FOREX MARKETS

Foreign Exchange Market

Largest
24 Hour
Financial
Market
Market

Average
daily trade $
3.5 trillion
2
Foreign Exchange Market

3
Participants Foreign Exchange Market

Authorised Foreign
Foreign
Dealers - Exchange
Banks
Banks Brokers

Central
Government
Banks

4
Participants Foreign Exchange Market

Non Bank
Retail Corporate
Authorised
Clients Sector
Dealers

Arbitrageurs Speculators

5
USD INR

6
7
Foreign Exchange Market

8
Factors affecting USD / INR Rates

9
Market Activity

10
11
12
13
14
15
16
17
18
19
20
FOREX MARKET

The market for foreign exchange involves the

Purchase and sale of national currencies.

A foreign exchange market exists because

economies employ national currencies.

If the world economy used a single currency

There would be no need for foreign exchange
markets.

21
The foreign exchange market is extremely
active . It is primarily an over the counter
market, the exchanges trade futures and
option but most transactions are
OTC.
It is difficult to assess the actual size of the
foreign exchange market because it is traded
in many markets.

22
Exchange Rates /Quotes

The price of one country’s currency in terms

of another
Most currency is quoted in terms of dollars

The price of a currency in terms of another

currency is called “quote”
A quote where US dollar is the base currency
is refereed as direct Quote for example
$ 1= ₹ 66 , while a quote where USD is
referred to as terms currency is an indirect
quote for example 1₹ = $.01520

23
24
A direct quote is a quote where the exchange rate is
expressed in terms of number of units of domestic
currency per unit of foreign currency.

Therefore , when we say $1 = Rs 66 , we are expressing

one unit of dollar ( a foreign currency for an Indian)
in terms of some units of domestic currency

Therefore it is a dollar direct quote for an Indian in India.

( remember that the same quote when quoted in USA
is not a direct quote for an American

25
Example: Exchange Rates

Suppose you have $10,000 , how many Indian

Rupees can you buy?

Exchange rate = Rs 66.00 Rupees per dollar

Buy 10,000 (66.00) = 6,60,000 Rupees

Suppose you are visiting Bombay and you want

to buy a souvenir that costs 1000 Indian
Rupees. How much does it cost in U.S. dollars?
Exchange rate 1 ₹ = $.0152
1000* $.0152 = $ 15.20

26
Major Forex Currency Pairs:
No. Currency Pair Symbol Nickname

1 Euro/US Dollar EUR/USD Fiber

Great British Pound/US

2 GBP/USD Cable
Dollar

3 US Dollar/Japanese Yen USD/JPY Yen

4 US Dollar/Swiss Franc USD/CHF Swissy

5 US Dollar/Canadian Dollar USD/CAD Loonie

6 Australian Dollar/US Dollar AUD/USD Aussie

New Zealand Dollar/US

7 NZD/USD Kiwi
Dollar

27
Minor Forex Currency Pairs:
No. Currency Pair Symbol

1 Euro/British Pound EUR/GBP

2 Euro/Swiss Franc EUR/CHF

3 British pound/Japanese Yen GBP/JPY

4 Swiss Franc/Japanese Yen CHF/JPY

5 New Zealand Dollar/Japanese Yen NZD/JPY

6 British Pound/Canadian Dollar GBP/CAD

7 Euro/Australian Dollar EUR/AUD

28
Market Quotes:

Direct - Indirect Quotes

»Direct quote is the home currency price of a

foreign currency.

»Indirect quote is the foreign currency price of

the home currency.
The total sum is 200% because each currency trade always involves a currency pair.

30
Foreign Exchange Markets
Exchange Rate - Amount of one currency
needed to purchase one unit of another
currency. $ £ € ₹
$1= £1.62 £1 = $0.617
$1 = ₹ 66 ₹ 100= $ 1.520
$1 = €1.10 €1 = $ .909
$1 = ¥105 ¥ 100= $ .952
Spot Rate of Exchange – the price of currency
for immediate delivery. Recorded by 2nd
business day
Forward Exchange Rate – the price of currency
for delivery at sometime in the future.
31
 American terms & European terms

American terms European terms

US dollar price per unit of Foreign currency units
foreign currency per dollar
Example Rs1= $.01520 Example $1 = Rs 66
€ 1 = $.909 $1 = €1.10
A direct quote in the United A direct quote outside
States the United States
A indirect quote outside the An indirect quote in
United States the United State

32
Illustrations

Given the following quotes , answer the following.

(1) if 1C$ = $ 0.7703 , find how many dollars we get by

selling C$ 10,000 ?

We have to sell C$ we need C$ quote . Since we have it

we use the quote directly to answer the question

C$ 10,000 X $0.7703 = $ 7703

33
Illustrations

if 1¥ = $ 0.0093 , find how many dollars we

get by selling ¥ 20,00,000 ?

We have to sell ¥ we need ¥ quote . Since

we have it we use the quote directly to
answer the question

¥ 20,00,000 X $0.0093 = $ 18,600

34
Illustrations

if 1$ = .99 Swiss Franc , find how many dollars we

get by selling 50,000 Swiss Francs ?

We have to sell Swiss Franc we need Swiss franc

quote . Since we have dollar quote we convert
dollar quote to swiss franc quote before using it.

Therefore 1 Swiss Franc = $ 1/.99= $ 1.01

50,000 SF X $1.01 = $50,500

35
Illustrations

if 1 S$ = Rs 50.55 , find how many Singapore dollars we

get by selling 5,00,000 Rupees ?

We have to sell Rupees so we need INR quote . Since

we have Singapore dollar quote we convert Singapore
dollar quote to Rupee quote before using it.

Therefore 1Rupee = S$ 1/50.55= $ .01978

500,000 Rs X S$ .01978 = S$ 9,890

36
Illustrations

if 1$ = Rs 68.61 , find how many dollars we get

by selling 25,000 Rupees ?

We have to sell Rupees so we need INR quote

. Since we have dollar quote we convert dollar
quote to Rupee quote before using it.

Therefore 1Rupee = $ 1/68.61= $ .014575

25,000 Rs X $ .014575 = $ 364.38

37
Illustrations

if 1£ = Rs 86.34 , find how many pounds we get

by selling 25,000 Rupees ?

We have to sell Rupees so we need INR quote

. Since we have pound quote we convert pound
quote to Rupee quote before using it.

Therefore 1Rupee = £ 1/86.34= £ .014575

25,000 Rs X £ 1/86.34 = 25,000/ 86.34= £ 289.55

38
Illustrations

if 1€= Rs 77.44 , find how many pounds we

get by selling 25,000 Rupees ?

We have to sell Rupees so we need INR

quote . Since we have Euro quote we convert
Euro quote to Rupee quote before using it.

Therefore 1Rupee = € 1/77.44

25,000 Rs X £ 1/77.44 = 25,000/ 77.44=€ 322.83

39
BID , ASK SPREAD

BID & ASK :A two-way price quotation that indicates

the best price at which a currency can be sold and
bought at a given point in time.

The difference between the bid and asked prices, or the

spread, is a key indicator of the liquidity of the asset
- generally speaking, the smaller the spread, the
better the liquidity.

40
Understanding Bid and Ask (offer)

For example, if the current price quotation for security A

is $10.50 / $10.55, investor X, who is looking to buy A
at the current market price, would pay $10.55, while
investor Y who wishes to sell A at the current market
price would receive $10.50.

Continuing with the above example, a market

maker who is quoting a price of $10.50 / $10.55 for
security A is indicating a willingness to buy A at $10.50
(the bid price) and sell it at $10.55 (the asked price).
The spread represents the market maker's profit.

41
Bid / Ask Spread

If you want to buy currency, you have to pay the

higher ask price, but if you want to sell currency,
you have to sell it at the lower bid price.

So if you were to buy currency, then immediately

sell it back to the same dealer, the dealer would
make money, and you would lose money.

Thus, the spread is the transaction cost of

trading currency.

42
 ASK, SELL
BID, BUY
, OFFER

43
CROSS RATE

It refers to a concept where one can calculate exchange rate

of two currencies by using exchange rates of other
currencies.

Given below is the process or way to calculate cross rates of

currencies –

Suppose we want to calculate cross rate between Euro and

Indian currency but since we do not have any available
exchange rate we will proceed to calculate exchange rate
through cross rate mechanism.

44
Example 1
We have USD and INR currency exchange rate and Euro and USD
currency rate
$1 = Rs 69 Rs / $ Quote ( Direct Quote for $ in India)
€ 1= $1.13 $ /€ quote ( Direct quote for Euro in USA)

Find Euro and Indian currency exchange rate we will use above
rates that is Rs / $ * $/€ = Rs / € , putting exchange rates in this
equation we get 1€ = Rs 69* $1.13 = Rs 77.97

Hence Rs / Euro exchange rate would be 77.97, or in simple

words one can buy 77.97 Rupees with 1 Euro.

45
Example 2 :Cross Exchange Rate

When direct quote is not available between a

pair of currencies , cross exchange rate
process is used to find the rate.

Example if exchange rate in Mumbai inter –

bank market is US $1 = Rs 66.2550/ 2600 and
in London inter-bank market is US $ 1= £
0.6545/ 0.6574. what would be the exchange
rate between Indian Rupee and Pound sterling

46
Mumbai inter-bank we need to purchase US $ by Surrendering
(selling) Rupee & Sell US $ in London inter- bank market to purchase
Pounds

Buy 1 US$ at Rs 66.2600 and Sell 1 US$ at £ 0.6545

So 1 US $ = £ 0.6545 = Rs 66.26

£ 0.6545 = Rs 66.26

1 £ = 66.26/ 0.6545 = Rs 101.23

47
Mumbai inter-bank we need to purchase US $ by Surrendering
(selling) Rupee & Sell US $ in London inter- bank market to purchase
Pounds

First Leg : Buy Dollar and Sell Rupee

Second Leg : Buy Pound and Sell Dollar

US $1 = Rs 66.2550/ 2600

Dollar buying rate US $ 1= Rs 66.2600

48
US $ 1= £ 0.6545/ 0.6574.

1£ = $ 1/0.6574: 1/0.6545

1£ = $ 1.5211: 1.5278

Pound buying rate 1£ = $ 1.5278

1 £ = Rs 66.2600X 1.5278= Rs 101.23

49
CROSS RATES

In India , all buy and sell transactions are

routed through US dollars .

All deals other than a dollar purchase or a

dollar sale with respect to rupee would
necessary involve transaction involving dollar.

Thus if an Indian importer wishes to purchase

Yen than he would have to buy Dollars first
and sell dollars to buy Yen .

50
The banker would obtain Yen /$ rate from
Tokyo and then apply the Rs/$ rate obtained
from local Indian market to arrive at the
exact rupees to be given for purchase of
Yen.

Since this transaction involves more than

two currencies , we call such rate a rate as
cross rate.

51
Reading the FX Table
Direct quote of $ in Japan

Cross-Rates ▪
Direct Quote of Yen in USA
RULES

»Rule 1
A = A X C
B C B
Bid (A/B) = Bid (A/C) X Bid (C/B)
Ask (A/B) = Ask (A/C) X Ask (C/B)
»Rule 2
Bid (A/B) = 1
Ask ( B/A)
53
RULES

»Rule 1
₹ = ₹ X $ European American
Quote Quote
€ $ €
Bid (₹ /€) = Bid (₹ /$) X Bid ($/ €)
Ask ( ₹ /€) = Ask (₹ /$) X Ask ($/ €)
»Rule 2
Bid (₹ /$) = 1
Ask ( $/ ₹)
54
Rule 2
Bid (₹ /$) = 1
Ask ( $/ ₹)
This is because when we want to transact in
dollars (say) we use $1= Rs 60/ 64 . It means
when we want to sell $ we would get Rs 60 and
when want to buy $ we need to give Rs 64

55
» Now let us assume that we want to transact in rupees . In
that case we use ₹ 1= $ .0163/ .0156
» It means when we want to sell ₹ we would get $ .0163
and when we want to buy ₹ we need to give $ .0156
» Now is not selling dollar akin to buying rupees and
vice versa ? From the first quote we get dollar sale
rate as $1 = Rs 60 from the second quote we get
rupee buying rate as Rs 1 = .0156 but both the quotes
are one and the same mathematically . Hence we say,
» Bid (₹ /$)= 1 / Ask ( $ / ₹)
» Ask (₹/$ ) = 1 / Bid ( $ / ₹)

56
 BID / ASK quotes
BID ( Dealer’s $ buy ASK ( Dealer’s $
rate selling rate

₹/$ $1 ₹ 68 ₹ 69 Indian direct

quote or
European
quote

From customer’s $ selling rate $ buying rate

point of view

₹ buying rate ₹ selling rate

57
 BID / ASK quotes

$/ ₹ 1₹ BID ( Dealers Rs buy rate)

ASK ( Dealers Rs sell rate) American
quote

1/69= $ .01449 1/68 = $.01470

From customer’s point ₹ selling rate ₹ buying rate

of view
$ buying rate $ selling rate

58
 CROSS RATE : RUPEE / EURO ₹ / €
BID ( banker’s ASK ( banker’s
buy rate selling rate
₹/$ $1 ₹ 68 ₹ 69 European
From trader/customer $ selling rate $ buying rate quote
/investor point of view ₹ buying rate ₹ selling rate

$/€ 1€ $ 1.1 $ 1.12 American quote

From trader/customer € selling rate € buying rate

/investor point of view $ buying rate $ selling rate

₹/€ ₹ 68 X $1.1= ₹ ₹ 69 X $1.12 = Indian direct

74.8 ₹77.28 quote

59
 CROSS RATE : RUPEE / POUND ₹ / £
BID ( banker’s ASK ( banker’s
buy rate selling rate
₹/$ $1 ₹ 66 ₹ 67 Indian direct
From trader/customer $ selling rate $ buying rate quote/
/investor point of view European
₹ buying rate ₹ selling rate

$ /£ 1£ $ 1.52 $ 1.53 American

quote
From trader/customer £ selling rate £ buying rate
/investor point of view $ buying rate $ selling rate

₹/£ ₹ 66 X $1.52= ₹ 67X $1.53 = ₹ Indian direct

₹100.32 103.85 quote

60
 CROSS RATE : RUPEE / POUND ₹ / £
BID ( banker’s ASK ( banker’s
buy rate selling rate
₹/$ $1 ₹ 66.2550 ₹ 66.2600 Indian direct
From trader/customer $ selling rate $ buying rate quote/
/investor point of view European
₹ buying rate ₹ selling rate

$ /£ 1£ $ 1.5211 $ 1.5279 American

quote
From trader/customer £ selling rate £ buying rate
/investor point of view $ buying rate $ selling rate

₹/£ ₹ 66.255 X ₹ 66.26 X Indian direct

$1.5211= $1.5278 = ₹ quote
₹100.78 101.23

61
 CROSS RATE : RUPEE / YEN ₹ / ¥
BID ( banker’s ASK ( banker’s
buy rate selling rate
₹/$ $1 = ₹ 66 ₹ 67 Indian direct
From trader/customer $ selling rate $ buying rate quote/
/investor point of view European
₹ buying rate ₹ selling rate

$/¥ 1¥ $ .0082 $ .0083 American

quote
From trader/customer ¥selling rate ¥ buying rate
/investor point of view $ buying rate $ selling rate

₹/¥ ₹ 66 X $.0082= ₹ ₹ 67X $ .0083 = Indian direct

.5412 ₹ .5561 quote

62
 CROSS RATE : RUPEE / SINGAPORE DOLLAR

BID ( banker’s ASK ( banker’s

buy rate selling rate
₹/$ $1 = ₹ 66 ₹ 67 Indian direct
From trader/customer $ selling rate $ buying rate quote/
/investor point of view European
₹ buying rate ₹ selling rate

S$ /$ 1$ S$ 1.230 S$ 1.243 European

Quote
Bid $ /S$ = 1/ Ask S$/$ Ask $/S$ = 1/ Bid S$/$
$/S$ 1 S$ $ .804 $ .813 American
Quote
₹ / S$ ₹ 66 X $.804= ₹ ₹ 67X $ .813= ₹ Indian direct
=53.064 54.47 quote

63
64
CONTRACT SPECIFICATION

65
Contract Specifications - Futures & Options on INR pairs

66
67
68
69
PRICING FUTURES – COST OF
CARRY MODEL
»Pricing of futures contract is very simple. Using
the cost-of-carry logic, we calculate the fair value
of a futures contract.
» Everytime the observed price deviates from the
fair value, arbitragers would enter into trades to
capture the arbitrage profit.
» This in turn would push the futures price back to
its fair value.

70
TICK SIZE

A tick is the minimum trading increment or price

differential at which traders are able to enter
bids and offers.

Tick values differ for different currency pairs and

different underlyings. For e.g. in the case of the
USD-INR currency futures contract the tick size
shall be 0.25 paise or 0.0025 Rupees.

71
TICK SIZE

To demonstrate how a move of one tick

affects the price, imagine a trader buys
a contract (USD 1000 being the value
of each contract) at Rs.69.2500.

One tick move on this contract will

translate to Rs.69.2475 or Rs.69.2525
depending on the direction of market
movement

72
TICK SIZE

»Purchase price: Rs.69.2500

» Price increases by one tick: +Rs.00.0025
»New price: Rs.69.2525

»Purchase price: Rs.69.2500

» Price increases by one tick: -Rs.00.0025
»New price: Rs.69.2475

73
TICK SIZE
» The value of one tick on each contract is Rupees
2.50. So if a trader buys 5 contracts and the price
moves up by 4 tick, she makes Rupees 50.
» Step 1: 69.2600 – 69.2500
» Step 2: 4 ticks * 5 contracts = 20 points
» Step 3: 20 points * Rupees 2.5 per tick = Rupees 50
» note: please note the above examples do not include
transaction fees and any other fees, which are essential
for calculating final profit and loss)

74
1

»In the case of the USD-INR currency futures

contract the tick size shall be……….
1. 0.25 paise or 0.0025 Rupees
2. .50 paise
3. .75 paise
4. .10 paise

75
2

»The currency futures contracts on the NSE have

one-month, two-month, three-month up to twelve-
month expiry cycles. Hence, NSE will have ……
contracts outstanding at any given point in time.
1. 4
2. 8
3. 12
4. 6

76
3

» if a trader buys 5 contracts and the price moves

up by 4 tick, she makes ……..
1. Rupees 50
2. Rupees 100
3. Rupees 75
4. Rupees 25

77
4

»The last business day of the month will be termed

the ……………….. of each contract.

1. Expiry date
2. Final Settlement date
3. Contract date
4. Trade date

78
5

» The last trading day ( expiry day) will be……

business days prior to the Value date / Final
Settlement Date.
1. Two
2. Four
3. One
4. Three

79
6

»The amount that must be deposited in the margin

account at the time a futures contract is first
entered into is known as ……..
1. margin
2. initial margin.
3. deposit margin
4. deposit

80
7

»In the futures market, at the end of each trading

day, the margin account is adjusted to reflect the
investor's gain or loss depending upon the futures
closing price. This is called …………………
1. Daily market
2. marking-to-market.
3. Market to day
4. settlement

81
8

» If the balance in the margin account falls below

the maintenance margin, the investor receives a
……….and is expected to top up the margin
account to the initial margin level before trading
commences on the next day.
1. Margin call
2. SMS
3. Deposit call
4. alarm

82
9

»When an underlying is an ‘exchange rate’, the

contract is termed as a ______________.

1. Currency Futures contract

2. Commodity Futures contract
3. Risks
4. None of the above

83
10

»A tick is the _____________ at which traders are

able to enter bids and offers.
1. maximum trading increment
2. price
3. minimum trading increment
4. None of the above

84
11

»The settlement price would be the

……………Reference Rate on the last trading
day.
1. Reserve Bank of India
2. State bank of India
3. Central Bank of India
4. Punjab national bank

85
What are Pips in Forex

To illustrate, if the following pair were provided as such:

USD / EUR 1.12265/69 OR 1.2265/9
Then the bidding price is set for 1.2265
with the ask price set to 1.2269

Pip :The minimum incremental move that of which is made

Possible by a currency pair is otherwise known as a pip, which
simply stands for price interest point.
For example, a move in the USD / EUR currency pair from 1.2545
to 1.2560 would be equivalent to 15 pips, whereas a move in the
USD / JPY currency pair from 112.05 to 113.05 would be
equivalent to 105 pips.

86
What are Pips in Forex

Forex traders often use pips to

reference gains or losses. For a
trader to say "I made 40 pips on
the trade" for instance, means
that the trader profited by 40 pips.
The actual cash amount this
represents however, depends on
the pip value.

87
Exchange Rates

The exchange rate is the price that is

determined in the foreign exchange market.
Of course, there are many concepts of
exchange rate we can consider. These include:

• Spot versus forward exchange rates versus

future exchange rates
• Fixed versus flexible exchange rates
• Nominal versus real exchange rate

88
Spot and Forward Exchange Rates

The exchange rate is simply the price of foreign

currency in terms of domestic currency.
The typical fashion is to quote the foreign
Currency price of the dollar; hence, the Rupee
has been trading at approximately Rs 68.92
to the dollar on July 20, 2019
The spot (or nominal) exchange rate refers to
The current price of foreign exchange. It is a
contract for immediate delivery, though that
might actually take a day or two.

89
A forward contract refers to a transaction for
delivery of foreign exchange at some
specified date in the future.
Suppose, for example, that a Indian company,
say Tata Motors, expects to receive $ 100,000
60 days from now. The value of these receipts
will vary with the actual value of the spot
exchange rate in the future.
The firm may wish, however, to hedge. It may
wish to reduce the risk that the rupee will
appreciate during these 60 days.
90
Consequently, it signs a contract to receive
$100,000 @ Rs 69.10 at 60 day
forward rate.

The company has hedged the exchange

rate risk.

91
Forward contracts are usually offered by
commercial banks, and this helps to explain
the difference with futures contracts.
Banks offer their important customers forward
contracts as part of their business
relationship. It enables firms to engage in
international trade with limited exposure to
Foreign currency risk.

92
Forward premium

It's the price paid for hedging by buying dollars

in the forward market.
Forward transactions take place at a premium
or discount to the spot rate.
The outright forward transactions are
over-the-counter transactions undertaken by
dealers. In India, it is generally the banks
that transact in forward markets.

93
The maturity date agreed upon by the parties
generally varies from months to a year or two.
But maturities beyond that tend to have wider
bid-ask spreads, in other words, tend to be
more expensive
The forward rate could be in premium or
discount, based on the interest rate differential
in case of currencies which are fully
convertible and in case of partially-convertible
currencies, they are determined purely on the
basis of demand and supply.
94
For example, in India, the USD/INR forward
rate for six months could be in premium or at
A discount over the spot rate, based on how
liquid the dollar is.

95
Forward Premium / Discount

»Annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

»Example: Suppose £ spot rate = $1.401,

90-day £ forward rate = $1.398.

$1.398 – $1.401 x 360 = – 0.86%

$1.398 90

So, forward discount = 0.86%

96
Forward Market

»annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

»Example: Suppose $ spot rate = Rs 61.12

90-day $ forward rate = Rs 61.95

Rs61.95 – Rs 61.12 x 360 = +5.43 %

Rs 61.12 90

So, forward premium = + 5.43%

97
Forward Market

»annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

»Example: Suppose $ spot rate = Rs 68.45

one year $ forward rate = Rs 71.77

Rs71.77 – Rs 68.45 x 360 = +4.85 %

Rs 68.45 360

So, forward premium = + 4.85%

98
99
Question

100
Question

»Suppose you open the newspaper today and

observe the following indirect exchange
quotations for the British Pound.
Forward Exchange Rate
Spot 30 60 90
exchange
rate
British pound ( pound/ .5376 .5395 .5412 .5435
dollar)
$1 = £ .5376

»The British Pound is selling at a……..in the

forward market $ forward rate

101
Forward Premium / Discount

»Annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

Spot rate $1 = £ .5376 spot rate 1 £ = $1.8601,

30 -day £ forward rate = $1.8535 (1/.5395)

$1.8535 – $1.8601 x 360 = – 4.257%

$1.8601 30

So, forward discount = -4.257

102
Forward Premium / Discount

»Annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

Spot rate $1 = £ .5376 ,

30 -day $ forward rate = £ .5395

5395 – .5376 x 360 = 4.257%

.5376 30

So, forward Premium = 4.257

103
Question

Suppose you make a £ 4,50,000 sale to a British

Customer who has 60 days to pay to you in cash
.the customer will pay you in British pounds , but
your company is based in United States , so you
are most concerned with the dollar value of the
payment .

if the customer pays you £ 4,50,000 today, how

much is that worth in dollars ?

104
Answer

»Suppose you make a £ 4,50,000 sale to a British

Customer who has 60 days to pay to you in cash
.the customer will pay you in British pounds , but
your company is based in United States , so you
are most concerned with the dollar value of the
payment .
»if the customer pays you £ 4,50,000 today, how
much is that worth in dollars ?
»Answer : £ 4,50,0000/ .5376 = $ 8,37,053

105
Question

Assume that the forward market is correct

and the 60 day forward exchange rate
quoted in the news paper today is the
spot exchange rate 60 days from now .

If the customer waits full 60 days and

pays you 4,50,000, how much you have
lost( in dollar terms) due to exchange rate
fluctuation ?

106
Answer

»Assume that the forward market is correct and

the 60 day forward exchange rate quoted in the
news paper today is the spot exchange rate 60
days from now . If the customer waits full 60 days
and pays you 4,50,000, how much you have lost(
in dollar terms) due to exchange rate fluctuation ?
»Answer : £ 4,50,0000/ .5412 = $ 8,31,485
» Loss : $ 8,37,053- 8,31,485. = $ 5,568

107
»What Is Meant By A Currency Trading At A
Discount Or At A Premium In The Forward
Market?
»The forward market involves contracting today for
the future purchase or sale of foreign exchange.
The forward price may be the same as the spot
price, but usually it is higher (at a premium) or
lower (at a discount) than the spot price

108
» Over The Past Six Years, The Exchange Rate
Between Swiss Franc And U.S. Dollar, Sfr/$,
Has Changed From About 1.30 To About 1.60.
Would You Agree That Over This Six-year
Period, The Swiss Goods Have Become
Cheaper For Buyers In The United States?
(update? Sf Has Gone From Sf1.67/$ To
Sf1.04/$ Over The Last Six Years.)
» The value of the dollar in Swiss francs has gone up from about 1.30
to about 1.60. Therefore, the dollar has appreciated relative to the
Swiss franc, and the dollars needed by Americans to purchase Swiss
goods have decreased.
»
109
What determines forward premium?

Countries that have fully-convertible currencies, the

forward premium is deduced from their interest
rate differentials, respectively.
The premium/discount is measured in points, which
represent the interest rate differential of the countries
to which the currencies belong, for the period of
maturity.

These points are the quantum of foreign exchange that

would neutralise the interest rate differential

110
Fully convertible currency

»A fully convertible currency, also known as a

freely convertible currency, is one that can be
traded without any limitations imposed by the
monetary authorities.
»They typically come from more stable countries,
although there are some exceptions to this rule.
» The Mexican peso is an example of a fully
convertible exotic currency.

111
Examples of fully convertible currencies

»The major currencies are examples of fully

convertible currencies, including the US dollar,
British pound sterling, Swiss franc, Japanese yen
and the euro.
»However, there are also several minor
currencies that are fully convertible. The New
Zealand dollar is an example of the former, while
the South African rand is another fully convertible
currency.

112
»That is, they may be traded in the global foreign
exchange market without any limitations or
government intervention in the process.
»In contrast, the Indian rupee is an example of a
partially convertible currency, as the Indian
government imposes restrictions on its trade.

113
Forward exchange rates

According to the interest parity theory ,

forward rate are dependent on the prevailing
interest rate in the two currencies .

The forward rate can be calculated by the

following formula :
F = 1+ Rh
S 1+ Rf
Where F and S are future and spot currency
rates . Rh and Rf are Simple interest rate in the
home and foreign currency

114
Forward exchange rates

If we consider continuously compounding

interest rate forward Rate can be computed
using the following formula
(rh-rf)*T
F= S * e
rh = continuously compounded interest
rates for the home currency
rf = continuously compounded interest
rates for the foreign currency
T = Time to maturity
e = 2.71828

115
116
Lets assume that one year rate interest rate
in US and India are say 3% and 8%
respectively and the spot rate of USD in
India is Rs 62

(rh-rf)*T
F= S * e

Using the above equation the one year

forward rate should be
.05
F = 62 * e = 62 * 1.0513 = 65.1806

117
ARBITRAGE

Suppose that the one-year forward rate is less

than this say Rs 64
An arbitrageur can :
Borrow 1000 USD at 3% per annum for one
year and convert to Rs 62000/- and invest the
same at 8%
An amount of USD 1030.50 has to be repaid ,
Buy a forward contract for USD 1030.50
for Rs 65,952 ( Rs 64 * 1030.50)

118
USD 1000 converted to Rs 62000 and
invested at 8% pa grows to Rs 67164.6 of
this Rs65952 shall be used to buy
$ 1030.5 and repay the US loan

The strategy therefore leaves a risk free

profit of Rs 1212.6 Suppose the rate was
greater than Rs 65.18 as given in the equation
above , the reverse strategy would have
worked.

119
Suppose , that the spot rate is Rs 60 per USD
that one year rate interest rate in US and India
are say 3% and 9% respectively

1. Compute the 2 year forward rate

2. If the future rate is say 66.50 .
3. Is there any opportunity of arbitrage

120
 (rh-rf)*T
F= S * e
From the equation above the two year
forward rate should be
.12
F = 60 * e = 60 * 1.1275 = 67.75

Since future rate is not equal to 67.75

Arbitrage opportunity exists.

121
CA FINAL NOV 2009/ May 2010

The rate of inflation in USA is

likely to be 3% per annum and in
India to be 6.5% . The current
spot rate of Us $ in India is Rs 68
. Find the expected rate of US $
in India after one year and 3
years from now using purchasing
parity theory

122
»After one year the expected rate of dollar can be
found using PPP formula

»F/ 68= 1.065/1.03

»F/68= 1.03398
»F= 1.03398X 68
»F= 70.31

123
»F/68= (1.065)(1.065)(1.065)/(1.03)(1.03)(1.03
»= 1.20795/1.092727
»F = 68( 1.1054)
»= Rs 75.1672

124
Example (Less than 1 year)
• Assume:
INR/ USD spot = 68.00
Inflation in India = 6.5%
Inflation in US = 3%
• Calculate the 6 month forward rate
F= 68.00 x [(1 + ((0.065x 180/360))/((1 + ((0.0300 x
180/360))]
F= 68 x (1.0325/1.015)
F = 68.00 x 1.01724
F = 69.17
Exercise
• Assume:
INR/ USD spot = 69.20
Inflation in India = 6%
Inflation in US = 2%
• Calculate the 3 month forward rate
Exercise 2

»Let us look at an example: If the spot CAD/USD

rate is 1.1239 and the three month interest rates
on CAD and USD are 0.75% and 0.4% annually
respectively, then calculate the 3 month
CAD/USD forward rate.
»In this case the forward rate will be

127
Exercise 3

»Let us look at an example: If the spot CAD/USD

rate is 1.1239 and the three month interest rates
on CAD and USD are 0.75% and 0.4% annually
respectively, then calculate the 3 month
CAD/USD forward rate.
»In this case the forward rate will be

128
CURRENCY DERIVATIVES

129
CURRENCY DERIVATIVES

»Volatility of the exchange rates affect of

corporate operating cash flows, income
statement and it’s competitive position.
»It affects the balance sheet by changing
the value of firm’s assets and liabilities
, accounts payable, accounts
receivables , inventory etc.

130
CURRENCY DERIVATIVES

»Forex derivatives market provides a basket

of hedging instruments for effective
management of foreign exchange exposure.
»Currency derivative has emerged as important
and interesting new asset class for investors
» Currency option would provide an
opportunity to take a view on exchange rate
and fulfill both investing and hedging
objectives

131
Chapter Objectives

»To explain how forward contracts are

used for hedging based on anticipated
exchange rate movements; and
»To explain how currency futures
contracts and currency options
contracts are used for hedging or
speculation based on anticipated
exchange rate movements.

132
Forward Market

»The forward market facilitates the

trading of forward contracts on
currencies.
»A forward contract is an agreement
between a corporation and a
commercial bank to exchange a
specified amount of a currency at a
specified exchange rate (called the
forward rate) on a specified date in the
future.
133
Forward Contracts

»When MNCs anticipate future need or

future receipt of a foreign currency, they
can set up forward contracts to lock in
the exchange rate.
»Forward contracts are often valued at $1
million or more, and are not normally
used by consumers or small firms.

134
Forward Market

»As with the case of spot rates, there is a

bid/ask spread on forward rates.
»Forward rates may also contain a
premium or discount.
»If the forward rate exceeds the existing
spot rate, it contains a premium.
»If the forward rate is less than the
existing spot rate, it contains a
discount.
135
Forward Market

»Annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

»Example: Suppose £ spot rate = $1.401,

90-day £ forward rate = $1.398.

$1.398 – $1.401 x 360 = – 0.86%

$1.398 90

So, forward discount = 0.86%

136
Forward Market

»annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

»Example: Suppose $ spot rate = Rs 61.12

90-day $ forward rate = Rs 61.95

Rs61.95 – Rs 61.12 x 360 = +5.43 %

Rs 61.12 90

So, forward premium = + 5.43%

137
Forward Market

»annualized forward premium/discount

forward rate – spot rate 360
= spot rate
 n
where n is the number of days to maturity

»Example: Suppose $ spot rate = Rs 68.45

one year $ forward rate = Rs 71.77

Rs71.77 – Rs 68.45 x 360 = +4.85 %

Rs 68.45 360

So, forward premium = + 4.85%

138
FORWARD MARKET

»The forward premium/discount

reflects the difference between the
home interest rate and the foreign
interest rate, so as to prevent
arbitrage.

139
Forward Contract - Example

»Assume that the exchange rate is USD1= INR

61.12 today , Bombay dyeing , an Indian
exporter has supplied garments to Macy’s
department store in San Francisco for USD 1
million , and Macy’s will pay this amount in 90
days . Bombay Dyeing is uncertain about the
exchange rate after 90 days and would like to
eliminate this uncertainty .
»The CFO of Bombay Dyeing can enter into a
currency forward contract with the ICICI bank
to sell US dollars to the banks after 90 days.
140
»Assume that the forward rate , which is the
rate at which the ICICI bank will buy US
dollars after 90 days is USD 1= INR 61.89.
»Suppose the exchange rate after 90 days is
USD 1 = INR 61.25 if Bombay Dyeing had not
entered into a currency forward contract , it
would have sold USD I million at the spot
market rate of USD 1 = INR 61.25 for a total of
INR 61.25 million .

141
»If the exchange rate after 90 days is USD
1 = Rs 61.05 , it would have sold USD 1
million at the spot rate of USD 1= INR
61.05 for a total of INR 61.05 million, in
the absence of a forward contract .
»Thus , the amount that the Bombay
Dyeing would receive after 90 days is
uncertain and depends on the spot
exchange rate at that time .

142
»On the other hand if Bombay Dyeing
enters into a forward contract at a
forward rate USD 1 = INR 61.89 ,
Raymond can be certain that it will
receive INR 61.89 million irrespective of
the spot rate on that date

143
Currency Futures Market

»Currency futures contracts specify a

standard volume of a particular
currency to be exchanged on a specific
settlement date .
»They are used by MNCs to hedge their
currency positions, and by speculators
who hope to capitalize on their
expectations of exchange rate
movements.

144
Currency Futures Market

»The contracts can be traded by firms or

individuals through brokers on the on
automated trading systems (e.g. in India
through NSE ), or over-the-counter.
»Participants in the currency futures
market need to establish and maintain a
margin when they take a position.

145
 Forward Markets Futures Markets
Contract size Customized Standardized.

Trading Informal Over the Traded on Exchange

Counter
Participants Banks, brokers, MNCs. Banks, brokers, MNCs.
Public speculation not Qualified Public
encouraged speculation
encouraged

Settlement Single- Pre-specified in Daily settlement & Final

the contract settlement
Risk Counter party risk is Exchange provides the
present guarantee of settlement
& hence no counter
party risk
Marketplace Worldwide telephone Central exchange floor
network. with global
communications
146
Currency Futures Market

»Normally, the price of a currency futures

contract is similar to the forward rate for a
given currency and settlement date, but
differs from the spot rate when the interest
rates on the two currencies differ.
»These relationships are enforced by the
potential arbitrage activities that would occur
otherwise.

147
Currency Futures Market

»Currency futures contracts have no

credit risk since they are guaranteed by
the exchange clearinghouse.
»To minimize its risk in such a guarantee,
the exchange imposes margin
requirements to cover fluctuations in
the value of the contracts.

148
Currency Futures Market

»Speculators often sell currency futures when

they expect the underlying currency to
depreciate, and vice versa.

149
Currency Futures Market

»Currency futures may be purchased by MNCs

to hedge foreign currency payables, or sold to
hedge receivables.

150
Currency Futures Market

»Holders of futures contracts can close out

their positions by selling similar futures
contracts.
»Sellers may also close out their positions by
purchasing similar contracts

151
Currency Futures Market

»Most currency futures contracts are closed

out before their settlement dates.
»Brokers who fulfill orders to buy or sell
futures contracts earn a transaction or
brokerage fee in the form of the bid/ask
spread.

152
FUTURE EXAMPLES

153
HEDGING –EXPORTER : SHORT

A Software Exporter would receive a payment

of USD 1,000,000 after 3 months . Suppose the
spot rate and the future 3 month rate is Rs 62 .

He expects Dollar to depreciate due to huge

increase in exports and FII inflow in India .
He would lose on account of Dollar
depreciation.
He plans to hedge the foreign currency risk
by selling dollars @ 62 in the Futures market

154
Thus Exporter is exposed to exchange rate risk , which he can
hedge by taking an by taking a short position in the future market.

By taking short position in 1000 future contracts ( USD –INR

future contract size is of 1000 USD) he can lock in the exchange
rate after 3 months at INR Rs 62/- ( Assuming 3 months future
price is 62).

Whatever may be the exchange rate after 3 months

exporter will be getting 6,20,00,000

Any loss in the Spot market will get off set from the gain in the
In the future market and vice versa

155
HEDGING- SHORT
If Dollar appreciates / strengthens in If the dollar depreciates/ weakens
exchange rate becomes $ 1= INR 63 and the exchange rate becomes$1=
INR 61
Spot Market : Exporter will receive Spot Market : Exporter will receive
INR 6,30,00,000 by selling I million INR 6,10,00,000 by selling I million
USD in the spot market USD in the spot market

Future Market : Exporter will lose Future Market : Exporter will gain
INR ( 62-63) *1000= INR 1000 per INR ( 62-61) *1000= INR 1000 per
contract . The total loss in 1000 contract . The total gain in 1000
contract s will be INR 10,00,000 contract s will be INR 10,00,000

Net Receipt = 63 million -1 million= Net Receipt = 61 million +1 million=

62million 62 million

156
HEDGING – IMPORTER - LONG

An Importer has ordered certain equipments

from US and has to make payment after
3 months .Suppose the spot rate and future
3 month rate is Rs 62 .

He expects Dollar to appreciate due to

announcement of QE tapering and outflow of
FII . He would lose on account of Dollar
appreciation.
He plans to hedge the foreign currency risk
by buying dollars @62 In the Futures market

157
Thus Importer is exposed to exchange rate risk , which he can
hedge by taking an by taking a long position in the future market.

By taking long position in 1000 future contracts ( USD –INR

future contract size is Of 1000 USD) he can lock in the exchange
rate after 3 months at INR Rs 62/- ( Assuming 3 months future
price is 62).

Whatever may be the exchange rate after 3 months

Importer will be paying 6,20,00,000

Any loss in the Spot market will get off set from the gain in the
In the future market and vice versa

158
HEDGING- LONG
If Dollar appreciates / strengthens If the Dollar weakens/ depreciates
and the exchange rate becomes and the exchange rate becomes
1$= INR 63 1$=INR 60
Spot Market : Importer has to pay Spot Market : importer will pay INR
INR 6,30,00,000 by buying I million 6,00,00,000 by buying I million USD
USD in the spot market in the spot market

Future Market : Importer will gain Future Market : Importer will lose
INR ( 63-62) *1000= INR 1000 per INR ( 60-62) *1000= INR 2000 per
contract . The total gain in 1000 contract . The total loss in 1000
contract s will be INR 10,00,000 contract s will be INR 20,00,000

Net payments = 63 million -1 million= Net payments = 60 million +2 million=

62 million 62 million

159
Currency Option Market

»A currency option is another type of contract

that can be purchased or sold by speculators
and firms.
»The standard options that are traded on an
exchange through brokers are guaranteed,
but require margin maintenance.
»U.S. option exchanges (e.g. Chicago Board
Options Exchange) are regulated by the
Securities and Exchange Commission.

160
Currency Options Market

»In addition to the exchanges, there is an over-

the-counter market where commercial banks
and brokerage firms offer customized
currency options.
»There are no credit guarantees for these OTC
options, so some form of collateral may be
required.
»Currency options are classified as either calls
or puts.

161
Currency Call Options

»A currency call option grants the holder the right

to buy a specific currency at a specific price
(called the exercise or strike price) within a
specific period of time.
»A call option is
» in the money if spot rate > strike price,
» at the money if spot rate = strike price,
» out of the money if spot rate < strike price.

162
EXAMPLE : CALL OPTION

»On 1st July 2018 XYZ buys a USD call

option for covering its import
transactions at a strike rate of 63.50. The
expiry date is 3 months i.e. 31st July
2018 .
»The premium is 50 paisa on the call.
Gain or loss on expiry at various levels
of exchange is demonstrated below vide
pay off table

163
Market rate Exercise rate Premium paid Gain / loss
call @ 63.5

62.5 .50 -.50

63 .50 -.50
63.5 .50 -.50
64 .5 .50 0
64.5 1 .50 .50
65 1.5 .50 1.0
65.5 2 .50 1.50
When the spot exchange rate rises above the strike price , there are gains
when it falls below the strike price there losses which are maximum to the
extent of premium

164
Currency Call Options

»Option owners can sell or exercise their

options. They can also choose to let their
options expire. At most, they will lose the
premiums they paid for their options.
»Call option premiums will be higher when:
» (spot price – strike price) is larger;
» the time to expiration date is longer; and
» the variability of the currency is greater.

165
Currency Call Options

»Firms with open positions in foreign

currencies may use currency call options to
cover those positions.
»They may purchase currency call options
» to hedge future payables;
» to hedge potential expenses when bidding on
projects; and
» to hedge potential costs when attempting to
acquire other firms.

166
Currency Call Options

»Speculators who expect a foreign currency to

appreciate can purchase call options on that
currency.
» Profit = selling price – buying (strike) price –
option premium

»They may also sell (write) call options on a

currency that they expect to depreciate.
» Profit = option premium – buying price + selling
(strike) price

167
Currency Call Options

»The purchaser of a call option will break even

when
selling price = buying (strike) price
+ option premium

»The seller (writer) of a call option will break even

when
buying price = selling (strike) price
+ option premium

168
Currency Put Options

»A currency put option grants the holder the right

to sell a specific currency at a specific price (the
strike price) within a specific period of time.
»A put option is
» in the money if spot rate < strike price,
» at the money if spot rate = strike price,
» out of the money if spot rate > strike price.

169
CURRENCY OPTION STRATEGY FOR EXPORT TRANSACTION

»On 1st October 2018 XYZ buys a USD

put option for covering its export
transactions at a strike rate of 63.50. The
expiry date is 3 months i.e. 31st
December 2018 .
»The premium is 50 paisa on the Put.
Gain or loss on expiry at various levels
of exchange is demonstrated below vide
pay off table

170
Market rate Exercise rate Premium paid Gain / loss
Put @ 63.5

61.50 2.00 .50 1.50

62.00 1.50 .50 1.00
62.50 1.00 .50 .50
63.50 .50 -.50
64.00 .50 -.50
64.5 .50 -.50

When the spot exchange rate fall below the strike price , there are gains
when it rises above the strike price there losses which are maximum to
the extent of premium paid

171
Currency Put Options

»Put option premiums will be higher when:

» (strike price – spot rate) is larger;
» the time to expiration date is longer; and
» the variability of the currency is greater.

»Corporations with open foreign currency

positions may use currency put options to
cover their positions.
» For example, firms may purchase put options to
hedge future receivables.

172
Currency Put Options

»Speculators who expect a foreign currency to

depreciate can purchase put options on that
currency.
» Profit = selling (strike) price – buying price –
option premium

»They may also sell (write) put options on a

currency that they expect to appreciate.
» Profit = option premium + selling price – buying
(strike) price

173
A CALL OPTION
» A trader buys a call option on US dollar with a strike price of Rs.49.50
and pays a premium of Rs.1.50. The current spot rate, St, is Rs.48.50.
His gain/loss at time T when the option expires depends upon the value
of the spot rate, ST, at that time
USD/INR ST AT EXPIRY Option Buyer’s Gain(+)/Loss(-)
48.2500 -Rs.1.50
48.5000 -Rs.1.50
48.7500 -Rs.1.50
49.0000 -Rs.1.50
49.2500 -Rs.1.50
49.5000 -Rs.1.50
49.7500 -Rs.1.25
50.0000 -Rs.1.00
51.0000 +Rs.0.00
52.0000 +Rs.1.00
54.5000 +Rs.3.50
56.0000 +Rs.5.00

174
A PUT OPTION

» A trader buys a put option on pound sterling at a strike price of

$1.8500, for a premium of $0.07 per sterling. The spot rate at the
time is $1.9465. At expiry, his gains/losses are as follows
» GBP/USD ST AT EXPIRY Option Buyer’s Gain(+)/Loss(-)
» 1.7000 +$0.0800
» 1.7300 +$0.0500
» 1.7500 +$0.0300
» 1.7600 +$0.0200
» 1.7800 $0.0000
» 1.7900 -$0.0100
» 1.8300 -$0.0500
» 1.8500 -$0.0700
» 1.8700 -$0.0700
» 1.9000 -$0.0700
» 1.9500 -$0.0700

175
Elementary Option Strategies

»Spread Strategies
»Bullish Call Spread: Consists of
selling the call with the higher strike
price and buying the call with the
lower strike price
»Bearish Call spread: If the investor
expects the foreign currency to
depreciate, he can adopt the reverse
strategy viz. buy the higher strike call
and sell the lower strike call
176
»Bullish Put Spread: Consists of selling
puts with higher strike and buying
puts with lower strike
»Bearish Put Spread: Opposite of
Bullish Put Spread
These strategies, involving options
with same maturity but different strike
prices are called Vertical or Price
Spreads

177
CURRENCY DERIVATIVES TRADING
SYSTEM
» The Currency Derivatives trading system of NSE, called
NEAT-CDS (National Exchange for Automated Trading -
Currency Derivatives Segment)
» Trading system, provides a fully automated screen-based
trading for currency futures on a nationwide basis as well
as an online monitoring and surveillance mechanism.
» It supports an order driven market and provides complete
transparency of trading operations.
» The online trading system is similar to that of trading of
equity derivatives in the Futures & Options (F&O)
segment of NSE.

178
Entities in the trading system

Trading Clearing
members (TM) members (CM)

Professional
clearing Participants
members (PCM)

179
Basis of trading
» The NEAT-CDS system supports an order driven market,
wherein orders match automatically.
» Order matching is essentially on the basis of security, its price
and time.
» All quantity fields are in contracts and price in Indian rupees.
» The exchange notifies the contract size and tick size for each
of the contracts traded on this segment from time to time.
» When any order enters the trading system, it is an active
order. It tries to find a match on the opposite side of the book. If
it finds a match, a trade is generated. If it does not find a
match, the order becomes passive and sits in the respective
outstanding order book in the system.

180
THANK YOU

181
Thank you

182
183
 Cross-Exchange Rate Formulae: Method 1

» How many euro's for one pound?

» Method 1
S  $/£  American Terms
S( € /£) =
S($/ € ) American Terms

» Notes:
» Both are in American terms.
» The first currency (€) goes into the denominator (bottom)
» The second currency (£) goes into the numerator (top)
NOTE: By ‘first currency’, I mean the first currency in the spot formula, i.e., X, in S(X/Y).
 Method 1: Example

» Find S(¥/€)–How many yen for a euro?

» If S($/€) = 1.4497 and S($/¥) =0.009228
S  $/ €  American Terms 1.4497
S(¥/ € ) =   157.0980
S($/¥) American Terms 0.009228

» Notes:
» Both are in American terms.
» The first currency (¥) goes into the denominator (bottom)
» The second currency (€) goes into the numerator (top)
Cross-Exchange Rate Formulae : Method 2

» How many euro's for one pound?

» Method 2

S(€/£) = S  $/£  × S(€/$) American Terms × European Terms

$ € €
= S   × S   = S   = S(€/£)
» Notes: £ $ £
» One in American terms; one in European terms
» The first currency (€) is in European terms.
» The second currency (£) is in American terms.
» The order of multiplication does not matter.
NOTE: By ‘first currency’, I mean the first currency in the spot formula, i.e., X, in S(X/Y).
186 (of 24)
Cross-Exchange Rate Formulae : Method 2

» Find S(¥/€)–How many yen for a euro?

» if S($/€) = 1.4497 and S($/¥) =0.009228

S(¥/€) = S  $/€  × S(¥/$) = 1.4497 × 108.3650 = 157.0967

American Terms × European Terms
» Notes:
» The first currency is in European terms.
» The second currency is in American terms.
» The order of multiplication does not matter.
» NOTE: When dealing in yen there can be rounding error.

187 (of 24)

Bid-Ask
Cross-Exchange Rates

» Using Method 2
» Multiply two bids to get a bid.
» Multiply two asks to get an ask.

» Example:
Sb (¥/€) = Sb  $/€  × Sb (¥/$)
American Terms × European Terms
Sb (¥/€) = 1.4497 × 108.3650 = 157.0967
The Basics of Currency Forwards

»Unlike other hedging mechanisms such

as currency futures and options
contracts– which require an upfront
payment for margin requirements and
premium payments, respectively –
currency forwards typically do not
require an upfront payment when used
by large corporations and banks

189 (of 24)

»However, a currency forward has little flexibility
and represents a binding obligation, which means
that the contract buyer or seller cannot walk away
if the “locked in” rate eventually proves to be
adverse.
» Therefore, to compensate for the risk of non-
delivery or non-settlement, financial
institutions that deal in currency forwards may
require a deposit from retail investors or smaller
firms with whom they do not have a business
relationship.
190
»Importers and exporters generally use currency
forwards to hedge against fluctuations in
exchange rates.
»An Example of a Currency Forward
» The mechanism for determining a currency forward
rate is straightforward, and depends on interest rate
differentials for the currency pair (assuming both
currencies are freely traded on the forex market). For
example, assume a current spot rate for the
Canadian dollar of US$1 = C$1.0500, a one-year
interest rate for Canadian dollars of 3 percent, and
one-year interest rate for US dollars of 1.5 percent.
191
»After one year, based on interest rate parity,
US$1 plus interest at 1.5 percent would be
equivalent to C$1.0500 plus interest at 3 percent,
meaning:
»$1 (1 + 0.015) = C$1.0500 x (1 + 0.03)
»US$1.015 = C$1.0815, or US$1 = C$1.0655

192
»The one-year forward rate in this instance is thus
US$ = C$1.0655. Note that because the
Canadian dollar has a higher interest rate than
the US dollar, it trades at a forward discount to
the greenback. As well, the actual spot rate of the
Canadian dollar one year from now has no
correlation on the one-year forward rate at
present.
»The currency forward rate is merely based on
interest rate differentials and does not incorporate
investors’ expectations of where the actual
exchange rate may be in the future.
193
»Currency Forwards and Hedging
»How does a currency forward work as a hedging
mechanism? Assume a Canadian export
company is selling US$1 million worth of goods to
a U.S. company and expects to receive the
export proceeds a year from now. The exporter is
concerned that the Canadian dollar may have
strengthened from its current rate (of 1.0500) a
year from now, which means that it would receive

194
»fewer Canadian dollars per US dollar. The
Canadian exporter, therefore, enters into
a forward contract to sell $1 million a year from
now at the forward rate of US$1 = C$1.0655.
»If a year from now, the spot rate is US$1 =
C$1.0300 – which means that the C$ has
appreciated as the exporter had anticipated – by
locking in the forward rate, the exporter has
benefited to the tune of C$35,500 (by selling the
US$1 million at C$1.0655, rather than at the spot
rate of C$1.0300).
195
»On the other hand, if the spot rate a year from
now is C$1.0800 (i.e. the Canadian dollar
weakened contrary to the exporter’s
expectations), the exporter has a notional loss of
C$14,500.

196
Symbol USDINR EURINR GBPINR JPYINR
CONTRACT NSPECSN
Market Type N N
Instrument Type FUTCUR FUTCUR FUTCUR FUTCUR
1 - 1 unit
1 - 1 unit
1 - 1 unit 1 - 1 unit denotes
denotes 1000
Unit of trading denotes 1000 denotes 1000 100000
POUND
USD. EURO. JAPANESE
STERLING.
YEN.
The
The
The The exchange
exchange
exchange exchange rate in Indian
Underlying / Order rate in Indian
rate in Indian rate in Indian Rupees for
Quotation Rupees for
Rupees for Rupees for 100
Pound
US Dollars Euro. Japanese
Sterling.
Yen.
Tick size 0.25 paise or INR 0.0025
Monday to Friday
Trading hours
9:00 a.m. to 5:00 p.m.
Contract trading cycle 12 month trading cycle.

197
Symbol
CONTRACT USDINR
SPECSEURINR GBPINR JPYINR

Two working days prior to the last business day of the

Last trading day
expiry month at 12:30 pm.
Last working day (excluding Saturdays) of the expiry
month.
Final settlement day
The last working day will be the same as that for Interbank
Settlements in Mumbai.

Quantity Freeze 10,001 or greater

Theoretical Theoretical Theoretical Theoretical

price on the price on the price on the price on the
1st day of the 1st day of the 1st day of the 1st day of the
Base price contract. contract. contract. contract.
On all other On all other On all other On all other
days, DSP of days, DSP of days, DSP of days, DSP of
the contract. the contract. the contract. the contract.
Tenure upto
+/-3 % of base price.
Price 6 months
operating Tenure
range greater than +/- 5% of base price.
6 months
198
» Currency risks could be hedged mainly through
forwards, futures, swaps and options.
» Each of these instruments has its role in managing
the currency risk.
» The main advantage of currency futures over it
closest substitute product, viz. forwards which are
traded over the counter lies in price transparency,
elimination of counterparty credit risk and greater
reach in terms of easy accessibility to all. Currency
futures are expected to bring about better price
discovery and also possibly lower transaction costs.

199
»Apart from pure hedgers, currency futures also
invite arbitrageurs, speculators and those traders
who may take a bet on exchange rate
movements without an underlying or an economic
exposure as a motivation for trading.

200
» From an economy-wide perspective, currency futures
contribute to hedging of risks and help traders and
investors in undertaking their economic activity.
» There is a large body of empirical evidence which
suggests that exchange rate volatility has an adverse
impact on foreign trade.
» Since there are first order gains from trade which
contribute to output growth and consumer welfare,
currency futures can potentially have an important impact
on real economy. Gains from international risk sharing
through trade in assets could be of relatively smaller
magnitude than gains from trade.

201
»However, in a dynamic setting these investments
could still significantly impact capital formation in
an economy and as such currency futures could
be seen as a facilitator in promoting investment
and aggregate demand in the economy, thus
promoting growth.

202
»The forward rate is a function of the spot rate and
the interest rate differential between the two
currencies, adjusted for time.
» In the case of fully convertible currencies, having
no restrictions on borrowing or lending of either
currency the forward rate can be calculated as
follows

203
204
1

»Long Hedger will

» A. Long currency futures
»B. Short Currency Futures
» C. Both of the Above
» D. None of the Above
»E. I am not attempting this question

205
2

»An Investor is holding Gold worth Rs. 10,60,000/-.

The USD/INR is 70.2525. How many Lots of
USD/INR will give him a proper Hedge?
»A. 2113
»B. 30
» C. 100
»D. 15
» E. I am not attempting this question

206
3
» An Indian Investor was highly bullish on S&P 500 so he
buys S&P500 worth $1,00,000/-.USD/INR was Rs.70/-
After one year the S&P500 went high giving him a profit of
$10,000/-. The USD/INR is Rs.77/- What is his profit on
Portfolio and USD/INR.
» A. 10%, 0%
» B. 0%, 10%
» C. 10%, 10%
» D. 10%, .1%
» E. I am not attempting this question

207
4
» When the value of the British pound changes from
$1.50 to $1.25, the pound has ________ and the dollar
has ________.

» A) appreciated; appreciated
» B) depreciated; appreciated
» C) appreciated; depreciated
» D) depreciated; depreciated

208
5

»When the value of the dollar changes from £0.50

to £0.75, the pound has ________ and the dollar
has ________.
»A) appreciated; appreciated
»B) depreciated; appreciated
»C) appreciated; depreciated
»D) depreciated; depreciated

209
6

»When the exchange rate changes from 1.0 euros

to the dollar to 1.2 euros to the dollar, the euro
has ________ and the dollar has ________.
»A) appreciated; appreciated
»B) depreciated; appreciated
»C) appreciated; depreciated
»D) depreciated; depreciated

210
7

»When the exchange rate changes from 1.0 euros

to the dollar to 0.8 euros to the dollar, the euro
has ________ and the dollar has ________.
»A) appreciated; appreciated
»B) depreciated; appreciated
»C) appreciated; depreciated
»D) depreciated; depreciated

211
8

» When the exchange rate for the euro changes from $1.00
to $1.20, then, holding everything else constant, the euro
has
» A) appreciated and German cars sold in the United States
become more expensive.
» B)appreciated and German cars sold in the United States
become less expensive.
» C) depreciated and American wheat sold in Germany
becomes more expensive.
» D) depreciated and American wheat sold in Germany
becomes less expensive.

212
9
» When the exchange rate for the euro changes from $1.20
to $1.00, then, holding everything else constant, the euro
has
» A) appreciated and German cars sold in the United States
become more expensive.
» B)appreciated and German cars sold in the United States
become less expensive.
» C) depreciated and American wheat sold in Germany
becomes more expensive.
» D)depreciated and American wheat sold in Germany
becomes less expensive.

213
10
» If the 2019 inflation rate in Britain is 6 percent, and the
inflation rate in the U.S. is 4 percent, then the theory of
purchasing power parity predicts that, during 2019, the
value of the British pound in terms of U.S. dollars will
» A) rise by 10 percent.
» B) rise by 2 percent.
» C) fall by 10 percent.
» D) fall by 2 percent.
» E) do none of the above.

214
11

»The theory of purchasing power parity is a theory

of how exchange rates are determined in
»A) the long run.
»B) the short run.
»C) both A and B of the above.
»D) none of the above.

215
8

» When the exchange rate for the euro changes from $1.00
to $1.20, then, holding everything else constant, the euro
has
» A) appreciated and German cars sold in the United
States become more expensive.
» B)appreciated and German cars sold in the United States
become less expensive.
» C) depreciated and American wheat sold in Germany
becomes more expensive.
» D) depreciated and American wheat sold in Germany
becomes less expensive.

216
9
» When the exchange rate for the euro changes from $1.20
to $1.00, then, holding everything else constant, the euro
has
» A) appreciated and German cars sold in the United States
become more expensive.
» B)appreciated and German cars sold in the United States
become less expensive.
» C) depreciated and American wheat sold in Germany
becomes more expensive.
» D)depreciated and American wheat sold in Germany
becomes less expensive.

217
1

» Spears Co. will receive SF1,000,000 in 30 days.

Use the following information to determine the
total dollar amount received (after accounting for
the option premium) if the firm purchases and
exercises a put option:
»Exercise price = $.61
Premium = $.02
Spot rate = $.60
Expected spot rate in 30 days = $.56
30 day forward rate = $.62

218
2

The spot market

»A. Involves the almost-immediate purchase or
sale of foreign exchange.
»B. Involves the sale of futures, forwards, and
options on foreign exchange.
»C. Takes place only on the floor of a physical
exchange.
»D. All of the above

219
3

»Suppose that the current exchange rate is €0.80

= $1.00. The direct quote, from the U.S.
perspective is
»A. €1.00 = $1.25
»B. €0.80 = $1.00
»C. 1.00 = $1.80
»D. None of the above

220
4

»Suppose that the current exchange rate is €1.00

= $1.60. The indirect quote, from the U.S.
perspective is:
»A. €1.00 = $1.60
»B. €0.6250 = $1.00
»C. €1.60 = $1.00
»D. None of the above

221
4

»Suppose that the current exchange rate is €1.00

= $1.60. The indirect quote, from the U.S.
perspective is:
»A. €1.00 = $1.60
»B. €0.6250 = $1.00
»C. €1.60 = $1.00
»D. None of the above

222
5

»The Bid price

»A. Is the price that the dealer has just paid for
something, his historical cost of the most recent
»trade.
»B. Is the price that a dealer stands ready to pay
»C. Refers only to auctions like eBay, not over the
counter transactions with dealers
»D. Is the price that a dealer stands ready to sell a

223
6
» If the $/€ bid and ask prices are $1.50/€ and $1.51/€,
respectively, the corresponding €/$ bid
» and ask prices are:
» A. €0.6667 and €0.6623
» B. $1.51 and $1.50
» C. €0.6623 and €0.6667
» D. cannot be determined with the information given

224
6
» If the $/€ bid and ask prices are $1.50/€ and $1.51/€,
respectively, the corresponding €/$ bid
» and ask prices are:
» A. €0.6667 and €0.6623
» B. $1.51 and $1.50
» C. €0.6623 and €0.6667
» D. cannot be determined with the information given

225
1

» Spears Co. will receive SF1,000,000 in 30 days. Use the following

information to determine the total dollar amount received
(after accounting for the option premium) if the firm purchases and
exercises a put option:
» Exercise price = $.61
Premium = $.02
Spot rate = $.60
Expected spot rate in 30 days = $.56
30 day forward rate = $.62
» a. $630,000.
b. $610,000.
c. $600,000.
d. $590,000.
e. $580,000.

226
227
»Using the table shown, what is the spot cross-
exchange rate between pounds and euro?
»A. €1.00 = $0.75
»B. $1.33 = €1.00
»C. $1.00 = €0.75
»D. None of the above

228
»The dollar-euro exchange rate is $1.25 = €1.00
and the dollar-yen exchange rate is 100 =
»$1.00. What is the euro-yen cross rate?
»A. =125 = €1.00
»B. 1.00 = €125
»C. 1.00 = €0.80
»D. None of the above

229
Exiting an Option Position

»Once you are long or short an option there are

a number of things you can do to close the
position:
1) Close it with an offsetting trade
2) Let it expire worthless on expiration day or,
3) If you are long an option you can exercise it.

230
Offsetting the Option

»Offsetting is simply a method of reversing

your original transaction to exit the trade.
You can always sell an option that you
previously bought, or buy an option that you
previously sold, at any time before the end of
the last trading day.
1. If you own (bought) a call, you have to “sell
to close" exactly the same call (with the same
strike price and expiration) to close your
position.

231
2. If you are short (sold) a call, you have to
“buy to close" that same exact call to close
your position.
3. If you own a put, you have to “sell to close"
exactly the same put.
4. And if you sold a put, you have to “buy to
close" the put with the same strike price and
expiration.

232
X ltd share is presently trading at 2500. Mr
Shyam expects the share price to go up .
He buys 10 ATM Call with a strike price Rs. 2500
at a premium of Rs. 100 (1 lot =100 Shares)
The share price after few days goes up to Rs 2700.
the option premium on 2500 strike call now is
selling at Rs 200.
He chooses to exit his position . (a)Explain how he can do
so and what will be his gain/loss (b) what is return on
investment compared to cash market ( c) Does he have
any other alternative

233
(a) He will exit the buy call option by selling the
call option at the same strike price within the
same expiration period.
He bought 10 lots of 2500 Call @ 100
He will sell 10 lots of 2500 Call @ 200
His investment on long call
Option premium= 1000X 100= 1,00,000
He sell call and gets 1000X 200= 2,00,000 and
profits Rs 1,00,000 ….gains 100 % ROI
234
»If he had bought 1000 shares of X ltd @ 2500 ,
his investment would have been Rs 25 ,00,000
and at Rs 2700 he would have gained Rs
2,00,000
»His ROI would have been = 2,00,000/ 25,00,000
= 8%
»So in option market you gain because of leverage
effect.

235
Question

»What is the major difference in the

obligation of one with a long
position in a futures (or forward)
contract in comparison to an
options contract?

236
» Options vs. Futures: An Overview
» Options and futures are both financial products that investors
use to make money or to hedge current investments. Both are
agreements to buy an investment at a specific price by a
specific date.
» An option gives an investor the right, but not the obligation, to
buy (or sell) shares at a specific price at any time, as long as
the contract is in effect.
» A futures contract requires a buyer to purchase shares, and a
seller to sell them, on a specific future date unless the holder's
position is closed before the expiration date.

237
 CALL OPTION BUYER CALL OPTION WRITER (Seller)
•Pays premium •Receives premium
•Right to exercise and buy the shares •Obligation to sell shares if exercised
•Profits from rising prices •Profits from falling prices or remaining
•Limited losses, Potentially unlimited neutral
gain •Potentially unlimited losses, limited
gain
PUT OPTION BUYER PUT OPTION WRITER (Seller)
•Pays premium •Receives premium
•Right to exercise and sell shares •Obligation to buy shares if exercised
•Profits from falling prices •Profits from rising prices or remaining
•Limited losses, Potentially unlimited neutral
gain •Potentially unlimited losses, limited
gain

238
Answer:

»A futures (or forward) contract is a vehicle for

buying or selling a stated amount of foreign
exchange at a stated price per unit at a specified
time in the future.
»If the long holds the contract to the delivery date,
he pays the effective contractual futures (or
forward) price, regardless of whether it is an
advantageous price in comparison to the spot
price at the delivery date.
»

239
»By contrast, an option is a contract giving the long
the right to buy or sell a given quantity of an asset
at a specified price at some time in the future, but
not enforcing any obligation on him if the spot
price is more favorable than the exercise price.
» Because the option owner does not have to
exercise the option if it is to his disadvantage, the
option has a price, or premium, whereas no price
is paid at inception to enter into a futures (or
forward) contract.

240
The inflation rate in Great Britain is expected to be 4% per year, and the inflation rate in Switzerland is expected to be 6% per year.
If the current spot rate is £1 = SF 12.50, what is the expected spot rate in two years?
Answer. Based on PPP, the expected value of the pound in two years is 12.5 x (1.06/1.04)2 = SF12.99.

241
10. If the $:¥ spot rate is $1 = ¥218 and interest rates in Tokyo and New York are 6% and 12%, respectively,
what is the expected $:¥ exchange rate one year hence?
Answer. According to the international Fisher effect, the dollar spot rate in one year should equal 218(1.06/1.12) = ¥206.32.

242