CHAPTER 6:

TYPES OF FOREIGN EXCHANGE

MARKET

PPT. Aid: Jahir Rayhan, 21st Batch MBA (Nov.20)

 Learning Outcomes
2

 6.1 Types of Foreign Exchange Markets

 6.2 Spot Market
 6.3 Forward Market
 6.4 Equilibrium in the Forward Currency Market
 6.5 Currency Futures
 6.6 Currency Options
 6.7 Currency Swaps
 Foreign Exchange Markets: Preamble
3

 Foreign Exchange Market (FEM) provides a mechanism of

exchanging different monetary units. It is essential when
countries trade with each other.

 Nationals of one country may prefer to hold financial assets

denominate in a foreign currency because domestic currency
is subject to high inflation and therefore less attractive as a
medium of ‘Store of Value.’

 Int’l Trade and Movements of Capital necessitate the

Conversion of currencies, Exchange dealers serve the
exchange and market demand and supply determines the
exchange rates.
 Types of Foreign Exchange Markets
4

FEMs represent the most important financial markets in the world

and their paramount role is to facilitate the international payments.
The major foreign exchange markets that exist are:
Spot markets
 Transactions involving sale and purchase of currencies for
immediate delivery.
 In practice, it may take one or two days to settle transactions.

Forward markets
 Transactions to be settled on a future date as specified in the
contract.
 Forward rates are quoted just like spot rates, but actual delivery
of currencies takes place much later, on a date in future.
 Types of Foreign Exchange Markets
5

Futures market
 Localized exchange where derivative instruments called 'futures' are
traded.
 Currency futures are somewhat similar to forward, yet distinctly
different.
Options markets
 Derivative instruments that give a choice to a foreign exchange market
operator to buy or sell a foreign currency
 On or up to a date (maturity date) at a specified rate (strike price).

Swaps
 Simply the instruments that permit exchange of two streams of cash
flows in two different currencies.

The most active market is London, followed by USA, Japan, Singapore,

Switzerland, Hong Kong, Germany, France and Australia.
 Volume of Transactions
6

• Represents only a small part of foreign exchange

operations
• About 5 per cent of volume traded fulfill the needs

• Constitute a major segment of exchange business.

• Volume figure is higher at 10 to 15 per cent, pertaining
to movement of capital like investment funds.

*There has been a sizeable growth in FE Trading due to increased and active
participation by FIs and Large Corporations for managing their exchange Risks.

Relative proportions may undergo changes in future –

• Trade are developing at a faster pace than those due to interbank exchanges.
• More and more exchange operations are concentrated in certain banks such as
Citibank, Morgan, Union des Banques Suisses, Barclays and Midland.
*The existing profit levels emanating from foreign exchange operations are quite
significant in cases of certain banks.
 Characteristics of Foreign Exchange Markets
7

 Currency Convertibility: 3-of-Kind

 Fully convertible - Freely converted into other currencies
 Partly convertible for non-residents
 Not convertible at all: scenario of developing nations

The most traded currencies are US dollar, Deutschemark,

Japanese Yen, Pound Sterling, Swiss franc, French franc
and Canadian dollar.

 All the professionals who deal in Currencies, Options,

Futures and swaps assemble in the Dealing Room
 Characteristics of Foreign Exchange Markets
8

 Dealing Room:
 Gathers traders operating on financial markets
 Deals in all transactions related to foreign exchange in a bank
 Concentrated information and communication system for dealers
to -
 Have instant access to the rates quoted at different places
 Be able to communicate amongst themselves
 Know the limits of each counterparty
 Achieving arbitrage gains, whenever possible

 The dealing room chief manages and coordinates all the

activities and acts as linking between dealers and higher
management.
 Characteristics of Foreign Exchange Markets
9

 Means of Communications:
 Supplied by Reuters, Telerate, Bloomberg Technology
 Help commercial banks to communicate between
themselves
 Current rates may be read on the screens at any point of
time
 Communication of economic, political and financial news
which is likely to influence the markets
 Automatic Trading Systems:
 'Dealing 2000‘, introduced by Reuters, ensures automatic
execution of orders.
 Characteristics of Foreign Exchange Markets
10

 'Electronic Booking Service' (EBS) brought together a

group of 200 dealers in 60 banks and institutions.
 MINEX, launched in April 1993, is supported by a
consortium of Japanese banks, Japanese brokers,
Japanese company of telecommunications KDD and
Telerate. It is used particularly in the Asian region.
 Advantages- enables the operators to reduce the

commissions charged by brokers.

Generally, access to dealing rooms provided by banks is to
big enterprises and for big orders only. But things are
changing now a days.
 Characteristics of Foreign Exchange Markets
11

 Front Office and Back Office:

 The role of the Front Office is to make profit from the
operations on currencies. Therefore, Dealers are judged on
the basis of their profitability.
 Front office are divided into several units and sectioned for
money markets and interest rate operations, spot rate
transactions, forward market transactions, currency options,
futures and so on.
 The Back Office, consists of a group of persons, work behind
the Front Office.
 Activities include managing of the information system,
accounting, control, administration, and follow-up of the
operations of Front Office.
 Spot Market
12

 Spot Transactions- In forms of buying/ selling of

currency notes, encashment of travellers‘ cheques and
transfers through banking channels (I.e., L/C payments,
direct fund transfer etc). About 90 per cent of spot
transactions are carried out exclusively for banks.
 In the spot market-
 Exchange of currencies takes place within 48 hours
 Market functions continuously, round the clock.
 Spot transaction effected on Monday will be settled by
Wednesday.
 Magnitude and Participants of Spot Market
13

Daily volume is about 50 per cent of the total transactions of

exchange markets (Estimated by Bank for Int’l Settlement, BIS)
London market is champion not only in terms of trades volume but
also in terms of diversity of currencies traded. But New York trades $
(75% of the total), Deutschmark, Yen Pound & Swiss Franc only.
Major Participants:
- Commercial banks: Trades for Client or for their own account

 Enable customers to change one currency into another

 Make profits through speculation and arbitrage

 Big commercial banks serve as market-makers (Simult. Buy & sell)

- Dealers, Brokers, Arbitrageurs and Speculators

 Buy currencies (low rate), sell (high rate)

 Dealers' operations- wholesale and interbank transactions

 Wholesale transactions account for appro. 90% forex deals.

 Magnitude and Participants of Spot Market
14

 Exchange brokers- Intermediation role between different

banks, not authorized tot take a position, rather find a buyer
& a seller for the same amount of given currencies. A large
portion of transaction is conducted by them.
 Brokers help to lower the dealers' costs, reduce risks and
provide anonymity. In interbank trade, brokers charge a small
commission of 0.01 percent of the transaction volume.
 Arbitrageurs- Make gains by discovering price discrepancies
(buy cheap and sell dear), risk-free operations but lower
scope in a free and open market due to the visibility of gap.
 Speculators- expose themselves to risk, involves in transaction
for an anticipated but uncertain gain as a result of an
exchange rate change.
 Magnitude and Participants of Spot Market
15

 Speculators are classified as bulls and bears. Bulls expect

currencies to become expensive in future (take long position),
bears expect currencies to be cheaper (take short position).
 Banks or corporations accepting either a net asset or a net liability
in foreign currency, are indulging in speculation.
 Central Banks
 Intervene in the market to reduce fluctuations of the domestic
currency
 To ensure an exchange rate compatible with the requirements
of the national economy
 Objective is not to make profit out of these interventions but
to influence the value of national currency in the interest of
country's economic well being.
 Equilibrium on Spot Markets
16

In inter-bank operations, the dealers indicate a buying rate and

a selling rate without knowing whether the counter-party wants
to buy or sell and thus important to give 'good' quotations. Two
types of arbitrages:
 Geographical arbitrage: Two-Point arbitrage

Profit from the difference in the rates of currencies based on

location (buying cheapest, selling dearest)
 Triangular arbitrage: Three-point arbitrage

Occurs when three currencies are involved. Can be realized

when there is distortion between cross rates of currencies.
Buy Dollar by selling Pound and then exchange with Euro
because the Cross-rate of $-to-Euro is more favorable to Pound-
to-Euro.
 Forward Market
17

 Unlike the spot market, Not located at any specific place. The
banks buying or selling currencies for forward/future
constitute the Forward market.
 Primarily deals in currencies that are frequently used and are
in demand in the international trade, such as US dollar, Pound
Sterling, Euro etc.
 Little or almost no Forward market for the currencies of
developing countries Outright
Forward Forward
Market Swap
Market
 Importance of Forward Market
18

 The Outright Forward market resembles the Spot market,

except that the period of delivery is much greater than 48
hours. Majority of the clients/corporations who decide to
cover against exchange risk from trade operations
 The Forward Swap market consists of two separate
operations: borrowing in one currency for short duration and
lending equivalent amount in different currency. $ is involved
in 95% of the transactions.
 Major participants include banks, arbitrageurs, speculators,
exchange brokers and hedgers.

 Quotations on Forward Markets

Forward rates are quoted for different maturities such as one
month, two months, three months, six months and one year.
 Forward Market

19
 Equilibrium in the Forward Currency Market
20

In practice, Forward rates do not fully incorporate the

interest rates. May be either overstated or understated.
 Quoting Prices of Goods Exported- Specially useful
when the export proceeds due is to be received or paid
in installments i.e., forwards rates for 3-month.
 Covering Exchange Risk on Forward Market

 Anticipating appreciation of the currency (import against

$), importer can buy the foreign currency immediately
and hold it up to the date of maturity. (Or buy foreign
currency forward)
 An exporter can eliminate the risk of currency fluctuation
by selling his receivables forward.
 Currency Futures
21

The first Currency Futures were launched in 1972 by Int’l Money

Market (IMM) at Chicago. Even before Currency futures came into
existence, Commodity futures (Corn, Oats, Wheat, Soybeans Butter,
Egg and Silver) has been in use for long time.

 The volume traded on the Futures market is much smaller than that
traded on Forward market.

 Participants:
There are three types of participants on the currency futures market:
 Floor Traders: Operate for their accounts or represent Bank/FIs

 Floor brokers: operate on behalf of their clients, brokerage firms

 Broker-Traders: operate either on the behalf of clients or for their

own accounts.
 Characteristics of Currency Futures
22

A currency future contract is a commitment to deliver or take

delivery of a given currency on a future date at a price fixed
earlier. It is different from Forward contract in many respects.
Distinguishing features of future contract are:
 Standardization

 Organized exchanges

 Minimum variation

 Clearinghouse

 Margins, and

 Marking to market
 Characteristics of Currency Futures
23

Clearing House:
 Responsible for keeping accounts, margin payments,
settlement of deliveries and collection of data.
 Two types of deposits needed with the clearing house in
order to be able to participate in the market of Futures:
1. Initial margin
 Varies according to individual contracts and volatility of
currencies.
 Deposit may be made in the form of a bank credit,
treasury bonds or in cash.

*** It’s better to have a look on the PDF for the better understanding of the topic (Page-19).
 Characteristics of Currency Futures
24

2. Variation margin
 Depend upon daily variations in the price of the contract.

 Every day, positions are calculated. The latest rate of the

day is compared with the latest rate of the previous day

and margins are called for.
Costs: Currency Futures have two types of costs-
 Commissions paid to brokers

 Variation margins paid in case of unfavorable movement

of rates.
 Characteristics of Currency Futures
25

Trading Process
 In currency futures, trading is done on trading floor.

 First, initial margin is deposited by the party involved

 The party gains if rate moves in his favor at the time of

settlement and loses if rate moves against

 Amount (gain) can be withdrawn or left in account

 For amount (loss), margin call is made and debited to

the account.
 Comparison between Forward and
Futures Market
26

Future Market Forward Market

 Organized and transparent  Traditional OTC market

market
 Prices are identical for all
 The amount to be paid on
Futures market is relatively
small but amounts involved and
maturity dates are tailor-made
as per need
 Involves an additional risk,
called basis risk and Future
markets may be used for
covering exchange rate risk
but are often used for
speculation.
 Prices differ as a function of
amounts involved and
financial strength of clients
 The amount to be paid on
Forward market is relatively
large and not tailor-made as
per need.
 No such risk in Forward
market
 Currency Options
27

 Financial instrument that gives its holder a right hut no

obligation to buy or sell a currency sometime in the future.
 Options are traded on over the counter (OTC) as well as
on organized market.

Retail market- Individual clients as well as enterprises, to

cover against exchange risk
Wholesale market- Commercial banks and investment
banks, to cover the positions for their clients or for
speculative purposes.
 Currency Options
28

OTC Options Markets :

 Represent a significant volume of transactions

 Operations are carried out either directly between

counterparties or through a broker by telephone or by

the system of Reuter or Telerate
 May take place round the clock

Different categories of operators:

Enterprises Banks Arbitrageurs

• Cover their receivables, • Make profit by • Make profit by taking

payables and future speculating advantage of price
cash flows distortions on different
markets
 Currency Options
29

Option on OTC market is a contract between two parties-

 The buyer desires to avoid a risk and the seller is ready

to assume that risk.

Call Option Put Option
(a right to buy (a right to sell
currency A at a currency A against
certain price against currency B at a pre-
currency B) fixed price)

European Option: Can be exercised on a fixed date

(Maturity date)
American Option: Can be exercised any time during the life
of the Option, up to the date of maturity
 Currency Options
30

Option price (Premium): Price paid upfront at the

beginning to the seller of option to acquire the right
Position of Buyer and Seller:
 For buyer, loss limited to the amount of premium paid
and a possibility of unlimited gain
 For seller, gain limited to the amount of premium and a
possibility of unlimited loss
Currencies traded on the OTC market: Those that are
actively traded on Spot and Forward market (such as US
dollar, Pound sterling, Swiss franc, etc.
Maturity Period: Limited period, may go up to 5 years. can
be repurchased or resold.
 Currency Options
31

Spread: Refers to simultaneous buying of an Option and

selling of another in respect of the same underlying
currency.
Vertical Horizontal
or price spread
spread Buying and Simultaneous
selling of an buying and
Option of the selling of
same type Options

Same maturity Different

with different maturities with
strike prices the same strike
price
 Currency Options
32

Covering Exchange Risk with Options:

 A currency option enables an enterprise securing a desired
exchange rate while retaining the possibility of benefiting
from a favorable evolution of exchange rate. Also, used for
speculation on the currency market
Organized Market of Currency Options:
 Organized Stock exchanges of Montreal and Philadelphia,
Chicago Mercantile Exchange, LIFFE of London exist for option
Two types of Options exist:
Options on cash or on spot- Buy or sell the currency on spot at
an agreed rate till the date of maturity
Options on currency futures- Buy or sell the currency on a
future date at an agreed rate
 Currency Swaps
33

 Exchange of a series of payments between two parties

 Effected through an intermediary financial institution; OTC

 Second most important market after the spot currency market

 Three types of currency swap:

1. Fixed-to-fixed currency swap- An agreement between two

parties who exchange future financial flows denominated in two
different currencies.
2. Floating-to-floating currency swap- Both floating rates with
similar operation as fixed-to-fixed.
3. Fixed-to-floating currency swap- An agreement between two
parties by which they agree to exchange financial flows
denominated in two different currencies with different type of
interest rates, one fixed and other floating.
 Participants in Swap Deals
34

(a) Financial institutions

May participate in the swap deal;
 (As a broker)- Only when not a counterparty in the deal

 (As a counterparty)- Incurs various risks such as credit risk,

market risk and delivery risk
 (As an intermediary)- Plays the role of a counterparty as well

as a broker at the same time

(b) Big Corporations:
Mostly multinationals, also big and medium enterprises with
good ratings. For example, French Public enterprises such as
SNCF (French Railways) and EDF (French Electricity Company)
 Participants in Swap Deals
35

(c) International organizations and public sector

institutions
Other institutions such as World Bank, and nation states also
often take recourse to currency swaps and currency coupon
swaps
Important Features of Swap Contracts:
Size and Maturity- 5 million US dollar(minimum size),
2 to 10 years of maturity
Process of Swap Deals- Two enterprises having
symmetrical requirement of capital and in two different
currencies, a swap is possible.
 Features of Swap Contracts
36

Pricing a Currency Swap:

Value (or price) of a swap should be equal to the
difference between the present values of all inflows and all
outflows.

For example, a bank is willing to swap 10 per cent fixed on

French franc with 8 per cent fixed on an equivalent US
dollar principal for 3 years. This means that the present
value of franc payments at 10 per cent is equal to the
present value of the dollar payments at 8 per cent, both
expressed in a common currency.
 Reasons for Currency Swap Contracts:
37

Reasons for Currency Swap Contracts:

Investors and borrowers may not have direct access to
acquire new assets/liabilities or access may be costly.

For example, a company may retire its foreign currency

loan prematurely by swapping it with home currency
loan. The same can also be achieved by direct access
to market and by paying penalty for premature
payment. A swap contract makes it possible at a lower
cost.
 Reasons for Currency Swap Contracts:
38

 Hedging Exchange Risk: Swapping one currency liability with another is a

way of eliminating exchange rate risk. For example, if a company (in UK)
expects certain inflows of deutschemarks, it can swap a sterling liability into
deutschemark liability.

 Differing financial Norms of Credit-worthiness:

For example, Germany or Japanese companies may have much higher debt-
equity ratios than what may be acceptable to US lenders.

 Emphasis on Credit Rating: USA attach greater importance to credit

rating then nations in Continental Europe.

 Market Saturation: If an organisation has borrowed a sizable sum in a

particular currency, it may find it difficult to raise additional loans due to
'saturation' of its borrowing in that currency.

Thank you for tolerating me, ha ha ha!