Introduction To The Foreign Exchange Markets The foreign exchange market is the market in which currencies of various countries

are bought and sold against each other. The foreign exchange market is an over-the-counter market. Geographically, the foreign exchange markets span all time zones from New ealand to the !est "oast of #nited $tates of %merica. The retail market for foreign exchange deals with transactions involving travelers and tourists exchanging one currency for another in the form of currency notes or travelers& che'ues. The wholesale market often referred to as the interbank market is entirely different and the participants in this market are commercial banks, corporations and central banks. Participants In The Foreign Exchange Market "ommercial banks are the (market makers( in this market. )n other words, on demand, they will 'uote buying and selling rates for one currency against another and express willingness to take either side of the transaction. They also buy and sell on their own account and carry inventories of currencies.. There are other players like the foreign exchange brokers, who are essentially middlemen providing information to market making banks about prices and a counterparty to transactions. *rokers do not buy or sell on their own account, instead they pocket a commission on the deals that they have helped strike between two marketmaking banks. "entral banks also intervene in the markets from time to time in order to move the market in a particular direction. "orporations use the foreign exchange markets for a variety of purposes. +n the operational front, they use the foreign exchange markets for payments towards imports, conversion of export receipts, hedging receivables and payables positions and payment of interest on foreign currency loans take abroad. "ompanies that are cash rich tend to also park surplus funds and take active positions in the market to earn profits from exchange rate movements. There are others who, as a matter of company policy, restrict their participation to producing and selling of goods and services. How Is Currency Trading Done? Typically, interbank market deals are struck on the telephone. $ubse'uently, a written confirmation is sent containing all the details of the transaction. ,or example, a trader in *ank - may call his counterpart in *ank . and ask for a 'uote on the yen against the dollar. )f the price is acceptable, they will enter the details of the transaction like date, price, amount bought / sold, identity of the counterparty etc. in their respective computerized record systems. +n

the day of the settlement, *ank - will turn over a yen deposit to *ank . and *ank . will turn over a 0ollar deposit to *ank -. "ommunications pertaining to international financial transactions are handled mainly by a large network called $ociety for !orldwide )nterbank ,inancial Telecommunication 1$!),T2. This is a non-profit *elgian cooperative with regional centers around the world connected by data transmission lines. % trader will typically give a two-way 'uote i.e. he 'uotes two prices 3 one at which he will buy a currency and one at which he will sell the currency against another currency. Typically, there will be two prices, which will be differentiated by a hyphen. The price on the left of the hyphen will be the bid rate, the rate at which the trader will buy the currency. The price on the right of the hyphen will be the offer or ask rate, the price at which the trader will sell the currency against another. The difference 1ask 3 bid2 is the bid-ask spread. )n a regular two-way market, the trader expects (to be hit( on both sides of his 'uote in roughly e'ual amounts. )n other words, the trader expects to buy and sell roughly e'ual amounts of currencies % and *. The bank&s margin would then be the bid-ask spread. )f the trader finds that he is being hit on one side of his 'uote 3 i.e. he is buying more of currency % than selling, he is actually building up a position. )f he has sold more of currency % than he has bought, he is building up a net short position and if the converse is true, he has built a net long position in currency %. The potential gain or loss from the position would depend upon the variability of the exchange rates and the size of the position. )t must be noted that building such positions for long durations is risky and amounts to speculation. *anks maintain tough control over such activities by prescribing limits on net positions for a given trading period. %s mentioned earlier, in the foreign exchange markets, there are no fees charged the bid-ask spread itself is the transaction cost. %lso, no distinction is made in terms of rates on the basis of creditworthiness of the counterparty. )nstead, default risk is also managed by prescribing limits of exposure to a particular corporate client. Exchange Rate Quotations 4astly, there is a need to clarify certain terms that appear in foreign exchange literature regarding types of 'uotes. They are as follows5 6uropean 'uotes5 These are 'uotes given as number of units of a currency per #.$.dollar.ome examples are 07 8.9:;< / =, $,r 8.>>;9 / =, ?s. >@.AA / =

%merican 'uotes5 These are 'uotes given as number of #$ dollars per unit of a currency. $ome examples are = B.>9:; / 07, = 8.@9>9 / *ritish Cound. 0irect 'uotes5 )n a country, direct 'uotes are those that give units of that country&s currency per unit of foreign currency. )ndirect 'uotes5 )ndirect or reciprocal 'uotes are given as number of units of foreign currency per unit of home currency. = A.<;:: / ?s. 8BB is an indirect 'uote. Introduction To Deri ati es % derivative is a financial instrument whose value depends on other, more basic, underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper, prices of oranges to even the amount of snow that falls on a ski resort. 0erivatives have become increasingly important in the field of finance. +ptions and futures are traded actively on many exchanges. ,orward contracts, swaps and different types of options are regularly traded outside exchanges by financial institutions, banks and their corporate clients in what are termed as over-the-counter markets 3 in other words, there is no single market place or an organized exchange. Rationa!e For "ptions #nd Futures De e!op$ent +rganized exchanges began trading in options on securities in 8D:@, whereas exchange traded debt options were not on the scene until 8D<A. +n the other hand, fixed income futures began trading in 8D:9, but e'uity related futures did not appear until 8D<A. !hen the nature of the markets are compared, one can easily discern the reasons why these differences have cropped up. This must be analyzed in the light of the fact that exchanges tend to introduce tose instruments that they think will succeed and contract design is a function of marketing. )n the e'uity market a relatively large proportion of the total risk of a security is unsystematic. %t the same time, many securities display a high degree of li'uidity that can be expected to be maintained for log periods of time. These two factors contributed to the viability of trading e'uity options on individual securities. This is because, for the contracts to be successful, the underlying instruments have to be traded in large 'uantities and with some price continuity so that the option related transactions need not create more than a minor disturbance in the market.

)n the debt market, a much larger proportion of the total risk of the security is systematic 3 in other words, risk that cannot be diversified by investing in a number of securities. 0ebt instruments are also characterized by a finite life and a small size in comparison to e'uity. The fundamental differences between futures and options are as follows5

!ith futures, both parties are obligated to perform. !ith options, on the seller 1writer2 is obligated to perform. !ith options, the buyer pays the seller 1writer2 a premium. )n the case of futures, neither party pays a premium. )n the case of futures, the holder of the contract is exposed to the entire spectrum of downside risk and has the potential for all the upside returns. )n the case of options, the buyer is able to limit the downside risk to the option premium but retains the upside potential. The parties to a futures contract must perform at the settlement date. They are, however, not obligated to perform before the settlement date. The buyers of an options contract can exercise any time prior to that expiration date.

Forward Contracts % forward contract is a simple derivative 3 )t is an agreement to buy or sell an asset at a certain future time for a certain price. The contract is usually between two financial institutions or between a financial institution and its corporate client. % forward contract is not normally traded on an exchange. +ne of the parties in a forward contract assumes a long position i.e. agrees to buy the underlying asset on a specified future date at a specified future price. The other party assumes a short position i.e. agrees to sell the asset on the same date at the same price. This specified price is referred to as the delivery price. This delivery price is chosen so that the value of the forward contract is e'ual to zero for both transacting parties. )n other words, it costs nothing to the either party to hold the long or the short position. % forward contract is settled at maturity. The holder of the short position delivers the asset to the holder of the long position in return for cash at the agreed upon rate. Therefore, a key determinant of the value of the contract is the market price of the underlying asset. % forward contract can therefore, assume a positive or negative value depending on the movements of the price of the asset. ,or example, if the price of the asset rises sharply after the two parties have entered into the contract, the party holding the long position stands to benefit, i.e. the value of the contract is positive for her.

"onversely, the value of the contract becomes negative for the party holding the short position. The concept of ,orward price is also important. The forward price for a certain contract is defined as that delivery price which would make the value of the contract zero. To explain further, the forward price and the delivery price are e'ual on the day that the contract is entered into. +ver the duration of the contract, the forward price is liable to change while the delivery price remains the same. This is explained in the following note on payoffs from forward contracts. Payo%%s Fro$ Forward Contracts
&pot and Forward Foreign Exchange Quotes on &ter!ing ' #ugust (' ())) $pot @B-day forward DB-day forward 8<B-day forward

= 8.;B<B = 8.;B:B = 8.;B9B = 8.;B8:

$uppose an investor has entered into a long forward contract on %ugust 8, 8DDD to buy one million pounds sterling in DB days at an exchange rate of = 8.;B9B. This contract would entail the investor to buy one million pounds sterling by paying #.$. = 8,;B9,BBB. )f the spot exchange rate rose to = 8.;9BB at the end of the DB-day period, the investor would gain #.$.= >9,BBB 18,;9B,BBB 3 8,;B9,BBB2, since these pounds can be sold in the spot market for = 8.;9BB. "onversely, if the spot exchange rate fell to = 8.99BB, the investor would lose #.$.= 99,BBB 18,;B9,BBB- 8,99B,BBB2 as he could have purchased the pounds in the spot market for a lower price. $ince it costs nothing for the investor to enter into a forward contract, the payoffs represent his total gain or loss from the contract. "ptions

% options agreement is a contract in which the writer of the option grants the buyer of the option the right purchase from or sell to the writer a designated instrument for a specified price within a specified period of time. The writer grants this right to the buyer for a certain sum of money called the option premium. %n option that grants the buyer the right to buy some instrument is called a call option. %n options that grants the buyer the right to sell an instrument is called a put option. The price at which the buyer an exercise his option is called the exercise price, strike price or the striking price. +ptions are available on a large variety of underlying assets like common stock, currencies, debt instruments and commodities. %lso traded are options on stock indices and futures contracts 3 where the underlying is a futures contract and futures style options. +ptions have proved to be a versatile and flexible tool for risk management by themselves as well as in combination with other instruments. +ptions also provide a way for individual investors with limited capital to speculate on the movements of stock prices, exchange rates, commodity prices etc. The biggest advantage in this context is the limited loss feature of options. Types "% "ptions %s mentioned earlier, the underlying asset for options could be a spot commodity or a futures contract on a commodity. %nother variety is the futures-style option. %n option on spot foreign exchange gives the option buyer the right to buy or sell a currency at a stated price 1in terms of another currency2. )f the option is exercised, the option seller must deliver or take delivery of a currency. %n option on currency futures gives the option buyer the right to establish a long or short position in a currency futures contract at a specified price. )f the option is exercised, the seller must take the opposite position in the relevant futures contract. ,or example, suppose you had an option to buy a 0ecember 07 contract on the )77 at a price of = B.9< / 07. .ou exercise the option when 0ecember futures are trading at = B.9<D9. .ou can close out your position at this price and take a profit of = B.BBD9 per 07 or, meet futures margin re'uirements and carry a long position with = B.BBD9 per 07 being credited to your margin account. The option seller automatically gets a short position in 0ecember futures. ,utures style options are a little bit more complicated. 4ike futures contracts, they represent a bet on a price. The price being betted on, is the price of an

option on spot foreign exchange. $imply put, the buyer of the option has to pay a price to the seller of the option i.e. the premium or the price of the option. )n a futures style option, you are betting on the changes in this price, which, in turn depends on several factors including the spot exchange rate of the currency involved. ,or instance, a trader feels that the premium on a particular option is going to increase. Ee buys a futures-style call option. The seller of this call option is betting that the premium will go down. #nlike the option on the spot, the buyer does not pay the premium to the seller. )nstead, they both post margins related to the value of the call on spot. "ptions Ter$ino!ogy To reiterate, the two parties to an options contract are the option buyer and the option seller, also called the option writer. ,or exchange traded options, as in the case of futures, once the agreement is reached between two traders, the exchange 1the clearing house2 interposes itself between the two parties becoming buyer to every seller and seller to every buyer. The clearing house guarantees performance on the part of every seller. Ca!! "ption % call option gives the option buyer the right to purchase currency . against currency -, at a stated price -/., on or before a stated date. ,or exchange traded options, one contract represents a standard amount of the currency .. The writer of a call option must deliver the currency if the option buyer chooses to exercise his option. Put "ption % put option gives the option buyer the right to sell a currency . against currency - at a specified price on or before a specified date. The writer of a put option must take delivery if the option is exercised.

&trike Price *a!so ca!!ed exercise price+ The price specified in the option contract at which the option buyer can purchase the currency 1call2 or sell the currency 1put2 . against -. Maturity Date

The date on which the option contract expires is the maturity date. 6xchange traded options have standardized maturity dates. #$erican "ption %n option, call or put, that can be exercised by the buyer on any business day from initiation to maturity. European "ption % 6uropean option is an option that can be exercised only on maturity date. Pre$iu$ *"ption price' "ption a!ue+

The fee that the option buyer must pay the option writer at the time the contract is initiated. )f the buyer does not exercise the option, he stands to lose this amount. Intrinsic a!ue o% the option

The intrinsic value of an option is the gain to the holder on immediate exercise of the option. )n other words, for a call option, it is defined as 7ax F1$--2, BG, where s is the current spot rate and - is the strike rate. )f $ is greater than -, the intrinsic value is positive and is $ is less than -, the intrinsic value will be zero. ,or a put option, the intrinsic value is 7ax F1--$2, BG. )n the case of 6uropean options, the concept of intrinsic value is notional as these options are exercised only on maturity. Ti$e a!ue o% the option The value of an %merican option, prior to expiration, must be at least e'ual to its intrinsic value. Typically, it will be greater than the intrinsic value. This is because there is some possibility that the spot price will move further in favor of the option holder. The difference between the value of an option at any time (t( and its intrinsic value is called the time value of the option. #t,the,Money' In,the,Money and "ut,o%,the,Money "ptions % call option is said to be at-the-money if $H- i.e. the spot price is e'ual to the exercise price. )t is in-the-money is $I- and out-of-the-money is $J-. "onversely, a put option is at-the-money is $H-, in-the-money if $J- and out-of-the-money if $I-. "ption Pricing

*lack K $choles, in their celebrated analysis on option pricing, reached the conclusion that the estimated price of a call could be calculated with the following e'uation5 Cc H FCsGFN1d82 3 FCeGFantilog 1-?ft2FN1dA2G !here5 Cc - market value of the call option Cs - price of the stock Ce - strike price of the option ?f - annualized interest rate t - time to expiration in years antilog 3 to the base e N1d82 and N1dA2 are the values of the cumulative normal distribution, defined as follows5 d8 H 4n 1Cs / Ce2 L 1?f L B.9 s A2t sMt dA H d8 - 1s M t2 where5 4n 1Cs / Ce2 is the natural logarithm of 1Cs / Ce2 s A is the is the variance of continuously compounded rate of return on stock per time period. %dmittedly, the definitions of d8 and dA are difficult to grasp for the reader as they involve complex mathematical e'uations. Eowever, the basic properties of the *lack-$choles model are easy to understand. !hat the model establishes is that the estimated price of options vary directly with an option&s term to maturity and with the difference between the stock&s market price and the option&s strike price. ,urther, the definitions of d8 and dA indicate that option prices increase with the variance of the rate of return on the stock price, reflecting that the greater the volatility, higher the chance that the option will become more valuable. Re!ationship -etween The "ption Pre$iu$ #nd &tock Price )t is obvious that the option premium fluctuates as the stock price moves above or below the strike price. Generally, option premiums rarely move point for point with the price of the underlying stock. This typically happens

only at parity, in other words, when the exercise price plus the premium e'uals the market price of the stock. Crior to reaching parity, premiums tend to increase less than point per point with the stock price. +ne reason for this are that point per point increase in premium would result in sharply reduced leverage for the option buyers 3 reduced leverage means reduced demand for the option. %lso, a higher option premium entails increased capital outlay and increased risk, once again reducing demand for the option. 0eclining stock prices also do not result in a point per point decrease in option premium. This is because, even a steep decline in the stock price in a span of a few days has only a slight effect on the option&s total value 3 its time value. This term to maturity effect tends to exist as the option is a wasting asset. "ption &trategies This section deals with some of the most basic strategies that can be devised using options. The idea is to familiarize the reader with the flexibility of options as a risk management tool. )n order to keep matters simple, we make the following assumptions5

!e shall ignore brokerage, commissions, margins etc. !e shall assume that the option is exercised only on maturity and not prematurely exercise - in other words, we assume that we are only dealing with 6uropean options %ll exchange rates, strike prices and premia will be in terms of dollars per unit of a currency and the option will be assumed to be on one unit of the currency.

Ca!! "ptions % call option buyerNs profit can be defined as follows5 %t all points where $J-, the payoff will be -c %t all points where $I-, the payoff will be $--- c, where $ H $pot price - H $trike price or exercise price c H call option premium "onversely, the option writerNs profit will be as follows5 %t all points where $J-, the payoff will be c %t all points where $I-, the payoff will be -1$--- c2 To illustrate this, let us look at an example and construct the payoff profile.

"onsider a trader who buys a call option on the $wiss ,ranc with a strike price of = B.;; and pays a premium of 8.D9 cents 1=B.B8D92. The current spot rate is B.;9DA. Eis gain or loss at time T when the option expires depends upon the value of the spot rate at that time. ,or all values of $ below B.;;, the option buyer lets the option lapse since the $wiss francs can be bough in the spot market at a lower price. Eis loss then will be limited to the premium he has paid. ,or spot values greater than the strike price, he will exercise the option. 4et us look at the payoff profile of the call option buyer.

&pot Rate B.;BBB B.;9BB B.;;BB B.;:BB B.;:D9 B.;<BB B.;DBB B.:BBB

.ain *&,/,c+ B.BBB9 B.B8B9 B.BAB9

0oss *,c+ -B.B8D9 -B.B8D9 -B.B8D9 -B.B8D9 -

$imilarly, we can construct the payoff profile for the call writer. This will be as follows5

&pot Rate B.;BBB B.;9BB

.ain *c+ B.B8D9 B.B8D9

0oss *&,/,c+ -

B.;;BB
B.;:BB

B.B8D9 B.B8D9

-B.BBB9 -B.B8B9 -B.BAB9

B.;:D9 B.;<BB B.;DBB B.:BBB Put "ption

% put option buyerNs profit can be defined as follows5 %t all points where $J-, the payoff will be --$-p %t all points where $I-, the payoff will be -p, where $ H $pot price - H $trike price or exercise price p H put option premium "onversely, the put option writerNs profit will be as follows5 %t all points where $J-, the payoff will be -1--$- p2 %t all points where $I-, the payoff will be p ,or example, let us take the case of a trader who buys a Oune put option on pound sterling at a strike price of =8.:>9B, for a premium of =B.B9 per sterling. The spot rate at that time is = 8.:@9B. ,or all values of $ greater than =8.:>9B, the option will not be exercised as the sterling has a higher price in the spot market. ,or values between =8.;D9B and = 8.:>9B, the option will be exercised, though there will still be a loss. Eere the option buyer is trying to minimize the loss. ,or values of spot rate below = 8.;D9B, the option will be exercised and will lead to a net profit. %t expiry, the put option buyerNs payoff profile can be depicted as follows5

&pot Rate

.ain */,&,p+

0oss *,p+

8.;;BB 8.;<BB 8.;DBB 8.;D9B 8.:>BB 8.:9BB 8.:<BB

B.B@9B B.B89B B.BB9B -

-B.B>9B -B.B9BB -B.B9BB

8.<BBB -B.B9BB $imilarly, we can construct a payoff profile for the put option writer. Eis gains and losses will look as follows5 &pot Rate
8.;;BB

.ain *p+ -

0oss ,*/,&,p+ -B.B@9B -B.B89B -B.BB9B -

8.;<BB 8.;DBB 8.;D9B 8.:>BB 8.:9BB 8.:<BB 8.<BBB &pread &trategies

B.B>9B B.B9BB B.B9BB B.B9BB

$pread strategies with options involve simultaneous sale and purchase of two different option contracts. The obPective in these strategies is to realize a profit if the underlying price moves in a fashion that is expected and to limit the magnitude of loss in case it moves in an unexpected fashion. 6vidently, these are speculative in nature. Eowever, these strategies are such that they provide limited gains while also ensuring limited losses. $pread strategies involving options with same maturity but different strike prices are called vertical spreads or price spreads. The types of vertical spread strategies are bullish call spreads, bearish call spreads, bullish put spreads and bearish put spreads. The expectation when going in for these strategies is that the underlying rate is likely to either appreciate or depreciate significantly. Eorizontal or time spread strategies involve simultaneous buying and selling of two options which are similar in all respects except in maturity. The basic idea behind this is that the time value of the short maturity option will decline faster than that of the long maturity option. The expectation when going for this strategy is that the underlying price will not change drastically but the difference in premia will over time. 1ertica! &pread &trategies % bullish call consists of selling the call with the higher strike price and buying the call with the lower strike price. The expectation is the underlying currency is likely to appreciate. The investor however, would like to limit his losses. $ince a lower priced call is being bought i.e. higher premium is paid and a higher priced call is being sold i.e. lower premium is received, the initial net investment would be the difference in the two premia. The maximum profit potential will be the difference in the strike prices minus the initial investment. The maximum loss is the initial investment. This strategy thus yields a limited profit if the currency appreciates and a limited loss if the currency depreciates. +n the other hand, if the investor expects the currency to depreciate, he can go in for the bearish call spread. This is the reverse of the bullish spread i.e. the call with the higher strike price is bought and that with the lower strike price is sold. The maximum gain will be the difference in the premia. The maximum loss will be the difference is premia minus the difference in the strike prices. % bullish put spread consists of selling a put option with higher strike price and buying a put option with a lower strike price. )n this case, if there is a significant appreciation in the underlying rate, neither put will be exercised

and the net gain will be the difference in premia. 7aximum loss will be the difference in strike prices minus the difference in premia. % bearish put spread is the opposite of a bullish put spread. %n extension of the idea of vertical spreads is the butterfly spread. % butterfly spread involves three options with different strike prices but same maturity. % butterfly spread is bought by purchasing two calls with the middle strike price and selling one call each with the strike price on either side. The investorNs expectation is that there will be a significant movement in the underlying rate - he is, however, unsure of the direction of this movement. This strategy yields a limited profit if there is a significant movement in the underlying rate - appreciation or depreciation. *ut if the movements are moderate or not very significant, it tends to result in a loss. $elling a butterfly spread involves selling two intermediate priced calls and buying one on either side. %s opposed to the buyer of a butterfly spread, the seller here is betting on moderate or non-significant movements. Ee does not expect drastic movements either way. Therefore, this strategy yields a small profit if there are moderate changes in the exchange rate and a limited loss if there are large movements on either side. Hori2onta! "r Ti$e &preads %s mentioned earlier, horizontal or time spread strategies involve simultaneous buying and selling of two options which are similar in all respects except in maturity. The basic idea behind this is that the time value of the short maturity option will decline faster than that of the long maturity option. &tradd!es #nd &trang!es % $traddle strategy consists of buying a call and a put both with identical strikes and maturity. )f there is a drastic depreciation, the investor gains on the put i.e. by exercising the option to sell. )f there is a drastic appreciation, the investor exercises the call and purchases at the lower price. Eowever, if there is a moderate movement either way, the investor will suffer a loss. % strangle is similar to a straddle. )t consists of buying a call with strike above the current spot rate and a put with a strike price below the current spot. 4ike the straddle, it yields a profit for drastic movements and a loss for moderate movements. "urrency options thus, provide the corporate treasurer a tool for hedging foreign exchange risks arising out of the firmNs operations. #nlike the forward contracts, options allow the hedger to gain from favorable exchange rate movements while being protected against unfavorable movements. Futures % futures contract is an agreement between two parties to buy or sell an asset at a certain specified time in future for a certain specified price. )n this,

it is similar to a forward contract. Eowever, there are a number of differences between forwards and futures. These relate to the contractual features, the way the markets are organized, profiles of gains and losses, kinds of participants in the markets and the ways in which they use the two instruments. ,utures contracts in physical commodities such as wheat, cotton, corn, gold, silver, cattle, etc. have existed for a long time. ,utures in financial assets, currencies, interest bearing instruments like T-bills and bonds and other innovations like futures contracts in stock indexes are a relatively new development dating back mostly to early seventies in the #nited $tates and subse'uently in other markets around the world. Ma3or Features "% Futures Contracts The principal features of the contract are as follows5 "rgani2ed Exchanges #nlike forward contracts which are traded in an over-the-counter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready, li'uid market in which futures can be bought and sold at any time like in a stock market. &tandardi2ation )n the case of forward currency contracts, the amount of commodity to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor-made to buyerNs re'uirements. )n a futures contract both these are standardized by the exchange on which the contract is traded. Thus, for instance, one futures contract in pound sterling on the )nternational 7onetary 7arket 1)772, a financial futures exchange in the #$, 1part of the "hicago *oard of Trade or "*T2, calls fore delivery of ;A,9BB *ritish Counds and contracts are always traded in whole numbers i.e. you cannot buy or sell fractional contracts. % three-month sterling deposit on the 4ondon )nternational ,inancial ,utures 6xchange 14),,62 has 7arch, Oune, $eptember, 0ecember delivery cycle. The exchange also specifies the minimum size of price movement 1called the (tick(2 and, in some cases, may also impose a ceiling on the maximum price change within a day. )n the case of commodity futures, the commodity in 'uestion is also standardized for 'uality in addition to 'uantity in a single contract. C!earing House

The exchange acts as a clearinghouse to all contracts struck on the trading floor. ,or instance, a contract is struck between % and *. #pon entering into the records of the exchange, this is immediately replaced by two contracts, one between % and the clearing house and another between * and the clearing house. )n other words, the exchange interposes itself in every contract and deal, where it is a buyer toe very seller and a seller to every buyer. The advantage of this is that % and * do not have to undertake any exercise to investigate each otherNs creditworthiness. )t also guarantees the financial integrity of the market. The exchange enforces delivery for contracts held until maturity and protects itself from default risk by imposing margin re'uirements on traders and enforcing this through a system called (marking to market(. Margins 4ike all exchanges, only members are allowed to trade in futures contracts on the exchange. +thers can use the services of the members as brokers to use this instrument. Thus, an exchange member can trade on his own account as well as on behalf of a client. % subset of the members is the (clearing members( or members of the clearinghouse and non-clearing members must clear all their transactions through a clearing member. The exchange re'uires that a margin must be deposited with the clearinghouse by a member who enters into a futures contract. The amount of the margin is generally between A.9Q to 8BQ of the value of the contract but can vary. % member acting on behalf of a client, in turn, re'uires a margin from the client. The margin can be in the form of cash or securities like treasury bills or bank letters of credit. Marking To Market The exchange uses a system called marking to market where, at the end of each trading session, all outstanding contracts are repriced at the settlement price of that trading session. This would mean that some participants would make a loss while others would stand to gain. The exchange adPusts this by debiting the margin accounts of those members who made a loss and crediting the accounts of those members who have gained. This feature of futures trading creates an important difference between forward contracts and futures. )n a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows. !hereas, in a futures contract, even though the gains and losses are the same, the time profile of the accruals is different. )n other words, the total gains or loss over the entire period is broken up into a daily series of gains and losses, which clearly has a different present value.

#ctua! De!i ery Is Rare )n most forward contracts, the commodity is actually delivered by the seller and is accepted by the buyer. ,orward contracts are entered into for ac'uiring or disposing off a commodity in the future for a gain at a price known today. )n contrast to this, in most futures markets, actual delivery takes place in less than one percent of the contracts traded. ,utures are used as a device to hedge against price risk and as a way of betting against price movements rather than a means of physical ac'uisition of the underlying asset. To achieve this, most of the contracts entered into are nullified by a matching contract in the opposite direction before maturity of the first. Types o% %utures %s is evident from the previous discussion, trading in futures is e'uivalent to betting on the price movements in futures prices. )f such betting is used to protect a position - either long or short - in the underlying asset, it is termed as hedging. +n the other hand, if the activity is undertaken only with the obPective of generating profits from absolute or relative price movements, it is termed as speculation. )t must be noted that speculators provide li'uidity to the markets by their willingness to enter open positions. !e shall briefly look at currency, interest rate and stock index futures. There are others like commodity futures as well which are not covered under this section. Currency Futures !e shall look at both hedging and speculation in currency futures. "orporations, banks and others use currency futures for hedging purposes. The underlying principle is as follows5 %ssume that a corporation has an asset e.g. a receivable in a currency % that it would like to hedge, it should take a futures position such that futures generate a positive cash whenever the asset declines in value. )n this case, since the firm in long, in the underlying asset, it should go short in futures i.e. it should sell futures contracts in %. +bviously, the firm cannot gain from an appreciation of % since the gain on the receivable will be eaten away by the loss on the futures. The hedger is willing to sacrifice this potential profit to reduce or eliminate the uncertainty. "onversely, a firm with a liability in currency % e.g. a payable, should go long in futures. )n hedging too, the corporation has the option of a direct hedge and a cross hedge. % *ritish firm with a dollar payable can hedge by selling sterling

futures 1same effect as buy dollar futures2 on the )77 or 4),,6. This is an example of a direct hedge. )f the dollar appreciates, it will lose on the payable but gain on the futures, as the dollar price of futures will decline. %n example of a cross hedge is as follows5 % *elgian firm with a dollar payable cannot hedge by selling *elgian franc futures because they are not traded. Eowever, since the *elgian franc is closely tied to the 0eutschemark in the 6uropean 7onetary $ystem 167$2. )t can sell 07 futures. %n important point to note is that, in a cross hedge, a firm must choose a futures contract on an underlying currency that is highly positively correlated with the currency exposure being hedged. %lso, even when a direct hedge is available, it is extremely difficult to achieve a perfect hedge. This is due to two reasons. +ne is that futures contracts are for standardized amounts as this is designed by the exchange. 6vidently, this will only rarely match the exposure involved. The second reason involves the concept of basis risk. The difference between the spot price at initiation of the contract and the futures price agreed upon is called the basis. +ver the term of the contract, the spot price changes, as does the futures price. *ut the change is not always perfectly correlated - in other words, the basis is not constant. This gives rise to the basis risk. *asis risk is dealt with through the hedge ratio and a strategy called delta hedging. % speculator trades in futures to profit from price movements. They hold views about the future price movements - if these differ from those of the general market, they will trade to profit from this discrepancy. The flip side is that they are willing to take the risk of a loss if the prices move against their views of opinions. $peculation using futures can be in the either open position trading or spread trading. )n the former, the speculator is betting on movements in the price of a particular futures contract. )n the latter, he is betting on the price differential between two futures contracts. %n example of open position trading is as follows5

45DM Prices
$pot

B.9:<9

7arch ,utures

B.9<D9
Oune ,utures

B.9D89
$eptember ,utures

B.;B89 These prices evidently indicate that the market expects the 07 to appreciate over the next ;-: months. )f there is a speculator who holds the opposite view - i.e. he believes that the 07 is actually going to depreciate. There is another speculator who believes that the 07 will appreciate but not to the extent that the market estimates - in other words, the appreciation of the 07 will fall short of market expectations. *oth these speculators sell a $eptember futures contract 1standard size - 07 8A9,BBB2 at = B.;B89. +n $eptember 8B, the following rates prevail5 $pot =/07 - B.9D>B, $eptember ,utures - B.9D9B *oth speculators reverse their deal with the purchase of a $eptember futures contract. The profit they make is as follows5 =1B.;B89-B.9D9B2 i.e. =B.BB;9 per 07 or =18A9BBB x B.BB;92 i.e. = <8A.9 per contract. % point to be noted in the above example is that the first speculator made a profit inspite the fact that his forecast was faulty. !hat mattered therefore, was the movement in $eptember futures price relative to the price that prevailed on the day the contract was initiated. )n contrast to the open position trading, spread trading is considered a more conservative form of speculation. $pread trading involves the purchase of one futures contract and the sale of another. %n intra-commodity spread involves difference in prices of two futures contract with the same underlying commodity and different maturity dates. These are also termed as time spreads. %n inter-commodity spread involves the difference in prices of two futures contracts with different but related commodities. These are usually with the same maturity dates. Interest Rate Futures )nterest rate futures is one of the most successful financial innovations in recent years. The underlying asset is a debt instrument such as a treasury

bill, a bond or time deposit in a bank. The )nternational 7onetary 7arket 1)772 - a part of the "hicago 7ercantile 6xchange, has futures contracts on #$ Government treasury bonds, three-month 6uro-dollar time deposits and medium term #$ treasury notes among others. The 4),,6 has contracts on euro-dollar deposits, sterling time deposits and #R Government bonds. The "hicago *oard of Trade offers contracts on long term #$ treasury bonds. )nterest rate futures are used by corporations, banks and financial institutions to hedge interest rate risk. % corporation planning to issue commercial paper can use T-bill futures to protect itself against an increase in interest rate. % treasurer who is expecting some surplus cash in the near future to be invested in some short term investments may use the same as insurance against a fall in interest rates. $peculators bet on interest rate movements or changes in the term structure in the hope of generating profits. % complete analysis of interest rate futures would be a complex exercise as it involves thorough understanding and familiarity with concepts such as discount yield, yield-to-maturity and elementary mathematics of bond valuation and pricing. &tock Index Futures % stock index futures contract is an obligation to deliver on the settlement date an amount of cash e'uivalent to the value of 9BB times the difference between the stock index value at the close of the last trading day of the contract and the price at which the futures contract was originally struck. ,or example, if the $KC 9BB $tock )ndex is at 9BB and each point in the index e'uals = 9BB, a contract struck at this level is worth = A9B,BBB 19BB S =9BB2. )f, at the expiration of the contract, the $KC 9BB $tock )ndex is at 9AB, a cash settlement of = 8B,BBB is to be made F 19AB - 98B2 S =9BBG. )t must be noted that no physical delivery of stock is made. Therefore, in order to ensure that sufficient funds are available for settlement, both parties have to maintain the re'uisite deposit and meet the variation margin calls as and when re'uired. &waps ,inancial swaps are a funding techni'ue, which permit a borrower to access one market and then exchange the liability for another type of liability. The global financial markets present borrowers and investors with a wide variety of financing and investment vehicles in terms of currency and type of coupon - fixed or floating. ,loating rates are tied to an index which could be the 4ondon )nterbank borrowing rate 14)*+?2, #$ treasury bill rate etc. This helps

investors exchange one type of asset for another for a preferred stream of cash flows. )t must be noted that swaps by themselves are not a funding instrumentT they are a device to obtain the desired form of financing indirectly. The borrower might otherwise have found this too expensive or even inaccessible. % common explanation for the popularity of swaps concerns the concept of comparative advantage. The basic principle is that some companies have a comparative advantage when borrowing in fixed rate markets while other companies have a comparative advantage in floating rate markets. This may lead to some companies borrowing in fixed markets when the need is of a floating rate loan and vice versa. $waps are used to transform the fixed rate loan into a floating rate loan. Types "% &waps %ll swaps involve exchange of a series of periodic payments between two parties. % swap transaction usually involves an intermediary who is a large international financial institution. The two payment streams are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant markets. The two most widely prevalent types of swaps are interest rate swaps and currency swaps. % third is a combination of the two to result in crosscurrency interest rate swaps. +f course, a number of variations are possible under each of these maPor types of swaps. Interest Rate &waps %n interest rate swap as the name suggests involves an exchange of different payment streams which fixed and floating in nature. $uch an exchange is referred to as a exchange of borrowings or a coupon swap. )n this, one party, *, agrees to pay to the other party, %, cash flows e'ual to interest at a predetermined fixed rate on a notional principal for a number of years. %t the same time, party % agrees to pay party * cash flows e'ual to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. The life of the swap can range from two years to over 89 years. This type of a standard fixed to floating rate swap is also called a plain vanilla swap in the market Pargon. 4ondon )nter-bank +ffer ?ate 14)*+?2 is often the floating interest rate in many of the interest rate swaps. 4)*+? is the interest rate offered by banks

on deposits from other banks in the 6urocurrency markets. 4)*+? is determined by trading between banks and changes continuously as the economic conditions change. Oust as the Crime 4ending ?ate 1C4?2 is used as the benchmark or the peg for many )ndian floating rate instruments, 4)*+? is the most fre'uently used reference rate in international markets. #sually, two non-financial companies do not get in touch with each other to directly arrange a swap. They each deal with a financial intermediary such as a bank who then structures the plain vanilla swap in such a way so as to earn them a margin or a spread. )n international markets, they typically earn about @ basis points 1B.B@Q2 on a pair of offsetting transactions. %t any given point of time, the swap spreads are determined by supply and demand. )f more participants in the swap markets want to receive fixed rather than floating, swap spreads tend to fall. )f the reverse is true, the swap spreads tend to rise. )n real life, it is difficult to envisage a situation where two companies contact a financial institution at exactly the same time with the proposal to take opposite positions in the same swap. 7ost large financial institutions are therefore prepared tow are house interest rate swaps. This involves entering into a swap with a counterparty, then hedging the interest rate risk until an opposite counterparty us found. )nterest rate future contracts are resorted to as a hedging tool in such cases. Currency &waps "urrency swaps involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an approximately e'uivalent loan in another currency. $uppose that a company % and company * are offered the fixed five-year rates of interest in #.$. dollars and sterling. %lso suppose that sterling rates are generally higher than the dollar rates. %lso, company % enPoys a better creditworthiness than company * as it is offered better rates on both dollar and sterling. !hat is important to the trader who structures the swap deal is that difference in the rates offered to the companies on both currencies is not the same. Therefore, though company % has a better deal in both the currency markets, company * does enPoy a comparatively lower disadvantage in one of the markets. This creates an ideal situation for a currency swap. The deal could be structured such that company * borrows in the market in which it has a lower disadvantage and company % in which it has a higher advantage. They swap to achieve the desired currency to the benefit of all concerned.

% point to note is that the principal must be specified at the outset for each of the currencies. The principal amounts are usually exchanged at the beginning and the end of the life of the swap. They are chosen such that they are e'ual at the exchange rate at the beginning of the life of the swap. 4ike interest rate swaps, currency swaps are fre'uently warehoused by financial institutions that carefully monitor their exposure in various currencies so that they can hedge their currency risk. "ther &waps % swap in its most general form is a contract that involves the exchange of cash flows according to a predetermined formula. There is no limit to the number of innovations that can be made given this basic structure of the product. +ne innovation is that principal in a swap agreement can be varied throughout the term of the swap to meet the needs of the two parties. )n an amortizing swap, the principal reduces in a predetermined way. This could be designed to correspond to the amortization schedule on a particular loan. %nother innovation could be the deferred or forward swaps where the two parties do not start exchanging interest payments until some future date. %nother innovation is the combination of the interest and currency swaps where the two parties exchange a fixed rate currency % payment for a floating rate currency * payment. $waps are also extendable, where one party has the option to extend the life of the swap or puttable, where one party has the option to terminate the swap before its maturity. +ptions on swaps or $waptions, are also gaining in popularity. % constant maturity swap 1"7$2 is an agreement to exchange a 4)*+? rate for a swap rate. ,oe example, an agreement to exchange ;-month 4)*+? for the 8B-year swap rate every six months for the next five years is a "7$. $imilarly, a constant maturity treasury swap 1"7T2 involves swapping a 4)*+? rate for a treasury rate. %n e'uity swap is an agreement to exchange the dividends and capital gains realized on an e'uity index for either a fixed or floating rate of interest. These are only a few of the innovations in swaps that exist in the financial markets. The above have been mentioned to underscore the fact that swaps and other derivatives that have been dealt with in this module are all born out of necessity or needs of the many participants in the international financial market.