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Currency Markets Trading & Operations

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Chapter 1: Introduction
Any individual or a company, who needs to sell or buy foreign currency, does so through an authorized dealer. Currency trading is primarily conducted in the Over-The-Counter (OTC) market. Foreign exchange market is a 24 hour market. In terms of time zones, the first market to open is Sydney, then Tokyo, Singapore, Frankfurt, London and then New York. As New York shuts, Sydney opens.

Market Participants
Authorised dealers access the foreign exchange markets Corporates buy or sell, based on their requirements, through the authorised dealers Brokers intermediaries between the ADs and The Central Bank intervene to stabilize the market.

Foreign Exchange Fundamentals


Foreign exchange rates express the value of one currency in terms of another. They involve a fixed currency (base currency), which is the currency being priced, and a variable currency (quoted currency), the currency used to express the price of the fixed currency. The market always talks in terms of the base currency. Direct quotations use USD as the base currency (BC). Indirect quotations use USD as the quoting currency (QC).

Market Segments
The currency market has two distinct segments: The interbank market is a trade between two banks.

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The commercial market is a trade between a client and a bank.

Interbank quotes rates against the USD, while the commercial market asks for rates against the home currency. The fundamental value of the exchange rate is based on what is known as the Purchasing Power Parity (PPP) principle.

Balance of Payments (BOP)


BoP of a country as the term suggests is the statement of foreign currency receipts (inflows) and payments (outflows) of a country. BoP has two components: The Current account & The Capital account The current account is further subdivided into the trade account and the invisibles account. The capital account is divided into the investments and the loan account.

If we have a BoP deficit, that means we are net buyers of foreign currency to bridge the gap. Hence the home currency should weaken. The reverse is true if we have a surplus.

Chapter 2: Spot Market Arithmetic Part I


Exchange rates or currency markets are classified based on the settlement or value date of the transaction. Cash: Transactions that settle the same day. Tom: Transactions are those that settle the next business day. Spot: Transactions are those, that settle two business days from the date of the transaction. Forward: Transactions are those that settle beyond spot date.

Bid: It is the rate at which the quoting party is willing to buy the base currency, or sell the quoted currency.

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Offer (also called Ask): It is the rate at which the quoting party is willing to sell the base currency, or buy the quoted currency. Thumb rule: Asker buys BC RHS, Asker sells BC LHS A cross rate is a foreign exchange rate between two currencies, derived via a third currency i.e. the USD. Thumb Rule: If both rates are Direct or Indirect Divide, If one is direct and the other Indirect Multiply. Banks charge a margin for all customer transactions. The margin is always expressed and charged in terms of the quoted currency. Thumb rule: If the bank is giving the QC, subtract margin, If the bank is receiving the QC, add margin.

Chapter 3: Spot Market Arithmetic Part II Selecting the Bank OTC trades
Select the bank that gives the cheapest price from your perspective. This means you should always look for the highest bid rate and the lowest offer rate to transact. Trending involves quoting a price to achieve your objective. Hence, trend higher or lower if you wish to buy or sell the BC respectively. Trading position denotes the size of holding in the currency pair expressed in terms of BC. Calculated as, Total Purchases Total Sales, Irrespective of maturity.

Overall Position

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Determine the net open position in each currency (not currency pair). Some may be long positions, while others short positions List all overbought (long) positions separately in one line and convert them into their INR equivalents, using the market closing rate. Similarly, all oversold (short) positions in each currency are listed in another line and their INR equivalents are determined at the same market closing rate. Total each line. The greater of the local currency equivalent totals is taken as the Banks position and is reported in the local currency.

Valuation or MTM
Cost of Purchases Sales, after squaring your position. Expressed in the quoted currency. Stop Loss & Take profit are prices at which a trader books his losses or profits respectively. As a matter of discipline, a trader must always place a stop loss , when he/she initiates a position.

Chapter 4: Spot Markets: Pre-trade Analysis


The fundamental factors that affect currency markets can be classified into:

Macro-economic factors:
GDP Balance of Payments Inflation

Structural Factors
Foreign Exchange reserves composition Import elasticity Exchange rate competitiveness

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GDP
This is the primary indicator of economic growth. This gives a birds eye view of the economy and its performance. A good positive growth in GDP is an indicator of the health of the economy, and thereby the stability and strength of the currency.

BOP
This has three components: Trade gap (imports less exports) Current account balance (trade gap including invisibles) Capital flows A consistent BoP deficit implies, the country needs to buy foreign currency on a net basis. This will result in a weaker local currency.

Inflation
This gives signals for future interest rate actions. Higher inflation signals monetary tightening i.e. higher interest rates. Typically, you would like to buy a currency with a higher interest rate as it gives a higher yield. However, if inflation and interest rates become high enough to stunt economic growth, then the exchange rate may actually weaken eventually.

Foreign Exchange Reserves


Reserves refer to the amount of foreign currency that a country holds. The composition of the reserves is important (a higher percentage of short term obligations tends to make the economy more vulnerable to exchange rate volatility). Import elasticity A lot of economies including Indias are dependent on oil imports which are p retty inelastic. Volatility in oil prices brings a greater degree of uncertainty to economies dependent to a large extent on oil imports.

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Exchange rate competitiveness RBI looks at INR, not only against the USD but against a basket of currencies. This is measured in the form of REER the Real Effective Exchange Rate. REER of INR is measured against a basket of currencies. This is adjusted for inflation and is expressed in the form of an index.

Short Term Factors


Capital Flows Carry Trades Political Factors Comments by Key Personnel Central Bank Intervention Safe Haven status Technical Market Factors

Carry Trades
These are typically done on dollar-yen, to exploit the interest rate differential. Let us understand how this works. The traders borrow in yen (at zero interest rates), convert the yen into (universally accepted) dollars in the spot market and then invest the dollars in global equity markets to generate a return. Even though the borrowing cost is zero, traders run the exchange rate risk on dollaryen, as they will have to sell dollars and buy back the yen at a later date, to repay the borrowing.

Safe Haven
The term safe haven currencies comes from the flight of global money to quality/stable currencies in unstable times. In the currency markets, dollar (USD) and Swiss francs (CHF) are considered safehavens.

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Technical Analysis
This technique is essentially based on the fact that history tends to repeat itself. By looking at past data, one can forecast future exchange rates.

Economic Data
Economic data must be analysed in 3 ways: As compared with the prior period. As compared to the same period in the previous year. This will account for seasonality if any. Finally, and most importantly, you need to look at the data as compared to market expectations.

Unemployment data
This gives the percentage of workers unemployed. Another indicator of unemployment is the data on weekly jobless claims. This indicates the number of people claiming to be jobless, and is another key indicator of the health of the US economy.

Durable Goods
This indicates the growth of consumer durable goods sector. A strong growth is an indicator of the health of the economy.

ISM-PMI
This is the Purchasing Managers' Index (PMI). It is one of the leading indicators of manufacturing growth, and is published as an index. The data is compiled by the Institute for Supply Management (ISM). A reading above 50 is a sign of economic expansion and below 50 indicates contraction. PPI: The published number gives the inflation at the factory level. CPI: This gives the inflation at the individual level.

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Traders also look at core inflation, that is, excluding food and energy. This is because energy and food are demand inelastic.

Retail Sales
This denotes local demand growth. It actually shows what customers are doing on the ground.

IFO Germany
This survey throws light on the business sentiment in Germany.

Quarterly Tankan
It is a quarterly index of the growth of big, medium and small manufacturers and nonmanufacturers. It is a gauge of business sentiment in Japan.

Indian Rupee Market


The daily volumes in the market are estimated to be over USD 5 bio. The bid-offer spread normally ranges between 0.5 ps. 1.5 ps. Standard market lots in the interbank market vary from USD 0.5 mio to USD 5 mio.

Flows: Supply side


Growing FDI & FII inflows Corporates accessing External Currency Borrowings (ECB) and bringing them into India NRI inflows Exports

Flows: Demand side


Oil demand (hence imports) Foreign debt repayments Non-oil imports

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The rupee still remains a flow based business, and the player with the larger flows tends to have the bigger clout. Hence large players like SBI (State Bank of India) continue to singly move the market and have been nicknamed 'Daddy'.

Factors affecting the Rupee spot market


Month-end demand DTC (Diamond Trading Corporation) remittances FII flows

Chapter 5: Spot Markets Trading Process


In an OTC market, banks need to call each other for a two-way price and then transact. This can be either on telephone or through a trading system. The quoting bank will always quote a bid rate and an offer rate. To make things faster, the market quotes only the last two digits. For example; 25/30

Trading Systems
The Reuters trading system is the most popular in currency markets. It is very user friendly, as you can contact any bank across the globe with just four alphabets. In India, traders also use the order matching system called FX Clear, provided by Clearing Corporation India Ltd. (CCIL), for trading USD/INR. Banks put up bids and offers, and the system matches the orders on price and time priority basis. In case of deals through a broker, he combines the best bid and offer available with various banks and quotes you a price.

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Chapter 6: Forward Market Arithmetic Part I


A forward transaction is a contractual commitment to buy or sell a specified amount of foreign exchange for a specified price at a specified future date. The key is that the price is fixed today, but the exchange will take place at a future date. Forward rates can be higher or lower than the applicable spot rate. If the interest rate of the base currency is lower, the forward rate is higher. If the forward exchange rate is higher, the base currency is said to be at a PREMIUM. If the forward exchange rate is lower, the base currency is said to be at a DISCOUNT. Let us take an example: In USD/INR, the base currency is the USD. The USD interest rate, as you probably know, is lower than the INR. Hence, based on the earlier statements, we can conclude that: As the interest rate of the base currency is lower, the forward rate for USD/I NR will be higher than the spot rate. As the forward rate is higher, USD (base currency) is at a premium to INR or INR (quoted currency) is at a discount to USD. Forward rate can be computed as follows: S * (1+Rq* Tq)/ (1+Rb * Tb) Where, S = Spot rate Rb = Base currency interest rate for the tenor T Rq = Quoted currency interest rate for the tenor T Tb = Year fraction for the period from the spot date to the forward FX settlement date using the day count basis for Rb Tq = Year fraction for the period from the spot date to the forward FX settlement date using the day count basis for Rq

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Swap Market
A sub-product of the forwards market is the swap market. Swap in currency markets means, exchange of two currencies today (say 1st Jan) and their re-exchange at a later date (say 1stJuly). A swap is essentially a lending and borrowing transaction structured in the foreign exchange market. In a USD/INR swap, Party A lends USD and borrows INR with Party B on spot date (known as near leg in swap jargon). At a later date, say after 1 month (known as far leg in swap jargon), Party A receives the USD (with interest-say, 2%) and repays the INR (with interest-say, 6%) to Party B. The net exchange, called the swap rate, is the interest rate differential i.e. 4%.

In the currency markets, you cant lend or borrow currencies, so you sell (lend) and buy (borrow) to achieve the same objective. Thus, a swap is a simultaneous sale/purchase and purchase/sale of two currencies across two different value dates. An outright forward transaction is structured in the interbank market as follows: Outright forward = Spot + Swap To illustrate: The bank will first transact on spot what they want to actually do on the forward. i.e. customer buys forward, so the bank needs to buy forward to cover. The bank then first buys spot. Now in the swap market, the bank does a Sell spot Buy 6 months (sell-buy swap) in the interest rate market. The spot legs would cancel out and you will be left with a buy on the 6 month forward date.

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The reverse will be true, in case the customer sold forward. i.e. Bank will sell spot, and then do a Buy-sell swap. Hence, swaps can be a Sell-Buy or a Buy-Sell transaction these are the two possibilities The swap rate is called a swap premium or a swap discount, depending on the interest rates of the base and quoted currencies. We know that, if the interest rate of the base currency is higher, the forward rate is lower. The swap rate is then a discount. If the interest rate of the base currency is lower, the swap rate is a premium. Swaps do not create a position as the same amount of base currency is sold (bought) and bought (sold). Swaps only help correct mismatches.

Chapter 7: Forward Market Arithmetic Part II


In a swap, you are borrowing one currency and lending the other, so you either receive or pay the interest difference. The swap rate is therefore a function of the interest rate differential of the two currencies involved. Interest rate differential (%) is converted into an exchange rate differential (pips) in the currency markets by the formula shown below. Exchange Rate Differential = {(Spot Rate * Interest Rate Differential)/100} * {No. of months forward/12months} Trading Swaps: If you expect the interest rate differential to narrow, swap rates will fall, and viceversa.

Swap quote Bid/Offer


As a Quoter you always sell/buy on LHS and buy/sell on RHS, irrespective of whether it is a premium or discount. Whether you will pay or receive depends on the interest rates of the two currencies involved. If you are lending a low interest currency (USD) and borrowing a high interest rate currency (INR), you pay.

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Premium/Discount
In the swap price quoted if, LHS<RHS Premium, LHS>RHS Discount Swap points quote with the same number of decimal places as the corresponding spot rate. A swap has two value dates, the first is called the near date and the second is called the far date A company may have a receivable or payable in a currency other than the USD. In that case, the ban will have to compute the cross rate. The cross rate is computed at the last step i.e., after the respective outright forward rates are computed against the USD.

Chapter 8: The Indian Swap Market


The market quotes calendar months unlike rolling months in the overseas markets. The Indian swap market quotes actively only upto tenors of 1 year. The bid/offer spread ranges from 1 to 2 paisa; in a volatile market, this can go up to 20 paisa. Standard market lots vary from USD 0.5 million to USD 5 million. The daily volumes are estimated to be over USD 5 billion.

Market Factors
Holiday time Dec 20-Jan 7 Markets tend to get illiquid. Yield curve play short term covers v/s long term covers Month-end Rollovers Corporates book forward contracts for month-end and then roll them on a monthly basis. 31st March Lenders stay away due to capital adequacy reasons. Hence call rates go up and so does the cash-tom premium in the FX market.

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Customer Transactions
Early delivery: This occurs when an importer has received the shipment early, and wishes to make an early payment. He may be getting a discount from his supplier for early payment. FII hedging: Some FIIs may tend to hedge their equity investments in India. FCNR conversions: NRIs deposit foreign currency in India through FCNR deposits. Banks in turn convert them into INR and on lend them to make money. The risk of conversion is borne by the bank.

Non Deliverable Forwards (NDFs)


NDFs are foreign exchange forward products traded over the counter. NDFs are distinct from deliverable forwards in that NDFs trade outside the direct jurisdiction of the authorities of the corresponding currencies and their pricing need not be constrained by domestic interest rates. The NDF market is a pure expectation of spot and has nothing to do with interest rates. This is because there is no delivery of the USD or INR between the buyer and seller - i.e., no lending or borrowing.

Chapter 9: Post Trade Risk Management


Risk management involves imposing various trading limits and taking suitable action when these limits are exceeded. Limits can be classified based on the nature of risk that they are addressing. Currency traders will have market risk limits and credit risk limits.

Market Risk Limits


Position Limits: This denotes the size of your position in each currency pair whether long or short.

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Gap Limits: These are limits imposed on every forward tenor in which you hold a position. Loss Limits: These relate to the loss that you can incur in a specific period a single day, a month etc.

Credit Risk Limits


Pre-Settlement Risk (PSR) : Pre-settlement Risk (PSR) is the risk that a counterparty may default on a contractual obligation before the actual settlement date of the contract. PSR = CMTM + MLIV MLIV = FS (Contract Tenor) Amount, where FS is the daily standard deviation of the exchange rate. Settlement Risk (SR): Settlement Risk is the risk that a counterparty may default on settlement date. The bank is then exposed to direct credit risk of 100% of the principal amount. Settlement risk in India has now been largely minimized through various mechanisms.USD/INR spot and forwards transactions are being guaranteed by the Clearing Corporation of India Ltd (CCIL) through a settlement guarantee fund provided by the counterparties. CCIL also settles CLS trades for its members by becoming a third party settlement agency to ABN AMRO which is a settlement bank for CLS. CLS Bank, a new financial institution, was set up to reduce the risk involved in settling foreign exchange transactions. Using this set up, the two legs of a transaction are settled simultaneously, and in such a way that one cannot occur without the other.

Back office - Settlement


Settlement of a foreign exchange transaction requires two transfers of money value, in opposite directions, since it involves the exchange of one national currency for another.

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The deal capture system then validates that all necessary components of a trade are present, before assigning a Trade Reference number (TR No.) to the trade. Subsequent trade amendment/cancellation relies upon correct identification of the trade via its reference number. The successful capture of a trade should result in the trade details being sent to the back office immediately for operational processing. The next step is the verification of the trade with the contract slip. This is done by the back office. In case of errors, the deal is sent back to the front office for rectification. Once the deal is validated (i.e. trade details verified against the contract slip), it is forwarded to CCIL for settlement. Traditionally, counterparties exchanged deal confirmations. With the CCIL and CLS mechanisms in place, counterparties do not need to exchange confirmations any more. The local payment mechanism in each country effects the final settlement. For example in case of transaction of USD/INR the rupee leg is settled through the members settlement accounts with RBI and the USD leg through CCILs account with the settlement bank at New York. Cross currency deals such as GBP/USD, USD/JPY etc. are settled through the CLS mechanism as explained earlier. The most common interbank global messaging system is SWIFT (Society for Worldwide Interbank Financial Telecommunications).

Back office Other functions


Position & Valuation Regulatory Reporting Nostro reconciliation

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Chapter 10: Currency Futures


They are absolutely similar to forward contracts except that Currency Futures are traded on exchanges like NSE, and not OTC. They are available for standard amounts and standard maturity dates. Participants have to put up an upfront margin (like a security deposit) for dealing in futures. Futures contracts have no delivery. The profit or loss on the contract is cash settled. These are more for retail players who want to speculate, or for really small businesses that deal in very small quantities, and are looking for transparency in their pricing. Remember, like stocks, you need to transact through a member of the exchange a broker, and pay the commission.

Margins:
The exchange imposes an initial margin. This is a percentage of the transacted amount. The exchange also charges an extreme loss margin. This is calculated as 1% of the MTM value of your open positions (for USD/INR pair). This has to be deposited at the end of every trading day. The daily MTM profit/loss is paid through the broker to the clearing house (CH). This is called daily settlement. On maturity, there will also be a final settlement.

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Derivatives A Brief Overview


Chapter 1: Building Blocks
Derivative products are of three types.

1. Credit extension
Credit extension products are forms of extending credit or loans. Credit extension products differ from each other in how they pay interest (Fixed or floating) and how the principal is repaid (Bullet or Amortising). Credit extension products usually appear on the balance sheet of the firm as a real asset or liability.

2. Price Fixing products


Price fixing products are financial products that fix the price at which exchange of value takes place at a future date. There are three main types of price fixing products: Forward contracts, Futures contracts & Swaps. The value of a price fixing product is simply a function of the current price for the same cash flow exchange, in relation to the price fixed in the contract. The P/L equation for a forward contract is: P/L = (Market Price Fwd Contract Price) x Amount Purchased Price fixing products create a two-way obligation. Price fixing products do not appear on the balance sheet as real assets or liabilities, but appear in the notes, as contingent items.

3. Price Insurance products


Price insurance products give the owner the right, but not the obligation, to exchange value at a future date, at a pre-determined price today. Price Insurance products are one-sided obligations. The credit risk is run by the buyer and the market risk by the seller.

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Hybrid products
An example is a Convertible bond a bond that can be converted into equity shares. This will fall under Credit extension plus Price Insurance.

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