Lecture Date: - Mesmerizers
INTERNATIONAL FINANCE
What is Foreign Exchange?
Foreign Exchange loosely refers to any foreign currency. In deeper sense, it is purchase and sale of one currency against sale and purchase for another currency. Here, currency does not necessarily mean bank notes and coins but includes Travellers Cheques, Bills of Exchange, Letters of Credit, any drafts, etc as well. In essence any financial instrument that entitles you to get another currency in lieu of one currency is treated as currency for this definition.
International Foreign Currency market is almost round the clock market starting in Tokyo/Sydney in the morning and closing in West Coast of USA shortly before it is time for opening of next day market in Tokyo (effect of changing time zones).
Indian Forex Market
Indian Forex Market is still in nascent stage of development. Prior to 1991, we had FERA which made possession of Foreign currency a criminal offence. Exchange rate was decided by the RBI and Forex market virtually did not exist. Post 1991, after replacement of FERA with FEMA, and current account convertibility, Indian forex market has begun to develop. With exports volume growing steadily at good pace, forex market is becoming important.
The Foreign Exchange Management Act (1999) popularly known as FEMA came into force from June 01, 2000. FEMA replaced the Foreign Exchange Regulation Act of 1973 (FERA). While FERA was aimed at conserving foreign exchange by restricting expenditure, FEMA is aimed at facilitating external trade and payments for promoting orderly development and maintenance of foreign exchange market in India. Violations under FEMA are considered civil offence and not criminal offence as was the case under FERA.
In India most of the trade happens in USD. Besides USD, Euro, Great British Pound, and Japanese Yen are other major currencies that are traded. Other currencies are also dealt but in small volume. SBI deals in 16 currencies in all.
Exchange rates are not constant and keep changing on minute to minute basis like stocks in stock market. Unlike stock exchange, there is no Forex Exchange where there is a central intermediary available for every transaction and hence single quote for any currency is not available. It is more like a vegetable market where there are so many shops and each is quoting its own rate and willing to bargain with you. Or, in the market language, it is Over the Counter (OTC) trade.
Foreign Currency Exchange Rate
The primary basis for exchange rate movement on day to day basis is Demand and Supply of foreign currency. Demand can spurt due to various reasons like large companies with considerable import requirements (like Maruti requiring import from Suzuki, Japan) of foreign currencies stocking forex for future requirement. Similarly, exporters may dump their forex holding if they perceive that rupee is going to appreciate leading to sudden excess availability of foreign currency in the market.
Although the exchange rate is affected by market forces of demand and supply, we do not have a fully flexible exchange rate, or as it is called Floating Exchange Rate, as yet. What we actually have is a Managed Exchange Rate.
What it means is that exchange rate is being macro managed by the Govt through RBI. RBI keeps a hawk eye on the forex market and keeps manipulating exchange rate by either buying excess forex or injecting liquidity by selling forex from its own holding of 165 Billion US Dollars. Like, SEBI is the controller of the Securities market, RBI is the controller of Forex market. It authorises certain entities like banks and even other companies like Thomas Cook to deal in Forex. It has a dealing room which keeps a track on exchange rate movement in the market on continuous basis. If the exchange rate starts moving wildly in either direction, it intervenes by either buying or selling forex in the market to control it.
Factors Affecting the Exchange Rate
a) Balance of Payment position of the country
b) Strength of economy
c) Fiscal and Monetary policy
d) Interest rates
e) Political Factors
f) Exchange control
g) Central Bank Intervention
h) Speculation
i) Technical Factors
j) Other factors.
Balance of Payment - Balance of Payment is the measure of demand and supply of foreign currency. If the balance of payment is high and positive (Exports higher than imports), it will lead to excess supply of foreign currencies and therefore local currency will appreciate. In the reverse case, domestic currency will depreciate.
Strength of the Economy - If the economy is strong and growing, foreign investment/capital will pour into the country again causing excess supply of foreign currencies leading to appreciation of local currency.
Fiscal and Monetary Policy - If fiscal policy leads to high deficit, it will result in inflation and therefore excess supply of local currency. High inflation rate leads to high interest rates (interest rates are mostly maintained a few percent higher than inflation rate so that real effective interest rate is positive) leading to weakening of local currency.
Interest Rates - Higher interest rates attract foreign currency deposits provided local currency is not depreciating faster than interest rate induced growth. Thus, higher interest rates coupled with relatively stable local currency acts like a self sustaining process. More inflow of foreign currency leads to further stability of exchange rates.
Political Factors - If a govt is considered to be unstable, or change of govt with socialistic inclination is expected, local currency will weaken. Currency will strengthen if the new govt is expected to take capitalistic policy decisions.
Exchange Control - Exchange control is generally aimed at free movement of capital flows and therefore foreign nationals will be vary of investing in the country.
Central Bank Intervention - Already explained as to how central bank can affect exchange rate in the short term.
Speculation - This is again a short run effect if some big players suddenly start accumulating foreign currency or vice versa for speculative reasons. Constant buying by big players and resultant upward movement in price leads even smaller player to start buying aggressively and foreign currency appreciates.
Technical Factors - Technical factors work best in regulated market. Indian forex market are still not as free and therefore they do not have much effect.
Other Factors - These are general factors which are hard to define. It could be world political and economic situation, prices of major import constituent like crude oil, etc. Fear of war with Pakistan can send the Rupee down overnight.
Reference Rate
What we have discussed above is mechanics of day to day changes in exchange rate. But how is the basic exchange rate of one currency set against the other currency? How is it determined that a dollar should cost approximately Rs 45 and not Rs 25?
Current mean of Rs 45 or so is called Reference Rate. This reference rate is decided using various different methods: -
a) Mint Parity System – Simply stated this system is based on amount of currency printed by any country for each ounce or Kg of gold. If India prints Rs 30,000 for each ounce of gold held with govt and US prints US$ 600 for each ounce of gold held with USA, exchange rate between US$ and INR would be – 30,000/600 = Rs 50 per dollar.
b) Gold Standard System – This system started in mid 1870s and lasted till 1914 ie till start of World War I. In this system, the coins had a fixed gold content and ratio of gold content in coins of any two countries denominated their exchange rate. In case of paper currency, amount of gold freely payable by Govt/Central Banks of two countries for each unit of paper currency determined the exchange ratio. The countries were committed not to print currency in excess of their gold holding or dilute the gold content in coins. However, during the World War II, countries began to renege on this commitment to meet the funding requirement of the war and the gold standard collapsed.
Many countries tried to revive the Gold Standard after the war ended in 1919 but failed. In the economic depression that followed the WW-I, when they tried to withdraw additional money they had pumped into the economy during the war, it led to Deflation (reverse of inflation where commodity prices start falling due to low demand (because people do not have money to buy goods) which deters the entrepreneurs and is therefore bad for economy). They, therefore had to wait for the economies to recover. But by the time they began their next attempt a couple of decades later, World War II started in 1939 and lasted till 1944. Thus, this standard was abandoned.
c) Bretton Woods System – Post World War II, in 1946, the newly-created Economic and Social Council of the United Nations called a conference at the Bretton Woods where in the troika of post-War economic agencies ie International Monetary Fund (IMF), World Bank and International Trade Organisation (ITO – which later came in avatar of GATT) were born. Countries were allowed to declare their currency value in gold or dollars and USA promised to freely exchange an ounce of gold for US$ 35 or vice versa. Since this system was born during Bretton Woods conference, this standard came to be known as Bretton Woods system.
The system worked very well till 1969. However, when USA got embroiled in the long and costly Vietnam war, its economy suffered. The U.S. balance on goods and services shifted to a surprising deficit in 1971. These deficits supported speculations that the dollar was overvalued. France realised that it was beneficial to exchange its forex holding into gold and began to convert it. Because of massive gold outflows from the United States, President Nixon suspended convertibility of the dollar in August 1971. This ended the Bretton Woods System.
d) Smithsonian Agreement - IMF’s attempts in the subsequent period to revive Bretton Woods system were unsuccessful as USA did not agree to make dollar convertible to gold. In the following period, there was complete chaos. In an attempt to restore order to the exchange market, 10 leading nations met at the Smithsonian on December 16 and 17, 1971. The “Smithsonian Agreement” was a new system of exchange-parity values. Although this new system was still a dollar-standard exchange-rate system, the dollar, was still not convertible to gold. Smithsonian Agreement collapsed within 15 months and a de facto system of floating rates emerged.
e) Now we have following systems of Exchange Rate being followed by different countries as per their convenience:
i) Fixed Exchange Rate Systems
a) Currency Board
b) Fixed Peg
c) Flexible Peg
ii) Floating Exchange Rate Systems
a) Managed Float System
b) Independent Float System
Scientific Way of Deciding Exchange Rate Between Currencies
1. Purchasing Power Parity System - This theory is based on the law of one price, the idea that, in an efficient market, identical goods must have only one price. This is thus Real Effective Exchange Rate (REER). A basket of representative goods and services has been identified and its cost in each country in its domestic currency is calculated. The ratio between its cost in any two countries in their respective domestic currencies is their exchange rate. To understand it better, let us take a case of cost of hair cut in India and US. While the average price of a hair cut in India is Rs 15, it costs upto US$ 3 in US. If this was to represent avarage rate of costs for all the goods in the basket, purchasing power parity of INR would be 5 against US$.
The differences between PPP and market exchange rates can be significant. For example, on plain conversion of Yuan to dollar basis, per capita GDP in China is about USD 1,500, while on a PPP basis, it is about USD 6,200. At the other extreme, Japan's nominal per capita GDP is around USD 37,600, but its PPP figure is only USD 31,400.
Exchange Rate = Price in domestic market for basket of goods = Pd
Price in foreign market for basket of goods Pf
This is called absolute version of PPP.
These special exchange rates are often used to compare the standards of living of two or more countries. The adjustments are meant to give a better picture than comparing gross domestic products (GDP) using market exchange rates.
2. Relative Purchasing Power Parity – This is a related theory, which predicts the relation between the two countries' relative inflation rates and the change in the exchange rate of their currencies. This is the economists definition. In business terms, it helps in deciding Forward Rate of Forex from Spot Rate by taking inflation into account.
Suppose, present Exchange Rate of dollar in India is Rs 47 and inflation in India is 5% and in US 1%. Thus, cost of same product after one year in India = PD (1+ 0.05) and in US = PF (1+ 0.01).
Thus, exchange rate after one year = PD (1+ 0.05)
PF (1+ 0.01)
= Rs 48.86
But Inflation is not the only element that affects the long term exchange rates. Interest rate is another element that severely affects the exchange rate (although interest rates are often a direct function of inflation, Interest rates is pegged to covered the depreciation of money through inflation and a little as incentive. Thus, if inflation is low, interest rates would automatically be correspondingly low).
3. Interest Parity Theory – Effect of interest on exchange rate is called Interest Parity theory. Let us see how an smart operator can benefit by playing currency of two countries having differential interest rates and gain from it.
Suppose, current exchange for US$ is INR 46. RBI bond interest rate is 7% and US treasury interest rate is 2%. A smart American investor instead of investing in US treasury bill would invest in RBI bonds. (this is what NRIs do with NRE and other accounts). However, whole thing is not as simple as it appears. When such arbitrage opportunity occurs, many people try to utilise the opportunity and resulting excess supply leads to fall in exchange rate. Further, inflation in India is higher than in US. Therefore, on maturity of deposit, reverse conversion of Rupee deposit to dollars is going to be at higher cost than the original conversion rate Thus, losing of some gains.
Sterilisation of Forex
While every country is bending over backwards to earn as much forex as possible, there is limit of each economy to absorb forex inflow. Uncontrolled influx of forex can be harmful, specially the hot money which can be withdrawn at short or nil notice, like portfolio and stock market investment with capital account convertibility. (This is what was the prime cause of South Asian Economic crisis of 1997). Also, influx of huge funds leads to inflation. Therefore, there are times when forex inflows have to be checked or controlled. Technically such a process is called Sterilisation of Forex. Recently, India adopted this approach by reducing interest rates on NRE deposits which made parking of funds in India less attractive. Another way of sterilisation is to liberalise Imports. Surge in imports takes away excess supply of dollars in the market. Yet another method is to Repay the Old Debts.
The methods we discussed above are the planned and controlled method of Sterilisation of Forex. In addition there could be host of uncontrollable and unpredictable reasons leading to sterilisation, like –
a) Threat of War
b) Increase in oil prices
c) Political Instability
d) Govt Policies
e) Social Disturbance
Thus, there is always a need for hedging.
Fixed Exchange Rate Systems
1. Currency Board – In this system, currency notes issued by the country depend upon the declared exchange rate and the amount of foreign currency reserves. If India has a forex reserve of US$ 150 Billion and exchange rate is Rs 40, India can issue 150 x 40 = 6000 Billion Rupees worth of currency notes. However, in this case, monetary policies have to be in consonance with other country. Thus, it kills the economic sovereignty of the nation and therefore difficult to follow.
Examples are Hong Kong, Estonia, and Bulgaria
2. Fixed Peg – In this system, exchange rate is declared by the country and ratified by the IMF. Thereafter, exchange rate does not change till it is revised by the Govt. Reluctance by the govt to revise the rate due to political or other compulsions can lead to long term consequences. South East Asian crisis was partly result of this system.
Reasons for South East Asian Crisis (1997)
a) Countries had adopted complete convertibility on Current as well as Capital account. This made flight of capital very easy. There was no way to control outward flight of capital at the time of crisis.
b) They adopted Fixed Peg system against dollar. There was massive influx of foreign currency through hot investments, foreign currency loans by banks, etc. This money was invested in assets like real estate and stocks. There was massive rise in asset prices and an asset bubble was created.
c) There was massive current account deficit. Imports far exceeded exports.
d) High inflation rates due to increased money supply. Inflation was not reflected in exchange rate; firstly, due to Fixed Peg system and secondly, due to govts’ reluctance to revise the rate downwards which would have affected investors’ sentiments. Speculators suddenly realized that due to overvalued currencies, it was beneficial to convert local currency into dollars and they went for it hammer and tongs. Due to relatively small size of economies (a few tens of billion dollars each), in three trading sessions, Forex reserves became nil.
3. Flexible Peg System - This system provides a “Parity band” which allows limited flexibility for movement of exchange rate on either side of the parity rate. Bands can be very narrow or very wide. Examples are Bangladesh, China, and Egypt.
Floating Exchange Rate Systems
1. Managed Float – This is the system that we are currently following in India. Exchange rate is free to float but under constant watch of Central Bank (RBI). It generally intervenes only on occasions when there are wild movements. It basically acts as stabiliser.
2. Independent Float – In this system Govt is just not bothered which way its currency is moving. This is the system followed by rich and advanced countries like USA, Kuwait, Saudi Arabia, etc.
India followed Fixed Peg System since independence. Indian rupee was pegged against UK ₤. In 1966, rupee was devalued. In 1975, India moved away from ₤ parity and pegged its rupee against an unknown basket of 5 currencies. It devalued rupee once again during the Balance of Payment Crisis in 1991. From 1993, we started following floating rate exchange system.
Impossible Trinity (The three events that can not occur together)
a) Having Fixed Peg system of Exchange Rate.
b) Having complete convertibility on current and capital account.
c) Having complete independence in deciding monetary policy.
No country to date has ever been able to achieve all the three conditions together at any point of time. That is why it is called impossible trinity.
Why did economies of Argentina, Chile and Mexico crash?
Argentina Economic Crash – 2001
Argentina had been having a see saw economy ever since the beginning of 20th century. It was the 4th largest economy in early 1915, fell down drastically in late 70s & 80s and then again recovered to become 56th economy in 1996. It suffered its first crash in 1929 during American Stock Market Crash. It recovered from there to become 15th largest economy only to suffer yet another crash in 1970s and 1980s. In 1980, the inflation was as high as 5000%. In a matter 22 years, ie between 1970 and 1992, money got devalued by 10 billion times. Yes! 10 billion pesos were reduced to a single peso.
Economic reforms launched in 1991 reduced inflation from 2300% in 1991 to just 1% in next few years. However, the recovery was short lived. Some wrong currency policies of Govt and economic crisis in countries like Mexico, Brazil and Russia, triggered another economic crisis in 2001.
In 1991, a currency stabilization regime established a currency board, which pegged the Argentine peso to the dollar on a 1-to-1 basis. Inflation was virtually eliminated. Foreign investment returned. GDP growth was strong in the early 1990s, but unemployment increased as a result of extensive structural reforms. Argentina finally seemed to have a handle on its chronic economic problems. However, external events in the late 1990s buffeted the Argentine economy:
• 1995: Mexico
• 1997: East Asia
• 1998: Russia
• 1999: Brazil
Because of its long history of economic instability, every economic crisis in the Third World, particularly in Latin America, caused investors to pull out of Argentina, creating a self-fulfilling prophesy. It was investors’ hair-trigger reaction to crises elsewhere that caused Argentina’s instability, Thus, the adverse effects of these crises were greater in Argentina than in most other new-growth economies. Another reason for this enhanced vulnerability is that Argentina stood alone with its fixed-exchange-rate policy, whereas the floating currencies of its neighbours depreciated. By 2001, the peso was significantly overvalued, in no small part due to the dollar itself having become overvalued. The devaluation of the Brazilian real had a particularly large effect. It reduced demand from Argentina’s largest trading partner, and businesses began to move from Argentina to Brazil in search of lower production costs. As the credibility of the peso at its pegged value declined, and the government had to expend huge sums to support the currency, which in turn necessitated more borrowing. Under these conditions, interest rates that were already high rose even higher, and as both debt and interest rates rose, the ability of the government to service its debt became increasingly doubtful. Argentina continued to keep the peso pegged to the dollar by external borrowings.
The buzzards came home to roost in December 2001. The nation rapidly descended into an unprecedented chaos. As economic activity shuddered to a virtual halt, governments resigned and were hastily replaced amid sporadic rioting. The following month, when Eduardo Duhalde (the fifth person to hold the presidency in two weeks) unpegged the peso in January 2002, the peso crashed hard, losing more than 70% of its value and inflation rising to 41% though it was still far far better than the expectations of four digit hyper inflation experienced in late 80s decades. But inflation had fallen back to 3.2% by 2003.
So, we know now what agony was the country saved from by the much maligned and ever pouting Mr PV Narsimha Rao, who displayed the rare courage to stand up against the economically blind political class of the country (including his own party men) in appointing Mr Man Mohan Singh as Finance Minister; and the practical economist Mr Man Mohan Singh himself, whose economic prescriptions to cure the ills of the economy were as effective as any measures ever were any where in the world in its modern history.
Mexican Economic Crisis
Mexican Economic trouble of 1994 was not a ‘Crash’ but a Crisis as it lasted just 10 months and the melt down was not as spectacular as in Argentina. This crisis was also triggered by wrong currency policies of the govt. In Dec 1994, Mexican Peso fell from the pegged rate of 3.3 peso to a dollar to 7.7 peso.
Though the crisis was triggered by; first: the devaluation of currency in December 1994 and second: floatation of currency soon after; the seeds were sown earlier.
Mexico had a fixed exchange rate of 3.3 peso to a dollar. In 1994, as the general election drew near, the incumbent govt went into a spending blitz (politicians are same every where). As a result, current account deficit ballooned to a record of 7%. In order to fund the spending, the govt issued bonds repayable in dollars. High current account deficit and fixed exchange rate led to over valuation of Peso by approximately 20%. Some investors were alarmed; other smelled the opportunity; and together they quickly encashed the bonds in dollars. Foreign exchange reserves fell drastically. Declining reserves necessitated devaluation of currency. However, political compulsions did not allow this simple but hard prescription till the incumbent govt lasted.
Next Govt which took over power in Dec 1994, devalued the currency to 4 pesos to dollar. That did not prove adequate and within days peso was allowed full float which led to crashing of peso to 7.2 pesos to a dollar.
Mexico’s immediate neighbour, USA, intervened immediately by first buying pesos from open market and then arranging a loan of US$ 50 billion. The currency then stabilized first at 6 pesos to a dollar and thereafter gradually declining over next two years to 7.7 dollars before beginning a regular recovery. Mexico repaid all loans by 1997.
27 Jul 2006
FOREX MARKET AND FOREX ARITHMETIC
Forex market is open almost 24 hrs a day. It starts in Tokyo and ends in West Coast of USA. By the time it closes in USA West Coast, it is within 2.5 hrs of opening of Tokyo market for the next day.
Total trade in the Forex market is to the tune of over US$ 5 trillion per day. The Indian Forex Market turnover itself averages US$ 5-10 billions/day.
Communication System – Forex Market has a dedicated worldwide telecommunication network called SWIFT (Society for International Financial Telecommunications).
Forex Dealers
There are two kinds of forex dealers in the market:
a) Full Fledged Money Changers – Mostly designated banks and Thomas Cook (an exception). These are the authorized dealers who are permitted to take positions. An authorized dealer deals in millions of dollars each day. They can go long or short (overbought or oversold positions). They are also allowed to appoint their franchisees.
b) Restricted Money Changers – These are the kind of money changers who line up the streets in tourist centres. They can only buy forex. They are not allowed to sell. They are essentially convenience centres for tourists for currency exchange.
One peculiarity of Forex Market is that it is mostly unregulated and completely driven by the Demand-Supply principal. There are few benchmarks. Rates fluctuate minute by minute, dealer by dealer, and customer by customer. There is nothing fixed. Two people doing a sell deal with the same dealer at the same time in the same place and of same currency may end up with vastly different rates. Money changers are free to quote their own rate for buying and selling any currency (technically called Bid and Ask rates respectively) based on customer, size of deal, their own current positions, etc.
How to make a Quote?
All money changers are connected to Reuters through SWIFT (Society for Worldwide Interbank Financial Telecommunications). The Reuters screen continuously flashes current going rate for various currencies at different centres. However, the rates are only indicative. They are representative rates for market as a whole. Individual rates with various dealers vary.
Exchange Rates are quoted in following format: -
USD/INR = [pic]
Above represents amount of currency in denominator (here INR) to be paid for each unit of currency in numerator (here USD). Quotation is always in double numbers with minor difference between the two. First number is called the Bid Rate and second number is called Ask Rate. Bid rate is always lower than the Ask Rate.
Bid Rate is the rate at which the money changer is willing to buy a particular currency.
Ask Rate is the rate at which the money changer is willing to sell same currency.
Spread – As stated earlier, there is always a positive difference between Ask Rate and Bid rate. This difference is called Spread and it is the profit margin that the dealer earns by trade.
Spread = Ask Rate – Bid Rate
Spread % = [pic]
Forex market behaves like any other commodity market. Here too, there is whole sale and retail market.
Whole sale market consists of Authorised Dealers and Big Corporate Houses like TCS, Infosys and Wipro who have high forex exposures. But spreads in whole sale market are lower.
Retail Market is populated by money changers, ordinary citizens, small exporters and importers and small corporates.
Positions
In any financial market, two positions can be taken – Long or overbought position and
– Short or oversold position.
Why are positions created?
Positions are taken in anticipation of currency exchange rate movement in one direction.
If a position is taken and the trend appears to be reversing (currency depreciates against expectation of appreciation or vice-versa), the positions are liquidated by manipulating the Bid and Ask rates. Example - If it is a long/overbought position, both Ask and Bid rates will be lowered. Similarly, if there is an oversold position, both Ask rate and Bid Rate will be hiked.
The quotations are normally in four decimal places. If a dollar is being quoted against Rupee, it will be quoted as follows: -
46.5230/46.5250
First figure of quote is Bid Rate and second figure is Ask Rate. Third and fourth decimal places are called PIPS. Thus, in the above case, 30 and 50 are pips.
In most cases, quotations are abbreviated to give only two or three digit pips in place of Ask Rate. Thus, above quote could also be represented as: -
46.5230/50
Inter dealer quotes are further abbreviated to only three digit pips on both sides since base rate of up to first decimal place is common across all dealers and therefore assumed to be known.
Arbitrage
As in any other trade, arbitrage opportunities exist in Forex trade also. Arbitrage is basically taking advantage of differential in rates at two locations or markets or sources. For instance, Bid (Buying) Rate of one dealer may be higher than Ask (Selling) Rate of another dealer. A smart operator can buy from second dealer and sell to first dealer and earn some money. This transaction is called Arbitrage. Let us see the above process in numbers.
Dealer A Dealer B
46.5030/46.5080 46.5090/46.5095
In the above case, Bid Rate of Dealer B (46.5090) is higher than Ask Rate of Dealer A (46.5080). If a person Buys one million dollars from Dealer A and sells to Dealer B, he earns - 0.0010 x 10,00,000 = Rs 1000
This is also called Single Point Arbitrage since there is only one Buying and Selling operation involved. It normally happens when the deal is in single market involving two dealers
Inverse Quote – Also called “Indirect Quote”. Normally, value of other currency is quoted in local currency, ie amount of local currency to be paid for each unit of foreign currency. In India, all currencies are quoted using INR as the base, ie value of other currency is quoted in Indian Rupees. Similar practice is adopted by all other countries, using their local currency as base and indicating number of local currency to be paid for each unit of other currency.
Thus, a person will obtain USD/INR quote = 46.3020/46.3090 from a dealer in India and INR/USD quote = 0.0213/0.0224 from another dealer in USA (US currency used as base in USA. So, the quotation will be number of USD to be paid for each INR). If the bases of quotes are different, how do we compare the quotes? Comparison of two quotes becomes difficult. Therefore, there is a need to INVERSE one of the quotes so that the base is common.
USD/INR = 46.3020
Inverse the quote
INR/USD = [pic]
That was a simple case when only mean rate is given. Now let us see what happens when bid and ask rates are quoted.
USD/INR = 46.3020/46.3090
( [pic]
[pic]
(Please note that for finding BID rate, we have to inverse ASK rate and for finding ASK rate we have to inverse BID rate. What is the logic for this?
Currency trade is basically a BARTER trade. In any other trade, commodity is traded against a currency. However, in currency trade, both sides have currencies but of different type. It is like one side having wheat and the other side having rice and both ready to exchange their commodity for the other’s for a negotiated exchange rate. In such a situation there is no seller and no buyer. Saying it other way round, both are sellers and both are buyers. When one buys other’s commodity, he simultaneously sells his commodity. So, when one trader says – I am willing to sell one dollar for
Rs 47, it can also be interpreted as - he is willing to buy Rupee for 1/47 dollar. Thus, his ASK rate of Rs 47 for a dollar has become his BID rate for a Rupee in inverse quote at 1/47 dollar. Therefore, when currency quotes (exchange rates) are inversed, Bid and Ask rates also have to be inversed).
Two Point Arbitrage – When two locations are involved in the dealing, it is possible to buy a currency from one location/market and sell it in other market and earn arbitrage. For example, some one can purchase dollars in India and sell them in US market for Rupee. This is called Two Point Arbitrage.
Three Point Arbitrage – Some times Arbitrage opportunity is available by currency exchange operations across two or three markets. In such an operation, first one currency is purchased in one market and then sold in second market for a third currency. Third currency is then sold in third or first market for original currency.
Suppose, there are three currencies A, B and C. Quotes are available for A/B, B/C and C/A
(C/A)BID = (B/A)BID X (C/B)BID
[pic]
AND
(C/A)ASK = (B/A)ASK X (C/B)ASK
[pic]
Forward Quotes
Forward quotes are one where a dealer quotes for purchase and selling of forex at a future date. These quotes are mainly useful for exporters and importers who commit to sell their ware or buy the imported stuff based on exchange rate prevailing on that date. However, money is received or paid in foreign currency at a much later date. Any large adverse movement of exchange rate in the interim can lead to heavy losses. Therefore, importers and exporters cover their risk by utilisation of these forward quotes. Various terminologies associated with forward quotes are as follows:
Spot Deal – Settlement on T+2 days (‘T’ refers to Transaction Date. Thus, delivery of forex and payment of cash for a transaction done on Monday has to be completed (settled) by Wednesday)
Spotcash Deal – Settlement on T + 0 days (Same day payment)
SpotTom Deal – Settlement on T + 1 Day (Next Day Payment)
Forward deals could be T+10, T + 30, T + 90, etc. (Add 2 working days for each settlement).
Inter Dealer Forward Quotes are not direct. Only differential amount to spot deal rates are quoted. Thus, if
GBP/INRspot = 85.8680/85.8950
Then, 30 days (one month) FP is quoted as 30/40 which means
30 days FP for GBP/INRspot = 85.8680 + 0.0030 /85.8950 + 0.0040
= 85.8710/85.8990
It is possible that Bid Rate for a Forward Quote is higher than Ask Rate. If such a situation occurs, it means that local currency is expected to appreciate. If local currency appreciates, for each unit of foreign currency, lesser amount of local currency would be paid. Thus, in such a situation, the quoted differential amount is decreased rather than added to Spot quotes.
In the above example, if dealer quotes were 40/30, then 30 days FP would be
30 days FP for GBP/INRspot = 85.8680 - 0.0040 /85.8950 - 0.0030
= 85.8640/85.8920
In the Forward Deals there are more variations –
Out Right Forward Deal – A deal where there is only one transaction of sell or buy at a future date. So, you decide to buy one million dollars after 60 days.
Spot Forward Deal – A deal where there is a Spot Deal and a covering deal on a future date. So, you buy one million dollars today and strike a forward deal for selling one million dollars after 60 days.
Forward Forward Deal – There is a Buy and a covering Sell deal on a future date (future dates of buy and sell deals are different). So, you do a forward deal to buy one million dollars after 30 days and do another forward deal to sell one million dollars after 45 days.
Broken Date/Forward Rate Calculation
Quotes are available for one month, three months or six months. There may be requirement to calculate for a date in between these quoted dates, say for 1 ½ months or 3 months and 25 days. Such calculations are done by interpolation of quotes for available dates (extrapolation is never done for dates beyond max quote) Let us take an example for conceptual clarity:
Spot USD/INRSpot = 46.8000/46.9000
1 month FP = 50/80
3 months FP = 100/200
6 months FP = 200/300
Find forward rates for 1 month 15 days and also for 3 months 25 days.
Ans. For 1 month 15 days = [pic]
(“60” because 3 months minus 1 month = 60 days)
= [pic]
= 46.8050 + .0013 / 46.9080 + 0.0030
= 46.8063 / 46.9110
For 3 month 25 days = [pic]
= [pic]
[pic]
= 46.8100 + .0028 / 46.9200 + 0.0028
= 46.8128 / 46.9228
Forward Premium/Discount Computation
FP = [pic] (MR means Mid Rate which is average of Bid and Ask Rates)
If FP is (+)ve, then foreign currency is appreciating
If FP is (–)ve then forward deal is at a discount which means that local currency is expected to appreciate.
Spot USD/INR = 46.8030/46.8500 ( Mid Rate = 46.8265
3M FR = 46.9030/46.9500 ( Mid Rate = 46.9265
n = 3 months
Forward Premium = [pic]
= 0.8542
Thus, there is a 0.85% premium on forward quotes.
In case the result was in negative, then there was a discount, which means that foreign currency is going to depreciate and local currency is expected to appreciate.
Factors affecting the Forex forward quote
1. Inflation – The currency of the country experiencing higher inflation rate will depreciate in value
2. Interest Rate – Capital will move from low interest rate country to higher interest country. Thus, currency of country with higher interest rate will appreciate due to higher demand.
Forward Rate = [pic]
Where
IRD = Interest Rate in Domestic Market
IRF = Interest Rate in Foreign Market
Problem 01
Given Spot USD/INR = 45.0020
6 Months Forward = 45.9010
Interest Rate USA = 7% and India = 12%
Forward Rate = [pic]
= [pic]
= 45.0020 x (1.0241)
= 46.0890
& the Forward Market Rate = 45.9010
Thus, six months Forward Premium = [pic]
= [pic]
= 3.995%
USD is going at a premium of 3.995%.
As per the interest rate differential, USD should be quoted at INR 46.0890. Also, Interest Rate Differential between two countries = 12 – 7 = 5% where as USD is being quoted at a forward premium of only 3.995%. Thus, there is an opportunity to borrow USD from USA @ 5%, convert to INR and invest in treasury bond at 12% while simultaneously buying USD 6 months Forward @ 45.9010 and earn an arbitrage of 1.005% on investment.
Scenario II
If forward rate was 46.9010
Then premium = [pic]
= 8.44%
Thus, if you invest in INR, you would make a loss of 8.44% in forward deal where as your earning from interest would be 12 – 7 = 5%. Thus, you be in net loss of 8.44 – 5 = 3.44%.
This kind of transaction is possible only when Govt gives freedom to buy and sell INR or USD in both countries.
Now in this case, borrow INR 45.0020 in India @ 12% and convert to 1 USD at spot rate. Invest this USD in money market in USD at 7% for six months. Simultaneously, sell USD 1.035 in 6 months forward for INR 48.5425. Your liability against borrowing in India =
[pic]
= 47.702
Thus, there would be gain of INR 48.5425 - 47.702 = INR 0.8405 per INR 4.0020 invested or 3.44%.
Problem 02
Spot Rate USD/INR : 43.70/44.05
Fwd Rate (Six Months) : 43.70+0.40/44.05+0.70
= 44.10/44.75
Annual Interest Rates in USA and India are 2% and 8%.
For buying USDfwd, Premium = [pic]
= [pic]
= 4.80%
Interest Rate Differential = 8 – 2 = 6%
Thus, while we lose 4.8% in forward mkt, we earn 6% in money mkt. Thus, net gain is 6–4.8=1.2%.
Start with USD 100 borrowed from US market.
Liability in US market after 6 months = [pic]
= USD 101
So, if we borrow INR and invest in USD is moving at a premium in INR we will make a loss
Interest Arbitrage
Interest Arbitrage refers to the international flow of short term liquid capital (Fixed Deposits denominated in Foreign Currencies or Convertible local currency) to earn a higher interest abroad. In India we have NRIs investing in fixed deposits to earn higher interest rates. Interest arbitrage can be uncovered or covered.
Uncovered Interest Arbitrage
In order to be able to able to take benefit of higher interest opportunity in foreign country, it is often necessary to convert the domestic currency to foreign currency while investing in foreign country and then reconverting principal and interest earned to local currency at the time of maturity.
In the countries where interest rates are higher, inflation is also higher. (nominal interest rate is mostly equal to real interest rate + inflation). When inflation is higher, the currency mostly depreciates over time. Thus, there is a risk of depreciation of investment due to lower exchange rate during the re-conversion after maturity. If such a foreign exchange risk is covered, we have covered interest arbitrage, else, we have uncovered interest arbitrage.
Suppose, interest rate in India is 11% where as it is 5% in US. A US investor will earn 6% extra per year or 3% every 6 months if he invests in India. However, since inflation rate is also high in India at 5% compared to just 2% in US, INR is likely to depreciate. If INR depreciates by 3% over one year, net return on investment by US investor falls to barely 3%. However, in case INR depreciates by more than 6%, the US investor will end up as net loser (and we have not even considered the transaction costs in conversion and reconversion processes).
Covered Interest Arbitrage
The scenario given above is not beyond real life events. In order to insure against exchange rate risks, investors usually go for covered interest rate arbitrage.
In this case, investor converts his investment into foreign currency at spot rate and at the same time sells forward the amount of foreign currency he is investing plus the interest he would earn to coincide with maturity date of investment. Though, he would be paying some premium for forward cover, he is insured against depreciation of currency. His return on investment will reduce by the amount of premium paid for forward deal compared to uncovered interest arbitrage but that is the price to be paid for insurance.
But such opportunities do not last long due to two reasons.
a) As funds move out of the home country, the interest rates rise there due to resultant paucity of funds. Vice versa as additional funds flow in to foreign country, excess liquidity of capital causes interest rates to soften.
b) As demand for foreign currency rises, exchange rates move in favour foreign currency. Currency appreciation coupled with excess demand for forward deals raise premium on forward deals. Thus, the cost of conversion and reconversion of currency to foreign currency increases and eats into profits to be earned from interest rate arbitrage.
Thus, the interest rate differential keeps reducing and forward premium keeps increasing till it comes to a level where it is no more advantageous to invest in foreign country.
Interest Rate Differential, Covered Interest Arbitrage and Interest Parity Theory
3
2
Arbitrage
1
0
-1 . .
-2
-3
-3 -2 -1 0 1 2 3
Forward Exchange Rate – Discount or premium in percent per annum
Explanation of the above figure
Arbitrage Outflow will take place
1. If (+)ve interest rate differential is > Forward Discount like at Point A, Interest Rate Differential = 2, and Fwd Discount = 0.5
2. If Forward Premium > (–)ve Interest Rate Differential like at Point A’,
Fwd Premium = 2.2, and Interest Rate Differential = 1.95
Arbitrage Inflow
3. If Forward Discount > (+)ve Interest Rate Differential, like at Point B,
Fwd Discount = 2.7, and (+)ve Interest Differential = 1.2
4. If (–)ve interest Rate Differential > Forward Premium, like at Point B’,
–ve Interest Rate Differential = 2.2, and Forward Premium = 0.7
Sample Practice Questions on Exch Rate (Forex Arithmetic)
Q1. The Spot Rate of two banks in US Market for GBP is as follows:
GBP/USD: Bank A: 1.4550/1.4560
Bank B: 1.4380/1.4548
Find Whether Arbitrage is possible.
Ans. The Ask Rate of Bank B is 1.4548 which is less than Bid Rate of Bank A at 1.4550. Thus, it is possible to Buy from Bank B and Sell to Bank A and earn an Arbitrage of GBP of 0.0002 for each dollar.
Q2. Rate for USD in Indian Market is as follows:
USD/INR: 46.2000/3000
Inverse the quotes.
Ans. [pic]
= 0.02164
[pic]
= 0.02159
Q3. In the Forex Market, following are the rates:
USD/JPY: 110.25/111.10
USD/AUD: 1.6520/1.6530
AUD/JPY: 68.30/69.00
Find Whether Arbitrage is possible in terms of AUD/JPY.
Ans. In this case, if we inverse the rate of USD/AUD and get AUD/USD, our job will become easy.
[pic]
AUD/JPY = AUD/USD X USD/JPY
(AUD/JPY)BID = (AUD/USD)BID X (USD/JPY)BID
[pic]
By Three Point Arbitrage - AUD/JPY = 66.6969/67.2533
Forex Market Rate for AUD/JPY = 68.30/69.00
Thus, there is a difference of almost one JPY for each AUD in two situations.
So, to earn arbitrage, Sell JPY and buy USD @ 111.10.
Then sell USD and buy AUD @ 1.6520. Now sell 1.6520 AUD and buy JPY @ JPY 68.3 for AUD 1.
[pic]
Thus, for every JPY 111.10 put into market, there is a return of JPY 112.83.
Q4. Following are the quotes in New York:
GBP/USD: 1.5275/85
USD/CHF: 1.5530/39
a) What rate do you expect for GBP in Basle?
b) If Basle quote is 1GBP= 2.3320/30 CHF then find whether Arbitrage is possible?
Ans GBP/USD: 1.5275/85, USD/CHF: 1.5530/39
[pic]
[pic]
[pic]
Basle Quote = 1GBP = 2.3320/30 CHF
GBP is cheaper to buy in Basle at 2.3330 CHF. Therefore, buy one GBP in Basle and sell in New York for USD 1.5275. Then sell USD 1.5275 for 2.3722 CHF and earn an arbitrage of (2.3722 - 2.3330) = 0.0398 CHF per GBP or
2.3722 CHF = [pic]
= 1.0168 GBP
So, the Arbitrageur will make GBP 0.0168 for every GBP invested.
Q5. Following are the EUR/INR quotes:
Spot: 49.9525/80
1 Month Forward: 100/120
3 Month Forward: 225/255
6 Month Forward: 300/275
Ans. 1 Month Forward: 49.9625/700
3 Month Forward: 49.9750/835
6 Month Forward: 49.9225/9305
Q6. A bank is quoting following rates:
EUR/USD: 1.5975/80
2 Month Forward Points :20/10
3 Month Forward Points: 25/10
Further,
AED/USD rate is 3.7550/60
2 month forwards points: 20/40
3 month Forward points: 30/50
A firm wishes to buy AED against EUR 3 month forward. Find the rate to be quoted by the bank.
Ans. AED/USD = 3.7550/60
3 months Forward Rate = 3.7580/610
[pic]
[pic]
EUR/USD = 1.5975/80
3 months Forward Rate = 1.5950/70
EUR/AED = EUR/USD X USD/AED
= 1.5950 X 0.2659
= 0.4241
Money Market Hedging
Q1. An American Exporter will be receiving ₤ 1000,000 3 months from now. Spot Rate for GBP/USD = 1.6 Rate of interest in USA and London Money market is 10% and 5% respectively.
Suggest hedging strategies for the exporter.
Q2. An American Importer has to pay ₤ 1000,000 to a party in London for the denim exports it has made-3 moths from now. The Spot rate for GBP is 1.6 USD. It is expected that USD may depreciate further in future. Rate of Interest in USA is 5% and in UK it is 10%.
Suggest hedging strategies for importer.
Interest Rate Arbitrage
Q1. Exchange rate for USD in India is
Spot: 45.0020
6 month forward: 45.9010
Interest rate (annual) in the money market is as follows:
USA: 7%
India: 12%
Work out the arbitrage opportunity.
Q2. In April 2005 USD/ INR quotes were 43.70/44.05.
6 moths Swap points were 40/70
Annual Interest Rate in USA and Indian were 2% and 6% respectively.
Work out the scope for arbitrage, if any.
Q3. A Customer obtains following quote-
EUR/USD: 1.2930/1.3270
Annual USIBBR/US IBOR: 4/5.5%
Annual LIBBR/LIBOR: 6/9%
Calculate the likely limits for the Forward Rate between the two countries.
FOREX RISK MANAGEMENT THROUGH FUTURES
A future is an exchange-traded derivative which is similar to a forward. Both futures and forwards represent agreements to buy/sell some underlying asset in the future for a specified price. Both can be for physical settlement or cash settlement. Both offer a convenient tool for hedging or speculation. For little or no initial cash outlay, both instruments provide price exposure without a need to immediately pay for, hold or warehouse the underlying asset. In this sense, both instruments are leveraged. Futures and forwards trade on a variety of underliers: wheat, oil, live beef, Eurodollar deposits, gold, foreign exchange, the S&P 500 stock index, etc.
The fundamental difference between futures and forwards is the fact that futures are traded on Exchanges. Forwards trade over the counter. This has three practical implications.
1. Futures are standardized instruments. You can only trade the specific contracts supported by the exchange. Forwards are entirely flexible. Because they are privately negotiated between parties, they can be for any conceivable underlier (currency) and for any settlement date. Parties to the contract decide on the notional amount and whether physical or cash settlement will be used. If the underlier is for a physically settled commodity or energy, parties agree on issues such as delivery point and quality.
2. Forwards entail both market risk and credit risk. A counterparty may fail to perform on a forward. With futures, there is only market risk. This is because exchanges employ a system whereby counterparties exchange daily payments of profits or losses on the days they occur. Through these margin payments, a futures contract's market value is effectively reset to zero at the end of each trading day. This all but eliminates credit risk.
3. The daily cash flows associated with margining can skew futures prices, causing them to diverge from corresponding forward prices.
A future is transacted through an authorised brokerage firm. Working through their respective brokers, two parties will transact a trade. Legally, that trade is structured as two trades, both with a clearinghouse owned by or closely affiliated with the exchange. For example, suppose Party A and Party B trade. Party A is long and Party B is short. This would be legally structured as
• Party A being long on One million USD futures at Rs 47 with the exchange's clearinghouse being the counterparty; and
• The exchange's clearinghouse being long on One million USD futures at
Rs 47 with Party B being the counterparty.
Party A and B then have no legal obligation to each other. Their respective legal obligations are to the exchange's clearinghouse. The clearinghouse never takes market risk because it always has offsetting positions with different counterparties.
Before you can trade a futures contract, the broker collects a deposit from you called initial margin. This may be in the form of cash or acceptable securities. The broker holds this deposit for you in a margin account. The amount of initial margin is determined according to a formula set by the exchange. For a single futures contract, it will be a small fraction of the market value of the futures' underlier. For futures spreads, or if you are using futures to hedge a physical position in the underlier, initial margin may be even lower. Generally, initial margin is intended to represent the maximum one-day net loss you could reasonably be expected to incur on a position.
Through the margining process, futures settle every day. Unlike a Forward, where all contract obligations are satisfied at maturity, obligations under the futures contract are satisfied every day on an ongoing basis as mark-to-market profits or losses are realized. This essentially eliminates credit risk for futures.
Maintenance Margin is some fraction—perhaps 75%—of initial margin for a position. Should the balance in your margin account fall below the maintenance margin, your broker will require that you deposit funds or securities sufficient to restore the balance to the initial margin level. Such a demand is called a Margin Call. The additional deposit is called Variation Margin. Should you fail to make a variation margin payment, your broker will immediately liquidate some or all of your positions.
Mechanism of Futures Trading
Components of Futures Trade
1. Futures Players
a) Hedgers – These are the importers and exporters who mitigate their risk of unfavourable movement of exchange rate when they need to buy or sell the foreign currency at a future date.
b) Speculators – These are investors who buy or sell foreign currency with the sole aim of earning money through correct anticipation of movement of exchange rate.
c) Arbitrage – These are people who utilise the opportunities presented by market due to asymmetric forex exchange bid and ask rates in the same market or in different markets
2. Clearing Houses – Futures trade is an organised trade. Futures are traded through exchanges akin to Securities Exchanges which provide guarantee performance of all the players. They play the role of buyer for every seller and vice versa. Thus, every trading party in the futures market has obligation only to the clearing house.
3. Margin Requirement – The risk of default of any player is insured by imposing the requirement of depositing the margin money which is adequate to cover the adverse movement of currency in the short term. Thus, margins are not uniform and vary across markets, contracts, currency and duration of contract. Since the currency movement is not as wild as stocks, the margin requirement is also relatively small. (Usually in the range of 5% of contract value).
4. Daily Settlement – Notional losses or gains incurred due to fall in the value of the currency are required to be settled between the party and the broker on daily basis to ensure maintenance of original level of margin (security) money. This is technically called “Mark to Market”.
5. Delivery Date – There are two types of contracts – European Contract, which are delivered/encashed only on the last day of the contract period and American Contracts, which can be delivered/encashed on any day during the contract period.
6. Manner of Delivery – The contract settlement, technically called “Delivery”, can be done by either of the following three modes:
a) Physical exchange of underlying assets ie Exchange of currencies.
b) Cash Settlement as in the case of Stock Index Futures. There is no exchange of currencies and only differential amount is paid.
c) Reversing Trade - It is the process of offsetting a long position by acquiring a short position or vice versa. The two positions square at the end of the day.
7. Types of Orders –
a) Market Order – Order placed with broker to Buy or sell at prevailing market price.
b) Limit Order – Buy or sell order at a specific price or better.
c) Fill-or-Kill Order – It instructs broker to fill an order immediately at a specified price.
d) All or none Order – It allows broker to fill part of the order at specified price and remaining at other price/s.
e) On the Open or Close Order – This represents order to trade within a few minutes of opening or closing of the exchange.
f) Stop Order – It triggers a reversing trade when prices hit a prescribed limit.
Functions of Futures Markets
Futures Markets function as
1. Price Discovery Agent
2. Speculation Tool
3. Hedging Tool
Price Discovery
“Futures” prices are generally treated as a consensus forecast by the market regarding prices of currency/commodity at the contract expiry date. Thus, for all and sundry, it is a free forecast available to them. Empirical studies have revealed that such forecasts are not very accurate, yet they are the best among all the alternatives available. More often than not, they provide a reasonably good hint in case of currencies and commodities but not equally accurately in case of stocks.
Speculation
Futures provide excellent tool for speculation since it is highly leveraged (only margin amount of approximately 5% needs to be paid upfront). Also, the transaction costs are lower than in case of delivery. Thus, percentage returns are higher.
Speculators are categorised based on the length of positions they hold.
a) Scalpers – They have the shortest holding horizons, typically closing a position within minutes of initiation.
b) Day Traders – They hold futures positions for a few hours but never longer than one trading session. They open and close positions within the same day. Their net holding at the end of any day is always zero. They play on the scheduled announcements and news related to money supply, trade deficit etc.
c) Position Traders – They have longer holding horizons, often a few months. There are two types of position traders:
i) Outright Position Holders – He takes position based on his belief on the underlying potential. He stands to make large gains or losses.
ii) Spread Position Holders – He does not have belief on a particular currency or commodity, but he speculates on relative movement of two commodities. So he holds simultaneous position in two commodities, long in commodity which is likely to appreciate and short in commodity which is likely to depreciate. The two commodities could be from same basket, like wheat and rice or could be from different baskets like wheat and Steel. If the spread between them widens, he gains else he loses. Such positions are less risky than Outright Positions.
Hedging
Hedging is process of engaging in a futures or forward contract by paying a small premium to eliminate risk associated with large unfavourable movement in exchange rate by the time payment or receipt is due. There are three types of hedges:
a) Long Hedge/Anticipatory Hedge – Investor does not own the asset but wants to purchase the same in foreseeable future. He protects against adverse price movement of the large escalation in prices of that asset by long hedge.
b) Short Hedge – An investor already owns an asset which he wants to sell in future. He wants protection against steep fall in its prices. He hedges the risk by selling its future.
c) Cross Hedge – The act of hedging ones position by taking an offsetting position in another good with similar price movements. Although the two goods are not identical, they are correlated enough to create a hedged position. A good example is cross hedging a long position in crude oil futures contract with a short position in natural gas. Even though these two products are not identical, their price movements are similar enough to use for hedging purposes. In currency matters, USD and Canadian Dollars can be used for cross hedging.
FOREX RISK MANAGEMENT THROUGH OPTIONS
An Option is a contract which gives its buyer the right either to buy (Call Option) or to sell (Put Option) a specified amount of a currency within/after a specified period at a predetermined price called Strike Price. An Option that gives the right to buy is called a Call Option and an Option that gives the right to sell is called a Put Option.
An option gives the buyer right to buy or sell but there is no obligation to do so. A buyer is at liberty not to exercise his option. But the seller is under obligation to honour the call or put option if the buyer decides to exercise it. And the buyer will do it only when it is profitable to him. He will exercise his Call Option (right to buy) when market rate of that currency is higher than the strike price. Similarly, he will exercise his put Option, only when market price has fallen below the strike price.
Suppose, Mr Yashwant buys a Call Option from Mr Joseph @ INR 46 for USD 1,000,000 on 01 Sep 2006 with the expiry date of 30 Sep 2006. Now, Mr Yashwant can demand from Mr Joseph to sell USD 1,000,000 on any day during this period. Mr Yashwant will want to buy these USD from Joseph only if rate of USD in the open market is higher than strike price of INR 46, say INR 47. In case, open market rate is lower than INR 46, say INR 45, Mr Yashwant will be better off buying the USD from open market.
If USD rate goes up to INR 47 and Mr Yashwant demands to exercise his Call Option, Mr Joseph will have to sell him those USD at strike price of Rs 46 which is now at a discount of INR 1/- to the market price. However, if the market price had fallen below the strike price to INR 45, Mr Yashwant is under no obligation to buy USD from Mr Joseph at Rs 46.
But why should Option Seller (also called Writer) take this risk? He sells the options for a price called Premium which is non refundable. He hopes that option would not be exercised and he would be able to keep the premium. In case an option is not exercised, it is his earning. In case the option gets exercised, his loss is partly offset by this amount.
Speciality of Options contracts is that the while max loss for the buyer of Option is limited to the premium he paid for purchasing the contract, his profits have no limits. The situation is just the reverse for the seller. His max profit is equal to the premium he has received but his losses have no cap.
Option Contracts also follow the American and European systems. An option which can be exercised at any time during the currency of the contract is called “American Style” Option. Another type of Option which can be exercised only at the end of the contract period is called the European Style. The probability of exercise of option is higher in case of American Options and therefore the premium is also higher. Similarly, if the contract period is longer, probability of exercise of option increases and the premium goes up again. Another factor which affects the premium is the Strike Price. Farther the strike price from spot price at the time of deal, lesser the probability of exercise and so lesser the premium.
An option can be “In the Money”, “At the money” or “Out of the money” depending upon Strike Price vis a vis market price of asset.
An option is called “In the Money” if the exercise of option at that market price would fetch him profit. So, in a Call Option, if the dollar’s spot price is INR 46, and strike price is INR 44, exercise of option will fetch a profit of INR 2.00 per dollar.
An option is called “At the Money” if the spot price and strike price are equal and therefore no gain or loss would accrue to either side (premium is not considered). Therefore, such options are not exercised.
An option is called “Out of Money” if its exercise would lead to loss to the buyer, ie, in a call option, the spot price of the USD falls below the strike price. Suppose, a dollar call option was purchased for INR 44. If the spot price of dollar falls to Rs 43, it would be cheaper to buy shares from market than exercise of option. Therefore, “Out of Money” options are never exercised.
Premiums are also influenced by following factors:
a) Volatility – Higher the volatility, higher the chances of asset prices breaching the strike price. So, higher the premiums.
b) Interest Rate – Relative interest rate between two currencies affect premiums.
c) Political uncertainty, inflation, etc, again pose risk of sharp movement in currency exchange rates.
This flexibility and variability in pricing of options and premium gives a multitude of opportunities to the players in the market. By buying or selling a combination of options, profit opportunities are created. Some of the strategies adopted by people are listed below: -
Naked Option – An option for which the buyer or seller has no underlying security position. A writer of a naked Call Option, therefore, does not own the asset or even a Long Position in the asset on which the call has been written. Similarly, the writer of a naked Put Option does not have a Short Position in the asset on which the put has been written. Naked options are very risky-although potentially very rewarding. If the underlying asset moves in the direction anticipated by the writer/seller, profits can be enormous, because the investor would only have had to put down a small amount of money to reap a large return. On the other hand, if the asset moved in the opposite direction, the writer of the naked option could be subject to huge losses. It is also called uncovered option.
Straddle – An options strategy in which the investor holds position in both, a call and a put with the same strike price and expiration date. Straddles are a good strategy to pursue as a buyer if an investor believes that a stock's price will move significantly, but is unsure as to which direction (volatile market). The stock price must move significantly if the buyer of option is to make a profit. As shown in the diagram below, should only a small movement in price occur in either direction, the buyer will experience a loss (due to premium he has paid for two contracts). As a result, a straddle is extremely risky to perform. Additionally, on assets that are expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly.
[pic]
There is a Long Straddle in which the person buys call and put options simultaneously.
Short Straddle - If the market is expected to be stable, the person can sell the call and put options at the same time. Thus, he will collect two premiums and may have to pay back only a small portion of that amount if the asset price moves in a narrow band. This is called a Short Straddle because he is selling without owning the asset.
[pic]
Strangle –It involves buying a call and a put option at two different rates but of equal value and of same maturity date.
In a Long Strangle, Call is bought at a lower rate and Put is bought at higher rate. Long Strangle is again a strategy for a volatile markets.
In the short Strangle, Call is sold at higher rate and Put is sold at lower rate. Short Strangle is used for stable markets.
In case of straddle, if the market is not volatile, purchaser loses the premium on both the sides. But this is not the case in Strangle.
[pic]
Take a hypothetical case where a Long straddle has been entered into with Put Option purchased at Strike Price of INR 47 and a Call Option at Strike Price of INR 45, both with a premium of INR 1 each (Graph as shown by dotted lines). Theoretically, profit will start in the call option the moment price goes above Rs 45. However, when we consider that we paid a premium of Re 1, the profit will actually start only after market price exceeds Rs 46. Similarly, in the put the option, theoretically profit will start the moment price falls below Rs 47. However, in order to recover the premium that we paid, price should fall to minimum Rs 46. Thus, when we account for premiums also, the lines shift and new graph will look like as shown by firm lines. Now we see that at any exchange rate, the person does not suffer any loss. In the worst case scenario, at the spot rate of INR 46, he would break even. In any other situation, he would make some profit. There could be some loss at times in case the premium is too high and spread between the call and put rate being relatively small (situation represented in graph with light blue lines. Loss is shown in such case as orange shaded area which is comparatively small).
Exotic Options
What have been discussed so far were Vanilla Options Contracts as practiced in India. These were the contracts where there were no conditions attached to the contracts. In many countries, options contracts are available with additional conditions. Such contracts are called Exotic Options Contracts. While these options contracts are not available in India through official channels, there is no bar in entering into them on OTC (Over the counter) basis.
1. Tunnel Option Contract with Zero Premium - This contract is also called cylinder options contract. In this case, the upper limits of exercise price for Call Option is specified. Even if the spot price of asset exceeds the limit price, deal would be done at limit price only. Thus, the loss to the Call Seller has been limited. Similarly, limit price for exercise of Put option is also specified thus limiting the max loss of the Put option writer. Since the loss of writer has been capped, and the possible gain of the buyer has been capped, there is zero premium.
Eg. Put Option sold at Strike Price of INR 46.25 with the exercise price capped at INR 46. Now, even if the spot rate falls to INR 44, the exercise price will be considered to be INR 46 only and the seller will pay only INR 0.25 per dollar to the buyer.
2. Knock Out Options – This is a further amendment to the Tunnel Option. In this case, if the spot price moves beyond the limit price, the contract is knocked out which means that contract becomes null and void and no settlement takes place. Such kind of contract is not possible under American Contracts method. This happens only in European contracts where the contract expiry date is fixed. The premium for such contract is again very low because seller’s position is well protected.
3. Look Back Option – This is one option which has very high premium because it is heavily loaded in favour of buyer. Under this option, the deal is done at most favourable price for the buyer in the period preceding the settlement date. It allows the buyer to look back and select the most favourable rate in the past for settlement. So, if the rates in the past were 46.11, 46.31, 46.55, 46,72, 46.95, 46.45, 46.39, 46.20 on the days from contract to the settlement date, Call option buyer can look back into the past and select 46.95 which is the highest in the period as the settlement price. At the same time a put option buyer will be allowed to select 46.11 as the exercise price because that is most favourable to him.
4. Average Rate Option Contract – This is also called Asian Contract. Under this contract, the exercise price is the average of closing prices since contract date.
SWAPS
Unlike Futures and Options, Swap is not a risk management strategy. It is a strategy to take advantage of differential opportunities for different people.
Swap, as the name suggests, is the exchange of liabilities. Two people having liabilities of different types exchange their liabilities for some perceived advantage. For example, a French company wanting dollar loan might be getting better rates in French Francs. Another company in US might want French Francs but it is advantageous for it to borrow dollars. The two can borrow what is advantageous to them and then mutually exchange their currencies along with their payment liabilities without involving their lenders.
It could also be a swap between current and future liabilities of same person. A person may purchase spot currency X by selling currency Y and simultaneously selling forward currency X buying currency Y. Thus, there is one spot deal and one forward deal. Suppose, you are due to receive USD 1000 three months from now and have some excellent investment opportunity in USD. So, you spot buy the USD 1000 against INR and forward sell (three months) USD 1000. Once you receive USD 1000 three months later, you square up the forward position and get back the rupees that you had invested.
Swap comes in many forms, like interest rate swaps, currency swaps, positions swap, etc.
a) Spot Forward Swap – As explained above.
b) Forward Forward Swap – Both transactions are in future but executable on different dates.
c) Interest Swap
d) Currency Swap
Interest Swaps
a) Fixed to Fixed Interest rate Swaps
b) Fixed to Floating Interest rate Swaps
c) Floating to Floating Interest Rate Swaps.
Example –
Company A is offered loan in the market @ 11% fixed and LIBOR + 0.5% floating. Company A prefers to take fixed rate loan. Company B enjoys better credit ratings and therefore has been offered loan @ 9.50 % fixed and LIBOR floating. Company B prefers floating rate. Find the Swap possibility.
Solution –
| |Fixed Rate |Floating Rate |
|Company A |11% |LIBOR + 0.50% |
|Company B |9.50% |LIBOR |
|Difference |1.50 |0.50 |
It is clear from above data that company B has lower rate in both the cases. However, company B enjoys more benefit compared to B in case of fixed rate where the differential is 1.50% as against floating rate where differential is barely 0.5%. However, company B wants floating rate where its relative advantage is less.
In order to derive full advantage of this situation, Company A can take Floating Rate loan even though it wants fixed rate loan and Company B should take Fixed rate loan. After taking the loans they can mutually swap their liabilities. Now let us draw the table and see how both companies can benefit from such a transaction.
|Company |Pay to Market |Receive fm Co B |Differential |Pay to Co B |Net Rate of Interest|Gain |
|A |Libor + 0.50 |Libor |0.5% loss |10% |10.5% |0.5% |
|B |9.5% |10% |0.5% gain |Libor |Libor -0.5% |0.5% |
To understand this problem, look at it from another angle. Let us take company A and forget about company B for the time being. Company A has taken loan from the market and lent to Company B. So, it will earn interest from company B but has to pay interest to the market. There will be some differential between the two interest rates which will be gain or loss (gain at this stage is not mandatory). Now company A has also taken a second loan from company B and has to pay interest for it. This interest plus the differential is the net interest cost to the company A. Compare it with what company A would have paid had it taken the desired loan directly from the market and you know the gain. Repeat same exercise for company B. What is very important to note here is that while gains to both the companies may not be equal, neither company should be in loss else it will not enter into this swap transaction.
International Financial Institutions (Banks) are ever eager to swap their loans. These banks have their assets at Floating rate where as liabilities are at fixed rate. To cover this mismatch between assets and liability, they use swap.
Similarly, long gestation period projects like infrastructure projects prefer fixed rate whereas banks are often reluctant to give fixed rate loans due to long maturity period.
Currency Swaps
Cross Currency Swaps Along With Swap of Interest Rate Liability.
First ever such deal was between IBM and the World Bank. IBM had CHF loan and wanted to convert into USD loan. On the other hand World Bank wanted CHF loan but interest rates in Switzerland had already risen quite a bit. The two agreed to swap the loan and World Bank floated USD bonds in US market for equivalent amount to CHF loan of IBM. Once the money was collected, they swapped their loans. IBM began to service US lenders on behalf of World Bank while World Bank began to service IBM lenders in Switzerland.
Now suppose, World Bank issued bonds @ 3% in US market for USD 100,000,000 and IBM loan was CHF 300,000,000 with exchange rate being CHF 3 per USD.
|Company |Pay to Market |Other Party pays to |Pay to other Party |Net Rate of Interest |Gain |
| | |Co | | | |
|World Bank |3% |3.10% |8.10 |8% | |
|IBM |8% |8.10% |3.10 |3% | |
Biggest Challenge in case of swap transaction is to find another party which has corresponding requirements where amount, duration, and type match. To fill this gap, banks act as a mediator/broker. They charge a small fees in form of percentage of interest gained from both the parties.
Even with banks acting as mediator, it is not always possible to finding a matching company. So, a trend is emerging where in the banks have started acting as the counter party. (Is it not the same as basic function of banks? In case of direct lending and deposits, they do not match the tenure and amount. Same is the condition in this case).
A normal deposit and lending function carries two risks:
(a) Credit Risk – The borrower may default in payment.
(b) Interest Rate Risk – In case of interest rates movement, the customer at disadvantage may foreclose his account but the one who gains will not. The loss will then have to be borne by the bank.
In case of swap functions there could be another risk, ie.
(c) Exchange Rate Risk – The two currencies may move in a divergent fashion leading to same situation as in case of interest rates.
Thus, it is necessary to cover their positions with counter swap.
Problem –
| Company |Fixed |Floating |Preference |
|A |10 % |Libor + 0.5% |Fixed |
|B |9.5% |Libor + 0.25% |Floating |
|Differential |0.5% |0.25 % |0.25 % (net) |
|Company |Pay to Market|Receive from other |Differential |Pay to Other Co|Net Rate of Interest|Gain |
| | |Co |(Interest loss/gain) | | | |
|A |Libor + 0.5% |Libor + 0.375% |0.125% loss |9.75% |9.875% |0.125% |
|B |9.5% |9.75% |0.25% gain |Libor + 0.375% |Libor + 0.125% |0.125% |
| | |9.6% | |0.15% | |0.05 |
Valuation of Swap
Valuation of swap is done by finding out present value of future earnings. Valuation of Fixed rate swap is easy since earnings every year are known. In case of Floating rate swaps, the interest is reset every six months. Thus, calculating long term valuation beyond one or two periods is not possible.
PV of earning of Rs 100/year over 5 years = [pic]
MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAP
The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale to the European Union market. The plant is expected to cost € 4,920,000 and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is $1,700,000; the remainder of the plant will be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it would have to pay 9 percent per annum to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 7 percent. Centralia could borrow dollars in the United States at a rate of 8 percent.
Study Questions:
1. Suppose a Spanish MNC has a mirror-image situation and needs $1,700,000 to finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at 7 percent. The exchange rate has been forecast to be $0.90/€1.00 in one year. Set up a currency swap that will benefit each counterparty.
2. Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC, the U.S. dollar fixed rate falls from 8 to 6 percent and the euro zone fixed rate for euros has fallen from 7 to 5.5 percent. In both dollars and euros, determine the market value of the swap if the exchange rate is $0.9043/€1.00.
|Company |Pay to Market |Receive fm other |Differential |Pay to other Co|Net Rate of Interest|Gain |
| | |Co | | | | |
|Centralia |8% |8.5% |0.5 % gain |8 % |7.5 % |1.5 % |
|Spanish MNC |7% |8 % |1.0 % gain |8.5 % |7.5 % |1.5 % |
Solution
Since both the countries have relative advantage in borrowing from their respective countries, Centralia will borrow from USA $1,700,000 @ 8% and Spanish MNC will borrow € 18,888,889 @ 7% from Spain. It is assumed that the two companies will go for plain currency swap without any bargaining on interest rate. Thus, Centralia will take over loan of € 18,888,889 ($1700000 x 0.9) and hand over $ 1,700,000 loan to Spanish MNC along with liability for payment of interest and principal.
Payments that needs to be paid/received by each party: -
(Centralia will receive payment @ 8% per annum (ie USD 1,36,000) from Spanish MNC for 7 years and then a lump sum payment of USD 1,700,000 at the end of 7 years. Spanish MNC will receive payment @ 7 % annum (ie Euro 1,32,22)2 from Centralia over the same period and then Euro 1888889 at the end of the 7 years).
|Loan |Y 1 |Y 2 |Y 3 |Y 4 |Y 5 |Y 6 |Y 7 |Y 8 |Y 8 | |Centralia |1700000 | |136000 |136000 |136000 |136000 |136000 |136000 |136000 |1700000 | |Spain MNC |1888889 | |132222 |132222 |132222 |132222 |132222 |132222 |132222 |1888889 | |
Calculating Present Value of above payments:
(Please note that above are ANNUITIES (where a fixed amount is paid every year for a number of years) of 7 year each at different rates of interests. There are three methods to calculate the Present Value of an annuity and can be calculated by any of the three methods. First method is explained on previous page).
Second Method : PV of an annuity = [pic]
Third Method: - Tables are available at the end of every FM book which give value of annuity factor for any given combination of interest rate and duration. The annuity factor can be used to multiply with principal amount to arrive at the present value of any annuity.
(The problem with first method is that it is too long and cumbersome, where as third method requires availability of tables. It also does not give value for fraction of interest rates like 5.5. Thus, second method is by far the best method).
So, PV of Centralia Income = 136000 [pic]
= 136000 x 5.582 (You will find same value against column 6% and line 7% in FM tables)
= $ 759,152
Present Value of lump sum payment of USD 1,700,000 = [pic]
= [pic] = $ 1,130,597
Total Present Value of Centralia Loan = 759,152 +1,130,597 = $1,889,749
PV of Spanish MNC Income = 132222 [pic]
= 132222 x 5.683 (You can take average value of 5 and 6% from the table)
= € 751,413
Similarly, Present Value of lump sum payment of Euro 1,888,889 = [pic]
= [pic] = € 1,298,492
Total Present Value of Spanish MNC Loan = 751,413 + 1,298,492 = € 2,049,905
Converting the Euro into dollar amount € 2,049,905 x 0.9043 = $1,853,729
Net Loss to Spanish MNC = 1,889,749 - 1,853,729 = $ 36020
Forward Rate Agreement (Possibly a short note)
A Forward Rate Agreement (FRA) is a forward contract where the parties agree that a certain interest rate will apply to a certain notional loan or deposit during a specified future period of time. A FRA is similar to an Forex forward contract where the exchange rate for a future date is set in advance. It is purely notional as the parties do not actually pay or receive the principal sum but only settle the differential amount arising out of difference between agreed rate of interest and the market rate of interest. Thus, suppose, a company negotiates with a bank on 14 Sep 2006 a loan of USD 500 million for 5 years @ 6% interest starting on 01 Jan 2007. If the interest rate in the market at the start of the loan period, ie on 01 Jan 2007, increases to 7 %, bank will pay the company interest @ 1% for 5 year period on USD 500 million. However, if the interest rate falls to 5%, company will be obliged to pay to the bank same amount. There is no option to back out of contract.
Interest Rate Options – In case of interest rate options, often there is a floor and a cap. In case of wild movement of interest rates, these floor and cap come into play. They restrict the upside and the down side for both the parties. The settlement is done within the band of floor and cap even if the interest rates move beyond these limits.
For quite a few years Japan had a ‘0’ interest rate regime. The interest rates have begun to harden a bit now. However, they are still abysmally low. Libor for Yen is currently at 0.15 – 0.18%. Yen loans are available at Libor plus 4 to 5 % where as Rupee loans cost as much as 8 to 10%. Thus, there is still margin of 3 to 5 % available for an Indian Company.
When an Indian company or bank takes a Yen loan, it is hoping that the Yen wont appreciate compared to Indian currency, nor will the interest rate in Japan fluctuate wildly during the loan period. But, lenders’ expectations are just the opposite. They are hoping that Yen will appreciate and even the interest rates in Japan will harden. The deal takes place because of contrary expectations of two parties.
Similarly, Swiss Frank Libor rate is currently at 2%. Add a few percent and it is still cheaper to borrow but with the risk of Libor increasing as also appreciation in value of Swiss Frank which may wipe out all the gains of lower interest rate prevailing now.
While there is a cap placed on ECB, there is no cap on Swap deals.
Balance of Payment Concept/Accounting
Balance of Payment Account is Accounting record of economic transactions with the world. Any transaction which can be converted into money terms is recorded. Balance of Payment account has three main heads: -
a) Current Account (Revenue Transactions)
b) Capital Account
c) Reserve Account (Liability of Central Bank)
The rules for accounting are –
a) Cr all transactions which lead to receipt of Forex from rest of the world and Dr the receipt of forex itself.
b) Dr all transactions which lead to payment of forex to Rest of World (RoW). Cr the payment of forex itself.
This account also follows the typical double entry book keeping system. There is a debit entry for every credit entry and vice versa. (It is the same principle which we studied while studying Accounting. Credit the account which generates the income (so Cr sales account for sales) but debit the account which receives the payment (so Dr cash account)
Reserve Bank Bulletin for Balance of Payment status (Sep 2006) is available at (internet) or Balance of Payment.pdf file separately.
Clarifications regarding some terminology:
Merchandise – Physical goods which can be seen and felt
Invisibles – Which have no physical existence, like services, software, BPO, etc
Travel – Money spent by tourists in India or by Indians tourists else where. Includes inland travelling ticket expenses.
Transport – Fares paid for material and men for international movement. Ticket fares paid for international travel are accounted under this head but not the travel fares within the country.
G.n.i.e. – Government Not Included Elsewhere
Some Typical Transactions:
1. An Indian Company exporting goods worth Rs 100 million to rest of the world and receiving payment in bank.
By Merchandise Cr 100 million
To Banking Dr 100 million
2. Indian Co. exporting to RoW on USD 500 million of goods of which it receives 50% payment immediately and rest in instalment over next 3 years
By Merchandise Cr 500 million
To Banking Dr 250 million
To Commercial Loan Dr 250 million
Suppose after one year USD 50 million is received.
By Commercial Loan Cr 50 million
To Banking Dr 50 million
3. Indian Govt receives a grant of goods worth USD 500 million after Gujarat Earth Quake from Govt of US
By Transfer Payment Ac (official) Cr 500 million
To Merchandise Ac Dr 500 million
(for accounting purpose cases of goods grant are treated as import)
4. BHEL floats out ECB deal to RoW worth 500 million and uses the money for buying plant and machinery for use:
By Commercial Borrowing Cr 500 million
To Merchandise Dr 500 million
5. Infosys receiving part of profit USD 500 million which is outcome of investment in software entities in Singapore, USA and UK
By Foreign Investment A/c. Cr 500 million
To Banking A/c Dr 500 million
CAPITAL ACCOUNT CONVERTIBILITY
The govt has allowed De-Jure Current Account Convertibility but not De-Facto convertibility. What it means is that current account convertibility is only in the name. While there are no limits placed on current account convertibility for import and export purposes, there are logical limits imposed on convertibility for other reasons like personal travel, business travel, medical treatment, Studies, Maintenance, etc.
Convertibility on Capital Account, also called full float of rupee, is still far way off. Even though Tarapore Committee (Salient Recommendations listed below) had recommended Capital Account Convertibility, Govt and RBI are treading a cautious approach. The repercussions of Capital Account Convertibility can be disastrous if things go wrong. The world learnt it through East Asian Economic Crisis in 1997. Booming Economies suddenly collapsed in a matter of days.
Once Capital Account convertibility is allowed, every one is allowed a free hand to invest in and dis-invest from the country as much as and whenever he wants. At the first sign of trouble, investors rush to dis-invest and the cascading effect on economy is crippling. Currently, there are caps on how much can one invest abroad or how much can a foreign company invest in which company/sector. In addition, before investing, companies have to register themselves. There are caps on ECB as well.
For further details on Capital account, read last semester notes on FEMA compiled and forwarded by Mr Parab.
RECOMMENDATIONS OF TARAPORE COMMITTEE ON
CAPITAL ACCOUNT CONVERTIBILITY
A committee on Capital Account Convertibility, was setup by the Reserve Bank of India (RBI) under the chairmanship of former RBI deputy governor S.S. Tarapore in to "lay the road map" to capital account convertibility. The committee submitted its report in 1997. At the moment it is still a report and central bank has to accept the recommendations of the committee.
The five-member committee had recommended a three-year time frame for complete convertibility by 1999-2000. The highlights of the report including the preconditions to be achieved for the full float of money are as follows:-
Pre-Conditions
1. Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 1997-98 to 3.5% in 1999-2000. (Yet to be achieved).
2. A consolidated sinking fund has to be set up to meet government's debt repayment needs; to be financed by increased in RBI's profit transfer to the govt. and disinvestment proceeds.
3. Inflation rate should remain between an average 3-5 per cent for the 3-year period 1997-2000. (had come down but inched up again over last two years).
4. Gross NPAs of the public sector banking system needs to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from the current 9.3% to 3%. (We are almost there).
5. RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate. RBI should be transparent about the changes in REER
6. External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%
7. Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act.
8. Phased Liberalisation of Capital Controls - The Committee's recommendations for a phased liberalisation of controls on capital outflows over the three year period which have been set out in detail in a tabular form in Chapter 4 of the Report, inter alia, include:-
a) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be allowed to invest up to US $ 50 million in ventures abroad at the level of the Authorised Dealers (ADs) in phase 1 with transparent and comprehensive guidelines set out by the RBI. The existing requirement of repatriation of the amount of investment by way of dividend etc., within a period of 5 years may be removed. Furthermore, JVs/WOs could be allowed to be set up by any party and not be restricted to only exporters/exchange earners.
b) Exporters/exchange earners may be allowed 100 per cent retention of earnings in Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in operation of these accounts including cheque writing facility in Phase I.
c) Individual residents may be allowed to invest in assets in financial market abroad up to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$ 100,000 in Phase III. Similar limits may be allowed for non-residents out of their non-repatriable assets in India. (Phase I limits allowed)
d) SEBI registered Indian investors may be allowed to set funds for investments abroad subject to overall limits of $ 500 million in Phase I, $ 1 billion in Phase II and $ 2 billion in Phase III.
e) Banks may be allowed much more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short and long term) may be subject to an overall limit of 50 per cent of unimpaired Tier 1 capital in Phase 1, 75 per cent in Phase II and 100 per cent in Phase III with a sub-limit for short term borrowing. in case of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act and the prudential norms for open position and gap limits would apply.
f) Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior RBI approval at various stages may be dispensed with subject to reporting by ADs. All non-residents may be treated on part purposes of such investments.
g) In order to develop and enable the integration of forex, money and securities market, all participants on the spot market should be permitted to operate in the forward markets; FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in India; all India Financial Institutions (FIs) fulfilling requisite criteria should be allowed to become full-fledged ADs; currency futures may be introduced with screen based trading and efficient settlement system; participation in money markets may be widened, market segmentation removed and interest rates deregulated; the RBI should withdraw from the primary market in Government securities; the role of primary and satellite dealers should be increased; fiscal incentives should be provided for individuals investing in Government securities; the Government should set up its own office of public debt.
h) There is a strong case for liberalising the overall policy regime on gold; Banks and FIs fulfilling well defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products.
INTERNATIONAL FINANCIAL MARKETS
International Financial Market can be divided as follows:
a) Euro Currency Market
b) International forex and bond market
c) International equity market
Euro Currency Markets
What is Euro Currency?
Euro currency is not to be confused with currency of European Union. It has no relation to Euro or for that matter with any currency in particular.
Eurocurrency is the term used to describe deposits residing in banks that are located outside the borders/legal jurisdiction of the country of currency the deposits are denominated in. For example, a deposit denominated in US dollars residing in a Japanese bank is a Eurocurrency deposit, or more specifically a Eurodollar deposit.
As the example identifies, it is important to note that despite its name, Eurocurrencies are not limited to Europe and as such it must not be confused with the Euro. The use of this idiosyncratic term arose from the fact that Eurocurrency markets first developed in Europe during the 1950s when the former Soviet Union asked London banks to hold US dollar denominated deposits in the fear that deposits in US banks would be frozen or even seized in the event of escalation of tension between USA and USSR.
Today, the Eurocurrency markets are active for the reason that they avoid domestic interest rate regulations, reserve requirements and other barriers to the free flow of capital.
Thus, Euro currency is not any currency in particular. A Eurocurrency is any currency that is deposited in a bank outside its country of origin. So, there can be Eurosterling, Eurodollar, Euroyen, Euromarks and so on.
Euro Currency operations are not limited to cash. They can be in any kind of financial instrument as long as the deal is cross currency and cross national. They can be in the form of:
a) Euro cash deposits
b) Euro Bonds
c) Euro Commercial Papers
What is Euro Currency Market?
Euro currency market is the foreign currency market which specializes in the facilitation of borrowing and lending of currencies outside their country of origin. For example USD deposits or USD loans made available by a bank in London.
Reasons for Rise of Euro Currency Markets
Euro currency markets emerged in the decade of 1950s’ and 1960s’ on account of following –
1. Cold War between USA and USSR – The dollars earned by USSR through weapons sale and other exports needed to be invested outside USSR.
2. Oil crisis which benefited gulf countries. Petro dollars earned by middle east countries needed to be invested. America has been having a love hate relationship with Middle East for a long time and therefore they did not want to part all their petro dollars in USA. In addition, deposit rates on external deposits were comparatively low in USA.
3. Relaxation of banking norms in the European region.
Main centers of Euro Currency markets are London, Frankfurt, Singapore, Hong Kong, etc.
Categorization of Euro Currency Market
1. Euro Deposit Market / Euro Credit Market – This refers to simple deposit and lending function of a third country currency in Euro Bank.
2. Euro commercial paper market.
3. Euro Bond Market – E.g. An Indian Corporate house floating bond denominated in terms of Yen or dollars in London.
Advantages of Euro Deposit / Credit Market
Euro Banks are normally beyond the tight controls of Central Banks of the country and do not need to follow the stringent SLR and CRR ratios, interest rate regulations, etc. This lowers their cost of operation and Thus, they are able to offer better deposit and lending rates than normal domestic banks.
Offshore Financial Centre
OFC are certain specific locations on the world map –
1. Which are tax heavens
2. Enjoy scenario of low or no government regulations and
3. Offer the advantage of banking secrecy and anonymity. Like erstwhile Swiss Banks which were notorious for being repository of black money of the world, Offshore Financial centres are provide similar secrecy and anonymity though they do not enjoy same kind of confidence as Swiss Banks.
There are some 55-60 OFCs in the world. Some well known financial centers are – Bahamas, British Virgin Island, Cayman Island, Hong Kong, Maldives etc.
Use of Offshore Financial Centers
1. For establishment of offshore banks.
2. For establishment of international business corporations.
3. For tax evasion and money laundering.
SEZs, which are mushrooming in India and China, are mini versions of Offshore Financial Centres.
What is an Offshore bank?
a) A bank which carries deposits of such depositors who either are non-residents or are residents but maintain the foreign currency accounts.
b) Offshore banking entities do not bank in terms of the currency of the country where they are located but deal in forex deposits and loans only. Thus, an Indian Offshore bank can not deal in INR. All its transaction will be in any currency but INR.
Advantages of Offshore Banking
a) Secrecy of accounts.
b) Tax advantage
c) Offshore banks do not need to follow the reserve requirement guidelines and have lower regulatory expenses Thus, their lending rates are lower and deposits rates more attractive.
International Bond Market
Categorization of International bond market –
a) Euro Bonds
b) Foreign Bonds
c) Global Bonds
Euro Bonds
Bonds which are floated in the currency other than the currency of the country in which they are floated by a company of the third country called Euro Bonds. Thus, if an Indian company floats USD denominated bonds in UK, they will be called Euro Bonds.
Foreign Bonds
Bonds which are floated in the local currency of the country of floatation by a foreign company are called Foreign Bonds. Thus, if an Indian company floats USD denominated bonds in USA, they will be called Foreign Bonds.
Types of Foreign Bonds
a) Yankee Bonds – These are foreign bonds floated in USA
b) Bulldog Bonds – These are foreign bonds floated in UK
c) Samurai and Shibosai Bonds –
i) Samurai – These are Yen bonds floated in Japan in open market.
ii) Shibosai – These are Yen bonds floated on Pvt Placement basis.
d) Dragon Bonds – These are foreign bonds issued in local currencies of the South Asian countries.
Other Types of Bonds
1. Straight Bonds – These are plain vanilla bonds with fixed rate of interest and fixed date of maturity.
2. Floating Rate Bonds – These are LIBOR linked interest rate variable interest rate bonds where in interest rate is adjusted every 6 months.
3. Convertible Bonds – These bonds convert into equity share after the specified period of time. In this category, there could be fully convertible or partly convertible bonds.
4. Floating rate bond with collars – These floating rate bonds have upper and lower limits of interest rate variation. Thus, the max and min interest payable are capped irrespective of movement of interest rate in the market.
5. Bonds with Warrants – These are the bonds which are accompanied by an option to the buyer of the bond to buy specified number of equity shares for a specified price at some specified time in future often prior to expiry of the bonds. He may or may not exercise this option depending on the market price of the share vis a vis offer price. He may even sell this option to some one else at a premium.
These are not same as Convertible Bonds. There is a minor variation from convertible bonds. In case of convertible bonds, the money which was paid as bond price is not paid back and shares are issued in lieu. In case of warrants, additional money is paid for exercise of option while bond money is paid back on maturity.
Warrant option is used as a sweetener to float bonds with lower interest rate. In case the probability of share price appreciation is very high, they could be even at Zero interest rate.
6. Zero Coupon Bonds – These are also called Deep Discount Bonds. These bonds are issued as zero percent interest rate bonds but at a discount to the face value. Bonds are paid back at face value on maturity. Thus, the discount on the face value actually represents the interest component. However, this trick is played to browbeat the tax system of the countries where interest is charged to income tax.
7. Callable Bonds – These are the bonds wherein the company reserves the option to call back the bonds prior to maturity but after the lock-in period. Such bonds are issued when
a) It is a fixed rate bond and there is strong probability of softening of interest rates in future.
b) It is a floating rate bond and there is strong probability of hardening of the interest rate in future.
8. Puttable Bonds – These are bonds wherein the buyer has option to sell back to company any time after the lock-in period. Such bonds are issued if the company does not enjoy very good credit rating in the market to give some confidence to the investors.
9. Dual Currency Bonds or Hybrid Bonds – These are bonds which are sold in one currency and payment of interest or principal or both is done in another currency. Eg. An Indian company may float a USD bond in US and pay the interest and principal back in INR.
Bond Issue Procedure
1. Issuing company takes the approval of the Board of Directors.
2. Issuing company appoints Lead Manager.
3. In consultation with the issue manager, the company appoints Co-Managers, Under writers, Brokers to the issue.
4. The Lead manager prepares the draft document for the bond issue and the bond rate is decided.
5. The draft prospectus is discussed and is given the final shape.
6. Listing formalities are completed by the company and the Issue Manager.
7. Announcement of the issue is made.
8. Investor response is monitored.
9. Final bond issue is made.
10. Tombstone advertisement is published – It is in the form of Thanks advertisement detailing the response and money collected.
External Commercial Borrowings
There are two routes for raising ECB:
a) Automatic Route
i) Corporates – up to USD 20 million for 3 years and upto USD 500 million for 5 years and above.
ii) NGOs – Allowed micro credit of upto USD 5 million.
b) Approval Route – Even though limit are same but banks and financial institutions have to take prior approval.
However, ECB can not be raised from just any body. Like the banks have to follow KYC (Know your customer) norms, ECB borrowers have to follow KYL (Know your lender) norms. The borrower needs to get a due diligence certificate from an approved overseas bank that the lender has held a satisfactory account with it for atleast 2 years.
Forms of External commercial borrowing – Following credits are deemed to be ECB
a) Buyers’ Credit – The advances received from a buyer is deemed ECB.
b) Suppliers’ Credit – The credit period allowed by supplier is deemed ECB.
c) Short Term Borrowings – Loans raised for one year or less. Commercial papers, issue of Certificates of Deposits.
d) Fixed rate and Floating rate bonds -.
e) Loans from International Financial Institutions – Various international financial institutions like Asian Development Banks, The International Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA) and including World Bank (But not IMF) lend for various projects.
f) Syndicate Loans – These are large loans for which no single bank wants to take full exposure. Thus, a group of banks join together and lend as a group. Thus, the risk is spread out. Loan to Enron Corporation for Dabhol Power Project is one example of syndicated loan.
Procedure of Syndicate Loans
1. Borrower prepares Information Memorandum.
2. IM carries details of the borrower, the amount of loan needed, proposed maturity period of the loan, purpose of the loan etc.
3. Borrowers send invitations to the international banks along with the IM.
4. Borrower receives credit proposals and analyses them.
5. It enters into agreement with lead syndicate bank which deals with other banks in the syndicate.
6. Information of the deal is submitted to the Ministry of Finance and to the Reserve Bank of India.
Equity Market
There are two routes for raising equity capital from foreign markets:
a) Listing company’s shares in those countries’ stock exchanges
b) Through Depository Receipts (ADRs and GDRs)
The biggest problems faced in raising the equity money from foreign markets are the accounting standards (US GAAP and others), disclosure norms (which are pretty tough in advanced countries), expenses and time involved.
However, raising money through ADR and GDR is still easier than listing on the foreign stock exchanges. Two popular terms for Depository Receipts are ADR and GDR which stand for American Depository Receipts and Global Depository Receipts respectively. ADRs are Depository Receipts issued in USA while GDRs are the Depository Receipts which are issued in many countries.
Definition: An ADR is a negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas, and help to reduce administration and duty costs on each transaction that would otherwise be levied.
The advantage of ADR/GDRs to local investors is that they do not have to buy and sell shares through the issuing company's home exchange, which may be difficult and expensive. In addition, the share price and all dividends are converted into the shareholder's home currency.
The process of ADRs and GDRs involves selling the shares (without voting rights) to a Depository Participants (Some International Bank). This Depository then sells those shares in its markets. Buyers of the Depository Receipts have right over the shares of the company. There is rarely one to one relationship between DR and the Shares of the company. It could be any ratio, say One ADR = 10 Shares.
Fungibility – Fungibility is Interchangeability. Here, it is facility to convert Depository Receipts in to actual shares. Two way fungibility means permission to convert Depository Receipts to shares and then back to ADRs.
-----------------------
.B
.A’
Arbitrage inflow
Arbitrage Outflow
Profit
46.50
45.50
46
Selling a Call
Selling a Put
Interest Parity
Intereest Differential in favour of foreign country in percent per annum
A
Loss
A Put Option Short Straddle
47
45
46
Long Strangle Graph
Call Option plus Premium
Put Option minus Premium
Call Option Strike Price Line
Put Option Strike Price Line
Profit
Loss
B’
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