Foreign Exchange Management

Foreign Exchange Market

• A global decentralized or over-the-counter
market for the trading of currencies.

• Determines foreign exchange rates for every

currency. It includes all aspects of buying
selling and exchanging currencies at current or
determined prices.
 Bid and Offer Price
• Normally a dealer quotes a two-way price,
whereby it indicates both at what level it is
prepared to buy the base currency against the
variable currency (the bid for the base
currency – a cheaper rate), and at what level it
is prepared to sell the base currency against
the variable currency (the offer of the base
currency – a more expensive rate)
 Bid and Offer Price
• A foreign exchange dealer will quote both bid
and offer foreign exchange prices.

• The bid price is the price at which the dealer

will purchase a currency.

• While the offer/ask price is the price at which

the dealer will sell a currency.
 Spread
• The difference between bid and offer price or
rate is called the Spread

• represents the dealer’s profit for being willing

to take the risk of quoting prices to other
parties.
 Spot Rate
• The current exchange rate between any two
currencies is known as the spot rate .

• When a company requires foreign exchange

immediately, it engages in a spot settlement ,
though there is actually a one - to - two day
delay in final settlement of the transaction.

• Such a transaction is generally used for

converting one currency to another.
 Spot Rate
• The Value Date

• A spot transaction is for delivery of two working

days after the dealing date (the date on which
the contract is made). This allows time for the
necessary paperwork and cash transfers to be
arranged.
 How Spot Rates are Quoted
• Base Currency
• When comparing the price of one currency to
another, the base currency is the unit of
currency that does not fluctuate in amount.
• for example, the US dollar/Japanese yen
exchange rate is written as ‘USD/JPY’ if it refers
to the number of yen equal to 1 US dollar . The
currency code written on the left is the base
currency; there is always 1 of the base unit.
 How Spot Rates are Quoted
• Quoted/ Counter/ Variable Currency
• while the quoted currency or price currency does
fluctuate.

• For example, the US dollar/Japanese yen exchange

rate is written as ‘USD/JPY’ The currency code
written on the right is the variable currency (or
counter currency or quoted currency); the number of
units of this currency equal to 1 of the base currency
varies according to the exchange rate.
 Cross Rate
• Cross exchange rates represent the
relationship between two currencies that are
different from one's base currency. It refers to
the exchange rate between two currencies,
given the values of currencies with respect to
a third currency.
 Long Position
• A long position is a surplus of purchases over
sales of a given currency – i.e., a position
which benefits from a strengthening of that
currency.
 Short Position
• A short position is a surplus of sales over
purchases of a given currency, which benefits
from a weakening of that currency.
 Square Position
• A square position is one which is neither long
nor short – i.e. one in which the sales and
purchases are equal.
 Types of Forex Derivatives
• Futures Contract

• Forward Contract

• Option Contract

• SWAP Contract
 Forward Exchange Rate
• The exchange rate between any two currencies at
some future date is known as Forward Rate.

• It is the most commonly used foreign exchange

hedge, a company agrees to purchase a fixed amount
of foreign currency on a specific date, and at a
predetermined rate.

• This allows it to lock in the rate of exchange up front

for settlement at a specified date in the future.
 Forward-Forwards
• A forward-forward swap is a swap deal
between two forward dates rather than from
spot to a forward date – for example, to sell
‘X’ dollars 1 month forward and buy them
back 3 months forward. In this case, the swap
is for the 2-month period between the 1-
month date and the 3-month date.
 Non-Deliverable Forwards
• A non-deliverable forward (NDF) is a forward
outright where, instead of settling the outright
amounts at maturity, the two parties agree at
the outset that they will settle only the change
in value between the forward rate dealt and
the spot rate two working days before
maturity.
 Non-Deliverable Forwards
• Advantages

• An NDF also reduces the counterparty credit

risk, as the risk is limited to the settlement
amount and does not involve the usual
settlement risk of the whole principal amount
of the deal.
 Futures Contract
• A currency future is the same as a forward
exchange contract, except that it trades on an
exchange. Each contract has a standardized
size, expiry date, and settlement rules.
 Futures Contract
• Participants in currency futures contracts can
be "hedgers" seeking to lock in a price to
diminish the risk of a future price change, or
they can be "speculators" who enter into a
trade seeking potential gains.
 Futures Contract

• ABC Company ships product to a German customer in February and

expects to receive a payment of 425,000 euros on June 12. ABC Co.
treasurer elects to hedge the transaction by selling a futures
contract. The standard contract size for the EUR/USD pairing is
100,000 euros, so ABC Co. sells four contracts to hedge its expected
receipt of 425,000 euros. This contract always expires on Fridays;
the nearest Friday following the expected receipt date of the euros
is on June 15, so ABC Co. enters into contracts having that expiry
date. Because the standardized futures contracts do not exactly fit
ABC Co ’ s transaction, ABC Co. is electing not to hedge 25,000
euros of the expected receipt, and it will also retain the risk of
exchange rate fluctuations between its currency receipt date of
June 12 and its currency sale date of June 15.
 Forward Contract
• Like a futures contract, a forward contract is
an agreement to buy or sell a quantity of a
currency at a pre-established price on a
particular date in the future.
 Forward Contract
• Forward contracts are traded on an over-the-
counter basis between two parties, and unlike
futures contracts, these are not regularly
bought and sold on exchanges.
 Option Contract
• An option is a contract which gives the buyer
(the owner or holder of the option) the right,
but not the obligation, to buy or sell an
underlying asset or instrument at specified
strike price prior to or on a specified date,
depending on the form of the option.
 Option Contract
• A call option permits the buyer to buy the
underlying currency at the strike price,

• while a put option allows the buyer to sell the

underlying currency at the strike price.
 Option Contract
• An option is easier to manage than a forward exchange
contract because a company can choose not to exercise its
option to sell currency if a customer does not pay it.

• Options are especially useful for those companies

interested in bidding on contracts that will be paid in a
foreign currency. If they do not win the bid, they can
simply let the option expire, without any obligation to
purchase currency. If they win the bid, then they have the
option of taking advantage of the exchange rate that they
locked in at the time they formulated the bid.
 Option Contract
• Currency options are both available over the
counter and are traded on exchanges. Those
traded on exchanges are known as listed
options .

• The contract value, term, and strike price of a

listed option is standardized, whereas these
terms are customized for an over - the -
counter option.
 Option Contract
• Within an option agreement, the strike price
states the exchange rate at which the
underlying currency can be bought or sold, the
notional contract amount is the amount of
currency that can be bought or sold at the
option of the buyer, and the expiry date is the
date when the contract will expire, if not
previously exercised.
 Option Contract
• an option agreement requires the payment of
an up -front premium to purchase the option,
so not exercising the option means that the
fee is lost.

• This may be fine if a gain from currency

appreciation offsets the fee.
 Time Options

• The disadvantage is the cost, given the wide

bid/offer spread involved, particularly if the
time period of the option is a long one.
 SWAP Contract
• A SWAP is an agreement between two
counterparties to exchange financial
instruments or cash flows or payments for a
certain time.
 Example
• consider the case of an American business that borrowed money
from a US-based bank (in USD) but wants to do business in the
UK. The company’s revenue and costs are in different currencies.
It needs to make interest payments in USD whereas it generates
revenues in GBP. However, it is exposed to risk arising from the
fluctuation of the USD/GBP exchange rate.
• The company can use a USD/GBP currency swap to hedge
against the risk. In order to complete the transaction, the
business needs to find someone who is willing to take the other
side of the swap. For example, it can look for a UK business that
sells its products in the US. It should be clear from the structure
of currency swaps that the two transacting parties must have
opposing views on the market movement of the USD/GBP
exchange rate.