Concepts Of Currency Markets
Till now, we have learned the concept of currency and why it is so important. As we have discussed a few ways to invest in currency markets, there is more to learn about before jumping into the trades. There are numerous concepts that must be learned to understand the complexities of currency. Let's discuss them here:
What is a Cross currency rate?
A cross rate is a foreign currency exchange rate between 2 currencies that is valued against a 3rd currency.
If the USD/INR exchange rate is valued at 67.4150/75, and,
If EUR/USD is valued at 1.1132/42,
Then, the EUR/INR spot rate can be calculated by multiplying the two rates so USD gets cancelled out and we get 75.1125/75.
What is Triangular Arbitrage?
In triangular arbitrage one currency is traded for another currency, which is traded for a third currency, which in turn, is traded for the 1st currency.
Triangular arbitrage opportunity arises when the currency direct quotes are not in alignment with the cross-exchange rates.
For example, the following are available in the foreign exchange market:
- Step1: Buying Indian rupee with 1 million GBP to get INR89.67 million.
- Step 2: Convert INR into USD: 89.67/67.41= USD 1.3302million.
- Step 3: Sell USD to GBP: 1.3302/1.33= GBP1.0002million.
Hence, the arbitrage gets a net gain.
What is Calendar Spread Trading?
Calendar spread in currency futures is the difference between the prices of two currency futures contracts with different expiry months but with the same underlying currency pair.
Usually, traders profit by identifying the relative movement of, say, the near-month futures contract price with the price of the subsequent month's futures contract.
Before we discuss this we need to know two concepts of Contango and Backwardation.
- Contango: When the far-month futures contract price is greater than the near-month contract price, the market condition is usually referred to as ‘normal’ or contango.
- Backwardation: When the far-month futures contract price is less than the near-month contract price, the market condition is known as ‘inverted’ or backwardation.
A trader can take opposite positions between futures contracts of different expiry months with the expectation that the spread either increases or decreases.
In a contango market, if the trader expects the spread differential to increase between the January and February MCX-SX USD/INR futures, it would be prudent to take a short position in the January contract and simultaneously take a long position in the February contract.
On the other hand, if the spread differential is expected to decrease, the trader should take the reverse positions.
10 lots of July USDINR contract, which is trading at Rs. 67.5800 are bought and10 lots of August USDINR contract, which is trading at ₹67.9600 are sold.
The spread works out to Rs. 0.38 (67.9600 – 67.5800).
So, the spread profit =spread x number of lots x lot size
= 0.38 x 10 x 1,000
What are currency options?
An option is a derivative contract that gives the buyer, the right to exchange a product at a pre-specified price on a specific date. Currency options have the same concept, as it gives a buyer the right to purchase or sell a currency on a specified date at a specified price.
Currency options can be used by corporations or individuals to hedge the uncertainty involved when dealing with foreign exchange rates. Additionally, currency options can be used for speculative purposes.
There are two basic types of options:
A)Call Option – The buyer of a call option has a right, but not an obligation to purchase a currency in exchange for a call premium.
B)Put Option – The buyer of a put option has a right, but not an obligation to sell a specific currency at a predetermined price. For this, the buyer needs to pay the put premium initially to purchase the option.
The concepts that we have learned so far are extremely important while trading the currency markets. As explained through various examples, the value of a currency is not fixed; rather, they change. Why so? There are multiple factors that we will learn in the next unit of our module.