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 Zealand to the West Coast of United
States of America.
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 cheques. 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
Commercial banks are the "market makers" in this market. In other words,
on demand, they will quote 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. Brokers 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.
Central banks also intervene in the markets from time to time in order to
move the market in a particular direction.
Corporations use the foreign exchange markets for a variety of purposes.
On 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. Companies 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. Subsequently,
a written confirmation is sent containing all the details of the transaction.
For example, a trader in Bank X may call his counterpart in Bank Y and ask
for a quote on the yen against the dollar. If 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. On the day of the settlement, Bank X will turn over a yen deposit to
Bank Y and Bank Y will turn over a Dollar deposit to Bank X.
Communications pertaining to international financial transactions are
handled mainly by a large network called Society for Worldwide Interbank
Financial Telecommunication (SWIFT). This is a non-profit Belgian
cooperative with regional centers around the world connected by data
transmission lines.
A trader will typically give a two-way quote i.e. he quotes two prices 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 (ask bid) is
the bid-ask spread.
In a regular two-way market, the trader expects "to be hit" on both sides of
his quote in roughly equal amounts. In other words, the trader expects to
buy and sell roughly equal amounts of currencies A and B. The banks
margin would then be the bid-ask spread. If the trader finds that he is being
hit on one side of his quote i.e. he is buying more of currency A than
selling, he is actually building up a position. If he has sold more of currency
A 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 A. The
potential gain or loss from the position would depend upon the variability of
the exchange rates and the size of the position. It must be noted that
building such positions for long durations is risky and amounts to
speculation. Banks maintain tough control over such activities by
prescribing limits on net positions for a given trading period.
As mentioned earlier, in the foreign exchange markets, there are no fees
charged the bid-ask spread itself is the transaction cost. Also, no distinction
is made in terms of rates on the basis of creditworthiness of the
counterparty. Instead, default risk is also managed by prescribing limits of
exposure to a particular corporate client.
Exchange Rate Quotations
Lastly, there is a need to clarify certain terms that appear in foreign
exchange literature regarding types of quotes. They are as follows:

European quotes: These are quotes given as number of units of a currency

per U.S.dollar.ome examples are DM 1.5768 / $, SFr 1.4465 / $, Rs. 43.22 / $
American quotes: These are quotes given as number of US dollars per unit
of a currency. Some examples are $ 0.4576 / DM, $ 1.3545 / British Pound.
Direct quotes: In a country, direct quotes are those that give units of that
countrys currency per unit of foreign currency.
Indirect quotes: Indirect or reciprocal quotes are given as number of units
of foreign currency per unit of home currency. $ 2.8677 / Rs. 100 is an
indirect quote.
Introduction To Derivatives
A 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.
Derivatives have become increasingly important in the field of finance.
Options and futures are traded actively on many exchanges. Forward
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 in other words, there is no
single market place or an organized exchange.
Rationale For Options And Futures Development
Organized exchanges began trading in options on securities in 1973,
whereas exchange traded debt options were not on the scene until 1982. On
the other hand, fixed income futures began trading in 1975, but equity
related futures did not appear until 1982. When 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.
In the equity market a relatively large proportion of the total risk of a
security is unsystematic. At the same time, many securities display a high
degree of liquidity that can be expected to be maintained for log periods of
time. These two factors contributed to the viability of trading equity options
on individual securities. This is because, for the contracts to be successful,

the underlying instruments have to be traded in large quantities and with

some price continuity so that the option related transactions need not
create more than a minor disturbance in the market.
In the debt market, a much larger proportion of the total risk of the security
is systematic in other words, risk that cannot be diversified by investing in
a number of securities. Debt instruments are also characterized by a finite
life and a small size in comparison to equity.
The fundamental differences between futures and options are as follows:

With futures, both parties are obligated to perform. With options, on the
seller (writer) is obligated to perform.
With options, the buyer pays the seller (writer) a premium. In the case of
futures, neither party pays a premium.

In 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. In
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
A forward contract is a simple derivative It 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. A forward contract is not normally traded on an exchange.
One 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 equal to zero for both transacting parties. In other words, it
costs nothing to the either party to hold the long or the short position.
A 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. A forward contract can
therefore, assume a positive or negative value depending on the movements

of the price of the asset. For 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. Conversely, the value of the contract becomes negative for the party
holding the short position.
The concept of Forward 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 equal on the day that the contract is entered into. Over
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.
Payoffs From Forward Contracts
Spot and Forward Foreign Exchange Quotes on Sterling , August 1, 1999
Spot
30-day forward
90-day forward
180-day forward

$ 1.6080
$ 1.6070
$ 1.6050
$ 1.6017

Suppose an investor has entered into a long forward contract on August 1,

1999 to buy one million pounds sterling in 90 days at an exchange rate of $
1.6050. This contract would entail the investor to buy one million pounds
sterling by paying U.S. $ 1,605,000.
If the spot exchange rate rose to $ 1.6500 at the end of the 90-day period,
the investor would gain U.S.$ 45,000 (1,650,000 1,605,000), since these
pounds can be sold in the spot market for $ 1.6500.
Conversely, if the spot exchange rate fell to $ 1.5500, the investor would
lose U.S.$ 55,000 (1,605,000- 1,550,000) as he could have purchased the
pounds in the spot market for a lower price.
Since it costs nothing for the investor to enter into a forward contract, the
payoffs represent his total gain or loss from the contract.

Options
A 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. An option that grants the buyer the right to buy some
instrument is called a call option. An 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.
Options are available on a large variety of underlying assets like common
stock, currencies, debt instruments and commodities. Also traded are
options on stock indices and futures contracts where the underlying is a
futures contract and futures style options.
Options have proved to be a versatile and flexible tool for risk management
by themselves as well as in combination with other instruments. Options
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 Of Options
As mentioned earlier, the underlying asset for options could be a spot
commodity or a futures contract on a commodity. Another variety is the
futures-style option.
An option on spot foreign exchange gives the option buyer the right to buy
or sell a currency at a stated price (in terms of another currency). If the
option is exercised, the option seller must deliver or take delivery of a
currency.
An 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. If
the option is exercised, the seller must take the opposite position in the
relevant futures contract. For example, suppose you had an option to buy a
December DM contract on the IMM at a price of $ 0.58 / DM. You exercise
the option when December futures are trading at $ 0.5895. You can close
out your position at this price and take a profit of $ 0.0095 per DM or, meet
futures margin requirements and carry a long position with $ 0.0095 per

DM being credited to your margin account. The option seller automatically

gets a short position in December futures.
Futures style options are a little bit more complicated. Like futures
contracts, they represent a bet on a price. The price being betted on, is the
price of an option on spot foreign exchange. Simply 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. In 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. For instance, a trader feels that the
premium on a particular option is going to increase. He buys a futures-style
call option. The seller of this call option is betting that the premium will go
down. Unlike the option on the spot, the buyer does not pay the premium to
the seller. Instead, they both post margins related to the value of the call on
spot.
Options Terminology
To reiterate, the two parties to an options contract are the option buyer and
the option seller, also called the option writer. For exchange traded options,
as in the case of futures, once the agreement is reached between two
traders, the exchange (the clearing house) 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.
Call Option
A call option gives the option buyer the right to purchase currency Y against
currency X, at a stated price X/Y, on or before a stated date. For exchange
traded options, one contract represents a standard amount of the currency
Y. The writer of a call option must deliver the currency if the option buyer
chooses to exercise his option.
Put Option
A put option gives the option buyer the right to sell a currency Y against
currency X at a specified price on or before a specified date. The writer of a
put option must take delivery if the option is exercised.

Strike Price (also called exercise price)

The price specified in the option contract at which the option buyer can
purchase the currency (call) or sell the currency (put) Y against X.
Maturity Date
The date on which the option contract expires is the maturity date.
Exchange traded options have standardized maturity dates.
American Option
An option, call or put, that can be exercised by the buyer on any business
day from initiation to maturity.
European Option
A European option is an option that can be exercised only on maturity date.
Premium (Option price, Option value)
The fee that the option buyer must pay the option writer at the time the
contract is initiated. If the buyer does not exercise the option, he stands to
lose this amount.
Intrinsic value of the option
The intrinsic value of an option is the gain to the holder on immediate
exercise of the option. In other words, for a call option, it is defined as Max
[(S-X), 0], where s is the current spot rate and X is the strike rate. If S is
greater than X, the intrinsic value is positive and is S is less than X, the
intrinsic value will be zero. For a put option, the intrinsic value is Max [(XS), 0]. In the case of European options, the concept of intrinsic value is
notional as these options are exercised only on maturity.
Time value of the option
The value of an American option, prior to expiration, must be at least equal
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.
At-the-Money, In-the-Money and Out-of-the-Money Options

A call option is said to be at-the-money if S=X i.e. the spot price is equal to
the exercise price. It is in-the-money is S>X and out-of-the-money is S<X.
Conversely, a put option is at-the-money is S=X, in-the-money if S<X and
out-of-the-money if S>X.
Option Pricing
Black & Scholes, in their celebrated analysis on option pricing, reached the
conclusion that the estimated price of a call could be calculated with the
following equation:
Pc = [Ps][N(d1) [Pe][antilog (-Rft)[N(d2)]
Where:
Pc - market value of the call option
Ps - price of the stock
Pe - strike price of the option
Rf - annualized interest rate
t - time to expiration in years
antilog to the base e
N(d1) and N(d2) are the values of the cumulative normal distribution,
defined as follows:
d1 = Ln (Ps / Pe) + (Rf + 0.5 s 2)t
st
d2 = d1 - (s t)
where:
Ln (Ps / Pe) is the natural logarithm of (Ps / Pe)
s 2 is the is the variance of continuously compounded rate of return on stock
per time period.
Admittedly, the definitions of d1 and d2 are difficult to grasp for the reader
as they involve complex mathematical equations. However, the basic
properties of the Black-Scholes model are easy to understand. What the
model establishes is that the estimated price of options vary directly with an
options term to maturity and with the difference between the stocks
market price and the options strike price. Further, the definitions of d1 and
d2 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.
Relationship Between The Option Premium And Stock Price
It 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
equals the market price of the stock.
Prior to reaching parity, premiums tend to increase less than point per point
with the stock price. One reason for this are that point per point increase in
premium would result in sharply reduced leverage for the option buyers
reduced leverage means reduced demand for the option. Also, a higher
option premium entails increased capital outlay and increased risk, once
again reducing demand for the option.
Declining 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 options total value its
time value. This term to maturity effect tends to exist as the option is a
wasting asset.
Option Strategies
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. In order to keep matters
simple, we make the following assumptions:

We shall ignore brokerage, commissions, margins etc.

We 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 European options

All 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.

Call Options
A call option buyer's profit can be defined as follows:
At all points where S<X, the payoff will be -c
At all points where S>X, the payoff will be S-X- c, where

S = Spot price
X = Strike price or exercise price
c = call option premium
Conversely, the option writer's profit will be as follows:
At all points where S<X, the payoff will be c
At all points where S>X, the payoff will be -(S-X- c)
To illustrate this, let us look at an example and construct the payoff profile.
Consider a trader who buys a call option on the Swiss Franc with a strike
price of $ 0.66 and pays a premium of 1.95 cents ($0.0195). The current
spot rate is 0.6592. His gain or loss at time T when the option expires
depends upon the value of the spot rate at that time.
For all values of S below 0.66, the option buyer lets the option lapse since
the Swiss francs can be bough in the spot market at a lower price. His loss
then will be limited to the premium he has paid. For spot values greater
than the strike price, he will exercise the option.
Let us look at the payoff profile of the call option buyer.

Spot Rate

Gain (S-X-c)

Loss (-c)

0.6000

-0.0195

0.6500

-0.0195

0.6600

-0.0195

0.6700

-0.0195

0.6795

0.6800

0.0005

0.6900

0.0105

0.7000

0.0205

Similarly, we can construct the payoff profile for the call writer. This will be
as follows:

Spot Rate

Gain (c)

Loss (S-X-c)

0.6000

0.0195

0.6500

0.0195

0.6600

0.0195

0.0195

0.6795

0.6800

-0.0005

0.6900

-0.0105

0.7000

-0.0205

0.6700

Put Option
A put option buyer's profit can be defined as follows:
At all points where S<X, the payoff will be X-S-p
At all points where S>X, the payoff will be -p, where
S = Spot price
X = Strike price or exercise price
p = put option premium
Conversely, the put option writer's profit will be as follows:
At all points where S<X, the payoff will be -(X-S- p)
At all points where S>X, the payoff will be p
For example, let us take the case of a trader who buys a June put option on
pound sterling at a strike price of $1.7450, for a premium of $0.05 per
sterling. The spot rate at that time is $ 1.7350.
For all values of S greater than $1.7450, the option will not be exercised as
the sterling has a higher price in the spot market. For values between
$1.6950 and $ 1.7450, the option will be exercised, though there will still be
a loss. Here the option buyer is trying to minimize the loss. For values of

spot rate below $ 1.6950, the option will be exercised and will lead to a net
profit.
At expiry, the put option buyer's payoff profile can be depicted as follows:

Spot Rate

Gain (X-S-p)

Loss (-p)

1.6600

0.0350

1.6800

0.0150

1.6900

0.0050

1.6950

1.7400

-0.0450

1.7500

-0.0500

1.7800

-0.0500

1.8000
-0.0500
Similarly, we can construct a payoff profile for the put option writer. His
gains and losses will look as follows:
Spot Rate

Gain (p)

Loss -(X-S-p)

-0.0350

1.6800

-0.0150

1.6900

-0.0050

1.6950

1.7400

0.0450

1.7500

0.0500

1.6600

1.7800

0.0500

1.8000

0.0500

Spread Strategies
Spread strategies with options involve simultaneous sale and purchase of
two different option contracts. The objective 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.
Evidently, these are speculative in nature. However, these strategies are
such that they provide limited gains while also ensuring limited losses.
Spread 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.
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. The expectation
when going for this strategy is that the underlying price will not change
drastically but the difference in premia will over time.
Vertical Spread Strategies
A 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.
Since 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.
On 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.
A bullish put spread consists of selling a put option with higher strike price
and buying a put option with a lower strike price. In 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. Maximum loss will be the
difference in strike prices minus the difference in premia. A bearish put
spread is the opposite of a bullish put spread.
An extension of the idea of vertical spreads is the butterfly spread. A
butterfly spread involves three options with different strike prices but same
maturity. A 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 investor's 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. But if the
movements are moderate or not very significant, it tends to result in a loss.
Selling a butterfly spread involves selling two intermediate priced calls and
buying one on either side. As opposed to the buyer of a butterfly spread, the
seller here is betting on moderate or non-significant movements. He 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.
Horizontal Or Time Spreads
As 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.
Straddles And Strangles
A Straddle strategy consists of buying a call and a put both with identical
strikes and maturity. If there is a drastic depreciation, the investor gains on
the put i.e. by exercising the option to sell. If there is a drastic appreciation,
the investor exercises the call and purchases at the lower price. However, if
there is a moderate movement either way, the investor will suffer a loss.
A strangle is similar to a straddle. It consists of buying a call with strike
above the current spot rate and a put with a strike price below the current
spot. Like the straddle, it yields a profit for drastic movements and a loss for
moderate movements.
Currency options thus, provide the corporate treasurer a tool for hedging
foreign exchange risks arising out of the firm's operations. Unlike the
forward contracts, options allow the hedger to gain from favorable

exchange rate movements while being protected against unfavorable

movements.
Futures
A 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. In
this, it is similar to a forward contract. However, 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.
Futures contracts in physical commodities such as wheat, cotton, corn,
gold, silver, cattle, etc. have existed for a long time. Futures 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 United States and
subsequently in other markets around the world.
Major Features Of Futures Contracts
The principal features of the contract are as follows:
Organized Exchanges
Unlike 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, liquid market in
which futures can be bought and sold at any time like in a stock market.
Standardization
In 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 buyer's requirements. In 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
International Monetary Market (IMM), a financial futures exchange in the
US, (part of the Chicago Board of Trade or CBT), calls fore delivery of
62,500 British Pounds and contracts are always traded in whole numbers
i.e. you cannot buy or sell fractional contracts. A three-month sterling
deposit on the London International Financial Futures Exchange (LIFFE)

has March, June, September, December delivery cycle. The exchange also
specifies the minimum size of price movement (called the "tick") and, in
some cases, may also impose a ceiling on the maximum price change within
a day. In the case of commodity futures, the commodity in question is also
standardized for quality in addition to quantity in a single contract.
Clearing House
The exchange acts as a clearinghouse to all contracts struck on the trading
floor. For instance, a contract is struck between A and B. Upon entering into
the records of the exchange, this is immediately replaced by two contracts,
one between A and the clearing house and another between B and the
clearing house. In 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 A and B do not have to undertake any
exercise to investigate each other's creditworthiness. It 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 requirements on traders and enforcing this through a
system called "marking to market".
Margins
Like all exchanges, only members are allowed to trade in futures contracts
on the exchange. Others 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. A 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 requires 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 2.5% to 10% of the value of the contract
but can vary. A member acting on behalf of a client, in turn, requires 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 adjusts 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. In a forward contract, gains or losses arise
only on maturity. There are no intermediate cash flows. Whereas, in a
futures contract, even though the gains and losses are the same, the time
profile of the accruals is different. In 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.
Actual Delivery Is Rare
In most forward contracts, the commodity is actually delivered by the seller
and is accepted by the buyer. Forward contracts are entered into for
acquiring or disposing off a commodity in the future for a gain at a price
known today. In contrast to this, in most futures markets, actual delivery
takes place in less than one percent of the contracts traded. Futures 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 acquisition 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 of futures
As is evident from the previous discussion, trading in futures is equivalent
to betting on the price movements in futures prices. If such betting is used
to protect a position - either long or short - in the underlying asset, it is
termed as hedging. On the other hand, if the activity is undertaken only
with the objective of generating profits from absolute or relative price
movements, it is termed as speculation. It must be noted that speculators
provide liquidity to the markets by their willingness to enter open positions.
We 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
We shall look at both hedging and speculation in currency futures.
Corporations, banks and others use currency futures for hedging purposes.
The underlying principle is as follows:

Assume that a corporation has an asset e.g. a receivable in a currency A

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. In
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 A. Obviously, the firm cannot
gain from an appreciation of A 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. Conversely, a firm
with a liability in currency A e.g. a payable, should go long in futures.
In hedging too, the corporation has the option of a direct hedge and a cross
hedge. A British firm with a dollar payable can hedge by selling sterling
futures (same effect as buy dollar futures) on the IMM or LIFFE. This is an
example of a direct hedge. If the dollar appreciates, it will lose on the
payable but gain on the futures, as the dollar price of futures will decline.
An example of a cross hedge is as follows:
A Belgian firm with a dollar payable cannot hedge by selling Belgian franc
futures because they are not traded. However, since the Belgian franc is
closely tied to the Deutschemark in the European Monetary System (EMS).
It can sell DM futures.
An 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.
Also, even when a direct hedge is available, it is extremely difficult to
achieve a perfect hedge. This is due to two reasons. One is that futures
contracts are for standardized amounts as this is designed by the exchange.
Evidently, 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. Over the term of the contract, the spot price changes, as does the
futures price. But the change is not always perfectly correlated - in other
words, the basis is not constant. This gives rise to the basis risk. Basis risk
is dealt with through the hedge ratio and a strategy called delta hedging.
A 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.

Speculation using futures can be in the either open position trading or

spread trading. In the former, the speculator is betting on movements in the
price of a particular futures contract. In the latter, he is betting on the price
differential between two futures contracts.
An example of open position trading is as follows:

$/DM Prices
Spot

0.5785
March Futures

0.5895
June Futures

0.5915
September Futures

0.6015
These prices evidently indicate that the market expects the DM to
appreciate over the next 6-7 months. If there is a speculator who holds the
opposite view - i.e. he believes that the DM is actually going to depreciate.
There is another speculator who believes that the DM will appreciate but
not to the extent that the market estimates - in other words, the
appreciation of the DM will fall short of market expectations. Both these
speculators sell a September futures contract (standard size - DM 125,000)
at $ 0.6015.
On September 10, the following rates prevail:
Spot $/DM - 0.5940, September Futures - 0.5950
Both speculators reverse their deal with the purchase of a September
futures contract. The profit they make is as follows:
$(0.6015-0.5950) i.e. $0.0065 per DM or $(125000 x 0.0065) i.e. $ 812.5 per
contract.
A point to be noted in the above example is that the first speculator made a
profit inspite the fact that his forecast was faulty. What mattered therefore,
was the movement in September futures price relative to the price that
prevailed on the day the contract was initiated.

In contrast to the open position trading, spread trading is considered a

more conservative form of speculation. Spread trading involves the
purchase of one futures contract and the sale of another. An intracommodity 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. An 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
Interest 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 International Monetary Market
(IMM) - a part of the Chicago Mercantile Exchange, has futures contracts
on US Government treasury bonds, three-month Euro-dollar time deposits
and medium term US treasury notes among others. The LIFFE has
contracts on euro-dollar deposits, sterling time deposits and UK
Government bonds. The Chicago Board of Trade offers contracts on long
term US treasury bonds.
Interest rate futures are used by corporations, banks and financial
institutions to hedge interest rate risk. A corporation planning to issue
commercial paper can use T-bill futures to protect itself against an increase
in interest rate. A 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. Speculators bet on interest rate
movements or changes in the term structure in the hope of generating
profits.
A 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.
Stock Index Futures
A stock index futures contract is an obligation to deliver on the settlement
date an amount of cash equivalent to the value of 500 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.
For example, if the S&P 500 Stock Index is at 500 and each point in the
index equals $ 500, a contract struck at this level is worth $ 250,000 (500 *

$500). If, at the expiration of the contract, the S&P 500 Stock Index is at
520, a cash settlement of $ 10,000 is to be made [ (520 - 510) * $500].
It 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 requisite deposit and meet the variation margin
calls as and when required.
Swaps
Financial swaps are a funding technique, 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. Floating rates are tied to an index which could
be the London Interbank borrowing rate (LIBOR), US treasury bill rate etc.
This helps investors exchange one type of asset for another for a preferred
stream of cash flows.
It must be noted that swaps by themselves are not a funding instrument;
they are a device to obtain the desired form of financing indirectly. The
borrower might otherwise have found this too expensive or even
inaccessible.
A 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. Swaps are used to transform the fixed rate
loan into a floating rate loan.
Types Of Swaps
All swaps involve exchange of a series of periodic payments between two
parties. A 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. A third is a combination of the two to result in crosscurrency interest rate swaps. Of course, a number of variations are possible
under each of these major types of swaps.

Interest Rate Swaps

An interest rate swap as the name suggests involves an exchange of
different payment streams which fixed and floating in nature. Such an
exchange is referred to as a exchange of borrowings or a coupon swap. In
this, one party, B, agrees to pay to the other party, A, cash flows equal to
interest at a predetermined fixed rate on a notional principal for a number
of years. At the same time, party A agrees to pay party B cash flows equal 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 15 years. This type of
a standard fixed to floating rate swap is also called a plain vanilla swap in
the market jargon.
London Inter-bank Offer Rate (LIBOR) is often the floating interest rate in
many of the interest rate swaps. LIBOR is the interest rate offered by banks
on deposits from other banks in the Eurocurrency markets. LIBOR is
determined by trading between banks and changes continuously as the
economic conditions change. Just as the Prime Lending Rate (PLR) is used
as the benchmark or the peg for many Indian floating rate instruments,
LIBOR is the most frequently used reference rate in international markets.
Usually, 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. In international markets, they typically
earn about 3 basis points (0.03%) on a pair of offsetting transactions.
At any given point of time, the swap spreads are determined by supply and
demand. If more participants in the swap markets want to receive fixed
rather than floating, swap spreads tend to fall. If the reverse is true, the
swap spreads tend to rise.
In 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. Most 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. Interest rate future contracts are
resorted to as a hedging tool in such cases.
Currency Swaps

Currency 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 equivalent loan in another currency.
Suppose that a company A and company B are offered the fixed five-year
rates of interest in U.S. dollars and sterling. Also suppose that sterling rates
are generally higher than the dollar rates. Also, company A enjoys a better
creditworthiness than company B as it is offered better rates on both dollar
and sterling. What 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 A has a better deal in both the
currency markets, company B does enjoy 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 B borrows
in the market in which it has a lower disadvantage and company A in which
it has a higher advantage. They swap to achieve the desired currency to the
benefit of all concerned.
A 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 equal at the exchange rate at the beginning of the life of the swap.
Like interest rate swaps, currency swaps are frequently warehoused by
financial institutions that carefully monitor their exposure in various
currencies so that they can hedge their currency risk.
Other Swaps
A 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.
One 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. In an
amortizing swap, the principal reduces in a predetermined way. This could
be designed to correspond to the amortization schedule on a particular
loan. Another innovation could be the deferred or forward swaps where the
two parties do not start exchanging interest payments until some future
date.

Another innovation is the combination of the interest and currency swaps

where the two parties exchange a fixed rate currency A payment for a
floating rate currency B payment.
Swaps 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. Options on swaps or Swaptions, are also gaining in
popularity.
A constant maturity swap (CMS) is an agreement to exchange a LIBOR rate
for a swap rate. Foe example, an agreement to exchange 6-month LIBOR for
the 10-year swap rate every six months for the next five years is a CMS.
Similarly, a constant maturity treasury swap (CMT) involves swapping a
LIBOR rate for a treasury rate. An equity swap is an agreement to exchange
the dividends and capital gains realized on an equity 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.