Foreign Exchange Risk

Management

Chapter-1: The Basics of the Foreign

Exchange Market

Course Instructor:
Md. Nazmul Hasan
Assistant Professor
Email: palashdu007@gmail.com
 What is Foreign Exchange?
Foreign Exchange refers to the process or mechanism by which
the currency of one country can be converted into the currency of
another country and, thereby, involves the international transfer
of money.
Dr. Paul Einzig defines FX as the system or process of converting
one national currency into another and transferring the ownership
of money from one country to another in settling the financial
trade.
FX is concerned with the settlement of international indebtedness, the
methods of effecting the settlement, the instruments used in this
connection and the variation in exchange rates at which settlement of
international indebtedness is made.

***Paul Einzig was an economic and political writer and journalist. He wrote 57 books, alongside many articles for newspapers
and journals, and regular columns for the newspapers Financial News and Commercial and Financial Chronicle.
 What is Foreign Exchange?

Thus Foreign exchange means foreign currency and includes

All deposits, credits, and balances payable in any foreign currency,
draft, travellers cheque, letter of credit, bill of exchange,
expressed or drawn in local currency but payable in any foreign
currency; and

Any instrument payable, at the option of the drawee (i.e., a

person to whom a bill of exchange is addressed, and who is
requested to pay the amount of money therein mentioned) or
holder thereof or any other party thereto, either in local or in
foreign currency or partly in one and partly in the other.
 Money Vs. currency
The term Money has a narrower meaning than the term
Currency. To be specific, the term money is used to describe
the actual money in the form of coin or notes or in any other
forms which passes freely from hand to hand as the
recognized medium of exchange within the country.

In contrast, currency is a generic term and covers not only the

actual coins and paper money in use in a country but also, any
credit instruments which convey the right to wealth in terms
of any given unit such as cheque, a promissory note, a bill of
exchange or any other instruments capable of transferring the
property in a stated number of the unit of accounts which are
in use in any given country.
 Defining The Foreign Exchange Market
The Foreign Exchange Market can be defined in terms of
specific functions, or the institutional structure that:
(1) Facilitates the conversion of one countrys currency into
another.
Through the buying and selling of currencies.
Allows global firms to move in and out of foreign currency as needed.
(2) Sets and quotes exchange rates.
This is the ratio of one currency to another.
These rates determine costs and returns to global businesses.
(3) Offers contracts to manage foreign exchange exposure.
These hedging contracts allow global firms to offset their foreign currency
exposures and manage foreign exchange risk.
Thus, they can concentrate on their core business.
 Quick Review of Market Characteristics
Worlds largest financial market.
Estimated at $3.2 trillion dollars per day in trades.
NYSE-Euronext currently running about $40 billion per day.
Market is a 24/7 over-the-counter market.
There is no central trading location.
Trades take place through a network of computer and telephone
connections all over the world.
Major trading center is London, England.
34% of all trades take place through London (New York second at
17%).
Most popular traded currency is the U.S. dollar.
Accounts for 86% of all trades (euro second at 27%).
Most popular traded currency pair is the U.S. dollar/Euro.
Represents 27% of all trades (dollar yen second at 13%)
Currencies are either traded for immediate delivery (spot) or
some specified future delivery (forward).
[In USA system, 1 trillion= 1000 billion; 1 billion=1000 million or 100 crore. In UK system, 1 trillion=1 million x 1 billion]
 How does the FX Market Quote Currencies?
In a currency pair, the first currecy is called the base currency and the second currency is
called the quote currency. Currency pair can be separated into two types, direct and indirect.
In a direct quote, the domestic currency is the base currency, while the foreign currency is
the quote currency. Alternatively, a direct quote is a foreign exchange rate quoted as the
domestic currency per unit of the foreign currency. In other words, it involves a quote in
fixed units of foreign currency against variable amounts of the domestic currency.
For example, if Pound (U.K) is the domestic currency, a direct quote would be 0.0067 GBP/JPY and means that 1JPY is
equals to 0.0067. Notice here base currency is GBP and quote currency is JPY.
In the indirect quote, on the other hand, the foreign currency is variable and the domestic
currency is fixed at one unit.
For example, if Canada is the domestic currency, a direct quote would be 1.18 USD/CAD and means that USD$1 will
purchase C$1.18

(1) American Terms:

Expresses the exchange rate as the number of U.S. dollars per one unit of some foreign
currency.
For example, $2.00 per (1) British pound.
(2) European Terms:
Expresses the exchange rate as the number of foreign currency units per one U.S. dollar.
For example, 120 yen per (1) U.S. dollar.
Most of the worlds currencies are quoted for trade purposes on the basis of European terms.
Exceptions include: British pound, Euro, Australian dollar.
Newspapers, like the Wall Street Journal, however, usually quote both.
 Quotes are Given by Time of Settlement
Spot Exchange Rate:
Quotes for immediate transactions (actually
within 1 or 2 business days)
Forward Exchange Rate:
Quotes for future transactions in a currency (3
business days and out).
Forward markets are used by businesses to protect
against unexpected future changes in exchange rates.
Forward rate allows businesses to lock in an exchange rate
for some future period of time.
For example, In case of Import payment and export receipt,
changes in exchange rate has serious implications.
 Observing Changes in Spot Exchange Rates:
What do they Mean?
Appreciation (or strengthening) of a currency:
When the currencys spot rate has increased in value in terms of
some other currency.
Suppose, the 3 years back the exchange rate was $1=BDT 90 but
now $1=BDT 82.45 (todays rate). This is an example of
appreciation in the value of BDT (TAKA) in compared to $.

Depreciation (or weakening) of a currency:

When the currencys spot rate has decreased in value in terms of
some other currency.
Suppose, the 3 years back the exchange rate was $1=BDT 75 but
now $1=BDT 82.45 (todays rate). This is an example of reduction
in the value of BDT (TAKA) in compared to $.
 Forward Rate Quotes
As a rule, forward exchange rates are set at either a
premium or discount of their spot rates. The choice
over the premium or discount depends on the future
expectations of the market condition.

If a currencys forward rate is higher in value than its spot

rate, the currency being quoted at a forward premium.
For example: the Japanese 1 month forward is greater than its
spot (0.009034 versus 0.008999)
If a currencys forward rate is lower in value than its spot
rate, the currency is being quoted at a forward discount.
For example, the British pound 6 month forward is less than its
spot (2.0417 versus 2.056).
 What Institutions are Involved in the Foreign
Exchange Market?
Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank)
acting on behalf of:
(1) Their external clients (primarily global firms:
exporters, importers, multinational firms)
Acting in a broker capacity at the request of these clients and meeting the
foreign currency needs of these clients.
(2) Their own banks (trading to generate profits).
Acting in a dealer (i.e., trading) capacity
Taking positions in currencies to make a profit.

In meeting the needs of their clients and their own trading

activities, these global banks establish the tone of the
market.
This is through a market maker function.
 Making the Market in FX
The market maker function of any global bank involves two
primary foreign exchange activities:

(1) A willingness of the market maker to provide the market

with on-going (i.e., continuous) two-way quotes (simultaneous
buying & selling) upon request:
(1) Provide a price at which they will buy a currency
(2) Provide a price at which they will sell a currency
This function provides the market with transparency

(2) A willingness of the market maker to actually buy and/or

sell at the prices they quote:
Thus the market maker offers firm prices into the market!
This function provides the market with liquidity.
 ISO Currency Designations
All foreign currencies are assigned an International Standards
Organization (ISO) abbreviation.
E.g., USD; JPY; GBP; EUR; AUD; HKD; CNY; MXN; SGD; ARS; THB; INR;
RUB; ZAR; NZD; CHF; KRW
For individual countries see:
http://www.oanda.com/site/help/iso_code.shtml
Since the exchange rate is simply the ratio (i.e., value) of one currency
against another, market makers express this relationship using the two
currencies ISO designations.
For Example:
USD/JPY
USD/MXN
EUR/USD
GBP/USD
EUR/JPY (this is a cross rate; since USD in not one of them)
 Base and Quote Currency
Given that a foreign exchange quote is simply the
ratio of one currency to another, a complete
market maker quote must have two ISO designations
(e.g., EUR/USD or USD/JPY):
The first ISO currency quoted is called the base currency.
The second ISO currency quoted is called the quote
currency.
For examples above:
EUR/USD: EUR is the base currency and USD is the quote currency.
USD/JPY: USD is the base currency and JPY is the quote currency.
 Bid and Ask Quotes
Recall that a market maker always provides the
market with two prices, both a buy and sell quote (or
price) for a currency.
For Example: EUR/USD: 1.2102/1.2106
The first number quoted by the market maker is the
market makers buy price ($1.2102).
It is called the market makers bid quote (or buy price)
The second quoted number is the market markers sell
price ($1.2106).
It is called the market makers ask quote (or sell price)
Note: The bid quote is always lower than the ask quote.
 What Currency is The Market Maker Buying and
Selling?

Given the example: EUR/USD: 1.2102/1.2106, which

currency is the market maker selling and which currency
is the market maker buying?
Answer: Market makers are always quoting prices at
which they will buy or sell ONE UNIT of the base
currency (against the quote currency).
So in the above example:
The market maker will buy Euros for $1.2102
This is the bid price for eEuros.
The market maker will sell Euros for $1.2106
This is the ask price for Euros.
 Reading and Understanding Quotes
When viewing a foreign exchange quote, assign a value of 1 to
the base currency (the base currency is the first in the ISO
pair). The quotes you see refer to one unit of this base
currency.
For example, if you see a market makers ask price for the EUR/USD of
1.2811, that means that if you were to buy one Euro (the base
currency) you are going pay $1.2811.
If you see a market makers bid price for the USD/JPY of 120.10 that
means if you were to sell one dollar (the base currency) you are going
to get 120.10 for it.
Also, whenever the bid and ask prices are moving up, that
means that the base currency is getting stronger and the
quote currency is getting weaker.
 Functions of the Foreign Exchange Markets
Foreign Exchange Market is the market in which
individuals, firms, and banks buy and sell foreign
currencies or foreign exchange.
The transfer of funds or purchasing power from
one nation and currency to another.
Demand for foreign currencies
-Import/expenditures abroad/investment abroad
Supply of foreign currencies
-Export/earnings from tourism/receipt of foreign investments

the credit function

the facilities for hedging and speculation
 Four levels of transactors or participants

1. Immediate users and suppliers of foreign

currencies: Importers/Exporters/tourists/investors

2. Clearinghouses-commercial bank

3. Foreign exchange brokers-interbank / wholesale

market

4. The nations central bank-lender of last resort

 Flexible Foreign Exchange Rates

FIGURE 14-1 The Exchange Rate Under a Flexible Exchange Rate System.

Flexible foreign exchange rates essentially refers to the exchange rate which is completely or mostly determined by
the changes in the market forces.
FIGURE 14-2 Disequilibrium Under a Fixed and Flexible Exchange Rate System.
 Spot and Forward Rates,
Currency Swaps, Futures, and Options

a. Spot and Forward Rates

b. Currency Swaps

c. Foreign Exchange Futures and Options

 a. Spot and forward rates
Spot transaction-Spot rate
The most common type of foreign exchange
transaction involves the payment and receipt of
the foreign exchange within two business days
after the day the transaction is agreed upon.

The two-day period gives adequate time for the

parties to send instructions to debit and credit the
appropriate bank accounts at home and abroad.
 Forward transaction-Forward rate
A forward transaction involves an agreement
today to buy or sell a specified amount of a
foreign currency at a specified future date at a
rate agreed upon today.
One month; Three months; six months
Forward contracts can be renegotiated for one
or more periods when they become due.
 FD (Forward Discount)
If the forward rate is below the present spot rate, the
foreign currency is said to be at a forward discount
with respect to the domestic currency.

FP (Forward Premium)
If the forward rate is above the present spot rate, the
foreign currency is said to be at a forward premium
with respect to the domestic currency.
 b. Currency swaps
A currency swap is an agreement in which two parties exchange
the principal amount of a loan and the interest in
one currency for the principal and interest in another currency.
At the inception of the swap, the equivalent principal amounts
are exchanged at the spot rate. It is also called cross-currency
swap.
Refer to a spot sale of a currency combined with a forward
repurchase of the same currency-as part of a single transaction.

Swap Rate: is the difference between the spot and forward

rates in the currency swap. (a yearly basis)
 c. Foreign exchange futures and options
A currency future, also known as an FX future or
a foreign exchange future, is a futures contract
to exchange one currency for another at a
specified date in the future at a price
(exchange rate) that is fixed on the purchase
date
A foreign exchange futures is a forward contract
for standardized currency amounts and selected
calendar dates traded on an organized market
(exchange).
 A foreign exchange option
Is a contract giving the purchaser the right, but not
the obligation, to buy (a call option) or to sell (a put
option) a standard amount of a traded currency on a
stated date (the European option) or at any time
before a stated date (the American option) and at a
stated price (the strike or exercise price)
The buyer pays the seller a premium (the option
price) ranging from 1 to 5 percent of the contracts
value for this privilege when he or she enters the
contract.
Foreign Exchange Risks, Hedging & Speculation

a. Foreign Exchange Risks

b. Hedging

c. Speculation
 a. Foreign Exchange Risk
Foreign Exchange Shift:

1.Changes in tastes for domestic and foreign

products in the nation and abroad
2.Different growth and inflation rates in different
nations
3.Changes in relative rates of interest
4.Changing expectations
 b. Hedging
Hedging is a way for a company to minimize or
eliminate foreign exchange risk. Two common hedges are
forward contracts and options. A forward contract will lock in
an exchange rate today at which the currency transaction will
occur at the future date.

Refers to the avoidance of a foreign exchange risk, or the

covering of an open position.
At spot market
At forward market
At futures and options markets
 c. Speculation
Speculation is the act of trading in an asset or conducting a
financial transaction that has a significant risk of losing most or
all of the initial outlay with the expectation of a substantial gain.

The opposite of hedging.

A speculator accepts and even seeks out a foreign exchange risk,

or an open position, in the hope of making a profit.

Speculation can take place in the spot, forward, futures, or

options markets
 Long Vs. Short Positions
Long position: When a speculator buys a foreign
currency on the spot, forward, or futures market, or
buys an option to purchase a foreign currency in the
expectation of reselling it at a higher future spot rate.

Short position: When a speculator borrows or sells

forward a foreign currency in the expectation of
buying it at a future lower price to repay the foreign
exchange loan or honor the forward sale contract or
option.
Thanks for your patient hearing!
Stay safe and blessed!