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Forex Market

Ashutosh Jaiswal
MoF, RBSC

Index
Overview
FX

of Forex Market

market convention

Exchange

6th Bourse Programme, RBSC

rate theories

Overview of FX
Market

6th Bourse Programme, RBSC

FX Market
International currency market has two components:
1.

Worldwide forex market-

2.

Retail forex market

Wholesale (Banks, market makers,


Specialized institutions etc.)
-

Investors & corporates dealing


with banks

It is the largest & most liquid market in the world

Carriers of systemic risk across global markets

Traded in OTC & exchanges, quotes are in bid-ask terms

Quotes are generally in 5 significant digits & 3 letter codes e.g.

EUR:USD=1.1035

GBP, EUR, USD are used as quoted currency in this seniority order

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Global trading in FX mkt averaged at $5.3 trn per day in Apr 2013. FX
swaps were the most traded instruments, followed by spot trading (BIS)

$ was the dominant currency, with 87% of all FX trades having $ on one
side in Apr 2013, followed by Euro at 33%

Global trading is concentrated in largest financial centres. UK, US,


Singapore & Japan accounted for 71% of FX trading in Apr 2013

FEDAI is self regulatory body of banks dealing in Foreign exchange in


India

All FX trades in India are mandatorily reported in CCIL reporting


platform

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FX Mkt T/o by instrument

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Avg Daily T/O in select Financial


Market-India

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How Did We Get Here?


Pre 1971

Gold linked exchange rate

1973

FERA Introduced

1991

Economic Liberalization

1993

Current A/c convertibility for rupee

2000

FEMA Introduced

2008

Currency futures introduced on Indian Bourse

6th Bourse Programme, RBSC

FX Market
Conventions

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FX Quotes
Direct Quote:
a

Foreign Cy

Domestic Cy

100
In Domestic Cy

Indirect Quote:
a
Domestic Cy

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b
Foreign Cy

1/100
In Foreign Cy

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Pip : Price Interest Point, refers to the one unit of the final digit of the quote
(Similar to tick in equity market)
The forex market quotes exchange rate in one direction such as USD:INR,
not INR:USD
USD:INR ask rate is reciprocal of INR:USD bid rate
USD:INR bid rate reciprocal of INR:USD ask rate
e.g.

Given USD:INR= 66.91-66.95

We get-INR:USD= .01494-.01495

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Cross Rates
Exchange rate between two currencies, inferred from the exchange rate of
each currency against a common third currency

For example:
EUR:USD & USD:YEN can be used to calculate EUR:YEN
Lets assume: EUR:USD=1.10 , USD:YEN=125
Calculate- EUR:YEN=

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1.10 x 125 = 137.5

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Exchange Rate
Theories

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Foreign Exchange Fundamentals

Supply & Demand for Forex

Net exports, Services


Current A/c

Net income from


cross border
investments, Current
trfrs

Balance of Payments

Capital A/c &


Financial A/c
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Direct investments,
Portfolio
investments,
borrowings
Unilateral trfrs

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Factors affecting capital A/c


Changes in real interest rates (Debt)
Differences in Economic Performance (Equity)
Changes in investment climate

N.B.-

Current economic growth impacts current account


Future economic growth impact financial account
A deficit in Overall Balance ( sum of current, capital & financial
A/c) is matched by reduction in official reserves and creates
depreciation pressure on the local currency)

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Exchange rate regimes


Fixed

Pegged

Floating

Like currency board.


Eliminates exchg risk in
short term
Impacts
monetary
independence
(impossible trinity)

A compromise between
fixed & floating rate.
Peg is against another
major currency or a
basket of currency.
Exchange
rate
is
allowed to fluctuate
within a small band.
Mostly followed by
Emerging economies

Exchange rate fully


determined by market
forces. Influence on
rates
is
achieved
through
macroeconomic policies such
as rates.
Can turn very volatile

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Exchange rate parity

Parity
relations
details
interplay
between
exchang
e rate,
inflation
&
interest
rates

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Interest rate parity


PPP relation

Links spot rate, forward rate &


interest rate
Links spot rate & inflation

Intl Fischer relation

Links interest rate & expected


inflation

Uncovered interest
rate parity relation

Links spot rate, expected rate &


interest rate

Expectation relation

Links forward exchange rate &


expected spot exchange rate
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Interest rate parity


Forward rate (F)=S* {(1+Rf)/(1+Rd)}
Currency quoted in DC:FC terms (indirect quote)
Forward discount/premium (f)~Rf-Rd

f= (F-S)/S

Higher rate currency depreciates, cancelling the gain


out of higher interest rate. Hence, no arbitrage
possible.
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PPP Theory
Spot exchange rate adjusts perfectly to
inflation differential between two countries.
There are two versions- Absolute & Relative

S1=S0*{(1+If)/(1+Id)}

Absolute PPP:

s = (S1-So)/S0

Based on law of one price states that the


real price of a good must be the same in all
countries. If goods price rise in country
relative to another, the countrys exchange
rate must depreciate to maintain a similar
real price of goods in the two currencies.

Or s ~ If-Id

Relative PPP:

Real return on an asset is identical for


investors from any country

So, exchange rate movement

Currency quoted in DC:FC terms


(indirect quote)

Exchange rate movements offset any


inflation differential between two countries
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International Fisher Relation


In domestic relation, nominal rate

(1+Rf)/(1+Rd)=

1+r = (1+real rate)(1+E(I))

{(1+real rate f)/(1+real rate d)}

Or r ~ real rate + E(I)

* {(1+E(If))/1+E(Id )}

Intl Fisher relation states that


interest rate differential between
two countries should be equal to
the
expected
inflation
rate
differential over the tenor of the
rate. It proposes that real rates are
stable over time

Or Rf-Rd = E(If)-E(Id)

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Differential in nominal interest


rates are caused only by differences
in
national
inflationary
expectations

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Uncovered Interest rate parity


PPP combined with Intl Fisher
relation implies that expected
currency depreciation should offset
the interest differential between the
two currencies over the term of
interest rate

PPP statesE(S1)=S * {(1+E(If))/(1+E(Id))


When combined with Intl Fisher
E(S1)=S * {(1+Rf)/(1+Rd)}

And
E(s) ~ Rf-Rd
Foreign currency movement to be
equal to interest rate differential
between two countries
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Foreign Exchange Expectation


Depends strongly upon certainty
assumption.
Forward exchange rate to be an
unbiased predictor of future spot
rate.
Otherwise,
arbitrage
opportunity exists.

F = E(S1)
Covered Interest rate parity:

A borrowing in low rate currency


and converting & investing in high
rate currency will not result in any
return, even if covered with forward
rate. i.e., forward rate adjust for
currency depreciation and are
reflected in the expected spot rate.
F*(1+Rd)= S*(1+Rf)
Comparing with uncovered interest
parity theory, we getF=E(S1) .Expected Exchange

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Consolidated View of Exchange Rate


Theories
Factor

Related To Factor

By Theory

Forward discount

Interest rate

Interest rate parity

Exchange rate movement

Inflation rate

PPP

Interest rate

Inflation rate

Fisher relation

Expected exchange rate


movement

Interest rate

Uncovered interest rate


theory (PPP+ Fisher)

Forward Discount

Expected exchange rate


movement

Foreign Exchange
expectation

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Thanks

Questions?

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