final eco assignment.doc

8/19/2019 final eco assignment.doc

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SUBMITTED TO

UNIVERSITY OF MUMBAI

PROJECT ON

INDIAN FOREIGN EXCHANGE MARKET

SUBMITTED BY

MS. SHABRI SHIVSHANKAR MAYEKAR

ROLL NO: 37

M.COM PART- I 20!-20"

UNDER THE GUDENCE OF

PROF. RACHANA JOSHI

PTVA#S

M.L.DAHANUKAR COLLEGE OF COMMERCE

VILE-PARLE $EAST%

MUMBAI !00 0"7.

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CERTIFICATE

We, hereby certify that M&. SHABRI S MAYEKAR of Master of Commerce (Business Management Part I)' Parle Tilak Vidyalaya

ssociation!s M. L. D()(*+,( C//1 C4 has com"leted the

"ro#ect *

INDIAN FOREIGN EXCHANGE MARKET in $emester I of the

academic year %&'%&'*+ The information and facts as submitted in the

"ro#ect are true and original to the best of our knoledge and information+

Internal -.aminer/ Coordinator/

-.ternal -.aminer/ Princi"al/

0ate/ 111111111111

Place/ 11111111111

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DECLARATION

I, hereby certify that MS. SHABRI S MAYEKAR , R// *: 37 of

M+C2M Part I (Management) of P34- TI45 VI0646

$$2CITI27!$ M.L.DAHANUKAR COLLEGE OF COMMERCE

has com"leted the "ro#ect re"ort on INDIAN FOREIGN EXCHANGE

MARKET in $emester I of the cademic 6ear %&'%&'*+ ll the

information and facts as submitted in the "ro#ect are true and original to the

best of my knoledge+

$I87T93-

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ACKNO5LEDGEMENTS

I ould like to thank a number of "eo"le for their hel" during the riting of

this dissertation+ I ould like to thank my "ro#ect guide Prof+ 3achana :oshi

for gi;ing me direction, belief and such a great encouragement throughout

my dissertation+

I ould also like to thank my college library for ha;ing "ro;ided ;arious

reference books and maga


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I*6:

S.N C*8*8 P1.*

' Introduction to =oreign

-.change Market in India %

% Ma#or currency Pairs *

> 2;er;ie of International

Currency Markets ?

Basis of Currency Markets

and "eculiarities in India+ @

* 2TC =orard Market 'A

Im"act of Market economics

on Currency Prices+ %'

A = 0eri;ati;es %A

? -.change Traded Currency=utures >'

@ Interest 3ate Parity and

Prices of Currency futures >@

'& Conclusion %

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I*86+489* 8 F91* E4)(*1 M(,8 9* I*69(

The foreign e.change market in India "icked u" earnest less than three decades ago hen in

'@A? the go;ernment in alignment ith the central bank (3BI) alloed banks to trade

foreign e.change ith one another+ Today o;er A&D of the trading in foreign e.change

continues to take "lace in the Interbank market+ The market consists of o;er @& uthori


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. B9 )9&8 91* 4)(*1 (,8&

The current currency rate mechanism has e;ol;ed o;er thousands of years of the orld

community trying ith ;arious mechanism of facilitating the trade of goods and ser;ices+

Initially, the trading of goods and ser;ices as by barter system here in goods ere

e.changed for each other+ =or e.am"le, a farmer ould e.change heat gron on his

farmland ith cotton ith another farmer+ $uch system had its difficulties "rimarily

because of nondi;isibility of certain goods, cost in trans"orting such goods for trading

and difficulty in ;aluing of ser;ices+ =or e.am"le, ho does a dairy farmer e.change his

cattle for fe liters of edible oil or one kilogram of saltF The farmer has no ay to di;ide

the cattleG $imilarly, su""ose heat is gron in one "art of a country and sugar is gron

in another "art of the country, the farmer has to tra;el long distances e;ery time he has to

e.change heat for sugar+ Therefore the need to ha;e a common medium of e.change

resulted in the inno;ation of money+

Peo"le tried ;arious commodities as the medium of e.change ranging from food items to

metals+ 8radually metals became more "rominent medium of e.change because of their

ease of trans"ortation, di;isibility, certainty of Huality and uni;ersal acce"tance+ Peo"le

started using metal coins as medium of e.change+ mongst metals, gold and sil;er coins

ere most "rominent and finally gold coins became the standard means of e.change+ The

"rocess of e;olution of medium of e.change further "rogressed into de;elo"ment of

"a"er currency+ Peo"le ould de"osit gold sil;er coins ith bank and get a "a"er

"romising that ;alue of that "a"er at any "oint of time ould be eHual to certain number

of gold coins+ This system of book entry of coins against "a"er as the start of "a"er

currency+

With time, countries started trading across borders as they reali


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amount of gold in their reser;e+ The ;alue of each currency against another currency as

deri;ed from gold e.change rate+ =or e.am"le, if one unit of gold is ;alued at Indian

3u"ees (I73) '&,&&& and 9$ dollar (9$0) *&& than the e.change rate of I73 ;ersus

9$0 ould be ' 9$0 L I73 %&+ This mechanism of ;aluing currency as called as gold

standard+

With further groth in international trade, changing "olitical situations (orld ars, ci;il

ars, etc) and situations of deficit sur"lus on trade account forced countries to shift from

gold standard to floating e.change rates+ In the floating e.change regime, central bank!s

inter;ention as a "o"ular tool to manage the ;alue of currency to maintain the trade

com"etiti;eness of the country+ Central bank ould either buy or sell the local currency

de"ending on the desired direction and ;alue of local currency+

0uring '@'@A', countries ado"ted a system called Bretton Woods $ystem+ This

system as a blend of gold standard system and floating rate system+ s "art of thesystem, all currencies ere "egged to 9$0 at a fi.ed rate and 9$0 ;alue as "egged to

gold+ The 9$ guaranteed to other central banks that they can con;ert their currency into

9$0 at any time and 9$0 ;alue ill be "egged to ;alue of gold+ Countries also agreed to

maintain the e.change rate in the range of "lus or minus 'D of the fi.ed "arity ith 9$

dollar+ With ado"tion of this system, 9$0 became the dominant currency of the orld+

=inally Bretton Woods system as sus"ended and countries ado"ted system of free

floating or managed float method of ;aluing the currency+ 0e;elo"ed countries gradually

mo;ed to a market determined e.change rate and de;elo"ing countries ado"ted either a

system of "egged currency or a system of managed rate+ In "egged system, the ;alue of currency is "egged to another currency or a basket of currencies+ The benefit of "egged

currency is that it creates an en;ironment of stability for foreign in;estors as they kno

the ;alue of their in;estment in the country at any "oint of time ould be fi.ed+ lthough

in long run it is difficult to maintain the "eg and ultimately the central bank may change

the ;alue of "eg or mo;e to a managed float or free float+ In managed float, countries

ha;e controls on flo of ca"ital and central bank inter;ention is a common tool to

contain shar" ;olatility and direction of currency mo;ement+

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.2 M(; 4+*4


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may be the "referred ay, since the 9$ 0ollarI73 market and the 9$ 0ollarPhili""ine

Peso market are much more acti;e and liHuid and ha;e much better information than a

bilateral market for the to currencies directly against each other+ By using the 9$ 0ollar

or some other currency as a ;ehicle, banks and other foreign e.change market

"artici"ants can limit more of their orking balances to the ;ehicle currency, rather than

holding and managing many currencies, and can concentrate their research and

information sources on the ;ehicle currency+

9se of a ;ehicle currency greatly reduces the number of e.change rates that must be dealt

ith in a multilateral system+ In a system of '& currencies, if one currency is selected as

the ;ehicle currency and used for all transactions, there ould be a total of nine currency

"airs or e.change rates to be dealt ith (i+e+ one e.change rate for the ;ehicle currency

against each of the others), hereas if no ;ehicle currency ere used, there ould be *

e.change rates to be dealt ith+ In a system of '&& currencies ith no ;ehicle currencies,

"otentially there ould be ,@*& currency "airs or e.change rates Nthe formula is/ n (n

')%O+ Thus, using a ;ehicle currency can yield the ad;antages of feer, larger and more

liHuid markets ith feer currency balances, reduced informational needs, and sim"ler

o"eration

E+ $EUR%

4ike the 9$ 0ollar, the -uro has a strong international "resence and o;er the years has

emerged as a "remier currency, second only to the 9$ 0ollar+

J(

S?9&& F(*4 $CHF%

The $iss =ranc is the only currency of a ma#or -uro"ean country that belongs neither to

the -uro"ean Monetary 9nion nor to the 8A countries+ lthough the $iss economy is

relati;ely small, the $iss =ranc is one of the ma#or currencies, closely resembling the10


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strength and Huality of the $iss economy and finance+ $it


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.3 O@@9? 9*8*(89*(/ 4+*4 (,8&

=or currency market, the conce"t of a %hour market has become a reality+ In financial

centers around the orld, business hours o;erla" as some centers close, others o"en and

begin to trade+ =or e.am"le, 95 and -uro"e o"ens during afternoon (as "er India time)

time folloed by 9$, ustralia and :a"an and then India o"ens+ The market is mostacti;e hen both 9$ and -uro"e is o"en+ In the 7e 6ork market, nearly tothirds of

the day!s acti;ity ty"ically takes "lace in the morning hours+ cti;ity normally becomes

;ery slo in 7e 6ork in the midto late afternoon, after -uro"ean markets ha;e closed

and before the Tokyo, ong 5ong, and $inga"ore markets ha;e o"ened+

8i;en this une;en flo of business around the clock, market "artici"ants often ill

res"ond less aggressi;ely to an e.change rate de;elo"ment that occurs at a relati;ely

inacti;e time of day, and ill ait to see hether the de;elo"ment is confirmed hen the

ma#or markets o"en+ $ome institutions "ay little attention to de;elo"ments in less acti;e

markets+ 7onetheless, the %hour market does "ro;ide a continuous JrealtimeKmarket

assessment of the ebb and flo of influences and attitudes ith res"ect to the traded

currencies, and an o""ortunity for a Huick #udgment of une."ected e;ents+ With many

traders carrying "ocket monitors, it has become relati;ely easy to stay in touch ith

market de;elo"ments at all times+

With access to all of the foreign e.change markets generally o"en to "artici"ants from all

countries, and ith ;ast amounts of market information transmitted simultaneously and

almost instantly to dealers throughout the orld, there is an enormous amount of cross

border foreign e.change trading among dealers as ell as beteen dealers and their

customers+ s "er Bank for International $ettlements (BI$) sur;ey of "ril %&'&, daily

turno;er of currencies in the global market is a""ro.imately 9$0 >+@trillion, making it

the largest traded asset class+

t any moment, the e.change rates of ma#or currencies tend to be ;irtually identical in all

the financial centers here there is acti;e trading+ 3arely are there such substantial "rice

differences among ma#or centers as to "ro;ide ma#or o""ortunities for arbitrage+ In

"ricing, the ;arious financial centers that are o"en for business and acti;e at any one time

are effecti;ely integrated into a single market+

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.! B(&94& 4+*4 (,8& (*6


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.!.3 I*8(*, (,8 (*6 4)(*8 (,8

There are to distinct segment of 2TC foreign e.change market+ 2ne segment is called

as JinterbankK market and the other is called as JmerchantK market+ Interbank market is

the market beteen banks here dealers Huote "rices at the same time for both buyingand selling the currency+ The mechanism of Huoting "rice for both buying and selling is

called as market making+ =or e.am"le, your close by ;egetable ;endor ill Huote "rices

only for selling and he ill not Huote "rices for buying it+ While in a holesale market,

the ;egetable holesaler ill Huote "rices for buying ;egetable from farmer and ill also

Huote "rices for selling to ;egetable retailer+ Thus the holesaler is a market maker as he

is Huoting to ay "rices (for both buying and selling)+ $imilarly dealers in interbank

market Huote "rices for both buying and selling i+e+, offer to ay Huotes+ In ma#ority of

the JmerchantK market, merchants are "rice takers and banks are "rice gi;ers+ lthough

fe large merchants or cor"orates may ask banks to Huote to ay "rices as such

merchants may ha;e both side interest i+e+, interest to sell or buy or both+

.!.! T? ?( +8&

In interbank market, currency "rices are alays Huoted ith to ay "rice+ In a to

ay Huote, the "rices Huoted for buying is called bid "rice and the "rice Huoted for

selling is called as offer or ask "rice+ Please note that these "rices are alays from the

"ers"ecti;e of the market maker and not from the "ers"ecti;e of the "rice taker+ 4et us

understand it ith an e.am"le+ $u""ose a bank Huotes 9$0I73 s"ot "rice as *+&*

*+& to a merchant+ In this Huote, *+&* is the bid "rice and *+& is the offer price or

ask "rice+ This Huotes means that the bank is illing to buy one unit of 9$0 for a "rice

of I73 *+&* and is illing to sell one unit of 9$0 for I73 *+&+ Thus a merchant

interested to buy one unit of 9$0 ill get it for a "rice of I73 *+& i+e+ the "rice at

hich bank is illing to sell+ The difference beteen bid and offer "rice is called as

Js"readK+ Please note that the "rice Huoted by a market maker is ;alid for certain

Huantity of the currency "air and it may ;ary if the amount for hich Huote is sought is

higher+ $"read is an im"ortant "arameter to note hile assessing market liHuidity,

efficiency of market maker and market direction+ Clearly, a narro s"read indicates

ahigher liHuidity and higher efficiency of the market maker+ In 9$0I73 s"ot market,

the s"reads are ide at the time of o"ening and gradually start narroing as the marketdisco;ers the "rice+ $imilarly, for a 9$0 '&& mn transaction the s"read is likely to be

higher hen com"ared to the s"read for 9$0 ' mn transaction+

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There are certain market norms for Huoting the to ay Huotes+ $ome of the im"ortant

norms are as follos/

'+ The bid "rice (loer "rice) is Huoted first folloed by offer "rice (higher "rice)

%+ The offer "rice is generally Huoted in abbre;iated form+ In case the currency "air is

Huoted u"to four decimal "laces then offer "rice is Huoted in terms of last to

decimal "laces and if the currency "air is Huoted in to decimal "laces then offer

"rice is Huoted in terms of to decimal "laces+

C+*49& A48+(/ B96-

O P94

A@9(86

B96-O

P94

9$0I73 *+&%*+&> *+&%&>-939$0 '+%%''+%%> '+%%'%>

8BP9$0 '+&?@'+&@% '+&?@@%

9$0:P6 ?+%?+%* ?+%%*

A


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P94 *4)(,&

There are to "rice benchmarks used in the 2TC market to "rice merchant transactions+

Banks "rice large ;alue merchant transactions from interbank rate (IB3)+ IB3 is the "rice

a;ailable to the bank in the interbank market+ Therefore IB3 could differ from bank to

bank+ oe;er, the "rice ;ariation in general seems to be ;ery small, may be in the range

of &+%* "aise to % "aise from bank to bank+ lso IB3 is the "rice at a s"ecific "oint of

time and for a s"ecific transaction amount+

=or small ;alue transactions, banks "ublish a standard "rice for the day called as card

rate+ 2n most days for most banks, the card rate is same for the hole day+ oe;er on

the days of high ;olatility, banks re;ise the card rate multi"le times during the day+ The

difference beteen IB3 and card rate is high to co;er the risk of "rice fluctuation+ Card

rate could ;ary significantly from bank to bank+

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P94 69&4@

Indian currency market is increasingly getting aligned to international markets+ The

o"ening le;els of 2TC market are "rimarily de"endent on the de;elo"ment in

international markets since closing of domestic market on the "re;ious day+ The ;alue of

im"act of o;ernight de;elo"ment on the o"ening le;el of currency is Huite sub#ecti;e andould ;ary from one "artici"ant to other and therefore the 2TC market is generally not

;ery liHuid in the first fe minutes of its o"ening+ 8radually, market disco;ers an

eHuilibrium "rice at hich market clears buy and sell orders+ This "rocess of disco;ering

an eHuilibrium "rice is called as "rice disco;ery+ The abo;e is true for transactions here

merchants e.ecute the transaction on the interbank "rices+ oe;er, for small ;alue

transactions, banks gi;e a standard "rice called as card rate for hole day+

=or large ;olume transactions, the bidask difference could be higher than that for small

;alue transactions+ The e.act bidask difference for a "articular deal si


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S88/*8 6(8 V(/+ 6(8

9nlike currency futures market, the settlement in the 2TC s"ot market ha""ens by actual

deli;ery of currency+ The mechanism of settlement here each counter"arty e.change the

goods traded on the maturity of contract is called as gross settlement and the mechanism

here market "artici"ants only settle the difference in ;alue of goods is called as netsettlement+ =or e.am"le, in currency futures market if an e."orter sells one month

9$0I73 futures contract at *+*+ 2n termination of contract (either on e."iry or e;en

before e."iry), if the "rice of 9$0I73 is *+% the e."orter ill recei;e the difference of

*+* and *+% i+e+ 3s &+> "er 9$0+ In 2TC s"ot market, if an e."orter sells one million of

9$0 at a "rice of *+*+ 2n the settlement date, he ill deli;er one million on 9$0 to the

bank and recei;e 3s *,&&&,&&&+& from the bank+ In 2TC currency market, settlement

date is also called as ;alue date+ Please note that ;alue date is different from trade date+

2n trade date, the to counter"arties agree to a transaction ith certain terms (currency,

"rice, and amount and ;alue date)+ The settlement of the transaction, hen counter"arties

actually e.change currency, is called as ;alue date+

The most im"ortant ;alue date is the Js"otK ;alue date, hich is settlement after to

business days+ In "ractice, it can be after Jto business daysK because the settlement

takes "lace in to different centers that may ha;e different holidays+ The correct

definition of s"ot ;alue date is settlement on second business day, sub#ect to both centers

being o"en on that day+ If one of them is closed, then the settlement ill be on the ne.t

business day (hich could be third or fourth, etc, after the trade date) on hich both

centers are simultaneously o"en+ ny settlement date after s"ot ;alue date is called

JforardK ;alue dates, hich are standardi


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on hat is the second business date at non 9$0 centre, then s"ot date is the ne.t date on

hich both non 9$0 centre and 7e 6ork are simultaneously o"en+

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OTC ?(6 (,8

In the "re;ious section e briefly e."lained about s"ot 2TC market+ In this section, e

ill e."lain about 2TC forard market+ The forard 2TC market can "ro;ide Huotes for

booking a forard contract for any maturity+ oe;er, the liHuidity is high for maturity

less than one year and beyond that liHuidity is less+ With res"ect to settlement, the market "artici"ant could decide to settle it ;ia gross settlement mechanism or net settlement

mechanism+ This is unlike currency futures market, here "rices are a;ailable for month

end maturity contract and the settlement is alays on net settlement basis+

2ne more uniHue feature of 2TC forard market is the reHuirement of underlying trade

contract before e.ecuting the forard contract+ ccording to 3BI guidelines, any resident

Indian desiring to book a forard contract should ha;e an underlying trade contract

hich could establish e."osure to foreign currency+ The amount and tenor of the contract

booked has to be eHual to or less than the amount and tenor of foreign e.change e."osure

as suggested by the underlying trade contract+ The market "artici"ant is e."ected to

submit the trade contract to bank ithin '* days of booking the forard contract+

oe;er, 3BI has made "ro;isions for cases here the e."osure to foreign e.change is

only estimated at the time of booking the forard contract and the actual e."osure

crystalli


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-939$0/ '+>*' '+>** 9$0I73/ +>? +>@

Please recollect, the "rices in currency "air is Huoted in terms of ;alue of one unit of base

currency+ While calculating cross rates, it is im"ortant to kee" in mind hich is the base

currency and that the "rice is being calculated for one unit of base currency in terms of

Huotation currency (also called as term currency)+ Therefore for -93I73 currency "air,e ha;e to calculate the "rice of ' -93 in terms of I73+

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4et us start the com"utation of cross rate, using the buy side argument i+e+ "rice of buying

' -93 in terms of I73+ s understood from underlying currency "airs, the "rice of -93

is directly a;ailable only in terms of 9$0+ Therefore you need to sell I73 to buy 9$0

and further sell the 9$0 recei;ed to buy -93+ It is im"ortant to identify this =

con;ersion "ath of selling one currency and buying another to calculate the cross rate+

7o e need to use a""ro"riate "rices (bid "rice ;ersus offer "rice) of underlying

currency "airs+

To buy 'unit of 9$0, the a""licable "rice is +>@ I73 (offer side) i+e+, you need I73

>+>@ to buy ' unit of 9$0+ 7o you need to sell certain units of 9$0 (recei;ed by

selling I73) to buy ' unit of -93+ The "rice for buying ' unit of -93 is '+>** 9$0

(offer side)+ Therefore ho many I73 you need to s"end to buy '+>** 9$0F The

anser to this Huestion ould the "rice of buying ' unit of -93 in terms of I73+ We

identified the "rice of buying ' unit of 9$0 as +>@+ Therefore "rice of buying '+>**

units of 9$0 ould be '+>** . +>@ I73 i+e+ >+A%'? I73+ Therefore the "rice of

buying ' unit of -93 in terms of I73 is >+A%'? I73+

$imilarly you could use the logic for selling 'unit of -93 and deri;e its "rice in term of

I73+ The "rice comes to >+?@A ('+>*' . +>?)+

Therefore the cross rate for -93 I73 ould be >+?@A >+A%'?+

.7.2 GBPINR

The underlying currency "airs are 8BP9$0 and 9$0I73+ ssume 8BP9$0 "rice as'+%@& '+%@> and 9$0 I73 as +>? >@, the "rice for 8BP I73 orks out to be

A%+%@*& A%+>%+ 6ou should identify the = con;ersion "ath and a""ro"riate "rice

le;els to arri;e at the abo;e cross rate+

.7.3 JPYINR

=or :P6I73, the market con;ention is to Huote "rice of '&& :P6 in terms of I73+ In all

other "airs mentioned abo;e, the con;ention is "rice of ' unit of base currency in terms

of Huotation currency+ The com"utation of :P6I73 from 9$0:P6 and 9$0I73 is

slightly different from the com"utation of 8BPI73 or -93I73+ We ill describe belothe com"utation of :P6I73 from 9$0:P6 and 9$0I73+ ssume 9$0:P6 "rice as

?>+>* ?>+>A and 9$0 I73 as +>? +>@+

4et us start the com"utation of cross rate, using the buy side argument i+e+ "rice of buying

'&& :P6 in terms of I73+ s understood from underlying currency "airs, the "rice of :P6

is directly a;ailable only in terms of 9$0+ Therefore you need to sell I73 to buy 9$0

and further sell the 9$0 to buy :P6+ It is im"ortant to identify this = con;ersion "ath of

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selling one currency and buying another to calculate the cross rate+ 7o e need to use

a""ro"riate "rices (bid "rice ;ersus offer "rice) of underlying currency "airs+

%&

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To buy ' unit of 9$0, the a""licable "rice is +>@ I73 (offer side) i+e+, you need I73

>+>@ to buy ' unit of 9$0+ 7o you need to sell one unit of 9$0 (recei;ed by selling

I73) and buy :P6+ The "rice for selling one unit of 9$0 is ?>+>* (bid side)+ Therefore

you get ?>+>* :P6 by s"ending +>@ I73+ Thus "rice of buying ':P6 is +>@ ?>+>* i+e+

&+*>%* I73 or in other ords "rice of buying '&& :P6 is *>+%* I73+ $imilarly, "rice of

selling ' :P6 is +>? ?>+>A i+e+ &+*>%> or in other ords "rice of selling '&& :P6 is

*>+%> I73+

Thus "rice of :P6I73 (for '&& :P6) ould be *>+%> *>+%* I73+

In the abo;e e.am"les, e ha;e elaborated com"uting cross rates using underlying rates+

$imilarly you could use one underlying rate and cross rate to calculate the other

underlying rate+ =or e.am"le, using -93I73 and 9$0I73 rate, -939$0 rate could be

calculated+

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To assess the im"act of economic factors on the currency market, it is im"ortant to

understand the key economic conce"ts, key data releases, their inter"retation and im"act

on market+

The analytical tools of foreigne.change market are the same as that of stock market/

fundamental analysis and technical analysis+ The underlying assum"tion of use of technical analysis in = is same as that of stock market/ "rice is assumed to ha;e

ca"tured all nes and a;ailable information and the charts are the ob#ects of analysis+

oe;er, ith res"ect to fundamental analysis, unlike com"anies countries do not ha;e a

balance sheet do not ha;e earnings re"ort etc+ Therefore ho can fundamental analysis

be conducted on a currencyF

$ince fundamental analysis is all about looking at the intrinsic ;alue of an in;estment, its

a""lication in = means analysis of the economic conditions of the country that may

affect the ;alue of its currency+ $ince currency market is a globalised market and the

;alue of currency is alays determined against another currency, therefore fundamental

analysis in = market also means analysis of economic conditions in other ma#or

countries of the orld+ :ust like stock market has key indicators like "rice earning

multi"le, re;enue groth, "rofit groth etc to analyse a basket of stocks or a "articular

stock, = market also has key indicators used by analysts in assessing the ;alue of a

currency "air+ These indicator are released at scheduled times, "ro;iding the market ith

an indication of hether a nationUs economy has im"ro;ed or declined+ The effects of

these indicators are com"arable to ho indicators affect stock "rices+ dditionally, #ust

like the stock market, any de;iation in the reading of the key economic indicator from the

e."ected number can cause large "rice and ;olume mo;ements in currency market also+

The inter"retation of changing ;alues of economic indicators on currency ;alue could be

difficult+ It cannot be said ith certainty that an indicator shoing healthy economic

health of the country ould mean strengthening of the currency of that country+ The e.act

im"act ould be a function of relati;e health of other economies, global risk a""etite

among in;estors and market e."ectation+ =or e.am"le, during global financial crisis of

%&&? and %&&@, 9$0 strengthened against all ma#or currencies like -93, 8BP and :P6+

This as des"ite 9$ running record high fiscal deficit and its economy not doing ell+

$ome of the im"ortant economic factors that ha;e direct im"act on currency markets are

inflation, balance of "ayment "osition of the country, trade deficit, fiscal deficit, 80P

groth, "olicies "ertaining to ca"ital flos and interest rate scenario+

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E4*94 9*694(8&

8i;en belo are key economic indicators and their im"act on currency market+

G&& D&894 P6+48 $GDP%

80P re"resents the total market ;alue of all goods and ser;ices "roduced in a country

during a gi;en year+ 80P groth rate higher than e."ected may mean relati;e

strengthening of the currency of that country, assuming e;erything else remaining the

same+

R8(9/ S(/&

It is a leading indicator and it "ro;ides early guidance on the health of the economy+ The

retailsales re"ort measures the total recei"ts of all retail stores in a gi;en country+ This

measurement is deri;ed from a di;erse sam"le of retail stores throughout a nation+ The

re"ort is "articularly useful because it is a timely indicator of broad consumer s"ending

"atterns that is ad#usted for seasonal ;ariables+ It can be used to "redict the "erformance

of more im"ortant lagging indicators, and to assess the immediate direction of an

economy+ retail sales number higher than e."ected may mean relati;e strengthening of

the currency of that country+

I*6+&89(/ P6+489*

The Inde. of Industrial Production (IIP) shos the changes in the "roduction in the

industrial sector of an economy in a gi;en "eriod of time, in com"arison ith a fi.ed

reference "oint in the "ast+ In India, the fi.ed reference "oint is '@@>@ and the IIPnumbers are re"orted using '@@>@ as the base year for com"arison+ healthy IIP

number indicates industrial groth and hich could result in relati;e strengthening of the

currency of that country+

C*&+ P94 I*6 $CPI%

CPI is a statistical timeseries measure of a eighted a;erage of "rices of a s"ecified set

of goods and ser;ices "urchased by consumers+ It is a "rice inde. that tracks the "rices of

a s"ecified basket of consumer goods and ser;ices "ro;iding a measure of inflation+CPI is

a fi.ed Huantity "rice inde. and considered by some a cost of li;ing inde.+ rising CPI

means a rising "rices for goods and ser;ices and is an early indicator of inflation+ssessing the im"act of CPI on ;alue of currency is difficult+ If rising CPI means likely

increase in interest rate by the central bank, the currency may strengthen in the short term

but may start eakening in the long run as rising inflation and rising interest may start

hurting the groth of the economy+

N*(


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7onfarm "ayrolls re"resent the number of #obs added or lost in the economy o;er the last

month, not including #obs relating to the farming industry, go;ernment #obs, household

#obs and em"loyees of non"rofit organisation that "ro;ide assistance to indi;iduals+ The

data is released monthly by the 9nited $tates 0e"artment of 4abor+=or 9$ market, 7=P

is an im"ortant leading indicator on the health of economy+ rising and "ositi;e number

means that the economy is adding #obs and is good for the currency+ In general, in non

recessionary times, 7=P number ranges beteen '&,&&& to %*&,&&&+

C*8(/ (*, 89*1& (*6 , 649&9*&

Market also tracks minutes of the central bank meetings and the key "olicy decisions+

$ome of the im"ortant announcements from central bank meetings are their interest rate

decisions, C33 (cash reser;e ratio) D+ Market also acti;ely looks forard to central

bank!s "ers"ecti;e on state of the economy+

In 9$, The =ederal 2"en Market Committee (=2MC), a com"onent of the =ederal

3eser;e $ystem, is res"onsible for making key decisions about interest rates and the

groth of the money su""ly+ Currency market acti;ely looks forard to =2MC meeting

minutes and its "ers"ecti;e on the interest rate+

It is im"ortant to kee" in mind, hoe;er, that the indicators discussed belo are not the

only ones that affect a currencyUs "rice+ There are third"arty re"orts, technical factors and

local demand su""ly situation that also can influence currency "rice+ It is suggested that

you kee" track of all the im"ortant economic indicators and be aare hich indicators

are getting most of the attention of market any gi;en "oint in time+ =or e.am"le,

sometimes market ill gi;e lot of im"ortance of crude "rice and commodity "rices hile

at other times may not gi;e too much im"ortance to it and rather focus on em"loyment

numbers and interest rate situation+

8i;en belo are some suggestions that may hel" you hen conducting fundamental

analysis in the foreign e.change market/

'+ 5ee" an economic calendar on hand that lists the indicators and hen they are

due to be released+

%+ 5ee" an eye on the data release e."ected in ne.t fe days often markets ill

mo;e in antici"ation of a certain indicator or re"ort due to be released at a later

time+

>+ 5no the market e."ectations for the data, and then "ay attention to hether or

not the e."ectations are met+ That is far more im"ortant than the data itself+

2ccasionally, there is a drastic difference beteen the e."ectations and actual

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results and, if there is, be aare of the "ossible #ustifications for this difference+

+ Take some time to analy


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F91* E4)(*1 D9@(89@&

2. D9@(89@& - D9*989*

0eri;ati;e is a "roduct hose ;alue is deri;ed from the ;alue of one or more basic

;ariables, called bases (underlying asset, inde., or reference rate)+ The underlying assetcan be eHuity, foreign e.change, commodity or any other asset+ =or e.am"le, heat

farmers may ish to sell their har;est at a future date to eliminate the risk of a change in

"rices by that date+ $uch a transaction is an e.am"le of a deri;ati;e+ The "rice of this

deri;ati;e is dri;en by the s"ot "rice of heat hich is the underlying+

0eri;ati;e "roducts initially emerged as hedging de;ices against fluctuations in

commodity "rices, and commodity linked deri;ati;es remained the sole form of such

"roducts for almost three hundred years+ =inancial deri;ati;es came into s"otlight in the

"ost '@A& "eriod due to groing instability in the financial markets+ oe;er, since their

emergence, these "roducts ha;e become ;ery "o"ular and by '@@&s, they accounted for about to thirds of total transactions in deri;ati;e "roducts+ In recent years, the market

for financial deri;ati;es has gron tremendously in terms of ;ariety of instruments

a;ailable, their com"le.ity and also turno;er+

In the Indian conte.t the $ecurities Contracts (3egulation) ct, '@* N$C(3)O defines

deri;ati;e to include

'+ security deri;ed from a debt instrument, share, loan hether secured or

unsecured, risk instrument or contract for differences or any other form of

security+

%+ contract hich deri;es its ;alue from the "rices, or inde. of "rices, of

underlying securities+

0eri;ati;es are securities under the $C(3) and hence the trading of deri;ati;es is

go;erned by the regulatory frameork under the $C(3)+

The term deri;ati;e has also been defined in section *9(a) of the 3BI act as follos/

n instrument, to be settled at a future date, hose ;alue is deri;ed from change in

interest rate, foreign e.change rate, credit rating or credit inde., "rice of securities (also

called JunderlyingK), or a combination of more than one of them and includes interest

rate sa"s, forard rate agreements, foreign currency sa"s, foreign currencyru"ee

sa"s, foreign currency o"tions, foreign currencyru"ee o"tions or such other

instruments as may be s"ecified by 3BI from time to time+

D9@(89@


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Though deri;ati;es can be classified based on the underlying asset class (such as fore.

deri;ati;es, eHuity deri;ati;es, etc), it is more useful to classify them based on cash flo

"attern into four JgenericJ ty"es of forard, futures, o"tion and sa"+ We take a brief

look at ;arious deri;ati;es contracts that ha;e come to be used+

F?(6&: forard contract is a customi


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+ 0e;elo"ment of more so"histicated risk management tools, "ro;iding a ider choice

of risk management strategies, and

*+ Inno;ations in the deri;ati;es markets, hich o"timally combine the risks and returns

o;er a large number of financial assets, leading to higher returns, reduced risk and

loer transactions costs as com"ared to indi;idual financial assets+

2.! M(,8


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markets+

*+ n im"ortant incidental benefit that flos from deri;ati;es trading is that it acts

as a catalyst for ne entre"reneurial acti;ity+ The deri;ati;es ha;e a history of

attracting many bright, creati;e, elleducated "eo"le ith an entre"reneurial

attitude+ They often energi


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3. C+*4 +8+& - D9*989*

futures contract is a standardi


36/46

threemonth u" to tel;emonth e."iry cycles+ ence, these e.changes ill ha;e

'% contracts outstanding at any gi;en "oint in time+

Value Date/Final Settlement Date: The last business day of the month ill be

termed as the Value date =inal $ettlement date of each contract+ The last business

day ould be taken to be the same as that for Interbank $ettlements in Mumbai+The rules for Interbank $ettlements, including those for knon holidays! and

subseHuently declared holiday! ould be those as laid don by =oreign

-.change 0ealers! ssociation of India (=-0I)+

• Expiry date: lso called 4ast Trading 0ay, it is the day on hich trading ceases

in the contract and is to orking days "rior to the final settlement date+

• Contract size: The amount of asset that has to be deli;ered under one contract+

lso called as lot si


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ith or ithout drift, hile real e.change rates o;er long run are mean re;erting+ s

such, it is "ossible that o;er a long E run, the incenti;e to hedge currency risk may not be

large+ oe;er, financial "lanning hori


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3.! D9&89*489* 8?* +8+& (*6 ?(6 4*8(48&

=orard contracts are often confused ith futures contracts+ The confusion is "rimarily

because both ser;e essentially the same economic functions of allocating risk in the

"robability of future "rice uncertainty+ oe;er futures ha;e some distinct ad;antages

o;er forard contracts as they eliminate counter"arty risk and offer more liHuidity and "rice trans"arency+ oe;er, it should be noted that forards en#oy the benefit of being

customi


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4et us assume that risk free interest rate for one year de"osit in India is AD and in 9$ it

is >D+ 6ou as smart trader in;estor ill raise money from 9$ and de"loy it in India

and try to ca"ture the arbitrage of D+ 6ou could continue to do so and make this

transaction as a non ending money making machine+ 4ife is not that sim"leG nd such

arbitrages do not e.ist for ;ery long+

We ill carry out the abo;e transaction through an e.am"le to e."lain the conce"t of

interest rate "arity and deri;ation of future "rices hich ensure that arbitrage does not

e.ist+

A&&+D and agree to return

'+&> 9$0 after one year (including interest of > cents)+ This ' 9$0 is con;erted into I73

at the "re;ailing s"ot rate of *&+ 6ou de"osit the resulting I73 *& for one year at interest

rate of AD+ t the end of one year, you recei;e I73 >+* (AD of *&) as interest on your

de"osit and also get back your "rinci"al of I73 *& i+e+, you recei;e a total of I73 *>+*+6ou need to use these "roceeds to re"ay the loan taken in 9$+

To im"ortant things to think before e "roceed/

• The loan taken in 9$ as in 9$0 and currently you ha;e I73+ Therefore you need

to con;ert I73 into 9$0

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• What e.change rate do you use to con;ert I73 into 9$0F

t the beginning of the transaction, you ould lock the con;ersion rate of I73 into 9$0

using one year future "rice of 9$0I73+ To ensure that the transaction does not result into

any risk free "rofit, the money hich you recei;e in India after one year should be eHual

to the loan amount that you ha;e to "ay in 9$+ We ill con;ert the abo;e argument intoa formula/

$('3 I73 )L =('3 9$0)

2r, = $ L ('3 I73 ) ('3 9$0)

nother ay to illustrate the conce"t is to think that the I73 *>+* recei;ed after one year

in India should be eHual to 9$0 '+&> hen con;erted using one year future e.change

rate+

Therefore,

= *& L ('+&A)

('+&>) =L *'+@'A

""ro.imately, = is eHual to the interest rate difference beteen to currencies i+e+, =

L $ (3 I73 3 9$0)X$

This conce"t of difference beteen future e.change rate and s"ot e.change rate being

a""ro.imately eHual to the difference in domestic and foreign interest rate is called the

JInterest rate "arityK+ lternati;e ay to e."lain, interest rate "arity says that the s"ot "rice and futures "rice of a currency "air incor"orates any interest rate differentials

beteen the to currencies assuming there are no transaction costs or ta.es+

more accurate formula for calculating, the arbitragefree forard "rice is as follos+

= L $ Y (' 3 QC Y Period) (' 3 BC Y Period)

Where

= L forard

"rice $ L s"ot "rice

3 BC L interest rate on base currency

3 QC L interest rate on Huoting currency

Period L forard "eriod in years

=or a Huick estimate of forard "remium, folloing formula mentioned abo;e for

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9$0I73 currency "air could be used+ The formula is generali+&D) and I73 interest rate are e."ected to remain constant say

at AD a trader ould initiate a short "osition in 9$0I73 futures market+

Illustration/

$u""ose month interest rate in India is *D (or '&D "er annum) and in 9$ are 'D (%D

"er annum)+ The current 9$0I73 s"ot rate is *&+ What is the likely month 9$0I73

futures "riceF

s e."lained abo;e, as "er interest rate "arity, future rate is eHual to the interest rate

differential beteen to currency "airs+ Therefore a""ro.imately month future rate

ould be/

$"ot month interest difference L *& D of

*& L *& % L

*%

The e.act rate could be calculated using the formula mentioned abo;e and the anser

comes to *'+@?+

*'+@? L *& . ('&+''% . ) ('&+&%'% . )

S8(819& U&9*1 C+*4 F+8+&

The ob#ecti;e of different market "artici"ants hile using currency futures and

calculation of "rofit loss under different market scenarios+

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M(,8 months+ 0uring the > month credit "eriod, shoe e."orter is

carrying the risk of -93I73 "rice mo;ement+ e is interested to hedge the currency

"rice risk+ In this e.am"le, the shoe e."orter is a hedger+

S


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This set of market "artici"ants identify mis"ricing in the market and use it for making

"rofit+ They ha;e neither e."osure to risk and nor do they take the risk+ rbitrageurs lock

in a "rofit by simultaneously entering o""osite side transactions in to or more markets+

=or e.am"le, if the relation beteen forard "rices and futures "rices differs, it gi;es rise

to arbitrage o""ortunities+ 0ifference in the eHuilibrium "rices determined by the demand

and su""ly at to different markets also gi;es o""ortunities to arbitrage+ s more and

more market "layers ill reali& "aisa "remium to s"ot Z *+'& hile at the same time one month

currency futures is trading Z 3s+ *+%*+ n acti;e arbitrager reali


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C


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The "a"er shos that the current debate on the reform of the International Monetary$ystem is dealing mainly ith sym"toms but not ith the fundamental "roblems+ The

strong increase of foreign e.change reser;es, the still hegemonic role of the dollar and

destabili


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