Lecture-1: Fundamentals of Foreign Exchange
Course Instructor:
Md. Nazmul Hasan
Associate Professor
Department of Banking and Insurance
Consulting Room: 6002 (5th Floor), MBA Building
Email: nhp@du.ac.bd
What is Foreign Exchange?
• Foreign Exchange (FX), in its simplest form, refers to the process or mechanism
by which the currency of one country can be converted into the currency of
another country and thereby, involves the international transfer of money.
• Dr. Paul Einzig defines FX as the system or process of converting one national
currency into another and transferring the ownership of money from one
country to another in settling the international trade.
• FX is the combination of the settlement of international debt (i.e., originated
from the payment of exports and imports, investments i.e., FDI, Ownership
transfer and grants), the methods of int’l settlement and the instruments used
in this connection as well as the variation in exchange rates at which settlement
of international indebtedness is made.
***Paul Einzig was an economic and political writer and journalist. He wrote 57 books, alongside many articles for newspapers
and journals, and regular columns for the newspapers Financial News and Commercial and Financial Chronicle.
Money Vs. Currency:
The term ‘Money’ has a narrower meaning than the term
‘Currency.’ To be specific, the term ‘money’ is used to describe
the actual money in the form of coin or notes or in any other
forms which passes freely from hand to hand as the recognized
medium of exchange within the country.
In contrast, ‘Currency’ is a generic term and covers not only the
actual coins and paper money in use in a country but also, any
credit instruments which convey the right to wealth. That
wealth may be in terms of any given Negotiable Instruments
such as Cheque, a Promissory Note, a Bill of Exchange which are
in use in any given country.
Defining The FX Market
The Foreign Exchange Market can be defined in terms of specific functions, or the
institutional structure that:
• (1) Facilitates the conversion of one country’s currency into another.
– Allows the buying & selling of currencies (Broker, dealer or exchange house)
– Allows global firms to move in and out of FC as needed (By investment)
(2) Sets and quotes exchange rates (i.e., through money exchanges and AD
branches of Commercial banks)
– This is the ratio of conversion of one currency into another.
– These rates determine costs (Investment) and returns to global businesses.
• (3) Offers contracts to manage foreign exchange exposures of Global Firms.
– These hedging contracts allow global firms to offset their foreign currency
exposures and manage foreign exchange risk. (Through Forward contract)
– Thus, they can concentrate on their core business and leave the FX Risk to
financial managers.
***Quick Review of Market Characteristics
• World’s largest financial market.
– Estimated at $3.2 trillion ($1,00,000 crore/trillion) dollars per day in trades.
• NYSE-Euronext currently running about $40 billion per day.
• Market is a 24/7 over-the-counter (Through online/Telephone) market.
– There is no central trading location.
– Trades take place through a network of computer and telephone connections all
over the world.
• Major trading center is London, England.
– 34% of all trades take place through London (New York second at 17%).
• Most popular traded currency is the U.S. dollar.
– Accounts for 86% of all trades take place worldwide (euro second at 27%).
• Most popular traded currency pair is the U.S. dollar/Euro. Why Euro?
– Represents 27% of all trades (dollar yen second at 13%)
• Currencies are either traded for immediate delivery (spot) or some specified
future delivery (forward).
[In USA system, 1 trillion= 1000 billion; 1 billion=1000 million or 100 crore. In UK system, 1 trillion=1 million x 1 billion]
Global FOREX Market Turnover by Instrument
Source: BIS Survey, September 2017, in billions of USD
Note: (1 B=1000 M or 100 Crore)
6
Global FOREX Market Turnover by Instrument
Source: BIS Survey, September 2017, in billions of US Dollars
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FOREX: Comparison with other Markets
• More than 25 times the average daily turnover of
global equity markets (about $205 billion a day
according to the World Federation of Exchanges, 2013)
• About 135 times the average daily turnover of the
NYSE group in 2013 (about $38 billion: NYSE Data)
• Nearly $750 a day for every man, woman, and child on
earth (based on a world population of 7.1 billion - US
Census Bureau, est. 2013)
• An annual turnover more than 16 times world GDP about $78 trillion (IMF, 2013)
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Turnover trends in FOREX Markets
• Average daily turnover in FOREX increased
– Approx 70% from 2004 to 2007
– Approx 20% from 2007 to 2010 (Growth slowed,
why? Any Guess? (Hints: Financial Downturn)
– Approx 35% from 2010 to 2013
– Fell very slightly from 2013 to 2016
• Turnover has (much) more than tripled since
2001 (depending on which exchange rate used
to measure volume, here it is USD)
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Global FOREX Market Turnover by Currency
Source: BIS Survey, September 2017, in billions of US Dollars
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Global FOREX Market Turnover by Currency Pairs
Source: BIS Survey, September 2016, in billions of US Dollars
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Stylised features of FOREX Data
• USD still dominant: share down from 90% (2001) to 85%
(2010), but up again to 88% (2016)
• EUR increased its share to 39% (2010), but post-euro crisis*
evidenced sharp decline to 31.3%(2016) [Debt crisis of Greece]
{In 1998 all EU currencies had 53% share}
• Yen jumped from 19% (2010) to 23% (2013) – mainly due to
expectations of a regime shift in monetary policy, down to
21.6% (2016)
• Trading increasingly dispersed across currencies
• Commodity backed currencies (AUD, CAD), and emerging
market currencies (Mexico + BRICS(Brazil, Russia, India,
China and South Africa)) have been increasing their share
(with some volatility)
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How does the FX Market Quote Currencies?
• Currency pair can be separated into two types, direct and indirect.
• In a direct quote:
– When we represent the exchange rates in a way where home currency is represented against
the foreign currency, then we call it direct quotation.
– Example: A/B where A is the home currency and B is the foreign currency.
– To be exact: In our country, we represent the currency like BDT. 86/$1, we call it direct
quotation, whereas it will be indirect quotes for USA.
In the indirect quote:
When we represent the exchange rates in a way where Foreign Currency is represented
against the Home Currency, then we call it indirect quotation.
– Example: B/A where B is the foreign currency and A is the home currency
– To be exact: In our country, we represent the currency like $1/BDT. 86, we call it indirect
quotation, whereas it will be direct quotes for USA.
• Two-way Quotation: Bid and Ask price for trading U.S. dollar.
– Example: Bid Price/Ask price or BDT. 86.52/BDT. 85.92 for buying and selling of 1 U.S dollar.
Quotes are Given by Time of Settlement
• Spot Exchange Rate:
– Quotes for immediate transactions (actually within T+0,
T+1 or T+2 business days).
• Forward Exchange Rate:
– Quotes for future transactions in a currency (3 business days
and out).
– Forward markets are used by businesses to protect against
unexpected future changes in exchange rates.
– Forward rate allows businesses to “lock” in an exchange rate
for some future period of time.
– For example, In case of Import payment and export receipt,
changes in exchange rate has serious implications on the
receipt of the proceeds from exports and payments for import.
Observing Changes in Spot Exchange Rates:
What do they Mean?
• Appreciation (or strengthening) of a currency:
– When a currency gains its value against its counterpart. That is, the
currency’s spot rate (current market rate) has increased in value in
terms of foreign currencies.
– Suppose, the 3-years back the exchange rate was $1=BDT 90 but
now $1=BDT 86.52 (today’s rate). This is an example of appreciation
in the value of BDT (TAKA) in compared to U.S. dollar.
• Depreciation (or weakening) of a currency:
– When a currency loses its value or currency’s spot rate has
decreased in value in terms of foreign currencies.
– Suppose, the 10 years back the exchange rate was $1=BDT 50 but
now $1=BDT 86.52 (today’s rate). This is an example of reduction in
the value of BDT (TAKA) in compared to $.
What Institutions are Involved in the Foreign
Exchange Market?
• Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank)
acting on behalf of:
– (1) Their “external” clients” (primarily global firms: exporters,
importers, multinational firms i.e., FDI)
• Acting in a broker capacity at the request of these clients and meeting the
foreign currency needs of these clients.
– (2) Their own banks (trading to generate profits): Proprietary
A/C
• Acting in a “dealer” (i.e., trading) capacity
• Taking positions in currencies to make a profit
• In meeting the needs of their clients and their own trading
activities, these global banks establish the “tone” of the market.
– This is only possible through a “market maker” function.
‘Market Making’ Function in FX
• The market maker function of any global bank involves two
primary foreign exchange activities:
(1) Willingness of the market maker to provide the market
with “on-going” (i.e., continuous) two-way quotes (simultaneous
buying & selling) upon request:
– (1) Provide a price at which they will buy a currency
– (2) Provide a price at which they will sell a currency
• This function provides the market with transparency of Bid &
ask Price
(2) Willingness of the market maker to actually buy and/or
sell at the prices they quote:
– Thus the market maker offers “firm” prices into the market!
• This function provides the market with liquidity meaning being
ready to buy and or sell simultaneously.
ISO Currency Designations
•
•
•
All foreign currencies are assigned an
International Standards Organization (ISO)
abbreviation.
– E.g., USD; JPY; GBP; EUR; AUD; HKD; CNY;
MXN; ZAR; NZD; CHF etc.
Since the exchange rate is simply the ratio (i.e.,
value) of one currency against another, market
makers express this relationship using the two
currencies’ ISO designations.
For Example:
– USD/JPY
– USD/MXN
– EUR/USD
– GBP/USD
– EUR/JPY (this is a cross rate; since USD in
not one of them)
SYMBOL
COUNTRY
CURRENCY
USD
United States
Dollar
AUD
Australia
Dollar
CAD
Canada
Dollar
CNY
China
Chinese
Yuan/Renminbi
CHF
Switzerland
Franc
CNH
China
Yuan
EUR
Eurozone
Euro
GBP
Great Britain
Pound
JPY
Japan
Yen
MXN
Mexico
Peso
NOK
Norway
Krone
NZD
New Zealand
Dollar
SEK
Sweden
Krona
TRY
Turkey
Lira
ZAR
South Africa
Rand
Base and Quote Currency
• Given that a foreign exchange quote is simply the
ratio of one currency to another, a “complete”
market maker quote must have two-ISO designations
(e.g., EUR/USD or USD/JPY):
– The first ISO currency quoted is called the base currency.
– The second ISO currency quoted is called the quote
currency.
• For examples above:
– EUR/USD: EUR is the base currency and USD is the quote currency.
– USD/JPY: USD is the base currency and JPY is the quote currency.
Bid and Ask Quotes
• Recall that a market maker always provides the
market with two prices, both a buy and sell quote (or
price) for a currency.
• For Example: EUR/USD: 1.2102/1.2106
– The first number quoted by the market maker is the
market maker’s buy price ($1.2102).
• It is called the market maker’s bid quote (or buy price)
– The second quoted number is the market marker’s sell
price ($1.2106).
• It is called the market maker’s ask quote (or sell price)
– Note: The bid quote is always lower than the ask quote.
Foreign Exchange Department
FX
Department
1. Export
Section
2. Import
Section
3. Remittance
Section
4. Dealings
Section
5. Statistics
Section
1. Financing Exports: The financial needs of the exporter, right from the
moment s/he conceives the order and till s/he realizes export
proceeds/payments, are met by the banks. Services rendered by the
export sections ranges from but not limited to, following:
• Pre-shipment finance (i.e., Packing Credit)
• Post-shipment finance (i.e., Discounting a L/C)
• Export Guarantees
• Advising/confirming letters of credit
• Facilitating Project Exports/Export orders (i.e., Back-to-back L/C)
• Bills for collection (By dint of export regulation, the export receipt
must be collected through an authorised dealer.)
Foreign Exchange Department
2. Financing Imports: Letters of credit are issued by banks on behalf of the
importer-client. The opening of the letter of credit by the bank, whereas it
undertakes to make payments to the exporter on shipment, enables the importer
to conclude the deal with ease. The services rendered by the bank to the importer
customers, are as follows:
•Opening of Letters of Credit
•Advance against Import Bills (Cash Credit or loans against the hypothecation or
pledge of goods imported)
•Import loans and Guarantees (i.e., Deferred payment guarantees for importers)
3. Remittance Facilities: An importer in Bangladesh has to pay the overseas
exporter. Similarly, a Bangladeshi exporter has to receive the payment from
abroad. A Bangladeshi who is employed outside of the country may remit funds
for the maintenance of his/her family in the home country.
•Issue of Demand Draft (DD), Telegraphic Transfer (T.T)
•Encashment of Cheques, DD and TT
•Issue and encashment of Travellers Cheques
•Sale and encashment of foreign currency notes
•Non-resident Deposits
Foreign Exchange Department
4. Dealings in Foreign Exchange: Banks buy and sell foreign exchange from and
to the public. To carry out this function, banks have to keep sufficient stocks of
foreign exchange. Banks in Bangladesh maintain accounts with foreign banks
located in important financial centers of the world (such as London, New York,
Beijing, Hongkong, Zurich, Tokyo and New Delhi) through which sale and purchases
of foreign exchange are routed. The usual services provided under this section, are:
•Offering Rate Computations for simultaneous buying and selling
•Managing Nostro and Vostro Account
• Offering Forwards, futures and derivative Contracts
•Taking Exchange Dealing Positions
5. Furnishing Credit Information: With a network of correspondent relations
with banks abroad, a bank in Bangladesh is in a position to furnish and facilitate
business information to exporters and importers at home. The information may
relate to credit reports on the prospective seller/buyer, market conditions,
exchange regulations in different countries. The bank is in a position to advise
customers on such matters as the currency in which the transaction is to be
designated in order to avoid the exchange risks.
•Submission of periodic reports
•Collection of credit and market conditions
Foreign Currency Accounts
Nostro Account: The term Nostro is used by the bank which maintains the
account to refer to its account with other bank. For a bank based in Dhaka, Nostro
account is an account maintained by it with a bank abroad.
For Example, a Bangladeshi Bank such Sonali Bank Ltd. (SBL) may
hold an account with Barclays Bank in London in pound-sterling.
Similarly, it may have a dollar account with Bank of America, New York.
While corresponding with the foreign bank, Bangladeshi Bank i.e., SBL would refer
its account with the foreign bank as Nostro account, meaning ‘our account with
you.’
Therefore, for a Bangladeshi bank Nostro account means the bank account it
maintains abroad in foreign currency. All foreign exchange transactions are routed
through the Nostro Account.
For Example, if the SBL issues a demand draft on London payable in poundsterling, it would draw on Barclays Bank, London. When the draft is presented in
London, the Barclays Bank will debit the SBL Nostro account with it.
Foreign Currency Accounts
Vostro Account: The term Vostro is used by the bank with which a home
currency account is opened by a foreign bank. A foreign bank may open a BDT
Taka account with a Bangladeshi Bank such as Sonali Bank Ltd. While
corresponding with the foreign bank maintaining an account with a Bangladeshi
Bank, the Bangladeshi Bank would refer to the account as Vostro account
meaning ‘your account with us.’ For Example: a Middle-East bank may open a
Taka-account with a Bangladeshi bank and draw a demand draft on it. On
presentation of drafts, the Bangladeshi bank would pay to the debit of the foreign
bank’s account with it.
It should be noted that credit to a non-resident bank account amounts to
remittance of foreign currency from Bangladesh to the country of the bank having
the Vostro account. Likewise, a debit to the accounts amounts to inflow of foreign
exchange from the country concerned into Bangladesh.
Loro Account: The term Loro is used when the account is referred by a bank
other than the account opening bank and the bank with which account is
maintained. In other words, it is used in respect of the third-part accounts.
For instance: suppose Citizen Bank of Bangladesh is having an account
with Lloyds Bank, London. When a third-party bank like Prime Bank Ltd. Would
like to refer the accounts of Citizen Bank with Lloyds bank, it is known as Loro
Account meaning ‘their account with you.’
Functions of the Foreign Exchange Markets




Foreign Exchange Market is the market in which individuals, firms,
and banks buy and sell foreign currencies.
The transfer of funds or purchasing power from one nation and
currency to another.
Demand for foreign currencies
-Import/expenditures abroad/investment abroad/Repaying loan
Supply of foreign currencies
-Export/earnings from tourism/receipt of foreign investments
Credit Function: FX players are allowed to take credit in different
currencies in order to facilitate them in international trading.
Facilities for Hedging and Speculation: Market participants can buy
the hedging tools (such as Forward, future, options and swaps) and
helps in speculating the market by allowing loans.
Four levels of Participants
1. Immediate users and suppliers of foreign
currencies: Importers/Exporters/tourists/investors
2. Clearinghouses-commercial bank (i.e., ACU)
3. Foreign exchange brokers-interbank / wholesale
market
4. The nation’s central bank-lender of last resort
Important FX Terms: Spot and forward rates
• Spot transaction-Spot rate
– The most common type of foreign exchange
transaction involves the payment and receipt of
the foreign exchange within two business days
after the day the transaction is agreed upon.
– The two-day period gives adequate time for the
parties to send instructions to debit and credit the
appropriate bank accounts at home and abroad.
Forward transaction-Forward rate
• A forward transaction involves an agreement today
to buy or sell a specified amount of a foreign
currency at a specified future date at a rate agreed
upon today.
• One month; Three months; six months
• Forward contracts can be renegotiated for one or
more periods when they become due.
Currency Swaps
• A currency swap, in which two parties, exchange principal and
interests in different currencies. Usually the financial institutions are
involved where they act on their behalf or agent of a non-financial
firm.
• At the inception of the swap, the equivalent principal amounts are
exchanged at the spot rate. It is also called cross-currency swap.
• The purpose of Currency Swaps is to hedge exposure to exchange rate
risk or reduce the cost of borrowing a foreign currency i.e.,
transaction costs involved in exchanging currencies. Additionally, it
helps to avoid the commission both in currency sale and currency buy
transaction.
Foreign Exchange Risks, Hedging & Speculation
a. Foreign Exchange Risks
b. Hedging
c. Speculation
a. Foreign Exchange Risk
• Foreign Exchange Shift:
1.Changes in tastes for domestic and foreign
products in the nation and abroad
2.Different growth and inflation rates in different
nations
3.Changes in relative rates of interest
4.Changing expectations
b. Hedging
• Hedging is a way for a firm to minimize or eliminate foreign
exchange risk. Two common hedges are forward contracts and options.
– A forward contract will lock in an exchange rate today at which
the currency transaction will occur at the future date.
– Options, call and put, are privileges bought to avoid any kind of uncertainty in
realisation of the future value of the export payment or any kind of incumbent
receipts.
• Suppose, Fakir Garments exported a $100 million worth RMG products to Walmart, the
largest retailer of the world, on 1st January, 2020. It is expected to receive the payment on
31st March, 2020. However, it is concerned about the future exchange rate of BDT against
31st March. So, they can open a put option with StanChart, HSBC
• Refers to the avoidance of a foreign exchange risk, or the covering of an open
position.
– At spot market
– At forward market
– At futures and options markets
c. Speculation
• Speculation is the act of trading in an asset or conducting a
financial transaction that has a significant risk of losing most or
all of the initial outlay with the expectation of a substantial gain.
• The opposite of hedging.
• A speculator accepts and even seeks out a foreign exchange risk,
or an open position, in the hope of making a profit.
• Speculation can take place in the spot, forward, futures, or
options markets.
Long and Short Position
• Long position: When a speculator buys a foreign currency on
the spot, forward, or futures market, or buys an option to
purchase a foreign currency in the expectation of reselling it
at a higher future spot rate.
• Short position: When a speculator borrows or sells forward a
foreign currency in the expectation of buying it at a future
lower price to repay the foreign exchange loan or honor the
forward sale contract or option.
Thanks for your patient hearing!