INTERNATIONAL FINANCE

MBA(FT)

TOPIC 04
Foreign Exchange Markets and Exchange
Rate Arithmetic
Introduction
• The businesses are moving across the nations and denominating transactions in
several currencies
• This pose serious issues for the managers working in MNCs;
• They have to understand the foreign exchange markets and conventions.
• They need to understand the causes of exchange rates to change
• The fluctuating exchange rate pose a serious challenge on the bottom line.
• The factors causing fluctuations are beyond the control of managers.
• We have informally tried to understand why the currency value goes up and down
in value.
• Currency change is a type of risk which affects the value of the firm.
• First let us understand the Foreign exchange markets.
• Later on we would focus on - How can we manage this risk in:
• The short term
• The long term
Topic Outline
• General information of the foreign exchange market.
• Definition
• Why does it exist?
• Characteristics:
• How big is it?
• Who does it include?
• Bid-Ask spread
• In what markets is FX traded?
• Specific kinds of market within FX market.
• Spot market
• Forward market
• Swap market
• Futures market
What is Exchange rate?
• The price of one currency in terms of another currency is called an
exchange rate.
• Forex Market
• Currencies are bought and sold in foreign exchange markets.
• This market provides the institutional, physical and technological
infrastructure to carry out foreign exchange transactions.
Foreign Exchange Transaction
What is FX Market?
• What is the foreign exchange market?
• It is market where currency traded
• What do you get when you trade currency?
• It is giving you purchasing power in different countries
• Therefore, the foreign exchange market is nothing more than a market to
exchange purchasing power in different countries.
Nature and Geographic Distribution of the Foreign Exchange Markets

• It exists all across the globe and Virtually, all currencies are traded in some
foreign exchange market or the other.

• The Dominant currencies which are traded everywhere are those of the
developed countries including US $, Euro, Yen, Pound Sterling.
• Foreign Exchange markets operate 24 by 7, Moving in sync with earth’s
rotation.
Structure and Features of Foreign Exchange Market
Exchange traded and OTC Markets
• Unlike most other financial assets, foreign exchange markets are OTC
markets.
• Buyers and sellers negotiate the price and other terms of the contract
between themselves
• SPOT markets are OTC whereas Derivatives markets are OTC as well as
Exchange Traded.
• Currency Futures are exchange traded
• Forwards and Swaps are OTC
• Options are mostly OTC but are also exchange traded
Structure and Features of Foreign Exchange Market
Participants
The foreign Exchange market consists of two tiers.
• The interbank or wholesale market,
• Client or retail market.
There are five broad categories of participants operating within these two
tiers:
• Bank and non bank foreign exchange dealers
• Foreign exchange brokers
• Hedgers, Speculators and arbitragers
• Central banks and treasuries
• Individuals and firms conducting commercial or investment transactions
Structure and Features of Foreign Exchange Market
Participants-Wholesale Forex Market
• The market is popularly known as inter-bank market.
• Bank and non-bank financial institutions transact with each other
• They undertake trading on behalf of customers, but majority of trading is
undertaken for their own account by proprietary desks
• Besides banks and non-bank financial institutions, multinational
corporations, hedge funds, pension and provident funds, insurance
companies, mutual funds etc. participate in the wholesale market.
Structure and Features of Foreign Exchange Market
Participants-FX Dealers and Brokers
• Banks and some nonblank financial institutions act as foreign exchange
dealers.
• These dealers quote both “bid” and “ask” for a particular currency pair (for
spot,forward and swap contracts) and take opposite side to either buyers or
sellers of currency.
• They make profit from the spreads between buying and selling prices ie., bid
and ask rate.
• The dealers are market makers.
• Dealers do not necessarily make markets for all currency but specialize in
some currency pair(s).
• Brokers are agents, which merely match buyers and sellers and get a
brokerage fee.
Structure and Features of Foreign Exchange Market
Participants-Authorized dealers in India
• In India, we have three categories of Authorized Dealers (ADs)
• CATEGORY-I:
Select banks to carry out all permissible current and capital account transactions as per
directions issued from time-to-time
• CATEGORY-II:
Select entities to carry out specified non-trade related current account transactions, all the
activities permitted to Full Fledged Money Changers and any other activity as decided by the
Reserve Bank
• CATEGORY-III
Select financial and other institutions to carry out specific foreign exchange transactions
incidental to their business / activities

• select registered companies as Full Fledged Money Changers (FFMC) to undertake

purchase of foreign exchange and sale of foreign exchange for specified purposes
viz. private and business travel abroad.
Structure and Features of Foreign Exchange Market
Participants-Authorized dealers in India

https://www.rbi.org.in/Commonman/English/Scripts/AuthorizedDealers.aspx#CI
Structure and Features of Foreign Exchange Market
Trading Volume
• How big is the wholesale market?
• E.g. if look at all currencies exchange markets – and calculate the dollar
equivalent amount to understand the size of this market.
• This information comes out every three years by the bank of international
settlements (BIS) together central banks around the world, the average daily $
and non-$ (converted into $) turnover was: (https://stats.bis.org/statx/srs/table/d11.1)
• 1986: $ 250 billion
• 1998: $1.4 trillion
• 2001: $ 1.2 trillion
• 2004: $ 1.9 trillion
• 2010: $ 4.0 trillion
• 2013: $ 5.3 trillion
• 2016: $ 5.1 trillion
• 2019: $ 6.6 trillion
Structure and Features of Foreign Exchange Market
Trading Volume
 Structure and Features of Foreign Exchange Market
Trading Volume

• Why are they so large?

• Foreign exchange market exists to facilitate international trade
• Trade gone up, You need more money to make the settlement.
• Why is it growing?
• World is becoming economically integrated.
• Why did the volume decline 2001?
• 1.1.1999 – Euro came into existence and then common currency reduced
trading of Belgium francs with Swiss francs and so on.
• September 11, 2001 – terrorists attacks – risk gone up – trade gone down,
investments gone down
Structure and Features of Foreign Exchange Market
Trading Volume
Structure and Features of Foreign Exchange Market
Communication
• Communication among the participants takes place through Society for
Worldwide Interbank Financial Telecommunication (SWIFT).
• Every currency has been assigned three letters code for avoiding
miscommunication.

• Currency Codes: https://www.iban.com/currency-codes

Structure and Features of Foreign Exchange Market
Communication-Example
• Trader Mike were asking market maker Hans to give quotes for buying and
selling $10 million for Swiss francs.
• Mike could contact Hans by electronic dealing system or by telephone and ask
rates on “spot dollar-swissie on ten dollars.”
• Hans might respond that “dollar-swissie is 1.4585-90;”or maybe “85-90 on
5,”but more likely, just “85-90,”
• Here, Hans is willing to buy $10 million at the rate of CHF 1.4585 per dollar,
and sell $10 million at the rate of CHF1.4590 per dollar.
• Hans will provide his quotes within a few seconds and Mike will respond
within a few seconds.
• In a fast-moving market, unless he responds promptly—in a matter of
seconds—the market maker cannot be held to the quote he has presented.
Also, the market maker can change or withdraw his quote at any time,
provided he says “change” or “off ” before his quote has been accepted by the
counterpart.
Structure and Features of Foreign Exchange Market
Communication-Example
• When he hears the quotes, Mike will either buy, sell, or pass—there is no
negotiation of the rate between the two traders.
• If Mike wants to buy $10 million at the rate of CHF1.4590 per dollar, Mike will
say “Mine” or “I buy” or some similar phrase. Hans will respond by saying
something like “Done—I sell you ten dollars at 1.4590.” Mike might finish up
with “Agreed—so long.”
• Each trader then completes a “ticket” with the name and amount of the base
currency, whether bought or sold, the name and city of the counterparty, the
term currency name and amount, and other relevant information.
• The two tickets, formerly written on paper but now usually produced
electronically, are promptly transmitted to the two “back offices” for
confirmation and payment.
•.
Forex Transaction Settlement
Forex Transaction Settlement
• In order to understand this, we must recognize two activities associated
with any forex Transaction
1. Trading activity – two counterparties to the transactions agree on the
quantum of currencies to be bought or sold and the exchange rate at
which it will be executed. This forex contract is binding on both the
counterparties.
• Trading date - The date on which the trade is carried out is called trading date
2. Settlement activity relates to when and how the trade was executed on
about the trading date is settled. How the currency amounts are to be
paid or received as per foreign exchange contract.
• Settlement date - The date on the which the process of debiting and crediting the
parties account take place is called settlement date.
Forex Transaction Settlement
• The transactions are classified based on the difference between trade date
and settlement date.
• ‘t’ referred to as ‘Trade date’
• Cash Transactions

• Example: transactions you undertake with moneychanger when you go to

the airport or hotel
Forex Transaction Settlement
• When a person goes to money changer/bank and buys one currency by
paying another currency is an example of Cash transaction and the rate
quoted by the money changer/bank is the spot / cash exchange rate.
• For example, in India, some hotels buy or sell foreign currency over the counter.
• Normally the hotel/antique shops will have a display board mentioning different INR rates for
different currency.
• Any guest visiting the hotel can buy or sell foreign currency at the rate displayed on the board. This
is an example of cash transaction where the trade date and settlement date coincide.
• Similarly in the interbank market, banks & financial institutions buy and sell
currencies at a rate prevailed on the trade date.
Forex Transaction Settlement
 THE SPOT MARKET
Exchange
•. Rate Quotations
• Types of Quotes
• Direct-Indirect quote
• American- European Quote
• Base-Variable quote
Direct- Indirect Quotes
(based on where currency is quoted)
Direct- Indirect Quotes
American Vs. European Quote
• A quote can be classified in American or European style only if one
of the currencies is Dollar.
1. American Quotation
• $ expressed in terms of any other currency
• S($/INR) = 0.0139
2. European Quotation
• Any other currency is expressed in terms of Dollar
• S(INR/$) = 72
Base-Variable Quotation
1 USD = 100 JPY
 Roll over of Spot/Tom contract:
• Many times, settlement for spot/tom transactions may not happen on the T+1 or T+2,
but gets rolled over.
• In a typical spot/tom transaction, actual delivery of one currency and receipt of other
currency happens between two parties.
• However, many forex traders are speculators.
• They do not trade with the intention of delivering (the currency they have sold) or
receiving currency (the currency they have bought), but wants to make profit from
speculation.
• Hence, forex brokers allow these speculators to rollover the contracts. Rollover delays the actual
settlement of the trade and it goes on until the trader closes its position.
• For deferring the settlement, forex brokers pay or receive interest from the trader. A
trader receives interest on the currency that has been bought and pays interest for the
currency that has been sold.
• Interest is calculated every day i.e., even for weekends. Depending on the prevailing
interest rate in the respective currencies, net interest is either added or subtracted from
traders account. This goes on until the trader squares up his open position. By providing
rollover facilities, forex brokers also earn significant brokerage fee.
 Roll over of Spot/Tom contract-Example
• On Day 1, a trader has entered into a spot transaction to sell USD 1000 to a forex broker and receive INR 67680.

• On the settlement day, (on Day 3), the trader should deliver USD 1000 and take INR 67680.
• However, both the trader and the broker agree not to settle but defer the settlement by another two days.
Hence, on Day 5, the trader pays USD 1000 and receives INR 67680.
• By deferring the settlement, it can be understood that the trader has given a loan of INR 67680 to the broker.
Simultaneously, the broker has given a loan of USD 1000 to the trader. Hence both owe each other interest for 2-
days.
• Hence, the trader pays interest rate on USD 1000 for two days. Similarly, the broker pays interest rate on INR
67680 for two days. The interest payment and receipt is netted off. After two days, either the trader or the broker
pays interest rate differential.
• The trader should receive INR interest (8%) for two days and pay USD interest (4%) for 2 days.
• The trader’s receipt would be (INR 29.67) and payment would be (USD 0.2222).
• Suppose the INR/US$ rate is INR 67.75 on day 2. Trader’s payment in INR terms is INR 15.05.
• With netting off, the trader receives INR 14.62.