FOREIGN EXCHANGE MARKET

INTRODUCTION

Forex Business
Each country has a Central Bank / Agency It regulates inflows and outflows of FCs Each country has certain regulations about who is authorised to convert the currencies In India RBI has the regulatory powers under FEMA It authorises commercial bank branches to conduct foreign exchange business

Authorised dealers in Foreign Exchange

Currency inflow outflow

EXPORTS

IMPORTS

INVISIBLE RECEIPTS
CA DEFICIT

TRADE DEFICIT
INVISIBLE PAYMENTS

CAPITAL RECEIPTS

CAPITAL PAYMENTS GROWTH IN RESERVES

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Forex Reserves at Present are USD 295.72 Billion (08.10.2010)

Forex Inflows
Inflows in FC arise mainly on account of: Export of goods and services Remittances from NRIs Tourism Investment Borrowings by Govt.,Corporates,Individuals Aid from International Agencies Gifts and Donations
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Evolution of the Forex Market in India

Fixed Exchange Rate Sterling as Intervention Currency Basket of Currencies in 1975 LERMS March 1992 ORE/MRE Unified Exchange Rate March 1993 Direct Quotation

Forex outflows
Outflows in FC arise mainly on account of: Import of goods and services Repatriation of NRI funds Educational expenses of Indian students Tourism Investment Lendings to Other countries, Repayment of loans, interest on loans etc. Aid by Indian Govt., Agencies Gifts and Donations
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Exchange Rate Basics

Bank buys currency from Customers at buy rate Bank sells currency to Customers at sell rate Sell rate is kept higher than the buy rate The difference is profit to the bank

All currencies bought have to be sold All currencies sold are bought back This matching of sale and purchase is called cover operation. Customers not always available for sale / purchase Banks deal among themselves Interbank market
This is a wholesale market for currencies
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FOREX MARKET
Participants - Banks, foreign exchange brokers, and dealers. Not a physical place Technology driven All participants are linked to each other through dedicated networks. e.g., REUTERS, TELERATE, BLOOMBERG It is a 24 hour market Open in some part of the globe. New Zealand Australia Japan - Hong Kong Singapore Mumbai Bahrain London - New York .. And again Back to New Zealand
SEVERAL LARGE BANKS RUN 24 HOUR DEALING ROOMS ON THREE SHIFT BASIS AT MAJOR FINANCIAL CENTRES

CHARACTERISTICS OF FOREX MARKET:

1. A 24-hour Market 2. An O-T-C Market 3. A Global Market with No Barriers/No Specific Location 4. A Market that supports large Capital & Trade Flows 5. Highly Liquid Markets 6. High Fluctuations in Currency Rates (Every 4 Seconds) 7. Settlements affected by Time Zone Factor

8. Markets affected by Govt. Policies & Controls

EXCHANGE RATE DETERMINANTS-Fundamental Reasons

1. BOP Surplus results in stronger currency Deficit weakens a currency

2. Economic Growth Rate A high growth leads to a rise in imports and a fall in the value of currency and vice versa
3. Fiscal Policy Lower taxes can lead to higher economic growth. 4. Monetary Policy Central Bank attempts to influence and control interest and money supply can impact the countrys currency value 5. Interest Rates High Domestic Interest Rates attract overseas capital & currency appreciates in the short term. In the longer run, high interest rates slow the economy, weakening the currency.

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6. Political Issues Political Stability likely to lead to economic stability and hence a steady currency. Political instability results in the opposite.
Technical Reasons Government Controls can lead to unrealistic value of a currency, resulting in violent fluctuation in exchange rates. Huge surpluses in the OECs have led to heavy investments elsewhere overseas,leading to huge movement of capital overseas and resultant appreciation of the relative currency. Speculation Speculative deals provide depth and liquidity to the market and at times act as a cushion, as long as this does not lead to a cotagious effect.

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Direct Quotation: 1 Foreign Currency Unit = (equals) X amount of Home Currency Units BID 44.205 ASK-44.210H.

USD EXCH. RATE- INR 44.205

Indirect Quotation: 1 Home Currency Unit = (equals) X amount of Foreign Currency Units INR EXCH. RATE USD 0.2262 BID 0.2262 ASK 0.2262

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Cash, Tom, Spot and Forwards

READY OR CASH Settlement of funds takes place on the same day (date of deal)

TOM - Settlement of funds takes place on the next working day after the deal
SPOT Settlement of funds takes place on the second working day after deal FORWARD Delivery of funds takes place any day after Spot date. Normally Rupee and dollar are to change hands on spot date

Cash to spot and tom to spot differences depend on the number of days between the
two dates. If there are intervening holidays difference will be larger.

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Discount and Premium

Rupee fetches higher interest than dollar If exchange takes place after the spot date party receiving rupee has to be compensated for difference in interest If exchange takes place before spot date, the party paying rupee has to be compensated for difference in interest
Forward dollar costlier than spot dollar We say dollar is at a premium in forward Or rupee is at a discount in the forward market Currencies with low interest are at a premium Currencies with high interest are at a discount Premia / discounts also quoted as percentage

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EXCHANGE ARITHMETIC
All forex rates calculations have to be worked out with extreme care and accuracy and the use of the decimal point has to be correctly placed. Constant check is also required to minimise the risk or mistake as the markets work on very thin margins. An error in one quote may erode, earnings from several trades/transactions.

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Factors affecting Exchange Rates

Balance of Payments Interest rates and Inflation Economic Growth Rate Political Stability / Fiscal Policy Speculation Central Bank Intervention Demand and Supply

Because exchange rates are volatile, who has to pay or receive Forex at a future date needs to hedge the currency risk
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Derivatives
A financial instrument that is valued according to the expected price movements of an underlying asset, which may be a commodity, currency or a security, is called a derivative As derivative is a contractual relationship established by two or more parties where payment is based on, or derived from, some agreed-upon benchmark, the types of derivative products that can be developed are limited only by the human imagination Therefore, there is no definitive list of derivative products

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Forward Contracts
A Forward Contract is a simple derivative contract to buy/sell a specified asset on a certain future date (maturity date) at a specified price (exercise price). A Forward contract is normally settled by delivery of the underlying asset.

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FUTURES
A Futures contract is a form of forward contract in that it conveys the right to purchase or sell a specified quantity of an asset at a fixed price on a fixed future date It involves a definite purchase or sale and not an option to buy or sell As Futures are exchange-traded instruments, the contract obligation is not between the two counter-parties to the transaction (the buyer and seller of the contract), but to the clearing house of the exchange

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FUTURES AND FORWARDS

FUTURES Exchange traded
Standard quantity, quality and date of maturity Counterparty risk of Exchange

FORWARDS
Negotiated between two parties All these can be negotiated

Counterparty risk of the opposite party

Offsetting transactions through the Exchange Transparent pricing

Offsetting transactions only with the original counterparty

Negotiated pricing

Margin required

Often no Margin required

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Call Options

Importer need to buy USD 1 mio on 31stDec He buys a call option at 43.50 from bank Right to buy dollar at 43.50 without obligation to do so If rate is 43.51 or above, he will buy from bank at 43.50

If rate is lower he will forfeit the option; buy from market

As rupee strengthens profit potential is unlimited

If rupee depreciates he is always protected at 43.50

His maximum loss is the premium paid.
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OPTIONS
An Option offers the buyer/holder the right, but not the obligation, to buy or sell a specified amount of the underlying asset at an agreed rate on or before a specified future date Option may either be a Call Option or a Put Option
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Put Options

Exporter need to sell USD 1 mio on 31st Dec He buys a put option at 43.50 from bank Right to sell dollar at 43.50, with no obligation to do so. If rate is 43.49 or lower, he will sell to bank at 43.50

If rate is higher, he will forfeit the option; sell in market

As rupee weakens profit potential is unlimited If rupee appreciates he is protected at 43.50

His maximum loss is the premium paid

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Option terminology
Customer making delivery or taking delivery under an option is called exercising the option European style option can be exercised only on due date American style option exercised any day before maturity

Price at which option can be exercised is the strike price

The upfront price paid by customer is called premium Options are normally custom made and sold by bank to customer Over

the Counter (OTC) options

Options quoted on Exchanges - Exchange Traded Options.

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