According to the interest rate parity theory, the currency margin is dependent mainly on the prevailing interest rate (for investment for the given time period) in the two currencies. The forward rate can be calculated by the following formula:
F/S = (1+Rh)/ (1+Rf)
Where, F and S are future and spot currency rate. Rh and Rf are simple interest rate in the home and foreign currency respectively.
Alternatively, if we consider continuously compounded interest rate then forward rate can be calculated by using the following formula:
F = S*e (rh- rf)*t
Where, rh and rf are the continuously compounded interest rate for the home currency and foreign currency respectively, T is the time to maturity and e = 2.71828 (exponential).
If the following relationship between the futures rate and the spot rate does not hold, then there will be an arbitrage opportunity in the market. This will force the futures rate to change so that the relationship holds true.
Let us assume that risk free interest rate for one year deposit in India is 7% and in USA it is 3%. You as smart trader/ investor will raise money from USA and deploy it in India and try to capture the arbitrage of 4%.…
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Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders’ often use the currency futures. For example, a long hedge (i.e., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currency’s value.
It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firm’s profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement.
The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is:
Loss from appreciating in Indian rupee= Short hedge
Loss from depreciating in Indian rupee= Long hedge
A short hedge involves taking a short position in the futures market.…
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Option Trading confers the right on the holder/buyer to buy/sell a specified asset (here foreign currency) on a specific price on or before a specific date but he has no obligation to buy/sell. Seller/Writer has an obligation to fulfill the contract if buyer/holder exercises the option. Whenever a person has an intention to buy foreign currency by paying a premium amount immediately, and settling the same on a later date, it is known as a Call option. Call option has two parties, one a buyer of a Call option and other a seller of a Call option.
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Mr. A is interested in buying a US dollar. Spot rate is US$ 1 = 45.50. Mr. A believes that some 30 days down the line, with the budget coming up and the price of the US dollar would increase. Not wanting to take any chances, he goes to a dealer and purchases a call option for US dollars 1,000 after 1 month. The dealer, knowing the Forex market only too well, agrees to that but demands Rs. 100 as a risk measure that he is ready to take. So now they enter into a contract whereby Mr. A would pay the dealer Rs.
The currency swap market is the oldest and most creative sector of the swap market. This is not distinguished in market terms between the fixed rate currency swap and the currency coupon swap. There is no distinction in market terms between these two types of currency swaps because the only difference is whether the counter currency receipt/payment is on a fixed or floating basis- in structure and result, the two types of swaps are identical and it is a matter of taste (or preference) for one or both counter-parties to choose a fixed or floating payment. When the dollar is involved on one side of a given transaction, the possibility to convert a fixed rate preference on one side to a floating rate preference on the other side through interest rate swap market makes any distinction even more irrelevant. However, for those who like fine distinctions, there is a tendency in the market to regard the fixed rate currency swap market as more akin to the long date forward foreign exchange market (because when one is executing a fixed currency swap one may often be competing with the long-date Forex market) and the currency coupon swap market as more akin to the dollar bond/ swap market (because the dollar bond issuer compares the below LIBOR spread available in the dollar market to that available, say, through tapping the Euro market).…
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The great bulk of swap activity of date has concentrated on currencies and interest rates, yet these do not exhaust the swap concept’s applicability. As one moves out the yield curve, the primary interest rate swap market becomes dominated by securities transactions and in particular the Eurodollar bond market. The advent of the swap market has meant that the Eurodollar bond market now never closes due to interest rate levels: issuers who would not come to market because of high interest rates now do so to the extent that a swap is available. Indeed, the Eurodollar bond market owes much of its spectacular growth to the parallel growth of its swap market. The firms that now dominate lead management roles in the Eurodollar bond market all have substantial swap capabilities and this trend will continue. One extension is seen in the beginning of the market for equity swaps- an exchange of coupons on some bonds for dividends on some equities, or an index instrument thereof (capital appreciation also may be included on one or both sides of the swap). The purpose is to earn equity returns when the investor deems them promising but without the transactions costs of liquidating an existing bond position or building an outright equities position, while also providing the complication of unfamiliar local market and the time and trouble of stock-picking if the index will suffice.…
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