Foreign Exchange
Foreign Exchange is essentially the area where a nation’s currency is exchanged for that of another. The foreign exchange market is the largest financial market in the world, with over $ 1.7 trillion being traded on a daily basis with only 25% of this amount being in actual merchant position. The rest of the amount denotes trading or speculation that is the principal reason why currency markets are extremely volatile, being at least ten times faster than stock markets in any country. Unlike other markets, forex markets have no physical location or central exchanges and operates through an electronic network of banks and corporations. It is for this reason that Forex markets operate on a 24-hour basis, spanning from one zone to another across major financial centers. It is for this reason that constant monitoring across time zones are required so as to negate adverse movements or book extra-ordinary profits.
Fundamental Analysis
It is one of the two main approaches of analyzing and forecasting currencies and basically comprises of financial situations, economic theories and political developments. Thus the health of a currency of a particular country would be dependent upon growth rates of GDP, interest rates, inflation, unemployment, money supply and foreign exchange reserves. While stock markets, bonds and real estate prices would affect the state of a currency, the state of a government and natural calamities if any would also be major influences.Government Policies of a particular country also have impact on their currency. Currencies may be pegged to a particular major currency or it may be partially or fully convertible which would dictate the extent to which a currency would be open to outside influence. Also, Central Banks of a country intervene wither singly or in conjunction with another Central Bank to move or strengthen/weaken it’s currency by either intervening directly or by moving interest rates which should be taken into consideration while evaluating the health of that particular currency.
Technical Analysis
Technical Analysis can be defined as the art of identifying trend changes at an early stage and to maintain an investment posture until the weight of evidence indicates that the trend has reversed. It is basically different methods of charting and mathematical tools to analyze movements of price. Price itself has been defined in many ways but to grasp technical analysis, we must be able to understand the meaning of price. Price would best be defined as a figure, which moves between panic, fear and pessimism of the crowd in one hand and confidence, excessive optimism and greed on the other.Thus Technical Analysis is a method of predicting future price movements by examining the past pattern of movements in those prices. These movements are depicted in Charts and Diagrams, which are analyzed to point our major and minor trends so as to pinpoint points of entry into and exist from markets.
TRENDOne of the first things to learn is that the market is supreme and thus at no point should one try to over-rule the underlying trend of a market. The Trend is the Biggest Friend and it is always wise to catch that signal. One should only enter the market after identifying the long term and them the intermediate and short-term trend of the market. As regards patterns of currency movements remember that ‘a currency always goes UP by the LADDER BUT comes DOWN by a LIFT’. SUPPORT AND RESISTANCESupport and Resistance are points where a chart experiences recurring upward or downward pressure. A Support level is the low point of a chart whereas the Resistance is the high point of the pattern. It is advisable to BUY when the price is close to a Support and SELL when it is close to a Resistance. Remember, once these support / resistance points are broken, they become quite the opposites; in a rising market when the resistance level is broken, it becomes a support for the next set of movements and the vice versa. The various tools of analysis used by us in this section and for forecasting various trends and cycles are briefly explained for our readers.MOVING AVERAGESMoving Averages tell the price in a given point of time over a defined period of time. They are so called because they reflect the latest average, while adhering to the same time measure. The problem with using moving averages is that they are lagging indicators, which means they change only after a trend has changed. This can be overcome by using a shorter period or by combining two averages of distinct time frame. So if one use a combination of 40and 200-day moving average, buy signals are detected when the shorter-term average crosses above the longer-term average and a sell signal in the reverse combination. Assigning of weights to moving averages also alleviates the problem of a single or a few day’s volatile data giving wrong signals. MOMENTUM ANALYSISMomentum Analysis measures the underlying strength of a price movement or the rate of change of price rather than plotting the actual price itself. It is plotted around a zero line and results may be either negative or positive. It should be remembered that a Top in the momentum line does not mean that the price has reversed, only a move through a zero line signals a price reversal. Thus a momentum indicator signals acceleration or deceleration of a price and can be classified as a leading indicator.RELATIVE STRENGTH INDEX (RSI)RSI reflects the overbought or oversold position of a market. For this calculation, to compute support the RSI figure should be taken at 70 and for the purpose of Resistance, RSI should be taken at 30. However, this method should ideally be used in a consolidating market and would best be avoided in a trending market.BOLLINGER BANDSThis tool carries the advantages of other tools and tried to nullify their disadvantages and is calculated at 1.95/2.00 Standard Deviation of the Moving Average (usually 20 day period) which results in an envelope within which majority of the prices move. The bands of this envelope act as support and resistance so it is easy to buy at the lower end of the band and sell at the upper end. Entry and exit should best be done when a price has closed outside the band and is definitely a leading indicator.FIBONACCI SERIESThis is a very popular retracement series based on mathematical ratios arising from mostly natural phenomenon and is used to determine how far a price has rebounded or backtracked from its underlying trend. Since the series is like 1,1,2,3,5,8, 13, 21,34…, the ratios we get are 23.6%, 38.2%, 50%, 61.8%, 76.4% and so on.ELLIOT WAVE ANALYSIS This is done by classifying prices into patterned waves that can indicate future targets and reversals. Waves moving with the trend are called impulse waves and waves moving against the trend are called corrective waves. These Impulse and Corrective waves are broken down into five primary and three secondary movements respectively which forms a complete wave cycle and these can be further subdivided. These wave patterns needs to be identified so as to predict accurately and is best used in conjunction with the Fibonacci theory.
Forex Risk Management
Forex Risk Management refers to scientific study of currencies and devising various hedging techniques based of predictions of such currencies. The expected movements might be either in favour or against the underlying exposure of a particular organisation , and as such the hedging mechanisms should be geared to extract the maximum profit of / reduce potential losses arising from such trends.Though the studies of currencies are based on fundamental and technical analysis, expected trends are also greatly influenced by the sentiments of the market which can best be assessed from an inter-bank dealing room where inter-bank trades takes place. Eforexindia is equipped with professional dealers and state of the art technology and is backed by the dealing room of its parent concern M/s S.C.Dutta & Co. The various studies and risk management strategies, which are done to estimate risk
arising from the forex exposures of an organisation, are :
Exposure AnalysisCurrency and Market Forecasts.
Risk Appraisal and Evolving a Foreign Exchange Risk Management Policy.
Setting up Risk Management Goals.
Formulating Hedging Strategies Designed to meet such Goals.
Implementing such strategies with the assistance of our highly equipped Dealing Room.
Structured Review / Analysis.
Daily Currency Updation with Weekly and Special Forex Reports.
Emerging Products
a. Interest Rate Swaps
An IRS can be defined as a contract between two parties (called Counter Parties) to exchange, on a particular date in the future, one series of Cash Flows ( fixed interest) for another series of Cash Flows (variable or Floating Interest) in the same currency on the same principal amount (called Notional Principal) for an agreed period of time. The two payment streams are called the legs or sides of a swap. The exchange of Cash Flows need not occur on the same date. This means payment may be different for each side of the swap. So the variable rate may be paid monthly and the fixed quaterly, in which case the pricing of the swap can allow for discounted timing cost. Swaps, unlike FRA’s, generally do not net settle the difference between the agreed Fixed interest rate and the Variable interest rate. Netting of payments is however allowable. The Floating rate of interest is referenced to a short-term interest rate like the LIBOR in the international market or the MIBOR in the Rupee market. The Floating Rate used as benchmark or index is RMIBOR (Reuters Mumbai Inter Bank Offered Rate) or N-MIBOR (NSE Mumbai Inter Bank Offered Rate).The reset frequency for the floating rate index is the term for the interest rate index itself. However, the reset frequency for the floating rate does not necessarily match the timetable of the floating rate index. Therefore the floating rate may be set daily, weekly, month, quarterly while settlement dates may fall monthly, quarterly, semi-annually etc. If the reset date and the settlement date do not coincide, the swap is said to be “ paid in arrears set in advance”.Quoting of SWAP pointsThe pricing of swaps is against the fixed interest rate. At the start of a swap, the expected NPV is zero for both couterparties. Theoretically, the floating leg’s worth is the same as those of a fixed rate leg and thus swaps are a zero sum game at the inception. In case at the inception the NPV’s are not exactly equal, one party pays higher to compensate the price. Generally, swaps have been quoted in a number of ways, but the most commonly used is setting the floating rate equal to a short term index (such as a given maturity of MIBOR) with no margin or plus/minus a given margin, which are payable in the money market by the couterparties. When no margin is added to a floating rate, such rate is said to be quoted 'Flat'. The price of a Fixed /Floating swap is quoted in two parts : a fixed interest rate and a short term index upon which the floating rate is based. The convention is to quote All-In-Cost (AIC) which means the fixed interest rate is quoted relative to the floating rate index without any margin. After having set the floating rate, the fixed rate is set appropriate to it. Each bank quotes its own swap rate to exchange fixed cash flows interest for floating in each maturity. Further one should take care of different day count conventions to calculate interest that is 30 days month means 360 days a year or actual number of days elapsed since the previous settlement is due based on a 360 days year.EFFECT OF RATE CHANGES ON AN IRSFloating Rate payers will gain if interest rate falls, as they will have to pay lesser interest whereas fixed rate payer will loose as they are locked in fixed rate. In case the Interest rate rises, The Floating payer will loose and the Fixed rate will gain.UNWINDING SWAPS
The party who wishes to unwind a swap has the following three alternatives:
Swap Buy-Back / Closeout/ Termination/ Cancellation.
Swap Reversal with new swap equaling the remaining period of original swap with Same Reference Rate and Same Notional Principal.
Swap Sale or Assignment
THE MECHANISM OF IRSIt is a known fact that investors willing to invest in fixed rate instruments are more sensitive to credit rating of the issuer than credit rate lenders. To compensate for this a higher premium is demanded from the issuer of lower credit quality in the fixed rate debt market than floating rate market. The counterparties obtain an arbitrage by drawing down funds where they have greater relative cost advantage , subsequently by entering into an IRS to cover the cost of funds so raised from a fixed rate to a floating rate ad vice-versa. Here it is a win-win situation. Therefore two companies can come together to an agreement such that both can reduce their cost of borrowings. The fact that such opportunities exist is due to imperfection in the money market, that is the difference in risk-premium in fixed and floating market. An example will illustrate the point:Suppose that there are two parties to the swap viz. X and Y and a dealer arranges a swap taking a margin (spread). The deal is for Rs. Hundred Million in One Year.
b. Forward Rate Agreement (FRA)
A FRA is an agreement between two counter-parties to pay or receive the difference (called settlement money) between
an agreed fixed rate (the FRA rate)
the interest rate prevailing an a stipulated future date (Fixing Date),
based on a notional amount for an agreed period.
In short, in a FRA interest rate is fixed now for a future period. The special feature of FRA is that the only payment is the difference between the FRA rate and the Reference rate and hence is single settlement contracts. As in IRS, the principal amount is not exchanged.The settlement sum is calculated on the fixing date by discounting the difference between the previously contracted FRA rate and the then prevailing Reference rate. Money changes hand only on the settlement day and not on the transaction day or the maturity date. So if an investor wants to lock in reinvestment rate of January 3rd 2000 for 90 days and is quoted a FRA of 7 / 7.5% , it means he can lock-in an interest rate of 7% if he wishes to protect himself from a falling interest rate or 7.5% if he is concerned that interest rate will go up. The settlement date will be two days before the value/maturity date.FRA’s are expressed in terms of giving or receiving the fixed rate Vs short term interest rate index and are quoted numerically like
3 months rate starting in 3 months time is 3/6
3 months rate starting in 6 months time is 6/9
6 months rate starting in 3 months time is 3/9
Two-way quotes are available in the market and levels can be found on the Reuters (MIBORO2). The lower rate is the bid at which the bank is ready to pay fixed and the higher rate will be the offer rate at which the bank will be ready to receive fixed.We take the case of a borrower who has obtained a one-year credit amounting to Rs.10 lakhs on September 5th 1999. The interest rate is based on 6 months MIBOR. For the first six months MIBOR has already been fixed. Now he is not confident about the second six months, as he is not confident about what he has to pay and apprehends rates to rise. To protect himself he can buy a FRA for the next 6 months with a matching notional principal. Suppose a bank quotes him for 6X12 FRA 9.10 / 90 on September 3rd itself. He can lock in at 9.90% by buying 6X12 FRA on Sept 3rd itself for the period Sept 5th `99 to Sept 4th `2000. On 3rd March 2000 the 6 months MIBOR will be known (we assume 10%) and on that date the 6m MIBOR rate is compared with the FRA rate and the settlement amount is computed by discounting back to the beginning of the contract period using the formula below :
SA = ((SR – FRA ) X NP X CP) / 360 + ( SR X CP )
Where SA is Settlement Amount, SR is Settlement Rate, NP is Notional Principal and CP is Contract period. Using the data in our example we get :
(.10 - .099) X 10,00,000 X 182 / 360 + (.10 X 182) = Rs. 481.23
Thus the borrower would receive Rs.481.23 and this amount will be used to pay the extra 10bp (10% -9.9%). It is clear from the calculation that the net cost to the borrower will be the same as agreed under the FRA contract in both the cases. It should be remembered that the counter-party of a customer is always a bank as there is no secondary market and an FRA price should be analysed /calculated by always keeping the corporate's point of view and not that of the market maker or the bank. There is no restriction on the Notional Principal of FRA/IRS and any domestic money market or debt market can be used as benchmark to enter into FRA/IRS once the basis is computing is acceptable to both the parties. There are various Exposure and Capital Adequacy Norms that are laid down by the apex bank to whom all such deals have to be reported on a fortnightly basis. However the derivative market in India is at a nascent stage with an underdeveloped MIBOR market, absence of big public sector banks, uniform pricing mechanism and of course a shaky approach which is more psychological than lack of knowledge of the product and thus care should be taken in the initial stages by engaging professional consultants to avoid untoward losses by either not using the instrument available or using it in an erroneous manner.
Foreign Exchange is essentially the area where a nation’s currency is exchanged for that of another. The foreign exchange market is the largest financial market in the world, with over $ 1.7 trillion being traded on a daily basis with only 25% of this amount being in actual merchant position. The rest of the amount denotes trading or speculation that is the principal reason why currency markets are extremely volatile, being at least ten times faster than stock markets in any country. Unlike other markets, forex markets have no physical location or central exchanges and operates through an electronic network of banks and corporations. It is for this reason that Forex markets operate on a 24-hour basis, spanning from one zone to another across major financial centers. It is for this reason that constant monitoring across time zones are required so as to negate adverse movements or book extra-ordinary profits.
Fundamental Analysis
It is one of the two main approaches of analyzing and forecasting currencies and basically comprises of financial situations, economic theories and political developments. Thus the health of a currency of a particular country would be dependent upon growth rates of GDP, interest rates, inflation, unemployment, money supply and foreign exchange reserves. While stock markets, bonds and real estate prices would affect the state of a currency, the state of a government and natural calamities if any would also be major influences.Government Policies of a particular country also have impact on their currency. Currencies may be pegged to a particular major currency or it may be partially or fully convertible which would dictate the extent to which a currency would be open to outside influence. Also, Central Banks of a country intervene wither singly or in conjunction with another Central Bank to move or strengthen/weaken it’s currency by either intervening directly or by moving interest rates which should be taken into consideration while evaluating the health of that particular currency.
Technical Analysis
Technical Analysis can be defined as the art of identifying trend changes at an early stage and to maintain an investment posture until the weight of evidence indicates that the trend has reversed. It is basically different methods of charting and mathematical tools to analyze movements of price. Price itself has been defined in many ways but to grasp technical analysis, we must be able to understand the meaning of price. Price would best be defined as a figure, which moves between panic, fear and pessimism of the crowd in one hand and confidence, excessive optimism and greed on the other.Thus Technical Analysis is a method of predicting future price movements by examining the past pattern of movements in those prices. These movements are depicted in Charts and Diagrams, which are analyzed to point our major and minor trends so as to pinpoint points of entry into and exist from markets.
TRENDOne of the first things to learn is that the market is supreme and thus at no point should one try to over-rule the underlying trend of a market. The Trend is the Biggest Friend and it is always wise to catch that signal. One should only enter the market after identifying the long term and them the intermediate and short-term trend of the market. As regards patterns of currency movements remember that ‘a currency always goes UP by the LADDER BUT comes DOWN by a LIFT’. SUPPORT AND RESISTANCESupport and Resistance are points where a chart experiences recurring upward or downward pressure. A Support level is the low point of a chart whereas the Resistance is the high point of the pattern. It is advisable to BUY when the price is close to a Support and SELL when it is close to a Resistance. Remember, once these support / resistance points are broken, they become quite the opposites; in a rising market when the resistance level is broken, it becomes a support for the next set of movements and the vice versa. The various tools of analysis used by us in this section and for forecasting various trends and cycles are briefly explained for our readers.MOVING AVERAGESMoving Averages tell the price in a given point of time over a defined period of time. They are so called because they reflect the latest average, while adhering to the same time measure. The problem with using moving averages is that they are lagging indicators, which means they change only after a trend has changed. This can be overcome by using a shorter period or by combining two averages of distinct time frame. So if one use a combination of 40and 200-day moving average, buy signals are detected when the shorter-term average crosses above the longer-term average and a sell signal in the reverse combination. Assigning of weights to moving averages also alleviates the problem of a single or a few day’s volatile data giving wrong signals. MOMENTUM ANALYSISMomentum Analysis measures the underlying strength of a price movement or the rate of change of price rather than plotting the actual price itself. It is plotted around a zero line and results may be either negative or positive. It should be remembered that a Top in the momentum line does not mean that the price has reversed, only a move through a zero line signals a price reversal. Thus a momentum indicator signals acceleration or deceleration of a price and can be classified as a leading indicator.RELATIVE STRENGTH INDEX (RSI)RSI reflects the overbought or oversold position of a market. For this calculation, to compute support the RSI figure should be taken at 70 and for the purpose of Resistance, RSI should be taken at 30. However, this method should ideally be used in a consolidating market and would best be avoided in a trending market.BOLLINGER BANDSThis tool carries the advantages of other tools and tried to nullify their disadvantages and is calculated at 1.95/2.00 Standard Deviation of the Moving Average (usually 20 day period) which results in an envelope within which majority of the prices move. The bands of this envelope act as support and resistance so it is easy to buy at the lower end of the band and sell at the upper end. Entry and exit should best be done when a price has closed outside the band and is definitely a leading indicator.FIBONACCI SERIESThis is a very popular retracement series based on mathematical ratios arising from mostly natural phenomenon and is used to determine how far a price has rebounded or backtracked from its underlying trend. Since the series is like 1,1,2,3,5,8, 13, 21,34…, the ratios we get are 23.6%, 38.2%, 50%, 61.8%, 76.4% and so on.ELLIOT WAVE ANALYSIS This is done by classifying prices into patterned waves that can indicate future targets and reversals. Waves moving with the trend are called impulse waves and waves moving against the trend are called corrective waves. These Impulse and Corrective waves are broken down into five primary and three secondary movements respectively which forms a complete wave cycle and these can be further subdivided. These wave patterns needs to be identified so as to predict accurately and is best used in conjunction with the Fibonacci theory.
Forex Risk Management
Forex Risk Management refers to scientific study of currencies and devising various hedging techniques based of predictions of such currencies. The expected movements might be either in favour or against the underlying exposure of a particular organisation , and as such the hedging mechanisms should be geared to extract the maximum profit of / reduce potential losses arising from such trends.Though the studies of currencies are based on fundamental and technical analysis, expected trends are also greatly influenced by the sentiments of the market which can best be assessed from an inter-bank dealing room where inter-bank trades takes place. Eforexindia is equipped with professional dealers and state of the art technology and is backed by the dealing room of its parent concern M/s S.C.Dutta & Co. The various studies and risk management strategies, which are done to estimate risk
arising from the forex exposures of an organisation, are :
Exposure AnalysisCurrency and Market Forecasts.
Risk Appraisal and Evolving a Foreign Exchange Risk Management Policy.
Setting up Risk Management Goals.
Formulating Hedging Strategies Designed to meet such Goals.
Implementing such strategies with the assistance of our highly equipped Dealing Room.
Structured Review / Analysis.
Daily Currency Updation with Weekly and Special Forex Reports.
Emerging Products
a. Interest Rate Swaps
An IRS can be defined as a contract between two parties (called Counter Parties) to exchange, on a particular date in the future, one series of Cash Flows ( fixed interest) for another series of Cash Flows (variable or Floating Interest) in the same currency on the same principal amount (called Notional Principal) for an agreed period of time. The two payment streams are called the legs or sides of a swap. The exchange of Cash Flows need not occur on the same date. This means payment may be different for each side of the swap. So the variable rate may be paid monthly and the fixed quaterly, in which case the pricing of the swap can allow for discounted timing cost. Swaps, unlike FRA’s, generally do not net settle the difference between the agreed Fixed interest rate and the Variable interest rate. Netting of payments is however allowable. The Floating rate of interest is referenced to a short-term interest rate like the LIBOR in the international market or the MIBOR in the Rupee market. The Floating Rate used as benchmark or index is RMIBOR (Reuters Mumbai Inter Bank Offered Rate) or N-MIBOR (NSE Mumbai Inter Bank Offered Rate).The reset frequency for the floating rate index is the term for the interest rate index itself. However, the reset frequency for the floating rate does not necessarily match the timetable of the floating rate index. Therefore the floating rate may be set daily, weekly, month, quarterly while settlement dates may fall monthly, quarterly, semi-annually etc. If the reset date and the settlement date do not coincide, the swap is said to be “ paid in arrears set in advance”.Quoting of SWAP pointsThe pricing of swaps is against the fixed interest rate. At the start of a swap, the expected NPV is zero for both couterparties. Theoretically, the floating leg’s worth is the same as those of a fixed rate leg and thus swaps are a zero sum game at the inception. In case at the inception the NPV’s are not exactly equal, one party pays higher to compensate the price. Generally, swaps have been quoted in a number of ways, but the most commonly used is setting the floating rate equal to a short term index (such as a given maturity of MIBOR) with no margin or plus/minus a given margin, which are payable in the money market by the couterparties. When no margin is added to a floating rate, such rate is said to be quoted 'Flat'. The price of a Fixed /Floating swap is quoted in two parts : a fixed interest rate and a short term index upon which the floating rate is based. The convention is to quote All-In-Cost (AIC) which means the fixed interest rate is quoted relative to the floating rate index without any margin. After having set the floating rate, the fixed rate is set appropriate to it. Each bank quotes its own swap rate to exchange fixed cash flows interest for floating in each maturity. Further one should take care of different day count conventions to calculate interest that is 30 days month means 360 days a year or actual number of days elapsed since the previous settlement is due based on a 360 days year.EFFECT OF RATE CHANGES ON AN IRSFloating Rate payers will gain if interest rate falls, as they will have to pay lesser interest whereas fixed rate payer will loose as they are locked in fixed rate. In case the Interest rate rises, The Floating payer will loose and the Fixed rate will gain.UNWINDING SWAPS
The party who wishes to unwind a swap has the following three alternatives:
Swap Buy-Back / Closeout/ Termination/ Cancellation.
Swap Reversal with new swap equaling the remaining period of original swap with Same Reference Rate and Same Notional Principal.
Swap Sale or Assignment
THE MECHANISM OF IRSIt is a known fact that investors willing to invest in fixed rate instruments are more sensitive to credit rating of the issuer than credit rate lenders. To compensate for this a higher premium is demanded from the issuer of lower credit quality in the fixed rate debt market than floating rate market. The counterparties obtain an arbitrage by drawing down funds where they have greater relative cost advantage , subsequently by entering into an IRS to cover the cost of funds so raised from a fixed rate to a floating rate ad vice-versa. Here it is a win-win situation. Therefore two companies can come together to an agreement such that both can reduce their cost of borrowings. The fact that such opportunities exist is due to imperfection in the money market, that is the difference in risk-premium in fixed and floating market. An example will illustrate the point:Suppose that there are two parties to the swap viz. X and Y and a dealer arranges a swap taking a margin (spread). The deal is for Rs. Hundred Million in One Year.
b. Forward Rate Agreement (FRA)
A FRA is an agreement between two counter-parties to pay or receive the difference (called settlement money) between
an agreed fixed rate (the FRA rate)
the interest rate prevailing an a stipulated future date (Fixing Date),
based on a notional amount for an agreed period.
In short, in a FRA interest rate is fixed now for a future period. The special feature of FRA is that the only payment is the difference between the FRA rate and the Reference rate and hence is single settlement contracts. As in IRS, the principal amount is not exchanged.The settlement sum is calculated on the fixing date by discounting the difference between the previously contracted FRA rate and the then prevailing Reference rate. Money changes hand only on the settlement day and not on the transaction day or the maturity date. So if an investor wants to lock in reinvestment rate of January 3rd 2000 for 90 days and is quoted a FRA of 7 / 7.5% , it means he can lock-in an interest rate of 7% if he wishes to protect himself from a falling interest rate or 7.5% if he is concerned that interest rate will go up. The settlement date will be two days before the value/maturity date.FRA’s are expressed in terms of giving or receiving the fixed rate Vs short term interest rate index and are quoted numerically like
3 months rate starting in 3 months time is 3/6
3 months rate starting in 6 months time is 6/9
6 months rate starting in 3 months time is 3/9
Two-way quotes are available in the market and levels can be found on the Reuters (MIBORO2). The lower rate is the bid at which the bank is ready to pay fixed and the higher rate will be the offer rate at which the bank will be ready to receive fixed.We take the case of a borrower who has obtained a one-year credit amounting to Rs.10 lakhs on September 5th 1999. The interest rate is based on 6 months MIBOR. For the first six months MIBOR has already been fixed. Now he is not confident about the second six months, as he is not confident about what he has to pay and apprehends rates to rise. To protect himself he can buy a FRA for the next 6 months with a matching notional principal. Suppose a bank quotes him for 6X12 FRA 9.10 / 90 on September 3rd itself. He can lock in at 9.90% by buying 6X12 FRA on Sept 3rd itself for the period Sept 5th `99 to Sept 4th `2000. On 3rd March 2000 the 6 months MIBOR will be known (we assume 10%) and on that date the 6m MIBOR rate is compared with the FRA rate and the settlement amount is computed by discounting back to the beginning of the contract period using the formula below :
SA = ((SR – FRA ) X NP X CP) / 360 + ( SR X CP )
Where SA is Settlement Amount, SR is Settlement Rate, NP is Notional Principal and CP is Contract period. Using the data in our example we get :
(.10 - .099) X 10,00,000 X 182 / 360 + (.10 X 182) = Rs. 481.23
Thus the borrower would receive Rs.481.23 and this amount will be used to pay the extra 10bp (10% -9.9%). It is clear from the calculation that the net cost to the borrower will be the same as agreed under the FRA contract in both the cases. It should be remembered that the counter-party of a customer is always a bank as there is no secondary market and an FRA price should be analysed /calculated by always keeping the corporate's point of view and not that of the market maker or the bank. There is no restriction on the Notional Principal of FRA/IRS and any domestic money market or debt market can be used as benchmark to enter into FRA/IRS once the basis is computing is acceptable to both the parties. There are various Exposure and Capital Adequacy Norms that are laid down by the apex bank to whom all such deals have to be reported on a fortnightly basis. However the derivative market in India is at a nascent stage with an underdeveloped MIBOR market, absence of big public sector banks, uniform pricing mechanism and of course a shaky approach which is more psychological than lack of knowledge of the product and thus care should be taken in the initial stages by engaging professional consultants to avoid untoward losses by either not using the instrument available or using it in an erroneous manner.
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