FOREIGN EXCHANGE: -

DEALING SYSTEM, SETTLEMENT,

EFFECT ON GDP & LIQUIDITY

Submitted by:-
Sushil Kumar (85)
FUNCTIONS OF FOREIGN EXCHANGE
MARKET
 It is the market where currencies are bought and
sold against each other.
It is the largest market in the world.

 The daily volumes in the UK, USA, Japan were

reported to be as follows -:

UK: $ 1359 b
USA: $ 664  b
                        Japan:   $ 238 b

 UK is contributed maximum liquidity in the forex 
market.
THE FUNCTIONS OF THE FOREIGN EXCHANGE
MARKET
enables the conversion of the
currency of one country into the
currency of another

2. It performs the hedging function

converting the risk on foreign
exchange transactions

3. Transfer purchasing power between

countries
4. TO PROVIDE CREDIT TO
IMPORTER DEBTOR
 INTERNATIONAL
Monetary System
EVOLUTION OF THE
INTERNATIONAL MONETARY SYSTEM
 Bimetallism: Before 1875

 Classical Gold Standard: 1875-1914

 Interwar Period: 1915-1944

 Bretton Woods System: 1945-1972

 The Flexible Exchange Rate Regime: 1973-Present

BIMETALLISM: BEFORE 1875
 A “double standard” in the sense that both gold and
silver were used as money.

 Some countries were on the gold standard, some on

the silver standard, some on both.

 Both gold and silver were used as international

means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents.

 Gresham’s Law implied that it would be the least

valuable metal that would tend to circulate.
CLASSICAL GOLD STANDARD:
1875-1914
 During this period in most major countries:
 Gold alone was assured of unrestricted coinage
 There was two-way convertibility between gold and
national currencies at a stable ratio.
 Gold could be freely exported or imported.

 The exchange rate between two country’s

currencies would be determined by their relative
gold contents.
CLASSICAL GOLD STANDARD:
1875-1914
For example, if the dollar is pegged to gold at U.S.
$30 = 1 ounce of gold, and the British pound is
pegged to gold at £6 = 1 ounce of gold, it must be
the case that the exchange rate is determined by
the relative gold contents:

$30 = £6
$5 = £1
CLASSICAL GOLD STANDARD:
1875-1914
 Highly stable exchange rates under the classical
gold standard provided an environment that was
conducive to international trade and investment.

 Misalignment of exchange rates and international

imbalances of payment were automatically
corrected by the price-specie-flow mechanism.
CLASSICAL GOLD STANDARD:
1875-1914
 There are shortcomings:
 The supply of newly minted gold is so restricted that the
growth of world trade and investment can be hampered
for the lack of sufficient monetary reserves.

 Even if the world returned to a gold standard, any

national government could abandon the standard.
INTERWAR PERIOD: 1915-1944
 Exchange rates fluctuated as countries widely used
“predatory” depreciations of their currencies as a
means of gaining advantage in the world export
market.

 Attempts were made to restore the gold standard,

but participants lacked the political will to “follow
the rules of the game”.

 The result for international trade and investment

was profoundly detrimental.
BRETTON WOODS SYSTEM: 1945-1972
 Named for a 1944 meeting of 44 nations at Bretton
Woods, New Hampshire.

 The purpose was to design a postwar international

monetary system.

 The goal was exchange rate stability without the

gold standard.

 The result was the creation of the IMF and the

World Bank.
BRETTON WOODS SYSTEM:
1945-1972
 Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.

 Each country was responsible for maintaining its

exchange rate within ±1% of the adopted par
value by buying or selling foreign reserves as
necessary.

 The Bretton Woods system was a dollar-based gold

exchange standard.
COLLAPSE OF BRETTON WOODS
(1971)
 U.S. high inflation rate

 U.S.$ depreciated sharply.

 Smithsonian Agreement (1971) US$ devalued to 1/38 oz.

of gold.

 1973 The US dollar is under heavy pressure, European

and Japanese currencies are allowed to float

 1976 Jamaica Agreement

 Flexible exchange rates declared acceptable

 Gold abandoned as an international reserve

BRETTON WOODS SYSTEM:
1945-1972

German
mark
British French
pound franc

r Par Pa
a
P lu Va r
Valu lu
Va e e e
U.S. dollar

Pegged at
$35/oz.
Gold
THE FLEXIBLE EXCHANGE RATE REGIME:
1973-PRESENT.
 Flexible exchange rates were declared acceptable
to the IMF members.
◦ Central banks were allowed to intervene in the exchange
rate markets to iron out unwarranted volatilities.

 Gold was abandoned as an international reserve

asset.

 Non-oil-exporting countries and less-developed

countries were given greater access to IMF funds.
CURRENT EXCHANGE RATE ARRANGEMENTS
 Free Float
◦ The largest number of countries, about 48, allow market forces
to determine their currency’s value.

 Managed Float
◦ About 25 countries combine government intervention with
market forces to set exchange rates.

 Pegged to another currency

◦ Such as the U.S. dollar or euro (through franc or mark).

 No national currency
◦ Some countries do not bother printing their own, they just use
the U.S. dollar. For example, Ecuador, Panama, and El Salvador
have dollarized.
EUROPEAN MONETARY SYSTEM
 Eleven European countries maintain exchange rates
among their currencies within narrow bands, and
jointly float against outside currencies.

 Objectives:
 To establish a zone of monetary stability in Europe.
 To coordinate exchange rate policies vis-à-vis non-
European currencies.
 To pave the way for the European Monetary Union.
WHAT IS THE EURO?
 The euro is the single currency of the European
Monetary Union which was adopted by 11 Member
States on 1 January 1999.

 These original member states were: Belgium,

Germany, Spain, France, Ireland, Italy, Luxemburg,
Finland, Austria, Portugal and the Netherlands.
 countries using different exchange rate
systems
FOREIGN EXCHANGE RATES
The foreign exchange rates between two
currencies specifies how much one currency
is worth in terms of other currency in term of
the home nation’s currency.
QUOTATIONS: -
 Direct :-
In a direct quotation, the exchange
rate is expressed as the number of units of
the home or domestic currency per unit of
the foreign currency

 Indirect :-
An indirect quotation is one that
the exchange rate is expressed as the
number of the foreign currency units per
domestic currency unit.
THE DETERMINATION OF EXCHANGE
RATES
The important theories which helps in determining
exchange are as:
1. Purchasing power parity (PPP).

2. Balance of payment approach.

3. Monetary and portfolio approach.

 PURCHASING POWER PARITY (PPP)
 It states that identical goods should be sold at
identical prices.
 Exchange rate should adjust for price differential.

 p (domestic price)=P (foreign price)/e (exchange

rate).
 Exchange rate will also compensate inflation rate.

 It hold in long run.

 BALANCE OF PAYMENT APPROACH
 It determines exchange rate at which both the
internal and external economy are in equilibrium.
 Internal equilibrium reflects a state of full
employment.
 External equilibrium reflects equilibrium in BOP.

 It is difficult to determine exact rate of

unemployment nor exchange rate consistent with
an equilibrium in the external account.
 It holds good in long term.
MONETARY AND PORTFOLIO APPROACH
 It assumes that economic agents can choose from a
portfolio of domestic and foreign assets.
 Assets can be in a form of money or bonds having
expected return.
 Arbitrage opportunity determines the exchange
rate.
INTERNATIONAL PARITY CONDITIONS
 It exists a definite relationship between
interest rates, inflation rates and exchange
rates.
INTEREST RATE PARITY
 The difference between the current exchange rate and the
forward rate results from the difference in the interest rate of two
countries. This is referred to as the interest rate parity.

Interest differential = Exchange rate (Forward and spot differential)

INFLATION RATES : -(PPP)
 The expected future spot rate deviates fro the current spot rate
because of the difference in the expected inflation rates in two
countries. This notion is based on the law of one price. The price of
similar goods should be same in foreign currency equivalent. This is
known as purchase power parity. Nominal interest rates reflect the
inflation rates.
EXCHANGE RATES :-
 A forward exchange rate should rate should be
what the foreign exchange market participants expect the
future spot rate to be. This is expectation theory of
exchange rates.
FOREIGN CURRENCY OPTIONS
CURRENCY OPTIONS
 Meaning of a Currency Option
 Types of Options

 Status of Options

 Option pricing and valuation

 Strategies using Options

 When to use currency options

 Market structure
CURRENCY OPTIONS
 “A foreign currency option contract is a financial
instrument from a writer (the seller) that gives the
holder (the buyer) the right but not the obligation to
sell or buy currencies at a set price either on a
specific date or before some expiration date.”

 First offered on Philadelphia Exchange (PHLX).

 Fastest growing segment of the hedge markets.

 Call
Option: An option that gives the
owner the right to buy a currency.

 Put
Option: An option that gives the
owner the right to sell a currency.
TYPES OF OPTIONS

 American Style: An option that can be

exercised any time before or on the
expiration date.

 European Style: An option that can only be

exercised on the expiration date.
CURRENCY OPTIONS
 Exercise or Strike Price: The price (spot
exchange rate) at which the option may be
exercised.

 Option Premium: The amount that must be

paid to purchase the option contract.

 Break-Even: The point at which exercising

the option exactly matches the premium
paid.
STATUS OF OPTIONS
 Out-of-Money Option :
The spot rate has not reached the exercise price,
the option cannot be exercised.

 At-the-Money Option :
The spot rate equals the exercise prices and would
lead to zero cash flow.

 In-the-Money Option :
The spot rate has surpassed the exercise price and
would lead to positive cash flows.
 In-Money Calls and Puts
 Call is in the money if ST > E
 Put is in the money if E > ST

 Out of Money Calls and Puts

 Call is out of money if ST < E
 Put is out of money if E < ST
OPTION PRICING AND VALUATION

1) Value of an option equals

a. Intrinsic value: the amount in-the-money
b. Time value: the amount the option is in
excess of its intrinsic value.
2) Other factors affecting the value of an
option :
a. value rises with longer time to expiration.

b. value rises when greater volatility in the

exchange rates.
STRATEGIES USING CURRENCY
OPTIONS
 Long a Call Option/Buy a Call Option
 Buy a right to purchase a foreign currency at a
predetermined exchange rate

 Long a Put Option

 Buy a right to sell a foreign currency at a
predetermined exchange rate
CALL OPTION
 The holder of a call option expects the
underlying currency to appreciate in value.

 Consider 4 call options on the euro, with a strike

of 92 ($/€) and a premium of 0.94 (both cents
per unit).

 The face amount of a euro option is €62,500.

 The total premium is:

$0.0094·4·€62,500=$2,350.
 Call Option: Hypothetical Pay-Off
Profit
Payoff Profile

$1,400
Break-Even
92 92.5 92.94
0 Spot Rate
88.15 93.5
--$1,100

--$2,350

Out-of-
Loss
the-money At In-the-money
PUT OPTION
 The holder of a put option expects the
underlying currency to depreciate in value.

 Consider 8 put options on the euro with a

strike of 90 ($/€) and a premium of 1.95
(both cents per unit).

 The face amount of a euro option is €62,500.

 The total premium is:

$0.0195·8·€62,500=$9,750.
 Put Option: Hypothetical payoff
Profit at a spot rate of 88.15

Payoff Profile

Break-Even
88.05 90
0 Spot Rate
-$500 88.15

--$9,750

Loss In-the-money At Out-of-the-money

WHEN TO USE CURRENCY OPTIONS

A) For Hedging Foreign Exchange Risk :

Foreign Currency Cash Outflows

 Risk: Foreign currency may increase in value
against domestic currency
 Strategy: Buy a call option on the foreign
currency
Foreign Currency Cash Inflows
 Risk: Foreign currency may decrease in value
against domestic currency
 Strategy: Buy a put option on the foreign currency

B) For Speculators :
- profit from favorable exchange rate changes.
MARKET STRUCTURE

Location :
a. Organized Exchanges
b. Over-the-counter
- Two levels: retail and wholesale.
FOREIGN CURRENCY SWAPS
 Currency swaps originally were developed by banks in the UK to help
large clients circumvent UK exchange controls in the 1970s.

 An agreement to make a currency exchange between two foreign

parties. The agreement consists of swapping principal and interest
payments on a loan made in one currency for principal and interest
payments of a loan of equal value in another currency.

 The World Bank first introduced currency swaps in 1981 in an effort to

obtain German marks and Swiss francs. This type of swap can be done
on loans with maturities as long as 10 years. It differ from interest rate
swaps because it also involve principal.

 fixed-floating currency swap is equivalent to a strip of

currency forwards.
COMPARATIVE ADVANTAGE FOR CURRENCY
SWAPS
 Two firms can enter into a currency swap to exploit their
comparative advantages regarding borrowing in different
countries.

 That is, suppose:

 Firm B can borrow in $ at 8.0%, or in € at 6.0%.
 Firm A can borrow in $ at 6.5% or in € at 5.2%.

 If A wants to borrow €, and B wants to borrow $, then they may

be able to save on their borrowing costs if each borrows in the
market in which they have a comparative advantage, and then
swapping into their preferred currencies for their liabilities.
Exploiting comparative advantages
A domestic company has comparative advantage in domestic
loan but it wants to raise foreign capital. The situation for a
foreign company happens to be reversed.
lend out
domestic domestic domestic foreign foreign foreign
bank principal Pd company company principal Pf bank

Pd = F0 Pf

domestic enter into a foreign

company currency swap company

Goal :- To exploit the comparative advantages in borrowing

rates for both companies in their domestic currencies.
 Cash flows between the two currency
swap counter parties
(assuming no inter temporal default)

domestic principal Pd
domestic (initiation) foreign
periodic foreign coupon payments cf Pf
company company
foreign principal Pf
(maturity)

foreign principal Pf
(initiation)
domestic periodic domestic coupon payments cd Pd foreign
company domestic principal Pd company
(maturity)
Settlement rules:-
Under the full (limited) two-way payment clause, the non-
defaulting counter party is required (not required) to pay
if the final net amount is favorable to the defaulting party.
THANK YOU