10-09-2013, 02:39 PM
Currency Derivatives Certification Examination
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INTRODUCTION TO CURRENCY MARKETS
BASIC FOREIGN EXCHANGE DEFINITIONS
Spot: Foreign exchange spot trading is buying one currency with a different currency for immediate delivery.
The standard settlement convention for Foreign Exchange Spot trades is T+2 days, i.e., two business days
from the date of trade. An exception is the USD/CAD (USD–Canadian Dollars) currency pair which settles T+1.
Rates for days other than spot are always calculated with reference to spot rate.
Forward Outright: A foreign exchange forward is a contract between two counterparties to exchange one
currency for another on any day after spot. In this transaction, money does not actually change hands until
some agreed upon future date. The duration of the trade can be a few days, months or years. For most major
currencies, three business days or more after deal date would constitute a forward transaction.
MAJOR CURRENCIES OF THE WORLD
The US Dollar is by far the most widely traded currency. In part, the widespread use of the US Dollar reflects
its substantial international role as “investment” currency in many capital markets, “reserve” currency held by
many central banks, “transaction” currency in many international commodity markets, “invoice” currency in
many contracts, and “intervention” currency employed by monetary authorities in market operations to
influence their own exchange rates.
In addition, the widespread trading of the US Dollar reflects its use as a “vehicle” currency in foreign exchange
transactions, a use that reinforces its international role in trade and finance. For most pairs of currencies, the
market practice is to trade each of the two currencies against a common third currency as a vehicle, rather
than to trade the two currencies directly against each other. The vehicle currency used most often is the US
Dollar, although very recently euro also has become an important vehicle currency.
Thus, a trader who wants to shift funds from one currency to another, say from Indian Rupees to Philippine
Pesos, will probably sell INR for US Dollars and then sell the US Dollars for Pesos. Although this approach
results in two transactions rather than one, it may be the preferred way, since the US Dollar/INR market and
the US Dollar/Philippine Peso market are much more active and liquid and have much better information than a
bilateral market for the two currencies directly against each other. By using the US Dollar or some other
currency as a vehicle, banks and other foreign exchange market participants can limit more of their working
balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate
their research and information sources on the vehicle currency.
OVERVIEW OF INTERNATIONAL CURRENCY MARKETS
During the past quarter century, the concept of a 24-hour market has become a reality. Somewhere on the
planet, financial centres are open for business; banks and other institutions are trading the US Dollar and other
currencies every hour of the day and night, except on weekends. In financial centres around the world,
business hours overlap; as some centres close, others open and begin to trade. The foreign exchange market
follows the sun around the earth.
Business is heavy when both the US markets and the major European markets are open -that is, when it is
morning in New York and afternoon in London. In the New York market, nearly two-thirds of the day’s activity
typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid-to late
afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets
have opened.
ECONOMIC VARIABLES IMPACTING EXCHANGE RATE MOVEMENTS
Various economic variables impact the movement in exchange rates. Interest rates, inflation figures, GDP are
the main variables; however other economic indicators that provide direction regarding the state of the
economy also have a significant impact on the movement of a currency. These would include employment
reports, balance of payment figures, manufacturing indices, consumer prices and retail sales amongst others.
Indicators which suggest that the economy is strengthening are positively correlated with a strong currency and
would result in the currency strengthening and vice versa.
Currency trader should be aware of government policies and the central bank stance as indicated by them from
time to time, either by policy action or market intervention. Government structures its policies in a manner such
that its long term objectives on employment and growth are met. In trying to achieve these objectives, it
sometimes has to work around the economic variables and hence policy directives and the economic variables
are entwined and have an impact on exchange rate movements.
CURRENCY FUTURES -DEFINITION
A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset
or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity,
e.g. Oil or Wheat, the contract is termed a “commodity futures contract”.
When the underlying is an exchange rate, the contract is termed a “currency futures contract”. In other words,
it is a contract to exchange one currency for another currency at a specified date and a specified rate in the
future. Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value and
delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date.
Internationally, currency futures can be cash settled or settled by delivering the respective obligation of the
seller and buyer. All settlements, however, unlike in the case of OTC markets, go through the exchange.
Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to
calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential
to know both the contract size (the number of currency units being traded) and also what the “tick” value is.
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 Rupee. 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.
42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction
of market movement.
SPECULATION IN FUTURES MARKETS
Speculators play a vital role in the futures markets. Futures are designed primarily to assist hedgers in
managing their exposure to price risk; however, this would not be possible without the participation of
speculators. Speculators, or traders, assume the price risk that hedgers attempt to lay off in the markets. In
other words, hedgers often depend on speculators to take the other side of their trades (i.e. act as counter
party) and to add depth and liquidity to the markets that are vital for the functioning of a futures market. The
speculators therefore have a big hand in making the market.
Speculation is not similar to manipulation. A manipulator tries to push prices in the reverse direction of the
market equilibrium while the speculator forecasts the movement in prices and this effort eventually brings the
prices closer to the market equilibrium. If the speculators do not adhere to the relevant fundamental factors of
the spot market, they would not survive since their correlation with the underlying spot market would be
nonexistent.
Conclusion
It must be noted that though the above examples illustrate how a hedger can successfully avoid negative
outcomes by taking an opposite position in FX futures, it is also possible, that on occasion the FX fluctuations
may have been beneficial to the hedger had he not hedged his position and taking a hedge may have reduced
his windfall gains from these FX fluctuations. FX hedging may not always make the hedger better-off but it
helps him to avoid the risk (uncertainty) and lets him focus on his core competencies instead.
Many people are attracted toward futures market speculation after hearing stories about the amount of money
that can be made by trading futures. While there are success stories, and many people have achieved a more
modest level of success in futures trading, the keys to their success are typically hard work, a disciplined
approach, and a dedication to master their trade.