FOREIGN EXCHANGE MARKETS

2 The Foreign Exchange includes... Foreign exchange (Fx): money denominated in the currency of another nation or group of nations Exchange rate: the price of one currency expressed in terms another currency What do you think causes the values of currencies to change daily?

Introduction to Currency Markets The exchange of currencies is done in the foreign exchange market, which is one of the biggest financial markets. The participants of the market are banks, corporations, exporters, importers etc. A foreign exchange contract typically states the currency pair, the amount of the contract, the agreed rate of exchange etc.

Exchange Rate A foreign exchange deal is always done in currency pairs, for example,  US Dollar – Indian Rupee contract (USD – INR);  British Pound – INR (GBP - INR),  Japanese Yen – U.S. Dollar (JPYUSD),  U.S. Dollar – Swiss Franc (USD-CHF) etc. Some of the liquid currencies in the world are USD, JPY, EURO, GBP, and CHF and some of the liquid currency contracts are on USD-JPY, USD-EURO, EURO-JPY, USD-GBP, and USD- CHF

5 Location of the 4 Biggest Foreign Exchange Market London is the largest foreign exchange market (followed by New York, Tokyo, and Singapore) because of its strategic location between Asia and the Americas.  1st peak when Asia & Europe are open  2nd peak when Europe and U.S. are open The most frequently traded currency pairs are:  U.S. Dollar/Euro (28%)  U.S. Dollar/Yen (17%)

6 Where do people go to exchange their currency? The Foreign Exchange Market  Most are Over-the-counter (OTC) market through commercial and investment banks  The Exchange-trade market specializes in securities, futures and options  to learn how to do-it-yourself

7 Top OTC Banks ESTIMATED TRADING BANK MKT.SHARE 1. Deutsche Bank 19.75% 2. UBS Warburg 11.61% 3. Citigroup 7.33% 4. HSBC 6.64% 5. Barclays 6.41% 6. JP Morgan 5.38% 7. ABN Amro 4.57% 8. Merrill Lynch 4.45% 9. Goldman Sachs 4.38% 10.Morgan Stanley 4.20% Source: “2005 Euromoney Foreign Exchange Poll,” Euromoney (May 2005).

8 Which currency is the most actively traded? CURRENCY U.S. Dollar Euro Japanese Yen Pound Sterling Swiss Franc All others Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity, Why do you think these currencies so popular?

9 The stability of the U.S. dollar has made it the most widely traded in the world Dollars are invested in many capital markets Dollars are used as a reserve currency for many governments’ central banks Dollars are a transaction currency in many international commodity markets Dollars are an invoice currency Dollars are an intervention currency used by monetary authorities to influence their own exchange rates

Exchange Rate In a currency pair, the first currency is referred to as the base currency and the second currency is referred to as the ‘counter/terms/quote’ currency. The exchange rate tells the worth of the base currency in terms of the terms currency, i.e. for a buyer, How much of the terms currency must be paid to obtain one unit of the base currency. For example, a USD-INR rate of Rs implies that Rs must be paid to obtain one US Dollar. Foreign exchange prices are highly volatile and fluctuate on a real time basis.

Base Currency / Terms Currency In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. E.g. the expression Dollar – Rupee, tells you that the Dollar is being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms currency. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the second currency.

Base Currency / Terms Currency Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. E.g. If Dollar – Rupee moved from to The Dollar has appreciated and the Rupee has depreciated.

Quotes In currency markets, the rates are generally quoted in terms of USD. The price of a currency in terms of another currency is called ‘quote’. A quote where USD is the base currency is referred to as a ‘direct quote’ (e.g. 1 USD – INR ) A quote where USD is referred to as the terms currency is an ‘indirect quote’ (e.g. 1 INR = USD).

Quotes USD is the most widely traded currency and is often used as the vehicle currency. Use of vehicle currency helps the market in reduction in number of quotes at any point of time, since exchange rate between any two currencies can be determined through the USD quote for those currencies. This is possible since a quote for any currency against the USD is readily available. Any quote not against the USD is referred to as ‘cross’ since the rate is calculated via the USD.

Quotes For example, the cross quote for EUR- GBP can be arrived through EUR-USD quote * USD-GBP quote (i.e * = 0.852). Therefore, availability of USD quote for all currencies can help in determining the exchange rate for any pair of currency by using the cross-rate.

Spreads Spreads or the dealer’s margin is the difference between bid price (the price at which a dealer is willing to buy a foreign currency) and ask price (the price at which a dealer is willing to sell a foreign currency). The quote for bid will be lower than ask, which means the amount to be paid in counter currency to acquire a base currency will be higher than the amount of counter currency that one can receive by selling a base currency. For example, a bid-ask quote for USDINR of Rs – Rs means that the dealer is willing to buy USD by paying Rs and sell USD at a price of Rs The spread or the profit of the dealer in this case is Rs

Fixed Exchange Rate Regime and Floating Exchange Rate Regime

Fixed exchange rate regime: Fixed exchange rate, also known as a pegged exchange rate, is when a currency's value is maintained at a fixed ratio to the value of another currency or to a basket of currencies or to any other measure of value e.g. gold. In order to maintain a fixed exchange rate, a government participates in the open currency market. When the value of currency rises beyond the permissible limits, the government sells the currency in the open market, thereby increasing its supply and reducing value. Similarly, when the currency value falls beyond certain limit, the government buys it from the open market, resulting in an increase in its demand and value. Another method of maintaining a fixed exchange rate is by making it illegal to trade currency at any other rate. However, this is difficult to enforce and often leads to a black market in foreign currency.

Floating exchange rate regime: Unlike the fixed rate, a floating exchange rate is determined by a market mechanism through supply and demand for the currency. A floating rate is often termed "self-correcting", as any fluctuation in the value caused by differences in supply and demand will automatically be corrected by the market. For example, if demand for a currency is low, its value will decrease, thus making imported goods more expensive and exports relatively cheaper. The countries buying these export goods will demand the domestic currency in order to make payments, and the demand for domestic currency will increase. This will again lead to appreciation in the value of the currency.

Spot Transaction and Forward Transaction The spot market transaction does not imply immediate exchange of currency, rather the settlement (exchange of currency) takes place on a value date, which is usually two business days after the trade date. The price at which the deal takes place is known as the spot rate (also known as benchmark price). The two-day settlement period allows the parties to confirm the transaction and arrange payment to each other. A forward transaction is a currency transaction wherein the actual settlement date is at a specified future date, which is more than two working days after the deal date. The date of settlement and the rate of exchange (called forward rate) is specified in the contract. The difference between spot rate and forward rate is called “forward margin”.

THE SPOT MARKET Percent Spread Formula (PS): Incase of direct quote the spread is in terms of domestic currency

THE FORWARD MARKET B.Forward Rate Quotations 1. Two Methods: a.Outright Rate: quoted to commercial customers. b.Swap Rate: quoted in the interbank market as a discount or premium. Express only the difference between the spot quote and forward quote. Spot 1m 3m Eg (20)-10 (40)-20 bid- ask

American Style ( Direct quote) Spot Rate $/Rs.42( Foreign Currency) Forward Rate $/ Rs. 40 Rupee appreciates Dollar depreciate – It is at discount.

Spot Transaction and Forward Transaction S.R. Rs. 42/$ F.R. Rs. 44/$ Rupee depreciate Dollar appreciate – It is at a Premium

THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 360 x 100 S 30 where F = the n days forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract

Question What will be the forward rate for 1 month and 10 days (broken date contract) if: Spot : Rs /$ 1-month forward : Rs /$ 3-month forward : Rs /$

Solution For one month and 10 days, swap points: Buying rate: 50+ (80-50) * 10/60 = 55 Selling rate: 70+ (110-70) * 10/60=77 The forward rate for one month and 10 days = Rs – 40.77/$

Spot Transaction and Forward Transaction Hence, a currency which depreciate is selling at a discount and vice versa. (40-42)/42 (44-42)/42 -2 / / 42 (Forward Discount) (Foreign currency is at a forward Foreign currency premium) Base currency Selling at discount