Spot Rates

• When two parties agree to exchange currency & execute the deal immediately the transaction is referred to as spot exchange.

• In other words, spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.

• When US tourist goes to a bank India to convert his dollars into Rupees, the exchange rate is the spot rate for that day.

• An exchange rate can be quoted in two ways:Direct quotation is where the cost of one unit of foreign currency is given in units of localcurrency, whereas indirect quotation is where the cost of one unit of local currency is given in units of foreign currency.

• Your local currency is INR:- Direct exchange rate: 1USD = 45 INR- Indirect exchange rate: 1INR = .02222USD

• The value of currency is determined by the interaction between the demand & supply of that currency related to the demand & supply of other currencies.

• If lots of people want US dollar & dollars are in short supply, and a few people want INR& INR are in plentiful supply, the spot exchange rate for converting dollars into INR will change.

• The dollars is likely to appreciate against the INR/conversely, the INR will depreciate against the dollar.

• Imagine the spot exchange rate is Rs 45=$1 when the market opens.

• As the day progresses, dealers demand more dollars and fewer INR and by the end of the day the spot exchange rate might be Rs 48 = $1. Thus the dollar appreciated and INR has depreciated

Operation of Forward Markets- Importers and Exporters aspect

IMPORTERS ASPECT • Suppose an Indian company that import laptop

computers from US knows that in 30 days it must pay Dollar to US supplier when the shipment arrives.

• The company will pay US supplier $500 for each laptop and the current Rupee/ dollar spot exchange rate is Rs 45= 1$.

• At this rate, each computer costs the Indian importer Rs 22500(i.e., 500 * 45).

• The importer knows that he can sell the computer at the day they arrive for Rs 25000 each which yields a gross profit of Rs 2500 ( 25000 – 22500 ) on each computer.

• If over the next 30 days the dollar unexpectedly appreciates against Rupee, say Rs 55 = 1$, the importer will have to pay US company Rs 27500 per computer (i.e., 500 * 55) which is more than he can sell the laptop for.

• Thus, an appreciation in the value of dollar against Rupee from $1 = Rs 45, to $1 = Rs 55 would transform a profitable deal into unprofitable for the Indian importer

• To avoid this risk the Indian importer might engage in a Forward Exchange contract.

• A Forward Exchange contract occurs when two parties agree to exchange currency and execute the deal at some specific date in future for a specific amount.

• Exchange rates governing such Forward contracts are quoted for 30, 90 and 180 days into the future.

• Returning to our laptop importer example, let us assume that a 30 days Forward Exchange rate for converting dollars into Rupee is $1 = Rs 47

• So, the Indian importer enters into a 30day forward exchange transaction with a foreign exchange dealer at this rate and thereby guarantee is that he will have to pay not more than Rs 23500 ( 500 * 47 )for each laptop guaranteeing him a profit of Rs 1500 per computer.

• Any further appreciation ( > INR47/USD) in the value of the dollar will be borne by the foreign exchange dealer

• If on the expiry date, if the dollar depreciates, for eg., $1=Rs 40, he will lose money in the forward contract Rs 3500 ( 23500 – 20000), where 20000 = 500*40.

• But, he will gain in selling the laptop at the spot rate and will earn a profit of Rs 5000 ( 25000 – 20000).

• And, he will end up with a Net profit of 1500 in either way.

EXPORTERS ASPECT • Suppose an Indian company that exports

laptop to US knows that in 30 days it will be paid by the US buyer on delivery.

• The company will be paid by the US buyer $500 for each laptop and the current Rupee/ dollar spot exchange rate is Rs 45= 1$.

• At this rate, each computer is paid for Rs 22500(i.e., 500 * 45).

• The exporter knows that he can buy laptops from the local market for Rs 20000 at the day of export which yields a gross profit of Rs 2000 ( 22500 – 20000 ) on each laptops.

• If over the next 30 days the dollar unexpectedly depreciates against Rupee, say Rs 35 = 1$, the exporter will be paid only Rs 17500 per computer (i.e., 500 * 35) which is less than he can buy the laptop from the local market.

• Thus, a depreciation in the value of dollar against Rupee from $1 = Rs 45, to $1 = Rs 35 would transform a profitable deal into unprofitable for the Indian exporter

• To avoid this risk the Indian exporter might engage in a Forward Exchange contract.

• let us assume that a 30 days Forward Exchange rate for converting dollars into Rupee is $1 = Rs 42

• So, the Indian exporter enters into a 30day forward exchange transaction with a foreign exchange dealer at this rate and thereby guarantee is that he will be paid not less than Rs 21000 ( 500 * 42 )for each laptop computer guaranteeing him a profit of Rs 1000 per laptop.

• Any further depreciation ( < INR42/USD) in the value of the dollar will be borne by the foreign exchange dealer

• If on the expiry date, if the dollar appreciates, for eg., $1=Rs 47, he will lose money in the forward contract Rs 2500 ( 23500 – 21000), where 23500 = 500*47.

• But, he will gain from the payment from the buyer of the laptop at the spot rate and will earn a profit of Rs 3500 in buying the same from the local( 23500 – 20000).

• And, he will end up with a Net profit of 1000 in either way.

Swap Operations

Swap Operations

• Commercial banks who conduct forward exchange business may resort to a swap operation to adjust their fund position.

• The term swap means simultaneous purchase of spot currency for the forward sale of the same currency or the sale of spot for the forward purchase of the same currency.

Foreign Exchange Swap Transactions

• Defined: The simultaneous purchase and sale of a given amount of foreign exchange for two different dates.– Both purchase and sale are usually conducted

with the same counterpart (i.e., the same global bank)

• The most common FX swap is a spot against forward– A bank buys FX in the spot market and

simultaneously sells the same amount back in the forward market

– Since the swap transaction is an offset, the bank incurs NO exchange rate exposure.

• A swap transaction is used to provide bank clients with needed foreign exchange for a specified period of time (e.g., a short term loan).

Example of FX Swap• Corporate approaches its bank wanting to

borrow 10,00,000 USD for 90 days.• Bank negotiates in interbank spot market to

purchase 10,00,000 USD’s, which in turn are lent to the corporate.

• Bank simultaneously sells 10,00,000 USD’s 90 days forward (i.e., for delivery in 90 days) in the interbank market.– When loan matures, bank will receive the

10,00,000 USD from the corporate borrower which provides it with the USD to be delivered at that time to complete the forward agreement.

• Thus, the lending bank assumes no exchange risk during the 90 day period.

• The bank’s return is the interest on the loan, minus any spot/forward spread not in it’s favor.

Arbitrage Operations

• Arbitrage exploits a price difference between two or more markets to make money with zero risk.

• Exchange arbitrage involves the simultaneous purchase and sale of a currency in different foreign exchange markets. Thus, arbitragers take a closed position (No risk).

• Arbitrage becomes profitable whenever the price of a currency in one market differs from that in another market.

• Suppose the pound quoted in NY is $1.75, but pound quoted in London is $1.78.

• It is evident that the exchange rate in both the markets are mispriced, due to supply and demand forces; supply for pound is higher in London with respect to Dollar and the reverse in New York

• The arbitrager would buy Pounds from NY and sell the same in London. He earns profit through the following steps(a) buy 10 M pounds in NY: cost = $17.5 M (b) sell 10 M pounds in London: revenue = $17.8 M (c) profit = $300,000 less the cost of telephone, cable transfer.