2. Foreign Exchange market
• The foreign exchange market (also known as forex, FX, or the
currencies market) is an over-the-counter (OTC) global
marketplace that determines the exchange rate for currencies
around the world.
• Participants in these markets can buy, sell, exchange, and
speculate on the relative exchange rates of various currency
pairs.
• Foreign exchange markets are made up of banks, forex
dealers, commercial companies, central banks, investment
management firms, hedge funds, retail forex dealers, and
investors.
4. • Transfer Function: The basic and the most visible function of
foreign exchange market is the transfer of funds (foreign
currency) from one country to another for the settlement of
payments.
• It basically includes the conversion of one currency to
another, wherein the role of FOREX is to transfer the
purchasing power from one country to another.
5. • Credit Function: FOREX provides a short-term credit to the
importers so as to facilitate the smooth flow of goods and
services from country to country.
• An importer can use credit to finance the foreign purchases.
• Such as an Indian company wants to purchase the machinery
from the USA, can pay for the purchase by issuing a bill of
exchange in the foreign exchange market, essentially with a
three-month maturity.
6. • Hedging Function:
• The third function of a foreign exchange market is to hedge
foreign exchange risks.
• The parties to the foreign exchange are often afraid of the
fluctuations in the exchange rates, i.e., the price of one currency
in terms of another.
• The change in the exchange rate may result in a gain or loss to
the party concerned.
7. Participates in Foreign exchange market
Forex Dealers
• Forex dealers are amongst the biggest participants in the
• They are also known as broker dealers. Most Forex
banks.
• It is for this reason that the market in which dealers
is also known as the interbank market.
8. Brokers
• The Forex market is largely devoid of brokers. This is
not deal with brokers necessarily. If they have sufficient
directly call the dealer and obtain a favorable rate.
Hedgers
• There are many businesses which end up creating an
priced in foreign currency in the regular course of their
9. Speculators
• Speculators are a class of traders that have no genuine
foreign currency. They only buy and sell these currencies
making a profit from it. The number of speculators
market sentiment is high and everyone seems to be
Forex markets.
10. Retail Market Participants
• Retail market participants include tourists, students and
travelling abroad. Then there are also a variety of small
indulge in foreign trade. Most of the retail participants
market whereas people with long term interests operate
12. • Spot Market: A spot market is the immediate delivery market,
representing that segment of the foreign exchange market
wherein the transactions (sale and purchase) of currency are
settled within two days of the deal.
• That is, when the seller and buyer close their deal for currency
within two days of the deal, is called as Spot Transaction.
• Thus, a spot market constitutes the spot sale and purchase of
foreign exchange. The rate at which the transaction is settled is
called a Spot Exchange Rate.
• It is the prevailing exchange rate in the market.
13. • Forward Market: The forward exchange market refers to the
transactions – sale and purchase of foreign exchange at some
specified date in the future, usually after 90 days of the deal.
• That is, when the buyer and seller enter into a contract for the
sale and purchase of foreign currency after 90 days of the deal
at a fixed exchange rate agreed upon now, is called a Forward
Transaction.
15. • Commercial Bank
• Commercial banks are important organs of foreign exchange market which
are termed as “market makers”. These banks trade in foreign currencies for
themselves and also for their clients. Commercial banks quote the foreign
exchange rate on a daily basis for purchasing and selling of foreign
currencies.
16. • Central Bank
• Central bank is the apex body in foreign exchange market which has power to
regulate operations related to trading of foreign currency. It directly intervenes
in the functioning of forex market to avoids aggressive fluctuations.
• Foreign Exchange Brokers
• Broker in foreign exchange market work as an intermediary in between the
commercial bank and central bank and also in between the commercial banks
and buyers.
17. • Buyers And Seller
• These are real buyers and sellers of foreign currencies who trade in foreign
exchange market with the help of brokers. They approach commercial banks
for purchasing and selling off currencies.
18. SWIFT Framework
• SWIFT is a byword for reliability, security and auditability for financial
transactions. Global dealers, regional bank, investment managers and
corporates all use SWIFT for FX operations.
• SWIFT has for many years played a crucial role in supporting effective
and reliable operations in the FX market and is therefore pleased to
confirm that the services that it offers its clients are fully aligned with
relevant principles of the Global Code.
19. • FX Market participants can be confident that their use of SWIFT plays
an integral part in helping them to align with the FX Global Code.
• Use of SWIFT can help ensure market participants are conducting
their FX Market activities in a manner consistent with many of the
Principles of the Code.
• The SWIFT environment applies strict security, confidentiality and
integrity protections to customers’ messages.
• SWIFT offers a variety of services to support both intra-day and end-
of-day account management. This includes use of intra-day credit and
debit advices, as well as intra- and end-of-day statements.
20. Exchange rate
• An exchange rate is the value of one nation's currency versus
the currency of another nation or economic zone.
• Most exchange rates are free-floating and will rise or fall based
on supply and demand in the market.
Example:
• John is traveling to Germany from his home in New York and he
wants to make sure he has 200 dollars’ worth of euros when he
arrives in Germany. He goes to the local currency exchange
shop and sees that the current exchange rate is 1.20. It means
if he exchanges $200, he will get €166.66 in return.
21. Factors determining exchange rate
• Inflation
• Inflation is the relative purchasing power of a currency
compared to other currencies. For example, it might cost one
unit of currency to buy an apple in one country but cost a
thousand units of a different currency to buy the same apple in
a country with higher inflation.
22. • Interest Rates
• Interest rates are tightly tied to inflation
and exchange rates. Different country’s central
banks use interest rates to modulate inflation
within the country. For example, establishing
higher interest rates attracts foreign capital,
which bolsters the local currency rates.
23. • Public Debt
• Most countries finance their budgets using
large-scale deficit financing. In other words,
they borrow to finance economic growth. If this
government debt outpaces economic growth, it
can drive up inflation by deterring foreign
investment from entering the country, two
factors that can devalue a currency.
24. • Political Stability
• A politically stable country attracts more
foreign investment, which helps prop up the
currency rate. The opposite is also true – poor
political stability devalues a country’s
currency exchange rate. Political stability
also affects local economic drivers and
financial policies, two things that can have
long term effects on a currency’s exchange
rate.
25. • Economic Health
• Economic health or performance is another way
exchange rates are determined. For example, a
country with low unemployment rates means its
citizens have more money to spend, which helps
establish a more robust economy. With a
stronger economy, the country attracts more
foreign investment, which in turn helps lower
inflation and drive up the country’s currency
exchange rate.
26. • Balance of Trade
• Balance of trade, or terms of trade, is the
relative difference between a country’s imports
and exports. For example, if a country has a
positive balance of trade, it means that its
exports exceed its imports. In such a case, the
inflow of foreign currency is higher than the
outflow. When this happens, a country’s foreign
exchange reserves grow, helping it lower
interest rates, which stimulates economic
growth and bolsters the local currency exchange
rate.
27. • Government Intervention
• Governments have a collection of tools at their
disposal through which they can manipulate
their local exchange rate. Primarily, central
banks are known to adjust interest rates, buy
foreign currency, influence local lending
rates, print money, and use other tools to
modulate currency exchange rates.
28. Exchange rate forecasting
• Economists and investors always tend to forecast the future
exchange rates so that they can depend on the predictions to
derive monetary value. There are different models that are used
to find out the future exchange rate of a currency.
• Exchange Rate Forecasts are derived by the computation of
value of vis-à-vis other foreign currencies for a definite time
period. There are numerous theories to predict exchange rates,
but all of them have their own limitations.
29. Exchange Rate Forecast: Approaches
The two most commonly used methods for forecasting exchange rates
are −
• Fundamental Approach − This is a forecasting technique that
utilizes elementary data related to a country, such as GDP, inflation
rates, productivity, balance of trade, and unemployment rate. The
principle is that the ‘true worth’ of a currency will eventually be
realized at some point of time. This approach is suitable for long-
term investments.
• Technical Approach − In this approach, the investor sentiment
determines the changes in the exchange rate. It makes predictions
by making a chart of the patterns. In addition, positioning surveys,
moving-average trend-seeking trade rules, and Forex dealers’
customer-flow data are used in this approach.
30. Exchange rate quotations
• Exchange rate quotations can be quoted in two ways – Direct
quotation and Indirect quotation.
• Direct quotation is when the one unit of foreign currency is
expressed in terms of domestic currency.
• Similarly, the indirect quotation is when one unit of domestic
currency us expressed in terms of foreign currency.
31. • The quote is direct when the price of one unit of foreign
currency is expressed in terms of the domestic currency.
• The quote is indirect when the price of one unit of domestic
currency is expressed in terms of Foreign currency.
32. Direct Quotation
• Under this method, the quote is expressed in terms of
domestic currency. This means that the rate expresses
how one unit of domestic currency relates to the foreign
currency.
• Therefore, if unit of the domestic currency were to be
exchanged, how many units of the foreign currency would
it beget? This method is also alternatively referred to as
the price quotation method.
33. Example: An example of direct quotation would be
USD/JPY: 143.15/18
This quote suggests that roughly 143 units of Japanese
for 1 unit of United States Dollar. The two rates provided
i.e. the different rates at which the market maker is willing
currency.
34. Indirect Quotation
• This method is the opposite of the direct quotation
method. Under this method, the quote is expressed in
terms of foreign currency. Therefore this rate assumes
one unit of foreign currency. It then expresses how many
units of domestic currency are required to obtain a single
unit of a foreign currency. Sometimes this quote is also
expressed in terms of 100 units of foreign currency. This
method is often referred to as the quantity quotation
method.
35. An example of indirect quotation would be:
EUR/USD: 0.875/79
In this case, the first currency i.e. EUR is the domestic currency. Therefore, the
indirect quote refers to approximately 0.875 EUR being exchanged for 1 unit of
USD. Once again the two rates provided are the bid ask rate i.e. the two
different rates at which market makers are willing to buy and sell the currency.
•
36. Foreign Exchange Transactions
• The Foreign Exchange Transactions refers to the sale and
purchase of foreign currencies. Simply, the foreign exchange
transaction is an agreement of exchange of currencies of one
country for another at an agreed exchange rate on a definite
date.
37. Types of Foreign Exchange Transactions
Spot Transaction:
• The spot transaction is when the buyer and seller of different
currencies settle their payments within the two days of the deal.
It is the fastest way to exchange the currencies.
• Here, the currencies are exchanged over a two-day period,
which means no contract is signed between the countries.
• The exchange rate at which the currencies are exchanged is
called the Spot Exchange Rate.
38. • Forward Transaction:
• A forward transaction is a future transaction where the buyer
and seller enter into an agreement of sale and purchase of
currency after 90 days of the deal at a fixed exchange rate on
a definite date in the future.
• The rate at which the currency is exchanged is called
a Forward Exchange Rate.
39. • Future Transaction:
• The future transactions are also the forward transactions and
deals with the contracts in the same manner as that of normal
forward transactions.
• Swap Transactions:
• The Swap Transactions involve a simultaneous borrowing
and lending of two different currencies between two investors.
• Here one investor borrows the currency and lends another
currency to the second investor.
40. • Option Transactions:
• The foreign exchange option gives an investor the right, but
not the obligation to exchange the currency in one
denomination to another at an agreed exchange rate on a pre-
defined date.
• An option to buy the currency is called as a Call Option, while
the option to sell the currency is called as a Put Option.
41. Derivatives
• Derivatives are financial contracts whose value is linked to
the value of an underlying asset. They are complex
financial instruments that are used for various purposes,
including hedging and getting access to additional assets
or markets.
• Most derivatives are traded over-the-counter (OTC).
However, some of the contracts, including options and
futures, are traded on specialized exchanges. The biggest
derivative exchanges include the CME Group (Chicago
Mercantile Exchange and Chicago Board of Trade), the
Korea Exchange, and Eurex.
42. Types of Derivatives
• Forwards and futures
• These are financial contracts that obligate the contracts’
buyers to purchase an asset at a pre-agreed price on a
specified future date. Both forwards and futures are
essentially the same in their nature.
• However, forwards are more flexible contracts because
the parties can customize the underlying commodity as
well as the quantity of the commodity and the date of the
transaction. On the other hand, futures are standardized
contracts that are traded on the exchanges.
43. • Options
• Options provide the buyer of the contracts the right, but
purchase or sell the underlying asset at a predetermined
option type, the buyer can exercise the option on the
options) or on any date before the maturity (American
44. • Swaps
• Swaps are derivative contracts that allow the exchange of
two parties. The swaps usually involve the exchange of a
floating cash flow. The most popular types of swaps
commodity swaps, and currency swaps.
45. Foreign Exchange Exposure
• Foreign Exchange Exposure refers to the risk
associated with the foreign exchange rates that
change frequently and can have an adverse
effect on the financial transactions denominated
in some foreign currency rather than the domestic
currency of the company.
46. Managing foreign exchange risk
• Exchange rate fluctuation is an everyday
occurrence. From the holidaymaker planning a
trip abroad and wondering when and how to
obtain local currency to the multinational
organization buying and selling in multiple
countries, the impact of getting it wrong can be
substantial.
47. • For example, if Indian company is competing against the
products imported from China and if the Chinese yuan per
Indian rupee falls, then the importers enjoy decreased cost
advantage over the Indian company. This shows, that the
companies not having any direct link to the forex do get affected
by the change in the foreign currency.
48. Foreign Exchange risk management policy
The FX policy must clearly articulate the following details:
• Hedging objective
• What is to be hedged
• Instruments to be used
• Delegations and controls
• Risk limits
49. Types of Foreign Exchange Risk
• Transaction risk
• Transaction risk is the risk faced by a company when making
financial transactions between jurisdictions. The risk is the
change in the exchange rate before transaction settlement.
Essentially, the time delay between transaction and
settlement is the source of transaction risk.
• For example, a Canadian company with operations in China
is looking to transfer CNY600 in earnings to its Canadian
account. If the exchange rate at the time of the transaction
was 1 CAD for 6 CNY, and the rate subsequently falls to 1
CAD for 7 CNY before settlement, an expected receipt of
CAD100 (CNY600/6) would instead of CAD86 (CNY600/7).
50. • Economic risk
• Economic risk, also known as forecast risk, is the risk that
market value is impacted by unavoidable exposure to
fluctuations.
• Such a type of risk is usually created by macroeconomic
geopolitical instability and/or government regulations.
51. • Translation risk
• Translation risk, also known as translation exposure,
by a company headquartered domestically but conducting
foreign jurisdiction, and of which the company’s financial
denoted in its domestic currency.
• Translation risk is higher when a company holds a greater
assets, liabilities, or equities in a foreign currency.
52.
53. Theory 1: Interest Rate Parity (IRP)
•Interest rate parity (IRP) is a theory according to
which the interest rate differential between two
countries is equal to the differential between the
forward exchange rate and the spot exchange
rate.
•Interest rate parity (IRP) plays an essential role
in foreign exchange markets by connecting
interest rates, spot exchange rates, and foreign
exchange rates.
57. Locational arbitrage
•Locational arbitrage can be defined
as the act where an investor tries to
exploit the minor exchange rate
differences for a given currency pair
between multiple banks for
generating a profit.
58. Triangular Arbitrage
•Triangular arbitrage is the result of a
discrepancy between three foreign
currencies that occurs when the
currency's exchange rates do not exactly
match up.
59. Covered interest arbitrage
• Covered interest arbitrage is a strategy in which
an investor uses a forward contract to hedge
against exchange rate risk. Covered interest rate
arbitrage is the practice of using favorable
interest rate differentials to invest in a higher-
yielding currency, and hedging the exchange risk
through a forward currency contract.
60. Types of exposure
Foreign exchange exposure is classified into three types
viz.
• Transaction exposure
• Translation exposure
• Economic Exposure.
61. Transaction Exposure
• The simplest kind of foreign currency
exposure which anybody can easily think of
is the transaction exposure.
• As the name itself suggests, this exposure
pertains to the exposure due to an actual
transaction taking place in business
involving foreign currency.
62. • Example:
If you have bought goods from a foreign country and
payables are in foreign currency to be paid after 3
months, you may end up paying much higher on the due
date as currency value may increase.
This will increase your purchase price and therefore the
overall costing of the product compelling the profit
percentage to go down or even convert to lose.
63. Translation Exposure
• This exposure is also well known as
accounting exposure.
• It is because the exposure is due to the
translation of books of accounts into the
home currency.
• Translation activity is carried out on
account of reporting the books to
the shareholders or legal bodies.
64. Economic Exposure
• The impact and importance of this type of
exposure are much higher compared to the
other two.
• Economic exposure directly impacts the value
of a firm.
• That means, the value of the firm is
influenced by the foreign exchange.
65.
66. Internal techniques of exposure management
• Internal hedging methods are those available within the
business itself.
• These typically should always be considered before resorting to
external methods as they can be cheap and relatively
straightforward.
• However, some businesses may not have all the methods
available to them.
• Internal techniques of exposure managament include the
following;
67. Do Nothing
• Make no attempt to manage FX risk. Exposes the business to
upside and downside movements in FX rates. May not be
feasible if company has large FX transaction or is a low margin
business. Business saves transaction costs with this policy as
no hedging involved.
Invoice in home currency
• A business can transfer all the FX risk to their customer if they
invoice in euro. However, this may result in lost sales especially
if they are in a competitive industry. Customer may not want to
have FX risk exposure.
68. • Risk Sharing
Business and customer enter into an agreement that both will
share any FX movements between the date of transaction and
date of payment. Split can be determined by negotiation. Less
extreme method than invoicing in home currency (where 100% of
risk is pushed onto customer).
• Matching
When a business has income and expenditure in a foreign
currency then it can operate a bank account in that currency and
match them against each other, removing the need to translate
them all back to euro first. The business then only needs to
translate the surplus back into euro, saving on transaction costs.
69. Leading and lagging
• Leads and lags in international business most
commonly refer to the alteration of normal
payment or receipts in a foreign
exchange transaction based on an expected
change in exchange rates
• Leads and lags refer to the timing of payments on
international agreements to take advantage of
exchange rate changes.
70. • Not all currency-rate events and be adequately
forecast, but those that can are usually tied to
political events.
• Entities that have control over the payments may
find it advantageous to delay or accelerate
payments based on anticipated currency
changes.
71. • For example, if the company that is buying the
Canadian asset chooses to hold off payment because it
believes the Canadian dollar will weaken and, before
making the payment, the Bank of Canada (BoC)
unexpectedly raises interest rates then the Canadian
dollar will strengthen making their decision to hold off
detrimental. For this reason, some companies will
choose to make part of the payment at the time of
agreement and wait to pay for the remainder.
72. External Techniques of exposure management
•External techniques which are also known as
active hedging techniques, essentially involve
contractual relationship with outside agency.
•The following are the external techniques of
exposure management
73. • Uncertainty : If a firm does not hedge the transaction, it cannot know
with certainty at what rate of exchange it can exchange its dollar
export proceeds for rupees, it could be at a better rate or a worse
rate.
• Opportunity : If firms enter into a hedge transaction such as a
forward contract they would, of course, be certain of the rate at
which they would be exchanging the export proceeds. But now they
have taken an infinite risk of ‘opportunity loss’.
74. • Hedging through forward contract
• Hedging through future contract
• Hedging through Money Market
75. Foreign currency invoicing
• If an investor trade with companies in other countries, the investor can
process foreign currency transactions in Accounting.
• Investor can easily record invoices, credit notes, payments, and receipts in
different currencies.
• Investor can choose to use live exchange rates from the Federal Reserve
System (FRS), which update daily so you're always using the most up to date
rate.
• Investor can also track any losses or gains as a result of changes in the rate.
