FUNCTIONS OF EURO CURRENCY MARKETS. 1.Cheap resource of working capital.

Euro currency loans attract lesser interest than the loans of the domestic economy. Interest rates are lowest because overhead costs are lower. Since the dealings are between banks with good credit rating, the costs of credit checking and processing are less. The lending rates can thus, be fixed lower than the domestic market. Similarly, it is possible to fix deposit rates higher than in the domestic markets. 2. Liquidity The financial institutions find it highly profitable to hold their idle resources in Euromarkets. Since there are lesser restrictions in the markets, the investors can make investments in bearer securities. It has an added advantage in the form of absence of tax withholding on interest, Most of these deposits have maturities ranging from less than one day to a few months. On an average, about 80% of these deposits have the maturity of 6 months. 3. Facilities of International Trade. They provide easy loans which facilitate International Trade. Most of the Banks prefer this form of financing to the traditional forms like the letter of credit (LC). Much of the preference for Euro Currencies arise from the lower interest rates and the absence of emphasis on procedural formalities. Considering the attractiveness of these funds, there has been a sizable increase in the volume of transactions in these markets. 4. Euro Debt Markets These markets can be studied under 2 broad classifications (a) Euro Dollar loans and (b) Euro bond markets. 4(a). Euro Dollar Loans The demand for Euro Dollar loans was pushed up during 1960, indirectly by the restriction imposed in obtaining loans within the U.S. These restrictions were the result of a voluntary restraint programme adopted in 1965. It was followed by certain mandatory controls in 1968. These structures controlled the creation of loans within the U.S. Borrowers are, therefore, forced to look for funds outside the U.S. The Euro Dollar loans provided the much needed alternate source of funds. From 1963 to 1974, The U.S. Interest Equalization Tax was in vogue. The tax was a levy on U.S. residents earnings on foreign securities. To equalize the expenditure to a U.S. resident lender on account of the levy, the foreign borrowers were forced to offer higher interest. Euro Dollar loans did not attract the interest equilisation as a result the interest rates offered were much lower. Euro currency loans, irrespective of the currency in which it is denominated, are easier to obtain as compared to the loans denominated in home currencies since it is also possible to obtain a loan of any currency within a country (e,g, Pound, Mark, Yen etc.,) in New York itself, it is easier for the borrowers to borrow locally than to approach the home market of a currency individually (i.e., Pounds in London, Marks in Germany, Yen in Tokyo etc.,) 4(b). Euro Bonds. These bonds are of more recent origin. They are unsecured bearer debt instruments with maturity of 5 years or more. The bond is sold in the markets other than those in the country in whose currency it is issued. Since Euro Bonds are not regulated strictly, their issue costs are lower than those of domestic issues. As such they had become an excellent source of raising long term capital. The issue of the

bonds is generally made simultaneously in several markets on behalf of international borrowers by syndicates.

OTHER TYPES OF EURO CURRENCY INSTRUMENTS

a).Bank Deposits These are conventional deposits of Euro currencies in Banks. Usually the period of maturity is either 30 days or 90 days. They are seldom made for periods longer than 90 days. Interest rates are pre fixed on the basis of the duration of the deposit. b) SDR denominated Deposits. Euro Currency deposits may be denominated in Special Drawing Rights (SDR) of the International Monetary Fund. They are non negotiable deposits with specific maturity dates. They are, however, not as popular as Euro currency Deposits. c) Certificates of Deposits (CDs) They are negotiable instruments, actively traded in the secondary markets. They are not term deposits, they offer a highest rate of liquidity. d). International Banking Facility These are separate set of accounts with a Bank. They can accept foreign currency deposits. If used to make loans to foreigners, they do not require insurance covers. In such cases, the reserve requirements too are waived. Withdrawals can be made offer giving 2 days notice. e). Euro Dollar Futures When the assets and liabilities of Euro banks are not equal in terms of volume and maturity, they are subject to risks of exchange rate fluctuations. Euro Dollar Futures market helps Euro Banks to avoid much risks by making a future sales

. CURRENCY OPTIONS A currency option is an arrangement between an option holder and an Option writer The option holder is the buyer and the option writer is the seller of an option. A currency option gives the buyer the right, but not the obligation, to either buy or sell a specified quantity of one currency in exchange for another at a pre determined exchange rate, known as the strike price. However, the option to buy or sell must be exercised on or before a specified expiry date. Though the holder has no obligation to increase an option, the writer of the option must comply with its terms and should be prepared to buy or sell the underlying currency when a holder decides to exercise and option. Now, in what follows, a brief description is provided on the salient features of the currency option. FEATURES OF CURRENCY OPTION

Currency options are of 2 types, viz, (1) Over The Counter (OTC) options and (2) Exchange Traded Options, (OTC) options can be arranged individually with a Bank, whereas the Exchange Traded option can be purchased through a broker on options exchange such as The philedelphia stock Exchange (PHLX), Chicago Mercantile Exchange (CME) etc., CALL OPTION Vs PUT OPTION A call option gives its holder the right but not the obligation, to buy the specified amount or quantity of a currency usually against the U.S.$ at the strike price. On the other hand, a put option given its holder the right to U.S.$ QUANTITY OF CURRENCY The option agreement specifies the Quantity of currency an option buyer can purchase or sell. In the case of Exchange Trade options, the quantity is a standard amount. For example, on PHLX, the currency options traded are, currently restricted to the following against the U.S.Dollars. Option Quantity Pound Sterling 31,250 Australian Dollar A$50,000 Canadian Dollar C$50,000 Japanese Yen 6,250,000 Strike Price of the Currency. The Exchange Rate at which the holder has the right, but not the obligation, to exchange the currencies. When an option is the strike price must be higher, or lower or exactly the same as the current spot rate. Thus a strike price could be (1) at the money (2) in the money and (3) out of the money. At the - money - option An option whose strikes price is the same as the current market exchange rate. An at the money option would be used by a customer who wants to guarantee todays rate while allowing himself some profit potential, if the exchange rates were to move in his favour. In the money - option A currency option whose strike rate is more favourable than the current spot rate. Normally this type of option would attract a high premium, as the holder can make an immediate exchange profit. By exercising his right. Expiry Date The date on which the right to exercise the option ends. American and European option: An American option can be exercised on or before its expiry date, for example: a 3 months American option purchased on January 1st can be exercised on any day on or before the expiry date i.e. on 1st April, European option, on the other hand, can be exercised only an the expiry date. For instance, in the above example, if it were to be a European option, it can be exercised only on the expiry date i.e. 1st of April. American options are preferred when the holder is uncertain about the exact date of an underlying transaction for which the option is being used as a hedge, for example, if a U.K. company expects to receive $ 1 Million between the end of March and at the end of April, which it will then, sell for sterling, if it could arrange an American OTC put option with a Bank to sell $

at any time upto 30th April, so that the option can be exercised as soon the $ are received. Whereas with a European option the company would have to wait until 30th April, regardless of when the $ are received, if it wished to exercise the option. If the currency options are bought to hedge an exposure in a particular currency, the buyer must feel at the risk of reduction justifies the premium to be paid, an option is preferred to the other alternatives of hedging such as futures, forward exchange Control act. In general, the option route is a desirable method of hedging a currency exposure for a buyer, who can lock in a worst possible exchange rate to avoid the risk of an adverse rate movement and at the same time benefit from any favourable movement in the rate by choosing to allow the option to lapse and buy or sell in the spot market. Currency option versus forward contracts: Forward exchange contracts, are widely used for hedging a currency exposure as they enable a company to lock in a rate which is acceptable to the company for a future currency transaction. Currency options could also be used for the same purpose. It would be possible to buy a currency option with a strike price equal to the currently available rate for a forward contract, so that the option holder would secure an exchange rate that is at worst, the same as the forward rate. However, the advantage of a currency option have a forward exchange contract lies in the fact that the option holder has the choice not to exercise the option and instead transact at the spot rate, if the rate movement is in his favour. Limitation of option: (1) Regular use of option involves high premium costs. The buyer of an option must be satisfied that these costs justify the risk that is being hedged. (2) Only a limited number of currencies are available in traded options. The trading centres are also limited in number. Currency Futures A currency future is a contract for the purchase or sale of a standard quantity of one currency in exchange for another currency at a specified exchange rate, to be delivered at a specified future time. Normally the maturity dates of currency futures are 10th March, 10th June, 10th September and 10th December. These are bought and sold on a future exchange at the stock exchange. Trading in currency futures began on 16th May 1972 at the International Monetary Market (IMM) which is a division of Chicago Mercantile Exchange (CCME). Most of the currency futures are for a major currency against the U.S. $. The currency futures contracts that are traded on the CME are in sterling (), Deustch Marks (DM) Japanese Yen () swiss Francs (sFr) French Francs (FFr) Canadian Dollars (C$) and EcUs. The exchange provides 3 essential elements. 1. An efficient central market which brings together differing view points of future values. 2. An open market available to all participants including inter-bank foreign exchange dealers and 3. A market that eliminates certain credit risks. The clearing house acts as the seller to every buyer and as a buyer to every seller in each futures transaction.

SWAPS: A swap is an arrangement between 2 parties for the exchange of a stream of cash flows over a specified term. The Currency swaps involve the exchange of a stream of cash flow in one currency for a stream of cash flows in another currency. The swap market can be said to date from 1981, the year in which IBM and world Bank effected a swap transaction. There are many types of swaps such as Currency swaps, Interest Rate Swaps etc. All these swaps work on the principle that different institutions have different comparative advantages, and that as a result, there can be gains from any 2 institutions trading with each other, Now, we will discuss in detail about the currency swaps and interest rate swaps. Currency swaps These are the agreements to exchange payments in one currency for these in another. The structure of a currency swap in similar to a forward contract or futures contract in foreign exchange, most of these swaps involve the U.S. $ on one side of the transaction, However, direct currency combination like the D.M. & Y are also gaining importance. A currency swap normally consists of the following 3 elements. 1. There is an exchange of principal at the beginning of the swap. One party exchanges one currency for another currency at an agreed rate of exchange. 2. At regular intervals, normally 6 monthly or annually, there is an exchange of payments. It is convenient to think of these as interest payments on the swapped amount of principal. But it must be remembered that swaps are not loans. The amount to be exchanged by each party is calculated as a Swap Rate on the amount of principal exchanged. This might be fixed rate or floating rate. 3. At the end of the term of the swap, there is a re-exchange of the principal amounts with each party repaying the currency that was received at the start of the swap period. The rate of exchange is therefore exactly the same as for the initial exchange of principal. Interest Rate Swaps An interest rate swap is an agreement between 2 parties to exchange fixed interest rate payments for floating interest rate payment or vice versa in the same currency, calculated with reference to an agreed national amount of principal. The principal amount which is equivalent to the value of the underlying assets or liabilities that are swapped is never physically exchanged but is used merely to calculate interest payments. The purpose of the swap is to transform a fixed rate liability into a floating rate liability and vice versa. The floating rate that is used in most swaps is calculated with reference to London Inter Bank Offer Rate (LIBOR). Interest rate swaps have a similar structure to interest rate futures in the sense that the terms of the future obligations under the swap are determined today. The motive underlying an interest swap is to exploit a comparative advantage and to make a gain from the swap.