Forex Cap- Ib

7/31/2019 Forex Cap- Ib

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Foreign Exchange Market


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A market for the purchase and sales of foreign currencies is

called foreign exchange market.


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Need of foreign

exchange market

Need for foreign exchange marketarises because of the multifarious internationalcurrencies and need for trading in suchcurrencies



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Foreign Exchange MarketCharacteristics

Electronic market

Geographical dispersal

Transfer of purchasing power

Intermediary

Volume

Provision of creditMinimizing risks


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ConstituentsInter bank market

Its a wholesale market through which

most currency transactions arechanneled.It is used for trading among bankersIts a market through which around

95% of the foreign exchange

transactions are carried out



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Three constituentsof inter bank market

Spot marketForward marketSwap market



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The SWIFTIt is an international bank communications

network that links electronically all brokers andtraders in foreign exchange.



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Participants(1)Foreign exchange dealers Bank and non-bank agencies take part in

activities of these dealers. Their role comprises inactual market making. They actively deal in foreigncurrency for their own account. They help inmaintaining the foreign currency within the trading limit.

Their profit comes from buying exchange at bid priceand selling it at a higher offer/ask price.



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(2)Individuals and firms

Exporters, importers, internationalportfolio investors, MNCs, tourists andothers who use foreign exchangemarket to facilitate the execution of

commercial or investment transaction.



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(3) Speculators and Arbitragers

Speculators buy and sell currencies solely to profit

from anticipated changes in exchange rates, withoutengaging in the other sorts of business dealing forwhich foreign exchange is essential. Biggest speculator

includes leading bank and investment bank.



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(4) Central Bank and Treasuries

They use FEM for the purpose buying and selling

countrys foreign exchange reserves.Government make deliberate attempt for altering theexchange rate between two countries by buying oneand selling another is called interventions.



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(5) Foreign exchange brokers

These are commission agents who bring togethersuppliers and buyers of foreign currency

Some of the service give by them are:-Provision of information on prevailing and future rates ofexchangeMaintaining confidentiality of participants in foreign

exchange marketHelping banks to keep at minimum the contacts withother traders.



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Transactions

Spottransactions

Foreign exchange transaction where by thepurchase of exchange, delivery and payment forthe same take place between banks usually on the

second following business day.



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Forward transactions

Foreign exchange transaction where by a specifiedamount of one currency is exchanged for aspecified amount of another currency at a futurevalue date



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Swap transactions

Foreign exchange transaction where bysimultaneously and sale of given amount of foreignexchange for different value dates takes place.



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Rate and QuotationsInter-bank Quotations

Direct QuotationIndirect QuotationBid QuotationAsk (offer) Quotation

Cross rates



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Foreign exchange risk

Fluctuation and consequent appreciation or

deprecation in the value of assets, liabilities, income orexpenditures owing to a unanticipated changes inexchange rates are known as foreign exchange risk ispresent in uncovered foreign exchange claim or

liability. Uncovered claim in foreign currency is longand an uncovered liability in foreign currency isshort.



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Payment methodsPayment in domestic currency

Payment in any currencyTravails of trading currenciesSpot exchange rateForward exchange rate



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Foreign exchange risk- illustration

Where some of the assets of an enterprise are notdenominated in the currency of its home country, foreignexchange risk or exposures arises. Owing to the exchangerate fluctuations, loss arises when domestic currency isexchanged for a foreign currency in relation to businessproposed to be under taken. The occurrence of exchange

risk can be explained as follows:



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Indian entrepreneur enters into a contract for thepurchase of machinery with the American

supplies, payment to be made after 3 months.

Exchange rate at the time of contract 47.50/$1

Value of machinery $50000

The value of Indian rupee declines to 49.00/$1 after3 months



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Results:Amount to be paid to US exporter at the time of

contract (U.S. dollar) = $50000Amount to be paid to US exporter at spot rate (Indian

rupees):$50000*Rs.47.50 = Rs.23,75,000

Amount to be paid to US exporter at future rate(Indian rupees)/amount required for purchasingUS $ 50000 on that date:

$50000*Rs.49.00 = Rs.24,50,000Loss suffered: Rs.75000



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Risk management toolsHedging techniquesMechanism through loss on a transaction

can be minimized by a bull operator buyinga put option (right to sell) where he agrees topurchase the security from some body.

Or

In short the method securing oneself againstloss from various risks is called hedging



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Types of exchange risks

Transaction exposureTranslation exposureEconomic exposure



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Techniques of hedging foreign exchange risk

Forward contract

Contract between banks which calls for delivery, ata future date, of a specified amount of one currencyagainst dollar payments at the rate which isdetermined at the time of contract

Future contractFirm legal commitment to buy or sell a stipulated

quantity of a specified asset at a predetermined priceon a predefined future, which is traded on a well-organized exchange.



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Currency Arbitrage

Buying currency in one market and selling thesame in another market simultaneously



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Interest rate parity theory

According to this theory the currency of the countrywith a lower interest rate should be at a forwardpremium in terms of the currency of the country withthe higher rate



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Covered Arbitrage

Movement of short-term funds between two currencies totake advantage of interest differentials with exchange riskeliminated by means of forward contracts.



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SWAPS

Private arrangements where by cash flows in future areexchange according to prearranged formula are calledswaps.



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Currency swap

Exchange of principle and fixed rate interest

payments on a loan in one currency for principle andfixed rate interest payments on approx. equivalent loanin another currency.

Types of currency SWAP

Fixed currency SWAPFloating currency SWAP



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Benefits of currency SWAPChoiceHedgeBenefit firms

EquilibriumLow costTax savingsRisk-free rate

Subsidized loansOff-balance sheet items



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Management of exchange rate

(A) Fixed rate system

Bretton woodsPegged rate

Currency boardGold standard

(B)Semi-fixed rate systemBandsTarget zones

Pegs and baskets

The crawling pegs



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(C) Floating rate system



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Indian Foreign Exchange Markets

Currency options-was introduced in 1982 inPhiladelphia; since 1982 option market witness atremendous growth this was on the account of desire tomanage foreign currency and interest rate risk more

effectively.

Indian context -until the beginning of 90s the currencyoption is largely unnoticed in India. This concept startedgaining relevance in 1991 when liberalization was initiated

by Govt. the main purpose was to enable cooperatesimporters and exporters with foreign investors.


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Incentives and uses

Provision of insurance cover against adverse rate

movement while keeping the chance to gain if the rate

move favorably. Thus to satisfy the cooperate and

financial institutions.

Provision of benefits of favorable movement in

rates.



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User of currency options

Financial firms

FirmsBanks



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Role of commercial banks

Take active part in financing of foreign trade.

They help in regulating the Foreign ExchangeRegulations Act (FEMA)

They maintain correspondent or agency relationship

with the banks abroad.

Maintain accounts abroad to meet public requirements.



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All sales and purchases of foreign currency arerouted through the accounts they maintain with thebanks in important financial centers abroad.

They quote rates at which they buy and sell foreignexchange in accordance with rules and regulations ofRBI and FEDAI (Foreign Exchange Dealer Associationof India)

The rates quoted depends upon the rates prevailingin inter-bank or international market and the banksmargin profit.



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Foreign currency accounts

NOSTRO a/c foreign currency a/cmaintained by banks in India with banks in

abroad (our a/c with you).CurrencyPaymentsBorrowings

VOSTRO a/c these constitutes the rupeea/c of foreign banks opened with Indianbanks. (Your a/c with us)

Payments



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EXCHANGE RATE MANAGEMENTEvery country that is the member of the agreement

with IMF has an obligation to keep the fund and the

members of the fund informed of the exchangearrangements they wish apply and of any subsequentchanges in them with fund to ensure orderly exchangearrangements

Main purpose is to promote a stable system ofexchange rate.



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EXCHANGE ARRANGEMENTFluctuating or Fixed exchange rate interm of other currencies or the special

drawing rights or some other basket ofcurrencies.Cooperative arrangements by whichmembers maintain the value of their

currencies in relation to the value of thecurrency or currencies of othermembers.



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Liberalized Exchange Rate Management System

It came to introduce with effort from March 1, 1992. Astriking feature of the LERMS has been that it followed a dual

exchange rate system. Some of the important features are asfollows.The U.S. dollar replaced pound sterling as the

intervention currency.All Foreign exchange receipts on the current account

transaction (exports and remittance) were required to besurrendered to the Authorized Dealers (Ads) in full as hitherto.



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Of the total Foreign Exchange receipts, 40percent was to be surrender to the RBI at theofficial rate of exchange announced by the

RBI.

The balance 60 percent of foreign exchangecan be sold in the free market for permissible

transactions at the free market rate quoted bythe ads, taxes to be levied on these exportsproceeds.



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Unified Market Determined System, 1993The unified Market Determined Exchange Rate System from

March 1993 replaced the dual exchange rate system. Theimportant features of the system are as follows:

All the Foreign exchange transactions, both currentand capital are put through by Authorized Dealers (ads)at market-determine-rates of exchange.

The exporters instead of surrendering their exportearnings to the RBI shall hereafter do so to the ads.

All payments involving foreign exchange are alsoeffected at market-determined exchange rate through ads



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The market rate of exchange is determined by the RBI onthe basis of the prevailing market rates within a 5 percentmargin on either side of the market rate. Accordingly, RBIbuys U.S. dollars from Ads for spot deliveries and sells

the same for purposes approved by the government ofIndia.

Using U.S. dollar as the intervening currency, RBI entersinto swap transactions under which it buys U.S. dollars

spot and sells forward for period ranging for 2 to 6months, instead of buying spot bound sterling, Duetschemark or Japanese yean.



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Beside the selling and buying rates of Ads RBImakes announcement of its own reference rate

based on the rates quoted by a few selectedbanks in Bombay at noon, the EBI reference ratebeing use for effecting transactions in SDRs andwith countries in Asian clearing union.

Splitting of currency exposure and long-termforward cover is allowed in order to provide depth

to the exchange market and flexibility to marketoperators.

Forward contracts are allowed for remittanceof dividend in respect to FDI.



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Currency ConvertibilityThe freedom to convert one currency into otherinternationally accepted currencies may be defined ascurrency convertibility.

Convertibility may be oftwo types

Current account convertibility: - Convertibilityfor current international transaction is known as

current account convertibility.Capital account convertibility : - Convertibilitycapital movements are known as capital accountconvertibility.



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Currency Convertibility has defined as thefreedom to buy or sell foreign exchange forthe following purposes:The international transaction consisting of payment

due in connection with foreign trade, other currentbusiness including services and normal short- termbanking and credit facilities.Payment due as interest on loans and as net incomefrom other investments.Payment of moderate amounts of amortization of loansfor depreciation of direct investments.Moderate remittances for family living expenses.



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Benefits of Currency Convertibility

Enhanced confidence:Providing a signal to the

international community that the country intends tomanage its affairs without exchange restrictions, whichwould eventually help enhance international confidencein the countrys policies.

Capital flows:Chances of increased capital inflows.



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BoP management:Freeing exchange restrictions woulduplift the quality management of balance of payments ofthe country. Flexible and realistic approach in exchangerate determination combined with favorable macro

economic policies would help provide

a viable of balanceof payments.

Efficient allocation:elimination of exchangerestrictions would tend to increase capital inflows in theshort run thus and promoting efficiency in the allocation ofthese inflows to the best advantage of the nationseconomy.



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Consequences of Capital AccountConvertibility Danger of India becoming fully vulnerable to freemovement of foreign capital, which might worsen our

macro economic imbalancesThe high interest rates prevalent in the Indian

economy would serve as an open invitation to theinflow of capital, which will result in an appreciation of

the rupee and consequent fall in exportsBanks and financial institutions with their capitalbase are not financially strong to grapple with theintricacies of full convertibility



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Exchange ratesThe different types of exchange rates are used inthe Indian foreign exchange market is explainedbelow briefly:

Merchant rate:The rate at which the foreign exchangedealing takes place between a bank and the merchantbusiness is called the merchant rate. Cash transaction

or ready transaction or spot transaction refers to thecontract for buying or selling foreign, which is agreed andexecuted the same day.



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Inter-bank rate: The inter-bank rate also known asthe base rate

Refers to exchange rate quoted between banks.Depending upon the time taken for the realization offoreign exchange by the bank, two types of buyingrates namely TT Buying Rate and Bill Buying Rate are

quoted in India.



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Merchant rate:The rate at which theforeign exchange dealing takes place between abank and the merchant business is called themerchant rate. Cash transaction or ready

transaction or spot transaction refers to thecontract for buying or selling foreign, which isagreed and executed the same day.

Transaction costs are fixed and charged tothe member banks by the FEDAI. In foreigncountries the charges are negotiable with theirclients.



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Nominal Real & Effective exchange rates

Nominal exchange rate it is the price of onecurrency in terms of others.

Real exchange rate it measures purchasingpower of the currency.

RE = [NE * DP]/ FPEffective exchange rate a measure of

appreciation and depreciation of currencyweighted against the basket of currency withwhom the country trades.



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RBIs substantial relaxation for ForexMarketsForeign currency-rupeeswaps earlier the banks werepermitted to access the market upto USD 50 million while

offering the product to the customers.Booking of forward contracts based on pastperformanceCancellation and rebooking of forward contracts

Forward cover for foreign direct investments inIndiaInvestments in overseas money/ debts marketsHedging of Tier I capital of foreign banks.



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(A) Fixedrate system

Gold standard

Bretton woodsPegged rateCurrency board


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Forex Cap- Ib