"Foreign Exchange Market" - INTERNATIONAL FINANCE -3

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Foreign Exchange Market

The foreign exchange market is an OTC (over-the-counter) market, i.e. there is no physical marketplace where the deals are made. Instead, it is a network of banks, brokers and dealers spread across the various financial centers of the world. These players trade in different currencies through (and are linked to each other by) telephones, faxes, computers and other electronic networks like the SWIFT system (Society for Worldwide Interbank Financial Tele-communications). These traders generally operate through a trading room. The deals are mostly done on an oral basis, with written confirmations following later.

The Structure

The main players in the foreign exchange market are large commercial banks, forex brokers, large corporations and the central banks. Central banks normally enter the market to smoothen out fluctuations in the exchange rate (as under dirty float) or to maintain fixed exchange rates.

Large commercial banks deal in the market both for executing their clients’ (both corporates and individuals) orders and on their own account. They act as the market makers in the forex markets, i.e, they stand ready to buy or sell various currencies at specific prices at all points of time. The commercial banks give, on demand, a quote for a particular currency against another currency; i.e., the rate at which they are ready to buy or sell the former against the latter. At these rates they stand ready to take any side of the transaction (buy or sell) that the customer chooses. The maximum and the minimum amount of the currencies acceptable to the bank at these rates, though not specified at the time of making the quote, are generally understood according to the conventions of the market. These rates may not necessarily be applicable to amounts smaller or larger than those acceptable according to the going conventions. In the forex markets there are numerous market makers, and all of them would be giving different quotes for the same pair of currencies simultaneously, at any point of time. It would be very difficult for a player to keep track of all the quotes available in the market, and hence choose the one which is considered the most favorable. As a result, a number of trades may be taking place simultaneously at different exchange rates. The market-making activity of the commercial banks, along with speculation, makes markets extremely liquid, especially for the major currencies of the world.

The foreign exchange brokers do not actually buy or sell any currency. They do the work of bringing buyers and sellers together. Though they deal in most of the major currencies, generally they specialize in a pair of currencies and hold exhaustive information about it. Other players in the market, specially the commercial banks, approach the brokers for information about the quotes of other commercial banks. The brokers serve three important purposes in the forex markets. First is, that instead of hunting around in the market for quotes, one can approach a broker and find out these prices. Second is, that brokers help the prospective buyer or seller keep their identity secret till the deal is struck. This prevents the quote being affected by the inquirer’s position, i.e., whether he needs to buy or to sell. Lastly, even when there is no buying or selling requirement, commercial banks can keep their quotes from going too far away from the quotes being given by other banks, by inquiring about the market quotes from the brokers.

While small corporations generally approach the commercial banks for their needs, larger corporations sometimes operate in the market on their own. They generally deal in the market to satisfy their needs arising out of their normal business operations. Yet, some big multinational companies also operate in the market to bet on the movement of the exchange rates, in an attempt to make profits out of their expertise in dealing in the market.

The market in which the commercial banks deal with their customers (both individuals and corporates) is called the retail market, while that in which the banks deal with each other is called the wholesale or the interbank market. The size of the deals in the retail market is much smaller than those in the interbank market.

The worldwide forex market is a 24-hour market, i.e., it is open virtually all of the 24-hours of a day, in at least one of the financial markets of the world. When the New York market closes at 3 p.m., the Los Angeles market remains open as the corresponding time there is 12 p.m. When the Los Angeles market closes, it is opening time at Sydney and Tokyo. When Tokyo closes, the Hong Kong market is still open as it would be only 2 p.m. there. At the time of the Hong Kong market closing, the Singapore market can be accessed, it being only 1 p.m. there. Before the closing of the Singapore market, the Bahrain market opens. The closing time of the Bahrain market finds both Frankfurt and Zurich markets open, it being only 12 p.m. there. London being one hour behind these two, it remains open even after these two markets close down. Again, before the London market closes down, it is opening time at New York. Out of these markets, London, New York and Tokyo markets are the biggest

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ones. The effect of the market being open 24 hours a day, is that the impact of any relevant event is immediately reflected on the exchange rates. Besides, it provides the facility of buying or selling a currency at any time of the day, even if the local market has closed down for the day.

The settlement of trades is completed by transfer of deposits denominated in relevant currencies between the parties involved. In the interbank market, it is normally done electronically. For e.g., if the Deutsche Bank sells dollars to the Global Trust Bank in exchange for French Francs, the nostro account of the Deutsche Bank with a bank in the US will be debited and that of GTB will be credited with the amount of the US dollars. At the same time, the nostro account of GTB with a bank in France will be debited and that of Deutsche Bank will be credited with the amount of the French Francs. (Nostro account is the overseas account held by a domestic bank with a foreign bank or with its own foreign branch, in that foreign country’s currency. The same account is called a vostro account from the holding bank’s point of view. For e.g., a dollar account held by State Bank of India with Bank of America in New York will be SBI’s nostro account and a vostro account from Bank of America’s point of view.) A currency’s settlement always takes place in the country of origin of the currency. In the US, the Clearing House Interbank Payments System (CHIPS) is used for the settlement of forex transactions.

Though the exchange rate between any two currencies is determined by the overall equilibrium between their demand and supply, it is also true that there is no single equilibrium market price for a currency. Each trader tries to keep his quote at that level where his own position would be in equilibrium. A trader normally keeps a margin between the price at which he buys a currency and that at which he sells it. Thus, if the trader is able to match a purchase of a currency with a corresponding sale, he would be able to make a profit. In reality, however, it is very difficult to find matching orders of sufficient volumes for the trader to realize a substantial profit. At any point of time, the trader may find that he is selling more of a currency than he is buying, or vice-versa. This would result in the trader having a position in a currency, which exposes him to currency risk (risk of future prices moving against him). To avoid such net positions, the trader would have to frequently change his quote (in order to attract desired orders) so that his exposure would be minimized. In forex trading, minimizing the net positions alone are not enough. Since a trader’s margins are very thin, volumes of trade become very important. A trader may find that though he is able to balance the buy and sell positions, the volume of trade coming his way is very low due to competitive prices quoted by other traders. A very low volume would result in miniscule profits. Hence, the trader has to make sure that his quote always remains competitive.

In India, all dealings in foreign exchange are regulated by the Foreign Exchange Management Act, 1999 (FEMA). Reserve Bank of India is the regulatory authority for the Act. According to FEMA, only those entities can deal in foreign exchange, who are authorized to do so by RBI. The Act provides for entities to be authorized either as authorized dealers or as moneychangers. Authorized dealers are generally commercial banks and form a large part of the interbank market in India. Moneychangers can be either full-fledged moneychangers or restricted moneychangers. While the former are authorized to both buy and sell foreign currency from their customers, the latter can only buy the same. Moneychangers are allowed to deal only in notes, coins and travelers’ cheques. The authorized dealers, on the other hand, are allowed to deal in all the items classified as foreign exchange by FERA. Thus, they are permitted to deal with all documents relating to exports and imports. The authorized dealers have to operate within the rules, regulations and guidelines issued by the Foreign Exchange Dealers’ Association of India (FEDAI) from time to time. The offices/branches of authorized dealers (ADs) are classified into 3 categories. These categories are

Category A: These are the offices/ branches, which keep independent foreign currency accounts with overseas correspondent banks/ branches in their own names.

Category B: These are the branches which do not maintain independent foreign currency accounts but have powers to operate the accounts maintained abroad by their head office or the branches categorized as ‘A’.

Category C: The branches, which fall in neither of the above categories and yet handle forex business through a Category A or B branch, fall under Category C.

The Indian foreign exchange market consists of three tiers. The first tier consists of all the transactions between the authorized dealers and the RBI. The second tier is the interbank market referred to earlier, i.e., the market in which the authorized dealers deal with one another. Moneychangers are required to offset their positions created by dealing with their customers, in this interbank market. The third tier is the retail segment, where authorized dealers and moneychangers deal with their customers.

Exchange Rate Quotations

An exchange rate quotation is the price of a currency stated in terms of another. It is similar to the expression of the price of a commodity. Yet, there is a peculiarity attached to exchange rate quotes. In case of a commodity,

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there is only one way to express its price– as number of units of money needed to buy one unit of the commodity. For e.g., it is always Rs.10 per kg. of potatoes, never 100gm. of potatoes per rupee. In case of an exchange rate quotation, both the items involved are a form of money, i.e. both are currencies. So, the price of any one of them can be quoted in terms of one unit of the other. Due to this, there exist a number of ways to express the exchange rate between a pair of currencies. The various reporting agencies use the following quotes:

The Economic Times gives the quotes as on 13-02-2002:

Table 3.1 Cross Currency Rates

Country	USD	AUD	GBP	CAD	Euro
US	–	1.9222	0.7089	1.5864	1.1438
Australia	0.5202	–	0.3688	0.8253	0.5951
Britain	1.4107	2.7117	–	2.2379	1.6136
Canada	0.6304	1.2117	0.4468	–	0.7210
France	0.8743	1.6805	0.6197	1.3869	–

It can be noticed that various methods of expressing exchange rates have been used. Throughout this book (unless otherwise specified), exchange rates will be mentioned in terms of A/B, where currency B is being bought or sold, with its value being expressed in terms of currency A. In such a quote, currency B is referred to as the base currency.

Various kinds of quotes are described in the following sections.

American vs. European Quote

A quote can be classified as European or American only if one of the currencies is the dollar. An American quote is the number of dollars expressed per unit of any other currency, while a European quote is the number of units of any other currency expressed per dollar. For example, Rs.48.28/$ is a European quote, while $1.6698/£ is an American quote. In almost all the countries, most of the exchange rates are quoted in European terms. The British pound, the Irish pound and the South African rand are a few examples of currencies quoted in American terms.

Direct vs. Indirect Quote

A direct quote is the quote where the exchange rate is expressed in terms of number of units of the domestic currency per unit of foreign currency. An indirect quote is where the exchange rate is expressed in terms of number of units of the foreign currency for a fixed number of units of the domestic currency. An example of an indirect quote would be:

$/100 Rs : 2.1978/98

Here, the bank would be buying dollars @ $2.1998/Rs.100 and selling dollars @ $2.1978/Rs.100. The corresponding direct quote would be:

Rs/$ : 45.4586/45.5000

Here, the bank would be buying dollars @ Rs.45.4586/$ and selling dollars @ Rs.45.5000/$.

Before August 2, 1993, the indirect methods of quoting exchange rates used to be followed in India. Since that date, however, the direct quote is being used. In other countries, the concepts of American and European quotes are more popular in comparison to direct and indirect quotes.

Bid and Ask Rate

In the quotes given above, there was one single rate at which the currencies were being bought and sold. For example, the rupee-dollar exchange rate was given as Rs./$ 45.50. In reality, the rate at which a bank is ready to buy a currency will be different from the rate at which it stands ready to sell that currency. These rates are called the bid and the ask rates respectively. The difference in these rates represents the cost the bank incurs in these transactions, a small return on the capital employed, and the compensation for the risk it takes. This risk arises on account of the possibility of the exchange rate moving in an unfavorable direction before the bank is able to offset the transaction. The single rate mentioned above is generally the mid-rate, i.e. the arithmetic mean of the bid and the ask rates. The difference between the bid rate and the ask rate is called the bid-ask

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spread, or simply the spread. This spread is seen to be higher in the retail market than in the interbank market. This is because of the higher volumes and greater liquidity in the interbank market (lower the liquidity, higher the risk of the transaction being set off at a disadvantageous rate, and hence, higher the spread). An additional reason is that the counter-party risk (the risk of the other party not fulfilling its commitment) is lower in the interbank market since most of the players are large commercial banks. As this bid-ask spread arises due to the presence of transaction costs, the absence of these costs would result in a single rate being quoted by banks for both buying and selling the currency.

Before we go into the explanations for the bid and the ask rates, it will be useful to look at some important conventions regarding these quotes. These are:

a. The bid rate always precedes the ask rate. Hence in the quote Rs/$: 45.45/45.50, 45.45 is the bid rate while 45.50 is the ask rate.

b. The bid and the ask rate are separated by either a slash (/) or a dash sign (–).

c. The quote is always from the banker’s point of view. That is, the banker is ready to buy dollars at Rs.45.45 per dollar and sell at Rs.45.50 per dollar. A banker’s buy rate is the rate at which the customer can sell a currency and vice-versa. So, if a customer wishes to sell dollars, it will have to sell them at the bank’s buying rate of Rs.45.45 per dollar.

Let us understand these rates with the help of an example. Let the exchange rate of the Indian rupee with the US dollar be

Rs/$ : 45.45/45.50

Here the US dollar (currency B) is being bought and sold, with its price quoted in terms of the Indian rupee (currency A). In this quote, bid rate is the rate at which the bank is ready to buy one dollar, which is the first term from the left, i.e. Rs.45.45. In other words, it is the number of rupees that a bank is ready to pay in exchange for one dollar. The bank is bidding for the dollar at this rate. The ask rate is the rate at which the bank stands ready to sell one dollar in exchange for rupees. It is the number of rupees the bank is ready to accept for, or is asking for selling a dollar. This rate is Rs.45.50. The bid rate is always lower than the ask rate. This is because the bank will be ready to pay less for a unit of currency than it receives, in order to make a profit.

Interbank Quote vs. Merchant Quote

Merchant quote is the quote given by a bank to its retail customers. On the other hand, a quote given by one bank to another (or to any other customer in the interbank market) is called an interbank quote. It has been mentioned that a quote is invariably the banker’s quote. The question that arises is that since both the parties involved in the interbank market are banks, whose quote will it be taken as. The convention is that the bank requesting the quote is the customer and the quote will be taken as that of the bank giving the quote, i.e. the one that is acting as the market maker.

Mechanics of Currency Dealing

Let us now see how deals are struck in the interbank market. Suppose a bank requires £1,000,000. The dealer of the bank approaches another bank and asks for a quote in the sterling, without mentioning whether he wants to buy or sell. The market-making bank gives him a two-way quote (i.e., both the bid and ask rates for sterling). If the ask rate for the pound is acceptable to the banker, he says – “One mine” – implying that he has bought £1,000,000. The trade will enter the books of both the banks and written confirmations of the trade would be sent later. The settlement of the trade will take place through any of the available electronic money transfer systems (like CHIPS). Suppose the bank wanted to sell pounds and found the quoting bank’s bid rate acceptable, it would instead have said – “One yours” – implying that it has sold £1,000,000 to the market making bank.

While giving a two-way quote, a bank keeps the bid and ask rates at such levels that both buyers and sellers of the relevant currency are likely to find attractive, and hence the bank expects to receive both buy and sell orders from the market. If the bank is getting orders for only one side of the transaction, it would mean either of two things – either the rates quoted by the bank are out of alignment with the rates being quoted by other players in the market, or there is too much buying or selling pressure in the market for that particular currency. In either of the cases, the bank would have to adjust its quote. Let us take the scenario where the bank is ending up getting only buy orders for a particular currency (i.e., the bank is only buying the currency), without being able to sell. It would mean that the market is getting a competitive rate for selling the currency to the bank, but the bank’s selling rate is too high to attract buyers. On the other hand, it could also mean that there are too many sellers in the market. In both the cases, the bank will have to reduce its rates on both the buy and sell side.

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The lower bid rate will attract a fewer number of sellers, while the lower ask rate would encourage customers to buy from the bank. In case the bank is getting too many orders to sell currency to customers, it would have to increase both the bid and the ask rates, in order to attract more customers interested in selling the currency and fewer interested in buying it.

The quotes are generally given in the market as:

Rs/$ : 1.6688/1.6693

It is also a practice to state the same quote as:

DM/$ : 1.6688/93

with 93 representing the last two digits of the ask rate, the rest of the digits being common with the bid rate.

Since the dealers in currencies would anyway be aware of the going rate, the big figures are not specified. In the interbank market the quote is generally further shortened to:

DM/$ : 88/93

There are a few currencies, which are quoted in 100s, rather than 1s or 2s. The reason is that their value is too small to be quoted otherwise. An example is the Japanese yen. Its quote generally looks like:

¥/$ : 109.28/31

When the quote is given with such currencies as the base currency, the quote is for 100 units of the currency rather than one unit. For e.g., the corresponding $/¥ quote will be:

$/100¥ : 0.9150/52

The last after-decimal digit of a quote is known as a point and the last two as a pip.

The quotes given by different banks for the same pair of currencies may not necessarily be the same, but they have to be within certain limits to prevent arbitrage. Let us see an example to understand these limits. Suppose there are two banks A and B. Their quotes for the Euro/$ rate are:

A — Euro/$ : 1.6688/1.6693

B — Euro/$ : 1.6683/1.6686

As A’s bid rate is greater than B’s ask rate, there is a risk-free arbitrage opportunity available. (Arbitrage is the process of buying and selling the same asset at the same time, to profit from price discrepancies within a market or across different markets. When it does not involve any commitment of capital or the taking on of risk, it is referred to as risk-free arbitrage). Dollars can be bought from B at Euro 1.6686/$ and sold to A at Euro 1.6688/$, thus making a gain of Euro 0.0002 per dollar. Thus, any bank’s bid rate has to be lower than other banks’ ask rate, and its ask rate greater than other banks’ bid rate. Sometimes, banks deliberately maintain their rates out of alignment with the rest of the market, because they require only one type of transactions to come to them. For e.g., a bank may have an overbought position in marks (i.e., it may have bought more marks than it sold). In such a case, it may like to keep its ask rate lower so as to attract customers who want to buy marks.

Note: According to FEDAI rules, exchange rates in the merchant as well as the interbank markets are to be quoted up to 4 decimals, with the last two digits being in multiples of 25 (for e.g., Rs/$: 45.4220/45). The card rates of banks (the reference rates given by the dealing room to the ‘B category’ branches at the beginning of the day) should be either quoted in two decimals, or quoted in 4 decimals with the last two figures being 0 (for e.g., Rs/$ : 45.5000 or 45.50). Also, all merchant transactions are to be settled after rounding off the final rupee amount to the nearest whole rupee. For this, amounts up to 49 paise are to be ignored, and amounts from 50 to 99 paise are to be rounded off to the next rupee. Throughout the chapter, these rules have been ignored and the Rs/$ quotes are given up to 2 decimals, only to make the computations convenient. These quotes result in a higher spread, while in the actual market the spread does not usually exceed 1 or 2 paise. The student should keep this digression from the real-time market quotes in mind while going through the chapter.

Inverse Quotes

For every quote (A/B) between two currencies, there exists an inverse quote (B/A), where currency A is being bought and sold, with its price expressed in terms of currency B. For e.g., for a Î/$ quote, there exists a $/Î quote. The implied inverse quote can be calculated from a given quote in a very simple way. Let us take the example of a Î/$ quote. Let the Î/$ quote in Frankfurt be:

Î/$ : 1.6688/1.6693

The (Î/$) bid rate is the rate at which the bank is ready to buy dollars (which also means the rate at which it is ready to sell Î, which will be the ask rate in the $/Î quote). Hence the (Î/$) bid rate would correspond to the ($/Î) ask rate. In Î/$ terms, this rate is 1.6688. In $/ Î terms, it would be the reciprocal of this figure, i.e.

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1/1.6688 which is equal to $0.5992/Î. Similarly, the (Î/$) ask rate would correspond to the ($/Î) bid rate. In Î/$ terms, this rate is 1.6693, which is equal to $0.5990/Î (1/1.6693). Hence, to calculate the implied inverse quote, the bid and the ask terms of the given quote have to be reversed and their reciprocals calculated. For this particular example, the calculations can be shown as:

Implied ($/Î)_bid = 1/(Î/$)_ask

Implied ($/Î)_ask = 1/(/$)_bid

So, the implied inverse rate is:

$/Î : 0.5990/0.5992

These equations can be generalized as:

Implied (B/A) quote:

Now suppose that the actual B/A quote differs from the implied inverse quote. The result may be an arbitrage opportunity similar to the one when two banks quote widely different rates for a pair of currencies. Let the $/Î quote in New York be:

$/Î : 0.5976/0.5981

In this scenario, there is a possibility of buying Î in New York for $0.5981/Î and selling them in Frankfurt for $0.5990/Î, thus making a riskless profit of $0.0009/Î. This arbitrage activity involving buying in one market and selling in another is termed as two-way arbitrage. Such arbitrage opportunities quickly go away on profit-making by arbitrageurs. As they buy Î in New York, the ask rate of the $/Î quote goes up, and as Î is sold in Frankfurt, the ask rate of the Î/$ quote will go up till its reciprocal becomes lower than the increasing ask rate of the $/Î quote. Hence, to avoid arbitrage opportunities, the ask rate of the actual B/A quote should be higher than the bid rate of the implied B/A quote and the bid rate of the actual B/A quote should be lower than the ask rate of the implied B/A quote (i.e., the two quotes must overlap).

Cross Rates

In the foreign exchange markets, it is a practice to quote most of the currencies against the dollar; and to calculate the exchange rates between other currencies with the dollar as the intermediate currency. For e.g., the Î/£ rate will be calculated through the Î/$ quote and the $/£ quote. The Î/£ rate thus calculated is called a cross rate or the synthetic rate. Though generally the third currency used is the dollar, the cross rate between two currencies can be calculated using any other currency as the intermediate currency.

These synthetic rates can be calculated using a process similar to the one we used in calculating the implied inverse quote. Let us assume that we need to calculate the Switzerland franc/Canadian dollar (SFr/Can$) rate from given SFr/$ and $/Can$ quotes. Let the given quotes be:

SFr/$ : 5.5971/5.5978

$/Can$ : 0.7555/0.7562

For calculating the synthetic rates, we shall have to see how the arbitrageur will operate if he wishes to operate in the markets giving the SFr/$ and the $/Can$ rate, instead of using the direct SFr/Can$ quote. The (SFr/Can$)_bid rate will be the number of francs which a bank would be ready to pay to buy one Can$. The arbitrageur, say X, can sell 1 Can$ for $ 0.7555.

The bank will be ready to buy one dollar for SFr 5.5971

Hence, for selling one Can$, X will get (0.7555 x 5.5971) = 4.2286 francs

That is, for buying one Can$, the bank would be ready to pay SFr 4.2286

Hence, the synthetic (SFr/Can$)_bidrate

= 4.2286

= 5.5971 x 0.7555

= (SFr/$)_bid x ($/Can$)_bid

Similarly, the (SFr/Can$)ask rate will be the number of francs the bank will require to be paid for selling one Can$. In terms of the $/Can$ rates, a bank would take 0.7562 dollars to sell one Can$. To be able to pay these dollars, X would need to buy them in the SFr/$ market. X can buy a dollar in that market for SFr 5.5978. Hence, X can buy one Can$ for:

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5.5978 x 0.7562 = 4.2330 francs.

In other words, the bank would be ready to sell one Can$ for 4.2330 francs

So the synthetic (SFr/Can$)_ask rate

= 4.2330

= 5.5978 x 0.7562

= (SFr/$)_ask x ($/Can$)_ask

Hence, the synthetic quote is:

SFr/Can$ : 4.2286/4.2330

These rates can be generalized as:

Synthetic (A/C)_bid = (A/B)_bid x (B/C)_bid (Eq. 3.1)

Synthetic (A/C)_ask = (A/B)_ask x (B/C)_ask (Eq. 3.2)

where A, B and C are three currencies.

As in case of implied inverse rate, the synthetic quote and the actual quote between a pair of currencies should overlap (i.e., the bid rate of one should always be lower than the ask rate of the other). There are two reasons for this. First, if the actual rates are too much out of line with the cross rates, then market players in genuine need of a currency would buy and sell through the markets giving them more favorable rates. The second reason is the arbitrage opportunity which would arise in case of a misalignment of actual and cross rates. In both the cases, the resultant demand-supply mismatch would force the synthetic cross rate and the actual rate to come in line with one another. Let us see how the arbitrage process works. As we have seen, the synthetic quote between the franc and the Can$ is:

SFr/Can$ : 4.2286/4.2330

This synthetic quote has been calculated from the following given quotes:

SFr/$ : 5.5971/5.5978

$/Can$ : 0.7555/0.7562

Now suppose that the actual quote between the franc and the Can$ is:

SFr/Can$ : 4.2333/4.2343

As we see, the synthetic ask rate is less than the actual bid rate, giving the arbitrageurs a chance to make a profit by three-point arbitrage (the process of making arbitrage profits involving three markets, where three transactions have to be entered into to achieve the desired results). To make profits, a person should buy low and sell high. The rate at which the arbitrageur, say X, can sell one Can$ against the franc is SFr 4.2333/Can$. The rate at which X can buy one Can$ (through the synthetic market) is SFr 4.2330/Can$. Let us say that X starts with one franc.

With one franc, he can buy: dollars.

Since 0.7562 dollars fetch one Can$, with 1/5.5978 dollars X can buy: Can$

These Can$ can then be sold by X in the SFr/Can$ market for: 4.2333 x francs

= SFr1.000058.

Thus, X makes a profit of SFr 0.000058 for every franc bought and sold.

Now let us see what will happen if the actual rates are

SFr/Can$ : 4.2278/4.2283

The actual ask rate is now lower than the synthetic bid rate. X can now buy Can$ at SFr 4.2283/Can$ and sell them through the synthetic market at SFr 4.2286/Can$. In the SFr/Can$ market, X can sell one franc for

Can$

As each Can$ can be sold for 0.7555 dollars, X can sell the Can$ for:

0.7555 x dollars

Since each dollar fetches 5.5971 francs, X can sell the dollars for:

5.5971 x 0.7555 x francs

= SFr1.000073 francs.

So, X makes a profit of 0.000073 francs for every franc bought and sold.

These arbitrage processes will adjust the rates in both the cases in all the three markets in such a way, that the actual SFr/Can$ rates will come in alignment with the synthetic rates. We can write the conditions for no arbitrage possibility as:

(A/C)_bid (actual) (A/C)_ask (synthetic) (Eq.3.3)

(A/C)_ask (actual) (A/C)_bid (synthetic) (Eq.3.4)

Using equations 3.1 and 3.2, we can rewrite the above equations as:

(A/C)_bid (A/B)_ask x (B/C)_ask (Eq. 3.5)

(A/C)_ask (A/B)_bid x (B/C)_bid (Eq. 3.6)

where all the rates are actual rates.

Equations 3.5 and 3.6 are called the no-arbitrage conditions. These signify the limits imposed by the synthetic rates on the actual quote for a pair of currencies (upper and lower limits for the bid and the ask rates respectively). The actual rates only have to be within these limits but they need not necessarily be the same as the synthetic rates. In fact, the synthetic rate having been calculated from two quotes, includes the bid-ask spread of both the quotes. This results in the synthetic rate having a very high bid-ask spread. In reality, a bank giving direct quotes between two such currencies may be able to quote at much lower spread, provided its business volumes in these currencies is high. In the example given above, the actual SFr/Can$ quote may be something like:

SFr/Can$ : 4.2298/4.2313

As in the case of inverse rates, transaction costs allow the actual A/C quote to deviate from the synthetic cross rates to some extent. As mentioned earlier, in the absence of such costs, the bid and the ask rates will be the same. These single rates will force the actual A/C quote to be exactly equal to the synthetic cross rates.

According to Eq. 3.5,

(A/C)_bid (A/B)_ask x (B/C)_ask

It can be rewritten as:

or, (A/B)_ask x (B/C)_ask x (C/A)_ask ³ 1 (Eq. 3.7)

Similarly, Eq. 3.6 says that:

(A/C)_ask ³ (A/B)_bid x (B/C)_bid

It can be rewritten as:

or, (A/B)_bid x (B/C)_bid x (C/A)_bid £ 1 (Eq. 3.8)

Types of Transactions

Foreign exchange transactions can be classified on the basis of the time between entering into a transaction and its settlement. They can basically be classified into spot and forward contracts. Spot transactions are those, which are settled after 2 business days from the date of the contract. A forward contract (also called an outright forward) is one where the parties to the transaction agree to buy or sell a commodity (here, a currency) at a predetermined future date at a particular price. This future date may be any date beyond two business days. The price and the terms of delivery and payment are fixed at the time of entering into the contract. In the forex markets, forward contracts generally mature after 1, 2, 3, 6, 9, or 12 months.

A forward contract is normally entered into to hedge oneself against exchange risk (i.e., the uncertainty regarding the future movements of the exchange rate). By entering into a forward contract, the customer locks-in the exchange rate at which he will buy or sell the currency.

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Forward Quotes

Forward quotes are given just like spot quotes given earlier. The same rules regarding calculation of implied inverse rates, synthetic cross rates etc. apply to the forward rates also. The conditions to be fulfilled for ensuring that there is no scope for two-way arbitrage and three-way arbitrage are also the same. For example, the three-month forward rate between the £ and the ¥ may look like:

3-m ¥/£ : 182.70/75

The implied inverse rate would be:

3-m £/100¥ : (1/182.75 x 100) / (1/182.70 x 100)

= 0.5472/0.5473

If the 2-month forward $/Aus$ and the $/SGD quotes are

2-m $/Aus$ : 0.6883/88

2-m $/SGD : 0.5754/58

then the SGD/Aus$ synthetic cross rates will be

2-m SGD/Aus$:

(1/0.5758 x 0.6883)/(1/0.5754 x 0.6888)

= 1.1953/70

Discount and Premium

A currency is said to be at premium against another currency if it is more expensive in the forward market than in the spot market. In this case, its forward rate will be higher than its spot rate. This happens when the future spot rate is expected to be higher than the current spot rate. Conversely, a currency is said to be at a discount if it is cheaper in the forward market than in the spot market. In this case, its forward rate will be lower than its spot rate. This happens when the future spot rate is expected to be lower than the current spot rate. Let us assume the Rs/$ quotes to be:

Rs/$ : 45.42/44

3-m Rs/$ : 46.62/70

Here, the bank is ready to give only Rs.45.42 currently in exchange for a dollar, while it is ready to give Rs.46.62 after 3 months. Similarly, the bank is charging only Rs.45.44 for selling a dollar now, while it is charging Rs.46.70 for a delivery 3 months hence. So the dollar is expected to be more expensive in the future, and hence is at a premium against the rupee. On the other hand, the rupee is expected to be cheaper in the future and hence is at a discount against the dollar.

Let us now assume the $/£ quotes to be:

$/£ : 1.6721/26

3-m $/£ : 1.6481/92

Here the dollar is at a premium against the pound, while the pound is at a discount against the dollar. It is possible that a currency may be at a premium against one currency, while being at a discount against another at the same time. It is also possible that a currency be at a premium against another for a particular forward maturity, while being at a discount against the same currency for another forward maturity. E.g., the $/£ quotes may be:

$/£ : 1.6721/26

2-m $/£ : 1.6726/34

3-m $/£ : 1.6481/92

Here, the pound is at a premium against the dollar for the 2-month maturity, but at a discount for the 3-month maturity. It is also possible to have such a situation where a currency is at a premium against another for a particular forward maturity, but a discount between two forward maturities. E.g., the $/£ quotes may be:

$/£ : 1.6721/26

1-m $/£ : 1.6730/37

2-m $/£ : 1.6726/35

Here, the pound is at a premium against the dollar for both the forward maturities, but at a discount between the one-month and the two-month maturities.

There is an important aspect about forward rates which needs to be observed here. Notwithstanding whether the base currency is at a premium or at a discount, the bid-ask spread increases as one goes into future. In the Rs/$ quotes (where the base currency, i.e. the dollar is at a premium), the spread increased from 2 paise to 8 paise. In the $/£ quotes (where the base currency is at a discount), the spread increases from 5 points to 11 points. This happens because the liquidity in the market decreases with increasing maturity of the contract. This makes it difficult for the bank to offset the positions created in the retail market. Longer the maturity, lower the trading volume, higher the possibility of loss on account of movement of exchange rates in an unfavorable direction. It is important to remember that the risk (due to which the spread increases for a forward maturity) is not of the exchange rate moving unfavorably between the date of the contract and its maturity, but that of an unfavorable movement in the exchange rate between the time of the contract and the time when the bank offsets its position.

The difference between the spot rates and the forward rates can be expressed in terms of swap points. In the rupee-dollar example, the swap points will be 120/126 (46.62 – 45.42 and 46.70 – 45.44). In the dollar-pound example, the 3-month swap points would be 240/234 (1.6721 – 1.6449 and 1.6726 – 1.6492). From this we can observe the following rules:

1. When the swap points are low/high (as in the rupee-dollar example given above), currency B is at premium, A is at a discount. Add swap points to spot rate to get the outright forward rate, deduct swap points from the outright forward rate to get the spot rate.

2. When the swap points are high/low (as in the dollar-pound example given above), currency B is at a discount and A is at a premium. Deduct the swap points from the spot rate to arrive at the outright forward rate, add them to the outright forward rate to arrive at the spot rate.

3. The bid side swap points (i.e., on the left side of the swap points quote) are to be added to or subtracted from the spot bid rate (depending on whether the currency is at premium or discount) to arrive at the forward bid rate. The ask side swap points added to or subtracted from the spot ask rate, give the forward ask rate.

The annualized percentage premium on currency B can be calculated as follows:

where m is maturity of the forward contract in months.

A negative figure signifies that currency B is at a forward discount and A is at a premium, with a positive figure signifying the opposite.

In the rupee-dollar example, the annualized percentage premium on the dollar can be calculated as follows:

Spot (Rs./$)_mid= = Rs.45.43/$

3-m (Rs./$)_mid= = Rs.46.66/$

Premium = = 10.82%

Similarly, in the $/£ example, the annualized discount on the pound for the 3-month maturity works out to 5.67%.

An important point that needs to be noted here is that the pound being at 5.67% annualized discount does not necessarily mean that the dollar will be at a 5.67% annualized premium against the pound. Let us verify with the help of an example. The implied inverse quotes in the Rs/$ example would be:

$/Rs : 0.022007/0.022016

3-m $/Rs : 0.021413/0.021450

Hence,

Spot ($/Rs)_mid = = $0.0220115/Rs

3-m($/Rs)_mid = = $0.0214315/Rs.

Therefore, the annualized percentage discount on the rupee will be:

= = 10.53%

Thus, while the dollar is at a 10.82% premium against the rupee, the rupee is at a 10.53% discount.

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Forward Rates vs. Expected Spot Rates

If the speculators in the market were risk-neutral and there were no transaction costs, then the forward rate would be equal to the market’s expected future spot rate. This is so, because otherwise it would be possible to buy in one market and sell in the other in order to make profits. Let us take the case where the forward rate is lower than the expected spot rate. In such a case, the speculator would buy a forward contract expecting to sell in the spot market in the future at a higher price. The resulting increased demand in the forward market would increase the forward rate and drive it towards equalization with the expected future spot rate. If the forward rate is higher, speculators would sell in the forward market, thus pushing the forward rate down. In reality, however, there is also the risk of the spot rate turning out to be different from the expected spot rate and the speculators are not really risk-neutral. They expect to be compensated for the risk that they take on. In addition, there is the presence of transaction costs to be contended with. These two factors result in the forward rate being different from the spot rate to some extent.

Links between forex Market and Money Market

The movement of funds between two currencies to take advantage of interest rate differentials is also a major determinant of the spread between forward and spot rates. In fact, the forward discount or premium is closely related to the interest differential between the two currencies.

According to interest rate parity theory, the currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate. More specifically, in an efficient market with no transaction costs, the interest differential should be (approximately) equal to the forward differential. When this condition is met, the forward rate is said to be at interest parity, and equilibrium prevails in the money markets.

Interest parity ensures that the return on a hedged (or "covered") foreign investment will just equal the domestic interest rate on investments of identical risk, thereby eliminating the possibility of having a money machine. When this condition holds, the covered interest differential—the difference between the domestic interest rate and the hedged foreign rate—is zero. If the covered interest differential between two money markets is nonzero, there is an arbitrage incentive to move money from one market to the other.

For example, suppose the interest rate on pounds sterling is 12% in London, and the interest rate on a comparable dollar investment in New York is 7%. The pound spot rate is $ 1.75 and the one-year forward rate is $ 1.68. These rates imply a forward discount on sterling of 4% [(1.68 - 1.75)/1.75] and a covered yield on sterling approximately equal to 8% (12% - 4%). Since there is a covered interest differential in favor of London, funds will flow from New York to London. This movement of money to take advantage of a covered interest differential is known as covered interest arbitrage. This has been discussed in detail in the next chapter.

Broken – Date Forward Contracts

A broken-date contract is a forward contract for a maturity which is not a whole month or for which a quote is not readily available. For example, if the quotes are available for a 6-month forward and a 9 month forward, but a customer wants a quote for a 7 month forward, it will be a broken date contract. The rate for a broken date contract is calculated by interpolating between the available quotes for the preceding and the succeeding maturities. Let us assume that in July, the quote for a contract maturing on August 31 is

SFr/$ : 5.5879/85

At the same time, the quote for a contract maturing on October 31 is

SFr/$ : 5.5908/20

Now suppose a customer wants to enter into a forward contract with the bank maturing on September 29, for purchasing dollars from the bank. For this purpose, the bank has to give a quote. It can be observed that the dollar is at a premium and the swap points are 29/35 between August and October maturity. On the ask side, the premium is 35 points which is spread over (30 + 31) 61 days. The required maturity is 29 days away from the August maturity. Hence, the premium charged by the bank over and above the August rate will be 35 x 29 / 61, i.e., 17 points. Hence, the rate charged will be 5.5885 + 0.0017 = SFr 5.5902/$. Similarly, the buy and the sell rates can be calculated for any intervening date between two given maturities.

Option Forwards

Under the forward contract discussed until now, the settlement of the contract has to take place on a specific date. This type of a contract can be used only when the customer knows the precise time as to when he would need to buy/sell a currency. There are circumstances in which the customer may know the estimated time when the need to deal in a foreign currency may arise, but may not be sure about the exact timing. For example, an exporter who has shipped his goods abroad, may be aware that the ship would be expected to reach its destination in a month’s time and expects to receive his payment within one month from the consignment being received by the buyer. Yet, he would not know the exact date the ship will reach and hence the date on which he will receive his payment. Similarly, for an importer, the time of requirement of foreign currency will depend upon the time when he receives communication from the foreign supplier regarding the dispatch of goods. Another example could be of a person who has bid for a contract. If the person’s need for dealing in foreign currency is dependent upon his bid being accepted, then he may not know when the need will arise. These kinds of needs can be fulfilled by a contract called the option forward contract or the option forward. Under this contract, the customer of the bank has the option to ask for the contract to be settled anytime during a particular period, referred to as the option period. For example, a customer enters into an option forward contract on September 29 for selling dollars to the bank. The contract matures on December 31. The customer takes the option to sell dollars to the bank anytime in December. Here, the month of December is the option period. Giving quotes for this kind of a contract is not as straightforward as giving a quote for an outright forward contract. This is so because the rate at which the exchange of currencies will take place is fixed, while the timing of the exchange is not. If the bank quotes a rate, which is appropriate for deals done at a particular period of time, and the exchange actually takes place at an unfavorable time, the bank would incur a loss on the deal. For example, if the bank enters into a contract to sell dollars to a customer when the dollar is commanding a forward premium, and the bank’s quote reflects the premium only up to the beginning of the option period, it will incur a loss if the customer exercises the option at the end of the option period (because the bank would get lesser premium than it would have charged for the complete period). Similarly, if the dollar were at a forward discount and the bank’s quote were to reflect the discount for the full period, the bank would be incurring a loss were the customer to exercise the option in between the option period. To avoid a loss (or rather, to make the maximum profit), banks follow these rules for giving a quote:

1. When the bank is buying a currency, it will add on the minimum premium possible (when the currency is at a premium) and deduct the maximum discount possible (when the currency is at a discount) from the spot rate. This would result in the bank quoting the rate applicable to the beginning of the option period when the currency is at a premium, and the rate applicable to the end of the option period when the currency is at a discount.

2. When the bank is selling a currency, it will add the maximum premium possible (when the currency is at a premium) and deduct the minimum discount possible (when the currency is at a discount) from the spot rate. This would result in the bank quoting the rate applicable to the end of the option period when the currency is at a premium, and the rate applicable to the beginning of the option period when the currency is at a discount. Thus the bank considers the applicable quotes for the beginning and the end of the option period and gives a quote which is disadvantageous to the client, which, in effect, is the cost incurred by the client for the flexibility.

Suppose the Euro/Swiss franc rate is given as:

                        Spot Euro/SFr   :           1.2245/49
                        3 – m forward     :               10/15
                        4 – m forward     :               15/25

The Swiss franc is at a premium. If the bank contracts to sell SFr, with the option to take delivery exercisable by the customer anytime during the 4th month, the bank will load the maximum premium to the spot rate. It will implicitly be assuming that the customer will demand delivery when the currency is most expensive, and hence will charge the maximum rate. So it will quote the rate Euro 1.2274/SFr (1.2249 + 0.0025). If the contract were to buy SFr with the option to give delivery exercisable by the customer anytime during the 4th month, the bank would have assumed that the customer would choose to exercise his option when the SFr is at its cheapest, i.e., at the beginning of the fourth month. Hence, the bank would have loaded the minimum premium to the spot rate while giving the quotation. The rate would have been Euro 1.2255/SFr (1.2245 + 0.0010).

Note that the 3-m forward rate is the rate applicable to the beginning of the option period (as the end of the 3rd month is the beginning of the fourth month), and the 4-m forward rate is the rate applicable to the end of the option period.

Suppose the Can$/£ rate is:

Can$/£ : 2.5643/49

2 – m : 20/15

3 – m : 30/20

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The bank enters into a forward contract whereby the customer has the option to buy pounds from the bank anytime during the third month. As the pound is at a discount and the bank would like to sell it at the maximum price possible, it will deduct the minimum discount from the spot rate, which is 15 points. The bank will hence quote Can$ 2.5634/£ (2.5649 – 0.0015). If the forward contract is such that it gives the customer the right to give delivery anytime during the third month, the bank would have deducted the maximum discount in order to buy pounds at the cheapest rate possible. The rate would be Can$ 2.5613/£ (2.5643 – 0.0030).

How would the bank decide on its quote if a currency is at a premium at the beginning of the option period, and at a discount during the option period? The bank would follow the simple rule of buying at the lowest and selling at the highest price. For example, if the SFr/Aus$ quotes were

SFr/Aus$ : 3.4925/30

1 – m : 3.4935/45

2 – m : 3.4930/42

For an option forward giving the right to the customer to buy Aus$ anytime during the second month, the bank would quote the rate of SFr3.4945/Aus$. If the customer’s option were to sell Aus$, the rate given by the bank would be SFr3.4930/Aus$.

Swaps

A transaction whereby two currencies are exchanged by the parties involved, only to be exchanged back later, is termed a currency swap. The quantity exchanged of one of the currencies remains constant in both the legs of the swap, though the quantity of the second generally changes. So, a swap is nothing but the selling of one currency at a point of time to purchase it back later at a lower or a higher price.

A currency swap is a combination of two transactions – one spot and one forward – with an exchange of currencies taking place at predetermined exchange rates. The forward leg is in the opposite direction to that of the spot leg, i.e. the party selling currency A in the spot leg buys it in the forward leg and vice versa. As mentioned, the price of the currencies is different in the spot leg from that of the forward leg. This happens because of the expected depreciation/appreciation of the currency w.r.t. the other currency. For example, two parties may enter into a swap whereby the first party sells one million pounds to the second party against dollars in the spot leg @ $1.6708/£, and the second party sells one million pounds to the first party against dollars one month forward @ $1.6652/£. Here the number of pounds exchanging hands is constant, whereas the number of dollars exchanging hands is changing, depending on the exchange rate applicable to the two legs of the swap transaction. As opposed to a swap transaction, an outright forward is not accompanied by any spot deal.

A swap transaction whereby the foreign currency is bought in the first leg and sold in the second leg against the local currency is called a swap-in or buy-sell swap. For example, a swap-in dollars in India would mean dollars bought against the rupee in the first leg and sold in the second leg. A swap-out or a sell-buy swap is the exact opposite, i.e. the foreign currency is sold in the first leg and bought in the second leg against the local currency. A forward-forward swap is one where both the legs of the transaction take place in the future. For example, if dollars are bought one month forward @ Rs.42.50/$ and sold two months forward @ Rs.42.70/$, it will be a forward-forward swap.

One of the uses of swaps is for hedging by entities investing or borrowing abroad. Hedging is the process through which an attempt is made to eliminate risk (or at least reduce it to tolerable levels) in a transaction. Take the example of a Canadian citizen who is investing in US bonds. He would know the amount of US dollars he would receive on maturity, but not the $/Can$ exchange rate that would prevail at that time. This would make his Can$ returns uncertain. To remove this uncertainty, the investor can enter into a swap-in dollars, whereby he would buy the dollars spot (which he could then use to invest in the bonds) and sell them forward at the time of maturity. This would fix the exchange rate at which he would translate his dollar earnings to Can $, thus making his Can$ returns certain. Similarly, a person raising money abroad may enter into a swap-out to fix his total cost of borrowing.

Swaps can also be used in place of option forwards. In the example of a person entering into a contract to sell dollars, with the month of December as the option period (given in the section on option forwards), the same objective can be met through use of swaps. Initially, the customer can sell dollars forward, maturity December 1. If by the end of November, he realizes that he would be receiving the dollars only by December 20, he can enter into a buy-sell swap for 20 days. This way he would be able to hedge his position in a cheaper way. Of course, for resorting to a cheaper method, he would have to pay the price of not knowing the premium/discount that will be applicable to the swap transaction till he actually enters into it. Hence, while option forward is likely to be more expensive than a swap transaction, it removes the exchange risk completely. On the other hand, in such situations the risk is not completely removed in a swap transaction, due to the uncertainty of the total cost of hedging.

The most important players in the swap markets are the banks. They use the swap markets to hedge their positions arising from merchant transactions. For example, if a bank sells more spot dollars than it has purchased, it creates a short (oversold) position. If the bank does not cover its open position, it may lose if the dollar appreciates since it will have to buy the dollar at a higher price. To cover its position, bank can buy dollars in the interbank spot market. A bank having a long (overbought) position can cover itself by selling dollars in the interbank spot market. But if the bank has sold forward more dollars than it has bought forward (or vice-versa), it will have to cover its position in the interbank forward market. While it is easy to find a counterparty in the spot market, it is difficult to find a counterparty with an exactly opposite exposure having a matching maturity. Hence, the banks prefer hedging by using swaps instead of outright forwards. Another reason for banks preferring swaps is that swaps have finer rates than outright forwards. A bank having an overbought forward position will enter into a swap to sell forward in the relevant maturity and buy the currency spot. Then the bank can sell the currency spot to counter the spot buying. Conversely, a bank with an oversold forward position can enter into a sell-buy swap, whereby it buys in the relevant forward maturity and sells spot. To cover the spot sale it can buy spot in the interbank market. In the interbank markets, the delivery week for the forward leg of the swap can be specified. Banks generally use rollovers to cover the resultant intra-week exposures.

The difference in the spot and the forward leg prices of a swap are given as swap points, just as in the case of a forward quote. In fact, the swap points applicable to outright forwards and swaps are the same. Yet, the way in which these points are to be added to / subtracted from the spot rate is different from the way in which the forward rate for a currency is calculated. The way to calculate the exchange rate applicable to the forward leg of a swap transaction is shown in the following example.

Assume that the following quotes are available in the inter-bank market:

Rs/$ : 45.42/46

3-m : 60/70

Suppose a bank wants to go for a buy-sell swap. It will buy dollars spot @ Rs.45.42/$. (As the bank would be dealing in the interbank market, it would have to buy at the ask rate. This needs to be remembered for the subsequent workings also). As the swap points are in low/high order, the dollar is at a premium. The bank will get 60 points premium if it sells dollars forward. To arrive at the rate applicable to the forward leg of a swap transaction, the relevant swap points are added to/deducted from (depending on whether the currency is at a premium or discount) the rate at which the spot leg of the transaction has taken place. Hence, the rate for the forward sale will be Rs.46.06/$ (45.46 + 0.60). As we can see, the rate which the bank gets for selling dollars in the forward leg of the swap is better than what it would have got had it sold dollars outright forward (45.42 + 0.60 = 46.02).

If a bank wanted to go for a sell-buy swap, the rate applicable to the spot sale would have been Rs.45.42/$. The dollar being at a premium, the bank would need to pay the 70 points premium for buying dollars forward. In accordance with the above-mentioned principle, the rate applicable to the forward leg would be (45.42 + 0.70) Rs.46.12/$. This rate is again better than the outright forward rate of (45.46 + 0.70) Rs.46.16/$.

Since the swap points are added to/deducted from the specific spot rate which is used for the spot leg of the swap, the spot rate does not really matter (as the real profit or cost of the swap is reflected in the swap points, which remain the same irrespective of the spot rate used). In fact, in many cases, the rate applied to the spot leg of the swap transaction may not equal either the bid or the ask rate of the bank’s spot quote.

A forward-forward swap can be considered as a combination of two spot-forward swaps. For example, a swap to buy dollars after 3 months and to sell dollars after 4 months can be taken as a combination of two spot transactions – (a) to sell dollars spot and buy them after 3 months, and (b) to buy dollars spot and sell them after 4 months. Identical rates are applied to the spot legs of both the swaps, and hence the spot transactions cancel out. The forward legs of the two swaps remain, and the premium/discount applicable to these decide the net profit/ cost of the forward-forward swap.

Settlement Dates

The settlement date of a forex transaction, also called its value date, is the day on which the transaction is settled by a transfer of deposits as explained in an earlier section. The settlement date for a spot transaction is generally the second business day from the date of the transaction, except for transactions between the US dollar and the Canadian dollar, and those between the US dollar and the Mexican peso. In these two cases the settlement takes place the next business day. This gap between the transaction date and the settlement date is needed in order to enable the banks to confirm and clear the deals through the communication networks.

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The term business day implies that neither of the days between the transaction date and the settlement date (including the settlement date) should be a holiday, either in any of the settlement locations, or in the dealing location of the market-making bank (i.e. the bank who gave the quote). The settlement locations are the countries whose currencies are involved in the transaction, and the dealing locations are the countries in which the banks involved in the transaction are located. For example, if a German bank sells Mexican peso against Canadian dollars to an Indian bank, Mexico and Canada would be the settlement locations, while Germany and India would be the dealing locations. In case any of the following two days is a holiday in either of these locations, the settlement date is shifted to the next business day.

According to these rules, a transaction entered into on a Monday would be settled on the following Wednesday (assuming that both Tuesday and Wednesday are working days in both the settlement locations and the dealing location of the market-making bank). Following the same rules, a transaction entered into on a Thursday would be settled on Monday, Saturday and Sunday being holidays in most of the countries. In order to avoid credit risk, both the parties turn over their deposits on the same day as a rule. The exception is made in case of transactions involving any of the mid-east currencies. These countries have their weekly off on Friday and have Saturdays and Sundays as working days. So if a deal is struck on a Wednesday involving any of these currencies against, say, the franc, the franc deposit will be turned over on Friday, while the mid-east currency will be transferred on Saturday. For a deal struck on Thursday, the mid-east currency deposit will be transferred on Saturday, while the francs will be transferred on Monday.

The settlement date for a forward contract depends on two things – the settlement date for a spot transaction entered on the same date as the forward contract, and the maturity of the forward contract in months. For arriving at the settlement date for a forward contract, first the settlement date for the corresponding spot transaction is calculated, and then the relevant number of calendar months is added to it. For example, if a 3-month (or 90 days) forward contract is entered into on July 20, first the spot settlement date will be calculated (in accordance with the previously specified rules). Suppose that it comes to July 23 because of July 21 being a holiday. Then the settlement date for the forward contract will be October 23. If it is a holiday on that day, the settlement date will be shifted to the next business day, i.e. October 24. By adding ‘calendar months’ it is meant that the specified number of months will be added to the spot settlement date, not 30 or 31 days (or the multiples thereof). Suppose the spot settlement date is the last date of a month, then the settlement date for the forward contract will be the last date of the relevant month, irrespective of the number of days in the two months. For example, if a one-month forward contract is entered into on January 29, the spot settlement date would be January 31. The settlement date for the forward contract would be February 28 (or February 29 if it is a leap year). One important point that has to be remembered while rounding off the settlement date due to holidays, etc. is that the rounding off should not shift the settlement date to the next calendar month. For example, if the settlement date of the forward contract is coming to October 31 which is a holiday, the settlement cannot be done on November 1. In such a case, the settlement date will be shifted to the previous business day. So, the settlement date would be October 30.

Short-Date Contracts

As said in the previous section, the settlement date for a spot transaction is two business days after the transaction date. There are some transactions which are an exception to this rule, i.e. where the settlement date is less than two business days after the date of the transaction. Such transactions, for which the settlement date is before the spot settlement date, are referred to as short-date contracts.

These transactions can be in the form of either outright contracts or swaps. The various swaps available in the market are: between today and tomorrow (called the cash/tom, C/T; it is also referred to as the overnight swap, O/N), between today and spot day (cash/spot, C/S), between tomorrow and next day, i.e. the spot day (tom/next, T/N or tom/spot, T/S) and between spot and the next day (spot/next, S/N). Strictly speaking, the S/N is not a short-date contract since the settlement does not take place before the spot day.

As in the case of swaps, the interbank market gives swap points for these contracts. A bank buying a currency has to pay the higher of the swap points as premium, and gets the lower of the swap points as discount. On the other hand, a bank selling a currency to the market will get the lower of the premium points, but will have to pay the higher of the swap points if the currency is at a discount. Here again, the spot rate to/from which these points are added/subtracted becomes irrelevant.

Quotes for Various Kinds of Merchant Transactions

There are different kinds of purchase and sale transactions in the retail market. The simplest is the outward or inward remittance. In this kind of transaction, the bank has to simply receive or send a currency through telegraphic transfer (TT), demand draft, postal order or mail transfer (MT). Since the work involved in such transactions is the least, a bank offers better rates for them. These rates are called the TT buying and TT selling rates. While the TT selling rate is applied for outward remittances in foreign currency (not being proceeds of import bills) and to cancellation of an earlier booked forward purchase contract, the TT buying rate is applied to inward remittances and for cancellation of a forward sale contract.

In India, TT buying and selling rates have to be determined in accordance with FEDAI rules. These rates are to be based on the base rate which may be derived from the on-going market rate. This base rate is marked up to cover the dealer’s margin (profit). The maximum permissible margin was earlier prescribed by FEDAI. Now it is left to the discretion of the ADs, subject to restrictions on the maximum spreads and other provisions relating to the calculation of exchange rates as specified by FEDAI. Bank managements generally specify the guidelines to their ADs in this regard. The ADs are also restricted from loading too high a margin by the competition that exists in this field. The margins prescribed by FEDAI which are now indicative are:

TT purchase 0.025% to 0.080%

TT sale 0.125% to 0.150%

The maximum permissible spreads between the TT Buying and TT selling rate are as follows:

US$ : 1.00 percent of the mean rate (the mid-rate)

Pound, DM, Yen, French franc, Swiss franc, Dutch Guilders and Australian dollars: 2.00 percent of the mean rate.

Other currencies: No limit at present but ADs are instructed to keep the spread to a minimum.

The TT rates are to be arrived at in the following manner:

Spot TT Buying Rate

Take the base rate and deduct the appropriate margin from it. For example, if the base rate for dollars is Rs.45.42 and the AD wishes to charge 0.08% margin, the spot TT buying rate would be:

Base rate	45.42
Less: Margin @ 0.08%	0.036
Spot TT buying rate	45.384

Spot TT Selling Rate

Take the base rate and add the appropriate margin to it. For example, if the base rate for dollars is Rs.45.50 and the AD wishes to charge a margin of 0.15%, then the TT selling rate would be:

Base rate	45.50
Add: Margin @ 0.15%	0.068
Spot TT buying rate	45.432

Forward TT Buying Rate

Take the base rate. Add (deduct) the on-going forward premium (discount) to (from) the base rate, depending upon the delivery period. From this, deduct the appropriate margin. For example, if a customer wants to sell dollars one month forward, with the base rate at Rs.45.42 and one month premium on dollar being 15 paise, the forward TT buying rate would be calculated as:

Base rate	45.42
Add: Premium	0.15
	45.57
Less: Margin @ 0.08%	0.0364
Forward TT buying rate	45.5336

Forward TT Selling Rate

Take the base rate. Add (deduct) the on-going forward premium (discount) to (from) the base rate, depending upon the delivery period. To this, add the appropriate margin. For example, with the base rate for dollar at Rs.45.50 and the one-month forward premium at 20 paise, the one-month forward TT selling rate will be:

Guest

selling rate will be:

Base rate	45.50
Add: Premium	0.20
	45.70
Add: Margin @ 0.15%	0.0688
Forward TT selling rate	45.6312

Bill Buying Rate

This rate is applied when the AD is giving the rate for an export transaction. The transaction can be either in the way of realization of a collection bill (where the amount has already been credited to the AD’s nostro account and the AD is only required to convert it into rupees), or in the form of purchase or discounting of an export bill (where the AD will be providing finance to the exporter till the bill gets collected and then convert the amount received into rupees). For the first type of transaction, the appropriate margin is deducted from the base rate to arrive at the bill buying rate. For the second type of transactions, the bill buying rate can be arrived at in the following manner. Take the base rate. Add (deduct) the on-going premium (discount) to (from) the base rate, the amount of premium (discount) depending on the notional due date (which includes the remaining tenor of the bill, the normal transit period and the grace period; the normal transit period and the grace period being specified by FEDAI guidelines). From this, deduct the appropriate margin. This will give the applicable bill buying rate. In addition, the AD will also charge interest from the customer for the credit extended for the period between the purchasing/discounting of the bill and the notional due date.

The bill buying rate can be calculated as follows. Let the base rate for dollar be Rs.45.42 and the premium for two months (till the notional due date) be 40 paise. If the AD requires a 15% margin, the rate will be:

Base rate	45.42
Add: Premium	0.40
	45.82
Less: Margin @ 15%	0.0687
Bill buying rate	45.7513

In addition, for both kinds of transactions, the AD has to charge a commission @ 0.25% subject to a minimum of Rs.10 as collection charges. The banks have been given the discretion of waiving the commission for an instrument having value up to Rs.5,000.

Bill Selling Rate

The bill selling rate is applied when the AD is giving the quote for an import transaction. This rate can be arrived at by adding the appropriate margin to the base rate. For example, if the base rate for dollars is Rs.42.70 and the AD requires a 0.02% margin over the TT selling rate, the bill selling rate will be:

Base rate	45.50
Add: Margin @ 0.15%	0.0682
TT Selling rate	45.5682
Add: Margin @ 0.2%	0.0911
Bill selling rate	45.6593

The third kind of merchant transaction is the purchase and sale of foreign currency notes and traveller’s cheques (TCs). The rate applicable to such transactions is calculated in the following manner:

TC Buying Rate

Take the one-month forward buying rate given by RBI as the base rate. If the RBI rate is not available, take the on-going market rate. Deduct margin from the base rate @ 1%. The resultant rate will be the TC buying rate. For example, if the one month forward rate is Rs.45.55, the TC buying rate would be:

Base rate	:	45.55
Less: Margin @ 1%	:	0.4555
TC buying rate	:	45.0945

TC Selling Rate

Take the TT selling rate and add a margin of 0.5% to it. Adding the margin is optional for the AD. On this gross amount, a commission is added (again at the option of the AD) at a maximum rate of 1%. If the TC is issued against foreign currency remittance, then the commission will be charged @ 0.25%. This gives the TC selling rate. For e.g., if the TT selling rate is Rs.42.7641/$ as calculated earlier, the TC selling rate would be:

TT selling rate	45.5682
Add: Margin @ 0.5%	0.2278
	45.7960
Add: Commission @ 1%	0.4579
TC selling rate	46.2539

The TC buying and selling rates thus arrived at, may be rounded off to the nearest 5 paise to get the final TC buying and selling rates.

The Indian Scenario

Prior to 1992, the Indian forex markets were totally regulated. The value of the Indian rupee was fixed, first in terms of the pound and later the US dollar. This value was revised once in a while when the regulator felt the need. All inward and outward remittances were required to be converted at this rate of exchange. The liberalization of the forex markets started in 1992. In March 1992, a dual exchange rate system was put into place. This was known as Liberalized Exchange Rate Management System (LERMS). Two exchange rates were prevailing during this period, one determined by RBI and the other determined by the market. This was the beginning of moving towards a market-oriented rate. Under this system, 40% of current account receipts were required to be converted at official rate and the balance could be converted at market-determined rates. This was later modified to become the Unified Exchange Rate System, which came into effect from March 1, 1993. Under this system, all forex transactions are required to be routed through the ADs at market-determined rates. The RBI also announces its rates (which act as reference rates) based on market rates. As mentioned earlier, only permitted persons can deal in foreign exchange (ADs etc.). Hence, any other person desiring to buy or sell foreign exchange can do so only through these permitted persons, and only for permissible transactions.

In August 1994, RBI announced relaxations on current account transactions and delegated further powers to ADs. They can now allow remittances for various purposes like travel, studies, medical treatment, gifts and services to the extent specified by RBI under the various provisions of the Exchange Control Manual. From time to time, RBI comes out with rules regarding the various players who are allowed to operate in the forex market, the various permissible instruments (like forward contracts, swaps etc.), the conditions in which these instruments can be used, etc. It thus regulates the operations of the market. Some of the important regulations, and the relevant FEDAI guidelines as on January 7, 1999 are given below:

Forward Exchange Contracts

· Can be booked only for genuine transactions and where there is exposure to exchange risk, not for speculative purposes.

· Cannot be booked for anticipated transactions, only for firm exposure.

· Can be booked in the currency in which the importer is exposed to exchange rate or in any other permitted currency, i.e. any freely convertible currency.

· Value of the forward cover should not exceed the value of the goods contracted for.

· The period and the extent of the exposure to be covered is left to the choice of the importer. However, the last date of delivery of the forward contract should not exceed six months from the date of shipment/expected shipment date (in case of contracts booked for covering exports or imports).

· Rollover forward covers are permitted to be booked as necessitated by the maturity dates of the underlying transactions, market conditions and the need to reduce costs to the customers. Each time a forward contract is rolled over, the new contract can be for a maximum period of six months.

· In case of merchanting trade transactions (i.e., transactions where some good is imported only to be exported elsewhere, in the same or a refined form), forward contracts will have to be booked simultaneously for both legs of the transactions or for the net amount of expected profit.

· No ready sale or purchase should be made for a transaction for which a forward contract has already been booked.

· Forward contracts can be cancelled by the party concerned whenever required. The exposure can be covered again by the customer through the same or another AD subject to genuine exposure risk and permissibility of the transaction. However, for non-trade transactions, contracts once cancelled cannot be rebooked. Corporates can rollover such contracts on maturity at ongoing rates.

· Forward cover can be taken by resident corporate clients in respect of dividend due to overseas investors who have made a direct foreign investment in India. The cover can be provided only after the Board of Directors has decided upon the rate of dividend.

· Forward cover can also be taken for foreign currency loans to be raised, anytime after the final approval for the loan arrangements have been obtained from RBI.

Guest

· For GDR issues forward cover can be obtained once the issue price has been finalized.

· On each forward sale/purchase contract booked, the ADs are required to charge a minimum commission of Rs. 250 (FEDAI rules).

Other Regulations

· Exporters and certain other recipients of forex, at their option, can retain a portion of the proceeds in forex in a foreign currency account opened with ADs in India. This account is known as Exchange Earners’ Foreign Currency deposit.

· Cross currency exposures can be covered in the overseas market through ADs, without necessarily covering the rupee/dollar leg of the transaction.

· All actual out of pocket expenses of the bank such as postage, telex charges including those of the corresponding bank shall be recovered from the customer.

· R – Returns are required to be submitted by ADs to the Exchange Control Department of RBI – pertaining to the transactions in foreign exchange, and in rupee with overseas banks during each fortnight. These returns serve as the principal source of information for compilation of BoP data. They also help RBI to check whether the powers delegated to ADs have been correctly exercised.

Early Delivery / Extension / Cancellation of Forward Exchange Contracts

In many cases, a customer books a forward contract on the basis of an estimation regarding the time when he would need to deal in the foreign currency. With the uncertainties prevailing in international trade, in many cases the customers may find themselves receiving export proceeds beyond the estimated due date, or preferring to pay for their imports before the due date to take advantage of a depreciating foreign currency or for any other reason. The actual date of delivery or purchase of foreign currency may vary from the date for which forward contract is booked, for a variety of reasons. In such circumstances, forward contracts may be extended or cancelled, or the customer could request an early delivery, if the bank is willing to accommodate him. In these cases, the customers will have to bear the losses arising out of the premature/extended performance or canceling of the contract. FEDAI Rule No.8 regulates the charges that the customer has to pay to the bank. The rule says that:

1. Customers can request for an early delivery / extension / cancellation of a forward contract on or before the maturity date of the contract.

2. The bank has to a charge a minimum sum of Rs.100 for entertaining any such request from the customer.

3. Early Delivery: If a bank accepts or gives early delivery, in addition to the flat charge of Rs.100, the bank has to charge/pay the swap charges for the early delivery period from/to the customer, irrespective of whether the bank actually enters into a swap or not. This swap cost/ gain may be recovered from/paid to the customer, either at the beginning of the swap period or at its end, as the bank may deem fit. As a result of the swap, if the bank faces an outlay of funds, it has to charge interest from the customer at a rate not less than the prime lending rate, for the period of the swap. If there is an inflow of funds, the bank may, at its discretion, pay interest to the customer at the rate applicable to term deposits with maturity equal to the period of the swap. The timing of this cash flow too is left to the discretion of the bank.

Let us see an example for early delivery. An exporter enters into a forward contract with a bank to sell 1 million US dollars to the bank, settlement date December 31. The contract price is Rs.45.40/$. On November 28, the exporter asks the bank to take delivery on November 30. The spot rate on that date is 45.22/27. The dollar is at a premium, with one month swap points being 10/15. To offset its position created by the early delivery, the bank will have to enter into a one month sell-buy swap. In the process, it will have to sell dollars spot @ Rs.45.22 and will have to pay a premium of 15 paise for the swap. This swap cost of 15 paise will be charged to the customer. On November 30, the bank buys dollars from the exporter @ Rs.45.40/$, i.e., the earlier contracted rate. Since on that day the bank pays Rs.45.40/$ (to A) and receives Rs.45.22/$ (from the market), there will be an outlay of funds to the extent of 18 paise per dollar for the duration of the swap, i.e. one month. The bank will charge interest at a rate not lower than the prime lending rate on this outlay for one month from the customer. In addition to the swap cost and the interest, A will have to pay Rs. 100 to the bank. The net inflow to A can be calculated in the following manner:

Assume that the bank charges interest @ 17%.

Inflow from dollar sale: 1,000,000 x 45.40	=		Rs.45,400,000
Swap charges paid: 0.15 x 1,000,000	=	150,000
Interest paid: 0.18 x 1,000,000 x 0.17/12	=	2,550
Flat charge	=	100
Total outflow	=		152,650
Net inflow	=		45,247,350

4. Extension: An extension of a contract entails cancelling an existing contract and rebooking a corresponding forward contract. The cancelling is required to be done at the relevant TT buying or selling rate as on the date of cancellation, and the rebooking would be done on the on-going rate for a new forward contract. The bank is required to collect / pay the difference between the rate at which the original contract was entered, and the rate at which it is cancelled, from/to the customer. This may be done either at the time of cancellation or at the time of maturity of the original contract. This would be in addition to the flat charge.

Let us see an example. An importer enters into a forward contract with a bank whereby the bank will sell 1 million dollars to the importer @ Rs.45.40, settlement date November 30. On November 15, the importer requests the bank to extend the contract up to December 31. On the day of the request, the forward TT buying rate for November 30 is Rs.45.45, and the TT selling rate for maturity December 31 is Rs.45.50. The bank will cancel the original contract (i.e. enter into an exact opposite contract, here, to buy dollars) at Rs.45.45 and book a new forward contract at Rs.45.50. The difference of 5 paise (45.40 – 45.45) per dollar would be passed on to the customer on either November 15, or on November 30. On December 31, the importer will buy dollars from the bank @ Rs.45.50. In addition, at the time of cancellation, the importer will pay Rs.100 to the bank. The net outflow for the importer will be:

On cancellation:
Gain on cancellation: 0.05 x 1000,000 =		Rs.50,000
Less: Flat charges	:	100
Net amount receivable	:	49,900
On December 31, the importer buys dollars from the bank for:
45.50 x 1000,000 = 45,400,000
The importer’s net outflow (ignoring timing of the different flows):		45,400,000
Less:		49,900
		45,350,100

5. Cancellation: In case of cancellation of a contract, it is required to be cancelled at the appropriate TT selling or buying rate and the difference between the contracted rate and the cancellation rate is to be collected from / paid to the customer. In addition, the flat rate is required to be collected.

If in the above example, the importer had requested the bank to cancel the contract on November 15 rather than getting it extended, the customer would have got 5 paise per dollar and would have paid charges of Rs.100 to the bank. The importer’s net inflow/outflow would be:

Gain on cancellation: 0.05 x 1000,000	=	Rs.50,000
Less: Flat charges	=	100
Net amount receivable	=	49,900

6. Any amount to be collected / paid by the bank on account of early delivery/ extension/ cancellation of a forward contract (except for the flat charge) shall be ignored if it is less than or equal to Rs.50.