Foreign Exchange Markets

Dr A Srihari Krishna
 Foreign Exchange Markets
• International transaction in cash requires two distinct purchases
– Purchase of foreign currency
– Purchase of good/service with the FC
• Organizational setting within which individuals, governments and
banks buy and sell foreign currencies
• Only a small fraction of daily transactions in foreign exchange involve
trading of currency
• Most Forex transactions involve transfer of bank deposits
• Three-tier Market Structure: Banks-Banks, Banks-Corporates,
Banks/Corporates-Individuals
• Money changers – Full fledged & Restricted
 FEMA Definition of Foreign Exchange
• Deposits, credits and balances payable in foreign currency
• Drafts, travellers’ cheques, letter of credit (L/C) or bill of
exchange expressed or drawn in Indian currency but
payable in foreign currency
• Drafts, travellers’ cheques, L/Cs, etc. drawn by banks,
institutions or persons outside India but payable in Indian
currency
 Currency Symbols
• Each currency is symbolized using 3-letter ISO (
International Organization for Standardization) codes: the 1st 2
letters designate the country, the 3rd designates the currency.
The most famous illustration of this is for the United States
dollar—USD.
• Sometimes the country name or currency that is symbolized is
not the most common name. Thus, the symbol for the Swiss
franc is CHF, where CH stands for Confederation Helvetica,
which refers to Switzerland, and MXN stands for the Mexican
Nuevo Peso, even though the most common name for Mexico's
currency is simply the peso.
 Foreign Exchange Rate
• Denotes the price or the ratio or the value at which one currency is
exchanged for another
• Exchange rate is very dynamic as the foreign exchange market is
round-the-clock market due to different time zones
• Major participants- central banks, commercial banks, forex brokers,
corporations, individuals
• Reasons to exchange foreign currency for domestic currency is:
– Pay for goods and services in the foreign country,
– Invest in foreign financial assets,
– Hedge against unfavorable rates of exchange in the future,
– Speculate to profit from forex rate changes.
– Foreign currency holders need to convert it back to their domestic currency
to take profits, so that businesses, governments, and other organizations
can use the money at home.
 Foreign Exchange Markets
• FX market is an over-the-counter (OTC) market consisting of a
network of dealers—central banks, commercial and investment banks,
funds, corporations, and individuals. Transactions are done
electronically, usually over the Internet, and traders buy and sell
through a broker. Thus, the forex market operates as a spot market.
• Futures and Forward  contracts are also available on currencies but
most forex transactions use the spot market. There is no central
exchange for the spot market, and brokers and dealers are located
throughout the world, so the forex market is a 24 hour market during
the weekdays. Forex is the largest financial market in the world—over
$6.5 trillion equivalent values of currency are traded daily.
Global Forex Markets
 Factors affecting exchange rate
• Major banks that act as market-makers always give
two-way quotes; gives depth and volume to the
market
• Fundamental reasons
• Technical reasons
• Trading, Arbitraging, Hedging, & Speculation
• (Calculation of one-point, two-point, and three-
point Arbitrage)
 Fundamental reasons

• Balance of Payments->Surplus->Appreciation of Currency

• Growth rate of the economy-> Lower growth->
Depreciation of Currency
• Fiscal policy-> Financing of Fiscal Deficit influences
Exchange Rate
• Monetary policy->Easy Monetary Policy->Depreciation of
Exchange Rate
 Technical reasons
• Freedom or restrictions on capital movements can
affect exchange rates to a large extent
• Among other factors there are:
– Huge trade surpluses of oil exporting countries
– Capital moving from low-yielding currencies to high
yielding currencies (interest differential)
 Speculation
• Self-fulfilling prophecies
– Anticipation of depreciation of a currency can cause dealers to
sell that currency
• Speculation serves to provide depth and liquidity to the
forex market
• Acts as a cushion as well - contrarian traders exist in the
market
 Types of exchange rate (1)
• Ready/cash- Settlement of funds on the same day (date of the
deal).
• Tom- Settlement of funds takes place on the next working day of
the date of the deal
• Spot- Settlement of funds takes place on the second working day
following the date of the deal
 Quotes of Exchange Rate
• Direct and Indirect rates: Reciprocals
• Cross rates- To obtain rates for a particular currency pair when
they are not available directly (Chain Rule)
• Chain rule- is used to attain comparison or ratio between two
quantities which are linked together through another or other
quantities. Equation in the form of a chain is derived.
• Bid and offered rates- In USD/INR 69.40/45 the bank is bidding
for USD at Rs. 69.40 and offering to sell USD at Rs. 69.45
 Types of exchange rate (2)
• Forward- Delivery takes place on any day after the date of the
deal
• All rates quoted in the forex market are generally spot rates
• When delivery takes place beyond the spot date then it is a
forward transaction and the forward rate is applicable
• Forward rate = Spot rate + Premium (- discount)
• Calculation of Forward Rates given the Swap Points
 Forward rate
• If the forward value of a currency is higher than the spot
value the currency is said to be at a premium
• If the above is reversed the currency is said to be at a
discount
• The forward premium/discount is based on interest rate
differentials of the two currencies involved
• Direct and indirect quotes of exchange rate- direct quote,
local currency is variable
 Forward Rate (1)
• Value date: It is customary, in foreign exchange market, to
quote a rate to do the deal but exchange the currencies not
on the same day but generally afterwards.
• Forward rate: Has two components
– Spot rate
– Forward points or forward differentials

• Forward rate is the rate when the value of the deal is fixed
beyond the spot date i.e. beyond the second working day
after the deal
 Forward Rate (2)
• Forward transactions are necessary in the foreign exchange
market as they serve number of purposes like:
– One can hedge or cover an existing future financial, commercial or trade
related exchange risk
– These types of deals, in combination with spot deals, are used for
money market operations through ‘swap’ transactions
– Taking a view of the market, these can be used for speculation
 Forward rate (3)
• When a currency is costlier in the future (forward) as
compared to the spot, the currency is said to be at a
premium vis-à-vis another currency
• In ‘direct rate’ premium is added to both the buying and
selling rate whereas discount is deducted
• In ‘indirect rate’ premium is deducted and discount is
added to the buying and selling rates
 Foreign exchange transactions (1)
• Arbitrage: Is an operation by which one can make risk-free profit
by undertaking offsetting transactions.
– Can be in interest rates: borrow in one centre and lend in another
– Can be in exchange rates: Buy a currency in one market and sell in
another
• Arbitrage keeps exchange rates uniform in all markets
 Foreign Exchange Transactions (2)
• Merchant rates: Quotes offered to merchants (importers,
exporters) by banks.
• Inter-bank rates: The rates quoted by banks for dealing in
the inter-bank market.
• Merchant quotations: In India all merchant quotations for
foreign currencies shall be in so many rupees for one unit of
foreign currency except for Japanese Yen, Italian Lira and
Belgian Franc (Rs/100 units of the currency)
• All quotes are in four decimal places with the last two digits
in the multiple of 25
 Modes of Remittances (1)
• Telegraphic Transfers (TT) of funds are done from one
center to another by way of instructions through telex,
telegram or SWIFT (Society for Worldwide Interbank
Financial Telecommunications).
• Mail Transfer (MT) of funds is done by way of instructions
sent by mail. An MT is an order in writing on the
correspondent bank/branch abroad to pay the beneficiary
the sum mentioned
 Modes of Remittances (2)
• Demand draft (DD): A DD is an order in writing on the
correspondent bank/branch abroad to pay the beneficiary
the sum mentioned therein.
• FEDAI prescribed types of rates of merchant transactions:
– TT (buying)- clean inward remittances
– Bill (buying)- purchase/discount of export bills
– TT (selling) clean outward remittances
– Bill (selling) remittance for import bills
 RBI/FEDAI Guidelines
• FEDAI (Foreign Exchange Dealers’ Association of India) is a
non-profit making body formed in 1958 with the approval
of RBI
• Its members are authorized dealers and it prescribes
guidelines and rules of the game for market operations,
merchant rates, quotations, delivery dates, holidays,
interest on defaults, etc.
• FEDAI also advises RBI on market related issues and
supplements RBI on strengthening the market
 RBI/FEDAI Guidelines
• RBI has issued Authorised Dealers (AD) licences to banks, all India
financial institutions and a few co-operative banks to undertake
foreign exchange transactions in India
• It has also issued Money Changer licences to a large number of
established firms, companies, hotels, shops, etc.
• Money changers help facilitate encashment of foreign currencies of
foreign tourists
• Entities authorised to buy and sell foreign currency notes, coins
and travellers’ cheques are called full fledged money changers
• Those authorised only to buy are called restricted money changers