1. International Financial Management
CHAPTER - 7
Foreign Exchange Markets
International Financial Management
P G Apte

2. …a peculiar currency of your own
So much of barbarism, however, still remains in the transactions of most civilized nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbors, a peculiar currency of their own.
John Stuart Mill, 1894

3. CURRENCY MARKETS
The foreign exchange market is the market in which currencies are bought and sold against each other.
The inter-bank foreign exchange market is an over-the-counter (OTC) market. London is the largest centre followed by New York/Tokyo other smaller centres. Average transaction size is about USD 5 million
The participants in the wholesale market are commercial banks, investment institutions, corporations and central banks. Currency brokers act as middlemen between dealers
A small number of currencies account for bulk of turnover: USD, EUR, GBP, CHF, JPY, CAD, AUD

4. Size Of the Global Forex Market
Largest market in the world
$3.99 trillion average daily turnover in 2007, which is equivalent to more than 10 times the average daily turnover of global equity markets. May reach $5 trillion in 2010.
More than 35 times the average daily turnover of the NYSE
In 2007, $500 a day for every man, woman, and child on earth
Annual turnover more than 10 times world GDP
Trade related transactions account for about 15% of the turnover; the rest are related to capital flows.
80% of the transactions are estimated to be for speculative purposes and the rest for commercial purposes

5. FOREX MARKET TURNOVER (NET)
DAILY AVERAGE, APRIL 2007
(US$ BILLION)
TOTAL
SPOT
OUTRIGHT FORWARDS
SWAPS
US$ vs. OTHERS
EURO vs. OTHERS
JPY vs. OTHERS
GBP vs. OTHERS
CHF vs. OTHERS

8. 2007 BIS SURVEY – FOREX MARKET.
Average daily FX turnover $3.99 trillion USD.
Increased by more than 2.7 time since 2001.
67% Forwards and Swaps.
33% Spot transactions.
Less than 10% delivered.
USD involved in 89% of trades – almost $1.7 trillion daily.

9. The forex market has not escaped the impact of global deleveraging and the failure of Lehman Brothers in 2008.
Central banks from around the world have released their semi-annual foreign exchange surveys and based upon all of the reports, forex trading volume decreased significantly between April 2008 and April 2009.
The lack of participation may explain why the major currency pairs have been stuck in a range since the beginning of May. In New York for example, forex spot trading volume fell to the lowest level in more than 3 years.
London remains the most active forex trading center followed by NY and Tokyo. The EUR/USD is still the most actively traded currency pair by far.

11. Geographic Distribution of Turnover (in percent)
Source: BIS

12. The BIS data in its triennial survey is incomplete.
The global turnover maybe around 6% higher than reported.
Turnover in Asian currencies (excluding Japanese Yen) is under-reported to a higher extent – maybe as much as 15%. In some Asian currencies like Chinese Yuan this is much higher.
Turnover on account of trade-related transactions is a larger fraction of total turnover for Asian currencies than for developed country currencies.
Although growing fast, the share of Asian currencies (excluding Yen) in the global turnover is only about 7.5%. Australian dollar alone has a 6.6% share. Japanese Yen has 17.5%.
Asian currencies have a larger share of inter-dealer activity in the total turnover compared to global average.

13. The turnover of Asian currencies is low relative to the volume of trade in goods and services compared to the global average. Thus for most Asian currencies activity in the markets is driven largely by trade.
Due to controls on capital flows, transactions with financial customers form a low share of total turnover for most Asian currencies. The exceptions are SGD and HKD.
For most Asian currencies, over 90% of the turnover is against the US dollar.
Again due to capital controls, the share of non-residents in the total turnover is quite small.

14. CURRENCY MARKETS
Among the participants, primary price makers or professional dealers make a two-way market to each other and to their clients
Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market-making banks
Corporations usually are price takers. However, some non-bank, non-financial companies do act as market makers.
Large money centre banks deal in a large number of currencies. Smaller banks have a restricted range.

15. It is a 24-hour market
The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore.
A few hours later, trading begins in Bahrain.
Late in the Tokyo day, markets open in Europe.
In the early afternoon in Europe, markets open in the United States.
In the mid to late afternoon in New York, markets open in the Asia-Pacific area.
Most of the activity takes place when European markets are open.

16. CURRENCY MARKETS
Geographically, the markets span all the time zones from Auckland, New Zealand to Los Angeles, United States.
3.00 pm in Tokyo pm in Hong Kong.
3.00 pm in Hong Kong pm in Singapore.
3.00 pm in Singapore noon in Bahrain.
3.00 pm in Bahrain noon in Frankfurt and Zurich and am in London.
3.00 pm in London am in New York.
3.00 pm in New York Noon in Los Angeles.
3.00 p.m. in Los Angeles a.m. of the next day in Sydney.
London, Tokyo and New York account for about 50% volume.

18. Geographic Extent of the Market
Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
Tokyo
opens
Asia
closing
10 AM
In Tokyo
Afternoon
in America
London
6 pm
In NY
Americas
open
Europe
opening
Lunch

19. How Volatile is the Market?
  The dollar’s value changes 18,000 times during an average trading day —that’s once every 4.8 seconds
In 2005 :
– The daily trading range was as much as 1–2%
– The average monthly difference between high and low
was 3–5%
Volatility is always part of the market behaviour
Annual currency volatility is typically 10–20% (or more)

20. Inter-bank Dealing Corporate Desk of Bank A or I/B Desk of Bank B I/B
of Bank C

21. Corporate Foreign Exchange (CorpFx) Desk of Bank A
Corporate Client of Bank A
CorpFx
Desk of
Bank A
I/B Desk of Bank B
I/B Desk of Bank A

22. Dealings of Corporate Foreign Exchange (CorpFx) Desk of Bank A
Export / Import Desk of Bank A
Client of Bank A
Outward / Inward Remittance Desk of Bank A

23. Foreign Exchange Brokers
Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction
For this service they charge a small commission
They maintain instant access to hundreds of dealers worldwide via open lines and at times may maintain such lines with several banks, with separate lines for differing currencies, spot and forward rates

25. Currency Distribution of Forex Turnover
Because two currencies are involved in each transaction the percentages sum to 200.
Source: BIS

27. Most traded currencies[2] Currency distribution of reported FX market turnover
Rank
Currency
ISO 4217 code (Symbol)
 % daily share (April 2007) 1
 United States dollar
USD ($)
86.3% 2
 Euro
EUR (€)
37.0% 3
 Japanese yen
JPY (¥)
17.0% 4
 Pound sterling
GBP (£)
15.0% 5
 Swiss franc
CHF (Fr)
6.8% 6
 Australian dollar
AUD ($)
6.7% 7
 Canadian dollar
CAD ($)
4.2%
8-9
 Swedish krona
SEK (kr)
2.8%
 Hong Kong dollar
HKD ($) 10
 Norwegian krone
NOK (kr)
2.2% 11
 New Zealand dollar
NZD ($)
1.9% 12
 Mexican peso
MXN ($)
1.3% 13
 Singapore dollar
SGD ($)
1.2% 14
 South Korean won
KRW (₩)
1.1%
Other
14.5%
Total
200%

28. DAILY TURNOVER IN INDIAN MARKET

29. CURRENCY MARKETS
Spot Markets : Value date two business days from transaction date. If bank holiday in either settlement centre, push to next business day.
Outright Forwards : Value date three business days and beyond.
Standard forward dates : 1, 2, 3, 6, 9, 12 months. Spot value date plus required calendar months. If holiday, push forward to next eligible business day; but pushing forward must not carry you to next calendar month; then push back
Swaps : A spot plus a forward or two forwards. Buy USD spot vs. INR, sell USD 3 month forward vs.INR. Sell USD 1 month forward, buy USD 3 month forward vs. GBP.

31. Top 10 Currency Traders % of Overall Volume, May 2009
Rank               Name                             Market Share
1                    Deutsche Bank                                  %
2                    UBS AG                                        14.58%
3                   Barclays Capital                               %
4              Royal Bank of Scotland                  %
5                      Citi                                          %
6                  JPMorgan                                        5.43%
7                HSBC                                            4.09%
8                 Goldman Sachs                                 %
9                   Credit Suisse                                     3.05%
10               BNP Paribas                                      2.26%

32. The monthly turnover in the inter-bank segment of the foreign exchange market in India increased from US $405 billion in March 2006 to US $533 billion in March 2007 and that in the merchant segment from US $141 billion to US $192 billion. As of now the average daily turnover is estimated to be around $35 billion.
Bulk of this is in the Mumbai market. Other centres are Delhi, Kolkata and Chennai.

33. IDR: INDONESIAN RUPIAH MYR: MALAYSIAN RINGITT
CNY: CHINESE YUAN
KRW: KOREAN WON
TWD: TAIWAN DOLLAR
INR: INDIAN RUPEE
PHP: PHILIPPINES PESO
THB: THAI BAHT
IDR: INDONESIAN RUPIAH
MYR: MALAYSIAN RINGITT
SGD: SINGAPORE DOLLAR
HKD: HONGKONG DOLLAR

34. CURRENCY MARKETS
A spot GBP/USD deal on Friday December 12: Value date Tuesday December 16
If December 16 holiday in NY/London, value date December 17.
Suppose the deal is between a French and a German bank and December 16 is holiday in Paris but not London or NY. Push forward?
A 2-month forward deal USD/CHF on Monday Dec 22: Value date Feb 24. If holiday in NY/Zurich, Aug 17.
A 3-month forward USD/JPY on Nov 26, Value date Feb 28, If holiday in Tokyo/NY, push forward? NO. Pushing forward must not carry into next calendar month. Push back to Feb 27, Could have pushed forward in a leap year – February 29.
Spot deals in some currency pairs in the same time zone such as US dollar-Canadian dollar, US dollar- Mexican peso settled in one business day

35. ACI QUOTATION CONVENTIONS
CURRENCY MARKETS
ACI QUOTATION CONVENTIONS
SPOT RATE QUOTATIONS:
Base Currency/Quoted Currency Bid Rate/Offer Rate
USD/CHF : USD base, CHF quoted
GBP/USD : GBP base, USD quoted
Most currencies quoted with USD as base. Exceptions are EUR, GBP, AUD, NZD, CAD
Quotation given as no. of units of quoted currency per unit of base currency, bid rate/offer rate.
Bid rate applies to market-maker buying base currency. Offer rate applies to market-maker selling base currency.

36. CURRENCY MARKETS
Currency Codes : All currencies have a 3-letter code used by SWIFT (Society for Worldwide Inter-bank Financial Telecommunications) for all inter-bank transactions.
USD : US Dollar AUD : Australian Dollar
CAD : Canadian Dollar JPY : Japanese Yen
GBP : British Pound INR : Indian Rupee
SAR : Saudi Riyal EUR : Euro
SEK : Swedish Kroner DKK : Danish Kroner
CHF : Swiss Franc SGD : Singapore Dollar
KRW : Korean Won THB : Thai Baht
European Currencies which have become history:
DEM : Deutschemark FRF : French Franc NLG :Dutch Guilder
ITL : Italian Lira ESP : Spanish Peseta PTE : Portugese Escudo
BEF : Belgian Franc LUF : Luxembourg Franc
IEP : Irish Pound FIM : Finnish Markka
ATS : Austrian Schilling GRD : Greek Drachma

37. CURRENCY MARKETS SPOT QUOTES : EXAMPLES USD/CHF SPOT: 1.2075/1.2080
Bid Offer (Ask)
Bank will buy 1 USD and give CHF
Bank will sell 1 USD and want to be paid CHF
Shortened to /80 or even 75/80 between dealers. “1.20” is the “big figure”

38. CURRENCY MARKETS SPOT QUOTES : EXAMPLES Interpret these quotes :
GBP/USD : /25 EUR/USD : /30
GBP/EUR : /55 USD/INR : /
USD/JPY : /55
Most currencies quoted upto six significant figures. Last two figures known as “points” or “pips”. A pip is In the GBP/USD quote the bid-offer spread is 8 pips. Smaller currencies such as JPY and INR are quoted to 2 decimals in merchant segments. Here a pip is 0.01

39. CURRENCY MARKETS
Quotations in European Terms: Units of a currency per US dollar. Example : USD/INR : /675
Quotations in American Terms : US dollars per unit of a currency. Example : GBP/USD : /55
Direct Quotations: Units of “home” currency per unit of “foreign” currency. Example : USD/INR above, a direct quote in India.
Reciprocal or Indirect Quotations: Units of “foreign” currency per unit of “home currency”. Example:
USD/GBP : /0.5090, an indirect quote in US.
GBP/USD : /55, an indirect quote in UK

40. INTERBANK SPOT DEALING
Friday December 25, am
BANK A : "Bank A calling. Dollar-Swissy 25 please.”
(Bank A is specifying the size of the deal because it is much larger than the market lot)
BANK B : "Forty -Fortyfive”
(Bank B is specifying a two-way price. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be / The quote is valid for 3-5 minutes.)
BANK A : “Mine”
(Bank A dealer finds bank B’s price acceptable and wishes to buy USD 25 million. She conveys this by saying “mine”; if she wanted to sell USD she would say “yours”)

41. SPOT DEALING (Contd.)
BANK B : OK. I sell you USD 25 million against CHF at , value 29 December. UBS Geneva for my CHF.
BANK A : CITIBANK NYK for my dollars. Thanks & Bye.
Deal is consummated. Back office staff will retrieve details, exchange confirmatory faxes/telexes and arrange settlement.
Spot deals (including those in swaps) account for about
60 % of total turnover.
Dealers work within limits assigned by management
Counter-party must be acceptable credit.

42. CURRENCY MARKETS
Inter-bank Arbitrage : Suppose banks A and B are quoting :
A B
GBP/USD : / /1.6348
  Bank A
Bid Ask
  Bank B
Bid Ask
Buy GBP from bank B, sell to bank A. Prices will move.
GBP/USD : / /1.6658
  Bank B
No arbitrage. Quotes must “overlap”.

43. INVERSE QUOTES AND TWO-POINT ARBITRAGE
USD/CHF : / A bank in Zurich
CHF/USD : / A bank in NY
Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich sell in New York.
$(1,000,000/1.2955) i.e. $ needed to acquire the Swiss francs.
$(  ) i.e. $772800, obtained on selling, a riskless profit of $897. Zurich USD/CHF quotes imply certain CHF/USD quotes:
Implied (CHF/USD)bid = 1/(USD/CHF)ask
Implied (CHF/USD)ask = 1/(USD/CHF)bid

44. INVERSE QUOTES AND TWO-POINT ARBITRAGE
USD/CHF : / implies CHF/USD :0.7715/
Any quote which does not overlap this would lead to arbitrage. For example CHF/USD : / allows arbitrage.
A quote such as / will not lead to arbitrage though it may lead to a one-way market for the banks.
The rates actually found in the markets will obey the above relations to a very close approximation.
GBP/USD: / USD/GBP ?
USD/INR: / INR/USD ?
GBP/EUR: / EUR/GBP?

45. CROSS-RATES AND THREE-POINT ARBITRAGE
A New York bank is currently offering these quotes :
USD/JPY : /111.10
USD/AUD : /1.6530
At the same time, a bank in Sydney is quoting :
AUD/JPY : 68.30/69.00
Is there an arbitrage opportunity?
Consider this sequence of transactions: Sell yen against US dollars and the US dollars against Australian dollars both in New York and finally sell the AUD for yen in Sydney.
This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C; Finally sell C buy A.

46. CROSS-RATES AND THREE-POINT ARBITRAGE
The calculations are :(N: NY S: Sydney)
1 JPY in NY gets USD [1/(USD/JPY)ask(N)] = USD (1/111.10)
Sell USD [1/(USD/JPY)ask(N)] in NY to get AUD
{[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520)
Sell AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } in Sydney to get
JPY{[1/(USD/JPY)ask(N)](USD/AUD)bid(N)(AUD/JPY bid(S) }
= JPY (1/111.10)(1.6520)(68.30) = JPY
A riskless gain of JPY per yen you started with.

47. CROSS-RATES AND THREE-POINT ARBITRAGE
Synthetic Rates must overlap observed market rates
Synthetic (C/A)bid = (C/B)bid  (B/A)bid Synthetic (C/A)ask = (C/B)ask  (B/A)ask
e.g. USD/INR: / USD/CHF: /70
Synthetic (CHF/INR)bid = (CHF/USD)bid  (USD/INR)bid = [1/(USD/CHF)ask]  (USD/INR)bid = (1/1.2770)( ) =
Synthetic (CHF/INR)ask = (CHF/USD)ask  (USD/INR)ask = [1/(USD/CHF)bid]  (USD/INR)ask = (1/1.2765)( ) =
 
    Acceptable
    not acceptable

48. Foreign Exchange Rates & Quotations
Intermarket Arbitrage
Cross rates can be used to check on opportunities for intermarket arbitrage
Example: Assume the following exchange rates are quoted
Citibank $1.2223/€
Barclays Bank $1.8410/£
Dresdner Bank €1.5100/£

49. 3-Point ARBITRAGE…. Citibank New York Dresdner Bank
End with $1,002,538
Start with $1,000,000
(6) Receive $1,002,538
Sell $1,000,000 to Barclays
Bank at $1.8410/£
Dresdner Bank
Barclays Bank, London
Sell €820,206 to Citibank
at $1.2223/€
(2) Receive £543,183
(4) Receive €820,206
Sell £543,183 to Dresdner Bank
at €1.5100/£

50. Intermarket Arbitrage
Foreign Exchange Rates & Quotations
Intermarket Arbitrage
The cross rate between Citibank and Barclays is
($1.8410/₤)
= €1.5062/ ₤
($1.2223/€)
This cross rate is not the same as Dresdner’s rate quote of €1.5100/£
Therefore, an opportunity exists for risk-less profit or arbitrage

51. EUR Locking Rates

52. FORWARD AND SWAP QUOTES
Forward outrights can be given like spot quotes.
USD/CHF 3-months /65 bid/ask
More commonly given as a spot quote and a pair of swap points
USD/CHF Spot : /35
1 month : 15/ months : 25/ months : 35/25
GBP/USD Spot : /65
1 month : 12/ months : 20/ months : 28/35

53. FORWARD AND SWAP QUOTES
To find outrights : Spot quote ± Swap Points
Each swap point is ( or 0.01)
When to add, when to subtract?
Take USD/CHF Spot : / month : 15/10
If you add, 1 month outright : ( )/( ) = /45
If you subtract, 1 month outright : /1.2525
Which is correct?
Two “rules” :
(1) Market makers’ Ask rate must exceed Bid rate
(2) Bid-Ask spread must widen as you go farther out into future

54. FORWARD AND SWAP QUOTES
Using rule 2, / is wrong /25 is correct.
Now take GBP/USD Spot / months : 20/25
If swap points added, 2 month outrights /1.7590; if subtracted / The former is correct.
Mechanical Rule : If swap points are Big/Small, subtract, base currency at forward discount, quoted currency at premium. If swap points Small/Big, add. Quoted currency at discount, base currency at premium.

55. FORWARD AND SWAP QUOTES
A quote like : USD/SEK Spot / month : 10/20
Bank will do either swap:
(1) Buy USD spot, sell USD 3 months forward against SEK. The forward selling or “ask” rate would be 20 points above the spot rate.
(2) Sell USD spot, buy 3 months forward, forward buying or “bid” rate would be 10 points above spot.
In a swap, amount of one currency - usually the base currency- is kept same in the spot and the forward leg. Buy USD 1m spot, sell USD 1m forward. Amount of SEK will be different.

56. BROKEN DATES
Standard forwards are whole months. Banks will do any number of days forward - 63 days, 135 days etc. These are “broken date” or “odd date” forwards.
Interpolate between two whole month dates. OK if the gap between the two dates is not too long and no special technical factors are at work. Example:
USD/INR spot 48.55/56 1 month:8/10 2 months:15/20
Recall that for INR each point is 0.01.
Customer wants to buy USD 43 days forward.
10paise (Rs.0.10) premium on the offer side from 1month to 2months. Suppose 30 days in 2nd month. 1/3paisa (1/3 of Rs.0.01) per day, 4 paise(Rs.0.04) for 12 days. The interpolated rate would be : = 48.70

57. SHORT DATES Delivery same day- cash
Delivery next day - Tomorrow or “Tom”.
Markets quote Overnight (O/N), Tom(orrow)/Next (T/N) and Spot/Next (S/N) swaps. These are used to compute rates for short date transactions.
Reverse swap points and follow add/subtract rule.
USD/CHF Spot /50 T/N : 5/ /5
Outright for Tom : /55

58. What’s the logic? Consider again
USD/CHF Spot /50 T/N : 5/3
This means: Going from TOM to NEXT CHF has a premium – 3 points on bank buying CHF, 5 points on bank selling CHF. “NEXT” after “TOM” is SPOT.
If you buy USD delivery tomorrow and sell delivery day-after i.e. Spot date, you will suffer a 5-point discount on the sale compared to your buying price. If you sell tomorrow buy spot you will get a 3 point discount on your selling price.
Suppose you want to buy CHF delivery tomorrow. Bank buys it delivery spot; then does a swap – buy tomorrow sell spot i.e. it sells USD delivery tomorrow, buys USD delivery spot; it gains 3 points. It passes on the gain to you – gives you CHF per USD.

59. If you wish to sell CHF (buy USD) delivery tomorrow bank sells delivery spot and then does a swap – buy CHF (sell USD) delivery spot, sell CHF (buy USD) delivery TOM. In this the bank suffers a 5-point discount which it would recover from you. Hence it charges you CHF per USD you wish to buy.
Hence the rule: Reverse swap points and follow the rule
BIG/SMALL subtract, SMALL/BIG add.
Same logic works for cash – same day – delivery. Now look at O/N swap points. From spot and T/N derive TOM quotes; then from TOM quotes and O/N swap quote derive CASH quotes following the same rule.

60. SWIFT WHAT IS SWIFT? Inter- bank Financial Telecommunication.
The acronym SWIFT stands for Society for Worldwide
Inter- bank Financial Telecommunication.
SWIFT allows member financial institutions worldwide to electronically exchange information amongst each other.
Messages are transmitted globally through high speed communication channels on standardized message formats for many international banking operations.
SWIFT provides a quick, reliable and cheap medium for communication of financial messages which has a direct impact on customer service. Under SWIFT, if both the members are hooked, messages can be transmitted within seconds.

61. Financial and non-financial messages can be transmitted which cover Funds Transfers between customers/banks, letters of credit/bank guarantees, customer account status, draft advices, foreign exchange transactions, nostro/vostro accounts status etc.
Message security is better as compared to other means of message transmission.
Standardized message formats eliminate ambiguity and facilitate automated handling at the source and the destination.
Message authentication is automatic.
SWIFT has a Regional Processor (RP) in each host country through which all messages meant for that country are routed. In India RP is located in the premises of M/s. CMC Ltd. at World Trade Centre, Cuffe Parade, Bombay. Each user in that country is required to install a Computer based Terminal (CBT) in his own premises. The CBT is a device for interfacing with the SWIFT RP through the telephone lines.