Forex Management Lecture Notes

what is treasury and forex management and what is forex reserve management and what is money management in forex trading, what is risk management in forex trading
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PONDICHERRY UNIVERSITY (A Central University) DIRECTORATE OF DISTANCE EDUCATION Forex Management and Currency Derivatives Paper Code : MBIB 4005 MBA - INTERNATIONAL BUSINESS IV - SemesterAuthors • Prof. S. Prakash • Prof. rajesh Chaudhury • Prof. Udhaya Kumar • Prof. Kesawaram • Prof. Pramod Kumar All Rights Reserved For Private Circulation Only TABLE OF CONTENTS UNIT LESSON TITLE PAgE NO. Foreign Exchange Market 1.1 3 Transaction in Interbank Market I 1.2 12 Transaction in Foreign Exchange Market 1.3 22 Exchange Rates 2.1 39 Determinant of Exchange Rates II 2.2 56 Exchange Controls 2.3 67 Foreign Exchange Transactions 3.1 77 III Merchant Rates and Interbank Transactions 3.2 95 Forex Management and Currency Derivatives IV 4.1 127 Currency Derivatives 5.1 165 Currency Options 5.2 177 V SWAPS 5.3 186 The Interest Rate SWAP 5.4 198MBA (International Business) - IV Semester Paper Code: MBIB 4005 Paper – XX Forex Management and Currency Derivatives Objectives ➢ To enable the students to have an in-depth understanding of the principles and procedures relating to Forex markets and different types of currency derivatives and its operations. Unit - I The Foreign Exchange Market - Organisation – Spot Vs Forward Markets – Bid and Ask rates – Interbank Quotations – International Market Quotations – Cross Rates – Merchant Rates – FEDAI Regulations – Role of RBI Unit - II Exchange Rates - Exchange rate systems – Gold Standard – Bretton Woods – Fixed Vs Floating Exchange Rate systems – Determinants of Exchange Rates – Exchange Controls. Unit - III Foreign Exchange Transactions – Purchase and Sale transactions – Spot Vs Forward transactions – Forward Margins – Interbank Deals – Cover deals – Trading – Swap deals – Arbitrage Operations – Factors determining Forward margins – Different types of Foreign exchange exposers. Unit - IV Ready and Forward Exchange Rates – Principle types of Ready Merchant rates – Ready rates based on cross rates – Forward exchange contracts – Execution of Forward 1contracts – cancellation and Extensions - Dealing position – Exchange position – Cash position. Unit - V Currency Derivatives – Currency Forwards – Currency Futures – Currency Options – Exchange traded transactions – Financial Swaps – Forward Rate agreements – Interest Rate Options. Reference 1. Alan C Shapiro, MULTINATIONAL FINANCIAL MANAGEMENT, Prentice Hall, New Delhi 2. Francis Cherunilam, INTERNATIONAL ECONOMICS, Tata Mc Graw Hill Pub Ltd, New Delhi 3. Ian H Giddy, GLOBAL FINANCIAL MARKETS, AITBS Publishers and Distributors, New Delhi 4. C Jeevanandam, FOREIGN EXCHANGE: PRACTICE, CONCEPTS, Sultan Chand & Sons, New Delhi 5. Vijayabhaskar P and Mahapatra B., DERIVATIVES SIMPLIFIED, RESPOSE BOOKS, Sage Publications, New Delhi 2UNIT – I Learning Objectives After reading this unit you should be able to: ➢ Understand meaning and features of Foreign Exchange Market ➢ Understand the functions of Foreign Exchange Market ➢ Familiarize with the quotations in Foreign Exchange Market ➢ Familiarize with the process of transaction in Foreign Exchange Market Unit Structure Lesson 1.1 - Foreign Exchange Market Lesson 1.2 - Transaction in Interbank Market Lesson 1.3 - Transaction in Foreign Exchange Market Lesson 1.1 - Foreign Exchange Markets Introduction A Foreign exchange market is a market in which currencies are bought and sold. It is to be distinguished from a financial market where currencies are borrowed and lent. General Features Foreign exchange market is described as an OTC (Over the counter) market as there is no physical place where the participants meet to execute their deals. It is more an informal arrangement among the banks and brokers operating in a financing centre purchasing and 3selling currencies, connected to each other by tele communications like telex, telephone and a satellite communication network, SWIFT. The term foreign exchange market is used to refer to the wholesale a segment of the market, where the dealings take place among the banks. The retail segment refers to the dealings take place between banks and their customers. The retail segment refers to the dealings take place between banks and their customers. The retail segment is situated at a large number of places. They can be considered not as foreign exchange markets, but as the counters of such markets. The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi is other centers accounting for bulk of the exchange dealings in India. The policy of Reserve Bank has been to decentralize exchages operations and develop broader based exchange markets. As a result of the efforts of Reserve Bank Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of foreign exchange market. Size of the Market Foreign exchange market is the largest financial market with a daily turnover of over USD 2 trillion. Foreign exchange markets were primarily developed to facilitate settlement of debts arising out of international trade. But these markets have developed on their own so much so that a turnover of about 3 days in the foreign exchange market is equivalent to the magnitude of world trade in goods and services. The largest foreign exchange market is London followed by New York, Tokyo, Zurich and Frankfurt. The business in foreign exchange markets in India has shown a steady increase as a consequence of increase in the volume of foreign trade of the country, improvement in the communications systems and greater access to the international exchange markets. Still the volume of transactions in these markets amounting to about USD 2 billion per day does not compete favorably with any well developed foreign exchange market of international repute. The reasons are not far to seek. Rupee is not an internationally traded currency and is not in great demand. Much of the external trade of the country is designated in leading currencies of the world, Viz., US dollar, pound sterling, Euro, Japanese yen and Swiss franc. Incidentally, these are the currencies that are traded actively in the foreign exchange market in India. 424 Hours Market The markets are situated throughout the different time zones of the globe in such a way that when one market is closing the other is beginning its operations. Thus at any point of time one market or the other is open. Therefore, it is stated that foreign exchange market is functioning throughout 24 hours of the day. However, a specific market will function only during the business hours. Some of the banks having international network and having centralized control of funds management may keep their foreign exchange department in the key centre open throughout to keep up with developments at other centers during their normal working hours In India, the market is open for the time the banks are open for their regular banking business. No transactions take place on Saturdays. Efficiency Developments in communication have largely contributed to the efficiency of the market. The participants keep abreast of current happenings by access to such services like Dow Jones Telerate and Teuter. Any significant development in any market is almost instantaneously received by the other market situated at a far off place and thus has global impact. This makes the foreign exchange market very efficient as if the functioning under one roof. Currencies Traded In most markets, US dollar is the vehicle currency, Viz., the currency used to denominate international transactions. This is despite the fact that with currencies like Euro and Yen gaining larger share, the share of US dollar in the total turn over is shrinking. Physical Markets In few centers like Paris and Brussels, foreign exchange business takes place at a fixed place, such as the local stock exchange buildings. At these physical markets, the banks meet and in the presence of the representative of the central bank and on the basis of bargains, fix rates for a number of major currencies. This practice is called fixing. The rates thus fixed are used to execute customer orders previously placed with the banks. An advantage claimed for this procedure is that exchange rate for commercial transactions 5will be market determined, not influenced by any one bank. However, it is observed that the large banks attending such meetings with large commercial orders backing up, tend to influence the rates. Participants The participants in the foreign exchange market comprise; (i) Corporates (ii) Commercial banks (iii) Exchange brokers (iv) Central banks Corporates The business houses, international investors, and multinational corporations may operate in the market to meet their genuine trade or investment requirements. They may also buy or sell currencies with a view to speculate or trade in currencies to the extent permitted by the exchange control regulations. They operate by placing orders with the commercial banks. The deals between banks and their clients form the retail segment of foreign exchange market. In India the foreign Exchange Management (Possession and Retention of Foreign Currency) Regulations, 2000 permits retention, by resident, of foreign currency up to USD 2,000. Foreign Currency Management (Realisation, Repatriation and Surrender of Foreign Exchange) Regulations, 2000 requires a resident in India who receives foreign exchange to surrender it to an authorized dealer: (a) Within seven days of receipt in case of receipt by way of remuneration, settlement of lawful obligations, income on assets held abroad, inheritance, settlement or gift: and (b) Within ninety days in all other cases. Any person who acquires foreign exchange but could not use it for the purpose or for any other permitted purpose is required to surrender the unutilized foreign exchange to authorized dealers within sixty days from the date of acquisition. In case the foreign exchange was acquired for travel abroad, the unspent foreign exchange should be surrendered within ninety days from the date of return to India when the foreign exchange is in the form of foreign currency notes and coins and within 180 days in case of travellers cheques. 6Similarly, if a resident required foreign exchange for an approved purpose, he should obtain from and authorized dealer. Commercial Banks Commercial Banks are the major players in the market. They buy and sell currencies for their clients. They may also operate on their own. When a bank enters a market to correct excess or sale or purchase position in a foreign currency arising from its various deals with its customers, it is said to do a cover operation. Such transactions constitute hardly 5% of the total transactions done by a large bank. A major portion of the volume is accounted buy trading in currencies indulged by the bank to gain from exchange movements. For transactions involving large volumes, banks may deal directly among themselves. For smaller transactions, the intermediation of foreign exchange brokers may be sought. Exchange Brokers Exchange brokers facilitate deal between banks. In the absence of exchange brokers, banks have to contact each other for quotes. If there are 150 banks at a centre, for obtaining the best quote for a single currency, a dealer may have to contact 149 banks. Exchange brokers ensure that the most favorable quotation is obtained and at low cost in terms of time and money. The bank may leave with the broker the limit up to which and the rate at which it wishes to buy or sell the foreign currency concerned. From the intends from other banks, the broker will be able to match the requirements of both. The names of the counter parities are revealed to the banks only when the deal is acceptable to them. Till then anonymity is maintained. Exchange brokers tend to specialize in certain exotic currencies, but they also handle all major currencies. In India, banks may deal directly or through recognized exchange brokers. Accred- ited exchange brokers are permitted to contract exchange business on behalf of authorized dealers in foreign exchange only upon the understanding that they will conform to the rates, rules and conditions laid down by the FEDAI. All contracts must bear the clause “subject to the Rules and Regulations of the Foreign Exchanges Dealers ‘Association of India’. 7Central Bank Central Bank may intervene in the market to influence the exchange rate and change it from that would result only from private supplies and demands. The central bank may transact in the market on its own for the above purpose. Or, it may do so on behalf of the government when it buys or sell bonds and settles other transactions which may involve foreign exchange payments and receipts. In India, authorized dealers have recourse to Reserve Bank to sell/buy US dollars to the extent the latter is prepared to transact in the currency at the given point of time. Reserve Bank will not ordinarily buy/sell any other currency from/to authorized dealers. The contract can be entered into on any working day of the dealing room of Reserve Bank. No transaction is entered into on Saturdays. The value date for spot as well as forward delivery should be in conformity with the national and international practice in this regard. Reserve Bank of India does not enter into the market in the ordinary course, where the exchages rates are moving in a detrimental way due to speculative forces, the Reserve Bank may intervene in the market either directly or through the State Bank of India. Settlement of Transactions Foreign exchange markets make extensive use of the latest developments in telecommunications for transmitting as well settling foreign exchange transaction, Banks use the exclusive network SWIFT to communicate messages and settle the transactions at electronic clearing houses such as CHIPS at New York. SWIFT SWIFT is a acronym for Society for Worldwide Interbank Financial Telecommunications, a co operative society owned by about 250 banks in Europe and North America and registered as a co operative society in Brussels, Belgium. It is a communications network for international financial market transactions linking effectively more than 25,000 financial institutions throughout the world who have been allotted bank identified codes. The messages are transmitted from country to country via central interconnected operating centers located in Brussels, Amsterdam and Culpeper, Virginia. The member countries are connected to the centre through regional processors in each country. The local banks in each country reach the regional processors through the national net works. 8The SWIFY System enables the member banks to transact among themselves quickly (i) International payments (ii) Statements (iii) Other messages connected with international banking. Transmission of messages takes place within seconds, and therefore this method is economical as well as time saving. Selected banks in India have become members of SWIFT. The regional processing centre is situated at Mumbai. The SWIFT provides following advantages for the local banking community: 1. Provides a reliable (time tested) method of sending and receiving messages from a vast number of banks in a large number of locations around the world. 2. Reliability and accuracy is further enhanced by the built in authentication facilities, which has only to be exchanged with each counterparty before they can be activated or further communications. 3. Message relay is instantaneous enabling the counterparty to respond immediately, if not prevented by time differences. 4. Access is available t a vast number of banks global for launching new cross border initiatives. 5. Since communication in SWIFT is to be done using structure formats for various types of banking transactions, the matter to be conveyed will be very clear and there will not be any ambiguity of any sort for the received to revert for clarifications. This is mainly because the formats are used all ove3r the world on a standardized basis for conducting all types of banking transactions. This makes the responses and execution very efficient at the receiving banks end thereby contributing immensely to quality service being provided to the customers of both banks (sending and receiving). 6. Usage of SWIFT structure formats for message transmission to counterparties will entail the generation of local banks internal records using at least minimum level of automation. This will accelerate the local banks internal automation activities, since the maximum utilization of SWIFT a significant internal automation level is required. 9CHIPS CHIPS stands for Clearing House Interbank Payment System. It is an electronic payment system owned by 12 private commercial banks constituting the New York Clearing House Association. A CHIP began its operations in 1971 and has grown to be the world’s largest payment system. Foreign exchange and Euro dollar transactions are settled through CHIPS. It provides the mechanism for settlement every day of payment and receipts of numerous dollar transactions among member banks at New York, without the need for physical exchange of cheques/funds for each such transaction. The functioning of CHIPS arrangement is explained below with a hypothetical transaction: Bank of India, maintaining a dollar account with Amex Bank, New York, sells USD 1 million to Canara Bank, maintaining dollar account with Citibank. 1. Bank of India intimate Amex Bank debuts the account of Bank through SWIFT to debit its account and transfer USD 1 million to Citibank for credit of current account of Canara Bank. 2. Amex Bank debits the account of Bank of India with USD 1 million and sends the equivalent of electronic cheques to CHIPS for crediting the account of Citibank. The transfer is effected the same day. 3. Numerous such transactions are reported to CHIPS by member banks and transfer effected at CHIPS. By about 4.30 p.m, eastern time, the net position of each member is arrived at and funds made available at Fedwire for use by the bank concerned by 6.00 p.m. eastern time. 4. Citibank which receives the credit intimates Canara Bank through SWIFT. It may be noted that settlement of transactions in the New York foreign exchange market takes place in two stages, First clearance at CHIPS and arriving at the net position for each bank. Second, transfer of fedfunds for the net position. The real balances are held by banks only with Federal Reserve Banks (Fedfunds) and the transaction is complete only when Fedfunds are transferred. CHIPS help in expediting the reconciliation and reducing the number of entries that pass through Fedwire. CHAPS CHAPS is an arrangement similar to CHIPS that exists in London. CHAPS stands for Clearing House Automated Payment System. 10Fedwire The transactions at New York foreign exchange market ultimately get settled through Fedwire. It is a communication network that links the computers of about 7000 banks to the computers of federal Reserve Banks. The fedwire funds transfer system, operate by the Federal Reserve Bank, are used primarily for domestic payments, bank to bank and third party transfers such as interbank overnight funds sales and purchases and settlement transactions. Corporate to corporate payments can also be made, but they should be effected through banks. Fed guarantees settlement on all payments sent to receivers even if the sender fails. 11Lesson 1.2 - Transactions in Interbank Markets The exchange rates quoted by banks to their customer are based on the rates prevalent in the interbank market. The big banks in the market are known as market makers, as they are willing to buy or sell foreign currencies at the rates quoted by them up to any extent. Depending buy or sell foreign currencies at the rates quoted by them up to any extent. Depending upon its resources, a bank may be a market maker in one or few major currencies. When a banker approaches the market maker, it would not reveal its intention to buy or sell the currency. This is done in order to get a fair price from the market maker. Two Way Quotations Typically, the quotation in the interbank market is a two – way quotation. It means the rate quoted by the market maker will indicate two prices. One at which it is willing to buy the foreign currency, and the other at which it is willing to sell the foreign currency. For example, a Mumbai bank may quote its rate for US dollar as under USD 1 = ` 48.1525/1650 More often, the rate would be quoted as 1525/1650 since the players in the market are expected to know the ‘big number’ i.e., ` 48. In the given quotation, one rate is ` 48.1525 per dollar and the other rate is ` 48.1650. per dollar. Direct Quotation It will be obvious that the quoting bank will be willing to buy dollars at ` 48.1525 and sell dollars at ` 48.1650. If one dollar bought and sold, the bank makes a gross profit of ` 0.0125. In a foreign exchange quotation, the foreign currency is the commodity that is being bought and sold. The exchange quotation which gives the price for the foreign currency in terms of the domestic currency is known as direct quotation. In a direct quotation, the quoting bank will apply the rule: “Buy low; Sell high”. 12Indirect Quotation There is another way of quoting in the foreign exchange market. The Mumbai bank quotes the rate for dollar as: ` 100 = USD 2.0762/0767 This type of quotation which gives the quantity of foreign currency per unit of domestic currency is known as indirect quotation. In this case, the quoting bank will receive USD 2.0767 per ` 100 while buying dollars and give away USD 2.0762 per ` 100 while selling dollars. In other world, he will apply the rule: “Buy high: Sell low”. The buying rate is also known as the ‘bid rate and selling rate as the ‘offer’ rate. The difference between these rates is the gross profit for the bank and is known as the ‘Spread’. Spot and Forward Transactions The transactions in the interbank market may place for settlement (a) On the same day; or (b) Two days later; or (c) Some day late; say after a month Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash or ready transaction. It is also known as value today. The transaction where the exchange of currencies takes place two days after the date of the contact is known as the spot transaction. For instance, if the contract is made on Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the delivery will take place on the next day, i.e., Thursday. Rupee payment is also made on the same day the foreign currency is received. The transaction in which the exchange of currencies takes places at a specified future date, subsequent to the spot date, is known as a forward transaction. The forward transaction can be for delivery one month or two months or three months etc. A forward contract for delivery one month means the exchange of currencies will take place after one month from the date of contract. A forward contract for delivery two months means the exchange of currencies will take place after two months and so on. 13Forward Margin/Swap points Forward rate may be the same as the spot rate for the currency. Then it is said to be ‘at par’ with the spot rate. But this rarely happens. More often the forward rate for a currency may be costlier or chapter tan its spot rate. The rate for a currency may be costlier or cheaper than nits spot rate. The difference between the forward rate and the spot rate is known as the ‘forward margin’ or swap points. The forward margin may be either at ‘premium’ or at ‘discount’. If the forward margin is at premium, the foreign correct will be costlier under forward rate than under the spot rate. If the forward margin is at discount, the foreign currency will be cheaper for forward delivery then for spot delivery. Under direct quotation, premium is added to spot rate to arrive at the forward rate. This is done for both purchase and sale transactions. Discount is deducted from the spot rate to arrive at the forward rate. Interpretation of Interbank quotations The market quotation for a currency consists of the spot rate and the forward margin. The outright forward rate has to be calculated by loading the forward margin into th the spot rate. For instance, US dollar is quoted as under in the interbank market on 25 January as under: Spot USD 1 = ` 48.4000/4200 Spot/February 2000/2100 Spot/March 3500/3600 The following points should be noted in interpreting the above quotation; 1. The first statement is the spot rate for dollars. The quoting bank buying rate is ` 48.4000 and selling rate is ` 48.4200. 2. The second and third statements are forward margins for forward delivery during the months of February. Spot/March respectively. Spot/February rate is valid for delivery end February. Spot/March rate is valid for delivery end March. 3. The margin is expressed in points, i.e., 0.0001 of the currency. Therefore the forward margin for February is 20 paise and 21 paise. 144. The first rate in the spot quotation is for buying and second for selling the foreign currency. Correspondingly, in the forward margin, the first rate relates to buying and the second to selling. Taking Spot/February as an example, the margin of 20 paise is for purchase and 21 paise is for sale of foreign currency. 5. Where the forward margin for a month is given in ascending order as in the quotation above, it indicates that the forward currency is at premium. The outright forward rates arrived at by adding the forward margin to the spot rates. The outright forward rates for dollar can be derived from the above quotations follows Buying rate Selling rate February March February March Spot rate 48.4000 48.4000 48.4200 48.4200 Add; Premium 0.2000 0.3500 0.2100 0.3600 - - 48.6000 48.7500 48.6300 48.7800 From the above calculation we arrive at the following outright rates; Buying Selling Spot delivery USD 1 = ` 48.4000 48.4200 Forward delivery February 48.6000 48.6300 Forward delivery March 48.7500 48.7800 If the forward currency is at discount, it would be indicated by quoting the forward th margin in the descending order. Suppose that on 20 April, the quotation for pound sterling in the interbank market is as follows: Spot GBR 1 = ` 73.4000/4300 Spot/May 3800/3600 Spot/June 5700/5400 Since the forward margin is in descending order (3800/3600), forward sterling is at discount. The outright forward rates are calculated by deducting the related discount from the spot rate. Thus is shown b 15 Buying rate Selling rate May June May June Spot rate 73.4000 73.4000 73.4300 73.4300 Less; discount 0.3800 0.5700 0.3600 0.5400 - - 73.0200 72.8300 73.0700 72.8900 From the above calculations the outright rates for pound sterling cab be restated as follows; Buying Selling Spot GBR 1 = ` 73.4000 73.4300 Forward delivery May 73.0200 73.0700 Forward delivery June 72.8300 72.8900 Factors Determining Spot Exchange Rates Balance of Payments Balance of Payments represents the demand for and supply of foreign exchange which ultimately determine the value of the currency. Exports, both visible and invisible, represent the supply side for foreign exchange. Imports, visible and invisible, create demand for foreign exchange. Put differently, export from the country creates demand for the currency of the country in the foreign exchange market. The exporters would offer to the market the foreign currencies they have acquired and demand in exchange the local currency. Conversely, imports into the country will increase the supply of the currency of the country in the foreign exchange market. When the balance of payments of a country is continuously at deficit, it implies that the demand for the currency of the country is lesser than its supply. Therefore, its value in the market declines. If the balance of payments is surplus continuously it shows that the demand for the currency in the exchange market is higher than its supply therefore the currency gains in value. Inflation Inflation in the country would increase the domestic prices of the commodities. With increase in prices exports may dwindle because the price may not be competitive. With the decrease in exports the demand for the currency would also decline; this in turn 16

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