Crown Agents Bank

An Introduction to Foreign
h

An Introduction to
Foreign Exchange

Crown Agents Bank

www.crownagentsbank.com

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Crown Agents Bank
An Introduction to Foreign Exchange

Contents

Foreword 3

What is Foreign Exchange? 4

Spot Transactions 5

Forward Transactions 8

Currency Options 15

Settlement 17

International Currency Codes 19

Crown Agents Bank 22

Contact Details 23

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Foreword

I am pleased to introduce this publication: an easy to read guide

for those who would like a better understanding of foreign
exchange.

Like all markets, the practice and terminology of the foreign

exchange market can be intimidating to outsiders and
newcomers. However, those involved in international business
need to understand how the market works, the risks when
transacting business in foreign currencies, and how those risks
can be mitigated, even if they do not speak the jargon.

This guide introduces basic transactions and processes, with

simple examples and pricing illustrations.

If you would like to discuss specific foreign exchange issues in

more detail, please contact our Treasury team whose details are
given on the back page.

Graham Godley
Managing Director
Crown Agents Bank

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An Introduction to Foreign Exchange

What is Foreign Exchange?

Foreign exchange is the exchanging of the currency of one country

for that of another. This is undertaken using the foreign exchange
market, a market that has no physical exchange or trading floor.
Deals are conducted by means of electronic trading systems, by
telephone or, at the retail level, over a bank’s counters. Users of
the market include banks, governments, companies and private
individuals.

Not all the world’s currencies are freely convertible. There are a
number which cannot be converted without satisfying official
exchange control regulations. Others are not in high enough
demand to ensure liquidity and a viable market. The range of
currencies that are traded is wide and includes the currencies of
all the major developed countries. Those that are less frequently
traded are known as “exotic” currencies.

The foreign exchange market is very active and prices are in a

constant state of change, reacting moment by moment to
variations in the pattern of trading, to announcements of new
economic data, to news items and to a myriad of other factors.
Quotations are therefore only good for very short periods and
customers must agree to deal quickly to avoid changes.

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Spot Transactions

A spot foreign exchange deal is a transaction in which one

currency is exchanged directly for another for settlement two
working days later (to allow each party time to arrange payment
to the other).

The price at which a deal takes place is known as the spot rate.
This is expressed as the value of a unit of one of the two
currencies in terms of the other currency. For example, the spot
rate for an exchange between the US dollar and the Swiss franc
would be quoted as 1 dollar = 1.6000 francs. In this example the
dollar is the unit or base currency and every dollar is worth 1.6
francs. The general practice in the spot market is to measure the
value of currencies against the US dollar and so, when the US
dollar is one of the currencies being exchanged, it is normally the
unit or base currency in the exchange rate. There are some
exceptions to this rule, notably the pound sterling and the euro.

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A spot rate of exchange

Foreign exchange rates are quoted in currency pairs. The first
currency named in the pair is always the unit currency. For
example:-
EUR/USD: = 1.1670/80 (i.e. 1.1670 to 1.1680)

EUR/USD are the two currencies. The codes are the

international three letter codes used by financial institutions.
EUR = Euros; USD = US dollars. Every currency has been
assigned such a code. The full list of currency codes is shown
on pages 19-21.
• Rates quoted are two-way. The left-hand side (i.e. 1.1670)
is where the dealer will buy the unit currency. This is known
as the bid. The right-hand side (i.e. 1.1680) is where the
dealer will sell the unit currency. This is known as the offer.
• Most prices are quoted to four decimal places (exceptions
include JPY which is usually quoted to two decimal places).
In the above example 1.16 is called the big figure and 70/80
are the points or ticks.
• The difference between the bid rate and the offer rate is
known as the spread. The exchange rate in this example has
a ten point spread.

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Other currency pairs

USD/CHF 1.2810/20 = Dealer will buy USD 1 for CHF 1.2810

or

will sell USD 1 for CHF 1.2820

GBP/USD 1.7500/10 = Dealer will buy GBP 1 for USD 1.7500

or

will sell GBP 1 for USD 1.7510

USD/JPY 116.00/10 = Dealer will buy USD 1 for JPY 116.00

or

will sell USD 1 for JPY 116.10

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Forward Transactions
A forward exchange deal is a transaction in which one currency is
exchanged directly for another for settlement at a specified time
more than two working days after the deal date. No money
changes hands until the specified settlement date, which can be
at any time (within certain limits) to suit the parties. Settlement
is made at the rate of exchange agreed between the parties at the
time of dealing.

The purpose of a forward exchange deal is to fix the cost of

exchange at a future date to cover an anticipated foreign
exchange commitment.

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Using a forward transaction

A transport company in Europe buying trucks directly from a
Japanese manufacturer will be required to make payment in yen
on delivery of the vehicles, which may be scheduled several
months after the order is placed. If the company maintains its
accounts in euros it will be necessary to sell euros for yen. Rather
than wait until the delivery date to buy yen, and risk an increase
in the cost of yen on the foreign exchange market, the company
could buy yen forward when it places the order. If the forward
settlement date is matched to the delivery date for the trucks,
the company will receive the yen it needs when it needs them
and, by dealing at the time the order is placed, avoid the risk of
suffering a loss on exchange, and the uncertainty of not knowing
what the cost in euros will be.

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How is the exchange rate of a forward transaction fixed?

There is no uncertainty or guesswork in calculating a forward
price. It is based on known market values: the prevailing interest
rates and the spot exchange rates for the two currencies.

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Example of a forward transaction

To demonstrate how a forward price is calculated, assume that
BRITCO, a UK company, expects a payment three months from
today of USD1m for goods which it needs to exchange into GBP.
If there was no forward exchange market, what would BRITCO’s
alternatives be?

Either:

(a) - Do nothing now. Wait until the payment is made and then
sell USD for GBP at the market rate available at that time;

Or

(b) - Borrow USD 1 million for three months from today and use
this to buy GBP at today’s exchange rate;

- place the purchased GBP on deposit for three months;

- use the USD payment expected in three months time to

repay the USD borrowing (note the interest earned on the
three month GBP deposit can be sold for USD in three
months time and put towards covering the interest
charges on the USD borrowing).
Continued …

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Alternative (a) is risky. The exchange rate could move in

either direction over a three month period. If the GBP
strengthens, the value of the dollar payment will be less in
three months time than it is now. Of course, the reverse will
be true if the GBP weakens but is it worth taking a chance?

Alternative (b) is the prudent choice. It locks in today’s

exchange rate and removes the risk of loss from a fall in the
value of the USD. The cost of borrowing dollars may be fully
covered by the interest earned on the GBP deposit depending
on the level of interest rates in the two currencies. If it is
not, then the shortfall will be an extra cost to be factored
into the exercise. It is a known extra cost, however, and the
exercise still achieves its objective of removing the
uncertainty over what will happen to exchange rates over the
three month period.

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A forward price calculation

A spot rate is adjusted to reflect the difference in interest
rates for each currency

GBP interest rate for 90 days = 4% per annum

USD interest rate for 90 days = 2% per annum
Spot GBP/USD exchange rate = 1.7500

So:
Interest rate differential, GBP/USD = 2% per annum
or = 0.5% for 90 days

This can be expressed in the exchange rate as follows:

GBP1 + 0.50% of one pound = GBP 1.0050

GBP1.0050 = USD1.7500

GBP1.0000 = USD1.7500 = 1.7413

1.0050

The forward margin = 0.0087 (1.7500-1.7413)

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The difference between the spot and forward rates is known as

the forward margin and it represents the difference between the
cost of borrowing USD and lending GBP for 90 days. The forward
margin is the amount by which the spot rate needs to be adjusted
to obtain a forward exchange rate.

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Currency Options
A currency option conveys the right, but not the obligation, either
to buy or sell a specific amount of a currency for another currency
at a fixed price at a future date. The future date may be either
the latest date on which the option may be exercised or the only
date on which the option is exercisable. The holder of an option is
not obliged to deal, however, and may choose simply to allow the
option to lapse.

The cost of a currency option is typically expressed as a

percentage of the underlying amount. These options can be used
to secure the future value of a currency by, in effect, establishing
a minimum future price without making a commitment to deal.

When used in this way an option can be thought of as an insurance

policy. An option purchaser pays a premium (the cost of the
option) for the right to buy (or sell) a currency at a fixed exchange
rate at a future date. If the spot rate at that future date is less
favourable than the option rate, the holder can exercise the
option. If the spot rate at that future date is more favourable than
the option rate, the holder can allow the option to lapse and deal
in the market.

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Either way, the option has “insured” a maximum cost of the

currency for the purchaser. The cost of the option is the price
the purchaser pays for the right to buy (or sell) at a fixed rate
and thereby limit the risk of loss on exchange. In the same way,
the cost of an insurance premium is the price of limiting the risk
of loss of the insured item.

Using an option

In this example DutchCo is bidding for a contract which, if it is

awarded to DutchCo, will be priced in US Dollars. The US dollar
income is a possible future cash flow that will need to be sold
for euros. Instead of entering into a commitment to sell dollars
forward, DutchCo could purchase an option to sell the dollars at
a predetermined rate if and when the contract is awarded. If
the value of the dollar has fallen by the date it receives
payment, it could exercise the option and deal at the better
option rate. If the value of the dollar has not fallen, or if it has
risen, DutchCo would simply allow the option to lapse and sell
its dollars in the market at the spot rate. In this way DutchCo
will be protected against a fall in the value of the dollar over
the period for a fixed cost, but will benefit from any rise in the
value of the dollar.

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Settlement
When an exchange deal is settled the currencies involved do not
cross their own national borders.

The settlement process

On Wednesday, the dealer at Bank A in London agrees to sell

spot US dollars in exchange for Swiss francs to Bank B in
Frankfurt.

Even though the two parties are located in London and

Frankfurt, they have to settle their US dollars in New York and
their Swiss francs in Zurich. Currencies do not cross their
national borders.

On Friday:-

i) the Swiss franc side of the transaction settles in Zurich

with Bank B’s franc account being debited and Bank A’s
franc account being credited (i.e. B pays francs to A).

ii) the US dollar side of the transaction settles in New York

with Bank A’s dollar account being debited and Bank B’s
dollar account being credited (i.e. A pays dollars to B).

This is illustrated in the diagram overleaf.

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Wednesday – Spot deal

London Frankfurt

Bank A Bank B

sells USD → USD buys

buys CHF ← CHF sells

Friday – Settlement

New York Zurich

Bank A Bank A

pays USD CHF receives

Bank B Bank B

receives USD CHF pays

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International Currency Codes

Code Country Currency Code Country Currency

ALL Albania Leke CHF Switzerland Francs

AMD Armenia Drams CLP Chile Pesos

ANG Netherlands Antilles Guilders CNY China Yuan Renminbi

AOA Angola Kwanza COP Colombia Pesos

ARS Argentina Pesos CRC Costa Rica Colones

AUD Australia Dollars CUP Cuba Pesos

AWG Aruba Guilders CVE Cape Verde Escudos

AZM Azerbaijan Manats CYP Cyprus Pounds

BAM Bosnia and Convertible CZK Czech Republic Koruny

Herzegovina Marka
BBD Barbados Dollars DJF Djibouti Francs

BDT Bangladesh Taka DKK Denmark Kroner

BGL Bulgaria Leva DOP Dominican Republic Pesos

BHD Bahrain Dinars DZD Algeria Algeria Dinars

BIF Burundi Francs EEK Estonia Krooni

BMD Bermuda Dollars EGP Egypt Pounds

BND Brunei Darussalam Dollars ERN Eritrea Nakfa

BOB Bolivia Bolivianos ETB Ethiopia Birr

BRL Brazil Brazil Real EUR Euro Member Countries Euro

BSD Bahamas Dollars FKP Falkland Islands Pounds

BTN Bhutan Ngultrum FJD Fiji Dollars

BWP Botswana Pulas GBP United Kingdom Pounds

BYR Belarus Rubles GEL Georgia Lari

BZD Belize Dollars GGP Guernsey Pounds

CAD Canada Dollars GHC Ghana Cedis

CDF Congo/Kinshasa Congolese Francs GIP Gibraltar Pounds

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GMD Gambia Dalasi LRD Liberia Dollars

GNF Guinea Francs LSL Lesotho Maloti

GTQ Guatemala Quetzales LTL Lithuania Litai

GYD Guyana Dollars LVL Latvia Lati

HKD Hong Kong Dollars LYD Libya Dinars

HNL Honduras Lempiras MAD Morocco Dirhams

HRK Croatia Kuna MDL Moldova Lei

HTG Haiti Gourdes MGF Madagascar Malagasy Francs

HUF Hungary Forint MKD Macedonia Denars

IDR Indonesia Rupiahs MMK Myanmar (Burma) Kyats

ILS Israel New Shekels MNT Mongolia Tugriks

IMP Isle of Man Pounds MOP Macau Patacas

INR India Rupees MRO Mauritania Ouguiyas

IQD Iraq Dinars MVR Maldives(Maldive Rufiyaa

Islands)
JMD Jamaica Dollars MWK Malawi Kwachas

JOD Jordan Dinars MXN Mexico Pesos

KES Kenya Shillings MYR Malaysia Ringgits

KGS Kyrgyzstan Soms MZM Mozambique Meticais

KHR Cambodia Riels NAD Namibia Dollars

KMF Comoros Francs NGN Nigeria Nairas

KPW Korea (North) Won NIO Nicaragua Gold Cordobas

KRW Korea (South) Won NOK Norway Kroner

KWD Kuwait Dinars NPR Nepal Nepal Rupees

KYD Cayman Islands Dollars NZD New Zealand Dollars

KZT Kazakstan Tenge OMR Oman Rials

LAK Laos Kips PAB Panama Balboa

LBP Lebanon Pounds PEN Peru Nuevos Soles

LKR Sri Lanka Rupees PGK Papua New Guinea Kina

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PHP Philippines Pesos TND Tunisia Dinars

PKR Pakistan Rupees TOP Tonga Pa'anga

PLN Poland Zlotych TRL Turkey Liras

PYG Paraguay Guarani TTD Trinidad and Tobago Dollars

QAR Qatar Rials TVD Tuvalu Tuvalu Dollars

ROL Romania Lei TWD Taiwan New Dollars

RUR Russia Rubles TZS Tanzania Shillings

RWF Rwanda Rwanda Francs UAH Ukraine Hryvnia

SAR Saudi Arabia Riyals UGX Uganda Shillings

SBD Solomon Islands Dollars USD United States of Dollars

America
SCR Seychelles Rupees UYU Uruguay Pesos

SDD Sudan Dinars UZS Uzbekistan Sums

SEK Sweden Kronor VEB Venezuela Bolivares

SGD Singapore Dollars VND Vietnam Dong

SHP Saint Helena Pounds VUV Vanuatu Vatu

SIT Slovenia Tolars WST Samoa Tala

SKK Slovakia Koruny XAG Silver Ounces

SLL Sierra Leone Leones XAU Gold Ounces

SOS Somalia Shillings XCD East Caribbean Dollars

SPL Seborga Luigini YUM Yugoslavia New Dinars

SRG Suriname Guilders ZAR South Africa Rand

STD São Tome and Dobras ZMK Zambia Kwacha

Principe
SVC El Salvador Colones ZWD Zimbabwe Zimbabwe Dollars

SYP Syria Pounds

SZL Swaziland Emalangeni

THB Thailand Baht

TJR Tajikistan Rubles

TMM Turkmenistan Manats

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Crown Agents
Contact Bank Team
our Treasury
Crown Agents Bank quotes competitive foreign exchange and
money market rates in all the major and many exotic currencies.
David
We alsoSmithson
offer accounts in many currencies for prompt receipt
Tel:payment
and +44 (0)208 710 6126 and domestic funds.
of overseas
Email: [email protected]
Our clients include central banks, governments, development
agencies, NGOs and other organisations worldwide.
Nick Goryn
Tel: combination
The +44 (0)208 710 of 6039
our competitive rates and flexible service
Email [email protected]
delivery is a winning formula for our clients.

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Contact our Treasury Team

David Smithson
Tel: +44 (0)208 710 6126
Email: [email protected]

Nick Goryn
Tel: +44 (0)208 710 6039
Email [email protected]

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