The foreign exchange market

Chapter learning objectives • • •

To explain the distinctive characteristics of foreign exchange market To distinguish between different methods of foreign exchange quotation and convert from one method to another To identify the major participants in Forex To identify profitable currency arbitrage opportunities and calculate the profits that could be made through currency arbitrage To describe various types of transactions take place in spot and forward market To explain how forward contracts can be used to minimize risk and who are the major users of forward contracts and their motives To understand the history of Bangladeshi taka and Forex dealing entity BAFEDA.

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The Foreign Exchange Market – definition

As defined in The Economist's Guide to Financial Markets, foreign exchange, more popularly referred to as "forex" is a worldwide decentralized over-the-counter financial market for the trading of currencies, wherein financial centers around the globe serves as anchors of trading between a wide range of different types of buyers and sellers 24 hours a day, five days a week. So the foreign exchange market is a market where foreign currencies are bought and sold. If a Bangladeshi importer imports Apple computer from the USA then he/she would have to pay in US Dollars. So he/she will have to come to foreign exchange market to buy dollars for Bangladeshi taka. On the other hand, an exporter would have to convert to export proceeds obtained in for example, US Dollar into Bangladeshi currency and for that he/she would have to approach foreign exchange market as well. The world’s three most common transactions are exchanges between dollar and the euro (30%), the dollar and the yen (20%), and the dollar and the British Pound (12%).

9% and 6. .98 trillion in April 2010. USA and Japan ranked second and third respectively which accounted for 17.98 trillion. despite having some controls on the capital account. Countries such as Korea. tourism and investment. foreign exchange brokers. currencies are delivered at a future date. All these developed countries already have fully convertible capital accounts. and dealers whose function is to bring together buyers and sellers of foreign exchange. Since Forex Dealers are spread all over the world. It is the timing of actual delivery of foreign exchange that separates spot market from the forward market. currency speculators. institutional investors. multinational corporations. FX swaps and other currency derivatives. rather.Most developed countries permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. In the spot market transactions it does require immediate delivery of the traded currency whereas in the forward market. $1. It is the most liquid market in the world. Spot Market The foreign exchange market is classified either as spot market or as forward market. it is virtually open 24/7 because of different time zone.Major participants in the FOREX The primary purpose of the foreign exchange market is to facilitate international trade. Foreign exchange market permits transfer of purchasing power denominated in one currency to another – that is. it is an electronically linked network of banks. Of this US$3.5 trillion was traded in outright forwards. central banks. In Bangladesh we also don’t have currency derivative market. making it by far the most important global center for foreign exchange trading. and retail investors. other financial investors. The daily turnover in the global foreign exchange market is around US$ 3. governments.7% of the total. The foreign exchange market is not a physical place. A number of emerging countries do not permit FX derivative products on their exchanges in view of controls on the capital accounts.2%. to trade one currency for another currency. South Africa. Forex traders include large multinational banks.5 trillion was spot foreign exchange transactions and $2. The use of foreign exchange derivatives is growing in many emerging economies. Trading in the UK accounted for 36. and India have established currency futures exchanges.

Spot trade represents a “direct exchange” between two currencies. there is seldom any actual movement of currencies. There are different types of foreign exchange quotes. and interest is not included in the agreedupon transaction. debit and credit entries are made in the bank accounts of the seller and the buyer. Consider the Bangladesh Taka and US Dollar exchange . Foreign Exchange Quotes Indirect rate Direct rate Cross rate I Single Quote Two-way Quote I Spot rate I Interbank rate TT rate Bill rate Forward rate Direct rate The exchange rate of a currency is said to be quoted on a direct rate when it fluctuates while the other currency in the currency pair remain constant. In view of the huge amounts involved in the transactions. has the shortest time frame. involves cash rather than a contract. Simply it is units of local currency per foreign currency. Most of the markets effect the transfer of funds electronically thus saving time and energy. Rather.

To do virtually any exchange rate calculation (for example appreciation/depreciation) you must first express the exchange rate as a direct quote.5/USD.012821= ¥ 1 When expressed in this fashion.012821 $/ ¥ $1.013423 USD.746 = £ 1 $0. To convert from indirect to direct use the formula: Direct = 1/Indirect.1 If direct quote is Rs.7250/$ ¥76.25 = $1 From a US perspective. and is conceptually equivalent to a commodity price. Problem 2. What it tells us our home currency Taka is fluctuating everyday against US dollar while Dollar is quoting constant. may be tomorrow .013423 $/BDT. Most currencies on the interbank market are quoted as units of foreign currency/dollar.013514 $/BDT.7250= $1 ¥ 78. Simply it is units of foreign currency per local currency. how can this exchange rate be presented quote? Solution US $ 1/Rs. Other examples as follows 1. The indirect rate is one in which the foreign currency fluctuates and the home currency remain constant. these quotes are indirect. Today it may be BDT 74/USD.013514 USD and tomorrow . To convert from direct to indirect use the formula: under indirect . 45 = US $ 0. a direct quote is expressed as US$/BDT. Examples: Today .256/$ €0. the exchange rate is the dollar price of a foreign currency.746 $/£ . From a US perspective. the next day it may be BDT 74. 45/US $.0222/Re Indirect rate The exchange rate of a currency is said to be quoted on an indirect rate when it remain constant while the other currency in the currency pair fluctuates. It means constant 1 taka will buy today . For example: €0.rate.

cross rates are calculated from US dollar rates. BDT/PKR rate =0.1756/BDT. So when in a direct quote BDT 74/US$. 1/US $ 0.566 BDT. INR 0.850.6250 DM/$) = 82. PKR 1.3 Convert the following exchange rates given by HSBC in Dhaka.880 Cross Rates A cross rate is an exchange rate involving two currencies other than the US dollar. . Generally. Problem 2. into direct rates.013514/BDT or $1/BDT 74. Problem 2.025/Rs. under the indirect quote it would be $. how can this exchange rate be shown under direct quote? Solution Rs.Indirect = 1/Direct From Bangladesh perspective an indirect quote is expressed as US$/BDT. BDT/SAR=19.6383/BDT.25 ¥/$) / (1.25 ¥/$ 1.6250 DM/$ The cross rate is: (133. So the relationship between direct and indirect quote is one is the reciprocal of the other. SAR0.025 = Rs.6383 = 1.2 If indirect quote is US $ 0. given the following dollar exchange rates: 133. For example.00 ¥/DM ¥/$  DM/$ .0503/BDT Solution: Since the above quotes are indirect rate the direct rate would be from Bangladesh perspectives BDT/INR rate = 1/. 40/US $.

keeping the units straight is crucial. we must do so in such a way that the $ cancels out in the accompanying unit calculation. in the above example.50/US $ and the bid-ask spread is 1.83-0.83 = Rs.4 Find Rs./Euro exchange rate if: the two exchange rates are: Rs.50 = 0. 40.95 = Rs.7 Find out the bid rate if ask rate is Rs.95/Euro Problem 2. How do we know.84 = Rs.93-43. and not 82. Solution (40.50 – x = 0. so we are left with one foreign currency in terms of another. 40-40. 52.00 ¥/DM. Find the bid-ask spread.50 .95/US $ and Euro 0. 52. 52.00 DM/¥? Because: (¥/$) / (DM/$) = (¥/$) * ($/DM) = ¥/DM When we divide or multiply the dollar rates to obtain the cross rate.0123 or 1.23%.6 Consider the following bid-ask prices: Rs.0123 Or 40.0123 × 40.30 Ask rate = Rs.00)/40.50/US $. 43.50 = 0.50 – 40.95/0. Solution (40.When expressing cross rates.50 – x)/40.93/0.84/US $ Solution Bid rate = Rs. 43. that the cross rate is 82.23% Problem 2. 43. Problem 2.30-52.

Solution 360/30 {(45.00} = 0.50 – 0. Problem 2.8 Find out the forward rate differential if spot rate US $ is Rs.12 Or (x – 45) = 0.45 or x =45.00)/45. It will be known as a forward premium as the value of US dollar has increased.12 × 45 × 30/360 Or x = 45 + 0.80.00. 45. Problem 2.80 – 45.00} × 100 = 21. 45.33 per cent.9 Find the one-month forward rate of US dollar if spot rate is Rs.00)/45.Or 40. 45.00 and one-month forward rate is Rs.45 .00 and the forward premium is 12 per cent. Solution 360/30 {(x – 45.50 = x Or x = 40.

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