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Amity International Business School

Namita SahayAssistant Professor,AIBS

FOREIGN EXCHANGE

MARKETSNamita Sahay

Assistant ProfessorAIBS, Amity University





Drivers of growth in the foreign exchangemarket

• Globalization of trade and investments : based on theoryof comparative advantage

• Establishment of the WTO: helped in dismantling manyinternational trade barriers & extending the scope ofinternational trade to include a variety of commodities

and services.• Buoyancy in cross-border investments: FDI and FIIs

• Surge in M& A and strategic alliances





Monetary System

• Here money is used as a medium of exchange

• Has replaced the earlier barter system wherethe value of a commodity or service wasexpressed in terms of another commodity orservice.

• Money gives the purchasing power over goodsand services.





Foreign Exchange

• Foreign exchange refers to money denominatedin the currency of other another nation or agroup of nations.

• FX can be cash, funds available on credit cards

and debit cards, travelers'’ cheques, bankdeposits, or other short-term negotiable financial

claims.





Foreign Exchange Rate

It is the price of one currency in terms of anothercurrency or the number of units of one currencythat must be surrendered in order to acquire oneunit of another currency.





“Trade-weighted” or “Effective” rates

• These show a currency’s movements against anaverage of various other currencies.

• Ex : Dollar index ( which is a weighted indexagainst world major currencies like Euro, Pound

Sterling, Yen, and Canadian dollar.)





Dollar can be used as a :

• Investment currency in capital markets

• Reserve currency by central banks

• Transaction currency in international commodity markets

• Invoice currency in many contracts

• Intervention currency employed by monetary authoritiesin market operations





Introduction to foreign exchangemarkets

• Not located in a physical place. Is a virtual market.

• Is a facilitating mechanism where currencies are boughtand sold against each other.

• It is an OTC market.• OTC market: No single market or organized exchange,

electronic or physical( like SE) and wherebrokers/dealers negotiate directly with one another.





Introduction to foreign exchangemarkets cont..

• It trades 24 hrs a day except on weekends and spans allthe time zones of the world.

• Heavy trading during overlapping hours.

• Communication is done through telephone, telexes andelectronic means.

• Major market centers: London, New York ,Frankfurt,Singapore and Tokyo





Role/Purpose of International FXmarket

• Determines the relative values of differentcurrencies

• Assist international trade and investment, by

allowing businesses to convert one currency toanother





International Organization for Standardization(ISO)

• ISO has developed a three letter code or abbreviation forall currencies in the world to facilitate easy and efficientcurrency trading.

• Codes under this standard are referred to as ISO 4217,indicate the name of the country and its currency.

Ex.• USA-US dollar-USD-$

• Japan-Yen-JPY-¥





The Participants: Classification I

• Individuals

• Businesses: Corporations, Traders

• Investors: Retail and Institutional

• Commercial Banks

• Government : central banks

• Facilitators: Primary dealers & brokers





Facilitators: Primary Dealers

• Act as a principal in a transaction

• Conduct business in their own account bycommitting their own funds

• Rely on the bid-ask spread





Facilitators: Brokers

• Act as agents for an actual buyer/seller of foreign

exchange

• Provide quick excess to information & wide choice ofcounterparties.

• Do not commit their own funds

• Do not take positions hence no foreign exchange risks

• Rely on brokerage commission or fees from clients





The Participants: Classification II

Individuals and Corporations can also be classifiedas:

• Hedgers

• Arbitrageurs

• Speculators





Participants in the foreign exchange marketcont.

Hedgers: Those who participate in the foreign exchange

market to reduce the foreign exchange risk they face byinsuring themselves against adverse exchange rate

movements while benefiting from favorable movements.





Participants in the foreign exchangemarket (cont.)

Speculators: Those who take positions in the

foreign exchange market by anticipating whetherthe exchange rate will go up or down.





Participants in the foreign exchangemarket (cont.)

Arbitrageurs: Participants who make riskless

profits by entering into foreign exchangetransactions simultaneously in two or moremarket centers.





Participants in the market :ClassificationIII

According to BIS , the market participants in the foreign

exchange market can be classified as:

– Dealers

– Other Financial Institutions – Non-financial customers





Participants in the market :Dealers

• are financial institutions that actively participate in local

and global foreign exchange and derivative markets.

• Example: large commercial banks, investment banks,securities houses.

• They participate in inter-dealer market and have active

business with large customers such as corporate firmsand government.





Participants in the market : OtherFinancial Institutions

• Comprise of smaller commercial banks,

investment banks, securities houses, mutualfunds, pension funds, hedge funds, moneymarket funds, leasing companies, insurancecompanies, and other financial subsidiaries of

corporate firms and central banks.





Participants in the market :Non-financial customers

• Covers any market participant other than thosedescribed in dealers and other financialinstitutions.

• Example: government and corporations.





Market Makers

• Are dealers who offer two way quotes- bid andask for the currencies in which they are dealing.

• Contribute to liquidity, price discovery, and pricestability in the FX market by providing a

continuous market and price-sensitiveinformation.





The Indian foreign exchange market structure:

In India, foreign exchange transactions are carried out in

three segments:

– Transactions between the RBI and authorized dealers(ADs).

– The interbank market , where the ADs deal with eachother.

– The retail segment , where ADs and money changersdeal with forex customers





The Indian foreign exchange market structure :

• Decentralized 'interbank' market and retail market.

• Retail market: travelers and tourists• Interbank markets: commercial, investment & central

banks and MNCs.





Major markets

• The US & UK markets account for over 50% ofdaily turnover

• Major markets: London, New York, Tokyo

• Trading activity is heaviest when major marketsoverlap

• Nearly two-thirds of NY activity occurs in themorning hours while European markets areopen





SizeOne of the largest financial markets in the world

• $4.0 trillion average daily turnover, equivalent to:

– More than 12 times the average daily turnover ofglobal equity markets

– More than 50 times the average daily turnover of theNYSE

– An annual turnover more than 10 times world GDP• The spot market accounts for over one-third of daily

turnover





Average daily turnover by Instrument

Source: BIS Triennial Survey 2010





Average Daily Turnover by Geographic Location

Source: BIS Triennial Survey 2010





Average Daily Turnover by Currency





Currency Pairs

• Majors: EUR/USD (Euro-Dollar), USD/JPY,GBP/USD – (commonly referred to as the"Cable"), USD/CHF

• Dollar bloc: USD/CAD, AUD/USD, NZD/USD -

(commonly referred to as the "Kiwi")• Major crosses: EUR/JPY, EUR/GBP, EUR/CHF





Average Daily Turnover by Currency pair





The U.S. Dollar as a Vehicle Currency

• A substantial proportion of foreign exchange tradingtakes place through an intermediate currency, known asvehicle currency .

• Vehicle currencies reduce transaction costs in theforeign exchange market as they eliminate the need fordealers to keep a large number of currencies in hand.

• The U.S. dollar is now the most widely used vehiclecurrency in the world.





Market Infrastructure

• Dealings rooms

• Information and dealing systems

• Payment and communication systems





The Indian foreign exchange market tradingplatforms:

In India, there are four important platforms for the spot

trading of currencies: – FX-CLEAR

– FX Direct

– Reuters D2

– Reuters Market Data System (RMDS)





Information and Communication Systems

• Communications, pertaining to international financial transactions,are handled mainly by a large network called Society for WorldwideInterbank Financial Telecommunications (SWIFT).

• This is a non-profit Belgian cooperative with main and regionalcentre's around the world connected by data transmission lines.

• Depending on the location, a bank can access a regional processor

or main centre which then transmits the information to theappropriate location.





Information and Communication Systems cont.

• This computer based communications system links

banks and brokers in every financial centre.• The banks and brokers are in almost instant contact,

with activity in some financial centre or other 24 hours aday.

• Because of the speed of communications, significantevents have almost instantaneous impact despite huge

distances separating market participants.





Payment Systems

Major banks use automated interbank fundtransfer systems such as:

• CHIPS( Clearing House Interbank PaymentSystems) in New York

• CHAPS (Clearing House Automated PaymentSystems in London

• EBA ( Euro Banking Association) in Europe





Settlement and dealing locations

• Settlement locations: The relevant countries, the

currencies of which are exchanged are called settlementlocations.

• Dealing locations: the location of 2 banks involved in thetrade are called dealing locations

• Ex. A London based bank can sell JPY against USD to aParis based bank. Here, settlement locations are NewYork and Tokyo and dealing locations are London andParis.





Base/Unit and Variable Currency

• Base currency: is the first currency in the

currency pair• Variable currency: this is the second currency in

the currency pair.

• Exchange rates are quoted in per unit of the

base currency.• Ex: $/Re-rupee is quoted in terms of per unit

of dollar





Conventions in foreign exchangemarkets are as follows:

• Euro, GBP, AUD and NZD are base currencies in caseof USD. Thus USD is quoted as number of USDs perEuro or GBP

• USD is the base currency in case of INR, SGD, JPY.

Thus USD is always quoted as number of rupees oryens per USDs





Types of foreign exchange transactions

• Spot: for delivery within 2 working days

• Forward: contract now but delivery later• Outright forward contract: Forward contracts without an

accompanying spot deal. Ex. In import payables orexport receivables

• Swaps: spot-forward swap & forward-forward swap





Swap transaction

• A swap transaction in a foreign exchange market is acombination of a spot and forward in a opposite

direction.• The term ‘swap’ implies a temporary exchange

of one currency for another with an obligation to reverseit at a specific future date.

• Swaps are double deals- one deal involving a buy and

the other involving a sell, separated in time, but one hasto cancel the other.• 2 types: spot-forward & forward-forward





Spot-forward swap

• Spot-forward swap: one buys in the spot market and

sells in the forward market or the converse• Ex. If an exporter expects to receive USD 1000 one

month hence but needs money at present, he goes tothe bank and asks for a swap. He buys USD1000 in the

present, and sells them in the forward at a agreed price.





Forward-forward Swap

Forward-forward swap: one buys 1m forwardand sells 3m forward ,each deal canceling otheror vice versa





Application of swap deals

•Banks use swaps to offset positionscreated in outright forwards done withcustomers.

• Swap deals alter the timing of cash flows.





Forward rate

Forward rate is the rate at which the actual exchange ofcurrencies takes place at a specified date in future.

• If FR (in the home currency)>SR foreign currency is ata premium.

• If FR (in the home currency)<SR foreign currency is ata discount.

• If FR=SR foreign currency is flat• Swap margin: difference between spot and forward

exchange rate





Forward Rate. Example

• Ex 1 Suppose the rates are:

Spot interbank rate of USD1 = Rs 45.20Three-month forward USD1 = Rs 45.50

Therefore, USD at premium than INR

• Ex 2 Suppose

Spot interbank rate of USD1 = JPY 117Three-month forward USD1 = JPY 116.30

Therefore, USD at discount than JPY




Namita Sahay

Forward premium /discount

• Forward Premium/discount =

Forward rate – Spot rate------------------------------

Spot rate

•Annualized percentage forward premium/discount =Forward rate – Spot rate 360

------------------------------ x -------------------------- x 100

Spot rate No of days of foreign contract

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