Foreign Exchange & Currency Derivatives.pptx

Foreign Exchange
• The trading of one currency for another or system of converting
one national currency into another (Rupee for Dollar)
• An exchange rate is the price of a currency (value of one
currency relative to the other)
• It is essential for the trading between nations
• For Example: how many Indian rupees does it take to buy one
US dollar?
• If the exchange rate is 71, it means Rs. 71 are needed to buy 1
USD

Foreign Exchange Market
• A market in which National currencies are bought and sold
against one another
• Foreign Exchange Market is a global network of banks, brokers
and foreign exchange dealers connected by electronic
communications system.
• It functions 24 hours of the day (different time zones of the
globe)
• Currencies are important to most people around the world,
whether they realize it or not, because currencies need to be
exchanged in order to conduct foreign trade and business
• Need to exchange currencies is the primary reason why the
forex market is the largest, most liquid financial market in the
world

Functions of Foreign Exchange
Market

Market
• Transfer Function: The basic and the most visible function of
foreign exchange market is the transfer of funds (foreign
currency) from one country to another for the settlement of
payments. It basically includes the conversion of one currency
to another
• Credit Function: Provides a short-term credit to the importers
so as to facilitate the smooth flow of goods and services from
country to country. An importer can use credit to finance the
foreign purchases. Such as an Indian company wants to
purchase the machinery from the USA, can pay for the purchase
by issuing a bill of exchange in the foreign exchange market,
essentially with a three-month maturity

Market
• Hedging Function: The third function of a foreign exchange
market is to hedge foreign exchange risks. The parties to the
foreign exchange are often afraid of the fluctuations in the
exchange rates, i.e., the price of one currency in terms of
another. The change in the exchange rate may result in a gain or
loss to the party concerned

What Exactly is Hedging?
• Hedging is measure usually taken by a firm or individual as a
cover against future potential adverse events
• It is like an insurance against economic or financial risk that may
occur in future
• Currency hedging is the one where an entity or person dealing
with foreign currencies takes safe measures against exchange
rate fluctuations.
• Currency hedging is covering the foreign exchange risk.

Example of Hedging
• Imagine that an Indian exporter has made export worth $1000.
If the prevailing exchange rate is 1$ = Rs 60, he can get Rs 60000
at the said date suppose after three months
• Now, if the rupee appreciates to 1$=50, he can get only Rs
50000. Here, he may have incurred some losses because of the
exchange rate fluctuations
• To overcome the situation, the exporter can hedge his position
by signing a contract with financial institutions providing
hedging services
• The exporter can convert his export earnings at the current
exchange rate (1$ = Rs 60) even if the rupee appreciates at the
time of reimbursement of his export earrings

Some of the Factors Affecting
Exchange Rates
• Increases in interest rates cause a country's currency to
appreciate because higher interest rates provide higher rates to
lenders, thereby attracting more foreign capital, which causes a
rise in exchange rates
• A country with a consistently lower inflation rate exhibits a
rising currency value while a country with higher inflation
typically sees depreciation in its currency
• A country with less risk for political turmoil is more attractive to
foreign investors. Increase in foreign capital, in turn, leads to an
appreciation in the value of its domestic currency

Spot Market and the Forwards
and Futures Markets
• There are actually three ways that institutions, corporations and
individuals trade forex:
The spot market
The forwards market
The futures market
• The forex trading in the spot market always has been the largest
market because it is the "underlying" real asset that the
forwards and futures markets are based on
• The forwards and futures markets tend to be more popular with
companies that need to hedge their foreign exchange risks out
to a specific date in the future

Spot Market
• The spot market is where currencies are bought and sold
according to the current price
• When a deal is finalized, this is known as a "spot deal“
• After a position is closed, the settlement is in cash
• Although the spot market is commonly known as one that deals
with transactions in the present (rather than the future), these
trades actually take two days for settlement

Forward & Future Markets
• Unlike the spot market, the forwards and futures markets do not trade actual
currencies. Instead they deal in contracts that represent claims to a certain
currency type, a specific price per unit and a future date for settlement
• In the forwards market, contracts are bought and sold OTC between two
parties, who determine the terms of the agreement between themselves
• In the futures market, futures contracts are bought and sold based upon a
standard size and settlement date; a futures contract is traded on an exchange
and is settled on a daily basis until the end of the contract
• Futures contracts have specific details, including the number of units being
traded, delivery and settlement dates, and minimum price increments that
cannot be customized. The exchange acts as a counterpart to the trader,
providing clearance and settlement
• Both types of contracts are binding and are typically settled for cash for the
exchange in question upon expiry, although contracts can also be bought and
sold before they expire
• The forwards and futures markets can offer protection against risk when
trading currencies
• Usually, big international corporations use these markets in order to hedge
against future exchange rate fluctuations, but speculators take part in these
markets as well

How to Read a Quote?
• When a currency is quoted, it is done in relation to another currency, so that
the value of one is reflected through the value of another.
• Main methods of making FX quotations are:
USD:JPY = 119.50
USD/JPY = 119.50
¥119.5/USD
The above quotations means the same thing
• The base currency (in this case, the U.S. dollar) is always equal to one unit (in
this case, US$1), and the quoted currency (in this case, the Japanese yen) is
what that one base unit is equivalent to in the other currency
• The quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can
buy 119.50 Japanese yen.
• The currency quoted as 1 unit is the base currency vs N units of counter
currency

Direct vs. Indirect Currency
Quote
• A direct currency quote is simply a currency pair in
which the domestic currency is the quoted currency
• An indirect quote, is a currency pair where the
domestic currency is the base currency
• Example: If you were looking at the Canadian dollar
as the domestic currency and U.S. dollar as the
foreign currency, a direct quote would be:
USD:CAD = 1.20
• Indirect Quote for the above example
would be:
CAD:USD = 0.83

Bid and Ask
• As with most trading in the financial markets,
when you are trading a currency pair there is a bid
price (buy) and an ask price (sell).
• These are in relation to the base currency.
• Ask Price: When buying a currency pair
(going long), the ask price refers to the amount of
quoted currency that has to be paid in order to
buy one unit of the base currency, or how much
the market will sell one unit of the base currency
for in relation to the quoted currency
• Bid Price: The bid price is used when selling a
currency pair (going short) and reflects how much
of the quoted currency will be obtained when
selling one unit of the base currency

Bid and Ask
• Let’s look at an example:
USD/CAD = 1.2000/05
Bid = 1.2000
Ask= 1.2005
• The quote before the slash is the bid price, and the two digits after
the slash represent the ask price (only the last two digits of the full
price are typically quoted). Note that the bid price is always smaller
than the ask price
• If you want to buy this currency pair, this means that you intend to
buy the base currency and are therefore looking at the ask price to
see how much (in Canadian dollars) the market will charge for U.S.
dollars. According to the ask price, you can buy one U.S. dollar with
1.2005 Canadian dollars.
• However, in order to sell this currency pair, or sell the base currency
in exchange for the quoted currency, you would look at the bid price.
It tells you that the market will buy US$1 base currency (you will be
selling the market the base currency) for a price equivalent to 1.2000
Canadian dollars, which is the quoted currency.

Bid and Ask
• Whichever currency is quoted first (the base
currency) is always the one in which the
transaction is being conducted. You either buy or
sell the base currency

Spreads and Pips
• The difference between the bid price and the ask
price is called a spread
• If we were to look at the following quote:
EUR/USD = 1.2500/03, the spread would be
0.0003 or 3 pips, also known as points
The pip is the smallest amount a price can move
in any currency quote
In the case of the U.S. dollar, euro, British pound
or Swiss franc, one pip would be 0.0001. With the
Japanese yen, one pip would be 0.01, because this
currency is quoted to two decimal places.
So, in a forex quote of USD/CHF, the pip would be
0.0001 Swiss francs. Most currencies trade within
a range of 100 to 150 pips a day

Spread Calculations
• Profits for currency market dealers are derived from the difference
between the bid, which is the exchange rate at which a dealer is willing
to purchase a particular currency, and the ask, which is the exchange rate
for which a dealer is willing to sell a particular currency
• The difference between the two is called the bid-ask spread. Foreign
currency dealers will quote both a bid and an ask for a particular
currency. The average of the bid and ask (ask plus bid divided by two) is
referred to as the midpoint price. The bid-ask spread is usually given as a
percentage and it is calculated as:
• Example: Suppose, the current quote in the market is EUR 1 = USD
1.3300 / 1.3302
• The bid-ask spread in this case is 2 pips. The spread as a percentage is
0.015% (i.e. 0.0002 / 1.3302)

Factors Influencing the Spread
Size

Currency Cross Rates
• The cross-rate between two currencies not
explicitly quoted is obtained by getting quotes for
each currency in terms of the exchange rate with
a third nation's currency
• Example: Suppose you are told that the exchange
rate of the U.S. dollar per euro is 1.2440 and that
the exchange rate for U.S. dollar per British pound
is 1.8146.
• Find euro-to-pound cross rate
• The rate above calculated as the euro-to-dollar
rate multiplied by the dollar-to-pound rate
• Note that this result is an indirect quote from the
viewpoint of a British entity, or a direct quote
from the viewpoint of a business whose domestic
currency is the euro

Currency Cross Rates
• In terms of formula, we can calculate the cross
rate as follows:

Forward Discount or Premium
• Forward currency exchange rates often differ from the spot exchange rate
• If the forward exchange rate for a currency is higher than the spot rate, there
is a premium on that currency.
• A discount exists when the forward exchange rate is lower than the spot rate.
A negative premium is equivalent to a discount
• The annualized rate can be calculated by using the following formula:

Forward Discount or Premium Example
• If the ninety day forward exchange rate of one dollar to japanese
yen is 109.50 and the spot rate is 109.38, then the dollar is
considered to be "strong" relative to the yen, as the dollar's
forward value exceeds the spot value. The dollar has a premium of
0.12 yen per dollar. The yen would trade at a discount because its
forward value in terms of dollars is less than its spot rate.
• So in the case listed above, the premium would be calculated as:
Annualized forward premium=
((109.50 - 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%
• Similarly, to calculate the discount for the Japanese yen, we first
want to calculate the forward and spot rates for the Japanese yen
in terms of dollars per yen. Those numbers would be (1/109.50 =
0.0091324) and (1/109.38 = 0.0091424), respectively. So the
annualized forward discount for the Japanese yen, in terms
of U.S. dollars, would be:
((0.0091324 - 0.0091424) ÷ 0.0091424) × (12 ÷ 3) × 100% = -0.44%

Example of Triangular Arbitrage:
As an example, suppose you have $1 million and you are provided
with the following exchange rates: 0.8631EUR/USD, 1.4600EUR/GBP
and 1.6939 USD/GBP

Forecast Exchange Rates
3 Ways To Forecast Currency Changes:
Purchasing Power Parity: The purchasing power parity (PPP) forecasting approach
is based on the theoretical law of one price, which states that identical goods in
different countries should have identical prices.
According to purchasing power parity, a pencil in Canada should be the same
price as a pencil in the United States after taking into account the exchange rate
and excluding transaction and shipping costs. In other words, there should be no
arbitrage opportunity for someone to buy inexpensive pencils in one country and
sell them in another for a profit.
The PPP approach forecasts that the exchange rate will change to offset price
changes due to inflation based on this underlying principle. To use the above
example, suppose that the prices of pencils in the U.S. are expected to increase by
4% over the next year while prices in Canada are expected to rise by only 2%. The
inflation differential between the two countries is: 4% - 2% = 2%

Purchasing Power Parity:
This means that prices of pencils in the U.S. are expected to rise faster relative to
prices in Canada. In this situation, the purchasing power parity approach would
forecast that the U.S. dollar would have to depreciate by approximately 2% to
keep pencil prices between both countries relatively equal. So, if the current
exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would
forecast an exchange rate of:
(1+0.02)×(US $0.90 per CA $1)=US $0.92 per CA $1
Meaning it would now take 92 cents U.S. to buy one Canadian dollar.

Relative Economic Strength:
As the name may suggest, the relative economic strength approach looks at the
strength of economic growth in different countries in order to forecast the
direction of exchange rates. The rationale behind this approach is based on the
idea that a strong economic environment and potentially high growth are more
likely to attract investments from foreign investors. And, in order to purchase
investments in the desired country, an investor would have to purchase the
country's currency—creating increased demand that should cause the currency to
appreciate.
This approach doesn't just look at the relative economic strength between
countries. It takes a more general view and looks at all investment flows. For
instance, another factor that can draw investors to a certain country is interest
rates. High interest rates will attract investors looking for the highest yield on their
investments, causing demand for the currency to increase, which again would
result in an appreciation of the currency.

Relative Economic Strength:
Conversely, low interest rates can also sometimes induce investors to avoid
investing in a particular country.
The relative economic strength method doesn't forecast what the exchange rate
should be, unlike the PPP approach. Rather, this approach gives the investor a
general sense of whether a currency is going to appreciate or depreciate and an
overall feel for the strength of the movement. It is typically used in combination
with other forecasting methods to produce a complete result.

Econometric Models of Forecasting Exchange Rates:
Another common method used to forecast exchange rates involves gathering
factors that might affect currency movements and creating a model that relates
these variables to the exchange rate. The factors used in econometric models are
typically based on economic theory, but any variable can be added if it is believed
to significantly influence the exchange rate.
As an example, suppose that a forecaster for a Canadian company has been
tasked with forecasting the USD/CAD exchange rate over the next year. They
believe an econometric model would be a good method to use and has
researched factors they think affect the exchange rate. From their research and
analysis, they conclude the factors that are most influential are: the interest rate
differential between the U.S. and Canada (INT), the difference in GDP growth
rates (GDP), and income growth rate (IGR) differences between the two countries.
The econometric model they come up with is shown as:

Econometric Models of Forecasting Exchange Rates:

Forward Contracts
• A currency forward is a binding contract in the foreign exchange
market that locks in the exchange rate for the purchase or sale of
a currency on a future date
• Its terms are not standardized and can be tailored to a particular
amount and for any maturity or delivery period, unlike exchange-
traded currency futures
• Unlike listed currency futures and options contracts, currency
forwards don't require up-front payments when used by large
corporations and banks
• To compensate for the risk of non-delivery or non-settlement,
financial institutions that deal in currency forwards may require a
deposit from retail investors or smaller firms with whom they do
not have a business relationship

Let’s look at an Example
• Assume a US exporter who is expecting to receive a payment of
EUR 10million after 3 months enters into currency forward
contract to exchange 10 million euros into US dollars after 3
months at a fixed exchange rate of 1EUR = 1.2 USD. That means
he will be able to exchange his 10 million euros for 12 million US
dollars after 3 months
• Now assume that the actual exchange rate after 3 months is 1
EUR = 1.18 USD
• If there were no forward contract, the exporter would have
received USD 11.8 million by exchanging EUR 10 million at the
market exchange rate
• Since there is a forward contract, the exporter should receive
USD 12 million at the rate of 1 EUR = 1.2 USD

Future Contracts
• Currency futures are a exchange-traded futures contract that
specify the price in one currency at which another currency can
be bought or sold at a future date
• Currency futures contracts are legally binding and counterparties
that are still holding the contracts on the expiration date must
deliver the currency amount at the specified price on the
specified delivery date
• Currency futures can be used to hedge other trades or currency
risks, or to speculate on price movements in currencies
• Currency futures may be contrasted with non-standardized
currency forwards, which trade OTC

Let’s look at an Example
• For example, buying a Euro FX future on the US exchange at 1.20
means the buyer is agreeing to buy euros at $1.20 US. If they let the
contract expire, they are responsible for buying 125,000 euros at $1.20
USD. Assuming each Euro FX future is 125,000 euros, which is why the
buyer would need to buy this much.
• On the flip side, the seller of the contract would need to deliver the
euros and would receive US dollars
• Most participants in the futures markets are speculators who close out
their positions before futures expiry date. They do not end up
delivering the physical currency. Rather, they make or lose money
based on the price change in the futures contracts themselves
• The daily loss or gain on a futures contract is reflected in the trading
account. It is the difference between the entry price and the current
futures price, multiplied by the contract unit, which in the example
above is 125,000. If the contract drops to 1.19 or rises to 1.21, for
example, that would represent a gain or loss of $1,250 on one
contract, depending on which side of the trade the investor is on

Currency Option
• A currency option (also known as a forex option) is a contract
that gives the buyer the right, but not the obligation, to buy or
sell a certain currency at a specified exchange rate on or before a
specified date
• For this right, a premium is paid to the seller
• Currency options are one of the most common ways for
corporations, individuals or financial institutions to hedge against
adverse movements in exchange rates
• Two main types of options are
 Call Options
 Put Options

Call Options
• Call options provide the holder the right (but not the obligation)
to purchase an underlying asset at a specified price (the strike
price), for a certain period of time
• If the it fails to meet the strike price before the expiration date,
the option expires and becomes worthless
• Investors buy calls when they think the price of the underlying
security will rise or sell a call if they think it will fall
• Selling an option is also referred to as ''writing'' an option
• The market price of the call option is called the premium. It is the
price paid for the rights that the call option provides

Call Options (cont.)
• If at expiry the underlying asset is below the strike price, the call
buyer loses the premium paid. This is the maximum loss
• If the underlying's price is above the strike price at expiry, the
profit is the current stock price, minus the strike price and the
premium. This is then multiplied by how many shares the option
buyer controls
• Let’s take an example of Apple Stock as an underlying asset to
understand the concept:
 If Apple is trading at $110 at expiry, the strike price is $100,
and the options cost the buyer $2, the profit is $110 - ($100
+$2) = $8
 If the buyer bought one contract that equates to $800 ($8 x
100 shares), or $1,600 if they bought two contracts ($8 x
200)
 If at expiry Apple is below $100, then the option buyer loses
$200 ($2 x 100 shares) for each contract they bought.

Put Options
• Put Options gives the owner the right, but not the obligation, to sell a
certain amount of the underlying asset, at a set price within a specific
time
• The buyer of a put option believes that the underlying stock will drop
below the exercise price before the expiration date
• The value of a put option appreciates as the price of the underlying
asset depreciates relative to the strike price
• Let’s take an example of Ford Motor Co. Stock as an underlying asset to
understand the concept:
 Max purchases one $11 put option on Ford Motor Co. Each option
contract is worth 100 shares, so this gives him the right to sell 100
shares of Ford at $11 before the expiration date
 Let's say the stock falls to $8 per share. Max would be able to sell
100 shares at $11 instead of the current $8 market price. By
buying the option, Max has saved himself $300 (less the cost of
the option), since he has sold 100 shares at $11, for a total $1,100,
instead of having to sell the shares at $8 for a total $800.

In the Money vs Out of the Money
• In options trading, the difference between "in the money" (ITM)
and "out of the money" (OTM) is a matter of the strike price's
position relative to the market value of the underlying stock,
called its moneyness
• If the strike price of a call option is $5 and the underlying asset is
currently trading at $6, the option is ITM. The higher above $5
the price goes, more the option is ITM; if the strike price of a call
option is $5 and the underlying asset is currently trading at $4,
the option is OTM. The lower below $5 the price goes, more the
option is OTM
• If the strike price of a put option is $5 and the underlying stock is
currently trading at $4, the option is ITM. The lower below $5 the
price goes, more the option is ITM; if the strike price of a put
option is $5 and the underlying stock is currently trading at $6,
the option is OTM. The higher above $5, more the option is OTM

Suppose we buy the put option for $20 when the strike is $100, the break-even
point will be $80 ($100 – $20). The put option will be in-the-money when the price
is below 80. We will suffer losses if this option is expired at a price above $80.

Suppose, we sell the put option for $20 when the strike price is $100
and then the asset price starts falling and reaches the break-even
point at 80. Below this level, we will suffer loss

Thank You
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Foreign Exchange & Currency Derivatives.pptx

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