FOREIGN EXCHANGE

MARKET
Dr. Tinaikar

Strictly for Private Circulation Only

Topics
 Characteristics
 Structure
 Exchange Rate Quotations
 Value Date/ Settlement Date
 Transfer of Funds
 Types of Foreign Exchange Transactions
 Covered and Uncovered Interest Parity
 Foreign Exchange Trading and Arbitrage
 Exchange Rate Determination & Forecasting
 Indian Foreign Exchange Market
 Non-Deliverable Forward Market 2
 Foreign Exchange

 Purchase and sale of currencies of different

nations
 Exchange rate is the price of one currency
vis-à-vis another
 Why do you need foreign exchange?
 Trade (Exports/Imports)
 Investments (Financial Transactions)
 Remittances (Inward/Outward)
 Speculation (Trading)
3
Foreign Exchange Market
Utility
 Provides physical and institutional structure
through which money of one country is
exchanged for that of another country
 Facilitates the conversion of one country’s
currency into another
 Sets and quotes exchange rates
 Offers contracts to manage foreign exchange
exposure

4
Foreign Exchange Market
Characteristics
 Worldwide daily turnover of US$ 6.6 trillion
(April 2019)
 Indian foreign exchange market daily turnover is
about USD 30 billion i.e. 0.5% of the global
foreign exchange market turnover
 Major Centers : London, New York, and Tokyo
 U.S. and U.K. markets constitute about 60% of
total daily turn over
 U.K. constitutes about 40% of the global market
 Other important markets are Hong Kong,
Singapore, Japan and Switzerland
 90%+ of daily turnover represent speculation
5
Foreign Exchange Market
Characteristics
 Forex market is a 24 hours a day currency trading market
9:00 AM in H.K. & Singapore = 10:00 AM in Tokyo
9:00 AM in Bahrain = 2:00 PM in Singapore
9:00 AM in Frankfurt & Zurich = 10:00 AM in Bahrain
9:00 AM in London = 10:00 AM in Frankfurt & Zurich
9:00 AM in New York = 2:00 PM in London
9:00 AM in Los Angeles = 12:00 PM in New York
9:00 AM in Sydney (next day) = 4:00 PM in L.A. (prev. day)

6
Foreign Exchange Market:
The Trading Day

7
Foreign Exchange Market
Characteristics
 O-T-C Market i.e. no physical location.
 Traders communicate through telephones, telexes,
computer terminals.
 Exchange of currencies in the form of exchange of
electronic messages.
 Traders located in commercial banks around the world
offer online quotes though Reuters, Bloomberg etc.
 Electronic trading platforms used include Reuters Market
Data System (RMDS) and Bloomberg FX GO.
 G-4 currencies viz. USD, JPY, GBP, and Euro are most
liquid currencies traded 24 hours. 8
Foreign Exchange Market
Characteristics
 Electronic Clearing of forex transactions through SWIFT,
CHIPS in New York, and ECHO
 SWIFT (The Society for Worldwide Interbank Financial
Telecommunications):
 Private non-profit message transfer system with H.Q. in Brussels
with intercontinental switching centers in Netherlands and
Virginia.
 CHIPS (Clearing House Interbank Payments System):
 In cooperation with the U.S. Federal Reserve Bank System,
called Fed-wire, provides a clearing house for interbank
settlement for over 95% of U.S. dollar payments between
international system.
 Processes more than $2 trillion of payments each day. 9
Foreign Exchange Market
Turnover

6.6 trillion

10
Foreign Exchange Market
Turnover by Instruments

Source: BIS Triennial Central Bank Survey 11

Foreign Exchange Market
Turnover by Instruments

Source: BIS Triennial Central Bank Survey

12
Foreign Exchange Market
Turnover by Geography
Country Share
U.K. 43%
U.S. 16%
Singapore 8%
Hong Kong 8%
Japan 4%
Australia 1%
Others 20%
Total 100%
13
Source: BIS Triennial Central Bank Survey
Forex Market Turnover by
Currency Pair
Currency Pair Share
EUR/USD 24%
USD/JPY 13%
GBP/USD 10%
AUD/USD 5%
USD/CAD 4%
USD/CNY 4%
USD/CHF 3%
EUR/GBP 2%
EUR/JPY 2%
Other 33%
Total 100%
Source: BIS Triennial Survey
14
Top 10 Currency Traders

Top 10 currency traders

% of overall volume, June 2020
Rank Name Market share
1 JP Morgan 10.78 %
2 UBS 8.13 %
3 XTX Markets 7.58 %
4 Deutsche Bank 7.38 %
5 Citi 5.50 %
6 HSBC 5.33 %
7 Jump Trading 5.23 %
8 Goldman Sachs 4.62 %
9 State Street Corporation 4.61 %
Bank of America Merrill
10 4.50 %
Lynch

15
Foreign Exchange Market Structure

 Major Participants
 Commercial Banks: make market, speculate, arbitrage,
and hedge risk
 Corporations: trade related (export/import), hedge rate
risks, speculate
 Central Banks: smoothen exchange rate fluctuations
 Nonbank Institutional Investors: mutual funds,
pension funds, hedge funds etc.
 Forex Brokers: act as middlemen
 Individuals: exchange currencies /travelers cheques
16
Foreign Exchange Market Structure

 The foreign exchange market consists of two tiers:

 Interbank or Wholesale Market:
 The size (or notional principal) for each contract is
multiples of US$ 10 million or the equivalent value in
other currencies
 Client or Retail Market:
 The size for each transaction is relatively smaller than the
size in the wholesale market
 The number of transactions in the retail market is far
larger than that in the wholesale market
17
Foreign Exchange Rate Quotations
 Direct or American Quote : The US Dollar price of a unit
of foreign currency

 Indirect or European Quote : Foreign currency price of a US

Dollar i.e. the reciprocal of Direct Quote
 American Quote : Dollars per unit of other currency
Examples : 1 EURO = 1.1310 USD
1 GBP = 1.3265 USD
1 AUD = 0.7175 USD
1 NZD = 0.6795 USD
 European Quote : Other currency units per dollar
Examples : 1 USD = 114.12 JPY
1 USD = 1.2800 CAD
1 USD = 7.8025 HKD
18
1 USD = 76.1055 INR
Foreign Exchange Rate Quotations
 Since 1978 in order to facilitate worldwide currency trading most
foreign currency quotations in the inter-bank market are European
Quotations
 Exceptions to European quotations being Euro, GBP, AUD, and
NZD which are American Quotes
 All foreign currencies are assigned ISO 4217 abbreviations:
E.g. USD, JPY, GBP, EUR, AUD, HKD, SGD, NZD, CHF, CNY,
THB, MYR, INR etc.
 Since exchange rate is the ratio (i.e. value) of one currency against
another, market makers express this relationship using two
currencies of ISO designation :
E.g. USD/JPY, USD/CHF, EUR/USD, GBP/USD, AUD/USD,
NZD/USD, USD/INR etc.
 The first currency is called “base currency” and second is called 19
“quote currency”
Foreign Exchange Rate Quotations

 Example:
 1 USD (base currency) = 76.00 INR (quote currency)
 1 USD (base currency) = 114.12 JPY (quote currency)
 1 EURO (base currency) = 1.3000 USD (quote currency)
 1 AUD (base currency) = 0.7175 USD (quote currency)

20
Foreign Exchange Rate Quotations
 In inter-bank market a dealer quotes two-way prices :
Bid Price : Price at which a trader is willing to buy
Offer or Asked Price : Price at which a trader is willing to sell
Bid /Offer Spread : Difference between bid and offered
price
Example: (December 16, 2021)
Currency* Bid Offer On Screen
EUR/USD 1.1310 1.1313 1.1310/13
GBP/USD 1.3265 1.3268 1.3265/68
AUD/USD 0.7175 0.7177 0.7175/77
NZD/USD 0.6795 0.6799 0.6795/99
USD/CAD 1.2800 1.2804 1.2800/04
USD/JPY 114.12 114.17 114.12/17
USD/SGD 1.3648 1.3652 1.3648/52
USD/HKD 7.8025 7.8029 7.8025/29
USD/INR 76.1550 76.1650 76.1550/650
*Normally quoted up to 4 decimal points
The Bid-Ask Spread
 A dealer offers a quote on the Reuter Screen:
EUR/USD 1.1310/13
 A bid price of $1.1310 per €.
 An ask price of $1.1313 per €.
 The dealer will say on the phone: 10/13
 While there are a variety of ways to quote the above, the bid-
ask spread represents the dealer’s expected profit.
Ask Price – Bid Price
Percent Spread = x 100
Bid Price
$1.1313 – $1.1310
0.0265% = x 100 22
$1.1310
The Bid-Ask Spread
 A dealer offers a quote on the Reuter Screen:
EUR/USD 1.1310/13
 A bid price of $1.1310 per €.
 An ask price of $1.1313 per €.
 The dealer will say on the phone: 10/13
 Bid Spread = 0.0003 USD i.e. 0.03 cent
 While there are a variety of ways to quote the above, the bid-
ask spread represents the dealer’s expected profit.
Ask Price – Bid Price
Percent Spread = x 100
Bid Price
$1.1313 – $1.1310
0.0265% = x 100
$1.1310 23
The Bid-Ask Spread

 A dealer offers a quote on the screen:

USD/INR 76.1550 /76.1650
 Bid/Offer Spread is INR 0.010 i.e. 1 paisa
 Percent Spread = 76.1650 – 76.1550
76.1550
= 0.0131%

24
Forex Transactions: Value Date /
Settlement Date
 Day or date on which a forex transaction is settled or
currencies are exchanged
 Settlement takes place through electronic transfer of
deposits between the two parties located in different time
zones
 Currencies cannot be settled at the same point in time
because of time zone difference in different countries
 Banks in both the dealing locations and settlement locations
of the countries of the two currencies involved must be open
for business on the settlement day i.e. “compensated value
principle”
 Dealing Locations: Location of the two banks
 Settlement Locations: Relevant countries of currencies 25
Forex Transactions: Value Date /
Settlement Date
 Example:
London Bank sells ‘X’ JPY against ‘Y’ USD to Paris
Bank

Dealing Locations : London & Paris

Settlement Locations : U.S. & Japan

26
Forex Transactions: Transfer of
Funds
 Settlement of currency always takes place in the country
of its origin through SWIFT or CHIPS (U.S.)
 Transfer of funds/deposits denominated in relevant
currencies between two parties is done electronically
through “NOSTRO” and “VOSTRO” accounts
 NOSTRO Account : Overseas Account held by domestic
bank with correspondent foreign bank or with its own
foreign branch in the foreign country’s currency
 VOSTRO Account : Nostro Account is called Vostro
Account for the overseas holding bank
27
Forex Transactions: Transfer of
Funds
 Example 1:
London Bank sells ‘X’ JPY to and buys ‘Y’ USD from Paris Bank
Dealing Locations : London & Paris
Settlement Locations : New York & Tokyo

Tokyo (JPY) N.Y. (USD)

(Nostro A/C) (Nostro A/C)
London Bank -X +Y
Paris Bank +X -Y

28
Forex Transactions: Transfer of
Funds
 Example 2:
SBI Mumbai buys ‘X’ USD and sells ‘Y’ INR to Citibank
Mumbai
Dealing Locations : Mumbai
Settlement Locations : Mumbai & New York

Mumbai N.Y. (USD)

(INR) (Nostro A/C)
SBI Bank -Y +X
Citibank +Y -X
29
Types of Foreign Exchange
Transactions
 Depending on the time elapsed between transaction date
and settlement date FOREX transaction can be classified
as:
Ready or cash : settlement today
Tomorrow (“tom”) : settlement tomorrow
Spot : settlement two business
days from date of contract
Forward : settlement beyond spot at a
predetermined price
Swap : combination of a spot and a
forward transaction 30
Types of Foreign Exchange
Transactions

FX Market

Spot Market Forward Market FX Swaps Market

Deals for delivery T + 2 Deals for delivery Deals with one
up to 12 months spot component
later than T + 2 and one forward
component

31
Spot Transactions
 Spot
Agreement on the price today with delivery or settlement two
business days later i.e. T+2
Currencies in countries in the same time zone are normally settled
one business day later e.g. trade between U.S. and Mexico
Both the dealing and settlement locations must be open for
business on the day of settlement
Example:
 London banks sells ‘X’ JPY and buys ‘Y’ USD to a Paris bank on
Monday
 London bank will credit ‘X’ JPY in Paris bank’s Nostro account in
Japan on Wednesday and Paris bank will credit ‘Y’ USD in London
bank’s Nostro account in U.S. the same day i.e. Wednesday
 If Wednesday is a holiday in either Japan or U.S. the value date is 32
shifted to next business day i.e. Thursday.
Spot Transactions

Example (Cont..):
 If Wednesday is a holiday in either of the dealing locations i.e. U.K.
or France, settlement is again postponed to Thursday
 If Tuesday is a holiday in U.K. and not in France value date is
Thursday for London bank and Wednesday for Paris bank
 If London bank made the market, value date would be Thursday and
if Paris bank made the market, value date would be Wednesday

33
Spot Transactions

 Spot Foreign Exchange Microstructure

 Market microstructure refers to the mechanics of how a
market place operates
 The bid-ask spreads in the spot FX market:
 Increases with FX exchange rate volatility
 Decreases with dealer competition
 “News” or information is an important determinant of spot
exchange rates

34
Spots – Reuter Screen

35
Asian Spots – Reuter Screen
(December 16, 2021)
Indian Foreign Exchange Market
USD-INR Spot Screen based Quotations
(December 16, 2021)
Forward Transactions
 Forward
Agreement on the price today with delivery or settlement at a
future date which is beyond the spot settlement
Usually quoted for 1, 2, 3, 4,……….12 months in inter-bank
market
Forward Value Date = Spot Value Date + Relevant number of
Calendar Days
Rolling forward must not take you to next calendar month in which
case you shift one day back
Example
1 month forward deal is done on January 26
Forward Value Date = February 28
If February 28 is holiday value date is February 27 38
Forward Transactions
 Types
 Premiums and Discounts
 Forward Rate Quotations
 Swaps
 Uses of Swaps/Forwards
 Forward Rate Quotations - Example
 Forward Rate Quotations - Reuter Screen

39
Types of Forwards
Outright Forward
Forward contract without accompanying spot deal
Long-dated Forward
Forward contract beyond one year and upto five years
Broken or Odd Date
Forward contracts for maturities which are not standard i.e. not
whole numbers of months e.g. 63 days
Option or Optional Forward
Forward contract with optional delivery i.e. delivery during a
specified period of the contract not later than a specified date
Example
In August 2016, a Japanese company knows that a shipment of German
equipment will arrive sometime in December and have to pay Euro on
delivery.
On August 30, the Japanese company may enter into Optional Forward 40
Contract to purchase Euro against JPY between Dec 1 and Dec 31 2016
Forward Transactions:
Premiums and Discounts
 Premiums and Discounts
Forward rate is either at premium or discount to the spot rate
Premium
Currency “A” (base currency) is costlier in the forward market
than spot market to currency “B” (quote currency) then “A” is
said to be at premium to “B” in the forward market
Discount
Currency “A” is cheaper in the forward market than in the spot
market to currency “B” then “A” is said to be at a discount to
currency “B” in the forward market
Example (On December 16,2021)
EUR/USD GBP/USD USD/JPY USD/INR
Spot 1.1305/10 1.3295/99 114.11/14 76.1050/150
1 Mth Forward 1.1322/23 1.3301/04 114.04/08 76.3350/450
Prem/(Disc) (Euro Prem) (GBP Prem) (USD Disc) (USD Prem)
Forward Transactions:
Premiums and Discounts

Example: EUR/USD
Spot 1.1305/10
1 mth Forward 1.1322/23

Forward Premium = 1.1322 – 1.1305 x 360 x 100

Euro (Bid) 1.1305 30
= 1.8044%
Forward Premium = 1.1323 – 1.1310 x 360 x 100
Euro (Offer) 1.1310 30
= 1.3798 % 42
Forward Rate Quotations

 Outright Forward Quotations

 Swap Quotations

43
Forward Rate Quotations
 Outright Forward Quotations
Full price is stated between USD and most currencies upto 4
decimals.
Generally quoted by banks when dealing with customers and reported
in newspapers.
Example:
Currency Bid Offer
EUR/USD 1.1310 1.1313
GBP/USD 1.3265 1.3268
AUD/USD 0.7175 0.7177
NZD/USD 0.6795 0.6799
USD/CAD 1.2800 1.2804
USD/JPY 114.12 114.17
USD/SGD 1.3648 1.3652
USD/HKD 7.8025 7.8029
USD/INR 76.1550 76.1650
Forward Rate Quotations
 FX Swap
Buy (Sell) foreign exchange spot with simultaneous agreement to
Sell (Purchase) the same amount forward to the same party in the
inter-bank market at an agreed price
Unlike a spot transaction or outright forward transaction a FX Swap
transaction is a combination of (i) a spot transaction and (ii) forward
transaction settling on two different value dates with two different
exchange rates

 Swap Rate
Forward rate is quoted in the inter-bank market as the difference
between the forward and spot rate i.e. (F-S) and is expressed in points

 Points
Swap Rate is expressed in Points or “Pips”
A Pip represents the last digit of a quotation and is equal to 0.0001
45
Forward Rate Quotations
 Points (Cont..)
Most currencies against USD (European terms) are expressed up to
four decimal points so point is equal to last digit of decimal point
except some currencies e.g. JPY which is quoted up to two decimal
points. For such currencies a point is equal to 0.01

 Rule
Add points to the spot rate if the USD (base currency) is
trading at a forward premium to the quote currency
Subtract points from the spot rate if the USD (base currency) is
trading at a discount to get the outright forward

46
 Forward Rate Quotations: Swaps
 Types of Swaps
“Buy-Sell” Swap
Bank ‘A’ buys USD 1 mio spot from Bank ‘B’ @ INR 76.00/USD
mio and simultaneously sells USD 1 mio 6 months forward to Bank
‘B’@ INR 76.25/USD
Swap Rate (USD Premium) is INR 0.25 = 1 USD i.e. Bank ‘A’
receives premium from Bank ‘B’
“Buy USD Spot” and simultaneously “Sell USD Forward” 
“Receive Premium”
“Sell-Buy” Swap
Bank ‘A’ sells USD 1 mio spot to Bank ‘B’ @ INR 76.00/USD and
simultaneously buys USD 1 mio from Bank ‘B’ 6 months forward @
INR 76.25/USD
Swap Rate (USD Premium) is INR 0.25 = 1 USD i.e. Bank ‘A’ pays
premium to Bank ‘B’
47
Swaps
 Types of Swaps (Cont..)
“Sell USD Spot” and simultaneously “Buy USD Forward”  “Pay
Premium”

48
 Forward Rate Quotations - Reuter
Screen (EUR/USD)
December 16, 2021
Forward Rate Quotations - Reuter
Screen (GBP/USD)
December 16, 2021
Forward Rate Quotations - Reuter
Screen (USD/JPY)
December 16, 2021
Forward Rate Quotations - Reuter
Screen (USD/INR)
December 16, 2021
USD/INR Annualized Forward
Premia
December 16, 2021
Forward Rate Quotations:
Examples
December 16, 2021
Swap Quotations
EUR/USD GBP/USD USD/JPY USD/INR
Spot 1.1311/14 1.3300/05 114.11/14 76.1550/650
1M Forward 13.25/13.85 6.95/7.70 -8.00/-7.00 22/24
3M Forward 27.35/27.95 4.13/4.90 -13.00/-14.00 72/74
6M Forward 52.85/54.50 -4.80/-3.50 -29.00/-30.00 175/177

Outright Forward Quotations

EUR/USD GBP/USD USD/JPY USD/INR
1M Forward 1.1324/28 1.3307/13 114.03/07 76.3750/4750
3M Forward 1.1338/42 1.3304/10 113.98/00 76.8750/9050
6M Forward 1.1364/69 1.3295/02 113.82/84 77.9050/9350
Forward Rate Quotations

 Calculating the Swap Rate

We know from CIP:
F$/£ × (1+ i )
(1 + i$) = £
S$/£
Therefore, Swap Rate = F$/£ − S$/£ = S$/£ × (1 + i$) − 1
(1 + i£)
Annualized Premium / Discount:

(F$/£ − S$/£) × 360 × 100 (1 + i$ × N/360) − 1

= × 100
S$/£ N (1 + i£ × N/360)
55
Forward Rate Quotations

 Example:
USD 6mth Libor = 1.45167% p.a.
GBP 6 mth Libor = 0.3976% p.a.
GBP/ USD = 1.3200
Therefore, Swap Rate = F$/£ − S$/£ = S$/£ × (1 + i$) − 1
(1 + i£)
= 1.32 × (1 + 0.00726) − 1
(1 + 0.00199)

= 1.32 × (1.0053 − 1.0000)

= 1.32 × 0.0053
= 0.0070 56

= 70 points or “pips”
Forward Rate Quotations

 Example (Contd..):
Annualized Premium / Discount:

(F$/£ − S$/£) × 360 × 100= (1 + i$ × N/360) − 1 ×

S$/£ N (1 + i£ × N/360) 100

= (1 + 0.00726) − 1 × 100
(1 + 0.00199)

= (1.0053 − 1.0000) × 100

= 0.0053 × 100
= 0.53 % 57
Forward-Forward Swap
 Forward - Forward Swap
Selling forward and simultaneously purchasing back on a further
future date or vice versa
Example:
Bank ‘A’ buys (sells) USD 1 mio from Bank ‘B’ 3 months
forward and simultaneously sells (buys) USD 1 mio 6 months
forward to Bank ‘B’
“Forward-Forward Swap” is a combination of two “Spot-
Forward Swaps”:
(1) “Sell Spot” and “Buy 3 months Forward” and simultaneously
(2) “Buy Spot” and “Sell 6 months Forward” with the same
counterparty
58
Uses of Swaps / Forwards

 Hedge Currency Risk

 Take advantage of interest rate differential

i.e. Covered Interest Parity (CIP)

59
Uses of Swaps / Forwards

 Hedge Currency Risk

 Banks quote and do outright forward deal with
their non-bank customers.
 In the inter-bank market forwards are done in
the form of swaps

60
Uses of Swaps / Forwards
 Example-1:
 If a bank has sold USD 1 mio forward to an
importer at rate ‘F1’ (INR/USD) it will square its
position in the interbank market as follows:
 Buy USD 1 mio spot at rate S0 and simultaneously;
 Do a Swap i.e. sell USD 1 mio spot at rate ‘S0’ and
buy USD 1 mio forward at rate ‘F2’ i.e. ‘sell-buy’
swap thus squaring off the short forward position.
+ S0 - F1 (Receive Premium)
- S0 + F2 (Pay Premium)
‘Sell-Buy’ Swap 61
Uses of Swaps / Forwards
 Example-1 (Cont..):
 So long as premium received (F1 − S0) is greater
than the premium paid (F2 − S0) the dealer will
make money i.e.
+S0 - F1
I-------------------------I (Receive Premium)
74.00 75.00 “Buy-Sell” Swap

- S0 + F2
I---------------------------I (Pay Premium)
74.00 74.75 “Sell-Buy” Swap
 Trader does not square off spot position S0 but waits
62
for the Rupee to appreciate to maximize profit.
Uses of Swaps / Forwards
 Example-2:
 A bank buys USD 1 mio for 1 month forward
from a customer (exporter) at rate ‘F1’ (INR/USD)
i.e. it has long position in USD 1 mio for 1 month
forward
 It will square its position in the interbank market
as follows:
 Sell USD 1 mio spot at rate ‘S0’and simultaneously
 Buy USD 1 mio spot at rate ‘S0’ and sell USD 1 mio
forward at rate F2 i.e. “buy sell” swap squaring off
the long forward position
63
Uses of Swaps / Forwards
- S0 + F1 (Pay Premium)
+ S0 - F2 (Receive Premium)
‘Buy-Sell’ Swap

 So long as premium received (F2 − S0) is greater

than the premium paid (F1 − S0) the dealer will
make money i.e.
F2 > F1
I--------------------------I (Pay Premium)
74.00 74.75
I---------------------------I (Receive Premium)
64
74.00 75.00
Cross Exchange Rate
 In forex markets cross rates mean any rate that does not
involve the USD
 It is the exchange rate between two currencies obtained from
their common relationship with a third currency
 Example-1:
Suppose S$/€ = 1.50 (i.e. $ 1.50 = €1.00)
and that S$/£ = 2.00 (i.e. $ 2.00 = 1£)
What is the €/£ cross rate?
Cross Rate = (S$/€) ÷ (S$/£)
$1.50 £1.00 £0.75
× =
€1.00 $2.00 €1.00
£0.75 = €1.00 65
Cross Exchange Rate
 Example - 2:
INR is not directly quoted against JPY. An Indian importer needs
JPY for payment to supplier from Japan.
If a bank’s USD/INR and USD/JPY quotes as of December 16, 2021
are given below is the INR/JPY quote it offers to follows:
USD/INR 76.1550/650
USD/JPY 114.11/14

Importer will buy 1 USD at the bank’s offer rate of INR

76.1650/USD.
Bank will sell 1 USD and buy JPY at the bank’s bid rate of 1 USD =
JPY 114.14
INR-JPY Cross Rate (Offer) = (76.1650 INR/USD) ÷ (114.11 JPY/USD)
= INR 0.6675/JPY
INR-JPY Cross Rate (Bid) = (76.1550 INR/USD) ÷ (114.14 JPY/USD)
= INR 0.6672/JPY
66
Foreign Exchange Trading
 Forex traders in money centre banks are market
makers offering two-way quotes i.e. bid/asked
quotes
 Dispersion of bid/asked prices throughout the
market
 Bid/Asked quote is not constant but continuously
changes minute to minute in tune with:
 market rates

 likely movement during the day

 book position i.e. long or short and the need to

square position and book profit
67
Foreign Exchange Trading
 Example
Trader “A” has square Euro position in the beginning of the day
and offered the following quotes :
Euro 1.3285/87
Trading Terminology
“Yours” : Trader “A” is required to buy Euro at “bid rate”
from another trader “B” who says “yours”
“Mine” : Trader “A” is required to sell Euro at the “offer
rate” to trader “B” who says mine
“My Risk” : Trader “B” is not happy with the above quote
(“Mom”) given by trader “A” and asks for fresh quotes
“Thanks : Trader “B” is not interested in the quotes given
Nothing” by Trader “A”

68
Foreign Exchange Trading
 Case 1:
Euro 1.3285/87
Trader “A” is able to buy and sell Euro 50 mio at the above quote
Profit = (0.0002 USD/Euro) x (Euro 50 mio) = USD 10,000
At any moment trader “A” may find that the number of times he is hit
on the “bid” side is different from the number of times he is hit on
the “offer” side.
Two cases possible :
(i) Number of hits on “bid” side > number of hits on “offer” side.
Trader is buying more than he is selling i.e. Overbought or Long
Position.
(ii) Number of hits on “offer” side > number of hits in “bid”
Trader is selling more than he is buying i.e. Over sold or Short
Position.
In order to avoid speculative position a trader has to keep on
varying his “bid/ask” prices in response to relative frequency
at which he gets hit on either side 69
Foreign Exchange Trading
 Case 2:
Euro 1.3285/87
Trader “A” sells Euro 50 mio at 1 Euro = USD 1.3287 without
squaring his position
Trader “A” has “oversold” or is “short” by Euro 50 mio
Two views possible:
(a) Trader views that during the day Euro will depreciate and
so he can buy back Euro at cheaper rate and reap profit.
Alternatively, he can sell the Euro in the market.
Suppose Euro depreciates to Euro 1.3280/82
Trader buys back Euro 50 mio at USD 1.3280 per Euro
Profit = (0.0007 USD/Euro) x (Euro 50 mio)
= USD 35,000
70
Foreign Exchange Trading
 Case 2 (Contd.):
(b) Trader is anxious to square up his oversold Euro 50 mio
position immediately.
Trader may change his quote to Euro 1.3287/89.
Trader has now made his buy rate more attractive than in
initial quote i.e. Euro 1.3285/87
Trader is able to square off his position by buying Euro 50
mio at USD 1.3287 per Euro
Profit = (0.0000 USD/Euro) x (Euro 50 mio)
= USD 0
If the trader cannot square his position at Euro 1.3287/89
then he may have to change it to say Euro 1.3289/91 in
which case he will incur a loss 71
Foreign Exchange Trading
 Case 3:
Euro 1.3285/87
Trader “A” buys Euro 50 mio at USD 1.3285 per Euro without
squaring his position.
Trader “A” has “overbought” or is “long” by Euro 50 mio.
Two views possible:
(a) Trader views that during the day Euro will appreciate so that
he can sell Euro at a higher rate and reap profit.
Suppose Euro appreciates to Euro 1.3290/92
Trader sells Euro 50 mio at Euro 1.3292
Profit = (0.0007 USD/Euro) x (Euro 50 mio)
= USD 35,000 72
Foreign Exchange Trading
 Case 3 (Contd.):
(b) Trader is anxious to square up his overbought Euro 50 mio
position immediately.
Trader may change his quote to Euro 1.3283/85.
Trader has now made his sell rate more attractive than in
initial quote i.e. Euro 1.3285/87.
Trader is able to square off his position by selling Euro 50
mio at USD 1.3285 per Euro.
Profit = (0.0000 USD/Euro) x (Euro 50 mio)
= USD 0
If the trader cannot square off his position at Euro
1.3283/85 then he may change his quote to 1.3284/86 in
which case he will incur a loss. 73
Foreign Exchange Arbitrage

74
Foreign Exchange Arbitrage

Example: INR = INR x USD

JPY USD JPY 75
Spatial Arbitrage

 New York: E$/£ = 2.0000

 London : E $/£ = 1.8182
 Buy £1 for $1.8182 in London
 Sell £1 for $2.0000 in New York
 Riskless Profit
 For no arbitrage the spot rates should be:
E$/£ (N.Y.) = E$/£ (London)

76
Spatial Arbitrage
Bank ‘A’ Euro 1.3285/87
Bank ‘B’ Euro 1.3280/82
A’s bid rate > B’s offer rate

 Risk Free arbitrage opportunity available

Buy 1 Euro from ’B’ for USD 1.3282
Sell 1 Euro to ‘A’ for USD 1.3285
Profit = USD 0.0003 per Euro bought and sold
(1) Any Bank’s “Bid” rate has to be < Other Bank’s “Offer” rate
(2) Any Bank’s “Offer” rate has to be > Other Bank’s “Bid” rate
Sometimes Banks keep their rates out of alignment with rest of the
market because they want to square off their exposures
E.g. A Bank with overbought position in Euro may want to keep
“Offer” rate lower than the market “Bid” rate and vice-versa 77
Triangular Arbitrage

 Cross exchange rates can be used to check on

opportunities for inter-market arbitrage
 Arbitrage opportunity arises because one bank’s
(Deutsche) quotation on €/£ is not the same as
calculated cross rate between $/£ (Barclay’s) and
$/€ (Citibank)

X (€/£) ≠ Y ($/£) ÷ Z ($/€)

78
Triangular Arbitrage

79
Triangular Arbitrage

80
 Triangular Arbitrage
Citibank, New York
End with $1,019,409 Start with $1,000,000

(1) Exchange $ 1,000,000 with

Barclays Bank for pounds at $1.8991/£
€ 684,535 × $ 1.4892/€ =
$ 1,019,409
$ 1,000,000 / $ 1.8991//£
= £ 526,565 (Receive)

Dresdner Bank, Frankfurt Barclays Bank, London

(3) Exchange € 684,535 with (2) Exchange £ 526,565 with Dresdner

Citibank for US$ at $ 1.4892/€ Bank for Euros at € 1.3000/£
£ 526,565 × € 1.3000/£ 81
= € 684,535 (Receive)
6-81
Indian Foreign
Exchange Market

82
Indian Foreign Exchange Market

83
Indian Foreign Exchange
Market Brief History
 The Indian forex market since independence has
evolved in three distinct phases:
 1947 – 1975: Par Value
 1975 – 1992: Basket Peg
 1992 onwards: Market Determined (Post-Reform
Period) or Managed Float

84
Indian Foreign Exchange
Market Brief History

85
Indian Foreign Exchange
Market Brief History
 1947-1975 (Par Value)
 During the Bretton Woods era from 1947-1971 India followed
the par value system of exchange rate. RBI fixed rupee’s
external value at 4.15 grains of fine gold.
 RBI maintained a par value of INR within permitted band of ±
1% using GBP as currency for intervention.
 Since the sterling-dollar exchange rate was kept stable by the US
Fed the exchange rates of the INR in terms of gold as well and
the dollar and other currencies were also indirectly kept stable.
 After breakdown of Bretton Woods in Aug 1971, INR was
briefly pegged to USD at INR 7.50 per USD before re-pegging it
to GBP at INR 18.97 with a band of ± 2 ¼% in Dec 1971.
 In June 1972 GBP was floated. INR-GBP parity revalued to
INR 18.95 and then in Oct to INR 18.80.
86
Indian Foreign Exchange
Market Brief History
 1975-1992 (Basket Peg)
 In Sept 1975 INR was pegged to an undisclosed currency
basket with margin of ± 2.25%.
 In 1978 RBI allowed interbank dealing in foreign exchange.
 In 1979 margins around basket parity widened to ± 5%.
 The central or mid rate fixed was INR 18.3084/GBP.
 RBI would set the mid rate every morning at 9.15 am.
 Post-Reform Period: 1992 onwards
 In 1991 INR was devalued by 20% between July 1 and July 3
in two steps of 9% and 11% from INR 21.50/USD to INR
25.80 /USD.
 In 1992 Liberalized Exchange Rate Management System
(LERMS) introduced with 60-40 dual exchange rates:
 Exporters of goods & services and remittances from abroad were
allowed to convert 60% of their forex receipts at market 87
determined rates and 40% at RBI official rate.
Indian Foreign Exchange
Market Brief History
 Post-Reform Period: 1992 onwards (Cont..)
 In 1993 Unified Market Determined Exchange Rate System
(UERS) was introduced as follows:
 All forex transactions (receipts & payments under both current
and capital a/c of BOP) would be put through at market rates by
ADs
 Forex receipts and payments continue to be governed by
Exchange Control Regulations laid down in Exchange Control
Manual.
 ADs are free to retain the entire forex surrendered to them for
being sold for permissible transactions and are not required to
surrender to RBI any portion of such receipts.
 Prior to March 1, 1993 u/s 40 of RBI Act 1934 RBI was
obliged to buy and sell Forex to ADs. However, effective
March 1, 1993, under UERS, RBI is not obliged to buy Forex
from or sell Forex to any one. But RBI has a right to intervene
88
with USD being intervention currency.
Indian Foreign Exchange
Market Brief History
 Post-Reform Period: 1992 onwards (Cont..)
 In 1994 RBI announced substantial relaxation of exchange
controls for current account transactions and declared INR
convertible on current account in Aug 1994.
 In 1997 Tarapore Committee on Capital Account
Convertibility submits its report and recommends phased
removal of restrictions on capital account transactions.
 FEMA enacted in 1999 to replace FERA of 1973.
 From 2001 onwards there has been significant liberalization of
the capital account.

89
Indian Foreign Exchange
Market Size
 Average daily turnover of about USD 25-30 bio.
 Interbank transactions : 80% of daily turnover
 Merchant transactions : 20% of daily turnover

Interbank Merchant Aggregate

(%) (%) (%)
Spot 50 50 40
Forward 4 50 40
Swap 46 - 20

90
Indian Foreign Exchange Market:
Regulatory Structure
 All dealings in forex are regulated by Foreign Exchange
Management Act (FEMA) of 1999 with RBI being the
regulatory authority.
 FEMA replaced FERA of 1973 post liberalization.
 Entities authorized by RBI u/s 10 of FEMA 1999 can deal
in forex either as ADs (commercial banks) or Money
Changers.
 Money changers are either full-fledged or restricted.
 AD are allowed to deal in all items classified as foreign
exchange under FEMA
 ADs have to operate within the rules, regulation, and
guidelines issued by Foreign Exchange Dealers’
Association of India (FEDAI) which is a self regulatory 91

body
Indian Foreign Exchange Market:
Regulatory Structure

 Minimum trading amount in the interbank market is USD

1 million
 Reuters Market Data System (RMDS) electronic platform
is used in interbank trading.
 Reuters – D2 is another electronic platform used by some
corporates
 FX – Go

92
Indian Foreign Exchange Market:
Regulatory Structure

93
Indian Foreign Exchange
Market Structure
 Three-Tier Structure:
 RBI and Authorized Dealers (ADs) i.e. commercial
banks
 ADs with each other i.e. interbank market
 ADs and corporate customers i.e. retail segment
 In retail segment in addition to ADs there are
authorized money changers in currency notes and
travelers cheques

94
Indian Foreign Exchange
Market Structure
 Foreign Exchange Dealers’ Association of India
(FEDAI) was set in 1958 as an Association of Banks
dealing in forex in India i.e. ADs as self regulatory body
and is incorporated u/s 25 of The Companies Act 1956
 Its major activities include framing of rules governing the
conduct of inter-bank foreign exchange business among
banks and liason with RBI for reforms and development
of forex market.
 FEDAI forms guidelines and rules for forex business

95
Indian Foreign Exchange
Market Structure
 Functions of FEDAI
 Formulates guidelines and rules for forex business
 Training of bank personnel in the areas of forex business
 Accreditation of brokers
 Advising/ Assisting in member banks in settling issues,
maters relating in their dealing
 Represent member banks on Govt. R.B.I and other bodies
 Announcement of daily and periodical rates to member
banks
 Prescribing margin for calculating exchange rates for
various merchant transactions
 Formulating code of conduct for dealers working in banks, 96
exchange brokers etc. for dealing with each other
Indian Foreign Exchange
Market Structure
 Members of FEDAI
 Public and private sector banks
 Foreign banks
 Co-operative banks
 Financial Institutions such as EXIM Bank, S.I.D.B.I and
others such as Thomas Cook (I) Ltd.
 As of May 2016 there were 108 members

97
Functions of a Forex Department

98
Indian Foreign Exchange
Market Structure
 Inter-bank Quotes given by one bank to another bank in
the inter-bank market.
 Merchant Quotes are quoted by banks to their non-bank
retail customers.
 According to FEDAI rules inter-bank and merchant rates
are quoted upto 4 decimals, last two digits being in
multiples of 25 (e.g. INR/USD: 76.5220/45)
 Inward/outward forex remittances through:
 Telegraphic Transfer (TT)
 Postal or Mail Transfer (MT)
 Demand Draft (DD) 99
Indian Foreign Exchange
Market Structure
 Merchant Rates:
 TT Rate
“TT buying rate” given by AD for clean inward forex
remittance and “TT Selling rate” for clean outward forex
remittance.
 Bill Rate
“Bill buying rate” given by AD for export transaction and
“Bill selling rate” for import transaction.
Two types of bills :
 Sight or Demand Bill
 Time or Usance Bill

 TT and Bill Rate are determined in accordance with

FEDAI rules. 100
Indian Foreign Exchange
Market Structure
Forward Rate Quotations - Reuter
Screen (USD/INR)
December 16, 2021
Forward Rate Quotations - Reuter
Screen (USD/INR)
December 16, 2021
Indian Foreign Exchange Forward
Market
 Forward market liquid upto 12 months.
 Because of exchange controls on capital
movement and imperfect domestic money market
forward premia and discount are not governed by
interest parity.
 This has resulted in one-way arbitrage.
 Forward Premia/Discount are determined by
demand and supply.
 Forex Swaps active in interbank market to cover
forward exposures with customers.
 Early Delivery/Extension/Cancellation of Forward
Contracts permitted by RBI. 104
Forward Rate Quotations - Reuter
Screen (USD/INR)
December 16, 2021
Indian Foreign Exchange Market
INR-USD Annualized Forward Premia
December 16, 2021
USD-INR Exchange Rate: Dec-
1994 to Dec-2021

USD/INR at 76.00
20 Dec, 2021

107
USD-INR Exchange Rate: Past
One Year
28 Oct 2022:
82.43 INR
1st Jan 2022 : USD/INR = 74.51
28 Oct 2022 : USD/INR = 82.43
INR Depreciation of 10.63% against USD since 1 st Jan 2022

Oct 28.2021:
74.88 INR

108
Source: https://www.exchangerates.org.uk/USD-INR-exchange-rate-history.html
Booking and Cancellation of
Forward Exchange Contracts
 Eligibility for Booking Forward Contracts
 Forward Contract booking will have to be based on
underlying documents
 Eligible Limit during the current FY (April-March) based
on past performance:
 Average of the previous 3 financial years’ actual export
turnover or the previous year’s actual export turnover,
whichever is higher
 Average of the previous 3 financial years’ actual import
turnover or the previous year’s actual import turnover,
whichever is higher for imports
 Minimum NW = INR 200 cr; Min Exports + Imports = Rs109
1000 cr.
Booking and Cancellation of
Forward Exchange Contracts
 Cancellation of Forward Contracts:
 Contracts booked upto 75% of the eligible limit mentioned
above may be cancelled with the exporter/importer
bearing/being entitled to the loss or gain as the case may be
 Contracts booked in excess of 75% of the eligible limit
mentioned above shall be on deliverable basis and cannot be
cancelled implying that in the event of cancellation, the
exporter/importer will have to bear the loss but will not be
entitled to receive the gain

110
Booking and Cancellation of
Forward Exchange Contracts
 Forward contracts booked to hedge capital account
 Transactions for tenor > 1 year if cancelled can be
rebooked subject to :
 Switch is warranted by competitive rates on offer and
termination of banking relationship with AD with whom
the contract was originally booked
 Cancellation and rebooking are done simultaneously on the
maturity date of the contract
 The above flexibilty in regard to roll over of contracts by
switching AD category banks on maturity date of contract
extended to all hedge transactions undertaken by
residents.

111
 Booking and Cancellation of
Forward Exchange Contracts
 Example 1:

------------------------I------------I----------------
0 3 mth 4 mth 6 mth (INR 77/USD)
I------------------------------> (INR 78/USD)
I-----------------> (INR 77.50/USD)

1) Importer books forward contract for 6 mths @ INR 77/USD

2) Cancels : t = 3 mths @ INR 78/USD. Gain = INR 1/USD
3) Re-books : t = 4 mths @ INR 77.50/USD. Loss = INR0.50/USD
4) Net Gain : INR 0.50/USD
5) Effective Forward Rate = INR 76.50/USD
If F (t=4) < INR 78/USD  Net Gain by rebooking Forward
If F (t=4) > INR 78/USD  Net Loss by rebooking Forward 112
 Booking and Cancellation of
Forward Exchange Contracts
 Example 2:

----------------------I------------I-----------------
0 3 mth 4 mth 6 mth (INR 77/USD)
I------------------------------> (INR 76/USD)
I-----------------> (INR 76.50/USD)

1) Exporter books forward contract for 6 mths @ INR 77/USD

2) Cancels : t = 3 mths @ INR 76/USD. Gain = INR 1/USD
3) Re-books : t = 4 mths @ INR 76.50/USD. Loss = INR 0.50/USD
4) Net Gain : INR 0.50/USD
5) Effective Forward Rate = INR 77.50/USD
If F(t=4) > INR 76/USD  Net Gain by rebooking Forward
If F(t=4) < INR 76/USD  Net Loss by rebooking Forward 113
Non-Deliverable Forward
What is Non-Deliverable Forward Contract ?
 NDF is similar to deliverable forward.

 The difference is that no physical delivery of the local

currency e.g. Indian Rupee takes place as the local
currency is not convertible and therefore ‘not deliverable’
offshore.
 No principal amount is exchanged.

 The deal is settled against spot fixing rate prevailing two

days prior to maturity date.
 Net settlement amount in USD is calculated as the
difference between the agreed NDF rate and the spot
fixing rate. 114
Non-Deliverable Forward Market
 The NDF markets have evolved in offshore centres for
domestic currencies because of following reasons:
 Foreign exchange convertibility restrictions
 Domestic forward foreign exchange market not developed
 Restrictions on non-resident access to domestic forward
markets.
 E.g. emerging Asian economies include Taiwan, Korea,
Indonesia, India, China, Philippines etc.
 Being offshore, the NDF market is outside the regulatory
purview of local monetary authorities.
 There is a linkage between onshore spot and forward
market and the NDF market. 115
NDF Market for Indian Rupee
 Genesis in the 1990’s as currency hedging avenue for
foreign investors investing in India
 Singapore and Hong Kong are the major centres followed
by Dubai and Bahrain
 It is Over the counter (OTC) market
 Average daily turnover of USD 4-5 bio in 2007 compared
to USD 100 mio in 2003.
 Major global banks offer NDF in INR offshore
 No controls by RBI for offshore participation in INR
NDF
 Indian banks/FIs not allowed to participate by RBI
116
NDF Market Players
 Non-residents speculate on INR without any exposure to
the country
 Arbitrageurs try to exploit differential in pricing in the
two markets without any outlay of capital by two
offsetting transactions e.g.
- Corporates/Banks/FIs with international presence
- Exporters and Importers
 MNCs / Foreign Investors participate in NDF market to
hedge their exposures

117
NDF Definitions
-----------------------------------------------I--------
0 T-2 T

1) Trade Date (t = 0) : Client enters into forward agreement to

buy/sell INR at contracted NDF rate
2) Settlement / Delivery : Date of maturity of NDF contract
Date (t = T)
3) Fixing Date (t = T-2) : Date for comparing the NDF rate with
prevailing spot rate
4) Contracted NDF Rate: Forward Rate agreed between the two
counterparties on the trade date
5) Prevailing Spot Rate : Spot rate on fixing date i.e. RBI
reference rate at 12:00 noon
118
NDF Definitions
6) Notional Amount : “Face Value” of NDF agreed between
the two counterparties. Notional
amounts in two currencies is not
exchanged

If NDF > S  Buyer of NDF pays the seller the difference i.e.
(NDF – S)
If NDF < S  Seller of NDF pays the Buyer the difference i.e.
(S – NDF)

119
NDF Examples
Example 1:
Assume NDF rate of 1 USD = INR 61 for settlement on 31 st
Dec in Singapore forex market.
Overseas buyer agrees to Buy USD 1 mio (Sell INR 61 mio)
for settlement on 31st Dec.
Overseas seller agrees to Sell USD 1mio (Buy INR 61 mio)
for settlement on 31st Dec.
If on fixing date i.e. 29th Dec :
(1) RBI Reference Rate = INR 62/USD
 Buyer makes profit of INR 1/USD
 Seller will pay the Buyer USD (1/62) x 1 mio
= USD 16,129
120
NDF Examples
(2) RBI Reference Rate = INR 60 /USD
 Seller makes profit of INR 1 /USD
 Buyer will pay the Seller USD (1/60) x 1 mio
= USD 16,667

(3) RBI Reference Rate = INR 61/USD

 No Profit /Loss
Greater the difference between RBI Reference Rate and
NDF Rate greater the Profit /Loss

121
NDF Examples
Example 2:
Singapore (NDF)
-----------------------------------------
T=0 Mumbai (Forward) T=6 mth

Singapore : NDF (6 mths) = INR 61/USD

Mumbai : Forward (6 mths) = INR 63/USD
NDF is quoting at a discount of INR 2 to Forward Rate
“Buy” NDF in S’pore and simultaneously “Sell” Forward in
Mumbai
(1) RBI Reference Rate on Fixing Date = INR 60/USD
Singapore: Loss INR 1 Mumbai: Profit INR 3
Net Profit : INR 2 122
NDF Examples

(2) RBI Reference Rate on Fixing Date = INR 64/USD

Singapore : Profit INR 3 Mumbai: Loss INR 1
Net Profit : INR 2
Net Profit on USD 1mio = USD (2/RBI Ref Rate) x 1mio
= USD 31,250
(A) Greater the difference between NDF Rate and Forward
Rate higher the Net Profit
(B) Lower the RBI Reference Rate compared to the NDF
Rate higher the Net Profit

123
NDF Examples
Example 3:
Singapore (NDF)
-----------------------------------------
T=0 Mumbai (Forward) T=6 mth

Singapore : NDF (6 mths) = INR 63.00/USD

Overseas Investor : Sells USD 1 mio and Buys INR 63 mio from
Bank ‘A’ at 6-mth NDF rate of INR 63.00/USD for payment of
equity purchase on 31st Dec 2015.
(1) If RBI Reference Rate on 29th Dec 2014 = INR 61/USD
 Bank ‘A’ pays the investor INR 2/USD.
Total amount paid = USD (2/RBI Ref Rate) x 1mio =
= USD 32,787
124
NDF Examples
Example 3 (Cont..):
Singapore (NDF)
---------------------------------------------------
T=0 Mumbai (Forward) T=6 mth

(2) If RBI Reference Rate on 29th Dec 2014 = INR 64/USD

 Investor pays Bank ‘A’ INR 1/USD.
Total amount paid = USD (1/RBI Ref Rate) x 1mio =
= USD 15,625

125
1 month Offshore vs. Onshore Forward
Analysis

Green Area shows that 1m Offshore Forward trades at discount i.e. 1m Offshore forward is less than 1m Onshore forward.
Red Area shows that 1m Offshore Forward trades at premium i.e. 1m Offshore forward is more than 1m Onshore forward

126
6 month Offshore vs. Onshore Forward
Analysis

Green Area shows that 6m Offshore Forward trades at discount i.e. 6m Offshore forward is less than 6m Onshore forward
Red Area shows that 6m Offshore Forward trades at premium i.e. 6m Offshore forward is more than 6m Onshore forward

127