forex

1. Foreign Exchange Market
Topic : Mechanics of Currency trading
&
Exchange rate quotations
Deepak Tandon IMI

2. Meaning& importance of Forex Market
• Market in which individuals, firms & banks buy & sell foreign
currencies (or foreign exchange)
• means by which payments made across boundaries, jurisdictions
& currencies
• Fundamental in international finance, huge & fast changing
global market
• Largest in the world, daily turnover runs to trillions of USD &
many deals are for several millions of US $ or equivalent in
other currencies.
• over the counter market(i.e.no single mkt price or an organised
exchange like stock exchange)
• Round the clock market as it spans all time zones of the world

3. • Mechanism by which currencies are valued relative to
one another i.e. prices of currencies in terms of other
currencies set & one currency is traded / exchanged for
another.
• Important centers-London, Newyork, Tokyo, Zurich,
Frankfurt, Hongkong, & Singapore
• All monetary centers are connected electronically & are
in constant touch with each other & thus forming a
single international forex market.

4. Participants of Forex market
4 level of participants:
1) At the bottom ,traditional users such as tourists, exporters,
importers, investors etc
2) Commercial banks which act as clearing houses between users
&earners of forex.
3) Forex brokers thru whom nations’ banks even out theirforex
inflows & outflows among themselves.(called as interbank
dealings)
4) Highest level is the country’s central bank.

5. Functions of Forex Market
• Primary function is transfer of funds or purchasing power from
one nation to another
• Credit function :normally 90 days credit for export import
• Thirdly, facilities for hedging & speculations
• Today, about 90 % trading reflects purely financial transactions
& only about 10 % trade financing.

6. Structure of Forex Market
• Primary –Main actors-whole sale, giant ,two way bid-offer
transaction (i.e. they quote two way price & be prepared to take
either buy or sell side.) Inter Bank trading – & adjusted margin; high
tension business, requiring alert mind, quick reflexes & the abilityto
keep one’s cool under pressure.
• Participants in this market are commercial banks, investment banks,
corporations and central banks.

7. • Primary price makers (professional dealers) sit in the offices (Forex
dealing rooms) of major commercial banks around the world &
communicate each other & Money transfer made via electronic
media, Inter & intra net, telegraphic (wire) & phone transactions,
Cheques, written transfer order etc
• secondary are Retail traders &third, Foreign currency brokers act as
middlemen between two market makers.
• SWIFT(Society for Worldwide Interbank Financial
Telecommunications)
• CHIPS(Clearing House Interbank Payment System)
• CHAPS ( in London through Clearing House Automated Payment)

8. SWIFT
• Banks from 17 countries formed the Society for Worldwide
Interbank Financial Telecommunications i.e. SWIFT that
began operations at the end of 1977.’ This is a non-profit
Belgium cooperative with main and regional centres around
the world connected by data transmission line.
• Depending on the location a bank can access regional
processor or main centre which then transmits the information
to the appropriate location.

9. CHIPS / CHAPS
• CHIPS : Clearing House Inter Bank Payment System
• Inter bankers play money.
• During the day, all international banks making dollar payments to
one another pass this CHIPS money to one another in lieu of real
money. At the end of the day the game-master totals up
everybody’s CHIPS money to see the net amount that is owed by
who to whom, and real money (“Fed Funds”) is transferred in that
amount.’
• Also known as CHAPS, clearinghouse automated payment
system.

10. FEDWIRE
• An automated communications and settlement system
linking the federal reserve bank (US) with other
banks and with depository institutions.

11. Concepts
• Nostro , Vostro & Loro accounts
• Vehicle Currency
• Direct quote ( foreign currency in terms of domestic currency) e.g Rs
47.50 per $ is direct in India written as USD/INR : 47.5000
• Indirect quote(Forex rate in terms of foreign currency per unit) e.g.
100 INR/USD 2.9034 is indirect quote in India
Note : 1st currency in the ISO quote is basic currency but
conventionally if it is mentioned as Rs.47.50 /$ it is other way
round.

12. Nastro A/c and VostroA/c
• The accounts held by a domestic bank with a bank abroad are
called “ Nostro accounts” or “due from accounts” (Our A/C with
u : IOB’s a/c with New york bank)
• The accounts held by a foreign bank with a domestic bank are
called as “Vostro Accounts” or “due to accounts”. (Your a/c with
us : Scottish bank’s a/c with SBI )
• Loro accounts (their a/c) third party a/c (London bank paying to a
french bank by crediting the amount in the french bank’s a/c held
with US bank)

13. Vehicle Currency
• Connecting link between domestic currency and all other international
currencies.
• External value of domestic currency gets established in local forex
mkt with a universally accepted major currency.& when rates of any
other currency is required, the local mkt quote of major currency &
other quote of major currency with the third currency is used to get the
desired cross rate.
• For eg.. If INR is to be exchanged with Thai Baht, Indian Banks will not have Baht
hence we shall have one quote for USD and INR and another for USD and Baht.
Then calculate the requisite currency price in effect to the trade. In such case USD is
called Vehicle Currency.

14. FOREX QUOTATIONS
• A currency pair is denoted by the 3-letter SWIFT codes (ISO code)for
the two currencies separated by an oblique or a hyphen .
• e.g. USD/CHF: US Dollar-Swiss Franc
GBP/JPY:
USD-SEK:
Great Britain Pound-JapaneseYen
US Dollar-Swedish Kroner
• The first currency in the pair is the “base” currency; the second is the
“quoted” currency.
• The exchange rate quotation is given as number of units of the quoted
currency per unit of base currency.

15. FOREX QUOTATIONS
• Thus in USD/CHF, US dollar is the base currency, Swiss
franc is the quoted currency. In GBP/USD, British pound
is the base currency, US dollar is the quoted currency.
• Thus a USD/INR quotation will be given as number of
rupees per dollar, a GBP/USD quote will be given as
number of dollars per pound.

16. Concepts
• Two way quote-Bid & Ask (offer)Rate & pips
• Spread, mid rate
• American terms (no. of $ units per unit of foreign currency)
• European terms ( No. of units of foreign currency per unit of
$) (Base currency $)
• Arbitrage (synthetic mechanism)
• Cross rates & two way arbitrage opportunity
• Triangular arbitrage (single rate quote & two way quote)

17. Direct Quote and Indirect Quote
• Direct Quote: Foreign Exchange rate expressed in terms of
domestic currency per unit of foreign currency is called as Direct
Quote. For instance, 54.32 Rs. / $ is a direct quote in India.
• Indirect Quote: Foreign Exchange rate expressed in terms of
foreign currency per unit (or per hundred units) of domestic
currency is called as Indirect Quote.
For instance, 2.0894 $/100 Rs. Is an indirect quote in India.
• American terms :expressed as no. of $ per unit of another
currency. $ 1.5613 / £
• European terms :no of units of another currency in terms of dollar.
SFr 1.4500/$

18. FOREX QUOTATIONS
A quotation consists of two prices.
Bid / ask
• bid price : the price at which the dealer giving the quote is prepared
to buy – is “bidding for” – one unit of the base currency against the
quoted currency. It is the amount of quoted currency the dealer will
give in return for one unit of the base currency .
• ask or offer rate : price at which the dealer is willing to sell – is
“offering” – one unit of the base currency. It is the amount of quoted
currency the dealer will want to be paid in return for one unit of base
currency.

19. BID AND ASKRATE
• Bid is the amount of quoted currency the dealer will give in return
for one unit of the base currency. (Trader is ready to pay base
currency to buy foreign currency his quote to buy one $.)
• The ask or offer is the price at which the dealer is willing to sell – is
“offering” – one unit of the base currency. (Trader is ready to give
one currency if you pay him. i.e. His quote is sell one $.)
• cross rate : An exchange rate between the two currencies, neitherof
which is the US dollar. (“neither of them is a vehicle currency”).
• It is a rate between third pair of currencies, by using the rates of two
pairs, in which one currency is common.

20. BID ASK SPREAD
• The difference between bid rate and ask rate (offer rate) is called as
bid ask spread (bid offer spread).
• In normal market trader expects “to be hit” on both sides of his
quote in roughly equal amounts. This means he assumes there is
approximately equal demand to buy and sell the currency.
• It is margin to cover transactions’ costs and othercosts.
• It covers normal profit on capital invested in dealing function.
• If trader is being hit on one side more than the other side, then this
spread indicates his encouragement / discouragement on either side

21. BID ASK SPREAD in percentage terms
The spread is generally expressed in percentage by the equation:
If Bid is at discount (i.e. lower) to ask rate
Ask Rate – Bid Rate
Ask Rate
If Ask is at premium (i.e. higher) thanBid
(b) Spread = Ask Rate – Bid Rate
Bid Rate
Expressing Bid as a discount over Ask is more commonly
practiced and hence we shall adhere to formula (a) for our
calculations.
X
10
0
(a) Spread
=
X
10
0

22. Type of transactions & Settlement dates
• Value / Settlement date (transfer effected day)
• Dealing locations & Settlement Locations
• Spot & Forward
• Swaps (a temporary exchange of one currency for other with an obligation to
reverse it at a future date. Spot sale of a currency combined with a forward
repurchase of the same currency – as a part of same transaction)
• Outright forward contracts ,spot-forward or forward –forward swaps
• roll over , cash, Tom
• Std & broken (odd)dates forward contract
• Forward premium & discount

23. Spot Rate Quotations - Examples
• USD / CHF Spot: 1.4550 / 1.4560
• The dealer will buy 1 USD and pay CHF 1.4550 in return.
His “bid” rate for USD is CHF 1.4550. He will sell one
USD and would want to be paid CHF 1.4560 in return.
His “offer” or “ask” rate for one USD is CHF 1.4560.
• GBP/EUR Spot: 1.3025/1.3035

24. Spot Rate Quotations - Examples
• GBP/EUR Spot: 1.3025 / 1.3035
• Bid rate : Dealer will pay 1.3025 Euros per GBP
when buying GBP
• Offer rate: Dealer will want to be paid 1.3035 Euros
per GBP when selling GBP.

25. Spot Rate Quotations - Examples
• For most currencies, quotations are given in European terms,
that is, the base currency is the US dollar. The major exceptions
rate EUR, GBP, AUD and NZD (New Zealand Dollar). These
are quoted in American terms, that is, USD becomes the quoted
currency against these. In market parlance, a “cross rate” and so
is EUR/INR. In the US< financial press gives quotations in both
European and American terms.

26. Spot Rate Quotations - Examples
• Quotations in inter-bank markets are usually given up to five
or six significant digits or four decimal places. The last digit
thus corresponds to (1/100)th of (1/100)th unit of the quoted
currency. Thus in the USD/CHF bid rate quoted above, the last
two digits, viz. “50” correspond to 0.0050 CHF. In the
GBP/EUR offer rate the last digit corresponds to 0.0005 EUR.
The last two digits are called “points” or “pips”.

27. Spot Rate Quotations - Examples
• The difference between the offer rate and the bid rate is called the
“bid-offer spread” or the bid-ask spread”. We say the bid-ask spread
in the USD/CHF rate is 10 points or 10 pips. If the GBP/EUR rate
moves to 1.3028/38, we say the GBP has moved up three pips. For
small denomination currencies like the JPY or the Italian Lira,
quotes are given up to 2 decimals only. In such cases a point or pip
has the value 0.01 or (1/100)th of the quoted currency.

28. Spot Rate Quotations - Examples
• The quotations are usually shortened as follows:
• USD/CHF: 1.4550/1.4560 will be given as 1.4550/60.
• When two dealers are conversing with each other this may be
further shortened to 50/60. The first three digits, viz. 1.45 are
known as the “big figure” and professional dealers are
supposed to know what the big figure is at all times.

29. Cross rate : chain rule
• When bid & ask rate is given
• (B/C) bid = (B/A)bid * (A/C) bid ………………(1)
•(B/C) ask = (B/A) ask * (A/C) ask……………….(2)
Therefore
(B/A) bid = 1 ÷ (A/B) ask
(B/A) ask = 1 ÷ (A/B) bid

30. CROSS RATE : CHAIN RULE
When single /mid rate is given :
Currency1=Currency2 Currency2=Currency3 Currency3=Currency1
Left side values are to be multiplied & equated with multiplication of right side values
e.g. Find Cross rate (Euro/UK Pound):
Rs 81.22 / pound & Rs 56.02 / Euro.
Rs –currency1;
81.22 Rs= 1pound ;
81.22 * 1 € * ? €
pound currency2;
1 Euro = 56.02 ;
= 1 pound
Eurocurrency3;
?euro =1pound
* 56.02 *1pound
( Multiplication of all Left side = all right side)
If 81.22RS * € = 56.02 RS * £
? € = 1 £
with cross multiplication, 81.22 / 56.02 =1.4498

31. List of Concepts
• EURO Currency
• Authorized dealers
• Fed-wire
• CHIPS
• SWIFT
• Nostro, Vostro, LoroAccounts
• Inter Bank Trading
• Two-way quote
• Outright quote
• Direct and Indirect quote
• American quote and European quote
• Spread
• Arbitrage
• Libor
• Vehicle Currency
• Spot and Forward transactions
• Swap Transactions
• Cross Rates
• Mid rate
• Value Dates
• Settlement Dates
• Fixed and flexible exchange rate
• Future contract and forward contract
• Currency option
• Forward premium and Forward
Discount
• Currency convertibility – partialand
full
• FII
• FDI
• FPI