International Finance

The Foreign Exchange Market

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 Foreign Exchange
• Money of a foreign country
– Currency
– Bank Balances
– Bank Notes
– Checks and Drafts
• May be converted to the currency of your or
other countries
 Foreign Exchange Transaction
• Agreement between buyer and seller
– That a fixed amount of one currency
– Will be delivered for some other currency
– At a specified rate
 The Foreign Exchange Market
• Provides the physical and institutional
structure through which
– Money of one country is exchanged for that of
another
– Rate of exchange between currencies determined
– Foreign exchange transactions are physically
completed
– Largest market in the world
– An Over-the-Counter Market
 Features of the Foreign Exchange Market

• Geographic Extent
• 3 Main Functions
• Participants
• Daily Volumes
• Types of Transactions
• Methods of stating exchange rates ,
quotations , changes in exchange rates
 Geographic Extent
• Spans the globe
• Prices move & currencies trade every hour
• Volumes ebb and flow through the day
• Methods change based on level of controls
• Connectivity , professional dealers and brokers
• Introduction of automated matching systems
Functions of the Foreign Exchange Market

• Transfer of purchasing power

• Provide a source of credit

• Provide hedging facilities for transferring

foreign exchange risk
 Participants
• 2 Tiers
– Interbank Market (wholesale)
– Client Market (retail)
• 4 Broad Categories
– Bank and non bank foreign exchange dealers
– Individuals and firms conducting commercial or
investment transactions
– Speculators and Arbitragers
– Central banks and Treasuries
Bank & Non Bank Foreign Exchange Dealers

• Operate in interbank and client markets

• Profit from buying at a price and selling at a slightly
higher price (bid / ask )
• Competition helps make market efficient and narrow ask-
bid rate
• Dealers at large banks – market makers
– Stand willing to maintain inventory positions
– Operate as profit centers within guidelines
• Currency trading profitable to banks
• Small banks too participate – may not be market makers
 Individuals and Firms conducting
commercial and investment transactions
– Importers and Exporters
– International Portfolio Investors
– MNE’s
– Tourists
– Others
• Use Foreign Exchange Markets to facilitate execution
of commercial and investment transactions
• Some use the market to hedge foreign exchange risk
 Speculators and Arbitragers
• Seek to profit by trading in the market
• Operate in their own interest
• Speculators – try to gain from movements in the
market
• Arbitragers - try to profit from exchange rate
differences in different markets
• A large proportion of S & A done on behalf of
banks by their traders
– Banks thus act as exchange dealers as well as S & A
 Central Banks & Treasuries
• Use the market to
– Acquire or spend their country’s foreign exchange reserves
– Influence the price of their currency
– Support the value of their currency
• Policies adopted at the national level
• Honor commitments entered into
– Motive not profit but to influence currency to benefit the
country
– Sometimes takes losses on Foreign Exchange transactions
– Differ in motives from all other market participants
Foreign Exchange Activities of a commercial
bank
• Maintain foreign currency account for client
• Perform foreign exchange related work for a
foreign bank (correspondent bank)
• Dealing Room
– Proprietary Trades
– Client Driven Trades
• Export Financing & Import Financing
 Exchange Rates
Rate Quotation
• Often described as ABC/DEF
– ABC is base currency ,DEF for which we need
quote
– The exchange rate quotation is normally given as #
of units of quoted currency per unit of base
currency
– Some currencies have symbols
– Examples £ ¥ € ₹
 Foreign Exchange Quote
• Rate at which an AD is willing to deal in a
particular currency pair
– Domestic currency and foreign currency
– 2 foreign currencies
• Base Currency (stated first) and Quote
Currency (stated second)
– Base currency in terms of Quote currency
• GBP/USD
• USD/INR
 Types of Foreign Exchange Quotes
• American Terms and European Terms (Wholesale
Market)
– European Terms - # of units of a currency per USD
• Example of ET : 100 Yen per USD
– American Terms - # of USD per unit of a currency
• Example of AT : 1.600 USD per Pound
 Types of Foreign Exchange Quotes
• Direct quote and Indirect quote (Retail Market)
– Direct Quote : Home currency expressed in terms
of 1 unit of foreign currency
• Example of DQ in India : 1 USD = Rs 60.00
• USD/INR = 60.00
– Indirect Quote : Foreign currency expressed in
terms of 1 unit of home currency
• Example of IQ in India : 1 INR = 0.01667 USD
• INR/USD = 0.01667
Calculation of Exchange Rate % Change
• If 100 grows to 110 , by what % did it
appreciate ?
• (New Value – Old Value )/ (Old Value)
• In exchange terms (E1-E0)/E0

• 12 months ago, EUR/USD was 1.3344 . Today it

is 1.2403 .
• Has the $ appreciated or depreciated ?
• By how much ?
 12 months ago, 1 Euro was 1.3344 . Today 1
Euro is 1.2403
• Let’s try a calculation
• (E1-E0)/E0
• (1.2403-1.3344)/1.3344 = -0.0705 =-7.05%
• Hey , what is this ? We said $ appreciated ,
then why this negative sign .
• Because this is how Euro changed , not USD
• Take reciprocals for USD
• (0.8063-0.7494)/0.7494 = +0.0759 = 7.59%
 Transactions & Settlement Dates
• Spot transaction
– Settlement or value date usually 2 business days ahead

• Forward transaction
– Settlement or value date usually spot date + forward cover maturity as agreed

• Swap
– Combination of spot and a forward (spot forward swap)
– Combination of forward and a forward (forward forward swap)
– Forward contracts without an accompanying spot deal are called “outright
forward contracts”
• Short date transactions
– Transactions settled before the spot value date CASH ,TOM

• Trade Date and Value Date

 Types of Foreign Exchange Quotes -
Continued
• Two way quote
– Rate at which Authorized Dealer is willing to buy and sell
the foreign currency
– Buying rate is BID rate and Selling rate is ASK rate
• Cross Rate
– If the exchange rate between a currency pair has to be
calculated based on the exchange rates for two other
currency pairs, then it is called a cross-rate.
• Base Currency and Quote Currency
– Quote is read as “base currency in terms of quote currency”
 What’s in a pair ?
EUR/USD USD/JPY

GBP/USD AUD/USD

USD/CHF USD/CAD

Which are the base currencies and quote currencies in these ?

 What are we doing - Pairs
• EUR/USD = 1.4205
• Which is the base currency and which is the
quote currency in the above ?
• It means that 1.4205 of USD is needed to
exchange for 1 Euro
 What are we doing - Pairs
• What do we do when we buy a currency pair ?
– Exchanging quote currency with base currency
– Buying the base currency & selling the quote currency
– In this case, exchanging USD with Euro

• Majors
• Crosses
• Exotics

• Majors make up close to 85% of the total volume

• Some have nicknames
CABLE Examples of nicknames

GBP/USD NZD/USD
KIWI

AUD/USD USD/CHF
AUSSIE
SWISSY
 How banks quote rates
• Exchange rates for USD
– Ascertain the going wholesale exchange rate (70.13/14)
– Load a margin (0.03)
– Quote a rate to the customer (70.10/70.17)
• Size of the transaction
– USD 100,000 versus USD 100
– What about USD 500 Million
– Card Rate
– References to Treasury
– Validity of Quotes
• Customer Relationship
• Customer Awareness
• Spread in the market
– f ( order costs , inventory costs , competition, volume, currency risk)
 Bid Ask Quotes
• IN USA (Direct Quote) •
IN INDIA (Direct Quote)
• 0.0198/0.0200 INR/USD •
50.00/50.50 USD/INR
• 0.0198 is bid price •
50.00 is bid price
• 0.0200 is ask price •
50.50 is ask price
• If I want to sell INR , I get •
If I want to sell USD , I get
$0.0198 from the bank 50.00 INR from the bank
(bid) (bid)
• If I need to buy INR, I pay • If I want to buy USD , I
$0.0200 to the bank (ask) pay 50.50 INR to the
Bid =when bank buys, webank
sell (ask)
Ask =when bank sells , we buy
 Cross Rates
– 1 USD = Rs 45.255 USD/INR
– 1 SGD = 0.7560 USD SGD/USD
– Cross Rate Calculation
– If I want to calculate how many Rupees I will get for
SGD
– Remember your algebra ?
– 45.255/1*0.7560/1 =34.21278
– SGD/INR =34.2128
– Simplified example : In real life , bid-ask rates come
into play
 Now try this !
– 1 USD = Rs 45.000 1 USD = 1.25 SGD

– What is the value of the SGD in terms of rupees ?

 A quick recap and refresher
• Direct : Indirect
• Bid: Ask
• Base : Quote
• Types of Pairs
• Cross Rates
• Spot
• Cash
• TOM
• Transaction date
• Value date
 Cross Rates using Bid : Ask
• I want to sell 100,000 pesos for INR
– Quotes available
• USD/INR 45.50/51 -> 1 USD =45.50(bid)/45.51(ask)
• USD/Peso 50.00/50 -> 1 USD = 50.00(bid)/50.50(ask)
– Peso/INR = Peso/USD *USD/INR
– I give pesos to bank and receive $
• (AD is selling $) 50.50 = 1/50.50 (why?)
– I give $ to bank and receive Rupees
• ( AD is buying $ ) 45.50 =45.50
– Peso/INR = 1/50.50 *45.50/1 = 45.50/50.50 = 0.9009
 Cross Rates using Bid : Ask
• I want to buy 100,000 pesos with INR
– Quotes available
• USD/INR 45.50/51 = 1 USD =45.50(bid)/45.51(ask)
• USD/Peso 50.00/50 = 1 USD = 50.00(bid)/50.50(ask)
– I give Rupees to bank and receive $
• (AD is selling $ ) 45.51
– I give $ to bank and receive Pesos
• ( AD is buying $ ) 50.00 =1/50.00 (why ?)
– Peso/INR = 1/50.00 *45.51/1 = 45.51/50.00 =
0.9102/peso
 Forward Rates
• It is the exchange rate agreed upon for the
delivery of the two currencies beyond two
business days from the trade date.
– In India , can go up to a year
– What about beyond 1 year ?
• It will be either lower or higher than the spot rate
– Discount or premium
• Who has access to the forwards market ?
• What would banks do with this exposure ?
 What would banks do subsequent to
entering into a forward deal

Customer
Bank Market /Other dealers
 Types of Rates
• Inter bank rate
– As the name indicates this is the spot rate or the forward rate quoted by one AD to another in the
inter-bank market.
– The inter- bank rates are typically lower than merchant rates (which are spot rates or forward
rates quoted by an AD to its clients).

• TT rate
– TT refers to telegraphic transfer. Though ‘TT’ stands called telegraphic transfer, the TT rate applies
to any transaction in foreign exchange where mail transfer or payment through demand draft
occurs.

• Bill rate
– Bills of Exchange are negotiable instruments.
– They are of two types— sight bills and usance bills.
• A sight bill can be presented by the holder after a certain number of days have elapsed.
• A usance bill can be presented by the holder only on the maturity date of the bill, and is payable on that date.
How are forward rates determined
• When currencies involved are freely tradable ,
the interest differential between the currencies
determines the premium or discount
• What about India ?
– Several factors affect including ‘supply and demand
of forward US dollars, interest differentials and
expectations of future interest rates; and
expectations of future US dollar– rupee exchange
rate’.
 Futures Market
• Conceptually same as forwards
• Differences
– Traded on exchanges
– Standardized
• Dates
• Lot or Contract Sizes
– Margins
• What are the positives and negatives between
Futures & Forwards ?
 Forwards & Futures
Forwards Futures
• Flexible amount (tailored) • Standard amount
• Flexible maturity (tailored) • Standard maturity
• OTC phone/fax/mail • On exchanges ,same price
• Settlement or honoring • Settlement or honoring
normally by delivery normally by cash settlement
• Counter party risk may exist • Counter party risk lower
due to MTM corrections
 Options – How is it different from a forward
cover
• As the name suggests , it gives the buyer of
the option , an option without an obligation
• On the future date, you can decide whether or
not you want to use the option contract that
you bought
• This is useful when you want to protect a rate
but also feel that there is potential for further
gain in the $/Rupee equation
 Parties to an option contract
• Writer or seller of the option : The party who
has an obligation to buy/sell the asset
underlying the contract ,at the agreed price
and time , if the option is exercised by the
buyer of the option
• Buyer of the option : The party who has the
right but not the obligation to sell/buy the
asset underlying the contract at the agreed
price and time
 Types of options
• Call Option : The right , without the obligation, to buy
an asset
• Put Option : The right , without the obligation, to sell
an asset
• American Option : An option , which can be exercised
at any time until the expiry date
• European Option : An option , which can be exercised
only on expiry
• Bermudan Option : An option , which can be exercised
only during a predefined portion of its life
 What do we do ?

BUY SELL
CALL CALL CALL

PUT BUY SELL

PUT PUT
BUY SELL
 Expiry
• Expiry : The last date on which the option may
be exercised
• Expiration time : Specified in the contract .
Current practice generally specifies it as 10am
New York time or 3pm Tokyo time
 Exercise or Strike Price
• Exercise or Strike Price : The specified price at which the buyer of
the contract can exercise his right to buy or sell the asset
• At-The-Money (ATM) : An option with a strike price equal to the
current price of the asset. In currency terms , this can refer to the
current spot rate (ATM spot) or the forward rate for the expiry
date (ATM forward)
• In-The-Money (ITM) : The strike price is more favorable to the
buyer than the current market rate. Premium will be higher than
in ATM
• Out-Of The-Money (OTM) : The strike price is less favorable to
the buyer than the current market rate. Premium will be lower
than in ATM
 Value/Price of an option
• Option Premium : Fee or price paid by the buyer of
the option to the seller of the option
• Value of an option : The market price of the option
• Intrinsic Value : The difference between the strike
price and the current market exchange rate , in the
case of an American style option it is profit available
on immediate exercise.
• Time Value : The difference between option premium
and intrinsic value reflecting the value arising from
time left until its expiry
 How do options in Fx Work?
– When an exporter buys a USD put option , he has
the right ,but no obligation to sell USD at the
“strike” price
• For example , if he bought an option at a strike price of
Rs 60 for April 2014, he can sell USD at 60 if the USD is
below Rs 60 on due date
• If it is above Rs 60,he can ignore his option and sell in
the market at a higher price
• His only cost is the option premium he paid
– Some people buy and sell options to reduce cost
• can work better than forwards if understood well
• but that can be very risky if done without knowledge!
 Simple Option - example
• I want to protect an expected outflow of $ 1
Million using an option
• Data as on date
– Spot price Rs 60.00
– Forward Rate after 6 months 62.00
– Strike rate requested for 62.00
– Option premium (price) quoted by bank 1.00
• Let’s discuss these #’s first
 I now own an option
• I have spent Rs 1.00 *$ 1 Mio = Rs 1.000 Mio
• I have the right to buy USD 1 Mio at Rs 62.00
• What happens after 6 months
– If USD is > 62.00 , I will exercise my option
– If USD is <62.00 , I will ignore my option (let it
lapse) (I will not exercise it)
• How is this different from a forward cover ?
 When will we use
• Spot
• Forwards
• Futures
• Options