IFM

The Foreign Exchange Market : 

The Foreign Exchange Market

INTRODUCTION : 

INTRODUCTION Currencies of different countries are important financial assets. These need to be exchanged on account of international trade, transnational services and cross-border borrowings and investments. A foreign exchange market or currency market comes into existence where currencies of different countries can be bought and sold. Such a market may be defined as a market in which currencies are bought and sold and exchange rates between different currencies are determined.

The Foreign Exchange Market : 

The Foreign Exchange Market The foreign exchange market is by far the largest and most liquid financial market in the world. It is many times larger than the next largest market: the US government securities market. According to the Bank for International Settlements, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, as of April 2010 a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Despite its size and importance of the foreign exchange market, it is largely unregulated. No international organization supervises it; no international institution sets rules.

Slide 4: 

The foreign exchange market (also referred to as forex market) is mostly an over-the-counter (OTC) market. The transactions are generally carried out through communication networks such as internet, telephone, telex, and fax. Electronic trading system is being used to see the rates The forex market, in other words, does not refer to a location; rather, it refers to the process by which currencies of different countries are exchanged. Wherever one currency is traded for another, the foreign exchange market exists.

It is a 24-hour market except on weekends : 

It is a 24-hour market except on weekends The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore. A few hours later, trading begins in Bahrain. Late in the Tokyo day, markets open in Europe. In the early afternoon in Europe, markets open in the United States. In the mid to late afternoon in New York, markets open in the Asia-Pacific area. Most of the activity takes place when European markets are open.

London is the largest market : 

London is the largest market London’s size as a financial centre London benefits from its proximity to major Eurocurrency market. Followed by New York, Singapore and Hong kong

Foreign Exchange Parties : 

Foreign Exchange Parties Global banks account for about two-thirds of the market volume, while foreign exchange brokers and dealers account for approximately 20 percent.

The foreign exchange market in India : 

The foreign exchange market in India The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade foreign exchange with one another. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self regulatory association of dealers.

Central Banks : 

Central Banks The Central Bank of a country is an important participant in the foreign exchange market. It has either official or unofficial target exchange rate for its domestic currency. When the actual exchange rates in the forex market deviate too much from these target rates, the Central Bank of the country may intervene in the market to stabilize the exchange rates around the target rates. It can use the foreign exchange reserves at its disposal for such intervention. A particular foreign currency may be sold by the Central Bank to increase its supply in the market and thereby bring down its value against domestic currency. Similarly, a foreign currency may be bought from the forex market by the Central Bank to absorb excess supply of that currency in the market. Such intervention will raise the value of the foreign currency against the domestic currency.

TYPES OF TRANSACTIONS : 

TYPES OF TRANSACTIONS BUSINESS TRANSACTION SPECULATION ARBITRAGE HEDGING

Speculators : 

Speculators A speculator may be defined as an investor who is willing to take a risk by taking futures position with the expectation to earn profits. Thus, out of various options, he will choose that option which will give more profits i.e., he is willing to take more risk. 11

Example : 

Example An investor feels that sterling will strengthen relative to the U.S. dollar over the next two months and is prepared to invest to the tune of 2,50,000 pounds. current exchange rate 1.6470 April future price 1.6410 Alternative strategies – Buy 2,50,000 pounds for $4,11,750, deposits the sterling in an interest earning account for two months. Take a long position in April future contract to buy 2,50,000 pounds for $4,10,250 How the investor will make profits by resorting to future contracts ? 12

Arbitrageurs : 

Arbitrageurs An Arbitrageur is a trader who attempts to make profits by locking in a risk less trading by simultaneously entering into transactions in two or more markets. These arbitrage opportunities do not last long Thus, he will be involved in a risk less trading to make profits. 13

EXAMPLE : 

EXAMPLE A stock is traded on both the New York stock Exchange and the London Stock Exchange. The following quotes have been obtained- New York stock Exchange - 172 dollars per share London Stock Exchange – 100 pounds per share Value of 1 pound – 1.7500 dollars. How trader can gain through arbitrage ? 14

Hedgers : 

Hedgers Hedging is the act of protecting oneself against futures loss In the context of Futures Trading, Hedging is regarded as the use of future transaction to avoid or reduce price risk in the spot market Hedgers enters into a futures position with the opposite exposure. As a result, risk is minimized. HOW? 15

Conti…. : 

Conti…. Hedging is defined as taking equal but opposite positions in the cash and futures market. For example, a producer who has 10,000 bushels of corn in a grain bin and who has sold 10,000 bushels of corn futures is in a hedged position. In this example, the position is long (owns) 10,000 bushels of cash corn and short (sold) 10,000 bushels of futures corn.

Example : 

Example Suppose a firm has an inventory of 100 kg of silver and intends to sell in June. The current spot price of silver is Rs 7500 per kg but firm is worried that the price of silver will fall between now and June. To hedge itself against this possibility, the firm enters into 100 kg of short position in June silver futures at a futures prices of Rs 7600 per kg. In first case, spot silver prices rise to Rs 7700 per kg In Second case, silver prices falls to Rs 7400 kg ( ITS ACTUAL WORRY) 17

Result : 

Result 18

TWO TYPES OF MARKET : 

TWO TYPES OF MARKET SPOT MARKET FORWARD MARKET

The Spot Market : 

The Spot Market A market for the immediate purchase and delivery of currencies. A foreign exchange spot market is a market for trading one currency against the another in such a way that the delivery takes place within 2 days of the execution of the trade. It usually takes two days to transfer cash from one bank to the other. The price is based on the ongoing exchange rate i.e. the current value of one country's currency relative to the another. The forex futures market is a minor derivative of this market

Forward Foreign Exchange Market : 

Forward Foreign Exchange Market The agreed-upon exchange rate for a forward contract on a currency. When a forward contract is made, the parties agree to buy/sell the underlying currency at a certain point in the future at a certain exchange rate. The rate is negotiated directly between the parties, unlike a futures contract which trades on an exchange.

Forward Market- Foreign Exchange Risk : 

Forward Market- Foreign Exchange Risk Foreign Exchange Risk The risk that the value of a future receipt or obligation will change due to variations in foreign exchange rates. Types of Foreign Exchange Risk Exposure Translation exposure Economic exposure

Accounting or Translation Risk Exposure : 

Accounting or Translation Risk Exposure Firms have income statements and balance sheets. The balance sheets reflect the valuation of the assets and liabilities of the firm. The changes in the valuation of assets and liabilities are particularly a problem in international operations because fluctuations in exchange rates can generate paper gains and losses for the parent company. Gains or losses from exchange rate changes that occur as a result of converting financial statements from one currency to another in order to consolidate them. Every company having at least one subsidiary using a different functional currency bears translation risk.

Economic exposure : 

Economic exposure Economic exposure, on the contrary, affects the cash flows of businesses engaged in international transactions. Sensitivity of cash flows to unanticipated changes in the exchange rates of foreign currencies is known as economic exposure. It is further subdivided into transaction exposure operating exposure.

Transaction exposure : 

Transaction exposure Transaction exposure affects the cash inflows and outflows arising from cross-border transactions such as export and import of goods and services, borrowing and lending in foreign currencies and intra-firm transfer of funds. When these transactions are denominated in foreign currencies, the domestic currency values of cash flows arising from these transactions would depend on the exchange rates of the foreign currencies. This dependence or sensitivity of cash flows arising from cross-border transactions to fluctuations in exchange rates of foreign currencies is termed as transaction exposure.

Operating Risk : 

Operating Risk Changes in exchange rates in future would have an impact on the operating income, operating cost and operating profit of firms in future. Such variability in the future operating revenue, cost and profit of firms on account of exchange rate fluctuations is referred to as operating exposure.

Conti…….. : 

Conti…….. In contrast to the transaction exposure which has a short time horizon, operating exposure has a longer time horizon. It refers to the impact of unanticipated changes in the exchange rates on a firm’s operating variables such as revenue, cost and profit over a medium term horizon (say, up to three or five years). While transaction exposure refers to the impact of exchange rate fluctuations on present cash flows, operating exposure refers to the impact of exchange rate fluctuations on future cash flows

Hedging Foreign Exchange Risk : 

Hedging Foreign Exchange Risk Hedging The act of offsetting or eliminating risk exposure. Covered Exposure A foreign exchange risk that has been completely eliminated with a hedging instrument. Forward contract for foreign exchange Derivative instruments

Meaning : 

Meaning Option is a contract between a buyer and a seller that gives the buyer the right—but not the obligation—to buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer

Let’s examine a typical Call Option quote on the stock ABC, which has a current stock market price of $50: : 

Let’s examine a typical Call Option quote on the stock ABC, which has a current stock market price of $50:

Conti…… : 

Conti…… Reading from left to right: This quote is for a CALL OPTION on the security ABC. The option contract EXPIRES IN APRIL. The STRIKE PRICE of $55 is what the option holder can purchase the shares of ABC for anytime up until the 3rd Friday of April. To purchase the ability to do this would cost the option holder $2.50 per contract per share.

Various situations- : 

Various situations- let’s look at some examples of purchasing the above call option contract with three different outcomes: Stock goes up Stock price doesn’t change Stock goes down.

Scenario 1: ABC goes up to $60 : 

Scenario 1: ABC goes up to $60 You bought the contract for $2.50, which multiplied by 100 shares = $250 (cost) You exercise your option so you buy 100 shares at $55 = $5,500 (cost) You then sell your shares immediately for the market price of $60 x 100 shares = $6,000 (proceed) $6,000 - $5,500 - $250 = $250 In this case the option contract become “in-the-money”.

Scenario 2: ABC stays at $57.50 : 

Scenario 2: ABC stays at $57.50 $5,750 - $5,500 - $250 = 0 In this case the option contract become “at-the-money”.

Scenario 3: ABC goes down to $55 : 

Scenario 3: ABC goes down to $55 $5,500 - $5,500 - $250 = - $250 In this case the option contract become “out-of-the-money”. Thus, anything Above 57.50 would give profits between 57.50 and 55 would minimize losses Less than 55, no exercise of call

Graph of this concept : 

Graph of this concept

Put option : 

Put option A put option (sometimes simply called a "put") is a contract between two parties, the seller (writer) and the buyer of the option. The buyer acquires a short position offering the right, but not obligation, to sell the underlying instrument at an agreed-upon price (the strike price). If the buyer exercises the right granted by the option, the seller has the obligation to purchase the underlying at the strike price. In exchange for having this option, the buyer pays the writer a fee (the option premium). The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date.

Example : 

Example Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock will fall sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Situation 1 : 

Situation 1 Say you were proven right and the price of XYZ stock crashes to $30 at option expiration date. With underlying stock price now at $30, your put option will now be in-the-money and you can sell it for that much. Since you had paid $200 to purchase the put option, your net profit for the entire trade is therefore $800 (4000-3000-200).

Situation 2 : 

Situation 2 With underlying stock price now at $38, your put option will now be at-the-money

Situation 3 : 

Situation 3 However, if you were wrong in your assessment and the stock price had instead rallied to $50, your put option will expire worthless and your total loss will be the $200 that you paid to purchase the option Thus, anything Below 38 would give profits between 38 and 40 would minimize losses more than 40, no exercise of put

Payoff for a put option contract : 

Payoff for a put option contract Put option Put option

Hedging by strangle : 

Hedging by strangle Long one put option with a lower strike price and long one call option at a higher strike price. Risk / Reward Maximum Loss: Limited to the total premium paid for the call and put options. Maximum Gain: Unlimited as the market moves in either direction. Characteristics When to use: When you are bullish on volatility but are unsure of market direction.

Example : 

Example Suppose XYZ stock is trading at $40 in June. An options trader executes a long strangle by buying a JUL 35 put for $100 and a JUL 45 call for $100. The net debit taken to enter the trade is $200, which is also his maximum possible loss. If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 35 put will expire worthless but the JUL 45 call expires in the money and has an intrinsic value of $500. Subtracting the initial debit of $200, the options trader's profit comes to $300. On expiration in July, if XYZ stock is still trading at $40, both the JUL 35 put and the JUL 45 call expire worthless and the options trader suffers a maximum loss which is equal to the initial debit of $200 taken to enter the trade.

Payoff : 

Payoff

Meaning of SWAP : 

Meaning of SWAP A private agreement to exchange cash flows at specified future times according to certain specified rules. A swap is a cash-settled OTC derivative. Except for forwards, swaps are the most simple form of OTC derivative.

Features : 

Features Counter parties Benefits to parties Facilitator/Intermediary Cash flows Documentation Low transaction costs Termination- not at one’s instance More Default risk

Purpose : 

Purpose While swaps are used for various purposes—from hedging to speculation—their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability.

Currency swaps : 

Currency swaps A swap deal can also be arranged across currencies. It is an oldest technique in swap market. In this swap, the two payment streams being exchanged are denominated in two different currencies, For example, a firm which has borrowed Japanese yen at a fixed interest rate can ‘swap away’ the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate in return for dollars at either a fixed or a floating interest rate. Currency swaps are motivated by comparative advantage.

Steps : 

Steps The currency swap is, like interest rate swap, also two party transaction, involving two counter parties with different but complimentary needs. In this swap, normally three basic steps are involved which are as under 1. Initial exchange of principal amount 2. Ongoing exchange of interest 3. Re-exchange of principal amounts on maturity

Continue : 

Continue It is noted that exchange of principal amounts, both at the beginning and at the end of swap contract may be notional or real, However, then cash flows resulting from interest rates are real.

For example : 

For example Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (i.e., the dollar is worth $0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays ¬40 million. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

Continue : 

Continue Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays ¬40,000,000 * 3.50% = ¬1,400,000 to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000( ¬1,400,000 *1.40), and Company D would pay the difference ($4,125,000 - $1,960,000 = $2,165,000).

Continue : 

Continue Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Example: How it works? : 

Example: How it works?