FOREIGN EXCHANGE MARKET

• FOREIGN EXCHANGE
• THE PLAYERS
• EXCHANGE RATEQUOTATION
• INVERSE QUOTE
• ARBITRAGE
 THE FOREIGN EXCHANGE MARKET

• This is over the counter market ( OTC ) i.e. there is no physical

market place to make the deals.

• Instead it is a net work of banks , brokers and dealers spread

across the various financial centers of the world .

• These players trade in different currency through telephones , faxes

, computers and other electronic networks like the SWIFT system
( Society for Worldwide Inter bank Financial Telecommunication) .

• These traders generally operate through a trading room .

• The deals are finalized orally with written communication

following later .
• The major markets are:
** London,
** New York ,
** Tokyo,
** Zurich,
** Frankfurt.

• Majorly the transactions are done in:

** US Dollar,
** Euro,
** Yen,
** Pound Sterling,
** Canadian Dollar ,
** Australian Dollar.
 THE PLAYERS

The main players in the foreign exchange market are :

• large commercial banks,
• forex brokers ,
• large corporations and
• the central banks .

The central banks enter the market to smoothen out fluctuations in

the exchange rates .
 STRUCTURE OF FOREIGN EXCHANE MARKET IN INDIA

• Tier I : the transaction between RBI and Authorized Dealers

(ADs)
• Tier II : the inter bank market in which ADs deal with each other
• Tier III : the transactions between ADs and their corporate
customers.

Category of ADs:

Category I : all commercial banks ;state and urban co-operative banks-engage in all
current and capital account transactions.
Category II: co-operative banks; regional rural banks and upgraded Full Fledged Money
Changers for specified non-trade related current account transactions such
as business travel, medical treatment abroad, film shooting abroad,
overseas education.
Category III: selected financial institutions such as EXIM bank – allowed to undertake
forex transactions related to their activities.

• The important centre are Mumbai , Delhi , Calcutta, Chennai , Cochin and Bangalore.
 FOREIGN EXCHANGE

As defined in Section 2 of FEMA , 1999 foreign exchange includes :

• all deposits ,credits , balance payable in any foreign currency ,
• any drafts , travelers` cheques , letter of credit and bills of exchange ,
• any instrument giving anyone the option of making it payable either partly
or fully in a foreign currency .

Here the term currency includes coins , bank notes , postal notes ,
postal orders and money orders .
• Market Makers :
The large commercial banks which stand ready to buy and sell various
currencies at specific prices at all points of time .

• Retail Market :
The market in which the commercial banks deal with the customers
both individuals and corporate .

• Inter bank Market / Wholesale Market:

The mkt. in which banks deal with each other

• A 24 Hour Market :
The world wide forex mkt. is a 24 – hour mkt. i.e. trading is going on
at least one of the forex market through out the day.
• Authorized Dealers ( A Ds ):
They are generally the commercial banks .They are permitted to deal in
all items classified as foreign exchange in FEMA ,1999 . They have to
operate within the rules regulations and guidelines issued by Foreign
Exchange Dealers Association of India ( FEDAI ) .

• Money Changers :
They can be either full – fledged MC (can both buy and sell) or restricted
MC ( can only buy ) are allowed to deal only in notes , coins and
travelers` cheque.

• Foreign Exchange Brokers:

They do not actually buy and sell any currency . They do the work of
bringing the buyer and seller together .
 EXCHANGE RATE QUOTATIONS

An exchange rate quotation is the price of a currency stated in terms

of another i.e. the price of one currency quoted in terms of 1unit of
the other currency .
For e.g. INR / USD : 46.40 / 1USD

• American Quote :
The number of dollars expressed per unit of any other currency .
For e.g. USD 1.6689 / 1GBP

• European Quote :
The number of units of any other currency expressed per dollar .
For e.g. INR 46.40 / 1USD
• Direct Quote :
The quote where the exchange rate is expressed in terms of number of
units of the domestic currency per unit of foreign currency.

For e.g. In India INR46.40 / USD

• Indirect Quote :
The quote where the exchange rate is expressed in terms of number of
units of the foreign currency per unit of domestic currency .

For e.g. In India USD2.0525 / INR 100 .

• Merchant Quote :
The quote given by a bank to its retail customers .

• Inter Bank Quote :

The quote given by one bank to another bank .
 BID & ASK RATE

• Bid Rate : The rate at which a bank is ready to buy a currency .

• Ask Rate : The rate at which a bank is ready to sell a currency.

INR / USD : 40.40 / 40.60 i.e. bid / ask

INR / USD : 40.40 / 60 , 60 represents the last two digits

of the ask rate, the rest being common with
the bid rate

INR / USD : 40 / 60 , this is used in the inter bank market

where the dealers would be aware of the
prevailing rate .
 NOTE :

• These last two digits are known as Pip .

• The quote is always from banker's point of view .

• The bid rate is always lower than the ask rate .

• The difference between the bid rate and the ask rate is called the
Bid – Ask Spread.

• The single rate mentioned is often the arithmetic average of the bid
and the ask rate.
 INVERSE QUOTE

For every quote (A/B) between two currencies , there exists an

inverse quote (B/A) .
For e.g. for a Euro / USD quote there exists a USD / Euro quote .

Implied Inverse Quote / Synthetic Inverse Rate :

If quote (A/B) is given to us we can easily calculate quote (B/A) :

Quote (B/A) = [ 1/ (A/B) ask ] / [1 / (A/B) bid ]

ILLUSTRATION :

1 The quote for INR / USD : 45 / 47 , what will be the prevailing

direct quote in USA ?

2 Rian Ltd has calculated a synthetic quote for CAD/USD ,

which is 1.2176/82 .Calculate the prevailing rate of USD/CAD.
1. Direct Quote in USA will be USD / INR :
= 1/ (INR/USD) ask / 1/ (INR/USD) bid
= 1/47 / 1 /45
= 0.0213 / 0.0222

2. USD/CAD
= 1/ CAD /USD ask / 1/ CAD/ USD bid
= 1/1.2182 / 1/1.2176
= 0.8208 / 0.8213
 Note :
1. Synthetic inverse quote is always different from actual inverse
quote because of the transaction cost .
2. Transaction cost is the lump some payment required to be made to
the dealer , from whom the currency is bought or sold , as his fee or
commission .

Arbitrage:
Arbitrage is the process of buying and selling the same asset at the same
time , to profit from price discrepancies within a market or across different
markets.

Risk Free Arbitrage:

When the arbitrage does not involve commitment of capital or any
assumption of risk it is called Risk Free Arbitrage.
ILLUSTRATION :

Suppose the USD / Euro rates in :

October 2008:
In country A : 1.0660 /1.0665
In country B : 1.0655 /1.0658

December 2008:
In country A : 1.0660 /1.0665
In country B : 1.0655 /1.0662

Is there an arbitrage opportunity?

October 2008:
The USD / Euro rates are :
In country A : 1.0660 /1.0665
In country B : 1.0655 /1.0658

An arbitrager can buy Euros in country B at Euro 1.0658/$ and

sell at country A at 1.0660 USD , thus making a profit of USD
0.0002 .
ILLUSTRATION : (Two Point Risk Free Arbitrage )

A businessman in India is eyeing an arbitrage opportunity. He

found that the quotation available from a bank in New York is
USD / INR : 0. 025 / 0. 027 , at the same time a bank at Bombay is
offering the following quote INR / USD : 50 / 52 .

If there an arbitrage opportunity help him earn a profit.

Implied inverse rate of INR/USD at New York is:
=[1/0.027] / [1/0.025]
=37 / 40

There exists a opportunity for Risk Free Arbitrage.

The businessman must Buy dollars in New York and

Sell them in Bombay to earn a profit.
 Suppose the businessman has Rs. 10 lac.

Buy dollars in New York :

= INR 10,00,000 * 0.025 USD/INR
= USD 25, 000

Sell 25,000 USD in Bombay :

= USD 25,000 * 50 INR/USD
= INR 12.50 lac

Even if he incurred some expense still he earns a profit

of 12.50 – 10 = INR 2.50 lac.
.
 TYPES OF TRANSACTIONS

Foreign exchange transactions can be classified on the basis of the

time between entering into a transaction and its settlement .

• Outright / Cash / Ready Transaction :

When the exchange of currency takes place on the date of the deal .

• TOM ( tomorrow ) Transaction :

When the exchange of currency takes place on the next working day .

• SPOT Transaction :
When the transaction will be settled after 2 business days from the
date of the contract .
• OUTRIGHT FORWARD Transaction :
A contract where the parties to the transaction agree to buy or sell a
currency at a pre determined future date at a particular price .This
future date may be any date beyond 2 business days . The price and the
terms of delivery and payment are fixed at the time of entering into the
contract .

• SWAP Transaction :
A transaction whereby 2 currencies are exchanged by the parties
involved , only to be exchanged back later .

• A currency swap is a combination of two transactions - one spot and

one forward – with exchange of currencies taking place at a pre-
determined exchange rate .
THANK YOU