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.