Foreign Currency Market Analysis Number
ForeignCurrency Market Analysis
ForeignCurrency Market Analysis
Foreignexchange market has over time grown into a massive and tremendousplatform. This is a market that entails buying selling, exchangingand speculating on different currencies. The man components of theforeign trade market include the banks investments firms, hedge fundsas well as investors and the forex brokers. Since its inception, themarket has grown to become one of the ever busy markets in the world.In addition, the market has played a key role in global trade. Themain function of the trade is to encourage international trade andinvestment. Within the foreign market, there are different platformsas well as ways to participate in the trade. Examples are forward andfuture contracts, options, and arbitrage. Wile each permit movementand activity in the market in their various forms, they share acommonality which is the consideration of risk involved with thatmovement.
Accordingto Mishra (2012), Forward Contract is defined as a contract that ismade between the buyer and the seller, that the assets in questionscan be bought or sold at a later date for an indicated amount.Compared to Spot Contract,forward contract is different from spot contract (Mishra, 2012). Asfor the forward contract, it’s transacted over the counter commonlyreferred to as ‘over the counter contract market’. Forwardcontract mainly involves a financial institution with a client. Oneof the shortcomings of this type of contact is that, it’s hard tochange is in case of a change both parties involved must agree(Mishra, 2012). One of the major uses of this type of contact is thatit shields the involved parties from any possible currency variationsthat may occur within a specified period of time. The period at whichthe contract runs is determined by use of previous volatility in theexchange rate. In summary, forward contact is mainly used to forprotecting from the risk of foreign exchange variations (IDBI Bank,n.d.).
Inaddition to the Forwards contract, there is also the ‘FuturesContract’,whichis similar to the forwards contact as it’s used to avoidfluctuation of prices or interest of the primary asset. According to(San José State University, n.d.), future contract is referred to asa derivative implement. With reference to the future contracts, theyare regular and can be traded through the exchange. Unlike theforward contract, the size of contract in the ‘futures contract’is fixed. One key merit of the futures contact is that, it can beused for both speculation and hedging functions (Mishra, 2012). Inthe case of the futures contract, the profit and loss are settled ondaily basis and in turn avoiding huge loss or gains for any givenparty in the contract, at the time of settling the contract, i.e. Theseller/buyer position is settled on daily basis (Damodaran, 2002, p.2). It can be deduced that, in the futures contract there is nocounterparty risk that is entailed within the transaction.
Optionson the other hand, offers a more appropriate market for numeroustraders as it offers them a right over obligation in exercising theiroptions. For example, an Option holder has a right to not choose anoption if it is not promising to him/her. One of the Options inexistence is the ‘American option’ which is an option which theholder can choose to exercise at any chosen time as far as it’sbefore its expiry date. European option on the other hand, variesfrom the American one, as it can only be exercised only during itsdue date (San José State University, ned). Examples of two basicoptions are the Call and Put. For the Call option, the holder isoffered the right to buy the underlying asset. In case of a Pullholder, he/she is offered a right to sell the underlying asset(DeRosa, 2011). The Options market takes place within the exchangemarket, but it is regulated by the stock exchange. In a briefexplanation, an Option is defined as contract between the selling andthe buying parties, and thus providing protection to both sides (theholder and the writer), from the unexpected fluctuation that mayoccur in the exchange rate. Their main task is reducing the marketrisk (Clarke & Clarke, Davin, 2011). In order to have the minimumchances of risks, a trader can take different positions together.
Anotheraspect within the exchange market is the Arbitrage Opportunity whichexists in all markets. Within the forward market, the Arbitrage issignificantly present and enables the taker or the arbitrager to makegains/profits from his/her exchange rate differences that may existwithin the exchange market and in different markets. Within theforward market case, the profits realized from arbitrage are obtainedfrom the mismatch in the estimated cross rates and rates (Khan &Jain, 2011). This is calculated using the difference between theinterest rates between the two countries that the arbitrager isinvolved with. A good scenario to note when there is a possiblechance for arbitrate in the market is a case when the forward ratethat is quoted in the market fails to match with the rate of interestdifferences between the two nations. The realization of the Arbitrageprofit can be derived through selling at the given forward rate andbuying at future spot rate.
Thekey hypothesis behind arbitrage feature is that, the client can tradethrough borrowing and lending at the same rate of interest(Damodaran, n.d.). Each time it’s anticipated that the futurecontract price is will be overpriced, and then the future contractselling client will short sell on the underlying asset. On the otherhand, if there is some hopes of a stronger dollar in the future overthe yen, then borrowing in yen will be a wise move. This is due tothe fact that, this value will be converted into USD with the use ofthe current spot exchange rate, which will be invested back into theUS market to earn interest from the venture. At the same time, afutures contract can on other hand be bought meant for selling theUSD at an elevated future price in exchange of yen. The result forthis is that, the seller will sell the USD for more Yen, which ontheir side will facilitate in closing the loan amount obtained and anin turn generate risk-less profit (Damodar, n.d.). In summary,through Mispricing of the currency in the future, there will be aroom for the arbitrage opportunity.
Oneof the factors that lead to arbitrate opportunities within theforeign currency market is the differences in the option pricing. The contributing reason behind this factor is the issue of pricevolatility. This instability itself is the standard deviation whichon a wider aspect poses a difference of about 2%, every time theprice quotations are done in different market (Nobile, n.d.). Throughidentification of this difference, the chance for an arbitrage comesup for the trading client. In other words, the put call equalityformulae can be deployed in order to determine whether the call andout option are being priced in the right direction. When a differencecomes in the options, then this is the chance for the arbitrager toembrace the chance and make profit (Sercu, n.d., p. 67). The simplestroute to an arbitrage opportunity comes up when the call value ismore than the equivalent underlying asset. In summary, the arbitrageprospects do exist in almost all types of markets.
Clarke, J.,& Clarke,Davin (2011). Options Made Simple: A Beginner`sGuide to Trading Options for Success. Milton: Wrightbooks[Imprint.
Damodar, A.(n.d.). Futures Arbitrage. Retrieved April 6,2014, fromhttp://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/futurearb.htm
Damodaran, A.(2002). Valuing Forward and Futures Contracts. In Investmentvaluation: Tools and techniques for determining the value of anyasset (2nd ed., p. 2). New York: Wiley.
Damodaran, A.(n.d.). Too good to be true? The Dream of Arbitrage.Retrieved from stern.nyu.edu website:http://people.stern.nyu.edu/adamodar/pdfiles/invphiloh/arbitrage.pdf
DeRosa, D. F.(2011). Options on foreign exchange (3rd ed.). Hoboken,N.J: Wiley.
IDBIBank (n.d.). Forward Contract | Treasury Products | IDBI BankForward Exchange Contract. Retrieved April 6, 2014,from http://www.idbi.com/tradefinance-forwardcontract.asp
Khan, M. Y.,& Jain, P. K. (2011). Financial management: Text,problems and cases (6th ed.). New Delhi: Tata McGraw-Hill.
Mishra, S.(2012, June 30). Fundamentals of forward and futures contract |Business Line. Retrieved April 6, 2014, fromhttp://www.thehindubusinessline.com/features/investment-world/market-watch/fundamentals-of-forward-and-futures-contract/article3588996.ece
Nobile, J.(n.d.). Option Arbitrage in the Forex Market.Retrieved April 6, 2014, fromhttp://www.earnforex.com/articles/option-arbitrage-in-the-forex-market
SanJosé State University (n.d.). Options, Forward Contracts, Swapsand Other Derivative Securities. Retrieved April 6,2014, from http://www.sjsu.edu/faculty/watkins/deriv.htm
Sercu, P.(n.d.). Chapter 8:- Currency Options (1): Concepts and Uses.Retrieved fromhttp://press.princeton.edu/releases/Sercu/Lecture_slides/08CHOptions1_slide.pdf