fundamental & technical analysis of forex market

8/14/2019 fundamental & technical analysis of forex market

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Simply stated Foreign Currency Exchange (Forex) means exchange of one countrys

currency with other countrys currency for the smooth flow of goods, services and investments

across the Countrys boundary. The overall Forex market is the largest, most liquid market in

the world with an average traded value that exceeds $2 trillion per day and includes all of thecurrencies in the world. Most international transactions, such as the international trade of goods

and services or international investment activities, involve the exchange of one currency for

another.

Foreign exchange is the buying and the selling of foreign exchange in pairs of currencies. But

question is why are currencies bought or sold? The answer is simple - Governments and

Companies need foreign exchange for their purchase and payments for various commodities

and services. This trade constitutes about 5% of all currency transactions; however the other

95% currency transactions are done for speculation and trade. In fact many companies will buy

foreign currency when it is being traded at a lower rate to protect their financial investments.

Another thing about foreign exchange market is that the rates are varying continuously and on

daily basis. Therefore investors and financial managers track the Forex rates and the Forex

market on a daily basis.

Exchange rates between the currencies are derived from large number of factors like Interest

rates, Inflation, GDP, FDIs, FIIs, Political change, Corporate Performance, National

Economic Policyetc. As a result, Forex rates tend to move in cleaner trends than any other

instruments. All these factors are to be monitored closely by economists in order to draft

different plans and policies for steady and overall development of the economy and by

corporate in order to take decision for the future course of action.

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1.1 Forex Markets and Players

The main players on the foreign exchange market are commercial banks, firms, non-bank

financial institutions and central banks which are involved in the debiting and crediting of

accounts at commercial banks, that is most transactions relate to the exchange of bank deposits

(in different locations and denominated in various currencies). This puts commercial banks at

the center of the foreign exchange market. Banks perform the role of intermediary for their

clients (mostly firms) by bringing together their demands and supplies, either directly or

indirectly through trade with other banks (inter-bank trading). The inter-bank trading accounts

for most of the market activity. The international exchange of goods and services by firms,

either related to inputs, final goods or intermediate (capital) goods and services, almost alwaysinvolves foreign exchange trading to pay for these activities. Central Banks of the country

depending on the various macro-economic circumstances, such as the unemployment rate, the

growth rate of the economy, the inflation rate, and explicit or implicit government policies may

decide to buy or sell foreign exchange. Although the size of these central bank interventions is

usually relatively modest, its impact can be substantial as the other players in the market may

view these interventions as indicative of other future macroeconomic policy changes.

The trade of different currencies takes place on the foreign exchange markets, at prices called

exchange rates. This rarely involves the exchange of bank notes between citizens. Instead, most

foreign exchange involves the trade of foreign-currency-denominated deposits between large

commercial banks in international financial centers such as London, New York, Tokyo. FX is

an OTC (over the counter) market i.e., there is no physical market place where the deals are

made, instead it is a network of banks, brokers and authorized dealers spread across the various

financial centers of the world. These players trade in different currencies through telephone,

faxes, computers and other electronic networks. These traders generally operate through a

trading room. The deals are mostly done on an oral basis, with written confirmation following

later.

Exposure to movements in foreign exchange rates and currency market volatility can be an

advantage, particularly to currency speculators. However, the hedger like for instance a

corporate treasurer is different from the speculator as all his efforts are directed to minimize the

risk. His priority is to reduce and eliminate currency exposure. But in reality the attitude to

Forex risk among corporate treasurers is wide-ranging. While some regard any Forex risk with

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alarm and hedge it as soon as it occurs, some hedge it actively. Others never use the forward

Forex market and regard all windfall profits or losses as "acts of God".

Changes in exchange rates are one of the major risks to which companies and investors are

exposed. It is thus impossible to imagine company managers or asset managers ignoring the

risks inherent in a shift in exchange rates.

The following chart shows the symbol and international code of the different currency

which are traded in the international FX Market:-

Country Currency Symbol ISO code

Australia Dollar A$ AUD

Canada Dollar C$ CAD

China Yuan - CNY

EMU countries Euro EUR India Rupee Rs INR

Iran Rial RI IRR

Japan Yen JPY

Kuwait Dinar KD KWD

Mexico Peso Ps MXP

Saudi Arabia Riyal SR SAR

Singapore Dollar S$ SGD

South Africa Rand R ZAR

Switzerland Franc SF CHF

United Kingdom Pound GBP

United States Dollar $ USD

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FX Market is mostly dominated by the following major economies:-

United States

United Kingdom

Euro Zone

Australia

Japan

Canada

China

Switzerland

Indian currency i.e., Rupee (INR) also takes clues from the above major economies. INR is

directly quoted only against US dollar and recently against EURO, rest all exchange rates

against other currencies are derived rates form dollar. Indian Forex Market trades between 9am

to 5pm from Monday to Friday. Only authorized dealers (ADs) are allowed to participate in

the inter-bank market. Corporates having the international transaction have to deal through the

authorized dealers for the exchange of currencies.

In order to understand the FX Market in a better way let us consider a small practical example

which occurs in the real life situation: -

A traderXYZ in India imports goods worth $1 million on 1st May 08 in the country.

He has got credit period of 6 months. The current rate of exchange of $=INR is 41.60 (one unit

of $ equals 41.60 units of Rupees). After 6 months he has to make a payment of $1 million.

Now after 6 months there can be three situations of exchange rates: -

a) USD/INR can be

above 41.60

b) Or USD/INR can

be below 41.60

c) Or USD/INR canbe same 41.60

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Currency exchange rate have a negligible probability for having same rate between two

points of time, as we can see in the current market situations where the local currency is trading

above 42.75 levels, which is due to various factors so the probability of the currency been

stable is minimum. But the currency in future can trade above the 41.60 levels or below it. If

after 6 months currency is below 41.60 levels then the trader will make additional profit arisingfrom the exchange rate as he has to shed fewer rupees to buy dollars but if the currency is

above 41.60 levels then the trader has to incur additional loss which may not be favorable for

his business.

A trader therefore constantly keeps an eye on the exchange rate for protecting

themselves from the unexpected loss of the FX market.

If we analyze the example closely then we can draw following two conclusions:-

Appreciation of the local currency increases the profit percentage of the Importer and

vise-versa.

Depreciation of the local currency increases the profit percentage of the Exporter and

vise-versa.

Due to the uncertainty of the FX Markets both the Importers and Exporters are always exposed

to the elements of risk. When the organizations are exposed to FX risk, treasure finds himself

in a situation with axe hanging over his head. In order to shield them selves from the risk of FX

markets various instruments of the FX market are available to the organization.

Generally the organization having international transaction have a person responsible for the

FX operations, his designation is that of the Treasure. He is not only responsible for the sources

and application of the funds but also held accountable for the foreign exchange operations. The

Forex market has a number of instruments and is very large as it involves many of the

economies of the world, so for an organization it becomes quite difficult to handle. Therefore it

requires services of the outside parties to guide through the international deals and handle their

derivatives portfolios.

In India such Forex service providers are still in its growth stage. There are not many players in

this field. The working of these types of firms is quite simple. These firms guide the

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organizations in dealing with the foreign parties and also maintaining their portfolios. The

detail profile of a firm will help us to understand the working of it.

Understanding the company profile of Green Back Forex Services will helps to know what

types of services actually they provide to the Corporates to overcome the problems of the FXmarkets. After that we will study the instruments of the Forex market and know how with the

help of it we can reduce the risk arising from Forex exchange to the minimum.

Profile of Greenback Forex

Services Pvt. Ltd

1.2 Corporate Profile:

Established in 1995, Greenback Forex Services Pvt. Ltd. has today grown into one of

the country's most renowned consultants in the area of currency and interest rate risk

management and international finance. By joining hands and pledging commitments with

India's leading conglomerates, our customized services have earned us heartfelt respect and

recognition.

After all, every piece of advice we give, every decision we help you to take, every idea

or product we implement at your end, is targeted at achieving 100% optimality - both cost

minimization as well as revenue maximization. Whether it's procuring finances, managing

risks, fine tuning your requirements or seeing a transaction through, we believe in adding value

at every stage. And it is this conviction that takes us under client's skin to give him a 'complete

solution' that is not only need based and innovative but also relevant, executable, profitable and

safe. Suffice to say, in an age ruled by dynamism, dedication and upbeat financial milestones,

Greenback has taken an oath to be an icon of trust and reliability.

Greenback Forex Services Pvt. Ltd provides the following financial services:

1. Information Services

2. Advisory Services

3. Derivative Services

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Information Services:

In what is arguably one of the most volatile markets, timeliness and relevance of

information about the movements and trends in the Forex markets is all the more crucial

because it has a direct impact on the bottom line of the corporate. Accurate and timelyinformation is not only a facilitator to decision making but also goes towards ensuring that the

corporate is obtaining rates in line with the market.

We satisfy the above need by means of our information service module. Acting as

information service providers to more than 500 corporate clients across the country, we ensure

that our clients remain informed about the market and the changes taking place therein.

Information is delivered through a variety of communication media like e - mail, fax and SMS.

Reports are sent on a daily basis with a weekly and monthly round up. The reports encompass

all possible information about the Forex market and the money market. Apart from data on

inter-bank rates and premiums, the reports would also provide data on various money market

and Forex benchmarks, indicative quotes for derivatives including fundamental and technical

commentaries.

Forex Advisory:

In simple words, risk could be defined as uncertainty about the future. Companies

which are into foreign trade are exposed to the risk of fluctuation in exchange rates and interest

rates as their cash flows and profitability are inseparably linked to these factors. This risk is

accentuated because the underlying variables, namely currencies and interest are volatile and

dependent on a host of macro economic and political factors.

We appreciate the fact that corporate personnel cannot be expected to devote their entire time

and effort to just monitoring the Forex market. We, therefore, step into the shoes of the

corporate as far as management of their Forex portfolio goes. Capitalizing on our expertise and

infrastructure, we assist Corporates right from the stage of drawing up Forex risk management

policies, proceeding to setting up benchmarking/costing levels for transactions and managing

Forex risk through hedging strategies. Our sole purpose is to see to it that we provide the

corporate with all the inputs and advice needed for them to take an informed decision. Our

Forex advisory module helps in relieving the corporate of the responsibility of constantly

monitoring Forex markets and enables them to concentrate on their core business areas.

Derivatives Advisory:

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Over the counter interest rates and cross currency derivatives like interest rate swaps,

forward rate agreements and currency options are one of the predominant tools used by

Corporates to manage interest rate and currency market risks. More so, apart from plain vanilla

structures, banks assist Corporates to hedge their liabilities and assets by offering tailor made,

specific structures. With options on currency now being allowed and further liberalization ofthe Indian financial markets, newer risk management products like interest rates options and

more complicated structures would tend to dominate a Corporates hedging needs.

However, Indian Corporates have been facing a very typical problem in terms of

pricing of various derivative structures at the time of entering into derivative contracts. These

problems faced are two fold - in terms of the pricing model used in the inter-bank markets and

also yield curves used for such pricing. Besides this, the Corporates also face a problem at the

time of unwinding or terminating the deal, and here too the valuation system plays a dominant

role. Apart from the above mentioned pricing and valuation issues, there are various

operational problems, which include limited number of dealing banks, limited lines of credit for

derivatives, actual transaction related issues, etc. Additionally, as the Indian markets open up

for the use of new derivative products, Corporates are typically shown exotic and nonstandard

derivative instruments. Here, the corporate clearly needs to understand the effectiveness of the

hedge of such derivative products.

We assist Corporates in readying them to face these challenges and consult corporate

treasuries on a real time basis with a specific focus on interest rate and currency derivatives.

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1.3 Exchange Rates & Instruments of FX Markets

There are different types of exchange rate & instruments of FX Markets available to corporate

and firms to hedge their foreign currency exposure such as Spot Rates, Forward Rates,

Options and Swaps. Hedging can be simply termed as protecting from the risk. It is the

process of protecting or crystallizing a future cash flow or eliminating risk by taking an

offsetting position in a financial instrument. Hedging can be done for both Forex risk and for

interest rate risk. The knowledge and the working of the different instruments will enable us to

provide protection from various risk of the Forex market.

1.3.1 Spot Market

Spot transactions are the basic type of foreign exchange operation. Under spot agreements, both

parties fulfill their obligations, two working days after conclusion of the trade. It is important to

realize that an exchange rate is a price, namely the price of one currency in terms of another

currency. As there are many countries with convertible currencies, there are many exchange

rates, such as the exchange rate of a Singapore dollar in terms of European euros or the

exchange rate of a Japanese yen in terms of British pounds. Simply it can be defined as the

market where settlement takes place two working days from today at the rate, which has been

fixed today. Most of the calculations are based on the spot rates that we will come to know as

we advance further. The date, which falls on two working days from today, is called as Spot

date.

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Authorized dealers (mostly banks) quote exchange rates. The rates quoted are inter-bank rates

or the rates at which one bank would deal with other bank. The quote is a two way referred as

Bid and Ask.

Bid is the rate at

which banks are ready to Buy.

Ask is the rate at

which banks are ready to Sell.

The difference between Bid and Ask is called Spread which is the profit of the bank. When we

look at the exchange rate it is 41.60/62 which means at 41.60 Ads (banks) are ready to buy and

at 41.62 ready to sell. Now the trader in order to make his payment has to buy Dollar at 41.62

and if he has receivables in Dollars he has to sell it at 41.60.

Coming back to example, XYZ tradercan wait for 6 months and buy dollar in the spot market

and make the payment but looking at the present market local currency is making history by

depreciating to the levels above 43.10 which causes creases on the forehead of the importers

and there are confused to take the next step to hedge their risk.

Other than Spot Market a trader can settle his transactions in the Forward Market.

1.3.2 Forward Market

Forward market is the market where settlement takes place on any day beyond the spot

date at the rate, which has been crystallized today. Forward exchange rate is the price at which

you agree upon today to buy or sell an amount of a currency at a specific date in the future.

A contract for delivery of currencies more than two working days later is known as a forward

transaction. Such transactions are concluded at Forward Rates, not at spot rates. Forward rates

reflect the time for which the agreement runs. Theoretically, the forward rate for a currency can

be identical to the spot rate, but in practice it is almost always higher (premium) or lower

(discount). Forward transactions are used for a variety of purposes. They are most commonly

used to hedge trading risks and the risks arising from financial transactions.

Forward operations can not be set a part from Currency Swaps, which are a mixture of spot and

forward transactions. To prevent confusion between these two types of forward transactions,

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dealers use the term outright transaction for simple forward rate transactions that are not a

part of Swap operation.

Thus the forward market provides an avenue to hedge FX risk as it crystallizes the rate at which

a future cash flow would be converted. Forward rates are not quoted directly. Professionaltraders work with the difference between spot and forward prices expressed in decimals. In

Forward market a simple contract is formed called Forward contract. It is the most popular

and simple hedging tool available to manage currency risk.

Forward contracts specify the terms of an exchange of two currencies. In this contract the

variables that are agreed upon are:-

The currencies to be bought and sold - in every contract there are two currencies the

one that is bought and the one that is sold.

The amount of currency to be bought or sold.

The date at which the contract matures.

The rate at which the exchange of currencies will occur.

In order to form a Forward Contract a premium has to be paid for buying a currency and

discount is received for selling it. The premium and discount in forward contract is called

Forward Premium and Forward Discount. These premium and discount are quoted on

monthly basis i.e., 1 month, 2 month, 3-month etc.

Characteristics of Forward Contract in International Market:-

Forward rate are the reflections of interest rate differentials between currencies and notnecessarily a forecast of what the spot rate will be at the future date.

The fair price is the rate that prevents an investor from making a risk less profit by

round tripping and exploiting the interest rate differential.

The currency with the higher interest rate will be at a discount on a forward basis against

the currency with the lower interest rate and vice-versa.

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Characteristics of Forward Contract in Indian Market:-

Forward Premiums / discounts in India do not reflect interest rate differentials between

the currencies.

Forward premiums / discount are based more on demand and supply and expectation of

direction of spot USD/INR.

Forward premiums / discount are quoted on a month end basis i.e., August-end,

September-end etc.

Forward market is active for 1 year. Forwards beyond a year are available through the

Derivative market.

Forward Rate Calculation:-

Features of Forward Premium / Discount:-

In general, forward premium/discounts are a reflection of interest rate differentials of the

two counties.

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Forward premium/discounts have nothing to do with future expectations of the way

exchange rates would move.

Forward premium or discount exist and are calculated such that there is no arbitrage or

risk free return by borrowing from the lower interest rate country and investing the same

in the higher interest yielding country.

Regulations Governing Forward Contract:-

Forward Contracts, in general, could be booked only against a genuine underlying

exposure to FX risk.

The exposure to FX risk could be supported by documentary evidence like export orders,

Letters of credit, etc.

Exposures could be split into its component legs and forward contracts could be booked

on each of them separately.

A third currency could be used to hedge an exposure in some other currency. For

example, an exporter can buy Euro against his underlying dollar exports.

Documents against which the forward contracts are booked are freely substitutable.

Due to uncertainty of Spot rates of the currencies, Forward Contracts always becomes the most

attractive tool after Spot Market to hedge the FX risk. But like any other instruments Forward

contract also suffers from certain limitation.

The following are the limitation of Forward Contract:-

Like Forward contract can be booked for 1 year only, which restricts the trader from

forming long term commitments of financial transactions.

In Forward contract the price of the underline asset will be locked and we are obliged to

perform according to the contract, irrespective of the market situations.

In case of Forward contract there is always a chance of loosing opportunity profit.

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All corporate treasurers, hedging their Forex exposures with forward contracts, are aware that

forward contracts are the best hedging instruments for safeguarding against adverse rate

movements. However, forward contracts only turn the risk upside down and lead to opportunity

losses in the event of favorable market movements. As against forward contracts, Currency

Options are flexible in as much as they not only provide protection against adverse marketmovements but also allow benefiting from favorable ones. This flexibility of currency options,

however, carries a price tag with it in the form of Option premium, which is usually payable

upfront.

Due to the limitation of the Forward Contract another instrument is designed which perfectly

overtakes the limitations of the Forward Contract and gives a much more flexibilities in the

hands of the trader to exploit the market in his favor. The instrument possessing such

characteristics is termed as Options.

1.3.3 Options

An option in the common parlance refers to choice or alternative or privilege or

opportunity or preference or right. To have Options is normally regarded good. One is

considered unfortunate without options. Options are valuable since they provide protection

against unwanted, uncertain happenings. They provide alternatives to bail out from difficult

situations. Options have assumed considerable significance in Finance.They can be written on

any assets including shares, bonds, portfolios, stock indices, currencies etc They are quite

useful in risk management of the above financial instruments, but Options in our study will

clearly focus and will be explained in the light of Currencies.

Simply stated an Option is a choice like Forwards, it is the way of buying or selling a

currency at a certain point in the future. An option is a unique financial instrument or contract

that confers upon the holder or the buyer thereof, the right but not an obligation to buy or sell

an underlying asset, at a specified price, on or up to a specified date. In short, the option buyer

can simply let the right lapse by not exercising it. On the other hand, if the option buyer

chooses to exercise the right, the seller of the option has an obligation to perform the contract

according to the terms agreed. An option is a contract, which specifies the price at which an

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amount of currency can be bought at a date in the future, called the expiration date. Unlike

Forwards, the owner of an option does not have to go through with the transaction if he or she

does not wish to do so. As its name suggests, an option is a right but not obligation to buy

or sell the underlying. Also, unlike Forwards, the price at which the currency is to be bought or

sold can be different from the current forward price.

The asset underlying a currency option can be a spot currency or a futures contract on a

currency. An option on a spot currency gives the option buyer the right to buy or sell the said

currency against another currency while an option on a currency futures contract gives the

option buyer the right to establish a long or short position in the relevant currency futures

contract. Options on spot currencies are commonly available in the inter-bank Over-the-counter

(OTC) markets while those on currency futures are traded on exchanges like the Chicago

Mercantile Exchange (CME) and the Singapore International Monetary Exchange (SIMEX).

Formally Options is defined as

A contract which provides to the buyer of the option, right but not the obligation, to

buy or sell a specific asset at a specific price, on or before any time prior to the specific date.

In order to avail these rights a premium is been charged from the Option buyer which is always

higher than the Forward Premium. But unlike Forward contract it is entirely up to the buyer

whether or not to exercise that right, only the seller of the option is obligated to perform. On

these platform Options proves to be more advantageous form the Forward Contract.

There are two main types of Options: Call Option and Put Option.

Both individually having two legs, the following is the classification of the Options in an

elaborated form: -

Types of Options:

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Figure 1.1

OPTIONS TERMINOLOGY

Call Option: A call option gives the option buyer the right to buy one currency X against

another Y at a stated price on or before a stated date.

Put Option: A put option gives the option buyer the right to sell one currency X against

another currency Y at a stated price on or before a stated date.

In foreign exchange transactions one currency is bought by selling another currency. Thus if we

consider the USD/INR currency pair, a call option on the Dollar is no different from a put

option on the Rupee. Similarly, a put option on the Dollar is nothing but a call option on the

Rupee.

Strike Price: This is the price specified in the option contract at which the option buyer can

buy or sell currency X against currency Y or for instance the euro against the dollar.

Depending on when an option can be exercised, it is classified in one of the following two

categories:-

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European Options when an option is allowed to be exercised only on the maturity

date, it is called European Option.

American Options when the option can be exercised any time before its maturity date

it is called American Option.

Maturity Date: The date on which option expires is called Maturity Date.

Premium (Option Price or Option Value): The upfront fee that option writer or seller

charges the buyer for giving the latter the right inherent in the option is called Option

Premium. If the option lapses unexercised, the buyer loses this amount. This premium

can be split into 2 parts: Intrinsic value and time value.

Intrinsic value: It is the amount an option would be worth was it to be exercised immediately.

For instance, if an American call option on EUR has a strike price of $0.85 and the

current spot EUR/USD rate is say $0.88, the intrinsic value is $0.03 per euro. European

options can be exercised only at maturity. Even so, they can have intrinsic value.

European put options will have intrinsic value if the forward rate applicable for the

maturity date exceeds the strike price.

Time Value: An option can have time value only if it has some time remaining to expiry. Time

value depends on the chances of the option gaining in value before expiry. At-the-

money and out-of-the-money options have no intrinsic value and can have only time

value. The time value of a currency option thus depends upon a number of factors such

as the spot price, strike price, time to maturity, volatility of the market price, domestic

interest rate and the foreign interest rate.

In-the-Money: A put or a call option is said to be in-the-money when it is advantageous for the

investor to exercise it. In the case of in-the-money call option, the exercise price is less

than the current value of the underlying assets, while in the case of in-the-money put

option; the exercise price is higher than the current value of the underlying assets.

Out-of-Money: A put or call option is out-of-money if it is not advantageous for the investor

to exercise it. In the case of out-of-money call options, the exercise price of higher than

the current value of the underlying assets, while in the case of the out-of-money put

option, the exercise price is lower than the current value of the underlying assets.

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At-the-Money: when the holder of the call or put option does not lose or gain whether or not

he exercise his option, the option is said to be at-the-money option the exercise price is

equal to the underlying assets.

Call Put Parity:

This is a very important relation. If we consider a call option and a put option on the same

currency (pair) with the same maturity and strike price, the difference between the call

premium and the put premium equals the forward rate minus the strike price. In an equation

form:

C - P = F - X

Thus, when F, the forward rate equals X, the strike price; the call and put premiums are equal.

Pay-off profiles at maturity: For a call option, if the maturity spot (S) is equal to or less than the

strike price (X), the pay-off is a loss equal to the upfront premium paid (C). On the other hand,

if S is greater than X, the pay-off equals S - X - C. For a put option, if S is equal to or greater

than X, the pay-off is minus P. And, if S is less than X, pay-off on a put option is X - S - P.

Let us now consider first how the total value of European euro call options varies withchanges in the variables like Strike price, Maturity, Volatility and Interest ratesdifferentials and then see how these options can be used to hedge exchange risk.

I. Strike price.

An out-of-the-money option has no intrinsic value. Now the more an option is out-of-

the-money, the less is the chance of its expiring in-the-money and consequently lower is its

time value. On the other hand, the value of an in-the-money option comprises of both intrinsic

value and time value. In this case, the more an option is in-the-money the more is its intrinsicvalue but the lower is its time value as greater is the chance of it losing value and hence of

being exercised. Thus other things being equal, an at-the-money option has the maximum time

value.

Example:

Current EUR/USD spot rate : 0.8700

Maturity : 3 months

Volatility : 13%Domestic int. rate (USD) : 6.80% p.a.

Foreign int. rate(EUR) : 4.98% p.a.

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Forward rate & ATM strike : 0.8740

Table 1.1

Strike Price Call Premium Intrinsic Value Time Value

0.9100 0.0092 nil 0.0092

0.9000 0.0121 nil 0.0121

0.8900 0.0155 nil 0.0155

0.8800 0.0196 nil 0.0196

0.8740 0.0224 nil 0.0224

0.8680 0.0255 0.0060 0.0195

0.8580 0.0311 0.0160 0.0151

0.8480 0.0374 0.0260 0.0114

0.8380 0.0443 0.0360 0.0073

Table 1.2

II. Maturity:

The longer the time to maturity, the greater is the chance that an option may move from

at-the-money or out-of-the-money to in-the-money. Hence, longer the maturity, higher the time

value but the relationship is not linear.

Example:

Current AUD/USD spot price : 0.5340

ATM strike price : 0.5340

Volatility : 15.4%

Table 1.3

Domestic interest rate = Foreign interest rate (assumed)

Maturity (months) Call Value % change in value

1 0.0094 ---

2 0.0134 43 %

3 0.0163 22 %

6 0.0231 42 %

12 0.0327 42 %

Table 1.4

III. Volatility:

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The greater the chances of the underlying currency moving higher or lower over the

maturity of the option, the higher will be the premium. The statistical measure normally used to

gauge the volatility of markets is the Standard Deviation, more correctly the standard deviation

of daily percentage changes in the underlying price. Volatility describes the size of likely price

variations around the trend rather than the trend itself. The figure is usually annualized to give aconstant measure. For instance, annualized volatility of 20% means that the currency has a 68%

chance of being up or down within a 20% band within one year. It is possible to convert this

figure into a daily volatility measure by dividing the annualized volatility by the square root of

the number of trading days in a year (sq. root of 250 = 15.8). For instance, with spot euro at

0.87 and volatility at 13%, there is a 68% probability that the spot rate will range between

0.8628 and 0.8772 in a one-day period.

Volatility is a key variable in option pricing. For at-the-money options, the relationship is

almost linear.

Example:

Current EUR/USD spot rate : 0.8700Forward rate & ATM strike price : 0.8740Maturity : 3 monthsDomestic interest rate : 6.80% p.a.Foreign interest rate : 4.98% p.a.

* EUR/USD = 0.8700 (1 USD = 0.87 EUR) Table 1.5

Volatility (%) Call Premium

4 % 0.0068

6 % 0.0103

8 % 0.0138

10 % 0.017212 % 0.0207

14 % 0.0241

16 % 0.0276

18 % 0.0310

Table 1.6

Essentially, there are two ways of looking at volatility. The first is to calculate the

standard deviation of a given series of spot prices. What the trader is trying to do here is to find

a measure of historical volatility, which adequately explains how the market has been moving

and, more significantly, will give a reasonable idea of how the market is likely to move in the

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future. Volatilities are however not constant and therefore a second method of measuring

volatility is to look at the actual premiums of traded options and to calculate the implied

volatility. Implied volatilities are available on Reuters, Bloomberg, Bridge or other similar

monitors.

IV. Interest rate differentials:

The effect of interest rates on option premiums is the least obvious, and yet, particularly

with currency options, it is one of the most important components of the premium. For stock or

commodity options, higher the interest rate, higher is the call option premium. This is so

because higher the interest rate, greater is the opportunity cost of funds, which have to be

deployed to buy the concerned stocks or commodities. In currency options, the situation is

complicated by the fact that there are two interest rates involved, the domestic interest rate and

the foreign interest rate. In this case, since the euro is priced in terms of the dollar, the domestic

interest rate is that for the dollar and the foreign interest rate is that for the euro. The premium

of a euro call option will increase if the dollar interest rate rises or the euro interest rate falls

because in either case the cost of holding euros increases.

Example:

Current EUR/USD spot rate : 0.8700

Strike price : 0.8740

Volatility : 13%

Maturity : 3 monthsForeign (euro) interest rate : 4.98% p.a.

Table 1.7

$ int. rate-% p.a. Call premium Put premium

4 0.0196 0.0257

5 0.0206 0.0245

6 0.0216 0.0234

7 0.0226 0.0223

8 0.0237 0.0212

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Table 1.8

We have seen earlier that with the dollar interest rate of 6.8% and given the euro

interest rate of 4.98% and the spot rate of 0.8700, the 3-month forward rate is 0.8740 and hencethe above strike price of 0.8740 is at-the-money. Right now, the euro is a premium because the

dollar interest rate is higher than that of the euro interest rate. If the dollar interest rate falls, the

forward rate will fall. Consequently, a call option with a strike price of 0.8740 will be more and

more out-of-the-money and its premium falls. Conversely, the call premium rises if the dollar

interest rate rises. A put option with a strike price of 0.8740 will however be more and more in-

the-money as the dollar interest rate falls and hence the put premium rises.

Let us now see what happens if the euro interest rate varies while dollar interest rate stands at

say 6.8% and other parameters such as spot rate, strike price and maturity remain the same.

Euro Int. Rate Call Premium Put Premium

3 % 0.0245 0.0203

4 % 0.0234 0.0214

5 % 0.0224 0.0225

6 % 0.0214 0.0236

7 % 0.0204 0.0248

Table 1.9

Now from the table 1.9 as we find that as the euro interest rate rises from 3% to 7%, the

call premium falls and the put premium rises. This is because the forward rate falls

progressively. As the euro rate moves from 3% to 4.98%, a call option with strike price of

0.8740 becomes less and less in-the-money. When the euro interest rises still further to 7%, the

said call option now becomes more and more out-of-the-money. Consequently, the call

premium falls. The converse is true for put options.

Studying the above variables is not an easy task but a step by step understanding of it

helps to determine the total value of the options which forms the base structure for hedging the

FX exposures through currency options.

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HEDGING WITH CURRENCY OPTIONS:

The objective of including currency options in our hedging arsenal has obviously to be

to get the best protection available at the least possible cost. This is easier said than done.

However, a corporate with foreign currency payables say in euro could use the following

decision tree as a guide: (Table 1.10)

Currency hedging decision tree:

View of currency View of risk ActionVery bullish Risk averse Buy currency forwardVery bullish Risk tolerant Buy currency forward

Bullish Risk averse Buy currency forwardBullish Risk tolerant Buy atm call

Flat market Risk averse Buy ootm callFlat market Risk tolerant Do nothing *No view Risk averse Buy atm call

No view Risk tolerant Do nothing *Bearish Risk averse Buy ootm callBearish Risk tolerant Do nothing *

Very bearish Risk averse Buy far ootm callVery bearish Risk tolerant Do nothing *

Table 1.10

Notes:

* Place good-till-cancelled stop-loss orders just in case the currency strengthens unexpectedly.

Atm = At-the-money

ootm = out-of-the-money

What is important to bear in mind is that options should be considered as complementary to

forwards and not used to the exclusion of forwards. Even so once a decision is taken to hedge

with options, one has to decide on the strike price and the maturity based on the expected

direction of the market, volatility and also interest rates if hikes or cuts are imminent.

Another area is to consider the use of Range forwards and Participating forwards as also exotic

options such as knock-ins, knock-outs, etc. In these cases, the option buyers main goal is to

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reduce or totally avoid the upfront premium payable in the case of plain call or put options.

However, it should be borne in mind that for reducing or avoiding the premium, the hedger

gives up a part of the protection and/or benefit. In the case of knock-in options, he risks not

having any protection at all if the price of the underlying doesnt reach a specified trigger level.

While in the case of knock-out options the hedger risk losing the protection completely if aspecified trigger level is traded even briefly.

Let us now examine how a euro call option would compare with a forward contract or an open

position depending on our choice of strike price and the spot price at maturity.

Example:

Current spot price : 0.8700

Maturity: 3 months

Current fwd price : 0.8740

Volatility: 13%

Domestic int. rate : 6.8%

Foreign int. rate : 4.98%

Table 1.11

Strike price Call premium Option better than

If spot rate at maturity is

Open position Forward contract higher than lower than

0.8740 0.0224 0.8964 0.8516

0.8900 0.0155 0.9055 0.8585

0.9100 0.0092 0.9192 0.8648

Table 1.12

For instance, say you buy ATM euro call option with strike price of 0.8740 to hedge a 3-month

euro liability. You pay an upfront premium $0.0224 per euro. Ignoring the interest lost on the

premium outlay, buying the euro call will be better than booking an outright forward contract at

0.8740 only if the spot rate at maturity is less than 0.8516. This is so because only in that case

the spot rate at maturity plus the call premium will be less than todays forward rate. On the

other hand, if the purchase of the call option is to be better than keeping the liability unhinged,

the spot rate at maturity will have to be higher than the strike price plus the premium. The

important thing to note in this illustration is that the option will fare worse than both a forward

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contract as well as an unhinged liability if the spot rate at maturity falls between 0.8516 and

0.8964.

From the above table, it is clear that you can reduce the premium payable by an option, which

is more and more out-of-the-money. However, as we mentioned earlier, you have to give up

more and more protection to get a larger and larger premium reduction. Far out-of-the-money

options may often be ruled out by your costing levels or risk limits.

Now let us compare the maturity pay-off of each of the above 3 options for different spot rates

at maturity. Please note if the spot rate at maturity is less than or equal to the strike price, the

option is not exercised and you lose the entire premium. If the spot rate at maturity is greater

than the strike price, the option is exercised and you begin to recover the premium paid.

However, the net pay-off to you from any option is positive only when spot rate at maturity is

greater than the corresponding strike price plus the premium. Let us see examine this through

the following table:

Option A: Strike price 0.8740 and premium 0.0224

Option B: Strike price 0.8900 and premium 0.0155

Option C: Strike price 0.9100 and premium 0.0092

Spot at maturity Option A Option B Option C

0.8500 -0.0224 -0.0155 -0.0092

0.8740 -0.0224 -0.0155 -0.0092

0.8809 -0.0155 -0.0155 -0.0092

0.8872 -0.0092 -0.0155 -0.0092

0.8900 -0.0064 -0.0155 -0.0092

0.8963 -0.0001 -0.0092 -0.0092

0.9000 0.0036 -0.0055 -0.0092

0.9055 0.0091 0.0000 -0.0092

0.9100 0.0136 0.0045 -0.0092

0.9192 0.0228 0.0137 0.0000

Table 1.13

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We can observe from the table 1.13 that Option A outperforms Option B when spot rate at

maturity exceeds 0.8809. Option A outperforms Option C when maturity spot exceeds 0.8872.

Finally, Option B outperforms Option C when maturity spot exceeds 0.8963. You can choose

the appropriate option depending on your market view and the maximum premium that you are

willing to pay.

We may well say that we want free or zero-cost protection or insurance at a given strike price.

This is possible under RBI guidelines. There are two simple ways to achieve this by buying

calls and selling puts or vice versa. The only restriction is that you cant receive a net premium.

Range Forward:

Suppose we have a euro liability 3 months from now. Present spot rate is 0.87 and the

forward rate is 0.8740. If we want to cap our cost at say 0.90 free of cost, we will have to

accept a floor at 0.8480. This involves buying an out-of-the-money call option with a strike of

0.90 and selling an out-of-the-money put option with a strike of 0.8480. The premium received

on the put exactly offsets the premium paid on the call. If the maturity spot is over 0.90, we

exercise the call and pay only $0.90 per euro. If the maturity spot is less than 0.8480, the put

sold by us gets exercised and we pay $0.8480 per euro. Thus, our windfall benefit is limited.

Finally, if the maturity spot is anywhere from 0.8480 to 0.9000, we pay the prevailing spot rate.

Participating Forward:

If we are very bearish on the euro and dont want to accept any floor but still want the

same cap as an insurance, there is still a way out. However, we will have to "lock in" the cap

rate for a part of the exposure by selling an in-the-money put option with the same strike as that

of the call. With an out-of-the-money 3-month euro call @ 0.90 costing $0.0121 per euro and

an in-the-money 3-month euro put @ 0.90 fetching $0.0380 per euro, the amount of the put

option has to be 31.8% of the amount of the call option. We will see that for 31.8% of the call

option amount, we have bought a call and sold a put with the same strike of 0.90. This is like a

synthetic forward inasmuch as either the call will be exercised or the put will be exercised and

we are committed to paying $0.90 for 31.8% of the call option amount. In consideration, we

have a free call option @ 0.90 for the balance 68.2% of the exposure so hedged.

Let us compare the effective cost under these 2 alternatives:

Spot at maturity Range Forward Participating Forward

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0.90+ 0.90 0.90

0.8480 0.8480 0.8645

0.8238 0.8480 0.8480

0.8000 0.8480 0.8318

0.7800 0.8480 0.8182

0.7600 0.8480 0.8045

Table 1.14

Knock-out and knock-in options:

These are together known as Barrier Options and have a conditionality clause built

into them. For instance, knock-out options cease to exist when the spot rate moves in a certaindirection and touches a specified trigger level while knock-in options come into existence only

when the spot rate touches a specified trigger level. The main advantage of these options is

their smaller up-front premia compared to plain vanilla options. The trigger level can be above

or below the present spot rate. Options that get knocked out when the spot rate touches a higher

trigger level are called Up-and-Out options while those that get knocked out when the spot rate

hits a lower trigger level are called Down-and-Out options. Knock-in options are also either

Up-and-In options or Down-and-In options. A simple - call or put - option is nothing but a

knock-out option plus a knock-in option with the same strike and same trigger level. If these

options are used for risk management, you would normally buy options which get knocked-out

when spot rate has moved and is expected to move in your favor or knocked in when the spot

rate has moved against you and is threatening your risk limit. That is a call option will get

knocked out when the spot rate falls to a lower trigger level or gets knocked in when the spot

rate rises to a higher trigger level. If you expect a temporary adverse price movement followed

by a major trend reversal in your favor, you could do the opposite, that is, buy a call option that

gets knocked in when the spot rate falls to lower trigger level. In such cases, you will still have

to guard against an earlier-than-expected trend reversal through good-till-cancelled stop-loss

orders. There are many zero-cost exotic combinations of simple options and knock-outs or

knock-ins. One such version is called Smart Forward. Essentially, this is an out-of-the-money

synthetic forward contract which you can walk away from if the maturity spot is more

favorable provided a pre-specified trigger level has not been traded at any time during the life

of the option. For example, for a 3-month euro liability with spot at 0.87 and ATM strike of

0.8740, if you specify your cap or risk limit as say 0.90, the bank may tell you that the trigger

for the zero-cost smart forward is say 0.85. What this means is that if the spot rate trades at

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0.85 any time during the life of the option, you will be obliged to buy euros at 0.90 irrespective

of the maturity spot. On the other hand, if the spot rate has never hit the trigger level, the smart

forward is like a simple out-of-the-money option. Besides, the more out-of-the-money the

strike price is, the further is the trigger from the current spot rate. A few words of caution

would not be out of place at this juncture. The names given to this and other similar hedges areso alluring as to make feel smart enhanced and so on. How would it look, if in the above case

the maturity spot of the euro is say 0.80 and you have to buy at 0.90? In a lighter vein, one slip

and a smart forward might look like a dumb backward!

1.3.4 Swaps

Swaps is a customized bilateral agreement between two parties which enables them to

exchange specified cash flows at periodic over a pre-determined life of Swaps. Or in the other

words its a private agreement between two parties to exchange cash flows in the future

according to a prearranged formula. They can be regarded as portfolios of forward contracts.

Swap is used by multinational corporations to fund their foreign investments and manage their

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interest rate risk. Different types of Swaps present opportunities to the multinational firm to

reduce financing costs and/or risk. Corporate financial managers can use swaps to arrange

complex, innovative financings that reduce borrowing costs and increase control over interest

rate risk and foreign currency exposure. Swaps have had a major impact on the treasury

function, permitting firms to tap new capital markets and to take further advantage ofinnovative products without an increase in risk. Through the swap, they can trade a perceived

risk in one market or currency for a liability in another. The swap has led to a refinement of

risk management techniques, which in turn has facilitated corporate involvement in

international capital markets.

The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash flows between the

parties in the currencies. It may be floating to floating or fixed to floating and vice-versa.

Currency swaps: These entail swapping both principal and interest between the parties, with

the cash flows in one direction being in a different currency than those in the opposite

direction.

Interest Rate Swaps

An interest rate swap is a derivative in which one party exchanges a stream of interest

payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to

manage their fixed or floating assets and liabilities. They can also be used by speculators to

replicate un-funded bond exposures to profit from changes in interest rates. As such, interest

rate swaps are very popular and highly liquid instruments. Today, interest rate swaps are often

used by firms to alter their exposure to interest-rate fluctuations, by swapping fixed-rate

obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able

to alter its interest rate exposures and bring them in line with management's appetite for interest

rate risk.

An interest rate swapis an agreement between two parties to exchange interest payments of a

currency for a specific maturity on an agreed notional amount. The term notional refers to the

theoretical principal underlying the swap. Thus, the notional principal is simply a reference

amount against which the interest is calculated. No principal ever changes hands. Maturities

range from less than a year to more than 15 years; however, most transactions fall within a two-

year to 10-year period. The two main types are coupon swaps and basis swaps. In a coupon

swap, one party pays a fixed rate calculated at the time of trade as a spread to a particular

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Treasury bond, and the other side pays a floating rate that resets periodically throughout the life

of the deal against a designated index. In a basis swap, two parties exchange floating interest

payments based on different reference rates. Using this relatively straightforward mechanism,

interest rate swaps transform debt issues, assets, liabilities, or any cash flow from type to type

and with some variation in the transaction structure from currency to currency.

The most important reference rate in swap and other financial transactions is the London Inter-

bank Offered Rate (LIBOR). LIBOR is the average interest rate offered by a specific group of

multinational banks in London (selected by the British Bankers Association for their degree of

expertise and scale of activities) for U.S dollar deposits of a stated maturity and is used as a

base index for setting rates of many floating rate financial instruments, especially in the

Eurocurrency and Eurobond markets.

The Classic Swap Transaction (Table 1.15) - Counter parties A and B both require $100

million for a five-year period. To reduce their financing risks, counter party A would like to

borrow at a fixed rate, whereas counter party B would prefer to borrow at a floating rate.

Suppose that A is a company with a BBB rating and B is an AAA-rated bank. Although A has

good access to banks or other sources of floating-rate funds for its operations, it has difficulty

raising fixed-rate fund from bond issues in the capital markets at a price it finds attractive. By

contrast borrow at the finest rates in either market. The cost to each party of accessing either

the fixed-rate or the floating-rate market for a new five-year debt issue as follows:

Borrower Fixed Rate Available Floating Rate Available

Counter Party A BBB-rated 8.05% 6-month LIBOR + 0.5%

Counter Party B AAA-rated 7% 6-month LIBOR

Difference 1.50% 0.5%

Table 1.15

To begin, A will take out a $100 million, five-year floating-rate Euro-dollar loan from a

syndicate of banks at an interest rate of LIBOR plus 50 basis points. At the same time, B will

issue a $100 million, five-year Eurobond carrying a fixed rate of 7%. A and B then will enter

into the following interest rate swaps with Big-Bank. Counter party A agrees that it will pay

Big-Bank 7.35% for five years, with payments calculated by multiplying that rate by the $100

million notional principal amount. In return for this payment, Big-Bank agrees to pay A six-

month LIBOR over five years, with reset dates matching the reset dates on its floating-rate

loan. Through the swap, A has managed to turn a floating-rate loan into a fixed loan costing

7.85%.

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In a similar fashion, B enters into a swap with Big-Bank whereby it agrees to pay six-month

LIBOR to Big-Bank on a notional principal amount of $l00 million for five years in exchange

for receiving payments of 7.25%. Thus, B has swapped a fixed-rate loan for a floating-rate loan

carrying an effective cost of LIBOR minus 25 basis points.

Why would Big-Bank or any financial intermediary enter into such transaction?

The reason Big-Bank is willing to enter into such contracts is more evident when looking at the

transaction in its entirety.

As a financial intermediary, Big-Bank puts together both transactions. The risk net out, and

Big-Bank is left with a spread of 10 basis points:

Receive (from A) 7.35%

Pay (to B) 7.25%

Receive (from B) LIBOR

Pay (to A) LIBOR

Net 10 basis points

Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to

varying levels of creditworthiness in companies, there is often a positive quality spread

differential which allows both parties to benefit from an interest rate swap.

Interest rate swaps expose users to following risks:-

Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-

for-floating swap, the party who pays the floating rate benefits when rates fall. (Note

that the party that pays floating has an interest rate exposure analogous to a long

bond position.)

Credit risk on the swap comes into play if the swap is in the money or not. If one of

the parties is in the money, then that party faces credit risk of possible default by

another party.

Currency Swaps

Swap contracts also can be arranged across currencies. Such contracts are known as currency

swaps and can help manage both interest rate and exchange rate risk. Many financial

institutions count the arranging of swaps, both domestic and foreign currency, as an important

line of business. Technically, a currency swap is an exchange of debt-service obligations

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denominated in one currency for the service on an agreed upon principal amount of debt

denominated in another currency. By swapping their future cash flow obligations, the counter

parties are able to replace cash flows denominated in one currency with cash flows in a more

desired currency. In this way, company A, which has borrowed, say, Japanese yen at a fixed

interest rate, can transform its yen debt into a fully hedged dollar liability by exchanging cashflows with counter party B.

Currency swaps contain the right of offset, which gives each party the right to offset any

nonpayment of principal or interest with a comparable non-payment. Absent a right of offset,

default by one party would not release the other from making its contractually obligated

payments. Moreover, because a currency swap is not a loan, it does not appear as a liability on

the parties balance sheets. Although the structure of currency swaps differs from interest rate

swaps in a variety of ways, the major difference is that with a currency swap, there is always an

exchange of principal amounts at maturity at a predetermined exchange rate. Thus, the swap

contract behaves like a long-dated forward foreign exchange contract, where the forward rate is

the current spot rate. According to interest rate parity theory, forward rate is a direct function of

the interest rate differential for the two currencies involved. As a result, a currency with a lower

interest rate has a correspondingly high forward exchange value. It follows that future exchange

of currencies at the present spot exchange rate would offset the current difference in interest

rates. This exchange of principals is what occurs in every currency swap at maturity based on

the original amounts of each currency and, by implication, done at the original spot exchange

rate. In the classic currency swap, the counter parties exchange fixed rate payment one currency

for fixed-rate payments in another currency.

For example, consider the US-based company ("Acme Tool & Die") that has raised money by

issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6%

on 100 million Swiss Francs. Upfront, the company receives 100 million Swiss Francs from the

proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss

Francs to fund their US operations.

Because this issue is funding US-based operations, we know two things straightaway. Acme is

going to have to convert the 100 million Swiss Francs into US dollars. And Acme would prefer

to pay its liability for the coupon payments in US dollars every six months.

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Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering

into a currency swap with the First London Bank. Acme agrees to exchange the 100 million

Swiss Francs at inception into US dollars, receive the Swiss Franc coupon payments on the

same dates as the coupon payments are due to Acme's Eurobond investors, pay US dollar

coupon payments tied to a pre-set index and re-exchange the US dollar notional into SwissFrancs at maturity.

Currency swaps allow companies to exploit the global capital markets more efficiently. They

are an integral arbitrage link between the interest rates of different developed countries. The

future of banking lies in the securitization and diversification of loan portfolios. The global

currency swap market will play an integral role in this transformation. Banks will come to

resemble credit funds more than anything else, holding diversified portfolios of global credit

and global credit equivalents with derivative overlays used to manage the variety of currency

and interest rate risk.

Market Analysis Tools

Since the foreign currency market is fluctuating on a continuous basis, one should be able to

understand the factors that affect this currency market. This is done through Technical Analysis

and Fundamental Analysis. These two tools of trade are used in a variety of other markets such

as equity markets, stock markets, mutual funds markets etc. Technical analysis is the

interpretation of facts and data based on the data generated by the market. Fundamental

analysis refers to the factors, which influence the market economy, and in turn how it would

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affect the currency trading, it seeks to trace out the factors and conditions which influence the

market economy and play a pivotal role in altering opinions. Several economic, political, social

events affect the Forex and its workings. A perfect investor in Forex is one who can understand

these factors and feel the pulse of the market before striking gold. Of course there are other

economic and non economic factors which can suddenly affect the trading of the FX marketssuch as the 9/11 tragedy etc. One needs to have a shrewd acumen and a few number crunching

abilities to strike gold in the FX market.

2.1 Structure of Fundamental Analysis:

Fundamental analysis means closely studying the numerical data of the domestic

economy and the other related economies and drawing conclusions from it. Economists believe

that all the activities of the economy are closely inter-related with each other, the change in one

activity will have marginal influence over other activities. Based upon this simple relation

Fundamental Analysis plays an important role in determining the move of the currency market.

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Since fundamental analysis is about looking at the intrinsic value of an investment, its

application in Forex entails looking at the economic conditions that affect the valuation of a

nation's currency.

Practically there are numerable factors which fundamental analysis covers but all of

them do not get considerable attention of the analyst. Factors which reflect the domestic

economys performance and are under the control of the government are called as Internal

Factors. Like wise the factors beyond the control of the domestic economy are studied under

External Factors. Beyond these Economic Indicators also plays a crucial role in predicting

the currency movement. Some major factors both Internal and External, which have a greater

potential to influence the market are discussed below which affects the foreign exchange rates:-

2.1.1 Internal Factors:-

Inflation A raise in the general price level of the commodities and services in

the country is called Inflation. The affect of it is easily understood from the current

market situations in which inflation is 11.89 % (for week ended 28 th June) and USD/INR

rates trading at 42.90 levels as compared to starting of the year in which inflation was in

4-5 % mark and the USD/INR hovering at 40.5 levels. Inflation has a negative influence

with currency as the inflation increases the domestic currency depreciates and vise-versa

being inflation of the other country unchanged. An above average inflation differential

hampers the international competitiveness of an exporter since it means higher labor costs

and higher costs for nationality bought semi products. It usually results in a decline in

exports earnings and by reducing the price of imports, an increase in import usually

accompanies the decrease in exports and aggravates negative aspects for Forex operations

of a country. Below average inflation, on the other hand, benefits foreign exchange

operations because it enhances export and reduces imports. Inflation been an important

spice in the recipe of the exchange market, it draws considerable and constant attention of

the market analysts.

Currency Parity Policy - The external parity of a countrys currency has a major

influence on its FX operations. If a country decides to float its exchange rate, the relation

of its currency to all others is formed by the forces of FX markets. For the markets it is no

longer only inflation discrepancies that change parities. Forecasts, market technicalities,

interest developments and political events have become major market movers. Non

floating currencies are still adjusted from time to time to take into account differences in

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the inflationary development of the major trading partners of the country making the

adjustment.

Economic Policies These have a major bearing on the external accounts of a

country. The economic policies fix the way in which a national economy is managed and

also influence the division of the economy into state and private sectors. They create or

eliminate the incentives for efficiency in all sectors of the economy. They are responsive

for the state of the public finances and influence inflation. Sound economic policies

create a favorable climate not only for investment in the country, but also for an efficient

production structure that can be competitive in international markets. Looking at

economic policies, it is also worth while determining the position of the central Bank

within the policy making process of a country. An independent Central Bank normally

allows at least some economic policies to be executed by an independent body. In

addition, the use of printing press to solve budgetary problems is discounted.

Use of Foreign Funds - The utilization of borrowed funds by private entities is

normally project-orient and therefore, easily recognized. Sovereign borrowing is also

often used for project financing that helps the country as well as its economy. And it can

be used to develop industries that have an import-substitution effect by creating domestic

production as a replacement for imported goods. Funds can, however, also be borrowed

to finance a budget deficit of Central or State Government, which can have its origins in

many different reasons. The use of foreign funds can create a new potential for foreign

exchange earning, or have a directly opposite effect by expanding the need for foreign

through increased foreign debt.

Terms of Trade and Service - The development of the terms of the trade and

services has a significant influence on a countrys foreign exchange operations. Inflation

and currency parity policy are not the only influences on the terms of trade and services.The relation between self-sufficiency and domestic demand, for example, can develop in

a negative way because of structural changes in production and demand, thereby affecting

the terms of trade and services, which are also influenced by the ingenuity, adaptability

and dynamism of countrys population.

Natural Resources - The development of the terms of the trade and services has

a significant influence on a countrys foreign exchange operations. Inflation and currency

parity policy are not the only influences on the terms of trade and services. The relation

between self-sufficiency and domestic demand, for example, can develop in a negative

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way because of structural changes in production and demand, thereby affecting the terms

of trade and services, which are also influenced by the ingenuity, adaptability and

dynamism of countrys population.

Customs, Excise and Taxes - Customs levies were used more to protect the

domestic industry. However, now they are used to restrict the import of certain goods in

order to protect the foreign exchange situation of a country. In addition, many of certain

goods in order to protect the foreign exchange situation of a country. In addition, many

non-tariff barriers are used to protect home industries, which help save foreign exchange.

Capital Movements and Unilateral Transfers - Under their most negative aspect,

capital movements become capital flight and a source of loss of foreign exchange. Capital

flight takes place primarily because the economic and political climate does not provide

the necessary incentive for accumulating capital in ones own country. The inflow of

foreign capital for investment helps not only to broaden the economic base but also brings

foreign exchange with it. Many countries have seen the beneficial aspect of this and have,

therefore created special development agencies. In a more specialized form, such capital

is provided under the terms of foreign aid. The remittances of savings by people working

abroad must also be included here.

2.1.2 External Factors:

Trade Barriers - These are either quantitative or qualitative, are typical case where a

countrys ability to earn foreign exchange can be seriously impaired. Trade barriers

normally have a negative effect on the foreign exchange operations of all the countries

concerned. They often support dying industries in industrialized countries with an ever

increasing cost to the community. Developing countries use trade barriers to protecttheir new industries; this can be at cost of efficiency.

Commodity Price - The development of commodity prices is usually beyond the

influence of a specific country. Price fluctuations, however, very much affect the

foreign exchange operations of the countries that are the main producers of the

commodities. The IMF has created a special facility for countries that have been

adversely affected by movements in commodity prices. Only in case of oil has a cartel

worked of the producers for several years, i.e. OPEC.

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Interest Rates -Because foreign debt or trade credit is incurred in foreign currencies,

the interest rate on those liabilities is fixed by the international financial markets, which

is beyond the influence of most of the countries. The rate if interest has, however, a

very direct on the foreign exchange operations of the countries involved. The higher the

rate, the more foreign exchange is needed. The widespread use of the floating interestrate as the price for international credit has added another element of uncertainty to the

management of foreign debt of the country. Preferential rates are applied by the IDA as

well as in foreign aid.

Natural Catastrophes -These mostly affect the agricultural; sector with destruction of

harvests. This leads to additional imports and therefore, to a loss of foreign exchange.

International aid programs help overcome/mitigate effects of natural catastrophes.

However, the destruction of eco-balance occurring in many countries will lead to

unmanageable problems for them in future.

Transportation - Cross-border trade usually involves transportation the costs of which

are often not within the control of a country. They can price a country out of the market.

Not only can the costs of transportation be a problem but also its availability.

Market Condition -These are principally influenced by market liquidity. When talking

about global financing market, we have take into account all the major money and

capital markets of all the markets, the situation on the EURO market is of prime

important since it is the major provider of funds for cross-border lending. Abundant

liquidity usually leads to easier borrowing and lending, as all banks tend to be builders

of assets in such times. But not only liquidity is an important factor allocating funds and

deciding on maturities available for lending, the emotional state of the market is

important as well. Allocation of funds or acquisition of assets is achieved by taking into

account the expected return as well as the potential risk. While decisions are always

supposed to be made by looking at the optimum between the risk and the return, the

concept of optimum is fairly strongly influenced expectations such as those of the

market.

Concessional Funds - These bear interest rate below the market rate and/or have a

maturity that is much longer than what is available in international market. Major

suppliers of concessional funds are Governments and Supra-national bodies.

Concessional funds are either negotiable bilaterally between governments or are

available after a credit and project assessment by one of the super-national bodies such

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as IDA. The availability of these funds does not follow market patterns but rather

political developments in the industrialized world.

2.1.3 Economic Indicators:

Economic indicators are reports released by the government or a private organization that gives

details of a country's economic performance. Economic reports are the means by which a

country's economic health is directly measured, but do remember that a great deal of factors

and policies will affect a nation's economic performance. These reports are released at

scheduled times, providing the market with an indication of whether a nation's economy has

improved or declined. In Forex, as in the stock market, any deviation from the norm can cause

large price and volume movements. Basically there are many indicators representing the

countrys economic performance but the important one that draws attention of the market

analysts and the investors are like GDP, Retail Sales, Industrial Production, Consumers Price

Index, Producers Price Index, Purchasing Managers Index, Employment Cost Index,

Unemployment Rate, etc,.

Gross Domestic Product - GDP is considered as the broadest measure of a country's

economy, and it represents the total market value of all goods and services produced in

a country during a given period. Since the GDP figure itself is often considered a

lagging indicator, most traders focus on the two reports that are issued in the months

before the final GDP figures: the advance report and the preliminary report. Significant

revisions between these reports can cause considerable volatility. The GDP is

somewhat analogous to the gross profit margin of a publicly traded company in that

they are both measures of internal growth.

Retail Sales - The retail-sales report measures the total receipts of all retail stores in agiven country. This measurement is derived from a diverse sample of retail stores

throughout a nation. The report is particularly useful because it is a timely indicator of

broad consumer spending patterns that is adjusted for seasonal variables. It can be used

to predict the performance of more important lagging indicators, and to assess the

immediate direction of an economy. Revisions to advanced reports of retail sales can

cause significant volatility. The retail sales report can be compared to the sales activity

of a publicly traded company.

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Industrial Production - This report shows the change in the production of factories,

mines and utilities within a nation. It also reports their 'capacity utilizations', the degree

to which the capacity of each of these factories is being used. It is ideal for a nation to

see an increase of production while being at its maximum or near maximum capacity

utilization. Investors using this indicator are usually concerned with utility production,which can be extremely volatile since the utilities industry, and in turn the trading of

and demand for energy, is heavily affected by changes in weather. Significant revisions

between reports can be caused by weather changes, which in turn, can cause volatility

in the nation's currency.

Consumer Price Index - The CPI is a measure of the change in the prices of consumer

goods across over 200 different categories. This report, when compared to a nation's

exports, can be used to see if a country is making or losing money on its products and

services. Be careful, however, to monitor the exports - it is a focus that is popular with

many traders because the prices of exports often change relative to a currency's strength

or weakness.

Some of the other major indicators include the purchasing managers index (PMI),

producer price index (PPI), durable goods report, employment cost index (ECI), and housing

stats. And it also includes the many privately issued reports, the most famous of which is the

Michigan Consumer Confidence Survey. All of these provide a valuable resource to traders and

investors, if used properly.

Since economic indicators gauge a country's economic state, changes in the conditions reported

will therefore directly affect the price and volume of a country's currency. It is important to

keep in mind, however, that the indicators discussed above are not the only things that affect a

currency's price. There are third-party reports, technical factors, and many other things that also

can drastically affect a currency's valuation.

There are many economic indicators, and even more private reports that can be used to evaluate

the fundamentals of Forex. It's important to take the time to not only look at the numbers, but

also understand what they mean and how they affect a nation's economy. When properly used,

these indicators can be an invaluable resource for any currency trader.

The end goal of performing fundamental analysis is to produce a value that an investor

can compare with the currency's current price in hopes of figuring out what sort of position to

take with that currency (under priced = buy or long, overpriced = sell or short).

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2.2 Structure of Technical Analysis:

The other avenue to analyze Forex market is Technical Analysis and it is completely different

from the Fundamental Analysis. Technical Analysis purely depends up on the historical data ofthe markets. It is the technique that claims the ability to forecast the future direction of currency

prices through the study of past market data, primarily price and volume. In its purest form,

technical analysis considers only the actual price behavior of the market or instrument, on the

assumption that price reflects all relevant factors before an investor becomes aware of them

through other channels.

The term Technical Analysis in its application to the Forex market, has come to have a very

special meaning, quite different from its ordinary dictionary definition. It refers to the study of

the action of the market itself as opposed to the study of the goods in which the market deals.

Technical analysis is the science of recording, usually in graphic form, the actual history of

trading (price changes, volume of transactions etc.) in a certain stock or in "the Averages" and

then interpreting from that pictured history the probable future trend.

The principles of technical analysis are derived from the observation of financial markets over

hundreds of years. The oldest known example of technical analysis was a method developed by

Homma Munehisa during early 18th century which evolved into the use of Candlestick

techniques and is today among the main charting tool.

Technical analysis is frequently contrasted with fundamental analysis; the study of economic

factors that some analysts say can influence prices in financial markets. Technical analysis

holds that prices already reflect all such influences before investors are aware of them, hence

the study of price action alone. Some traders use technical or fundamental analysis exclusively,

while others use both types to make trading decisions.

Technical analysis is research of market dynamics that is done mainly with the help of charts

and with the purpose of forecasting future price development. Technical analysis