Nalsar - Forex Presentation

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    FOREIGN EXCHANGE MARKET

    INTRODUCTION

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    Forex Business

    Each country has a Central Bank / Agency

    It regulates inflows and outflows of FCs

    Each country has certain regulations about who isauthorised to convert the currencies

    In India RBI has the regulatory powers under FEMA

    It authorises commercial bank branches to conductforeign exchange business

    Authorised dealers in Foreign Exchange

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    EXPORTS

    INVISIBLERECEIPTS INVISIBLE

    PAYMENTS

    IMPORTS

    CAPITAL

    PAYMENTSGROWTH

    IN RESERVES

    Currency inflow outflow

    CA DEFICIT

    CAPITAL

    RECEIPTS

    TRADE DEFICIT

    Forex Reserves at Present are USD 295.72 Billion (08.10.2010) 3

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    Inflows in FC arise mainly on account of:

    Export of goods and services

    Remittances from NRIs

    Tourism

    Investment

    Borrowings by Govt.,Corporates,Individuals

    Aid from International Agencies

    Gifts and Donations

    Forex Inflows

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    Evolution of the Forex Market in India

    Fixed Exchange Rate

    Sterling as Intervention Currency

    Basket of Currencies in 1975 LERMSMarch 1992ORE/MRE

    Unified Exchange RateMarch 1993

    Direct Quotation

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    Outflows in FC arise mainly on account of:Import of goods and servicesRepatriation of NRI funds

    Educational expenses of Indian studentsTourismInvestmentLendings to Other countries, Repayment

    of loans, interest on loans etc.Aid by Indian Govt., AgenciesGifts and Donations

    Forex outflows

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    Exchange Rate Basics

    Bank buys currency from Customers at buy rate

    Bank sells currency to Customers at sell rate

    Sell rate is kept higher than the buy rate

    The difference is profit to the bank

    All currencies bought have to be sold

    All currencies sold are bought back

    This matching of sale and purchase is called cover operation.

    Customers not always available for sale / purchase

    Banks deal among themselvesInterbank market

    This is a wholesale market for currencies

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    FOREX MARKET

    Participants - Banks, foreign exchange brokers, and dealers.

    Not a physical place

    Technology drivenAll participants are linked to each other

    through dedicated networks.

    e.g., REUTERS, TELERATE, BLOOMBERG

    It is a 24 hour marketOpen in some part of the globe.

    New ZealandAustraliaJapan - Hong KongSingapore

    MumbaiBahrainLondon - New York .. And again Back to

    New Zealand

    SEVERAL LARGE BANKS RUN 24 HOUR DEALING ROOMS ON THREE SHIFT BASIS AT MAJOR

    FINANCIAL CENTRES

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    CHARACTERISTICS OF FOREX MARKET:

    1. A 24-hour Market

    2. An O-T-C Market

    3. A Global Market with No Barriers/No Specific Location

    4. A Market that supports large Capital & Trade Flows

    5. Highly Liquid Markets

    6. High Fluctuations in Currency Rates (Every 4 Seconds)

    7. Settlements affected by Time Zone Factor

    8. Markets affected by Govt. Policies & Controls

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    EXCHANGE RATE DETERMINANTS-Fundamental Reasons

    1. BOPSurplus results in stronger currencyDeficit weakens a

    currency

    2. Economic Growth RateA high growth leads to a rise in imports

    and a fall in the value of currency and vice versa

    3. Fiscal PolicyLower taxes can lead to higher economic growth.

    4. Monetary PolicyCentral Bank attempts to influence and control

    interest and money supply can impact the countrys currency value

    5. Interest RatesHigh Domestic Interest Rates attract overseas

    capital & currency appreciates in the short term. In the longer run,

    high interest rates slow the economy, weakening the currency.

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    6. Political IssuesPolitical Stability likely to lead to economic

    stability and hence a steady currency. Political instability results in

    the opposite.

    Technical Reasons

    Government Controls can lead to unrealistic value of a currency,

    resulting in violent fluctuation in exchange rates. Huge surpluses in

    the OECs have led to heavy investments elsewhere overseas,leading

    to huge movement of capital overseas and resultant appreciation ofthe relative currency.

    Speculation

    Speculative deals provide depth and liquidity to the market and at

    times act as a cushion, as long as this does not lead to a cotagiouseffect.

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    Direct Quotation: 1 Foreign Currency Unit = (equals) X amount of

    Home Currency Units

    USD EXCH. RATE- INR 44.205 BID44.205 ASK-44.210H.

    Indirect Quotation: 1 Home Currency Unit = (equals) X amount of

    Foreign Currency Units

    INR EXCH. RATEUSD 0.2262 BID0.2262 ASK0.2262

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    Cash, Tom, Spot and Forwards

    READY OR CASHSettlement of funds takes place on the same day (date of deal)

    TOM - Settlement of funds takes place on the next working day after the deal

    SPOTSettlement of funds takes place on the second working day after deal

    FORWARDDelivery of funds takes place any day after Spot date.

    Normally Rupee and dollar are to change hands on spot date

    Cash to spot and tom to spot differences depend on the number of days between the

    two dates.

    If there are intervening holidays difference will be larger.

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    Discount and Premium

    Rupee fetches higher interest than dollar

    If exchange takes place after the spot date party receiving rupee

    has to be compensated for difference in interest

    If exchange takes place before spot date, the party paying rupeehas to be compensated for difference in interest

    Forward dollar costlier than spot dollar

    We say dollar is at a premium in forward

    Or rupee is at a discount in the forward market

    Currencies with low interest are at a premium Currencies with high interest are at a discount

    Premia / discounts also quoted as percentage

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    EXCHANGE ARITHMETIC

    All forex rates calculations have to be worked out with extreme care and

    accuracy and the use of the decimal point has to be correctly placed.

    Constant check is also required to minimise the risk or mistake as the

    markets work on very thin margins.

    An error in one quote may erode, earnings from several

    trades/transactions.

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    Factors affecting Exchange Rates

    Balance of Payments

    Interest rates and Inflation

    Economic Growth Rate

    Political Stability / Fiscal Policy

    Speculation

    Central Bank Intervention

    Demand and Supply

    Because exchange rates are volatile, who has to pay or receive

    Forex at a future date needs to hedge the currency risk

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    Derivatives

    A financial instrument that is valuedaccording to the expectedprice movementsof an underlying asset, which may be acommodity, currency or asecurity, is called a derivative

    As derivative is a contractual relationship established by two or

    more parties where payment is based on, or derivedfrom, someagreed-upon benchmark, the types of derivative products that canbe developed are limited only by the human imagination

    Therefore, there is no definitive list of derivative products

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    Forward Contracts

    A Forward Contract is a simple derivative

    contract to buy/sell a specified asset on

    a certain future date (maturity date) at aspecified price (exercise price).

    A Forward contract is normally settled by

    delivery of the underlying asset.

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    FUTURES

    A Futures contract is a form of forward contractin that it conveys

    the right to purchase or sell a specified quantity of an asset at a

    fixed price on a fixed future date

    It involves a definite purchase or saleand not an option to buy or

    sell

    As Futures are exchange-traded instruments, the contract

    obligation is not between the two counter-parties to thetransaction(the buyer and seller of the contract), but to the

    clearing house of the exchange

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    Exchange traded

    Standard quantity, quality

    and date of maturity

    Counterparty risk of

    Exchange

    Offsetting transactions

    through the Exchange

    Transparent pricing

    Margin required

    Negotiated between two

    parties

    All these can be negotiated

    Counterparty risk of the

    opposite party

    Offsetting transactions only

    with the original counterparty

    Negotiated pricing

    Often no Margin required

    FUTURES FORWARDS

    FUTURES ANDFORWARDS

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    Call Options Importer need to buy USD 1 mio on 31stDec

    He buys a call option at 43.50 from bank

    Right to buy dollar at 43.50 without obligation to do so

    If rate is 43.51 or above, he will buy from bank at 43.50

    If rate is lower he will forfeit the option; buy from

    market

    As rupee strengthens profit potential is unlimited

    If rupee depreciates he is always protected at 43.50

    His maximum loss is the premium paid.

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    OPTIONS

    An Option offers the buyer/holdertheright, but not the obligation, to buy or sell

    a specified amount of the underlying assetat an agreed rateon or before a specifiedfuture date

    Option may either be a Call Optionor aPut Option

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    Put Options Exporter need to sell USD 1 mio on 31stDec

    He buys a put option at 43.50 from bank

    Right to sell dollar at 43.50, with no obligation to do so.

    If rate is 43.49 or lower, he will sell to bank at 43.50

    If rate is higher, he will forfeit the option; sell in market

    As rupee weakens profit potential is unlimited

    If rupee appreciates he is protected at 43.50

    His maximum loss is the premium paid

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    Option terminology

    Customer making delivery or taking delivery under an option is called

    exercising the option

    European style optioncan be exercised only on due date

    American style optionexercised any day before maturity

    Price at which option can be exercised is the strike price

    The upfront price paid by customer is called premium

    Options are normally custom made and sold by bank to customerOver

    the Counter (OTC) options

    Options quoted on Exchanges - Exchange Traded Options.

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