FOREX MARKETS

International Finance Group 3 Roll no- 11, 16, 30, 45, 47, 58

FOREIGN EXCHANGE MARKET

The foreign exchange market is a form of exchange for the global decentralized trading of international currencies.
Financial centres around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.

AGENDA
Types of quotations Types Explain quotation ( Bid, Ask, Spread, Points, PIPS, Cross rate) Accounting conventions Nostro/Vostro accounts and how it works Need for mirror account Settlement conventions t+0, t+1, t+2, forward, short forward Cause for movement of Spot rate Inflation, BOT, Dealer speculation, trending Bull, Bear operations Hot money flow Forward rate movement, inflation movement Interest rate parity IRP theorem PPP theorem Currency rate arrangements, Types of Arbitrages

Quotation
Relative value of a currency unit against the unit of another currency in the foreign exchange market.

Types Of Quotations
Direct
A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other words, it involves quoting in fixed units of foreign currency against variable amounts of the domestic currency. For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1. Conversely, in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.

Indirect
A foreign exchange rate quoted as the foreign currency per unit of the domestic currency. In an indirect quote, the foreign currency is a variable amount and the domestic currency is fixed at one unit.
For example, in the U.S., an indirect quote for the Canadian dollar would be C$1.17 = US$1. Conversely, in Canada an indirect quote for U.S. dollars would be US$0.85 = C$1.

 Bid Rate : Bid price is the highest price that a buyer (i.e., bidder) is willing to pay for a good. It is usually referred to simply as the "bid." Ask - Ask price, also called offer price, offer, asking price, or simply ask, is the price a seller states she or he will accept for a good Spread - The difference between the bid price and the ask price is called the spread.

Please Note: The use of bid and ask is a fundamental part of the market system, as it details the exact amount that you could buy or sell at any point in time. Remember that the current price is not the price for which you can purchase the security, but the price at which the shares last traded hands. If you want to get an idea of the price for which you can buy a security, you need to look at the bid and ask prices because they will often differ from the current price.

Points
It is common to hear changes in bond prices stated in points. For example, if a bond with a face value of $1,000 increases in price by $20, it is said to have risen two points (2%) For futures traded in decimal form, the price of a contract can change in increments of one point. This means that if a futures contract decreased in price by 50 points, it would have dropped $0.50 If a stock is up two points, then it really means that the stock is up $2. Don't confuse points with percentages when talking about stocks. If a $5 stock rises by $2, it has risen two points. Similarly, if a $50 stock rises by $2, it has also risen two points, although the two-point increase is a much greater percentage change for the $5 stock than for the $50 stock

 PIPS The smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100 of one percent, or one basis point. For example, the smallest move the USD/CAD currency pair can make is $0.0001, or one basis point. The smallest move in a currency does not always need to be equal to one basis point, but this is generally the case with most currency pairs. Cross Rate The currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in. This phrase is also sometimes used to refer to currency quotes which do not involve the U.S. dollar, regardless of which country the quote is provided in.

Nostro Account
Nostro our account of our money, held by you Vostro -your account of your money, held by us Customers- Banks

How it Works ?
Bank A India Bank B USA Entity C counter party having Re. A/c with A and USD a/c with B Transaction recording at Bank A

 Transaction recording at Bank B

Mirror Account- contra account which reflects nostro account. Necessary for reconciliation- checking frauds. Entries opposite to Nostro Account overseas.

Settlement Conventions
A trade is said to be Forward Settled if it settles on some date after spot In case of a forward contract settlement a buyer is said to have entered a long forward position a seller is said to have entered a short forward position The standard settlement timeframe for foreign exchange spot transactions is T + 2 days; i.e., two business days from the trade date A Notable exception for the same convention is USD/CAD currency pair which settles at T+1 days

MARKET TRENDS
Trend
The general direction of a market or of the price of an asset. Trends can vary in length from short, to intermediate, to long term. If you can identify a trend, it can be highly profitable, because you will be able to trade with the trend. As a general strategy, it is best to trade with trends, meaning that if the general trend of the market is headed up, you should be very cautious about taking any positions that rely on the trend going in the opposite direction. Trends are what allow traders and investors to capture profits.

Major Market Forces

Governments
Fiscal & Monetary policy

International Transactions
The flow of funds between countries impacts the strength of a country's economy and its currency. The more money that is leaving a country, the weaker the country's economy and currency.

Speculation and Expectation

Understanding the Consumer Confidence Index and Investors Intelligence Sentiment Index

Supply and Demand

Supply and demand for products, currencies and other investments creates a push-pull dynamic in prices.

These areas are all linked as expected future conditions shape current decisions and those current decisions shape current trends. Government affects trends mainly through monetary and fiscal policy. These policies affect international transactions which in turn affect economic strength. Speculation and expectation drive prices based on what future prices might be. Finally, changes in supply and demand create trends as market participants fight for the best price.

Bull Markets and Bear Markets

The "bear" market is synonymous with a market that is going down. o Sellers are more and buyers are less Market falls down A "bull" market means that the market is going up. o Buyers are more, sellers are lessMarket rises

Bull and bear markets are usually measured in years.These describe longterm trends, not short-term changes.

Investment Strategies -- How to Ride the Bull and Tame the Bear
The best strategy to make money in a bull market is to recognize the trend early and make smart buys. Buy low -- sell high. It may seem counterintuitive that you can make money during a bear market.But here are a few ways one can tame the bear: Short sell: A short sell is a trade that consists of borrowing stock you don't own, selling it, waiting for the price to fall, then buying it back at a lower price, thus obtaining a profit. Invest in U.S. Treasury bonds: Bond interest rates tend to rise during bear markets, which makes for an attractive opportunity during a time of uncertainty Buy defensive stocks: This is a low-risk way for investors to keep their money in the stock market. A defensive stock is so named because its value doesn't fluctuate much. Utility stocks (energy, water, etc.) are popular defensive stocks.

Hot Money
Money that flows regularly between financial markets as investors attempt to ensure they get the highest short-term interest rates possible. Hot money will flow from low interest rate yielding countries into higher interest rates countries by investors looking to make the highest return. These financial transfers could affect the exchange rate if the sum is high enough and can therefore impact the balance of payments.

Banks usually attract "hot money" by offering relatively short-term certificates of deposit that have above-average interest rates. As soon as the institution reduces interest rates or another institution offers higher rates, investors with "hot money" withdraw their funds and move them to another institution with higher rates

Forward Foreign Exchange Contract

Definition: An agreement to exchange one currency for another, where
The exchange rate is fixed on the day of the contract, but The actual exchange takes place on a pre-determined date in the future

Characteristics and Features of FX Forwards

Available daily in major currencies in 30-, 90-, and 180-day maturities Forwards are entered into over the counter Deliverable forwards: face amount of currency is exchanged on settlement date Non-deliverable forwards: only the gain or loss is exchanged

Characteristics and Features of FX Forwards

Contract terms specify:
forward exchange rate
term amount value date (the day the forward contract expires) locations for payment and delivery.

The date on which the currency is actually exchanged, the settlement date, is generally two days after the value date of the contract.

Characteristics and Features of FX Forwards

Forward Exchange Rates: The IronClad Law

Forward exchange rates are different from spot rates, but they are not a prediction of what the spot rate will be when the deal settles!

The difference between the forward exchange rate and the spot exchange rate is the interest differential between the two currencies

Uses of FX Forwards
(1)Hedge foreign currency risk (2) Arbitrage FX rate discrepancies within and between markets (3) Speculate on future market movements (4) Profit by acting as market maker Financial institutions, money managers, corporations, and traders use these instruments for managing currency risk

Two Types of Hedging

Corporations engaged in international trade
Hedge payments and receipts denominated in foreign currencies.

For example, a Croatian corporation that exports to Germany and expects payment in Euro (EUR) could sell EUR forward to eliminate the risk of a depreciation of the EUR at the time that the payment arrives.

Hedge the translation of foreign earnings for presentation in financial statements.

Effect of Inflation on Currency Exchange Rates

Prices increases in other countries thus the cost of our imports Salary earners demand increase in line with increased cost of living Prices increases again to an extent of salary demand are satisfied and labor cost Our prices have increased, exports have become more expensive, we sell less abroad and payment deficit gets even worse

Inflation effects
Currency is devaluated to stay competitive Our export become cheaper But we have to pay more for imports Increase cost of import increase our prices Devaluation reduces the standard of living as our produce is cheaper and others produce is expensive Need greater volume of exports to improve our position and benefit from devaluation

Interest Rate Parity

An understanding of forward rates is fundamental to interest rate parity, especially as it pertains to arbitrage Forward rate = Spot Rate x (1 + Interest rate of overseas country) / (1+ Interest rate of the domestic country) Example: Spot rate : 1 USD = 1.0650 CAD 1 USD = 1.065 x ( 1 + 3.64 %)/(1+ 3.15 %)= 1.0700 CAD

Covered Interest Rate Parity

According to covered interest rate parity, forward exchange rates should incorporate the difference in interest rates between two countries; otherwise, an arbitrage opportunity would exists Borrow an amount in a currency with a lower interest rate

Convert the borrowed amount into a currency with a higher interest rate Invest the proceeds in an interest-bearing instrument in this (higher interest rate) currency Simultaneously hedge exchange risk by buying a forward contract to convert the investment proceeds into the first (lower interest rate) currency.

Covered Interest Rate Arbitrage

Borrows 100,000 of Currency A at 3% for a one-year period. Immediately converts the borrowed proceeds to Currency B at the spot rate. Places the entire amount in a one-year deposit at 5%. Simultaneously enters into a one-year forward contract for the purchase of 103,000 Currency A.

Uncovered Interest Rate Parity

Uncovered interest rate parity (UIP) states that the difference in interest rates between two countries equals the expected change in exchange rates between those two countries if the interest rate differential between two countries is 3%, then the currency of the nation with the higher interest rate would be expected to depreciate 3% against the other currency In reality, however, it is a different story. Since the introduction of floating exchange rates in the early 1970s, currencies of countries with high interest rates have tended to appreciate, rather than depreciate, as the UIP equation states

Purchasing Power Parity

An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power. Relative version of PPP is calculated as: S = P1/P2 S = Exchange rate of currency 1 to 2 P1 = Cost of good X in currency 1 P2 = Cost of good X in currency 2

Currency rate arrangements

The exchange or currency rate arrangements are done on the basis of the degree of flexibility and the existence of formal or informal commitments to exchange rate paths.

Types of currency rate arrangements

Currency board arrangements:
exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfilment of its legal obligation

Other Conventional Fixed Peg Arrangements:

The country pegs its currency at a fixed rate to another currency or a basket of currencies The basket is formed from the currencies of major trading or financial partners and the weights reflect the geographical distribution of trade, services, or capital flows.

 Crawling Pegs:
The currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials vis--vis major trading partners, etc The rate of crawl can be set to generate inflationadjusted changes in the exchange rate (backward looking), or set at a preannounced fixed rate and/or below the projected inflation differentials (forward looking).

Independently Floating:
The exchange rate is market-determined, with any official foreign exchange market intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.

Arbitrage With the help of arbitrage strategies, an arbitrageur (an individual who is involved in arbitrage transactions) can avail the benefit of price differences existing in various markets. An arbitrage is commonly referred to as a riskfree gain or risk-free profit.

Types of Arbitrages
Regulatory arbitrage:
In this type of arbitrage, a regulated organization avails the benefit of the deviation between the regulatory positioning and the economic or real risk.

Covered interest arbitrage:

In this kind of arbitrage, a financial instrument or security is bought by an investor in the denomination of a foreign exchange or foreign currency, and the foreign exchange risk is hedged through the sale of a forward contract in the sales proceeds of the financial instrument again in the home currency.

Uncovered interest arbitrage:

In case of uncovered interest arbitrage, funds or monies are sent to another country for availing the benefit of increased interest rates in forex agencies.