Forex Markets and Rates

International Corporate Finance

BHUSNUR MATH
Professor (Finance)
M D I , Gurgaon

Segments of Financial Markets

Capital Markets

Equity Markets
Debt Markets
Govt Bonds
Corporate Bonds

Credit Markets

Money Markets

Foreign Exchange Markets

2

Foreign Exchange

What constitutes Foreign Exchange?

Foreign Currency
Receivables from a Non-resident
Travelers Cheques
Cheques, Demand Drafts drawn by an
overseas bank on a bank in India
Wire Transfer
Bills-of-Exchange Bills of Exchange
3

Exchange Rate

Price of a currency in domestic currency

(rupees)
Determined by market supply & demand
forces floating currency

Rupee is Dirty Float not entirely left to

market forces but the RBI intervenes in
the market when it so desires.
BHUSNUR MATH - Forex markets

Supply of Forex

Remittances & Travel

Export of Goods & Services

Inward Investment FDI, FII

External Commercial Borrowings

Current
Account

Capital
Account

Demand for Forex

Remittances & Travel

Import of Goods & Services

Overseas Investment

Current
Account

Capital
Account

Forex Inflow - Flow Chart

Cy, TCs, Remittances (In), Export Bill Payment,

ECBs, FDI/FII, Flow from Maturing Investments abroad
Recipient / Beneficiary
Bank / Authorized Dealers: Gives Rupees and takes
Bank sells

Clients who want

$ (makes profit)
Other Banks

in need of $
Inter-Bank Market

R B I (Intervention)
if it is buying

Forex Outflow - Flow Chart

Cy, TCs, Remittances (Out), Import Bill Payment,

Investments abroad, Flow from Maturing FDI/FII
Client / Customer
Bank Buys/Aquires

Clients who wants to sell

$ (makes profit)

Other Banks

-who want to sell $

Inter-Bank Market

R B I (Intervention)
if it is selling

Bank / Authorized Dealers: Gives $ takes Rs

Sells Cy / TCs, Remits, Makes payment to O/S Seller

Bank

Inter Bank
Forex Market

Intervention

RBI

Other Banks

Customers

Forex Markets

RBI Intervention in Forex Markets

If RBI Buys

Increases Demand

Adds to Forex Reserves

If RBI Sells

Increases Supply

Reduces Forex reserves

10

Factors affecting Forex Rate

Supply and demand

Import, Export, Trade deficit
Remittances
Capital Flows- ECBs, FDI, FII
Interest rate in India
Interest rate in US

US / EU Policies, economy prospects

Indian Policies, economy prospects
BHUSNUR MATH - Forex markets

11

Types of Forex Transactions

Value Date / Settlement Date

Settlement locations
Spot Transactions
Value second working day
Cash - Value same day
Tom Value next working day
Forwards
Value spot + the calendar month(s)
Swaps
Combination of a Buy & a Sell -spot &
forward or forward and a forward

Exchange Rate Quotations

Currency Notations INR, GBP, USD, JPY

AUD, EUR, CHF

Currency Pairs - convention

Base / Quoted Cy GBP/USD

Currency bought or sold /
no of units of quoted currency
Not a fraction

Two way quotes Bid / Ask or Buy/Sell

USD/CHF 1.4550/ 1.4555 ;
USD/JPY 159.00/80 AND 160.98/05

Spread, Big Figure, Points or pips

1.4550/55

Forward Rates

We have to quote a rate for sale of $

effective one year from today

We need to buy dollars today at today's

rate keep it so that we can deliver these
dollars at t=1yr

But we need rupees to buy dollars today

borrow
We need to at least recover our cost of
buying and holding

Calculation of forward rates

We need $
Borrow Rs
Buy $

1
(1 r$ )

1
(1 r$ )

1
Sp *(
)
1 r$

@ rRe

@ S p using these rupees

Deposit these $
After one year

1
(1 r$ )

Re Loan Payment:

for one year @ r

[(

1
* s p ] * (1 rRe )
(1 r$ )

Receive $1 deposit maturity value

Deliver this 1$ and receive the forward rate= F

Forward Premium

To break even :
Forward Rate=

1 rRe
S
*
p

r
$

Spot Rate + Forward Premium=

% Forward Premium =
=

1 rRe
1

r
$

rRe r$
1 r$

1 rRe
S
*
p

r
$

(rRe r$ ) = diff in interest rates

InterBank and Merchant Transactions

Interbank Transactions
With other banks
Deal lots 1 mln of base currency
For cover operations
Own account trading

Merchant Transactions
To facilitate remittances & Trade
Mostly as per customers requirements
Clean and Doc

An Interbank Deal

On Monday 16 April 2012:

Tom from Bank A Dollar Swiss pl
Forty forty-five
Mine
OK. Bank B sells Bank A USD 10 Mln against
CHF at 1.5545 value 18 April 2012, UBS
Geneva for CHF
Citi Ny for my Dollars, Thanks Bye

Rate Quotations

Inter Bank

Bid / Ask , Spread

Arbitrage

Cross Rates Quotes though not

fractions, work like math fractions

Usually only forward differentials quoted

Merchant Rates

Normally single rate no two way quote

Base Rate Acquiring or Disposal Rate

Exchange Margin (add or subtract % of Base)

Extra margin/charges for docs as handling
charges
TT Buying and TT Selling; Bills Buying and
Bills Selling
Usance Bills rates

Basic Principles for Retail Quotes

Principles on which rate are calculated by the banks:

Forex sold to a customer is simultaneously bought in the

inter-bank (wholesale) market acquiring rate

Forex bought from the customer is simultaneously sold in

the inter-bank market disposal rate
The Margin over the acquiring or disposal rate would
include
a) Transaction costs ie., overheads , brokerage etc

b) And profit

$/Re market in India is very efficient and competitive

Covered Interest Arbitrage

If efficient Money Market and Forex Market exist

And one is able to operate freely in both

the money market (borrow/lend freely) and

the Forex Market (buy/sell the currency)

The forward rate for the currency can be fixed

Any divergence from this will lead to arbitrage

opportunities

Because there are no restrictions, the market rate

will have to fall in line with the theoretical rate.

Covered Interest Parity Theorem

(1 ni A ) Fn ( B / A)

(1 niB ) S ( B / A)

Fn ( B / A) (1 ni A )

S ( B / A) (1 niB )

Fn ( B / A) S ( B / A) (ni A niB )

S ( B / A)
(1 niB )

(ni A niB )
Forward Differential (%)
Interest Rate Differential
niB

Not a causal relationship

Equilibrium relationship

International Corporate Finance

International Business
and Trade Finance

Overseas Trade

Export

Import

Third country trade

High-seas trade
Barter trade

Why do companies export?

No local market
Better price

Components off-shoring
Incentives -tax and duty
Cheaper credit

Risks faced by exporters

Payment risk

Exchange rate risk

Regulatory risk
Political risk

Why do companies import?

Raw material
Components

Trading Supply gap

Value addition

Value addition and export

Ways of settling
Cross-Border Transactions

Currency of Invoicing (exchange rate risk or forex

risk)
Advance Payment
Bills for collection
Bills discounting
Use of LCs

Negotiation of Bills / drafts drawn under LCs

INCO Terms

Counter- Trade

High Seas Trade

Risks importers face

Delivery risk

Goods may not be delivered after

payment

Exchange rate risk

Quality risk
Price risk

Regulatory risk

Managing Payment Risk

Advance Payment

Bill for Collection thro a bank

Bill Discounting

Factors / Forfaiting

Commercial Documents

Sale Purchase Contract, Purchase Order

Invoice

Bill-of-Exchange, Draft

Sight Bill, Usance Bill / Time Draft

Consignment Sale
Counter Trade

High-seas sale

Bills for Collection -- flow chart

Documents

Advice

SBI
Delhi
Documents

Account Credited
Seller

Intimation

Sale / Purchase contract

SBI
Coimbatore

Documents
against
Payment

Buyer

Collection of Usance Bills- flow chart

Documents

SBI
Delhi
Documents
taken and
A/c
Seller
Credited

Intimation

Sale / Purchase contract

SBI
Coimbatore

Docs
against
Acceptance

Buyer

Bills Discounted-- flow chart

Documents

SBI
Delhi
Documents
taken and
A/c
Seller
Credited

Intimation

Sale / Purchase contract

SBI
Coimbatore

Documents
against
Payment

Buyer

Discounting of Usance Bills- flow chart

Documents

Documents
taken and
A/c
Seller
Credited

Intimation

Sale / Purchase contract

SBI
Coimbatore
Doc against
Acceptance

Buyer

Payment

SBI
Delhi

Export transaction -- flow chart

ADVICE
SBI
INDIA

SBI
NEW YORK

PAY INR
EXPORTER
INDIA

RECEIVE
USD

SELLS GOODS

IMPORTER
ITALY

Import Transaction -- flow chart

ADVICE
SBI
INDIA

SBI
NEW YORK
Pays Rupees

IMPORTER
INDIA

OWES MONEY

PAY USD
SUPPLIER
JAPAN

Mechanics of Documentary Credit

Contract
IMPORTER

OPENING
BANK

GOODS

DOCS

SHIPPING
COMPANY

OPEN CREDIT
DOCUMENTS
PAYMENT

GOODS
DOCS

ADVISING/

NEGOTIATING

BANK

EXPORTER

DOCUMENTS
PAYMENT

Important elements of a credit

Name of issuing bank, confirmation??
Irrevocable??

Amount of credit

Details of goods and unit price.

Place and time of expiry

Last date of shipment, submission of

documents.
Terms of payment sight, usance

Documents required - Specified

Part-shipment/ trans-shipment

Benefit to exporters & importers

Exporter:

Exposure to Bank

Opening Bank to pay without reference to

the applicant (importer)
Importer

Ensure proper documents

Can include quality inspection certificates

Can negotiate for better price

Factoring

A Financial Intermediary

That buys invoices of a manufacturer or a

trader, at a discount, and
Takes responsibility for collection of
payments.

Factoring Services

Follow-up and collection of Receivables

Help in getting information and credit
line on customers (credit protection)

Sorting out disputes, if any, due to his

relationship with Buyer & Seller.

Factor charges Commission (as a flat

percentage of value of Debts purchased)
(0.50% to 1.50%)

Types of Factoring

Recourse Factoring
Non-recourse Factoring
Maturity Factoring
Cross-border Factoring

Forfaiting

Forfait is derived from French word A Forfait

which means surrender of fights.

Forfaiting is a mechanism by which the right for

export receivables of an exporter (Client) is
purchased by a Financial Intermediary (Forfaiter)
without recourse to him.

It is different from International Factoring in as

much as it deals with receivables relating to
deferred payment exports, while Factoring deals
with short term receivables.

FACTORING

FORFAITING

Individual Sale
Transaction

Service of Sale
Transaction

Individual Sale
Transaction

3. Recourse

With Recourse

Without
Recourse

4. Sales
Administration

Not Done

With or
Without
Recourse

Done

Not Done

5. Term

Short Term

Short Term

Medium Term

6. Charge
Creation

Hypothecation

Assignment

Assignment

1. Scrutiny
2. Extent of
Finance

BILLS
DISCOUNTED

Upto 75 80% Upto 80%

Upto 100%

Bankers Acceptance (BAs)

A time draft, which is accepted and

guaranteed by a bank as good as the
Banks word
Exposure to the Bank so high creditrating

A short-term debt instrument issued by

a firm that is guaranteed by a
commercial bank

Trade Finance

Pre-shipment /Packing Credit

Post Shipment credit Bills discounting

L/Cs

B As

Suppliers Credit
Buyers credit

Buyer's credit

Credit availed by an importer (buyer)

from overseas lenders for payment of his
imports on due date

Usually against a letter of comfort / bank

guarantee issued by the importers bank

Suppliers Credit

A financing arrangement under which an

exporter extends credit to a foreign
importer to finance his purchase.
Importer pays a portion of the contract
value in cash and issues a Promissory
note or accepts a draft
LC with Usance Terms
Deferred payment

Basics of Derivatives

BHUSNUR MATH

Basics of Derivatives

51

Derivatives

Derivatives are contracts whose value is

derived from / dependent on value of
another (underlying) commodity /
contract

BHUSNUR MATH

Basics of Derivatives

52

Types of Derivatives
Futures & Forwards
Options
Swaps

BHUSNUR MATH

Basics of Derivatives

53

Futures & Forwards

Forward Contract

A contract to sell (buy) a certain

quantity of some thing at a price agreed
today and delivered and paid for paid for
on a future date
Futures are standardized forward
contracts traded on an exchange
BHUSNUR MATH

Basics of Derivatives

54

Forwards Characteristics

An agreement / contract
Price fixed on day 0

Compulsory settlement - No choice

Cancellation

Before due date at opposite contract

for the same maturity
On due date at opposite spot rate

BHUSNUR MATH

Basics of Derivatives

55

Futures Contract Specs

Standardized quantity

1 mln bbl crude

1 mln US Dollars

1000 shares of SocGen

Buy or Sell n number of contracts

Settlement dates specified by exchange

Quarter end - commodities

10th of every month crude

BHUSNUR
Deliver
Specs
MATH

Basics of Derivatives

56

Futures Delivery Specs

Quality
Quality

Mode of delivery

Alternatives, if any , Cheapest-to-deliver

Indicies compulsory settlement against

spot
Procedures in case of default

? Short Selling or naked positions

BHUSNUR MATH

Basics of Derivatives

57

Futures Pay-Off

Long

Short

BHUSNUR MATH

So

Basics of Derivatives

So

58

Options

Contracts which give the holder an

option to buy (sell) a certain quantity
of the underlying at a price agreed upon
today (Strike Price - X) to be settled on
an agreed future date
Types of Options
Put and Call

BHUSNUR MATH

Basics of Derivatives

59

Options - characteristics

Choice to exercise

If not exercised, the option lapses

Options have to be purchased by paying

a premium
Premium upfront outlay
Kind of an insurance

Can have more than one Strike Price for

same maturity

MATH
Basics of Derivatives
BHUSNUR
Counterparty
writes
the option - writer 60

Options OTC & Exchange Traded

OTC Over-the-Counter
Customized

Opaque market

Availability / Liquidity

Exchange Traded - Listed

Regulated

Transparent & No default

StandardizedBasics
Contract
Specs
of Derivatives

BHUSNUR MATH

Deliver mostly set off

61

Options Pay-Off - calls

Call Holder

BHUSNUR MATH

Call Writer

So

Basics of Derivatives

So

62

Options Pay-Off - puts

Put Holder

Put Writer

So
X

BHUSNUR MATH

Basics of Derivatives

So

63

Use of Derivatives

Hedging

Hedging locks in the price

Spot price fluctuations do not affect

Both down-side & upside cut out

Trading - Speculation

BHUSNUR MATH

Basics of Derivatives

64

Derivatives - Hedging

Producer

Sell Forward

Sell Futures contracts

Buy Put

Write a Call ?? (covered call?)

Consumer

Buy Forward / Futures

Buy Call

BHUSNUR MATH

Write a Put

Basics of Derivatives

65

Swaps

Contracts to exchange streams of cashflows determined according to an

agreement, on a future date.

BHUSNUR MATH

Basics of Derivatives

66

Interest Rate Swaps

Need : Hedging interest Rate Risk

L+ 0.5

BHUSNUR MATH

6%

L+ 0.5

Basics of Derivatives

6%

67

IRS - Characteristics

Fixed-to-Floating

Floating-to- fixed

Notional Principal

Interest receivable and payable are setoff and net paid / received
Default / Counter-party risk
BHUSNUR MATH

Basics of Derivatives

68

IRS - Warehousing

Counter Party may not be easily

available Banks become counter-party
and warehouse swaps till they find a
counter-party.

L+ 0.5

BHUSNUR MATH

6+ 0.5%

L+ 0.5

Basics of Derivatives

Bank

69

Currency Swaps

Need

swap a borrowing (liability) in one

currency into a liability in another
currency

BHUSNUR MATH

Basics of Derivatives

70

Currency Swaps Cash Flows 1

t= 0

$ 1.3 mln

BHUSNUR MATH

$ 1.3 mln

Euro 1 mln

Basics of Derivatives

Bank

71

Currency Swaps Cash Flows 2

t= 6m

$0.039 mln

BHUSNUR MATH

Euro 0.045 mln

$ 0.039 mln

Basics of Derivatives

Bank

72

Currency Swaps Cash Flows 3

t= 10 yrs

$1.3 mln

BHUSNUR MATH

Euro 1 mln

$1.3 mln

Basics of Derivatives

Bank

73

Caps, Floors, Collars

Caps: If the interest rate goes above an

agreed level, the bank will make good the
difference
Floors: If the interest rate goes below an
agreed level, the bank will make good the
difference

Collars: If the interest rate goes above an

agreed level or below and agreed level, the
bank will make good the difference
BHUSNUR MATH

Basics of Derivatives

74

FRA Forward rate Agreement

(?) Forward Rate contract for a deposit

A promise to accept a deposit on a future date

at interest rate agreed upon today
A contract to make good the loss which would
be incurred by the buyer of FRA for a certain
term, on a notional sum of money, if spot
interest rates for that term, on the fixed future
date is lower than an agreed rate,

in exchange for the profit the buyer

would make if the rate is higher

BHUSNUR MATH

Basics of Derivatives

75

FRA An example

A buys from B an FRA .5m / 3m , 6%

for a notional sum of Euro 1 mln
Effective date 2m from now
Interest rate term: 3m
On t=2m, if 3m rate is
<6% B pays A
>6% A pays B
BHUSNUR MATH

Basics of Derivatives

76

FRA Utility in hedging

Locking-in interest rates for intended

asset / liability creation on a future date
If funds are to be invested on a future
date -- Buy FRA

If funds are to be borrowed on a future

date -- Sell

BHUSNUR MATH

Basics of Derivatives

77