Introduction

During 2003-04 the average monthly turnover in the Indian foreign exchange

market touched about 175 billion US dollars. Compare this with the monthly trading

volume of about 120 billion US dollars for all cash, derivatives and debt instruments put

together in the country, and the sheer size of the foreign exchange market becomes

evident. Since then, the foreign exchange market activity has more than doubled with the

average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the

daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,

foreign exchange constitutes the largest financial market by far.

Liberalization has radically changed India’s foreign exchange sector. Indeed the

liberalization process itself was sparked by a severe Balance of Payments and foreign

exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system

replete with severe import and foreign exchange controls and a thriving black market is

being replaced with a less regulated, “market driven” arrangement. While the rupee is

still far from being “fully floating” (many studies indicate that the effective pegging is no

less marked after the reforms than before), the nature of intervention and range of

independence tolerated have both undergone significant changes. With an overabundance

of foreign exchange reserves, imports are no longer viewed with fear and

skepticism. The Reserve Bank of India and its allies now intervene occasionally in the

foreign exchange markets not always to support the rupee but often to avoid an

appreciation in its value. Full convertibility of the rupee is clearly visible in the horizon.

The effects of these development s are palpable in the explosive growth in the foreign

exchange market in India.

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Foreign Exchange Markets in India – a brief background

The foreign exchange market in India started in earnest less than three decades

ago when in 1978 the government allowed banks to trade foreign exchange with one

another. Today over 70% of the trading in foreign exchange continues to take place in the

inter-bank market. The market consists of over 90 Authorized Dealers (mostly banks)

who transact currency among themselves and come out “square” or without exposure at

the end of the trading day. Trading is regulated by the Foreign Exchange Dealers

Association of India (FEDAI), a self regulatory association of dealers. Since 2001,

clearing and settlement functions in the foreign exchange market are largely carried out

by the Clearing Corporation of India Limited (CCIL) that handles transactions of

approximately 3.5 billion US dollars a day, about 80% of the total transactions.

The liberalization process has significantly boosted the foreign exchange market

in the country by allowing both banks and corporations greater flexibility in holding and

trading foreign currencies. The Sodhani Committee set up in 1994 recommended greater

freedom to participating banks, allowing them to fix their own trading limits, interest

rates on FCNR deposits and the use of derivative products.

The growth of the foreign exchange market in the last few years has been nothing

less than momentous. In the last 5 years, from 2000-01 to 2005-06, trading volume in the

foreign exchange market (including swaps, forwards and forward cancellations) has more

than tripled, growing at a compounded annual rate exceeding 25%. Figure 1 shows the

growth of foreign exchange trading in India between 1999 and 2006. The inter-bank

forex trading volume has continued to account for the dominant share (over 77%) of total

trading over this period, though there is an unmistakable downward trend in that

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proportion. (Part of this dominance, though, result s from double-counting since purchase

and sales are added separately, and a single inter-bank transaction leads to a purchase as

well as a sales entry.) This is in keeping with global patterns.

In March 2006, about half (48%) of the transactions were spot trades, while swap

transactions (essentially repurchase agreements with a one-way transaction – spot or

forward – combined with a longer- horizon forward transaction in the reverse direction)

accounted for 34% and forwards and forward cancellations made up 11% and 7%

respectively. About two-thirds of all transactions had the rupee on one side. In 2004,

according to the triennial central bank survey of foreign exchange and derivative markets

conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee

featured in the 20th position among all currencies in terms of being on one side of all

foreign transactions around the globe and its share had tripled since 1998. As a host of

foreign exchange trading activity, India ranked 23rd among all countries covered by the

BIS survey in 2004 accounting for 0.3% of the world turnover. Trading is relatively

moderately concentrated in India with 11 banks accounting for over 75% of the trades

covered by the BIS 2004 survey.

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Features of the Forward premium on the Indian rupee

The Indian rupee has had an active forward market for some time now. The

forward premium or discount on the rupee (vis-à-vis the US dollar, for instance) reflects

the market’s beliefs about future changes in its value. The strength of the relationship of

this forward premium with the interest rate differential between India and the US – the

Covered Interest Parity (CIP) condition – gives us a measure of India’s integration with

global markets. The CIP is a no-arbitrage relationship that ensures that one cannot borrow

in a country, convert to and lend in another currency, insure the returns in the original

currency by selling his anticipated proceeds in the forward market and make profits

without risk through this process.

Chakrabarti (2006) reports that between late 1997 and mid-2004 the average

discount on the rupee was about 4% per annum. During the period the average difference

between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was

about 4.5% for 3-months and 3.5% for the 6-months period. With these two figures in the

same ballpark (particularly given that bank deposit rates and inter-bank rates are not

strictly comparable), annual averages of interest rate differences and the forward

exchange premium also indicate a moderate degree of co-movement between the two

variables. The interest rate differential explains about 20% of the total variation in the

forward discount. The deviation of the Indian rupee-US dollar from the covered interest

parity, however, exhibits long-lived swings on both sides of the zero line. This would

indicate arbitrage opportunities and market imperfections provided we could be sure of

the comparability of the interest rates considered. Therefore, while the behavior of the

forward premium on the Indian rupee is broadly in lines with the CIP, more careful

empirical analysis involving directly comparable interest rates is necessary to measure

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the strength of the covered interest parity condition and the efficiency of the foreign

exchange market. Under market efficiency, the forward exchange rate is considered to be an

unbiased predictor of the future spot rate, with random prediction errors. While the

prediction errors of forward rates on the rupee appear to show some degree of

persistence, any conclusion in this matter too must await more rigorous analysis.

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Intervention in Foreign Exchange Markets

The two main functions of the foreign exchange market are to determine the price

of the different currencies in terms of one another and to transfer currency risk from more

risk-averse participants to those more willing to bear it. As in any market essentially the

demand and supply for a particular currency at any specific point in time determines its

price (exchange rate) at that point. However, since the value of a country’s currency has

significant bearing on its economy, foreign exchange markets frequently witness

government intervention in one form or another, to maintain the value of a currency at or

near its “desired” level. Interventions can range from quantitative restrictions on trade

and cross-border transfer of capital to periodic trades by the central bank of the country

or its allies and agents so as to move the exchange rate in the desired direction. In recent

years India has witnessed both kinds of intervention though liberalization has implied a

long-term policy push to reduce and ultimately remove the former kind. It is safe to say

that over the years since liberalization, India has allowed restricted capital mobility and

followed a “managed float” type exchange rate policy.

During the early years of liberalization, the Rangarajan committee recommended

that India’s exchange rate be flexible. Officially speaking, India moved from a fixed

exchange rate regime to “market determined” exchange rate system in 1993. The overt

objective of India’s exchange rate policy, according to various policy pronouncements,

has been to manage “volatility” in exchange rates without targeting any specific levels.

This has been hard to do in practice.

The Indian rupee has had a remarkably stable relationship with the US dollar.

Meanwhile the dollar appreciated against major currencies in the late 90’s and then went

into an extended decline particularly during 2003 and 2004. The lock-step pattern of the

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US dollar and the Rupee is best reflected in the movements in the two currencies against

a third currency like the Euro. The correlation of the exchange rates of the two currencies

against the Euro during 1999-2004 was 0.94. Several studies have established the pegged

nature of the rupee in recent years (see Chakrabarti (2006) for a more detailed

discussion). Based on volatility, India had a de facto crawling peg to the US dollar

between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995,

with a major devaluation in March 1993. From mid-1995 to end-2001, the rupee reverted

to a crawling peg arrangement in practice. An analysis of the ratio of the variance of the

exchange rate to the sum of the variances of the interest rate and the foreign exchange

reserves reveals a move even closer to the fixed exchange rate system. A comparison of

the sensitivity (beta) of the Dollar-rupee rate with the Euro-rupee rate for a three year

period (1999 through 2001), indicates that India had a dollar beta of 1.01 – tenth highest

among the 53 countries considered. More importantly, the US dollar-Euro exchange rate

explained about 97% of all movements in the Indian rupee-Euro exchange rate – highest

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Concepts

1. Value Date:

The settlement of a transaction takes place by transfers of deposits between two parties.

The day on which these transfers are effected is called the Settlement Date or the Value Date.

2. Spot Rate:

When the exchange of currencies takes place on the second working day after the date of the

deal, it is called spot rate.

3. Forward Transactions :

If the exchange of currencies takes place after a certain period from the date of the deal (more

than 2 working days), it is called a forward rate. A trader may quote a forward transaction for

any future date. It is a binding contract between a customer and dealer for the purchase or

sale of a specific quantity of a stated foreign currency at the rate of exchange fixed at the time

of making the contract.

4. Swap Transaction:

A swap transaction in the foreign exchange market is combination of a spot and a forward in

the opposite direction. Thus a bank will buy DEM spot against USD and simultaneously enter

into a forward transaction with the same counter party to sell DEM against USD against the

mark coupled with a 60- day forward sale of USD against the mark. As the term ‘swap’

implies, it is a temporary exchange of one currency for another with an obligation to reverse

it at a specific future date.

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5. Bid Rate:

The bid rate denotes the number of units of a currency a bank is willing to pay when it buys

another currency.

6. Offer Rate :

The offer rate denotes the number of units of a currency a bank will want to be paid when it

sells a currency.

7. Bid - Offer Rate:

The bid offer Rate is the rate which states both, the price which is the bank is willing to pay

to buy other currencies and the price the bank expects when it sells the same currency. Bid

and Ask will always be from a bank’s point of view. Thus (A/B)bid will denote the number

of units of A the bank will pay when it buys one unit of B and (A/B)ask will mean the

number of units of A the bank will want to be paid in order to sell one unit of B.

8. European Quote:

The quotes are given as number of units of a currency per USD. Thus

DEM1.5675/USD is a European quote.

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9. American Quotes:

American quotes are given as number of dollars per unit of a currency. Thus

USD0.4575/DEM is an American quote.

10. Direct Quotes :

In a country, direct quotes are those that give unit of the currency of that

country per unit of a foreign currency. Thus INR 35.00/USD is a direct quotein India.

11.Indirect Quote:

Indirect or Reciprocal Quotes are stated as number of units of a foreign

currency per unit of the home currency. Thus USD 3.9560/INR 100 is an

indirect quote in India.

12. Arbitrage:

Arbitrage may be defined a san operation that consists in deriving a profit without risk from a

differential existing between different quoted rates. It may result from 2 currencies, also

known as, geographical arbitrage or from 3 currencies, also known as, triangular currencies.

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Descriptive questions

1.What is foreign exchange market? Explain the functions.

Answer:

In a business setting, there is a fundamental difference between making

payment in the domestic market and making payment abroad. In a domestic transaction, only

one currency is used while in a foreign transaction, two or more currencies maybe used.

The foreign exchange market is the market in which currencies are brought and sold against

each other it is the largest market in the world.

The foreign exchange market also known, as forex market is an over-thecounter market, this

means that there is no single market place or an organized exchange like a stock exchange.

The traders sit in the foreign exchange dealing room of major commercial banks around the

world, they communicate with each other through telephone telex computer terminals and

other electronic menace of communication.

They are four main participants in the foreign exchange market.

1. Broker

2. Bankers

3. Corporations

4. Central bank.

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Bankers: large commercial banks operating either at retail level for individual exporters and

corporations or at wholesale level in the InterBank market.

Central bank: central banks of various countries that intervene in order to maintain or to

influence the exchange rate of their currencies within a certain range as also to execute the

orders of government.

Individual brokers or corporations: bank dealers often used brokers to stay anonymous since

the identity of banks can influence short-term course.

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2.Elaborate the structure of the foreign exchange market and

compare it with the foreign exchange of India

Answer:

The Foreign exchange market may be broadly classified into -:

Wholesale market and Retail market .

WHOLESALE MARKET (primary price maker)

The wholesale market is also referred to as interbank market the

average transaction size in this market is very small.

Participants: Commercial banks, Corporations and Central bank

Among these participants, primary price maker or professional dealer make a two way market

to each other & their clients, i.e. on request they will quote a two-way price & be prepared to

take either the buy or sell side .This group mainly include commercial bank but some large

investment dealer & a few large corporation have also assumed the role of primary dealers.

Primary price makers perform an important role in taking positions off the hands of another

dealer or corporate customer & then offsetting these by doing an opposite deal with another

entity which has a matching requirement.

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15

Among primary price maker there is a kind of tiering –

RETAIL MARKET (Secondary price maker )

It is the market in which travelers & tourists exchange one currency for another in the form of

currency notes & traveler’s cheques. Total turnover & transaction size is very small. The bid-

ask spread is large. The secondary price maker make foreign exchange prices but do not

make a two way market .

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Foreign currency brokers

Foreign currency brokers act as middlemen between two market makers. Their main function

is to provide information to market making banks about prices at which there are firm buyers

& sellers in a pair of currencies. broker hunts around for an appropriate counterparty –

another bank - & collects commission on conclusion of deal. Banks may also use brokers to

acquire information about the general state of the market even when they do not have a

specific deal in mind. The important thing is brokers do not sell or buy on their own account.

The broker hunts around for an appropriate counterparty –another bank - & collects

commission on conclusion of deal. Banks may also use brokers to acquire information about

the general state of the market even when they do not have a specific deal in mind. The

important thing is brokers do not sell or buy on their own account.

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The structure of foreign exchange market in India

The foreign exchange market in India may broadly said to have 3

segments or layers :-

First layer consists of the Central bank i.e. RBI & the Authorized

dealers (ADs). ADs are mostly commercial banks &Financial institutions such as IDBI,

ICICI & the travel agent like Thomas cook.

The daily turn over in the foreign exchange market is currently

estimated to be between US $ 1.5- 3 billion. The most important centre is Mumbai whereas

other active centres are Delhi, Calcutta, Chennai, Cochin & Bangalore

Indian market also has accredited brokers who match buyers & sellers.

FEDAI i.e. Foreign Exchange Dealer’s Association of India has made it

mandatory to route deals between two ADs through brokers .

3.Write a note on Inter bank dealing

Answer:

Primary dealers quote two – way prices and are willing to deal either side, i.e. they buy and

sell the base currency up to conventional amounts at those prices. However, in interbank

markets this is a matter of mutual accommodation. A dealer will be shown a two-way quote

only if he / she extends the privilege to fellow dealers when they call for a quote.

Communications between dealers tend to be very terse. A typical spot

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transaction would be dealt as follows:

BANK A : “ Bank A calling. Your price on mark – dollar please.”

BANK B : “ Forty forty eight.”

BANK A : “ Ten dollars mine at forty eight.”

Bank A dealer identifies and asks himself for B’s DEM/USD. Bank A is dealing at

1.4540/1.4548. The first of these, 1.4540, is bank B’s price for buying USD against DEM or

its bid for USD; it will pay DEM 1.4540 for every USD it buys. The second 1.4548, is its

selling or offer price for USD, also called ask price; it will charge DEM 1.4548 for very USD

it sells. The difference between the two, 0.0008 or 8 points is bank B’s bid – offer or bid –

ask spread. It compensates the bank for costs of performing the market making function

including some profit. Between dealers it is assumed that the caller knows the big figure, viz.

1.45. Bank B dealer therefore quotes the last two digits (points) in her bid offer quote viz. 40

– 48.

Bank A dealer whishes to buy dollars against marks and he conveys this in the third line

which really means “ I buy ten million dollars at your offer price of DEM 1.4548per US

dollar.”

Bank B is said to have been “hit” on its offer side. If the bank A dealer wanted to sell say 5

million dollars, he would instead said “Five dollars yours at forty”. Bank B would have been

“hit” on its bid side.

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When a dealer A calls another dealer B and asks for a quote between a pair of currencies,

dealer B may or may not wish to take on the resulting position on his books. If he does, he

will quote a price based on his information about the current market and the anticipated

trends and take the deal on his books. This is known as “warehousing the deal”. If he does not

wish to warehouse the deal, he will immediately call a dealer C, get his quote and show that

quote to A. If A does a deal, B will immediately offset it with C. This is known as “back-to-

back” dealing. Normally, back-to-back deals are done when the client asks for a quote on a

currency, which a dealer does not actively trade.

In the interbank market deals are done on the telephone. Suppose bank A wishes to buy the

British pound sterling against the USD. A trader in bank A might call his counterpart in bank

B and asks for a price quotation. If the price is acceptable they will agree to do the deal and

both will enter the details- the amount bought/sold, the price, the identity of the counter party,

etc.-in their respective banks’ computerized record systems and go to the next transaction.

Subsequently, written confirmations will be sent containing all the details. On the day of the

settlement, bank A will turn over a US dollar deposit to bank and B will turn over a sterling

deposit to A. The traders are out of the picture

once the deal is agreed upon and entered in the record systems. This enables them to do deals

very rapidly.

In a normal two-way market, a trader expects “to be hit” on both sides of his quote amounts.

That is in the pound – dollar case above. On a normal business day the trader expects to buy

and sell roughly equal amounts of pounds / dollars. The bank margin would then be the bid –

ask spread.

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But suppose in the course of trading the trader finds that he is being hit on one side of hiss

quote much more often than the other side. In the pound – dollar example this means that he

is buying many more pounds that he selling or vie versa. This leads to a trader building up a

position. If he has sold / bough t more pounds than he has bought/ sold he is said to have a net

short position / long position in pounds. Given the variability of exchange rates, maintaining

a large net short or long position in pounds of 1000000. The pound suddenly appreciates from

say $1.7500 to $1.7520. This implies that the banks liability increases by $2000 ($0.0020 per

pound for 1 million pounds. Of course pound

depreciation would have resulted in a gain. Similarly a net long position leads to a loss if it

has to be covered at a lower price and a gain if at a higher price. (By covering a position we

mean undertaking transactions that will reduce the net position to zero. A trader net long in

pounds must sell pounds to cover a net short must buy pounds. A potential gain or loss from a

position depends upon the size of the position and the variability of exchange rates. Building

and carrying such net positions for a long duration would be equivalent to speculation and

banks exercise tight control over their traders to prevent such activity. This is done by

prescribing the maximum size of net positions a trader can build up during a trading day and

how much can be carried overnight. When a trader realizes that he is building up an

undesirable net position he will adjust his bid ask quotes in a manner designed to discourage

on type of deal and encourage the opposite deal. For instance a trader who has overbought

say DEM against USD, will want to discourage further sellers of marks and encourage

buyers. If his initial quote was say DEM/USD 1.7500 – 1.7510 he might move it to 1.7508 –

1.7518 i.e offer more marks per USD sold to the bank and charge more marks per dollar

bought from the bank. nSince most of the trading takes place between market making banks,

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it is a zero – sum game, i.e. gains made by one trader are reflected in losses made by another.

However when central banks intervene, it is possible for banks as a group to gain or lose at

the expense of the central bank. Bulk of the trading of the convertible currencies. Takes place

against the US dollar. Thus quotations for Deutschemarks, Swiss Francs, yen, pound sterling

etc will be commonly given against the US dollar. If a corporate customer wants to buy or

sell yen against the DEM, a cross rate will be worked out from the DEM/USD and JPY/USD

quotation. One reason for using a common currency (called the vehicle currency) for all

quotations is to economize on the number of exchange rates. With 10 currencies 54 two-way

quotes will be needed. By using a common currency to quote against, the number is reduced

to 9 or in general n – 1ss. Also by this means the possibility of triangular arbitrage is

minimized. However some banks specialize in giving these so called cross rates.

4.Define the value date and classify the transactions into spot

and forward transactions based on value date

Answer:

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Value Date: A settlement of any transaction takes place by transfers of deposits between the

two parties. The day on which these transactions are effected is called the settlement date or

the value date.

Settlement location:

To effect the transfers, the banks in the countries of the

two currencies involved must be open for business. The relevant countries are called

settlement locations.

Dealing locations: The location of the two banks involved in the trade is

dealing locations, which need not be the same as the settlement locations.

Classification of transaction based on value date

Where T represents the current day when trading takes place and n

represents number of days.

Cash – Cash rate or Ready rate is the rate when the exchange of

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currencies takes place on the date of the deal itself. There is no delay in

payment at all, therefore represented by T + 0. When the delivery is made

on the day of the contract is booked, it is called a Telegraphic Transfer or cash or value – day

deal.

Tom – It stands for tomorrow rate, which indicates that the exchange of

currencies takes place on the next working day after the date of the deal,

and therefore represented by T+ 1.

Spot – When the exchange of currencies takes place on the second day after the date

of the deal (T+2), it is called as spot rate. The spot rate is the rate quoted for current

foreign – currency transactions. It applies to interbank transactions that require

delivery on the purchased currency within two business days in exchange for

immediate cash payment for that currency.

For e. g. a London bank sells yen against dollar to a Paris bank on

Monday, 1st march, the London bank will turn over yen deposit in Japan

to the Paris bank on Wednesday and the Paris bank will turn over $

deposit in US to the London bank on same day i. e. 3rd march,

Wednesday. If the 3rd march is holiday in any bank in dealing location or

settlement location deposit will takes place on next business day.

Forward –The forward rate is a contractual rate between a foreign –

exchange trader and the trader’s client for delivery of foreign currency

sometime in the future. Here rate of transaction is fixed on transaction

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date for transactions in future. Standard forward contract maturities are

1,2,3,6, 9, and 12 months.

e. g. 1 month forward purchase of pounds against dollars on 1st Jan.

Value date is arrived as follows:

Value date for spot transaction: 3rd Jan.

Value date for forward transaction:

3rd Jan + 1 calendar month = 3rd Feb

If the 3rd Feb. is holiday in any bank in dealing location or settlement location deposit will

takes place on next business date. But this must not take you for next month, for e. g. if value

date is Feb 28 is value date and it is ineligible your cannot shift it to 1st March it must be

rolled back to Feb 27.

Swap: A swap transactions in the foreign exchange market is combination of spot and

forward transaction. Thus a bank will buy deutchemarks spot against US dollar and

simultaneously enter into forward transaction with the same counterparty to sell

deutchemarks against US dollar.

5 .Define arbitrage and explain the different types of arbitrage.

Answer:

Sometimes companies deal in foreign exchange to make a profit, even though the transaction

is not connected to any other business purpose, such as trade flows or investment flows.

Usually, however, this type of foreign – exchange activities is more likely to be persuaded by

foreign – exchange traders and investors. One type of profit – seeking activity is arbitrage,

which is the purchase of foreign currency on one market for immediate resale on another

market (in a different country) in order to profit from a price discrepancy. Hence, arbitrage

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may be defined as an operation that consists in deriving a profit without risk from a

differential existing between different quoted rates. It may result from two currencies (also

known as geographical arbitrage) or from three currencies (also known as triangular

arbitrage).

Interest arbitrage involves investing in foreign – bearing instruments in foreign exchange in

an effort to earn a profit due to interest – rates differentials. For example, a trader may invest

$ 1000 in the United States for ninety days or convert $1000 into British pounds, invest the

money in the United Kingdom for ninety days and then convert the pounds back into dollars.

The investor would try to pick the alternative that would be the highest yielding at the end of

ninety days.

But Speculation is the buying or the selling of the commodity i.e. foreign

currency, where the activity contains both the element of risk and the chances of a greater

profit. Speculators are important in the foreign – exchange market because they spot trends

and try to take advantage of them. Thus they can be a valuable source of both supply and

demand for a currency. As a protection against risk, foreign – exchange transactions can be

used to hedge against a potential loss due to an exchange – rate change.

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Spot Quotations:

·Arbitraging between Banks:

Though one hears the term “market rate”, it is not true that all banks will have identical

quotes for a given pair of currencies at a given point of time. The rates will be close to each

other but it may be possible for a corporate customer to save some money by shopping

around.

Inverse quotes and 2 – point arbitrage:

The arbitrage transaction that involve buying a currency in one market and selling it at a

higher price in another market is called Two – point Arbitrage. Foreign exchange markets

quickly eliminate two – point arbitrage opportunities if and when they arise.

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Numerical Examples

1. An Arbitrage between two Currencies.

Suppose two traders A and B are quoting the following rates:

Trader A (Paris) Trader B (New York) FFr 5.5012/US$ US $ 0.1817/FFr

We assume that the buying and selling rates for these traders are the same. We find out the

reciprocal rate of the quote given by the trader B, which is FFr 5.5036 / US $ (= 1/0.1817) .A

combiste buys, say, US $ 10,000 from the trader A by paying FFr 55,012. Then he sells these

US $ to trader B and receives FFr 55,036. in the process he gains FFr 24 (=55,036 - 55,012).

Since, in practice buying and selling rates are likely to be different, so the quotation is likely

to be as follows:

Trader A Trader B FFr 5.4500/US $ - FFr 5.5012 US $ US $ 0.1785/FFr - US $ 0.1817/ FFr

These rates mean that trader A would be willing to buy one unit of US dollar by paying FFr

5.45 while he would sell one US dollar for FFr 5.501. The same holds true for the

corresponding figures of trader B.

But this process would tend to increase the selling rate at the trader A because of the increase

in demand of US dollars and the reverse would happen at the trader B because of increased

supply of US dollars. This would lead to an equilibrium after some time

2.An Arbitrage between three currencies

Suppose two traders, both located at New York are quoting as follows:

Trader A Trader B $ 0.60/SF $ 0.60/SFr

$ 0.51 DM $ 0.52 DM Since three currencies are involved here, we find the cross rates

between SFr and DM as well. These are:

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SFr 0.85/DM (= 0.51/0.60) at the trader A and SFr 0.867/DM (=

0.52/0.60) at the trader B. Thus, the situation looks like as follows:

Trader A Trader B

$ 0.60/SFr $ 0.60/SFr

$ 0.51/DM $ 0.52/DM

SFr 0.85/DM SFr 0.867/ DM

Hence what are the arbitrage possibilities?

There is no arbitrage gain possible between the US $ and the Swiss franc.

The following two arbitrages are, however possible.

a. Deutschmarks against the US $ is being quoted at the trader B. So

buy DM’s from the trader A and sell them to trader B.

b. Buy DM’s against SFr’s from the trader A and sell them to the

trader B.

6. Examine clearly the different types of forward transactions and describe discount and

premium evaluation in forward quotations.

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Outright forward quotation:

Some of the major currencies quoted in the forward market are

Deutschmarks, Pound sterling, Japanese yen, Swiss franc, Canadian dollar etc. they are

generally quoted in terms of US dollars. Currencies may be quoted in terms of one, three, six

months and one year forward. But enterprises may obtain form banks quotations for different

periods.

As mentioned earlier, the spot market is for foreign – exchange transactions within two

business days. However, some transactions maybe entered into on one day but not completed

until after two business days. For example, a French exporter of perfume might sell perfume

to an US importer with immediate delivery but payment not required for thirty days. The US

importer is obligated to pay in francs in thirty days and may enter into a contract with a trader

to deliver francs in thirty days at a forward rate, a rate today for future delivery.

Thus the forward rate is the rate quoted by foreign – exchange traders for the purchase or sale

of foreign exchange in the future. The difference between the spot and the forward rates is

known as either the forward discount or the forward premium on the contract. If the

domestic currency is quoted on a direct basis and the forward rate is greater than the spot rate,

the foreign currency is selling at a premium. It is calculated as follows:

Forward discount/ premium = Forward mid – Spot mid * 12/n * 100

Spot mid

Where n indicates the number of months forward.

When Fwd rate > Spot rate, it implies premium.

Fwd rate < Spot rate, it implies discount.

In the case of forward market, the arbitrage operates in the differential of

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interest rates and the premium or discount on exchange rates.

Numerical problems

1. Spot 1-month 3-months 6-months

(FFr/US$) 5.2321/2340 25/20 40/32 20/26

In outright terms these quotes would be expressed as below:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot FFr 5.2321 per US $ FFr 5.2340 per US $ 0.0019

1-month FFr 5.2296 per US $ FFr 5.2320 per US $ 0.0024

3-months FFr 5.2281 per US $ FFr 5.2308 per US $ 0.0027

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6-months FFr 5.2341 per US $ FFr 5.2366 per US $ 0.0025

It may be noted that in the forward deals of one month and 3 months, US $ is at discount

against the French franc while 6 months forward is at a premium. Themfirst figure is greater

than the second both in one month and three months forward quotes. Therefore, these quotes

are at a discount and accordingly these points have been subtracted from the spot rates to

arrive at outright rates. The reverse is the case for 6 months forward.

2. We take an example of a quotation for the US $ against Rupees, given by a trader in New

Delhi.

Spot 1-month 3-months 6-months

Rs 32.1010-Rs32.1100 225/275 300/350 375/455

Spread 0.0090 0.0050 0.0050 0.0080

The outright rates from these quotations will be as follows:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot Rs 32.1010 per US $ Rs 32.1100 per US $ 0.0090

1-month Rs 32.1235 per US $ Rs 32.1375 per US$ 0.0140

3-months Rs 32.1310 per US $ Rs 32.1450 per US $ 0.0140

6-months Rs 32.1385 per US $ Rs 32.1555 per US $ 0.0170

Here we notice that the US $ is at a premium for all three forward periods.

Also, it should be noted that the spreads in forward rates are always equal to the sum of the

spread of the spot rate and that of the corresponding forward points.

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Numerical problems and solutions

1. On a particular date the following DEM/$ spot quote is

obtained from a bank: -1.6225/35

a) Explain this quotation.

Ans. The above quotation shows the bid rate and the ask rate of the currencies in question,

the initial figure i.e. 1.6225 being the bid rate and the latter being the ask rate. Also it shows

the number of DEM used to buy or sell one US dollar i.e. the bank will pay 1.6225 DEM for

each US

dollar it buys and will want to be paid 1.6235 DEM for each US dollar

it sells.

b) Compute implied inverse quote.

Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:

$/DEM becomes 0.6159/63

(1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163)

c) Another bank quoted $/DEM 0.6154/59. Is there an

arbitrage? If so how would it work?

Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM 0.6159/63. There

is no arbitrage opportunity since the main purpose of doing an arbitrage is making a profit

without any risk or commitment of capital. This doesn’t exist in the given case as a potential

buyer would end up buying a DEM at 0.6159 $ from Bank A and would have to sell it to

Bank B at the same price since that would be the only way of not making any losses. It is

clear form the diagram shows that shows no arbitrage is possible:

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$/DEM 0.6154 59 63

Bank A Bank B

2. The following quotes are obtained from the banks:

Bank A Bank B

FFr/$ spot 4.9570/80 4.9578/90

i. Is there an arbitrage opportunities

Ans. There is no arbitrage opportunity in this case. This can be

represented diagrammatically as:

FFr/$ 4.9570 78 80 90

Bank A

Bank B

The quotes are overlapping each other hence preventing an

arbitrage. The buyer will go into a loss if he buys from bank A at 4.9580 FFr since he would

have to sell it to bank B for 4.9578 FFr undergoing a loss of 0.0002 FFr.

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b) What kind of market will it result into?

Ans. This will result into a one – way market.

c) What might be the reason for this?

Ans. A one – way market may be created when a bank wants to either

encourage the seller of dollars and discourage buyers or vice – versa. In

this case, Bank A wants to encourage buyers of dollars and discourage

sellers of the same thus creating a net long positioning dollars. At the

same time Bank B wants to encourage the sellers of dollars and

discourage buyers thus creating a net short position in dollars. Hence the outcome would be

that Bank A will be confronted largely with buyers of US dollars and few sellers while for

Bank B the reverse case will hold

true. Eventually, it would mean that regular clients of Bank B wanting to

buy dollars can save some money by going to Bank A and vice – versa.

3. In London a dealer quotes: DEM/ GPB spot 3.5250/55

JPY/ GPB spot 180.0080/181.0030

a) What do you expect the JPY/ DEM rate to be in Frankfurt?

Ans. In London: DEM/ GPB spot 3.5250/55

JPY/ GPB spot 180.0080/181.0030

Therefore, JPY/ DEM = B1 A1/ [where B1 - 180.0080

A2 B2 A1 – 181.0030

B2 - 3.5250

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A2 – 3.5255]

= 180.0080/ 181.0030

3.5255 3.5250

= 51.0588 / 51.3483 JPY/ DEM

b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot

51.1530/ 51.2250.

Is there an arbitrage opportunity?

Ans. When in London: JPY/ DEM 51.0588 / 51.3483 and

In Frankfurt: JPY/ DEM 51.1530/ 51.2250

There is no arbitrage opportunity as the quotes overlap each other and the buyer will stand to

make a loss. If he buys in Frankfurt where 1 DEM is 51.2250 JPY and sells it in London for

51.0588 JPY, he makes a loss of 0.1662JPY. Diagrammatically it can be represented as:

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4. The following quotes are obtained in New York: DEM/$

spot 1.5880/ 90

1- month forward 10/ 5

2- month forward 20/ 10

3- month forward 30/ 15

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Calculate the outright forward rates.

Ans. While observing the forward quotations, it is clear that the US dollar is at discount in the

forward market since the points corresponding to the

bid price are higher than those corresponding to the ask price.

Therefore, the forward points will be subtracted form the spot rate

figure. Thus, the outright rates are:

DEM/$ spot - 1.5880/ 90

1 – month forward - 1.5870/ 85

2 – month forward - 1.5860/ 80

3 – month forward - 1.5850/ 75

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Outlook

Liberalization has transformed India’s external sector and a direct beneficiary of

this has been the foreign exchange market in India. From a foreign exchange-starved,

control-ridden economy, India has moved on to a position of $150 billion plus in

international reserves with a confident rupee and drastically reduced foreign exchange

control. As foreign trade and cross-border capital flows continue to grow, and the country

moves towards capital account convertibility, the foreign exchange market is poised to

play an even greater role in the economy, but is unlikely to be completely free of RBI

interventions any time soon.

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Forex Trading activity

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CONCLUSION

Currency markets present a good investment opportunity. However, investors should participate

only after a thorough understanding of how they work. In options, the risk is lower because the

loss is limited to the premium paid. But investors need to know how puts and calls work and

whether the premium being paid for an option is feasible. It's advisable to take a course on forex

derivatives offered by currency exchanges and associations.

One has to be clued in to global developments, trends in world trade as well as economic

indicators of different countries. These include GDP growth, fiscal and monetary policies,

inflows and outflows of the currency, local stock market performance and interest rates.

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BIBLIOGRAOHY

Foreign Exchange MarketsFinancial risk management

Financial risk management: Currency risk managementGlobal Professional Series

Lessons Risk Management SeriesRisk management series

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