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FOREIGN EXCHANGE MARKET
INTRODUCTION
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Forex Business
Each country has a Central Bank / Agency
It regulates inflows and outflows of FCs
Each country has certain regulations about who isauthorised to convert the currencies
In India RBI has the regulatory powers under FEMA
It authorises commercial bank branches to conductforeign exchange business
Authorised dealers in Foreign Exchange
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EXPORTS
INVISIBLERECEIPTS INVISIBLE
PAYMENTS
IMPORTS
CAPITAL
PAYMENTSGROWTH
IN RESERVES
Currency inflow outflow
CA DEFICIT
CAPITAL
RECEIPTS
TRADE DEFICIT
Forex Reserves at Present are USD 295.72 Billion (08.10.2010) 3
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Inflows in FC arise mainly on account of:
Export of goods and services
Remittances from NRIs
Tourism
Investment
Borrowings by Govt.,Corporates,Individuals
Aid from International Agencies
Gifts and Donations
Forex Inflows
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Evolution of the Forex Market in India
Fixed Exchange Rate
Sterling as Intervention Currency
Basket of Currencies in 1975 LERMSMarch 1992ORE/MRE
Unified Exchange RateMarch 1993
Direct Quotation
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Outflows in FC arise mainly on account of:Import of goods and servicesRepatriation of NRI funds
Educational expenses of Indian studentsTourismInvestmentLendings to Other countries, Repayment
of loans, interest on loans etc.Aid by Indian Govt., AgenciesGifts and Donations
Forex outflows
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Exchange Rate Basics
Bank buys currency from Customers at buy rate
Bank sells currency to Customers at sell rate
Sell rate is kept higher than the buy rate
The difference is profit to the bank
All currencies bought have to be sold
All currencies sold are bought back
This matching of sale and purchase is called cover operation.
Customers not always available for sale / purchase
Banks deal among themselvesInterbank market
This is a wholesale market for currencies
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FOREX MARKET
Participants - Banks, foreign exchange brokers, and dealers.
Not a physical place
Technology drivenAll participants are linked to each other
through dedicated networks.
e.g., REUTERS, TELERATE, BLOOMBERG
It is a 24 hour marketOpen in some part of the globe.
New ZealandAustraliaJapan - Hong KongSingapore
MumbaiBahrainLondon - New York .. And again Back to
New Zealand
SEVERAL LARGE BANKS RUN 24 HOUR DEALING ROOMS ON THREE SHIFT BASIS AT MAJOR
FINANCIAL CENTRES
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CHARACTERISTICS OF FOREX MARKET:
1. A 24-hour Market
2. An O-T-C Market
3. A Global Market with No Barriers/No Specific Location
4. A Market that supports large Capital & Trade Flows
5. Highly Liquid Markets
6. High Fluctuations in Currency Rates (Every 4 Seconds)
7. Settlements affected by Time Zone Factor
8. Markets affected by Govt. Policies & Controls
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EXCHANGE RATE DETERMINANTS-Fundamental Reasons
1. BOPSurplus results in stronger currencyDeficit weakens a
currency
2. Economic Growth RateA high growth leads to a rise in imports
and a fall in the value of currency and vice versa
3. Fiscal PolicyLower taxes can lead to higher economic growth.
4. Monetary PolicyCentral Bank attempts to influence and control
interest and money supply can impact the countrys currency value
5. Interest RatesHigh Domestic Interest Rates attract overseas
capital & currency appreciates in the short term. In the longer run,
high interest rates slow the economy, weakening the currency.
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6. Political IssuesPolitical Stability likely to lead to economic
stability and hence a steady currency. Political instability results in
the opposite.
Technical Reasons
Government Controls can lead to unrealistic value of a currency,
resulting in violent fluctuation in exchange rates. Huge surpluses in
the OECs have led to heavy investments elsewhere overseas,leading
to huge movement of capital overseas and resultant appreciation ofthe relative currency.
Speculation
Speculative deals provide depth and liquidity to the market and at
times act as a cushion, as long as this does not lead to a cotagiouseffect.
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Direct Quotation: 1 Foreign Currency Unit = (equals) X amount of
Home Currency Units
USD EXCH. RATE- INR 44.205 BID44.205 ASK-44.210H.
Indirect Quotation: 1 Home Currency Unit = (equals) X amount of
Foreign Currency Units
INR EXCH. RATEUSD 0.2262 BID0.2262 ASK0.2262
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Cash, Tom, Spot and Forwards
READY OR CASHSettlement of funds takes place on the same day (date of deal)
TOM - Settlement of funds takes place on the next working day after the deal
SPOTSettlement of funds takes place on the second working day after deal
FORWARDDelivery of funds takes place any day after Spot date.
Normally Rupee and dollar are to change hands on spot date
Cash to spot and tom to spot differences depend on the number of days between the
two dates.
If there are intervening holidays difference will be larger.
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Discount and Premium
Rupee fetches higher interest than dollar
If exchange takes place after the spot date party receiving rupee
has to be compensated for difference in interest
If exchange takes place before spot date, the party paying rupeehas to be compensated for difference in interest
Forward dollar costlier than spot dollar
We say dollar is at a premium in forward
Or rupee is at a discount in the forward market
Currencies with low interest are at a premium Currencies with high interest are at a discount
Premia / discounts also quoted as percentage
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EXCHANGE ARITHMETIC
All forex rates calculations have to be worked out with extreme care and
accuracy and the use of the decimal point has to be correctly placed.
Constant check is also required to minimise the risk or mistake as the
markets work on very thin margins.
An error in one quote may erode, earnings from several
trades/transactions.
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Factors affecting Exchange Rates
Balance of Payments
Interest rates and Inflation
Economic Growth Rate
Political Stability / Fiscal Policy
Speculation
Central Bank Intervention
Demand and Supply
Because exchange rates are volatile, who has to pay or receive
Forex at a future date needs to hedge the currency risk
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Derivatives
A financial instrument that is valuedaccording to the expectedprice movementsof an underlying asset, which may be acommodity, currency or asecurity, is called a derivative
As derivative is a contractual relationship established by two or
more parties where payment is based on, or derivedfrom, someagreed-upon benchmark, the types of derivative products that canbe developed are limited only by the human imagination
Therefore, there is no definitive list of derivative products
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Forward Contracts
A Forward Contract is a simple derivative
contract to buy/sell a specified asset on
a certain future date (maturity date) at aspecified price (exercise price).
A Forward contract is normally settled by
delivery of the underlying asset.
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FUTURES
A Futures contract is a form of forward contractin that it conveys
the right to purchase or sell a specified quantity of an asset at a
fixed price on a fixed future date
It involves a definite purchase or saleand not an option to buy or
sell
As Futures are exchange-traded instruments, the contract
obligation is not between the two counter-parties to thetransaction(the buyer and seller of the contract), but to the
clearing house of the exchange
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Exchange traded
Standard quantity, quality
and date of maturity
Counterparty risk of
Exchange
Offsetting transactions
through the Exchange
Transparent pricing
Margin required
Negotiated between two
parties
All these can be negotiated
Counterparty risk of the
opposite party
Offsetting transactions only
with the original counterparty
Negotiated pricing
Often no Margin required
FUTURES FORWARDS
FUTURES ANDFORWARDS
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Call Options Importer need to buy USD 1 mio on 31stDec
He buys a call option at 43.50 from bank
Right to buy dollar at 43.50 without obligation to do so
If rate is 43.51 or above, he will buy from bank at 43.50
If rate is lower he will forfeit the option; buy from
market
As rupee strengthens profit potential is unlimited
If rupee depreciates he is always protected at 43.50
His maximum loss is the premium paid.
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OPTIONS
An Option offers the buyer/holdertheright, but not the obligation, to buy or sell
a specified amount of the underlying assetat an agreed rateon or before a specifiedfuture date
Option may either be a Call Optionor aPut Option
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Put Options Exporter need to sell USD 1 mio on 31stDec
He buys a put option at 43.50 from bank
Right to sell dollar at 43.50, with no obligation to do so.
If rate is 43.49 or lower, he will sell to bank at 43.50
If rate is higher, he will forfeit the option; sell in market
As rupee weakens profit potential is unlimited
If rupee appreciates he is protected at 43.50
His maximum loss is the premium paid
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Option terminology
Customer making delivery or taking delivery under an option is called
exercising the option
European style optioncan be exercised only on due date
American style optionexercised any day before maturity
Price at which option can be exercised is the strike price
The upfront price paid by customer is called premium
Options are normally custom made and sold by bank to customerOver
the Counter (OTC) options
Options quoted on Exchanges - Exchange Traded Options.
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