forex

1

The Foreign Exchange Market

Forex and Treasury Management

Session 1 and 2

2

The Foreign Exchange Market

The Structure of the Forex Market Foreign Exchange Types of Transactions Settlement Dates Quotes for Various Kinds of Merchant Transactions The Indian Scenario

Convertibility

Exchange Control

The FEDAI Rules Regarding Inter-bank Dealings

Forex Dealing Room Operations

3

Structure of the Forex Market

Decentralized, over-the-counter market, also known as the 'interbank' market

Main participants: Central Banks, commercial and investment banks, hedge funds, pension funds, corporations & private speculators

The free-floating currency system began in 1973, and was officially mandated in 1978

Online trading began in the mid to late 1990's

4

Structure of the Forex MarketTrading Hours

24 hour market Sunday 5pm EST through Friday 4pm EST. Rollover at 5pm EST Trading begins in New Zealand, followed by Australia, Asia, the Middle East, Europe, and America

SizeLargest market in the world$1.9 trillion average daily turnover, equivalent to: 15 times the average daily turnover of global equity markets Nearly 50 times the average daily turnover of the NYSE $300 a day for every man, woman, and child on earth The spot market accounts for about one-third of daily turnover

5

Structure of the Forex Market

Major Markets The US & UK account for more than 50% of turnover Major markets: London, New York, Tokyo Trading activity is heaviest when major markets overlap Nearly two-thirds of NY activity occurs in the morning

hours while European markets are openTrading An estimated 95% of transactions are speculative More than 40% of trades last less than two days About 80% of trades last less than one week Brokers research: 90% of traders lose money, 5% break

even, 5% make money

6

Structure of the Forex MarketCountry wise turnover

Country Percentage Share

UK 31.3

USA 19.2

Japan 8.3

Singapore 5.2

Germany 4.9

Hong Kong 4.2

Australia 3.4

Others 23.5

Total 100

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Structure of the Forex MarketCurrency wise turnover

Currency Percentage Share

USD 88.7

EURO 37.2

JPY 20.3

GBP 16.9

CHF 6.1

AUD 5.5

CAD 4.2

Others 21.1

Total 200.0

8

Structure of the Forex MarketCurrency Pair wise turnover

Currency Percentage Share

EURO/USD 28

USD/JPY 17

GBP/USD 14

AUD/USD 5

USD/CHF 4

USD/ CAD 4

EURO/JPY 3

Others 25

Total 100

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Around-the-clock FX trading

0

5,000

10,000

15,000

20,000

25,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Average Electronic Conversions Per Hour

Greenwich Mean Time

Tokyoopens

Asiaclosing

10 AMIn Tokyo

Afternoonin America

Londonclosing

6 pmIn NY

Americasopen

Europeopening

LunchIn Tokyo

10

spot33%

forw ard11%gap

6%

FX sw aps50%

World FX transactions$1.9 trillion/day (2004)

FX market in the U.S. is the most active market in the U.S.

$461 billion turnover per day, in 2004 Comparisons with U.S. asset markets:

· 10 times the turnover of U.S. govt. bonds· 50 times the turnover of NYSE stocks

Comparisons with real activity in U.S.:· 10 times U.S. daily GDP· 30 times U.S. daily exports + imports

Primary functions of FX Market

Currency conversions associated with international payments process

Provision of credit to clients(also part of international payments process)

Managing exchange rate risk

Structure of FX Market (retail level)

Interbank mkt($/FC)

domestic ($) foreign (FC)

Exchange-tradedfutures & options

central bank

firms

investors

for. firms

for. central bank

for. investors

Structure of FX Market: interbank (wholesale) level

Banks trade with each other· in response to the retail orders they receive· to manage their own accounts

Banks trade· directly with other banks· indirectly through FX brokers

FX market

dom.bank

Corp.order for.

bank

dom.bank

for.bank

FX broker

Corp.order

Corp.order

Corp.order

domestic ($)

foreign (FC)

$/FC

Direct vs. brokered interbank trades Direct dealing Banks face another bank’s bid-ask spread, at which they can

transact immediately Brokered trades

Get best price of all posted buys/sells· 56% of all dealers’ trades are with other dealers· 31% are with other financial institutions

(brokers, mutual funds, ...)· 13% are with non-financial customers

· 66% of all trades are with foreign counterparties Much (56%) of FX trading is in the interbank (wholesale)

market

However, the retail orders are the important ones that determine exchange rates

· Interbank traders are intermediaries (market makers)

· temporarily take positions intra-daily, but work hard to zero out their positions regularly and by

the end of the day

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Structure of the Forex Market

Function and Structure of the FOREX Market The Spot Market

Spot Rate Quotations The Bid-Ask Spread Spot FX Trading Cross Exchange Rate Quotations Triangular Arbitrage Spot Foreign Exchange Market Microstructure

The Forward Market

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FOREX Market Participants The FOREX market is a two-tiered market:

Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a

market in Foreign exchange. Nonbank dealers account for about 20% of the

market. There are FX brokers who match buy and sell orders

but do not carry inventory and FX specialists. Client Market (Retail)

Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

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Correspondent Banking Relationships

Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market.

International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial

Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global

clearinghouse for settling interbank FOREX transactions.

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The Spot Market

Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

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Spot Rate Quotations Spot Rate Quotations

Direct quotation the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” =

$.01/yen

Indirect Quotation the price of a U.S. dollar in the foreign currency =

Y100/$ e.g. “you get 100 yen to the dollar”

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Spot Rate Quotations

The direct quote for British pound is:

£1 = $1.5627

Country

USD equiv Friday

USD equiv Thursday

Currency per USD Friday

Currency per USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.5906 0.5934 1.6932 1.6852

Brazil (Real) 0.2939 0.2879 3.4025 3.4734

Britain (Pound) 1.5627 1.566 0.6399 0.6386

1 Month Forward 1.5596 1.5629 0.6412 0.6398

3 Months Forward 1.5535 1.5568 0.6437 0.6423

6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975

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Spot Rate Quotations

The indirect quote for British pound is:

£.6399 = $1 1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)

Currency per USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv FridayCountry

25

Spot Rate Quotations

Note that the direct quote is the reciprocal of the indirect quote:

6399.

15627.1

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)

Currency per USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv FridayCountry

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The Bid-Ask Spread

The Bid price is the price a dealer is willing to pay for a currency = S(j/kb)

The Ask price is the amount the dealer offers to sell you a currency. It’s the price the dealer wants for the sale of currency = S(j/ka)

Bid-Ask Spread = [Ask price - Bid price] > 0

27

Spot FX trading

In the interbank market, the standard size trade is about U.S. $10 million.

A bank trading room is a noisy, active place.

The stakes are high. The “long term” is about 10 minutes.

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Cross Rates: Example

Suppose that S(€/$) = € 1.0240/$

and S(£/$) = £ .6550/$ What must the S(£/€) cross rate be?

,€

/£

€

£

$$since

£€ or €£.€)£S/$.€

£ ./5635.1/6396/(

02401

$/6550

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Triangular Arbitrage

$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an arbitrage exists.

30

Triangular Arbitrage

$Credit

Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

80¥

1£

120¥

1$

1$

50.1£

The implied S(¥/£) cross rate is S(¥/£) = 80

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.

So, how can we make money?

Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.

¥ £

31

Triangular Arbitrage

$Credit

Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell our $ for £,

2. Sell our £ for ¥,

3. Sell those ¥ for $.¥ £

1

2

3

$

32

Triangular ArbitrageSell $100,000 for £ at S(£/$) = 1.50

receive £150,000

Sell our £ 150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000

Sell ¥ 12,750,000 for $ at S(¥/$) = 120receive $106,250

profit per round trip = $ 106,250- $100,000 = $6,250

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Spot Foreign Exchange Microstructure

Market Microstructure are the mechanics of how a marketplace operates.

Spot mkt Bid-Ask spreads in the: increase with FX exchange rate volatility and

decrease with dealer competition. Private information is an important determinant of spot

exchange rates. - Mkt adjusts to econ info in 1min.

- 1/3 of traders claim adjustment < 10 sec

- Cbank intervention does not work; it increase volatility.

34

The Forward Market

Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

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Forward Rate Quotations

The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.

Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

Longer-term swaps are available.

36

Quotations

Clearly the market participants expect that the pound will be worth less in dollars in six months.

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)

Currency per USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv FridayCountry

37

Forward Rate Quotations

Consider the example from above:

for Japanese yen, the spot rate is

$1.5627 = £1.00

While the 180-day forward rate is

$1.5445 = £1.00 What’s up with that?

38

Long and Short Forward Positions

If you have agreed to sell anything (spot or forward), you are “short”.

If you have agreed to buy anything (forward or spot), you are “long”.

If you have agreed to sell FX forward, you are short.

If you have agreed to buy FX forward, you are long.

39

Payoff Profiles

0 S180($/¥)

F180($/¥) = .009524 direct quote

Short position

loss

profit(1) If you agree to sell currency in the future at a set price and the spot price later falls then you gain.

(2) If you agree to sell currency in the future at a set price and the spot price later rises then you lose.

40

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

profit Whether the payoff profile

slopes up or down depends upon whether

you use the direct or indirect

quote:

F180(¥/$) = 105 or F180($/¥)

= .009524.

short position

41

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105

profitshort position

42

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

120

If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105.

15¥

profitshort position

43

SWAPS/ Forward Premium

A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want.Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

Forward Premium is just the interest rate differential implied by forward premium or discount.

44

01375.5235.

5235.5307.

180

360

€)/($

€)/($€)/($180$,€180

S

SFf v

For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307 The forward premium is given by:

45

Convertibility-Definition The ease with which a country's currency can be

converted into gold or another currency. Convertibility is extremely important for international commerce. When a currency in inconvertible, it poses a risk and barrier to trade with foreigners who have no need for the domestic currency

The quality of being exchangeable (especially the ability to convert a currency into gold or other currencies without restriction)

46

Convertibility-Definition Government restrictions can often result in a

currency with a low convertibility. For example, a government with low reserves of hard foreign currency often restrict currency convertibility because the government would not be in a position to intervene in the foreign exchange market (i.e. revalue, devalue) to support their own currency if and when necessary

47

Rupee Convertibility

The Indian Rupee is1) for all intents and purposes, fully Convertible to the US$ on the Trade Account and Current Account. This means Indians can buy US$ for their Trade, Travel, Fees, Education, Interest, Dividend payments etc. US Dollars can also be converted into Rupees2) largely, NOT convertible to US$ on the Capital Account, especially when the flow of capital is from India to outside.

48

Rupee Convertibility

However, degrees of convertibility have been brought in. For instance,- Indian companies can invest in/ set up subsidiaries abroad. Limits are placed on the amount of investment- Indian mutual funds, since last year, have been allowed to invest in overseas markets, though we doubt if activity has picked up on this front- Dividend and Interest payments to investors abroad are unhindered

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Rupee Convertibility Flow of Capital from outside India (investments into

India) are unencumbered from the "convertibility" point of view.

Investors may need to garner various necessary permissions as required to invest in the equity market, debt market or to set up greenfield projects or buy over existing companies. These are, essentially, outside the ambit of "convertibility"

Indian Rupee is not legally pegged to the Dollar. It is market traded currency, though the trading itself is controlled by various measures. Technically, the Indian Rupee is in a "Managed Float" or "Dirty Float", like the Yen.

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Exchange Control

Introduced during post-WW II period More stringent in post-independence era FERA 1948, MORE powers in 1973

( Rigid import controls, highest duties, industrial policy towards import substitution, foreign investment discouraged etc.– CLOSED ECONOMY)

1991 BOP crisis – Policy shifts August 1994—Current account convertibility 1999 FEMA

51

Forex Dealing Room Operations

Objectives of Dealing Room Affording the best possible customer service Managing the bank’s foreign currency exposures Generating profit for the bank Ensuring the compliance of relevant regulations

Participants Organizations Commercial banks Central banking authority Brokers

52

Forex Dealing Room Operations

Indian Regulations

Brokers not allowed to as principals or maintaining foreign currencies

Brokers notes to be received promptly and acted upon on the same day by dealers

Nominations of deals not done by them not permitted Spread of brokers Duty separation for dealers

53

Forex Dealing Room Operations

Dealing Process

Customer Bank BranchDealingRoom

Front Office

Mid-Office

Back Office

Domestic market

Global Market

Front Office: Actual dealingMid-Office: Risk management, accounting and MISBack Office: Settlement, Reconciliation, compliance and accounting

54

Forex Dealing Room Operations

Regulatory Requirements

Daily Fx turnover and Gaps position and Cash Balance

Monthly statement in USD denomination Aggregate gap limit (AGL) approved Maximum AGL on any day VaR approved Maximum VaR on any day during the month

55

Forex Dealing Room Operations

Front Office: Confirmation, stamped agreement, P/L evaluation monthly report, gold and record maintenance

Policy prescriptions Strategy formulation Concentration limits Risk processes Task delineation Internal accounting/reporting Secrecy issues

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Forex Dealing Room OperationsManaging Risks

Open position Maturity

mismatch Credit risk Operational

Risk Legal Risk Sovereign

Risks

Day light, overnight and cut loss IGL, Monthly Limits, AGL, etc.

Country/group, currency limits Duty segregation, processes, etc

Responsibility fixation, supports, etc.

External data, monitoring, etc.

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Rate Mechanism

Transaction Buying Selling

Spot TT Base 48.5500

Less Margin@.08% 0.0380

Spot TT 48.5120

Base 48.7000

Add Margin@.15% 0.0731

Spot TT 48.7731

Forward TT Base 48.5500

Add Premium 0.1500

Less Margin@0.08% 0.0389

Forward 48.6611

Base 48.7000

Add Premium 0.2000

Add Margin@.15% 0.0734

Forward 48.9734

Bill Base 48.5500

Premium 0.4000

Less Margin@.15% 0.0734

Bill 48.8766

Base 48.7000

Add Margin@.15% 0.0731

Add Margin@0.2% 0.0975

Bill 48.8706

TC Base 48.7500

Less Margin@1% 0.4875

TC 48.2625

TT Selling 48.7641

Add Margin@0.5% 0.2438

Add Commission@1% 0.4900

TC 49.4979

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THANKS