foreign exchange managements

04/10/2023 Foreign Exchange Management 1

Foreign exchange management

By:Srikant Gupta (86)Zaki Azfar (107)Manushi Mishra (116)


WHAT IS FOREX?

The foreign exchange market (FOREX) is a

worldwide decentralized over-the-counter financial

market for the trading of currencies

In simple words, it is a place where one currency is

exchanged with another currency based on

fluctuation rates

For every international sale or purchase of

commodities, services or assets, there corresponds

an international sale or purchase of currencies


Codes for selected Currenciesrequired for quotes USD – US Dollar EUR – Euro

GBP – British Pound IEP – Irish Pound

JPY – Japanese Yen CHF – Swiss Franc

CAD – Canadian Dollar AUD – Australian Dollar

SEK – Swedish Kroner MEP – Mexican Peso

DKK – Danish Kroner NZD – New Zealand $

INR – Indian Rupee SAR – Saudi Riyal


CHARACTERISTICS OF FOREIGN EXCHANGE MARKET

Only market open 24 hours: FX Market is a 24 hour market

It starts when a calendar business day opens in Sydney, Tokyo, Hong Kong, Singapore and then moves to Middle East to Europe to New York to the West Coast of United States where the calendar business comes to a close

FX Market operates seven days a week (Middle East Markets function on Saturdays and Sundays)

Effectively it is a 24 hour a day / seven days a week / 365 days a year Market!

Size : Daily turnover of over $3.98 trillion


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Currency appreciation/depreciation

Increase in foreign currency price

From Rs.60.80 to Rs.65.12/ USD

Foreign currency appreciation

Home currency depreciation

From USD 0.0164 to USD 0.0163/ Re

04/10/2023 Foreign Exchange Management 8-7

A Day of Foreign-Exchange Trading


Foreign exchange markets

Organizational setting within which

individuals, governments and banks

buy and sell foreign currencies.

Only a small fraction of daily

transactions in foreign exchange

involve trading of currency.

Most foreign exchange transactions

involve transfer of bank deposits.


Foreign Exchange Markets

The foreign exchange market has mainly two segments:

Spot markets Forward markets

The rate at which one currency is traded foranother is called exchange rate


Spot Market

The exchange rate for immediate delivery is called Spot Exchange Rate and is denoted by S (.) e.g. S (Rs./$) = Rs.60.80/$

Here immediate delivery means delivery after two business days

The market where the purchase and sale of currencies is contracted for spot delivery is called the Spot Market


Quotations at the FX Market


Direct Quotes

In case of ‘direct’ quotes, a unit of foreign currency is quoted in terms of domestic currency

For example:At Mumbai foreign exchange market , the US dollar is quoted as:

USD 1 = Rs. 60.6978/8060

Spot (bid) = Rs. 60.6978/$Spot (ask) = Rs. 60.8060/$

Rule : “ Buy low: Sell high”


Indirect Quotes

In case of ‘indirect’ quotes, a unit of domestic currency is quoted in terms of foreign currency

For example:At Mumbai foreign exchange market , the quotation are made as:

Rs. 100 = USD 2.0762/0767

Spot (bid) = $ 2.0767/Rs.100Spot (ask) = $ 2.0762/ Rs.100

Rule : “ Buy high: Sell low”


Direct & Indirect Quotes

Sometimes the quotes are made against 100

units of a currency instead of a unit of the

currency

European quotes are indirect quotes

Indian quotes are direct quotes


Spread

Ask and bid differential is called the spread When quotes are direct :

Spread = Ask – Bid When quotes are indirect :

Spread = Bid – Ask Spread represents cost of transaction It is represented by the percentage of spread and is given by: 1.[( Ask- Bid)/ Ask] x 100 when quotes are direct 2. [(Bid – Ask)/ Bid] x 100 when quotes are indirect


Forward Market

Forward contracts are bought and sold at forward exchange rates

Hedging and speculation are the main activities which pertain to forward markets


Forward Exchange Rate

The exchange rates for delivery and payment at specified future dates are called Forward Exchange Rates and is denoted by F(.)

For example, 60 days F (Rs./$) : forward rate between rupees and dollar is the rate at which the foreign exchange dealer can arrange a transaction between rupees and dollar 60 days


Forward Exchange Rate

Forward exchange rates are determined by forward demand and forward supply of various currencies

A foreign currency is said to be at a forward premium if its future value exceeds its present value in terms of domestic currency and it is said to be at discount if the converse is true

For example : S (Rs./$) = Rs. 60.70 F (Rs./$) = Rs. 60.90


Quotation for Forward Exchange Rate

These rates are also quoted in the form of ‘bid’ and ‘ask’ rates and the spread also depend on approximately the same factors as spot rates plus:

Rate of Interest Demand and Supply Speculation about Spot Rates and Exchange Regulations


Indian Forex Market

In Indian forex market, not all currencies are bought or sold

For non-traded currencies, the banks use London, New York or Singapore markets

Exchange Market Segments:

1. RBI and ADs( Commercial Banks)2. Interbank market3. Retail segment – ADs with corporate clients and other retail customers


Indian Forex Market

The rates quoted by authorised dealers (ADs) are merchant rates at which trading can take place in the Retail segment

Merchant rates are different than

inter-bank rates and contain administrative cost, cover for exchange fluctuation and some profit on the transaction for the Bank


Indian Forex Market

In India, the official rate is determined by the RBI on the basis of the multi-currency basket

The official buying and selling rates are announced

FEDAI announces indicative free market rate on

every business day

The RBI has the discretion to enter the market so as to stabilize the exchange rate


Foreign exchange market

Foreign exchange market

Retail wholesale

Bank and money changes

(currencies and bank note, cheques)

Interbank(Bank account

or deposits)

Central bank

Indirect(Through broker)

Spot

Direct

Forward Derivatives(Future options etc.)


Interbank Foreign Exchange Trading

About 90% of foreign

exchange trading is in

the Interbank part of

the market.


Interbank Foreign Exchange Trading

Provides continuous

information on the

foreign exchange

market—

Talking with traders at

other banks.

Observing prices (exchange

rates) being quoted.


Foreign Exchange and Forward Contracts

What is a forward

foreign exchange

contract?

An agreement to exchange

one currency for another

on some date in the

future at a price set now

[the forward exchange

rate].

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Participants of FE Market

The participants in the foreign exchange market are:-

Individuals Corporate/Firm Commercial Banks Central Bank/Governments International Agencies/Exchange

Brokers


Balance of Payments B of P – is a record of the value of all

economic transactions between residents of a country


Settlement of Transactions

SWIFT :

Society for Worldwide Interbank Financial Telecommunications

- a co-operative society owned by about 250

banks in Europe and North America

- registered in Brussels, Belgium


Settlement of Transactions

CHIPS :

Clearing House Interbank Payment System- an electronic payment system owned by 12 private commercial banks constituting New York Clearing House Association

CHAPS : Clearing House Automated Payment System - London


Determinants of Spread

The currency being traded The volume of currency being traded The nature of organization making quotes Overall perception of the Dealer about the

conditions of the economy and forex market

Usually these spreads are regulated by foreign exchange dealers associations such as FEDAI


Factors Determining Spot Exchange Rates

Balance of Payments Inflation Interest Rates Money Supply National Income Resource Discoveries Capital Movements Political Factors Psychological Factors and Speculation Technical and Market Factors


Need and Importance of Foreign Exchange Markets

Foreign exchange markets represent by far the most important financial markets in the world. Their role is of paramount importance in the system of international payments. In order to play their role effectively, it is necessary that their opera tions/dealings be reliable. Reliability essentially is concerned with contractual obligations being honored. For instance, if two parties have entered into a forward sale or purchase of a currency, both of them should be willing to honors their side of contract by delivering or taking delivery of the currency, as the case may be.

Types of foreign exchange

Ready/cash- Settlement of funds on the

same day (date of the deal).

Tom- Settlement of funds takes place on

the next working day of the date of the

deal.

Spot- Settlement of funds takes place on

the second working day following the date

of the deal.


Types of Exchange Rates

Types of rates are quoted:

1. TT( Telegraphic Transfer) rate2. Bill rate


TT (Telegraphic Transfer) Rate

Transactions where TT rate is applied:

Issue/ Payment of demand drafts, mail transfers, telegraphic transfers etc.

Foreign bill collected and amount received in Nostro account

Cancellation of foreign exchange sold/ purchased earlier


Bill Rate

Rate applied for a foreign bill purchased or payment

against import bill

Bill Buying rate: Basic rate (+ or -) Forward Premium ( Discount) for transit period plus usage period –Exchange margin

Bill selling rate = TT selling rate + service margin


FOREX SYSTEM IN BANKING

FOREX

import export

REMITTANCE

EXPORTIMPORT

Outright sale basic

Consignment basic

physicalnon-

physical

Merchandise and

software

04/10/2023 Foreign Exchange Management

Theory of Purchasing Power Parity (PPP)

The prices of tradable goods, when expressed

in a common currency, will tend to equalize

across countries as a result of exchange rate

changes

Occurs because process of buying goods in a

cheap market and reselling them in expensive

market affects demand for (and price of) the

foreign currency and the market price of the

good in the two product markets in question 8-38

04/10/2023 Foreign Exchange Management

The prices

these Mexican

shoppers pay

for foreign-

made goods are

affected by

fluctuations in

the value of the

peso in the

foreign-

exchange

market8-39


CASE STUDY : McDonald’s

McDonald’s Corporation is the world’s leading global food service retailer, with nearly 29000 restaurants in 120 countries

Today more than 65% of total revenue is derived internationally which is increasing its foreign exchange & interest rate risks

THE NEED: Further increase the effectiveness of the interest rates

and foreign exchange hedging programs Wanted to implement a leading-edge solution that

would help achieve this goal while containing costs. Needed to maintain consistency with the long-standing

risk management to policy requiring Treasury to be able to price and manage every derivative they transact


They used ‘basket option strategies’ to hedge their interest rate & foreign exchange risks

A basket option is an option whose payoff depends on the value of a portfolio(or basket) of assets

McDonald’s was looking for an upgrade in technology to help the Treasury build the currency basket option, so….


SOLUTION: It hedges their interest rate & foreign

exchange exposures, which are made up of foreign income & assets & their domestic & foreign debt portfolio, by using following approaches:

1. Qualitative Analysis: uses the underlying economic fundamentals for each country, and the currency is analyzed to determine when it is necessary to hedge

2. Quantitative Analysis: relies on mathematical models to analyze assets vs. liabilities implies using different weightings of different baskets


McDonald’s evaluated several system based software solutions to evaluate hedge effectiveness but they lacked the flexibility & the analytical coverage needed to price many of the complex derivatives

In 1996, they choose FINCAD’s Microsoft Excel based financial engineering software as a pricing tool which allows them to price their derivatives portfolio, enabling them to work more efficiently with instruments such as baskets, average rate & double average rate options.

Those exotic currency option allow them to hedge their exposures in a more cost-effective manner


McDonald’s also uses FINCAD Analytics to analyze their portfolio of interest rate swaps, currency swaps & swaptions.

They built spreadsheet templates for these instruments and linked them to live market data from Reuteurs & Bloomberg which enables them to calculate mark-to-market values in real time

It saved their lot of time. FINCAD listens to its customers & continues to improve its product based on user feedback & industry trends


Education

foreign exchange managements