Unit - 3

The Foreign Exchange

Market

Lekhanath sir
An overview
3.1 Introduction
3.2 Objectives
3.3 History of Foreign Exchange
3.4 Fixed and Floating Rates
3.5 Foreign Exchange Transactions
3.6 Foreign Exchange Quotations
3.7 Interpreting Foreign Exchange Quotation
3.8 Forward, Futures and Options Market
Introduction
Discussed about
the concepts and principles of balance of
payments and its various components
the Current Account, Deficit and Surplus
Capital account convertibility were also discussed.
Now focus on
the origin of the concept of foreign exchange and
the difference between fixed and floating rates.
study foreign exchange transactions and the types
of foreign exchange transactions.
the derivatives instruments traded in foreign
exchange market such as forwards, futures, swaps,
and options.
History of Foreign exchange market

The 17th century saw the start of the depositing of coins and
bullion with money changers, goldsmiths, etc.
The first people to start the system of money by book entry were
the goldsmiths in England.
The expansion of banking services and the people started gaining
the confidence that they can receive certain commodities against
the bank note they possessed.
The history of foreign exchange can be traced back to the time
when the moneychangers in the Middle East would exchange
money from all over the world.
History of Foreign exchange market
contd
Under the gold standard exchange rates, currency
was backed by gold and was measured in ounces.
For this, the countries needed huge reserves of gold
in order to back the demand for currency.
The foreign exchange rate was determined by the
difference of the price of gold between these two
countries.
The foreign exchange history changed due to the
birth of an international standard through which
foreign exchange can take place conveniently
between different countries.
During the First World War, financial issues arose in
Europe which gave way to a lack of gold and this led
to a historical change in foreign exchange.
History of Foreign exchange market
The new Bretton Woods monetary system led to a
contd
changed forex market which put forward the following
solutions:
A new method was to be established in order to obtain a
fixed foreign exchange rate
The US Dollar is to replace the gold standard as the new final
exchange currency
The US dollar will be the only currency which will be backed
by gold
Three international authorities will be founded who would
guard over all the foreign transactions.
However, the Bretton Woods monetary system also
failed after a period of 25 years and on 15 August
1971, the US announced the end of the exchange of
gold for US dollar.
Fixed exchange
The currency rate
system in system
which the regulator tries to
keep exchange rate constant between domestic
currency and foreign currencies.
In this system, the government of a country
determines the value of its currency against a fixed
amount of another currency.
The gold standard is the oldest fixed exchange rate
regime.
The gold standard functioned till the beginning of the
World War I and even few years after that.
According to the gold standard, the currency in
circulation is convertible into gold at a fixed rate.
Therefore, the exchange rate between any two
currencies is determined by the value of the
currencies in terms of gold.
Advantages of Fixed exchange rate
system
1. The system provides exchange rates stability by
eliminating uncertainty.
2. Volatility of exchange rate is controlled as it
insulates the economy from external disturbances.
3. Foreign investors are encouraged to invest in
countries without the fear of exchange rate
fluctuations.
4. Poorer nations could get foreign exchange for
development purposes at low costs.
Disadvantages of Fixed exchange rate
system
1. The system required regular rigorous control and
monitoring by the monetary authorities.
2. The system is not self equilibrating therefore over-
valuation and undervaluation existed.
3. Since the realignment was to be done only when all other
avenues to correct the balance of payment were
exhausted, therefore the burden accumulated and the
economies which resorted to devaluation faced a lot of
economic problems.
4. The system required regular rigorous control and
monitoring by the monetary authorities.
Floating exchange rate system
Broadly classified into two types: clean float and dirty float.
In the clean float exchange rate system, the exchange rate is
determined by the forces of demand and supply without any
intervention from the central authorities.
But when the central banks intervene to either raise or lower the
exchange rate in the floating exchange rate system, it is referred to
as dirty float or managed float.
In the dirty float, there are two main reasons why the central banks
and other authorities intervene in the exchange rate system.
The reasons are as follows:
To stabilize fluctuations in the exchange rate
To reverse the growth of trade deficit
Other exchange rate system
The crawling peg system allows for modifications within
the narrow band of +1 or -1 per cent, and thus,
replaces the abrupt parity changes of the adjustable
peg system. In simple words, the crawling peg is the
system in which a currency exchange rate is changed
frequently, may be many times a year, mainly to
make adjustments for rapid inflation.
The wider bands system is more flexible as it has wider
bands of variation around the central parity. The
parity can either be shifted as in the case of the
crawling peg and then the wider bands are referred to
as gliding bands or there may be discrete jumps as in
the adjustable peg.
Other exchange rate system
The multiple exchange rate system allows for applying
different exchange rates to different transactions. For
example, in 1992, India had two exchange ratesthe
'official' exchange rate applicable to certain imports
and a 'market determined' exchange rate for other
transactions.
Foreign exchange transactions
Spot and forward transactions.
Spot rates and forward rates.
The spot rate is the rate paid for delivery within two
business days after the day the transaction takes
place.
The rate is quoted for delivery of foreign currency at
some future date is the forward rate.
In the forward rate, the exchange rate is established
at the time of the contract, though payment and
delivery are not required until maturity.
Forward rates are usually quoted for fixed periods of
30, 60, 90 or 180 days from the day of the contract.
The Spot Market
The rate is quoted in terms of the number of units of
the foreign currency for one unit of the domestic
currency. This is called an indirect quote.
India quotes its exchange rates in terms of the
amount of rupees that can be exchanged for one unit
of foreign currency. For example, if the Indian rupee
is the home currency and the foreign currency is the
French franc (FF) then the exchange rate between
the rupee and the French franc might be stated as FF
0.1462/Rs. 1 reads 0.1462 French franc per rupee.
This means that for one Indian rupee one can buy
0.1462 French franc.
The alternative method, called the American terms,
expresses the home currency price of one unit of the
foreign currency. It is direct quote.
The Direct and Indirect
quote
Currency Direct quote Indirect quote

Pound sterling 68.41 0.0146

US dollar 44.57 0.0224

Canadian dollar 44.47 0.0225

Euro 58.94 0.0170

Swiss franc 41.37 0.0242

Swedish krona 6.16 0.1623

Japanese yen 0.48 2.0833

Australian dollar 27.76 0.0243

Exchange Rates Quotations
Two methods of quotation for exchange rates
between the dollar and the currency of another
country.
The two methods are referred to as the direct
(American) and indirect (European).
The exchange rate between any two non-dollar
currencies is referred to as a cross rate.
Direct/American Quotation
The dollar price of one unit of foreign
currency.
For example, a direct quotation of the exchange
rate between dollar and the British pound
(German mark) is $1.6000/1 ($0.6000/DM1),
indicating that the dollar cost of one British pound
(German mark) is $1.6000 ($0.6000).

Frequently used by banks in dealing with their

non-bank customers.
The prices of currency futures contracts
traded on the Chicago Mercantile exchange
Indirect/European Quotation
The number of units of a foreign currency that are
required to purchase one dollar.
For example, an indirect quotation of the exchange
rate between the dollar and the Japanese yen (German
mark) is 125.00/$1 (DM 1.6667/$1), indicating that
one dollar can be purchased for either 125.00
Japanese Yen or 1.6667 German Marks.
Cross Rate
The exchange rate between any two non-dollar currencies
is referred to as a cross rate.
A relatively large number of cross rates would be
required to trade every currency directly against every
other currency.
Calculated using chain rule.
For example, N currencies would require N x (N-1)/2 separate
cross rates. For this reason, most exchange rates are quoted in
terms of dollars and by far the greatest volume of trading directly
involves the dollar. This reduces the number of cross-currency
quotes that dealers must keep track of and reduces the potential
losses associated with mispricing currencies relative to one
another (which permit Triangular Arbitrage).
Arbitrage
Arbitrage is the practice of taking advantage
of a price differential between two or more
markets: striking a combination of matching
deals that capitalize upon the imbalance, the
profit being the difference between the
market prices.
When used by academics, an arbitrage is a
transaction that involves no negative cash
flow at any probabilistic or temporal state and
a positive cash flow in at least one state; in
simple terms, a risk-free profit.
 Two-pointquote
Inverse arbitrageand
is thetwo-point
condition when
there is a chance to buy a currency from one
arbitrage
market and sell that currency in another
market where the price of the currency is
higher.
For example, Bank A in France has quoted
USD/EUR: 1.9345/ 1.9350 and Bank B in
America has also quoted for the same
currency pair as EUR/USD: 0.5345/0.5360
which is the inverse or reciprocal quote of
Bank A.
This means ask rate of Bank A, which is
EUR/USD, is the reciprocal of the bid rate of
Bank B, that is, USD/EUR.
This means reciprocal of the ask rate of Bank
Inverse quote and two-point
arbitrage
We can also say that the EUR/USD bid rate of
Bank B implies 1/(USD/EUR) ask rate of Bank
A and EUR/USD ask rate of Bank A implies 1/
(USD/EUR) bid rate of Bank B.
In this way an inverse quotation is used in a
two-point arbitrage situation.
The bid rate in the quotation of Bank B should
be overlapped with the ask rate in the
quotation of Bank A to avoid two-point
arbitrage situation.
Triangular arbitrage
Triangular arbitrage is that market situation in
which a bank provides some exchange rates
that are not directly inverse of the exchange
rate of another bank but provides an indirect
way to make a profit without any risk to the
trader.
 Some transactions may be entered into on one day
Forward Market
but not completed until sometime in the future. For
example, a French exporter of perfume might sell
perfume to a US importer with immediate delivery
but not require payment for 30 days.
The US importer has an obligation to pay the
required francs in 30 days, so he or she may enter
into a contract with a trader to deliver dollars for
francs in 30 days at a forward rate the rate today for
future delivery.
the forward rate is the rate quoted by foreign
exchange traders for the purchase or sale of foreign
exchange in the future.
There is a difference between the spot rate and the
forward rate known as the spread in the forward
market.
In order to understand how spot and forward rates
Future Market
The foreign exchange market involving forward
contracts has a long history but the market for
currency futures has a comparatively recent origin.
It came into being in 1972 when the Chicago
Mercentile Exchange has set up its international
monetary market division for trading of currency
futures.
Currency futures are traded only in a limited number
of currencies.
A forward contract is finalized on telephone, etc.
meaning that it represents an over-the-counter
market.
But in case of currency futures, brokers strike the
deals sitting face to face under a trading roof, known
as pits.
The brokers can trade for themselves as well as on
behalf of the customers.
Future Market
On the other hand, when the brokers trade on behalf
of their customers, they are known as commission
brokers or floor brokers.
When a trader has to enter a currency futures
contract, he informs his agent who in turn informs
the commission broker at the stock exchange.
The commission broker executes the deal in the pit
for a commission/fee.
After the deal is executed, the commission broker
confirms the trade with the agent of the trader.
There are different costs associated with the
transactions in the
Option Market
The market for currency options is the other form
of the derivatives market representing large-scale
sale and purchase of currencies.
This form of market possesses some
distinguishing features and also the methods of
operation are different.
There are three different types of option market.
They are listed currency options market, currency
futures options market and over-the-counter
options market.
Listed
Listedcurrency optionsare
currency options market
standardized contracts. In such
contracts, the clearinghouse is
essentially a party to the contract.
For the option- buyer, the clearinghouse
is a seller of options and for the seller of
the options, it is a buyer.
It guarantees both sides of the contract
and charges a small fee for facilitating
such contracts.
Currency futures
In this market, options
which market
is basically a listed
currency options market, the contracts
present a mixture of currency futures
and currency options.
The buyer and the seller of options
have, however, to deposit margin
money with the exchange that is equal
to a small function of the contract price.
The options are marked to market
meaning that they undergo daily
settlement as in the case of a futures
contract.
Over-the-counter
The second type ofoptions
market market
for currency
options is known as inet-bank currency
options market or the over-the-counter
options market.
Such a market is centered in New York
or London and the size of transactions is
many times that of the market in the
organized exchanges.
Thank You