session 1-8 fx arithmetics

Prof. (Dr.) Paresh Shah, FCMA., Ph.D.(Finance), F.D.P. (IIMA)

Foreign Exchange Airthmetic

Domestic Currency And Foreign Currency

Domestic Currency denotes the currency in which the Annual Reports prepared. Known as Home Currency

Foreign currency denotes any currency other than the domestic currency

Foreign currency is a medium of exchange, and also store of value – an asset

Foreign currency is commodity in terms of commercial life

Exchange rate

Rate at which one currency is exchanged i.e., bought or sold for another currency

For any currency, there is an exchange rate for every other traded currency on the foreign exchange market

In an exchange rate , two currencies are involved Exchange rate quoted in four decimal places Rs./US$ means Rs. ……. Per unit US Dollar Rs. / € means Rs. ………….. Per unit Euro currency

Direct Quote

Direct quote - the exchange rate in terms of home currency per unit of foreign currency - used in India 1 € = Rs. 35 The price comes first, the commodity next FC is the commodity which is being sold and bought

Indirect Quote

Indirect quote – exchange rate in terms of foreign currency per unit of home currency Re. 1 = € 0.0286 The currency for which unit is fixed as “1” is the

commodity and the currency for which units vary is the price

An indirect quote is the reciprocal of direct quote

( 1/35) = 0.0286

Spot Rate Quotations

The direct quote for British pound is:

£1 = $1.5627

CountryUSD equiv Friday

USD equiv Thursday

Currency per USD Friday

Currency per USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.5906 0.5934 1.6932 1.6852

Brazil (Real) 0.2939 0.2879 3.4025 3.4734

Britain (Pound) 1.5627 1.566 0.6399 0.6386

1 Month Forward 1.5596 1.5629 0.6412 0.6398

3 Months Forward 1.5535 1.5568 0.6437 0.6423

6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975


The indirect quote for British pound is:

£.6399 = $1

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday

USD equiv FridayCountry


Note that the direct quote is the reciprocal of the indirect quote:

6399.

15627.1

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)


3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday


American quote v/s European term

A quote which is a direct quote for the American is said to be in American quote

A quote which is an indirect quote for the American is said to be European quote

The direct quote for British pound is: £1 = $1.5627

The indirect quote for British pound is: £.6399 = $1

American quote v/s European term

Since American term and European term are direct and indirect respectively for American, the European term can be said to be reciprocal of the American term

International quotes except £, NZ $, AU$, SA Rand, and € are all expressed in European terms

The Spot Market

Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

The Bid-Ask Spread

The bid price is the price a dealer (Bankers) is willing to pay you for something.

The ask price is the amount the dealer (Bankers) wants you to pay for the thing.

The bid-ask “spread “is the difference between the bid and ask prices. Spread will provide a margin to bank to cover costs and make a small profit

Factors determine size of Spread

Stability of exchange rate If exchange rate stable, the spread will be narrow If exchange rate volatile, the spread will be wider

Depth of the market Depth means volume of transactions in the market

Deep market – high volume of transactions - spread will be narrow

Thin market – low volume of transactions – spread will be larger

Two way quote

Bid and Ask on Foreign Currency Bid Ask

Bank Buys FC Sells FC

Sells LC Buys LC Customer

Buys LC Sells LC

Sells FC Buys FC

Three – tier Architecture

Header: Authorised dealers i.e., Scheduled banks Full fledged foreign exchange business

Sub-header: Co-operative and commercial banks Licensed to maintain

Bottom level: Money changers Licensed to carry our FOREX transactions by RBI

Two way Quotes

In the direct quote: Bid rate < Ask rate Bank always wants to gain

In the indirect quote:Ask rate > Bid rate

Bid (Rs./$) = 1 / Ask ($/Rs.) Ask (Rs./$) = 1 / Bid ($/Rs.)

Cross rate

Denotes an exchange rate that does not involve the home currency

Cross multiplication is the mechanism used to derive the exchange for a set of currencies, when the exchange rates for two other sets of currencies are available

A/B = A/C x C/B Bid (A/B) = Bid (A/C ) x Bid (C/B) Ask (A/B) = Ask (A/C ) x Ask (C/B)

Cross Rates

Suppose that S($/€) = .50 i.e. $1 = 2 €

and that S(¥/€) = 50 i.e. €1 = ¥50

What must the $/¥ cross rate be?

,¥

€

€

$

¥

$ since

¥100 $1or .01 ¥)/($¥100

1$

¥50

1€

2€

1$ S

Cross rate

Bid (A/B) = 1 / Ask (B/A ) Ask (A/B) = 1 / Bid (B/A )

Fluctuations

Inter day fluctuation intra-day fluctuation

Transaction based rates, rate for Bills - Export / Imports TT Buying / Selling TC Buy / Sell Currency Buy/ sell

Spot v/s Forward Rate

Spot rate- rate applicable for immediate settlement Transaction will be settled on the second working day

Forward rate – rate contracted today for exchange of currencies at a specified future date Customer and banker - obliged to perform on the

specified future date

Spot Foreign Exchange Microstructure

Market Microstructure refers to the mechanics of how a marketplace operates.

Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and decrease with dealer competition.

Private information is an important determinant of spot exchange rates.

The Forward Market

Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

The Forward Market

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

Forward contract to mean a transaction involving delivery, other than cash (delivery of the FX on the day of transaction), or TOM (delivery of FX on a working day next to the day of transaction) or Spot delivery of FX.

Forward Rate Quotations

The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.

Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

Longer-term swaps are available.

Forward Rate Quotations

Consider the example from above:

for US $, the spot rate is

$1.5627 = £1.00

While the 180-day forward rate is

$1.5445 = £1.00 What’s up with that?


Clearly the market participants expect that the pound will be worth less in dollars in six months.

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)


3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday


Forward Premium V/s. Discount

Forward premium – LC appreciating means LC become expensive and FC loose its value

Forward discount – LC depreciating means FC become expensive and local currency loose its value

RELATIONSHIP (Direct quote) FC > LC FC appreciating; LC depreciating FC < LC LC appreciating; FC depreciating

Forward Premium

It’s just the interest rate differential implied by forward premium or discount.

For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307

The forward premium is given by (Direct Quote): Indicates with respect to foreign currency %

02751.5235.

5235.5307.

180

360

€)/($

€)/($€)/($180$,€180

S

SFf v

Forward premium (Indirect Quote)Indicates with respect to Local currency %

02713.5307.

5307.5235.

180

360

€)/($

€)/($€)/($180$,€180

F

FSf v

Forward premium or Discount

If the answer is positive as per direct quote it means LC at Discount and FC at premium

If the answer is negative as per direct quote it means FC at Discount and LC at premium FC i.e., commodity Direct quote

Indirect quote Appreciating (LC Discount) Add

Deduct Depreciating (LC Premium) Deduct

Add

Determination

If swap Ask > Swap Bid, the LC is depreciating, FC is appreciating

If Swap Ask < Swap Bid, the LC is appreciating, FC is depreciating

Spot Rs./ US $ 45 / 45.20 Swap points 0.10/0.15 means INR depreciate

FR 45.10 / 45.35 Swap points 0.15/0.10 means INR appreciating

FR 44.85 / 45.10

Forward Cross Exchange Rates

It’s just an “delayed” example of the spot cross rate discussed above.

In generic terms

)/($

)/($)/(

and

)/($

)/($)/(

kF

jFjkF

jF

kFkjF

N

NN

N

NN

SWAPS

A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want.

Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

Swap points

FX can be quoted as Outright forward or Adjustment to sport rates (known as swap point)

The difference between the outright forward rate and spot rate known as swap differential or swap points.

Spread is difference between Bid and Ask rate

Swap V/s Spread

Term Bid Ask Spread Spot A B B – A Forward C D D – C

Swap C – A D – B Forward Bid : Bank’s buying rate in the forward

market Forward Ask : Bank’s selling rate in the forward

market

session 1-8 fx arithmetics

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