Essentials on Foreign Exchange - An India perspective

1. THE FOREIGN EXCHANGE
MARKET
The world’s most traded market place

2. PRIMER’S FOR THE FOREIGN
EXCHANGE MARKET IN INDIA
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3. CONTENT
 Introduction
 The Foreign Exchange Market Place
 Interesting Pointers
 Essential Terminologies
 The Forward Market
 Interest Rate Parity Theory
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4. DEFINING FOREIGN EXCHANGE
Foreign Exchange, or more popularly known as “Forex” or even
“FX”, is the trade of a single currency for another at a decided or
contracted price (called as the trade price) on the Forex
Marketplace.
In simpler terms it is essentially money – denominated in one
currency, is bought or sold with money – denominated in another
currency.
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WHEN the different currencies meet

5. “
”
A CURRENCY SERVES THREE FUNCTIONS: PROVIDING A MEANS OF
PAYMENT, A UNIT OF ACCOUNT AND A STORE OF VALUE. GOLD MAY BE A
STORE OF VALUE FOR WEALTH, BUT IT IS NOT A MEANS OF PAYMENT. YOU
CANNOT PAY FOR YOUR GROCERIES WITH IT. NOT IS IT A UNIT OF
ACCOUNT. PRICES OF GOODS AND SERVICES, AND OF FINANCIAL
ASSETS, ARE NOT DENOMINATED IN GOLD.
NOURIEL ROUBINI
Nouriel Roubini is an American Economist. He anticipated the collapse of
the United States housing market and the worldwide recession which
started in 2008
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6. THE FOREIGN EXCHANGE MANAGEMENT
ACT (FEMA) DEFINITION
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A currency other than the Indian Rupee
Deposits, Credits and Balances payable in foreign currency
Drafts, traveller’s cheques, cash currencies, letters of credit, bills of exchange
expressed or drawn in Indian currency but payable in foreign currency
Drafts, traveller’s cheques, cash currencies, letters of credit, bills of exchange
drawn by banks, institutions or persons outside India but payable in Indian
Currency

7. COMMON USAGE
 International Trade and Capital Account Transactions
 Import or export of goods and services
 Loans and borrowings
 Investments
 Pertaining to Individuals
 Speculative –This essentially would and should form a part
of the advanced course on Forex
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8. COMMON TRANSACTION METHODS
 Over the Counter
 Commonly seen during purchase of currency for tours and travel
 Telecommunications
 Most commonly through SWIFT (Society for worldwide financial
telecommunications), Interbank settlements, Fedwire.
 An earlier form was through TELEX though there are still a few
practioners of this method to date.
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9. CONTENT
 Introduction
 The Foreign Exchange Market Place
 Interesting Pointers
 Essential Terminologies
 The Forward Market
 Interest Rate Parity Theory
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10. THE MAJOR
CURRENCIES
THEM WHO have the need for
currency dealings
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Currency Abbreviation Nickname Mkt Share
The United States
Dollar
USD Greenback; Buck 89%
The Euro EUR 37%
The Japanese Yen JPY Jap 20%
The British Pound GBP Cable; Sterling 17%
The Swiss Franc CHF Swissy 6%
The Australian
Dollar
AUD Aussie6% 6%
The Canadian
Dollar
CAD Goose; Loonie 4%
Others 21%
Total 200% ***
*** The total traded is shown as 200%, due to the fact that in the FX
market currencies are always traded in pairs

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THE MAJOR CURRENCY PAIRS AT THE
FOREX MARKET PLACE
 Major Currency Pairs: These account for 75% of all FX market
transactions. All of these involve the USD as one of the currency
 USD / EUR
 USD / GBP
 USD / CHF
 USD / JPY

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THE CROSS CURRENCY PAIRS AT THE
FOREX MARKET PLACE
 Cross Currency Pairs: Where USD does not form one of the currencies
in the FX trade. The most actively traded Cross Currency Pairs are
 EUR / CHF
 EUR / GBP
 EUR / JPY
 GBP / JPY
 AUD / JPY
 NZD / JPY

13. THE FOREX MARKET PLACE USERS
 Financial Institutions: Since the currency market is regulated by needs and trusts,
banks form secured third party for mediating an FX trade.
 Trade Consumers: Companies and corporates who need Forex dealings to handle
their import, export and loan transactions
 Retail Consumers: Individuals who would need to buy sell currency towards their travel
and tour requirements
 Retail Consumers: Towards overseas purchases online or transfer to near and dear
 Non Residents: Salary paid and transferred
 Travel and Tour Operators: For their operational ventures and tie – ups with overseas
counterparties
 Traders, Speculators, Arbitrageurs, Hedgers, Insurers etc: These would form a part of a
more advanced requirement
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14. THE FOREX MARKET PLACE SETTLEMENT
MECHANISMS
 Interbank & or Intrabank clearing houses: eg:
Clearing House Interbank Payment Systems
(CHIPS) or FEDwire
 Automated Trading Platforms: Used by traders
 Telecommunications Services: SWIFT, Telex
etc.
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15. FOREX TRANSACTION EXEMPLIFIED
Let’s say you are taking a trip to New Zealand. You have bought the tickets and
have planned the trip well in advance. Now you need to travel abroad. Once
you leave the Indian Airport, you are no longer in India. Which means that to
spend money you can no longer make use of Indian Rupees. You now need
New Zealand Dollors or NZD. What do you do?
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A traveler or a tourist who is off to a foreign country
All spending can be in
Indian Rupees
All spending has to be
in New Zealand Dollors

16. THE FOREX MARKETPLACE BENEFITS
Secure and trustworthy mediators – Banks & Other Financial Institutions
Reduces the cost of trading
Liquidity in the immediately required currency
Opens up the traders’ oligopoly of information
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17. CONTENT
 Introduction
 The Foreign Exchange Market Place
 Interesting Pointers
 Essential Terminologies
 The Forward Market
 Interest Rate Parity Theory
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18. INTERESTING TRIVIA ON FOREIGN
EXCHANGE
WONDER WHO would have ever thought about it?
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19. SIZE MATTERS
Even the largest equity trading bourse in the
world is of no comparison
 Daily turnover of the FX marketplace is
around USD 5 trillion and growing
 NYSE trading is at a mere USD 70 billion in
comparison
The FX market clearly crosses the time horizons
 The buying and selling of currency begins
each Monday morning at Wellington, New
Zealand and concludes at New York, USA on
Friday evenings
The forex market is definitely the
largest financial market in the
whole wide world
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20. WOULD YOU KNOW
THIS?
Just Imagine…
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The “Black Wednesday” occurred on Sept
16, 1992, when Great Britain participated in
the European Currency System. This saw a 25%
fall in their currency value and resulted in
interest rates going up by 5% in a single day.
The Global Economic Crisis of new millennium
touched almost all fields of the human activity.
Including the FX market place. However,
despite the crisis, the FX market functioned
successfully and was even profitable at the
end of it.

21. WOULD YOU KNOW
THIS?
“A weak currency is the sign of a
weak economy, and a weak
economy leads to a weak nation”
- Ross Perot
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The early 90’s saw a devaluation of the JPY
currencies that created a wave of bankruptcies of
one of the most developed countries in the modern
world. The JPY traded at negative 79.80 to a USD.
Imagine, instead of receiving for something you sell,
you end up paying for it
However, the financial crisis of 2007 led to drastic
changes in all of world’s major currencies. In this time,
the JPY strengthened against most major currencies. It
even beat the USD and EUR. One of the reason’s for
such strengthening is attributed to the fact that traders
needed to find a sanctuary amidst a monetary chaos.
Seems like the FX world is small and round afterall

22. CONTENT
 Introduction
 The Foreign Exchange Market Place
 Interesting Pointers
 Essential Terminologies
 The Forward Market
 Interest Rate Parity Theory
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23. ESSENTIAL FOREX TERMINOLOGY
The next time someone talks about it, I would understand.
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24. THE FOREX TRADE TYPES
CASH : When a Forex Trade is settled the same day of the deal
TOM : When a Forex Trade is settled the next working day of the deal
SPOT: When a Forex Trade is settled on the second working day of the deal
FORWARD : When a Forex Trade is settled any day after the date of deal
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25. THE RATE TYPES
BUY : The local currency price at which a Merchant Bank or a Financial
Institute buys Foreign Currency from you
SELL: The local currency price at which a Merchant Bank or a Financial
Institute sells Foreign Currency to you
INTERBANK: The local currency price at which a Merchant Bank buys or sells
Foreign Currency to other Merchant Banks in the Forex Market
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26. THE FORWARD METRICS
PREMIUM : When the Forward value of the currency is higher than the spot
value
DISCOUNT : When the Forward value of the currency is lower than the spot
value
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27. THE ARBITRAGE
An Arbitrage is an operation when one offsets one Forex / Interest
Rate transaction for another thus making it a risk free transaction.
Arbitrage keeps the exchange rates uniform in all the markets
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28. FACTORS AFFECTING
THE EXCHANGE RATES
 The exchange rates are very dynamic and
might vary day to day
 Major banks who are market makers always
give two way quotes
 Freedom or restrictions on capital
movements can affect exchange rates to a
large extent
 Huge trade surpluses of Oil Exporting
countries have the most telling effect on
fluctuations in currency values
 Speculations serves to provide depth and
liquidity in the forex market
The price / ratio / value at which
one currency is exchanged for
another
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29. CONTENT
 Introduction
 The Foreign Exchange Market Place
 Interesting Pointers
 Essential Terminologies
 The Forward Market
 Interest Rate Parity Theory
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30. THE FORWARD MARKET
Why wait until tomorrow when you can do so today!
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31. DEFINING FORWARD CONTRACT
In general, is is a contract between two parties agreeing to buy /
sell an asset at a specified future time. The price of the asset,
however, is finalised on the date of the contract.
In the foreign exchange market, the asset is normally a receivable
in a currency that is different from the local currency.
A forward contract is the most used foreign exchange hedging
mechanism in the world
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When you commit to buy an asset tomorrow at a price negotiated today

32. DEFINING FORWARD CONTRACT
Say, you are a phone manufacturer from India. And you have engaged in a export of 50,000
mobile phones to a buyer in the United States. You invoice USD 0.5mn for it. The payment
terms are 3 months from delivery and you have delivered it today.
If you had got your money today, you would have converted the USD 0.5mn to Indian
Rupees at today’s exchange rate. Which is, say, at INR 60 to USD 1. In other words, you would
have received INR 30mn into your account today.
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The steps you take today to save for a better tomorrow
You Importer in US50000 mobiles
Your delivery reached today
USD 0.5mn
You get your money after 3 months

33. DEFINING FORWARD CONTRACT
But you do not know what the rate for 1 USD would be after 3 months when you receive the
payment. There is a probability that it goes below INR 60 per USD in which case you would
make a loss. There is also a probability that the rate per USD goes above INR 60. In this case
you make a gain.
These two are called as Forex Loss or Forex Gain.
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The steps you take today to save for a better tomorrow

34. CONTENT
 Introduction
 The Foreign Exchange Market Place
 Interesting Pointers
 Essential Terminologies
 The Forward Market
 Interest Rate Parity Theory
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35. INTEREST RATE PARITY
Sometimes when $1 is not equal to $1
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36. DEFINING INTEREST RATE PARITY
Interest Rate Parity or IPR is used to understand the relationship
between the spot rate of a currency and a corresponding future or
forward rate of another currency
The difference in the interest rates between these two currencies
will reflect in a state of Premium or Discount of the currencies in the
forward market
Since it would be a no arbitrage condition, the size of the forward
premium or the discount on a foreign currency would be equal to
the interest rate differentials between the currencies in comparison
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A no arbitrage condition representing a state of equilibrium.

37. INTEREST RATE PARITY EXEMPLIFIED
Interest Rate Parity or IPR is used to understand the relationship
between the spot rate of a currency and a corresponding future or
forward rate of another currency
The difference in the interest rates between these two currencies
will reflect in a state of Premium or Discount of the currencies in the
forward market
Since it would be a no arbitrage condition, the size of the forward
premium or the discount on a foreign currency would be equal to
the interest rate differentials between the currencies in comparison
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The Real versus Notional stages