ARBITRAGE,SPECULATION & HEDGING IN FOREX MARKET

CHAPTER- I

INTRODUCTION

Foreign Exchange Market

The foreign exchange market is the "place" where currencies are traded. Currencies
are important to most people around the world, whether they realize it or not, because
currencies need to be exchanged in order to conduct foreign trade business.  

The Foreign exchange market is a place in which participants are able to buy, sell,
exchange and speculate on currencies. Foreign exchange markets are made up of banks,
commercial companies, central banks, investment management firms, hedge funds, and
retail forex brokers and investors. The forex market is considered to be the largest financial
market in the world.

Foreign exchange analysis gives you information on the main currencies. Opening
and closing rates, daily and annual variations, forward contract rates, options, technical and
daily forecasts are presented .This analysis also provides comments on financial relating to
currency issues, and strategic advice that will help you make the most of the current market
situation.

The foreign exchange market (forex or FX for short) is one of the most exciting, fast-
paced markets around. Until recently, forex trading in the currency market had been the
domain of large financial institutions, corporations, central banks, hedge funds and extremely
wealthy individuals. The emergence of the internet has changed all of this, and now it is
possible for average investors to buy and sell currencies easily with the click of a mouse
through online brokerage accounts. 
Characteristics of the Foreign Exchange Market

Barter Exchange

Barter exchange (Double coincidence of wants): In the foreign exchange market, for
anybody wanting to sell dollars to get British pound, there must be someone else wanting to
sell the pound for the dollar at the same exchange rate (like in barter exchange).

Role

The FE market performs an international clearing function by bringing two parties

wishing to trade currencies at agreeable exchange rates. The FE market takes place between
dealers and brokers in financial centers around the world. During the hours of business
common to different time zones, they rapidly exchange shorthand messages expressing their
bids for different currencies. To make a profit on FE maneuvers, a trader or broker has to
make quick decisions correctly. The fastest possible communications are used. Modern
telephone links have reduced the transaction costs on foreign exchange to near zero for large
transactions.

History of Forex Market

The history of forex market in India owes its origin to an important decision taken
by the Reserve Bank of India (RBI) in the year 1978 which allows banks to undertake intra-
day trading in foreign currency exchange. As a result of this step, the agreement of
maintaining ‘square’ or ‘near square’ position was to be complied with only at the close of
business every day. The history of currency trading in India also clearly shows that during the
initial period when these economic reforms started, the exchange rate of national currency i.e.
Indian rupee used to be determined by the RBI in terms of a weighted basket of currencies of
India’s major trading partners.

Another landmark in Forex history of India came with the appointment of an

Expert Group committee on Forex currency in 1994. This committee was made to study the
forex market in detail so that step can be taken out to develop, deepen and widen the forex
market in India. The result of this exercise was that banks were significant freedom in many
of its market operations related to like forex market development and liberalization. The
freedom was granted to banks in term of fixing their trading limits, allowed to borrow and
invest funds in the overseas markets up to specified limits, accorded freedom to make use of
derivative products for asset-liability management purposes.

The other feature of forex history in India is that a large sum of foreign exchange
in India came through the large Indian population working in foreign countries. However, the
common man was not much interested in forex trading. The things are changing now and
with the growing economy more and more people are showing interest in forex trading and
are looking out for hedging currency risks.

National Stock Exchange of India popularly known as (NSE) was the first
recognized exchange in Indian forex history to launch forex currency futures trading in India.
These currency futures are beneficial over overseas forex trading especially to comparatively
small traders and retail investors. Another important point to know is that before discussing
the history of forex market in India, it is important to know the central government of India
has the powers to control transactions in foreign exchange and hence forex transactions in
India are managed by the government authorities.

NEED FOR FOREX MARKET IN INDIA

INFLOWS OUTFLOWS
1 Inward Remittances Outward Remittances

2 Remittances to to all bank accounts Payments relating imports

Export related payments like

3 Foreign Aids/Loans /Borrowings by commission,
Corporates etc. legal fees, etc.
4 Export Receivables Tour/Travel related expenses
5 Tourists’ income Loan repayments / servicing of loans

PARTICIPANTS IN FOREIGN EXCHANGE MARKET

Commercial companies
An important part of the foreign exchange market comes from the financial activities
of companies seeking foreign exchange to pay for goods or services. Commercial companies
often trade fairly small amounts compared to those of banks or speculators, and their trades
often have little short-term impact on market rates.
 Nevertheless, trade flows are an important factor in the long-term direction of a
currency's exchange rate. Some multinational corporations (MNCs) can have an
unpredictable impact when very large positions are covered due to exposures that are not
widely known by other market participants.

Central banks
National central banks play an important role in the foreign exchange markets. They
try to control the money supply, inflation, and/or interest rates and often have official or
unofficial target rates for their currencies. They can use their often substantial foreign
exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank
"stabilizing speculation" is doubtful because central banks do not go bankrupt if they make
large losses, like other traders would, and there is no convincing evidence that they do make a
profit trading.

Foreign exchange fixing

Foreign exchange fixing is the daily monetary exchange rate fixed by the national
bank of each country. The idea is that central banks use the fixing time and exchange rate to
evaluate behavior of their currency. Fixing exchange rates reflects the real value of
equilibrium in the market. Banks, dealers and traders use fixing rates as a market trend
indicator.

The mere expectation or rumor of a central bank foreign exchange intervention might
be enough to stabilize a currency, but aggressive intervention might be used several times
each year in countries with a dirty float currency regime. Central banks do not always achieve
their objectives. The combined resources of the market can easily overwhelm any central
bank.[66] Several scenarios of this nature were seen in the 1992–93 European Exchange Rate
Mechanism collapse, and in more recent times in Asia.

Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions conducted are speculative.
This means the person or institution that bought or sold the currency has no plan to actually
take delivery of the currency in the end; rather, they were solely speculating on the movement
of that particular currency. Since 1996, hedge funds have gained a reputation for aggressive
currency speculation. They control billions of dollars of equity and may borrow billions
more, and thus may overwhelm intervention by central banks to support almost any currency,
if the economic fundamentals are in the hedge funds' favour.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of
customers such as pension funds and endowments) use the foreign exchange market to
facilitate transactions in foreign securities. For example, an investment manager bearing an
international equity portfolio needs to purchase and sell several pairs of foreign currencies to
pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency
overlay operations, which manage clients' currency exposures with the aim of generating
profits as well as limiting risk. While the number of this type of specialist firms is quite
small, many have a large value of assets under management and, hence, can generate large
trades.

Retail foreign exchange traders

Individual retail speculative traders constitute a growing segment of this market with
the advent of retail foreign exchange trading, both in size and importance. Currently, they
participate indirectly through brokers or banks. Retail brokers, while largely controlled and
regulated in the USA by the Commodity Futures Trading Commission and National Futures
Association, have in the past been subjected to periodic foreign exchange fraud. To deal with
the issue, in 2010 the NFA required its members that deal in the Forex markets to register as
such (I.e., Forex CTA instead of a CTA).

Those NFA members that would traditionally be subject to minimum net capital
requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they
deal in Forex. A number of the foreign exchange brokers operate from the UK under
Financial Services Authority regulations where foreign exchange trading using margin is part
of the wider over-the-counter derivatives trading industry that includes Contract for
differences and financial spread betting.
 There are two main types of retail FX brokers offering the opportunity for speculative
currency trading: brokers and dealers or market makers. Brokers serve as an agent of the
customer in the broader FX market, by seeking the best price in the market for a retail order
and dealing on behalf of the retail customer. They charge a commission or mark-up in
addition to the price obtained in the market. Dealers or market makers, by contrast, typically
act as principal in the transaction versus the retail customer, and quote a price they are willing
to deal at.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international
payments to private individuals and companies. These are also known as foreign exchange
brokers but are distinct in that they do not offer speculative trading but rather currency
exchange with payments (i.e., there is usually a physical delivery of currency to a bank
account).

It is estimated that in the UK, 14% of currency transfers/payments are made via
Foreign Exchange Companies. These companies' selling point is usually that they will offer
better exchange rates or cheaper payments than the customer's bank. These companies differ
from Money Transfer/Remittance Companies in that they generally offer higher-value
services.

Money transfer/remittance companies

Money transfer companies/remittance companies perform high-volume low-value
transfers generally by economic migrants back to their home country. In 2007, the Aite
Group estimated that there were $369 billion of remittances (an increase of 8% on the
previous year). The four largest markets (India, China, Mexico and the Philippines) receive
$95 billion. The largest and best known provider is Western Union with 345,000 agents
globally followed by UAE Exchange.
SETTLEMENT OF FOREIGN EXCHANGE TRANSACTIONS:

Settlements of Foreign Exchange Transactions are made through the following accounts: -

NOSTRO Account: Our Account with you;

The account maintained by an Authorised Dealer with a foreign bank is called
"NOSTRO" Account or "Our Account with You". When an instrument like a cheque or
an export bill is purchased the same is sent to the overseas bank (correspondent) for
realisation, the amount is collected and credited to Authorised Dealer’s account with
them. Similarly, when a draft is issued on a banks foreign correspondent it will be paid
at the overseas centre by debiting the NOSTRO Account of the issuing bank.

VOSTRO Account: Your Account with us

Foreign banks (Correspondents) also maintain accounts with any bank in India
in Indian Rupees for the purpose of settling their rupee transactions and these accounts
are called "VOSTRO" Accounts meaning "Your Account with us".

LORO Account: Their account with them

Just like State bank Of India maintaining an account with foreign correspondent
say BTC, New York, Canara Bank may also maintain a Nostro Account with them.
When SBI advises BTC New York for transfer of funds to Canara Bank Account with
them, Canara Bank Account is titled as Loro Account "i.e. their account with you".

When our bank deals in an export credit bill on collection basis/on realisation of export
bills negotiated /purchased/discounted, the foreign currency funds is to be credited to our
account. For this purpose, we maintain Foreign Currency accounts with our various
correspondents abroad. The account is called NOSTRO account. Once the proceeds are
credited in our NOSTRO account, we receive the statement, based on which, the concerned
branch, who have handled the transaction, will be informed.

Likewise, when we would like to make remittances, on behalf of our customers

towards import payments, miscellaneous remittances etc., we give instructions to our
correspondents, to debit our NOSTRO account and effect payment.

Market participants

Commercial companies

An important part of the foreign exchange market comes from the financial activities
of companies seeking foreign exchange to pay for goods or services. Commercial companies
often trade fairly small amounts compared to those of banks or speculators, and their trades
often have little short-term impact on market rates. Nevertheless, trade flows are an important
factor in the long-term direction of a currency's exchange rate. Some multinational
corporations (MNCs) can have an unpredictable impact when very large positions are
covered due to exposures that are not widely known by other market participants.

Central banks

National central banks play an important role in the foreign exchange markets. They
try to control the money supply, inflation, and/or interest rates and often have official or
unofficial target rates for their currencies. They can use their often substantial foreign
exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank
"stabilizing speculation" is doubtful because central banks do not go bankrupt if they make
large losses, like other traders would, and there is no convincing evidence that they do make a
profit trading.
Foreign exchange fixing

Foreign exchange fixing is the daily monetary exchange rate fixed by the national
bank of each country. The idea is that central banks use the fixing time and exchange rate to
evaluate behavior of their currency. Fixing exchange rates reflects the real value of
equilibrium in the market. Banks, dealers and traders use fixing rates as a market trend
indicator.

The mere expectation or rumor of a central bank foreign exchange intervention might
be enough to stabilize a currency, but aggressive intervention might be used several times
each year in countries with a dirty float currency regime. Central banks do not always achieve
their objectives. The combined resources of the market can easily overwhelm any central
bank.[66] Several scenarios of this nature were seen in the 1992–93 European Exchange Rate
Mechanism collapse, and in more recent times in Asia.

Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions conducted are speculative.
This means the person or institution that bought or sold the currency has no plan to actually
take delivery of the currency in the end; rather, they were solely speculating on the movement
of that particular currency. Since 1996, hedge funds have gained a reputation for aggressive
currency speculation. They control billions of dollars of equity and may borrow billions
more, and thus may overwhelm intervention by central banks to support almost any currency,
if the economic fundamentals are in the hedge funds' favour.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of

customers such as pension funds and endowments) use the foreign exchange market to
facilitate transactions in foreign securities. For example, an investment manager bearing an
international equity portfolio needs to purchase and sell several pairs of foreign currencies to
pay for foreign securities purchases.
 Some investment management firms also have more speculative specialist currency
overlay operations, which manage clients' currency exposures with the aim of generating
profits as well as limiting risk. While the number of this type of specialist firms is quite
small, many have a large value of assets under management and, hence, can generate large
trades.

Retail foreign exchange traders

Individual retail speculative traders constitute a growing segment of this market with
the advent of retail foreign exchange trading, both in size and importance. Currently, they
participate indirectly through brokers or banks. Retail brokers, while largely controlled and
regulated in the USA by the Commodity Futures Trading Commission and National Futures
Association, have in the past been subjected to periodic foreign exchange fraud. To deal with
the issue, in 2010 the NFA required its members that deal in the Forex markets to register as
such (I.e., Forex CTA instead of a CTA).

Those NFA members that would traditionally be subject to minimum net capital
requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they
deal in Forex. A number of the foreign exchange brokers operate from the UK under
Financial Services Authority regulations where foreign exchange trading using margin is part
of the wider over-the-counter derivatives trading industry that includes Contract for
differences and financial spread betting.

There are two main types of retail FX brokers offering the opportunity for speculative
currency trading: brokers and dealers or market makers. Brokers serve as an agent of the
customer in the broader FX market, by seeking the best price in the market for a retail order
and dealing on behalf of the retail customer. They charge a commission or mark-up in
addition to the price obtained in the market. Dealers or market makers, by contrast, typically
act as principal in the transaction versus the retail customer, and quote a price they are willing
to deal at.
Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international

payments to private individuals and companies. These are also known as foreign exchange
brokers but are distinct in that they do not offer speculative trading but rather currency
exchange with payments (i.e., there is usually a physical delivery of currency to a bank
account).

It is estimated that in the India, 14% of currency transfers/payments are made via
Foreign Exchange Companies. These companies' selling point is usually that they will offer
better exchange rates or cheaper payments than the customer's bank. These companies differ
from Money Transfer/Remittance Companies in that they generally offer higher-value
services.

Money transfer/remittance companies

Money transfer companies/remittance companies perform high-volume low-value

transfers generally by economic migrants back to their home country. In 2007, the Aite
Group estimated that there were $369 billion of remittances (an increase of 8% on the
previous year). The four largest markets (India, China, Mexico and the Philippines) receive
$95 billion. The largest and best known provider is Western Union with 345,000 agents
globally followed by UAE Exchange.

TRADERS IN FOREIGN EXCHANGE MARKET

Foreign Exchange Traders can be separated into two groups They are

HEDGERS:
Governments, Companies & some Investors have Foreign exchange exposure. Adverse
movements between their local or domestic currency and the foreign currency of the group
they are either doing business with (for the exchange of goods and services) or investing in
will affect their bottom line. This is the core of all foreign exchange trading; however it only
makes up approximately 5% of the actual market.
SPECULATORS:
This groups, which includes banks, funds, corporations and individuals creates artificial rate
exposure in order to profit from the variations or movements in the price. They play a vital
role in forex market. Speculators are people who analyze and forecast futures price
movement, trading contracts with the hope of making a profit. Speculators put their money at
risk and must be prepared to accept outright losses in the futures market.

Foreign Exchange Management Act (1999) (FEMA)

The Foreign Exchange Management Act, 1999 (FEMA) is an Act of the Parliament of
India to consolidate and amend the law relating to foreign exchange with the objective of
facilitating external trade and payments and for promoting the orderly development and
maintenance of foreign exchange market in India.

FEMA is a regulatory mechanism that enables the Reserve Bank of India and the
Central Government to pass regulations and rules relating to foreign exchange in tune with
the Foreign Trade policy of India.

FEMA  contains 7 chapters divided into 49 sections (Supreme Legislation)       

 5 sets of Rules made by Ministry under section 46 of FEMA (Delegated legislations)

 23 sets of Regulations made by RBI under section 47 of FEMA (Subordinate

Legislations)       Master Circular issued by Reserve Bank of India every year

 Foreign Direct  Inverstment (FDI) policy issued by Department of Industrial Policy

and Promotion is issued from time to time.

Foreign Exchange Dealer's Association of India (FEDAI)

It was set up in 1958 as an Association of banks dealing in foreign exchange in

India (typically called authorised dealers - ADs) as a self regulatory body and is
incorporated under Section 25 of The Companies Act, 1956. It's major activities include
framing of rules governing the conduct of inter-bank foreign exchange business among
banks vis-à-vis public and liaison with RBI for reforms and development of forex market.

Presently some of the functions are as follows:

  Guidelines and Rules for Forex Business.
 Training of Bank Personnel in the areas of Foreign Exchange Business.

 Accreditation of Forex Brokers

 Advising/Assisting member banks in settling issues/matters in their dealings.

 Represent member banks on Government/Reserve Bank of India/Other Bodies.

 Announcement of daily and periodical rates to member banks.

Due to continuing integration of the global financial markets and increased pace of
de-regulation, the role of self-regulatory organizations like FEDAI has also transformed.
In such an environment, FEDAI plays a catalytic role for smooth functioning of the
markets through closer co-ordination with the RBI, other organizations like FIMMDA, the
Forex Association of India and various market participants. FEDAI also maximizes the
benefits derived from synergies of member banks through innovation in areas like new
customized products, bench marking against international standards on accounting, market
practices, risk management systems, etc.

Foreign Exchange Market Mechanism

Exchange rate:
A foreign exchange rate is the parity between two currencies i.e. the amount of one
currency needed to sell (or buy) in order to buy (or sell) one unit of the other currency. There
are two ways to express such a rate. The most common (or international way) quotes the
amount of any currency that corresponds to one U.S. Dollar.

For example:
One US Dollar (USD) can be exchanged for 68.21 Rupees (INR)

Rate direction and currency direction:

In the foreign extern market it is a mistake to say that the market is going up or down.
In the stock market one can use this expression as stocks either go up or go down. However,
in the FX market a rate as we said defines the parity of two currencies, hence at any time one
goes up, so the other goes down. Therefore we can talk about the dollar going up or down but
not about the market doing so. Another issue that often confuses people (even traders and
bankers) is the difference between a currency moving up and its rate going up. We have to
explain this in more detail as any misunderstanding can lead to painful surprises when trading
in the real market.

A foreign exchange rate usually consists of an integer part and 4 decimal points. Thus
the decimals are expressed either at 10th thousands or hundreds. Each such 0.0001 or 0.01 is
called basis point or pip. E.g. a 50 pips change of 1.5000 is either 1.5050 or 1.4950.

Spot Market and the Forwards and Futures Markets 

There are actually three ways that institutions, corporations and individuals trade
forex: the spot market, the forwards market and the futures market. 

The spot market is where currencies are bought and sold according to the current
price. That price, determined by supply and demand, is a reflection of many things, including
current interest rates, economic performance, sentiment towards ongoing political situations
(both locally and internationally), as well as the perception of the future performance of one
currency against another. When a deal is finalized, this is known as a "spot deal". It is a
bilateral transaction by which one party delivers an agreed-upon currency amount to the
counter party and receives a specified amount of another currency at the agreed-upon
exchange rate value. After a position is closed, the settlement is in cash.

Although the spot market is commonly known as one that deals with transactions in
the present (rather than the future), these trades actually take two days for settlement.  Unlike
the spot market, the forwards and futures markets do not trade actual currencies. Instead they
deal in contracts that represent claims to a certain currency type, a specific price per unit and
a future date for settlement.  In the forwards market, contracts are bought and sold OTC
between two parties, who determine the terms of the agreement between themselves. 

In the futures market, futures contracts are bought and sold based upon a standard
size and settlement date on public commodities markets. Futures contracts have specific
details, including the number of units being traded, delivery and settlement dates, and
minimum price increments that cannot be customized. The exchange acts as a counterpart to
the trader, providing clearance and settlement.
Reading A Quote

When a currency is quoted, it is done in relation to another currency, so that the

value of one is reflected through the value of another. Therefore, if you are trying to
determine the exchange rate between the U.S. dollar (USD) and the Indian Rupee (INR), the
forex quote would look like this:

USD/INR = 68.22
This is referred to as a currency pair. The currency to the left of the slash is the base
currency, while the currency on the right is called the quote or counter currency. The base
currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and
the quoted currency (in this case, the Indian Rupee) is what that one base unit is equivalent to
in the other currency. The quote means that US$1 =68.22Indian Rupee. In other words, US$1
can buy 68.22 Indian Rupee . The forex quote includes the currency abbreviations for the
currencies in question.

There are two ways to quote a currency pair, either  directly or indirectly. A direct
currency quote is simply a currency pair in which the domestic currency is the quoted
currency; while an indirect quote, is a currency pair where the domestic currency is the base
currency. So if you were looking at the Canadian dollar as the domestic currency and U.S.
dollar as the foreign currency, a direct quote would be USD/INR, while an indirect quote
would be INR/USD. The direct quote varies the domestic currency, and the base, or foreign
currency, remains fixed at one unit. In the indirect quote, on the other hand, the foreign
currency is variable and the domestic currency is fixed at one unit.

For example,

If Indian Rupee is the domestic currency, a direct quote would be USD/INR and
means that USD$1 will purchase 68.22 Rupees.

In the forex spot market, most currencies are traded against the U.S. dollar, and the
U.S. dollar is frequently the base currency in the currency pair. In these cases, it is called a
direct quote. This would apply to the above USD/INR currency pair, which indicates that
US$1 is equal to 68.22 Indian Rupee

However, not all currencies have the U.S. dollar as the base. The Queen's currencies -
those currencies that historically have had a tie with Britain, such as the British pound,
Australian Dollar and New Zealand dollar - are all quoted as the base currency against the
U.S. dollar. The euro, which is relatively new, is quoted the same way as well. In these cases,
the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect
quote.

Most currency exchange rates are quoted out to four digits after the decimal place,
with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.

EXCHANGE QUOTING BASE CURRENCY NOTATION USED

RATES CURRENCY

USD/INR USD INR INR

EUR/INR EUR INR INR

JPY/INR JPY INR INR

The quote before the slash is the bid price, and the two digits after the slash represent the
ask price (only the last two digits of the full price are typically quoted). Note that the bid price is
always smaller than the ask price. Let's look at an example:

USD/INR=68.210
Bid = 68.180
Ask= 68.240

One of the biggest sources of confusion for those new to the currency market is the
standard for quoting currencies.

Cross Currency
 When a currency quote is given without the U.S. dollar as one of its components, this
is called a cross currency. The most common cross currency pairs are the EUR/GBP,
EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the forex
market, but it is important to note that they do not have as much of a following (for example,
not as actively traded) as pairs that include the U.S. dollar, which also are called the majors.

Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair
there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base
currency. When buying a currency pair (going long), the ask price refers to the amount of
quoted currency that has to be paid in order to buy one unit of the base currency, or how
much the market will sell one unit of the base currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how
much of the quoted currency will be obtained when selling one unit of the base currency, or
how much the market will pay for the quoted currency in relation to the base currency.

The quote before the slash is the bid price, and the two digits after the slash represent the
ask price (only the last two digits of the full price are typically quoted). Note that the bid price is
always smaller than the ask price. Let's look at an example:

USD/INR = 1$/68.21
Bid = 68.21
Ask = 68.21
If you want to buy this currency pair, this means that you intend to buy the base
currency and are therefore looking at the ask price to see how much (in Canadian dollars) the
market will charge for U.S. dollars. According to the ask price, you can buy one U.S. dollar
with 1.2005 Canadian dollars.

However, in order to sell this currency pair, or sell the base currency in exchange for
the quoted currency, you would look at the bid price. It tells you that the market will buy
US$1 base currency (you will be selling the market the base currency) for a price equivalent
to 68.21 Indian Rupees which is the quoted currency.
 Whichever currency is quoted first (the base currency) is always the one in which the
transaction is being conducted. You either buy or sell the base currency. Depending on what
currency you want to use to buy or sell the base with, you refer to the corresponding currency
pair spot exchange rate to determine the price

Spread and Pips

The difference between the bid price and the ask price is called a spread. Although
these movements may seem insignificant, even the smallest point change can result in
thousands of dollars being made or lost due to leverage. Again, this is one of the reasons
that speculators are so attracted to the forex market; even the tiniest price movement can
result in huge profit. The spread plays an important role in forex market as it only decides the
profit and loss of investors in forex market

The pip is the smallest amount a price can move in any currency quote. In the case of
the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the
Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places.
So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies
trade within a range of 100 to 150 pips a day.

Currency Quote Overview

USD/INR =1$=68.22
Base Currency Currency to the left (USD)
Quote/Counter
Currency to the right (INR)
Currency
Price for which the market
maker will buy the base
Bid Price 68.180
currency. Bid is always smaller
than ask.
Price for which the market
Ask Price 68.240
maker will sell the base currency.
One point move, in USD/INR it is
The pip/point is the smallest
Pip .0001 and 1 point change would
movement a price can make.
be from 68.180 to 68.240
Spread Spread in this case is 60
 pips/points; difference between
bid and ask price (68.240-68.180).

Main Types of Foreign Exchange Rates

Some of the major types of foreign exchange rates are as follows:

1. Fixed Exchange Rate System (or Pegged Exchange Rate System).

2. Flexible Exchange Rate System (or Floating Exchange Rate System).

3. Managed Floating Rate System.

1. Fixed Exchange Rate System:

Fixed exchange rate system refers to a system in which exchange rate for a currency
is fixed by the government.

1. The basic purpose of adopting this system is to ensure stability in foreign trade and capital
movements.

2. To achieve stability, government undertakes to buy foreign currency when the exchange
rate becomes weaker and sell foreign currency when the rate of exchange gets stronger.3. For
this, government has to maintain large reserves of foreign currencies to maintain the
exchange rate at the level fixed by it.

4. Under this system, each country keeps value of its currency fixed in terms of some
‘External Standard’.

5. This external standard can be gold, silver, other precious metal, another country’s currency
or even some internationally agreed unit of account.

6. When value of domestic currency is tied to the value of another currency, it is known as
‘Pegging’.
7. When value of a currency is fixed in terms of some other currency or in terms of gold, it is
known as ‘Parity value’ of currency.

2. Flexible Exchange Rate System:

Flexible exchange rate system refers to a system in which exchange rate is determined
by forces of demand and supply of different currencies in the foreign exchange market.

1. The value of currency is allowed to fluctuate freely according to changes in demand and
supply of foreign exchange.

2. There is no official (Government) intervention in the foreign exchange market.

3. Flexible exchange rate is also known as ‘Floating Exchange Rate’.

4. The exchange rate is determined by the market, i.e. through interactions of thousands of
banks, firms and other institutions seeking to buy and sell currency for purposes of making
transactions in foreign exchange.

Fixed Exchange Rate System vs Flexible Exchange Rate System:

Basis Fixed Exchange Flexible Exchange

Rate Rate
Determination of It is officially fixed It is determined by
Exchange Rate: in terms of gold or forces of demand and
any other currency supply of foreign
by government. exchange.
Government There is complete There is no
Control: government control government
as only government intervention and it
has the power to fluctuates freely
change it. according to market
conditions.

3. Managed Floating Rate System

India is having this type of exchange rate system. In this hybrid exchange rate system, the
exchange rate is basically determined in the foreign exchange market through the operation
of market forces. Market forces mean the selling and buying activities by various individuals
and institutions. So far, the managed floating exchange rate system is similar to the flexible
exchange rate system.
           But during extreme fluctuations, the central bank under a managed floating exchange
rate system (like the RBI) intervenes in the foreign exchange market. Objective of this
intervention is to minimise the fluctuation in the exchange rate of rupee.
           Since, the exchange rate is basically determined by market forces, the upward and
downward movement in the value of rupee are appreciation and depreciation.

What is Depreciation?
Depreciation of the rupee refers to the decrease in the external value of the domestic
currency occurred due to the operation of market forces. Here, the exchange rate is moving
with demand and supply of dollar. Depreciation happens under a flexible exchange rate
system or under a managed floating exchange rate system. (Eg. 1$ = Rs 40 to 1$ = Rs 50)

What is Appreciation?
           Appreciation of the rupee refers to the increase in the external value of the domestic
currency occurred due to the operation of market forces. Here, the exchange rate is moving in
accordance with the demand and supply of dollar. Appreciation happens under a flexible
exchange rate system or under a managed floating (Eg. 1$ = Rs 65 to 1$ = Rs 50).
           In India, the exchange rate system is managed floating (from 1994 onwards) and hence
the relevant currency movements are appreciation and depreciation. Here, the exchange rate
is determined in the open market through the pressure of buying and selling of foreign
currencies

Features of this System

1. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.

2. In this system, central bank intervenes in the foreign exchange market to restrict the
fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close
to desired target values.

3. For this, central bank maintains reserves of foreign exchange to ensure that the exchange
rate stays within the targeted value.
4. It is also known as ‘Dirty Floating.

RESEARCH DESIGN

OBJECTIVE OF THE STUDY

 To understand the concept and meaning of Foreign Exchange Market.
 To study the various operations of Foreign Exchange Market.

 To analyse the functions of Speculation of currencies in Foreign Exchange Market.

 To know about the components of arbitrage & speculation of currencies in Forex

Market.

CHAPTER –II

Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which
guarantee a fixed profit at the time of the transactions, although the life of the assets and,
hence, the consummation of the profit may be delayed until some future date. The key
element in the definition is that the amount of profit be determined with certainty. It
specifically excludes transactions which guarantee a minimum rate of return but which also
offer an option for increased profits.

Hedging is the simultaneous purchase and sale of two assets in the expectation of a
gain from different subsequent movements in the price of those assets. Usually the two assets
are equivalent in all respects except maturity.

Speculation is the purchase or sale of an asset in the expectation of a gain from

changes in the price of that asset.

Arbitrage .
 Arbitrage is the market activity of buying and selling of same security on exchanges
or between spot prices of a security and its future contract.

Definition:
  Arbitrage is the profit making market activity of buying and selling of same security
on different exchanges or between spot prices of a security and its future contract. Here
exchange refers to the stock market where shares are traded, like the NSE and BSE.

Description:
 A stock is traded in multiple stock exchanges and on each stock exchange the quoting
price may be a bit different. Hence arbitrage as a practice is followed to take advantage of the
price disparity. Originally arbitrage occurred in the currency market, but now it applies
equally in the commodity, futures and the stock market as well.

For example:
 Infosys is quoting at Rs 2750 on the BSE and Rs 2760 on the NSE. Hence one can
sell the stock on the NSE and buy from the BSE at the same time. This trade will lead to a
profit without any risk.
Forex arbitrage is a risk-free trading strategy that allows retail forex traders to make a
profit with no open currency exposure. The strategy involves acting fast on opportunities
presented by pricing inefficiencies, while they exist. This type of arbitrage trading involves
the buying and selling of different currency pairs to exploit any inefficiency of pricing. If we
take a look at the following example, we can better understand how this strategy works.

Arbitrage Pricing Theory

Definition

An alternative asset pricing model to the Capital Asset Pricing Model. Unlike the
Capital Asset Pricing Model, which specifies returns as a linear function of only systematic
risk, Arbitrage Pricing Theory may specify returns as a linear function of more than a single
factor.

The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976). It is a
one-period model in which every investor believes that the stochastic properties of returns of
capital assets are consistent with a factor structure. Ross argues that if equilibrium prices
offer no arbitrage opportunities over static portfolios of the assets, then the expected returns
on the assets are approximately linearly related to the factor loadings.

The APT is a substitute for the Capital Asset Pricing Model (CAPM) in that both
assert a linear relation between assets’ expected returns and their covariance with other
random variables. (In the CAPM, the covariance is with the market portfolio’s return.) The
covariance is interpreted as a measure of risk that investors cannot avoid by diversification.
The slope coefficient in the linear relation between the expected returns and the covariance is
interpreted as a risk premium. The APT is used by arbitrage traders for earning profit in forex
market. The Arbitrage is an International tool for earning profits in Foreign exchange market.

ARBITRAGE IN INDIA

Arbitrage is an often-used term in share markets. The arbitrager is an important

intermediary that helps in price discovery mechanism in all markets be it equity, moneyforex
or derivatives. There are three important participants that are important in a cash market, the
speculator, arbitrager and an investor. In futures market the investor is replaced by a hedger.
Arbitrager and Speculator are often confused and both are termed as Speculators.

Arbitraging in India has been going on for several years. Initially arbitrage activity
was between Stock Exchange Mumbai and all other regional exchanges. Mr. Babulal Bagri
the founder of BLB Securities and Mr. Manubhai Maneklal were legendary arbitragers of that
era. They traded between Mumbai, Delhi and Calcutta markets. Arbitraging in those days was
done manually and not on any online system. The way the fingers of these brokers flew on
telex machines giving trade instructions was an experience by itself. Then it shifted to
cashing on price difference between NSE and BSE limited. Today large amount of arbitrage
happens between cash and derivative markets. Arbitrage is also possible between the current
month and near or far month contracts. In case of Commodity exchanges also there is an
arbitrage opportunity between the local cash markets or mandis and the future markets which
are popularly known as National Commodity Exchanges.

The arbitrager is one who plays the role of balancing the price differences across the
markets. The markets may be two exchanges trading in the same product or two segments
such as cash and derivatives or across international markets and local markets. The arbitrager
continuously tracks prices across the chosen segment. are momentary price differences in two
markets due to difference in level of information as well as demand supply situation in the
market. These price differences are an

Opportunity for the arbitrager.

The arbitrager has money power at his disposal. He takes deliveries in a particular
market segment and is able to give deliveries in another market segment. There is a time gap
between giving and taking deliveries. He holds the stock for this time and earns an interest on
the funds invested which comes by way of price differential between buy and sell rates. The
arbitrager has a particular interest return as his target. He does not have any open positions
and all his purchases or sells in a particular market segment have a counter position in
another market segment. At the net level his position is always zero. This is how the
arbitrager earns a risk free return.

The arbitrager does not always wait for the expiry of the contract or the settlement of
the transaction. They may reverse the position before the actual settlement date even if they
have to compromise on some percentage of the price difference earned by them. Lesser return
is acceptable if it is earned with smaller or no investment. All decisions are taken with
reference to a benchmark-targeted return.

Arbitrage activity thus adds to liquidity in the markets and also helps in balancing the
prices of same shares across various markets. Prices continuously balance out once the
differences are cash upon. Arbitrage Helps in reducing volatility in markets since continuous
flow of orders reduces impact cost and more depth means less volatility.

A small investor may not always be able to capture small differences in prices. They
are not constantly in front of the trading screen nor do they have sophisticated trading
systems to execute the orders. They are often linked to Internet or a network connection that
is not direct feed into the stock exchange system i.e. BOLT or NEAT. Streaming quotes on
online trading is closest that is available for such trading.

Best strategy is to look for difference in shares prices of stocks that you already have,
hence delivery is not a problem. Otherwise it is a volume game, small returns over thousands
of transactions is the name of the game. It is advisable to study the opportunities. You may
not act on all of them, but it prepares you to invest your money wisely when you are a
Billionaire….
Arbitrage Advantage Fund.

The objective of this Scheme is to generate income through arbitrage opportunities

emerging out of mis-pricing between the cash and the derivatives markets and through
deployment of surplus cash in fixed-income instruments. Arbitrage Advantage Fund is an
extended version of the JM Equity & Derivatives Fund, which

According to the new guidelines by SEBI can hedge the entire position of its equity stock,
opposed to earlier when a mutual fund scheme could buy/sell futures for only up to 50% of the
corpus. Therefore in this new scheme, there is a mandate to deploy up to 80% of the corpus into
equity shares and hedge equivalent futures by allocating the balance 20% towards margins. This will
enhance the returns of an arbitrage scheme phenomenally, just as the Company delivered 7% per
annum returns in the past; and with the new Scheme, the returns to investors would be higher, at
8.5-9% a year.

Scheme Feature Asset Allocation

Instruments Risk Profile Min-Max

Equity & Equity-linked instruments Medium-High 65-80%

Derivatives, including stock futures and stock

options Medium-High 65-80%

Debt Securities, Money Market Instruments Medium-High 20-35%

JM Arbitrage Advantage Fund 14th June 2006

Arbitrage Strategies

Arbitrage is a strategy involving a simultaneous purchase and sale of identical or

equivalent instruments across two or more markets in order to benefit from a discrepancy in
their price relationship. It is a risk-free transaction, as the long and short legs of the
transaction offset each other exactly. Thus, arbitrage engages in a strategy in order to reduce
risk of loss caused by price fluctuations of securities held in the portfolio. It involves buying
and selling of equal quantities of a security in two different markets, with the expectations
that a future change in price will offset by an opposite change in the other.

Daily turnover in the derivatives segment is around 3.5 times the cash market
volumes and is to the tune of Rs 30,000 crores. Arbitrage activity is largely concentrated in
single stock futures, while index arbitrage is not very popular, although it contributes about
25-30% of the total stock futures volumes. In India, stock borrowing in the cash market is
cumbersome, making the “Sell Stock buy Futures” strategy Difficult; hence, almost the
entire arbitrage activity is concentrated in “Buy Stock-Sell Futures”. This strategy helps to
develop both stock & forex market in India as large no of investors are attracted by the
returns gained by them in markets than in other normal investments.

Advantages of Arbitrage Strategy

 Capitalising opportunities of mis-pricing (cost of carry) between cash and

derivatives.

 It is safe, as it does not carry equity market risk, as all equity positions are completely

hedged.

 Potential returns are higher than comparable investment avenues with similar risks.

 Benefits of investing in an Arbitrage Fund

 Since the arbitrage fund is categorized as equity fund, there will be no tax on Long-

Term capital gains;

 Dividends are also tax-free.

 Potential returns are higher than those in comparable investment avenues with similar

risks like bank

 Fixed-deposits or liquid schemes.

 It does not carry risk equivalent to the equity market risk, as all equity positions are

hedged.
Arbitrage Currency Trading

The current exchange rates of the INR/USD, EUR/USD, EUR/GBP, GBP/USD pairs

are 0.0149, 1.1837, 0.7231, and 1.6388 respectively. In this case, a forex trader could buy one
mini-lot of EUR for $11,837 USD. The trader could then sell the 10,000 Euros, for 7,231
British pounds. The 7,231 GBP, could then be sold for $11,850 USD, for a profit of $13 per
trade, with no open exposure as long positions cancel short positions in each currency. The
same trade using normal lots (rather than mini-lots) of 100K, would yield a profit of $130.
This can be continued until the pricing error is traded away.

As with other arbitrage strategies, the act of exploiting the pricing inefficiencies will
correct the problem so traders must be ready to act quickly. For this reason, these
opportunities are often around for a very short-time, before being acted upon. Arbitrage
currency trading requires the availability of real-time pricing quotes, and the ability to act fast
on the opportunities. To aid in the ability to find these opportunities quickly, forex arbitrage
calculators are available.

Forex Arbitrage Calculator 

Doing the calculations to find pricing inefficiencies yourself, can be time consuming
to actually be able to act upon any opportunities found. For this reason, many tools have
appeared across the Internet. One of these tools is the forex arbitrage calculator, which
provides the retail forex trader with real time forex arbitrage opportunities. A Forex arbitrage
calculator are sold for a fee on many Internet sites by both third parties and forex brokers;
and is offered for free or for trial by some upon opening an account. As with all software
programs and platforms used in retail forex trading, it is important to try out a demo account
if possible. The wide variety of products available, it is near impossible to determine which is
best. Trying out multiple products before deciding on one is the only way to determine what
is best for the forex trader.
Cross-broker Arbitrage

Arbitrage between broker-dealers is probably the easiest and most accessible form of
arbitrage to retail FX traders. To use this technique you need at least two separate broker
accounts, and ideally, some software to monitor the quotes and alert you when there is a
discrepancy between your price feeds. You can also use software to back-test your feeds for
arbitrage opportunities.

A mainstream broker-dealer will always want to quote in step with the FX interbank

market. In practice, this is not always going to happen. Variances can come about for a few
reasons: Timing differences, software, positioning, as well as different quotes between price
makers. Remember, foreign exchange is a diverse, non-centralized market. There are always
going to be differences between quotes depending on who is making that market.

Contract Specifications of Currency Futures

S.No Features Details
a) Symbol USD/INR, EUR/INR, GBP/INR, JPY/INR
b) Unit of trading 1 (1 unit denotes 1000) except JPY (100,000)
c) Underlying The exchange rate in INR for USD/EUR/GBP/ JPY
d) Tick size INR 0.0025
e) Trading hours Monday to Friday (9.00 am to 5.00 pm)
f) Contract trading cycle 12 month trading cycle.
g) Final settlement day Last working day of the expiry month.
h) Position limits Clients (per exchange):  6% of total open interest or
USD 10mn , whichever is higher
i) Minimum-Initial 4% of notional value of the contract.
margin
j) Extreme loss margin 1%
l) Settlement Daily : T+ 1,Final : T+ 2
m) Mode of settlement Cash settled in INR
n) Daily settlement price Calculated on the basis of last half an hour weighted
average price.

o) Final settlement price RBI reference rate. (Last working day of the month)
The below table shows the following currencies which are most traded currencies in the
world in a year. These are some of the data which are being used by hedgers, speculators &
arbitragers for the prediction and to make the Investment decision in a particular currency.

The below data is also depend upon the country’s development in all sectors & economic
policy, Inflation & Interest rates etc.

Rank Currency Symbol % daily s hare

1 United States dollar USD ($) 84.90
2 Euro EUR (€) 39.10
3 Japanese yen JPY (¥) 19.00
4 Pound sterling GBP (£) 12.90
5 Australian dollar AUD ($) 7.60
6 Swiss franc CHF (Fr) 6.40
7 Canadian dollar CAD ($) 5.30
8 Hong Kong dollar HKD ($) 2.40
9 Swedish krona SEK (kr) 2.20
10 New Zealand dollar NZD ($) 1.60
11 South Korean won KRW 1.50
12 Singapore dollar SGD ($) 1.40
13 Norwegian krone NOK (kr) 1.30
14 Mexican peso MXN ($) 1.30
15 Indian rupee INR (₹) 0.90
16 Other Other 12.20
Total 200.00%
This table shows the most traded currencies sorted by value in 2010.

Spreads
When arbitraging, it is critical to account for the spread or other trading costs. That is,
you need to be able to buy high and sell low. In the example above, if Broker A had quoted
1.3038/1.3048, widening the spread to 10 pips, this would have made the arbitrage
unprofitable.

The outcome would have been:

Entry trade: Buy 1 lot from A @ 1.3048 / Sell 1 lot to B @ 1.3048

Exit trade: Sell 1 lot to A @ 1.3049 / Buy 1 lot from B @ 1.3053
Profit: -4 pips

In fact, this is what many brokers do. In fast moving markets, when quotes are not in
perfect sync, spreads will blow wide open. Some brokers will even freeze trading, or trades
will have to go through multiple re quotes before execution takes place. By which time the
market has moved the other way. Sometimes these are deliberate procedures to thwart
arbitrage when quotes are off. The reason is simple. Brokers can run up massive losses if they
are arbitraged in volume.

Arbitraging Currency Futures

Anywhere you have a financial asset derived from something else, you have the
possibility of pricing discrepancies. This would allow arbitrage. The FX futures market is one
such example.

In case you have placed orders in a near month contract and the middle month
contract of the same underlying, for calculating the margin at order level,value of all buy
orders and sell orders (in the same underlying-group) are added.

Margin is levied on the higher of two i.e. if sum of buy orders is higher than the sum
of the sell order value, then all buy orders will be margined and vice versa.

In other words, margin is levied at the maximum marginable order value in the same
underlying. For example, you have placed the following buy and sell orders. 

Buy Orders Sell Orders

Contract Details No. of Order No. of Order
Qty Rate Qty Rate
Lots Value Lots Value
FUT-USDINR-27-Aug- 1 1000 45 45000        
2009
FUT-USDINR-28-Sep- 1 1000 49 49000 2 2000 52 104000
2009
FUT-USDINR-28-Oct-         1 1000 40 40000
2009
d) Total 2 2000    94000 3 3000   144000

As explained above, margin is levied on the higher of Buy and Sell Order value. In the above
given example, Sell Order Value is greater than Buy Order Value. Hence margin would be
levied at specified margin % on Rs. 144000.

Value Trade Alternatives

Seeing the futures contract was overvalued, a value trader could simply have sold a
contract hoping for it to converge to fair value. However, this would not be an
arbitrage. Without hedging, the trader has exchange rate risk. And given the mispricing was
tiny compared to the 12-month exchange rate volatility, the chance of being able to profit
from it would be small.

As a hedge, the value trader could have bought one contract in the spot market. But
this would be risky too because he would then be exposed to changes in interest rates because
spot contracts are rolled-over nightly at the prevailing interest rates. So the likelihood of the
non-arb trader being able to profit from this discrepancy would have been down to luck rather
than anything else, whereas the arbitrageur was able to lock-in a guaranteed profit on opening
the deal.

Cross-currency arbitrage
Trading text books always talk about cross-currency arbitrage, also called triangular
arbitrage. Yet the chances of this type of opportunity coming up, much less being able to
profit from it are remote.With triangular arbitrage, the aim is to exploit discrepancies in the
cross rates of different currency pairs.
CURRENCY TABLE
Currency Last Day High Day Low % Change Bid Ask
EUR/INR  75.658 -- --  +0.03% 75.658 75.721
GBP/INR  98.310 -- --  -0.21% 98.310 98.373
INR/JPY  1.7235 -- --  -0.28% 1.7235 1.7243
INR/CHF  0.014605 -- --  -- 0.014605 0.014624
INR/CAD  0.020518 -- --  +0.01% 0.020518 0.020531
AUD/INR  47.880 -- --  -1.50% 47.880 48.023

Arbitrage plays a crucial role in the efficiency of markets. The trades in

themselves have the effect of converging prices. This makes “gaps” disappear so removing
the opportunities of risk free profits.

Over the years, financial markets have becoming increasingly efficient because of
computerization and connectivity. As a result, arbitrage opportunities have become fewer and
harder to exploit.

At many banks, arbitrage trading is now entirely computer run. The software scours
the markets continuously looking for pricing inefficiencies on which to trade. For the
“ordinary trader”, this makes finding exploitable arbitrage even harder.

Nowadays, when they arise, arbitrage profit margins tend to be wafer thin. You need
to use high volumes or lots of leverage, both of which increase the risk of something getting
out of control.

Some brokers forbid clients from arbitraging altogether, especially if it is

against them. Always check their terms and conditions. Beware because some brokers will
even back test your trades, to check if your profits have coincided with anomalies in their
quotes.
 Forbidding arbitraging is shortsighted in my opinion. Seeing a “no arbitrage” clause
should raise red flags about the broker concerned. Arbitrage is one of the linchpins of a fair
and open financial system.

Without the threat of arbitraging, broker-dealers have no reason to keep quotes fair.
Arbitrageurs are the players who push markets to be more efficient. Without them, clients can
become captive within a market rigged against them.

Disadvantages of Arbitrage

Challenges to the Arbitrage Trader

Arbitraging can be a profitable low risk strategy when correctly used. Before you rush out
and start looking for arbitrage opportunities, there are a few important points to bear in mind.

Liquidity discount/premiums 

When checking an arbitrage trade, make sure the price anomaly is not down to vastly
different liquidity levels. Prices may discount in less liquid markets, but this is for a
reason. You may not be able to unwind your trade at your desired exit point. In this case,
the price difference is a liquidity discount, not an anomaly.
Execution speed challenge –
Arbitrage opportunities often require rapid execution. If your platform is slow or if you
are slow entering the trades, it may hamper your strategy. Successful arb traders use software
because there are a lot of repetitive checks and calculations.
Lending/borrowing costs –
Advanced arbitrage strategies often require lending or borrowing at near risk free rates.
But once fees are added, traders outside of banks cannot lend or borrow at anywhere near
risk free rates. This invalidates many arbitrage opportunities.
Spreads and trade costs 
Always factor in all trading costs from the start.

SPECULATION
 Currency speculation exists whenever someone buys a foreign currency, not because
she needs to pay for an import or is investing in a foreign business, but because she hopes to
sell the currency at a higher rate in the future (in technical language the currency
"appreciates"). This is nothing more than the old rule of buying low and selling high—only
with foreign money.

Some currency speculation is necessary to facilitate international trade. Take, for

example, a car manufacturer in India which exports cars to the United States. As the U.S.
importer of Indian cars is paying her bill in U.S. dollars, the Indian exporter receives U.S.
currency. But the exporter has to pay her workers and suppliers in Indian currency, and thus
needs to exchange the U.S. currency into Indian Rupees. Someone has to buy U.S. dollars
(U.S.$) so that she can buy INR . Currency traders can make money from simply being
middlemen in this process, buying the U.S.$ and charging transaction fees. But many also act
as speculators, hoping that they can profit from selling the dollars at a higher price in the
future.

Another transaction for which currency speculation is needed is so-called foreign

direct investment (FDI). FDI occurs when residents of one country buy or establish
production facilities in another country.

Examples of FDI in the India include Ford cars plant in Kanchipuram, Hyundai cars
plant in Sriperumbuthur. If a foreign company wants to build a plant here they need to
exchange their foreign currency for U.S.$. Again, they need to find currency speculators who
will buy Yen, DM or French Francs because they expect these currencies to gain in value.

The sum of currency transactions that are directly related to trade and investment is
considered the "primary exchange market," because it is linked to the exchange of real goods
and services. Most currency transactions do not occur in the primary market, though, but in
the secondary, or speculative, market—through which five times as much money changes
hands as in the primary market.

The more currency speculators are involved in the secondary market, the easier it is
for traders and investors to buy and sell foreign exchange when they need to. Hence,
"increased liquidity" means easier access to foreign currencies because there is a larger
market for such currencies.
The Laissez-Faire Bias of "Information"
Since currency speculation is a high-risk undertaking, any information that could
potentially be important will be collected. Hence, currency traders spend a fair amount of
time devouring up-to-date information on their computer screens. Traders look out for basic
economic variables such as unemployment, inflation, and productivity growth.

They are also interested in the economic institutions of a particular economy, such as
labor-management relationships and financial market stability. When these indicators seem to
portend higher profits, that suggests to speculators that the currency will rise in value in the
future. But if the indicators predict lower profits (such as, in some cases, from falling
unemployment), speculators will unload the currency and its value will drop.

Much of what currency speculators go by are their subjective perceptions (often based
on the actions of other large speculators), rather than objective standards for evaluating the
performance of an economy. For example, during the recent crisis, currency traders argued
that the Southeast Asian nations brought about their own downfall because they never got rid
of corruption. Yet the business world seems generally to agree that Italy is as corrupt as
Thailand, and more corrupt than Malaysia or South Korea, yet nobody has proposed selling-
off Italian Lira.

Herd Behavior
While the processing and interpretation of information is an integral part of currency
markets, "herd behavior" among currency traders is equally important, especially since it
makes many interpretations self-fulfilling. If large numbers of traders behave in the same
way, a currency will automatically gain or lose in value—just like the speculators had
guessed in the first place.

If a country introduces more "business friendly policies," such as deregulation or

lower labor standards, a few speculators will decide that it is worth buying a currency, thus
driving the price of the currency up. To make sure that the value of this currency continues to
rise, the original buyers will provide enough information to convince other speculators to buy
the currency also.

A consensus is formed for a while where everybody believes that the particular
currency will only gain in value, and for a while this is true as everybody continues to buy.
Thus, the profits which the original buyers had expected are generated by more speculators
buying this particular currency.

Speculation Tricks

The trick in making money with currency speculation is to know when to get in or
out. At some point the first speculators decide to get out because they have made enough
money, or they think that the currency is likely to fall in value. Information that signals
speculators to sell are usually indications that local profit opportunities are decreasing.

Such signals include more government regulation, tougher environmental standards,

or an emerging labor movement. Speculators will begin selling the currency, and if many
speculators decide to get out the value of the currency will fall, more speculators will sell, the
value will fall further, and a downward spiral will ensue.

If a currency's sell-off is in response to particular domestic events, most governments

will attempt to halt the fall of their currency by reversing the policies or events that initially
prompted speculators to sell. In the cases of South Korea and Indonesia, the governments
have been reluctant to reverse their initial policies, making speculators wary of buying these
currencies again.

So far we have been focusing on exchanges in the present, or what currency traders
call the "spot market," where U.S.$ are exchanged for French Franc or Dutch Guilder right
now. Speculative purchases in the spot market are done with the intent to sell the currency
relatively quickly. Many speculators will hold foreign currency that they buy in the spot
market for a mere 15 to 20 minutes. After this time a speculator simply decides to take her
gain or loss, and to start all over again.

Profit in Speculation

Surprisingly enough, a speculator can make a handsome profit in that short amount of
time. Let's say that a U.S. speculator thinks that Indian Rupee (INR) are going to rise in
value, so she takes $10 million and buys INR. If the original price is 66.50 per U.S.$ , she
will get 669889500 Rs .
 After twenty minutes, the value of the INRhas increased to 66.8 cents. Her 669889500
Rs can now be converted back into U.S.$, yielding $10.020 million (0.668 times of
669889500 Rs), leaving the trader with a profit of $20,000 for less than half an hour of work.
Even though the margins between the selling and buying prices of a currency are usually less
than 1%, the large volume of each transaction, generally $10 million or more, make
handsome profits possible.

Because foreign exchange transactions are potentially so profitable, large speculators

(mainly multinational banks) are devoting more and more of their resources to such
activities.Since these earnings are the fastest growing part of bank incomes, it is not
surprising that billions of new dollars continue to enter the global currency markets, thus
enhancing the power of speculators.

"Forward Exchange" Hedging and Speculating

Besides the spot market, speculators also make money in the "forward market," where
a person can commit themselves to sell a fixed amount of a foreign currency at a specific
time in the future, at an exchange rate that is set today. There are two reasons for engaging in
a transaction in the forward market. One is if a currency trader knows that she will have a
certain amount of foreign currency in her possession at a specific time in the future, such as
from an export deal. Or she may simply guess that a foreign currency will move in a certain
direction. In the first case, the trader is "hedging" against the risk of losing money if the
currency devalues between now and the future date; while in the second case she is engaging
in speculation.

Forward markets can be very profitable instruments of currency speculation. If a

speculator expects a foreign currency, for example the Indian Rupees (INR), to appreciate
over the next three months, she will contract to buy Indian Rupees in three months at a fixed
exchange rate. If the current rate is 66 Rs , and the speculator thinks that the currency will
increase to 69 per Indian Rupees, she will try to set up a forward contract. Suppose she writes
a contract to buy $10 million worth of Indian Rupees in three months for today's rate, 66 Rs,
so that she will get Rs13,333,000. If her speculation is correct, she will be able to sell them
immediately at the market rate of 69 Rs for $10,667,000. She makes a profit of $667,000
from one moment to the next because she guessed right.
 One important side effect of forward transactions is that they can become self-
fulfilling prophecies, especially in the case of forward sales, which have been at the core of
various currency crises. In a forward sale a speculator guesses that the value of a currency
will fall in the future.

Consequently, she will enter an agreement to sell a fixed amount of this currency at a
specified time in the future, at something close to the current rate. If her guess is correct, at
the specified future date she will be able to buy the currency cheaply in the market and sell it
at the higher contracted exchange rate.

But by offering a forward sales contract to other market participants, the speculator
signals that she thinks the currency is going to depreciate in the future. Since foreign
exchange markets rely on a lot of intangible information, and since the number of large
currency speculators is relatively small, such a signal can have a relatively large impact. If
George Soros, for example, decides to offer a forward sale on Thai bhat, other speculators are
likely to take notice, and adjust their predictions about the future value of the Thai currency
downwards. If a growing number of speculators think that the Thai currency will fall, they
will start selling their holdings, thus driving down the value of the currency, and hence
making George Soros' prediction come true.

Exchange Rate "Regimes"

So far this discussion has assumed that there are no restrictions on exchanging one
currency for another, and that foreign currency exchange rates are set only by the supply of
and demand for each currency. In this case, we have a flexible exchange rate "regime," since
the value of a currency can move whenever supply and demand are out of balance. But to
understand some of the most recent currency crises, it is important to note that many
exchange rates are not flexible, but are fixed either unilaterally by their own governments
against one other currency, or multilaterally in an agreement between different countries.

Contrary to intuition, currency speculation can also occur in fixed exchange rate
regimes. In fact, almost all cases of fixed exchange rates have eventually been abandoned
because of currency speculation. Under such a regime, a government makes a commitment to
buy or sell its own currency to keep it at a fixed exchange rate.
 If a currency's exchange rate is set too high (overvalued), the nation's central bank has
to constantly prop it up. The bank does this by buying its own currency (thereby raising
demand relative to supply), or by selling its reserves of other currencies.

But since a central bank holds only limited amounts of foreign currency, it will
eventually be unable to buy more of its own currency. At that point, a government has three
options. The first is to impose austerity on its own people through higher interest rates and
reduced government spending—which will reduce imports, raise exports, and so increase
foreign currency reserves.

If the government is unwilling to force a recession, it will have to let its currency
depreciate, either by setting a new, lower exchange rate, or by allowing its currency to be
flexible ("float"). Either way, if speculators regard an exchange rate as too high and likely to
fall soon, they will sell the currency in the forward market. If they guess right, they will be
able to buy it in the future at a low market price, and sell it high at the already-contracted for
rate. If many speculators sell the currency in the forward market, this will signal that the
currency is overvalued, and people will begin selling the currency in the spot market.

Eventually, the central bank will be unable to support the fixed exchange rate and the
currency's value will fall. This is another self-fulfilling prophecy, as the speculators who
originally began the downward trend pull others along with them, thus actually devaluing the
currency.

So through herd behavior and self-fulfilling proposals, speculation creates an

international economy more prone to crisis. It also makes global capitalism more impatient
with reforms that aid the many rather than the few—union protections, environmental
regulations, welfare provisions, and efforts to promote employment.

• These risks and constraints are a problem for more than the developing economies in
Southeast Asia and elsewhere. Nowadays, no single country is large enough to
stabilize its own currency if speculators, who have billions of dollars at their beck and
call, decide to speculate against it. We all, it seems, have to be vigilant against the
risks and ravages of currency speculation. Reducing currency speculation is not an
easy task, and cannot be accomplished by a single country.
• Floating Regimes (n = 35):
 USD, JPY, EUR, GBP, CAD, AUD, NZD, CHF, ZAR, MXN, KRW, SEK, ILS

• Managed Float Regimes (n = 48):

THB, SGD, INR, RUB, CZK, CNY (as of 2014)

• Pegged (and Crawling Pegs*) Regimes (n = 94):

HKD (7.81:1USD),

SAR (3.75: 1USD);

VND* (18,932:1USD, announced August 18, 2015)

Disadvantages of speculation

  Winner’s Curse:

Auctions are a method of squeezing out speculators from a transaction, but they may
have their own perverse effects.  The winner’s curse says that in an auction, the winner will
tend to overpay in one of two ways:

 The winning bid exceeds the value of the auctioned asset such that the winner is
worse off in absolute terms; or
 The value of the asset is less than the bidder anticipated, so the bidder may still
have a net gain but will be worse off than anticipated.

The winner’s curse is not very significant to markets with high liquidity for both
buyers and sellers, as the auction for selling the product and the auction for buying the
product occur simultaneously, and the two prices are separated only by a relatively small
spread. This mechanism prevents the winner’s curse phenomenon from causing mispricing to
any degree greater than the spread.

  Economic Bubbles:

Speculation is often associated with economic bubbles. A bubble occurs when the
price for an asset exceeds its intrinsic value by a significant margin. Speculative bubbles are
characterized by rapid market expansion driven by word-of-mouth as initial rises in
commodity price attract new buyers and generate further inflation. Speculative bubbles are
essentially social epidemics whose contagion is mediated by the structure of the market.

  Volatility

For a speculator, a good performance would occur when there is a very high level of
volatility. It is a controversial point whether the presence of speculators increases or
decreases the short-term volatility in a market. Their provision of capital and information
may help stabilize prices closer to their true values. On the other hand, crowd behaviour and
positive feedback loops in market participants may also increase volatility at times.

HEDGING

When a currency trader enters into a trade with the intent of protecting an existing or
anticipated position from an unwanted move in the foreign currency exchange rates, they can
be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that
is long a foreign currency pair, can protect themselves from downside risk; while the trader
that is short a foreign currency pair, can protect against upside risk.

The primary methods of hedging currency trades for the retail forex trader is through:

 Spot contracts, and

 Foreign currency options.

Spot contracts are essentially the regular type of trade that is made by a retail forex trader.
Because spot contracts have a very short-term delivery date (two days), they are not the most
effective currency hedging vehicle. Regular spot contracts are usually the reason that a hedge
is needed, rather than used as the hedge itself.

Foreign currency options, however are one of the most popular methods of currency
hedging. As with options on other types of securities, the foreign currency option gives the
purchaser the right, but not the obligation, to buy or sell the currency pair at a particular
exchange rate at some time in the future. Regular options strategies can be employed, such as
long straddles, long strangles and bull or bear spreads, to limit the loss potential of a given
trade.

Forex hedging strategy 

A forex hedging strategy is developed in four parts, including an analysis of the forex
trader's risk exposure, risk tolerance and preference of strategy. These components make up
the forex hedge:

Analyze risk:

 The trader must identify what types of risk (s)he is taking in the current or proposed
position. From there, the trader must identify what the implications could be of taking on
this risk un-hedged, and determine whether the risk is high or low in the current forex
currency market.

Determine risk tolerance:

  In this step, the trader uses their own risk tolerance levels, to determine how much of
the position's risk needs to be hedged. No trade will ever have zero risk; it is up to the
trader to determine the level of risk they are willing to take, and how much they are
willing to pay to remove the excess risks.

Determine forex hedging strategy:

 If using foreign currency options to hedge the risk of the currency trade, the trader
must determine which strategy is the most cost effective.

Implement and monitor the strategy:

  By making sure that the strategy works the way it should, risk will stay minimized.
The forex currency trading market is a risky one, and hedging is just one way that a trader
can help to minimize the amount of risk they take on. So much of being a trader is money
and risk management, that having another tool like hedging in the arsenal is incredibly
useful.
Advantages of currency Hedging
The main advantage of this investment approach is to help reduce the risks and losses
of the investor. Hedging is a good strategy when dealing with foreign investment
opportunities. The price of currencies are volatile, however, hedging currencies can provide
investors with more leverage when they put money in the very risky Forex market.

Moreover, investors who do not have the time to monitor and check their investments
can also benefit from hedging. There are many hedging tools that can effectively lock profits
for investors. The gains from hedging are often realized in long term gains.
Also, since the objective of hedging currencies is to minimize losses, it can also allow traders
to survive economic downturns, or bearish market periods. If you are a successful hedger,
you will be protected against inflation, interest rate changes, commodity price volatility and
currency exchange rate fluctuations.

WORKING OF HEDGING IN BUSINESS

You are an exporter who wants to protect himself from the likely appreciation in the
rupee. You have dispatched a consignment on 5th November and are expecting payment of
$25,000 by December end. The current spot rate of USD-INR is 48.80
• On 5th November sell 25 units of USD-INR future contracts (each of $1000) of
December month at the prevailing rate of 48.95
• On 28th December cover sell position by purchasing 25 contracts of December
month at the then prevailing rate of say 48.45
• Simultaneously sell $25,000 (receipt from overseas party) in the spot market at the
rate of 48.45
• In spot market: Loss due to currency appreciation from 48.80
• in September to 48.45 in December = 25,000 x (48.80 – 48.45) = 8, 750
• Your notional net profit as a result of Hedging transactions would be: 12,500 - 8,750
= 3,750
• NOTE: Had you not taken position in the currency futures market, you would have
made a loss of ` 8,750. By taking position in this market, you have not only covered
your loss but also earned a profit from the futures transaction
EXAMPLES OF HEDGING
Suppose an edible oil importer wants to import edible oil worth USD 100,000 and
places his import order on July 15, 2008, with the delivery date being 4 months ahead. At the
time when the contract is placed, in the spot market, one USD was worth say INR 44.50. But,
suppose the Indian Rupee depreciates to INR 44.75 per USD when the payment is due in
October 2008, the value of the payment for the importer goes up to INR 4,475,000 rather than
INR 4,450,000. The hedging strategy for the importer, thus, would be:

 Current Spot Rate (15th July '08) Buy 100 USD - INR Oct '08 Contracts on 15th July

08 : 44.5000 (1000 * 44.5500) * 100 (Assuming the Oct '08 contract is trading at 44.5500 on
15th July, '08),Sell 100 USD - INR Oct '08 Contracts in Oct '08 Profit/Loss (futures market) :

44.7500 1000 * (44.75 -44.55) * 100 = 20,000 Purchases in spot market @ 44.75

Total cost of hedged transaction : 44.75 * 100,000 100,000 * 44.75 20,000 = INR
4,455,000

A jeweller who is exporting gold jewellery worth USD 50,000, wants protection
against possible Indian Rupee appreciation in Dec 08, i.e. when he receives his payment. He
wants to lock-in the exchange rate for the above transaction.

One USD - INR contract size : USD 1,000 Sell 50 USD - INR Dec '08 Contracts (on
15th Jul '08) : 44.6500 Buy 50 USD - INR Dec '08 Contracts in Dec '08 : 44.3500 Sell USD
50,000 in spot market @ 44.35 in Dec '08 (Assume that initially Indian rupee depreciated ,
but later appreciated to 44.35 per USD as foreseen by the exporter by end of Dec '08)
Profit/Loss from futures (Dec '08 contract) : 50 * 1000 *(44.65 44.35) = 0.30 *50 * 1000 =
INR 15,000  

The net receipt in INR for the hedged transaction would be: 50,000 *44.35 + 15,000 =
2,217,500 + 15,000 = 2,232,500. Had he not participated in futures market, he would have
got only INR 2,217,500. Thus, he kept his sales unexposed to foreign exchange rate risk. 

Consider a small Indian company that has exported goods to a U.S. customer and
expects to receive US$50,000 in one year. The Indian CEO views the current exchange rate
of US$1 = 68.22 as favorable, and would like to lock it in, since he thinks that the Indian
Rupees may appreciate over the year ahead (which would result in fewer Indian Rupee for
the U.S. dollar export proceeds when received in a year’s time). The Indian company can
borrow US$ at 1.75% for one year and can receive 2.5% per annum for Indian Rupees
deposits.
From the perspective of the Indian Company, the domestic currency is the Indian Rupee and
the foreign currency is the US dollar. Here’s how the money market hedge is set up.

1. The Indian Rupee borrows the present value of the U.S. dollar receivable (i.e.
US$50,000 discounted at the US$ borrowing rate of 1.75%) = US$50,000 / (1.0175) =
US$49,140.05. Thus, after one year, the loan amount including interest at 1.75%
would be exactly Rs 3350772

2. The amount of US$49,104.15 is converted into Indian Rupee at the spot rate of 1.10,
to get 3290726 Rs.

3. The Indian Rupee amount is placed on deposit at 2.5%, so that the maturity amount
(after one year) is = Rs 3350772 x (1.025) = Rs 3434541.

4. When the export payment is received, the Indian company uses it to repay the US
dollar loan of US$50,000. Since it received Rs 3434541 for this US dollar amount, it
effectively locked in a one-year forward rate = Rs 3350772 / US$50,000.

Potential reasons could be that the company is too small to obtain a forward currency facility
from its banker; or perhaps it did not get a competitive forward rate and decided
To hedge money market hedge instead.

Hedging through Rupee Options

To hedge, Exporters should buy a put option.

To hedge, importers should buy a call option.

If an importer who is expected to pay $ 300000 in March 2011 wants to hedge his exchange
risk, he has to buy 300 lots (300000/1000) of USDINR call option by paying a total amount
of 300 multiplied by the premium quoted for that particular contract. There is no need for the
buyer of an option to worry about the margin money as he pays the premium upfront and
fixes the price at which he has to buy. Meanwhile a seller of options should park in margin
money similar to the Rupee futures contract whenever he receives a margin call from the
brokerage.
To hedge, exporters and those who receive payment from abroad should sell a contract of a
particular currency pair in which they have exposures.

Hedging through Rupee Futures

To hedge, importers and those who want to remit money abroad should buy a contract of a
particular currency pair in which they have exposures.

A company Gk exports will receive $1 million payment in May 2011 from an importer.  The
company expects the dollar to lose value versus the rupee in the month of May. To hedge its
exchange risk, GK exports should sell 1000 lots of USDINR May futures contract to hedge
its exchange risk.(1000000/1000) If the company wants to hedge only for 50% then it has to
sell 500 lots of USD/INR May contract. However, hedging doesn’t negate the exchange risk
when the company’s assumption on the USD/INR exchange rate goes awry.
 
Margin for one lot USDINR pair is Rs. 1250(approx). So the initial margin money parked
should be equivalent to Rs. 12, 50,000. Apart from this the Company has to park in the
margin money on receiving the margin call from the brokerage/bank based on the market
vagaries.

Though Rupee Futures platform provides hedging avenue for exporters & importers to hedge
their risk, the hedging volumes has not increased compared to the speculative volume due to
the following reasons.
 
 Lack of Awareness

 Timing and Amount mismatch in hedging through futures.

 Only near month contracts are liquid and pricing is reasonable, whereas far- month
contracts are illiquid and prices remain distorted.

 Fears about receiving margin calls and procedure hassle for corporate in dealing with
futures is keeping away many participants. Also the margin money which remains
idle for few months is viewed as a flaw in managing the cash in many companies, as
the same benefits they can get in the forward market without parking margin money.
There lies the key differentiator for this market.
  Few companies have a policy of not hedging their exchange risk fearing the market
volatility and in some other companies they prefer to hedge only in OTC
markets(Forward contracts)
 
Hedging through long term capital flows

The various possibilities are explored under the assumption that short-term capital
flows only serve as a means of hedging.

A. Constant hedge ratio

In this case capital imports and capital exports are both hedged in equal
proportions. Consequently net short-term capital flows are a constant fraction of net. Long-
term capital flows (always going in the opposite direction) .

B. Variable hedge ratio

In this case, the hedge ratio for long-term capital exports and imports is still equal.
However. It varies over time. Therefore. Even when net long-term capital flows are constant,
net short-term capital flows vary. However, net short-term capital still flows in the opposite
direction.

Long term capital flows

a.Constant Hedge Ratio

 b.Variable Hedge Ratio

Hedging in the forward market has a lot in common with a money market hedge. In
both cases of hedging there is a short-term capital movement. In the case of a forward hedge
the short-term capital movement of the hedger is replaced by a capital movement of a bank.
Therefore, such forward transactions can be interpreted as a credit from the bank to the
counterparty in the forward deal . Since forward transactions with customers also involve
counterparty risk for the bank, just like credit risk in case of a loan, they require a certain
amount of collateral.

In principle, hedging of long-term flows should also produce a pattern of long-term

and short-term capital movements flowing in opposite directions. Unlike in the case of
international intermediation these flows do not have to be equal in size. If hedging is not
complete, long-term flows should be larger. Furthermore, once it is taken into account that
hedge ratios may be different for locals and foreigners and that they may change over time, it
becomes clear that hedging may be difficult to detect.

Hedging in the option market

The connection between derivative and the underlying cash market is not as close for
options as for forwards. Open options positions are also routinely covered, but not 100
percent , since it is not known whether the option will be exercised or not. Therefore, only a
proportion which is given by the 'delta' of an option will be hedged. For an option "close at
the money' this is about 50 percent.

The covering of an open option position can be brought about by spot purchases and
sales, the net amount at the end of the day being swapped (thus creating a forward position)
or by forward/futures transactions. In both cases, there will be repercussions in the credit
markets in both countries, just as described above for forward and swap transactions.
Therefore, the use of options for hedging purposes will also become visible in the short-term
capital account, but not to the same extent as hedging operations via the forward market.

Disadvantages of Currency Hedging

 The risk protection advantages of hedging can also be viewed as its main weakness. Since
hedging is intended to protect investors against losses and risks, it does not provide ample
flexibility that allows investors to quickly react to market dynamics. When it comes to
investments, risks and rewards are directly proportional to each other. If you minimize your
risks, you are also reducing your potential profits. The major disadvantage is that there will a
loss of money for small investors

Next, hedging usually involves huge costs and expenses that can eat up a big chunk of
your profits. In order to be successful with this investment approach, you need to have
enough money to fund your investments and you should also be willing to wait for a long
time before you can enjoy the profits. The major disadvantage is that there will a loss of
money for small investors with limited capital.

In the end, currency hedging can be an investment trap if you think that it is without
risks. As with any type of investment approach, hedging also has risks that can result in huge
losses. Before you embark on any type of hedging strategy, you need to understand its
underlying concepts clearly.

CHAPTER –IV

DATA ANALYSIS

• World’s largest financial market trades at $4.0 trillion values of currency per day in
trades ($3.3 in 2007).
• NSE stock exchange of India currently trades about 40 Million Rupee per day.
• Market is a 24/5(7) over-the-counter market.
 • Major markets open Monday through Friday; Middle East markets also open on
weekends
• There is no central trading location (i.e., no central trading floor).
• Trades take place through a network of computer (Reuters screens) and telephone
connections all over the world.
• 37% of all trades take place through banks located in the U.K. (London);
• 29% the U.S. (New York);
• 27% in Indian Markets (NSE)
• 6% Japan (Tokyo).
• Saudi Arabia and Bahrain each 0.1%.
Most popular traded currency is the
• USD (86%);
• EUR (52%);
• GBP (39%);
• JPY (27%);
• INR (11%)
• AUD (8%);
• CHF (6%);
Most popular traded currency pair is the
 USD/EUR (28%);
 USD/JPY (14%);
 USD/GBP (9%);
 USD/AUD (6%)
 USD/INR (5%)
 EUR/INR (3.5%)
 GBP/INR (1%)

FX Market Currencies Quote

• (1) American Terms Quote:

 Expresses the exchange rate as the number of U.S. dollars and cents per one
unit of a foreign currency.
• For example, 68 Rs per1 US Dollar.

• (2) European Terms Quote:

Expresses the exchange rate as the number of foreign currency units per one
U.S. dollar.
• For example, 95 Rs per 1 Euro.
• Most of the world’s currencies are quoted for trade purposes on the basis of European
terms.

Role of Banks in the Foreign Exchange Market

Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank) operate in the foreign
exchange markets through:
• Their “external” clients” (primarily large global firms: exporters, importers,
multinational firms, investment companies, hedge firms)
• Acting in a broker capacity at the request of these clients.
• Their own banks (trading in currencies to generate profits).
• Acting in a “dealer” (i.e., trading) capacity.
• In meeting the needs of their clients and their own trading activities, these global
banks establish the “tone” of the foreign exchange market.
• This is done through their “market maker” function
Traders in this market include large banks, central banks, institutional investors,
currency speculators, corporations, governments, other financial institutions, and retail
investors.

The below table shows us the banks which deal with Forex transactions In a year and
the market share of those banks in dealing in forex & mainly in settlement, handling of INR
transactions in a year

Rank Name Market s hare

1 State Bank Of India (SBI) 15.18%
2 Citi Bank 14.90%
3 ICICI Bank 10.24%
4 HDFC Bank 10.11%
 5 HSBC 6.93%
6 Axis Bank 6.07%
7 Deutsche Bank 5.62%
8 IDBI Bank 3.70%
9 Bank of Baroda 3.15%
10 Royal Bank of Scotland 3.08%
Total 78.98%

COST OF INR FOR ARBITRAGE TRADERS

Volume of INR Cost of INR

Upto 1 crore(10 million) 5
1 crore to 500 crores 7
500 crores to 1000 crores 9
1000 Crores to 10000 Crores 11
10000 Crores to 100000 Crores 13
Above 100000 Crores 20

The brokerage fee per unit of a base currency becomes negligible since the electronic
dealing/matching system of Reuters places restrictions on the minimum size of a currency
trade. Moreover, it is only possible to trade multiples of the minimum quantity of a currency.
The matching system does not accept trading orders that violate these restrictions. Deposits,
however, do not face such restrictions on quantity traded as they are traded at other
venues.The below table shows the minimum trading volume of Indian Rupee(INR) in an year

Currency pair Minimum Traded Volume in an year

USD/INR 100 Billion

EUR/INR 75 Billion
 GBP/INR 67 Billion

JPY/INR 10 Billion

The settlement costs are associated with messages/notices that are sent to counterparts
of a trade. In our case, a trade is settled and implemented through the SWIFT (Society for
Worldwide Interbank Financial Telecommunication) network. There are three notices
associated with each transaction: notice of confirmation, payment instructions and notice
of incoming payments.

Confirmation of a deal is sent to both sides of the deal on the trading date. This is
followed by payment instructions to the banks where both parties have accounts that will be
debited.

Finally, a notice of incoming payments may be sent to the banks where both parties
want the incoming payments to be credited.The cost of a notice is 14–28 cents and is the
same for transactions in the FX and security markets.

The cost does not depend on the venue of trading, i.e. it is the same for trading
directly or via a broker (voice or electronic). Thus each party incurs a total cost of 0.42–0.84
cents for the three messages per transaction.

These costs are charged at the end of each month. SWIFT invoices its customers
either in dollars or euros, depending on the country in which the customer is located
irrespective of the invoicing address. The following table illustrates the volume of arbitrage
done in Indian Rupees

YEAR VOLUME OF ARBITRAGE DONE IN

INR
2007 8243

2008 12992
 2009 16758

2010 21663

2011 23112

2012 28004

2013 31850

2014 36487

2015 39009

DATA RELATED TO PROFIT MADE ON ARBITRAGE TRADES

YEAR CURRENCY PAIRS ARBITRAGE IN PROFIT PER TRADE IN AN

YEAR (IN INR Crores)
INR(In Crores)
2012 USD/INR 2150 150
2013 GBP/INR 1997 852
2014 JPY/INR 1012 96
2015 EUR/INR 1229 120

PROFIT EARNED THROUGH ARBITRAGE IN TERMS OF %

MONTH TOTAL PROFIT IN %

JANUARY 0.8938
FEBRUARY 1.6179
MARCH 1.2974
APRIL 0.9421
MAY 0.7215
JUNE 0.9473
 JULY 1.2565
AUGUST 0.3543
SEPTEMBER 0.2752
OCTOBER 0.4052
NOVEMBER 0.2324
DECEMBER 0.2808
TOTAL 9.244

Evidence of Derivative use for Hedging FX Risk in Indian Firms

Instruments Currency(mn) Rs (Cr) Nature of exposure
Reliance Industries
Earnings in all businesses are
Currency Swaps 1064.49 linked to
Options Contracts 2939.76 USD. The key input, crude oil is

purchased in USD. All export

revenues
Forward Contracts 5764.10
are in foreign currency and local
prices

are based on import parity prices

as
well.
Maruti Udyog Ltd
6411 (INR- Import/Royalty payable in Yen
JPY) and
Forward Contracts 70 ($-INR) Exports Receivables in dollars.

124.70(USD
Currency swaps -INR) Interest rate and forex risk.
Mahindra and Mahindra
Trade payables in Yen and Euro
Forward Contracts 350 (INR-JPY) and
2(INR-EUR) export receivables in dollars.
27.3($-INR)
5390 (JPY- Interest rate and foreign
Currency Swaps INR) exchange risk.
Arvind Mills
Most of the revenue is either in
Forward Contracts 152.98 ($-INR) 703.67 dollars
2.25 (GBP-
INR) or linked to dollars due to export.
5 (INR-$) 21.88
Option Contracts 122.5 ($-INR) 547.16

Infosys

Forward Contracts 119 ($-INR) 529 Revenues denominated in these

currencies.
Options Contracts 4 ($-INR) 18
8 (INR-$) 36

Range barrier options 2 ($-INR) 971

3 (Eur-INR)
Tata Consultancy Services
Forward Contracts 15 (Eur-INR) 265.75 Revenues largely denominated in
foreign currency, predominantly
21 (GBP-INR) US$,
GBP, and Euro. Other currencie
Option Contracts 830 ($-INR) 4057 include
Australian $, Canadian $, South
47.5 (Eur-INR) African
76.5 (GBP- Rand, and Swiss Franc
 INR)
Ranbaxy
Exposed on accounts receivable
Forward Contracts 2894.589 and
loans payable. Exposure in USD
and
Jap Yen
Dr. Reddy’s Labs
Foreign currency earnings
Forward Contracts 398 ($-INR) through
11(Eur $) export, currency requirements for
settlement of liability for import
of
Options Contracts 30 (EUR-$) goods.

Note:
1. $-INR Forward contracts denote selling of USD forwards to convert revenues to
INR. INR-$ Forward contracts denote buying of USD forwards to meet USD
payment obligations.
2. $-INR Option contracts are Put options to sell USD. INR-$ are Call options to buy
USD

From the above table it can be seen that earnings of all the firms are linked to either US
dollar, Euro or Pound as firms transact primarily in these foreign currencies globally.
Forward contracts are commonly used and among these firms, Ranbaxy and RIL depend
heavily on these contracts for their hedging requirements. As discussed earlier, forwards
contracts can be tailored to the exact needs of the firm and this could be the reason for their
popularity. The tailorability is a consideration as it enables the firms to match their exposures
in an exact manner compared to exchange traded derivatives like futures that are standardised
where exact matching is difficult.

RIL, Maruti Udyog and Mahindra and Mahindra are the only firms using currency
swaps. Swap usage is a long term strategy for hedging and suggests that the planning
horizons for these companies are longer than those of other firms. These businesses, by
nature involve longer gestation periods and higher initial capital outlays and this could
explain their long planning horizons.
Another observation is that TCS prefers to hedge its exposure to the US Dollar through
options rather than forwards. This strategy has been observed among many firms recently in
India11. This has been adopted due to the marked high volatility of the US Dollar against the
Rupee.
Options are more profitable instruments in volatile conditions as they offer unlimited
upside profitability while hedging the downside risk whereas there is a risk with forwards if
the expectation of the exchange rate (the guess) is wrong as firms lose out on some profit.
The use of Range barrier options by Infosys also suggests a strategy to tackle the high
volatility of the dollar exchange rates. Software firms have a limited domestic market and
rely on exports for the major part of their revenues and hence require additional flexibility in
hedging when the volatility is high. Another implication of this is that their planning horizons
are shorter compared to capital intensive firms.

It is evident that most Indian firms use forwards and options to hedge their foreign
currency exposure. This implies that these firms chose short-term measures to hedge as
opposed to foreign debt. This preference is possibly a consequence of their costs being in
Rupees, the absence of a Rupee futures exchange in India and curbs on foreign debt. It also
follows that most of these firms behave like Net Exporters and are adversely affected by
appreciation of the local currency.
There are a few firms which have import liabilities which would be adversely affected
by Rupee depreciation. However it must be pointed out that the data set considered for this
study does not indicate how the use of foreign debt by these firms hedges their exposures to
foreign exchange risk and whether such a strategy is used as a substitute or complement to
hedging with derivatives
.
Analysis for Cash Flow Hedging

Cash Flow Factors Average of Three Stages

(All figures in millions) INR US $ € Total in INR
Net Cash Flow Pre Interest 30 10 7 47
Interest -3 -2 -5

Net Cash Flow 30 7 5 42

INR Depreciate by 5 % 31.5 7 5 43 .5

INR Appreciate by 5 % 28.5 7 5 40 .5

Fluctuation *+/-3. 57%

Impact Of Hedged Currency on Cash Flow

Average of Three Stages

Cash Flow Factors
(All figures in Total in
millions) INR US $ € INR
Net Cash Flow Pre
Interest 30 10 7 47

Interest -5 -5

Net Cash Flow 25 10 7 42

INR Depreciate by 5
% 26.25 10 7 43 .25

INR Appreciate by 5
% 23.75 10 7 40 .75
Fluctuation +/-2. 98 %

SPECULATION TRADING DATA AS ON FINANCIAL YEAR 2013-2014

PROFIT & LOSS MADE THROUGH SPECULATION OF DIFFERENT

CURRENCIES IN DIFFERENT DATES

SYMBOL VOLUME DATE PROFIT/LOSS PIPS HOLDED TIME

PERIOD
(P/L)
GBP/INR 0.1 18/01/2013 45.60 45.60 5 mins
USD/INR 0.2 7/02/2013 28.20 14.10 17 mins
EUR/INR 0.1 21/03/2013 40.27 40.00 42 mins
SGD/INR 0.03 8/04/2013 (26.93) 21.00 54 mins
MYR/INR 0.5 10/06/2013 (3.76) 8.93 32 mins
JPY/INR 0.9 27/09/2013 38.69 29.68 7 mins
TOTAL 152.76 159.31