IFFM Session Two

PAN African e-Network Project
MFM
International Finance & Forex Management
Semester - 3
Session - 2
Mr. Navneet Saxena

Objective
In this session we will learn about:

Module II: Foreign Exchange Markets
Spot and Forward Foreign Exchange
Markets, Speculation and Arbitrage in
Foreign Exchange Markets and
Implications of Market Efficiency, Currency
Swaps, Currency Futures and Options.
Markets
Foreign exchange markets are sometimes
classified into spot market and forward
market on the basis of the period of
transaction carried out.
It is explained below:
(a) Spot Market:
If the operation is of daily nature, it is
called spot market or current market.
Markets
It handles only spot transactions or current
transactions in foreign exchange.
Transactions are affected at prevailing rate
of exchange at that point of time and
delivery of foreign exchange is affected
instantly. The exchange rate that prevails
in the spot market for foreign exchange is
called Spot Rate.
Markets
Expressed alternatively, spot rate of
exchange refers to the rate at which foreign
currency is available on the spot.
For instance, if one US dollar can be
purchased for Rs 40 at the point of time in the
foreign exchange market, it will be called spot
rate of foreign exchange. No doubt, spot rate
of foreign exchange is very useful for current
transactions but it is also necessary to find
what the spot rate is.
Markets
In addition, it is also significant to find the
strength of the domestic currency with
respect to all of home countrys trading
partners. Note that the measure of average
relative strength of a given currency is called
Effective Exchange Rate (EER).
(b) Forward Market:
A market in which foreign exchange is bought
and sold for future delivery is known as
Forward Market.
Markets
It deals with transactions (sale and
purchase of foreign exchange) which are
contracted today but implemented
sometimes in future. Exchange rate that
prevails in a forward contract for purchase
or sale of foreign exchange is called
Forward Rate. Thus, forward rate is the
rate at which a future contract for foreign
currency is made.
Markets
This rate is settled now but actual
transaction of foreign exchange takes
place in future. The forward rate is quoted
at a premium or discount over the spot
rate. Forward Market for foreign exchange
covers transactions which occur at a future
date. Forward exchange rate helps both
the parties involved.
Markets
A forward contract is entered into for two
reasons:
(i) To minimise risk of loss due to adverse
change in exchange rate (i.e., hedging)
and [ii] to make a profit (i.e., speculation).
Two Exchange rate quotes: In foreign
exchange market, there are two exchange
rate quotes, namely, buying rate and
selling rate.
Markets
If a person goes to the exchange market
to buy foreign currency, say, US dollars,
he has to pay higher rate than when he
goes to sell dollars.
In other words, for a person buying rate is
higher than selling rate.
The forward rate and spot rate are
different prices, or quotes, for different
contracts.
Markets
The forward rate is the settlement price of
a forward contract, while the spot rate is
the settlement price of a spot contract.
A spot contract is a contract that involves
the purchase or sale of a commodity,
security or currency for immediate delivery
and payment on the spot date, which is
normally two business days after the trade
date.
Markets
The spot rate, or spot price, is the price
quoted for the immediate settlement of the
spot contract. For example, say an investor
believes orange juice is more expensive in
the winter due to supply and demand.
However, the investor cannot buy a spot
contract for delivery in December because
the commodity will spoil. A forward contract is
a better fit for the investment.
Markets
Unlike a spot contract, a forward contract
is a contract that involves an agreement of
contract terms on the current date with the
delivery and payment at a specified future
date. Contrary to a spot rate, a forward
rate is used to quote a financial
transaction that takes place on a future
date and is the settlement price of a
forward contract.
Markets
However, depending on the security being
traded, the forward rate can be calculated
using the spot rate.
For example, say a Chinese electronic
manufacturer has a large order to be shipped
to America in one year. The Chinese
manufacturer engages in a currency forward
and sells $20 million in exchange for Chinese
yuan at a forward rate of $6.21 per Chinese
yuan.
Markets
Therefore, the Chinese electronic
manufacturer is obligated to deliver 20
million euros at the specified rate on the
specified date, six months from the current
date, regardless of fluctuating currency
spot rates.
Markets
The foreign exchange market provides the
physical and institutional structure through which
the money of one country is exchanged for that
of another country, the rate of exchange
between currencies is determined, and foreign
exchange transactions are physically completed.
A foreign exchange transaction is an agreement
between a buyer and a seller that a given
amount of one currency is to be delivered at a
specified rate for some other currency.
Markets
Geographical Extent of the Foreign Exchange
Market
Geographically, the foreign exchange market
spans the globe, with prices moving and
currencies traded somewhere every hour of
every business day.
The market is deepest, or most liquid, early in
the European afternoon, when the markets of
both Europe and the U.S. East coast are
open.
Markets
The market is thinnest at the end of the
day in California, when traders in Tokyo
and Hong Kong are just getting up for the
next day.
In some countries, a portion of foreign
exchange trading is conducted on an
official trading floor by open bidding.
Markets
Closing prices are published as the official
price, or 'fixing' for the day and certain
commercial and investment transactions are
based on this official price.
The Size of the Market
In April 1992, the Bank of International
Settlements (BIS) estimated the daily volume
of trading on the foreign exchange market
and its satellites (futures, options, and swaps)
at more than USD 1 trillion.
Markets
This is about 5 to 10 times the daily
volume of international trade in goods and
services.
The market is dominated by trading in
USD, DEM, and JPY respectively. The
major markets are London (USD 300
billion), New York (USD 200 billion), and
Tokyo (USD 130 billion).
Speculation and Arbitrage in Foreign
Exchange Markets
Functions of the Foreign Exchange Market
The foreign exchange market is the
mechanism by which a person of firm
transfers purchasing power form one
country to another, obtains or provides
credit for international trade transactions,
and minimizes exposure to foreign
exchange risk.
Exchange Markets
Transfer of Purchasing Power:
Transfer of purchasing power is necessary
because international transactions
normally involve parties in countries with
different national currencies.
Each party usually wants to deal in its own
currency, but the transaction can be
invoiced in only one currency.
Exchange Markets
Provision of Credit:
Because the movement of goods between
countries takes time, inventory in transit
must be financed.
Minimizing Foreign Exchange Risk:
The foreign exchange market provides
"hedging" facilities for transferring foreign
exchange risk to someone else.
Exchange Markets
Market Participants
The foreign exchange market consists of
two tiers: the interbank or wholesale
market, and the client or retail market.
Individual transactions in the interbank
market usually involve large sums that are
multiples of a million USD or the
equivalent value in other currencies.
Exchange Markets
By contrast, contracts between a bank and its
client are usually for specific amounts,
sometimes down to the last penny.
Foreign Exchange Dealers:
Banks, and a few nonbank foreign exchange
dealers, operate in both the interbank and client
markets.
They profit from buying foreign exchange at a
bid price and reselling it at a slightly higher ask
price.
Exchange Markets
Worldwide competitions among dealers
narrows the spread between bid and ask
and so contributes to making the foreign
exchange market efficient in the same
sense as securities markets.
Dealers in the foreign exchange
departments of large international banks
often function as market makers.
Exchange Markets
They stand willing to buy and sell those
currencies in which they
specialize by maintaining an inventory position
in those currencies.
Participants in Commercial and Investment
Transactions:
Importers and exporters, international portfolio
investors, multinational firms, tourists, and
others use the foreign exchange market to
facilitate execution of commercial or investment
transactions.
Exchange Markets
Some of these participants use the foreign
exchange market to hedge foreign
exchange risk.
Speculators and Arbitragers:
Speculators and arbitragers seek to profit
from trading in the market. They operate in
their own interest, without a need or
obligation to serve clients or to ensure a
continuous market.
Exchange Markets
Speculators seek all of their profit from
exchange rate changes.
Arbitragers try to profit from simultaneous
exchange rate differences in different markets.
Central Banks and Treasuries:
Central banks and treasuries use the market to
acquire or spend their country's foreign
exchange reserves as well as to influence the
price at which their own currency is traded.
Exchange Markets
In many instances they do best when they willingly take
a loss on their foreign exchange transactions.
As willing loss takers, central banks and treasuries differ
in motive and
behavior form all other market participants.
Foreign Exchange Brokers:
Foreign exchange brokers are agents who facilitate
trading between dealers without themselves becoming
principals in the transaction.
Exchange Markets
For this service, they charge a small
commission, and maintain access to hundreds of
dealers worldwide via open telephone lines.
It is a broker's business to know at any moment
exactly which dealers want to buy or sell any
currency.
This knowledge enables the broker to find a
counterpart for a client quickly without revealing
the identity of either party until after an
agreement has been reached.
Exchange Markets
Transactions in the Interbank Market
Transactions in the foreign exchange
market can be executed on a spot,
forward, or swap basis.
Spot Transactions:
A spot transaction requires almost
immediate delivery of foreign exchange.
Exchange Markets
In the interbank market, a spot transaction
involves the purchase of foreign exchange
with delivery and payment between banks to
take place, normally, on the second following
business day.
The date of settlement is referred to as the
"value date."
Spot transactions are the most important
single type of transaction (43 % of all
transactions).
Exchange Markets
Outright Forward Transactions:
A forward transaction requires delivery at
a future value date of a specified amount
of one currency for a specified amount of
another currency.
The exchange rate to prevail at the value
date is established at the time of the
agreement, but payment and delivery are
not required until maturity.
Exchange Markets
Forward exchange rates are normally
quoted for value dates of one, two, three,
six, and twelve months.
Actual contracts can be arranged for other
lengths.
Outright forward transactions only account
for about 9 % of all foreign exchange
transactions.
Exchange Markets
Swap Transactions:
A swap transaction involves the simultaneous
purchase and sale of a given amount of
foreign exchange for two different value
dates.
The most common type of swap is a spot
against forward, where the dealer buys a
currency in the spot market and
simultaneously sells the same amount back
to the same back in the forward market.
Exchange Markets
Since this agreement is executed as a
single transaction, the
dealer incurs no unexpected foreign
exchange risk.
Swap transactions account for about 48 %
of all foreign exchange transactions.
Exchange Markets
There are different ways the price of a currency
can be determined against another:
Through a fixed, or pegged, rate which is a rate
the central bank sets and maintains as the
official exchange rate. In this case a set price will
be determined against a major world currency
(usually the US Dollar, but also other major
currencies such as the Euro, the Yen, or a
basket of currencies).
Exchange Markets
In order to maintain the local exchange
rate, the central bank buys and sells its
own currency on the foreign exchange
market in return of the currency to which it
is pegged.
To do this, the central bank must keep
enough foreign reserves to release or
absorb into or out of the market.
Exchange Markets
Some governments may also choose to
have a semi-peg whereby the government
periodically reassesses the value of the
peg and then changes the peg rate
accordingly.
Usually the change is devaluation but one
that is controlled so that market panic is
avoided. This method is often used in the
transition from a peg to a floating regime.
Implications of Market
Efficiency
Although the peg has worked in creating
global trade and monetary stability, it was
only used at a time when all the major
economies were a part of it.
And while a floating regime has its flaws, it
has proven to be an efficient means of
determining the long term value of a
currency and creating equilibrium in the
international market.
Efficiency
"Why the need to fix a currency?"
It has to do with the aim to create a stable
atmosphere for foreign investment, specially
among developing nations. If the currency is
pegged, the investor will always know what
its value is and will not fear hyperinflation.
However the peril exists that such countries
experience financial crisis as well, like Mexico
in 1995 and Russia in 1997.
Efficiency
An attempt to maintain a high value of the local
currency to the peg can result in the currencies
eventually becoming overvalued. This means
that the governments could no longer meet the
demands to convert the local currency into the
foreign currency at the pegged rate. With
speculation and panic, investors would start to
convert their currency into foreign currency
before the local currency is devalued against the
peg, depleting the central bank's foreign
reserves.
Efficiency
There is also a floating condition, which
allows the Forex market to function as we
know it nowadays with most of the major
currencies. A floating exchange rate is
determined by the private market through
supply and demand. A floating rate is often
termed "self-correcting", as any
differences in supply and demand will
automatically be corrected in the market.
Efficiency
A floating exchange rate is constantly
changing as a decrease in demand for a
currency will lower its value in the market.
This in turn will make imported goods
more expensive and stimulate demand for
local goods and services. As a
consequence, more jobs are created, and
hence an auto-correction occurs in the
market.
Efficiency
In a floating regime, the central bank may
also intervene when it is necessary to
ensure stability and to avoid inflation;
however, compared with a fixed system, it
is less frequent that the central bank of a
floating regime interferes.
A country can also opt to implement a dual
or multiple foreign exchange rate system,
where both modalities run in parallel.
Efficiency
Unlike a pegged or floating system, the dual
and multiple systems consist of different rates,
fixed and floating, running at the same time.
The fixed rate is usually a preferential rate and
the floating a more discouraging one.
While the fixed rate is only applied to certain
segments of the market, like the import/export of
essential goods, the floating rate is set by the
forces of supply and demand in the market and
is applied to non-essential goods like luxury
imports.
Efficiency
This system is also usual in transitional
periods as a means by which governments
can quickly implement control over foreign
currency transactions. In those cases,
instead of depleting its foreign reserves,
the government diverts the heavy demand
for foreign currency to the free-floating
exchange rate market.
Efficiency
As with the other solutions, a multiple
exchange rates system is not free from
negative consequences: creating artificial
conditions for certain market segments is
one of them. But it could also be used as
an effective means to address the problem
in the balance of payments developed
under the conditions of a completely free
floating system.
Efficiency
Note that none of these systems are
perfect, but that all are thought as
mechanisms to deal with those underlying
problems in economic crisis and inflation
periods. Their aim is to eventually keep
the equilibrium in the monetary system.
These are the four mentioned exchange
rate systems, or regimes:
Efficiency
Pegged exchange rate system: the value
of the currency is tied to another currency,
to a basket of currencies or to the price of
gold. The purpose of a fixed exchange
rate system is to maintain a country's
currency value within a very narrow band.
Semi-pegged exchange rate system: the
central bank periodically readjusts the
fixed (pegged) value of its currency.
Efficiency
Floating exchange rate system: the value
of a currency changes freely and is
determined by supply and demand in the
Forex market.
Multiple exchange rate system: both
systems are simultaneously used in
different segments of the economy.
Efficiency
The most fundamental answer why gold
was needed to establish an international
monetary system is perhaps that even
fluctuations in the value of money caused
by the supply and demand of gold are
better than experimenting hyperinflation or
deep devaluation because of irresponsible
monetary policy.
Efficiency
But history shows that there were serious
problems associated with the gold-money
peg and that it was impossible to keep the
linkage. Difficulties arrived when the
supply of gold oscillated, causing short
term price fluctuations. Moreover, the
rapid growth of the world economy was
faster than the supply of new gold, and a
long term shortage of gold became a
constraint to maintain the peg.
Efficiency
The abandonment of the convertibility to
gold was the start of the Forex market as
we know it today. The US Dollar, already
under serious pressure due to the US
trade deficit, was allowed to float and all
currencies were set adrift to find their
place in the global economy. From there
on many speculative opportunities started
to afloat.
Efficiency
Since the early 70's the major world currencies
started to float freely, mainly controlled by offer
and demand on the exchange market, and has
kept floating for almost 4 decades now. Among
these currencies, there were the Deutsche Mark,
the British Pound and the Japanese Yen, and
their prices were calculated on a daily basis. The
volumes, velocity and volatility started to
increase and new financial instruments were
created.
Efficiency
Since then, exchange rate instability among
major currencies has been the norm.
The Transformation Of Currency Exchange In
The '70s
The following decades saw the Forex being
transformed by far in the largest and less
regulated financial market in the world thus
abolishing restrictions on capital flows in almost
all countries, and allowing market forces to move
exchange rates.
Efficiency
But the idea to fix exchange rates did not
disappear. Some major economies attempted
to move back to a peg or valuate currencies
relatively to something: it happened during
the 70's and 80's when Asian communities
tried to group together as the west
Europeans did. During these years
currencies exhibited short-term volatility,
medium-term misalignment and long-term
drift.
Efficiency
While after the breakdown of Bretton
Woods the majority of policy makers
thought the free floating system had an
automatic adjusting mechanism, the fact
was that exchange rate instability itself
became a serious threat to the world
economy.
Efficiency
In December 1971, there was an international
effort to re-establish the fixed exchange rate
system at adjusted levels: the monetary
authorities of major countries gathered in
Washington, DC to set their mutual exchange
rates at new levels and the Smithsonian
Agreement is signed, similar to the previous
Bretton Woods, but allowing higher foreign
exchange fluctuations.
Currency Swaps
Currency swaps involve an exchange of
cash flows in two different currencies. It is
generally used to raise funds in a market
where the corporate has a comparative
advantage and to achieve a portfolio in a
different currency of his choice, at a cost
lower than if he accessed the market of
the second currency directly.
Currency Swaps
However, since these types of swaps
involve an exchange of two currencies, an
exchange rate, generally the prevailing
spot rate is used to calculate the amount
of cash flows, apart from interest rates
relevant to these two currencies. By its
special nature, these instruments are used
for hedging risk arising out of interest rates
and exchange rates.
Currency Swaps
Definition: A currency swap is a contract
which commits two counter parties to an
exchange, over an agreed period, two
streams of payments in different
currencies, each calculated using a
different interest rate, and an exchange, at
the end of the period, of the corresponding
principal amounts, at an exchange rate
agreed at the start of the contract.
Currency Swaps
Consider a swap in which:
Bank UK commits to pay Bank US, over a
period of 2 years, a stream of interest on
USD 14 million, the interest rate is agreed
when the swap is negotiated; in exchange,
Bank US commits to pay Bank UK, over the
same period, a counter stream of sterling
interest on GBP 10 million; this interest rate is
also agreed when the swap is negotiated.
Currency Swaps
Bank UK and Bank US also commit to
exchange, at the end of the two year period,
the principals of USD 14 million and GBP 10
million on which interest payments are being
made; the exchange rate of 1.4000 is agreed
at the start of the swap.
We can now see from the above that
currency swaps differ from interest rate
swaps in that currency swaps involve:
Currency Swaps
An exchange of payments in two
currencies.
Not only exchange of interest, but also an
exchange of principal amounts.
Unlike interest rate swaps, currency swaps
are not off balance sheet instruments
since they involve exchange of principal at
the end of the period.
Currency Swaps
The idea of entering into the currency
swap is that, Bank US is probably
expecting an amount of GBP 10 million at
the end of the period, while Bank UK is
expecting an amount of USD 14 million,
which they agreed to exchange at the end
of the period at a mutually agreed
exchange rate.
Currency Swaps
The interest payments at various intervals are
calculated either at a fixed interest rate or a
floating rate index as agreed between the
parties.
Currency swaps can also use two fixed
interest rates for the two different currencies
different from the interest rate swaps.
The agreed exchange rate need not be
related to the market.
Currency Swaps
The principal amounts can be exchanged
even at the start of the swap
If in the above-mentioned swap, the two
banks agree to exchange the principal at
the beginning.
Bank UK will sell GBP to Bank US in
exchange for US Dollars.
This would be at an exchange rate, most
likely the spot rate.
Currency Swaps
These banks would borrow the respective
currencies, which they have sold.
But at maturity, this exchange of principal
would be reversed at the original
exchange rate. (This kind of swap is called
a par swap).
Types of Currency Swaps:
Cross-currency coupon swaps:
These are fixed-against-floating swaps.
Currency Swaps
Cross-currency basis swap:
These swaps involve payments attached
to a floating rate index for both the
currencies. In other words, floating-
against-floating cross-currency basis
swaps.
Risk Management with currency swaps:
Currency Swaps
Example: (Principal exchanged at
Maturity)
A UK Co. With mainly sterling revenues,
has borrowed fixed-interest dollars in order
to purchase machinery from the U.S. It
now expects the GBP to depreciate
against the USD and is worried about
increase in its cost of repayment.
Currency Swaps
It could now hedge its exposure to a dollar
appreciation by using a GBP/USD
currency swap. It would fix the rate at
which the company, at maturity, could
exchange its accumulated sterling
revenues for the dollars needed to repay
the borrowing. Fixing the exchange rate
hedges the currency risk in borrowing
dollars and repaying through sterling.
Currency Swaps
Assuming, the Company expects not only the
dollar to appreciate, but also the GBP interest
rates to fall. It could take advantage of this
situation, by swapping from fixed-interest dollars
into floating interest sterling.
Stages:
At the start of the swap, the GBP/USD rate is
agreed at which the principal amounts will be
exchanged at maturity (probably, the prevailing
GBP/USD spot rate)
Currency Swaps
At the same time, interest rates for use in the
swap are also agreed
Over the life of the swap, the UK Company
will pay a stream of sterling floating interest
through the swap and will receive a counter
stream of dollar fixed interest in exchange.
The dollar interest received through the swap
will be used to service the dollar borrowing;
the sterling interest paid through the swap will
be funded from earnings.
Currency Swaps
At maturity, the company will pay a sterling
principal amount through the swap and
receive a dollar principal amount in
exchange. The exchange is made at the
GBP/USD rate agreed at the start of the
swap. The company will fund its payment of
principal through the swap from accumulated
sterling earnings from its business and will
use the dollar principal it receives in
exchange to repay its dollar borrowing.
Currency Swaps
Example: (Principal exchanged at the
beginning)
This will be the case when the UK co.
wants to swap its dollar loan into a sterling
loan, but needs dollars at the outset to pay
for dollar imports or for any other purpose.
In this case, the UK co. would simply
acquire the dollars from the spot foreign
exchange market.
Currency Swaps
It would fund this spot purchase of dollars
with the sterling received through the swap
in the initial exchange of principal
amounts.
Stages:
At the start of the swap, the UK co. buys
dollars against sterling in the spot market.
Currency Swaps
The dollar bought in the spot are
exchanged through the swap for sterling,
at the same GBP/USD exchange rate at
which the UK co. had to buy dollars
against sterling in the spot market; the
sterling received through the swap is used
to fund the spot purchase of the dollars.
Currency Swaps
At the same time, the GBP/USD rate at
which the principal amounts will be
exchanged at maturity is fixed at the spot
rate at which the UK co. had to buy dollar
against sterling in the spot.
The interest rates for use in the swap are
also agreed;
Currency Futures and
Options
Currency options and futures are both
derivative contracts they derive their values
from the underlying asset -- in this case,
currency pairs. Currencies always trade in
pairs. For example, the euro/U.S. dollar pair
is denoted as EUR/USD. Buying this pair
means going long, or buying, the numerator,
or base, currency --the euro -- and selling the
denominator, or quote, currency -- the dollar.
Options
If you sold the pair, these relationships
would be reversed. You make money
when the long currency appreciates
against the short currency.
Foreign Currency Futures
Currency futures oblige the contract buyer
to purchase the long currency and pay for
it with the short currency. The contract
seller has the reverse obligation.
Options
The obligation comes due on the futures
expiration date, and the ratio of bought
and sold currencies is agreed to in
advance.
The profit or loss arises from the
difference between the agreed price and
the actual price on the expiration date.
Options
Margin is always deposited for futures trades it
is cash that acts as a performance bond to
ensure both parties fulfill their obligations.
Options on Currency Pairs
The buyer of a currency pair call option may
decide to execute or to sell the option on or
before the expiration date. The option has a
strike price that denotes a particular exchange
ratio for the pair.
Options
If the actual price of the currency pair
exceeds the strike price, the call holder
can sell the option for a profit, or execute
the option to buy the base and sell the
quote on profitable terms. A put buyer is
betting on the quote currency appreciating
against the base currency.
Options
Options on Currency Futures
Instead of having an option to buy and sell
currency pairs, an option on a currency
future gives holders the right, but not
obligation, to buy a futures contract on the
currency pair. The strategy at play here is
that the option buyer can benefit from the
futures market without putting down any
margin.
Options
Should the futures contract appreciate, the
call holder can simply sell the call for a profit
and need not purchase the underlying futures
contract. A put buyer profits if the futures
contract loses value.
Differences between Options and Futures
The main difference is that option buyers are
not obligated to actually purchase or sell the
long currency futures traders are.
Options
Option sellers may have to buy or sell the
underlying asset if the trades go against
them. Option buyers need not put up any
margin and their potential loss is limited to
the purchase cost, or premium, of the option.
Option sellers and futures traders must put
up margin and have virtually unlimited risk.
Finally, the premium of an options contract is
almost always lower than the required margin
on a similar futures contract.
Options
In nearly every case, exchange-traded
futures and option contracts are liquid and
public.
Prices are determined by the open outcry
of trades in a ring or pit or through an
electronic auction taking place at light-
speed in a computer.
Options
While most trading today takes place on
electronic exchanges, certain option
transactions still require the expertise of a
floor broker, trading on an exchange floor.
For most of their 2,000-year history, options
have been a mystery to most investors.
While that is changing, most individual
investors have only a vague notion of
options.
Options
When used properly, futures and options may
provide exciting and very substantial rewards
and in numerous cases prove to be the optimal
strategy, even for the most conservative
investor.
What is a futures contract? A futures or
commodity contract is an agreement between
two people.
The seller of a futures contract agrees to
deliver a specific item to the buyer for a certain
price on a fixed date in the future.
Options
The buyer of a futures contract agrees to
take delivery of the same item under the
same terms.
The buyer of a futures contract is said to
be long the market.
The seller of a futures contract is said to
be short the market.
Options
FX futures contracts are essentially paper
transactions as they do
not involve the purchase and sale of actual
investment instruments.
They are contracts for delivery at a future
date.
Because no delivery takes place prior to a
specified period, no money changes
hands.
Options
The vast majority of FX futures contracts are
exited prior to the delivery period, so actual
foreign currency rarely changes hands.
Instead, both the buyer and the seller must post
margin with their
respective brokers.
Margin requirements are set by the individual
exchanges and, for the most part, based upon
volatility and not price.
Options
Unlike stocks, the treatment of long and short
futures contracts positions is identical.
Unlike a short seller in stocks, the seller of a
futures contract does not need to borrow his
contract from another party making it just
as easy to sell as to buy.
Unlike stock margin, margin to trade an FX
futures contract is not a down payment on a
loan.
Options
It is a performance bond that guarantees your
broker that you are good for a fixed amount of
losses.
Not only do you not pay interest on a margin
deposit, you can receive interest while using the
money to back up your positions. How? By
posting margin with your broker in the form of a
U.S. Treasury bill. Since a T-bill is backed by the
U.S. government, it is nearly as good as cash,
so most brokers accept it.
Options
Meanwhile, you get to keep the interest.
Options are not necessarily better than
actual futures contracts, but they generally
require less time, money and stress than
futures.
While options are not a cure-all, they
eliminate the need for stop loss orders,
providing the investor with far more
staying power.
Options
But this isnt their only advantage.
Options are largely misunderstood, as much if
not more than futures contracts.
The same people who tell you to stay away
from futures will tell you to stay away from
options.
Options are a favorite tool of professional
investors precisely because they are one of the
most flexible investment tools ever devised.
Options
The trading desks of central banks,
multinational corporations and
governments use options to lock-in the
risks of their large investments and as
surrogates for future investments.
The phenomenal growth of FX global
option markets is the direct result of the
benefits they may provide.
Options
There are options on many, if not most, of the
major Forex currency trading pairs.
Perhaps one of the biggest barriers to
understanding options is the inability to
understand their basic premise.
Investors get caught up in the jargon rather than
what they are buying and selling.
As a result, they lose their way when introduced
to more advanced strategies especially selling
options.
Recap
In this session we learnt about:

Module II: Foreign Exchange Markets
Markets, Speculation and Arbitrage in
Foreign Exchange Markets and
Implications of Market Efficiency, Currency
Swaps, Currency Futures and Options.
Please forward your query
To: nsaxena1@amity.edu

IFFM Session Two

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PAN African e-Network Project

Mr. Navneet Saxena

In this session we will learn about:

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