FX MKTS M1

Foreign Currency MarketsModule 1

FX MKTS M1

Meaning of FX Rate

• FX rate– FX rate between two currencies specifies how

much one currency is worth in terms of another currency.

– Exchange rate between two currencies are quoted and can be viewed on sites like Bloomberg and Reuters.

– For eg., USD/JPY = 120• 1 unit of USD is worth 120 units of Japanese Yen

FX MKTS M1

Meaning of FX Rate

• Quote (USD/JPY = 120)– Quote Currency

• In the above example the price of 1 USD is expressed in terms of Japanese Yen, here Yen is called the Quote Currency or Price Currency.

– Base Currency• Since the exchange rate gives the price of one unit

of USD, USD is called the base currency.

– In general in a currency pair the left hand currency is the base currency and the right hand currency is the quote currency.

FX MKTS M1

Meaning of FX Rate

• Quote– Direct Quote

• Quote for a currency pair where the base currency is USD is called direct quote.

• All currencies except GBP,AUD,NZD and EUR are quoted in terms of direct quote.

– Indirect Quote• The exchange rate between GBP and USD is expressed as

GBP/USD = 2.0200.• Here the quote currency is USD.• Indirect quotes are given for GBP,AUD,NZD and EUR

FX MKTS M1

Meaning of FX Rate

• Foreign and Domestic Currency– In USD/JPY, USD is the foreign currency– In USD/JPY, JPY is the home currency

• Buy USD/JPY– This means that the trader is buying USD by selling

JPY. Or the trader is buying USD by paying in JPY.• Sell USD/JPY

– Trader sells USD and buys JPY.• In general buy or sell a currency pair means

buying or selling the base currency against the quote currency.

FX MKTS M1

Meaning of FX Rate

• Bid Ask Spread– Market makers always quote two way exchange rate.– For eg. USD/INR = 40.45/46– The left hand price is always lower than the right hand

price.– The lower price is the bid price ( left hand) and the

higher price is the ask or offer price.– Bid is the price at which market makers are ready to

buy a currency pair, in other words a seller can sell USD/INR to market maker at 40.45.

FX MKTS M1

Meaning of FX Rate

• Bid Ask Spread (USD/INR = 40.45/46)– Ask or Offer price is the price at which a market

maker is ready to sell a currency pair or in other words a buyer can buy a currency pair from the market maker.

– In the above example a buyer can buy USD by paying INR 40.46 to the market maker.

• Spread– The difference between the ask and bid price is called

spread. Here the spread is 1 paise ( or 1/100 of INR 1).

FX MKTS M1

Fluctuations in FX Rate

• During the market hours the exchange rate for currency pairs frequently change.

• The smallest amount by which the rate of a currency pair can change is called ‘PIPS’.

• For eg. GBP/USD = 2.0201/2.0202– Here the smallest amount by which the rate change is

0.0001 USD. Thus pips for GBP/USD is 0.0001.– Another measure of change is BPS ( called bips).– 1 BPS = 0.01– Pips is often called as small figure and bips as big fig.

FX MKTS M1

Fluctuations in FX Rate

• Appreciation– If USD/JPY = 120 changes to USD/JPY = 119 then

we say that Yen has appreciated against USD.– In other words price of USD has fallen in terms of

YEN.– This means YEN has strengthened against USD.– Similarly if GBP/USD = 2.0201 changes to GBP/USD

= 2.0202 then GBP has appreciated against USD.– The price of GBP has increased in terms of USD.

FX MKTS M1

Fluctuations in FX Rate

• Depreciation– If USD/JPY = 120 changes to USD/JPY = 121 then

we say that Yen has depreciated against USD.– In other words price of USD has risen in terms of

YEN.– This means YEN has weakened against USD.– Similarly if GBP/USD = 2.0201 changes to GBP/USD

= 2.0200 then GBP has depreciated against USD.– The price of GBP has decreased in terms of USD.

FX MKTS M1

Spot and Forward (Fwd) Rates

• Spot Rate– Spot exchange rate is the rate at which transactions can be

executed instantaneously in the market.– However the transactions are settled 2 days from the transaction

date (T+2) in all currencies except CAD/USD where it is settled on T+1 day.

– The settlement date is called ‘Spot Date’ or ‘Value Date’.

• Forward Rate– Forward exchange rate is the rate at which transactions can be

executed at a future date at a rate that is agreed today.

• There can be only one two way quote for the spot rate.• There can be many forward rate quotes, each quote

corresponds to a different future date.

FX MKTS M1

Covered Interest Rate Parity

• Assume– The spot exchange rate for USD/JPY = S– 1 year forward exchange rate for USD/JPY =

F– 1 year Interest rate in US ( or foreign country)

= rf

– 1 year Interest rate in Japan (domestic) = rd

FX MKTS M1

Covered Interest Rate Parity

• Transactions– At t = 0

• Borrow an amount P in USD for 1 year• Sell USD in spot market to buy JPY for spot

exchange rate of S = JPY P*S • Lend JPY for 1 year in Japan• Buy a 1 year forward contract in USD/JPY, forward

exchange rate = F.

FX MKTS M1

Covered Interest Rate Parity

• Transactions– At t = 1 yr

• Receive Yen amount = P*S(1+ rd)• Convert this into USD at forward rate

= USD P*S(1+ rd)/F• Payoff the USD loan, amount = USD P*(1+ rf)

• According to No Arbitrage Principle, the value of USD amount received from forward contract should be equal to the value of loan after 1 year.

FX MKTS M1

Covered Interest Rate Parity

• For no arbitrage

P*S(1+ rd)/F = P*(1+ rf)

or S/F = (1+ rf)/(1+ rd) …… Eq 1.• The above equation (Eq 1) explains the

fundamental relationship between the spot rate, forward rate and the interest rate in two countries.

• This concept is called ‘Covered Interest rate Parity’.

FX MKTS M1

Forward Rates

• One assumption of the covered interest rate parity is that one can borrow as much as one wishes from foreign country and convert it into domestic currency.

• In countries where the domestic currency is not fully convertible like India, the relation between forward and spot USD/INR rate does hold.

• If the domestic currency is fully convertible, then the forward exchange rate will exactly follow the covered interest rate parity.

FX MKTS M1

Forward Discount and Premium

• From Equation 1.S/F = (1+ rf)/(1+ rd) …… Eq 1.

• If rf > rd then S > F– Forward exchange rate will be less than the spot

exchange rate. – Or we can say that the forward rate is in discount

compared to spot.• If rf < rd then S < F

– Forward exchange rate is in premium in comparison to the spot rate. This premium is also referred as forward premia.

FX MKTS M1

Forward Discount and Premium

• Forward Points– The difference between S and F is called forward

points, it can be positive or negative indicating whether the forward is in premium or discount.

• Assume USD/INR spot = 40.45 and 1 yr fwd = 40.85.– In this currency pair the dollar is in premium against

rupee.– However the rupee is in discount against the dollar.

FX MKTS M1

FX Terminology

• G3 Currencies– GBP, EUR and USD

• G7 Currencies– GBP,EUR,JPY,CHF,AUD,CAD and USD

• Currency Pair Names– The following currency pairs are called by their name

• GBP/USD – Cable• USD/CHF – Swissy• AUD/USD – Aussie• CAD/USD – Loonie/Caddy

FX MKTS M1

Cross Currency

• In all exchange rate quotes one of the currency is USD for both direct and indirect quotes.

• If in a currency pair none of the currency is USD, then the exchange rate is called ‘Cross Currency’ rate.

• The cross currency rate is calculated by combining the quotes of both currency against USD.

FX MKTS M1

Cross Currency

• Example to Calculate CHF/INR rateAssume spot USD/INR rate = 40.45/40.46Assume spot USD/CHF rate = 1.2500/1.2510

• Transaction 1 – Buy CHF Sell INR– Buy USD Sell INR (take the ask price) = 40.46– Sell USD Buy CHF (take the bid price) = 1.25– Buy CHF Sell INR (CHF/INR)

= 40.46/1.25 = 32.3680.

FX MKTS M1

Cross Currency

• Transaction 2 – Sell CHF Buy INR– Buy USD Sell CHF (take the ask price) =

1.2510– Sell USD Buy INR ( take the bid price) =

40.45– Sell CHF Buy INR (CHF/INR)

= 40.45/1.2510= 32.3341

• CHF/INR = 32.3341/32.3680