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Foreign Exchange Foreign Exchange Markets Markets By Akshay Samant By Akshay Samant

Exchange rates

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Page 1: Exchange rates

Foreign Exchange MarketsForeign Exchange Markets

By Akshay SamantBy Akshay Samant

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History Of MoneyHistory Of Money

• Barter & Ancient TradeBarter & Ancient Trade

– Historians trace the origins of barter to the early Historians trace the origins of barter to the early stone age period between 8000 BC and 6000 BC stone age period between 8000 BC and 6000 BC in middle east, Greece, Turkey, Asia & Africa.in middle east, Greece, Turkey, Asia & Africa.

– Barter – To trade by exchanging goods and Barter – To trade by exchanging goods and services for other goods & services not money.services for other goods & services not money.

– Successful Barter – Mr. A must want what Mr. B Successful Barter – Mr. A must want what Mr. B has & Mr. B must simultaneously want what Mr. A has & Mr. B must simultaneously want what Mr. A has.has.

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– Coins first struck in the region of Lydia now Coins first struck in the region of Lydia now modern Turkeymodern Turkey

– The paper money first emerged in China under The paper money first emerged in China under Tang Dynasty (618 AD - 907 AD)Tang Dynasty (618 AD - 907 AD)

– The functions of currency The functions of currency • Medium of exchange Medium of exchange

• Value of exchangeValue of exchange

• Store of valueStore of value

– Characteristics of money - convertibility, Characteristics of money - convertibility, portability, divisibility, durability, stability of portability, divisibility, durability, stability of value value

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The History of Foreign The History of Foreign Exchange MarketsExchange Markets

• The origins of modern – day financial The origins of modern – day financial centers were the late 17centers were the late 17thth century century

• Coffee houses of London close to the Royal Coffee houses of London close to the Royal Exchange, mercantile hub set up by Exchange, mercantile hub set up by English merchant and financier Sir Thomas English merchant and financier Sir Thomas Gresham in the 16Gresham in the 16thth century. century.

• Information list, Lloyd’s list – Exchange Information list, Lloyd’s list – Exchange raterate

• East India Company – Longest surviving East India Company – Longest surviving company of all time, global trade.company of all time, global trade.

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• The advent of Fx markets in 1970s led to The advent of Fx markets in 1970s led to the development of inter bank markets, Fx the development of inter bank markets, Fx trading.trading.

• Sole domain of commercial banks & Sole domain of commercial banks & investment banks.investment banks.

• New players – Insurance companies, New players – Insurance companies, pension funds, mutual funds & hedge pension funds, mutual funds & hedge funds.funds.

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• Before the invention of fax machines and Before the invention of fax machines and internet Fx business was conducted via internet Fx business was conducted via telex and dedicated telephone linestelex and dedicated telephone lines

• These channels were replaced by electronic These channels were replaced by electronic communications networks ECN’s set up by communications networks ECN’s set up by information service providers such as information service providers such as Reuters & EBS (electronic broking service)Reuters & EBS (electronic broking service)

• The advent of ECN’s fueled explosive The advent of ECN’s fueled explosive growth in foreign exchange trading.growth in foreign exchange trading.

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• The growth was further driven by the The growth was further driven by the emergence of the internet in the 1990’semergence of the internet in the 1990’s

• It lowered the cost of handling and It lowered the cost of handling and processing information, and brought processing information, and brought foreign exchange trading services online.foreign exchange trading services online.

• Services such as prime brokerage, white – Services such as prime brokerage, white – labeling & algorithmic trading are growing labeling & algorithmic trading are growing in these markets. Amid intense in these markets. Amid intense competition between the different liquidity competition between the different liquidity providers to capture market share in providers to capture market share in foreign exchange tradingforeign exchange trading

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• Prime brokerage – The term ‘prime broker’ Prime brokerage – The term ‘prime broker’ describes an investment banks package of describes an investment banks package of services for clients, mostly hedge funds services for clients, mostly hedge funds clients.clients.

• White labelling – this allows smaller banks & White labelling – this allows smaller banks & financial institution to outsource their financial institution to outsource their currency pricing to providers with large currency pricing to providers with large liquidity base, such as HSBC, Citigroup, liquidity base, such as HSBC, Citigroup, Deutsch bank, while promoting these Deutsch bank, while promoting these services under their own name.services under their own name.

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• Algorithmic trading – Also known as Algorithmic trading – Also known as ‘automatic’, blackbox, or robo trading where ‘automatic’, blackbox, or robo trading where the investor places an order to buy or sell and the investor places an order to buy or sell and the computer automatically generates the the computer automatically generates the timing of orders and the size of orders based timing of orders and the size of orders based on goals specified by algorithmic parameters on goals specified by algorithmic parameters and constraints.and constraints.

• The online foreign Exchange trading platform – The online foreign Exchange trading platform – Fx connect, Fxall & Currenex. These are Fx connect, Fxall & Currenex. These are multibank foreign exchange trading network multibank foreign exchange trading network that provides secure, real time trade execution that provides secure, real time trade execution with multiple counterparties 24 hours a day with multiple counterparties 24 hours a day

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• The most important component of daily The most important component of daily trading volume is speculation activitytrading volume is speculation activity

• This usually relates to global capital This usually relates to global capital seeking the most profitable return in the seeking the most profitable return in the shortest period of time.shortest period of time.

• Currency market players worldwide Currency market players worldwide followed two key strategies followed two key strategies – One is based on interest rate differentials by One is based on interest rate differentials by

investing in high yielding currencies. Popular investing in high yielding currencies. Popular among high leveraged players among high leveraged players “carry trade”“carry trade”

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– Momentum trading – where investors took Momentum trading – where investors took large positions in currencies aimed at large positions in currencies aimed at exploiting long swings or runs in exchange exploiting long swings or runs in exchange ratesrates

• Characteristics of Fx marketCharacteristics of Fx market– 24 hour market – time zone enter / exit24 hour market – time zone enter / exit– Liquidity – better depth & breadthLiquidity – better depth & breadth– Easy entry – (online trading)Easy entry – (online trading)– Simple trading decisions – (a few of the worlds Simple trading decisions – (a few of the worlds

currenciescurrencies

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– High leverage possible – (leverage their High leverage possible – (leverage their position as much as 100 times)position as much as 100 times)

– Low transaction cost – (commission free Low transaction cost – (commission free & no exchange or Clearing free)& no exchange or Clearing free)

– Real time quotes, instant execution Real time quotes, instant execution (execute their trades directly off real (execute their trades directly off real time bid-ask quotes, trade executed time bid-ask quotes, trade executed with much more certainty)with much more certainty)

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• Leading currencies Leading currencies – The four most imp currencies in foreign The four most imp currencies in foreign

exchange markets in term of trading exchange markets in term of trading volume are:volume are:•US Dollar – USDUS Dollar – USD

•Euro – EUREuro – EUR

• Japanese yen – JPYJapanese yen – JPY

•UK pound sterling – GBP UK pound sterling – GBP

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– International organization for International organization for standardization (ISO) has assigned the standardization (ISO) has assigned the above codes. Generally currency code is above codes. Generally currency code is composed of the country’s two character composed of the country’s two character code plus extra character to denote the code plus extra character to denote the currency unitcurrency unit•Swiss Franc – CHF (Confoederatio Helvetica)Swiss Franc – CHF (Confoederatio Helvetica)•Canadian dollar – CADCanadian dollar – CAD•Australian dollar – AUD Australian dollar – AUD •New Zealand dollar – NZDNew Zealand dollar – NZD• Indian rupee – INR Indian rupee – INR

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– Currencies trade in pairs in foreign exchange Currencies trade in pairs in foreign exchange market. This involves simultaneously buying market. This involves simultaneously buying one currency and selling another currency.one currency and selling another currency.

– Important currency pairs areImportant currency pairs are• EUR/USDEUR/USD• USD/JPYUSD/JPY• GBP/USDGBP/USD• USD/CHFUSD/CHF• USD/CADUSD/CAD• AUD/USDAUD/USD• NZD/USD NZD/USD

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– The first currency in the pair is The first currency in the pair is considered the base currency and the considered the base currency and the second currency is the quote currencysecond currency is the quote currency

– Most of the time, the US dollar acts as Most of the time, the US dollar acts as the base currency. Quotes are the base currency. Quotes are expressed in units of US $1 per quote expressed in units of US $1 per quote currency.currency.

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Exchange Rates Exchange Rates Need of exchange of currency of one Need of exchange of currency of one

country or another country.country or another country.

Inflow or outflow of goods, capital or Inflow or outflow of goods, capital or services, cross border movement of services, cross border movement of man power travel and tourism.man power travel and tourism.

Foreign exchange has become an Foreign exchange has become an integral part of the world financial integral part of the world financial system. system.

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DefinitionDefinition

(FEMA) defines(FEMA) defines 1. 1. Foreign Exchange means foreign currency, and includes Foreign Exchange means foreign currency, and includes

(a) All deposits, credits and balances payable in foreign (a) All deposits, credits and balances payable in foreign currency, and any drafts, travellers chques, letter of credit currency, and any drafts, travellers chques, letter of credit and bills of exchange expressed or drawn in Indian and bills of exchange expressed or drawn in Indian currency and payable in any foreign currency.currency and payable in any foreign currency.

(b) Any instrument payable at the option of the drawee or (b) Any instrument payable at the option of the drawee or holder, then of or any other party then to, either in Indian holder, then of or any other party then to, either in Indian currency or its foreign currency or partly in one and partly currency or its foreign currency or partly in one and partly in the other.in the other.

2.2. Exchange rate is the price or the ratio or the value at Exchange rate is the price or the ratio or the value at which one currency is exchanged for another currency.which one currency is exchanged for another currency.

3.3. Exchange rate is the dynamic rate. Exchange rate is the dynamic rate.

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Who Uses Foreign Exchange?Who Uses Foreign Exchange? Comprise individuals, business entities, banks investors, users and Comprise individuals, business entities, banks investors, users and

arbitrageurs, across the globe.arbitrageurs, across the globe. OTC (over the counter) communication system based, with no boundries and OTC (over the counter) communication system based, with no boundries and

round the clock.round the clock. Tokyo and Sydney (east) through Hong Kong, Singapore, Middle East, India, Tokyo and Sydney (east) through Hong Kong, Singapore, Middle East, India,

London, Europe, New York – Different time zones.London, Europe, New York – Different time zones. Participants:Participants:

Central BanksCentral Banks

Commercial BanksCommercial Banks

Investment funds / BanksInvestment funds / Banks

Forex BrokersForex Brokers

CorporationsCorporations

IndividualIndividual Global forex turnover US $ 1.90 trillion trade turnover 750 Billion (other Global forex turnover US $ 1.90 trillion trade turnover 750 Billion (other

investment / speculation) India turn over 1.20 billion investment / speculation) India turn over 1.20 billion

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Factors Affecting Exchange RatesFactors Affecting Exchange Rates

Exchange controlExchange control

Balance of paymentBalance of payment

Relative price – inflation, asset market, Relative price – inflation, asset market, economic growth rate, monetary policyeconomic growth rate, monetary policy

Interest rate Interest rate

Political issuesPolitical issues

Demand and supply – visible / invisible trade Demand and supply – visible / invisible trade export and import, services, shipping, insurance export and import, services, shipping, insurance banking, tourists, student studying, gifts banking, tourists, student studying, gifts

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Currency Trading TrendsCurrency Trading Trends

Foreign exchange trading volume is $1.9 Foreign exchange trading volume is $1.9 trillion a daytrillion a day

It is estimated 95% of foreign exchange It is estimated 95% of foreign exchange transactions are speculationtransactions are speculation

This usually relates to global capital This usually relates to global capital sucking the most profitable return tn the sucking the most profitable return tn the shortest period of time.shortest period of time.

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UK & US accounted for the 50% of the daily UK & US accounted for the 50% of the daily turnover while Japan 8% and Singapore 5% of turnover while Japan 8% and Singapore 5% of the average daily turnoverthe average daily turnover

The major attraction of foreign exchange The major attraction of foreign exchange markets includemarkets include High liquidity levelHigh liquidity level High accessibility for many different types of High accessibility for many different types of

participants.participants. Efficiency Efficiency

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The USD, Euro, UK pound and Japanese The USD, Euro, UK pound and Japanese continue to be the four most important continue to be the four most important currencies in the world and account for the currencies in the world and account for the dominant share of foreign exchange dominant share of foreign exchange trading.trading.There is also a notion that currencies have There is also a notion that currencies have become an asset class in themselves as become an asset class in themselves as investors search for yield around the investors search for yield around the globe.globe.

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Exchange Rates & Their Exchange Rates & Their MovementsMovements

There is no exchange rate model that can There is no exchange rate model that can predict future currency prices with 100% predict future currency prices with 100% accuracy.accuracy.

In rapidly growing global foreign exchange In rapidly growing global foreign exchange markets, currency movements become harder to markets, currency movements become harder to predict as more participants enter the market on predict as more participants enter the market on daily basis.daily basis.

Research, opinions, emotions, expectations Research, opinions, emotions, expectations about where currencies headed.about where currencies headed.

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Currency movements in the short term Currency movements in the short term can be influenced by publicly available can be influenced by publicly available information's – information's –

a)a) Country’s GDP dataCountry’s GDP datab)b) Consumer price indexConsumer price indexc)c) Employment dataEmployment data

Central banks, such as the US Federal Central banks, such as the US Federal reserve or the European Central bank reserve or the European Central bank raising or covering interest ratesraising or covering interest rates

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Central banks making public their thoughts on Central banks making public their thoughts on monetary policymonetary policy

Political developments, both globally and in Political developments, both globally and in individual countries.individual countries.

Natural disasters and perceptions about how Natural disasters and perceptions about how they will impact economies.they will impact economies.

Changes in commodity prices, particularly oil Changes in commodity prices, particularly oil and gold. and gold.

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Individual traders – in – house strategic analyze an Individual traders – in – house strategic analyze an currencies or buy & sell orders that come from currencies or buy & sell orders that come from customers, which can affect the decisions process of customers, which can affect the decisions process of market participants.market participants.

FOMC – Federal Open Market committeeFOMC – Federal Open Market committee

If a country’s stock market rallies, its currency If a country’s stock market rallies, its currency could strengthen – the correlation between could strengthen – the correlation between stocks and currencies is strong enough to make stocks and currencies is strong enough to make currency traders watch stock markets for cues currency traders watch stock markets for cues on the performance of currencies.on the performance of currencies.

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If oil prices surge to record high, it can If oil prices surge to record high, it can have a negative impact on some have a negative impact on some currencies.currencies.An increase in a country’s unemployment An increase in a country’s unemployment numbers can have a negative impact on numbers can have a negative impact on its currencyits currencyIf a country’s Central bank makes a If a country’s Central bank makes a surprise decision to raise rates by more surprise decision to raise rates by more than expected, its currency could rally. than expected, its currency could rally.

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Exchange Rate MechanismExchange Rate Mechanism

• Spot - settlement / delivery of funds takes place on the second after / following the date of contract deal 21.7.09 - 23.7.09

• Forward - Delivery takes place after day• Ready \ Cash - settlement on the same day 21.7.09 -

21.7.09• TOM - settlement takes place next day of date of deal

21.7.09 - 22.7.09 • Value date - The date of delivery of funds on the date on

which the exchange of currencies actually takes place is also referred as value date

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Forward MarginsForward Margins

Forward rate are derived from spot rates and are either at Forward rate are derived from spot rates and are either at premium or discount. (forward margin) premium or discount. (forward margin) Forward rate= spot rate +/- premium or discount Forward rate= spot rate +/- premium or discount

Forward value of the currency is higher than the spot Forward value of the currency is higher than the spot (present) value, the currency is said to be in premium. (present) value, the currency is said to be in premium.

₤ ₤ = $ 1.8350 21.7.09= $ 1.8350 21.7.09 ₤ ₤ = $ 1.8450 21.8.09 (100 pips)= $ 1.8450 21.8.09 (100 pips) GBP- is dearer and at PremiumGBP- is dearer and at Premium USD – is at Discount against GBPUSD – is at Discount against GBP

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1$ = 47.50/52 Spot (21.7.09)1$ = 47.50/52 Spot (21.7.09) 1 USD being bought at 47.50 & sold at 47.521 USD being bought at 47.50 & sold at 47.52 40/42 Six month premium 40/42 Six month premium It means that USD being quoted dearer in It means that USD being quoted dearer in

forward & is quoted 47.90/94forward & is quoted 47.90/94 Rupee is quoted at discountRupee is quoted at discount

The correlations clearly established as the The correlations clearly established as the

quotes are for a pair of currencies, where quotes are for a pair of currencies, where one is exchanged for another. one is exchanged for another.

The forward premiums & discount are The forward premiums & discount are based on the interest rate differentials of based on the interest rate differentials of two currencies involved as also the two currencies involved as also the demand and supply of forward in the demand and supply of forward in the marketsmarkets

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Direct – one unit of FC to so many units of Direct – one unit of FC to so many units of home currency (variable).home currency (variable).

Indirect – one unit of home currency to so Indirect – one unit of home currency to so many units of FC (GBP, Euro, AUd, NZd, many units of FC (GBP, Euro, AUd, NZd, indirect rates) indirect rates)

Purchase and SalePurchase and Sale Export – purchase – FC to Rs (domestic Export – purchase – FC to Rs (domestic

currencies) currencies) Import sale – sale – Rs to FCImport sale – sale – Rs to FC Outward – saleOutward – sale Inward – purchaseInward – purchase US $ 1 = 40.50 Buy Low (give less)US $ 1 = 40.50 Buy Low (give less) = 40.52 Sell High (take more)= 40.52 Sell High (take more)

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When we deal in a market where rate for a When we deal in a market where rate for a particular currency pair are not particular currency pair are not directly availabledirectly available, , the price for the said currency pair is then obtained the price for the said currency pair is then obtained indirectlyindirectly with help of a cross rate mechanism. with help of a cross rate mechanism.

Quote for Euro / RupeeQuote for Euro / Rupee No one will quote Euro / Rupee No one will quote Euro / Rupee Directly Directly The rate can be worked out by the Euro/USD & USD/Rupee The rate can be worked out by the Euro/USD & USD/Rupee

quotes.quotes. Euro/USD is available in the international market.Euro/USD is available in the international market. USD/Rs is available in the domestic market. USD/Rs is available in the domestic market.

Cross RateCross Rate

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By crossing out USD in both the quotes, By crossing out USD in both the quotes, we can arrive at Euro/Rswe can arrive at Euro/Rs

For example we need to quote For example we need to quote GBP against INRGBP against INR

USD/INR & GBP/USDUSD/INR & GBP/USD to compute GBP / INR rateto compute GBP / INR rate 1 USD = Rs 45.50/601 USD = Rs 45.50/60

$1.8340/50= $1.8340/50= ££ 1 1 ££ 1= 83.447 Rs (buying) 1= 83.447 Rs (buying)

83.676 Rs (selling)83.676 Rs (selling)

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Fixed vs. Floating RatesFixed vs. Floating Rates

Fixed Exchange rate is official rate Fixed Exchange rate is official rate set by the monetary authorities for set by the monetary authorities for one or more currencies. It is usually one or more currencies. It is usually pegged to one or more currencies.pegged to one or more currencies.

Floating Exchange rate – The value of Floating Exchange rate – The value of the currency is decided by supply the currency is decided by supply and demand factorsand demand factors

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Bid and Offer RateBid and Offer Rate

Buying rates and selling rates are Buying rates and selling rates are also referred to as bid and offered also referred to as bid and offered rates (bid & ask)rates (bid & ask) In USD/INR = 47.00/02In USD/INR = 47.00/02

The quoting bank is bidding for USD at 47 The quoting bank is bidding for USD at 47 and is offering to sell the USD at 47.02and is offering to sell the USD at 47.02

On the other hand in GBP/USD = On the other hand in GBP/USD = 1.8810/151.8810/15

The quoting bank is willing to buy GBP at The quoting bank is willing to buy GBP at 1.8810 and willing to sell at 1.8815.1.8810 and willing to sell at 1.8815.