You are on page 1of 67

Foreign Exchange Market

Dr. Amit Kumar Sinha dramitksinha@gmail.com

Definitions

FOREIGN CURRENCY: Any currency other than the countrys currency is known as foreign currency. For example, in India all other currencies than Rupee will be foreign currencies. FOREIGN EXCHANGE: Forex includes foreign currency, Traveler Cheques, foreign DDs, Cheques, LCs in denomination of foreign currencies.
1

Foreign Exchange Market Definition


The Foreign exchange market provides the Physical & Institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies are determined, and foreign exchange transaction are physically completed .

Foreign Exchange Transaction


A foreign exchange transaction is an agreement between a buyer and seller that a fixed amount of one currency will be delivered for some other currency at a specified rate.

Functions/ Significance of Forex Markets


The Foreign exchange market is the mechanism by which participant Transfer purchasing power between countries, obtain or provide credit for international trade transactions, and minimize exposure to the risk of exchange rate fluctuations. Hence there are three major functions of Foreign exchange market: 1. Transfer of purchasing power 2. Provide Credit 3. Minimization of foreign exchange risk 4

Functions/ Significance of Forex Markets


Transfer of Purchasing Power:
Transfer of purchasing power is necessary because international trade and capital transactions normally involves parties living in countries with different national currencies. Each party usually wants to deal in its own currency, but the trade or capital transaction can be invoiced in only one currency.
5

Functions/ Significance of Forex Markets


Provide Credit:
The movement of good s between countries take time, inventory in transit must be financed. The foreign exchange market provide a source of credit. Specialized instruments, such as Bankers acceptances and letters of credit are available to finance international trade.
6

Functions/ Significance of Forex Markets


Minimization of Foreign Exchange Risk:
The foreign exchange market provides Hedging facilities for transferring foreign exchange risk to someone else more willing to carry risk.

PARTICIPANTS IN THE FE MARKET

a)

b)

c)

Major participants in the FE market are: Large commercial banks operating either at retail level for individual exporters and corporations or at a wholesale level in the inter bank market. Central Banks of various countries that intervene in order to maintain or influence the exchange rate of their currencies within a certain range, as also to execute the orders of the government. Individual brokers or corporations: Bank dealers often use brokers to stay anonymous since the identity of banks can influence short term quotes.

Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. International commercial banks communicate with one another with:

Correspondent Banking Relationships

SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions. CHAPS :Clearing House Automated Payment System. 9

Kinds of Forex Markets


Spot market Forward market Derivative market- currency swaps, futures options

10

Spot Market

Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

11

Spot market of foreign exchange


Definition: Spot market is the system under

which purchase and sale of foreign exchange with delivery either immediately or on the second following business day. The Indian rupee Vs dollar settlements take place first following business day. The spot transactions should not be rolled over to next month.
12

Quoting in FE Market

Foreign exchange rates are quoted either for immediate delivery (spot rate) or for delivery on a future date (forward rate). In practice, delivery in spot rate is made two days later. A FE quotation is the price of currency expressed in units of another currency.

Quoting in FE Market

The quotation can be either direct or indirect. Quotation is direct when quoted as so many units of local currency per unit of foreign currency. Ex: INR 46= USD 1, is a direct quotation for USD in India. An indirect quotation is the one where the exchange rate is given in terms of variable units of foreign currency as equivalent to a fixed number units of home currency. Ex: In India USD 2.1739= Rs.100 is an indirect quotation. Since August 2,1993 all quotations in India use direct method of quotation.

Quoting in FE Market

Some currencies are quoted as so many rupees against one unit while others as so many rupees against 100 units. Foreign currencies Quoted against their One Unit
Finish Mark (FM) French Franc (FFr) Hong Kong Dollar (HKD) Irish Pound Kuwaiti Dinar Malaysian ringgit New Zealand Dollar Norvegian Kroner Omani Riyak Qatar Riyal Saudi Riyal (SR) Singapore Dollar (SGD) Sterling Pound (GBP) Sewdish Kroner Swiss Franc Thai Bhat UAE Dirham USD

Australian Dollar (AD) Austrian Schilling (Sch) Bahrain Dinar Canadian Dollar (CAD) Danish Kroner (DKr) Deutschmark (DM) Dutch Guilder Eqyptian Pound European Currency Unit

Quoting in FE Market
Foreign currencies Quoted against their 100 units.
Belgian Franc Indonesian Rupiah Italian Lira Japanese Yen Kenyan Shilling Spanish peseta

Quoting in FE Market

Exchange rates are always quoted as a two way price, i.e. a rate at which the bank (dealer) is willing to buy foreign currency (buying rate) and a rate at which the bank sells foreign currency (selling rate). Dealers do expect some profit in exchange operations and hence there is always some difference in buying and selling rates. However maximum spread available to dealers may be restricted by their central bank. Authorized dealers give both buy and sell exchange rates.

Quoting in FE Market- Two Way Quotes

A dealer usually quotes a two way price for a given currency i.e. bid price and offer or ask price. In either case, the currency for which bid or ask price is given is the unit of item priced. In a bid quote of Rs.35/USD 1, the dealer conveys that he will buy dollars at the price of Rs.35 per dollar, which also means that he is willing to sell 35 rupees at the price of one dollar. Likewise, when the dealer quotes an offer price per dollar, he implicitly quote the rate at which rupees would be bought per dollar.

Quoting in FE Market- Two Way Quotes

Dealer make profit from each transactionwhether it is buy or sell. Ex: a dealer in New Delhi may quote USD = Rs.46.0000-46.0050 This means that he will buy dollars from an exporter at USD 1= Rs.46.0000 and sell dollars to an importer at USD 1= Rs.46.0050. Thus lower rate is the buy (bid) quote and the higher rate is the selling (ask) quote.

Spread

1. 2. 3.

Spread means the difference between a banks buying (bid) and selling (offer or ask) rates in an exchange rate quotation. It fluctuates according to The level of stability in the market. The currency in question The volume of the business. Thus if there is a degree of volatility in an exchange rate, and if the business is thin and if the current rate of the currency is rumored to be unsustainable, the dealer will protect himself by widening the quote i.e. he will offer less currency while selling but demand more when buying.

Spread

The spread can also be expressed as a percentage i.e. Percent Spread= Ask Price- Bid Price *100 Ask Price Ex: With dollar quoted at Rs.35.0000-35.0050, the percent spread equals 0.014.

Cross Rates (Chain Rule)

Cross rate is the price of any currency other than home currency. In other words, it is direct relationship between two non-home currencies in a foreign exchange market concerned with or used in transactions in a country to which none of the currencies belongs. Thus, in India, a cross rate is an exchange rate which excludes rupees, for example USD/FFr, DM/FFr etc. If an importer has to remit French Francs from India with the knowledge that INR/FFr rates are not normally quoted would first buy dollars against the rupees and same dollars will be used overseas to acquire French Francs.

Cross Rates (Chain Rule)


Ex: If say rates in New Delhi are INR/USD 35.0010/80 and rates in Paris are FFr/USD 5.1025/50. Thus an importer will get 1 USD by paying Rs.35.0080 and for 1 USD he will get FFr 5.1025. Thus a sort of chain is formed as under: FFr 5.1025 =1 USD 1 USD = INR 35.0080 1 FFr = INR 35.0080/5.1025= INR 6.8609

Settlements
Cash Cash rate or Ready Rate is the rate when the exchange of currencies takes place on the date of the deal. If the delivery is made on the day the contract is booked, it is called a Telegraphic Transfer (TT) or cash or value-today deal. Tom When the exchange of currencies takes place on the next working day after the date of deal, it is called the TOM (tomorrow) rate.

Settlements
Spot When the exchange of currencies takes place on the second working day after the date of deal, it is called the spot rate. This time is allowed to banks to process the necessary paperwork and transfer the funds. Normally, a deal done on Tuesday will be settled on Thursday and a deal done on Friday will be settled on the following Tuesday. A business day is defined as one in which both banks are open for business in both settlement countries. In the case of a USD/DM deal done, say in London, the occurrence of a bank holiday in the UK during the spot period is entirely irrelevant. This is because all bank account transfers are made in the settlement country rather than dealing centre.

Settlements
Spot The principle that the two sides of the deal should be completed on the same date is referred to as the principle of compensated value. The only exception to the principle of compensated value arises for deals in Middle East countries for settlement on Friday. This is a holiday in most Middle East countries. Even though person buying a Middle Eastern currency (say Saudi Riyals) may make payments (say in GBP) on Friday, the delivery of Riyals would take place on Saturday, provided it was a business day in both the relevant countries. For some currencies such as USD/CAD transactions, a spot transaction is only one day by convention.

Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage

Arbitrage can be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. Arbitrage may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage).

Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage


Example: An arbitrage between two currencies Suppose two traders A & B are quoting the following rates: Trader A(Paris) Trader B(New York) FFr/ USD 5.5012 USD/FFr 0.1817 We assume that buying and selling rates for these traders are same. Work out if an arbitrage opportunity exists.

Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage

First we find out the reciprocal rate of the quote given by the trader B, which is FFr/USD =5.5036 (=1/0.1817) Strategy An arbitrageur buys, say USD 10000, by paying FFr 55012. He sells these USD to the trader B and receives FFr 55036. In the process he gains FFr 24 (=5503655012)

Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage

This process would tend to increase the selling rate at the trader A because of increase in demand of USD and reverse would happen at the trader B because of the increased supply of USD. This would lead to an equilibrium after some time.

Adjustment of Demand and Supply on the Spot Market: Process of Triangular Arbitrage
Example: An arbitrage between three currencies Suppose both traders A & B are located at New York and giving the following quotes Trader A Trader B USD/CHF 0.6000 USD/CHF 0.6000 USD/DM 0.5100 USD/DM 0.5200 We assume that buying and selling rates for these traders are same. Work out if an arbitrage opportunity exists.

Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage

Since three currencies are involved we will have to find the cross rate between CHF and DM. For Trader A, CHF/DM rate is 0.85 (=0.51/0.60) For Trader B, CHF/DM rate is 0.867 (=0.52/60)

Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage: Problem

Are there any arbitrage gains possible from the data given below? Assume there is no transaction costs.
INR/GBP INR/USD USD/GBP 55.500 in London 35.625 in Delhi 1.5820 in New York

USD/GBP rate at London and New Delhi is 1.5579 which is different from the rate prevailing in New York. Because of the difference in rate triangular currency arbitrage is possible. The strategy of the arbitrageur is as follows: Use USD 1000 to buy rupees in Delhi. The arbitrageur would get Rs.35625 (=1000*35.625) Sell Rs.35625 in London to get GBP 641.89 (=35625/55.500) Sell GBP 641.89 in New York to get USD 1015.47 (=64189*1.5820) Net Profit is USD 15.47 (=1015.47-1000)

The Forward Market

A forward contract is an agreement to buy or sell a financial asset in the future at prices agreed upon today. If the exchange of currencies takes place after a certain period from the date of the deal (more than two working days) it is called the Forward Rate.
34

The Forward Market

A forward contract is a binding contract between a customer and a dealer for the purchase or sale of specific quantity of stated foreign currency, at a rate of exchange fixed at the time of making the contract (for executing by delivery & payment at a future time agreed upon when making the contract). Forward rates are generally expressed by indicating premium/discount on the spot rates for the forward period.
35

The Forward Market

Premium on one countrys currency implies discount on another countrys currency. The forward market is not located at any specified place. Operations take place mostly by telephone/telex etc through brokers. Generally, participants in the market are banks which want to cover order for their clients. Though the forward rate may be quoted for any future date, the normal practice is to quote them for 30 days, 60 days, 90 days and 180 days. 36

Forward Rate Quotations

Quotations for forward rates can be made in two ways. They can be made in terms of exact amount of local currency at which the trader quoting the rates will buy and sell a unit of foreign currency. This is called the outright rate and it is used by traders in quoting rates to the customers. The forward rates can also be quoted in terms of points of premium or discount on the spot rate, which is used in inter bank quotations37

Forward Rate Quotations

The points are added to the spot price if the foreign currency is trading at a forward premium; the points are subtracted from the spot price if the foreign currency is trading at a forward discount.

38

Premium or Discount

Premium or Discount of a currency in the forward market on the spot rate is calculated as follows: Premium or discount (percent)= (Fwd Rate- Spot rate)/Spot rate * 12/n * 100 where n is the number of months forward. FR>SR it implies premium. FR<SR it implies discount.

Long and Short Forward Positions

If you have agreed to sell anything (spot or forward), you are short. If you have agreed to buy anything (forward or spot), you are long. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long.
40

Forward Rate- Problem

Convert the following rates into outright rates and indicate their spreads:
Spot 1-mth 3-mth 6-mth

Currency Pair INR/USD

45.6300/25

20/25

25/35

30/40

INR/GBP

75.2200/35

40/30

50/35

55/42

INR/DM

23.9000/30

30/25

40/60

45/65

Forward Rate- Problem

Rupee Rate of Dollar


Spot 1-mth 3-mth 6-mth

INR/USD

Bid

45.6300

45.6320

45.6325

45.6330

Ask

45.6325

45.6350

45.6360

45.6365

Spread

0.0025

0.0030

0.0035

0.0035

Forward Rate- Problem

Rupee Rate of Deutschmark


INR/DM Bid Ask Spread Spot 23.9000 23.9030 0.0030 1-mth 23.8970 23.9005 0.0035 3-mth 23.9040 23.9090 0.0050 6-mth 23.9045 23.9095 0.0050

Speculation

A speculator is a trader who enters the market to profit from short term price changes. In doing so, he/she assumes risk that other individuals are trying to dispose of. Most individuals have no heavy exposure in the futures market. As such when they enter the futures market it is for speculation. There are three kind of speculators:
1.
2. 3.

Scalpers Day Traders Position Traders

44

Scalpers

A scalper is an individual that enters the futures market to profit from very short term price movements. A scalper is generally trying to guess the short term psychology of the market. How Long of Intervals?

By trading very frequently, scalpers provide liquidity to the market. 45

From the next few seconds to the next few minutes. Requires the scalper to be in the trading pit to observe the behavior of other buyers and sellers. Generally involves a great many trades earning a small profit on each trade. One study shows that scalpers make about 70 trades per day.

Services Provided by Scalpers


1.

2.

3.

4.

Provide a party willing to take the opposite side of a trade for an off-the-floor trader. Actively trade, thereby generating price quotations and allowing the market to discover prices more effectively. By competing for trades, help to close the bidasked spread, thereby reducing execution costs for other traders. Attract hedging activity, because hedgers know their orders can be executed. Chapter 4 46

Day Traders

Day traders attempt to profit from trades that occur during a single trading day. Day traders close all of their positions before the end of the trading day. As such, day traders have no position in the futures market overnight. By closing all of their positions at the end of the day, day traders are able to reduce their risk. Holding a position overnight is a risky proposition as the supply of many commodities is driven by weather.
47

Position Traders

A position trader is a speculator that holds a position overnight. Sometimes they may hold them for weeks or months. There a two types of position traders:

Outright Position Spread Position

48

Outright Positions

This is simply taking a naked position in a commodity. For example, a trader thinks that long-term interest rate will increase, and consequently futures prices for bonds will fall. Therefore, the trader sells a futures contract on U.S. Treasury bonds. If long-term interest rates rise as the trader expected, the trader will earn a profit. The risk is that the long-term interest rate will decline rather than increase. In which case the position trader will lose money.
49

Spread Positions

1.

Spread positions involve trading multiple contracts on the same or related commodities. The idea is to profit when the difference in prices between the two related commodities changes. There are two basic types of spreads: Inter-commodity spread
In an inter-commodity spread, a trader takes a position in two or more different but related commodities.

2. Intra-commodity spread
In an intra-commodity spread, a trader takes a position in two or more maturity months for the same good. 50

DERIVATIVES FX MARKETS CURRENCY SWAPS

A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Swap transactions account for approximately 51 percent of interbank FX trading, whereas outright trades are less than 9 percent.
51

CURRENCY SWAPS

A swap can be viewed as a portfolio of spot and forward positions. For example, firm A would borrow in dollars and then swap for pounds with the bank and simultaneously enter into a series of forward contracts with the bank to exchange dollars for pounds.
52

CURRENCY SWAPS-Types

Back to back currency swaps suppose Co. A in U.K. wants to invest in Germany DM 1 million and Co. B of Germany wants to invest 1 million in U.K.. Both companies can raise loans in local currencies and exchange the loan obligations. In this swaping they may avoid any tax on foreign exchange transactions and also take advantage of favourable rate of interest. Swaps became popular only after 1981- World Bank/IBM case. Spot cum forward swaps. Forward forward swaps.

53

FOREIGN CURRENCY FUTURES

DEFINITION: Foreign currency futures contract is a standardized agreement to deliver or receive a specified amount of the specified currency at a specified price (exchange rate ) on a specified date. CHARACTERISTICS: Buyer of futures receives the foreign currency and seller of futures contract delivers the currency. Forex futures are traded on organized exchanges, e.g., at International Monetary Market Chicago It is a standardized, specific sized contract. For example, at IMM, Australian dollars futures size is 1.00.000 dollars .India-only Re/$ Futures .Lot: $1000. Forex futures quotations are in direct quotes, e.g., dollars futures in rupees will be quoted $1 =Rs 43 54

FOREIGN CURRENCY FUTURES Characteristics (contd.)

Forex futures have standard maturity date. At IMM it is third Wednesday of March, June, September and December. Margins are to be deposited with the Clearing House. Margins are transferred to respective accounts daily. Futures contracts are transacted in exchange clearing house through brokers.
55

Difference Between Foreign Currency Futures & Forward Contracts


1. 2. 3. 4.

5.
6. 7.

Characteristics Futures Size of contract Standardized Maturity Fixed Location Exchange Margin Required Settlement Flexible Commission Yes Risk Low

Forwards Desired size Flexible Banks No margin Fixed date No High


56

Advantages of Foreign currency Futures


1.

2. 3. 4.

Contracts are flexible, i.e., contract can be liquidated any time. Risk lower. Speculative gains Hedging against exchange rate risk

57

Limitations of Foreign Currency Futures


1. 2.

3.

Available only in developed countries Futures are not available in all currencies of the world Futures need specialized skills to forecast prices

58

FOREIGN CURRENCY OPTIONS


DEFINITION: An option is a financial contract in which the buyer of the option has the right but not the obligation to buy or sell the foreign exchange, at a prespecified rate, on or upto a specified date. The seller of the option has obligation to perform the other side of option, if the buyer exercises his /her option. EXAMPLE: Life Insurance-Premium-Protection, if adverse happens .A fortune if favourable happening .Options can be related to exchange dealings or any commodity, shares, debt-instruments or interest, etc.

59

FOREIGN CURRENCY OPTIONS TYPES


1. CALL OPTIONS: Right but not obligation to buyer to purchase currency Y against currency x at a given price on or before a specified date. EXAMPLE: 3 months call option on U.S.$ against rupee @ $1= Rs. 44. Amount $1 million for a premium of 5%.

Buyer is called Option Buyer. Seller is called Option Seller or Option Writer .
2. PUT OPTION: Gives buyer the right but not the obligation to sell currency Y against currency X, on a before an agreed date, for an agreed premium. EXAMPLE: 3 MONTHS Put option on X against INR @ $1 = Rs. 44 for $10,00- option to Buyer only. Writer must take delinery ,if required.
60

FOREIGN CURRENCY OPTIONS TYPES


AMERICAN OPTIONS: Can be exercised by buyers on any day from initiation to expiry.
EUROPEAN OPTIONS: Can be exercised only on expiry date.
61

TECHNICAL TERMS USED


Strike Price Or Exercise Price: Exchange rate agreed upon in option. Maturity Date or Expiry Date: Date on which option expires. Option Premium/ Option Price/Option Value: The fee which option buyer pays to option writer at the time of writing. It is non-refundable. At-the-Money, In-the-Money & Out-of-Money : In the Call Option If S (Spot Price) = X (Exercise Price) it is called Atthe-Money. ,If S>X ,then it is In-the-Money & if S < X, then it is Out-of-Money. In a Put Option: If S=X, it is At-the-Money, if S>X ,then it is Out-of-Money & if S<X, it is In-the-Money. Note: Gains & Losses are debited / Credited Daily in Buyers and Writer s A/cs.

62

ADVATAGES OF OPTIONS

Allows Hedging against Exchange Rate Risk Also facilitates Speculation/ Return.

63

LIMITATIONS OF OPTIONS
In India Options are written only by the banks. They are allowed only for hedging & not for speculation.

64

SPECULATION & ARBITRAGE IN FOREX MARKETS


SPECULATION :Investment for windfall pofit. ARBITRAGE: Refers to a set of transactions ,e.g., selling & buying, lending & borrowing the same financial asset or equivalent groups of assets, to gain profit from price differentials. Most often Arbitrage does not involve investment or risk. EXAPLES:SPOT-SPOT or FORWARD-FORWARD ARBITRAGE: Suppose Bank A quotes GBP/USD:1.4550/1.4560(Bid/Ask) & Bank B quotes 1.4538/1.4548 . Suppose you buy 1,00,000 GBP from bank B paying $ 1,45,480. Now you sell GBP 1,00,000 to bank A @ 1.4550 and get $ 1,45,500. You may 65 gain $ 20.

TRIANGULAR ARBITRAGE
Transactions in 3 Currencies: Suppose Bank A quotes rates of 3 currencies as follows: USD/JPY = 110.25/111.10( Bid/ Ask ) USD/AUD= 1.6520/1.6530 Suppose Bank B quotes as follows : AUD/JPY = 68.30/ 69.00 Suppose you sell 11,02,500 JPY to Bank @ 110.25 & buy 10,000 USD. Now ,sell 10,000 USD @ 1.6520 & get 16,520 AUD . Then, sell these 16,520 AUD to Bank B & buy JPY @ 69.00,i.e.,total JPY= 11,39,880. Now, GAIN = JPY 37,380.

66

You might also like