CHAPTER 1 1.

1 INTRODUCTION TO CURRENCY MARKET

The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized over-the-counter financial market for trading currencies. The currency market includes the Foreign Currency Market and the Euro-currency Market.

1.1.1 FOREIGN CURRENCY MARKET & EURO-CURRENCY MARKET

The Foreign Currency market is virtual. There is no one central physical location that is the foreign currency market. It exists in the dealing rooms of various central banks, large international banks, and some large corporations. The dealing rooms are connected via telephone, computer, and fax. Some countries co-locate their dealing rooms in one center. The Euro-currency Market is where borrowing and lending of currency takes place. Interest rates for the various currencies are set in this market. Trading on the Foreign Exchange Market establishes rates of exchange for currency. Exchange rates are constantly fluctuating on the forex market. As demand rises and falls for particular currencies, their exchange rates adjust accordingly. Instantaneous rate quotes are available from a service provided by Reuters.

1.1.2 HOW CURRENCY MARKET WORK

A rate of exchange for currencies is the ratio at which one currency is exchanged for another. The foreign exchange market has no regulation, no restrictions or overseeing board & should there be a world monetary crisis in this market; there is no mechanism to stop trading. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The Federal Reserve Bank of New York publishes guidelines for Foreign Exchange trading. In their "Guidelines for Foreign Exchange Trading", they outline 50 best practices for trading on the forex market.

1.1.3 PRIMARY OJECTIVE

The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the worlds major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

1.2 BASIC FOREIGN EXCHANGE DEFINITIONS 1.2.1 SPOT

Spot: Foreign exchange spot trading is buying one currency with a different currency for immediate delivery. The standard settlement convention for Foreign Exchange Spot trades is T+2 days, i.e., two business days from the date of trade. An exception is the USD/CAD (USD Canadian Dollars) currency pair which settles T+1.Rates for days other than spot are always calculated with reference to spot rate.

1.2.2 FORWARD OUTRIGHT

Forward Outright: A foreign exchange forward is a contract between two counterparties to exchange one currency for another on any day after spot. In this transaction, money does not actually change hands until some agreed upon future date. The duration of the trade can be a few days, months or years. For most major currencies, three business days or more after deal date would constitute a forward transaction.

Settlement date / Value Date Definition Value Cash Value Tom (Tomorrow) Trade Date Trade Date + 1

Value Cash Trade Date Same day as deal date Same day as deal date 1 business day after deal date 2 Business days after deal date 3 business days or more after deal date, always longer than Spot

Spot

Trade Date+2

Forward Outright

Trade Date + 3 or any later date Table 1.1 * USD/CAD is the exception

1.2.3 DIFFERENCE BETWEEN THE FORWARD RATE AND THE SPOT RATE The difference between the forward rate and the spot rate reflects the difference in interest rates between the two currencies. This prevents an opportunity for arbitrage. If the rates did not differ, there would be a profit difference in the currencies. That is, investing in one currency for a year and then selling it should be the same profit or loss as setting up a forward contract at the forward rate one year in the future. Investing in one currency would be more profitable than investing in the other. Thus there would exist an opportunity for arbitrage. Forward exchange contracts are settled at a specified date in the future. The parties exchange funds at this date. Forward contracts are typically custom written between the party needing currency and the bank, or between banks. 1.2.4 BASE CURRENCY Base Currency / Terms Currency: In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. Eg. The expression US DollarRupee, tells you that the US Dollar is being quoted in terms of the Rupee. The US Dollar is the base currency and the Rupee is the terms currency. Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as

strengthening or weakening of one currency vis--vis the other currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. Eg. If US DollarRupee moved from 43.00 to 43.25, the US Dollar has appreciated and the Rupee has depreciated.

1.2.5 SWAPS Swaps: A foreign exchange swap is a simultaneous purchase and sale, or sale and purchase, of identical amounts of one currency for another with two different value dates. Foreign Exchange Swaps are commonly used as a way to facilitate funding in the cases where funds are available in a different currency than the one needed. Effectively, each party to the deal is given the use of an amount of foreign currency for a specific time. The Forward Rate is derived by adjusting the Spot rate for the interest rate differential of the two currencies for the period between the Spot and the Forward date. Liquidity in one currency is converted into another currency for a period of time. 1.3 EXCHANGE RATE MECHANISM Foreign Exchange refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his own nations currency for money denominated in another nations currency acquires foreign exchange. This holds true whether the amount of the transaction is equal to a few rupees or to billions of rupees; whether the person involved is a tourist cashing a travellers cheque or an investor exchanging hundreds of millions of rupees for the acquisition of a foreign company; and whether the form of money being acquired is foreign currency notes, foreign currency-denominated bank deposits, or other short-term claims denominated in foreign currency. A foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency

other than the Indian Rupees (INR) is, broadly speaking, foreign exchange. Foreign Exchange can be cash, funds available on credit cards and debit cards, travellers cheques, bank deposits, or other short-term claims. It is still foreign exchange if it is a short-term negotiable financial claim denominated in a currency other than INR. Almost every nation has its own national currency or monetary unit - Rupee, US Dollar, Peso etc used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for foreign exchange transactions exchange of one currency for another. The exchange rate is a price - the number of units of one nations currency that must be surrendered in order to acquire one unit of another nations currency. There are scores of exchange rates for INR and other currencies, say US Dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the Euro or the International Monetary Funds SDR. There are also various trade-weighted or effective rates designed to show a currencys movements against an average of various other currencies (for eg US Dollar index, which is a weighted index against world major currencies like Euro, Pound Sterling, Yen, and Canadian Dollar). Apart from the spot rates, there are additional exchange rates for other delivery dates in the forward markets. The market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range. But in countries like the United States, which follows a complete free floating regime, the authorities are not known to intervene in the foreign exchange market on a continuous basis to influence the exchange rate. The market participation is made up

of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling US Dollars at that particular time. The participants in the foreign exchange market are thus a heterogeneous group. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whatever is the constitution of participants, and whether their motive is investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market price at that instant. Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain exercise. At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much more. The role of the foreign exchange market in the determination of that price is critically important.

CHAPTER 2 2.1 EVOLUTION OF CURRENCY MARKETS

The Bretton Woods Agreement, established in 1944, fixed national currencies against the dollar, and set the dollar at a rate of USD 35 per ounce of gold. In 1967, a Chicago bank refused to make a loan in pound sterling to a college professor by the name of Milton Friedman because he had intended to use the funds to short the British currency. The bank's refusal to grant the loan was due to the Bretton Woods Agreement. This agreement aimed at establishing international monetary steadiness by preventing money from taking flight across countries, and curbing speculation in the international currencies. Prior to Bretton Woods, the gold exchange standard -- paramount between 1876 and World War I -ruled over the international economic system. Under the gold exchange, currencies experienced a new era of stability because they were supported by the price of gold. However, the gold exchange standard had a weakness of boom-bust patterns. As an economy strengthened, it would import a great deal until it ran down its gold reserves required to support its currency. As a result, the money supply would diminish, interest rates escalate and economic activity slowed to the point of recession. Ultimately, prices of commodities would hit bottom, appearing attractive to other nations, who would sprint into a buying fury that injected the economy with gold until it increased its money supply, driving down interest rates and restoring wealth into the economy. Such boom-bust patterns abounded throughout the gold standard until World War I temporarily discontinued trade flows and the free movement of gold.

The Bretton Woods Agreement was founded after World War II, in order to stabilize and regulate the international Forex market. Participating countries agreed to try to maintain the value of their currency within a narrow margin against the dollar and an equivalent rate of gold as needed. The dollar gained a premium position as a reference currency, reflecting the shift in global economic dominance from Europe to the USA. Countries were prohibited from devaluing their currencies benefit their foreign trade and were only allowed to devalue their currencies by less than 10%. The great volume of international Forex trade led to massive movements of capital, which were generated by post-war construction during the 1950s, and this movement destabilized the foreign exchange rates established in Bretton Woods. 1971 heralded the abandonment of the Bretton Woods in that the US dollar would no longer be exchangeable into gold. By 1973, the forces of supply and demand controlled major industrialized nations' currencies, which now floated more freely across nations. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s, and new financial instruments, market deregulation and trade liberalization emerged. The onset of computers and technology in the 1980s accelerated the pace of extending the market continuum for cross-border capital movements through Asian, European and American time zones. Transactions in foreign exchange increased intensively from nearly $70 billion a day in the 1980s, to more than $1.5 trillion a day two decades later. The rapid development of the euro-dollar market, where US dollars are deposited in banks outside the US, was a major mechanism for speeding up Forex trading. Likewise, Euro markets are those where assets are deposited outside the currency of origin. The Eurodollar market first came into being in the 1950s when the Soviet Union's oil revenue -- all in US dollars -- was being deposited outside the US in fear of being frozen by US regulators. That gave rise to a vast offshore pool of dollars outside the control of US authorities. The US government imposed laws to restrict dollar lending to foreigners. Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the late 1980s onwards, US companies began to borrow offshore, finding Euro markets an advantageous place for holding excess liquidity, providing short-term loans and financing imports and exports.

London was and remains the principal offshore market. In the 1980s, it became the key center in the Eurodollar market when British banks began lending dollars as an alternative to pounds in order to maintain their leading position in global finance. London's convenient geographical location (operating during Asian and American markets) is also instrumental in preserving its dominance in the Euro market.

2.2 THE FOREIGN EXCHANGE MARKET IN INDIA

The Indian forex market owes its origin to the important step that RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange. As a consequence, the stipulation of maintaining "square" or "near square" position was to be complied with only at the close of business each day. During the period 1975-1992, the exchange rate of rupee was officially determined by the RBI in terms of a weighted basket of currencies of Indias major trading partners and there were significant restrictions on the current account transactions. The initiation of economic reforms in July 1991 saw significant two-step downward adjustment in the exchange rate of the rupee on July 1 and 3, 1991 with a view to placing it at an appropriate level in line with the inflation differential to maintain the competitiveness of exports. Subsequently, following the recommendations of the High Level Committee on Balance of Payments (Chairman:Dr C. Rangarajan) the Liberalized Exchange Rate Management System(LERMS) involving dual exchange rate mechanism was instituted in March 1992, which was followed by the ultimate convergence of the dual rates effective from March 1, 1993(christened modified LERMS). The unification of the exchange rate of the rupee marks the beginning of the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It is also an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund. The appointment of an Expert Group on Foreign Exchange (popularly known as Sodhani Committee) in November 1994 is a landmark in the design of foreign exchange market in India.

The Group studied the market in great detail and came up with far reaching recommendations to develop, deepen and widen the forex market. In the process of development of forex markets, banks have been accorded significant initiative and freedom to operate in the market. To quote a few important measures relating to market development and liberalization, banks were allowed freedom to fix their trading limits, permitted to borrow and invest funds in the overseas markets up to specified limits, accorded freedom to determine interest rates on FCNR deposits within ceilings and allowed to use derivative products for asset-liability management purposes. Similarly, corporates were given flexibility to book forward cover based on past turnover and allowed to use a variety of instruments like interest rates and currency swaps, caps/collars and forward rate agreements in the international forex market. Rupee-foreign currency swap market for hedging longer -term exposure has developed substantially in the last few years.

2.3 THE FOREIGN EXCHANGE MARKET IS UNIQUE

2.3.1 The foreign exchange market is unique because of following reasons


its huge trading volume representing the largest asset class in the world leading to high liquidity.

 

its geographical dispersion. its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday.

  

the variety of factors that affect exchange rates. the low margins of relative profit compared with other markets of fixed income. the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion. The $3.98 trillion break-down is as follows:

    

$1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion currency swaps $207 billion in options and other products

CHAPTER 3
3.1 PARTICIPANTS OF DERIVATIVE MARKET y y y y Speculators Market Hedgers The Interbank Market Central Banks / Federal & Foreign Governments

3.1.1 The Speculators - FOREX Players This is you, a FOREX beginner or currency trader - one of a group of four distinct foreign exchange market participants. Our mission if we choose to accept it is to speculate in the buying or selling of foreign currency pairs and through shrewd trading strategy, sound risk management and trading savvy make a profit off of fluctuating FOREX currency rates at the end of a trade. Individual FOREX speculators like you make up a small but important part of the huge foreign exchange trading market. Speculators also include hedge funds. With what can often be massively sized financial portfolios which hedge funds manage, they look to earn equally large to massive returns off of their FOREX speculation efforts. Because hedge fund speculators can wield such huge trade leverage in the market, are often a target for the Central Banks overseeing a countries' monetary policy, who want to ensure their trading leverage doesn't cause unwanted ripples in that policy.

3.1.2 The Hedgers - FOREX Players Another of the Foreign Exchange Market Participants is large hedgers.These are large corporations with multi-national operations that span the planet. Think Proctor & Gamble, CocaCola, BASF, etc. Their worldwide operations entail numerous international financial transactions with various vendors in any number of countries. And that means having to deal with many different foreign currencies, all of which fluctuate day-to-day. An example of a large hedger could be a major global company like United Airlines. They need to have an ongoing supply of Jet-A or jet aircraft fuel to keep their planes flying and Jet-A is one of their largest ongoing costs. Airlines run on pretty thin profit margins, and they need to hold their costs, like fuel, down, to ensure profitability. Example of how a corporate hedger might trade in the FOREX trading markets:If United is buying jet fuel from Canada, and paying in Canadian Dollars, and the Canadian Dollar was rising against the US Dollar, United could lock in a lower, current exchange rate today (via a futures contract) for fuel delivery 3, 6 or even 12 months out into the future. This group of foreign exchange market participants "hedge" or minimizing their risk of losing money against a rising Canadian Dollar. If the Canadian Dollar did rise against the US Dollar, and United not hedged, United would have incurred a higher cost, which could have had a negative impact on their thin profit margins. 3.1.3 The Interbank Market Major Forex Players The third major foreign exchange market participant is a group of large commercial banks and other large financial institutions who make up whats called the Interbank Market. Interbank Market currency trading participants handle FOREX trade transactions with each other around the globe through electronic brokerage systems. This Interbank market has a direct impact on what & how you as a speculator interact in trading the FOREX. How?

The various foreign currency prices you as a trader see on trading platforms are the result of these large banks and financial firms' foreign exchange trading activity in the Interbank market as major foreign exchange market participants. Their activity sets the exchange rates/prices/quotes, as they buy and sell currencies at the bid/ask price throughout the day.

3.1.4 Central Banks Big Foreign Exchange Participants behind the Scenes The Central Banks are the fourth group of Foreign Exchange Market Participants that play in the FOREX space. In the USA, the Central Bank is the Federal Reserve, comprised of its 13 regional banks. In other countries it would be a similar Central Bank setup, serving that specific country and their government. We dont see or hear too much about Central Banks as they are more behind the scenes, and tend to work hand-in-hand with their countries government regarding monetary policy, etc. However, they exert a huge influence in when it comes to currency exchange. One of their main functions is monitoring and helping to set /adjust a countries monetary policy, helping keep watch over the money supply, interest rates, and other issues that can affect a countries economic growth, including inflation or deflation. We may remember when Allen Greenspan was the chairman of the US Federal Reserve, for what seemed like forever. His periodic announcements on the US monetary policy were awaited and held in such high regard and expectation on Wall Street and across the globe, that news coming out of his mouth could have a direct and sometimes dramatic impact in FOREX currency market movements, speaking on behalf of one of worlds most recognizable Foreign Exchange Participants.

With the 2009 global financial crisis, it became crystal clear that serious financial issues can span the globe and not just be restricted to a single country. Thus, foreign government Central banks have taken a greater interest in working more collaboratively with on global monetary issues that affect the world community, so that a repeat of such a serious financial meltdown doesnt occur again. So, we have it a short overview of the major foreign exchange participants. As noted earlier, you surely realize by now, that there is some incredible talent out there trading in the ultimate money game called FOREX. That means, for you to have a chance at success against far more resource-driven and wellfunded Foreign Exchange Market Participants and competitors including some of the most brilliant mathematical and trading minds on the planet - you need to learn as much as you can to improve your currency trading success odds. Remember, the FOREX market doesnt care if you win or lose at trading. It will gladly take your money when you make mistakes, or it can pay you well when you trade smartly and in an unemotional and disciplined fashion.

CHAPTER 4 HEDGING & SPECULATION Why is hedging using derivatives termed risk transfer? One key motivation for derivatives is to enable the transfer of risk between individuals and firms in the economy. This can be viewed as being like insurance, with the difference that anyone in the economy (and not just insurance companies) would be able to sell insurance. A risk averse person buys insurance; a riskseeking person sells insurance. On an options market, an investor who tries to protect himself against a drop in the index buys put options on the index, and a risktaker sells him these options. One special motivation which drives some (but not all) trades is mutual insurance between two persons, both exposed to the same risk, in an opposite way. In the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This is a situation where both parties in the transaction seek to avoid risk. In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, this is a considerable gain. The largest derivatives markets in the world are on government bonds (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk). What happens to market quality and price formation on the cash market once derivatives trading commences? The empirical evidence broadly suggests that market efficiency and liquidity on the spot market improve once derivatives trading come about. Speculators generally prefer implementing their positions using derivatives rather than using a sequence of trades on the underlying spot market. Hence, access to derivatives increases the rate of return on information gathering, research and forecasting activities, and thus serves to spur investments into information gathering and forecasting. This helps improve market efficiency. From a market microstructure perspective, derivatives markets may reduce the extent to which informed speculators are found on the spot market, thus reducing the adverse selection on the

spot market. Derivatives also help reduce the risks faced by liquidity providers on the spot market, by giving them avenues for hedging. These effects help improve liquidity on the spot market. A liquid derivatives market tends to become the focus of speculation and price discovery. When news breaks, the derivative market reacts first. The information propagates down to the cash market a short while later, through the activities of arbitrageurs.

CHAPTER 5 FORWARD CONTRACTS

Why is forward contracting useful? Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest, at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because (a) The costs of taking or making delivery of wheat is avoided (b) Funds are not blocked for the purpose of speculation.

What is leverage? Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a goodfaith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is leverage of 20 times. This example involves a forward market. More generally, all derivatives involve leverage. Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling leverage is equivalent to understanding and controlling derivatives.

What are the problems of forward markets? Forward markets tend to be afflicted by poor liquidity and from unreliability deriving from counterparty risk (also called credit risk).

Why do forward markets have poor liquidity? One basic problem of forward markets is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form customdesigned contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation; this can make the contracts non-tradeable since others might not find those specific terms useful. In addition, forward markets are like the real estate market in that buyers and sellers find each other using telephones. This is inefficient and timeconsuming. Every user faces the risk of not trading at the best price available in the country. Forward markets often turn into small clubs of dealers who earn elevated intermediation fees. This elevates the fees paid by users, i.e. it makes the forward market illiquid from the user perspective.

Why are forward markets afflicted by counterparty risk? A forward contract is a bilateral relationship between two people. Each requires good behaviour on the part of the other for the contract to perform as promised. Suppose L agrees to buy gold from S at a future date T at a (forward) price of Rs.5,000/tola. If, on date T, the gold spot price is at Rs.4,000/tola, then L loses Rs.1,000/tola and S gains Rs.1,000/tola by living up to the terms of the contract. When L buys at Rs.5,000/tola by the terms of the contract, he is paying Rs.1,000 more than what could be obtained on the spot market at the same time. Hence, L is tempted to declare bankruptcy and avoid performing as per the contract. Conversely, if on date T the gold spot price is at Rs.6,000/tola, then L gains and S loses by living up to the terms of the contract. S stands to sell gold at Rs.5,000/tola by the terms of the contract, which is Rs.1,000/tola worse than what could be obtained by selling into the spot market at date T. In this case, S is tempted to declare bankruptcy and avoid performing as per the contract. In either case, this leads to counterparty risk. When one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counterparty risk.

How does counterparty risk affect liquidity? A market where counterparty risk is present generally collapses into a small club of participants, who have homogeneous credit risk, and who have formed social and cultural methods for handling bankruptcies. Club markets do not allow for free entry into intermediation. They support elevated intermediation fees for club members, have fewer market participants, and result in reduced liquidity. Sometimes, regulators who are afraid of payments crises forcibly shut out large numbers of participants from an OTC derivatives market. This automatically generates a club market, and yields a fraction of the liquidity which could come about if participation could be enlarged.

Chapter 5 Futures What is pricetime priority? A market has pricetime priority if it gives a guarantee that every order will be matched against the best available price in the country, and that if two orders are equal in price, the one which came first will be matched first. Forward markets, which involve dealers talking to each other on phone, do not have pricetime priority. Floorbased trading with openoutcry does not have pricetime priority. Electronic exchanges with order matching, or markets with a monopoly market maker, have pricetime priority. On markets without pricetime priority, users suffer greater search costs, and there is a greater risk of fraud.

What is a futures contract? A futures contract is a forward contract which trades on an exchange.

How does the futures market solve the problems of forward markets? Futures markets feature a series of innovations in how trading is organised: Futures contracts trade at an exchange with pricetime priority. All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. This harnesses the gains that are commonly obtained in going from a nontransparent club market (based on telephones) to an anonymous, electronic exchange which is open to participation. The anonymity of the exchange environment largely eliminates cartel formation. Futures contracts are standardised all buyers or sellers are constrained to only choose from a small list of tradeable contracts defined by the exchange. This avoids the illiquidity that goes along with the unlimited customisation of forward contracts. A new credit enhancement institution, the clearing corporation, eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This is called novation. This insulates each from the credit risk of the other. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk. Novation at the clearing corporation makes it possible to have safe trading between strangers. This is what enables largescale participation into the futures market in contrast with small clubs which trade by telephone and makes futures markets liquid.

What is cash settlement? The forward or futures contracts discussed so far involved physical settlement. On 31 Dec 2001, the seller was supposed to come up with 100 tolas of gold and the buyer was supposed to pay for it. In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an interbank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use cash settlement. Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement. Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Dec 2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a loss of Rs.100 per Nifty.

A profit/loss of Rs.100 per nifty applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation organises a payment of Rs.3,000 from S and a payment of Rs.3,000 to L. This is called cash settlement. Cash settlement was an important advance, which extended the reach of derivatives into many products where physical settlement was unviable.

What determines the price of a futures product? Supply and demand on the secondary market determines the futures price. On dates prior to 31 Dec 2000, the Nifty futures expiring on 31 Dec 2000 trade at a price that purely reflects supply and demand. There is a separate order book for each futures product which generates its own price. Economic arguments give us a clear idea about what the price of a future should be. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market which forces the theoretical prices to come about. Doesnt the clearing corporation adopt an enormous risk by giving out credit guarantees to all brokerage firms? Yes, it does.If a brokerage firm goes bankrupt with net obligations of Rs.1 billion, the clearing corporation has a legal obligation of Rs.1 billion. The clearing corporation is legally obliged to either meet these obligations, or go bankrupt itself. There is no third alternative. There is no committee that meets to decide whether the settlement fund can be utilised; there are no escape clauses. It is important to emphasise that when L buys from S, at a legal level, L has bought from the clearing corporation and the clearing corporation has bought from S. Whether S lives up to his obligations or not, the clearing corporation is the counterparty to L. There is no escape clause which can be invoked by the clearing corporation if S defaults.

How does the clearing corporation assure it does not go bankrupt itself? The futures Clearing Corporation has to build a sophisticated risk containment system in order to survive. Two key elements of the risk containment system are the mark to market margin and

initial margin. These involve taking collateral from traders in such a way as to greatly diminish the incentives for traders to default. Electronic trading has generated a need for online, realtime risk monitoring. In India, trading takes place swiftly and funds move through the banking system slowly. Hence the only meaningful notion of initial margin is one that is paid up front. This leads to the notion of brokerage firms placing collateral and obtaining limits upon the risk of their position as a function of the amount of collateral with the clearing corporation.

Can we concretely sketch the operations of one futures market? On 1 January, an exchange decides to trade three gold futures contracts with expiration 31 Jan, 28 Feb and 31 Mar respectively. The three futures contracts all trade at the same time, with three distinct prices. Traders can buy/sell all three contracts as they please. All through January, no settlement takes place. Positions are netted; i.e. if a person buys 100g of 31 Jan gold and then (a few days later) sells off 100g of 31 Jan gold, his new position drops to 0. Trading for the January contract stops on 31 Jan. All net open positions on this contract, as of the close of trading of 31 Jan, have to do settlement on 2 February (T+2 settlement). A buy position (as of close of trading on 31 Jan) has to bring money on 2 Feb, and a sell position (as of close of trading on 31 Jan) has to bring gold on 2 Feb. On 1 Feb, when trading commences, the exchange announces the start of trading on a new contract, one which expires on 30 Apr, thus ensuring that three contracts always trade at any one time. Similarly, on 28 Feb, trading for the Feb contract stops. On 1 March, a new 31 May contract is born. On 2 March, open positions of the Feb contract are settled.

Why is the equity cash market in India said to have futures-style settlement? Indias cash market for equity is ostensibly a cash market, but it functions like a futures markets in every respect. NSEs EQ market is a weekly futures market with tuesday expiration. The trading modalities on NSE from wednesday to tuesday, in trading ITC, are exactly those that would be seen if a futures market was running on ITC with tuesday expiration. On NSE, when a person buys on thursday, he is not obligated to do delivery and payment right

away, and this buy position can be reversed on friday thus leaving no net obligations. Equity trading on NSE involves leverage of seven times. Like all futures markets, trading at the NSE is centralised and there is no counterparty risk owing to novation at the clearing corporation (NSCC). The only difference between ITC trading on NSE, and ITC trading on a true futures market, is that futures contracts with several different expiration dates would all trade at the same time on a true futures market; this is absent on Indias cash market.

Chapter 4 Options Q4.1: What is an option? A: An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A call option gives one the right to buy, a put option gives one the right to sell. Consider a typical transaction. On 1 July 2000, S sells a call option to L for a price of Rs.3.25. Now L has the right to come to S on 31 Dec 2000 and buy 1 share of Reliance at Rs.500. Here, Rs.3.25 is the option price, Rs.500 is the exercise price and 31 Dec 2000 is the expiration date. L does not have to buy 1 share of Reliance on 31 Dec 2000 at Rs.500 from S (unlike a forward/futures contract which is binding on both sides). It is only if Reliance is above Rs.500, on 31 Dec 2000, that L will find it useful to exercise his right. If L chooses to exercise the option, S is obliged to live up to his end of the deal: i.e. S stands ready to sell a share of Reliance to L at Rs.500 on 31 Dec 2000. Hence, at option expiration, there are two outcomes that are possible: an option could be profitably exercised, or it could be allowed to die unused. If the option lapses unused, then L has lost the original option price (Rs.3.25) and S has gained it. When L and S enter into a futures contract, there is no payment (other than initial margin). In contrast, the option has a positive price which is paid in full on the date that the option is purchased. Options come in two varieties european and american. In a european option, the

holder of the option can only exercise his right (if he should so desire) on the expiration date. In an american option, he can exercise this right anytime between purchase date and the expiration date. The price of an option is determined on the secondary market. An option always has a non-negative value: i.e., the value of an option is never negative. Q4.2: How would index options work? A: As with index futures, index options are cash settled. 23 24 CHAPTER 4. OPTIONS Table 4.1 Option prices: some illustrative values Option strike price 1400 1450 1500 1550 1600 Calls 1 mth 117 79 48 27 13 3 mth 154 119 90 67 48 Puts 1 mth 8 19 38 66 102 3 mth 25 39 59 84 114 Assumptions: Nifty spot is 1500, Nifty volatility is 25% annualised, interest rate is 10%, Nifty dividend yield is 1.5%. Suppose Nifty is at 1500 on 1 July 2000. Suppose L buys an option which gives him the right to buy Nifty at 1600 from S on 31 Dec 2000. It turns out that this option is worth roughly Rs.90. So a payment of Rs.90 passes from L to S for having this option. When 31 Dec 2000 arrives, if Nifty is below 1600, the option is worthless and lapses without exercise. Suppose Nifty is at 1650. Then (in principle) L can exercise the option, buy Nifty using the option at 1600, and sell off this Nifty on the open market at 1650. So L has a profit of Rs.50 and S has a loss of Rs.50. In this case, cash settlement consists of NSCC imposing a charge of Rs.50 upon S and paying it to L. Q4.3: What kinds of Nifty options would trade? A: The strike prices and expiration dates for traded options are selected by the exchange.

For example, NSE may choose to have three expiration months, and five strike prices (1200,1300,1400,1500,1600). There would be two types of options: put and call. This gives a total of 30 distinct traded options (3 5 2), with 30 distinct order books and prices. A typical set of option prices is shown in Table 4.1. It illustrates the intruiging nature of option prices. When Nifty is at 1500, the right to buy Nifty at 1600 one month away is worth little (Rs.13). The buyer of this option puts down Rs.13 when the option is purchased, and this fee is nonrefundable. If Nifty turns out to be above 1600 after a month, this option will prove to be valuable. If Nifty proves to be at 1602 after a month, the option will pay Rs.2. Conversely when Nifty is at 1500, the right to sell Nifty at 1400 one month away isnt worth much (Rs.8): this is the insurance premium for protecting yourself against a fall in Nifty of worse than a hundred points. However, when we increase the time to expiration of the option, there is a greater chance that prices can move around, and these same options become worth more: e.g. the 25 right to sell Nifty at 1600 is worth Rs.25 when we consider a threemonth horizon (i.e. insurance against a hundredpoint drop on a threemonth horizon). Also see: Hull (1996).