FOREIGN EXCHANGE

MARKET
RISKS
 Evolution …. History….

 Different Countries – Different Langages

 Civilisation / Culture / Practices
 Different Governments / Governance / Rules
 Trade / Industries : Evolved / Grew
 Evolution …. History….
 Barter system
 Common Mode of Exchange
 Evolution of Money
 Convenience : Leather / Metal / Grains / Beads
 Different Monies / Values
 International Trade / Travelling
 Colonisation / Invasion : Mughals / East India
Co
 International Monetary System

 Bimetallism : Before 1875

 Classical Gold Standard : 1875 - 1914
 Interwar Period : 1915 - 1944
 Bretton Woods System : 1945 - 1972
 Flexible Exchange Rate Regime : Since 1973
 International Monetary System
Bimetallism : Before 1875
 Initially, only coins : Gold & Silver
 Value : Based upon Gold / Silver Content in the Coins
 Britain : Gold ; France : Bimetallic ; Germany : Silver
 British Pound to German Mark : Through French Franc
 Germany, Holland, China & India : Only Silver
 Other Metals were also used, in other countries
 International Monetary System
Classic Gold Standard :1875-1914

 Gold : Universal Fondness : Many Centuries Old

 Greek / Roman Empires and Earlier : Popular
 Even in India : Ancient Empires used Gold
 Gold Standard : Not Gold Coins : Money Backed by Gold
 France : 1850s, Germany:1875; USA : 1879; Japan : 1897
 International Monetary System
Classic Gold Standard :1875-1914
 Gold alone is assured of unrestricted coinage
 Two-way Convertibility between Gold & Currency
 Value of Money : Linked to Value of Gold in the country
 Gold may be freely imported / exported
 Net Trade Balance : Settled by Gold : Specie Flow Mech.
 Exchange Rate between 2 currencies : Gold Content
 (E.g.): UK : 6 Pound / Ounce; France : 12 Francs / Ounce
 1 Pound = 2 Francs
 During that period, Pound Sterling = $4.84 – $4.90
 Interwar
 After WW-I :
Period :1915-1944
 UK, France, Germany & Russia : Stopped Redemption
 Placed Embargo on Gold Exports
 Germany, Austria, Hungary, Poland : Hyperinflation
 Germany : Worst : 1923 : WPI : 1 Trillion Times
 Currency values not pegged to Gold : Fluctuation
 Acute Shortage of items : Devaluation : Exports..
 Gold Standard disappeared
 1919 : USA restored Gold Standard
UK, Switzerland, France, Scandinavian Countries : 1928
Most countries kept some gold out of Currency Float
1929 : Great Depression / Stock Market Crash : Erosion
UK experienced huge outflow of Gold: Chronic BOP issue
1931:UK, Canada, Sweden, Austria, Japan Got off Gold
Std
 Interwar Period :1915-1944

Huge erosion in Gold Stock across Europe

Massive Bank Failures in the US and other countries
Flight of Capital across borders
Half-hearted attempts to restore Gold Standard & Failure
Economic and Political Instabilities
 BRETTON WOODS SYSTEM : 1945-1972
• July 1944 : Reps of 44 Nations met at New Hampshire
• Agreement between countries : IMF formed
• British : International Reserve Asset : ‘bancor’
• Americans : Currency Pool from Member Countries
• Suggestions from America were built into Articles of IMF
• All countries agreed to peg their currencies par value to USD
• US $ then linked to Gold Price : $ 35 = 1 Ounce of Gold
• Called the Gold Exchange Standard, based on Dollar
• When market price of Gold fell below $ 35, became an issue
BRETTON WOODS SYSTEM : 1945-1972
 BRETTON WOODS SYSTEM : 1945-1972

• New asset created at IMF : SDR : Special Drawing Rights

• SDR : Initially average of 16 currencies : World Export
• 1981 : 5 currencies : USD, DM, Yen, PDS, FF
• Currently: 4 : USD : 45%; Euro :29%; Yen : 15%; PDS:11%
• SDR : Portfolio of Currencies
• Can be an attractive denomination for International Contracts
COMPOSITION OF SDR
 FLOATING EXCHANGE RATE : 1973 …

• Gold Rates : Widely beyond benchmark rate

• Higher inflation in the US - US$ un-attractive link currency
• Countries revalued their exchange rate with US$
• European and Japanese currencies were de-linked from US$
• US $, PDS, DM, Yen : Fluctuating against each other
• Gold ceased to be the standard for money value
• IMF returned half of their gold holding to member nations
• Central Banks of countries were authorised to intervene
 Current Foreign Currency Arrangement
1. Pegged to the US Dollar :Hong Kong
2. Pegged to Euro : Estonia
3. Pegged to Other Currencies : Single / Basket
• Narrow Range : 1%; Malaysia / China
4. European Monetary Union - Euro
5. Limited Flexibility : Israel / Romania
6. Managed Floating : 42 Countries
• Govt. intervenes: Singapore / India / Thailand
7. Independent Floating : 41 Countries
• Market Driven : UK / Canada / Japan / Australia
EXCHANGE RATES-1999 :
 FOREIGN EXCHANGE
• Means the money of a Foreign Country
• Bank Balances, Notes, Coins, Cheques, Drafts
Movement in US $
 FOREIGN EXCHANGE MARKET
The Foreign Exchange Market :
The physical and institutional structure through which the
money of one country is exchanged for that of another
country
The determination rate of exchange between currencies
Is where foreign exchange transactions are physically
completed

Foreign exchange transaction :

An agreement between a buyer and a seller
Fixed amount of one currency will be delivered for some
other currency
At an agreed Exchange Rate
At a specified date
 FOREX MARKET - FUNCTIONS
Forex Market is the mechanism by which participants:
• Transfer purchasing power between countries
• Obtain / provide credit for international trade
transactions
• Minimize exposure to the risks of exchange rate
changes
FOREX MARKET – PARTICIPANTS

• Reserve Bank of India (RBI)

• All Scheduled Commercial Banks (Authorised Dealers
only)
• Corporate Treasuries
• Public Sector/Government
• Inter Bank Brokerage Houses
• Resident Indians
• Non Residents
• Speculators and Arbitragers
BALANCE OF PAYMENT
 BALANCE OF PAYMENT

• Net Balance of All International Financial Transactions

• Country’s Total Exports – Total Imports
• Net ‘+’ : Favourable; ‘-’ : Un-Favourable
• One Country with All Other Countries
• ‘+’ with one country and ‘-’ with many possible
• Generally, world over, in US $
• Imports / Exports of Goods, Services, Cross-Border
Investments, Bank A/c, Bonds, Stocks, Real Estate etc.
 BALANCE OF PAYMENT
• Statistical record of a country’s international transactions
over a certain period of time presented in the form of
Double-Entry Book-keeping
• Over a Certain Period of time, same as national income a/c
• ‘+’ : Receipts : Credits : Sales, Financial Claims, Assets
• ‘-’ : Payments : Debits : Purchase, Obligations
• One Country with All Other Countries
• ‘+’ with one country and ‘-’ with many country possible
• Under 3 Heads : Current / Capital / Official Reserve A/c
 B O P – Current A/c
CONTAINS :
• Merchandise : Trade Balance : Tangible Goods : Oil,
Automobiles, Machines, Computers, Food Grains, Clothes, etc
• Services : Invisible Trade: Consulting, Royalties, Legal,
Patents, Insurance, Intellectual Properties, Tourism, etc.
• Factor Income : Interest, Dividend, Return on Investments
• Unilateral Transfers :Foreign Aid, Official /Personal Gifts,
Grants. This is the only Uni-directional flow

DEFICIT / SURPLUS :
• Deficit : Fund by Borrowings / From Accumulation
• Surplus : Collect IOUs from Foreign Countries
 B O P – Capital A/c
CONTAINS :
• FDI : Invest in a Company / Subsidiary in another Country
• Portfolio : Invest in Stocks / Bonds etc: No Transfer of
Control
• Other Investment : Deposits / Trade Credits, Currency, etc. to
utiilise advantage of Interest Rate Differential

B O P – Statistical Discrepancies
CONTAINS :
• Omitted / Mis-recorded Transactions
 BOP–
Overall Balance / Official Settlement Balance

Total of Current A/c, Capital A/c, Statistical Discrepancies

• ‘–’ : Owes to the rest of the World

• ‘+’ : Due from the rest of the World
• Settled accordingly : Loan / Gold / Forex / SDR
• Under the earlier Fixed Exchange Rate Regime :
Current A/c + Capital A/c = 0
• Under the present Flexible Exchange Regime :
Current A/c Surplus / Deficit : Change in Capital A/c
US - BOP – Year 2000 – $ - Billion
US - BOP – Year 2000 – $ - Billion
US - BOP – Year 2000 – $ - Billion
 International Reserve Assets /
US - BOP – Year 2000 – $ - Billion

Official Reserve Assets

• Gold
• Foreign Exchange
• SDR
• Reserve Position in the IMF

• Gold : No longer Popular : 3%

• 94% : Foreign Exchange
US - BOP – Year 2000 – $ - Billion
US - BOP – Year 2000 – $ - Billion

Markets & Institutions

 FX Markets
US - BOP – Year 2000 – $ - Billion

• Purchase / Sale of Foreign Currency

• Biggest Market : $ 1.2 Trillion / day!
• $ 200 per living person on this Earth!!
• Not a physical structure but Virtual
• Contains Wholesale / Retail Dealers
• Dealings through Two-way Quotes
• Network of Computers, Phones, Dealing
Machines
• Runs on Safe, Best Communication Systems
• Reuters and EBS : Largest vendors of Quotes
• 24 / 7 / 365; Most of the trading : 9 – 12 Hrs
 3 FX Market Segments
US - BOP – Year 2000 – $ - Billion

Australasia
Sydney, Tokyo, Hong Kong, Singapore, Bahrain
Europe
Zurich, Frankfurt, Paris, Brussels, Amsterdam London
North America
N Y, Montreal, Toronto, Chicago, San Francisco & L A
US - BOP – Year 2000 – $ - Billion
International FX Business
US - BOP – Year 2000 – $ - Billion
FX : Average Daily Turnover
Types of FX Markets – Two Tiers
Wholesale/Interbank :
• International Banks : Buy both for themselves
and for other retail clients

Retail / Client :
• Bank Customers : MNCs, Money managers,
Speculators
• Non – Bank Dealers : Investment Banks etc.
• Brokers : Match Buy / Sell requirements
• Central Banks : More to regulate Rates
 Deals in FX Markets
• Dealing Rooms : Secure Environment
• Individual Traders for Particular Currency
• Generally : Most Trades : US $ denominated
• Quotes : Direct (American) / Indirect (European)
• Two Way Quotes : Sell ( Bid ) / Buy ( Ask/Offer )
• Spread : Difference between Sell / Buy
• Inter-Bank: Standard Size: US $ 10 M (ten dollars)
• Real-Time Quotes : Immediate Decision : Freeze
• $/£ Quote : $ 1.5267 - $ 1.5272
Big Figure / Small Figure : Quotes :Small Figure
• Screen Based Trade : Automatically Appear
• Cross Currency : Through $ Rate S(€/£) = S($/£)
S($/€)
 FX Payment Gateways
US - BOP – Year 2000 – $ - Billion

SWIFT : Society for Worldwide Interbank Fin. Telecom

• Private Non-Profit Message Transfer System
• Headquarters in Brussels
• Switching Centers in Netherlands and Virginia
• All Constituents of the FX market connected through this
• Transactions involving All Currencies

CHIPS : Clearing House Interbank Payments System

• Along with Federal Reserve Bank System, provides a
Clearing House
• Settlement of Interbank USD Payments
 FX Rates
US - BOP – Year 2000 – $ - Billion

SPOT : Exchange Rate for Immediate Delivery

• Quoted and Traded everyday - Today
• Settlement in generally 2 working days
FORWARD : Exchange Rate for Future Delivery
• Quoted and Traded everyday - Today
• Settlement at agreed Rate at an Agreed Future Date

DIRECT QUOTE: American Terms

• Home Currency / 1 Unit of Foreign Currency
• $ 1 = Rs.43.64 ; £ 1 = Rs.68.96 ; € 1 = Rs.52.23
INDIRECT Quote : European Terms
• Foreign Currency / 1 Unit of Home Currency
• 1 / Direct Quote
• Re 1 = $ 0.2291; Re 1 = £ 0.0145 ; Re 1 = € 0.0191
 Forward Contract
Contracting today for Future Purchase / Sale :
• Premium ( for Sale ) / Discount ( for Purchase )
• Major Currencies : $ / £ / €
• Standard Maturities : 1,3,6,9,12 Months
• Other Maturities are also available
• Longer terms : Even up to 10 Years possible
• Notation : FN($ / £) ; ‘N’ : Number of Months : 1,3,6,9,…
• S ($ / £) Spot rate between $ and £

S($/SF) .6653
F1($/SF) .6660
F3($/SF) .6670
F6($/SF) .6684
 Swap Transaction
Simultaneous Sale ( Purchase ) of Spot against Forward :
• Account for about 50% - 60% in Interbank Trade
• Bulk of Trade :Swaps for Forwards
• FX Dealers Conversations / Quotes : ‘Forward Points’
Spot $/£ 1.5267–1.5272
One-Month 32–30
Three-Month 57–54
Six-Month 145–138
Spot $/£ : 1.5267–1.5272
Forward Point Outright Forward
Quotations Quotations
One-Month 32–30 1.5235–1.5242
Three-Month 57–54 1.5210–1.5218
Six-Month 145–138 1.5122–1.5134
 Risk - Forex
US - BOP – Year 2000 – $ - Billion

• Translation Risk – Accounting Risk

• Parent Company – Having Subsidiaries Globally
• A/c maintained in different Reporting Currencies
• Consolidation : Parent Company’s Home Currency
• Current Rate ( Balance Sheet Items )
• Temporal : Individual Assets Revalued – Existing Rate
• Monetary/Non-monetary: Current/Average/Historical
• Average Rate (P/L A/c Items)
• Impacts the Networth of Parent / Holding Company
• Transaction Risk
• Real Operating Risk