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Crown Agents Bank An Introduction to Foreign

An Introduction to Foreign Exchange

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Crown Agents Bank

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Crown Agents Bank An Introduction to Foreign Exchange

Contents
Foreword What is Foreign Exchange? Spot Transactions Forward Transactions Currency Options Settlement International Currency Codes Crown Agents Bank Contact Details 3 4 5 8 15 17 19 22 23

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Crown Agents Bank An Introduction to Foreign

Foreword
I am pleased to introduce this publication: an easy to read guide for those who would like a better understanding of foreign exchange. Like all markets, the practice and terminology of the foreign exchange market can be intimidating to outsiders and newcomers. However, those involved in international business need to understand how the market works, the risks when transacting business in foreign currencies, and how those risks can be mitigated, even if they do not speak the jargon. This guide introduces basic transactions and processes, with simple examples and pricing illustrations. If you would like to discuss specific foreign exchange issues in more detail, please contact our Treasury team whose details are given on the back page.

Graham Godley Managing Director Crown Agents Bank

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Crown Agents Bank An Introduction to Foreign Exchange

What is Foreign Exchange?
Foreign exchange is the exchanging of the currency of one country for that of another. This is undertaken using the foreign exchange market, a market that has no physical exchange or trading floor. Deals are conducted by means of electronic trading systems, by telephone or, at the retail level, over a bank’s counters. Users of the market include banks, governments, companies and private individuals. Not all the world’s currencies are freely convertible. There are a number which cannot be converted without satisfying official exchange control regulations. Others are not in high enough demand to ensure liquidity and a viable market. The range of currencies that are traded is wide and includes the currencies of all the major developed countries. Those that are less frequently traded are known as “exotic” currencies.

The foreign exchange market is very active and prices are in a constant state of change, reacting moment by moment to variations in the pattern of trading, to announcements of new economic data, to news items and to a myriad of other factors. Quotations are therefore only good for very short periods and customers must agree to deal quickly to avoid changes.

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Crown Agents Bank An Introduction to Foreign

Spot Transactions
A spot foreign exchange deal is a transaction in which one currency is exchanged directly for another for settlement two working days later (to allow each party time to arrange payment to the other).

The price at which a deal takes place is known as the spot rate. This is expressed as the value of a unit of one of the two currencies in terms of the other currency. For example, the spot rate for an exchange between the US dollar and the Swiss franc would be quoted as 1 dollar = 1.6000 francs. In this example the dollar is the unit or base currency and every dollar is worth 1.6 francs. The general practice in the spot market is to measure the value of currencies against the US dollar and so, when the US dollar is one of the currencies being exchanged, it is normally the unit or base currency in the exchange rate. There are some exceptions to this rule, notably the pound sterling and the euro.

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Crown Agents Bank An Introduction to Foreign Exchange

A spot rate of exchange
Foreign exchange rates are quoted in currency pairs. The first currency named in the pair is always the unit currency. For example:EUR/USD: = 1.1670/80 (i.e. 1.1670 to 1.1680) EUR/USD are the two currencies. The codes are the international three letter codes used by financial institutions. EUR = Euros; USD = US dollars. Every currency has been assigned such a code. The full list of currency codes is shown on pages 19-21. • Rates quoted are two-way. The left-hand side (i.e. 1.1670) is where the dealer will buy the unit currency. This is known as the bid. The right-hand side (i.e. 1.1680) is where the dealer will sell the unit currency. This is known as the offer. • Most prices are quoted to four decimal places (exceptions include JPY which is usually quoted to two decimal places). In the above example 1.16 is called the big figure and 70/80 are the points or ticks. • The difference between the bid rate and the offer rate is known as the spread. The exchange rate in this example has a ten point spread.

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Crown Agents Bank An Introduction to Foreign

Other currency pairs
USD/CHF 1.2810/20 = Dealer will buy USD 1 for CHF 1.2810 or will sell USD 1 for CHF 1.2820 GBP/USD 1.7500/10 = Dealer will buy GBP 1 for USD 1.7500 or will sell GBP 1 for USD 1.7510 USD/JPY 116.00/10 = Dealer will buy USD 1 for JPY 116.00 or will sell USD 1 for JPY 116.10

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Crown Agents Bank An Introduction to Foreign Exchange

Forward Transactions
A forward exchange deal is a transaction in which one currency is exchanged directly for another for settlement at a specified time more than two working days after the deal date. No money changes hands until the specified settlement date, which can be at any time (within certain limits) to suit the parties. Settlement is made at the rate of exchange agreed between the parties at the time of dealing.

The purpose of a forward exchange deal is to fix the cost of exchange at a future date to cover an anticipated foreign exchange commitment.

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Crown Agents Bank An Introduction to Foreign

Using a forward transaction
A transport company in Europe buying trucks directly from a Japanese manufacturer will be required to make payment in yen on delivery of the vehicles, which may be scheduled several months after the order is placed. If the company maintains its accounts in euros it will be necessary to sell euros for yen. Rather than wait until the delivery date to buy yen, and risk an increase in the cost of yen on the foreign exchange market, the company could buy yen forward when it places the order. If the forward settlement date is matched to the delivery date for the trucks, the company will receive the yen it needs when it needs them and, by dealing at the time the order is placed, avoid the risk of suffering a loss on exchange, and the uncertainty of not knowing what the cost in euros will be.

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Crown Agents Bank An Introduction to Foreign Exchange

How is the exchange rate of a forward transaction fixed? There is no uncertainty or guesswork in calculating a forward price. It is based on known market values: the prevailing interest rates and the spot exchange rates for the two currencies.

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Crown Agents Bank An Introduction to Foreign

Example of a forward transaction
To demonstrate how a forward price is calculated, assume that BRITCO, a UK company, expects a payment three months from today of USD1m for goods which it needs to exchange into GBP. If there was no forward exchange market, what would BRITCO’s alternatives be? Either: (a) - Do nothing now. Wait until the payment is made and then sell USD for GBP at the market rate available at that time; Or (b) - Borrow USD 1 million for three months from today and use this to buy GBP at today’s exchange rate; - place the purchased GBP on deposit for three months; - use the USD payment expected in three months time to repay the USD borrowing (note the interest earned on the three month GBP deposit can be sold for USD in three months time and put towards covering the interest charges on the USD borrowing). Continued …

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Crown Agents Bank An Introduction to Foreign Exchange

Alternative (a) is risky. The exchange rate could move in either direction over a three month period. If the GBP strengthens, the value of the dollar payment will be less in three months time than it is now. Of course, the reverse will be true if the GBP weakens but is it worth taking a chance? Alternative (b) is the prudent choice. It locks in today’s exchange rate and removes the risk of loss from a fall in the value of the USD. The cost of borrowing dollars may be fully covered by the interest earned on the GBP deposit depending on the level of interest rates in the two currencies. If it is not, then the shortfall will be an extra cost to be factored into the exercise. It is a known extra cost, however, and the exercise still achieves its objective of removing the uncertainty over what will happen to exchange rates over the three month period.

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Crown Agents Bank An Introduction to Foreign

A forward price calculation
A spot rate is adjusted to reflect the difference in interest rates for each currency GBP interest rate for 90 days USD interest rate for 90 days Spot GBP/USD exchange rate So: Interest rate differential, GBP/USD or = 4% per annum = 2% per annum = 1.7500

= 2% per annum = 0.5% for 90 days

This can be expressed in the exchange rate as follows: GBP1 + 0.50% of one pound = GBP 1.0050 GBP1.0050 = USD1.7500 GBP1.0000 = USD1.7500 = 1.7413 1.0050 The forward margin = 0.0087 (1.7500-1.7413)

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Crown Agents Bank An Introduction to Foreign Exchange

The difference between the spot and forward rates is known as the forward margin and it represents the difference between the cost of borrowing USD and lending GBP for 90 days. The forward margin is the amount by which the spot rate needs to be adjusted to obtain a forward exchange rate.

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Crown Agents Bank An Introduction to Foreign

Currency Options
A currency option conveys the right, but not the obligation, either to buy or sell a specific amount of a currency for another currency at a fixed price at a future date. The future date may be either the latest date on which the option may be exercised or the only date on which the option is exercisable. The holder of an option is not obliged to deal, however, and may choose simply to allow the option to lapse.

The cost of a currency option is typically expressed as a percentage of the underlying amount. These options can be used to secure the future value of a currency by, in effect, establishing a minimum future price without making a commitment to deal. When used in this way an option can be thought of as an insurance policy. An option purchaser pays a premium (the cost of the option) for the right to buy (or sell) a currency at a fixed exchange rate at a future date. If the spot rate at that future date is less favourable than the option rate, the holder can exercise the option. If the spot rate at that future date is more favourable than the option rate, the holder can allow the option to lapse and deal in the market.

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Crown Agents Bank An Introduction to Foreign Exchange

Either way, the option has “insured” a maximum cost of the currency for the purchaser. The cost of the option is the price the purchaser pays for the right to buy (or sell) at a fixed rate and thereby limit the risk of loss on exchange. In the same way, the cost of an insurance premium is the price of limiting the risk of loss of the insured item.

Using an option
In this example DutchCo is bidding for a contract which, if it is awarded to DutchCo, will be priced in US Dollars. The US dollar income is a possible future cash flow that will need to be sold for euros. Instead of entering into a commitment to sell dollars forward, DutchCo could purchase an option to sell the dollars at a predetermined rate if and when the contract is awarded. If the value of the dollar has fallen by the date it receives payment, it could exercise the option and deal at the better option rate. If the value of the dollar has not fallen, or if it has risen, DutchCo would simply allow the option to lapse and sell its dollars in the market at the spot rate. In this way DutchCo will be protected against a fall in the value of the dollar over the period for a fixed cost, but will benefit from any rise in the value of the dollar.

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Crown Agents Bank An Introduction to Foreign

Settlement
When an exchange deal is settled the currencies involved do not cross their own national borders.

The settlement process
On Wednesday, the dealer at Bank A in London agrees to sell spot US dollars in exchange for Swiss francs to Bank B in Frankfurt. Even though the two parties are located in London and Frankfurt, they have to settle their US dollars in New York and their Swiss francs in Zurich. Currencies do not cross their national borders. On Friday:i) the Swiss franc side of the transaction settles in Zurich with Bank B’s franc account being debited and Bank A’s franc account being credited (i.e. B pays francs to A).

ii) the US dollar side of the transaction settles in New York with Bank A’s dollar account being debited and Bank B’s dollar account being credited (i.e. A pays dollars to B). This is illustrated in the diagram overleaf.

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Crown Agents Bank An Introduction to Foreign Exchange

Wednesday – Spot deal London Bank A sells buys Friday – Settlement New York Bank A pays Bank B receives USD USD Zurich Bank A CHF receives Bank B CHF pays USD → USD CHF ← CHF Frankfurt Bank B buys sells

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Crown Agents Bank An Introduction to Foreign

International Currency Codes
Code ALL AMD ANG AOA ARS AUD AWG AZM BAM BBD BDT BGL BHD BIF BMD BND BOB BRL BSD BTN BWP BYR BZD CAD CDF Country Albania Armenia Netherlands Antilles Angola Argentina Australia Aruba Azerbaijan Bosnia and Herzegovina Barbados Bangladesh Bulgaria Bahrain Burundi Bermuda Brunei Darussalam Bolivia Brazil Bahamas Bhutan Botswana Belarus Belize Canada Congo/Kinshasa Currency Leke Drams Guilders Kwanza Pesos Dollars Guilders Manats Convertible Marka Dollars Taka Leva Dinars Francs Dollars Dollars Bolivianos Brazil Real Dollars Ngultrum Pulas Rubles Dollars Dollars Code Country CHF CLP CNY COP CRC CUP CVE CYP CZK DJF DKK DOP DZD EEK EGP ERN ETB EUR FKP FJD GBP GEL GGP GHC Switzerland Chile China Colombia Costa Rica Cuba Cape Verde Cyprus Czech Republic Djibouti Denmark Dominican Republic Algeria Estonia Egypt Eritrea Ethiopia Euro Member Countries Falkland Islands Fiji United Kingdom Georgia Guernsey Ghana Gibraltar Currency Francs Pesos Yuan Renminbi Pesos Colones Pesos Escudos Pounds Koruny Francs Kroner Pesos Algeria Dinars Krooni Pounds Nakfa Birr Euro Pounds Dollars Pounds Lari Pounds Cedis Pounds

Congolese Francs GIP

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Crown Agents Bank An Introduction to Foreign Exchange

GMD GNF GTQ GYD HKD HNL HRK HTG HUF IDR ILS IMP INR IQD JMD JOD KES KGS KHR KMF KPW KRW KWD KYD KZT LAK LBP LKR

Gambia Guinea Guatemala Guyana Hong Kong Honduras Croatia Haiti Hungary Indonesia Israel Isle of Man India Iraq Jamaica Jordan Kenya Kyrgyzstan Cambodia Comoros Korea (North) Korea (South) Kuwait Cayman Islands Kazakstan Laos Lebanon Sri Lanka

Dalasi Francs Quetzales Dollars Dollars Lempiras Kuna Gourdes Forint Rupiahs New Shekels Pounds Rupees Dinars Dollars Dinars Shillings Soms Riels Francs Won Won Dinars Dollars Tenge Kips Pounds Rupees

LRD LSL LTL LVL LYD MAD MDL MGF MKD MMK MNT MOP MRO MVR

Liberia Lesotho Lithuania Latvia Libya Morocco Moldova Madagascar Macedonia Myanmar (Burma) Mongolia Macau Mauritania Maldives(Maldive Islands)

Dollars Maloti Litai Lati Dinars Dirhams Lei Malagasy Francs Denars Kyats Tugriks Patacas Ouguiyas Rufiyaa Kwachas Pesos Ringgits Meticais Dollars Nairas Gold Cordobas Kroner Nepal Rupees Dollars Rials Balboa Nuevos Soles Kina

MWK Malawi MXN MYR MZM NAD NGN NIO NOK NPR NZD OMR PAB PEN PGK Mexico Malaysia Mozambique Namibia Nigeria Nicaragua Norway Nepal New Zealand Oman Panama Peru Papua New Guinea

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Crown Agents Bank An Introduction to Foreign

PHP PKR PLN PYG QAR ROL RUR RWF SAR SBD SCR SDD SEK SGD SHP SIT SKK SLL SOS SPL SRG STD SVC SYP SZL THB TJR TMM

Philippines Pakistan Poland Paraguay Qatar Romania Russia Rwanda Saudi Arabia Solomon Islands Seychelles Sudan Sweden Singapore Saint Helena Slovenia Slovakia Sierra Leone Somalia Seborga Suriname São Tome and Principe El Salvador Syria Swaziland Thailand Tajikistan Turkmenistan

Pesos Rupees Zlotych Guarani Rials Lei Rubles

TND TOP TRL TTD TVD TWD TZS

Tunisia Tonga Turkey Trinidad and Tobago Tuvalu Taiwan Tanzania Ukraine Uganda United States of America Uruguay Uzbekistan Venezuela Vietnam Vanuatu Samoa Silver Gold East Caribbean Yugoslavia South Africa Zambia Zimbabwe

Dinars Pa'anga Liras Dollars Tuvalu Dollars New Dollars Shillings Hryvnia Shillings Dollars Pesos Sums Bolivares Dong Vatu Tala Ounces Ounces Dollars New Dinars Rand Kwacha Zimbabwe Dollars

Rwanda Francs UAH Riyals Dollars Rupees Dinars Kronor Dollars Pounds Tolars Koruny Leones Shillings Luigini Guilders Dobras Colones Pounds Emalangeni Baht Rubles Manats UGX USD UYU UZS VEB VND VUV WST XAG XAU XCD YUM ZAR ZMK ZWD

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Crown Agents Bank An Introduction to Foreign Exchange

Crown Agents Bank Team Contact our Treasury
Crown Agents Bank quotes competitive foreign exchange and money market rates in all the major and many exotic currencies. David Smithson We also offer accounts in many currencies for prompt receipt Tel: +44 (0)208 710 6126 and payment of overseas and domestic funds. Email: david.smithson@crownagents.co.uk Our clients include central banks, governments, development agencies, NGOs and other organisations worldwide. Nick Goryn Tel: +44 (0)208 710 our The combination of 6039 competitive rates and flexible service Email nick.goryn@crownagents.co.uk delivery is a winning formula for our clients.

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Crown Agents Bank An Introduction to Foreign

Contact our Treasury Team
David Smithson Tel: +44 (0)208 710 6126 Email: david.smithson@crownagents.co.uk Nick Goryn Tel: +44 (0)208 710 6039 Email nick.goryn@crownagents.co.uk

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