The foreign exchange market is a global marketplace in which banks, non-financial corporations, governments, and institutional investors trade currencies around the clock. It is one of the most extensive financial markets in the world. It is an over-the-counter market, meaning deals1 are made directly between market participants instead of deals made on an exchange.
The term ‘foreign exchange’ can have two related meanings:
1. A transaction for the exchange of one currency for another; and
2. Any currency other than domestic currency.
Key Features of the FX market
- Approximately USD 7 trillion equivalent is estimated to be traded every day. This huge trading volume results in a highly liquid market.
- The high volumes, geographical dispersion, and range of factors influencing movements in FX rates result in highly volatile prices.
- Due to the number of participants and size of the market, profit margins are shallow on any individual transaction.
- It is increasingly technological, and while the telephone is still used, most prices are posted, and deals are struck using electronic media.
- There is no physical marketplace or exchange for foreign currency.
- The foreign exchange markets are dominated by traders who take speculative positions, effectively a ‘bet’ on the strengthening or weakening of particular currencies. The traders may work for a bank or for institutions such as hedge funds.
- With trade becoming more global, there is an increasing business need to buy and sell currencies in to order to make foreign currency payments or convert foreign currency receipts. However, the volume of corporate hedging activity (i.e., exchange of currency flows associated with firms’ businesses) is comparatively small.
- The foreign exchange markets facilitate the movement of capital around the world.
Users of the FX Market
Inter-bank participants, e.g., commercial and investment banks
- Commercial companies
- Central banks
- Investment management firms, including
- Pension funds
- Insurance companies
- Hedge funds
- Individuals
Large commercial banks such as Deutsche Bank, Barclays Capital, UBS, and Citibank make the bulk of FX deals. They facilitate the trading and investment activities of their corporate and institutional clients by standing ready to lend or exchange a wide range of currencies and making markets in currencies amongst themselves. The vast majority of foreign exchange transactions are traded in London (around a third of all trades); the next largest market is the US, where around 18-20% of transactions occur.
Traditionally, flows of money between currencies are primarily determined by:
- Import and export transactions.
- Institutional investors such as pension funds and insurance companies invest in securities such as shares and bonds denominated in foreign currencies.
- International corporations make direct investments in their foreign subsidiaries.
- Repatriating funds or completing cross-border takeovers of foreign companies.
As currency restrictions were gradually lifted in the later part of the 20th century, speculative currency trading (i.e., buying and selling currencies to profit from such transactions alone) began to assume increasing importance and now accounts for up to 90% of daily volume.
The Central Banks
In the major developed economies such as the US, Eurozone, UK, Japan, and a few leading Asian economies like India, there is no official exchange rate, and the national currency usually floats freely against other currencies. In this context, the central bank plays two leading roles:
- It supervises the market within its jurisdiction.
- It maintains control over the supply of money and domestic interest rates, which will influence the currency’s attractiveness to foreign investors.
The central bank may seek to smooth out fluctuations in currency movements by buying and selling currency in the markets, often working together with other central banks worldwide. The central bank fixes official exchange rates in countries with exchange controls. It may also act as the central counterparty in all FX transactions.
Market Participants in Forex Market
There are three types of participants in the foreign exchange markets:
Market Makers
Banks that maintain a firm bid and offer price in a given currency pair by standing ready, willing, and able to buy or sell at these quoted prices are market makers (they make a market, and when they quote, they “make” a price). Market makers display bids and offer prices for specific currency pairs; if these prices are met, they must immediately buy for or sell from their accounts. Market makers are crucial for maintaining liquidity and market efficiency for the currencies that they make markets in. The essential characteristic of a liquid market (i.e., a market in which it is easy and cheap to transact) is that there are always ready and willing buyers and sellers.
Market Takers
All other participants are market takers3. They don’t set prices and have to transact at the best price they can find amongst market makers. Market takers may be:
- Corporates
- Non-bank financial institutions, including hedge funds and asset managers
- Market makers wishing to correct an unforeseen surplus or shortfall quickly
- Smaller banks who are either not market makers or who need to trade currencies outside their areas of specialist expertise
Brokers
Brokers act on behalf of clients, introducing currency buyers and sellers and taking a commission for their services (i.e., brokerage). They do not enter into deals in their own right (i.e., as principals). Electronic dealing platforms, where available, have primarily made brokers obsolete in the FX market.
Dealing Methods
Corporations gain access to the FX market via their banks. A foreign exchange facility (or “line”) is usually established with various credit limits. Without a line, the bank will not trade. Even if electronic dealing solutions are available, most corporates will maintain telephone contact with their banks’ corporate dealing desks because most companies wish to collect intelligence on the market. The bank may also offer more favorable rates for specific customers or deal sizes not apparent on screen. However, most medium to large companies now transacts most deals using web-based portals.
These have the following advantages:
- There is almost no opportunity for misunderstanding or inappropriate deal pricing.
- Confirmation is immediate.
- Multi-bank portals give competitive pricing, i.e., quotes from more than one bank.
- They facilitate straight-through processing.
Regardless of the dealing system, once two parties have agreed on terms (currency pair, who buys which currency and who sells which currency, exchange rate, and settlement date), both are committed to the transaction, both by market convention and in major currency centers by law (“a trade is a trade”). Hard copies or electronic confirmations are exchanged between the parties to confirm their understanding of the deal (particularly important for phone-based dealing, where voice recording of phone dealing is commonplace), preferably before settlement.
Traded Currencies
Currency markets can be classified by the ease with which the currency can be bought and sold or borrowed or lent (i.e., its degree of liquidity). “Liquid” currencies are freely traded, ‘open’ or fully convertible, and have no Government restrictions. “Illiquid” currencies are subject to exchange controls; there is limited demand for them, or their market is still developing, making them less liquid.
Traditionally, most currencies are quoted against the dollar, and most transactions still involve the dollar as one of the traded currencies (although increasingly, currencies are also being quoted against the euro). If a customer wants to exchange two currencies, neither of which is the USD, they must enter into a ‘cross currency deal’.
Some cross-currency deals might be quoted directly (for example, GBP/EUR, EUR/JPY, EUR/CHF). However, many cross-currency deals involve two USD deals for the bank. For example, a transaction to sell GBP in exchange for Singapore dollars (SGD) would involve the bank in two transactions, one to sell GBP in exchange for USD and the second to sell USD in exchange for SGD. The bank, behind the scenes, would carry out the two transactions and offer the customer a single price for the cross-currency deal.
The corporate selling GBP in exchange for SGD from the bank sees and executes only one deal.
Currency Codes
A standard code identifies each traded currency (a ‘SWIFT currency code’ but defined by ISO4217). Some examples are listed below.
| Australian Dollar | AUD | Japanese Yen | JPY |
| Canadian Dollar | CAD | Malaysian Ringgit | MYR |
| Chinese Renminbi | CNY | New Zealand Dollar | NZD |
| Danish Krona | DKK | Singaporean Dollar | SGD |
| EURO | EUR | British Pound (Sterling) | GBP |
| Hong Kong Dollar | HKD | Swiss Franc | CHF |
| Indian Rupee | INR | US Dollar | USD |
Generally, the first two letters refer to the country, and the third to the currency. For example, GBP refers to Great Britain and the Pound.
Foreign Exchange Quotations
A foreign exchange rate is quoted as one unit of fixed currency equal to a variable amount of another currency for delivery on the value date. All quotations are made up of two currencies: the ‘fixed’ or ‘base’ currency, which is always shown first on the left, and the ‘variable’ currency, which is always shown on the right. A quotation shows 1 unit of the fixed / base currency compared to many units of the variable currency.
Example 1: Spot quote
What does the USD/INR rate of 81.2500 mean?
| Rate | Fixed / Base | Variable | |
| US Dollar / Indian Rupee (USD/INR) | 81.2500 | 1 USD | 81.2500 INR |
The fixed currency, the US dollar, is the ‘base’ currency. The variable currency, Indian Rupee, is the ‘variable’ currency. Therefore, USD/INR 81.2500 means that USD 1 is the equivalent of INR 81.2500.
Buying and Selling Foreign Currency
Informational rates are shown as a single rate (at the mid-point), but in reality, when dealing with a market-maker (usually a bank) will quote two prices:
- a price for buying the base currency (bid price) and
- a price for selling the base currency (the asking price or offer price).
| USD/INR | Bid Price | Offer Price |
| 81.4500 | 81.4550 | |
| The market maker (bank) buys the base currency | The market maker (bank) sells the base currency | |
| The market taker (customer) sells the base currency | The market taker (customer) buys the base currency | |
| The market maker (bank) sells the variable currency | The market maker (bank) buys the variable currency | |
| The market taker (customer) buys the variable currency | The market taker (customer) sells the variable currency |
The bank and the customer are on opposite sides of a transaction. If the bank sells a currency, then the customer buys that currency. For example, if a bank buys INR and sells USD, the customer must be selling INR and buying USD. The bank is the price maker, and the customer is the price taker.
Example 2: Buying Currency
Say the bank quotes USD/INR at 81.7925 – 81.7950 (this type of quote is a two-way price). The base currency is the US dollar because it is set first in the currency pair.
So the bank’s two-way prices are to:
- buy USD 1.00 and sell INR 81.7925 and to
- sell USD 1.00 and buy AUD 81.7950
And a customer can:
- sell USD 1.00 and buy INR 81.7925 and to
- buy USD 1.00 and sell INR 81.7950.
We can generalize the above result: the bank always “buys the base” at the bid (lower) rate (“low”) and “sells the base” at the higher rate (“high”).
In other words: The bank will deal at the rate that is more favorable to itself.
The guiding rule is that the bank customer will always receive the least amount for the currency when selling and pay the highest amount when buying.
How foreign exchange rates are quoted?
Rates are often quoted in an abbreviated fashion rather than spelled out in full.
For example:
USD/INR 81.2750 – 75
The first component (before the dash) refers to the bid price (what the customer will obtain in INR when they sell USD to the bank), and in this case, includes four digits after the decimal point.
The second component (after the dash) is used to obtain the offer price (what the customer has to pay in INR if they buy USD from the bank). The offer price is obtained by increasing the first component until the last two digits are equal to the digits in the second component.
In this example, the bid price of 81.2750 is increased until the final 2 digits are 75 giving an offer price of 1.2775.
As another example: GBP/USD 1.2500 – 25
This refers to a bid price of 1.2500. To get to the offer price, the bid price must be increased until the last 2 digits are 25 – giving an offer price of 1.2525.
In the spot quote, the RHS number will always be larger than the LHS number.
The FX market is very fast-moving, and prices change even as they are made by the market maker, whether by electronic methods or over the telephone. Web-based portals have a set time for which the price is valid. While full prices are shown in web-based or proprietary dealing systems, the telephone language has developed to speed up the dealing process, and dealers may quote only the spread (referred to as the points or pips). It is assumed that participants in the market will know what the ‘big figure’ (usually the first three or four digits) is.
Given a rate: of USD/INR 81.1125 – 81.1175
Big figure = 81.11 (‘handle’ in US parlance)
Points = 25-75. These are the figures that will be quoted
The difference between the two rates, i.e., the spread, is the compensation to the bank for making the market. In highly traded currencies, the spread will be quite narrow. The spread will be wider in lightly traded currencies or in the case of market disruption, where the bank accepts more risk.
Spot Foreign Exchange Rates
A spot transaction is an FX transaction made now (the deal or trade date) for settlement on the spot date (the value date or maturity date). The exchange rate applied is known as the spot rate. The trade details – the currencies exchanged, who buys and sells which currency, amounts, exchange rate, and payment information – are agreed upon by the counterparties on the deal date, and the two currencies are exchanged on the spot date.
The general definition of the spot date is the second working day following the deal date (i.e., deal on day T, settle on day T+2), except for a few currencies where a settlement could be T+1 day also.
Alternatively, a forward transaction is for settlement at an agreed date later than the spot date—the spot rate (price) in freely floating currencies results from supply and demand.
Identifying the Spot Date
The spot date was defined as typically two working days after the spot transaction is agreed upon. If today, the trade date, is day T, the next working day is T+1, and the second working day is T+2. However, the ‘second working day’ definition calls for some care.
For a deal to be completed, the dealing centers for both currencies involved in the exchange must be open on the spot date. If either is closed, the spot value date moves forward to the next working day when they are both open.
If the T+1 date is a holiday, then this causes the deal to roll forward one day.
In some deals, ‘split delivery’ may be followed by express agreement or local practice (e.g., for Islamic countries where the Islamic weekend covers Thursday afternoon and Friday). Split delivery involves settling the two currencies on different dates (e.g., USD against an Islamic currency dealt on a Wednesday may settle USD on Friday and the Islamic currency on Saturday).
Holiday logic can be complex and, with the extension of dealing capability and internationalization of banks, also increasingly blurred. Holidays depend not only on date and currency but also on the dealing center and possibly counterparty.
Due to these complexities, dealing and value dates for all material or unusual FX deals should be confirmed with counterparties well in advance.
Forward Foreign Exchange Market
The foreign exchange market is a global, technology-based marketplace in which banks, corporations, governments, and institutional investors trade currencies around the clock. Companies gain access to the FX market through their banks’ corporate dealing desks by telephone or proprietary or web-based portals. They can transact for spot settlement or at another time (today, tomorrow, or forward dates).
A spot transaction is an FX transaction entered into now (the deal or trade date) for settlement on the spot date (the value date or maturity date). The exchange rate applied is known as the spot rate. The spot is the default maturity for a foreign exchange contract. It is usually set two business days after the deal date, although there are some complicated rules to allow for public holidays.
A forward foreign exchange contract is, like a spot contract, an FX transaction entered into now (the deal or trade date) for settlement on a fixed date. The difference between a spot and a forward contract is that the settlement date is later than the spot date.
Forward FX rates differ from spot rates because the time value of money, i.e., cash receivable or payable today, is worth more than the same cash receivable or payable in the future. The difference in value is due to interest rates, and the effects of interest rates are adjusted when calculating the forward rate between two currencies. The international markets establish the interest rates in each currency for borrowing and lending currencies.
The forward price derives from the spot rate plus interest rate differentials and not directly from market expectations. Within stable markets, the forward rate is theoretically an unbiased predictor of the future spot rate, although there is a significant question about how often markets are ‘stable.’
Value Dates for Forward Foreign Exchange Transactions
The foreign exchange market quotes forward rates for dates at standard intervals (daily, weekly, and 1, 2, 3, 6, and 12 months) from the spot date. Most traded currencies have a liquid forward market of up to 12 months. A ‘long-dated forward market’ exists for actively-traded currencies of up to five years or more, but this is a very specialized market.
All forward dates are calculated from the spot date. For example, the 1-month forward date is calculated by taking the spot date and the numerically equivalent date in the next month. If this is a non-working day in either center, then the 1-month forward date moves on to the next working day.
Customers can, however, request any date for settlement to suit their requirements, and a date that does not fall precisely as weeks or months is called a “broken date.” The rates obtainable by corporate customers for such broken dates will be slightly less favorable than those for standard settlement dates but generally insufficient to merit trading for standard settlement dates with the resultant loss of hedge effectiveness.
Outright forward foreign exchange deals and foreign exchange swap transactions
Forward FX transactions may be conducted in two forms:
- Outright Forward FX Deals
- Foreign Exchange Swap Contracts
Outright Forward Foreign Exchange Deals
Outright forward purchases or sales involve only one transaction whereby two currencies are agreed for exchange at a contracted rate on a fixed future date. The two currencies are not exchanged until the value date is reached, but the rate is agreed on the trade date. Outright deals are commonly used by companies with known foreign currency cash flows that are payable or receivable on specific dates in the future. The company can enter into a contract with a bank that will lock it into a known exchange rate and eliminate the risk of losses resulting from adverse foreign exchange movements.
Of course, the contract must be honored even if the company could obtain a better rate in the spot market. The company surrenders any potential gains resulting from favorable movements in FX rates in return for certainty. For example, an Indian company might sell USD forward outright in exchange for INR if it anticipated receiving a USD payment from a customer.
Foreign Exchange Swaps
Foreign exchange swap contracts involve a combination of two contracts executed simultaneously. An FX swap is the exchange of one currency for another on one date (commonly spot) combined with a reverse exchange of the two currencies at a later date. For example, if a company has a shortfall of USD and a surplus of INR for a week, it could enter into the following agreement:
- Buy USD and sell INR for value spot,
- Simultaneously agree to sell USD and buy INR for value a week later.
Foreign Exchange Swaps should not be confused with Currency Swaps. A currency swap involves the conversion of a stream of multiple future cashflows in one currency into a stream of multiple future cashflows in another currency, typically over months or years. Foreign Exchange swaps are typically short-term and are limited to two transactions (or legs).
Swap contracts may also adjust (roll) an outright forward contract to an alternative date.
Currency Futures
A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future at a specified price. A currency futures contract, also called an FX future, is a type of financial futures contract where the underlying is an exchange rate. In other words, it is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) fixed on the last trading date. The buyer or seller in a futures market locks into an exchange rate for a specific value date or delivery date. In other words, currency futures are used primarily as a price-setting mechanism rather than for the physical exchange of currencies.
The future date is called the delivery date or final settlement date. The pre-set price is termed the future price, while the underlying asset’s price on the delivery date is termed the settlement price. The future price normally converges toward the spot price on the settlement date.
The futures contract gives the holder the right to buy or sell, in contrast to the option contract, which gives the holder the right, but not the obligation, to buy or sell the underlying. Thus, both parties of the futures contract must fulfill their contractual obligations on the settlement date. However, such contracts provide options to deliver the underlying asset or settle the difference in cash. The contract holder could exit from the commitment before the settlement date by either selling a long position or buying back a short position (offset or reverse trade). The futures contracts are exchange-traded derivatives, and the exchange’s clearing house acts as a counterparty to all contracts, sets margin requirements, etc.
Futures contracts are essentially traded through an exchange and are very liquid. The size and maturities of a futures contract are standardized. Marking to market outstanding positions at the end of each trading day is a special feature of futures markets. Initial and Minimum margins are to be maintained with the exchange by participants of the futures market. The futures exchange like NSE and BSE guarantees the settlement between various parties to the market; hence, counter-party risk is absent.
Margin Requirement in Currency Futures
The exchange assumes credit risk in the futures market. To minimize the credit risk to the exchange, traders must deposit margins, typically in the range of 3 percent to 15 percent of the contracts’ value. In Currency futures, the margin requirement is on the lower side, i.e., around 3%. It may vary with different currency pairs. USDINR requires less margin than other currency pairs like EURINR, GBPINR, and JPYINR.
Different margins might be required in currency futures, i.e., Initial Margin and Minimum Margin. The initial deposit, called the initial margin, is the amount a trader (buyer and seller) must deposit before trading in any future. This usually is approximately taken as the maximum daily price fluctuation permitted for the contract being traded.
The initial margin could be decided based on the underlying price volatility and is built into the system for daily mark-to-market. Whenever the position on the exchange shows a loss on the mark to market, the same is deducted from the deposited margin. When this drops below a threshold level called the maintenance margin, established by the exchange, a margin call is made to the trader to replenish the margin. Sometimes, an additional margin might be required as mandated by the clearing corporation and is usually termed an Exposure Margin.
Currency Futures Contract Specifications
The contract specifications of USDIINR Currency futures traded in Stock Exchanges of India are listed below:
Underlying
US dollar-Indian rupee (USDIINR) rate.
Trading Days
The Exchange operates on all days except Saturdays, Sundays, and Exchange-specified holidays. The Exchange notifies a list of holidays for each calendar year in advance.
Trading Hours
The trading on currency futures is from 9:00 a.m. to 5:00 p.m.
Size of the Contract
The minimum size of the currency futures contract is US$ 1,000. The contract size would be periodically aligned to ensure that the size of the contract remains close to the minimum size.
Quotation
The currency futures contract is quoted in rupee terms. However, the outstanding positions would be in dollar terms.
Tenure of the Contract
The currency futures contract shall have a maximum maturity of 12 months.
Available Contracts
All monthly maturities from 1 to 12 months are available.
Settlement Mechanism
The currency futures contract shall be settled in cash in the Indian rupee.
Settlement Price
The settlement price would be the RBI reference rate on the expiry date. The RBI may publicly disclose the methodology of computation and dissemination of the reference rate.
Final Settlement Day
A currency futures contract would expire on the month’s last working day (excluding Saturdays) in a monthly expiry contract. Whereas a currency futures contract would expire on Friday in a weekly expiry contract. In both cases, the contract will expire by 12’O clock, i.e., noon of the day. The last working day would be taken to be the same as that for Interbank Settlements in Mumbai.
The rules for Interbank Settlements, including those for known and subsequently declared holidays, would be those laid down by FEDAI.
Settlement Process in the Currency Exchanges
Settlement is done in cash mode payable in INR (Daily Marking to Market (MTM) settlement takes place based on the Daily Settlement Price (DSP), which is calculated by taking the weighted average of the last half an hour’s trades.
Everyday exchanges disseminate DSP on its website. Daily MTM or profit and loss are calculated by taking the difference between the trade price and DSP. If a client has. carried forward the position from the previous day, then MTM is calculated as the difference between the previous day’s DSP and the current day’s DSP. Clearing members with a net loss in daily MTM must pay the amount in cash. Clearing members with net profit will receive the amount in cash. Payment and receipts are to be settled based on T+1 day. Clearing members are responsible for the collection/payment of daily MTM from/to the trading members responsible for the client’s liabilities. All the net positions are carried forward to the next day after resetting the current DSP.
Final settlement is also done in cash mode in terms of INR. The final settlement price is the RBI reference rate on the last trading day of the expiry contract. The final profit and loss or MTM of all the net open positions of the clearing members will be based on the final settlement price. Settlement takes place based on T+2 days.
Determination of Daily Prices
During a trading session, the Currency Exchange continuously disseminates open, high, low, and last-traded prices through its trading system on a real-time basis. At the end of the day’s trading session, the currency exchange system calculates the closing price of each and every contract traded on the system.
The logic for calculating the closing price is as follows: The closing price is equal to the weighted average price of all the trades done during the last 30 minutes of a trading session. If the numbers of trades during the last 30 minutes are less than 5, then the closing price is based on the weighted average price of the last 5 trades executed during the day. If the numbers of trades during the day are less than 5, then the closing price is taken as the weighted average of all trades executed during the day. If no trades have been executed in a contract for the entire day, then the official closing price of the last session is taken as the official closing price. In such cases, if there is a high volatility of the underlying spot prices, the exchange will have the right to modify the closing price to mark to market and make the open positions closer to the market.
Determination of Settlement Price
The closing price or the daily settlement price of a futures contract is the weighted average price of all trades executed for that futures contract during the last half an hour of the trading session. The final settlement price for the currency futures contract is the RBI reference rate on the last trading day of the futures contract. Trading is allowed in the expiring contract only up to noon since the RBI reference rate is released every day between 12:00 p.m. and 12:30 p.m.
Delivery Process
All currency futures contracts are cash settled on the maturity date. Under the cash settlement system, a cash payment is made to the investor or collected from the investor for the difference between the contract price and the closing price on the maturity date.
Hedging Strategies Using Currency Futures
Hedging involves taking an opposite position in the futures market to offset any potential price risk in the cash segment. The objective behind this mechanism is to offset loss in one market with gain in the other. For example, if an exporter is likely to receive USD after three months, there is a risk of USD depreciation. To offset this risk, the exporter can hedge the USD receivables by selling USD in the forward or futures market. Alternatively, an importer with a risk of USD appreciation can take a long position in the forward or futures market.
Example: Risk Mitigation by an Importer
An edible oil refiner wants to import soya beans worth USD 100,000. The importer is exposed to the risk of INR depreciation against USD. This could potentially increase his import bill. The importer places an order on July 15, 20XY, with delivery and payment dates being three months ahead, in October 20XY. The spot rate at the time of booking the import in July is USD-INR 83.00. If INR depreciates by October, this can result in a loss for the importer. On the other hand, if the INR appreciates, this is favorable for the
importer. The uncertainty of the movement of the USD-INR is the extent of risk for the importer. The importer decides to hedge against USD-INR volatility using exchange-traded currency futures.
On July 15, 20XY:
- Oct USD-INR Futures is trading at 83.00
- Hedge Strategy: Buy 100 lots of Oct USDINR Futures contracts on July 15, 20XY@ 84.00
| Spot Rate
in Oct 20XY |
Profit / Loss on Exchange Traded Currency Futures (Amount in INR) | Profit/Loss in Cash Market on the exchange of USD for INR(Amount in INR) | Net Profit / Loss(Amount in INR) |
| 84 | (84-83) *1,000*100=100,000 | (83-84) *1,000*100=(100,000) | No Profit / No Loss1 |
| 82 | (82-83) *1,000*100= (100,000) | (83-82) *1,000*100=100,000 | Np profit / No Loss2 |
Note:
- Cash market loss is offset by profit in exchange-traded futures contracts.
- Cash market gain sets off loss realized in the exchange-traded futures contract.
Currency Options
Options give the buyer the right, not the obligation, to enter into a transaction, and they need only do so if it is in their interests. Thus an OTC currency option is the right, but not the obligation, to buy (a call option) or sell (a put option) a particular currency at a specified exchange rate on a future date. The ‘underlying’ is the forward rate.
The benefits of using currency options as opposed to fixing instruments are twofold. Firstly they protect against ‘downside’ risk whilst preserving the ‘upside’ potential of exposure. Secondly, they enable a firm to hedge currency risk when there is uncertainty regarding whether the foreign currency transaction will materialize, for example, where a corporate is tendering for a contract, and income or costs would be in a foreign currency (pre-transaction risk). Note that a firm can choose between several different strike prices depending on what ‘level’ of ‘insurance’ they require and what they are prepared to pay. The downside is the upfront cost of the premium payable irrespective of whether the option is exercised.
A currency option will be ‘At the Money’ if the strike price is the same as the current forward rate.
Option screen quotes will show 2 prices – the rate at which the bank will buy the relevant options from you and the (higher) rate at which you can buy them from the bank.
Example 2: Option Premium
The table shows option premia for EUR options at a strike price of EUR/USD 1.3000. The premia are quoted in $ per €1.0000:
| Maturity | EURO Call | EURO Put |
| 6 months | 0.008/0.010 | 0.03/0.005 |
| 12 months | 0.018/0.020 | 0.08/0.010 |
| 18 months | 0.027/0.030 | 0.012/0.015 |
| 24 months | 0.036/0.040 | 0.016/0.020 |
Question: If a USD-based corporate wants to hedge a €10,000 payment to one of its suppliers, what should it do?
Solution: The corporate needs to buy EUR (and sell USD). The corporate should buy a EUR call, i.e., the right to buy EUR.
Question: How much will the premium be to hedge a €10,000 payment in 6 months?
Solution: The corporate is buying the call, so the higher price applies. The premium will be €10,000 x 0.010 $/€ = $100
Question: If rates in 6 months,i.e., the spot rate has risen to EUR/USD 1.40, what will be:
i) the value of the option position alone, ii) the total $ cost of €10,000, and hence the worst-case hedged result? Ignore interest.
Solution: If the EUR/USD spot rate has risen, the USD has weakened against the EUR, so more USD will be needed to buy the EUR 10,000. Therefore the cost of buying EUR10,000 will have risen, and the option will be exercised at the more advantageous strike rate of EUR/USD 1.30.
i) The option’s value is the difference between the USD cost of EUR 10,000 at the spot versus the USD cost of EUR 10,000 under the option. That is, €10,000 x 1.40 – €10,000 x 1.30 = $1,000.00
ii) Time 0: Cost of premium = $100
- Time 6 mths: Cost of €10,000 under option = €10,000 x 1.30 = $13,000.
- Total cost of €10,000: $13,000 + $100 = $13,100.
- Giving a worst-case hedged result of 13,100 / 10,000 = EUR/USD 1.31
Hedging With Currency Options
Hedging with Collars
Options tend to be expensive unless the option strike is a long way “out of the money,” i.e., to the purchaser’s disadvantage. Cheap options often offer no more than disaster insurance. However, options can be combined into “collar” structures by offsetting the premium for buying protection against adverse movements in FX rates, with premiums received from selling back some advantages of favorable moves. Thus the premium income on the options sold partially or offsets the premium paid on the options purchased.
To construct an FX collar, one either buys a call and sells a put or buys a put and sells a call. The strike prices for the options bought and sold are set to construct a range over which the collar operates. Exhibit 1 shows the changed costs/savings profile of a collar compared with that of the unhedged exposure.
Suppose a EUR-based company wants to hedge an expected USD payment. To minimize the cost, it wants the USD/EUR rate to be as low as possible (so $1 costs as little EUR as possible). Say the current spot rate for USD/EUR is 0.6400. The company could enter into a collar by buying a USD call with a strike of 0.6550 and selling a USD put with a strike of 0.6275. If the USD/EUR rate rises above 0.6550, it will exercise the option to buy (call) USD from the bank at a rate of 0.6550. If the USD/EUR rate falls below 0.6275, the bank will exercise its option to put (sell) USD to the company at a rate of 0.6275. Between the two rates, the exposure is fully floating, giving the company some opportunity to benefit from reductions in the rate in return for a limit on its exposure to an increase in the rate. Collars can be constructed to provide reduced or even zero-cost option protection.
Application of Foreign Currency Options
Foreign currency options are commonly used to hedge foreign exchange risk for a future date.
Buyers of Foreign Currency Options use it :
- To protect (insure) their foreign currency exposures against adverse currency movements.
- To set a known worst-case exchange rate.
- To protect against uncertain or contingent foreign exchange exposures.
- To reduce the usage of credit facilities.
- As part of their foreign exchange risk management exposure tools strategy.
Sellers of Foreign Currency Options use it :
- To speculate on future currency movements.
- To generate cash flow through premiums.
- As a foreign exchange risk management technique to offset costs and exposures of bought options.
- To offset existing foreign currency positions.
Types of Currency Options
An option is, for its buyer, the right (but not the obligation) to buy or sell at a specific price at a certain future date and time. An option is similar to a forward deal, with the difference that they can subsequently decide whether or not to fulfill the deal. The Buyer of the Option pays the seller a “premium” up front to retain his right but not the obligation. The seller (or “writer”) should buy or sell the asset if the option owner exercises it. The contract will only be fulfilled if it is advantageous to the Buyer of the Option and consequently disadvantageous to the Seller (Writer) of the Option.
Buyers and sellers have asymmetric payout profiles. Given below are the different types of options that are in use:
Calls / Puts
- An FX Option is the right to exchange two currencies and, therefore, to buy and sell simultaneously.
- A USDGBP call gives the right to BUY USD/SELL GBP.
- A GBPUSD put gives the right to SELL GBP/BUY USD.
European / American
- A European option can be exercised only at expiry.
- An American option can be exercised at any time before or at expiry.
In the Money & Out of the Money
- A European-style 3-month USDJPY Call with strike 105.00 gives the purchaser the right, in three months, to buy US Dollars for 105.00 Yen per US Dollar.
- To buy this option, the option buyer has to pay the price, known as the premium, to the option seller.
- If the spot exchange rate at expiry is higher than 105.00, the option is ‘In-the-Money’, and the purchaser will exercise the Call Option.
- If the spot exchange rate at expiry is lower than 105.00, i.e., the option is ‘Out of -the Money,’ then the purchaser will not exercise the Call Option.
Hedging Using Currency Options
Since the holder of a Currency Option has the right but not the obligation to trade currency, it is beneficial to use options to hedge potential transactions. Banks in India cannot offer option products with no underlying exposures, and only European options are allowed. This restriction discourages the applicability of various options combinations. The option’s expiry date should not exceed the maturity of the underlying exposure. Corporations have to sign ISDA agreements with banks before undertaking option deals. Nonetheless, a market participant like a hedger, speculator, or arbitrageur can take a position in currency options at a recognized stock exchange offering currency derivatives trading like NSE or BSE in India. There is no need to hold a physical position in currency to trade in currency derivatives at an exchange.
Hedging through the Purchase of Options
XYZ Company,· an importer of raw material, buys a call option for USD 100,000 on August 1st, 20XY, for Delivery on December 20XY at a premium of Rs.0.05 to protect against adverse movement in rates
- Call Option for USD 100,000
- Spot rate today = Rs 81 per dollar
- Strike price (August 1st, 20XY) = Rs.81 at a premium of Rs 0.05/- per USDINR
- One lot of USDINR= 1,000 USD
- Total Lots purchased = 100 (USD 100,000/ USD 1,000)
- Total Premium Paid on buying USDINR Dec Call Option= Rs 5,000 (100 lots * Rs 50 premium per lot) on maturity in Dec 20XY
Scenario 1: If the spot price is Rs 81.50 in Dec 20XY
Since the strike price is less than the spot price, the call option will be exercised, and the profit will be Rs 45,000.
- Profit in Call Options: Rs 50,000 {(81.50-81.00)*USD 100,000}
- Less: Option Premium Paid: Rs 5,000
- Net Profit Realized: Rs 45,000 (Rs 50,000- Rs 5,000)
Scenario 2: If USDINR is 81 in Dec 20XY
Since the strike price is the same as the spot price in Dec 20XY, the call option would not be exercised and will go worthless. The maximum loss would be the premium paid, i.e., Rs 5,000
Scenario 3: if USDINR is 80 in Dec 20XY
Since the strike price is more than the spot price in Dec 20XY, the call option would not be exercised, and the call option would go worthless. The maximum loss would be the premium paid, i.e., Rs 5,000.