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Forex Markets and RatesInternational Corporate Finance

BHUSNUR MATHProfessor (Finance)M D I , Gurgaon

2Segments of Financial Markets Capital Markets Equity Markets Debt Markets Govt Bonds Corporate Bonds Credit Markets Money Markets Foreign Exchange Markets

3Foreign Exchange What constitutes Foreign Exchange? Foreign Currency Receivables from a Non-resident Travelers Cheques Cheques, Demand Drafts drawn by an overseas bank on a bank in India Wire Transfer Bills-of-Exchange Bills of Exchange

BHUSNUR MATH - Forex markets 4

Exchange Rate Price of a currency in domestic currency (rupees) Determined by market supply & demand forces floating currency Rupee is Dirty Float not entirely left to market forces but the RBI intervenes in the market when it so desires.

5Supply of Forex Remittances & Travel Export of Goods & Services Inward Investment FDI, FII External Commercial Borrowings

CurrentAccount

Capital Account

6Demand for Forex Remittances & Travel Import of Goods & Services Overseas Investment

CurrentAccount

Capital Account

Forex Inflow - Flow ChartCy, TCs, Remittances (In), Export Bill Payment, ECBs, FDI/FII, Flow from Maturing Investments abroad

Recipient / Beneficiary

Bank / Authorized Dealers: Gives Rupees and takes $Bank sells $ (makes profit)

Clients who want $ Other Banksin need of $ Inter-Bank Market

R B I (Intervention)if it is buying

Forex Outflow - Flow ChartCy, TCs, Remittances (Out), Import Bill Payment, Investments abroad, Flow from Maturing FDI/FII

Client / Customer

Bank / Authorized Dealers: Gives $ takes RsSells Cy / TCs, Remits, Makes payment to O/S Seller

Bank Buys/Aquires $ (makes profit)

Clients who wants to sell $ Other Banks-who want to sell $ Inter-Bank MarketR B I (Intervention)if it is selling

Forex MarketsCus

tomers

Bank Inter BankForex Market

Other Banks

R B IIntervention

10

RBI Intervention in Forex Markets If RBI Buys

Increases Demand Adds to Forex Reserves

If RBI Sells Increases Supply Reduces Forex reserves

BHUSNUR MATH - Forex markets 11

Factors affecting Forex Rate Supply and demand Import, Export, Trade deficit Remittances Capital Flows- ECBs, FDI, FII Interest rate in India Interest rate in US US / EU Policies, economy prospects Indian Policies, economy prospects

Types of Forex Transactions Value Date / Settlement Date Settlement locations Spot Transactions Value second working day Cash - Value same day Tom Value next working day Forwards Value spot + the calendar month(s) Swaps Combination of a Buy & a Sell -spot & forward or forward and a forward

Exchange Rate Quotations Currency Notations INR, GBP, USD, JPYAUD, EUR, CHF Currency Pairs - convention Base / Quoted Cy GBP/USD Currency bought or sold / no of units of quoted currency Not a fraction Two way quotes Bid / Ask or Buy/SellUSD/CHF 1.4550/ 1.4555 ; 1.4550/55 USD/JPY 159.00/80 AND 160.98/05 Spread, Big Figure, Points or pips

Forward Rates We have to quote a rate for sale of $ effective one year from today We need to buy dollars today at today's rate keep it so that we can deliver these dollars at t=1yr But we need rupees to buy dollars today borrow We need to at least recover our cost of buying and holding

Calculation of forward rates We need $ Borrow Rs @ Buy $ @ using these rupees Deposit these $ for one year @ After one year

Re Loan Payment: Receive $1 deposit maturity value Deliver this 1$ and receive the forward rate= F

)1(1

$rRer

)1(1

$r)1

1(*$rS p pS

)1(1

$r $r

)1(*]*)1(1[( Re$ rsr p

Forward Premium To break even : Forward Rate= Spot Rate + Forward Premium= % Forward Premium =

= = diff in interest rates

$Re1

1* rrS p

$Re1

1* rrS p

111 $Rerr

$$Re1 rrr

)( $Re rr

InterBank and Merchant TransactionsInterbank Transactions With other banks Deal lots 1 mln of base currency For cover operations Own account tradingMerchant Transactions To facilitate remittances & Trade Mostly as per customers requirements Clean and Doc

An Interbank Deal On Monday 16 April 2012: Tom from Bank A Dollar Swiss pl Forty forty-five Mine OK. Bank B sells Bank A USD 10 Mln against CHF at 1.5545 value 18 April 2012, UBS Geneva for CHF Citi Ny for my Dollars, Thanks Bye

Rate Quotations Inter Bank

Bid / Ask , Spread Arbitrage

Cross Rates Quotes though not fractions, work like math fractions Usually only forward differentials quoted

Merchant Rates Normally single rate no two way quote Base Rate Acquiring or Disposal Rate Exchange Margin (add or subtract % of Base) Extra margin/charges for docs as handling charges TT Buying and TT Selling; Bills Buying and Bills Selling Usance Bills rates

Basic Principles for Retail QuotesPrinciples on which rate are calculated by the banks: Forex sold to a customer is simultaneously bought in the inter-bank (wholesale) market acquiring rate Forex bought from the customer is simultaneously sold in the inter-bank market disposal rate The Margin over the acquiring or disposal rate would include

a) Transaction costs ie., overheads , brokerage etc b) And profit

$/Re market in India is very efficient and competitive

Covered Interest Arbitrage If efficient Money Market and Forex Market exist And one is able to operate freely in both

the money market (borrow/lend freely) and the Forex Market (buy/sell the currency)

The forward rate for the currency can be fixed Any divergence from this will lead to arbitrage opportunities Because there are no restrictions, the market rate will have to fall in line with the theoretical rate.

Not a causal relationship Equilibrium relationship

alDifferenti RateInterest )( (%) alDifferenti Forward)1()(

)/()/()/(

)1()1(

)/()/(

)/()/(

)1()1(

BBA

BBAn

BAn

nBA

nininininini

ABSABSABF

nini

ABSABF

ABSABF

nini

Covered Interest Parity Theorem

International Corporate FinanceInternational Business and Trade Finance

Overseas Trade Export Import Third country trade High-seas trade Barter trade

Why do companies export? No local market Better price Components off-shoring Incentives -tax and duty Cheaper credit

Risks faced by exporters Payment risk Exchange rate risk Regulatory risk Political risk

Why do companies import? Raw material Components Trading Supply gap Value addition Value addition and export

Ways of settling Cross-Border Transactions Currency of Invoicing (exchange rate risk or forex risk) Advance Payment Bills for collection Bills discounting Use of LCs Negotiation of Bills / drafts drawn under LCs INCO Terms Counter- Trade High Seas Trade

Risks importers face Delivery risk

Goods may not be delivered after payment Exchange rate risk Quality risk Price risk Regulatory risk

Managing Payment Risk Advance Payment Bill for Collection thro a bank Bill Discounting Factors / Forfaiting

Commercial Documents Sale Purchase Contract, Purchase Order Invoice Bill-of-Exchange, Draft Sight Bill, Usance Bill / Time Draft Consignment Sale Counter Trade High-seas sale

SBI Delhi

Seller

SBI Coimbatore

BuyerSale / Purchase contract

Advice

Bills for Collection -- flow chart

Account CreditedDocuments Documents against PaymentIntimation

Documents

SBI Delhi

Seller

SBI Coimbatore


Collection of Usance Bills- flow chart

Documents taken and A/c Credited

Docs against AcceptanceIntimation

Documents

SBI Delhi

Seller

SBI Coimbatore


Bills Discounted-- flow chart


Documents against PaymentIntimation

Documents

SBI Delhi

Seller

SBI Coimbatore


Discounting of Usance Bills- flow chart


Doc against AcceptanceIntimation

DocumentsPayment

SBI INDIA

EXPORTERINDIA

SBI NEW YORK

IMPORTERITALY

RECEIVE USDPAY INR

SELLS GOODS

ADVICEExport transaction -- flow chart

SBI INDIA

IMPORTERINDIA

SBI NEW YORK

SUPPLIERJAPAN

PAY USDPays Rupees

OWES MONEY

ADVICEImport Transaction -- flow chart

Mechanics of Documentary Credit

IMPORTER EXPORTER

Contract

OPENINGBANKADVISING/NEGOTIATINGBANK

SHIPPINGCOMPANY GOODSDOCS

DOCUMENTSOPEN CREDIT

DOCUMENTSPAYMENT PAYMENT

GOODSDOCS

Important elements of a credit Name of issuing bank, confirmation?? Irrevocable?? Amount of credit Details of goods and unit price. Place and time of expiry Last date of shipment, submission of documents. Terms of payment sight, usance Documents required - Specified Part-shipment/ trans-shipment

Benefit to exporters & importersExporter: Exposure to Bank Opening Bank to pay without reference tothe applicant (importer)Importer Ensure proper documents Can include quality inspection certificates Can negotiate for better price

Factoring A Financial Intermediary That buys invoices of a manufacturer or a trader, at a discount, and Takes responsibility for collection of payments.

Factoring Services Follow-up and collection of Receivables Help in getting information and credit line on customers (credit protection) Sorting out disputes, if any, due to his relationship with Buyer & Seller. Factor charges Commission (as a flat percentage of value of Debts purchased) (0.50% to 1.50%)

Types of Factoring Recourse Factoring Non-recourse Factoring Maturity Factoring Cross-border Factoring

Forfaiting Forfait is derived from French word A Forfait which means surrender of fights. Forfaiting is a mechanism by which the right for export receivables of an exporter (Client) is purchased by a Financial Intermediary (Forfaiter) without recourse to him. It is different from International Factoring in as much as it deals with receivables relating to deferred payment exports, while Factoring deals with short term receivables.

BILLS DISCOUNTED FACTORING FORFAITING1. Scrutiny Individual Sale Transaction Service of Sale Transaction Individual Sale Transaction2. Extent of Finance Upto 75 80% Upto 80% Upto 100%3. Recourse With Recourse With or Without Recourse

Without Recourse4. Sales Administration Not Done Done Not Done5. Term Short Term Short Term Medium Term6. Charge Creation Hypothecation Assignment Assignment

Bankers Acceptance (BAs) A time draft, which is accepted and guaranteed by a bank as good as the Banks word Exposure to the Bank so high credit-rating A short-term debt instrument issued by a firm that is guaranteed by a commercial bank

Trade Finance Pre-shipment /Packing Credit Post Shipment credit Bills discounting L/Cs B As Suppliers Credit Buyers credit

Buyer's credit Credit availed by an importer (buyer) from overseas lenders for payment of his imports on due date Usually against a letter of comfort / bank guarantee issued by the importers bank

Suppliers Credit A financing arrangement under which an exporter extends credit to a foreign importer to finance his purchase. Importer pays a portion of the contract value in cash and issues a Promissory note or accepts a draft LC with Usance Terms Deferred payment

BHUSNUR MATH Basics of Derivatives 51

Basics of Derivatives


DerivativesDerivatives are contracts whose value is derived from / dependent on value of another (underlying) commodity / contract


Types of Derivatives Futures & Forwards Options Swaps


Futures & ForwardsForward Contract A contract to sell (buy) a certain quantity of some thing at a price agreed today and delivered and paid for paid for on a future date Futures are standardized forward contracts traded on an exchange


Forwards Characteristics An agreement / contract Price fixed on day 0 Compulsory settlement - No choice Cancellation

Before due date at opposite contract for the same maturity On due date at opposite spot rate


Futures Contract Specs Standardized quantity

1 mln bbl crude 1000 shares of SocGen 1 mln US Dollars

Buy or Sell n number of contracts Settlement dates specified by exchange

Quarter end - commodities 10th of every month crude

Deliver Specs


Futures Delivery Specs Quality Quality Mode of delivery Alternatives, if any , Cheapest-to-deliver Indicies compulsory settlement against spot Procedures in case of default ? Short Selling or naked positions


Futures Pay-Off Long Short

SoP SoP


Options Contracts which give the holder an option to buy (sell) a certain quantity of the underlying at a price agreed upon today (Strike Price - X) to be settled on an agreed future date Types of Options

Put and Call


Options - characteristics Choice to exercise If not exercised, the option lapses Options have to be purchased by paying a premium Premium upfront outlay Kind of an insurance Can have more than one Strike Price for same maturity Counterparty writes the option - writer


Options OTC & Exchange Traded OTC Over-the-Counter

Customized Opaque market Availability / Liquidity

Exchange Traded - Listed Regulated Transparent & No default Standardized Contract Specs Deliver mostly set off


Options Pay-Off - calls Call Holder Call Writer

X XSo So


Options Pay-Off - puts Put Holder Put Writer

X XSo So


Use of Derivatives Hedging

Hedging locks in the price Spot price fluctuations do not affect Both down-side & upside cut out

Trading - Speculation


Derivatives - Hedging Producer

Sell Forward Sell Futures contracts Buy Put Write a Call ?? (covered call?)

Consumer Buy Forward / Futures Buy Call Write a Put


Swaps Contracts to exchange streams of cash-flows determined according to an agreement, on a future date.


Interest Rate Swaps Need : Hedging interest Rate Risk

A BL+ 0.56%

L+ 0.5

6%


IRS - Characteristics Fixed-to-Floating

Floating-to- fixed Notional Principal Interest receivable and payable are set-off and net paid / received Default / Counter-party risk


IRS - Warehousing Counter Party may not be easily available Banks become counter-party and warehouse swaps till they find a counter-party.

A BankL+ 0.56+ 0.5%

L+ 0.5


Currency Swaps Need

swap a borrowing (liability) in one currency into a liability in another currency


Currency Swaps Cash Flows 1t= 0

A Bank$ 1.3 mln$ 1.3 mln

Euro 1 mln


Currency Swaps Cash Flows 2t= 6m

A Bank$0.039 mlnEuro 0.045 mln

$ 0.039 mln


Currency Swaps Cash Flows 3t= 10 yrs

A Bank$1.3 mlnEuro 1 mln

$1.3 mln


Caps, Floors, Collars Caps: If the interest rate goes above an agreed level, the bank will make good the difference Floors: If the interest rate goes below an agreed level, the bank will make good the difference Collars: If the interest rate goes above an agreed level or below and agreed level, the bank will make good the difference


FRA Forward rate Agreement (?) Forward Rate contract for a deposit A promise to accept a deposit on a future date at interest rate agreed upon today A contract to make good the loss which would be incurred by the buyer of FRA for a certain term, on a notional sum of money, if spot interest rates for that term, on the fixed future date is lower than an agreed rate,

in exchange for the profit the buyer would make if the rate is higher


FRA An exampleA buys from B an FRA .5m / 3m , 6% for a notional sum of Euro 1 mln Effective date 2m from now Interest rate term: 3m On t=2m, if 3m rate is

6% A pays B


FRA Utility in hedging Locking-in interest rates for intended asset / liability creation on a future date If funds are to be invested on a future date -- Buy FRA If funds are to be borrowed on a future date -- Sell

icf

Documents

forex rate supply

exchange rate price

domestic currency rupees

demand import

foreign currency receivables

todays rate

units of quoted currency

market supply demand