Foreign Exchange Markets: Meaning

•Foreign exchange markets are the markets where individuals, firms and banks
buy and sell foreign currencies or foreign exchange

•The foreign exchange market for any currency say US Dollar, comprised of all
locations such as London, Paris, Frankfurt, Hongkong, Singapore and Tokyo as
well as New York, where dollars are bought and sold for other currencies
Foreign Exchange Markets: Functions

•Transfer of purchasing power from one nation currency to another

•Credit creation
•Provide facilities for hedging & speculation
Foreign Exchange Rates:

•Foreign exchange rate is the domestic currency price of the foreign currency
or it is the foreign currency price of a unit of the domestic currency.

•If there are only two economies – India and the United States (US), with rupee
as the domestic currency and the dollar as the foreign currency. The exchange
rate between rupee and dollar is equal to the number of rupees required to
purchase one dollar.
Foreign Exchange Rates: Spot and forward rates

Spot Rate
•A spot foreign exchange transaction refers to the purchase or sale of the foreign
exchange for delivery within two business days.

•The exchange rate at which the transaction take place is called spot rate.

•If the exchange rate is ₹ 1/ $1, Rs 1000 could be obtained immediately for a
total of $1000.
Spot Rate

•The spot rate is the current exchange rate at which a currencies can be bought
or sold for immediate delivery.
Or
•It is the rate at which currencies are traded 'on the spot' or at the prevailing
market price.
Or
•Usually, spot rates are quoted for settlement within two business days
Forward Rates

•Forward foreign exchange transaction involves an agreement today to buy or

sell a specific amount of foreign currency at a specified future date at rate
agreed upon today (the forward rate)

•For example, one can enter into an agreement today to buy $1000, 3 months
from today at ₹ 1.01 / $1, and get $1000 at the given rate irrespective of the spot
rate at that time.
Forward Rates

•The forward rate is the exchange rate at which a currency pair can be bought or
sold for delivery at a specified future date.
•agreed today but implemented in the future
• allows businesses and investors to hedge against currency risk by locking in
an exchange rate for a future transaction.
•Forward rates are determined by the spot rate and the interest rate differentials
between the two currencies
Forward Rates: forward premium & forward discount

forward premium

•if the forward rate is above the present spot rate, the foreign currency is
said to beat forward premium
•the spot rate is ₹ 1/ $1, but the three month forward rate is ₹ 1.01 / $1, the
dollar is said to be at forward premium of 1% for 3 months with respect to
rupee..
forward premium

• A forward premium occurs when the forward rate > the spot rate
• foreign currency is expected to appreciate relative to the domestic currency in
the future.
• Reason: higher interest rates in the foreign country (compared to the domestic
country), leading to an increased demand for the foreign currency in the forward
market
forward discount

•If the forward rate is below the present spot rate, the foreign currency is said
to be at forward discount

•the spot rate is ₹ 1/ $1, but the three month forward rate is ₹ 0.99/ $1, the dollar
is said to be at forward discount of 1% for 3 months with respect to rupee..
forward discount

• A forward discount occurs when the forward rate of a currency pair < the spot
exchange rate
• foreign currency is expected to depreciate relative to the domestic currency in the
future.
• Reason: lower interest rates in the foreign country (compared to the domestic
country), leading to a decreased demand for the foreign currency in the forward
market
Foreign Exchange Options
A foreign exchange option is a contract giving the purchaser the
right, not the obligation to buy (call option) or sell (put option)
standardized amount of traded currency either on a stated date (the
European option)or at any time before the stated date (an American
option) at a stated rice(the strike or exercise price).
Foreign Exchange futures

• A Foreign exchange future is a forward contract to buy or sell standardized

amount of a foreign currency at selected calendar dates.
Specific features:
• only few currencies are traded such as British Pound, Canadian Dollar,
German Mark, Japanese Yen.
• Trade occurs in standardized contracts for few specified delivery dates, the third
Wednesday in March, June, September ,December.
• Transactions are subjected to daily limits on exchange rate fluctuation.
• Trade take place in few geographical locations such as New York, London,
Singapore and Chicago.
• Future contracts are smaller amount than forward contract
• Future contract can be sold any time until maturity, but forward contract can’t.
Foreign Exchange Rates: Risks involved

•The equilibrium in the exchange rate:

the US demand for euro = US supply of euro.

•When the supply of euro > demand for euro

- excess supply of euro lowers the exchange rate towards euro
- lead to depreciation (an increase in the domestic currency price of the foreign
currency) of euro.