The Foreign Exchange Market

Forex and Treasury Management

Session 1 and 2

1
 The Foreign Exchange Market
 The Structure of the Forex Market
 Foreign Exchange
 Types of Transactions
 Settlement Dates
 Quotes for Various Kinds of Merchant Transactions
 The Indian Scenario
Convertibility
Exchange Control
The FEDAI Rules Regarding Inter-bank Dealings
Forex Dealing Room Operations

2
 Structure of the Forex Market
Decentralized, over-the-counter market, also
known as the 'interbank' market
 Main participants: Central Banks, commercial
and investment banks, hedge funds, pension
funds, corporations & private speculators
 The free-floating currency system began in
1973, and was officially mandated in 1978
 Online trading began in the mid to late 1990's

3
 Structure of the Forex Market
Trading Hours
24 hour market
Sunday 5pm EST through Friday 4pm EST. Rollover at
5pm EST
Trading begins in New Zealand, followed by Australia,
Asia, the Middle East, Europe, and America
Size
Largest market in the world
$1.9 trillion average daily turnover, equivalent to:
15 times the average daily turnover of global equity
markets
Nearly 50 times the average daily turnover of the NYSE
$300 a day for every man, woman, and child on earth
The spot market accounts for about one-third of daily
turnover

4
 Structure of the Forex Market
Major Markets
 The US & UK account for more than 50% of turnover

 Major markets: London, New York, Tokyo

 Trading activity is heaviest when major markets overlap

 Nearly two-thirds of NY activity occurs in the morning

hours while European markets are open

Trading
 An estimated 95% of transactions are speculative

 More than 40% of trades last less than two days

 About 80% of trades last less than one week

 Brokers research: 90% of traders lose money, 5% break

even, 5% make money

5
 Structure of the Forex Market
Country wise turnover
Country Percentage Share
UK 31.3
USA 19.2
Japan 8.3
Singapore 5.2
Germany 4.9
Hong Kong 4.2
Australia 3.4
Others 23.5
Total 100
6
Structure of the Forex Market
Currency wise turnover
Currency Percentage Share
USD 88.7
EURO 37.2
JPY 20.3
GBP 16.9
CHF 6.1
AUD 5.5
CAD 4.2
Others 21.1
Total 200.0
7
Structure of the Forex Market
Currency Pair wise turnover
Currency Percentage Share
EURO/USD 28
USD/JPY 17
GBP/USD 14
AUD/USD 5
USD/CHF 4
USD/ CAD 4
EURO/JPY 3
Others 25
Total 100 8
 Around-the-clock FX trading
Average Electronic Conversions Per Hour

25,000

20,000

15,000

10,000

5,000

Greenwich Mean Time

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyo opening closing open closing in America In NY opens
9
 World FX transactions
$1.9 trillion/day (2004)

spot
33%

FX sw aps
50%

forw ard
gap 11%
6%

10
 FX market in the U.S. is the most
active market in the U.S.
 $461 billion turnover per day, in 2004
 Comparisons with U.S. asset markets:
· 10 times the turnover of U.S. govt. bonds
· 50 times the turnover of NYSE stocks
 Comparisons with real activity in U.S.:
· 10 times U.S. daily GDP
· 30 times U.S. daily exports + imports
 Primary functions of FX Market

 Currency conversions associated with

international payments process
 Provision of credit to clients
(also part of international payments process)
 Managing exchange rate risk
 Structure of FX Market (retail level)

domestic ($) foreign (FC)

central bank for. central bank

Interbank mkt
firms ($/FC) for. firms

investors Exchange-traded for. investors

futures & options
 Structure of FX Market: interbank
(wholesale) level

 Banks trade with each other

· in response to the retail orders they receive
· to manage their own accounts
 Banks trade
· directly with other banks
· indirectly through FX brokers
 FX market
domestic foreign
($) (FC)
FX broker

Corp.
order dom. for. Corp.
bank bank order

Corp. dom. for. Corp.

order bank bank order
$/FC
 Direct vs. brokered interbank trades
 Direct dealing
Banks face another bank’s bid-ask spread, at which they can
transact immediately
 Brokered trades
Get best price of all posted buys/sells
· 56% of all dealers’ trades are with other dealers

· 31% are with other financial institutions

(brokers, mutual funds, ...)

· 13% are with non-financial customers

· 66% of all trades are with foreign counterparties

 Much (56%) of FX trading is in the interbank (wholesale)
market
 However, the retail orders are the important ones that
determine exchange rates
· Interbank traders are intermediaries

(market makers)
· temporarily take positions intra-daily, but

work hard to zero out their positions regularly and by

the end of the day
 Structure of the Forex Market
 Function and Structure of the FOREX Market
 The Spot Market
 Spot Rate Quotations

 The Bid-Ask Spread

 Spot FX Trading

 Cross Exchange Rate Quotations

 Triangular Arbitrage

 Spot Foreign Exchange Market Microstructure

 The Forward Market

18
 FOREX Market Participants
 The FOREX market is a two-tiered market:
 Interbank Market (Wholesale)

 About 700 banks worldwide stand ready to make a

market in Foreign exchange.

 Nonbank dealers account for about 20% of the

market.
 There are FX brokers who match buy and sell orders

but do not carry inventory and FX specialists.

 Client Market (Retail)

 Market participants include international banks, their

customers, nonbank dealers, FOREX brokers, and central
banks.

19
 Correspondent Banking Relationships
 Large commercial banks maintain demand deposit accounts
with one another which facilitates the efficient functioning
of the forex market.
 International commercial banks communicate with one
another with:
 SWIFT: The Society for Worldwide Interbank Financial

Telecommunications.
 CHIPS: Clearing House Interbank Payments System

 ECHO Exchange Clearing House Limited, the first global

clearinghouse for settling interbank FOREX transactions.

20
 The Spot Market
 Spot Rate Quotations
 The Bid-Ask Spread
 Spot FX trading
 Cross Rates

21
 Spot Rate Quotations Spot Rate
Quotations
 Direct quotation
 the U.S. dollar equivalent

 e.g. “a Japanese Yen is worth about a penny” =

$.01/yen

 Indirect Quotation
 the price of a U.S. dollar in the foreign currency =

Y100/$
 e.g. “you get 100 yen to the dollar”

22
 Spot Rate Quotations

USD
equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina
(Peso) 0.3309 0.3292 3.0221 3.0377
Australia
(Dollar) 0.5906 0.5934 1.6932 1.6852
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
Britain (Pound) 1.5627 1.566 0.6399 0.6386
1 Month The direct
Forward 1.5596 1.5629 0.6412 0.6398 quote for
3 Months British pound
Forward 1.5535 1.5568 0.6437 0.6423 is:
6 Months
Forward 1.5445 1.5477 0.6475 0.6461 £1 = $1.5627
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month
Forward 0.6681 0.6741 1.4968 1.4835
23
3 Months
 Spot Rate Quotations

USD equiv USD equiv Currency per Currency per

Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
The
Britain (Pound) 1.5627 1.566 0.6399 0.6386 indirect
1 Month Forward 1.5596 1.5629 0.6412 0.6398 quote for
1.5535 1.5568 0.6437 0.6423
3 Months Forward

6 Months Forward 1.5445 1.5477 0.6475 0.6461

British
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 pound is:
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888 £.6399 =
6 Months Forward 0.662 0.6678 1.5106 1.4975 $1
24
 Spot Rate Quotations

USD equiv USD equiv Currency per Currency per

Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Note that the
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
direct quote
Brazil (Real) 0.2939 0.2879 3.4025 3.4734 is the
Britain (Pound) 1.5627 1.566 0.6399 0.6386 reciprocal of
1 Month Forward 1.5596 1.5629 0.6412 0.6398 the indirect
3 Months Forward 1.5535 1.5568 0.6437 0.6423 quote:
6 Months Forward 1.5445 1.5477 0.6475 0.6461
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 1
1.5627 
1 Month Forward 0.6681 0.6741 1.4968 1.4835 .6399
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975

25
 The Bid-Ask Spread
 The Bid price is the price a dealer is willing to pay for a
currency = S(j/kb)
 The Ask price is the amount the dealer offers to sell you
a currency. It’s the price the dealer wants for the sale of
currency = S(j/ka)

 Bid-Ask Spread = [Ask price - Bid price] > 0

26
 Spot FX trading
 In the interbank market, the standard size
trade is about U.S. $10 million.
 A bank trading room is a noisy, active
place.
 The stakes are high.
 The “long term” is about 10 minutes.

27
 Cross Rates: Example
 Suppose that S(€/$) = € 1.0240/$

and S(£/$) = £ .6550/$

 What must the S(£/€) cross rate be?
£ £ €
since  / ,
€ $ $

£ .6550 / $
 S ( £ / €)  £.6396 / € or € 1.5635 / £
€ 1.0240 /$
28
 Triangular Arbitrage
Suppose we
$
observe these Credit
banks posting Barclays
Lyonnais
these exchange S(¥/$)=120
S(£/$)=1.50
rates.

¥ Credit Agricole
First calculate the £
implied cross S(¥/£)=85
rates to see if an
arbitrage exists.
29
 Triangular Arbitrage

The implied S(¥/£) cross $

rate is S(¥/£) = 80 Barclays Credit
Lyonnais
S(¥/$)=120
S(£/$)=1.50
Credit Agricole has
posted a quote of Credit Agricole
S(¥/£)=85 so there is an ¥ £
arbitrage opportunity. S(¥/£)=85
£1.50 $1 £1
So, how can we make money?  
$1 ¥120 ¥80
Buy the £ @ ¥80; sell @ ¥85.
Then trade yen for dollars. 30
 Triangular Arbitrage
As easy as 1 – 2 – 3:
$
Credit
1. Sell our $ for £, Barclays
Lyonnais
2. Sell our £ for ¥, S(¥/$)=120
3 1 S(£/$)=1.50
3. Sell those ¥ for $. 2
¥ Credit Agricole
£
S(¥/£)=85

31
 Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
¥ 12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250

32
 Spot Foreign Exchange Microstructure
 Market Microstructure are the mechanics of how a
marketplace operates.
 Spot mkt Bid-Ask spreads in the:
 increase with FX exchange rate volatility and

decrease with dealer competition.

 Private information is an important determinant of spot
exchange rates. - Mkt adjusts to econ info in 1min.
- 1/3 of traders claim adjustment < 10 sec
- Cbank intervention does not work; it increase
volatility.

33
 The Forward Market
 Forward Rate Quotations
 Long and Short Forward Positions
 Forward Cross Exchange Rates
 Swap Transactions
 Forward Premium

A forward contract is an agreement to buy or sell an asset in

the future at prices agreed upon today.
If you have ever had to order an out-of-stock textbook, then
you have entered into a forward contract.

34
 Forward Rate Quotations
 The forward market for FOREX involves
agreements to buy and sell foreign currencies in
the future at prices agreed upon today.
 Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
 Longer-term swaps are available.

35
 Quotations

USD equiv USD equiv Currency per Currency per Clearly the
Country Friday Thursday USD Friday USD Thursday
market
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
participants
Brazil (Real) 0.2939 0.2879 3.4025 3.4734 expect that the
Britain (Pound) 1.5627 1.566 0.6399 0.6386 pound will be
1 Month Forward 1.5596 1.5629 0.6412 0.6398 worth less in
3 Months Forward 1.5535 1.5568 0.6437 0.6423 dollars in six
6 Months Forward 1.5445 1.5477 0.6475 0.6461 months.
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975

36
 Forward Rate Quotations

 Consider the example from above:

for Japanese yen, the spot rate is
$1.5627 = £1.00
While the 180-day forward rate is
$1.5445 = £1.00
 What’s up with that?

37
Long and Short Forward Positions
 If you have agreed to sell anything (spot or
forward), you are “short”.
 If you have agreed to buy anything (forward
or spot), you are “long”.
 If you have agreed to sell FX forward, you
are short.
 If you have agreed to buy FX forward, you
are long.

38
 Payoff Profiles
profit
(1) If you agree to sell currency in
the future at a set price and the spot
price later falls then you gain.
Short position

S180($/¥)
0
F180($/¥) = .009524 direct quote

(2) If you agree to sell currency in

the future at a set price and the spot
loss price later rises then you lose.
39
 Payoff Profiles
profit Whether the
short position
payoff profile
slopes up or
down depends
upon whether
you use the
0 S180(¥/$)
direct or indirect
F180(¥/$) = 105 quote:
F180(¥/$) = 105 or
-F180(¥/$) F180($/¥) = .
loss 009524.40
 Payoff Profiles
profit
short position

S180(¥/$)
0
F180(¥/$) = 105
When the short entered into this forward contract,
he agreed to sell ¥ in 180 days at F180(¥/$) = 105
-F180(¥/$)
loss
41
 Payoff Profiles
profit
short position

15¥

S180(¥/$)
0
120
F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the short will
-F180(¥/$) make a profit by buying ¥ at S180(¥/$) = 120 and
loss delivering ¥ at F180(¥/$) = 105.
42
 SWAPS/ Forward Premium
A swap is an agreement to provide a counterparty with
something he wants in exchange for something that
you want.Swap transactions account for
approximately 56 percent of interbank FX trading,
whereas outright trades are 11 percent.
Forward Premium is just the interest rate differential
implied by forward premium or discount.

43
 For example, suppose the € is appreciating
from S($/€) = .5235 to F180($/€) = .5307
The forward premium is given by:

F180 ($ / €)  S ($ / €) 360 .5307  .5235

f180,€ v $     .01375
S ($ / €) 180 .5235

44
 Convertibility-Definition
 The ease with which a country's currency can be
converted into gold or another currency.
Convertibility is extremely important for
international commerce. When a currency in
inconvertible, it poses a risk and barrier to trade
with foreigners who have no need for the domestic
currency
 The quality of being exchangeable (especially the
ability to convert a currency into gold or other
currencies without restriction)

45
 Convertibility-Definition
 Government restrictions can often result in a
currency with a low convertibility. For example, a
government with low reserves of hard foreign
currency often restrict currency convertibility
because the government would not be in a position
to intervene in the foreign exchange market (i.e.
revalue, devalue) to support their own currency if
and when necessary

46
 Rupee Convertibility

The Indian Rupee is

1) for all intents and purposes, fully Convertible to
the US$ on the Trade Account and Current
Account. This means Indians can buy US$ for
their Trade, Travel, Fees, Education, Interest,
Dividend payments etc. US Dollars can also be
converted into Rupees
2) largely, NOT convertible to US$ on the Capital
Account, especially when the flow of capital is
from India to outside.

47
 Rupee Convertibility

However, degrees of convertibility have been

brought in. For instance,
- Indian companies can invest in/ set up
subsidiaries abroad. Limits are placed on the
amount of investment
- Indian mutual funds, since last year, have been
allowed to invest in overseas markets, though we
doubt if activity has picked up on this front
- Dividend and Interest payments to investors
abroad are unhindered

48
 Rupee Convertibility
 Flow of Capital from outside India (investments into
India) are unencumbered from the "convertibility"
point of view.
 Investors may need to garner various necessary
permissions as required to invest in the equity market,
debt market or to set up greenfield projects or buy
over existing companies. These are, essentially,
outside the ambit of "convertibility"
 Indian Rupee is not legally pegged to the Dollar. It is
market traded currency, though the trading itself is
controlled by various measures. Technically, the
Indian Rupee is in a "Managed Float" or "Dirty
Float", like the Yen. 49
 Exchange Control
 Introduced during post-WW II period
 More stringent in post-independence era
 FERA 1948, MORE powers in 1973
( Rigid import controls, highest duties, industrial policy
towards import substitution, foreign investment discouraged
etc.– CLOSED ECONOMY)
 1991 BOP crisis – Policy shifts
 August 1994—Current account convertibility
 1999 FEMA

50
 Forex Dealing Room Operations

Objectives of Dealing Room

 Affording the best possible customer service

 Managing the bank’s foreign currency exposures

 Generating profit for the bank

 Ensuring the compliance of relevant regulations

Participants
 Organizations

 Commercial banks

 Central banking authority

 Brokers

51
 Forex Dealing Room Operations

Indian Regulations

 Brokers not allowed to as principals or maintaining

foreign currencies
 Brokers notes to be received promptly and acted upon
on the same day by dealers
 Nominations of deals not done by them not permitted
 Spread of brokers
 Duty separation for dealers

52
 Forex Dealing Room Operations

Dealing Process

Dealing
Customer Bank Branch Room
Front Office

Front Office: Actual dealing Mid-Office

Domestic market
Mid-Office: Risk
management,
accounting and MIS Back Office
Back Office: Settlement,
Reconciliation, compliance
and accounting Global Market

53
 Forex Dealing Room Operations

Regulatory Requirements
Daily Fx turnover and Gaps position and Cash
Balance
Monthly statement in USD denomination
 Aggregate gap limit (AGL) approved

 Maximum AGL on any day

 VaR approved

 Maximum VaR on any day during the month

54
 Forex Dealing Room Operations

 Front Office: Confirmation, stamped agreement, P/L

evaluation monthly report, gold and record
maintenance
 Policy prescriptions
 Strategy formulation
 Concentration limits
 Risk processes
 Task delineation
 Internal accounting/reporting
 Secrecy issues

55
 Forex Dealing Room Operations
Managing Risks
 Open position  Day light, overnight and cut loss
 Maturity  IGL, Monthly Limits, AGL, etc.
mismatch
 Credit risk  Country/group, currency limits
 Operational  Duty segregation, processes, etc
Risk
 Legal Risk  Responsibility fixation, supports,
 Sovereign etc.
Risks  External data, monitoring, etc.

56
 Rate Mechanism
Transaction Buying Selling
Spot TT Base 48.5500 Base
Less Margin@.08% 0.0380 48.7000
Spot TT 48.5120 Add Margin@.15%
0.0731
Spot TT 48.7731
Forward TT Base 48.5500 Base 48.7000
Add Premium 0.1500 Add Premium 0.2000
Less Margin@0.08% 0.0389 Add Margin@.15% 0.0734
Forward 48.6611 Forward 48.9734
Bill Base 48.5500 Base 48.7000
Premium 0.4000 Add Margin@.15% 0.0731
Add Margin@0.2% 0.0975
Less Margin@.15% 0.0734 Bill 48.8706
Bill 48.8766
TC Base 48.7500 TT Selling 48.7641
Less Margin@1% 0.4875 57
THANKS

58