Currency Derivative

Forex market

Currency Derivative: Business PerspectivePage 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

automated and back tested

efficiently.

It has very rigid rules.

Either, there is a trade or there isn’t.

Mechanical traders are less

susceptible to emotions than

discretionary traders.

Most traders back test Forex trading systems incorrectly.

In order to produce accurate results you need tick data.

The Forex market is always changing.

The Forex market (and all markets) has a random component.

The market conditions may look similar, but they are never the same.

A system that worked successfully the past year doesn’t

necessary mean it will work this year.

Discretionary systems

Discretionary systems are easily

adaptable to new market conditions

.

Trading decisions are based on

experience.

Traders learn to see which trading

signals have higher probability of

success.

They cannot be back tested or automated, since there is

always a thought decision to be made.

It takes time to develop the experience required to trade

successfully and track trades in a discretionary way.

At early stages this can be dangerous.

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).


http://en.wikipedia.org/wiki/Economic_inequality

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)_per_capita

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)_per_capita

http://en.wikipedia.org/wiki/Per_capita_income

http://en.wikipedia.org/wiki/Computer_software

http://en.wikipedia.org/wiki/Industrial_sector

http://en.wikipedia.org/wiki/Service_(economics)

http://en.wikipedia.org/wiki/Agriculture_in_India

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(real)_growth_rate

http://en.wikipedia.org/wiki/Economic_development_in_India

http://en.wikipedia.org/wiki/Market_economy

http://en.wikipedia.org/wiki/Economic_liberalisation_in_India

http://en.wikipedia.org/wiki/Hindu_rate_of_growth

http://en.wikipedia.org/wiki/Corruption_in_India

http://en.wikipedia.org/wiki/Corruption_in_India

http://en.wikipedia.org/wiki/Protectionism

http://en.wikipedia.org/wiki/License_Raj

http://en.wikipedia.org/wiki/Social_democratic

http://en.wikipedia.org/wiki/India

http://en.wikipedia.org/wiki/Economy

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)

Demographic data and statistics:

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.


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

Indian economy’s indicators

2006 2007 2008 2009 2010

Annual

Disposable

Income (US$

million)

733,601.07 908,057.36 967,743.25 980,725.06 1,039,894.00

Consumer

Expenditure

(US$ million)

501,477.25 617,942.52 658,790.84 704,029.47 764,390.05

Population

Aged 65+:

January 1st

('000)

52,128.16 53,626.68 55,132.74 56,656.42 58,215.24

GDP

Measured at

Purchasing

Power Parity

(million

international

$)

2,783,397.37 3,120,021.14 3,341,338.61 3,630,359.36 3,924,782.88

Real GDP

Growth (%

growth)

9.80 9.36 7.41 5.60 7.70

Population

Density

(people per sq

km)

376.62 382.17 387.66 393.11 398.51

Inflation (%

growth)

6.17 6.39 8.32 10.83 8.41

Annual Gross

Income (US$

754,849.44 946,420.51 1,012,168.00 1,024,791.56 1,083,677.00


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


http://www.euromonitor.com/World_Economic_Factbook

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

contract

Standardized Negotiated/Tailor made

Quotation Generally U.S.

Dollar/Currency unit

US $/ Currency Unit

Maturity Standardized , generally

shorter than one year

Negotiated

Location of

trading

Futures exchanges Linkages by telephone or fax

Price Fixed on the market Quotation of rates

Settlement Generally no settlement but

compensation through reverse

operations

Generally delivery of currencies

Counterpartie

s

Generally do not know each

other

Generally in contact with each

other

Negotiation

Hours

During market sessions Round the clock

Guarantee Guarantee Deposit No guarantee deposit

Marking to

market

Gains or losses on positions

settled every day

No marking to market


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.


TRADER( BUYER )

TRADER( SELLER )

MEMBER( BROKER )

MEMBER( BROKER )

CLEARINGHOUSE

Purchase order Sales order

Transaction on the floor (Exchange)

Informs

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:

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 Quote

Rs. per EUR

Tick size 0.25 paisa or INR 0.0025

Trading hoursMonday to Friday9:00 a.m. to 5:00 p.m.

Contract trading cycle

12 month trading cycle.

Settlement price RBI Reference Rate on the date of expiry

Last trading dayTwo working days prior to the last business day of the expiry month at 12 noon.

Final settlement day

Last working day (excluding Saturdays) of the expiry month.The last working day will be the same as that for Interbank Settlements in Mumbai.

Base priceTheoretical price on the 1st day of the contract. On all other days, DSP of the contract

Price operating range

Tenure up to 6 months Tenure greater than 6 months

+/-3 % of base price +/- 5% of base price

Position limits

Clients Trading Members Banks

Higher of 6% of total open interest or EUR 5 million

Higher of 15% of the total open interest or EUR 25 million

Higher of 15% of the total open interest or EUR 50 million

Minimum initial margin

2.8% on First day & 2% thereafter

Extreme loss margin

0.3% of MTM value of gross open positions.

Calendar spreadsRs.700/- for a spread of 1 month, 1000/- for a spread of 2 months, Rs.1500/- for a spread of 3 months or more

SettlementDaily settlement : T + 1 Final settlement : T + 2


Mode of settlement Cash settled in Indian Rupees

Daily settlement price (DSP)

DSP shall be calculated on the basis of the last half an hour weighted average price of such contract or such other price as may be decided by the relevant authority from time to time.

Final settlement price (FSP)

RBI reference rate

Contract Specifications for Pound Sterling-INR

Symbol GBPINR


Unit of trading 1 (1 unit denotes 1000 POUND STERLING)

Underlying POUND STERLING


Rs. per GBP

Tick size 0.25 paise or INR 0.0025




Settlement priceExchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.



Last working day (excluding Saturdays) of the expiry month.The last working day will be the same as that for Interbank Settlements in Mumbai.





Position limits

Clients Trading Members Banks

Higher of 6% of total open interest or GBP 5 million

Higher of 15% of the total open interest or GBP 25 million

Higher of 15% of the total open interest or GBP 50 million


3.2% on first day & 2% thereafter

Extreme loss 0.5% of MTM value of gross open positions.


margin

Calendar spreadsRs.1500/- for a spread of 1 month, 1800/- for a spread of 2 months, Rs.2000/- for a spread of 3 months or more






Exchange rate published by the Reserve Bank in its Press Release 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


Rs per 100 YEN

Tick size 0.25 paise or INR 0.0025




Settlement priceExchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.



Last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai.





Position limits Clients Trading Members Banks

Higher of 6% of total Higher of 15% of the total Higher of 15% of the


open interest or JPY 200 million

open interest or JPY 1000 million

total open interest or JPY 2000 million


4.50% on first day & 2.30% thereafter

Extreme loss margin

0.7% of MTM value of gross open positions.

Calendar spreadsRs. 600 for a spread of 1 month; Rs 1000 for a spread of 2 months and Rs 1500 for a spread of 3 months or more






Exchange rate published by the Reserve Bank in its Press Release 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)

Money Changers

Tourists

Foreign branches of Indian banks, branches of foreign banks and correspondents

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

29-Aug-0

8

23-Sep-08

18-Oct-

08

12-Nov-0

8

7-Dec-

08

1-Jan-09

26-Jan-09

20-Feb-09

17-Mar-

09

11-Apr-0

9

6-May

-09

31-May

-09

25-Jun-09

20-Jul-0

9

14-Aug-0

9

8-Sep-09

3-Oct-

09

28-Oct-

09

22-Nov-0

9

17-Dec-

09

11-Jan-10

5-Feb-10

2-Mar-

10

27-Mar-

100

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

4500000

5000000

VolumeOpen Inerest


29-Aug-0

8

2-Sep-08

6-Sep-08

10-Sep-08

14-Sep-08

18-Sep-08

22-Sep-08

26-Sep-08

30-Sep-08

4-Oct-

08

8-Oct-

08

12-Oct-

08

16-Oct-

08

20-Oct-

08

24-Oct-

08

28-Oct-

08

1-Nov-0

8

5-Nov-0

8

9-Nov-0

8

13-Nov-0

8

17-Nov-0

8

21-Nov-0

8

25-Nov-0

840

42

44

46

48

50

52 3 months trend chart

SPOT PRICEFUTURE PRICE


29-Dec-

08

15-Jan-09

1-Feb-09

18-Feb-09

7-Mar-

09

24-Mar-

09

10-Apr-0

9

27-Apr-0

9

14-May

-09

31-May

-09

17-Jun-09

4-Jul-0

9

21-Jul-0

9

7-Aug-0

9

24-Aug-0

9

10-Sep-09

27-Sep-09

14-Oct-

09

31-Oct-

09

17-Nov-0

9

4-Dec-

09

21-Dec-

0942

44

46

48

50

52

54

one year trend chart



GBPINR

29-Jan-10

1-Feb-10

4-Feb-10

7-Feb-10

10-Feb-10

13-Feb-10

16-Feb-10

19-Feb-10

22-Feb-10

25-Feb-10

28-Feb-10

3-Mar-

10

6-Mar-

10

9-Mar-

10

12-Mar-

10

15-Mar-

10

18-Mar-

10

21-Mar-

10

24-Mar-

10

27-Mar-

10

30-Mar-

100

5000

10000

15000

20000

25000

Open InerestVolume


29-Jan-10

1-Feb-10

4-Feb-10

7-Feb-10

10-Feb-10

13-Feb-10

16-Feb-10

19-Feb-10

22-Feb-10

25-Feb-10

28-Feb-10

3-Mar-

10

6-Mar-

10

9-Mar-

10

12-Mar-

10

15-Mar-

10

18-Mar-

10

21-Mar-

10

24-Mar-

10

27-Mar-

100

20

40

60

80

2 month trend chart


EURINR

1-Feb-10

4-Feb-10

7-Feb-10

10-Feb-10

13-Feb-10

16-Feb-10

19-Feb-10

22-Feb-10

25-Feb-10

28-Feb-10

3-Mar-

10

6-Mar-

10

9-Mar-

10

12-Mar-

10

15-Mar-

10

18-Mar-

10

21-Mar-

10

24-Mar-

10

27-Mar-

10

30-Mar-

100

50000

100000

150000

200000

250000

300000

350000

400000

VolumeOpen Inerest


29-Jan-10

1-Feb-10

4-Feb-10

7-Feb-10

10-Feb-10

13-Feb-10

16-Feb-10

19-Feb-10

22-Feb-10

25-Feb-10

28-Feb-10

3-Mar-

10

6-Mar-

10

9-Mar-

10

12-Mar-

10

15-Mar-

10

18-Mar-

10

21-Mar-

10

24-Mar-

10

27-Mar-

100

10

20

30

40

50

60

70

two month trend chart


JPYINR

1-Feb-10

4-Feb-10

7-Feb-10

10-Feb-10

13-Feb-10

16-Feb-10

19-Feb-10

22-Feb-10

25-Feb-10

28-Feb-10

3-Mar-

10

6-Mar-

10

9-Mar-

10

12-Mar-

10

15-Mar-

10

18-Mar-

10

21-Mar-

10

24-Mar-

10

27-Mar-

10

30-Mar-

100

5000

10000

15000

20000

25000

30000

35000

40000

VolumeOpen Inerest


29-Jan-10

1-Feb-10

4-Feb-10

7-Feb-10

10-Feb-10

13-Feb-10

16-Feb-10

19-Feb-10

22-Feb-10

25-Feb-10

28-Feb-10

3-Mar-

10

6-Mar-

10

9-Mar-

10

12-Mar-

10

15-Mar-

10

18-Mar-

10

21-Mar-

10

24-Mar-

10

27-Mar-

100

10

20

30

40

50

60

two month trend chart


Moving Average Technical IndicatorThe 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

InterpretationIn 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:

RSI = 100 - 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

InterpretationIn 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.go forex .net

www. fema .gov

www. fema .rbi.org.in

www.rbi.org.in

www.fedai.org.in

www.forextheory.com

www. forexindia .org

www. forex cap.com

www.sebi.com

www.nseindia.com

www.bseindia.org


http://www.bseindia.org/

http://www.nseindia.com/

http://www.sebi.com/

http://www.forexcap.com/

http://www.forexindia.org/

http://www.forextheory.com/

http://www.fedai.org.in/

http://www.rbi.org.in/

http://www.fema.rbi.org.in/

http://www.fema.gov/

http://www.goforex.net/

http://www.bis.org/

Documents

Currency Derivative