FOREIGNEXCHANGEINSTRUMENTS :

FOREIGNEXCHANGEINSTRUMENTS …tools of international exchange PRESENTED

BY : PRIYA JAIN

APPROACH :
FOREIGN EXCHANGE INSTRUMENTS FOREIGN EXCHANGE FX MARKET RATE
OF EXCHANGE RELATED TERMS SPOT MARKET FORWARD MARKET FX SWAP
CURRENCY SWAP OPTIONS FUTURES APPROACH FOREIGN EXCHANGE &
RELATED TERMS

FOREIGN EXCHANGE & RELATED TERMS :

FOREIGN EXCHANGE & RELATED TERMS

FOREIGN EXCHANGE :
FOREIGN EXCHANGE & RELATED TERMS A mechanism by which currency of one
country gets converted into the currency of another country. Also referred to as FOREX
or FX Can be in form of cash, funds available on debit and credit cards, traveler’s
cheques, bank deposits or other short-term claims Foreign currency or claims relating to
foreign currency To an Indian, a £ 10 currency note or a £ 10 traveler’s cheque or a
demand draft drawn on London Bank would be forex FOREIGN EXCHANGE

FOREIGN EXCHANGE MARKET :

FOREIGN EXCHANGE & RELATED TERMS contd… A market where money
denominated in one currency is traded with money denominated in another currency
FOREX MARKET OVER-THE-COUNTER (OTC) MARKET EXCHANGE TRADED
MARKET Venue of maximum forex activity Composed of commercial banks, investment
banks & financial institutions Venue of specific forex instruments like exchange-traded
options & futures Composed of securities exchanges FOREIGN EXCHANGE MARKET

RATE OF EXCHANGE :
FOREIGN EXCHANGE & RELATED TERMS contd… RATE OF EXCHANGE Can be
expressed in two ways : DIRECT QUOTATION INDIRECT QUOTATION One unit of
foreign currency expressed in terms of domestic currency. Method also known as
American terms E.g. In New Delhi : $1 / Rs 45 One unit of domestic currency expressed
in terms of foreign currency. Method also known as European terms E.g. In New Delhi :
Rs 1 / $ 0.0222 The number of units of one currency that buys one unit of another
currency.

OTHER TERMS :
FOREIGN EXCHANGE & RELATED TERMS BID (Buyer’s rate): price at which trader is
willing to buy foreign currency ASK (Seller’s rate): price at which trader is willing to sell
foreign currency SPREAD : difference between bid and ask price –> the profit margin
for the trader = (Ask price – Bid price) / Ask price X 100 OTHER TERMS Suppose, in
India, a customer exchanges US dollar for the rupee at Rupee-US Dollar rate of Rs.
40.00-40.30/US $ Bid rate = Rs. 40.00 (bank will buy US $ at 40.00 for transaction) Ask
rate = Rs. 40.30 (bank will sell US $ at 40.3. to Indian) Spread = (40.30 – 40.00) / 40.30
X 100 = 0.744% or bank makes a profit of Rs. 0.30 per US dollar

FOREIGN EXCHANGE INSTRUMENTS :

FOREIGN EXCHANGE INSTRUMENTS

TYPES :
TYPES FOREIGN EXCHANGE INSTRUMENTS FOREIGN EXCHANGE
INSTRUMENTS TRADITIONAL FOREX INSTRUMENTS DERIVATIVE
INSTRUMENTS CURRENCY SWAPS OPTIONS FUTURES FX SWAP SPOT
FORWARD EQUITY & DEBT INSTRUMENTS ADR GDR FOREIGN BONDS EURO
BONDS

1 : SPOT MARKET :
1 : SPOT MARKET FOREIGN EXCHANGE INSTRUMENTS contd… Spot
transactions : Exchange of currency the second day after the date on which two foreign-
exchange traders agree to do the transaction Spot rate : Rate at which transaction is
settled Value date/ Settlement date : Day on which delivery of currency takes place i.e.
on the second day of the agreement Example : On Thursday, an Indian and an
American agree to execute the deal in spot market. When will the deal be effected ?
Now, the exchange of currencies will take place on Saturday. If the particular market is
closed on Saturday and Sunday , delivery of currency shall take place on Monday.

CURRENCY ARBITRAGE IN SPOT MARKET :

CURRENCY ARBITRAGE IN SPOT MARKET FOREIGN EXCHANGE INSTRUMENTS
contd… Arbitrageurs buy a particular currency at cheaper rate in one market and sell it
at a higher rate in another. Suppose, bid rate in : New York : US $ 1.9810 – 10 £
London : US $ 1.9700 – 10 £ The arbitrageurs will buy pound in London and will sell the
pound in New York. Assuming no transaction costs, they make a profit of : $ 1.9810 - $
1.9700 = $ 0.0110 per pound sterling

2 : FORWARD MARKET :
2 : FORWARD MARKET FOREIGN EXCHANGE INSTRUMENTS contd… Contracts
are made to buy and sell currencies for future delivery, say after a fortnight, one month,
two months and so on. Rate of exchange for the transaction is agreed upon on the very
day the deal is finalized. Forward Rate : rate quoted for transaction that call for delivery
after two business days Example : The one month forward contracts were contracted
respectively on the 28th & 29th January 2001. What would be the settlement date ? For
both, it will be 28th February as 2001 was not a leap year. So this is the value date in
both the transactions.

RELATION TO SPOT RATES :

RELATION TO SPOT RATES FOREIGN EXCHANGE INSTRUMENTS contd…
Forward exchange rate is generally expressed in relation to spot rate ruling at the time
when forward rate is quoted. Forward quotations can be made as : At a premium on the
spot rate or at a discount from it, referred to as forward differential or at par with the spot
rate. If forward rate > spot rate : forward premium If forward rate < spot rate : forward
discount

3 : FX SWAP :
3 : FX SWAP FOREIGN EXCHANGE INSTRUMENTS contd… FX Swap is a
simultaneous spot and forward transaction A simultaneous sale and purchase of a
certain amount of foreign currency for two different dates It is 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) Also known as spot-forward swap

EXAMPLE :
EXAMPLE FOREIGN EXCHANGE INSTRUMENTS contd… Parties - Punjab National
Bank (PNB) & State Bank of India (SBI) Currency - Euro FOR PNB : It is long on current
holdings of Euro and considers itself short one-month forward because of net forward
sales. FOR SBI : It is short on current holdings of Euro but long one-month forward.
Solution: First Peg : Spot Transaction PNB will sell Euro Spot to SBI & SBI will buy Euro
Spot from PNB Second Peg : Forward Transaction PNB will buy Euro forward from SBI
& SBI will sell Euro forward to PNB

4 : CURRENCY SWAP :
4 : CURRENCY SWAP FOREIGN EXCHANGE INSTRUMENTS contd… A combination
of a spot foreign exchange transaction and an offsetting forward foreign transaction
undertaken with the same counterparty An exchange of debt or assets denominated in
one currency for debt or assets denominated in another currency They are OTC
instruments A currency swap between the World Bank and IBM in August 1981 was the
first of its kind with Salomon Brothers acting as intermediary between the two. Involve
exchange of principal and interest payments for an agreed period of time and to
exchange rate at maturity

EXAMPLE :
EXAMPLE FOREIGN EXCHANGE INSTRUMENTS contd… A borrower wishes to
obtain Swiss francs (SFr) to finance business expansion in Switzerland but may not be
able to do so. At the same time, this borrower has access to dollar capital market and
may be able to borrow it on relatively attractive terms. If a counterparty exists who has,
a net asset position in SFr and a desire for low-cost dollar funds, the opportunity for
currency swap exists.

5 : OPTIONS :
5 : OPTIONS FOREIGN EXCHANGE INSTRUMENTS contd… A right but not the
obligation to buy or sell a foreign currency within a certain time period or on a specific
date at a specific exchange rate. Parties : option buyer and option seller/writer The rate
at which one currency can be purchased or sold is one of the terms of the option and is
known as exercise/strike price. The fee or cost of the option is called premium. Can be
purchased OTC from a commercial or investment bank or it can be purchased on a
stock exchange where options are traded
OPTIONS - types :
OPTIONS - types FOREIGN EXCHANGE INSTRUMENTS contd… CALL OPTION An
option to purchase the underlying currency It gives the right but not the obligation to
purchase an option PUT OPTION An option to sell the underlying currency It gives the
right but not the obligation to sell an option

EXAMPLE :
EXAMPLE FOREIGN EXCHANGE INSTRUMENTS contd… A person decides to
acquire options to buy SFr at a price of US $ 0.70 along with a premium for US $ 0.02.
On the maturity date, if: a) Spot rate of SFr (0.65) < Agreed rate (0.70) The buyer will let
the option expire as he can purchase it in the spot market at a cheaper rate. b) Spot
rate of SFr (0.75) > Agreed rate (0.70) The buyer will exercise the option as his cost of
buying the Swiss francs under the options contract will be 0.72 (0.70+0.02), whereas,
he can sell this currency in spot market at a higher rate (0.75).

6 : FUTURES :
6 : FUTURES FOREIGN EXCHANGE INSTRUMENTS contd… An agreement between
two parties to buy or sell a particular currency at a particular price on a particular date,
as specified in the contract to all participants in that currency futures exchange. Its
market is an organized market like an exchange and not OTC. Currencies in which
futures contracts are traded : Euro, Japanese Yen, Pound sterling, Canadian dollars,
Swiss francs, Mexican pesos, Australian dollars Futures deals are struck sitting face-to-
face under a trading roof known as ‘pits’.

FUTURES contd… :
FUTURES contd… FOREIGN EXCHANGE INSTRUMENTS contd… 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 trader’s account everyday respectively.
This is known as marking to market. Parties : Traders, Exchanges, Clearing houses It
came into being in 1972 when Chicago Mercantile Exchange set up its international
monetary market division for currency futures. Costs in futures deal : brokerage
commission, floor trading and clearing fees

7 : AMERICAN DEPOSITORY RECEIPTS :

7 : AMERICAN DEPOSITORY RECEIPTS FOREIGN EXCHANGE INSTRUMENTS
contd… A dollar denominated negotiable certificate that represents a non-US
company’s 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
ADR requires compliance with US GAAP and parting with voting rights to individual
investors with directors of company being personally liable to shareholders

8 : GLOBAL DEPOSITORY RECEIPTS :

8 : GLOBAL DEPOSITORY RECEIPTS FOREIGN EXCHANGE INSTRUMENTS
contd… A negotiable instruments denominated in dollars or other 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
company’s 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 company’s stock without
being subject to Indian stock market regulations to a large extent.

9 : INTERNATIONAL BONDS :
9 : INTERNATIONAL BONDS FOREIGN EXCHANGE INSTRUMENTS contd…
FOREIGN BONDS EURO BONDS Bonds floated in a particular domestic capital market
and in the domestic currency of that market by non-resident entities. Dollar
denominated bonds issued in US markets by non-US companies are known as Yankee
bonds Yen denominated bonds issued in Japanes markets by non-Japanese
companies are Samurai bonds Pound denominated bond in UK are Bulldog bonds
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. A dollar denominated bond issued in UK is a EURO (dollar) bond. A Yen
denominated bond issued in US is a EURO (yen) bond.

RESOURCES :
RESOURCES INTERNATIONAL BUSINESS Environments & Operations : Daniels,
Radebaugh, Sullivan INTERNATIONAL FINANCIAL MANAGEMENT : Varshney &
Bhashyam

THE END :
THE END FOREIGNEXCHANGEINSTRUMENTS …tools of international exchange