Master of Management Studies- MMS

Degree in partial requirement during 3rd

Semester, 2009-11

Submitted to the

IBSAR INSTITUTE OF MANAGEMENT STUDIES,

KARJAT

TITLE OF THE PROJECT

Operations of foreign exchange markets

(modes & mechanism of spot & forward)

 SUBMITTED

By

NAME ROLL

NO

Rachana Bhavsar

Rahul Meher 26

Rinku Yadav 28

Rupesh Chavan 30

Seema Kesarwani

Under the guidance of

Prof. Ashalata

Foreign exchange market

The foreign exchange market (forex, FX, or currency market) is a
worldwide decentralized over-the-counter financial market for the trading of
currencies. Financial centers around the world function as anchors of trading
between a wide range of different types of buyers and sellers around the
clock, with the exception of weekends. The foreign exchange market
determines the relative values of different currencies.

The primary purpose of the foreign exchange market is to assist international

trade and investment, by allowing businesses to convert one currency to
another currency. For example, it permits a US business to import British
goods and pay Pound Sterling, even though the business's income is in US
dollars. It also supports speculation, and facilitates the carry trade, in which
investors borrow low-yielding currencies and lend (invest in) high-yielding
currencies, and which (it has been claimed) may lead to loss of
competitiveness in some countries.

In a typical foreign exchange transaction, a party purchases a quantity of

one currency by paying a quantity of another currency. The modern foreign
exchange market began forming during the 1970s when countries gradually
switched to floating exchange rates from the previous exchange rate regime,
which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of

• its huge trading volume, leading to high liquidity;

• its geographical dispersion;
• its continuous operation: 24 hours a day except weekends, i.e. trading
from 20:15 GMT on Sunday until 22:00 GMT Friday;
• the variety of factors that affect exchange rates;
• the low margins of relative profit compared with other markets of fixed
income; and
• the use of leverage to enhance profit margins with respect to account
size.

The foreign exchange market is the market where one currency is traded for
another. It is the largest market in the world. The foreign exchange market is
an over-the-counter market.

This means that there is no single physical or electronic market place or an

organized exchange with a central trading clearing mechanism, where
traders meet and exchange currencies. The market is actually a worldwide
network of inter-bank traders, consisting of banks, connected by telephone
lines and computers. With direct dialing telephone services anywhere in the
world, foreign exchange markets have become truly global in the sense that
currency transactions now require only single telephone calls and take place
twenty-four hours a day.
Geographically, the markets span all the time zones from New Zealand to
the West Coast of the United States. When it is 3:00 PM in Tokyo, it is 2:00
PM in Hong Kong. When it is 3:00 PM in Hong Kong, it is 1:00 PM in
Singapore. At 3:00 PM in Singapore, it is 12:00 noon in Bahrain. When it is
3:00 PM in Bahrain, it is noon in Frankfurt and Zurich, and 11:00 AM in
London. When it is 3:00 PM in London, it is 10:00 AM in New York. By the
time New York is starting to wind down at 3:00 PM, it is noon in Los Angeles.
By the time it is 3:00 PM in Los Angeles, it is 9:00 AM of the next day in
Sydney. The gap between New York closing and Tokyo opening is about 2.5
hours. Thus, the market functions 24 hours enabling a trader to offset a
position created in one market using another market.

Types of transactions and settlement dates

Settlement of a transaction takes place by transfer of deposits between the

two parties and the day when these transactions are effected is called the
settlement date, or the value date. The countries where the transfers take
place are called settlement locations. The locations of the two banks in the
countries of the two currencies involved in the trade, are dealing locations,
which need not be the same as settlement locations. For e.g. a London bank
can sell Swiss francs against US dollar to a Paris bank. Settlement locations
may be New York and Geneva, while dealing locations are London and Paris.
Depending upon the time elapsed between the transaction date and the
settlement date; FOREX transactions can be categorized into ‘spot’ and
‘forward’ transactions. A third category called ‘swaps’ is a combination of a
spot and a forward transaction.

In a spot transaction, the settlement or value date is two business days

ahead for European currencies, or the Yen traded against the dollar. The two-
day period gives adequate time for the parties to send instructions to debit
and credit the appropriate bank accounts at home and abroad. A complete
requirement under the forex regulations and the exchange rate at which the
transaction takes place is called the spot rate. A forward transaction involves
an agreement today to buy or sell a specified amount of a foreign currency
at a specified future date at a rate agreed upon today. The typical forward
contract is for one month; three months; or six months, with three months
being most common. Forward contracts for longer periods are not as
common because of the great uncertainties involved. However, forward
contract can be renegotiated for one or more periods when they become
due.

The equilibrium forward rate is determined at the intersection of the market

demand and supply forces of forex for future delivery. The demand and
supply of forward forex arise in the course of hedging, from forex speculation
and from covered interest arbitrage.
A swap transaction in the forex market is a combination of a spot and a
forward in the opposite direction. Thus, a bank will buy Euros spot against US
dollar and enter into a forward transaction with the same counter party to
sell Euros against US dollar. A spot 60-day dollar-euro swap will consist of a
spot purchase of dollars against the euro coupled with a 60-day forward sale
of dollar against euro. When both the transactions are forward transactions,
we have a forward-forward swap. Thus, a 1-3 month dollar-sterling swap will
consist of purchase of sterling versus dollars one month forward, coupled
with a sale of sterling versus dollars three months forward. The term “swap”
implies a temporary exchange of one currency for another with an obligation
to reverse it at a specific future date. Forward contracts without an
accompanying spot deal are known as “outright forward contracts” to
distinguish them from swaps.

Exchange rate regimes and the forex market in india

Exchange Rate Calculations

Forex contracts are for “cash” or “ready” delivery which means delivery
same day, “value next day” which means delivery next business day and
“spot” which is two business days ahead. The rates quoted by banks to their
non-bank customers are called “Merchant Rates”. Banks quote a variety of
exchange rates. The so-called “TT” rates are applicable for clean inward or
outward remittances. “TT buying rate” applies when an exporter asks the
bank to collect an export bill and the bank pays the exporter only when it
receives payment from the foreign buyer as well as in cancellation of forward
sale contracts. “TT selling rate” is applicable when the bank sells a foreign
currency draft.

Spot TT Buying Rate

This rate is calculated as: Spot TT Buying Rate = A Base Rate – Exchange
Margin The base rate is the inter-bank rate. The purpose of exchange margin
is to recover the costs involved and provide a profit margin to the bank.

Spot Bill Buying Rate

This rate is calculated as: Spot Bill Buying Rate = Inter-bank forward rate for
a forward tenor equal to transit plus issuance period of the bill of any
exchange margin For a forward bill purchase, the bank will start from the
inter-bank forward rate for a tenor, which includes •Interval between current
time and delivery date of the bill

•Transit period

•Issuance period of the bill and deduct an exchange margin

Spot TT Selling Rate

This rate is calculated as: TT Selling Rate = A Base Rate + Exchange Margin
The base rate is the inter-bank spot selling rate. The exchange margin is
subject to a ceiling specified by the FEDAI (Foreign Exchange Dealers’
Association of India).

Bill Selling Rate

When an importer requests the bank to make a payment to a foreign

supplier against a bill drawn on the importer, the banker has to handle
documents related to the transaction. For this, the bank loads another
margin over the TT selling rate to arrive at the Bill Selling Rate. Thus, Spot
Bill Selling Rate = TT Selling Rate + Exchange Margin

Market participants

Unlike a stock market, the foreign exchange market is divided into levels of
access. At the top is the inter-bank market, which is made up of the largest
commercial banks and securities dealers. Within the inter-bank market,
spreads, which are the difference between the bid and ask prices, are razor
sharp and usually unavailable, and not known to players outside the inner
circle. The difference between the bid and ask prices widens (from 0-1 pip to
1-2 pips for some currencies such as the EUR). This is due to volume. If a
trader can guarantee large numbers of transactions for large amounts, they
can demand a smaller difference between the bid and ask price, which is
referred to as a better spread. The levels of access that make up the foreign
exchange market are determined by the size of the "line" (the amount of
money with which they are trading). The top-tier inter-bank market accounts
for 53% of all transactions. After that there are usually smaller banks,
followed by large multi-national corporations (which need to hedge risk and
pay employees in different countries), large hedge funds, and even some of
the retail FX-metal market makers
Banks

The interbank market caters for both the majority of commercial turnover
and large amounts of speculative trading every day. A large bank may trade
billions of dollars daily. Some of this trading is undertaken on behalf of
customers, but much is conducted by proprietary desks, trading for the
bank's own account. Until recently, foreign exchange brokers did large
amounts of business, facilitating interbank trading and matching anonymous
counterparts for large fees. Today, however, much of this business has
moved on to more efficient electronic systems. The broker squawk box lets
traders listen in on ongoing interbank trading and is heard in most trading
rooms, but turnover is noticeably smaller than just a few years ago

Retail foreign exchange brokers

Retail traders (individuals) constitute a growing segment of this market, both

in size and importance. Currently, they participate indirectly through brokers
or banks. Retail brokers, while largely controlled and regulated in the USA by
the CFTC and NFA have in the past been subjected to periodic foreign
exchange scams. To deal with the issue, the NFA and CFTC began (as of
2009) imposing stricter requirements, particularly in relation to the amount
of Net Capitalization required of its members. As a result many of the
smaller, and perhaps questionable brokers are now gone.

There are two main types of retail FX brokers offering the opportunity for
speculative currency trading: brokers and dealers or market makers. Brokers
serve as an agent of the customer in the broader FX market, by seeking the
best price in the market for a retail order and dealing on behalf of the retail
customer. They charge a commission or mark-up in addition to the price
obtained in the market. Dealers or market makers, by contrast, typically act
as principal in the transaction versus the retail customer, and quote a price
they are willing to deal at—the customer has the choice whether or not to
trade at that price.

In assessing the suitability of an FX trading service, the customer should

consider the ramifications of whether the service provider is acting as
principal or agent. When the service provider acts as agent, the customer is
generally assured of a known cost above the best inter-dealer FX rate. When
the service provider acts as principal, no commission is paid, but the price
offered may not be the best available in the market—since the service
provider is taking the other side of the transaction, a conflict of interest may
occur.
Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and

international payments to private individuals and companies. These are also
known as foreign exchange brokers but are distinct in that they do not offer
speculative trading but currency exchange with payments. I.e., there is
usually a physical delivery of currency to a bank account. Send Money Home
offers an in-depth comparison into the services offered by all the major non-
bank foreign exchange companies.

It is estimated that in the UK, 14% of currency transfers/payments are made

via Foreign Exchange Companies. These companies' selling point is usually
that they will offer better exchange rates or cheaper payments than the
customer's bank. These companies differ from Money Transfer/Remittance
Companies in that they generally offer higher-value services

Money transfer/remittance companies

Money transfer companies/remittance companies perform high-volume low-

value transfers generally by economic migrants back to their home country.
In 2007, the Aite Group estimated that there were $369 billion of remittances
(an increase of 8% on the previous year). The four largest markets (India,
China, Mexico and the Philippines) receive $95 billion. The largest and best
known provider is Western Union with 345,000 agents globally followed by
UAE Exchange & Financial Services Ltd.

Trading characteristics

There is no unified or centrally cleared market for the majority of FX trades,

and there is very little cross-border regulation. Due to the over-the-counter
(OTC) nature of currency markets, there are rather a number of
interconnected marketplaces, where different currencies instruments are
traded. This implies that there is not a single exchange rate but rather a
number of different rates (prices), depending on what bank or market maker
is trading, and where it is. In practice the rates are often very close,
otherwise they could be exploited by arbitrageurs instantaneously. Due to
London's dominance in the market, a particular currency's quoted price is
usually the London market price. A joint venture of the Chicago Mercantile
Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired
but failed to the role of a central market clearing mechanism.

The main trading center is London, but New York, Tokyo, Hong Kong and
Singapore are all important centers as well. Banks throughout the world
participate. Currency trading happens continuously throughout the day; as
the Asian trading session ends, the European session begins, followed by the
North American session and then back to the Asian session, excluding
weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows

as well as by expectations of changes in monetary flows caused by changes
in gross domestic product (GDP) growth, inflation (purchasing power parity
theory), interest rates (interest rate parity, Domestic Fisher effect,
International Fisher effect), budget and trade deficits or surpluses, large
cross-border M&A deals and other macroeconomic conditions. Major news is
released publicly, often on scheduled dates, so many people have access to
the same news at the same time. However, the large banks have an
important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each currency pair thus
constitutes an individual trading product and is traditionally noted XXXYYY or
XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code
of the currencies involved. The first currency (XXX) is the base currency that
is quoted relative to the second currency (YYY), called the counter currency
(or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is
the price of the euro expressed in US dollars, meaning 1 euro = 1.5465
dollars. Historically, the base currency was the stronger currency at the
creation of the pair. However, when the euro was created, the European
Central Bank mandated that it always be the base currency in any pairing.

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes
positive currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the BIS study, the most heavily traded
products were:

• EURUSD: 27%
• USDJPY: 13%
• GBPUSD (also called cable): 12%

and the US currency was involved in 84.39% of transactions, followed by the

euro (39.1%), the yen (19.0%), and sterling (12.9%) (see table). Volume
percentages for all individual currencies should add up to 200%, as each
transaction involves two currencies.

Trading in the euro has grown considerably since the currency's creation in
January 1999, and how long the foreign exchange market will remain dollar-
centered is open to debate. Until recently, trading the euro versus a non-
European currency ZZZ would have usually involved two trades: EURUSD
and USDZZZ. The exception to this is EURJPY, which is an established traded
currency pair in the interbank spot market. As the dollar's value has eroded
during 2008, interest in using the euro as reference currency for prices in
commodities (such as oil), as well as a larger component of foreign reserves
by banks, has increased dramatically. Transactions in the currencies of
commodity-producing countries, such as AUD, NZD, CAD, have also
increased.

Determinants of FX rates

The following theories explain the fluctuations in FX rates in a floating

exchange rate regime (In a fixed exchange rate regime, FX rates are decided
by its government):

(a) International parity conditions: Relative Purchasing Power Parity, interest

rate parity, Domestic Fisher effect, International Fisher effect. Though to
some extent the above theories provide logical explanation for the
fluctuations in exchange rates, yet these theories falter as they are based on
challengeable assumptions [e.g., free flow of goods, services and capital]
which seldom hold true in the real world.
(b) Balance of payments model (see exchange rate): This model, however,
focuses largely on tradable goods and services, ignoring the increasing role
of global capital flows. It failed to provide any explanation for continuous
appreciation of dollar during 1980s and most part of 1990s in face of soaring
US current account deficit.
(c) Asset market model (see exchange rate): views currencies as an
important asset class for constructing investment portfolios. Assets prices
are influenced mostly by people’s willingness to hold the existing quantities
of assets, which in turn depends on their expectations on the future worth of
these assets. The asset market model of exchange rate determination states
that “the exchange rate between two currencies represents the price that
just balances the relative supplies of, and demand for, assets denominated
in those currencies.”

None of the models developed so far succeed to explain FX rates levels and
volatility in the longer time frames. For shorter time frames (less than a few
days) algorithm can be devised to predict prices. Large and small institutions
and professional individual traders have made consistent profits from it. It is
understood from above models that many macroeconomic factors affect the
exchange rates and in the end currency prices are a result of dual forces of
demand and supply. The world's currency markets can be viewed as a huge
melting pot: in a large and ever-changing mix of current events, supply and
demand factors are constantly shifting, and the price of one currency in
relation to another shifts accordingly. No other market encompasses (and
distills) as much of what is going on in the world at any given time as foreign
exchange.

Supply and demand for any given currency, and thus its value, are not
influenced by any single element, but rather by several. These elements
generally fall into three categories: economic factors, political conditions and
market psychology.

Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except in the case of

trades between the US Dollar, Canadian Dollar, Turkish Lira, EURO and
Russian Ruble, which settle the next business day), as opposed to the futures
contracts, which are usually three months. This trade represents a “direct
exchange” between two currencies, has the shortest time frame, involves
cash rather than a contract; and interest is not included in the agreed-upon
transaction.

Forward

One way to deal with the foreign exchange risk is to engage in a forward
transaction. In this transaction, money does not actually change hands until
some agreed upon future date. A buyer and seller agree on an exchange rate
for any date in the future, and the transaction occurs on that date,
regardless of what the market rates are then. The duration of the trade can
be one day, a few days, months or years. Usually the date is decided by both
parties. and forward contract is a negotiated and agreement between two
parties

Swap
The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded
through an exchange.

Future

Foreign currency futures are exchange traded forward transactions with

standard contract sizes and maturity dates — for example, $1000 for next
November at an agreed rate [4],[5]. Futures are standardized and are usually
traded on an exchange created for this purpose. The average contract length
is roughly 3 months. Futures contracts are usually inclusive of any interest
amounts.
Option
A foreign exchange option (commonly shortened to just FX option) is a derivative
where the owner has the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed exchange rate
on a specified date. The FX options market is the deepest, largest and most liquid
market for options of any kind in the world..

Speculation

Controversy about currency speculators and their effect on currency

devaluations and national economies recurs regularly. Nevertheless,
economists including Milton Friedman have argued that speculators
ultimately are a stabilizing influence on the market and perform the
important function of providing a market for hedgers and transferring risk
from those people who don't wish to bear it, to those who do.[18] Other
economists such as Joseph Stiglitz consider this argument to be based more
on politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main
professional speculators. According to some economists, individual traders
could act as "noise traders" and have a more destabilizing role than larger
and better informed actors

Currency speculation is considered a highly suspect activity in many

countries.While investment in traditional financial instruments like bonds or
stocks often is considered to contribute positively to economic growth by
providing capital, currency speculation does not; according to this view, it is
simply gambling that often interferes with economic policy. For example, in
1992, currency speculation forced the Central Bank of Sweden to raise
interest rates for a few days to 500% per annum, and later to devalue the
krona.[21] Former Malaysian Prime Minister Mahathir Mohamad is one well
known proponent of this view. He blamed the devaluation of the Malaysian
ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to

"vigilantes" who simply help "enforce" international agreements and
anticipate the effects of basic economic "laws" in order to profit. In this view,
countries may develop unsustainable financial bubbles or otherwise
mishandle their national economies, and foreign exchange speculators made
the inevitable collapse happen sooner. A relatively quick collapse might even
be preferable to continued economic mishandling, followed by an eventual,
larger, collapse. Mahathir Mohamad and other critics of speculation are
viewed as trying to deflect the blame from themselves for having caused the
unsustainable economic conditions.
Risk aversion in forex
Risk aversion in the forex is a kind of trading behavior exhibited by the foreign
exchange market when a potentially adverse event happens which may affect
market conditions. This behavior is caused when risk averse traders liquidate their
positions in risky assets and shift the funds to less risky assets due to uncertainty.

In the context of the forex market, traders liquidate their positions in various
currencies to take up positions in safe haven currencies, such as the US Dollar.[24]
Sometimes, the choice of a safe haven currency is more of a choice based on
prevailing sentiments rather than one of economic statistics. An example would be
the Financial Crisis of 2008. The value of equities across world fell while the US
Dollar strengthened . This happened despite the strong focus of the crisis in the USA

Forex swap

In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of

identical amounts of one currency for another with two different value dates
(normally spot to forward)

Structure

A forex swap consists of two legs:

• a spot foreign exchange transaction, and

• a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and
therefore offset each other.

It is also common to trade forward-forward, where both transactions are for

(different) forward dates.

Uses

By far and away the most common use of FX swaps is for institutions to fund
their foreign exchange balances.
Once a foreign exchange transaction settles, the holder is left with a positive
(or long) position in one currency, and a negative (or short) position in
another. In order to collect or pay any overnight interest due on these
foreign balances, at the end of every day institutions will close out any
foreign balances and re-institute them for the following day. To do this they
typically use tom-next swaps, buying (selling) a foreign amount settling
tomorrow, and selling (buying) it back settling the day after.

The interest collected or paid every night is referred to as the cost of carry.
As currency traders know roughly how much holding a currency position will
make or cost on a daily basis, specific trades are put on based on this; these
are referred to as carry trades.

Pricing

The relationship between spot and forward is as follows:

where:

• F = forward rate
• S = spot rate
• r1 = simple interest rate of the term currency
• r2 = simple interest rate of the base currency
• T = tenor (calculated according to the appropriate day count
convention)

The forward points or swap points are quoted as the difference between
forward and spot, F - S, and is expressed as the following:

where r1 and r2 are small. Thus, the absolute value of the swap points
increases when the interest rate differential gets larger, and vice versa.

Spot Forex

The spot foreign exchange market has a 2 day delivery date, originally due
to the time it would take to move cash from one bank to another. Most
speculative retail forex trading is done as spot transaction on an online
trading platform.
Forward market

The forward market is the over-the-counter financial market in contracts

for future delivery, so called forward contracts. Forward contracts are
personalized between parties (i.e., delivery time and amount are determined
between seller and customer). The forward market is a general term used to
describe the informal market by which these contracts are entered into.
Standardized forward contracts are called futures contracts and traded on a
futures exchange.It should not be confused with the futures market.

Foreign exchange option

In finance, a foreign exchange option (commonly shortened to just FX

option or currency option) is a derivative financial instrument where the
owner has the right but not the obligation to exchange money denominated
in one currency into another currency at a pre-agreed exchange rate on a
specified date; see Foreign exchange derivative.

The FX options market is the deepest, largest and most liquid market for
options of any kind in the world. Most of the FX option volume is traded OTC
and is lightly regulated, but a fraction is traded on exchanges like the
International Securities Exchange, Philadelphia Stock Exchange, or the
Chicago Mercantile Exchange for options on futures contracts. The global
market for exchange-traded currency options was notionally valued by the
Bank for International Settlements at $158,300 billion in 2005
Example
For example a GBPUSD FX option might be specified by a contract giving the
owner the right but not the obligation to sell £1,000,000 and buy $2,000,000
on December 31. In this case the pre-agreed exchange rate, or strike price,
is 2.0000 USD per GBP (or 0.5000 GBP per USD) and the notionals are
£1,000,000 and $2,000,000.

This type of contract is both a call on dollars and a put on sterling, and is
often called a GBPUSD put by market participants, as it is a put on the
exchange rate; it could equally be called a USDGBP call, but market
convention is quote GBPUSD (USD per GBP).

If the rate is lower than 2.0000 come December 31 (say at 1.9000), meaning
that the dollar is stronger and the pound is weaker, then the option will be
exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it
back in the spot market at 1.9000, making a profit of (2.0000 GBPUSD -
1.9000 GBPUSD)*1,000,000 GBP = 100,000 USD in the process. If they
immediately exchange their profit into GBP this amounts to 100,000/1.9000
= 52,631.58 GBP.