foreign exchange markets

Foreign Exchange___ SN edited 3 The major players are____  Individuals: tourists, migrants  Firms: importers and exporters  Banks: short position, long position, square position  Go

An Overview

Foreign exchange

Foreign exchange market

 Largest and most liquid market in the world total world turnover in a single day in 2006 was USD 1400 billion (approx).

 No central market - key markets in several cities around the world

 Participating banks and brokers are in constant contact via phone and computer

 Three general types of transaction

 Between banks and their customers

 Domestic interbank market conducted through brokers

 Trading with overseas banks

Foreign Exchange _ SN (edited) 3

 The major players are

 Individuals: tourists, migrants

 Firms: importers and exporters

 Banks: short position, long position, square position

 Governments/ monetary authorities: market intervention

 International agencies: lending

 Two tier market: First tier: ultimate customer and banker

 Second tier: between banks

 Classifications of participants

 Non-banking entities: business transactions and hedging

 Banks: foreign exchange dealers

 Arbitrageurs: profit seeking from variations in rates in

different markets

 Speculators: profit seeking from movements in exchange rates

Foreign exchange

Types of FX transactions

 Spot transactions - executed nearly immediately

 Forward transactions - agreement to buy or sell a currency

at a date in the future, at a rate agreed in advance

 Currency swaps - agreement to trade one currency for

another now, and to trade currencies back again later, both

at prices agreed at the beginning

Foreign Exchange _ SN (edited) 5

Foreign exchange quotations

 Exchange rate is the price of one currency in terms of another

 One country’s currency has depreciated when more of it is

needed to buy a unit of a foreign currency (is worth less relative

to the other currency) [ direct quote like $ 1 = Rs 39.75]

 A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency)

 Two –way quote: $ 1 = INR 39.72 / 77

 With a spread of 05

Foreign exchange

Foreign exchange quotations

 Cross exchange rate between two currencies is

calculated from their exchange rates with a third, benchmark currency - frequently the US dollar

 Since USD is the anchor currency, any INR / CAD

rate will be given by dealer in India with the help of cross rates _ through INR / USD and CAD / USD rates

Foreign Exchange _ SN (edited) 7

Forward markets, futures & options

 Forward contracts obligate buyer to buy or sell a certain amount

of foreign currency at a future date_ margin money deposited with the seller bank

 Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount

of currency and the date are set by the agreement

Foreign Exchange _ SN (edited) 9

Forward markets, futures & options

 Futures, traded on special exchanges, are contracts

to trade given amounts of currencies at a specified date

 Only a small number of major currencies can

be so traded, and only in fixed lots with fixed trade dates

Foreign exchange markets

Forward markets, futures & options

 Options provide the holder with the right (but not the obligation)

to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option

 Options to buy are called call options, and those to sell are called put options

 Options are frequently used to reduce risk from exchange rate changes

 Other concepts Option : In-the-money: Out-of-the money:

At –the- money

 Asset price, strike price

Foreign Exchange _ SN (edited) 11

Exchange rate determination

Theory #1: Purchasing power parity [ Cassel, 1927]

Foreign Exchange _ SN (edited) 13

 A commodity will have the same price in terms of common currency in every country

 In the absence of frictions (e.g shipping costs, tariffs, )

Absolute PPP

 Extension of law of one price to a basket of goods

 Absolute PPP examines price levels

 Apply the law of one price to a basket of goods with

price P € and P US (use upper-case P for the price of the basket):

where P€ = i (wFR,i  p€,i )

PUS = i (wUS,i  pUS,i )

S€/$ = P€ / PUS

Foreign Exchange _ SN (edited) 15

Relative PPP

 Main idea – The difference between (expected) inflation

rates equals the (expected) rate of change in exchange

rates:

1 + i€ = E( s€/$)

1 + i$ s€/$

Foreign Exchange _ SN (edited) 17

START (today) END (in one

(Invest in $)

(Invest in €)

Summary of theories #1 and #2:

Foreign Exchange _ SN (edited) 19

most productive uses

(1 + rNominal) = (1 + rReal)(1 + i ) (1 + rReal) = (1 + rNominal) / (1 + i )

Theory #4: Expectations theory of forward rates

Foreign Exchange _ SN (edited) 21

 1 i = R + п [ nominal interest = real interest + inflation rate]

Summary of all four theories

.

Difference in interest rates

1 + r€

1 + r$

Exp difference in inflation rates

1 + i€

1 + i$

Difference between forward & spot rates

Relative PPP

Interest

Rate parity

Exp Theory

Foreign Exchange _ SN (edited) 23

Impact of an appreciating Indian Rupee

 Pros

 Lower prices on foreign goods

 Keeps inflation down

 Foreign travel is cheaper

 Less expensive to invest abroad

 Cons

become more expensive abroad

firms face price competition

for foreign tourists

investment

 Foreign tourism is encouraged

 Indian capital markets more attractive

 Cons

 Higher prices on imports

 Upward pressure on inflation

 Travel abroad more expensive

 Harder for Indian firms

to expand into foreign markets

Foreign Exchange _ SN (edited) 25

Arbitrage and hedging

 Exchange arbitrage involves taking advantage of exchange rate

differences in different markets to make a profit

 Helps equalize exchange rates globally

 Three point Arbitrage Pound, Dollar and Euro example

 Three point arbitrage _ let GBP 1 = $ 1.50,

GBP 1 = franc 4, and franc 1 = $ 0.50

 arbitrage facility can make a profit by buy and sell of currency through 3-point arbitrage

 Interest arbitrage involves taking advantage of differences in

international interest rates to get a higher return

 Subject to exchange rate risk

Foreign exchange markets

Arbitrage and hedging

minimize exchange rate risk in international transactions

the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings

Foreign Exchange _ SN (edited) 27

Speculation

 Speculation differs from arbitrage, in that it involves the

purchase or sale of a currency in the expectation that its value will change in the future basically a position is created in the expectation of positive gain

 Speculation can either reduce or increase volatility in foreign exchange

What about Indian rupee ?

 How rupee’s exchange rate is determined ?

 Present scenario _ INR has appreciated about 12 % in the last one year…

Foreign Exchange _ SN (edited) 29