Description
In calculus, a branch of mathematics, the derivative is a measure of how a function changes as its input changes. Loosely speaking, a derivative can be thought of as how much one quantity
Foreign Exchange Market
Interest Rate Derivatives and Forex
Name Roll No.
Chintan Shah Dhrumit Shah Manali Sunil Rajput Vinay Navlakha Atik
Harshil Desai Bhavesh
5136 5137 5103 5127 5182 5170
5091 5217
2
DERIVATIVES
DERIVATIVES
Derivative Contracts are wasting assets, which derive their values from an underlying asset. These underlying can be : ? Stocks (Equity) ? Agri Commodities including grains, coffee beans, etc. ? Precious metals like gold and silver. ? Foreign exchange rate ? Bonds ? Short-term debt securities such as T-bills
TYPES OF DERIVATIVES
? Forwards
? Futures
? Option
Forward Contract
“A Forward Contract is a transaction wherein the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified date in future. The price may be agreed on in advance or in future.”
Risk in Forward Contract
?
Liquidity Risk:
– Ability of the parties to buy or sell the asset whenever he wants to do so without any significant price movement.
? Other Risks – Counter party Risk.
– Standardisation Risk
FUTURES CONTRACT
It involves an obligation on both the parties i.e the buyer and the seller to fulfill the terms of the contract (i.e. these are pre-determined contracts entered today for a date in the future)
? Obligation to buy or sell ? Stated quantity ? At a specific price ? Stated date (Expiration Date) ? Marked to Market on a daily basis
Features
Operational Mechanism
Forward
Not traded on exchange
Futures
Traded on exchange.
Contract Specifications
Differs from trade to trade.
Contracts are standardized contracts.
Counterparty Risk
Exists.
Exists, but assumed by Clearing Corporation/ house
Very high Liquidity as contracts are standardized contracts. Better; as fragmented markets are brought to the common platform.
Liquidation
Poor Liquidity as contracts are tailor made contracts Poor; as markets are fragmented.
Profile Price Discovery
OPTIONS
“An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. ” The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.
Types of option:
? Call Option ? Put option
Classification of Option
?
According to exercise of option
European option : Index : NIFTY, CNXIT
-
American option : Stocks : TATA MOTORS, ONGC
? According to type of option
Call Option Put Option
Option Jargons
Infosys (2800) CALL
In-the-Money (ITM) At-the-Money (ATM) Out -the-Money (OTM)
S>K 2800 > 2700
S=K 2800 = 2800
S<K 2800 < 2900
PUT
S<K 2800 < 2900
S=K 2800 = 2800
S>K 2800 > 2700
S = Spot price K = Strike price
OPTION PREMIUM
INTRINSIC VALUE
TIME VALUE
? Intrinsic Value : When option is in-the-money we have maximum Intrinsic Value. If the option is out of the money or at the money its Intrinsic Value is zero. For a call option intrinsic value : Max (0, (St – K) ) and For a put option intrinsic value : Max (0, (K - St ) )
? Time Value.
- Time value of option is difference between Premium and Intrinsic value.
- ATM and OTM option only have time value and no Intrinsic value. - The time value decreases as time remaining to maturity reduces and. becomes zero on maturity.
ITM
Time value Reduces
ATM
Time value Reduces
OTM
Eg. Stock ONGC
TYPE EXPIRY CALL / PUT STRIKE SPOT TYPE OF OPTION PREMIUM INTRINSIC VALUE TIME VALUE
OPTSTK
25/01/2006
CA
1170
1200
ITM
37
(1200-1170) = 30 (1200-1200) = 0 (1200-1230) = (-30) or 0
7
OPTSTK
25/01/2006
CA
1200
1200
ATM
24
24
OPTSTK
25/01/2006
CA
1230
1200
OTM
11
11
PARTICIPANTS
? Speculators - willing to take on risk in pursuit of profit.
?
Hedgers - transfer risk by taking a position in the Derivatives Market.
?
Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously.
FUTURES STRATEGIES
?TECHNICAL INDICATORS ?FUTURES ARBITRAGE ?HEDGING STRATEGIES
TECHNICAL INDICATORS
1) OPEN INTEREST ? Open Interest means the total number of contracts of an underlying asset that have not been offset and closed by an opposite transaction or delivery of the
underlying commodity or by cash settlement. ? Sum of all positions taken by different traders are reflected in the Open Interest.
Predicting the F&O markets based on Open Interest movements
?Increasing OI with increase in price trend is considered positive.
? Increasing OI with decrease in price is considered negative.
? Decreasing OI with increase in price trend is considered positive. ? Decreasing OI with decrease in price trend is considered negative.
2) PUT CALL RATIO
? The Put/Call Ratio is the number of put options contracts traded divided by the number of call options contracts traded. ? If put call ratio is high, it means more put options are trading in the market which is an indicator of bearishness. ? ? Whereas if the put call ratio is low then it indicates bullishness. Put call ratio of options shows an inverse relationship with market.
Volatility
? It is a statistical measure of a market or a security's price movements over a period of time. ? Mathematically volatility is often expressed as standard deviation.
? There are two types of volatility:
- Historical Volatility. - Implied Volatility.
Historical Volatility
• Historical volatility is a measure of actual price changes during a specific time period in the past.
• It is the annualized standard deviation of daily returns during a specific period. • Historical volatility is also referred to as actual volatility or realized volatility. • For short-term volatility, generally 5 days, 10 days, 20 days or 30 days time frame is considered. Whereas for long term volatility, normally 60 day, 180 day or 360 day time period is considered.
Implied Volatility
• Implied volatility of a stock or an index is computed using an option pricing model such as the Black-Scholes or Binomial.
• Rising implied volatility causes option prices to rise while falling implied
volatility results in lower option premiums.
• The value of an option consists of several components like - strike price, spot price, expiration date, implied volatility of the stock and prevailing interest rates.
• On a given stock, there would generally be a number of calls outstanding, which may have different exercise prices and expiration dates. • From each of these we can make an estimate about the standard deviation of the stock?s rate of return.
Derivatives’ Strategies
• The various standard deviations are then combined on a simple or weighted
average basis and an estimate about the volatility can be made. • Therefore implied volatility is that level of volatility which is calculated from the current trading option price.
FUTURES ARBITRAGE
? Arbitrage
is the act of simultaneously buying and selling assets or commodities in an attempt to exploit a profitable opportunity.
? Arbitrage is done between two related instruments which are temporarily
mis-priced. For example, the futures price and spot price are related by the interest rate, time to maturity and corporate benefit, if any, in the interregnum.
? If
the two prices do not move in tandem, then it throws up arbitrage opportunity. An arbitrageur will buy what is cheap and sell what is costly and lock in profits without any risk.
INDEX ARBITRAGE
?Index Arbitrage is the basis between the Index (Nifty) futures and its constituents (Basket).
?Nifty future is in discount to Nifty spot – Buy Nifty Futures and Sell Basket.
?Nifty future is in premium to Nifty spot – Buy Basket and Sell Nifty Futures. ?As we can?t trade in Nifty spot, we have to create Basket of Nifty components either with underlying stock or stock futures.
PROCESS
?If Nifty is in discount (as quite often), then you have to sell basket. ?As you futures.
cannot short sell in cash, we will be creating basket using stock
?Advantage of using stock futures is – only margin money will be deployed. ?We will be creating Basket based on the weight of the constituents in the Nifty.(Market Capitalization Method) ?We have to make portfolio - “Perfect Hedge”.
Contd… ?Minimum exposure of 242 contracts in Nifty (12,100 units) as it will be best hedge. All the stocks will participate according to their actual weights on the exposure of 242 contracts in Nifty. ?Once good returns have been observed we will execute the strategy. Execution requires highly skilled arbitrageurs.
RISKS
?Lot size constraint :
As we have to buy/sell stocks in lot size in futures, so weights of stocks may differ from actual weights which may lead to some loss.
?Execution risk :
As both trades have to be executed simultaneously, there can be slippage costs. As we have to execute trades at Market Price and due to low liquidity in some of the stocks Bid/Ask spread can be high which may lead to some loss.
MANAGING RISKS
?Lot size risk can be minimized by making the portfolio close to “Perfect
Hedge”. If we execute the strategy for 242 contracts then the problem will be solved as most of the stocks will participate in their actual weights.
?These
transactions are very execution intensive and hence require highly skilled dealers and researchers who can explore all the opportunities available in the market and exploit them in the best possible manner.
HEDGING
?Protecting the value of an asset against risk arising out of fluctuations in price is known as hedging. Technically hedging means transfer of risk from the asset holder to another person who is willing to carry risk.
?When an investor is bearish on market, he can hedge his position by taking countervailing position against his portfolio, say, selling Nifty futures.
?If the market falls, the fall in portfolio value will be compensated by the gains on the Nifty futures. But if the market rises, the rise in the portfolio value would be offset against the futures loss. ?The same concept can be applied to any stocks which have a presence in futures market. The result of any Perfect Hedge contract is – “No Profit and No Loss”
PORTFOLIO HEDGING
?To hedge portfolio, we need to calculate the Beta of the Portfolio and then hedge the Portfolio against the price risk. ?Beta measures the sensitivity of the stock to the broad market index. So if the beta of the stocks Portfolio is 1.05, and if the markets rises by 1%, then the Portfolio is likely to go up 1.05% and same goes for negative movement too. ?Calculate the number of Nifty contracts needed for Hedging. We can use the formula (Portfolio Beta x Portfolio Value) / Futures Value. e.g.:- Portfolio value = Rs. 1,00,00,000, Nifty value = 3,50,000(3500*100) and Beta of Portfolio = 1.05 No. of contracts = (1,00,00,000*1.05)/3,50,000 = 30 contracts ?So we need to sell 30 contracts of Nifty to hedge the Long Portfolio.
Structure of the Presentation
Basic Concepts, Terminologies, Instruments & Mechanism. ? Exchange Rate Regimes ? Historical perspective ? Foreign Exchange Trading & rate quotations ? Role of Reserve Bank of India (RBI) in the FX Market.
33
BASIC CONCEPTS/TERMINOLOGIES
Foreign Currency vs. Foreign Exchange
As per Foreign Exchange Act, (Section 2), 1947.
?(c) "Foreign Currency" means any currency other than Indian currency;
?(d) "Foreign Exchange" means includes any instrument drawn, accepted, made or issued under clause (8) of section 17 of the Banking Regulation Act, 1956, all deposits, credits and balance payable in any foreign currency, and any drafts, traveler?s cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency;
Financial Markets
? Financial market is a place where Resources/funds are transferred from those having surplus/excess to those having a deficit/shortage.
35
Foreign Exchange Markets
? The market where the commodity traded is Currencies. ? Price of each currency is determined in term of other currencies.
36
What is an Exchange Rate ?
Exchange Rate is the price of one country's currency expressed in another country's currency. In other words, the rate at which one currency can be exchanged for another. e.g. Rs. 48.50 per one USD Major currencies of the World ?USD ?EURO ?YEN ?POUND STERLING
What is a Foreign Exchange Transaction ?
– Any financial transaction that involves more than one currency is a foreign exchange transaction. – Most important characteristic of a foreign exchange transaction is that it involves Foreign Exchange Risk.
PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET
? All Scheduled Commercial Banks (Authorized Dealers only). ? Reserve Bank of India (RBI). ? Corporate Treasuries. ? Public Sector/Government. ? Inter Bank Brokerage Houses. ? Resident Indians ? Non Residents ? Exchange Companies ? Money Changers
FOREIGN EXCHANGE REGIMES
? ? ? ? FIXED PEGGED COMPOSITE MANAGED FLOAT
? FREE FLOATING
Components of a Standard FX Transaction
? ? ? ? ? ? Base Currency (USD/INR) „Dealt? or „Variable? Currency Exchange Rate Amount Deal Date Value Date
? Settlement Instructions
Value Date Conventions
Currencies are traded both in Ready and forward value dates.
1) Ready: Settlement on the deal date. e.g. India
2) Value Tom : Settlement on next day. e.g. Canada 3) Spot Transaction : Settlement usually in two working days. In International FX transactions, Spot is the Standard value date. Why Spot Date ? ? Time Zone Difference ? Herstat Risk
4) Forward Transaction: Settlement at some future date ahead of the spot.
42
FX Rate Quotation:
In the forex market rates are always quoted „two way?. Two way quote gives both „Bid? and „Offer?.
e.g. USD/INR= 48.50 / 60 Bid / Offer
„Big Figure?:
Term referring to the first digits of an exchange rate. These figures are rarely change in normal market fluctuations and are usually omitted in dealer quotes.
„Pips (or Point): The smallest incremental move an exchange rate can make. „Base Currency? Vs. „Dealt Currency?
Number of variable or dealt currency unit in one unit of base currency.
In international quotes base currency comes first. e.g. BC/VC
USD/INR= 48.50/60
Price maker Vs. Price Taker
The bank quoting the price is „price maker? or „market maker?. The bank asking for the price or „quote? is the „price taker? or „user?.
RATE QUOTATION CONVENTIONS IN-DIRECT QUOTATION:
“Price of one Unit of Foreign Currency in terms of Domestic Currency”
e.g. USD/INR = 48.50/60 Buy One USD at Sell One USD at Spread 48.50 48.60 00.10
In the international market, almost all currencies are quoted indirectly.
45
RATE QUOTATION CONVENTIONS DIRECT QUOTATION:
“Price of one Unit of Domestic Currency in terms of Foreign Currency” e.g. EURO= 1.2805/12
Buy One Euro at 1.2805 Sell One Euro at 1.2812 Spread 0.0007
Five Currencies are quoted in Direct Terms
1) Pound Sterling 2) Euro 3) Australian Dollar 4) New Zealand Dollar 5) Irish Punt
46
FORWARD TRANSACTIONS
1. Out right sale/purchase of a currency against the other for settlement at a future date at the predetermined exchange rate. Forward rates are quoted as premium or discount over spot rate. Forward rates depend upon interest rate differential between the two currencies. Currency with higher interest rates is at discount wrt currency having lower interest rate. Currency with lower interest rates is at premium wrt currency having higher interest rate.
2. 3. 4. 5.
Calculating Forward Rate
Interest rate of USD Interest rate of INR Spot Rate DB for INR DB for USD = = = = = 1.25% 6.00% 48.50 Actual/365 Actual/360
Six month Forward Rate = spot rate (48.50) x (1+ .06*181/365)/(1+.0125*181/360) =59.87
FX SWAP Transaction
“An FX swap is a contract to buy an amount of currency for one value date at an agreed rate, and to simultaneously resell the same amount of currency for a later value date, also at an agreed rate, to the same counter party”.
FX swap is essentially a „funding? or „Money Market? transaction and does not involve exchange risk.
– Foreign exchange transactions are settled through Nostro and Vostro accounts.
? Nostro: our account with banks abroad. Reserve Bank of India (RBI) maintains various Nostro accounts in a number of countries. ? Vostro: their account with us. Many multilateral agencies (e.g. IMF, World Bank) maintain their Nostro accounts at Reserve Bank of India (RBI).
– SWIFT (Society for Worldwide Interbank Financial Telecommunications)
Deals are done over Telephone, REUTERS dealing system etc REUTERS
Dealing Terminal
– – – – Industry Standard for FX trading. Security guaranteed by Reuters Int. Password Protected. Maintains record of all transactions.
News Terminal
– – – – Domestic Market Data/ news available on line. Real Time Exchange Rate quotes of all major Currencies. Data about Interest Rates (e.g. LIBOR) Various Reserve Bank of India (RBI) pages on REUTERS.
Forex Transactions
The Demand Side of inter-bank market – importers – buying foreign exchange to finance their imports. – A host of regulations governing imports into India. – Out ward remittances for debt servicing. – Out ward remittances for services. – PTEQ and BTQ, Medical treatment etc.
Forex Transactions
The Demand Side of inter-bank market – Remittances on account of education abroad. – Remittances on account medical treatment. – Repatriation of profit of foreign controlled companies and „freight collection? etc. – Disinvestment through SCRA. – A host of other invisible payments.
Forex Transactions
The Supply Side of inter-bank market – Exports – regulations governing export receipts. – Home remittances. – Foreign Direct Investment. – Capital account receipts. – Investment through SCRA. – A host of other invisible receipts.
Foreign Exchange Risk
Exposure to exchange rate movement. 1. Any sale or purchase of foreign currency entails foreign exchange risk. 2. Foreign exchange transaction affects the net asset or net liability position of the buyer/seller. 3. Carrying net assets or net liability position in any currency gives rise to exchange risk.
Foreign Exchange Markets Role of Reserve Bank of India (RBI) and linkages with economy
INTERVENTION
? To keep exchange rate in line with macro objectives RBI has to intervene from time to time ? Intervention is a process where FX is sold or purchased to keep the right amount of liquidity available in the FX market so that demand / supply equilibrium is maintained ? Intervention can be in READY or FORWARD
OTHER FX RELATED FUNCTIONS
? OFFSITE MONITORING ? DAILY RATES FOR MARKET ? THIRD CURRENCY ACTIVITY FOR GoP PAYMENTS ? RESERVE MANAGEMENT
Off Site monitoring of banks by RBI
Inputs of Computerized Reporting System (CRS)
All individual foreign exchange transactions reported by each bank on daily basis on a floppy diskette
?Amount ?Counter Party ?Type of Deal
?Currency
?Rate ?Maturity Date
?Posting date ?Deal Date ?Mode of Deal
Off Site monitoring of banks by RBI
? Reports from CRS
?Exposure Report ?FE - 25 balances & other deposits ?Nostro Balances ?Un-reconciled interbank deals
Off Site monitoring of banks by RBI
? Reports from CRS Cont’d
Reports for research & statistical purposes
?Types of transactions/customers/currency ?Business volume - banks/customers/currency ?Broker wise market volume report ?History of exchange rates - trend analysis
How does RBI manages exchange rate in the interbank market?
• Non-Quantitative Tools • Quantitative Tools
Non-Quantitative Tools
• • •
Moral suasion facilitating large commercial outflows Relaxation in FEEL
How does RBI manages exchange rate in the interbank market?
Quantitative Measures
Foreign Exchange Exposure Limit (FEEL) ? Basically restricts the banks to keep a net asset (long) or net liability (short) position in foreign currencies. ? Presently FEEL for each bank is set at 10 % of it?s paid up capital. ? In the presence of FEEL, banks? net purchases or net sales in foreign exchange on a given day have to be within their FEEL.
Physical intervention
• • • Direct selling or buying of foreign exchange by State Bank in the interbank market. Such sale/purchase can be in spot or forward value It can have two objectives To provide support to the market for lumpy payments To manage the Rs/$ parity Intervention may be direct or indirect. Currently RBI only indirectly intervenes in the market. RESERVE BUILDING
• •
Thank You
66
doc_713700161.ppt
In calculus, a branch of mathematics, the derivative is a measure of how a function changes as its input changes. Loosely speaking, a derivative can be thought of as how much one quantity
Foreign Exchange Market
Interest Rate Derivatives and Forex
Name Roll No.
Chintan Shah Dhrumit Shah Manali Sunil Rajput Vinay Navlakha Atik
Harshil Desai Bhavesh
5136 5137 5103 5127 5182 5170
5091 5217
2
DERIVATIVES
DERIVATIVES
Derivative Contracts are wasting assets, which derive their values from an underlying asset. These underlying can be : ? Stocks (Equity) ? Agri Commodities including grains, coffee beans, etc. ? Precious metals like gold and silver. ? Foreign exchange rate ? Bonds ? Short-term debt securities such as T-bills
TYPES OF DERIVATIVES
? Forwards
? Futures
? Option
Forward Contract
“A Forward Contract is a transaction wherein the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified date in future. The price may be agreed on in advance or in future.”
Risk in Forward Contract
?
Liquidity Risk:
– Ability of the parties to buy or sell the asset whenever he wants to do so without any significant price movement.
? Other Risks – Counter party Risk.
– Standardisation Risk
FUTURES CONTRACT
It involves an obligation on both the parties i.e the buyer and the seller to fulfill the terms of the contract (i.e. these are pre-determined contracts entered today for a date in the future)
? Obligation to buy or sell ? Stated quantity ? At a specific price ? Stated date (Expiration Date) ? Marked to Market on a daily basis
Features
Operational Mechanism
Forward
Not traded on exchange
Futures
Traded on exchange.
Contract Specifications
Differs from trade to trade.
Contracts are standardized contracts.
Counterparty Risk
Exists.
Exists, but assumed by Clearing Corporation/ house
Very high Liquidity as contracts are standardized contracts. Better; as fragmented markets are brought to the common platform.
Liquidation
Poor Liquidity as contracts are tailor made contracts Poor; as markets are fragmented.
Profile Price Discovery
OPTIONS
“An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. ” The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.
Types of option:
? Call Option ? Put option
Classification of Option
?
According to exercise of option
European option : Index : NIFTY, CNXIT
-
American option : Stocks : TATA MOTORS, ONGC
? According to type of option
Call Option Put Option
Option Jargons
Infosys (2800) CALL
In-the-Money (ITM) At-the-Money (ATM) Out -the-Money (OTM)
S>K 2800 > 2700
S=K 2800 = 2800
S<K 2800 < 2900
PUT
S<K 2800 < 2900
S=K 2800 = 2800
S>K 2800 > 2700
S = Spot price K = Strike price
OPTION PREMIUM
INTRINSIC VALUE
TIME VALUE
? Intrinsic Value : When option is in-the-money we have maximum Intrinsic Value. If the option is out of the money or at the money its Intrinsic Value is zero. For a call option intrinsic value : Max (0, (St – K) ) and For a put option intrinsic value : Max (0, (K - St ) )
? Time Value.
- Time value of option is difference between Premium and Intrinsic value.
- ATM and OTM option only have time value and no Intrinsic value. - The time value decreases as time remaining to maturity reduces and. becomes zero on maturity.
ITM
Time value Reduces
ATM
Time value Reduces
OTM
Eg. Stock ONGC
TYPE EXPIRY CALL / PUT STRIKE SPOT TYPE OF OPTION PREMIUM INTRINSIC VALUE TIME VALUE
OPTSTK
25/01/2006
CA
1170
1200
ITM
37
(1200-1170) = 30 (1200-1200) = 0 (1200-1230) = (-30) or 0
7
OPTSTK
25/01/2006
CA
1200
1200
ATM
24
24
OPTSTK
25/01/2006
CA
1230
1200
OTM
11
11
PARTICIPANTS
? Speculators - willing to take on risk in pursuit of profit.
?
Hedgers - transfer risk by taking a position in the Derivatives Market.
?
Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously.
FUTURES STRATEGIES
?TECHNICAL INDICATORS ?FUTURES ARBITRAGE ?HEDGING STRATEGIES
TECHNICAL INDICATORS
1) OPEN INTEREST ? Open Interest means the total number of contracts of an underlying asset that have not been offset and closed by an opposite transaction or delivery of the
underlying commodity or by cash settlement. ? Sum of all positions taken by different traders are reflected in the Open Interest.
Predicting the F&O markets based on Open Interest movements
?Increasing OI with increase in price trend is considered positive.
? Increasing OI with decrease in price is considered negative.
? Decreasing OI with increase in price trend is considered positive. ? Decreasing OI with decrease in price trend is considered negative.
2) PUT CALL RATIO
? The Put/Call Ratio is the number of put options contracts traded divided by the number of call options contracts traded. ? If put call ratio is high, it means more put options are trading in the market which is an indicator of bearishness. ? ? Whereas if the put call ratio is low then it indicates bullishness. Put call ratio of options shows an inverse relationship with market.
Volatility
? It is a statistical measure of a market or a security's price movements over a period of time. ? Mathematically volatility is often expressed as standard deviation.
? There are two types of volatility:
- Historical Volatility. - Implied Volatility.
Historical Volatility
• Historical volatility is a measure of actual price changes during a specific time period in the past.
• It is the annualized standard deviation of daily returns during a specific period. • Historical volatility is also referred to as actual volatility or realized volatility. • For short-term volatility, generally 5 days, 10 days, 20 days or 30 days time frame is considered. Whereas for long term volatility, normally 60 day, 180 day or 360 day time period is considered.
Implied Volatility
• Implied volatility of a stock or an index is computed using an option pricing model such as the Black-Scholes or Binomial.
• Rising implied volatility causes option prices to rise while falling implied
volatility results in lower option premiums.
• The value of an option consists of several components like - strike price, spot price, expiration date, implied volatility of the stock and prevailing interest rates.
• On a given stock, there would generally be a number of calls outstanding, which may have different exercise prices and expiration dates. • From each of these we can make an estimate about the standard deviation of the stock?s rate of return.
Derivatives’ Strategies
• The various standard deviations are then combined on a simple or weighted
average basis and an estimate about the volatility can be made. • Therefore implied volatility is that level of volatility which is calculated from the current trading option price.
FUTURES ARBITRAGE
? Arbitrage
is the act of simultaneously buying and selling assets or commodities in an attempt to exploit a profitable opportunity.
? Arbitrage is done between two related instruments which are temporarily
mis-priced. For example, the futures price and spot price are related by the interest rate, time to maturity and corporate benefit, if any, in the interregnum.
? If
the two prices do not move in tandem, then it throws up arbitrage opportunity. An arbitrageur will buy what is cheap and sell what is costly and lock in profits without any risk.
INDEX ARBITRAGE
?Index Arbitrage is the basis between the Index (Nifty) futures and its constituents (Basket).
?Nifty future is in discount to Nifty spot – Buy Nifty Futures and Sell Basket.
?Nifty future is in premium to Nifty spot – Buy Basket and Sell Nifty Futures. ?As we can?t trade in Nifty spot, we have to create Basket of Nifty components either with underlying stock or stock futures.
PROCESS
?If Nifty is in discount (as quite often), then you have to sell basket. ?As you futures.
cannot short sell in cash, we will be creating basket using stock
?Advantage of using stock futures is – only margin money will be deployed. ?We will be creating Basket based on the weight of the constituents in the Nifty.(Market Capitalization Method) ?We have to make portfolio - “Perfect Hedge”.
Contd… ?Minimum exposure of 242 contracts in Nifty (12,100 units) as it will be best hedge. All the stocks will participate according to their actual weights on the exposure of 242 contracts in Nifty. ?Once good returns have been observed we will execute the strategy. Execution requires highly skilled arbitrageurs.
RISKS
?Lot size constraint :
As we have to buy/sell stocks in lot size in futures, so weights of stocks may differ from actual weights which may lead to some loss.
?Execution risk :
As both trades have to be executed simultaneously, there can be slippage costs. As we have to execute trades at Market Price and due to low liquidity in some of the stocks Bid/Ask spread can be high which may lead to some loss.
MANAGING RISKS
?Lot size risk can be minimized by making the portfolio close to “Perfect
Hedge”. If we execute the strategy for 242 contracts then the problem will be solved as most of the stocks will participate in their actual weights.
?These
transactions are very execution intensive and hence require highly skilled dealers and researchers who can explore all the opportunities available in the market and exploit them in the best possible manner.
HEDGING
?Protecting the value of an asset against risk arising out of fluctuations in price is known as hedging. Technically hedging means transfer of risk from the asset holder to another person who is willing to carry risk.
?When an investor is bearish on market, he can hedge his position by taking countervailing position against his portfolio, say, selling Nifty futures.
?If the market falls, the fall in portfolio value will be compensated by the gains on the Nifty futures. But if the market rises, the rise in the portfolio value would be offset against the futures loss. ?The same concept can be applied to any stocks which have a presence in futures market. The result of any Perfect Hedge contract is – “No Profit and No Loss”
PORTFOLIO HEDGING
?To hedge portfolio, we need to calculate the Beta of the Portfolio and then hedge the Portfolio against the price risk. ?Beta measures the sensitivity of the stock to the broad market index. So if the beta of the stocks Portfolio is 1.05, and if the markets rises by 1%, then the Portfolio is likely to go up 1.05% and same goes for negative movement too. ?Calculate the number of Nifty contracts needed for Hedging. We can use the formula (Portfolio Beta x Portfolio Value) / Futures Value. e.g.:- Portfolio value = Rs. 1,00,00,000, Nifty value = 3,50,000(3500*100) and Beta of Portfolio = 1.05 No. of contracts = (1,00,00,000*1.05)/3,50,000 = 30 contracts ?So we need to sell 30 contracts of Nifty to hedge the Long Portfolio.
Structure of the Presentation
Basic Concepts, Terminologies, Instruments & Mechanism. ? Exchange Rate Regimes ? Historical perspective ? Foreign Exchange Trading & rate quotations ? Role of Reserve Bank of India (RBI) in the FX Market.
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BASIC CONCEPTS/TERMINOLOGIES
Foreign Currency vs. Foreign Exchange
As per Foreign Exchange Act, (Section 2), 1947.
?(c) "Foreign Currency" means any currency other than Indian currency;
?(d) "Foreign Exchange" means includes any instrument drawn, accepted, made or issued under clause (8) of section 17 of the Banking Regulation Act, 1956, all deposits, credits and balance payable in any foreign currency, and any drafts, traveler?s cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency;
Financial Markets
? Financial market is a place where Resources/funds are transferred from those having surplus/excess to those having a deficit/shortage.
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Foreign Exchange Markets
? The market where the commodity traded is Currencies. ? Price of each currency is determined in term of other currencies.
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What is an Exchange Rate ?
Exchange Rate is the price of one country's currency expressed in another country's currency. In other words, the rate at which one currency can be exchanged for another. e.g. Rs. 48.50 per one USD Major currencies of the World ?USD ?EURO ?YEN ?POUND STERLING
What is a Foreign Exchange Transaction ?
– Any financial transaction that involves more than one currency is a foreign exchange transaction. – Most important characteristic of a foreign exchange transaction is that it involves Foreign Exchange Risk.
PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET
? All Scheduled Commercial Banks (Authorized Dealers only). ? Reserve Bank of India (RBI). ? Corporate Treasuries. ? Public Sector/Government. ? Inter Bank Brokerage Houses. ? Resident Indians ? Non Residents ? Exchange Companies ? Money Changers
FOREIGN EXCHANGE REGIMES
? ? ? ? FIXED PEGGED COMPOSITE MANAGED FLOAT
? FREE FLOATING
Components of a Standard FX Transaction
? ? ? ? ? ? Base Currency (USD/INR) „Dealt? or „Variable? Currency Exchange Rate Amount Deal Date Value Date
? Settlement Instructions
Value Date Conventions
Currencies are traded both in Ready and forward value dates.
1) Ready: Settlement on the deal date. e.g. India
2) Value Tom : Settlement on next day. e.g. Canada 3) Spot Transaction : Settlement usually in two working days. In International FX transactions, Spot is the Standard value date. Why Spot Date ? ? Time Zone Difference ? Herstat Risk
4) Forward Transaction: Settlement at some future date ahead of the spot.
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FX Rate Quotation:
In the forex market rates are always quoted „two way?. Two way quote gives both „Bid? and „Offer?.
e.g. USD/INR= 48.50 / 60 Bid / Offer
„Big Figure?:
Term referring to the first digits of an exchange rate. These figures are rarely change in normal market fluctuations and are usually omitted in dealer quotes.
„Pips (or Point): The smallest incremental move an exchange rate can make. „Base Currency? Vs. „Dealt Currency?
Number of variable or dealt currency unit in one unit of base currency.
In international quotes base currency comes first. e.g. BC/VC
USD/INR= 48.50/60
Price maker Vs. Price Taker
The bank quoting the price is „price maker? or „market maker?. The bank asking for the price or „quote? is the „price taker? or „user?.
RATE QUOTATION CONVENTIONS IN-DIRECT QUOTATION:
“Price of one Unit of Foreign Currency in terms of Domestic Currency”
e.g. USD/INR = 48.50/60 Buy One USD at Sell One USD at Spread 48.50 48.60 00.10
In the international market, almost all currencies are quoted indirectly.
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RATE QUOTATION CONVENTIONS DIRECT QUOTATION:
“Price of one Unit of Domestic Currency in terms of Foreign Currency” e.g. EURO= 1.2805/12
Buy One Euro at 1.2805 Sell One Euro at 1.2812 Spread 0.0007
Five Currencies are quoted in Direct Terms
1) Pound Sterling 2) Euro 3) Australian Dollar 4) New Zealand Dollar 5) Irish Punt
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FORWARD TRANSACTIONS
1. Out right sale/purchase of a currency against the other for settlement at a future date at the predetermined exchange rate. Forward rates are quoted as premium or discount over spot rate. Forward rates depend upon interest rate differential between the two currencies. Currency with higher interest rates is at discount wrt currency having lower interest rate. Currency with lower interest rates is at premium wrt currency having higher interest rate.
2. 3. 4. 5.
Calculating Forward Rate
Interest rate of USD Interest rate of INR Spot Rate DB for INR DB for USD = = = = = 1.25% 6.00% 48.50 Actual/365 Actual/360
Six month Forward Rate = spot rate (48.50) x (1+ .06*181/365)/(1+.0125*181/360) =59.87
FX SWAP Transaction
“An FX swap is a contract to buy an amount of currency for one value date at an agreed rate, and to simultaneously resell the same amount of currency for a later value date, also at an agreed rate, to the same counter party”.
FX swap is essentially a „funding? or „Money Market? transaction and does not involve exchange risk.
– Foreign exchange transactions are settled through Nostro and Vostro accounts.
? Nostro: our account with banks abroad. Reserve Bank of India (RBI) maintains various Nostro accounts in a number of countries. ? Vostro: their account with us. Many multilateral agencies (e.g. IMF, World Bank) maintain their Nostro accounts at Reserve Bank of India (RBI).
– SWIFT (Society for Worldwide Interbank Financial Telecommunications)
Deals are done over Telephone, REUTERS dealing system etc REUTERS
Dealing Terminal
– – – – Industry Standard for FX trading. Security guaranteed by Reuters Int. Password Protected. Maintains record of all transactions.
News Terminal
– – – – Domestic Market Data/ news available on line. Real Time Exchange Rate quotes of all major Currencies. Data about Interest Rates (e.g. LIBOR) Various Reserve Bank of India (RBI) pages on REUTERS.
Forex Transactions
The Demand Side of inter-bank market – importers – buying foreign exchange to finance their imports. – A host of regulations governing imports into India. – Out ward remittances for debt servicing. – Out ward remittances for services. – PTEQ and BTQ, Medical treatment etc.
Forex Transactions
The Demand Side of inter-bank market – Remittances on account of education abroad. – Remittances on account medical treatment. – Repatriation of profit of foreign controlled companies and „freight collection? etc. – Disinvestment through SCRA. – A host of other invisible payments.
Forex Transactions
The Supply Side of inter-bank market – Exports – regulations governing export receipts. – Home remittances. – Foreign Direct Investment. – Capital account receipts. – Investment through SCRA. – A host of other invisible receipts.
Foreign Exchange Risk
Exposure to exchange rate movement. 1. Any sale or purchase of foreign currency entails foreign exchange risk. 2. Foreign exchange transaction affects the net asset or net liability position of the buyer/seller. 3. Carrying net assets or net liability position in any currency gives rise to exchange risk.
Foreign Exchange Markets Role of Reserve Bank of India (RBI) and linkages with economy
INTERVENTION
? To keep exchange rate in line with macro objectives RBI has to intervene from time to time ? Intervention is a process where FX is sold or purchased to keep the right amount of liquidity available in the FX market so that demand / supply equilibrium is maintained ? Intervention can be in READY or FORWARD
OTHER FX RELATED FUNCTIONS
? OFFSITE MONITORING ? DAILY RATES FOR MARKET ? THIRD CURRENCY ACTIVITY FOR GoP PAYMENTS ? RESERVE MANAGEMENT
Off Site monitoring of banks by RBI
Inputs of Computerized Reporting System (CRS)
All individual foreign exchange transactions reported by each bank on daily basis on a floppy diskette
?Amount ?Counter Party ?Type of Deal
?Currency
?Rate ?Maturity Date
?Posting date ?Deal Date ?Mode of Deal
Off Site monitoring of banks by RBI
? Reports from CRS
?Exposure Report ?FE - 25 balances & other deposits ?Nostro Balances ?Un-reconciled interbank deals
Off Site monitoring of banks by RBI
? Reports from CRS Cont’d
Reports for research & statistical purposes
?Types of transactions/customers/currency ?Business volume - banks/customers/currency ?Broker wise market volume report ?History of exchange rates - trend analysis
How does RBI manages exchange rate in the interbank market?
• Non-Quantitative Tools • Quantitative Tools
Non-Quantitative Tools
• • •
Moral suasion facilitating large commercial outflows Relaxation in FEEL
How does RBI manages exchange rate in the interbank market?
Quantitative Measures
Foreign Exchange Exposure Limit (FEEL) ? Basically restricts the banks to keep a net asset (long) or net liability (short) position in foreign currencies. ? Presently FEEL for each bank is set at 10 % of it?s paid up capital. ? In the presence of FEEL, banks? net purchases or net sales in foreign exchange on a given day have to be within their FEEL.
Physical intervention
• • • Direct selling or buying of foreign exchange by State Bank in the interbank market. Such sale/purchase can be in spot or forward value It can have two objectives To provide support to the market for lumpy payments To manage the Rs/$ parity Intervention may be direct or indirect. Currently RBI only indirectly intervenes in the market. RESERVE BUILDING
• •
Thank You
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