forex primers

THE FOREIGN EXCHANGE

MARKETThe world’s most traded market place

PRIMER’S FOR THE FOREIGN

EXCHANGE MARKET IN INDIA

Ptotem Learning Projects 2

CONTENT

Introduction

The Foreign Exchange Market Place

Interesting Pointers

Essential Terminologies

The Forward Market

Interest Rate Parity Theory


DEFINING FOREIGN EXCHANGE

Foreign Exchange, or more popularly known as “Forex” or even

“FX”, is the trade of a single currency for another at a decided or

contracted price (called as the trade price) on the Forex

Marketplace.

In simpler terms it is essentially money – denominated in one

currency, is bought or sold with money – denominated in another

currency.


WHEN the different currencies meet

“

”

A CURRENCY SERVES THREE FUNCTIONS: PROVIDING A MEANS OF

PAYMENT, A UNIT OF ACCOUNT AND A STORE OF VALUE. GOLD MAY BE A

STORE OF VALUE FOR WEALTH, BUT IT IS NOT A MEANS OF PAYMENT. YOU

CANNOT PAY FOR YOUR GROCERIES WITH IT. NOT IS IT A UNIT OF

ACCOUNT. PRICES OF GOODS AND SERVICES, AND OF FINANCIAL

ASSETS, ARE NOT DENOMINATED IN GOLD.

NOURIEL ROUBINI

Nouriel Roubini is an American Economist. He anticipated the collapse of

the United States housing market and the worldwide recession which

started in 2008


THE FOREIGN EXCHANGE MANAGEMENT

ACT (FEMA) DEFINITION


A currency other than the Indian Rupee

Deposits, Credits and Balances payable in foreign currency

Drafts, traveller’s cheques, cash currencies, letters of credit, bills of exchange

expressed or drawn in Indian currency but payable in foreign currency

Drafts, traveller’s cheques, cash currencies, letters of credit, bills of exchange

drawn by banks, institutions or persons outside India but payable in Indian

Currency

COMMON USAGE

International Trade and Capital Account Transactions

Import or export of goods and services

Loans and borrowings

Investments

Pertaining to Individuals

Speculative –This essentially would and should form a part

of the advanced course on Forex


COMMON TRANSACTION METHODS

Over the Counter

Commonly seen during purchase of currency for tours and travel

Telecommunications

Most commonly through SWIFT (Society for worldwide financial

telecommunications), Interbank settlements, Fedwire.

An earlier form was through TELEX though there are still a few

practioners of this method to date.


CONTENT

Introduction




The Forward Market



THE MAJOR

CURRENCIESTHEM WHO have the need for

currency dealings


Currency Abbreviation Nickname Mkt Share

The United States Dollar

USD Greenback; Buck 89%

The Euro EUR 37%

The Japanese Yen JPY Jap 20%

The British Pound GBP Cable; Sterling 17%

The Swiss Franc CHF Swissy 6%

The AustralianDollar

AUD Aussie6% 6%

The Canadian Dollar

CAD Goose; Loonie 4%

Others 21%

Total 200% ***

*** The total traded is shown as 200%, due to the fact that in the FX

market currencies are always traded in pairs


THE MAJOR CURRENCY PAIRS AT THE

FOREX MARKET PLACE

Major Currency Pairs: These account for 75% of all FX market

transactions. All of these involve the USD as one of the currency

USD / EUR

USD / GBP

USD / CHF

USD / JPY


THE CROSS CURRENCY PAIRS AT THE

FOREX MARKET PLACE

Cross Currency Pairs: Where USD does not form one of the currencies

in the FX trade. The most actively traded Cross Currency Pairs are

EUR / CHF

EUR / GBP

EUR / JPY

GBP / JPY

AUD / JPY

NZD / JPY

THE FOREX MARKET PLACE USERS

Financial Institutions: Since the currency market is regulated by needs and trusts,

banks form secured third party for mediating an FX trade.

Trade Consumers: Companies and corporates who need Forex dealings to handle

their import, export and loan transactions

Retail Consumers: Individuals who would need to buy sell currency towards their travel

and tour requirements

Retail Consumers: Towards overseas purchases online or transfer to near and dear

Non Residents: Salary paid and transferred

Travel and Tour Operators: For their operational ventures and tie – ups with overseas

counterparties

Traders, Speculators, Arbitrageurs, Hedgers, Insurers etc: These would form a part of a

more advanced requirement


THE FOREX MARKET PLACE SETTLEMENT

MECHANISMS

Interbank & or Intrabank clearing houses: eg:

Clearing House Interbank Payment Systems

(CHIPS) or FEDwire

Automated Trading Platforms: Used by traders

Telecommunications Services: SWIFT, Telex

etc.


FOREX TRANSACTION EXEMPLIFIED

Let’s say you are taking a trip to New Zealand. You have bought the tickets and

have planned the trip well in advance. Now you need to travel abroad. Once

you leave the Indian Airport, you are no longer in India. Which means that to

spend money you can no longer make use of Indian Rupees. You now need

New Zealand Dollors or NZD. What do you do?

Ptotem Learning Projects 15A traveler or a tourist who is off to a foreign country

All spending can be in Indian Rupees

All spending has to be in New Zealand Dollors

THE FOREX MARKETPLACE BENEFITS

Secure and trustworthy mediators – Banks & Other Financial Institutions

Reduces the cost of trading

Liquidity in the immediately required currency

Opens up the traders’ oligopoly of information


CONTENT

Introduction




The Forward Market



INTERESTING TRIVIA ON FOREIGN

EXCHANGE

WONDER WHO would have ever thought about it?


SIZE MATTERSEven the largest equity trading bourse in the

world is of no comparison

Daily turnover of the FX marketplace is

around USD 5 trillion and growing

NYSE trading is at a mere USD 70 billion in

comparison

The FX market clearly crosses the time horizons

The buying and selling of currency begins

each Monday morning at Wellington, New

Zealand and concludes at New York, USA on

Friday evenings

The forex market is definitely the

largest financial market in the

whole wide world


WOULD YOU KNOW

THIS?

Just Imagine…


The “Black Wednesday” occurred on Sept

16, 1992, when Great Britain participated in

the European Currency System. This saw a 25%

fall in their currency value and resulted in

interest rates going up by 5% in a single day.

The Global Economic Crisis of new millennium

touched almost all fields of the human activity.

Including the FX market place. However,

despite the crisis, the FX market functioned

successfully and was even profitable at the

end of it.

WOULD YOU KNOW

THIS?

“A weak currency is the sign of a

weak economy, and a weak

economy leads to a weak nation”

- Ross Perot


The early 90’s saw a devaluation of the JPY

currencies that created a wave of bankruptcies of

one of the most developed countries in the modern

world. The JPY traded at negative 79.80 to a USD.

Imagine, instead of receiving for something you sell,

you end up paying for it

However, the financial crisis of 2007 led to drastic

changes in all of world’s major currencies. In this time,

the JPY strengthened against most major currencies. It

even beat the USD and EUR. One of the reason’s for

such strengthening is attributed to the fact that traders

needed to find a sanctuary amidst a monetary chaos.

Seems like the FX world is small and round afterall

CONTENT

Introduction




The Forward Market



ESSENTIAL FOREX TERMINOLOGY

The next time someone talks about it, I would understand.


THE FOREX TRADE TYPES

CASH : When a Forex Trade is settled the same day of the deal

TOM : When a Forex Trade is settled the next working day of the deal

SPOT: When a Forex Trade is settled on the second working day of the deal

FORWARD : When a Forex Trade is settled any day after the date of deal


THE RATE TYPES

BUY : The local currency price at which a Merchant Bank or a Financial

Institute buys Foreign Currency from you

SELL: The local currency price at which a Merchant Bank or a Financial

Institute sells Foreign Currency to you

INTERBANK: The local currency price at which a Merchant Bank buys or sells

Foreign Currency to other Merchant Banks in the Forex Market


THE FORWARD METRICS

PREMIUM : When the Forward value of the currency is higher than the spot

value

DISCOUNT : When the Forward value of the currency is lower than the spot

value


THE ARBITRAGE

An Arbitrage is an operation when one offsets one Forex / Interest

Rate transaction for another thus making it a risk free transaction.

Arbitrage keeps the exchange rates uniform in all the markets


FACTORS AFFECTING

THE EXCHANGE RATES The exchange rates are very dynamic and

might vary day to day

Major banks who are market makers always

give two way quotes

Freedom or restrictions on capital

movements can affect exchange rates to a

large extent

Huge trade surpluses of Oil Exporting

countries have the most telling effect on

fluctuations in currency values

Speculations serves to provide depth and

liquidity in the forex market

The price / ratio / value at which

one currency is exchanged for

another


CONTENT

Introduction




The Forward Market



THE FORWARD MARKET

Why wait until tomorrow when you can do so today!


DEFINING FORWARD CONTRACT

In general, is is a contract between two parties agreeing to buy /

sell an asset at a specified future time. The price of the asset,

however, is finalised on the date of the contract.

In the foreign exchange market, the asset is normally a receivable

in a currency that is different from the local currency.

A forward contract is the most used foreign exchange hedging

mechanism in the world


When you commit to buy an asset tomorrow at a price negotiated today


Say, you are a phone manufacturer from India. And you have engaged in a export of 50,000

mobile phones to a buyer in the United States. You invoice USD 0.5mn for it. The payment

terms are 3 months from delivery and you have delivered it today.

If you had got your money today, you would have converted the USD 0.5mn to Indian

Rupees at today’s exchange rate. Which is, say, at INR 60 to USD 1. In other words, you would

have received INR 30mn into your account today.

Ptotem Learning Projects 32The steps you take today to save for a better tomorrow

You Importer in US50000 mobilesYour delivery reached today

USD 0.5mnYou get your money after 3 months


But you do not know what the rate for 1 USD would be after 3 months when you receive the

payment. There is a probability that it goes below INR 60 per USD in which case you would

make a loss. There is also a probability that the rate per USD goes above INR 60. In this case

you make a gain.

These two are called as Forex Loss or Forex Gain.

Ptotem Learning Projects 33The steps you take today to save for a better tomorrow

CONTENT

Introduction




The Forward Market



INTEREST RATE PARITY

Sometimes when $1 is not equal to $1


DEFINING INTEREST RATE PARITY

Interest Rate Parity or IPR is used to understand the relationship between the spot rate of a currency and a corresponding future or

forward rate of another currency

The difference in the interest rates between these two currencies

will reflect in a state of Premium or Discount of the currencies in the forward market

Since it would be a no arbitrage condition, the size of the forward

premium or the discount on a foreign currency would be equal to

the interest rate differentials between the currencies in comparison


A no arbitrage condition representing a state of equilibrium.

INTEREST RATE PARITY EXEMPLIFIED

Interest Rate Parity or IPR is used to understand the relationship between the spot rate of a currency and a corresponding future or

forward rate of another currency

The difference in the interest rates between these two currencies

will reflect in a state of Premium or Discount of the currencies in the forward market

Since it would be a no arbitrage condition, the size of the forward

premium or the discount on a foreign currency would be equal to

the interest rate differentials between the currencies in comparison


The Real versus Notional stages

forex primers

Economy & Finance