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Forex Markets

Forex Markets. Dr.P.Govindarajan. Forex Markets in 20 th Century. Affected by the two world wars Post WW 1 forex markets were very volatile and subject to large-scale speculations Forex transactions became so risky that hedging by forwards became basic components of forex transactions

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Forex Markets

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  1. Forex Markets Dr.P.Govindarajan

  2. Forex Markets in 20th Century • Affected by the two world wars • Post WW 1 forex markets were very volatile and subject to large-scale speculations • Forex transactions became so risky that hedging by forwards became basic components of forex transactions • Forwards were considered speculative in nature • Failure of gold standard in 1931 and bank failures caused significant setback • By middle of the decade markets returned to normalcy • London was the largest center of forex dealings between the two World Wars

  3. Post World War II • US Dollars ($) became the dominant currency • About 25 years post WW II forex markets were too stable and controlled • Focus was on controlling the currency value • UN conference held at Bretton Woods focused on • Stability • Confidence • Foster worldwide growth and prosperity • Bretton Woods Agreement in 1944 • World currencies pegged against US $ • US $ was pegged to gold at $35 per ounce • US promised to convertibility of US $ to gold at the pegged rate on demand • Pegged-exchange-rate system broke in 1971

  4. Exchange Rate Systems

  5. Exchange Rate Systems • Gold Standard – this system was in vogue till WW 1 consisting of the Gold Specie and Gold Bullion Standards • Gold Specie Standard • Gold coins were an accepted medium of exchange and the total money supply in a country was determined by the gold available for monetary purposes • The country’s central bank guaranteed to buy and sell gold in unrestricted amounts at a fixed price

  6. Exchange Rate Systems • Gold Bullion Standard • Where the money in circulation was either partly or entirely paper and gold served as reserve asset for the money supply • The currencies of the countries which were on gold standards could be exchanged freely • The exchange rate was determined by the content of the gold in the respective currency e.g..if the gold content in the currency of Britain was 3 times as much as that of USA then • 1 GBP = 3 USD • Also known as Mint Parity Theory

  7. Exchange Rate Systems • Purchasing Power Parity Theory • Gold Standard abandonment forced the world to look for a new exchange system • Simply stated currencies are valued for what they can buy • E.g. If 100 Jpy can buy a Parker pen and the same pen can be bought by 1 USD it can be inferred that since 1 USD and 100 Jpy can buy the same pen then 1 USD = 100 Jpy

  8. Purchasing Power Parity (PPP) This is just a broader/generalized form of “Law of one price” PPP  Domestic price level  10%, domestic currency  10% 1. Application of law of one price to price levels 2. Works in long run, not short run Problems with PPP (and Law of one price) 1. All goods not identical in both countries 2. Many goods and services are not traded

  9. Exchange Rate Systems • Bretton Woods System • to establish an international monetary system with stable exchange rates • to eliminate existing exchange controls • to bring about convertibility of all currencies • System required the member countries to fix the parities of their currencies in terms of USD or gold • USA fixed the parity at USD 35 per ounce of gold • Collapse of the system in 1971 as USA pulled out due to a run on the dollar • Then came the Smithsonian Agreement - Floating Rate System

  10. Exchange rate system in India • Historically linked to the Pound Sterling • As a signatory to the Bretton Woods RBI was authorized to maintain par value of rupee within the permitted band of 1% • First devaluation in 1966 running up to to 1995 • Delinked from the Pound Sterling in 1975 and linked to a basket of currencies

  11. Determinants of the Exchange Rate

  12. Determinants of the Exchange Rate • Under a flexible rate system, the exchange rate is determined by supply and demand. • The dollar demand for foreign exchange originates from American demand for foreign goods, services, & assets (real or financial). • The supply of foreign exchange originates from sales of goods, services, & assets from Americans to foreigners. • The foreign exchange market brings the quantity demanded and quantity supplied into balance. • As it does so, it brings the purchases by Americans from foreigners into equality with the sales of Americans to foreigners.

  13. S(sales to foreigners) Excess supplyof pounds Excess demandfor pounds e D(purchases from foreigners) Foreign Exchange Market Equilibrium • The dollar price of the English pound is measured on the vertical axis. The horizontal axis indicates the flow of pounds to the foreign exchange market. Dollar price of foreign exchange(for pounds) • The demand and supply of pounds are in equilibrium at the exchange rate of $1.50 = 1 English pound. • At this price, quantity demanded equals quantity supplied. $1.80 • A higher price of pounds (like $1.80 = 1 pound), would lead to an excess supply of pounds ... $1.50 $1.20 causing the dollar price of the pound to fall (depreciate). • A lower price of pounds (like $1.20 = 1 pound), would lead to an excess demand for pounds … Quantity of foreign exchange (pounds) Q causing the dollar price of the pound to rise (appreciate).

  14. Changes in the Exchange Rate • Factors that cause a currency to depreciate: • A rapid growth of income (relative to trading partners) that stimulates imports relative to exports. • A higher rate of inflation than one's trading partners. • A reduction in domestic real interest rates (relative to rates abroad).

  15. b D2 Foreign Exchange Market Equilibrium Dollar price of foreign exchange(for pounds) • Other things constant, if incomes increase in the United States, U.S. imports of foreign goods and services will grow. S(sales to foreigners) • The increase in imports will increase the demand for pounds (in the foreign exchange market) $1.80 causing the dollar price of the pound to rise from $1.50 to $1.80. $1.50 a D1 Quantity of foreign exchange (pounds) Q1 Q2

  16. S2 b D2 Inflation With Flexible Exchange Rates Dollar price of foreign exchange(for pounds) • If prices were stable in England while the price level in the U.S. increased by 50 percent … S1 the U.S. demand for British goods (and pounds) would increase … $2.25 as U.S. exports to Britain would be relatively more expensive they would decline and thereby cause the supply of pounds to fall. $1.50 a • These forces would cause the dollar to depreciaterelative to the pound. D1 Quantity of foreign exchange (pounds) Q1

  17. Changes in the Exchange Rate • Factors that cause a currency to appreciate: • A slower growth rate relative to one’s trading partners. • A lower inflation than one's trading partners. • An increase in domestic real interest rates (relative to rates abroad).

  18. Factors affecting exchange rates • Balance of payments • Strength of the economy • Fiscal policy • Interest rate • Monetary policy • Political factors • Exchange control • Central bank intervention • Speculation • Technical factors

  19. Forex Market Practices & Participants

  20. Tokyo opens Asia closing 10 AM In Tokyo Lunch In Tokyo Europe opening Americas open London closing Afternoon in America 6 pm In NY Around-the-clock FX trading Average Electronic Conversions Per Hour Greenwich Mean Time

  21. Structure of FX Market (retail level) domestic (Rs.) foreign (FC) for. central bank central bank Interbank mkt (Rs./$/FC) firms for. firms investors for. investors Exchange-traded futures & options

  22. FX Interbank Market domestic (Rs.) foreign (FC) FX broker Corp. order for. bank Corp. order dom. bank for. bank Corp. order Corp. order dom. bank Rs./ $ / FC

  23. Market participants • Customers those who buy and sell forex for their trade requirements and other needs • Commercial banks are those authorized to deal in forex • Hedge Funds – Invest and speculate on the forex movements • Central banks – control volatile and undue movements of their currency • Exchange brokers who act as intermediary between banks for doing the deals

  24. Market participants • Customers • who are engaged in foreign trade avail these services provided by the banks • exporters need to convert their receivables • importers need to remit their payables • may also need forex for settlement of other international obligations • are allowed to trade with some limitations

  25. Market participants • Commercial banks • deal with international trade transactions offer services for converting one currency into another • specialized in international trade transactions and have branch/correspondent network • have the authority to trade in forex besides merchant transactions • Exchange brokers • deal on behalf of banks • act as intermediaries

  26. Market participants • Hedge funds • manage huge funds for their investors • have the mandate to trade a certain percentage of this fund • invest based on the forecast of currency movements and also try to move the market • Central banks • have the responsibility to maintain the external value of their currency • ensure that there is orderliness in exchange movements through intervention

  27. Features of Indian FX Market • Limited market makers • More market takers • RBI presence • Growing awareness amongst corporates to hedge • Gross daily volumes approx USD 6 billion • Limited time i.e.. 9 am to 4 pm for the market

  28. Exchange Rate Arithmetic – settlement • Value date is a date on which the exchange of currencies actually takes place • Cash is the same day transaction • Tom is the transaction on the next working day after the deal date • Spot is the transaction on the second working day after the deal date • Forward is the transaction after a period of spot date

  29. Quotes in Forex • Direct Quotes A foreign currency quoted in terms of the local currency e.g..USD/INR -- 1 USD = INR 45.25 • Indirect Quotes Local currency unit quoted in terms of number of foreign currency e.g.. INR/USD -INR100=USD2.2099

  30. Currency pairs – Way they are quoted

  31. Examples To book an import cover in JPY/INR value spot • Spot USD / INR is 45.2725 / 2825 • Spot USD / JPY is 110.75 / 79 • 45.2825 / 110.75 = 40.8870 To book an Export rate for value Spot in JPY/INR • 45.2725 / 110.79 = 40.8633

  32. Examples To book an Import cover for AUD/INR value spot • Spot USD / INR 45.2725 / 45.2800 • AUD / USD 0.7530 / 39 • 45.28 X 0.7539 = 34.1365 To book an export cover in GBP/INR value spot • Spot USD / INR 45.2550 / 2625 • GBP / USD 1.7975 / 78 • 45.2550 X 1.7975 = 81.3460

  33. Examples To calculate the rate for an import cancellation value spot in USD/INR • Spot rate is USD/INR 45.2525 / 45.2650 • Rate is 45.2525 To calculate an import cancellation rate in EUR/INR for value spot • Spot EUR/USD is 1.2338 / 41 • Rate is 1.2338 x 45.2525 = 55.8325

  34. Forex Forwards

  35. Foreign exchange forward contract • An agreement between a bank and a counter party to buy or sell a specific amount of one currency against another currency on a specific future date at a fixed rate

  36. Forward Contracts – Bookings • For any transaction that is to happen after the spot date a customer/bank can book either a purchase or sale forward contract • Utilization of forward contracts on the due dates

  37. Forward Contracts – Cancellations • In the absence of any instructions from the customer, matured / unutilized contracts will be automatically cancelled after the specified grace period • At the request of the customer it is optional for the bank to • Accept or give early delivery • Extend the contract • Cancel the contract before or after the maturity date • In all the above cases bank shall recover the costs incurred in effecting the transactions

  38. Forward contracts - merits • Simple hedge instruments • Works well when rates move in a band • Useful in long unidirectional movements • To overcome the time lag between buying or selling goods and payment for the same

  39. Factors affecting USD/INR forwards • Call rate / G-sec yields • USD o/n rate / treasury yields • Govt. borrowing program • Credit policy announcements • Spot INR • Demand & Supply

  40. Premium/discount • Determined by the interest rate differential between the two countries e.g. : Spot USD/JPY 110.25 EUR/USD 1.2325 INT rate USD 1.00% INT rate USD 1.00% 6 mths JPY 0.02% 6 mths EUR 2.00% Fwd disc 0.65 pips Fwd prm 59 pips • The currency associated with the higher interest rate will be at a discount • The currency associated with the lower interest rate will be at a premium

  41. Forward rates • Derived by adding or deducting the premium or discount to the spot rate e.g. : Spot $/INR 45.25 Euro/$ 1.2325 Aug end +0.085(Pr) (-)0.0049 (Dis) 2004 ----------------------------- 45.3350 1.2276

  42. Examples • To book a forward contract for an import transaction in USD/INR value 30st Nov,04 Spot USD/INR 45.2550 / 2650 Fwd (sp/Nov) 14.50 / 15.50 Rate is 45.2650 + 15.50 = 45.4200 • To book a forward contract for an exporter in USD/INR value 31st Aug,04 Fwd (sp/Aug) 8.50 / 9.50 Rate is 45.2550 + 8.50 = 45.3400

  43. Examples • To book a contract to cover Euro export value 31 Oct , 2004 Spot USD/INR 45.25 / 27 EUR/USD 1.2335 / 38 Fwd 11.5 / 12.5 72 / 70 (45.25 + 0.115) x (1.2335 - 0.0072) 45.365 x 1.2263 Rate 55.63

  44. Examples To calculate rate for an export cancellation for value Jul,04 in USD/INR • USD/INR spot rate is 45.2750 / 2850 • USD/INR fwd rate is sp/Jul 7 / 8 • Rate is 45.2850 + 8 = 45.3650 To calculate a rate for an export cancellation in GBP/INR for value Jul,04 • GBP/USD fwd is 146 / 144 and spot is 1.8185 / 88 • Rate is 45.365 x ( 1.8188 – 144) 1.8044 = 81.8565

  45. Where we stand and the road ahead: • Increasing private and foreign participation in major sectors such as insurance etc • Comfortable inflation position • Rapid adoption of technological advances in almost all spheres • Move away from regulated regimes for all sectors including the social sector • Linking of small savings rate to GSec rates • Move towards universal banking and stricter NPA norms imply progressive cleaning up of banking and para-banking activities • more transparent and robust financial system

  46. THANK YOU

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