Suman Banerjee 2006-10

Financial Products

Foreign Exchange Markets

1.

What is a Foreign Exchange Market?

The foreign exchange market is the market for buying and selling dierent currencies. It is primarily an over-the-counter market with trades between large commercial banks accounting for most foreign currency transactions. Other participants in the foreign exchange market include: Brokers, who match buyers and sellers in the market Customers of banks or brokers, mainly large businesses who engage in international trade and/or investment Central banks The OTC market accounts for well over 90 percent of total U.S. foreign exchange market activity, covering both the traditional (pre-1970) products (spot, outright forwards, and FX swaps) as well as the more recently introduced (post-1970) OTC products (currency options and currency swaps).

On the organized exchanges, foreign exchange products traded are currency futures and certain currency options.

The Foreign Exchange Market is vast in size and scope and exists to full a number of purposes ranging from the nance of cross-border investment, loans, trade in goods and services and of course, currency speculation. It is by far the largest and most liquid market in the world.

Suman Banerjee 2006-10

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The estimated worldwide turnover of reporting dealers, at around $1? trillion a day, is several times the level of turnover in the U.S. Government securities market, the worlds second largest market. Turnover is equivalent to more than $200 in foreign exchange market transactions,every business day of the year, for every man, woman, and child on earth! The breadth, depth, and liquidity of the market are truly impressive. Individual trades of $200 million to $500 million are not uncommon. Quoted prices change as often as 20 times a minute. It has been estimated that the worlds most active exchange rates can change up to 18,000 times during a single day. Large trades can be made, yet econometric studies indicate that prices tend to move in relatively small increments a sign of a smoothly functioning and liquid market. Trading may be for spot or forward delivery. A spot contract is a binding obligation to buy or sell a certain amount of foreign currency at the current market rate. A forward contract is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on or before a certain date. A participant in the Foreign Exchange Market will normally ask for a price in, for example, rupee-dollar, the number of US Dollars, which can be bought for one INR. They will be quoted two prices - these are called a bid price and an oer price.

Suman Banerjee 2006-10

Financial Products

If the rate of exchange is $1 = INR 45, this will be quoted as 0.02-23; i.e., the dealers buy dollars at 0.023 and sell dollars at 0.21. The dollar is by far the most widely traded currency. According to a 2006 survey, the USD was one of the two currencies: Involved in an estimated 87% of global foreign exchange transactions, equal to about $1.3 trillion a day. In part, the widespread use of the dollar reects its substantial international role as: Investment currency in many capital markets, Reserve currency held by many central banks, Transaction currency in many international commodity markets, Invoice currency in many contracts, Intervention currency employed by monetary authorities in market operations to inuence their own exchange rates.

1.1.

Spot Currency Dealing

Spot dealing has the advantage of being the simplest way to meet all your foreign currency requirements, but it also carries with it the greatest risk of exchange rate uctuations, as there is no certainty of the rate until the transaction is carried out. The spot rate you receive will be set by: Current market conditions, the supply and demand for the currencies being traded The amount you are dealing. Generally speaking, the larger the amount being dealt, the better the spot rate you will receive. 3

Suman Banerjee 2006-10

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A spot deal will settle (in other words the physical exchange of currencies takes place) two working days after the deal is struck. Major pairs EUR/USD GBP/USD USD/JPY USD/CHF AUD/USD NZD/USD USD/CAD EUR/GBP EUR/JPY EUR/CHF GBP/JPY Bid 1.2809 1.54463 84.00 1.0127 0.9308 0.7297 1.0328 0.82919 107.6 1.2972 129.73 Ask 1.281 1.54493 84.02 1.0128 0.9309 0.73 1.0329 0.8293 107.63 1.2974 129.79 Change 0.0094 0.0085 -0.2250 -0.0073 0.0012 -0.0015 -0.0006 0.0014 0.4800 -0.0004 0.3200 % change 0.7393 0.5520 -0.2671 -0.7108 0.1237 -0.2119 -0.0629 0.1727 0.4480 -0.0308 0.2472

1.2.

The Forward Currency Market

The Forward Market requires a more complicated calculation - a forward rate is based on the prevailing spot rate plus (or minus) a premium (or discount) which are determined by the interest rate dierential between the two currencies involved. For example: UK interest rates are higher than those in the U.S. and so an adjustment is made to the spot rate to reect the monetary eect of this dierential over the period of the forward contract. The important thing to remember is that a forward rate is not a guess as to what the spot rate is going to be in the future; it is purely a mathematically driven calculation. A forward rate will 4

Suman Banerjee 2006-10 Protect you against unfavourable movements

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But will not allow gains to be made should the exchange rate move in your favour in the period between entering the contract and nal settlement of the currency. Forward contracts are available for any period up to two years - longer periods are available in certain currencies.

1.3.

Who are Aected by Foreign Exchange Movements

Importers & Exporters If you are an Importer or Exporter, you will nd yourself exposed to easily identiable form of foreign exchange risk known as Transactional exposure. This arises from your need to either buy or sell currency relating to a trade transaction in return for sterling. Movements in exchange rates can work in your favour and enhance profitability but, equally, they can have the opposite eect and seriously erode prot margins or lead to making a loss. Owning Assets Abroad If you own an overseas subsidiary, asset of liability, you will need to think about how to record it on your balance sheet in local currency as uctuations in exchange rates will aect the value. This type of foreign exchange exposure is known as translation exposure. Trading Overseas Foreign exchange risk may apply even if both your costs and income are in same currency. For example: You have overseas customers who pay you in USD, a strengthening in USD may make your products too expensive and aect your competitiveness. 5

Suman Banerjee 2006-10

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In essence, by using USD abroad you are merely passing the foreign exchange risk to your trading partners who may in turn, nd someone else to deal with who are prepared to deal in their own currency. Emerging Markets Certain markets, particularly in Latin America, Eastern Europe and Asia, still have developing economies compared with Western countries which often means that they will have restrictions in the form of legal and regulatory frameworks designed to protect their currencies and economies from speculators. This makes trading in these currencies much more dicult than with the major world currencies and you may need to consider dealing in those countries in a hard currency such as the USD instead. Companies Trading Only in Local Market Any company can be aected by uctuations in the foreign exchange markets whether they are directly involved in international trade or not. If you trade only in India, depreciation in the value of INR against the euro, for example, will aect your relative competitiveness and you may nd an inux of competition from other countries which could in turn lead to a loss of market share for you. This problem is often referred to as being Economic foreign exchange exposure. Perhaps the most dicult form of exposure to protect your business from.

1.4.

Managing YourForeign Exchange Risk

Once you have a clear idea of what your foreign exchange exposure will be and the currencies involved, you will be in a position to consider how best to manage the risk. The options available to you fall into three categories:

Suman Banerjee 2006-10

Financial Products

Do Nothing : You might choose not to actively manage your risk, which means dealing in the spot market whenever the cash ow requirement arises. This is a very high-risk and speculative strategy, as you will never know the rate at which you will deal until the day and time the transaction takes place. Foreign exchange rates are notoriously volatile and movements make the dierence between making a prot or a loss. It is impossible to properly budget and plan your business if you are relying on buying or selling your currency in the spot market. Take Position in Forward Foreign Exchange Contract: As soon as you know that a foreign exchange risk will occur, you could decide to book a forward foreign exchange contract with your bank. This will enable you to x the exchange rate immediately to give you the certainty of knowing exactly how much that foreign currency will cost or how much you will receive at the time of settlement whenever this is due to occur. You can budget with complete condence. However, you will not be able to benet if the exchange rate then moves in your favour as you will have entered into a binding contract which you are obliged to full. You will also need to agree a credit facility with your bank for you to enter into this kind of transaction. Use Currency Options: A currency option will protect you against adverse exchange rate movements in the same way as a forward contract does, but it 7

Suman Banerjee 2006-10

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will also allow the potential for gains should the market move in your favour. For this reason: A currency option is often described as a forward contract that you can rip up and walk away from if you dont need it. Many banks oer currency options which will give you protection and exibility, but this type of product will always involve a premium of some sort. The premium involved might be a cash amount or it could be factored into the pricing of the transaction. Finally, you may consider opening a Foreign Currency Account if you regularly trade in a particular currency and have both revenues and expenses in that currency as this will negate to need to exchange the currency in the rst place.

The method you decide to use to protect your business from foreign exchange risk will depend on what is right for you but you will probably decide to use a combination of all three methods to give you maximum protection and most exibility.