Foreign Exchange

Market

Learning Objectives
Tho present chaptoc with tho foreign oxchangq market and the
particular, it:
Explains tho difitinctivocharact0fi%ticsof foreign oxchango market,
Delineates who actually participatos in tho forgign oxchangc mar%et,
Describes how various typos of transactions toko placo in spot and forward mare.ets.

ne octhe numjorinternnt,ionnl financial function" ig the exchange of currencies.

Currenciesare exchanged or, in other wordg, bought and sold in foreign
exchange market, Chat is eqproadaround the globe. The present chapter thus
tdeals with the various aspect,Hol' Cheforeign exchange market and with the varieties
of transactions taking place therein,
Dnijy Averages of Global Foreign Exchange Turnover
6,000
6,000
4,000
a,ooo
2,000
pa 1,000

April April April

1996 2004 2010
ounce:BIS Triennial Central Bank Survey, Doc. 2010.
111
 DISTINCTIVE FEATURES
The exchange market is a market where foreign currencies
are bought
has to
in VS dollars, it will approach the foreign exchange market to buymake pahnents
rupees. An exporter converts the export proceeds obtained in a Us dollars
into its own currency. These two are the simplest examples of tr foreign currencyfor
exchange market. There are many types of transactionsansactionsinthe
that involve
The exchange market is an over-the-counter market. It
does
a particular place or floor where dealers assemble and transact foreign not
currenq•es
Rather, it consists of trading desks at major agencies dealing in foreign
throughout the world that are connected by telephone, telex, etc. This exchange
transactions are based normally on oral followed by written is
Fore. exchange communication.
It may, however, be mentioned that although the market is global,
met-the- market features in each country are influenced by the localregulatory the
co.-net nar€et. framework. In the UK or the USA, the market relies moreonthe
2- operates round- communication network; while in Frankfurt, Paris and some
other European
3- normalty countries, physical meeting of participants at bourses is also CUStomary.
transact•on of Since foreign exchange dealers are spread all over the globe,the
strong, stable and time of transaction differs from one place to another dependinguponthe
longitude of the place. If a dealer in India transacts at 10 A.M.,it will
just be 4.30 A.M. in London. In order to accommodate dealers fromdifferent
countries, the foreign exchange market has to function round-the-clock.
Again, the currencies transacted in the foreign exchange markets are normally
the strong, stable and convertible currencies which are in great demandbecause
of their strength, stability and convertibility. is
The market has two segments: one is the wholesale segment and the other
the retail segment. The wholesale segment is also known as the inter-bank
market

where the size of transaction is quite large and the operators are the andhigh
commercial

banks, investment banks, the central bank of the country, companies oftransacåß
net-worth individuals. On the contrary, in the retail segment, the volume individuals.
and
is small and the operators are normally the tourists, hotels, shops
etc.
foreign exchange trading centre.
From the viewpoint of the relative ranking of
for 36.7%, of all foreignexchange
banks located in the United Kingdom accounted (6%),Singapore
market turnover, followedby the United States (18%), Japan
(5%), Switzerland (5%), Hong Kong SAR (5%) and Australia (4%).
Source: BIS website

MAJOR PARTICIPANTS banks,

The participants in the foreign exchange market are individuals' firms'

ally
norm
Individuals are
governments, and occasionallythe international agencies. sending a P
the tourists who exchange the currencies, as also migrants
 Chapter 5 Foreign ExchangeMarket 113

incometo their family members living in their home countries. The firms Partcypants are:
are generally the importers and exporters. An exporter prefers to get the indrnduals, ftrn.s.
payments in its own currency or in a strong convertible currency. Importers banks. central
need foreign exchange for making payments for their imports. When banks and
!international
. firms and individuals approach the local branch of a bank, the local organisations.
branch in turn approachesthe foreign exchangedepartment in its regional Functjonaffy. they
office or head office. The latter deals actually in foreign exchange with are hedgers•
other banks on behalf of the customers. arbitrageurs and
speculators

Customer buying Buyer's Major banks Customer setltng

representing Seller's US dollar to get
US S for Indian rupee local bank
Inter-bank market local bank Indian rupee

Foreign exchange broker

Thus there are two tiers in the foreign exchange market: one tier involves the
transactions between ultimate customers and the banks while the other tier consists
of the transactions between banks. Since the purpose of inter-bank transactions is
not only to meet the foreign exchange demand of the ultimate customers but also
to reap gains out of movement in foreign exchangerates, it is the second tier of the
market that accounts for the largest segment of the total foreign exchange transactions
in the market. In some cases, the inter-bank dealings take place directly without
any help from an intermediary, but generally the banks operate through foreign
exchange brokers.
It is either because of the length of transactions passing through two
• tiers of the market or because of the profit motive involved in the Short position
transactions that there is often a gap between the amount of purchase =currency supply of a
and the amount of sale of a currency by banks. If a bank buys less of a < demand for
currency than it contracts to sell, the position is known as a short position currency
iin that currency. The reverse situation, where a bank buys more of a Long position
currencythan it contractsto sell, is known as a long position in that = supply of a
currency. When the quantum of sale and purchase is equal, the equality currency
denotes a square position. > demand for
Though it is a fact that commercial banks dominate, the governments currency
or monetary authorities too participate in the foreign exchange market Square position
= supply of a
but to help stabilise the value of domesticcurrency.The market intervention currency=
{lby the monetary authorities has been discussed in detail in Chapter 3. demand for
International agencies sometimes purchase and sell foreign currencies in currency
the foreign exchangemarket, but that is not a routine affair.
Again, the participants may be grouped also according to their motive and
behaviour in their foreign exchange transactions as follows:
Non-banking entities which simply exchange currencies to honour their
obligations or to get the desired currency.
Non-banking entities such as traders that use the foreign exchange market
for the purpose of hedging their foreign exchange exposure on account of
changes in the exchange rate.
Banks which exchange currencies on behalf of their customers. In such
cases, their profit is limited to the amount of spread between the bid and
the ask rates.
 • Arbitrageurs who change currencies because
markets The vat-yangrates are the source rates
of
• Speculatorswho buy or sell currencies Then thev
exchange rate in a particular They make
of exchangerate in the desired direction-

SPOT MARKET
Features
The foreign exchange market is classifiedeither as spot
marketas or
market It is the timing of actual delivery of foreign
exchange that
between spot market and forFard market transactions- the spot markets
are traded for immediate delivery at a rate existing on
the day of
making book-keeping entries,delivery takes F.
•orking days afterthe
is complete although in the case of Canadian dollar the delivery
Spa ma.r«et takes place the very next •orking day. If a particular
market is cQ
nnesate Saturday and Sunday and iftransaction takes place
on Thursday,
ot the of currency shall take place on Monday. Monday in this case is
c..ercy- the value date or settlernentdate - Sometimes there are short-date
where the time zones permit the delivery of the
currency even earlWE
at a the currency is delivered the same day, it is kno•-n as
the
date. contract. If it is done the next day, the contract is knovn as
the
next-day contract.
In view of the huge amounts involved in the
transactions, there is
actual movement of currencies. Rather, debit and credit entries are in
bank accounts of the sellerand the purchaser. Most
of the markets
transfer of funds electronically
thus saving time and The system
in New York is known as the Clearing
House Inter-bank Payment System (CHIÄ

Currency Arbitrage in Spot Market

With fast development in to
the telecommunication system, rates are
uniform in differentforeign
exchange markets. Nevertheless, inconsistency
at times. The arbitrageurs
take advantage of the inconsistency and garner prÆts
by buying and selling of currencies. rate
in one market
Tney buy a particular currency at cheaper
and sell it at a
higher rate in the other. This is kno«a
currency arbitrage. The process supply
particular currencyin the two influences the demand for, and to
inconsistencyin the value of markets which leads ultimately
Suppose, currencies in two markets.
In New York: $ 19800 10/E; and
Jn London: $ 1.9700 10/E
The arbitrageurs will sell
profit of 1.9810 1.9700 pound in New York and buy pound in London
In the above example, $ 0.0110 per sterling.
particular currency is two currencies are and two markets
There are also examplesbought or sold. This is why it is known as two-pint
three currenciesand threeof three.pointarbitrage or triangular arbitrag
markets are involved.
 • Arbitrageurs who change currencies because of varying rates
different markets. The varying rates are the source of their of exchange
profit. in
• Speculators who buy or sell currencies when they expect movement
exchange rate in a particular direction. They make their profit from

SPOT MARKET
Features
The foreign exchange market is classified either as spot market or as forward
market. It is the timing of actual delivery of foreign exchange that distinguishe
between spot market and forward market transactions. In the spot market,currencies
are traded for immediate delivery at a rate existing on the day of transaction. For
making book-keeping entries, delivery takes two working days after the transaction
is complete although in the case of Canadian dollar the deliveryofcurrencies
takes place the very next working day. If a particular market is closedon
Saturday and Sunday and if transaction takes place on Thursday, delivery
ergnediate
the of currency shall take place on Monday. Monday in this case is knownas
arrency. the value date or settlement date. Sometimes there are short-date contracts
market. where the time zones permit the delivery of the currency even earlier.If
are
at a
the currency is delivered the same day, it is known as the value-same-day
dag. contract. If it is done the next day, the contract is known as the value.
next-day contract.
In view of the huge amounts involved in the transactions, there is seldomany
are madein the
actual movement of currencies. Rather, debit and credit entries
marketseffectthe
bank accounts of the seller and the purchaser. Most of theThe systemexisting
transfer of funds electronically thus saving time and energy. System (CHIPS).
in New York is known as the Clearing House Inter-bank Payment
Currency Arbitrage in Spot Market
are expected tobe
With fast development in the telecommunication system, rates
inconsistencyexists
uniform in different foreign exchange markets. Nevertheless, and garnerprofits
at times. The arbitrageurs take advantage of the inconsistency at cheaperrate
by buying and selling of currencies. They buy a particular currency is as
known
process
in one market and sell it at a higher rate in the other. This and supply of,the
current-y arbitrage. The process influences the demand for, d
to removal
particular currency in the two markets which leads ultimately
inconsistency in the value of currencies in two markets.
Suppose,
New York: $ 1.9800 IO/E; and
J
London making
arbitrageurs pound in New York and buy pound in
two markets where
arbitrage.
Jn the above example, two currencies are involved and point
particular currency is bought or sold, This is why it iBknown as two-
arbitrage
There are also examples of three-potnt arbitrage or triangular
three currencies and three markets are involved.
 Suppose,bid rate in:
New York: $ 1.9810/C,
London: DM 3.1650/$, and
Frankfurt: $ 0.6250/DM
In this case, the arbitrageur will exchange the (10110",
gay $ for if/
Frankfurt to get DM 1,600. He will convert DM 1,600 for pound gLerJ;ngiti
to get 505.63. Finally, he will sell $ 505.63 f'or dollarg in York f/' got
$ 1,001.46.This means that he would gain $ 1.46 per $ through fyri"t'guj$it
arbitrage.
The above example does not, of course, include trangacLion cogt, Jn V/OtJtJ
transaction cost exists that lowers the amount of gain, Suppose, cogt ig
0.5 per cent. When $ 1,000is converted into DM in Frankfurt, the arbitrageur
receive DM 1,600 x (1 0.005) or DM 1,592 and the receåpL of the
currencywill be similarly lower at the other two pointg€It follows, Lhereftyreg,
arbitrage will take place only when the burden of transaction cogt ig
gain from the exchange.

PROBLEM 5.1
If the rate of exchange is:
US $ 2.0000-2.0100/$in New York
US $ 1.9800-1.9810/Cin London
Explain how the arbitrageurs will gain.
Solution
The arbitrageur will sell Pound in New York and with the game dollar, buy
in London. The profit per pound, assuming no trangaction cost, will be:
$ 2.0100 1.9800 = 0.0300.
Note: It is the difference between the selling rate and the buying rat,eg OfPound
in the two markets.

Speculationin Spot Market

Speculationin the spot market occurs when the speculator ant,icipat,ega change in
the value of a currency. Suppose the exchange rate today ig 40/US $. speculator
anticipates this rate to become 41/US $ within the coming three monthg, Under
these circumstances, he will buy US $ 1,000 for 40,000 and hold thig amount, for
three months, although he is not committed to this particular time horizon, When
the target exchangerate is reached, he will sell US $ 1,000 at the new exchange
rate, that is at 41 per dollar and earn a profit of 41,000 40,000 1,000,

PROBLEM 5.2
Presently, the spot rate is 44.50/US $. A speculator feelg that, after a week, Ug
dollar should appreciate to 44.60. What should he do if he hag 10,000 at hig
disposal?
116 InrernationalFinancmlManagement

Solution
The speculator should buy US dollar to-day to get 1(),()()()/44.50US $ 224.72
After a week, he should sell those dollars to get 224.72 x 44.60 10,022
The rofit from speculation will be: 10,022.47 -- 1(),()()0.00 22.47.

FORWARD MARKET
Features
In the forward market, contracts are made to buy and sell currencies for future
delivery, say, after a fortnight, one month, two months and so on. The rate of
exchange for the transaction is agreed upon on the very day the deal is finaliged.
The forward rates with varying maturity are quoted in the newspapers and those
rates form the basis of the contract. Both parties have to abide by the contractat
the exchange rate mentioned therein irrespective of whether the spot rate on the
maturity date resembles the forward rate or not. In other words, no party canback
out of the deal if changes in the future spot rate are not in his or her favour,
The value date in case of a forward contract lies definitely beyondthe
Valuedate/ value date applicable to a spot contract. If it is a one-monthforward
settlement date is
the dayon which contract, the value date will be the date in the next month corresponding
thetraded to the spot value date. Suppose a currency is purchased on 1 August.If
currencyis it is a spot transaction, the currency will be delivered on 3 August.
delivered. But if it is a one-month forward contract, the value date will fallon
3 September. If the value date falls on a holiday, the subsequent date willbe the
value date. In this case, the maturity date will be different from the value date.
Then the maturity date will be the 3rd of September and the value date will be the
4th of September. If the value date does not exist in the calendar, such as the
29 February (if it is not a leap year), the value date will fall on the 28 February.

PROBLEM 5.3
28th and
Three one-month forward deals were contracted respectively on the
29th January 2001. What would be the settlement date?
Solution
28th February
to the
Sometimes the value date is structured to enable one of the partiesperiod'
transaction to have freedom to select a value date within the prescribed on which
This happens when the party does not know in advance the precise date who sellsa
it would be able to deliver the currency, for instance, an exporter
shipment'
foreign currency forward without knowing in advance the precise date of for one
Again, the maturity period of forward contract is normally may not be
Broken-date month, two months, three months and so on but sometimes it
contract a involved.
for the whole month and a fraction of a month may also be example•
apposite
with maturity of forward contract with a maturity period of 35 days is an two whole
not a whole NaturaJJy, in thig cage, the value date falls on a date between
months, Such a contract ig known as a broken-date contract.
 Chapter 5 ForeignExchangeMarket 117

PROBLEM 5.4
What will be the forward rate for 1 month and 10 days (broken date contract) if:
Spot 40.00-40.10/$
I-month forward : 40.50—40.70/$
S-month forward : 40.80—41.10/$
Solution
For one month and 10 days, swap points:
Buying rate: 50 + (SO —50) x 10/60 = 55
Selling rate: 70 + (110 - 70) x 10/60 = 77
The forward rate for one month and 10 days = 40.55—40.77/$.

Arbitrage in Forward Market

In Chapter 4. we discussed that the forward rate differential is approximately
equal to the interest rate differential. Sometimesthere may be marked deviation
between these two differentials. In such cases, covered interest arbitrage begins
and continues till the two differentials become equal. This is arbitrage in a forward
market. The explanation can be found in the preceding chapter. The readers are
suggested to go through it.

Forward Market Hedging

The forward market is used not only by the arbitrageurs but by the hedgers too.
Changes in the exchange rate are a usual phenomenon.Such changes entail some
foreign exchange risk in terms of loss or gain to the traders and other participants
in the foreign exchange market. The risk is reduced or hedged through forward
market transactions. Under the process of hedging, currencies are bought and sold
forward. Forward buying and selling depends upon whether the hedger finds himself
in a long, or a short, position. An export billed in foreign currency creates a long
position for the exporter. On the contrary, an import billed in foreign currency
leads to a short positionfor the importer.
Export Import
Long Position Short Position

Sale of Foreign Currency Purchase of Foreign Currency

Let us first take the long position.An Indian exporter enters into a contract for
mica export to the USA for US $ 1,000. The export proceeds are to be received
within three months. The exporter fears a drop in the value of the US dollar that
may diminish the export earnings in terms of rupee. To avoid this diminution, the
exporter opts for a three-month forward contract and sells forward one thousand
VS dollars. Supposethe spot as well as the forward rate is 40/US $. If the dollar
depreciatesto 39 after three months, the export earnings will diminish to
39 thousand, but since the exporter has already sold forward similar amount in
dollars, the loss due to depreciation of the dollar will be met through the forward
An Indian importer expects appreciation of US dollar while importing goodsfor
VS S 1.000. So he goes for bu$ng S 1,000 one-month forward coinciding the time
of paynent for the import. The spot rate and the forward rate is respectively
40 and 40.50.Surprisingly,the future spot rate (on the maturity) is only
40.30/S,will the forward deal be beneficial?
Solution
After entering into the contracts the importer has to abide by the contract. Hevil
buy S 1,000for 40,500. Had he not gone for the contract, he would have bought
VS dollar only for 40,300, Thus forward contract causes a net loss of e 200•
International Financial Management

contract. By selling dollars, it would fetch 40 thousand that

will be equal
However, the forward deal has disadvantages too. The ad
value of the dollar falls, the exporter will not have to suffevantage is
r any lossthatifth
while the disadvantageis that if the value of the dollar appreciates, ofincome
will not benefit from the appreciation. Moreover, in case a part of the
is not accepted by the importer, the exporter will have to arrange the
for the dollars
In the event of a short position where the Indian importer buys
USA for US $ 1,000, and where the importer fears an appreciation goods fromthe
in thevalueof
the US dollar, the forward deal will involve the buying of dollars. If
appreciates to 41 after the three-month period, the importer will have the dollar
topaft
1,000 more but if he has opted for a forward deal to buy a similar amount in
dollars, he will purchase US $ 1,000 with 40,000 and pay US $ 1,000tothe
exporter and so save himself from the 1,000 loss. Here again, if the dollarappreciates,
the importer eliminates the loss, but if it depreciates, the importer doesnotbenefit
from the depreciation.

PROBLEM 5.5
An Indian importer expects appreciation of US dollar while importinggoodsfor
US $ 1,000. So he goes for buying $ 1,000 one-month forward coincidingthetime
of payment for the import. The spot rate and the forward rate is respectively
40 and 40.50. Surprisingly, the future spot rate (on the maturity)is only
40.30/$,will the forward deal be beneficial?
Solution
Hewill
After entering into the contract, the importer has to abide by the contract.bought
buy $ 1,000 for 40,500. Had he not gone for the contract, he wouldhave 200,
US dollar only for 40,300. Thus forward contract causes a net loss of?
In these two examples of forward deals, we have assumed thatmay the spotrate
beeither
and the forwardrate are equal but this is not always true. There 40/US$,and
a forward premium or a forward discount. Suppose the spot rate is spot rate after
the three-month forward rate is 39.50/US $. In this case, if theIndianexporter
the expiry of three months turns out to be 39/US $, and if the will be ableto
he
has a forward contract for selling the same amount in dollars, forward deal.Had
diminish the loss by 500 because he will get 39,500 from the 39,000
only
recewed depreciates
dollar
following the depreciation of the US dollar. If however, the US it of
only to 39.80, the forward deal will cause a loss for 300 becausethe absence
only 39,500 instead of 39,800that would have been received in
a forward deal. onlybythe
not discount
The advantage or disadvantage of the forward deal is reapedforwardexchange
exporter but also by the importer. In case of a short position, a foreign
is favourable to the hedger because it enables the hedger to obtain premiurl)
forward
at a rate lower than the current spot rate. On the contrary, a
 q that

Chnptcr 5 Foreign ExchangeMarket 119

costlier. However,the
unfavourablebecause it makes the forward foreign currencyupon the difference between
depends
exact magnitude of loss or gain to the importer we have just discussed, If the
the forwardrate and the future spot rate that rate is 39.80[US$, the Indian
forwardrate is 39.50/US$ and if the future spot get US $ 1,000 only for 39,500
importerwill be able to save 300 because he will
had to pay 39,800 for one
under the forward contract; whereas he would have But if the future spot rate
thousanddollars, had there been no forward contract.
a loss of 500 under the
comesdownto 39/US $, the importer will have to face whether it concerns a long
forward contract. Thus hedging in a forward market, trend in the exchange
positionor a short position, is a double-edgedsword and if the
rate movementis not accordingto expectations, it can result in a loss.
,OOO

ere Limitationsto forward and futures hedges

ates,
the
imp
In view of the above discussion, a hedger's decision to go for a forward/futures
Orte
hedge depends on two factors. They are:
(a) Differencebetween future spot rate and the forward rate
(b) Expected transaction costs
Hedgingin a forward market will be beneficialfor an importer only when the
dollar while impoflng future spot rate of the currency in which he/she has to make the payments is
higher than the forward rate. Alternatively, it will be beneficial for an exporter
1011th forward coinciding
when the future spot rate of the currencyin which it has to receive the export
the forward rateis proceedsis lower than the forward rate. If these conditions are not met, the hedging
rate (on the matlfr in the forward market will not be helpful.
The above discussion of the forward market hedging is based on the assumption
that there is no transaction cost. But in the real world, the transaction cost exists.
Thus, the forward market hedge is lucrative only till the transaction cost is lower
than the total gains from hedging.
by the
s to abide
he wouldb:t:,
le contract, logdt Speculation in Forward Market
net
causes a
ract In addition to the arbitrageur or the hedger, speculators are also very active in
that forward market operations. Their purpose is not to reduce the risk but to reap profits
have
assumed
from the changes in the exchange rates. The source of profit to them being the
true• differencebetweenthe forward rate and the future spot rate, they are not very
always
spot
the
case,
Supposea speculator sells US $ 1,000 three-month forward at the rate of
this 40.50[US$. If, on maturity, the US dollar depreciates to 40, the speculator will
get 40,500 under the forward contract. At the same time, he will exchange
40,500at the then future spot rate of 40/1-JS$ and will get US $ 1,012.50.Both
these activities—the selling and the purchasing of US dollars will be simultaneous.
39,50 Thus without making any investment, the speculator will make a profit of
US $ 12.50through the forward market deal. This is an example of speculation in
the forward market. Offsettingcontract
Forward market speculation cannot be extended beyond the maturity is a reverse
date of the forward contract. However,if the speculator wants to close contract
following
out the speculation operation prior to the maturity, say by one month, he the original
contract.
120 International Financial Management

contract. In other words, if he has already entered

for selling US dollars, he would have to •
may buy an offsetting
three-month forward contract
forward contract for buying US dollars. The profit or loss would optfor
two-month involvedin the two forward contracts. naturally
depend upon the exchange rate
simple example. Many other examples
The aforementionedis a very forward market. In fact, the type of canb
cited about speculationin the of the future spot rate. speculation
dependsupon the expectedmovement

PROBLEM 5.6
Spot rate is 44.50/$.Three-monthforward rate is 44.3()/$.Speculator's
estimate is that the future spot rate after three months shouldbe
for a forward contract if he has
44.10/$.Will the speculator go $ 10,000at his
disposal?
Solution
The speculatorwill sell dollar in the forward market to get 4,43,000. Immediately
after getting rupee, he will convert rupee into dollars in the open market to get
$ 10,045.35.Profit will be: $ 10,045.35- 10,000 = $ 45.35.

Swapping of Forward Contracts

The purpose of swap in the forward market is to reap profits. There are two kinds
of swap. One is known as an option forward while the other is known as a forward-
forward swap. In the former, the basis of swap is the difference between the spot
rate and the forwardrate and in the latter, it is the differencebetweenthe two
forward rates.
Contractsfor optionforward take place normally between a bank and its customers.
Two delivery dates are mentioned between which delivery of currencies is made. One
of the two dates is the date on which the deal is finalised. The other is a future date
that may be the date of maturity. Similarly, two exchange rates are mentioned.One
is the spot rate prevailing on the date when the deal is finalised and the other is the
forward rate. The bank exchangesthe currency with the customer on any date
between the two dates at one of the two rates which is favourable for it. SupPOSe
there is a contractfor an exchangebetween rupees
are 1 January and 1 April. The spot and dollars and the twodates
rate on 1 January is 40/US $ and the three-
this
month forward rate is 39.50[US$.
This shows depreciation Ofthe dollar and in
case, if the customersells rupees at thespot
rate. If the customerbuys rupees,to the bank, the latter will buy them
the bank will sell them at the forwardrate•and
Forward-forward In caseof a forward-forward swap, chosen
profit emerges from the future dates are
two
swap means difference forward rates. Suppos.e
buyingandsetrtngthe trend of the quote shows between the two next
a currencyforwardmonths followedby appreciation in the dollar for the •
depending upon spot rate and depreciation during three months
the forward rates would the following
rates for
be:
diffeftng Spot rate:
maturities. 40-40.20/Us $
6-month forward rate:
9-month forward rate: 41.50—41.80/US $
40.25—40.75/US$
 In this case, it would be beneficialfor the customer to sell the dollar 6-month
forwardand buy the dollar 9-month forward. If it involves US $ 1,000,the profit
will amount to: (e 41.50 40.75) x 1,000 or 750.

PROBLEM 5.7
The followingare the rates of forward market deals of different maturity. Explain
what should be the process of forward-forwardswap.
One-monthforward rate: 40.50/US $
Two-month forward rate: 41.10/US $
Three-month forward rate: 40.80[US $
Solution
get (a) Buy US $ I-month forward
In the
(b) Sell US $ 2-month forward
o (c) Buy US $ 3-month forward.
45.35.

SUMMARY
The foreign exchange market is a market where foreign currencies are bought
rofits. There and sold. It is an over-the-countermarket. It operates round-the-clock.
her is knowncut The participants are the real customers,such as the individuals and the
ifference betTE2 firms who have to actually exchange one currency for another. The commercial
lifference betwæ: banks are the most important participants, although the monetary authorities
of the country also participate for the purpose of stabilising the exchange
andiÉ rates. The international agencies are also occasionalparticipants whose aim
a bank
currencies
is either hedging or arbitraging or speculationor restoration of exchange
Of rate stability.
Other is
The
The market may have spot as well as forward transactions. The former
rates are involvesimmediate delivery of currencies, while the latter involves delivery
alised at a future date.
he c Normally, the rates should not vary among different markets, but when
they vary, arbitrage takes place conferring profits upon arbitrageurs and
ultimately making the rates uniform among different markets.
40 The forward market is normally used for hedging risk but sometimes it is
11
oftbe used by arbitrageurs who take advantages of differences in interest rates
among different markets. Speculators too use the forward market for making
profits. Forward options and forward-forward swap are common tools for
making profits in the foreign exchange market.

doll

boewißg
22 Intemational Financial Management

STUDY TOPIC
Indian Foreign Exchange Market

STRUCTURE OF THE MARKET

big cities, is a three-tier
The Indian foreign exchange market, broadly concentrated in market.
The first tier covers the transactions between the Reserve Bank and the authoriseddealers
(ADS). As per the Foreign Exchange Regulation Act, now FEMA, the responsibilityand authority
of foreignexchange administrationis vested with the RBI. It is the apex body in this areaand
for its own convenience, has delegated its responsibility of foreign exchange transactionfunctions
to ADS, primarily the scheduled commercial banks. They have formed the Foreign Exchange
Dealers' Association of India which frames rules regarding the conduct of business, coordinates
with the RBI in the properadministrationof foreign exchange control and acts as a clearing
house for informationamong ADS. Besides the commercial banks, there are the money-changers
operating on the periphery.They are well-established firms and hotels doing this business under
licence from the RBI. In the first tier of the market, the RBI buys and sells foreign currencyfrom
and to ADS according to the exchange control regulations in force from time to time. Priorto the
introductionof the Liberalised Exchange Rate Management System, ADS had to sell foreign
currency acquired by them from the primary market at rates administered by the RBI. The latter
too sold pounds sterling or US dollars, spot as well as forward, to ADS to cover the latter's
primary market requirements. But with the unified exchange rate system, the RBI now intervenes
in the marketto stabilisethe value of the rupee.
The second tier of the market is the inter-bank market where ADS transact business among
themselves. They normally do their business within the country, but they can transact business
also with overseas banks in order to cover their own position. Though they can do it independently,
they do it normally through a recognised broker. The brokers are not allowed to executeany
deals on their own account or for the purpose of jobbing. Within the country, the inter-ba nk
transactions can be both spot and forward.There may be swap transactions. Any permitted
currency can be used. But while dealing with the overseas ADS, because the Indianmarket
lacks depth in other currencies; the Indian banks can deal mainly in two currencies, viz. theUS
dollar and the pound sterling. Dealings with overseas banks or overseas branches mustcover
only genuine transactions relating to a customer in India or for the purpose of adjustingor
squaring the bank's own position. Forward trading with overseas banks is also allowedif it is
done for the above two purposes, that is for covering genuine transactions or for squaringthe
currency position,and does not exceed a period of six months. In case the importis madeon
deferred payment terms and the period exceeds six months, permission has to be obtained from
the RBI.
Cancellation of forwardcontracts is allowed in India, although it has to be referredto the
RBI. Previously, the banks used to get the forward transactions covered with the RBi, butsince in
1994--95the RBI has stopped giving this cover and has permittedthe banks to tradefreely
the forward market. Cancellation of a forward contract involves entering into a reverse transacti0n
at
at the going rate. Suppose, US $ 1,000 was bought forward on 1 February for three months on
40/1JS S. On 1 March, it is cancelled involving selling the US dollar at the rate prevalent
dollar
this day. If the exchange rate on 1 March is 39.50/US $, there will be a loss of 500 (thevalue
sold for 39.5 rninus dollar boughtat 40.00). The loss is borne by the customer.If the
RecentlY'
of the US dollar is greater on the cancellation day, the customer shall reap the profit.
RBI has allowed ADS to re-bookcancelled forwardcontract falling due within one year•
 Chnpter 5 Foreign ExchangeMarket 123
The third tier of the foreign exchange market is
represented by the primary market where
ADS transact in foreign currency with the customers. The
very existence of this tier is the
outcome of the legal provision that all foreign exchange transactions of the Indian
residents
must take place through ADS. The tourists exchange currency, exporters
and importersexchange
currency, and all these transactions come under the primary market.

TYPES OF TRANSACTION
There are cases where delivery of foreign exchange takes place the same day. Such transactions
are known as ready transactions. When the actual delivery takes place the next day, the transactions
and are known as the value next day transactions.There are also spot transactionswhere the actual
acts
delivery takes place within two business days. Forward transactions, as per the regulationsin
India, cannot normally exceed six months. Truly speaking, the forward contracts between banks
and the non-bank customers are of the option-forwardtype. The general rule for the quotation
s
foreign
of option rate is to quote the worst of the rates prevailingat the beginning and at the end of
me to the option period. If a currency is purchased when forward premium exists, the premium prevailing
time.
s had
at the beginning of the option period will be used, and when a currency is sold forward, the
tow premiumprevailing at the end of the period will be taken into account.
by the
Forward premium/discount is governed not entirely by interest rates because of the existence
s to cover of exchange control, at least to some extent. Nevertheless, call money market rates influence
he RBI largely the forward premia/discount.Moreover,they are influenced also by the supply of and
demand for forward dollars on account of exporter' and importers'involvement.In the Indian
foreignexchange market, third currency forward is also available where a firm may have forward
Isact business
deal betweenthe currency of exposure and any other currency.
can ADS are allowed to hedge their exchange risk either through cross-currency options or
an do itind through foreign currency-rupee options for long-term exposure in foreign currency. Banks with
owed to minimumcapital to risk-adjusted asset ratio of 9 per cent are allowed to offer foreign currency
)untry, the
rupeeoptionson a back-to-back basis since July 2003. ADS with adequate risk management
I systems are allowed to run an option book after obtainingone-time approval from RBI. Option
)tions, Any
writingby customers is not permitted.
the
The options market has been an over-the-countermarket. It is only since October 2010 that
jrrencies, the exchange-traded options have been started at the National Stock Exchange.
19
branches Besides options, the currency futures market was started at NSE, BSE and MCX during the
second half of 2008. The readers may have a glimpse of options and futures market in India
in the following two chapters.
also

is
Exchange Rates
e beobt3L4
In India, since August 1993 direct quote is used where the rupee value is shown per unit of
foreigncurrency. Buying and selling rates are quoted separately. There are differentrates prevailing
in the Indian market. One is known as the merchant rate when ADS quote rates to their customers
maintaininga cushion over and above the inter-bank rate in order to hedge the risk arising from
changes in the exchange rate since whenever ADS quote rates to their customers, they
are based on the previous day's London market quotation.There is always possibility for a
variationbetweenthe closing rates of the previous day and the opening rates of today in London
market.The cushion is, therefore, deducted from the buying rate and added to the selling rate
in the direct method of the quote. The merchant rate is the rate that emerges out of such
adjustments.

nift
 transfer (TT) rate. This is normally applicable to
The other is the telegraphic inward
bank draft issued by a bank based in New York on remittances.
Suppose, an exportergets a
Bombay-based bank, on the presentation of draft by the Indian a bank
in Bombay.The fixed after deducting exchange exporter, buy
TT buying rate which is
the US dollar at the bid rate. If the
margin on
account
the base rate or the inter-bank inter-bank
of bank charges from bid rateis
1.0 per cent, the TT buying rate would be 40 40/
US $ and the exchange margin is x (1 0.01)
or 39.60.
bank is selling a foreign currency
The TT selling rate is applicablewhen the draft.Suppose
importer asks its banker in Bombay to issue a draft in favour of a bank
an Indian in NewYork.
The Bombay-based bank will charge rupees from the customer at the TT selling rate.This
rate is equal to the inter-bank selling rate plus the exchange margin. If the inter-bankselling
rate is 40.20/US $ and exchange margin is 1.0 per cent, TT selling rate will be
40.20 x (1 + 0.01) or 40.60. However,the spread between the spot merchantrateandthe
spotTT rate should not exceed 2.0 per cent in case of British pound, Euro and Japaneseyen,
and 1.0 per cent in case of the US dollar.
Yet again, there are bill buying rates and bill selling rates. Suppose an Indian exporter
draws a bill on a New York-based importer.The AD in India will buy the bill and collectthe
amountfrom the US-based importer.This involves an additional margin; and so, this ratewill
be equal to the TT buying rate minus the additional margin. When an AD in India has to collect
funds from an Indian importerand to transmit the funds to a US-based exporter,the rate
charged by the AD would be known as the bill selling rate that would be equal to the sumof
TT selling rate and the additionalexchange margin. Besides the above, there are traveller's
cheque rate and CCY rate, the computationof which is the same as TT rates, and bills buying
and selling rates.
The normalpracticeis to quotethe rates in inter-banktransactions up to 4 decimalpoints,
but in case of transactionsbetweena bank and the customer, the rate is quoted to 2 decimal
points.

Foreign Exchange Clearing

As regards clearing and settlementof inter-bank dollar-rupee transactions, Clearing Corporation
of India Limited (CCIL) offers a multilateralnetting mechanism. As a central counterparty guaranteeing
trade settlement,it interposesas a buyer in a defined trade through a process called novation'
therebygiving rise to two contractsfrom the single original contract between the two parties•
Live operationsin this respect began in November
2002. While the US dollar leg of transaction
is settled throughCClL's account with its
settlementagent in the USA, the rupee leg is settled
through the member banks' current account substantial
maintained with the RBI. This way banks get
cost benefit and time benefit concerning
clearing and settlement Of rUpee-dollar transactions,
On 7 August 2003 CCIL launched trading platform
(FX-CLEAR) to settle the foreign its foreign exchange
exchange transactions more smoothly.
Besides FX-CLEAR, there is also one offers
more platformwhich is known as FX-Direct that
real time order matching and
negotiationmodes for trading. Again, Reuters D2 and Reuters
MarketData System bring
unprecedentedspeed to data operations.
In December2009, CCIL
launched clearing and settlement for foreign exchange forward
trade from the trade date in response to in the
product. counterparty credit and settlement risks inherent
 Chapter 5 Foreign Exchange Market

QUESTIONS
1. Comment on the structure of Indian
foreign exchange market.

2. Explain the different types of transactions.

3. What is a forward contract? Can it be
cancelled?
Omer
4. In what way the merchant rate is different from
the T.T. rate?
matinthe
5. How are the transactions settled and cleared?
cent,

pound, CASE STUDY

ites. FOREIGN EXCHANGE TRANSACTIONS TURNOVER IN INDIAN MARKET
Suppose
Will a foreign currency and
buy
the The Indian market involves transactions between Indian rupee and
as well as both
inal bill
margin; and between different foreign currencies. They are both merchant and inter-bank
the month.
[hen an spot and forward. The following table shows the turnover for the whole of
AD in
) a
US-based Turnover in the Indian Foreign Exchange Market during July 2011
(US $ million)
at Would
be equal Inter-bank
Position Merchant
the above, FCY/INR FCY/FCY
there Date FCY/INR FCY/FCY
me as TT Forward Spot Swap Forward Spot Swap Forward
rates, Spot Forward Forward Spot Fonvard
Cancellation Cancellation
4 5 6 7 8 9 10 11 12
1 2 3
Isactions up to 4 Purchases
629 463 6,254 3,334 886 3,704 1,536 151
the rate is quotedt2 July 1, 2011 1,071 967 115
540 516 455 6,006 6,778 890 2,835 1 ,820 177
July 4, 2011 1 ,536 1 ,786 191
597 420 212 352 7,265 7,823 2,028 3,515 5,646 244
July 5, 2011 2,354 1,924
849 319 546 574 8,541 8,380 1,234 4,472 3,112 273
July 6, 2011 2,739 1,525
486 201 464 438 5,980 7,108 1 ,370 3,439 1,820 297
July 7, 2011 2,391 1,316
July 8, 2011 2,250 1,407 811 237 687 641 6,883 5,847 1,422 4,867 1,616 198
569 135 1,709 1 ,835 6,247 6,866 1,303 6,176 2,535 631
July 11, 2011 2,264 1 ,265
Clearing 981 442 1,175 1,199 8,037 8,690 1 ,700 6,494 3,114 337
July 12, 2011 2,199 1 ,847
356 349 1 ,050 1,041 6,935 6,847 1,119 4,729 2,520 372
counterpart/ July 13, 2011 1,872 1,232
central July 14, 2011 2,317 1,514 425 213 1 ,299 1,307 6,755 6,607 1 ,361 4,963 2,777 791

ough a process July 15, 2011 2,452 1,030 791 156 404 388 8,310 6,894 2,029 2,952 1,389
I ,446
147
the July 18, 2011 2,449 914 194 692 696 7,076 6,094 I ,479 3,952 182
between
ntract July 19, 2011 1,955 733 514 232 1,011 919 5,286 6,329 1,150 5,285 1,412 233
legof 194
dollar July 20, 2011 2,490 1 ,961 573 204 968 898 6,659 7,265 1,659 4,428 1,437
the US
July 21, 2011 2,021 1,558 716 225 897 867 6,499 6,329 981 6,197 2,479 253
e USA, July 22, 2011 2,760 2,068 154 885 806 6,668 6,675 1 ,597 4,759 1,655 343
way July 25, 2011 2,673 1,658 382 337 730 726 4,678 4,585 201 4,527 3,070 92
51.This
rupeedollar July 26, 2011 2,534 3,204 803 272 737 893 6,389 7,150 679 4,109 2,672 141

nt of July 27, 2011 4,558 4,060 2,612 192 785 772 9,914 7,618 1,011 4,773 3,568 228
exchange July 28, 2011 3,421 2,919 1,315 321 826 699 6,699 6,386 701 4,600 2,951 451
July 29, 2011 3,099 2,164 1,960 260 1,011 1 ,346 8,124 8,890 1,781 5,193 4,056 463
Sales
July 1, 2011 871 2,120 556 113 522 5,991 3,039 1,149 3,623 1 ,527 176
July 4, 2011 1,020 2,372 627 196 511 450 6,693 6,705 1 ,219 2,785 1,746 169
"y 5, 2011 3,564 1 ,799 635 418 183 395 7,441 8, 183 1 ,998 3,486 5,638 214
July 6, 2011 2,451 2,081 842 314 552 555 9,038 8,178 1,328 4 ,458 3,209 277
tions.
July 7, 2011 1,901 1 ,351 463 203 487 450 6,449 7,177 1 ,603 3,392 1 ,886 294
(Contd.)
126 International Financial Management

Turnover in the Indian Foreign Exchange Market during July

2011
Merchant (Us $
FCY/FCY Inter-bank
Oate FCY/INR FCY/INR
Spot Forward Forward Spot Forward Forward
FCY/FCY
spot
Swap
1 2 3 4 5 6 7 Forward
8 9
10
Jury S. 2011 2,528 1,553 700 215 691 6,922 5,716 11
1 ,611 12
4,832
July 11, 2011 2,486 1,284 599 132 1,807 1,772 6,195 6,675 1,640
1,189 20a
6,154
July 12, 2011 2,366 1,890 938 442 1,184 1,298 8,532 8,509 1 ,465 2,492
6,632 385
1,256 445 357 1,016 1,086 7,047 3,147
July 13, 2011 2,365 7,501 1,156 4,639 335
535 223 1,212 1,311 7,279 2,464
July 14, 2011 2,238 1 ,466 6,465 1 ,367 4,928
1 ,566 157 419 338 7,823 2,869
Jury 15, 2011 2,738 7,641 1,913 2,903 718
407 197 661 754 7,243 1,401
Jury 18, 2011 2,553 989 6,771 1,560 6,986
156
1,430
July 19, 2011 1,858 1,117 419 232 988 916 5,481 7,079 1,276 183
5,210 1,416
July 20, 2011 2,471 1,419 832 206 981 864 6,714 7,500 2,085 209
4,338 1 ,676
772 226 908 827 5,696 6,247 155
July 21, 2011 2,366 1,191 856 6,162 2,565
779 153 837 815 6,852 7,220 243
July 22, 2011 2,342 1,860 1,724 4,669 1,781 287
July 25, 2011 2,789 1,280 818 337 719 685 4,783 4,796 424 4,300 3,033 77
July 26, 2011 2,434 2,391 1,480 277 764 861 6,611 6,417 755 3,632 2,949 126
July 27, 2011 3,468 5,087 2,639 216 781 745 10,714 7,693 792 4,003 3,665 258
July 28, 2011 3,021 2,106 2,217 323 821 649 6,528 6,597 787 4,471 3,087 427
July 29, 2011 3,186 1.856 2,032 250 1 ,074 1 ,303 8,076 8,864 1 ,802 5,001 3,836 511

INR : Indian Rupee FCY: ForeignCurrency

Note: Data relate to sales and purchases of foreign exchange on account of merchant and inter-bank transactions. Data are provisional.

QUESTIONS
1. Do spot contracts dominate the scene? Give possible reasons for that.
2. Does cancellation of the forward contracts figure large? If so, why?
of inter-bank
3. Why do contracts between two foreign currencies figure large in case
dealings?
4. Analyse the figures presented in the table.

EVIEW QUESTIONS

Objective-Type Questions

exchange rate risk. [3

(a) The purpose of arbitrage is to minimise/eliminate
currency is actually
(b) Value date/settlement date is the date on which
delivered.
-(c) In practice, exchange rate differs among markets. C]
s after a week. are to
they
(e) Exporters are in short position in respect of the currency
receive.
 Chapter 5 Foreign ExchangeMarket 127

2. Choose the correct answer:

922 (a) Swap quote in forward market:
(i) makes use of decimal
(ii) does not make use of decimals
(iii) none of these
7,823 6'465
(b) Currency arbitrage between two markets is encouraged because
(i) the exchangerates in two markets are different
(ii) the exchangerates in two markets are the same
(iii) none of these
(c) Speculatorswill buy a foreign currency through a forward market deal
if:
4,783
4,796
1,724
(i) future spot rate of that currency is expected to be lower than the
424
forward rate
10,714
7,693 (ii) future spot rate of that currency is expected to be higher than the
6,528
6,597
792
forward rate
8,076
8,864
1,802
(iii) if future spot rate is expectedto be equal to the forward rate

and interbank
transactnten Short-Answer Questions
1. Distinguish between:
(a) option forward swap and forward-forward swap
(b) long and short positions in respect of a currency
;ible reasons forthat (c) two-point arbitrage and triangular arbitrage
arge? If so, why? 2. What do you mean by over-the-countermarket?
figure large in 3. What is broken-date contract in a forward market?

Long-Answer Questions
1. Who are the participants in foreign exchange market?
2. Explain with suitable examples hedging in a forward market.
3. How is speculation done in forward market?

Numerical Problems
1. Three one-monthforward deals were contracted respectively on the 27th,
28th and 29th January 2001. What would be the settlement date?
2. The followingsare the rates of forward market deals of different maturity.
Explain what should be the process of forward-forward swap.
which
One-month forward rate: 40.50/US $
Two-month forward rate: 41.10/US $
Three-month forward rate: 40.80/US $
128 Intemational Financial Management

S. If the rate of exchange is:

US $ 2.0000-2.0100/$in New York
VS $ 1.9800-1.9810/$in London
Explainhowthe arbitrageurs will gain.
4. An Indianimporter expects appreciation of US dollar while
for US $ 1,000.so he goes for buying $ 1,000 one-month i
the timeofpaymentforthe import. The spot forward
rate and the coinciding
respectively,40 and 40.50per US dollar. forward rate
rate (onmaturity)is only 40.30/$.Will Surprisingly,
the forward dealthe future spot
be beneficial?
SUGGESTED FURTHER
READING
Bhardwaj,H.P.(1994),
Foreign Exchange Handbook,
New Delhi,
Waimsley,
J. (1983),Foreign Wheeler Publishing
ExchangeHandbook:
A user's guide,
New York,
John