MBA (Finance specialisation) & MBA – Banking and Finance (Trimester) Term VI Module : – International Financial Management Unit II: Foreign Exchange Markets Lesson 2.1 (Introduction to Foreign Exchange Markets- Functions, quotations, etc.)

Foreign Exchange Market A foreign exchange market is the one where one currency (foreign currency) is bought and sold against another currency (domestic or home currency). This market has been developed to facilitate international trade, foreign investment and borrowing from or / lending to foreigners. In order to pay for imports or receive payments for exports, companies/individuals residing in one country have to acquire or dispose off the currency of another country. Foreign exchange markets provide the facility of exchanging different currencies.

Foreign Exchange Market The price of one currency in terms of another is known as exchange rate. Exchange dealers do the job of the exchange of currencies. The transactions in the foreign exchange market can be either to exchange cash or to buy/sell some other instruments. The major instruments are currency forward, currency futures, currency options and currency swaps.

Foreign Exchange Market Various kinds of transactions conducted in the foreign exchange market are briefly given below:  Spot transactions refers to the transaction involving sale and purchase of currencies for immediate delivery.  Currency forward contracts are settled on a future date even though the forward rate are quoted at present moment (today). They are quoted like spot rate but actual delivery of currencies takes place much later.  Currency options are the instruments that give the choice to their holder to buy or sell a foreign currency on or up to date ( also called maturity date) at a specified exchange rate ( also called strike rate).  Swaps are the instrument that enable two parties to exchange the stream of cashflows in two different currencies.

Foreign Exchange Market Exchange rate quotations Exchange rate means the price of one unit of a currency in terms of some units of another country. For example, Rs 45/US$ means that an amount of Rs 45 is needed to buy one US dollar or Rs 45 will be received for selling one US dollar. When there is no difference between buying and selling rate, the rate is unified. But in practice, it is rarely so. A dealer, who is willing to buy and sell the same currency against another, does not quote an identical price for buying as well as selling. Buying rate is also called bid rate while selling rate is also known as offer rate or ask rate.

Foreign Exchange Market Spread The dealer keeps a difference between buying and selling price. This difference is known as spread and constitute his profit. Look at the example given below Now consider the rupee/dollar rate. The dealer will buy dollar for Rs where he will sell a dollar for Rs The difference between buying rate and selling rate ( = 0.30) is spread. This is the profit of the dealer. The amount of spread or the profit of the dealer depends on the volume of transactions. The currencies which are frequently traded have smaller spread whereas the currencies which are not very frequently traded have larger spread. Currency PairBuying rateSelling rate Rupee/US $ Rupee/Swiss Franc

Foreign Exchange Market Spread can be expressed in absolute figures or in terms of percentage. In absolute terms, Spread = Selling rate – Buying rate Spread in percentage can be expressed either with reference to buying rate or with reference to selling rate. When buying rate is taken as reference, the denominator is buying rate. Thus, Spread ( in percentage) = [( Selling rate – Buying rate)/ Buying rate] x 100 When selling rate is taken as reference, the denominator is selling rate. Thus, Spread ( in percentage) = [( Selling rate – Buying rate)/ Selling rate] x 100

Foreign Exchange Market Direct and Indirect quotations When one unit of FOREIGN currency (i.e. dollar) is quoted in terms of some number of HOME currency (i.e. rupees), it is a direct quotation. For example, Rs 60/US $. When one unit of HOME currency (i.e. rupees) is quoted in terms of some number of FOREIGN currency (i.e. dollar), it is a indirect quotation. For example, $0.0166/rupee. Cross Rates An exchange rate between two currencies that is derived from the exchange rates of those currencies with a third currency is known as a cross rate of exchange. For example, exchange rate may be given between a pair, A and B and another pair, A and C. Then the rate between B and C derived from the given rates of the two pairs ( A and B, and, A and C) is called cross rate.

Foreign Exchange Market Reciprocal Rates A quotation in direct form can easily be converted into quotation in indirect form and vice versa. This is done by making the reciprocal of the given rate. For example, a unique rate Rs 62/$ is in direct form if quoted in India. Its reciprocal $ (1/62)/Re or $ (0.0161)/Re is the indirect quote in India. In general, the reciprocal rate between two currencies A and B is found as follows : (A/B) bid = (B/A) ask and (A/B) ask = (B/A) bid Example: Rs/$ is direct form in India is given as follows: Rs 60 /$ - Rs 63/$ Solution : To find reciprocal rates, we apply above equations : $(1/63)/Re - $ (1/60)/Re $ /Re - $ /Re

Foreign Exchange Market Exchange rate quotations in Forward market In case of forward market, the exchange of currencies takes place after some period from the date of the deal. The exchange rates are quoted for maturity of one month, two months, three months, etc. using swap points as shown below: Currency pairSpot One month forward Two month forward Three month forward $/euro1.2000/5030/4060/85100/140

Foreign Exchange Market The interpretation of swap points is as follows: Here spot rate is /50 which implies spot buying rate is $ per euro and spot selling rate is $ per euro since the last two digits of buying rate are replaced by 50. In order to determine, the forward rate, we shall see the relationship between numerator and denominator of the forward period. Like, in the case of one month forward, numerator (30) is smaller than denominator (40), then these points are to be added to the respective figures of spot buying and selling rates. So, one month forward buying rate becomes ( ) and one month selling rate becomes ( ). Here the forward rate figures are greater than spot rate figures therefore we may say forward rate is at premium vis- à-vis spot rate. Similarly, second month rate would be ( = and = ) and third month rates would be ( = and = ).

Foreign Exchange Market In case numerator is larger than denominator, than these swap points are to be subtracted from the respective figures of spot buying and selling rates. Consider the example given below: In case of one month forward, numerator (50) is greater than denominator (40), therefore, these swap point will be deducted from the spot rate to arrive at outright rate of one month forward. Buying rate of one month forward will be – = Selling rate of one month forward will be – = Here the forward rate figures are smaller than spot rate figures therefore we may say forward rate is at discount vis-à-vis spot rate. Currency pairSpotOne month forward Two month forward Three month forward $/euro1.7100/25050/40100/85155/125

Foreign Exchange Market Similarly, In case of two month forward, numerator (100) is greater than denominator (85), therefore, these swap point will be deducted from the spot rate to arrive at outright rate of one month forward. Buying rate of one month forward will be – = Selling rate of one month forward will be – = In case of three month forward, numerator (155) is greater than denominator (125), therefore, these swap point will be deducted from the spot rate to arrive at outright rate of one month forward. Buying rate of one month forward will be – = Selling rate of one month forward will be – =

Foreign Exchange Market Example : A foreign exchange trader gives the following quotes for the Euro vs. dollar spot, one month, three months and six months to a US based treasurer. Calculate the outright quotes for one, three and six month forward. Also calculate spread at these periods. currency pairSpot1 Month3 Months6 Months Euro vs dollar$ /704/58/714/12

Foreign Exchange Market Solution MaturityRemarksBid (buy)Ask (sell) Spread = Difference between ask and bid Spot$ $ Month Since numerator (4) is less than denominator (5), points are added to the spot rate $ $ Months Since numerator (8) is more than denominator (7), points are subtracted from the spot rate $ $ MonthsSince numerator (14) is more than denominator (12), points are subtracted from the spot rate $ $

Exercise Problem 1: A foreign exchange trader gives the following quotes for the Rs vs. dollar spot, one month, three months and six months to a US based treasurer Calculate the outright quotes for one, two and three month forward. Also calculate spread and spread percentage ( based on selling as well as buying price) at these periods. Spot rate (Rs/$) One – month forward Two – month forward Three – month forward

Exercise Problem 2: A foreign exchange trader gives the following quotes for the Rs vs. dollar spot, one month, three months and six months to a US based treasurer Calculate the outright quotes for one, two and three month forward. Also calculate spread and spread percentage ( based on selling as well as buying price) at these periods. Spot rate (Rs/$) One – month forward Two – month forward Three – month forward

Forward Premium or Discount If forward rate of a currency is greater than the its spot rate, it is said to be at a forward premium. On the other hand,if its forward rate is smaller than its spot rate, it is at forward discount. For example, Rs/$ spot rate is Rs 60/$ and three month forward rate is Rs 61/$. This shows that dollar is at forward premium. The premium or discount is calculated using equation given below : Forward premium/discount = [ (F – S)/ S ] x (12/N) x 100 where N is the number of months forward, F = Forward rate S = Spot rate

Foreign Exchange Market Example : From the data given below calculate forward premium or discount as the case may be Solution Forward Premium (using bid price) = [( – )/ ] x (12/3) x 100 = 1.18 percent per annum [Dollar is at premium] Forward Premium (using ask price) = [( – )/ ] x (12/3) x 100 = 2.63 percent per annum [Dollar is at premium] ParticularSpot3-month forward Rs/$ / /9990

Foreign Exchange Market Example : From the data given below calculate forward premium or discount (on annualized basis) as the case may be Solution Forward Premium/ discount = [(62.50 – 62.15)/ 62.15] x (12/3) x 100 = percent per annum [Dollar is at premium] ParticularSpot3-month forward Rs/$