Indian Foreign Exchange Market is a decentralised multiple dealership market having two major segments:
- the Spot and Forward market
- the Exchange traded Derivatives market
Players in the Forex Exchange market use different instruments and look for different maturities in the market. Some of the instruments in the exchange market are cash, tom, spot, forward, futures, swaps and options.
The Spot Market:
Spot market refers to mode where buyers and sellers undertake transactions for immediate delivery. Spot transaction can be explained such as one going to a bank to buy some currency, rates charged by the bank are spot rates for selling the desired currency.
In such cases, the spot rates are quoted by the buyers and sellers. The ‘immediate delivery can go up to maximum of 2 working days.
In forex market, the trade date is the day on which both parties agree to buy and sell the currencies. The settlement date/value date is the day on which funds are actually transferred between the buyer and seller. On settlement/value date, the buying or selling actions will be realized by settlement of payment and receipt.
In the above example of one going to bank, trade date and settlement date coincide. Similarly, the interbank market, banks and financial institutions buy and sell currencies at a rate present on the trade date. However, the actual settlement for the agreed amount may take place on T+1 or latest by T+2 days.
In India, the spot transactions can be classified into various types depending upon the gap between trade and value date, spot forex trading can either be categorized as cash, tom or spot transaction.
- Ready/cash transaction: The transaction is settled on the same day. The transaction is undertaken at cash rate. It is different from spot rate which shows the rate for transactions taking place today and being settled on the second working day. Cash rate is generally lower than spot rate. The Cash-Spot market is largely a high-volume interbank market as it is based upon banks borrowing in one currency and lending in the other, usually to meet overnight reserve requirements. Thus, the Cash-Spot Difference depends on the difference between the Overnight or Call rates between the two currencies concerned.
- Tom transactions: It refers to those transaction in which the settlement happens next working day of trade date so it is T(Trade date) + 1-working day (please remember it is one ‘working day’). For example, the trade date happens on Friday and Saturday and Sunday are not working day then the settlement date will be Monday.
- Spot transactions refer to those transactions which take place on 2nd working date of trade date i.e T+2. They happen at spot rates.
The Cash-Spot and Cash-Tom rates are quoted on most forex rate services such as Reuters, Bloomberg, Newswire 18 etc.
An important concept on this is Roll over of Tom/spot contract. This happens as when the settlement does not take place on the designated date i.e T+1 or T+2. Since, most of the foreign traders are speculators, their intention is neither to buy nor to sell currency but rather extract profits with this dealing. Thus forex brokers allow the traders to have rollover contracts. Rollover delays the actual settlement of the trade and it goes on until the trader closes its position. Traders are required to pay interest to forex brokers to defer the settlement.
Forward Forex Transactions
In a forward contract both parties enter into a contract on a given day and lock in a fixed rate on specific future date for settlement.
In such types of contract, the terms of the purchase (buy or sell) are agreed up front (trade execution date) but actual exchange take place on a date in the future (maturity date). On the maturity date, both parties exchange the pre-agreed rate.
For example, an Indian company which is likely to earn foreign currency i.e, USD on account of an export order after one month, may enter into a contract today ( trade execution date) to sell USD and receive Indian Rupees after 1 month ( maturity date). The rate is fixed on the trade date and the rate is known as Fwd- 1 month rate.
Forward contracts can be many types depending on the rigidness associated with the maturity date. In a Fixed Maturity Contract, the maturity date is fixed. The payment and receipt happens on the maturity date. Partially Optional Contracts provide some flexibility. In such type of contract, there are three dates, trade execution date, option start date and maturity
Forex Futures Contract
An exchange traded forward contract is known as futures contract. Forward contracts are customised depending on the requirement of the contract buyers or sellers. As they are exchange traded, futures contracts are standardized – contract size, maturity period etc. Being exchange traded, futures contract can be squared off easily which may not be possible in case of forward contract.
In case of futures contract, the clearing house associated with exchange takes the counterparty risk – risk that the loss making party does not deliver during the maturity period. Traders also have to pay margins – initial and daily margin as exchanges require all traders to pay margin.
In India, forex futures contracts on INR/US$, INR/Euro, INR/Pound Sterling and INR/Japanese Yen are traded at some Indian exchanges like National Stock Exchange and United Stock Exchange.
Currency derivative of various types are traded in forex market. Currency derivatives are exchange-based futures and options contracts that allow one to hedge against currency movements.
In India, one can use such derivative contracts to hedge against currencies like Dollar, Euro, U.K. pound and Yen. Corporates, especially those with a significant exposure to imports or exports, use these contracts to hedge against their exposure to a certain currency.
The two national-level stock exchanges, BSE and the National Stock Exchange (NSE), have currency derivatives segments. The Metropolitan Stock Exchange of India (MSEI) also has such a segment but the volumes are a fraction of that witnessed on the BSE or the NSE. One can trade in currency derivatives through brokers. Incidentally, all the leading stock brokers offer currency trading services too.
It is just like trading in equity or equity derivatives segment and can be done through the trading app of the broker. While a dollar-rupee contract size is $1,000, one can trade by just providing the 2-3% margin.
Prior to the introduction of currency derivatives on exchanges, there was only the OTC – over the counter – market to hedge currency risks and where forward contracts were negotiated and entered into. It was kind of an opaque and closed market where mostly banks and financial institutions traded. Exchange-based currency derivatives segment is a regulated and transparent market that can be used by small businesses and even individuals to hedge their currency risks.
Read about Structure of Indian Forex Market