FOREIGN EXCHANGE

jan surya sharma

FOREIGN EXCHANGE RELATED TERMS

FOREIGN EXCHANGE: a financial instrument issued by a foreign country. FX MARKET : a market for converting the currency of one country into that of another country. RATE OF EXCHANGE : the number of units of a given currency needed to buy one unit of another currency 1 1 49.0 3 0.0204
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FOREIGN EXCHANGE

FOREX or FX: A mechanism by which currency of one country gets converted into the currency of another country.

[a financial instrument issued by a foreign country]

Can form of cash, funds available on debit & credit cards, travelers cheques, bank deposits or other short-term claims i.e., Foreign currency or claims relating to foreign currency

E.g. In India, a US$ 10 currency note or a US$ 10 travelers cheque or a demand draft drawn on New York Bank

banks & currency exchanges that buy & sell foreign currencies and other exchange instruments [a market for converting the currency of one country into that of another country] FOREX MARKET OVER-THE-COUNTER (OTC) Venue of maximum forex activity Composed of commercial banks, investment banks & financial institutions MARKET EXCHANGE TRADED MARKET Composed of securities exchanges Venue of specific forex instruments like exchange-traded options & futures

FOREIGN EXCHANGE MARKET

RATE OF EXCHANGE

the price of one currency expressed in terms of another currency.

[the number of units of a given currency needed to buy one unit of another currency] Expressed in two ways : DIRECT QUOTATION: One unit of foreign currency expressed in terms of domestic currency. Method also known as American terms E.g. In India: US$1 / INR 49.03 INDIRECT QUOTATION: One unit of domestic currency expressed in terms of foreign currency. Method also known as European terms E.g. India: INR1 / US$ 0.0204

BID (Buyers rate): price at which trader is willing to buy foreign currency ASK/Offer (Sellers rate): price at which trader is willing to sell foreign currency SPREAD : The amount by which ask price exceeds the bid, i.e., the difference between ask & bid price (the margin of trader) = (Ask price Bid price) / Ask price X 100
E.g., A customer exchanges US dollar against rupee in India Bid rate = Rs. 48.63 (bank will buy US $ at 48.63 for transaction) Ask rate = Rs. 49.03 (bank will sell US $ at 49.03)

OTHER TERMS & CONVENTIONS

FOREIGN EXCHANGE INSTRUMENTS

TYPES :

TRADITIONAL FOREX INSTRUMENTS

SPOT FORWARD FX SWAP

DERIVATIVE INSTRUMENTS
CURRENCY SWAPS OPTIONS FUTURES

EQUITY & DEBT INSTRUMENTS

ADR GDR FOREIGN BONDS EURO BONDS

SPOT MARKET

Spot transactions : the market in which foreign

exchange transactions occur on the spot, Spot rate : rate quoted for transactions that require immediate delivery, i.e. within two days
Value

date/ Settlement date : Day on which delivery of currency takes place i.e. on the second day of the agreement A deal in spot market is executed on Thursday, the exchange of currency has to take place by Saturday & if the particular market is closed on Saturday &

CURRENCY ARBITRAGE IN SPOT MARKET

Arbitrageurs buy a particular currency at cheaper rate in one market and sell it at a higher rate in another.
bid rate in : New York : US$ 1.382 Euro 1 Frankfurt : US$ 1.372 Euro 1 The arbitrageurs will buy Euro in Frankfurt and will sell the Euro in New York. Assuming zero transaction costs, Arbitrageurs will profit: US$ 1.382 US$ 1.372 = US$ 0.010 per Euro
E.g.,

FORWARD MARKET

Forward Market : where foreign exchange transactions occur at a set rate for delivery beyond two business days following the date of agreement to trade.

Rates are negotiated in present but exchange occurs in future, say after 30, 90, 180 or 360 days

Forward Rate : a contractually established exchange rate between a foreign exchange trader and the client for delivery of foreign currency on a specified date

E.g.: for the one month forward contracts signed respectively on 28th & 29th January 2010. What would

FORWARD & SPOT RATE RELATION

Forward exchange rate is expressed in relation to prevalent spot rate at the time when forward rate is quoted. Forward quotations can be made at forward differential or at par with spot rate:
forward

premium: when forward rate > spot rate at a premium on the spot rate discount: when forward rate < spot rate at a discount on the spot rate

forward

a simultaneous spot & forward trans-action, i.e., one currency is swapped for another on one date and then swapped back on a future date (but accounted as a single transaction).
FIRST LEG : SPOT TRANSACTION (Trader buys or sells on the spot market) SECOND LEG : FORWARD TRANSACTION - reverse (Trader buys or sells on the forward market) E.g., : Parties BNP Paribas & HDFC Currency - Euro FOR BNP Paribas: It is long on current holdings of Euro expecting Euro to go up and considers itself short one-month forward because of net forward sales. FOR HDFC : It is short expecting Euro to go dpwn on current holdings of Euro but long one-month forward.

FOREIGN EXCHANGE OR FX SWAP

Transactions:

First Leg : Spot Transaction BNP Paribas will sell Euro Spot to HDFC & HDFC will buy Euro Spot from BNP Paribas Second Leg: Forward Transaction BNP Paribas will buy Euro forward from HDFC & HDFC will sell Euro forward to BNP Paribas

Long buy Short sell

CURRENCY SWAP

A currency swap is a foreign-exchange agreement between two parties to exchange the principle & interest payment of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. Currency swaps are motivated by. comparative advantage Currency swaps are OTC derivatives covering an exchange of debt or assets denominated in one currency for debt or assets denominated in another currency. E.g. :

Company X of US issues bond of $ 20 m in US. Another company Y of Europe issues bond of Euro 10 m. Both companies agree for exchanging the principal & interest of both bonds. X will get Euro 10 m Bonds with its interest payment and Company Y will get $ 20 m bond for exchanging his principal and interest. This is the simple example of currency swap Suzuki wishes to obtain US $ to finance business expansion in USA but has access to Yen capital market at relatively attractive terms. A counterparty existence with a net asset position in US$

OPTIONS

an instrument traded both OTC & on exchanges that gives the purchaser the right (but not the obligation) to buy or sell a certain amount of foreign currency at a specified exchange rate within a specified amount of time [more expensive but also more flexible than a forward contract]
Parties : option buyer and option seller/writer Strike price The exchange rate specified in the option to purchase or sell the currency, i.e., exercise price Premium: The fee or cost of the option paid to the writer of the option.

OPTIONS - types :
CALL OPTION: It gives the right but not the obligation to purchase an option PUT OPTION : It gives the right but not the obligation to sell

FUTURES

an agreement between two parties to buy or sell a given currency at a given (negotiated) price on a particular future date, as specified in a standardized contract to all participants in that currency futures exchange. (Started in 72 with CME division for currency futures. ) Its market is an organized market like an exchange and not like OTC. [not as flexible as a forward contract] Futures contracts traded currencies: Euro, J.Yen, Pound sterling, Canadian $, Sfr, Mexican pesos, Australian dollars Futures deals are struck sitting face-to-face under a trading roof known as pits. Deal is not settled on maturity instead rates are matched daily with the movements in spot market and gains and losses are credited and debited to the traders account everyday respectively. This is known as marking to market.

Parties : Traders, Exchanges, Clearing houses. Costs in futures deal : brokerage commission, floor trading and clearing

AMERICAN DEPOSITORY RECEIPTS - ADRs

A dollar denominated negotiable certificate that represents a non-US companys publicly traded equity Devised in late 1920s to help non-US companies to have their stock traded in the American markets Regulatory framework for the ADRs is provided by Securities and Exchange Commission operating through Securities Act of 1933 and the Securities Exchange of Act of 1934 To raise money from US market via ADRs requires compliance with US GAAP and parting with voting rights to individual investors with directors of

GLOBAL DEPOSITORY RECEIPTSdollars or other - GDRs A negotiable instruments denominated in

freely convertible currency which represents publically traded local currency-equity shares. A global finance vehicle that allows an issuer to raise capital simultaneously in two or more markets through a global offering Example : A European investor wanting an exposure in Indian securities could do so via two routes :
i) Enter Indian stock market & buy the companys stock on one of the Indian markets exposing him to exchange risks and statutory rules & regulations governing purchase & sale of securities in Indian markets. ii) Through GDRs giving the investor ownership of the Indian companys stock without being subject to Indian stock market regulations to a large extent.

INTERNATION AL BONDS

Bonds floated in a particular domestic capital market and in the domestic currency of that market by non-resident entities.
Yankee bonds: Dollar denominated bonds issued in US markets by non-US companies. Samurai bonds: Yen denominated bonds issued in Japanese markets by non-Japanese companies. Bulldog bonds: Pound denominated bond in UK are

Unsecured debt securities issued & sold in markets outside the home currency of the issuer(borrower) and denominated in a currency different from that of the home country of the issuer.

EURO (dollar) bond: A dollar denominated bond issued in

THANKS !

INTERNATIONAL BUSINESS
Determination of Exchange Rates

Objectives
1021

To describe the International Monetary Fund and its role in the determination of exchange rates To discuss the major exchange rate arrangements that countries use To explain how the European Monetary System works and how the euro came into being as the currency of the euro zone To identify the major determinants of exchange rates To show how managers try to forecast exchange rate movements To explain how exchange rate movements influence business decisions

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A multi-national institution established in 1945 as part of the Bretton Woods Agreement to maintain order in the international monetary system is now an organization of 187 nations.

The International Monetary Fund (IMF)

Initially the Bretton Woods Agreement established a system of fixed exchange rates under which each IMF member country set a par value [benchmark] for its currency quoted in terms of gold and the U.S. dollar.

 To promote exchange rate stability

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Objectives of the IMF

To facilitate the international flow of currencies and hence the balanced growth of international trade To promote international monetary cooperation To establish a multilateral system of payments To make resources available to member nations experiencing balance-of-payments difficulties*
*IMF loan criteria are designed to help stabilize a countrys economy. However, they are often unpopular with affected constituencies.

What the IMF Does ?

Three main functions: Surveillance: involves the monitoring of economic & financial developments, and the provision of policy advice specially at crisis-prevention.

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Lending: to those countries with BOP difficulties, to provide temporary financing and to support policies aimed at correcting the underlaying problems: loans to low-income countries are also aimed at poverty reduction. Technical Assistance: provides technical assistance and training in its areas of expertise.
All the three activities is IMF work in economic research & statistics IMF is also supporting fight against money-laundering & terrorism

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The IMF Quota

IMF Quota: the sum of the total assessments levied on member countries to form the pool of money from which the IMF draws to make loans to member nations

National quotas are based upon countries national incomes, monetary reserves, trade balances, and other economic indicators. Quotas form the basis for the voting power of each member nationthe higher the quota, the

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Special Drawing Rights (SDRs)

An artificial international reserve asset created in 1969 to supplement IMF members existing reserves of gold and foreign exchange
The SDR is used as the IMFs unit of account for purposes of financial record-keeping, but it has not assumed the role of gold as a primary reserve asset. The value of the SDR is based upon the weighted average of a basket of four currencies.
Weights as of Dec. 31, 2004

U.S. dollar Euro Japanese yen British pound

39% 36% 13% 12%

Role of IMF
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Articles of Agreement influenced by financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation & general economic disintegration Discipline: fixed exchange rate Control inflation Prevent competitive devaluation Flexibility IMF lending facilities lend foreign currencies during periods of balance of payment deficits (Member pool of gold & currencies) Adjustable parities IMF mandated targets on domestic money supply growth, exchange rate policy, tax policy, government spending & other macroeconomic policies

Role of World Bank (IBRD International Bank for Reconstruction & Development)
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Initial mission to help finance the building of Europes economy Marshal Plan supplanted 1950s 3rd World public sector projects (power stations, road building, transportation)

1960s Agriculture, education, population control & urban development

Lending IBRD bond sales in international capital markets low interest loans to risky customers with poor credit ratings banks cost of funds + margin for expenses

IDA Wealthy member subscriptions (US, Japan, Germany) go only to poorest countries 50 year repayment at 1% interest rate per year

IMS Evolution
Gold standard:

1029

Pegging currencies to gold & guaranteeing convertibility Gold par value amount of currency needed to buy 1 oz of gold By 1880 US, GB, Germany, Japan - Breakup 1930s with wars Mechanism for achieving BOT equilibrium ($ Xport = $ Mports)

Bretton Woods System 1944

Competitive devaluation with gold standard during war Fixed Xchange rates against USDmaintain within 1% of par value Commitment not to use devaluation as weapon of competitive trade policy Established IMF (maintain order in IMS) & World Bank (promote development)

Jamaica Agreement - IMS since 1973

Mixed system with some currencies allowed to float freely, some managed by government intervention & some pegged to another currency

Collapse of Fixed Rate System

1030

Dollar occupied central role in system Only one converted into gold Reference point for all others US Macroeconomic policy of 1965-68 US importing more than exporting US Govt. spending on Vietnam War & welfare Dollar devalued only if all other countries agree to simultaneously revalue against dollar 1971 Nixon announce in dollar no longer convertible into gold

The Evolution to Floating Exchange Rates

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The Smithsonian Agreement of 1971:

a restructuring of the international monetary system that widened exchange rate flexibility from 1 percent to 2.25 percent from par value

The Jamaica Agreement of 1976:

an amendment to the original IMF rules that eliminated the concept of fixed exchange rates and par values in order to accommodate greater exchange rate flexibility via a spectrum of exchange rate regimes

Exchange Rate Arrangements: Three Broad Categories

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Peg the exchange rate to another currency or basket of currencies with little or no flexibility
[Ecuador, El Salvador, Finland, Niger]

Peg the exchange rate to another currency or basket of currencies with trading occurring within a band
[Denmark, Cyprus, Hungary]

Allow the currency to float in value against other currencies, either managed or not managed
[Britain, Brazil, India, Norway, Turkey, So. Africa, USA] IMF member countries are permitted to select & maintain their exchange rate regimes, but they must be open & act responsibly with respect to their exchange rate policies.

IMS Terms
1033

International monetary system: Institutional arrangements that countries adopt to govern exchange rates Floating exchange rate: Exchange rate for converting one currency to another is continuously adjusted based on supply & demand Pegged exchange rate: Currency value is fixed relative to a reference currency (Before 2005 US dollar $ 1 = 8.28 Chinese yuan)

Dirty float system: Currency nominally allowed to float & Government will step in if it deviates too far from fair value
Fixed exchange rate: Exchange rate for changing one currency into another is fixed

Exchange Rate Arrangements: Three Broad Categories

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Peg the exchange rate to another currency or basket of currencies with little or no flexibility
[Ecuador, El Salvador, Finland, Niger]

Peg the exchange rate to another currency or basket of currencies with trading occurring within a band
[Denmark, Cyprus, Hungary]

Allow the currency to float in value against other currencies, either managed or not managed
[Britain, Brazil, India, Norway, Turkey, So. Africa, USA] IMF member countries are permitted to select and maintain their exchange rate regimes, but they must be open and act responsibly with respect to their exchange rate policies.

Exchange Rate Regimes: 2004

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NO. OF

REGIMES

COUNTRIES

Arrangements with no separate legal tender Currency board arrangements Other conventional fixed peg arrangements Pegged exchange rates within horizontal bands Crawling pegs Exchange rates within crawling bands Managed float with no pronounced path Independently floating Total
Source: International Monetary Fund, IMF Annual Report, 2004, pp. 118-120.

41 7 41

4
5 5 49 35 187

The Role of Central Banks

1036

Each country has a central bank responsible for the policies affecting the value of its currency.
[The RBI is the central bank of India and intervenes in foreign exchange markets on behalf of the Govt. of India under its monetary policies]

Central banks intervene in currency markets by buying or selling a particular currency in order to affect its price; central banks are primarily concerned with liquidity. SDRs
[Selling a currency puts downward pressure on its value; buying a currency puts upward pressure on its value.]

Central banks keep their reserve assets in three major forms: gold, foreign exchange, and IMFrelated assets (SDRs).
[continued]

Depending on market conditions, a central bank may:

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coordinate

its actions with other central banks or go it

alone aggressively enter the market to change attitudes about its views and policies call for reassuring action to calm markets intervene to reverse, resist, or support a market trend be very visible or be very discrete operate openly or operate indirectly through brokers The Bank for International Settlements (BIS) in Basel, Switzerland, acts as the central bankers central bank & also serves as a place to gather & discuss monetary cooperation.

The Euro
1038

European Monetary System (EMS): established by the EU (then the EC) in 1979 as a means of creating exchange rate stability within the bloc European Central Bank: established by the EU on July 1, 1998, to set monetary policy and to administer the euro Euro: the common European currency established on Jan. 1, 1999 as part of the EUs move toward monetary union as called for by the Treaty of Maastricht of 1992 European Monetary Union (EMU): a formal arrangement linking many but not all of the currencies of the EU
[continued]

The Exchange Rate Mechanism (ERM), i.e., the Stability and Growth Pact that defines the criteria that EU member nations must meet to qualify for adoption 1039 of the euro, requires:

an annual government deficit not to exceed 3% of GDP total outstanding government debt not to exceed 60% of GDP rates of inflation within 1.5% of the three best performing EU countries average nominal interest rates within 2% of the average rate in the three countries with the lowest inflation rates exchange rate stability, i.e., for at least two years, ex-change rate fluctuations within the normal margins of the ERM
The UK, Sweden, and Denmark are the only members of the initial group of 15 that opted not to adopt the euro.

Exchange Rate Determination: Fixed to Floating Regimes

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Floating rate regimes:

currencies float freely, i.e., free from govt. intervention, in response to demand & supply conditions

Managed fixed rate regimes: a nations central

bank intervenes in the foreign exchange market in order to influence its currencys relative price
Demand for a countrys currency is a function of the demand for that countrys goods, services, and financial assets.
Equilibrium exchange rates are achieved when supply equals demand.
[continued]

Meaning of Exchange Rate & Measuring Changes in Exchange Rates

1041

Value of one currency in units of another currency A decline in a currencys value is referred to as depreciation and an increase in currencys value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated & foreign currency depreciated

If currency A can buy you less units of foreign

Exchange Rate Equilibrium in Floating Rate Regime

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Forces of Demand & Supply Demand for foreign currency negatively related to the price of foreign currency. Supply of foreign currency positively related to the price of foreign currency. Forces of demand and supply together determine the exchange rate

Demand for Foreign Currency

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Price for Foreign Currency

D $2.00 $1.50 D
50m 75 m

Units of Foreign Currency (Yen)

Supply of Foreign Currency

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S $2.00 $1.50 S
50 m 75 m

Units of Foreign Currency (Yen)

Equilibrium Exchange Rate

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D
Units of Foreign Currency(Yen)

Exchange Rate Determination

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An interaction of factors Is it possible for a country with high real returns to have a low currency value? Is it possible for a country with low real returns to have a high currency value?

The Equilibrium Exchange Rate

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Factors that influence the Exchange Rate

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Expectations of the Market: High expected returns from currency instruments increase the demand & thus value Political Events: Uncertainty affects the currency rates Relative Inflation Rates: Inflation at home makes the home currency less valuable making it to depreciate Relative Interest Rates: High interest rates at home relative to a foreign country cause domestic currency to appreciate. Relative Income Levels: Increase in domestic income relative to foreign income may reduce the value of domestic currency

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The prices of tradable products, when expressed in a common currency, will tend to equalize across countries as a result of exchange rate changes. If economic policies and intervention are ineffective, governments may be forced to revalue or devalue their currencies. A currency that is pegged is usually changed on a formal basis. The G20 group of finance ministers meets often to discuss global economic issues, including exchange rate values and policies.
Black markets closely approximate prices based on supply and demand for currencies, rather than government-controlled prices.

Purchasing Power Parity:

School of Salamanca (16 AD) later Gustav Cassel
1050

Purchasing power parity: the number of units of a countrys currency required to buy the same amount of goods and services in the domestic market that one unit of income would buy in another country

Purchasing power parity [PPP] is estimated by calculating the value of a universal basket of goods that can be purchased with one unit of a countrys currency.

Purchasing Power Parity: The Theory

1051

Purchasing power parity predicts that the exchange rate will change if relative prices change.
A change in the comparative rates of inflation in two countries necessarily causes a change in their relative exchange rates in order to keep prices fairly similar.

An example: If the domestic inflation rate is lower than the rate in the foreign country, the domestic currency should be stronger than the currency of the foreign country. The alternative example: If the domestic inflation rate is higher than the rate in the foreign country, the domestic currency should be weaker than the currency of the foreign country.

Inflation represents a monetary phenomenon in which a nations money supply increases faster than its stock of goods and services, thus causing prices to rise.
[continued]

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Purchasing power parity seeks to define the relationships between currencies. While PPP may be a reasonably good long- term indicator of exchange rate movements, it is less accurate in the short run because:
the

theory falsely assumes that no barriers to trade exist and that transportation costs are zero it is difficult to determine an appropriate basket of commodities for comparative purposes profit margins vary according to the strength of competition

The Role of Interest Rates

1053

Fisher Effect Theory: [links interest rates and inflation]

r: the nominal interest rate, i.e., the actual rate of interest earned on an investment R: the real interest rate, i.e., the nominal interest rate less inflation

A countrys nominal interest rate r is determined by the real interest rate R and the inflation rate i as follows: (1 + r) = (1 + R)(1 + i).

International Fisher Effect Theory (IFE):

[links interest rates and exchange rates]

The currency of the country with the lower interest rate will strengthen in the future because the interest rate differential is an unbiased predictor of future changes in

 Like PPP, the International Fisher Effect is not a particularly good predictor of short-run changes in spot exchange rates. An example of the Fisher Effect: Because the interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. Thus, if R = 5%, the U.S. inflation rate is 2.9%, and the Japanese inflation rate is 1.5%, the nominal interest rates are:
rus = (1.05)(1.029) 1 = .08045 or 8.045% rj = (1.05)(1.015) 1 = .06575 or 6.575% On the other hand, if inflation rates were the same, investors would place their money in countries with higher interest rates in order to get higher real returns.

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Forecasting Exchange Rates:

Fundamental vs. Technical Approaches
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Fundamental forecasting: trend analyses and econometric models that use economic variables to predict future exchange rates Technical forecasting: analyses that use past trends in exchange rate movements to predict future exchange rates Forecasters need to provide ranges or point estimates within subjective probabilities based on available date and subjective interpretations.

Forecasting Exchange Rates:

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Factors to Monitor
The institutional settingthe extent and nature of government intervention Fundamental factorsPPP rates, balance-ofpayments levels, macroeconomic data, levels of foreign exchange reserves, fiscal and monetary policies, etc. Confidence factors Critical events, e.g., Failures of Leading Financial Institutions of the world. Technical factorsexpectations and market trends

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Operational Implications of Exchange Rate Fluctuations

Exchange rate changes can affect:

marketing decisions, i.e., demand for a firms products, both at home and abroad production decisions, i.e., production site locations, insourcing vs. outsourcing financial decisions, i.e., sourcing of funds (debt and equity), the timing and level of the remittance of funds, and the reporting of financial results

Implications/Conclusions
1058

- Central banks are the key institutions in countries that opt to intervene in foreign exchange markets to influence currency values. - Exchange rates affect business operations in three primary areas: marketing, production, and finance. - A country may change the exchange rate regime that it uses, so managers must monitor country policies carefully. - A country that strictly controls and regulates the convertibility of its currency is likely to have a black market that maintains a currency exchange rate which

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Thanks !

THE STRUCTURE OF FOREIGN EXCHANGE MARKET

Interbank Market

FX Brokers
Local Banks: Retail Market Financial Center Banks: Foreign Exchange Market Local Banks: Retail Market

Customer Buy FX with Dollars

Customer Sell FX for Dollars

Stockbrokers

FX Future/ Options Market

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