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Foreign Exchange Market

Foreign Exchange Market

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Foreign Exchange Market

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  1. Foreign Exchange Market • What is Foreign Exchange • What does it involve • What does FX provide • Foreign Exchange Market

  2. What is Foreign Exchange? • Is the exchange between two currencies • Domestic Currency to Foreign Currency • Foreign to Domestic Currency • Foreign Currency to Foreign Currency

  3. What does FX Involve? • An exchange between two currencies • The exchange is at a rate called the FX Rate • For an agreed settlement date called the Value Date • With transfer of funds

  4. What does FX Provide? • The means to settle international trade • Hedging through the use of various products • Speculation for generating profits • Raising/Deployment of Capital

  5. Foreign Exchange Market • A mechanism to exchange currencies • Is not restricted to a place or a time zone • Is global and works on a 24-hour basis • Is characterised by speed, volume and large number of participants • Is supported by advanced communications, information and computer system

  6. FX Market (Contd.) • However this foreign exchange market has various time zones across the world • Once we talk of a market in a certain location, we give it a time zone • An that then is the Domestic FX Market • The Domestic FX Market is characterised by a domestic currency

  7. FX Market (Contd.) • In the Domestic FX Market, all rates are quoted against the Domestic Currency • The currency other than the Domestic Currency is the Foreign Currency • However when a trade takes place in a market that is not the Domestic FX Market, that market is the International FX Market

  8. FX Market (Contd.) • The International FX Market is one where there is no domestic currency • Both the currencies are foreign currencies

  9. Foreign Exchange Rates • A FX transaction takes place at a rate called the FX Rate • FX Rate is the value of one currency expressed in terms of another currency • Types of Rates • Direct Rate • Indirect Rate • Cross Rate

  10. FX Rates (Contd.) • In FX Markets, practice is to quote direct rates • Moreover all trades take place in foreign currency amount • Domestic currency is used for the purpose of exchange in domestic markets • In International Markets, base currency is used for exchange

  11. FX Rates (Contd.) • The FX Market is a professional market where two-way rates are quoted • Rates are Bid (Buying) and Ask (Selling) • The person quoting the price Buys FC at the Bid Rate and Sells FC at the Ask rate • The difference between the Ask and the Ask is called the Spread • The Spread is always positive

  12. Direct Rate • In the domestic market, direct rate is an expression of the value of a unit of foreign currency in domestic currency terms. For example; • 1 USD = INR 39.92 • 1 GBP = INR 78.44 • 100 JPY = INR 36.99 • 1 EUR = INR 59.14

  13. Direct Rate (Contd.) • In the international market, direct rate is an expression of the value of a unit of foreign currency in terms of base currency. For example; • 1 USD = CAD 0.9980 • 1 USD = JPY 107.90 • 1 GBP = USD 1.9652 • 1 EUR = USD 1.4817

  14. Direct Rate (Contd.) • In the international market, direct rate is 1 unit of USD being equal to a certain amount of all other currencies. • USD is the FC and others are the base currencies (BC),e.g., USD/INR, USD/JPY , USD/CAD etc. • The exception is in the case of • GBP/USD • EUR/USD • AUD/USD • NZD/USD

  15. Direct Rate (Contd.) • GBP, EUR, AUD and NZD are foreign currencies and USD is the base currency • In the case of these 4 currencies, direct rate is the value of 1 unit of these currencies in terms of US Dollars

  16. Indirect Rate • In the domestic market, indirect rate is an expression of the value of domestic currency in foreign currency terms. For example; • 100 INR = USD 2.5050 • 100 INR = GBP 1.2748 • 1 INR = JPY 2.7034 • 100 INR = EUR 1.6909

  17. Indirect Rate (Contd.) • In the international market, indirect rate is an expression of the value of base currency in foreign currency terms. For example; • 1 CAD = USD 1.0020 • 100 JPY = USD 0.9268 • 1 USD = GBP 0.5089 • 1 USD = EUR 0.6749

  18. Indirect Rate (Contd.) • Indirect rates are also called Reciprocals • Indirect rates are never used in FX markets • The direct rate for one country becomes the reciprocal (indirect rate) for the other country • USD/INR is Direct Rate for India but Indirect Rate for US • Likewise, INR/USD is Direct Rate for US and an Indirect Rate for India

  19. Cross Rate • In the domestic market, cross rateis the expression of the value of one foreign currency in terms of another foreign currency • Neither of the currencies is the domestic currency • For example; • USD/CHF = 1.0900 • USD/JPY = 107.90 • EUR/USD = 1.4817

  20. Cross Rate (Contd.) • In international markets, cross rate is the expression of the value of a unit of foreign currency in terms of another foreign currency, neither of which is the US Dollar • For example; • CHF/INR = 36.63 • EUR/JPY = 159.88 • GBP/CAD = 1.9613

  21. Cross Rate Calculation • What is available in markets are international direct rates, which are used to calculate cross rates • Rate = DC / BC Amount  FC Amount • Suppose USD/INR = 39.92 • USD/CHF = 1.0900 • CHF/INR = INR Amount  CHF Amount • 39.92  1.0900 = 36.6238 = 36.63

  22. Cross Rate Calc. (Contd.) • Suppose USD/INR = 39.92/93 • USD/CHF = 1.0900/05 • CHF/INR Bid Rate = • INR Amount Bid CHF Ask Amount • 39.92  1.0905 = 36.6071= 36.61 • CHF/INR Ask Rate = • INR Amount Ask  CHF Bid Amount • 39.93  1.0900 = 36.6330 = 36.63

  23. Settlement of FX Trades • The date on which the FX Trade is done is called the Contract Date, Trade Date or Transaction Date. • Every FX transaction involves the exchange of currencies • You receive the currency you have bought and give the currency you have sold

  24. Settlement (Contd.) • The date on which the parties agree to exchange the currencies is pre-determined on the transaction date • This pre-determined settlement date is called the Value Date • This date can be the same as or different from the one on which the trade is done

  25. Value Date • Where currencies are settled on the trade date itself, settlement is for ‘Value Today’ or called Value Cash in India. Used mainly for retail/corporate settlement • Where currencies are settled on the working day immediately following the trade date it is called “Value Tomorrow”. It is used mainly for corporate/account settlement

  26. Value Date (Contd.) • Where currencies are exchanged 2 working days following the trade date – settlement is for ‘Value SPOT’ • Where the currencies are exchanged on any date (being a working day) after the Spot, settlement is for ‘Value Forward’ or ‘Value Outright’.Used mainly for hedging • Working Day, normally Monday to Friday, is one when both the countries are open for settlement of funds

  27. FX Rates • All market rates are for Value Spot Date • Therefore market rates are also known as Spot Rates • Where settlement is required for a date other than Spot, the person asking for the price has to specify the settlement date • The Forward value of a currency may be higher, lower or equal to the Spot Rate

  28. Premium • When the Forward value of a currency is higher than the Spot Rate, it is more expensive in the future • The currency is then said to be at a ‘Premium’ • In Direct Rates, Premium is added to the Spot Rate to calculate the Forward Rate

  29. Discount • When the Forward value of a currency is lower than the Spot Rate, it is cheaper in the future • The currency is then said to be at a ‘Discount’ • In Direct Rates, Discount is deducted from the Spot Rate to calculate the Forward Rate

  30. Par • When the Forward value of a currency is the same as the Spot Rate, it is then said to be at a ‘Par’ • When currencies are at Par, no adjustment is required to the Spot Rate to derive the Forward Rate

  31. Forward Points • Market rates are for value Spot. • But where an exchange is required for a forward date, an adjustment has to be made to the spot rate, to derive the forward rate • The adjustment depends on whether the currency is at a premium, discount or par • And premium, discount or par is a function of interest rates in the two currencies

  32. Forward Points (Contd.) • Forward points reflect, in the long term, the interest differential between the currencies • However in the short term, forward rates could get influenced by expectations and liquidity • In the case of direct quotes, premium is positive forward points, discount is negative forward points while par reflects no forward points

  33. Forward Rate • Forward Rate is the rate at which exchange of currencies take place on the agreed forward date. • A Forward Rate has two components, namely Spot Rate and Forward Points • Where there are no restrictions on capital flows, the only factor determining forward points is the interest differential between the currencies involved

  34. Forward Rate Calculation • Suppose market rates are as follows: • Spot USD/INR = 39.92 • 1 year USD interest rates = 3.25 % and • 1 year INR interest rate = 6.00 %. • What we can see is that INR Interest Rates are higher than USD Rates • The USD/INR Forward Rate should reflect this difference interest rates to prevent speculators from taking undue advantage

  35. Forward Rate Calc. (Contd.) • Since Forward Date Means any date after Spot, Forward Date Can also be defined as Spot plus a certain duration • In financial markets compensation for duration comes in the form of interest rates • Since a FX transaction involves 2 currencies, we take the difference in interest rates to calculate the forward rate • FR = SR + (SR x ID x Duration  100), where • FR = Forward Rate • SR = Spot Rate • ID (Interest Differential) = DC Int. rate – FC Int. rate

  36. Forward Rate Calc. (Contd.) • Suppose market rates are as follows: • Spot USD/INR = 39.92 • 1 year USD interest rate = 3.25 % and • 1 year INR interest rate = 6.00 % •  FR = 39.92 + {39.92 x 2.75  100) • FR = 39.92 + 1.0978 = 41.0178 • Here we can see 1 USD is equal to INR 39.92 in Spot and 41.0178 in the Forward • The USD is more expensive in the Forward • Therefore the USD is at a premium

  37. Forward Rate Calc. (Contd.) • Now suppose we change the Interest Rates and: • Spot USD/INR = 39.92 • 1 year USD interest rates = 6.00 %and • 1 year INR interest rate = 3.25 % •  FR = 39.92 + {39.92 x - 2.75  100) • FR = 39.92 - 1.0978 = 38.8222 • Here we can see 1 USD is equal to INR 39.92 in Spot and 38.8222 in the Forward • The USD is cheaper in the Forward • Therefore the USD is at a discount

  38. Forward Rate Calc. (Contd.) • Suppose we change the Interest Rates again and: • Spot USD/INR = 39.92 • 1 year USD interest rates = 6.00 %and • 1 year INR interest rate = 6.00 % •  FR = 39.92 + {39.92 x 0  100) • FR = 39.92 • Here we can see USD Value in the Forward is same as in Spot • So both USD and INR are at Par

  39. Forward Rate Calc. (Contd.) • We can now conclude that • The currency with the lower interest rate is at a premium • The currency with the higher interest rate is at a discount • When the interest rates in the two currencies are the same they are at Par • Also, forward rates, are a function of interest rates in the two currencies

  40. Forward Rate Calc. (Contd.) • As we know the FX Market is professional market where you get a 2-way price • Say market rates are • Spot USD/INR = 39.92/93 • 1 year USD interest rates = 3.25 – 3.50% and • 1 year INR interest rate = 6.00 – 6.25% • We need to calculate the Forward Bid and Forward Ask Rates • First of all, we need to determine what rates to use

  41. Forward Rate Calc. (Contd.) • The Forward Bid Rate is the rate to Buy Forward USD • To calculate the Forward Bid Rate use • Spot USD/INR Bid Rate = 39.92 • USD Lending rate = 3.50% and • INR Borrowing rate = 6.00 % • FR = SR + (SR x ID x Duration  100) •  FR = 39.92 + {39.92 x 2.5  100) • FR Bid = 39.92 + 0.9980 = 40.9180

  42. Forward Rate Calc. (Contd.) • The Forward Ask Rate is the rate to Sell Forward USD • So to calculate the Forward Ask Rate use • Spot USD/INR Bid Rate = 39.93 • USD Borrowing rate = 3.25% and • INR Lending rate = 6.25 % • FR = SR + (SR x ID x Duration  100) •  FR = 39.93 + {39.93 x 3.00  100) • FR Ask = 39.93 + 1.1979 = 41.1279

  43. Exchange Rate & The Rupee • The rupee is fully convertible on the Current Account since August 1994 • This means for the purpose of International Trade there are no restrictions on rupee convertibility • But restrictions remain on capital account • Conversion of domestic assets to foreign assets is restricted • With substantial improvement in the country’s FX Reserves position the government has been relaxing these restrictions

  44. Devaluation of the Rupee • The RBI can change the value of the rupee to meets its fiscal and/or monetary goals • When the value of a currency is increased by the central bank that process is called Revaluation • When the value of a currency is decreased by the central bank the process is called Devaluation

  45. Devaluation of the Rupee • India has been following a process of rupee devaluation initially to address Balance of Payment deficit and later on to defend the country’s export competitiveness • The following is the history of the rupee • Under Bretton Woods System, as a member of IMF, India declared its par value of Rupee in terms of Gold • The RBI maintained par value of Rupee within the permitted band of 1% using Pound Sterling as currency of intervention.

  46. Devaluation of the Rupee • India had to devalue the Rupee in June 1966 when the par value of Rupee was re-fixed at 0.118489 gram of fine gold per Indian Rupee. The corresponding rate was fixed at GBP 1 = INR 18.00 • When the Bretton Woods System broke down in August 1971, the Rupee was pegged to the US Dollar at INR 7.50 per USD • After the Smithsonian Agreement in December 1971, the Rupee was de-linked from the US Dollar and was again linked to the Pound Sterling

  47. Devaluation of the Rupee • However, as the developed countries started floating in 1972 the Pound Sterling also started floating • As the Rupee was pegged to Sterling Pound, it fluctuated with the other currencies as the Sterling fluctuated vis-à-vis other currencies of the world • Shortly afterwards, the Pound Sterling was under great pressure, because of UK’s poor economic fundamentals, and the GBP depreciated by 20% in September 1975.

  48. Devaluation of the Rupee • The Rupee got depreciated automatically although on account of necessary imports it led to inflation at undesirable levels • On September 25, 1975, Rupee was de-linked from Pound Sterling and was linked to a basket of currencies • India was hit by a severe balance of payment crisis in May 1991, when it’s foreign exchange reserve was down to barely a week’s imports • The country was on the brink of its first international default

  49. Devaluation of the Rupee • The RBI devalued the rupee by 9% on July 1st 1991 and another 11% on July 3rd 1991, from Rs 20.50 to Rs 24.50 per US $ • It adopted a more open foreign trade and investment regime and move towards current account convertibility. • April 1992 the rupee was devalued 17.5% • By August 1994, India built sufficient foreign currency reserves and accepted IMF’s Article VIII, making the rupee convertible on current account and trade-related transactions

  50. Devaluation of the Rupee • The Rupee devalued 11% from August 1995 to July 1996 • The South East Asian crisis saw the rupee lose almost 13.5% in value • The US sanctions after India’s Nuclear tests saw the rupee lose another 8.50% • The rupee fell all the way to 49.08 to a US $ in May 2002 before the upward move commenced • Rupee gained all the way to 39.16 in November 2007 and currently stands at 40.20