Foreign Exchange Concepts Part I

What is FOREIGN EXCHANGE MARKET?

Foreign Exchange market is simply a market where an individual, bank, companies, etc. can buy one currency by paying another currency.

For example: INR/USD quote of 60rs. means 1USD costs 60rs.

The quoting convention used above is called Price Currency/ Base Currency which practically means cost of buying one base currency in terms of price currency.

** It is very important to realize here that since both the commodities in question here are currencies hence buying one currency is equal to sell another. In our above example buying 1 USD against 60INR is equal to selling 60INR to buy 1 USD (for sake of simplicity consider it like a barter, wherein we give one currency and take another).

We will be using this concept later in the material.

How is Exchange Rate quoted in the Market?

Exchange rate can be quoted as either a Direct Quote or Indirect Quote

-          In Direct Quote, foreign currency is used as base currency and domestic currency is used as price currency.

The above example is a direct quote for investors in India.

-          In Indirect Quote, reverse is true i.e., domestic currency is used as base currency and foreign currency is used as price currency.

For Example : For investors in India a quote of USD/INR will be indirect quote, meaning cost of buying 1 INR is 1/60 USD.

Note both the quotes practically mean the same thing.

Why participate in Foreign Exchange Market?

Investors can purchase foreign exchange to speculate, utilize arbitrage opportunities, tourism purposes or hedging foreign exchange risk.

What is Foreign Exchange Risk?

It is the risk that the price of the foreign currency would move in an unfavorable direction for an investor.

For example : If an individual in India is about to receive 100000USD in 1 month’s time then his risk is that price of USD in terms of INR will fall, i.e. USD (the asset that he will recieve in 1month) will depreciate.

Alternatively, if an individual in India has to pay 100000USD in 1 month’s time then his risk is that price of USD in terms of INR will increase, i.e. USD( the commodity he has to purchase in 1 month) will appreciate.

Classification of Foreign Exchange Markets.

What is Spot Market?

Spot market is the foreign exchange market where one can buy the respective currency today.

It is important to note that the delivery of the currency bought will be made two business days after today.

For example: If today is Monday then delivery will be made on Wednesday.

If today is Friday then delivery will be made on Tuesday. (Since Saturday and        Sunday are holidays.)

How is exchange rate quoted in markets?

Exchange rate is quoted in terms of bid and ask, i.e. there are two quotes, one is to buy the base currency and other is to sell the base currency.

For example : if exchange rate of INR/USD is quoted in market as 60.00 – 60.20 then 60.00 is the bid price at which a market participant can sell USD (base currency) and 60.20 is the ask price at which a market participant can buy USD (base currency).

It is important to note that Bid Price is always less than Ask Price and the difference between them is called Bid – Ask Spread.

What is Forward Market?

It is the market in which an investor can buy a particular currency in future but however decide the price of it today.

For example : An investor willing to buy 100000 USD after 1 month can enter into a forward contract and decide its price today, let’s say 61.20rs./USD (hypothetical).

Forward rate is usually quoted in terms of forward points, i.e. spread over and above spot rate.

For Example :

Time	Forward Points
1month	0.85-1.00
2months	1.20-1.50
3months	1.60-1.90

Here, if the spot rate is 60.00 – 60.20 then the forward rate 1month from now will be 60.85 – 61.20 i.e. (60.00 + 0.85, 60.20 + 1.00)

What is Cross Currency Rate?

It is important to note that so far we have assumed that a currency exchange rate quote is available for all the desired currencies. However it is often possible that an exchange rate quote might not be available directly for a particular currency, in such a case we use Cross Currency Rates to determine the applicable bid and ask rates for our desired currency.

For example lets say a currency exchange quote is not available directly for INR and CHF (swiss currency), however we have following two quotes INR/USD and USD/CHF.

INR/USD = 60.20

USD/CHF = 1.20

Now let’s say that the investor in India wants to purchase 1000 Swiss Currency (CHF), here is how he can do it.

1)      Buy 1000 CHF using 1.2*1000 = 1200 USD.

2)      Buy 1200 USD using 60.20*1200 = 722400 INR

Now lets see what do these two transactions effectively do :

1)       First by buying 1000CHF using USD we have purchased the commodity (CHF) that we desired. Note that this is equal to selling 1200 USD and buying 1000CHF

2)      Since we have sold 1200 USD in our first transaction, we should now buy them back. Hence we buy 1200 USD using 72240INR.

3)      So the final effect of these transactions is that we have effectively purchased 1000CHF using 72240INR which makes our exchange rate quote to be INR/CHF = 72.24rs.

Having understood the above concept, now let us introduce bid-ask rates in this framework.

Consider the following rates :

INR/USD = 60.00 – 60.20

USD/CHF = 1.10 – 1.20

Here since we are buying in both the transaction we use Ask rates (60.20 and 1.20) in both the cases.

However let us say that we wanted to sell 1000CHF and receive INR against it, how will we do it?

Steps :

1)      Sell 1000CHF against dollars. This transaction will result in inflow of 1.1*1000 = 1100 USD.

2)      Sell 1100 USD against INR. This transaction will result in inflow of 60.00*1100 = 66000.

Which rate to use (bid or ask) depends on whether we want to sell the base currency in a particular transaction or purchase it.

Let us look at one more variant to get a proper understanding of this framework.

In the above example lets say the quote for USD and CHF was quoted in terms of CHF/USD.

So now,

INR/USD = 60.00 – 60.20

CHF/USD = 0.83 – 0.90 (**to see how did we convert this rate from USD/CHF please see the bottom of this article)

Now, again our investor wants to sell 1000CHF and receive INR in return.

Steps :

1)      Sell CHF against USD. Note here that now since the base currency for this quote is USD we will have to actually purchase USD by using ask price of CHF/USD (recall that buying USD is equivalent to selling CHF).

Therefore, inflow of 1000CHF/0.90 = 1100USD

Since           0.90 CHF = 1 USD

Therefore,    1000CHF = ? USD

  By cross multiplying we get our answer of 1100USD.

2)      Now we sell 1100 USD for INR. Net inflow of 1100*60.00 = 66000INR

**Conversion of USD/CHF quote to CHF/USD quote.

USD/CHF = 1.10 – 1.20

Here, 1.20 is ask rate at which we can buy CHF (base currency) and sell USD. Now let us invert it i.e., (1/1.2) = 0.833. This rate becomes the corresponding rate in CHF/USD, i.e. the rate at which we can buy CHF(price currency) and sell USD(base currency)

Similarly inverting 1.1 i.e., (1/1.1) = 0.90. This becomes the rate at which we can sell CHF(price currency) and buy USD(base currency)

Hence, USD/CHF = 0.83 – 0.90.

In short,

Various Risk Management Strategies using Options

1)    Covered Call

What does it include?

-          Long underlying asset.

-          Selling a Call Option on underlying asset.

What does it do?

-          Provides protection on the downside by the amount of premium collected on the Call option sold.

-          Limits upside gains to the exercise price of the call option i.e. Maximum Value = S₀ – X

Pay off graph of the strategy:

2)    Protective Puts

What does it involve?

-          Long on underlying.

-          Long on put options.

What does it do?

-          Provides protection on the downside, limiting the maximum loss that an investor might have to bear, i.e.,  S₀ – X. ( Please note that generally the exercise price of put bought is less than current price of the underlying.)

-          Reduces upside gains on the underlying for the investor by the amount of put premium, i.e., S_T – S₀ – P.

Pay off graph for this strategy

3)    Money Spreads

In these type of strategies, pay off is based on the difference or spread between option exercise prices.

i)                    Bull Spreads

What is the market view of the investor?

o   Bullish. (Mostly bullish within a range.)

What does the strategy involve?

o   Long call with exercise price of X₁ .

o   Short call with exercise price of X₂ .

Here, X₁  <  X₂

                    What does it do?

o   Reduces the cost of purchasing Long Call by the amount of premium collected by shorting the call with higher exercise price.

o   Puts a limit on the upside value to X₂ – X₁. ( Maximum value of this strategy.)

Pay off graph of this strategy is

Here, P_s = Price of underlying at expiration.

           c(X_1­) and c(X₂) = Premium on calls with exercise price X₁ and X₂ respectively.

ii)                  Bear Spreads.

What is the market view of the investor?

o   Bearish. (Probably within a range)

What does this strategy involve?

o   Long put with exercise price X₂.

o   Short put with exercise price X₁.      

       

Here, X₁ < X₂.

What does it do?

o   Reduces the cost of purchasing long put by the amount of premium collected on short puts.

o   Limits the value of the long put to X₂ – X₁ (Maximum Value)

Pay off graph of this strategy is

                       

iii)                Butterfly Spreads

What is the market view of the investor?

o   Volatility in the underlying will be less than what the market expects it to be.

What does the strategy involve?

o   Long on call with exercise price X₁.

o   Short on two calls with exercise price X₂.

o   Long on call with exercise price X₃.

Here, X₁ < X₂ < X₃

Also note that for most of the cases, (X₂ – X₁) = (X₃ – X₂)

What does it do?

o   This strategy is effectively a combination of long and short bull spreads. (X₁ and –X₂) being the long bull spread and (-X₂ and X₃) being the short bull spread.

o   When investor’s view is correct, the market becomes less volatile leading to price of the underlying being around X₂ (Current market price of the underlying)

o   Maximum profit occurs when price stays around X₂.

Pay off graph of this strategy is

Here note the symmetry on both sides of the current underlying price, which is also the exercise price of the calls the investor is short on. Also the profit of the strategy starts declining as the underlying price at expiration moves either towards the lowest exercise price X_{1 ­}or highest exercise price X₂.

Also note that this is the only strategy that we have discussed so far where in the investor does not bet on the direction of change in price of underlying, instead it bets on the volatility of the underlying.

Keep visiting, more strategies to be put up soon.

Current Economic Scenario - Part III

Current Economic Scenario – Part III


Last two blogs talked about the current situation of Indian Economy, here we will be talking about what happens if one of the Components of our economy changes.

• Appreciation/Depreciation of rupee and its effects

This suggests that the most favorable scenario for the economy would be of Rupee Appreciation. Here, it is important to note that in an ideal scenario (Good GDP Growth rate, controlled inflation measures) Foreign Domestic Investment i.e. Foreign Investment in India increases with the weakening of rupee (more rupee for 1$) but in current scenario it is very important to infuse confidence into the Foreigners regarding Indian Economy.

Let’s say if You and I have got 1 billion dollars to invest than a rupee conversion rate would not matter as much as a prospective return on our investment which is indicated by a good GDP growth rate.

Investment opportunities if the Rupee appreciates:-

1. Buy Govt. bonds as the yields will most likely decrease (due to decreasing inflation), increasing the Bond’s price.

2. Buy the stocks of cyclical industries (industry which do well in good economic times). Example: Auto industry, Infrastructure industries, Luxury Goods industry, etc.

Investment opportunities if the Rupee depreciates:-

1. Buy stocks of non-cyclical industry like staple goods, agriculture, etc. as the demand for these goods will increase with the ever-rising population.

*This scenario is very unlikely looking at the current situation and policy actions.

-Change in Crude Oil Prices


A further decrease in crude oil prices would be the most fortunate thing that could happen to revive the economy. This would mean that the supply side pressures get eased automatically reducing the inflation rate (disinflation) and thereby also increasing the demand for other industrial products and reviving the GDP growth rate marginally.


Investment opportunities if the Oil Prices Reduce:

1. Buy Govt. bonds as reduced inflation would mean a decrease in require yields and an increase in bond prices.
2. Buy stocks of non-cyclical industries as only a reduction in oil prices with other scenario unchanged is not supposed to revive the economy substantially.

An increase in crude oil prices with no change in currency exchange rate would be an economic disaster for the country, creating an upward inflationary spiral and reducing GDP to a great extent i.e. a situation of severe stagflation. It is very important for the Economic Bodies to react before any of these happen as a key to this problem has not been found till now and could lead to a severe depression.

Current Economic Scenario - Part II

GLOSSARY
Headline Inflation: A measure of the total inflation within an economy and is affected by areas of the market which may experience sudden inflationary spikes such as food or energy.

Core Inflation: Also called underlying inflation, which excludes factors such as food and energy costs.
Exchange rate: INR/USD means amount of Indian rupees per U.S dollar

Appreciation of rupee: Rupee getting stronger i.e. less rupees is needed to get 1 dollar.

Depreciation of rupee: Rupee getting weaker i.e. more of rupees is needed to get 1 dollar.

* Inflation chart, Growth Chart, and population chart has been taken from the website www.tradingeconomics.com

* Crude oil prices chart has been taken from www.infomine.com


             Inflation And Growth

Growth of Indian Economy has been quite a story in itself, growing faster and more sustainably then most of the other economies in the world. USP of Indian Economy is the population of India which allows it to be a self-sustaining nation. However recent trend has not been quite favorable i.e. Indian economy has been witnessing slowing growth, population increasing at an exponential rate and an increasing inflation, worsening the standard of living in the country.

Parameter	Growth Rate
G.D.P	5.3%
Inflation	8%
Population	4.7%

Again a graphical representation of these would help us better understand the state of the economy.

As can be seen since the starting of the year 2012 Indian economy is facing slowing growth and increasing inflation (economics name it “Stagflation”).

Now to get a better insight into the causes of this scenario we can look into the data of population growth. Before saying anything further it would be better to look at the population growth graph of India:

According to last census Indian population grew at a rate of 4.7% to get to 1210 million people.

So this certainly means that there is enough willingness of the people to buy more goods but maybe it is the constant increase in prices which is hammering the growth in demand. However it would be wrong to say that demand has been decreasing, because looking at the demographics India has enough demand generation within the economy. But it would not be wrong to mention that this demand however is for staple goods i.e. “Roti, Kapda, Makaan”. Here is another figure which would prove this point:

India industrial production growth had slipped into negative and now getting just to around zero percent. It’s important to note here that this means Indian Industrial Production is approximately at the level at which it was in August-October 2011.

Now the GDP rising at around 6% annually and Industrial production not rising at all suggests that this growth in GDP has practically been achieved from Agriculture and Tertiary sectors.

The demand for agriculture products and basic services has what kept GDP from falling further.

Now shifting our focus to inflation figures, it has been increasing at very rapid rate even though the economy is experiencing a slowing growth.

From the starting of the year inflation has been increasing almost at the rate of 7% which is undoubtedly high even for a growing economy like India. Recent policy action of RBI of choosing to tame inflation instead of fueling slowing growth hints how big this problem really is.

It is important to see here that this inflation is probably not caused by an increase in demand (the general theory that if demand increases price will also be increased by the producers) but because of pressures on the supply side of the economy.

Now what do we mean by pressures on supply side? It simply means that there has been an increase in the input cost for suppliers (manufacturers) of the goods namely natural resources and inputs which are inevitable for the production process to complete. Out of everything “ Crude Oil “ is the most talked about resource and correctly so, being the most essential input to any production process.

Crude oil prices have dipped from around 115$ to 90$ in about a year which suggests that there should be a decrease in the input costs of the suppliers, however since India depends largely on Crude Oil imports and because of the rupee depreciation being more than the percentage fall in oil prices it has been a major reason behind the current rise in inflation rate.

It is also important to know that Headline Inflation (the total inflation considering also Food items) is at 7.5% whereas Core inflation which does not consider food items is just below 5% i.e. 4.96%. As earlier mentioned this again supports the point that demand for staple goods like food and basic services has been increasing because of the increasing population. Therefore, Headline inflation has been increasing because of both supply side as well as demand side pressures. A good action here would be to easing of the supply side pressures of the Staple Goods producers like farmers, transport services, etc. This would help lowering the inflation rate prevailing in the economy.

It is also important to understand here that because the income of common man is getting consumed in purchasing now more costlier staple goods or basic necessities of life hence the demand for other Industrial products is decreasing which is consequently reducing the IIP(India Industrial Production)