FOREX (FX)

FX-Definition
 The foreign-exchange market ("forex" or
"FX") can be defined as the cash market
where currencies are traded.

 Its an over-the-counter market which

involves simultaneous buying of one
currency and selling of another.
 Characteristics of Forex market
 Large trading volume.
 No central marketplace for currency exchange,
rather, trade is conducted over-the-counter.
 Extreme liquidity of the market.
 Large number of, and variety of, traders in the
market.
 Geographical dispersion.
 Its long trading hours - 24 hours a day (except
on weekends).
 Variety of factors that affect exchange rates.
 Characteristics-cont.
 Law of One Price
 “In competitive markets free of transportation cost barriers to trade,
identical products sold in different countries must sell at the same price
when the prices are stated in terms of the same currency”.

 Interest rate factor

 Higher the interest rates greater will be the value of currency because
investors want to buy currency to invest at high rates.

 Political factors
 Stable the political factor, higher will be the demand for the particular currency

 Economic data
 Economic data such as labor reports (payrolls, unemployment rate and
average hourly earnings), consumer price indices (CPI), producer price
indices (PPI), gross domestic product (GDP), international trade,
productivity, industrial production, consumer confidence etc., also affect
fluctuations in currency exchange rates.
Factors Affecting Exchange Rates
 Demand - Supply Factor
 If Demand>Supply, value of currency rises.
 If Demand <Supply, value of currency falls.
 Inflation
 Higher the inflation, lower the value of currency.
 Trade Balance
 The more the price of the exports than what the
country is paying for the imports, the higher will be the
demand of the currency of that country.
 Type of FX Contracts
 Spot FX contract – short term FX contract used
to cover the cost of a foreign currency trade or
other short term foreign currency requirements.
These are usually marked to spot FX rates. Also
used for speculation.

 Forward FX contract – long term FX used to

cover the FX exposure incurred by holding
foreign securities. These are usually marked to
forward FX prices. Also used for speculation.
 Example
Trade date 10-15-06
Buy EUR 25,000
Rate of 1.1582
Versus $28,955
Expiry date 12-15-06

In the above example on 10-15-06 the

investment manager has committed to
purchasing EUR 25,000 for $28,955 on
12-15-06
 Example – FX Spot contract
Example Spot FX:
 Fund ABC is a USD based fund. On trade date
(T/D) 10-15-06 it purchases 10,000 shares in
Vodafone at a price of 20 EUR, settlement date
(S/D) 10-17-06, net cost 200,000 EUR.
 Fund ABC enters into the following FX trade:
T/D 10-15-06, Buy 200,000 EUR V’s USD, expiry
10-17-06, at a rate of 1.1582.
 Fund X locks into the USD cost of this trade
($231,640) on 12-15-06 and eliminates the risk
of the FX rate moving against it between T/D
and S/D.
 Example – FX Forward Contract
Example Forward FX:
 Sell EUR 200,000 versus USD, expiry 03-15-07 at a rate
of 1.1625.
 As the EUR exchange rate moves against USD, any loss
in the FX rate on the holding of Vodafone will be offset
by a gain on the FX position and vice-versa.
 The FX exposure on the two trades is limited to the
difference the rate at which the trade was booked
(1.1582) and the rate at which the 3 month forward FX
was booked (1.1625).
 However as the market value of the security changes
every day, it is difficult to maintain a perfect hedge.
 Types of exchange rate systems
 Fully fixed exchange rates
 Government intervenes in the currency market in order to keep
the exchange rate close to a fixed target.
 It is committed to a single fixed exchange rate and does not
allow major fluctuations from this central rate.
 Semi-fixed exchange rates
 Exchange rate is given a specific target and the currency can
move inside permitted ranges of fluctuation.
 Free floating
 The value of the currency is determined solely by market supply
and demand forces in the foreign exchange market.
 Managed floating exchange rates
 Governments normally engage in managed floating if not part of
a fixed exchange rate system.
 Forex Instruments
 Spot market:
 Over the counter (OTC)
 Profits from Bid-Ask spreads.

 Currency Derivatives

 Forward exchange market

 A market for contracts that ensure the future delivery of a foreign currency at
a specified exchange rate.
 The price of a forward contract is known as the forward rate.
 Forward exchange market is an OTC market.
 Eg: Contract to buy or sell EUR/USD at 1.2745 (forward price) at a future
date.

 Futures
 A contract for the purchase of a country's currency at a price agreed now for
delivery at a later date.
 Currency futures are exchange traded derivatives.

 Options
 An option which gives the owner the right to buy or sell the indicated amount
of foreign currency at a specified price before a specific date.
 Eg: an importer who needs to SELL Australian Dollars will purchase a PUT
option AUD.
 Similarly, an exporter, who needs to BUY Australian Dollars will purchase a
CALL option in AUD.
 FX Trading Characterstics
 Over the counter market.

 24 Hr market hence the traders’ reaction to market news

are spontaneous.

 Exchange rate fluctuations are usually caused by actual

or expected monetary flow due to micro and macro
economic parameters.

 It is estimated that anywhere from 70%-90% of the FX

market is speculative.

 Currencies are traded against one another. For Eg.,

EUR/USD is the price of the euro expressed in US
dollars.
 FX Market participants
 Banks

 Commercial companies.

 Central banks.

 Investment management firms.

 Hedge funds
 Exchange rate Mechanism
 Since currencies are traded in pairs and exchanged one against the
other when traded, the rate at which they are exchanged is called
the exchange rate.

 The first currency in the exchange pair is referred to as the base

currency and the second currency as the counter or quote currency.
Eg:EURUSD.

 The exchange rate tells a buyer how much of the counter or quote
currency must be paid to obtain one unit of the base currency.

 For example, an exchange rate for EUR/USD of 1.2083 specifies to

the buyer of euros that 1.2083 USD must be paid to obtain 1 euro.
 FX Reconciliation
 IFS FX holding – Spot and Forward must
be checked with Bloomberg
 Copy Broker data into the Rec file
 Compare IFS FX holding with Broker
Holdings
 Any difference which is more than 2 basis
points needs to be highlighted
 Forex Risks
 Exchange rate risks
 Interest rate risks
 Credit risks
 Country risks.
 Volatile markets offering profit opportunities.
 Lost payments.
 Delayed confirmation of payments and
receivables.
 Divergence between bank drafts received and
the contract price.
 Forex Risk Management Strategies
 Exit the Forex market at profit targets.

 Control risk by capping losses

 If you are short a currency pair, the stop/loss order should be placed
above the current market price.
 If you are long the currency pair, the stop/loss order should be placed
below the current market price .

 Know exactly where to place stop and limit orders.

 As a general rule of thumb, traders should set stop/loss orders closer to
the opening price than limit orders.

 Avoid/lower risk when trading Forex.

 Understanding the fundamentals behind an investment.
 Use technical analysis while trading like using simple support and
resistance technical analysis .
 Be disciplined.
THANK YOU