FOREIGN EXCHANGE MARKET• International transaction in cash requires two distinct purchases – Purchase of foreign currency – Purchase of good/service with the FC • Term foreign exchange is used to denote foreign currency • Foreign exchange market exists to cater to the demand for foreign currency/currencies. It involves transfers through Nostro/Vostro accounts between international banks. • Location 1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications Contd… • Organizational setting within which individuals, governments and banks buy and sell foreign currencies • Only a small fraction of daily transactions in foreign exchange involve trading of currency • Most foreign exchange transactions involve transfer of bank deposits. • The foreign exchange market is round-theclock market due to different time zones • Major participants- central banks, commercial banks, forex brokers, corporations, individuals 3. Hedging function Forward contract helps to cover the risk of changes in exchange rate between two currencies . 2. Foreign bills of exchange etc. It is done through the instruments such as Telegraphic transfer. Transfer function Conversion of one currency into another currency results in transfer of purchasing power between countries. Credit function credit facility is offered through foreign bills of exchange and foreign letter of credit.• Functions of Foreign Exchange Market 1. business customers. Participants at 2 Levels 1. Wholesale Level (95%) . .major banks 2. Participants in Foreign Exchange Market A. Retail Level .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET I. transactions take place at a specified future date .recorded by 2nd business day 2. Two Types of Currency Markets 1. Spot Market: .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Forward Market: .immediate transaction . Participants by Market 1. commercial banks b.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Spot Market a. brokers c. customers of commercial and central banks . Forward Market a.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. hedgers d. arbitrageurs b. traders c. speculators . • Foreign Exchange . At other locations it should be viewed as a commodity having time value.• Important terminologies in Foreign Exchange transaction: • Fiat currencies Paper currency notes issued by the Central Monetary Authority of the respective countries. credits and balances payable in foreign currency • Drafts. travelers’ cheques. institutions or persons outside India but payable in Indian currency . letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency • Drafts.Definition as per FEMA (1999) • Deposits. etc. drawn by banks. L/Cs. travelers’ cheques. It is the money only in the country of issue. • Foreign Currency: the legal tender applicable in a country outside the domestic area. It contains a promise to redeem the notes at its face value. • LORO account It is used for referring to third party accounts. London has an INR account with Bank of Baroda”. When Canara Bank has to refer to this account while corresponding with Citibank it would refer to it as LORO account. Loro account means “their account with you”. New York. • VOSTRO account Demand deposit accounts. . by a bank other than the account maintaining bank and the bank with which account is maintained. This term is used when the NOSTRO/VOSTRO account is referred to. Example: Indian Bank has a USD account with Citi Bank.• NOSTRO account Demand deposit account denominated in foreign currencies maintained by domestic banks with banks overseas. denominated in domestic currency maintained by overseas banks with domestic banks. Vostro account means “your account with us.” Example: Barclays Bank. Nostro means “our account with you”. New York. Example: Indian Bank has a US dollar account with Citi Bank. Providing trade related data and product data to help the principal bank to help its customer for business development. advising of LC. . Correspondent banks: The Foreign exchange transactions centered around the transfers and payments made between banks from different countries. Receiving and making payments on behalf of the principal bank. Assisting principal bank in its agency functions such as presentation of documents.• 1. confirmation of LC etc. Providing credit reports on companies located in their country. 2. It undertakes the following functions: Maintaining foreign currency account. The bank with whom the nostro or vostro account relationship established is called as correspondent bank. 4. 3. the rate is based on the demand supply factors affecting each currency pair.international trade contributes to economic growth. -international trade settlements take place through conversion of one currency with another.the rate of conversion is called as the Exchange Rate. . Being the significant participant in the forex market. . In nutshell . .trade is the base for international monetary flows. .• Role of banks in Foreign Exchange transactions: Every transactions involving foreign exchange passes through Nostro and Vostro accounts maintained by the international banks. banks provide quotes for the pairs of currency traded in the market. Thus they play a crucial role in establishing demand supply equilibrium between currencies. Such transactions are settled at the rate called forward rate.Settlement of funds takes place on the second working day following the date of the deal • Forward – settlement of funds takes place beyond spot date is called as forward contract.Settlement of funds on the same day (date of the deal).Settlement of funds takes place on the next working day of the date of the deal • Spot .Types of exchange rate • Exchange rate denotes the price or the ratio or the value at which one currency is exchanged for another • Ready/cash . • Tom . . American quote – Number of dollars expressed per unit of any other currency.96/$ 2.45. Merchant quote : Interbank quote .Method of Quotation 1.5613/£ b. European quote –Number of units of any other currency expressed per dollar. example: $1. For interbank dollar trades: a. example: Rs. 100 .• For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency.0525/Rs. Example: Rs.8700/$ Indirect quote gives foreign currency price for a fixed number of units of domestic currency. Example : $2.46. 40/41 the bank is bidding for USD at Rs.• Cross rates.To obtain rates for a particular currency pair when they are not available directly • Bid and Ask rates. 39.41 . 39.In USD/INR 39.40 and offering to sell USD at Rs. Types of exchange rate (2) • In the forex market all rates that are quoted are generally spot rates • When delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicable • Forward rate = Spot rate + Premium (discount) . .THE FORWARD MARKET Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate. Forward rate • If the forward value of a currency is higher than the spot value the currency is said to be at a premium • If the above is reversed the currency is said to be at a discount • The forward premium/discount is based on interest rate differentials of the two currencies involved . these can be used for speculation . in combination with spot deals. are used for money market operations through ‘swap’ transactions – Taking a view of the market.Forward Rate (2) • Forward transactions are necessary in the foreign exchange market as they serve number of purposes like: – One can hedge or cover an existing future financial. commercial or trade related exchange risk – These types of deals. Forward rate (3) • When a currency is costlier in the future (forward) as compared to the spot. the currency is said to be at a premium vis-à-vis another currency • In ‘direct rate’ premium is added to both the buying and selling rate whereas discount is deducted • In ‘indirect rate’ premium is deducted and discount is added to the buying and selling rates . • Forwards are quoted as follows – Spot/1 month 17/18 – Spot/ 2 months 35/37 – Spot/ 3 months 53/56 • If forward differentials are in the ascending order (bid rate is lower than ask rate) the base currency is at premium. • If forward differentials are in the descending order (bid rate is greater than the ask rate) the base currency is at discount.Forward rate (4) • Base currency is the currency which is being bought and sold and the other currency is incidental. . Outright Rate: quoted to commercial customers. b. Forward rate calculation: through the use of forward schedule through the use of Formula Annualized Forward Margin • Arithmetical difference between the interest rates of the variable and base currencies in annualized percentage terms = F-S x 12 x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract . Swap Rate: quoted in the interbank market at a discount or premium.Two Methods: a.Forward Rate Quotations 1. Contract Terms a. 90-day c. 30-day b. 360-day Longer-term Contracts 2. Forward Contract Maturities 1.THE FORWARD MARKET C. . 180-day d. for electronic fund transfers.S. Automated Trading . B. CLEARING SYSTEMS A.genuine screen-based market .used in U.used for domestic transfers .operated by the Fed . Clearing House Interbank System (CHIPS) . Fed Wire . ELECTRONIC TRADING A.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET . Results: 1. Threatens traders’ oligopoly of information 3.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Provides liquidity . Reduces cost of trading 2. 1% of the total New York= accounted for 16. .6% Tokyo = accounted for 6. • Market Centers (Between 2007-08): $3.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE MARKET The foreign exchange market is the largest and most liquid financial market in the world.0%.98 trillion daily global turnover London =accounted for around $1.36 trillion. or 34. but all during prescribed business hours. .Dealing Room • A centralised establishment. usually of a commercial bank. which is willing to make/offer a two way dealing price for different currencies at all times even when they may not wish to deal. • Dealing Room . shops. all India financial institutions and a few co-operative banks to undertake foreign exchange transactions in India • It has also issued Money Changer licenses to a large number of established firms. hotels. etc.RBI/FEDAI Guidelines (1) • RBI has issued Authorised Dealers (AD) licenses to banks. companies. . coins and travellers’ cheques are called full fledged money changers • Those authorised only to buy are called restricted money changers .RBI/FEDAI Guidelines (2) • Money changers help facilitate encashment of foreign currencies of foreign tourists • Entities authorised to buy and sell foreign currency notes. quotations. interest on defaults. • FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market . delivery dates. holidays. merchant rates. etc.RBI/FEDAI Guidelines (3) • FEDAI (Foreign Exchange Dealers’ Association of India) is a non-profit making body formed in 1958 with the approval of RBI • Its members are authorised dealers and it prescribes guidelines and rules of the game for market operations.