FOREIGN EXCHANGE MARKET

International transaction in cash requires two distinct purchases Purchase of foreign currency Purchase of good/service with the FC Term foreign exchange is used to denote foreign currency Foreign exchange market exists to cater to the demand for foreign currency/currencies. It involves transfers through Nostro/Vostro accounts between international banks.

Location
1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications

Contd
Organizational setting within which individuals, governments and banks buy and sell foreign currencies Only a small fraction of daily transactions in foreign exchange involve trading of currency Most foreign exchange transactions involve transfer of bank deposits. The foreign exchange market is round-theclock market due to different time zones Major participants- central banks, commercial banks, forex brokers, corporations, individuals

 Functions of Foreign Exchange Market 1. Transfer function Conversion of one currency into another currency results in transfer of purchasing power between countries. It is done through the instruments such as Telegraphic transfer, Foreign bills of exchange etc. 2. Credit function credit facility is offered through foreign bills of exchange and foreign letter of credit. 3. Hedging function Forward contract helps to cover the risk of changes in exchange rate between two currencies

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

I. Participants in Foreign Exchange Market A. Participants at 2 Levels 1. Wholesale Level (95%) - major banks 2. Retail Level - business customers.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B.
Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2nd business day 2. Forward Market: - transactions take place at a specified future date

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

C. Participants by Market 1. Spot Market a. commercial banks b. brokers c. customers of commercial and central banks

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators

 Important terminologies in Foreign Exchange transaction: Fiat currencies Paper currency notes issued by the Central Monetary Authority of the respective countries. It contains a promise to redeem the notes at its face value. Foreign Currency: the legal tender applicable in a country outside the domestic area. It is the money only in the country of issue. At other locations it should be viewed as a commodity having time value. Foreign Exchange - Definition as per FEMA (1999) Deposits, credits and balances payable in foreign currency Drafts, travelers cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency Drafts, travelers cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency

NOSTRO account

Demand deposit account denominated in foreign currencies maintained by domestic banks with banks overseas. Nostro means our account with you. Example: Indian Bank has a US dollar account with Citi Bank, New York.
VOSTRO account

Demand deposit accounts, denominated in domestic currency maintained by overseas banks with domestic banks. Vostro account means your account with us. Example: Barclays Bank, London has an INR account with Bank of Baroda.
LORO account

It is used for referring to third party accounts. Loro account means their account with you. This term is used when the NOSTRO/VOSTRO account is referred to, by a bank other than the account maintaining bank and the bank with which account is maintained. Example: Indian Bank has a USD account with Citi Bank, New York. When Canara Bank has to refer to this account while corresponding with Citibank it would refer to it as LORO account.

1.
2. 3.

4.

Correspondent banks: The Foreign exchange transactions centered around the transfers and payments made between banks from different countries. The bank with whom the nostro or vostro account relationship established is called as correspondent bank. It undertakes the following functions: Maintaining foreign currency account. Receiving and making payments on behalf of the principal bank. Providing credit reports on companies located in their country. Providing trade related data and product data to help the principal bank to help its customer for business development. Assisting principal bank in its agency functions such as presentation of documents, advising of LC, confirmation of LC etc.

 Role of banks in Foreign Exchange transactions: Every transactions involving foreign exchange passes through Nostro and Vostro accounts maintained by the international banks. Being the significant participant in the forex market, banks provide quotes for the pairs of currency traded in the market. Thus they play a crucial role in establishing demand supply equilibrium between currencies. In nutshell - trade is the base for international monetary flows. - international trade contributes to economic growth. -international trade settlements take place through conversion of one currency with another. - the rate of conversion is called as the Exchange Rate. - the rate is based on the demand supply factors affecting each currency pair.

Types of exchange rate

Exchange rate denotes the price or the ratio or the value at which one currency is exchanged for another Ready/cash - Settlement of funds on the same day (date of the deal). Tom - Settlement of funds takes place on the next working day of the date of the deal Spot - Settlement of funds takes place on the second working day following the date of the deal Forward settlement of funds takes place beyond spot date is called as forward contract. Such transactions are settled at the rate called forward rate.

Method of Quotation 1. For interbank dollar trades: a. American quote Number of dollars expressed per unit of any other currency. example: $1.5613/ b. European quote Number of units of any other currency expressed per dollar. example: Rs.45.96/$ 2. Merchant quote : Interbank quote

 For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency. Example: Rs.46.8700/$

Indirect quote
gives foreign currency price for a fixed number of units of domestic currency. Example : $2.0525/Rs.100

 Cross rates- To obtain rates for a particular currency pair when they are not available directly Bid and Ask rates- In USD/INR 39.40/41 the bank is bidding for USD at Rs. 39.40 and offering to sell USD at Rs. 39.41

Types of exchange rate (2)

In the forex market all rates that are quoted are generally spot rates When delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicable Forward rate = Spot rate + Premium (discount)

THE FORWARD MARKET

Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

Forward rate
If the forward value of a currency is higher than the spot value the currency is said to be at a premium If the above is reversed the currency is said to be at a discount The forward premium/discount is based on interest rate differentials of the two currencies involved

Forward Rate (2)

Forward transactions are necessary in the foreign exchange market as they serve number of purposes like:
One can hedge or cover an existing future financial, commercial or trade related exchange risk These types of deals, in combination with spot deals, are used for money market operations through swap transactions Taking a view of the market, these can be used for speculation

Forward rate (3)

When a currency is costlier in the future (forward) as compared to the spot, the currency is said to be at a premium vis--vis another currency In direct rate premium is added to both the buying and selling rate whereas discount is deducted In indirect rate premium is deducted and discount is added to the buying and selling rates

Forward rate (4)

Base currency is the currency which is being bought and sold and the other currency is incidental. Forwards are quoted as follows
Spot/1 month 17/18 Spot/ 2 months 35/37 Spot/ 3 months 53/56

If forward differentials are in the ascending order (bid rate is lower than ask rate) the base currency is at premium. If forward differentials are in the descending order (bid rate is greater than the ask rate) the base currency is at discount.

Forward Rate Quotations

1.Two Methods: a. Outright Rate: quoted to commercial customers. b. Swap Rate: quoted in the interbank market at a discount or premium.

Forward rate calculation: through the use of forward schedule

through the use of Formula

Annualized Forward Margin

Arithmetical difference between the interest rates of the variable and base currencies in annualized percentage terms = F-S x 12 x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract

THE FORWARD MARKET

C. Forward Contract Maturities 1. Contract Terms
a. 30-day b. 90-day c. 180-day d. 360-day Longer-term Contracts

2.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

. CLEARING SYSTEMS A. Clearing House Interbank System (CHIPS) - used in U.S. for electronic fund transfers. B. Fed Wire

- operated by the Fed

- used for domestic transfers . ELECTRONIC TRADING A. Automated Trading - genuine screen-based market

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B.Results:

1. Reduces cost of trading

2. Threatens traders oligopoly of information 3. Provides liquidity

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

IV. SIZE OF THE MARKET
The foreign exchange market is the largest and
most liquid financial market in the world. Market Centers (Between 2007-08): $3.98 trillion daily global turnover London =accounted for around $1.36 trillion, or 34.1% of the total New York= accounted for 16.6% Tokyo = accounted for 6.0%.

Dealing Room
A centralised establishment, usually of a commercial bank, which is willing to make/offer a two way dealing price for different currencies at all times even when they may not wish to deal, but all during prescribed business hours.

 Dealing Room

RBI/FEDAI Guidelines (1)

RBI has issued Authorised Dealers (AD) licenses to banks, all India financial institutions and a few co-operative banks to undertake foreign exchange transactions in India It has also issued Money Changer licenses to a large number of established firms, companies, hotels, shops, etc.

RBI/FEDAI Guidelines (2)

Money changers help facilitate encashment of foreign currencies of foreign tourists Entities authorised to buy and sell foreign currency notes, coins and travellers cheques are called full fledged money changers Those authorised only to buy are called restricted money changers

RBI/FEDAI Guidelines (3)

FEDAI (Foreign Exchange Dealers Association of India) is a non-profit making body formed in 1958 with the approval of RBI Its members are authorised dealers and it prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc. FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market