bfms l08 financial markets iii

IIM PCN PGP-II T4 BFMS L08

Financial markets III

1

Banking, Financial Markets

and Systems

Set - 8

Financial Markets - 3

P C Narayan



2

Foreign Exchange Market A market for the sale and purchase of currencies

The price of one currency in terms of another is the exchange rate (ER)

Types of transactions: Cash / Tom / Spot / Forward

Bid rate : Quote in one currency at which the dealer will buy another currency

Ask rate : Quote in one currency at which the dealer will sell another currency

Participants in the FX Market: individuals and firms / FX dealers (banks) / Speculators and Arbitragers / Central bank / Brokers .



3

Foreign

Exchange

Market

Retail Wholesale

Money changers Banks Central Bank

Direct Indirect

(through brokers)

Derivatives

( futures, options etc.) Spot

Forward

(outright and swaps)

Merchant (Trade Based) Non merchant (inter-bank)



4

Typical Merchant / Corporate

FX transactions Banks Corporate Dealer makes two deals with customers,

as follows:

Export Customer Import Customer

Bid price (ER) INR 45.00 / USD Ask price (ER) INR 45.25 / USD

Bank buys USD 100,000 Bank sells USD 100,000

Bank sells INR 4500000 Bank buys INR 4525000

Bank has made a profit of Rs. 25000, since the two transactions are equal and opposite

But it is not always possible to find equal and opposite transaction



5

Typical Merchant / Corporate +

Inter Bank FX Transaction Banks Corporate Dealer makes two deals with customers, as

follows:

Export Customer Import Customer

Bid price (ER) INR 40 / USD Ask price (ER) INR 40.25 / USD

Corp Dlr buys USD 100,000 Corp Dlr sells USD 200,000

Corp Dlr sells INR 4000000 Corp Dlr buys INR 8050000

Banks Corporate dealer buys (transfers net over sold position) USD 100,000 from the Banks Inter-bank dealer at internal ask price (ER) of, say, INR 40.10 / USD

Corporate Dealer has made a profit of INR 25,000 on USD 100,000 and INR 15,000 on USD 100,000. He has also squared (closed out) his position



6

Typical Merchant / Corporate

cum Inter Bank FX Transaction

To square ( close out) the Banks position on the same day, Inter bank dealer buys USD 100,000, say, @ INR 40.05 / USD.

His profit will be INR 5,000.

Total profit for the bank will be INR 45,000 ( INR 40,000 by Corp Dlr + INR 5,000 by Inter Bank Dlr)

However, the Inter-Bank dealer could decided to carry over the oversold position, in anticipation of the INR strengthening in the days ahead

If he buys USD 100,000 five days later at INR 39.50 / USD, his profit will be INR 60,000.



7

Why do exchange rates fluctuate

Theory of purchasing power parity : Exchange rates between any two countries will adjust to

reflect changes in price levels of the two countries

Example: American Steel costs USD 100 / ton Japanese Steel costs JPY 10000 / ton

ER will be USD 1 = JPY 100

If Japanese steel prices rise to JPY 11000, ER will change to USD 1 = JPY 110



8

Why do exchange rates fluctuate

PPP catches the trend in the long term but very little predictive power in the short term

Factors that affect ER in the long term:

Relative price levels: rise in the countrys price level (relative to foreign price level) causes its currency to

Suppose US imposes tariffs and quotas on Japs steel, US steel will sell well causing USD to

Preference for domestic vs foreign goods: If Japs love American chocolates and Florida oranges, USD

Productivity: Higher productivity lowers price of goods relative to foreign goods and hence that countrys currency



9

Exchange rate behaviour in the short term Assume you are an NRI from the US. Hence, USD is your home currency vs.

INR

Assume you have received INR 4,000,000 today through sale of real estate in India

Say, prevailing interest rate for 1 yr is INR: 8% and USD 5%

You have two options (1) to turn the INR to USD at current spot rate (USD/INR 40.00) immediately and place it on a 1 yr deposit in USD or (2) hold the deposit for 1 yr in INR and turn it into USD at end of 1 yr

Assume USD expected to appreciate to 41.50 in 1 yr ( forward rate)

Option 1 would give you a return of USD 5000 at end of 1 yr while option 2 would give a return of USD 4100 (approx). Hence you would go for option 1 above

Assume USD expected to depreciate to 38.50 in 1yr ( forward rate)

Option 1 would give you a return of USD 5000 at end of 1 yr while option 2 would give a return of USD 12200 (approx). Hence you would go for option 2 above

This arbitrage stops at the interest parity condition (equilibrium)

Id = Ie { ( Et+1 Et) / Et } i.e Domestic interest rates equals foreign interest rates minus the expected

appreciation of the domestic currency



10

Exchange rate behaviour in the short term

Consider USD as home currency vs. EUR

Say, you have EUR 1 mio to put in a bank for one year Say, Interest rate on EUR for one year is 4%

Assume USD would appreciate by 2% in one year and USD interest rate for one year is, say, 3%, return on EUR 1 mio for one year is 5%, you will put your money as a USD deposit rather than as a Euro deposit

Assume USD would depreciate by 2% in one year and USD interest rate for one year is 3%, return on EUR 1 mio for one year is 1%, you will keep your money as a EUR Deposit

This arbitrage stops at the interest parity condition (equilibrium)

Id = Ie { ( Et+1 Et) / Et } i.e Domestic interest rates equals foreign interest rates

minus the expected appreciation of the domestic currency



11

In summary

Goes Domestic currency

Up / down Appreciate / Depreciate

Domestic interest rate

Foreign Interest rate

Expected dom. price level

Expected tariff and quota

Expected import demand

Expected export demand

Productivity

Money supply

FX Dealing Suppose bank A needs USD 1 mio and is willing to sell INR

Dealer of bank A approaches bank Y and asks for a quote USD / INR, does not mention buy or sell

Bank Y gives him a two-way quote, bid and ask

If ask rate is acceptable to bank A, he says one mine, implying he will buy USD 1 mio from bank Y and deliver INR at the agreed deal rate

( Recap: ask rate : Quote at which the dealer of bank Y will sell USD buy INR. bid rate : Quote at which the dealer of bank Y will buy USD sell INR)

Instead, if bank A wants to sell USD one mio and buy INR, he says one yours implying he will sell USD 1 mio to bank Y and take delivery of the INR at the agreed deal rate

Quotes are usually in points or pips

12 IIMB PCN BFMS L09

Foreign Exchange Dealing

Settlement and Accounting

Deal confirmation

Deal Matching

Correspondent Bank

Nostro and Vostro Accounts

SWIFT Payments

Accounting

13 IIMB PCN BFMS L09

bfms l08 financial markets iii

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