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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.

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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.

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TREND
One 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 RESISTANCE
Support 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 AVERAGES
Moving 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 ANALYSIS
Momentum 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 BANDS
This 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 SERIES
This 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.

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• 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.

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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 IRS

It 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. The other related data are hereunder:

It is clear from the above that each of the parties have a comparative advantage in either the floating or fixed rate market. The company X can borrow more cheaply than Y both fixed and floating loans, but its comparative advantage is in fixed rate market whereas Y has an advantage in the floating market. But X wants to be a floating rate payer and Y a fixed rate payer. One way which will divide the gain equally is for X to actually borrow at fixed rate and service floating rate in the swap and Y to borrow in floating and service fixed. But there are other methods of reaching the same goal and is generally done through an intermediary who takes credit risk on each counterparty. Suppose the swap dealer quotes 7.50/100 for the swap:

In the swap, X , the floating payer

• Pays floating to the swap bank at the prevailing rate.
• Receives fixed rate 7.5%
• Pays fixed rate 8%

Receives floating rate from the swap bank at the prevailing rate.

The net cost of funds and savings to X and Y using the swap arrangement can be worked out clearly. With swap X makes a payment of Floating rate to bank at 8% and receives 7.5% from swap bank. Thus his cost is floating rate + 50 bp. Without swap on the other hand his cost would be Floating rate +100bp. For Y with swap will involve a payment of Floating rate +150bp to swap bank and receive 8% from swap bank. His borrowing cost would be Floating Rate + 150bp + 8% - Floating Rate. Thus we can observe that X and Y are not only better by 50bp but also the swap bank has made a margin of 50bp (8%-7.5%). Thus the gain has been shared out between the swap parties and the bank is 150bp that are equal to the Quality Spread Differential in two markets.

USAGE OF SWAPS

Interest Rate Swaps are used to achieve one of the following :

• To lower the cost of borrowings as compared to those otherwise available in the market or from bank.
• To hedge against, or speculate upon Interest Rate Movements .
• To obtain fixed rate financing when it is impossible to access the market directly.

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• 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.