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INTRODUCTION TO FOREX
AND FOREX DERIVATIVES
Outright
Swap
Increased Development of
Volatility Sophisticated
Increased Innovations in tools
Integration Derivatives market
Improvement in
Communication system
Derivatives Product
Forwards
Futures
Options
Swaps
Explanation of various
Derivatives products:
Forwards: A forward contract is a customized
contract between two entities, where
settlement takes place on a specific date in the
future at today's pre-agreed price.
Futures: A futures contract is an agreement
between two parties to buy or sell an asset at
a certain time in the future at a certain price.
Futures contracts are special types of forward
contracts in the sense that they are
standardized exchange traded contracts.
Options: Options are of two types
- calls and puts. Calls give the
buyer the right but not the
obligation to buy a given quantity
of the underlying asset, at a given
price on or before a given future
date. Puts give the buyer the right,
but not the obligation to sell a
given quantity of the underlying
asset at a given price on or before
a given date.
Swaps: Swaps are private agreements
between two parties to exchange cash flows in
the future according to a prearranged formula.
They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
Advantages of
Futures
Transparenc
y and
efficient
price
Transparent
discovery
trading
Elimination Standardized platform
of Access to all products
Counterparty types of
credit risk market
participants
Limitations of Futures
Limitations
Of futures
Sale
Purchase
commodity.
The Foreign Exchange
Rates
Suppose there are two nations: US
and UK and the exchange rate is R.
R=2, i.e. R= 2 $/
or
R= $/ = 2
i.e. 2 dollars are required to buy
one pound.
The Foreign Exchange
Rates
X axis- Quantity of
pounds
Y axis- exchange
rate i.e. R
R= $/
Analysis:
Lower exchange rate:
a) fewer dollars will be required to
purchase one pound.
b) It will be cheaper for US to import
funds from UK.
c) Better for us to invest in UK.
Therefore, Demand for pound
increases.
Analysis:
Higher exchange rate:
a) Uk gets more dollars for pound.
b) They find UK goods to be cheaper.
c) They find investing in US
attractive.
US dollars.
Factors that affect the
Equilibrium Exchange Rate
2. Relative interest rates
If real interest rates of US are higher
rate -
Inflation
If interest rate of US > int. rate of UK
investment
Short sell
Bid and Ask Rates
A bank is ready to buy and sell a
currency at different prices.
Buy price- Bid rate
Sell price- Ask rate
Spread- Difference between Bid and Ask
rate is called Bid- ask Spread.
It is more in retail market and less in
interbank market as there is more
volume, greater liquidity and lower
counterparty risk in interbank
Causes of spread are:
Transaction cost
Return on capital employed
Reward / Compensation for taking
risk