FOREX

Introduction

The foreign exchange market is a crucial part of the global economy. Various instruments are
used in forex trading, such as forwards, futures, options, and swaps.

Forex market basics

The foreign exchange market (also referred to as the forex or currency market) is the
marketplace for exchanging currencies between all stakeholders such as governments, central
and commercial banks, firms, forex dealers, brokers and individuals. Such players can use the
market for trading, hedging and speculating in currencies as well as obtaining credit. 

How are exchange rates determined?

Currencies are always traded in pairs e.g.: USD-EUR, USD-INR etc. The relationship
between the currencies is given by the formula: 

Base currency / Quotation Currency = Value

For example, if the base currency is USD and the quotation currency is INR then the value
would be roughly around 79 as the rupee is trading at around INR 79 per USD. 

Now exchange rates are determined by various factors depending on whether the currencies
in question have “free float” or “fixed float”.

1. Free floating currencies are those whose value depends solely on the demand and
supply of the currency relative to other currencies. 

2. Fixed floating currencies are those whose value is fixed by the government or the
central bank, sometimes by pegging it to a standard. For example, the Russian Ruble
was recently pegged to gold at 5000 rubles per gram of gold.

Types of Forex Market

There are 5 types of currency markets in India – spot, forward, futures, options and swaps.

The spot market is the marketplace for currency trading at real-time exchange rates.

On the other hand, forward markets deal in over-the-counter (OTC) forward contracts.
Forward contracts are agreements between parties to exchange a particular quantity of
currency pair at a specific rate and on a given date.
They help in hedging currency risks i.e. the risk of changing values of currency assets due to
fluctuations in currency exchange rates. However, forward markets do not have a central
exchange for their operations. Therefore:

1. They are highly illiquid (hard to find buyers or sellers randomly)

2. They usually do not require any collateral and thus have counterparty risk i.e. risk of
parties not following through with an agreement

The futures markets are basically forward markets, but with centralised exchanges like the
NSE. Therefore, they have higher liquidity and lower counterparty risk than forward
markets. Currency futures or FX futures or currency derivatives are available on the NSE on
INR and four currencies viz. US Dollars (USD), Euro (EUR), Japanese Yen (JPY) and Great
Britain Pound (GBP). Cross Currency Futures & Options contracts on EUR-USD,  USD-JPY
and GBP-USD are also available for trading in the currency derivatives segment. Since all
transactions are publicly available and settled in cash, it is easier to trade, speculate and
perform arbitrage in the futures market.

The options market allows traders the right to buy/sell currency at a specified price on a

specified date through a central exchange such as the NSE. The currencies available are the
same as that of the NSE currency futures market.

Currency swaps are agreements between two parties to exchange a principal and interest
amount in different currencies only to be re-exchanged at a specific later date. At least one of
the interest rates in the agreement is fixed.

Special features of the forex market

 The forex market has a higher degree of leverage than other markets (such as the
stock market). Leverage is the loan given by a broker to a trader to allow the trader to
invest in greater quantities than otherwise. However, higher leverage also means risk
of higher losses.

 There are no central clearing houses that oversee international currency trade.
However, the central banks and governments usually regulate the forex trade.
  The forex market has a large variety of currencies and is open 245 as it is an
international market. The market opens on Sunday 5pm EST and closes on Friday
5pm EST.  Therefore, there is a wider range of opportunities for trade. However, the
risk also increases as an international incident in some far-away time-zone might
devalue your currency assets while you are sleeping.

 There are fewer commissions and fees to be paid in currency trading. 

Currency market in India

As per the RBI, OTC and spot markets are dominant in the Indian currency market where
around USD 33 billion was traded daily in 2019. Currency futures are traded on exchanges
such as NSE, BSE, and MCX-SX.

Trends in the forex market

The USD is the most traded currency in the world (being a part of over 85% of trades), which
allows it to act as an unofficial reserve currency among other countries. The Euro and Yen
come as distant second and third. As per a BIS report, trading in currency globally reached
$6.6 trillion per day in April 2019.
 Value for money (VFM) and the 3 E’s

Introduction

A significant number of NFPs are funded from the public purse, the lack of clear financial
performance measures has been seen as a particular problem. It is argued that the public are
entitled to reassurance that their money (in the form of taxes for public sector organisations
or donations for charities) is being properly spent. In addition, the complex mix of objectives
with no absolute priority has also led to concern that the money may be being directed
towards the wrong ends. These issues, along with a growth in the perceived need for greater
accountability among public officials, led to the development of the concept of evaluating
VFM in public sector organisations. The principles developed are now widely applied in
NFPs.

VFM can be defined as ‘achieving the desired level and quality of service at the most
economical cost’.

Systems analysis

A more detailed analysis of what is meant by VFM can be achieved by viewing the
organisation as a system set up to achieve its objectives by means of processing inputs into
outputs.

The organisation of a system

The three E’s

Assessing whether the organisation provides value for money involves looking at all
functioning aspects of the organisation. Performance measures have been developed to permit
evaluation of each part separately.

Economy: Minimising the costs of inputs required to achieve a defined level of output.
Efficiency: Ratio of outputs to inputs – achieving a high level of output in relation to the
resources put in (input driven) or providing a particular level of service at reasonable input
cost (output driven)

Effectiveness: Whether outputs are achieved that match the predetermined objectives.

Use of the 3 Es as a performance measure and a way to assess VFM is a key issue that relate
to NFPs and public sector organisations.

Known as the 3 Es these measures are fundamental to an understanding of VFM. An

organisation achieving economy, efficiency and effectiveness in each part of the system is
considered to be providing good VFM.

Public sector organisations are subject to regular VFM (or best value) reviews and the results
have important impacts on future plans and funding decisions.

Economy

Acquiring resources of appropriate quality and quantity at the lowest cost. Note that whilst
obtaining low prices is an important consideration it is not the only one. Achieving true
economy will include ensuring the purchases are fit for purpose and meet any predetermined
standards.
Efficiency

Maximising the useful output from a given level of resources, or minimising the inputs
required to produce the required level of output. Some public services fall within the first
definition as they try to provide as much of a service as possible with strictly limited
resources and few opportunities to generate further income sources. This is defined as ‘input-
driven’ efficiency. This would include services such as library provision.

However, in many areas there is a statutory obligation to provide a particular standard of

service, for example prison services, which cannot be significantly reduced or withdrawn. In
this case, the obligation is to provide the service at a reasonable cost and is known as ‘output-
driven’ efficiency.

In both areas, the key consideration is whether the resources used were put to good use and
the methods and processes carried out represent best practice.

Effectiveness

Ensuring that the output from any given activity is achieving the desired result. For example,
the cheapest site on which to build and run a sports centre may be a disused brownfield site
on the edge of town. However, if the council’s objectives included reduction in car use and
accessible opportunities for health improvement, then the output of the building process – the
sports centre, even if built economically and efficiently, would not be considered effective as
it failed to meet the stated objectives
Payback method of appraisal

The payback period is the time a project will take to pay back the money spent on it. It is
based on expected cash flows and provides a measure of liquidity.

Decision rule:

 only select projects that pay back within the specified time period
 choose between options on the basis of the fastest payback Constant annual cash
flows

Payback period = initial investment / annual cash flow.

A project is expected to have the following cash flows:

Year Cash flow $000

0 (1900)
1 300
2 500
3 600
4 800
5 500
What is the expected payback period?

Year Cashflow Cumulative Cashflow

0 (1900) (1900)
1 300 (1600)
2 500 (1100)
3 600 (500)
4 800 300
5 500 800

In the table above a column is added for cumulative cash flows for the project to date. Figures
in brackets are negative cash flows.

Each year’s cumulative figure is simply the cumulative figure at the start of the year plus the
figure for the current year. The cumulative figure each year is therefore the expected position
as at the end of that year.
Payback is between the end of Year 3 and the end of Year 4 – that is during Year 4. This is
the point at which the cumulative cash flow changes from being negative to positive. If we
assume a constant rate of cash flow throughout the year, we could estimate that payback will
be three years plus ($500/800) of Year 4. This is because the cumulative cash flow is minus
$500 at the start of the year and the Year 4 cash flow would be $800.

$500/800 = 0.625

Therefore, payback is after 3.625 years.

Payback in years and months is calculated by multiplying the decimal fraction of a year by 12
months. In this example, 0.625 years = 7.5 months (0.625 × 12 months), which is rounded to
8 months. So therefore, payback occurs after 3 years 8 months.

Net Present Value

To appraise the overall impact of a project using DCF techniques involves discounting all the
relevant cash flows associated with the project back to their PV. If we treat outflows of the
project as negative and inflows as positive, the NPV of the project is the sum of the PVs of all
flows that arise as a result of doing the project.

The NPV represents the surplus funds (after funding the investment) earned on the project,
therefore:

 if the NPV is positive – the project is financially viable

 if the NPV is zero – the project breaks even (just returning enough money to cover the
funding costs)
 if the NPV is negative – the project is not financially viable
 if the company has two or more mutually exclusive projects under consideration it
should choose the one with the highest NPV
 the NPV gives the impact of the project on shareholder wealth.

There are a number of alternative terms used to refer to the rate a firm should use to take
account of the time value of money:

 cost of capital
 discount rate

Whatever term is used, the rate of interest used for discounting reflects the cost of the finance
that will be tied up in the investment.
An organisation is considering a capital investment in new equipment. The estimated cash
flows are as follows.

Year Cash Flow $

0 (240000)
1 80000
2 120000
3 70000
4 40000
5 20000
The company’s cost of capital is 9%.

Calculate the NPV of the project to assess whether it should be undertaken

Year Cashflow Discount factor @ 9% Present Value

0 (240000) 1.0 (240000)
1 80000 0.917 73360
2 120000 0.842 101040
3 70000 0.772 54040
4 40000 0.708 28320
5 20000 0.650 13000
Net Present Value 29760

The PV of cash inflows exceeds the PV of cash outflows by $29,760, which means that the
project will earn a DCF return in excess of 9%, i.e. it will earn a surplus of $29,760 after
paying the cost of financing. It should therefore be undertaken.