Module 2-IF-MG

International Finance – Imperial School of Banking and Management Studies 1
Meena Goyal, Ph.D, CA
Module II Foreign Exchange Markets
History of Forex
Foreign exchange trading has a long history, with evidence of currency trading
dating back to ancient civilizations. However, modern forex trading as we know it
today began in the 1970s when the Bretton Woods system of fixed exchange rates
collapsed, leading to the adoption of floating exchange rates. The emergence of
electronic trading platforms and the internet in the 1990s transformed the forex
market, making it more accessible and providing greater opportunities for individual
traders. Today, the forex market is the largest financial market in the world, with
trillions of dollars traded daily.
What is Foreign Exchange Market?
The Foreign Exchange Market is a global decentralized marketplace where
currencies are bought and sold. It is the largest and most liquid financial market in
the world, with trading volumes exceeding $6 trillion per day. The forex market
facilitates international trade and investment by enabling businesses to convert one
currency into another.
The forex market operates 24 hours a day, 5 days a week, with trading taking place
in major financial centers around the world. The market is driven by various factors,
including economic data, geopolitical events, and central bank policies. The exchange
rate, which is the value of one currency relative to another, is determined by supply
and demand forces in the market. It is a highly decentralized market, with no single
entity controlling the exchange rates or setting the prices of currencies.
What are the Different Types of Foreign Exchange Markets?
There are three main types of foreign exchange markets:

1. Spot Forex Market
The spot forex market is where currencies are traded for immediate delivery. This
means that the exchange of currencies takes place at the current market price,
which is determined by supply and demand forces. The spot forex market is the most
liquid and actively traded market in the world, with trading taking place 24 hours a
day across major financial centers.
2. Forward Forex Market
The forward forex market is where contracts are used to buy or sell currencies at a
future date at a predetermined exchange rate. This allows participants to lock in a
future exchange rate, providing protection against currency fluctuations. The
forward forex market is used for hedging purposes and is not as actively traded as
the spot market.
3. Futures Forex Market
The futures forex market is a centralized exchange where standardized contracts
are traded for the future delivery of a specified currency at a predetermined price.
Futures contracts are used for hedging and speculative purposes and are traded on
regulated exchanges. The futures forex market is less liquid than the spot market
and requires participants to post margin.
4. Swap Market
When there is a simultaneous borrowing and lending of two types of currencies
between two investors, it is known as a swap transaction. Here, one investor borrows
a currency and in turn, pays in the form of a second currency to the second investor.
The transaction is done to pay off their obligations without having to deal with
a foreign exchange risk.
5. Option Market
In the options market, the currency of exchange from one denomination to the other
is agreed upon by the investor at a specific rate and on a specific date. The investor
has a right (by paying a premium) to convert the currency on a future date but there
is no obligation to do so. A call option allows you to buy, while a put option allows you
to sell.
Foreign exchange transactions also include the conversion of currencies done at the
airport kiosks or the payments made by government and financial institutions.
Features of the Foreign Exchange Market
The foreign exchange market has several key features that set it apart from other
financial markets.
1. It is a decentralized market that operates 24 hours a day, 5 days a week, across
multiple time zones.
2. It is the largest and most liquid market in the world, with high trading volumes
and low transaction costs.
3. The market is influenced by a variety of factors, including economic indicators,
geopolitical events, and central bank policies.
4. The market provides opportunities for traders to speculate on the movement of
currency values through a range of trading strategies.
5. The market is accessible to a wide range of participants, including individuals,
financial institutions, and governments.
Who are the Participants in a Foreign Exchange Market?

There are a wide range of participants in the foreign exchange market, including:
● Commercial banks: Banks are the most active participants in the forex market,
trading on behalf of their clients and for their own accounts.
● Central banks: Central banks participate in the market to manage their
country's monetary policy and stabilize currency values.
● Hedge funds and investment firms: These institutions trade in the forex
market to generate returns for their clients.
● Corporations: Multinational corporations use the forex market to manage their
currency risk, particularly when conducting international trade.
● Retail traders: Individual traders can participate in the forex market through
online brokers, seeking to profit from currency price movements.
● Governments: Governments participate in the forex market to manage their
currency values and maintain their country's economic stability.
Forex Trading Volume
More than 50 currencies trade globally, but the volume in forex or FX market is
concentrated in few trading hubs and currencies. According to BIS survey, 78% of
all forex or FX trading takes place in five forex trading hubs that are major
financial centres-- the United Kingdom, the United States, Singapore, Hong Kong
SAR and Japan. The UK is the most important forex trading location globally, with
38% of global turnover, followed by the US with 19% Singapore with 9%, Hong Kong
with 7% and Japan with 4%.

Among the currencies, the US Dollar is the world‘s most dominant currency and is on
one side of 88% of all trades, followed by the Euro with 31%, the Japanese Yen at
17% and the Pound Sterling at 13%, according to the BIS survey.
Understanding Forex Market Trading Hours
Global foreign exchange market is largely unregulated and decentralized. Thanks to
different time zones, foreign exchange market is globally open 24 hours except on
weekends. The global foreign exchange trade is mainly driven by sessions in four
continents, namely Australia (Sydney), Asia (Tokyo), Europe (London) and North
America (New York). The trading volumes vary from one session to another, but the
market is most active when sessions in London and New York overlap.
Though Tokyo is generally considered to be the main Asia session, Singapore and
Hong Kong have overtaken Japan in trading volume in the last 10 years.
Forex Market Trading Sessions
The forex markets work from 9:00 PM UTC (Coordinated Universal Time) on Sunday
which is 7:00 AM on Monday in Sydney, to 9:00 PM UTC on Friday, which is 5:00 PM
on Friday in New York. Following are the timing for the four sessions.
Sydney 9:00 PM to 6:00 AM UTC
Tokyo 11:00 PM to 8:00 AM UTC
London 7:00 AM to 4:00 PM UTC
New York 12:00 PM to 9:00 PM UTC

The day starts with the Australian session, followed by the Asian, the European and
the US sessions. The European session is the most active session, which is reflected
in the UK accounting for 38% of global foreign exchange trade turnover. The best
time to trade is when the markets are most active and liquid and this usually happens
when two sessions overlap. The most liquid time is when the timing of the two
biggest trading centres, that is European and the US sessions, overlap that is from
12:00 PM UTC to 4:00 PM UTC.
Indian Forex Market Trading Hours
Indian forex market is miniscule compared with global markets. According to BIS
survey, India accounted for just 0.5% of global turnover of foreign exchange in April
2022. Though forex markets globally can be characterised as OTC markets, a
significant portion of the trade in Indian rupee--12.9%--is done in exchange-traded
derivatives.
The market timing for OTC currency trades including forex derivatives in India is
9:00 AM IST to 3:30 PM IST. The timing was 9:00 AM IST to 5:00 PM IST before
the COVID-19 pandemic, but the Reserve Bank of India curtailed the market hours
for foreign currency trades to 10:00 AM IST to 2:00 PM IST in April 2020 following
the nationwide lockdown due to COVID-19 pandemic. The market hours were
extended till 3:30 PM IST in November 2020 and further to 9:00 AM IST to 3:30
IST PM in April 2022. Though the market hours for government securities market
have since been restored to pre-COVID-19 timing of 9:00 AM IST to 5:00 PM IST,
the timing for foreign exchange still continues to be 9:00 AM IST to 3:30 PM IST.
The OTC market offers foreign exchange trades in spot, forward, swap and call and
put options.
Besides the OTC market, there are exchange traded currency derivatives in India.
Exchanges offer currency futures contracts and options on four rupee pairs for US
dollar (USD-INR), euro (EUR-INR), Pound Sterling (GBP-INR) and Japanese Yen
(JPY-INR). These are traded from 9:00 AM IST to 5:00 PM IST in exchanges. The
exchanges also offer cross currency futures and options contracts on Euro and
Dollar (EUR-USD), Pound Sterling and US Dollar (GBP-USD) and US Dollar and
Japanese Yen (USD-JPY). Trading in these cross-currency futures have slightly
extended time from 9:00 AM IST to 7:30 PM IST since these contracts are purely
dependent on trades happening overseas.
The difference between a forward contract in OTC market and a futures contract in
exchanges is that the former is customized agreement between two parties, while
the latter is a standard contract that is traded on an exchange.
How to Trade in Rupee in Forex Market
Since rupee is not fully convertible, there are restrictions on trading in foreign
exchange by retail investors in India. Though India allows residents to spend up to
US $250,000 a year outside India under the Liberalised Remittance Scheme for
investments including shares, mutual funds and property, trading in foreign exchange
is not allowed. Even within the country, retail investors are allowed to undertake
forex transactions only for permitted purposes like investment in foreign securities,
payment for foreign trade and expenses in connection with travel, education and
medical care. The only option for residents to invest in currencies is through
exchange traded derivatives.
Foreign exchange trading, though the most liquid and the biggest financial market, is
a very complex market. The RBI allows retail investors to buy or sell foreign
exchange only for limited purposes, not as a speculative investment.

For investment, retail investors will have to trade in exchange traded currency
derivatives. Since the foreign market is mostly driven by external factors and is
globally active 24 hours, Indian investors can potentially make losses or profits if
the currencies move overnight when Indian market is closed for trading.
What is Clearing and Settlement?
The lifecycle of and FX trade has three components:
 Execution.
 Clearing.
 Settlement.
Execution: This is the transaction whereby the seller agrees to sell, and the buyer
agrees to buy a currency in a legally binding manner. The process in between
execution and settlement is the clearing process, including recording of the
transaction. The settlement includes the actual exchange of money for the securities
transacted.
Clearing: The clearing process involves updating the account values of the involved
parties (traders) to ensure that they actually have the funds in the first place and
preparing for the exchange of those funds.
Settlement: This is the final process where the actual exchange of funds and
securities takes place. Here, for instance, the base currency is transferred to the
buyer, and the counter currency is transferred to the seller.

This clearing and settlement procedure relies heavily on technology, matching, and
human input in the background that ensures the clearing and settlement procedure is
smooth and consistent.
Continuous Linked Settlements (CLS)
There is a risk of one party (buyer or seller) defaulting before concluding the
transaction in the foreign exchange market, much like Lehman Brothers did on
September 15th, 2008. The settlement happens through accounts in the respective
banks based in the countries where the corresponding currencies are issued.
Additionally, because the various payment methods are based in different time zones
across the globe, one part of an FX transaction will likely be settled before the
other.
For instance, euro transactions are settled before dollar transactions but later than
the Japanese yen. As such, a trader purchasing in dollars, but paying in euros, will
settle the euro part of the transaction before getting the dollars. If a glitch were to
happen in the middle of the transaction, the buyer would have paid in dollars but
would lose the counterbalancing euros. This is known as settlement risk.
Global banks came up with the Continuous Linked Settlement (CLS) system to
mitigate the settlement risk while facilitating fast settlements. The CLS Bank
International controls the system, and the founder banks are the shareholders.
However, other banks are allowed to forward their FX transactions via the founding
member banks.
The CLS system is a real-time system that facilitates simultaneous global
settlements regardless of the time zones, curtailing the chances of one party
defaulting the transaction. The CLS process involves:

 Submitting instructions: obtaining payments in respective currencies from
traders
 Funding: establishing pairs of instruction that meet all requirements
 Execution: carrying out payoffs in respective currencies.
Member banks receive real-time market and settlement information that is vital in
the effective management of liquidity, mitigation of credit risks, and the introduction
of operational efficiencies. These member banks referred to as ‗settlement members‘
submit the transaction details via the CLS Bank. The bank, in turn, matches the
transactions and settles them by debiting/crediting their respective accounts as per
the instructions received.
Exchange Rate Quotations
Exchange rate quotations can be quoted in two ways – Direct quotation and Indirect
quotation. Direct quotation is when the one unit of foreign currency is expressed in
terms of domestic currency. Similarly, the indirect quotation is when one unit of
domestic currency us expressed in terms of foreign currency.
A currency pair is the quotation of two different currencies, with the value of one
currency being quoted against the other. The first listed currency of a currency
pair is called the base currency, and the second currency is called the quote
currency. It indicates how much of the quote currency is needed to purchase one
unit of the base currency.
Currency pairs are quoted based on their bid (buy) and ask prices (sell).
The bid price is the price that the forex broker will buy the base currency from you
in exchange for the quote or counter currency.
The ask—also called the offer—is the price that the broker will sell you the base
currency in exchange for the quote or counter currency.
7 major forex pairs

 The euro and US dollar: EUR/USD.
 The US dollar and Japanese yen: USD/JPY.
 The British pound sterling and US dollar: GBP/USD.
 The US dollar and Swiss franc: USD/CHF.
 The Australian dollar and US dollar: AUD/USD.
 The US dollar and Canadian dollar: USD/CAD.
 The New Zealand dollar and US dollar: NZD/USD.
Cross Currency Quotes

Cross rates is the currency exchange rate between two currencies, both of which
are not the official currencies of the country in which the exchange rate quote is
given in. This phrase is also sometimes used to refer to currency quotes which do
not involve the U.S. dollar, regardless of which country the quote is provided in.
For example, if an exchange rate between the US$ and the Japanese Yen was
quoted in an Indian newspaper, this would be considered a cross rate in this
context, because neither the US$ or the yen is the standard currency of India.
If an Indian Business firm has imported certain goods from Japan, it needs to pay
it in Yen. So the firm needs to buy Yen from the Bank. But, there is no quote
available for INR/Yen. The banker would obtain Yen/$ rate from Tokyo and then
apply the Rs. /$ rate obtained from the local Indian market to arrive at the exact
rupees to be given for purchase of Yen. Since, this transaction involves more than
two currencies; we call such a rate as cross rate. While finding the cross rates,
the following points are important:
Spot rate: It is the rate that is applicable for immediate settlement (i.e. T+2
working days). For example, if a spot transaction is done on a Friday, the
settlement will be done on Tuesday, since Saturday and Sunday are holidays and
Monday is the first working day.
Forward rate: It is the rate contracted today for exchange of currencies at a

specified future date. Thus, the price is decided today but the delivery and
settlement is made on a specified future date. Both the parties, i.e. customer and
the dealer banker are obliged to perform the contract on the specified date
irrespective of the exchange rate prevailing on that date.
Forward at par: When the forward rate is same as the spot rate for the
currency, then it is said to be at ‗par‘
Forward premium: When a currency is costlier in forward, it is said to be at

premium. Forward discount: When a currency is cheaper in forward, it is said to be
at discount.
What is forex arbitrage?
Forex arbitrage strategy leverages forex market price disparity and inefficiencies. In this
strategy, a trader profits by opening different currency positions (of the same currency
pair) with different brokers offering different prices.
How does forex arbitrage work?
The forex market is highly decentralised, but there is still some difference in how the
urrency pairs are quoted in different trading locations. If you are trading in a particular
country, all forex brokers will offer you the same price. Hence, to use the arbitrage
trading strategy, you need to open forex positions in entirely two different countries
having a forex trading platform. The arbitrager spots the price difference in two
locations and opens long positions at the lower of the two prices and short or sell
positions at the higher of the two prices to lock in profits from the difference.
What is purchasing power parity?
Purchasing power parity (PPP) is an economic theory of exchange rate determination. It
states that the price levels between two countries should be equal.
This means that goods in each country will cost the same once the currencies have been
exchanged. For example, if the price of a Coca Cola in the UK was 100p, and it was $1.50
in the US, then the GBP/USD exchange rate should be 1.50 (the US price divided by the
UK‘s) according to the PPP theory.
However, if you were then to look at the market exchange rate of the GBP/USD pair, it
is actually closer to 1.25. The discrepancy occurs because the purchasing power of these
currencies is different. As with any asset, there is the real value of a currency and the
notional value, which financial markets trade at. The aim of the PPP measurement is to
make comparisons between two currencies more valid, by adjusting for local purchasing
power differences.
PPP measures are widely used by global institutions, such as the World Bank, United
Nations, International Monetary Fund and European Union.
The economic theory is often broken down into two main concepts:
1. Absolute purchasing power parity
2. Relative purchasing power parity
1. Absolute parity
Absolute purchasing power parity (APPP) is the basic PPP theory, which states that once
two currencies have been exchanged, a basket of goods should have the same value.
Usually, the theory is based on converting other world currencies into the US dollar.
For example, if the price of a can of Coca Cola was $1.50, APPP would suggest that a can
of Coca Cola in any other country should cost $1.50 after you‘ve converted USD into the
local currency.
If this does not hold true, then APPP suggests that the currency exchange rate will
change over time until the goods are of equal value – as without any barriers to trade,
there should be an equilibrium in the price of goods. This is a completely price-level
theory, which only looks at the exact same basket of goods in each country, with no other
factors included.
Learn more about how foreign exchange works
However, the theory ignores the existence of inflation and consumer spending, as well as
transportation costs and tariffs, which can impact the short-term exchange rate.
Without these inclusions, a currency‘s power is poorly represented.
2. Relative parity
Relative purchasing power parity (RPPP) is an extension of APPP and can be used in
tandem with the first concept. While it maintains that the value of the same good in
different countries should equal out over time, RPPP suggests that there is a correlation
between price inflation and currency exchange rates. It looks at the amount of a good or
service that one unit of currency can buy, which can change over time as inflation rates
alter. The theory suggests that inflation will reduce the real purchasing power of a
currency, so in order to properly adjust the PPP, inflation must be taken into account.
For example, if the UK had an annual inflation rate of 2%, then one unit of pound sterling
would be able to purchase 2% less per year.
One we add this concept onto APPP, we can see that inflation rates will account for part
of the change in the power of currencies. So suppose that the UK has a 2% inflation rate,
while Brazil has a 5% inflation rate. This means that after one year, the price of a basket
of goods in Brazil has increased by 5%, while the same basket of goods in the UK has only
increased by 2%.
How to calculate PPP: the PPP formula

The PPP formula calculation will vary depending on what you are trying to achieve and
which PPP you want to use.
The absolute PPP calculation is calculated by dividing the cost of a good in one currency,
by the cost of a good in another currency (usually the US dollar).
Then, to calculate the relative PPP rate, you‘d simply assume that the ratio of price levels
was equal to the exchange rate from one currency to another, adjusted for the inflation
rate. This would give you the rate of depreciation for one currency compared to another,
and an estimate of the future exchange rate.
How to use purchasing power parity?
On a macroeconomic level, the PPP measurement is used to compare economic productivity
and living standards between countries – as we have seen above, it is most commonly used
to adjust GDP. However, there are so many other ways that individuals and institutions
can use PPP to interpret socioeconomic data. These include assessing contributions to
carbon emissions, measuring global poverty and even predicting financial markets.
The Big Mac index
Perhaps the most famous PPP index was devised by The Economist to measure how many
units of a currency are needed to purchase a McDonald‘s Big Mac – known as the Big Mac
index. This is considered a fun-focused take on PPP but has nevertheless become
extremely widely used. Once the value of a hamburger in each country is known, exchange
rates can then be adjusted to show the purchasing power of each currency.
The burger was chosen due to the global reach of McDonald‘s, with an estimated 36,889
outlets in 120 countries. Although it‘s worth noting that due to differences in
ingredients, even this isn‘t a perfect measure of PPP.
Let‘s say you wanted to compare the purchasing power of the US dollar and Danish krone
using the Big Mac index. In January 2018, the index showed that the krone was
undervalued against the dollar by 6.6% – the average Big Mac in the US was worth $5.28,
while it was worth kr30 (the equivalent of $4.93). The PPP implied exchange rate would
have worked out at 5.58, which is 6.6% lower than the actual exchange rate at the time
of 6.08.
International Fisher Effect?
The International Fisher Effect (IFE) is an economic theory stating that the expected
disparity between the exchange rate of two currencies is approximately equal to the
difference between their countries' nominal interest rates.
The IFE is based on the analysis of interest rates associated with present and future
risk-free investments, such as Treasuries, and is used to help predict currency
movements. This is in contrast to other methods that solely use inflation rates in the
prediction of exchange rate shifts, instead functioning as a combined view relating
inflation and interest rates to a currency's appreciation or depreciation.
The theory stems from the concept that real interest rates are independent of other
monetary variables, such as changes in a nation's monetary policy, and provide a better
indication of the health of a particular currency within a global market. The IFE
provides for the assumption that countries with lower interest rates will likely also
experience lower levels of inflation, which can result in increases in the real value of the
associated currency when compared to other nations. By contrast, nations with higher
interest rates will experience depreciation in the value of their currency.
This theory was named after U.S. economist Irving Fisher.
Formula
The international fisher effect formula is as follows.
(1+RR nominal ) = (1 + RR real) x (1 + Inflation Rate)
In this equation,
 RRnominal denotes the nominal rate of return.
 RRreal denotes the real rate of return.

What Is Interest Rate Parity?
Interest rate parity is a theory that suggests a strong relationship between interest
rates and a currency's current exchange rate (called "spot" and its forward exchange
rate.
The underlying concept behind interest rate parity is that it doesn‘t matter whether a
person invests money in their home country and then converts their earnings to another
currency, or converts the money first and invests the money overseas. Because interest
rates and forward currency rates are intertwined, the investor makes the same amount
of money either way.
The two key exchange rates in interest rate parity are the ―spot‖ rate and the ―forward‖
rate. The spot rate is the current exchange rate, while the forward rate refers to the
rate at which a bank agrees to exchange one currency for another in the future.
Interest Rate Parity Example
Suppose Country ABC has an interest rate of 4%, and Country XYZ has a rate of 2%. If
an investor in ABC invests in Country XYZ, they will exchange their home currency for
XYZ's currency at the current spot rate, investing their cash, earning 2% for the year.
However, the investor locks in the forward exchange rate at which the money is to be
exchanged back from XYZ's currency to ABC's currency at the end of the year.
On the surface, it might appear that the investor is losing 2% by investing in XYZ when
they can earn 4% at home in Country ABC. However, the forward exchange is adjusted to
account for the interest rate differential between the two countries. In other words,
the forward rate gives the investor back more money than what was initially exchanged
to account for the 2% interest rate differential.
With interest rate parity, it doesn't matter whether a person invests money and
converts the earnings to another currency first, or converts the money and then invests
it. Due to the relationship between interest rates and forward currency rates, the
investor ends up making the same amount of money.

How Does Interest Rate Parity Work?
Suppose there is a spot exchange rate of 0.75 British pounds for every U.S. dollar.
(£0.75/$1). That means we can exchange $1,000 and receive 750 pounds.
If interest rates in the U.K. are 3%, we can invest 750 pounds at 3% for the year,
yielding us $772.50.
Now, suppose that instead of exchanging our currency and investing it in the U.K., we
first invest our money in the U.S. and exchange it for British pounds in a year. And let‘s
say the interest rate in the U.S. is 5%.
In this case, the exchange rate will be the forward exchange rate, which is calculated
using the difference in interest rates. The formula is: (0.75 x 1.03) / (1 x 1.05), or
(0.7725/1.05). Rounding up, the resulting total is 0.736.
Suppose we start with $1,000 and invest it in the U.S. at 5%. This results in $1,050 at
year‘s end. We then exchange the $1,050 at the forward exchange rate of 0.736, or
$772.80. In other words, we end up with the same amount of money as if we had
exchanged our money first and then invested it in the U.K. (Rounding introduces the
$0.30 discrepancy.)
Convertibility of currency
Currency convertibility can be defined as the ability to exchange one currency for
another at a given conversion rate and in terms of the usability of a currency for foreign
transactions.
A convertible currency is any nation's legal tender that can be easily bought or sold on
the foreign exchange market with little to no restrictions.
Convertibility of Currency in India
Prior to the First World War the whole world was having gold standard under which the
currency in circulation was allowed to get converted either in gold or other currencies
based on the gold standard. But after the failure of Bretton woods system in 1971 this
system changed. Presently convertibility of money implies a system where a country‘s
currency becomes convertible in foreign exchange and vice versa. Since 1994, Indian
rupee has been made fully convertible in current account transactions.
Convertibility of Rupee:
For the first time, the Union Budget for 1992-93 has made the Indian rupee
partially convertible. This was an inevitable move for the expeditious integration of
Indian economy with that of the world In order to face the serious current account
deficit in the balance of payments, the Government of India introduced the partial
convertibility of rupee from March 1. 1992.
Under this system, which remained in operation for a period of one year, 60 per cent of
the exchange earnings were convertible in rupees at market determined exchange rate
and the remaining 40 per cent earnings were convertible in rupees at the officially
determined exchange rate. The term convertibility of a currency indicates that it can be
freely converted into any other currency. Convertibility can also be identified as the
removal of quantitative restrictions on trade and payments on current account.
Convertibility establishes a system where the market place determines the rate of
exchange through the free interplay of demand and supply forces.

Current account convertibility relates to the removal of restrictions on payments relating
to the international exchange of goals, services and factor incomes, while capital account
convertibility refers to a similar liberalization of a country‘s capital transactions such as
loans and investment, both short term and long term
Capital Account Convertibility: Meaning
Capital account convertibility refers to a liberalization of a country‘s capital transactions
such as loans and investment, both short term and long term as well as speculative capital
flows.
In a way, capital account convertibility removes all the restrains on international flows on
India‘s capital account. There is a basic difference between current account
convertibility and capital account convertibility. In the case of current account
convertibility, it is important to have a transaction – importing and exporting of goods,
buying and selling of services, inward or outward remittances, etc. involving payment or
receipt of one currency against another currency. In the case of capital account
convertibility, a currency can be converted into any other currency without any
transaction.
Advantages of Currency Convertibility
 Export promotion: An important advantage of currency convertibility is that it
encourages exports by increasing their profitability. With convertibility
profitability of exports increases because market foreign exchange rate is higher
than the previous officially fixed exchange rate. This implies that from given
exports, exporters can get more rupees against foreign exchange (e.g. US dollars)
earned from exports. Currency convertibility especially encourages those exports
which have low import-intensity.
 Incentive to Import Substitution: Since free or market determined exchange
rate is higher than the previous officially fixed exchange rate, imports become
more expensive after convertibility of a currency. This discourages imports and
gives boost to import substitution.
 Incentive to send remittances from abroad: Thirdly, rupee convertibility
provided greater incentives to send remittances of foreign exchange by Indian
workers living abroad and by NRI. Further, it makes illegal remittance such ‗hawala
money‘ and smuggling of gold less attractive.
 A self – Balancing Ability: Another important merit of currency convertibility lies
in its self-balancing mechanism. When balance of payments is in deficit due to
over-valued exchange rate, under currency convertibility, the currency of the
country depreciates which gives boost to exports by lowering their prices on the
one hand and discourages imports by raising their prices on the other. In this way,
deficit in balance of payments get automatically corrected without intervention by
the Government or its Central bank. The opposite happens when balance of
payments is in surplus due to the under-valued exchange rate.
 Integration of World Economy: Currency convertibility gives the chance to
Indian economy to interact with the rest the world economy. As under currency
convertibility there is easy access to foreign exchange, it greatly helps the growth
of trade and capital flows between the countries. The expansion in trade and
capital flows between countries will ensure rapid economic growth in the economies
of the world. In fact, currency convertibility is said to be a prerequisite for the
success of Globalisation.
Numericals:
Q1 If direct quote is Rs 39/US $, how can this exchange rate be presented under
indirect quote?
Solution US $ 1/Rs 39 = US $ 0.0256/Re.
Q2 If indirect quote is US $ 0.025/Re, how can this exchange rate be shown under
direct quote?
Solution Re 1/US $ 0.025 = Rs 40/US $.
Q3 Consider the following bid-ask prices: Rs 40 − 40.40/ US $. Find the bid-ask spread.
Solution Bid-ask spread = {(ask rate - bid rate)/ask rate} × 100
(40.40 − 40.00)/40.40 = 0.0099 or 0.99%
Q4 On April 1, 3 months interest rate in the € and ¥ are 4% and 7% per
annumrespectively. The € /¥ spot rate is 0.00787. What would be the forward rate for ¥
for delivery on 30th June?
Solution : As per interest rate parity
[ ]
= 0.00787[{1+ (0.04x3/12)}/{1+(0.07x3/12}]
= 0.00787 × 0.09926
= € /¥ 0.00781
Q5 Followings are the spot exchange rates quoted at three different forex markets:
USD/INR 59.25/ 59.35 in Mumbai GBP/INR 102.50/103.00 in London GBP/USD 1.70/
1.72 in New York The arbitrageur has USD1,00,00,000. Assuming that bank wishes to
retain anexchange margin of 0.125%, explain whether there is any arbitrage gain possible
from the quoted spot exchange rates (TRIANGULAR ARBITRAGE)
Solution : The arbitrageur can proceed as stated below to realize arbitrage gains.
i. Buy GBP at New York for USD USD 1,00,00,000
GBP/USD 1.72
Add: Exchange Margin @ 0.125% 0.002
1.722
Accordingly, GBP acquired in exchange of USD1,00,00,000 is GBP 58,07,200

ii. Sell these GBP at London Market and get INR
GBP/INR 102.50
Less: Exchange Margin@ 0.125% 0.13
102.37
INR on conversion of GBP (58,07,200 X 102.37) = INR 59,44,83,064
iii. Acquire USD by selling INR at Mumbai
USD/INR 59.35
Add: Exchange Margin @ 0.125% 0.07
59.42
Accordingly, USD acquired in exchange of INR is USD 1,00,04,763
Net Gain (USD 1,00,04,763 - USD 1,00,00,000) = USD 4,763
Q6 ABC Limited is a listed real estate development company in Nepal, with a
significant operation in Kathmandu Metropolitan Region. The company bas a export
exposure of HKD 5,00,000 payable August 31, 2020. Hong Kong Dollar (HKD) is not
directly quoted in Nepalese Rupees. The current spot rates are:
NPR/GBP Rs. 164.72
HKD/GBP HKD 10.72
It is estimated that Hong Kong Dollar will depreciated to 12.54 level and Nepalese
Rupees to depreciate against GBP to Rs. 166.68. Forward rates for August 2020
are
NPR/GBP Rs.167.30
HKD/GBP HKD 11.77
Calculate:
a) Calculate the expected profit/loss, if the hedging is not done. How the position
will change, if the firm takes forward cover?

b) If the spot rates on August 31 2020, 2014 are:
NPR/GBP= Rs. 165
HKD/GBP= HKD 11 Is the decision to take forward cover justified?
Solution:
We first calculate the cross exchange rate between Nepalese Rupees and Hong Kong
Dollar as follows:
NPR/GBP*GBP/HKD = 164.72/10.72 = Rs 15.365
Spot rate on date of export 1HKD = Rs 15.365
Expected Rate of HKD for August 2020 = 166.68/12.54 = Rs.13.29
Forward Rate of HKD for August 2020 = 167.30/11.77 = Rs. 14.21
a) Calculation of expected profit/loss (without Hedging)
Value of export at the time of export (Rs.15.365*5,00,000) Rs.76,82,500
Estimated payment to be received on August 2020 (Rs.

Rs.66,45,000
13.29*500,000)
Loss Rs. 10,37,500
Hedging of loss under Forward cover
Value of export at the time of export (Rs.15.365*5,00,000) Rs.76,82,500
Payment conditions under forward cover (Rs. 14.21*500,000) Rs. 71,05,000
Loss Rs. 5,77,500
By considering Forward cover, the company can actually reduce its loss in the process by
Rs. 460,000.
b) Actual rate of HKD on August 2020 = Rs. (165/11) = Rs. 15
Value of export at the time of export (Rs. 15.365*500,000) Rs. 76,82,500
Estimated payment to be received on August 2020 (Rs.15*500,000) Rs. 75,00,000
Loss Rs.1,82,500
By considering Forward cover with given condition, the company incurred the loss by Rs.
1,82,500. Hence, the decision of forward cover is justified

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International Finance – Imperial School of Banking and Management Studies 1

Meena Goyal, Ph.D, CA

Module II Foreign Exchange Markets

dating back to ancient civilizations. However, modern forex trading as we know it

collapsed, leading to the adoption of floating exchange rates. The emergence of

trillions of dollars traded daily.

What is Foreign Exchange Market?

The Foreign Exchange Market is a global decentralized marketplace where

facilitates international trade and investment by enabling businesses to convert one

currency into another.

entity controlling the exchange rates or setting the prices of currencies.

What are the Different Types of Foreign Exchange Markets?

There are three main types of foreign exchange markets:

1. Spot Forex Market

day across major financial centers.

2. Forward Forex Market

future date at a predetermined exchange rate. This allows participants to lock in a

future exchange rate, providing protection against currency fluctuations. The

the spot market.

3. Futures Forex Market

The futures forex market is a centralized exchange where standardized contracts

and requires participants to post margin.

When there is a simultaneous borrowing and lending of two types of currencies

a foreign exchange risk.

airport kiosks or the payments made by government and financial institutions.

Features of the Foreign Exchange Market

1. It is a decentralized market that operates 24 hours a day, 5 days a week, across

multiple time zones.

and low transaction costs.

3. The market is influenced by a variety of factors, including economic indicators,

geopolitical events, and central bank policies.

4. The market provides opportunities for traders to speculate on the movement of

currency values through a range of trading strategies.

5. The market is accessible to a wide range of participants, including individuals,

financial institutions, and governments.

Who are the Participants in a Foreign Exchange Market?

trading on behalf of their clients and for their own accounts.

● Central banks: Central banks participate in the market to manage their

country's monetary policy and stabilize currency values.

market to generate returns for their clients.

● Corporations: Multinational corporations use the forex market to manage their

currency risk, particularly when conducting international trade.

online brokers, seeking to profit from currency price movements.

● Governments: Governments participate in the forex market to manage their

currency values and maintain their country's economic stability.

Forex Trading Volume

with 7% and Japan with 4%.

Understanding Forex Market Trading Hours

Global foreign exchange market is largely unregulated and decentralized. Thanks to

Forex Market Trading Sessions

which is 7:00 AM on Monday in Sydney, to 9:00 PM UTC on Friday, which is 5:00 PM

Sydney 9:00 PM to 6:00 AM UTC

Tokyo 11:00 PM to 8:00 AM UTC

London 7:00 AM to 4:00 PM UTC

New York 12:00 PM to 9:00 PM UTC

12:00 PM UTC to 4:00 PM UTC.

Indian Forex Market Trading Hours

2022. Though forex markets globally can be characterised as OTC markets, a

significant portion of the trade in Indian rupee--12.9%--is done in exchange-traded

Japanese Yen (USD-JPY). Trading in these cross-currency futures have slightly

dependent on trades happening overseas.

the latter is a standard contract that is traded on an exchange.

How to Trade in Rupee in Forex Market

exchange by retail investors in India. Though India allows residents to spend up to