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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.
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
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Market Segments
The currency market has two distinct segments:
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.
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.
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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.
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.
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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.
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Macro-economic factors:
GDP
Balance of Payments
Inflation
Structural Factors
Foreign Exchange reserves composition
Import elasticity
Exchange rate competitiveness
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.
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Economic Data
Economic data must be analyzed in 3 ways:
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.
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Retail Sales
This denotes local demand growth. It actually shows what customers are doing on the ground.
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.
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.
Corporates accessing External Currency Borrowings (ECB) and bringing them into India
NRI inflows
Exports
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Non-oil imports
Month-end demand
Oil demand
FII flows
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.
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Trading Vocabulary
Asking Etiquette
When asking for a price, to specify whether buying or selling when not a market lot.
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
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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.
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.
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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.
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Trading Swaps: If you expect the interest rate differential to narrow, swap rates will fall, and
vice versa.
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.
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.
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Market Factors
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
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.
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.
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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.
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.
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).
Regulatory Reporting
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Nostro reconciliation
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.
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Uses of derivatives
Derivatives reduce cost of financial distress and increase the debt capacity of the firm.
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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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.
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