A REPORTON ANALYTICAL STUDY OF THE DYNAMICS OF THE INDIAN FOREIGN EXCHANGE DERIVATIVE MARKET SUBMITTED BYNEHA JAIN PUNJAB NATIONAL BANK A REPORT ON ANALYTICAL STUDY OF THE DYNAMICS OF THE INDIAN FOREIGN EXCHANGE DERIVATIVE MARKET SUBMITTED TOPROF A.K.MITRA SUBMITTED BYNEHA JAIN IBS, KOLKATA 08BS0001906 Neha Jain .ACKNOWLEDGEMENT Bernard Shaw once remarked: "If you teach a man anything. Treasury. FEO and many others in Mid Office. he will forget them quickly. Manager Treasury. Overseas Operations. if one desires to master the principles he is studying. he will never learn. Senior Manager. Vibha Aren. I would also like to extend my gratitude to Ms. So. Rakesh Grover ." Learning is an active process.Punjab National Bank without whose guidance I would never have started this voyage of discovery. he has to do something about them.Chief Manager. I would like to express my utmost and sincere thanks to Mr. I would like to thank Prof. Working on this project has been a great learning experience for me. Back Office and Research Desk in the treasury division.Suman Aggrawal. We learn by doing. Senior Manager. Mr. Senior Manager .KMitra for his encouragement and guidance as faculty guide. Only knowledge that is used sticks in one‘s mind. If he doesn‘t. Ashok Gandhi.A.Chinmay Gopal. IBD for his support over the last three months. I am thankful to Punjab National Bank for providing me this opportunity. Apply these rules at every opportunity. Finally I would like to thank Mrs. Mr. TABLE OF CONTENTS INTRODUCTION PURPOSE SOPE LIMITATION METHODOLOGY OVERVIEW FOREIGN EXCHANGE MARKET FOREIGN EXCHANGE DERIVATIVE INSTRUMENTS PARTICIPANTS TYPES RISKS CRITICISM FOREIGN EXCHANGE MARKET NEED MEANING CHARACTERISTICS RISKS HOW DERIVATIVES DEVELOPED USERS FOREIGN EXCHANGE DERIVATIVE INSTRUMENTS FORWARDS TYPES FUTURES SWAPS TYPES OPTIONS TYPES OTHER EXOTIC PRODUCTS FACTORS INFLENCING EXCHANGE RATES FACTORS INFLUENCING CURRENCY FORECASTING FORECASTING MODELS FINANCIAL CRISIS-INDIAN CONTEXT REFERENCES ANNEXURE ABOUT PUNJAB NATIONAL BANK MAJOR CURRENCIES QUESTIONNAIRE . require a respondent to indicate the degree of agreement or disagreement with each of a series of statements related to the object attitude. LIMITATIONS Time constraint. Models.Time series model Econometric model To find out what went wrong in the Indian context-the financial crisis SCOPE Better understanding of the trends and products of the market dealt with. . METHODOLOGY The research methodology to be used in the report is as follows: The report has broadly four parts. involves analysis that helps in describing the major factors influencing the transactions Part c. Part b. Part a. Part d. involves construction of forecasting models for USD/INR exchange rates. The Likert Scale Method has been used. Updated statistical data not available. Unwillingness among respondents to give accurate and complete data. involves the description of the current financial crisis in the Indian context. Descriptive study of the questionnaire could not be done as only few people responded to the questionnaires which was not enough to do a statistical study. Opinion oriented interpretation of the statistical data used for constructing the forecasting models. Study of the foreign exchange derivative products. undertakes the literature survey that will help in understanding the different theoretical concepts of the derivative products and their structures. A questionnaire has also been prepared and sent to all Indian companies listed in NIFTY and BSE A group. Measurement technique A simple method Multiple Choice Question of selecting the most appropriate option(s) from those listed has been used. It also involves studying the Indian market in the same context. To find the relationship between exchange rates and different factors influencing it. Help in making a view towards the USD/INR exchange rate which plays a vital role in taking any decision. An insight of the requirements of the corporate towards the market.INTRODUCTION PURPOSE To find out the characteristics of the foreign exchange derivative market. Constructing the forecasting models for exchange rates. Likert Scales sometimes referred to as Summated Scales. and other institutions. governments. central banks. FOEIGN EXCHANGE DERIVATIVE INSTRUMENTS A Foreign Exchange Derivative is a financial instrument where the underlying is a particular currency and/or its exchange rates. and the need for trading in such currencies. The foreign exchange market is where currency trading takes place. Participants . According to Euromoney's annual FX Poll. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. The average daily volume in the global foreign exchange and related markets is continuously growing.OVERVIEW FOREIGN EXCHANGE MARKET The FOREX market is one of the largest and most liquid financial markets in the world. corporations. and includes trading between large banks. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. Since then. etc. currency speculators. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar. the market has continued to grow. Traditional daily turnover was reported to be over US$ 3. The purpose of FOREX market is to facilitate trade and investment. Pound Sterling.2 trillion in April 2007 by the Bank for International Settlements. volumes grew a further 41% between 2007 and 2008. Exchange traded instruments b. investors could lose large amounts if the price of the underlying moves against them significantly. Swap d. The loss of $7. . However. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. Over the counter traded instruments On basis of structure a. It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarter.2bn by Societe Generalein January 2008 through misuse of futures contracts. . Forward b. Types The derivative instruments can be categorized in different ways On basis of place a. Future c. such as: The need to recapitalize insurer American AIG with $85 billion of debt provided by the US federal government. An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written. There have been several instances of massive losses in derivative markets. or borrowing. Option Risks involved Exchange risk Interest risk‘ Credit risk Replacement risk Settlement risk Dictatorship risk Derivatives are often subject to the following criticisms: Possible large losses The use of derivatives can result in large losses due to the use of leverage. because it may not be prepared to pay the higher variable rate. there is the danger that their use could result in losses that the investor would be unable to compensate for. swaps payments with another business who wants a variable rate. synthetically creating a fixed rate for the person. The possibility that this could lead to a chain reaction ensuing in an economic crisis. it is possible that the first business may be adversely affected.Counter-party risk Derivatives (especially swaps) expose investors to counter-party risk. For example. has been pointed out by famed investor Warren Buffet. there may not be benchmarks for performing due diligence and risk analysis. to transfer risk among parties based on their willingness to assume additional risk. Because derivatives offer the possibility of large rewards. As such. If interest rates have increased. requiring commensurate experience and market knowledge. standardized stock options by law require the party at risk to have a certain amount deposited with the exchange. However. Buffett called them 'financial weapons of mass destruction. suppose a person wanting a fixed interest rate loan for his business.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. for example. Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. speculation in derivatives often assumes a great deal of risk. a reason why some financial planners advise against the use of these instruments. For example. which can cause a recession or even depression . Leverage of an economy's debt Derivatives massively leverage the debt in an economy. especially for the small investor. they offer an attraction even to individual investors. However if the second business goes bankrupt. Large notional value Derivatives typically have a large notional value. showing that they can pay for any losses. However in private agreements between two companies. Unsuitably high risk for small/inexperienced investors Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Different types of derivatives have different levels of risk for this effect. or hedge against it. Derivatives are complex instruments devised as a form of insurance. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. but finding that banks only offer variable rates. making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity. it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. Thus. the way the market has performed those tasks has changed enormously. the foreign exchange market plays the indispensable role of providing the essential machinery for making payments across borders. transferring funds and purchasing power from one currency to another. But foreign currencies are usually needed for payments across national borders. or other short term claims denominated in foreign currency.FOREIGN EXCHANGE MARKET In a universe with a single currency. WHAT ―FOREIGN EXCHANGE‖ MEANS ―Foreign exchange‖ refers to money denominated in the currency of another nation or group of nations. CHARACTERISTICS . broadly speaking. from one country and currency to another. funds available on credit cards and debit cards. and determining that singularly important price. no foreign exchange rates. WHY WE NEED FOREIGN EXCHANGE Almost every nation has its own national currency or monetary unit—its dollar. But. so that payments can be made in a form acceptable to foreigners. its peso. the exchange rate. its rupee—used for making and receiving payments within its own borders. Over the past twenty-five years. traveler‘s checks. whether the person involved is a tourist cashing a traveler‘s check in a restaurant abroad or an investor exchanging hundreds of millions of dollars for the acquisition of a foreign company. ―foreign exchange. there would be no foreign exchange market. In other words. If one bank agrees to sell dollars for Deutsche marks to another bank. within India. Any person who exchanges money denominated in his own nation‘s currency for money denominated in another nation‘s currency acquires foreign exchange. any money denominated in any currency other than the Indian rupee is.‖ Foreign exchange can be cash. bank deposits. there must be a mechanism for providing access to foreign currencies. or short-term financial claims. It is still ―foreign exchange‖ if it is a short-term negotiable financial claim denominated in a currency other than the Indian rupee. there will be an exchange between the two parties of a dollar bank deposit for a DEM bank deposit. Thus. or other short-term claims. But in our world of mainly national currencies. no foreign exchange. and whether the form of money being acquired is foreign currency notes. A foreign exchange transaction is still a shift of funds. there is need for ―foreign exchange‖ transactions— exchanges of one currency for another. in the foreign exchange market —the international network of major foreign exchange dealers engaged in high-volume trading around the world—foreign exchange transactions almost always take the form of an exchange of bank deposits of different national currency denominations. That holds true whether the amount of the transaction is equal to a few dollars or to billions of dollars. in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries. foreign currency denominated bank deposits. even though that nation‘s currency—the pound sterling—is less widely traded in the market than several others. others open and begin to trade. the largest amount of foreign exchange trading takes place in the United Kingdom. The foreign exchange market follows the sun around the earth. Quoted prices change as often as 20 times a minute. The International Date Line is located in the western Pacific. trading begins in Bahrain and elsewhere in the Middle East. Later still. as the dealer institutions readjust their own positions to hedge. it is not necessarily a useful measure of other forces in the world economy. woman. While turnover of around $1½ trillion per day is a good indication of the level of activity and liquidity in the global foreign exchange market. a sign of a smoothly functioning and liquid market. while markets remain active in those Asian centers. Hong Kong. financial centers are open for business. at around $1½ trillion a day. and liquidity of the market are truly impressive. Turnover is equivalent to more than $200 in foreign exchange market transactions.S. markets in Europe open for business. as some centers close. is several times the level of turnover in the U. Large trades can be made. It Is A Twenty-Four Hour Market During the past quarter century. the world‘s second largest market. business hours overlap. when it is late in the business day in Tokyo. every hour of the day and night. or offset the risks involved. It has been estimated that the world‘s most active exchange rates can change up to 18. The result is that the amount of trading with customers of a large dealer institution active in the interbank market often accounts for a very small share of that institution‘s total foreign exchange activity. The estimated worldwide turnover of reporting dealers. and each business day arrives first in the Asia-Pacific financial centers— first Wellington. Somewhere on the planet. In financial centers around the world. Individual trades of $200 million to $500 million are not uncommon. New Zealand. It is important to realize that an initial dealer transaction with a customer in the foreign exchange market often leads to multiple further transactions. followed by Tokyo. and Singapore. aside from possible minor gaps on weekends. Almost two-thirds of the total represents transactions among the reporting dealers themselves—with only one third accounted for by their transactions with financial and non-financial customers. It Is The World‘s Largest Market The foreign exchange market is by far the largest and most liquid market in the world. yet econometric studies indicate that prices tend to move in relatively small increments. . Among the various financial centers around the world. for every man. the concept of a twenty-four hour market has become a reality. and child on earth! The breadth. then Sydney. sometimes over an extended period. Government securities market. Australia. manage. depth.000 times during a single day. A few hours later. every business day of the year. and banks and other institutions are trading the dollar and other currencies. the next day has arrived in the Asia-Pacific area. and still others follow different approaches.Subsequently. With many traders carrying pocket monitors. Activity normally becomes very slow in New York in the mid. Sellers want to sell when they have access to the maximum number of potential buyers. The large dealing institutions have adapted to these conditions. and Singapore markets have opened. Some keep their New York or other trading desks open twenty-four hours a day. centers starts . when it is mid or late afternoon in the United States. nearly two thirds of the day‘s activity typically takes place in the morning hours. when it is early afternoon in Europe. Most of the trading takes place when the largest number of potential counterparties is available or accessible on a global basis. there is a cycle characterized by periods of very heavy activity and other periods of relatively light activity. Business is heavy when both the U. Hong Kong. Some institutions pay little attention to developments in less active markets. and the process begins again. the twenty-four hour market does provide a continuous ―real-time‖ market assessment of the ebb and flow of influences and attitudes with respect to the traded currencies.Finally. the first markets there have opened. and have introduced various arrangements for monitoring markets and trading on a twenty-four hour basis. It also means that traders and other market participants must be alert to the possibility that a sharp move in an exchange rate can occur during an off hour. elsewhere in the world. and an opportunity for a quick judgment of unexpected events. and will wait to see whether the development is confirmed when the major markets open. Nonetheless. when it is morning in New York and afternoon in London. market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day. markets and the major European markets are open—that is. Given this uneven flow of business around the clock.S. Over the course of a day. The twenty-four hour market means that exchange rates and market conditions can change at any time in response to developments that can take place at any time.to late afternoon. it has become relatively easy to stay in touch with market developments at . Market liquidity is of great importance to participants. and buyers want to buy when they have access to the maximum number of potential sellers. after European markets have closed and before the Tokyo. In the New York market. foreign exchange activity does not flow evenly. completing the circle. However. trading in New York and other U.S. others pass the torch from one office to the next. each country enforces its own laws. Similarly. London. The Market Is Made Up Of An International Network Of Dealers The market consists of a limited number of major dealer institutions that are particularly active in foreign exchange. are commercial banks and investment banks. Rarely are there . Tokyo. and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world. these institutions are linked to. even in a global foreign exchange market with currencies traded on essentially the same terms simultaneously in many financial centers. This holds true regardless of the location of the financial center at which the dollar deposit is purchased. too easy. the exchange rates of major currencies tend to be virtually identical in all of the financial centers where there is active trading. But no matter in which financial center a trade occurs. Paris. At any moment. there is an enormous amount of cross border foreign exchange trading among dealers as well as between dealers and their customers. make up the global foreign exchange market. and many.‖ the foreign exchange market comes closest to functioning in a truly global fashion. Thus. each other through telephones. worldwide market. Los Angeles. there are different national financial systems and infrastructures through which transactions are executed. as noted above. many others. And so on for other currencies. bank deposits denominated in the same currencies. At a time when there is much talk about an integrated world economy and ―the global village. and within which currencies are held. a dealer buying Deutsche marks. accounting rules. There are around 2. computers. and. the same currencies. cohesive. A foreign exchange dealer buying dollars in one of those markets actually is buying a dollar-denominated deposit in a bank located in the United States. Chicago. or rather.000 dealer institutions whose foreign exchange activities are covered by the Bank for International Settlements‘ central bank survey. Most. and tax code. and other electronic means. Singapore. are being bought and sold.It is estimated that there are more than 100200 market-making banks worldwide. actually is buying a mark deposit in a bank in Germany or a claim on a mark deposit in a bank in Germany. trading with customers and (more often) with each other. A much smaller subset of those institutions account for the bulk of trading and market making activity . essentially. These dealer institutions are geographically dispersed. but not all. Frankfurt. Wherever located. and in close communication with. Foreign exchange trading takes place among dealers and other market professionals in a large number of individual financial centers— New York. With access to all of the foreign exchange markets generally open to participants from all countries. banking regulations.all times—indeed. located in numerous financial centers around the world. Milan. Each nation‘s market has its own infrastructure. no matter where the purchase is made. and who. where market participants can continuously adjust their bets to reflect their changing views. Zurich. linking the various foreign exchange trading centers from around the world into a single. some harassed traders might say. major players are fewer than that. The foreign exchange market provides a kind of never-ending beauty contest or horse race. unified. or a claim of a bank abroad on a dollar deposit in a bank located in the United States. For foreign exchange market operations as well as for other matters. it operates its own payment and settlement systems. the various financial centers that are open for business and active at any one time are effectively integrated into a single market. a bank in the United States is likely to trade foreign exchange at least as frequently with banks in London. legal compliance. In the United States. . Surveys indicate that when major dealing institutions in the United States trade with other dealers. 58 percent of the transactions are with dealers located outside the United States. focusing on the safety and soundness of the institution and its activities. regulatory authorities examine the foreign exchange market activities of banks and certain other institutions participating in the OTC market. control systems. Although the OTC market is not regulated as a market in the way that the organized exchanges are regulated. As with other business activities in which these institutions are engaged. dealers also use brokers located both domestically and abroad. and other factors relating to the safety and soundness of the institution. Hours. a commercial bank in the United States does not need any special authorization to trade or deal in foreign exchange. and exposure. securities firms and brokerage firms do not need permission from the Securities and Exchange Commission (SEC) or any other body to engage in foreign exchange activity. sound banking practice. the OTC market was then.‖ foreign exchange products traded are currency futures and certain currency options. The OTC market accounts for well over 90 percent of total foreign exchange market activity. largely unregulated as a market. Buying and selling foreign currencies is considered the exercise of an express banking power. trading practices. daily marking to market.‖ (OTC) by banks in different locations making deals via telephone and telex. The trading conventions have been developed mostly by market participants. Accordingly. Similarly. disclosure. and cash settlements through a central clearinghouse. Thus. On the ―organized exchanges. There is no official code prescribing what constitutes good market practice. trading takes place publicly in a centralized location. subject to the standard commercial law governing business transactions in the United States. In the exchanges. Examinations deal with such matters as capital adequacy. products are standardized. Dealer institutions in other major countries also report that more than half of their trades are with dealers that are across borders. Transactions can be carried out on whatever terms and with whatever provisions are permitted by law and acceptable to the two counterparties. Trading practices on the organized exchanges. are markedly different from those in the OTC market. examiners look at trading systems. and is now.such substantial price differences among major centers as to provide major opportunities for arbitrage. all foreign exchange trading in the United States (and elsewhere) was handled ―over-the-counter. There are no official rules or restrictions in the United States governing the hours or conditions of trading. The United States is not unique in that respect. and other matters are regulated by the particular exchange. activities. There are margin payments. and the regulatory arrangements covering the exchanges. In pricing. It is an ―over-the-counter‖ market with an ―exchange-traded‖ segment Until the 1970s. and other open foreign centers as with other banks in the United States. Frankfurt. and to encourage greater transparency and disclosure. Over the past decade. With respect to the internationally active banks. including foreign exchange. international discussions have not yet produced agreements on common capital adequacy standards. the regulators of a number of nations have accepted common rules proposed by the Basle Committee with respect to capital adequacy requirements for credit risk.Steps are being taken internationally to help improve the risk management practices of dealers in the foreign exchange market. covering exposures of internationally active banks in all activities. there has been a move under the auspices of the Basle Committee on Banking Supervision of the BIS to introduce greater consistency internationally to risk-based capital adequacy requirements. . With respect to investment firms and other financial institutions. Further proposals of the Basle Committee for risk-based capital requirements for market risk have been adopted more recently. such as the clearinghouse of Chicago. Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed. one sets limits on the total size of mismatches. Australian and New Zealand dollars are credited first. A common approach is to separate the mismatches. end users must consider not only the market value of their currency portfolios. followed by the European currencies and ending with the U. dollar.RISKS EXCHANGE RATE RISK. This risk is pertinent to currency swaps. CREDIT RISK. The most popular measures to cut losses short and ride profitable positions that losses should be kept within manageable limits are the position limit and the loss limit. Therefore. To minimize interest rate risk. INTEREST RATE RISK. futures. but also the potential exposure of these portfolios. where appropriate accounts became unbalanced. but prior to executing its own payments. The computerized systems currently available are very useful in implementing credit risk policies. trading occurs on regulated exchanges. based on their maturity dates. Therefore in assessing the credit risk. All the transactions are entered in computerized systems in order to calculate the positions for all the dates of the delivery. forward outright. By the position limitation a maximum amount of a certain currency a trader is allowed to carry at any single time during the regular trading hours is to be established. Settlement risk occurs because of the time zones on different continents. The following forms of credit risk are known: Replacement risk occurs when counterparties of the failed bank find their books are subjected to the danger not to get refunds from the bank. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps. The loss limit is a measure designed to avoid unsustainable losses made by traders by means of stop-loss levels setting. currencies may be traded at the different price at different times during the trading day. payment may be made to a party that will declare insolvency (or be declared insolvent) immediately after. In . In these cases. due to a voluntary or involuntary action by a counter party. and options (See below). The potential exposure may be determined through probability analysis over the time to maturity of the outstanding position. the position will be subject to all the price changes. Exchange rate risk is the effect of the continuous shift in the worldwide market supply and demand balance on an outstanding foreign exchange position. Consequently. gains and losses. For the period it is outstanding.S. along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. Credit lines are easily monitored. into up to six months and past six months. Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads. then Japanese yen. traders have to realize that kind of the risk and be in state to account possible administrative restrictions. . the matching systems introduced in foreign exchange since April 1993 are used by traders for credit policy implementation as well. the line of credit is automatically adjusted. If the line is fully used. Hence.addition. because the major currency futures markets are located in the USA. During the trading session. Dictatorship (sovereign) risk refers to the government's interference in the Forex activity. Traders input the total line of credit for a specific counterparty. DICTATORSHIP RISK. After maturity. Although theoretically present in all foreign exchange instruments. for all practical purposes. the credit line reverts to its original level. excepted from country risk. currency futures are. the system will prevent the trader from further dealing with that counterparty. Bretton Woods Agreement was an agreement that was established in 1944 and is known as the first Foreign Exchange system. market deregulation. According to which the US dollar‘s value was ―pegged‖ (to peg means to connect the value of a certain currency to gold) at $35 per ounce. In 1973 two additional agreements failed. At the end of this conference the formation of the International Monetary Fund (IMF) was established. And indeed for a certain amount of time. The system of fixed prices came under stress from the 1970s onwards.HOW DERIVATIVES DEVELOPED Foreign exchange history can be traced back to times of bartering when goods were traded for other good. Both failed and resulted in the emergence of new markets along with new financial instruments. it was able to do exactly that. Derivative securities provide them a valuable set of tools for managing this risk. market systems and trade liberalization. gold) were traded in the form of coin sizes. The Bretton Woods system was dismantled in 1971. Other currencies were to be compared to the values of the U. and the European Joint Float. The idea behind this system was to stabilize world economy. which allowed greater fluctuation band for currencies.S. Representatives from 45 countries attended this conference and discussed the foreign exchange system. paper became a mean of exchange with which trading was carried out. Inflation and unemployment rates made interest rates more volatile. completing the transition to a free-floating system. This meant that the US dollar was no longer convertible to gold and that the economic system was much more free-floating from that point onward. Later on. silver. which was followed by the introduction of the gold standard system The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. freeing exchange rates to fluctuate. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. . dollar. At that time metals (bronze. which allowed a greater fluctuation range in currency values. These agreements were the Smithsonian Agreement. 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. Central banks National central banks play an important role in the foreign exchange markets. Whilst the number of this type of specialist firms is quite small. they were solely speculating on the movement of that particular currency. For example. which manage clients' currency exposures with the aim of generating profits as well as limiting risk. They try to control the money supply. Retail foreign exchange brokers There are two types of retail brokers offering the opportunity for speculative trading: . and hence can generate large trades. Nevertheless. but much is conducted by proprietary desks. In other words. rather. inflation. Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. Some of this trading is undertaken on behalf of customers. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end. Some investment management firms also have more speculative specialist currency overlay operations. trading for the bank's own account. and/or interest rates and often have official or unofficial target rates for their currencies. and their trades often have little short term impact on market rates.USERS OF FOREIGN EXCHANGE DERIVATIVE INSTRUMENTS Banks The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. trade flows are an important factor in the long-term direction of a currency's exchange rate. Commercial companies often trade fairly small amounts compared to those of banks or speculators. many have a large value of assets under management (AUM). The four largest markets (India. China. i. In 2007. the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The largest and best known provider is Western Union with 345. Money Transfer/Remittance Companies Money transfer/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. Mexico and the Philippines) receive $95 billion.a. there is usually a physical delivery of currency to a bank account.000 agents globally. Retail foreign exchange brokers b.e. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. Market makers Non-bank Foreign Exchange Companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies.. . The delivery of the foreign currency at the rate fixed in the FEC will be made on the exact date (fixed date) specified in the contract. and are not predictions of what the rates of exchange will be in the future. dollar difference offsets the change in market pricing of the currency hedged. commonly known as FEC or forward cover. Partially optional contract This contract is fixed during the first period (from opening to option start date) and then fully optional from option start date to due/maturity date. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. but allows you to select up to a 30-day time frame during which the forward can settle at the contract rate. FORWARDS A forward exchange contract. TYPES OF FORWARD CONTRACTS On basis of delivery date Fixed contract A specific delivery date is agreed upon. The net U.FOEIGN EXCHANGE DERIVATIVE INSTRUMENTS A Foreign Exchange Derivative is a financial instrument where the underlying is a particular currency and/or its exchange rates.S. No delivery of foreign currency will occur under this contract. The foreign exchange market is where currency trading takes place. Window Forward Similar to a traditional forward. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. The delivery of the foreign currency at the forward contract rate can take place at any time during the optional period. Forward exchange contract rates are based on interest differentials between the countries concerned. . Fully optional contract The delivery of the foreign currency can take place at the forward contract rate at any time throughout the entire existence of the FEC. Other contracts Non-deliverable Forwards Allows a company to hedge foreign currency risk where no traditional forward market exists. dollars.S. may be defined as a contract between a bank and its customer whereby a rate of exchange is fixed immediately for the purchase (or sale) of one currency for another. It is a synthetic hedge that is net settled in U. or for delivery at an agreed future date. If the receivable currency is weaker during the averaging period compared to the hedge rate. which is not more than 3 months from the current date. Unlike options. India and Brazil. There is a time boundary within which the transaction must be closed. Range forward contract Similar to a forward contract. FUTURES Future contracts are similar to forward contracts. the forward seller will make a payment to the forward buyer. Also these are exchange traded instruments. a transaction can be agreed to be carried out at a time. On that particular date. there is an averaging period of daily spot observations to determine an average rate which. either a loss or a profit might arise out of a currency future transaction. Break forward contract A forward contract that permits the holder to profit if the price of foreign exchange rises. but puts a floor on losses if it falls. Conversely. . This type of hedge is often used as an overlay on a U. This payoff profile can be obtained using both FX options and forward contracts. the exchange takes place irrespective of the Forex rate that prevails on that date. The only difference between a forward contract and a futures contract is that. when compared to the hedge rate. if the receivable currency appreciates during the averaging period. Also known as cancelable forward FX contract. Due to the unpredictability of the Forex rates. dollar-based cash flow to protect margins. Currency Future This is a futures contract where the parties of a contract agree to exchange their currencies at a specified future date for a price. the forward buyer must make a payment to the forward seller. Examples include: China. The size and the time period of the transaction are fixed in a futures contract unlike a forward contract. Average rate range forward An average rate forward allows the buyer the ability to create a hedge rate for a future exposure by locking in forward points and a spot rate today. it provides 100% protection against unfavorable currency fluctuations while allowing limited participation in favorable currency rate market movements. Participating forward contract A participating forward contract provides 100% protection against an unfavorable currency fluctuation while allowing unlimited participation in favorable currency rate market movements. this hedge tool is a forward contract and has no premium cost associated with it.S. At some point in the future. These structures are cash settled. in a futures contract.Ideal for companies who need to protect exposures in countries that do not have a freely traded forward market. will set the payout. Company Company A Company B Fixed Rate 11% 10% Floating Rate LIBOR + 1% LIBOR + 0. for some reason the market for fixed rate loans values B’s creditworthiness more than does the market for floating rate loans. Example: Two firms want to borrow $10 million.5% Note that the difference between the rates available to each firm is smaller for floating rates than for fixed rates. In return. . There is no actual exchange of principals. regular forward contracts are generally referred to as outright forwards. Because FOREX swaps are actually far more common than regular forward transactions in the FOREX market. For example. The simplest type of swap is a plain vanilla interest rate swap. Interest Rate Swaps Interest rate swaps (including currency swaps to be discussed later) are basically the exchange (between two firms. the annualized difference between spot and forward. This implies a type of inefficiency in the debt markets and swaps are designed to take advantage of this. The notional principal is simply the amount used to determine the size of the payments. Company B has a better credit rating and can therefore get better rates. they get cash flows equal to a floating rate of interest on that same notional principal. In other words. most inter-bank trading of forwards is done through the trade of FOREX swaps. A swap trader is really trading in the difference between the spot rate and the forward rate. with a bank as an intermediary) of one type of debt for another type of debt. an agreement is made to exchange currencies now at the prevailing spot rate and also to exchange the currencies back in the future at the prevailing forward rate. when a swap trader enters a swap she may agree to give DM and receive $US now (with amounts determined by the current spot) and also agree to give $US and get DM in one year (amounts determined by the prevailing one year forward rate). In a plain vanilla swap. SWAPS FOREX Swaps In the FOREX market. one party agrees to pay the other party cash flows equal to a fixed rate of interest on some notional principal. A FOREX swap is just a spot trade and a forward trade rolled into one. A FOREX swap is simply two transactions entered into simultaneously. This is why forward rates are normally quoted in terms of forward points. A bank will act as the middle-man in these swaps and collects part of the profits. Because of the inefficiency in debt markets.7% LIBOR LIBOR + 0. Each firm should borrow where it has the comparative advantage and then go to the bank to arrange a swap. Company A goes to bank and agrees to make payments equal to 9. B has a comparative advantage in the fixed rate market.7% .3% (for loan) (from swap with bank) (from swap with bank) Company B pays less than if it had borrowed at a floating rate itself.8% (for loan) (from swap with bank) (from swap with bank) Company is effectively paying a fixed rate of 10. This is A’s swap. that B wants to borrow at a floating rate and A at a fixed rate.8% Bank 9. Less than it could have gotten on a fixed rate loan itself.8%.8% and receive payments from the bank of LIBOR (on a notional principal of $10 million). Company B: Pays Receives Pays Total 10% 9.8% 10. This is B’s swap. Bank: Pays Receives Pays LIBOR LIBOR 9.7% B 10% LIBOR LIBOR You can now look at the net payments that each firm is making: Company A: Pays Receives Pays Total LIBOR + 1% LIBOR 9. A has a comparative advantage in borrowing floating rate funds (its floating rate is not as much above B’s as is its fixed rate). however. Assume. Similarly. Company B goes to the bank and agrees to make payments equal to LIBOR and receive payments equal to 9.7%. The situation ends up looking like this: LIBOR + 1% A 9. Net. a market in which banks and other large institutions enter swaps between themselves.1% The bank is making a profit of 0. then the payments you are making stay the same.10% = (A’s floating . For instance. Fixed-for-fixed currency swap. The bank will not actually match up two firms who each want to take opposite sides of a swap. banks and other large investors will often enter swaps for speculative purposes. Also. If you want. the difference in value of the payments going each way is calculated and the party owing more sends a difference cheque to the other. but the payments you are receiving go up. The total gain to all parties involved is: A saves 0.1% per year on a $10 million notional principal.2% over its own floating rate. subsequently. The swap market is.1% 0.5% 1% 0.5%) = Difference 0. you can offset that swap with by entering a new swap where you pay floating and get fixed and effectively pocket your profits. in reality.5% total gain. the bank can simply go to the swap market to obtain the necessary offsetting swaps. the above example is simplified (obviously).5% Note that. suppose you enter a plain vanilla swap where you make fixed rate payments and receive floating rate payments.Receives Total 9. the bank will enter many swaps with firms wanting to make fixed rate payments. Instead. Rather. If. Currency Swaps A currency swap involves the exchange of interest payments on debt which is denominated in different currencies. Plain vanilla swaps may be used to obtain cheaper financing. both parties to a swap do not make payments to each other each year. Because of this. This amount of total gain is determined by the degree of inefficiency in the bond market: (A’s fixed .2% over its own fixed rate. You win.(LIBOR+0.B’s fixed) = 11% . leaving a profit for the bank. . in effect. They do this simply by entering a swap without having an offsetting initial loan. Therefore. but they are actually a bet on the direction of interest rates. Bank makes 0. and enter many swaps with firms wanting to make floating rate payments. Swaps are actually a form of derivative security. everybody wins. all of the banks swaps taken together should cancel out. interest rates rise.8% -0. B saves 0.B’s floating) = (LIBOR+1%) . If all of the swaps entered into with customers do not cancel each other out. principals are also exchanged. swapping $1.000 Can. at the current spot rate.000. PV of what A gets = t 1 (11) 5 = $1.000. However. at 10% for five years.000 in debt is a fair deal. At the fifth year. t (11) 5 .000 Can. this is a fair deal in that NPV=0.000.000. In the swap markets.000.05) = ¥5.000.000 100. Basically.000 Can. A wants to borrow ¥. Firm B has borrowed ¥100. Note also that at a current spot rate of 100 ¥/$Can.000 Can in debt for ¥100. wherein payments in one currency at a floating rate are swapped for payments in another currency at a fixed rate. Note that the swap does not have to include trading the principals now.000.000. Assume no intermediary for convenience (i.10) = $100.000 . the firms can set up a swap between themselves).e.000(0. (105) 5 . Therefore. and B wants to borrow $Can.000.000. Current spot rate = 100 ¥/$Can.000 at 5% for five years.000(0. Because currency swaps are .000 (105) t . 5.Party A makes periodic interest payments to Party B in one currency and receives payments in another currency. Example: Firm A has borrowed $1.000. Principals for the loans are also exchanged at the end of the swap.000.000 1. A gives B ¥100.000 B gives A 1. the advantage of a currency swap is that a firm can borrow in the currency where it has a comparative advantage and then swap into the currency that it actually needs.000 Can. A gives B 100.000. t 1 PV of what A gives = 5 = ¥100.000 B gives a $1. since Firm A could simply take the $Can it borrowed and buy the ¥ that it needs on the spot market. Both sets of payments are based on fixed interest rates. Enter a swap agreement: Each year.000 100. Fixed-for-floating currency swap The most common type of currency swap is actually a fixed-for-floating currency swap. swaps are generally quoted as floating $US payments at LIBOR versus a fixed rate in another currency.000. firm is paying 8% in $US.000 US at a fixed rate. These rates are better than either firm could have done on its own.000 US at a fixed rate. Hence.S.000. First. Rates available to German Firm: fixed 8% 7% floating LIBOR+2% LIBOR+1% $US DM Rates available to U. The payments between the firms look like: $US @ 8% German Firm DM @ LIBOR US Firm DM @ LIBOR $US @ 8% Net. the German firm is paying LIBOR in DM and the U. in order to get a fixed-for-fixed swap you would have to enter both a fixed-for-floating currency swap and a plain vanilla interest rate swap. At the end of the swap (in five years). German firm borrows $1.000 at a floating rate.S.000. firm wishes to borrow $1. firm: $US DM fixed 9% 8% floating LIBOR+1% LIBOR Current spot rate is 2 DM/$US. The market for a firm‘s debt in a particular currency may be saturated.S. the principals amounts are also exchanged.000. Basic motivation for swaps include: Market inefficiencies (just as with interest rate swaps). fixed-forfixed swaps are generally referred to as circus swaps (―combined interest rate and currency swaps‖). Note that the German firm borrows $US but is not exposed top any exchange rate risk as the swap provides exactly enough $US to meet its needs. Tax Arbitrage . There are many other types of currency swaps (the types of swaps are only limited by your imagination) such as floating-for-floating swaps and off-market swaps.000 at a floating rate. A German firm wishes to borrow DM 2.000. firm borrows DM 2.S. A U. they use the borrowed funds to purchase the currency that they actually need on the spot market.always fixed-for-floating. Example: Again assume no intermediary for simplicity. They then enter a swap with one another. U. Introduction of USD-INR options would enable Indian forex market participants manage their exposures better by hedging the dollar-rupee risk. Swaptions A swaption is an option to get into a swap. The advantages of currency options in dollar rupee would be as follows: Hedge for currency exposures to protect the downside while retaining the upside. Swaptions can also allow a firm to get out of a swap if they want to.g. for hedging the USD-INR risk. exporters (of both goods and services) as well as businesses with exposures to international prices. say you enter swap where you make floating rate payments. Rupee currency options Corporates in India can use instruments such as forwards. This would be a big advantage for importers. . However. e. Using forwards or currency swaps would create the reverse positions if the company is not allotted the contract. Currency options would enable Indian industry and businesses to compete better in the international markets by hedging currency risk. then the company runs a risk till the contract is awarded. Options Cross currency options The Reserve Bank of India has permitted authorised dealers to offer cross currency options to the corporate clients and other interbank counter parties to hedge their foreign currency exposures. Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures. If interest rates rise in the future then the payments you are making through the original swap increase. The customer pays the bank an upfront premium to get the right to enter a swap with the bank at a pre-determined interest rate if the customer wants to in the future. For instance. Currency options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium. by paying a premium upfront. swaps and options for hedging cross-currency exposures. The two swaps then cancel each other out. Swaptions allow firms to pre-arrange swaps that they can use if the rates of interest they find in the market turn out to not be what they want. corporates are restricted to the use of forwards and USDINR swaps. Before the introduction of these options the corporates were permitted to hedge their foreign currency exposures only through forwards and swaps route. A swaption call gives the holder the right to enter a swap where they receive a fixed rate and pay a floating rate. At the same time you buy a swaption put. In order to get out of the swap you can use the swaption to enter a new swap where you receive floating rate payments. If an Indian company is bidding for an international assignment where the bid quote would be in dollars but the costs would be in rupees. A swaption put gives the holder the right to enter s swap where they receive a floating rate and pay a fixed rate. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. strips. Exotic options Options being over the counter products can be tailored to the requirements of the clients. bull and bear spreads. Hence. Simple exotic options such as barrier options. etc Some of the above-mentioned products especially the structure involvingsimple European calls and puts may even be introduced alongwith the options itself. straps. Attract further forex investments due to the availability of another mechanism for hedging forex risk. More sophisticated hedging strategies call for the use of complex derivative products. Option structures can be used to hedge the volatility along with the non-linear nature of payoffs. introduction of USD-INR options would complete the spectrum of derivative products available to hedge INR currency risk. . barrier and range digital options. etc. Look-back options and also American options More complex range of exotics including binary options. but the use of an option contract in this case would freeze the liability only to the option premium paid upfront. which go beyond plain vanilla options. The nature of the instrument again makes its use possible as a hedge against uncertainty of the cash flows. forward-start options. These products could be introduced at the inception of the Rupee vanilla options or in phases. Asian options. strangles. risk reversals. Some of these products are mentioned below: Simple structures involving vanilla European calls and puts such as range-forwards. depending on the speed of development of the market as well as comfort with competencies and Risk Management Systems of market participants. straddles. butterflies. in which the buyer is fully protected against a rise in the exchange rate. There are a large number of options with reduced or zero cash outlay up front—which is made possible by combinations (buying one or more options and selling others) that result in a small or zero net initial outlay. but partly or exclusively by the path that the exchange rate took in arriving there. Split fee options enable the purchaser to pay a premium up front. or binary. giving the appearance (which can be misleading) of cost-free protection. in which the premium is paid in the future but only if the exchange rate. and for which the option was needed. option. options. rather than by paying cash. in which the option pays off only if some pre-specified exchange rate is reached prior to expiration. and a ―back fee‖ in the future Contingent options involve a payoff that depends. the option expires worthless if the exchange rate hits some pre-agreed level. but pays a proportion of any decrease in the exchange rate. There are various forms of path dependent options. There are downand-out options. for example. if the exchange rate is beyond the strike price at expiration. and kick-out options. There is the all-or-nothing. alternatively. There are look back options. which gives the buyer assurance that not more than an agreed maximum rate will be paid for needed foreign currency. There are Bermuda options (somewhere between American and European options) in which rights are exercisable on certain specified dates. or average rate. where. and the amount is not affected by the magnitude of the difference between the underlying and the strike price. but requires that the buyer agree he will pay no less than a stipulated (lower) minimum rate. knock-out options.FOREIGN EXCHANGE OPTIONS GALORE The array of foreign exchange options available in the OTC market to dealers and the broader market of customers is almost endless. or. which pay off at maturity on the difference between the strike price and the average exchange rate over the life of the contract. Multi-currency options give the right to exchange one currency. and new forms are being created all the time. Another example is the conditional forward. to obtain the foreign currency if the exchange rate moves in favor of the option. there is a fixed payout. for one of a number of foreign currencies at specified rates of exchange. A third example is the participating forward. Naturally. the following list is not comprehensive. is below a specified level. or ―no regrets‖ options. One example is the range forward or cylinder option. which give the holder the retroactive right to buy (sell) the underlying at its minimum (maximum) within the look back period. There are Asian. in which the option‘s value is determined. not only on the exchange rate. but also on such conditions as whether the firm buying the option obtains the contract for which it is tendering. Such options— and there are any number of varieties—are popular since the buyer pays for his option by providing another option. or the proverbial free lunch. say dollars. in which. that expire if the market . There are barrier options. not simply by the exchange rate at the expiration of the option. . that take effect only if the underlying drops to a predetermined (in strike) price. There are non-deliverable currency options (as there are non-deliverable forwards) which do not provide for physical delivery of the underlying currency when the option is exercised. the option seller pays the holder the ―in the money‖ amount on the settlement date in dollars or other agreed settlement currency. and chooser options allow the holder to select before a certain date whether the option will be a put or a call.. If exercised. Other permutations include models developed in-house by the major dealers to meet individual customers‘ needs. and down-andin options etc. and any number of customized arrangements that attach or embed options as part of more complex transactions.price of the underlying drops below a predetermined (out strike) price. Compound options are options on options. But a country who struggles to attract enough capital inflows will see a depreciation in the currency. Therefore demand for Sterling will rise. This is known as ―hot money flows‖.4 to $1. This increase in demand will cause the value to rise. Also foreign goods will be less competitive and so UK citizens will supply less £s.5 Interest Rates If UK interest rates rise relative to elsewhere it will become more attractive to deposit money in the UK. (For example current account deficit in US of 7% of GDP is one reason for depreciation of dollar in 2006) . then UK exports will become more competitive and there will be an increase in demand for £s. If this is financed by a suplus on the financial/ capital account then this is OK.FACTORS INFLUENCING EXCHANGE RATES Inflation If inflation in the UK is lower than elsewhere. Therefore the value of sterling £ will appreciate Speculation If speculators believe the sterling will rise in the future They will demand more now to be able to make a profit. Therefore the rate of £ will increase from say £1=$1. Therefore movements in the exchange rate do not always reflect economic fundamentals. but are often driven by the sentiments of the financial markets Change in competitiveness If British goods become more attractive and competitive this will also cause the value of the ER to rise Relative strength of other currencies Between 1999 and 2001 the £ appreciated because the Euro was seen as a weak currency Balance of Payments A large deficit on the current account means that the value of imports is greater than the value of exports. the possible changes in the political life of the country. There are many factors that influence both. natural disasters. Price behavior includes both opportunities of quick gain of profit and possibilities of quick and considerable loss. the discount rates of the central banks.FACTORS AFFECTING CURRENCY FORECASTING The most important and most complicated component of currency dealing is the ability to analyze tendencies of market changes and. The first one assesses the situation from the point of view of political. The second one is based on methods of graphic research and analysis based on mathematical principles. that can influence the development of the foreign exchange market. force majeure. assessment of events. The economic group of the factors influencing the market can be divided into the following components: information about the economic development of the country trade negotiations meetings of the central banks any changes in the monetary and credit policy meetings of G-7. There are two main analysis methods of the market situation: fundamental analysis and technical analysis. Information about the functioning of stock exchanges and of big companies of the type of market-makers. the economic and administration policies. Fundamental factors that influence the FOREX market. more rare – political news. as well as the understanding of rumors and expectations. That‘s why correct forecasting of market movements. about the activity in the political and economic life in both specific countries and in the world community. in particular. etc. forecast what factors and how will influence currency rates. wars. Fundamental analysis distinguishes four groups of factors that influence the market directly: economic. From the point of view of the condition of the national economy of the country. The economic group of factors and their influence on the market are based on the axiom that any currency is a derivative of the economic development of the country and its cost may be regulated with the help of certain economic measures. is a required component of broker‘s or dealer‘s work and is a guarantee of his successful activity.). as well as various signs and expectations are found to be important here. Some analysis is done to understand what changes in the currency rates they can cause. as a rule: From the point of view of their influence on the official discount rate. Fundamental analysis implies the study of various messages about financial events in the world. signs and expectations. Fundamental factors are assessed from two positions. economic. more rare economic news (political instability in the country. political. economic unions or commercial alliances . planned and expected – usually news of economic character. respectively. financial and credit policy. in general. Classification of news according to the degree of their expectancy: accidental and unexpected – usually some news of political and natural origin. the whole currency market in general and some currencies. One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments simultaneously. the history of development of currencies. being decisive. one of the key types of work on the foreign exchange market. may become utterly insignificant. In addition to some basic and very formal rules. It is necessary to know the interrelation and mutual influence of two different currencies that reflect the ties between various states. For many given patterns there is a high probability that they will produce the expected results. and creates charts from that data to use as the primary tool. as the same factors influence the market differently in various conditions or. open-closing) Trends (following moving average).: Relative Strength Index (RSI) Number theory (Fibonacci numbers. rather than what should happen and takes into account the price of instruments and the volume of trading. However. Technical analysis is built on three essential principles: Market action discounts everything! This means that the actual price is a reflection of everything that is known to the market that could affect it. It is much more difficult to make fundamental analysis than any other analysis. speeches of the heads of central banks. it is required to have considerable work experience at the foreign exchange market. supply and demand. History repeats itself Forex chart patterns have been recognized and categorized for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little over time. Gann numbers) Waves (Elliott wave theory) Gaps (high-low. the pure technical analyst is only concerned with price movements. there are recognized patterns that repeat themselves on a consistent basis. Also. Prices move in trends Technical analysis is used to identify patterns of market behavior that have long been recognized as significant. There are five categories in Forex technical analysis theory: Indicators (oscillators. at the same time.g.economic situation in the country or their forecasts interventions neighbouring markets speculation Fundamental analysis is one of the most complicated parts. Forex charts are based on market action involving price. for example. political factors and market sentiment. Technical analysis Technical analysis is a method of predicting price movements and future market trends by studying charts of past market action. Some major technical analysis tools are described below: . not with the reasons for any changes. to determine the cumulative result of some economic measures and to establish connection between events that may originally seem to have no connection at all. heads of governments. e. distinguished economists concerning the situation of the foreign exchange market. and. Technical analysis is concerned with what has actually happened in the market. changes in the economic policy. Waves Elliott wave theory: The Elliott wave theory is an approach to market analysis that is based on repetitive wave patterns and the Fibonacci number sequence. which is a popular Fibonacci retracement number. For that reason. known as time/price equivalents. closing prices tend to be near to the extreme low of the period range. then the instrument is assumed to be overbought (a situation in which prices have risen more than market expectations).2.3.21. but in essence he used angles in charts to determine support and resistance areas and predict the times of future trend changes. Moving Average Convergence Divergence (MACD): This indicator involves plotting two momentum lines. The indicator is based on the observation that in a strong up trend. Trends A trend refers to the direction of prices. A breakaway gap is a price gap that forms on the completion of an important price pattern. which is 38%. is also used as a Fibonacci retracement number. which is an exponential moving average of the difference. It usually signals the beginning of an important price move. while a down gap is a sign of market weakness. Stochastic oscillator: This is used to indicate overbought/oversold conditions on a scale of 0-100%. Rising peaks and troughs constitute an up trend.. He made his fortune using methods that he developed for trading instruments based on relationships between price movement and time.. There is no easy explanation for Gann's methods. If the MACD and trigger lines cross.1. A down gap is formed when the highest price of the day is lower than the lowest price of the prior day. The inverse of 62%. Number theory: Fibonacci numbers: The Fibonacci number sequence (1. Relative Strength Index (RSI): The RSI measures the ratio of up-moves to down-moves and normalizes the calculation so that the index is expressed in a range of 0-100.) is constructed by adding the first two numbers to arrive at the third. The ratio of any number to the next larger number is 62%.5. period closing prices tend to concentrate in the higher part of the period's range. as prices fall in a strong down trend. An exhaustion gap is a price gap that occurs at the end of an important trend and signals that the trend is ending. An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation in which prices have fallen more than the market expectations). Conversely.13. Gann numbers: W. Gaps Gaps are spaces left on the bar chart where no trading has taken place. Stochastic calculations produce two lines. then this is taken as a signal that a change in the trend is likely. An up gap is usually a sign of market strength. A runaway gap is a price gap that usually occurs around the mid-point of an important market trend. Gann was a stock and a commodity trader working in the '50s who reputedly made over $50 million in the markets. An up gap is formed when the lowest price on a trading day is higher than the highest high of the previous day. %K and %D that are used to indicate overbought/oversold areas of a chart.8. An ideal Elliott wave patterns shows a five-wave advance followed by a three-wave decline. If the RSI is 70 or greater. He also used lines in charts to predict support and resistance areas. it is also called a measuring gap.D.34. . Divergence between the stochastic lines and the price action of the underlying instrument gives a powerful trading signal. The MACD line is the difference between two exponential moving averages and the signal or trigger line. Unlike the fundamental analyst. but concentrates on the activity of that instrument's market. particularly in futures trading or a market with a strong up or down trend. The most common technical tools: Coppock Curve is an investment tool used in technical analysis for predicting bear market lows. Moving averages are used to smooth price information in order to confirm trends and support and resistance levels. . The breaking of a trend line usually signals a trend reversal. DMI (Directional Movement Indicator) is a popular technical indicator used to determine whether or not a currency pair is trending.falling peaks and troughs constitute a downtrend that determines the steepness of the current trend. Horizontal peaks and troughs characterize a trading range. the technical analyst is not much concerned with any of the "bigger picture" factors affecting the market. They are also useful in deciding on a trading strategy. The only way to get this benefit is to leverage the position and enter into a high-leverage derivative (HLD) . In July 2007. Cost (hedge) = Cost (payout) Cost of a hedge is proportional to the benefit one can realise from the hedge and the probability that the hedge will be live at the time of exercise. MTM losses (due to exotic derivatives) could be ~USD 4-5 bn. Given the prominence of foreign banks in these products. The exotic options entered into require a strong understanding of highly correlated international macro-economics. Given that very few of these companies have any transaction in JPY or CHF. Now.5% Amount (payout) = INR 6. while the worst case loss is unknown. Large corporate houses. This gives rise to the undesirable position where the best case profit is known. Benefit (hedge) = INR 5/USD x 1 mn USD x 60 months = INR 300 mn.10.FINANCIAL CRISIS-INDIAN CONTEXT A simplistic explanation of the logic of high leverage derivatives (HLD) USD/INR has depreciated from INR 46. an export hedging structure has to be constructed that gives a benefit of 11% over-and-above a risk neutral hedge. with the ability to feed MTM margin calls. assuming the rest of the P&L is in INR. are likely to account for ~70-80% of these losses. To restore the margins. possibly even to the market maker.5%. roughly two-third of this exposure is likely to be with foreign banks. the company would be actually risking INR 6.50. hence: Benefit (hedge) x Probability (hedge) = Amount (payout) x Probability (payout) Let us say. probability (hedge) = 1. . difficult to quantify.11). made the payout situation a 3-sigma event with a probability of less than 4. Given that the hedge is not contingent on any market parameter. Trading in these options has become a popular tool for profit management in these companies‘ treasuries. the small and medium enterprises (SMEs) will incur the remaining. a company wants to sell USD 1 mn @ INR 46. Doing the math: INR 300 mn x 1 = Amount (payout) x 4. it translates into an 11% drop in gross margins. let's say the payout is to happen only if USD/CHF goes below 1.66 bn. If a majority of a company‘s revenues are from exports. cost (HLD) = 0 Then. Understanding the possible blowout risks is difficult and in many cases. Cost (HLD) = Cost (Hedge) .66 bn (which it does not realize in the beginning) in order to save/earn INR 300 mn. and the remaining with Indian banks.50/USD to INR 40/USD.Cost (Payout) Assuming that the bank makes no money on the transaction. In the above example. why have these exotic option structures found such favor with the otherwise astute finance teams? The answer is: • The same exotic options exploding today had been boosting bottom lines for these companies consistently in the previous quarters.50 every month for five years and the average forward price is INR 41.with USD/CHF the lowest it has ever been in the last 20 years (1. USD/CHF had not traded below 1. RBI bought dollars from the market by paying with INR. whenever it looked to depreciate. Genesis – High interest rates and an appreciating INR were looking to severely impact earnings Indian companies were faced with a two-pronged problem over the past years that were looking to adversely affect their financials: • Unprecedented appreciation of INR against USD • Increase in domestic interest rates These two factors. depending on short-term calls on the international currency markets. This increased liquidity started to lead towards runaway inflation that threatened the economy at large. USD went into a free fall against the rupee and started hurting those companies. By beginning 2007. the worst case scenarios were difficult to envision upfront and quantify. This creates a problem. four breeds of products were developed in the market: • ECBs denominated in JPY. • Purely speculative products that allowed various payout strategies. financed by the companies selling back high-value USD/CHF & USD/JPY blowout risk options with a ‗perceived‘ low probability of getting exercised. as the companies cannot track their own positions on a daily basis. With the gargantuan inflows India received over 2005-2007 by way of FDI.10 in over 20 years and USD/JPY had remained strong at ~110 consistently. • Cross currency swaps from INR loans into CHF. A large part of these were breakout or mean reverting strategies encouraged by the low volatilities prevalent in the international currency markets earlier this year. All through this. The levels at which the blowout barriers were placed were beyond historical precedent. again hedged with barrier options (to access lower CHF interest rates). offshore dollars relentlessly flowed into the Indian market. which dramatically increased the monetary liquidity in the system. . Possibly. though distinct in their effect. Every time a USD/INR down move was supported. there was little option left for the regulators to support the dollar. corporates were paying 3. RBI consistently prodded the interest rates in the market higher over the later part of 2006-07. to be hedged with barrier options (to access lower JPY interest rates). INR was no exception. to maintain the strong focus that India has on promoting exports. In response. These were in some cases. this proved to be expensive.5% higher on their borrowing programs than in 2005. To begin to appreciate the structures entered. it is impossible to predict the ‗loss‘ probabilities at various currency levels at the beginning of the transaction. With USD tending to depreciate against most Asian currencies. the Reserve Bank of India (RBI) worked to support the USD/INR pair. Complicating the situation further is the fact that the payoffs being non-linear. ECB and FII inflows.Mark-to-market positions on the exotic structures can only be estimated through mark-to-model approaches. on an average. we need to delve into the motivations of the companies to take up these positions in the first place. dependant on good forex rates for their INR top line. To counter the losses being suffered on the above market situations. With the interest rates having already increased sharply and the sword of inflation still hanging over their heads. are closely tied in their causes. However. • USD/INR export hedging ‗strips‘ to allow the corporate to sell their export receivables at rates significantly higher than market. if this leg is hedged with an option costing only 1.The yen ECB . The CHF Swap . Cost of a USD/JPY forward cover by the same logic is 3.5%. However. The underlying risk on the loan is that.USD/JPY must not go to the knockout level during the loan tenor. This risk is partially hedged with an embedded option with two benefits illustrated to the company: . With a depreciating USD/INR and a possible natural hedge through export receivables. since the borrowing is in JPY. Various combinations of the two benefits are packaged to suit the company's appetite and a loan of 6% cost is designed with only one predominant risk .A benefit of ~2. These swaps were typically of a tenor of 1-2 years and completely off-balance sheet. the underlying risk on the swap was that now a payment had to be made in CHF. the company will have to pay INR to buy CHF at the then prevalent rate. cost of a JPY/INR 3-year average tenor forward cover is 7. most companies preferred to leave the USD/INR leg open.5% Repayment in JPY. i. Table 1: Interest rate differentials in INR and JPY/CHF created cost saving opportunities Base cost of funds(3year average tenor) Risk premium Final interest rate Open risks INR loan 9% (FD interest rate used as a surrogate for cost of funds).The interest rate on a partially hedged ECB was as low as 6%.e. 3% 4.5% (3-year JPY IRS) 3% 8% Repayment in USD.5%. Again.USD/INR conversion risk unhedged. as against 12% on a similar INR borrowing A company will raise funds through an ECB with an average tenor of three years at a cost of LIBOR +3%. The choice of currency is left to the company with a strong justification given for denominating the loan in JPY.75% could be realized by swapping INR loans into CHF loans A company with an existing INR loan could re-denominate the loan into CHF and receive the 'carry' (part of the differential between the CHF LIBOR and INR MIFOR).5% (to arrive at target loan cost of 6%). the loan has to be repaid in JPY for which the company will have to pay INR to buy JPY at the then prevalent rate. the realized interest rates work out at par. for which. • Protection such that USD/JPY risk is hedged as long as USD/JPY does not depreciate to a much lower knockout level (says USD/JPY = 100).USD/JPY conversion risk unhedged. there are two benefits illustrated to the company: • Participation (full or partial) in favorable movements in USD/JPY. If one purchases hedges for the open risks through forward covers (fully hedged). 3% 12% None USD ECB 5% (3-year USD IRS) JPY ECB 1. As a result. which the entire market was willing to bet over. making it unviable. the structure was sound. the company would have to convert its USD at INR 44 instead of a higher spot rate. This was possible by averaging out the forward premiums i. make money. USD/JPY at 110 and USD/CHF at 1.Short-term structures were entered into with high payoffs and high blowouts in the belief that the market was predictable in the short term. was a level for significant global option congestion.e.• Participation (full or partial) in favorable movements in USD/CHF.10 consistently or USD/JPY below 105 or so. companies had to resort to complex structures to raise the levels higher. The logic of these structures were simple. To maintain the realization. Most of these structures relied on the currencies remaining within stable ranges or at worst.50.10 in 20 years. Once again. For instance. additional value was derived by selling blowout options. then one can have an average higher realization of INR 2. . and get out before the markets move.10 became sacred cows.Long forward premiums were averaged to yield better export realizations and once these proved insufficient. not breaching historical extremes definitively. companies have aggressively entered into derivative contracts to generate lower interest costs. except that underlying exposures existed. if 5-year forward premium was INR 5 per USD. or in extreme cases as geometrically increasing monthly realizations. Truly speculative . albeit in a different currency. a lot of companies found that their benchmark realization rates were being busted. get in.The currency movements that are hurting the companies Over the past few years. monthly accruals. subsidizing the closer forwards by the higher longer forwards.10).5. At this stage. the forward premiums contracted such that these 'par' forward structures started yielding only ~INR 42. These have given annual benefits of upwards of 2% in interest cost reductions and created an impression of a strong understanding of the currency markets. As the USD/INR spot slipped from INR 46+ levels down to INR 42. and hence. The companies sold options in CHF and JPY to finance these higher realizations for their receivables. USD/INR strips . This was an acceptable risk for most companies and the market was flooded with such deals. the structures would be protected as long as USD/CHF does not trade below 1. The blowout risk on the structure devolves if USD/INR goes above INR 50 in the next five years. A segment of the market entered into complex exotics with a life span of 1 year or less. With low volatilities in the currency market holding sway. This structure was primarily resting on the premise that USD/CHF had not traded at 1. Again barring the blowout risk of USD/CHF defying history. What has gone wrong? . These had no direct correlation to their books. some companies entered into forward strips where they contracted to sell a fixed number of dollars every month for the next five years at a higher rate than spot (say INR 44). • Protection such that USD/CHF risk is hedged as long as USD/CHF does not touch a knockout level (says USD/CHF = 1. the predictability was perceived high in the extreme short term and the speculative plays relied on a low likelihood of sudden dramatic movements. The risk on this structure is that if USD/INR appreciates to above INR 44. The payoff was received as single barrier knockouts. The embedded protections in a lot of the cases have collapsed. and EUR/USD and GBP/USD have been making historical highs every second day. USD/JPY broke below 110. Because the currency movements are killing them softly by way of MTM margin calls. right? Wrong. however the options are still live and will not expire for the next six months on an average. will the companies have much to worry about.USD/CHF in the last month broke below 1. and some sold options have exploded. .10. Only if this level hold till expiry or worsens. everything is notional. 107 0.65 P 0.SELECTION OF FORECASTING MODEL Simple Linear Regression The USD/INR exchange rate is forecasted using the simple liner regression with exchange rate as dependent variable and interest rate differential as independent variable. the first criteria to justify the model is the residual analysis of the model as shown below. a) It can be seen that the residual are not following a normal probability distribution.06 F 1716. -0.20 MS 104. The model is analyzed for its application.43 0.71 115.49 0.2451 1.49 10. The regression equation obtained is: E = -0.409 <0. Coef.000 Durbin-Watson statistic (d value) = 0.06 * I Where E – exchange rate I – interest rate differential Model Analysis While analyzing the regression model.06*I ANALYSIS OF VARIANCE Source Regression Residual Error Total DF 1 176 177 SS 104.Both of these values are indicating that the residuals are not following a normal distribution.06124 SE Coef 0.245+1.246713 Hence.0794856 .409 and the p-value is less than 0.02561 T -1. N AD P-Value 60 8.62 41.005.7% R-Sq = 90.1513 0. Even it can be justified from the box which shows Anderson-Darling Normality Test Statistics(A2) is around 8.000 P R-Sq = 90.005 REGRESSION OUTPUT Predictor Constant I S = 0.245 + 1.6% E = -0. 353 and the p-value is less than 0. Now the most important thing to notice the ‗Durbin-Watson Statistic‘ that is equal to 0.e. the p-value represents the probability of making a Type I error.0794856 shows the autocorrelation is present in the residuals.005.40 – 0. or rejecting the null hypothesis when it is actually true.69 and 0. Hence the model is rejected. all µj are equal.e. The regression equation obtained after applying the model is E = 4. The smaller the p-value. the smaller the probability is that you would be making a mistake by rejecting the null hypothesis.e. Quadratic Regression Model As shown above in the ‗Linear Regression Model‘ is not fit for forecasting so a Quadratic Model which is the most common form of non-linear relationships (i.65 dU (upper limit of DW statistic) = 1. As in this case as the p-value is even less than ‗α‘ so the null hypothesis is rejected.e.0794856 is less than the lower limit so positive autocorrelation exists. Even it can be justified from the box which shows Anderson-Darling Normality Test Statistics(A2) is around 5.353 <0.Both of these values are indicating that the residuals are not following a normal distribution. As the value of R-Sq is quite high so from this perspective the model is justified.005 REGRESSION OUTPUT . N AD P-Value 60 5. As we know that For n=60.145I2 Where E – exchange rate I – interest rate differential Model Analysis a) It can be again seen that the residual are not following a normal probability distribution. of independent variables) = 1. dL (lower limit of DW statistic) = 1. While analyzing the ANOVA table as p is less than α so the null hypothesis is again rejected i.ANALYSIS Analyzing the t-value and the p-value i. k (no.595*I+0. if the null hypothesis is true i. the probability of obtaining a test statistic that is at least as extreme as the actual calculated value. Hence the model is not appropriate for forecasting. quadratic relationship between two variables) is applied to the time series and is analyzed for its applicability. 0916674 ANALYSIS ‗t-value‘ and ‗p-value‘ from the table shows that the null hypothesis is violated for constant and I2. E = 4. The procedures to build models are broadly referred to as Box-Jenkins or ARIMA model building methods. UNIVARIATE ARIMA Model In the time series analysis.As we know that For n=60.0% Hence.21 P 0.5563 0.396 -0. the underlying stochastic process) is analogous to the relationship between the sample and the population as studied in statistical hypothesis testing. The purpose of the time series analysis is to use the realization of a process to identify a model of ARIMA process that generated the series.40 – 0.564 0.241367 R-Sq = 91.0916674 is less than the lower limit so positive autocorrelation exists. diagnosing and forecasting time series.000 Durbin-Watson statistic (d value) = 0. there is a fundamental distinction between the terms ‗process‘ and ‗realization‘.201 MS 52.72 and 0. the relation between the realization (i.006 0.0916674 shows that autocorrelation is present in the residuals.286 0. 4. The actual values in the observed time series are the realization of some underlying process (stochastic generating process) that generated those values.145*I2 ANALYSIS OF VARIANCE Source Regression Residual Error Total DF 2 175 177 SS 105.503 0.63 dU (upper limit of DW statistic) = 1. dL (lower limit of DW statistic) = 1.2% R-Sq = 91. It is |empirically driven methodology of systematically identifying. estimating.005 10. As per ANOVA.14528 SE Coef 1. the observed sample values) and the process (i.8 S = 0. Now it can be implied from the above results that neither ‗Simple Regression‘ nor Quadratic Regression‘ are appropriate tools for forecasting of exchange rates.5950 0. the null hypothesis is rejected as again p is less than α.195 115.003 VIF 492.058 F 901.8 492. Now the final and the most important thing to notice is the ‗Durbin-Watson Statistic‘ which is equal to 0. Hence the model is not appropriate for forecasting.04874 T 2.e.81 -1.595*I + 0. In the time series analysis.Predictor Constant I I2 Coef.e. k (no. .07 2. of independent variables) = 2.98 P 0. θ1et-1 + et Where θ1 is an estimated coefficient and Yt is only correlated with the previous forecast error.An ARIMA(0. Φ1 coefficients chosen to minimize the sum of squared errors.0.1. summed series) include random walks and trends(because their means or levels are not constant.d.1) model commonly called an MA(1) model is Yt = µ . and differences should be used to model the time series.0.050 0.0. the previous actual value is a best predictor of all future values. the absolute value of coefficient Φ1 is normally constrained to be less than 1. Bound of invertibility | θ1| <1 If this bound is exceeded. absolute value of θ1 for a moving average model is constrained to be less than 1. a concept related to stationarity. For a random walk series.0) 1 The descriptive statistics for ARIMA (1. Moving Average Process-ARIMA(0.1) ARIMA moving averages are similar to the exponential smoothing. An ARIMA(1. the model is not stationary. commonly called an AR(1) model is Yt = θ0 + Φ1Yt-1 + et where θ0 .e.0) Integrated processes are level-nonstationary series. It(i.0) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared 5 59 55 0.0) model. So the model is Yt = Yt-1 + et These three models are the basic models in the ARIMA model building processes. The means either randomly changes as the series randomly walks or consistently increases/decreases). For this model.q) p = order of auto-regression d = order of integration q = order of moving average Auto-regressive Process-ARIMA(1. APPLYING THE UNIVARIATE ARIMA MODEL TO EXCHANGE RATES TIME SERIES AND MODEL SELECTION ARIMA(1. In this model.This constraint is called a bound of stationarity: Bound of Stationarity | Φ1| <1 If the bound is exceeded then the series is not autoregressive.1. This constraint is called the Bound of invertibility. Integrated Process-ARIMA(0.1.980 . ARIMA Notation (p. et-1. it is either drifting or trending.0.0) Auto-regression is an extension of simple linear regression. This measure is most useful when the series is stationary.377 Stationary R-Squared is a measure that compares the stationary part of the model to a simple mean model.070 -4.478 18. MAE(Mean Absolute Error) measures how much the series varies from its model-predicted level.1. This measure is preferable to ordinary R-squared when there is a trend or seasonal pattern. expressed in the same units as the dependent series.032 Significance 0. Positive values mean that the model under consideration is better than the baseline model.RMSE MAPE MAE Normalized BIC Statistic Ljung –Box Q DF Statistic Significance 0. Positive values mean that the model under consideration is better than the baseline model. MAPE(Mean Absolute Square Error) is a measure of how much a dependent series varies from its model-predicted level. R-Squared is an estimate of the proportion of the total variation in the series that is explained by the model. Constant AR.193 0.223 SE 0. R-Squared can be negative with a range of negative infinity to 1.003 So the model equation for ARIMA (1.010 0. Negative values mean that the model under consideration is worse than the baseline model.074 T 0. Stationary R-Squared can be negative with a range of negative infinity to 1.008 0. RMSE(Root Mean Square Error) is a measure of how much a dependent series varies from its model-predicted level. Normalized BIC(Normalized Bayesian Information Criterion) is a general measure of the overall fit of a model that attempts to account for model complexity. making the statistic easy to compare across different models for the same series.104 1.0) 1 becomes Yt = Yt-1 + ф*(Yt-1 – Yt-2 ) + θ0 .194171 17 0. Negative values mean that the model under consideration is worse than the baseline model. It is independent of the units used and can therefore be used to compare series with different units. MAE is reported in the original series units.421 0. The penalty removes the advantage of models with more parametes.806 3.Φ1 Estimate 0. It is a score based upon the mean square error and includes a penalty for the number of parameters in the model and the length of the series. e.1.332 0.1. (-4.1.0)1.1) 1 Now while applying ARIMA(1.980 0.806 0. Yt = Yt-1 + 0.0) 1 as it has the smaller BIC coefficient.0637 -0.1.1 model The descriptive statistics for ARIMA (1.1 Now by applying the ARIMA(1.1) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared RMSE MAPE MAE Normalized BIC Statistic Ljung –Box Q DF Statistic Significance Estimate 0.1.525 0.i.036 Significance 0.1.194 0.980 .0) 1 and ARIMA(1.012 15 59 54 0.θ12 While comparing the two models i.008 ARIMA(1.0) 1 is preferred.008 0.104 1.0) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared 5 59 55 0. But still the value of Stationary R-Squared and the R-Square is quite low which shows that there is still some kind of variance non-stationarity which can be removed by taking the first difference of log of the natural time series.0) 1 is much less than ARIMA(1.070 -4.1.422 0. So ARIMA(1.050 0.340 T 0.1) 1 (5 < 15).315 SE 0.1.e.443) Secondly the number of iterations in ARIMA(1.971 Constant AR. ARIMA(1.478 < -4.1.1.1.212 -0.154 16 0.Φ1 MA.1.1) 1 .061 0.010 0. the best fit model decided on the criteria of Normalized BIC is ARIMA(1.223*(Yt-1 – Yt-2 ) + 0. ARIMA(1.1) 1 The descriptive statistics for ARIMA (1.443 18.0)1. RMSE MAPE MAE Normalized BIC Statistic Ljung –Box Q DF Statistic Significance Estimate 0.001 0.245 0.104 1.198 0.070 -4.477 19.354 17 0.309 SE 0.002 0.073 T 0.757 3.343 Significance 0.450 0.001 Constant AR,Φ1 So the model equation for ARIMA (1,1,0) 1,1 becomes LnYt =Ln Yt-1 + ф*(LnYt-1 – LnYt-2 ) + θ0 i.e. LnYt = LnYt-1 + 0.245*(LnYt-1 –Ln Yt-2 ) + 0.001 Now the next forecasted value will be for ARIMA(1,1,0)1,1 Forecasted Value No. Forecasted Value UCL LCL ARIMA(1,1,1)1,1 Now applying the ARIMA(1,1,1)1,1 model so as to see whether it fits the forecasted model better or not. The descriptive statistics for ARIMA (1,1,1) 1 are: Iterations Taken Usable Observations Degree of Freedom Stationary R-Squared R-Squared RMSE MAPE MAE Normalized BIC Statistic Ljung –Box Q DF Statistic Significance Estimate 0.001 0.309 8 59 54 0.061 0.980 0.104 1.197 0.070 -4.441 19.455 16 0.246 SE 0.002 0.293 T 0.743 1.055 Significance 0.459 0.293 60 50.4577 51.4657 50.2333 Constant AR,Φ1 MA,θ12 0.068 0.308 0.222 0.0825 So the model equation for ARIMA(1,1,1)1,1 becomes Ln Yt = Ln Yt-1+ ф1*(Ln Yt-1 - Ln Yt-2) +θ12*( Ln Yt-1 - Ln Yt-2) + θ0 i.e. Ln Yt = Ln Yt-1+ 0.309*(Ln Yt-1 - Ln Yt-2) +0.068*( Ln Yt-1 - Ln Yt-2) + 0.001 Now the next forecasted value will be for ARIMA(1,1,1)1,1 Forecasted Value No. Forecasted Value UCL LCL 60 51.3487 52.6690 50.1145 While comparing the two models i.e. ARIMA(1,1,0) 1,1 and ARIMA(1,1,1) 1,1 , the best fit model decided on the criteria of Normalized BIC is ARIMA(1,1,0) 1,1 as it has the smaller BIC coefficient. (-4.477 < -4.441) Secondly the number of iterations in ARIMA(1,1,0) 1,1 is much less than ARIMA(1,1,1) 1,1 (5 < 15). So ARIMA(1,1,0) 1,1 is preferred. Hence the bst fit model is ARIMA(1,1,0)1,1 to forecast the exchange rates and the forecasting equation is LnYt = LnYt-1 + 0.245*(LnYt-1 –Ln Yt-2 ) + 0.001 VALIDATION OF FORECASTING MODEL Now to test the validity of the forecasting model stated above, monthly exchange rates for last 8 months were taken. month september,2008 october,2008 november,2008 december,2008 january,2009 february,2009 march,2009 april,2009 exchange rate 45.4264 48.6196 48.7905 48.4804 48.7326 49.1914 51.2062 50.3333 predicted exchange rate 45.2712 48.7849 48.9703 48.8286 48.9432 48.8968 50.9564 50.4577 difference 0.1552 -0.1653 -0.1798 -0.3482 -0.2106 0.2946 0.2498 -0.1244 Now after observing the difference and the graph plotted between actual and predicted exchange rates confirms the validity of the forecasting model. Consumer price index Real price of oil Export to import ratio Interest rate differential Thus exchange rates depends on the above mentioned factors.LTOT. Let Xt denotes the exchange rate at a time t thus.Q) Where RRL=g(MG.ECONOMETRIC MODEL Econometric model has its own significance among all the forecasting models. The Money Market Factors influencing the money market are GDP Real money supply Thus interest rate differential depends on the above mentioned factors.RRL) Y = k(RRL.ROIL.ROIL) RRL Q Y MG Interest rate differential Real exchange rate Annual growth rate Real money supply . The Goods Market Factors influencing the goods market are Interest rate differential Consumer price index Real oil prices Export to import ratio Thus growth rate differential depend on the above mentioned factors. The foreign exchange market The foreign exchange market is primarily influenced by the following macro economic variables.LTNT.Y) Q = h(LTNT. Broadly the economic model is built considering the simultaneous equilibrium of exchange. Xt= f(RRL. interest rate differential and growth rate differential are taken into account.LTOT. It takes into consideration all the macro economic factors and thus is more reliable.Y. money and goods market. Therefore the joint behavior of bilateral exchange rates. 5337 0.0000 0.28 120.75 18.61 111.2910 0.70 Equilibrium dynamics.1467 0.5620 t-value 11.2077 Equilibrium dynamics-growth rate differential Variable Coefficient Standard error t-value .4780 Skewness+kurtosis 0.real exchange rates Variable LTNT LTOT ROIL RRL Coefficient -2.8770 0.40 45.4480 0.0370 0.72 155.5467 Standard error 0.7978 Standard error 0.08 99% 193.0010 0.0100 0.0367 0.55 119.0120 0.015 Equilibrium dynamics-interest rate differential Variable Y MG Coefficient 6.06 35.54 172.3710 0.49 64.18 41.86 144.0030 0.2485 -15.5055 0.7677 95% 181.1057 0.LTNT LTOT ROIL Descriptive study of the variable utilized Equation RRL Q Y MG LTNT LTOT ROIL Skewness 0.0420 0.81 P value 0.2281 0.3260 Consumer price index Export to import ratio Real oil prices Kurtosis 0.0004 0.0033 -8.4300 0.8750 0.86 90.0128 0.39 82.2315 5.4800 Rank Test Number of lags considered .3050 0.9320 0.2989 t-value -9.0970 0.1178 0.3316 0.75 23.6540 0.5913 -16.1318 -4.50 75.5518 3.72 6.20 57.3190 0.66 22.0310 0.3350 0.3 H0: Rank <= r r=0 r=1 r=2 r=3 r=4 r=5 r=6 Test Statistic 233. 4262 0.1037 0.1370 4.0319 0.8167 -4.2546 7.1748 Graph-Actual v/s Forecasted Values .1942 0.1099 4.5180 -0.1181 0.2947 16.LTNT LTOT ROIL RRL 1. com www.ecnomagic.realtimeforex.rbi.nseindia.-Options. Futures and Other Derivatives.com www. ICFAI Journal of Derivatives LIST OF WEBSITES: www. NCFM Module-Derivatives 3.rbi. Hull John C.com www.Prentice Hall Finance Series 2.REFERENCES 1.com www.bis.org www.google.org www.org . Master Circulars by RBI 4. Fifth Edition Pearson Education Inc.fxstreet.org www.2003. agricultural finance.largest among Nationalized banks. The bank‘s attempt at providing best customer service has earned it 9th place among India‘s Most . non-resident Indians and multinational companies. The bank was recently ranked 21st amongst top 500 companies by the leading financial daily. exporters.4589 including 322 extension counters Ranked as 255th biggest bank in the world by ‗The Banker‘ Strong correspondent banking relationships with more than 217 international banks More than 50 renowned international banks maintain their rupee account with PNB With its presence virtually in all the important cities of the country. financing of trade and international banking. The Economic Times.” Mission: “To provide excellent professional services and improve its position as a leader in the field of financial and related services. Punjab National Bank offers a wide variety of banking services which include corporate and personal banking. build and maintain a team of motivated and committed workforce with high work ethos.ANNEXURE 1 ABOUT PUNJAB NATIONAL BANK Company Profile: Vision: “To evolve and position the Bank as a world class progressive. Among the clients of the bank are Indian conglomerates. committed to excellence in serving the public and also excelling in corporate values. undivided India The first Indian bank to be solely started with Indian capital Nationalized in July 1969 along with 13 other banks Ranked as the third largest bank in the country (after SBI and ICICI Bank) and has the second largest network of branches .5 Crore customers through 4589 branches and 322 extension counters. medium and small industrial units.” Features: Established in 1895 at Lahore. Punjab National Bank is serving over 3. use latest technology aimed at customer satisfaction and act as an effective catalyst for socio-economic development. industrial finance. The large presence and vast resource base have helped the bank to build strong links with trade and industry. cost effective and customer friendly institution providing comprehensive financial and related services: integrating frontiers of technology and s4rving various segments of society especially the weaker sections. With its state-of-art dealing rooms and well-trained dealers.PNB is also ranked 255 amongst the top 1000 banjs in the world according to ‗The Banker‘ London. Work on assessing potential at other international centers is progressing. anywhere" banking to its clients. the bank has already set up representative offices at Almaty (Kazakhstan). Backed by strong domestic performance. Towards developing a cost effective alternative channels of delivery. The delegation of powers is decentralized up to the branch level to facilitate quick decision making. bank has established 31 specialized branches to finance exclusively such industries. Besides. With PNB‘s management. The bank has also been offering Internet banking services to the customers of CBS branches like booking of tickets. purchase of airline tickets etc. EBL has become one of the leading banks in Nepal. any where‖ banking. making available a pool of additional 21. The bank also has a joint venture with Everest Bank Ltd. Bank is a member of the SWIFT and over 150 exchange branches of the bank are connected through its computer based terminal at Mumbai. a branch at Kabul (Afghanistan) and a subsidiary at London (UK) and a branch at Hongkong. Considering the importance of the small scale industries. PNB has always looked at technology as a key facilitator to provide better customer service and ensured that its ‗IT strategy‘ follows the ‗Business strategy‘ so as to arrive at ―Best Fit‖.Trusted top 50 service brands in Economic Times-A. bank has Rupee Drawing Arrangements with 15 exchange companies in the Gulf and one in Singapore.500 ATMs throughout the country to its customers. Strong correspondent banking relationship which Punjab National Bank maintains with over 200 leading international banks all over the world enhances its capabilities to handle transaction world-wide. the bank offers efficient foreign exchange dealing operations in India.C. the bank has installed more than 1516 ATMs and entered into ATM sharing arrangement with other banks & IDRBT. Nepal.Nelson Survey. payment of bills of utilities. In order to increase its international presence. At the same time the bank has been conscious of its social responsibilities by financing agriculture and allied activities and small scale industries(SSI). Dubai (UAE) & Shanghai (China) . Organization Structure: Bank has its corporate office at New Delhi. . the bank is planning to realize its global aspirations. (EBL). with 20 per cent equity participation. PNB has implemented CBS in 3503 service outlets at around centers to facilitate "anytime. The bank has made rapid strides in this direction and achieved 100% branch computerisation. A pioneering effort of the bank in the use of IT is the implementation of Core Banking Solution (CBS) which facilitates ―any time. Head Office Circle Office(58) Branches(4267) . who were forced to liquidate their losing investments in euro-denominated assets. The yen is much more sensitive to the fortunes of the Nikkei index. and the real estate market. All currencies are generally quoted in U. The British Pound. The currency remains plagued by unequal growth. dollar is the main safe-haven currency. Moreover. dollar. the U. Under conditions of international economic and political unrest. The currency is heavily traded against the euro and the U. as the other currencies were virtually pegged against it. The yen is very liquid around the world. the pound was the currency of reference. provided that the U. dollar terms. the U. The euro was designed to become the premier currency in trading by simply being quoted in American terms. practically around the clock.S. dollar. it has a much smaller international presence than the U. Bank of England is attempting to bring the high U.ANNEXURE 2 MAJOR CURRENCIES Kinds of major currencies and exchange systems The U. both the pound benefited from any doubts about the currency convergence. European money managers rebalanced their portfolios and reduced their euro exposure as their needs for hedging currency risk in Europe declined. and government resistance to structural changes. The United States dollar is the world's main currency – an universal measure to evaluate any other currency traded on Forex. The Euro. which was proven particularly well during the Southeast Asian crisis of 1997-1998 As it was indicated. high unemployment. dollar or the euro. The pound could join the euro in the early 2000s. Like the U. rates closer to the lower rates in the euro zone. The Japanese yen is the third most traded currency in the world.K. The introduction of the euro in 1999 reduced the dollar's importance only marginally. Dollar. Prior to the introduction of the euro. the euro has a strong international presence stemming from members of the European Monetary Union. . but has a spotty presence against other currencies.S.S. dollar are the euro. the economic and financial conglomerates.S. Japanese yen. dollar became the leading currency toward the end of the Second World War along the Breton Woods Accord.S. British pound. After the introduction of the euro. referendum is positive. The other major currencies traded against the U. the Japanese stock market.K. and Swiss franc.S. The Japanese Yen. particularly Japanese.S. Until the end of World War II. The pair was also weighed in 1999 and 2000 by outflows from foreign investors. The natural demand to trade the yen concentrated mostly among the Japanese keiretsu. The Swiss Franc.S. from a foreign exchange point of view. As the demand for it exceeds supply. the Swiss franc is favored generally over the euro. the Swiss franc is one of the four major currencies.The Swiss franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. it is believed that the Swiss franc is a stable currency. Therefore. and thus to the euro zone. in terms of political uncertainty in the East. Switzerland has a very close economic relationship with Germany. Actually. Although the Swiss economy is relatively small. . the Swiss franc can be more volatile than the euro. but lacks its liquidity. Typically. closely resembling the strength and quality of the Swiss economy and finance. the Swiss franc closely resembles the patterns of the euro. Derivative is used as Risk managing instrument Profit making instrument Both of them None of them 3. Strongly disagree Somewhat disagree Neither agree or disagree Somewhat agree Strongly agree YToxOntzOjc6IlFS 2. Companies can manage financial risk more efficiently through derivatives.ANNEXURE 3 QUESTIONNAIRE …………………………………………………………………………………………………………… QUESTIONNAIRE SURVEY ON FOREIGN EXCHANGE DERIVATIVES NAME DESIGNATION ORGANISATION’S NAME ………………………………………………. Stop loss/take profit limit is set at the time of finalizing the contract . ………………………………………………. The most important factor kept in mind before finalizing any contract Fundamental analysis Technical analysis Banker’s opinion YToxOntzOjc6IlFS 4. ………………………………………………. 1. The approximate range of losses incurred (in INR) in the financial year 2008-09 No losses 0-10 crores 10-15 crores 15-20 crores 20 crores and above YToxOntzOjc6IlFS 8. Rank (on a scale of 1-4)the following in order of volumes of trade done Forward . The reason for companies incurring huge losses can be Inability to predict currency movement Opinion of bankers went otherwise Personal judgment /forecast Optimism that trend reversal will happen 9. If the limit is set. then it is religiously followed Yes No Limit can be reset depending on market YToxOntzOjc6IlFS 6. The approximate range of exposure towards hedging(in INR) 0-20 crores 20-30 crores 30-40 crores 40 crores and above 7.Yes No The limit is not considered important YToxOntzOjc6IlFS 5. Future Swaps Option 10. Derivatives have created a new type of risk Strongly disagree Somewhat disagree Neither agree nor disagree Somewhat agree Strongly agree 12. Impact of derivatives on the global financial system is beneficial Strongly disagree Somewhat disagree Neither agree nor disagree Somewhat agree Strongly agree 13. The most important benefit that derivatives offer is Flexibility in customizing risk profile . Based on the past experience do you still continue to have an exposure in this market Yes No Yes but the volume has decreased 11. Contribution by derivative to the stability of the global financial system It stabilizes the system It destabilizes the system Any of them-depends on the way it is used 14. Inexpensive risk management tool Both of them None of them 15. The area that will be benefitted most from the innovations in the next 5 years is Credit risk Financial services International and emerging markets ………………………………………………………………………………………………………… .