Exchange rates

• 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

Foreign Exchange Market

• Organisational 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

Definition of foreign exchange

• Deposits, credits and balances payable in foreign currency

• Drafts, travellers’ cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency

• Drafts, travellers’ cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency

• The above definition is as per FEMA (1999)

Exchange rate (1)

• Denotes the price or the ratio or the value at which one currency is exchanged for another

• Exchange rate is very dynamic• The foreign exchange market is round-the-

clock market due to different time zones • Major participants- central banks, commercial

banks, forex brokers, corporations, individuals

Factors affecting exchange rate

• Major banks that act as market-makers always give two-way quotes; gives depth and volume to the market

• Fundamental reasons• Technical reasons• Speculation

Fundamental reasons

• Balance of payments->surplus->appreciation• Growth rate of the economy-> higher growth-

>depreciation of currency• Fiscal policy-> financing of fiscal deficit

influences exchange rate• Monetary policy->loose monetary policy->

depreciation of exchange rate

Technical reasons

• Freedom or restrictions on capital movements can affect exchange rates to a large extent

• Among other factors there are:– Huge trade surpluses of oil exporting countries– Capital moving from low-yielding currencies to

high yielding currencies (interest differential)

Speculation

• Self-fulfilling prophecies– Anticipation of depreciation of a currency can

cause dealers to sell that currency

• Speculation serves to provide depth and liquidity to the forex market

• Acts as a cushion as well- contrarian traders exist in the market

Types of exchange rate (1)

• 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

Types of exchange rate (2)

• Forward- Delivery takes place on any day after the date of the deal

• 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)

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

• Direct and indirect quotes of exchange rate- direct quote, local currency is variable

Quotes of Exchange Rate

• Cross rates- To obtain rates for a particular currency pair when they are not available directly

• Bid and offered 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

Exchange Arithmetic

• All foreign exchange calculations have to be worked with care and accuracy and several rules have to be kept in mind

• Chain rule- is used to attain comparison or ratio between two quantities which are linked together through another or other quantities. Equation in the form of a chain is derived.

• Per cent and per mille- Per 100 units/per 1000 units

Example of a Chain Rule (1)

• Query: If we have to remit French Francs to France from India how do we go about it? (We have to arrive at cross rates between FRF and INR.)

• Mumbai interbank market:– US $ 1 = Rs. 41.2550/2650

• London Market – US $ 1 = FRF 6.0500/6.0550

Chain rule (2)

• At what rate can one buy FRF against rupees?• How many Rs----- = FRF 1?• FRF 6.0500 = US $ 1• US $ 1 = 41.2650, therefore,• FRF 6.0500 = US $ 1 = Rs. 41.2650• Hence, FRF 1 = 41.2650/6.0500• Or FRF 1 = Rs. 6.8206

Forward Rate (1)• Value date: It is customary, in foreign exchange

market, to quote a rate to do the deal but exchange the currencies not on the same day but generally afterwards.

• Forward rate: Has two components– Spot rate– Forward points or forward differentials

• Forward rate is the rate when the value of the deal is fixed beyond the spot date i.e. beyond the second working day after the deal

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-à-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 (1st figure is lower than the 2nd) the base currency is at premium

Foreign exchange transactions (1)

• Arbitrage: Is an operation by which one can make risk free profit by undertaking offsetting transactions.– Can be in interest rates: borrow in one centre and

lend in another– Can be in exchange rates: Buy a currency in one

market and sell in another

• Arbitrage keeps exchange rates uniform in all markets

Foreign Exchange Transactions (2)• Merchant rates: Quotes offered to merchants

(importers, exporters) by banks.• Inter-bank rates: The rates quoted by banks for dealing

in the inter-bank market.• Merchant quotations: In India all merchant quotations

for foreign currencies shall be in so many rupees for one unit of foreign currency except for Japanese Yen, Italian Lira and Belgian Franc (Rs/100 units of the currency)

• All quotes are in four decimal places with the last two digits in the multiple of 25

Modes of remittances (1)

• Telegraphic Transfers (TT) of funds are done from one centre to another by way of instructions through telex, telegram or SWIFT (Society for Worldwide Interbank Financial Transfer). Of late SWIFT is becoming popular

• Mail Transfer (MT) of funds is done by way of instructions sent by mail. An MT is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned

Modes of Remittances (2)

• Demand draft (DD): A DD is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned therein.

• Fedai prescribed types of rates of merchant transactions:– TT (buying)- clean inward remittances– Bill (buying)- purchase/discount of export bills– TT (selling) clean outward remittances– Bill (selling) remittance for import bills

RBI/FEDAI Guidelines (1)

• RBI has issued Authorised Dealers (AD) licences 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 licences 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

PART I. INTRODUCTION

I. INTRODUCTIONA. The Currency Market:

where money denominated in one currency is bought and sold with money

denominated in another currency.

INTRODUCTION

B. International Trade and Capital Transactions:

- facilitated with the ability

to transfer purchasing power

between countries

INTRODUCTION

C. Location1. OTC-type: no specific

location2. Most trades by phone,

telex, or SWIFTSWIFT: Society for Worldwide

Interbank Financial Telecommunications

PART II.ORGANIZATION OF THE FOREIGN EXCHANGE

MARKET

I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKETA. 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

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

2. Forward Market:- transactions take place at a specified future date

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

C. Participants by Market1. Spot Market

a. commercial banksb. brokersc. customers of commercial

and central banks

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

2. Forward Marketa. arbitrageursb. tradersc. hedgersd. speculators

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

II. CLEARING SYSTEMSA. Clearing House Interbank Payments System (CHIPS)

- used in U.S. for electronic fund transfers.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. FedWire

- operated by the Fed

- used for domestic transfers

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

III. ELECTRONIC TRADINGA. 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

A. Largest in the world

1995: $1.2 trillion daily

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. Market Centers (1995): London = $464 billion

dailyNew York= $244 billion

dailyTokyo = $161 billion

daily

PART III.THE SPOT MARKET

I. SPOT QUOTATIONSA. Sources

1. All major newspapers2. Major currencies have four different quotes:

a. spot priceb. 30-dayc. 90-dayd. 180-day

THE SPOT MARKET

B. Method of Quotation1. For interbank dollar

trades:a. American terms

example: $.5838/dm

b. European termsexample: dm1.713/$

THE SPOT MARKET

2. For nonbank customers:

Direct quote

gives the home currency price of one unit of foreign currency.

EXAMPLE: dm0.25/FF

THE SPOT MARKET

C. Transactions Costs1. Bid-Ask Spread

used to calculate the feecharged by the bank

• Bid = the price at which the bank is willing to buy

• Ask = the price it will sellthe currency

THE SPOT MARKET

4. Percent Spread Formula (PS):

100xAsk

BidAskPS

THE SPOT MARKET

D. Cross Rates

1. The exchange rate

between 2 non - US$

currencies.

THE SPOT MARKET

2. Calculating Cross RatesWhen you want to know what the dm/ cross rate

is, and you know dm2/US$ and .55/US$

then dm/ = dm2/US$ .55/US$= dm3.636/

THE SPOT MARKET

E.Currency Arbitrage1. If cross rates differ from

one financial center to another, and profit opportunities exist.

THE SPOT MARKET

2. Buy cheap in one int’l market,sell at a higher price in

another

3. Role of Available Information

THE SPOT MARKET

F.Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of original transaction.

THE SPOT MARKET

G. Exchange Risk1. Bankers = middlemen

a. Incurring risk of adverseexchange rate moves.

b. Increased uncertainty about future exchange

rate requires

THE SPOT MARKET

1.) Demand for higher riskpremium

2.) Bankers widen bid-ask spread

PART II.MECHANICS OF SPOT

TRANSACTIONSSPOT TRANSACTIONS: An

ExampleStep 1. Currency transaction: verbal

agreement, U.S. importer specifies:

a. Account to debit (his acct)b. Account to credit

(exporter)

MECHANICS OF SPOT TRANSACTIONS

Step 2. Bank sends importercontract note including:

- amount of foreign

currency

- agreed exchange rate

- confirmation of Step 1.

MECHANICS OF SPOT TRANSACTIONS

Step 3. SettlementCorrespondent bank in HongKong transfers HK$ fromnostro account to exporter’s.

Value Date.

U.S. bank debits importer’saccount.

PART III.THE FORWARD MARKET

I. INTRODUCTIONA. 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.

THE FORWARD MARKET

2. Purpose of a Forward:

Hedging

the act of reducing exchange

rate risk.

THE FORWARD MARKET

B. Forward Rate Quotations1. Two Methods:

a. Outright Rate: quoted to commercial customers.

b. Swap Rate: quoted in theinterbank market as a discount or premium.

THE FORWARD MARKET

CALCULATING THE FORWARDPREMIUM OR DISCOUNT

= 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 Maturities1. Contract Terms

a. 30-dayb. 90-dayc. 180-dayd. 360-day

2. Longer-term Contracts

PART IV.INTEREST RATE PARITY THEORY

I. INTRODUCTIONA. The Theory states:

the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.

INTEREST RATE PARITY THEORY

2. The forward premium ordiscount equals the interest

rate differential. (F - S)/S = (rh - rf)

where rh = the home rate

rf = the foreign rate

INTEREST RATE PARITY THEORY

3. In equilibrium, returns oncurrencies will be the samei. e. No profit will be realized

and interest parity existswhich can be written

(1 + rh) = F

(1 + rf) S

INTEREST RATE PARITY THEORY

B. Covered Interest Arbitrage

1. Conditions required:

interest rate differential does

not equal the forward premium or discount.

2. Funds will move to a country

with a more attractive rate.

INTEREST RATE PARITY THEORY3. Market pressures develop:

a. As one currency is more

demanded spot and sold

forward.

b. Inflow of fund depresses

interest rates.

c. Parity eventually reached.

INTEREST RATE PARITY THEORY

C. Summary:Interest Rate Parity states:

1. Higher interest rates on a

currency offset by forward discounts.

2. Lower interest rates are offset by forward premiums.