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