Unit 2, 3- Forex Markets and

Managing Currency Exposure

K Lubza Nihar
UNIT 2 and 3- Syllabus
UNIT 2: Foreign Exchange Market: Structure, mechanism of
currency trading, exchange rate quotations
forward contracts, interest arbitrage, exchange rate regimes and the
foreign exchange market in India (NP)

UNIT 3: Management of Currency Exposure: Measurement of exposure

and risk, managing transaction exposure, operating exposure, short-term
financial management in multinational corporation(NP). Currency
Derivatives –Netting – forfeiting.
What is the Structure of FX Markets?
• Three Tier
• Central Bank and Authorised Dealers
• Authorised Dealers and Authorised Dealers
• Authorised Dealers and Customers
• Formats
• Electronic Trading through SWIFT and CHIPS between Banks and Dealers
• Over The Counter Market, Electronic Broking Systems for Customers-
Banks
• Exchange Traded for Cash, Tom and Spot Trans-CCIL(India) – since Aug,
2019 – Fx Clear operated by CCIL (Clearing Corporate of India Ltd.)
• Exchange Traded for Derivatives
Bank Accounts – nostro and vostro accounts
For Bank Y, A
and Z they are
Vostro accounts- Bank Y In USA- Correspondent
For Bank X they USD bank or
are Nostro
facilitator bank,
Accounts
Y, Z and A

Bank A in Bank X in Bank Z in UK-

Australia-AUD India POUND
How a typical Fx transaction takes place?
Dena Bank Purchases 1 Mn US Dollars from Bank of Baroda, by paying 10 Mn
Japanese Yen.
Dena Bank has its Nostro Account (account that a bank holds in a foreign currency at
another bank) with Bank of Japan, in Tokyo and HSBC in New York
Bank of Baroda has its Nostro Account with HSBC, New York, and Bank of Japan in
Tokyo
Example: Transaction: BRL for JPY

• Parties: Argentine Bank: Banco de Galicia (BG),

• Malayan Bank: Malayan Banking Berhard (MB).
• Transaction: BG sells BRL (Brazilian real) to MBB for JPY.
• Settlement: a transfer of two bank deposits:
• (1) BG turns over to MB a BRL deposit at a bank in Brazil,
• (2) MB turns over to BG a JPY deposit at a bank in Japan.
How to understand Rates – Based on Markets
• The transactions between the central bank and the respective
authorised dealers happen at BASE RATE

• The transactions between the banks in the interbank market happen at

INTERBANK RATE

• The transactions between the banks and customers happen at the

MERCHANT RATES.
Understanding Rates – based on markets
• In India, everyday morning the RBI opens and displays its base or
reference exchange rate at around 10 to 11 am.
• It actually is a rate at which RBI (NPO) is interested to buy or sell.
• Single rate- No bid or ask rate
• The base rate becomes the basis for the authorised dealers to start
adding their margins
• The FEDAI (Foreign exchange dealers association of India) sets the
guidelines and rules and regulations to create the ranges within which
the bid and ask margins can be loaded for interbank and merchant
rates.
Rates on basis of delivery of FX
• CASH - Immediate Delivery
• TOM - Delivery Tomorrow
• SPOT - Delivery on the second Business Day (If the date of
transaction is Monday, then Wednesday is the delivery and settlement,
If transaction is on Friday, then Monday is the delivery, since it is
TWO BUSINESS DAYS, not TWO DAYS)
• FORWARD - Delivery any day beyond TWO BUSINESS DAYS is
forward.
Exchange rates classified based on the nature of instrument transacted or tendered

• TT - Telegraphic Transfer Rates –

• The rates which the Authorised Dealers apply to the customers when
they tender or buy Currency, Traveller’s Cheques, Demand Drafts,
Credit Card Payments, Cheque Payments, Money Transfers,
Telegraphic Transfers.
• Foreign currency in the deal is changing hands immediately and the
bank is receiving or giving the currency immediately.
• There is no delay or waiting time between the customer pay Rupees
and getting the foreign currency.
Exchange rates classified based on the nature
of instrument transacted or tendered
• BILL Rates –
• are applied when the customers submits a Bill of exchange
• the bank has to negotiate the bill through the banking channel
• send it to the foreign importer’s bank or exporter’s bank and then to
the importers,
• receive the confirmation of credit to his account in foreign currency,
• finally credits the converted rupee amount into the Indian customer’s
account, or debits the customer’s account if he bought foreign
currency.
Rates on basis of action of parties
• If the bank buys, it buys at BID RATE and if it sells it is at ASK
RATE.
• there has to be a system of TWO WAY QUOTE.
• This procedure of OFFERING THE QUOTE is called MARKET
MAKING.
Conventions in quotes
• Currencies are given in THREE CAPITAL LETTER CODES
• USD / INR - Left side of the slash is the Base Currency- Right side of
the slash is the Quote Currency.
• Base Currency is being bought and sold IN TERMS of Quote
Currency
• USD / INR - SPOT - 65.20 / 30.
• This means that a market maker, (an authorised dealer or a bank) is
ready to give Rs. 65.20 to anyone who is going to tender 1 US dollar,
and asking for Rs. 65.30 to sell 1 US dollar. Or the BANK is BUYING
at 65.20 and SELLING at 65.30.
Conventions in quotes
• interbank market operates with FOUR DECIMAL
• ALL MERCHANT RATES HAVE TO BE ROUNDED OFF TO TWO
DECIMAL POINTS as Paise 100 is one Re in India.
• ALWAYS THE BID (BUY) rate is LESSER than the ASK (SELL) rate
• DIRECT QUOTE:
• NUMBER OF HOME CURRENCY units PER unit FOREIGN CURRENCY
units, in a particular country.
• USD/INR
• INR/USD
Conventions in quotes
• INDIRECT QUOTE:
• Number of units of FOREIGN CURRENCY per unit HOME
CURRENCY (reciprocal of Direct Quote)
• A U.S. tourist wishes to buy JPY at Shop.
• Indirect quotation (JPY/USD).
• A quote of JPY 110.34-111.09 means the dealer is willing to buy one
USD for JPY 110.34 (bid) and
• sell one USD for JPY 111.09 (ask).
• For each round-trip USD transaction, she makes a profit of JPY .75.
Conventions in Quotes
• Direct quotation (USD/JPY).
• If the dealer at shop uses direct quotations, the bid-ask quote will
be .009002-.009063 USD/JPY.
• Note: S(direct)bid = 1/S(indirect)ask,
• S(direct)ask = 1/S(indirect)bid.
Convention for Quotes
• Cross Rate:
• A cross rate is a foreign currency exchange transaction between two
currencies that are both valued against a third currency.
• Rule for cross-rates (based on triangular arbitrage. We will see this
later):
• (Quote X/Z)/(Quote Y/Z) = Quote X/Y (currency Z has to cancel out)
– depends on Quote given
Cross Rate -Example
• Calculate the CHF/EUR cross rate:
• St = 1.00 CHF/USD
• St = 0.97 EUR/USD
• SCHF/EUR,t = 1.00 CHF/USD / 0.97 EUR/USD = 1.03093
CHF/EUR.
• CHF/USD * USD/EUR = CHF/EUR
Cross Rate - Example
• JPY/GBP cross rate.
• St = 0.00833 USD/JPY = 120 JPY/USD.
• St = 1.30 USD/GBP

• SJPY/GBP,t = 120 JPY/USD x 1.30 USD/GBP = 92.3077 JPY/GBP.

Forward Market – Settlement days above spot
market
• T (=Maturity): 7-day, 1-, 2-, 3- and 12-month settlements. (Up to 10-
year contracts.)
• Forward transactions are tailor-made.
• Forward contracts allow firms and investors to transfer risk.
• Notation. Ft,T: Forward price at time t, with a T day maturity.
• Forward transactions are classified into two classes: outright and swap.
• Outright forward transaction: an uncovered speculative position in a
currency (though it might be part of a currency hedge to the other side).
Example – Forward-Outright
• Activities in forward –
• Speculation (open positions)
• Hedging (covered positions)
• Arbitrage (establish positions to take advantage of pricing mistakes in
one or more markets)
• BOFA holds British bonds worth GBP 1,000,000. BOFA fears the GBP
will lose value against the USD in 7 days. BOFA sells a 7-day GBP
forward contract at Ft,7-day=1.305 USD/GBP to transfer the currency
risk of position.
Settlement -Outright
• In 7 days, BOFA will receive USD 1,305,000 and will transfer to the
counterparty GBP 1M
FX swap transaction
• FX swap transaction (a “package trade”): The simultaneous sale (or
purchase) of spot foreign exchange
• against a forward purchase (or sale) of approximately an equal amount
of the foreign currency.
• Motivation for a FX swap transaction: A position taken to reduce the
exposure in a forward trade.
FX Swap
• is an agreement to simultaneously borrow one currency and lend
another at an initial date, then exchanging the amounts at maturity.
• Leg 1 is the transaction at the prevailing spot rate
• Leg 2 is the transaction at the predetermined forward rate.
FX Swap mechanics
Example FX swap
• Party A is Canadian and needs EUR. Party B is European and needs
CAD. The parties enter into a foreign exchange swap today with a
maturity of six months. They agree to swap 1,000,000 EUR, or
equivalently 1,500,000 CAD at the spot rate of 1.5 EUR/CAD. They
also agree on a forward rate of 1.6 EUR/CAD because they expect the
Canadian Dollar to depreciate relative to the Euro.

• Today, Party A receives 1,000,000 Euros and gives 1,500,000 Canadian

Dollars to Party B. In six months’ time, Party A returns 1,000,000 EUR
and receives (1,000,000 EUR * 1.6 EUR/CAD = 1,600,000 CAD) from
Party B, ending the foreign exchange swap.
Arbitrage
• Definition: It involves no risk and no capital of your own. It is an
activity that takes advantages of pricing
• mistakes in financial instruments in one or more markets. That is,
arbitrage involves
• (1) Pricing mistake
• (2) No own capital
• (3) No Risk
Arbitrage and the law of one price (LOOP)
A. THE LAW OF ONE PRICE: States that identical goods sell for the same
price worldwide.
B. If the prices after exchange-rate adjustment were not equal, arbitrage for
the goods worldwide ensures that eventually they will be.
C. Five parity conditions result from these arbitrage activities

• 1. Purchasing Power Parity (PPP).

• 2. The Fisher Effect (FE).
• 3. The International Fisher Effect (IFE).
• 4. Interest Rate Parity (IRP).
• 5. Unbiased Forward Rate (UFR).
Arbitrage and the law of one price
D. Five parity conditions linked by
The adjustment of various rates and prices to inflation.
The notion that money should have no effect on real variables
(since they have been adjusted for price changes).

E. Inflation and home currency depreciation

Jointly determined by the growth of domestic money supply.
Relative to the growth of domestic money demand.
F. This law is enforced by international arbitrage
Evolution of Parity theories

• HOW MANY OUNCES OF GOLD or the kings started minting coins

and they started conveying the message, that each coin would contain
a particular amount of GOLD in the coin
• After the coin age the political governments started creating the FIAT
MONEY buy the guarantee of GOLD against a currency.
• This was the birth of the GOLD PARITY or GOLD STANDARD.
• So lets say UK had 1 ounce of gold equal to 2 pounds. Then at the
same time India had 1 ounce of gold equal to 200 INR, then logically
2 Pounds are equal to 200 INR. isn’t it?
THE THEORY OF PURCHASING POWER
PARITY
• Later the people started arguing that it is completely biased towards
the RICH NATIONS.
• UK who have been dominating the world through war and invasions
and have amassed lot of GOLD from every other country, and hence
the POUND used to be the strongest currency due to LOT OF
SUPPLY OF GOLD in their country .
• for others it used to be costly and hence by default the other countries’
currencies used to be WEAK. JUST BECAUSE THEY DID NOT
HAVE GOLD.
THE THEORY OF PURCHASING POWER
PARITY
• This gave rise to the arguments amongst nations especially US and
other major allies who won the world wars, and the economists that
CURRENCY IS TO BE POSSESSED OR ACQUIRED NOT TO BUY
GOLD BUT TO LIVE AND SURVIVE.
• Hence the definition that the VALUE OF A CURRENCY IS WHAT IT
CAN BUY TO LIVE and a CONSUMPTION BASKET WAS
CREATED.
• If the consumption basket is 1 DOLLAR = 0.5 POUND = 100 INR =
200 YEN , then this is how the currency exchange rate got equated.
THE THEORY OF PURCHASING POWER
PARITY
• The researchers tried to argue that the basket can change the patterns
of consumption and life styles can be different then why to base on a
typical consumption basket, rather one can base on a broader PRICE
LEVEL, since a currency can buy something today at a particular price
and later a different price.
• so the exchange rates started moving and changing at different times.
• Due to the demand and supply conditions, and income levels, tastes
and preferences of the customers, competition etc.
• This gave to the birth of PPP Purchasing Power Parity.
PPP
• States that spot exchange rates between currencies will change to the
differential in inflation rates between countries.
• same goods once denominated in a common currency should have the
same price. If they are not, then pseudo-arbitrage is possible.
• E/R between Country A and Country B
• = E/R(A/B) = Price of the Basket in country A / Price of the Basket in
country B
• Which ever country you want to arrive is at the numerator.
• Say 500 USD is equal to 5000 INR the
• USD / INR rate would be 5000 / 500 = 10 INR for 1 USD
PPP
• The biggest argument of this theory is that if the price levels of a
particular basket of commodity was differing between two countries,
• the exchange rate was not allowing to converge,
• Then there is an arbitrage opportunity
• This will bring in traders to buy the basket in one country and sell it in
another country and in the process they will bring the price levels to an
equilibrium and also the exchange rate to equilibrium.
Assumptions of PPP
• No transportation costs
• Full information about the products and prices
• The prices of the products in countries are influenced only BY FOREIGN
TRADE
• There are no import or export restrictions on the products for movement
• And the forex markets are entered or exited ONLY FOR THE PURPOSE
OF EXPORT AND IMPORT TRADE, or only for TRADE
CONVERSIONS
• Tastes and preferences of consumers for products are the same across the
world
PPP -Example
• Price oil-USA = USD 40.
• Price of oil-SWIT = CHF 80.
• 𝐋𝐎𝐎𝐏 = Poil-USA/Poil-SWIT =USD 40/CHF 80 =0.50 USD/CHF.
• Suppose St = 0.75 USD/CHF
• Poil-SWIT (in USD) = CHF 80 x 0.75 USD/CHF = USD 60.
• That is, a barrel of oil in Switzerland is more expensive -once denominated in
USD- than in the US.
• Arbitrageurs/traders will buy oil in the U.S. (to export it to Switzerland) and
simultaneously sell oil in Switzerland. This movement of oil will simultaneously
increase the price of oil in the U.S. (Poil-USA ↑);
• decrease the price of oil in Switzerland (Poil-SWIT ↓); and appreciate the USD
against the CHF (St ↓).
PPP
• Complete the sentence correctly. In its absolute version, purchasing
power parity states that price levels worldwide should _______when
expressed in a common currency.
• a) be equal
• b) be roughly equal
• c) be different
• d) provide opportunities for arbitrage
• Answer : Equal
PPP
• Which one of the following statements concerning exchange rate
changes is correct?
• a) Changes in expected, as well as actual, inflation will cause exchange
rate changes.
• b) Changes in expected, but not actual, inflation will cause exchange rate
changes.
• c) An increase in a currency’s expected rate of inflation makes that
currency less expensive to hold over time, all other things being equal.
• d) An increase in a currency’s expected rate of inflation makes that
currency more in demand at the same price, all other things being equal.
Answer-b
PURCHASING POWER PARITY
In mathematical terms:

where et = future spot rate

e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
PURCHASING POWER PARITY
2. If purchasing power parity is expected to hold,
then the best prediction for the one-period spot rate
should be written as:

=
PURCHASING POWER PARITY
3. A more simplified but less precise relationship is
written:
et
 ih  i f
e0

that is, the percentage change should be

approximately equal to the inflation rate
differential.
 PURCHASING POWER PARITY

4. PPP states:

the currency with the higher inflation rate is expected to depreciate

relative to the currency with the lower rate of inflation.
 PURCHASING POWER PARITY

Real exchange rates

The quoted or nominal rate adjusted for a country’s inflation rate is:

(1  i f ) t

e '
t  et
(1  ih ) t
PURCHASING POWER PARITY
Real exchange rates: If exchange rates adjust to
inflation differential, PPP states that real exchange rates
stay the same.
PPP
• Suppose annual inflation rates in the U.S. and Mexico are expected to
be 6% and 80%, respectively, over the next several years. Which of the
following is correct? If the current spot rate for the Mexican peso is
$.005, then the best estimate of the peso's spot value in 3 years is
• a) $.00276
• b) $.01190
• c) $.00321
• d) $.00102
• 1 USD =.005$ (Peso)
• $.005 × (1.06)^3 / (1.80)^3 = $.00102
PPP
• The inflation rates in the Eurozone and Morocco are expected to be
4% per year and 7% per year, respectively. Which of the following is
correct? If the current spot rate for the Moroccan dirham (MDr) is
9.5238 against the euro, then the expected spot rate in three years
would be
• a) MDr 8.6957
• b) MDr 8.9928
• c) MDr 10.3720
• d) MDr 10.0806
• 1 EUR=9.5238 MDR
• (1.07)^3 / (1.04)^3 × 9.5238 = 10.3720 MDR
PPP
• Which of the following is correct? Suppose the expected inflation in
the U.S. on was projected at 5% annually for the next 5 years and at
12% annually in Turkey for the same time period, and the Turkish
lira/$ spot rate that day was currently at L2400 = $1, then the PPP
estimate of the spot rate five years from now would be
• a) 1738
• b) 3314
• c) 2560
• d) 2250
• L2400 × (1.12)5 / (1.05)5 = 3314
PPP
• Suppose the Swiss franc revalues from SFr 2.50/$ at the beginning of
the year to $2.2727/$ at the end of the year. U.S. inflation is 5% and
Swiss inflation is 3% during the year. What is the real devaluation (- )
or real revaluation (+) of the Swiss franc during the year?
• a) + 7.9%
• b) 5.3%
• c) + 8.1%
• d) 1.6%
• (2.50/2.27 × 1.03/1.05) – 1 = 7.9%
PPP
• Suppose the value of the Polish zloty moves from Zl 1000 = $1 at the
start of the year to Zl 1,800 at the end of the year. At the same time,
the Polish price level changes from an index of 100 on January 1 to
134 on December 31. U.S. inflation during the year was 4.5%. If the
one-year interest rate on the zloty is 44%, what was the real U.S.
dollar cost of borrowing the zloty during the year?
• a) 17.53%
• b) 27.81%
• c) -23.44%
• d) -8.76%
• – 23.44%
Types of Arbitrage
• There are 3 types of arbitrage:
• (1) Local (sets uniform rates across banks)
• (2) Triangular (sets cross rates)
• (3) Covered (sets forward rates)