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UNDERSTANDING FOREX MARKETS

Basix Forex & Financial Solutions Pvt.Ltd.

Global Foreign Exchange Market

Facilitates Cross border trade in goods & services Financial & Investment flows Borrowing & Lending

Global Foreign Exchange Market

The largest market in the world

$3.2 trillion average daily turnover, equivalent to:

More than 10 times the average daily turnover of global equity markets More than 35 times the average daily turnover of the NYSE Nearly $500 a day for every man, woman, and child on earth An annual turnover more than 10 times world GDP The spot market accounts for just under one-third of daily turnover

Major Markets

The US & UK markets account for just over 50% of turnover Major markets: London, New York, Tokyo Trading activity is heaviest when major markets overlap Nearly two-thirds of NY activity occurs in the morning hours while European markets are open

Global Foreign Exchange Market

Round-the-clock market Three major time zones Sunday 5pm EST through Friday 4pm EST. Rollover at 5pm EST Trading begins in New Zealand, followed by Australia, Asia, the Middle East, Europe, and America Positions get passed from one time zone to another Major banks operate 24-hour desks

Overnight orders can be placed

Global Forex Market

Chicago 9:30p.m Los Angeles 7:30p.m London Zurich 3:30a.m 4:30a.m Dubai 7:30a.m Mumbai 9:00a.m

N.York 10:30p.m

Tokyo 12:30p.m Hong kong 11:30a.m

Singapore 11:30a.m

Sydney 1:30p.m
4:30a.m 6:30a.m 7:30a.m 12:30p.m 1:30p.m 6:00p.m 8:30p.m 9:30p.m

Global Foreign Exchange Market...

Other features

More than 90% of the turnover is speculative

Market lot $ 3 mn to $ 5 mn US $ predominant currency of trade (86% of total trade) Reuters, Bloomberg & EBS big facilitators Electronic market OTC market

Global Foreign Exchange Market

Players
Individuals Commercial banks Institutional players Pension Funds Insurance Cos. Trusts and postal savings Mutual Funds Hedge Funds Corporates Central banks Brokers

Indian Forex Market

Daily volume approximately $ 34 bn

Market lot $ 1.0 mio 9:00 a.m - 5:00 p.m market Main centres - Mumbai, Kolkata, Delhi, Chennai Real market only in USD/INR - other currency rates are

derived

Indian Forex Market.

Participants

Individuals Corporates and FIIs Banks and FIs RBI Brokers Forward market active upto 1 year Getting more integrated with money markets

Factors Affecting Exchange Rates

Economic
Growth prospects Current Account balance Investment outlook and

Technical Psychological / Sentiment /

Speculation
Random shocks (Gulf war/ U.K. ERM entry) Resource discoveries Exchange rate policy/Central bank intervention

reforms scenario
Inflation and Interest rates Budget deficit / surplus Political

Factors affecting Rupee exchange rates

Relative Inflation
Nominal Exchange rates of major trading partners and

competitors Budget Deficit Current Account Deficit Politics Ratings Investment outlook for India

Factors affecting Rupee exchange rates

Capital Flows
FDI/FII/NRI GDR/ECB Official Transactions
Reserves Herd Mentality - Leads & Lags Random Shocks - Unexpected Events (Pokhran/Kargil) RBI policy

Exchange Rate Quotations

Direct Q uote Variable Unit
Direct Quote USD/INR 48.75/76 USD/JPY 91.35/38 Buy Dollar at 48.75 and Sell Dollar at 48.76 Indirect Quote EUR/USD 1.4650/55

Indirect Q uote Foreign Currency

Home Currency

GBP/USD 1.6651/53
Sell Dollars 1.4650 against 1 euro Buy Dollars 1.4655 against 1 euro

Delivery - Value Dates

Cash/Ready Tom Spot Forward

- Settlement today - Settlement on the next working day - Settlement on the 2nd working day - Settlement any date beyond spot

Interest Parity Principle

Currency with lower interest rate will be at a premium Currency with higher interest rate will be at a discount

Forward rate is no indication of future spot rate

Purchase and Sale Transaction

Spot Dollar / Rupee : 48.75 48.76

From Bankers point of view

Purchase - Bank acquires foreign currency and parts with home currency at 48.75 Sale - Bank parts with foreign currency and acquires home currency at 48.76

Forward Contracts

Booking
Delivery Cancellation - Automatic cancellation Rollover Early Delivery

Exchange Control Aspects

Existence of a genuine underlying exposure No Doc proof required up to higher of last 3 years avg or last years imp/exp turnover Choice of currency & tenor left to customer Maturity of cover should not exceed maturity of transaction

No restrictions on rebooking cancelled contracts in respect of export and cross-currency exposures. No limit on rebooking cancelled contracts in respect of payable exposures falling due within one year. Contracts booked to cover exposures due beyond 1 year cant be rebooked after cancellation. Details in prescribed format to be submitted to Bank

Exchange Control Aspects

Transactions involving cross currencies remain out of the purview of

this rule The customer can be given the facility of booking a single forward contract for several orders provided that the receivables are in the same

currency and the likely cash flow period falls within the same contract
period Banks are allowed to permit substitution of export contracts if circumstances so warrant

Exporters are allowed to deliver exchange representing a portion of the

export value in part utilisation of the forward contract

Financial Derivatives

A derivative is like a razor. You can use it to shave yourself. Or you can use it to commit suicide. - James Morgan, Financial Times

Financial Derivatives

Derivatives are off balance sheet products that enable a

corporate to hedge risks arising out of its core business in terms of FX, interest rates or commodities

So called because their value is derived from basic products

like the forward exchange cover and dependent on underlying assets like bonds, stocks, and commodities

Types - Financial Derivatives

Firm Derivatives
Optional Derivatives

Firm Derivatives

Forward Rate Agreements

Interest Rate Swaps Currency Swaps Single Rate Forward Contract

Optional Derivatives

Currency Options
Caps & Floors Collars Options on FRAs Swaptions

Forward Rate Agreement

What are FRAs?

It is an agreement between two parties that determines the forward interest rate that will apply to an agreed notional principal (loan or deposit amount) for a specified period.
The Buyer ( or the Seller) of the FRA compensates the Seller (or the Buyer) any difference between the agreed rate and the cash rate prevailing on the start date of the specified period

Basic structure of an FRA

Fixing date
Deal date

Settlement date Period of depo

Maturity date

Interest taken from cash market

Features of a FRA

It is an off balance sheet transaction. Allows forward fixing of rates Transactions can be closed at any stage before expiry. Interest difference between the FRA rate and the cash rate is settled at the beginning of the agreed period. Can be tailor made to meet specific requirements. FRAs are used to eliminate interest rate risk A borrower buys the FRA while a lender sells the FRA.

Interest Rate Swaps

An Interest Rate Swap

is an off-balance sheet contract

between two counter parties to exchange a stream of payments (interest obligations) on specified dates based on a notional principal

Basic Characteristics - IRS

Contractual agreement Exchange a series of cash flows Over a period of time Not in itself either a borrowing or lending No exchange of principal

The size of the swap is referred to as the notional amount and is the basis for calculation

Interest Rate Swap

Fixed Borrower Floating Floating Lender

Swap C/P

Types of IRS
Standard Swap One side is Fixed stream of interest while the other side is Floating stream of interest linked to an index Fixed rate Bank Floating rate Basis Swap Both the streams of interest payments are linked to two different indices. Corporate

Bank
Floating rate

Corporate

Interest Rate Options

Interest Rate Cap Interest rate caps protect floating rate borrowers from upward movements in rates, as a maximum rate can be reserved by the buyer of the option Interest Rate Floor Interest rate floors protect floating rate lenders from downward movements in rates, as it guarantees a minimum rate Interest rate Collar A collar is a simultaneous purchase and sale of a cap and a floor. It can be a zero cost option by way of selling and buying the option

Currency Swaps

A Currency Swap

Is a legal agreement between two counterparties to exchange principals and interest obligations or receipts in two different currencies on specified dates over a specified period calculated on a notional principal

Exchange of principals is optional at the beginning but typically mandatory at the end.

Currency Swap transactions

Currency Swap could be any of the following between two currencies Fixed to Fixed Rate Fixed Rate to Floating Rate (and vice-versa) Floating rate to Floating Rate (based on different benchmarks) Basis Swap

Regulations

Approvals Internal approval (Board authorisation required) and adequate control systems should be in place Documentation ISDA (International Swap and Derivatives Dealers Association) Master Document supported by individual deal confirmations

Capital Adequacy
as per RBI guidelines

Corporates Existing Liability

Corporate's underlying borrowing

Currency Principal Amount Maturity Interest rate payable by the Corporate Interest payment dates Appetite for Exchange Risk

USD $ 10 mn 5 years bullet USD 6M LIBOR + X % p.a. Mar 15, Jun 15, Sept 15 and Dec 15 Low

Can enter into a Currency Swap or

Principal only swap or Coupon only Swap

Illustration - Currency Swap

On Start Date : Exchange flows @ Spot rate prevailing on swap date (39.50)
Pays $10 mn

Dollar Loan

Draw down of $10 mn

Corporate
Receives Rs 49.5 cr.

Swap Counterparty

Interest payment dates: Exchange interest flows @ Spot rate of the initial exchange (49.50)
Pays INR fixed (8%) 6m Libor + spread

Existing $ Loan

Corporate
Receives USD floating 6m Libor

Swap Counterparty

On Maturity : Exchange of Principals Mandatory @ Spot rate of the initial exchange (49.50)
Dollar Loan
Repays $10 mn Receives $10 mn

Corporate
Pays Rs 49.50 cr.

Swap Counterparty

Illustration Principal only Swap

On Start Date : Exchange flows @ Spot rate prevailing on swap date (49.50)
Existing $ Loan
Pays $10 mn Receives $10 mn

Corporate

Swap Counterparty

Receives Rs 49.50 cr.

Interest payment dates: No Exchange of interest flows

On Maturity : Exchange of Principals Mandatory @ Spot rate of the initial exchange (49.50)
Receives $10 mn Pays Rs 49.50 cr.

Existing
$ Loan
Pays $10 mn

Corporate

Swap Counterparty

Coupon only Swap

Coupon payments in one currency is swapped into fixed

or floating coupon payments in another currency To take advantage of views on interest and exchange rates of the two currencies Notional Principal Amount

No Exchange Risk on Principal

Illustration - Coupon only Swap

1yr IRS (4.24%)

Swap Counterparty
6m LIBOR

Corporate

Corporate has an existing loan benchmarked to 6m LIBOR for a tenure of say 1 year If corporate has a view Libor is set to increase, it can enter into a swap deal where by;
Corporate Corporate

receives floating- 6m Libor will pay fixed say the one-year IRS rate

Lender

CURRENCY OPTIONS

What is an Option?

Holder buys the right but not the obligation to buy or sell an agreed amount of an underlying currency / commodity at a predetermined price, over a specified time period.

Forward Contract vs Options

Forward Contracts
Fixes the rate irrevocably
Cannot take advantage of favorable movement

Options
Protects the downside

Can let the option lapse

& take advantage of spot rate

in the rate
No upfront costs

Premium payable
upfront

Option Terminologies

Call Option Gives the holder the right but not the obligation to BUY an underlying at a fixed price from the writer of the option Put Option

Gives the holder the right but not the obligation to SELL an underlying at a fixed price to the writer of the option

Risk / Profit Profile

Buyer Profit Unlimited

Seller Premium

Loss

Premium

Unlimited

Types of Option

American Option

May be exercised at any time during the life of a contract

European Option

May be exercised only at maturity or expiry date

Price of an option

Premium
It is the price of an option, paid by the buyer / holder to the writer / seller Usually paid upfront

Strike Price or Exercise Price

The fixed price at which the option holder has the right to

buy or sell the underlying currency.

Expiry Date

The last day on which the option may be exercised

Life or Exercise Period

The period of time during which the option holder enjoys the right to exercise under the option contract

In The Money

The option is In the Money when the Strike Price is favourable to the option holder in relation to the current market rate. Illustration: A USD Call option has a strike of 49.15. The current forward

market is 49.60
The option is said to be In-the-Money

Out of The Money

The option is Out of the Money when the Strike Price is

unfavourable to the option holder in relation to the current

market rate. Illustration:

A USD call option has a strike of 49. The current forward

market is 47.60. The option is said to be Out of the Money

At The Money

The option is At the Money when the Strike Price is equal

to the current market rate. Illustration: A USD call option has a strike of 49.60. The current forward market is 49.60. The option is said to be At the Money

Factors determining Premium Value

Strike Price Underlying Price Time to Expiry Interest Rate Volatility

:
Pricing Model

Premium

OTC and Exchange Traded Options

Over the Counter (OTC)

Options negotiated between writer and buyer, and traded bilaterally.

Exchange Traded
Standardized options traded on a Central Exchange, where the underlying is often a futures contract. These types of options have standard instrument/quality, expiry date and

contract amount.
They also have standard strike price intervals

Options available in the market

Plain Vanilla options Low cost options Zero Cost options Range Forward options Knock in /Knock out (Barrier) options Average rate options

Regulations

Currency Options can be used for genuine exposures or contingent exposures like tender bids The amount & maturity of an option hedge cannot exceed the amount & maturity of the underlying exposure Corporate cannot be a net receiver of premium Option deals can be freely booked and cancelled.

Documentation

Copy

of

Board

Resolution

authorizing

duly

approved

documented policy on currency risk management and specific personnel to enter into derivative transactions and authorizing signing of relevant documents ISDA Master Agreement (International Swap Dealers Association Master Agreement) Copy of underlying exposure Deal confirmation

Any Questions?

Presenter :

Mr. K. N. Dey
Director, Basix Forex & Financial Sol. Pvt. Ltd. kndey@basixfx.com