Forex MarketsDr.P.Govindarajan

Forex Markets in 20th Century

• Affected by the two world wars• Post WW 1 forex markets were very volatile and subject

to large-scale speculations• Forex transactions became so risky that hedging by

forwards became basic components of forex transactions

• Forwards were considered speculative in nature• Failure of gold standard in 1931 and bank failures

caused significant setback• By middle of the decade markets returned to normalcy• London was the largest center of forex dealings between

the two World Wars

Post World War II• US Dollars ($) became the dominant currency• About 25 years post WW II forex markets were too

stable and controlled– Focus was on controlling the currency value

• UN conference held at Bretton Woods focused on– Stability– Confidence– Foster worldwide growth and prosperity

• Bretton Woods Agreement in 1944– World currencies pegged against US $– US $ was pegged to gold at $35 per ounce– US promised to convertibility of US $ to gold at the pegged

rate on demand– Pegged-exchange-rate system broke in 1971

Exchange Rate Systems

• Gold Standard – this system was in vogue till WW 1 consisting of the Gold Specie and Gold

Bullion Standards• Gold Specie Standard• Gold coins were an accepted medium of

exchange and the total money supply in a country was determined by the gold available for monetary purposes

• The country’s central bank guaranteed to buy and sell gold in unrestricted amounts at a fixed price

Exchange Rate Systems

• Gold Bullion Standard • Where the money in circulation was either partly

or entirely paper and gold served as reserve asset for the money supply

• The currencies of the countries which were on gold standards could be exchanged freely

• The exchange rate was determined by the content of the gold in the respective currency e.g..if the gold content in the currency of Britain was 3 times as much as that of USA then

• 1 GBP = 3 USD• Also known as Mint Parity Theory

Exchange Rate Systems

• Purchasing Power Parity Theory– Gold Standard abandonment forced the

world to look for a new exchange system– Simply stated currencies are valued for

what they can buy – E.g. If 100 Jpy can buy a Parker pen and

the same pen can be bought by 1 USD it can be inferred that since 1 USD and 100 Jpy can buy the same pen then 1 USD = 100 Jpy

Exchange Rate Systems

Purchasing Power Parity (PPP)This is just a broader/generalized form of “Law of one price”

PPP Domestic price level 10%, domestic currency 10%

1. Application of law of one price to price levels

2. Works in long run, not short run

Problems with PPP (and Law of one price)

1. All goods not identical in both countries

2. Many goods and services are not traded

• Bretton Woods System• to establish an international monetary system

with stable exchange rates• to eliminate existing exchange controls• to bring about convertibility of all currencies• System required the member countries to fix the

parities of their currencies in terms of USD or gold

• USA fixed the parity at USD 35 per ounce of gold• Collapse of the system in 1971 as USA pulled

out due to a run on the dollar• Then came the Smithsonian Agreement -

Floating Rate System

Exchange Rate Systems

Exchange rate system in India

• Historically linked to the Pound Sterling• As a signatory to the Bretton Woods RBI

was authorized to maintain par value of rupee within the permitted band of 1%

• First devaluation in 1966 running up to to 1995

• Delinked from the Pound Sterling in 1975 and linked to a basket of currencies

Determinants of the Exchange Rate

Determinants of the Exchange Rate

• Under a flexible rate system, the exchange rate is determined by supply and demand. – The dollar demand for foreign exchange originates

from American demand for foreign goods, services, & assets (real or financial).

– The supply of foreign exchange originates from sales of goods, services, & assets from Americans to foreigners.

– The foreign exchange market brings the quantity demanded and quantity supplied into balance.

• As it does so, it brings the purchases by Americans from foreigners into equality with the sales of Americans to foreigners.

Quantity offoreign exchange (pounds)

Q

$1.20

$1.50

$1.80

Dollar price of foreign exchange(for pounds)

Foreign Exchange Market Equilibrium

S(sales to

foreigners)

Excess demandfor pounds

Excess supplyof pounds

• The dollar price of the English pound is measured on the vertical axis. The horizontal axis indicates the flow of pounds to the foreign exchange market.

• The demand and supply of pounds are in equilibrium at the exchange rate of $1.50 = 1 English pound.

• At this price, quantity demanded equals quantity supplied.

• A higher price of pounds (like $1.80 = 1 pound), would lead to an excess supply of pounds ...

causing the dollar price of the pound to fall (depreciate).

• A lower price of pounds (like $1.20 = 1 pound), would lead to an excess demand for pounds …

causing the dollar price of the pound to rise (appreciate).

D(purchases from

foreigners)

e

Changes in the Exchange Rate

• Factors that cause a currency to depreciate: – A rapid growth of income (relative to trading

partners) that stimulates imports relative to exports.

– A higher rate of inflation than one's trading partners.

– A reduction in domestic real interest rates (relative to rates abroad).

Quantity offoreign exchange (pounds)

Q1

$1.50

$1.80

Dollar price of foreign exchange(for pounds)

a

Foreign Exchange Market Equilibrium

S(sales to

foreigners)

• Other things constant, if incomes increase in the United States, U.S.

imports of foreign goods and services will grow.• The increase in imports will increase the demand for pounds (in the foreign exchange market) causing the dollar price of the pound to rise from $1.50 to $1.80.

D1

Q2

D2

b

Quantity offoreign exchange (pounds)

Q1

$1.50

Dollar price of foreign exchange(for pounds)

Inflation With Flexible Exchange Rates

S1

• If prices were stable in England while the price level in the U.S. increased by 50 percent … the

U.S. demand for British goods (and pounds) would increase …

D1

D2

a

$2.25

S2

as U.S. exports to Britain would be relatively more expensive they would decline and thereby cause the supply of pounds to fall.• These forces would cause the dollar to depreciate relative to the pound.

b

Changes in the Exchange Rate

• Factors that cause a currency to appreciate: – A slower growth rate relative to one’s

trading partners.– A lower inflation than one's trading partners. – An increase in domestic real interest rates

(relative to rates abroad).

Factors affecting exchange rates • Balance of payments

• Strength of the economy• Fiscal policy• Interest rate• Monetary policy• Political factors• Exchange control• Central bank intervention• Speculation• Technical factors

Forex Market Practices & Participants

Around-the-clock FX trading

0

5,000

10,000

15,000

20,000

25,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Average Electronic Conversions Per Hour

Greenwich Mean Time

Tokyoopens

Asiaclosing

10 AMIn Tokyo

Afternoonin America

Londonclosing

6 pmIn NY

Americasopen

Europeopening

LunchIn Tokyo

Structure of FX Market (retail level)

Interbank mkt(Rs./$/FC)

domestic (Rs.) foreign (FC)

Exchange-tradedfutures & options

central bank

firms

investors

for. firms

for. central bank

for. investors

FX Interbank Market

dom.bank

Corp.order for.

bank

dom.bank

for.bank

FX broker

Corp.order

Corp.order

Corp.order

domestic (Rs.)

foreign (FC)

Rs./ $ / FC

Market participants• Customers those who buy and sell forex for

their trade requirements and other needs• Commercial banks are those authorized to

deal in forex• Hedge Funds – Invest and speculate on the

forex movements• Central banks – control volatile and undue

movements of their currency• Exchange brokers who act as intermediary

between banks for doing the deals

Market participants

• Customers– who are engaged in foreign trade avail these

services provided by the banks

– exporters need to convert their receivables

– importers need to remit their payables– may also need forex for settlement of other

international obligations

– are allowed to trade with some limitations

Market participants• Commercial banks

– deal with international trade transactions offer services for converting one currency into another

– specialized in international trade transactions and have branch/correspondent network

– have the authority to trade in forex besides merchant transactions

• Exchange brokers – deal on behalf of banks – act as intermediaries

Market participants

• Hedge funds – manage huge funds for their investors– have the mandate to trade a certain percentage of this

fund– invest based on the forecast of currency movements

and also try to move the market

• Central banks– have the responsibility to maintain the external value of

their currency– ensure that there is orderliness in exchange

movements through intervention

• Limited market makers• More market takers

• RBI presence

• Growing awareness amongst corporates to hedge

• Gross daily volumes approx USD 6 billion

• Limited time i.e.. 9 am to 4 pm for the market

Features of Indian FX Market

Exchange Rate Arithmetic – settlement

• Value date is a date on which the exchange of currencies actually takes place

• Cash is the same day transaction• Tom is the transaction on the next working day

after the deal date• Spot is the transaction on the second working

day after the deal date • Forward is the transaction after a period of

spot date

Quotes in Forex

• Direct Quotes

A foreign currency quoted in terms of the local currency e.g..USD/INR -- 1 USD = INR 45.25

• Indirect Quotes

Local currency unit quoted in terms of number of foreign currency

e.g.. INR/USD -INR100=USD2.2099

Currency pairs – Way they are quoted

USD/INR45.2500/2600

USD/JPY110.85/90

USD/SGD1.7085/90

USD/CHF1.2805/10

USD/AED3.6730/33

USD/HKD7.7922/32

USD/CAD1.3228/30

USD/LKR96.95/99

AUD/USD0.7605/10

EUR/USD1.2320/25

GBP/USD1.8205/08

NZD/USD0.6682/86

USD/PKR57.10/25

USD/PHP56.17/21

USD/TWD33.22/29

USD/KRW1172.50/80

ExamplesTo book an import cover in JPY/INR value spot• Spot USD / INR is 45.2725 / 2825• Spot USD / JPY is 110.75 / 79

• 45.2825 / 110.75 = 40.8870

To book an Export rate for value Spot in JPY/INR

• 45.2725 / 110.79 = 40.8633

Examples

To book an Import cover for AUD/INR value spot• Spot USD / INR 45.2725 / 45.2800• AUD / USD 0.7530 / 39• 45.28 X 0.7539 = 34.1365

To book an export cover in GBP/INR value spot• Spot USD / INR 45.2550 / 2625• GBP / USD 1.7975 / 78• 45.2550 X 1.7975 = 81.3460

ExamplesTo calculate the rate for an import cancellation value spot in USD/INR•Spot rate is USD/INR 45.2525 / 45.2650•Rate is 45.2525

To calculate an import cancellation rate in EUR/INR for value spot •Spot EUR/USD is 1.2338 / 41•Rate is 1.2338 x 45.2525 = 55.8325

Forex Forwards

Foreign exchange forward contract

• An agreement between a bank and a counter party to buy or sell a specific amount of one currency against another currency on a specific future date at a fixed rate

Forward Contracts – Bookings

• For any transaction that is to happen after the spot date a customer/bank can book either a purchase or sale forward contract

• Utilization of forward contracts on the due dates

Forward Contracts – Cancellations• In the absence of any instructions from the

customer, matured / unutilized contracts will be automatically cancelled after the specified grace period

• At the request of the customer it is optional for the bank to – Accept or give early delivery– Extend the contract– Cancel the contract before or after the maturity

date

• In all the above cases bank shall recover the costs incurred in effecting the transactions

Forward contracts - merits

• Simple hedge instruments• Works well when rates move in a band• Useful in long unidirectional movements• To overcome the time lag between buying

or selling goods and payment for the same

Factors affecting USD/INR forwards

• Call rate / G-sec yields• USD o/n rate / treasury yields• Govt. borrowing program• Credit policy announcements• Spot INR• Demand & Supply

Premium/discount• Determined by the interest rate differential between the two

countriese.g. : Spot USD/JPY 110.25 EUR/USD 1.2325INT rate USD 1.00% INT rate USD1.00%6 mths JPY 0.02% 6 mths EUR 2.00%Fwd disc 0.65 pips Fwd prm 59 pips

• The currency associated with the higher interest rate will be at a discount

• The currency associated with the lower interest rate will be at a premium

Forward rates• Derived by adding or deducting the premium or

discount to the spot ratee.g. : Spot $/INR 45.25 Euro/$ 1.2325

Aug end +0.085(Pr) (-)0.0049 (Dis)

2004

---------------- -------------

45.3350 1.2276

Examples

• To book a forward contract for an import transaction in USD/INR value 30st Nov,04

Spot USD/INR 45.2550 / 2650

Fwd (sp/Nov) 14.50 / 15.50

Rate is 45.2650 + 15.50 = 45.4200

• To book a forward contract for an exporter in USD/INR value 31st Aug,04

Fwd (sp/Aug) 8.50 / 9.50

Rate is 45.2550 + 8.50 = 45.3400

Examples• To book a contract to cover Euro export

value 31 Oct , 2004

Spot USD/INR 45.25 / 27 EUR/USD 1.2335 / 38

Fwd 11.5 / 12.5 72 / 70

(45.25 + 0.115) x (1.2335 - 0.0072)

45.365 x 1.2263

Rate 55.63

ExamplesTo calculate rate for an export cancellation for

value Jul,04 in USD/INR• USD/INR spot rate is 45.2750 / 2850• USD/INR fwd rate is sp/Jul 7 / 8• Rate is 45.2850 + 8 = 45.3650

To calculate a rate for an export cancellation in GBP/INR for value Jul,04

• GBP/USD fwd is 146 / 144 and spot is 1.8185 / 88• Rate is 45.365 x ( 1.8188 – 144) 1.8044 = 81.8565

Where we stand and the road ahead:• Increasing private and foreign participation in

major sectors such as insurance etc• Comfortable inflation position• Rapid adoption of technological advances in

almost all spheres• Move away from regulated regimes for all sectors

including the social sector– Linking of small savings rate to GSec rates

• Move towards universal banking and stricter NPA norms imply progressive cleaning up of banking and para-banking activities– more transparent and robust financial system

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