MBA (Business Economics) Unit I Foreign Exchange Markets

Unit I Foreign Exchange Markets

Dr. Pravin Kumar Agrawal

Assistant Professor

Department of Business Management

CSJMU

MBA (Business Economics)

Foreign Exchange Market

•

Foreign exchange market is the market in which

foreign currencies are bought and sold. This market

is also termed as Currency, FX, or forex market.

•

Its 

participant comprises of individuals, firms,

commercial banks, the central banks, importers and

exporters, investors, brokers, immigrants, tourists

.

Foreign Exchange Market

•

The foreign exchange market assists

international trade and investment by

enabling currency conversion. For example, it

permits a business in the India to import

goods from the United States and pay dollars,

even though its income is in Indian rupees.

Characteristics of foreign exchange market

•

High Liquidity

•

Market Transparency

•

Dynamic Market

•

Lower Trading Cost

•

Operates 24 Hours

•

Dollar Most Widely Traded

Base Currency / Terms Currency

•

In foreign exchange markets, the base currency is the

first currency in a currency pair. The second currency

is called as the terms currency. Exchange rates are

quoted in per unit of the base currency.

•

Eg. The expression US Dollar–Rupee, tells you that

the US Dollar is being quoted in terms of the Rupee.

The US Dollar is the base currency and the Rupee is

the terms currency

.

Base Currency / Terms Currency

•

Exchange rates are constantly changing, which means that

the value of one currency in terms of the other is

constantly in flux. Changes in rates are expressed as

strengthening or weakening of one currency vis-à-vis the

other currency.

•

Changes are also expressed as appreciation or depreciation

of one currency in terms of the other currency. Whenever

the base currency buys more of the terms currency, the

base currency has strengthened / appreciated and the

terms currency has weakened / depreciated.

•

Eg. If US Dollar–Rupee moved from 73.00 to 73.25, the US

Dollar has appreciated and the Rupee has depreciated.

Market participates of foreign exchange Market

•

The foreign exchange market assists international trade

and investment by enabling currency conversion.

•

For example, it permits a business in the United States

to import goods from the European Union member

states especially Euro zone members and pay Euros,

even though its income is in United States dollars.

•

The foreign exchange market (forex, FX, or currency

market) is a form of exchange for the global

decentralized trading of international currencies.

Commercial Bank

•

These banks are the major players in the market. Commercial

and investment banks are the main players of the foreign

exchange market; they not only trade on their own behalf but

also for their customers. A major chunk of the trade comes by

trading in currencies indulged by the bank to gain from

exchange movements. Interbank transaction is done in case

the transaction volume is huge. For small volume

intermediation of foreign exchange, a broker may be sought.

Central bank

•

Central banks like RBI in India (RBI) intervene in the

market to reduce currency fluctuations of the country

currency (like INR, in India) and to ensure an exchange

rate compatible with the requirements of the national

economy. For example, if rupee shows signs of

depreciation, RBI (central bank) may release (sell) a

certain amount of foreign currency (like dollar).

•

This increased supply of foreign currency will halt the

depreciation of rupee. The reverse operation may be

done to halt rupee from appreciating too much.

Foreign exchange fixing

•

Foreign exchange fixing is the daily monetary

exchange rate fixed by the national bank of each

country. The idea is that central banks use the fixing

time and exchange rate to evaluate behavior of their

currency. Fixing exchange rates reflects the real value

of equilibrium in the market. Banks, dealers and

traders use fixing rates as a trend indicator.

Hedge funds as speculators

•

About 70% to 90% of the foreign exchange transactions are

speculative. In other words, the person or institution that

bought or sold the currency has no plan to actually take

delivery of the currency in the end; rather, they were solely

speculating on the movement of that particular currency.

Investment management firms

•

Investment management is the professional

management of various securities (shares, bonds and

other securities) and assets (e.g., real estate) in order

to meet specified investment goals for the benefit of

the investors.

•

These firms (who typically manage large accounts on

behalf of customers such as pension funds and

endowments) use the foreign exchange market to

facilitate transactions in foreign securities

Retail foreign exchange traders

•

One of the most important tools required to perform

a foreign exchange transaction is the trading

platform providing retail traders and brokers with

accurate currency quotes. Retail foreign exchange

trading is a small segment of the large foreign

exchange market.

Functions of Foreign Exchange Market

Transfer Function

•

The basic and the most obvious function of

the foreign exchange market is to transfer the

funds or the foreign currencies from one

country to another for settling their payments.

The market basically converts one’s currency

to another.

Credit Function

•

It provides credit for foreign trade. Bills of

exchange, with maturity period of three

months, are generally used for international

payments.

•

Credit is required for this period in order to

enable the importer to take possession of

goods, sell them and obtain money to pay off

the bill.

Hedging Function

•

A third function of the foreign exchange market is to hedge

foreign exchange risks.

•

Hedging means the avoidance of a foreign exchange risk.

•

 In a free exchange market when exchange rate, i. e., the

price of one currency in terms of another currency, change,

there may be a gain or loss to the party concerned.

•

Under this condition, a person or a firm undertakes a great

exchange risk if there are huge amounts of net claims or

net liabilities which are to be met in foreign money.

•

Exchange risk as such should be avoided or reduced. For

this the exchange market provides facilities for hedging

anticipated or actual claims or liabilities through forward

contracts in exchange.

Hedging Function

•

A forward contract which is normally for three months is a

contract to buy or sell foreign exchange against another

currency at some fixed date in the future at a price agreed

upon now.

•

No money passes at the time of the contract. But the contract

makes it possible to ignore any likely changes in exchange

rate.

•

The existence of a forward market thus makes it possible to

hedge an exchange position.

Minimizing Foreign Exchange Risk

•

The foreign exchange market provides "hedging"

facilities for transferring foreign exchange risk to

someone else.

•

Thus, the foreign exchange market is merely a part of

the money market in the financial centers. It is a place

where foreign moneys are bought and sold.

•

The buyers and sellers of claim on foreign money and

the intermediaries together constitute a foreign

exchange market.

•

It is not restricted to any given country or a

geographical area.

Types of FX Market

Spot market

•

Spot market refers to the transactions involving sale

and purchase of currencies for immediate delivery. In

practice, it may take T+2  business days to settle

transactions. Transactions are affected at prevailing

rate of exchange at that point of time and delivery of

foreign exchange is affected instantly. The exchange

rate that prevails in the spot market for foreign

exchange is called Spot Rate.

Forward Market

•

A market in which foreign exchange is bought and

sold for future delivery is known as Forward Market.

It deals with transactions (sale and purchase of

foreign exchange) which are contracted today but

implemented sometimes in future. Exchange rate

that prevails in a forward contract for purchase or

sale of foreign exchange is called Forward Rate. Thus,

forward rate is the rate at which a future contract for

foreign currency is made.

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

‘. 

The market in

which the deals for the sale and purchase of currency

at some future date are made is called a Forward

Market‘.

Future Market

•

Standardized forward contracts are called futures

contracts and traded on a futures exchange. A

futures contract  is a standardized contract between

two parties to buy or sell a specified asset of

standardized quantity and quality for a price agreed

upon today (the futures price or strike price) with

delivery and payment occurring at a specified future

date.

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. But however, the transactions made in a future

contract differ from the transaction made in the forward contract

on the following grounds:

–

The forward contracts can be customized on the client‘s

request, while the future contracts are standardized such

as the features, date, and the size of the contracts is

standardized.

–

The future contracts can only be traded on the organized

exchanges, while the forward contracts can be traded

anywhere depending on the client‘s convenience.

–

No margin is required in case of the forward contracts,

while the margins are required of all the participants and

an initial margin is kept as collateral so as to establish the

future position.

Option Market

•

A currency option gives an investor the right,

but not the obligation, to buy or sell a

quantity of currency at a pre-established price

on or before the date that the option expires.

The right to sell a currency is known as a “put

option" and the right to buy is known as a “call

option.”

Example

•

An option to buy US Dollar ($) for Indian

Rupees (INR, base currency) is a USD call and

an INR put. The symbol for this will be 

USDINR

or USD/INR. Conversely, an option to sell USD

for INR is a USD put and an INR call. The

symbol for this trade will be like 

INRUSD

 or

INR/USD.

SWAP

•

A currency swap is an agreement in which two

parties exchange the principal amount of a loan

and the interest in one currency for the principal

and interest in another currency.

•

At the inception of the swap, the equivalent

principal amounts are exchanged at the spot rate.

•

During the length of the swap each party pays the

interest on the swapped principal loan amount.

SWAP..

•

At the end of the swap the principal amounts are

swapped back at either the prevailing spot rate, or at a

pre-agreed rate such as the rate of the original

exchange of principals. Using the original rate would

remove transaction risk on the swap.

•

Currency swaps are used to obtain foreign currency

loans at a better interest rate than a company could

obtain by borrowing directly in a foreign market or as a

method of hedging transaction risk on foreign currency

loans which it has already taken out.

Fixed for Fixed currency swap

•

An American company may be able to borrow in the United

States at a rate of 6%, but requires a loan in Indian Rupees for

an investment in India, where the relevant borrowing rate is

9%. At the same time, an Indian company wishes to finance a

project in the United States, where its direct borrowing rate is

11%, compared to a borrowing rate of 8% in India.

Example

RBI signs $400 million currency swap pact with Central Bank of Sri Lanka

:

The Reserve Bank of India (RBI) has signed a currency swap agreement with

the Central Bank of Sri Lanka, the central bank said on Monday.

The Central Bank of Sri Lanka can make drawals of US Dollar, Euro or

Indian Rupee in multiple tranches up to a maximum of USD 400 million or

its equivalent under a currency swap agreement, the RBI said in a release.

The agreement signed under the SAARC Currency Swap Framework 2019-

22 would be valid till November 13, 2022.

Source: https://economictimes.indiatimes.com/markets/forex/rbi-signs-400-million-currency-swap-pact-with-central-bank-of-sri-lanka/articleshow/77201835.cms?from=mdr

Exchange Rate Mechanism

•

“Foreign Exchange” refers to money denominated in

the currency of another nation or a group of nations.

Any person who exchanges money denominated in

his own nation’s currency for money denominated in

another nation’s currency acquires foreign exchange.

Exchange Rate Mechanism

•

This holds true whether the amount of the

transaction is equal to a few rupees or to billions

of rupees; whether the person involved is a

tourist or an investor exchanging hundreds of

millions of rupees for the acquisition of a foreign

company; and whether the form of money being

acquired is foreign currency notes, foreign

currency-denominated bank deposits, or other

short-term claims denominated in foreign

currency.

Exchange Rate Mechanism

•

A foreign exchange transaction is still a shift of

funds or short-term financial claims from one

country and currency to another. Thus, within

India, any money denominated in any

currency other than the Indian Rupees (INR)

is, broadly speaking, “foreign exchange.”

Exchange Rate Mechanism

•

Almost every nation has its own national currency or

monetary unit - Rupee, US Dollar, Peso etc.- used for making

and receiving payments within its own borders. But foreign

currencies are usually needed for payments across national

borders.

•

Thus, in any nation whose residents conduct business abroad

or engage in financial transactions with persons in other

countries, there must be a mechanism for providing access to

foreign currencies, so that payments can be made in a form

acceptable to foreigners. In other words, there is need for

“foreign exchange” transactions—exchange of one currency

for another.

Exchange Rate Mechanism

•

The market price is determined by the interaction of buyers and

sellers in that market, and a market exchange rate between two

currencies is determined by the interaction of the official and

private participants in the foreign exchange rate market.

•

For a currency with an exchange rate that is fixed, or set by the

monetary authorities, the central bank or another official body is a

participant in the market, standing ready to buy or sell the currency

as necessary to maintain the authorized pegged rate or range.

•

But in countries like the United States, which follows a complete

free floating regime, the authorities are not known to intervene in

the foreign exchange market on a continuous basis to influence the

exchange rate. The market participation is made up of individuals,

non-financial firms, banks, official bodies, and other private

institutions from all over the world that are buying and selling US

Dollars at that particular time.

Exchange Rate Mechanism

•

The participants in the foreign exchange market are thus a

heterogeneous group. The various investors, hedgers, and

speculators may be focused on any time period, from a few

minutes to several years. But, whatever is the constitution of

participants, and whether their motive is investing, hedging,

speculating, arbitraging, paying for imports, or seeking to

influence the rate, they are all part of the aggregate demand

for and supply of the currencies involved, and they all play a

role in determining the market price at that instant.

•

Given the diverse views, interests, and time frames of the

participants, predicting the future course of exchange rates is

a particularly complex and uncertain exercise.

MAJOR CURRENCIES OF THE WORLD

US Dollar ($)

The Euro (€)

The Japanese Yen (¥)

Quoting foreign Exchange Rates

•

The ratio between 2 currencies is called

exchange rate.

Direct Quotes

•

The home currency price of a certain amount

of a foreign currency eg. INR 45 / USD

Indirect Quotes

•

The value of one unit of home currency is

presented in terms of Foreign Currency.

•

USD 0.02857/INR

•

Numerical

•

If the direct quote is INR 63/USD, then how

can this exchange rate be presented in Indirect

quotes.

•

Exchange Rate

•

An exchange rate between two currencies is

the rate at which one currency can be

exchanged for another.

•

Exchange rates can be either fixed or floating.

Fixed exchange rates are decided by central

banks of a country whereas floating exchange

rates are decided by the mechanism of market

demand and supply.

Example

•

In  February 2,  2022, one USD was equal to

76.92 Rs., and one Indian ruppes was equal to

0.013 USD.

“Bid" and “Ask"

•

The terms "bid" and "ask" refer to price quotes. The

bid price is the highest amount a buyer is willing to

pay for a security, such as a share of a stock. The ask

price is the least amount the seller is willing to

accept for that security.

•

The bid is the price at which the market will buy a

currency pair (before any commissions or fees), the

offer (or ask) is the price at which the market will sell

the currency pair (before any commissions or fees).

•

For example, a USDCAD exchange rate of

0.9950 means that 1 USD will return .9950

CAD.

•

For example, with USDINR, one would buy

USD from the customer on the bid, thereby

selling them INR.

•

Alternatively, one would sell (or offer) the unit

currency, USD, on the offer and buy the

second currency (INR).

Example

•

An Indian company needs to purchase 100,000 US

dollars to pay for imported goods.

•

The USDINR quoted rate is 76.25 on the bid and 76.45

on the offer.  By convention the USD is the unit

currency and INR is the terms currency.

•

The company will have to buy the USD on the dealer's

offer, and will pay 76.45 for each dollar bought.

•

The importer pays 100,000 x 76.45= 7645000 INR.

Spread

•

Buying Rate is known as Bid rate

•

Selling rate is known as ask/offer rate.

•

Bid rate = rate at which bank purchase foreign

currency from customers

•

Ask rate = rate at which bank sell foreign currency

to customers

•

The difference is banks profit known as spread.

•

It would be written as Rs. 40 – 40.30/USD

•

Eg. Bid rate = Rs. 40   Ask rate 40.30 for

customers

Spread

•

This difference is banks profit known as

spread.

     % Spread = (Ask rate – Bid Rate) *100

Ask Rate

Cross Rate

•

Sometimes value of one currency in terms of another

one is unknown

•

Thus one currency is sold for a common currency

•

Again common currency is exchanged for a desired

currency

•

This is known as cross rate trading.

•

Rate establish between two currencies is known as

cross rates.

Example

•

Newspaper quotes: INR 35.00  -  35.20 /USD

& CAD 0.76 – 0.78/USD

Cross rate allows to establish relation between

CAD and USD

How to Derive a Cross Rate from a Direct

Quote & Direct Quote

Example

Rule: Divide the terms currency by the base currency on the opposite side.

How to Derive a Cross Rate from a Direct

Quote & Indirect Quote

Rule: multiply on the same side

Quoting forward Rates

Forward premium and Discount

•

Change in forward rates may be Increase or

decrease.

•

Thus, disparity arises between spot and forward

rates.

•

This is known as forward rate differential.

•

If forward rate< spot rate  = forward discount

•

If forward rate > spot rate  = forward premium

•

This premium/discount expressed as annulaized %

deviation.

Forward Premium/Discount  =

(N day forward rates  - spot rate)  X  360

Spot Rate

(N)

( 39.80  - 40.00)  X  360

40.00

30

 =  -0.06

= 6 % forward discount

CURRENCY FUTURES -DEFINITION

•

A futures contract is a standardized contract, traded on an

exchange, to buy or sell a certain underlying asset or an

instrument at a certain date in the future, at a specified price.

When the underlying asset is a commodity,

•

e.g. Oil or Wheat, the contract is termed a “commodity

futures contract”.

•

When the underlying is an exchange rate, the contract is

termed a “currency futures contract”. In other words, it is a

contract to exchange one currency for another currency at a

specified date and a specified rate in the future. Therefore,

the buyer and the seller lock themselves into an exchange

rate for a specific value and delivery date. Both parties of the

futures contract must fulfill their obligations on the

settlement date.

FACTORS DETERMINING

EXCHANGE RATES

Inflation

•

Inflation in the country would increase the

domestic prices of the commodities. With

increase in prices exports may dwindle

because the price may not be competitive.

•

With the decrease in exports the demand for

the currency would also decline; this in turn

would result in the decline of external value of

the currency.

Inflation

•

If, for instance, both India and the USA

experience 10% inflation, the exchange rate

between rupee and dollar will remain the

same. If inflation in India is 15% and in the

USA it is 10%, the increase in prices would be

higher in India than it is in the USA. Therefore,

the rupee will depreciate in value relative to

US dollar

Interest rate

•

The interest rate has a great influence on the short –

term movement of capital. When the interest rate of a

country rises, it attracts short term funds from other

countries. This would increase the demand for the

currency of the home country and hence its value.

Rising of interest rate may be adopted by a country due

to tight money conditions or as a deliberate attempt to

attract foreign investment. The effect of an increase in

interest rate is to strengthen the currency of the

country through larger inflow of investment and

reduction in the outflow of investments by the

residents of the country.

Country’s  Balance of Payments

•

A country’s current account reflects balance of trade

and earnings on foreign investment. It consists of

total number of transactions including its exports,

imports, debt, etc. A deficit in current account due to

spending more of its currency on importing products

than it is earning through sale of exports causes

depreciation. Balance of payments fluctuates

exchange rate of its domestic currency.

Political Stability & Performance

•

A country's political state and economic performance can

affect its currency strength. A country with less risk for

political turmoil is more attractive to foreign investors, as a

result, drawing investment away from other countries with

more political and economic stability. Increase in foreign

capital, in turn, leads to an appreciation in the value of its

domestic currency. A country with sound financial and trade

policy does not give any room for uncertainty in value of its

currency. But, a country prone to political confusions may see

a depreciation in exchange rates.

Recession

•

When a country experiences a recession, its

interest rates are likely to fall, decreasing its

chances to acquire foreign capital. As a result,

its currency weakens in comparison to that of

other countries, therefore lowering the

exchange rate.

References

•

https://iare.ac.in/sites/default/files/LECTURE

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 on 24.4.22