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Treasury & Fund Management

Szabist Islamabad
By Muhammad Ahmed Khan

Session Five Foreign Exchange Management

Session Five Agenda


International Monetary Fund. The Balance of Payments & Balance of Trade. Concept of FOREX Management. Scope And Significance of FOREX Management. Role of FOREX Treasurer. Foreign Exchange Market. Determinants of Foreign Exchange Rates. Exchange Rate QuotationsDirect And Indirect. FOREX Market Risk. Currency Exposure Management Managing Foreign Exchange Rate Risk. Exchange Rate Forecasting. Mechanics of FOREX Trading. Cross- Border Payments And Receipts. Capital Account Convertibility. Managing Multinational Operations. Interest Rate And Currency Swaps. Foreign Exchange Market In Pakistan.

Balance of Trade & Balance of Payments


Two Commonly Used Terms In International Economics

That Are Different Yet Closely Related To Each Other.

Balance of Trade (BOT)


A component of balance of payments arising from merchandising of tangible goods and services. Included as a current item in balance of payments Represents the difference between the value of goods and services exported out of a country and the value of goods and services imported into the country. Favorable bot means exports exceed imports.

Balance of Payment (BOP)


Method used to monitor Intl monetary transactions for a period of time. Determines how much money is moving in and out of the country through trades conducted by private & public sectors. Three components: Current Account Capital Account Financial Account

FOREX Management - Introduction


Unlike other markets Foreign Exchange (FX) market is not linked to any stock exchange. Value of currency is generically reflective of a countrys economy. FX Trading Platform : Network of banks (Interbank or OTC market). Brokers on electronic dealing platforms or bilateral contacts. Through interaction currencies are: Valued and traded in relation to each other. Rates are determined through interaction of market forces influencing the supply demand. Global market is dominated by investment players, Commercial banks; Portfolio managers; large corporations; money brokers, etc.

FOREX Management - Introduction


How A Currency Dealer Makes Money:
Sale & purchase of currencies (spot and forward). Keeping stock of currencies to meet companys business needs as well as capitalize on projected future outlook.

Exotic products, i.e., Swaps, derivatives, options, etc.

Motives For Currency Trading:


Reactive trading- In response to a commercial transaction or political and / or economic event. Speculative trading In anticipation of certain event
Off late speculation for profit has become a major consideration for individuals and big time participants..

Scope of FX Management
Mutual interdependence of countries around the world needs an efficient cross-currency settlement mechanism. Global trade integration underscores the important of smooth international trade regime. Development of international trade owes a lot to free movement of funds from one financial centre to another. However benefits of trade and swift FX movement also bring to fore country, political and exchange rate risks.

Scope of FX Management
USD
SGD/ AUD/ CAD /AED

EUR
Commonly traded Currncies

SFR

GBP
JPY

A currency can be sold or bought in one transaction. Trading is done in pairs of currencies where the currency bought (Top) is mentioned first followed by sold (Bottom) currency. Trading carried out either on Spot or Forward basis.

Scope of FX Management
Typical FX Inflows and Outflows for a country Inflows:
Workers emigrants send foreign exchange back home for family maintenance or savings. Inwards remittances. Receipts of proceeds against exports made. Unfinished goods imported into the country for value addition and re-export at a premium. Receipts from international donors as loan, grants, etc. Foreign investment into the country.

Outflows:
Issuance of foreign currency for personal or business travel to foreign countries. Purchase of foreign books; magazines; or subscriptions to foreign technical, educational & professional bodies Payments for imports into the country Payment of loans with interest to international donors Payment of royalties and dividend. Private Remittances.

Role of A Foreign Exchange Manager


Typical FX Inflows and Outflows for a country
Distinctly different from that of Financial or Treasury Managers. Dealing with numerous counterparts in many currencies, many countries. Exposed to special kind of risks, opportunities and challenges.

Essential Prerequisites For Effective FX Management:


Awareness about historical development of world trade. Ability to forecast future trends. Comparative analysis skills. In-depth knowledge of local and international fx market. Knowledge of interest rates. Readiness to take risks. Hedging skills to avoid possible losses and exploit the potential.

What is Foreign Exchange Market ?


An over the counter marketplace where one currency is traded for another. Commercial banks are the market makers. Corporates use the market for their operations, e.g., payments of: Imports. Principle & interest on FCY loans. Export receipts. Conversion of currencies. Hedging. Fund placements. Speed and efficiency in settlement is reflected in extreme thin trade margins.

What is Foreign Exchange (FX) Market ?

Retail Market

Spot Market

Interbank Market

What is Foreign Exchange (FX) Market ?


Just like Treasury, FX Market also operates at three levels. i. Retail market - Currency Dealers/ Exchange companies
It is also referred as Open Market & used for: 1. Encashment of Travelers Cheques. 2. Sale / purchase of currencies for travelers.

What is Foreign Exchange (FX) Market ?


Spot Market.
1. Sale / purchase at spot rate of currencies held in accounts. 2. Spot exchange rate is driven by demand supply equations and other market forces. 3. Delivery (settlements) through accounts is (spot), i.e., within two business days. 4. A deal results in taking a position at the deal rate which may be squared afterwards at a rate prevailing then. 5. Open (unadjusted) positions are rolled over next day until settled. 6. The process results in eventual gain / loss on trading.

What is Foreign Exchange (FX) Market ?

iii. Interbank Market.


The Largest Financial Market In The World
Linkage through Electronic Dealing platform, Telephone, Fax, SWIFT.

An Informal Arrangement Of Large Commercial Banks And FX Brokers


Average daily turnover in September 2010 was USD: 4.00 Trillion

Turnover is far greater than global stock markets.

FX Rates
Price of one currency in terms of another.
Rate of USD/ PKR: 99.50 mean that one unit of US Dollar costs PKR: 99.50. Question: What would be the impact if the rate moves to: i. 99.60 ii. 99.40 Why all currencies in the world are not traded against each other? Book keeping and reconciliation issues. Exchange rate complexities and their volatility. Problems in Payment and settlement mechanism

FX Rates
Determinants of Foreign Exchange Rates.
Basic economic and fiscal policies of the host government with regard to: o Fiscal and monitory policy. o Inflation. o Trade policies o Balance of payment position. Countries with a consistently lower inflation rate exhibit a rising currency value, as their purchasing power increases relative to other currencies. Other things remaining same, sound economic policies result in stronger currencies. Political and psychological factors- e.G., US dollar is a safe heaven.

FX Rates
Technical Factors:
Capital movement
Relative inflation rates Exchange rate policy.- Free float or managed Interest rates - By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values.

Speculative moves and profit taking


Balance of payments Demand and supply

FX Rates
Exchange Rate Quotations- Direct And Indirect
In a currency pair, the first currency in the pair is called the Base currency and the second the quote or counter currency.

Direct quote:
The domestic currency is the base currency, while the foreign currency is the quote currency. e.g., EUR 0.7210 = USD 1.00 (in the Euro zone).
Direct quotes formula is used by most countries. For a USA dealer the above direct quote would read as USD/EUR: 1.3869 ( $ 1.00 /0.7210)

FX Rates
Indirect quotes:
Just the opposite of a Direct quote. Here: Foreign currency is the base currency. Domestic currency the quote currency. For a dealer in USA, the EUR/USD quote is an indirect one. Indirect quote of 0.7210 EUR/USD means that it takes 0.7210 euros to purchase US$1.00 It is used in UK, Australia, New Zealand & Canada. General Rules. All cross-currency rates contain four decimal points, e.g., USD/ GBP rate would appear as 1.5729. For deals involving JPY, rate will contain two decimal points, e.g., USD/ JPY : 114.14 Spreads in pricing are quoted in pip, i.e., counted from fourth decimal place.

FX Rates
Bid Price:
Rate at which a market maker is ready to buy a unit of currency A, against currency B, or vice versa. It reflects what the trader of currency A will receive for sale (shortening) of a position.

Ask Price:
Rate at which a market player is ready to sell a unit of currency A, against currency B or vice-versa.

It is the price a trader will pay to buy (Long) currency B.


Bid/ ask quotation is a TWO way quote where the bid price is always mentioned first, e.g., for USD/ GBP deal, the quote will be 1.5726/29. (Here the spread is 3 pips) *

FX Rates
Example: Base currency: USD Quote currency: GBP Deal amount: GBP: 100 Bid : 100 x 1.5726 = USD :157.26 Ask: 100 x 1.5729 = USD :157.29 Here a trader pays $ 1.5726 for one GBP bought and receives $ 1.5729 for each unit of GBP sold. Percentage Spread = Ask Bid x100 Ask

FX Rates
Cross Rate
Exchange rate for a currency that is based on exchange rate of two other currencies.

Direct Quotes Bid

Direct Ask

Indirect Bid

Indirect Ask

GBP
EUR

1.9712
1.4739

1.9717
1.4744

0.5072
0.6783

0.5073
0.6785

Direct Quotes GBP EUR Bid 1.9712 1.4739

Direct Ask 1.9717 1.4744

Indirect Bid 0.5072 0.6783

Indirect Ask 0.5073 0.6785

Example A.
A bank customer wants to sell 1,000 for EURO. The Bank will sell $ (to buy ) @ $1.9712. The sale yields Bank Customer: 1,000 x 1.9712 = $1,972. The Bank will buy $ (and sell EURO) @ 0.6783. The sale of $ yields Bank Customer: $1,972 x 0.6783 = :1,337. Bank Customer has effectively sold British pounds at / bid price of 1,337/1,000 = 1.3371/1.00.

Direct Quotes GBP Bid 1.9712

Direct Ask 1.9717

Indirect Bid 0.5072

Indirect Ask 0.5073

EUR

1.4739

1.4744

0.6783

0.6785

Example B
A bank customer wants to sell 1,000 for GBP. The Bank will sell $ (to buy ) @ 0.6785. The sale yields Bank Customer: 1,000 .6785 = $1,474. The Bank will buy $ (to sell ) @ $1.9717. The sale of $ yields Bank Customer: $1,474 1.9717 = 747. Here the customer has effectively bought GBP at a / ask price of 1,000,000/747,497 = 1.3378/1.00. Currency against currency bid-ask spread for GBP is 1.3371- 1.3378.

FX Rates
Forward Rate:
A quotation used in forward market to deliver one currency in future against another currency based on the exchange rate determined at the time of conclusion of contract. Delivery is made according to the choice of the customer, e.G., 1,3,6,9 and 12 months. Depending on market trends and future outlook, forward rate may be higher or lower that the spot rate. If forward rate is higher than the spot rate then currency is said to be trading at a premium and vice-versa. Calculation of premium or discount percentage: = (Forward rate- Spot rate) x 12 x100 Spot rate n (Where n is the number of months till maturity)

Intermediate Arrangements For Determination Of Exchange Rates


Domestic currency pegged to a foreign currency

A currency pegged to a basket of currencies Flexibility limited in terms of a single currency Independent / free float. Managed / Dirty float

Foreign Exchange Market Risk.


Risk that the value of an asset or liability will change because of a change in exchange rates. Because these international obligations span time, foreign exchange risk can arise.

Types of Risk: Transaction Exposure: The risk that the domestic cost or
proceeds of a transaction may change, i.e., Rate, Credit or liquidity risk, etc.
contd

Foreign Exchange Market Risk.


Types of Risk:
Translation Exposure: Risk in translation of value of foreign-currency-denominated assets affected by exchange rate changes. Economic Exposure: Risk that exchange rate changes may affect the present value of future income streams.
Hedging A tool for offsetting the exposure to risk.

Currency Exposure Management


Currency Exposure Management

Foreign Exchange Position - Balances of banks FX


assets and liabilities that generates the risk of obtaining additional revenues or expenditures upon modification of exchange rates.

Open Foreign Exchange Position - Represents the


difference between the amount of FX assets in a certain currency and the amount of FX liabilities in the respective currency.
contd

Long & Short Position


Currency Exposure Management

Foreign Exchange Position - Balances of banks FX


assets and liabilities that generates the risk of obtaining additional revenues or expenditures upon modification of exchange rates.

Open Foreign Exchange Position - Represents the


difference between the amount of FX assets in a certain currency and the amount of FX liabilities in the respective currency.
contd

Long & Short Position


The Open Foreign Exchange Position Is Long:
If the sum of FX assets in a certain currency exceeds the sum of FX liabilities in the respective foreign currency.

Long Position:
A situation where a quote currency is purchased at a price with a motive to sell it afterwards at a profit. Also referred as the notion of Buy low sell high.
contd

Long & Short Position


Managing Foreign Exchange Rate Risk
In foreign exchange transactions the rate risk appears in two forms: Net exchange positions. If the position is long or overbought and there is a depreciation of the currency, a loss is sure to occur.
The opposite result would occur if the net exchange position is short or oversold in that currency Swap positions or mismatched maturities By definition, a swap involves a simultaneous buy and sale of currency for two different maturities. A swap transaction does not affect the net exchange position

Long & Short Position


The Open Foreign Exchange Position Is Short:
If the sum of FX liabilities in a certain currency exceeds the sum of FX assets in the respective currency.
Short Position Just the opposite of long position. If one currency in pair is rising and the other is falling and trend is likely to continue The dealer will sell the falling currency (short) with an objective to buy it back later (cover) at a lower rate. Every trader has long position on one currency of the pair and short on another currency.
contd

Managing Foreign Exchange Rate Risk


In foreign exchange transactions the rate risk appears in two forms: Net Exchange Positions. If the position is long or overbought and there is a depreciation of the currency, a loss is sure to occur. The opposite result would occur if the net exchange position is short or oversold in that currency

Swap Positions Or Mismatched Maturities By definition, a swap involves a simultaneous buy and sale of currency for two different maturities. A swap transaction does not affect the net exchange position. contd

Managing Foreign Exchange Rate Risk


Usual Risk Management Measures.
Exchange Risk hedging Internationally diversified portfolio Cost of HEDGING risk vs. UNCOVERED EXPOSURE.

Currency Derivatives

Forward contract fixed and option

Foreign Currency options

Forward rate agreement

Exchange Risk Products In Pakistam

Swap transaction

Interest rate Swap

Currency swap

Exchange Risk Hedging


a. Forward Contract Fixed And Option.
A forward contract (Deal) is: A binding agreement between the bank and its customer. For purchase and / or sale of a specified amount of foreign currency. At a rate (forward rate) fixed at the time the contract is taken up. For delivery in future. Deals having a delivery period of more than two business days from the date of the deal (generally one month onwards) are classified as forward deals. contd

Exchange Risk Hedging


a. Forward contract fixed and option.
Forward rate is: The exchange rate fixed on the date of deal. Delivery against which will take place on a fixed date, or between two dates in future.
Forward contracts: Can be arranged to cover periods for as long as 10 years ahead in some major currencies.

But generally for periods between one and twelve months.


contd

Exchange Risk Hedging


b. Swap Transaction. It entails: Simultaneous sale and purchase or vice versa of the same foreign currency. With the same counter-party as a single transaction with two different value dates at the agreed exchange rates. The bank to pay and receive the same (or nearly the same) amount of foreign currency, the difference in rates represents the interest differential of the foreign exchange currencies involved for the period of the swap. contd

Exchange Risk Hedging


b. Swap Transaction.

It enables a company to utilize funds held in one currency towards meeting obligations denominated in another currency, without incurring foreign exchange risk. It is an effective and efficient Cash Management tool for companies that have assets and liabilities denominated in different currencies. contd

Exchange Risk Hedging


c. Currency Swap.
Is similar to a parallel or back-to-back loan.
The counter-parties do not lend currencies to each other but: Sell them to each other with a simultaneous agreement to reverse the exchange of currencies. At a fixed date in future at the same price.

Interest rates for the two currencies are not reflected in the two exchanges but are paid separately.
contd

Exchange Risk Hedging


c. Currency Swap.
It is a useful financial tool utilized by banks, multinational corporations and institutional investors, under which: The bank exchanges with the customer notional amounts of different currencies initially, and a series of interest payments on the initial cash flows. Quite often, one party may have to pay a fixed interest rate, while the other pays a floating exchange rate. At the maturity of the swap, the principal amounts are exchanged back. Unlike an interest rate swap, the principal and interest are both exchanged in full in a currency swap. contd

Exchange Risk Hedging


c. Currency Swap.
Generally, both interest rate and currency swaps have the same benefits for a company. Currency Swap: Essentially helps to manage exposure to fluctuations in interest rates or to acquire a lower interest rate than a company would otherwise be able to obtain. Often used because a domestic firm can usually receive better rates than a foreign firm. Help companies hedge against interest rate exposure by reducing the uncertainty of future cash flows. Allow companies to revise their debt conditions to take advantage of current or expected future market conditions

Exchange Risk Hedging


c. Currency Swap.
Company A is located in the USA and company B operates in UK. Company A needs a loan denominated in GBP and company B needs a loan in USD. The two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. These companies could receive interest rate savings by combining the privileged access they have in their respective markets. Swap maturities are negotiable for long periods, e.g. up to 10 years, making them a very flexible method of foreign exchange.

Example

Exchange Risk Hedging


d. Financial Derivatives:
Under this category the following products are offered by banks in Pakistan:

i.

Foreign Currency Options

Foreign Currency (FX) options are contracts that give the buyer the right, but not the obligation, to buy or sell one currency against another, at a pre-determined price and on or before a pre-determined date.

Buyer of a call (put) FX option has the right to buy (sell) a currency against another at a specified rate. If this right can only be exercised on a specific date, then the option is said to be European, whereas if the option can be exercised on any date prior to its maturity, the option is said to be American. Maximum tenor of the option may not exceed one year.

contd

Exchange Risk Hedging


d.
ii.

Financial Derivatives:
Forward Rate Agreement

A Forward Rate Agreement (FRA) is: An interest rate contract between two parties. It allows an entity to position itself in the interest rate market. Economically. FRA is similar to forward borrowing or lending transactions, however, in case of FRA, the actual lending / borrowing does not take place. contd

Exchange Risk Hedging


d.
ii.

Financial Derivatives:
Forward Rate Agreement

The parties enter into a contract at a rate for a Notional Principal amount. On settlement date, the transactions are Net Settled against a pre-determined Benchmark or Reference rate. The party incurring a negative interest rate differential under the transaction settles this by paying the counter-party the difference amount. FRAs are off-balance sheet transactions. contd

Exchange Risk Hedging


d.
ii.

Financial Derivatives:
Forward Rate Agreement

The payment of the interest differential is usually settled "upfront", i.e. on settlement date, with the interest differential "discounted back" to the present value. This discount is calculated by using the settlement interest rate. The party quoting the future rate agreement is called the "quoter" and the party receiving the quote is called the "receiver".

contd

Exchange Risk Hedging


d.
ii.

Financial Derivatives:
Forward Rate Agreement

The party quoting the future rate agreement is called the "quoter" and the party receiving the quote is called the "receiver". Either party can be called the "seller/ lender" or the "buyer/ borrower". Dealing in FRA is permitted in Pak Rupee only, and while there is no restriction on the minimum tenor, the maximum tenor of the FRA is restricted to twenty four months.

Exchange Risk Hedging


e.

Interest Rate Swap

It is a financial contract between two parties exchanging or swapping a stream of interest payments for a `notional principal amount on multiple occasions during a specified period. The principal amount is the same for both sides and not actually exchanged. On each payment date during the swap period, the cash payments, based on the difference in fixed/ floating or floating / floating rates, are exchanged by the parties with one another. The party incurring a negative interest rate differential for that leg pays the other counter-party. Contd

Exchange Risk Hedging


e.

Interest Rate Swap


There are two types of interest rate swaps: Single currency interest rate swap Plain Vanilla fixed-for-floating swaps often called Interest rate swaps. Cross-Currency interest rate swap. fixed for fixed rate debt service in two (or more) currencies which is also called a currency swap.
Contd

Exchange Risk Hedging


e.

Interest Rate Swap

A company typically uses interest rate swap to: Limit or manage its exposure to fluctuations in interest rates. To obtain a marginally lower interest rate than it would have been able to get. While there is no restriction on the minimum or maximum size of notional principal amounts of interest rate swap or tenor, the maximum tenor of the interest rate swap is restricted to 5 years.

Exchange Rate Forecasting


WHY & HOW?
Study of Exchange rates behaviour is crucial to have an ability to forecast exchange rates. A forecast represents an expectation about a future value or values of a variable. The expectation is constructed using an information set selected by the forecaster. Based on the information set used by the forecaster, there are two pure approaches to forecasting foreign exchange rates:

Exchange Rate Forecasting


WHY & HOW?
Study of Exchange rates behaviour is crucial to have an ability to forecast exchange rates. A forecast represents an expectation about a future value or values of a variable. The expectation is constructed using an information set selected by the forecaster.

Based on the information set used by the forecaster, there are two pure approaches to forecasting foreign exchange rates. Two Approaches for Exch Rate Forecasting:
Fundamental & Technical.

Exchange Rate Forecasting


1. Fundamental / Conventional Approach.
Based on a wide range of data of fundamental economic variables that determine exchange rates. Economic variables included are GNP, consumption, trade balance, inflation rates, interest rates, unemployment, productivity indexes, etc. Structural model is used to generate equilibrium exchange rates which can be used for projections / generate trading signals.

A trading signal can be generated every time there is a significant difference between the model-based expected or forecasted exchange rate and the exchange rate observed in the market.

Exchange Rate Forecasting


(2) Technical Approach.
A forecaster collects data to estimate the forecasting equation.
The estimated forecasting equation is evaluated using different statistics or measures.

If the forecaster is happy with the model, he/ she will move to the next step, the generation of forecasts. The final step is the evaluation of the forecast.

Mechanics of FX Trading
On a normal business day:
Trading is done in Retail Market and wholesale market. Dealings are via electronic platforms, SWIFT or telephone. In wholesale dealing pricing for currency pair is quoted as a two way quote, i.e., pricing to buy and sell. If agreeable, deal is concluded and settlement details exchanged. For payment / Receipts communication is channel is SWIFT .

Short position is covered through purchase of the currency & Long position by sale of the currency.
Potential gain or loss from positions depends on the size of position and exchange rate at which transactions are concluded.

Capital Account Convertibility


It is relatively a recent development and partly attributed to growth of the international trading markets and FOREX markets in particular. It implies freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.

In simple words language it means that CAC allows anyone to freely move from local currency into foreign currency and back. Since value of the currencies is established in comparison to each other, the ready trade of currencies potentially offers investors an opportunity for profit.

Capital Account Convertibility


Relatively a recent development; partly attributed to growth of Intl trading & FOREX markets in particular. Implies freedom to convert local financial assets into foreign financial assets & vice versa at market driven FX rates.

it means that CAC allows anyone to freely move from local currency into foreign currency and back.

Since value of the currencies is established in comparison to each other, the ready trade of currencies potentially offers investors an opportunity for profit.

Foreign Exchange Market In Pakistan


Since 1948, Pakistans exchange rate policy has undergone several changes. Up until September 1971, exchange rate remained pegged to GBP; thereafter it was tied with the US Dollar which is now Pakistans reserve currency.

In January 1982, an exchange rate regime of managed float was adopted which was based on a basket of currencies.
In 1991, with the onset of financial sector reforms, a liberalized exchange regime was introduced with the objective of achieving current account convertibility of the Pak Rupee, which was realized in 1993. The reform process was finally completed in 2000-2001.
Contd

Foreign Exchange Market In Pakistan


Nominal value of Pak Rupee also went through various changes.

In Sept, 1949, the decision was taken not to devalue the Rupee in spite of the fact that the current account deficit in 1948-49 was around 2.5% of the countrys GDP.
Fortuitously, the Korean War helped Pakistan to come out of this deficit and in 1950-51 and Pakistan witnessed a surplus in its current account. However, with the end of the Korean War in the latter half of 1953, the tide was reversed and the country was again drowned in the quagmire of current account deficit.
Contd

Foreign Exchange Market In Pakistan


In July, 1955, the Rupee was devalued for the first time and nominal exchange rate was fixed at PKR: 4.76 per USD. In 1971, the Rupee was adjusted at PKR: 7.76, and in 1972 it was again adjusted at PKR: 11.00 per USD. In 1973, Rupee was devalued by 56.73%.

Pak rupee has depreciated by about 900% since 1971.

Positives Developments
During the 10 years the countrys foreign exchange market has Exhibited a degree of maturity. Following SBP sponsored market reforms , close monitoring and occasional market interventions by SBP has reduced the instances of market jitters.