Market for Foreign Exchange

Meaning of Forex
• Foreign Exchange Market is a place where foreign
money are bought and sold.
• It is a institutional arrangement for buying and
selling of foreign currencies.
• Exporter sell the Foreign currencies and importers
buy them.
• The FX Market encompasses the conversion of
purchasing power from one currency into another,
bank deposits of foreign currency, the extension of
credit dominated in a foreign currency, foreign
trade financing, trading in foreign currency options
and future contracts and currency swaps.
 Definition
• Foreign exchange market is the market in which foreign
currencies are bought and sold. The buyers and sellers
include individuals, firms, foreign exchange brokers,
commercial banks and the central bank.
• Like any other market, foreign exchange market is a
system, not a place. The transactions in this market are
not confined to only one or few foreign currencies. In
fact, there are a large number of foreign currencies
which are traded, converted and exchanged in the
foreign exchange market.
 Characteristics
• Electronic market
• Geographical dispersal
• Transfer of purchasing power
• Intermediary
• Provision of credit through letter of credit
• Minimization of risk
Functions of Foreign Exchange
• Transfer function
• Credit function
• Hedging function
 1. Transfer Function:
• The basic function of the foreign exchange market is to
facilitate the conversion of one currency into another,
i.e., to accomplish transfers of purchasing power
between two countries. This transfer of purchasing
power is effected through a variety of credit
instruments, such as telegraphic transfers, bank draft
and foreign bills.
• In performing the transfer function, the foreign
exchange market carries out payments internationally
by clearing debts in both directions simultaneously,
analogous to domestic clearings.
 2. Credit Function:
• It provides credit for foreign trade. Bills of
exchange, with maturity period of three
months, are generally used for
international payments. Credit is required
for this period in order to enable the
importer to take possession of goods, sell
them and obtain money to pay off the bill.
 3. Hedging Function:
• A third function of the foreign exchange market is
to hedge foreign exchange risks. Hedging means
the avoidance of a foreign exchange risk. In a free
exchange market when exchange rate, i. e., the
price of one currency in terms of another
currency, change, there may be a gain or loss to
the party concerned. Under this condition, a
person or a firm undertakes a great exchange risk
if there are huge amounts of net claims or net
liabilities which are to be met in foreign money.
• Exchange risk as such should be avoided or
reduced. For this the exchange market provides
facilities for hedging anticipated or actual claims or
liabilities through forward contracts in exchange. A
forward contract which is normally for three
months is a contract to buy or sell foreign exchange
against another currency at some fixed date in the
future at a price agreed upon now.
• No money passes at the time of the contract. But
the contract makes it possible to ignore any likely
changes in exchange rate. The existence of a
forward market thus makes it possible to hedge an
exchange position.
• Foreign bills of exchange, telegraphic transfer, bank
draft, letter of credit, etc., are the important foreign
exchange instruments used in the foreign exchange
market to carry out its functions.
Structure of Foreign Exchange Market

Retail Wholesale
market market
Bank and money Inter bank(bank
changers(currenci account and
es, bank notes, deposits) central
cheque) bank
 Major Participants
• 1. Retail clients
• 2. Commercial banks
• 3. Foreign exchange brokers
• 4. Central banks
Foreign Exchange Transactions

• It is an agreement between two parties to

exchange one currency for another at an
agreed exchange rate on an agreed date. It
also provides protection against
unfavorable exchange rates .
 Nature of Forex Transaction
1. Hedging to avoid loss
2. Arbitrage to purchase currency of two or
more countries.
3. Speculation price less purchase high sell
 Types of Transaction
• Spot Transaction
• Forward Transaction
• Future Transaction
• Swap Transactions
• Option Transactions
 Spot Transaction
• The spot transaction is when the buyer and seller of
different currencies settle their payments within the
two days of the deal. It is the fastest way to exchange
the currencies.
• Here, the currencies are exchanged over a two day
period, which means no contract is signed between
the countries.
• The exchange rate at which the currencies are
exchanged is called the Spot Exchange Rate. This rate
is often the prevailing exchange rate. The market in
which the spot sale and purchase of currencies is
facilitated is called as a Spot Market.
 Forward Transaction
• A forward transaction is a future transaction
where the buyer and seller enter into an
agreement of sale and purchase of currency
after 90 days of the deal at a fixed exchange
rate on a definite date in the future.
• The rate at which the currency is exchanged is
called a Forward Exchange Rate. The market
in which the deals for the sale and purchase of
currency at some future date is made is called
a Forward Market.
 Future Transaction
• The future transactions are also the forward
transactions and deals with the contracts in the same
manner as that of normal forward transactions. But
however, the transactions made in a future contract
differs from the transaction made in the forward
contract on the following grounds:
– The forward contracts can be customized on the
client’s request, while the future contracts are
standardized such as the features, date, and the
size of the contracts is standardized
– The future contracts can only be traded on the
organized exchanges, while the forward contracts
can be traded anywhere depending on the client’s
convenience.
– No margin is required in case of the forward
contracts, while the margins are required of all
the participants and an initial margin is kept as
collateral so as to establish the future position.
 Swap Transactions
• The Swap Transactions involve a simultaneous
borrowing and lending of two different currencies
between two investors. Here one investor borrows the
currency and lends another currency to the second
investor.
• The obligation to repay the currencies is used as
collateral, and the amount is repaid at a forward rate.
The swap contracts allow the investors to utilize the
funds in the currency held by him/her to pay off the
obligations denominated in a different currency
without suffering a foreign exchange risk.
 Option Transactions
• The foreign exchange option gives an
investor the right, but not the obligation to
exchange the currency in one
denomination to another at an agreed
exchange rate on a predefined date.
• An option to buy the currency is called as a
Call Option.
• While the option to sell the currency is
called as a Put Option.
 Settlement Date
• Settlement Date is a securities industry term
describing the date on which a trade (bonds, equities,
foreign exchange, commodities, etc.) settles. That is,
the actual day on which transfer of cash or assets is
completed and is usually a few days after the trade was
done.
• The number of days between trade date and
settlement date depends on the security and the
convention in the market it was traded.
• For example when settling a share transaction on the
London Stock Exchange this is set at
– trade date + 2 business days.
 Settlement Date for Transactions
1. Spot transaction
– Here the transaction takes place on T+2 basis i.e. in
spot exchange transaction settlement usually takes two
working days.
2. Ready or cash transaction
– in these types of transaction is settled on same day i.e.
on the trade day .
3. Tomorrow transaction
– in these types of contract settlement of underlying is
to be done on the next day (Tomorrow)
4. Future or Forward contract
– these contract are settled on a specific futures date at
a fixed price
 Foreign Exchange Rates
• An exchange rate is the rate at which one
currency will be exchanged for another. It is also
regarded as the value of one country’s currency
in relation to another currency.
• For example, an interbank exchange rate of 114
Japanese yen to the United States dollar means
that ¥114 will be exchanged for each US$1 or that
US$1 will be exchanged for each ¥114. In this
case it is said that the price of a dollar in relation
to yen is ¥114, or equivalently that the price of a
yen in relation to dollars is $1/114.
 Foreign Exchange Determination
• Demand for foreign exchange:
– When Indian people and business firms want to make
payments to the US nationals for buying US goods and
services or to make gifts to the US citizens or to buy
assets there, the demand for foreign exchange (here
dollar) is generated. In other words, Indians demand
or buy dollars by paying rupee in the foreign market.
– A country releases its foreign currency for buying
imports. Thus, what appears in the debit side of the
BOP account is the sources of demand for foreign
exchange. The larger the volume of imports the
greater is the demand for foreign exchange
• Supply Function:
– We can determine supply of foreign exchange.
Supply of foreign currency comes from its
receipts for its exports. If the foreign nationals
and firms intend to purchase Indian goods or
buy Indian assets or give grants to the
Government of India, the supply of foreign
exchange is generated.
Foreign Exchange Quotations
• It is the amount of currency that is
exchanged for a unit of another currency.
• For example the exchange rates of rupees
in India may be quoted in terms of dollar.
E.g. RS/$=60
Types of Foreign Exchange Quotation

• Bid and Ask prices

• Direct rates
• Spot rates
• Inter bank quotations
• Indirect rates /quotes
• Cross currency rates
• Forward rates
 Common Currency Symbols
• INR : Indian Rupee
• USD : US Dollar
• HKD : Hong Kong Dollar
• EUR : Euro
• JPY : Japanese Yen
• GBP : British Pound
• CHF : Swiss Franc
• CAD : Canadian Dollar
• SGD : Singapore Dollar
• AUD : Australian Dollar
• RMB : Chinese Renminbi
 Direct & Indirect Quotes
• Direct Quotes
– Gives the units of currency of domestic country per unit of a foreign
currency
– Price of foreign currency is quoted in terms of home currency.
– In this system variable units of home currency equivalent to a fixed
unit of foreign currency are quoted.
– Domestic currency is quoted currency
– For Eg – USD/INR = 45.30 Rs. / $
• Indirect Quotes
– Gives the units of currency of foreign country per unit of the domestic
currency
– Price of home currency is quoted in terms of foreign currency
– In this system variable units of foreign currency equivalent to a fixed
unit of home currency are quoted.
– Foreign currency is the quoted currency
– For Eg – INR/USD = 0.0220 $ / Rs.
 American Terms/ European Terms
Cross Rates
• Exchange rate quoted in American Terms
– USD becomes the quoted currency.
– For Eg – INR/USD = 0.0220 $ / Rs.
• Exchange rate quoted in European Terms
– USD becomes the base currency
– For Eg – USD/INR = 45.30 Rs. / $
– Or USD/CHF = 1.4550 CHF/$
• Cross Rate
– Quotation between two non dollar currencies
– For Eg – GBP/INR = 90.4587 Rs./pound
 Cross Rates
• USD is the most widely traded currency and is often
used as the vehicle currency
• This helps in reduction of no. of quotes in the market,
as exchange rate between two currencies can be
determined through their quotes against the USD.
• Any quote not against the USD is a ‘Cross Quote’
• Availability of USD quote for all currencies can help in
determining the exchange rate for any pair of
currencies by using the cross rate
• For eg. Cross quote for EUR-GBP =
• EUR/USD * USD/GBP
 Bid & Ask Rates
• Bid rate
– Price at which the Forex dealer is willing to buy a unit of
the base currency
– As a customer this will be the price at which you will sell
the currency
• Ask rate/offer rate
– Price at which the Forex dealer is willing to sell a unit of
the base currency
– As a customer this will be the price at which the currency
is offered to you or at which you buy.
• Eg – USD/CHF = 1.4550/1.4560
Direct & Indirect Quotes when Bid/Ask is Given
• When a bank quotes a currency, it simultaneously offers
another currency in lieu; if it buys dollars for rupees, it is
simultaneously offering rupees for dollars.
• For example if a bank quotes bid rate at spot for dollars as (S)
USD/INR bid= Rs. 35.50/$; (it is buying dollars at this rate;
recall that base currency is the one being traded);
• It also sells rupees for dollars simultaneously; this rate is ask
price of rupees in terms of dollars; in indirect quotes.
• (S) USD/INR bid= Rs. 35.50/$ = ask price of rupees in indirect
quotes
• Therefore,
• S (USD/INR)ask= 1/ S (INR/USD)bid
• S (USD/INR)bid = 1/S (INR/USD)ask
 SPREAD
• Spread or dealer's margin or cost of transaction is the
difference between bid price and ask price
• If exchange rate quotation is given in “direct quote” form, bid
rate < ask rate, and vice versa as the dealer will want to make
a profit on currency dealing
• Eg – USD/CHF = 1.4550/1.4560 , (the spread is 10 pips). It may
be shortened to 1.4550/60
• In Sweden, USD/SEK = 8.9595/10 means 8.9595/83.9610
• In Japan, USD/JPY = 106.98/05 means 106.98/107.05
• Calculating spread and percentage spread
– For Direct quotes, Spread = Ask Price-Bid Price
– Percentage Spread = (Ask Price – Bid Price)/ Ask Price * 100
– A bank in India quotes, USD/INR = 35.7621/35.8024
– (For Indirect quotes reverse ask and bid price)
 Determinants of SPREAD
• Liquidity/trading volume in the market; high volume, lower spread;
as cost of service per unit falls
• Nature of the organization making quotes (bank vs. money changer
or finance company)
• Overall perception of the dealer about the conditions of the
economy and the Forex market
• Size of the transaction
• Number of players, time of the day etc
• Currency rate volatility.
• In the United States, spreads tend to be narrowest in the New York
morning-Europe afternoon period, when the biggest markets are
open and activity is heaviest. Bid-ask spread is widest in the late
New York afternoon, when European and most large Asian markets
are closed.
• In India the spread is set by Foreign Exchange Dealers Association of
India
 Mid Rate & Spread Given
• A term used to describe the average rate agreed
upon when conducting foreign exchange.
• The middle rate is calculated using the median
average of the bid and offer rates.
• The middle rate is the average of bid and ask
rates.
• For direct quotes,
– S(bid) = M - c
– S(ask) = M + c
– Where, M= Mid rate and c = one side average spread
or cost of transaction
 Forward Market Premium
• A foreign currency is said to be selling at a forward discount
when forward price of the foreign currency is lower in
terms of the domestic currency than its spot rate.
• Conversely, a foreign currency is said to be selling at a
forward premium when its forward price in terms of
domestic currency is higher than the spot price
• If, USD/INR (S) = Rs. 31.9812/$ and USD/INR (F) = Rs.
32.1345/$, the foreign currency is at a premium and
• domestic currency is at a discount. Premium/discount =
[F(bid) – S(bid)]/S(bid) *100
• Annualized Premium/discount = [F(bid) – S(bid)]/S(bid)
*12/N *100 when quotes are in months (N = Months)
• Annualized Premium/discount = [F(bid) – S(bid)]/S(bid)
*360/ND *100 when quotes are in days (ND=No of days)
 Various Practice of Writing Quotations
In terms of discounts and premiums
• Brokers may quote currencies in terms of
discounts and premiums on them in the forward
market.
• Eg: if USD/INR (S) = Rs. 36.3500 and broker says:
dollar is at 3% premium in the three months
forward market. The outright forward rate can be
found by using the formula
• If the broker said that dollar is at 3% annualised
premium then the premium would be 3% *
(3/12)
In terms of basis points or swap rates or forward margins

• Forward rate may be the same as spot rate, but generally

the currency becomes costlier or cheaper.
• The difference is called swap points or forward margin
• A basis point is 1/100th of 1 percentage
• Suppose a broker at new york quotes for French Francs:
FF/USD (S) = $0.2144/FF, 30 days forward discount 100
basis points and 60 days forward discount 20 basis points
and for German Mark, DM/USD (S) = $ 0.4860/DM, 30
days forward premium120 basis points and 60 days
forward premium 160 basis points
-For direct rates, premium has to be added to the spot rate and
discount has to be subtracted from the spot rate
-For indirect quotes, reverse is true

Spot 30 days 60 days 30 days 60 days

exchange rate swap swap forward rate forward
rate/forwa rate/forwar rate
rd d
margins margins
$0.2144/FF -100 -20 $0.2044/FF $0.2124/FF
$0.4860/DM 120 160 $ 0.4980/DM $0.5020/D
M
In terms of a-b or a/b where a and b are
numbers
• When forward bid/ask quotes are given in this
format;
• USD/INR (S) = Rs. 47.8525/9775, one month;
50/150 and 2 months; 200/300 or
• USD/INR (S) = Rs. 47.8525, one month; 50-150
and 2 months; 200-300 or
• If first figure is smaller than second figure
then, base currency is at a premium and basis
points have to be added to spot rate
 • If first figure is greater than second figure
then, base currency is at a discount and basis
points have to be deducted from spot rate
• Therefore you can see the forward points and
tell if base currency is at discount or premium
Spot 1 month 2 month swap 1 month 2 month forward
exchange rate swap rate/forward forward rate rate
rate/forward margins
margins

47.8525/9775 50/150 200/300 47.8575/9925 47.8725/48.0075

$0.4860/DM 120 160 $ $0.5020/DM
0.4980/DM
Thank You….