Session2_ForexMarkets

7/29/2019 Session2_ForexMarkets

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The Foreign Exchange Market


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Features of the global forex market

Oldest and biggest financial market in the world

Geographically spread out

Most active, quick and liquid market

Not a physical market; electronically linked network ofbanks, forex brokers and dealers

Round-the-clock trading through telephones, telex and faxmachines and the Society for Worldwide International

Financial Telecommunications (SWIFT)

Two parts : Wholesale and Retail


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Structure of the market

Wholesale market

Inter-bank market

Head offices of major banks are market-makers

Have correspondent relationships with banks in other countries No physical transfer of currencies, simply book entries

Continuous 24-hour trading

Extremely narrow bid-ask spreads

Dealing banks profit from the spread

Retail market

Exchange of bank notes, bank drafts, travelers cheques, currencyetc between private customers, tourists and banks

Authorized dealers and money-changers permitted to deal in thissegment


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A brief history

Dates back to ancient times; barter system; useof gold and silver coins

Paper notes used in Italy in late 14th century

bankers dealt in the notes and discounted themaccording to the relative values of the currencies

Paper money widely used in 18th century- theGold Standard

Bretton Woods System after WWII


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A brief history contd..

Collapse of Bretton Woods system in 1970s andbirth of market-determined exchange rates explosion in currency trading

Birth of the Euro in late 1990s led to a declinein volume of currency trading

Trading rebounded in 2003-04 because ofspeculative activities of institutional investorslike hedge funds

Largest and most widespread market today


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Market Participants

Can be grouped into 4 categories:

Exporters and Importers

Investors (FDI and FPI)Speculators

Governments


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Determination of exchange rates

Short-term movements influenced by:

Release of domestic economic data and anticipationof the release

Release of economic data in foreign countries

Central bank actions

Central banks making public their thoughts on

monetary policy Political developmentsdomestic and global

Changes in commodity prices, oil and gold

Natural disasters and perception of their impact


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Short-term movement scenarios

Scenarios likely to impact exchange rates :

Stock market rally may lead to currency appreciation

Oil price surge to record high may weaken currency for an oilimporter

Increase in unemployment numbers may lead to fall I currencyvalue

Surprise hike in interest rates by the central bank of the countrycould lead to appreciation of currency


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Long-term movements

Guided by expectations of real interest rates

Real interest rates means nominal interest rateless inflation rate

Mechanism of covered interest arbitrage

Example


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Foreign Exchange Models

Monetarist Model

Exchange rate responds to factors of supply and demand just as anyother commodity

Hence no formal devaluation and revaluation by government is necessary

Portfolio Balance Model Demand for and supply of financial assets

Forex market participants hold portfolios of domestic money, domesticbonds and foreign currency bonds

Exchange rate determined by the process of bringing total demand andsupply of financial assets in the country to an equilibrium level


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Foreign Exchange Models contd..

Purchasing Power Parity

Exchange rates will adjust to equalize the relative purchasingpower of currencies

Identical goods will sell at identical prices when valued insame currency

Tracked by dividing inflation rate in one country by inflationrate in another

Big Mac index published by the Economist


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Exchange rate Regimes

Mechanisms adopted by government formanaging exchange rates

Fixed rate regimes

Gold Standard: No devaluation permitted

Bretton Woods arrangement: Conditionaldevaluation permitted; IMF could lend to countries

with BoP problems Pegs: Currency value held constant in terms of

another currency, usually a major trading partner


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Exchange rate Regimes contd..

Currency Board

Type of peg designed to avoid destabilization

Board is like a central bank

Issues currency only to extent of equivalent forex reserves If investors sell domestic currency, forex reserves decline and

automatically reduces domestic money supply to that extent

Hence interest rates rise and economy slows down

Changing exchange rate under Currency Board requireslegislation

Hong Kong has a currency board


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Shortcomings of fixed interest rates

Interest rates have to remain high so thatinvestors may hold the currency

Central bank cannot lower interest rates to fightdepression

Risk less opportunity for domestic investors toborrow in foreign currency at lower rates andinvest in own country at higher rates


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Semi-fixed exchange rates

Bands: European Exchange rate Mechanism

Target zones

Pegs and baskets Crawling peg

Asian currency crisis


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Floating exchange rates

Monetary policy does not target exchange rates

Free movement allowed

Floating rates management Occasional intervention by central bank

BOJ, Swiss Bank and Brazilian Central Bank haveintervened recently


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Countries and exchange rate regimes

Regime No. of countries as of

April 2006

I. Hard Peg 48

- No separate legal tender 41

- Currency Board

arrangement

7

II. Soft peg 60

- Conventional peg 49

- Intermediate pegs 11

III. Floating regimes 79

- Managed floating 53

- Independently floating 26

Based on RBI Report on Currency and Finance


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Forex market in India

Regulated by the RBI

Authorised Dealers divided into 3 categories

Category I include all scheduled commercial banks

(public sector banks, private banks and foreign banksoperating in India)

Catgeory II include all upgraded full-fledged moneychangers, select RRBs and co-operative banks

Category III includes select financial institutions likeEXIM Bank

All merchant transactions in forex must be undertaken

through ADs only


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Forex market in India

Forex brokers active in inter-bank transactions

Organization of ADs known as the FEDAI

Set up in 1958 as a self-regulatory body under the Companies Act 1956

Concerned with framing rules for conduct of inter-bank forex business

and vis--vis the public

Liasoning with RBI for reforms and development of the market

Currently has 99 members ( as of Feb 2012) including PSU banks, privateand foreign banks and institutions like EXIM bank, IFCI and SIDBI andothers like Thomas Cook

Important role n functioning of forex market and works closely withRBI, FIMMDA, Forex Association of India etc

Customers mainly oil companies such as IOC, BPCL, HPCL andother PSUs and also private companies and FIIs


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Definition of foreign exchange

Market in which national monetary units or claimsexchanged for foreign monetary units

Foreign exchange defined under the FERA 1973 means

foreign currency and includes the following: Deposits, credits and balances payable in any foreign currency

Any drafts, travelers cheques, letters of credit and bills of exchangeexpressed or drawn in Indian currency but payable in any foreigncurrency

Any instrument payable at the option of the drawee or holderthereof or any other party thereto either in Indian currency or inforeign currency or partly in one and partly in the other


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Evolution of Indian forex market

Par Value system of exchange rate followed from 1947 to 1971

Rupees external or par value fixed at 4.15 grains of fine gold

RBI maintained par value within permitted band of +-1%

using sterling as intervention currency Devaluation of rupee in terms of gold in 1966

Exchange rate of rupee in terms of gold, dollar and othercurrencies remained stable

Forex market was defunct; FERA 1947 applied Central government and RBI controlled regulated demand

for forex to match available supply

Banks required to maintain square position at all times


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Evolution of Indian forex market..

With breakdown of Bretton Woods System, rupee linked to sterling inDecember 1971

As sterling was fixed to the US dollar under the SmithsonianAgreement, the rupee-dollar rate also remained stable

From September 1975 rupee pegged to basket of currencies In 1978 banks allowed to undertake intra-day trading and maintain

square position only end of day

Bank managements allowed to fix open position limits as well as intra-

day trading limits RBI announced daily its buying and selling rate to ADs for merchant

transactions; spread of 0.5 per cent leading to active trading within thislimit

AD s permitted cross-currency trading


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Trading volumes started building up; banks offered two-wayquotes

Highly regulated market with restrictions on externaltransactions, barriers to entry, low liquidity and high transactioncosts

Exchange rate managed strictly for facilitating countrys imports

Strict control through the FERA resulted in parallel, unofficial(hawala) market

Trade imbalances, widening of current account deficit, Gulfcrisis of 1990-91 and drying up of capital flows led to need forcorrective action


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HLC on Balance of Payments (Rangarajan)recommended moving towards market-determinedexchange rates

Liberalized Exchange Rate Management System(LERMS) introduced in March 1992

Required surrender of all forex receipts on current accountto AD s

60% converted at market rates and 40% at RBI rate

AD s required to surrender the 40% to RBI and retain the60% for sellign in market for permissible transactions


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Dual exchange rate system replaced by unifiedexchange rate system in March 1993

Under this system all forex receipts could beconverted at market rates

Restrictions on several current accounttransactions were relaxed

Rupee became freely convertible on currentaccount in August 1994


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Measures for development of forex

market FERA 1973 replaced by market-friendly FEMA 1999

AD s were delegated power by RBI to release forex for variouspurposes

CCIL set up in 2001 under Sodhani Committeerecommendations

Introduction of new instruments such as rupee-foreign currencyswaps, foreign currency options, cross-currency options, IRS andcurrency swaps, FRAs, caps and collars

AD s permitted to initiate trading positions, borrow and invest inoverseas markets subject to their Board approval


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Measures contd..

Banks permitted to

fix net overnight position limits and gap limits (with RBIapproval)

Determine interest rates (subject to a ceiling) and maturityperiod of FCNR(B) deposits

Use derivatives for asset-liability management

Market participants with genuine exposure permitted to

avail forward cover and enter into swaps without any limit Foreign exchange earners permitted to open foreign

currency accounts and residents permitted to open suchaccounts up to a general limit


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Market segments

Spot market immediate delivery in case of bank notes

Delivery up to 2 business days in case of inter-bank funds

Spot segment is dominant in Indian forex market as in other

emerging markets

Derivatives segment

Forward contracts for maturities up to one year; majority arefor one month, three months or six months

FX swaps are a combination of a spot and a forward inopposite direction

Foreign currency options


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Sources of Demand and Supply

Supply of foreign exchange is through

Receipts on account of exports and invisibles in currentaccount

Inflows in capital account by way of FDI, portfolioinvestment, ECBs and NRI deposits

Demand for forex by way of

Imports and invisible payments on current account

Amortisation of ECB Redemption of NRI deposits and outflows on account of

direct and portfolio investment


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Change in sources

Capital account transactions acquired moresignificance over the last few years

Expectations and reactions to news affect thecapital flows and hence the exchange rateleading to higher volatility

RBI attempts to stabilize exchange rate through

direct purchase/sale of foreign exchange,sterilization through OMOs and LAF, changesin reserve requirements etc


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Exchange rate quotation

American term: Exchange rates quoted in amounts ofUS dollar per unit of foreign currency

E.g. USD 0.0192 per unit of INR is an American

quote European term: Exchange rates quoted in amounts of

foreign currency per US dollar

E.g. INR 52 per USD is a European quote Most foreign currencies quoted in European terms


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Exchange rate quotation contd..

Direct quote: Home currency price for one unitof foreign currency

Eg. 1 USD = Rs.52 is a direct quote for an Indian

Indirect quote: Foreign currency price for oneunit of home currency

E.g. Re.1 = USD 0.0192 is an indirect quote for an

Indian

Direct and Indirect quotes are reciprocals ofeach other


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Trading platforms in India

FX Clear set up by CCIL, FX Direct set up by IBSForex (P) Ltd in collaboration with FTIL, Reutersplatforms

FX Clear offers straight-through-processing (STP ) aslinked to CCILs settlement platform

Offer real-time order matching as well as negotiationmodes for dealing


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Global forex market v/s Indian

Estimated that roughly 90 per cent of global forex marketturnover is for arbitrage and speculation

Forex market in developed countries more free and de-

regulated than Indian market Greater emphasis on providing service to exporters and

importers than on pure exchange trading in Indian market

Hence more exchange control in Indian market


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Risk management

CCIL set up to mitigate risks in Indian financial markets

Undertakes settlement of inter-bank spot and forwardtrades

Multilateral netting Net amount payable to or receivable from CCIL in each

currency is arrived at member-wise

Rupe leg settled through members current account with

RBI and USD leg through CCILs account with thesettlement bank in New York

Limits for each member bank based on its net worth, creditrating etc


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Risk Management contd..

Board of Directors required to frame appropriate policy for andoperational limits for forex business

Net overnight open positions and aggregate gap limits need tobe approved by the RBI

Front-office operates within these limits, exposures confirmed,accounted and settled by back-office and profit/loss and riskcompliance monitored by mid-office

Market risk generally measured throough VaR techniques

Credit risk managed by aggregating all exposures for a counter-party

Liquidity risk monitored through asset-liability profile in variouscurrencies in various buckets


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Global forex market turnover

Average daily turnover $4 trillion (April 2010) as compared to $3.3trillion in April 2007

Higher turnover associated with increased trading activity of other

financial institutions

Category includes non-reporting banks, hedge funds, pension funds,mutual funds, insurance companies and central banks

Turnover by this category grew 42% over 2007

Turnover of this category exceeded inter-bank turnover for the first timein 2010

Cross-border transactions represented 65% of trading activity in April2010 and local transactions 35%; forex market activity has thusbecome more global


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Global forex market turnover contd..

Spot transactions accounted for 37% of the forex market turnover inApril 2010 while outright forwards, forex swaps, currency swaps,currency options and other products accounted for the rest

Average daily turnover of OTC currency derivatives (outright

forwards, swaps, currency options etc) was around $2.5 trillion in April2010 as against $168 billion for exchange-traded derivatives

Banks in UK accounted for 37% of all forex market turnover followedby US (18%), Japan (6%), Singapore(5%), Switzerland (5%), HongKong SAR (5%) and Australia (4%)

Top 3 currencies traded are the USD, Euro and JPY; USD/EUR is thedominant pair

Session2_ForexMarkets

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