Foreign Exchange
FOREX
1
1. Three Layer Structure of Forex Market
Layer 1
RBI
FEDAI
Regulator
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
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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
3. Cash Flow Movement in Merchant Transaction
Merchant Transaction
Purchase From Bank
Exporter
Sell to Bank
Importer
Bank
FC
Bank
Home
Currency
Customer
FC
HC
Customer
Exchange Rate: 1 Unit of FC = How many units of HC
4
4. How to Interpret IB Rate and Transaction
1 USD
= 45.2031 / 45.2031
Base
Bid Price
(Less Rate)
Ask or Offer Price
(High Rate)
INR
Price
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
The Bank which gives quote
in IB Market.
Market User
The Bank which uses the given
Quote
In Exam the given IB Quote is the Exchange Rate quoted by Market maker
(we will simply call it quote given by Market)
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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
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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.
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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 :
a)
b)
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.
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5. How to Calculate Merchant Rate
SBI
Market Maker
BOB will
SBI
Market Maker
BOB will
Buy FC
Sell FC
BOB
BOB
Market User
Market User
BOB will
Buy FC
Exporter
(Inward Remittance)
Bank will Sell FC at Lowest of the
Quote
BOB will
Sell FC
Importer
(Outward Remittance)
Bank will Sell FC at Highest of
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the Quote
6. Adjustment Of Exchange Margin in Merchant
Transaction
Type of Merchant Transactions :
Bank
Exchange Margin (EM)
Purchase
Deduct
Sell
Add
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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 : >
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SBI
Mumbai
CITI BANK
HSBC
New York
London
i)
SBI will call this A/c as Nostro with respect to CITI BANK.
ii)
CITI BANK will call this A/c Vostro with respect to SBI.
iii)
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.
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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
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8. Type of transaction in IB Market
The definition of transaction depends upon two terms:
Date of Transaction
DOS = DOT
Date of Settlement
Cash/ Ready/ TT/ Value Today
DOS = DOT + 1 BWD
TOM
DOS = DOT + 2 BWD
SPOT
DOS = DOT + 2 BWD +….
FWD
BWD = Business working Day
TT
= Telegraphic Transfer
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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.
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9. Currency Point Convention
i)
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
Base
Price
45.2030 / 35
Bid
Ask
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Academic World :
Base
ii)
1 USD = INR 44.55 / 56
iii)
120 INR / USD
iv)
GBP / USD
90.20/21
v)
GBP / USD
GBP 90.20/ 21
Price
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10. CROSS Rate
It is an exchange rate where neither currency is USD.
1 FRF = How many INR ?
1 USD = 43.2550 / 43.650 INR
1 USD = 6.0500 / 6.0550 FRF
Given rate for
Conversion
Therefore neither Base or Price Currency or price
currency is in USD so this is an example of cross
rate.
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Short Cut For Calculating Cross Rate
Case 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
Case II
Case III
Common Currency is
in Price Side in Both
Quote
Common Currency is
in Base Side as
well as in Price
Side
Rule
Rule
Divide across by the
currency which is
going to be the Price
in the Cross rate.
We use inverse rate
concept to convert
this situation into
either Case I or Case
II
Price
Bid
×
÷ Base
÷ Price
Bid
Ask
And
×
Ask
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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.
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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.
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12.
World
Direct Quote, Indirect Quote,
American Quote & European Quote
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 HC
1 Unit of $ = How many units of ROW
Indirect Quote or American Quote :
1 unit of HC
= How many units of FC
1 unit of ROW = How many units of $
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13. Currency Appreciation
Currency Revaluation
Currency Depreciation
( )
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
=
Value of currency
× 100
Old Value
Always talk Appreciation or Depreciation with respect to
Base Currency First.
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14. Siegel Paradox
Time
t=0
t=1
1£ = 2$
1£ = 1.8$
% Change in value of £ = 1.8 -2 × 100
= -10%
Depreciation
2
Time
t=0
1$ = 1/2£
t=1
1$ = 1/1.8£
% Change in value of $ = .5556 -.50 × 100
.50
= 11.2
Appreciation
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As per Siegel’s 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.
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15.
International Finance Theory
IRP (Interest Rate Parity) or
CIP (Covered Interest Parity)
All these theory
are used to
calculate
Forward rate
or Expected
Spot Rate by
different
market parity.
PPP (Purchasing Power Parity)
Fisher Effect
IFE (International Fisher Effect)
Expectation Theory
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i) IRP (Interest Rate Parity)
a)
Basis = Interest
This theory tries to establish equilibrium between Forex
Market and Money Market.
(Money market i.e short term interest rate
sold like commercial paper etc.)
Alternative 1
USA 5%
Alternative 2
India 8%
instruments are bought and
Time = 0
1
1$
1.05 $
Time = 0
1
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.
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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
×
rq
[ 1 + rb
[1+
]
]
rq = rate of interest of quote or price
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.
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i) PPP (Purchasing Power Parity)
Absolute form of PPP
Basis = Inflation
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 ]
[ 1 + Ib ]
Iq = rate of inflation of quote or price
Ib = rate of inflation of Base currency
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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)
or Forward Point
Annualized Premium
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.
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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
Quote
-
Rate of
Base
×
SR
×
n
12
Annualized Premium or Discount :
This also represent Interest differences but expressed in %.
SR ×
rq - rb
1 + rb
Exact
or
SR ×
rq - rb
Approx
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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
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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.
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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
L-H
( Low – High)
SWAP Point
H–L
This Show Base currency is
This show Base currency is
At premium
at Discount
ADD
Deduct
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19. Merchant Forward Rate
IB Market
IB Spot Rate
SWAP Point
Exchange
Margin
Buy Rate for Bank
Sell Rate for Bank
Bid Side
Ask Side
Premium/ Discount
Less
Premium/ Discount
Add
36
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:
Step 2:
Step 3:
IB Spot Rate ( Bid Side)
SWAP point up to last month.
Broken Period SWAP Rate :
Last month
SWAP Rate
-
Next Month
SWAP Rate
× Difference in Days
No. of days in the month
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21. Arbitrage in International Financial Market
Arbitration
Hedging
Objective :
Risk Less Profit
Loss Minimization
Speculation
(trading)
Risky Profit
(or mitigation)
Operational Issue:
Mispricing of assets
either in the same
market or between
markets.
Buy and Sell or
Sell and Buy
(Same amount or
Quantity)
Mismatch in assets and
Liability
Buy and Sell or
Sell and Buy
(Same amount or
quantity not necessary)
Simply Buy and Sell or
Sell or Buy
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Arbitrage
Currency Market
Currency Market and
(or Forex Market)
Money Market
Two Point Arbitrage
Three Point Arbitrage
Or
Or
Locational Arbitrage
Triangular Arbitrage
Or
Geographical Arbitrage
When IRP is invalid than it
gives opportunity for
arbitrage.
This type of arbitrage is
called CIA (Covered
Interest Arbitrage)
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Currency Market Arbitration
a) Two Point Arbitration:
Example
SBI
BOI
1$ = 45.2030/31 Rs
1$= 45.2028/29 Rs
BOI (Lowest Rate)
Bid
45.2028
Ask
45.2029
SBI (High Quote)
Bid
45.2030
Buy
Ask
45.2031
Sell
This Gap Provides opportunity for Profit
40
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
Than
More
Arbitrage
Equal
No Arbitrage
Less
No Arbitrage
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Three Point Arbitrage
Start with currency ‘A’ then go to
Currency ‘B’ (sell A and Buy B).
A
B
C
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.
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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)
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22. Forex Risk Management
i) 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)
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ii) Types of Risk (Exposure)
Transaction Risk
Translation Risk
This risk arises due to
Settlement of
contractual
transactions (assets
or liability)
denominated FC.
This Risk arises due to
translation of
contractual transactions
(asset and liability) in
FC.
Cash is involved
No cash is involved.
This is both Accounting
and Cash gain or
Loss.
This involves
Accounting Gain or Loss
Economic Risk
Or 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.
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23. Forex Risk Management tool [Hedging tool]
Internal Tools
Neting
External Tools
Currency Forwards
(Forward Contract)
Currency Option
Matching
Currency Future
Leading & Legging
Pricing / Invoicing
Currency SWAP
MMH (Money Market Hedge)
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MMH (Money Market Hedge)
Exporter
Importer
Foreign Currency Receivable
Foreign Currency Payable
Risk :
Risk :
FC Value Decreases
Balance sheet :
Liability
----
FC Value Increases
Balance sheet :
Asset
Foreign
Currency
Liability
Foreign
Currency
Asset
----
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Hedging :



Borrow Foreign Currency
equivalent to the Present
Value of FC to be received.
Hedging :

Convert FC to Home Currency

Repay Loan in FC when you
receive your FC payment.


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.
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Netting Vs Matching
Netting :
Matching : (Hedging Tool)
Under this process payable &
receivables are adjusted and net
balance is settled.
Under matching process receivables and
payables are matched in order to decide
the net forex exposure amount.
As a result of this no. of
transaction is reduced and hence
there is saving of transaction
cost.
However transaction are settled
separately and hence there is no
transaction cost saving.
Bilateral
Multilateral
One-to-one
One-to-many
One party receivable & payables with
other party is adjusted and balance
amount is settled.
One party receivable & payables with
all other parties are adjusted and
balance amount is settled.
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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.
Two Types of Forward Contract
Outright Forward Contract
Or Forward Contract
Option Forward Contract
1. Three Information is required for calculating Forward rate for both product :
SPOT Rate , SWAP Point and Exchange Margin
2. Hedge
Strategy
Exporter
Sell FC today on Forward Basis
Importer
Buy FC today on Forward Basis
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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.
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Option Forward Contract
Contract Period
Option Period
t=0
Date of Booking
1.
t=1
t=2
Expiry Date
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
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Pricing of Forward Contract
Forward Contract
Spot Rate
t=0
SWAP Point
t=0 to t=1
SWAP Point
Option Forward Contract
t=0
Normal Treatment
t=0 to t=1
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.
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Early Delivery, Extension & Cancellation
Extention : 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.
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Extension/ Rollover
Cancellation of
existing Contract
Cancellation of
existing Contract
Simultaneous
re-booking of fresh
Contract
Follow normal
procedure for forward
contract booking
Forward
Purchase
Appropriate
Selling Rate by IB
Market
Interpreted with
respect to bank
Cancellation
Rate
Forward
Sale
Appropriate
Buying Rate by IB
Market
55