You are on page 1of 40

Foreign Exchange

Definition
Foreign Exchange is simultaneously buying of one currency and selling of another currency at agreed price.

The fist currency in the pair is referred to as the base currency or commodity currency and the second currency is the quote currency or term currency.

FX Trading : Why? Where? How?


Trade and Investment needs
Travelling abroad Imports from abroad Exports to abroad Borrowing from abroad Investments from abroad Repayment of Principal loan + Interest

Speculation Hedging Where does trading take place?


Foreign Exchange is traded over-the-counter (OTC), operating worldwide, 24 hours a day. Trading tends to occur in a center during its normal working hours.

Main methods of trading


Direct Inter-bank trading Voice brokers Electronic trading systems

Players in the FX Market


Banks Corporates Govt Individuals Central Banks

Factors Impacting FX Rates


Demand Supply Political Situations Rating of a Country Countrys economic factors like fiscal deficit, monetary policy, inflation and capital inflow/outflow War / natural calamities in and around the country

Exchange Rates
The first currency quoted in a currency pair is the Base/ Commodity currency and the second currency is the Term/Quote currency.
USD/INR = 59.455

Buy and Sell rates quoted simultaneously


USD/INR quoted as 59.455/59.488 The dealer, giving the quote will buy(bid) or sell(ask) 1 USD in exchange for INR 59.455 and INR 59.480 respectively.

1 USD = INR 59.455 (Buy ) /INR 59.480 (Sell) B id/Offer--Yours/Mine Spread


The difference between the bid and the ask price is referred as the spread. Spread is measured in pips. The last two digits are referred to as pips. Eg : 25 pips

Quotes
Direct Quotes
One unit of foreign currency equals to X units of domestic currency. Eg: 1 USD = 59.60 INR

Indirect Quotes
One unit of domestic currency equals to X units of foreign currency. Eg: 1 INR = 0.01677 USD

Cross rates
Cross rate is rate of exchange calculated by comparing two different currencies with the same third currency. Computing EUR/INR USD/INR = 59.60 EUR/USD=1.30

EUR/INR = USD/INR * EUR/USD = 59.60 *1.30 = 77.48

FX Deal - Parameters
Trade date Type of Deal(Spot, Forward, Swap..etc) Deal direction(Buy/Sell) Counterparty Book Currencies Exchange Rate Amounts Value Date Payment Instructions(PAY/REC)

Trade Life Cycle


Foreign Exchange is simultaneously buying of one currency and selling of another currency at agreed price.

The fist currency in the pair is referred to as the base currency or commodity currency and the second currency is the quote currency or term currency.

FO/MO/BO
Front Office
The front office is responsible for trade capture and execution. This is where the trade originates and the client relationship is maintained. The front office makes/takes orders and executions. Traders and sales staff are considered front office staff.

Middle Office
The middle office, as the name implies, is a hybrid function between the front and back office. The middle office handles validations (of stock orders), bookings (orders) and confirmations. Technically, these are all back office operations, however, they often require the help of front office staff to resolve.

Back Office
The back office exists for three reasons: clearance, settlements and accounting. These three function interact directly with external agencies like the custodian (actual holder of the security), the clearing firm (third party) and a commercial bank. The back office maintains external relationships and control functions and is where the trade ends.

Functions - FO/MO/BO
Front Office Middle Office
Order Management System
Order Routing
Workflow

Back Office

Compliance
Auditing

Calculation set-up (taxes, fees)

Clearing & Settlement

Trade Blotter

Reporting

Custodial Record Keeping Analytics Portfolio / Modeling

Risk Analytics

Portfolio Accounting Corporate Actions

Portfolio Optimization Exception Handling Performance Attribution

General Ledger

Reporting - Print, Web, statements

Reconciliation

Reconciliation Market Data Integration & Mgmt

Client Contact Mgmt

Client Billing Data Warehouse

FX Screen in Calypso

Type of FX Trades
FX Cash
Cash Spot

FX Derivatives
Forward Future Swap NDF Options Exotic Options
Asian Digital Barrier

Cash and Spot Trades


Cash
Cash transactions use cash rate and have the value date same as the transaction date. This is different from Spot transaction since in spot transaction settlement happens after two business day i.e T+2.

Spot
A FX spot trade, is an agreement between two parties to buy one currency against selling another currency at the current exchange rate for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate. The standard settlement timeframe for foreign exchange spot transactions is T + 2 days; i.e., two business days from the trade date Except for USD/CAD currency pair, which settles at T + 1.

Forward Trade
A FX Forward contract is a contract to exchange a predetermined amount of one currency for another at a certain price on a specified date in the future. Forward Rate
Forward rates are implied by the spot rate and interest rates for the two currencies. Forward FX Rate = Spot Rate *(( 1+TCIR*Days/360)/(1+CCIR*Days/360)) TCIR = Term currency Interest Rate CCIR = Commodity Currency Interest Rate Days = Actual number of days in period from the spot value date to forward value date.

Premium
The spot rate is less than the forward rate.
Currency Pair Spot rate 1-month forward rate 3-month forward rate 6-month forward rate

USD/INR

59.60

59.75

59.80

60.00

Forward Trade
Discount
The Spot rate is greater than Forward rate Currency Pair Spot rate 1-month forward rate 3-month forward rate 6-month forward rate

USD/INR

59.60

59.55

59.40

59.00

Future Trade
A future trade, like a forward, is an agreement between a buyer and a seller to trade a currency at a certain price on a specified date in the future. Futures are exchange traded trades. Future positions require a margin deposit to be posted and maintained daily.

FX Swap
FX Swap is the simultaneous purchase and sale of one currency for another currency with two different value dates. FX Swap transaction can be made of spot-forward. The value date of the buy and sell leg should be different. On 8th July 2013 at 10:00 AM Bank of New York acting as a dealer purchase spot GBP 10 million at GBP/USD =1.5169, at 10:05 Bank of New York sells 3-month forward GBP 10 million at GBP/USD =1.5170 and squares off its exchange position.
The difference between the spot and the forward rate reflects the interest rate differentials between the two currencies.

FX NDF(Non Deliverable Forward)


FX NDF is essentially an out- right forward contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. No principal amount is exchanged and no upfront fee. No physical delivery of the local currency. Non-deliverable forwards (NDF) are used when there are limitations for the delivery of the underlying currency, and this usually happens to countries which are having currency control policies. When counterparties enter into an NDF, nominate the amount of the transaction (the notional principal amount) and the two currencies involved (the settlement currency and the non-deliverable currency). These currencies are known as the currency pair. The notional principal amount will be denominated in units of the non-deliverable currency.

FX NDF Example
Company XYZ imports from China and is concerned about the effects a potential upward revaluation of the Chinese yuan may have on its import costs. To protect itself, XYZ enters into an NDF contract as per the following terms: Company XYZ buys CNY NDF
Amount: CNY 2,030,500 Rate: USD/CNY = 8.1220 USD Amount: USD 250,000 Maturity: 6-months

Scenario 1: CNY has appreciated vs. the NDF contract rate. Fixing rate = CNY 8.00 XYZ receives USD 3,812.50 (CNY 2,030,500/8.00 = USD 253,812.50 - USD 250,000). XYZ is protected at the NDF contract rate of 8.1220 and receives a compensating USD payment between the fixing rate at maturity and the NDF contract rate.

FX NDF Example
Scenario 2: CNY has weakened vs. the NDF contract rate. Fixing rate = CNY 8.25 XYZ pays USD 3,878.79 (CNY 2,030,500/8.25 = USD 246,121.21 - USD 250,000). XYZ is fixed at the NDF contract rate and makes a compensating payment equivalent to the difference between the fixing rate and the NDF contract

FX NDF Example

FX NDF Example
A customer entered a short position on USD/CNY NDF contract to hedge against payments to a supplier in CNY. Tenor: 6 months NDF rate (SF) USD/CNY= 7.0750 Notional amount: USD 100,000
Scenario at maturity Scenario 1 Fixing rate (SR) is 6.9500, lower than NDF rate (SF) Total return The customer receives from the bank Notional amount x (SR SF) / SR USD 100,000 x (6.9500 7.0750) / 6.9500 = USD 1,798.56 The customer need to pay the bank Notional amount x (SF SR) / SR USD 100,000 x (7.0750 7.2000) / 7.2000 = USD 1,736.11

Scenario 2 Fixing rate (SR) is 7.2000, higher than NDF rate (SF)

FX NDF Currency List


Argentina (ARS) Brazil (BRL) Chile (CLP) China (CNY) Colombia (COP) India (INR) Peru (PEN) Philippines (PHP) Korea (KRW) Taiwan (TWD) Venezuela (VEB)

FX Options
An Option is a contract which gives the buyer the right (but not the obligation) to buy or sell an underlying asset at a specified price or agreed price on or before a specified date. On the other hand the seller is underlying obligation to perform the contract (buy or sell the underlying).

Option Terminology
Option Holder
Option Writer
Buyer of the option
Seller of the option Can represent Stocks, Bonds, FX, Interest rate, Commodities etc. Price at which the underlying asset can be bought or sold

Underlying asset
Exercise Price (Strike Price)

Option Premium
Expiration date

Price of the option. Paid upfront by the buyer of the option to the seller of the option
Maturity date of the option.

Types of Options
Call Option
Call option is a contract which gives buyer the right but not the obligation to buy an underlying asset at an agreed price on or before a specific date

Put Option
Put option is a contract which gives buyer the right but not the obligation to sell an underlying asset at an agreed price on or before a specific date

Types of Options
Call Option In the money Strike price < Market price Put Option Strike price > Market price

Out of the money

Strike price > Market price

Strike price < Market price

At the money

Strike price = Market price

Strike price = Market price

Option Styles
American Option
American Option can be exercised at any time before the expiry date.

European Option
European Option can be exercised on the expiry date only.

FX Option Example
USD CALL / JPY PUT Strike 120 JPY / USD Amount USD = 10.000.000,Premium .37 % Of The USD Amt ( i.e. USD = 37,000 )

At Expiry... 3:00 p.m. Tokyo Time, 1 month from today: Spot JPY/ USD Action Option expires without value Option expires without value Option will be exercised ( Value Date = Spot Date )

< 120.00 = 120.00 > 120.00

At-expiry P&L Diagram


> 120 = 120 < 120 Option will be exercised Option expires without value Option expires out of the money

P&L
B/e point

Option has intrinsic value, i.e in the money, above 120. Hence, P & L increases if spot is further away from 120 at expiry.

USDJPY
P& L is limited to initial premium

Spot at expiry

Bought USD Call JPY Put

120

The Four Elementary Strategies: P/L @ Expiry


Break Even Rate Break Even Rate

Long Call
STRIKE Break Even Rate STRIKE Break Even Rate

Long Put

Short Call
STRIKE STRIKE

Short Put

Option Summary
CALL OPTION HOLDER (BUYER) Pays premium Right to exercise and buy the underlying asset Profits from rising prices Limited losses, Potentially unlimited gain PUT OPTION HOLDER (BUYER) Pays premium Right to exercise and sell the underlying asset Profits from falling prices Limited losses, Potentially unlimited gain CALL OPTION WRITER (SELLER) Receives premium Obligation to sell the underlying asset if exercised Profits from falling prices or remaining neutral Potentially unlimited losses, limited gain PUT OPTION WRITER (SELLER) Receives premium Obligation to buy the underlying asset if exercised Profits from rising prices or remaining neutral Potentially unlimited losses, limited gain

Intrinsic value
Intrinsic Value
The value of the difference between Strike Price and Market Price is called Intrinsic value. Intrinsic value is either zero or positive. Intrinsic value is positive then the amount by which it is In-the-money When the option is either out-of-the-money or at-the-money the intrinsic value is zero.

Intrinsic Value of a USD CALL option...


Strike
105.00 105.00 105.00 105.00 105.00

Outright Intrinsic
110.00 107.50 105.00 102.50 100.00 5.00 2.50 0.00 0.00 0.00

Option is
In The Money In The Money At The Money Out Of Money Out Of Money
no inbuilt profit

For the first example: We can buy at 105 with our option, sell at the market at 110, and lock in 5 points of profit. Any option that has intrinsic value is said to be in the money. Any option that has same strike as market, is at the money. Any option that has no intrinsic value, is out of the money (So, no in-built profit) All inter-bank trades involve OTM options as option traders are primarily

Intrinsic Value of a USD PUT option...


Strike Outright Intrinsic Option is
In The Money In The Money At The Money Out Of Money Out Of Money

105.00
105.00

100.00
102.50

5.00
2.50

105.00
105.00 105.00

105.00
107.50 110.00

0.00
0.00 0.00

Option Pricing - The Model


Spot Price Interest Rates Strike Price

Theoretical Pricing Formula

Theoretical Value

Time To Expiration

Volatility

In reality, we use a model to calculate our option pricing. The five main inputs to the model are: spot, interest rates of both currencies, strike price, tenor of the option and implied volatility that comes from the described option Option Theory Pricing

Exotic Options
Barrier Option
Barrier Option is a path dependent option that has two features 1) Knock-In 2) Knock-Out 1. Knock-In Knock-In means the option will only become alive when spot reaches a barrier level. If the Knock-In level is not reached before the option matures the option will not exist.

E.g: Call USD/JPY Strike =106, Spot=109, barrier level =111.0


2. Knock-Out A Knock-Out means the option will cease to exist when spot reaches a barrier level. 3. Digital Option Digital Option the payout is pre-determined at the beginning of the contract, and is paid according to whether the spot touches or doesnt touch the trigger level.

Exotic Options
Asian Option
An Asian option (also called average option) is an option whose payoff is linked to the average value of the underlier on a specific set of dates during the life of the option.

Thank You