foreign exchange managements
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04/10/2023 Foreign Exchange Management 1
Foreign exchange management
By:Srikant Gupta (86)Zaki Azfar (107)Manushi Mishra (116)
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WHAT IS FOREX?
The foreign exchange market (FOREX) is a
worldwide decentralized over-the-counter financial
market for the trading of currencies
In simple words, it is a place where one currency is
exchanged with another currency based on
fluctuation rates
For every international sale or purchase of
commodities, services or assets, there corresponds
an international sale or purchase of currencies
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Codes for selected Currenciesrequired for quotes USD – US Dollar EUR – Euro
GBP – British Pound IEP – Irish Pound
JPY – Japanese Yen CHF – Swiss Franc
CAD – Canadian Dollar AUD – Australian Dollar
SEK – Swedish Kroner MEP – Mexican Peso
DKK – Danish Kroner NZD – New Zealand $
INR – Indian Rupee SAR – Saudi Riyal
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CHARACTERISTICS OF FOREIGN EXCHANGE MARKET
Only market open 24 hours: FX Market is a 24 hour market
It starts when a calendar business day opens in Sydney, Tokyo, Hong Kong, Singapore and then moves to Middle East to Europe to New York to the West Coast of United States where the calendar business comes to a close
FX Market operates seven days a week (Middle East Markets function on Saturdays and Sundays)
Effectively it is a 24 hour a day / seven days a week / 365 days a year Market!
Size : Daily turnover of over $3.98 trillion
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Currency appreciation/depreciation
Increase in foreign currency price
From Rs.60.80 to Rs.65.12/ USD
Foreign currency appreciation
Home currency depreciation
From USD 0.0164 to USD 0.0163/ Re
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A Day of Foreign-Exchange Trading
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Foreign exchange markets
Organizational setting within which
individuals, governments and banks
buy and sell foreign currencies.
Only a small fraction of daily
transactions in foreign exchange
involve trading of currency.
Most foreign exchange transactions
involve transfer of bank deposits.
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Foreign Exchange Markets
The foreign exchange market has mainly two segments:
Spot markets Forward markets
The rate at which one currency is traded foranother is called exchange rate
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Spot Market
The exchange rate for immediate delivery is called Spot Exchange Rate and is denoted by S (.) e.g. S (Rs./$) = Rs.60.80/$
Here immediate delivery means delivery after two business days
The market where the purchase and sale of currencies is contracted for spot delivery is called the Spot Market
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Quotations at the FX Market
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Direct Quotes
In case of ‘direct’ quotes, a unit of foreign currency is quoted in terms of domestic currency
For example:At Mumbai foreign exchange market , the US dollar is quoted as:
USD 1 = Rs. 60.6978/8060
Spot (bid) = Rs. 60.6978/$Spot (ask) = Rs. 60.8060/$
Rule : “ Buy low: Sell high”
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Indirect Quotes
In case of ‘indirect’ quotes, a unit of domestic currency is quoted in terms of foreign currency
For example:At Mumbai foreign exchange market , the quotation are made as:
Rs. 100 = USD 2.0762/0767
Spot (bid) = $ 2.0767/Rs.100Spot (ask) = $ 2.0762/ Rs.100
Rule : “ Buy high: Sell low”
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Direct & Indirect Quotes
Sometimes the quotes are made against 100
units of a currency instead of a unit of the
currency
European quotes are indirect quotes
Indian quotes are direct quotes
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Spread
Ask and bid differential is called the spread When quotes are direct :
Spread = Ask – Bid When quotes are indirect :
Spread = Bid – Ask Spread represents cost of transaction It is represented by the percentage of spread and is given by: 1.[( Ask- Bid)/ Ask] x 100 when quotes are direct 2. [(Bid – Ask)/ Bid] x 100 when quotes are indirect
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Forward Market
Forward contracts are bought and sold at forward exchange rates
Hedging and speculation are the main activities which pertain to forward markets
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Forward Exchange Rate
The exchange rates for delivery and payment at specified future dates are called Forward Exchange Rates and is denoted by F(.)
For example, 60 days F (Rs./$) : forward rate between rupees and dollar is the rate at which the foreign exchange dealer can arrange a transaction between rupees and dollar 60 days
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Forward Exchange Rate
Forward exchange rates are determined by forward demand and forward supply of various currencies
A foreign currency is said to be at a forward premium if its future value exceeds its present value in terms of domestic currency and it is said to be at discount if the converse is true
For example : S (Rs./$) = Rs. 60.70 F (Rs./$) = Rs. 60.90
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Quotation for Forward Exchange Rate
These rates are also quoted in the form of ‘bid’ and ‘ask’ rates and the spread also depend on approximately the same factors as spot rates plus:
Rate of Interest Demand and Supply Speculation about Spot Rates and Exchange Regulations
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Indian Forex Market
In Indian forex market, not all currencies are bought or sold
For non-traded currencies, the banks use London, New York or Singapore markets
Exchange Market Segments:
1. RBI and ADs( Commercial Banks)2. Interbank market3. Retail segment – ADs with corporate clients and other retail customers
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Indian Forex Market
The rates quoted by authorised dealers (ADs) are merchant rates at which trading can take place in the Retail segment
Merchant rates are different than
inter-bank rates and contain administrative cost, cover for exchange fluctuation and some profit on the transaction for the Bank
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Indian Forex Market
In India, the official rate is determined by the RBI on the basis of the multi-currency basket
The official buying and selling rates are announced
FEDAI announces indicative free market rate on
every business day
The RBI has the discretion to enter the market so as to stabilize the exchange rate
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Foreign exchange market
Foreign exchange market
Retail wholesale
Bank and money changes
(currencies and bank note, cheques)
Interbank(Bank account
or deposits)
Central bank
Indirect(Through broker)
Spot
Direct
Forward Derivatives(Future options etc.)
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Interbank Foreign Exchange Trading
About 90% of foreign
exchange trading is in
the Interbank part of
the market.
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Interbank Foreign Exchange Trading
Provides continuous
information on the
foreign exchange
market—
Talking with traders at
other banks.
Observing prices (exchange
rates) being quoted.
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Foreign Exchange and Forward Contracts
What is a forward
foreign exchange
contract?
An agreement to exchange
one currency for another
on some date in the
future at a price set now
[the forward exchange
rate].
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Participants of FE Market
The participants in the foreign exchange market are:-
Individuals Corporate/Firm Commercial Banks Central Bank/Governments International Agencies/Exchange
Brokers
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Balance of Payments B of P – is a record of the value of all
economic transactions between residents of a country
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Settlement of Transactions
SWIFT :
Society for Worldwide Interbank Financial Telecommunications
- a co-operative society owned by about 250
banks in Europe and North America
- registered in Brussels, Belgium
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Settlement of Transactions
CHIPS :
Clearing House Interbank Payment System- an electronic payment system owned by 12 private commercial banks constituting New York Clearing House Association
CHAPS : Clearing House Automated Payment System - London
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Determinants of Spread
The currency being traded The volume of currency being traded The nature of organization making quotes Overall perception of the Dealer about the
conditions of the economy and forex market
Usually these spreads are regulated by foreign exchange dealers associations such as FEDAI
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Factors Determining Spot Exchange Rates
Balance of Payments Inflation Interest Rates Money Supply National Income Resource Discoveries Capital Movements Political Factors Psychological Factors and Speculation Technical and Market Factors
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Need and Importance of Foreign Exchange Markets
Foreign exchange markets represent by far the most important financial markets in the world. Their role is of paramount importance in the system of international payments. In order to play their role effectively, it is necessary that their opera tions/dealings be reliable. Reliability essentially is concerned with contractual obligations being honored. For instance, if two parties have entered into a forward sale or purchase of a currency, both of them should be willing to honors their side of contract by delivering or taking delivery of the currency, as the case may be.
Types of foreign exchange
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.
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Types of Exchange Rates
Types of rates are quoted:
1. TT( Telegraphic Transfer) rate2. Bill rate
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TT (Telegraphic Transfer) Rate
Transactions where TT rate is applied:
Issue/ Payment of demand drafts, mail transfers, telegraphic transfers etc.
Foreign bill collected and amount received in Nostro account
Cancellation of foreign exchange sold/ purchased earlier
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Bill Rate
Rate applied for a foreign bill purchased or payment
against import bill
Bill Buying rate: Basic rate (+ or -) Forward Premium ( Discount) for transit period plus usage period –Exchange margin
Bill selling rate = TT selling rate + service margin
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FOREX SYSTEM IN BANKING
FOREX
import export
REMITTANCE
EXPORTIMPORT
Outright sale basic
Consignment basic
physicalnon-
physical
Merchandise and
software
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Theory of Purchasing Power Parity (PPP)
The prices of tradable goods, when expressed
in a common currency, will tend to equalize
across countries as a result of exchange rate
changes
Occurs because process of buying goods in a
cheap market and reselling them in expensive
market affects demand for (and price of) the
foreign currency and the market price of the
good in the two product markets in question 8-38
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The prices
these Mexican
shoppers pay
for foreign-
made goods are
affected by
fluctuations in
the value of the
peso in the
foreign-
exchange
market8-39
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CASE STUDY : McDonald’s
McDonald’s Corporation is the world’s leading global food service retailer, with nearly 29000 restaurants in 120 countries
Today more than 65% of total revenue is derived internationally which is increasing its foreign exchange & interest rate risks
THE NEED: Further increase the effectiveness of the interest rates
and foreign exchange hedging programs Wanted to implement a leading-edge solution that
would help achieve this goal while containing costs. Needed to maintain consistency with the long-standing
risk management to policy requiring Treasury to be able to price and manage every derivative they transact
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They used ‘basket option strategies’ to hedge their interest rate & foreign exchange risks
A basket option is an option whose payoff depends on the value of a portfolio(or basket) of assets
McDonald’s was looking for an upgrade in technology to help the Treasury build the currency basket option, so….
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SOLUTION: It hedges their interest rate & foreign
exchange exposures, which are made up of foreign income & assets & their domestic & foreign debt portfolio, by using following approaches:
1. Qualitative Analysis: uses the underlying economic fundamentals for each country, and the currency is analyzed to determine when it is necessary to hedge
2. Quantitative Analysis: relies on mathematical models to analyze assets vs. liabilities implies using different weightings of different baskets
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McDonald’s evaluated several system based software solutions to evaluate hedge effectiveness but they lacked the flexibility & the analytical coverage needed to price many of the complex derivatives
In 1996, they choose FINCAD’s Microsoft Excel based financial engineering software as a pricing tool which allows them to price their derivatives portfolio, enabling them to work more efficiently with instruments such as baskets, average rate & double average rate options.
Those exotic currency option allow them to hedge their exposures in a more cost-effective manner
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McDonald’s also uses FINCAD Analytics to analyze their portfolio of interest rate swaps, currency swaps & swaptions.
They built spreadsheet templates for these instruments and linked them to live market data from Reuteurs & Bloomberg which enables them to calculate mark-to-market values in real time
It saved their lot of time. FINCAD listens to its customers & continues to improve its product based on user feedback & industry trends
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