Foreign Exchange market


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Foreign Exchange market

  2. 2. Foreign Exchange • A foreign exchange transaction is an agreement between a buyer and a seller that a given amount of one currency is to be delivered at a specified rate for some other currency. • The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies.
  3. 3. Foreign Exchange Definition Import & Export Tourism, Education, etc Forex Transaction Investment Avenues Abroad Inter bank Settlement
  4. 4. Features Largest financial market in the world with average daily turnover of approximately $5 trillion The forex market is greater than the stock market. It is 75 times greater than the combined volumes at New York Stock Exchange Dominated by large Multinational banks, Central banks, Hedge funds & Currency Brokers Round the clock market starting from Sydney, Tokyo, Honk Kong, Singapore, Bahrain, London, New York. Almost open 24hours x 5 days
  5. 5. Important facts about Indian Rupee • Indian Rupee is partially convertible currency Convertibility Current Account 1. Imports & Exports 2. Tourism , employment, study etc. Capital Account 1. Investments and loans 2. Strict rules & regulations • There is a maximum limit on conversion of Rupee • India has floating Exchange rate with active participation of RBI • INR is fast emerging as a major South East Asian Currency
  6. 6. Transactions • Spot – Immediate delivery is the basis – Standard settlement is T+2 days – USD-CAD is exception settles on T+1 day • Forward – Contract of exchange between two parties for a future date – Any transaction settling more than T+2 days Settlement date / Value date • Trade date • Trade date + 1 • Trade date + 2 • Trade date + 3 or any later date Term Used • Value cash • Value Tom • Spot • Forward
  7. 7. Functions of FX Market The foreign exchange market is the mechanism by which participants: – transfer purchasing power between countries; – obtain or provide credit for international trade transactions, and – minimize exposure to the risks of exchange rate changes. 7
  8. 8. Participants in Forex Market • The major participants in the foreign exchange market are central banks, like the U.S. Federal Reserve and European Central Bank, large financial institutions like commercial and investment banks, multinational corporations, and investors of varying shapes and sizes. Participants at 2 Levels 1. Wholesale Level (95%) - major banks 2. Retail Level - business customers.
  9. 9. Indian Foreign Exchange Markets Participants
  10. 10. Factors Affecting Exchange Rates • • • • • • • • • • • Fundamental factors Interest rates Inflation rate National Income Exchange rate policy Central Bank interventions Balance of Payments Government Intervention Technical factors Political factors Speculation
  11. 11. Derivatives • A derivative is a financial instrument whose return is derived from the return on another instrument. • Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
  12. 12. Basic Purpose Of Derivatives • In derivatives transactions, one party’s loss is always another party’s gain • The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance • If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant • Derivatives improve overall performance of the economy
  13. 13. Growth Drivers of Derivatives • Increased volatility in financial markets • Increased integration of national & international financial markets • Improvement in communication facilities & decrease in transaction costs • Development of sophisticated risk management tools providing better risk management strategies • Innovation in the derivatives market leading to higher returns, reduced risk & reduced transaction cost compared with other financial markets
  14. 14. Ways Derivatives are Used • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability • To change the nature of an investment without incurring the costs of selling one portfolio and buying another
  15. 15. Actors in the Market • There are three broad categories of market participants: • Hedgers • Speculators • Arbitrageurs 15
  16. 16. Actors in the Market • Hedgers Hedgers trade with an objective to minimize the risk in trading or holding the underlying securities. Hedgers willingly bear some costs in order to achieve protection against unfavorable price changes.
  17. 17. Actors in the Market • Speculators Speculators use derivatives to bet on the future direction of the markets. They take calculated risks but the objective is to gain when the prices move as per their expectation.
  18. 18. Actors in the Market • Arbitrageurs Arbitrageurs try to make risk-less profit by simultaneously entering into transactions in two or more markets or two or more contracts. For example, they try to benefit from difference in currency rates in two different markets. They also try to profit from taking a position in the cash market and the futures market.
  19. 19. Types of Derivatives Futures: Buy or sell an asset at a date specified at the price prevailing currently. Options: Right to Buy or sell shares but not an obligation to buy or sell. Forwards: A Contract were settlement takes place at the future date at current prevailing price on the day the agreement has been made. Swaps: Private agreements between 2 parties to exchange Currencies in the future.
  20. 20. Futures • Futures contracts are also agreements to buy or sell an asset for a certain price at a future time. • futures contracts are exchange traded and are more standardized. • They are standardized in terms of contract sizes, trading parameters, settlement procedures and are traded on a regulated exchange. • The contract size is fixed and is referred to as lot size.
  21. 21. Options • A currency option provides the buyer with the right but not the obligation, to buy or sell a set amount of currency at an agreed exchange rate, known as the “strike price” or the “exercise price”. • Strike price: agreed upon price for buying or selling.
  22. 22. TYPES OF OPTIONS • There are two basic types of options are American & European options. • American Option American options are options contracts that can be exercised at any time upto the expiration date. Options on individual securities available at NSE are American type of options. • European Options European options are options that can be exercised only on the expiration date. All index options traded at NSE are European Options.
  23. 23. TYPES OF OPTIONS • Call option: A call option gives the option buyer the right to buy an agreed amount of the specified currency at the strike price. • Put option: A put option gives the option buyer the right to sell an agreed amount of the specified currency at the strike price.
  24. 24. Forward Contracts Forward contracts are agreements to exchange currencies at an agreed rate on a specified future date. The actual settlement date is more than two working days after the deal date. Forward contracts are bilateral contracts (privately negotiated), traded outside a regulated stock exchange and suffer from counter -party risks and liquidity risks.
  25. 25. Swaps A swap is the exchange of one set of cash flows for another on a future date. In simple terms Swaps means exchange of obligation in two different currencies. Company A Indian Company having operations in USA Company B Agrees to pay $100000 over next one year US Company having operations in India Agrees to pay 6200000 Rs over next one year Obligation of $100000 over next one year Prevalent Exchange Rate 1USD= 62 Rs Obligation of Rs 6200000 over next one year Both parties having similar obligation but susceptible to exchange rate risk. These two parties will eliminate the risk by entering into a swap
  26. 26. Swap Transactions: Illustrations Firm Objective Fixed interest Floating interest rates X Fixed rate 10.75% LIBOR +0.50% Y Floating rate 10.00% LIBOR +0.25% From the above table: Cost of borrowing → Firm Y < Firm X in both the markets. The difference is called quality spread. Fixed market 10.75% - 10.00% = 0.75% Floating Market LIBOR +0.50% - (LIBOR +0.25%) =0.25% Paid to counterparty X LIBOR Y 10% Received from counter party 10% LIBOR Swap Arrangement X Paid to Market Net Cost 10% LIBOR LIBOR +0.50 10.50% Savings LIBOR + 0.25% Minus LIBOR 10.75% Minus 10.50% Fixed Rate 10.00% Y LIBOR LIBOR + 0.50 Fixed Rate 10% Market Market
  27. 27. Types of Swaps Interest Rate Swaps Currency Swaps Swapping only the interest related cash flows between the parties of the same currency Swapping both principal & interest between the parties in two different currencies Swaptions: • Options to buy or sell a swap. Two types receiver & payer swaptions. •Receiver swaptions: received fixed and pay floating •Payer swaptions: pay fixed receive floating
  28. 28. Key Points of Swaps • Foreign exchange becomes necessary for import and export • SDR is the monetary unit of IMF • Dollar Index is weighted index to show the movement of dollar against six major currencies. Euro, GBP, Yen, CHF,CAD and SKE • Floating Exchange rate is where market forces determine price. Most countries have adopted this. • Fixed Exchange rate is where central authority fixes the rate. • Market participants are Investors, Speculators. Hedgers, Arbitrageurs
  29. 29. Spreads • Spreads involve taking advantage of the price difference between two different contracts of the same commodity. • Spreading is considered to be one of the most conservative forms of trading in the futures market, because it is much safer than the trading of long / short futures contracts
  30. 30. FORWARD vs. FUTURE CONTRACT Nature Trading Customised OTC Standardised Contract Through Exchange only Liquidity Counter Party Less Liquid Risk Highly Liquid Negligible Settlement Delivery Offset or thro delivery Margin No Margin Compulsorily needs to be paid System & perform Not Marked to Marked to Market on Daily basis Market Mark to Market
  31. 31. OTC vs ETF Over The Counter Exchange Traded Funds Accessibility Low High Price Transparency Low High Liquidity Subject to credit limits High Agreements Customized Standard Credit Exposure Yes Mitigated through the clearing corporation Settlement Physical Delivery Net Settled in INR Underlying exposure Required Not required
  32. 32. Categories of Derivatives Traded In India • Commodities Derivatives Ex: Gold Futures, Silver Futures, Crude oil Futures • Equity Derivatives Ex:Stock Future,Stock Options, Index Future, Index Options • Currency Derivatives Ex:Currency Futures& Currency Options • Interest Rate Derivatives Ex: Interest Rate Futures
  33. 33. Recent Developments on Derivatives Trading in India Index Futures contracts introduced in June 2000. Index Options introduced in June 2001. Stock Options introduced in July 2001. Commodity Futures contracts Introduced in 2003. Currency Futures introduced in August 2008. Interest rate Futures introduced in August 2009. Currency Options introduced in October 2010.
  34. 34. Major Currencies of the World US Dollar Most widely used in the world, also know as reserve currency Vehicle currency as it is the most liquid currency Know as greenback in forex lingo Euro Common currency for 16 European nations Emerged as the most traded in recent times next to US dollar Japanese Yen Third most traded currency, highly liquid Large business volume between Japan & USA in the primary reason for the popularity of YEN British Pound Once heavily traded has lost to dollar after second world war Nick named Cable
  35. 35. Major Currencies of the World • The most traded currency pairs in the world are called the Majors , it includes following : These currencies follow free floating method of valuation. – Euro (EUR) – US Dollar (USD) – Japanese Yen (JPY) – Pound Sterling (GBP) – Australian Dollar (AUD) Currency Market Share % – Canadian Dollar (CAD) and the EURUSD 28 – Swiss Franc (CHF). USDJPY 14 Market Share of Currency pairs in world market: GBPUSD 9 AUDUSD 6 USDCHF 4 USDCAD 5 USD/Others 18 Others/ Others 16 TOTAL 100
  36. 36. Currencies Derivatives in NSE • • • • US Dollar Euro Japanese yen Pound
  37. 37. Product Specifications: NSE Traded Currency Futures Category Description Trading Hours 9:00 am to 5:00 pm (Monday to Friday on all business days) Contract Months o Order driven market o Revised methodology of computation and dissemination of Reference rate: Rates will be polled in a 5 minute window from 11:45 AM to 12:15 PM chosen randomly o Expiry at 12:15PM 12 near calendar months Last Trading Day Final Settlement Day Settlement Holiday Calendar Two business days prior to last business day of the month. Last working day of the month INR cash settled at RBI reference rate Mumbai-Interbank
  38. 38. Features of Currency Pairs USD-INR Quotation Contract Size Calendar Spread Margin EUR-INR GBP-INR JPY-INR Rate of exchange between 1 USD and INR (USDINR) Rate of exchange between 1 EURO and INR (EUR-INR) Rate of exchange between 1 GBP and INR (GBPINR) Rate of exchange between 100 JPY and INR (JPY-INR) USD 1000 EURO 1000 GBP 1000 JPY 100000 Rs. 400 for a spread of 1 month; Rs 500 for a spread of 2 months, Rs 800 for a spread of 3 months Rs.700 for spread of 1 month Rs.1000 for spread of 2 months Rs.1500 for spread of 3 months or more Rs.1500 for Rs.600 for spread of 1 spread month of 1 month Rs.1800 for Rs.1000 for spread of 2 spread of 2 months months Rs.2000 for Rs.1500 for spread of 3 spread of 3 months or more months or more
  39. 39. Product Specifications: Exchange Traded Currency Options Category Description Type of Option Premium Styled European Call and Put Options Trading Hours 9:00 am to 5:00 pm (Monday to Friday on all business days) Permitted Lot Size One lot denotes $ 1000 Tick Size 0.25 paisa or INR 0.0025 Contracts Available Three serial monthly contracts followed by three quarterly contracts of the cycle March/June/September/December Last Trading Day Two business days prior to last business day of the month Final Settlement Day Last working day of the contract month (Excluding Saturdays) Settlement INR cash settled at RBI reference rate Holiday Calendar Mumbai-Interbank
  40. 40. Trading Strategies – Directional views View: INR will depreciate against USD, caused by India’s sharply rising import bill and poor FII equity flows Trade: USDINR 31 Dec contract : 63.50 Current Spot rate (08 Nov 13): 62.70 Buy 1 Dec contract : Value Rs. 63.50 (USD 1000 *63.50) Hold contract to expiry: RBI fixing rate – 64.00 Economic return : Profit, Rupees 500 (64.00 – 63.50)
  41. 41. Long position in Futures Speculative long positions in currency futures market means buying futures contract without any exposure in the cash market Illustration On 1st November 2013 mr X a currency trader expects that dollar will strengthen against the rupee in the coming months. He decides to go long and buys one December USD-INR contract at 63.50 & he wants to hold the contract till expiry. The market moves as his anticipation and the Dollar strengthens against the rupee and the RBI reference rate moves to USD-INR 65.50 on 31st December. Date Contract Rate !st November 2013 USD-INR December Futures 63.50 27th December 2013 USD-INR December Futures 65.50 Profit = Sell – Buy Price x lot size Profit = ( 63.50 – 65.50) x 1000 Profit = Rs 2000
  42. 42. Short position in Futures Speculative short positions in currency futures market means selling futures contract without any exposure in the cash market Illustration On 1st November 2013 mr A a currency trader expects that dollar will weaken against the rupee in the coming months. He decides to go short and sells one December USD-INR contract at 66.50 & he wants to hold the contract till expiry. The market moves as his anticipation and the Dollar depreciates against the rupee and the RBI reference rate moves to USD-INR 64.50 on 31st December. Mr A decides to square his position and makes a profit of Rs 2000 (65.50 – 63.50x 1000). Date Contract Rate 1 st November 2013 USD-INR December Futures 66.50 27th December 2013 USD-INR December Futures 64.50 Profit = Buy – Sell Price x lot size Profit = ( 66.50 – 64.50) x 1000 Profit = Rs 2000
  43. 43. Hedging using Currency Futures Hedging means taking a long positions in futures market that is opposite to the position in the physical market in order to reduce risk associated with exchange rates. The overall portfolio of a hedger consists of the following two positions: • Underlying Position •Hedging position which is totally opposite to underlying positions Types of Hedge Long Hedge Underlying Positions : short in foreign currency Hedging Positions: Long in Currency futures Short Hedge Underlying Positions : Long in foreign currency Hedging Positions: Short in Currency futures
  44. 44. Arbitrage Arbitrage can potentially exist between, currency futures, OTC forwards and the non-deliverable forwards traded offshore An arbitrage can be executed by an entity having access to any two of the above Corporate entities with an underlying exposure, can straddle both markets Sell 1st month in currency futures Buy 1 month forward in OTC markets This scenario can exist when currency futures are trading higher than forwards which will also be governed by interest rate differentials and USD supply with banks Restricted access to the OTC and NDF markets could translate to the arbitrage gap not closing
  45. 45. Trading
  46. 46. Clearing, Settlement & Risk Management Mark to Market: • Online real time calculation • Maximum 75% of total deposit allowed to be lost • Warning given at 60%, 75% and 90% of breaching this limit • On utilizing the 75% limit member is suspended Position Limit: • To avoid huge built up of positions • Monitored at day end • Monitored at both client level and member level • Violation of limits used for further surveillance • CM accountable for TM violation • TM accountable for Client violation Limits: • Client level = 10 million USD or 6% of all open positions whichever is higher • Exchange disseminates warning when 3% crossed for any client • Non Bank Member = 50 Million USD or 15% • Bank Member = 100 million USD or 15% • Clearing member = no separate limits
  47. 47. Clearing, Settlement & Risk Management • • • • Clearing Corporation (CC) undertakes clearing & settlement Acts as legal counter party to all trades This is called NOVATION Guarantees financial settlement Clearing & Settlement includes: 1. Clearing 2. Settlement 3. Risk Management Clearing Entities: Clearing Members = TCM and PCM clear trades. For each additional TM under them they have to bring additional deposit Clearing Banks = Used for Funds settlement Each member required to open an account with Clearing Bank
  48. 48. Clearing and Settlement -MTM • Daily marked to market(MTM) Settlement • Netted MTM settlement on T+1 • End of day open positions MTM @ daily settlement price(DSP) • Through clearing member’s settlement account
  49. 49. FOREIGN EXCHANGE MANAGEMENT ACT-1999 • The Foreign Exchange Management Act (FEMA) was an act passed in the winter session of Parliament in 1999 which replaced Foreign Exchange Regulation Act. • FEMA has brought a new management regime of Foreign Exchange consistent with the emerging framework of the World Trade Organisation (WTO).
  50. 50. BROAD STRUCTURE OF FEMA • It mainly deals with matters pertaining to foreign exchange • All current account transactions are free However, Central government can impose restrictions by issuing rules. S.3 • Capital accounts transactions are permitted to the extent specified by RBI regulations s.6 • RBI controls management of foreign exchange • Since it cannot directly deal with foreign exchange it authorises” authorised persons ” to deal in foreign exchange according to RBI Regulations s.10 • RBI issues directions to such persons u/s.11 • These directions are issued through AP(DIR) circulars. Authorised Persons (Directions)