Foreign Exchange Market

FOREIGN EXCHANGE MARKET •

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FOREIGN EXCHANGE THE PLAYERS EXCHANGE RATEQUOTATION INVERSE QUOTE ARBITRAGE

THE FOREIGN EXCHANGE MARKET •

This is over the counter market ( OTC ) i.e. there is no physical market place to make the deals.

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Instead it is a net work of banks , brokers and dealers spread across the various financial centers of the world .

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These players trade in different currency through telephones , faxes , computers and other electronic networks like the SWIFT system ( Society for Worldwide Inter bank Financial Telecommunication) .

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These traders generally operate through a trading room .

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The deals are finalized orally with written communication following later .

• The major markets are: ** London, ** New York , ** Tokyo, ** Zurich, ** Frankfurt. • Majorly the transactions are done in: ** US Dollar, ** Euro, ** Yen, ** Pound Sterling, ** Canadian Dollar , ** Australian Dollar.

THE PLAYERS

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The main players in the foreign exchange market are : large commercial banks, forex brokers , large corporations and the central banks . The central banks enter the market to smoothen out fluctuations in the exchange rates .

STRUCTURE OF FOREIGN EXCHANE MARKET IN INDIA • Tier I • Tier II • Tier III

: the transaction between RBI and Authorized Dealers (ADs) : the inter bank market in which ADs deal with each other : the transactions between ADs and their corporate customers.

Category of ADs: Category I : all commercial banks ;state and urban co-operative banks-engage in all current and capital account transactions. Category II: co-operative banks; regional rural banks and upgraded Full Fledged Money Changers for specified non-trade related current account transactions such as business travel, medical treatment abroad, film shooting abroad, overseas education. Category III: selected financial institutions such as EXIM bank – allowed to undertake forex transactions related to their activities. • The important centre are Mumbai , Delhi , Calcutta, Chennai , Cochin and Bangalore.

FOREIGN EXCHANGE As defined in Section 2 of FEMA , 1999 foreign exchange includes : • all deposits ,credits , balance payable in any foreign currency , • any drafts , travelers` cheques , letter of credit and bills of exchange , • any instrument giving anyone the option of making it payable either partly or fully in a foreign currency .

Here the term currency includes coins , bank notes , postal notes , postal orders and money orders .

• Market Makers : The large commercial banks which stand ready to buy and sell various currencies at specific prices at all points of time . • Retail Market : The market in which the commercial banks deal with the customers both individuals and corporate . • Inter bank Market / Wholesale Market: The mkt. in which banks deal with each other • A 24 Hour Market : The world wide forex mkt. is a 24 – hour mkt. i.e. trading is going on at least one of the forex market through out the day.

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Authorized Dealers ( A Ds ): They are generally the commercial banks .They are permitted to deal in all items classified as foreign exchange in FEMA ,1999 . They have to operate within the rules regulations and guidelines issued by Foreign Exchange Dealers Association of India ( FEDAI ) .

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Money Changers : They can be either full – fledged MC (can both buy and sell) or restricted MC ( can only buy ) are allowed to deal only in notes , coins and travelers` cheque.

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Foreign Exchange Brokers: They do not actually buy and sell any currency . They do the work of bringing the buyer and seller together .

EXCHANGE RATE QUOTATIONS An exchange rate quotation is the price of a currency stated in terms of another i.e. the price of one currency quoted in terms of 1unit of the other currency . For e.g. INR / USD : 46.40 / 1USD • American Quote : The number of dollars expressed per unit of any other currency . For e.g. USD 1.6689 / 1GBP • European Quote : The number of units of any other currency expressed per dollar . For e.g. INR 46.40 / 1USD

• Direct Quote : The quote where the exchange rate is expressed in terms of number of units of the domestic currency per unit of foreign currency. For e.g.

In India

INR46.40 / USD

• Indirect Quote : The quote where the exchange rate is expressed in terms of number of units of the foreign currency per unit of domestic currency . For e.g.

In India

USD2.0525 / INR 100 .

• Merchant Quote : The quote given by a bank to its retail customers . • Inter Bank Quote : The quote given by one bank to another bank .

BID & ASK RATE • •

Bid Rate : The rate at which a bank is ready to buy a currency . Ask Rate : The rate at which a bank is ready to sell a currency.

INR / USD :

40.40 / 40.60 i.e. bid / ask

INR / USD :

40.40 / 60 , 60 represents the last two digits of the ask rate, the rest being common with the bid rate

INR / USD :

40 / 60 , this is used in the inter bank market where the dealers would be aware of the prevailing rate .

NOTE : • These last two digits are known as Pip . • The quote is always from banker's point of view . • The bid rate is always lower than the ask rate . • The difference between the bid rate and the ask rate is called the Bid – Ask Spread. • The single rate mentioned is often the arithmetic average of the bid and the ask rate.

INVERSE QUOTE For every quote (A/B) between two currencies , there exists an inverse quote (B/A) . For e.g. for a Euro / USD quote there exists a USD / Euro quote . Implied Inverse Quote / Synthetic Inverse Rate : If quote (A/B) is given to us we can easily calculate quote (B/A) : Quote (B/A) = [ 1/ (A/B) ask ]

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[1 / (A/B) bid ]

ILLUSTRATION : 1 The quote for INR / USD : 45 / 47 , what will be the prevailing direct quote in USA ? 2 Rian Ltd has calculated a synthetic quote for CAD/USD , which is 1.2176/82 .Calculate the prevailing rate of USD/CAD.

1. Direct Quote in USA will be USD / INR : = 1/ (INR/USD) ask / 1/ (INR/USD) bid = 1/47 / 1 /45 = 0.0213 / 0.0222 2. USD/CAD = 1/ CAD /USD ask / 1/ CAD/ USD bid = 1/1.2182 / 1/1.2176 = 0.8208 / 0.8213

Note : 1. Synthetic inverse quote is always different from actual inverse quote because of the transaction cost . 2. Transaction cost is the lump some payment required to be made to the dealer , from whom the currency is bought or sold , as his fee or commission . Arbitrage: Arbitrage is the process of buying and selling the same asset at the same time , to profit from price discrepancies within a market or across different markets. Risk Free Arbitrage: When the arbitrage does not involve commitment of capital or any assumption of risk it is called Risk Free Arbitrage.

ILLUSTRATION : Suppose the USD / Euro rates in : October 2008: In country A : 1.0660 /1.0665 In country B : 1.0655 /1.0658 December 2008: In country A In country B

: 1.0660 /1.0665 : 1.0655 /1.0662

Is there an arbitrage opportunity?

October 2008: The USD / Euro rates are : In country A : 1.0660 /1.0665 In country B : 1.0655 /1.0658 An arbitrager can buy Euros in country B at Euro 1.0658/$ and sell at country A at 1.0660 USD , thus making a profit of USD 0.0002 .

ILLUSTRATION : (Two Point Risk Free Arbitrage ) A businessman in India is eyeing an arbitrage opportunity. He found that the quotation available from a bank in New York is USD / INR : 0. 025 / 0. 027 , at the same time a bank at Bombay is offering the following quote INR / USD : 50 / 52 . If there an arbitrage opportunity help him earn a profit.

Implied inverse rate of INR/USD at New York is: =[1/0.027] / [1/0.025] =37 / 40 There exists a opportunity for Risk Free Arbitrage. The businessman must Buy dollars in New York and Sell them in Bombay to earn a profit.

Suppose the businessman has Rs. 10 lac. Buy dollars in New York : = INR 10,00,000 * 0.025 USD/INR = USD 25, 000 Sell 25,000 USD in Bombay : = USD 25,000 * 50 INR/USD = INR 12.50 lac Even if he incurred some expense still he earns a profit of 12.50 – 10 = INR 2.50 lac. .

TYPES OF TRANSACTIONS Foreign exchange transactions can be classified on the basis of the time between entering into a transaction and its settlement . • Outright / Cash / Ready Transaction : When the exchange of currency takes place on the date of the deal . • TOM ( tomorrow ) Transaction : When the exchange of currency takes place on the next working day . • SPOT Transaction : When the transaction will be settled after 2 business days from the date of the contract .

• OUTRIGHT FORWARD Transaction : A contract where the parties to the transaction agree to buy or sell a currency at a pre determined future date at a particular price .This future date may be any date beyond 2 business days . The price and the terms of delivery and payment are fixed at the time of entering into the contract . • SWAP Transaction : A transaction whereby 2 currencies are exchanged by the parties involved , only to be exchanged back later . • A currency swap is a combination of two transactions - one spot and one forward – with exchange of currencies taking place at a predetermined exchange rate .

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