Currency Markets - Trading & Operations

7/27/2019 Currency Markets - Trading & Operations

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Currency Markets – Trading & Operations

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©Finitiatives Learning India Pvt. Ltd. (FLIP), 2013. Proprietary content. Please do not misuse!

Chapter 1: Introduction

Any individual or a company, who needs to sell or buy foreign currency, does so through anauthorized dealer. Currency trading is primarily conducted in the Over-The-Counter (OTC)

market.

Foreign exchange market is a 24 hour market. In terms of time zones, the first market to open

is Sydney, then Tokyo, Singapore, Frankfurt, London and then New York. As New York shuts,

Sydney opens.

Market Participants

Authorised dealers – access the foreign exchange markets

Corporates – buy or sell, based on their requirements, through the authorised dealers

Brokers – intermediaries between the ADs and

The Central Bank – intervene to stabilize the market.

Foreign Exchange Fundamentals

Foreign exchange rates express the value of one currency in terms of another.

They involve a fixed currency (base currency), which is the currency being priced, and a

variable currency (quoted currency), the currency used to express the price of the fixed

currency.

‘The market always talks in terms of the ‘base currency’.

Direct quotations use USD as the base currency (BC). Indirect quotations use USD as the

quoting currency (QC).

Market Segments

The currency market has two distinct segments:

The interbank market is a trade between two banks.






The commercial market is a trade between a client and a bank.

Interbank quotes rates against the USD, while the commercial market asks for rates against the

home currency.

The fundamental value of the exchange rate is based on what is known as the ‘Purchasing

Power Parity (PPP)’ principle.

Balance of Payments (BOP)

BoP of a country as the term suggests is the statement of foreign currency receipts (inflows)

and payments (outflows) of a country.

BoP has two components: The Current account & The Capital account

The current account is further subdivided into the ‘trade account’ and the ‘invisibles

account’.

The capital account is divided into the ‘investments’ and the ‘loan account’.

If we have a BoP deficit, that means we are net buyers of foreign currency to bridge the gap.

Hence the home currency should weaken. The reverse is true if we have a surplus.

Chapter 2: Spot Market Arithmetic – Part I

Exchange rates or currency markets are classified based on the settlement or value date of the

transaction.

Cash: Transactions that settle the same day.

Tom: Transactions are those that settle the next business day.

Spot: Transactions are those, that settle two business days from the date of the

transaction.

Forward: Transactions are those that settle beyond spot date.

Bid: It is the rate at which the quoting party is willing to buy the base currency, or sell the

quoted currency.






Offer (also called Ask): It is the rate at which the quoting party is willing to sell the base

currency, or buy the quoted currency. Thumb rule: Asker buys BC – RHS, Asker sells BC – LHS

A cross rate is a foreign exchange rate between two currencies, derived via a third currency i.e.

the USD.

Thumb Rule: If both rates are Direct or Indirect – Divide, If one is direct and the other

Indirect – Multiply.

Banks charge a margin for all customer transactions. The margin is always expressed and

charged in terms of the quoted currency.

Thumb rule: If the bank is giving the QC, subtract margin, If the bank is receiving the QC, add

margin.

Chapter 3: Spot Market Arithmetic – Part II

Selecting the Bank – OTC trades

Select the bank that gives the cheapest price from your perspective. This means you should

always look for the highest bid rate and the lowest offer rate to transact.

Trending involves quoting a price to achieve your objective. Hence, trend higher or lower if

you wish to buy or sell the BC respectively.

Trading position denotes the size of holding in the currency pair – expressed in terms of BC.

Calculated as, Total Purchases – Total Sales, Irrespective of maturity.

Overall Position






• Determine the net open position in each currency (not currency pair). Some may be long

positions, while others short positions

• List all overbought (long) positions separately in one line and convert them into their INR equivalents, using the market closing rate.

• Similarly, all oversold (short) positions in each currency are listed in another line and their

INR equivalents are determined at the same market closing rate.

• Total each line. The greater of the local currency equivalent totals is taken as the Bank’s

position and is reported in the local currency.

Valuation or MTM

Cost of Purchases – Sales, after squaring your position. Expressed in the quoted currency.

Stop Loss & Take profit are prices at which a trader books his losses or profits respectively. As a

matter of discipline, a trader must always place a stop loss , when he/she initiates a position.

Chapter 4: Spot Markets: Pre-trade Analysis

The fundamental factors that affect currency markets can be classified into:

Macro-economic factors:

• GDP

• Balance of Payments

• Inflation

Structural Factors

• Foreign Exchange reserves composition

• Import elasticity • Exchange rate competitiveness






GDP

This is the primary indicator of economic growth. This gives a bird’s eye view of the economy

and its performance. A good positive growth in GDP is an indicator of the health of the

economy, and thereby the stability and strength of the currency.

BOP

This has three components:

• Trade gap (imports less exports)

• Current account balance (trade gap including invisibles)

• Capital flows

A consistent BoP deficit implies, the country needs to buy foreign currency on a net basis. This

will result in a weaker local currency.

Inflation

This gives signals for future interest rate actions. Higher inflation signals monetary tightening –

i.e. higher interest rates. Typically, you would like to buy a currency with a higher interest rate

as it gives a higher yield. However, if inflation and interest rates become high enough to stunt

economic growth, then the exchange rate may actually weaken eventually.

Foreign Exchange Reserves

Reserves refer to the amount of foreign currency that a country holds. The composition of the

reserves is important (a higher percentage of short term obligations tends to make the

economy more vulnerable to exchange rate volatility).

Import elasticity

A lot of economies including India’s are dependent on oil imports which are pretty inelastic.

Volatility in oil prices brings a greater degree of uncertainty to economies dependent to a large

extent on oil imports.






Exchange rate competitiveness

RBI looks at INR, not only against the USD but against a basket of currencies. This is measuredin the form of REER – the Real Effective Exchange Rate.

REER of INR is measured against a basket of currencies. This is adjusted for inflation and is

expressed in the form of an index.

Short Term Factors

• Capital Flows

• Carry Trades

• Political Factors

• Comments by Key Personnel

• Central Bank Intervention

• Safe Haven status

• Technical Market Factors

Carry Trades

These are typically done on dollar-yen, to exploit the interest rate differential.

Let us understand how this works.

The traders borrow in yen (at zero interest rates), convert the yen into (universally accepted)

dollars in the spot market and then invest the dollars in global equity markets to generate a

return. Even though the borrowing cost is zero, traders run the exchange rate risk on dollar-

yen, as they will have to sell dollars and buy back the yen at a later date, to repay the

borrowing.

Safe Haven

The term ‘safe haven currencies’ comes from the flight of global money to quality/stable

currencies in unstable times.

In the currency markets, dollar (USD) and Swiss francs (CHF) are considered ‘safehavens’ .






Technical Analysis

This technique is essentially based on the fact that history tends to repeat itself. By looking

at past data, one can forecast future exchange rates.

Economic Data

Economic data must be analysed in 3 ways:

As compared with the prior period.

As compared to the same period in the previous year. This will account for seasonality if

any.

Finally, and most importantly, you need to look at the data as compared to market

expectations.

Unemployment data

This gives the percentage of workers unemployed. Another indicator of unemployment is the

data on weekly jobless claims. This indicates the number of people claiming to be jobless, and

is another key indicator of the health of the US economy.

Durable GoodsThis indicates the growth of consumer durable goods sector. A strong growth is an indicator of

the health of the economy.

ISM-PMI

This is the Purchasing Managers' Index (PMI). It is one of the leading indicators of

manufacturing growth, and is published as an index. The data is compiled by the Institute for

Supply Management (ISM). A reading above 50 is a sign of economic expansion and below 50

indicates contraction.

PPI: The published number gives the inflation at the factory level.

CPI: This gives the inflation at the individual level.






Traders also look at core inflation, that is, excluding food and energy. This is because energy

and food are demand inelastic.

Retail Sales

This denotes local demand growth. It actually shows what customers are doing on the ground.

IFO – Germany

This survey throws light on the business sentiment in Germany.

Quarterly Tankan

It is a quarterly index of the growth of big, medium and small manufacturers and non-

manufacturers. It is a gauge of business sentiment in Japan.

Indian Rupee Market

• The daily volumes in the market are estimated to be over USD 5 bio.

• The bid-offer spread normally ranges between 0.5 ps. – 1.5 ps.

• Standard market lots in the interbank market vary from USD 0.5 mio to USD 5 mio.

Flows: Supply side• Growing FDI & FII inflows

• Corporates accessing External Currency Borrowings (ECB) and bringing them into India

• NRI inflows

• Exports

Flows: Demand side

• Oil demand (hence imports)

• Foreign debt repayments

• Non-oil imports






The rupee still remains a flow based business, and the player with the larger flows tends to

have the bigger clout. Hence large players like SBI (State Bank of India) continue to singlymove the market and have been nicknamed 'Daddy'.

Factors affecting the Rupee spot market

• Month-end demand

• DTC (Diamond Trading Corporation) remittances

• FII flows

Chapter 5: Spot Markets – Trading Process

In an OTC market, banks need to call each other for a two-way price and then transact. This

can be either on telephone or through a trading system. The quoting bank will always quote a

bid rate and an offer rate.

To make things faster, the market quotes only the last two digits. – For example; 25/30

Trading Systems

The Reuters trading system is the most popular in currency markets. It is very user friendly, as

you can contact any bank across the globe with just four alphabets.

In India, traders also use the order matching system called ‘FX Clear’, provided by Clearing

Corporation India Ltd. (CCIL), for trading USD/INR. Banks put up bids and offers, and the

system matches the orders on price and time priority basis.

In case of deals through a broker, he combines the best bid and offer available with various

banks and quotes you a price.






Chapter 6: Forward Market Arithmetic – Part I

A forward transaction is a contractual commitment to buy or sell a specified amount of foreignexchange for a specified price at a specified future date.

The key is that the price is fixed today, but the exchange will take place at a future date.

• Forward rates can be higher or lower than the applicable spot rate.

• If the interest rate of the base currency is lower, the forward rate is higher.

• If the forward exchange rate is higher, the base currency is said to be at a PREMIUM.

• If the forward exchange rate is lower, the base currency is said to be at a DISCOUNT.

Let us take an example:

In USD/INR, the base currency is the USD. The USD interest rate, as you probably know, is

lower than the INR.

Hence, based on the earlier statements, we can conclude that:

• As the interest rate of the base currency is lower, the forward rate for USD/INR will be

higher than the spot rate.

• As the forward rate is higher, USD (base currency) is at a premium to INR or INR

(quoted currency) is at a discount to USD.

Forward rate can be computed as follows:

S * (1+Rq* Tq)/ (1+Rb * Tb)

Where,

S = Spot rate

Rb = Base currency interest rate for the tenor T

Rq = Quoted currency interest rate for the tenor T

Tb = Year fraction for the period from the spot date to the forward FX settlement date using

the day count basis for Rb

Tq = Year fraction for the period from the spot date to the forward FX settlement date using

the day count basis for Rq






Swap Market

A sub-product of the forwards market is the swap market. Swap in currency markets means,

exchange of two currencies today (say 1st Jan) and their re-exchange at a later date (say

1stJuly).

A swap is essentially a lending and borrowing transaction structured in the foreign exchange

market.

In a USD/INR swap, Party A lends USD and borrows INR with Party B on spot date

(known as near leg in swap jargon).

At a later date, say after 1 month (known as far leg in swap jargon), Party A receivesthe USD (with interest-say, 2%) and repays the INR (with interest-say, 6%) to Party B.

The net exchange, called the ‘swap rate’ , is the interest rate differential i.e. 4%.

In the currency markets, you can’t lend or borrow currencies, so you sell (lend) and buy

(borrow) to achieve the same objective. Thus, a swap is a simultaneous sale/purchase and

purchase/sale of two currencies across two different value dates.

An outright forward transaction is structured in the interbank market as follows:

Outright forward = Spot + Swap

To illustrate:

The bank will first transact on spot what they want to actually do on the forward. i.e.

customer buys forward, so the bank needs to buy forward to cover. The bank then first

buys spot.

Now in the swap market, the bank does a ‘Sell spot Buy 6 months (sell-buy swap)’ in the

interest rate market.

The spot legs would cancel out and you will be left with a buy on the 6 month forward

date.






The reverse will be true, in case the customer sold forward. i.e. Bank will sell spot, and then do

a Buy-sell swap.

Hence, swaps can be a Sell-Buy or a Buy-Sell transaction – these are the two possibilities

The swap rate is called a ‘swap premium’ or a ‘swap discount’ , depending on the interest rates

of the base and quoted currencies. We know that, if the interest rate of the base currency is

higher, the forward rate is lower. The swap rate is then a discount. If the interest rate of the

base currency is lower, the swap rate is a premium.

Swaps do not create a position as the same amount of base currency is sold (bought) and

bought (sold). Swaps only help correct mismatches.

Chapter 7: Forward Market Arithmetic – Part II

In a swap, you are borrowing one currency and lending the other, so you either receive or pay

the interest difference. The swap rate is therefore a function of the interest rate differential of

the two currencies involved.

Interest rate differential (%) is converted into an exchange rate differential (pips) in the

currency markets by the formula shown below.

Exchange Rate Differential = {(Spot Rate * Interest Rate Differential)/100} * {No.

of months forward/12months}

Trading Swaps: If you expect the interest rate differential to narrow, swap rates will fall, and

viceversa.

Swap quote – Bid/Offer

As a Quoter you always sell/buy on LHS and buy/sell on RHS, irrespective of whether it is

a premium or discount.

Whether you will pay or receive depends on the interest rates of the two currencies involved.

If you are lending a low interest currency (USD) and borrowing a high interest rate currency

(INR), you pay.






Premium/Discount

In the swap price quoted if, LHS<RHS – Premium, LHS>RHS – Discount

Swap points quote with the same number of decimal places as the corresponding spot rate.

A swap has two value dates, the first is called the ‘near date’ and the second is called the ‘far

date’

A company may have a receivable or payable in a currency other than the USD. In that case,

the ban will have to compute the cross rate.

The cross rate is computed at the last step i.e., after the respective outright forward rates are

computed against the USD.

Chapter 8: The Indian Swap Market

The market quotes calendar months unlike rolling months in the overseas markets.

The Indian swap market quotes actively only upto tenors of 1 year.

The bid/offer spread ranges from 1 to 2 paisa; in a volatile market, this can go up to 20

paisa.

Standard market lots vary from USD 0.5 million to USD 5 million. The daily volumes are estimated to be over USD 5 billion.

Market Factors

• Holiday time – Dec 20-Jan 7 – Markets tend to get illiquid.

• Yield curve play – short term covers v/s long term covers

• Month-end Rollovers – Corporates book forward contracts for month-end and then roll

them on a monthly basis.

• 31st March – Lenders stay away due to capital adequacy reasons. Hence call rates go

up and so does the cash-tom premium in the FX market.






Customer Transactions

Early delivery: This occurs when an importer has received the shipment early, and

wishes to make an early payment. He may be getting a discount from his supplier for

early payment.

FII hedging: Some FIIs may tend to hedge their equity investments in India.

FCNR conversions: NRIs deposit foreign currency in India through FCNR deposits.

Banks in turn convert them into INR and on lend them to make money. The risk of

conversion is borne by the bank.

Non Deliverable Forwards (NDFs)

NDFs are foreign exchange forward products traded over the counter.

NDFs are distinct from deliverable forwards in that NDFs trade outside the direct

jurisdiction of the authorities of the corresponding currencies and their pricing need not

be constrained by domestic interest rates.

The NDF market is a pure expectation of spot and has nothing to do with interest

rates. This is because there is no delivery of the USD or INR between the buyer and

seller - i.e., no lending or borrowing.

Chapter 9: Post Trade

Risk Management

Risk management involves imposing various trading limits and taking suitable action when these

limits are exceeded.

Limits can be classified based on the nature of risk that they are addressing. Currency traders

will have ‘market risk limits’ and ‘credit risk limits’ .

Market Risk Limits

Position Limits: This denotes the size of your position in each currency pair whether ‘long’ or

‘short’ .






Gap Limits: These are limits imposed on every forward tenor in which you hold a position.

Loss Limits: These relate to the loss that you can incur in a specific period – a single day, a

month etc.

Credit Risk Limits

Pre-Settlement Risk (PSR) : Pre-settlement Risk (PSR) is the risk that a counterparty may

default on a contractual obligation before the actual settlement date of the contract.

PSR = CMTM + MLIV

MLIV = FS × √(Contract Tenor) × Amount, where FS is the daily standard deviation of the

exchange rate.

Settlement Risk (SR): Settlement Risk is the risk that a counterparty may default on

settlement date.

The bank is then exposed to direct credit risk of 100% of the principal amount. Settlement risk

in India has now been largely minimized through various mechanisms.USD/INR spot and

forwards transactions are being guaranteed by the Clearing Corporation of India Ltd (CCIL)

through a settlement guarantee fund provided by the counterparties.

CCIL also settles CLS trades for its members by becoming a third party settlement agency to

ABN AMRO which is a settlement bank for CLS.

CLS Bank, a new financial institution, was set up to reduce the risk involved in settling foreign

exchange transactions. Using this set up, the two legs of a transaction are settled

simultaneously, and in such a way that one cannot occur without the other.

Back office - Settlement

Settlement of a foreign exchange transaction requires two transfers of money value, in

opposite directions, since it involves the exchange of one national currency for another.






• The deal capture system then validates that all necessary components of a trade are

present, before assigning a Trade Reference number (TR No.) to the trade.

• Subsequent trade amendment/cancellation relies upon correct identification of thetrade via its reference number.

• The successful capture of a trade should result in the trade details being sent to the

back office immediately for operational processing.

• The next step is the verification of the trade with the contract slip. This is done by the

back office. In case of errors, the deal is sent back to the front office for rectification.

• Once the deal is validated (i.e. trade details verified against the contract slip), it is

forwarded to CCIL for settlement.

• Traditionally, counterparties exchanged deal confirmations. With the CCIL and CLS

mechanisms in place, counterparties do not need to exchange confirmations any more.

The local payment mechanism in each country effects the final settlement.

For example in case of transaction of USD/INR the rupee leg is settled through the member’s

settlement accounts with RBI and the USD leg through CCIL’s account with the settlement bank

at New York.

Cross currency deals such as GBP/USD, USD/JPY etc. are settled through the CLS mechanism as

explained earlier.

The most common interbank global messaging system is SWIFT (Society for Worldwide

Interbank Financial Telecommunications).

Back office – Other functions

• Position & Valuation

• Regulatory Reporting

• Nostro reconciliation






Chapter 10: Currency Futures

They are absolutely similar to forward contracts except that Currency Futures are traded on

exchanges like NSE, and not OTC.

They are available for standard amounts and standard maturity dates. Participants have to put

up an upfront margin (like a security deposit) for dealing in futures. Futures contracts have no

delivery. The profit or loss on the contract is cash settled.

These are more for retail players who want to speculate, or for really small businesses that deal

in very small quantities, and are looking for transparency in their pricing.

Remember, like stocks, you need to transact through a member of the exchange – a broker,

and pay the commission.

Margins:

The exchange imposes an initial margin. This is a percentage of the transacted amount.

The exchange also charges an ‘extreme loss margin’. This is calculated as 1% of the MTM valueof your open positions (for USD/INR pair). This has to be deposited at the end of every trading

day.

The daily MTM profit/loss is paid through the broker to the clearing house (CH). This is called

daily settlement.

On maturity, there will also be a final settlement.






Derivatives − A Brief Overview Chapter 1: Building Blocks

Derivative products are of three types.

1. Credit extension

Credit extension products are forms of extending credit or loans. Credit extension products

differ from each other in how they pay interest (Fixed or floating) and how the principal is

repaid (Bullet or Amortising).

Credit extension products usually appear on the balance sheet of the firm as a real asset or

liability.

2. Price Fixing products

Price fixing products are financial products that fix the price at which exchange of value takes

place at a future date. There are three main types of price fixing products: Forward contracts,

Futures contracts & Swaps.

The value of a price fixing product is simply a function of the current price for the same cash

flow exchange, in relation to the price fixed in the contract.

The P/L equation for a forward contract is:

P/L = (Market Price – Fwd Contract Price) x Amount Purchased

Price fixing products create a two-way obligation. Price fixing products do not appear on the

balance sheet as real assets or l iabilities, but appear in the notes, as contingent items.

3. Price Insurance productsPrice insurance products give the owner the right, but not the obligation, to exchange value at

a future date, at a pre-determined price today.

Price Insurance products are one-sided obligations. The credit risk is run by the buyer and the

market risk by the seller.





©Fi iti ti L i I di P t Ltd (FLIP) 2013 P i t t t Pl d t i !

Hybrid products

An example is a Convertible bond – a bond that can be converted into equity shares.

This will fall under Credit extension plus Price Insurance.

Currency Markets - Trading & Operations

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