introduction forex

8/9/2019 Introduction Forex

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Management of Forex TransactionsRecommended Books:

International Financial Management

by Jeff Madura International Financial Management

By P.G.Apte

Foreign Exchange : Practice,Concepts and Control by C.Jeevanandam


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Foreign ExchangeIntroduction

Prof Mahesh Kumar

Amity Business School

[email protected]


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3

A Comment

There is no sphere of human influence

in which it is easier to showsuperficial cleverness and theappearance of superior wisdom as inmatters of currency and exchange

Winston Churchill

House of Commons 1946


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Introduction Every nation has its own currency. Most

international financial transactions involves anexchange of one currency for another.

The price of one currency in terms of anotheris known a exchange rate.

Foreign exchange markets provide themechanism of exchanging different monetary

units. Foreign Exchange Markets facilitate transfer of

purchasing power from one country to another.


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Introduction Apart from trade, sometimes, nationals of one

country may prefer to hold financial assets in aforeign currency or denominate in foreign

currency because domestic currency is subjectto high inflation and therefore less attractive asa store of value.

Exchange dealers do the job of exchange ofcurrencies.

The demand and supply in the foreignexchange market permits the establishment ofrates of different currencies in terms of localcurrencies.


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Importance of Foreign Exchange Markets Foreign exchange markets role is of paramount

importance in the system of internationalpayments.

Reliability, essentially concerned withcontractual obligations being honoured, is oneof the important feature of foreign exchangemarket.


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As per Foreign Exchange Act, (Section 2), 1947.

(c) "Foreign Currency" means any currency other

than Indian currency;(d) "Foreign Exchange" means includes anyinstrument drawn, accepted, made or issued underclause (8) of section 17 of the Banking RegulationAct, 1956, all deposits, credits and balance payable

in any foreign currency, and any drafts, travelerscheques, letters of credit and bills of exchange,expressed or drawn in Indian currency but payablein any foreign currency;

BASIC CONCEPTS/TERMINOLOGIES

Foreign Currency vs.

Foreign Exchange


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Financial Markets Financial market is a place where

Resources/funds are transferred from thosehaving surplus/excess to those having a

deficit/shortage.


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Foreign Exchange Markets The market where the commodity traded is

Currencies.

Price of each currency is determined in term of

other currencies.


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The Demand Side of inter-bank market

importers buying foreign exchange to financetheir imports.

A host of regulations governing imports intoIndia.

Out ward remittances for debt servicing.

Out ward remittances for services.

PTEQ and BTQ, Medical treatment etc.

Repatriation of profit of foreign controlledcompanies and freight collection etc.

A host of other invisible payments.

Disinvestment through SCRA

Forex Transactions


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The Supply Side of inter-bank market

Exports regulations governing exportreceipts.

Home remittances.

Foreign Direct Investment.

Capital account receipts.

Investment through SCRA.

A host of other invisible receipts.

Forex Transactions


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Exposure to exchange rate movement.

Any sale or purchase of foreign currency entails

foreign exchange risk. Foreign exchange transaction affects the net

asset or net liability position of the buyer/seller.

Carrying net assets or net liability position in

any currency gives rise to exchange risk.

Foreign Exchange Risk


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NOP is the Net Asset/Net Liability position in all FCs

together (Both B/S & Off B/S).

Net Asset Position is also called LONG or

Overbought position. Net liability Position is also called SHORT or

Oversold position.

NOP is a single statistic that provides a fairly good idea

about exchange risk assumed by the bank.

Its major flaw is that FX exposures in third currenciesremain hidden.

NET OPEN POSITIONNET OPEN POSITION-- (NOP)(NOP)A measure of foreign exchange riskA measure of foreign exchange risk


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EXAMPLE (NOP)EXAMPLE (NOP) (USD in Mio)

Opening Position $ 0.00

ReadyPurchasesfrom Exporter $ 1.00

FwdPurchasesfromCorporate(1.00 Euro) \ $ 0.90

ReadySelltoimporter( 60 Mio Yen) - $ 0.50

FwdSelltoCorporate - $ 0.40

NET OPEN POSITION $ 1.00


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Any financial transaction that involves more than onecurrency is a foreign exchange transaction.

Most important characteristic of a foreign exchangetransaction is that it involves Foreign ExchangeRisk.

What is a Foreign ExchangeTransaction ?


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PARTICIPANTS IN THE FOREIGNEXCHANGE MARKET

All Scheduled Commercial Banks

(Authorized Dealers only).

Reserve Bank of India (RBI).

Corporate Treasuries. Public Sector/Government.

Inter Bank Brokerage Houses.

Resident Indians

Non Residents Exchange Companies

Money Changers


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Exchange Rate

Is the price of foreign currency.

INR/USD is usually stated as Indianrupees per dollar. An increase inexchange rate implies depreciation incurrency and vice versa.


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Foreign Exchange Market Types

Markets driven by float method- Central bankdoes not buy or sell foreign exchange and the price isdetermined in private market place. Exchange rate isdetermined by demand and supply of foreign

exchange. Markets driven by fix method- Central bank fix

their exchange rates by active trading in the fxmarket.

Markets driven by intermediate method- CentralBank practices managed floating whereby they

intervene in the FX market by leaning against thewind. Central Bank sells foreign exchange when theexchange rate is going up thereby dampening its riseand buying when it is going down so as reduce thevariability in the exchange rate.


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Forex Market-Control & Influencing Factors

Market Sterilization :An increase in foreignexchange reserves will add to the money supplywhich could lead to inflation. To offset central banktakes steps which are known as sterilization

operations. A common way to accomplish it is byselling bonds in the open market or by increasingthe reserve requirements for commercial banks.


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Factors affecting foreign exchange rates Fundamental factors: Exports and imports of

merchandise. Political and psychological factors Technical factors

- capital movement- relative inflation rates- exchange rates policy and intervention- Interest rates

Speculation

Others: Macro economic fundamentals like growthrate of economy, trade balances, inflation ratesetc.


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Types of Foreign Exchange MarketsThe major foreign exchange markets that existare:

1. Spot markets

2. Forward markets3. Futures markets

4. Options markets

5. Swaps markets

Futures, Options & Swaps are calledderivatives because they derive their valuefrom underlying exchange rates.


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Types of Foreign Exchange Markets Spot market refers to the transactions

involving sale and purchase of currencies forimmediate delivery. In practice, it may takeone or two days to settle the transaction.

Forward market transactions are meant to besettled on a future date as specified in thecontract. Though forward rates are quoted justlike spot rates, but actual delivery of currency

takes place much later, on a date in future. Future market transactions are meant to be

settled on exchange on a future date asspecified in the contract.


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Types of Foreign Exchange Markets Options are derivative instruments that give a

choice to foreign exchange instruments thatgive a choice to foreign exchange operator to

buy or sell a foreign currency on or up to adate (maturity date) at a specified rate (strikeprice).

Swaps, as the very term suggests, are simplythe instruments that permit exchange of twostreams of cash flows in two differentcurrencies.


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Important Foreign Exchange Markets The most active foreign exchange market is

that of UK (London) followed by that of USA,Japan, Singapore, Switzerland, Hong Kong,

Germany, France & Australia. All other markets, combined together,

represent only about 15% of the total volume,traded globally.


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V

olume of Transactions International trade represents only a small

part of foreign exchange operations.

Movement of capital & currency positions held

by banks constitute a major segment ofexchange business.

About 5% of volume traded on marketsrepresents the need of international trade and

international tourism. 10-15% pertains tomovement of capital like investment funds.


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V

olume of Transactions The larger part of currency movements are of

short term type and the bulk comes from foreignexchange operations of big commercial banks.

This percentage may however undergo changes infutures. Firstly because foreign exchange needsdue to trade are developing at a faster pace thanthose due to inter bank exchanges. Secondly, aftercoming into existence of common currency, like

Euro, profit due to exchange operations bydifferent banks within European Union are going todisappear.


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Characteristics of Foreign Exchange Market The transactions on exchange markets are

carried out among banks. Rates are quotedround the clock. Every few seconds quotations

are updated. Quotations start in the dealing room of

Australia & Japan (Tokyo) and they pass on tothe markets of Hong Kong, Singapore,Bahrain, Frankfurt, Zurich, Paris, London, NewYork, San Francisco & Los Angeles beforerestarting.


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Characteristics of Foreign Exchange MarketIn terms of convertibility there are three kind of currencies:

1. The first kind is fully convertible in that it can be freelyconverted into other currencies.

2. The second is partly convertible for non residents.

3. The third kind is not convertible at all and it holds true forcurrencies of a large number of developing countries.

It is the convertible currencies which are mainly quoted on theforeign exchange markets. The most traded currencies are USdollars, Deutsche Mark, Japanese Yen, Pound Sterling, SwissFranc, French Franc & Canadian Dollar.

Currencies of developing countries such as India are not yetin much demand internationally. The rates of such currenciesare quoted but their traded volumes are insignificant.


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Characteristics of Foreign Exchange Market The composition of transaction in terms of

different instruments varies with time. Spottransactions remain to be the most important

in terms of volume. Next come Swaps,Forwards, Options & Futures in that order.


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Typical Distribution of Counterparties of

Banks in the Foreign Exchange Market

Counterparty Percentage

Exchange Brokers 42.5

Non Resident Banks 25.2

Resident Banks 17.3

Other Clients 15.0


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Dealing Room All the professionals who deal in currencies,

options, futures and swaps assemble in dealingroom. This is the forum where all transactionsrelated to foreign exchange in a bank are carried

out.

There are several reasons for concentrating theentire information and communication system in asingle room. It is necessary for the dealers to haveinstant access to the rates quoted at differentplaces and to be able to communicate amongstthemselves, as well as to know the limits of eachcounterparty etc. This enables them to makearbitrage gains, whenever possible.


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Connection with Commercial Banks Commercial banks which participate in the

market communicate between themselvesthrough a network of telephones, faxes and

the means of communication supplied byReuters, Telerate, Bloomberg etc.

Similarly economic, political and financial newswhich is likely to influence the markets iscommunicated rapidly.


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Competing Automatic Trading System There are number of trading systems e.g.

1. Reuters- Dealing 2000 which ensures automaticexecution of orders. This means that dealer who placesan order is automatically linked to a counter party

instead of his having to search for counterparty.

2. Other system is known as Electronic Booking System(EBS) which provides trading platform to a group of 200dealers in 60 banks and institutions.

3. Another system is MINEX which is supported by a

consortium of Japanese banks, Japanese Brokers,Japanese company of telecommunication, KDD &Telerate and is used particularly in the Asian region.


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Competing Automatic Trading System

The advantage of the above systems is that itenables the operators to

1. Reduce commission charged by brokers.

2. Know rapidly the divergences which mayappear, for instance, with respect to interestrates on the one hand and spot and forwardrates on the other. Significant difference may

yield arbitrage operations profitable for them


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The Front Office and Back Office

The dealers who work directly in the market andare located in the dealing rooms of big bankconstitute the Front Office.

They meet the clients regularly and advise themregarding the strategy to be adopted with regardto their treasury management.

The role of dealer is two fold

1. To manage the positions of client.

2. To quote bid-ask rates without knowing whether aclient is a buyer or a seller. Dealer should be readyto buy or sell as per the wishes of the client andmake profit for the bank.


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The dealers also need to consider the limits fixed by theManagement of the bank with respect to each singleoperation or single counterparty or position in aparticular currency. Dealers are judged on the basis of

their profitability. The operations of front office are divided into several

units. There can be sections for money market andinterest rate operations, for spot transaction, forforward market transactions, for currency options, for

dealing in futures & so on. Each transaction involves determination of amount

exchanged, fixation of an exchange rate, indication ofdate of settlement and instructions regarding delivery.


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The Back Office (BO) consists of group of persons whowork, so to say, behind the FO. Their activities includemanaging of the information system, accounting,control, administration and follow up of operations of

Front Office. Back Office ensures an effective financial and

management control of market operations.

In principle, Front Office and Back Office should functionin a symbiotic manner on equal footing.


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Forex Market- Definition & Introduction

Def: The foreign exchange is the market in whichforeign currency e.g. USD, GBP, JPY,EURO is traded fordomestic currency e.g. INR.

Forex Market is a decentralized network highly

integrated via modern information & telecommunicationtechnology.

Spot Market

Futures Market

Forex Market Options Market

Forward MarketSwap Market


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Salient Features of Forex Market

Location

Foreign exchange market is an OTC market as there is noplace where participants meet to execute the deals.

The term foreign exchange market is used to refer to thewholesale segment of the market, where the dealings takeplace among the banks.

The retail segment refers to the dealings that take placebetween banks and their customers.

The leading foreign exchange market in India is Mumbai.

Kolkata, Chennai and Delhi are the other major centres.


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Size of the Market

Foreign exchange market is the largest financial market inthe world.

The average daily turnover is USD 3.98 trillion.

The largest foreign exchange market is in London followedby New York, Tokyo, Zurich and Frankfurt.

Indian Rupee (INR) is not an internationally tradedcurrency as it is involved in only 0.3% of the transactionstaking place in world foreign exchange markets.

USD, GBP, Euro, JPY and Swiss Franc are the leadingcurrencies in which most of the global trade takes place.


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24 hour Market

Foreign exchange market functions throughout24 hours of the day.

In India, the market is open for the time thebanks are open for their regular bankingbusiness. No transactions take place onSaturdays and Sundays.


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Efficiency

Developments in communications have largelycontributed to the efficiency of the market and

the foreign exchange markets are very efficientfinancial markets.

Any significant development in any market isalmost instantaneously received by other

market situated at a far off place and thus has aglobal impact.


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Participants of Forex Market

The participants of foreign exchange market comprise:

1. Corporates: They operate in the market to meet theirgenuine trade or investment requirements.

2. Commercial banks: They buy and sell currencies for their

clients. They also operate on their own. When the bankenters a market to correct excess sale or purchaseposition in a foreign currency arising from its various dealswith its customers, it is said to a cover operation.However major volume of foreign exchange trade by thebank is to gain from exchange movements.

3. Exchange brokers: They ensure that the most favorablequotation is obtained at a low cost in terms of time andmoney.

4. Central Banks:


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Purpose of Transacting

There are three main purposes for transacting inforex market:

1. Hedging: Hedgers are those who have an

exposure to risk and resort to foreign exchangemarket as a means of covering their position.Hedging is the method of entering into anopposite position in the market to that of theposition held in a currency so that ultimately theposition becomes zero.


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2. Speculation: Speculators enter into deals withthe expectation of making profit out of suchtransactions. A speculator watches the market

carefully and makes his own estimates of thefuture movements in the rates. Based on hisestimates he makes moves in the market andhopes to gain from the ultimate results.Speculators as a class are risk takers. They are

the cause for both volatility and efficiency of themarket.


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3. Arbitrage: Arbitrageurs keep constant vigil onthe market, across products and locations, toidentify temporary imperfections and convert

such opportunities into risk less profits. In pureform of arbitrating, the operator:

a) Has no investment and

b) Simultaneous buys and sells in different markets

and/or for different periods which ensures riskless profits to him.


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Settlement of Transactions

Banks use exclusive network SWIFT (Society forWorldwide Interbank Financial Telecommunication) tocommunicate messages and settle the transactions atelectronic clearing houses such as CHIPS (Clearing HouseInterbank Payment System) at New York and CHAPS

(Clearing House Automated Payment System) at London. Foreign exchange transactions are settled through Nostro

and Vostro accounts. Nostro: our account with banks abroad. Reserve

Bank of India (RBI) maintains various Nostroaccounts in a number of countries.

Vostro: their account with us. Many multilateralagencies (e.g. IMF, World Bank) maintain theirVostro accounts at Reserve Bank of India (RBI).


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Transactions in Interbank Markets

In foreign exchange transactions two points need to be kept inmind:

a) The transaction is always talked of from the quoting banks point ofview;

b) The item referred to is the foreign currency Therefore when we say purchase, we imply that

a) The quoting bank has purchased

b) It has purchased foreign currency

Similarly when we say a sale, we imply that

a) The quoting bank has sold; and

b) It has sold foreign currency.

Thus in purchase transaction the quoting bank acquires foreigncurrency and parts with home currency. In a sale transaction thequoting bank parts with foreign currency and acquires homecurrency.


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Types of Transactions

The transactions in inter-bank market may fall underany of the following categories:

a) Spot transactions

b) Forward transactionsc) Swap transactions

d) Non-deliverable forwards


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a) Spot transactions:

These are transactions where the exchange of currenciestake place two days after the date of contract.

The date on which the currencies are exchanged is thevalue date.

Both the currencies are paid on the same day so thatthere is no loss of interest to either of the parties.

Where the agreement to buy or sell is agreed upon andexecuted on the same date, the transaction is known as

cash or ready transaction. It is also known as value today.

A transactions in which the currencies are to beexchanged on the next day the transaction are known asvalue tomorrow or tom transaction.


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b) Forward Transactions:

The transaction in which the exchange of currencies takesplace at a specified future date, subsequent to the spotdate, is known as a forward transaction or outright

forward transaction. The forward transaction can be for delivery one month or

two months or three months etc.

A forward contract for delivery one month means theexchange of currencies will take place after one month

from the date of contract. The date of forward contract will be calculated from spot

date. For instance, 1 month forward contract entered intoon 22nd March will fall due on 24th April.


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c) Swap Transaction:

A swap transaction is a deal between the samecounterparties in which the same currency for same valueis purchased and sold for different maturities.

For instance, Dena Bank and IDBI Bank agree underwhich Dena Bank buys USD 5 million spot and sells itforward for 2 months.

The difference between the spot price and forward price isequivalent to the forward margin and is also known as

swap point.


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d) Non Deliverable Forwards

In this type of transaction, on the due date, the spot ratefor the currency concerned is compared with the forwardrate agreed under the contract and the difference is

settled. The settlement is invariably done in US dollars.


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Quotations in Inter Bank Markets

The big banks in the market are known as marketmakers, as they are willing to buy or sell foreigncurrencies at them up to any extent.

a) Two Way Quotation:

Typically, the quotation in the inter bank market is a twoway quotation. It means, the rate quoted by the marketmaker will indicate two prices, one at which it is willing tobuy the foreign currency, and the other at which it iswilling to sell the foreign currency. E.g. USD1=Rs.46.1523/1650

The buying rate is also known as the bid rate and theselling rate as the ask rate. The difference between theserates is the gross profit for the bank and is known as thespread.


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a) Direct Quotation:

The exchange rate quotation which gives the price for theforeign currency in terms of the domestic currency is knownas direct quotation.

In a direct quotation, the unit of foreign currency is keptconstant and change in price is indicated by the change inthe number of units of the domestic currency equivalent toone foreign currency.

Direct quotation is also known as home currency quotation.

The Maxim- Buy Low; Sell High: The prime motive of any

trader is to make profit. In foreign exchange too, the bankbuys the foreign exchange at a lesser price and sells it at ahigher price. For instance it may buy US dollars at Rs.48 andsell at Rs.48.10. Thus in direct quotation the principleadopted is buy at a lower price and sell at higher price.


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b) Indirect Quotation: The type of quotation that gives the quantity of

foreign currency per unit of domestic currency isknown as indirect quotation.

In indirect quotation, the unit of domestic currency iskept constant and the change in the price of thecurrency is indicated by the varying units of theforeign currency for fixed sum of domestic currency.

Indirect quotation is also known as foreign currencyquotation or simply currency quotation.

The Maxim-Buy High; Sell Low: For example, forRs.100, the bank may quote a selling rate of USD2.30 and buying rate of USD 2.31. The differencebetween USD 2.31 and USD 2.30 is the banksmargin of profit.


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c) American and European Quotation: Interpretation of quotations as direct and indirect is not

convenient when the market quotes rates for twocurrencies neither of which is the domestic currency.

International markets adopt the US dollar as the standard

currency and exchange rates are quoted in terms of oragainst this currency.

The quotation is in American terms when the rate isexpressed as so many units of US dollars per unit offoreign currency.

The quotation is in European terms when the quotation is

the number of foreign currency per unit of US dollar. In international markets rates are generally quoted in

European terms.


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d) Cross Rates and Chain Rule: The exchange rate in the foreign exchange market

is quoted in terms of the standard currency, vizUS dollar. The exchange rate between a pair of

currencies, neither of them being US dollar isworked by using the rate for each of thesecurrencies in terms of US dollars.

For instance, suppose the rate of Swiss Franc isrequired in terms of Indian rupees and the ratesof Mumbai market are as under

USD 1 =Rs.46.50USD 1 = CHF 1.8000

The rate of Swiss Franc in terms of rupees can becalculated by chain rule as follows:


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?Rs. = CHF 1if CHF 1.80= USD 1

USD 1 = Rs.46.50 It should be noted that the currency which appears

as the second item (the right hand side) in the firstequation appears as the first item (left hand side) inthe second equation. US dollars which appears onthe right hand side in the second equation appearson the left hand side in the third equation.

The rate of exchange between Indian rupee and

Swiss franc can be calculated by dividing the productof the right hand side by the product of the left handside.

46.50*1*1/1.80= Rs.25.83


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d) Forward Rates Forward rate may be the same as the spot rate

for the currency. More often the forward rate for a currency may

be costlier or cheaper than its spot rate. The difference between the forward rate and the

spot rate is known as the forward margin orswap points.

The forward margin may be either at premium

or at discount.


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If the forward rate is at premium, the foreigncurrency will be costlier under the forward ratethan under the spot rate.

If the forward margin is at discount, the foreign

currency will be cheaper for forward deliverythan for spot delivery. Under direct quotation, premium is added to the

spot rate to arrive at the forward rate. This isdone for both purchase and sale transactions.

Discount is deducted from the spot rate toarrive at the forward rate.


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Interpretation of Inter Bank Quotations

The market quotation for a currency consists of the spotrate and the forward margin.

For instance, US dollar is quoted as under in the interbank market on 25th January as under:

Spot USD 1= Rs.48.4000/4200

Spot/ February 2000/2100Spot/ March 4000/3600

From above quotations following points are to be noted:1. The quoting banks spot buying rate is 48.4000 and the

selling rate is Rs.48.4200

2. Spot/ February rate is valid for delivery end February.Spot/ March rate is valid for delivery end March.3. The margin is expressed in points, i.e.0.0001 of the

currency. Therefore the forward margin for February is 20paisa and 21 paisa


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introduction forex

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