MBA (Finance specialisation)

&

MBA – Banking and Finance

(Trimester)

Term VI

Module : – International Financial Management

Unit II: Foreign Exchange Markets

Lesson 2.1 (Introduction to Foreign Exchange Markets- Functions, quotations, etc.)

Foreign Exchange Market

A foreign exchange market is the one where one currency (foreign currency) is bought and sold against another currency (domestic or home currency). This market has been developed to facilitate international trade, foreign investment and borrowing from or / lending to foreigners. In order to pay for imports or receive payments for exports, companies/individuals residing in one country have to acquire or dispose off the currency of another country. Foreign exchange markets provide the facility of exchanging different currencies.

Foreign Exchange Market

The price of one currency in terms of another is known as exchange rate. Exchange dealers do the job of the exchange of currencies. The transactions in the foreign exchange market can be either to exchange cash or to buy/sell some other instruments. The major instruments are currency forward, currency futures, currency options and currency swaps.

Foreign Exchange MarketVarious kinds of transactions conducted in the foreign exchange market are briefly given below:Spot transactions refers to the transaction involving sale and purchase of currencies for immediate delivery.Currency forward contracts are settled on a future date even though the forward rate are quoted at present moment (today). They are quoted like spot rate but actual delivery of currencies takes place much later.Currency options are the instruments that give the choice to their holder to buy or sell a foreign currency on or up to date ( also called maturity date) at a specified exchange rate ( also called strike rate).Swaps are the instrument that enable two parties to exchange the stream of cashflows in two different currencies.

Foreign Exchange MarketExchange rate quotationsExchange rate means the price of one unit of a currency in terms of some units of another country. For example , Rs 45/US$ means that an amount of Rs 45 is needed to buy one US dollar or Rs 45 will be received for selling one US dollar. When there is no difference between buying and selling rate , the rate is unified. But in practice, it is rarely so. A dealer, who is willing to buy and sell the same currency against another, does not quote an identical price for buying as well as selling. Buying rate is also called bid rate while selling rate is also known as offer rate or ask rate.

Foreign Exchange MarketSpread The dealer keeps a difference between buying and selling price. This difference is known as spread and constitute his profit. Look at the example given below

Now consider the rupee/dollar rate. The dealer will buy dollar for Rs 62.50 where he will sell a dollar for Rs 62.80. The difference between buying rate and selling rate ( 62.80 -62.50 = 0.30) is spread. This is the profit of the dealer. The amount of spread or the profit of the dealer depends on the volume of transactions. The currencies which are frequently traded have smaller spread whereas the currencies which are not very frequently traded have larger spread.

Currency Pair Buying rate Selling rateRupee/US $ 62.50 62.80Rupee/Swiss Franc 35.40 35.90

Foreign Exchange MarketSpread can be expressed in absolute figures or in terms of percentage.

In absolute terms, Spread = Selling rate – Buying rate

Spread in percentage can be expressed either with reference to buying rate or with reference to selling rate.

When buying rate is taken as reference, the denominator is buying rate . Thus,Spread ( in percentage) = [( Selling rate – Buying rate)/ Buying rate] x 100

When selling rate is taken as reference, the denominator is selling rate . Thus,Spread ( in percentage) = [( Selling rate – Buying rate)/ Selling rate] x 100

Foreign Exchange MarketDirect and Indirect quotationsWhen one unit of FOREIGN currency (i.e. dollar) is quoted in terms of some number of HOME currency (i.e. rupees), it is a direct quotation. For example , Rs 60/US $.

When one unit of HOME currency (i.e. rupees) is quoted in terms of some number of FOREIGN currency (i.e. dollar), it is a indirect quotation. For example , $0.0166/rupee.Cross RatesAn exchange rate between two currencies that is derived from the exchange rates of those currencies with a third currency is known as a cross rate of exchange. For example, exchange rate may be given between a pair, A and B and another pair, A and C. Then the rate between B and C derived from the given rates of the two pairs ( A and B, and , A and C) is called cross rate.

Foreign Exchange MarketReciprocal RatesA quotation in direct form can easily be converted into quotation in indirect form and vice versa. This is done by making the reciprocal of the given rate. For example , a unique rate Rs 62/$ is in direct form if quoted in India. Its reciprocal $ (1/62)/Re or $ (0.0161)/Re is the indirect quote in India. In general , the reciprocal rate between two currencies A and B is found as follows :

(A/B)bid = (B/A)ask

and (A/B)ask = (B/A)bid

Example: Rs/$ is direct form in India is given as follows:

Rs 60 /$ - Rs 63/$

Solution : To find reciprocal rates, we apply above equations :

$(1/63)/Re - $ (1/60)/Re $ 0.0158/Re - $ 0.0166/Re

Foreign Exchange Market

Exchange rate quotations in Forward marketIn case of forward market, the exchange of currencies takes place after some period from the date of the deal. The exchange rates are quoted for maturity of one month , two months, three months, etc. using swap points as shown below:Currency pair Spot One month

forwardTwo month forward

Three month forward

$/euro 1.2000/50 30/40 60/85 100/140

Foreign Exchange MarketThe interpretation of swap points is as follows:Here spot rate is 1.2000/50 which implies spot buying rate is $ 1.2000 per euro and spot selling rate is $1.2050 per euro since the last two digits of buying rate are replaced by 50.

In order to determine , the forward rate , we shall see the relationship between numerator and denominator of the forward period.

Like , in the case of one month forward, numerator (30) is smaller than denominator (40) , then these points are to be added to the respective figures of spot buying and selling rates. So, one month forward buying rate becomes 1.2030 (1.2000 + 0.0030) and one month selling rate becomes 1.2090 (1.2050 + 00.40). Here the forward rate figures are greater than spot rate figures therefore we may say forward rate is at premium vis-à-vis spot rate.

Similarly , second month rate would be ( 1.2000+0.0060 = 1.2060 and 1.2050+ 0.0085 = 1.2135) and third month rates would be (1.2000+0.0100 = 1.2100 and 1.2050+ 0.0140 = 1.2190).

Foreign Exchange MarketIn case numerator is larger than denominator, than these swap points are to be subtracted from the respective figures of spot buying and selling rates. Consider the example given below:

In case of one month forward, numerator (50) is greater than denominator (40) , therefore , these swap point will be deducted from the spot rate to arrive at outright rate of one month forward.Buying rate of one month forward will be 1.7100 – 0.0050 = 1.7050Selling rate of one month forward will be 1.7250 – 0.0040 = 1.7210

Here the forward rate figures are smaller than spot rate figures therefore we may say forward rate is at discount vis-à-vis spot rate.

Currency pair Spot One month forward

Two month forward

Three month forward

$/euro 1.7100/250 50/40 100/85 155/125

Foreign Exchange Market

Similarly, In case of two month forward, numerator (100) is greater than denominator (85) , therefore , these swap point will be deducted from the spot rate to arrive at outright rate of one month forward.Buying rate of one month forward will be 1.7100 – 0.0100 = 1.7000Selling rate of one month forward will be 1.7250 – 0.0085 = 1.7165

In case of three month forward, numerator (155) is greater than denominator (125) , therefore , these swap point will be deducted from the spot rate to arrive at outright rate of one month forward.Buying rate of one month forward will be 1.7100 – 0.0155 = 1.6945Selling rate of one month forward will be 1.7250 – 0.0125 = 1.7125

Foreign Exchange MarketExample : A foreign exchange trader gives the following quotes for the Euro vs. dollar spot, one month, three months and six months to a US based treasurer.

Calculate the outright quotes for one, three and six month forward. Also calculate spread at these periods.

currency pair Spot 1 Month 3 Months 6 Months

Euro vs dollar $0.02368/70 4/5 8/7 14/12

Foreign Exchange MarketSolutionMaturity Remarks Bid (buy) Ask (sell) Spread = Difference

between ask and bid

Spot $0.02368 $0.02370 .00002

1 Month Since numerator (4) is less than denominator (5), points are added to the spot rate

$0.02372 $0.02375 .00003

3 Months Since numerator (8) is more than denominator (7), points are subtracted from the spot rate

$0.02360 $0.02363 .00003

6 Months Since numerator (14) is more than denominator (12), points are subtracted from the spot rate

$0.02354 $0.02358 .00004

Exercise

Problem 1: A foreign exchange trader gives the following quotes for the Rs vs. dollar spot, one month, three months and six months to a US based treasurer

Calculate the outright quotes for one, two and three month forward. Also calculate spread and spread percentage ( based on selling as well as buying price) at these periods.

Spot rate (Rs/$) 62.32 62.53

One – month forward 0.05 0.09

Two – month forward 0.07 0.03

Three – month forward 0.08 0.06

Exercise

Problem 2: A foreign exchange trader gives the following quotes for the Rs vs. dollar spot, one month, three months and six months to a US based treasurer

Calculate the outright quotes for one, two and three month forward. Also calculate spread and spread percentage ( based on selling as well as buying price) at these periods.

Spot rate (Rs/$) 61.45 61.6

One – month forward 0.06 0.08

Two – month forward 0.05 0.03

Three – month forward 0.07 0.05

Forward Premium or DiscountIf forward rate of a currency is greater than the its spot rate, it is said to be at a forward premium. On the other hand ,if its forward rate is smaller than its spot rate, it is at forward discount. For example, Rs/$ spot rate is Rs 60/$ and three month forward rate is Rs 61/$. This shows that dollar is atforward premium. The premium or discount is calculated using equation given below :

Forward premium/discount = [ (F – S)/ S ] x (12/N) x 100

where N is the number of months forward, F = Forward rate S = Spot rate

Foreign Exchange MarketExample : From the data given below calculate forward premium or discount as the case may be

Solution Forward Premium (using bid price) = [(44.7000 – 44.5000)/ 44.5000] x (12/3) x 100 = 1.18 percent per annum[Dollar is at premium]

Forward Premium (using ask price) = [(44.9990 – 44.7050)/ 44.7050] x (12/3) x 100 = 2.63 percent per annum[Dollar is at premium]

Particular Spot 3-month forward

Rs/$ 44.5000/7050 44.7000/9990

Foreign Exchange MarketExample : From the data given below calculate forward premium or discount (on annualized basis) as the case may be

Solution Forward Premium/ discount= [(62.50 – 62.15)/ 62.15] x (12/3) x 100 = 2.252 percent per annum[Dollar is at premium]

Particular Spot 3-month forward

Rs/$ 62.15 62.50