Foreign Exchange

Exchange rate quotations

• Base currency and Price Currency- USDINR- INR/USD
• Direct Quote- 1 unit of base currency in terms of Price currency
• Indirect Quote- 1 unit of price currency in terms of base currency
• Real V/s Nominal Exchange rates- The exchange rates we discussed or
normally see are referred to as nominal exchange rates. (Lets first
understand PPP).
• Real exchange rate (stated with the domestic currency as the price
currency) as representing the real price you face in order to purchase
foreign goods and services:
• REER- The weighted average of a country's currency relative to an index
or basket of other major currencies adjusted for the effects of inflation.
 PPP -According to the law of one price, identical goods should trade at the
same price across countries when valued in terms of a common currency.

Purchasing Power Parity (PPP) – Absolute Terms

Law of One Price

Cost of a basket of P
Cost of a basket of DC

domestic goods in Equals

foreign goods in FC E = ------
FC PFC
However in practical world, transaction costs are significant and not all goods are tradeable, so sizeable and
persistent departures from absolute PPP are likely.

But the changes in notional price levels are related and comparable, so according to relative PPP, the
percentage change in spot exchange rate = Inflation in Foreign currency – Inflation in Domestic currency

If Inflation in India = 6% and inflation in US= 2%, the long term rate of depreciation/ Appreciation of USD INR
=?
Examples
• Real Exchange rate = Real Spot (Base Price)= Nominal Spot x CPI (Base)/ CPI
(Price)

• https://www.ceicdata.com/en/indicator/india/real-effective-exchange-rate

• USDINR (Nominal)= 75, CPI India= 148 and CPI US is 256 then USD INR (Real)= ?
• Percentage change in NER between Rupee and dollar equals the percentage
change in RER plus the difference in rates of inflation in the two countries (India
& USA). See the chart from 2011
Example
FOREX TRANACTIONS

TRANSACTION
DOT DOS
TYPE

Cash / Ready Today Today

TOM Today Tomorrow

Day after
SPOT Today
tomorrow

Beyond day after

Forward Today
tomorrow
Determinants of Foreign exchange prices
• PPP- Is useful in assessing long-term exchange rate trends and can provide valuable information
about long-run equilibrium.

• Balance of Payment approach

• Monetary Approach- that excessive monetary expansion leads to currency depreciation.

• Portfolio Balance approach- Each individual and firm chooses a portfolio to suit its needs, based on
a variety of considerations - the level of domestic and foreign interest rates, expectations of future
inflation, interest rates, and so on. Any significant change in the underlying factors will cause the
holder to adjust his portfolio. These actions to balance portfolios will influence exchange rates.

• Saving Investment Imbalance

• Interest rate parity and Carry Trades

Interest Rate Parity- Example forward rate calculation

USD/INR spot : 71.50

1 year USD rate : 1.75%
1 year INR rate : 6.00%
To calculate 1 year forward rate:

FR (Base Price quote) = SR X [ 1+ R (Price)]

[1+ R (Base)]

71.5X(1+6%)/(1+1.75%) = INR 74.5

We can use simulations to estimate spot prices and accordingly forward prices.
8
Value at Risk
• VaR measures the max possible loss in a particular period of time with
a given confidence level.
• For eg. if One day 5% VaR is -2% then with 95% confidence we can say
that the returns will not go below 2% in one day or there is only 5%
chance that returns will be lower than 2% in one day.
• Methods to calculate VaR-
1) Historical
2) Analytical/ Parametric
3) Simulations
Forex Derivatives
• Futures/ Forwards
• Options- Calls and Puts
• Currency Swaps

Popular Option Strategies:

1. Collars- Zero cost or low cost
2. Spreads- Bull and Bear
• Knock in Knock Outs-  knock-out option is an option which is cancelled if the trigger
level (the outstrike) is reached.
• A knock-in option is an option which is activated if the trigger level (the instrike) is
reached.
Knock In-
• Assume an investor purchases a down-and-in put option with a barrier price of 90 and
a strike price of 100. The underlying security is trading at 110, and
the option expires in three months. If the price of the underlying security reaches 90,
the option comes into existence and becomes a vanilla option with a strike price of
100.
• Thereafter, the holder of the option has the right to sell the underlying asset at the
strike price of 100, even though it is trading below 90. It is this right that gives the
option value.

Knock Out-
• Let's say an investor is interested in Reliance at 1700 a share. By June 2, it closed at
1750 per share. Say our investor is bullish on the stock, but still cautious.
• So they may write a call option on, with a strike price of 1800 and a knock-out level of
1900. This option only allows the option holder to profit up to 1900, and after that the
option expires worthlessly, limiting the loss potential for the option writer.