FOREX MARKET GUIDE

FOREIGN EXCHANGE
MARKET
Dr. Tinaikar
Topics
 Characteristics
 Structure
 Exchange Rate Quotations
 Value Date/ Settlement Date
 Transfer of Funds
 Types of Foreign Exchange Transactions
 Covered and Uncovered Interest Parity
 Foreign Exchange Trading and Arbitrage
 Exchange Rate Determination & Forecasting
 Indian Foreign Exchange Market
 Non-Deliverable Forward Market
Foreign Exchange
 Purchase and sale of currencies of different nations

 Exchange rate is the price of one currency vis-à-vis
another
 Why do you need foreign exchange?
 Trade (Exports/Imports)
 Investments (Financial Transactions)
 Remittances (Inward/Outward)
 Speculation (Trading)
Foreign Exchange Market
Utility
 Provides physical and institutional structure
through which money of one country is exchanged
for that of another country
 Facilitates the conversion of one country’s currency
into another
 Sets and quotes exchange rates
 Offers contracts to manage foreign exchange
exposure
Characteristics
 World’s Largest Financial Market - worldwide daily
volume of US$ 5.1 trillion (April 2016)
 More than 15 times the average daily turn over of
US$ 325 billion of global equity markets
 More than 70 times the average daily turnover of
US$ 69 billion of NYSE
 Annual turnover > 10 times world GDP
 Major Centers : London, New York, and Tokyo
 London is the largest market
 U.S. and U.K. markets > 50% of daily turn over
 Other important centers: Paris, Zurich, Frankfurt,
Bahrain, Hong Kong, Singapore, and Sydney.
 90%+ of daily turnover represent speculation
Characteristics
 Forex market is a 24 hours a day currency trading market
9:00 AM in H.K. & Singapore = 10:00 AM in Tokyo
9:00 AM in Bahrain = 2:00 PM in Singapore
9:00 AM in Frankfurt & Zurich = 10:00 AM in Bahrain
9:00 AM in London = 10:00 AM in Frankfurt & Zurich
9:00 AM in New York = 2:00 PM in London
9:00 AM in Los Angeles = 12:00 PM in New York
9:00 AM in Sydney (next day) = 4:00 PM in L.A. (prev. day)
Measuring Foreign Exchange Market
Activity: Average Electronic
Conversations per Hour
Foreign Exchange Market:
The Trading Day
Characteristics
 O-T-C Market i.e. no physical location.
 Traders communicate through telephones, telexes,
computer terminals.
 Traders located in commercial banks around the world
offer online quotes though Reuters, Bloomberg etc.
 Electronic trading platforms used include Reuters Market
Data System (RMDS) and Bloomberg FX GO.
 Exchange of currencies in the form of exchange of
electronic messages.
 G-4 currencies viz. USD, JPY, GBP, and Euro are most
liquid currencies traded 24 hours.
Characteristics
 Electronic Clearing of forex transactions through SWIFT,
CHIPS in New York, and ECHO
 SWIFT (The Society for Worldwide Interbank Financial
Telecommunications):
 Private non-profit message transfer system with H.Q. in Brussels
with intercontinental switching centers in Netherlands and
Virginia.
 CHIPS (Clearing House Interbank Payments System):
 In cooperation with the U.S. Federal Reserve Bank System,
called Fed-wire, provides a clearing house for interbank
settlement for over 95% of U.S. dollar payments between
international system.
 Processes more than $2 trillion of payments each day.
Foreign Exchange Market Structure
 International commercial banks communicate with one

another using:
 ECHO (Exchange Clearing House Limited)
 The first global clearing house for settling interbank forex
transactions launched in August 1995.
 ECHO is a multilateral netting system which on each
settlement date nets a client’s payments and receipts in each
currency whether they are due to or from multiple
counterparties.
 Multilateral netting eliminates the risk and inefficiency of
individual settlement.
Turnover
Turnover by Instruments
Source: BIS Triennial Central Bank Survey, September 2016



Turnover by Counterparty
Source: BIS Triennial Central Bank Survey , September 2016


Turnover by Geography
Country Share
U.K. 37%
U.S. 19%
Singapore 8%
Hong Kong 7%
Japan 6%
Australia 2%
Other 21%
Total 100%
Forex Market Turnover by
Currency Pair
Currency Pair Share
EUR/USD 23%
USD/JPY 18%
GBP/USD 9%
AUD/USD 5%
USD/CAD 4%
USD/CNY 4%
USD/CHF 3%
EUR/GBP 2%
EUR/JPY 2%
Other 30%
Total 100%
Source: BIS Triennial Survey, September 2016
Currency Distribution of
Forex Market Turnover
Currency Share
USD 87%
EUR 31%
JPY 22%
GBP 13%
AUD 7%
CAD 5%
CHF 5%
CNY 4%
Other 26%
Total 200%
Source: BIS Triennial Survey, September 2016
Top 10 Currency Traders
Top 10 Currency Traders
 Major Participants
 Commercial Banks: make market, speculate, arbitrage,
and hedge risk
 Corporations: trade related (export/import), hedge rate
risks, speculate
 Central Banks: smoothen exchange rate fluctuations
 Nonbank Institutional Investors: mutual funds,
pension funds, hedge funds etc.
 Forex Brokers: act as middlemen
 Individuals: exchange currencies /travelers cheques
 The foreign exchange market consists of two tiers:

 Interbank or Wholesale Market:
 The size (or notional principal) for each contract is
multiples of US$ 10 million or the equivalent value in
other currencies
 Client or Retail Market:
 The size for each transaction is relatively smaller than the
size in the wholesale market
 The number of transactions in the retail market is far
larger than that in the wholesale market
Foreign Exchange Rate Quotations
 In inter-bank market a dealer quotes two-way prices :
Bid Price : Price at which a trader is willing to buy
Offer or Asked Price : Price at which a trader is willing to sell
Bid /Offer Spread : Difference between bid and offered
price
Example:
Currency Bid Offer On Screen
EUR/USD 1.1794 1.1795 1.1794/95
GBP/USD 1.2792 1.2794 1.2792/94
AUD/USD 0.7876 0.7878 0.7876/78
NZD/USD 0.7201 0.7206 0.7201/06
USD/CAD 1.2551 1.2553 1.2551/53
USD/JPY 109.14 109.15 109.14/15
USD/SGD 1.3621 1.3623 1.3621/23
USD/HKD 7.8255 7.8258 7.8255/58
USD/INR 64.1075 64.1175 64.1075/175
 Direct or American Quote : The US Dollar price of a unit of
foreign currency
 Indirect or European Quote : Foreign currency price of a US
Dollar i.e. the reciprocal of Direct Quote
 American Quote : Dollars per unit of other currency
Examples : 1 EURO = 1.1794 USD
1 GBP = 1.2792 USD
1 AUD = 0.7876 USD
1 NZD = 0.7201 USD
 European Quote : Other currency units per dollar
Examples : 1 USD = 109.14 JPY
1 USD = 1.3098 CAD
1 USD = 7.8255 HKD
1 USD = 64.1075 INR
 Since 1978 in order to facilitate worldwide currency trading most
foreign currency quotations in the inter-bank market are European
Quotations
 Exceptions to European quotations being Euro, GBP, AUD, and NZD
which are American Quotes
 All foreign currencies are assigned ISO 4217 abbreviations:
E.g. USD, JPY, GBP, EUR, AUD, HKD, SGD, NZD, CHF, CNY,
THB, MYR, INR etc.
 Since exchange rate is the ratio (i.e. value) of one currency against
another, market makers express this relationship using two currencies of
ISO designation :
E.g. USD/JPY, USD/CHF, EUR/USD, GBP/USD, AUD/USD,
NZD/USD, USD/INR etc.
 The first currency is called “base currency” and second is called “quote
currency”
The Bid-Ask Spread
 A dealer offers a quote on the Reuter Screen:
EUR/USD 1.1794/95
 A bid price of $1.1794 per €.
 An ask price of $1.1795 per €.
 The dealer will say on the phone: 94 / 95
 While there are a variety of ways to quote the above, the bid-
ask spread represents the dealer’s expected profit.
Ask Price – Bid Price
Percent Spread = x 100
Bid Price
$1.1795 – $1.1794
0.0085% = x 100
$1.1794
Forex Transactions: Value Date /
Settlement Date
 Day or date on which a forex transaction is settled or
currencies are exchanged
 Settlement takes place through electronic transfer of deposits
between the two parties located in different time zones
 Currencies cannot be settled at the same point in time
because of time zone difference in different countries
 Banks in both the dealing locations and settlement locations
of the countries of the two currencies involved must be open
for business on the settlement day i.e. “compensated value
principle”
 Dealing Locations: Location of the two banks
 Settlement Locations: Relevant countries of currencies
Forex Transactions: Value Date /
Settlement Date
 Example:
London Bank sells ‘X’ JPY against ‘Y’ USD to Paris
Bank
Dealing Locations : London & Paris

Settlement Locations : U.S. & Japan
Forex Transactions: Transfer of
Funds
 Settlement of currency always takes place in the country
of its origin through SWIFT or CHIPS (U.S.)
 Transfer of funds/deposits denominated in relevant
currencies between two parties is done electronically
through “NOSTRO” and “VOSTRO” accounts
 NOSTRO Account : Overseas Account held by domestic
bank with correspondent foreign bank or with its own
foreign branch in the foreign country’s currency
 VOSTRO Account : Nostro Account is called Vostro
Account for the overseas holding bank
Funds
 Example 1:
London Bank sells ‘X’ JPY to and buys ‘Y’ USD from Paris Bank
Dealing Locations : London & Paris
Settlement Locations : New York & Tokyo
Tokyo (JPY) N.Y. (USD)

(Nostro A/C) (Nostro A/C)
London Bank -X +Y
Paris Bank +X -Y
Funds
 Example 2:
SBI Mumbai buys ‘X’ USD and sells ‘Y’ INR to Citibank Mumbai
Dealing Locations : Mumbai
Settlement Locations : Mumbai & New York
Mumbai N.Y. (USD)

(INR) (Nostro A/C)
SBI Bank -Y +X
Citibank +Y -X
Types of Foreign Exchange
Transactions
 Depending on the time elapsed between transaction date and
settlement date FOREX transaction can be classified as:
Ready or cash : settlement today
Tomorrow (“tom”) : settlement tomorrow
Spot : settlement two business
days from date of contract
Forward : settlement beyond spot at a
predetermined price
Swap : combination of a spot and a
forward transaction
Types of Foreign Exchange
Transactions
FX Market
Spot Market Forward Market FX Swaps Market

Deals for delivery T + 2 Deals for delivery Deals with one
up to 12 months spot component
later than T + 2 and one forward
component
Spot Transactions
 Spot
Agreement on the price today with delivery or settlement two
business days later i.e. T+2
Currencies in countries in the same time zone are normally
settled one business day later e.g. trade between U.S. and Mexico
Both the dealing and settlement locations must be open for
business on the day of settlement
Example:
 London banks sells ‘X’ JPY and buys ‘Y’ USD to a Paris bank on
Monday
 London bank will credit ‘X’ JPY in Paris bank’s Nostro account in
Japan on Wednesday and Paris bank will credit ‘Y’ USD in London
bank’s Nostro account in U.S. the same day i.e. Wednesday
 If Wednesday is a holiday in either Japan or U.S. the value date is
shifted to next business day i.e. Thursday.
Spot Transactions
Example (Cont..):
 If Wednesday is a holiday in either of the dealing locations i.e. U.K.
or France, settlement is again postponed to Thursday
 If Tuesday is a holiday in U.K. and not in France value date is
Thursday for London bank and Wednesday for Paris bank
 If London bank made the market, value date would be Thursday and
if Paris bank made the market, value date would be Wednesday
Spot Transactions
 Spot Foreign Exchange Microstructure

 Market microstructure refers to the mechanics of how a
market place operates
 The bid-ask spreads in the spot FX market:
 Increases with FX exchange rate volatility
 Decreases with dealer competition
 “News” or information is an important determinant of spot
exchange rates
Spots – Reuter Screen
Asian Spots – Reuter Screen
Indian Foreign Exchange Market
USD-INR Spot Screen based Quotations
Forward Transactions
 Forward
Agreement on the price today with delivery or settlement at a
future date which is beyond the spot settlement
Usually quoted for 1, 2, 3, 4,……….12 months in inter-bank
market
Forward Value Date = Spot Value Date + Relevant number of
Calendar Days
Rolling forward must not take you to next calendar month in which
case you shift one day back
Example
1 month forward deal is done on January 26
Forward Value Date = February 28
If February 28 is holiday value date is February 27
Forward Transactions
 Types
 Premiums and Discounts
 Forward Rate Quotations
 Swaps
 Uses of Swaps/Forwards
 Forward Rate Quotations - Example
 Forward Rate Quotations - Reuter Screen
Types of Forwards
Outright Forward
Forward contract without accompanying spot deal
Long-dated Forward
Forward contract beyond one year and upto five years
Broken or Odd Date
Forward contracts for maturities which are not standard i.e. not whole
numbers of months e.g. 63 days
Option or Optional Forward
Forward contract with optional delivery i.e. delivery during a
specified period of the contract not later than a specified date
Example
In August 2016, a Japanese company knows that a shipment of German
equipment will arrive sometime in December and have to pay Euro on delivery.
On August 30, the Japanese company may enter into Optional Forward Contract
to purchase Euro against JPY between Dec 1 and Dec 31 2016
Forward Transactions:
Premiums and Discounts
 Premiums and Discounts
Forward rate is either at premium or discount to the spot rate
Premium
Currency “A” (base currency) is costlier in the forward market than
spot market to currency “B” (quote currency) then “A” is said to be at
premium to “B” in the forward market
Discount
Currency “A” is cheaper in the forward market than in the spot market
to currency “B” then “A” is said to be at a discount to currency “B” in
the forward market
Example
EUR/USD GBP/USD USD/JPY USD/INR
Spot 1.1794/95 1.2792/94 109.14/15 64.1075/175
1 Mth Forward 1.1813/14 1.2805/06 108.99/00 64.3475/775
Prem/(Disc) (Euro Prem) (GBP Prem) (USD Disc) (USD Prem)
Forward Transactions:
Premiums and Discounts
Example: EUR/USD
Spot 1.1794/95
1 mth Forward 1.1813/14
Forward Premium = 1.1813 – 1.1794 x 360 x 100

Euro (Bid) 1.1794 30
= 1.9332%
Forward Premium = 1.1814 – 1.1795 x 360 x 100

Euro (Offer) 1.1795 30
= 1.9330 %
Forward Rate Quotations
 Outright Forward Quotations

 Swap Quotations
 Outright Forward Quotations
Full price is stated between USD and most currencies upto 4 decimals.
Generally quoted by banks when dealing with customers and reported in
newspapers.
Example:
Currency Bid Offer
EUR/USD 1.1183 1.1187
GBP/USD 1.3294 1.3298
AUD/USD 0.7540 0.7544
NZD/USD 0.7283 0.7285
USD/CAD 1.3096 1.3099
USD/JPY 103.25 103.30
USD/SGD 1.3597 1.3600
USD/HKD 7.7571 7.7574
USD/INR 66.9500 66.9600
Long and Short Forward
Positions
 If you have agreed to sell anything (spot or
forward without squaring your position you
are “short”.
 If you have agreed to buy anything (spot or
forward) without squaring your position you
are “long”.
 So if you have agreed to sell an FX forward,
you are “short”, and if you have agreed to buy
an FX forward you are “long”.
Forward Rate Payoff Profile
Forward Rate Payoff Profile
 Value of Forward Contract (V) = (ST - FT)
 For the buyer of the Forward Contract (Long Position):
V > 0 if ST > FT
V < 0 if ST < FT
 For the buyer of the Forward Contract (Short Position):

V > 0 if ST < FT
V < 0 if ST > FT
 FX Swap
Buy (Sell) foreign exchange spot with simultaneous agreement to
Sell (Purchase) the same amount forward to the same party in the
inter-bank market at an agreed price
Unlike a spot transaction or outright forward transaction a FX Swap
transaction is a combination of (i) a spot transaction and (ii) forward
transaction settling on two different value dates with two different
exchange rates
 Swap Rate
Forward rate is quoted in the inter-bank market as the difference
between the forward and spot rate i.e. (F-S) and is expressed in points
 Points
Swap Rate is expressed in Points or “Pips”
A Pip represents the last digit of a quotation and is equal to 0.0001
 Points (Cont..)
Most currencies against USD (European terms) are expressed up to four decimal
points so point is equal to last digit of decimal point except some currencies e.g. JPY
which is quoted up to two decimal points. For such currencies a point is equal to 0.01
 Rule
Add points to the spot rate if the USD (base currency) is trading at a forward
premium to the quote currency
Subtract points from the spot rate if the USD (base currency) is trading at a
discount to get the outright forward
Calculating the Swap Rate

We know from CIP:
F$/£ × (1+ i )
(1 + i$) = £
S$/£
Therefore, Swap Rate = F$/£ − S$/£ = S$/£ × (1 + i$) − 1
(1 + i£)
Annualized Premium / Discount:
(F$/£ − S$/£) × 360 × 100 (1 + i$ × N/360) − 1

= ×
S$/£ N (1 + i£ × N/360) 100
Example:
USD 6mth Libor = 1.45167% p.a.
GBP 6 mth Libor = 0.3976% p.a.
GBP/ USD = 1.3200
Therefore, Swap Rate = F$/£ − S$/£ = S$/£ × (1 + i$) − 1
(1 + i£)
= 1.32 × (1 + 0.00726) − 1
(1 + 0.00199)
= 1.32 × (1.0053 − 1.0000)

= 1.32 × 0.0053
= 0.0070
= 70 points or “pips”
 Example (Contd..):
Annualized Premium / Discount:
(F$/£ − S$/£) × 360 × 100 = (1 + i$ × N/360) − 1 ×

S$/£ N (1 + i£ × N/360) 100
= (1 + 0.00726) − 1 × 100
(1 + 0.00199)
= (1.0053 − 1.0000) × 100

= 0.0053 × 100
= 0.53 %
Forward Rate Quotations: Swaps
 Types of Swaps
“Buy-Sell” Swap
Bank ‘A’ buys USD 1 mio spot from Bank ‘B’ @ INR 60.50/USD mio
and simultaneously sells USD 1 mio 6 months forward to Bank ‘B’@ INR
60.75/USD
Swap Rate (USD Premium) is INR 0.25 = 1 USD i.e. Bank ‘A’ receives
premium from Bank ‘B’
“Buy USD Spot” and simultaneously “Sell USD Forward”  “Receive
Premium”
“Sell-Buy” Swap
Bank ‘A’ sells USD 1 mio spot to Bank ‘B’ @ INR 60.50/USD and
simultaneously buys USD 1 mio from Bank ‘B’ 6 months forward @ INR
60.75/USD
Swap Rate (USD Premium) is INR 0.25 = 1 USD i.e. Bank ‘A’ pays
premium to Bank ‘B’
Swaps
 Types of Swaps (Cont..)
“Sell USD Spot” and simultaneously “Buy USD Forward”  “Pay
Premium”
Forward Rate Quotations - Reuter
Screen (EUR/USD)
Screen (GBP/USD)
Screen (USD/JPY)
Screen (USD/INR)
Screen (USD/INR)
USD/INR Annualized Forward
Premia
Forward Rate Quotations:
Examples
Swap Quotations
Spot 1.1794/95 1.2792/94 109.14/15 64.1075/175
1M Forward 18.62/18.82 12.63/12.88 14.36/14.34 24/26
3M Forward 58.67/58.79 39.42/39.77 47.98/47.44 72/74
6M Forward 120.92/121.52 79.77/80.77 105.12/104.62 143.75/145.75
Outright Forward Quotations

1M Forward 1.1813/14 1.2805/07 108.99/00 64.3475/775
3M Forward 1.1853/54 1.2831/34 108.66/68 64.8275/575
6M Forward 1.1915/16 1.2872/75 108.09/10 65.5450/750
Forward Rate Quotations:
Examples
Swap Quotations
Outright Forward Quotations

Forward-Forward Swap
 Forward - Forward Swap
Selling forward and simultaneously purchasing back on a further
future date or vice versa
Example:
Bank ‘A’ buys (sells) USD 1 mio from Bank ‘B’ 3 months
forward and simultaneously sells (buys) USD 1 mio 6 months
forward to Bank ‘B’
“Forward-Forward Swap” is a combination of two “Spot-
Forward Swaps”:
(1) “Sell Spot” and “Buy 3 months Forward” and simultaneously
(2) “Buy Spot” and “Sell 6 months Forward” with the same
counterparty
Uses of Swaps / Forwards
 Hedge Currency Risk
 Take advantage of interest rate differential

i.e. Covered Interest Parity (CIP)
 Hedge Currency Risk

 Banks quote and do outright forward deal with
their non-bank customers.
 In the inter-bank market forwards are done in
the form of swaps
 Example-1:
 If a bank has sold USD 1 mio forward to an
importer at rate ‘F1’ it will square its position in
the interbank market as follows:
 Do a Swap i.e. sell USD 1 mio spot at rate ‘S1’ and
buy USD 1 mio forward at rate ‘F2’ i.e. ‘sell-buy’
swap thus squaring off the short forward position.
 Buy USD 1 mio spot at rate S2 to square off the
short spot position.
+ S2 - F1 (Receive Premium)
- S1 + F2 (Pay Premium)
‘Sell-Buy’ Swap
 Example-1 (Cont..):
 So long as premium received (F1 − S2) is greater
than the premium paid (F2 − S1) the dealer will
make money i.e.
F 1 > F 2 > S 1 > S2

I-----------I (Pay Premium)
I---------------------------I (Receive Premium)
 Example-2:
 A bank buys USD 1 mio for 1 month forward
from a customer (exporter) at rate ‘F1’ i.e. it has
long position in USD 1mio for 1 month forward
 It will square its position in the interbank market
as follows:
 Do a Swap i.e. buy USD 1 mio spot at rate ‘S1’and
sell USD 1 mio forward at rate ‘F1’ i.e. ‘buy-sell’
swap thus squaring the long forward position.
 Sell USD 1 mio spot at rate S2 to square off the long
spot position.
- S2 + F1 (Pay Premium)
+ S1 - F2 (Receive Premium)
‘Buy-Sell’ Swap
 So long as premium received (F2 − S1) is greater

than the premium paid (F1 − S2) the dealer will
make money i.e.
F2 > F 1 > S 2 > S 1
I-----------I (Pay Premium)
I---------------------------I (Receive Premium)
Uses of Swaps / Forwards: CIP
 USD interest rate = 5% p.a.; GBP interest rate = 8% p.a.
Current spot rate = $1.48/£; 1 year forward rate = $1.48/£.
Can arbitrage profits be made?
Ft ,t 1 1.48
1  id   (1  i f ) 1.05   (1.08) ??
St 1.50
1.05 ≠ 1.0656
 Borrow $1m @ 5%
 Purchase £666,667 Spot using $1m at $1.50/£
 Invest £ at 8% (will receive £720,000 in one year’s time)
 Simultaneously sell £720,000 Forward at $1.48/£ (receive
$1,065,600)
 Repay loan + interest = $1,050,000
 ARBITRAGE PROFIT = $15,600
 To eliminate arbitrage, £720,000 = $1.05 m or F = $1.4583/£
Uses of Swaps / Forwards: CIP
 Cash Flows:
US$ £
At the time of borrowing +1000,000 -
Convert into £ @ $1.50/£ -1000,000 666,667
After 1 year pay (@ 5%)
receive (@ 8%) interest -50,000 53,333
_________ _______
Amount Paid / Received -1,050,000 720,000
No Arbitrage is possible if US$ 1.05 m = £ 0.72 m or

Forward Rate = 1.4583 US$/£
LIBOR Quotations - Reuter Screen
Cross Exchange Rate
 In forex markets cross rates mean any rate that does not
involve the USD
 Its is the exchange rate between two currencies obtained
from their common relationship with a third currency
 Example-1:
Suppose S$/€ = 1.50 (i.e. $ 1.50 = €1.00)
and that S$/£ = 2.00 (i.e. $ 2.00 = 1£)
What is the €/£ cross rate?
Cross Rate = (S$/€) ÷ (S$/£)
$1.50 £1.00 £0.75
× =
€1.00 $2.00 €1.00
€1.00 = £0.75
Cross Exchange Rate
 Example - 2:
INR is not directly quoted against JPY. An Indian importer needs
JPY for payment to supplier from Japan.
If a bank’s USD/INR and USD/JPY quotes are give s below is the
INR/JPY quote it offers to follows:
USD/INR 64.1075/175
USD/JPY 109.14/15
Bank will buy 1 USD at the bank’s bid rate of INR 64.1075/USD.
Bank will sell 1 USD and buy JPY at the bank’s offer rate of 1 USD
= JPY 109.15
INR-JPY Cross Rate (Bid) = (64.1075 INR/USD) ÷ (109.15 JPY/USD)
= INR 0.5873/JPY
INR-JPY Cross Rate (Offer) = (64.1175 INR/USD) ÷ (109.148 JPY/USD)
= INR 0.5874/JPY
Cross Exchange Rate
 Example - 3:
INR is not directly quoted against JPY. An Indian importer needs
JPY for payment to supplier from Japan.
If a bank’s USD/INR and USD/JPY quotes are give s below is the
INR/JPY quote it offers to follows:
USD/INR 66.8400/00
USD/JPY 103.38/42
Bank will buy 1 USD at the bank’s bid rate of INR 66.84/USD.
Bank will sell 1 USD and buy JPY at the bank’s offer rate of 1 USD
= JPY 103.42
INR-JPY Cross Rate (Bid) = (66.84 INR/USD) ÷ (103.42 JPY/USD)
= INR 0.6463/JPY
INR-JPY Cross Rate (Offer) = (66.85 INR/USD) ÷ (103.38 JPY/USD)
= INR 0.6466/JPY
Forward Cross Exchange Rate
Currencies
U.S.-dollar foreign-exchange rates in late New York trading.
--------Friday-------
Country/currency in US$ per US$
The 3-month forward €/£
Euro area euro 1.1183 .7638
cross rate is:
1-mos forward 1.1197 .7638
$1.1126 £1.00 £0.8354 3-mos forward 1.1126 .7635
× = 6-mos forward 1.1275 .7630
€1.00 $1.3318 €1.00
UK pound 1.3294 .6491
1-mos forward 1.3304 .6493
3-mos forward 1.3318 .6495
6-mos forward 1.3345 .6498
Foreign Exchange Trading
 Forex traders in money centre banks are market
makers offering two-way quotes i.e. bid/asked
quotes
 Dispersion of bid/asked prices throughout the market
 Bid/Asked quote is not constant but continuously
changes minute to minute in tune with:
 market rates
 likely movement during the day
 book position i.e. long or short and the need to

square position and book profit
 Example
Trader “A” has square Euro position in the beginning of the day
and offered the following quotes :
Euro 1.3285/87
Trading Terminology
“Yours” : Trader “A” is required to buy Euro at “bid rate”
from another trader “B” who says “yours”
“Mine” : Trader “A” is required to sell Euro at the “offer
rate” to trader “B” who says mine
“My Risk” : Trader “B” is not happy with the above quote
(“Mom”) given by trader “A” and asks for fresh quotes
“Thanks : Trader “B” is not interested in the quotes given
Nothing” by Trader “A”
 Case 1:
Euro 1.3285/87
Trader “A” is able to buy and sell Euro 50 mio at the above quote
Profit = (0.0002 USD/Euro) x (Euro 50 mio) = USD 10,000
At any moment trader “A” may find that the number of times he is
hit on the “bid” side is different from the number of times he is hit on
the “offer” side.
Two cases possible :
(i) Number of hits on “bid” side > number of hits on “offer” side.
Trader is buying more than he is selling i.e. Overbought or Long
Position.
(ii) Number of hits on “offer” side > number of hits in “bid”
Trader is selling more than he is buying i.e. Over sold or Short
Position.
In order to avoid speculative position a trader has to keep on
varying his “bid/ask” prices in response to relative frequency
at which he gets hit on either side
 Case 2:
Euro 1.3285/87
Trader “A” sells Euro 50 mio at 1 Euro = USD 1.3287 without
squaring his position
Trader “A” has “oversold” or is “short” by Euro 50 mio
Two views possible:
(a) Trader views that during the day Euro will depreciate and
so he can buy back Euro at cheaper rate and reap profit.
Alternatively, he can sell the Euro in the market.
Suppose Euro depreciates to Euro 1.3280/82
Trader buys back Euro 50 mio at USD 1.3280 per Euro
Profit = (0.0007 USD/Euro) x (Euro 50 mio)
= USD 35,000
 Case 2 (Contd.):
(b) Trader is anxious to square up his oversold Euro 50 mio
position immediately.
Trader may change his quote to Euro 1.3287/89.
Trader has now made his buy rate more attractive than in
initial quote i.e. Euro 1.3285/87
Trader is able to square off his position by buying Euro 50
mio at USD 1.3287 per Euro
= USD 0
If the trader cannot square his position at Euro 1.3287/89
then he may have to change it to say Euro 1.3289/91 in
which case he will incur a loss
 Case 3:
Euro 1.3285/87
Trader “A” buys Euro 50 mio at USD 1.3285 per Euro without
squaring his position.
Trader “A” has “overbought” or is “long” by Euro 50 mio.
Two views possible:
(a) Trader views that during the day Euro will appreciate so that
he can sell Euro at a higher rate and reap profit.
Suppose Euro appreciates to Euro 1.3290/92
Trader sells Euro 50 mio at Euro 1.3292
= USD 35,000
 Case 3 (Contd.):
(b) Trader is anxious to square up his overbought Euro 50 mio
position immediately.
Trader may change his quote to Euro 1.3283/85.
Trader has now made his sell rate more attractive than in
initial quote i.e. Euro 1.3285/87.
Trader is able to square off his position by selling Euro 50
mio at USD 1.3285 per Euro.
= USD 0
If the trader cannot square off his position at Euro
1.3283/85 then he may change his quote to 1.3284/86 in
which case he will incur a loss.
Foreign Exchange Arbitrage
Foreign Exchange Arbitrage
Example: INR = INR x USD

JPY USD JPY
Spatial Arbitrage
 New York: E$/£ = 2.0000
 London : E $/£ = 1.8182
 Buy £1 for $1.8182 in London
 Sell £1 for $2.0000 in New York
 Riskless Profit
 For no arbitrage the spot rates should be:
E$/£ (N.Y.) = E$/£ (London)
Spatial Arbitrage
Bank ‘A’ Euro 1.3285/87
Bank ‘B’ Euro 1.3280/82
A’s bid rate > B’s offer rate
 Risk Free arbOffer” rate itrage opportunity available

Buy 1 Euro from ’B’ for USD 1.3282
Sell 1 Euro to ‘A’ for USD 1.3285
Profit = USD 0.0003 per Euro bought and sold
(1) Any Bank’s “Bid” rate has to be < Other Bank’s “Offer” rate
(2) Any Bank’s “Offer” rate has to be > Other Bank’s “Bid” rate
Sometimes Banks keep their rates out of alignment with rest of the
market because they want to square off their exposures
E.g. A Bank with overbought position in Euro may want to keep
“Offer” rate lower than the market “Bid” rate and vice-versa
Triangular Arbitrage
 Cross exchange rates can be used to check on

opportunities for inter-market arbitrage
 Arbitrage opportunity arises because one bank’s
(Deutsche) quotation on €/£ is not the same as
calculated cross rate between $/£ (Barclay’s) and
$/€ (Citibank)
X (€/£) ≠ Y ($/£) ÷ Z ($/€)

Citibank, New York
End with $1,019,409 Start with $1,000,000
(1) Exchange $ 1,000,000 with

Barclays Bank for pounds at $1.8991/£
684,535 × $ 1.4892/€ =
1,019,409
$ 1,000,000 / $ 1.8991//£
= £ 526,565 (Receive)
Dresdner Bank, Frankfurt Barclays Bank, London
Exchange
(3) € 684,535 with (2) Exchange £ 526,565 with Dresdner
Citibank for US$ at $ 1.4892/€ Bank for Euros at € 1.3000/£
£ 526,565 × € 1.3000/£
= € 684,535 (Receive) 6-
102
Covered Interest Arbitrage
 USD interest rate = 5% p.a.; GBP interest rate = 8% p.a.
Current spot rate = $1.48/£; 1 year forward rate = $1.48/£.
Can arbitrage profits be made?
Ft ,t 1 1.48
1  id   (1  i f ) 1.05   (1.08) ??
St 1.50
1.05 ≠ 1.0656
 Borrow $1m @ 5%
 Purchase £666,667 Spot using $1m at $1.50/£
 Invest £ at 8% (will receive £720,000 in one year’s time)
 Simultaneously sell £720,000 Forward at $1.48/£ (receive
$1,065,600)
 Repay loan + interest = $1,050,000
 ARBITRAGE PROFIT = $15,600
 To eliminate arbitrage, £720,000 = $1.05 m or F = $1.4583/£
Determinants of Foreign
Exchange Rates
 Exchange rate determination is complex.
 Four major schools of thought :
 Parity Conditions
 Balance of Payments Approach
 Monetary Approach
 Asset Market Approach
 These are not competing theories but rather
complementary theories.
 It is also important to gain a working knowledge of
 the complexities of international political economy.
 random political, economic, or social events that affect
the exchange rate markets.
Determinants of Foreign
Exchange Rates
Parity Conditions
1. Relative inflation rates
2. Relative interest rates
3. Forward exchange rates
4. Interest rate parity
Is there a well-developed Is there a sound and secure

and liquid money and capital banking system in-place to support
Spot currency trading activities?
market in that currency?
Exchange
Rate
Asset Approach Balance of Payments
1. Relative real interest rates
1. Current account balances
2. Prospects for economic growth
2. Portfolio investment
3. Supply & demand for assets
3. Foreign direct investment
4. Outlook for political stability
4. Exchange rate regimes
5. Speculation & liquidity
5. Official monetary reserves
6. Political risks & controls
Parity Conditions
 (A) Purchasing Power Parity
 Percentage change in spot exchange rate is equal to
expected inflation differential between the two countries
(St+1 - St)/St =  - *
 (B) Covered Interest Parity

 Interest differential between home and foreign currency is
equal to premium / discount of foreign currency
F–S ≈ i – i*
S
Parity Conditions
 (C) Uncovered Interest Parity (“Carry Trade”)
 Interest differential between home and foreign currency is
equal to change in expected future spot rate
(Set+1 - St)/St ≈ i – i*
 (D) Forward Rate as an Unbiased Predictor

 Forward rate is an unbiased predictor of future spot rate
assuming that the foreign exchange market is reasonably
efficient
F = Se
Parity Conditions
 (E) Fisher Effect

 Nominal interest differential between two currencies is
equal to expected inflation differential between the two
countries
i  i*    *
Parity Conditions: Prices, Interest
Rates and Exchange Rates in
Equilibrium
(Set+1 - St) /St =  - * = i – i* = (Ft+1 – St) /St

(1) (2) (3) (4)
 (1) – (2) : Purchasing Power Parity (PPP)

 (1) – (3) : Uncovered Interest Parity (UIP)
 (1) – (4) : Forward Rate = Expected Future Spot Rate
 (2) – (3) : Fisher Effect
 (3) – (4) : Covered Interest Parity (CIP)
Parity Conditions : Prices, Interest Rates
and Exchange Rates in Equilibrium
Forecast change in
Forward rate spot exchange rate Purchasing power
as an unbiased +4% parity
predictor (yen strengthens) (A)
(E)
Uncovered
Forward premium Interest Forecast difference
on foreign currency Parity in rates of inflation
+4% (C) +4%
(yen strengthens) (less in Japan)
Covered Difference in nominal

Interest Fisher effect
interest rates (B)
Parity
(D)
+4%
(less in Japan)
Exchange Rate Determination:
Theories
 The theory of Purchasing Power Parity is the oldest,
and most widely accepted theory of all exchange rate
determination theories:
 The ratio of domestic prices to foreign prices
determine long-run equilibrium exchange rate
 Many versions of PPP but the most relevant for
explaining exchange rate values is the Relative
PPP which explains that changes in relative prices
between countries drive change in exchange rates
over time
Theories
 Most exchange rate determination theories have
PPP elements embedded within their frameworks
 PPP calculations and forecasts are however
plagued with structural differences across countries
and significant data challenges in estimation
Theories
• The Balance of Payments (Flows) Approach is the
second most utilized theoretical approach in exchange
rate determination:
 Demand and supply of a currency reflected in current
and capital accounts determines the exchange rate.
 This theory has wide appeal among practitioners as
BOP transaction data is readily available and widely
reported.
 This theory does not find favor among academics as
it does not take into account stocks of money or
financial assets.
Theories
• A surplus in the BOP implies that the supply of foreign
currency exceeds the demand and so the foreign currency
will depreciate in value (domestic currency will
appreciate ) or the Central Bank will intervene and
accumulate additional foreign currency reserves in the
Official Reserves Account.
• A deficit in the BOP implies an excess demand for foreign
currency and so the foreign currency will appreciate in
value (domestic currency will depreciate) or the Central
Bank will intervene and either devalue the currency or
expend its official reserves to support its value.
Theories
• Equilibrium exchange rate is attained when the net
inflow (outflow) of foreign exchange arising from
current account activities matches the net outflow
(inflow) of foreign exchange arising from capital
account activity :
CA + KA = 0
where, CA = Current Account
KA = Capital Account
Theories
• Fixed Exchange Rate Countries

 Under a fixed exchange rate system, the
government bears the responsibility to ensure that
the BOP is near zero.
• Floating Exchange Rate Countries

 Under a floating exchange rate system,
surpluses/deficits influence exchange rate.
Theories
• A country’s BOP can have a significant impact

on the level of its exchange rate and vice versa
• The relationship between the BOP and
exchange rates can be illustrated by use of a
simplified equation that summarizes the BOP
(see next slide)
Theories
 BOP and Exchange Rates :
(X – M) + (KI – KO) + RFX = BOP
CA + KA + RFX = 0
Where:
X = exports of goods and services
M = imports of goods and services
KI = capital inflows
KO = capital outflows
RFX = change in official reserves
CA = current account
KA = capital account
Theories
• A country’s import and export of goods and
services is affected by changes in exchange rates.
• The transmission mechanism is in principle quite
simple: changes in exchange rates change relative
prices of imports and exports, and changing prices
in turn result in changes in quantities demanded
through the price elasticity of demand.
• Theoretically, this is straightforward, in reality
global business is more complex.
Theories
 The Monetary Approach postulates that the exchange
rate is determined by the supply and demand for
national monetary stocks, as well as the expected
future levels and rates of growth of monetary stocks.
 An increase in a country’s money supply causes
interest rates to fall, rate of return on domestic
currency to fall and domestic currency to depreciate
 A decrease in a country’s money supply causes
interest rates to rise, rate of return on domestic
currency to rise and domestic currency to appreciate
 Changes in money stocks affect the inflation rate,
which in turn affects the exchange rates through the
PPP effect.
Theories
 Prices are flexible in the short-run and long-run and so
the transmission impact is immediate.
 Other financial assets, such as bonds are not
considered relevant for exchange rate determination.
Money Market / Exchange Rate
Linkages
Theories
 Also known as Portfolio Balance or Relative Prices of
Bonds approach
 The Asset Market Approach postulates that exchange
rates are determined by the supply and demand for a
wide variety of financial assets:
 Shifts in the supply and demand for financial assets
alter exchange rates.
 Changes in monetary and fiscal policy alter expected
returns and perceived relative risks of financial
assets, which in turn alter exchange rates.
Theories
 The Asset Market Approach assumes that whether
foreigners are willing to hold claims in monetary form
depends on an extensive set of investment considerations or
drivers (among others):
 Relative real interest rates
 Prospects for economic growth
 Capital market liquidity
 A country’s economic and social infrastructure
 Political safety
 Corporate governance practices
 Contagion (spread of a crisis within a region)
 Speculation
Theories
 Foreign investors are willing to hold securities and
undertake foreign direct investment in highly
developed countries based primarily on relative real
interest rates and the outlook for economic growth
and profitability.
 Prospects for economic growth and profitability are
an important determinant of cross-border equity
investment in both securities and foreign direct
investment
Theories
 Capital market liquidity is particularly important to
foreign institutional investors. Cross-border investors
are not only interested in the ease of buying assets,
but also in the ease of selling those assets quickly for
fair market value if desired
 A country’s economic and social infrastructure is an
important indicator of its ability to survive
unexpected external shocks and to prosper in a
rapidly changing world economic environment
Theories
 Political safety is exceptionally important to both
foreign portfolio and direct investors. The outlook for
political safety is usually reflected in political risk
premiums for a country’s securities and for purposes
of evaluating foreign direct investment in that
country
 The credibility of corporate governance practices is
important to cross-border portfolio investors. A
firm’s poor corporate governance practices can
reduce foreign investors 'influence and cause
subsequent loss of the firm’s focus on shareholder
wealth objectives
Theories
 Contagion is defined as the spread of a crisis in one
country to its neighboring countries and other
countries with similar characteristics—at least in the
eyes of cross-border investors. Contagion can cause
an “innocent” country to experience capital flight
with a resulting depreciation of its currency
 Speculation can both cause a foreign exchange crisis
or make an existing crisis worse
Theories
 The experience of the U.S. is the case in point. U.S.
dollar strengthened despite growing current account
deficits during the 1981-85, 1990 and 2000. Foreign
capitals flowed into U.S. due to
 rising stock and real estate prices
 low inflation and relatively high real returns
 low political risk
 However, the 9/11 attack caused a negative assessment

of long-term prospect for growth and profitability, and
political risk in the U.S.
Theories
 Loss of confidence in the U.S. economy led to a large
outflow of foreign capital and subsequently
depreciation of U.S. dollar by 18% between Jan-July
2002.
Equilibrium
$/€ Equilibriu
D m
S
$1.50
Qty (€)
Short-Run and Long-Run
 Economic Growth :
 Y  Capital Flows  Demand for Home Currency  Value of Home
Currency (Short-Run).
 Y  Inflation  Value of Home currency (via PPP) (Long-Run).
 Interest Rates :
 i (real)  Capital Flows  Supply of Foreign Currency  Value of
Home Currency (Short-Run)
 i (real)  Y  Supply of Foreign Currency  Value of Home
currency (Long-Run).
 Inflation :
 P   Demand for Domestic Goods internationally &  in
Demand for Foreign Goods  CAD  Demand for Foreign Currency
 Value of Home Currency (Medium Term)
 P  Value of Home Currency (via PPP) (Long-Run).
Short-Run and Long-Run
 Political & Economic Risk :
 Political and Economic risk  Supply of Foreign Currency 
Value of Home Currency (Medium Term / Long Run)
 Future Expectations / News :
Positive future expectations or news  Value of Home Currency
(Short-Run).
Exchange Rate Forecasting
 Efficient Markets Approach

 Fundamental Approach
 Technical Approach
Exchange Rate Forecasting:
Efficient Markets Approach
• Financial markets are efficient if prices reflect all
available and relevant information.
• If this is true, exchange rates will only change
when new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
• Predicting exchange rates using the efficient
markets approach is affordable and is hard to beat.
Fundamental Approach
• Involves econometrics to develop models that use a
variety of explanatory variables such as domestic and
foreign money supply, national income, etc. This
involves three steps:
– Step 1: Estimate the structural model.
– Step 2: Estimate future values of independent variables.
– Step 3: Use the model to develop forecasts.
• Decades of theoretical and empirical evidence show
that exchange rates adhere to fundamentals principles
and theories in the long-term
• Therefore there is something of a fundamental
equilibrium path of a currency’s value
Fundamental Approach
• In the short-term, a variety of random events,
institutional frictions, and technical factors may cause
currency values to deviate significantly from their long-
term fundamental path – this is sometimes referred to as
noise.
Exchange Rate Forecasting : Differentiating
Short-Term Noise from Long-Term Trends
Foreign currency per
unit of domestic currency
Technical or random events Fundamental

may drive the exchange Equilibrium
rate from the long-term path Path
Short-term forces
may induce noise – short term
volatility around long-term path
Time
Technical Approach
• Technical analysis looks for patterns in the past
behavior of exchange rates.
• It is based upon the premise that history repeats itself.
• Technical analysts, traditionally referred to as chartists,
focus on price and volume data to determine past trends
that are expected to continue into the future.
• The single most important element of technical analysis
is that future exchange rates are based on the current
exchange rate i.e. exchange rates follow “random
walk”.
• Thus, it is at odds with the EMH.
Forecasting in Practice
 Although the various theories surrounding exchange

rate determination are clear and sound, it may appear
on a day-to-day basis that the currency markets do
not pay much attention to the theories
 Predictions can be based on elaborate econometric
models, technical analysis of charts and trends,
intuition, etc.
 The longer the time horizon of the forecast, the more
inaccurate the forecast is likely to be.
Forecasting in Practice
 Whereas forecasting for the long run must depend on
the economic fundamentals of exchange rate
determination, many of the forecasting needs of the
firm are short to medium term in their time horizon
and can be addressed with less theoretical
approaches.
 The difficulty is understanding which fundamentals
are driving markets at which points in time
 One example of this relative confusion over exchange
rate dynamics is the phenomenon known as
overshooting
Exchange Rate Dynamics:
Overshooting
Spot Exchange
Rate, $/
S1
Overshooting
S2
S0
t1 t2
The Fed announces a monetary expansion at time t 1. This results immediately in $ Time
depreciating from S0 to S1 based on interest differentials. However, over a period of
time as PPP comes into effect and the $ settles at a value S between S and S .
Indian Foreign
Exchange Market
Indian Foreign Exchange
Market Brief History
 The Indian forex market since independence has
evolved in three distinct phases:
 1947 – 1975: Par Value
 1975 – 1992: Basket Peg
 1992 onwards: Market Determined (Post-Reform
Period)
 1947-1975 (Par Value)
 During the Bretton Woods era from 1947-1971 India followed
the par value system of exchange rate. RBI fixed rupee’s
external value at 4.15 grains of fine gold.
 RBI maintained a par value of INR within permitted band of ±
1% using GBP as currency for intervention.
 Since the sterling-dollar exchange rate was kept stable by the US
Fed the exchange rates of the INR in terms of gold as well and
the dollar and other currencies were also indirectly kept stable.
 After breakdown of Bretton Woods in Aug 1971, INR was
briefly pegged to USD at INR 7.50 per USD before re-pegging it
to GBP at INR 18.97 with a band of ± 2 ¼% in Dec 1971.
 In June 1972 GBP was floated. INR-GBP parity revalued to
INR 18.95 and then in Oct to INR 18.80.
 1975-1992 (Basket Peg)
 In Sept 1975 INR was pegged to an undisclosed currency basket
with margin of ± 2.25%.
 In 1978 RBI allowed interbank dealing in foreign exchange.
 In 1979 margins around basket parity widened to ± 5%.
 The central or mid rate fixed was INR 18.3084/GBP.
 RBI would set the mid rate every morning at 9.15 am.
 Post-Reform Period: 1992 onwards
 In 1991 INR was devalued by 20% between July 1 and July 3 in
two steps of 9% and 11% from INR 21.50/USD to INR
25.80 /USD.
 In 1992 Liberalized Exchange Rate Management System
(LERMS) introduced with 60-40 dual exchange rates:
 Exporters of goods & services and remittances from abroad were
allowed to convert 60% of their forex receipts at market determined
rates and 40% at RBI official rate.
 Post-Reform Period: 1992 onwards (Cont..)
 In 1993 Unified Market Determined Exchange Rate System
(UERS) was introduced as follows:
 All forex transactions (receipts & payments under both current
and capital a/c of BOP) would be put through at market rates by
ADs
 Forex receipts and payments continue to be governed by
Exchange Control Regulations laid down in Exchange Control
Manual.
 ADs are free to retain the entire forex surrendered to them for
being sold for permissible transactions and are not required to
surrender to RBI any portion of such receipts.
 Prior to March 1, 1993 u/s 40 of RBI Act 1934 RBI was
obliged to buy and sell Forex to ADs. However, effective
March 1, 1993, under UERS, RBI is not obliged to buy Forex
from or sell Forex to any one. But RBI has a right to intervene
with USD being intervention currency.
 Post-Reform Period: 1992 onwards (Cont..)
 In 1994 RBI announced substantial relaxation of exchange
controls for current account transactions and declared INR
convertible on current account in Aug 1994.
 In 1997 Tarapore Committee on Capital Account
Convertibility submits its report and recommends phased
removal of restrictions on capital account transactions.
 FEMA enacted in 1999 to replace FERA of 1973.
 From 2001 onwards there has been significant liberalization of
the capital account.
Market Size
 Average daily turnover of about USD 25-30 bio.
 Interbank transactions : 80% of daily turnover
 Merchant transactions : 20% of daily turnover
Interbank Merchant Aggregate

(%) (%) (%)
Spot 50 50 40
Forward 4 50 40
Swap 46 - 20
Foreign Exchange Turnover
Indian Foreign Exchange Market:
Regulatory Structure
 All dealings in forex are regulated by Foreign Exchange
Management Act (FEMA) of 1999 with RBI being the
regulatory authority.
 FEMA replaced FERA of 1973 post liberalization.
 Entities authorized by RBI u/s 10 of FEMA 1999 can deal in
forex either as ADs (commercial banks) or Money Changers.
 Money changers are either full-fledged or restricted.
 AD are allowed to deal in all items classified as foreign
exchange under FEMA
 ADs have to operate within the rules, regulation, and
guidelines issued by Foreign Exchange Dealers’ Association
of India (FEDAI) which is a self regulatory body
 Minimum trading amount in the interbank market is USD

1 million
 Reuters Market Data System (RMDS) electronic platform
is used in interbank trading.
 Reuters – D2 is another electronic platform used by some
corporates
Market Structure
Market Structure
Market Structure
 Three-Tier Structure:
 RBI and Authorized Dealers (ADs) i.e. commercial
banks
 ADs with each other i.e. interbank market
 ADs and corporate customers i.e. retail segment
 In retail segment in addition to ADs there are
authorized money changers in currency notes and
travelers cheques
Market Structure
 Foreign Exchange Dealers’ Association of India
(FEDAI) was set in 1958 as an Association of Banks
dealing in forex in India i.e. ADs as self regulatory body
and is incorporated u/s 25 of The Companies Act 1956
 Its major activities include framing of rules governing the
conduct of inter-bank foreign exchange business among
banks and liason with RBI for reforms and development
of forex market.
 FEDAI forms guidelines and rules for forex business
Market Structure
 Functions of FEDAI
 Formulates guidelines and rules for forex business
 Training of bank personnel in the areas of forex business
 Accreditation of brokers
 Advising/ Assisting in member banks in settling issues,
maters relating in their dealing
 Represent member banks on Govt. R.B.I and other bodies
 Announcement of daily and periodical rates to member
banks
 Prescribing margin for calculating exchange rates for
various merchant transactions
 Formulating code of conduct for dealers working in banks,
exchange brokers etc. for dealing with each other
Market Structure
 Members of FEDAI
 Public and private sector banks
 Foreign banks
 Co-operative banks
 Financial Institutions such as EXIM Bank, S.I>D.B.I and
others such as Thomas Cook (I) Ltd.
 As of May 2016 there were 108 members
Functions of a Forex Department
Market Structure
 Inter-bank Quotes given by one bank to another bank in
the inter-bank market.
 Merchant Quotes are quoted by banks to their non-bank
retail customers.
 According to FEDAI rules inter-bank and merchant rates
are quoted upto 4 decimals, last two digits being in
multiples of 25 (e.g. INR/USD: 55.5220/45)
 Inward/outward forex remittances through:
 Telegraphic Transfer (TT)
 Postal or Mail Transfer (MT)
 Demand Draft (DD)
Market Structure
 Merchant Rates:
 TT Rate
“TT buying rate” given by AD for clean inward forex
remittance and “TT Selling rate” for clean outward forex
remittance.
 Bill Rate
“Bill buying rate” given by AD for export transaction and
“Bill selling rate” for import transaction.
Two types of bills :
 Sight or Demand Bill
 Time or Usance Bill
 TT and Bill Rate are determined in accordance with

FEDAI rules.
Market Structure
LIBOR Rates
Indian Foreign Exchange Forward
Market
 Forward market liquid upto 12 months.
 Because of exchange controls on capital
movement and imperfect domestic money market
forward premia and discount are not governed by
interest parity.
 This has resulted in one-way arbitrage.
 Forward Premia/Discount are determined by
demand and supply.
 Forex Swaps active in interbank market to cover
forward exposures with customers.
 Early Delivery/Extension/Cancellation of Forward
Contracts permitted by RBI.
Screen (USD/INR)
Screen (USD/INR)
USD/INR Annualized Forward Premia
INR-USD Annualized Forward Premia
USD/INR 6-Mthly Annualized
Fwd Premia – Reuter Screen
USD/INR Annualized 1-Year
Fwd Premia – Reuter Screen
INR-USD Exchange Rate: 1993
to 2017
USD/INR 6 mth Forward Rates v/s Spot
Rates (Aug 2015 – Aug 2017)
Booking and Cancellation of
Forward Exchange Contracts
 Eligibility for Booking Forward Contracts
 Forward Contract booking will have to be based on underlying
documents
 Eligible Limit during the current FY (April-March) based on past
performance:
 Average of the previous 3 financial years’ actual export turnover
or the previous year’s actual export turnover, whichever is higher
 Average of the previous 3 financial years’ actual import turnover
or the previous year’s actual import turnover, whichever is higher
for imports
 Minimum NW = INR 200 cr; Min Exports + Imports = Rs 1000
cr.
 Cancellation of Forward Contracts:
 Contracts booked upto 75% of the eligible limit mentioned
above may be cancelled with the exporter/importer
bearing/being entitled to the loss or gain as the case may be
 Contracts booked in excess of 75% of the eligible limit
mentioned above shall be on deliverable basis and cannot
be cancelled implying that in the event of cancellation, the
exporter/importer will have to bear the loss but will not be
entitled to receive the gain
 Forward contracts booked to hedge capital account
 Transactions for tenor > 1 year if cancelled can be
rebooked subject to :
 Switch is warranted by competitive rates on offer and
termination of banking relationship with AD with whom
the contract was originally booked
 Cancellation and rebooking are done simultaneously on the
maturity date of the contract
 The above flexibilty in regard to roll over of contracts by
switching AD category banks on maturity date of contract
extended to all hedge transactions undertaken by
residents.
 Example 1:
------------------------I------------I----------------
0 3 mth 4 mth 6 mth (INR 67/USD)
I------------------------------> (INR 68/USD)
I-----------------> (INR 67.50/USD)
1) Importer books forward contract for 6 mths @ INR 67/USD

2) Cancels : t = 3 mths @ INR 68/USD. Gain = INR 1/USD
3) Re-books : t = 4 mths @ INR 67.50/USD. Loss = INR0.50/USD
4) Net Gain : INR 0.50/USD
5) Effective Forward Rate = INR 66.50/USD
If F (t=4) < INR 68/USD  Net Gain by rebooking Forward
If F (t=4) > INR 68/USD  Net Loss by rebooking Forward
 Example 2:
----------------------I------------I-----------------
0 3 mth 4 mth 6 mth (INR 67/USD)
I------------------------------> (INR 66/USD)
I-----------------> (INR 66.50/USD)
1) Exporter books forward contract for 6 mths @ INR 67/USD

2) Cancels : t = 3 mths @ INR 66/USD. Gain = INR 1/USD
3) Re-books : t = 4 mths @ INR 66.50/USD. Loss = INR 0.50/USD
4) Net Gain : INR 0.50/USD
5) Effective Forward Rate = INR 67.50/USD
If F(t=4) > INR 66/USD  Net Gain by rebooking Forward
If F(t=4) < INR 66/USD  Net Loss by rebooking Forward
Non-Deliverable Forward
What is Non-Deliverable Forward Contract ?
 NDF is similar to deliverable forward.
 The difference is that no physical delivery of the local
currency e.g. Indian Rupee takes place as the local
currency is not convertible and therefore ‘not deliverable’
offshore.
 No principal amount is exchanged.
 The deal is settled against spot fixing rate prevailing two
days prior to maturity date.
 Net settlement amount in USD is calculated as the
difference between the agreed NDF rate and the spot
fixing rate.
Non-Deliverable Forward Market
 The NDF markets have evolved in offshore centres for
domestic currencies because of following reasons:
 Foreign exchange convertibility restrictions
 Domestic forward foreign exchange market not developed
 Restrictions on non-resident access to domestic forward
markets.
 E.g. emerging Asian economies include Taiwan, Korea,
Indonesia, India, China, Philippines etc.
 Being offshore, the NDF market is outside the regulatory
purview of local monetary authorities.
 There is a linkage between onshore spot and forward
market and the NDF market.
NDF Market for Indian Rupee
 Genesis in the 1990’s as currency hedging avenue for
foreign investors investing in India
 Singapore and Hong Kong are the major centres followed
by Dubai and Bahrain
 It is Over the counter (OTC) market
 Average daily turnover of USD 4-5 bio in 2007 compared
to USD 100 mio in 2003.
 Major global banks offer NDF in INR offshore
 No controls by RBI for offshore participation in INR
NDF
 Indian banks/FIs not allowed to participate by RBI
NDF Market Players
 Non-residents speculate on INR without any exposure to
the country
 Arbitrageurs try to exploit differential in pricing in the
two markets without any outlay of capital by two
offsetting transactions e.g.
- Corporates/Banks/FIs with international presence
- Exporters and Importers
 MNCs / Foreign Investors participate in NDF market to
hedge their exposures
NDF Definitions
-----------------------------------------------I--------
0 T-2 T
1) Trade Date (t = 0) : Client enters into forward agreement to

buy/sell INR at contracted NDF rate
2) Settlement / Delivery : Date of maturity of NDF contract
Date (t = T)
3) Fixing Date (t = T-2) : Date for comparing the NDF rate with
prevailing spot rate
4) Contracted NDF Rate: Forward Rate agreed between the two
counterparties on the trade date
5) Prevailing Spot Rate : Spot rate on fixing date i.e. RBI
reference rate at 12:00 noon
NDF Definitions
6) Notional Amount : “Face Value” of NDF agreed between
the two counterparties. Notional
amounts in two currencies is not
exchanged
If NDF > S  Buyer of NDF pays the seller the difference i.e.
(NDF – S)
If NDF < S  Seller of NDF pays the Buyer the difference i.e.
(S – NDF)
NDF Examples
Example 1:
Assume NDF rate of 1 USD = INR 61 for settlement on 31st
Dec in Singapore forex market.
Overseas buyer agrees to Buy USD 1 mio (Sell INR 61 mio)
for settlement on 31st Dec.
Overseas seller agrees to Sell USD 1mio (Buy INR 61 mio)
for settlement on 31st Dec.
If on fixing date i.e. 29th Dec :
(1) RBI Reference Rate = INR 62/USD
 Buyer makes profit of INR 1/USD
 Seller will pay the Buyer USD (1/62) x 1 mio
= USD 16,129
NDF Examples
(2) RBI Reference Rate = INR 60 /USD
 Seller makes profit of INR 1 /USD
 Buyer will pay the Seller USD (1/60) x 1 mio
= USD 16,667
(3) RBI Reference Rate = INR 61/USD

 No Profit /Loss
Greater the difference between RBI Reference Rate and
NDF Rate greater the Profit /Loss
NDF Examples
Example 2:
Singapore (NDF)
-----------------------------------------
T=0 Mumbai (Forward) T=6 mth
Singapore : NDF (6 mths) = INR 61/USD

Mumbai : Forward (6 mths) = INR 63/USD
NDF is quoting at a discount of INR 2 to Forward Rate
“Buy” NDF in S’pore and simultaneously “Sell” Forward in
Mumbai
(1) RBI Reference Rate on Fixing Date = INR 60/USD
Singapore: Loss INR 1 Mumbai: Profit INR 3
Net Profit : INR 2
NDF Examples
(2) RBI Reference Rate on Fixing Date = INR 64/USD

Singapore : Profit INR 3 Mumbai: Loss INR 1
Net Profit : INR 2
Net Profit on USD 1mio = USD (2/RBI Ref Rate) x 1mio
= USD 31,250
(A) Greater the difference between NDF Rate and Forward
Rate higher the Net Profit
(B) Lower the RBI Reference Rate compared to the NDF
Rate higher the Net Profit
NDF Examples
Example 3:
Singapore (NDF)
-----------------------------------------
Singapore : NDF (6 mths) = INR 63.00/USD

Overseas Investor : Sells USD 1 mio and Buys INR 63 mio from
Bank ‘A’ at 6-mth NDF rate of INR 63.00/USD for payment of
equity purchase on 31st Dec 2015.
(1) If RBI Reference Rate on 29th Dec 2014 = INR 61/USD
 Bank ‘A’ pays the investor INR 2/USD.
Total amount paid = USD (2/RBI Ref Rate) x 1mio =
= USD 32,787
NDF Examples
Example 3 (Cont..):
Singapore (NDF)
---------------------------------------------------
(2) If RBI Reference Rate on 29th Dec 2014 = INR 64/USD

 Investor pays Bank ‘A’ INR 1/USD.
Total amount paid = USD (1/RBI Ref Rate) x 1mio =
= USD 15,625
NDF Bloomberg Screen Quotes
USD-INR Onshore Forward Rates v/s
NDF Rates
1 month Offshore vs. Onshore Forward
Analysis
Green Area shows that 1m Offshore Forward trades at discount i.e. 1m Offshore forward is less than 1m Onshore forward.
Red Area shows that 1m Offshore Forward trades at premium i.e. 1m Offshore forward is more than 1m Onshore forward
6 month Offshore vs. Onshore Forward
Analysis
Green Area shows that 6m Offshore Forward trades at discount i.e. 6m Offshore forward is less than 6m Onshore forward
Red Area shows that 6m Offshore Forward trades at premium i.e. 6m Offshore forward is more than 6m Onshore forward
INR-USD 6 mth Onshore Forward v/s 6
mth NDF Rates (Aug 2014 – Aug 2017)

FOREX MARKET GUIDE

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FOREIGN EXCHANGE

 Purchase and sale of currencies of different nations

 International commercial banks communicate with one

Source: BIS Triennial Central Bank Survey, September 2016

Source: BIS Triennial Central Bank Survey, September 2016

Source: BIS Triennial Central Bank Survey, September 2016

Source: BIS Triennial Central Bank Survey , September 2016

Source: BIS Triennial Central Bank Survey, September 2016

 The foreign exchange market consists of two tiers:

Dealing Locations : London & Paris

Tokyo (JPY) N.Y. (USD)

Mumbai N.Y. (USD)

Spot Market Forward Market FX Swaps Market

 Spot Foreign Exchange Microstructure

Forward Premium = 1.1813 – 1.1794 x 360 x 100

Forward Premium = 1.1814 – 1.1795 x 360 x 100

 Outright Forward Quotations

 For the buyer of the Forward Contract (Short Position):

Calculating the Swap Rate

(F$/£ − S$/£) × 360 × 100 (1 + i$ × N/360) − 1

= 1.32 × (1.0053 − 1.0000)

(F$/£ − S$/£) × 360 × 100 = (1 + i$ × N/360) − 1 ×

= (1.0053 − 1.0000) × 100

Outright Forward Quotations

Outright Forward Quotations

 Hedge Currency Risk

 Take advantage of interest rate differential

 Hedge Currency Risk

F 1 > F 2 > S 1 > S2

 So long as premium received (F2 − S1) is greater

No Arbitrage is possible if US$ 1.05 m = £ 0.72 m or

 likely movement during the day

 book position i.e. long or short and the need to

Example: INR = INR x USD

 Risk Free arbOffer” rate itrage opportunity available

 Cross exchange rates can be used to check on

X (€/£) ≠ Y ($/£) ÷ Z ($/€)

(1) Exchange $ 1,000,000 with

Dresdner Bank, Frankfurt Barclays Bank, London

Is there a well-developed Is there a sound and secure

 (B) Covered Interest Parity

 (D) Forward Rate as an Unbiased Predictor

 (E) Fisher Effect

(Set+1 - St) /St =  - * = i – i* = (Ft+1 – St) /St

 (1) – (2) : Purchasing Power Parity (PPP)

Covered Difference in nominal

• Fixed Exchange Rate Countries

• Floating Exchange Rate Countries

• A country’s BOP can have a significant impact

 Prospects for economic growth

 Capital market liquidity

 A country’s economic and social infrastructure

 Corporate governance practices

 Contagion (spread of a crisis within a region)

 low inflation and relatively high real returns

 low political risk

 However, the 9/11 attack caused a negative assessment

 Efficient Markets Approach

Technical or random events Fundamental

 Although the various theories surrounding exchange

Interbank Merchant Aggregate

 Minimum trading amount in the interbank market is USD

 TT and Bill Rate are determined in accordance with