UNIT I

FOREIGN EXCHANGE MARKET & TRANSACTIONS

Introduction

A global market place for the buying, selling, exchanging and trading of currencies. International corporations and financial institutional use the FX markets every day to conduct business worldwide. Unlike the stock exchanges, all foreign exchanges are virtual.

Foreign exchange market:

It

is a global in nature. Decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers. The foreign exchange market determines the relative values of different currencies. Assists international trade and investment, by allowing businesses to convert one currency to another currency. Largest financial market in the world

Foreign

exchange markets exist to allow business owners to purchase currency in another country so they can do business in that country.
It

is a worldwide network of currency traders

Work

around the clock to complete these transactions.

Offers

opportunities for individuals to invest

Participants
Corporates Commercial Banks Exchange Brokers Central Banks

Types of Foreign Exchange Market

Spot Market Futures Market Forward Market

Spot Market
Quickest

transactions involving currency in foreign

markets.
Involve

immediate payment at the current exchange

rate, which is also called the spot rate.

Accounts

for one-third of all currency exchange, and

trades usually take place within two days of the agreement.

This

does leave the traders open to the volatility of

the currency market, which can raise or lower the price between the agreement and the trade.

Future Market
Involve

future payment and future delivery at an agreed exchange rate, also called the future rate.
These

contracts are standardized.

Elements

of the agreement are set and nonnegotiable.

It

also takes the volatility of the currency market

Popular

among traders who make large currency transactions and are seeking a steady return on their investment

Forward Market

Identical to the Futures Market except for one important difference---the terms are negotiable between the two parties. This way, the terms can be negotiated and tailored to the needs of the participants. It allows for more flexibility. In many instances, this type of market involves a currency swap, where two entities swap currency for an agreed-upon amount of time, and then return the currency at the end of the contract.

How to Read an FX Quote :

Currencies are quoted in pairs, for example - EUR/USD. The first currency in the pair is called the base currency The second is called the counter (or quote) currency.The base currency is the 'basis' for purchases and sales. When you buy, you buy the base currency. When you sell, you sell the base currency. For example, if you buy EUR/USD, you acquire Euros and sell Dollars. You do this if you expect the Euro to grow against the Dollar. Each transaction must have two sides - a buy and a sell (or a sell and a buy). By this we mean that it is impossible to buy 100,000 EUR/USD and then exchange it for another currency pair (e.g. EUR/JPY) without closing the first position.

Types Of Transactions

Spot Transactions

A spot contract is undertaken when you buy currency at the prevailing exchange rate at the time of the transaction and make payment within two working days. Because of this the day of conclusion may be different from the day of execution of the transaction. The date on which actually a deal is called valaor . This type of currency transaction is typically used for deposit payments on property or for full payment if the funds to pay for the transaction are available.

Forward Contract Transactions

An agreement between two parties, requiring the delivery

at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract.

The rate of exchange applicable to the forward contract is called the forward exchange rate. Helpful to exporters and importers as they can cover the risks arising out of exchange rate fluctuations be entering into an appropriate forward exchange contract. . With reference to its relationship with spot rate, the forward rate may be at

Par: If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making the contract the forward exchange rate is said to be at par. At Premium: when one dollar buys more units of another currency, say rupee, in the forward than in the spot rate on a per annum basis. At Discount: when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on a per annum basis.

The forward exchange rate is determined mostly be the demand for and supply of forward exchange. When the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium . When the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par.

Future Transaction

While a forward contract is tailor made.

A future contract has standardized features the contract size and maturity dates are standardized.
Futures can be traded only on an organized exchange and they are traded competitively. Margins are not required in respect of a forward contract but margins are required of all participants in the futures market and initial margin must be deposited into a collateral account to establish a futures position.

Limit Order Contracts

Limit Orders currency contracts allow a client to set

the rate at that which they would like to exchange

their currency.

Global Currency Exchange Network will monitor

the market for you and if the rate can be achieved,

purchase the currency at that time

This is particularly important for contracts of

substantial value where a small currency

fluctuation may have huge implications.

Options

While the forward or futures contract protects the purchaser of the contract from the adverse exchange rate movements, it eliminates the possibility of gaining a windfall profit from favorable exchange rate movement. An option transaction is a contract that gives holder the right, but not the obligation, to sell or buy a given quantity of an asset as a specified price at a specified future date. An option to buy the underlying asset is known as a call option. An option to sell the underlying asset is known as a put option. Buying or selling the underlying asset via the option is known as exercising the option. The stated price paid (or received) is known as the exercise or striking price. The buyer of an option is known as the long and the seller of an option is known as the writer of the option, or the short. The price for the option is known as premium. Types of options: With reference to their exercise characteristics, there are two types of options,
A European option can be exercised only at the maturity or expiration date of the contract, American option can be exercised at any time during the contract.

Swap operation
Commercial banks who conduct forward exchange business The term swap means simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency. The spot is swapped against forward. Operations consisting of a simultaneous sale or purchase of spot currency accompanies by a purchase or sale, respectively of the same currency for forward delivery are technically known as swaps or double deals as the spot currency is swapped against forward.

Arbitrage

Arbitrage is the simultaneous buying and selling of foreign currencies with intention of making profits from the difference between the exchange rate prevailing at the same time in different markets

Quoting FX rates
Exchange rate Foreign Exchange rate (or FX rate) is the rate at which the one currency is valued in terms of another currency Two way

Buying(Bid Rate) Selling(Offer Rate)

PIP
Based on the market practice, foreign exchange rates quotation normally consists of 5 significant figures. Starting from right to left, the first digit, is known as the pip. This is the smallest unit of movement in the exchange rate. The second digit is known as 10 pips, so on and so forth.

. For e.g., 1USD = 96.62 JPY. This is the exchange rate between the US Dollar and Japanese Yen, which means that 1 US dollar is equal to 96.62 Yen.

DIRECT QUOTE
X UNITS OF DOMESTIC CURRENCY EQUAL ONE UNIT OF FOREIGN CURRENCY. EXAMPLE- Rs44.20 per USD IS A DIRECT QUOTE FOR USD IN INDIA

Direct quotation:

This is also known as price quotation. The exchange rate of the domestic currency is expressed as equivalent 01 or 100 units of a foreign currency. variable amounts of the domestic currency. the domestic currency is always listed as the base currency. The more valuable the domestic currency, the smaller the amount of domestic currency needed to exchange for a foreign currency unit and this gives a lower exchange rate. When the domestic currency becomes less valuable, a greater amount is needed to exchange for a foreign currency unit and the exchange rate becomes higher. Under the direct quotation, the variation of the exchange rates are inversely related to the changes in the value of the domestic currency. When the value of the domestic currency rises, the exchange rates fall; and when the value of the domestic currency falls, the exchange rates rise. Most countries uses direct quotation. Most of the exchange rates in the market such as USD/JPY, USD/HKD and USD/RMD are also quoted using direct quotation.

Indirect quotation:
This is also known as the quantity quotation. The exchange rate of a foreign currency is expressed as equivalent to a 1 or 100units of the domestic currency. The more valuable the domestic currency, the greater the amount of foreign currency it can exchange for and the lower the exchange rate. When the domestic currency becomes less valuable, it can exchange for a smaller amount of foreign currency and the exchange rate drops.

Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in value of the domestic currency. When the value of the domestic currency rises, the exchange rates also rise; and when the value of the domestic currency falls, the exchange rates fall as well. Most Commonwealth countries such as the United Kingdom, Australia and New Zealand use indirect quotation. Exchange rates such as GBP/USD and AUD/USD are quoted indirectly.

5.CONVERTION (D TO I)

RUPEES Rs44.20=1$- DIRECT QUOTE

INDIRECT QUOTE Re1= 1/44.20=.0227

American Quote
Rate is expressed as so many units of US Dollar per unit of foreign currency. GBP1= USD 1.4326/4348 EUR1= USD 0.9525/9548 Foreign Currency / Dollar rate. Rarely used.

European quote
Number of foreign currency per unit of US Dollar. USD 1 = JPY 104.67/70 USD1= CHF 1.5425/5440 Dollar / Foreign Currency Rate Mostly used.

Cross rate
Exchange rate between a pair of currencies, neither of them being US Dollar- cross rate. USD 1 = INR 45.70 USD 1 = PND 1.50 PND 1 = INR ?

QUOTING FORWARD RATES

SPOT RATE

ADD PREMIUM

DEDUCT DISCOUNT

FORWARD RATE

SPOT USD1 = 48.4000/4200 SPOT/ SEPT 3200/3400 SPOT/ OCT 3800/4200

Spread Rate
ASK MINUS BID=SPREAD