forex markets.doc

8/19/2019 Forex Markets.doc

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Introduction To The Foreign Exchange Markets

The foreign exchange market is the market in which currencies of variouscountries are bought and sold against each other. The foreign exchangemarket is an over-the-counter market. Geographically, the foreign exchangemarkets span all time zones from New ealand to the !est "oast of #nited$tates of %merica.

The retail market for foreign exchange deals with transactions involvingtravelers and tourists exchanging one currency for another in the form ofcurrency notes or travelers& che'ues. The wholesale market often referredto as the interbank market is entirely di(erent and the participants in thismarket are commercial banks, corporations and central banks.

Participants In The Foreign Exchange Market

"ommercial banks are the )market makers) in this market. *n other words,on demand, they will 'uote buying and selling rates for one currencyagainst another and express willingness to take either side of thetransaction. They also buy and sell on their own account and carryinventories of currencies.. There are other players like the foreign exchangebrokers, who are essentially middlemen providing information to marketmaking banks about prices and a counterparty to transactions. +rokers donot buy or sell on their own account, instead they pocket a commission onthe deals that they have helped strike between two marketmaking banks."entral banks also intervene in the markets from time to time in order tomove the market in a particular direction.

"orporations use the foreign exchange markets for a variety of purposes.n the operational front, they use the foreign exchange markets for

payments towards imports, conversion of export receipts, hedgingreceivables and payables positions and payment of interest on foreigncurrency loans take abroad. "ompanies that are cash rich tend to also parksurplus funds and take active positions in the market to earn pro ts fromexchange rate movements. There are others who, as a matter of companypolicy, restrict their participation to producing and selling of goods andservices.

How Is Currency Trading Done?

Typically, interbank market deals are struck on the telephone. $ubse'uently,a written con rmation is sent containing all the details of the transaction.

or example, a trader in +ank / may call his counterpart in +ank 0 and askfor a 'uote on the yen against the dollar. *f the price is acceptable, they will


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enter the details of the transaction like date, price, amount bought 1 sold,identity of the counterparty etc. in their respective computerized recordsystems. n the day of the settlement, +ank / will turn over a yen deposit to+ank 0 and +ank 0 will turn over a 2ollar deposit to +ank /.

"ommunications pertaining to international nancial transactions arehandled mainly by a large network called $ociety for !orldwide *nterbank

inancial Telecommunication 3$!* T4. This is a non-pro t +elgiancooperative with regional centers around the world connected by datatransmission lines.

% trader will typically give a two-way 'uote i.e. he 'uotes two prices 5 oneat which he will buy a currency and one at which he will sell the currencyagainst another currency. Typically, there will be two prices, which will bedi(erentiated by a hyphen. The price on the left of the hyphen will be thebid rate, the rate at which the trader will buy the currency. The price on theright of the hyphen will be the o(er or ask rate, the price at which thetrader will sell the currency against another. The di(erence 3ask 5 bid4 isthe bid-ask spread.

*n a regular two-way market, the trader expects )to be hit) on both sides ofhis 'uote in roughly e'ual amounts. *n other words, the trader expects tobuy and sell roughly e'ual amounts of currencies % and +. The bank&smargin would then be the bid-ask spread. *f the trader nds that he is beinghit on one side of his 'uote 5 i.e. he is buying more of currency % thanselling, he is actually building up a position. *f he has sold more of currency

% than he has bought, he is building up a net short position and if theconverse is true, he has built a net long position in currency %. Thepotential gain or loss from the position would depend upon the variability of the exchange rates and the size of the position. *t must be noted thatbuilding such positions for long durations is risky and amounts tospeculation. +anks maintain tough control over such activities byprescribing limits on net positions for a given trading period.

%s mentioned earlier, in the foreign exchange markets, there are no feescharged the bid-ask spread itself is the transaction cost. %lso, no distinctionis made in terms of rates on the basis of creditworthiness of thecounterparty. *nstead, default risk is also managed by prescribing limits ofexposure to a particular corporate client.

Exchange Rate Quotations

6astly, there is a need to clarify certain terms that appear in foreignexchange literature regarding types of 'uotes. They are as follows7


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8uropean 'uotes7 These are 'uotes given as number of units of a currencyper #.$.dollar.ome examples are 29 :.; 1 ?, $ r :.@@=; 1 ?, As. @B.CC 1 ?

%merican 'uotes7 These are 'uotes given as number of #$ dollars per unitof a currency. $ome examples are ? D.@;=C. !hen the nature of the marketsare compared, one can easily discern the reasons why these di(erenceshave cropped up. This must be analyzed in the light of the fact thatexchanges tend to introduce tose instruments that they think will succeedand contract design is a function of marketing.

*n the e'uity market a relatively large proportion of the total risk of asecurity is unsystematic. %t the same time, many securities display a highdegree of li'uidity that can be expected to be maintained for log periods oftime. These two factors contributed to the viability of trading e'uity optionson individual securities. This is because, for the contracts to be successful,


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the underlying instruments have to be traded in large 'uantities and withsome price continuity so that the option related transactions need notcreate more than a minor disturbance in the market.

*n the debt market, a much larger proportion of the total risk of the securityis systematic 5 in other words, risk that cannot be diversi ed by investing ina number of securities. 2ebt instruments are also characterized by a nitelife and a small size in comparison to e'uity.

The fundamental di(erences between futures and options are as follows7

• !ith futures, both parties are obligated to perform. !ith options, on theseller 3writer4 is obligated to perform.

• !ith options, the buyer pays the seller 3writer4 a premium. *n the case offutures, neither party pays a premium.

• *n the case of futures, the holder of the contract is exposed to the entirespectrum of downside risk and has the potential for all the upside returns. *nthe case of options, the buyer is able to limit the downside risk to the optionpremium but retains the upside potential.

• The parties to a futures contract must perform at the settlement date. Theyare, however, not obligated to perform before the settlement date. Thebuyers of an options contract can exercise any time prior to that expirationdate.

Forward Contracts

% forward contract is a simple derivative 5 *t is an agreement to buy or sellan asset at a certain future time for a certain price. The contract is usuallybetween two nancial institutions or between a nancial institution and itscorporate client. % forward contract is not normally traded on an exchange.

ne of the parties in a forward contract assumes a long position i.e. agreesto buy the underlying asset on a speci ed future date at a speci ed futureprice. The other party assumes a short position i.e. agrees to sell the asseton the same date at the same price. This speci ed price is referred to as thedelivery price. This delivery price is chosen so that the value of the forward

contract is e'ual to zero for both transacting parties. *n other words, itcosts nothing to the either party to hold the long or the short position.

% forward contract is settled at maturity. The holder of the short positiondelivers the asset to the holder of the long position in return for cash at theagreed upon rate. Therefore, a key determinant of the value of the contractis the market price of the underlying asset. % forward contract cantherefore, assume a positive or negative value depending on the movements


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of the price of the asset. or example, if the price of the asset rises sharplyafter the two parties have entered into the contract, the party holding thelong position stands to bene t, i.e. the value of the contract is positive forher. "onversely, the value of the contract becomes negative for the partyholding the short position.The concept of orward price is also important. The forward price for acertain contract is de ned as that delivery price which would make the

value of the contract zero. To explain further, the forward price and thedelivery price are e'ual on the day that the contract is entered into. verthe duration of the contract, the forward price is liable to change while thedelivery price remains the same. This is explained in the following note onpayo(s from forward contracts.

Payo%s Fro$ Forward Contracts

&pot and Forward Foreign Exchange Quotes on &ter!ing ' #ugust (' ()))

$pot? :.=D>D

BD-day forward? :.=DD-day forward? :.=D:<

$uppose an investor has entered into a long forward contract on %ugust :,:FFF to buy one million pounds sterling in FD days at an exchange rate of ?:.=D;D. This contract would entail the investor to buy one million poundssterling by paying #.$. ? :,=D;,DDD.

*f the spot exchange rate rose to ? :.=;DD at the end of the FD-day period,the investor would gain #.$.? @;,DDD 3:,=;D,DDD 5 :,=D;,DDD4, since thesepounds can be sold in the spot market for ? :.=;DD.

"onversely, if the spot exchange rate fell to ? :.;;DD, the investor wouldlose #.$.? ;;,DDD 3:,=D;,DDD- :,;;D,DDD4 as he could have purchased thepounds in the spot market for a lower price.

$ince it costs nothing for the investor to enter into a forward contract, thepayo(s represent his total gain or loss from the contract.


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"ptions

% options agreement is a contract in which the writer of the option grantsthe buyer of the option the right purchase from or sell to the writer adesignated instrument for a speci ed price within a speci ed period of time.The writer grants this right to the buyer for a certain sum of money calledthe option premium. %n option that grants the buyer the right to buy someinstrument is called a call option. %n options that grants the buyer the rightto sell an instrument is called a put option. The price at which the buyer anexercise his option is called the exercise price, strike price or the strikingprice.

ptions are available on a large variety of underlying assets like commonstock, currencies, debt instruments and commodities. %lso traded areoptions on stock indices and futures contracts 5 where the underlying is afutures contract and futures style options.

ptions have proved to be a versatile and exible tool for risk managementby themselves as well as in combination with other instruments. ptionsalso provide a way for individual investors with limited capital to speculateon the movements of stock prices, exchange rates, commodity prices etc.The biggest advantage in this context is the limited loss feature of options.

Types "* "ptions

%s mentioned earlier, the underlying asset for options could be a spotcommodity or a futures contract on a commodity. %nother variety is thefutures-style option.

%n option on spot foreign exchange gives the option buyer the right to buyor sell a currency at a stated price 3in terms of another currency4. *f theoption is exercised, the option seller must deliver or take delivery of acurrency.

%n option on currency futures gives the option buyer the right to establish along or short position in a currency futures contract at a speci ed price. *fthe option is exercised, the seller must take the opposite position in therelevant futures contract. or example, suppose you had an option to buy a2ecember 29 contract on the *99 at a price of ? D.;> 1 29. 0ou exercisethe option when 2ecember futures are trading at ? D.;>F;. 0ou can closeout your position at this price and take a pro t of ? D.DDF; per 29 or, meetfutures margin re'uirements and carry a long position with ? D.DDF; per


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29 being credited to your margin account. The option seller automaticallygets a short position in 2ecember futures.

utures style options are a little bit more complicated. 6ike futurescontracts, they represent a bet on a price. The price being betted on, is theprice of an option on spot foreign exchange. $imply put, the buyer of theoption has to pay a price to the seller of the option i.e. the premium or theprice of the option. *n a futures style option, you are betting on the changesin this price, which, in turn depends on several factors including the spotexchange rate of the currency involved. or instance, a trader feels that thepremium on a particular option is going to increase. He buys a futures-stylecall option. The seller of this call option is betting that the premium will godown. #nlike the option on the spot, the buyer does not pay the premium tothe seller. *nstead, they both post margins related to the value of the call onspot.

"ptions Ter$ino!ogy

To reiterate, the two parties to an options contract are the option buyer andthe option seller, also called the option writer. or exchange traded options,as in the case of futures, once the agreement is reached between twotraders, the exchange 3the clearing house4 interposes itself between the twoparties becoming buyer to every seller and seller to every buyer. Theclearing house guarantees performance on the part of every seller.

Ca!! "ption

% call option gives the option buyer the right to purchase currency 0 againstcurrency /, at a stated price /10, on or before a stated date. or exchangetraded options, one contract represents a standard amount of the currency

0. The writer of a call option must deliver the currency if the option buyerchooses to exercise his option.

Put "ption

% put option gives the option buyer the right to sell a currency 0 againstcurrency / at a speci ed price on or before a speci ed date. The writer of aput option must take delivery if the option is exercised.

&trike Price +a!so ca!!ed exercise price,


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The price speci ed in the option contract at which the option buyer canpurchase the currency 3call4 or sell the currency 3put4 0 against /.

Maturity Date

The date on which the option contract expires is the maturity date.8xchange traded options have standardized maturity dates.

#$erican "ption

%n option, call or put, that can be exercised by the buyer on any businessday from initiation to maturity.

European "ption

% 8uropean option is an option that can be exercised only on maturity date.

Pre$iu$ +"ption price' "ption a!ue,

The fee that the option buyer must pay the option writer at the time thecontract is initiated. *f the buyer does not exercise the option, he stands tolose this amount.

Intrinsic a!ue o* the option

The intrinsic value of an option is the gain to the holder on immediateexercise of the option. *n other words, for a call option, it is de ned as 9axI3$-/4, DJ, where s is the current spot rate and / is the strike rate. *f $ isgreater than /, the intrinsic value is positive and is $ is less than /, theintrinsic value will be zero. or a put option, the intrinsic value is 9ax I3/-$4, DJ. *n the case of 8uropean options, the concept of intrinsic value isnotional as these options are exercised only on maturity.

Ti$e a!ue o* the option

The value of an %merican option, prior to expiration, must be at least e'ualto its intrinsic value. Typically, it will be greater than the intrinsic value.This is because there is some possibility that the spot price will movefurther in favor of the option holder. The di(erence between the value of anoption at any time )t) and its intrinsic value is called the time value of theoption.

#t-the-Money' In-the-Money and "ut-o*-the-Money "ptions


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% call option is said to be at-the-money if $K/ i.e. the spot price is e'ual tothe exercise price. *t is in-the-money is $L/ and out-of-the-money is $M/."onversely, a put option is at-the-money is $K/, in-the-money if $M/ andout-of-the-money if $L/.

"ption Pricing

+lack $choles, in their celebrated analysis on option pricing, reached theconclusion that the estimated price of a call could be calculated with thefollowing e'uation7

Ec K IEsJIN3d: 4 5 IEeJIantilog 3-A f t4IN3dC4J

!here7

Ec - market value of the call optionEs - price of the stock Ee - strike price of the optionA f - annualized interest ratet - time to expiration in yearsantilog 5 to the base e

N3d: 4 and N3dC4 are the values of the cumulative normal distribution,de ned as follows7

d : K 6n 3Es 1 Ee4 O 3A f O D.; s C4t

s P t

dCK d : - 3s P t4

where7

6n 3Es 1 Ee4 is the natural logarithm of 3E s 1 Ee4s C is the is the variance of continuously compounded rate of return on stockper time period.

%dmittedly, the de nitions of d : and d C are di(icult to grasp for the readeras they involve complex mathematical e'uations. However, the basicproperties of the +lack-$choles model are easy to understand. !hat themodel establishes is that the estimated price of options vary directly with anoption&s term to maturity and with the di(erence between the stock&smarket price and the option&s strike price. urther, the de nitions of d: anddC indicate that option prices increase with the variance of the rate of


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return on the stock price, re ecting that the greater the volatility, higherthe chance that the option will become more valuable.

Re!ationship .etween The "ption Pre$iu$ #nd &tock Price

*t is obvious that the option premium uctuates as the stock price movesabove or below the strike price. Generally, option premiums rarely movepoint for point with the price of the underlying stock. This typically happensonly at parity, in other words, when the exercise price plus the premiume'uals the market price of the stock.

Erior to reaching parity, premiums tend to increase less than point per pointwith the stock price. ne reason for this are that point per point increase inpremium would result in sharply reduced leverage for the option buyers 5reduced leverage means reduced demand for the option. %lso, a higheroption premium entails increased capital outlay and increased risk, onceagain reducing demand for the option.

2eclining stock prices also do not result in a point per point decrease inoption premium. This is because, even a steep decline in the stock price in aspan of a few days has only a slight e(ect on the option&s total value 5 itstime value. This term to maturity e(ect tends to exist as the option is awasting asset.

"ption &trategies

This section deals with some of the most basic strategies that can bedevised using options. The idea is to familiarize the reader with the

exibility of options as a risk management tool. *n order to keep matterssimple, we make the following assumptions7

• !e shall ignore brokerage, commissions, margins etc.• !e shall assume that the option is exercised only on maturity and not

prematurely exercise - in other words, we assume that we are only dealingwith 8uropean options

• %ll exchange rates, strike prices and premia will be in terms of dollars per

unit of a currency and the option will be assumed to be on one unit of thecurrency.

Ca!! "ptions

% call option buyerQs pro t can be de ned as follows7 %t all points where $M/, the payo( will be -c %t all points where $L/, the payo( will be $-/- c, where


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$ K $pot price/ K $trike price or exercise pricec K call option premium"onversely, the option writerQs pro t will be as follows7 %t all points where $M/, the payo( will be c

%t all points where $L/, the payo( will be -3$-/- c4To illustrate this, let us look at an example and construct the payo( pro le."onsider a trader who buys a call option on the $wiss ranc with a strikeprice of ? D.== and pays a premium of :.F; cents 3?D.D:F;4. The currentspot rate is D.=;FC. His gain or loss at time T when the option expiresdepends upon the value of the spot rate at that time.

or all values of $ below D.==, the option buyer lets the option lapse sincethe $wiss francs can be bough in the spot market at a lower price. His lossthen will be limited to the premium he has paid. or spot values greaterthan the strike price, he will exercise the option.

6et us look at the payo( pro le of the call option buyer.

&pot Rate /ain +&-0-c, 1oss +-c,

D.=DDD - -D.D:F;

D.=;DD - -D.D:F;

D.==DD - -D.D:F;

D.=


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&pot Rate /ain +c, 1oss +&-0-c,

D.=DDD D.D:F; -D.=;DD D.D:F; -

D.==DD D.D:F; -D.=


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spot rate below ? :.=F;D, the option will be exercised and will lead to a netpro t.

%t expiry, the put option buyerQs payo( pro le can be depicted as follows7

&pot Rate /ain +0-&-p, 1oss +-p,

:.==DD D.DB;D -

:.=>DD D.D:;D -

:.=FDD D.DD;D -

:.=F;D - -

:.DD - -D.D:;D

:.=FDD - -D.DD;D:.=F;D - -

:.


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:.DD D.D;DD -

:.>DDD D.D;DD

-

&pread &trategies

$pread strategies with options involve simultaneous sale and purchase oftwo di(erent option contracts. The obSective in these strategies is to realizea pro t if the underlying price moves in a fashion that is expected and tolimit the magnitude of loss in case it moves in an unexpected fashion.8vidently, these are speculative in nature. However, these strategies aresuch that they provide limited gains while also ensuring limited losses.

$pread strategies involving options with same maturity but di(erent strikeprices are called vertical spreads or price spreads. The types of verticalspread strategies are bullish call spreads, bearish call spreads, bullish putspreads and bearish put spreads. The expectation when going in for thesestrategies is that the underlying rate is likely to either appreciate ordepreciate signi cantly.

Horizontal or time spread strategies involve simultaneous buying andselling of two options which are similar in all respects except in maturity.The basic idea behind this is that the time value of the short maturity optionwill decline faster than that of the long maturity option. The expectationwhen going for this strategy is that the underlying price will not changedrastically but the di(erence in premia will over time.

2ertica! &pread &trategies

% bullish call consists of selling the call with the higher strike price andbuying the call with the lower strike price. The expectation is theunderlying currency is likely to appreciate. The investor however, would liketo limit his losses.

$ince a lower priced call is being bought i.e. higher premium is paid and ahigher priced call is being sold i.e. lower premium is received, the initial netinvestment would be the di(erence in the two premia. The maximum pro tpotential will be the di(erence in the strike prices minus the initialinvestment. The maximum loss is the initial investment. This strategy thus

yields a limited pro t if the currency appreciates and a limited loss if thecurrency depreciates.

n the other hand, if the investor expects the currency to depreciate, hecan go in for the bearish call spread. This is the reverse of the bullish


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spread i.e. the call with the higher strike price is bought and that with thelower strike price is sold. The maximum gain will be the di(erence in thepremia. The maximum loss will be the di(erence is premia minus thedi(erence in the strike prices.

% bullish put spread consists of selling a put option with higher strike priceand buying a put option with a lower strike price. *n this case, if there is asigni cant appreciation in the underlying rate, neither put will be exercisedand the net gain will be the di(erence in premia. 9aximum loss will be thedi(erence in strike prices minus the di(erence in premia. % bearish putspread is the opposite of a bullish put spread.

%n extension of the idea of vertical spreads is the butter y spread. %butter y spread involves three options with di(erent strike prices but samematurity. % butter y spread is bought by purchasing two calls with themiddle strike price and selling one call each with the strike price on eitherside. The investorQs expectation is that there will be a signi cant movementin the underlying rate - he is, however, unsure of the direction of thismovement. This strategy yields a limited pro t if there is a signi cantmovement in the underlying rate - appreciation or depreciation. +ut if themovements are moderate or not very signi cant, it tends to result in a loss.$elling a butter y spread involves selling two intermediate priced calls andbuying one on either side. %s opposed to the buyer of a butter y spread, theseller here is betting on moderate or non-signi cant movements. He doesnot expect drastic movements either way. Therefore, this strategy yields asmall pro t if there are moderate changes in the exchange rate and alimited loss if there are large movements on either side.Hori3onta! "r Ti$e &preads

%s mentioned earlier, horizontal or time spread strategies involvesimultaneous buying and selling of two options which are similar in allrespects except in maturity. The basic idea behind this is that the time valueof the short maturity option will decline faster than that of the long maturityoption.&tradd!es #nd &trang!es

% $traddle strategy consists of buying a call and a put both with identicalstrikes and maturity. *f there is a drastic depreciation, the investor gains onthe put i.e. by exercising the option to sell. *f there is a drastic appreciation,the investor exercises the call and purchases at the lower price. However, ifthere is a moderate movement either way, the investor will su(er a loss.

% strangle is similar to a straddle. *t consists of buying a call with strikeabove the current spot rate and a put with a strike price below the currentspot. 6ike the straddle, it yields a pro t for drastic movements and a loss formoderate movements."urrency options thus, provide the corporate treasurer a tool for hedgingforeign exchange risks arising out of the rmQs operations. #nlike theforward contracts, options allow the hedger to gain from favorable


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exchange rate movements while being protected against unfavorablemovements.

Futures

% futures contract is an agreement between two parties to buy or sell anasset at a certain speci ed time in future for a certain speci ed price. *nthis, it is similar to a forward contract. However, there are a number ofdi(erences between forwards and futures. These relate to the contractualfeatures, the way the markets are organized, pro les of gains and losses,kinds of participants in the markets and the ways in which they use the twoinstruments.

utures contracts in physical commodities such as wheat, cotton, corn,gold, silver, cattle, etc. have existed for a long time. utures in nancialassets, currencies, interest bearing instruments like T-bills and bonds andother innovations like futures contracts in stock indexes are a relatively newdevelopment dating back mostly to early seventies in the #nited $tates andsubse'uently in other markets around the world.

Ma4or Features "* Futures Contracts

The principal features of the contract are as follows7

"rgani3ed Exchanges

#nlike forward contracts which are traded in an over-the-counter market,futures are traded on organized exchanges with a designated physicallocation where trading takes place. This provides a ready, li'uid market inwhich futures can be bought and sold at any time like in a stock market.

&tandardi3ation

*n the case of forward currency contracts, the amount of commodity to bedelivered and the maturity date are negotiated between the buyer andseller and can be tailor-made to buyerQs re'uirements. *n a futures contractboth these are standardized by the exchange on which the contract istraded. Thus, for instance, one futures contract in pound sterling on the*nternational 9onetary 9arket 3*994, a nancial futures exchange in the#$, 3part of the "hicago +oard of Trade or "+T4, calls fore delivery of=C,;DD +ritish Eounds and contracts are always traded in whole numbersi.e. you cannot buy or sell fractional contracts. % three-month sterlingdeposit on the 6ondon *nternational inancial utures 8xchange 36* 84


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who made a loss and crediting the accounts of those members who havegained.

This feature of futures trading creates an important di(erence betweenforward contracts and futures. *n a forward contract, gains or losses ariseonly on maturity. There are no intermediate cash ows. !hereas, in afutures contract, even though the gains and losses are the same, the timepro le of the accruals is di(erent. *n other words, the total gains or lossover the entire period is broken up into a daily series of gains and losses,which clearly has a di(erent present value.

#ctua! De!i ery Is Rare

*n most forward contracts, the commodity is actually delivered by the sellerand is accepted by the buyer. orward contracts are entered into forac'uiring or disposing o( a commodity in the future for a gain at a priceknown today. *n contrast to this, in most futures markets, actual deliverytakes place in less than one percent of the contracts traded. utures areused as a device to hedge against price risk and as a way of betting againstprice movements rather than a means of physical ac'uisition of theunderlying asset. To achieve this, most of the contracts entered into arenulli ed by a matching contract in the opposite direction before maturity ofthe rst.

Types o* *utures

%s is evident from the previous discussion, trading in futures is e'uivalentto betting on the price movements in futures prices. *f such betting is usedto protect a position - either long or short - in the underlying asset, it istermed as hedging. n the other hand, if the activity is undertaken onlywith the obSective of generating pro ts from absolute or relative pricemovements, it is termed as speculation. *t must be noted that speculatorsprovide li'uidity to the markets by their willingness to enter open positions.

!e shall brie y look at currency, interest rate and stock index futures.There are others like commodity futures as well which are not coveredunder this section.

Currency Futures

!e shall look at both hedging and speculation in currency futures."orporations, banks and others use currency futures for hedging purposes.The underlying principle is as follows7


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%ssume that a corporation has an asset e.g. a receivable in a currency %that it would like to hedge, it should take a futures position such thatfutures generate a positive cash whenever the asset declines in value. *nthis case, since the rm in long, in the underlying asset, it should go shortin futures i.e. it should sell futures contracts in %. bviously, the rm cannotgain from an appreciation of % since the gain on the receivable will be eatenaway by the loss on the futures. The hedger is willing to sacri ce thispotential pro t to reduce or eliminate the uncertainty. "onversely, a rmwith a liability in currency % e.g. a payable, should go long in futures.

*n hedging too, the corporation has the option of a direct hedge and a crosshedge. % +ritish rm with a dollar payable can hedge by selling sterlingfutures 3same e(ect as buy dollar futures4 on the *99 or 6* 8. This is anexample of a direct hedge. *f the dollar appreciates, it will lose on thepayable but gain on the futures, as the dollar price of futures will decline.

%n example of a cross hedge is as follows7

% +elgian rm with a dollar payable cannot hedge by selling +elgian francfutures because they are not traded. However, since the +elgian franc isclosely tied to the 2eutschemark in the 8uropean 9onetary $ystem 389$4.*t can sell 29 futures.

%n important point to note is that, in a cross hedge, a rm must choose afutures contract on an underlying currency that is highly positivelycorrelated with the currency exposure being hedged.

%lso, even when a direct hedge is available, it is extremely di(icult toachieve a perfect hedge. This is due to two reasons. ne is that futurescontracts are for standardized amounts as this is designed by the exchange.8vidently, this will only rarely match the exposure involved. The secondreason involves the concept of basis risk. The di(erence between the spotprice at initiation of the contract and the futures price agreed upon is calledthe basis. ver the term of the contract, the spot price changes, as does thefutures price. +ut the change is not always perfectly correlated - in otherwords, the basis is not constant. This gives rise to the basis risk. +asis riskis dealt with through the hedge ratio and a strategy called delta hedging.

% speculator trades in futures to pro t from price movements. They hold views about the future price movements - if these di(er from those of thegeneral market, they will trade to pro t from this discrepancy. The ip sideis that they are willing to take the risk of a loss if the prices move againsttheir views of opinions.


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$peculation using futures can be in the either open position trading orspread trading. *n the former, the speculator is betting on movements in theprice of a particular futures contract. *n the latter, he is betting on the pricedi(erential between two futures contracts.

%n example of open position trading is as follows7

56DM Prices$pot

D.;;9arch utures

D.;>F; Rune utures

D.;F:;$eptember utures

D.=D:;

These prices evidently indicate that the market expects the 29 toappreciate over the next =-< months. *f there is a speculator who holds theopposite view - i.e. he believes that the 29 is actually going to depreciate.There is another speculator who believes that the 29 will appreciate butnot to the extent that the market estimates - in other words, theappreciation of the 29 will fall short of market expectations. +oth thesespeculators sell a $eptember futures contract 3standard size - 29 :C;,DDD4at ? D.=D:;.

n $eptember :D, the following rates prevail7

$pot ?129 - D.;F@D, $eptember utures - D.;F;D

+oth speculators reverse their deal with the purchase of a $eptemberfutures contract. The pro t they make is as follows7

?3D.=D:;-D.;F;D4 i.e. ?D.DD=; per 29 or ?3:C;DDD x D.DD=;4 i.e. ? >:C.; percontract.

% point to be noted in the above example is that the rst speculator made apro t inspite the fact that his forecast was faulty. !hat mattered therefore,was the movement in $eptember futures price relative to the price thatprevailed on the day the contract was initiated.


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*n contrast to the open position trading, spread trading is considered amore conservative form of speculation. $pread trading involves thepurchase of one futures contract and the sale of another. %n intra-commodity spread involves di(erence in prices of two futures contract withthe same underlying commodity and di(erent maturity dates. These are alsotermed as time spreads. %n inter-commodity spread involves the di(erencein prices of two futures contracts with di(erent but related commodities.These are usually with the same maturity dates.

Interest Rate Futures

*nterest rate futures is one of the most successful nancial innovations inrecent years. The underlying asset is a debt instrument such as a treasurybill, a bond or time deposit in a bank. The *nternational 9onetary 9arket3*994 - a part of the "hicago 9ercantile 8xchange, has futures contractson #$ Government treasury bonds, three-month 8uro-dollar time depositsand medium term #$ treasury notes among others. The 6* 8 hascontracts on euro-dollar deposits, sterling time deposits and #UGovernment bonds. The "hicago +oard of Trade o(ers contracts on longterm #$ treasury bonds.

*nterest rate futures are used by corporations, banks and nancialinstitutions to hedge interest rate risk. % corporation planning to issuecommercial paper can use T-bill futures to protect itself against an increasein interest rate. % treasurer who is expecting some surplus cash in the nearfuture to be invested in some short term investments may use the same asinsurance against a fall in interest rates. $peculators bet on interest ratemovements or changes in the term structure in the hope of generatingpro ts.

% complete analysis of interest rate futures would be a complex exercise asit involves thorough understanding and familiarity with concepts such asdiscount yield, yield-to-maturity and elementary mathematics of bond

valuation and pricing.

&tock Index Futures

% stock index futures contract is an obligation to deliver on the settlementdate an amount of cash e'uivalent to the value of ;DD times the di(erencebetween the stock index value at the close of the last trading day of thecontract and the price at which the futures contract was originally struck.

or example, if the $ E ;DD $tock *ndex is at ;DD and each point in theindex e'uals ? ;DD, a contract struck at this level is worth ? C;D,DDD 3;DD V


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Interest Rate &waps

%n interest rate swap as the name suggests involves an exchange ofdi(erent payment streams which xed and oating in nature. $uch anexchange is referred to as a exchange of borrowings or a coupon swap. *nthis, one party, +, agrees to pay to the other party, %, cash ows e'ual tointerest at a predetermined xed rate on a notional principal for a numberof years. %t the same time, party % agrees to pay party + cash ows e'ual tointerest at a oating rate on the same notional principal for the same periodof time. The currencies of the two sets of interest cash ows are the same.The life of the swap can range from two years to over :; years. This type ofa standard xed to oating rate swap is also called a plain vanilla swap inthe market Sargon.

6ondon *nter-bank (er Aate 36*+ A4 is often the oating interest rate inmany of the interest rate swaps. 6*+ A is the interest rate o(ered by bankson deposits from other banks in the 8urocurrency markets. 6*+ A isdetermined by trading between banks and changes continuously as theeconomic conditions change. Rust as the Erime 6ending Aate 3E6A4 is usedas the benchmark or the peg for many *ndian oating rate instruments,6*+ A is the most fre'uently used reference rate in international markets.

#sually, two non- nancial companies do not get in touch with each other todirectly arrange a swap. They each deal with a nancial intermediary suchas a bank who then structures the plain vanilla swap in such a way so as toearn them a margin or a spread. *n international markets, they typicallyearn about B basis points 3D.DB 4 on a pair of o(setting transactions.

%t any given point of time, the swap spreads are determined by supply anddemand. *f more participants in the swap markets want to receive xedrather than oating, swap spreads tend to fall. *f the reverse is true, theswap spreads tend to rise.

*n real life, it is di(icult to envisage a situation where two companiescontact a nancial institution at exactly the same time with the proposal totake opposite positions in the same swap. 9ost large nancial institutionsare therefore prepared tow are house interest rate swaps. This involvesentering into a swap with a counterparty, then hedging the interest rate risk until an opposite counterparty us found. *nterest rate future contracts areresorted to as a hedging tool in such cases.

Currency &waps


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"urrency swaps involves exchanging principal and xed rate interestpayments on a loan in one currency for principal and xed rate interestpayments on an approximately e'uivalent loan in another currency.

$uppose that a company % and company + are o(ered the xed ve-yearrates of interest in #.$. dollars and sterling. %lso suppose that sterling ratesare generally higher than the dollar rates. %lso, company % enSoys a bettercreditworthiness than company + as it is o(ered better rates on both dollarand sterling. !hat is important to the trader who structures the swap dealis that di(erence in the rates o(ered to the companies on both currencies isnot the same. Therefore, though company % has a better deal in both thecurrency markets, company + does enSoy a comparatively lowerdisadvantage in one of the markets. This creates an ideal situation for acurrency swap. The deal could be structured such that company + borrowsin the market in which it has a lower disadvantage and company % in whichit has a higher advantage. They swap to achieve the desired currency to thebene t of all concerned.

% point to note is that the principal must be speci ed at the outset for eachof the currencies. The principal amounts are usually exchanged at thebeginning and the end of the life of the swap. They are chosen such thatthey are e'ual at the exchange rate at the beginning of the life of the swap.

6ike interest rate swaps, currency swaps are fre'uently warehoused bynancial institutions that carefully monitor their exposure in various

currencies so that they can hedge their currency risk.

"ther &waps

% swap in its most general form is a contract that involves the exchange ofcash ows according to a predetermined formula. There is no limit to thenumber of innovations that can be made given this basic structure of theproduct.

ne innovation is that principal in a swap agreement can be variedthroughout the term of the swap to meet the needs of the two parties. *n anamortizing swap, the principal reduces in a predetermined way. This couldbe designed to correspond to the amortization schedule on a particularloan. %nother innovation could be the deferred or forward swaps where thetwo parties do not start exchanging interest payments until some futuredate.


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%nother innovation is the combination of the interest and currency swapswhere the two parties exchange a xed rate currency % payment for a

oating rate currency + payment.

$waps are also extendable, where one party has the option to extend the lifeof the swap or puttable, where one party has the option to terminate theswap before its maturity. ptions on swaps or $waptions, are also gaining inpopularity.

% constant maturity swap 3"9$4 is an agreement to exchange a 6*+ A ratefor a swap rate. oe example, an agreement to exchange =-month 6*+ A forthe :D-year swap rate every six months for the next ve years is a "9$.$imilarly, a constant maturity treasury swap 3"9T4 involves swapping a6*+ A rate for a treasury rate. %n e'uity swap is an agreement to exchangethe dividends and capital gains realized on an e'uity index for either a xedor oating rate of interest.

These are only a few of the innovations in swaps that exist in the nancialmarkets. The above have been mentioned to underscore the fact that swapsand other derivatives that have been dealt with in this module are all bornout of necessity or needs of the many participants in the international

nancial market.

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