Major US Indicators and Their Interpretation

Author:-Mr. Dilip Mathew

Posted Date:-12-May-2017

Major US Indicators and Their Interpretation

Monitoring the economic indicators helps analysts evaluate the economy and formulate fundamental views on the health of the economy which in turn can help in the making currency outlook. This is one of the major aspects of Fundamental analysis. In this article we intend to look at the major US economic indicators which readers should focus and how to interpret them, while the succeeding articles will focus on economic indicators from Eurozone and Asia.

Let us look at the major economic data and which report to focus on in them:

  1. Gross Domestic Product (GDP)

GDP is perhaps the most comprehensive way of gauging the health and well being of an economy. GDP represents the value of all goods and services produced during a specific time period (usually quarterly).  The percentage change GDP is closely watched by US Fed when taking decision on the monetary policy.

The GDP data is released by the US Department of Commerce’s Bureau of Economic Analysis on a quarterly basis. The report will indicate the reasons why the GDP went higher or lower.

  1. Employment

Employment report is among the most important monthly economic releases and is particularly important in analyzing the current health of the consumer sector.  The Non Farm payrolls (NFP)change, considered the most important among the employment releases, represents the change in number of paid workers in US excluding the some segments like government employees, farm employees etc. Other major employment data include unemployment rate, Average weekly earnings, average weekly hours etc.

The employment data is released by The U.S. Department of Labor’s Bureau of Labor Statistics. The report will give detailed insights into the job creation on the basis of sector, worker groups etc. The market usually considers a NFP increase of above 200,000 as a positive release.

  1. Inflation

When looking at the inflations statistics, the Consumer Price Index (CPI) and Producers Price Index (PPI) are considered to be among the most important.  The CPI is a measure of the change in the prices paid for the goods and services for a specified month. Financial analysts consider CPI to be the best indicator of the inflation levels in the economy. PPI represents the change in selling prices of goods and services received by the US producers over a given period of time. PPI usually measures prices for goods at three stages of production: finished goods, intermediate goods and raw goods.

The PPI and CPI data are released by the U.S. Department of Labor’s Bureau of Labor Statistics on a monthly basis (usually the second week following the reporting month). 

  1. Housing

The housing data release came into the limelight especially after the housing bubble which was a precursor to the financial crisis of 2008. Analysts majorly look at housing starts and building permits data to gauge the health of the housing sector.  Housing starts refers to the Annualized number of new residential buildings that began construction during the previous month while building permits refers to the Annualized number of new residential building permits issued during the previous month.

The housing data is released by the U.S. Department of Commerce’s U.S. Census Bureau on a monthly basis usually within two to three weeks after the end of the reporting month.

  1. Retail Sales

Retail sales data is considered the most important indicator of the consumer sector. It tracks the monthly US retail and food service sales, with details on the sector and the percentage changes in the sectors. The Retails sales data is mostly used by analysts to track the consumer spending and make forecasts on the same.

This is again released by the U.S. Department of Commerce’s U.S. Census Bureau on a monthly basis.

  1. Consumer Confidence

Consumer confidence Index broadly refers to the willingness of consumers to undertake large expenditures and debt commitments which will depend on their outlook for the economy and their own personal financial situation. The choice between spending and saving is based on a plan, rather than impulse, and reflects not only one’s current financial situation, but expectations of future earnings, prices.  

There are multiple consumer confidence releases in US, but we would recommend readers to monitor the major releases like the conference board Consumer confidence and University of Michigan consumer sentiment.

  1. Purchasing Manager’s Index

The Purchasing Managers' Index (PMI) is an indicator of the economic health of the manufacturing/non manufacturing sector. The PMI is based on indicators like new orders, inventory levels, production, supplier deliveries, job environment etc. A PMI value above 50 represents an expansion in the economy while a PMI value below 50 indicates a contraction in the economy. 

Markit  and Institute of Supply Management (ISM) publishes the PMI for manufacturing and services industry. 

Exchange Earner’s Foreign Currency (EEFC)

Author:-Dilip Mathew

Posted Date:-09-May-2017

Exchange Earner’s Foreign Currency Account

 

 As per the Reserve Bank of India guidelines (refer to Master Circular 14), the Authorized dealer (i.e. the bank) can allow exporters to open an account in foreign currency called the Exchange Earners’ Foreign Currency (EEFC) Account, in terms of Regulation 4 of the Foreign Exchange Management. In this knowledge series article we will touch upon the major things one must know while using EEFC account.

The RBI permits any individual or company that earns in foreign currency to open an EEFC account. We will turn our focus to regulations from the point of view of an exporter.

  • The major benefit of using a EEFC account is that the exchange earner can save on conversion/transaction cost while undertaking netting transaction for the amount which is there in the EEFC account.  

Illustration on time period for which funds can be kept in EEFC

 

As mentioned in the FAQ above the foreign currency can be kept till last day of succeeding month. Let’s look at how many days foreign currency can be kept unconverted based on when the credit happened.

As illustrated above the maximum time for which the foreign currency can be kept in EEFC account can be up to 60 (after which it has to be mandatorily converted) if the inward comes in on the first day of the month.  But then again one must also ask oneself if it is a good idea to keep funds idle for such a long time since it doesn’t earn any interest.

The exporters who have considerable foreign currency payments usually find EEFC accounts useful since the conversion and transaction cost is saved. Also EEFC is used in such a way that the export remittance can be used to net import payments without taking currency risk. This helps companies save forward contract commissions, since if they don’t use EEFC, they will have to take forwards for imports and exports separately to protect themselves from currency volatility.

Forward Booking :Past Performance And Documentary Evidence

Author:-Dilip Mathew

Posted Date:-05-May-2017

Booking Forwards On Past Performance and Documentary Evidence

 

 As per the Reserve Bank of India guidelines (refer to Master Circular 14), the Authorized dealer (i.e. the bank) can allow importers and exporters to book a forward contract on the following basis:

  • documentary evidence (like an export/import order copy, export/import invoice, LC etc)
  • past performance limit

Booking Forward with Documentary Evidence

 

An importer/exporter can enter into a forward contract with his Bank against an underlying exposure once the Bank is satisfied about the genuineness of the documentary evidence that the customer has submitted to the bank.  The document submitted should contain the full particulars of the export/import transaction.  The below chart includes the major takeaways from the RBI master circular:

Booking Forward Against Past Performance Limit

 

Banks also permit the importer/exporter to book forwards on the basis of a declaration by the company: the limits for which will depend on the past performance of their respective export/import turnover. The limit is setup based on the formula: higher of the following:

  1. average import/export turnover of the previous three financial years
  2. previous years import/export turnover,

Some of the major take away from the RBI circular on past performance limit is as follows:

Factoring and Forfaiting

Author:-Dilip Mathew

Posted Date:-01-May-2017

Factoring and Forfaiting

In this second part of the series, on ways in which exporters can avail credit on their export financing, we will look at the Factoring and Forfeiting process. Even though both the methods align with the requirement of immediate cash flow; there are subtle differences between the two which we will discuss here.

Factoring

Factoring is a transaction in which a business sells its invoices, or receivables, to a third-party financial company known as a “factor.” The factor then collects payment on those invoices from the business’s customers. Factoring is known in some industries as “accounts receivable financing.”

The main reason that companies choose factoring is that they want to receive cash quickly on their receivables, rather than waiting (usually 30 to 60 days) for customer to pay. Factoring allows companies to quickly build up their cash flow.

 Factoring is available in both recourse and non recourse mode, though the former is more prevalent.  Factoring with recourse means that in case the buyer defaults, the factor has the right to recourse to the seller for the advanced money. In case of non recourse mode, the factor will have to bear the risk of a bad debt.

When companies go for factoring an invoice, the factoring provider advances to company a percentage of that invoice value, usually within 24 hours. The factor will then pay the balance of the invoice, minus fees, after it collects payment from your customer. The cash advance rate can vary depending on what industry the company is in and whom it chooses as a factor. The advance rate can range from 80% - 95% of the invoice value. The industry, customers’ credit histories and other criteria help determine the advance rate exporters receive.

Let us look at Factoring procedure in a step by step manner. 

Understanding factoring will not be complete without going through Factoring Chain International (or FCI). FCI was set up in 1968 as an umbrella organization for independent factoring companies around the world. Today it has grown into the world's representative factoring network and association with more than 400 members in 90 countries.Receivables Finance is the core focus of the association and includes Factoring, Invoice Discounting and other Supply Chain Finance solutions.FCI  basically facilitates and promotes International Factoring through a Correspondent Factoring platform. 

Forfaiting

It is a method of export trade financing, especially when dealing in capital goods (which have long payment periods) or with high risk countries. In forfeiting, a bank advances cash to an exporter against invoices or promissory notes guaranteed by the importer's bank. The amount advanced is always 'without recourse' to the exporter, and is less than the invoice or note amount as it is discounted by the bank. The discount rates depend upon the terms of the invoice/note and the level of the associated risk. The forfeiter provides immediate cash to the exporter.  The major difference of Forfeiting from Factoring is that, the Forfeiting is always on a non recourse basis.  These transactions are mostly done with support of the buyer’s bank. When the payment arrives the forfeiter receives the payment and if there is any extra amount, it will be paid to the exporter on a non-recourse basis.

Looking at the other major differences between forfeiting and factoring, forfeiting is done for longer term maturity, while factoring usually involves accounts receivables of shorter maturities. Because of the maturity difference, factoring is usually done for ordinary goods, while forfeiting is usually done for capital goods.

 

 

 

 

Bill Discounting

Author:-Mr. Dilip Mathew

Posted Date:-18-Apr-2017

Bill Discounting

In this series we look in detail in to how the exporters can avail financing against an export bill. This series will focus on three major concepts Bill Discounting, Factoring and Forfeiting. As the first article in the series we will look towards the working of Bill Discounting process. The exporters mostly demand these instruments as opposed to waiting for the payment to come on due date since it gives them ready cash.

Bill Discounting Process Illustration

For discounting a bill, the bank basically purchases the exporters bill which is to be realized at a later date and credits the value of the bill to the exporter after deducting a suitable discount. Bill discounting can be classified as a fund/asset based financial instrument. The process basically works as an advance for the exporter against the export which will act as the asset and the discount being deducted can be understood better as the interest being charged on the advance which is given by the bank. The difference between the money paid by the bank and the face value of the bill is called the discount.

 Let us look at Bill discounting procedure in a step by step manner.  

 The above image is pretty much self explanatory. The exporters can avail Bill discounting facility in both Rupee terms and foreign currency terms. If the exporter decides to avail the discounting in foreign currency, the interest rate (which basically will decide how much of a deduction will be done by the bank) will be based on Libor rate. 

Dollar Index

Author:-Mr. Dilip Mathew

Posted Date:-05-Apr-2017

US Dollar Index Introduction

In this series we look in detail in to the much heard about concept of the US Dollar Index. There must have been multiple times that we have heard that Rupee has weakened against the Dollar as US dollar index garners strength. 

The US dollar index is a measure of the value of the US dollar relative to the six major currency pairs. The index which works much like a weighted index was started by the US Federal Reserve in 1973 with the base at 100. In the later part of the series we look at what constitutes the Dollar index and how it has fared since its inception.

Dollar Index Constituents

The currency basket against which the US dollar strength is measured in the US Dollar index consist of Euro (EUR), Pound (GBP), Japanese Yen (JPY), Canadian Dollar (CAD), Swedish Krona (SEK) and Swiss Franc (CHF). The Euro has the maximum weight in the basket at over 57%. The below image illustrates the percentage weight of the different currencies in the Dollar index.

As we can see that dollar index is highly influenced by the movements in Euro, add to that the absence of one of the most traded currencies like the Australian dollar and the presence of Swedish Krona in the basket have had many critics question the relevance of the Dollar index. But as things stand, the US dollar index continues to be one of the most reliable sources to measure the Dollar strength.

Interpreting the Dollar Index and Looking At How Dollar Index Have Fared Since Inception

Reading the Dollar Index is just like reading any weighted index. The base was set at 100 in 1973. Now if dollar index goes to 120, it means over time Dollar have appreciated against the other major currencies by 20%. Similarly if Dollar index falls to say 80, it means that Dollar have fallen against the basket of currencies by 20%. 

Looking at the above graph, the highs of 160+ levels was attainted by the Dollar index during the Latin American Crisis, while the low levels below 80 was during the global Financial Crisis of 2007 which eventual led to the Quantitative easing drive by the US Fed.

Cross Currency Rates

Author:-Mr. Dilip Mathew

Posted Date:-30-Mar-2017

Cross Currency Rates

In this series we look in detail in to the concept of cross currency rates and how forward rates on cross currency pairs are determined. In the foreign exchange markets, cross currency refers to any currency quote which does not involve the US dollar. Such cross currency rates are determined by equating their respective rate against the US dollar. For example, EUR/INR is not quoted directly, instead derived from the prevailing EUR/USD rate and the USD/INR rate.

Illustration On How To Calculate Spot Rate

In below illustration we will look at how the spot rate of EUR/INR is derived from the USD/INR and EUR/USD Rates. Assume the USD/INR and EUR/USD spot rates are presently at 64.90 and 1.0747. Now to find the EUR/INR rate we simply multiple the two, whereby the USD part will get negated and we can derive the EUR/INR rate.

Similar treatment can be given to other currency pairs too, the idea here is to negate the USD part from both sides. So if we need to find JPY/INR from USD/JPY and USD/INR, we just divide USD/INR from USD/JPY where by the USD part will get negated and we will be left with JPY/INR value.

Illustration On How To Calculate Forward Rate

The calculation of forward rate in a cross currency pair is slightly more complex than in direct pairs. For example , to find the USD/INR forward rate we just need to add the USD/INR spot rate to the USD/INR forward premium which are both directly available. But to find the forward rate in a cross currency pair, the forward premium/discount of both the currencies with respect to the USD should be considered. The below illustration shows how the forward rate for EUR/INR pair can be calculated:

The table is pretty much self explanatory, but do notice how we have added in the calculation both the forward premium in USD/INR pair and the EUR/USD pair to find the forward rate in the EUR/INR currency pair. Similar steps can be adopted in all cross currency pairs, depending on whether they are at a discount or premium with the US dollar.

Direct and Indirect Quotes

Author:-Mr. Dilip Mathew

Posted Date:-28-Mar-2017

Direct and Indirect Quotes

A currency quotation represents the amount of foreign currency required to buy or sell one unit of the domestic currency.  In this knowledge series article we will look at the two ways, direct and indirect quote, in which currencies pairs are quoted and the conventional quoting in major currencies. Before going into the definition, we would like to remind readers that this system of quoting is dependent on the location of the speaker.

Direct Quote

In the direct quote system, the home currency will be the variable part and the foreign currency will be fixed.  This basically means direct quote will represent, 1 unit of foreign currency against variable units of domestic currency. 

Let’s take the example of EUR/USD from an American’s point of view. Assume EUR/USD is 1.04, this means that 1 unit (fixed) of Euro (the foreign currency) can fetch you 1.04 units (variable) of US Dollars (the domestic currency).Thus making EUR/USD a direct quote for an American.    

Indirect Quote

In the indirect quote system, the home currency will be the fixed part and the foreign currency will be variable.  This basically means an indirect quote will represent, 1 unit of domestic currency against variable units of foreign currency. 

 

Let’s take the example of USD/EUR from an American’s point of view. Assume USD/EUR is 0.97, this means that 1 unit (fixed) of USD (the domestic currency) can fetch you 0.97 units (variable) of EURO (the foreign currency).Thus making USD/EUR an indirect quote for an American.

 

Conventional Quoting Norms In Major Currencies Pairs               

                As discussed above we have seen that currencies can be quoted in two ways (eg: USD/INR and INR/USD), but what is the global convention of currency quoting? Why is it usually USD/INR and not INR/USD?

The US dollar is the most traded currency in the world, which made it a convention to quote the currencies against the dollar. This means that the dollar will be the fixed currency usually.  The foreign exchange quoting conventions are meant to transcend borders. So for non-Indian, USD/INR will be indirect quote as US dollar will be considered as the home currency. There are only four exceptions to this dollar based quoting convention which are the EUR/USD, GBP/USD, AUD/USD and the NZD/USD. These four currencies pairs are conventionally quoted directly.

Bid and Ask

Author:-Mr. Dilip Mathew

Posted Date:-17-Mar-2017

In this series we look in detail in to the concept of Bid-Ask Spread. As an exporter/importer you must have multiple times come across the currency being quoted at two different prices with a slight difference between the two prices (two way price quotation).  For example, you must have seen USD/INR quoted as 66.50/66.51, the first price is called ‘Bid’ and second is called ‘Ask’ and the difference between the two (0.01 in this case) is called the ‘Spread’.

Illustration

In below illustration we will look at two currency pairs, the USD/INR pair and the EUR/USD pair.

Given that the price is quoted at 66.50/66.51 for the dollar rupee currency pair. The bid or 66.50, represents the price at which the market maker (in case of foreign exchange transactions it’s usually the bank) is willing to buy the currency from you. From customer point of view, it means he can sell 1 dollar to the bank and in return get 66.50 rupees. Similarly in terms of EUR/USD, the customer can sell 1 Euro to the bank and in return get 1.0450 Dollar.

The ask or 66.51, represent the price at which the bank will sell dollar to you. From the customer point of view, it means that he can buy 1 dollar from the bank by paying 66.51 rupees to the bank.  Similarly in terms of EUR/USD, the customer can buy 1 Euro from the bank by paying 1.0454 Dollars.

Why  is there a spread?

After one understands the ‘bid’ and ‘ask’, the obvious question would be that why is there a difference between the bid and the ask, since buying and selling should happen at the actual price of the currency?

As explained before in foreign exchange transaction, the banks acts as the market maker. When an exporter wants to sell his currency, the bank will execute the transaction for him, provided they can find a buyer for the currency that the exporter wants to sell. The spread can be considered as a transaction cost.  The lower the spread the better it is for the buyer/seller. 

In the above illustration we say that the spread in terms of USD/INR pair is 0.01 paisa, while that of EUR/USD pair is 4 pips. These spreads can also have slight variations depending on the market liquidity. The spread of an asset with higher liquidity is usually lower than that of an asset which has a lower liquidity.

In this series we look in detail in to the concept of Bid-Ask Spread. As an exporter/importer you must have multiple times come across the currency being quoted at two different prices with a slight difference between the two prices (two way price quotation).  For example, you must have seen USD/INR quoted as 66.50/66.51, the first price is called ‘Bid’ and second is called ‘Ask’ and the difference between the two (0.01 in this case) is called the ‘Spread’.

Illustration

In below illustration we will look at two currency pairs, the USD/INR pair and the EUR/USD pair.

Given that the price is quoted at 66.50/66.51 for the dollar rupee currency pair. The bid or 66.50, represents the price at which the market maker (in case of foreign exchange transactions it’s usually the bank) is willing to buy the currency from you. From customer point of view, it means he can sell 1 dollar to the bank and in return get 66.50 rupees. Similarly in terms of EUR/USD, the customer can sell 1 Euro to the bank and in return get 1.0450 Dollar.

The ask or 66.51, represent the price at which the bank will sell dollar to you. From the customer point of view, it means that he can buy 1 dollar from the bank by paying 66.51 rupees to the bank.  Similarly in terms of EUR/USD, the customer can buy 1 Euro from the bank by paying 1.0454 Dollars.

Why  is there a spread?

After one understands the ‘bid’ and ‘ask’, the obvious question would be that why is there a difference between the bid and the ask, since buying and selling should happen at the actual price of the currency?

As explained before in foreign exchange transaction, the banks acts as the market maker. When an exporter wants to sell his currency, the bank will execute the transaction for him, provided they can find a buyer for the currency that the exporter wants to sell. The spread can be considered as a transaction cost.  The lower the spread the better it is for the buyer/seller. 

In the above illustration we say that the spread in terms of USD/INR pair is 0.01 paisa, while that of EUR/USD pair is 4 pips. These spreads can also have slight variations depending on the market liquidity. The spread of an asset with higher liquidity is usually lower than that of an asset which has a lower liquidity.

Rollover of Forwards

Author:-Mr. Dilip Mathew

Posted Date:-10-Mar-2017

Rollover of a Forward Contract

This is a continuation to the earlier series on cancellation, but over here we will focus on how rollover can be used when payments gets delayed. We would urge readers to read the earlier series before going into the details of rollover.

 Looking at the regulation stand point, the exporter/importer can seek to rollover the forward for any forward booked with documentary backing, where a delay in remittance/payment is anticipated .  The rollover is a two step process which needs to be executed simultaneously:

  1. cancellation of the existing forward on or before maturity and
  2. rebooking of a fresh forward contract for the new maturity.  

 

Cancellation Mathematics

We will look at how the rollover mathematics works and how simultaneous cancellation and rebooking has a neutral effect on the forward rate.

The first part calculation for rollover, as expected, is exactly the same as that which happens in cancellation. Still we will briefly go through the same.

As depicted in the above table, the exporter has taken a forward contract for April 30th on January 1st. This gives him a premium of 120 paisa, making the overall rate 68.20. Now due to some unforeseen events, he forecasts the export order payment to get delayed by another 2 months (60 days). So the exporter decided to rollover the forward since the delay is already anticipated. So on March 1st, he decides to cancel the existing forward and rebook a fresh forward for June 30th. The bank will initially have to do a reverse transaction to nullify the existing forward contract and then do a rebooking of the forward contract.

Lets look at two scenarios, one where the cancellation results in a loss and the other where cancellation results in a gain and see how both has a neutral effect whenever rollover happens.

In the first case the forward contract is in gain, since the forward rate is well above the existing spot rate, the bank will deduct the cash spot and the forward premium from March 1st to April 30th from the forward rate to arrive at 67.58 (68.20- 0.60 – 0.02). Since the spot rate on March 1st is 66.00, the bank will be obliged to pass on the gains of Rs 1.58 to the exporter. In the second scenario if the spot rate was above the forward rate after deduction of premium, the exporter would have to pay the difference (Rs 1.42) to the bank. 

Now since the re booking of the forward is done simultaneously, if the cancellation resulted in loss, he will get a higher forward rate for June 30th since the spot has gone up. But if the spot had gone down which would has resulted in a cancellation gain, his forward rate will be lower. But as evident from the table, the rollover has a neutral effect since both are done simultaneously.  The net rate (68.78) remains the same as the initial booking rate plus the premium for the new two months less the cash spot(68.20 + 0.60 -0.02), thus clearly depicting the overall neutral effect of the rollover process.

Forward Cancellation

Author:-Mr. Dilip Mathew

Posted Date:-04-Mar-2017

Cancellation of a Forward Contract

Let’s start the series by looking at what are the various things an exporter can do with his forward contract based on when he receives his export proceeds.

 We have already seen pre utilization in the previous series and we will be looking at rollover in the next series. Here the focus will be on cancellation in terms of regulations and mathematics.

Looking at the regulation stand point, the exporter/importer has the right to cancel the forward contract any time before the forward contract maturity date.  The customer shall be paid the difference / charged the difference between the forward contract rate and the rate at which the cancellation is effected - this will be discussed in an illustration later.

An important part of the regulation is that the customer will be paid the gains in cancellation only if the customer intimates the bank to cancel the forward contract. If a forward contract gets cancelled automatically (with no intimation from customer) after reaching the due date, the gains if any, will not be passed to the customer but the losses will be debited from the customer. The basic argument is that without an intimation to the bank, the exporter / importer will be deemed to have defaulted on honoring the forward contract.

Cancellation Mathematics

The calculation for cancellation is very much similar to the pre utilization mathematics, so we will focus only on the export side and also on the minor difference which are involved.

As depicted in the above table, the exporter has taken a forward contract on 1-Jan-17 for a maturity of 30-Apr-17. This gives him a premium of 120 paisa, making the overall rate 68.20. Now due to some unforeseen events, the export order did not go through. So the exporter decided to cancel the forward since he is not going to receive the dollars which he was expecting. On 1-Mar-17 he decides to cancel the forward, so here the bank will have to do a reverse transaction to nullify the existing forward contract.

In this case the forward contract is in gain, since the forward rate is well above the existing spot rate, the bank will deduct the cash spot and the forward premium from March 1st to April 30th from the forward rate to arrive at 67.58 (68.20 - 0.60 – 0.02). Since the spot rate on March 1st is 66.00, the bank will be obliged to pass on the gains of Rs 1.58 to the exporter. In an alternate scenario if the spot rate was above the forward rate after deduction of premium and cash spot, the exporter would have to pay the difference to the bank. 

So how does this calculation differ from pre utilization? There are two major differences. Even though the underlying mathematics is same, in terms of cancellation there is no actual conversion of currency taking place, we are only concerned with the gains/losses (Gain of Rs 1.58 in this case) in the forward contract. While in terms of pre utilization, the exporter will be converting the dollars at 67.58. Also during pre utilization, there will be a notional gain/loss (depending upon spot on pre utilization date and forward rate). While in cancellation, in the odd case that the exporter forgets to intimate the bank about the cancellation, only the losses will be debited and profits will not be passed on.

Interest Rate Parity Principle

Posted Date:-01-Mar-2017

Interest Rate Parity Principle and Its Impact on Forward Premiums/Discounts

 

We know that when we book a forward for some currency pairs we get a premium, while some others trade at a discount. In this knowledge series we intend to look at the reason for premiums and discounts. Now to understand why some currency pairs are at a discount while others are at a premium, we will look at the interest rate parity principle. Interest rate parity principle states that between two freely convertible currencies, the difference between the spot rate and the forward rate is determined by the interest rate differential between the two currencies. 

 

Let’s look at an example to see how interest rate parity works. We will look at fully convertible currencies like GBP/USD in this illustration since partially convertible currencies will be heavily impacted by demand and supply factors in addition to interest rate parity principle.

Forward premium for a fully convertible currency pair can be calculated as follows

Forward Premium =               Spot Rate * Interest Rate Differential * Forward Period

                                                                    100 * No. of Months in the Year

 

 

Illustration                                               

Let’s apply this formula to the GBP/USD pair to get a better understanding of the formula.

As on February 28, 2017,

Spot Rate: 1 GBP = 1.2425 USD ;

6 Month US Interest Rate (USD 6 Month LIBOR) = 1.36072%;

6 Month UK Interest Rate (GBP 6 Month LIBOR) = 0.5121%;

6 Month Forward Premium=                              

= 1.2425 * [1.36%- (0.51%)] * 6

                        100*2

                      = 0.0053

This value is nearly equal to the actual 6 month GBPUSD forward premium (available in live data terminals of Bloomberg and Thomson Reuters) on Feb 28th which stood at 0.0058. Thus the forward rate stands at 1.2483 (1.2425+0.0058).

The above table looks into how the interest rate parity is ensured by the forward rate.  Let’s assume an investor decides to borrow 1 GBP for six months. He will pay an interest of 0.51% for the same which will make the net amount to be paid 1.0026 GBP. Now if he decides to convert the 1 GBP at spot rate to USD, he will get 1.2425 USD. If he invests it he will get an interest of 1.36% which will amount to 1.2509 USD for six months. As we must have heard multiple times “There is no free lunch in financial markets”. So to avoid any arbitrage (opportunity for a risk free gain) the 6 month forward rate should be such that, (Amount borrowed + Interest paid) should be equal to (Amount invested + interest Received). This means that 1.2509 USD should be equal to 1.0025 GBP after 6 months. Or in other words after six months 1 GBP should be nearly equal to 1.2477 USD (i.e. 1.2509/1.0026),which as we saw above was achieved using the forward rates.

 

MIBOR & LIBOR

In the above illustration we took USD and GBP LIBOR (London Interbank Offer Rate) as proxies for interest rate respectively. Similarly if we want to apply the same principle to the Indian Rupee, we will use MIBOR (Mumbai Inter Bank Offer Rate) as the interest rate. To understand why we choose these rates, let’s look a bit more into what these rates signify.

 

LIBOR is the benchmark rate that is being charged by the leading banks to one another for short term rate making it the most ideal proxy for short term interest rates. It is available for multiple currencies like US Dollar, Euro, Pound, Swiss Franc and Japanese Yen.  Of the above the US LIBOR is the most frequently used.  LIBOR is quoted in multiple maturities like overnight, weekly and 1, 2, 3, 6 and 12 months.

 

MIBOR is more like the Indian equivalent of LIBOR since LIBOR is not available in Rupee terms.  The MIBOR is set by the Financial Benchmarks India Private Limited (FBIL) with Clearing Corporation of India (CCIL) doing the computations based on interbank call money transactions.  Thus MIBOR acts as a more market driven proxy for Indian interest rates.

Quickly looking at how there is a forward premium in the USD/INR pair. We know that the USD LIBOR stands at 1.36%, while the Indian MIBOR is around 6.08%. The interest rate differential between the two is ~4.50-4.75%. This is nearly equal to the actual forward premiums available in the forex markets, showing how interest rate parity principle works for every currency pair. 

Different Types Of Forwards

Author:-Mr. Dilip Mathew

Posted Date:-21-Feb-2017

In the last knowledge series we discussed on how forwards work and terminologies like spot and cash spot etc.  In this series we will further explore into forwards, in terms of what are the different kinds of forwards:

  • Period  Forwards

Period forward is the one of the commonly used practice of booking forwards, where in the exporter/importer hedges his exposures for a time period. The time period usually taken include 7 days, 15 days, 30 days etc. By definition, the period can range from a minimum of 2 days to a maximum of 30 days. Eg: Booking a forward for entire month from April 1st to 30th.

 The practice of booking period forwards is considered as the traditional method and was prevalent nearly a decade back since at that time the forward premiums where low. We will later look at a illustration to see why period forwards are not a viable option in current scenario especially for exporters and importers.

  • Fixed Date Forwards

The present decade is an era of high forward premiums. This gave rise to a more advanced type forward booking referred to as the Fixed date forwards. In here instead of booking for the time period, the customer can ask the bank to book for a single date. Since it is not always possible to know the exact date on which the remittance/payment might happen, the customer can ask the bank to pre utilize the contract in case it has to be exercised before the date for which forward was booked. The mechanics of how pre utilization works will be explained in the next knowledge series.

Eg: Booking a forward for a single date, say April 30th.

 

Illustration On How Fixed Date Is Better Than Period Forward

In the below illustration we look at why exporters should implement the Fixed date forwards to ensure greater profits in the competitive market.

Period Forward

Date

1-Jan-16

USD/INR Spot

67.00

Forward Contract Period

1/4/2016 to 30/4/2016

Premium for Contract Period

90 Paisa

Forward Rate for April 1 to 30th

67.90

 

Fixed Date Forward

Date

1-Jan-16

USD/INR Spot

67.00

Forward Contract Date(Single Day)

30/4/2016

Forward Premium till 30 April

120 Paisa

Forward Rate for 30 April

68.20

In the above scenario, clearly the fixed date forward provides a higher premium than period forward in case of an exporter. But as we can see the forward contract date for ‘Fixed date forward’ is taken for a date which is the end of the period (April 30th) in the ‘Period Forward’. Now in the above example the exporter can get his remittance any time between April 1st to 30th. So let us look at how the realization rates for the exporter will be in both cases if the forward is executed in various days within the one month period.

Date

USD/INR Realization Rate

Period Forward

Fixed Date Forward

1-Apr-16

67.90

67.90

15-Apr-16

67.90

68.05

30-Apr-16

67.90

68.20


 

The above table clearly depicts a gain for the exporter who goes for a fixed date forward.  The illustration looks at the exporter getting the remittance on three different dates. As we can see if the remittance is received on the First day of the one month period under consideration, both period forward and fixed date forward will give the exporter the same realization rate. But if the remittance comes on April 15th, the exporter who did a fixed date forward and pre utilized his contract stand to gain an extra 15 paisa. Similarly, if the remittance is received on April 30th, the fixed forward will give an extra 30 paisa to the exporter. The mechanics is similar for an importer, who also stands to gain by taking a fixed date forward instead of a period forward. 

In conclusion we can see that using a fixed date forward over a period forward can help the exporter/importer gain an additional 15-20 paisa. The gains will be greater in terms of other currencies like Euro and Pound as the forward premium are higher for them. 

Pre utilization

Author:-Mr. Dilip Mathew

Posted Date:-21-Feb-2017

Pre utilization of a forward is defined as the act of exercising the forward contract prior to the actual maturity date. This is usually done when

  • A remittance is received by the exporter well before the maturity date of the forward contract
  • A  payment is to be done by the importer well before the maturity date of the forward contract

Pre utilization mathematics for exporters

According to the below illustration, the exporter has booked forward contract for his receivable after 4 months on January. This enabled him to get a premium of 120 paisa over the USD/INR spot rate of 67.00, making his effective rate 68.20.

Forward Booking Day

Date

1-Jan-16

USD/INR Spot

67.00

Forward Contract Date

30-Apr-16

Forward Premium for April 30

120 Paisa

Forward Rate for 30 April

68.20

 

Pre utilisation Day

Date

1-Mar-16

USD/INR Spot

66.00

USD/INR Cash Spot

2 Paisa

Forward Premium Till 30 April

60 Paisa

Forward Rate for 30 April

68.20

After 2 months, when the spot is 66.00, the exporter receives his payment. This is two months ahead of his estimated schedule of April 30. The exporter can approach the bank for pre utilizing his April end forward contract.  The bank will give a rate after reducing the extra premium from March 1st to April 30th. The forward premium for this period stands at 60 paisa. After deducting the 60 paisa  and cash spot 2 paisa from his existing forward rate, the exporter stands to get a rate of 67.58 (68.20 - 0.60 - 0.02). Thus by pre utilizing the forward contract rather than going for the spot rate, the exporter gained Rs 1.58 (67.58 - 66.00).

Pre utilization mathematics for importers

Importers who take a forward contract pay the premium unlike in case of exporters who receive the premium. In the below illustration, the importer is taking a forward contract on January 1st, paying a premium of 120 paisa to fix a rate of 68.20 for April 30th (Fixed date forward).

 

Forward Booking Day

Date

1-Jan-16

USD/INR Spot

67.00

Forward Contract Date

30-Apr-16

Forward Premium for April 30

120 Paisa

Forward Rate for 30 April

68.20

In this case, after two months on March 1st let’s assume the spot went to 69.00. He has to make the payment on March 1, so he decides to approach the bank to pre utilize his contact.  The bank will give him a rate after deducting the cash spot and forward premium from March 1st to April 30th, which is 60 paisa from the forward rate. So he will have to pay rate of 67.58(68.20 -0.60 - 0.02). 

Pre utilisation Day

Date

1-Mar-16

USD/INR Spot

69.00

USD/INR Cash Spot

2 Paisa

Forward Premium Till 30 April

60 Paisa

Forward Rate for 30 April

69.60

Thus by pre utilizing his contract, the importers stand to gain Rs 1.42 (69.00 -67.58), which is spot price less the actual rate he got from pre utilization. We want readers also to understand that in both the above cases there is a considerable gain in pre utilization as the forward rates were better than spot rates. At times when the vice versa happens the bank can debit the customer of the difference.

What is forward? What are Spot, Cash and Tom rates?

Posted Date:-20-Feb-2017

What is a foreign exchange forward contract?

A foreign exchange forward contract is an agreement to exchange a specified amount of a currency against another currency at a future date, at a pre-determined exchange rate (set at the time of entering into the contract). This pre-determined exchange rate is called a forward rate.

The forward rate is determined by adding/subtracting the forward premium/discount to the current running spot rate.

 

Spot Transaction

A spot transaction has a settlement date of 2 working days from the current trading date. It is transacted (or traded – rate fixing) at the current trading date and the actual settlement (debit or credit to bank account) happens 2 working days later. In financial markets parlance, a spot is called as T+2 settlement.

 

Cash Rate

A basic doubt will be, as an importer/exporter, most of the times when you do a forex transaction; the amount is credited/debited on the same day and not after 2 days which is mentioned in the definition of Spot rate. This is where we need to understand the concept of cash rate.

A cash rate (applicable to a cash transaction) has the same working day as the trading date as well as settlement date. One trades today (rate fixing) and settles today (bank debit/credit). In the USDINR context, cash rate is lower than the spot rate. The forward premium for 2 working days is called cashx spot.

 

Tom Rate

A tom transaction has a settlement of one working day – in other words, tom rate applies when one trades today (rate fixing) and settlement (bank debit/credit) takes place on the next working day (tomorrow). It is the short form for “tomorrow”. In the USDINR context, tom rate is lower than the spot rate (but higher than the cash rate). The forward premium for 1 working day is called tom spot.

 

Illustration

Cash Rate

USDINR Spot Rate

66.9600

USDINR Cash Spot ( - )

0.0100

USDINR Cash Rate

66.9500

 

Tom Rate

USDINR Spot Rate

66.9600

USDINR Tom Spot ( - )

0.0050

USDINR Tom Rate

66.9550

 

Please note that an agreed bank margin will be adjusted against the above USDINR Cash or Tom Rates.

 

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Posted Date:-16-Jun-2015

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