forex
TRANSCRIPT
1
The Foreign Exchange Market
Forex and Treasury Management
Session 1 and 2
2
The Foreign Exchange Market
The Structure of the Forex Market Foreign Exchange Types of Transactions Settlement Dates Quotes for Various Kinds of Merchant Transactions The Indian Scenario
Convertibility
Exchange Control
The FEDAI Rules Regarding Inter-bank Dealings
Forex Dealing Room Operations
3
Structure of the Forex Market
Decentralized, over-the-counter market, also known as the 'interbank' market
Main participants: Central Banks, commercial and investment banks, hedge funds, pension funds, corporations & private speculators
The free-floating currency system began in 1973, and was officially mandated in 1978
Online trading began in the mid to late 1990's
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Structure of the Forex MarketTrading Hours
24 hour market Sunday 5pm EST through Friday 4pm EST. Rollover at 5pm EST Trading begins in New Zealand, followed by Australia, Asia, the Middle East, Europe, and America
SizeLargest market in the world$1.9 trillion average daily turnover, equivalent to: 15 times the average daily turnover of global equity markets Nearly 50 times the average daily turnover of the NYSE $300 a day for every man, woman, and child on earth The spot market accounts for about one-third of daily turnover
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Structure of the Forex Market
Major Markets The US & UK account for more than 50% of turnover Major markets: London, New York, Tokyo Trading activity is heaviest when major markets overlap Nearly two-thirds of NY activity occurs in the morning
hours while European markets are openTrading An estimated 95% of transactions are speculative More than 40% of trades last less than two days About 80% of trades last less than one week Brokers research: 90% of traders lose money, 5% break
even, 5% make money
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Structure of the Forex MarketCountry wise turnover
Country Percentage Share
UK 31.3
USA 19.2
Japan 8.3
Singapore 5.2
Germany 4.9
Hong Kong 4.2
Australia 3.4
Others 23.5
Total 100
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Structure of the Forex MarketCurrency wise turnover
Currency Percentage Share
USD 88.7
EURO 37.2
JPY 20.3
GBP 16.9
CHF 6.1
AUD 5.5
CAD 4.2
Others 21.1
Total 200.0
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Structure of the Forex MarketCurrency Pair wise turnover
Currency Percentage Share
EURO/USD 28
USD/JPY 17
GBP/USD 14
AUD/USD 5
USD/CHF 4
USD/ CAD 4
EURO/JPY 3
Others 25
Total 100
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Around-the-clock FX trading
0
5,000
10,000
15,000
20,000
25,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Average Electronic Conversions Per Hour
Greenwich Mean Time
Tokyoopens
Asiaclosing
10 AMIn Tokyo
Afternoonin America
Londonclosing
6 pmIn NY
Americasopen
Europeopening
LunchIn Tokyo
10
spot33%
forw ard11%gap
6%
FX sw aps50%
World FX transactions$1.9 trillion/day (2004)
FX market in the U.S. is the most active market in the U.S.
$461 billion turnover per day, in 2004 Comparisons with U.S. asset markets:
· 10 times the turnover of U.S. govt. bonds· 50 times the turnover of NYSE stocks
Comparisons with real activity in U.S.:· 10 times U.S. daily GDP· 30 times U.S. daily exports + imports
Primary functions of FX Market
Currency conversions associated with international payments process
Provision of credit to clients(also part of international payments process)
Managing exchange rate risk
Structure of FX Market (retail level)
Interbank mkt($/FC)
domestic ($) foreign (FC)
Exchange-tradedfutures & options
central bank
firms
investors
for. firms
for. central bank
for. investors
Structure of FX Market: interbank (wholesale) level
Banks trade with each other· in response to the retail orders they receive· to manage their own accounts
Banks trade· directly with other banks· indirectly through FX brokers
FX market
dom.bank
Corp.order for.
bank
dom.bank
for.bank
FX broker
Corp.order
Corp.order
Corp.order
domestic ($)
foreign (FC)
$/FC
Direct vs. brokered interbank trades Direct dealing Banks face another bank’s bid-ask spread, at which they can
transact immediately Brokered trades
Get best price of all posted buys/sells· 56% of all dealers’ trades are with other dealers· 31% are with other financial institutions
(brokers, mutual funds, ...)· 13% are with non-financial customers
· 66% of all trades are with foreign counterparties Much (56%) of FX trading is in the interbank (wholesale)
market
However, the retail orders are the important ones that determine exchange rates
· Interbank traders are intermediaries (market makers)
· temporarily take positions intra-daily, but work hard to zero out their positions regularly and by
the end of the day
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Structure of the Forex Market
Function and Structure of the FOREX Market The Spot Market
Spot Rate Quotations The Bid-Ask Spread Spot FX Trading Cross Exchange Rate Quotations Triangular Arbitrage Spot Foreign Exchange Market Microstructure
The Forward Market
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FOREX Market Participants The FOREX market is a two-tiered market:
Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a
market in Foreign exchange. Nonbank dealers account for about 20% of the
market. There are FX brokers who match buy and sell orders
but do not carry inventory and FX specialists. Client Market (Retail)
Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.
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Correspondent Banking Relationships
Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market.
International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial
Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global
clearinghouse for settling interbank FOREX transactions.
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The Spot Market
Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates
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Spot Rate Quotations Spot Rate Quotations
Direct quotation the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” =
$.01/yen
Indirect Quotation the price of a U.S. dollar in the foreign currency =
Y100/$ e.g. “you get 100 yen to the dollar”
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Spot Rate Quotations
The direct quote for British pound is:
£1 = $1.5627
Country
USD equiv Friday
USD equiv Thursday
Currency per USD Friday
Currency per USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
Britain (Pound) 1.5627 1.566 0.6399 0.6386
1 Month Forward 1.5596 1.5629 0.6412 0.6398
3 Months Forward 1.5535 1.5568 0.6437 0.6423
6 Months Forward 1.5445 1.5477 0.6475 0.6461
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975
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Spot Rate Quotations
The indirect quote for British pound is:
£.6399 = $1 1.49751.51060.66780.6626 Months Forward
1.48881.5020.67170.66583 Months Forward
1.48351.49680.67410.66811 Month Forward
1.48131.49430.67510.6692Canada (Dollar)
0.64610.64751.54771.54456 Months Forward
0.64230.64371.55681.55353 Months Forward
0.63980.64121.56291.55961 Month Forward
0.63860.63991.5661.5627Britain (Pound)
3.47343.40250.28790.2939Brazil (Real)
1.68521.69320.59340.5906Australia (Dollar)
3.03773.02210.32920.3309Argentina (Peso)
Currency per USD Thursday
Currency per USD Friday
USD equiv Thursday
USD equiv FridayCountry
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Spot Rate Quotations
Note that the direct quote is the reciprocal of the indirect quote:
6399.
15627.1
1.49751.51060.66780.6626 Months Forward
1.48881.5020.67170.66583 Months Forward
1.48351.49680.67410.66811 Month Forward
1.48131.49430.67510.6692Canada (Dollar)
0.64610.64751.54771.54456 Months Forward
0.64230.64371.55681.55353 Months Forward
0.63980.64121.56291.55961 Month Forward
0.63860.63991.5661.5627Britain (Pound)
3.47343.40250.28790.2939Brazil (Real)
1.68521.69320.59340.5906Australia (Dollar)
3.03773.02210.32920.3309Argentina (Peso)
Currency per USD Thursday
Currency per USD Friday
USD equiv Thursday
USD equiv FridayCountry
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The Bid-Ask Spread
The Bid price is the price a dealer is willing to pay for a currency = S(j/kb)
The Ask price is the amount the dealer offers to sell you a currency. It’s the price the dealer wants for the sale of currency = S(j/ka)
Bid-Ask Spread = [Ask price - Bid price] > 0
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Spot FX trading
In the interbank market, the standard size trade is about U.S. $10 million.
A bank trading room is a noisy, active place.
The stakes are high. The “long term” is about 10 minutes.
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Cross Rates: Example
Suppose that S(€/$) = € 1.0240/$
and S(£/$) = £ .6550/$ What must the S(£/€) cross rate be?
,€
/£
€
£
$$since
£€ or €£.€)£S/$.€
£ ./5635.1/6396/(
02401
$/6550
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Triangular Arbitrage
$
£¥
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
Suppose we observe these banks posting these exchange rates.
First calculate the implied cross rates to see if an arbitrage exists.
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Triangular Arbitrage
$Credit
Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
80¥
1£
120¥
1$
1$
50.1£
The implied S(¥/£) cross rate is S(¥/£) = 80
Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.
So, how can we make money?
Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.
¥ £
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Triangular Arbitrage
$Credit
Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
As easy as 1 – 2 – 3:
1. Sell our $ for £,
2. Sell our £ for ¥,
3. Sell those ¥ for $.¥ £
1
2
3
$
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Triangular ArbitrageSell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥ 12,750,000 for $ at S(¥/$) = 120receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250
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Spot Foreign Exchange Microstructure
Market Microstructure are the mechanics of how a marketplace operates.
Spot mkt Bid-Ask spreads in the: increase with FX exchange rate volatility and
decrease with dealer competition. Private information is an important determinant of spot
exchange rates. - Mkt adjusts to econ info in 1min.
- 1/3 of traders claim adjustment < 10 sec
- Cbank intervention does not work; it increase volatility.
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The Forward Market
Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium
A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.
If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.
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Forward Rate Quotations
The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.
Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.
Longer-term swaps are available.
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Quotations
Clearly the market participants expect that the pound will be worth less in dollars in six months.
1.49751.51060.66780.6626 Months Forward
1.48881.5020.67170.66583 Months Forward
1.48351.49680.67410.66811 Month Forward
1.48131.49430.67510.6692Canada (Dollar)
0.64610.64751.54771.54456 Months Forward
0.64230.64371.55681.55353 Months Forward
0.63980.64121.56291.55961 Month Forward
0.63860.63991.5661.5627Britain (Pound)
3.47343.40250.28790.2939Brazil (Real)
1.68521.69320.59340.5906Australia (Dollar)
3.03773.02210.32920.3309Argentina (Peso)
Currency per USD Thursday
Currency per USD Friday
USD equiv Thursday
USD equiv FridayCountry
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Forward Rate Quotations
Consider the example from above:
for Japanese yen, the spot rate is
$1.5627 = £1.00
While the 180-day forward rate is
$1.5445 = £1.00 What’s up with that?
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Long and Short Forward Positions
If you have agreed to sell anything (spot or forward), you are “short”.
If you have agreed to buy anything (forward or spot), you are “long”.
If you have agreed to sell FX forward, you are short.
If you have agreed to buy FX forward, you are long.
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Payoff Profiles
0 S180($/¥)
F180($/¥) = .009524 direct quote
Short position
loss
profit(1) If you agree to sell currency in the future at a set price and the spot price later falls then you gain.
(2) If you agree to sell currency in the future at a set price and the spot price later rises then you lose.
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Payoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
profit Whether the payoff profile
slopes up or down depends upon whether
you use the direct or indirect
quote:
F180(¥/$) = 105 or F180($/¥)
= .009524.
short position
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Payoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105
profitshort position
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Payoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
120
If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105.
15¥
profitshort position
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SWAPS/ Forward Premium
A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want.Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.
Forward Premium is just the interest rate differential implied by forward premium or discount.
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01375.5235.
5235.5307.
180
360
€)/($
€)/($€)/($180$,€180
S
SFf v
For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307 The forward premium is given by:
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Convertibility-Definition The ease with which a country's currency can be
converted into gold or another currency. Convertibility is extremely important for international commerce. When a currency in inconvertible, it poses a risk and barrier to trade with foreigners who have no need for the domestic currency
The quality of being exchangeable (especially the ability to convert a currency into gold or other currencies without restriction)
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Convertibility-Definition Government restrictions can often result in a
currency with a low convertibility. For example, a government with low reserves of hard foreign currency often restrict currency convertibility because the government would not be in a position to intervene in the foreign exchange market (i.e. revalue, devalue) to support their own currency if and when necessary
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Rupee Convertibility
The Indian Rupee is1) for all intents and purposes, fully Convertible to the US$ on the Trade Account and Current Account. This means Indians can buy US$ for their Trade, Travel, Fees, Education, Interest, Dividend payments etc. US Dollars can also be converted into Rupees2) largely, NOT convertible to US$ on the Capital Account, especially when the flow of capital is from India to outside.
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Rupee Convertibility
However, degrees of convertibility have been brought in. For instance,- Indian companies can invest in/ set up subsidiaries abroad. Limits are placed on the amount of investment- Indian mutual funds, since last year, have been allowed to invest in overseas markets, though we doubt if activity has picked up on this front- Dividend and Interest payments to investors abroad are unhindered
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Rupee Convertibility Flow of Capital from outside India (investments into
India) are unencumbered from the "convertibility" point of view.
Investors may need to garner various necessary permissions as required to invest in the equity market, debt market or to set up greenfield projects or buy over existing companies. These are, essentially, outside the ambit of "convertibility"
Indian Rupee is not legally pegged to the Dollar. It is market traded currency, though the trading itself is controlled by various measures. Technically, the Indian Rupee is in a "Managed Float" or "Dirty Float", like the Yen.
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Exchange Control
Introduced during post-WW II period More stringent in post-independence era FERA 1948, MORE powers in 1973
( Rigid import controls, highest duties, industrial policy towards import substitution, foreign investment discouraged etc.– CLOSED ECONOMY)
1991 BOP crisis – Policy shifts August 1994—Current account convertibility 1999 FEMA
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Forex Dealing Room Operations
Objectives of Dealing Room Affording the best possible customer service Managing the bank’s foreign currency exposures Generating profit for the bank Ensuring the compliance of relevant regulations
Participants Organizations Commercial banks Central banking authority Brokers
52
Forex Dealing Room Operations
Indian Regulations
Brokers not allowed to as principals or maintaining foreign currencies
Brokers notes to be received promptly and acted upon on the same day by dealers
Nominations of deals not done by them not permitted Spread of brokers Duty separation for dealers
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Forex Dealing Room Operations
Dealing Process
Customer Bank BranchDealingRoom
Front Office
Mid-Office
Back Office
Domestic market
Global Market
Front Office: Actual dealingMid-Office: Risk management, accounting and MISBack Office: Settlement, Reconciliation, compliance and accounting
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Forex Dealing Room Operations
Regulatory Requirements
Daily Fx turnover and Gaps position and Cash Balance
Monthly statement in USD denomination Aggregate gap limit (AGL) approved Maximum AGL on any day VaR approved Maximum VaR on any day during the month
55
Forex Dealing Room Operations
Front Office: Confirmation, stamped agreement, P/L evaluation monthly report, gold and record maintenance
Policy prescriptions Strategy formulation Concentration limits Risk processes Task delineation Internal accounting/reporting Secrecy issues
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Forex Dealing Room OperationsManaging Risks
Open position Maturity
mismatch Credit risk Operational
Risk Legal Risk Sovereign
Risks
Day light, overnight and cut loss IGL, Monthly Limits, AGL, etc.
Country/group, currency limits Duty segregation, processes, etc
Responsibility fixation, supports, etc.
External data, monitoring, etc.
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Rate Mechanism
Transaction Buying Selling
Spot TT Base 48.5500
Less [email protected]% 0.0380
Spot TT 48.5120
Base 48.7000
Add [email protected]% 0.0731
Spot TT 48.7731
Forward TT Base 48.5500
Add Premium 0.1500
Less [email protected]% 0.0389
Forward 48.6611
Base 48.7000
Add Premium 0.2000
Add [email protected]% 0.0734
Forward 48.9734
Bill Base 48.5500
Premium 0.4000
Less [email protected]% 0.0734
Bill 48.8766
Base 48.7000
Add [email protected]% 0.0731
Add [email protected]% 0.0975
Bill 48.8706
TC Base 48.7500
Less Margin@1% 0.4875
TC 48.2625
TT Selling 48.7641
Add [email protected]% 0.2438
Add Commission@1% 0.4900
TC 49.4979
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THANKS