Sometimes companies deal in foreign exchange to make a profit, even though the transaction is not connected to any other business purpose, such as trade flows or investment flows. Usually, however, this type of foreign exchange activities is more likely to be persuaded by foreign exchange traders and investors. One type of profit seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) in order to profit from a price discrepancy. Hence, arbitrage may be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage). Interest arbitrage involves investing in foreign-bearing instruments in foreign exchange in an effort to earn a profit due to interest Continue reading
Forex Investments
Factors Determining Spot Exchange Rates in Forex Markets
It is the interplay of the forces of demand and supply that determines the exchange rate between two currencies in a floating rate regime. The exchange rate between, say, the rupee and US dollar depends upon the demand for US dollars and the supply of US dollars in the Indian foreign exchange market. The demand for foreign currency comes from individuals and firms who have to make payments to foreigners in foreign currency mostly on account of the import of goods and services and purchase of securities. The supply of foreign exchange results from the receipt of foreign currency normally on account of export or sale of financial securities to foreigners. Important Factors Determining Spot Exchange Rates 1. Balance of Payments: Balance of Payments represents the demand for and supply of foreign exchange which ultimately determine the value of the currency. Exports, both visible and invisible, represent the supply side Continue reading
Foreign Exchange Risk or FOREX Risk
Foreign Exchange dealing is a business that one get involved in, primarily to obtain protection against adverse rate movements on their core international business. Foreign Exchange dealing is essentially a risk-reward business where profit potential is substantial but it is extremely risky too. Foreign exchange business has the certain peculiarities that make it a very risky business. These would include: Forex deals are across country borders and therefore, often foreign currency prices are subject to controls and restrictions imposed by foreign authorities. Needless to say, these controls and restrictions are invariably dictated by their own domestic factors and economy. Forex deals involve two currencies and therefore, rates are influenced by domestic as well as international factors. The Forex market is a 24-hour global market and overseas developments can affect rates significantly. The Forex market has great depth and numerous players shifting vast sums of money. Forex rates therefore, can move Continue reading
Features of Currency Swap Market
The currency swap market is the oldest and most creative sector of the swap market. This is not distinguished in market terms between the fixed rate currency swap and the currency coupon swap. There is no distinction in market terms between these two types of currency swaps because the only difference is whether the counter currency receipt/payment is on a fixed or floating basis – in structure and result, the two types of swaps are identical and it is a matter of taste (or preference) for one or both counter-parties to choose a fixed or floating payment. When the dollar is involved on one side of a given transaction, the possibility to convert a fixed rate preference on one side to a floating rate preference on the other side through interest rate swap market makes any distinction even more irrelevant. However, for those who like fine distinctions, there is a Continue reading
Pricing of Futures Contracts Using Interest Rate Parity in Forex Trading
According to the interest rate parity theory, the currency margin is dependent mainly on the prevailing interest rate (for investment for the given time period) in the two currencies. The forward rate can be calculated by the following formula: F/S = (1+Rh)/ (1+Rf) Where, F and S are future and spot currency rate. Rh and Rf are simple interest rate in the home and foreign currency respectively. Alternatively, if we consider continuously compounded interest rate then forward rate can be calculated by using the following formula: F = S*e (rh- rf)*t Where, rh and rf are the continuously compounded interest rate for the home currency and foreign currency respectively, T is the time to maturity and e = 2.71828 (exponential). If the following relationship between the futures rate and the spot rate does not hold, then there will be an arbitrage opportunity in the market. This will force the futures Continue reading
Some terms and concepts related to foreign exchange market
1 & 2. Exposure and Risk: Exposure is a measure of the sensitivity of the value of a financial item (asset, liability or cash flow) to changes in the relevant risk factor while risk is a measure of variability of the value of the item attributable to the risk factor. Let us understand this distinction clearly. April 1993 to about July 1995 the exchange rate between rupee and US dollar was almost rock steady. Consider a firm whose business involved both exports to and imports from the US. During this period the firm would have readily agreed that its operating cash flows were very sensitive to the rupee-dollar exchange rate, i.e.; it had significant exposure to this exchange rate; at the same time it would have said that it didn’t perceive significant risk on this account because given the stability of the rupee-dollar fluctuations would have been perceived to be Continue reading