potentially lethal.”
Reasons why Companies are moving away from it:
1) They face pretty high trading costs to a build a “replicating portfolio”
2) To replicate a ‘call option’ one has to shuffle the ‘replicating portfolio’ that involves repeated
trades in which the prices of underlying asset changes.
3) Difficulty in identifying the correct ‘replicating strategy’
Risks involved in Derivatives
• Credit Risks
• Market Risks
• Operational Risks
• Entrepreneurial Risks
• Systematic Risks
Forward deals are a form of insurance against the risk that exchange rates will change
between now and the delivery date of the contract. A forward is a simple kind of a derivative - a
financial instrument whose price is based on another underlying asset. The price in a forward
contract is known as the delivery price and allows the investor to lock in the current exchange
rate and thus avoid subsequent Forex fluctuations.
Futures contracts are like forwards, except that they are highly standardized. The futures
contracts traded on most organized exchanges are so standardized that they are fungible -
meaning that they are substitutable one for another. This fungibility facilitates trading and results
in greater trading volume and greater market liquidity.

While futures and forward contracts are both a contract to trade on a future date, key
differences include:
 Futures are always traded on an exchange, whereas forwards always trade over-the-
counter
 Futures are highly standardized, whereas each forward is unique
 The price at which the contract is finally settled is different:
 Futures are settled at the settlement price fixed on the last trading date of the contract (i.e.
at the end)
 Forwards are settled at the forward price agreed on the trade date (i.e. at the start)
 The credit risk of futures is much lower than that of forwards:
 The profit or loss on a futures position is exchanged in cash every day. After this the
credit exposure is again zero.
 The profit or loss on a forward contract is only realized at the time of settlement, so the
credit exposure can keep increasing
 In case of physical delivery, the forward contract specifies to whom to make the delivery.
The counterparty on a futures contract is chosen randomly by the exchange.
 In a forward there are no cash flows until delivery, whereas in futures there are margin
requirements and periodic margin calls.

CURRENCY FORWARD MARKET:
Forward (Cash) Contract is a cash contract in which a seller agrees to deliver a specific
cash commodity to a buyer sometime in the future. Forward contracts, in contrast to futures
contracts, are privately negotiated and are not standardized.
Many market participants want to exchange currencies at a time other than two days in
advance but would like to know the rate of exchange now. Forward foreign exchange contracts
are generally used by importers, exporters and investors who seek to lock in exchange rates for a
future date in order to hedge their foreign currency cash flows.
For example, if a company had contracted to purchase equipment for the price of GBP 1
million payable in 3 months time but was concerned that the GBP would rise against the
Australian dollar in the interim, the company could agree today to buy the USD for delivery in 3
months time. In other words, the company could negotiate a rate at which it could buy GBP at
some time in the future, setting the amount of GBP needed; the date needed etc. and hence be
sure of the Australian Dollar purchasing price now.
There are two components to the price in forward transaction and they are the spot
price and the forward rate adjustment.
The spot rate is simply the current market rate as determined by supply and demand. The
forward rate adjustment is a slightly more complicated calculation that involves the applicable
interest rates of the currencies involved.
Forward Exchange Contracts, both Buying and Selling, may be either fixed or optional
term contracts.
Fixed Term Contracts
With a Fixed Term Contract the customer specifies the date on which delivery of the
overseas currency is to take place. An earlier delivery can be arranged but it may involve a
marginal adjustment to the Forward Contract Rate.

Optional Term Contracts
Optional Term Contracts can be entered into for a specific period and the customer states
the period within which delivery is to be made (normally for periods not more than one month)
eg. a contract may be entered into for a six month period with the customer having the option of
delivery at anytime during the last week.
In each case there is a firm contract to affect delivery by both the Bank and the customer.
An optional delivery contract does not give the customer an option to not deliver the Forward
Exchange Contract. It is only the period during which delivery may occur that is optional.
Forward rates are quoted for transactions where settlement is to take place more than
two business days after the transaction date. Forward Contract rates consist of the Spot rate for
the currency concerned adjusted by the relative Forward Margin.
Forward Margins are a reflection of the interest rate differentials between currencies,
and not necessarily a forecast of what the spot rate will be at the future date.
The Forward rate may be expressed as being at parity (par), or at a Premium (dearer) or at
a Discount (cheaper), when related to the spot rate. It follows therefore that premiums are
deducted from the spot rate and discounts are added to the spot rate.
Forward Rates incorporating a 'Premium' are more favorable to exporters and less
favorable to importers than the relative spot rates on which they are based. Similarly, Forward
rates incorporating a 'Discount' are more favorable to importers and less favorable to exporters
that the relative spot rates on which they are based.
The general rule in determining whether a currency will be quoted at a premium or a discount
is as follows:
 The currency with the higher interest rate will be at a discount on a forward basis against
the currency with the lower interest rate.
 The currency with the lower interest rate will be at a premium on a forward basis against
the currency with the high interest rate.

As the interest differential between the currencies widens then the premium or discount
margin increases (i.e. moves farther from parity) and similarly as the interest differential narrows
then the premium or discount margin decreases (ie moves towards parity).
Comparison between currency Futures and Currency Forward Markets:-
Features Currency Futures Currency Forwards

Size of Standardized Negotiated/Tailor made
contract
Quotation Generally U.S. US $/ Currency Unit
Dollar/Currency unit
Maturity Standardized , generally Negotiated
shorter than one year
Location of Futures exchanges Linkages by telephone or fax
trading
Price Fixed on the market Quotation of rates
Settlement Generally no settlement but Generally delivery of currencies
compensation through reverse
operations
Counterparties Generally do not know each Generally in contact with each
other other
Negotiation During market sessions Round the clock
Hours
Guarantee Guarantee Deposit No guarantee deposit
Marking to Gains or losses on positions No marking to market
market settled every day

CURRENCY OPTION MARKET:
Forex option is a contract that conveys the right, but not the obligation, to buy or sell a
particular item at a certain price for a limited time. Only the seller of the option is obligated to
perform.
Simply stated, a buyer of a currency option acquires the right - but not the obligation - to
buy (a “call”) or sell (a “put”) a specific amount of one currency for another at a predetermined
price and date in the future. The cost of the option is called a ‘premium’ and is paid by the buyer
to the seller. The seller determines the price of the premium at which they are willing to grant the
option, based on current rates, nominated delivery and expiry dates, the nominated strike rate and
option style.
It is entirely up to the buyer whether or not to exercise that right; only the seller of the
option is obligated to perform.
Call option
Call Option - an option to BUY an underlying asset (stock or currency) at an agreed

upon price (Strike Price or Exercise Price) on or before the expiration date. Since this option has
economic value, you have to pay a price, called the Premium.
Example: Microsoft (MSFT) was recently selling at $29.50/share, and there were 4
different options. For example, for $1.00 (premium) you could buy one call option that would
allow you to buy a share of MSFT for $30 (strike P) on or before January 16, 2005. You will
exercise the option if P > $30, and you will make money if the P > $31.00 ($30 + $1.00). If P =
$30, you will not exercise the option, it will expire worthless and you will lose the premium
($1.50).

Next example shows two ways to calculate profit from call option:
You have paid a premium of $187.50 in July that gives you the right to buy SF @ $0.67
on or before September 10. If the SF sells at $.7025 on expiration, you can exercise your right to
buy @$0.67 and then sell at $0.7025, for proceeds of $2,031.25. Subtracting the cost of your
option premium of $187.50, you have a net profit of $1,843.75 ($2,031.25 - $187.50). The writer
(seller) of the call option would lose $1,843.75.
1. Profit = S - (Exercise Price + Premium) x SF62,500
Profit = $.7025 - ($0.670 + $0.003) = $0.0295/SF x SF62,500 = $1,843.75
2. Profit = (S - Exercise Price) x SF62,500 - PREMIUM
Profit = ($0.7025 - $0.67) x SF62,500 = $2,031.25 - $187.50 = $1,843.75
ROI: Your return on investment (ROI) would be $1843.75 / $187.50 (Profit /

Investment) = 983% for 2 months! Illustrates leverage. You control about $42,000 worth of SFs
(SF62,500 x $.67/SF) with only $187.50, or less than 1% of the underlying value of the currency.
If spot rate at expiration is only $.6607/SF (or any rate < $.67/SF), the option expires
worthless, and you lose the premium of $187.50, which would be the gain to the writer (seller) of
the call. Note: If the spot rate was between $.67 and $.673, you would exercise, but lose money.
For example, if S = $0.671, you would lose ($.671 - .673) x SF62,500 = -$125 by exercising, vs.
-$187.50 without exercising.
Like futures trading, option trading is a zero-sum game. The buyer of the option
purchases it from the seller or the person who "writes" the call. Options are traded in units of 100
shares.

Put option
Put Option - gives the owner the right, but not the obligation to sell an underlying asset
at a stated price on or before the expiration date.
Example: MSFT $30 January 2005 puts were selling for $2 (premium). You will make
money if the P < $28. You will exercise if P < $30, exercise but lose money if P $28-30. If P >
$30, put will expire worthless.
The option extends only until the expiration date. The rate at which one currency can be
purchased or sold is one of the terms of the option and is called the exercise price or strike price.
The total description of a currency option includes the underlying currencies, the contract size,
the expiration date, the exercise price and another important detail: that is whether the option is
an option to purchase the underlying currency - a call - or an option to sell the underlying
currency - a put.
A Currency Option is a bilateral contract between two counterparties, and therefore

each party is responsible for assessing the credit standing and capacity of the other party, before
entering into a transaction.
There are two types of option expirations - American-style and European-style.

American-style options can be exercised on any business day prior to the expiration date.
European-style options can be exercised at expiration only.
Currency options give the holder the right, but not the obligation, to buy or sell a fixed
amount of foreign currency at a specified price. 'American' options are exercisable at any time
prior to the expiration date, while 'European' options are exercisable only on the expiration date.
Most currency options have 'American' exercise features. Call options give the holder the right to
buy foreign currency, while put options give the holder the right to sell foreign currency.
Call options make money when the exchange rate rises above the exercise price (allowing
the holder to buy foreign currency at a lower rate), while put options make money when the

exchange rate falls below the exercise price (allowing the holder to sell foreign currency at a
higher rate). If the exchange rate doesn't reach a level at which the option makes money prior to
expiration, it expires worthless – unlike forwards and futures, the holder of an option does not
have an obligation to buy or sell if it is not advantageous to do so.
Options allow investors even greater flexibility. Although more expensive than futures
contracts, options are valued because they allow investors to choose whether to exercise a futures
contract or not. The option-holder is under no obligation to buy or sell the underlying asset. Call
options give an investor the right, but not the obligation, to purchase the indicated asset at a
specified (strike) price by a certain date.
Foreign currency swaps can be defined as a financial foreign currency contract whereby the
buyer and seller exchange equal initial principal amounts of two different currencies at the spot
rate. It is worth mentioning in this regard that the buyer and seller exchange fixed or floating rate
interest payments in their respective swapped currencies over the term of the contract.
According to experts upon the maturity, the principal amount is effectively re-swapped at
a predetermined exchange rate so that the parties end up with their original currencies. Foreign
currency swaps are more often than not been used by commercials as a foreign currency-hedging
vehicle rather than by retail Forex traders.

2.6 FOREIGN EXCHANGE QUOTATIONS
Foreign exchange quotations can be confusing because currencies are quoted in terms of other
currencies. It means exchange rate is relative price.
For example,
If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45 Indian
rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US dollar which is simply
reciprocal of the former dollar exchange rate.
EXCHANGE RATE
Direct Indirect
The number of units of domestic the number of unit of foreign
Currency stated against one unit Currency per unit of domestic
of foreign currency. Currency.
Re/$ = 45.7250 ( or ) Re 1 = $ 0.02187
$1 = Rs. 45.7250
There are two ways of quoting exchange rates: the direct and indirect. Most countries use the
direct method. In global foreign exchange market, two rates are quoted by the dealer: one rate for
buying (bid rate), and another for selling (ask or offered rate) for a currency. This is a unique
feature of this market. It should be noted that where the bank sells dollars against rupees, one
can say that rupees against dollar. In order to separate buying and selling rate, a small dash or
oblique line is drawn after the dash.
For example,
If US dollar is quoted in the market as Rs 46.3500/3550, it means that the forex dealer is
ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs 46.3550. The difference
between the buying and selling rates is called spread.
It is important to note that selling rate is always higher than the buying rate. Traders, usually
large banks, deal in two way prices, both buying and selling, are called market makers.

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. That is 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.
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. Whenever the base currency buys more of the terms currency, the base
currency has strengthened / appreciated and the terms currency has weakened / depreciated.
For example,
If Dollar – Rupee moved from 43.00 to 43.25. The Dollar has appreciated and
the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has depreciated
and Rupee has appreciated.

2.7 TRADING PROCESS AND SETTLEMENT PROCESS
Like other future trading, the future currencies are also traded at organized exchanges. The
following diagram shows how operation take place on currency future market:
TRADER TRADER
( BUYER ) ( SELLER )
Purchase order Sales order
Transaction on the floor (Exchange)

MEMBER MEMBER
( BROKER ) ( BROKER )
Informs
CLEARING
HOUSE
It has been observed that in most futures markets, actual physical delivery of the underlying
assets is very rare and hardly has it ranged from 1 percent to 5 percent. Most often buyers and
sellers offset their original position prior to delivery date by taking an opposite positions. This is
because most of futures contracts in different products are predominantly speculative
instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two
contracts, first, X party and clearing house and second Y party and clearing house. Assume next
day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z
and buyer from Y, and hence, this process is goes on.

2.8 PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE
The contract specification in a tabular form is as under:
Contract Specifications for Euro-INR

Symbol EURINR
Instrument Type FUTCUR
Unit of trading 1 (1 unit denotes 1000 EURO)
Underlying EURO
Quotation/Price
Rs. per EUR
Quote
Tick size 0.25 paisa or INR 0.0025
Monday to Friday
Trading hours
9:00 a.m. to 5:00 p.m.
Contract trading
12 month trading cycle.
cycle
Settlement price RBI Reference Rate on the date of expiry
Two working days prior to the last business day of the expiry month at 12
Last trading day
noon.
Last working day (excluding Saturdays) of the expiry month.
Final settlement
The last working day will be the same as that for Interbank Settlements in
day
Mumbai.
Theoretical price on the 1st day of the contract. On all other days, DSP of
Base price
the contract
Price operating Tenure up to 6 months Tenure greater than 6 months
range +/-3 % of base price +/- 5% of base price
Clients Trading Members Banks
Position limits Higher of 6% of total Higher of 15% of the Higher of 15% of the
open interest or EUR total open interest or total open interest or
5 million EUR 25 million EUR 50 million
Minimum initial
2.8% on First day & 2% thereafter
margin
Extreme loss
0.3% of MTM value of gross open positions.
margin
Rs.700/- for a spread of 1 month, 1000/- for a spread of 2 months,
Calendar spreads
Rs.1500/- for a spread of 3 months or more
Settlement Daily settlement : T + 1

Final settlement : T + 2
Mode of settlement Cash settled in Indian Rupees
DSP shall be calculated on the basis of the last half an hour weighted
Daily settlement
average price of such contract or such other price as may be decided by the
price (DSP)
relevant authority from time to time.
Final settlement
RBI reference rate
price (FSP)
Contract Specifications for Pound Sterling-INR

Symbol GBPINR
Unit of trading 1 (1 unit denotes 1000 POUND STERLING)
Underlying POUND STERLING
Quotation/Price
Rs. per GBP
Quote
Tick size 0.25 paise or INR 0.0025
Monday to Friday
Trading hours
9:00 a.m. to 5:00 p.m.
Contract trading
cycle
Exchange rate published by the Reserve Bank in its Press Release
Settlement price
captioned RBI Reference Rate for US$ and Euro.
Last trading day
noon.
Final settlement
day
Mumbai.
Base price
the contract
open interest or GBP total open interest or GBP total open interest or
5 million 25 million GBP 50 million
Minimum initial 3.2% on first day & 2% thereafter

margin
Extreme loss
margin
Rs.1500/- for a spread of 1 month, 1800/- for a spread of 2 months,
Calendar spreads
Rs.2000/- for a spread of 3 months or more
Daily settlement : T + 1
Settlement
Daily settlement
price (DSP)
Final settlement Exchange rate published by the Reserve Bank in its Press Release
price (FSP) captioned RBI Reference Rate for US$ and Euro.
Contract Specifications for Japanese Yen-INR

Symbol JPYINR
Unit of trading 1 (1 unit denotes 100000 YEN)
Underlying JPY
Quotation/Price
Rs per 100 YEN
Quote
Tick size 0.25 paise or INR 0.0025
Monday to Friday
Trading hours
9:00 a.m. to 5:00 p.m.
Contract trading
cycle
Exchange rate published by the Reserve Bank in its Press Release
Settlement price
captioned RBI Reference Rate for US$ and Euro.
Last trading day
noon.
Final settlement
day
Mumbai.
Base price
the contract

open interest or JPY total open interest or JPY total open interest or
200 million 1000 million JPY 2000 million
Minimum initial
4.50% on first day & 2.30% thereafter
margin
Extreme loss
margin
Rs. 600 for a spread of 1 month; Rs 1000 for a spread of 2 months and Rs
Calendar spreads
1500 for a spread of 3 months or more
Daily settlement : T + 1
Settlement
Daily settlement
price (DSP)
Final settlement Exchange rate published by the Reserve Bank in its Press Release
price (FSP) captioned RBI Reference Rate for US$ and Euro.

2.9 REGULATORY FRAMEWORK FOR CURRENCY FUTURES
With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007
issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options
in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the
advantages of introducing currency futures. The Report of the Internal Working Group of RBI
submitted in April 2008, recommended the introduction of exchange traded currency futures.
With the expected benefits of exchange traded currency futures, it was decided in a joint meeting
of RBI and SEBI on February 28, 2008, that an RBI-SEBI Standing Technical Committee on
Exchange Traded Currency and Interest Rate Derivatives would be constituted. To begin with,
the Committee would evolve norms and oversee the implementation of Exchange traded
currency futures. The Terms of Reference to the Committee was as under:
1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and
Interest Rate Futures on the Exchanges.
2. To suggest the eligibility norms for existing and new Exchanges for Currency and
Interest Rate Futures trading.
3. To suggest eligibility criteria for the members of such exchanges.
4. To review product design, margin requirements and other risk mitigation measures on an
ongoing basis.
5. To suggest surveillance mechanism and dissemination of market information.
To consider microstructure issues, in the overall interest of financial stability.

2.10 Foreign Exchange Derivatives Market in India − Status and Prospects
The gradual liberalization of Indian economy has resulted in substantial inflow of foreign
capital into India. Simultaneously dismantling of trade barriers has also facilitated the integration
of domestic economy with world economy. With the globalization of trade and relatively free
movement of financial assets, risk management through derivatives products has become a
necessity in India also, like in other developed and developing countries. As Indian businesses
become more global in their approach, evolution of a broad based, active and liquid Forex
derivatives markets is required to provide them with a spectrum of hedging products for
effectively managing their foreign exchange exposures.
The global market for derivatives has grown substantially in the recent past. The Foreign
Exchange and Derivatives Market Activity survey conducted by Bank for International
Settlements (BIS) points to this increased activity. The total estimated notional amount of
outstanding OTC contracts increasing to $111 trillion at end− December 2001 from $94trillion at
end− June 2000. This growth in the derivatives segment is even more substantial when viewed in
the light of declining activity in the spot foreign exchange markets. The turnover in traditional
foreign exchange markets declined substantially between 1998 and2001. In April 2001, average
daily turnover was $1,200 billion, compared to $1,490 billion in April 1998, a 14% decline when
volumes are measured at constant exchange rates. Whereas the global daily turnover during the
same period in foreign exchange and interest rate derivative contracts, including what are
considered to be "traditional" foreign exchange derivative instruments, increased by an estimated
10% to $1.4 trillion.

Reserve Bank of India
Forex Market
Inter bank-forex market (Dealing

rooms of Commercial Banks,
Financial Institutions)
Retail Market (Commercial

Bank, Financial Institutions)
Foreign branches of Indian

banks, branches of foreign
Money Changers banks and correspondents
Tourists Customers
(Exporters, Importers, Remitters, External
commercial borrowers, tourists etc.)

Evolution of the forex derivatives market in India
This tremendous growth in global derivative markets can be attributed to a number of

factors. They reallocate risk among financial market participants, help to make financial markets
more complete, and provide valuable information to investors about economic fundamentals.
Derivatives also provide an important function of efficient price discovery and make unbundling
of risk easier.
In India, the economic liberalization in the early nineties provided the economic rationale
for the introduction of FX derivatives. Business houses started actively approaching foreign
markets not only with their products but also as a source of capital and direct investment
opportunities. With limited convertibility on the trade account being introduced in 1993, the
environment became even more conducive for the introduction of these hedge products.
Hence, the development in the Indian Forex derivatives market should be seen along with
the steps taken to gradually reform the Indian financial markets. As these steps were large
instrumental in the integration of the Indian financial markets with the global markets.
Rupee Forwards
An important segment of the forex derivatives market in India is the Rupee forward
contracts market. This has been growing rapidly with increasing participation from corporates,
exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only
against trade related exposures and these contracts could not be cancelled except where the
underlying transactions failed to materialize. In March 1992, in order to provide operational
freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all
genuine exposures, whether trade related or not, were permitted.
Although due to the Asian crisis, freedom to rebook cancelled contracts was suspended, which
has been since relaxed for the exporters but the restriction still remains for the importers.

The forward contracts are also allowed to be booked for foreign currencies (other than
Dollar) and Rupee subject to similar conditions as mentioned above. The banks are also allowed
to enter into forward contracts to manage their assets − liability portfolio.
The cancellation and rebooking of the forward contracts is permitted only for
genuine exposures out of trade/business up-to 1 year for both exporters and importers,
whereas in case of exposures of more than 1 year, only the exporters are permitted to
cancel and rebook the contracts. Also another restriction on booking the forward contracts
is that the maturity of the hedge should not exceed the maturity of the underlying
transaction.
RBI Regulations:
These contracts were allowed with the following conditions:
 These currency options can be used as a hedge for foreign currency loans provided that
the option does not involve rupee and the face value does not exceed the outstanding
amount of the loan, and the maturity of the contract does not exceed the un−expired
maturity of the underlying loan.
 Such contracts are allowed to be freely rebooked and cancelled. Any premia
payable on account of such transactions does not require RBI approval
 Cost reduction strategies like range forwards can be used as long as there is no net inflow
of premia to the customer.
 Banks can also purchase call or put options to hedge their cross currency
proprietary trading positions. But banks are also required to fulfill the condition
that no ’stand alone’ transactions are initiated.

 If a hedge becomes naked in part or full owing to shrinking of the portfolio, it may be
allowed to continue till the original maturity and should be marked to market at regular
intervals.
There is still restricted activity in this market but we may witness increasing activity in cross
currency options as the corporates start understanding this product better.
In short, The Indian forex derivatives market is still in a nascent stage of development but
offers tremendous growth potential. The development of a vibrant forex derivatives market in
India would critically depend on the growth in the underlying spot/forward markets, growth in
the rupee derivative markets along with the evolution of a supporting regulatory structure.
Factors such as market liquidity, investor behavior, regulatory structure and tax laws will have a
heavy bearing on the behavior of market variables in this market.
Increasing convertibility on the capital account would accelerate the process of

integration of Indian financial markets with international markets. Some of the necessary
preconditions to this as suggested by the Tarapore committee report are already being met.
Increasing convertibility does carry the risk of removing the insularity of the Indian markets to
external shocks like the South East Asian crisis, but a proper management of the transition
should speed up the growth of the financial markets and the economy. Introduction of derivative
products tailored to specific corporate requirements would enable corporate to completely focus
on its core businesses, de-risking the currency and interest rate risks while allowing it to gain
despite any upheavals in the financial markets.
Increasing convertibility on the rupee and regulatory impetus for new products should see
a host of innovative products and structures, tailored to business needs. The possibilities are
many and include INR options, currency futures, exotic options, rupee forward rate agreements,
both rupee and cross currency swap options, as well as structures composed of the above to
address business needs as well as create real options. A further development in the derivatives
market could also see derivative products linked to commodities, weather, etc which would add
great value in an economy where a substantial section is still agrarian and dependent on the
vagaries of the monsoon.

Technical
Analysis

Technical Analysis of Currency Derivative in Indian Exchange Market
USDINR
5000000
4500000
4000000
3500000
3000000
2500000
Volume
2000000
Open Inerest
1500000
1000000
500000
0
29/Sep/08
28/Feb/09
30/Apr/09
31/Jul/09
30/Sep/09
28/Feb/10
29/Dec/08
31/May/09
31/Dec/09
29/Aug/08
31/Aug/09
31/Mar/09
30/Jun/09
31/Mar/10
29/Oct/08
29/Jan/09
31/Jan/10
29/Nov/08
31/Oct/09
30/Nov/09

52
3 months trend chart
50
48
46
SPOT PRICE
FUTURE PRICE
44
42
40

54
one year trend chart
52
50
48
SPOT PRICE
FUTURE PRICE
46
44
42

GBPINR
25000
20000
15000
Open Inerest
10000 Volume
5000
80
70 2 month trend chart
60
50
40
30 SPOT PRICE
20
FUTURE PRICE
10
0

EURINR
400000
350000
300000
250000
200000
Volume
150000 Open Inerest
100000
50000
70
two month trend chart
60
50
40
30 SPOT PRICE
20 FUTURE PRICE
10

JPYINR
40000
35000
30000
25000
20000
Volume
15000
Open Inerest
10000
5000
60
two month trend chart
50
40
30
SPOT PRICE
FUTURE PRICE
20
10

Moving Average Technical Indicator
The Moving Average Technical Indicator shows the mean instrument price value for a certain
period of time. When one calculates the moving average, one averages out the instrument price
for this time period. As the price changes, its moving average either increases, or decreases.
There are four different types of moving averages: Simple (also referred to as Arithmetic),
Exponential, Smoothed and Linear Weighted. Moving averages may be calculated for any
sequential data set, including opening and closing prices, highest and lowest prices, trading
volume or any other indicators. It is often the case when double moving averages are used.
The only thing where moving averages of different types diverge considerably from each other is
when weight coefficients, which are assigned to the latest data, are different. In case we are
talking of simple moving average, all prices of the time period in question are equal in value.
Exponential and Linear Weighted Moving Averages attach more value to the latest prices.
The most common way to interpreting the price moving average is to compare its dynamics to
the price action. When the instrument price rises above its moving average, a buy signal appears,
if the price falls below its moving average, what we have is a sell signal.
This trading system, which is based on the moving average, is not designed to provide entrance
into the market right in its lowest point, and its exit right on the peak. It allows to act according
to the following trend: to buy soon after the prices reach the bottom, and to sell soon after the
prices have reached their peak.
Moving averages may also be applied to indicators. That is where the interpretation of indicator
moving averages is similar to the interpretation of price moving averages: if the indicator rises
above its moving average, that means that the ascending indicator movement is likely to
continue: if the indicator falls below its moving average, this means that it is likely to continue
going downward.

Interpretation
As per the chart, in Oct 2008 price is traded above the 50 day Moving Average line and
generated a buying signal. From sep 2009 to march 2010, the spot price is continuously traded
below the 50 days moving average line, Which indicates selling signal. It can be predicted that
price will decrease in the future time period.
GBPINR
Interpretation
Since GBP allow in the derivative exchange market it remain below the moving average line.
Spot price trend line shows continuously in decreasing result. Even in month of feb 2010 price of
GBP decrease to great extent.

EURINR
Interpretation
From month of feb 2010 euro price remain below the moving average line and remain constant
below till end of month march. But euros try to performance in month of March as reach to near
to price of Rs 63 as at the end didn’t receive support from market and close at price below Rs 60.
JPYINR

Interpretation
In the beginning month only yen show better performance as it goes above the moving average
line and as price cuts the moving avg line from above it indicate the selling signal and in the
month of feb price of yen cuts sharply from above so price goes too down .
Bollmger Bands .
Bollinger Bands are volatility curves used to identify extreme highs or lows in relation to price.
Bollinger Bands establish trading parameters, or bands, based on the moving average of a
particular instrument and a set number of standard deviations around this moving average.
For example, a trader might decide to use a 10-day moving average and 2 standard deviations to
establish Bollinger Bands for a given currency. After doing so, a chart will appear with price bars
capped by an upper boundary line based on price levels 2 standard deviations higher than the 10-
day moving average and supported by a lower boundary line based on 2 standard deviations
lower than the 10-day moving average. In the middle of these two boundary lines will be another
line running somewhat close to the middle area depicting in this case, the 10-day moving
average. Both the moving average and the number of standard deviations can be altered to best
suit a particular currency.
Jon Bollinger, creator of Bollinger Bands recommends using a simple 20-day moving average
and 2 standard deviations. Because standard deviation is a measure of volatility, Bollinger Bands
are dynamic indicators that adjust themselves (widen and contract) based on the current levels of
volatility in the market being studied.
When prices hit the upper or lower boundaries of a given set of Bollinger Bands, this is not
necessarily an indication of an imminent reversal in a trend. It simply means that prices have
moved to the upper limits of the established parameters. Therefore, traders should use another
study in conjunction with Bollinger Bands to help them determine the strength of a trend.
The following traits are particular to the Bollinger Band:
1. Abrupt changes in prices tend to happen after the band has contracted due to decrease of
volatility.
2. If prices break through the upper band, a continuation of the current trend is to be
expected.
3. If the pikes and hollows outside the band are followed by pikes and hollows inside the
band, a reverse of trend may occur.
4. The price movement that has started from one of the band’s lines usually reaches the
opposite one. The last observation is useful for forecasting price guideposts

Interpretation
In the month nov 2008 march 2009 there is big volatility space and after that it get narrow in the
succeeding months. In the case of oversold can be seen in the month of dec 2008 as it cut below
the line and over bought it can be seen in the month of march 2009 as its cut from the above line.
In the succeeding month of aug 2009 it remain in between the upper lower level in decreasing
manner.
GBPINR

Interpretation
In the beginning month of GBP touch the bottom level in the decreasing order till 26 feb but
there is sharp cut from the above to bottom level and there is cross from the below and remain
rises the ending month of march. As its cut below at 29 march we can predict price will rises in
coming month.
EURINR
Interpretation
In the starting month only its cross from the below we can see rise in price but in the descending
order. It improve the performance in next month till march 15 after there is sharp cut to the
bottom level so it indicate selling signal and in the last date the chance rise in price and there is
having great volatility space in succeeding months so it gives buying signal.

JPYINR
Interpretation
In the starting month feb price touch the upper level its show the selling signal to participants. 17
feb it touch the bottom level this indicate the buying signal to all. In the coming months we can
predict price will decrease as it cut from the above the line.

MACD
trend-following momentum indicator that shows the relationship between two moving averages
of prices. The MACD is calculated by subtracting the 26-day exponential moving average
(EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the "signal line", is then
plotted on top of the MACD, functioning as a trigger for buy and sell signals.
There are three common methods used to interpret the MACD:
1. Crossovers - As shown in the chart above, when the MACD falls below the signal line, it is a
bearish signal, which indicates that it may be time to sell. Conversely, when the MACD rises
above the signal line, the indicator gives a bullish signal, which suggests that the price of the
asset is likely to experience upward momentum. Many traders wait for a confirmed cross above
the signal line before entering into a position to avoid getting getting "faked out" or entering into
a position too early, as shown by the first arrow.
2. Divergence - When the security price diverges from the MACD. It signals the end of the
current trend.
3. Dramatic rise - When the MACD rises dramatically - that is, the shorter moving average pulls
away from the longer-term moving average - it is a signal that the security is overbought and will
soon return to normal levels.
Traders also watch for a move above or below the zero line because this signals the position of
the short-term average relative to the long-term average. When the MACD is above zero, the
short-term average is above the long-term average, which signals upward momentum. The
opposite is true when the MACD is below zero. As you can see from the chart above, the zero
line often acts as an area of support and resistance for the indicator
This is used to indicate overbought/oversold conditions on a scale 0-100%. The indicator is

based on the observation that in a b up trend, closing prices for periods tend to concentrate in the
higher part of the period’s range. Conversely, as prices fall in a b down trend, closing prices tend
to be near to the extreme low of the period range.
Stochastic calculations produce two lines, %K and %D which are used to indicate
overbought/oversold areas of a chart. Divergence between the stochastic lines and the price
action of the underlying instrument gives a powerful trading signal.

Interpretation
In nov 2008 the MACD line cuts the Signal line and traded above signal line even in the march
2009, it show the bearish market which will indicate selling signal. When it cut the signal line
and traded from below its bullish market which will indicate buying signal.

GBPINR
Interpretation
In the beginning month MACD remain below the signal for consistent in the month of march.
We can predict from the available information as it cut from the below and traded above the
signal line price will rises in the coming short period.
EURINR

Interpretation
In the initial month as it remain near to the signal line very difficult to interpret the price
movement in the time. From the above we can predict the price for next coming period as
MACD cut from the below the signal line, means it will rise.
JPYINR
Interpretation
In the initial month the MACD line remain above the signal which mean bullish market and
price will rise and on feb 15 2010 it cut signal lines from the above and traded below the signal
line it show the current market condition as bearish and price will go down. From the available
information we can predicted the price will decrease in coming month.

RSI
technical momentum indicator that compares the magnitude of recent gains to recent losses in an
attempt to determine overbought and oversold conditions of an asset. It is calculated using the
following formula:
100
RSI = 100 - ______
1 + RS
RS = Average of x days' up closes / Average of x days' down closes
As the RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches
the 80 level, meaning that it may be getting overvalued and is a good candidate for a pullback.
Likewise, if the RSI approaches 20, it is an indication that the asset may be getting oversold and
therefore likely to become undervalued.
A trader using RSI should be aware that large surges and drops in the price of an asset will affect
the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to
other stock-picking tools.
Interpretation
In sep 2008 it clear seen it touch upper level , gives selling signals .In the march 2009 relative
strength touch 80 so indicates selling signal and in months of may and oct 2009 it touch bottom
20 level its indicates buying signal.

GBPINR
Interpretation
In the month of feb its remain below 50 and gradually remain below in the decreasing order. As
it recover from the market the relative strength gain and reach near to 50. At the end of the
month remain below 50.
EURINR

Interpretation
Relative strength remains below 50 and near to 20 as market does not show good performance.
We can see there is descending order in the price and also relative strength remain near to 20 till
march 8 . we can predict from the information that price will go down as result relative strength
remain near to 20 in constant way.
JPYINR
Interpretation
this currency have show good performance as it rise to above Rs 52 aand relative strength above
the 50. In the succeeding time it again the Rs 52 and even relative strength same way. But after
march 22 there is sharp decrease in price and even relative strength touch 20. From this we can
predict that price will remain low.

ROC
The margin between the present price and the one that an existed n-time period ago is
indicated by the oscillator called the Rate of Change. ROC increases when the prices trend up
whether it declines when they trend down. The scale of the prices changes calls the
corresponding ROC change.
Overbought or oversold at the short- and long-term periods are perfectly shown by the 12-
day ROC. The more security is supposed the higher the ROC is though the ROC decline shows
the approaching rally. This indicator should be monitored during the trade in order to find out the
start of the market changes. The current trend may go on in case the overbought or oversold
indicators take dramatic values and the overbought market may keep its trend for a while as well
The ROC measures changes in prices amount during the certain time and represents it as
an oscillator showing the cyclical movement. The ROC increases along with the prices up
trending and it decreases when the prices go down. A high price changing gives the according
significant ROC changing.
Interpretation
In the march 2009 ROC cross the upper level, its gives selling signal and even in the month of
june and oct 2009 this also gives buying signal to participants.

GBPINR
Interpretation
From the initial stage rate of change is below zero it mean there is decrease in value in currency
and on march 15 market recover but it came little bit above zero. At the end we can predict price
will remain below the expected rate.
EURINR

Interpretation
In the beginning trend line, show not good performance and reducing way. On march 15 price
but not sustain to long .from the given information we predict the price to be below Rs60.
JPYINR
Interpretation
In the beginning JPY rise to above to 0.02 and even in the spot price. But at the end of the month
it reduce and reach to below -0.02 and also in spot Rs 48. So we can forecast the price to remain
reduce in the next coming months.

Conclusion
Majority of the people know what currency derivative market is, how transaction take place in it
etc. Traders generally take decision on their own but who do not have knowledge about the
currency market depend, mostly on broker. Traders trade in future and option higher compare to
only future or only options market. It has been observed that traders trading in currency F&O
market are using such markets for hedging purpose mainly. Traders who do not invest in
currency F&O market are of the opinion that such markets are highly risky and uncertain.
Political factor is the most affected factor to the market movement in the stock broking industry.
Along with derivatives, majority of the traders would like to invest in cash market for long term
investment purpose. Lack of fund is the main cause which hold respondent back to invest in cash
market and trade in currency derivative market. There are very less people whose purpose to
trade in currency derivative market is arbitrage compare to speculation. Risk is the most
considerable factor by the respondent while trading in currency derivative compare to the price,
return, volatility and status of the countries.

Bibliography:
 Primary Data Source:

Mr. ROHAN RANE, TEAM LEADER IN FOREX INVESTIGATION Dept.,
J.P.MORGAN CHASE, MUMBAI
 Secondary Data Source:

1) “Foreign Exchange Markets” –
Author: - Surendra S. Yadav & P.K.Jain
2) “Foreign Exchange International Finance and Risk Management”
Author: - A.V. Rajwade
3) “Foreign Exchange Risk”
Author: - Raghu Palat
4)”Foreign Currency Management”
Author: - Gary Shoup
5)”Currency Market Derivatives”
Author: - GRK Murty
 Websites:
www.bis.org
www.goforex.net
www.fema.gov
www.fema.rbi.org.in
www.rbi.org.in
www.fedai.org.in
www.forextheory.com
www.forexindia.org
www.forexcap.com
www.sebi.com
www.nseindia.com
www.bseindia.org

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Currency Derivative

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Forex market

Currency Derivative: Business Perspective Page 1

Currency Derivative: Business Perspective Page 2

1.2 Trade systems on Forex

Currency Derivative: Business Perspective Page 3

Currency Derivative: Business Perspective Page 4

A trading system is created by generating signals, setting up a decision making

1.3 Pitfalls of Trading Systems

Currency Derivative: Business Perspective Page 5

Currency Derivative: Business Perspective Page 6

This kind of system can be

It has very rigid rules.

Mechanical traders are less

Discretionary systems are easily

Traders learn to see which trading

Currency Derivative: Business Perspective Page 7

There are 7 most traded currencies in forex market.

Currencies are always traded in pairs in the FOREX.

Here are some of the common symbols used in the Forex:

 USD - The US Dollar

Every foreign exchange transaction is an exchange between two currencies, each

Currency Derivative: Business Perspective Page 8

 EUR/USD: euro/US dollar

EUR/GBP EUR/JPY GBP/CAD GBP/CHF AUD/CAD CHF/JPY

EUR/CHF EUR/AUD GBP/JPY AUD/JPY AUD/NZD CHF/NZD

Currency Derivative: Business Perspective Page 9

Currency Derivative: Business Perspective Page 10

Included in this category are monies whose competitiveness is effectively compromised

Permeated Currencies confront what amounts to a competitive invasion from abroad.

Currency Derivative: Business Perspective Page 11

1. Powerful forex leverage

3. Forex trading online is instant.

4. Zero forex commissions

Currency Derivative: Business Perspective Page 12

8. Free 'demo' accounts, news, charts and analysis

Currency Derivative: Business Perspective Page 13

The main players in foreign exchange market are as follows:

Currency Derivative: Business Perspective Page 14

Currency Derivative: Business Perspective Page 15

Trading foreign currencies is a challenging and potentially profitable opportunity for

There is considerable exposure to risk in any foreign exchange transaction. Any

Currency Derivative: Business Perspective Page 16

Currency Trade Profit/Loss Calculation Example

Currency Derivative: Business Perspective Page 17

1.8 FOREX SPREADS

USD/GBP = 1/1.5550 (bid)/(1/1.5545 (offer) = 0.6431/33

Currency Derivative: Business Perspective Page 18

Spread Terminology - "Pip"

Currency Derivative: Business Perspective Page 19

Currency Derivative: Business Perspective Page 20

1.9 Determinants of Exchange Rates

Currency Derivative: Business Perspective Page 21

Currency Derivative: Business Perspective Page 22

Exchange Rate Impacts:

BOP = (X-M) + (CI-CO) + (FI-FO) +FXB

Currency Derivative: Business Perspective Page 23

Currency Derivative: Business Perspective Page 24

Currency Derivative: Business Perspective Page 25

1. Prices and Exchange Rates:

2. Purchasing Power Parity and the Law of One Price:

Currency Derivative: Business Perspective Page 26

4. Exchange Rate Indices: Real and Nominal:

Currency Derivative: Business Perspective Page 27

1. The Fisher Effect: