Dr Pravin Kumar Agrawal Assistant Professor Department of Business Management CSJMU MBA Business Economics Foreign Exchange Market Foreign exchange market is the market in which foreign currencies are bought and sold This market is also termed as Currency FX or ID: 1027722
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1. Unit I Foreign Exchange MarketsDr. Pravin Kumar AgrawalAssistant ProfessorDepartment of Business ManagementCSJMUMBA (Business Economics)
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4. Foreign Exchange Market Foreign exchange market is the market in which foreign currencies are bought and sold. This market is also termed as Currency, FX, or forex market.Its participant comprises of individuals, firms, commercial banks, the central banks, importers and exporters, investors, brokers, immigrants, tourists.
5. Foreign Exchange Market The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the India to import goods from the United States and pay dollars, even though its income is in Indian rupees.
6. Characteristics of foreign exchange market High LiquidityMarket TransparencyDynamic MarketLower Trading CostOperates 24 HoursDollar Most Widely Traded
7. Base Currency / Terms CurrencyIn foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. Eg. The expression US Dollar–Rupee, tells you that the US Dollar is being quoted in terms of the Rupee. The US Dollar is the base currency and the Rupee is the terms currency.
8. Base Currency / Terms CurrencyExchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the other currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. Eg. If US Dollar–Rupee moved from 73.00 to 73.25, the US Dollar has appreciated and the Rupee has depreciated.
9. Market participates of foreign exchange MarketThe foreign exchange market assists international trade and investment by enabling currency conversion.For example, it permits a business in the United States to import goods from the European Union member states especially Euro zone members and pay Euros, even though its income is in United States dollars. The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies.
10. Commercial Bank These banks are the major players in the market. Commercial and investment banks are the main players of the foreign exchange market; they not only trade on their own behalf but also for their customers. A major chunk of the trade comes by trading in currencies indulged by the bank to gain from exchange movements. Interbank transaction is done in case the transaction volume is huge. For small volume intermediation of foreign exchange, a broker may be sought.
11. Central bankCentral banks like RBI in India (RBI) intervene in the market to reduce currency fluctuations of the country currency (like INR, in India) and to ensure an exchange rate compatible with the requirements of the national economy. For example, if rupee shows signs of depreciation, RBI (central bank) may release (sell) a certain amount of foreign currency (like dollar). This increased supply of foreign currency will halt the depreciation of rupee. The reverse operation may be done to halt rupee from appreciating too much.
12. Foreign exchange fixing Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator.
13. Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.
14. Investment management firms Investment management is the professional management of various securities (shares, bonds and other securities) and assets (e.g., real estate) in order to meet specified investment goals for the benefit of the investors. These firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities
15. Retail foreign exchange traders One of the most important tools required to perform a foreign exchange transaction is the trading platform providing retail traders and brokers with accurate currency quotes. Retail foreign exchange trading is a small segment of the large foreign exchange market.
16. Functions of Foreign Exchange Market Transfer Function The basic and the most obvious function of the foreign exchange market is to transfer the funds or the foreign currencies from one country to another for settling their payments. The market basically converts one’s currency to another.
17. Credit Function It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are generally used for international payments. Credit is required for this period in order to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.
18. Hedging Function A third function of the foreign exchange market is to hedge foreign exchange risks. Hedging means the avoidance of a foreign exchange risk. In a free exchange market when exchange rate, i. e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money. Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange.
19. Hedging Function A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate. The existence of a forward market thus makes it possible to hedge an exchange position.
20. Minimizing Foreign Exchange Risk The foreign exchange market provides "hedging" facilities for transferring foreign exchange risk to someone else. Thus, the foreign exchange market is merely a part of the money market in the financial centers. It is a place where foreign moneys are bought and sold. The buyers and sellers of claim on foreign money and the intermediaries together constitute a foreign exchange market. It is not restricted to any given country or a geographical area.
21. Types of FX Market
22. Spot market Spot market refers to the transactions involving sale and purchase of currencies for immediate delivery. In practice, it may take T+2 business days to settle transactions. Transactions are affected at prevailing rate of exchange at that point of time and delivery of foreign exchange is affected instantly. The exchange rate that prevails in the spot market for foreign exchange is called Spot Rate.
23. Forward Market A market in which foreign exchange is bought and sold for future delivery is known as Forward Market. It deals with transactions (sale and purchase of foreign exchange) which are contracted today but implemented sometimes in future. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called Forward Rate. Thus, forward rate is the rate at which a future contract for foreign currency is made.
24. Forward Transaction A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate‘. The market in which the deals for the sale and purchase of currency at some future date are made is called a Forward Market‘.
25. Future MarketStandardized forward contracts are called futures contracts and traded on a futures exchange. A futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and payment occurring at a specified future date.
26. Future TransactionThe future transactions are also the forward transactions and deals with the contracts in the same manner as that of normal forward transactions. But however, the transactions made in a future contract differ from the transaction made in the forward contract on the following grounds: The forward contracts can be customized on the client‘s request, while the future contracts are standardized such as the features, date, and the size of the contracts is standardized. The future contracts can only be traded on the organized exchanges, while the forward contracts can be traded anywhere depending on the client‘s convenience. No margin is required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept as collateral so as to establish the future position.
27. Option MarketA currency option gives an investor the right, but not the obligation, to buy or sell a quantity of currency at a pre-established price on or before the date that the option expires. The right to sell a currency is known as a “put option" and the right to buy is known as a “call option.”
28. ExampleAn option to buy US Dollar ($) for Indian Rupees (INR, base currency) is a USD call and an INR put. The symbol for this will be USDINR or USD/INR. Conversely, an option to sell USD for INR is a USD put and an INR call. The symbol for this trade will be like INRUSD or INR/USD.
29. SWAPA currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency.At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.During the length of the swap each party pays the interest on the swapped principal loan amount.
30. SWAP..At the end of the swap the principal amounts are swapped back at either the prevailing spot rate, or at a pre-agreed rate such as the rate of the original exchange of principals. Using the original rate would remove transaction risk on the swap.Currency swaps are used to obtain foreign currency loans at a better interest rate than a company could obtain by borrowing directly in a foreign market or as a method of hedging transaction risk on foreign currency loans which it has already taken out.
31. Fixed for Fixed currency swap An American company may be able to borrow in the United States at a rate of 6%, but requires a loan in Indian Rupees for an investment in India, where the relevant borrowing rate is 9%. At the same time, an Indian company wishes to finance a project in the United States, where its direct borrowing rate is 11%, compared to a borrowing rate of 8% in India.
32. ExampleRBI signs $400 million currency swap pact with Central Bank of Sri Lanka:The Reserve Bank of India (RBI) has signed a currency swap agreement with the Central Bank of Sri Lanka, the central bank said on Monday.The Central Bank of Sri Lanka can make drawals of US Dollar, Euro or Indian Rupee in multiple tranches up to a maximum of USD 400 million or its equivalent under a currency swap agreement, the RBI said in a release.The agreement signed under the SAARC Currency Swap Framework 2019-22 would be valid till November 13, 2022.Source: https://economictimes.indiatimes.com/markets/forex/rbi-signs-400-million-currency-swap-pact-with-central-bank-of-sri-lanka/articleshow/77201835.cms?from=mdr
33. Exchange Rate Mechanism“Foreign Exchange” refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his own nation’s currency for money denominated in another nation’s currency acquires foreign exchange.
34. Exchange Rate MechanismThis holds true whether the amount of the transaction is equal to a few rupees or to billions of rupees; whether the person involved is a tourist or an investor exchanging hundreds of millions of rupees for the acquisition of a foreign company; and whether the form of money being acquired is foreign currency notes, foreign currency-denominated bank deposits, or other short-term claims denominated in foreign currency.
35. Exchange Rate MechanismA foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian Rupees (INR) is, broadly speaking, “foreign exchange.”
36. Exchange Rate MechanismAlmost every nation has its own national currency or monetary unit - Rupee, US Dollar, Peso etc.- used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for “foreign exchange” transactions—exchange of one currency for another.
37. Exchange Rate MechanismThe market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range. But in countries like the United States, which follows a complete free floating regime, the authorities are not known to intervene in the foreign exchange market on a continuous basis to influence the exchange rate. The market participation is made up of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling US Dollars at that particular time.
38. Exchange Rate MechanismThe participants in the foreign exchange market are thus a heterogeneous group. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whatever is the constitution of participants, and whether their motive is investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market price at that instant. Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain exercise.
39. MAJOR CURRENCIES OF THE WORLD US Dollar ($) The Euro (€) The Japanese Yen (¥)
40. Quoting foreign Exchange RatesThe ratio between 2 currencies is called exchange rate.
41. Direct QuotesThe home currency price of a certain amount of a foreign currency eg. INR 45 / USD
42. Indirect QuotesThe value of one unit of home currency is presented in terms of Foreign Currency.USD 0.02857/INR
43. NumericalIf the direct quote is INR 63/USD, then how can this exchange rate be presented in Indirect quotes.
44. Exchange RateAn exchange rate between two currencies is the rate at which one currency can be exchanged for another.Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central banks of a country whereas floating exchange rates are decided by the mechanism of market demand and supply.
45. ExampleIn February 2, 2022, one USD was equal to 76.92 Rs., and one Indian ruppes was equal to 0.013 USD.
46. “Bid" and “Ask"The terms "bid" and "ask" refer to price quotes. The bid price is the highest amount a buyer is willing to pay for a security, such as a share of a stock. The ask price is the least amount the seller is willing to accept for that security.The bid is the price at which the market will buy a currency pair (before any commissions or fees), the offer (or ask) is the price at which the market will sell the currency pair (before any commissions or fees).
47. For example, a USDCAD exchange rate of 0.9950 means that 1 USD will return .9950 CAD.
48. For example, with USDINR, one would buy USD from the customer on the bid, thereby selling them INR. Alternatively, one would sell (or offer) the unit currency, USD, on the offer and buy the second currency (INR).
49. ExampleAn Indian company needs to purchase 100,000 US dollars to pay for imported goods.The USDINR quoted rate is 76.25 on the bid and 76.45 on the offer. By convention the USD is the unit currency and INR is the terms currency.The company will have to buy the USD on the dealer's offer, and will pay 76.45 for each dollar bought.The importer pays 100,000 x 76.45= 7645000 INR.
50. SpreadBuying Rate is known as Bid rateSelling rate is known as ask/offer rate.Bid rate = rate at which bank purchase foreign currency from customersAsk rate = rate at which bank sell foreign currency to customersThe difference is banks profit known as spread.It would be written as Rs. 40 – 40.30/USDEg. Bid rate = Rs. 40 Ask rate 40.30 for customers
51. SpreadThis difference is banks profit known as spread. % Spread = (Ask rate – Bid Rate) *100Ask Rate
52. Cross Rate Sometimes value of one currency in terms of another one is unknownThus one currency is sold for a common currency Again common currency is exchanged for a desired currencyThis is known as cross rate trading.Rate establish between two currencies is known as cross rates.
53. ExampleNewspaper quotes: INR 35.00 - 35.20 /USD & CAD 0.76 – 0.78/USDCross rate allows to establish relation between CAD and USD
54. How to Derive a Cross Rate from a Direct Quote & Direct Quote
55. ExampleRule: Divide the terms currency by the base currency on the opposite side.
56. How to Derive a Cross Rate from a Direct Quote & Indirect Quote
57. Rule: multiply on the same side
58. Quoting forward RatesSpot1 Months3 Months Rs. 40.000 - 40.30Rs. 39.80 - 40.20Rs. 39.60 - 40.10
59. Forward premium and DiscountChange in forward rates may be Increase or decrease.Thus, disparity arises between spot and forward rates.This is known as forward rate differential.If forward rate< spot rate = forward discountIf forward rate > spot rate = forward premiumThis premium/discount expressed as annulaized % deviation.
60. Forward Premium/Discount = (N day forward rates - spot rate) X 360Spot Rate(N)( 39.80 - 40.00) X 36040.0030 = -0.06= 6 % forward discount
61. CURRENCY FUTURES -DEFINITIONA futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity futures contract”.When the underlying is an exchange rate, the contract is termed a “currency futures contract”. In other words, it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future. Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value and delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date.
62. FACTORS DETERMINING EXCHANGE RATES
63. InflationInflation in the country would increase the domestic prices of the commodities. With increase in prices exports may dwindle because the price may not be competitive. With the decrease in exports the demand for the currency would also decline; this in turn would result in the decline of external value of the currency.
64. InflationIf, for instance, both India and the USA experience 10% inflation, the exchange rate between rupee and dollar will remain the same. If inflation in India is 15% and in the USA it is 10%, the increase in prices would be higher in India than it is in the USA. Therefore, the rupee will depreciate in value relative to US dollar
65. Interest rateThe interest rate has a great influence on the short – term movement of capital. When the interest rate of a country rises, it attracts short term funds from other countries. This would increase the demand for the currency of the home country and hence its value. Rising of interest rate may be adopted by a country due to tight money conditions or as a deliberate attempt to attract foreign investment. The effect of an increase in interest rate is to strengthen the currency of the country through larger inflow of investment and reduction in the outflow of investments by the residents of the country.
66. Country’s Balance of PaymentsA country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.
67. Political Stability & PerformanceA country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.
68. RecessionWhen a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.
69. Referenceshttps://iare.ac.in/sites/default/files/LECTURE%20NOTES-IFM.pdfaccesed on 24.4.22