International Financial Management P G Apte

a peculiar currency of your

own
So much of barbarism, however, still remains in the transactions of most civilized nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbors, a peculiar currency of their own. John Stuart Mill, 1894

CURRENCY MARKETS
The foreign exchange market is the market in which currencies are bought and sold against each other.

The inter-bank foreign exchange market is an over-thecounter (OTC) market. London is the largest centre followed by New York/Tokyo. 20-25 other smaller centres. Average transaction size is about USD 5 million The participants in the wholesale market are commercial banks, investment institutions, corporations and central banks. Currency brokers act as middlemen between dealers A small number of currencies account for bulk of turnover: USD, EUR, GBP, CHF, JPY, CAD, AUD

Size Of the Global Forex Market

Largest market in the world $3.99 trillion average daily turnover in 2007, which is

equivalent to more than 10 times the average daily turnover

of global equity markets. May reach $5 trillion in 2010. More than 35 times the average daily turnover of the NYSE

In 2007, $500 a day for every man, woman, and child on

earth Annual turnover more than 10 times world GDP

Trade related transactions account for about 15% of the

turnover; the rest are related to capital flows. 80% of the transactions are estimated to be for speculative

purposes and the rest for commercial purposes

FOREX MARKET TURNOVER (NET)

DAILY AVERAGE, APRIL 2007

(US$ BILLION)
TOTAL
SPOT OUTRIGHT FORWARDS

3988
1305 433

SWAPS
US$ vs. OTHERS EURO vs. OTHERS JPY vs. OTHERS GBP vs. OTHERS

2250
2660.262 1139.406 509.731 460.779

CHF vs. OTHERS

208.790

2007 BIS SURVEY FOREX MARKET.

Average daily FX turnover $3.99 trillion USD. Increased by more than 2.7 time since 2001. 67% Forwards and Swaps. 33% Spot transactions. Less than 10% delivered. USD involved in 89% of trades almost $1.7 trillion daily.

 The forex market has not escaped the impact of global deleveraging and the failure of Lehman Brothers in 2008. Central banks from around the world have released their semiannual foreign exchange surveys and based upon all of the reports, forex trading volume decreased significantly between April 2008 and April 2009. The lack of participation may explain why the major currency pairs have been stuck in a range since the beginning of May. In New York for example, forex spot trading volume fell to the lowest level in more than 3 years. London remains the most active forex trading center followed by NY and Tokyo. The EUR/USD is still the most actively traded currency pair by far.

Geographic Distribution of Turnover (in percent)

40 35 30 25 20 15 10 5 0 1992 1998 2004 2007 UK US Japan Singapore Switzerland

Source: BIS

 The BIS data in its triennial survey is incomplete.

The global turnover maybe around 6% higher than reported.

Turnover in Asian currencies (excluding Japanese Yen) is under-reported to a higher extent maybe as much as 15%. In some Asian currencies like Chinese Yuan this is much higher. Turnover on account of trade-related transactions is a larger fraction of total turnover for Asian currencies than for developed country currencies. Although growing fast, the share of Asian currencies (excluding Yen) in the global turnover is only about 7.5%. Australian dollar alone has a 6.6% share. Japanese Yen has 17.5%. Asian currencies have a larger share of inter-dealer activity in the total turnover compared to global average.

 The turnover of Asian currencies is low relative to the volume

of trade in goods and services compared to the global average. Thus for most Asian currencies activity in the markets is driven largely by trade.

Due to controls on capital flows, transactions with financial customers form a low share of total turnover for most Asian currencies. The exceptions are SGD and HKD. For most Asian currencies, over 90% of the turnover is against the US dollar.
Again due to capital controls, the share of non-residents in the total turnover is quite small.

CURRENCY MARKETS
Among the participants, primary price makers or professional dealers make a two-way market to each other and to their clients

Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market-making banks Corporations usually are price takers. However, some nonbank, non-financial companies do act as market makers.
Large money centre banks deal in a large number of currencies. Smaller banks have a restricted range.

It is a 24-hour market
The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore. A few hours later, trading begins in Bahrain. Late in the Tokyo day, markets open in Europe. In the early afternoon in Europe, markets open in the United States. In the mid to late afternoon in New York, markets open in the Asia-Pacific area. Most of the activity takes place when European markets are open.

CURRENCY MARKETS
Geographically, the markets span all the time zones from Auckland, New Zealand to Los Angeles, United States. 3.00 pm in Tokyo 2.00 pm in Hong Kong. 1.00 pm in Singapore. 12.00 noon in Bahrain.

3.00 pm in Hong Kong 3.00 pm in Singapore

3.00 pm in Bahrain 11.00 am in London.

3.00 pm in London

12.00 noon in Frankfurt and Zurich and

10.00 am in New York.

3.00 pm in New York

3.00 p.m. in Los Angeles

Noon in Los Angeles.

9.00 a.m. of the next day in Sydney.

London, Tokyo and New York account for about 50% volume.

Geographic Extent of the Market

Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
25,000

20,000

15,000

10,000

5,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

10 AM Lunch Europe In Tokyo In Tokyo opening

Asia closing

Americas London open closing

Afternoon in America

6 pm Tokyo In NY opens

How Volatile is the Market?

The dollars value changes 18,000 times during an average trading day thats once every 4.8 seconds

In 2005 :
The daily trading range was as much as 12% The average monthly difference between high and low

was 35%
Volatility is always part of the market behaviour Annual currency volatility is typically 1020% (or more)

Inter-bank Dealing
Corporate Desk of Bank A or I/B Desk of Bank B I/B Desk of Bank A

I/B Desk
of Bank C

Corporate Foreign Exchange (CorpFx) Desk of Bank A

Corporate Client of Bank A CorpFx Desk of Bank A I/B Desk of Bank B

I/B Desk of Bank A

Dealings of Corporate Foreign Exchange (CorpFx) Desk of Bank A

CorpFx Desk of Bank A

Export / Import Desk of Bank A Client of Bank A Outward / Inward Remittance Desk of Bank A

Foreign Exchange Brokers

Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction For this service they charge a small commission They maintain instant access to hundreds of dealers worldwide via open lines and at times may maintain such lines with several banks, with separate lines for differing currencies, spot and forward rates

Currency Distribution of Forex Turnover

100 80 60 40 20 0 2001 2004 2007 dollar euro yen pound

Because two currencies are involved in each transaction the percentages sum to 200. Source: BIS

Most traded currencies[2] Currency distribution of reported FX market turnover

Rank 1 2 3 4 5 6 7 8-9 8-9 10 11 12

Currency
United States dollar Euro Japanese yen Pound sterling Swiss franc Australian dollar Canadian dollar Swedish krona Hong Kong dollar Norwegian krone New Zealand dollar Mexican peso

ISO 4217 code (Symbol)

% daily share (April 2007) 86.3% 37.0% 17.0% 15.0% 6.8% 6.7% 4.2% 2.8% 2.8% 2.2% 1.9% 1.3%

USD ($) EUR () JPY () GBP () CHF (Fr) AUD ($) CAD ($) SEK (kr) HKD ($) NOK (kr) NZD ($) MXN ($)

13
14

Singapore dollar
South Korean won

SGD ($)
KRW () Other

1.2%
1.1% 14.5%

Total

200%

DAILY TURNOVER IN INDIAN MARKET

CURRENCY MARKETS
Spot Markets : Value date two business days from transaction date. If bank holiday in either settlement centre, push to next business day. Outright Forwards : Value date three business days and beyond.

Standard forward dates : 1, 2, 3, 6, 9, 12 months. Spot value date plus required calendar months. If holiday, push forward to next eligible business day; but pushing forward must not carry you to next calendar month; then push back
Swaps : A spot plus a forward or two forwards. Buy USD spot vs. INR, sell USD 3 month forward vs.INR. Sell USD 1 month forward, buy USD 3 month forward vs. GBP.

Top 10 Currency Traders % of Overall Volume, May 2009

Rank
1 2 3 4 5 6 7 8 9 10

Name
Deutsche Bank UBS AG Barclays Capital Royal Bank of Scotland Citi JPMorgan HSBC Goldman Sachs Credit Suisse BNP Paribas

Market Share
20.96% 14.58% 10.45% 8.19% 7.32% 5.43% 4.09% 3.35% 3.05% 2.26%

The monthly turnover in the inter-bank segment of the foreign exchange market in India increased from US $405 billion in March 2006 to US $533 billion in March 2007 and that in the merchant segment from US $141 billion to US $192 billion. As of now the average daily turnover is estimated to be around $35 billion.
Bulk of this is in the Mumbai market. Other centres are Delhi, Kolkata and Chennai.

CNY: CHINESE YUAN

KRW: KOREAN WON TWD: TAIWAN DOLLAR

INR: INDIAN RUPEE

PHP: PHILIPPINES PESO THB: THAI BAHT IDR: INDONESIAN RUPIAH MYR: MALAYSIAN RINGITT

SGD: SINGAPORE DOLLAR

HKD: HONGKONG DOLLAR

CURRENCY MARKETS
A spot GBP/USD deal on Friday December 12: Value date Tuesday December 16 If December 16 holiday in NY/London, value date December 17. Suppose the deal is between a French and a German bank and December 16 is holiday in Paris but not London or NY. Push forward?

A 2-month forward deal USD/CHF on Monday Dec 22: Value date Feb 24. If holiday in NY/Zurich, Aug 17.
A 3-month forward USD/JPY on Nov 26, 2008. Value date Feb 28, 2009. If holiday in Tokyo/NY, push forward? NO. Pushing forward must not carry into next calendar month. Push back to Feb 27, 2009. Could have pushed forward in a leap year February 29. Spot deals in some currency pairs in the same time zone such as US dollar-Canadian dollar, US dollar- Mexican peso settled in one business day

CURRENCY MARKETS
ACI QUOTATION CONVENTIONS
SPOT RATE QUOTATIONS:

Base Currency/Quoted Currency

USD/CHF : USD base, CHF quoted GBP/USD : GBP base, USD quoted

Bid Rate/Offer Rate

Most currencies quoted with USD as base. Exceptions are EUR, GBP, AUD, NZD, CAD
Quotation given as no. of units of quoted currency per unit of base currency, bid rate/offer rate.

Bid rate applies to market-maker buying base currency. Offer rate applies to market-maker selling base currency.

CURRENCY MARKETS
Currency Codes : All currencies have a 3-letter code used by SWIFT (Society for Worldwide Inter-bank Financial Telecommunications) for all inter-bank transactions.
USD : US Dollar CAD : Canadian Dollar GBP : British Pound SAR : Saudi Riyal SEK : Swedish Kroner CHF : Swiss Franc KRW : Korean Won AUD : Australian Dollar JPY : Japanese Yen INR : Indian Rupee EUR : Euro DKK : Danish Kroner SGD : Singapore Dollar THB : Thai Baht

European Currencies which have become history:

DEM : Deutschemark ITL : Italian Lira BEF : Belgian Franc IEP : Irish Pound ATS : Austrian Schilling FRF : French Franc NLG :Dutch Guilder ESP : Spanish Peseta PTE : Portugese Escudo LUF : Luxembourg Franc FIM : Finnish Markka GRD : Greek Drachma

CURRENCY MARKETS
SPOT QUOTES : EXAMPLES USD/CHF SPOT: 1.2075/1.2080
Bid Offer (Ask)

Bank will buy 1 USD and give CHF 1.2075 Bank will sell 1 USD and want to be paid CHF 1.2080. Shortened to 1.2075/80 or even 75/80 between dealers. 1.20 is the big figure

CURRENCY MARKETS
SPOT QUOTES : EXAMPLES
Interpret these quotes : GBP/USD : 1.5218/25 EUR/USD : 1.2525/30

GBP/EUR : 1.2150/55 USD/INR : 49.1850/49.2075 USD/JPY : 98.3550/55 Most currencies quoted upto six significant figures. Last two figures known as points or pips. A pip is 0.0001. In the GBP/USD quote the bid-offer spread is 8 pips. Smaller currencies such as JPY and INR are quoted to 2 decimals in merchant segments. Here a pip is 0.01

CURRENCY MARKETS
Quotations in European Terms: Units of a currency per US dollar. Example : USD/INR : 48.5560/675 Quotations in American Terms : US dollars per unit of a currency. Example : GBP/USD : 1.6650/55 Direct Quotations: Units of home currency per unit of foreign currency. Example : USD/INR above, a direct quote in India. Reciprocal or Indirect Quotations: Units of foreign currency per unit of home currency. Example:

USD/GBP : 0.5085/0.5090, an indirect quote in US.

GBP/USD : 1.6650/55, an indirect quote in UK

INTERBANK SPOT DEALING

Friday December 25, 10.45 am

BANK A : "Bank A calling. Dollar-Swissy 25 please.

(Bank A is specifying the size of the deal because it is much larger than the market lot)

BANK B : "Forty -Fortyfive

(Bank B is specifying a two-way price. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 1.1540/1.1545. The quote is valid for 3-5 minutes.)

BANK A : Mine
(Bank A dealer finds bank Bs price acceptable and wishes to buy USD 25 million. She conveys this by saying mine; if she wanted to sell USD she would say yours)

SPOT DEALING (Contd.)

BANK B : OK. I sell you USD 25 million against CHF at 1.1545, value 29 December. UBS Geneva for my CHF. BANK A : CITIBANK NYK for my dollars. Thanks & Bye. Deal is consummated. Back office staff will retrieve details, exchange confirmatory faxes/telexes and arrange settlement. Spot deals (including those in swaps) account for about 60 % of total turnover. Dealers work within limits assigned by management Counter-party must be acceptable credit.

CURRENCY MARKETS
Inter-bank Arbitrage : Suppose banks A and B are quoting : A B GBP/USD : 1.6550/1.6560 1.6338/1.6348 --------- Bank A Bid Ask ---------- Bank B Bid Ask Buy GBP from bank B, sell to bank A. Prices will move. A B GBP/USD : 1.6652/1.6662 1.6648/1.6658 --------- Bank A ---------- Bank B No arbitrage. Quotes must overlap.

INVERSE QUOTES AND TWO-POINT ARBITRAGE

USD/CHF : 1.2955/1.2962 A bank in Zurich CHF/USD : 0.7728/0.7735 A bank in NY

Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich sell in New York.
$(1,000,000/1.2955) i.e. $771902.74 needed to acquire the Swiss francs. $(0.7728 1000000) i.e. $772800, obtained on selling, a riskless profit of $897. Zurich USD/CHF quotes imply certain CHF/USD quotes:

Implied (CHF/USD)bid = 1/(USD/CHF)ask

Implied (CHF/USD)ask = 1/(USD/CHF)bid

INVERSE QUOTES AND TWO-POINT ARBITRAGE

USD/CHF : 1.2955/1.2962 implies CHF/USD :0.7715/0.7719. Any quote which does not overlap this would lead to arbitrage. For example CHF/USD : 0.7728/0.7735 allows arbitrage. A quote such as 0.7718/0.7723 will not lead to arbitrage though it may lead to a one-way market for the banks.

The rates actually found in the markets will obey the above relations to a very close approximation.
GBP/USD: 1.6015/20 USD/INR: 48.7550/48.7650 GBP/EUR: 1.2735/45 USD/GBP ? INR/USD ? EUR/GBP?

CROSS-RATES AND THREE-POINT ARBITRAGE

A New York bank is currently offering these quotes : USD/JPY : 110.25/111.10 USD/AUD : 1.6520/1.6530 At the same time, a bank in Sydney is quoting : AUD/JPY : 68.30/69.00 Is there an arbitrage opportunity? Consider this sequence of transactions: Sell yen against US dollars and the US dollars against Australian dollars both in New York and finally sell the AUD for yen in Sydney. This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C; Finally sell C buy A.

CROSS-RATES AND THREE-POINT ARBITRAGE

The calculations are :(N: NY S: Sydney) 1 JPY in NY gets USD [1/(USD/JPY)ask(N)] = USD (1/111.10) Sell USD [1/(USD/JPY)ask(N)] in NY to get AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520) Sell AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } in Sydney to get JPY{[1/(USD/JPY)ask(N)](USD/AUD)bid(N)(AUD/JPY bid(S) } = JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156 A riskless gain of JPY 0.0156 per yen you started with.

CROSS-RATES AND THREE-POINT ARBITRAGE

Synthetic Rates must overlap observed market rates Synthetic (C/A)bid = (C/B)bid (B/A)bid Synthetic (C/A)ask = (C/B)ask (B/A)ask

e.g. USD/INR: 44.7550/44.7725 USD/CHF: 1.2765/70

Synthetic (CHF/INR)bid = (CHF/USD)bid (USD/INR)bid = [1/(USD/CHF)ask] (USD/INR)bid = (1/1.2770)(44.7550) = 35.0470

Synthetic (CHF/INR)ask = (CHF/USD)ask (USD/INR)ask = [1/(USD/CHF)bid] (USD/INR)ask = (1/1.2765)(44.7725) = 35.0744

----------------- 35.0470 35.0744 ---------------- --------------- --------------- Acceptable ------------- not acceptable

Foreign Exchange Rates & Quotations

Intermarket Arbitrage
Cross rates can be used to check on opportunities for intermarket arbitrage Example: Assume the following exchange rates are quoted
Citibank Barclays Bank Dresdner Bank $1.2223/ $1.8410/ 1.5100/

3-Point ARBITRAGE.
Citibank New York
End with $1,002,538 Start with $1,000,000 (1) Sell $1,000,000 to Barclays Bank at $1.8410/

(6)

Receive $1,002,538

Dresdner Bank
(5)
(4)

Barclays Bank, London

(2)
(3)

Sell 820,206 to Citibank at $1.2223/ Receive 820,206

Receive 543,183
Sell 543,183 to Dresdner Bank at 1.5100/

Foreign Exchange Rates & Quotations

Intermarket Arbitrage The cross rate between Citibank and Barclays is ($1.8410/) ---------------- = 1.5062/ ($1.2223/) This cross rate is not the same as Dresdners rate quote of 1.5100/ Therefore, an opportunity exists for risk-less profit or arbitrage

EUR Locking Rates

EUR Locking Rates EUR/ATS= EUR/BEF= EUR/DEM= EUR/ESP= EUR/FIM= EUR/FRF= EUR/IEP= EUR/ITL= EUR/LUF= EUR/NLG= EUR/PTE= 13.760300 40.339900 1.955830 166.386000 5.945730 6.559570 0.787564 1936.270000 40.339900 2.203710 200.482000

FORWARD AND SWAP QUOTES

Forward outrights can be given like spot quotes. USD/CHF 3-months 1.2555/65 bid/ask

More commonly given as a spot quote and a pair of swap points

USD/CHF Spot : 1.2525/35

1 month : 15/10 2 months : 25/18 3 months : 35/25

GBP/USD Spot : 1.7555/65 1 month : 12/15 2 months : 20/25 3 months : 28/35

FORWARD AND SWAP QUOTES

To find outrights : Spot quote Swap Points
Each swap point is 0.0001 ( or 0.01) When to add, when to subtract? Take USD/CHF Spot : 1.2525/35 1 month : 15/10 If you add, 1 month outright : (1.2525+0.0015)/(1.2535+0.0010) = 1.2540/45 If you subtract, 1 month outright : 1.2510/1.2525 Which is correct? Two rules : (1) Market makers Ask rate must exceed Bid rate

(2) Bid-Ask spread must widen as you go farther out into future

FORWARD AND SWAP QUOTES

Using rule 2, 1.2540/1.2545 is wrong. 1.2510/25 is correct. Now take GBP/USD Spot 1.7555/65 2 months : 20/25 If swap points added, 2 month outrights 1.7575/1.7590; if subtracted 1.7535/1.7540. The former is correct. Mechanical Rule : If swap points are Big/Small, subtract, base currency at forward discount, quoted currency at premium. If swap points Small/Big, add. Quoted currency at discount, base currency at premium.

FORWARD AND SWAP QUOTES

A quote like : USD/SEK Spot 6.7565/70 3 month : 10/20 Bank will do either swap: (1) Buy USD spot, sell USD 3 months forward against SEK. The forward selling or ask rate would be 20 points above the spot rate.

(2) Sell USD spot, buy 3 months forward, forward buying or bid rate would be 10 points above spot.
In a swap, amount of one currency - usually the base currencyis kept same in the spot and the forward leg. Buy USD 1m spot, sell USD 1m forward. Amount of SEK will be different.

BROKEN DATES
Standard forwards are whole months. Banks will do any number of days forward - 63 days, 135 days etc. These are broken date or odd date forwards.

Interpolate between two whole month dates. OK if the gap between the two dates is not too long and no special technical factors are at work. Example:
USD/INR spot 48.55/56 1 month:8/10 2 months:15/20 Recall that for INR each point is 0.01. Customer wants to buy USD 43 days forward.

10paise (Rs.0.10) premium on the offer side from 1month to 2months. Suppose 30 days in 2nd month. 1/3paisa (1/3 of Rs.0.01) per day, 4 paise(Rs.0.04) for 12 days. The interpolated rate would be : 48.56+0.10+0.04 = 48.70

SHORT DATES
Delivery same day- cash Delivery next day - Tomorrow or Tom. Markets quote Overnight (O/N), Tom(orrow)/Next (T/N) and Spot/Next (S/N) swaps. These are used to compute rates for short date transactions.

Reverse swap points and follow add/subtract rule.

USD/CHF Spot 1.1745/50 T/N : 5/3 Outright for Tom : 1.1748/55 3/5

Whats the logic? Consider again

USD/CHF Spot 1.1745/50 T/N : 5/3 This means: Going from TOM to NEXT CHF has a premium 3 points on bank buying CHF, 5 points on bank selling CHF. NEXT after TOM is SPOT. If you buy USD delivery tomorrow and sell delivery day-after i.e. Spot date, you will suffer a 5-point discount on the sale compared to your buying price. If you sell tomorrow buy spot you will get a 3 point discount on your selling price. Suppose you want to buy CHF delivery tomorrow. Bank buys it delivery spot; then does a swap buy tomorrow sell spot i.e. it sells USD delivery tomorrow, buys USD delivery spot; it gains 3 points. It passes on the gain to you gives you CHF 1.1748 per USD.

If you wish to sell CHF (buy USD) delivery tomorrow bank sells delivery spot and then does a swap buy CHF (sell USD) delivery spot, sell CHF (buy USD) delivery TOM. In this the bank suffers a 5-point discount which it would recover from you. Hence it charges you CHF 1.1755 per USD you wish to buy.
Hence the rule: Reverse swap points and follow the rule BIG/SMALL subtract, SMALL/BIG add. Same logic works for cash same day delivery. Now look at O/N swap points. From spot and T/N derive TOM quotes; then from TOM quotes and O/N swap quote derive CASH quotes following the same rule.

SWIFT
WHAT IS SWIFT?
The acronym SWIFT stands for Society for Worldwide

Inter- bank Financial Telecommunication.

SWIFT allows member financial institutions worldwide to electronically exchange information amongst each other. Messages are transmitted globally through high speed communication channels on standardized message formats for many international banking operations. SWIFT provides a quick, reliable and cheap medium for communication of financial messages which has a direct impact on customer service. Under SWIFT, if both the members are hooked, messages can be transmitted within seconds.

 Financial and non-financial messages can be transmitted which cover Funds Transfers between customers/banks, letters of credit/bank guarantees, customer account status, draft advices, foreign exchange transactions, nostro/vostro accounts status etc. Message security is better as compared to other means of message transmission.
Standardized message formats eliminate ambiguity and facilitate automated handling at the source and the destination. Message authentication is automatic. SWIFT has a Regional Processor (RP) in each host country through which all messages meant for that country are routed. In India RP is located in the premises of M/s. CMC Ltd. at World Trade Centre, Cuffe Parade, Bombay. Each user in that country is required to install a Computer based Terminal (CBT) in his own premises. The CBT is a device for interfacing with the SWIFT RP through the telephone lines.