Banking, Financial Markets

and Systems
Set - 8
Financial Markets - 3
P C Narayan

IIM PCN PGP-II T4 BFMS L08

Financial markets III

Foreign Exchange Market

A market for the sale and purchase of currencies
The price of one currency in terms of another is
the exchange rate (ER)
Types of transactions: Cash / Tom / Spot /
Forward
Bid rate : Quote in one currency at which the
dealer will buy another currency
Ask rate : Quote in one currency at which the
dealer will sell another currency
Participants in the FX Market: individuals and
firms / FX dealers (banks) / Speculators and
Arbitragers / Central bank / Brokers .
IIM PCN PGP-II T4 BFMS L08
Financial markets III

Foreign
Exchange
Market

Retail

Wholesale

Money changers

Banks

Indirect
(through brokers)

Direct

Spot

Merchant (Trade Based)

Central Bank

Forward

(outright and swaps)

Derivatives
( futures, options etc.)

Non merchant (inter-bank)

IIM PCN PGP-II T4 BFMS L08

Financial markets III

Typical Merchant / Corporate

FX transactions
Banks Corporate Dealer makes two deals with customers,
as follows:
Export Customer
Bid price (ER) INR 45.00 / USD
Bank buys USD 100,000
Bank sells INR 4500000

Import Customer
Ask price (ER) INR 45.25 / USD
Bank sells USD 100,000
Bank buys INR 4525000

Bank has made a profit of Rs. 25000, since the two

transactions are equal and opposite
But it is not always possible to find equal and opposite
transaction
IIM PCN PGP-II T4 BFMS L08
Financial markets III

Typical Merchant / Corporate +

Inter Bank FX Transaction
Banks Corporate Dealer makes two deals with customers, as
follows:
Export Customer
Import Customer
Bid price (ER) INR 40 / USD
Ask price (ER) INR 40.25 / USD
Corp Dlr buys USD 100,000
Corp Dlr sells USD 200,000
Corp Dlr sells INR 4000000
Corp Dlr buys INR 8050000
Banks Corporate dealer buys (transfers net over sold position)
USD 100,000 from the Banks Inter-bank dealer at internal ask
price (ER) of, say, INR 40.10 / USD
Corporate Dealer has made a profit of INR 25,000 on USD 100,000
and INR 15,000 on USD 100,000. He has also squared (closed out)
his position
IIM PCN PGP-II T4 BFMS L08
Financial markets III

Typical Merchant / Corporate

cum Inter Bank FX Transaction
To square ( close out) the Banks position on the same day, Inter
bank dealer buys USD 100,000, say, @ INR 40.05 / USD.

His profit will be INR 5,000.

Total profit for the bank will be INR 45,000 ( INR 40,000 by Corp Dlr
+ INR 5,000 by Inter Bank Dlr)
However, the Inter-Bank dealer could decided to carry over the
oversold position, in anticipation of the INR strengthening in the
days ahead
If he buys USD 100,000 five days later at INR 39.50 / USD, his
profit will be INR 60,000.
IIM PCN PGP-II T4 BFMS L08
Financial markets III

Why do exchange rates fluctuate

Theory of purchasing power parity : Exchange
rates between any two countries will adjust to
reflect changes in price levels of the two countries
Example: American Steel costs USD 100 / ton
Japanese Steel costs JPY 10000 / ton
ER will be USD 1 = JPY 100
If Japanese steel prices rise to JPY 11000,
ER will change to USD 1 = JPY 110

IIM PCN PGP-II T4 BFMS L08

Financial markets III

Why do exchange rates fluctuate

PPP catches the trend in the long term but very
little predictive power in the short term
Factors that affect ER in the long term:
Relative price levels: rise in the countrys price level
(relative to foreign price level) causes its currency to
Suppose US imposes tariffs and quotas on Japs steel,
US steel will sell well causing USD to
Preference for domestic vs foreign goods: If Japs love
American chocolates and Florida oranges, USD
Productivity: Higher productivity lowers price of goods
relative to foreign goods and hence that countrys
IIM PCN PGP-II T4 BFMS L08
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currency
Financial markets III

Exchange rate behaviour in the short term

Assume you are an NRI from the US. Hence, USD is your home currency vs.
INR
Assume you have received INR 4,000,000 today through sale of real estate in
India
Say, prevailing interest rate for 1 yr is INR: 8% and USD 5%
You have two options (1) to turn the INR to USD at current spot rate (USD/INR
40.00) immediately and place it on a 1 yr deposit in USD or (2) hold the deposit
for 1 yr in INR and turn it into USD at end of 1 yr
Assume USD expected to appreciate to 41.50 in 1 yr ( forward rate)
Option 1 would give you a return of USD 5000 at end of 1 yr while option 2
would give a return of USD 4100 (approx). Hence you would go for option 1
above
Assume USD expected to depreciate to 38.50 in 1yr ( forward rate)
Option 1 would give you a return of USD 5000 at end of 1 yr while option 2
would give a return of USD 12200 (approx). Hence you would go for option 2
above
This arbitrage stops at the interest parity condition (equilibrium)

Id = Ie { ( Et+1 Et) / Et }
i.e Domestic interest rates equals foreign interest rates minus the expected
appreciation of the domestic currency
IIM PCN PGP-II T4 BFMS L08
Financial markets III

Exchange rate behaviour in the short term

Consider USD as home currency vs. EUR
Say, you have EUR 1 mio to put in a bank for one year
Say, Interest rate on EUR for one year is 4%
Assume USD would appreciate by 2% in one year and USD interest
rate for one year is, say, 3%, return on EUR 1 mio for one year is
5%, you will put your money as a USD deposit rather than as a Euro
deposit
Assume USD would depreciate by 2% in one year and USD interest
rate for one year is 3%, return on EUR 1 mio for one year is 1%, you
will keep your money as a EUR Deposit

This arbitrage stops at the interest parity condition

(equilibrium)

Id = Ie { ( Et+1 Et) / Et }
i.e Domestic interest rates equals foreign interest rates
minus the expected appreciation of the domestic currency
IIM PCN PGP-II T4 BFMS L08
Financial markets III

10

In summary
Goes
Up / down

Domestic currency
Appreciate / Depreciate

Domestic interest rate

Foreign Interest rate
Expected dom. price level
Expected tariff and quota
Expected import demand
Expected export demand
Productivity
Money supply
IIM PCN PGP-II T4 BFMS L08
Financial markets III

11

FX Dealing
Suppose bank A needs USD 1 mio and is willing to sell INR
Dealer of bank A approaches bank Y and asks for a quote
USD / INR, does not mention buy or sell
Bank Y gives him a two-way quote, bid and ask
If ask rate is acceptable to bank A, he says one mine,
implying he will buy USD 1 mio from bank Y and deliver
INR at the agreed deal rate
( Recap: ask rate : Quote at which the dealer of bank Y will
sell USD buy INR. bid rate : Quote at which the dealer of
bank Y will buy USD sell INR)
Instead, if bank A wants to sell USD one mio and buy INR,
he says one yours implying he will sell USD 1 mio to
bank Y and take delivery of the INR at the agreed deal rate
Quotes are usually in points or pips
IIMB PCN BFMS L09

12

Foreign Exchange Dealing

Settlement and Accounting

Deal confirmation
Deal Matching
Correspondent Bank
Nostro and Vostro Accounts
SWIFT Payments
Accounting
IIMB PCN BFMS L09

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