MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit II: Foreign Exchange Markets
Lesson 2.1
(Introduction to Foreign Exchange Markets- Functions, quotations, etc.)

Foreign Exchange Market
A foreign exchange market is the one where one
currency (foreign currency) is bought and sold
against another currency (domestic or home
currency). This market has been developed to
facilitate international trade, foreign investment
and borrowing from or / lending to foreigners. In
order to pay for imports or receive payments for
exports, companies/individuals residing in one
country have to acquire or dispose off the
currency of another country. Foreign exchange
markets provide the facility of exchanging
different currencies.
Foreign Exchange Market
The price of one currency in terms of another
is known as exchange rate. Exchange dealers
do the job of the exchange of currencies. The
transactions in the foreign exchange market
can be either to exchange cash or to buy/sell
some other instruments. The major
instruments are currency forward, currency
futures, currency options and currency
swaps.
Foreign Exchange Market
Various kinds of transactions conducted in the foreign exchange
market are briefly given below:
Spot transactions refers to the transaction involving sale and
purchase of currencies for immediate delivery.
Currency forward contracts are settled on a future date even
though the forward rate are quoted at present moment (today).
They are quoted like spot rate but actual delivery of currencies
takes place much later.
Currency options are the instruments that give the choice to
their holder to buy or sell a foreign currency on or up to date ( also
called maturity date) at a specified exchange rate ( also called
strike rate).
Swaps are the instrument that enable two parties to exchange
the stream of cashflows in two different currencies.
Foreign Exchange Market
Exchange rate quotations
Exchange rate means the price of one unit of a
currency in terms of some units of another country.
For example , Rs 45/US$ means that an amount of Rs
45 is needed to buy one US dollar or Rs 45 will be
received for selling one US dollar. When there is no
difference between buying and selling rate , the rate is
unified. But in practice, it is rarely so. A dealer, who is
willing to buy and sell the same currency against
another, does not quote an identical price for buying
as well as selling. Buying rate is also called bid rate
while selling rate is also known as offer rate or ask
rate.
Foreign Exchange Market
Spread
The dealer keeps a difference between buying and selling price. This
difference is known as spread and constitute his profit. Look at the
example given below





Now consider the rupee/dollar rate. The dealer will buy dollar for Rs
62.50 where he will sell a dollar for Rs 62.80. The difference between
buying rate and selling rate ( 62.80 -62.50 = 0.30) is spread. This is the
profit of the dealer. The amount of spread or the profit of the dealer
depends on the volume of transactions. The currencies which are
frequently traded have smaller spread whereas the currencies which are
not very frequently traded have larger spread.

Currency Pair Buying rate Selling rate
Rupee/US $ 62.50 62.80
Rupee/Swiss Franc 35.40 35.90
Foreign Exchange Market
Spread can be expressed in absolute figures or in terms of percentage.

In absolute terms, Spread = Selling rate Buying rate

Spread in percentage can be expressed either with reference to buying
rate or with reference to selling rate.

When buying rate is taken as reference, the denominator is buying rate .
Thus,
Spread ( in percentage) = [( Selling rate Buying rate)/ Buying rate] x 100

When selling rate is taken as reference, the denominator is selling rate .
Thus,
Spread ( in percentage) = [( Selling rate Buying rate)/ Selling rate] x 100

Foreign Exchange Market
Direct and Indirect quotations
When one unit of FOREIGN currency (i.e. dollar) is quoted in terms
of some number of HOME currency (i.e. rupees), it is a direct
quotation. For example , Rs 60/US $.

When one unit of HOME currency (i.e. rupees) is quoted in terms
of some number of FOREIGN currency (i.e. dollar), it is a indirect
quotation. For example , $0.0166/rupee.
Cross Rates
An exchange rate between two currencies that is derived from the
exchange rates of those currencies with a third currency is known
as a cross rate of exchange. For example, exchange rate may be
given between a pair, A and B and another pair, A and C. Then the
rate between B and C derived from the given rates of the two pairs
( A and B, and , A and C) is called cross rate.

Foreign Exchange Market
Exchange rate quotations in Forward market
In case of forward market, the exchange of currencies takes
place after some period from the date of the deal. The
exchange rates are quoted for maturity of one month , two
months, three months, etc. using swap points as shown
below:



Currency pair Spot One month
forward
Two month
forward
Three month
forward
$/euro 1.2000/50 30/40 60/85 100/140
Foreign Exchange Market
The interpretation of swap points is as follows:
Here spot rate is 1.2000/50 which implies spot buying rate is $ 1.2000 per euro and spot
selling rate is $1.2050 per euro since the last two digits of buying rate are replaced by 50.

In order to determine , the forward rate , we shall see the relationship between
numerator and denominator of the forward period.

Like , in the case of one month forward, numerator (30) is smaller than denominator
(40) , then these points are to be added to the respective figures of spot buying and
selling rates. So, one month forward buying rate becomes 1.2030 (1.2000 + 0.0030) and
one month selling rate becomes 1.2090 (1.2050 + 00.40). Here the forward rate figures
are greater than spot rate figures therefore we may say forward rate is at premium vis-
-vis spot rate.

Similarly , second month rate would be ( 1.2000+0.0060 = 1.2060 and 1.2050+ 0.0085 =
1.2135) and third month rates would be (1.2000+0.0100 = 1.2100 and 1.2050+ 0.0140 =
1.2190).
Foreign Exchange Market
In case numerator is larger than denominator, than these swap points are to be subtracted from the
respective figures of spot buying and selling rates. Consider the example given below:








In case of one month forward, numerator (50) is greater than denominator (40) , therefore , these
swap point will be deducted from the spot rate to arrive at outright rate of one month forward.
Buying rate of one month forward will be 1.7100 0.0050 = 1.7050
Selling rate of one month forward will be 1.7250 0.0040 = 1.7210

Here the forward rate figures are smaller than spot rate figures therefore we may say forward rate
is at discount vis--vis spot rate.
Currency pair Spot One month
forward
Two month
forward
Three month
forward
$/euro 1.7100/250 50/40 100/85 155/125
Foreign Exchange Market

Similarly, In case of two month forward, numerator (100) is greater than
denominator (85) , therefore , these swap point will be deducted from
the spot rate to arrive at outright rate of one month forward.
Buying rate of one month forward will be 1.7100 0.0100 = 1.7000
Selling rate of one month forward will be 1.7250 0.0085 = 1.7165

In case of three month forward, numerator (155) is greater than
denominator (125) , therefore , these swap point will be deducted from
the spot rate to arrive at outright rate of one month forward.
Buying rate of one month forward will be 1.7100 0.0155 = 1.6945
Selling rate of one month forward will be 1.7250 0.0125 = 1.7125
Foreign Exchange Market
Example : A foreign exchange trader gives the following quotes for
the Euro vs. dollar spot, one month, three months and six months
to a US based treasurer.




Calculate the outright quotes for one, three and six month forward.
Also calculate spread at these periods.
currency pair Spot 1 Month 3 Months 6 Months
Euro vs dollar $0.02368/70 4/5 8/7 14/12
Foreign Exchange Market
Solution
Maturity Remarks Bid (buy) Ask (sell) Spread = Difference
between ask and bid
Spot $0.02368 $0.02370 .00002
1 Month Since numerator (4)
is less than
denominator (5),
points are added to
the spot rate
$0.02372 $0.02375 .00003
3 Months Since numerator (8)
is more than
denominator (7),
points are subtracted
from the spot rate
$0.02360 $0.02363 .00003
6 Months Since numerator (14)
is more than
denominator (12),
points are subtracted
from the spot rate
$0.02354 $0.02358 .00004
Exercise
Problem 1: A foreign exchange trader gives the following quotes for
the Rs vs. dollar spot, one month, three months and six months to a
US based treasurer






Calculate the outright quotes for one, two and three month forward.
Also calculate spread and spread percentage ( based on selling as
well as buying price) at these periods.

Spot rate (Rs/$) 62.32 62.53
One month forward 0.05 0.09
Two month forward 0.07 0.03
Three month forward 0.08 0.06
Exercise
Problem 2: A foreign exchange trader gives the following quotes for
the Rs vs. dollar spot, one month, three months and six months to a
US based treasurer






Calculate the outright quotes for one, two and three month forward.
Also calculate spread and spread percentage ( based on selling as
well as buying price) at these periods.

Spot rate (Rs/$) 61.45 61.6
One month forward 0.06 0.08
Two month forward 0.05 0.03
Three month forward 0.07 0.05
Forward Premium or Discount
If forward rate of a currency is greater than the its spot rate, it is said to be
at a forward premium. On the other hand ,if its forward rate is smaller than
its spot rate, it is at forward discount. For example, Rs/$ spot rate is Rs 60/$
and three month forward rate is Rs 61/$. This shows that dollar is at
forward premium. The premium or discount is calculated using equation
given below :

Forward premium/discount = [ (F S)/ S ] x (12/N) x 100


where
N is the number of months forward,
F = Forward rate
S = Spot rate

Foreign Exchange Market
Example : From the data given below calculate forward premium or
discount as the case may be




Solution
Forward Premium (using bid price)
= [(44.7000 44.5000)/ 44.5000] x (12/3) x 100 = 1.18 percent per annum
[Dollar is at premium]

Forward Premium (using ask price)
= [(44.9990 44.7050)/ 44.7050] x (12/3) x 100 = 2.63 percent per annum
[Dollar is at premium]

Particular Spot 3-month forward
Rs/$ 44.5000/7050 44.7000/9990
Foreign Exchange Market
Example : From the data given below calculate forward
premium or discount (on annualized basis) as the case may be




Solution
Forward Premium/ discount
= [(62.50 62.15)/ 62.15] x (12/3) x 100 = 2.252 percent per annum
[Dollar is at premium]


Particular Spot 3-month forward
Rs/$ 62.15 62.50