International Financial Management

Foreign Exchange
Markets

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 Foreign Exchange
Foreign exchange is defined in terms of Sec 2 of FEMA,
1999 as foreign currency including:
(i) All deposits, credits, balances payable in any foreign
currency
(ii) Any drafts, travellers cheques, letters of credit and
bills of exchange expressed or drawn in Indian
currency and payable in foreign currency
(iii) 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.
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 Foreign Exchange Markets
• Foreign exchange markets is an over the counter
market, where there is no physical market or
place to make deals and instead, it is a network
of banks, brokers and dealers spread across the
various financial centers of the world.
• Hence players trade in different currencies
through telephone, faxes, computers and other
electronic networks.

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Measuring Foreign Exchange Market Activity:
Average Electronic Conversions Per Hour

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Global Currency Trading: The Trading Day

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 Foreign Exchange Markets - Participants
• The main players in the foreign exchange market
are large commercial banks, forex brokers, large
corporations and central banks.
• First tier - Transactions between Authorised
Dealer and RBI.
• Second tier – Whole sale or Interbank market
where banks deal with each other
• Third tier – Retail market where commercial
banks deal with customers (both individuals and
corporates)
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 FEMA, 1999 says
• RBI is the regulatory body in India for all foreign
exchange related issues
• Only those entities authorized by RBI can deal in
foreign exchange – Authorized Dealers or Money
changers
• Authorized dealers are allowed to deal with all
items classified as foreign exchange by FEMA
• Money changers can be either full fledged or
restricted. They are allowed to deal only in notes,
coins and travellers cheques. While the former is
allowed to buy and sell, the latter can only buy the
same.
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 Exchange rate quotations
• An exchange rate quotation is the price of a
currency stated in terms of another.
• The various kinds of quotes are
• American, European, Direct, Indirect, Merchant,
Interbank, Inverse, Cross, Bid and Ask

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 Quotes
• An American quote is the number of dollars
expressed per unit of any other currency.
E.g.. $2 / £
• An European quote is the number of units of
any other currency expressed per dollar.
E.g. ₹ 61 / $
• A Direct quote is the quote where the exchange
rate is expressed in terms of number of units of
domestic currency for a fixed number of units of
foreign currency
E.g. ₹ 61 / $
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 Quotes
• An Indirect quote is where the exchange rate is
expressed in terms of number of units of foreign
currency for a fixed number of units of domestic
currency. E.g. $ 0.01639 / ₹
• Before Aug,2,1993, Indirect quotes were
followed in India. Since that date, direct quote is
followed.
• A Merchant quote is the quote given by a bank
to its retail customers.

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 Quotes
• An Interbank quote is the quote given by one
bank to another.
• An Inverse quote is where for every quote (A/B),
there exists (B/A). For e.g. for ₹ / £ quote, there
exists £ / ₹
• A Cross quote is one which is calculated
between two currencies by using their exchange
rates with a third currency. It is also called
synthetic rate.
E.g. P / Q and Q / R can give P / R
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 Quotes
• A Bid quote is the price a buyer is ready to pay
for a product, in our context, currency.
• A Ask quote is the price for which a seller is
ready to sell a product, in our context , currency.
• E.g. ₹ / $ = 48.62 / 72
• Here, bank would be ready to buy dollars @
Rs 48.62 per $
The bid rate is always lower than the ask rate.

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 Bid – Ask Spread
• A Bid – Ask spread is nothing but the difference
between the bid rate and ask rate. This
represents the cost the bank incurs in these
transactions, a small return on the capital
employed and compensation.
• The following points are worth noting:
• Spread seems to be higher in retail market than
in interbank market
• Bid rate always precedes the ask rate
• The quote is always from banker’s point
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 Types of transactions
• Cash
• Tom
• Spot
• Forward – broken forward
• Swap
• Futures
• Options

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Foreign Exchange Settlement in Europe

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 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.
• One way arbitrage
• Two way arbitrage
• Three way arbitrage

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 Arbitrage
• One way arbitrage – arises when the bid rate of one
bank is greater than the ask rate of another
E.g. A - € / $ = 1.0660 / 65
B - € / $ = 1.0655 / 58
• Two way arbitrage – involves buying in one market
and selling in another. When actual quote differs
from inverse quote, arbitrage arises.
• E.g. Let $ / £ quote in New York be 0.9362 / 67. If
you can buy at 0.9367 in NY and can sell the same
in Frankfurt for 0.9376, arbitrage profit is made.
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 Arbitrage
• Three way arbitrage – involves three markets
and three currencies. When actual quote differs
from cross or synthetic quote, arbitrage arises
• E.g. Assume CHF/$ = 1.5669 and $/Can$ =
0.6527
• Synthetic quote is CHF / Can$ = 1.0227
• If the actual quote is 1.0246, then arbitrage
possibility exists.

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Triangular Arbitrage by a Market Trader

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 Indian scenario
• Prior to 1992, Indian forex markets were totally
regulated. Indian rupee was fixed, first in terms
of Pound and later, USD.
• In March, 1992, dual exchange rate system
known as LERMS was introduced
• Under this system, 40% of current account
receipts were required to be converted at
official rate, as fixed by RBI and the balance at
market rates.

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 Indian scenario
• On 1st, March, 1993, Unified exchange rate
system was introduced, under which all forex
transactions are required to be routed through
ADs at market determined rate.
• In Aug, 1994, RBI announced relaxation on
current account transactions and delegated
further powers to AD – like travel, studies,
medical treatment, gifts, etc.
• Till date, Capital account convertibility is not
allowed.

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 Foreign Exchange Rates
and Quotes in Percentage Terms
• Measuring a change in the spot rate for quotations expressed in
home currency terms (direct quotations):
%∆ = Ending rate – Beginning Rate x 100

Beginning Rate

• Quotations expressed in foreign currency terms (indirect

quotations):
%∆ = Beginning Rate – Ending Rate x 100
Ending Rate

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 Foreign Exchange Rates and Quotes
• For quotations expressed in foreign currency
terms (Indirect quotations) the formula
becomes:
f ¥ = Spot – Forward 360
x x 100
Forward n
• For quotations expressed in home currency
terms (Direct quotations) the formula becomes:
f ¥ = Forward – Spot 360
x x 100
Spot n

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Foreign Exchange Markets

Conclusion

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