a guide to foreign exchange

8/14/2019 A Guide to Foreign Exchange

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www.crownagentsbank.com 1

Crown Agents BankAn Introduction to Foreign

An Introduction toForeign Exchange

Crown Agents Bankwww.crownagentsbank.com


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Crown Agents BankAn Introduction to Foreign Exchange

2 www.crownagentsbank.com

Contents

Foreword 3

What is Foreign Exchange? 4

Spot Transactions 5

Forward Transactions 8

Currency Options 15

Settlement 17

International Currency Codes 19

Crown Agents Bank 22

Contact Details 23


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Foreword

Graham GodleyManaging DirectorCrown Agents Bank

I am pleased to introduce this publication: an easy to read guidefor those who would like a better understanding of foreignexchange.

Like all markets, the practice and terminology of the foreign

exchange market can be intimidating to outsiders andnewcomers. However, those involved in international businessneed to understand how the market works, the risks whentransacting business in foreign currencies, and how those riskscan be mitigated, even if they do not speak the jargon.

This guide introduces basic transactions and processes, withsimple examples and pricing illustrations.

If you would like to discuss specific foreign exchange issues inmore detail, please contact our Treasury team whose details aregiven on the back page.


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What is Foreign Exchange?

Foreign exchange is the exchanging of the currency of one countryfor that of another. This is undertaken using the foreign exchangemarket, a market that has no physical exchange or trading floor.Deals are conducted by means of electronic trading systems, bytelephone or, at the retail level, over a banks counters. Users of the market include banks, governments, companies and private

individuals.

Not all the worlds currencies are freely convertible. There are anumber which cannot be converted without satisfying officialexchange control regulations. Others are not in high enoughdemand to ensure liquidity and a viable market. The range of currencies that are traded is wide and includes the currencies of all the major developed countries. Those that are less frequently

traded are known as exotic currencies.

The foreign exchange market is very active and prices are in a

constant state of change, reacting moment by moment tovariations in the pattern of trading, to announcements of neweconomic data, to news items and to a myriad of other factors.Quotations are therefore only good for very short periods andcustomers must agree to deal quickly to avoid changes.


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Spot Transactions

A spot foreign exchange deal is a transaction in which onecurrency is exchanged directly for another for settlement two working days later (to allow each party time to arrange paymentto the other).

The price at which a deal takes place is known as the spot rate .This is expressed as the value of a unit of one of the twocurrencies in terms of the other currency. For example, the spotrate for an exchange between the US dollar and the Swiss francwould be quoted as 1 dollar = 1.6000 francs. In this example thedollar is the unit or base currency and every dollar is worth 1.6francs. The general practice in the spot market is to measure thevalue of currencies against the US dollar and so, when the USdollar is one of the currencies being exchanged, it is normally theunit or base currency in the exchange rate. There are someexceptions to this rule, notably the pound sterling and the euro.


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A spot rate of exchange Foreign exchange rates are quoted in currency pairs. The firstcurrency named in the pair is always the unit currency. Forexample:-

EUR/USD: = 1.1670/80 (i.e. 1.1670 to 1.1680)

EUR/USD are the two currencies. The codes are the

international three letter codes used by financial institutions.EUR = Euros; USD = US dollars. Every currency has beenassigned such a code. The full list of currency codes is shownon pages 19-21. Rates quoted are two-way. The left-hand side (i.e. 1.1670)

is where the dealer will buy the unit currency. This is knownas the bid . The right-hand side (i.e. 1.1680) is where thedealer will sell the unit currency. This is known as the offer .

Most prices are quoted to four decimal places (exceptionsinclude JPY which is usually quoted to two decimal places).In the above example 1.16 is called the big figure and 70/80are the points or ticks .

The difference between the bid rate and the offer rate isknown as the spread . The exchange rate in this example hasa ten point spread.


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Other currency pairs

USD/CHF 1.2810/20 = Dealer will buy USD 1 for CHF 1.2810

or

will sell USD 1 for CHF 1.2820

GBP/USD 1.7500/10 = Dealer will buy GBP 1 for USD 1.7500

or

will sell GBP 1 for USD 1.7510

USD/JPY 116.00/10 = Dealer will buy USD 1 for JPY 116.00or

will sell USD 1 for JPY 116.10


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Forward TransactionsA forward exchange deal is a transaction in which one currency isexchanged directly for another for settlement at a specified time more than two working days after the deal date . No moneychanges hands until the specified settlement date, which can beat any time (within certain limits) to suit the parties. Settlementis made at the rate of exchange agreed between the parties at thetime of dealing.

The purpose of a forward exchange deal is to fix the cost of exchange at a future date to cover an anticipated foreign

exchange commitment.


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Using a forward transaction A transport company in Europe buying trucks directly from aJapanese manufacturer will be required to make payment in yenon delivery of the vehicles, which may be scheduled severalmonths after the order is placed. If the company maintains itsaccounts in euros it will be necessary to sell euros for yen. Ratherthan wait until the delivery date to buy yen, and risk an increasein the cost of yen on the foreign exchange market, the company

could buy yen forward when it places the order. If the forwardsettlement date is matched to the delivery date for the trucks,the company will receive the yen it needs when it needs themand, by dealing at the time the order is placed, avoid the risk of suffering a loss on exchange, and the uncertainty of not knowingwhat the cost in euros will be.


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How is the exchange rate of a forward transaction fixed?There is no uncertainty or guesswork in calculating a forwardprice. It is based on known market values: the prevailing interestrates and the spot exchange rates for the two currencies.


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Example of a forward transaction To demonstrate how a forward price is calculated, assume thatBRITCO, a UK company, expects a payment three months fromtoday of USD1m for goods which it needs to exchange into GBP.If there was no forward exchange market, what would BRITCOsalternatives be?

Either:

(a) - Do nothing now. Wait until the payment is made and thensell USD for GBP at the market rate available at that time;

Or

(b) - Borrow USD 1 million for three months from today and usethis to buy GBP at todays exchange rate;

- place the purchased GBP on deposit for three months;

- use the USD payment expected in three months time torepay the USD borrowing (note the interest earned on thethree month GBP deposit can be sold for USD in threemonths time and put towards covering the interestcharges on the USD borrowing).

Continued


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Alternative (a) is risky. The exchange rate could move in

either direction over a three month period. If the GBPstrengthens, the value of the dollar payment will be less inthree months time than it is now. Of course, the reverse willbe true if the GBP weakens but is it worth taking a chance?

Alternative (b) is the prudent choice. It locks in todaysexchange rate and removes the risk of loss from a fall in thevalue of the USD. The cost of borrowing dollars may be fullycovered by the interest earned on the GBP deposit dependingon the level of interest rates in the two currencies. If it isnot, then the shortfall will be an extra cost to be factoredinto the exercise. It is a known extra cost, however, and theexercise still achieves its objective of removing theuncertainty over what will happen to exchange rates over thethree month period .


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A forward price calculation

A spot rate is adjusted to reflect the difference in interestrates for each currency

GBP interest rate for 90 days = 4% per annumUSD interest rate for 90 days = 2% per annumSpot GBP/USD exchange rate = 1.7500

So:Interest rate differential, GBP/USD = 2% per annum

or = 0.5% for 90 days

This can be expressed in the exchange rate as follows:

GBP1 + 0.50% of one pound = GBP 1.0050

GBP1.0050 = USD1.7500

GBP1.0000 = USD1.7500 = 1.74131.0050

The forward margin = 0.0087 (1.7500-1.7413)


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The difference between the spot and forward rates is known asthe forward margin and it represents the difference between thecost of borrowing USD and lending GBP for 90 days. The forwardmargin is the amount by which the spot rate needs to be adjustedto obtain a forward exchange rate.


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Currency Options

A currency option conveys the right, but not the obligation, eitherto buy or sell a specific amount of a currency for another currencyat a fixed price at a future date. The future date may be eitherthe latest date on which the option may be exercised or the onlydate on which the option is exercisable. The holder of an option isnot obliged to deal, however, and may choose simply to allow theoption to lapse.

The cost of a currency option is typically expressed as apercentage of the underlying amount. These options can be used

to secure the future value of a currency by, in effect, establishinga minimum future price without making a commitment to deal.

When used in this way an option can be thought of as an insurancepolicy. An option purchaser pays a premium (the cost of theoption) for the right to buy (or sell) a currency at a fixed exchangerate at a future date. If the spot rate at that future date is lessfavourable than the option rate, the holder can exercise the

option. If the spot rate at that future date is more favourable thanthe option rate, the holder can allow the option to lapse and dealin the market.


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Either way, the option has insured a maximum cost of thecurrency for the purchaser. The cost of the option is the price

the purchaser pays for the right to buy (or sell) at a fixed rateand thereby limit the risk of loss on exchange. In the same way,the cost of an insurance premium is the price of limiting the riskof loss of the insured item.

Using an option

In this example DutchCo is bidding for a contract which, if it isawarded to DutchCo, will be priced in US Dollars. The US dollarincome is a possible future cash flow that will need to be sold

for euros. Instead of entering into a commitment to sell dollarsforward, DutchCo could purchase an option to sell the dollars ata predetermined rate if and when the contract is awarded. If the value of the dollar has fallen by the date it receivespayment, it could exercise the option and deal at the betteroption rate. If the value of the dollar has not fallen, or if it hasrisen, DutchCo would simply allow the option to lapse and sellits dollars in the market at the spot rate. In this way DutchCowill be protected against a fall in the value of the dollar overthe period for a fixed cost, but will benefit from any rise in thevalue of the dollar.


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Settlement

When an exchange deal is settled the currencies involved do notcross their own national borders .

The settlement process

On Wednesday, the dealer at Bank A in London agrees to sellspot US dollars in exchange for Swiss francs to Bank B inFrankfurt.

Even though the two parties are located in London andFrankfurt, they have to settle their US dollars in New York andtheir Swiss francs in Zurich. Currencies do not cross theirnational borders.

On Friday:-

i) the Swiss franc side of the transaction settles in Zurich

with Bank Bs franc account being debited and Bank Asfranc account being credited (i.e. B pays francs to A).

ii) the US dollar side of the transaction settles in New Yorkwith Bank As dollar account being debited and Bank Bsdollar account being credited (i.e. A pays dollars to B).

This is illustrated in the diagram overleaf.


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Wednesday Spot deal

London Frankfurt

Bank A Bank B

sells USD USD buys

buys CHF CHF sells

Friday Settlement

New York Zurich

Bank A Bank A

pays USD CHF receives

Bank B Bank B

receives USD CHF pays


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International Currency Codes

Code Country Currency Code Country Currency

ALL Albania Leke CHF Switzerland Francs

AMD Armenia Drams CLP Chile Pesos

ANG Netherlands Antilles Guilders CNY China Yuan Renminbi

AOA Angola Kwanza COP Colombia Pesos

ARS Argentina Pesos CRC Costa Rica Colones

AUD Australia Dollars CUP Cuba Pesos

AWG Aruba Guilders CVE Cape Verde EscudosAZM Azerbaijan Manats CYP Cyprus Pounds

BAM Bosnia andHerzegovina

ConvertibleMarka

CZK Czech Republic Koruny

BBD Barbados Dollars DJF Djibouti Francs

BDT Bangladesh Taka DKK Denmark Kroner

BGL Bulgaria Leva DOP Dominican Republic Pesos

BHD Bahrain Dinars DZD Algeria Algeria Dinars

BIF Burundi Francs EEK Estonia Krooni

BMD Bermuda Dollars EGP Egypt Pounds

BND Brunei Darussalam Dollars ERN Eritrea Nakfa

BOB Bolivia Bolivianos ETB Ethiopia Birr

BRL Brazil Brazil Real EUR Euro Member Countries Euro

BSD Bahamas Dollars FKP Falkland Islands Pounds

BTN Bhutan Ngultrum FJD Fiji Dollars

BWP Botswana Pulas GBP United Kingdom PoundsBYR Belarus Rubles GEL Georgia Lari

BZD Belize Dollars GGP Guernsey Pounds

CAD Canada Dollars GHC Ghana Cedis

CDF Congo/Kinshasa Congolese Francs GIP Gibraltar Pounds


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GMD Gambia Dalasi LRD Liberia Dollars

GNF Guinea Francs LSL Lesotho Maloti

GTQ Guatemala Quetzales LTL Lithuania Litai

GYD Guyana Dollars LVL Latvia Lati

HKD Hong Kong Dollars LYD Libya Dinars

HNL Honduras Lempiras MAD Morocco Dirhams

HRK Croatia Kuna MDL Moldova Lei

HTG Haiti Gourdes MGF Madagascar Malagasy Francs

HUF Hungary Forint MKD Macedonia Denars

IDR Indonesia Rupiahs MMK Myanmar (Burma) Kyats

ILS Israel New Shekels MNT Mongolia Tugriks

IMP Isle of Man Pounds MOP Macau Patacas

INR India Rupees MRO Mauritania Ouguiyas

IQD Iraq Dinars MVR Maldives(MaldiveIslands)

Rufiyaa

JMD Jamaica Dollars MWK Malawi Kwachas

JOD Jordan Dinars MXN Mexico Pesos

KES Kenya Shillings MYR Malaysia Ringgits

KGS Kyrgyzstan Soms MZM Mozambique Meticais

KHR Cambodia Riels NAD Namibia Dollars

KMF Comoros Francs NGN Nigeria Nairas

KPW Korea (North) Won NIO Nicaragua Gold Cordobas

KRW Korea (South) Won NOK Norway Kroner

KWD Kuwait Dinars NPR Nepal Nepal Rupees

KYD Cayman Islands Dollars NZD New Zealand Dollars

KZT Kazakstan Tenge OMR Oman Rials

LAK Laos Kips PAB Panama Balboa

LBP Lebanon Pounds PEN Peru Nuevos Soles

LKR Sri Lanka Rupees PGK Papua New Guinea Kina


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PHP Philippines Pesos TND Tunisia Dinars

PKR Pakistan Rupees TOP Tonga Pa'anga

PLN Poland Zlotych TRL Turkey Liras

PYG Paraguay Guarani TTD Trinidad and Tobago Dollars

QAR Qatar Rials TVD Tuvalu Tuvalu Dollars

ROL Romania Lei TWD Taiwan New Dollars

RUR Russia Rubles TZS Tanzania Shillings

RWF Rwanda Rwanda Francs UAH Ukraine Hryvnia

SAR Saudi Arabia Riyals UGX Uganda Shillings

SBD Solomon Islands Dollars USD United States of

America

Dollars

SCR Seychelles Rupees UYU Uruguay Pesos

SDD Sudan Dinars UZS Uzbekistan Sums

SEK Sweden Kronor VEB Venezuela Bolivares

SGD Singapore Dollars VND Vietnam Dong

SHP Saint Helena Pounds VUV Vanuatu Vatu

SIT Slovenia Tolars WST Samoa Tala

SKK Slovakia Koruny XAG Silver Ounces

SLL Sierra Leone Leones XAU Gold Ounces

SOS Somalia Shillings XCD East Caribbean Dollars

SPL Seborga Luigini YUM Yugoslavia New Dinars

SRG Suriname Guilders ZAR South Africa Rand

STD So Tome andPrincipe

Dobras ZMK Zambia Kwacha

SVC El Salvador Colones ZWD Zimbabwe Zimbabwe Dollars

SYP Syria PoundsSZL Swaziland Emalangeni

THB Thailand Baht

TJR Tajikistan Rubles

TMM Turkmenistan Manats


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Contact our Treasury Team

David SmithsonTel: +44 (0)208 710 6126Email: [email protected]

Nick GorynTel: +44 (0)208 710 6039

Email [email protected]

Crown Agents Bank Crown Agents Bank quotes competitive foreign exchange andmoney market rates in all the major and many exotic currencies.We also offer accounts in many currencies for prompt receiptand payment of overseas and domestic funds.

Our clients include central banks, governments, developmentagencies, NGOs and other organisations worldwide.

The combination of our competitive rates and flexible service

delivery is a winning formula for our clients.


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Contact our Treasury Team

David SmithsonTel: +44 (0)208 710 6126Email: [email protected]

Nick GorynTel: +44 (0)208 710 6039

Email [email protected]

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