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Fundamentals of foreign exchange market

Fundamentals of Foreign Exchange Market

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Fundamentals of foreign exchange market

  1. 1. The foreign exchange market Mohammad Maksudul Huq Chowdhury Manager Export Import Bank of Bangladesh Limited, Islampur Branch
  2. 2. The Foreign Exchange Market Foreign exchange means the money of a foreign country; that is, foreign currency, bank balances, banknotes, checks and drafts. A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate. The foreign exchange market spans the globe, with currencies trading somewhere every hour of every business day.  
  3. 3. The Foreign Exchange Market provides:  the physical and institutional structure through which the money of one country is exchanged for that of another country;  the determination of rate of exchange between currencies, and  is where foreign exchange transactions are physically completed.
  4. 4. Characteristics of FX Market  The FX market is an over-the-counter market.  There is no physical location where traders get together to exchange currencies. Rather traders are located in the offices of major commercial banks around the world and communicate using computer terminals, telephones, telexes, and other information channels.
  5. 5. Characteristics of FX Market  The FX market is almost a 24 hour market.  Inter-bank traders are major players in FX market.  90% of trading takes place with respect to the US dollars.  The reasons for quoting most exchange rates against a common currency (a “vehicle currency”)
  6. 6. Functions of the Foreign Exchange Market The foreign exchange Market is the mechanism by which participants:  transfer purchasing power between countries;  obtain or provide credit for international trade transactions, and  minimize exposure to the risks of exchange rate changes.  the facilities for hedging and speculation
  7. 7. Market structure The foreign exchange market consists of two tiers:  the inter-bank or wholesale market (multiples of $1 trillion US or equivalent in transaction size), and  the client or retail market (specific, smaller amounts).
  8. 8. Types of Transactions Three types of transactions:  Spot  Forward  Swap
  9. 9.  An agreement on price today, with settlement usually two business days later. The most common type of foreign exchange transaction involves the payment and receipt of the foreign exchange within two business days after the day the transaction is agreed upon. The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad.
  10. 10. Spot transaction Settlement = actual delivery of currency for currency In the case of the US dollar for the Canadian dollar (or the Mexican peso), settlement is on the next day of the transaction.
  11. 11. Forward  An agreement on price today for settlement at some date (called the “value date”) in the future (one or two weeks, or 1 ~ 12 months).  A forward transaction involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today.  Forward contracts can be renegotiated for one or more periods when they become due.
  12. 12. Example Exxon has a scheduled payment of £25 million in 8 months and buys that amount of British pounds forward today. No money will change hands now. FD (forward discount) - If the forward rate is below the present spot rate, the foreign currency is said to be at a forward discount with respect to the domestic currency. FP (forward premium) - If the forward rate is above the present spot rate, the foreign currency is said to be at a forward premium with respect to the domestic currency.
  13. 13. SWAP  A sale (purchase) of a foreign currency with a simultaneous agreement to repurchase (resell) it at some date in the future.  Usually in the inter-bank market. Refer to a spot sale of a currency combined with a forward repurchase of the same currency-as part of a single transaction.
  14. 14.  Swap rate: is the difference between the spot and forward rates in the currency swap. (a yearly basis). Example  Citibank buys DM 2.5 million from Deutsch Bank for $1 million, with a simultaneous agreement to sell the DM back in 6 months for $1.05 million. $50,000 = swap rate.
  15. 15. Foreign exchange futures and options  Foreign exchange futures: is a forward contract for standardized currency amounts and selected calendar dates traded on an organized market (exchange).  Foreign exchange option: Is a contract giving the purchaser the right, but not the obligation, to buy (a call option) or to sell (a put option) a standard amount of a traded currency on a stated date (the European option) or at any time before a stated date (the American option) and at a stated price (the strike or exercise price).
  16. 16. Market Participants Four broad categories of participants:  Bank and non-bank foreign exchange dealers,  Individuals and firms,  Speculators and arbitragers, and  Central banks and treasuries.  Foreign Exchange Brokers
  17. 17. Bank and Non-bank Foreign Exchange Dealers  Banks and a few non-bank foreign exchange dealers operate in both the inter-bank and client markets.  The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.  Dealers in large international banks often function as “market makers.”  These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.
  18. 18. Individuals and Firms  Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.  Their use of the foreign exchange market is necessary for their underlying commercial or investment purpose.  Some of the participants use the market to “hedge” foreign exchange risk.
  19. 19. Speculators and Arbitragers  Speculators and arbitragers seek to profit from trading in the market itself.  They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.  While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.
  20. 20. Central Banks and Treasuries  Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.  The motive is not to earn a profit  Central banks and treasuries differ in motive from all other market participants.
  21. 21. Foreign Exchange Brokers  Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction.  For this service, they charge a commission.  It is a brokers business to know at any moment exactly which dealers want to buy or sell any currency.  Dealers use brokers for their speed, and because they want to remain anonymous since the identity of the participants may influence short term quotes.
  22. 22. Market-makers  Traders in the major money center banks around the world who deal in two-way prices. They announce bid and offer prices at which they will exchange two currencies.  The difference between the two prices is referred to as the bid/asked spread, which is traders’ profits.  Bid (ask or offer) price = a price at which a trader is willing to buy (sell).
  23. 23. Transactions in the Inter-bank Market  A spot transaction in the inter-bank market is the purchase of foreign exchange, with delivery and payment between banks to take place on the second following business day.  The date of settlement is referred to as the value date.  An outright forward transaction (or a forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.
  24. 24. Transactions in the Inter-bank Market  The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.  Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.  A swap transaction in the inter-bank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates (settlement date).
  25. 25. Transactions in the Inter-bank Market  Both purchase and sale are conducted with the same counterparty.  Some different types of swaps are: o spot against forward, o forward-forward, o non-deliverable forwards (NDF).
  26. 26. Foreign Exchange Rates and Quotations  A foreign exchange rate is the price of one currency expressed in terms of another currency.  A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.  Most foreign exchange transactions involve the US dollar.
  27. 27.  Professional dealers and brokers may state foreign exchange quotations in one of two ways: o the foreign currency price of one dollar, or o the dollar price of a unit of foreign currency.  Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar.
  28. 28.  Foreign exchange quotes: o direct or o indirect quote    A direct quote is a home currency price of a unit of foreign currency  An indirect quote is a foreign currency price of a unit of home currency.  The form of the quote depends on what the speaker regard as “home.”  For example, the exchange rate between US dollars and the Swiss franc is normally stated: o SF 1.6000/$ (European terms or direct quote)
  29. 29.  However, this rate can also be stated as: o $0.6250/SF (American terms or indirect quote)  most inter-bank quotations around the world are stated in European terms.  Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate.  This method of quotation makes it easier to compare premiums or discounts in the forward market
  30. 30.  If a currency increases in value in the future, it is traded at a premium, if decreases, it is at a discount against the other currency.  Some currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate).  Cross rates can be used to check on opportunities for inter-market arbitrage.  one bank’s (Dresdner) quotation on €/£ is not the same as calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank).
  31. 31. Understanding Exchange Rates  Dollar/Swiss Francs -- USD/CHF  Note the order of the currencies  “USD” comes before the “CHF”  The first currency($) - Base currency  Second currency (CHF) - Terms currency  It is important to remember that Bid & Offer in trading always refers to the BASE CURRENCY.
  32. 32. Forward Rates  Rate agreed for settlement on an agreed date in the future  All rates are derived from Spot rates  Forward rate is the spot rate adjusted for the premium / discount  Forward Rate = Spot Rate + / - premium or discount
  33. 33. Premium/Discount  Forward price = Spot price plus or minus forward margin.  Premium –forward value of currency is higher than spot rate. A currency with lower rate of interest is said to be at premium in the forwards. Forward margins added to spot rate.  Discount – forward value of currency is lower than spot rate. A currency with higher rate of interest is said to be at discount. Forward margins deducted from spot rate.
  34. 34. Factors Determining Exchange Rates a. Fundamental Reasons:  Balance of Payment – surplus leads to stronger currency.  Economic Growth Rates –High/Low growth rate.  Fiscal / Monetary Policy- deficit financing leads to depreciation of currency.  Interest Rates –currency with higher interest will appreciate in the short term.  Political Issues –Political stability leads to stable rates
  35. 35. Factors Determining Exchange Rates b. Technical Reasons:  Government Control can lead to unrealistic value.  Free flow of Capital from lower interest rate to higher interest rates. c. Speculation – higher the speculation higher the volatility in rates
  36. 36. EXCHANGE RATE SYSTEMS 1. Freely floating or flexible exchange rate:  Market forces of supply and demand determine rates.    Forces influenced by a. price levels b. interest rates c. economic growth  Rates fluctuate over time randomly.
  37. 37. Advantages  No problems with international liquidity  Automatic correction in the balance of payment  Insulated from external events
  38. 38. Disadvantages  Uncertainty  Speculation can be destabilizing specially in the short run  Today’s crises questioning the power of the market
  39. 39. 2. Managed Float (Dirty Float)  Market forces set rates unless excess volatility occurs.  The government intervenes to influence the exchange rate
  40. 40. 3. Target-Zone Arrangement  Central bank intervenes to set the exchange rate at the preannounced price, by selling or buying foreign exchange currency in return for the national currency  Market forces constrained to upper and lower range of rates  Members to the arrangement adjust their national economic policies to maintain target.
  41. 41. Forecasting Exchange Rates Market participants who use foreign exchange derivatives tend to take positions based on their expectations of future exchange rates to hedge their future cash flows denominated in foreign currencies, especially when they expect that they will be adversely affected by that exposure. Thus, the initial task is to develop a forecast of specific exchange rates. There are various techniques for forecasting future exchange rates, but no specific technique stands out because most have had limited success. Usual forecasting techniques are of the following types:
  42. 42. 1. Technical forecasting - involves the use of historical exchange rate data to predict future values. There are also several time-series models that examine moving average and thus allow a forecaster to identify patterns. 2. Fundamental forecasting – is based on fundamental relationships between economic variables and exchange rates. For example, high inflation in a given country can lead to depreciation in its currency.
  43. 43. 3. Market-based forecasting – process of developing forecasts from market indicators, is usually based on either spot rate or the forward rate. 4. Mixed forecasting – as no single forecasting techniques has been found to be consistently superior to the others, some participants of FX market use a combination of forecasting techniques. Various forecasts for a particular currency value are developed using several forecasting techniques. Each of the techniques used is assigned a weight, and the techniques believed to be more reliable are assigned higher weights.
  44. 44. Method of payment in International Trade: Parties to the international transaction normally negotiate a method of payment based on the exporter’s assessment of the importer’s creditworthiness and the norms of their industry. In International trade there are four methods of payment. These are:   a. Cash in Advance b. Open account c. Collection & d. Documentary Credit.   The first three are the traditional trade payment methods. The ordering of the payment and delivery of goods depends upon the situation and convenience of the buyer and seller.
  45. 45. Cash in Advance Under this system the buyer puts funds at the disposal of the seller prior to shipment of goods or provision of services. In other words, exporter receives the value of goods/services before shipment through Cheque, Draft or TT or any other mode. This is an advantageous system for the exporter as he can use the fund immediately. But the risk lies to the importer as he cannot receive goods in quantity & quality in time as per contract/agreement. In this system the Credit report of the exporter should be obtained and carefully to be examined before making payment.
  46. 46. Open account An open account method is an arrangement between buyer (importer) and seller (exporter) whereby the goods delivered before payment is made. Open account thus obviously more advantageous for the importer as he will pay the price of the goods after satisfying the delivery date, quantity & quality. In this system the risk is very much high for the exporter. Thus he will collect credit worthiness of the buyer before agreeing open account business term.
  47. 47. Collection Collection is a method under which goods are shipped and the Bill of Exchange (Draft) is drawn by the seller on the buyer. The documents are sent to the bank with clear instruction for collection through one of its’ correspondent bank located in the buyers country. The documents are to be delivered only after the payment has been made or Draft is accepted.
  48. 48. Documentary Credit Documentary Credit is the classic form of international trade payment. This method substantially reduce payment related risk for both exporter and importer. Documentary Credit is a conditional bank undertaking of payment on behalf of the buyer /applicant /importer to the seller /beneficiary/exporter against complying presentation of documents.  
  49. 49. Balance of Trade Balance of Trade refers to the net difference value of Export and Import of commodities from/into a country. The movement of goods or commodities between countries is known as the visible trade. Therefore balance of trade refers to the net balance of the visible trade of a country. When the value of the export goods exceed value of import goods for a given period of time, there is net gain of foreign exchange to the country and the balance of trade is said to be favourable or surplus or positive. If the value of import goods exceeds the value of export goods within a period then it is called negative or deficit or unfavourable.
  50. 50. Balance of Payment Balance of Payment is a statement that contain details of all the international economic transactions both visible and invisible items of a country within a given period of time, usually a year. Here visible items includes export import of commodities/goods and invisible items are shipping, banking, insurance, tourist, gift, interest on investment, technical know how, consultancy etc. The balance arrived at taking into account both the visible and invisible items in foreign trade is known as Balance of payment. Balance of payment includes Balance of trade and other invisible items of foreign trade. As in the case of Balance of trade, the total amounts payable and receivable do not balance and the balance of payments for a given period ends up in favourable/surplus/positive or unfavourable/deficit/negative.

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Fundamentals of Foreign Exchange Market

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