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8/14/2019 fundamental & technical analysis of forex market
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Simply stated Foreign Currency Exchange (Forex) means exchange of one countrys
currency with other countrys currency for the smooth flow of goods, services and investments
across the Countrys boundary. The overall Forex market is the largest, most liquid market in
the world with an average traded value that exceeds $2 trillion per day and includes all of thecurrencies in the world. Most international transactions, such as the international trade of goods
and services or international investment activities, involve the exchange of one currency for
another.
Foreign exchange is the buying and the selling of foreign exchange in pairs of currencies. But
question is why are currencies bought or sold? The answer is simple - Governments and
Companies need foreign exchange for their purchase and payments for various commodities
and services. This trade constitutes about 5% of all currency transactions; however the other
95% currency transactions are done for speculation and trade. In fact many companies will buy
foreign currency when it is being traded at a lower rate to protect their financial investments.
Another thing about foreign exchange market is that the rates are varying continuously and on
daily basis. Therefore investors and financial managers track the Forex rates and the Forex
market on a daily basis.
Exchange rates between the currencies are derived from large number of factors like Interest
rates, Inflation, GDP, FDIs, FIIs, Political change, Corporate Performance, National
Economic Policyetc. As a result, Forex rates tend to move in cleaner trends than any other
instruments. All these factors are to be monitored closely by economists in order to draft
different plans and policies for steady and overall development of the economy and by
corporate in order to take decision for the future course of action.
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1.1 Forex Markets and Players
The main players on the foreign exchange market are commercial banks, firms, non-bank
financial institutions and central banks which are involved in the debiting and crediting of
accounts at commercial banks, that is most transactions relate to the exchange of bank deposits
(in different locations and denominated in various currencies). This puts commercial banks at
the center of the foreign exchange market. Banks perform the role of intermediary for their
clients (mostly firms) by bringing together their demands and supplies, either directly or
indirectly through trade with other banks (inter-bank trading). The inter-bank trading accounts
for most of the market activity. The international exchange of goods and services by firms,
either related to inputs, final goods or intermediate (capital) goods and services, almost alwaysinvolves foreign exchange trading to pay for these activities. Central Banks of the country
depending on the various macro-economic circumstances, such as the unemployment rate, the
growth rate of the economy, the inflation rate, and explicit or implicit government policies may
decide to buy or sell foreign exchange. Although the size of these central bank interventions is
usually relatively modest, its impact can be substantial as the other players in the market may
view these interventions as indicative of other future macroeconomic policy changes.
The trade of different currencies takes place on the foreign exchange markets, at prices called
exchange rates. This rarely involves the exchange of bank notes between citizens. Instead, most
foreign exchange involves the trade of foreign-currency-denominated deposits between large
commercial banks in international financial centers such as London, New York, Tokyo. FX is
an OTC (over the counter) market i.e., there is no physical market place where the deals are
made, instead it is a network of banks, brokers and authorized dealers spread across the various
financial centers of the world. These players trade in different currencies through telephone,
faxes, computers and other electronic networks. These traders generally operate through a
trading room. The deals are mostly done on an oral basis, with written confirmation following
later.
Exposure to movements in foreign exchange rates and currency market volatility can be an
advantage, particularly to currency speculators. However, the hedger like for instance a
corporate treasurer is different from the speculator as all his efforts are directed to minimize the
risk. His priority is to reduce and eliminate currency exposure. But in reality the attitude to
Forex risk among corporate treasurers is wide-ranging. While some regard any Forex risk with
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alarm and hedge it as soon as it occurs, some hedge it actively. Others never use the forward
Forex market and regard all windfall profits or losses as "acts of God".
Changes in exchange rates are one of the major risks to which companies and investors are
exposed. It is thus impossible to imagine company managers or asset managers ignoring the
risks inherent in a shift in exchange rates.
The following chart shows the symbol and international code of the different currency
which are traded in the international FX Market:-
Country Currency Symbol ISO code
Australia Dollar A$ AUD
Canada Dollar C$ CAD
China Yuan - CNY
EMU countries Euro EUR India Rupee Rs INR
Iran Rial RI IRR
Japan Yen JPY
Kuwait Dinar KD KWD
Mexico Peso Ps MXP
Saudi Arabia Riyal SR SAR
Singapore Dollar S$ SGD
South Africa Rand R ZAR
Switzerland Franc SF CHF
United Kingdom Pound GBP
United States Dollar $ USD
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FX Market is mostly dominated by the following major economies:-
United States
United Kingdom
Euro Zone
Australia
Japan
Canada
China
Switzerland
Indian currency i.e., Rupee (INR) also takes clues from the above major economies. INR is
directly quoted only against US dollar and recently against EURO, rest all exchange rates
against other currencies are derived rates form dollar. Indian Forex Market trades between 9am
to 5pm from Monday to Friday. Only authorized dealers (ADs) are allowed to participate in
the inter-bank market. Corporates having the international transaction have to deal through the
authorized dealers for the exchange of currencies.
In order to understand the FX Market in a better way let us consider a small practical example
which occurs in the real life situation: -
A traderXYZ in India imports goods worth $1 million on 1st May 08 in the country.
He has got credit period of 6 months. The current rate of exchange of $=INR is 41.60 (one unit
of $ equals 41.60 units of Rupees). After 6 months he has to make a payment of $1 million.
Now after 6 months there can be three situations of exchange rates: -
a) USD/INR can be
above 41.60
b) Or USD/INR can
be below 41.60
c) Or USD/INR canbe same 41.60
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Currency exchange rate have a negligible probability for having same rate between two
points of time, as we can see in the current market situations where the local currency is trading
above 42.75 levels, which is due to various factors so the probability of the currency been
stable is minimum. But the currency in future can trade above the 41.60 levels or below it. If
after 6 months currency is below 41.60 levels then the trader will make additional profit arisingfrom the exchange rate as he has to shed fewer rupees to buy dollars but if the currency is
above 41.60 levels then the trader has to incur additional loss which may not be favorable for
his business.
A trader therefore constantly keeps an eye on the exchange rate for protecting
themselves from the unexpected loss of the FX market.
If we analyze the example closely then we can draw following two conclusions:-
Appreciation of the local currency increases the profit percentage of the Importer and
vise-versa.
Depreciation of the local currency increases the profit percentage of the Exporter and
vise-versa.
Due to the uncertainty of the FX Markets both the Importers and Exporters are always exposed
to the elements of risk. When the organizations are exposed to FX risk, treasure finds himself
in a situation with axe hanging over his head. In order to shield them selves from the risk of FX
markets various instruments of the FX market are available to the organization.
Generally the organization having international transaction have a person responsible for the
FX operations, his designation is that of the Treasure. He is not only responsible for the sources
and application of the funds but also held accountable for the foreign exchange operations. The
Forex market has a number of instruments and is very large as it involves many of the
economies of the world, so for an organization it becomes quite difficult to handle. Therefore it
requires services of the outside parties to guide through the international deals and handle their
derivatives portfolios.
In India such Forex service providers are still in its growth stage. There are not many players in
this field. The working of these types of firms is quite simple. These firms guide the
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organizations in dealing with the foreign parties and also maintaining their portfolios. The
detail profile of a firm will help us to understand the working of it.
Understanding the company profile of Green Back Forex Services will helps to know what
types of services actually they provide to the Corporates to overcome the problems of the FXmarkets. After that we will study the instruments of the Forex market and know how with the
help of it we can reduce the risk arising from Forex exchange to the minimum.
Profile of Greenback Forex
Services Pvt. Ltd
1.2 Corporate Profile:
Established in 1995, Greenback Forex Services Pvt. Ltd. has today grown into one of
the country's most renowned consultants in the area of currency and interest rate risk
management and international finance. By joining hands and pledging commitments with
India's leading conglomerates, our customized services have earned us heartfelt respect and
recognition.
After all, every piece of advice we give, every decision we help you to take, every idea
or product we implement at your end, is targeted at achieving 100% optimality - both cost
minimization as well as revenue maximization. Whether it's procuring finances, managing
risks, fine tuning your requirements or seeing a transaction through, we believe in adding value
at every stage. And it is this conviction that takes us under client's skin to give him a 'complete
solution' that is not only need based and innovative but also relevant, executable, profitable and
safe. Suffice to say, in an age ruled by dynamism, dedication and upbeat financial milestones,
Greenback has taken an oath to be an icon of trust and reliability.
Greenback Forex Services Pvt. Ltd provides the following financial services:
1. Information Services
2. Advisory Services
3. Derivative Services
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Information Services:
In what is arguably one of the most volatile markets, timeliness and relevance of
information about the movements and trends in the Forex markets is all the more crucial
because it has a direct impact on the bottom line of the corporate. Accurate and timelyinformation is not only a facilitator to decision making but also goes towards ensuring that the
corporate is obtaining rates in line with the market.
We satisfy the above need by means of our information service module. Acting as
information service providers to more than 500 corporate clients across the country, we ensure
that our clients remain informed about the market and the changes taking place therein.
Information is delivered through a variety of communication media like e - mail, fax and SMS.
Reports are sent on a daily basis with a weekly and monthly round up. The reports encompass
all possible information about the Forex market and the money market. Apart from data on
inter-bank rates and premiums, the reports would also provide data on various money market
and Forex benchmarks, indicative quotes for derivatives including fundamental and technical
commentaries.
Forex Advisory:
In simple words, risk could be defined as uncertainty about the future. Companies
which are into foreign trade are exposed to the risk of fluctuation in exchange rates and interest
rates as their cash flows and profitability are inseparably linked to these factors. This risk is
accentuated because the underlying variables, namely currencies and interest are volatile and
dependent on a host of macro economic and political factors.
We appreciate the fact that corporate personnel cannot be expected to devote their entire time
and effort to just monitoring the Forex market. We, therefore, step into the shoes of the
corporate as far as management of their Forex portfolio goes. Capitalizing on our expertise and
infrastructure, we assist Corporates right from the stage of drawing up Forex risk management
policies, proceeding to setting up benchmarking/costing levels for transactions and managing
Forex risk through hedging strategies. Our sole purpose is to see to it that we provide the
corporate with all the inputs and advice needed for them to take an informed decision. Our
Forex advisory module helps in relieving the corporate of the responsibility of constantly
monitoring Forex markets and enables them to concentrate on their core business areas.
Derivatives Advisory:
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Over the counter interest rates and cross currency derivatives like interest rate swaps,
forward rate agreements and currency options are one of the predominant tools used by
Corporates to manage interest rate and currency market risks. More so, apart from plain vanilla
structures, banks assist Corporates to hedge their liabilities and assets by offering tailor made,
specific structures. With options on currency now being allowed and further liberalization ofthe Indian financial markets, newer risk management products like interest rates options and
more complicated structures would tend to dominate a Corporates hedging needs.
However, Indian Corporates have been facing a very typical problem in terms of
pricing of various derivative structures at the time of entering into derivative contracts. These
problems faced are two fold - in terms of the pricing model used in the inter-bank markets and
also yield curves used for such pricing. Besides this, the Corporates also face a problem at the
time of unwinding or terminating the deal, and here too the valuation system plays a dominant
role. Apart from the above mentioned pricing and valuation issues, there are various
operational problems, which include limited number of dealing banks, limited lines of credit for
derivatives, actual transaction related issues, etc. Additionally, as the Indian markets open up
for the use of new derivative products, Corporates are typically shown exotic and nonstandard
derivative instruments. Here, the corporate clearly needs to understand the effectiveness of the
hedge of such derivative products.
We assist Corporates in readying them to face these challenges and consult corporate
treasuries on a real time basis with a specific focus on interest rate and currency derivatives.
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1.3 Exchange Rates & Instruments of FX Markets
There are different types of exchange rate & instruments of FX Markets available to corporate
and firms to hedge their foreign currency exposure such as Spot Rates, Forward Rates,
Options and Swaps. Hedging can be simply termed as protecting from the risk. It is the
process of protecting or crystallizing a future cash flow or eliminating risk by taking an
offsetting position in a financial instrument. Hedging can be done for both Forex risk and for
interest rate risk. The knowledge and the working of the different instruments will enable us to
provide protection from various risk of the Forex market.
1.3.1 Spot Market
Spot transactions are the basic type of foreign exchange operation. Under spot agreements, both
parties fulfill their obligations, two working days after conclusion of the trade. It is important to
realize that an exchange rate is a price, namely the price of one currency in terms of another
currency. As there are many countries with convertible currencies, there are many exchange
rates, such as the exchange rate of a Singapore dollar in terms of European euros or the
exchange rate of a Japanese yen in terms of British pounds. Simply it can be defined as the
market where settlement takes place two working days from today at the rate, which has been
fixed today. Most of the calculations are based on the spot rates that we will come to know as
we advance further. The date, which falls on two working days from today, is called as Spot
date.
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Authorized dealers (mostly banks) quote exchange rates. The rates quoted are inter-bank rates
or the rates at which one bank would deal with other bank. The quote is a two way referred as
Bid and Ask.
Bid is the rate at
which banks are ready to Buy.
Ask is the rate at
which banks are ready to Sell.
The difference between Bid and Ask is called Spread which is the profit of the bank. When we
look at the exchange rate it is 41.60/62 which means at 41.60 Ads (banks) are ready to buy and
at 41.62 ready to sell. Now the trader in order to make his payment has to buy Dollar at 41.62
and if he has receivables in Dollars he has to sell it at 41.60.
Coming back to example, XYZ tradercan wait for 6 months and buy dollar in the spot market
and make the payment but looking at the present market local currency is making history by
depreciating to the levels above 43.10 which causes creases on the forehead of the importers
and there are confused to take the next step to hedge their risk.
Other than Spot Market a trader can settle his transactions in the Forward Market.
1.3.2 Forward Market
Forward market is the market where settlement takes place on any day beyond the spot
date at the rate, which has been crystallized today. Forward exchange rate is the price at which
you agree upon today to buy or sell an amount of a currency at a specific date in the future.
A contract for delivery of currencies more than two working days later is known as a forward
transaction. Such transactions are concluded at Forward Rates, not at spot rates. Forward rates
reflect the time for which the agreement runs. Theoretically, the forward rate for a currency can
be identical to the spot rate, but in practice it is almost always higher (premium) or lower
(discount). Forward transactions are used for a variety of purposes. They are most commonly
used to hedge trading risks and the risks arising from financial transactions.
Forward operations can not be set a part from Currency Swaps, which are a mixture of spot and
forward transactions. To prevent confusion between these two types of forward transactions,
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dealers use the term outright transaction for simple forward rate transactions that are not a
part of Swap operation.
Thus the forward market provides an avenue to hedge FX risk as it crystallizes the rate at which
a future cash flow would be converted. Forward rates are not quoted directly. Professionaltraders work with the difference between spot and forward prices expressed in decimals. In
Forward market a simple contract is formed called Forward contract. It is the most popular
and simple hedging tool available to manage currency risk.
Forward contracts specify the terms of an exchange of two currencies. In this contract the
variables that are agreed upon are:-
The currencies to be bought and sold - in every contract there are two currencies the
one that is bought and the one that is sold.
The amount of currency to be bought or sold.
The date at which the contract matures.
The rate at which the exchange of currencies will occur.
In order to form a Forward Contract a premium has to be paid for buying a currency and
discount is received for selling it. The premium and discount in forward contract is called
Forward Premium and Forward Discount. These premium and discount are quoted on
monthly basis i.e., 1 month, 2 month, 3-month etc.
Characteristics of Forward Contract in International Market:-
Forward rate are the reflections of interest rate differentials between currencies and notnecessarily a forecast of what the spot rate will be at the future date.
The fair price is the rate that prevents an investor from making a risk less profit by
round tripping and exploiting the interest rate differential.
The currency with the higher interest rate will be at a discount on a forward basis against
the currency with the lower interest rate and vice-versa.
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Characteristics of Forward Contract in Indian Market:-
Forward Premiums / discounts in India do not reflect interest rate differentials between
the currencies.
Forward premiums / discount are based more on demand and supply and expectation of
direction of spot USD/INR.
Forward premiums / discount are quoted on a month end basis i.e., August-end,
September-end etc.
Forward market is active for 1 year. Forwards beyond a year are available through the
Derivative market.
Forward Rate Calculation:-
Features of Forward Premium / Discount:-
In general, forward premium/discounts are a reflection of interest rate differentials of the
two counties.
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Forward premium/discounts have nothing to do with future expectations of the way
exchange rates would move.
Forward premium or discount exist and are calculated such that there is no arbitrage or
risk free return by borrowing from the lower interest rate country and investing the same
in the higher interest yielding country.
Regulations Governing Forward Contract:-
Forward Contracts, in general, could be booked only against a genuine underlying
exposure to FX risk.
The exposure to FX risk could be supported by documentary evidence like export orders,
Letters of credit, etc.
Exposures could be split into its component legs and forward contracts could be booked
on each of them separately.
A third currency could be used to hedge an exposure in some other currency. For
example, an exporter can buy Euro against his underlying dollar exports.
Documents against which the forward contracts are booked are freely substitutable.
Due to uncertainty of Spot rates of the currencies, Forward Contracts always becomes the most
attractive tool after Spot Market to hedge the FX risk. But like any other instruments Forward
contract also suffers from certain limitation.
The following are the limitation of Forward Contract:-
Like Forward contract can be booked for 1 year only, which restricts the trader from
forming long term commitments of financial transactions.
In Forward contract the price of the underline asset will be locked and we are obliged to
perform according to the contract, irrespective of the market situations.
In case of Forward contract there is always a chance of loosing opportunity profit.
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All corporate treasurers, hedging their Forex exposures with forward contracts, are aware that
forward contracts are the best hedging instruments for safeguarding against adverse rate
movements. However, forward contracts only turn the risk upside down and lead to opportunity
losses in the event of favorable market movements. As against forward contracts, Currency
Options are flexible in as much as they not only provide protection against adverse marketmovements but also allow benefiting from favorable ones. This flexibility of currency options,
however, carries a price tag with it in the form of Option premium, which is usually payable
upfront.
Due to the limitation of the Forward Contract another instrument is designed which perfectly
overtakes the limitations of the Forward Contract and gives a much more flexibilities in the
hands of the trader to exploit the market in his favor. The instrument possessing such
characteristics is termed as Options.
1.3.3 Options
An option in the common parlance refers to choice or alternative or privilege or
opportunity or preference or right. To have Options is normally regarded good. One is
considered unfortunate without options. Options are valuable since they provide protection
against unwanted, uncertain happenings. They provide alternatives to bail out from difficult
situations. Options have assumed considerable significance in Finance.They can be written on
any assets including shares, bonds, portfolios, stock indices, currencies etc They are quite
useful in risk management of the above financial instruments, but Options in our study will
clearly focus and will be explained in the light of Currencies.
Simply stated an Option is a choice like Forwards, it is the way of buying or selling a
currency at a certain point in the future. An option is a unique financial instrument or contract
that confers upon the holder or the buyer thereof, the right but not an obligation to buy or sell
an underlying asset, at a specified price, on or up to a specified date. In short, the option buyer
can simply let the right lapse by not exercising it. On the other hand, if the option buyer
chooses to exercise the right, the seller of the option has an obligation to perform the contract
according to the terms agreed. An option is a contract, which specifies the price at which an
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amount of currency can be bought at a date in the future, called the expiration date. Unlike
Forwards, the owner of an option does not have to go through with the transaction if he or she
does not wish to do so. As its name suggests, an option is a right but not obligation to buy
or sell the underlying. Also, unlike Forwards, the price at which the currency is to be bought or
sold can be different from the current forward price.
The asset underlying a currency option can be a spot currency or a futures contract on a
currency. An option on a spot currency gives the option buyer the right to buy or sell the said
currency against another currency while an option on a currency futures contract gives the
option buyer the right to establish a long or short position in the relevant currency futures
contract. Options on spot currencies are commonly available in the inter-bank Over-the-counter
(OTC) markets while those on currency futures are traded on exchanges like the Chicago
Mercantile Exchange (CME) and the Singapore International Monetary Exchange (SIMEX).
Formally Options is defined as
A contract which provides to the buyer of the option, right but not the obligation, to
buy or sell a specific asset at a specific price, on or before any time prior to the specific date.
In order to avail these rights a premium is been charged from the Option buyer which is always
higher than the Forward Premium. But unlike Forward contract it is entirely up to the buyer
whether or not to exercise that right, only the seller of the option is obligated to perform. On
these platform Options proves to be more advantageous form the Forward Contract.
There are two main types of Options: Call Option and Put Option.
Both individually having two legs, the following is the classification of the Options in an
elaborated form: -
Types of Options:
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Figure 1.1
OPTIONS TERMINOLOGY
Call Option: A call option gives the option buyer the right to buy one currency X against
another Y at a stated price on or before a stated date.
Put Option: A put option gives the option buyer the right to sell one currency X against
another currency Y at a stated price on or before a stated date.
In foreign exchange transactions one currency is bought by selling another currency. Thus if we
consider the USD/INR currency pair, a call option on the Dollar is no different from a put
option on the Rupee. Similarly, a put option on the Dollar is nothing but a call option on the
Rupee.
Strike Price: This is the price specified in the option contract at which the option buyer can
buy or sell currency X against currency Y or for instance the euro against the dollar.
Depending on when an option can be exercised, it is classified in one of the following two
categories:-
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European Options when an option is allowed to be exercised only on the maturity
date, it is called European Option.
American Options when the option can be exercised any time before its maturity date
it is called American Option.
Maturity Date: The date on which option expires is called Maturity Date.
Premium (Option Price or Option Value): The upfront fee that option writer or seller
charges the buyer for giving the latter the right inherent in the option is called Option
Premium. If the option lapses unexercised, the buyer loses this amount. This premium
can be split into 2 parts: Intrinsic value and time value.
Intrinsic value: It is the amount an option would be worth was it to be exercised immediately.
For instance, if an American call option on EUR has a strike price of $0.85 and the
current spot EUR/USD rate is say $0.88, the intrinsic value is $0.03 per euro. European
options can be exercised only at maturity. Even so, they can have intrinsic value.
European put options will have intrinsic value if the forward rate applicable for the
maturity date exceeds the strike price.
Time Value: An option can have time value only if it has some time remaining to expiry. Time
value depends on the chances of the option gaining in value before expiry. At-the-
money and out-of-the-money options have no intrinsic value and can have only time
value. The time value of a currency option thus depends upon a number of factors such
as the spot price, strike price, time to maturity, volatility of the market price, domestic
interest rate and the foreign interest rate.
In-the-Money: A put or a call option is said to be in-the-money when it is advantageous for the
investor to exercise it. In the case of in-the-money call option, the exercise price is less
than the current value of the underlying assets, while in the case of in-the-money put
option; the exercise price is higher than the current value of the underlying assets.
Out-of-Money: A put or call option is out-of-money if it is not advantageous for the investor
to exercise it. In the case of out-of-money call options, the exercise price of higher than
the current value of the underlying assets, while in the case of the out-of-money put
option, the exercise price is lower than the current value of the underlying assets.
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At-the-Money: when the holder of the call or put option does not lose or gain whether or not
he exercise his option, the option is said to be at-the-money option the exercise price is
equal to the underlying assets.
Call Put Parity:
This is a very important relation. If we consider a call option and a put option on the same
currency (pair) with the same maturity and strike price, the difference between the call
premium and the put premium equals the forward rate minus the strike price. In an equation
form:
C - P = F - X
Thus, when F, the forward rate equals X, the strike price; the call and put premiums are equal.
Pay-off profiles at maturity: For a call option, if the maturity spot (S) is equal to or less than the
strike price (X), the pay-off is a loss equal to the upfront premium paid (C). On the other hand,
if S is greater than X, the pay-off equals S - X - C. For a put option, if S is equal to or greater
than X, the pay-off is minus P. And, if S is less than X, pay-off on a put option is X - S - P.
Let us now consider first how the total value of European euro call options varies withchanges in the variables like Strike price, Maturity, Volatility and Interest ratesdifferentials and then see how these options can be used to hedge exchange risk.
I. Strike price.
An out-of-the-money option has no intrinsic value. Now the more an option is out-of-
the-money, the less is the chance of its expiring in-the-money and consequently lower is its
time value. On the other hand, the value of an in-the-money option comprises of both intrinsic
value and time value. In this case, the more an option is in-the-money the more is its intrinsicvalue but the lower is its time value as greater is the chance of it losing value and hence of
being exercised. Thus other things being equal, an at-the-money option has the maximum time
value.
Example:
Current EUR/USD spot rate : 0.8700
Maturity : 3 months
Volatility : 13%Domestic int. rate (USD) : 6.80% p.a.
Foreign int. rate(EUR) : 4.98% p.a.
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Forward rate & ATM strike : 0.8740
Table 1.1
Strike Price Call Premium Intrinsic Value Time Value
0.9100 0.0092 nil 0.0092
0.9000 0.0121 nil 0.0121
0.8900 0.0155 nil 0.0155
0.8800 0.0196 nil 0.0196
0.8740 0.0224 nil 0.0224
0.8680 0.0255 0.0060 0.0195
0.8580 0.0311 0.0160 0.0151
0.8480 0.0374 0.0260 0.0114
0.8380 0.0443 0.0360 0.0073
Table 1.2
II. Maturity:
The longer the time to maturity, the greater is the chance that an option may move from
at-the-money or out-of-the-money to in-the-money. Hence, longer the maturity, higher the time
value but the relationship is not linear.
Example:
Current AUD/USD spot price : 0.5340
ATM strike price : 0.5340
Volatility : 15.4%
Table 1.3
Domestic interest rate = Foreign interest rate (assumed)
Maturity (months) Call Value % change in value
1 0.0094 ---
2 0.0134 43 %
3 0.0163 22 %
6 0.0231 42 %
12 0.0327 42 %
Table 1.4
III. Volatility:
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The greater the chances of the underlying currency moving higher or lower over the
maturity of the option, the higher will be the premium. The statistical measure normally used to
gauge the volatility of markets is the Standard Deviation, more correctly the standard deviation
of daily percentage changes in the underlying price. Volatility describes the size of likely price
variations around the trend rather than the trend itself. The figure is usually annualized to give aconstant measure. For instance, annualized volatility of 20% means that the currency has a 68%
chance of being up or down within a 20% band within one year. It is possible to convert this
figure into a daily volatility measure by dividing the annualized volatility by the square root of
the number of trading days in a year (sq. root of 250 = 15.8). For instance, with spot euro at
0.87 and volatility at 13%, there is a 68% probability that the spot rate will range between
0.8628 and 0.8772 in a one-day period.
Volatility is a key variable in option pricing. For at-the-money options, the relationship is
almost linear.
Example:
Current EUR/USD spot rate : 0.8700Forward rate & ATM strike price : 0.8740Maturity : 3 monthsDomestic interest rate : 6.80% p.a.Foreign interest rate : 4.98% p.a.
* EUR/USD = 0.8700 (1 USD = 0.87 EUR) Table 1.5
Volatility (%) Call Premium
4 % 0.0068
6 % 0.0103
8 % 0.0138
10 % 0.017212 % 0.0207
14 % 0.0241
16 % 0.0276
18 % 0.0310
Table 1.6
Essentially, there are two ways of looking at volatility. The first is to calculate the
standard deviation of a given series of spot prices. What the trader is trying to do here is to find
a measure of historical volatility, which adequately explains how the market has been moving
and, more significantly, will give a reasonable idea of how the market is likely to move in the
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future. Volatilities are however not constant and therefore a second method of measuring
volatility is to look at the actual premiums of traded options and to calculate the implied
volatility. Implied volatilities are available on Reuters, Bloomberg, Bridge or other similar
monitors.
IV. Interest rate differentials:
The effect of interest rates on option premiums is the least obvious, and yet, particularly
with currency options, it is one of the most important components of the premium. For stock or
commodity options, higher the interest rate, higher is the call option premium. This is so
because higher the interest rate, greater is the opportunity cost of funds, which have to be
deployed to buy the concerned stocks or commodities. In currency options, the situation is
complicated by the fact that there are two interest rates involved, the domestic interest rate and
the foreign interest rate. In this case, since the euro is priced in terms of the dollar, the domestic
interest rate is that for the dollar and the foreign interest rate is that for the euro. The premium
of a euro call option will increase if the dollar interest rate rises or the euro interest rate falls
because in either case the cost of holding euros increases.
Example:
Current EUR/USD spot rate : 0.8700
Strike price : 0.8740
Volatility : 13%
Maturity : 3 monthsForeign (euro) interest rate : 4.98% p.a.
Table 1.7
$ int. rate-% p.a. Call premium Put premium
4 0.0196 0.0257
5 0.0206 0.0245
6 0.0216 0.0234
7 0.0226 0.0223
8 0.0237 0.0212
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Table 1.8
We have seen earlier that with the dollar interest rate of 6.8% and given the euro
interest rate of 4.98% and the spot rate of 0.8700, the 3-month forward rate is 0.8740 and hencethe above strike price of 0.8740 is at-the-money. Right now, the euro is a premium because the
dollar interest rate is higher than that of the euro interest rate. If the dollar interest rate falls, the
forward rate will fall. Consequently, a call option with a strike price of 0.8740 will be more and
more out-of-the-money and its premium falls. Conversely, the call premium rises if the dollar
interest rate rises. A put option with a strike price of 0.8740 will however be more and more in-
the-money as the dollar interest rate falls and hence the put premium rises.
Let us now see what happens if the euro interest rate varies while dollar interest rate stands at
say 6.8% and other parameters such as spot rate, strike price and maturity remain the same.
Euro Int. Rate Call Premium Put Premium
3 % 0.0245 0.0203
4 % 0.0234 0.0214
5 % 0.0224 0.0225
6 % 0.0214 0.0236
7 % 0.0204 0.0248
Table 1.9
Now from the table 1.9 as we find that as the euro interest rate rises from 3% to 7%, the
call premium falls and the put premium rises. This is because the forward rate falls
progressively. As the euro rate moves from 3% to 4.98%, a call option with strike price of
0.8740 becomes less and less in-the-money. When the euro interest rises still further to 7%, the
said call option now becomes more and more out-of-the-money. Consequently, the call
premium falls. The converse is true for put options.
Studying the above variables is not an easy task but a step by step understanding of it
helps to determine the total value of the options which forms the base structure for hedging the
FX exposures through currency options.
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HEDGING WITH CURRENCY OPTIONS:
The objective of including currency options in our hedging arsenal has obviously to be
to get the best protection available at the least possible cost. This is easier said than done.
However, a corporate with foreign currency payables say in euro could use the following
decision tree as a guide: (Table 1.10)
Currency hedging decision tree:
View of currency View of risk ActionVery bullish Risk averse Buy currency forwardVery bullish Risk tolerant Buy currency forward
Bullish Risk averse Buy currency forwardBullish Risk tolerant Buy atm call
Flat market Risk averse Buy ootm callFlat market Risk tolerant Do nothing *No view Risk averse Buy atm call
No view Risk tolerant Do nothing *Bearish Risk averse Buy ootm callBearish Risk tolerant Do nothing *
Very bearish Risk averse Buy far ootm callVery bearish Risk tolerant Do nothing *
Table 1.10
Notes:
* Place good-till-cancelled stop-loss orders just in case the currency strengthens unexpectedly.
Atm = At-the-money
ootm = out-of-the-money
What is important to bear in mind is that options should be considered as complementary to
forwards and not used to the exclusion of forwards. Even so once a decision is taken to hedge
with options, one has to decide on the strike price and the maturity based on the expected
direction of the market, volatility and also interest rates if hikes or cuts are imminent.
Another area is to consider the use of Range forwards and Participating forwards as also exotic
options such as knock-ins, knock-outs, etc. In these cases, the option buyers main goal is to
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reduce or totally avoid the upfront premium payable in the case of plain call or put options.
However, it should be borne in mind that for reducing or avoiding the premium, the hedger
gives up a part of the protection and/or benefit. In the case of knock-in options, he risks not
having any protection at all if the price of the underlying doesnt reach a specified trigger level.
While in the case of knock-out options the hedger risk losing the protection completely if aspecified trigger level is traded even briefly.
Let us now examine how a euro call option would compare with a forward contract or an open
position depending on our choice of strike price and the spot price at maturity.
Example:
Current spot price : 0.8700
Maturity: 3 months
Current fwd price : 0.8740
Volatility: 13%
Domestic int. rate : 6.8%
Foreign int. rate : 4.98%
Table 1.11
Strike price Call premium Option better than
If spot rate at maturity is
Open position Forward contract higher than lower than
0.8740 0.0224 0.8964 0.8516
0.8900 0.0155 0.9055 0.8585
0.9100 0.0092 0.9192 0.8648
Table 1.12
For instance, say you buy ATM euro call option with strike price of 0.8740 to hedge a 3-month
euro liability. You pay an upfront premium $0.0224 per euro. Ignoring the interest lost on the
premium outlay, buying the euro call will be better than booking an outright forward contract at
0.8740 only if the spot rate at maturity is less than 0.8516. This is so because only in that case
the spot rate at maturity plus the call premium will be less than todays forward rate. On the
other hand, if the purchase of the call option is to be better than keeping the liability unhinged,
the spot rate at maturity will have to be higher than the strike price plus the premium. The
important thing to note in this illustration is that the option will fare worse than both a forward
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contract as well as an unhinged liability if the spot rate at maturity falls between 0.8516 and
0.8964.
From the above table, it is clear that you can reduce the premium payable by an option, which
is more and more out-of-the-money. However, as we mentioned earlier, you have to give up
more and more protection to get a larger and larger premium reduction. Far out-of-the-money
options may often be ruled out by your costing levels or risk limits.
Now let us compare the maturity pay-off of each of the above 3 options for different spot rates
at maturity. Please note if the spot rate at maturity is less than or equal to the strike price, the
option is not exercised and you lose the entire premium. If the spot rate at maturity is greater
than the strike price, the option is exercised and you begin to recover the premium paid.
However, the net pay-off to you from any option is positive only when spot rate at maturity is
greater than the corresponding strike price plus the premium. Let us see examine this through
the following table:
Option A: Strike price 0.8740 and premium 0.0224
Option B: Strike price 0.8900 and premium 0.0155
Option C: Strike price 0.9100 and premium 0.0092
Spot at maturity Option A Option B Option C
0.8500 -0.0224 -0.0155 -0.0092
0.8740 -0.0224 -0.0155 -0.0092
0.8809 -0.0155 -0.0155 -0.0092
0.8872 -0.0092 -0.0155 -0.0092
0.8900 -0.0064 -0.0155 -0.0092
0.8963 -0.0001 -0.0092 -0.0092
0.9000 0.0036 -0.0055 -0.0092
0.9055 0.0091 0.0000 -0.0092
0.9100 0.0136 0.0045 -0.0092
0.9192 0.0228 0.0137 0.0000
Table 1.13
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We can observe from the table 1.13 that Option A outperforms Option B when spot rate at
maturity exceeds 0.8809. Option A outperforms Option C when maturity spot exceeds 0.8872.
Finally, Option B outperforms Option C when maturity spot exceeds 0.8963. You can choose
the appropriate option depending on your market view and the maximum premium that you are
willing to pay.
We may well say that we want free or zero-cost protection or insurance at a given strike price.
This is possible under RBI guidelines. There are two simple ways to achieve this by buying
calls and selling puts or vice versa. The only restriction is that you cant receive a net premium.
Range Forward:
Suppose we have a euro liability 3 months from now. Present spot rate is 0.87 and the
forward rate is 0.8740. If we want to cap our cost at say 0.90 free of cost, we will have to
accept a floor at 0.8480. This involves buying an out-of-the-money call option with a strike of
0.90 and selling an out-of-the-money put option with a strike of 0.8480. The premium received
on the put exactly offsets the premium paid on the call. If the maturity spot is over 0.90, we
exercise the call and pay only $0.90 per euro. If the maturity spot is less than 0.8480, the put
sold by us gets exercised and we pay $0.8480 per euro. Thus, our windfall benefit is limited.
Finally, if the maturity spot is anywhere from 0.8480 to 0.9000, we pay the prevailing spot rate.
Participating Forward:
If we are very bearish on the euro and dont want to accept any floor but still want the
same cap as an insurance, there is still a way out. However, we will have to "lock in" the cap
rate for a part of the exposure by selling an in-the-money put option with the same strike as that
of the call. With an out-of-the-money 3-month euro call @ 0.90 costing $0.0121 per euro and
an in-the-money 3-month euro put @ 0.90 fetching $0.0380 per euro, the amount of the put
option has to be 31.8% of the amount of the call option. We will see that for 31.8% of the call
option amount, we have bought a call and sold a put with the same strike of 0.90. This is like a
synthetic forward inasmuch as either the call will be exercised or the put will be exercised and
we are committed to paying $0.90 for 31.8% of the call option amount. In consideration, we
have a free call option @ 0.90 for the balance 68.2% of the exposure so hedged.
Let us compare the effective cost under these 2 alternatives:
Spot at maturity Range Forward Participating Forward
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0.90+ 0.90 0.90
0.8480 0.8480 0.8645
0.8238 0.8480 0.8480
0.8000 0.8480 0.8318
0.7800 0.8480 0.8182
0.7600 0.8480 0.8045
Table 1.14
Knock-out and knock-in options:
These are together known as Barrier Options and have a conditionality clause built
into them. For instance, knock-out options cease to exist when the spot rate moves in a certaindirection and touches a specified trigger level while knock-in options come into existence only
when the spot rate touches a specified trigger level. The main advantage of these options is
their smaller up-front premia compared to plain vanilla options. The trigger level can be above
or below the present spot rate. Options that get knocked out when the spot rate touches a higher
trigger level are called Up-and-Out options while those that get knocked out when the spot rate
hits a lower trigger level are called Down-and-Out options. Knock-in options are also either
Up-and-In options or Down-and-In options. A simple - call or put - option is nothing but a
knock-out option plus a knock-in option with the same strike and same trigger level. If these
options are used for risk management, you would normally buy options which get knocked-out
when spot rate has moved and is expected to move in your favor or knocked in when the spot
rate has moved against you and is threatening your risk limit. That is a call option will get
knocked out when the spot rate falls to a lower trigger level or gets knocked in when the spot
rate rises to a higher trigger level. If you expect a temporary adverse price movement followed
by a major trend reversal in your favor, you could do the opposite, that is, buy a call option that
gets knocked in when the spot rate falls to lower trigger level. In such cases, you will still have
to guard against an earlier-than-expected trend reversal through good-till-cancelled stop-loss
orders. There are many zero-cost exotic combinations of simple options and knock-outs or
knock-ins. One such version is called Smart Forward. Essentially, this is an out-of-the-money
synthetic forward contract which you can walk away from if the maturity spot is more
favorable provided a pre-specified trigger level has not been traded at any time during the life
of the option. For example, for a 3-month euro liability with spot at 0.87 and ATM strike of
0.8740, if you specify your cap or risk limit as say 0.90, the bank may tell you that the trigger
for the zero-cost smart forward is say 0.85. What this means is that if the spot rate trades at
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0.85 any time during the life of the option, you will be obliged to buy euros at 0.90 irrespective
of the maturity spot. On the other hand, if the spot rate has never hit the trigger level, the smart
forward is like a simple out-of-the-money option. Besides, the more out-of-the-money the
strike price is, the further is the trigger from the current spot rate. A few words of caution
would not be out of place at this juncture. The names given to this and other similar hedges areso alluring as to make feel smart enhanced and so on. How would it look, if in the above case
the maturity spot of the euro is say 0.80 and you have to buy at 0.90? In a lighter vein, one slip
and a smart forward might look like a dumb backward!
1.3.4 Swaps
Swaps is a customized bilateral agreement between two parties which enables them to
exchange specified cash flows at periodic over a pre-determined life of Swaps. Or in the other
words its a private agreement between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.
Swap is used by multinational corporations to fund their foreign investments and manage their
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interest rate risk. Different types of Swaps present opportunities to the multinational firm to
reduce financing costs and/or risk. Corporate financial managers can use swaps to arrange
complex, innovative financings that reduce borrowing costs and increase control over interest
rate risk and foreign currency exposure. Swaps have had a major impact on the treasury
function, permitting firms to tap new capital markets and to take further advantage ofinnovative products without an increase in risk. Through the swap, they can trade a perceived
risk in one market or currency for a liability in another. The swap has led to a refinement of
risk management techniques, which in turn has facilitated corporate involvement in
international capital markets.
The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows between the
parties in the currencies. It may be floating to floating or fixed to floating and vice-versa.
Currency swaps: These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the opposite
direction.
Interest Rate Swaps
An interest rate swap is a derivative in which one party exchanges a stream of interest
payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to
manage their fixed or floating assets and liabilities. They can also be used by speculators to
replicate un-funded bond exposures to profit from changes in interest rates. As such, interest
rate swaps are very popular and highly liquid instruments. Today, interest rate swaps are often
used by firms to alter their exposure to interest-rate fluctuations, by swapping fixed-rate
obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able
to alter its interest rate exposures and bring them in line with management's appetite for interest
rate risk.
An interest rate swapis an agreement between two parties to exchange interest payments of a
currency for a specific maturity on an agreed notional amount. The term notional refers to the
theoretical principal underlying the swap. Thus, the notional principal is simply a reference
amount against which the interest is calculated. No principal ever changes hands. Maturities
range from less than a year to more than 15 years; however, most transactions fall within a two-
year to 10-year period. The two main types are coupon swaps and basis swaps. In a coupon
swap, one party pays a fixed rate calculated at the time of trade as a spread to a particular
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Treasury bond, and the other side pays a floating rate that resets periodically throughout the life
of the deal against a designated index. In a basis swap, two parties exchange floating interest
payments based on different reference rates. Using this relatively straightforward mechanism,
interest rate swaps transform debt issues, assets, liabilities, or any cash flow from type to type
and with some variation in the transaction structure from currency to currency.
The most important reference rate in swap and other financial transactions is the London Inter-
bank Offered Rate (LIBOR). LIBOR is the average interest rate offered by a specific group of
multinational banks in London (selected by the British Bankers Association for their degree of
expertise and scale of activities) for U.S dollar deposits of a stated maturity and is used as a
base index for setting rates of many floating rate financial instruments, especially in the
Eurocurrency and Eurobond markets.
The Classic Swap Transaction (Table 1.15) - Counter parties A and B both require $100
million for a five-year period. To reduce their financing risks, counter party A would like to
borrow at a fixed rate, whereas counter party B would prefer to borrow at a floating rate.
Suppose that A is a company with a BBB rating and B is an AAA-rated bank. Although A has
good access to banks or other sources of floating-rate funds for its operations, it has difficulty
raising fixed-rate fund from bond issues in the capital markets at a price it finds attractive. By
contrast borrow at the finest rates in either market. The cost to each party of accessing either
the fixed-rate or the floating-rate market for a new five-year debt issue as follows:
Borrower Fixed Rate Available Floating Rate Available
Counter Party A BBB-rated 8.05% 6-month LIBOR + 0.5%
Counter Party B AAA-rated 7% 6-month LIBOR
Difference 1.50% 0.5%
Table 1.15
To begin, A will take out a $100 million, five-year floating-rate Euro-dollar loan from a
syndicate of banks at an interest rate of LIBOR plus 50 basis points. At the same time, B will
issue a $100 million, five-year Eurobond carrying a fixed rate of 7%. A and B then will enter
into the following interest rate swaps with Big-Bank. Counter party A agrees that it will pay
Big-Bank 7.35% for five years, with payments calculated by multiplying that rate by the $100
million notional principal amount. In return for this payment, Big-Bank agrees to pay A six-
month LIBOR over five years, with reset dates matching the reset dates on its floating-rate
loan. Through the swap, A has managed to turn a floating-rate loan into a fixed loan costing
7.85%.
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In a similar fashion, B enters into a swap with Big-Bank whereby it agrees to pay six-month
LIBOR to Big-Bank on a notional principal amount of $l00 million for five years in exchange
for receiving payments of 7.25%. Thus, B has swapped a fixed-rate loan for a floating-rate loan
carrying an effective cost of LIBOR minus 25 basis points.
Why would Big-Bank or any financial intermediary enter into such transaction?
The reason Big-Bank is willing to enter into such contracts is more evident when looking at the
transaction in its entirety.
As a financial intermediary, Big-Bank puts together both transactions. The risk net out, and
Big-Bank is left with a spread of 10 basis points:
Receive (from A) 7.35%
Pay (to B) 7.25%
Receive (from B) LIBOR
Pay (to A) LIBOR
Net 10 basis points
Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to
varying levels of creditworthiness in companies, there is often a positive quality spread
differential which allows both parties to benefit from an interest rate swap.
Interest rate swaps expose users to following risks:-
Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-
for-floating swap, the party who pays the floating rate benefits when rates fall. (Note
that the party that pays floating has an interest rate exposure analogous to a long
bond position.)
Credit risk on the swap comes into play if the swap is in the money or not. If one of
the parties is in the money, then that party faces credit risk of possible default by
another party.
Currency Swaps
Swap contracts also can be arranged across currencies. Such contracts are known as currency
swaps and can help manage both interest rate and exchange rate risk. Many financial
institutions count the arranging of swaps, both domestic and foreign currency, as an important
line of business. Technically, a currency swap is an exchange of debt-service obligations
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denominated in one currency for the service on an agreed upon principal amount of debt
denominated in another currency. By swapping their future cash flow obligations, the counter
parties are able to replace cash flows denominated in one currency with cash flows in a more
desired currency. In this way, company A, which has borrowed, say, Japanese yen at a fixed
interest rate, can transform its yen debt into a fully hedged dollar liability by exchanging cashflows with counter party B.
Currency swaps contain the right of offset, which gives each party the right to offset any
nonpayment of principal or interest with a comparable non-payment. Absent a right of offset,
default by one party would not release the other from making its contractually obligated
payments. Moreover, because a currency swap is not a loan, it does not appear as a liability on
the parties balance sheets. Although the structure of currency swaps differs from interest rate
swaps in a variety of ways, the major difference is that with a currency swap, there is always an
exchange of principal amounts at maturity at a predetermined exchange rate. Thus, the swap
contract behaves like a long-dated forward foreign exchange contract, where the forward rate is
the current spot rate. According to interest rate parity theory, forward rate is a direct function of
the interest rate differential for the two currencies involved. As a result, a currency with a lower
interest rate has a correspondingly high forward exchange value. It follows that future exchange
of currencies at the present spot exchange rate would offset the current difference in interest
rates. This exchange of principals is what occurs in every currency swap at maturity based on
the original amounts of each currency and, by implication, done at the original spot exchange
rate. In the classic currency swap, the counter parties exchange fixed rate payment one currency
for fixed-rate payments in another currency.
For example, consider the US-based company ("Acme Tool & Die") that has raised money by
issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6%
on 100 million Swiss Francs. Upfront, the company receives 100 million Swiss Francs from the
proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss
Francs to fund their US operations.
Because this issue is funding US-based operations, we know two things straightaway. Acme is
going to have to convert the 100 million Swiss Francs into US dollars. And Acme would prefer
to pay its liability for the coupon payments in US dollars every six months.
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Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering
into a currency swap with the First London Bank. Acme agrees to exchange the 100 million
Swiss Francs at inception into US dollars, receive the Swiss Franc coupon payments on the
same dates as the coupon payments are due to Acme's Eurobond investors, pay US dollar
coupon payments tied to a pre-set index and re-exchange the US dollar notional into SwissFrancs at maturity.
Currency swaps allow companies to exploit the global capital markets more efficiently. They
are an integral arbitrage link between the interest rates of different developed countries. The
future of banking lies in the securitization and diversification of loan portfolios. The global
currency swap market will play an integral role in this transformation. Banks will come to
resemble credit funds more than anything else, holding diversified portfolios of global credit
and global credit equivalents with derivative overlays used to manage the variety of currency
and interest rate risk.
Market Analysis Tools
Since the foreign currency market is fluctuating on a continuous basis, one should be able to
understand the factors that affect this currency market. This is done through Technical Analysis
and Fundamental Analysis. These two tools of trade are used in a variety of other markets such
as equity markets, stock markets, mutual funds markets etc. Technical analysis is the
interpretation of facts and data based on the data generated by the market. Fundamental
analysis refers to the factors, which influence the market economy, and in turn how it would
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affect the currency trading, it seeks to trace out the factors and conditions which influence the
market economy and play a pivotal role in altering opinions. Several economic, political, social
events affect the Forex and its workings. A perfect investor in Forex is one who can understand
these factors and feel the pulse of the market before striking gold. Of course there are other
economic and non economic factors which can suddenly affect the trading of the FX marketssuch as the 9/11 tragedy etc. One needs to have a shrewd acumen and a few number crunching
abilities to strike gold in the FX market.
2.1 Structure of Fundamental Analysis:
Fundamental analysis means closely studying the numerical data of the domestic
economy and the other related economies and drawing conclusions from it. Economists believe
that all the activities of the economy are closely inter-related with each other, the change in one
activity will have marginal influence over other activities. Based upon this simple relation
Fundamental Analysis plays an important role in determining the move of the currency market.
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Since fundamental analysis is about looking at the intrinsic value of an investment, its
application in Forex entails looking at the economic conditions that affect the valuation of a
nation's currency.
Practically there are numerable factors which fundamental analysis covers but all of
them do not get considerable attention of the analyst. Factors which reflect the domestic
economys performance and are under the control of the government are called as Internal
Factors. Like wise the factors beyond the control of the domestic economy are studied under
External Factors. Beyond these Economic Indicators also plays a crucial role in predicting
the currency movement. Some major factors both Internal and External, which have a greater
potential to influence the market are discussed below which affects the foreign exchange rates:-
2.1.1 Internal Factors:-
Inflation A raise in the general price level of the commodities and services in
the country is called Inflation. The affect of it is easily understood from the current
market situations in which inflation is 11.89 % (for week ended 28 th June) and USD/INR
rates trading at 42.90 levels as compared to starting of the year in which inflation was in
4-5 % mark and the USD/INR hovering at 40.5 levels. Inflation has a negative influence
with currency as the inflation increases the domestic currency depreciates and vise-versa
being inflation of the other country unchanged. An above average inflation differential
hampers the international competitiveness of an exporter since it means higher labor costs
and higher costs for nationality bought semi products. It usually results in a decline in
exports earnings and by reducing the price of imports, an increase in import usually
accompanies the decrease in exports and aggravates negative aspects for Forex operations
of a country. Below average inflation, on the other hand, benefits foreign exchange
operations because it enhances export and reduces imports. Inflation been an important
spice in the recipe of the exchange market, it draws considerable and constant attention of
the market analysts.
Currency Parity Policy - The external parity of a countrys currency has a major
influence on its FX operations. If a country decides to float its exchange rate, the relation
of its currency to all others is formed by the forces of FX markets. For the markets it is no
longer only inflation discrepancies that change parities. Forecasts, market technicalities,
interest developments and political events have become major market movers. Non
floating currencies are still adjusted from time to time to take into account differences in
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the inflationary development of the major trading partners of the country making the
adjustment.
Economic Policies These have a major bearing on the external accounts of a
country. The economic policies fix the way in which a national economy is managed and
also influence the division of the economy into state and private sectors. They create or
eliminate the incentives for efficiency in all sectors of the economy. They are responsive
for the state of the public finances and influence inflation. Sound economic policies
create a favorable climate not only for investment in the country, but also for an efficient
production structure that can be competitive in international markets. Looking at
economic policies, it is also worth while determining the position of the central Bank
within the policy making process of a country. An independent Central Bank normally
allows at least some economic policies to be executed by an independent body. In
addition, the use of printing press to solve budgetary problems is discounted.
Use of Foreign Funds - The utilization of borrowed funds by private entities is
normally project-orient and therefore, easily recognized. Sovereign borrowing is also
often used for project financing that helps the country as well as its economy. And it can
be used to develop industries that have an import-substitution effect by creating domestic
production as a replacement for imported goods. Funds can, however, also be borrowed
to finance a budget deficit of Central or State Government, which can have its origins in
many different reasons. The use of foreign funds can create a new potential for foreign
exchange earning, or have a directly opposite effect by expanding the need for foreign
through increased foreign debt.
Terms of Trade and Service - The development of the terms of the trade and
services has a significant influence on a countrys foreign exchange operations. Inflation
and currency parity policy are not the only influences on the terms of trade and services.The relation between self-sufficiency and domestic demand, for example, can develop in
a negative way because of structural changes in production and demand, thereby affecting
the terms of trade and services, which are also influenced by the ingenuity, adaptability
and dynamism of countrys population.
Natural Resources - The development of the terms of the trade and services has
a significant influence on a countrys foreign exchange operations. Inflation and currency
parity policy are not the only influences on the terms of trade and services. The relation
between self-sufficiency and domestic demand, for example, can develop in a negative
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way because of structural changes in production and demand, thereby affecting the terms
of trade and services, which are also influenced by the ingenuity, adaptability and
dynamism of countrys population.
Customs, Excise and Taxes - Customs levies were used more to protect the
domestic industry. However, now they are used to restrict the import of certain goods in
order to protect the foreign exchange situation of a country. In addition, many of certain
goods in order to protect the foreign exchange situation of a country. In addition, many
non-tariff barriers are used to protect home industries, which help save foreign exchange.
Capital Movements and Unilateral Transfers - Under their most negative aspect,
capital movements become capital flight and a source of loss of foreign exchange. Capital
flight takes place primarily because the economic and political climate does not provide
the necessary incentive for accumulating capital in ones own country. The inflow of
foreign capital for investment helps not only to broaden the economic base but also brings
foreign exchange with it. Many countries have seen the beneficial aspect of this and have,
therefore created special development agencies. In a more specialized form, such capital
is provided under the terms of foreign aid. The remittances of savings by people working
abroad must also be included here.
2.1.2 External Factors:
Trade Barriers - These are either quantitative or qualitative, are typical case where a
countrys ability to earn foreign exchange can be seriously impaired. Trade barriers
normally have a negative effect on the foreign exchange operations of all the countries
concerned. They often support dying industries in industrialized countries with an ever
increasing cost to the community. Developing countries use trade barriers to protecttheir new industries; this can be at cost of efficiency.
Commodity Price - The development of commodity prices is usually beyond the
influence of a specific country. Price fluctuations, however, very much affect the
foreign exchange operations of the countries that are the main producers of the
commodities. The IMF has created a special facility for countries that have been
adversely affected by movements in commodity prices. Only in case of oil has a cartel
worked of the producers for several years, i.e. OPEC.
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Interest Rates -Because foreign debt or trade credit is incurred in foreign currencies,
the interest rate on those liabilities is fixed by the international financial markets, which
is beyond the influence of most of the countries. The rate if interest has, however, a
very direct on the foreign exchange operations of the countries involved. The higher the
rate, the more foreign exchange is needed. The widespread use of the floating interestrate as the price for international credit has added another element of uncertainty to the
management of foreign debt of the country. Preferential rates are applied by the IDA as
well as in foreign aid.
Natural Catastrophes -These mostly affect the agricultural; sector with destruction of
harvests. This leads to additional imports and therefore, to a loss of foreign exchange.
International aid programs help overcome/mitigate effects of natural catastrophes.
However, the destruction of eco-balance occurring in many countries will lead to
unmanageable problems for them in future.
Transportation - Cross-border trade usually involves transportation the costs of which
are often not within the control of a country. They can price a country out of the market.
Not only can the costs of transportation be a problem but also its availability.
Market Condition -These are principally influenced by market liquidity. When talking
about global financing market, we have take into account all the major money and
capital markets of all the markets, the situation on the EURO market is of prime
important since it is the major provider of funds for cross-border lending. Abundant
liquidity usually leads to easier borrowing and lending, as all banks tend to be builders
of assets in such times. But not only liquidity is an important factor allocating funds and
deciding on maturities available for lending, the emotional state of the market is
important as well. Allocation of funds or acquisition of assets is achieved by taking into
account the expected return as well as the potential risk. While decisions are always
supposed to be made by looking at the optimum between the risk and the return, the
concept of optimum is fairly strongly influenced expectations such as those of the
market.
Concessional Funds - These bear interest rate below the market rate and/or have a
maturity that is much longer than what is available in international market. Major
suppliers of concessional funds are Governments and Supra-national bodies.
Concessional funds are either negotiable bilaterally between governments or are
available after a credit and project assessment by one of the super-national bodies such
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as IDA. The availability of these funds does not follow market patterns but rather
political developments in the industrialized world.
2.1.3 Economic Indicators:
Economic indicators are reports released by the government or a private organization that gives
details of a country's economic performance. Economic reports are the means by which a
country's economic health is directly measured, but do remember that a great deal of factors
and policies will affect a nation's economic performance. These reports are released at
scheduled times, providing the market with an indication of whether a nation's economy has
improved or declined. In Forex, as in the stock market, any deviation from the norm can cause
large price and volume movements. Basically there are many indicators representing the
countrys economic performance but the important one that draws attention of the market
analysts and the investors are like GDP, Retail Sales, Industrial Production, Consumers Price
Index, Producers Price Index, Purchasing Managers Index, Employment Cost Index,
Unemployment Rate, etc,.
Gross Domestic Product - GDP is considered as the broadest measure of a country's
economy, and it represents the total market value of all goods and services produced in
a country during a given period. Since the GDP figure itself is often considered a
lagging indicator, most traders focus on the two reports that are issued in the months
before the final GDP figures: the advance report and the preliminary report. Significant
revisions between these reports can cause considerable volatility. The GDP is
somewhat analogous to the gross profit margin of a publicly traded company in that
they are both measures of internal growth.
Retail Sales - The retail-sales report measures the total receipts of all retail stores in agiven country. This measurement is derived from a diverse sample of retail stores
throughout a nation. The report is particularly useful because it is a timely indicator of
broad consumer spending patterns that is adjusted for seasonal variables. It can be used
to predict the performance of more important lagging indicators, and to assess the
immediate direction of an economy. Revisions to advanced reports of retail sales can
cause significant volatility. The retail sales report can be compared to the sales activity
of a publicly traded company.
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Industrial Production - This report shows the change in the production of factories,
mines and utilities within a nation. It also reports their 'capacity utilizations', the degree
to which the capacity of each of these factories is being used. It is ideal for a nation to
see an increase of production while being at its maximum or near maximum capacity
utilization. Investors using this indicator are usually concerned with utility production,which can be extremely volatile since the utilities industry, and in turn the trading of
and demand for energy, is heavily affected by changes in weather. Significant revisions
between reports can be caused by weather changes, which in turn, can cause volatility
in the nation's currency.
Consumer Price Index - The CPI is a measure of the change in the prices of consumer
goods across over 200 different categories. This report, when compared to a nation's
exports, can be used to see if a country is making or losing money on its products and
services. Be careful, however, to monitor the exports - it is a focus that is popular with
many traders because the prices of exports often change relative to a currency's strength
or weakness.
Some of the other major indicators include the purchasing managers index (PMI),
producer price index (PPI), durable goods report, employment cost index (ECI), and housing
stats. And it also includes the many privately issued reports, the most famous of which is the
Michigan Consumer Confidence Survey. All of these provide a valuable resource to traders and
investors, if used properly.
Since economic indicators gauge a country's economic state, changes in the conditions reported
will therefore directly affect the price and volume of a country's currency. It is important to
keep in mind, however, that the indicators discussed above are not the only things that affect a
currency's price. There are third-party reports, technical factors, and many other things that also
can drastically affect a currency's valuation.
There are many economic indicators, and even more private reports that can be used to evaluate
the fundamentals of Forex. It's important to take the time to not only look at the numbers, but
also understand what they mean and how they affect a nation's economy. When properly used,
these indicators can be an invaluable resource for any currency trader.
The end goal of performing fundamental analysis is to produce a value that an investor
can compare with the currency's current price in hopes of figuring out what sort of position to
take with that currency (under priced = buy or long, overpriced = sell or short).
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2.2 Structure of Technical Analysis:
The other avenue to analyze Forex market is Technical Analysis and it is completely different
from the Fundamental Analysis. Technical Analysis purely depends up on the historical data ofthe markets. It is the technique that claims the ability to forecast the future direction of currency
prices through the study of past market data, primarily price and volume. In its purest form,
technical analysis considers only the actual price behavior of the market or instrument, on the
assumption that price reflects all relevant factors before an investor becomes aware of them
through other channels.
The term Technical Analysis in its application to the Forex market, has come to have a very
special meaning, quite different from its ordinary dictionary definition. It refers to the study of
the action of the market itself as opposed to the study of the goods in which the market deals.
Technical analysis is the science of recording, usually in graphic form, the actual history of
trading (price changes, volume of transactions etc.) in a certain stock or in "the Averages" and
then interpreting from that pictured history the probable future trend.
The principles of technical analysis are derived from the observation of financial markets over
hundreds of years. The oldest known example of technical analysis was a method developed by
Homma Munehisa during early 18th century which evolved into the use of Candlestick
techniques and is today among the main charting tool.
Technical analysis is frequently contrasted with fundamental analysis; the study of economic
factors that some analysts say can influence prices in financial markets. Technical analysis
holds that prices already reflect all such influences before investors are aware of them, hence
the study of price action alone. Some traders use technical or fundamental analysis exclusively,
while others use both types to make trading decisions.
Technical analysis is research of market dynamics that is done mainly with the help of charts
and with the purpose of forecasting future price development. Technical analysis