basics of foreign exchange

1. FOREIGN EXCHANGE If you have built castles in the air, your work need not be lost; that is where they should be. Now put the foundations under them. —Henry David Thoreau PRESENTED BY: ASHISH MAKHIJA PGD/FM/026

2. FOREX Foreign currency. The Foreign Exchange Market: a market for converting the currency of one country into that of another country. Price of each currency is determined in term of other currencies.

4. The Exchange Rate: is the price of one country's currency expressed in another country's currency. In other words, the rate at which one currency can be exchanged for another. e.g. Rs. 48.50 per one USD

6. There would be an opportunity for Arbitrage

7. The process of buying a currency low and selling it high,

8. The US dollar is often used as a vehicle currency.

11. THE FUNCTIONS OF FOREIGN EXCHANGE MARKET Currency Conversion Insurance for exchange risk

14. CURRENCY CONVERSION.

16. Expect $ depreciate over Rupee.

17. Current exchange rate $1=Rs50.

18. Company exchange $10M=Rs500M

19. 3 months later $ depreciated.

20. Exchange rate $1=Rs40

21. Company converts Rs500M=$12.5M.

22. Made $2.5 M profit from this exchange rate movement !The short term movement of funds from one currency to another. In the hopes of profiting from shifts in exchange rates.

23. REDUCING RISKS. The foreign exchange market can be used to provide insurance to protect against foreign exchange risk.. Spot exchange rate : The rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Spot ex rate depends upon S&D.

24. Forward Exchange Rate: Two parties agree to exchange currencies on a specific future date @ predetermined exchange rate. US co. imports laptops from India Must pay in 30 days on the arrival of the shipment Cost : Rs70,000 at $1=Rs50 ex. Rate 70,000/50 = $ 1400 / laptop He can sell at $1600 $1400-$1600 = $200 / laptop profit He doesn’t have money to pay Until he sells the laptop What If $ depreciates in next 30 days ? $1 = Rs42 US co still have to pay Rs70,000/laptop Now cost: 70,000/42= $1,667 He sell at $1600 $1667-1600 = $ -67 loss

25. What if the US co. enter a forward exchange rate? 30 day forward ex. Rate @ $1 = $45 Guarantee that he pays no more than 70,000/45 = $1555.5 Now he sell the laptop at $1600 Makes $1600-$1555.5=$44.5 profit This profit is guaranteed. Insured against unexpected change in $/Rs ex. Rate

26. Spot rate @ $1=Rs 50 vs. Forward rate @ $1=Rs 45 The difference : reflects the expectations of future currency movements. You can buy more Rs at spot rate than the forward rate. $ is selling at a ‘discount’ on the 30 day forward market Indicates $ expected to ‘depreciate’ in the next 30 days. What if the 30 day forward rate is @ $1=Rs 55 ? $ is selling at a ‘premium’ on the 30 day forward market The dealers expect $ to ‘appreciate’.

27. Currency Swap: Simultaneous purchase and sale of given amount of foreign exchange for two different value dates. An FX swap is a contract to buy an amount of currency for one value date at an agreed rate, and to simultaneously resell the same amount of currency for a later value date, also at an agreed rate. It does not involve exchange risk.

28. What is Hedging???

29. Basic Concept The forex hedge’s change in value is opposite to the change in value of the foreign currency exposure (hedged item). These two amounts offset each other to obtain cost certainty or revenue certainty.

30. Types of FOREX Hedges Designated for accounting purpose: Cash flow hedges. Fair value hedges. Net investment hedges. Economic hedges are transactions that hedges the value of: A foreign currency asset or liability. The value of firm commitment. The value of a forecasted transaction. Hedges that are not designated: Hedge is not properly documented or effective. Its value must be recorded directly to the income statement.

31. Purchase Power Parity Fisher effect Bretton woods system Fixed & Floating Exchange rates Theories of Exchange rate determination

32. Theories of Exchange rate determination Exchange rates are determined by the demand and supply for different currencies. Three factors impact future exchange rate movements: a country’s price inflation a country’s interest rate market psychology

33. Purchase Power Parity PPP theory argues Given relatively efficient markets (markets in which no barrier to international trade and investment exist) The price of a “basket of goods” should be roughly equivalent in each country

34. The Law of One Price In competitive markets free of transportation costs and barriers to trade, Identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency This process continues until The price is equalized between these two places.

35. If $200 for a good, @ $1 = Rs 50 exchange rate The price in Rs should be Rs10,000 according to PPP In India price increased by 10% : inflation If Indian price increase + no inflation in the US $200, Rs 11,000 Now ex. Rate is $1 = Rs55 Rs depreciated due to inflation in India. Change in relative price  change in exchange rate

37. When the growth in the money supply is greater than the growth in output,

38. Inflation will occur Increase in Money supply  giving people more money Easier for banks to borrow from government Easier for individual, firms to borrow from banks Increase in credits Increase in demand for goods and services  inflation A country with high inflation rate Depreciation of currency ex. Rate

39. The Fisher Effect The Fisher Effect states A country’s nominal interest rate is determined by i = r + L i ; nominal interest rate r ; real interest rate L ; the expected rate of inflation If r = 5%, L = 10% Nominal interest rate i = 5 + 10 = 15 % If investors are free to transfer capitals between nations, Real interest rate will be the same everywhere. If the difference in real interest rate emerge between countries, Arbitrage soon equalize them.

40. If r = 10% in India; r = 6 % in the US  investors arbitrage Borrow from the US, invest in India to make money. Money Demand increases in the US  raise r in the US Money Supply increases in India  lower r in India Equalize r between these countries.