Swap contracts can be arranged across currencies. Such contracts are known as currency swaps and can help manage both interest rate and exchange rate risk. Many financial institutions count the arranging of swaps, both domestic and foreign currency, as an important line of business. This method is virtually cheaper than covering by way of forward options. Technically, a currency swap is an exchange of debt service obligations denominated in one currency for the service in an agreed upon principal amount of debt denominated in another currency. By swapping their future cash flow obligations, the counterparties are able to replace cash flows denominated in one currency with cash flows in a more desired currency. A ‘swap deal’ is a transaction in which the bank buys and sells the specified foreign currency simultaneously for different maturities. Thus a swap deal may involve: simultaneous purchase of spot and sale of forward or vice Continue reading
Forex Trading
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
Currency Arbitrage – Definition and Examples
Arbitrage traditionally has been defined as the purchase of assets or commodities on one market for immediate resale on another in order to profit from a price discrepancy. In recent years however arbitrage has been used to describe a broader range of activities. The concept of arbitrage is of particular importance in International finance because so many of the relationships between domestic and international financial markets, exchange rates, interest rates and inflation rates depend on arbitrage for their existence. In fact it is the process of arbitrage that ensures market efficiency. The purchase of currencies on one market for immediate resale on another in order to profit from the exchange rate differential is known as currency arbitrage. If perfect conditions prevail in the market, the exchange rate for a currency should be the same in all centers. Until recently, the pervasive practice among bank dealers was to quote all currencies Continue reading
How Options are Used to Cover Foreign Exchange Risks?
Currency options provide corporate treasurer another tool for hedging foreign exchange risks arising out of firms operations. Unlike forward contract, options allow the hedger to gain from favorable exchange rate movements, while been unprotected from unfavorable movements. However forward contracts are costless while options involve up front premium cost. Examples are: a) Hedging a Foreign Currency with calls. In late February an American importer anticipates a yen payment of JYP 100 million to a Japanese supplier sometime late in May. The current USD/JYP spot is 0.007739 (which implies a JYP/USD rate of 129.22.). A June yen call option on the PHLX, with strike price of $0.0078 per yen is available for a premium of 0.0108 cents per yen or $0.000108 per yen. Each yen contract is for JPY 6.25 million. Premium per contract is therefore: $(0.000108 * 6250000) = $675. The firm decides to purchase 16 calls for a premium Continue reading
Exchange Rate Factors – Factors Affecting Exchange Rates
When trade takes place between the residents of two countries, the two countries being a sovereign state have their own set of regulations and currency. The exporter would like to get the payment in the currency of his own country, the importer can pay only in the currency of the importers country. This creates a need for the conversion of the currency of importer’s into that of the exporter’s country. Foreign exchange is the mechanism by which the currency of one country is gets converted into the currency of another country. The conversion is done by banks and financial institutions, who deals with foreign exchange business. When one currency is converted into another, there must be some basis in effecting the conversion. The basis by which the currency unit of one country gets converted into currency units of another country is known as foreign exchange rate. Foreign exchange rate is Continue reading
Fixed and Option Forward Exchange Contracts
Under the fixed forward contract the delivery of foreign exchange should take place on a specified future date. Then it is known as ‘fixed forward contract’. Suppose a customer enters into a three months forward contract on 5th January with his bank to sell Euro 15,000, then the customer would be presenting a bill or any other instrument on 7th April to the bank for Euro 15,000. The delivery of foreign exchange cannot take place prior to or later than the determined date. Though forward exchange is a mechanism wherein the customer tries to overcome the exchange risk, the purpose will be defeated if the delivery of foreign exchange does not take place exactly on the due date. Practically speaking, it is not possible for any exporter to determine in advance the precise date on which he will be tendering export documents for reasons which are internal relating to production. Continue reading