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Basic Concepts II: Nature of the Foreign Exchange Market


The Foreign Exchange Market is an over-the-counter (OTC) market, which means that there is no central exchange and clearing house where orders are matched. With different levels of access, currencies are traded in different market makers: The Inter-bank Market - Large commercial banks trade with each other through the Electronic Brokerage System (EBS). Banks will make their quotes available in this market only to those banks with which they trade. This market is not directly accessible to retail traders. The Online Market Maker - Retail traders can access the FX market through online market makers that trade primarily out of the US and the UK. These market makers typically have a relationship with several banks on EBS; the larger the trading volume of the market maker, the more relationships it likely has.

Market Hours Forex is a market that trades actively as long as there are banks open in one of the major financial centers of the world. This is effectively from the beginning of Monday morning in Tokyo until the afternoon of Friday in New York. In terms of GMT, the trading week occurs from Sunday night until Friday night, or roughly 5 days, 24 hours per day. Price Reporting Trading Volume Unlike many other markets, there is no consolidated tape in Forex, and trading prices and volume are not reported. It is, indeed, possible for trades to occur simultaneously at different prices between different parties in the market. Good pricing through a market maker depends on that market maker being closely tied to the larger market. Pricing is usually relatively close between market makers, however, and the main difference between Forex and other markets is that there is no data on the volume that has been traded in any given time frame or at any given

price. Open interest and even volume on currency futures can be used as a proxy, but they are by no means perfect. Fisher blacks optional pricing model:http://bradley.bradley.edu/~arr/bsm/pg04.html

FOREIGN EXCHANGE REGULATIONS IN INDIA


India has liberalized its foreign exchange controls. Rupee is freely convertible on current account. Rupee is also almost fully convertible on capital account for non-residents. Profits earned, dividends and proceeds out of the sale of investments are fully repatriable for FDI. There are restrictions on capital account for resident Indians for incomes earned in India. The Reserve Bank of Indias Foreign Exchange Department administers Foreign Exchange Management Act 1999(FEMA). Foreign Exchange Management (transfer of securities to any person resident outside India) Regulation as amended from time to time regulates transfer for issue of any security by a person resident outside India. Repatriation of investment capital and profits earned in India (i) All foreign investments are freely repatriable, subject to sectoral policies and except for cases where Non Resident Indians choose to invest specifically under non-repatriable schemes. Dividends declared on foreign investments can be remitted freely through an Authorized Dealer. (ii) Non-residents can sell shares on stock exchange without prior approval of RBI and repatriate through a bank the sale proceeds if they hold the shares on repatriation basis and if they have necessary NOC/ tax clearance certificate issued by Income Tax authorities. (iii) For sale of shares through private arrangements, Regional offices of RBI grant permission for recognized units of foreign equity in Indian company in terms of guidelines indicated in Regulation 10.B of Notification No. FEMA.20/2000 RB dated May 2000. The sale price of shares on recognized units is to be determined in accordance with the guidelines prescribed under Regulation 10B(2) of the above Notification. (iv) Profits, dividends, etc. (which are remittances classified as current account transactions) can be freely repatriated. Acquisition of Immovable Property by Non-resident A person resident outside India, who has been permitted by Reserve Bank of India to establish a branch, or office, or place of business in India (excluding a Liaison Office), has general permission of Reserve Bank of India to acquire immovable property in India, which is necessary for, or incidental to, the activity. However, in such cases a declaration, in prescribed form (IPI),

is required to be filed with the Reserve Bank, within 90 days of the acquisition of immovable property. Foreign nationals of non-Indian origin who have acquired immovable property in India with the specific approval of the Reserve Bank of India cannot transfer such property without prior permission from the Reserve Bank of India. Please refer to the Foreign Exchange Management (Acquisition and transfer of Immovable Property in India) Regulations 2000 (Notification No. FEMA.21/ 2000-RB dated May 3, 2000). Acquisition of Immovable Property by NRI An Indian citizen resident outside India (NRI) can acquire by way of purchase any immovable property in India other than agricultural/ plantation /farm house. He may transfer any immovable property other than agricultural or plantation property or farm house to a person resident outside India who is a citizen of India or to a Person of Indian Origin resident outside India or a person resident in India.

Over-the-Counter Options
Normally, if an investor wants to trade or speculate in options, he or she will peruse the options tables in the newspaper or on their brokers website. The various puts and calls for a given security will be shown for different expiration dates, going out as far as a couple of years in the case of LEAPs. These types of options are listed on an exchange and trade through a clearinghouse. Don't panic it sounds advanced but it's not. Without going into the technical details, what it effectively means is that the performance of your option is guaranteed by the exchange itself. Each participant is charged a fee to help cover potential default, with the odds considered remote. In other words, if you were to buy 10 call contracts giving you the right to buy Coca-Cola at $50.00 per share between now and Friday, January 15th, 2010, you would pay $3.00 per share, or $3,000 total (each call option contract represents 100 shares so 10 contracts x 100 shares x $3.00 per share = $3,000). If Coke were to go to $60 per share, you could exercise the call options and pocket the profit in this case, $60.00 sale price - $53.00 cost (consisting of $50.00 for the stock and $3.00 for the option) or $7.00 per share. Thus, a 20% rise in Coca-Colas stock resulted in a 133% gain on your options. The option you bought had to be sold by someone, perhaps a conservative investor who was selling covered calls as part of a buy-write transaction. They have to deliver the stock. What happens if the other person, known as the counterparty, cant? What if they died? Went bankrupt? Thats where the clearinghouse steps in and fulfills the contract. In essence, each of you was making a deal with the exchange / clearinghouse itself. Thus, there is virtually no counterparty risk.

Over-the-Counter Options for Customized Solutions The only problem with listed exchange-traded options is that a suitable derivative for an investment strategy youve developed may not exist in standardized form. For the well-heeled investor, this presents no problem because he or she can work with an investment bank through their wealth manager to structure custom over-the-counter options tailored to their exact needs. How Over-the-Counter Options Differ from Regular Stock Options In essence, these are private party contracts written to the specifications of each side of the deal. There are no disclosure requirements and you are limited only in your imagination as to what the terms of the over-the-counter options are. In an extreme example, you and I could structure an over-the-counter option that required me to deliver a set number of Troy ounces of pure 24 karat gold based upon the number of whales spotted off the coast of Japan over the next 36 months. Frankly, that would be a very stupid transaction, but you get the idea. The appeal of over-the-counter options is that you can transact in private and negotiate terms. If you can find someone who doesnt think your over-the-counter option proposal presents much risk to their side, you can get an absolute steal. Counterparty Risk in Over-the-Counter Options The problem with over-the-counter options is that they lack the protection of an exchange or clearinghouse. You are effectively relying on the promise of the counterparty to live up to their end of the deal. If they cant perform, you are left with a worthless promise. This is especially dangerous if you were using the over-the-counter options to hedge your exposure to some risky asset or security. (When this happens, its known as basis risk your hedges fall apart and youre left exposed. That is why the world financial institutions panicked when Lehman Brothers failed as a huge investment bank, they were party to countless overthe-counter options that would have entered a black hole of bankruptcy court.) This is what is referred to in financial regulatory circles as a daisy-chain risk. It only takes a few over-the-counter derivative transactions before it becomes virtually impossible to determine the total exposure an institution would have to a given event or asset. The problem becomes even more complex when you realize that you may be in a position where your firm could be wiped out because one of your counterpartys had their counterparty default on them, making them insolvent. This is why famed investor Warren Buffett had referred to unchecked derivatives as financial weapons of mass destruction.