2. Introduction
The foreign exchange market is the market in which currencies are bought
and sold against each other. It is the largest market in the world. The survey
carried out by the Bank of International Settlement in April 2013 reported that
the average trading volume per day was over US $5.3 trillion.
This corresponds to 160(1) times the daily volume of the NYSE. Bulk of this is
accounted for by a small number of currencies - US dollar, euro, yen, pound
sterling, Swiss frane, Canadian dollar and Australian dollar. Prior to the
introduction of euro in 1999, deutsche mark had an important position.
3. After the Euro crisis
in early 2010 there
was an indication that
the volume growth in
global currency
markets is slowing
down. Figure 7.1
depicts the growth in
the volume of
turnover from 2001
to 2012.
4. The market itself is actually a worldwide network of inter-bank traders, consisting primarily of banks,
connected by telephone lines and computers. While a large part of inter-bank trading takes place with
electronic trading systems such as Reuters Dealing 2001 and Electronic Broking Systems, banks and large
commercials, i.e. corporate customers, still use the telephone to negotiate prices and consummate the
deal.
5. Structureoftheforeign
exchangemarket
Some of us are familiar with the retail market in foreign exchange. This is the
market in which travellers and tourists exchange one currency for another in the
form of currency notes or travellers' cheques. The total turnover and average
transaction size are very small. The spread between buying and selling prices
(see below) is large.
The market referred to in section I of this chapter is the wholesale market, often
called the inter-bank market. The major categories of participants in this market
are commercial banks, other financial institutions, non-financial corporations
and central banks. The average transaction size is very large. For example, the
average transaction in the US market was reported to be 4 million dollars with
many transactions being of much larger size. This is the market we will be
studying in this chapter.
Among the primary price makers there is a kind of layering or a pyramid. A few
giant multinational banks deal in a large number of currencies, in large amounts
and often deal directly with each other without using brokers. Their transactions
can have significant influence on the market. In the second tier are large banks
which deal in a smaller number of currencies and use the services of brokers
more often. Lastly
6. there are price takers who take the prices quoted by
primary price makers as given and buy or sell currencies for
their own purposes, but do not make a market themselves.
Corporations use the foreign exchange market for a variety
of purposes related to their operations. Among these are
payments for imports, conversion of export receipts,
hedging of receivables and payables in foreign currencies,
payment of interest on foreign currency loans and
repayment of principal amounts of the loans, placement of
surplus funds and so forth.
In the retail market, there are entities which quote foreign
exchange rates, but do not make a two way market. They are
secondary price makers. Restaurants, hotels, shops catering to
tourists buy foreign currency in payment of bills; some entities
specialise in retail business for travellers and buy and sell
foreign currencies and traveller's cheques. Typically, their bid-
ask spreads are much wider than those of primary price
makers.
Foreign currency brokers act as middlemen
between two market-makers. Their main function
is to provide information to market-making banks
about prices at which there are firm buyers and
sellers in a pair of currencies.
7. Typesoftransactionsand
settlementdates
The day on which these transfers are carried out is called the settlement date or the value date.
Obviously, to implement the transfers, banks in the countries of the two currencies involved must be
open for business. The relevant countries are called settlement locations. The locations of the two
banks involved in the trade are dealing locations which need not be the same as settlement
locations. Thus, a London bank can sell Swiss francs against US dollar to a Paris bank.
Settlement locations may be New York and Geneva, while dealing locations are London and Paris.
The transaction can be settled only on a day on which both US and Swiss banks are open.
8. A swap transaction in the foreign exchange market is
a combination of a spot and a forward in the opposite
direction or two forward transactions maturing at two
different dates. Both the transactions are in the same
pair of currencies and between the same two parties.
Thus, a bank will buy euros spot against US dollar and
simultaneously enter into a forward transaction with
the same counterparty to sell euros against US dollar.
Forward contracts without an accompanying spot deal
are known as "outright forward contracts" to
distinguish them from swaps.
Short date transactions are transactions which call for
settlement before the spot value date.
"Cash" transactions are for settlement same day as
the transactions date while some deals will involve
settlements "tomorrow", i.e. one business day ahead
when a spot deal would be settled two business days
later.
9. Exchangerate
quotationsand
arbitrage
In stating prices of goods and services in terms of
money, the most natural format is to state them as units
of money per unit of the good rather than as amount of a
good per unit of money.
When is two moneis, either way would be equally
natural. The choice of a “unit” is also a matter of
convenience.
10. EUR 0.7720 per USD, CHF
1.0500 per USD, inr 61.75 per
USD
Spotratequotations
USD 0.8040 pero CHF, USD
1.6545 per GBP
Europeanterms
Americanterms
In any country, a direct quote gives amount of the
currency of that country per unit of a foreign
currency
Directquotes
Indirect quotes are stated as number of units of a
foreign currency per unit of the home currency
Indirectquotes
11. A currency pair is denoted by 3-letter SWIFT codes for the
two currencies separated by an oblique or a hyphen.
Examples:
USD:CHF: US dollar-Swiss franc
GBP/JYP: Great Britain pound-Japanese yen
The first currency in the pair is the base currency; the
second is the quoted currency.
Theinter-bankmarketuses
quotationconventionsadoptedby
ACI
12. The exchange rate quotation is given as the amount of the
quoted currency per unit of the base currency
The price shown on the left of the oblique or hyphen is the
“bid” price, the one on the right is the “ask” or “offer” price
13. These days in the inter-bank market deals are
mostly done with computerised dealing systems
such as Reuters, Real-time information on
exchange rates is provided by a number of
information services
14. TheMechanicsofInter-bank
Trading
The main actors in the forex markets are the primary market
makers who trade on their own account and make a two-way bid-
offer market. In the process of dealing, they shift around their
quotes, actively take positions, offset positions taken earlier or
roll them forward.
Their performance is evaluated on the basis amount of profit
their activities generate and whether they are operating within
the risk parameters established by the management.
15. Banks have corporate dealers who
are the contact points for the bank’s
corporate customers. A corporate
treasurer who needs to buy or sell
foreign currency or just get a feel for
the market would contact a
corporate dealer probably on the
phone and ask for a quotation. The
corporate dealer will, in turn,
request the bank’s intern-bank
dealer on the appropriate “desk” to
provide a rate quotation which will
be transmitted back to the corporate
client.
16. Banks sometimes employs services of a currency broker ro
execute a deal. The advantage of dealing through a broker
is anonymity. A bank delaer can “show” his or her prices to
the market without revealing the identity of the banks. The
brokers receive a limit price as the maximum that they are
willing wo pay or to buy a currency, once the broker has the
number they can create a plan to get the best deal.
Banks have different rates but they will usually keep the
numbers close to each other. that is why it is important to
investigate which banks have the best rates when doing a
transaction with them.
Arbitragingbetweenbanks
17. Customers who flit from bank to bank in
search of tiny savings often find that when
it comes to executing a complex
transaction, no bank is willing to give them
the kind of service that it would be given to
its more “loyal” customers. Also, even when
rutine foreign exchange transactions,
regular cusotmers get better rates
Nevertheless, it is good idea to do some
comparison shopping from time to time to
keep the bank on its toes.
Arbitragingbetweenbanks
18. two points arbitrage it is when
banks buy a currency at a price
an then sells it in another
market in a higher price, but in
most sitations the market will
cancel this transactions as it is
eliminated by the Foreign
exchange markets very quicky
when they arise
three point arbitrage refers to
the kinid of transactions that
starts with currency A, sell it for
B, sell B for C and finally sell C
back for A ending up with a
larger amount of A than you
begin with
twopointsarbitrage threepointsarbitrage
19. Quotations for outright forward transactions
are given in the same manner as spot
quotations. An outright froward or currency
forward is a contract that locks in the
exchange rate and delivery date beyond the
spot value date.
it is the simplest type of foreign exchange
forward contract and it protects an investor,
importer or exporter from excahnge rate
fluctations.
FowardQuotations
Outrightforward
20. Reverse exchange: If party A defaults, the bank
must fulfil its commitment to party B possibly by
buying currency X in the spot market and in the
meanwhile currency X may have appreciated
strongly against currency.
OPTION FORWARDS
The contract is entered into at some time with the rate and quantities being fixed at this
time, but the buyer has the option to take or make delivery on any day between two
specified future dates.
Margin requirements
1. When a forward contract is between two banks,
nothing more than a telephonic agreement on
the price and amount is involved.
2. When a bank enters into a forward deal
with a non-bank corporation, it will want
to protect itself against the possibility that
the firm may default on its commitment.
21. SWAPS IN FOREIGN EXCHANGE MARKETS
A swap transaction between currencies A and B consists of a spot purchase (sale) of A coupled
with a forward sale (purchase) of A both against B.
The amount of one of the currencies is identical in the spot and forward deals.
Since usually there will be a forward discount or premium, the rate applicable to the forward leg
of the swap will differ from that applicable to the spot leg.
The difference between the two,
which corresponds to a forward
premium or discount.
Swap margin:
22. Suppose a bank buys pounds
one-month forward against
dollars from a customer. It
has created a long position
in pounds (short in dollars)
one-month forward. If it
wants to square this in the
inter-bank market, it will do
it as follows:
A swap in which it buys pounds spot and sells one
month forward, thus creating an offsetting short
pound position one-month forward.
Coupled with a spot sale of pounds to offset the long
pound position in spot created in the above swap.
The reason for this is that it is very difficult to find counterparties with matching
opposite needs to cover the original forward position by an opposite outright forward
whereas swap position can be easily offset be dealing in the euro deposit markets.
23. It is possible to do a swap between two forward dates. It can be looked upon as a
combination of two spot-forward swaps:
Purchase (sale) of currency A 3-month forward and simultaneous sale
(purchase) of currency A 6-month forward, both against currency B
In such a deal, both swaps will be “done off” an identical spot so that the spot
transactions offset each other.
FORWARD- FORWARD SWAPS
SWAP
POSITION
The customer and the bank have created what is known as a swap position,
matched inflow, and outflow in a currency but with mismatched timing, with
an inflow of 3 months later and a matching outflow six months later for the
customer.
Thegain/losswilldependonlyintherelativesizesofthemonthsswapmargins.
24. Banks use swaps amongst themselves to offset positions created in
outright forwards done with customers.
A firm with uncertain timing of foreign currency payables or
receivables can use swaps as an alternative to option forwards.
Swaps can be used to roll over forward positions to cover long-term
exposures.
Forward-forward swaps can be used to speculate on interest rate
movements with minimal exchange rate risk.
It can also be used to lock-in the forward margin between two future
dates.
Banks use swaps to gain access to currencies for which there may not
be liquid deposit markets.
APPLICATIONS OF SWAPS
25. PRICING OF SHORT-DATE AND
BROKEN DATE CONTACTS
The normal value date for a spot transaction is two business days ahead. It is possible to deal
for shorter maturities, in currencies whose time zones permit the transaction to be processed.
It is possible to do a €/$ deal for delivery same day because the
five-to-six-hour delay between New York and London allows
instructions to be transmitted to and processes in New York.
A $/¥ deal for some day value would not be possible because by
the time New York opens for business, Tokyo is closed.
Short date transactions are those in which value date is before the spot value date.
27. 7.7.1ExchangeRateRegime
andExchangeControl
The exchange rate regime in India has undergone significant
changes since independence and, particularly, during the
1990s.
The trend towards greater liberalisation continues. Full
convertibility on current and capital accounts is expected to
be in place in the near future.
Throughout this period, the RBI has administered a very
complex system of exchange control.
The statutory framework was provided by the Foreign
Exchange Regulation Act (FERA) of 1947 which was amended in
1973, 1974 and 1993.
It has been replaced by Foreign Exchange Management Act
(FEMA) of 1999.
28. Transactions which do not fall in capital account
category are current account transactions which are
permitted freely subject to a few restrictions:
Certain current account transactions would
require RBI permission, if they exceed a certain
ceiling.
A few current account transactions need
permission of appropriate Government of India
authority irrespective of the amount.
There are seven types of current account
transactions which are totally prohibited and no
transaction can, therefore, be undertaken
relating to them.
Application of FEMA may be seen broadly from two angles:
Capital account transactions relate to
movement of capital, for example
transactions in property and
investments and lending and
borrowing money.
Capitalaccounttransactions Currentaccounttransactions
29. While exchange controls on some current
account transactions and all capital account
transactions are still in place there is now a
distinct possibility that the former will be
eliminated in the near future while the latter
will be relaxed though only gradually.
However, during episodes of excessive volatility
in the market, the RBI may and does bring back
some of the restrictions at least temporarily.
The RBI uses a combination of persuasion, administrative
fiats, monetary policy measures such as raising the
discount rate or the cash reserve ratio and direct
intervention in the forex market to "manage the rupee
exchange rate.
30. The Foreign Exchange Management Act and Rules give
full freedom to a person resident in India who was
earlier resident outside India to hold or own or transfer
any foreign security or immovable property situated
outside India and acquired when he/she was resident
there.
Similar freedom is also given to a resident who inherits
such security or immovable property from a person
resident outside India.
The Exchange Earners' Foreign Currency (EEFC) account
holders and Residents* Foreign Exchange (RFC) account
holders are permitted to freely use the funds held in
EEFC/RFC accounts for payment of all permissible
current account transactions.
SomeotherhighlightsofthenewActare:
31. In February 1993, the rupee experienced substantial depreciation and forward premiums
on the US dollar also increased significantly.
From April 1993 to October 1995, the rupee ruled very firm moving in a very narrow band.
After nearly two and a half years of stability, the rupee suddenly plunged from a level little
above ₹31 per USD to ₹38.00 per USD in October 1995.
Following the Asian crisis in the summer of 1997, the rupee experienced another sharp
decline weakening above ₹39 to a dollar.
The downtrend continued till the middle of 1998 with the dollar climbing above ₹42.50.
For most of 1999 it ruled slightly above ₹43.50.
The rupee again came under pressure around the middle of 2000, and continued to
weaken through the rest of the year with the dollar touching almost ₹47.00
The rupee continued to decline against the dollar through 2001 reaching a peak of almost
₹50 per USD by late 2002.
In 2008-09, capital flows turned negative due to the financial crisis in US and the rupee
depreciated by nearly 22 per cent.
Therupee'sbehavior
32. 7.7.2TheStructureoftheIndian
foreignExchangeMarket
The foreign exchange market in India consists of three segments
or tiers.
1. The first consists of transactions between the Reserve Bank of
India (RBI) and the Authorised Dealers (ADs).
2. The second segment of the forex market is the inter-bank
market in which the ADs deal with each other
3. The third segment consists of transactions between ADs and
their corporate customers.
The retail market in currency notes and travellers' cheques caters
to tourists. In the retail segment, in addition to the ADs, there are
Money Changers who are allowed to deal in foreign currencies.
33. The RBI has relaxed a number of restrictions on AD's
holding of open positions, balances held abroad and
their dealings with customers. The market has
acquired some depth though it remains considerably
skewed.
One of the risks involved in a foreign exchange
transaction between two parties is known as
"settlement risk". It is the danger that a bank could
lose the principal amount it pays out in a transaction.
34. 7.7.3 EXCHANGE RATE
CALCULATIONS
Foreign exchange contracts are for:
"cash" or "ready" delivery which means delivery same day,
"value next day" which means delivery next business day
and "spot" which is two business days ahead.
For forward contracts, either the delivery date may be
fixed in which case the tenor is computed from the spot
value date or it may be an option forward in which case
delivery may be during a specified week or fortnight, in
any case not exceeding one calendar month.
35. The rates quoted by banks to their non-bank customers are
called "Merchant Rates". Banks quote a variety of exchange
rates.
The so called "TT" rates (the abbreviation TT denotes
"Telegraphic Transfer') are applicable for clean inward or
outward remittances,
When the individual sells the draft to CitiBank Bombay, the
bank will buy the dollars at its "TT Buying Rate". Similarly,
"TT Selling Rate" is applicable when the bank sells a foreign
currency draft or MT.
36. Spot TT Buying Rate
When cashing a personal cheque or a banker's cheque payable overseas, the bank will
not give this rate because it has to send the cheque overseas for collection. This means a
delay which is called transit period.
Spot Bill Buying Rate
Exporters draw bills of exchange on their foreign customers. They can sell these bills to
an AD for immediate payment.
Bills are of two kinds:
1. Sight or demand bills: require payment by the drawee on presentation.
2. Time or sance bills: give time to the importer to settle the payment.
37. Spot TT Selling Rate
When cashing a personal cheque or a banker's cheque payable overseas, the bank will
not give this rate because it has to send the cheque overseas for collection. This means a
delay which is called transit period.
Bill Selling Rate
When an importer requests the bank to make a payment to a foreign supplier against a
bill drawn on the importer, the bank has to handle documents related to the transaction.
For this, the bank loads another margin over the TT selling rate to arrive at the Bill Selling
Rate.