What is a Foreign Exchange

Transaction ?
• Any financial transaction that involves
more than one currency is a foreign
exchange transaction.
• Most important characteristic of a foreign
exchange transaction is that it involves
Foreign Exchange Risk.

BBAE0301-IFM 1
 Foreign Exchange Market
• The foreign exchange market is a global online
network where traders buy and sell currencies. It
has no physical location and operates 24 hours a
day.
• The market in which national currencies of various
countries are converted, exchanged or traded for
one another is called foreign exchange market.
• It includes banks, specialized foreign exchange
dealers, brokers and official government agencies
through which the currency of one country can be
exchanged (converted) for that of another country.
Features of Foreign Exchange Market

• High Liquidity- The foreign exchange market

is the most liquid financial market in the
world. It involves the trading of various
currencies across the globe. All traders in
this market are free to buy or sell currencies
anytime as per their choice.
• Market Transparency- Trader in the foreign
exchange market has full access to all market data
and information. They can easily monitor different
countries’ currencies price fluctuations through real-
time portfolio and account tracking without the
need of a broker. All this information helps in making
better trading decisions and control over
investments.
• Dynamic Market-The foreign exchange market is
a dynamic market. In these markets, currency
values change every second and hour. These
values changes in accordance with changing
forces of demand and supply which also helps in
determining the exchange rates. Due to its fast-
changing character, this market is termed as the
perfect market to trade.
• Operates 24 Hours- Foreign exchange markets
function 24 hours a day. It provides a platform where
currencies can be traded anytime by traders. It
provides a convenient time to all necessary
adjustments when and wherever needed.
• Lower Trading Cost-The forex market has a very low
trading cost. In these markets, there are no
commissions like in case of any other investments.
Any difference between buying and selling prices of
currencies is the only cost of trading in the forex
market. As there are low costs then the possibility of
incurring losses is also minimum thereby making it
possible for small investors to make good profit from
trading.
 Participants in Foreign Exchange Market

• Participants in Foreign exchange market can

be categorized into five major groups, viz.;
• commercial banks,
• Foreign exchange brokers,
• Central bank,
• MNCs
• Individuals and Small businesses.
 Commercial Banks:
• The major participants in the foreign exchange
market are the large Commercial banks who provide
the core of market. As many as 100 to 200 banks
across the globe actively “make the market” in the
foreign exchange. These banks serve their retail
clients, the bank customers, in conducting foreign
commerce or making international investment in
financial assets that require foreign exchange.
 Cont…
• These banks operate in the foreign exchange market at two levels. At
the retail level, they deal with their customers-corporations, exporters
and so forth. At the wholesale level, banks maintain an inert bank
market in foreign exchange either directly or through specialized foreign
exchange brokers.

• The bulk of activity in the foreign exchange market is conducted in an

inter-bank wholesale market-a network of large international banks and
brokers. Whenever a bank buys a currency in the foreign currency
market, it is simultaneously selling another currency.

• A bank that has committed itself to buy a certain particular currency is

said to have long position in that currency. A short-term position occurs
when the bank is committed to selling amounts of that currency
exceeding its commitments to purchase it.
 Foreign Exchange Brokers:

• Foreign exchange brokers also operate in the international

currency market. They act as agents who facilitate trading
between dealers. Unlike the banks, brokers serve merely as
matchmakers and do not put their own money at risk.

• They actively and constantly monitor exchange rates

offered by the major international banks through
computerized systems such as Reuters and are able to find
quickly an opposite party for a client without revealing the
identity of either party until a transaction has been agreed
upon. This is why inter-bank traders use a broker primarily
to disseminate as quickly as possible a currency quote to
many other dealers.
Central Banks or Reserve Bank of India:

• To protect the financial strength and stability

of the country’s balance of payments, internal
money supply, interest rates and inflation, RBI
intervenes in the foreign exchange markets to
protect the disequilibrium in the prices of
foreign exchange conversion.
 MNCs
• MNCs are the major non-bank participants in the forward
market as they exchange cash flows associated with their
multinational operations. MNCs often contract to either
pay or receive fixed amounts in foreign currencies at
future dates, so they are exposed to foreign currency risk.
This is why they often hedge these future cash flows
through the inter-bank forward exchange market.
 Individuals and Small Businesses:
• Individuals and small businesses also use foreign exchange
market to facilitate execution of commercial or investment
transactions. The foreign needs of these players are
usually small and account for only a fraction of all foreign
exchange transactions. Even then they are very important
participants in the market. Some of these participants use
the market to hedge foreign exchange risk.
 Exchange Rate Quotations
• The ratio between two currencies is known as an exchange
rate.
• Direct Quote – Direct quotation is where the cost of one
unit of foreign currency is given in units of local currency.
• Ex- if India quotes the exchange rate between the rupee
and the US Dollar in a direct way,
• the quotation will be written as 1 USD = 79.56
• Indirect Quote- indirect quotation is where the cost of one
unit of local currency is given in units of foreign currency.
• 1Rs = 0.012569 Rs
• If direct quote is Rs. 40/US $,
how can this exchange rate be
presented under indirect quote?
• If indirect quote is US $
0.025/Rs., how can this
exchange rate be shown under
direct quote?
 Buying and Selling Rates
• Normally, two rates are published –one being the
buying rate and the other selling rate. The buying
rate is also known as the bid rate. The selling rate is
known as the ask rate or offer rate. The bid rate is
always given first, followed by the ask rate quote. if
the rupee-US $ rate is Rs. 40.00-40.30/US$.
• The difference between these two quotes forms the
banks’ profit and is known as the spread.
• Spread = X 100
https://www.wallstreetmojo.com/profit-
percentage-formula/
• Consider the following bid-ask prices: Rs. 40-
40.50US $ . Find the bid-ask spread.

• Find out the bid rate if ask rate is Rs. 40.50 US

$ and the bid-ask spread is 1.2%.
 Cross Rate
• One currency is sold for a common currency; and
again, the common currency is exchanged for the
desired currency. This is known as cross trade.
• Ex. A news paper quotes Rs. 35.00-35.20 / U S $, and
at the same time, it quotes Canadian $ 0.76-0.78/ U
S $ but does not quote the exchange rate between
the rupee and the Canadian dollar. Thus the rate of
exchange between the rupee and the Canadian $
will be found through the common currency, the US
$.
• The Selling rate of Canadian dollar in India can
be worked out by selling the rupee for the US
dollar at Rs. 35.20/ US $ and then buying
Canadian Dollars with the US $ at 0.76/US $.
• Rs. 35.20/US $ 1 X US $ 1/C$ .76 = 35.20 X
1.316 = 46.32

• Rs. 35.00/US $ 1 X US $ 1/C$ .78 = 35 X 1.282

= 44.87
Nominal, Real and Effective Exchange Rates
• The exchange rates mentioned in the preceding section are the
nominal exchange rates / bilateral exchange rates. They represent
the ratio between the value of two currencies at a particular time.
• Real exchange rate is the inflation adjusted nominal exchange rate.
• The relationship between nominal exchange rate, e and the real
exchange rate, er can be written in the form:
er = eP/P*
Where P and P* are domestic and foreign price indices. If the price
index in India and USA rises from 100 in 2020 to 120 and 110,
respectively in 2021 and if the nominal exchange rate between the
two currencies between the two dates remains at Rs. 40/US $, the
real exchange rate will move to:
40.00 X 120/110 = 43.64/ US $.
• Effective Exchange rates- it is the measure of the
average value of a currency relative to two or
more other currencies, normally shown in form
of an index.
• It is possible that the Indian Rupee tends to
depreciate against US $, but it appreciates against
Japanese Yen. It is also possible that rupee
depreciates vis-a vis different currencies at
different rates. So it is essential to develop an
index or a summary measure of how rupee fares,
on an average, in the foreign exchange market.
Such an index is called an effective exchange rate.
 Process of an effective exchange rate index

• 1- Select the currency for the basket.

• 2- Find out the weight of different currencies in the basket.
Suppose India has trade link with only two countries, viz. USA
and Japan. India’s export to USA and Japan value,
respectively, $ 6000 and $ 4,000 , and its imports from these
two countries value, respectively, $ 7000 and $ 3,000. The
weight for these two countries will be:
USA = (6000 + 7000)/[(6000+7000) + (4000 + 3000 )] = 0.65
Japan = (4000 + 3000)/ [(4000 +3000) + (6000 + 7000)] = 0.35
• 3 – To find out the exchange rate index.
Suppose in 2019, the exchange rate was Rs. 40/US$ and
Rs. 50/yen 100; in 2020, the exchange rate changed to
Rs. 44/US$ and Rs. 60/Yen 100. if 2019 is the base, the
exchange rate index in 2020 will be 110 for the US $ and
120 for Yen.
If the effective exchange rate index for 2019 is
EER = [(0.65 X 100 ) + (0.35 X 100) ] = 100
Then the effective exchange rate index for 2020 will be
EER = [(0.65 X 110 ) + (0.35 X 120) ] = 113.5
This means the rupee depreciated on an average by
13.5% during period.
 Numerical
• The USA, EU and Japan are India’s biggest trade
partners sharing respectively 40%, 35 % and
25% of its trade respectively. Assuming 2018-19
as the base year, when the exchange rates were
Rs. 45.68/US $, Rs. 41.48/Euro and Rs.
0.414/Yen. These rates changed over the years
and in 2021-22, they were as: Rs. 43.91/US $,
Rs. 52.67/ Euro and Rs. 0.48/ Yen. Find out the
effective exchange rate index during 2021-22.
 Solution
• Exchange Rate Index:
• A) Rs. Appreciated against dollar to 43.91/ 45.68 X 100 =
96.13
• B ) Rs Depreciated against Euro to 52.67/ 41.48 X 100 =
126.98
• C ) Rs Appreciated against Yen to 0.408/0.414 X 100 =
98.55
• 0.40 X 96.13 + 0.35 X 126.98 + 0.25 X 98.55 = 107.53
 Activities
• Speculation is the activity that leaves a currency
position open to the risks of currency
movements.
• Speculators take a position to "speculate" the
direction of exchange rates. A speculator takes on
a foreign exchange position on the expectation of
a favorable currency rate change. That is, a
speculator does not take any other position to
reduce or cover the risk of this open position.
 Hedging
• Hedging is a way to transfer part of the foreign
exchange risk inherent in all transactions, such
as an export or an import, which involves two
currencies. That is, by contrast to speculation,
hedging is the activity of covering an open
position. A hedger makes a transaction in the
foreign exchange market to cover the currency
risk of another position.
 Arbitrage
• Arbitrage refers to the process by which banks,
firms or individuals attempt to make a risk-profit by
taking advantage of discrepancies among prices
prevailing simultaneously in different markets.
• The simplest form of arbitrage in the foreign
exchange market is spatial arbitrage, which takes
advantage of the geographically dispersed nature
of the market. For example, a spatial arbitrageur
will attempt to buy GBP at 1.61 USD/GBP in London
and sell GBP at 1.615 USD/GBP in New York.
 Triangular arbitrage
• Triangular arbitrage takes advantage of
pricing mistakes between three currencies. As
we will see below, cross-rates are determined
by triangular arbitrage. Covered interest
arbitrage takes advantage of a misalignment
of spot and forward rates, and domestic and
foreign interest rates.
Classification of the Foreign Exchange Market

• Spot Market
• Forward Market
• Spot Market- Currencies are traded for
immediate delivery at a rate existing on the day
of transaction. For making book-keeping entries,
delivery takes two working days after the
transaction is complete although in the case of
Canadian dollar the delivery of currencies takes
place the very next working day.
Currency Arbitrage in Spot Market
• The arbitrageurs take advantage of the
inconsistency and garner profits by
buying and selling of currencies. They
buy a particular currency at cheaper rate
in one market and sell it at a higher rate
in the other. This process is known as
currency arbitrage. HA~riprap12
• Suppose,
In New York: $ 1.9800-10/ £
In London : $ 1.9700-10/ £
The arbitrageurs will sell £ in New York and buy £ in
London making a profit of $ 1.9800-1.9700 = $
0.0100 per £ sterling. This is called two-point
arbitrage.
 Speculation in Spot Market
• Speculation in the spot market occurs when the
speculator anticipates a change in the value of a
currency. Suppose the exchange rate today is Rs. 40/ US
$. The speculator anticipates this rate to become Rs.
41/US $ within the coming three months. Under these
circumstances, he will buy U S $ 1,000 for Rs. 40,000
and hold this amount for three months, although he is
not committed to this particular time horizon. When
the target exchange rate is reached, he will sell US $
1,000 at the new exchange rate, that is at Rs. 41 per $
and earn a profit of Rs. 41,000 – 40,000 = 1,000.
 Forward Market
• Forward Market, Contracts are made to buy and
sell currencies for future delivery, say, after a
fortnight, one month, two months and so on.
• Both parties have to abide by the contract at the
exchange rate mentioned therein irrespective of
whether the spot rate on the maturity date
resembles the forward rate or not.
• In other words, no party can back out the deal if
changes in the future spot rate are not in his or
her favour.
 Speculation in Forward Market
• Their purpose is not to reduce the risk but to reap
profits from the changes in the exchange rates.
• Suppose a speculator sells US $ 1,000 3 months
forward at the rate of Rs. 40.50 /US$. If on
maturity, the US$ depreciates to Rs. 40, the
speculator will get Rs. 40,500 under the forward
contract. At the same time, he will exchange Rs.
40,500 at the then future spot rate Rs. of
Rs.40/US$ and will get US$ 1012.50
 Swapping of Forward Contract
• The purpose of swap in the forward market is to reap profits.
• There are two kinds of swap.
• Option forward
• Forward-forward swap
• The basis of swap is the difference between the spot rate and the
forward rate and in the latter, it is the difference between the two
forward rates.
• Suppose 1 Jan. and 1 April. The spot rate on 1 Jan is Rs. 40/US$ and
the 3 month forward rate is Rs. 39.50 US$. This shows depreciation of
the $ and in this case, if the customer sells rupees to the bank, the
latter will buy them at the spot rate. if the customer buys rupees,
bank will sell them at the forward rate.
• Forward- Forward Swap- buying and selling a
currency forward depending upon differing
exchange rates for differing maturities.
• Spot rate : Rs 40-40.20/US$
• 6 Months forward rate : Rs. 41.50 – 41.80/ US$
• 9 Months forward rate : Rs. 40.25 – 40.75/ US$
 Future Contracts
• Currency futures market is an organized market and not
over the counter, for the sale and purchase of specified
amount of currencies.
• Brokers strike the deals sitting face to face under a trading
roof, known as pits.
• When traders trade for themselves, they are called locals or
floor traders or scalpers.
• When the brokers trade on the behalf of their customers,
they are known as commission brokers or floor brokers.
• Traders acting for themselves as well as on behalf of their
customers are known as dual traders.
• Clearing House- is a part of system with which traders strike
the deal.
 Margin Money
• Margin Money represents traders deposit
with the clearing house for the adjustment
of gain/loss.
• Margin money have has two components.
One is the initial margin which is the amount
of money that must be deposited at the time
of signing of the contract. The other is
maintenance margin. It denotes the
minimum level to which the margin is
allowed to fall in the sequel of loss.
 Marking to the market
• Marking to market involves daily comparison
of spot rate with yesterday’s rate up to the
maturity for the assessment of loss/gain.
 Determinants of Exchange rate
• Purchasing power parity (Inflation) theorem-
Difference in inflation rates between two
countries is considered as the most important
factor for variations in exchange rates.
• If domestic inflation is high, it means
domestic goods are costlier than foreign goods.
This results in higher imports creating more
demand for foreign currency, making it costlier.
(In other words the value of domestic currency
will decline).
• PPP theory can be expressed by the formula: PPPr =
Spot rate (1+rh) (1+rf) where rh is inflation rate at
home; rf is the inflation rate of foreign country
• If a basket of goods cost Rs470 in India and $10 in US
then it is quite natural that the exchange rate should be
Rs47/$1
• Weakness of PPP theory :
• It is not only inflation, which affects foreign currency
movements PPP ignores substitution effects – i.e.
instead of importing goods might be substituted.
 Interest rate parity theorem :
• The second most important factor in determining
exchange rates after PPP theory.
• Money tends to move towards country offering a higher
interest rate thereby resulting in more demand for the
foreign country’s currency.
• If interest rates in Japan are lower than interest rates in
US then Japanese investors would prefer to invest in US
which would result in more demand for US $ in Japan (this
will cause US$ to appreciate in Japan).
• Interest rates provide the basis for computing forward
rates as under: Forward rate = {} + S
• S = Spot Price
• rA = Rate of Interest Home Country
• rB = Rate of Interest Foreign Country
• A = Time Covered, Generally take 360 days in a
year (4)
• Ex1. interest rates in India and the USA are
respectively 10% and 7 %. The spot rate is Rs.
40/US $. The 90-day forward rate can be
calculate.
• Calculate the 3-months forward rate, if spot
rate is Rs. 46/US$; interest rate in India and
the USA is respectively 6% and 3%.