Foreign Exchange Market

y Organisational setting within which individuals,

governments and banks buy and sell foreign currencies y Only a small fraction of daily transactions in foreign exchange involve trading of currency y Most foreign exchange transactions involve transfer of bank deposits

Definition of foreign exchange

y Deposits, credits and balances payable in foreign

currency y Drafts, travellers cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency y Drafts, travellers cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency y The above definition is as per FEMA (1999)

Exchange rate (1)

y Denotes the price or the ratio or the value at which one

currency is exchanged for another y Exchange rate is very dynamic y The foreign exchange market is round-the-clock market due to different time zones y Major participants- central banks, commercial banks, forex brokers, corporations, individuals

Factors affecting exchange rate

y Major banks that act as market-makers always give

two-way quotes; gives depth and volume to the market y Fundamental reasons y Technical reasons y Speculation

Fundamental reasons
y Balance of payments->surplus->appreciation y Growth rate of the economy-> higher growth-

>depreciation of currency y Fiscal policy-> financing of fiscal deficit influences exchange rate y Monetary policy->loose monetary policy-> depreciation of exchange rate

Technical reasons
y Freedom or restrictions on capital movements can

affect exchange rates to a large extent y Among other factors there are:
y Huge trade surpluses of oil exporting countries y Capital moving from low-yielding currencies to high

yielding currencies (interest differential)

Speculation
y Self-fulfilling prophecies y Anticipation of depreciation of a currency can cause dealers to sell that currency y Speculation serves to provide depth and liquidity to

the forex market y Acts as a cushion as well- contrarian traders exist in the market

Types of exchange rate (1)

y Ready/cash- Settlement of funds on the same day

(date of the deal). y Tom- Settlement of funds takes place on the next working day of the date of the deal y Spot- Settlement of funds takes place on the second working day following the date of the deal

Types of exchange rate (2)

y Forward- Delivery takes place on any day after the date

of the deal y In the forex market all rates that are quoted are generally spot rates y When delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicable y Forward rate = Spot rate + Premium (- discount)

Forward rate
y If the forward value of a currency is higher than the

spot value the currency is said to be at a premium y If the above is reversed the currency is said to be at a discount y The forward premium/discount is based on interest rate differentials of the two currencies involved y Direct and indirect quotes of exchange rate- direct quote, local currency is variable

Quotes of Exchange Rate

y Cross rates- To obtain rates for a particular currency

pair when they are not available directly y Bid and offered rates- In USD/INR 39.40/41 the bank is bidding for USD at Rs. 39.40 and offering to sell USD at Rs. 39.41

Exchange Arithmetic
y All foreign exchange calculations have to be worked

with care and accuracy and several rules have to be kept in mind y Chain rule- is used to attain comparison or ratio between two quantities which are linked together through another or other quantities. Equation in the form of a chain is derived. y Per cent and per mille- Per 100 units/per 1000 units

Example of a Chain Rule (1)

y Query: If we have to remit French Francs to France

from India how do we go about it? (We have to arrive at cross rates between FRF and INR.) y Mumbai interbank market:
y US $ 1 = Rs. 41.2550/2650

y London Market y US $ 1 = FRF 6.0500/6.0550

Chain rule (2)

y At what rate can one buy FRF against rupees? y How many Rs----- = FRF 1? y FRF 6.0500 = US $ 1 y US $ 1 = 41.2650, therefore, y FRF 6.0500 = US $ 1 = Rs. 41.2650 y Hence, FRF 1 = 41.2650/6.0500 y Or FRF 1 = Rs. 6.8206

Forward Rate (1)

y Value date: It is customary, in foreign exchange

market, to quote a rate to do the deal but exchange the currencies not on the same day but generally afterwards. y Forward rate: Has two components
y Spot rate y Forward points or forward differentials

y Forward rate is the rate when the value of the deal is

fixed beyond the spot date i.e. beyond the second working day after the deal

Forward Rate (2)

y Forward transactions are necessary in the foreign

exchange market as they serve number of purposes like:

y One can hedge or cover an existing future financial,

commercial or trade related exchange risk y These types of deals, in combination with spot deals, are used for money market operations through swap transactions y Taking a view of the market, these can be used for speculation

Forward rate (3)

y When a currency is costlier in the future (forward) as

compared to the spot, the currency is said to be at a premium vis--vis another currency y In direct rate premium is added to both the buying and selling rate whereas discount is deducted y In indirect rate premium is deducted and discount is added to the buying and selling rates

Forward rate (4)

y Base currency is the currency which is being bought

and sold and the other currency is incidental. y Forwards are quoted as follows
y Spot/1 month 17/18 y Spot/ 2 months 35/37 y Spot/ 3 months 53/56

y If forward differentials are in the ascending order (1st

figure is lower than the 2nd) the base currency is at premium

Foreign exchange transactions (1)

y Arbitrage: Is an operation by which one can make risk

free profit by undertaking offsetting transactions.

y Can be in interest rates: borrow in one centre and lend

in another y Can be in exchange rates: Buy a currency in one market and sell in another

y Arbitrage keeps exchange rates uniform in all markets

Foreign Exchange Transactions (2)

y Merchant rates: Quotes offered to merchants

(importers, exporters) by banks. y Inter-bank rates: The rates quoted by banks for dealing in the inter-bank market. y Merchant quotations: In India all merchant quotations for foreign currencies shall be in so many rupees for one unit of foreign currency except for Japanese Yen, Italian Lira and Belgian Franc (Rs/100 units of the currency) y All quotes are in four decimal places with the last two digits in the multiple of 25

Modes of remittances (1)

y Telegraphic Transfers (TT) of funds are done from

one centre to another by way of instructions through telex, telegram or SWIFT (Society for Worldwide Interbank Financial Transfer). Of late SWIFT is becoming popular y Mail Transfer (MT) of funds is done by way of instructions sent by mail. An MT is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned

Modes of Remittances (2)

y Demand draft (DD): A DD is an order in writing on the

correspondent bank/branch abroad to pay the beneficiary the sum mentioned therein.
y Fedai prescribed types of rates of merchant transactions:
y TT (buying)- clean inward remittances y Bill (buying)- purchase/discount of export bills y TT (selling) clean outward remittances y Bill (selling) remittance for import bills

RBI/FEDAI Guidelines (1)

y RBI has issued Authorised Dealers (AD) licences to

banks, all India financial institutions and a few cooperative banks to undertake foreign exchange transactions in India y It has also issued Money Changer licences to a large number of established firms, companies, hotels, shops, etc.

RBI/FEDAI Guidelines (2)

y Money changers help facilitate encashment of

foreign currencies of foreign tourists y Entities authorised to buy and sell foreign currency notes, coins and travellers cheques are called full fledged money changers y Those authorised only to buy are called restricted money changers

RBI/FEDAI Guidelines (3)

y FEDAI (Foreign Exchange Dealers Association of

India) is a non-profit making body formed in 1958 with the approval of RBI y Its members are authorised dealers and it prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc. y FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market