Currency Markets

“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing!”
-Warren Buffet (Business Magnate, Investor, Philanthropist)

Currency markets facilitate the buying and selling of international currencies. Individual investors participate in currency trading to benefit from the fluctuations in the exchange rate of the currencies. However Importers. Exporters and Corporates are those who often take part in currency trading for hedging purposes. The currency market, also known as the Foreign Exchange (FOREX) market is the biggest and the fastest growing market in the world economy with a daily turnover of more than 2 trillion dollars. FOREX markets are effectively open 24 hours a day with the global cooperation among currency traders. At the end of a business day in Asia, the open currency positions are passed on to traders in Europe, who – at the end of their business day – pass it on to the American traders, who just begin their working day and pass positions on to Asia at the end of their business day. The FOREX market is open 24hours a day, 6 days a week.

Aren’t there enough markets to trade and invest already, why one just for currency itself? Here’s why:


In India, currency can only be traded in 4 pairs, namely:


  1. US Dollar – Indian Rupee (USD-INR),
  2. Euro – Indian Rupee (EUR-INR),
  3. Great Britain Pound – Indian Rupee (GBP-INR), and
  4. Japanese Yen – Indian Rupee (JPY-INR).

Similar to Capital and Commodity Markets, Currency Market also operates in both Spot and Derivatives Markets.

Trading in currencies can be profitable and tricky at the same time. Before getting ahead, lets understand a few concepts as listed below:

  1. Lot Size: It is the size of the Contract held, which is to say the number of units one shall hold in one currency pair;
  2. Margin: It is the amount that allows you to purchase 1 lot/contract of the Currency Pair;
  3. Price: It is the price at which the currency is traded in the exchange.
  4. Expiry: Date specified in the contract on which the contract expires, and positions are settled in cash.
  5. Tick: A tick is the minimum value of currency that can increase or decrease at a particular time. This is fixed at 0.0025. So if the current price is 25.0000, and moves up by one tick, it becomes 25.0025.

To understand the mechanism of Currency Trading, let’s take an example of a currency pair, say USD-INR with an expiry after two months, and see how trading in it is carried out. Details of the Futures Contract being:

Lot Size : USD 1000
Price ($1=) : INR 66.0225
Lot Value (1000x66.0225) : INR 66,022.5000
Margin required : INR 1,327.0000

As shown in the above table, the margin to buy one lot of the currency pair USD-INR which is valued at INR 66,022.50, is INR 1,327 only. Thus, a person with an amount as low as INR 132,700 can buy 100 such lots, the actual value of which would be INR 66,02,250.

Consider you purchased 100 lots. Now let's assume that the value of Rupee strengthens, falling 800 ticks (800 x 0.0025 = 2) and the value of $1 = INR 64.0225, then the holder of the contract is at a gain of INR 2,00,000. This is the difference between the value it was purchased at and current value, multiplied by the lot size accumulated over 100 lots,


i.e. [ (66.0225 – 64.0225) x 1000 ] x 100 = INR 2,00,000

A currency options gives the holder of the option a right, but not an obligation, to either buy or sell the underlying asset (currency) in future. In contrast, in a futures contract, the two parties are legally bound or are obligated to meet their commitments as specified in the contract. Whereas, the buyer of an option contract is only required to pay an upfront fee called option premium.

There are two types of options:

  1. Call option: It gives the holder the right to buy an asset by a certain date for a certain price, but not an obligation; and
  2. Put option: It gives the holder the right to sell an asset by a certain date for a certain price, but not an obligation.

Let’s first understand some concepts related to Options;

  1. Option Premium: The price to be paid to the seller of the option contract for buying a Call/Put Option;
  2. Strike Price: The Strike (or Exercise) Price is the price at which the underlying security can be bought or sold as specified in the option contract.
  3. Expiry: Date specified in the contract on which the contract expires, and positions are settled in cash.
  4. In-the-Money: For Call Option – Price higher than strike price
    For Put Option – Price lower than strike price
  5. Out-of-the-Money: For Call Option – Price lower than strike price
    For Put Option – Price higher than strike price
  6. At-the-Money: Price equivalent to strike price

Before seeing how a currency option works, let’s take a simpler example of call option. Suppose you want buy a piece of land worth INR 1,00,000 after 3 months. You are speculating that within such time period, the value of the land would increase. So at present, you engage in an agreement with the seller to buy the land at INR 1,00,000 (Strike Price) within 3months (Expiry) and pay an agreement fee of INR 10,000 (Option Premium). Now;


  • If after 3months, your speculation serves you well, and the price of the land increases to INR 3,00,000, you are at the option to purchase the same INR 1,00,000 due to the agreement between you and the seller. In this case, your total cost for purchasing the land would be INR 1,10,000 (1,00,000 + 10,000), for a land that is worth INR 3,00,000 now. Thus you are at a gain of INR 1,90,000 (3,00,000 – 1,10,000).
  • If after 3 months, your speculation does not serve you well, and the price of the land decreases to INR 50,000, you are at the option to not purchase the land. You may withdraw from the agreement as; you would be required to purchase the land at a total cost of INR 1,10,000 (1,00,000 + 10,000), for a land that is worth only INR 50,000 now, which would put you at a loss of INR 60,000. Here your loss will be limited to INR 10,000 which you paid as the agreement fee or Option premium.
  • If after 3months, the price of the land neither increases nor decreases, and stays at INR 1,00,000, you are again at the option to purchase the land or not purchase it. If you purchase the land, you will be at loss of INR 1,000 as the value of the land is INR 10,000, and your total cost of purchase would be INR 1,10,000 (1,00,000 + 10,000).

Let’s understand this with an example of Currency Options. Suppose the USD-INR is priced at $1 = INR 66.50 now and you are speculating that the value of rupee is going to fall or rise and buy 100 lots of options in USD-INR at a strike price of INR 66.50 by paying a premium of just INR 70,000, the value of 100 lots being INR 66,50,000 [(66.50 x 1000) x 100] .

Now let’s see how buying a call option and put option function differently;

   Call Option Put Option   
In-the-Money: (Value Increased to 67.50)
You have the option to buy it at 66.50 and gain INR 30,000;
{ [(67.50 – 66.50)x1000 x 100] – 70,000 }
Out-of-the-Money: (Value Increased to 67.50)
You have the option to not sell it and limit your loss to 70,000

Out-of-the-Money: (Value Decreased to 65.50)
You have the option to not buy and limit your loss to 70,000 instead of 1,70,000
{ [(66.50 – 65.50)x1000 x 100] + 70,000 }
In-the-Money: (Value Decreased to 65.50)
You have the option to sell at 66.50 and gain INR 30,000
{ [(66.50 – 65.50)x1000 x 100] - 70,000 }

At-the-Money: (Value remains at 66.50)
You have the option to not buy and limit your loss to 70,000
At-the-Money: (Value remains at 66.50)
You have the option to not sell and limit your loss to 70,000

As you can see above, while buying options, the maximum loss you will have to bear is the amount of option premium, whereas, your potential for gain is unlimited. Keeping this in mind, while selling options, the maximum potential gain you may have will be limited to the Option Premium with a possibility to bear unlimited loss if not squared off appropriately before expiry.

Currency Derivatives can be used as a great hedging tool against existing positions to decrease risk. Let’s get to know the concept of Hedging with the following example of how to use Currency Futures as a Hedging tool.

You are expecting a payment of USD 1,00,000 in 2 months. The current exchange rate is valued at INR 65.35 for $1. If this spot exchange rate remains unchanged after 2 months, then you will get INR 65,35,000 by converting the payment you are expecting. If the exchange rate increases to INR 66.35 for $1, then you will get INR 66,35,000, a gain of INR 1,00,000 and likewise if the exchange rate falls to INR 64.35 for $1, you will get INR 64,35,000, a loss of INR 1,00,000. This is the exchange risk which you can hedge by taking exposure in Futures market.

In the Futures market, by holding a short position you can lock-in the exchange rate after 2 months at INR 65.35 itself, considering that is the future price too. Since one lot of the USD-INR pair is 1000, you must buy 100 lots to accumulate it to INR 65,35,000. Here, irrespective of an increase or decrease in the exchange rate, you will be sure of getting this value. This is how it works:


If the Exchange Rate Increases      If the Exchange Rate Decreases
In Spot Market:
You will get INR 66,35,000 by selling the payment you are expecting in the market
(Gain)
In Spot Market:
You will get INR 64,35,000 by selling the payment you are expecting in the market
(Loss)
Futures Market:
You will lose INR 1,00,000; i.e. INR 1 x
1000(lot size) x 100(number of Lots)
(Loss)
Futures Market:
You will gain INR 1,00,000; i.e. INR 1 x
1000(lot size) x 100(number of Lots)
(Gain)
Net Amount Received
66,35,000 – 1,00,000 = 65,35,000
Net Amount Received
64,35,000 + 1,00,000 = 65,35,000

For the loss that you suffer in the spot market, you will be compensated by the gain in the futures market and vice versa, thus eliminating your risk.

Similar to Stock Exchange, FOREX is also effected a number of economic factors such as:


  • Interest Rates;
  • Inflation;
  • GDP;
  • Unemployment Rate;
  • Balance of Payments (BoP);
  • Trade Deficit;
  • Fiscal Deficit;
  • Manufacturing Indices; and
  • Consumer Prices & Retail Sales.

Currency market being open 24hours a day, the market is continuously effected by any financial news or information of the Country’s economy and can a direct impact on the movement of the currency in FOREX. Relations between the countries, (in case of USD-INR currency pair; USA and India), are also an important factor that effects the movement of currency’s value in the market.

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