International Business

Foreign exchange markets

Foreign exchange markets

It is a market for converting the currency of one country into that of another country Exchange rate is simply the rate at which one currency is converted in to another Without this market international trade and international investment would become impossible Foreign exchange market is the lubricant that enables companies based in one country trade with companies in another country

Foreign exchange markets

International trade has several risks associated with it, but some of these risks exist because future exchange rates cannot be perfectly predicted Example: USD/ Euro Jan 1999 1 Euro=1.17USD Oct 2000 1 Euro=0.82USD Dec 2002 1 Euro=1USD Jan 2005 1Euro= 1.30USD Today it is at 1.309

Foreign exchange markets

In 2007 - 2008 the USD depreciated against the Rupee from 46.44 to 39.50 in three months Exporters lost hugely The govt. came to their rescue by increasing 2% interest reimbursement and duty draw back by 3%

Foreign exchange markets

The foreign exchange serves two purposes To convert currency of one country in to another To provide some insurance against foreign exchange risk

Foreign exchange markets

Currency conversion: Each country has a currency in which the prices of goods and services are quoted Within the borders of one country the national currency is used When one currency is converted in to another the exchange rate comes in to play This allows us to compare the relative prices of goods and services in different countries There are mainly four reasons for currency conversion: 1. Tourism ( Minor participant ) 2. Trade 3. Investments short term money markets, and FDI 4. Currency speculation

Foreign exchange markets

Insuring against foreign exchange risks: These markets give participants the ability to hedge against future fluctuations through the use of Spot trades, Forward trades and currency swaps Managing exchange risks is one of the key functions of any international business

Nature of foreign exchange markets

This market not located in one place It is a global network of Banks, Brokers and foreign exchange dealers connected by electronic communications systems When companies wish to convert currencies they typically go through own banks The major trading centers are London (31% activity), New York (19% activity), Tokyo (8% activity) and Singapore (5% activity) the rest is taken care of by secondary trading centers like Zurich, Frankfurt, Paris, Hong Kong and Sydney

Nature of foreign exchange markets

There are two features of the foreign exchange markets First is that the market never sleeps, in a 24 hour day the major markets of London, New York and Tokyo are shut only for 3 hours During these 3 hours trading continues in the minor centers particularly, San Francisco and Sydney The second feature is the integration of the various trading centers through high speed computer linkages This has effectively created a single market Though some arbitrage opportunities are available they disappear very quickly

Nature of foreign exchange markets

The role of USD is also a significant feature in the foreign markets Where direct quotes are not available the conversion takes place through the USD Example: A dealer whishing to sell Korean won for Brazilian real, will sell won to buy USD and then use the USD to buy the Brazilian real This is because it is difficult to find direct buyers for won who have Brazilian real So a transaction routed through the USD is cheaper The USD is called a vehicle currency and 89-90% of all forex transactions involve USD on one side

Nature of foreign exchange markets

We know that the exchange fluctuations happen due to demand and supply But if we can predict/ forecast these fluctuations we can do our business with out the exchange risks Unfortunately there is no consensus on how to forecast the fluctuations in these markets But most economists agree that exchange rate fluctuations are affected by three factors in a country; price inflation, interest rate and market psycology

Prices and exchange rates

The law of one price- This states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency Example if the exchange rate between the British pound and USD is BP1=USD 1.5, a jacket that retails at USD 75 in New York should sell for BP 50 in London. Consider now that the price in London is BP40 (or USD 60). At this price it would give a trader USD15 in profit if he buys in London and sells in New York ( an example of arbitrage) However the increase in demand for Jackets in London would increase the price in London and increased supply in New York will lower price in New York This will continue till a equilibrium is achieved at the same exchange rate of 1 to 1.5 the equilibrium will be reached at BP44 in London and USD66 in New York If the law of one price were true for all goods and services the purchasing power parity (PPP) exchange rate could be found from any individual set of prices

Prices and exchange rates

By comparing the prices of identical products in different currencies, it would be possible to determine the real or PPP exchange rate that would exist if markets were efficient ( an efficient market has no impediments to the free flow of goods and services) A less extreme version of PPP theory states that given relatively efficient markets the price of a basket of goods should be roughly equivalent in each country Thus if a basket of goods costs USD 200 in the US and JY20,000 in Japan, PPP theory predicts that the dollar/ yen exchange rate should be 200/ 20000 or 0.01 per JY (ie., USD 1= JY100) The Big Mac index is one such example of PPP theorem The Big Mac index converts the local price to USD at the local exchange rates. This dollar value is then divided by US prices. All being equal the result should be 1. anything greater than 1 is over valued and less than 1 is undervalued. Example: In the Euro area a Big Mac is USD 3.58 at the current exchange rate Euro/ USD. Divide this by US price of Big Mac of USD3.06. This gives an index of 1.17, which means that the Euro is over valued by 17%

Prices and exchange rates

The next step in PPP theory is that the exchange rate will change if relative prices change Example, if there is no inflation in the US, while prices in Japan are increasing by 10% a year At the beginning of the year a basket of goods costs USD 200 in the US and JY20,000 in Japan, so the USD JY will be USD1=JY100, but at the end of the year the basket will be the same USD 200 in the US but will be JY22,000 in Japan PPP theory predicts that the exchange rate should change as a result of this, so by the end of the year the exchange situation will be 200/22,000 which is 1USD=JY110 So 1USD will buy 10% more JY at the end of the year as compared to the beginning PPP theory predicts that changes in relative prices will result in a change in exchange rates So when there is inflationary pressure in one country the currency will depreciate against other currencies

Prices and exchange rates

Inflation is a monetary phenomenon It occurs when money supply increases faster than output increases When the growth in a countrys money supply is faster than the growth in output price inflation is fueled The PPP theory tells us that a country with high inflation rate will see a depreciation in its exchange rate The other way to look at this is that an increase of money supply in a country increases the currency available and therefore changes the relative demand and supply conditions in the foreign markets Example, in the US if the money supply is growing faster than output, dollars will be relatively more plentiful than the currencies of other countries where monetary growth is closer to output growth, as a result of this relative increase in supply of dollars the dollar will depreciate on the foreign exchange market against the currencies with slower monetary growth Expansion in money supply usually happens when govts. Fund public expenditure by resorting to issue of more money It is therefore important to look at monetary policy and controls on money supply for predicting exchange rates

Interest Rates and exchange rates

High Inflation rates lead to high interest rates as investors want compensation for the decline in the value of money This relationship between interest rates and inflation is called Fisher effect Fisher effect states that a countrys nominal interest rate (i) is the sum of the required real rate (r) and the expected rate of inflation (I), ie., i=r+I For example if the real rate in a country is 5% and the annual inflation is 10% than the nominal rate of interest will be 15% As per Fisher effect if the real interest is the same world wide any difference in interest rates results because of differing expectations about inflation rates If the inflation rate in the US is greater than in Japan then the nominal interest rate will be greater in the US as compared to Japan Since as per PPP inflation has a direct link to exchange rates and interest has an impact on inflation, therefore interest rates have a bearing on exchange rates

Investor Psychology and band wagon effect

Empirical evidence proves that short term movements in exchange cannot be explained either by PPP or Fisher effect Evidence accumulated over several years reveals that various psychological factors play an important role in determining short term exchange movements If one large player decides to convert large sums from one currency to another than a bunch of other traders also follow suit, called band wagon effect, one currency will gain and another currency will loose in the short run These effects play a big role in short term movements but are not prdictable

The structure of the Forex market

Broadly the foreign exchange market encompasses the conversion of purchasing power from one currency into another like Bank deposits in foreign currency Credit denominated in a foreign currency Foreign trade financing Trading in foreign currency options and futures contracts Currency swaps The structure of the foreign exchange market is an outgrowth of one of the primary functions of a commercial banks- to assist clients in the conduct of international commerce

FX market participants

The market for foreign exchange can be viewed as a two-tier market- wholesale or inter-bank market and retail or client market International banks provide the core of the FX market These banks serve their retail clients in conducting foreign exchange transactions both for trade and making international investments Banks also stand willing to buy or sell foreign currency on their own account- interbank transactions These inter-bank transactions also include large non-bank financial institutions (non-bank dealers) like investment banks who trade directly in the inter-bank market for their foreign needs

FX market participants

Part of the inter-bank trading is for adjustment of inventory positions they hold in foreign currencies Most inter-bank trades are speculative or arbitrage transactions Where market participants attempt to judge future price movements in one currency versus another in order to make profit Market psychology is a key ingredient in currency trading A dealer can often infer anothers trading intention from the currency position being accumulated FX brokers where used extensively but now with automation in dealing systems brokers are not used much

FX market participants

The central bank through interventions can attempt to influence the price of its currency against that of other major trading partners Buys ones own currency to increase its value in the market Sells ones own currency in order to decrease its value in the market The inter-bank market is actually a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another called correspondent banking accounts This correspondent bank account network allows for the efficient functioning of the foreign exchange market

FX market participants

For example, if the Deutsche bank sells USD to Global Trust Bank in exchange for Euros, the nostro account of Deutsche bank with a bank in the US will be debited and that of GTB will be credited with the amount of Euros Nostro account is the overseas account held by the domestic bank with a foreign bank or with its own branch in that foreign countrys currency The same account is called a Vostro account from the holding banks point of view A currency settlement always takes place in the country of origin of the currency In the US, the clearing house interbank payments system (CHIPS) is used for the settlement of forex transactions

Indian forex market

All dealings in foreign exchange are required to comply with FEMA, 1999 The RBI is the regulatory authority for the act As per FEMA only those entities can deal in FX as authorised to do so by the RBI The act provides for entities to be authorised either as authorised dealers or money changers Authorised dealers are generally commercial banks and form a large part of the inter-bank market Money changers can be either full fledged money changers (buy and sell foreign exchange) or restricted money changers (only buy foreign exchange)

Indian forex market

Money changers are allowed to deal only in coins, notes and TCs (loans in a few cases) Authorised dealers can deal in any type of foreign exchange instrument relating to exports and imports and any other transaction requiring foreign exchange All dealers are governed by the Foreign Exchange Dealers Association of India (FEDAI) The branches of ADs are classified into categories A, B and C where Cat A- can hold overseas accounts on their own, Cat Bcannot hold accounts on their own but can operate independently the account help by their head office and Cat C cannot hold accounts and have to operate through Cat A or Cat B dealers

Indian forex market

The Indian forex markets operates in three tiers Tier one consists of all transactions between ADs and the RBI Tier two consists of all interbank transactions between ADs Money changer have to square all their positions in this market Tier three consists of the retail segment where ADs and Money changers deal with their customers FEMA defines foreign exchange as: All deposits, credits, balance payable in any foreign currency Any draft, TCs, L/Cs and bills of exchange expressed or drawn in Indian currency and payable in foreign currency Any instrument giving anyone the option of making it payable either partly or fully in a foreign currency In other words, foreign exchange includes all kinds of claims of the residents of our country to foreign currency payable abroad

Exchange rate quotations

An exchange rate quotation is the price of a currency stated in terms of another But it is different as compared to any other price quotation because both items are currencies

Exchange rate quotations

Country USD AUD GBP CAD EURO

USA
Australia Britain Canada EU

0.7503 1.7585 0.8241 1.2089

1.3328
2.3437 1.0983 1.6112

0.5687
0.4267 0.4686 0.6875

1.2135
0.9105 2.1339 1.4670

0.8272
0.6206 1.4546 0.6817 -

Exchange rate quotations

Direct quote is the quote where the exchange rate is expressed in terms of number of units of the domestic currency per unit of foreign currency Like INR/USD = 52.28, which means 1USD = 52.28 INR USD is called the base currency as this currency is being bought An indirect quote is where the exchange rate is expressed in terms of the number of units of the foreign currency for a fixed number of units of the domestic currency Like $/ 100 Rs. = 1.9128 Since August 2 1993 the direct quote is generally used Generally bank quote is as follows: INR/USD = 52.28/ 52.82 ( Buy/ Sell or Bid/ Ask) This is commonly state as INR/USD = 52.28/82 The difference between Bid and Ask is the spread that the bank earns to cover transaction costs and some profit

Exchange rate quotations

There are a few currencies, which are quoted in 100s rather than 1s The reason is that their value is too small to be quoted otherwise An example is the Japanese yen; Yen/USD = 78. 0312/ 25 When quotes are given for such currencies the quote is for 100 units of the currency

Inter-bank quote and Merchant quote

Merchant quote is the quote given by a bank to its retail customers On the other hand, a quote given by a bank to another bank ( or any other customer in the interbank market) is called an interbank quote Arbitrage is the process of buying and selling the same asset at the same time, to profit from price discrepancies within a market or across different markets when it does not involve any commitment of capital or taking on of risk, it is referred to as risk free arbitrage For example suppose there are two banks A & B and there quotes are: A EURO/ $ = 1.2089/ 94 B EURO/ $ = 1.2084/ 87 Dollars can be bought from B at 1.2087/$ and sold to A at 1.2089/$, thus making a gain of Euro 0.0002 per dollar

Types of Forex transactions

Foreign exchange transactions are classified on the basis of the time between entering into a transaction and its settlement (Typically Spot and Forward contracts) Spot transactions are settled after two business days from the date of contract Forward contract (also called an outright forward) is one where the parties to the transaction agree to buy or sell currency at a predetermined date at a particular price This future date may be any date beyond two business days Generally in the forex markets, forward contracts mature after 1, 2, 3, 6, 9 or 12 months A forward contract is entered into in order to hedge against exchange risk

Essentially it is a mechanism to lock-in the exchange at which one will buy or sell the currency

Types of Forex transactions

Forward quotes are given similar to spot quotes which has a bid and ask element The only addition is the prefix by the contract months For example a three month forward rate for INR/ USD will be: 3-m INR/USD = 52.28/ 82 Discount and premium: A currency is said to be at a premium against another currency if the forward rate is higher than the current spot rate Conversely, a currency is said to be at a discount if it is cheaper in the forward market than the spot market Lets assume INR/USD quotes to be: INR/USD = 52.28/82 3-m INR/USD = 53.20/95 Here the dollar is at a premium and the Rupee is at a discount

Forward contracts

Usually the forward rates are not quoted straight Instead the premium or discount is quoted for different periods All of these are in Paise per USD
Jan Exporters Importers 5 7 Feb 22 24 Mar 44 47 Apr 70 73 May 91 94 June 116 119

Forward contracts

In the Indian context forward contracts with a maturity of more than one year are not allowed But if there is a requirement for hedging for more then a year there is an option of roll over Here the forward contract is extended by cancelling the existing contract and entering into a new contract for the extended period This process can be used as a partial hedge in case of exposure for longer periods than what is allowed Broken-date forward contracts A broken-date contract is a forward contract for a maturity which is not a whole month or for which a quote is not readily available For such transactions a separate quote is worked by the bank