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BASIC FOREIGN EXCHANGE
• Spot: Foreign exchange spot trading is
buying one currency with a different
currency for immediate delivery. The
standard settlement convention for
Foreign Exchange Spot trades is T+2
days, i.e., two business days from the
date of trade. An exception is the
USD/CAD (USD–Canadian Dollars)
currency pair which settles T+1.
• Forward Outright: A
forward is a contract between two
counterparties to exchange one
currency for another on any day after
• The duration of the trade can be a few
days, months or years.
Base Currency / Terms
• In foreign exchange markets, the base currency
is the first currency in a currency pair. The
second currency is called as the terms currency.
• Eg. The expression US Dollar–Rupee, tells you
that the US Dollar is being quoted in terms of
the Rupee. The US Dollar is the base currency
and the Rupee is the terms currency.
• Exchange rates are constantly changing, which
means that the value of one currency in terms of
the other is constantly in flux. Changes in rates
are expressed as strengthening or weakening of
one currency vis-à-vis the other currency.
• Changes are also expressed as
appreciation or depreciation of one
currency in terms of the other
• Eg. If US Dollar–Rupee moved from
43.00 to 43.25, the US Dollar has
appreciated and the Rupee has
• A foreign exchange swap is a
simultaneous purchase and sale, or
sale and purchase, of identical
amounts of one currency for another
with two different value dates.
• Foreign Exchange Swaps are
commonly used as a way to facilitate
funding in the cases where funds are
available in a different currency than
the one needed.
• Foreign Exchange - The exchange rate
is a price - the number of units of one
nation’s currency that must be
surrendered in order to acquire one unit
of another nation’s currency.
• A foreign exchange transaction is still a
shift of funds or short-term financial
claims from one country and currency to
another. Thus, within India, any money
denominated in any currency other than
the Indian Rupees (INR) is, broadly
speaking, “foreign exchange.
• Foreign Exchange can be cash, funds
available on credit cards and debit
cards, travellers’ cheques, bank
deposits, or other short-term claims.
• Foreign currencies are usually
needed for payments across national
• The exchange rate is a price - the
number of units of one nation’s
currency that must be surrendered in
order to acquire one unit of another
• The participants in the foreign exchange
market are thus a heterogeneous group.
• The various investors, hedgers, and
speculators may be focused on any time
period, from a few minutes to several
• The exchange rate important price in an
open economy, influencing consumer
prices, investment decisions, interest
rates, economic growth, the location of
industry, and much more.
• The US Dollar is by far the most widely
• The market practice is to trade each of
the two currencies against a common
third currency as a vehicle, rather than to
trade the two currencies directly against
• The vehicle currency used most often is
the US Dollar, although very recently
euro also has become an important
• Thus, a trader who wants to shift funds
from one currency to another, say from
Indian Rupees to Philippine Pesos, will
probably sell INR for US Dollars and
then sell the US Dollars for Pesos.
• The US Dollar took on a major vehicle
currency role with the introduction of the
Bretton Woods par value system, in
which most nations met their IMF
exchange rate obligations by buying and
selling US Dollars.
• The Euro: Like the US
Dollar, the Euro has a strong
international presence and
over the years has emerged as
a premier currency, second
only to the US Dollar.
• The Japanese Yen : The
Japanese Yen is the third most
traded currency in the world. It
has a much smaller
international presence than the
US Dollar or the Euro. The Yen
is very liquid around the world,
practically around the clock.
• The British Pound: Until the
end of World War II, the Pound
was the currency of reference.
The nickname Cable is derived
from the telegrams used to
update the GBP/USD rates
across the Atlantic. The
currency is heavily traded
against the Euro and the US
• The Swiss Franc : The Swiss
Franc is the only currency of a
major European country that
belongs neither to the
European Monetary Union nor
to the G-7 countries.
Currency Derivatives in
• Launched on 29th August 2008 on NSE.
• Launched on 7th October 2008 on MCX-
• Launched on 14th October 2008 on BSE.
• Current Daily average turnover is Rs.
4500 crore, on each NSE & MCX-SX. (
last year the figure was only Rs. 300
• July 6th 2009, was the most active day,
to hit the total turnover of Rs. 11,600
crore from 24 lakh contracts.
• A futures contract is a standardized
contract, traded on an exchange, to
buy or sell a certain underlying asset
or an instrument at a certain date in
the future, at a specified price.
• In other words, it is a contract to
exchange one currency for another
currency at a specified date and a
specified rate in the future.
• For example:
• Spot price
• Future price
• Contract cycle
• Value date
• Expiry date
• Contract size
• Cost of carry
• Initial margin
• Marking to market
INTEREST RATE PARITY AND
PRICING OF CURRENCY
Interest Rate Parity
• Interest rate parity is a non-arbitrage condition
• If the returns are different, an arbitrage transaction could,
in theory, produce a risk-free return.
DERIVATION OF FUTURE
RATE FROM SPOT RATE
• The price of future can be derived by
Term : Base Formula
Spot-Forward r& p Formula
Term: Base Formula
• Forward = Spot + Points
Points =Spot 1 + terms i * days
1 + base i * days
i = rate of interest
basis = day count basis
(Most currencies use a 360-day basis, except the pound sterling and a few
others, which use a 365-day year.)
Spot-Forward r& p
• F(0,T) = (1+ r)T/ (1+p)T
CONTINUOUS COMPOUNDING FORMULA
• F(0,T) =(r-p)T
• Long position in a currency futures
contract without any exposure in the
cash market is called a speculative
• If the exchange rate strengthens Profit
• If the exchange rate weakens Loss
Observation: The trader has effectively analysed the market conditions
and has taken a right call by going long on futures and thus has made a
gain of Rs. 1,880.
SHORT POSITION IN
• Short position in a currency futures contract without any
exposure in the cash market is called a speculative transaction.
If the exchange rate weakens Profit
If the exchange rate strengthens Loss
Observation: The trader has effectively analysed the market
conditions and has taken a right call by going short on futures and
thus has made a gain of Rs. 362.50 per contract with small
investment (a margin of 3%, which comes to Rs. 1270.80)
in a span of 6 days.
– USD INR Currency Derivatives
Underlying Rate of exchange between one USD and
Contract Size USD 1000
Tick Size Re. 0.0025
Trading Cycle .
Last Trading Day
Final Settlement Price
Final settlement date.
• Base Price
• Closing Price
• Dissemination of
Open, High, Low, and Last-Traded
TENORS OF FUTURES
• Expiry Date
• Final Settlement Rate
ENTITIES IN THE TRADING
• Trading Members (TM)
• Clearing Members (CM)
• Trading-cum-Clearing Member (TCM)
• Professional Clearing Members (PCM)
TYPES OF ORDERS
• Time conditions
Immediate or Cancel (IOC)
• Price condition
HEDGING USING CURRENCY
A hedger has an Overall Portfolio (OP)
composed of (at least) 2 positions:
1. Underlying position
2. Hedging position with negative correlation with
Types of FX Hedgers using
• Long hedge
• Short hedge
The proper size of the Hedging
• Basic Approach: Equal hedge
• Modern Approach: Optimal hedge
Long Futures Hedge Exposed to the
Risk of Strengthening USD
Short Futures Hedge Exposed to
the Risk of Weakening USD
TRADING SPREADS USING
Spread movement is based on following
• Interest Rate Differentials
• Liquidity in Banking System
• Monetary Policy Decisions (Repo, Reverse
Repo and CRR)
• Arbitrage means locking in a profit by
simultaneously entering into
transactions in two or more markets.
If the relation between forward prices
and futures prices differs, it gives rise
to arbitrage opportunities.
• Difference in the equilibrium prices
determined by the demand and
supply at two different markets also
gives opportunities to arbitrage.
• Example – Let’s say the spot rate for
USD/INR is quoted @ Rs. 44.325 and one
month forward is quoted at 3 paisa
premium to spot @ 44.3550 while at the
same time one month currency futures is
trading @ Rs.44.4625. An active
arbitrager realizes that there is an
arbitrage opportunity as the one month
futures price is more than the one month
Clearing , settlement
and risk management
Nirav K. Dhruve
• Clearing members
• Clearing banks
• It involves working out open position and
obligations of CM
• This position is considered for exposure and
daily margin purposes
• The open positions of Clearing Members
(CMs) are arrived at by aggregating the
open positions of all the TMs and all
custodial participants clearing through him,
in contracts in which they have traded.
• TMs are required to identify the orders,
whether its proprietary or client based
Determinant of open position of a clearing member
• Settlement of futures contract
1) Mark to market settlement
P/L are computed as the difference
between trade price and day’s settlement
price during that day which are not squared
The previous day;s settlement price and
today’s settlement price if the contract is b/f
Buy/sell price of the contract if it is squared
2) Final settlement:
On the last trading day of the futures
contracts, after the close of trading
hours, the Clearing Corporation
marks all positions of a CM to the final
settlement price and the resulting
profit/loss is settled in cash
Settlement price of a future
• Daily settlement price on a trading day is the
closing price of the respective futures
contracts on such day
• Last half an hour weighted average price of
• The final settlement price is the RBI
reference rate for the last trading day of the
• All open positions will be mark to market on
the final settlement price
Risk management measures
• The financial soundness
• Initial margin
• Open positions are MOM based
• Members positions are based on
• Separate settlement guarantee
funds are created
• Initial margin
• Portfolio based margin
• Real time computation
• Calendar spread margins
• Extreme loss margin
• Liquid net worth
• MOM settlement
Over the counter Options
Used mainly by Multinational
companies and large commercial
Options are frequently written for U.S
dollars against Pound Sterling,
Deusche Marks, Swiss francs,
Canadian Dollar, Euro,etc.
Maturity ranges from 2 to 6 months.
Divided into subparts: Retail Market
and Wholesale Market
Market is relatively illiquid because of
its tailor made nature
Contracts are not standardized
because of which there is lack of
secondary market operators.
Counter party risk
First trading commenced in 1982 by
Philadelphia Stock Exchange(PHLX).
In June 1987, Currency Exchange
Warrants (CEW) were introduced on
American Stock Exchange (AMEX)
with long maturity exceeding 1 year.
In February 1988, CEWs traded in
AMEX had foreign currency put
options with 5 years to expiration.
Basics of Currency Options
Call Option: Option to buy
Sell Option: Option to sell
Exercise or Strike Price: Rate at
which foreign currency can be bought
Premium: Which is the cost or price
of the option itself
Underlying or Actual Spot exchange
rate: Rate in the currency market
exists on exercise date.
American Options: Can be exercised
at any time between the writing date
and expiration date.
European Option: Can only be
exercised at the expiration date and
not before this date. Mostly popular in
Switzerland and Germany.
Determinants of the
currency option value
Changes in forward rate
Changes in spot rate
Time to Maturity
Impact of changing volatility
Changes in interest rate differential
Alternative option strike price
Changes in Forward Rate
• The standard foreign currency is
priced around the forward rate.
• It gives an idea how the future rate
will move because the forward rate is
determined after considering the
interest rate differential of both the
• Forward rate also provides
information to the trader to manage
Spot Rate Changes (Delta)
• It has direct impact on the time value of the option
• As long as the option has time remaining the option
will posses the time value element
• The sensitivity of the option premium to a small
change in the spot exchange is called as delta
• The change in the spot rate is $1.70 to $1.72 and
also assume that option premium changes from
$0.038/£ to $0.032/£
Delta=ΔPremium = 0.038-0.032= 0.60
Δspot rate 1.72-1.76
Time To Maturity(Theta)
• Longer the period to maturity the greater will be the
• This relation is referred as Theta.
• Rule of thumb is trader will normally find longer
maturity options better value, giving the trader to alter
an option position without suffering Time value
Impact of changing volatility
• Volatility in the context of option may
be defined as The standard deviation
of daily percentage changes in the
underlying exchange rate.
• If exchange rate volatility increases
then risk in option increases.
• It will result in increase in option
• Option has annual volatility of 10.5%, so
Daily volatility = Annual volatility/√365.
Lambda = Δpremium
Thumb rule- Traders who believe volatility will fall,
will sell options and buy-back for a profit after
volatility falls and cause option premium to fall.
Changes in interest rate
differentials. (Rho and Phi)
• The expected change in option
premium from a small change in
domestic interest rate is called Rho
• The expected change in option
premium from a small change in
Foreign interest rate is called Phi
RHO = Δ Premium
Δ Re interest rate
PHI= Δ Premium
Δ Foreign interest rate
Rule of thumb- A trader who is purchasing a call option
on foreign currency should do so before the domestic
interest rate rises.
Alternative strike price and
• The most important thing in option valuation
is the availability of alternative strike price In
the market and finally selecting the same.
• How to choose?
• This is determined by exercising various
strike prices and respective option premium
at each strike price. The option which has
more option premium will be selected and
then finally a final strike price will be