FOREX MARKETS

Dr Deepak Tandon
LBSIM
Introduction to Forex
Market
 The Foreign Exchange Market (FX
Market)
va market for converting the currency
of one country into the currency of
another country.
 Functions
vconverting currencies
vreducing risk
Introduction to Forex
Market
Important places of the FX
  Important places of the FX
market market
 

v Tokyo v London
v Hong Kong v New York
v Singapore v Paris
v Dubai v Chicago
v Mumbai
v Frankfurt
v Sydney
v Hamburg
v Rio de Janeiro
v Vienna v Düsseldorf
v Madrid v Amsterdam
v Brussels v San Francisco
v Mexico City v Melbourne
v Sao Paulo v Zurich
v v
v
Introduction to Forex
Market
Organization of the FX market


 Market levels in the FX market

 1. Wholesale Level (95% of transaction
volume)
 Major banks (Inter-bank market)
 2. Retail Level
 Banks deal with business customers (large firms)
Basic Types of FX Markets


 Spot Market
 Immediate transaction (Cash or, Tom)
 Currencies to be delivered within 2 business
days.
 Forward Market
 Currencies delivery at a specified future date

Introduction to Forex
Market
Organization of the FX Market


Participants in the Inter-Bank Market



 Major commercial banks (market makers)

 Sell and buy foreign currency
 Brokers
 Match supply and demand
 Commission Rs 2500 (For USD 1 million or,
equivalent)
 Other Commercial Banks
 To participate in foreign exchange market
 To cover revenues received in foreign currency
 Central banks
 To participate for intervention purposes.

Functions of Market
Transfer of Purchasing power is necessary
Inventory in transit is to be financed
Forex Markets provide hedging facilities
for transferring Forex Risk to someone
else more willing to carry risk
Foreign Exchange Markets
 The FOREX market provides the physical and
institutional structure through which
The money of one country is exchanged for
that of another country
The rate of exchange between currencies is
determined
Foreign exchange transactions are physically
completed
 A foreign exchange transaction is an
agreement between a buyer and a seller that
a fixed amount of one currency will be
delivered for some other currency at a
specified rate
Foreign Exchange Markets
There are six main characteristics of the
FOREX markets which will be discussed
The geographic extent
The three main functions
The market’s participants
Its daily transaction volume
Types of transactions including spot,
forward and swaps
Methods of stating exchange rates,
quotations, and changes in exchange
rates
Geographic Extent of the
Market
Geographically, the FOREX market spans
the globe with prices moving and
currencies trading every hour of every
business day
Major world trading starts each morning in
Sydney and Tokyo
Then moves west to Hong Kong and
Singapore
Continuing to Europe and finishing on the
West Coast of the U.S.
 Geographic Extent of the
Market
Measuring FOREX Market Activity: Average Electronic Conversations Per
Hour
25,000

20,000

15,000

10,000

5,000

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Greenwich Mean
Time

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyoopening closing open closing in America In NY opens
Functions of the FOREX
Market
 The FOREX market is the mechanism by which
participants
Transfer purchasing power between countries
 This is necessary as international trade and
capital transactions normally involve parties
living in countries with different national
currencies
Obtain or provides credit for international trade
transactions
 Inventories in transit must be financed
Minimize exposure to exchange rate risk
 FOREX markets provide instruments utilized in
“hedging” or transferring risk to more willing
parties
Market Participants
The FOREX market consists of two tiers, the
interbank or wholesale market, and the
client or retail market
Five broad categories of participants
operate within these two tiers
Bank and non bank foreign exchange
dealers
Individuals and firms conducting
commercial or investment transactions
Speculators and arbitragers
Central banks and treasuries
Foreign exchange brokers
Bank and Non-bank Dealers
These participants profit from buying
currencies at a bid price and then
reselling them at an offer or ask price
Competition among dealers narrows the
spread between the bid and offer rate
contributing to the market’s efficiency
Dealers on behalf of large international
banks often act as market makers, often
willing to stand in and buy or sell these
currencies without having a counterpart
with which to unload the “inventory”
Bank and Non-bank Dealers
They trade amongst other banks and
dealers in order to keep their inventory
levels at manageable levels
Currency trading is profitable and often
contributes between 10% - 20% of a
banks’ average net income
Small- to medium-sized banks rarely act as
market makers yet still participate in the
interbank market
Individuals and Firms Conducting
Commercial/Investment Transactions
Importers, exporters, portfolio investors,
MNEs, tourists and others use the FOREX
market to facilitate execution of
commercial or investment transactions
Some of these participants use the market
to hedge foreign exchange rate risk
Risks in Foreign Exchange
PLAYERS IN FOREIGN EXCHANGE MARKET


1.CUSTOMERS
2.
3.COMMERCIAL BANKS
4.
5.CENTRAL BANK
6.
7.BROKERS
 IIBANKS+NON BANK FOREX DEALERS
(speculators+arbitragers,treasuries,
brokers)
Risks in Foreign Exchange
FEATURES OF FOREIGN EXCHANGE MARKET


qOMNI-PRESENT
qSLEEPLESS
qEXTRA INFORMATION DRIVEN
qEXPONENTIAL VOLATILITY
qCAPITAL FLOW SENSITIVE
qTWO TIER MARKET
Ø INTER-BANK
Ø OTC MARKET
Risks in Foreign Exchange
IMPORTER BANK EXPORTER
Currency Risk Currency Risk Currency Risk
Transaction Position carrying Transaction
Translation Translation Translation
Economic Economic

Interest Risk Interest Risk Interest Risk

Country Risk Country Risk Country Risk
Credit Risk Credit Risk Credit Risk
Risks in Foreign Exchange
Importer Bank  Exporter

Transit Risk/ Mismatch of Transit Risk/
Marine Peril maturities Marine Peril

Inferior Operational Goods

quality of Risk rejected by
goods buyer
False/ fake Adverse Insolvency
documents selection of LC
issuing
bank.
 FX Forwards: Definition,
Characteristics and Features
Forward Foreign
Exchange Contract
 Definition:
 An agreement to exchange one
currency for another, where
 The exchange rate is fixed on the day of the
contract, but
 The actual exchange takes place on a pre-
determined date in the future

Forward Foreign
Exchange Contract

As per FEMA, Foreign Exchange forward
contracts are transactions in which one of
the counterparties being an AD agrees to
exchange a specified amount of different
currencies at some future date, with the
exchange rate being set at the time the
contract is entered into.

 Characteristics and Features of
FX Forwards

 Quotes available daily in major currencies in 30-, 90-, and

180-day maturities, however, forwards can be customised
for any value or, maturity forward.
 Forwards are entered into “over the counter”
 Deliverable forwards: face amount of currency is
exchanged on settlement date
 Non-deliverable forwards: only the gain or loss is
exchanged
Characteristics and Features of
FX Forwards
Contract terms specify:
forward exchange rate
term
amount
‘‘value date’’ (the day the forward contract expires)
locations for payment and delivery.

In Inter-bank contracts the date on which the
currency is actually exchanged, the
‘‘settlement date,’’ is generally two days after
the value date of the contract.
Characteristics and Features of
FX Forwards

 Forward Exchange Rates: “The Iron-Clad

Law”
 Forward exchange rates are different from spot rates,
but they are not a prediction of what the spot rate
will be when the deal settles!

 The difference between the forward exchange
rate and the spot exchange rate is the interest
differential
 between the two currencies
Forward Contracts
Foreign Exchange forward rates, Foreign


Exchange spot rates, and interest rates are

interrelated by the interest rate parity (IRP)
principle.


This principle is based on the notion that there
should be no arbitrage opportunity between
the Foreign Exchange spot market, Foreign
Exchange forward market, and the term
structure of interest rates in the two countries.

Forward Contracts

Interest Rate Parity

THIS INTEREST RATE PARITY FOR SIX MONTH
MATURITY CAN ALSO BE ILLUSTRATED AS FOLLOWS:



@ 4% p.a.

EUR 980.39 EUR 1000



1 EUR = INR 65.50 1 EUR= INR 66.15



INR 64,215.55 INR 66,142.01



@ 6% p.a.

Forward Contracts

Interest Rate Parity

IF INTEREST RATE SCENARIO IS ALTERED WHAT IS
THE RESULT THAT WILL BE SHOWN BY THIS PARITY
FOR SIX MONTH MATURITY :



@ 6% p.a.

EUR 970.87 EUR 1000



1 EUR = INR 65.50 1 EUR= INR 64.86



INR 63,591.98 INR 64,863.82



@ 4% p.a.

Forward Contracts
Premiums and Discounts

As previously discussed, the forward rates are
closely related to the spot rates and interest
rates of the two countries. A result of the IRP
theory is that for the country with the higher
interest rate, its currency is weaker in the
forward market than in the spot market. As
shown in the first example, the INR interest
rate was higher than the EUR interest rate, and
the resulting theoretical forward rate was
65.50, compared with the spot rate of 66.15

Forward Contracts
Premiums and Discounts

As shown in the second example, the
INR interest rate was lower than the US
interest rate, and the resulting
theoretical forward rate was 64.86,
compared with the spot rate of 65.50

In this case the forward rate is then at
a discount of 64 points
Forward Contracts

Premiums and Discounts

The terms premium and discount refer
to whether the forward rates are higher
or lower than the spot rates. A premium
means the forward price is higher than
the spot price and a discount means
lower.
In this case the forward rate is then at a
premium of 51 points



Forward Contracts
 Premiums and Discounts

In order to apply forward points to a spot rate to come up with
an outright quote for the forward price,
one needs to know whether the forward points are premiums or
discounts.
For premiums, bid forward points are added to bid spot prices
and ask forward points are added to ask spot prices.
For discounts bid forward points are subtracted from ask spot
prices and ask forward points are subtracted from bid spot
prices.
If all this seems confusing, just remember the rule that the
bid-ask spreads of the forward price should always be greater
than the spot price, and that the sum of the bid-ask spreads of
the spot price and forward points should equal the spread of
the forward price.
The bigger spread in the forward market can be viewed as
compensation for the increased risk the market maker takes in
the forward market relative to the spot market.



 PART II
Foreign Exchange Rates &
Quotations
 A foreign exchange quote is a statement of
willingness to buy or sell at an announced
rate
In the retail market (newspapers and exchange
booths), quotes are often given as the home
currency price of the foreign currency
 Interbank quotes – professional dealers or
brokers may state quotes in one of two ways
The foreign currency price of one dollar
 Sfr1.6000/$, read as 1.600 Swiss francs per
dollar
The dollar price of a unit of foreign currency
 $0.6250/Sfr, read as 0.625 dollars per Swiss
franc
Foreign Exchange Rates &
Quotations
The former quote is considered to be in
“European terms” and the latter is
considered to be “American terms”
Almost all European currencies, except two,
are quoted the European way
The Pound Sterling and the Euro are the
exceptions
Additionally, Australian and New Zealand
dollars are also quoted in American terms
Foreign Exchange Rates &
Quotations
Direct and Indirect Quotes
A direct quote is a home currency price of
a unit of a foreign currency
 Sfr1.6000/$ is a direct quote in Switzerland
An indirect quote is a foreign currency
price in a unit of the home currency
 Sfr1.600/$ is an indirect quote in the US,
 $0.625/Sfr is a direct quote in the US and an
indirect quote in Switzerland
Foreign Exchange Rates &
Quotations
Interbank quotes are given as a bid and ask
The bid is the price at which a dealer will
buy another currency
The ask or offer is the price at which a
dealer will sell another currency
 Example: ¥118.27 - ¥118.37/$ is the
bid/ask for Japanese yen
 The bank will buy yen at ¥118.27 per dollar
and sell yen at ¥118.37 per dollar making
profit on the spread
 Foreign Exchange Rates &
Quotations
Expressing Forward Quotations on a Points
Basis
The previously mentioned rates for yen
were considered outright quotes
Forward quotes are different and typically
quoted in terms of points
A point is the last digit of a quotation, with
convention dictating the number of digits
to the right of the decimal
 Hence a point is equal to 0.0001 of most
currencies

39 Copyright © 2006 Pearson Addiso

Foreign Exchange Rates &
Quotations
Expressing Forward Quotations on a Points
Basis
The yen is quoted only to two decimal
points
A forward quotation is not a foreign
exchange rate, rather the difference
between the spot and forward rates
Example:
Bid Ask

Outright spot: ¥118.27 ¥118.37

Plus points (3 months) -1.43 -1.40

Outright forward: ¥116.84 ¥116.97

 Foreign Exchange Rates &
Quotations
 Forward Quotations in Percentage Terms
Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate
 This is similar to the forward discount or premium
calculated earlier
The important thing to remember is which
currency is being used as the home or base
currency
 For indirect quotes (i.e. quote expressed in
foreign currency terms), the formula is

Spot - Foward 360

f FC
= x x 100
Foward days
41 Copyright © 2006 Pearson Addiso
Foreign Exchange Rates &
Quotations
Forward Quotations in Percentage Terms
For direct quotes (i.e. quote expressed in
home currency terms), the formula is

Forward - Spot 360

f =
H
x x 100
Spot days
Foreign Exchange Rates &
Quotations
Forward Quotations in Percentage Terms
Example: Indirect quote


¥ 105.65 - 105.04 360
f = x x 100 = + 2.32% p.a.
105.04Direct quote
Example: 90

0.009520183 - 0.009465215 360

f =
$
x x 100 = + 2.32% p.a.
0.009465215 90
Foreign Exchange Rates &
Quotations
Cross Rates
Many currencies pairs are inactively
traded, so their exchange rate is
determined through their relationship to a
widely traded third currency
Example: A Mexican importer needs
Japanese yen to pay for purchases in
Tokyo. Both the Mexican peso (MXP) and
Japanese yen (¥) are quoted in US dollars
 Assume the following quotes:

Japanese yen ¥110.73/$

Mexican peso MXP 11.4456/$
 Foreign Exchange Rates &
Quotations
Cross Rates
The Mexican importer can buy one US dollar for
11.4456 Mexican pesos and with that dollar buy
¥110.73; the cross rate would be

Japaneseyen/USdollar = ¥110.73/$ = ¥
9.6745/MXP
Mexicanpesos/USdollar MXP11.4456/$
Foreign Exchange Rates &
Quotations
Intermarket Arbitrage
Cross rates can be used to check on
opportunities for intermarket arbitrage
Example: Assume the following exchange
rates are quoted

Citibank $1.2223/€
Barclays Bank $1.8410/£
Dresdner Bank €1.5100/£
Foreign Exchange Rates &
Quotations
Intermarket Arbitrage
The cross rate between Citibank and
Barclays is


 $1.8410/£ =
€1.5062/£
 $1.2223/€
This cross rate is not the same as
Dresdner’s rate quote of €1.5100/£
Therefore, an opportunity exists for risk-
less profit or arbitrage
 Foreign Exchange Rates &
QuotationsCitibank New York
End with Start with
$1,002,538 $1,000,000
(6) Receive $1,002,538 (1)Sell $1,000,000 to Barclays
Bank at $1.8410/£

Deutsche Bank Barclays Bank, London

(5)Sell €820,206 to Citibank (2) Receive £543,183
at $1.2223/€
(4) Receive €820,206 (3)Sell £543,183 to Dresdner Bank
at €1.5100/£
THANX