The foreign exchange market

Chapter learning objectives

To explain the distinctive characteristics of foreign exchange market To distinguish between different methods of foreign exchange quotation and convert from one method to another To identify the major participants in Forex To identify profitable currency arbitrage opportunities and calculate the profits that could be made through currency arbitrage To describe various types of transactions take place in spot and forward market To explain how forward contracts can be used to minimize risk and who are the major users of forward contracts and their motives To understand the history of Bangladeshi taka and Forex dealing entity BAFEDA.

The Foreign Exchange Market definition

As defined in The Economist's Guide to Financial Markets, foreign exchange, more popularly referred to as "forex" is a worldwide decentralized over-the-counter financial market for the trading of currencies, wherein financial centers around the globe serves as anchors of trading between a wide range of different types of buyers and sellers 24 hours a day, five days a week. So the foreign exchange market is a market where foreign currencies are bought and sold. If a Bangladeshi importer imports Apple computer from the USA then he/she would have to pay in US Dollars. So he/she will have to come to foreign exchange market to buy dollars for Bangladeshi taka. On the other hand, an exporter would have to convert to export proceeds obtained in for example, US Dollar into Bangladeshi currency and for that he/she would have to approach foreign exchange market as well. The worlds three most common transactions are exchanges between dollar and the euro (30%), the dollar and the yen (20%), and the dollar and the British Pound (12%).

Major participants in the FOREX

The primary purpose of the foreign exchange market is to facilitate international trade, tourism and investment. Foreign exchange market permits transfer of purchasing power denominated in one currency to another that is, to trade one currency for another currency.

The foreign exchange market is not a physical place; rather, it is an electronically linked network of banks, foreign exchange brokers, and dealers whose function is to bring together buyers and sellers of foreign exchange. It is the most liquid market in the world. Since Forex Dealers are spread all over the world, it is virtually open 24/7 because of different time zone. Forex traders include large multinational banks, central banks, institutional investors, currency speculators, multinational corporations, governments, other financial investors, and retail investors. The daily turnover in the global foreign exchange market is around US$ 3.98 trillion in April 2010. Of this US$3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other currency derivatives. Trading in the UK accounted for 36.7% of the total, making it by far the most important global center for foreign exchange trading. USA and Japan ranked second and third respectively which accounted for 17.9% and 6.2%.Most developed countries permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. A number of emerging countries do not permit FX derivative products on their exchanges in view of controls on the capital accounts. The use of foreign exchange derivatives is growing in many emerging economies. Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some controls on the capital account. In Bangladesh we also dont have currency derivative market.

Spot Market

The foreign exchange market is classified either as spot market or as forward market. It is the timing of actual delivery of foreign exchange that separates spot market from the forward market. In the spot market transactions it does require immediate delivery of the traded currency whereas in the forward market, currencies are delivered at a future date.

Spot trade represents a direct exchange between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreedupon transaction. In view of the huge amounts involved in the transactions, there is seldom any actual movement of currencies. Rather, debit and credit entries are made in the bank accounts of the seller and the buyer. Most of the markets effect the transfer of funds electronically thus saving time and energy.

There are different types of foreign exchange quotes.

Foreign Exchange Quotes

Indirect rate

Direct rate

Cross rate

I Single Quote Two-way Quote I Spot rate I Interbank rate TT rate Bill rate Forward rate

Direct rate

The exchange rate of a currency is said to be quoted on a direct rate when it fluctuates while the other currency in the currency pair remain constant. Simply it is units of local currency per foreign currency. Consider the Bangladesh Taka and US Dollar exchange

rate. Today it may be BDT 74/USD, the next day it may be BDT 74.5/USD. What it tells us our home currency Taka is fluctuating everyday against US dollar while Dollar is quoting constant. From a US perspective, a direct quote is expressed as US$/BDT. Examples: Today .013514 $/BDT, may be tomorrow .013423 $/BDT. It means constant 1 taka will buy today .013514 USD and tomorrow .013423 USD. Other examples as follows 1.746 $/ .012821 $/ $1.746 = 1 $0.012821= 1

When expressed in this fashion, the exchange rate is the dollar price of a foreign currency, and is conceptually equivalent to a commodity price. To do virtually any exchange rate calculation (for example appreciation/depreciation) you must first express the exchange rate as a direct quote. Most currencies on the interbank market are quoted as units of foreign currency/dollar. For example: 0.7250/$ 76.256/$
0.7250= $1

78.25 = $1

From a US perspective, these quotes are indirect. To convert from indirect to direct use the formula: Direct = 1/Indirect. Problem 2.1 If direct quote is Rs, 45/US $, how can this exchange rate be presented quote? Solution US $ 1/Rs. 45 = US $ 0.0222/Re Indirect rate The exchange rate of a currency is said to be quoted on an indirect rate when it remain constant while the other currency in the currency pair fluctuates. The indirect rate is one in which the foreign currency fluctuates and the home currency remain constant. Simply it is units of foreign currency per local currency. To convert from direct to indirect use the formula: under indirect

Indirect = 1/Direct From Bangladesh perspective an indirect quote is expressed as US$/BDT. So when in a direct quote BDT 74/US$; under the indirect quote it would be $.013514/BDT or $1/BDT 74. So the relationship between direct and indirect quote is one is the reciprocal of the other. Problem 2.2 If indirect quote is US $ 0.025/Rs. , how can this exchange rate be shown under direct quote? Solution Rs. 1/US $ 0.025 = Rs. 40/US $.

Problem 2.3 Convert the following exchange rates given by HSBC in Dhaka, into direct rates.

INR 0.6383/BDT,

PKR 1.1756/BDT,

SAR0.0503/BDT

Solution: Since the above quotes are indirect rate the direct rate would be from Bangladesh perspectives BDT/INR rate = 1/.6383 = 1.566 BDT, BDT/PKR rate =0.850, BDT/SAR=19.880

Cross Rates A cross rate is an exchange rate involving two currencies other than the US dollar. Generally, cross rates are calculated from US dollar rates. For example, given the following dollar exchange rates: 133.25 /$ 1.6250 DM/$ The cross rate is: (133.25 /$) / (1.6250 DM/$) = 82.00 /DM /$ DM/$

When expressing cross rates, keeping the units straight is crucial. How do we know, in the above example, that the cross rate is 82.00 /DM, and not 82.00 DM/? Because: (/$) / (DM/$) = (/$) * ($/DM) = /DM When we divide or multiply the dollar rates to obtain the cross rate, we must do so in such a way that the $ cancels out in the accompanying unit calculation, so we are left with one foreign currency in terms of another.
Problem 2.4 Find Rs./Euro exchange rate if: the two exchange rates are: Rs. 43.93-43.95/US $ and Euro 0.83-0.84/US $ Solution Bid rate = Rs. 43.93/0.84 = Rs. 52.30 Ask rate = Rs. 43.95/0.83 = Rs. 52.95 = Rs. 52.30-52.95/Euro

Problem 2.6 Consider the following bid-ask prices: Rs. 40-40.50/US $. Find the bid-ask spread. Solution (40.50 40.00)/40.50 = 0.0123 or 1.23% Problem 2.7 Find out the bid rate if ask rate is Rs. 40.50/US $ and the bid-ask spread is 1.23%. Solution (40.50 x)/40.50 = 0.0123 Or 40.50 x = 0.0123 40.50

Or 40.50 0.50 = x Or x = 40.00.

Problem 2.8

Find out the forward rate differential if spot rate US $ is Rs. 45.00 and one-month forward rate is Rs. 45.80. Solution 360/30 {(45.80 45.00)/45.00} 100 = 21.33 per cent. It will be known as a forward premium as the value of US dollar has increased. Problem 2.9 Find the one-month forward rate of US dollar if spot rate is Rs. 45.00 and the forward premium is 12 per cent. Solution 360/30 {(x 45.00)/45.00} = 0.12 Or (x 45) = 0.12 45 30/360 Or x = 45 + 0.45 or x =45.45