There are several factors which affect the exchange rate. Over the years researchers have come up with various relationships to structure exchange rate movement. But, we need to understand that prediction of the exact exchange rate movement is practically impossible. Another important thing to remember that the relationships tentatively hold in stable markets. During international market distress, rationality is often abandoned due to panic and exchange rates may not follow any relationships.
PURCHASING POWER PARITY (PPP)
The effect of relative inflation on the exchange rate is formalised as the Purchasing Power Parity (PPP) Theory. The PPP theory is based on Law of One Price which states that the price of one good, asset, security etc. should be the same in two economies when currency exchange rates are taken into consideration.
1. Absolute PPP theory
Exchange Rate of Currency = (Wt. Avg Price of basket of goods in price currency) / ( Wt. Avg Price of basket of goods in base currency)
The USD / INR exchange rate, according to Absolute PPP is the ratio of the weighted average price of a basket of goods in India in INR and the weighted average price of the same basket of goods in America in USD.
You can easily calculate that Absolute PPP does not hold in reality. The reason is that the internal logic behind the Absolute PPP is an arbitrage opportunity. It assumes that when the relative price between the two economies vary, start traders can buy from one economy and sell in the other economy. In reality, there are frictions such as tariffs, transportation costs, taxes an duties etc which makes arbitrage expensive if not impossible.
2. Relative PPP theory
Changes in Exchange Rate of Currency = Changes in (Wt. Avg Price of basket of goods in price currency) / ( Wt. Avg Price of basket of goods in base currency)
So, the Relative PPP theory says that the movement in the exchange rate is based on the movement in the relative prices. The changes in the relative prices are caused by inflation. Consider the example of the exchange rate of USD / INR. According to Relative PPP, the exchange rate should increase when the Inflation in India (INR is the price currency) is higher than the US (USD is the base currency). Note that an increase in the USD / INR exchange rate means depreciation of INR in terms of USD.
So, the higher relative inflation causes the currency to depreciate at least in the short term. Prolonged higher inflation causes the central bank to increase the interest which may cause the currency to appreciate.
To be continued...
There are different facets of currency – it is the unit of money, the medium of exchange, can be an asset class for investment.
A currency may play a role as “reserve currency” by central banks, “transaction currency” for international currency markets, “invoice currency” for contracts and “intervention currency” for market operational by central banks.
At its core, Foreign Exchange means exchanging one currency for another. The primary reason for foreign exchange is international trade. Say, you are an Indian student who is studying in the USA. You took a loan from an Indian bank for paying for the fees and your lifestyle costs. Now, the US institution will not accept Indian Rupees, neither the merchants in the US will sell you stuff in exchange for the Indian rupees. So, you need to get US Dollars in exchange for Indian Rupees. This is the primary purpose foreign exchange serves.
As trading in Foreign Exchange is basically buying a currency by paying in terms of other currency. The price of a physical good or security in a domestic market is defined in terms of a single currency. For example, a pen for Rs. 20.
Now, say you have to buy US dollars. But, how do you pay for that? Currency trading is done using currency pairs. Some popular currency pairs are EUR/ USD, GBP / USD, USD / JPY etc.
BASE AND QUOTE CURRENCY
In the above example of buying USD using INR (Rupees), the USD is the base currency and the INR is the quote currency. So, if currently, USD is selling for Rs.71.3400 then the (ask) quote is shown as USD / INR = 71.3400.
BID AND ASK FOR FOREX
As in the case of trading securities in the exchanges, Bid and Ask prices exist in case of the Forex market as well. The bid price is the price at which the market is willing to buy and Ask (or Offer) price is the price at which the market is willing to sell. The Ask price is slightly higher than the Bid price. The difference between the Bid-Ask price is called the Bid-Ask spread which is the compensation for the market makers.
For example, if the EUR / USD Bid price is 1.1293 and the Ask price is 1.1297 the Bid-Ask spread is 0.0004.
Quotes for all currency pairs are not readily available. In such a case, the quote is derived from the available currency pair quotes.
Consider, you need the quotes for EUR / INR i.e. we need EUR in terms of INR. But, it is not available in the market. The quotes for EUR / USD is 1.1293 1.1297 (Bid and Ask price). The same for USD / INR is 71.3200 71.3400.
Now, we can get USD selling INR and then EUR selling USD.
In case of a buy order:
The USD / INR Ask price is 71.3400. So, Rs. 71.3400 for 1 USD can be procured. But, the Ask price of EUR / USD is 1.1297. So, to get 1 EUR we need $1.1297 USD. To get $1.1297 USD, we need Rs. 71.3400 X 1.1297 = Rs. 80.5928.
So, the Cross Ask Rate for EUR / INR is 80.5928.
Similarly, the Cross Bid Rate (for sell order) for EUR / INR is = 71.3200 X 1.1293 = 80.5417
There are various costs (apart from the cost of the security) when we trade in the securities markets. These costs can be broadly classified into two groups – ‘Explicit Costs’ which are visible to the traders and appear on transaction documents, ‘Implicit Costs’ which are not visible to the traders.
1. Transaction costs / Usage Costs
These are the costs involved in using the infrastructures of the brokers, stock exchanges, and depositories etc. service providers. Brokers charge brokerage, exchanges charge exchange transaction charges, depository participants pass on the charges by the depositories.
These costs vary from broker to broker and by stock exchanges. The maximum costs are limited by regulations.
2. Statutory Charges
These charges are payable to the statutory authorities in form of Securities Transaction Tax (STT), Service Tax, Stamp Duty, and SEBI Turnover Fees, etc.
You can find these details about these fees and charges in the link provided below.
1. Bid-Ask Spread
A Bid price is a maximum price a buyer is willing to pay for a security.
An Ask price is the minimum price at which a seller is willing to sell a security.
So, an order is executed when the Bid price of the buyer matches the Ask price of the seller. Buyers are sellers do not directly deal with each other but with the market makers who buy securities from the sellers and sell securities to the buyers. Market makers can only make a profit when the price at which they buy the securities is lower than the price at which they sell. That is why the Ask price is higher than the Bid price for the same security. The difference between the best Ask price and best Bid price is called the Bid-Ask spread. The spread is generally dependent on the liquidity and volatility of the security. The spread tends to increase with lower liquidity and higher volatility.
Refer to the attached image. Consider this is the order book for a particular share at a point. Now, you want to buy 100 shares. The best (lowest) ask price is Rs. 6. So, you pay Rs.6 for each share ignoring other costs. Now, if you immediately sell those shares, you will be matched with the best (highest) Bid price of Rs. 5.51. Due to this round-trip, you lost Rs. 0.49 (Rs. 6 - Rs. 5.51) per share which is the Bid-Ask spread.
2. Impact Cost
The concept of Impact Cost is the extension of the concept of the Bid-Ask spread for larger transactions. We can see in the attached order book that the Bid-Ask spread is only limited to 1000 shares.
Consider that you want to do the same round-trip for 3000 shares. As the quantity for the best ask price (Rs. 6) is 2000, your buy order cannot be fulfiled with the best ask price and you will have to pay more for the rest 1000 shares (Rs. 6.12). The weighted average buying cost is Rs. 6.04.
Same goes with the sell order of 3000 shares. You will be matched with 1000 shares at Rs. 5.51, 1000 shares at Rs. 5.21 and 1000 shares at Rs. 5.01. The weighted average selling price is Rs. 5.24.
So, your loss due to the round trip increased to Rs. 0.8 (Rs. 6.04 - Rs. 5.24).
The Impact Cost is defined separately for the buy and sell orders. The calculation of the Impact Cost is based on the ideal price. What is the ideal price? Well, consider in an ideal world of infinite liquidity there is no bid-ask spread- what would the buy or sell price of the security. This can be calculated as the average of the best bid and best ask price. In our example, the Ideas Price is Rs. 5.76 ((Rs. 6 + Rs. 5.51)/2).
Now, to buy order of 3000 shares the actual cost is Rs. 6.04 which is 4.86% higher than the Ideal cost of Rs. 5.76. So, the Impact cost for the buy order of 3000 shares is 4.86%.
For a sell order of 3000 shares, the actual price is Rs. 5.24 which is 9.03% lower than the Ideal Price of Rs. 5.76. So, the Impact Cost for the sell order of 3000 shares is 9.03%.
Trading orders can be broadly classified into two groups – Time Condition based classification and Price Condition based classification. Below, we are showing the basic types. Order types can be various combinations of the types mentioned.
1. Day Order
A Day Order is valid until the end of the trading session of the day in which the order was placed.
2. Immediate or Cancel (IOC)
As the name suggests, an IOC order expires if it could not be placed fulfilled immediately.
3. Valid Till Cancelled (VTC)
A Valid Till Cancel or a Good Till Cancel order remains active till it is fulfilled or cancelled by the trader.
Before we discuss the order, let us take some time to introduce the concept of Bid and Ask price quotations.
A Bid price is a maximum price a buyer is willing to pay for a security.
An Ask price is the minimum price at which a seller is willing to sell a security.
So, an order is executed when the Bid price of the buyer matches the Ask price of the seller. Buyers are sellers do not directly deal with each other but with the market makers who buy securities from the sellers and sell securities to the buyers. Market makers can only make a profit when the price at which they buy the securities is lower than the price at which they sell. That is why the Ask price is higher than the Bid price for the same security. The difference between the best Ask price and best Bid price is called the Bid-Ask spread. The spread is generally dependent on the liquidity and volatility of the security. The spread tend to increase with lower liquidity and higher volatility.
Now, let us see some order types.
1. Limit Order
Limit Order is based on the prices specified by the traders. So, a limit buy order is only executed when the market ask price is equal to or lower than the limit price and a limit sell order is only fulfilled when the market bid price is equal to or higher than the limit price.
2. Market Order
A market order is fulfilled at the best possible price (market ask price for a buy order and market bid price for a sell order) when the order is placed. The trader does not need to specify any price.
3. Stop-Loss Order
Stop-Loss is a mechanism of triggering a market or limit order based on the price of a security. Consider, that you bought a security at Rs. 150 and expected that the price will go up. But, the price started going down. Now, you created a Stop-Loss sell order which triggers a market sell order when the market price reaches Rs. 100 and the security is sold at the best available market price.
Warrants give the buyer right but not obligation to buy (or sell) common stock of the company at a predefined price. In some respect, warrants are similar to the Call (Put) Options but there are some differences which we will talk about later in this post.
Like Options, Warrants are of two types – Call Warrants (right but not obligation to buy common stock) and Put Warrant (right but not obligation to sell common stock).
The fundamental concept of Warrants is similar to the Options. So, it gives the holder an option to buy (or sell) a certain number of common stocks at a predefined price (strike price) before a certain date. Obviously, a Call (Put) Warrant will be exercised only when the market price of the stock is higher than (or lower than) the strike price in.
Call Warrants are often issued along with debentures or preferred to sweeten the deal.
WARRANTS vs OPTIONS
1. Issued by the company itself
Options can be issued by anyone but Warrants are mandatorily issued by the company itself.
2. Dilution for current stakeholders
When a Call Option gets exercised the stocks which the holder gets were already issued by the company and traded in the secondary market (exchange). In the case of Call Warrant, the company needs to issues new stocks. This means that the Paid Up Capital of the company increases and the stakes of the current stockholders get diluted.
3. Longer trading cycle
Options are generally short term contracts (maximum 3 months). Even the Long Dated Options have a maximum of 3 years trading cycle.
Warrants can have much longer term even a decade or more.
WARRANTS vs CONVERTIBLE SECURITIES
Convertible Securities such as Convertible Debentures and Convertible Preferred Stock gives the option (can be mandatory, for example in case of Mandatorily Convertible Preferred Stock) to convert the security itself to common stock of the company. The securities have some intrinsic value before the conversion as well and the security holder may receive benefits. For example, the holders of Convertible Debentures may receive interest (coupon), the holders of Convertible Preferred Stocks may receive the dividend.
But, Warrants have no value in itself. The value of the Warrant is totally tied to the underlying stock. So, unless the market price of the underlying goes above the strike price, a Call Warrant is worthless. Similarly, a Put Warrant is worthless when the market price of the underlying is above the strike price.
Another important difference between Convertible Securities and a Warrant is that Warrants are often detachable from the Debenture or Bond it was issued with. If the holder of a Convertible Debenture sales the security, the option of the conversion also goes along with that. But, it is not the same in the case of a Warrant. The holder can sell the Debenture or the Warrant separately.
MARKET LINKED DEBENTURES (MLD)
MLDs are structured products with debt instruments which promise returns benchmarked to some market index or basket of stocks or commodities etc. with variable capital protection.
MLDs have a high minimum ticket size (Rs. 10 lakhs as per SEBI guidelines) and are illiquid products. They are issued for a fixed term of 1-4 years and difficult to transfer before the term completion.
MLDs are generally issued by Non-Banking Financial Companies (NBFCs) to raise funds. The capital protection is achieved with debt instruments and the market benchmarked return with derivatives.
WHO SHOULD INVEST IN THEM?
As the higher ticket size suggests, these products are suitable for High Net-worth Individuals looking for market-linked returns with capital protection and are comfortable with the lack of liquidity.
It is mentioned above that MLDs offer market benchmarked return but the extent of that is defined by the Participation. Consider an example of an MLD with 150% participation with the Sensex 30. So, if the Sensex rise by 20% during the term of the MLD, then the return from the MLD will be in the range of 30%.
1. Liquidity Risk
As mentioned before, MLDs offer very limited liquidity if at all any liquidity.
2. Market Risk
Depending on the extent of capital protection, MLDs can have significant market risk.
3. Credit/Default Risk
The investor needs to be aware of the credit risk associated with the issuers. MLDs are generally issued by NBFCs who may have significant credit risks. Choosing MLDs solely based on return (yield) may not be the best idea as the high yield may be linked with the high credit risk of the issuer.
NEW FUND OFFER (NFO)
A New Fund Offer or NFO is comparable to Initial Public Offering (IPO) of a company. In NFO an Asset Management Company (AMC) reaches out to the general investors with the units of a new scheme. NFO is offered for a limited period and the units are offered at a fixed price (generally Rs. 10 although there is a minimum subscription amount) in this period only. After the NFO, investors have to buy the units in the prevailing NAV.
AMCs launch NFO to arrange funds for buying securities of the scheme. Fundamentally, a scheme does not exist before the NFO from an operational point of view. This is where an NFO is different from an IPO. In case of most companies, the company operations exist before the IPO. So, it is possible to get information regarding the financial performance of a company before IPO. But, there is no performance data for a mutual fund scheme before the NFO.
In the case of Open-Ended funds, NFO is the beginning of a scheme. As Open-Ended funds do not limit the number of units issued, investors can purchase units during and after the NFO directly from the AMC through their brokers.
In case of Closed-Ended Funds, NFO is the only time the AMC sales units. The scheme gets listed on the exchange to provide liquidity to the investors.
Mutual Funds are regulated by SEBI (Mutual Funds) Regulation,1996. As per section 28 of this act, any scheme has to be approved by the trustees before launch and a copy of the NFO has to be submitted to SEBI.
Only if SEBI does not ask for any modifications in 21 working days, the AMC can launch the NFO.
SEBI Requires that the NFO document must contain enough information to facilitate the investors to make informed decisions (section 29).
The advertisement of the NFO is guided by section 30 and the Sixth Schedule (Advertisement Code) of the act. The advertisements cannot be misleading and exploitative of the inexperience of the investors. The advertisement must contain the Investment Objective of the scheme.
HOW TO KNOW ABOUT NFO?
An investor may know about the current active NFO from the AMFI website. Find the link below
Other than that, every AMC lists the NFOs on their websites.
For example, SBI - https://www.sbimf.com/en-us/new-fund-offer
ICICI Prudential - https://www.icicipruamc.com/icici-prudential-mutual-fund/NFO.aspx
You can invest in the NFO directly through the AMC website.
There are various fees and charges credit card companies charge the credit card holders. Unfortunately, most credit card holders do not even know that those charges exist or are not aware of the true implication of those charges. Even the interest period calculation methods can be different.
Credit card holder must read the Most Important Terms and Conditions (MITC) Documents with the ‘Schedule of Charges’ thoroughly before signing for the credit card. There are links to MITC document of some credit card companies at the end of this post.
COMMON FEES AND CHARGES
1. Joining Fee
One time fee at the time of availing the credit card. Most companies do not charge this fee.
2. Annual Fees / Renewal Fee
As the name suggests, this is the annual fees for holding the credit card membership. This fee is generally applicable for premium credit cards and often waived off if the annual usage of the credit card is above a certain limit.
Often credit card companies attract customer by giving “free” credit cards. Be careful about what “free” means. Generally, the annual fee for the first year along with the joining fee may be waived off but you may be charged annual fee from the 2nd year.
3. Cash-Advance Fees
First of all, what is cash-advance? Cash advance is withdrawing money using credit from ATM instead of paying a merchant with a credit card. Understanding what constitutes cash-advance is immensely important not only because of the cash-advance fee but also because cash-advances do not have any ‘interest-free period’ or ‘grace period’. The credit card company may also charge a higher interest rate of the cash advances.
Credit card companies charge a flat fee and/or a percentage of the amount withdrawn on the cash-advances.
4. Late Payment Charge
This is a flat charge is applicable if the Minimum Amount Due (MAD) is not paid and the amount depends on the statement balance.
5. Finance Cost / Interest
This is the interest charge on outstanding amounts. Interest is payable in case of regular transactions (with a merchant) if the total amount due is not paid back by the payment due date. In the case of cash-advance, the interest calculation starts from the transaction date.
Interest is calculated according to the following formula
Interest = (Outstanding Amount x Monthly Rate x Interest Period in days x 12) / 365
Here, the monthly rate depends is generally known. Be careful about how the Interest Period is calculated. An important point to remember that in case of non-payment of dues by the due date, credit card companies may calculate the interest on regular transactions from the transaction date – not from the payment due date or statement date.
Refer to the MITC of ICICI Bank (link provided below) and refer to the sample calculation of interest for Gold Card on page 6. In this sample calculation, the billing date is the 15th of every month and payment due date for a statement on 15th April 2009 is May 3rd. Notice that for calculation of interest for Rs. 2000 transaction on April 10th the interest period starts from April 10th, not April 15th
The interest for the Rs. 2000 from transaction date April 10th to the bill payment of Rs. 1500 on May 10th with 3.4% monthly rate (40.8% / 12months)
= (Rs. 2000 x 3.4% x 30 days x 12) / 365
= Rs. 67.07
We have seen an example of an interest period starting from the transaction date. We can now see an example of an interest period starting from the statement date. Refer to the MITC of HDFC Bank, page 2. In the sample calculations, the statement date is the 18th of a month. The interest for the Rs. 1,5000 dated 10th of April, is calculated for the period starting 19th April (the day after the statement date) and not the transaction date itself.
The interest for the Rs. 1,5000 dated 10th of April, calculated based on interest period from 19th April (the day after the statement date) to 11th May (the day before the bill payment of Rs. 2000), at a 3.49% monthly rate
= (Rs. 15,000 x 3.49% x 23 days x 12) /365
= Rs. 395.85
Note: The assumption in both cases is that all the previous outstanding balance was paid in full.
The point is that interest period calculations may vary significantly from one credit card to another. People generally compare the credit cards based on the interest rate but they must also understand how the interest periods may differ. Read the MITC document thoroughly.
In case there is some amount outstanding, the interest on all new transactions is calculated from the transaction dates.
6. Over-limit Charge
For each type of credit card, there is a maximum account balance. The cardholder will be charged Over-Limit Charges if the account balance is higher than the limit (even by Rs. 1). Companies generally charge Rs. 500 or 2.5% of the over-limit amount whichever is higher.
7. Foreign currency transactions
The credit card company may charge up to 3.5% markup for the foreign currency transactions. This fee is over and above the currency conversion fee. The currency conversion fee is not charged by the credit card issuer but by the payment procession (Mastercard, VISA etc.) which is in the range of 1%. So, it is advisable not to use a domestic credit card, which does charge foreign currency markup, to make payments using foreign currencies, because they are too expensive.
8. Payment Processing charges
There are a number of charges associated with just making payment to the credit card account. Some examples are, Payment Return Charge which is charged if you try to pay the credit card balance with insufficient balance, Cash Processing Fee which is charged in case of payment of credit card bill with cash at a bank or ATM etc.
9. Other Charges
Depending on the credit card, there can be a plethora or other fees and charges such as Reward Redemption Charges, Balance Transfer Processing Charges, Fuel Transaction Surcharge, Railway Ticket Purchase Fee, etc. Ask for all the relevant charges before getting the credit card.
10. Goods and Services Tax (GST)
All fees, charges and finance costs attract GST.
BASIC INTEREST RATE CONCEPTS
1. Annual Percentage Rate (APR)
This is also called the Quoted Rate. So, when a bank says that they will charge X% on a loan or on your credit card, they are talking about APR.
2. Effective Annual Rate (EAR)
This is the actual interest rate you pay on an annual basis in any kind of loan. EAR depends on the compounding interval which can be daily, monthly or quarterly.
So, if the creditor uses a monthly compounding the EAR would be
= (( 1+ (APR / 12)) ^ (12)) - 1
So, if the quoted rate is 33%, the EAR based on monthly-compounding is
= (( 1+ (33% / 12)) ^ (12)) - 1
In the case of daily compounding, the EAR would be
= (( 1+ (APR / 365)) ^ (365)) - 1
So, if the quoted rate is 33%, the EAR based on monthly compounding is
= (( 1+ (33% / 365)) ^ (365)) – 1
3. Monthly Rate
Monthly rate = APR / 12
So, for a 33% APR,
Monthly rate = 33% / 12 = 2.75%
1. Minimum Amount Due (MAD)
This is the minimum amount you need to pay to avoid paying any late fee. Paying this amount does not save you from the interest payment.
2. Total Amount Due
This is the actual amount due to the credit card company.
OTHER BASIC TERMS
1. Statement Date or Billing Date
In the date when the credit card statement is prepared and sent to the credit card holder.
2. Payment due date
It is the date by which the credit card dues to be paid. It is mentioned in the statement and depends on the interest-free period.
3. Interest-Free Period
The interest-free period is the maximum days for which interest is not payable on transactions. Consider your billing date is the 10th of a Month and the interest-free-period is 50 days. The dues for the transactions from 11th April to 10th May will be payable by the 30th of May.
For cash-advances and new transactions when there is an outstanding due, the Interest-Free Period is not applicable.
4. Card Limit
This is the maximum balance a credit card company allows on a credit card. The credit card company generally charges a penalty for going above this limit.
These are some basic terms. For all the terms read the MITC (Most Important Terms and Conditions) document for your credit card thoroughly.
To be continued...