Foreign Exchange

Market
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Foreign Exchange Market
The foreign exchange market is a market where
foreign currencies are bought and sold.
A market for the free trade of currencies.

Traders place orders to buy one currency with

another currency.
The forex market is the worlds largest financial

market.
Over $4 trillion dollars worth of currency are

traded each day. The amount of money traded

in a week is bigger than the entire annual GDP
of the United States.
Market Participants
Non- Bank Entities
Banks
Speculators
Arbitrageurs
Government
Nostro and Vostro
Accounts
Nostro Account: Anostroaccount is one
which is held within a foreign country by a
domestic bank, in the currency of the
foreign country.
Vostro Account: Avostroaccount is one

which is held within a domestic country by a

foreign bank, in the currency of the
domestic country.
Risk Management
Financial Risk
Business Risk
Country Risk
Credit Risk
Interest rate Risk
Liquidity Risk
Determinants of Currency
Movements or Exchange Rates
Differentials in Inflation
Differentials in Interest Rates
Current-Account Deficits
Public Debt
Terms of Trade
Political Stability and Economic

Performance
Differentials in Inflation
A country with a consistently lower inflation
rate exhibits a rising currency value, as its
purchasing power increases relatively to
other currencies.
Those countries with higher inflation

typically see depreciation in their currency

in relation to the currencies of their trading
partners.
This is also usually accompanied by higher

interest rates.
Differentials in Interest
Rates
Interest rates, inflation and exchange rates
are all highly correlated
Changing interest rates impact inflation and

currency values.
Higher interest rates attract foreign capital

and cause the exchange rate to rise.

The opposite relationship exists for

decreasing interest rates - that is, lower

interest rates tend to decrease exchange
rates.
Current-Account Deficits
Thecurrent accountis the balance of
trade between a country and its trading
partners, reflecting all payments between
countries for goods, services, interest and
dividends.
Adeficitin the current account shows the

country is spending more on foreign trade

than it is earning, and that it is borrowing
capital from foreign sources to make up
the deficit.
The excess demand for foreign currency

lowers the country's exchange rate

Public Debt
Countries will engage in large-scale deficit financing to
pay for public sector projects and governmental
funding.
While such activity stimulates the domestic economy,
nations with large public deficits and debts are less
attractive to foreign investors.
A large debt may prove worrisome to foreigners if they
believe the country risks defaultingon its obligations.
Foreigners will be less willing to own securities
denominated in that currency if the risk of default is
great.
For this reason, the country's debt rating is a crucial
determinant of its exchange rate.
Terms of Trade
The terms of trade is related to current
accounts and thebalance of payments.
If the price of a country's exports rises by a

greater rate than that of its imports, its terms

of trade have favorably improved.
Increasing terms of trade shows greater

demand for the country's exports.

If the price of exports rises by a smaller rate

than that of its imports, the currency's value

will decrease in relation to its trading partners.
Political Stability and Economic
Performance
Foreign investors inevitably seek out stable
countries with strong economic
performance in which to invest their capital.
A country with such positive attributes will

draw investment funds away from other

countries perceived to have more political
and economic risk.
Types of Exposure
Transaction Exposure
Translational Exposure
Operating Exposure/Economic Exposure
Transaction Exposure

The risk, faced by companies involved in

international trade, that currency exchange
rates will change after the companies have
already entered into financial obligations.
Such exposure to fluctuating exchange
rates can lead to major losses for firms.
Translation Exposure
Also known as "accounting exposure".
It refers to gains or losses caused by

translation of foreign currency assets and

liabilities into the currency of the parent
company for consolidation purpose.
Economic Exposure/Operating
Exposure
Economic exposureis the risk that a company'scash
flow, foreigninvestments, andearningsmay suffer as
a result of fluctuating foreigncurrencyexchange rates.
The extent to which a company may be affected by

economic exposure depends very much on the

company's specific industry and business interests.
For example : Say Company XYZ is a business

importing goods from Japan to sell in the United

States. If the Japanese yen weregainagainst the
dollar, it would make it more expensive for Company
XYZ to purchase goods for import, thereby hurting its
operations.
 Forex Spot
Bid , Ask and Spread,
Direct & Indirect Quotes
Forward Forex Contract
Spot Rate
Aforeign exchange spottransaction, also known
asFX spot, is an agreement between two parties to
buy one currency against selling another currency
at an agreed price for settlement on thespot date.

Theexchange rateat which the transaction is done

is called thespot exchange rate.

The average daily turnover of global Forex spot

transactions has exceeded 1.5 trillion USD,
accounting for almost 40% of all foreign exchange
transactions
Ask , Bid and Spread
Ask rate is the exchange rate at which a bank
sells to you currency A in exchange of
currency B

Bid rate is the exchange rate at which a bank

accepts currency A from you and gives you
currency B

Spread Is the difference between the Ask rate

and the Bid rate i.e. The profit/Brokerage for
the bank
 Ask , Bid and Spread
Numerical
Ask rate : 1 USD = INR 62
Bid rate : 1 USD = INR 60

Now if you go to a bank and u want USD 1000 for going

for a trip to the US, the bank will charge you INR 62 per
USD , so you will have to pay INR 62,000 for buying USD
1000 from the bank

On the other hand, if you have USD 1000 and you want to
convert it into INR, the bank will give you INR 60 per USD,
so you will get INR 60,000 from the bank

The INR 2 per USD is the spread , i.e. the profit for the
bank
Direct and Indirect Quote
Direct Quote : A foreign exchange rate quoted as the
domestic currency per unit of the foreign currency. In
other words, it involves quoting in fixed units of foreign
currency against variable amounts of the domestic
currency.
Eg: 1 GBP = INR 100 is a direct quote for India

Indirect Quote : A foreign exchange rate quoted as the

Foreign currency per unit of the domestic currency. In
other words, it involves quoting in fixed units of domestic
currency against variable amounts of the foreign currency
Eg: 1 INR = GBP 0.01 is an indirect quote for India
Forex Forward Contract

A forward contract in a forex market is a contract in

which the party and the bank agree to do a
transaction in the future with a pre-determined
exchange rate.

The party cannot walk away from the transaction if

the market rate in future is more favorable
compared to the contract rate.

The party has to complete the transaction once it

has entered into the forward contract with the bank
Example

If an IT company sells its services to the US

and will receive the payment of USD 1
million after 3 months, The IT company can
have a forward contract with a bank
whereby they will decide a price let us say
1USD=INR62. Now, after 3 months when
the company receives 1 million USD, the
bank will give the company 6.2 crore INR
irrespective of the exchange rate after 3
months
Exchange Rate
An exchange rate is the rate at which one currency can
be exchanged for another.
In other words, it is the value of another country's
currency compared to that of your own.
If you are traveling to another country, you need to
"buy" the local currency.
Just like the price of any asset, the exchange rate is
the price at which you can buy that currency
There are two ways the price of a currency can be
determined against another
Fixed/Pegged Exchange Rate
Floating Exchange Rate
Fixed Exchange Rate
A fixed, or pegged, rate is a rate the
government or central bank sets and maintains
as the official exchange rate.
A set price will be determined against a major

world currency.
In order to maintain the local exchange rate, the

central bank buys and sells its own currency on

the foreign exchange market in return for the
currency to which it is pegged.
Floating Exchange Rate
Unlike the fixed rate, a floating exchange rate is
determined by the private market through
supply and demand.
A floating rate is often termed "self-correcting,"

as any differences in supply and demand will

automatically be corrected in the market.
A floating exchange rate is constantly changing.
Advantages of Fixed
Exchange
Price stability
Rate
Price stability implies that changes in prices are small,
gradual, and expected. One of the most important factors
that can affect price stability is monetary policy.
Reduced risk in international trade
By maintaining a fixed rate, buyers and sellers of goods
internationally can agree a price and not be subject to the risk
of later changes in the exchange rate before contracts are
settled. The greater certainty should help encourage
investment.
Fixed rates should eliminate destabilising
speculation
Speculation flows can be very destabilising for an economy
and the incentive to speculate is very small when the
exchange rate is fixed.
Limitations of Fixed Exchange
Rate
Loss of freedom in your internal policy
The needs of the exchange rate can dominate policy and this may
not be best for the economy at that point. Interest rates and
other policies may be set for the value of the exchange rate
rather than the more important macro objectives of inflation and
unemployment.
Large holdings of foreign exchange reserves
required
Fixed exchange rates require a government to hold large scale
reserves of foreign currency to maintain the fixed rate - such
reserves have an opportunity cost.
Discourage Foreign Investment
Fixed exchange rates are not permanently fixed or rigid.
Therefore, such a system discourages long-term foreign
investment which is considered available under the really fixed
exchange rate system.
Advantages of Floating
Exchange Rate
No need for international management of exchange
rates
Unlike fixed exchange rates based on a metallic standard, floating
exchange rates dont require an international manager such as the
International Monetary Fund to look over current account imbalances.
Under the floating system, if a country has large current account
deficits, its currency depreciates.
No need for frequent central bank intervention
Central banks frequently must intervene in foreign exchange markets
under the fixed exchange rate regime to protect the gold parity, but
such is not the case under the floating regime. Here theres no parity
to uphold.
Lower foreign exchange reserves
A country with a fixed rate usually has to hold large amounts of
foreign currency in order to prepare for a time when they have to
defend that fixed rate. These reserves have an opportunity cost.
Limitations of Floating
Exchange Rate
Higher volatility
Floating exchange rates are highly volatile. Additionally,
macroeconomic fundamentals cant explain especially
short-run volatility in floating exchange rates.
Lack of investment
The uncertainty can lead to a lack of investment
internally as well as from abroad.
Inflation
The floating exchange rate can be inflationary.
Apart from not punishing inflationary economies, which,
in itself, encourages inflation, the float can cause
inflation by allowing import prices to rise as the
exchange rate falls.
Nominal Exchange Rate
Nominal exchange rate is the price of one
currency in terms of number of units of
some other currency.
It is 'nominal' because it measures only the

numerical exchange value, and does not

say anything about other aspects such as
the purchasing power of that currency
Real Exchange Rate
To incorporate the purchasing power and
competitiveness aspect and, therefore, make the
measure more meaningful, real exchange rates
are used. The real exchange rates are nothing but
the nominal exchange rates multiplied by the
price indices of the two countries. This means the
market price level of goods and services, given
by indices of inflation. So if the price level in the
US is higher than the price level in India, then the
real exchange rate of the rupee versus the dollar
will be greater than the nominal exchange rate.
 Suppose the nominal exchange rate is Rs 50 and US
prices are greater than Indian prices, a dollar will buy
more in India than what Rs 50 will buy in the US. So the
real rupee-dollar exchange rate is greater than the
nominal rate. If the real exchange rate is calculated
using the price levels of common traded goods, then it
gives a measure of export competitiveness. For
example, if both the US and India manufacture the
same (or highly comparable) pharmaceutical drug, and
Indian drug prices are lower than US prices, then the
exchange rate in terms of drugs is favorable to India.
This can be generalized to all the goods manufactured
by the two economies that compete in the export
market. If the real rupee-dollar exchange rate based on
export-competing goods depreciates, then Indian
exports enjoy an enhanced pricing advantage over US
goods. The converse is true for a real appreciation.
Factors affecting change in Real
Exchange rate
PPP
Market sentiments
Speculation
Regulator intervention
Imports/Exports
Fiscal policy
Interest rates
Theories of exchange rate
determination
Theories which determine the prices of
forex rate considering inflation, interest rate,
and elasticity of price etc..
Methods:
a) Long run theory
b) Short run theory
Long Run Theory of Exchange rate
Determination:

This take into account the fundamental changes of economy.

Here fundamental changes refers to the change which are
going to change the economic performance of the economy
Purchasing power for all times to come.

Types of theory:
Purchasing power parity.
1) Absoulte purchasing power parity.

2) Relative purchasing power parity.

Interest Rate parity

1) Covered Interest Rate parity

2) UnCovered Interest Rate parity

Short Run theory of exchange
rate determination

This theories are based more on current

information or immediate performance of
economic variables.
This theories try to take into account the

short run factor which may be eliminated in

the long run.
Purchasing power parity theory

Founder Swedish economist Gustav Cassel in

1918.
Meaning : According to this theory ,the price

levels and the changes in these price levels in

different countries determine the exchanges
rates of these countries currencies.

The basic principle of this theory is that the

exchange rates between various currencies
reflect the purchasing power of these currencies
.This theory is based law of one price.
Absolute form of PPP Theory

If the law of one price were to hold good for

each and every commodity then the theory
is termed as Absolute form of PPP Theory.
This theory describes the link between the

spot exchange rate and price levels at a

particular point of time
Relative form of PPP
This theory describes the link between the
changes in spot exchange rate and in the
price levels over a period of time.
According to this theory ,changes in spot

rates over a period of time reflect the

changes in the price level over the same
period in the concerned economies.
This theory relaxes three assumptions of

PPP ie Absences of transportation cost

,transaction costs and tarriffs.
Interest Rate Parity Theory
Definition :
The process that ensures that the annualized
forward premium or discount equals the
interest rate differential on equivalent
securities in two currencies.
International Fisher effect:
Expected Rate of change = Interest rate of

the exchange rate differential

Interest Rate = Real Interest Expected

Differential Rate + inflation rate

Modern theory: demand &
supply theory
The most satisfactory explanation of the
determination of the rate of exchange is
that a free exchange rate tends to be such
as to equate the demand and supply of
foreign exchange..
The intersection of supply curve and

demand curve gives the equilibrium price

Modern theory also called balance of

payments theory of foreign exchange

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