Chapter-1: The Basics of the Foreign Exchange Market Course Instructor: Md. Nazmul Hasan Assistant Professor Foreign Exchange Risk Management

What is Foreign Exchange? Foreign Exchange refers to the process or mechanism by which the currency of one country can be converted into the currency of another country and, thereby, involves the international transfer of money. Dr. Paul Einzig defines FX as the system or process of converting one national currency into another and transferring the ownership of money from one country to another in settling the financial trade. FX is concerned with the settlement of international indebtedness, the methods of effecting the settlement, the instruments used in this connection and the variation in exchange rates at which settlement of international indebtedness is made. ***Paul Einzig was an economic and political writer and journalist. He wrote 57 books, alongside many articles for newspapers and journals, and regular columns for the newspapers Financial News and Commercial and Financial Chronicle.

Thus ‘Foreign exchange’ means foreign currency and includes— – All deposits, credits, and balances payable in any foreign currency, draft, traveller’s cheque, letter of credit, bill of exchange, expressed or drawn in local currency but payable in any foreign currency; and – Any instrument payable, at the option of the drawee (i.e., a person to whom a bill of exchange is addressed, and who is requested to pay the amount of money therein mentioned) or holder thereof or any other party thereto, either in local or in foreign currency or partly in one and partly in the other. What is Foreign Exchange ?

Money Vs. currency The term ‘Money’ has a narrower meaning than the term ‘Currency.’ To be specific, the term ‘money’ is used to describe the actual money in the form of coin or notes or in any other forms which passes freely from hand to hand as the recognized medium of exchange within the country. In contrast, ‘currency’ is a generic term and covers not only the actual coins and paper money in use in a country but also, any credit instruments which convey the right to wealth in terms of any given unit such as cheque, a promissory note, a bill of exchange or any other instruments capable of transferring the property in a stated number of the unit of accounts which are in use in any given country.

Defining The Foreign Exchange Market The Foreign Exchange Market can be defined in terms of specific functions, or the institutional structure that: (1) Facilitates the conversion of one country’s currency into another. – Through the buying and selling of currencies. – Allows global firms to move in and out of foreign currency as needed. (2) Sets and quotes exchange rates. – This is the ratio of one currency to another. – These rates determine costs and returns to global businesses. (3) Offers contracts to manage foreign exchange exposure. – These hedging contracts allow global firms to offset their foreign currency exposures and manage foreign exchange risk. – Thus, they can concentrate on their core business.

Quick Review of Market Characteristics World’s largest financial market. – Estimated at $3.2 trillion dollars per day in trades. NYSE-Euronext currently running about $40 billion per day. Market is a 24/7 over-the-counter market. – There is no central trading location. – Trades take place through a network of computer and telephone connections all over the world. Major trading center is London, England. – 34% of all trades take place through London (New York second at 17%). Most popular traded currency is the U.S. dollar. – Accounts for 86% of all trades (euro second at 27%). Most popular traded currency pair is the U.S. dollar/Euro. – Represents 27% of all trades (dollar yen second at 13%) Currencies are either traded for immediate delivery (spot) or some specified future delivery (forward). [In USA system, 1 trillion= 1000 billion; 1 billion=1000 million or 100 crore. In UK system, 1 trillion=1 million x 1 billion]

How does the FX Market Quote Currencies? In a currency pair, the first currecy is called the base currency and the second currency is called the quote currency. Currency pair can be separated into two types, direct and indirect. In a direct quote, the domestic currency is the base currency, while the foreign currency is the quote currency. Alternatively, a direct quote is a foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other words, it involves a quote in fixed units of foreign currency against variable amounts of the domestic currency. – For example, if Pound (U.K) is the domestic currency, a direct quote would be GBP/JPY and means that 1JPY is equals to £ Notice here base currency is GBP and quote currency is JPY. In the indirect quote, on the other hand, the foreign currency is variable and the domestic currency is fixed at one unit. – For example, if Canada is the domestic currency, a direct quote would be 1.18 USD/CAD and means that USD$1 will purchase C$1.18 (1) American Terms: – Expresses the exchange rate as the number of U.S. dollars per one unit of some foreign currency. For example, $2.00 per (1) British pound. (2) European Terms: – Expresses the exchange rate as the number of foreign currency units per one U.S. dollar. For example, 120 yen per (1) U.S. dollar. Most of the world’s currencies are quoted for trade purposes on the basis of European terms. – Exceptions include: British pound, Euro, Australian dollar. Newspapers, like the Wall Street Journal, however, usually quote both.

Quotes are Given by Time of Settlement Spot Exchange Rate: – Quotes for immediate transactions (actually within 1 or 2 business days) Forward Exchange Rate: – Quotes for future transactions in a currency (3 business days and out). Forward markets are used by businesses to protect against unexpected future changes in exchange rates. – Forward rate allows businesses to “lock” in an exchange rate for some future period of time. – For example, In case of Import payment and export receipt, changes in exchange rate has serious implications.

Observing Changes in Spot Exchange Rates: What do they Mean? Appreciation (or strengthening) of a currency: – When the currency’s spot rate has increased in value in terms of some other currency. – Suppose, the 3 years back the exchange rate was $1=BDT 90 but now $1=BDT (today’s rate). This is an example of appreciation in the value of BDT (TAKA) in compared to $. Depreciation (or weakening) of a currency: – When the currency’s spot rate has decreased in value in terms of some other currency. – Suppose, the 3 years back the exchange rate was $1=BDT 75 but now $1=BDT (today’s rate). This is an example of reduction in the value of BDT (TAKA) in compared to $.

Forward Rate Quotes As a rule, forward exchange rates are set at either a premium or discount of their spot rates. The choice over the premium or discount depends on the future expectations of the market condition. – If a currency’s forward rate is higher in value than its spot rate, the currency being quoted at a forward premium. For example: the Japanese 1 month forward is greater than its spot ( versus ) – If a currency’s forward rate is lower in value than its spot rate, the currency is being quoted at a forward discount. For example, the British pound 6 month forward is less than its spot ( versus 2.056).

What Institutions are Involved in the Foreign Exchange Market? Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank) acting on behalf of: – (1) Their “external” clients” (primarily global firms: exporters, importers, multinational firms) Acting in a broker capacity at the request of these clients and meeting the foreign currency needs of these clients. – (2) Their own banks (trading to generate profits). Acting in a “dealer” (i.e., trading) capacity Taking positions in currencies to make a profit. In meeting the needs of their clients and their own trading activities, these global banks “establish” the “tone” of the market. – This is through a “market maker” function.

Making the Market in FX The market maker function of any global bank involves two primary foreign exchange activities: (1) A willingness of the market maker to provide the market with “on-going” (i.e., continuous) two-way quotes (simultaneous buying & selling) upon request: – (1) Provide a price at which they will buy a currency – (2) Provide a price at which they will sell a currency This function provides the market with transparency (2) A willingness of the market maker to actually buy and/or sell at the prices they quote: – Thus the market maker offers “firm” prices into the market! This function provides the market with liquidity.

ISO Currency Designations All foreign currencies are assigned an International Standards Organization (ISO) abbreviation. – E.g., USD; JPY; GBP; EUR; AUD; HKD; CNY; MXN; SGD; ARS; THB; INR; RUB; ZAR; NZD; CHF; KRW – For individual countries see: Since the exchange rate is simply the ratio (i.e., value) of one currency against another, market makers express this relationship using the two currencies’ ISO designations. For Example: – USD/JPY – USD/MXN – EUR/USD – GBP/USD – EUR/JPY (this is a cross rate; since USD in not one of them)

Base and Quote Currency Given that a foreign exchange quote is simply the ratio of one currency to another, a “complete” market maker quote must have two ISO designations (e.g., EUR/USD or USD/JPY): – The first ISO currency quoted is called the base currency. – The second ISO currency quoted is called the quote currency. For examples above: – EUR/USD: EUR is the base currency and USD is the quote currency. – USD/JPY: USD is the base currency and JPY is the quote currency.

Bid and Ask Quotes Recall that a market maker always provides the market with two prices, both a buy and sell quote (or price) for a currency. For Example: EUR/USD: / – The first number quoted by the market maker is the market maker’s buy price ($1.2102). It is called the market maker’s bid quote (or buy price) – The second quoted number is the market marker’s sell price ($1.2106). It is called the market maker’s ask quote (or sell price) – Note: The bid quote is always lower than the ask quote.

What Currency is The Market Maker Buying and Selling? Given the e xample: EUR/USD: /1.2106, which currency is the market maker selling and which currency is the market maker buying? – Answer: Market makers are always quoting prices at which they will buy or sell ONE UNIT of the base currency (against the quote currency). – So in the above example: The market maker will buy Euros for $ – This is the bid price for eEuros. The market maker will sell Euros for $ – This is the ask price for Euros.

Reading and Understanding Quotes When viewing a foreign exchange quote, assign a value of 1 to the base currency (the base currency is the first in the ISO pair). The quotes you see refer to one unit of this base currency. – For example, if you see a market maker’s ask price for the EUR/USD of , that means that if you were to buy one Euro (the base currency) you are going pay $ – If you see a market maker’s bid price for the USD/JPY of that means if you were to sell one dollar (the base currency) you are going to get for it. Also, whenever the bid and ask prices are moving up, that means that the base currency is getting stronger and the quote currency is getting weaker.

Functions of the Foreign Exchange Markets  Foreign Exchange Market is the market in which individuals, firms, and banks buy and sell foreign currencies or foreign exchange.  The transfer of funds or purchasing power from one nation and currency to another. Demand for foreign currencies -Import/expenditures abroad/investment abroad Supply of foreign currencies -Export/earnings from tourism/receipt of foreign investments  the credit function  the facilities for hedging and speculation

Four levels of transactors or participants 1.Immediate users and suppliers of foreign currencies: Importers/Exporters/tourists/investors 2.Clearinghouses-commercial bank 3.Foreign exchange brokers-interbank / wholesale market 4.The nation’s central bank-lender of last resort

Flexible Foreign Exchange Rates FIGURE 14-1 The Exchange Rate Under a Flexible Exchange Rate System. Flexible foreign exchange rates essentially refers to the exchange rate which is completely or mostly determined by the changes in the market forces.

FIGURE 14-2 Disequilibrium Under a Fixed and Flexible Exchange Rate System.

Spot and Forward Rates, Currency Swaps, Futures, and Options a. Spot and Forward Rates b. Currency Swaps c. Foreign Exchange Futures and Options

a. Spot and forward rates Spot transaction-Spot rate – The most common type of foreign exchange transaction involves the payment and receipt of the foreign exchange within two business days after the day the transaction is agreed upon. – The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad.

Forward transaction-Forward rate A forward transaction involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today. One month; Three months; six months Forward contracts can be renegotiated for one or more periods when they become due.

FD (Forward Discount) If the forward rate is below the present spot rate, the foreign currency is said to be at a forward discount with respect to the domestic currency. FP (Forward Premium) If the forward rate is above the present spot rate, the foreign currency is said to be at a forward premium with respect to the domestic currency.

b. Currency swaps 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. It is also called cross-currency swap. Refer to a spot sale of a currency combined with a forward repurchase of the same currency-as part of a single transaction. Swap Rate: is the difference between the spot and forward rates in the currency swap. (a yearly basis)

c. Foreign exchange futures and options A currency future, also known as an FX future or a foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date A foreign exchange futures is a forward contract for standardized currency amounts and selected calendar dates traded on an organized market (exchange).

A foreign exchange option Is a contract giving the purchaser the right, but not the obligation, to buy (a call option) or to sell (a put option) a standard amount of a traded currency on a stated date (the European option) or at any time before a stated date (the American option) and at a stated price (the strike or exercise price) The buyer pays the seller a premium (the option price) ranging from 1 to 5 percent of the contract’s value for this privilege when he or she enters the contract.

Foreign Exchange Risks, Hedging & Speculation a. Foreign Exchange Risks b. Hedging c. Speculation

a. Foreign Exchange Risk Foreign Exchange Shift: 1.Changes in tastes for domestic and foreign products in the nation and abroad 2.Different growth and inflation rates in different nations 3.Changes in relative rates of interest 4.Changing expectations

b. Hedging Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forward contracts and options. A forward contract will lock in an exchange rate today at which the currency transaction will occur at the future date. Refers to the avoidance of a foreign exchange risk, or the covering of an open position. – At spot market – At forward market – At futures and options markets

c. Speculation Speculation is the act of trading in an asset or conducting a financial transaction that has a significant risk of losing most or all of the initial outlay with the expectation of a substantial gain. The opposite of hedging. A speculator accepts and even seeks out a foreign exchange risk, or an open position, in the hope of making a profit. Speculation can take place in the spot, forward, futures, or options markets

Long Vs. Short Positions Long position: When a speculator buys a foreign currency on the spot, forward, or futures market, or buys an option to purchase a foreign currency in the expectation of reselling it at a higher future spot rate. Short position: When a speculator borrows or sells forward a foreign currency in the expectation of buying it at a future lower price to repay the foreign exchange loan or honor the forward sale contract or option.

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