Foreign Exchange Market

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Dr. Amit Kumar Sinha dramitksinha@gmail.com

Definitions

FOREIGN CURRENCY: Any currency other than the country’s currency is known as foreign currency. For example, in India all other currencies than Rupee will be foreign currencies. FOREIGN EXCHANGE: Forex includes foreign currency, Traveler Cheques, foreign DDs, Cheques, LCs in denomination of foreign currencies.
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Foreign Exchange Market Definition
The Foreign exchange market provides the Physical & Institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies are determined, and foreign exchange transaction are physically completed .

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Foreign Exchange Transaction “A foreign exchange transaction is an agreement between a buyer and seller that a fixed amount of one currency will be delivered for some other currency at a specified rate”. 3 .

Functions/ Significance of Forex Markets The Foreign exchange market is the mechanism by which participant Transfer purchasing power between countries. Hence there are three major functions of Foreign exchange market: 1. Transfer of purchasing power 2. Minimization of foreign exchange risk 4 . Provide Credit 3. obtain or provide credit for international trade transactions. and minimize exposure to the risk of exchange rate fluctuations.

but the trade or capital transaction can be invoiced in only one currency. 5 .Functions/ Significance of Forex Markets Transfer of Purchasing Power: Transfer of purchasing power is necessary because international trade and capital transactions normally involves parties living in countries with different national currencies. Each party usually wants to deal in its own currency.

Functions/ Significance of Forex Markets
Provide Credit:
The movement of good s between countries take time, inventory in transit must be financed. The foreign exchange market provide a source of credit. Specialized instruments, such as Banker’s acceptances and letters of credit are available to finance international trade.
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Functions/ Significance of Forex Markets
Minimization of Foreign Exchange Risk:
The foreign exchange market provides “Hedging” facilities for transferring foreign exchange risk to someone else more willing to carry risk.

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PARTICIPANTS IN THE FE MARKET

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Major participants in the FE market are: Large commercial banks operating either at retail level for individual exporters and corporations or at a wholesale level in the inter bank market. Central Banks of various countries that intervene in order to maintain or influence the exchange rate of their currencies within a certain range, as also to execute the orders of the government. Individual brokers or corporations: Bank dealers often use brokers to stay anonymous since the identity of banks can influence short term quotes.

CHAPS :Clearing House Automated Payment System.  Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. the first global clearinghouse for settling interbank FOREX transactions. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited. International commercial banks communicate with one another with:  Correspondent Banking Relationships    SWIFT: The Society for Worldwide Interbank Financial Telecommunications. 9 .

currency swaps. futures options 10 .Kinds of Forex Markets    Spot market Forward market Derivative market.

Spot Market     Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates 11 .

12 . The spot transactions should not be rolled over to next month. The Indian rupee Vs dollar settlements take place first following business day.Spot market of foreign exchange Definition: Spot market is the system under which purchase and sale of foreign exchange with delivery either immediately or on the second following business day.

Quoting in FE Market    Foreign exchange rates are quoted either for immediate delivery (spot rate) or for delivery on a future date (forward rate). . In practice. delivery in spot rate is made two days later. A FE quotation is the price of currency expressed in units of another currency.

Quoting in FE Market     The quotation can be either direct or indirect. is a direct quotation for USD in India.1993 all quotations in India use direct method of quotation. An indirect quotation is the one where the exchange rate is given in terms of variable units of foreign currency as equivalent to a fixed number units of home currency. Since August 2. Quotation is direct when quoted as „so many units of local currency per unit of foreign currency.1739= Rs. Ex: In India USD 2.100 is an indirect quotation. .‟ Ex: INR 46= USD 1.

Quoting in FE Market  Some currencies are quoted as so many rupees against one unit while others as so many rupees against 100 units. Foreign currencies Quoted against their One Unit Finish Mark (FM) French Franc (FFr) Hong Kong Dollar (HKD) Irish Pound Kuwaiti Dinar Malaysian ringgit New Zealand Dollar Norvegian Kroner Omani Riyak Qatar Riyal Saudi Riyal (SR) Singapore Dollar (SGD) Sterling Pound (GBP) Sewdish Kroner Swiss Franc Thai Bhat UAE Dirham USD Australian Dollar (AD) Austrian Schilling (Sch) Bahrain Dinar Canadian Dollar (CAD) Danish Kroner (DKr) Deutschmark (DM) Dutch Guilder Eqyptian Pound European Currency Unit .

Quoting in FE Market Foreign currencies Quoted against their 100 units. Belgian Franc Indonesian Rupiah Italian Lira Japanese Yen Kenyan Shilling Spanish peseta .

e. Dealers do expect some profit in exchange operations and hence there is always some difference in buying and selling rates. However maximum spread available to dealers may be restricted by their central bank. Authorized dealers give both buy and sell exchange rates. a rate at which the bank (dealer) is willing to buy foreign currency (buying rate) and a rate at which the bank sells foreign currency (selling rate). i.Quoting in FE Market     Exchange rates are always quoted as a two way price. .

which also means that he is willing to sell 35 rupees at the price of one dollar.Two Way Quotes     A dealer usually quotes a two way price for a given currency i. In a bid quote of Rs. . In either case.35/USD 1. the dealer conveys that he will buy dollars at the price of Rs. bid price and offer or ask price. when the dealer quotes an offer price per dollar. the currency for which bid or ask price is given is the unit of item priced.Quoting in FE Market.e. Likewise.35 per dollar. he implicitly quote the rate at which rupees would be bought per dollar.

Ex: a dealer in New Delhi may quote USD = Rs. .0000-46.0050.46.46.Two Way Quotes   Dealer make profit from each transactionwhether it is buy or sell.0000 and sell dollars to an importer at USD 1= Rs.0050 This means that he will buy dollars from an exporter at USD 1= Rs.Quoting in FE Market. Thus lower rate is the buy (bid) quote and the higher rate is the selling (ask) quote.46.

.e. Thus if there is a degree of volatility in an exchange rate.  Spread means the difference between a bank‟s buying (bid) and selling (offer or ask) rates in an exchange rate quotation. The currency in question The volume of the business. 2. It fluctuates according to The level of stability in the market. and if the business is thin and if the current rate of the currency is rumored to be unsustainable. the dealer will protect himself by widening the quote i. he will offer less currency while selling but demand more when buying. 3.Spread   1.

the percent spread equals 0.Bid Price *100 Ask Price Ex: With dollar quoted at Rs.014.0050. .Spread  The spread can also be expressed as a percentage i.0000-35.35.e. Percent Spread= Ask Price.

Cross Rates (Chain Rule)     Cross rate is the price of any currency other than home currency. If an importer has to remit French Francs from India with the knowledge that INR/FFr rates are not normally quoted would first buy dollars against the rupees and same dollars will be used overseas to acquire French Francs. In other words. a cross rate is an exchange rate which excludes rupees. Thus. in India. it is direct relationship between two non-home currencies in a foreign exchange market concerned with or used in transactions in a country to which none of the currencies belongs. for example USD/FFr. . DM/FFr etc.

1025/50.Cross Rates (Chain Rule) Ex: If say rates in New Delhi are INR/USD 35. Thus an importer will get 1 USD by paying Rs.1025= INR 6.1025 =1 USD 1 USD = INR 35. Thus a sort of chain is formed as under: FFr 5.0080 and for 1 USD he will get FFr 5.0080 1 FFr = INR 35.0080/5.8609 .35.0010/80 and rates in Paris are FFr/USD 5.1025.

. it is called the TOM (tomorrow) rate.Settlements Cash  Cash rate or Ready Rate is the rate when the exchange of currencies takes place on the date of the deal.  If the delivery is made on the day the contract is booked. it is called a Telegraphic Transfer (TT) or cash or value-today deal. Tom  When the exchange of currencies takes place on the next working day after the date of deal.

 A „business day‟ is defined as one in which both banks are open for business in both settlement countries.  Normally. a deal done on Tuesday will be settled on Thursday and a deal done on Friday will be settled on the following Tuesday. the occurrence of a bank holiday in the UK during the spot period is entirely irrelevant. say in London. . This is because all bank account transfers are made in the settlement country rather than dealing centre.Settlements Spot  When the exchange of currencies takes place on the second working day after the date of deal. it is called the spot rate.  In the case of a USD/DM deal done.  This time is allowed to banks to process the necessary paperwork and transfer the funds.

provided it was a business day in both the relevant countries. Even though person buying a Middle Eastern currency (say Saudi Riyals) may make payments (say in GBP) on Friday. This is a holiday in most Middle East countries. the delivery of Riyals would take place on Saturday. .  For some currencies such as USD/CAD transactions.  The only exception to the principle of compensated value arises for deals in Middle East countries for settlement on Friday. a spot transaction is only one day by convention.Settlements Spot  The principle that the two sides of the deal should be completed on the same date is referred to as the principle of compensated value.

.Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage   Arbitrage can be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. Arbitrage may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage).

.1817 We assume that buying and selling rates for these traders are same.5012 USD/FFr 0. Work out if an arbitrage opportunity exists.Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage Example: An arbitrage between two currencies Suppose two traders A & B are quoting the following rates: Trader A(Paris) Trader B(New York) FFr/ USD 5.

• In the process he gains FFr 24 (=5503655012) . which is FFr/USD =5.5036 (=1/0. say USD 10000. • He sells these USD to the trader B and receives FFr 55036.1817) Strategy • An arbitrageur buys.Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage   First we find out the reciprocal rate of the quote given by the trader B. by paying FFr 55012.

.Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage  This process would tend to increase the selling rate at the trader A because of increase in demand of USD and reverse would happen at the trader B because of the increased supply of USD. This would lead to an equilibrium after some time.

5100 USD/DM 0.6000 USD/CHF 0.6000 USD/DM 0.5200 We assume that buying and selling rates for these traders are same. . Work out if an arbitrage opportunity exists.Adjustment of Demand and Supply on the Spot Market: Process of Triangular Arbitrage Example: An arbitrage between three currencies Suppose both traders A & B are located at New York and giving the following quotes Trader A Trader B USD/CHF 0.

85 (=0.867 (=0. CHF/DM rate is 0.Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage    Since three currencies are involved we will have to find the cross rate between CHF and DM. CHF/DM rate is 0.52/60) .60) For Trader B. For Trader A.51/0.

35625 (=1000*35.500 in London 35.89 (=35625/55.625) • Sell Rs. Because of the difference in rate triangular currency arbitrage is possible. The strategy of the arbitrageur is as follows: • Use USD 1000 to buy rupees in Delhi.5579 which is different from the rate prevailing in New York.89 in New York to get USD 1015.Adjustment of Demand and Supply on the Spot Market: Process of Arbitrage: Problem  Are there any arbitrage gains possible from the data given below? Assume there is no transaction costs.47 (=64189*1.47 (=1015.500) • Sell GBP 641.35625 in London to get GBP 641. INR/GBP INR/USD USD/GBP 55.625 in Delhi 1. The arbitrageur would get Rs.5820 in New York USD/GBP rate at London and New Delhi is 1.47-1000) .5820) • Net Profit is USD 15.

The Forward Market   A forward contract is an agreement to buy or sell a financial asset in the future at prices agreed upon today. 34 . If the exchange of currencies takes place after a certain period from the date of the deal (more than two working days) it is called the Forward Rate.

Forward rates are generally expressed by indicating premium/discount on the spot rates for the forward period. 35 . at a rate of exchange fixed at the time of making the contract (for executing by delivery & payment at a future time agreed upon when making the contract).The Forward Market   A forward contract is a binding contract between a customer and a dealer for the purchase or sale of specific quantity of stated foreign currency.

90 days and 180 days. participants in the market are banks which want to cover order for their clients. the normal practice is to quote them for 30 days. Generally. 60 days.The Forward Market     Premium on one country‟s currency implies discount on another country‟s currency. 36 . Though the forward rate may be quoted for any future date. Operations take place mostly by telephone/telex etc through brokers. The forward market is not located at any specified place.

The forward rates can also be quoted in terms of points of premium or discount on the spot rate.Forward Rate Quotations    Quotations for forward rates can be made in two ways. This is called the „outright rate‟ and it is used by traders in quoting rates to the customers. which is used in „inter bank quotations‟37 . They can be made in terms of exact amount of local currency at which the trader quoting the rates will buy and sell a unit of foreign currency.

the points are subtracted from the spot price if the foreign currency is trading at a forward discount. 38 .Forward Rate Quotations  The points are added to the spot price if the foreign currency is trading at a forward premium.

.Spot rate)/Spot rate * 12/n * 100 where n is the number of months forward.Premium or Discount  Premium or Discount of a currency in the forward market on the spot rate is calculated as follows: Premium or discount (percent)= (Fwd Rate. FR>SR it implies premium. FR<SR it implies discount.

40 . you are long. If you have agreed to buy anything (forward or spot). you are short. If you have agreed to sell forex forward. you are “long”. If you have agreed to buy forex forward.Long and Short Forward Positions     If you have agreed to sell anything (spot or forward). you are “short”.

9000/30 30/25 40/60 45/65 .6300/25 20/25 25/35 30/40 INR/GBP 75.Forward Rate.2200/35 40/30 50/35 55/42 INR/DM 23.Problem  Convert the following rates into outright rates and indicate their spreads: Spot 1-mth 3-mth 6-mth Currency Pair INR/USD 45.

6360 45.0030 0.6325 45.6320 45.Forward Rate.6365 Spread 0.6350 45.6330 Ask 45.Problem  Rupee Rate of Dollar Spot 1-mth 3-mth 6-mth INR/USD Bid 45.0035 0.6300 45.0025 0.6325 45.0035 .

9040 23.0050 .9045 23.9095 0.Problem  Rupee Rate of Deutschmark INR/DM Bid Ask Spread Spot 23.9000 23.0030 1-mth 23.9090 0.9030 0.8970 23.0035 3-mth 23.9005 0.Forward Rate.0050 6-mth 23.

Speculation    A speculator is a trader who enters the market to profit from short term price changes. There are three kind of speculators: 1. As such when they enter the futures market it is for speculation. 3. he/she assumes risk that other individuals are trying to dispose of. 2. Most individuals have no heavy exposure in the futures market. In doing so. Scalpers Day Traders Position Traders 44 .

scalpers provide liquidity to the market.  Generally involves a great many trades earning a small profit on each trade.  Requires the scalper to be in the trading pit to observe the behavior of other buyers and sellers. A scalper is generally trying to guess the short term psychology of the market. One study shows that scalpers make about 70 trades per day. .Scalpers   A scalper is an individual that enters the futures market to profit from very short term price movements. How Long of Intervals?   By trading very frequently. 45 From the next few seconds to the next few minutes.

Provide a party willing to take the opposite side of a trade for an off-the-floor trader. 2. because hedgers know their orders can be executed. Actively trade. 3. thereby reducing execution costs for other traders. thereby generating price quotations and allowing the market to discover prices more effectively. 4. help to close the bidasked spread. Attract hedging activity.Services Provided by Scalpers 1. By competing for trades. Chapter 4 46 .

By closing all of their positions at the end of the day. day traders are able to reduce their risk. As such. day traders have no position in the futures market overnight.Day Traders    Day traders attempt to profit from trades that occur during a single trading day. Holding a position overnight is a risky proposition as the supply of many commodities is driven by weather. 47 . Day traders close all of their positions before the end of the trading day.

Position Traders   A position trader is a speculator that holds a position overnight. There a two types of position traders:   Outright Position Spread Position 48 . Sometimes they may hold them for weeks or months.

Therefore. If long-term interest rates rise as the trader expected. the trader sells a futures contract on U. and consequently futures prices for bonds will fall. a trader thinks that long-term interest rate will increase. 49 .S. the trader will earn a profit. Treasury bonds.Outright Positions    This is simply taking a naked position in a commodity. In which case the position trader will lose money. The risk is that the long-term interest rate will decline rather than increase. For example.

Spread Positions    1. a trader takes a position in two or more maturity months for the same good. Intra-commodity spread In an intra-commodity spread. The idea is to profit when the difference in prices between the two related commodities changes. 50 . Spread positions involve trading multiple contracts on the same or related commodities. There are two basic types of spreads: Inter-commodity spread In an inter-commodity spread. a trader takes a position in two or more different but related commodities.  2.

DERIVATIVES FX MARKETS CURRENCY SWAPS   A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Swap transactions account for approximately 51 percent of interbank FX trading. 51 . whereas outright trades are less than 9 percent.

CURRENCY SWAPS   A swap can be viewed as a portfolio of spot and forward positions. 52 . firm A would borrow in dollars and then swap for pounds with the bank and simultaneously enter into a series of forward contracts with the bank to exchange dollars for pounds. For example.

Both companies can raise loans in local currencies and exchange the loan obligations.CURRENCY SWAPS-Types      Back to back currency swaps suppose Co.. Swaps became popular only after 1981. In this swaping they may avoid any tax on foreign exchange transactions and also take advantage of favourable rate of interest. Spot cum forward swaps. Forward – forward swaps. 53 .K. B of Germany wants to invest £ 1 million in U. A in U.K. wants to invest in Germany DM 1 million and Co.World Bank/IBM case.

specific sized contract.g.India-only Re/$ Futures .FOREIGN CURRENCY FUTURES       DEFINITION: Foreign currency futures contract is a standardized agreement to deliver or receive a specified amount of the specified currency at a specified price (exchange rate ) on a specified date. For example. at IMM. Forex futures quotations are in direct quotes.000 dollars . dollars futures in rupees will be quoted $1 =Rs 43 54 . e.Lot: $1000.00. at International Monetary Market Chicago It is a standardized.g.. e. CHARACTERISTICS: Buyer of futures receives the foreign currency and seller of futures contract delivers the currency. Forex futures are traded on organized exchanges.. Australian dollar‟s futures size is 1.

Margins are transferred to respective accounts daily. At IMM it is third Wednesday of March. September and December.FOREIGN CURRENCY FUTURES Characteristics (contd.)    Forex futures have standard maturity date. 55 . Futures contracts are transacted in exchange clearing house through brokers. June. Margins are to be deposited with the Clearing House.

2. 6. Characteristics Futures Size of contract Standardized Maturity Fixed Location Exchange Margin Required Settlement Flexible Commission Yes Risk Low Forwards Desired size Flexible Banks No margin Fixed date No High 56 . 5. 7. 3.Difference Between Foreign Currency Futures & Forward Contracts 1. 4.

4.Advantages of Foreign currency Futures 1.. i. 2. 3. Speculative gains Hedging against exchange rate risk 57 . Risk lower.e. contract can be liquidated any time. Contracts are flexible.

Available only in developed countries Futures are not available in all currencies of the world Futures need specialized skills to forecast prices 58 .Limitations of Foreign Currency Futures 1. 2. 3.

at a prespecified rate. debt-instruments or interest.FOREIGN CURRENCY OPTIONS DEFINITION: An option is a financial contract in which the buyer of the option has the right but not the obligation to buy or sell the foreign exchange.A fortune if favourable happening . if the buyer exercises his /her option. if adverse happens . The seller of the option has obligation to perform the other side of option. etc. 59 . on or upto a specified date.Options can be related to exchange dealings or any commodity. EXAMPLE: Life Insurance-Premium-Protection. shares.

CALL OPTIONS: Right but not obligation to buyer to purchase currency Y against currency x at a given price on or before a specified date. Writer must take delinery . EXAMPLE: 3 months call option on U.$ against rupee @ $1= Rs. EXAMPLE: 3 MONTHS Put option on X against INR @ $1 = Rs. 44.00. Buyer is called ‘Option Buyer’. Seller is called ‘Option Seller’ or ‘Option Writer‟ . PUT OPTION: Gives buyer the right but not the obligation to sell currency Y against currency X. 44 for $10. Amount $1 million for a premium of 5%. on a before an agreed date.FOREIGN CURRENCY OPTIONS TYPES 1. for an agreed premium.if required. 60 . 2.option to Buyer only.S.

FOREIGN CURRENCY OPTIONS TYPES AMERICAN OPTIONS: Can be exercised by buyers on any day from initiation to expiry. 61 . EUROPEAN OPTIONS: Can be exercised only on expiry date.

Note: Gains & Losses are debited / Credited Daily in Buyer‟s and Writer‟ s A/cs.  Option Premium/ Option Price/Option Value: The fee which option buyer pays to option writer at the time of writing.TECHNICAL TERMS USED Strike Price Or Exercise Price: Exchange rate agreed upon in option.  At-the-Money.  62 . . if S>X . In-the-Money & Out-of-Money : In the Call Option – If S (Spot Price) = X (Exercise Price) it is called Atthe-Money. it is In-the-Money. it is At-the-Money. then it is Out-of-Money.  Maturity Date or Expiry Date: Date on which option expires. In a Put Option: If S=X.If S>X .then it is Out-of-Money & if S<X. It is non-refundable.then it is In-the-Money & if S < X.

63 .ADVATAGES OF OPTIONS   Allows Hedging against Exchange Rate Risk Also facilitates Speculation/ Return.

LIMITATIONS OF OPTIONS In India Options are written only by the banks. 64 . They are allowed only for hedging & not for speculation.

000 GBP from bank B paying $ 1. selling & buying.00.4560(Bid/Ask) & Bank B quotes 1.4538/1.4548 . You may 65 gain $ 20.480.500.e.g.45.00.000 to bank A @ 1.45.SPECULATION & ARBITRAGE IN FOREX MARKETS      SPECULATION :Investment for windfall pofit. Now you sell GBP 1..4550 and get $ 1. EXAPLES:SPOT-SPOT or FORWARD-FORWARD ARBITRAGE: Suppose Bank A quotes GBP/USD:1. Most often Arbitrage does not involve investment or risk.4550/1. Suppose you buy 1. . ARBITRAGE: Refers to a set of transactions . lending & borrowing the same financial asset or equivalent groups of assets. to gain profit from price differentials.

520 AUD .  66 .30/ 69.10( Bid/ Ask ) USD/AUD= 1.500 JPY to Bank @ 110.i.6530 Suppose Bank B quotes as follows : AUD/JPY = 68.25/111.520 AUD to Bank B & buy JPY @ 69. sell these 16.000 USD @ 1.total JPY= 11.39. Now .380.e.6520 & get 16.880.00. GAIN = JPY 37. Then. Now..TRIANGULAR ARBITRAGE Transactions in 3 Currencies:  Suppose Bank A quotes rates of 3 currencies as follows: USD/JPY = 110.00 Suppose you sell 11.sell 10.6520/1.000 USD.25 & buy 10.02.

380.30/ 69. GAIN = JPY 37.6520 & get 16..500 JPY to Bank @ 110.39.i.00.sell 10.  66 .total JPY= 11.520 AUD to Bank B & buy JPY @ 69.25/111. Now. Then.10( Bid/ Ask ) USD/AUD= 1.000 USD @ 1.6530 Suppose Bank B quotes as follows : AUD/JPY = 68. sell these 16.6520/1.TRIANGULAR ARBITRAGE Transactions in 3 Currencies:  Suppose Bank A quotes rates of 3 currencies as follows: USD/JPY = 110.25 & buy 10.00 Suppose you sell 11. Now .02.000 USD.e.880.520 AUD .

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