Foreign

Exchange
Markets
Compile by: Achyut Raj Pyakurel,MBA
Study Content
Foreign Exchange Centres and Vehicle Currency,
Market Participants,
Mechanics in Foreign Exchange Trading,
Spot Rate and Forward Contracts,
Currency Swaps and OTC Currency Options,
Exchange-Traded Currency Futures and Options,
Risk Management in Foreign Exchange Trading
 Foreign Exchange Centres and Vehicle Currency
• The foreign exchange market (Forex, FX, or currency market) is a
global decentralized or over-the-counter (OTC) market for the trading of currencies.
This market determines foreign exchange rates for every currency. It includes all
aspects of buying, selling and exchanging currencies at current or determined prices.
In terms of trading volume, it is by far the largest market in the world, followed by
the credit market.
• Foreign Exchange (forex or FX) is the trading of one currency for another. For example,
one can swap the U.S. dollar for the euro. Foreign exchange transactions can take
place on the foreign exchange market, also known as the forex market.
• The forex market is the largest, most liquid market in the world, with trillions of
dollars changing hands every day. There is no centralized location. Rather, the forex
market is an electronic network of banks, brokers, institutions, and individual traders
(mostly trading through brokers or banks).
• Foreign exchange trading utilizes currency pairs, priced in terms of one versus the
other.
• Forwards and futures are another way to participate in the forex market.
Contd.

• Traditionally, the market is separated into three peak activity sessions:

the Asian, European and North American sessions. These three periods
are also referred to as the Tokyo, London and New York sessions.
Sometimes a fourth, Australian (Sydney) session is used that fills in the
gap between New York and Tokyo hours.These national or city names
are used interchangeably, as the cities represent the major financial
centers for each of the regions. The markets are most active when these
three powerhouses are conducting business, as most banks and
corporations make their day-to-day transactions in these regions and
there is a greater concentration of speculators online.
 Vehicle Currency

• A currency which is extensively used by traders and bankers in international trade

transactions, i.e. used as an international medium of exchange (such as the
dollar). legacy.intracen.org
• The currency used to invoice an international trade transaction, especially when
it is not the national currency of either the importer or the exporter. -
investorwords.com
• The currency used to invoice an international trade transaction, especially when
it is not the national currency of either the importer or the exporter.
• A commonly accepted currencies that is used to denominate the transaction that
does not takes place in the nation that issue the currency.
Market Participants,
• The main participants in this market are the larger international banks. Financial
centers around the world function as anchors of trading between a wide range of
multiple types of buyers and sellers around the clock, with the exception of weekends.
Since currencies are always traded in pairs, the foreign exchange market does not set a
currency's absolute value but rather determines its relative value by setting the market
price of one currency if paid for with another.
• There is no centralized location. Rather, the forex market is an electronic network of
banks, brokers, institutions, and individual traders (mostly trading through brokers or
banks)
Mechanics in Foreign Exchange Trading,

• Forex trading is also a part of Forex management. Various Forex transactions like
purchasing, selling, receipt of sums of money, payments of money, etc. in foreign
currency for the transactions done with parties situated in other country is covered
under Forex trading. Forex trading normally happens either in retail markets or
wholesale markets.

• The retail markets include tourists and individuals and normally cover small
amounts. The wholesale markets include banks (Commercial and Central), various
trade organizations and other markets with high market capacity. Wholesale
markets have huge turnover in comparison to retail markets. Normally, the spread
between ask – bid rate is more in retail markets in comparison to wholesale markets.
 Mechanics in Foreign Exchange Trading
• Placing an Order
• Long and short position in forex trading
• The concepts of buying, selling, long and short can be confusing in currency trading, since in every
forex trade one currency is exchanged for another - essentially there is a buy/long and a sell/short in
every trade. For simplicity, it might be easiest to think of a currency pair as being an abstract financial
instrument to which a price is assigned by the forex market.

• At the same time, it is important to maintain perspective and remember that the abstract-appearing
instrument, in a very real way represents the actual relative value of two very real currencies. When a
currency pair is purchased, the trader is purchasing the base currency and selling the quote currency.
When a currency pair is sold, the opposite is true: the trader is buying the quote currency and selling
the base currency.

• Order Types
• Market Order :instructs the broker to buy at the current market rate
• Limit Order : instructs the forex broker to execute a trade to enter a forex trade at a
specific price
• Stop Order : an order to buy above the present market price, or sell below the present
market price. This order is normally used to limit losses if the currency pair price
changes unfavorably in a forex position.
 Mechanics in Foreign Exchange Trading
• Pairs and Pips
• All currency trading is done in pairs. Unlike the stock market, where you can buy or sell a single
stock, you have to buy one currency and sell another currency in the forex market. Next, nearly
all currencies are priced out to the fourth decimal point. A pip or percentage in point is the
smallest increment of trade. One pip typically equals 1/100 of 1%.

• Currency is traded in various sized lots. The micro-lot is 1,000 units of a currency. If your account is
funded in U.S. dollars, a micro lot represents $1,000 of your base currency, the dollar. A mini lot is
10,000 units of your base currency and a standard lot is 100,000 units

• Most often traded are the U.S. dollar (USD), Canadian dollar (CAD), euro (EUR), British pound (GBP),
Swiss franc (CHF), New Zealand dollar (NZD), Australian dollar (AUD) and the Japanese yen (JPY).
 Mechanics in Foreign Exchange Trading
• What Moves Currencies?
• An increasing amount of stock traders are taking interest in the currency
markets because many of the forces that move the stock market also move the
currency market. One of the largest is supply and demand. When the world needs
more dollars, the value of the dollar increases and when there are too many
circulating, the price drops.
• Other factors like interest rates, new economic data from the largest countries and
geopolitical tensions, trade & financial flows are just a few of the events that may
affect currency prices.
 Spot Rate and Forward Contracts
• The spot rate is the price quoted for immediate settlement on an interest rate, commodity, a security,
or a currency. The spot rate, also referred to as the "spot price," is the current market value of an asset
available for immediate delivery at the moment of the quote. This value is in turn based on how much
buyers are willing to pay and how much sellers are willing to accept, which usually depends on a blend
of factors including current market value and expected future market value.

• While spot prices are specific to both time and place, in a global economy the spot price of most
securities or commodities tends to be fairly uniform worldwide when accounting for exchange rates. In
contrast to the spot price, a futures or forward price is an agreed-upon price for future delivery of the
asset.

• In currency transactions, the spot rate is influenced by the demands of individuals and businesses
wishing to transact in a foreign currency, as well as by forex traders. The spot rate from a foreign
exchange perspective is also called the "benchmark rate," "straightforward rate" or "outright rate."
 Spot Rate and Forward Contracts
• Spot settlement (i.e., the transfer of funds that completes a spot contract transaction) normally occurs
one or two business days from the trade date, also called the horizon. The spot date is the day when
settlement occurs. Regardless of what happens in the markets between the date the transaction is
initiated and the date it settles, the transaction will be completed at the agreed-upon spot rate.

• The spot rate is used in determining a forward rate—the price of a future financial transaction—since a
commodity, security, or currency’s expected future value is based in part on its current value and in part
on the risk-free rate and the time until the contract matures. Traders can extrapolate an unknown spot
rate if they know the futures price, risk-free rate, and time to maturity.

• The difference between spot prices and futures contract prices can be significant. Futures prices can be
in contango or backwardation. Contango is when futures prices fall to meet the lower spot
price. Backwardation is when futures prices rise to meet the higher spot price. Backwardation tends to
favor net long positions since futures prices will rise to meet the spot price as the contract get closer to
expiry. Contango favors short positions, as the futures lose value as the contract approaches expiry and
converges with the lower spot price
 Spot Rate and Forward Contracts
• A forward contract is a customized contract between two parties to buy or sell an asset at a specified
price on a future date. A forward contract can be used for hedging or speculation, although its non-
standardized nature makes it particularly apt for hedging.

• KEY TAKEAWAYS
• A forward contract is a customizable derivative contract between two parties to buy or sell an asset at a
specified price on a future date.
• Forward contracts can be tailored to a specific commodity, amount, and delivery date.
• Forward contracts do not trade on a centralized exchange and are considered over-the-counter (OTC)
instruments.
• For example, forward contracts can help producers and users of agricultural products hedge against a change
in the price of an underlying asset or commodity.
• Financial institutions that initiate forward contracts are exposed to a greater degree of settlement and default
risk compared to contracts that are marked-to-market regularly
 Spot Rate and Forward Contracts
• Unlike standard futures contracts, a forward contract can be customized to a commodity,
amount, and delivery date. Commodities traded can be grains, precious metals, natural
gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery
basis.

• Forward contracts do not trade on a centralized exchange and are therefore regarded as
over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize
terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default
risk.

• Both forward and futures contracts involve the agreement to buy or sell a commodity at a
set price in the future. But there are slight differences between the two. While a forward
contract does not trade on an exchange, a futures contract does.

• Settlement for the forward contract takes place at the end of the contract, while the
futures contract settles on a daily basis. Most importantly, futures contracts exist
as standardized contracts that are not customized between counterparties.
 Spot Rate and Forward Contracts
• Risks of Forward Contracts
• The market for forward contracts is huge since many of the world’s biggest corporations use it
to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to
the buyer and seller—and are not known to the general public—the size of this market is difficult to
estimate.

• The large size and unregulated nature of the forward contracts market mean that it may be susceptible to
a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate
this risk by being very careful in their choice of counterparty, the possibility of large-scale default does
exist.

• Another risk that arises from the non-standard nature of forward contracts is that they are only settled on
the settlement date and are not marked-to-market like futures. What if the forward rate specified in the
contract diverges widely from the spot rate at the time of settlement?

• In this case, the financial institution that originated the forward contract is exposed to a greater degree of
risk in the event of default or non-settlement by the client than if the contract were marked-to-market
regularly.
 Currency Swaps and OTC Currency Options

• Derivative is an instrument that derives its value from another underlying asset or rate. Without
the underlying asset, a derivative would have no independent existence or value. Derivative
product is created by the introduction of a new security having a relationship with the underlying
cash or spot market. The common derivatives are Futures, Options and Swaps.

• A Futures Contract is an agreement to make or take delivery of a specified quantity at an agreed

price on a future date in the underlying market. Futures contracts exist in commodities, equities,
equity indices, interest rates and currencies. We will discuss specifically currency futures.

• An Option is a right but not an obligation to make or take delivery of a specified quantity of an
underlying asset at an agreed price on a future date. Option contracts also exist, just like future
contracts, on different underlying assets or rates such as equities, currencies and interest rates
etc. We will discuss currency options in this unit.

• A Swap contract represents an exchange of two streams of payments between two parties.
 Currency Swaps and OTC Currency Options

• Cross-currency swaps are an over-the-counter (OTC) derivative in a form of an agreement between two parties
to exchange interest payments and principal denominated in two different currencies. In a cross-currency
swap, interest payments and principal in one currency are exchanged for principal and interest payments in a
different currency. Interest payments are exchanged at fixed intervals during the life of the agreement. Cross-
currency swaps are highly customizable and can include variable, fixed interest rates, or both.

• Since the two parties are swapping amounts of money, the cross-currency swap is not required to be shown on a
company's balance sheet

• KEY TAKEAWAYS
• Cross-currency swaps are used to lock in exchange rates for set periods of time.
• Interest rates can be fixed, variable, or a mix of both.
• These instruments trade OTC, and can thus be customized by the parties involved.
• While the exchange rate is locked in, there is still opportunity costs/gains as the exchange rate will likely change.
This could result in the locked-in rate looking quite poor (or fantastic) after the transaction occurs.
• Cross-currency swaps are not typically used to speculate, but rather to lock in an exchange rate on a set amount of
currency with a benchmarked (or fixed) interest rate.
Currency Swaps and OTC Currency Options

• Types of currency swap

• (A) Fixed-to-fixed rate Currency Swaps:
• In a fixed-to-fixed swap, the two parties want to borrow at a fixed rate of interest. The
swap deal enables them to get the desired currency at a favorable rate

• (B) Fixed-to-floating currency swap :

• The steps to be followed in the fixed-to-floating rate swap are the same as in fixed to
fixed swap. Here the only difference is that one currency has fixed rate while the
other has floating rate
 Currency Swaps and OTC Currency Options

• The Uses of Currency Swaps

Currency swaps are mainly used in three ways.
• First, currency swaps can be used to purchase less expensive debt. This is done by getting the best rate
available of any currency and then exchanging it back to the desired currency with back-to-back loans.

• Second, currency swaps can be used to hedge against foreign exchange rate fluctuations. Doing so
helps institutions reduce the risk of being exposed to large moves in currency prices which could
dramatically affect profits/costs on the parts of their business exposed to foreign markets.

• Last, currency swaps can be used by countries as a defense against a financial crisis. Currency swaps
allow countries to have access to income by allowing other countries to borrow their own currency.
 Currency Swaps and OTC Currency Options

• A currency option, as the name suggests, gives its holder a right and not an obligation to buy or sell
or not to buy or sell a currency at a predetermined rate on or before a specified maturity date. Options are
traded on the Over-the-Counter (OTC) market as well as on organised exchanges. _There are different
categories of market operators such as enterprisers (known as hedgers) who use options to cover their
exposures, banks that profit by speculating and arbitrageurs who profit by taking advantage of price
distortions on different markets.

• KEY TAKEAWAYS
• Currency options give investors the right, but not the obligation, to buy or sell a particular currency at a
pre-specific exchange rate before the option expires.
• Currency options allow traders to hedge currency risk or to speculate on currency moves.
• Currency options come in two main varieties, so-called vanilla options and over-the-counter SPOT options
 Currency Swaps and OTC Currency Options

• Important Terms relating to Options

• Call option: It is the type of option that gives its holder a right to buy a currency at a pre-specified rate
on or before the maturity date.

• Put option: It is the type of option that gives its holder a right to sell a currency at a pre-specified rate
on or before the maturity date.

• Premium: It is the initial amount that the buyer (also called the option holder) of the option pays up-
front to the seller (also called the option writer) of the option. By paying this premium, the holder
acquires a right for himself and by receiving it, the writer takes an obligation upon himself to fulfil the
right of the holder. Generally, it is a small percentage of the amount to be bought or sold under the
option. We use notation, c, to denote premium on call option and notation, p, to denote premium on
put option.

• Exercise/Strike Price (Rate): It is the exchange rate at which the holder of a call option can buy and
the holder of a put option can sell the currency under the deal, irrespective of the actual spot rate at
the time of exercise of option. We use "X" to denote exercise price.
 Currency Swaps and OTC Currency Options

• Maturity Date or Expiration Date: The date on or up to which an option can be exercised. After this
date, it becomes defunct and loses its validity.
• American option: When the option has the possibility of being exercised on any date up to matur ity,
it is called American type.
• European option: When an option has the possibility of being exercised only on the maturity date, it
is called uropean type.
 Exchange-Traded Currency Futures

• CURRENCY FUTURES
• A Currency Futures Contract is a commitment to either take delivery or give delivery of a certain
amount of a foreign currency on a future date at a specified exchange rate. Currency futures are
conceptually similar to currency forward contracts. But they differ widely in terms of operational
process.
• For example, A needs • 1000 on a date sometime in near future. So, instead of buying this amount
now and keeping it idle, A buys a futures contract maturing around the date when he needs • 1000.
Suppose this particular futures contract is quoting at Rs 56 per euro today. Once A enters into a
contract to buy •1000 at Rs 56 per euro, he will have to pay neither more nor less than Rs 56 per
euro irrespective of the actual spot rate on the date of delivery of the •1000
 Exchange-Traded Currency Futures

• The participants on currency futures market may be traders, brokers or brokerstraders. Traders are
speculators who buy and sell to take positions on the market for their own account.

• Brokers do not trade but enable other clients to find buyers/sellers. They do so by charging a
commission. Broker-traders operate for their own account as well as for their clients.

• Business enterprises, operating through their brokers, buy or sell currency futures in order to cover or
hedge their currency exposures. They are called hedgers for this reason. On the other hand, speculators
take positions in futures market to make profits.
 Exchange-Traded Currency Futures
• Features of Currency Futures:
As mentioned above, currency futures are conceptually similar to currency
forwards. Yet, they are different in terms of their dealing. Following are the
characteristic features of the currency futures that distinguish them from
forward contracts:
• (i) Standardisation,
• (ii) Organised exchanges,
• (iii) Clearing house,
• (iv) Initial and maintenance margin,
• (v) Marking-to-market process.
 Exchange-Traded Currency Futures

• Currency futures are standardised in terms of contract size, maturity date and minimum
variation in their value. Standardization of size means that a certain minimum amount
would constitute one futures contract in a particular currency.

• For example, a pound sterling futures has a size of £62500 on Chicago Mercantile
Exchange (CME). This means that one can buy or sell pound sterling futures only as
multiples of £62500. If an enterprise needs to buy £300000, it has to enter into a
futures contract either to buy £250000 (4 contracts of £62500 each) or buy £312500 (5
contracts). While buying or selling futures for hedging purpose an enterprise normally
either underhedges or overheadges since the hedged amount is rarely an exact multiple
of standard contract size
Exchange-Traded Currency Futures
Comparison Between Forward and Futures Contract
 Risk Management in Foreign Exchange Trading
• Forex risk management enables you to implement a set of rules and measures to ensure any negative impact of a
forex trade is manageable. An effective strategy requires proper planning from the outset, since it’s better to have
a risk management plan in place before you actually start trading.
• What are the risks of forex trading?
• Currency risk is the risk associated with the fluctuation of currency prices, making it more or less expensive
to buy foreign assets

• Interest rate risk is the risk related to the sudden increase or decrease of interest rates, which
affects volatility. Interest rate changes affect FX prices because the level of spending and investment across
an economy will increase or decrease, depending on the direction of the rate change

• Liquidity risk is the risk that you can’t buy or sell an asset quickly enough to prevent a loss. Even though
forex is a highly liquid market, there can be periods of illiquidity – depending on the currency and
government policies around foreign exchange

• Leverage risk is the risk of magnified losses when trading on margin. Because the initial outlay is smaller than
the value of the FX trade, it’s easy to forget the amount of capital you are putting at risk
 Risk Management in Foreign Exchange Trading

How to manage risk in forex trading?

Don’t focus on making money; focus on protecting what you have.-Paul Tudor Jones
• Understand the forex market
• Get a grasp on leverage
• Build a good trading plan
• Set a risk-reward ratio
• Use stops and limits
• Manage your emotions
• Keep an eye on news and events
• Start with a demo account
 Thank you...!

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