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The foreign exchange (currency

or forex or FX) market exists
wherever one currency is traded
for another. It is the largest and
most liquid financial market in the
Basic forms of Exchanging


When two parties exchange one currency

for another the transaction is called an
When two parties agree to exchange and
re-exchange (in future) one currency for
another, it is called a swap.
Foreign Exchange in Spot and
Spot: Foreign exchange spot trading is
buying one currency with a different
currency for immediate delivery. The
standard settlement convention for
Foreign Exchange Spot trades is T+2
days, i.e., two business days from the
date of trade execution.
Forward Outright: A foreign exchange
forward is a contract between two
counterparties to exchange one
currency for another on any date after
spot. In this transaction, money does
not actually change hands until some
Base Currency / Terms
In foreign exchange markets, the base
currency is the first currency in a
currency pair.
The second currency is called as the
terms currency.
Exchange rates are quoted in per unit
of the base currency.
E.g. the expression Dollar Rupee,
tells you that the Dollar is being quoted
in terms of the Rupee. The Dollar is the
base currency and the Rupee is the
terms currency.
Exchange rates are constantly
changing, which means that the value
of one currency in terms of the other is
constantly in flux.
Changes in rates are expressed as
strengthening or weakening of one
currency vis--vis the second currency.
Changes are also expressed as
appreciation or depreciation of one
currency in terms of the second
Functions of Forex Market
Transfer of funds from one nation &
currency to another.
Why exchange?
# Import & Export of goods
# Import & Export of services
# Tourism
# Investment
Eg. A US commercial bank has
oversupply of pounds, then sell excess
pounds, then finally a nation pays for its
tourist exp. imports, investments etc.
Participants in Forex
Level 1:
Tourists, importers, exporters,
investors- immediate users &
suppliers of foreign currencies.
Level 2:
Commercial banks- they act as
clearing houses between users and
earners, do not actually buy & sell-
Retail market
Participants in Forex
Level 3:
Forex brokers- They deal with
commercial banks.
Level 4:
Nations central bank:
Act as Lender/ Buyer of last resort-
Interbank market/ wholesale
Entities in Forex market
Authorised dealers-are commercial
Money changers- Buy/ sell form
customers- deal in notes, coins and
travelers cheque.

FEDAI- Forex Dealers Association

of India
What are Swaps.?
A foreign exchange swap is a
simultaneous purchase and sale, or vice
versa, of identical amounts of one
currency for another with two different
value dates.
The two currencies are initially
exchanged at the Spot Rate and are
exchanged back in the future at the
Forward Rate.
The Forward Rate is derived by
adjusting the Spot rate for the interest
rate differential of the two currencies
for the period between the Spot and the
Forward date.
FX Swaps are commonly used as a way
to facilitate funding in the cases where
funds are available in a different
currency than the one needed.
Derivatives means

Derivative is a product whose value is

derived from the value of one or more
basic variables, called bases (underlying
asset, index, or reference rate), in a
contractual manner.

The underlying asset can be equity,

foreign exchange, commodity or any
other asset.

Growth Driving Factors

Increased Development of
Volatility Sophisticated
Increased Innovations in tools
Integration Derivatives market

Improvement in
Communication system
Derivatives Product

Explanation of various
Derivatives products:
Forwards: A forward contract is a customized
contract between two entities, where
settlement takes place on a specific date in the
future at today's pre-agreed price.
Futures: A futures contract is an agreement
between two parties to buy or sell an asset at
a certain time in the future at a certain price.
Futures contracts are special types of forward
contracts in the sense that they are
standardized exchange traded contracts.
Options: Options are of two types
- calls and puts. Calls give the
buyer the right but not the
obligation to buy a given quantity
of the underlying asset, at a given
price on or before a given future
date. Puts give the buyer the right,
but not the obligation to sell a
given quantity of the underlying
asset at a given price on or before
a given date.
Swaps: Swaps are private agreements
between two parties to exchange cash flows in
the future according to a prearranged formula.
They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping

only the interest related cash flows between
the parties in the same currency.

Currency swaps: These entail swapping both

principal and interest between the parties, with
the cash flows in one direction being in a
different currency than those in the opposite
Currency future is a contract to
exchange one currency for another
currency at a specified date and a
specified rate in the future
The buyer and the seller lock
themselves into an exchange rate
for a specific value or delivery
date. Both parties of the futures
contract must fulfill their
obligations on the settlement date
Settlement of Currency
Currency futures can be cash
settled or settled by delivering the
respective obligation of the seller
and buyer
All settlements however, unlike in
the case of OTC markets, go
through the exchange.
Calculation of Profit &
Loss in Currency Futures
Currency futures are a linear product, and
calculating profits or losses on Currency
Futures is similar to calculating profits or
losses on Index futures.
In determining profits and losses in futures
trading, it is essential to know both the
contract size (the number of currency units
being traded) and also what is the tick value.
A tick is the minimum trading increment or
price differential at which traders are able to
enter bids and offers.
Spot price: The price at which an asset
trades in the spot market. In the case of USD
INR, spot value is
T + 2.
Futures price: The price at which the futures
contract trades in the futures market.
Contract cycle: The period over which a
contract trades. The currency futures contracts
on the NSE have one-month, two-month,
three-month up to twelve-month expiry cycles.
Hence, NSE will have 12 contracts outstanding
at any given point in time.
Value Date/Final Settlement Date: The last
business day of the month will be termed the
Value date / Final Settlement date of each
Expiry date: It is the date specified in the
futures contract. This is the last day on which the
contract will be traded, at the end of which it will
cease to exist. The last trading day will be two
business days prior to the Value date / Final
Settlement Date.
Contract size: The amount of asset that has to
be delivered under one contract. Also called as
lot size. In the case of USDINR it is USD 1000.
Basis: In the context of financial futures, basis
can be defined as the futures price minus the
spot price. In a normal market, basis will be
positive. This reflects that futures prices
normally exceed spot prices.
Cost of carry: The relationship between
futures prices and spot prices can be
summarized in terms of what is known as the
cost of carry. This measures (in commodity
markets) the storage cost plus the interest that
is paid to finance or carry the asset till
delivery less the income earned on the asset.
For equity derivatives carry cost is the rate of
Types of Margins.
Initial margin: The amount that must be deposited in
the margin account at the time a futures contract is first
entered into is known as initial margin.
Marking-to-market: In the futures market, at the end
of each trading day, the margin account is adjusted to
reflect the investor's gain or loss depending upon the
futures closing price. This is called marking-to-market.
Maintenance margin: This is somewhat lower than
the initial margin. This is set to ensure that the balance
in the margin account never becomes negative. If the
balance in the margin account falls below the
maintenance margin, the investor receives a margin call
and is expected to top up the margin account to the
initial margin level before trading commences on the
next day.
Advantages of futures

Advantages of
y and
Elimination Standardized platform
of Access to all products
Counterparty types of
credit risk market
Limitations of Futures

Of futures

Lack of High Cost

Features of Forex Market
1. Location
Forex market is described as OTC-as
there is no physical place of trading.
Informal arrangements between banks
and brokers connected to each other by
telephone and satelleite network.
Wholesale segment- Is between banks.
Retail customers between banks and
their customers.
RBIs policy- to decentralise exchange
2. Size of the market
Worlds largest
Avg daily turnover in April 2004- USD 1.9
Largest forex market is London, followed
by New York, Tokyo, Zurich and Frankfurt.
The Rupee is involves in only 0.3% of the
transactions taking place in world forex
Leading currencies of the world are: US
Dollar, Pound-sterling, Euro, Japanese yen
and Swiss franc.
3. 24 Hour Market
The markets are situated throughout
different time zones of the globe in such
a way that when one market is closing
the other is beginning its operations.
Major markets are situated in Sydney,
Tokyo, Zurich, Hong Kong, Chicago and
Los Angeles.
In India, the market is open for the time
the banks are open for their regular
banking business. No transactions take
place on Saturdays.
4. Efficiency
Developments in communication
have largely contributes to the
efficiency of the market.
5. Currencies Traded
In most of the markets, the US
dollar is the vehicle currency, i.e.
the currency used to denominate
international transactions.
US dollar is involved as one of the
currencies in 87% of the
transactions followed by Euro
(37%), Japanese yen (20%) and
Pound Sterling (17%).
Corporates- They operate by
placing orders with the commercial
banks. They form the retail
segment of the forex market.
Commercial Banks- Major players-
work for themselves and for their
Exchange Brokers- They facilitate
deals between banks. In the
absence of exchange brokers,
banks have to contact each other
for quotes. Exchange brokers
ensure that the most favourable
quotation is obtained at low cost in
terms of money and time.
Central Bank
Transactions in inter bank
Forex market is a market where
currencies are traded. Any trading
has two aspects: Purchase and
In currencies market, the standard
practice in the market is to
interpret the transaction from the
perspective of the market maker
(quoting bank) who is the price
Transactions in inter bank
Two points to be kept in mind:
The transaction is always talked of
from the quoting banks point of view,
The item referred to is the foreign
Transactions in inter bank
Foreign Exchange Transaction


Quoting Bank Quoting Bank

Acquires Acquires Parts with

Parts with
Foreign Home Foreign
currency currency currency

Sale and Purchase Transactions

Types of Transactions
Spot transactions
Forward transactions
Non- deliverable forwards
Quotations in inter bank
Two way quotation:
It means that the rate quoted by the bank
(market Maker) will indicate two prices,
one at which it is willing to buy the
foreign currency, and the other is at
which it is willing to sell it.
For ex: USD 1 = Rs. 46.1525/1650 or
Here, the buying rate is also called bid
rate and the selling rate is called ask
rate / offer rate.
Exchange Rate
1. Direct quote:
No. of units of home currency for
one unit of foreign currency.

eg. Rs 50/ $, means that 50

rupees are required to buy one
unit of foreign currency/ dollar.
Exchange Rate
2. Indirect quote:
No. of units of foreign currency required to
buy one unit of home currency. i.e. for
one unit of home currency, how many
units of foreign currency is required?
eg. $0.02/ Rs 1, means that 0.02 dollars
are required to buy one unit of home
currency/ rupees.
FF 0.1462/ Rs 1, 0.1462 French Franc per
The Foreign Exchange
Definition- An exchange rate
quotation is the price of a
currency stated in terms of
For eg. Rs 50/ $
This means that price of one dollar
is Rs 50.
It is like quoting the price of a

The Foreign Exchange
Suppose there are two nations: US
and UK and the exchange rate is R.

R=2, i.e. R= 2 $/
R= $/ = 2
i.e. 2 dollars are required to buy
one pound.
The Foreign Exchange
X axis- Quantity of
Y axis- exchange
rate i.e. R
R= $/
Lower exchange rate:
a) fewer dollars will be required to
purchase one pound.
b) It will be cheaper for US to import
funds from UK.
c) Better for us to invest in UK.
Therefore, Demand for pound
Higher exchange rate:
a) Uk gets more dollars for pound.
b) They find UK goods to be cheaper.
c) They find investing in US

Therefore, Supply of pound in US

If exchange rate becomes 3, i.e.
R= 3 $/ , means that now three
dollars are required to buy a pound
thus, depicting Depreciation of US
If exchange rate becomes 1, i.e.
R= 1 $/ , means that now one
dollar is required to buy a pound
thus, depicting Appreciation of US
Factors that affect the
Equilibrium Exchange Rate
1. Relative inflation rates- Eg. R= 2$ / , If
inflation in US in higher than in UK, then
US goods will be costlier than that of UK
goods and therefore, UK will export
more goods to US and US will export
less goods to UK.
This means that value of Dollar has

Depreciated w.r.t. Pounds, or

Value of Pounds has Appreciated w.r.t.

US dollars.
Factors that affect the
Equilibrium Exchange Rate
2. Relative interest rates
If real interest rates of US are higher

than that of UK, then the dollar is said

to have appreciated as compared to
Real interest rate = Nominal interest

rate -
If interest rate of US > int. rate of UK

(because of inflation, then wrong

Factors that affect the
Equilibrium Exchange Rate
3. Relative economic growth rates:
Strong economic growth- attract


4. Political & Economic risk:

High risk currency- more valuable
Numerator and
The higher fraction is supposed to
be the numerator and the
Denominator corresponds to its
lower part.
Eg. EUR / USD,
EUR is the basic currency
(Numerator) & USD is the counter
currency (Denominator).
Buying and selling a
Buy/ Long EUR/ USD, means that
you want to buy EUR and sell USD.

Sell / Short EUR/ USD, means that

you want to sell the basic currency
and buy the counter currency i.e.
sell EUR and buy USD.

Short sell
Bid and Ask Rates
A bank is ready to buy and sell a
currency at different prices.
Buy price- Bid rate
Sell price- Ask rate
Spread- Difference between Bid and Ask
rate is called Bid- ask Spread.
It is more in retail market and less in
interbank market as there is more
volume, greater liquidity and lower
counterparty risk in interbank
Causes of spread are:
Transaction cost
Return on capital employed
Reward / Compensation for taking

Mid rate- Arithmetic mean of bid

and ask rates i.e. when one rate is
Important conventions
regarding quotes:
a) The bid rate always precedes the ask
E.g Rs/$ 45.45 / 45.50
b) The bid and ask rates are always
separated either by slash(/) or (-).
c) The quote is always from the bankers
point of view. Rs/$ 45.45 / 45.50
E.g The banker is ready to buy
dollar at 45.45 and sell at 45.50. i.e.
Bankers buy rate= Customers sell rate.
d) The Bid is always lower than the ask.
(ask rate- Bid rate = profit)
Interbank quote vs
Merchant quote
Merchant quote is by bank to its
retail customers.
Interbank quote is given by one
bank to another bank.
Since, both the parties are banks,
then whose quote will be
considered. The bank requesting
the quote will is the customer and
the other banks quote will be
Basis Point (BPS)
A unit that is equal to 1/100th of
1%, and isusedto denote the
change in a financial instrument.
Thebasis point is commonly used
forcalculating changes in interest
rates, equityindexes and theyield
of a fixed-income security.
The relationship between
percentage changesand basis
points can be summarized as
Basis Point (BPS)
So,a bond whose yield increases
from 5% to 5.5% is said to increase
by 50 basis points; or interest rates
thathave risen 1% are said
tohave increased by 100 basis
Cross Rates / Synthetic
When we calculate the exchange
rates between other currencies
with the dollar (or any other
currency) as the intermediate

The / rate will be calculated

through the / $ quote and the $/
Thank You