CHAPTER 1: FOREIGN EXCHANGE MARKET(CONT.

VII. FOREIGN EXCHANGE MARKET

The foreign exchange refers the organizational setting within which individuals, businesses, governments, and banks buy and sell foreign currencies and other debt instruments. The foreign-exchange market is by far the largest and most liquid market in the world. Unlike stock or commodity exchanges, the foreign-exchange market is not an organized structure. It has no centralized meeting place and no formal requirements for participation. Foreign-exchange dealers are in constant telephone and computer contact, the market is very competitive; in effect, it functions no differently than if it were a centralized market. The foreign exchange market is a round-the-clock operation
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THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET

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The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk, by which we mean the adverse consequences of unpredictable changes in exchange rates.

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TYPES OF FOREIGN EXCHANGE

TRANSACTIONS

SPOT TRANSACTION

A spot transaction is an outright purchase and sale of foreign currency for cash settlement not more than two business days after the date the transaction is recorded as a spot deal. The 2-day period is known as immediate delivery. By convention, the settlement date is the second business day after the date on which the transaction is agreed to by the two traders. The 2-day period provides sample time for the two parties to confirm the agreement and arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.
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WHAT IS A DERIVATIVE?
A derivative is an instrument whose value depends on, or is derived from, the value of another asset. Examples: futures, forwards, swaps, options,

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WHY DERIVATIVES ARE IMPORTANT

Derivatives play a key role in transferring risks in the economy The underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc Many financial transactions have embedded derivatives The real options approach to assessing capital investment decisions has become widely accepted

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HOW DERIVATIVES ARE TRADED

On exchanges such as the Chicago Board Options Exchange In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly

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SIZE OF OTC AND EXCHANGE-TRADED MARKETS

(FIGURE 1.1, PAGE 3)

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Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
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HOW DERIVATIVES ARE USED

To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit

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FORWARD EXCHANGE CONTRACT

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A forward exchange contract is entered into between a bank and a customer, the bank fixes the rate of exchange at which a foreign currency will be bought or sold. The exchange rate may fluctuate during and at the time of maturity but it will not have any affect on the forward contract agreed between the bank and the customer. Through forward exchange contracts both the importer and exporter know the exact amount of their payables and receivable in foreign currency thereby covering against fluctuation of any exchange rates during the period. Forward exchange contract is a legal contract to receive or deliver foreign currency at the agreed date

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Forward rates apply to transactions for completion at an agreed future date beyond two working days. The Forward Exchange rates can be Fixed Forward Rate or Option Forward Rate. FIXED FORWARD EXCHANGE RATES is for receipt or delivery of a foreign currency at a fixed date some time in the future i.e. after one month, three month or six months etc.

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OPTION FORWARD EXCHANGE RATES is for the receipt or delivery of a foreign currency sometime in the future between two agreed dates. For example an importer has to pay for goods in foreign currency and wishes to enter into a three months forward contract with one months option. Here the customer has the option to buy the foreign currency any time during the third month. In this case the two dates in the future are after the end of the second month and before the end of the third month from the date of the forward contract

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FORWARD TRANSACTION

In many cases, a business or financial institution knows it will be receiving or paying an amount of foreign currency on a specific date in the future. For example, in August a U.S. importer may arrange for a special Christmas-season shipment of Japanese radios to arrive in October. The agreement with the Japanese manufacturer may call for payment in yen on October 20. To guard against the possibility of the yen's becoming more expensive in terms of the dollar, the importer might contract with a bank to buy yen at a stipulated price, but not actually receive them until October 20 when they are needed. When the contract matures, the U.S. importer pays for the yen with a known amount of dollars. This is known as a forward transaction 17

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FORWARD TRANSACTION
Forward transactions differ from spot transactions in that their maturity date is more than two business days in the future. A forward-exchange contract's maturity date can be a few months or even years in the future. The exchange rate is fixed when the contract is initially made. No money necessarily changes hands until the transaction actually takes place, although dealers may require some customers to provide collateral in advance.

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FOREIGN EXCHANGE QUOTES FOR GBP, MAY 24, 2010 (SEE PAGE 5)

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Spot 1-month forward

Bid 1.4407 1.4408

Offer 1.4411 1.4413

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3-month forward
6-month forward

1.4410
1.4416

1.4415
1.4422
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SWAP RATE

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SWAP RATE
SWAP RATE= Rs. K (Iv- Iu)/ (1+ Iu.K) Swap rate > 0 : Premium Swap rate < 0 : Discount

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HOW THE FORWARD EXCHANGE RATE IS CALCULATED

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HOW THE FORWARD EXCHANGE RATE IS CALCULATED

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HOW THE FORWARD EXCHANGE RATE IS CALCULATED

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FORWARD PRICE
The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities (as shown by the table)

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EXAMPLE (PAGE 5)
On May 24, 2010 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of 1.4422 This obligates the corporation to pay $1,442,200 for 1 million on November 24, 2010 What are the possible outcomes?

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FUTURES CONTRACTS (PAGE 7)

Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

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STANDARDISED CONTRACT
Contract size / Trading unit Price quote Minimum price fluctuation Daily price limit Trading hours Delivery month / Settlement month / Contract month Delivery date / Settlement date Last day of trading

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EXAMPLE: FUTURE CONTRACT SIZE

Currency transacted at IMM (CME) Pound Sterling Japanese Yen Contract size GBP 62,500 JPY 12,500,000

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Swiss Franc
Canadian Dollar Australian Dollar Mexican Peso Euro

CHF 125,000
CAD 100,000 AUD 100,000 MXN 500,000 EUR 125,000 (Source : www.cme.com)

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EXAMPLE: FUTURE CONTRACT FOR EUR AT IMM Contract size / Trading unit EUR 125,000
Price quote Minimum price fluctuation Daily price limit Trading hours Delivery month / Settlement month / Contract month Delivery date / Settlement date Last day of trading USD against EUR 0.0001 USD (= USD 12.50 /contract) unlimited 7:20 am - 2:00 pm. Last day of trading: 7:20am - 9:16 am 3, 6, 9 & 12

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two working days before the third Wednesday of delivery month T he third Wednesday of delivery month

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INITIAL MARGIN AND MAINTENANCE MARGIN

Currency AUD GBP CAD EUR JPY CHF MXN Initial margin 2,025 1,890 1,755 3,240 2,700 2,565 1,875 Maintenance margin 1,500 1,400 1,300 2,400 2,000 1,900 1,500

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(Source : www.cme.com, dated on 20/08/2008)

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EXAMPLE
On Monday (Oct 6th), buy a future contract of EUR, which will deliver in December. Initial price USD 1.4568/EUR Contract size: EUR 125,000 Value of the contract USD 182,100 Intial margin USD 3,240 and maintenance margin USD 2,400 You maintain the long position until you sell the contract at the price of 1.4590 USD per EUR

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FUTURE: MARKED TO MARKET- DAILY SETTLEMENT (FROM OCT THE 6TH TO OCT THE 15TH)
Date Exchange Contract rate value Marked to Margin market + deposit withdraw (225) (275) (450) (200) 650 575 300 (450) (575) 950 3,240 Margin account

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6 Oct 7 Oct 8 - Oct 9 Oct 10 Oct 13 Oct 14 Oct

1.4550 1.4528 1.4492 1.4476 1.4528 1.4574 1.4598

181,875 181,600 181,150 181,575 182,225 182,925 182,450

3,015 2,740 2,290 3,040 3,690 3,815 3,540

15 Oct

1.4590

182,375

(100)

(3,440)
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FUTURES CONTRACTS
Trading in foreign exchange can also be done in the futures market. In this market, contracting parties agree to future exchanges of currencies and set applicable exchange rates in advance. The futures market is distinguished from the forward market in that only a limited number of leading currencies are traded; moreover, trading takes place in standardized contract amounts and in a specific geographic location.

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FUTURES CONTRACTS
Forward Contract Issuer Trading Contract size Commercial bank "Over the counter" Tailored to the needs of the exporter/importer/invest or; no set size Negotiable Future Contract Futures Exchange On the IMM's market floor Standardized in round lots

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Date of delivery

Only on particular dates

Contract costs Based on the bid/offer spread

Settlement On expiration date only, at prearranged price

Brokerage fees for sell and buy orders

Profits or losses paid daily at close of trading

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EXCHANGES TRADING FUTURES

CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade) NYSE Euronext BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book)

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CURRENCY SWAP
A currency swap is the conversion of one currency to another currency at one point in time, with an agreement to reconvert it back to the original currency at a specified time in the future. The rates of both exchanges are agreed to in advance. Swaps provide an efficient mechanism through which banks can meet their foreignexchange needs over a period of time. Banks are able to use a currency for a period in exchange for another currency that is not needed during that time.

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CURRENCY SWAP

For example, Chase Manhattan Bank may have excess balances of dollars but needs pounds to meet the requirements of its corporate clients. At the same time, Royal Bank of Scotland may have excess balances of pounds and insufficient amounts of dollars. The banks could negotiate a swap agreement in which Chase Manhattan Bank agrees to exchange dollars for pounds today and pounds for dollars in the future. The key aspect is that the two banks arrange the swap as a single transaction in which they agree to pay and receive stipulated amounts of currencies at specified rates. 38

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CURRENCY SWAP
Spot Forward Swap Forward Forward Swap

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SPOT FORWARD SWAP

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FORWARD FORWARD SWAP

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CASE STUDY
At present, on September the 1st , company A has VND in its bank account but it needs 1,000,000 USD to pay for imported machines. Simultaneously in 3 months, the company will receive 1,000,000 USD from its importer but will needs VND to compensate for their domestic expenditure. What is the solution for the company As situation? Assumption: Spot: 16,480 16,496 3m Swap / Forward: 120 145

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OPTIONS
An option is simply an agreement between a holder (buyer) and a writer (seller) that gives the holder the right, but not the obligation, to buy or sell financial instruments at any time through a specified date. Although the holder is not obligated to buy or sell currency, the writer is obligated to fulfill a transaction. Having a throwaway feature, options are a unique type of financial contract in that you only use the contract if you want to. By contrast, forward contracts obligate a person to carry out a transaction at a specified price, even if the market has changed and the person would rather not .

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FOREIGN-CURRENCY OPTIONS
Foreign-currency options provide an options holder the right to buy or sell a fixed amount of foreign currency at a prearranged price, within a few days or a couple of years. The options holder can choose the exchange rate she wants to guarantee, as well as the length of the contract. Foreign-currency options have been used by companies seeking to hedge against exchange-rate risk as well as by speculators in foreign currencies.

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FOREIGN-CURRENCY OPTIONS

There are two types of foreign currency options. A call option gives the holder the right to buy foreign currency at a specified price, whereas a put option gives the holder the right to sell foreign currency at a specified price. The price at which the option can be exercised (that is, the price at which the foreign currency is bought or sold)is called the strike price. The holder of a foreign currency option has the right to exercise the contract but may choose not to do so if it turns out to be unprofitable. The writer of the options contract (for example, Bank of America, Citibank, Merrill Lynch International Bank) must deliver the foreign currency if called on by a call-holder or must buy foreign currency if it is put to them by a putholder. For this obligation, the writer of the options contract receives a premium, or fee (the option price).

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OPTIONS
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

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AMERICAN VS EUROPEAN OPTIONS

An American option can be exercised at any time during its life A European option can be exercised only at maturity

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OPTIONS VS FUTURES/FORWARDS
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

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