You are on page 1of 18

Currency Markets Trading & Operations

A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

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.
Currency 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

Corporates

Brokers

The Central Bank

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).
Exchange rates are normally expressed upto four decimal places. The last decimal place in the
rate is known as a pip. The first two numbers after the decimal are called the big figures
and the number before the decimal is called the super big figure.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Market Segments
The currency market has two distinct segments:

The interbank market is a trade between two banks.

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
local currency.
The fundamental value of the exchange rate is based on what is known as the Purchasing
Power Parity (PPP) principle.
The implied PPP rate is based on the price of the Big Mac in the US vis--vis the other country.
If the actual exchange rate is lower that the implied PPP rate, the Big Mac theory suggests that
the value of the currency might go up until it reaches the implied PPP rate.

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.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

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.

The party who quotes the price is called the quoting party or the Quoter.
The party who is calling or asking for the price is called the Asker.
Bid: It is the rate at which the quoting party is willing to buy the base currency, or sell the
quoted currency.
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: Quoter buys BC LHS (Bid Rate), Quoter sells BC RHS (Offer Rate)
Asker buys BC RHS (Offer Rate), Asker sells BC LHS (Bid Rate)
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 both are Indirect Divide, If one is direct and the
other Indirect Multiply.

Margins
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.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

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

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
The procedure of calculating gains or losses for the day is called Valuation or marking to
market. It is calculated as,
Cost of Purchases Sales, after squaring your position. Expressed in the quoted currency.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Stop Loss & Take Profit


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

Short Term Factors


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

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.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Economic Data
Economic data must be analyzed 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.

US Economic Data
Unemployment data
This gives the percentage of workers unemployed. Another indicator of unemployment is the
data on weekly jobless claims. These two are key indicators 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. The equivalent data in India is the Index of Industrial
Production (IIP).

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

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

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

Monetary Policy Meeting


Any FOMC action on interest rates affects the US dollar. Any rise in interest rates,
indicating an economic pick up, would typically result in a stronger dollar.

Short- Term Factors


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


Features

The daily volumes in the market are estimated to be over USD 20 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

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Non-oil imports

Factors affecting the Rupee spot market

Month-end demand

Oil demand

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.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Trading Vocabulary

Asking Etiquette

When asking for a price, to specify whether buying or selling when not a market lot.

Never refuse a choice price.

Whenever quoter narrows spread, courtesy dictates you must accept the offer.

Conventions

If you wish to buy/ sell x currency of value y mio you ask x y mio pls

The quoter then quotes the bid- ask rate, say 1.3590/00

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

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.

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

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 1st
July).
A swap is essentially a lending and borrowing transaction structured in the foreign exchange
market.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

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
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}

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Trading Swaps: If you expect the interest rate differential to narrow, swap rates will fall, and
vice versa.

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.

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.
The sides you take on the spot take the same side on the swap.
If it is a premium, then add to arrive at the forward rate.
If it is a discount - subtract to arrive at the forward rate.
Forward Rate for Cross Rates
A company may have a receivable or payable in a currency other than the USD. In that case,
the bank 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.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

The daily volumes are estimated to be over USD 25 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.

Customer Transactions

Nature of Transactions: Early Delivery, Rollovers or extension of a forward contract,


Booking/Cancellation of a forward contract

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.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Chapter 9: Post Trade


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


Credit risk is the risk of default by counterparty.
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
CMTM = This is the current cost to replace the defaulted contract in the market (called Current
Mark to Market - CMTM).
MLIV = FS (Contract Tenor) Amount, where FS is the daily standard deviation of the
exchange rate. It is the possible increase in the replacement cost due to future market volatility
(Maximum Likely Increase in Value - MLIV).
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.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
RBS which is a settlement bank for CLS.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Continuous Linked Settlement - 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.

Front office inputs trade

Assigning a trade reference number

Front office authorizes the deal

Send trade details to the back office

Verify the trade with contract slip

Forward to CCIL for settlement

Deals are matched within the CCIL system

Contracts between counterparties are substituted with contracts between each member
and CCIL

CCIL generates reports on the net settlement obligation due to, or from, the various
members.

CCIL settles deals on a DNS basis.

The local payment mechanism in each country effects the final settlement.
Cross currency deals such as GBP/USD, USD/JPY etc. are settled through the CLS mechanism .
The most common interbank global messaging system is SWIFT (Society for Worldwide
Interbank Financial Telecommunications).

Back office Other functions

Position & Valuation

Regulatory Reporting

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Nostro reconciliation

Chapter 10: Currency Futures


The Forwards Market
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.

Currency Futures
They are absolutely similar to forward contracts except that Currency Futures are traded on
exchanges like NSE, and not OTC.

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.
Futures - Settlement
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.

Derivatives A Brief Overview


Chapter 1: Derivatives Introduction
Derivatives are used to hedge or minimize risk and not to assume risk.
Financial Derivative- It is a financial instrument that derives its value from the value of
some more basic underlying instrument or variable. The underlying may be an equity share,
a barrel of crude oil, a foreign exchange rate, a bond, all of these, or another derivative!

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Uses of derivatives

Derivatives help alter risk

Derivatives reduce Transaction Costs

Derivatives reduce cost of financial distress and increase the debt capacity of the firm.

Chapter 2: 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 in the future. They are also known as options.
Options are of two types

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

Currency Markets Trading & Operations


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Call- It gives the owner the right to buy the underlying at a pre-determined price in
the future.

Put It gives the owner the right to sell the underlying at a pre-determined price in
the future.

Price Insurance products are one-sided obligations. The credit risk is run by the buyer and the
market risk by the seller.

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.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2014. Proprietary content. Please do not misuse!

You might also like