Use of Technical Analysis For Risk Management in The Context of Forx Market

Use of Technical Analysis for Risk Management in context of Forex Markets
LIST OF FIGURES
Figure. Figures Pg. no

no.
1 Types Of Financial Risk 12
2 Appreciation Due To Rise In Demand In Market 26
3 Appreciation And Depreciation 27
4 Organisation And Structure Of FEM 36
5 Intrinsic Value 101
6 Intrinsic Value Of Put Option 101
7 Profit Profile Of Call Option 105
8 Profit Profile Of Put Option 106
9 Profit Profile Of The Buyers Of A Straddle 108
10 Profit Profile Of The Sellers Of A Straddle 108
11 Bullish Call Spread With Buying And Selling Of Call 110
Option
12 Spread With Buying And Selling Of Call Option 110
13 Profit Profile 114
14 A Line Chart 132
15 A Bar Chart 133
16 A Candle Stick Chart 134
17 A Point And Figure Chart 135
18 Up Trend 136
19 Down Trend 137
20 Sideway Trend 138
21 Support And Resistance Line 139
22 Traders Remorse 141
23 Resistance Become Support 142
24 Volumes 142
25 Simple Moving Average 145
26 Experimental Moving Average 146
27 Use Of Moving Average 146
31 MACD 149
32 Stochastic Oscillator 151
33 Relative Strength Index 152
34 Bollinger Bond 154
35 Pivot Point 155
36 Absolute Breadth Index 156
37 Fibonacci Retracement 157
38 Track Record Of Dollar – Rupee 157
39 EUR – USD 158
40 GBP- USD 159
41 Percentage Of People Use Fundamental And 164
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Technical Analysis For Risk Management.

42 Percentage Returns That People Got On Their 165
Investment In Last Calendar Year.
LIST OF TABLES
Table Perticulers Page No.
No.
1 Forex Market v/s Other Markets 50
2 Currency Quotetions 76
3 Re/FFr quotetions 88
4 Spot Rate of call option 105
5 Spot rate of Put option 108
6 Disadvantages of trading in one currency 124
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EXECUTIVE SUMMARY
The identification and acceptance or offsetting of the risks threatening the

profitability or existence of an organization. The project is to study how the Forex
market behaves differently from other markets! The speed, volatility, and
enormous size of the Forex market are unlike anything else in the financial world.
Beware: the Forex market is uncontrollable - no single event, individual, or factor
rules it. Enjoy trading in the perfect market! Just like any other speculative
business, increased risk entails chances for a higher profit/loss.
RISKS INVOLVED
 Unexpected corrections in currency exchange rates

 Wild variations in foreign exchange rates
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 Volatile markets offering profit opportunities

 Lost payments
 Delayed confirmation of payments and receivables
 Divergence between bank drafts received and the contract price
Thus, the project will show how Currency Markets are highly speculative and
volatile in nature. Any currency can become very expensive or very cheap in
relation to any or all other currencies in a matter of days, hours, or sometimes,
in minutes. This unpredictable nature of the currencies is what attracts an
investor to trade and invest in the currency market. And how an investor can
enter this market with a speculated view on the basis of some detailed study of
“nature and trend” of any particular market.
All this is simply divided into different categories the initial part of the
project covers about the forex Market and its working. And the later part covers
the detailed study of Technical analysis, different indices and the use of these
indices to cover the Risks involved in the forex Market.
1. RISK MANAGEMENT- AN
INTRODUCTION
Definition of Risk?
 What is Risk?
"What is risk?" And what is a pragmatic definition of risk? Risk means different
things to different people. For some it is "financial (exchange rate, interest-call
money rates), mergers of competitors globally to form more powerful entities and
not leveraging IT optimally" and for someone else "an event or commitment
which has the potential to generate commercial liability or damage to the brand
image". Since risk is accepted in business as a trade off between reward and
threat, it does mean that taking risk bring forth benefits as well. In other words it
is necessary to accept risks, if the desire is to reap the anticipated benefits.
Risk in its pragmatic definition, therefore, includes both threats that can
materialize and opportunities, which can be exploited. This definition of risk is
4
very pertinent today as the current business environment offers both challenges
and opportunities to organizations, and it is up to an organization to manage these
to their competitive advantage.
 What is Risk Management - Does it eliminate risk?
Risk management is a discipline for dealing with the possibility that some future
event will cause harm. It provides strategies, techniques, and an approach to
recognizing and confronting any threat faced by an organization in fulfilling its
mission. Risk management may be as uncomplicated as asking and answering
three basic questions:
1. What can go wrong?
2. What will we do (both to prevent the harm from occurring and in the
aftermath of an "incident")?
3. If something happens, how will we pay for it?
Risk management does not aim at risk elimination, but enables the organization to
bring their risks to manageable proportions while not severely affecting their
income. This balancing act between the risk levels and profits needs to be well-
planned. Apart from bringing the risks to manageable proportions, they should
also ensure that one risk does not get transformed into any other undesirable risk.
This transformation takes place due to the inter-linkage present among the various
risks. The focal point in managing any risk will be to understand the nature of the
transaction in a way to unbundle the risks it is exposed to.
Risk Management is a more mature subject in the western world. This is largely a
result of lessons from major corporate failures, most telling and visible being the
Barings collapse. In addition, regulatory requirements have been introduced,
which expect organizations to have effective risk management practices. In India,
whilst risk management is still in its infancy, there has been considerable debate
on the need to introduce comprehensive risk management practices.
 Objectives of Risk Management Function
Two distinct viewpoints emerge –

• One which is about managing risks, maximizing profitability and creating
opportunity out of risks
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• And the other which is about minimising risks/loss and protecting

corporate assets.
The management of an organization needs to consciously decide on whether they
want their risk management function to 'manage' or 'mitigate' Risks.
• Managing risks essentially is about striking the right balance between risks
and controls and taking informed management decisions on opportunities
and threats facing an organization. Both situations, i.e. over or under
controlling risks are highly undesirable as the former means higher costs
and the latter means possible exposure to risk.
• Mitigating or minimising risks, on the other hand, means mitigating all
risks even if the cost of minimising a risk may be excessive and outweighs
the cost-benefit analysis. Further, it may mean that the opportunities are
not adequately exploited.
In the context of the risk management function, identification and management of
Risk is more prominent for the financial services sector and less so for consumer
products industry. What are the primary objectives of your risk management
function? When specifically asked in a survey conducted, 33% of respondents
stated that their risk management function is indeed expressly mandated to
optimise risk.
 Risks in Banking
Risks manifest themselves in many ways and the risks in banking are a result of
many diverse activities, executed from many locations and by numerous people.
As a financial intermediary, banks borrow funds and lend them as a part of their
primary activity. This intermediation activity, of banks exposes them to a host of
risks. The volatility in the operating environment of banks will aggravate the
effect of the various risks. The case discusses the various risks that arise due to
financial intermediation and by highlighting the need for asset-liability
management; it discusses the Gap Model for risk management.
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2. OBJECTIVE OF THE PROJECT
Objectives are the base for any work without its work can’t be done in
similar way I have kept Objectives before going for my project.
1. My basic objective is to study the risk involved in FOREX TRADING
with the latest risk management tools.
2. Understand the foreign exchange mechanism so as to use the hedging
techniques effectively.
3. To know about the Technical Analysis of the market on the basis of
different trends and Indices.
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4. Survey to check the practical use of the technical analysis for risk
management.
3. LITERATURE REVIEW
International Financial Management
(Author: P. G. Apte, IIM Beglore)
New edition incorporates the changes in markets, policy and regulatory

environment as well as conceptual and theoretical developments -- especially in
the Indian context where there have been rapid and significant economic
developments, progress towards globalization, policy initiatives, regulatory
8
changes and several new instruments since the publication of the third edition in
the year 2002.
This Book contains :

 Ten Case studies, prepared in the Indian setting, have been included for
classroom discussion
 Data on global capital flows, balance of payments, external debt, nominal
and effective exchange rates, futures and options quotes, financing in
global markets and so on have been updated.
 Examples with new products such as rupee-based currency options have
been added.
Review Excerpts:
The author has been quite clear in his use of pedagogical aids. The topics have
been properly elaborated with diagrams, graphs and models. One excellent
feature of this book is the presence of footnotes giving vital additional
information to the interested reader. The appendices at the end of chapters are
quite apt and useful for the more inquisitive students.
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4. RESEARCH METHODOLOGY
Research is a human activity based on intellectual investigation and is

aimed at discovering, interpreting and revising human knowledge on different part
of the world.
Type of Research: Exploratory

Sample Size: 30 managers
Data Source: Used primary and secondary data for analysis, interpretation and
report preparation.
Research Methodology:-
A systematic study of methods having application within a discipline for
human activity with an aim of discover, interpret and revise knowledge.
Quantitative Research:-
It is the systematic scientific investigation of qualitative properties and
phenomena and their relationship.
Methods use in quantitative research are research techniques that are used
together quantitative data – information dealing with numbers and anything that is
measurable. Statistics, tables and graphs are often used to present from qualitative
methods.
Qualitative research:-
Qualitative researchers aim to acquire an in-depth understanding of human
behaviour and the reasons that govern human behaviour.
Qualitative research relies on reasons behind various aspects of behaviour.
It investigates the why and how of decision making, not just what, where and
when.
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Primary data includes:-

1. Questionnaires
Secondary Data Collection:
 Books
 Press Releases of RBI
 Newspapers
 Websites
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5. FINANCIAL
RISKS
MARKET LIQUIDITY OPERATIONAL HUMAN

RISK RISK FACTOR RISK
RISK
CREDIT RISK LEGAL &

REGULATORY RISK
FUNDING TRADING
LIQUIDITY RISK
LIQUIDITY RISK
TRANSACTION PORTFOLIO
RISK CONCENTRATION
COUNTERPARTY
ISSUE RISK ISSUER RISK
RISK
INEREST CURRENCY COMMODITY

EQUITY RISK
RATE RISK RISK RISK
TRADING
GAP RISK
RISK
GENERAL SPECIFIC
MARKET RISK RISK
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Fig 1: Types of Financial Risk
1. MARKET RISK
Market risk is that risk that changes in financial market prices and rates will
reduce the value of the bank’s positions. Market risk for a fund is often measured
relative to a benchmark index or portfolio, is referred to as a “risk of tracking
error” market risk also includes “basis risk,” a term used in risk management
industry to describe the chance of a breakdown in the relationship between price
of a product, on the one hand, and the price of the instrument used to hedge that
price exposure on the other. The market-Var methodology attempts to capture
multiple component of market such as directional risk, convexity risk, volatility
risk, basis risk, etc.
2. CREDIT RISK
Credit risk is that risk that a change in the credit quality of a counterparty will
affect the value of a bank’s position. Default, whereby counterparty is unwilling
or unable to fulfill its contractual obligations, is the extreme case; however banks
are also exposed to the risk that the counterparty might downgraded by a rating
agency.
Credit risk is only an issue when the position is an asset, i.e., when it exhibits a
positive replacement value. In that instance if the counterparty defaults, the bank
either loses all of the market value of the position or, more commonly, the part of
the value that it cannot recover following the credit event. However, the credit
exposure induced by the replacement values of derivative instruments are
dynamic: they can be negative at one point of time, and yet become positive at a
later point in time after market conditions have changed. Therefore the banks must
examine not only the current exposure, measured by the current replacement
value, but also the profile of future exposures up to the termination of the deal.
3. LIQUIDITY RISK
Liquidity risk comprises both
• Funding liquidity risk
• Trading-related liquidity risk.
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Funding liquidity risk relates to a financial institution’s ability to raise the

necessary cash to roll over its debt, to meet the cash, margin, and collateral
requirements of counterparties, and (in the case of funds) to satisfy capital
withdrawals. Funding liquidity risk is affected by various factors such as the
maturities of the liabilities, the extent of reliance of secured sources of funding,
the terms of financing, and the breadth of funding sources, including the ability to
access public market such as commercial paper market. Funding can also be
achieved through cash or cash equivalents, “buying power,” and available credit
lines.
Trading-related liquidity risk, often simply called as liquidity risk, is the risk that
an institution will not be able to execute a transaction at the prevailing market
price because there is, temporarily, no appetite for the deal on the other side of the
market. If the transaction cannot be postponed its execution my lead to substantial
losses on position. This risk is generally very hard to quantify. It may reduce an
institution’s ability to manage and hedge market risk as well as its capacity to
satisfy any shortfall on the funding side through asset liquidation.
4. OPERATIONAL RISK
It refers to potential losses resulting from inadequate systems, management
failure, faulty control, fraud and human error. Many of the recent large losses
related to derivatives are the direct consequences of operational failure. Derivative
trading is more prone to operational risk than cash transactions because
derivatives are, by heir nature, leveraged transactions. This means that a trader can
make very large commitment on behalf of the bank, and generate huge exposure
in to the future, using only small amount of cash. Very tight controls are an
absolute necessary if the bank is to avoid huge losses.
Operational risk includes” fraud,” for example when a trader or other employee
intentionally falsifies and misrepresents the risk incurred in a transaction.
Technology risk and principally computer system risk also fall into the operational
risk category.
5. LEGAL RISK
Legal risk arises for a whole of variety of reasons. For example, counterparty
might lack the legal or regulatory authority to engage in a transaction. Legal risks
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usually only become apparent when counterparty, or an investor, lose money on a

transaction and decided to sue the bank to avoid meeting its obligations. Another
aspect of regulatory risk is the potential impact of a change in tax law on the
market value of a position.
6. HUMAN FACTOR RISK

Human factor risk is really a special form of operational risk. It relates to the
losses that may result from human errors such as pushing the wrong button on a
computer, inadvertently destroying files, or entering wrong value for the
parameter input of a model.
Market Risk
 What is Market Risk?
• Market Risk may be defined as the possibility of loss to a bank caused by
changes in the market variables. The Bank for International Settlements
(BIS) defines market risk as “the risk that the value of 'on' or 'off' balance
sheet positions will be adversely affected by movements in equity and
interest rate markets, currency exchange rates and commodity prices".
Thus, Market Risk is the risk to the bank's earnings and capital due to
changes in the market level of interest rates or prices of securities, foreign
exchange and equities, as well as the volatilities of those changes. Besides,
it is equally concerned about the bank's ability to meet its obligations as
and when they fall due. In other words, it should be ensured that the bank
is not exposed to Liquidity Risk. Thus, focus on the management of
Liquidity Risk and Market Risk, further categorized into interest rate risk,
foreign exchange risk, commodity price risk and equity price risk. An
effective market risk management framework in a bank comprises risk
identification, setting up of limits and triggers, risk monitoring, models of
analysis that value positions or measure market risk, risk reporting, etc.
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 Types of market risk
• Interest rate risk:

Interest rate risk is the risk where changes in market interest rates might adversely
affect a bank's financial condition. The immediate impact of changes in interest
rates is on the Net Interest Income (NII). A long term impact of changing interest
rates is on the bank's net worth since the economic value of a bank's assets,
liabilities and off-balance sheet positions get affected due to variation in market
interest rates. The interest rate risk when viewed from these two perspectives is
known as 'earnings perspective' and 'economic value' perspective, respectively.
Management of interest rate risk aims at capturing the risks arising from the
maturity and reprising mismatches and is measured both from the earnings and
economic value perspective.
Earnings perspective involves analyzing the impact of changes in interest rates
on accrual or reported earnings in the near term. This is measured by measuring
the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the
difference between the total interest income and the total interest expense.
Economic Value perspective involves analyzing the changes of impact on
interest on the expected cash flows on assets minus the expected cash flows on
liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk
to net worth arising from all reprising mismatches and other interest rate sensitive
positions. The economic value perspective identifies risk arising from long-term
interest rate gaps.
The management of Interest Rate Risk should be one of the critical components of
market risk management in banks. The regulatory restrictions in the past had
greatly reduced many of the risks in the banking system. Deregulation of interest
rates has, however, exposed them to the adverse impacts of interest rate risk. The
Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on
the movements of interest rates. Any mismatches in the cash flows (fixed assets or
liabilities) or reprising dates (floating assets or liabilities), expose bank's NII or
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NIM to variations. The earning of assets and the cost of liabilities are now closely
related to market interest rate volatility
Generally, the approach towards measurement and hedging of IRR varies with the
segmentation of the balance sheet. In a well functioning risk management system,
banks broadly position their balance sheet into Trading and Banking Books.
While the assets in the trading book are held primarily for generating profit on
short-term differences in prices/yields, the banking book comprises assets and
liabilities, which are contracted basically on account of relationship or for steady
income and statutory obligations and are generally held till maturity. Thus, while
the price risk is the prime concern of banks in trading book, the earnings or
economic value changes are the main focus of banking book.
• Equity price risk:
The price risk associated with equities also has two components” General market
risk” refers to the sensitivity of an instrument / portfolio value to the change in the
level of broad stock market indices.” Specific / Idiosyncratic” risk refers to that
portion of the stock’s price volatility that is determined by characteristics specific
to the firm, such as its line of business, the quality of its management, or a
breakdown in its production process. The general market risk cannot be eliminated
through portfolio diversification while specific risk can be diversified away.
• Foreign exchange risk:
Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as
a result of adverse exchange rate movements during a period in which it has an
open position, either spot or forward, or a combination of the two, in an individual
foreign currency. The banks are also exposed to interest rate risk, which arises
from the maturity mismatching of foreign currency positions. Even in cases where
spot and forward positions in individual currencies are balanced, the maturity
pattern of forward transactions may produce mismatches. As a result, banks may
suffer losses as a result of changes in premia/discounts of the currencies
concerned.
In the forex business, banks also face the risk of default of the counterparties or
settlement risk. While such type of risk crystallization does not cause principal
loss, banks may have to undertake fresh transactions in the cash/spot market for
replacing the failed transactions. Thus, banks may incur replacement cost, which
depends upon the currency rate movements. Banks also face another risk called
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time-zone risk or Herstatt risk which arises out of time-lags in settlement of one
currency in one center and the settlement of another currency in another time-
zone. The forex transactions with counterparties from another country also trigger
sovereign or country risk (dealt with in details in the guidance note on credit risk).
The three important issues that need to be addressed in this regard are:
1. Nature and magnitude of exchange risk
2. Exchange managing or hedging for adopted be to strategy>
3. The tools of managing exchange risk
• Commodity price risk:
The price of the commodities differs considerably from its interest rate risk and
foreign exchange risk, since most commodities are traded in the market in which
the concentration of supply can magnify price volatility. Moreover, fluctuations in
the depth of trading in the market (i.e., market liquidity) often accompany and
exacerbate high levels of price volatility. Therefore, commodity prices generally
have higher volatilities and larger price discontinuities.
Risk can be explained as uncertainty and is usually associated with the
unpredictability of an investment performance. All investments are subject to risk,
but some have a greater degree of risk than others. Risk is often viewed as the
potential for an investment to decrease in value.
Though quantitative analysis plays a significant role, experience, market

knowledge and judgment play a key role in proper risk management. As
complexity of financial products increase, so do the sophistication of the risk
manager’s tools.
We understand risk as a potential future loss. When we take an insurance

cover, what we are hedging is the uncertainty associated with the future events.
Financial risk can be easily stated as the potential for future cash flows (returns) to
deviate from expected cash flows (returns).
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There are various factors that give raise to this risk. Return is measured as
Wealth at T+1- Wealth at T divided by Wealth at T. Mathematically it can be
denoted as (WT+1-WT)/WT. Every aspect of management impacting profitability
and therefore cash flow or return, is a source of risk. We can say the return is the
function of:
Prices, Productivity, Market Share, Technology and Competition etc
Financial risk management Risk management is the process of measuring
risk and then developing and implementing strategies to manage that risk.
Financial risk management focuses on risks that can be managed ("hedged") using
traded financial instruments (typically changes in commodity prices, interest rates,
foreign exchange rates and stock prices). Financial risk management will also play
an important role in cash management. This area is related to corporate finance in
two ways. Firstly, firm exposure to business risk is a direct result of previous
Investment and Financing decisions. Secondly, both disciplines share the goal of
creating, or enhancing, firm value. All large corporations have risk management
teams, and small firms practice informal, if not formal, risk management.
Derivatives are the instruments most commonly used in Financial risk

management. Because unique derivative contracts tend to be costly to create and
monitor, the most cost-effective financial risk management methods usually
involve derivatives that trade on well-established financial markets. These
standard derivative instruments include options, futures contracts, forward
contracts, and swaps.
The most important element of managing risk is keeping losses small,

which is already part of your trading plan. Never give in to fear or hope when it
comes to keeping losses small.
Risk can be explained as uncertainty and is usually associated with the

unpredictability of an investment performance. All investments are subject to risk,
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but some have a greater degree of risk than others. Risk is often viewed as the
potential for an investment to decrease in value.
What is Risk Management?

Risk is anything that threatens the ability of a nonprofit to accomplish its
mission.
Risk management is a discipline that enables people and organizations to

cope with uncertainty by taking steps to protect its vital assets and resources.
But not all risks are created equal. Risk management is not just about
identifying risks; it is about learning to weigh various risks and making decisions
about which risks deserve immediate attention.
Risk management is not a task to be

completed and shelved. It is a process
that, once understood, should be
integrated into all aspects of your
organization's management.
Risk management is an essential

component in the successful management
of any project, whatever its size. It is a process that must start from the inception
of the project, and continue until the project is completed and its expected benefits
realised. Risk management is a process that is used throughout a project and its
products' life cycles. It is useable by all activities in a project. Risk management
must be focussed on the areas of highest risk within the project, with continual
monitoring of other areas of the project to identify any new or changing risks.
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Managing risk - How to manage risks

There are four ways of dealing with, or managing, each risk that you have
identified. You can:
 Accept it
 Ttransfer it
 Reduce it
 Eliminate it
For example, you may decide to accept a risk because the cost of
eliminating it completely is too high. You might decide to transfer the risk, which
is typically done with insurance. Or you may be able to reduce the risk by
introducing new safety measures or eliminate it completely by changing the way
you produce your product.
When you have evaluated and agreed on the actions and procedures to
reduce the risk, these measures need to be put in place.
Risk management is not a one-off exercise. Continuous monitoring and

reviewing is crucial for the success of your risk management approach. Such
monitoring ensures that risks have been correctly identified and assessed, and
appropriate controls put in place. It is also a way to learn from experience and
make improvements to your risk management approach.
All of this can be formalised in a risk management policy, setting out your
business' approach to and appetite for risk and its approach to risk management.
Risk management will be even more effective if you clearly assign responsibility
for it to chosen employees. It is also a good idea to get commitment to risk
management at the board level.
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Contrary to conventional wisdom, risk management is not just a matter of

running through numbers. Though quantitative analysis plays a significant role,
experience, market knowledge and judgment play a key role in proper risk
management. As complexity of financial products increase, so do the
sophistication of the risk manager's tools.
“Good risk management can improve the quality and returns of your
business.”
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6. Introduction to Foreign Exchange

Foreign Exchange is the process of conversion of one currency into
another currency. For a country its currency becomes money and legal tender. For
a foreign country it becomes the value as a commodity. Since the commodity has
a value its relation with the other currency determines the exchange value of one
currency with the other. For example, the US dollar in USA is the currency in
USA but for India it is just like a commodity, which has a value which varies
according to demand and supply.
Foreign exchange is that

section of economic activity, which
deals with the means, and methods
by which rights to wealth expressed
in terms of the currency of one
country are converted into rights to
wealth in terms of the current of
another country. It involves the
investigation of the method, which
exchanges the currency of one
country for that of another. Foreign
exchange can also be defined as the means of payment in which currencies are
converted into each other and by which international transfers are made; also the
activity of transacting business in further means.
Most countries of the world have their own currencies The US has its
dollar, France its franc, Brazil its cruziero; and India has its Rupee. Trade between
the countries involves the exchange of different currencies. The foreign exchange
market is the market in which currencies are bought & sold against each other. It
is the largest market in the world. Transactions conducted in foreign exchange
markets determine the rates at which currencies are exchanged for one another,
which in turn determine the cost of purchasing foreign goods & financial assets.
The most recent, bank of international settlement survey stated that over $900
billion were traded worldwide each day. During peak volume period, the figure
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can reach upward of US $2 trillion per day. The corresponding to 160 times the
daily volume of NYSE.
Brief History of Foreign Exchange

Initially, the value of goods was expressed in terms of other goods, i.e. an
economy based on barter between individual market participants. The obvious
limitations of such a system encouraged establishing more generally accepted
means of exchange at a fairly early stage in history, to set a common benchmark
of value. In different economies, everything from teeth to feathers to pretty stones
has served this purpose, but soon metals, in particular gold and silver, established
themselves as an accepted means of payment as well as a reliable storage of value.
Originally, coins were simply minted from the preferred metal, but in
stable political regimes the introduction of a paper form of governmental IOUs (I
owe you) gained acceptance during the middle Ages. Such IOUs, often introduced
more successfully through force than persuasion were the basis of modern
currencies.
Before the First World War, most central banks supported their currencies
with convertibility to gold. Although paper money could always be exchanged for
gold, in reality this did not occur often, fostering the sometimes disastrous notion
that there was not necessarily a need for full cover in the central reserves of the
government.
At times, the ballooning supply of paper money without gold cover led to
devastating inflation and resulting political instability. To protect local national
interests, foreign exchange controls were increasingly introduced to prevent
market forces from punishing monetary irresponsibility. In the latter stages of the
Second World War, the Bretton Woods agreement was reached on the initiative of
the USA in July 1944. The Bretton Woods Conference rejected John Maynard
Keynes suggestion for a new world reserve currency in favour of a system built on
the US dollar. Other international institutions such as the IMF, the World Bank
and GATT (General Agreement on Tariffs and Trade) were created in the same
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period as the emerging victors of WW2 searched for a way to avoid the
destabilizing monetary crises which led to the war. The Bretton Woods agreement
resulted in a system of fixed exchange rates that partly reinstated the gold
standard, fixing the US dollar at USD35/oz and fixing the other main currencies to
the dollar - and was intended to be permanent.
The Bretton Woods system came under increasing pressure as national

economies moved in different directions during the sixties. A number of
realignments kept the system alive for a long time, but eventually Bretton Woods
collapsed in the early seventies following President Nixon's suspension of the gold
convertibility in August 1971. The dollar was no longer suitable as the sole
international currency at a time when it was under severe pressure from increasing
US budget and trade deficits.
The following decades have seen foreign exchange trading develop into
the largest global market by far. Restrictions on capital flows have been removed
in most countries, leaving the market forces free to adjust foreign exchange rates
according to their perceived values.
The lack of sustainability in fixed foreign exchange rates gained new

relevance with the events in South East Asia in the latter part of 1997, where
currency after currency was devalued against the US dollar, leaving other fixed
exchange rates, in particular in South America, looking very vulnerable.
But while commercial companies have had to face a much more volatile
currency environment in recent years, investors and financial institutions have
found a new playground. The size of foreign exchange markets now dwarfs any
other investment market by a large factor. It is estimated that more than USD1,
200 billion is traded every day, far more than the world's stock and bond markets
combined.
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Fixed and Floating Exchange Rates

In a fixed exchange rate system, the government (or the central bank
acting on the government's behalf) intervenes in the currency market so that the
exchange rate stays close to an exchange rate target. When Britain joined the
European Exchange Rate Mechanism in October 1990, we fixed sterling against
other European currencies
Since autumn 1992, Britain has adopted a floating exchange rate system.
The Bank of England does not actively intervene in the currency markets to
achieve a desired exchange rate level. In contrast, the twelve members of the
Single Currency agreed to fully fix their currencies against each other in January
1999. In January 2002, twelve exchange rates become one when the Euro enters
common circulation throughout the Euro Zone.
Exchange Rates under Fixed and Floating Regimes

With floating exchange rates, changes in market demand and market
supply of a currency cause a change in value. In the diagram below we see the
effects of a rise in the demand for sterling (perhaps caused by a rise in exports or
an increase in the speculative demand for sterling). This causes an appreciation in
the value of the pound.
Fig 2: Appreciation due to Rise in Demand in Market
26
Changes in currency supply also have an effect. In the diagram below there is an
increase in currency supply (S1-S2) which puts downward pressure on the market
value of the exchange rate.
Fig 3: Appreciation and Depreciation
A currency can operate under one of four main types of exchange rate system
FREE FLOATING
 Value of the currency is determined solely by market demand for
and supply of the currency in the foreign exchange market.
 Trade flows and capital flows are the main factors affecting the
exchange rate In the long run it is the macro economic performance of the
economy (including trends in competitiveness) that drives the value of the
currency. No pre-determined official target for the exchange rate is set by the
Government. The government and/or monetary authorities can set interest
rates for domestic economic purposes rather than to achieve a given exchange
rate target.
 It is rare for pure free floating exchange rates to exist – most
governments at one time or another seek to “manage” the value of their
currency through changes in interest rates and other controls.
 UK sterling has floated on the foreign exchange markets since the
UK suspended membership of the ERM in September 1992
MANAGED FLOATING EXCHANGE RATES
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 Value of the pound determined by market demand for and supply

of the currency with no pre-determined target for the exchange rate is set by
the Government
 Governments normally engage in managed floating if not part of a
fixed exchange rate system.
 Policy pursued from 1973-90 and since the ERM suspension from
1993-1998.
SEMI-FIXED EXCHANGE RATES

 Exchange rate is given a specific target
 Currency can move between permitted bands of fluctuation
 Exchange rate is dominant target of economic policy-making
(interest rates are set to meet the target)
 Bank of England may have to intervene to maintain the value of the
currency within the set targets
 Re-valuations possible but seen as last resort
 October 1990 – September 1992 during period of ERM
membership
FULLY-FIXED EXCHANGE RATES

 Commitment to a single fixed exchange rate
 Achieves exchange rate stability but perhaps at the expense of
domestic economic stability
 Bretton-Woods System 1944-1972 where currencies were tied to
the US dollar
 Gold Standard in the inter-war years – currencies linked with gold
 Countries joining EMU in 1999 have fixed their exchange rates
until the year 2002
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Exchange Rate Systems in Different Countries

The member countries generally accept the IMF classification of exchange
rate regime, which is based on the degree of exchange rate flexibility that a
particular regime reflects. The exchange rate arrangements adopted by the
developing countries cover a broad spectrum, which are as follows:
⇒ Single Currency Peg

The country pegs to a major currency, usually the U. S. Dollar or the
French franc (Ex-French colonies) with infrequent adjustment of the parity. Many
of the developing countries have single currency pegs.
⇒ Composite Currency Peg
A currency composite is formed by taking into account the currencies of
major trading partners. The objective is to make the home currency more stable
than if a single peg was used. Currency weights are generally based on trade in
goods – exports, imports, or total trade. About one fourth of the developing
countries have composite currency pegs.
⇒ Flexible Limited vis-à-vis Single Currency
The value of the home currency is maintained within margins of the peg.
Some of the Middle Eastern countries have adopted this system.
⇒ Adjusted to indicators
The currency is adjusted more or less automatically to changes in selected
macro-economic indicators. A common indicator is the real effective exchange
rate (REER) that reflects inflation adjusted change in the home currency vis-à-vis
major trading partners.
⇒ Managed floating
The Central Bank sets the exchange rate, but adjusts it frequently
according to certain pre-determined indicators such as the balance of payments
position, foreign exchange reserves or parallel market spreads and adjustments are
not automatic.
⇒ Independently floating
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Free market forces determine exchange rates. The system actually operates
with different levels of intervention in foreign exchange markets by the central
bank. It is important to note that these classifications do conceal several features
of the developing country exchange rate regimes.
30
Need and Importance of Foreign Exchange
Markets
Foreign exchange markets represent by far the most important financial

markets in the world. Their role is of paramount importance in the system of
international payments. In order to play their role effectively, it is necessary that
their operations/dealings be reliable. Reliability essentially is concerned with
contractual obligations being honored. For instance, if two parties have entered
into a forward sale or purchase of a currency, both of them should be willing to
honour their side of contract by delivering or taking delivery of the currency, as
the case may be.
Why Trade Foreign Exchange?

Foreign Exchange is the prime market in the world. Take a look at any
market trading through the civilised world and you will see that everything is
valued in terms of money. Fast becoming recognised as the world’s premier
trading venue by all styles of traders, foreign exchange (forex) is the world’s
largest financial market with more than US$2 trillion traded daily. Forex is a
great market for the trader and it’s where “big boys” trade for large profit potential
as well as commensurate risk for speculators.
Forex used to be the exclusive domain of the world’s largest banks and
corporate establishments. For the first time in history, it’s barrier-free offering an
equal playing-field for the emerging number of traders eager to trade the world’s
largest, most liquid and accessible market, 24 hours a day. Trading forex can be
done with many different methods and there are many types of traders – from
fundamental traders speculating on mid-to-long term positions to the technical
trader watching for breakout patterns in consolidating markets.
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Consolidation & Fragmentation Of Fx Markets
2006 continues to provide dramatic evidence of the rapid transformation

that is sweeping the vast and growing FX asset class that now exceeds $2 trillion
in daily volume. Significant investments are being made on the part of banks,
brokerages, exchanges and vendors – individually and in joint ventures – to
automate, systematize and consolidate what has historically been a manual,
fragmented and decentralized collection of trading venues. Combine this with the
shifting ownership of the major FX trading exchanges, and one needs a scorecard
to keep track of the players, their strategies and target markets. Fragmentation in
markets results from competition based on business and technology innovations.
As markets centralize or consolidate to gain scale, certain segments become
underserved and are open to alternative trading venues that more specifically meet
their trading needs.
Opportunities From Around the World

Over the last three decades the foreign exchange market has become the
world’s largest financial market, with over $2 trillion USD traded daily. Forex is
part of the bank-to-bank currency market known as the 24-hour interbank market.
The Interbank market literally follows the sun around the world, moving from
major banking centres of the United States to Australia, New Zealand to the Far
East, to Europe then back to the United States.
Functions of Foreign Exchange Market

The foreign exchange market is a market in which foreign exchange
transactions take place. In other words, it is a market in which national currencies
are bought and sold against one another.
A foreign exchange market performs three important functions:
⇒ Transfer of Purchasing Power:
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The primary function of a foreign exchange market is the transfer of

purchasing power from one country to another and from one currency to another.
The international clearing function performed by foreign exchange markets plays
a very important role in facilitating international trade and capital movements.
⇒ Provision of Credit:
The credit function performed by foreign exchange markets also plays a
very important role in the growth of foreign trade, for international trade depends
to a great extent on credit facilities. Exporters may get pre-shipment and post-
shipment credit. Credit facilities are available also for importers. The Euro-dollar
market has emerged as a major international credit market.
⇒ Provision of Hedging Facilities:
The other important function of the foreign exchange market is to provide
hedging facilities. Hedging refers to covering of export risks, and it provides a
mechanism to exporters and importers to guard themselves against losses arising
from fluctuations in exchange rates.
Advantages of Forex Market

Although the forex market is by far the largest and most liquid in the
world, day traders have up to now focus on seeking profits in mainly stock and
futures markets. This is mainly due to the restrictive nature of bank-offered forex
trading services. Advanced Currency Markets (ACM) offers both online and
traditional phone forex-trading services to the small investor with minimum
account opening values starting at 5000 USD.
There are many advantages to trading spot foreign exchange as opposed to

trading stocks and futures. Below are listed those main advantages.
⇒ Commissions:
ACM offers foreign exchange trading commission free. This is in sharp
contrast to (once again) what stock and futures brokers offer. A stock trade can
cost anywhere between USD 5 and 30 per trade with online brokers and typically
up to USD 150 with full service brokers. Futures brokers can charge commissions
anywhere between USD 10 and 30 on a round turn basis.
⇒ Margins requirements:
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ACM offers a foreign exchange trading with a 1% margin. In layman’s

terms that means a trader can control a position of a value of USD 1’000’000 with
a mere USD 10’000 in his account. By comparison, futures margins are not only
constantly changing but are also often quite sizeable. Stocks are generally traded
on a non-margined basis and when they are, it can be as restrictive as 50% or so.
⇒ 24 hour market:
Foreign exchange market trading occurs over a 24 hour period picking up
in Asia around 24:00 CET Sunday evening and coming to an end in the United
States on Friday around 23:00 CET. Although ECNs (electronic communications
networks) exist for stock markets and futures markets (like Globex) that supply
after hours trading, liquidity is often low and prices offered can often be
uncompetitive.
⇒ No Limit up / limit down:
Futures markets contain certain constraints that limit the number and type
of transactions a trader can make under certain price conditions. When the price of
a certain currency rises or falls beyond a certain pre-determined daily level traders
are restricted from initiating new positions and are limited only to liquidating
existing positions if they so desire. This mechanism is meant to control daily price
volatility but in effect since the futures currency market follows the spot market
anyway, the following day the futures market may undergo what is called a ‘gap’
or in other words the futures price will re-adjust to the spot price the next day. In
the OTC market no such trading constraints exist permitting the trader to truly
implement his trading strategy to the fullest extent. Since a trader can protect his
position from large unexpected price movements with stop-loss orders the high
volatility in the spot market can be fully controlled.
⇒ Sell before you buy:
Equity brokers offer very restrictive short-selling margin requirements to
customers. This means that a customer does not possess the liquidity to be able to
sell stock before he buys it. Margin wise, a trader has exactly the same capacity
when initiating a selling or buying position in the spot market. In spot trading
when you’re selling one currency, you’re necessarily buying another.
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The Role of Forex in the Global Economy
Over time, the foreign exchange market has been an invisible hand that
guides the sale of goods, services and raw materials on every corner of the globe.
The forex market was created by necessity. Traders, bankers, investors, importers
and exporters recognized the benefits of hedging risk, or speculating for profit.
The fascination with this market comes from its sheer size, complexity and almost
limitless reach of influence.
The market has its own momentum, follows its own imperatives, and
arrives at its own conclusions. These conclusions impact the value of all assets –it
is crucial for every individual or institutional investor to have an understanding of
the foreign exchange markets and the forces behind this ultimate free-market
system.
Inter-bank currency contracts and options, unlike futures contracts, are not
traded on exchanges and are not standardized. Banks and dealers act as principles
in these markets, negotiating each transaction on an individual basis. Forward
“cash” or “spot” trading in currencies is substantially unregulated – there are no
limitations on daily price movements or speculative positions.
35
The Organisation & Structure of FEM Is Given In

the Figure Below –
Fig 4: Organisation and Structure of FEM
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Main Participants In Foreign Exchange Markets
There are four levels of participants in the foreign exchange market.
At the first level, are tourists, importers, exporters, investors, and so on.
These are the immediate users and suppliers of foreign currencies. At the second
level, are the commercial banks, which act as clearing houses between users and
earners of foreign exchange. At the third level, are foreign exchange brokers
through whom the nation’s commercial banks even out their foreign exchange
inflows and outflows among themselves. Finally at the fourth and the highest
level is the nation’s central bank, which acts as the lender or buyer of last resort
when the nation’s total foreign exchange earnings and expenditure are unequal.
The central then either draws down its foreign reserves or adds to them.
CUSTOMERS:
The customers who are engaged in foreign trade participate in foreign
exchange markets by availing of the services of banks. Exporters require
converting the dollars into rupee and importers require converting rupee into the
dollars as they have to pay in dollars for the goods / services they have imported.
Similar types of services may be required for setting any international obligation
i.e., payment of technical know-how fees or repayment of foreign debt, etc.
COMMERCIAL BANKS
They are most active players in the forex market. Commercial banks
dealing with international transactions offer services for conversation of one
currency into another. These banks are specialised in international trade and other
transactions. They have wide network of branches. Generally, commercial banks
act as intermediary between exporter and importer who are situated in different
countries. Typically banks buy foreign exchange from exporters and sells foreign
exchange to the importers of the goods. Similarly, the banks for executing the
orders of other customers, who are engaged in international transaction, not
necessarily on the account of trade alone, buy and sell foreign exchange. As every
time the foreign exchange bought and sold may not be equal banks are left with
the overbought or oversold position. If a bank buys more foreign exchange than
37
what it sells, it is said to be in ‘overbought/plus/long position’. In case bank sells

more foreign exchange than what it buys, it is said to be in ‘oversold/minus/short
position’. The bank, with open position, in order to avoid risk on account of
exchange rate movement, covers its position in the market. If the bank is having
oversold position it will buy from the market and if it has overbought position it
will sell in the market. This action of bank may trigger a spate of buying and
selling of foreign exchange in the market. Commercial banks have following
objectives for being active in the foreign exchange market:
 They render better service by offering competitive rates to their customers

engaged in international trade.
 They are in a better position to manage risks arising out of exchange rate
fluctuations.
 Foreign exchange business is a profitable activity and thus such banks are
in a position to generate more profits for themselves.
 They can manage their integrated treasury in a more efficient manner.
CENTRAL BANKS
In most of the countries central bank has been charged with the
responsibility of maintaining the external value of the domestic currency. If the
country is following a fixed exchange rate system, the central bank has to take
necessary steps to maintain the parity, i.e., the rate so fixed. Even under floating
exchange rate system, the central bank has to ensure orderliness in the movement
of exchange rates. Generally this is achieved by the intervention of the bank.
Sometimes this becomes a concerted effort of central banks of more than one
country.
Apart from this central banks deal in the foreign exchange market for the
following purposes:
38
 Exchange rate management:

Though sometimes this is achieved through intervention, yet where a
central bank is required to maintain external rate of domestic currency at a level or
in a band so fixed, they deal in the market to achieve the desired objective
 Reserve management:
Central bank of the country is mainly concerned with the investment of the
countries foreign exchange reserve in stable proportions in range of currencies and
in a range of assets in each currency. These proportions are, inter alias, influenced
by the structure of official external assets/liabilities. For this bank has involved
certain amount of switching between currencies.
Central banks are conservative in their approach and they do not deal in
foreign exchange markets for making profits. However, there have been some
aggressive central banks but market has punished them very badly for their
adventurism. In the recent past Malaysian Central bank, Bank Negara lost billions
of dollars in foreign exchange transactions.
 Intervention by Central Bank
It is truly said that foreign exchange is as good as any other commodity. If

a country is following floating rate system and there are no controls on capital
transfers, then the exchange rate will be influenced by the economic law of
demand and supply. If supply of foreign exchange is more than demand during a
particular period then the foreign exchange will become cheaper. On the contrary,
if the supply is less than the demand during the particular period then the foreign
exchange will become costlier. The exporters of goods and services mainly supply
foreign exchange to the market. If there are no control over foreign investors are
also suppliers of foreign exchange.
During a particular period if demand for foreign exchange increases than

the supply, it will raise the price of foreign exchange, in terms of domestic
39
currency, to an unrealistic level. This will no doubt make the imports costlier and
thus protect the domestic industry but this also gives boost to the exports.
However, in the short run it can disturb the equilibrium and orderliness of the
foreign exchange markets. The central bank will then step forward to supply
foreign exchange to meet the demand for the same. This will smoothen the
market. The central bank achieves this by selling the foreign exchange and buying
or absorbing domestic currency. Thus demand for domestic currency which,
coupled with supply of foreign exchange, will maintain the price of foreign
currency at desired level. This is called ‘intervention by central bank’.
If a country, as a matter of policy, follows fixed exchange rate system, the

central bank is required to maintain exchange rate generally within a well-defined
narrow band. Whenever the value of the domestic currency approaches upper or
lower limit of such a band, the central bank intervenes to counteract the forces of
demand and supply through intervention.
In India, the central bank of the country, the Reserve Bank of India, has
been enjoined upon to maintain the external value of rupee. Until March 1, 1993,
under section 40 of the Reserve Bank of India act, 1934, Reserve Bank was
obliged to buy from and sell to authorised persons i.e., AD’s foreign exchange.
However, since March 1, 1993, under Modified Liberalised Exchange Rate
Management System (Modified LERMS), Reserve Bank is not obliged to sell
foreign exchange. Also, it will purchase foreign exchange at market rates. Again,
with a view to maintain external value of rupee, Reserve Bank has given the right
to intervene in the foreign exchange markets.
EXCHANGE BROKERS
Forex brokers play a very important role in the foreign exchange markets.
However the extent to which services of forex brokers are utilized depends on the
tradition and practice prevailing at a particular forex market centre. In India
dealing is done in interbank market through forex brokers. In India as per FEDAI
guidelines the AD’s are free to deal directly among themselves without going
40
through brokers. The forex brokers are not allowed to deal on their own account
all over the world and also in India.
 How Exchange Brokers Work?
Banks seeking to trade display their bid and offer rates on their respective
pages of Reuters screen, but these prices are indicative only. On inquiry from
brokers they quote firm prices on telephone. In this way, the brokers can locate the
most competitive buying and selling prices, and these prices are immediately
broadcast to a large number of banks by means of hotlines/loudspeakers in the
banks dealing room/contacts many dealing banks through calling assistants
employed by the broking firm. If any bank wants to respond to these prices thus
made available, the counter party bank does this by clinching the deal. Brokers do
not disclose counter party bank’s name until the buying and selling banks have
concluded the deal. Once the deal is struck the broker exchange the names of the
bank who has bought and who has sold. The brokers charge commission for the
services rendered.
In India broker’s commission is fixed by FEDAI.
SPECULATORS
Speculators play a very active role in the foreign exchange markets. In fact
major chunk of the foreign exchange dealings in forex markets in on account of
speculators and speculative activities.
The speculators are the major players in the forex markets.
Banks dealing are the major speculators in the forex markets with a view
to make profit on account of favourable movement in exchange rate, take position
i.e., if they feel the rate of particular currency is likely to go up in short term. They
buy that currency and sell it as soon as they are able to make a quick profit.
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Corporations particularly Multinational Corporations and Transnational

Corporations having business operations beyond their national frontiers and on
account of their cash flows. Being large and in multi-currencies get into foreign
exchange exposures. With a view to take advantage of foreign rate movement in
their favour they either delay covering exposures or does not cover until cash flow
materialize. Sometimes they take position so as to take advantage of the exchange
rate movement in their favour and for undertaking this activity, they have state of
the art dealing rooms. In India, some of the big corporate are as the exchange
control have been loosened, booking and cancelling forward contracts, and a times
the same borders on speculative activity.
Governments narrow or invest in foreign securities and delay coverage of

the exposure on account of such deals.
Individual like share dealings also undertake the activity of buying and
selling of foreign exchange for booking short-term profits. They also buy foreign
currency stocks, bonds and other assets without covering the foreign exchange
exposure risk. This also results in speculations.
Corporate entities take positions in commodities whose prices are

expressed in foreign currency. This also adds to speculative activity.
The speculators or traders in the forex market cause significant swings

in foreign exchange rates. These swings, particular sudden swings, do not do any
good either to the national or international trade and can be detrimental not only to
national economy but global business also. However, to be far to the speculators,
they provide the much need liquidity and depth to foreign exchange markets. This
is necessary to keep bid-offer which spreads to the minimum. Similarly, liquidity
also helps in executing large or unique orders without causing any ripples in the
foreign exchange markets. One of the views held is that speculative activity
provides much needed efficiency to foreign exchange markets. Therefore we can
say that speculation is necessary evil in forex markets.
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Fundamentals in Exchange Rate
Typically, rupee (INR) a legal lender in India as exporter needs Indian

rupees for payments for procuring various things for production like land, labour,
raw material and capital goods. But the foreign importer can pay in his home
currency like, an importer in New York, would pay in US dollars (USD). Thus it
becomes necessary to convert one currency into another currency and the rate at
which this conversation is done, is called ‘Exchange Rate’.
Exchange rate is a rate at which one currency can be exchange in to

another currency, say USD 1 = Rs. 42. This is the rate of conversion of US dollar
in to Indian rupee and vice versa.
METHODS OF QUOTING EXCHANGE RATES
There are two methods of quoting exchange rates.
 Direct method:
For change in exchange rate, if foreign currency is kept constant and home
currency is kept variable, then the rates are stated be expressed in ‘Direct
Method’ E.g. US $1 = Rs. 49.3400.
 Indirect method:
For change in exchange rate, if home currency is kept constant and foreign
currency is kept variable, then the rates are stated be expressed in ‘Indirect
Method’. E.g. Rs. 100 = US $ 2.0268
In India, with the effect from August 2, 1993, all the exchange rates are quoted in
direct method, i.e.
US $1 = Rs. 49.3400 GBP1 = Rs. 69.8700
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 Method of Quotation
It is customary in foreign exchange market to always quote tow rates

means one rate for buying and another for selling. This helps in
eliminating the risk of being given bad rates i.e. if a party comes to know
what the other party intends to do i.e., buy or sell, the former can take the
latter for a ride.
There are two parties in an exchange deal of currencies. To initiate the deal
one party asks for quote from another party and the other party quotes a rate. The
party asking for a quote is known as ‘Asking party’ and the party giving quote is
known as ‘Quoting party’
THE ADVANTAGE OF TWO-WAY QUOTE IS AS UNDER:
 The market continuously makes available price for buyers and sellers.
 Two-way price limits the profit margin of the quoting bank and
comparison of one quote with another quote can be done instantaneously.
 As it is not necessary any player in the market to indicate whether he
intends to buy of sell foreign currency, this ensures that the quoting bank
cannot take advantage by manipulating the prices.
 It automatically ensures alignment of rates with market rates.
 Two-way quotes lend depth and liquidity to the market, which is so very
essential for efficient.
In two-way quotes the first rate is the rate for buying and another rate is
for selling. We should understand here that, in India, the banks, which are
authorized dealers, always quote rates. So the rates quote – buying and selling is
for banks will buy the dollars from him so while calculation the first rate will be
used which is a buying rate, as the bank is buying the dollars from the exporter.
The same case will happen inversely with the importer, as he will buy the dollars
form the banks and bank will sell dollars to importer.
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BASE CURRENCY
Although a foreign currency can be bought and sold in the same way as a
commodity, but they’re us a slight difference in buying/selling of currency aid
commodities. Unlike in case of commodities, in case of foreign currencies two
currencies are involved. Therefore, it is necessary to know which the currency to
be bought and sold is and the same is known as ‘Base Currency’.
BID &OFFER RATES

The buying and selling rates are also referred to as the bid and offered
rates. In the dollar exchange rates referred to above, namely, $ 1.6290/98, the
quoting bank is offering (selling) dollars at $ 1.6290 per pound while bidding for
them (buying) at $ 1.6298. In this quotation, therefore, the bid rate for dollars is $
1.6298 while the offered rate is $ 1.6290. The bid rate for one currency is
automatically the offered rate for the other. In the above example, the bid rate for
dollars, namely $ 1.6298, is also the offered rate of pounds.
CROSS RATE CALCULATION

Most trading in the world forex markets is in the terms of the US dollar –
in other words, one leg of most exchange trades is the US currency. Therefore,
margins between bid and offered rates are lowest quotations if the US dollar. The
margins tend to widen for cross rates, as the following calculation would show.
Consider the following structure:
GBP 1.00 = USD 1.6290/98

EUR 1.00 = USD 1.1276/80
In this rate structure, we have to calculate the bid and offered rates for the
euro in terms of pounds. Let us see how the offered (selling) rate for euro can be
calculated. Starting with the pound, you will have to buy US dollars at the offered
45
rate of USD 1.6290 and buy euros against the dollar at the offered rate for euro at
USD 1.1280. The offered rate for the euro in terms of GBP, therefore, becomes
EUR (1.6290*1.1280), i.e. EUR 1.4441 per GBP, or more conventionally, GBP
0.6925 per euro. Similarly, the bid rate the euro can be seen to be EUR 1.4454 per
GBP (or GBP 0.6918 per euro). Thus, the quotation becomes GBP 1.00 = EUR
1.4441/54. It will be readily noticed that, in percentage terms, the difference
between the bid and offered rate is higher for the EUR: pound rate as compared to
dollar: EUR or pound: dollar rates.
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Dealing in Forex Market
The transactions on exchange markets are carried out among banks. Rates
are quoted round the clock. Every few seconds, quotations are updated.
Quotations start in the dealing room of Australia and Japan (Tokyo) and they pass
on to the markets of Hong Kong, Singapore, Bahrain, Frankfurt, Zurich, Paris,
London, New York, San Francisco and Los Angeles, before restarting.
In terms of convertibility, there are mainly three kinds of currencies. The

first kind is fully convertible in that it can be freely converted into other
currencies; the second kind is only partly convertible for non-residents, while the
third kind is not convertible at all. The last holds true for currencies of a large
number of developing countries.
It is the convertible currencies, which are mainly quoted on the foreign

exchange markets. The most traded currencies are US dollar, Deutschmark,
Japanese Yen, Pound Sterling, Swiss franc, French franc and Canadian dollar.
Currencies of developing countries such as India are not yet in much demand
internationally. The rates of such currencies are quoted but their traded volumes
are insignificant.
As regards the counterparties, gives a typical distribution of different

agents involved in the process of buying or selling. It is clear, the maximum
buying or selling is done through exchange brokers.
The composition of transactions in terms of different instruments varies

with time. Spot transactions remain to be the most important in terms of volume.
Next come Swaps, Forwards, Options and Futures in that order.
DEALING ROOM
All the professionals who deal in Currencies, Options, Futures and Swaps
assemble in the Dealing Room. This is the forum where all transactions related to
foreign exchange in a bank are carried out. There are several reasons for
47
concentrating the entire information and communication system in a single room.

It is necessary for the dealers to have instant access to the rates quoted at different
places and to be able to communicate amongst themselves, as well as to know the
limits of each counterparty etc. This enables them to make arbitrage gains,
whenever possible. The dealing room chief manages and co-ordinates all the
activities and acts as linkpin between dealers and higher management.
THE DEALING ARENA
The range of products available in the FX market has increased

dramatically over the last 30 years. Dealers at banks provide these products for
their clients to allow them to invest, speculate or hedge.
The complex nature of these products , combined with huge volumes of

money that are being traded, mean banks must have three important functions set
up in order to record and monitor effectively their trades.
THE FRONT OFFICE AND THE BACK OFFICE

It would be appropriate to know the other two terms used in connection
with dealing rooms. These are Front Office and Back Office. The dealers who
work directly in the market and are located in the Dealing Rooms of big banks
constitute the Front Office. They meet the clients regularly and advise them
regarding the strategy to be adopted with regard to their treasury management.
The role of the Front Office is to make profit from the operations on currencies.
The role of dealers is twofold: to manage the positions of clients and to quote bid-
ask rates without knowing whether a client is a buyer or seller. Dealers should be
ready to buy or sell as per the wishes of the clients and make profit for the bank.
They should take into account the position that the bank has already taken, and the
effect that a particular operation might have on that position. They also need to
consider the limits fixed by the Management of the bank with respect to each
single operation or single counterparty or position in a particular currency. Dealers
are judged on the basis of their profitability.
The operations of front office are divided into several units. There can be
sections for money markets and interest rate operations, for spot rate transactions,
48
for forward market transactions, for currency options, for dealing in futures and so
on. Each transaction involves determination of amount exchanged, fixation of an
exchange rate, indication of the date of settlement and instructions regarding
delivery.
The Back Office consists of a group of persons who work, so to say,

behind the Front Office. Their activities include managing of the information
system, accounting, control, administration, and follow-up of the operations of
Front Office. The Back Office helps the Front Office so that the latter is rid of
jobs other than the operations on market. It should conceive of better information
and control system relating to financial operations. It ensures, in a way, an
effective financial and management control of market operations. In principle, the
Front Office and Back Office should function in a symbiotic manner, on equal
footing.
All the professionals who deal in Currencies, Options, Futures and Swaps
assemble in the Dealing Room. This is the forum where all transactions related to
foreign exchange in a bank are carried out. There are several reasons for
concentrating the entire information and communication system in a single room.
It is necessary for the dealers to have instant access to the rates quoted at different
places and to be able to communicate amongst themselves, as well as to know the
limits of each counterparty etc. This enables them to make arbitrage gains,
whenever possible. The dealing room chief manages and co-ordinates all the
activities and acts as linkpin between dealers and higher management.
49
FOREX MARKETS V/S OTHER MARKETS
FOREX MARKETS OTHER MARKETS

The Forex market is open 24 hours a Limited floor trading hours dictated by
day, 5.5 days a week. Because of the the time zone of the trading location,
decentralised clearing of trades and significantly restricting the number of
overlap of major markets in Asia, hours a market is open and when it can
London and the United States, the be accessed.
market remains open and liquid
throughout the day and overnight.
Most liquid market in the world Threat of liquidity drying up after
eclipsing all others in comparison. Most market hours or because many market
transactions must continue, since participants decide to stay on the
currency exchange is a required sidelines or move to more popular
mechanism needed to facilitate world markets.
commerce.
Commission-Free Traders are gouged with fees, such as
commissions, clearing fees, exchange
fees and government fees.
One consistent margin rate 24 hours a Large capital requirements, high margin
day allows Forex traders to leverage rates, restrictions on shorting, very little
their capital more efficiently with as autonomy.
high as 100-to-1 leverage.
No Restrictions Short selling and stop order restrictions.
Table 1
7. FOREX EXCHANGE RISK
50
Any business is open to risks from movements in competitors’ prices, raw

material prices, competitors’ cost of capital, foreign exchange rates and interest
rates, all of which need to be (ideally) managed.
This section addresses the

task of managing exposure to
Foreign Exchange movements.
These Risk Management

Guidelines are primarily an
enunciation of some good and
prudent practices in exposure management. They have to be understood, and
slowly internalised and customised so that they yield positive benefits to the
company over time.
It is imperative and advisable for the Apex Management to both be aware

of these practices and approve them as a policy. Once that is done, it becomes
easier for the Exposure Managers to get along efficiently with their task.
Forex Risk Statements

The risk of loss in trading foreign exchange can be substantial. You should
therefore carefully consider whether such trading is suitable in light of your
financial condition. You may sustain a total loss of funds and any additional funds
that you deposit with your broker to maintain a position in the foreign exchange
market. Actual past performance is no guarantee of future results. There are
numerous other factors related to the markets in general or to the implementation
of any specific trading program which cannot be fully accounted for in the
preparation of hypothetical performance results and all of which can adversely
affect actual trading results.
The risk of loss in trading the foreign exchange markets can be

substantial. You should therefore carefully consider whether such trading is
suitable for you in light of your financial condition. In considering whether to
51
trade or authorize someone else to trade for you, you should be aware of the
following:
If you purchase or sell a foreign exchange option you may sustain a

total loss of the initial margin funds and additional funds that you deposit with
your broker to establish or maintain your position. If the market moves against
your position, you could be called upon by your broker to deposit additional
margin funds, on short notice, in order to maintain your position. If you do not
provide the additional required funds within the prescribed time, your position
may be liquidated at a loss, and you would be liable for any resulting deficit in
you account.
Under certain market conditions, you may find it difficult or

impossible to liquidate a position. This can occur, for example when a currency
is deregulated or fixed trading bands are widened. Potential currencies include,
but are not limited to the Thai Baht, South Korean Won, Malaysian Ringitt,
Brazilian Real, and Hong Kong Dollar.
The placement of contingent orders by you or your trading advisor, such

as a “stop-loss” or “stop-limit” orders, will not necessarily limit your losses to the
intended amounts, since market conditions may make it impossible to execute
such orders.
A “spread” position may not be less risky than a simple “long” or “short”
position.
The high degree of leverage that is often obtainable in foreign exchange

trading can work against you as well as for you. The use of leverage can lead to
large losses as well as gains.
In some cases, managed accounts are subject to substantial charges for

management and advisory fees. It may be necessary for those accounts that are
subject to these charges to make substantial trading profits to avoid depletion or
exhaustion of their assets.
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Currency trading is speculative and volatile Currency prices are highly

volatile. Price movements for currencies are influenced by, among other things:
changing supply-demand relationships; trade, fiscal, monetary, exchange control
programs and policies of governments; United States and foreign political and
economic events and policies; changes in national and international interest rates
and inflation; currency devaluation; and sentiment of the market place. None of
these factors can be controlled by any individual advisor and no assurance can be
given that an advisor’s advice will result in profitable trades for a partic0pating
customer or that a customer will not incur losses from such events.
Currency trading can be highly leveraged The low margin deposits

normally required in currency trading (typically between 3%-20% of the value of
the contract purchased or sold) permits extremely high degree leverage.
Accordingly, a relatively small price movement in a contract may result in
immediate and substantial losses to the investor. Like other leveraged investments,
in certain markets, any trade may result in losses in excess of the amount invested.
Currency trading presents unique risks The interbank market consists

of a direct dealing market, in which a participant trades directly with a
participating bank or dealer, and a brokers’ market. The brokers’ market differs
from the direct dealing market in that the banks or financial institutions serve as
intermediaries rather than principals to the transaction. In the brokers’ market,
brokers may add a commission to the prices they communicate to their customers,
or they may incorporate a fee into the quotation of price.
Trading in the interbank markets differs from trading in futures or

futures options in a number of ways that may create additional risks. For example,
there are no limitations on daily price moves in most currency markets. In
addition, the principals who deal in interbank markets are not required to continue
to make markets. There have been periods during which certain participants in
interbank markets have refused to quote prices for interbank trades or have quoted
prices with unusually wide spreads between the price at which transactions occur.
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Frequency of trading; degree of leverage used It is impossible to predict

the precise frequency with which positions will be entered and liquidated. Foreign
exchange trading , due to the finite duration of contracts, the high degree of
leverage that is attainable in trading those contracts, and the volatility of foreign
exchange prices and markets, among other things, typically involves a much
higher frequency of trading and turnover of positions than may be found in other
types of investments. There is nothing in the trading methodology which
necessarily precludes a high frequency of trading for accounts managed.
Foreign Exchange Exposure

Foreign exchange risk is related to the variability of the domestic currency
values of assets, liabilities or operating income due to unanticipated changes in
exchange rates, whereas foreign exchange exposure is what is at risk. Foreign
currency exposure and the attendant risk arise whenever a business has an income
or expenditure or an asset or liability in a currency other than that of the balance-
sheet currency. Indeed exposures can arise even for companies with no income,
expenditure, asset or liability in a currency different from the balance-sheet
currency. When there is a condition prevalent where the exchange rates become
extremely volatile the exchange rate movements destabilize the cash flows of a
business significantly. Such destabilization of cash flows that affects the
profitability of the business is the risk from foreign currency exposures.
We can define exposure as the degree to which a company is affected by

exchange rate changes. But there are different types of exposure, which we must
consider.
Adler and Dumas defines foreign exchange exposure as ‘the sensitivity of

changes in the real domestic currency value of assets and liabilities or operating
income to unanticipated changes in exchange rate’.
In simple terms, definition means that exposure is the amount of assets; liabilities
and operating income that is ay risk from unexpected changes in exchange rates.
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Types of Foreign Exchange Risks\ Exposure

There are two sorts of foreign exchange risks or exposures. The term
exposure refers to the degree to which a company is affected by exchange rate
changes.
 Transaction Exposure
 Translation exposure (Accounting exposure)
 Economic Exposure
 Operating Exposure
TRANSACTION EXPOSURE:
Transaction exposure is the exposure that arises from foreign currency

denominated transactions which an entity is committed to complete. It arises from
contractual, foreign currency, future cash flows. For example, if a firm has entered
into a contract to sell computers at a fixed price denominated in a foreign
currency, the firm would be exposed to exchange rate movements till it receives
the payment and converts the receipts into domestic currency. The exposure of a
company in a particular currency is measured in net terms, i.e. after netting off
potential cash inflows with outflows.
Suppose that a company is exporting deutsche mark and while costing the
transaction had reckoned on getting say Rs 24 per mark. By the time the exchange
transaction materializes i.e. the export is effected and the mark sold for rupees, the
exchange rate moved to say Rs 20 per mark. The profitability of the export
transaction can be completely wiped out by the movement in the exchange rate.
Such transaction exposures arise whenever a business has foreign currency
denominated receipt and payment. The risk is an adverse movement of the
exchange rate from the time the transaction is budgeted till the time the exposure
55
is extinguished by sale or purchase of the foreign currency against the domestic

currency.
Transaction exposure is inherent in all foreign currency denominated

contractual obligations/transactions. This involves gain or loss arising out of the
various types of transactions that require settlement in a foreign currency. The
transactions may relate to cross-border trade in terms of import or export of goods,
the borrowing or lending in foreign currencies, domestic purchases and sales of
goods and services of the foreign subsidiaries and the purchase of asset or take
over of the liability involving foreign currency. The actual profit the firm earns or
loss it suffers, of course, is known only at the time of settlement of these
transactions.
It is worth mentioning that the firm’s balance sheet already contains items
reflecting transaction exposure; the notable items in this regard are debtors
receivable in foreign currency, creditors payable in foreign currency, foreign loans
and foreign investments. While it is true that transaction exposure is applicable to
all these foreign transactions, it is usually employed in connection with foreign
trade, that is, specific imports or exports on open account credit. Example
illustrates transaction exposure.
Example
Suppose an Indian importing firm purchases goods from the USA,
invoiced in US$ 1 million. At the time of invoicing, the US dollar exchange rate
was Rs 47.4513. The payment is due after 4 months. During the intervening
period, the Indian rupee weakens/and the exchange rate of the dollar appreciates
to Rs 47.9824. As a result, the Indian importer has a transaction loss to the extent
of excess rupee payment required to purchase US$ 1 million. Earlier, the firm was
to pay US$ 1 million x Rs 47.4513 = Rs 47.4513 million. After 4 months from
now when it is to make payment on maturity, it will cause higher payment at Rs
47.9824 million, i.e., (US$ 1 million x Rs 47.9824). Thus, the Indian firm suffers
a transaction loss of Rs 5, 31,100, i.e., (Rs 47.9824 million – Rs 47.4513 million).
In case, the Indian rupee appreciates (or the US dollar weakens) to Rs
47.1124, the Indian importer gains (in terms of the lower payment of Indian
56
rupees); its equivalent rupee payment (of US$ 1 million) will be Rs 47.1124
million. Earlier, its payment would have been higher at Rs 47.4513 million. As a
result, the firm has profit of Rs 3,38,900, i.e., (Rs 47.4513 million – Rs 47.1124
million).
Example clearly demonstrates that the firm may not necessarily have
losses from the transaction exposure; it may earn profits also. In fact, the
international firms have a number of items in balance sheet (as stated above); at a
point of time, on some of the items (say payments), it may suffer losses due to
weakening of its home currency; it is then likely to gain on foreign currency
receipts. Notwithstanding this contention, in practice, the transaction exposure is
viewed from the perspective of the losses. This perception/practice may be
attributed to the principle of conservatism.
TRANSLATION EXPOSURE
Translation exposure is the exposure that arises from the need to convert
values of assets and liabilities denominated in a foreign currency, into the
domestic currency. Any exposure arising out of exchange rate movement and
resultant change in the domestic-currency value of the deposit would classify as
translation exposure. It is potential for change in reported earnings and/or in the
book value of the consolidated corporate equity accounts, as a result of change in
the foreign exchange rates.
Translation exposure arises from the need to “translate” foreign currency

assets or liabilities into the home currency for the purpose of finalizing the
accounts for any given period. A typical example of translation exposure is the
treatment of foreign currency borrowings. Consider that a company has borrowed
dollars to finance the import of capital goods worth Rs 10000. When the import
materialized the exchange rate was say Rs 30 per dollar. The imported fixed asset
was therefore capitalized in the books of the company for Rs 300000.
57
In the ordinary course and assuming no change in the exchange rate the
company would have provided depreciation on the asset valued at Rs 300000 for
finalizing its accounts for the year in which the asset was purchased.
If at the time of finalization of the accounts the exchange rate has moved
to say Rs 35 per dollar, the dollar loan has to be translated involving translation
loss of Rs50000. The book value of the asset thus becomes 350000 and
consequently higher depreciation has to be provided thus reducing the net profit.
Translation exposure relates to the change in accounting income and

balance sheet statements caused by the changes in exchange rates; these changes
may have taken place by/at the time of finalization of accounts vis-à-vis the time
when the asset was purchased or liability was assumed. In other words, translation
exposure results from the need to translate foreign currency assets or liabilities
into the local currency at the time of finalizing accounts. Example illustrates the
impact of translation exposure.
Example
Suppose, an Indian corporate firm has taken a loan of US $ 10 million,
from a bank in the USA to import plant and machinery worth US $ 10 million.
When the import materialized, the exchange rate was Rs 47.0. Thus, the imported
plant and machinery in the books of the firm was shown at Rs 47.0 x US $ 10
million = Rs 47 crore and loan at Rs 47.0 crore.
Assuming no change in the exchange rate, the Company at the time of preparation
of final accounts, will provide depreciation (say at 25 per cent) of Rs 11.75 crore
on the book value of Rs 47 crore.
However, in practice, the exchange rate of the US dollar is not likely to

remain unchanged at Rs 47. Let us assume, it appreciates to Rs 48.0. As a result,
the book value of plant and machinery will change to Rs 48.0 crore, i.e., (Rs 48 x
US$ 10 million); depreciation will increase to Rs 12.00 crore, i.e., (Rs 48 crore x
0.25), and the loan amount will also be revised upwards to Rs 48.00 crore.
58
Evidently, there is a translation loss of Rs 1.00 crore due to the increased value of
loan. Besides, the higher book value of the plant and machinery causes higher
depreciation, reducing the net profit.
Alternatively, translation losses (or gains) may not be reflected in the

income statement; they may be shown separately under the head of ‘translation
adjustment’ in the balance sheet, without affecting accounting income. This
translation loss adjustment is to be carried out in the owners’ equity account.
Which is a better approach? Perhaps, the adjustment made to the owners’ equity
account; the reason is that the accounting income has not been diluted on account
of translation losses or gains.
On account of varying ways of dealing with translation losses or gains,

accounting practices vary in different countries and among business firms within a
country. Whichever method is adopted to deal with translation losses/gains, it is
clear that they have a marked impact of both the income statement and the balance
sheet.
ECONOMIC EXPOSURE
An economic exposure is more a managerial concept than an accounting
concept. A company can have an economic exposure to say Yen: Rupee rates even
if it does not have any transaction or translation exposure in the Japanese
currency. This would be the case for example, when the company’s competitors
are using Japanese imports. If the Yen weekends the company loses its
competitiveness (vice-versa is also possible). The company’s competitor uses the
cheap imports and can have competitive edge over the company in terms of his
cost cutting. Therefore the company’s exposed to Japanese Yen in an indirect
way.
In simple words, economic exposure to an exchange rate is the risk that a

change in the rate affects the company’s competitive position in the market and
hence, indirectly the bottom-line. Broadly speaking, economic exposure affects
the profitability over a longer time span than transaction and even translation
59
exposure. Under the Indian exchange control, while translation and transaction
exposures can be hedged, economic exposure cannot be hedged.
Of all the exposures, economic exposure is considered the most important

as it has an impact on the valuation of a firm. It is defined as the change in the
value of a company that accompanies an unanticipated change in exchange rates.
It is important to note that anticipated changes in exchange rates are already
reflected in the market value of the company. For instance, when an Indian firm
transacts business with an American firm, it has the expectation that the Indian
rupee is likely to weaken vis-à-vis the US dollar. This weakening of the Indian
rupee will not affect the market value (as it was anticipated, and hence already
considered in valuation). However, in case the extent/margin of weakening is
different from expected, it will have a bearing on the market value. The market
value may enhance if the Indian rupee depreciates less than expected. In case, the
Indian rupee value weakens more than expected, it may entail erosion in the firm’s
market value. In brief, the unanticipated changes in exchange rates (favorable or
unfavorable) are not accounted for in valuation and, hence, cause economic
exposure.
Since economic exposure emanates from unanticipated changes, its
measurement is not as precise and accurate as those of transaction and translation
exposures; it involves subjectivity. Shapiro’s definition of economic exposure
provides the basis of its measurement. According to him, it is based on the extent
to which the value of the firm—as measured by the present value of the expected
future cash flows—will change when exchange rates change.
OPERATING EXPOSURE
Operating exposure is defined by Alan Shapiro as “the extent to which the
value of a firm stands exposed to exchange rate movements, the firm’s value
being measured by the present value of its expected cash flows”. Operating
exposure is a result of economic consequences. Of exchange rate movements on
the value of a firm, and hence, is also known as economic exposure. Transaction
60
and translation exposure cover the risk of the profits of the firm being affected by
a movement in exchange rates. On the other hand, operating exposure describes
the risk of future cash flows of a firm changing due to a change in the exchange
rate.
Operating exposure has an impact on the firm’s future operating revenues,

future operating costs and future operating cash flows. Clearly, operating exposure
has a longer-term perspective. Given the fact that the firm is valued as a going
concern entity, its future revenues and costs are likely to be affected by the
exchange rate changes. In particular, it is true for all those business firms that deal
in selling goods and services that are subject to foreign competition and/or uses
inputs from abroad.
In case, the firm succeeds in passing on the impact of higher input costs
(caused due to appreciation of foreign currency) fully by increasing the selling
price, it does not have any operating risk exposure as its operating future cash
flows are likely to remain unaffected. The less price elastic the demand of the
goods/ services the firm deals in, the greater is the price flexibility it has to
respond to exchange rate changes. Price elasticity in turn depends, inter-alia, on
the degree of competition and location of the key competitors. The more
differentiated a firm’s products are, the less competition it encounters and the
greater is its ability to maintain its domestic currency prices, both at home and
abroad. Evidently, such firms have relatively less operating risk exposure. In
contrast, firms that sell goods/services in a highly competitive market (in technical
terms, have higher price elasticity of demand) run a higher operating risk exposure
as they are constrained to pass on the impact of higher input costs (due to change
in exchange rates) to the consumers.
Apart from supply and demand elasticities, the firm’s ability to shift
production and sourcing of inputs is another major factor affecting operating risk
exposure. In operational terms, a firm having higher elasticity of substitution
between home-country and foreign-country inputs or production is less
susceptible to foreign exchange risk and hence encounters low operating risk
exposure.
61
In brief, the firm’s ability to adjust its cost structure and raise the prices of
its products and services is the major determinant of its operating risk exposure.
62
Key terms in foreign currency exposure

It is important that you are familiar with some of the important terms
which are used in the currency markets and throughout these sections:
DEPRECIATION – APPRECIATION
Depreciation is a gradual decrease in the market value of one currency
with respect to a second currency. An appreciation is a gradual increase in the
market value of one currency with respect another currency.
SOFT CURRENCY – HARD CURRENCY

A soft currency is likely to depreciate. A hard currency is likely to
appreciate.
DEVALUATION – REVALUATION
Devaluation is a sudden decrease in the market value of one currency with
respect to a second currency. A revaluation is a sudden increase in the value of
one currency with respect to a second currency.
WEAKEN – STRENGTHENS
If a currency weakens it losses value against another currency and we get
less of the other currency per unit of the weaken currency ie. If the £ weakens
against the DM there would be a currency movement from 2 DM/£1 to 1.8 DM/
£1. In this case the DM has strengthened against the £ as it takes a smaller amount
of DM to buy £1.
LONG POSITION – SHORT POSITION

A short position is where we have a greater outflow than inflow of a given
currency. In FX short positions arise when the amount of a given currency sold is
greater than the amount purchased. A long position is where we have greater
inflows than outflows of a given currency. In FX long positions arise when the
amount of a given currency purchased is greater than the amount sold.
63
Managing Your Foreign Exchange Risk

Once you have a clear idea of what your foreign exchange exposure will
be and the currencies involved, you will be in a position to consider how best to
manage the risk. The options available to you fall into three categories:
22. DO NOTHING:
You might choose not to actively manage your risk, which means dealing
in the spot market whenever the cash flow requirement arises. This is a very high-
risk and speculative strategy, as you will never know the rate at which you will
deal until the day and time the transaction takes place. Foreign exchange rates are
notoriously volatile and movements make the difference between making a profit
or a loss. It is impossible to properly budget and plan your business if you are
relying on buying or selling your currency in the spot market.
2. TAKE OUT A FORWARD FOREIGN EXCHANGE CONTRACT:

As soon as you know that a foreign exchange risk will occur, you could
decide to book a forward foreign exchange contract with your bank. This will
enable you to fix the exchange rate immediately to give you the certainty of
knowing exactly how much that foreign currency will cost or how much you will
receive at the time of settlement whenever this is due to occur. As a result, you
can budget with complete confidence. However, you will not be able to benefit if
the exchange rate then moves in your favour as you will have entered into a
binding contract which you are obliged to fulfil. You will also need to agree a
credit facility with your bank for you to enter into this kind of transaction
22. USE CURRENCY OPTIONS:

A currency option will protect you against adverse exchange rate
movements in the same way as a forward contract does, but it will also allow the
potential for gains should the market move in your favour. For this reason, a
currency option is often described as a forward contract that you can rip up and
walk away from if you don’t need it. Many banks offer currency options which
will give you protection and flexibility, but this type of product will always
64
involve a premium of some sort. The premium involved might be a cash amount
or it could be factored into the pricing of the transaction. Finally, you may
consider opening a Foreign Currency Account if you regularly trade in a particular
currency and have both revenues and expenses in that currency as this will negate
to need to exchange the currency in the first place. The method you decide to use
to protect your business from foreign exchange risk will depend on what is right
for you but you will probably decide to use a combination of all three methods to
give you maximum protection and flexibility.
Foreign Exchange Policy
A good foreign exchange policy is critical to the sound risk management

of any corporate treasury. Without a policy decision are made as-hoc and
generally without any consistency and accountability. It is important for treasury
personnel to know what benchmarks they are aiming for and it’s important for
senior management or the board to be confident that the risk of the business are
being managed consistently and in accordance with overall corporate strategy.
Scenario Planning – Making Rational Decisions
The recognition of the financial risks associated with foreign exchange

mean some decision needs to be made. The key to any good management is a
rational approach to decision making. The most desirable method of management
is the pre-planning of responses to movements in what are generally volatile
markets so that emotions are dispensed with and previous careful planning is
relied upon. This approach helps eliminate the panic factor as all outcomes have
been considered including ‘worst case scenarios’, which could result from either
action or inaction. However even though the worst case scenarios are considered
and plans ensure that even the ‘worst case scenarios’ are acceptable (although not
desirable), the pre-planning focuses on achieving the best result.
65
VAR (Value at Risk)
Banks trading in securities, foreign exchange, and derivatives but with the
increased volatility in exchange rates and interest rates, managements have
become more conscious about the risks associated with this kind of activity As a
matter of fact more and more banks have started looking at trading operations as
lucrative profit making activity and their treasuries at times trade aggressively.
This has forced the regulator’ authorities to address the issue of market risk apart
from credit risk, these market players have to take an account of on-balance sheet
and off-balance sheet positions. Market risk arises on account of changes in the
price volatility of traded items, market sentiments and so on.
Globally the regulators have prescribed capital adequacy norms under

which, the risk weighted value for each group of assets owned by the bank is
calculated separately, and then added up The banks have to provide capital, at the
prescribed rate, for total assets so arrived at.
However this does not take care of market risks adequately. Hence an
alternative approach to manage risk was developed for measuring risk on
securities and derivatives trading books. Under this new-approach the banks can
use an in-house computer model for valuing the risk in trading books known as
‘VALUE AT RISK MODEL (VaR MODEL).
Under VaR model risk management is done on the basis of holistic

approach unlike the approach under which the risk weighted value for each group
of assets owned by a bank is calculated separately.
66
HEDGING FOREX
If you are new to forex, before focusing on currency hedging strategy, we

suggest you first check out our forex for beginners to help give you a better
understanding of how the forex market works.
A foreign currency hedge is placed when a trader enters the forex market
with the specific intent of protecting existing or anticipated physical market
exposure from an adverse move in foreign currency rates. Both hedgers and
speculators can benefit by knowing how to properly utilize a foreign currency
hedge. For example: if you are an international company with exposure to
fluctuating foreign exchange rate risk, you can place a currency hedge (as
protection) against potential adverse moves in the forex market that could
decrease the value of your holdings. Speculators can hedge existing forex
positions against adverse price moves by utilizing combination forex spot and
forex options trading strategies.
Significant changes in the international economic and political landscape

have led to uncertainty regarding the direction of currency rates. This uncertainty
leads to volatility and the need for an effective vehicle to hedge the risk of adverse
foreign exchange price or interest rate changes while, at the same time, effectively
ensuring your future financial position.
Currency hedging is not just a simple risk management strategy, it is a

process. A number of variables must be analyzed and factored in before a proper
currency hedging strategy can be implemented. Learning how to place a foreign
exchange hedge is essential to managing foreign exchange rate risk and the
professionals at CFOS/FX can assist in the implementation of currency hedging
programs and forex trading strategies for both individual and commercial forex
traders and forex hedgers. For more hedging information, please click on the
links below.
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HOW TO HEDGE FOREIGN CURRENCY RISK

As has been stated already, the foreign currency hedging needs of banks,
commercials and retail forex traders can differ greatly. Each has specific foreign
currency hedging needs in order to properly manage specific risks associated with
foreign currency rate risk and interest rate risk.
Regardless of the differences between their specific foreign currency

hedging needs, the following outline can be utilized by virtually all individuals
and entities who have foreign currency risk exposure. Before developing and
implementing a foreign currency hedging strategy, we strongly suggest
individuals and entities first perform a foreign currency risk management
assessment to ensure that placing a foreign currency hedge is, in fact, the
appropriate risk management tool that should be utilized for hedging fx risk
exposure. Once a foreign currency risk management assessment has been
performed and it has been determined that placing a foreign currency hedge is the
appropriate action to take, you can follow the guidelines below to help show you
how to hedge forex risk and develop and implement a foreign currency hedging
strategy.
22. Risk Analysis: Once it has been determined that a foreign currency hedge
is the proper course of action to hedge foreign currency risk exposure, one
must first identify a few basic elements that are the basis for a foreign
currency hedging strategy.
22. Identify Type(s) of Risk Exposure. Again, the types of foreign currency
risk exposure will vary from entity to entity. The following items should
be taken into consideration and analyzed for the purpose of risk exposure
management: (a) both real and projected foreign currency cash flows, (b)
both floating and fixed foreign interest rate receipts and payments, and (c)
both real and projected hedging costs (that may already exist). The
aforementioned items should be analyzed for the purpose of identifying
foreign currency risk exposure that may result from one or all of the
following: (a) cash inflow and outflow gaps (different amounts of foreign
68
currencies received and/or paid out over a certain period of time), (b)
interest rate exposure, and (c) foreign currency hedging and interest rate
hedging cash flows.
2. Identify Risk Exposure Implications. Once the source(s) of foreign currency

risk exposure have been identified, the next step is to identify and quantify the
possible impact that changes in the underlying foreign currency market could have
on your balance sheet. In simplest terms, identify “how much” you may be
affected by your projected foreign currency risk exposure.
22. Market Outlook. Now that the source of foreign currency risk exposure
and the possible implications have been identified, the individual or entity
must next analyze the foreign currency market and make a determination
of the projected price direction over the near and/or long-term future.
Technical and/or fundamental analyses of the foreign currency markets are
typically utilized to develop a market outlook for the future.
B. Determine Appropriate Risk Levels: Appropriate risk levels can vary greatly
from one investor to another. Some investors are more aggressive than others and
some prefer to take a more conservative stance.
22. Risk Tolerance Levels. Foreign currency risk tolerance levels depend on
the investor’s attitudes toward risk. The foreign currency risk tolerance
level is often a combination of both the investor’s attitude toward risk
(aggressive or conservative) as well as the quantitative level (the actual
amount) that is deemed acceptable by the investor.
2. How Much Risk Exposure to Hedge. Again, determining a hedging ratio is

often determined by the investor’s attitude towards risk. Each investor must
decide how much forex risk exposure should be hedged and how much forex risk
should be left exposed as an opportunity to profit. Foreign currency hedging is
not an exact science and each investor must take all risk considerations of his
business or trading activity into account when quantifying how much foreign
currency risk exposure to hedge.
69
C. Determine Hedging Strategy: There are a number of foreign currency

hedging vehicles available to investors as explained in items IV. A – E above.
Keep in mind that the foreign currency hedging strategy should not only be
protection against foreign currency risk exposure, but should also be a cost
effective solution help you manage your foreign currency rate risk.
D. Risk Management Group Organization: Foreign currency risk management

can be managed by an in-house foreign currency risk management group (if cost-
effective), an in-house foreign currency risk manager or an external foreign
currency risk management advisor. The management of foreign currency risk
exposure will vary from entity to entity based on the size of an entity’s actual
foreign currency risk exposure and the amount budgeted for either a risk manager
or a risk management group.
E. Risk Management Group Oversight & Reporting. Proper oversight of the

foreign currency risk manager or the foreign currency risk management group is
essential to successful hedging. Managing the risk manager is actually an
important part of an overall foreign currency risk management strategy.
Prior to implementing a foreign currency hedging strategy, the foreign

currency risk manager should provide management with foreign currency hedging
guidelines clearly defining the overall foreign currency hedging strategy that will
be implemented including, but not limited to: the foreign currency hedging
vehicle(s) to be utilized, the amount of foreign currency rate risk exposure to be
hedged, all risk tolerance and/or stop loss levels, who exactly decides and/or is
authorized to change foreign currency hedging strategy elements, and a strict
policy regarding the oversight and reporting of the foreign currency risk
manager(s).
Each entity’s reporting requirements will differ, but the types of reports
that should be produced periodically will be fairly similar. These periodic reports
should cover the following: whether or not the foreign currency hedge placed is
70
working, whether or not the foreign currency hedging strategy should be

modified, whether or not the projected market outlook is proving accurate,
whether or not the projected market outlook should be changed, any changes
expected in overall foreign currency risk exposure, and mark-to-market reporting
of all foreign currency hedging vehicles including interest rate exposure.
Finally, reviews/meetings between the risk management group and

company management should be set periodically (at least monthly) with the
possibility of emergency meetings should there be any dramatic changes to any
elements of the foreign currency hedging strategy.
Forex risk management strategies
The Forex market behaves differently from other markets! The speed,
volatility, and enormous size of the Forex market are unlike anything else in the
financial world. Beware: the Forex market is uncontrollable – no single event,
individual, or factor rules it. Enjoy trading in the perfect market! Just like any
other speculative business, increased risk entails chances for a higher profit/loss.
Currency markets are highly speculative and volatile in nature. Any

currency can become very expensive or very cheap in relation to any or all other
currencies in a matter of days, hours, or sometimes, in minutes. This unpredictable
nature of the currencies is what attracts an investor to trade and invest in the
currency market.
But ask yourself, “How much am I ready to lose?” When you terminated,
closed or exited your position, had you had understood the risks and taken steps to
avoid them? Let’s look at some foreign exchange risk management issues that
may come up in your day-to-day foreign exchange transactions.
71
 Unexpected corrections in currency exchange rates

 Wild variations in foreign exchange rates
 Volatile markets offering profit opportunities
 Lost payments
 Delayed confirmation of payments and receivables
 Divergence between bank drafts received and the contract price
There are areas that every trader should cover both BEFORE and DURING a
trade.
 EXIT THE FOREX MARKET AT PROFIT TARGETS
Limit orders, also known as profit take orders, allow Forex traders to exit
the Forex market at pre-determined profit targets. If you are short (sold) a
currency pair, the system will only allow you to place a limit order below the
current market price because this is the profit zone. Similarly, if you are long
(bought) the currency pair, the system will only allow you to place a limit order
above the current market price. Limit orders help create a disciplined trading
methodology and make it possible for traders to walk away from the computer
without continuously monitoring the market.
Control risk by capping losses

Stop/loss orders allow traders to set an exit point for a losing trade. If you
are short a currency pair, the stop/loss order should be placed above the current
market price. If you are long the currency pair, the stop/loss order should be
placed below the current market price. Stop/loss orders help traders control risk by
capping losses. Stop/loss orders are counter-intuitive because you do not want
them to be hit; however, you will be happy that you placed them! When logic
dictates, you can control greed.
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Where should I place my stop and limit orders?

As a general rule of thumb, traders should set stop/loss orders closer to the
opening price than limit orders. If this rule is followed, a trader needs to be right
less than 50% of the time to be profitable. For example, a trader that uses a 30 pip
stop/loss and 100-pip limit orders, needs only to be right 1/3 of the time to make a
profit. Where the trader places the stop and limit will depend on how risk-adverse
he is. Stop/loss orders should not be so tight that normal market volatility triggers
the order. Similarly, limit orders should reflect a realistic expectation of gains
based on the market’s trading activity and the length of time one wants to hold the
position. In initially setting up and establishing the trade, the trader should look to
change the stop loss and set it at a rate in the ‘middle ground’ where they are not
overexposed to the trade, and at the same time, not too close to the market.
Trading foreign currencies is a demanding and potentially profitable

opportunity for trained and experienced investors. However, before deciding to
participate in the Forex market, you should soberly reflect on the desired result of
your investment and your level of experience. Warning! Do not invest money you
cannot afford to lose.
So, there is significant risk in any foreign exchange deal. Any transaction
involving currencies involves risks including, but not limited to, the potential for
changing political and/or economic conditions, that may substantially affect the
price or liquidity of a currency.
Moreover, the leveraged nature of FX trading means that any market

movement will have an equally proportional effect on your deposited funds. This
may work against you as well as for you. The possibility exists that you could
sustain a total loss of your initial margin funds and be required to deposit
additional funds to maintain your position. If you fail to meet any margin call
within the time prescribed, your position will be liquidated and you will be
responsible for any resulting losses. ‘Stop-loss’ or ‘limit’ order strategies may
lower an investor’s exposure to risk.
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Avoiding \ lowering risk when trading Forex:
Trade like a technical analyst. Understanding the fundamentals behind an

investment also requires understanding the technical analysis method. When your
fundamental and technical signals point to the same direction, you have a good
chance to have a successful trade, especially with good money management skills.
Use simple support and resistance technical analysis, Fibonacci Retracement and
reversal days.
Be disciplined. Create a position and understand your reasons for having

that position, and establish stop loss and profit taking levels. Discipline includes
hitting your stops and not following the temptation to stay with a losing position
that has gone through your stop/loss level. When you buy, buy high. When you
sell, sell higher. Similarly, when you sell, sell low. When you buy, buy lower.
Rule of thumb: In a bull market, be long or neutral – in a bear market, be short or
neutral. If you forget this rule and trade against the trend, you will usually cause
yourself to suffer psychological worries, and frequently, losses. And never add to
a losing position. With any online Forex broker, the trader can change their trade
orders as many times as they wish free of charge, either as a stop loss or as a take
profit. The trader can also close the trade manually without a stop loss or profit
take order being hit. Many successful traders set their stop loss price beyond the
rate at which they made the trade so that the worst that can happen is that they get
stopped out and make a profit.
74
SPOT EXCHANGE MARKET
Introduction
Spot transactions in the foreign exchange market are increasing in volume.
These transactions are primarily in forms of buying/ selling of currency notes,
encashment of traveler’s cheques and transfers through banking channels. The last
category accounts for the majority of transactions. It is estimated that about 90 per
cent of spot transactions are carried out exclusively for banks. The rest are meant
for covering the orders of the clients of banks, which are essentially enterprises.
The Spot market is the one in which the exchange of currencies takes
place within 48 hours. This market functions con75enuously, round the clock.
Thus, a spot transaction effected on Monday will be settled by Wednesday,
provided there is no holiday between Monday and Wednesday. As a matter of
fact, certain length of time is necessary for completing the orders of payment and
accounting operations due to time differences between different time zones across
the globe.
Magnitude of Spot Market

According to a Bank of International Settlements (BIS) estimate, the daily
volume of spot exchange transactions is about 50 per cent of the total transactions
of exchange markets. London market is the first market of the world not only in
terms of the volume but also in terms of diversity of currencies traded. While
London market trades a large number of currencies, the New York market trades,
by and large, Dollar (75 per cent of the total), Deutschmark, Yen, Pound Sterling
and Swiss Franc only. Amongst the recent changes observed on the exchange
markets, it is noted that there is a relative decline in operations involving dollar
while there is an increase in the operations involving Deutschmark. Besides,
deregulation of markets has accelerated the process of international transactions.
75
Quotations on Spot Exchange Market

The exchange rate is the price of one currency expressed in another
currency. Each quotation, naturally, involves two currencies. There is always one
rate for buying (bid rate) and another for selling (ask or offered rate) for a
currency. Unlike the markets of other commodities, this is a unique feature of
exchange markets. The bid rate is the rate at which the quoting bank is ready to
buy a currency. Selling rate is the rate at which it is ready to sell a currency. The
bank is a market maker. It should be noted that when the bank sells dollars against
rupees, one can say that it buys rupees against dollars. In order to separate buying
and selling rates, a small dash or an oblique line is drawn between the two. Often,
only two or four digits are written after the dash indicating a fractional amount by
which the selling rate is different from buying rate. For example, if dollar is
quoted as Rs 42.3004-3120, it means that the bank is ready to buy dollar at Rs
42.3004 and ready to sell dollar at Rs 42.3120. Dealers do not quote the entire
figure. They may quote, for example, 3004-3120 for dollar. It is these four digits
that vary the most during the day. Here, the operators understand because of their
experience that a quote of 3004-3120 means Rs 42.3004-42.3120.
The banks buy at a rate lower than that at which they sell a currency. The
difference between the two constitutes the profit made by the bank. When an
enterprise or client wants to buy a currency from the bank, it buys at the selling
rate of the bank. Likewise, when the enterprise wants to sell a currency to the
bank, it sells at the buying rate of the bank. Table gives typical quotations. As is
clear from the rates in the table, the buying rate is lower than selling rate.
TABLE: Currency Quotations given by a Bank
CURRENC BUYING SELLING

Y RATE RATE
Rupee/US $ 42.3004 42.3120
Rupee /DM 22.2025 22.2080
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Table 2
The prices, as we see quoted in the newspapers, are for the interbank
market involving trade among dealers. These rates may be direct or European. The
direct quote or European type takes the value of the foreign currency as one unit.
In India, price is quoted as so many rupees per unit of foreign currency. It is a
direct quote or European quote. If we say forty-two rupees are needed to buy one
dollar, it is an example of direct quote. There are a few countries, which follow
the system of indirect quote or American quote. This way of quoting is prevalent,
mainly, in the UK, Ireland and South Africa. In UK, for example, the quote would
be one unit of pound sterling equal to seventy rupees. This is indirect or American
type of quote.
Examples of direct quotes in India are Rs 42 per dollar, Rs 22 per DM and

Rs 7 per French franc, etc. Similarly the examples of direct quote in USA are $
1.6 per pound, $ 0.67 per DM and $ 0.2 per French franc, etc. One can easily
transform a direct quote into an indirect quote and vice versa. For example, a
rupee-dollar direct quote of Rs 42.3004-42.3120 can be transformed into indirect
quote as $ 1/(42.3120)-1/(42.3004) (or $ 0.02363-0.02364). It is important to note
that selling rate is always higher than buying rate.
Financial newspapers daily publish the rates of different currencies as

quoted at a certain point of time during the day. Financial Times, for example,
indicates closing mid-point (middle of buying and selling rate), change on the day
bid-offer spread and the day’s high and low mid-point. Table gives a typical
quotation. These quotations relate to transactions, which have taken place on the
interbank markets and are of the order of millions of dollars. These rates are not
the ones used for enterprises or clients. The rates for the latter will be close to the
ones quoted for interbank transactions. The variation from interbank rates will
depend on the magnitude of the transaction entered into by the enterprise.
Traders in the major banks that deal in two-way prices, for both buying
and selling, are called market-makers. They create the market by quoting bid and
77
ask prices.
The Wall Street Journal gives quotations for selling rates on the interbank
market for a minimum sum of 1 million dollars at 3 p.m.
The difference between buying and selling rate is called spread. The
spread varies depending on market conditions and the currency concerned. When
market is highly liquid, the spread has a tendency to diminish and vice versa.
The spread is generally expressed in percentage by the equation:

Spread = Selling Rate – Buying Rate x 100
Buying Rate
For example, if the quotation for dollar is Rs 42.3004/3120, the spread is

given by
Spread = 42.3120 – 42.3004 x 100 or 0.0274 %
42.3004
Currencies which are least quoted have wider spread than others.
Similarly, currencies with greater volatility have higher spread and vice-versa.
The average amount of transactions on spot market is about 5 million dollars or
equivalent in other currencies.
Banks do not charge commission on their currency transactions but rather

profit from the spread between buying and selling rates. Spreads are very narrow
between leading currencies because of the large volume of transactions. Width, of
spread depends on transaction costs and risks, which in turn are influenced by the
size and frequency of transactions. Size affects the transaction costs per unit of
currency traded while frequency or turnover rate affects both costs and risks by
spreading fixed costs of currency trading.
In the interbank market, spreads depend upon the depth of a market of a

particular currency as well as its volatility. Currencies with greater volatility and
higher trade have larger spreads. Spreads may also widen during financial and
78
economic uncertainty. It may be noted that spreads charged from customers are
bigger than interbank spreads.
Evolution of Spot Rates

How does one calculate the change in spot rate from one quotation to the
next? In case of direct quotation, it is given by the equation:
Change in Percentage = Rate N – Rate (N-1) x 100
Rate (N-1)
For example, the dollar rate has changed from Rs 42.50 to Rs 42.85; the change
is calculated to be
Change in Percentage = 42.85 – 42.50 x 100 percent or 0.909per cent

42.50
Similarly, if the quotation is in indirect form, the percentage change is given

by equation:
Change in percentage =Rate (N – 1) – Rate N x 100 per cent
Rate N
For example, the above rate has passed from 1/42.50 to 1/42.85 so the
decrease in the rupee is
Change in Percentage = 1/42.50 – 1/42.85 x 100
1/42.85
OR Change in Percentage= 0.02597 – 0.02574 x 100 or 0.89%

0.02574
Cross Rate
Let us say an Indian importer is to settle his bill in Canadian dollars. His
operation involves buying of Canadian dollars against rupees. In order to give him
a Can $/Re rate, the banks should call for US $/Can $ and US $/Re quotes. That
means that the bank is going to buy Canadian dollars against American dollars
and sell those Canadian dollars to the importer against rupees. Suppose the rates
are
79
Can$/US$: 1.3333-63
Rupee/US $: 42.3004-3120
Finally, the importer will get the Canadian dollars at the following rate:
Rupee/Can $ =42.3120 = Rs 31.7348/Can $

1.3333
That is, importer buys US $ (or bank sells US $) at the rate of Rs 42.3120
per US $ and then buys Can $ at the buying rate of Can $ 1 .3333 per US $.
So Rupee 31. 7348/Can $ is a cross rate as it has been derived from the
rates already given as Rupee/US $ and Can $/ US $. So cross rate can be defined
as a rate between a third pair of currencies, by using the rates of two pairs, in
which one currency is common. It is basically a derived rate.
Likewise, the buying rate would be obtained as Rs 31.4304/ Can $

(OR)
42.0004
1.3363
Contains cross rates between different pairs of currencies.

In general, the equations can be used to find the cross rates between two
currencies B and C, if the rates between A and B and between A and C are given:
(B/C)bid = (B/A)bid x (A/C)bid

(B/C)ask = (B/A)ask x (A/C)ask
Here
(B/A)bid = (A/B)ask
and
(B/A)ask = (A/B)bid
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Example: Following rates are given: Rs 22/DM and Rs 6.60/FFr.

What is FFr/DM rate?
Solution: It is clear from the data that bid and ask rates are equal. Cross rate will
give the relationship between FFr and DM:
Rs22 x 1 = FFr22 x FFr22 = FFr

3.3333/DM
DM Rs 6.60 DM 6.60 DM 6.60
FFr
Example: From the following rates, find out Re/DM relationship:
Re/US $: 42.1000/3650
DM/US$: 1.5020/5100
Solution: Applying the equations we get
(Re/DM)bid = (Re/US $)bid x (US $/DM)bid
= 42.1000 x 1/ (1.5100)
= 27.8808
(Re/DM)ask = (Re/US $)ask x (US $/DM)ask

= 42.3650 x l/(1.5020)
= 28.2057
So, the Re/DM relationship is
27.8808-28.2057
Equilibrium on Spot Markets
In inter-bank operations, the dealers indicate a buying rate and a selling

rate without knowing whether the counterparty wants to buy or sell currencies.
That is why it is important to give ‘good’ quotations. When differences exist
between the Spot rates of two banks, the arbitrageurs may proceed to make
arbitrage gains without any risk. Arbitrage enables the re-establishment of
equilibrium on the exchange markets. However, as new demands and new offers
come on the market, this equilibrium is disturbed constantly.
81
On the Spot exchange market, two types of arbitrages are possible:
(1) Geographical arbitrage, and

(2) Triangular arbitrage.
 GEOGRAPHICAL ARBITRAGE
Geographical arbitrage consists of buying a currency where it is the

cheapest, and selling it where it is the dearest so as to make a profit from the
difference in the rates. In order to make an arbitrage gain, the selling rate of one
bank needs to be lower than the buying rate of the other bank. Example explains
how geographical arbitrage gain is made.
Example: Two banks are quoting the following US dollar rates:

Bank A: Rs 42.7530-7610
Bank B: Rs 42.7650-7730
Find out the arbitrage possibilities.

Solution: An arbitrageur who has Rs 10, 00,000 (let us suppose) will buy dollars
from the Bank A at a rate of Rs 42.76107$ and sell the same dollars at the Bank B
at a rate of Rs 42.7650/$.
Thus, in the process, he will make a gain of
Rs 10, 00,000 x (42.7650)-Rs 10, 00,000
42.7610
Or
Rs 93.50
Though the gain made on Rs 10, 00,000 is apparently small, if the sum
involved was in couple of million of rupees, the gain would be substantial and
without risk.
82
It is to be noted that there will be no geographical arbitrage gain possible if

there is an overlap between the rates quoted at two different dealers. For example,
consider the following two quotations:
Dealer A: Rs 42.7530-7610
Dealer B: Rs 42.7600-7700
42.7530 42.7610
42.7600 42.7700
Since there is an overlap between the rates of dealers A and B respectively,

no arbitrage gain is possible, unlike in the example
 TRIANGULAR ARBITRAGE
Triangular arbitrage occurs when three currencies are involved. This can
be 83ealized when there is distortion between cross rates of currencies. Example
illustrates the triangular arbitrage.
Example: Following rates are quoted by three different dealers:
£/US $: 0.6700……….Dealer A
FFr/£: 8.9200 ………Dealer B
FFr/US $: 6.1080 ………Dealer C
Are there any arbitrage gains possible?
Solution: Cross rate between French franc and US dollar is 0.6700 x 8.9200 or
FFr 5.9764/US $. Compare this with the given rate of FFr 6.1080/US $. Since
there is a difference between the two FFr/$ rates, there is a possibility of arbitrage
gain. The following steps have to be taken:
83
1. Start with US $ 1,00,000 and acquire with these dollars a sum of FFr
6,10,800 (1,00,000 x 6.1080)
2. Convert these French francs into Pound sterling, to get £ 68475.34
(6,10,800/8.92
3. Further convert these Pound sterling into US dollar, to obtain $ 1,02,202
(68,475.34/0.67).
Thus, there is a net gain of US $ 2,202. Of course, the real gain will be
less, as we have not taken into account the transaction costs here.
The arbitrage operations on the market continue to take place as long as

there are significant differences between quoted and cross rates. These arbitrages
lead to the re-establishment of the equilibrium on currency markets.
84
8. FORWARD EXCHANGE MARKET
Intro to Forward Exchange Market
The forward transaction is an agreement between two parties, requiring the

delivery at some specified future date of a specified amount of foreign currency
by one of the parties, against payment in domestic currency by the other party, at
the price agreed upon in the contract. The rate of exchange applicable to the
forward contract is called the forward exchange rate and the market for forward
transactions is known as the forward market.
The foreign exchange regulations of various countries, generally, regulate

the forward exchange transactions with a view to curbing speculation in the
foreign exchanges market. In India, for example, commercial banks are permitted
to offer forward cover only with respect to genuine export and import
transactions.
Forward exchange facilities, obviously, are of immense help to exporters

and importers as they can cover the risks arising out of exchange rate fluctuations
by entering into an appropriate forward exchange contract.
Forward Exchange Rate

With reference to its relationship with the spot rate, the forward rate may be
at par, discount or premium.
At Par: If the forward exchange rate quoted is exactly equivalent to the spot rate
at the time of making the contract, the forward exchange rate is said to be at par.
At Premium: The forward rate for a currency, say the dollar, is said to be at a
premium with respect to the spot rate when one dollar buys more units of another
85
currency, say rupee, in the forward than in the spot market. The premium is
usually expressed as a percentage deviation from the spot rate on a per annum
basis.
At Discount: The forward rate for a currency, say the dollar, is said to be at
discount with respect to the spot rate when one dollar buys fewer rupees in the
forward than in the spot market. The discount is also usually expressed as a
percentage deviation from the spot rate on a per annum basis.
The forward exchange rate is determined mostly by the demand for and
supply of forward exchange. Naturally, when the demand for forward exchange
exceeds its supply, the forward rate will be quoted at a premium and, conversely,
when the supply of forward exchange exceeds the demand for it, the rate will be
quoted at discount. When the supply is equivalent to the demand for forward
exchange, the forward rate will tend to be at par. The Forward market primarily
deals in currencies that are frequently used and are in demand in the international
trade, such as US dollar, Pound Sterling, Deutschmark, French franc, Swiss franc,
Belgian franc, Dutch Guilder, Italian lira, Canadian dollar and Japanese yen.
There is little or almost no Forward market for the currencies of developing
countries. Forward rates are quoted with reference to Spot rates as they are always
traded at a premium or discount vis-à-vis Spot rate in the inter-bank market. The
bid-ask spread increases with the forward time horizon.
Importance of Forward Markets

The Forward market can be divided into two parts-Outright Forward and
Swap market. The Outright Forward market resembles the Spot market, with the
difference that the period of delivery is much greater than 48 hours in the Forward
market. A major part of its operations is for clients or enterprises who decide to
cover against exchange risks emanating from trade operations.
86
The Forward Swap market comes second in importance to the Spot market
and it is growing very fast. The currency swap consists of two separate operations
of borrowing and of lending. That is, a Swap deal involves borrowing a sum in
one currency for short duration and lending an equivalent amount in another
currency for the same duration. US dollar occupies an important place on the
Swap market. It is involved in 95 per cent of transactions.
Major participants in the Forward market are banks, arbitrageurs,

speculators, exchange brokers and hedgers. Commercial banks operate on this
market through their dealers, either to cover the orders of their clients or to place
their own cash in different currencies. Arbitrageurs look for a profit without risk,
by operating on the interest rate differences and exchange rates. Speculators take
risk in the hope of making a gain in case their anticipation regarding the
movement of rates turns out to be correct. As regards brokers, their job involves
match making between seekers and suppliers of currencies on the Spot market.
Hedgers are the enterprises or the financial institutions that want to cover
themselves against the exchange risk.
Quotations on Forward Markets

Forward rates are quoted for different maturities such as one month, two
months, three months, six months and one year. Usually, the maturity dates are
closer to month-ends. Apart from the standardized pattern of maturity periods,
banks may quote different maturity spans, to cater to the market/client needs.
The quotations may be given either in outright manner or through Swap

points. Outright rates indicate complete figures for buying and selling. For
example, Table contains Re/FFr quotations in the outright form. These kinds of
rates are quoted to the clients of banks.
87
Re/FFr QUOTATIONS
Buying rate Selling rate Spread
Spot 6.0025 6.0080 55 points
One-month forward 6.0125 6.0200 75 points
3-month forward 6.0250 6.0335 85 points
6-month forward 6.0500 6.0590 90 points
Table 3
If the Forward rate is higher than the Spot rate, the foreign currency is said
to be at Forward premium with respect to the domestic currency (in operational
terms, domestic currency is likely to depreciate). On the other hand, if the
Forward rate is lower than Spot rate, the foreign currency is said to be at Forward
discount with respect to domestic currency (likely to appreciate).
The difference between the buying and selling rate is called spread and it
is indicated in terms of points. The spread on Forward market depends on (a) the
currency involved, being higher for the currencies less traded, (b) the volatility of
currencies, being wider for the currency with greater volatility and (c) duration of
contract, being normally wider for longer period of maturity. Table gives Forward
quotations for different currencies against US dollar.
Apart from the outright form, quotations can also be made with Swap
points. Number of points represents the difference between Forward rate and Spot
rate. Since currencies are generally quoted in four digits after the decimal point, a
point represents 0.0001 (or 0.01 per cent) unit of currency. For example, the
difference between 6.0025 and 6.0125 is 0.0100 or 100 points.
The quotation in points indicates the points to be added to (in case of

premium) or to be subtracted from (in case of discount) the Spot rate to obtain the
Forward rate. The first figure before the dash is to be added to (for premium) or
subtracted from (for discount) the buying rate and the second figure to be added to
or subtracted from the selling rate. A trader knows easily whether the forward
points indicate a premium or a discount. The buying rate should always be less
than selling rate. In case of premium, the points before the dash (corresponding to
buying rate) are lower than points after the dash. Reverse is the case for discount.
These points are also known as Swap points.
88
Covering Exchange Risk on forward Market

Often, the enterprises that are exporting or importing take recourse to
covering their operations in the Forward market. If an importer anticipates
eventual appreciation of the currency in which imports are denominated, he can
buy the foreign currency immediately and hold it up to the date of maturity. This
means he has to block his rupee cash right away. Alternatively, the importer can
buy the foreign currency forward at a rate known and fixed today. This will do
away with the problem of blocking of funds/cash initially. In other words,
Forward purchase of the currency eliminates the exchange risk of the importer as
the debt in foreign currency is covered.
Likewise, an exporter can eliminate the risk of currency fluctuation by

selling his receivables forward.
Example
From the data given below calculate forward premium or discount, as the
case may be, of the £ in relation to the rupee.
Spot 1 month forward 3 months forward 6 months forward

Re/£ Rs 77.9542/78.1255 Rs 78.2111/4000 Rs 78.8550/9650
Solution
Since 1 month forward rate and 6 months forward rate are higher than the
spot rate, the British £ is at premium in these two periods, the premium amount is
determined separately both for bid price and ask price. It may be recapitulated that
the first quote is the bid price and the second quote (after the slash) is the
ask/offer/sell price. It is the normal way of quotation in foreign exchange markets.
Premium with respect to bid price
89
1 month = Rs78.2111 -Rs 77.9542 x 12 x 100 = 3.95% P.a

Rs 77.9542 1
6 months = Rs 78.8550 -Rs 77.9542 x 12 x 100 = 2.31% P.a

Rs 77.9542 6
Premium with respect to ask price
1 month = Rs 78.4000 -Rs 78.1255 x 12 x 100 = 4.21% P.a

Rs 78.1255 1
6 months = Rs78.9650-Rs 78.1255 x12 x 100 = 2.15% P.a

Rs 78.1255 6
In the case of 3 months forward, spot rates are higher than the forward
rates, signalling that forward rates are at a discount.
Discount with respect to bid price
3 months = Rs 77.9542 -Rs 77.6055 x 12 x 100 = 1.79% P.a

Rs 77.9542 3
Discount with respect to ask price
3 months= Rs 78.1255-Rs 77.7555 x 12 x 100 = 1.89% P.a

Rs 78.1255 3
9. CURRENCY FUTURES
90
Introduction
Currency Futures were launched in 1972 on the International Money

Market (IMM) at Chicago. They were the first financial Futures that developed
after coming into existence of the floating exchange rate regime. It is to be noted
that commodity Futures (corn, oats, wheat, soybeans, butter, egg and silver) had
been in use for a long time. The Chicago Board of Trade (CBOT), established in
1948, specialized in future contract of cereals. The Chicago Mercantile Exchange
(CME) started with the future contracts of butter and egg. Later on, other
Currency Future markets developed at Philadelphia (Philadelphia Board of Trade),
London (London International Financial Futures Exchange (LIFFE)), Tokyo
(Tokyo International Financial Futures Exchange), Sydney (Sydney Futures
Exchange), and Singapore International Monetary Exchange (SIMEX).
The volume traded on the Futures market is much smaller than that traded
on Forward market. However, it holds a very significant position in USA and UK
(especially London) and it is developing at a fast rate.
While a futures contract is similar to a forward contract, there are several

differences between them. While a forward contract is tailor-made for the client
by his international bank, a futures contract has standardized features - the
contract size and maturity dates are standardized. Futures can be traded only on an
organized exchange and they are traded competitively. Margins are not required in
respect of a forward contract but margins are required of all participants in the
futures market-an initial margin must be deposited into a collateral account to
establish a futures position.
There are three types of participants on the currency futures market: floor
traders, floor brokers and broker-traders. Floor traders operate for their own
accounts. They are the speculators whose time horizon is short-term. Some of
them are representatives of banks or financial institutions which use futures to
supplement their operations on Forward market. They enable the market to
91
become more liquid. In contrast, floor brokers, representing the brokers' firms,
operate on behalf of their clients and, therefore, are remunerated through commis-
sion. The third category, called broker-traders, operate either on the behalf of
clients or for their own accounts.
Enterprises pass through their brokers and generally operate on the Future
markets to cover their currency exposures. They are referred to as hedgers. They
may be either in the business of export-import or they may have entered into the
contracts for' borrowing or lending.
Characteristics of Currency Futures

A Currency Future contract is a commitment to deliver or take delivery of
a given amount of currency (s) on a specific future date at a price fixed on the date
of the contract. Like a Forward contract, a Future contract is executed at a later
date. But a Future contract is different from Forward contract in many respects.
The major distinguishing features are:
 Standardization,
 Organized exchanges,
 Minimum variation,
 Clearing house,
 Margins, and
 Marking to market
Futures, being standardized contracts in nature, are traded on an organised

exchange; the clearinghouse of the exchange operates as a link between the two
parties of the contract, namely, the buyer and the seller. In other words,
transactions are through the clearinghouse and the two parties do not deal directly
between themselves.
92
While it is true that futures contracts are similar to the forward contracts in
their objective of hedging foreign exchange risk of business firms, they differ in
many significant ways.
Differences between Forward Contracts &

Future Contracts
The major differences between the forward contracts and futures contracted are as
follows:
 Nature and size of Contracts: Futures contracts are standardized

contracts in that dealings in such contracts is permissible in standard-size
sums, say multiples of 125,000 German Deutschmark or 12.5 million yen.
Apart from standard-size contracts, maturities are also standardized. In
contrast, forward contracts are customized/tailor-made; being so, such
contracts can virtually be of any size or maturity.
 Mode of Trading: In the case of forward contracts, there is a direct link

between the firm and the authorized dealer (normally a bank) both at the time
of entering the contract and at the time of execution. On the other hand, the
clearinghouse interposes between the two parties involved in futures contracts.
 Liquidity: The two positive features of futures contracts, namely their

standard-size and trading at clearinghouse of an organized exchange, provide
them relatively more liquidity vis-à-vis forward contracts, which are neither
standardized nor traded through organized futures markets. For this reason, the
future markets are more liquid than the forward markets.
 Deposits/Margins: while futures contracts require guarantee deposits

from the parties, no such deposits are needed for forward contracts. Besides,
93
the futures contract necessitates valuation on a daily basis, meaning that gains
and losses are noted (the practice is known as marked-to-market). Valuation
results in one of the parties becoming a gainer and the other a loser; while the
loser has to deposit money to cover losses, the winner is entitled to the
withdrawal of excess margin. Such an exercise is conspicuous by its absence
in forward contracts as settlement between the parties concerned is made on
the pre-specified date of maturity.
 Default Risk: As a sequel to the deposit and margin requirements in the

case of futures contracts, default risk is reduced to a marked extent in such
contracts compared to forward contracts.
 Actual Delivery: Forward contracts are normally closed, involving actual

delivery of foreign currency in exchange for home currency/or some other
country currency (cross currency forward contracts). In contrast, very few
futures contracts involve actual delivery; buyers and sellers normally reverse
their positions to close the deal. Alternatively, the two parties simply settle the
difference between the contracted price and the actual price with cash on the
expiration date. This implies that the seller cancels a contract by buying
another contract and the buyer by selling the contract on the date of settlement.
In view of the above, it is not surprising to find that forward contracts and
futures contracts are widely used techniques of hedging risk. It has been estimated
that more than 95 per cent of all transactions are designed as hedges, with banks
and futures dealers serving as middlemen between hedging Counterparties.
Trading Process
Trading is done on trading floor. A party buying or selling future contracts
makes an initial deposit of margin amount. If at the time of settlement, the rate
moves in its favour, it makes a gain. This amount (gain) can be immediately
withdrawn or left in the account. However, in case the closing rate has moved
against the party, margin call is made and the amount of 'loss' is debited to its
account. As soon as the margin account falls below the maintenance margin, the
94
trading party has to make up the gap so as to bring the margin account again to the
original level.
10 CURRENCY OPTIONS
INTRODUCTION TO CURRENCY OPTIONS
95
Forward contracts as well as futures contracts provide a hedge to firms

against adverse movements in exchange rates. This is the major advantage of such
financial instruments. However, at the same time, these contracts deprive firms of
a chance to avail the benefits that may accrue due to favourable movements in
foreign exchange rates. The reason for this is that the firm is under obligation to
buy or sell currencies at pre-determined rates. This limitation of these contracts,
perhaps, is the main reason for the genesis/emergence of currency options in forex
markets.
Currency option is a financial instrument that provides its holder a right

but no obligation to buy or sell a pre-specified amount of a currency at a pre-
determined rate in the future (on a fixed maturity date/up to a certain period).
While the buyer of an option wants to avoid the risk of adverse changes in
exchange rates, the seller of the option is prepared to assume the risk. Options are
of two types, namely, call option and put option.
Call Option
In a call option the holder has the right to buy/call a specific currency at a
specific price on a specific maturity date or within a specified period of time;
however, the holder of the option is under no obligation to buy the currency. Such
an option is to be exercised only when the actual price in the forex market, at the
time of exercising option, is more that the price specified in call option contract;
to put it differently, the holder of the option obviously will not use the call option
in case the actual currency price in the spot market, at the time of using option,
turns out to be lower than that specified in the call option contract.
Put Option
A put option confers the right but no obligation to sell a specified amount
of currency at a pre-fixed price on or up to a specified date. Obviously, put
options will be exercised when the actual exchange rate on the date of maturity is
lower than the rate specified in the put-option contract.
96
It is very apparent from the above that the option contracts place their
holders in a very favourable/ privileged position for the following two reasons: (i)
they hedge foreign exchange risk of adverse movements in exchange rates and (ii)
they retain the advantage of the favourable movement of exchange rates. Given
the advantages of option contracts, the cost of currency option (which is limited to
the amount of premium; it may be absolute sum but normally expressed as a
percentage of the spot rate prevailing at the time of entering into a contract) seems
to be worth incurring. In contrast, the seller of the option contract runs the risk of
unlimited/substantial loss and the amount of premium he receives is income to
him. Evidently, between the buyer and seller of call option contracts, the risk of a
currency option seller is/seems to be relatively much higher than that of a buyer of
such an option.
In view of high potential risk to the sellers of these currency options,

option contracts are primarily dealt in the major currencies of the world that are
actively traded in the over-the-counter (OTC) market. All the operations on the
OTC option markets are carried out virtually round the clock. The buyer of the
option pays the option price (referred to as premium) upfront at the time of
entering an option contract with the seller of the option (known as the writer of
the option). The pre-determined price at which the buyer of the option (also called
as the holder of the option) can exercise his option to buy/sell currency is called
the strike/exercise price. When the option can be exercised only on the maturity
date, it is called an European option; in contrast, when the option can be exercised
on any date upto maturity, it is referred to as an American option. An option is
said to be in-money, if its immediate exercise yields a positive value to its holder;
in case the strike price is equal to the spot price, the option is said to be at-money,
when option has no positive value, it is said out-of-money
Example An Indian importer is required to pay British £ 2 million to a UK

company in 4 months time. To guard against the possible appreciation of the
pound sterling, he buys an option by paying 2 per cent premium on the current
prices. The spot rate is Rs 77.50/£. The strike price is fixed at Rs 78.20/£.
97
The Indian importer will need £ 2 million in 4 months. In case, the pound
sterling appreciates against the rupee, the importer will have to spend a greater
amount on buying £ 2 million (in rupees). Therefore, he buys a call option for the
amount of £ 2 million. For this, he pays the premium upfront, which is: £ 2
million x Rs 77.50 x 0.02 = Rs 3.1 million
Then the importer waits for 4 months. On the maturity date, his action will
depend on the exchange rate of the £ vis-à-vis the rupee. There are three
possibilities in this regard, namely £ appreciates, does not change and depreciates.
POUND STERLING APPRECIATES If the pound sterling appreciates, say to

Rs 79/£, on the settlement date. Obviously, the importer will exercise his call
option and buy the required amount of pounds at the contract rate of Rs 78.20/£.
The total sum paid by importer is: (£ 2 million x Rs 78.20) + Premium already
paid = Rs 156.4 million + Rs 3.1 million = Rs 159.5 million.
⇒ Pound Sterling Exchange rate does not Change - This implies that the
spot rate on the date of maturity is Rs 78.20/£. Evidently, he is
indifferent/netural as he has to spend the same amount of Indian rupees
whether he buys from the spot market or he executes call option contract; the
premium amount has already been paid by him. Therefore, the total effective
cash outflows in both the situations remain exactly identical at Rs 159.5
million, that is, [(£ 2 million x Rs 78.20) + Premium of Rs 3.1 million already
paid].
⇒ Pound Sterling Depreciates - If the pound sterling depreciates and the

actual spot rate is Rs 77/£ on the settlement date, the importer will prefer to
abandon call option as it is economically cheaper to buy the required amount
of pounds directly from the exchange market. His total cash outflow will be
lower at Rs 157.1 million, i.e., (£ 2 million x Rs 77) + Premium of Rs 3.1
million, already paid.
98
Thus, it is clear that the importer is not to pay more than Rs 159.5 million
irrespective of the exchange rate of £ prevailing on the date of maturity. But he
benefits from the favourable movement of the pound. Evidently, currency options
are more ideally suited to hedge currency risks. Therefore, options markets
represent a significant volume of transactions and they are developing at a fast
pace.
Above all, there is an additional feature of currency options in that they

can be repurchased or sold before the date of maturity (in the case of American
type of options). The intrinsic value of an American call option is given by the
positive difference of spot rate and exercise price; in the case of a European call
option, the positive difference of the forward rate and exercise price yields the
intrinsic value.
Intrinsic value (American option) = Spot rate -Exercise price

Intrinsic value (European option) = Forward rate - Exercise price
Of course, the option expires when it is either exercised or has attained

maturity. Normally, it happens when the spot rate/forward rate is lower than the
exercise price; otherwise holders of options will normally like to exercise their
options if they carry positive intrinsic value.
Quotations of Options
99
On the OTC market, premia are quoted in percentage of the amount of

transaction. The payment may take place either in foreign currency or domestic
currency. The strike price (exercise price) is at the choice of the buyer. The
premium is composed of: (1) Intrinsic Value, and (2) Time Value.
Thus, we can write the Option price as given by the equation:
Option price = Intrinsic value + Time value
INTRINSIC VALUE
Intrinsic value of an Option is equal to the gain that the buyer will make on
its immediate exercise. On the maturity, the only value of an Option is the
intrinsic one. If, on that date, it does not have any intrinsic value, then, it has no
value at all.
Intrinsic value of Call Option
Intrinsic value of American call Option is equal to the difference between

Spot rate and Exercise price, because the option can be exercised any moment.
The equation gives the intrinsic value of an American call Option.
Intrinsic value = Spot rate - Exercise price
Likewise, the intrinsic value of a European call Option is given by the equation:
Intrinsic value = Forward rate - Exercise price
The intrinsic value of a European Option uses Forward rate since it can be
exercised only on the date of maturity.
The intrinsic value of an Option is either positive or nil. It is never

negative.
For example, the intrinsic value, V, of a European call Option whose

exercise price is Rs 42.50 while forward rate is Rs 43.00, is going to be
100
V = Rs 43.00 - 42.50 = Rs 0.50

But in case, the Forward rate was Rs 42.00, then the intrinsic value of the
call Option would be zero.
Fig 5: Intrinsic Value

Intrinsic value Put Option
Intrinsic value of a put Option is equal to the difference between exercise
price and spot. rate (in case of American Option) and between exercise price and
Forward rate (in case of European Option). Figure graphically presents the
intrinsic value of a put Option. Equations give these values.
Fig 6: Intrinsic Value of Put Option
101
Intrinsic value of American put Option

= Exercise price - Spot rate
Intrinsic value of European put Option

= Exercise price - Forward rate
Options—in-the money, out-of-the-money and

at- the-money
An Option is said to be in-the-money when the underlying exchange rate is

superior to the exercise price (in the case of call Option) and inferior to the
exercise price (in case of put Option).
Likewise, it is said to be out-of-the-money when the underlying exchange

rate is inferior to the exercise price (in case of call Option) and superior to
exercise price (in case of put option).
Similarly, it is at-the-money when the exchange rate is equal to the

exercise price.
For example, an American type call Option that enables purchase of US

dollar at the rate of Rs 42.50 (exercise price) while the spot exchange rate on the
market is Rs 43.00 is in-the-money. If the US dollar on the spot market is at the
rate of Rs 42.50, then the call Option is at-the-money. Further, if the US dollar in
the Spot market is at the rate of Rs 42.00, it is obviously out-of-the-money.
It is evident that an Option-in-the-money will have higher premium than

the one out-of-the-money, as it enables to make a profit.
102
Time Value
Time value or extrinsic value of Options is equal to the difference between
the price or premium of Option and its intrinsic value. Equation defines this value.
Time value of Option = Premium - Intrinsic value
Suppose a call option enables purchase of a dollar for Rs 42.00 while it is
quoted at Rs 42.60 in the market, and the premium paid for the call option is Re
1.00, then,
Intrinsic value of the option = Rs 42.60 - Rs 42.00 = Re 0.60

Time value of the option = Re 1.00 - (42.60 - 42.00) = Re 0.40
Following factors affect the time value of an Option:
 Period that remains before the maturity date: As the Option

approaches the date of expiration, its time value diminishes. This is logical,
since the period during which the Option is likely to be used is shorter. On the
date of expiration, the Option has no time value and has only intrinsic value
(that is, premium equals intrinsic value).
 Differential of interest rates of currencies for the period corre-

sponding to the maturity date of the Option: Higher interest rate of
domestic currency means a lower PV (present value) of the exercise price. So
higher interest rate of domestic currency has the same effect as lower exercise
price. Thus higher domestic interest rate increases the value of a call, making
it more attractive and decreases the value of put. On the other hand, higher
interest rate on foreign currency makes holding of the foreign currency more
attractive since the interest income on foreign currency deposit increases. This
would have the effect of reducing the value of a call and increasing the value
of put.
 Volatility of the exchange rate of underlying (foreign) currency:

Greater the volatility greater is the probability of exercise of the Option and
hence higher will be the premium. Greater volatility increases the probability
103
of the spot rate going above exercise price for call or going below exercise
price for put. So price is going to be higher for greater volatility.
 Type of Option: American Option will be typically more valuable than

European Option because American type gives greater flexibility of use
whereas the European type is exercised only on maturity.
 Forward discount or premium: More a currency is likely to decline or

greater is forward discount on it, higher will be the value of put Option on it.
Likewise, when a currency is likely to harden (greater forward premium), call
on it will have higher value.
Strategies for using Options

Different strategies of options may be adopted depending on the
anticipations of the market as regards the evolution of exchange rates and
volatility.
ANTICIPATION OF APPRECIATIONS OF UNDERLYING

CURRENCY
Buying of a call Option may result into a net gain if market rate is more
than the strike price plus the premium paid. Equation gives the profit of the buyer
of the call Option. Call option will be exercised only if the exercise price is lower
than spot price.
Profit = St - X - c for St > X }

=-c for St < X }
Where
St = spot rate
X = strike price
c = premium paid
The profit profile will be exactly opposite for the seller (writer) of a call
Option. Graphically, Figure presents the profits of a call Option. Examples call
Option strategy.
104
Fig 7: Profit Profile of Call Option

Example: Strategy with call Option.
X = $ 0.68/DM
c = 2.00 cents/DM
On expiry date of Option (assuming European type), the gain or loss will
depend on the then Spot rates (St) as shown in the Table:
TABLE Spot Rate and Financial Impact of Call Option
Gain (+)/Loss (-)for

St The buyer of call option
$ 0.6000 - $ 0.02
$ 0.6200 -$0.02
$ 0.6400 - $ 0.02
$ 0.6500 - $ 0.02
$ 0.6600 - $ 0.02
$ 0.6700 -$0.02
$ 0.6800 -$0.02
$ 0.6900 -$0.01
$ 0.7000 $0.00
$0.7100 + $0.01
$0.7200 + $ 0.02
$ 0.7400 + $ 0.04
$ 0.7600 + $ 0.06
Table 4: Spot Rate
105
⇒ For St < $ 0.68/DM, the Option is allowed to lapse. Since DM can be

bought at a lower price than X, the loss is limited to the premium paid, i.e. $
0.02.
⇒ At St > 0.68, the Option will be exercised.
⇒ Between 0.68 < St < 0.70, a part of loss is recouped.
⇒ At St > 0.70, net profit is realized.
Reverse profit profile is obtained for the writer of call Option.
ANTICIPATION OF DEPRECIATION OF UNDERLYING

CURRENCY
Buying of a put Option anticipates a decline in the underlying currency.
The profit profile of a buyer of put Option is given by the equation. A put
Option will be exercised only if the exercise price is higher than spot rate.
Profit = X - St - p for X > St }
=-p for X < St }
Here p represents-the premium paid for put Options.
The opposite is the profit profile for the seller of a put Option. Graphically
Figure presents the profits of a put Option. Example illustrates a put Option
strategy.
Fig 8: Profit Profile of Put Option

Example: Strategy with put Option.
Spot rate at the time of buying put Option: $ 1.7000/E
X= $ 1.7150/E
106
p = $ 0.06/E
The gain/loss for the buyer of put Option on expiry are given in Table
⇒ For St > 1.7150, the Option will not be exercised since Pound sterling has
higher price in the market. There will be net loss of $ 0.06.
⇒ For 1.6550 < St < 1.7150, Option will be exercised, but there will be net
loss.
⇒ For St < 1.6550, the Option will be exercised and there will be net gain.
TABLE Spot Rate and Financial Impact of Put Option
St Gain(+)/loss (-)
1.6050 +0.050
1.6150 +0.040
1.6250 +0.030
1.6350 +0.020
1.6450 +0.010
1.6500 +0.005
1.6550 +0.000
1.6600 -0.005
1.6650 -0.010
1.6750 -0.020
1.6850 -0.030
1.6950 -0.040
1.7050 -0.050
1.7150 -0.060
1.7250 -0.060
1.7350 -0.060
Table 5
The reverse will be the profit profile of the seller of put Option.
STRADDLE
A straddle strategy involves a combination of a call and a put Option.
Buying a straddle means buying a call and a put Option simultaneously for the
same strike price and same maturity. The premium paid is the sum of the premia
paid for each of them. The profit profile for the buyer of a straddle is given by
equation:
Profit = X - St - (c + p) for X > St (a)
Profit = St, - X - (c + p) for St > X (b)
107
It is to be noted that the equation a is the combination of use of put Option

(X - St - p) and non-use of call Option (- c) whereas the equation b is the
combination of use of call Option (St - X - c) and non-use of put Option (- p). In
other words, while equation a shows the use of put Option, equation b relates to
the use of call Option. Figures show graphically .the profit files of a straddle.
Example illustrates this option strategy in numerical form.
Fig 9
Fig 10
108
The straddle strategy is adopted when a buyer is anticipating significant

fluctuations of a currency, but does not know the direction of fluctuations. On the
contrary, the seller of straddle does not expect the currency to vary too much and
hopes to be able to keep his premium. He anticipates a diminishing volatility. He
makes profits only if the currency rate is between X1 (X – c – p) and X2 (X + c +
p). His profit is maximum if the spot rate is equal to the exercise price. In that
case, he gains the entire premium amount. The gains for the buyer of a straddle
are unlimited while losses are limited.
SPREAD
Spread refers to the simultaneous buying of an Option and selling of

another in respect of the same underlying currency. Spreads are often used by
traders in banks.
A spread is said to be vertical spread or price spread if it is composed of

buying and selling of an Option of the same type with the same maturity with
different strike prices. Spreads are called vertical simply because in newspapers,
quotations of Options for different strike prices are indicated one above the other.
They combine the anticipations on the rates and the volatility. On the other hand,
horizontal spread combines simultaneous buying and selling of Options of
different maturities with the same strike price.
When a call option is bought with a lower strike price and another call is
sold with a higher strike price, the maximum loss in this combination is equal to
the difference between the premium earned on selling one option and the premium
paid on buying another. This combination is known as bullish call spread. The
opposite of this is a bearish call.
The other combination is to sell a put Option with a higher strike price of
X2 and to buy another put Option with a lower strike price of X 1 Maximum gain is
the difference between the premium obtained for selling and the premium paid for
buying. This combination is called bullish put spread while the opposite is bearish
109
put. Figures show the profit profile of bullish spreads using call and put Options
respectively. The strategies of spread are used for limited gain and limited loss.
Examples are illustrations of bullish and bearish put spreads respectively.
Fig 11
Fig 12
110
Covering Exchange Risk with Options

A currency option enables an enterprise to secure a desired exchange rate
while retaining the possibility of benefiting from a favorable evolution of
exchange rate. Effective exchange rate guaranteed through the use of options is a
certain minimum rate for exporters and a certain maximum rate for importers.
Exchange rates can be more profitable in case of their favorable evolution.
Apart from covering exchange rate risk, Options are also used for
speculation on the currency market.
Covering Receivables Denominated in Foreign Currency

In order to cover receivables, generated from exports and denominated in
foreign currency, the enterprise may buy put option as illustrated in Examples
Example: The exporter Vikrayee knows that he would receive US $

5,00,000 in three months. He buys a put option of three months maturity at a
strike price of Rs 43.00/US $. Spot rate is Rs 43.00/US $. Forward rate is also Rs
43.00/US $. Premium to be paid is 2.5 per cent.
Show various possibilities of how Option is going to be exercised.
Solution: The exporter pays the premium immediately, that is, a sum of 0.025 x $
5,00,000 x Rs 43.00 = Rs 537,500. Now let us examine different possibilities that
may occur at the time of settlement of the receivables.
(a) The rate becomes Rs 42/US $. That is, the US dollar has depreciated. In this
situation, put Option holder would like to make use of his Option and sell his
dollars at the strike price, Rs 43.00 per dollar. Thus, net receipts would be:
Rs 43 x $ 5, 00,000 - Rs 43.00 x 0.025 x $ 5,00,000
= Rs 43 x $ 5, 00,000 (1 - 0.025)
= Rs 41.925 x 5, 00,000
= Rs 2, 09, 62,500
If he had not covered, he would have received Rs 42 x 5, 00,000 or Rs 21, 00,000.
But he would not be certain about the actual amount to be received until the date
of maturity.
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(b) Dollar rate becomes Rs 43.50. This means that dollar has appreciated a
bit. In this case, the exporter does not stand to gain anything by using his Option.
He sells his dollars directly in the market at the rate of Rs 43.50. Thus, the net
amount that he receives is:
Rs 43.50 x $ 5, 00,000 - Rs 43.00 x 0.025 x $ 5, 00,000
= Rs (43.50 - 43.00 x 0.025) x $ 5, 00,000
= Rs 42.425 x $ 5, 00,000
= Rs 2, 12, 12,500
If he had not covered, he would have got Rs 43.50 x $ 5, 00,000 or Rs 21,750,000.
(c) Dollar Rate, on the date of settlement, becomes Rs 43.00, that is, equal to
strike price. In this case also, the exporter does not gain any advantage by using
his option. Thus, the net sum that he gets is:
Rs 43.00 x 5, 00, 000 - Rs 43 x 0.025 x 5, 00,000
= Rs (43 - 43 x 0.025) x 5, 00,000
= Rs 2, 09, 62,500
It is apparent from the above calculations that irrespective of the evolution of the
exchange rate, the minimum amount that he is sure to get is Rs 2, 09, 62,500 and
any favourable evolution of exchange rate enables him to reap greater profit.
Covering Payables Denominated in Foreign Currency

In order to cover payables denominated in a foreign currency, an enterprise
may buy a currency call Option. Examples illustrate the use of call Option.
Example An importer, Vikrayee, is to pay one million US dollars in two
months. He wants to cover exchange risk with call Option. The data are as
follows:
Spot rate, forward rate and strike price are Rs 43.00 per dollar. The
premium is 3 per cent. Discuss various possibilities that may occur for the
importer.
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Solution: The importer pays the premium amount immediately. That is, a sum of
Rs 43 x 0.03 x 10, 00,000 or Rs 1,290,000 is paid as premium.
Let us examine the following three possibilities.
(a) Spot rate on the date of settlement becomes Rs 42.50. That is, there is slight
depreciation of US dollar. In such a situation, the importer does not exercise his
Option and buys US dollars from the market directly. The net amount that he pays
is:
Rs (42.50 x $ 10, 00,000 + 43 x 0.03 x $ 10, 00,000)
OR
Rs 4, 37, 90,000
(b) Spot rate, on the settlement date, is Rs 43.75 per US dollar. Evidently, the US
dollar has appreciated. In this case, the importer exercises his Option. Thus, the
net sum that he pays is:
Rs 43 x $ 10, 00,000 + Rs 43 x 0.03 x $ 1, 00,000
OR
Rs43 x 1.03 x $ 10, 00,000
OR
Rs 4, 42, 90,000
(c) Spot rate, on the settlement, is the same as the strike price. In such a situation,
the importer does not exercise Option, or rather; he is indifferent between exercise
and non-exercise of the Option. The net payment that he makes is:
Rs43 x 1.03 x $ 10, 00,000
or
Rs 4, 42, 90,000
Thus, the maximum rate paid by the importer is the exercise price plus the
premium.
Example: An importer of France has imported goods worth US $ 1 million

from USA. He wants to cover against the likely appreciation of dollars against
Euro. The data are as follows:
Spot rate: Euro 0.9903/US $
Strike price: Euro 0.99/US $
Premium: 3 per cent
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Maturity: 3 months
What are the operations involved?
Solution: While buying a call Option, the importer pays upfront the
premium amount of
$ 10, 00,000 x 0.03
Or
Euro 10, 00,000 x 0.03 x 0.9903
Or
Euro 29,709
Thus, the importer has ensured that he would not have to pay more than
Euro 10, 00,000 x 0.99 + Euro 29709
Or
Euro 10, 19,709
On maturity, following possibilities may occur:
 US dollar appreciates to, say, Euro 1.0310. In this case, the importer
exercises his call Option and thus pays only Euro 10, 19,709 as calculated
above.
 US dollar depreciates to, say, Euro 0.9800. Here, the importer abandons
the call Option and buys US dollar from the market. His net payment is Euro
(0.9800 x 10, 00,000 + 29,709) or Euro 10, 09,709.
 US dollar Remains at Euro 0.99. In this case, the importer is indifferent.
The sum paid by him is Euro 10, 19,709.
The payment profile while using call Option is shown in Figure
Fig 13
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Covering a Bid for an Order of Merchandise

An enterprise that has submitted a tender will like to cover itself against
unfavorable movement of currency rates between the time of submission of the
bid and its acceptance (in case it is through). If the enterprise does not cover, it
runs a risk of squeezing its profit margin, in case foreign currency undergoes
depreciation in the meantime.
However, if it covers on forward market, and its offer is not accepted, in

that eventuality, it will have to sell the currency on the market, perhaps with a
loss. Therefore, a better solution in the case of submission of bid for future orders
is to cover with put options. The put Option enables the enterprise to cover against
a decrease in the value of currency on the one hand, and allows him to retain the
possibility of benefiting from the increase in the value of the currency on the
other.
Example: A company bids for a contract for a sum of 1 million US

dollars. While the period of response is 6 months, the current exchange rate is Rs
43.50 per US dollar. Six month forward rate is Rs 44.50 per US dollar.
Premium for a put option of 6 months maturity is 3 per cent with a strike price of
Rs 43.50.
Discuss various possibilities of losses/gains in case the enterprise decides

to cover or not to cover.
Solution:
(a) If the enterprise does not cover and the dollar rate decreases, the potential loss
is unlimited.
(b) If the enterprise covers on forward market and if its bid is not accepted and the
dollar rate increases, its potential loss is unlimited, since the enterprise will be
required to deliver dollars to the bank after buying them at a higher rate.
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(c) If the enterprise buys a put option, it pays the premium amount of Rs 0.03 x $
10,00,000 x 43.50 or Rs 13,05,000. Now, there may be two situations:
1. The bid is accepted and the rate on the date of acceptance is Rs 42.00
per dollar, i.e. the US dollar has depreciated. In this case, the put option is resold
(exercised) with a gain of Rs (43.50 - 42.00) x $ 10, 00,000 or Rs 15, 00,000
After deducting the premium amount, the net gain works out to be Rs 1,
95,000 (Rs 15, 00,000 -Rs 13, 05,000). And, future receipts are sold on forward
market.
Other possibility is that the bid is accepted but the US dollar has
appreciated to Rs 44.00. In that case, the Option is abandoned. And, the future
receipts are sold on forward market.
2. The bid is not accepted and the US dollar depreciates to Rs 42.00. In
that case, the enterprise exercises its put option and makes a net gain of Rs 1,
95,000.
In case the bid is not accepted and US dollar appreciates, the enterprise
simply abandons its Option and its loss is equal to the premium amount paid.
Other Variants of Options
Average Rate Option

Average rate Option (also called Asian Option) is an Option whose strike
price is compared against the average of the rate that existed during the life of the
Option and not with the rate on the date of maturity. Since the volatility of an
average of rates is lower than that of the rates themselves, the premium of
average-rate-Option is lower. At the end of the maturity of Option, the average of
exchange rates is calculated from the well-defined data and is compared with
exercise price of a call or put Option, as the case may be. If the Option is in the
money, that is, if average rate is greater than the exercise price of a call Option
(and reverse for a put option), a payment in cash is made to the profit of the buyer
of the Option.
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Lookback Option
A lookback option is the one whose exercise price is determined at the
moment of the exercise of the option and not when it is bought. The exercise price
is the one that is most favourable to the buyer of the option during the life of the
option.
Thus, for a lookback call option, the exercise price will be the lowest
attained during its life and for a lookback put option, it will be the highest attained
during the life of the option. Since it is favorable to the option-holder, the
premium paid on a lookback option is higher.
There are other variants of options such as knock-in and knock-out options
and hybrid option. These are not discussed here. Most of these variants aim at
reducing the premia of option and are instrument tailor-made for a particular
purpose.
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11 CURRENCY SWAPS
Introduction
Swaps involve exchange of a series of payments between two parties.
Normally, this exchange is effected through an intermediary financial institution.
Though swaps are not financing instruments in themselves, yet they enable
obtainment of desired form of financing in terms of currency and interest rate.
Swaps are over-the-counter instruments.
The market of currency swaps has been developing at a rapid pace for the
last fifteen years. As a result, this is now the second most important market after
the spot currency market. In fact, currency swaps have succeeded parallel loans,
which had developed in countries where exchange control was in operation. In
parallel loans, two parties situated in two different countries agreed to give each
other loans of equal value and same maturity, each denominated in the currency of
the lender. While initial loan was given at spot rate, reimbursement of principal as
well as interest took into account forward rate.
However, these parallel loans presented a number of difficulties. For

instance, default of payment by one party did not free the other party of its
obligations of payment. In contrast, in a swap deal, if one party defaults, the
counterparty is automatically relived of its obligation.
Currency swaps can be divided into three

categories: -
(a) fixed-to-fixed currency swap,
(b) floating-to-floating currency swap,
(c) fixed-to-floating currency swap.
A fixed-to-fixed currency swap is an agreement between two parties who

exchange future financial flows denominated in two different currencies. A
currency swap can be understood as a combination of simultaneous spot sale of a
currency and a forward purchase of the same amounts of currency. This double
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operation does not involve currency risk. In the beginning of exchange contract,
counterparties exchange specific amount of two currencies. Subsequently, they
settle interest according to an agreed arrangement. During the life of swap
contract, each party pays the other the interest streams and finally they reimburse
each other the principal of the swap.
A simple currency swap enables the substitution of one debt denominated

in one currency at a fixed rate to a debt denominated in another currency also at a
fixed rate. It enables both parties to draw benefit from the differences of interest
rates existing on segmented markets. A similar operation is done with regard to
floating-to- floating rate swap.
A fixed-to-floating currency coupon swap is an agreement between two

parties by which they agree to exchange financial flows denominated in two
different currencies with different type of interest rates, one fixed and other
floating. Thus, a currency coupon swap enables borrowers (or lenders) to borrow
(or lend) in one currency and exchange a structure of interest rate against another-
fixed rate against variable rate and vice versa. The exchange can be either of
interest coupons only or of interest coupons as well as principal. For example, one
may exchange US dollars at fixed rate for French francs at variable rate. These
types of swaps are used quite frequently.
Important Features Of Swaps Contracts

Minimum size of a swap contract is of the order of 5 million US dollar or
its equivalent in other currencies. But there are swaps of as large a size as 300
million US dollar, especially in the case of Eurobonds. The US dollar is the most
sought after currencies in swap deals. The dollar-yen swaps represent 25 per cent
of the total while dollar-deutschemark account for 20 per cent of the total. The
swaps involving Euro are also likely to be widely- prevalent in European
countries.
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Life of a swap is between two and ten years. As regards the rate of interest
of the swapped currencies, the choice depends on the anticipation of enterprise.
Interest payments are made on annual or semi-annual basis.
Reasons for Currency Swap Contracts

At any given point of time, there are investors and borrowers who would
like to acquire new assets/liabilities to which they may not have direct access or to
which their access may be costly. For example, a company may retire its foreign
currency loan prematurely by swapping it with home currency loan. The same can
also be achieved by direct access to market and by paying penalty for premature
payment. A swap contract makes it possible at a lower cost. Some of the
significant reasons for entering into swap contracts are given below.
Hedging Exchange Risk

Swapping one currency liability with another is a way of eliminating
exchange rate risk. For example, if a company (in UK) expects certain inflows of
deutschemarks, it can swap a sterling liability into deutschemark liability.
Differing Financial Norms

The norms for judging credit-worthiness of companies differ from country
t6 country. For example, Germany or Japanese companies may have much higher
debt-equity ratios than what may be acceptable to US lenders. As a result, a
German or Japanese company may find it difficult to raise a dollar loan in USA. It
would be much easier and cheaper for these companies to raise a home currency
loan and then swap it with a dollar loan.
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Credit Rating
Certain countries such as USA attach greater importance to credit rating
than some others like those in continental Europe. The latter look, inter-alia, at
company's reputation and other important aspects. Because of this difference in
perception about rating, a well reputed company like IBM even-with lower rating
may be able to raise loan in Europe at a lower cost than in USA. Then this loan
can be swapped for a dollar loan.
Market Saturation
If an organisation has borrowed a sizable sum in a particular currency, it
may find it difficult to raise additional loans due to 'saturation' of its borrowing in
that currency. The best way to tide over this difficulty is to borrow in some other
'unsaturated' currency and then swap. A well-known example of this kind of swap
is World Bank-IBM swap. Having borrowed heavily in German and Swiss
market, the WB had difficulty raising more funds in German and Swiss
currencies. The problem was resolved by the WB making a dollar bond issue and
swapping it with IBM's existing liabilities in deutschemark and Swiss franc.
Parties involved
Currency swaps involve two parties who agree to pay each other's debt
obligations denominated in different currencies. Example illustrates currency
swaps.
Example
Suppose Company B, a British firm, had issued £ 50 million pound-
denominated bonds in the UK to fund an investment in France. Almost at the
same time, Company F, a French firm, has issued £ 50 million of French franc-
denominated bonds in France to make the investment in UK. Obviously,
Company B earns in French franc (Ff) but is required to make payments in the
British pound. Likewise, Company F earns in pound but is to make payments in
French francs. As a result, both the companies are exposed to foreign exchange
risk.
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Foreign exchange risk exposure is eliminated for both the companies if

they swap payment obligations. Company B pays in pound and Company F pays
in French francs. Like interest rate swaps, extra payment may be involved from
one company to another, depending on the creditworthiness of the companies. It
may be noted that the eventual risk of non-payment of bonds lies with the
company that has initially issued the bonds. This apart, there may be differences
in the interest rates attached to these bonds, requiring compensation from one
company to another.
It is worth stressing here that interest rate swaps are distinguished from
currency swaps for the sake of comprehension only. In practice, currency swaps
may also include interest-rate swaps. Viewed from this perspective, currency
swaps involve three aspects:
1. Parties involve exchange debt obligations in different currencies,

2. Each party agrees to pay the interest obligation of the other party and
3. On maturity, principal amounts are exchanged at an exchange rate agreed
in advance.
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The majority of Indian corporates have at least 80% of their foreign

exchange transactions in US Dollars. This is wholly unacceptable from the point
of view of prudent Risk Management. "Don't put all your eggs in one basket" is
the essence of Risk Diversification, one of the cornerstones of prudent Risk
Management.
Disadvantages of $-Rupee Advantages of Major currencies

1. The very nature or structure of the $- 1.By diversifying into a more liquid
Rupee market can be harmful because it is market, such as Euro-Dollar, the risk
small, thin and illiquid. Thus, dealer arising from the Structure of the Indian
spreads are quite wide and in times of Rupee Market can be hedged
volatility, the price can move in large
gaps
2. Impacted in full by the Trend of the 2. Trends in one currency can be

market. For instance, if the Rupee is hedged by offsetting trends in another
depreciating, its impact will be felt in full currency. Refer to graphs and
by an Importer calculations below.
3.Dollar-Rupee, in particular, brings the 3. These constraints do not apply in the

following risks: case of the Major currencies:
1) Lack of Flexibility...Payables once 1) Flexibility...Hedge contracts in
covered cannot be cancelled and rebooked Euro-Dollar or Dollar-Yen etc. can be
2) Unpredictability...Dollar-Rupee is not a entered into and squared off as many
freely traded currency and hence times as required
extremely difficult to predict. The normal 2) Predictability...the Majors are much
tools of currency forecasting, such as more predictable and liquid than
Technical Analysis are best suited to Dollar-Rupee and hence Entry-Exit-
freely traded markets Stop Loss can be planned with ease,
3) Lack of Information...Price information accuracy and effectiveness
on Dollar-Rupee is not freely available to 3) Free Information...The Internet
all market participants. Only subscribers provides LIVE and FREE prices on
to expensive "quote services" can get these currencies.
accurate information
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4.$-Rupee rose 2.35% from mid-June to 4.Euro-Rupee fell 4.63% over the same
11th Aug. period
5.· An Importer with 100% exposure to 5.An Importer with 25% exposure to
USD, saw its liabilities rise from a base of the Euro saw its liability rise from a
100 to 102.35 base of 100 to only 100.60
Table 6: Disadvantages of trading in one currency
Even if a Corporate does not have a direct exposure to any currency other
than the USD, it can use Forward Contracts or Options to create the desired
exposure profile. Thankfully, this is permitted by the RBI. This is not Speculation.
It is prudent, informed and proactive Risk Management.
As seen, the bad news is that Dollar-Rupee volatility has increased. The
good news is that forecasts can put you ahead of the market and ahead of the
competition.
If you look at the chart below you will observe, Dollar-Rupee volatility
has increased from 5 paise per day in 2004 to about 20 paise per day today. It is
set to increase further, to 35-45 paise per day over the next 12 months.
Now the question here is, how do you protect your business from Forex
volatility? Just need to track the Market every moment and by any dealer’s
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forecasts. They help keep you on the right side of the market. They have an
enviable track record. So as to keep these record technical analysis of markets
gives a very important help to back up profits from high volatile market. Take the
services of many FX-dealers that include long-term forecasts, daily updates as
well as hedging advice for the corporates. In the further part of the projects let’s
now discuss the fundamentals of Technical Analysis, the indices that are mainly
used to forecast the market movement and the actual use of this Technical
Analysis in Risk Management.
12 TECHNICAL ANALYSIS
WHAT DOES TECHNICAL ANALYSIS MEAN?
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A method of evaluating securities by analyzing statistics generated by

market activity, such as past prices and volume. Technical analysts do not attempt
to measure a security's intrinsic value, but instead use charts and other tools to
identify patterns that can suggest future activity.
General Description
Technical analysts seek to identify price patterns and trends in financial

markets and attempt to exploit those patterns. While technicians use various
methods and tools, the study of price charts is primary.
Technicians especially search for archetypal patterns, such as the well-

known head and shoulders or double top reversal patterns, study indicators such
as moving averages, and look for forms such as lines of support, resistance,
channels, and more obscure formations such as flags, pennants or balance days.
Technical analysts also extensively use indicators, which are typically

mathematical transformations of price or volume. These indicators are used to
help determine whether an asset is trending, and if it is, its price direction.
Technicians also look for relationships between price, volume and, in the case
of futures, open interest. Examples include the relative strength index,
and MACD. Other avenues of study include correlations between changes
in options (implied volatility) and put/call ratios with price. Other technicians
include sentiment indicators, such as Put/Call ratios and Implied Volatility in their
analysis.
Technicians seek to forecast price movements such that large gains from
successful trades exceed more numerous but smaller losing trades, producing
positive returns in the long run through proper risk control and money
management.
There are several schools of technical analysis. Adherents of different

schools (for example, candlestick charting, Dow Theory, and Elliott wave theory)
may ignore the other approaches, yet many traders combine elements from more
than one school. Technical analysts use judgment gained from experience to
decide which pattern a particular instrument reflects at a given time, and what the
interpretation of that pattern should be.
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Technical analysis is frequently contrasted with fundamental analysis, the

study of economic factors that influence prices in financial markets. Technical
analysis holds that prices already reflect all such influences before investors are
aware of them, hence the study of price action alone. Some traders use technical
or fundamental analysis exclusively, while others use both types to make trading
decisions.
.1 Principles
Technicians say that a market's price reflects all relevant information, so

their analysis looks more at "internals" than at "externals" such as news events.
Price action also tends to repeat itself because investors collectively tend toward
patterned behavior – hence technicians' focus on identifiable trends and
conditions.
.1.1 Market Action Discounts Everything
Based on the premise that all relevant information is already reflected by

prices, pure technical analysts believe it is redundant to do fundamental analysis –
they say news and news events do not significantly influence price, and cite
supporting research such as the study by Cutler, Poterba, and Summers titled
"What Moves Stock Prices?"
On most of the sizable return days [large market moves]...the information that the
press cites as the cause of the market move is not particularly important. Press
reports on adjacent days also fail to reveal any convincing accounts of why future
profits or discount rates might have changed. Our inability to identify the
fundamental shocks that accounted for these significant market moves is difficult
to reconcile with the view that such shocks account for most of the variation in
stock returns.
.1.2 Prices Move In Trends
Technical analysts believe that prices trend. Technicians say that markets
trend up, down, or sideways (flat). This basic definition of price trends is the one
put forward by Dow Theory.
An example of a security that had an apparent trend is AOL from November 2001
through August 2002. A technical analyst or trend follower recognizing this trend
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would look for opportunities to sell this security. AOL consistently moves
downward in price. Each time the stock rose, sellers would enter the market and
sell the stock; hence the "zig-zag" movement in the price. The series of "lower
highs" and "lower lows" is a tell tale sign of a stock in a down trend. In other
words, each time the stock edged lower, it fell below its previous relative low
price. Each time the stock moved higher, it could not reach the level of its
previous relative high price.
Note that the sequence of lower lows and lower highs did not begin until
August. Then AOL makes a low price that doesn't pierce the relative low set
earlier in the month. Later in the same month, the stock makes a relative high
equal to the most recent relative high. In this a technician sees strong indications
that the down trend is at least pausing and possibly ending, and would likely stop
actively selling the stock at that point.
.1.3 History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of

the investors that preceded them. "Everyone wants in on the next Microsoft," "If
this stock ever gets to $50 again, I will buy it," "This company's technology will
revolutionize its industry, therefore this stock will skyrocket" – these are all
examples of investor sentiment repeating itself. To a technician, the emotions in
the market may be irrational, but they exist. Because investor behavior repeats
itself so often, technicians believe that recognizable (and predictable) price
patterns will develop on a chart.
Technical analysis is not limited to charting, but it always considers price

trends. For example, many technicians monitor surveys of investor sentiment.
These surveys gauge the attitude of market participants, specifically whether they
are bearish or bullish. Technicians use these surveys to help determine whether a
trend will continue or if a reversal could develop; they are most likely to anticipate
a change when the surveys report extreme investor sentiment. Surveys that show
overwhelming bullishness, for example, are evidence that an uptrend may reverse
– the premise being that if most investors are bullish they have already bought the
market (anticipating higher prices). And because most investors are bullish and
invested, one assumes that few buyers remain. This leaves more potential sellers
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than buyers, despite the bullish sentiment. This suggests that prices will trend
down, and is an example of contrarian trading.
USE
Many traders say that trading in the direction of the trend is the most
effective means to be profitable in financial or commodities markets. John W.
Henry, Larry Hite, Ed Seykota, Richard Dennis, William Eckhardt, Victor
Sperandeo, Michael Marcus and Paul Tudor Jones (some of the so-called Market
Wizards in the popular book of the same name by Jack D. Schwager) have each
amassed massive fortunes via the use of technical analysis and its
concepts. George Lane, a technical analyst, coined one of the most popular
phrases on Wall Street, "The trend is your friend!"
Many non-arbitrage algorithmic trading systems rely on the idea of trend-
following, as do many hedge funds. A relatively recent trend, both in research and
industrial practice, has been the development of increasingly sophisticated
automated trading strategies. These often rely on underlying technical analysis
principles (see algorithmic trading article for an overview).
SYSTEMATIC TRADING
Neural Networks
Since the early 1990s when the first practically usable types
emerged, artificial neural networks (ANNs) have rapidly grown in popularity.
They are artificial intelligence adaptive software systems that have been inspired
by how biological neural networks work. They are used because they can learn to
detect complex patterns in data. In mathematical terms, they are universal function
approximators,[21][22] meaning that given the right data and configured correctly,
they can capture and model any input-output relationships. This not only removes
the need for human interpretation of charts or the series of rules for generating
entry/exit signals, but also provides a bridge to fundamental analysis, as the
variables used in fundamental analysis can be used as input.
As ANNs are essentially non-linear statistical models, their accuracy and
prediction capabilities can be both mathematically and empirically tested. In
various studies, authors have claimed that neural networks used for generating
trading signals given various technical and fundamental inputs have significantly
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outperformed buy-hold strategies as well as traditional linear technical analysis

methods when combined with rule-based expert systems.[23][24][25]
While the advanced mathematical nature of such adaptive systems has kept neural
networks for financial analysis mostly within academic research circles, in recent
years more user friendly neural network software has made the technology more
accessible to traders. However, large-scale application is problematic because of
the problem of matching the correct neural topology to the market being studied.
Rule-Based Trading
Rule-based trading is an approach intended to create trading plans using
strict and clear-cut rules. Unlike some other technical methods and the approach
of fundamental analysis, it defines a set of rules that determine all trades, leaving
minimal discretion. The theory behind this approach is that by following a distinct
set of trading rules you will reduce the number of poor decisions, which are often
emotion based.
For instance, a trader might make a set of rules stating that he will take a long
position whenever the price of a particular instrument closes above its 50-
day moving average, and shorting it whenever it drops below.
Combination With Other Market Forecast Methods
John Murphy says that the principal sources of information available to
technicians are price, volume and open interest. Other data, such as indicators and
sentiment analysis, are considered secondary.
However, many technical analysts reach outside pure technical analysis,
combining other market forecast methods with their technical work. One advocate
for this approach is John Bollinger, who coined the term rational analysis in the
middle 1980s for the intersection of technical analysis and fundamental
analysis. Another such approach, fusion analysis, overlays fundamental analysis
with technical, in an attempt to improve portfolio manager performance.
Technical analysis is also often combined with quantitative
analysis and economics. For example, neural networks may be used to help
identify intermarket relationships. A few market forecasters combine financial
astrology with technical analysis. Chris Carolan's article "Autumn Panics and
Calendar Phenomenon", which won the Market Technicians Association Dow
Award for best technical analysis paper in 1998, demonstrates how technical
analysis and lunar cycles can be combined. It is worth noting, however, that some
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of the calendar related phenomena, such as the January effect in the stock market,
have been associated with tax and accounting related reasons.
Investor and newsletter polls, and magazine cover sentiment indicators, are
also used by technical analysts.
13 TYPES OF CHARTS
There are four main types of charts that are used by investors and traders
depending on the information that they are seeking and their individual skill
levels. The chart types are: the line chart, the bar chart, the candlestick chart and
the point and figure chart. In the following sections, we will focus on the S&P 500
Index during the period of January 2006 through May 2006. Notice how the data
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used to create the charts is the same, but the way the data is plotted and shown in
the charts is different.
Line Chart
The most basic of the four charts is the line chart because it represents only the
closing prices over a set period of time. The line is formed by connecting the
closing prices over the time frame. Line charts do not provide visual information
of the trading range for the individual points such as the high, low and opening
prices. However, the closing price is often considered to be the most important
price in stock data compared to the high and low for the day and this is why it is
the only value used in line charts.
Fig 14: A line chart
Bar Charts
The bar chart expands on the line chart by adding several more key pieces of
information to each data point. The chart is made up of a series of vertical lines
that represent each data point. This vertical line represents the high and low for
the trading period, along with the closing price. The close and open are
represented on the vertical line by a horizontal dash. The opening price on a bar
chart is illustrated by the dash that is located on the left side of the vertical bar.
Conversely, the close is represented by the dash on the right. Generally, if the left
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dash (open) is lower than the right dash (close) then the bar will be shaded black,
representing an up period for the stock, which means it has gained value. A bar
that is colored red signals that the stock has gone down in value over that period.
When this is the case, the dash on the right (close) is lower than the dash on the
left (open).
Fig 15: A bar chart
Candlestick Charts
The candlestick chart is similar to a bar chart, but it differs in the way that
it is visually constructed. Similar to the bar chart, the candlestick also has a thin
vertical line showing the period's trading range. The difference comes in the
formation of a wide bar on the vertical line, which illustrates the difference
between the open and close. And, like bar charts, candlesticks also rely heavily on
the use of colors to explain what has happened during the trading period. A major
problem with the candlestick color configuration, however, is that different sites
use different standards; therefore, it is important to understand the candlestick
configuration used at the chart site you are working with. There are two color
constructs for days up and one for days that the price falls. When the price of the
stock is up and closes above the opening trade, the candlestick will usually be
white or clear. If the stock has traded down for the period, then the candlestick
will usually be red or black, depending on the site. If the stock's price has closed
above the previous day’s close but below the day's open, the candlestick will be
black or filled with the color that is used to indicate an up day.
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Fig 16: A candlestick chart

Point and Figure Charts
The point and figure chart is not well known or used by the average investor but it
has had a long history of use dating back to the first technical traders. This type of
chart reflects price movements and is not as concerned about time and volume in
the formulation of the points. The point and figure chart removes the noise, or
insignificant price movements, in the stock, which can distort traders' views of the
price trends. These types of charts also try to neutralize the skewing effect that
time has on chart analysis.
Fig 17: A point and figure chart
When first looking at a point and figure chart, you will notice a series of Xs and
Os. The Xs represent upward price trends and the Os represent downward price
trends. There are also numbers and letters in the chart; these represent months, and
give investors an idea of the date. Each box on the chart represents the price scale,
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which adjusts depending on the price of the stock: the higher the stock's price the
more each box represents. On most charts where the price is between $20 and
$100, a box represents $1, or 1 point for the stock. The other critical point of a
point and figure chart is the reversal criteria. This is usually set at three but it can
also be set according to the chartist's discretion. The reversal criteria set how
much the price has to move away from the high or low in the price trend to create
a new trend or, in other words, how much the price has to move in order for a
column of Xs to become a column of Os, or vice versa. When the price trend has
moved from one trend to another, it shifts to the right, signaling a trend change.
Types of Trends
Up trend- The graph shows Up trend in which if the closing points are connected
they give rising trend line.
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Fig 18: Uptrend

Down Trend- The down trend is when the line connecting all closing points
shows falling trend line. As shown in following graph.
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Fig 19: Down trend
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Sideways Trend- when there is no up or down movement in the market it is said

to be in the Sideways Trend. As shown in following graph.
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Fig 20 : Sideway trend

Trend Lines-
Support and Resistance Lines-
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Think of prices for financial instruments as a result of a head-to-

head battle between a bull (the buyer) and a bear (the seller). Bulls push prices
higher, and bears lower them. The direction prices actually move shows who wins
the battle.
Fig 21: Support and Resistance Line

Support is a level at which bulls (i.e., buyers) take control over the prices and
prevent them from falling lower.
Resistance, on the other hand, is the point at which sellers (bears) take
control of prices and prevent them from rising higher. The price at which a trade
takes place is the price at which a bull and bear agree to do business. It represents
the consensus of their expectations.
Support levels indicate the price where the most of investors believe that prices
will move higher. Resistance levels indicate the price at which the most of
investors feel prices will move lower.
But investor expectations change with the time, and they often do so
abruptly. The development of support and resistance levels is probably the most
noticeable and reoccurring event on price charts. The breaking through
support/resistance levels can be triggered by fundamental changes that are above
or below investor's expectations (e.g., changes in earnings, management,
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competition, etc.) or by self-fulfilling prophecy (investors buy as they see prices

rise). The cause is not so significant as the effect: new expectations lead to new
price levels. There are support/resistance levels, which are more emotional.
Supply And Demand

There is nothing mysterious about support and resistance: it is classic
supply and demand. Remembering ’Econ 101’ class, supply/demand lines show
what the supply and demand will be at a given price.
The supply line shows the quantity (i.e., the number of shares) that sellers
are willing to supply at a given price. When prices increase, the quantity of sellers
also increases as more investors are willing to sell at these higher prices. The
demand line shows the number of shares that buyers are willing to buy at a given
price. When prices increase, the quantity of buyers decreases as fewer investors
are willing to buy at higher prices.
At any given price, a supply/demand chart shows how many buyers and
sellers there are. In a free market, these lines are continually changing. Investor's
expectations change, and so do the prices buyers and sellers feel are acceptable. A
breakout above a resistance level is evidence of an upward shift in the demand
line as more buyers become willing to buy at higher prices. Similarly, the failure
of a support level shows that the supply line has shifted downward.
The foundation of most technical analysis tools is rooted in the concept of
supply and demand. Charts of prices for financial instruments give us a superb
view of these forces in action.
Traders’ Remorse
After a support/resistance level has been broken through, it is common for
traders to ask themselves about to what extent new prices represent the facts. For
example, after a breakout above a resistance level, buyers and sellers may both
question the validity of the new price and may decide to sell. This creates a
phenomenon that is referred to as "traders’ remorse": prices return to a
support/resistance level following a price breakout.
The price action following this remorseful period is crucial. One of two
things can happen: either the consensus of expectations will be that the new price
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is not warranted, in which case prices will move back to their previous level; or
investors will accept the new price, in which case prices will continue to move in
the direction of the breaking through.
In case number one, following traders’ remorse, the consensus of
expectations is that a new higher price is not warranted, a classic "bull trap" (or
false breakout) is created. For example, the prices broke through a certain
resistance level (luring in a herd of bulls who expected prices to move higher),
and then prices dropped back to below the resistance level leaving the bulls
holding overpriced stock. Similar sentiment creates a bear trap. Prices drop below
a support level long enough to get the bears to sell (or sell short) and then bounce
back above the support level leaving the bears out of the market.
The other thing that can happen following traders’ remorse is that
investors expectations may change causing the new price to be accepted. In this
case, prices will continue to move in the direction of the penetration.
A good way to quantify expectations following a breakout is with the
volume associated with the price breakout. If prices break through the
support/resistance level with a large increase in volume and the traders’ remorse
period is on relatively low volume, it implies that the new expectations will rule (a
minority of investors are remorseful). Conversely, if the breakout is on moderate
volume and the "remorseful" period is on increased volume, it implies that very
few investor expectations have changed and a return to the original expectations
(i.e., original prices) is warranted.
Fig 22: Trader’s Remorse

Resistance becomes support
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When a resistance level is successfully broken through, that level becomes

a support level. Similarly, when a support level is successfully broken through,
that level becomes a resistance level.
The reason for it is that a new "generation" of bulls appears, who refused
to buy when prices were low. Now they are anxious to buy at any time the prices
return to the previous level. Similarly, when prices drop below a support level,
that level often becomes a resistance level that prices have a difficult time
breaking through. When prices approach the previous support level, investors seek
to limit their losses by selling.
Fig 23: Resistance Becomes Support
VOLUMES-
Volume is simply the number of shares or contracts that trade over a given
period of time, usually a day. The higher the volume, the more active the security.
To determine the movement of the volume (up or down), chartists look at the
volume bars that can usually be found at the bottom of any chart. Volume bars
illustrate how many shares have traded per period and show trends in the same
way that prices do.
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Fig 24: Volumes

Why Volume is Important
Volume is an important aspect of technical analysis because it is used to
confirm trends and chart patterns. Any price movement up or down with relatively
high volume is seen as a stronger, more relevant move than a similar move with
weak volume. Therefore, if you are looking at a large price movement, you should
also examine the volume to see whether it tells the same story.
Say, for example, that a stock jumps 5% in one trading day after being in a
long downtrend. Is this a sign of a trend reversal? This is where volume helps
traders. If volume is high during the day relative to the average daily volume, it is
a sign that the reversal is probably for real. On the other hand, if the volume
is below average, there may not be enough conviction to support a true trend
reversal.
Volume should move with the trend. If prices are moving in an upward
trend, volume should increase (and vice versa). If the previous relationship
between volume and price movements starts to deteriorate, it is usually a sign of
weakness in the trend. For example, if the stock is in an uptrend but the up trading
days are marked with lower volume, it is a sign that the trend is starting to lose its
legs and may soon end. When volume tells a different story, it is a case
of divergence, which refers to a contradiction between two different indicators.
The simplest example of divergence is a clear upward trend on declining volume.
Volume and Chart Patterns
The other use of volume is to confirm chart patterns. Patterns such as head
and shoulders, triangles, flags and other price patterns can be confirmed with
volume, a process which we'll describe in more detail later in this tutorial. In most
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chart patterns, there are several pivotal points that are vital to what the chart is
able to convey to chartists. Basically, if the volume is not there to confirm the
pivotal moments of a chart pattern, the quality of the signal formed by the pattern
is weakened.
Volume Precedes Price
Another important idea in technical analysis is that price is preceded by
volume. Volume is closely monitored by technicians and chartists to form ideas
on upcoming trend reversals. If volume is starting to decrease in an uptrend, it is
usually a sign that the upward run is about to end.
14. MOVING AVERAGES

Most chart patterns show a lot of variation in price movement. This can
make it difficult for traders to get an idea of a security's overall trend. One simple
method traders use to combat this is to apply moving averages. A moving average
is the average price of a security over a set amount of time. By plotting a
security's average price, the price movement is smoothed out. Once the day-to-day
fluctuations are removed, traders are better able to identify the true trend and
increase the probability that it will work in their favor
Types of Moving Averages
There are a number of different types of moving averages that vary in the
way they are calculated, but how each average is interpreted remains the same.
The calculations only differ in regards to the weighting that they place on the price
data, shifting from equal weighting of each price point to more weight being
placed on recent data. The three most common types of moving averages
are simple, linear and exponential.
1. Simple Moving Average (SMA)
This is the most common method used to calculate the moving average of
prices. It simply takes the sum of all of the past closing prices over the time period
and divides the result by the number of prices used in the calculation. For
example, in a 10-day moving average, the last 10 closing prices are added together
and then divided by 10. As you can see in Figure 1, a trader is able to make the
average less responsive to changing prices by increasing the number of periods
used in the calculation. Increasing the number of time periods in the calculation is
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one of the best ways to gauge the strength of the long-term trend and the
likelihood that it will reverse.
Figure 25: Simple Moving Average

Many individuals argue that the usefulness of this type of average is
limited because each point in the data series has the same impact on the result
regardless of where it occurs in the sequence. The critics argue that the most
recent data is more important and, therefore, it should also have a higher
weighting. This type of criticism has been one of the main factors leading to the
invention of other forms of moving averages.
2. Linear Weighted Average
This moving average indicator is the least common out of the three and is
used to address the problem of the equal weighting. The linear weighted moving
average is calculated by taking the sum of all the closing prices over a certain time
period and multiplying them by the position of the data point and then dividing by
the sum of the number of periods. For example, in a five-day linear weighted
average, today's closing price is multiplied by five, yesterday's by four and so on
until the first day in the period range is reached. These numbers are then added
together and divided by the sum of the multipliers.
3. Exponential Moving Average (EMA)
This moving average calculation uses a smoothing factor to place a higher
weight on recent data points and is regarded as much more efficient than the linear
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weighted average. Having an understanding of the calculation is not generally

required for most traders because most charting packages do the calculation for
you. The most important thing to remember about the exponential moving average
is that it is more responsive to new information relative to the simple moving
average. This responsiveness is one of the key factors of why this is the moving
average of choice among many technical traders. As you can see in Figure 2, a 15-
period EMA rises and falls faster than a 15-period SMA. This slight difference
doesn’t seem like much, but it is an important factor to be aware of since it can
affect returns.
Figure 26: Exponential Moving Average
Major Uses of Moving Averages

Moving averages are used to identify current trends and trend reversals as
well as to set up support and resistance levels.
Moving averages can be used to quickly identify whether a security is
moving in an uptrend or a downtrend depending on the direction of the moving
average. As you can see in Figure 3, when a moving average is heading upward
and the price is above it, the security is in an uptrend. Conversely, a downward
sloping moving average with the price below can be used to signal a downtrend.
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Figure 27: Use of Moving Average

Another method of determining momentum is to look at the order of a pair
of moving averages. When a short-term average is above a longer-term average,
the trend is up. On the other hand, a long-term average above a shorter-term
average signals a downward movement in the trend.
Moving average trend reversals are formed in two main ways: when the
price moves through a moving average and when it moves through moving
average crossovers. The first common signal is when the price moves through an
important moving average. For example, when the price of a security that was in
an uptrend falls below a 50-period moving average, like in Figure 4, it is a sign
that the uptrend may be reversing.

The other signal of a trend reversal is when one moving average crosses
through another. For example, as you can see in Figure 5, if the 15-day moving
average crosses above the 50-day moving average, it is a positive sign that the
price will start to increase.
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Figure 29: Use Of Moving Average

If the periods used in the calculation are relatively short, for example 15
and 35, this could signal a short-term trend reversal. On the other hand, when two
averages with relatively long time frames cross over (50 and 200, for example),
this is used to suggest a long-term shift in trend.
Another major way moving averages are used is to identify support and
resistance levels. It is not uncommon to see a stock that has been falling stop its
decline and reverse direction once it hits the support of a major moving average.
A move through a major moving average is often used as a signal by technical
traders that the trend is reversing. For example, if the price breaks through the
200-day moving average in a downward direction, it is a signal that the uptrend is
reversing.

Moving averages are a powerful tool for analyzing the trend in a security. They
provide useful support and resistance points and are very easy to use. The most
common time frames that are used when creating moving averages are the 200-
day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a
good measure of a trading year, a 100-day average of a half a year, a 50-day
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average of a quarter of a year, a 20-day average of a month and 10-day average of

two weeks
Moving averages help technical traders smooth out some of the noise that
is found in day-to-day price movements, giving traders a clearer view of the price
trend. So far we have been focused on price movement, through charts and
averages. In the next section, we'll look at some other techniques used to confirm
price movement and patterns.
INDICATORS-
Moving Average Convergence Divergence - MACD
A trend-following momentum indicator that shows the relationship
between two moving averages of prices. The MACD is calculated by subtracting
the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-
day EMA of the MACD, called the "signal line", is then plotted on top of the
MACD, functioning as a trigger for buy and sell signals.
Fig 32: MACD

There are three common methods used to interpret the MACD:
1. Crossovers - As shown in the chart above, when the MACD falls below
the signal line, it is a bearish signal, which indicates that it may be time to sell.
Conversely, when the MACD rises above the signal line, the indicator gives a
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bullish signal, which suggests that the price of the asset is likely to experience
upward momentum. Many traders wait for a confirmed cross above the signal line
before entering into a position to avoid getting getting "faked out" or entering into
a position too early, as shown by the first arrow.
2. Divergence - When the security price diverges from the MACD. It
signals the end of the current trend.
3. Dramatic rise - When the MACD rises dramatically - that is, the shorter
moving average pulls away from the longer-term moving average - it is a signal
that the security is overbought and will soon return to normal levels.
Traders also watch for a move above or below the zero line because this
signals the position of the short-term average relative to the long-term average.
When the MACD is above zero, the short-term average is above the long-term
average, which signals upward momentum. The opposite is true when the MACD
is below zero. As you can see from the chart above, the zero line often acts as an
area of support and resistance for the indicator.
Stochastic Oscillator
The stochastic oscillator is one of the most recognized momentum
indicators used in technical analysis. The idea behind this indicator is that in an
uptrend, the price should be closing near the highs of the trading range, signaling
upward momentum in the security. In downtrends, the price should be closing
near the lows of the trading range, signaling downward momentum.
The stochastic oscillator is plotted within a range of zero and 100 and
signals overbought conditions above 80 and oversold conditions below 20. The
stochastic oscillator contains two lines. The first line is the %K, which is
essentially the raw measure used to formulate the idea of momentum behind the
oscillator. The second line is the %D, which is simply a moving average of the
%K. The %D line is considered to be the more important of the two lines as it is
seen to produce better signals. The stochastic oscillator generally uses the past 14
trading periods in its calculation but can be adjusted to meet the needs of the user.
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Figure 33: Stochastic oscillators
Relative Strength Index - RSI

A technical momentum indicator that compares the magnitude of recent
gains to recent losses in an attempt to determine overbought and oversold
conditions of an asset. It is calculated using the following formula:
100
RSI = 100 - ______
1 + RS
RS = Average of x days' up closes / Average of x days' down closes
As you can see from the chart below, the RSI ranges from 0 to 100. An
asset is deemed to be overbought once the RSI approaches the 70 level, meaning
that it may be getting overvalued and is a good candidate for a pullback. Likewise,
if the RSI approaches 30, it is an indication that the asset may be getting oversold
and therefore likely to become undervalued.
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Fig 34: Relative Strength Index

Dynamic Momentum Index
An indicator used in technical analysis that determines overbought and

oversold conditions of a particular asset. This indicator is very similar to the
relative strength index (RSI). The main difference between the two is that the RSI
uses a fixed number of time periods (usually 14), while the dynamic momentum
index uses different time periods as volatility changes.
This indicator is interpreted in the same manner as the RSI where readings
below 30 are deemed to be oversold and levels over 70 are deemed to be
overbought. The number of time periods used in the dynamic momentum
index decreases as volatility in the underlying asset increases, making this
indicator more responsive to changing prices than the RSI.
Oversold
1. A condition in which the price of an underlying asset has
fallen sharply, and to a level below which its true value resides. This
condition is usually a result of market overreaction or panic selling.
2. A situation in technical analysis where the price of an asset has fallen

to such a degree - usually on high volume - that an oscillator has
reached a lower bound. This is generally interpreted as a sign that the
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price of the asset is becoming undervalued and may represent a buying

opportunity for investors.
3. Assets that have experienced sharp declines over a brief period of time
are often deemed to be oversold. Determining the degree to which an
asset is oversold is very subjective and could easily differ between
investors.
4. Identifying areas where the price of an underlying asset has been

unjustifiably pushed to extremely low levels is the main goal of many
technical indicators such as the relative strength index, the stochastic
oscillator, the moving average convergence divergence and the money
flow index.
Overbought
1. A situation in which the demand for a certain asset unjustifiably pushes
the price of an underlying asset to levels that do not support the
fundamentals.
2. In technical analysis, this term describes a situation in which the price

of a security has risen to such a degree - usually on high volume - that
an oscillator has reached its upper bound. This is generally interpreted
as a sign that the price of the asset is becoming overvalued and may
experience a pullback.
3. An asset that has experienced sharp upward movements over a very

short period of time is often deemed to be overbought. Determining the
degree in which an asset is overbought is very subjective and can differ
between investors.
4. Technicians use indicators such as the relative strength index, the

stochastic oscillator or the money flow index to identify securities that
are becoming overbought.
An overbought security is the opposite of one that is oversold.
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Bollinger Band
A band plotted two standard deviations away from a simple moving
average, developed by famous technical trader John Bollinger.
Fig 35: Bollinger Band
In this example of Bollinger bands, the price of the stock is banded by an

upper and lower band along with a 21-day simple moving average.
Because standard deviation is a measure of volatility, Bollinger bands
adjust themselves to the market conditions. When the markets become more
volatile, the bands widen (move further away from the average), and during less
volatile periods, the bands contract (move closer to the average). The tightening of
the bands is often used by technical traders as an early indication that the volatility
is about to increase sharply.
This is one of the most popular technical analysis techniques. The closer
the prices move to the upper band, the more overbought the market, and the closer
the prices move to the lower band, the more oversold the market.
Pivot Point
A technical indicator derived by calculating the numerical average of a
particular stock's high, low and closing prices.
The pivot point is used as a predictive indicator. If the following day's
market price falls below the pivot point, it may be used as a new resistance level.
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Conversely, if the market price rises above the pivot point, it may act as the new
support level. This could help decide the future trend in that particular stock.
Fig 36: Pivot Point

Absolute Breadth Index-
Major financial newspapers and magazines and investment television
programs often refer to market breadth as the difference between advancing and
declining issues. It’s just as easy to understand that the absolute breadth-indicator
calculates the difference between advancing and declining issues and then
indicates this value for each bar on the chart. Therefore, a chartist can look at the
absolute-breadth index and determine the activity level of the market, determining
the stability of market movements.
One common form of describing the parameters that make up the index is
as follows: advancing issues are those that close above their opening price that
day and conversely, declining issues close below their opening price of the day.
There are other data that can be inserted to provide other looks to the idea of
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advancing/declining issues; however, these are the most common parameters.

Please note that whatever data is used for the advancing issues, the same data
must be used for the declining issues.
If for example the market is rallying but more issues are declining than
advancing, we could then determine that the rally is somewhat unstable as many
issues on the exchange are falling off and not advancing with the few making all
the noise.
If a technician sees high values indicating on the chart, the assumption is
that the market is moving primarily in one direction. On the other hand, the
market is showing no significant direction at all if the values indicated are low.
The absolute-breadth index can also be an early indicator of future trend changes
in the market and offer signals either to confirm or warn against the weakness or
strength of the market as a whole.
Fig 37: Absolute breadth Index
Fibonacci Retracement
A term used in technical analysis that refers to the likelihood that a
financial asset's price will retrace a large portion of an original move and find
support or resistance at the key Fibonacci levels before it continues in the original
direction. These levels are created by drawing a trendline between two extreme
points and then dividing the vertical distance by the key Fibonacci ratios of
23.6%, 38.2%, 50%, 61.8% and 100%.
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Fig 38: Fibonacci Retracement

These are the details about the Technical analysis and different indicators which
are used for deciding the future movement of any market. This gives fore view to
an investor about his steps so as to minimize the risk and maximize the profit. In
the above graph we can see the application of Technical Analysis for an investor
who wants to invest in Forex Market. The graph shows the Track Record of
Dollar to rupee price fluctuations in the period Nov 2001 – May 2006. According
to movement of the price the signals has bee given in the graph itself the signal are
nothing but the actions that a investor needs to take.
Fig 39: Track Record in Dollar - Rupee
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Lets See some more examples of using technical analysis in Forex Market to
Forecast the future movement of a share market.
Fig40: EUR/USD :
Euro against U.S dollar fell sharply at the beginning of the trading today, after it
breakthrough the support point 1.42900 and closed four hours candle below it, we
expect today more decline for the pair to the first target at 1.40500 then to the
level 1.39650, with the possibility of some volatility in price before this decline to
get rid its saturation in selling process, which That emerge from the Stochastic.
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Fig 41: GBP/USD :

The pair sterling against the U.S. dollar also fell with the start of trading,
approaching the central support level 1.63100, we expect this day more landing to
the first target at the level 1.61650 then to the level 1.60450 , taking into our
account the positive signals emerge from the stochastic indicator.
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15 Avoiding Mistakes in Forex Trading

A Difficult challenge facing a trader, and particularly those trading e-
forex, is finding perspective. Achieving that in markets with regular hours is hard
enough, but with forex, where prices are moving 24 hours a day, seven days a
week, it is exceptionally laborious. When inundates with constantly shifting
market information, it is hard to separate yourself from the action and avoid
personal responses to the market. The market doesn’t care about your feelings.
Traders have heard it in many different ways — the only thing you can control is
when you buy and when you sell. In response to that, it is easier to know how not
to trade then how to trade. Along those lines, here are some tips on avoiding
common pitfalls when trading forex.
1) Don’t read the news —analyze the news.

Many times, seemingly straightforward news releases from government
agencies are really public relation vehicles to advance a particular point of view or
policy. Such “news,” in the forex markets more than any other, is used as a tool to
affect the investment psychology of the crowd. Such media manipulation is not
inherently a negative. Governments and traders try to do that all the time. The new
forex trader must realize that it is important to read the news to assess the message
behind the drums. For example, Japan’s Prime Minister Masajuro Shiokowa was
quoted in a news report on Dec. 13 that “an excessive depreciation of the yen
should be avoided. But we should make efforts and give consideration to guide the
yen lower if it is relatively overvalued.” When a government official is asking, in
effect, if traders would please slow down the weakening of his currency, then we
must wonder whether there is fear the opposite will happen. In this case, that was
the outcome as on Dec. 14 the dollar vs. the yen surged to a three-year high. The
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Prime Minister’s statement acted as a contrarian indicator. This is what “fade the
news” means. Often, a bank analyst or trader will be quoted with a public
statement on a bank forecast of a currency’s move. When this occurs, they are
signaling they hope it will go that way. Why put your reputation on the line,
saying the currency is going to break out, if you don’t benefit by that move? A
cynical position, yes, but traders in the forex markets always need to be on guard.
Read the news with the perspective that, in forex, how the event is reported can be
as important as the event itself. Often, news that might seem definitively bullish to
someone new to the forex market might be as bearish as you can get.
2) Don’t trade surges.

A price surge is a signature of panic or surprise. In these events,
professional traders take cover and see what happens. The retail trader also should
let the market digest such shocks. Trading during an announcement or right
before, or amid some turmoil, minimizes the odds of predicting the probable
direction. Technical indicators during surge periods will be distorted. You should
wait for a confirmation of the new direction and remember that price action will
tend to revert to pre-surge ranges providing nothing fundamental has occurred. An
example is the Nov.12 crash of the airplane in Queens, N.Y. Instantly, all
currencies reacted. But within a short period of time, the surge that reflected the
tendency to panic retraced.
3) Simple is better.
The desire to achieve great gains in forex trading can drive us to keep
adding indicators in a never-ending quest for the impossible dream. Similarly,
trading with a dozen indicators is not necessary. Many indicators just add
redundant information. Indicators should be used that give clues to:
1) Trend direction,
2) Resistance,
3) Support and
4) Buying and selling pressure.
Getting the Point
163
Market analysis should be kept simple, particularly in a fast-moving

environment such as forex trading. Point-and-figure charts are an elegant tool that
provides much of the market information a trader needs.
16 DATASHEET
%
Amoun Return
Sr. Experien
Qualificati Ag Proffessi t s in Invest on
No Name ce in
on e on Investe last the basis of
. Trading
d calend
er year
Fundament
al and
Uttam More 3 to 5 30 to Technical
1 Padhiar Bcom 53 Business then 4 lacs 45% analysis
Fundament
al and
Saurabh 1 to 3 30 to Technical
2 Shinde BE 36 Service 2 to 3 lacs 45% analysis
tips given
50000 0 to by the
3 Ramesh Mane BSc 30 Farmer 1 to 2 to 1 lac 15% broker
Fundament
al and
Shrikant Bcom, More 1 to 3 30 to Technical
4 Bagal MBA 46 Service then 4 lacs 45% analysis
tips given
Vijay 50000 0 to by the
5 Kumbhar BA 45 Farmer 2 to 3 to 1 lac 15% broker
Fundament
al and
Aniket More 1 to 3 15 to Technical
6 Mahindre BSc 58 Business then 4 lacs 30% analysis
Tips given
1 to 3 0 to by the
7 Ashish Kore 12th 34 Service 2 to 3 lacs 15% friends
Fundament
al and
More 50000 30 to Technical
8 Vasudev Joshi BE 38 Service then 4 to 1 lac 45% analysis
tips given
Suhas Below 0 to by the
9 Dahanukar BSc 24 Farmer 1 to 2 50000 15% broker
164
Fundament
al and
Sudhir Bcom, 1 to 3 15 to Technical
10 Kulkarni MBA 37 Business 3 to 4 lacs 30% analysis
Fundament
al and
3 to 5 30 to Technical
11 Vishwas Sutar Bcom 40 Business 3 to 4 lacs 45% analysis
Tips given
by the
Business
Lakshmikant More Below 0 to News
12 Chavan BSc 33 Service then 4 50000 15% Channel
Fundament
al and
50000 30 to Technical
13 Umesh Jagtap BE 30 Service 2 to 3 to 1 lac 45% analysis
tips given
1 to 3 0 to by the
14 Mohd. Shaikh BSc 55 Farmer 3 to 4 lacs 15% broker
%
Amoun Return
Sr. Experien
Qualificati Ag Proffessi t s in Invest on
No Name ce in
on e on Investe last the basis of
. Trading
d calend
er year
Tips given
by the
Business
Vinayak More above 15 to News
15 Thalange BSc 60 Business then 4 5 lacs 30% Channel
Fundament
al and
Bcom, 50000 30 to Technical
16 Sagar Gawai MBA 41 Service 2 to 3 to 1 lac 45% analysis
Fundament
al and
Manish More above 30 to Technical
17 Sawant BE 57 Service then 4 5 lacs 45% analysis
Fundament
al and
Shardul 50000 15 to Technical
18 Kulkarni BSc 39 Farmer 3 to 4 to 1 lac 30% analysis
Fundament
al and
More above 15 to Technical
19 Vaibhav Mane BSc 66 Business then 4 5 lacs 30% analysis
Umakant tips given
Sahastrabudh 50000 0 to by the
20 e 12th 25 Service 3 to 4 to 1 lac 15% broker
21 Rahul BSc 32 Farmer More 3 to 5 15 to Fundament
Farakate then 4 lacs 30% al and
Technical
165
analysis
Fundament
al and
1 to 3 0 to Technical
22 Sushil Datar Bcom 40 Service 2 to 3 lacs 15% analysis
Negati
ve Tips given
Avinash Below Return by the
23 Kunte 12th 38 Farmer 3 to 4 50000 s friends
Fundament
al and
More 3 to 5 30 to Technical
24 Jatin Patel BSc 49 Business then 4 lacs 45% analysis
Fundament
al and
25 Suraj Sarada Bcom 39 Business then 4 lacs 30% analysis
tips given
More 50000 15 to by the
26 Murli Sarada 12th 28 Business then 4 to 1 lac 30% broker
tips given
Nilesh 1 to 3 15 to by the
27 Chavan 12th 37 Business 3 to 4 lacs 30% broker
Fundament
al and
28 Kapil Rene BSc 48 Farmer then 4 lacs 30% analysis
Fundament
al and
Chetan 50000 15 to Technical
29 Kotecha Bcom 57 Business 2 to 3 to 1 lac 30% analysis
Fundament
al and
Kunal 3 to 5 30 to Technical
30 Kapadia 12th 54 Business 3 to 4 lacs 45% analysis
17 DATA ANALYSIS
166
Fig 42: This Pie chart shows the % of people who use Fundamental and
Technical Analysis to decide their Investment portfolio so as to keep the risk
minimum and the returns maximum. In the Data sheet we can see that the
candidates who use Technical Analysis has got higher returns as compared to
the candidates who did not used this analysis so from this observation we can
say that the Technical analysis has got positive effect on the returns of a
particular investment.
167
Fig: 43 This pie chart shows the % of people who got different returns on
their investment in lat calendar year. We can see that the total % of
candidates who has got returns above 15% are 70% and the ones who get
lesser returns are 30%. And also the candidates who use Technical Analysis
are also 67%.
Limitation of Study: -
1. The Sample size selected is situated in same geographical area.
2. The Sample contains all the male candidates so the gender
heterogeneity is not present.
CONCLUSION
168
In today’s world people say that the Financial Markets are the easy way of
earning money but actually its not true. The volatility of any market is nothing but
the potential that it has to earn from it, but at the same time the same volatility can
be a serious problem to the investor for the investment.
The study shows that the Investment in Financial market can be safe only
if the investor can have a fore look on the movement of the market. The technical
analysis is the process of studying the trend of a market for similar situation in
past and on that basis deciding the future movement. This needs a very keen
observation of market. The indicators give a very fair picture of market.
The Risk can be managed by using Hedging techniques, but to earn
maximum returns the person has to take same risk the survey shows that the
people who do Technical Analysis can take risk more confidently and can earn
maximum profit.
So at the end can conclude that Investing in the share market is like
walking on a dark road but Technical Analysis can become a cat eye to make the
walking easy and fast.
RECOMMENDATIONS
169
1. The Fluctuation in any market makes it profitable but so as to earn

profit one has to predict the market movement.
2. The Technical Analysis helps the user to get the future movement of
the market on the basis of which the investment should be done.
3. The study also says that if the investment is done on the basis of
Technical Analysis the chances of getting higher returns is more
compared to others. So use of Technical Analysis is neccesory.
BIBLIOGRAPHY
170
 WEBSITES
 www.forex.com
 www.rbi.org
 www.genius-forecasting.com
 www.Risk-
management.guide.com
 www.forexcentre.com
 www.kshitij.com
 www.Fxstreet.com
 www.Mensfinancial.com
 www.StandardChartered.com
 NEWSPAPERS
 DNA Money,
 Business Standard &
 Business line
 BOOKS
 International finance by P.G.APTE
 Options, Futures and other Derivatives by JOHN C HULL.
 Management of Foreign Exchange by BIMAL JALAN
 Foreign Exchange Markets by P.K. Jain
 E-BOOKS on Trading Strategies in Forex Market.
ANNEXURE
171
The Questionneir used for Research is attached here.
QUESTIONNEIR
1. Name:-
2. Educational Qualification :-
3. Age:-
4. Profession:-
5. Since how many years you are trading in the markets
a. 0 – 1
b. 1 – 2
c. 2 – 3
d. 3 – 4
e. More than 4
6. You prefer:-
a. Intra day trading
b. Long term trading
c. Both
7. You look at trading in the Markets as:
a. Investment option
b. Main Earning Source
c. Additional Earning Source
d. Tax Saving Option
e. Investment and Tax Saving Option
8. Average Amount invested in long term investment options

for last calendar year.(The Maximum amount invested for
more than 9 months last year.)
a. Below 50000
b. 50000 – 100000
c. 100000 – 300000
172
d. 300000 – 500000
e. Above 500000
9. % returns you got on the above investment for last

calendar Year
a. Negative Returns
b. 0 – 15%
c. 15% - 30%
d. 30% - 45%
e. More than 45%
10. You decide your investment portfolio on the basis of
a. Tips given by the broker
b. Tips given by friends
c. Tips given by the Business News channels (Ex. CNBC)
d. Fundamental and Technical Analysis of the particular

option
e. Other
11. If you use Fundamental and Technical analysis then

for deciding
a. Risk involved in the investment
b. To check Past performance of that particular security
c. To do future prediction about the performance of the

security
d. All of the above
e. Other
12. Why you use fundamental and technical analysis
a. You have a good past experience
b. You found it useful for others so want to check for

yourself
c. Curiosity to check its usefulness
173
d. Somebody insisted you to do that
e. Other
13. “Technical analysis helps in minimizing the risk and

maximizing the returns from the investment” True or False
a. True b. False
14. If market is down which option will you choose for

investment
a. Commodities market (Gold, Silver, etc)
b. Forex Market
c. Bank Deposits schemes (FD, PPF, etc)
d. Post Office Investment schemes
e. Other
174

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Use of Technical Analysis for Risk Management in context of Forex Markets

Figure. Figures Pg. no

Technical Analysis For Risk Management.

The identification and acceptance or offsetting of the risks threatening the

 Unexpected corrections in currency exchange rates

 Volatile markets offering profit opportunities

Two distinct viewpoints emerge –

• And the other which is about minimising risks/loss and protecting

2. OBJECTIVE OF THE PROJECT

International Financial Management

(Author: P. G. Apte, IIM Beglore)

New edition incorporates the changes in markets, policy and regulatory

This Book contains :

Research is a human activity based on intellectual investigation and is

Type of Research: Exploratory

Primary data includes:-

Secondary Data Collection:

MARKET LIQUIDITY OPERATIONAL HUMAN

CREDIT RISK LEGAL &

INEREST CURRENCY COMMODITY

MARKET RISK RISK

Fig 1: Types of Financial Risk

Funding liquidity risk relates to a financial institution’s ability to raise the

usually only become apparent when counterparty, or an investor, lose money on a

6. HUMAN FACTOR RISK

 Types of market risk

• Interest rate risk:

Though quantitative analysis plays a significant role, experience, market

We understand risk as a potential future loss. When we take an insurance

Derivatives are the instruments most commonly used in Financial risk

The most important element of managing risk is keeping losses small,

Risk can be explained as uncertainty and is usually associated with the

What is Risk Management?

Risk management is a discipline that enables people and organizations to

Risk management is not a task to be

Risk management is an essential

Managing risk - How to manage risks

Risk management is not a one-off exercise. Continuous monitoring and

Contrary to conventional wisdom, risk management is not just a matter of

6. Introduction to Foreign Exchange

Foreign exchange is that

Brief History of Foreign Exchange

The Bretton Woods system came under increasing pressure as national

The lack of sustainability in fixed foreign exchange rates gained new

Fixed and Floating Exchange Rates

Exchange Rates under Fixed and Floating Regimes

Fig 2: Appreciation due to Rise in Demand in Market

MANAGED FLOATING EXCHANGE RATES

 Value of the pound determined by market demand for and supply

SEMI-FIXED EXCHANGE RATES

FULLY-FIXED EXCHANGE RATES

Exchange Rate Systems in Different Countries

⇒ Single Currency Peg

Need and Importance of Foreign Exchange

Foreign exchange markets represent by far the most important financial

Why Trade Foreign Exchange?

Consolidation & Fragmentation Of Fx Markets

2006 continues to provide dramatic evidence of the rapid transformation

Opportunities From Around the World

Functions of Foreign Exchange Market

A foreign exchange market performs three important functions:

⇒ Transfer of Purchasing Power: