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Balance of payment

Account in which all the foreign transaction are captured of a particular country.
Systematic record of all economic transactions between the residence of a given country
and the residents of other countries(the rest of the world) carried our in a specific period
of time normally a year.
It also refers to merchandise imports and exports(visible trade) and to all
economic transaction including invisible transaction like banking, insurance, transport
services and so on. Balance of payment is based on the standard double entry system of
book-keeping i.e. every entry enters twice once as a debit and once as a credit.
Ex- Export of Goods, Export of services like travel insurance, capital inflow into the
country and decrease in foreign currency reserves.
Balance of payment is divided in three parts:-
1 Current Accounts

2 Capital Accounts

3 Monetary Movements

Balance of payment account always balances:-


Balance in current a/c + Balance in capital a/c + Change in monetary movement = 0
-10+30-20=0

Limitation of Balance of Payment:-


The Balance of payment data for one country can only give an idea together that
countries currency is likely to increase or decline in value. It would not help in
predicting the currency movement with respect to a particular currency. That movement
can be estimated only it the Balance of Payment data for both the countries are studied
together.

Foreign Currency Convertible Bonds:- A type of convertible bond issued in a currency


different than the issuer’s domestic currency. In other words the money being raised by
the issuing company is in the form of a foreign currency. A convertible bond is a mix
between a debt and equity instrument. It acts like a bond by making regular coupon and
principal payments, but these bonds also give the bondholder the option to convert the
bond into stock.
Spot and Forward Rate:-
Foreign Exchange transaction can be classified on the basis of the time between
entering into a transaction and its settlement. They can be classified into spot & forward
contracts.
Spot transactions are those which are settled after two business days from the date
of transaction. For Ex- T+2 for two working days. If transaction is made on Friday the
payment is paid on Tuesday due to two days holidays.
Forward contract is one where the parties to the transaction agrees to buy or sell a
commodity (here a currency) at a predetermined future rate at a particular fixed price.
This future date may be any date beyond two business risk. The price and the terms of
delivery and payment are fixed at the time of entering into the forward contract. In the
forex markets forward contracts generally mature after 1,2,3,6,9 OR 12 months. A
forward contract is normally entered into to hedge oneself against the exchange risk (i.e.
uncertainty regarding the future movements) by entering into a forward contract customer
locks in the rate at which he buys or sell the currency.
DERIVATIVES:-
Difference between the future & forward markets:-
1 Future markets are not counterparty risk but forward markets are counterparty
risk.
2 Future markets are standardized markets but forward markets are customized
between two parties.
3 Forward market have no concept of margin but in future market concept of
margin requirement takes place.

Brief of future & forward contracts:-


1 Future contracts are standardized that paid on futures exchange have a
secondary market and are guaranteed again default by means of a daily setting
of gains and losses. Forward contracts are customized instruments that are not
guaranteed against default and are created anywhere other than a change.
2 Future contracts have a secondary market giving them an element of liquidity
and have a clearing house which collects margins and settles, gains & losses
daily to provide a guarantee against default. Futures markets are also
regulated unlike forward market. Margin in the security market is the deposit
of money and a loan for the remainder of the funds required to purchase a
stock or bond. Margin in the future market is much smaller and doesn’t
involved the loan. Futures margin is more like a security deposit or down
payment.
3 A party to a futures contract may go long which means committing to buy the
underlying asset at an agreed upon price or may go start which means
committing to sell the underlying asset at an agreed upon price.
4 A futures trader who has established a position can re-enter the market and
close out the position by doing the opposite transaction a sell if the original
position was long or buy if the original position was short. The party has off
settled the position no longer has a contract outstanding and has no further
obligation.
5 The futures clearing house engages in a practice called marking to market also
known as the daily settlement in which gains and losses on a futures position
are credited and debited to the traders margin account on a daily basis. Thus
the profits available for withdrawal and losses must be paid quickly before
they build up and pause a risk that the party will be unable to cover large
losses.
6 Initial margin is the amount of money in a margin account on the day of a
transaction of when a margin call is made. Maintenance margin is the lease
amount of margin the investor has to maintain with the clearing house to keep
his position open in the market and the maintenance margin requirement is
lower than the initial margin requirement. Variation margin is the amount of
money that must be deposited into the account to bring the balance up to the
initial margin requirement. The settlement price is an average of the last few
trades of the day and is used to determine the gains and losses market to the
party’s account.
Options:-
There are two types of options i.e. call & put.
Call Option is an option to granting the right to buy the underlying currency.
Put Option is an option granting the right to sell the underlying currency.
The party holding the right is the option buyer and the party giving or granting the right is
the option seller.
The right to buy or sell is held by the option buyer also called the long party or option
holder and the right is granted by the option seller also called the short party or option
seller/rider. To obtain this right the option buyer pays the seller a sum of money known
as option premium or option price.
The fixed price at which the option holder can buy or sell the underlying currency is
called the exercise price or strike price. The use of this right to buy or sell the underlying
currency is referred to as exercising the option like all derivatives contracts an option has
expiry date giving rights to the notion of an option time to expiry. When the expiry date
arise an option i.e. not exercised simply expires.
** In case of option expires, the premium will be loosed and premium amount is decided
by the buyer and the seller both and it is a variable contract because premium price is not
fixed.**

A currency option allowed the holder to buy (if it is a call) or sell (if it is a put) and
underlying currency at a fixed exercised way expressed at an exchange rate. Many
companies knowing that they will need to convert a currency X at a future date into a
currency Y, will buy a call option on currency Y specified in terms of currency X.

Example:- A U.S. company will be needing 50 million euro for an expansion project in
three months. Thus it will be buying euros and is exposed to the risk of the euro valuing
against the dollar. Even though it has that concerned it would also like to benefit it the
euro weakest against the dollar. Thus it might buy a call option on the euro. Let us say it
specifies an exercise rate of 0.90 dollars, so it pays cash up front (option premium) for the
right to buy 50 million euros @ 0.9 dollar per euro. If the option expires with the euro
above 0.90 dollars the company can buy euros at 0.90 dollars and avoid any additional
cost over 0.90 dollar but if the option expires with the euro 0.90 dollars the company will
not exercise the option and the affective cost to the company would be euro marker price
and option premium.
Q- What happens at exercise depends upon whether the option is a call or a put?
Ans.- If the buyer is exercising a call she pays the exercise price and receives the
underlying. On the opposite side of the transaction is the seller who receives the exercise
price from the buyer and delivers the underlying which is currency. If the buyer is
exercising a put she delivers the stock and receives the exercise price. The seller of the
put option therefore receives the underlying and must pay the exercise price. This type of
settlement is known as physical type of settlement.
Another type of settlement is called cash settlement in that case the option holder
exercising the call receives the difference between the market value of the underlying
which is currency and the exercise price from the seller in cash. If the option holder
exercises the put she receives the difference between the exercise price and the market
value of the underlying i.e. currency in cash..
Cash settlement:- There is no concept of delivery only profit & loss should be exchanged.
For example:-

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