Foreign Exchange Market

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FOREIGN EXCHANGE MARKET

Transcript of Foreign Exchange Market

Page 1: Foreign Exchange Market

FOREIGN EXCHANGE MARKET

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• International transaction in cash requires two distinct purchases– Purchase of foreign currency– Purchase of good/service with the FC

• Term foreign exchange is used to denote foreign currency• Foreign exchange market exists to cater to the demand for foreign

currency/currencies. It involves transfers through Nostro/Vostro accounts between international banks.

• Location1. OTC-type: no specific location2. Most trades by phone, telex, or SWIFT

SWIFT: Society for Worldwide Interbank Financial Telecommunications

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Contd…• Organizational setting within which individuals,

governments and banks buy and sell foreign currencies

• Only a small fraction of daily transactions in foreign exchange involve trading of currency

• Most foreign exchange transactions involve transfer of bank deposits.

• The foreign exchange market is round-the-clock market due to different time zones

• Major participants- central banks, commercial banks, forex brokers, corporations, individuals

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• Functions of Foreign Exchange Market1. Transfer function

Conversion of one currency into another currency results in transfer of purchasing power between countries. It is done through the instruments such as Telegraphic transfer, Foreign bills of exchange etc.

2. Credit function credit facility is offered through foreign bills of

exchange and foreign letter of credit.3. Hedging function Forward contract helps to cover the risk of

changes in exchange rate between two currencies

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

I. Participants in Foreign Exchange MarketA. Participants at 2 Levels

1. Wholesale Level (95%) - major banks

2. Retail Level - business customers.

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. Two Types of Currency Markets

1. Spot Market:- immediate transaction- recorded by 2nd business day

2. Forward Market: - transactions take place at a

specified future date

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

C. Participants by Market1. Spot Market

a. commercial banksb. brokersc. customers of commercial

and central banks

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

2. Forward Marketa. arbitrageursb. tradersc. hedgersd. speculators

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• Important terminologies in Foreign Exchange transaction:• Fiat currencies Paper currency notes issued by the Central Monetary Authority of

the respective countries. It contains a promise to redeem the notes at its face value.

• Foreign Currency: the legal tender applicable in a country outside the domestic area. It

is the money only in the country of issue. At other locations it should be viewed as a commodity having time value.

• Foreign Exchange - Definition as per FEMA (1999)• Deposits, credits and balances payable in foreign currency• Drafts, travelers’ cheques, letter of credit or bill of exchange

expressed or drawn in Indian currency but payable in foreign currency

• Drafts, travelers’ cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency

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• NOSTRO account Demand deposit account denominated in foreign currencies maintained by domestic banks with banks overseas. Nostro means “our account with

you”. Example: Indian Bank has a US dollar account with Citi Bank, New York.

• VOSTRO account Demand deposit accounts, denominated in domestic currency maintained by

overseas banks with domestic banks. Vostro account means “your account with us.” Example: Barclays Bank, London has an INR account with Bank of Baroda”.

• LORO account It is used for referring to third party accounts. Loro account means “their

account with you”. This term is used when the NOSTRO/VOSTRO account is referred to, by a bank other than the account maintaining bank and the bank with which account is maintained. Example: Indian Bank has a USD account with Citi Bank, New York. When Canara Bank has to refer to this account while corresponding with Citibank it would refer to it as LORO account.

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• Correspondent banks: The Foreign exchange transactions centered around the transfers and

payments made between banks from different countries. The bank with whom the nostro or vostro account relationship established is called as correspondent bank. It undertakes the following functions:

1. Maintaining foreign currency account. Receiving and making payments on behalf of the principal bank.

2. Providing credit reports on companies located in their country. 3. Providing trade related data and product data to help the principal bank to

help its customer for business development.4. Assisting principal bank in its agency functions such as presentation of

documents, advising of LC, confirmation of LC etc.

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• Role of banks in Foreign Exchange transactions: Every transactions involving foreign exchange passes through

Nostro and Vostro accounts maintained by the international banks. Being the significant participant in the forex market, banks provide

quotes for the pairs of currency traded in the market. Thus they play a crucial role in establishing demand supply equilibrium between currencies. In nutshell

- trade is the base for international monetary flows. - international trade contributes to economic growth. -international trade settlements take place through conversion of one

currency with another. - the rate of conversion is called as the Exchange Rate. - the rate is based on the demand supply factors affecting each

currency pair.

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Types of exchange rate• Exchange rate denotes the price or the ratio or the

value at which one currency is exchanged for another• Ready/cash - Settlement of funds on the same day

(date of the deal). • Tom - Settlement of funds takes place on the next

working day of the date of the deal• Spot - Settlement of funds takes place on the second

working day following the date of the deal• Forward – settlement of funds takes place beyond spot

date is called as forward contract. Such transactions are settled at the rate called forward rate.

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Method of Quotation1. For interbank dollar trades:

a. American quote – Number of dollars expressed per unit of any other currency. example: $1.5613/£b. European quote –Number of units of any other currency expressed per dollar. example: Rs.45.96/$

2. Merchant quote : Interbank quote

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• For nonbank customers:

Direct quote

gives the home currency price of one unit of foreign currency.

Example: Rs.46.8700/$

Indirect quote

gives foreign currency price for a fixed number of units of domestic currency.

Example : $2.0525/Rs.100

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• Cross rates- To obtain rates for a particular currency pair when they are not available directly

• Bid and Ask rates- In USD/INR 39.40/41 the bank is bidding for USD at Rs. 39.40 and offering to sell USD at Rs. 39.41

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Types of exchange rate (2)

• In the forex market all rates that are quoted are generally spot rates

• When delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicable

• Forward rate = Spot rate + Premium (- discount)

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THE FORWARD MARKET

Definition of a Forward Contractan agreement between a bank and a

customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

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Forward rate

• If the forward value of a currency is higher than the spot value the currency is said to be at a premium

• If the above is reversed the currency is said to be at a discount

• The forward premium/discount is based on interest rate differentials of the two currencies involved

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Forward Rate (2)

• Forward transactions are necessary in the foreign exchange market as they serve number of purposes like:– One can hedge or cover an existing future financial,

commercial or trade related exchange risk– These types of deals, in combination with spot deals,

are used for money market operations through ‘swap’ transactions

– Taking a view of the market, these can be used for speculation

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Forward rate (3)

• When a currency is costlier in the future (forward) as compared to the spot, the currency is said to be at a premium vis-à-vis another currency

• In ‘direct rate’ premium is added to both the buying and selling rate whereas discount is deducted

• In ‘indirect rate’ premium is deducted and discount is added to the buying and selling rates

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Forward rate (4)• Base currency is the currency which is being bought and

sold and the other currency is incidental.• Forwards are quoted as follows

– Spot/1 month 17/18– Spot/ 2 months 35/37– Spot/ 3 months 53/56

• If forward differentials are in the ascending order (bid rate is lower than ask rate) the base currency is at premium.

• If forward differentials are in the descending order (bid rate is greater than the ask rate) the base currency is at discount.

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Forward Rate Quotations1.Two Methods:

a. Outright Rate: quoted to commercial customers.

b. Swap Rate: quoted in the interbank market at a discount or premium. Forward rate calculation: through the use of forward schedule through the use of FormulaAnnualized Forward Margin• Arithmetical difference between the interest rates of the variable and base

currencies in annualized percentage terms = F-S x 12 x 100 S n

where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract

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THE FORWARD MARKET

C. Forward Contract Maturities1. Contract Terms

a. 30-dayb. 90-dayc. 180-dayd. 360-day

2. Longer-term Contracts

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

. CLEARING SYSTEMSA. Clearing House Interbank System (CHIPS) - used in U.S. for electronic fund transfers.B. Fed Wire

- operated by the Fed

- used for domestic transfers. ELECTRONIC TRADING

A. Automated Trading- genuine screen-based market

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B.Results:

1. Reduces cost of trading

2. Threatens traders’ oligopoly of

information

3. Provides liquidity

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

IV. SIZE OF THE MARKET

The foreign exchange market is the largest and most liquid financial market in the world.

• Market Centers (Between 2007-08): $3.98 trillion daily global turnoverLondon =accounted for around $1.36 trillion, or 34.1% of the total

New York= accounted for 16.6% Tokyo = accounted for 6.0%.

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Dealing Room

• A centralised establishment, usually of a commercial bank, which is willing to make/offer a two way dealing price for different currencies at all times even when they may not wish to deal, but all during prescribed business hours.

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• Dealing Room

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RBI/FEDAI Guidelines (1)

• RBI has issued Authorised Dealers (AD) licenses to banks, all India financial institutions and a few co-operative banks to undertake foreign exchange transactions in India

• It has also issued Money Changer licenses to a large number of established firms, companies, hotels, shops, etc.

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RBI/FEDAI Guidelines (2)

• Money changers help facilitate encashment of foreign currencies of foreign tourists

• Entities authorised to buy and sell foreign currency notes, coins and travellers’ cheques are called full fledged money changers

• Those authorised only to buy are called restricted money changers

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RBI/FEDAI Guidelines (3)• FEDAI (Foreign Exchange Dealers’ Association

of India) is a non-profit making body formed in 1958 with the approval of RBI

• Its members are authorised dealers and it prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc.

• FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market