It includes all the people engaged from the instant an order is put to the trading system till it is dealt and matched by a counter party. This category is being handled by the "straight-through-processing" STP technology. Like the prices of a Forex broker's platform, a lot of inter-bank deals are now being handled electronically by two primary platforms: the Reuters web-based dealing system, and the Icap's EBS which is short for "electronic brokering system that replace the voice broker once common in the foreign exchange markets.
Some online trading platforms are shown below. The last segment of the Forex markets, the brokers , are usually very huge companies with huge trading turnovers. This turnover provides the basic infrastructure to the common individual investors to invest and profit in the interbank market. Most of the brokers are taken to be a market maker for the retail trader. To provide competitive and popular two-way pricing model, these brokers usually adapt to the technological changes available in the Forex industry.
A trader needs to produce gains independently while using a market maker or having a convenient and direct access through an ECN. The Forex broker-dealers offset their positions in the interbank market, but they do not act exactly the same way as banks do.
Instead, they have their own data feed that supports their pricing engines. Brokers typically need a certain pool of capitalization, legal business agreements, and straightforward electronic contacts with one or multiple banks. Interest Rate Parity IRP is a theory in which the differential between the interest rates of two countries remains equal to the differential calculated by using the forward exchange rate and the spot exchange rate techniques.
Interest rate parity connects interest, spot exchange, and foreign exchange rates. It plays a crucial role in Forex markets. IRP theory comes handy in analyzing the relationship between the spot rate and a relevant forward future rate of currencies. According to this theory, there will be no arbitrage in interest rate differentials between two different currencies and the differential will be reflected in the discount or premium for the forward exchange rate on the foreign exchange.
The theory also stresses on the fact that the size of the forward premium or discount on a foreign currency is equal to the difference between the spot and forward interest rates of the countries in comparison. Thus, when there is no arbitrage, the Return on Investment ROI is equal in both cases, regardless the choice of investment method. Arbitrage is the activity of purchasing shares or currency in one financial market and selling it at a premium profit in another.
According to Covered Interest Rate theory, the exchange rate forward premiums discounts nullify the interest rate differentials between two sovereigns. Assume Yahoo Inc. Yahoo Inc. Yahoo can buy Euro forward a month 30 days to lock in the exchange rate. Then it can invest this money in dollars for 30 days after which it must convert the dollars to Euro. This is known as covering, as now Yahoo Inc. Yahoo can also convert the dollars to Euro now at the spot exchange rate.
Then it can invest the Euro money it has obtained in a European bond in Euro for 1 month which will have an equivalently loan of Euro for 30 days. Then Yahoo can pay the obligation in Euro after one month. Under this model, if Yahoo Inc. It is also known as covering because by converting the dollars to Euro at the spot rate, Yahoo is eliminating the risk of exchange rate fluctuation.
Uncovered Interest Rate theory says that the expected appreciation or depreciation of a particular currency is nullified by lower or higher interest. In the given example of covered interest rate, the other method that Yahoo Inc. This method is known as uncovered, as the risk of exchange rate fluctuation is imminent in such transactions.
Contemporary empirical analysts confirm that the uncovered interest rate parity theory is not prevalent. However, the violations are not as huge as previously contemplated. The violations are in the currency domain rather than being time horizon dependent.
In contrast, the covered interest rate parity is an accepted theory in recent times amongst the OECD economies, mainly for short-term investments. The apparent deviations incurred in such models are actually credited to the transaction costs. If IRP theory holds, then it can negate the possibility of arbitrage. It means that even if investors invest in domestic or foreign currency, the ROI will be the same as if the investor had originally invested in the domestic currency. When domestic interest rate is below foreign interest rates, the foreign currency must trade at a forward discount.
This is applicable for prevention of foreign currency arbitrage. If a foreign currency does not have a forward discount or when the forward discount is not large enough to offset the interest rate advantage, arbitrage opportunity is available for the domestic investors.
So, domestic investors can sometimes benefit from foreign investment. When domestic rates exceed foreign interest rates, the foreign currency must trade at a forward premium. This is again to offset prevention of domestic country arbitrage. When the foreign currency does not have a forward premium or when the forward premium is not large enough to nullify the domestic country advantage, an arbitrage opportunity will be available for the foreign investors.
So, the foreign investors can gain profit by investing in the domestic market. Monetary assets are cash in possession of a corporation, country, or a company. The cash in hand determines the strength of an economy. Monetary assets have a dollar value that will not change with time. These assets have a constant numerical value.
For example, a dollar is always a dollar. The numbers will not change even if the purchasing power of the currency changes. We can understand this concept by contrasting them against a non-monetary item like a production facility. It may lose or gain value over the years. In other words, monetary items are just cash. It can be a debt owed by an entity, a debt owed to it, or a cash reserve in its account. Also, speculators who are looking for a profit relying on the changes in currency values create demand.
The supply of a particular currency is derived by domestic demands for imports from the foreign nations. For example, let us suppose the UK has imported some cars from Japan. To buy Yen, it must sell supply Pounds. The more the imports, the greater will be the supply of Pounds onto the Forex market. Due to demand and supply, there is always an exchange rate that keeps changing over time. The rate of exchange is the price of one currency expressed in terms of another.
Due to increased or decreased demand, the currency of a country always has to maintain an exchange rate. The more the exchange rate, the more is the demand of that currency in forex markets. Exchanging the currencies refer to trading of one currency for another.
The value at which an exchange of currencies takes place is known as the exchange rate. The equilibrium between supply and demand of currencies is known as the equilibrium exchange rate. Let us assume that both France and the UK produce goods for each other.
They will naturally wish to trade with each other. However, the French producers will have to pay in Euros and the British producers in Pounds Sterling. However, to meet their production costs, both need payment in their own local currency. These needs are met by the forex market which enables both French and British producers to exchange currencies so that they can trade with each other.
The market usually creates an equilibrium rate for each currency, which will exist where demand and supply of currencies intersect. Changes in currency exchange rate may occur due to changes in demand and supply. When exports increase, it would shift the demand curve for Sterling to the right and the exchange rate will go up.
Each currency carries an interest rate. It is like a barometer of the strength or weakness of an economy. This may sometimes result in a situation where more money is spent for roughly the same goods. This can increase the price of the goods. To stop this imminent danger, the central bank usually raises the interest rates. When the interest rate is increased, it makes the borrowed money more expensive. This, in turn, demotivates the consumers from buying new products and incurring additional debts.
It also discourages the companies from expansion. The companies that do business on credit have to pay interest, and hence they do not spend too much in expansion. The higher rates will gradually slow the economies down, until a point of saturation will come where the Central Bank will have to lower the interest rates.
This reduction in rates is aimed at encouraging the economic growth and expansion. When the interest rate is high, foreign investors desire to invest in that economy to earn more in returns. Consequently, the demand for that currency increases as more investors invest there. Countries offering the highest RoI by offering high interest rates tend to attract heavy foreign investments.
When a country's stock exchange is doing well and offer a good interest rate, the foreign investors are encouraged to invest capital in that country. In fact, it is not just the interest rate that is important. The direction of movement of the interest rate is a good pointer of demand of the currency.
It is aimed at controlling the foreign exchange rates so that the interest rates and thereby the inflation in the country is kept under control. Many developed countries nowadays believe in non-intervention. It has been backed by research that intervention may not be a good policy for the developed economies. However, the recession has again brought the topic under consideration as whether Forex intervention is really necessary to keep the economy affluent.
Central banks generally intervene in the Forex market to increase the reserves, stabilize the fluctuating exchange rate and rectify misalignments. The success of intervention depends on the sterilization of the impact, and the general government macroeconomic policies.
There are mainly two difficulties in an intervention process. They are the determination of the timing and the amount. These decisions are often a judgment and not a set policy. Forex interventions can be risky because it can degrade the central bank's credibility in case of a failure. The primary objective of Forex intervention is to adjust the volatility or to change the level of the exchange rate.
Excessive short-term volatility diminishes market confidence and affects both the financial and the real goods markets. In case of instability, exchange rate uncertainty results in extra costs and reduction of profits for companies. Investors do not invest in foreign financial assets and firms do not trade internationally. Exchange rate fluctuation affects the financial markets and thereby threatens the financial system.
In such situations, intervention is necessary. Moreover, during change of economic condition and when the market misinterprets the economic signals, foreign exchange intervention rectifies the rates so that overshooting can be avoided.
Today, forex market intervention is hardly used in developed countries. Intervention is only effective when seen as preceding interest rate or other similar policy adjustments. Intervention has no lasting impact on the real exchange rate and thus on competitive factors for the tradable sector. Direct currency intervention is generally defined as foreign exchange transactions that are conducted by the monetary authority and aimed at influencing the exchange rate.
Depending on the monetary base changes, currency intervention can be broadly divided into two types: sterilized and non-sterilized interventions. Sterilized intervention influences the exchange rate without changing the monetary base. There are two steps in it. First, the central bank buys selling foreign currency bonds with domestic currency.
Then the monetary base is sterilized by selling buying equivalent domestic-currency-denominated bonds. The net effect is the same as a swap of domestic bonds for foreign bonds without money supply changes. The purchase of foreign exchange is accompanied by a sale of an equivalent amount of domestic bonds, and vice versa. The sterilized intervention has little or no effect on domestic interest rates. In case of any change, a new equilibrium is reached by changing the portfolios.
Portfolio balancing influences the exchange rates. The change of expectation affects the current level of the exchange rate. Non-sterilized intervention affects the monetary base. The exchange rate is affected due to purchase or sale of foreign money or bonds with domestic currency. In general, non-sterilization influences the exchange rate by bringing changes in the monetary base stock, which, in turn, changes the monetary assets, interest rates, market expectations and finally, the exchange rate.
Capital controls taxing international transactions and exchange controls restricting trade in currencies are indirect interventions. Indirect intervention influences the exchange rate indirectly. There had been a large increase in American imports of Chinese goods in the s and s.
This has increased the supply of the Yuan in the market, and also increased the demand for US dollars, increasing the Dollar price. The actual effects of the devalued Yuan on capital markets, trade deficits, and the US domestic economy are highly debated. It is believed that the Yuan devaluation helps China as it boosts its exports, but hurts the United States by widening its trade deficit.
It has been suggested that the US should apply tariffs on Chinese goods. Another viewpoint is that US protectionism may hurt the US economy. Thus, they argue that importers within China have been substantially hurt due to the large-scale foreign exchange intervention. A money market is one of the safest financial markets available for currency transactions.
It is often used by the big financial institutions, large corporations, and national governments. The investments made in money markets are usually for a very short period of time and therefore they are commonly known as cash investments. The international money market is a market where international currency transactions between numerous central banks of countries are carried on. The transactions are mainly carried out using gold or in US dollar as a base.
The basic operations of the international money market include the money borrowed or lent by the governments or the large financial institutions. Unlike share markets, the international money market sees very large funds transfer.
The players of the market are not individuals; they are very big financial institutions. The international money market investments are less risky and consequently, the returns obtained from the investments are less too. The best and most popular investment method in the international money market is via money market mutual funds or treasury bills.
The international money market keeps track of the exchange rates between currency- pairs on a regular basis. Currency bands, fixed exchange rate, exchange rate regime, linked exchange rates, and floating exchange rates are the common indices that govern the international money market in a subtle manner.
By the end of , IMM was the second biggest futures exchange in terms of currency volume in the world. The major purpose of the IMM is to trade currency futures. It is comparatively a new product which was earlier studied by the academics as a tool to operate a freely-traded exchange market to initiate trade among the nations.
The challenge of the IMM was in connecting the values of IMM foreign exchange contracts to the interbank market, which is the prominent means of currency trading in the s. The other aspect was how to allow the IMM to become the best and a free-floating exchange. To contain these aspects, clearing member-firms were allowed to act as the arbitrageurs between central banks and the IMM to allow orderly markets between the bid and ask spreads.
Later on, the Continental Bank of Chicago was incorporated as a delivery agent for contracts. These initial successes led to fierce competition for new futures products. The Chicago Board Options Exchange was a competitor.
It had received the right to trade US year bond futures while the IMM obtained the official right to trade Eurodollar contracts. The Eurodollars were a day interest rate contract settled in cash and not in any physical delivery. This cash settlement aspect later introduced index futures known as IMM Index. Cash settlements also allowed the IMM to later known as a "cash market" because the trades were interest rate sensitive instruments of short-term.
As competition grew, a transaction-system to handle the transactions in IMM was required. The system became the single clearing entity to link the major financial centres like Tokyo and London. Now, PMT is called Globex, which deals not only in clearing but also in electronic trading for traders around the world.
T-bill futures were introduced in April that was approved by the Commodities Futures Trading Commission. In financial crises, central banks need to provide liquidity to stabilize markets, as risks may trade at premiums money rates to a bank's target rates. Central bankers then need to infuse liquidity to the banks that trade and control rates. These are known as repo rates, and these are traded via IMM. Repo markets allow the participating banks to offer rapid refinancing in the interbank market that is independent of any credit limits to smoothen the market.
A borrower has to pledge for securitized assets, such as equity, in exchange for cash to allow its operations to continue. Unlike Equity and Money markets, there is no specific bond market to trade bonds. However, there are domestic and foreign participants who sell and buy bonds in various bond markets.
A bond market is much larger than equity markets, and the investments are huge too. However, bonds pay on maturity and they are traded for short-time before maturity in the markets. Bonds also have risks, returns, indices, and volatility factors like equity and money markets. The international bond market is composed of three separate types of bond markets: Domestic Bonds, Foreign Bonds, and Eurobonds.
Domestic bonds trade is a part of the international bond market. Domestic bonds are dealt in local basis and domestic borrowers issue the local bonds. Domestic bonds are bought and sold in local currency.
In foreign bond market, bonds are issued by foreign borrowers. Foreign bonds normally use the local currency. The concerned local market authorities supervise the issuance and sale of foreign bonds. Foreign bonds are traded in the foreign bond markets. In the past, Continental private banks and old merchant houses in London linked the investors with the issuers. Eurobonds are not sold in any specific national bond market. A group of multinational banks issue Eurobonds.
A Eurobond of any currency is sold outside the nation that has the currency. It is commonly an offshore market. Bond market participants are either buyers debt issuer or sellers institution of funds and often both of these. Since there is a specificity of individual bond issues, and a condition of lack of liquidity in case of many smaller issues, a significantly larger chunk of outstanding bonds are often held by institutions, such as pension funds, banks, and mutual funds.
For the market participants owning bonds, collecting coupons and holding it till maturity, market volatility is not a matter to ponder over. The principal and interest rates are pre-determined for them. However, participants who trade bonds before maturity face many risks, including the most important one — changes in interest rates. When interest rates increase, the bond-value falls.
Therefore, changes in bond prices are inversely proportional to the changes in interest rates. Economic indicators and paring with actual data usually contribute to market volatility. Only little price movement is seen after the release of "in-line" data. When economic release does not match the consensus view, a rapid price movement is seen in the market. Uncertainty is responsible for more volatility.
Bonds are priced as a percentage of par value. Many bonds have minimums imposed on them. Bonds pay interests at given intervals. Bonds with fixed coupons usually divide the coupon according to the payment schedule. Bonds with floating rate coupons have set calculation schedules. The rate is calculated just before the next payment.
Bond interest is taxed, but in contrast to dividend income that receives favorable taxation rates, they are taxed as ordinary. Many government bonds are, however, exempt from taxation. Individual investors can participate through bond funds, closed-end funds, and unit-investment trusts offered by investment companies. A number of bond indices exist. International equity markets are an important platform for global finance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper.
To understand the importance of international equity markets, market valuations and turnovers are important tools. Moreover, we must also learn how these markets are composed and the elements that govern them. In this chapter, we will discuss all these aspects along with the returns from international equity markets.
The secondary equity markets provide marketability and share valuation. Investors or traders who purchase shares from the issuing company in the primary market may not desire to own them forever. The secondary market permits the shareholders to reduce the ownership of unwanted shares and lets the purchasers to buy the stock. The secondary market consists of brokers who represent the public buyers and sellers.
There are many different designs for secondary markets. A secondary market is structured as a dealer market or an agency market. In a dealer market, the broker takes the trade through the dealer. Public traders do not directly trade with one another in a dealer market. The over-the-counter OTC market is a dealer market. Not all stock market systems provide continuous trading. For example, the Paris Bourse was traditionally a call market where an agent gathers a batch of orders that are periodically executed throughout the trading day.
The major disadvantage of a call market is that the traders do not know the bid and ask quotations prior to the call. Crowd trading is a form of non-continuous trade. In crowd trading, in a trading ring, an agent periodically announces the issue. The traders then announce their bid and ask prices, and look for counterparts to a trade. Unlike a call market which has a common price for all trades, several trades may occur at different prices. Second, the prominent capital markets got more liberalized through the elimination of fixed trading commissions.
Third, internet and information and communication technology facilitated efficient and fair trading in international stocks. Cross-listing refers to having the shares listed on one or more foreign exchanges. Cross-listing offers recognition of the company in a new capital market, thus allowing the firm to source new equity or debt capital from local investors.
Cross-listing offers more investors. International portfolio diversification is possible for investors when they trade on their own stock exchange. Cross-listing may be seen as a signal to investors that improved corporate governance is imminent. In s, many international companies, including the Latin Americans, have listed their stocks on U.
One of the reasons is the pressure for privatization of companies. Another reason is the rapid growth in the economies. An ADR is a receipt that has a number of foreign shares remaining on deposit with the U. This is easier than purchasing and trading in US stocks by entering the US exchanges.
Dividends received on the shares are issued in dollars by the custodian and paid to the ADR investor, and a currency conversion is not required. ADR trades clear in three business days as do U. ADRs are registered securities and they offer protection of ownership rights. Most other underlying stocks are bearer securities.
ADRs frequently represent a set of underlying shares. Sponsored ADRs are created by a bank after a request of the foreign company. The sponsoring bank offers lots of services, including investment information and the annual report translation. New ADR issues must be sponsored. Unsponsored ADRs are generally created on request of US investment banking firms without any direct participation of the foreign issuing firm.
GRS are a share that are traded globally, unlike the ADRs that are receipts of the bank deposits of home-market shares and are traded on foreign markets. They usually trade in both US dollars and euros. The main disadvantage is the cost of establishing the global registrar and the clearing facility. Macroeconomic factors, exchange rates, and industrial structures affect international equity returns.
Solnik examined the effect of exchange rate fluctuations, interest rate differences, the domestic interest rate, and changes in domestic inflation expectations. He found that international monetary variables had only weak influence on equity returns. Asprem stated that fluctuations in industrial production, employment, imports, interest rates, and an inflation measure affect a small portion of the equity returns.
Adler and Simon tested the sample of foreign equity and bond index returns to exchange rate changes. They found that exchange rate changes generally had a variability of foreign bond indexes than foreign equity indexes. However, some foreign equity markets were more vulnerable to exchange rate changes than the foreign bond markets. Roll concluded that the industrial structure of a country was important in explaining a significant part of the correlation structure of international equity index returns.
In contrast, Eun and Resnick found that the correlation structure of international security returns could be better estimated by recognized country factors rather than industry factors. Economists and investors always tend to forecast the future exchange rates so that they can depend on the predictions to derive monetary value. There are different models that are used to find out the future exchange rate of a currency.
There are numerous theories to predict exchange rates, but all of them have their own limitations. This approach is suitable for long-term investments. It makes predictions by making a chart of the patterns. It states that same goods in different countries should have identical prices. For example, this law argues that a chalk in Australia will have the same price as a chalk of equal dimensions in the U. That is, there will be no arbitrage opportunity to buy cheap in one country and sell at a profit in another.
Depending on the principle, the PPP approach predicts that the exchange rate will adjust by offsetting the price changes occurring due to inflation. For example, say the prices in the U. Then, the inflation differential between America and Australia is:. According to this assumption, the prices in the U. Therefore, the PPP approach would predict that the U.
So, in case the exchange rate was 90 cents U. The relative economic strength model determines the direction of exchange rates by taking into consideration the strength of economic growth in different countries. The idea behind this approach is that a strong economic growth will attract more investments from foreign investors.
To purchase these investments in a particular country, the investor will buy the country's currency — increasing the demand and price appreciation of the currency of that particular country. Another factor bringing investors to a country is its interest rates.
High interest rates will attract more investors, and the demand for that currency will increase, which would let the currency to appreciate. Conversely, low interest rates will do the opposite and investors will shy away from investment in a particular country. The investors may even borrow that country's low-priced currency to fund other investments. This was the case when the Japanese yen interest rates were extremely low. This is commonly called carry-trade strategy.
The relative economic strength approach does not exactly forecast the future exchange rate like the PPP approach. It just tells whether a currency is going to appreciate or depreciate. It is a method that is used to forecast exchange rates by gathering all relevant factors that may affect a certain currency.
It connects all these factors to forecast the exchange rate. The factors are normally from economic theory, but any variable can be added to it if required. Now, using this model, the variables mentioned, i. The coefficients used a, b, and c will affect the exchange rate and will determine its direction positive or negative. The time series model is completely technical and does not include any economic theory. The popular time series approach is known as the autoregressive moving average ARMA process.
The rationale is that the past behavior and price patterns can affect the future price behavior and patterns. The data used in this approach is just the time series of data to use the selected parameters to create a workable model. To conclude, forecasting the exchange rate is an ardent task and that is why many companies and investors just tend to hedge the currency risk. Still, some people believe in forecasting exchange rates and try to find the factors that affect currency-rate movements.
For them, the approaches mentioned above are a good point to start with. Exchange rate fluctuations affect not only multinationals and large corporations, but also small and medium-sized enterprises. Therefore, understanding and managing exchange rate risk is an important subject for business owners and investors.
There are various kinds of exposure and related techniques for measuring the exposure. Of all the exposures, economic exposure is the most important one and it can be calculated statistically. Transaction exposure arises from this effect and it is short-term to medium-term in nature. Translation exposure arises due to this effect. It is medium-term to long-term in nature. Note that economic exposure is impossible to predict, while transaction and translation exposure can be estimated.
Consider a big U. The management expected that the Dollar will be bearish due to the recurring U. However, the rapidly improving U. The outlook suggests further gains, as the monetary policy in Japan is stimulative and the European economy is coming out of recession. The U. This will have a negative effect on sales and cash flows. Foreign asset or overseas cash flow value fluctuates with the exchange rate changes. Where, a is the regression constant, b is the regression coefficient, and e is a random error term with a mean of zero.
The regression coefficient is the ratio of the covariance between the asset value and the exchange rate, to the variance of the spot rate. It would like to estimate its economic exposure. In the strong-Euro scenario, the Euro will be at 1. In the weak-Euro scenario, currency will be at 1. Whether the markets where the company inputs and sells its products are competitive or monopolistic? If both costs and prices are relative or secluded to currency fluctuations, the effects are cancelled by each other and it reduces the economic exposure.
Whether a firm can adjust to markets, its product mix, and the source of inputs in a reply to currency fluctuations? Flexibility would mean lesser operating exposure, while sternness would mean a greater operating exposure. The economic exposure risks can be removed through operational strategies or currency risk mitigation strategies. However, the drawback is the company may lose economies of scale. For example, if a U. Price adjustment is made in this, so that the base price of the transaction is adjusted.
The back-to-back loan stays as both an asset and a liability on their balance sheets. Here, two firms borrow in the markets and currencies so that each can have the best rates, and then they swap the proceeds. Depending on the selection of buying or selling the numerator or denominator of a currency pair, the derivative contracts are known as futures and options. There are various ways to earn a profit from futures and options, but the contract-holder is always obliged to certain rules when they go into a contract.
There are some basic differences between futures and options and these differences are the ways through which investors can make a profit or a loss. Currency futures and options are derivative contracts. These contracts derive their own values from utilization of the underlying assets, which, in this case, are currency pairs. Currencies are always traded in pairs. For example, the Euro and U.
When someone buys this pair, they are said to be going long buying with the numerator, or the base, currency, which is the Euro; and thereby selling the denominator quote currency, which is the Dollar. When someone sells the pair, it is selling the Euro and buying the Dollar. When the long currency appreciates against the short currency, people make money.
Currency futures make the buyer of the contract to buy the long currency numerator by paying with the short currency denominator for it. The seller of a contract has the reverse obligation. The obligation of the contact is usually due on the expiration date of the future. The ratio of currencies, bought and sold, is settled in advance between the parties involved.
People make a profit or loss depending on the gap between the settled price and the real, effective price on the date of expiration. Margins are deposited for the futures trades — cash is the important part that serves as the performance bond to make sure that both parties are obliged to fulfil their obligations. The party that purchases a currency pair call option may also decide to settle for an execution or to sell out the option on or before the date of expiration.
There is a strike price of the option that shows a particular exchange ratio for the given pair of currencies. When the actual price of the currency pair is more than the strike price, the call holder earns a profit. It is said to execute the option by buying the base and selling the quote at a profitable term.
A put buyer always bets on the denominator or quote currency appreciating against the numerator or the base currency. Instead of having to buy and sell currency pairs, options in a currency future offers the contract-holders the right, but not an obligation, to purchase a futures contract on the particular currency pair.
The strategy in such a case is that the option buyer can profit from the futures market without having to put down any margin in the contract. When the futures contract appreciate, the call or contract holder can just sell the call for a profit. The call holder does not need to buy the underlying futures contract.
A put buyer can easily earn a profit if the futures contract loses value. The basic and most prominent difference between options and futures is related with the obligations they create on part of the buyers and sellers. An option offers the buyer the basic right, but not an obligation, to buy or sell a certain kind of asset at a decided or settled price, which is specific at any time while the contract is alive.
On the other hand, a futures contract offers the buyer the obligation to buy a specific asset, and the seller the obligation to sell and deliver that asset on a specific future date, provided the holder does not close the position prior to expiration. An investor can go in into a futures contract with no upfront cost apart from commissions, whereas purchasing an options position does not need to pay a premium. While comparing the absence of any upfront cost of futures, the premium of the option can be considered as the fee for not being obligated to purchase the underlying asset in the case of an adverse movement in prices.
The premium paid on the option is the maximum value a purchaser can lose. Another important difference between futures and options is the size of the given or underlying position. Usually, the underlying position is considerably bigger in case of futures contracts. Moreover, the obligation to purchase or sell this given amount at a settled price turns the futures a bit riskier for an inexperienced investor. The final and one of the prominent differences between futures and options is the way the gains or earnings are obtained by the parties.
On the other hand, gains on the futures positions are naturally 'marked to market' every day. This means that the change in the price of the positions is assigned to the futures accounts of the parties at the end of every trading day.
However, a futures call-holder can also realize gains by going to the market and opting for the opposite position. There are various techniques available for managing transactional exposure. The objective here is to shun the transactions from exchange rate risks. In this chapter, we will discuss the four major techniques that can be used to hedge transactional exposure. In addition, we will also discuss some operational techniques to manage transactional exposure. The main feature of a transaction exposure is the ease of identifying its size.
Additionally, it has a well-defined time interval associated with it that makes it extremely suitable for hedging with financial instruments. This removes the uncertainty of future home currency value of the liability asset into a certain value. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure.
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