Calculation of Option Forward rates| Forex Management

It may be noted that as between two banks, the option of delivery under a forward contract rests with  buying bank. If the customer delivers foreign exchange on 1st April, the has to pay Yen to the customer immediately. In case the counterpart (buyer) in the cover deal chooses to require delivery on 30th April, the bank has to either keep the dollars received form the customer with itself or invest it for one month. Dollar is at premium because the cost of dollar funds is lower that that of yen funds. For one month, even if the dollar is invested the bank would be losing on the interest differential which has to be compensated by offering lower premium to the customer.

From the above discussion , we may deduce the following rule: for purchase transactions quote premium for the earliest delivery.

Next post we’ll discuses more.

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Forex Management | Option Forward

In fact option forward contract is a part of forex management.  Under an option forward contract the customer has the freedom to deliver the foreign exchange on any day during the option period. The bank should quote a single exchange rate valid for the entire period. Suppose that the following rates prevail for US dollar on 17th February:

      Buying        Selling

        Yen             Yen

Spot             49.45          49.50

Spot/March  0.05            0.06 pm

Spot/ April   0.08             0.09

Spot/ May     0.11            0.12

In respect of purchase transaction, the forward premium for delivery March is 0.05 Yen and for delivery April is 0.08 Yen. We have already seen that normally forward margin is to compensate the interest differential. The additional premium of 0.03 Yen for April over that for March represents the interest differential for one month. If a customer requires forward purchase rate for fixed delivery 30th April, the bank would concede him the premium up to April end, and quote him the rate of Yen.49.53 per dollar. On the other hand , if the customer wants to deliver foreign exchange on 1st April, he is not entitled to the premium for April. The forward premium for April beginning would be the same as that for March end. The bank will therefore quote him a rate of Yen 49.50 , inclusive of premium up to march. Suppose the customer requires the bank to book a forward purchase contract delivery April. It means, the customer can delivery foreign exchange on any day during April. i.e. 1st April to 30th April, but the bank should quote a single rate which would be applicable to any these days. The bank would play safe and quote the rate of Yen 49.50 (i.e. the rate for March) for an option forward contract with option to the customer over the entire April.

It may be argued on behalf of the customer that the option forward rate quoted to him is based on the inter-bank option forward rate as a part of bank’s forex management. The bank would cover itself by entering into a forward sale with the market with option of delivery 1st to 30th April, in which case the premium of 0.08 Yen is available to it.

                                                                                                            

                                                                                                                     

Forex Management and Calculation of Option Forward rates

 

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Best Forex Trading Information-Introduction to Forward Contract

The forward contract under which the delivery of foreign exchange should take place on a specified future date is known as ‘fixed forward contract’. For instance, if on 5th March, 20XX a customer enters into a three months forward contract with his bank to sell GBP 10,000 it means the customer would be presenting a bill or any other instrument on 7th June, 20XX to the bank for GBP 10,000. He cannot deliver foreign exchange prior to or later than the determined date.

Basics of forward contract

We saw that forward contract is a device by which the customer tries to cover the exchange risk. The purpose will be defeated if he is unable to deliver foreign exchange exactly on the due date. In real situations, it is not possible for any exporter to determine in advance the precise date on which he will be tendering export documents. Besides internal factors relating to production, many other external factors also have a bearing on the date of shipment and presentation of documents to the bank. At the most, the exporter can only estimate the probable date around which he would be able to complete his commitment.

Option contract definition With view to eliminating the difficulty in fixing the exact date for delivery of foreign exchange, the customer may be given an option to deliver the foreign exchange during a given period of days. An arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is known as ‘Option Contract’. The rate at which the deal takes place is the option forward rate. For example, on 15th September, 20XX a customer enters into two months forward contract with the bank with option over November, 20XX. It means the customer can sell foreign exchange to the bank on any day between 1st November and 30th November 20XX. The period from 1st to 30th November is known as the ‘Option Period'.

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The International Money Market and Euro currencies, Eurodollar

We’ve explained that when US Dollar deposits are re-deposited outside America it is known as Euro-dollar. Same Euro-yen when it is re-deposited outside Japan. The bank balance in the UK of our familiar pound sterling would also take on the name of Euro-sterling when re-deposited outside Great Britain, Collectively; then, we can say that Eurocurrencies are deposits in currencies that are re-deposited outside the home countries of the currencies concerned. Although generally known as Euro-dollar, it is also know locally as, Asian dollar in Singapore। We also talk of petrodollar alluding to the huge amounts dollars accumulated by oil producing countries that keep on recycling in the
Eurocurrency market.

One may ask why the banks deposit or re-deposit US dollar outside USA. There are number of reasons. Perhaps the growth of Euro-dollar can be traced to an American law regulation Q, that laid down maximum retes which domestic banks could pay on time deposit. Sometime in 1950s, the European banks, especially the innovation loving bankers in London, staerted to lure holders of these dollar deposits by offering higher interest rates. Another regulation called interest equalization tax imposed by President Kennedy in 1963 discouraged foreigner’s use of domestic US bond market. This regulation drove the US Corporation outside the US to borrow Euro-dollar. Finally, since the euro market was exempt from Federal Reserve Bank’s reserve requirements, the American banks developed a practice of borrowing and lending outside the United States to avoid sterilizing part of their funds by way of statutory deposit with the central bank.

What is Euro-Dollar

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The International Money Market, Euro Currency, Euro-dollar.

Euro dollar

Dealing in foreign exchange inevitably require some amount of knowledge about money markets. In reality, the borderline between money market and foreign exchange markets is getting thinner, because the operation of the foreign exchange market quite often takes us to the money market. For instance, selling a currency forward may involve buying it in the spot market and depositing in the money market at London or Paris or wherever it is found convenient for security and yield. Emergence of Euro-currency since the late fifties has added new dimensions as well as greater depths to international money market.

Euro Currency, Euro-dollar.

It is important to make clear at the outset that Euro-currency are not European currencies as the name seems to suggest,. Nor it must be thought that Europe is the only place where this market for Euro-currency exists. Euro-currency are the collective name for Euro-dollar, Euro-sterling, and Euro-yen etc. The term Euro is a legacy from the 1950s when these so-called Euro-currencies, especially Euro-dollar, made their appearance in the money market in Europe.

When we talk about say, Euro-dollar, it must be remembered that it is the real U.S dollar ; that is, the ordinary US dollar which we keep as deposits with banks in the USA. Like the Holy Roman which was neither holy, nor Roman, nor an empire the so-called Euro-dollar market is neither European nor a market for dollars. Nor is the Euro-yen domiciled in Europe, it is the ordinary Japanese yen that does not owe its origin to Europe.

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The phenomenal growth of volume of transactions in the foreign exchange market

The foreign exchange

The business house, international investors and multinationals operate to meet their requirement for spot or forward currencies. They deal directly with the banks by placing orders for sale of specified currencies. Commercial banks are the main players in the market. They buy and sale in response to the clients requirement or on their own account as permitted by the open position. Central bank may participate in the market to influence the exchange rates especially when it apprehends a draw down of the foreign currency reserves or to toward off speculative pressure. The central bank also enters the market to make or receive payments in the foreign exchange.

The phenomenal growth of volume of transactions in the international foreign exchange market is very big, and is getting bigger, so to say, by leaps and bounds. Phenomenal growth of international trade and most of all cross country movement of fund and international reserves have all contributed to unprecedented rise in the foreign exchange market. International financial statistics, a publication of IMF, put the level of world exports in 1950 as only US dollar $57.20 billion. Within a space of about 30 years it rose to $1,508.20 billion in 1979. by 2004 it reached $7430.20 billion. Even if we adjust the numbers for inflation the rise in word trade is phenomenal in relation to, say early this century when world trade had barely crossed $ 3 billion mark.

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Foreign Exchange Market Basics

Foreign Exchange Market

The foreign exchange market is not like the one we encounter in our every day lives, sometimes with a morbid fear of losing the battle for balancing our personal budgets. Foreign exchange market, like those for money, are markets in the abstract sense. In these markets buyers and sellers need not meet face to face not at least in these days of high-tech communications, internet, fax, telephone and the fast vanishing wire service – with instant round the clock monitoring services like SWIFT, Reuters, Knight Ridder and Tele rate.

It is not that the foreign exchange market has become completely impersonal. In the early stage of the evolution of foreign exchange market there emerged meeting places know as ‘bourse’ to conduct dealings in foreign exchange. In the seventeenth century, traders, bankers and money changers developed the practice of settling cross border debts at the fairs held in important commercial centres. Bills of exchange were an important medium for settlement of payments in these fairs. A French trader, for instance, could buy at the Milan fair a sterling bill for, say pound 10,000.00 drawn on London to pay his debt to a British exporter from whom he has bought or intends to buy some merchandise. An analogy of this practice is also seen in some country even today. For instance, buy what is known some countries as ‘hundi’ to transfer money to other countries for a variety of reasons. A hundi, in reality has all the characteristics of a real bill of exchange but, because of exchange control and money laundering, its use for transfer of fund to and from abroad is illegal.

Today foreign exchange market can be described as the over the counter (OTC) market. There is no specified place for the participant to meet and execute the deals. It is an informal arrangement among the participants who are in touch with each other through telephone, telex, SWIFT, Internet and other means of communications. The term foreign exchange market actually refers to the wholesale segment of the market where dealings take place between banks and financial institutions or the fund managers. The retail segment refers to the dealings that take place between banks and their customers.

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Let us call the currency (other than US Dollar) for which the exchange rates is to be calculated as the foreign currency. Suppose a customer tenders a foreign currency bill for purchase by the bank. When the customer tenders a dollar bill, the bank disposes of the dollar acquired from the customer in the inter bank market at the market buying rate and therefore the inter bank buying rate for dollar forms the basis for quoting dollar buying rate to the customer. In case of a foreign currency being tendered by the customer, the bank should first get foreign currency converted to US dollar in the international market. In other words, it has to buy dollar in the international market against foreign currency. the bank can do so at the market selling rate for dollar. Therefore the merchant rate for the foreign currency would be calculated by crossing the dollar selling rate against the foreign currency in the international market.

Exchange Rates

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Foreign Exchange-Best Forex Trading Info

Foreign Exchange

The foreign exchange dealing of a bank with its customer is known as merchant business and the exchange rate at the transaction takes place is the ‘merchant rate’. The merchant business in which the contract with the customer to buy or sell foreign exchange is agreed to and executed on the same day is known as ‘ready transaction’ or ‘cash transaction’. As in the case of inter bank transactions, a ‘value next day’ contract is deliverable on the next business day and a‘spot contract’ is deliverable on the second succeeding business day following the date of the contract. Most of the transactions with customers are on ready basis. In practice, the terms ‘ready’ and ‘spot’ are used synonymously to refer to transactions concluded and executed on the same day.

Foreign Exchange Transactions

Foreign exchange dealing is a business in which foreign currency is the commodity. It was seen earlier that foreign currency is not a legal tender. The foreign currency can be considered as the commodity in foreign exchange dealings.

Foreign Exchange

Purchase and Sale transactions of foreign exchange transaction:

Any trading has two aspects 1. Purchase. 2. Sale. A trader has to purchase goods from his suppliers which he sells to his customers. Likewise, the bank purchases as well as sells its commodity, -- the foreign currency.

Two points need be constantly kept in mind while talking of a foreign exchange transaction:

1. The transaction is always talked of from the bank’s point of view

2. The item referred to is the foreign currency. Therefore, when we say a purchase, we imply that the bank has purchased, and it has purchased foreign currency. Similarly, when we say a sale , we imply that the bank has sold; ans it has sold foreign currency. In a purchase transaction the bank acquires foreign currency and parts with home currency. In a sale transaction the bank parts with foreign currency acquires home currency.

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