Tag: International Finance Mumbai University BMS Notes

Investors who want to increase the diversification and total return of their portfolios are often advised to get into international assets. Many hesitate to take that advice.

There are, in fact, three big risks that investors add when they enter international investing. Knowing what they are and how you can mitigate those risks may help you decide if going global is worth the risk and potential rewards.

International equity is a great way to get exposure to companies and sectors which are not available in the Indian markets. E-commerce, search engines, payment infrastructure, cloud computing, electric mobility, enterprise software, digital OTT platforms are some of the sectors which are showing good growth globally but we don’t have listed companies in India. Exposure to international equity also provides us a hedge against the depreciating rupee, which can also add to returns in the long term. It also helps us to diversify our portfolio outside our home country, which will prove helpful in the long run.

1. Higher Transaction Costs

The biggest barrier to investing in international markets is the added transaction cost. Yes, we live in a relatively globalized and connected world, but transaction costs still vary greatly depending on which foreign market you are investing in. Brokerage commissions in international markets are almost always higher than U.S. rates.

2. Currency Volatility

When investing directly in a foreign market (and not through ADRs), you first have to exchange your U.S. dollars into a foreign currency at the current exchange rate.

Say you hold the foreign stock for a year and then sell it. That means you will have to convert the foreign currency back into USD. That could help or hurt your return, depending on which way the dollar is moving. It is this uncertainty that scares off many investors.

A financial professional would tell you that the solution to mitigating currency risk is to simply hedge your currency exposure. The available tools include currency futures, options, and forwards. These are not strategies most individual investors would be comfortable using.

A more user-friendly version of those tools is the currency exchange-traded fund (ETF). Like any ETF, these have good liquidity and accessibility and are relatively straightforward.

3. Liquidity Risks

Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. This is the risk of not being able to sell an investment quickly at any time without risking substantial losses due to a political or economic crisis.

There is no easy way for the average investor to protect against liquidity risk in foreign markets. Investors must pay particular attention to foreign investments that are or may become illiquid by the time they want to sell.

There are some common ways to evaluate the liquidity of an asset. One method is to observe the bid-ask spread of the asset over time. An illiquid asset will have a wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity.

Minimizing Currency Risk

Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated, hedging involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in this case, a currency. An investor expecting to receive cash flows denominated in a foreign currency on some future date can lock in the current exchange rate by entering into an offsetting currency futures position.

In the currency markets, speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take long or short positions in their currency of choice, depending on how they believe that currency will perform. For example, if a speculator believes that the euro will rise against the U.S. dollar, they will enter into a contract to buy the euro at some predetermined time in the future. This is called having a long position. Conversely, you could argue that the same speculator has taken a short position in the U.S. dollar.

There are two possible outcomes with this hedging strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise too, and the speculator will earn a profit. However, if the euro declines against the dollar, the value of the contract decreases.

When you buy or sell a futures contract, as in our example above, the price of the good (in this case the currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are calculated each day. Currency hedging can also be accomplished in a different way. Rather than locking in a currency price for a later date, you can buy the currency immediately at the spot price instead. In either scenario, you end up buying the same currency, but in one scenario you do not pay for the asset upfront.

Investing in the Currency Market

The value of currencies fluctuates with the global supply and demand for a specific currency. Demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price. Fortunately, there is an entire market dedicated to the trade of foreign currencies called the foreign exchange market (forex, for short). This market has no central marketplace like the New York Stock Exchange; instead, all business is conducted electronically in what is considered one of the largest liquid markets in the world.

There are several ways to invest in the currency market, but some are riskier than others. Investors can trade currencies directly by setting up their own accounts, or they can access currency investments through forex brokers.

However, margined currency trading is an extremely risky form of investment, and is only suitable for individuals and institutions capable of handling the potential losses it entails. In fact, investors looking for exposure to currency investments might be best served acquiring them through funds or ETFs and there are plenty to choose from.

Some of these products make bets against the dollar, some bet in favor, while other funds simply buy a basket of global currencies. For example, you can buy an ETF made up of currency futures contracts on certain G10 currencies, which can be designed to exploit the trend that currencies associated with high-interest rates tend to rise in value relative to currencies associated with low-interest rates. Things to consider when incorporating currency into your portfolio are costs (both trading and fund fees), taxes (historically, currency investing has been very tax inefficient) and finding the appropriate allocation percentage.

Benefits of International Equity

• Diversification

Diversification is the most obvious yet the most crucial benefit of global investing. A diversified portfolio acts as a source of stability during market volatility.

When you spread out your investments across geographies, there is a low correlation between them. This means that the volatility in one market is likely not to affect your other assets.

Many of the US-listed companies have global revenues. Over 40% of the revenues of the S&P500 companies come from outside the US. By investing in the US itself, you can build a globally diversified portfolio.

• Wide range of investment options

Global investing enables you to access investment opportunities that are not present domestically. Developed markets like the US are home to some of the world’s largest tech companies something you cannot access by investing in India.

You may even choose a theme or a combination of multiple sectors. For example, you can prefer the US market for technology, Europe for engineering, and Australia for commodities.

If you are interested in healthcare or pharmaceuticals, there are several options in the US and Europe.

You can access multiple geographies through ETFs. For example, you can invest in German equities through the US-listed EWG ETF or in the Brazilian market through the EWZ ETF.

• Investment Protection

Another significant benefit of global investing is the protection of investments against fraud and liquidations.

Developed market companies generally have strong regulations that ensure sound corporate governance and severe penalties for market abuse. This protects retail investors from potential scams and insider trading losses.

Remember, capital is always at risk, but many foreign financial institutions, offer protection from seizures and other threats such as liquidation of the broker-dealer. For instance, in the US, SIPC protects investments up to $500,000 if your broker-dealer faces liquidation.

• Currency Diversification

Investing overseas exposes you to currency appreciation (or depreciation). For example, the USD has been appreciating, on average, between 3-5 percent versus the INR over the last few years.

Emerging markets’ currencies depreciate over the longer term. Interest rates in domestic savings accounts are at a low of 3-4 percent on average.

By investing globally, portfolios have generally had the dual benefit of better markets and appreciating currencies.

Role of Forex Manager

Have an Idea about the Historical Development of the International Trade and Evolvement of Forex Management:

The Forex manager must have a fair idea of how the current international trade and Forex management has reached its present status. The continuously evolving changes in the alliances between the countries in the nature of political, economic, social conditions of the countries and the economic superpowers of the globe help to have a proper idea about the current Global Economic situation, and can also provide him with experiences of past.

Able to Forecast the Future Trends:

The Forex manager should be able to forecast about the future trends of the Global Economy from the history and current scenario, so as to be able to exploit the opportunities emerging out and in turn to reduce the risks faced by firm.

Able to analyse the Various Situation in a Comparative Manner (Comparative Analytical Skills):

The Forex manager should be able to comparatively analyse various situations currently arising with the past events and situations, and be able to forecast it properly.

He should also be able to analyse the various components of costs of the goods and services and changes in the various rates like shipping rates, insurance costs, other regulatory charges, etc. It is also required to decide whether it would be beneficial for organization to involve in export activities or to do domestic trade only or both and in which proportions.

Knowledge of Forex Market:

He should have an in-depth knowledge of the functioning of Forex Markets and the rules and regulations to be followed. He should also have in depth knowledge of the size, profile and movement of foreign currency exchange rates with various currencies of the globe, so as to have proper pricing of International Deals.

Knowledge of Interest Rates:

He should have an idea of interest rates prevailing and expected movement in interest rates of various countries of the globe, and to estimate and judge the expected future currency exchange rates. Such knowledge and skills will support him to take necessary steps to reduce the risks going to arise due to them.

Willingness to Undertake Risk:

He should be armed with the knowledge of Forex management, and should be able to take reasonable level of risks as and when needed, and try to reduce its overall impact on the organization.

Covering and Protection Strategies (Hedging Strategies):

He should have a proper understanding and awareness about the techniques useful for reducing the risk proportions and risk exposures. Hedging means to cover or protect the current position. As per Forex management, he should be able to hedge his positions to the best extent possible, keeping in view the timing and current changes in the Forex market.

FDI v/s FPI

Foreign Portfolio Investment (FPI) and Foreign Direct Investment (FDI) are the two essential and well-sought type of foreign capital by the countries, especially by the developing world. Post Union Budget FY 2019-20, most of you surely would have heard the words “FPIs” being used, in the context of the stock markets crash through financial news channels or social media platforms.

Foreign Direct Investment (FDI)

FDI pertains to foreign investment in which the investor obtains a lasting interest in an enterprise in another country.

It involves establishing a direct business interest in a foreign country, such as buying or establishing a manufacturing business, building warehouses, or buying buildings. Also, it tends to involve creating more of a substantial, long-term interest in the economy of a foreign country.

Due to the significantly higher level of investment required, FDIs are usually undertaken by MNCs, large institutions, or venture capital firms. FDI tends to be viewed more favorably since they are considered long-term investments, as well as investments in the well-being of the foreign country itself.

This kind of investment may result in the transfers of funds, resources, technical know-how, strategies, etc.

There are several ways of making FDI like:

• Creating a joint venture
• Through merger and acquisition
• By establishing a subsidiary company

Foreign Portfolio Investment (FPI)

FPI, on the other hand, refers to investing in the financial assets of a foreign country, such as stocks or bonds available on an exchange.

In simple words, FPI involves the purchase of securities that can be easily bought or sold.

The intent with FPI is generally to invest money into the foreign country’s stock market with the hope of generating a quick return.

Hence, this type of investment is at times viewed less favourably than direct investment because portfolio investments can be sold off quickly and are at times seen as short-term attempts to make money, rather than a long-term investment in the economy.

In India, FPIs includes investment groups of Foreign Institutional Investors (FIIs), Qualified Foreign Investors (QFIs) and subaccounts, etc. NRIs doesn’t come under FPI.

Role of FEDAI in Foreign Exchange Market

The Foreign Exchange Dealers Association of India (FEDAI) is an association of commercial banks that specializes in the foreign exchange (forex) markets in India. These institutions are also called Authorised Dealers or ADs.

Created in 1958 and incorporated under Indian law, Section 25 of The Companies Act of 1956, the Association regulates the rules that determine commissions, fees, and charges that are attached to the interbank foreign exchange business.

FEDAI is a self-regulatory body that evolved various rules and guidelines for transactions related to foreign exchange like rules regarding trading hours, Transit period, Crystallization, Forward covers, etc. Besides, it has prescribed a code of conduct in settling issues /matters related to forex dealing of member banks and provided a standardized settlement process for all market participants. FEDAI represents member banks while liaising with RBI and other organizations like Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex Association of India, International Chamber of Commerce, and other world bodies related to foreign trade and business.  Further, it is liaising with other market participants, in its endeavor for reforms and development of the forex market.

The FEDAI’s core functions include:

• Advising and supporting member banks with issues that arise in their dealings
• Representing member banks on the Reserve Bank of India (India’s central bank)
• Announcement of daily and periodical interest rates to member banks
• Guidelines and Rules for Forex Business.
• Training of Bank Personnel in the areas of Foreign Exchange Business.
• Accreditation of Forex Brokers.

The other functions of FEDAI include circulating various policies matters and decisions related to foreign exchange business amongst the members, approving Foreign Exchange brokers, circulating ‘spot date’ to its members at the start of each trading day to ensure uniformity in a settlement between different market participants. It also provides at the end of a calendar month a schedule of forwarding rates to be used by AD’s for revaluating foreign currency denominated assets and liabilities.

Scope

Transfer Function

This function is to transfer finance and purchasing power from one country to another country. Through foreign bills or remittances which were made through telegraphic transfer, such type of transfer gets affected.

Hedging Function

This function is for hedging facilities such as; facilitate buying and selling spot or forward foreign exchange. Hedging refers to the “foreign exchange risk avoidance” as in foreign exchange market there might be gain or loss to the party because of change in the price of one currency in terms of another currency. In case of huge amount of net claims or net liabilities in foreign exchange then a person or a firm as the case may undertake a high exchange risk.

Such exchange risk should be reduced. In exchange, through forwarding contracts, foreign exchange market provides such facilities for anticipated hedging. A forward contract is a type of contract related to buying or selling foreign exchange against another currency in future at the fixed date on the agreed price. This type of contract makes it possible to avoid changes in exchange rate. This forward market helps in hedging exchange position.

Credit Function

This function is to issue credit for the purpose of international trade.

Foreign Exchange Markets helps in determining the value of foreign savings. It is a marketplace where the foreign money is bought and sold and we can also say it is a type of institutional arrangement where the foreign currencies are bought and sold. Under this, importers buy the foreign currency which is sold by the exporters.

In financial centers, this type of market merely forms a part of money market where the foreign money is bought and sold. Foreign exchange market is not restricted to any geographical area. It is a market for foreign currencies.

In foreign exchange markets, there are a wide variety of dealers such as banks. Banks which deal in foreign exchange have their branches in different countries. These are also called as “Exchange Banks” from where the services are available in all over the world.

Significance

• It acts as a central focus whereby prices are set for different currencies.
• With the help of foreign exchange market investors can hedge or minimize the risk of loss due to adverse exchange rate changes.
• Foreign exchange market transfers purchasing power across different countries, which results in enhancing the feasibility of international trade and overseas investment.
• Foreign exchange market allows traders to identify risk free opportunities and arbitrage these away.
• It facilitates investment function of banks and corporate traders who are willing to expose their firms to currency risks.

Exchange Rate Forecasts are derived by the computation of value of vis-à-vis other foreign currencies for a definite time period. There are numerous theories to predict exchange rates, but all of them have their own limitations.

Economists and investors always tend to forecast the future exchange rates so that they can depend on the predictions to derive monetary value. There are different models that are used to find out the future exchange rate of a currency.

Efficient Market Approach

Financial markets are said to be efficient if the current asset prices fully reflect all the available and relevant information (efficient market hypothesis).

Suppose that foreign exchange markets are efficient. This means that the current exchange rate has already reflected all relevant information, such as money supplies, inflation rates, trade balances, and output growth. The exchange rate will then change only when the market receives new information. News is unpredictable, the exchange rate will change randomly over time. -Incremental changes in the exchange rate will be independent of the past history of the exchange rate. If the exchange rate indeed follows a random walk, the future exchange rate is expected to be the same as the current exchange rate.

Random walk hypothesis suggests that today’s exchange rate is the best predictor of tomorrow’s exchange rate.

Those who subscribe to the efficient market hypothesis may predict the future exchange rate using either the current spot exchange rate or the current forward exchange rate.

Advantages:

Since the efficient market approach is based on market-determined prices, it is costless to generate forecasts. Both the current spot and forward exchange rates are public information. Everyone has free access to it.

Given the efficiency of foreign exchange markets, it is difficult to outperform the market-based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate.

Fundamental Approach

This is a forecasting technique that utilizes elementary data related to a country, such as GDP, inflation rates, productivity, balance of trade, and unemployment rate. The principle is that the ‘True worth’ of a currency will eventually be realized at some point of time. This approach is suitable for long-term investments.

• Relative Money supplies
• Relative Velocity of monies
• Relative National outputs

Steps

• Estimation of the structural model to determine the numerical values for the parameters such as betas.
• Estimation of future values of the independent variables.
• Substituting the estimated values of the independent variable into the estimated structural model to generate the exchange rate forecasts.

Technical Approach

In this approach, the investor sentiment determines the changes in the exchange rate. It makes predictions by making a chart of the patterns. In addition, positioning surveys, moving-average trend-seeking trade rules, and Forex dealers’ customer-flow data are used in this approach.

Performance of the Forecasters

Time Series Model

The time series model is completely technical and does not include any economic theory. The popular time series approach is known as the autoregressive moving average (ARMA) process.

The rationale is that the past behavior and price patterns can affect the future price behavior and patterns. The data used in this approach is just the time series of data to use the selected parameters to create a workable model.

To conclude, forecasting the exchange rate is an ardent task and that is why many companies and investors just tend to hedge the currency risk. Still, some people believe in forecasting exchange rates and try to find the factors that affect currency-rate movements. For them, the approaches mentioned above are a good point to start with.

Relative Economic Strength Model

The relative economic strength model determines the direction of exchange rates by taking into consideration the strength of economic growth in different countries. The idea behind this approach is that a strong economic growth will attract more investments from foreign investors. To purchase these investments in a particular country, the investor will buy the country’s currency – increasing the demand and price (appreciation) of the currency of that particular country.

Another factor bringing investors to a country is its interest rates. High interest rates will attract more investors, and the demand for that currency will increase, which would let the currency to appreciate.

Conversely, low interest rates will do the opposite and investors will shy away from investment in a particular country. The investors may even borrow that country’s low-priced currency to fund other investments. This was the case when the Japanese yen interest rates were extremely low. This is commonly called carry-trade strategy.

The relative economic strength approach does not exactly forecast the future exchange rate like the PPP approach. It just tells whether a currency is going to appreciate or depreciate.

Purchasing Power Parity Model

The purchasing power parity (PPP) forecasting approach is based on the Law of One Price. It states that same goods in different countries should have identical prices. For example, this law argues that a chalk in Australia will have the same price as a chalk of equal dimensions in the U.S. (considering the exchange rate and excluding transaction and shipping costs). That is, there will be no arbitrage opportunity to buy cheap in one count Econometric Models

It is a method that is used to forecast exchange rates by gathering all relevant factors that may affect a certain currency. It connects all these factors to forecast the exchange rate. The factors are normally from economic theory, but any variable can be added to it if required.

For example, say, a forecaster for a Canadian company has researched factors he thinks would affect the USD/CAD exchange rate. From his research and analysis, he found that the most influential factors are: the interest rate differential (INT), the GDP growth rate differences (GDP), and the income growth rate (IGR) differences.

The econometric model he comes up with is:

USD/CAD (1 year) = z + a(INT) + b(GDP) + c(IGR)

Now, using this model, the variables mentioned, i.e., INT, GDP, and IGR can be used to generate a forecast. The coefficients used (a, b, and c) will affect the exchange rate and will determine its direction (positive or negative).ry and sell at a profit in another.

Each currency carries an interest rate. It is like a barometer of the strength or weakness of an economy. If a country’s economy strengthens, the prices may sometime rise due to the fact that the consumers become able to pay more. This may sometimes result in a situation where more money is spent for roughly the same goods. This can increase the price of the goods.

When inflation goes uncontrolled, the money’s buying power decreases, and the price of ordinary items may rise to unbelievably high levels. To stop this imminent danger, the central bank usually raises the interest rates.

When the interest rate is increased, it makes the borrowed money more expensive. This, in turn, demotivates the consumers from buying new products and incurring additional debts. It also discourages the companies from expansion. The companies that do business on credit have to pay interest, and hence they do not spend too much in expansion.

The higher rates will gradually slow the economies down, until a point of saturation will come where the Central Bank will have to lower the interest rates. This reduction in rates is aimed at encouraging the economic growth and expansion.

When the interest rate is high, foreign investors desire to invest in that economy to earn more in returns. Consequently, the demand for that currency increases as more investors invest there.

Countries offering the highest RoI by offering high interest rates tend to attract heavy foreign investments. When a country’s stock exchange is doing well and offer a good interest rate, the foreign investors are encouraged to invest capital in that country. This again increases the demand for the country’s currency, and value of the currency rises.

In fact, it is not just the interest rate that is important. The direction of movement of the interest rate is a good pointer of demand of the currency.

The interest rate that impacts the stock market is the central funds rate. The central funds rate is the interest rate that depository institutions banks, savings and loans, and credit unions charge each other for overnight loans (whereas the discount rate is the interest rate that Central Reserve Banks charge when they make collateralized loans usually overnight to depository institutions).

The influences the central funds rate in order to control inflation. By increasing the central funds rate, the Central Reserve is effectively attempting to shrink the supply of money available for making purchases. This, in turn, makes money more expensive to obtain. Conversely, when the Central Reserve decreases the central funds rate, it increases the money supply. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns.

When the Central Reserve acts to increase the discount rate, it immediately elevates short-term borrowing costs for financial institutions. This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy.

Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So, individuals’ consumers are impacted through increases to their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.

Consumers still have to pay their bills. When those bills become more expensive, households are left with less disposable income. When consumers have less discretionary spending money, businesses’ revenues and profits decrease.

So, as you can see, as rates rise, businesses are not only impacted by higher borrowing costs, but they are also exposed to the adverse effects of flagging consumer demand. Both of these factors can weigh on earnings and stock prices.

When Interest Rates Fall

When the economy is slowing, the Central Reserve cuts the central funds rate to stimulate financial activity. A decrease in interest rates by the Central Reserve has the opposite effect of a rate hike. Investors and economists alike view lower interest rates as catalysts for growth a benefit to personal and corporate borrowing. This, in turn, leads to greater profits and a robust economy.

Consumers will spend more, with the lower interest rates making them feel that, perhaps, they can finally afford to buy that new house or send their kids to a private school. Businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential. This, in turn, leads to higher stock prices.

Particular winners of lower central funds rates are dividend-paying sectors, such as utilities and real estate investment trusts (REITs). Additionally, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing.

Shifts in Demand and Supply in Financial Markets

Those who supply financial capital face two broad decisions: how much to save, and how to divide up their savings among different forms of financial assets. We will discuss each of these in turn.

Participants in financial markets must decide when they prefer to consume goods: now or in the future. Economists call this intertemporal decision making because it involves decisions across time. Unlike a decision about what to buy from the grocery store, decisions about investment or saving are made across a period of time, sometimes a long period.

Most workers save for retirement because their income in the present is greater than their needs, while the opposite will be true once they retire. So they save today and supply financial markets. If their income increases, they save more. If their perceived situation in the future changes, they change the amount of their saving. For example, there is some evidence that Social Security, the program that workers pay into in order to qualify for government checks after retirement, has tended to reduce the quantity of financial capital that workers save. If this is true, Social Security has shifted the supply of financial capital at any interest rate to the left.

By contrast, many college students need money today when their income is low (or nonexistent) to pay their college expenses. As a result, they borrow today and demand from financial markets. Once they graduate and become employed, they will pay back the loans. Individuals borrow money to purchase homes or cars. A business seeks financial investment so that it has the funds to build a factory or invest in a research and development project that will not pay off for five years, ten years, or even more. So when consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right.

For example, in the technology boom of the late 1990s, many businesses became extremely confident that investments in new technology would have a high rate of return, and their demand for financial capital shifted to the right. Conversely, during the Great Recession of 2008 and 2009, their demand for financial capital at any given interest rate shifted to the left.

A domestic market, also referred to as an internal market or domestic trading, is the supply and demand of goods, services, and securities within a single country. In domestic trading, a firm faces only one set of competitive, economic, and market issues and essentially must deal with only one set of customers, although the company may have several segments in a market.

Most countries have their own currencies, but not all. Sometimes small economies use the currency of an economically larger neighbor. For example, Ecuador, El Salvador, and Panama have decided to dollarize that is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. The best example of a common currency is the Euro, a common currency used by 19 members of the European Union. With these exceptions duly noted, most international transactions require participants to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. The market in which people or firms use one currency to purchase another currency is called the foreign exchange market.

The term is also used to refer to the customers of a single business who live in the country where the business operates.

There are certain limitations when competing in a domestic market, many of which encourage firms to expand abroad. The main reasons why a business would decide to expand abroad are limited market size and limited growth within the domestic market.

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.

Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveller’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveller’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.

Purchasing Power Parity

Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England

If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.

The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.

Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.

Asset Market Model

Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.

Real Exchange Rate

The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.

A measure of the differences in price levels is Purchasing Power Parity (PPP). The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.

Calculating Exchange Rates

Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.

The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.

Demanders and Suppliers of Currency in Foreign Exchange Markets

In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market:

(1) Firms that import or export goods and services.

(2) Tourists visiting other countries.

(3) International investors buying ownership (or part-ownership) in a foreign firm.

(4) International investors making financial investments that do not involve ownership. Let’s consider these categories in turn.

Firms that sell exports or buy imports find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. So, a Chinese firm exporting abroad will earn some other currency say, U.S. dollars but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan.

International tourists need foreign currency for expenses in the country they are visiting; they will supply their home currency to receive the foreign currency. For example, an American tourist who is visiting China will supply U.S. dollars into the foreign exchange market and demand Chinese yuan.

Financial investments that cross international boundaries, and require exchanging currency, are often divided into two categories. Foreign direct investment (FDI) refers to purchasing (at least ten percent) ownership in a firm in another country or starting up a new enterprise in a foreign country. For example, in 2008 the Belgian beer-brewing company InBev bought the U.S. beer-maker Anheuser-Busch for $52 billion. To make this purchase of a U.S. firm, InBev had to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S. dollars.

The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased bonds issued by the government of the United Kingdom, or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds.

In finance, a foreign exchange option (Commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.

The foreign exchange options market is the deepest, largest and most liquid market for options of any kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $578.3 trillion in 2019.

Terms

Call option: The right to buy an asset at a fixed date and price.

Put option: The right to sell an asset at a fixed date and price.

Foreign exchange option: The right to sell money in one currency and buy money in another currency at a fixed date and rate.

Strike price: The asset price at which the investor can exercise an option.

Spot price: The price of the asset at the time of the trade.

Forward price: The price of the asset for delivery at a future time.

Notional: The amount of each currency that the option allows the investor to sell or buy.

Ratio of notionals: The strike, not the current spot or forward.

Numéraire: The currency in which an asset is valued.

Non-linear payoff: The payoff for a straightforward FX option is linear in the underlying currency, denominating the payout in a given numéraire.

Change of numéraire: The implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of xà 1/x.

In the money for a put option, this is when the current price is less than the strike price, and would thus generate a profit were it exercised; for a call option the situation is inverted.

A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller.

Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.

Investors can hedge against foreign currency risk by purchasing a currency put or call. Currency options are derivatives based on underlying currency pairs. Trading currency options involves a wide variety of strategies available for use in forex markets. The strategy a trader may employ depends largely on the kind of option they choose and the broker or platform through which it is offered. The characteristics of options in decentralized forex markets vary much more widely than options in the more centralized exchanges of stock and futures markets.

Traders like to use currency options trading for several reasons. They have a limit to their downside risk and may lose only the premium they paid to buy the options, but they have unlimited upside potential. Some traders will use FX options trading to hedge open positions they may hold in the forex cash market. As opposed to a futures market, the cash market, also called the physical and spot market, has the immediate settlement of transactions involving commodities and securities. Traders also like forex options trading because it gives them a chance to trade and profit on the prediction of the market’s direction based on economic, political, or other news.

Option on Spot

The term spot price is not limited to options or stocks you can use it when referring to the current market price of any security. It is most commonly used with securities which besides the spot market also have futures or forward markets, such as commodities, currencies or interest rates.

For instance, you can hear about the “gold spot price” as opposed to gold futures prices, or you can “buy euros on the spot market” as opposed to the forward market. Generally, spot price is the price for immediate delivery or settlement (in practice, immediate typically means settled within a very few, like 1-3, days), while a futures or forward price, although agreed now, is for settlement at a given date in the future (e.g. one month or even one year from now).

Futures & Futures Style Options

An option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option’s expiration date. These work similarly to stock options, but differ in that the underlying security is a futures contract.

Most options on futures, such as index options, are cash settled. They also tend to be European-style options, which means that these options cannot be exercised early.

A proposed contract to replace many traditional options on futures contracts. Unlike traditional options, the buyer of a futures-style option does not prepay the premium. Buyers and sellers post margin as in a futures contract, and the option premium is marked to the market daily. Valuation differs from traditional futures options primarily in the analysis of the timing of cash flows associated with the buyer’s nonpayment of an upfront premium.

An option on a futures contract is very similar to a stock option in that it gives the buyer the right, but not obligation, to buy or sell the underlying asset, while creating a potential obligation for the seller of the option to buy or sell the underlying asset if the buyer so desires by exercising that option. That means the option on a futures contract, or futures option, is a derivative security of a derivative security. But the pricing and contract specifications of these options does not necessarily add leverage on top of leverage.

An option on an S&P 500 futures contract, therefore, can be thought of as a second derivative of the S&P 500 index since the futures are themselves derivatives of the index. As such, there are more variables to consider as both the option and the futures contract have expiration dates and their own supply and demand profiles. Time decay (also known as theta), works on options futures the same as options on other securities, so traders must account for this dynamic.

For call options on futures, the holder of the option would enter into the long side of the contract and would buy the underlying asset at the option’s strike price. For put options, the holder of the option would enter into the short side of the contract and would sell the underlying asset at the option’s strike price.

For calls:

ITM: underlying price > strike price

OTM: underlying price < strike price

For puts it’s the opposite:

ITM: underlying price < strike price

OTM: underlying price > strike price

For both calls and puts:

ATM: underlying price = strike price

A Currency option is a derivative contract which gives the buyer of the option the right, but not the obligation, to buy or sell the currency at a stated date and at a predetermined price. The seller of the contract has the obligation to honour the contract when the contract is exercised. The dynamics and mechanism of currency options trading are very similar to equity options.

There are two types of currency options: Call and Put. A call option gives the right to buy and a put option gives the right to sell. In every transaction, one currency is bought and another sold.

Benefits of opting for the USD-INR pair in the currency derivatives market

Any resident Indian or NRI can participate in the USD-INR pair, even if there is no underlying, up to a limit. This is unlike the forward market where you can only hedge an underlying currency exposure.

The bid-ask spreads are as low as 0.0025 in the near month pair and that substantially reduces the liquidity risk while trading. Also, the USD-INR is a fairly liquid pair and is possible to get quotes both ways with minimal risk.

Unlike the forward market mechanism, which is a closed market, the USD-INR pair is based on the transparent market mechanism. This makes it a lot more preferable for individual traders with limited access to information and insights. In fact, like your normal equity / F&O trading screen, you can log into your trading terminal and see the 5 best buy and sell quotes with volumes that reduces information asymmetry substantially.

You can access the USD-INR pair either through your broker or directly from your internet trading platform which adds to the convenience and reduces the hassles of trading

Trading in the USD-INR Futures in the currency derivatives market

As traders intending to take positions in the USD-INR pair, you need to understand a basic difference vis-à-vis the equity markets. When you buy the equities, you are actually betting on the price of the equity to go up. On the contrary when you are buying the USD-INR paid, you are actually betting on the US dollar to appreciate or in other words you are expecting the INR to depreciate against the US dollar. If you are actually expecting the INR to appreciate against the dollar then you should be selling the USD-INR futures. Settlement of currency derivatives will happen on the last working day of the month which will also be the date for interbank settlements in Mumbai. Unlike commodities trading, all USD-INR pairs as well as pairs with Pound, Euro and Yen are all necessarily cash settled.

Currency Options Contract Specifications

Four types of currency pairs are available for trading in currency options-

• USD-INR
• EUR-INR
• GBP-INR
• JPY-INR

Lot Size: The lot size varies depending on the currency pair. For USD-INR, 1 lot size denotes USD 1000. For EURINR, 1 lot size is EUR 1000. For GBPINR, it is GBP 1000 and for JPYINR, it is JPY 10000.

Underlying: The underlying would be the exchange rate in Indian rupees for each currency pair.

Exercise Style: European in nature which means the contracts can either be squared off by taking an opposite position or can be exercised on expiry.

Tick Size: The strike price interval in these contracts is Rs 0.25.

Contract Cycle: There are three monthly contracts and 1 quarterly contract.

Margin: Premium for buying and SPAN + Exposure margin for selling

Expiration day: Two days prior to the last working day of the month.

Forward is a transaction where two different currencies are exchanged between accounts on the prefixed future value date.

The exchange of currencies takes place on the prefixed accounts, on the same value date. The Client is protected from adverse movements in future FX rates, but he also does not benefit from favourable movements.

 Foreign Exchange forwards avoid uncertainty and are therefore valid instruments for Clients to mitigate the foreign exchange risk for future transactions denominated in a foreign currency.

 On the trading day of the Forward transaction the Client is obliged to place a collateral deposit at the Bank. If the parties do not agree otherwise, the amount of the deposit is 15% of the forward nominal value.

The minimum size of the transaction is EUR 500.000 or its equivalent in other currency (if the parties do not agree otherwise). (Precondition of the transaction is a valid spot-forward frame agreement.)

Forward points are the number of basis points added to or subtracted from the current spot rate of a currency pair to determine the forward rate for delivery on a specific value date. When points are added to the spot rate this is called a forward premium; when points are subtracted from the spot rate it is a forward discount. The forward rate is based on the difference between the interest rates of the two currencies (currency deals always involve two currencies) and the time until the maturity of the deal.  Forward points are also known as the forward spread.

Forward points are used to calculate the price for both an outright forward contract and a foreign currency swap. Points can be calculated and transactions executed for any date that is a valid business day in both currencies. The most commonly traded forward currencies are the U.S. dollar, the euro, Japanese yen, British pound and Swiss franc.

Forwards are most commonly done for periods of up to one year. Prices for further out dates are available, but liquidity is generally lower. In an outright forward foreign exchange contract, one currency is bought against another for delivery on any date beyond spot. The price is the spot rate plus or minus the forward points to the value date. No money changes hands until the value date.

In a foreign exchange swap, a currency is bought for the near date (usually spot) against another currency, and the same amount is sold back for the forward date. The rate for the forward leg of the swap is the near date rate plus or minus the forward points to the far date. Money changes hands on both value dates.

Discount Spreads

In contrast to the forward spread, a discount spread is the currency forward points that are subtracted from the spot rate, to obtain a forward rate for a currency. In the currency markets, forward spreads, or points, are presented as two-way quotes; that is, they have a bid price and an offer price. In a discount spread, the bid price will be higher than the offer price, while in a premium spread, the bid price will be lower than the offer price.

The forward margin, or forward spread, reflects the difference between the spot rate and the forward rate for a certain commodity or currency. The difference between the two rates can either be a premium or a discount, depending on if the forward rate is above or below the spot rate, respectively.

Forward Margins & Forwards Markets

Foreign exchange markets are global exchanges (notable centers in London, New York, Singapore, Tokyo, Frankfurt, Hong Kong and Sydney), where currencies are traded virtually around the clock. These are large and highly active traded financial markets around the world, with an average daily traded volume of $6.6 trillion in early 2019.

Institutional investors such as banks, multinational corporations, hedge funds and even central banks are active participants in these markets.

Similar to foreign exchange markets, commodities markets attract (and are only accessible to) certain investors, who are highly knowledgeable in the space. Commodities markets can be physical or virtual for raw or primary products. Major commodities by liquidity include crude oil, natural gas, heating oil, sugar, RBOB gasoline, gold, wheat, soybeans, copper, soybean oil, silver, cotton, and cocoa. Investment analysts spend a great deal of time speaking with producers, understanding global macro trends for supply and demand for these products around the world, and even take into account the political climate to assess what their prices will be in the future.

Standardized forward contracts are also referred to as futures contracts. While forward contracts are private agreements between two parties and carry a high counterparty risk, futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default.

Interest rate parity (IRP) is a theory according to which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic and foreign assets. Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. Investors then cannot earn arbitrage profits by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, due to gains or losses from exchanging back to their domestic currency at maturity. Interest rate parity takes on two distinctive forms: uncovered interest rate parity refers to the parity condition in which exposure to foreign exchange risk (unanticipated changes in exchange rates) is uninhibited, whereas covered interest rate parity refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk. Each form of the parity condition demonstrates a unique relationship with implications for the forecasting of future exchange rates: the forward exchange rate and the future spot exchange rate.

Economists have found empirical evidence that covered interest rate parity generally holds, though not with precision due to the effects of various risks, costs, taxation, and ultimate differences in liquidity. When both covered and uncovered interest rate parity hold, they expose a relationship suggesting that the forward rate is an unbiased predictor of the future spot rate. This relationship can be employed to test whether uncovered interest rate parity holds, for which economists have found mixed results. When uncovered interest rate parity and purchasing power parity hold together, they illuminate a relationship named real interest rate parity, which suggests that expected real interest rates represent expected adjustments in the real exchange rate. This relationship generally holds strongly over longer terms and among emerging market countries.

Interest rate parity (IRP) plays an essential role in foreign exchange markets by connecting interest rates, spot exchange rates, and foreign exchange rates.

IRP is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of IRP is that hedged returns from investing in different currencies should be the same, regardless of their interest rates.

IRP is the concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and sale of an asset to profit from a difference in the price). Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate.

The formula for IRP is:

where:

F0 = Forward Rate

S0 = Spot Rate

ic = Interest rate in country c

ib =Interest rate in country b

Assumptions

Interest rate parity rests on certain assumptions, the first being that capital is mobile – investors can readily exchange domestic assets for foreign assets. The second assumption is that assets have perfect substitutability, following from their similarities in riskiness and liquidity. Given capital mobility and perfect substitutability, investors would be expected to hold those assets offering greater returns, be they domestic or foreign assets. However, both domestic and foreign assets are held by investors. Therefore, it must be true that no difference can exist between the returns on domestic assets and the returns on foreign assets. That is not to say that domestic investors and foreign investors will earn equivalent returns, but that a single investor on any given side would expect to earn equivalent returns from either investment decision.

Important

Interest rate parity is an important concept. If the interest rate parity relationship does not hold true, then you could make a riskless profit. The situation where IRP does not hold would allow for the use of an arbitrage strategy. For example, let us look at the scenario where the forward exchange rate is not in equilibrium with the spot exchange rate.

If the actual forward exchange rate is higher than the IRP forward exchange rate, then you could make an arbitrage profit. To do this, you would borrow money, exchange it at the spot rate, invest at the foreign interest rate and lock in the forward contract. At maturity of the forward contract, you would exchange the money back into your home currency and pay back the money you borrowed. If the forward price you locked in was higher than the IRP equilibrium forward price, then you would have more than the amount you must pay back. You have essentially made riskless money with nothing but borrowed funds.

Interest rate parity is also important in understanding exchange rate determination. Based on the IRP equation, we can see how changing the interest rate can affect what we would expect the spot rate to be at a later date. For example, by holding the foreign country interest rate steady and increasing the home country’s interest rate, we would expect the home country currency to appreciate in relation to the foreign currency. This would affect the expected exchange rate.