Foreign Exchange

What is an Exchange Rate

Depreciation and Devaluation of Currency
'Square Position or Flat Position in F E
Trading

Exchange Rate
An exchange rate is the rate at which one
currency can be exchanged for another.
In other words, it is the value of another
country's currency compared to that of own
country
Foreign exchange markets provide the facility of
exchanging different currencies.
The price of one currency in terms of another is
known as exchange rate.

 The market for foreign exchange is the

largest financial market in the world.
It is open somewhere or the other in the
world all the time such that it is said to be a
24 hours-a-day and 356 days-a-year
market.
The worldwide trading is more than a
colossal amount of US $1.5 trillion per day.
While London is the world's largest
foreign exchange trading centre, New York
is the largest trading centre in the USA

Exchange Rate Regimes

The exchange rate regime is the way a
country manages its currency in respect to
foreign currencies and the foreign exchange
market.
The foreign exchange market exists
wherever one currency is traded for another.
It is by far the largest market in the world,
in terms of cash value traded, and includes
trading between large banks, central banks,
currency speculators, multinational
corporations, governments, and other
financial markets and institutions

Foreign Exchange Markets

Overview
Foreign exchange (FX) markets - markets in which
cash flows from the sale of products or assets
denominated in a foreign currency are transacted
Foreign exchange rate - the price at which one
currency can be exchanged for another currency
Foreign exchange risk - risk that cash flows will
vary as the actual amount of U.S. dollars received
on a foreign investment changes due to a change in
FX rates
Currency depreciation/appreciation - when a
countrys currency falls/rises in value relative to
other currencies

 Depreciation and devaluation are two economic

events that deal with the value of your country's
currency.
However, they have two different causes and
long-term effects on your country's economy.
Depreciation happens in countries with a floating
exchange rate

Devaluation happens in countries with a fixed exchange rate. In a

fixed-rate economy, the government decides what its currency
should be worth compared with that of other countries. The
exchange rate can change only when the government decides to
change it.

Evolution of Indian ForexMarket

Market players in forex became active in the
seventies, consequent upon the collapse of
Bretton Woods Agreement
In 1978, RBI allowed banks to undertake intraday trading in foreign exchange and as a
consequence, the stipulation of maintaining
`square' or `near square' position was to be
complied with only at the close of business hours
each day. This was the beginning of forex market
in India.

 During the period, 1975-92 the exchange

rate regime in India was characterised by
daily announcement by the RBI of its buying
and selling rates to Authorised Dealers (ADs)
for merchant transactions
RBI performed a market-clearing role on a
day-to-day basis, which naturally introduced
some variability in the size of reserves.
Certain categories of current and capital
account transactions on behalf of the
Government were directly routed through
the reserves account

 Functions
1. Transfer of funds or Purchasing power
from one currency and nation to another
2. Minimize foreign exchange risk
Four level of participants
1. Tourists 2. C. B.
3. F. E. Brokers 4. Central Banks

The Foreign Exchange Rates

The exchange rate (R) between the dollar and the pound
is equal to the number of dollars needed to purchase
one pound. That is R = $ /. For example, if R = $/=2,
this means that two dollars are required to purchase one
pound.
SR , FR
Spot transactions refer to the transactions involving sale
and purchase of currencies for immediate delivery.
Currency forward contracts are settled on a future date
even though the forward rates are quoted at present
moment (or today). They are quoted just like spot rate
but actual delivery of currencies takes place much later

SPOT EXCHANGE MARKET

Spot market is the market where transactions of buying and selling are done for
immediate delivery. In real practice, cash settlement is made after two working
(business) days, excluding holidays. In some cases, it takes less than two days also.
For example, the trades between US dollar and Canadian dollar or Mexican peso are
settled in one day.
London market is the first market not only in terms of volume but also in terms of the
number of currencies traded there. The most significant currencies in terms of volume
of their trade are dollar, yen, euro, UK pound and Swiss franc.
The spot exchange market is an over-the-counter (OTC) market. This
market is a worldwide linkage of currency traders, non-bank dealers, foreign
exchange brokers who are connected to one another via a network of
telephones, computer terminals and automated dealing systems. The largest
vendors of quote screen monitors used in the currency trading are Reuters,
Bloomberg etc

FORWARD RATE AND

FORWARD MARKET
If the exchange of currencies takes place after
some period from the date of the deal, it is a
deal in forward market. In other words, forward
rate is the price of one currency against another
to be settled on a future date. Though the rate is
contracted today, settlement would take place on
a future date. The forward rate, once contracted,
will be valid for settlement irrespective of the
actual spot rate on the maturity date of the
forward

 F E Quotation
Is the price of a currency expressed in
units of another currency
FD = FR < SR
FP = FR > SR

Premium, Discount
SR =$ 0.8576
FR =$0.8500
For a 90 day contract
Prem or Dis = FR-SR * 4 * 100
SR
FD = 0.8500 - 0.8576 * 4 * 100
0.8576
= 3.54%

 Depreciation refers to an increase in the

domestic price of the foreign currency.
Appreciation refers to a decline in the
domestic price of the foreign currency.
An appreciation of the domestic currency
means a depreciation of the foreign
currency and vice versa.

 European terms, the rate is quoted in terms of

the number of units of the foreign currency for
one unit of the domestic currency. This is called
an indirect quote.
The alternative method, called the American
terms, expresses the home currency price of
one unit of the foreign currency. This is called a
direct quote
Currency
Direct quote
Indirect quote
Pound sterling
US dollar

71.479
46.700

.0139
.0214

Arbitrage
If the dollar price of pounds were $1.98 in New
York and $2.01 in London, an arbitrager (usually
a commercial bank or a foreign exchange
dealer) would purchase pounds at $1.98 in New
York and immediately resell them in London for
$2.01, thus realizing a profit of $0.03 per pound.
If the transaction involved 1 million, the profit
would be $30,000 for only a few minutes work

Bid Offer in FE quotations

A foreign exchange trader gives the
following quotes for the Belgian franc
spot, one month, three months and
six months to a US based treasurer
$0.02368/70
4/5 8/7 14/12
Calculate the outright quotes for one,
three and six months forward.

 1st Month: Since first (buy quote) is less

than the second (sell quote) currency is
trading at a premium. Hence points are
added to the spot rate
3rd Month: Since first (buy quote) is
greater than the second (sell quote)
currency is trading at a discount. Hence
points are deducted from the spot rate
6th Month: Since first (buy quote) is
greater than the second (sell quote)
currency is trading at a discount. Hence
points are deducted from the spot rate

BID (Buy)
ASK (Sell)
US $ per 1 Belgian Franc
Spot rate $ 0.02368 $ 0.02370
1 Month $ 0.02372
$0.02375
3 Month $ 0.0236
$0.02363
6 Month $ 0.02354 $ 0.02358
US $ per 1 Belgian Franc

Interest Arbitrage
Interest arbitrage refers to the international
flow of short-term liquid capital to earn a
higher return abroad. Interest arbitrage
can be covered or uncovered.
UNCOVERED INTEREST ARBITRAGE
If the interest rate on three-month treasury
bills is 13 per cent at an annual basis in
Germany and 18 per cent in London.
COVERED INTEREST ARBITRAGE

INTEREST RATE PARITY

THEORY
The Interest Rate Parity Model states:
That in equilibrium the forward rate on a foreign currency will be equal to,
but opposite in sign to, the difference in the interest rates associated with
the two currencies in the transaction.
In case interest rate differential does not equal the forward premium or
discount.
Covered Interest Arbitrage Occurs.
Mechanism
Funds will move to a country with a more attractive rate.
As one currency is more demanded spot and sold forward.
Inflow of fund depresses interest rates.
Parity eventually reached.

Covered Interest Arbitrage

Covered interest arbitrage results when an investor can secure a
higher covered
return on a foreign investment compared to return in the investors
home market.
Example:
1 year interest rate in U.S. is 4%
1 year interest rate in India is 7%
Assume the Indian Rupee 1 year forward rate is trading at a
discount of 2%.
In this case, a U.S. investor could invest in India,
And cover (sell India Rupee forward) and
Obtain a riskless return of 5% (7% - 2%)
Which is 100 basis points greater than investing at home in
the U.S. (5% versus 4%)
This is covered interest arbitrage: earning more (when
covering) than the rate at home.

Covered Interest Arbitrage

(Contd.)
If the forward rate is not priced correctly, the
chance of covered interest arbitrage exists.
As the market participants take advantage of
covered interest arbitrage opportunities, market
maker banks will respond and restored
equilibrium through adjustments in their forward
rate quotes.
Market makers will adjust the 1 year forward
discount on INR to 3%, thus
Producing a covered INR investment equal to the
U.S. investment (i.e., both at 4%).
US rate = 4%; INR covered = 4% = 7% - 3%
The cost of the forward is equal, but opposite in
sign, to the interest rate differential.

Question
1. Spot Rate: Rs 42.0010 = $1
6 month forward rate: Rs 42.8020 = $1
Annualized interest rate on 6 month rupee : 12
per cent
Annualized interest rate on 6 month dollar: 8 per
cent.
Calculate the arbitrage possibilities
Solution: The rule is that if the interest rate
differential is greater than the premium or
discount, place the money in the currency that
has a higher rate of interest or vice-versa.

 Negative interest rate differential = (12

8) = 4%
Forward Premia (annualized)
= FR-SR * 12 * 100
SR
6
42.8020 - 42.0010 * 12 * 100 = 3.8141%
42.0010
6
As the negative interest rate differential >
forward premia, there is a possibility of
arbitrage inflow in India.

 Evaluate the arbitrage possibility for an

investment of $1000 by taking a loan @ 8% in
US. An arbitrageur would invest in India at the
spot rate of Rs 42.0010 @ 12% for six months
and cover the principal + interest in the six
month forward rate
The arbitrageur gains ($1,040.16 - $1,040) =
$0.16 on borrowing $1,000 for six months.