The Characteristics of Foreign Exchange markets

Foreign exchange refers to money denominated in the currency of another nation or group of nations. Foreign exchange can be cash, bank deposits or other short-term claims. But in the foreign exchange market as the network of major foreign exchange dealers engaged in high-volume trading, foreign exchange almost always take the form of an exchange of bank deposits of different national currency denominations.

Market Characteristics

The foreign exchange market place is a twenty-four hour market with exchange rates and market conditions changing constantly. However, foreign exchange activity does not flow evenly. Over the course of a day, there is a cycle characterized by periods of very heavy activity and other periods or relatively light activity. Business is most heavy when two or more market places are active at the same time such as Asia and Europe or Europe and America. Give this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relative inactive time of day, and will wait to see whether the development is confirmed when the major markets open. Nonetheless, the twenty-four hour market does provide a continuous “real-time” market assessment of the currencies’ values.

The market consists of a limited number of major dealer institutions that are particularly active in foreign exchange, trading with customers and (more often) with each other. Most, but not all, are commercial banks and investment banks. The institutions are linked each other through telephones, computers and other electronic means. There are estimated 2,000 dealer institutions in the world, making up the global exchange market.

Each nation’s market has its own infrastructure. For foreign exchange market operations as well as for other matters, each country enforces its own laws, banking regulations, accounting rules, and tax codes. They also have different national financial systems and infrastructures through which transactions are executed and within the currencies are held. With access to all of the foreign exchange markets generally open to participants from all countries, and with its vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross-border foreign exchange trading amongst dealers as well as between dealers and their customers. At any moment, the exchange rates of major currencies tend to be virtually identical in all of the financial centers. Rarely are there such substantial price differences among these centers as to provide major opportunities for arbitrage.

Over-the-Counter vs. Exchange-Traded Segment

There are generally two different market segments within the foreign exchange market: “over-the-counter” (OTC) and “exchange-trade”.

In the OTC market, banks indifferent locations make deals via telephone or computer systems. The market is largely unregulated. Thus, a bank in a country such the USA does not need any special authority to trade or deal in foreign exchange. Transactions can be carried out on whatever terms and with whatever provisions are permitted by law and acceptable to the two counter-parties, subject to the standard commercial law governing business transactions in the respective countries. However, there are “best practice recommendations” such from the Federal Reserve Bank of New York with respects to trading activities, relationships, and other matters.

Trading practices on the organized exchanges and the regulatory arrangements covering the exchanges, are markedly different from those in the OTC market. In the exchange, trading takes place publicly in a centralized location and products are standardized. There are margin payments, daily marking to market, and a cash settlement through a central clearinghouse. With respects to regulations in the USA, exchanges at which currency futures are traded are under the jurisdiction of the Commodity Futures Trading Corporation (CFTC). Steps are being taken internationally to harmonize trade regulations and to improve the risk management practices of dealers in the foreign exchange market and to encourage greater transparency and disclosure.

The various parties involved

Today, commercial banks and investment banks serve as the major dealers by executing transactions and providing foreign exchange services. Some, but not all, are market makers, that regularly quote both bids and offers for one ore more particular currencies thus standing ready to make a two-sided market for its customers. Dealers also trade foreign exchange as part of the bank’s proprietary trading activities, where the firm’s own capital is put at risk on various strategies. A proprietary trader is looking for a larger profit margin based on a directional view about a currency, volatility, an interest rate that is about to change, a trend or a major policy move. .

Payment and Settlement Systems

Executing a foreign exchange transaction requires two transfers of money value, in opposite directions, since it involves the exchange of one national currency for another. Execution of the transaction engages the payment and settlement systems of both nations. “Payment” is the transmission of an instruction to transfer value that results from a transaction in the economy, and “settlement” is the final and unconditional transfer of the value specified in a payment instruction.

The foreign exchange instruments

Spot:

A spot transaction is a straight forward (or “outright”) exchange of one currency for another. The sport rate is the current market price, the benchmark price.

Outright Forwards:

An outright forward transaction is a straight forward single purchase/sale of one currency for another, that is settled on a day pre-arranged date three or more business days after the deal date.

FX Swaps:

In the FX swap market, one currency is swapped for another for a period of time, and then swapped back, creating an exchange and re-exchange.

Currency swaps:

In a typical currency swap, counter-parties will

(i) exchange equal initial principle amounts of two currencies at the spot exchange rate,

(ii) exchange a stream of fixed or floating interest rate payments in their swapped currencies for the agreed period of the swap and then

(iii) re-exchange the principle amount at maturity at the initial spot exchange rate.

Direct and Indirect Quotation for Exchange Rates

Purpose:

This component enables you to manage exchange rates for each currency pair using direct or

indirect quotation. The type of quotation used is dependent on the market standard. You can

define the type of quotation per client and currency pair (business transaction).

Indirect quotation has not been required until now, because direct quotation was usually used for exchange rates. With the start of the dual currency phase of the European Monetary Union

(EMU), indirect quotation is now used within Europe for exchange rates with the euro. Indirect

quotation is also becoming more widely accepted internationally. Until now, there were many

limitations involved in processing indirect exchange rates.

Direct quotation is where the cost of one unit of foreign currency is given in units of local

currency, whereas indirect quotation is where the cost of one unit of local currency is given in

units of foreign currency.

Your local currency is GBP:

– Direct exchange rate: 1USD = 0.6464 GBP

– Indirect exchange rate: 1GBP = 1.5470 USD

Direct or indirect quotation can be maintained as the standard form of quotation for a certain

currency pair. You use:

– ‘1’ for direct quotation

– ‘2’ for indirect quotation

If a standard form of quotation has not been specified for a currency pair, the system

automatically uses direct quotation.

Foreign currency options:

A foreign exchange or currency option contract gives the buyer the right, but not the obligation, to buy/sell a specified amount of one currency for another at a specified price on a specified date. That differs from a forward contract, in which the parties are obligated to execute the transaction on the maturity date. An OTC foreign exchange option is a bilateral contract between two parties. In contrast to the exchange-traded options market, in the OTC market, no clearing-house stands between the two parties, and there is no regulatory body establishing trading rules.

Trade mechanics

Dealer institutions trade with each other in two basic ways: direct dealing and through a brokers market. The mechanics of the two approaches are quite different, and both have been changed by technological advances in recent years.

Direct Dealing:

Each of the major market makers shows a running list of its main bid and offer rates – that is, the prices at which it will buy and sell the major currencies, spot and forward – and those rates are displayed to all market participants on their computer screens. The dealer shows his prices for the base currency expressed in amounts of the terms currency. Although the screens are updated regularly throughout the day, the rates are only indicative-to get a firm price, a trader or customer must contact the bank directly. A trader can contact a market maker to ask for a two-way quote for a particular currency.

Theories of Fund Flow

Fund flow is usually measured on a monthly or quarterly basis. The performance of an asset or fund is not taken into account, only share redemptions (outflows) and share purchases (inflows).  Net inflows create excess cash for managers to invest, which theoretically creates demand for securities such as stocks and bonds.  

Law of one price

The law of one price is another way of stating the concept of purchasing power parity. The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will purchase the asset in the cheaper market and sell it where prices are higher. When the purchasing power parity doesn’t hold, arbitrage profits will persist until the price converges across markets.

Foreign exchange risk exposure :

We can define exposure as the sensitivity real home currency value of an asset, liability or an operating income to an unknown change in the exchange rate, moreover foreign exchange risk means variabilty of the domestic currency values of assets, liabilities operating income due to unknown changes in exchange rate.

The foreign exchange business is by nature risky because it deals primarily in risk – measuring it, pricing it, accepting it when appropriate managing it.

Market Risk:

Market risk, in simple terms, is price risk, or exposure to adverse price change. For a dealer in foreign exchange, two major elements of market risk are exchange risk and interest rate risk. Exchange rate risk is inherent in foreign exchange trading. Interest rate risk arises when there is any mismatching or gap in the maturity structure. Thus, an uncovered outright forward position can change in value, not only because of a change in spot rate but also because of a change in interest rates, since a forward rate reflects interest rate differential between the two currencies.

Credit Risk:

Credit risk arises from the possibility that the counter-party to a contract cannot or will not make the agreed payment at maturity. In foreign exchange trading, banks have long been accustomed to dealing with the broad and pervasive problem of credit risk. “Know your customer” is a cardinal rule and credit limits or dealing limits are set for each counter-party and adjusted in response to changes in financial circumstances. Over the past decade or so, banks have become willing to consider “margin trading” when a client requires a dealing limit larger than the banks is prepared to provide. Under this arrangement, the client places a certain amount of collateral with the bank and can then trade much larger amounts.

Other Risks:

Numerous other forms of risks can be involved in the foreign exchange trading, such as liquidity risk, legal risk and operational risk. The latter is the risk of losses from inadequate systems, human error, or lack of proper oversight policies and procedures and management control.

Interest rate swap and currency swap:

Interest rate swaps:

This type of swaps are derivatives as the the underlying asset is not exchanged in the trancation. It is an agreement in which two parties exchange interest payments of differing nature on an imaginary amount of principal for a defined time span. Actually, it is an exchange of different cash flows; one generated by a fixed interest rate on a sum, the other by a floating interest rate on the same sum. For instance, a party (such as a depository institute) that earns a steady stream of income may prefer one which matches (fluctuates with) the market interest rates. It may agree to exchange its interest income on a certain sum (say ten million dollars of principal) for a certain period (say one year) with another party (such as a mutual fund) which earns a fluctuating interest income but prefers a steady one.

Currency swap:

An agreement between two parties to exchange interest payments and principal on loans denominated in two different currencies. In a cross currency swap, a loan’s interest payments and principal in one currency would be exchanged for an equal valued loan and interest payments in a different currency.

Different Types of Foreign currency option:

Arrangement in which a party acquires (upon payment of a fee) the right but not the obligation to buy or sell a specified amount of a currency on a fixed date and at a fixed rate. Such options are used usually by importers as a hedge against exchange rate fluctuations. See also foreign exchange contract.

Call Option: The call options give the buyer the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a determined date.

Put Option: A Put Option gives the holder the right to sell a specified number of shares of an underlying security at a fixed price for a period of time.

Knock-Out Options: These are like standard options except that they extinguish or cease to exist if the underlying market reaches a pre-determined level during the life of the option. The knockout component generally makes them cheaper than a standard Call or Put.

Knock-in Options These options are the reverse of knockout options because they don’t come into existence until the underlying market reaches a certain pre-determined level, at this time a Call or Put option comes into life and takes on all the usual characteristics.

Average Rate Options The options have their strikes determined by an averaging process, for example at the end of every month. The profit or loss is determined by the difference between the calculated strike and the underlying market at expiry.

Basket Options A basket option has all the characteristics of a standard option, except that the strike price is based on the weighted value of the component currencies, calculated in the buyer’s base currency. The buyer stipulates the maturity of the option, the foreign currency amounts which make up the basket, and the strike price, which is expressed in units of the base currency.

Difference between a call and a put option :

The main diffenence in writing a put option and buying a call option is that they both are opposite to each other an elaboration of a put and call option will diffenciate clearly.

An inverstor who writes a call option sees the future price of the underlying asser will go up and they will be able to get profit from this investment.

An investor who buy put options believe the price of the underlying asset will go down and they will be able to purchase another option on the same asset for reselling at a price lower than the current exercise price.

Put Option :

Because put options vest the buyer with the right to sell stock at a pre-determined price, these option contracts are frequently used to protected stock holdings from losses in the event of a market decline.  Much like insurance, a stock investor can pay a premium and purchase a put option to protect his holdings.  In the event of a market downturn, he may sell the put option at an increased value to offset any losses or the option may be exercised, and the stock sold, at what would be above market prices.

Call option :

A call option, often it is simply labeled a “call”, is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

Why are the premiums different with the same contact specifications but different trading dates:

The premium is the amount that is offered to the contactor for taking the risk while making a forwad, future or options contract as the investor is making his/her investment safe the contractor is exposed to risk so he/she might charged an amount called premium.

The reason that the contract might have different premium amount with the same specifications is that the risk of currency appriciation or depriciation or the maturity of the contract, foir instance if the contract is one month long the premium might be low as the contract time is less and more accurate predictoins can be made by the contractor but if the maturity date is too long it will be difficult for the contractor to predict the future or will be difficult for him to manage his/her own risk do he/she might charge more premium for the transaction.

Deep in the money :

An option with an exercise price, or strike price, significantly below (for a call option) or above (for a put option) the market price of the underlying asset. Significantly, below/above is considered one strike price below/above the market price of the underlying asset. For example, if the current price of the underlying stock was $10, a call option with a strike price of $5 would be considered deep in the money. Many option traders (both professionals and individual investors) will exercise, as they have the right, an expiring option that is in-the-money by any amount, even though this amount may be less than OCC’s thresholds for automatic exercise. Therefore, you might anticipate assignment on any in-the-money option at expiration. An option is in-the-money if it has positive intrinsic value – that is, if the holder would profit from exercising it. In terms of strike price, a call is in-the-money if the exercise price is below the underlying stock’s spot price. A put is in-the-money if the exercise price is above the stock’s spot price.

If GBP would depreciate against the dollar a call or put option would have been better for a British exporter

If the GBP would depreciate against the dollar a call option will be beneficial for a British exporter as he is carrying transactions in dollar and he can buy GBP on low price at the future date and when it appreciates he can again write a put put option to get the benefit