FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION & CURRENCY DERIVATIVES

CHAPTER - 4
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Foreign Exchange Market

It is the market in which currencies are bought and sold against each other. It is an Over-the-Counter market.

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Functions of Foreign Exchange Markets

To transfer purchasing power between countries To obtain or provide credit from international trade transactions To minimize exposure to risk of

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Participants of the Foreign Exchange Markets

The foreign exchange market consists of two tiers
Interbank or Wholesale Market Client or Retail Market

5 categories of participants operate within these 2 tiers:

Bank & Non-Bank foreign exchange dealers Individuals and firms conducting commercial and investment transactions Speculators &

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Foreign Exchange Market: Transactions

Spot Transactions Forward Transactions Swap Transactions

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Foreign Exchange Market: Transactions

Spot Transactions: Purchase of foreign exchange with delivery and payment between banks to take place normally on the second following business day

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Forward Transactions: An outright forward transaction requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.

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Swap Transactions: It refers to the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

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Exchange Rate Quotations

Direct Quote: Home currency price of a certain amount of foreign exchange Rupee Dollar Quote: Rs.52/ US $ Indirect Quote: Amount of foreign currency per unit of home currency Rupee Dollar Quote: 5/10/12 US $ 0.01923/ Re.

Buying and Selling Rates

Buying Rate/ Bid Rate: Bank buys a foreign currency at this rate Selling Rate/ Ask Rate: Bank sells foreign currency to its customers Spread: Ask Rate Bid Rate 100 Ask Rate
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The first rate of the quote (known as bid) is the rate at which the bank buys left hand currency, the second rate of the quote (known as ask) is the rate at which the bank sells the left hand currency.
1 $ = Rs.40.10 / Rs.40.15 It is direct quote with reference to India. $ is left hand currency. So it is rate of $.
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Spread size depends upon:

Strength of the currency Type of transaction Demand & supply position of the currency with the transacting bank

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Cross Currency Quotes

International Quotes (also known as cross currency quotes). In this case, both the currencies are foreign currencies. Examples of international quotes in India: 1$ = 0.5488 1 = $ 1.8222 1 Euro = $ 1.2000
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Numericals
Example (A) Convert the following direct quotes (in India) into indirect quotes: 1$ = Rs.40 1 = Rs.82 Answer: Indirect quotes (in India) Re. 1 = $ 1/40 i.e. $ 0.0250 Re. 1 = 1/82 i.e. 0.0122 Example (B) Convert the following indirect quotes (in India) into direct quotes: Re. 1 = $ 0.0222 Re. 1 = 0.0122 Answer: Direct quotes (In India) 1$ = Rs.1 / 0.0222 i.e. Rs.45 5/10/12 1 = Rs.1/ 0.0122 i.e. Rs.82

Q.No.1: Convert the direct quotes into indirect quotes: (a) 1$ = Rs.40.00 / 40.05 (b) 1 = Rs.82.00/82.07 (c) 1Euro = Rs.56.00/ 56.18 Answer (a) $1 = Rs.40.00 40.05 Re.1 = 1/40.05 - 1/40.00 = $ 0.02496879 - 0.02500000 (b) 1 = Rs.82.00/82.07 Re.1 = 1/82.07 - 1/82.00 = 0.0121847 - 0.01219512 (c) 1 Euro = Rs.56.00 56.18 1 Re. 5/10/12 = Euro 1/56.18 1/56.00

Q. No.2: Calculate how many rupees Shri Ras Bihari Ji Ltd., a New Delhi based firm, will receive or pay for its following four foreign currency transactions: (i) The firm receives dividend amounting to Euro 1,12,000 from its French Associate Company. (ii) The firm pays interest amounting to 2,00,000 Yens for its borrowings from a Japanese Bank. (iii) The firm exported goods to USA and has just received USD 3,00,000. (iv) The firm has imported goods from Singapore amounting to Singapore Dollars (SGD) 4,00,000. Given: 1$ = Rs.40.00/40.05 1 Euro = Rs.56.00/56.04 1 SGD = Rs.24.98/25.00 100 5/10/12 Yens = Rs.44.00/44.10

Answer 2: (i) Foreign Exchange rate: 1 Euro = Rs.56.00/56.04 The firm shall be selling Euros; the bank shall be buying the Euros @ Rs.56.00. The firm will receive 1,12,000 x 56 i.e. Rs.62,72,000. (ii) Foreign Exchange rate: 1 Yen = Re.0.4400/0.4410 The firm shall be buying the Yens; the bank shall be selling the Yens @ Re. 0.4410. The firm will pay 2,00,000 x 0.4410 i.e. Rs.88,200. (iii) Foreign Exchange rate: 1$ Euro = Rs.40.00/40.05 The firm shall be selling $; the bank shall be buying the $ @ Rs.40.00. The firm will receive 3,00,000 x 40 i.e. Rs.1,20,00,000. (iv) Foreign Exchange rate: 1 SGD = Rs..24.98/25.00 The firm shall be buying the SGD; the bank shall be selling the SGD @ Re. 25.00. The firm will pay 4,00,000 x 25.00 i.e. Rs.1,00,00,000
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Q.No.3: Calculate how many British pounds a London-basedfirm will receive or pay for its following four foreign currency transactions: (i) The firm receives dividend amounting to Euro 1,00,000 from its French Associate Company. (ii) The firm pays interest amounting to 2,30,000 Yens for its borrowings from a Japanese Bank. (iii) The firm exported goods to USA and has just received USD 3,00,000. (iv) The firm has imported goods from Singapore amounting to Singapore Dollars (SGD) 4,00,000. Spot rates (per Pound) Euro 1.59/1.60 Yen 230/234
5/10/12 1.99/2.00 USD

Answer 3: Answer (i) FER 1 = 1.59/1.60 Euro The bank is selling . Hence, applicable rate is ask i.e. 1 =1.60 The firm receives: 1,00,000/1.60 i.e. 62,500.00 Answer (ii) FER 1 = 230/234 YENS The bank is buying . Hence, applicable rate is bid i.e. 1 = 230 Yens The firm pays: 2,30,000 /230 i.e. 1,000. Answer (iii) FER 1 = $1.99/2.00 The bank is selling . Hence , applicable rate is ask i.e. 1 = $2.00
5/10/12 firm receives: 3,00,000/2.00 i.e. 1,50,000 The

Spot Rates & Forward Rates

Purchase and sale of one currency against other currency may be either on spot basis or for future delivery. In spot transaction, the currencies are delivered either immediately (the same day) or within two days from the date of transaction. The exchange rate of a spot transaction is called as Spot Rate. A future delivery transaction is one in which a contract is made between two parties for purchase and sale of the one currency against 1 other at a stipulated future date at a rate agreed upon at the time of contact. In such contacts, deliveries of currencies are made on the stipulated future date. The exchange rate of a future delivery transaction is 5/10/12 as Forward Rate. called

Forward Margin Premium or Discount

The forward rate for a currency may be costlier or cheaper than its spot rate. The difference between the forward rate and spot rate is known as forward margin or swap points. If a currency is costlier in future as compared to spot, it is said at premium. Example Spot : $ 1 = Rs.40, Six months Forward: $ 1 = Rs.42.00. $ is at premium. If a currency is cheaper in future as compared to spot, it is said to be at discount. 5/10/12

For quantifying premium / discount of a currency (whether home currency or foreign currency), we should (i) find Forward price of that currency (ii) find Spot price of that currency (iii) apply the following formula:

% change in price of A currency Forward price Spot price = ------------------------------------ x 100 Spot price of that currency

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Rules for adding/ subtracting Premium/ Discount

Forward rates are quoted at premium or discount in relation to the spot rates. The rules for adding or subtracting discount / premium are as follows: (i) If left hand currency is at premium, the amount of premium is added to the right hand currency. (ii) If left hand currency is at discount, the amount of discount is subtracted from the right had currency. There are two possibilities regarding discount / premium: A) Which currency is at premium/ discount this may be given or this can be interpreted. B) Amount of forward margin i.e. swap points given. If forward margin is in ascending order, it represents premium of left hand currency; if it is in 5/10/12 descending order, it represents discount of left hand currency.

Example A: A person has to pay $ 13750 after three months today. Spot Rate: Re l = $ 0.0275. Rupee is likely to depreciate by 5% over three months. What is likely forward rate? Answer: Rupee is left had currency. It is at discount. Amount of discount should be deducted from right hand currency for estimating the forward rate. Hence forward rate is: Re. 1 = $ 0.0275 - $ 0.0275 (5/100) i.e. 0.026125. Example B: Spot 1 $ = Rs. 40.00 / 40.10 1 month forward .10 /.11 2 months forward .12/.13 3 months forward .14/.15 Calculate 1 month, 2 months and 3 months forward rates. Answer: 1 month forward 1 $ Rs. .40.10/ 40.21 5/10/12 2 months forward 1 $ Rs. 40.12/ 46.23

Q.No.4 You are given the following $ quotes: Spot Rs 40.50/40.60 2 months forward 0.10/0.20 3 months forward 0.20/0.10 4 months forward 0.25/0.30 (a) Calculate 2 months, 3 months and 4 months forward rates. (b) What amount you will pay in rupees for purchasing 5,00,000 USD? (c) How many Dollars you will sell to get Rs.5, 00,000? (You have enough Dollars) (d) Calculate % of discount/premium of Dollars on 3 months and 4 months forward rates. 5/10/12 Assume (i) You are buying $ (ii) You are selling $.

Answer (a) Spot 1 $ = Rs40.50/40.60 2 months forward 0.10/0.20 3 months forward 0.20/0.10 4 months forward 0.25/0.30 2 m forward rate: 1$ = Rs.40.60 /40.80 3 m forward rate: 1$ = Rs.40.30 /40.50 4 m forward rate: 1$ = Rs.40.75 /40.90 (b) FER 1$ = Rs.40.50 / 40.60 You are buying $. The bank is selling $. The applicable rate is Rs.40.60 Amount payable in Rupees = 5,00,000 x 40.60 = Rs.2,03,00,000 (c) FER 1$ = Rs.40.50 / 40.60 You are selling $. The bank is buying $. The applicable rate is Rs.40.50 Amt. payable in $. =5,00,000/40.50 = 12,345.70
5/10/12 (d)(i) You are buying $.

Q.No.5: The following foreign currency rates, per Pound, are being quoted in London Market: Spot 3 months forward 4 months forward USD 1.6200/1.6220 0.30/0.40 c 0.40/0.30 c Canadian Dollars 1.9000/1.9010 0.40/0.50 c 0.50/0.40 c Japanese Yens 200/205 1/2 2/1 How many Pounds a person will pay for purchasing (i) 1,00,000 USD on spot (ii) 1,00,000 Canadian Dollars on 3 months forward and (iii) 1,00,000 Japanese Yens on 4 months forward?

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Answer 5: (i) 1 = $ 1.6200/1.6220 Bank is purchasing . The applicable rate : 1 = $1.62 The person has to pay (1,00,000 /1.62) i.e. 61,728.40 (ii) Spot rate: 1 =CD 1.9000/1.9010 Swap points = 0.40/0.50 cents = 0.0040/0.0050 CD 3 months forward rate: 1 = CD 1.9040 /1.9060 Bank is buying . Applicable rate 1 = CD 1.9040 The customer has to pay: (1,00,000 /1.0940) = 52,521 (iii) Spot rate: 1 = 200/205 Yens 4 months Swap points = 2/1 Yens 4 months forward rate: 1 = JY 198/204 Bank is buying . Applicable rate 1 = JY 198
5/10/12 customer has to pay: (1,00,000 /198) = 505.05 The