Forex Notes on basics of it

8/11/2019 Forex Notes on basics of it

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Basic Concept

1.Foreign Exchange Market- The Foreign exchange market is a large,

growing and liquid financial market that operates 24 hours a day. It

is not a market in the traditional sense because there is no central

trading location or exchange".

2.Exchange Rate- The value of one currency expressed in terms of

another. For example, if EUR/USD is 1.3200, 1 Euro is worth

US$1.3200.

3.Currency Pair- The two currencies that make up an exchange rate.

When one is bought, the other is sold, and vice versa.

4.Spot Market- The market for buying and selling currencies at the

current market rate.

5.Base Currency- The first currency in the pair. Also the currency your

account is denominated in.

6.Counter Currency- The second currency in the pair i.e the terms

currency.

7.

Currency Pair Terminology

EUR/USD = "Euro"

USD/JPY = "Dollar Yen"

GBP/USD = "Cable" or "Sterling"

USD/CHF = "Swissy"


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USD/CAD = "Dollar Canada

AUD/USD = "Aussie Dollar"

NZD/USD = "Kiwi"

8.Bid Price- The quote is displayed on the left and is the price at

which you can buy one unit of the base currency.

9.Ask Price- The quote is displayed on the right and is the price at

which you can sell one unit of the base currency.

10.

Spread -The difference between the sell quote and the buy

quote or the bid and offer price.

11. Pip- The smallest price increment a currency can make. Also

known as points.

12. Direct Quote- A foreign exchange which represent a relationship

between a fixed number of units of foreign currency against

variable number of units of domestic currency.

1USD=INR59.35 is a directquote in India

13.

Indirect Quote- A foreign exchange which represent a

relationship between a fixed number of units of domestic currency

against variable number of units of foreign currency.

1 INR = 0.0168481 USD is a directquote in India


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14. Cross Rate- The exchange rate between two currencies that are

not the official currencies of the country that the exchange was

quoted in. Cross rates usually do not involve the U.S. dollar. The

cross rate is the exchange rate between currency A and currency C

derived from actual exchange rate between currency A and

currency B and between currency B and currency

15. Two-Way Quote- A type of quote that gives both the bid and the

ask price of a security, informing would-be traders of the current

price at which they could buy or sell the security.

16. Fiat money- Any money declared by a government to be legal

tender

17. Vehicle Currency- The currency used to invoice an international

trade transaction, especially when it is not the national currency of

either the importer or the exporter.

18. Vostro Account- Account held by a foreign bank in a domestic

bank is called Vostro account. A Vostro is our account of your

money, held by us.

For example Bank A(Barclays Bank of UK) opening an account

in Bank B(ICICI Bank of India), this is Vostro account for Bank B(ICICI

Bank of India).


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19. Nostro Account

Account held by a particular domestic bank in a foreign bank is

called Nostro account. A Nostro is our account of our money, held

by you.

Here in the above example given in Vostro account the same

account is a Nostro account for Bank A(Barclays Bank of UK),

20.

Loro Account- An account held by a domestic bank in itself on

behalf of a foreign A Loro is our account of their money, held by

you. Loro account is a record of an account held by a second bank

on behalf of a third party

The Loro account is an account wherein a bank remits funds in

foreign currency to another bank for credit to an account of a third

bank.

Ch.1

Meaning of International Trade

International business means carrying on business activities beyond

national boundaries.


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The exchange of goods and

services among individuals and businesses in multiple countries.

A specific entity, such as a multinational corporation or international

business company that engages in business among multiple countries.


Capital

Goods

Services

Technology

Skilled labour


Production of physical goods

Provision of services

Banking

Finance,

Insurance,

Construction,

Trading

Foreign investment, Foreign Direct Investment


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Objectives of International Trade

Improved Sale and Profitability

Risk Diversification

Economy of Scope and Scale

Competition and Survival

Global Branding

Multinational Companies

An enterprise operating in several countries but managed from one

(home) country.

A corporation that has its facilities and other assets in at least one

country other than its home country.

Such companies have offices and/or factories in different countries.

They have a centralized head office where they co-ordinate global

management.

Features of Multinational Companies

Huge business enterprises operating in many countries.

Large resources and Potential.

Extend production, marketing and management to host countries.

Centralized ownership and control.

Multinational stock ownership.


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Reasons for growth of Multinational Companies

Limited Scalability in domestic market.

Cost Advantage.

Indian Expertise.

Government Policies.

Social Environment.

Examples of Multinational Companies

Tata Motors.

Infosys.

Tata Consultancy Services.

Ranbaxy Laboratories Ltd.

Asian Paints.

Dr. Reddys Laboratories Ltd.

Bharat Forge.

Theory of Comparative Advantage

Assumptions

There are no transport costs.

Costs are constant and there are no economies of scale.

There are only two economies producing two goods.

The theory assumes that traded goods are homogeneous.


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Factors of production are assumed to be perfectly mobile within a

country but no movement internationally.

There are no tariffs or other trade barriers.

Theory of Comparative Advantage

Comparative advantages and the mutually beneficiary exchanges

between countries

In one year, England requires labor of 100 men to produce cloth and

120 men to make wine.

Whereas, Portugal requires only the labor of 80 men to produce cloth

and 90 men to make wine.

The two countries must acquire their respective benefit if theyexchange production with each other on the basis of comparative

advantage.


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Portugal has its comparative advantages in the wine industry while

England could be considered to be comparatively advantageous in thecloth industry.

For the country enjoying overall advantages in the both industries,

choose one in which it is comparatively more advantageous, while for

the other country with overall disadvantages in the both industries,

choose one in which it is comparatively less disadvantageous.

A country enjoys a comparative advantage in the production of a good

when that good can be produced at a lower cost in terms of other

goods.


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For the country enjoying overall advantages in the both industries,

choose one in which it is comparatively more advantageous, while for

the other country with overall disadvantages in the both industries,

choose one in which it is comparatively less disadvantageous.

Gains from Comparative Advantage

When countries specialize in producing the goods in which they have a

comparative advantage, they maximize their combined output and

allocate their resources more efficiently.

Methods of International Business

International Trade

Licensing

Franchising Joint Ventures

Acquisitions

Foreign Subsidiaries

Ch3

Foreign Exchange Dealings


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Features of Forex market

Decentralized interbank market

Online Trading

24-Hour Market

High liquidity

Lower trading costs

Geographical dispersion

Market Participants of Forex market

Banks

Financial Institutions

Central Bank

Brokers

Hedgers

Investment Management Firms

Consumers and

Travellers

Businessmen

Types of Orders

Market Order

Limit Order


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Stop Order

Once Cancel the Order (OCO)

If Done Order

Chpt.5 Forex Spot and Forward

Types of Currency Markets

Spot Market

Forward Market

Types of Currency Markets

Spot Market:

- immediate transaction

- recorded by 2nd

business day

Forward Market:- transactions take place at a specified future date

FORWARD MARKET

Definition of a Forward Contract:

An agreement between a bank and a customer to deliver a specified amou

of currency against another currency at a specified future date and at a fix

exchange rate.

Purpose of a Forward:

Hedging:


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Act of reducing exchange rate risk.

Forward Rate Quotations

Two Methods:

Outright Rate: quoted to commercial customers.

Swap Rate: quoted in the interbank market as a discount or premium.

CALCULATING THE FORWARD PREMIUM OR DISCOUNT

= F-S x 12 x 100

S n

where F = the forward rate of exchange

S = the spot rate of exchange

n = the number of months in the forward contract

Forward Contract Maturities

30-day

90-day

180-day

360-day


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Forward Market Players

Forward Market Players

Arbitrageurs

Traders

Hedgers

Speculators

Arbitrageurs

A forex strategy in which a currency trader takes advantage of different

spreads offered by brokers for a particular currency pair by making trades

Different spreads for a currency pair imply disparities between the bid and

prices.

Currency arbitrage involves buying and selling currency pairs from differen

brokers to take advantage of this disparity.

Traders

The act of buying and selling foreign currencies.

Currency trading is most often engaged in by banks and other institutions

the purposes of international trade.

Individual investors may engage in currency trading as well, attempting to

benefit from variations in exchange rates of the currencies.


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Hedgers

Currency hedging is the act of entering into a financial contract in order to

protect against unexpected, expected or anticipated changes in currency.

It is used by financial investors and businesses to eliminate risks they

encounter when conducting business internationally. Hedging limits the

impact of foreign exchange rate risk.

Speculators

A person who trades derivatives, commodities, bonds, equities

or currencies with a higher-than-average risk in return for a higher-than-

average profit potential.

Speculators take large risks, especially with respect to anticipating future

movements, in the hope of making quick, large gains.

Chpt.6 Arbitrage in Forex markets

Meaning of Arbitrage

A forex strategy in which a currency trader takes advantage of different

spreads offered by brokers for a particular currency pair by making trades

Different spreads for a currency pair imply disparities between the bid an

ask prices.


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Currency arbitrage involves buying and selling currency pairs from

different brokers to take advantage of this disparity.

A trading strategy that is used by forex traders who attempt to make a

profit on the inefficiency in the pricing of currency pairs.

Types of Arbitrage

Geographical

Triangular

Geographical Arbitrage

Geographical arbitrage is possible when a banks buying price (bid price) i

higher than another banks selling price (ask price) for the same currency.

Example: Bid Ask

Bank C NZ$ $.635 $.640

Bank D NZ$ $.645 $.650

Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit =

$.005/NZ$.

Triangular arbitrage


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Triangular arbitrage is possible when a cross exchange rate quote differs

from the rate calculated from spot rates.

Example: Bid Ask

/$ 1.60 1.61

MYR/$ 0.200 0.202

/MYR 8.1 8.2

Buy @ $1.61, convert @ MYR8.1/, then sell MYR @ $.200. Profit =

$.01/. (8.1.2=1.62)

Chpt.11 Risk and Exposure

Foreign Exchange Risk

Foreign exchange risk (also known as FX risk, exchange rate risk or

currency risk) is a financial risk that exists when a financial transaction is


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denominated in a currency other than that of the base currency of the

company.

Foreign-exchange risk is the risk that an asset or investment denominated

in a foreign currency looses value as a result of unfavourable exchange

rate fluctuations between the investment's foreign currency and the

investment holder's domestic currency.

Types of Foreign Exchange Risk

Transaction risk

Position Risk

Credit Risk

Liquidity/ Mismatch risk

Operational Risk

Sovereign/ Political/ Country Risk

Cross Country Risk

Transaction risk


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Transaction risk is the risk that a company will incur losses in a

transaction comprising multiple currencies due to exchange rate

movements.

The exchange rate risk associated with the time delay between entering

into a contract and settling it. The greater the time differential between

the entrance and settlement of the contract, the greater the transaction

risk, because there is more time for the two exchange rates to fluctuate.

Transaction risk creates difficulties for individuals and corporations dealin

in different currencies, as exchange rates can fluctuate significantly over a

short period of time. This volatility is usually reduced, or hedged, by

entering into currency swaps and other similar securities.

Position Risk

In investing, any trade that has been established, or entered, that has yet

to be closed with an opposing trade involves position risk.

An open position can exist following a buy (long) position, or a sell (short)

position. In either case, the position will remain open until an opposing

trade has taken place.


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Probability of loss associated with a particular trading (long or short)

position due to price changes.

Any investment that has been entered into but not closed.

For example, an investor who is long 100 shares of INTC has an open

position until an order to sell those 100 shares has been placed and filled.

Credit Risk Credit risk refers to the risk that a borrower will default on any type of

debt by failing to make required payments. The risk is primarily that of the

lender and includes lost principal and interest, disruption to cash flows,

and increased collection costs.

The risk of loss of principal or loss of a financial reward stemming from a

borrower's failure to repay a loan or otherwise meet a contractual

obligation.

Investors are compensated for assuming credit risk by way of interest

payments from the borrower or issuer of a debt obligation.

Liquidity/ Mismatch risk


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Liquidity risk is the risk that a given security or asset cannot be traded

quickly enough in the market to prevent a loss (or make the required

profit).

A category of risk that refers to the possibility that a swap dealer will be

unable to find a suitable counterparty for a swap transaction for which it i

acting as an intermediary.

Operational Risk

Operational risk is defined as the risk of loss resulting from inadequate or

failed processes, people and systems or from external events.

A form of risk that summarizes the risks a company or firm undertakes

when it attempts to operate within a given field or industry.

It is the risk remaining after determining financing and systematic risk, and

includes risks resulting from breakdowns in internal procedures, people

and systems.

Sovereign / Political/ Country Risk


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The risk that a government will either default on its obligations or will

impose regulations restricting the ability of issuers in that country to meet

their obligations, such as foreign currency restrictions.

The risk that a foreign central bank will alter its foreign-exchange

regulations thereby significantly reducing or completely nulling the value

of foreign-exchange contracts.

The risk that an investment's returns could suffer as a result of political

changes or instability in a country.

Instability affecting investment returns could stem from a change in

government, legislative bodies, other foreign policy makers, or military

control.

Cross Country Risk

A collection of risks associated with investing in a foreign country.

These risks include political risk, exchange rate risk, economic risk,

sovereign risk and transfer risk, which is the risk of capital being locked up

or frozen by government action.

Country risk varies from one country to the next. Some countries have

high enough risk to discourage much foreign investment.


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Foreign Exchange Exposure

Foreign exchange exposure is the possibility that a firm will gain or

lose because of changes in exchange rates.

Foreign exchange risk is the risk of loss due to changes in the

relative value of world currencies.

There are three types of Foreign Exchange Exposures:

A Translation Exposure

B Economic Exposure

C Transaction Exposure

Types of foreign exchange exposure

Transaction Exposuremeasures changes in the value of outstanding

financial obligations due to exchange rate changes.

Translation Exposurealso calledAccounting Exposure, is the changes in

owners equity because of the need to translate financial statements of

foreign subsidiaries into a single reporting currency for consolidated

financial statements.


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Economic Exposurealso called Operating Exposure,measures the

change in the present value of the firm resulting from any change in

expected future operating cash flows caused by an unexpected change in

exchange rates.

Conceptual Comparison of Foreign Exchange

Exposure


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Transaction Exposure

Transaction exposure measures changes in the value of

outstanding financial obligations incurred prior to a change

in exchange rates but not due to be settled until after the

exchange rates change.

Thus, this type of exposure deals with changes in cash flows

the result from existing contractual obligations.


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Transactions exposure results from particular transactions

such as an export where a known cash flow in a given

currency will take place at a certain date

Transaction Exposure

Transactions exposure arises when a company must pay

or receive a foreign currency at an unknown future

exchange rate

It is contractual

It affects the income statement

It can often be hedged directly using forwards, futures or

currency options.

Translation Exposure

Translation exposure, also calledAccounting exposure, is the

potential for changes in owners equity to occur because of

the need to translate foreign currency financial

statements of foreign subsidiaries into a single reporting

currency to prepare worldwide consolidated financial

statements.


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Results from the need of a global firm to consolidated its

financial statements to include results from foreign

operations.

oConsolidation involves translating subsidiary financial

statements from local currencies (in the foreign

markets where the firm is located) to the home

currency of the firm (i.e., the parent).

o

Consolidation can result in either translation gains or

translation losses.

Translation Exposure

Translation or accounting exposure results from the way

accounting conventions dictate that a companys foreign

assets and liabilities should be booked.

Economic Exposure

Economic Exposure, also called Operating Exposure,

measures the change in the present value of the firm


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resulting from any change in future operating cash flows

of the firm caused by an unexpectedchange in exchange

rates.

This is a long term foreign exchange exposure resulting

from a previous FDI location decision.

Over time, the firm will acquire foreign currency

denominated assets and liabilities in the foreign country.

The firm will also have operating income and operating

costs in the foreign country.

Economic exposure impacts the firm through contracts

and transactions which have yet to occur, but will, in the

future, because of the firms location. Economic exposure can have impacts on a global firms

competitive position and on the market value of that firm.

Economic Exposure

oChange in the economic value of the firm resulting from

unanticipated exchange rate changes.

Booked vs. anticipated transactions


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Expected vs. unexpected changes; the "cost of hedging"

Exposure and the parity assumptions: "We are not exposed

in the long run"

Currency of denomination vs currency of determination;

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Forex Notes on basics of it