Nature of Forex Market

The Foreign Exchange Market is an over-the-counter (OTC) market, which means that there is no central exchange and clearing house where orders are matched. With different levels of access, currencies are traded in different market makers:

The Inter-bank Market - Large commercial banks trade with each other through the Electronic Brokerage System (EBS). Banks will make their quotes available in this market only to those banks with which they trade. This market is not directly accessible to retail traders. 

The Online Market Maker - Retail traders can access the FX market through online market makers that trade primarily out of the US and the UK. These market makers typically have a relationship with several banks on EBS; the larger the trading volume of the market maker, the more relationships it likely has.

Market Hours

Forex is a market that trades actively as long as there are banks open in one of the major financial centers of the world. This is effectively from the beginning of Monday morning in Tokyo until the afternoon of Friday in New York. In terms of GMT, the trading week occurs from Sunday night until Friday night, or roughly 5 days, 24 hours per day. 

Price Reporting Trading Volume

 

Unlike many other markets, there is no consolidated tape in Forex, and trading prices and volume are not reported. It is, indeed, possible for trades to occur simultaneously at different prices between different parties in the market. Good pricing through a market maker depends on that market maker being closely tied to the larger market. Pricing is usually relatively close between market makers, however, and the main difference between Forex and other markets is that there is no data on the volume that has been traded in any given time frame or at any given price. Open interest and even volume on currency futures can be used as a proxy, but they are by no means perfect

Fundamental Analysis

Fundamental analysis refers to the study of the core underlying elements that influence the economy of a particular entity. It is a method of study that attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors (to name just a few elements) within a business cycle framework. 

For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events. Therefore, it is best to get a handle on the most influential contributors to this diverse mix than it is to formulate a comprehensive list of all "The Forex Fundamentals."

• Economic indicators of the currency
• Government Monetary policy
• Employment indicators, especially unemployment
• Consumer spending indicators
• Interest rates
• Inflation
• Social and political forces
• Economic growth rates

Cross Currency Swaps

A Currency Swap is the best way to fully hedge a loan transaction as the terms can be structured to exactly mirror the underlying loan. It is also flexible in that it can be structured to fully hedge a fixed rate loan with a combined currency and interest rate hedge via a fixed-floating cross currency swap.

In a non-deliverable swap (NDS) there is no physical exchange of the two currency flows. Instead, the USD equivalent of the local currency payment (determined at the spot rate on the date of the payment) will be set against the opposite USD payment, with the net paid to the appropriate party.

NDSs are used to avoid transfer risk and to avoid the cost of local market exchange. MFX will contract primarily on an NDS basis.

There are three components in a Cross Currency Swap and the mechanics are as follows: (Opposite USD cash flows will be settled on a net basis.)

For an MIV lending in local currency:

• Initial exchange: The MIV makes the initial loan in local currency or in dollars which the MIV immediately exchanges for local currency.

• Periodic Exchanges: The MIV receives local currency repayments (or the USD equivalent) on its local currency loan and pays them to MFX while retaining its profit spread. In exchange it receives a dollar payment at the agreed LIBOR rate.

• Final Exchange: The MIV receives the principal repayment in local currency (or USD equivalent) and pays it to MFX. MFX pays the MIV the dollar amount calculated at the initial exchange rate for the start of the contract.

For an MFI hedging hard currency exposure:

• Initial Exchange: The MFI exchanges the principal of the loan in hard currency for a local currency principal amount with MFX. The exchange of principal is done at market rates i.e. the spot rate as of the effective date of the swap.

• Periodic Exchanges: Over the life of the loan, the MFI makes interest payments on the local currency principal amount to MFX, and in exchange receives the interest amounts due on the hard currency loan.

• Final Exchange: At maturity, the MFI repays the principal amount in local currency to MFX and in turn receives the hard currency principal amount owed to its lender at the same exchange rate that is used for the principal at the inception of the swap.

Pricing: For a floating-floating currency swap where only the exchange rate is hedged, a market exchange rate (typically, the spot rate as of the effective date of the swap) is used to convert the payment amounts of the local currency into the target currency. The same exchange rate is used for the final principal exchange in the swap.

Interest rate swap terms (fixed for floating) are set so market participants are indifferent between paying (receiving) this fixed rate over time or paying (receiving) a rate that can fluctuate over time. Therefore at origination, the value of the swap equals zero and the present value of the two (expected) cash flow streams equal each other.

Currency SWAP

A currency swap is an agreement between two parties to exchange the principal loan amount and interest applicable on it in one currency with the principal and interest payments on an equal loan in another currency.

These contracts are valid for a specific period, which could range up to ten years, and are typically used to exchange fixed-rate interest payments for floating-rate payments on dates specified by the two parties. 

Since the exchange of payment takes place in two different currencies, the prevailing spot rate is used to calculate the payment amount. This financial instrument is used to hedge interest rate risks.

How Does a Currency Swap Work?

A currency swap agreement specifies the principal amount to be swapped, a common maturity period and the interest and exchange rates determined at the commencement of the contract. The two parties would continue to exchange the interest payment at the predetermined rate until the maturity period is reached. On the date of maturity, the two parties swap the principal amount specified in the contract.

The equivalent amount of the loan value in another currency is calculated by using the net present value (NPV). This implies that the exchange of the principal amount is carried out at market rates during the inception and maturity periods of the agreement.

Benefits of Currency Swaps

The benefits of currency swaps are:

• Help portfolio managers regulate their exposure to interest rates.

• Speculators can benefit from a favorable change in interest rates.

• Reduce uncertainty associated with future cash flows as it enables companies to modify their debt conditions.

• Reduce costs and risks associated with currency exchange.

• Companies having fixed rate liabilities can capitalize on floating-rate swaps and vise versa, based on the prevailing economic scenario.

Limitations of Currency Swaps

The drawbacks of currency swaps are:

• Exposed to credit risk as either one or both the parties could default on interest and principal payments.

• Vulnerable to the central government’s intervention in the exchange markets. This happens when the government of a country acquires huge foreign debts to temporarily support a declining currency. This leads to a huge downturn in the value of the domestic currency.

Risk Associated with Commodities Markets

No risk can be eliminated, but the same can be transferred to someone who can handle it better or to someone who has the appetite for risk. Commodity enterprises primarily face the following classes of risks, namely: the price risk, the quantity risk, the yield/output risk and the political risk. Talking about the nationwide commodity exchanges, the risk of the counter party (trading member, client, vendors etc) not fulfilling his obligations on due date or at any time thereafter is the most common risk.

This risk is mitigated by collection of the following margins: - 

·         Initial Margins

·         Exposure margins

·         Market to market of positions on a daily basis

·         Position Limits and Intra day price limits

·         Surveillance 

Commodity price risks include: - 

·         Increase in purchase cost vis-�-vis commitment on sales price

·         Change in value of inventory

·         Counter party risk translating into commodity price risk 

Key Factors for success of commodity market

The following are some of the key factors for the success of the commodities markets: - 

·         How one can make the business grow?

·         How many products are covered?

·         How many people participate on the platform? 

Key Factors For Success Of Commodities Exchanges

The following are some of the key factors for the success of the commodities exchanges: -

Strategy, method of execution, background of promoters, credibility of the institution, transparency of platforms, scaleable technology, robustness of settlement structures, wider participation of Hedgers, Speculators and Arbitrageurs, acceptable clearing mechanism, financial soundness and capability, covering a wide range of commodities, size of the trade guarantee fund, reach of the organisation and adding value on the ground. In addition to this, if the Indian Commodity Exchange needs to be competitive in the Global Market, then it should be backed with proper "Capital Account Convertibility".

The interests of Indian consumers, households and producers is most important, as these are the people who are exposed to risk and price fluctuations.

Key Expectations Of Commodities Exchanges

The following are some of the key expectations of the investor's w.r.t. any commodity exchange: - 

·         To get in place the right regulatory structure to even out the differences that may exist in various fields.

·         Proper Product Conceptualization and Design.

·         Fair and Transparent Price Discovery & Dissemination.

·         Robust Trading & Settlement systems.

·         Effective Management of Counter party Credit Risk. 

Self-Regulation to ensure: Overview of Trading and Surveillance, Audit and review of Members, Enforcement of Exchange rules.

Option Trading

An option is a contract written by a seller that conveys to the buyer the right — but not the obligation — to buy (in the case of a call option) or to sell (in the case of a put option) a particular asset, at a particular price (Strike price / Exercise price) in future. In return for granting the option, the seller collects a payment (the premium) from the buyer.

Exchange traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among large number of investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.

OPTION TERMINOLOGY

· Index options: These options have the index as the underlying. In India, they have a European style settlement. Eg. Nifty options, Mini Nifty options etc.

· Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement.

· Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

· Writer / seller of an option: The writer / seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

· Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

· Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

· Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

· Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

· Strike price: The price specified in the options contract is known as the strike price or the exercise price.

· American options: American options are options that can be exercised at any time upto the expiration date.

· European options: European options are options that can be exercised only on the expiration date itself.

· In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

· At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

· Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

· Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0,K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price. 

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

What is Derivatives?

Commodities whose value is derived from the price of some underlying asset like securities, commodities, bullion, currency, interest level, stock market index or anything else are known as “Derivatives”.

In more simpler form, derivatives are financial security such as an option or future whose value is derived in part from the value and characteristics of another security, the underlying asset.

It is a generic term for a variety of financial instruments. Essentially, this means you buy a promise to convey ownership of the asset, rather than the asset itself. The legal terms of a contract are much more varied and flexible than the terms of property ownership. In fact, it’s this flexibility that appeals to investors.

When a person invests in derivative, the underlying asset is usually a Commodity, Bond, Stock, or Currency. He bet that the value derived from the underlying asset will increase or decrease by a certain amount within a certain fixed period of time.

‘Futures’ and ‘Options’ are two commodity traded types of derivatives. An ‘options’ contract gives the owner the right to buy or sell an asset at a set price on or before a given date. On the other hand, the owner of a ‘futures’ contract is obligated to buy or sell the asset.

The other examples of derivatives are Warrants and Convertible bonds (similar to shares in that they are assets). But derivatives are usually contracts. Beyond this, the derivatives range is only limited by the imagination of investment banks. It is likely that any person who has funds invested, an insurance policy or a pension fund, that they are investing in, and exposed to, derivatives – wittingly or unwittingly.

Shares or bonds are financial assets where one can claim on another person or corporation; they will be usually be fairly standardised and governed by the property of securities laws in an appropriate country.

On the other hand, a contract is merely an agreement between two parties, where the contract details may not be standardised.

Derivatives securities or derivatives products are in real terms contracts rather than solid as it fairly sounds.

Financial New Resources

Top 7 News Sources for Financial Trader

Getting the latest important news is a vital requirement for every Forex, stocks or options trader. The Internet is full of various sites, but not all them feature financial news or provide such news in a timely manner. This list consists of top ten sources for the trader’s news that are updated often and are not mixed up with irrelevant news.

• Bloomberg — the ultimate news source about everything that is in any way related to the financial markets. Categorization by the regions helps in finding important international news.

• Forbes.com Breaking News — a great site to get the recent financial information, it also provides free news from several paid news sources (i.e. Associated Press). Stock market traders will like the coverage of almost all kinds of companies.

• Reuters Business & Finance — Reuters is one of the most professional informational companies in the world and they offer news as a free service to everyone.

• BusinessWeek — they may be too old-fashioned, but BusinessWeek still features some exclusive news content and the very professional analysis.

• Financial Times — I like FT for they are not as US-centered as some other financial news sites, they offer a pretty good world news outlook. Can be recommended as a source of Forex related news if you prefer trading exotic currency pairs.

• CNNMoney — opposite to FT, CNN prefers news from United States, but it’s still good because the majority of world stocks are concentrated on the Wall Street. It will also be useful to the Forex dollar traders.

• CNBC — a "must have" bookmark for every currency trader; news on foreign currency markets are delivered at the top quality level.