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The Foreign Exchange Market

The Foreign Exchange Market



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Published by manojpatel51
this are the international finance notes for bms sem 6, mumbai university.
this are the international finance notes for bms sem 6, mumbai university.

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Published by: manojpatel51 on Mar 14, 2009
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The Foreign Exchange MarketI Conceptual Questions
Value Date:
The settlement of a transaction takes place by transfers of deposits between two parties. The day on which these transfers are effected is called theSettlement Date or the Value Date.
Spot Rate: When the exchange of currencies takes place on the second working dayafter the date of the deal, it is called spot rate.
Forward Transactions: If the exchange of currencies takes place after a certain periodfrom the date of the deal (more than 2 working days), it is called a forward rate. Atrader may quote a forward transaction for any future date. It is a binding contract between a customer and dealer for the purchase or sale of a specific quantity of astated foreign currency at the rate of exchange fixed at the time of making thecontract.
Swap Transaction: A swap transaction in the foreign exchange market is combinationof a spot and a forward in the opposite direction. Thus a bank will buy DEM spotagainst USD and simultaneously enter into a forward transaction with the samecounter party to sell DEM against USD against the mark coupled with a 60- dayforward sale of USD against the mark. As the term ‘swap’ implies, it is a temporaryexchange of one currency for another with an obligation to reverse it at a specificfuture date.
Bid Rate: The bid rate denotes the number of units of a currency a bank is willing to pay when it buys another currency.
Offer Rate: The offer rate denotes the number of units of a currency a bank will wantto be paid when it sells a currency.
Bid - Offer Rate: The bid offer Rate is the rate which states both, the price which isthe bank is willing to pay to buy other currencies and the price the bank expects whenit sells the same currency. Bid and Ask will always be from a bank’s point of view.Thus (A/B)bid will denote the number of units of A the bank will pay when it buysone unit of B and (A/B)ask will mean the number of units of A the bank will want to be paid in order to sell one unit of B.
European Quote: The quotes are given as number of units of a currency per USD.Thus DEM1.5675/USD is a European quote.
American Quotes: American quotes are given as number of dollars per unit of acurrency. Thus USD0.4575/DEM is an American quote.
Direct Quotes: in a country, direct quotes are those that give unit of the currency of that country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote inIndia.1
Indirect Quote: Indirect or Reciprocal Quotes are stated as number of units of aforeign currency per unit of the home currency. Thus USD 3.9560/INR 100 is anindirect quote in India.
Arbitrage: Arbitrage may be defined a san operation that consists in deriving a profitwithout risk from a differential existing between different quoted rates. It may resultfrom 2 currencies, also known as, geographical arbitrage or from 3 currencies, alsoknown as, triangular currencies.
II Descriptive questions1.What is foreign exchange?
In a business setting, there is a fundamental difference between making payment inthe domestic market and making payment abroad. In a domestic transaction, only onecurrency is used while in a foreign transaction, two or more currencies maybe used.Suppose an U.S importer has agreed to purchase a certain quantity of Indian spicesand to pay the Indian exporter Rs. 1000000 for it. How would he go about doing this? Hewould have to pay the amount in dollars, which will be equivalent to its existing rate inrupees at a decided date. That is why the foreign exchange market comes into existence sothat such transactions become possible and easier.The special checks and other instruments for making payment abroad are referred tocollectively as
foreign exchange
. In other words, Foreign exchange includes currencies andother instruments of payment denominated in currencies.
2.Elaborate the structure of the foreign exchange market and compare it with theforeign exchange of India
The major participants in the foreign exchange markets are commercial banks; foreignexchange brokers and other authorized dealers, and the monetary authorities. It is necessaryto understand that the commercial banks operate at retail level for individual exporters andcorporations as well as at wholesale levels in the inter – bank market. The foreign exchange brokers involve either individual brokers or corporations. Bank dealers often use brokers tostay anonymous since the identity of banks can influence short – term quotes. The monetaryauthorities mainly involve the central banks of various countries, which intervene in order tomaintain or influence the exchange rate of their currencies within a certain range and also toexecute the orders of the government.It is important to recognize that, although the participants themselves may be basedwithin the individual countries, and countries may have their own trading centers, the marketitself is world – wide. The trading centers are in close and continuous contact with oneanother, and participants will deal in more than one market.Primarily, exchange markets function through telephone and telex. Also, it isimportant to note that currencies with limited convertibility play a minor role in the exchangemarket. Besides this, only a small number of countries have established their fullconvertibility of their currencies for full transactions.2
The foreign exchange market in India consists of 3 segments or tires. The firstconsists of transactions between the RBI and the authorized dealers. The latter are mostlycommercial banks. The second segment is the interbank market in which the AD’s deal witheach other. And the third segment consists of transactions between AD’s and their corporatecustomers.The retail market in currency notes and travelers cheques caters to tourists. In theretail segment in addition to the AD’s there are moneychangers, who are allowed to deal inforeign currencies. The Indian market started acquiring some depth and features of wellfunctioning market e.g. active market makers prepared to quote two-way rates only around1985. Even then 2 - way forward quotes were generally not available. In the interbank market, forward quotes were even in the form of near – term swaps mainly for AD’s to adjusttheir positions in various currencies.Apart from the AD’s currency brokers engage in the business of matching sellers with buyers. In the interbank market collecting a commission from both. FEDAI rules requiredthat deals between AD’s in the same market centers must be effected through accredited brokers.
3.Write a note on Inter bank dealing
Primary dealers quote two – way prices and are willing to deal either side, i.e. they buy and sell the base currency up to conventional amounts at those prices. However, ininterbank markets this is a matter of mutual accommodation. A dealer will be shown a two-way quote only if he / she extends the privilege to fellow dealers when they call for a quote.Communications between dealers tend to be very terse. A typical spot transactionwould be dealt as follows:BANK A : “ Bank A calling. Your price on mark – dollar please.”BANK B : “ Forty forty eight.”BANK A : “ Ten dollars mine at forty eight.”Bank A dealer identifies and asks himself for B’s DEM/USD. Bank A is dealing at1.4540/1.4548. The first of these, 1.4540, is bank B’s price for buying USD against DEM or its bid for USD; it will pay DEM 1.4540 for every USD it buys. The second 1.4548, is itsselling or offer price for USD, also called ask price; it will charge DEM 1.4548 for very USDit sells. The difference between the two, 0.0008 or 8 points is bank B’s bid – offer or bid – ask spread. It compensates the bank for costs of performing the market making function includingsome profit. Between dealers it is assumed that the caller knows the big figure, viz. 1.45.Bank B dealer therefore quotes the last two digits (points) in her bid offer quote viz. 40 – 48.Bank A dealer whishes to buy dollars against marks and he conveys this in the thirdline which really means “ I buy ten million dollars at your offer price of DEM 1.4548per USdollar.”Bank B is said to have been “hit” on its offer side. If the bank A dealer wanted to sellsay 5 million dollars, he would instead said “Five dollars yours at forty”. Bank B would have been “hit” on its bid side.When a dealer A calls another dealer B and asks for a quote between a pair of currencies, dealer B may or may not wish to take on the resulting position on his books. If hedoes, he will quote a price based on his information about the current market and theanticipated trends and take the deal on his books. This is known as “warehousing the deal”. If he does not wish to warehouse the deal, he will immediately call a dealer C, get his quote and3

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