CHAPTER 1

Currency Basics
1.1 Module Orientation
At the onset, let me give you a quick orientation, so you can set your expectations for
this module. The focus of this module will be on three main topics
1.

Currencies and currency trading

2.

Understanding Commodities

3.

Interest Rate Futures

I agree that each of these topics is vast, and commands an entire module on its own.
However these assets are not as liquid as equities. We are still at a very nascent stage
when it comes to trading these alternate assets in India. Given this, the idea here would
be introduce these assets, familiarize you with what drives these assets, and what you
need to watch out for before placing your trades. So, in a sense, you could consider this
module as a thought starter of sorts for trading these alternative assets. Needless to
say, we will try and discuss these topics to a reasonable depth, ensuring you have more
than just the bare basics on these topics.

Well begin the module by discussing Currencies. Well discuss some of the popular
currency pairs traded in India such as USD-INR, GBP-INR, and INR-JPY. We also
discuss other (non INR) currency pairs such as EUR-USD, GBP-USD, and USD-JPY.
The discussion on currencies would be spread across a few chapters. The objective
here would be to introduce these currency pairs, and familiarize with not just the
contract specification but also with a few fundamental factors that affect these
currencies.
Once this is done, well move on to the next part of the module. Thisd deal with
Commodities. Well follow a similar template here i.e. introduce the commodities (both
agri and non-agri) and get familiarize you with not just the contract specifications but
also a few fundamental factors which would influence the movement of these
commodities. Some of the commodities well be discussing would be Gold, Silver,
Zinc, Aluminum, Crude oil, Natural Gas, Turmeric, Cardamom, Pepper, Cotton, etc. Of
course, the formula to calculate the price of commodities such as Gold, based on the
price of Gold in International markets will also be discussed.
Lastly, this module will discuss Interest Rate Futures (IFR), which I think is a very
exciting space. The discussion would deal with topics related to RBIs borrowing pattern,
issuance of sovereign bonds, listing on NSE, and eventually trading them. Based on
how we progress, we can even touch topics related to bond trading and bond trading
strategies.
As you see, we have some really interesting stuff lined up. I believe thisll be a great
learning experience for you, and me!
Please note, the prerequisites for this course
1.

Futures Trading

2.

Options Theory

3.

Technical Analysis
The above mentioned topics are absolutely essential before learning about currencies.
Id suggest you brush up these topics before proceeding.
Lets now begin this module by discussing few basics about currencies.

1.2 Currency (in)equality

Before we get started on currencies, let me share with you an interesting conversation I
had with my 6 year old daughter. Perhaps this could set a good starting point for our
discussion on currencies.
I had recently been to Austria with my family on vacation. As you can imagine, the
country is extremely beautiful. It was my daughters first visit to Europe and she was in
complete awe. Needless to say, she was attracted to all the small little stores selling
pretty little things. On one of the days while we were there, she forcibly took me to this
toy store she spotted off the street, and I knew I was in for trouble. After spending about
5-10 minutes scanning through the shop, she finally picked up a colorful wooden
caterpillar, and she wanted me to buy her that. It looked really nice, and I was willing to
buy her that, until I saw the price! The wooden caterpillar had a 25 Euro price tag. I
thought Id negotiate with her and buy her something else.
I tried telling her that it was 25 Euros, and 25 Euros was quite steep especially for a tiny
wooden caterpillar! She obviously didnt understand my point, and refused to budge
from her stance. In fact she said its just 25 Euros, and I realised that she equated 25
Euros to 25 Rupees, completely oblivious to the fact that she needs to multiply each
Euro with 78 to get the exact Rupee equivalent.
However this got me thinking why isnt one Euro or for that matter one Dollar equal to
one Rupee? More generally why isnt one unit of currency belonging to country A
equivalent to another unit of currency belonging to country B? I understand this may
sound very basic and some of you may already know the answer, but I think it is very
important to discuss this and understand why the inequality between currencies exists.
After all, it is this inequality which allows us to trade the currency pairs.
To understand this, we need to brush up a bit on the history of currencies and how
currency trading evolved. Dont worry, I wont get into history lessons here; will restrict
this to a quick recap . For the sake of simplicity, let me break this down into different
stages for you based on my own understanding of the evolution of currency.

Stage 1 The Barter era

Before the advent of currencies, transactions occurred through something called the
barter system. Barter system is a method of exchange which has existed for many
centuries. In a typical barter, people exchange goods for other goods (or services). A
classic example would be say a farmer has harvested cotton, he could exchange (or
barter) cotton with another farmer giving him wheat. Similarly a farmer who has oranges
could exchange the oranges he has harvested with someone who agrees to wash his
cows and sheep.
The problem with the barter system was the scale and divisibility of the system. For
example assume a farmer had 5 bales of cotton and he wants to barter cotton with
someone selling cattle, assuming 2 bales for 1 cow, after the barter hed be left with 2
cows and a bale of cotton. He would certainly not get half a cow for 1 bale of cotton.
This caused a divisibility issue within the system.
The scalability was also an issue with the barter system it required our farmer to travel
from one part of the country (with all his produce) to another part of the country to barter
for goods of his choice.
Both these issues were eventually overcome with an improved system Goods for
metal.

Stage 2 Goods for Metal era

The problems that plagued the barter system eventually paved way to the next
transaction methodology. People tried to invent a common denominator for the
exchange. The common denominator ranged from food grains to metals. But
eventually metals thrived for obvious reasons. Metal was divisible, easily movable, and
metal had no issue with shelf life. Further, of all the metals, Gold and Silver were the
most popular; therefore eventually these metals became the standard for transactions.
The direct exchange between gold/silver and goods lasted for many centuries; however
things started to change when people deposited gold and silver coins in safe havens
and issued a paper against the value of gold. This paper derived its value based on the
gold/silver coins deposited in safe haven.
With time, safe havens evolved to banks and the paper transformed to different
currencies. Perhaps this was the start of the book entry of the currency system.

Stage 3 The Gold Standard era

Over time, as domestic trade flourished, trading across borders also flourished.
Economic sense prevailed and merchants realized producing everything locally did not
make sense. Merchants started exploring cross border trade simple import and export
of goods thrived. This also meant merchants transacting across border also required to
pay for it in a currency that was acceptable across borders. Banking systems also
evolved, and somewhere around the late 19 th Century exchanging goods for Gold (not
silver) became the norm. Valuing the local currency against the value of gold was called
the Gold Standard.
As things progressed, geo political situation changed (world wars, civil wars, cold wars
etc) and so did the economic situation across the world. When it came to cross border
transactions, there was an urgent need for merchants to trust one currency and value
their own currency against that currency. This is when Bretton Woods System came to
the picture. You can read more on the Bretton Woods System.
However, here is a simplified version of the Bretton Woods System (BWS). The BWS
was a way of defining the monetary relationship between countries, where the
currencies were pegged to USD at a fixed rate while the value of the USD itself was
marked against the value of Gold. Countries accepted this system with a room for 1%
variation either side (against the pegged value). Needless to say, with BWS in place the
USD became the currency the world transacted in, as USD was backed by Gold!
Developed countries slowly withdrew from the BWS system and eventually BWS
became history. Countries adopted a more market driven approach, where the market

decided the value of one currency against the other. The market drives the value of
currencies based on the political and economic landscape of a country versus the other.
This brings us to where we are now.

1.3 International Currency market (Forex)

Internationally, the notional currency trading volume is massive and needs a moment to
digest the figure. As per the April 2013 survey conducted by Bank of International
Settlement (BIS) the size of International Markets stands at $5.4 Trillion! Here is
the link for the detailed report. My guess is we could be close to $5.8 6 Trillion as of
April 2016. If you can imagine, this is roughly 20% higher than the entire Indian annual
GDP that gets traded on a daily basis!
Probably what really contributes to such massive trading is the fact that currency
markets chases the Sun. Currencies are traded across all the major markets, and
information flows seamlessly.
To understand what I mean, keep the Indian markets as reference and think about it
before Indian markets are open, the Australian, Japanese, Hong Kong, and Singapore
markets are open. In fact we get some overlap with these markets. While the Southeast
market closes, Indian markets would have just warmed up with Middle Eastern markets
opening up. This leads to the European markets opening up London, Frankfurt, and
Paris being the financial nerve center of the Europe. In fact Indian markets are situated
in a sweet spot as our time zone overlaps with major Southeast Asian markets and the
European markets. Finally the US markets open, followed by the Japanese markets and
the cycle continues 24 hours a day, 6 days a week!
Having said that, the most active time for currencies is when the US, UK, Japanese,
and Australian markets are open. This is when the order flow gets brimful.
This leads us to an interesting question who are these people trading currencies and
why are the notional values so crazy? More importantly how are currencies traded?
Unlike Equity markets, the participation in Forex is not just restricted to investors and
traders. The participants in the Foreign Exchange (Forex) markets are many Central
Banks, Corporate, Banks, Travelers, and of course traders. Each of these participants
have their own agenda while participating in the Forex markets. For example the
corporate maybe buying/selling USD to hedge their order book, and a traveler maybe
buying USD for his travel expense. While the trader maybe just speculating on the
movement of the currency. Obviously since participation comes in from many quarters,

the volumes are driven up. More so, Forex trading is highly leveraged, hence the
notional value appears large.
There is no centralized International exchange where the Forex transactions take place.
Transactions occur at different financial institutions (like NSE in India) and information
flows from one platform to another making it borderless.

1.4 Currency Pairs and quotes

The standard practice while trading currencies is to trade the currency as a pair. The
value of the pair keeps fluctuating as the trades flow through. An example of the pair
could be USD INR or GBP INR. The currency pair has a standard format, as shown
below
Base Currency / Quotation Currency = value
There are three parts here, lets figure out each one of them
Base Currency Base Currency is always fixed to 1 unit of a currency (like 1 US
Dollar, 1 Indian Rupee, 1 Euro etc)
Quotation Currency Refers to another currency which equates to the base currency
(obviously it can be any currency apart from the base currency)
Value Indicates the value of the Quotation Currency against the Base Currency.
Confusing? Let take an example to make it clearer. Assume USD/INR = 67.
The Base Currency here is USD, and as I mentioned earlier the Base Currency is
always fixed to 1 unit, hence this is fixed to 1 US Dollar.
Quotation Currency is in Indian Rupees (INR)
Value is 67, which means for 1 unit of Base Currency i.e. 1 USD the equivalent
quotation currency is 67. In simpler terms $1 = Rs.67.
The most active currency pairs that get traded across the world and its current value as
on 3rd June 3, 2016 are as follows
SL No

Base Currency

Quotation Currency

Pair

Pair Value

1
2
3

Euro
US Dollar
Great Britain Pound

US Dollar
Japanese Yen
US Dollar

EUR/USD
USD/JPY
GBP/USD

1.11
108.94
1.44

SL No

Base Currency

Quotation Currency

Pair

Pair Value

4
5
6

Australian Dollar
UD Dollar
US Dollar

US Dollar
Canadian Dollar
Swiss Franc

AUD/USD
USD/CAD
USD/CHF

0.72
1.31
0.99

Now here is the big question what makes the pairs move? Why do they move? Are
there events that influence the pairs?
We will explore this in the next chapter.

Key takeaways from this chapter

1.

The Gold Standard system of evaluating currencies existed for a long time, but
eventually got phased out

2.

The currency inequality between currencies exist because of political and

economic differences between two countries

3.

By volumes, the currency markets is easily one of the largest

4.

The currency markets are open 24 hours, 6 days a week

5.

Currency is traded as pairs

6.

7.

Currency Pairs have a standard format to include Base Currency and Quotation
Currency
The Base Currency is always fixed to 1 unit

CHAPTER 2

Reference Rates &

Impact of events

2.1 Dual View

Think about a stock, Infosys for example, when you buy or sell Infosys your view on
the stock is straightforward you are either bullish or bearish on Infosys therefore you
buy or sell Infosys. Now think about a currency pair say USD INR, when you buy or
sell USD INR, whether you know or not, you have a dual view on the pair. For instance
when you buy USD INR; it implies you are bullish on the US Dollar and bearish on the
Indian currency.
Why is it this way you may ask?
Well, the value of a currency is always quoted against another. Recall from the previous
chapter the currency pair is quoted as
Base Currency / Quotation Currency = Value
In other words, this format tells us, how many units of quotation currency one can buy
for 1 unit of base currency.
If you buy a currency pair, clearly it implies that you expect the value of the pair to go
up. Consider this example USD INR = 65, one would buy the pair, hoping for the price
of the pair to hit 68.
Now if the price of the pair is expected to increase, then it implies that going forward 1
unit of base currency can buy more units of quotation currency i.e. 1 USD to buy more
INR.

In other words, if the value of the pair goes up then the power of the Base currency
goes up while at the same time the quotation currency weakens. This translates to you
being bullish on the Base currency and bearish on the quotation currency at the same
time.
Similarly if you sell the USD INR pair, it implies that you anticipate the Base Currency to
buy lesser amount of quotation currency. This translates to you being bearish on base
currency and bullish on the quotation currency.
Given this, strengthening/weakening of a currency refers to the following situations
1.

Base currency strengthens when it can buy more units of quotation currency.
For example USD INR moves from 67 to 68 it means the base currency (USD)
strengths and the quotation currency (INR) weakens.

2.

Quotation currency strengths when the base currency buys lesser units of
quotation currency. For example USD INR moves from 66 to 65 it means the base
currency (USD) weakens and the quotation currency (INR) strengthens.
Note that strengthening and weakening of a currency is equivalent to a currency
appreciating and depreciating. These terminologies are often used interchangeably.
Before we proceed, here is something you need to know. Just like a stock, the currency
(and the currency pair) has a two way quote. The two-way quote enables one to
identify the rate at which one can buy and sell the currency (and currency pair).
Dont get thinking on the two way quote, it simply refers to Bid and Ask rates J, but we
do need to touch upon this as its vital to know how the two way quote works.
Have a look at the image below

This is a snap shot of the currency spot rates, as quoted on a Forex trading site. For the
sake of this discussion, Ive highlighted the two way quote for EUR USD and GBP USD.
The quote gives you the rate at which you can buy and sell the currency pair.
For example if you want to buy the EUR/USD you will have to buy the pair at the Ask
price i.e. 1.1270. When you buy the pair, technically you are long EUR and short USD.
Likewise if you want to sell the EUR/USD, then you would do so at 1.1269 (Bid price),
and here you would be short EUR and long USD (remember the dual view concept).
The pairs are sometimes quoted in a short form, which is actually quite a popular way to
quote currencies internationally. The shortened two way quote would be something like
this for the EUR/USD pair
EUR/USD 1.1269/70.
If you notice in the shortened version, the bid price is stated in full, but only the last two
digits of ask is stated.
Further, in the Forex lingo, digits are referred to as pips. Therefore, if the EURUSD
moves from 1.1270 to 1.1272, then it means that the pair has moved 2 pips.

2.2 Rate fixing and conversion path

As of today, the USD/INR rate stands at 67.0737. This rate is fixed by the RBI on a daily
basis, and is called RBIs Reference Rate; in fact RBI publishes these rates on a daily
basis on their website. The Reference rate acts as crucial input for the currency futures
trading as all settlements are based on this Reference rate.
Have a look at this

The above is a snapshot from the RBIs site showing the reference rate for 14 th June
2016. Do note, these are spot rates, and not future rates. Future rates are as seen on
NSEs website.
Anyway, the obvious question is how does the RBI arrive at this rate?

Well, nothing hi tech here, RBI follows the age-old method of polling to arrive at the spot
rate! Click here to see the RBI circular that explains the rate fixing procedure, but if you
are in no mood to read the circular, you could read the following points that summarize
the procedure.
1.

RBI has identified a list of banks based on their market share in the foreign
exchange market. RBI calls them the contributing banks

2.

Every day between 11:30AM and 12:30PM RBI calls a set of banks (randomly
selected) listed under the contributing banks and ask them to give a two way quote on
USD INR

3.

RBI collates these rates and averages out the rate based on the bid and ask

4.

The average rate is set as the USD INR rate for the day

5.

The same process is repeated every day except for weekends and bank holidays
Its as simple as that!
The procedure is quite simple; however RBI polls only for the USD INR rates. For the
other major rates i.e. EUR INR, GBP INR, JPY INR RBI adopts a technique called
Crossing also referred to as the cross rate mechanism.
While crossing, the direct rate of one currency is not available with respect to another.
For example the direct rate of Euro with respect to INR is not readily available; one
needs to cross these rates with a common denominator to arrive at the rates.
Let me take the example of deriving the EUR INR rate by crossing, keeping USD as the
common denominator, hopefully this will give you a better clarity on the crossing
technique.
Let us begin with getting the spot rate for USD INR, as we can see from snap shot
above, the USD INR spot is
USD INR 67.0737
This is the spot rate; the two-way quote for this would be something like this
USD INR 67.0730 / 67.0740
This means if I have to buy 1 USD, I need to pay INR 67.0740 and if I have to sell 1
USD, Id receive INR 67.0730.

Lets keep this information aside. We now focus on EUR USD spot rates from the
international markets.
The two-way quote from Bloomberg suggests
EUR USD 1.1134/40
This means I need USD 1.1140 (Ask price) to buy 1 Euro. In other words the cost of 1
Euro in terms of the US Dollar is 1.1140. Hence if I convert the price of 1.1140 USD to
INR, then I will have enough INR to buy 1 Euro and by doing so, I will also get the
EUR/INR rate.
Now going back to the USD INR rate
1 USD = Rs.67.0730
1.1140 USD = How many Rupees?
= 67.0730 * 1.1140
= 74.719322
Hence to buy 1 Euro I need 74.719322 INR, or EUR INR = 74.719322.
Notice how the USD acts as a pivot in the crossing technique.
Now here is a simple task for you using the crossing technique, we have calculated
the ASK price of the EUR INR pair, can you extend this logic to calculate the Bid price
for the EUR INR pair? Feel free to post your answers in the comments section below.
If you think about this, its now clear that the reference rates and the cross rates change
everyday based the sentiments of the contributing banks. This leads us to a bigger
question what influences the sentiment of the contributing banks?
The answer is quite simple domestic and international events.

2.3 Events that matter

Think about an event that can potentially change the sentiment on a stock. Quarterly
result of company is one such event. Estimating the change in sentiment based on this
event is quite straightforward. If the quarterly result is good, the sentiment is positive;
therefore the stock price is expected to go up. Alternatively, if the quarterly result is not
great, sentiment is hurt and therefore the stock price is expected to go down. The point
here is, there is some sort of linearity between the event and the expected outcome.

However when it comes to currency pairs, there is no such linearity, which makes it a
herculean task to assess the impact of events, a.k.a. fundamentals on currencies. The
complexity mainly stems from the fact that currencies are quoted as pairs. While some
factors lead to strengthening of a pair, an event could occur at the exact same time that
weakens the pair.
Let me give you an example to illustrate this imagine two economic events running in
parallel. Event 1 India receives a continuous inflows of Foreign Direct Investments
(FDI) geared towards long term investments, clearly this is a big positive for the
economy and therefore it tends to strengthen the INR. Event 2 There is an uptick in
the US economy (or a fear of a crash in commodities) leading to an appreciation in the
US Dollar.
Given these two events occur in parallel which direction will the USD INR currency
pair move? Well, the answer to this is not straightforward. Eventually the currency pair
will take cues from the more dominant of the two factors and head in that direction, but
until this happens the pair invariably exhibits volatile behavior. Hence, to successfully
trade currencies, it becomes extremely important to track world events and assess their
impact on the currency pair in question.
Here are few such events and data that you should track
Import/Export Data These numbers are highly significant, especially for a country like
India, whose economy is highly sensitive to trade deficits. India exports goods and
services such as rice and software and imports commodities such as crude oil and
bullion. In general, increase in exports tends to strength domestic currency and
increase in imports tends to weaken the domestic currency. Why so you may ask?
When imports are made (crude oil for example), the purchase has to be made in the
International market which requires one to pay in USD. Therefore one has to sell INR
and buy USD to facilitate this purchase, which in turn causes a demand for USD and
hence USD strengths.
We can extend the same logic to exports. When we export goods, we receive USD; we
sell the USD received and convert to INR. This causes the INR to strength.
The Trade Deficit the excess of imports over exports is a key factor to track as it
influences the direction in which the currency trades. In general, narrowing the trade
deficit is a positive for the domestic currency. The trade deficit is also referred to as the
Current account deficit. Id suggest you read this news piece, just to reinforce your
understanding on this topic.

Interest Rates Typically investors borrow money from countries where the interest
rate is low and invest in countries where the interest rates are high and profit from the
interest rate difference. This is called the carry trade. Clearly the country offering
higher interest attracts a lot more foreign investment into the country, naturally this leads
to the strengthening of the domestic currency. This clearly implies that the Interest rate
is one big number currency traders watch out for.
The monetary policy review conducted by the central banks (RBI in India, Federal
Reserves in US, and ECB in Euro region) reviews the interest rates of the country. This
is the reason why there is so much attention paid for the policy review. Besides tracking
the actual change in numbers in the on-going review, the market participants look for
cues regarding the policy stance. The monetary stance helps the participants
understand the future course of action concerning the interest rate.
Dovish Dovish is a term used to describe the central banks stance wherein they are
likely to lower the interest rate in the future. Remember, lower interest rate weakens the
domestic currency. Here is a new headline talking about the relationship between a
dovish stance and the currency.

Click here to see the article.

Hawkish Hawkish is a term used to describe the central banks stance wherein they
are likely to increase the interest rate in the future. Remember, higher interest rates
attract foreign investments to the country and therefore strengthens the domestic
currency.
And here is another new headline which talks about hawkish stance.

Inflation Inflation, as you may know, is the rate at which the prices of basic goods and
services increase over time. If inflation increases, then it means the cost of basic

necessities is increasing, therefore this affects the day to day living of the common man.
Given this, the central bank strives hard to keep inflation in control. The link between
inflation and currency movement is a bit tricky.
One of the direct mechanisms to curb inflation is by tweaking the interest rates. If the
inflation is perceived as high, then the central bank is likely to take a hawkish stance
and increase the interest rates.
What do you think is the logic here?
Well, easy money in the hands on consumers and corporates increases spending; when
spending increase merchants smell an opportunity to make higher margins and
therefore this leads to rapid increase in prices, and thus the inflation increases. When
inflation increases, the central banks tend to curb the spending by cutting the access to
easy money. And how do they do that? Well, they increase the interest rates!
Therefore, when inflation is on the rise, expect the central banks to take a hawkish
stance and increase the interest rates. When interest rates increase, the domestic
currency strengths!
Therefore, as I mentioned earlier, the relationship between interest rates and currencies
is a little tricky. So traders eagerly track inflation data to figure out what the central
banks are likely to do, and accordingly take positions on the currency pair.
Remember this if the inflation is high, expect a hawkish stance by the central
government and therefore expect the domestic currency to strengthen. Likewise, if
inflation is low, expect a dovish stance (as the central bankers wants to encourage
spending), therefore the interest rates are likely to come down. This leads to the
domestic currency weakening.
Consumer Price Index (CPI) The CPI is a time series data, averaged out to capture
the prices of basic goods and services. Hence the CPI is a measure for inflation. A rising
CPI means inflation is increasing, and vice versa. For the most accurate Indian CPI data
and information check this website
Gross Domestic Product (GDP) The GDP of a country represents the total Rupee
value (for Indian GDP of course) of all the goods and services produced in the country
for a given year. As you can imagine the GDP would be a massive number and it does
not make sense to repeat the GDP number while making estimates or during
conversations. Therefore one always refers to the GDP as a growth rate. For example if
the GDP of a country is 7.1%, it means that the GPD number is growing at a rate of
7.1%.

Higher the GDP growth rate, higher is the investor confidence in that country, and
therefore the stronger the countries domestic currency.
The list of events that matter while trading currencies is virtually endless, and at some
point you will realize that every piece of data you can possibly look at is inter-connected
with one another. Honestly, you need not know the details of each event the way an
economist would. Understanding the cause and effect relationship is good enough. Ive
listed some of the key events/data points that matter while trading currencies. I guess
this would serve as a good start, If nothing more.

Key takeaways form this chapter

1.

The base currency is said to strengthen/appreciate against the quotation

currency when it can buy more units of quotation currency.

2.

The base currency is said to weaken/depreciate against the quotation currency

when it buys lesser units of the quotation currency.

3.

When you go long on a currency pair, you are essentially going long on the base
currency and short on the quotation currency.

4.

When you go short on a currency pair, you are essentially going short on the
base currency and long on the quotation currency.

5.

The RBI sets the reference rate of USD INR on a daily basis by conducting a
poll, the contributing banks participate in this poll.

6.
7.

The reference rates for other currency pairs are derived by crossing technique.
Understanding events and its impact on currencies is complicated, simply
because of the currency is quoted in pairs and impact on the pair could be similar.

8.

Eventually the more dominating event will set the direction for the pair.

9.

Countries with higher interest rates tend to have stringer currencies and vice
versa.

10.

Lower the trade deficit of the country, stronger is the countrys currency.

11.

Higher inflation leads to strengthening of currency and vice versa.

12.

Knowing the cause and effect of events on currencies helps while trading
currencies.

CHAPTER 3

Impact of events
(Brexit) & Interest Rate
Parity

3.1 Brexit, the event extraordinaire!

I originally planned to dedicate this entire chapter to the USD INR pair, which as you
may know is the largest traded currency contract in India. But then, the BREXIT issue
happened today and I cant help writing about it as it has a huge relevance to what we
just discussed in the previous chapter events and their impact on currency pairs.

To give you a sense of what happened, have a look at how the Great Britain Pound
(GBP) reacted to the event. It was down a massive 8.64%, which you will eventually
realize is a big deal in currencies.

The Guardian UK, had this to say about the event

Here is the article.

My objective here is to simplify Brexit to the best of my knowledge and help you
understand why the pound reacted the way it did. Obviously, the bigger agenda here is
to help you understand the potential impact of such events on currencies. By doing so,

youll get a grip on how to summarize global events such as Brexit and understand what
kind of impact they could have on currencies.
For the sake of simplicity and brevity, let me bullet point Brexit for you. We start with a
bit of history
1.

After the World War 2, Germany and France debated the idea of forming a union
of sorts. The thought process was that if countries traded and did business together,
then they are less likely to wage war against each other.

2.

This laid the foundation for forming a bigger union called the European Union
(EU) with more European countries agreeing to join the EU.

3.

The EU formed a single market of sorts where goods, service, and people moved
easily across countries. So much so that the EU decided to have its own currency called
the Euro.

4.

UK, although was a part of the EU, never accepted Euro as their currency. Note
there are many other countries in the EU which still have their own currency, example
Switzerland, Chez Republic, Denmark etc.,.

5.

There was a growing debate in UK in the recent times on whether the UK should
remain in the EU. Many of UKs citizens believed that UK was better off outside the
union as the rules laid out by the EU commission was more taxing on UKs citizen than
actually benefiting them. In simpler words they believe they would progress faster and
better economically and as a society being outside the EU.

6.

Britain option to exit from the EU was called Brexit.

7.

The UK decided to formally seek its citizens vote on 23 rd June 2016, where in the
citizen would vote for being in or leaving the EU. This is called a referendum

8.

The outcome of the referendum was a bit of shocker with the UK actually
deciding to opt out of the EU. In fact many in the UK and the world believed that UK
would vote to stay in the EU.
The referendums outcome sent a shiver down the spine for traders and investors round
the globe. The GBP crashed to a 31 year low, the major European indices dove close to
8-10%.

Now why did this happen? Why did the markets fall? What is the connection between
Brexit and the currency markets and the work markets?
Now here is where Im hoping the previous chapter comes to help us J
Recall in the previous chapter we discussed how a strong economy (defied by inflation,
interest rates, trade deficit etc) leads to a strong currency.
Given this, think about the UK clearly UK is one of the strongest economies in the
world and contributes significantly the EU. Now with UK opting out of the EU, things are
set to change both economically and politically.
While UK has a trade deficit with the rest of the world, it maintains a trade surplus with
EU. This should give you a sense of how strongly the UKs economy is coupled with
EU. With UK opting out of the EU, its finances are certainly going to take a hit.
Further the problem is with clarity. Everyone knows that the economic situation is bound
to change, but to what extent is something no one really knows. How will the Bank of
England react? Will they cut the rates to near zero?
Uncertainty is one thing that the market despises, and given its nature, Brexit has many.
Therefore as a result, the markets cracked.
You as a currency trader should be in a position to study the event and understand
some basics. From my experience, sometimes the best trades are set up backed by
simple common sense and basic knowledge.
Remember if you had studied the event and arrived at a conclusion to not take on a
trade, then that in itself would have been a good trade, as the rule of thumb says when
in confusion, do nothing.
The point is when you have events of this magnitude around the corner, it is
mandatory for you to know what is happening. Taking on a trade without the perquisite
knowledge is equivalent to a blind speculative bet!
So, thats about Brexit and how events like this can impact the currencies.
Let us move ahead to figure out few other currency concepts.

3.2 Fairy Trade

Imagine a perfect world, where in you can borrow money at a certain interest rate,
invest the borrowed money at a higher rate, and earn the differential in the rates.
Confusing? Let me give you an example to simplify this.

The interest rate in the United Sates is about 0.5%, arguably one of the lowest in the
world. Assume you borrow $10,000 from a bank in United Sates at 0.5%; invest this
borrowed money in a country like India where the interest rate is about 6-7%.
To do this, you will have to convert the borrowed money (which is in USD), to INR. At
todays conversion rate, a US dollar gets you 67 INR. Therefore $10,000 fetches
Rs.670,000/-. We invest the converted money in India at say 7%.
At the end of the invested year, we get back 7% interest plus the initial capital. This
would be
670000 + 670000*(7%)
= 670000 + 46900
= Rs.716,900/We convert this money to USD, assume the conversion rate is 67, we get back $10,700.
We now have to repay the principle amount plus 0.5% in interest. This would be $10000
plus $50.
So after repaying back $10,050 we get to retain $650, which if you realize is a risk free
gain!
If you realize, $650 is the interest rate differential times the borrowed money
10000*(7%-0.5%)
10000*(6.5%)
650
This is a simple case of arbitrage, quite easy to implement, dont you think so?
Given this, imagine a situation where you could borrow large amounts of money from
US and invest this large amount in India and make pot loads of money year on year
right?
Well, sorry to burst the bubble, such trades happen only in fairy tales J. In the world we
live in, such easy risk free profits does not exist. Even if it did, it would vanish before
even you realize.
However, the bigger question we need to answer is why is this fairy trade not
possible?

3.3 Forward Premia & Interest Rate parity

The problem with the above trade is that there are one too many assumptions, we
assumed
1.

We could borrow unlimited amounts of money in US

2.

We could deposit unlimited amounts of money in India

3.

There is no cost of transaction, no taxes

4.

Easy movement of currency between countries

5.

Most importantly we assumed the conversion rate stayed flat at 67 after 1 year
Given that such arbitrage cannot exist for long, the currency rate a year later should be
such that it would prohibit the arbitrage to exist. In other words,
The money we receive from India a year later = Money we repay to banks in US a year
later
From the example we discussed above, we borrowed $10,000 from US, invested the
same in India and a year later we received Rs.716,900/-.
For the arbitrage to NOT exist, at the end of 1 year, Rs.716,900/- should be equal to
$10,050.
This means the conversion rate should be
716900/10050
= 71.33
This is called the Forward Premia in the currency world. The approximate formula to
calculate the Forward Premia is
F = S * ( 1+ Roc * N) / (1 + Rbc * N)
Where,
F = Future Rate
S = Todays spot rate
N = Period in years

Roc = Interest rate in quotation currency

Rbc = Interest rate in base currency
Lets apply this formula to check if we get the forward rate right for the above situation.
Remember the spot rate is 67,
F = 67*(1+7%*1) / (1+0.5%*1)
= 71.33
Further, note that the forward premia rate is approximately equal to the spot rate plus
spot times the difference in interest rate i.e.
F = S*(1+difference in interest rates)
= 67*(1+ 7% 0.5%)
= 67*(1+6.5%)
= 71.35
This is called the Interest rate parity.
Think about this Indian Rupees is trading at 67 today compared to 71.35 in the future,
therefore the Rupee is considered to be at a discount now. Generally speaking, the
future value of any currency which has a higher interest rate is at a discount to a
currency which has a lower interest rate.
So why are we discussing all this and what is the relevance to currency trading? Well,
the forward premia plays an important role in determining the futures price!
We will discuss more on this going forward.

Key takeaways from this chapter

1.

Events like Brexit tend to have extra ordinary influence on currencies

2.

A country whose economy is expected to suffer tends to have a weaker currency

3.

Forward premia is the expected spot rate over a given period

4.

Forward premia = S * ( 1+ Roc * N) / (1 + Rbc * N)

5.

Interest Rate parity indicated that the forward premia is approximately equal to
the spot rate plus spot times the difference in interest rate

6.

Future value of any currency which has a higher interest rate is at a discount to a
currency which has a lower interest rate

CHAPTER 4

The USD INR pair

4.1 The contract
We make an extremely critical assumption at this stage we will assume you are
familiar with how Future and Option contracts work.
Technical Analysis plays an important role in setting up short term currency trades, so
well assume you know Technical Analysis as well.
If you are not familiar with these topics, then Id strongly suggest you to read through
these modules before proceeding further. The currency and commodities market is
largely a Futures market; hence a working knowledge of these derivative instruments is
the key.
Now, assuming you understand these concepts fairly well, let us begin by slicing and
dicing the USD INR futures contract. The contract specification of the USD INR futures
gives us insights on the trade logistics.
Here are the salient features of the USD INR pair
Particular

Details

Remark

Lot Size

$1,000

In equity derivatives, lot is

number of shares, but here its a
dollar amount

Underlying
Tick Size
Trading Hours
Expiry Cycle

The rate of Indian Rupee against 1 USD

0.25 Paise or in Rupee terms INR 0.0025
Monday to Friday between 9:00 AM to 5:00 PM
Upto 12 month contracts
Note, equity derivatives have an

Last trading day

Contracts trades till 12:30 PM, 2 days prior to

the last working day

Final Settlement
day
Margin

Last working day of the month

Settlement Price

RBI Reference rate on the day of Final

settlement

SPAN + Exposure

expiry upto 3 months

Equity derivatives continue to
trade till 3:30 PM of the expiry
day

Usually SAPN is about 1.5%, and

exposure is around 1%, hence
roughly about 2.5% is the overall
margin requirement
Closing price of spot

To give you a sense of how this works, lets take an example

This is the 15 minute chart of the USD INR pair, as you can see the encircled candle
has formed a bearish Marubuzo. One can initiate a short trade based on this, keeping
the high of the Marubuzo as the stoploss.

Note that Im not trying to justify a trade here, my objective is to showcase how the USD
INR contract works.
The trade details are as below
Date: 1st July 2016
Position Short
Entry 67.6900
SL 67.7500
Number of lots to short 10
1 lot of USD INR = $ 1000
Contract value of 1 lot of USD INR = Lot size * price
=1000 * 67.7000
=67,700
The margin required for this can be fetched from Zerodhas margin calculator; here is
the snapshot of the same.

As you can see, the margin required to initiate a fresh position in USD INR is about
Rs.1,524/-. Therefore on a contract size of 67700, this works out to
1525/67700
= 2.251%
Out of this, Im guessing about 1.5% would be SAPN margin requirement (read as
minimum margin required as per exchange) and the rest as exposure margin.
Further, the idea is to short 10 lots, hence total margin required is
10 * 1525
= 15,250/A point to note here when trading equity futures, one has to earmark anywhere
between 15% and 65% of the contract value as margins, this obviously varies from

stock to stock. In contrast to equities, the margin charged in currencies is way lower.
This should give you a sense of how leveraged currency trading really is.
On the other hand, currency sticks to a tight trading range compared to equities. Hence
higher leverage.

4.2 The contract logistics

Notice how the currency futures are quoted they go upto the 4 th decimal digit. There is
a reason for this when it comes to currency futures, a number as small as this
0.0025 is considered big.
When RBI states the reference rate, they quote upto the 4 th decimal. Even a minor
difference at the 4th decimal can alter the foreign reserves by a large degree. In fact it is
a norm world over to quote the currency to 4th decimal in case of USD INR this is
0.0025. This is called the tick size or in currency parlance, a pip. A pip/tick is the
minimum number of points by which a currency can move.
So when the USD INR moved from 67.9000 to 67.9025, it is said that the currency has
moved up by a pip.
How much money would you make per pip in the USD INR pair? Well, this should be
easy to figure out
Lot Size * pip (tick size)
= 1000 * 0.0025
= 2.5
This means to say, for every pip or every tick movement you make Rs.2.5/-.
Going back to the short trade, here is how the Marubuzo panned out

After initiating the short, the currency pair declined 67.6000. If I choose to close this
position, he is how much I would make
Entry = 67.6900
CMP = 67.6000
Total number of points = 67.6900 67.6000 = 0.0900
Position Short
This could be a bit tricky, do pay attention. A pip as you know is the minimum number of
points the currency can move. To know how many pips a currency has moved when it
moved by 0.09 paise, we divide the total number of points moved by the pip size.
Number of pips = 0.0900/0.0025
= 36
As you can see the trade managed to capture 36 pips, et us now calculate how much
money one would make
Lot size * number of lots * number of pips * tick size

We know, Number of pips * tick size is as good as the total number of points caught
with this trade, therefore we can restate the above formula
Lot Size * Number of lots * total number of points
= 1000 * 10 * 0.0900
= 900
Remember this is an intraday trade. What if you were to carry this forward to expiry?
Well, we can carry this forward as long as we maintain the adequate margin
requirements. The July contract will stay in series 2 days prior to the last working day of
the month.
Here is the calendar

So 29th July happens to be the last working day of the month, hence 27 th July will be the
expiry of this series. In fact you can hold the contract only till 12:30 PM on 27 th July.
Of course you can always look at the contract to see the exact date of the expiry.
Another question at this stage at what price will the settlement happen?
The settlement will happen at the RBI reference rate set for 27 th July, and it is important
to note that the P&L will be settled in INR.
So for example if I hold this position till 12:30 PM on 27 th July and let it expiry, assume
the price is 67.4000, then Id stand to make
= 1000 * 0.29 * 10
=2900/-

And this money will be credited to my trading account on 28 th July 2016. Needless to
say as long as you hold the contract, your position will be marked to market (M2M). This
is similar to the way it works for equity futures.
Hopefully this example should give you a sense of how the logistics for the currency
futures work.
Let us quickly run through the USDINR options contract.

4.3 USD INR options contract

Let us have a look at how the USDINR option contract is structured. You may be
interested to know that the option contract is made available only for the USD INR pair.
Hopefully going forward we could see option contracts on other currency pairs as well.
While most of the parameters are similar to the future contract, there are few features
specific to option contracts.
Option expiry style European
Premium Quoted in INR
Contract cycle While the future contracts are available for 12 months forward, the
option contracts are available just 3 months forward. This is similar to equity derivatives.
So, since we are in July, contracts are available for July, August, and September.
Strikes available 12 In the Money, 12 Out of the Money, and 1 Near the money
option. So this is roughly 25 strikes available for you to pick and choose from. Of

course, more options are added based on how the market behaves. Strikes are
available at every 0.25 paisa intervals.
Settlement Settled in INR based on the settlement price (RBI reference rate on expiry
date).
Lets have a look at the USD INR option contract and figure out the logistics. Have a
look at the following image

From the option quote, we know the following

Option type Call option
Strike 67.0000
Spot price (see RBI reference rate) 67.1848
Expiry Date 27th July 2016

Position Long
Premium 0.7400 (quoted in INR)
We know the lot size is $1000, although the lot size has not been mentioned in the
quote above. Usually this information is made available in the quote for equity
derivatives. So if you are seeing this for the first time, just be aware that the lot size is
$1000.
Now, if you were to buy this option, what would be the premium outlay? Well, this is
fairly easy to calculate
Premium to be paid = lot size * premium
= 1000 * 0.7400
= 740
The option contract works similar to the equity derivative contracts. Here is an another
snapshot I captured

As you can see, the premium has shot up, and I can choose to close my trade right
away. If I did, here is how much I would make
= 1000 * 0.7750
=775
This translated to a profit of 775 740 = 35 per lot.
What if you were to sell/write this option instead? Well, you know that option selling
requires you to deposit margins. You can use Zerodhas F&O Margin calculator to get
an estimate on the margin required.
Have a look at the snapshot below, Ive used the calculator to identify the margin
required to write (short) this option

As you can see, the margin required is Rs.2,390/-.

I hope this chapter has gives you a basic sense of how the USD INR contracts are
designed. In the next chapter, we will try and discuss some quantitative aspects of the
USD INR pair, and perhaps look at the contract specification of other currency pairs.

Key takeaways from this chapter

The contract specification specs out the logistics of the USD INR derivative.

Lot size is fixed to $1,000 but this can be changed by the exchange anytime.

Expiry of the USD INR contract is 2 days prior to the last working day of the
month. The contract can be held/traded till 12:30 PM.

Margins applicable = SPAN + Exposure, usually the margins add upto 2.25
2.5%.

Currency pairs are quoted upto the 4th decimal place.

A pip is the minimum price moment allowed in a currency.

Currency options are European in nature.

The premium quoted in currency options is in INR.

Strikes are available at every 25 paisa price difference.

Margins are blocked when you intend to write currency options.