Foreign Exchange Foreign Exchange

(1)

Foreign Exchange Foreign Exchange

FOREX

(2)

2 2

Layer 1 RBI FEDAI Layer 1 RBI FEDAI

Regulator Regulator

IB Rate Prevail IB Rate Prevail

Layer 2 Bank to Bank Transaction

Layer 2 Bank to Bank Transaction Wholesale Market Wholesale Market

^Segment ^Segment

Inter Bank Market or IB Market Inter Bank Market or IB Market Operational Layer

Operational Layer

Merchant Rate Prevail Merchant Rate Prevail

Layer 3

Layer 3 Bank to Customer Transaction Bank to Customer Transaction Retail Market Retail Market

Segment Segment

Merchant Market Merchant Market

1. Three Layer Structure of Forex Market

(3)

2. How to Interpret Merchant Transaction 2. How to Interpret Merchant Transaction

Always Interpret Merchant Transactions with Always Interpret Merchant Transactions with Respect to

Respect to BANK. BANK.

E.g. E.g. If an exporter approaches a Bank for selling FC If an exporter approaches a Bank for selling FC than we will say Bank is Buying FC ( from

than we will say Bank is Buying FC ( from the exporter)

the exporter)

(4)

4 4

3. 3. Cash Flow Movement in Merchant Cash Flow Movement in Merchant Transaction

Transaction

Merchant Transaction Merchant Transaction

Purchase From Bank

Purchase From Bank Sell to Bank Sell to Bank

Exporter Importer Exporter Importer

Bank Bank Bank Bank

FC Home FC HC FC Home FC HC

Currency Currency

Customer Customer Customer Customer

Exchange Rate: 1 Unit of FC = How many units of HC Exchange Rate: 1 Unit of FC = How many units of HC

(5)

4. How to Interpret IB Rate and Transaction 4. How to Interpret IB Rate and Transaction

1 USD = 45.2031 / 45.2031 INR 1 USD = 45.2031 / 45.2031 INR

Base Bid Price Ask or Offer Price Price Base Bid Price Ask or Offer Price Price

(Less Rate) (High Rate) (Less Rate) (High Rate)

i) In IB market Exchange Rate is quoted upto 4 Decimal places.

Except in Japanese Yen (JPY) which is quoted up to two gits after decimal. Except in Japanese Yen (JPY) which is quoted up to two gits after decimal.

ii) Market Maker Market User ii) Market Maker Market User

The Bank which gives quote The Bank which uses the given The Bank which gives quote The Bank which uses the given

in IB Market. Quote in IB Market. Quote

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6 6

iii)

iii) Interpretation with Respect to Market maker : Interpretation with Respect to Market maker :

The market maker is ready to BUY at Lowest of the Quote i.e. 1 The market maker is ready to BUY at Lowest of the Quote i.e. 1 USD for INR 45.2030

USD for INR 45.2030 and and

at the same time market maker is ready to SELL 1 USD for at the same time market maker is ready to SELL 1 USD for INR 45.2031 i.e. Highest of the quote.

INR 45.2031 i.e. Highest of the quote.

iv) Difference between BID Rate and ASK Rate is called

iv) Difference between BID Rate and ASK Rate is called SPREAD SPREAD . .

(or Trading Profit). (or Trading Profit).

45.2031 / 45.2032 45.2031 / 45.2032

Spread (Difference) Spread (Difference)

i.e .0001 i.e .0001

(7)

v) Interpretation with respect to Market User : v) Interpretation with respect to Market User :

The market user can only BUY at Highest Quote The market user can only BUY at Highest Quote and and at the same time market user can SELL at Lowest of the at the same time market user can SELL at Lowest of the

quote.

The User bank can do this transaction in IB market on behalf The User bank can do this transaction in IB market on behalf of customer. Than this deal with customer is called

of customer. Than this deal with customer is called Merchant Merchant Deal Deal and it is arrived at by adjusting and it is arrived at by adjusting Exchange Margin Exchange Margin to IB to IB

Rate.

The market user can do transaction in IB market for their own The market user can do transaction in IB market for their own purpose than it is called

purpose than it is called Trading or Speculation. Trading or Speculation.

This is a risky transaction. This is a risky transaction.

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8 8

vi) Interpretation of Abbreviation Offer Price (or ASK Price) vi) Interpretation of Abbreviation Offer Price (or ASK Price)

1 USD = 45.1550 / 45.1551 INR 1 USD = 45.1550 / 45.1551 INR

45.15 50 45.15 50 / 51 / 51

Big Figure Small Figure Big Figure Small Figure

Rule : Rule :

a) a) The offer price (Ask Price) should have equal number The offer price (Ask Price) should have equal number of digits of digits after decimal as Bid Price.

after decimal as Bid Price.

b) b) Offer Price must be the next numeric Offer Price must be the next numeric after the bid and the after the bid and the quoted offer price

quoted offer price should be the last digit should be the last digit. .

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5. How to Calculate Merchant Rate 5. How to Calculate Merchant Rate

SBI SBI

Market Maker Market Maker

^{BOB will} ^{BOB will}

Sell FC Sell FC

BOB BOB

Market User Market User

BOB will BOB will

Buy FC Buy FC

Exporter Exporter

SBI SBI

Market Maker Market Maker

BOB will BOB will

Buy FC Buy FC

BOB BOB

Market User Market User

BOB will BOB will

Sell FC Sell FC

Importer Importer

(Outward Remittance) (Outward Remittance)

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10 10

6. 6. Adjustment Of Exchange Margin in Merchant Adjustment Of Exchange Margin in Merchant Transaction

Transaction

Type of Merchant Transactions : Type of Merchant Transactions :

Bank Exchange Margin (EM) Bank Exchange Margin (EM) Purchase Deduct Purchase Deduct

Sell Add Sell Add

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7. How to settle Forex Transaction in IB Market 7. How to settle Forex Transaction in IB Market

For this purpose each party opens account in Foreign For this purpose each party opens account in Foreign currency.

currency.

Nostro A/c Vostro A/c Loro A/c Nostro A/c Vostro A/c Loro A/c

My a/c with You Your A/c with us Third Party A/c My a/c with You Your A/c with us Third Party A/c

These are A/c for settlement of interbank transactions.

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12 12

SBI CITI BANK HSBC SBI CITI BANK HSBC

Mumbai

Mumbai New York London New York London

i) i) SBI will call this A/c as SBI will call this A/c as Nostro Nostro with respect to CITI BANK. with respect to CITI BANK.

ii) ii) CITI BANK will call this A/c CITI BANK will call this A/c Vostro Vostro with respect to SBI. with respect to SBI.

iii) iii) SBI will call HSBC as Loro SBI will call HSBC as Loro A/c as it Nostro to CITI Bank. A/c as it Nostro to CITI Bank.

Summary :

Summary : Bank which open cash credit in FC will call it Nostro Bank which open cash credit in FC will call it Nostro

and and Bank where A/c is opened will call it Vostro. Bank where A/c is opened will call it Vostro.

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Types of Authorizations ( License) Types of Authorizations ( License)

In India RBI Gives 3 types of Licenses for dealing in In India RBI Gives 3 types of Licenses for dealing in FOREX Market.

FOREX Market.

License Type of Transaction License Type of Transaction Category A IB Transaction Category A IB Transaction Category B

Category B Money Changer + Export Import Transaction Money Changer + Export Import Transaction

Category C Money Changer

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14 14

8. Type of transaction in IB Market 8. Type of transaction in IB Market

The definition of transaction depends upon two terms:

Date of Transaction Date of Settlement Date of Transaction Date of Settlement

DOS = DOT

DOS = DOT Cash/ Ready/ TT/ Value Today Cash/ Ready/ TT/ Value Today

DOS = DOT + 1 BWD TOM DOS = DOT + 1 BWD TOM DOS = DOT + 2 BWD SPOT DOS = DOT + 2 BWD SPOT DOS = DOT + 2 BWD +…. FWD DOS = DOT + 2 BWD +…. FWD

BWD = Business working Day BWD = Business working Day TT = Telegraphic Transfer

TT = Telegraphic Transfer

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For Exam For Exam : :

In IB Market the exchange rate is quoted on SPOT In IB Market the exchange rate is quoted on SPOT Basis [ This means in exam, unless otherwise given Basis [ This means in exam, unless otherwise given

IB Rate means SPOT basis transaction.

All other transaction like Cash, TOM, FWD are All other transaction like Cash, TOM, FWD are derived from SPOT Rate.

derived from SPOT Rate.

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16 16

9. Currency Point Convention 9. Currency Point Convention

i) What is market Convention (or ACI Convention) i) What is market Convention (or ACI Convention)

for writing currency pair.

Each currency is identified by three capital Each currency is identified by three capital

letters ( USD, INR, EVR) and the first currency letters ( USD, INR, EVR) and the first currency before oblique (/) is the ‘Base Currency’ after before oblique (/) is the ‘Base Currency’ after oblique is the quote or ‘Price Currency’.

oblique is the quote or ‘Price Currency’.

USD / INR 45.2030 / 35 USD / INR 45.2030 / 35

Base Price Bid Ask

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Academic World :

Academic World : Base Base Price Price

ii) ii) 1 1 USD USD = = INR INR 44.55 / 56 44.55 / 56

iii) iii) 120 120 INR INR / / USD USD

iv) iv) GBP GBP / / USD USD 90.20/21 90.20/21

v) v) GBP GBP / / USD USD GBP 90.20/ 21 GBP 90.20/ 21

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18 18

10. CROSS Rate 10. CROSS Rate

It is an exchange rate where neither currency is USD.

1 FRF = How many INR ? 1 FRF = How many INR ?

1 USD = 43.2550 / 43.650 INR Given rate for 1 USD = 43.2550 / 43.650 INR Given rate for 1 USD = 6.0500 / 6.0550 FRF Conversion 1 USD = 6.0500 / 6.0550 FRF Conversion

Therefore neither Base or Price Currency or price Therefore neither Base or Price Currency or price currency is in USD so this is an example of cross currency is in USD so this is an example of cross

rate.

(19)

Short Cut For Calculating Cross Rate Short Cut For Calculating Cross Rate

Case I Case I

Common Currency Common Currency is in

is in Base Side in Base Side in Both Quote

Both Quote Rule Rule

Divide Across by the Divide Across by the currency which is currency which is going to be the going to be the Base in the Cross Base in the Cross rate.

rate.

Base Base

Case II Case II

Common Currency is Common Currency is in Price Side in Price Side in Both in Both Quote

Quote Rule Rule

Divide across by the Divide across by the currency which is currency which is going to be the Price going to be the Price in the Cross rate.

in the Cross rate.

Price Price

Case III Case III

Common Currency is Common Currency is in Base Side as in Base Side as

well as in Price well as in Price Side Side

Rule Rule

We use inverse rate We use inverse rate concept to convert concept to convert this situation into this situation into either Case I or Case either Case I or Case II II

Bid Ask Bid Ask

× And × × And ×

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20 20

Square up or Square off Square up or Square off

The ‘Square up’ means taking exactly opposite The ‘Square up’ means taking exactly opposite transaction as compared to earlier transaction.

transaction as compared to earlier transaction.

For e.g..

If you bought $on SPOT Basis at 10:10 Am than a If you bought $on SPOT Basis at 10:10 Am than a square transaction at 12 PM would be to Sall $.

square transaction at 12 PM would be to Sall $.

In this process you can make Loss or Gain as it In this process you can make Loss or Gain as it

involves Risk as the Forex market is Volatile.

(21)

11. Cover Rate : 11. Cover Rate :

It is IB Spot Rate at which It is IB Spot Rate at which merchant transaction merchant transaction is is covered in the IB market. covered in the IB market.

That means if Bank That means if Bank Buys $ Buys $ from customer in from customer in

merchant transaction merchant transaction the cover transaction would the cover transaction would be to be to Sell $ Sell $ in IB market. in IB market.

Base Rate :

It is an IB Spot rate (ongoing) which forms the It is an IB Spot rate (ongoing) which forms the

basis for computation of merchant. basis for computation of merchant.

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22 22

12. Direct Quote, Indirect Quote, 12. Direct Quote, Indirect Quote,

American Quote & European Quote American Quote & European Quote

World

World America America

Europe & ROW (Rest of the World) Europe & ROW (Rest of the World) Direct Quote or European Quote :

Direct Quote or European Quote :

For one unit of Base Currency What is the Price

1 unit of FC = How many Units of HC

1 Unit of $ = How many units of ROW

Indirect Quote or American Quote :

1 unit of HC = How many units of FC

1 unit of ROW = How many units of $

(23)

13. Currency Appreciation Currency Depreciation ( ) 13. Currency Appreciation Currency Depreciation ( )

Currency Revaluation Currency Devaluation ( ) Currency Revaluation Currency Devaluation ( ) Currency Appreciation/ Depreciation

Currency Appreciation/ Depreciation depends upon Market Forces depends upon Market Forces like Demand

like Demand and Supply. and Supply.

Currency Revaluation/ Devaluation

Currency Revaluation/ Devaluation depends upon Forced Action depends upon Forced Action by Regulatory Authority.

by Regulatory Authority.

% Change in the New Value - Old Value

= × 100 = × 100 Value of currency Old Value

Value of currency Old Value

Always talk Appreciation or Depreciation with respect to

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24 24

14. Siegel Paradox 14. Siegel Paradox

Time t=0 t=1 Time t=0 t=1

1£ = 2$ 1£ = 1.8$ 1£ = 2$ 1£ = 1.8$

% Change in value of £ = % Change in value of £ = 1.8 -2 1.8 -2 × × 100 = -10% 100 = -10% Depreciation Depreciation

2 2

Time t=0 t=1 Time t=0 t=1

1$ = 1/2£ 1$ = 1/1.8£ 1$ = 1/2£ 1$ = 1/1.8£

% Change in value of $ = % Change in value of $ = .5556 -.50 .5556 -.50 × × 100 = 11.2 100 = 11.2 Appreciation Appreciation

.50 .50

(25)

As per Siegel’s Paradox, appreciation of one As per Siegel’s Paradox, appreciation of one currency

currency is not exactly equal is not exactly equal to depreciation of to depreciation of another currency.

another currency.

In exam, we may In exam, we may ignore ignore Siegel Paradox unless Siegel Paradox unless specifically

specifically asked for asked for . .

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26 26

15. International Finance Theory

IRP (Interest Rate Parity) or CIP (Covered Interest Parity)

PPP (Purchasing Power Parity)

Fisher Effect

IFE (International Fisher Effect)

Expectation Theory

All these theory are used to

calculate

Forward rate

or Expected

Spot Rate by

different market

parity.

(27)

i) IRP (Interest Rate Parity)

i) IRP (Interest Rate Parity) Basis = Interest Basis = Interest a) This theory tries to establish equilibrium between Forex Market a) This theory tries to establish equilibrium between Forex Market

and Money Market.

(Money market ( Money market i.e short term interest rate instruments are bought and sold i.e short term interest rate instruments are bought and sold like commercial paper etc.)

like commercial paper etc.)

Alternative 1 Time = 0

Alternative 1 Time = 0 1 1 USA 5% 1 $ 1.05 $ USA 5% 1 $ 1.05 $

Alternative 2 Time = 0 1 Alternative 2 Time = 0 1

India 8% 40 Rs 43.2 Rs India 8% 40 Rs 43.2 Rs

If Exchange rate t =0 continues at t =1 alternative 2 gives more $ and If Exchange rate t =0 continues at t =1 alternative 2 gives more $ and

hence opportunity for profit.

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28 28

b) IRP theory is used to calculate Forward Rate (FR) b) IRP theory is used to calculate Forward Rate (FR)

For this purpose we take today's Spot Rate and today's For this purpose we take today's Spot Rate and today's prevailing Interest rate (from market only).

prevailing Interest rate (from market only).

FR = SR × [ 1 + FR = SR × [ 1 + r r ^q ^q ] ] r r ^q ^q = = rate of interest of quote or price rate of interest of quote or price

[ 1 + [ 1 + r r ^b ^b ] ] r r ^b ^b = = rate of interest of Base currency rate of interest of Base currency

c) If IRP is not valid the arbitrage opportunity is not available.

d) FR is an exchange rate which prevail today but settlement d) FR is an exchange rate which prevail today but settlement

will take place in future.

The Rate of currency of the country with high interest is The Rate of currency of the country with high interest is

lower wit respect to rate of currency of the country with low lower wit respect to rate of currency of the country with low interest rate.

interest rate.

(29)

Absolute form of PPP Relative form of PPP Absolute form of PPP Relative form of PPP Relative Form of PPP :

Relative Form of PPP :

This Form of PPP helps to compute This Form of PPP helps to compute Expected Spot Rate Expected Spot Rate (further (further SPOT Rate). For this purpose we require today's

SPOT Rate). For this purpose we require today's SR SR and and Expected Inflation Rate

Expected Inflation Rate of the two countries. of the two countries.

FR = SR × [ 1 + I FR = SR × [ 1 + I q q ] I ] I q q = = rate of inflation of quote or price rate of inflation of quote or price

[ 1 + I [ 1 + I b b ] I ] I b b = = rate of inflation of Base currency rate of inflation of Base currency

i) PPP (Purchasing Power Parity)

i) PPP (Purchasing Power Parity) Basis = Inflation Basis = Inflation

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30 30

(31)

16. Computation of Forward Rate and how the forward 16. Computation of Forward Rate and how the forward

quotes are expressed.

a) FR = SR

a) FR = SR + + Interest Differential between two countries Interest Differential between two countries

(Converted into amount) (Converted into amount)

b) Expression of Forward Quote : b) Expression of Forward Quote :

Outright FR SWAP Point (margin) Annualized Premium Outright FR SWAP Point (margin) Annualized Premium

or Forward Point or Discount (in %) or Forward Point or Discount (in %) Outright FR :

Outright FR : This is not directly quoted but it is derived using This is not directly quoted but it is derived using SR and Forward Point.

SR and Forward Point.

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32 32

SWAP point :

SWAP point : It represents interest difference converted into It represents interest difference converted into amount or simply it is a

amount or simply it is a difference between difference between outright FR outright FR and and today's Spot Rate

today's Spot Rate . .

SWAP Point = Rate of - Rate of × SR × n SWAP Point = Rate of - Rate of × SR × n

Quote Base 12 Quote Base 12

Annualized Premium or Discount : Annualized Premium or Discount :

This also represent Interest differences but expressed in %.

SR × SR × r r ^q ^q - - r r ^b ^b or SR × or SR × r r ^q ^q - - r r ^b ^b

1 + 1 + r r ^b ^b

Exact Approx Exact Approx

(33)

17. International of SWAP point (or Forward Point) 17. International of SWAP point (or Forward Point)

a) SWAP point should have

a) SWAP point should have similar similar number of digits as the Spot number of digits as the Spot Rate has.

Rate has.

(i.e. number of digits after decimal in SWAP point should be equal to number of (i.e. number of digits after decimal in SWAP point should be equal to number of digits after decimal Inter Rank Spot Rate)

digits after decimal Inter Rank Spot Rate)

Whenever we are calculating Forward Rate we need to Whenever we are calculating Forward Rate we need to incorporate

incorporate adequate amount of zeros adequate amount of zeros into SWAP point into SWAP point before adding to or subtracting from.

before adding to or subtracting from.

Remember that interpretation of SWAP point is required only Remember that interpretation of SWAP point is required only when number of digits in SWAP point is less than number of when number of digits in SWAP point is less than number of

digits in IB Spot rate after decimal.

SWAP Value = SWAP Point SWAP Value = SWAP Point

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34 34

b) In India SWAP points are quoted on

b) In India SWAP points are quoted on month end basis month end basis and the and the quote is directly available up to 12 month.

quote is directly available up to 12 month.

SWAP Point in India is Directly quoted for USD/INR and for SWAP Point in India is Directly quoted for USD/INR and for Foreign Currency/INR it is derived using concept of Forward Foreign Currency/INR it is derived using concept of Forward

Cross Rate.

c) SWAP Point or Forward Point is not an exchange rate but it is c) SWAP Point or Forward Point is not an exchange rate but it is

simply an Interest Differential.

However when we However when we adjust adjust SWAP point SWAP point with with SR SR we get we get FR, FR, which is an Exchange Rate.

which is an Exchange Rate.

d) SWAP Point or Forward Point are quoted in

d) SWAP Point or Forward Point are quoted in Cumulative Style. Cumulative Style .

(35)

18. How to adjust SWAP point to calculate Forward 18. How to adjust SWAP point to calculate Forward

Rate.

Rate. (whether to add or subtract SWAP Point) (whether to add or subtract SWAP Point)

a) If

a) If Plus Plus sign is attached before SWAP point than it indicates sign is attached before SWAP point than it indicates that Base currency is at premium.

that Base currency is at premium. ADD ADD

Similarly if Similarly if Minus Minus sign is attached before SWAP point than it sign is attached before SWAP point than it indicates Discount.

indicates Discount. Deduct Deduct

b) When no sign is attached before SWAP point than we need to b) When no sign is attached before SWAP point than we need to

decide whether to add or subtract.

How to Decide ? How to Decide ?

IB Spot Rate : L – H ( Low – High) IB Spot Rate : L – H ( Low – High)

L - H SWAP Point L - H SWAP Point H – L H – L

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36 36

19. Merchant Forward Rate 19. Merchant Forward Rate

IB Market Buy Rate for Bank Sell Rate for Bank IB Market Buy Rate for Bank Sell Rate for Bank

IB Spot Rate Bid Side Ask Side IB Spot Rate Bid Side Ask Side

SWAP Point Premium/ Discount Premium/ Discount SWAP Point Premium/ Discount Premium/ Discount Exchange Less Add

Exchange Less Add Margin

Margin

(37)

20. How to calculate FR for Broken Period 20. How to calculate FR for Broken Period

In India SWAP Point are quoted on month end basis In India SWAP Point are quoted on month end basis (International it is quoted on whole month basis).

(International it is quoted on whole month basis).

The month is called FLAT date and all dates are called The month is called FLAT date and all dates are called broken period

broken period . .

Steps for calculating FR for Broken Period: Steps for calculating FR for Broken Period:

Step 1: IB Spot Rate ( Bid Side) Step 1: IB Spot Rate ( Bid Side)

Step 2: SWAP point up to last month.

Step 3: Broken Period SWAP Rate : Step 3: Broken Period SWAP Rate :

Last month - Next Month Last month - Next Month

SWAP Rate SWAP Rate × Difference in Days SWAP Rate SWAP Rate × Difference in Days

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38 38

21. Arbitrage in International Financial Market 21. Arbitrage in International Financial Market

Arbitration

Objective :

Risk Less Profit

Operational Issue:

Mispricing of assets either in the same market or between markets.

Buy and Sell or Sell and Buy

(Same amount or Quantity)

Hedging

Loss Minimization (or mitigation)

Mismatch in assets and Liability

Buy and Sell or Sell and Buy

(Same amount or

quantity not necessary)

Speculation

(trading) Risky Profit

Simply Buy and Sell or

Sell or Buy

(39)

Arbitrage

Currency Market (or Forex Market)

Currency Market and Money Market

When IRP is invalid than it gives opportunity for

arbitrage.

This type of arbitrage is called CIA (Covered

Interest Arbitrage) Two Point Arbitrage

Or

Locational Arbitrage Or

Geographical Arbitrage

Three Point Arbitrage Or

Triangular Arbitrage

(40)

40 40

Currency Market Arbitration Currency Market Arbitration

a) Two Point Arbitration:

Example SBI BOI

1$ = 45.2030/31 Rs 1$= 45.2028/29 Rs

BOI (Lowest Rate)

Bid Ask

45.2028 45.2029 SBI (High Quote)

Bid Ask 45.2030 45.2031

Buy Sell

This Gap Provides opportunity for Profit

(41)

This example shows that two quotes should This example shows that two quotes should not overlap not overlap (or (or simply there must be a

simply there must be a gap between gap between Ask rate Ask rate of one bank of one bank and and Bid rate Bid rate of another bank. of another bank.

Bid rate of one bank and Ask Rate of another bank Bid rate of one bank and Ask Rate of another bank If

If More Equal Less More Equal Less Than

Than Arbitrage No Arbitrage No Arbitrage Arbitrage No Arbitrage No Arbitrage

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42 42

Three Point Arbitrage Three Point Arbitrage

B

C A

Start with currency ‘A’ then go to Currency ‘B’ (sell A and Buy B).

Then go to currency ‘C’ and finally come back to currency ‘A’

In this process if you end up more ‘A’

then you started with or simply if you

can produce more ‘A’ at the end of

arbitrage then initial investment then

triangular arbitrage is possible.

(43)

1. Which currency should be chosen for initiating 1. Which currency should be chosen for initiating

the arbitrage process.

The currency in which the profit is reported. The currency in which the profit is reported.

2. Which market we should refer for action.

First Create Buy Position First Create Buy Position

(this will be either Synthetic or quoted market) (this will be either Synthetic or quoted market)

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44 44

22. Forex Risk Management 22. Forex Risk Management

i) Forex Risk Management is about management of i) Forex Risk Management is about management of

currency exposure.

Exchange Risk (currency risk):

Adverse movement of exchange rate. Exchange risk is nothing Adverse movement of exchange rate. Exchange risk is nothing but deviation of

but deviation of actual actual Exchange rate with expected Exchange rate with expected exchange rate).

exchange rate).

Exchange Exposure (Currency risk):

Quantification of Risk (For magnitude or extent) Quantification of Risk (For magnitude or extent)

(45)

ii) Types of Risk (Exposure) ii) Types of Risk (Exposure)

Transaction Risk Transaction Risk

This risk arises due to This risk arises due to

Settlement of Settlement of contractual contractual

transactions (assets transactions (assets or liability)

or liability)

denominated FC.

Cash Cash is involved is involved

This is both

This is both Accounting Accounting and Cash gain or and Cash gain or Loss.

Loss.

Translation Risk Translation Risk

This Risk arises due to This Risk arises due to translation of

translation of

contractual transactions contractual transactions (asset and liability) in (asset and liability) in FC. FC.

No No cash cash is involved. is involved.

This involves This involves

Accounting Gain or Loss Accounting Gain or Loss

Economic Risk

Or Strategic Risk, Or Operating Risk, Or Competitive Risk.

This Risk arises due to change in exchange rate and it effects existing contractual transactions (including contingent) and all future

contractual transactions.

Therefore it affects

operating cash flow and

hence the valuation of

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46 46

23. Forex Risk Management tool [Hedging tool]

Internal Tools Internal Tools

Neting

Matching

Leading & Legging

Pricing / Invoicing

External Tools External Tools

Currency Forwards (Forward Contract)

Currency Option

Currency Future

Currency SWAP

MMH (Money Market Hedge)

(47)

MMH (Money Market Hedge) MMH (Money Market Hedge)

Exporter Exporter

Foreign Currency Receivable Foreign Currency Receivable Risk : FC Value Decreases Risk : FC Value Decreases

Balance sheet : Balance sheet :

Liability Asset Liability Asset

---- Foreign ---- Foreign Currency Currency

Importer Importer

Foreign Currency Payable Foreign Currency Payable Risk : FC Value Increases Risk : FC Value Increases

Balance sheet : Balance sheet :

Liability Asset

Foreign Foreign ---- ----

Currency Currency

(48)

48 48

Hedging : Hedging :

 Borrow Borrow Foreign Currency Foreign Currency equivalent

equivalent to the Present to the Present Value of

Value of FC to be received FC to be received . .

 Convert FC to Home Currency Convert FC to Home Currency

 Repay Loan in FC when you Repay Loan in FC when you receive your FC payment.

receive your FC payment.

Hedging : Hedging :

 Borrow Borrow Home Currency Home Currency equivalent

equivalent to the Present to the Present Value of

Value of FC to be payable. FC to be payable .

 Convert Home Currency Convert Home Currency Borrowing to FC.

Borrowing to FC.

 Deposit FC in the Foreign Deposit FC in the Foreign Country.

Country.

 Repay FC when the date of Repay FC when the date of payment become due.

payment become due.

When IRP Theory is not valid than only Forward cover and MMH will

give Different Result.

(49)

Netting Vs Matching Netting Vs Matching

Netting : Netting :

Under this process payable & Under this process payable &

receivables are adjusted and net receivables are adjusted and net balance is settled.

balance is settled.

As a result of this no. of As a result of this no. of

transaction is reduced and hence transaction is reduced and hence there is saving of transaction there is saving of transaction cost.

cost.

Matching : (Hedging Tool)

Under matching process receivables and payables are matched in order to decide the net forex exposure amount.

However transaction are settled separately and hence there is no transaction cost saving.

Bilateral

One-to-one

One party receivable & payables with

Multilateral

One-to-many

One party receivable & payables with

all other parties are adjusted and

(50)

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Note 24: Forward Contract

Note 24: Forward Contract (or Currency Contract) (or Currency Contract)

 Entering into a Forward Contract. Entering into a Forward Contract.

 No Outflow takes place at t=0 except No Outflow takes place at t=0 except Minimum Transaction Charges. Minimum Transaction Charges.

 Rate is agreed today for settlement at Future Date. Rate is agreed today for settlement at Future Date.

Two Types of Forward Contract

Outright Forward Contract

Or Forward Contract Option Forward Contract

1. Three Information is required for calculating Forward rate for both product :

SPOT Rate , SWAP Point and Exchange Margin

2. Hedge Exporter Sell FC today on Forward Basis

Strategy Importer Buy FC today on Forward Basis

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Outright Forward Contract Outright Forward Contract

Contract Period 1 Year Contract Period 1 Year

t=0 t=1 t=0 t=1

Date of Booking Maturity Date or Expiry Date Date of Booking Maturity Date or Expiry Date

Settlement is allowed only at t=1 (that means on particular date Settlement is allowed only at t=1 (that means on particular date

which is always expiry date).

If on last date settlement is not made penalty is imposed this is If on last date settlement is not made penalty is imposed this is

the only drawback to overcome which Option Forward Contract the only drawback to overcome which Option Forward Contract

is made.

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Option Forward Contract Option Forward Contract

Contract Period Contract Period

Option Period Option Period

t=0 t=1 t=2 t=0 t=1 t=2

Date of Booking Expiry Date Date of Booking Expiry Date

1. This Product allow to settle at any day between t=1 and t=2 (that means we have range of dates rather than particular date)

2. Maximum option period as per FEDAI is One month

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Pricing of Forward Contract Pricing of Forward Contract

Forward Contract Option Forward Contract

Spot Rate t=0 t=0 SWAP Point t=0 to t=1 Normal Treatment t=0 to t=1

SWAP Point Option Period t=1 to t=2 Exchange Margin

Foreign Currency Premium Foreign Currency Discount Exporter NOT be Passed Will be Passed

Importer Will be Passed NOT be Passed

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Early Delivery, Extension & Cancellation Early Delivery, Extension & Cancellation

Extention :

Extention : Entire amount of contract is extended for settlement Entire amount of contract is extended for settlement on future date.

on future date.

Rollover :

Rollover : Partial Extention Partial Extention

Part amount is settled on due date and balance is Part amount is settled on due date and balance is extended for settlement for future date. extended for settlement for future date.