Foreign ExchangeFOREX

Layer 1 RBI FEDAIRegulator IB Rate Prevail

Layer 2 Bank to Bank Transaction Wholesale Market Segment Inter Bank Market or IB Market Operational Layer Merchant Rate Prevail Layer 3 Bank to Customer Transaction Retail Market Segment Merchant Market 1. Three Layer Structure of Forex Market

2. How to Interpret Merchant Transaction Always Interpret Merchant Transactions with Respect to BANK.

E.g. If an exporter approaches a Bank for selling FC than we will say Bank is Buying FC ( from the exporter)

3. Cash Flow Movement in Merchant Transaction Merchant Transaction

Purchase From Bank Sell to Bank Exporter Importer Bank Bank

FC Home FC HC Currency

Customer Customer

Exchange Rate: 1 Unit of FC = How many units of HC

4. How to Interpret IB Rate and Transaction 1 USD = 45.2031 / 45.2031 INR

Base Bid Price Ask or Offer Price Price (Less Rate) (High Rate)

i) In IB market Exchange Rate is quoted upto 4 Decimal places. Except in Japanese Yen (JPY) which is quoted up to two gits after decimal.

ii) Market Maker Market User

The Bank which gives quote The Bank which uses the given in IB Market. Quote

In Exam the given IB Quote is the Exchange Rate quoted by Market maker (we will simply call it quote given by Market)

iii) Interpretation with Respect to Market maker :

The market maker is ready to BUY at Lowest of the Quote i.e. 1 USD for INR 45.2030 and at the same time market maker is ready to SELL 1 USD for INR 45.2031 i.e. Highest of the quote.

iv) Difference between BID Rate and ASK Rate is called SPREAD. (or Trading Profit).

45.2031 / 45.2032 Spread (Difference) i.e .0001

v) Interpretation with respect to Market User : The market user can only BUY at Highest Quote and at the same time market user can SELL at Lowest of the quote.

The User bank can do this transaction in IB market on behalf of customer. Than this deal with customer is called Merchant Deal and it is arrived at by adjusting Exchange Margin to IB Rate.

The market user can do transaction in IB market for their own purpose than it is called Trading or Speculation. This is a risky transaction.

vi) Interpretation of Abbreviation Offer Price (or ASK Price) 1 USD = 45.1550 / 45.1551 INR

45.15 50 / 51

Big Figure Small Figure

Rule :

The offer price (Ask Price) should have equal number of digits after decimal as Bid Price.

Offer Price must be the next numeric after the bid and the quoted offer price should be the last digit.

5. How to Calculate Merchant Rate

SBIMarket Maker

BOB will Sell FC

BOBMarket User

BOB will Buy FC

Exporter

(Inward Remittance) Bank will Sell FC at Lowest of the Quote SBIMarket Maker

BOB will Buy FC

BOBMarket User

BOB will Sell FC

Importer

(Outward Remittance) Bank will Sell FC at Highest of the Quote

6. Adjustment Of Exchange Margin in Merchant TransactionType of Merchant Transactions :

Bank Exchange Margin (EM)

Purchase Deduct

Sell Add

7. How to settle Forex Transaction in IB Market For this purpose each party opens account in Foreign currency.

Nostro A/c Vostro A/c Loro A/c My a/c with You Your A/c with us Third Party A/c

These are A/c for settlement of interbank transactions.

Example on the next slide : >

SBI CITI BANK HSBCMumbai New York London

SBI will call this A/c as Nostro with respect to CITI BANK.

CITI BANK will call this A/c Vostro with respect to SBI.

SBI will call HSBC as Loro A/c as it Nostro to CITI Bank.

Summary : Bank which open cash credit in FC will call it Nostro and Bank where A/c is opened will call it Vostro.

Types of Authorizations ( License) In India RBI Gives 3 types of Licenses for dealing in FOREX Market.

License Type of Transaction

Category A IB Transaction

Category B Money Changer + Export Import Transaction

Category C Money Changer

8. Type of transaction in IB MarketThe definition of transaction depends upon two terms:

Date of Transaction Date of Settlement

DOS = DOT Cash/ Ready/ TT/ Value Today

DOS = DOT + 1 BWD TOM

DOS = DOT + 2 BWD SPOT

DOS = DOT + 2 BWD +. FWD

BWD = Business working DayTT = Telegraphic Transfer

For Exam : In IB Market the exchange rate is quoted on SPOT Basis [ This means in exam, unless otherwise given IB Rate means SPOT basis transaction.

All other transaction like Cash, TOM, FWD are derived from SPOT Rate.

9. Currency Point Conventioni) What is market Convention (or ACI Convention) for writing currency pair.

Each currency is identified by three capital letters ( USD, INR, EVR) and the first currency before oblique (/) is the Base Currency after oblique is the quote or Price Currency. USD / INR 45.2030 / 35

Base Price Bid Ask

Academic World : Base Price

1 USD = INR 44.55 / 56

120 INR / USD

GBP / USD 90.20/21

GBP / USD GBP 90.20/ 21

10. CROSS RateIt is an exchange rate where neither currency is USD.

1 FRF = How many INR ?

1 USD = 43.2550 / 43.650 INR Given rate for 1 USD = 6.0500 / 6.0550 FRF Conversion

Therefore neither Base or Price Currency or price currency is in USD so this is an example of cross rate.

Short Cut For Calculating Cross RateCase I

Common Currency is in Base Side in Both Quote

Rule

Divide Across by the currency which is going to be the Base in the Cross rate.

Base

Base

Case II

Common Currency is in Price Side in Both Quote

Rule

Divide across by the currency which is going to be the Price in the Cross rate.

Price

Price

Case III

Common Currency is in Base Side as well as in Price Side

Rule We use inverse rate concept to convert this situation into either Case I or Case II

Bid Ask And Bid Ask

Square up or Square off

The Square up means taking exactly opposite transaction as compared to earlier transaction.

For e.g..

If you bought $on SPOT Basis at 10:10 Am than a square transaction at 12 PM would be to Sall $.

In this process you can make Loss or Gain as it involves Risk as the Forex market is Volatile.

11. Cover Rate :

It is IB Spot Rate at which merchant transaction is covered in the IB market.

That means if Bank Buys $ from customer in merchant transaction the cover transaction would be to Sell $ in IB market.

Base Rate :

It is an IB Spot rate (ongoing) which forms the basis for computation of merchant.

In Exam unless Specifically mentioned Cover Rate and Base Rate are same and both represent IB Spot Rate.

12. Direct Quote, Indirect Quote, American Quote & European QuoteWorld America Europe & ROW (Rest of the World)

Direct Quote or European Quote :

For one unit of Base Currency What is the Price

1 unit of FC = How many Units of HC1 Unit of $ = How many units of ROW

Indirect Quote or American Quote :

1 unit of HC = How many units of FC1 unit of ROW = How many units of $

13. Currency Appreciation Currency Depreciation ( )

Currency Revaluation Currency Devaluation ( )

Currency Appreciation/ Depreciation depends upon Market Forces like Demand and Supply.

Currency Revaluation/ Devaluation depends upon Forced Action by Regulatory Authority.

% Change in the New Value - Old Value = 100Value of currency Old Value

Always talk Appreciation or Depreciation with respect to Base Currency First.

14. Siegel ParadoxTime t=0 t=1

1 = 2$ 1 = 1.8$

% Change in value of = 1.8 -2 100 = -10% Depreciation 2

Time t=0 t=1

1$ = 1/2 1$ = 1/1.8

% Change in value of $ = .5556 -.50 100 = 11.2 Appreciation .50

As per Siegels Paradox, appreciation of one currency is not exactly equal to depreciation of another currency.

In exam, we may ignore Siegel Paradox unless specifically asked for.

All these theory are used to calculate Forward rate or Expected Spot Rate by different market parity.

i) IRP (Interest Rate Parity) Basis = Interesta) This theory tries to establish equilibrium between Forex Market and Money Market.

(Money market i.e short term interest rate instruments are bought and sold like commercial paper etc.)

Alternative 1 Time = 0 1

USA 5% 1 $ 1.05 $

Alternative 2 Time = 0 1

India 8% 40 Rs 43.2 Rs

If Exchange rate t =0 continues at t =1 alternative 2 gives more $ and hence opportunity for profit.

But as per IRP theory, the exchange rate should be 43.2 /1.05=41.1429

If this Happens there is no opportunity available for profit.

b) IRP theory is used to calculate Forward Rate (FR) For this purpose we take today's Spot Rate and today's prevailing Interest rate (from market only).

FR = SR [ 1 + rq ] rq = rate of interest of quote or price [ 1 + rb ] rb = rate of interest of Base currency

c) If IRP is not valid the arbitrage opportunity is not available.

d) FR is an exchange rate which prevail today but settlement will take place in future.

The Rate of currency of the country with high interest is lower wit respect to rate of currency of the country with low interest rate.

i) PPP (Purchasing Power Parity) Basis = Inflation

Absolute form of PPP Relative form of PPP

Relative Form of PPP :

This Form of PPP helps to compute Expected Spot Rate (further SPOT Rate). For this purpose we require today's SR and Expected Inflation Rate of the two countries.

FR = SR [ 1 + Iq ] Iq = rate of inflation of quote or price [ 1 + Ib ] Ib = rate of inflation of Base currency

16. Computation of Forward Rate and how the forward quotes are expressed.a) FR = SR + Interest Differential between two countries (Converted into amount)

b) Expression of Forward Quote :

Outright FR SWAP Point (margin) Annualized Premium or Forward Point or Discount (in %)

Outright FR : This is not directly quoted but it is derived using SR and Forward Point.

This is an Exchange rate agreed today for settlement in future.

SWAP point : It represents interest difference converted into amount or simply it is a difference between outright FR and today's Spot Rate.

SWAP Point = Rate of - Rate of SR n Quote Base 12

Annualized Premium or Discount :

This also represent Interest differences but expressed in %.

SR rq - rb or SR rq - rb 1 + rb

Exact Approx

17. International of SWAP point (or Forward Point) a) SWAP point should have similar number of digits as the Spot Rate has. (i.e. number of digits after decimal in SWAP point should be equal to number of digits after decimal Inter Rank Spot Rate)

Whenever we are calculating Forward Rate we need to incorporate adequate amount of zeros into SWAP point before adding to or subtracting from.

Remember that interpretation of SWAP point is required only when number of digits in SWAP point is less than number of digits in IB Spot rate after decimal. SWAP Value = SWAP Point 10N

b) In India SWAP points are quoted on month end basis and the quote is directly available up to 12 month. SWAP Point in India is Directly quoted for USD/INR and for Foreign Currency/INR it is derived using concept of Forward Cross Rate.

c) SWAP Point or Forward Point is not an exchange rate but it is simply an Interest Differential.

However when we adjust SWAP point with SR we get FR, which is an Exchange Rate.

d) SWAP Point or Forward Point are quoted in Cumulative Style.

18. How to adjust SWAP point to calculate Forward Rate. (whether to add or subtract SWAP Point)a) If Plus sign is attached before SWAP point than it indicates that Base currency is at premium. ADD

Similarly if Minus sign is attached before SWAP point than it indicates Discount. Deduct

b) When no sign is attached before SWAP point than we need to decide whether to add or subtract.

How to Decide ?

IB Spot Rate : L H ( Low High)

L - H SWAP Point H L This Show Base currency is This show Base currency is At premium ADD at Discount Deduct

19. Merchant Forward Rate

IB Market Buy Rate for Bank Sell Rate for Bank

IB Spot Rate Bid Side Ask Side

SWAP Point Premium/ Discount Premium/ Discount

Exchange Less AddMargin

20. How to calculate FR for Broken Period In India SWAP Point are quoted on month end basis (International it is quoted on whole month basis).

The month is called FLAT date and all dates are called broken period.

Steps for calculating FR for Broken Period:

Step 1: IB Spot Rate ( Bid Side)Step 2: SWAP point up to last month.Step 3: Broken Period SWAP Rate : Last month - Next Month SWAP Rate SWAP Rate Difference in Days

No. of days in the month

21. Arbitrage in International Financial MarketArbitration

Objective :

Risk Less Profit

Operational Issue:

Mispricing of assets either in the same market or between markets.

Buy and Sell or Sell and Buy(Same amount or Quantity)Hedging

Loss Minimization(or mitigation)

Mismatch in assets and Liability

Buy and Sell orSell and Buy(Same amount or quantity not necessary)

Speculation (trading)

Risky Profit

Simply Buy and Sell orSell or Buy

ArbitrageCurrency Market(or Forex Market)Currency Market andMoney Market

When IRP is invalid than it gives opportunity for arbitrage.

This type of arbitrage is called CIA (Covered Interest Arbitrage)Two Point ArbitrageOrLocational ArbitrageOrGeographical ArbitrageThree Point ArbitrageOr Triangular Arbitrage

Currency Market ArbitrationTwo Point Arbitration:

Example SBI BOI 1$ = 45.2030/31 Rs 1$= 45.2028/29 Rs BOI (Lowest Rate)

Bid Ask45.2028 45.2029 SBI (High Quote)

Bid Ask 45.2030 45.2031 Buy SellThis Gap Provides opportunity for Profit

This example shows that two quotes should not overlap (or simply there must be a gap between Ask rate of one bank and Bid rate of another bank.

Bid rate of one bank and Ask Rate of another bank

If More Equal Less

Than Arbitrage No Arbitrage No Arbitrage

Three Point ArbitrageStart with currency A then go to Currency B (sell A and Buy B).

Then go to currency C and finally come back to currency A

In this process if you end up more A then you started with or simply if you can produce more A at the end of arbitrage then initial investment then triangular arbitrage is possible.

1. Which currency should be chosen for initiating the arbitrage process.

The currency in which the profit is reported.

2. Which market we should refer for action. First Create Buy Position (this will be either Synthetic or quoted market)

22. Forex Risk Managementi) Forex Risk Management is about management of currency exposure.

Exchange Risk (currency risk):

Adverse movement of exchange rate. Exchange risk is nothing but deviation of actual Exchange rate with expected exchange rate).

Exchange Exposure (Currency risk):

Quantification of Risk (For magnitude or extent)

ii) Types of Risk (Exposure)

Transaction Risk

This risk arises due to Settlement of contractual transactions (assets or liability) denominated FC.

Cash is involved

This is both Accounting and Cash gain or Loss.

Translation Risk

This Risk arises due to translation of contractual transactions (asset and liability) in FC.

No cash is involved.

This involves Accounting Gain or Loss

Economic RiskOr Strategic Risk, Or Operating Risk,Or Competitive Risk.

This Risk arises due to change in exchange rate and it effects existing contractual transactions (including contingent) and all future contractual transactions.

Therefore it affects operating cash flow and hence the valuation of firm.

23. Forex Risk Management tool [Hedging tool]

MMH (Money Market Hedge)Exporter

Foreign Currency Receivable

Risk : FC Value Decreases

Balance sheet :

Liability Asset

---- Foreign CurrencyImporter

Foreign Currency Payable

Risk : FC Value Increases

Balance sheet :

Liability Asset

Foreign ---- Currency

Hedging :

Borrow Foreign Currency equivalent to the Present Value of FC to be received.

Convert FC to Home Currency

Repay Loan in FC when you receive your FC payment.

Hedging :

Borrow Home Currency equivalent to the Present Value of FC to be payable.

Convert Home Currency Borrowing to FC.

Deposit FC in the Foreign Country.

Repay FC when the date of payment become due.When IRP Theory is not valid than only Forward cover and MMH will give Different Result.

Netting Vs MatchingNetting :

Under this process payable & receivables are adjusted and net balance is settled.

As a result of this no. of transaction is reduced and hence there is saving of transaction cost.Matching : (Hedging Tool)

Under matching process receivables and payables are matched in order to decide the net forex exposure amount.

However transaction are settled separately and hence there is no transaction cost saving.

BilateralOne-to-one

One party receivable & payables with other party is adjusted and balance amount is settled.

MultilateralOne-to-many

One party receivable & payables with all other parties are adjusted and balance amount is settled.

Note 24: Forward Contract (or Currency Contract)Entering into a Forward Contract.

No Outflow takes place at t=0 except Minimum Transaction Charges.

Rate is agreed today for settlement at Future Date.

Three Information is required for calculating Forward rate for both product : SPOT Rate , SWAP Point and Exchange Margin

Hedge Exporter Sell FC today on Forward Basis

Strategy Importer Buy FC today on Forward Basis

Outright Forward Contract Contract Period 1 Year

t=0 t=1

Date of Booking Maturity Date or Expiry Date

Settlement is allowed only at t=1 (that means on particular date which is always expiry date).

If on last date settlement is not made penalty is imposed this is the only drawback to overcome which Option Forward Contract is made.

Option Forward Contract Contract Period

Option Period

t=0 t=1 t=2 Date of Booking Expiry Date1. This Product allow to settle at any day between t=1 and t=2 (that means we have range of dates rather than particular date)

2. Maximum option period as per FEDAI is One month

Pricing of Forward ContractForward Contract Option Forward Contract Spot Rate t=0 t=0

SWAP Point t=0 to t=1 Normal Treatment t=0 to t=1 SWAP Point Option Period t=1 to t=2

Exchange Margin Foreign Currency Premium Foreign Currency Discount Exporter NOT be Passed Will be Passed

Importer Will be Passed NOT be Passed As uncertainty is involved between t=1 to t=2 therefore bank will not give profit to customer but loss will be passed on.

Early Delivery, Extension & CancellationExtention : Entire amount of contract is extended for settlement on future date.

Rollover : Partial Extention Part amount is settled on due date and balance is extended for settlement for future date.

Cancellation : Settlement id cancelled.

Extension/ Rollover Cancellation of existing ContractCancellation of existing ContractSimultaneous re-booking of fresh ContractFollow normal procedure for forward contract bookingAppropriate Selling Rate by IB MarketAppropriate Buying Rate by IB MarketCancellation Rate