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Foreign Exchange Market

Foreign Exchange Market. What is Foreign Exchange What does it involve What does FX provide Foreign Exchange Market. What is Foreign Exchange?. Is the exchange between two currencies Domestic Currency to Foreign Currency Foreign to Domestic Currency Foreign Currency to Foreign Currency.

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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

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