Module - 1 :
The foreign exchange market, structure and organization- mechanics of currency trading
– types of transactions and settlement dates – exchange rate quotations and arbitrage – arbitrage with and without transaction costs – swaps and deposit markets – option forwards – forward swaps and swap positions – Interest rate parity theory.
2. Module - 1 :
The foreign exchange market, structure and organization-
mechanics of currency trading – types of transactions and
settlement dates – exchange rate quotations and arbitrage
– arbitrage with and without transaction costs – swaps and
deposit markets – option forwards – forward swaps and
swap positions – Interest rate parity theory.
3. EVOLUTION OFAN OPEN FOREX MARKET
1. Gold Standard System: Introduced in 1875, earlier
countries would commonly use gold and silver as method
of international payment.
2. Countries need to convert their local currency to gold and
vice versa. In other words a currency was backed by gold.
3. Governments needed a fairly substantial gold reserve in
order to meet the demand for currency exchanges.
4. The gold standard eventually broke down during the
beginning of World War I. Political tension in Germany
and other European Countries on Military Equipment's.
5. Scarcity of Gold Reserves created a to print extra currency.
6. Gold Standard dropped and came back in between World
War I & II but couldn’t sustain for a longer period of time.
4. EVOLUTION OFAN OPEN FOREX MARKET
1. Bretton Woods System:
Before the end of World War II, the Allied nations felt the
need to set up a monetary system in order to fill the void
(containing nothing) that was left when the gold standard
system was abandoned.
In July 1944, more than 700 representatives from the Allies
met in Bretton Woods, New Hampshire, to deliberate over
what would be called the Bretton Woods system of
international monetary management.
5. To simplify, Bretton Woods led to the formation of the
following:
• A method of fixed exchange rates; "pegging" 1 Troy
Ounce of Gold = $35
• The U.S. dollar replacing the gold standard to become a
primary reserve currency; and
• The creation of three international agencies to oversee
economic activity: the International Monetary Fund (IMF),
International Bank for Reconstruction and Development, and
the General Agreement on Tariffs and Trade (GATT).
The U.S government was obligated to maintain gold reserves
equal to the amount of currency in circulation, making the
United States a true gold standard economy.
EVOLUTION OFAN OPEN FOREX MARKET
6. Over the next 25 or so years, the system ran into a number of
problems. By the early 1970s, U.S. gold reserves were so low
that the U.S. Treasury did not have enough gold to cover all
the U.S. dollars that foreign central banks had in reserve.
Finally, on August 15, 1971, U.S. President Richard Nixon
closed the gold window, essentially refusing to exchange U.S.
dollars for gold. This event marked the end of Bretton Woods.
EVOLUTION OFAN OPEN FOREX MARKET
The Chicago Mercantile Exchange (CME) became the first
exchange to offer currency trading.
In 1971, the CME launched the International Monetary Market
(IMM).
7. BRETTON WOODS SYSTEM - TRAP
1. The Eurodollar Market
• The first attack on Bretton Woods came in the form of what would
be known as the Eurodollar market.
• The term “Eurodollar", defines any instance of U.S. dollars
deposited in a bank outside the United States – initially, the source of
much of the foreign-held dollars was oil.
• The Soviet Union became an important oil producer shortly after
World War II, and because oil contracts sold on the international markets
were settled in U.S. dollars, the Soviet Union started receiving huge
amounts of U.S. currency.
• Coincidently, this period also marked the beginning of the "Cold
War" between the east and the west.
• Worried that their bank accounts could be seized by the U.S., the
Soviet Union opted to deposit its U.S. dollars in European banks, out of
the reach of American authorities.
• As the number of U.S. dollars held in this new eurodollar market
grew, it soon became an important source of lending capital for
governments and large companies around the world.
8. 2. U.S. Inflation and the Energy Crisis
• In 1971, inflation in the U.S. continued to erode the purchasing
power of the dollar. At the same time, an energy crisis was
simultaneously pushing up the price of oil and other commodities.
• As a result, investors – as is often the case when confusion
reigns in the markets – turned to gold as a hedge to protect savings.
• The increased demand caused gold prices to soar and because
the dollar was tied to gold, the U.S. dollar followed suit, further
exacerbating the inflationary pressures.
• Finally, in an attempt to deal with surging inflation in the U.S.
economy, President Nixon dropped the gold standard requirement and
devalued the U.S. dollar to 1/35th of an ounce of gold.
• This effectively ended not only the gold standard, but also the
Bretton Woods-imposed pegging of currencies, leading ultimately to
free-floating individual currencies based on market conditions and
other economic factors.
9. HISTORY OF FOREX MARKET IN INDIA
1. Reserve Bank of India (RBI) in the year 1978 allows banks to
undertake intra-day trading in foreign currency exchange. Ex:
‘square’ or ‘near square’ positions on each closing day of mkt.
2. The exchange rate used to be determined by RBI on the basis of
weighted basket of currencies of India’s major trading partners.
3. Landmark: Appointment of an Expert Group committee on
Forex currency in 1994 to study and develop forex mkt.
4. Freedom was granted to banks in term of fixing their trading
limits, allowed to borrow and invest funds in the overseas
markets up to specified limits, accorded freedom to make use of
derivative products for asset-liability management purposes.
5. National Stock Exchange of India popularly known as NSE was
the first recognized exchange in Indian forex history to launch
forex currency futures trading in India.
6. Forex transactions in India are managed by the government
authorities.
10. 1966 The Rupee was devalued by 57.5% against on June 6.
1967 Rupee-Sterling parity change as a result of devaluation of the
sterling.
1971 Bretton Woods’s system broke down in August. Rupee briefly
pegged to the USD @ Rs 7.50 before reneging to Sterling at Rs.
18.8672 with a 2.25% margin on either side
1972 Sterling floated on June 23. Rupee sterling parity revalued to Rs
18.95 and the in October to Rs 18.80
1975 Rupee pegged to an undisclosed basket with a margin of 2.25%
on either side. Sterling the intervention currency with a central bank
rate of Rs 18.3084
1979 Margins around basket parity widened to 5% on each side in
January
1981 the “Guidelines for Internal Control over Foreign Exchange
Business” was framed for adoption by banks.
LANDMARKS
11. 1991 Rupee devalued by 22% July 1st and 3rd. Rupee dollar rate
depreciated from 21.20 to 25.80. A version of dual exchange rate
introduced through EXIM scrip scheme, given exporters freely
tradable import entitlements equivalent to 30-40% of export earnings.
1992 LERMS (Liberalized Exchange Rate Management System)
introduced with a 40-60 dual rate converting export proceeds, market
determined rate for all but specified imports and market rate for
approved capital transaction.
1993 Unified market determined exchange rate introduced for all
transactions. RBI would buy/sell US Dollars for specified purposes. It
will not buy or sell forward Dollars though it will enter into Dollar
swaps.
1994 Rupee made fully convertible on current account from August
20th.
1998 Foreign Exchange Management Act – FEMA Bill 1998, which
was placed in the Parliament to replace FERA 1973.
1999 Implication of FEMA start.
12.
13.
14.
15.
16. Authorized Person: The Reserve Bank Provide Licenses to three
categories of persons transact with public at different levels and they are as
follows:
1. Authorized Dealers: The bulk of foreign exchange transactions
undertaken in the country involve end-users and banks. Ex: Banks –
License by RBI.
2. Offshored Banking Units: Branches of banks in india established in
Special Economic Zones (SEZ) are accorded the status of Offshore
Banking Units (OBU’s). They are allowed to undertake banking
operations only in designated foreign currencies essentially with non-
residents.
3. Authorized Money Changers: These people are sub-classified as Full
Fledged and Restricted Money Changes.
a. Full fledged money changers are permitted to both buy as well
as sell foreign exchange. Ex: Travel Agencies
b. Restricted money changers can purchased foreign exchange in
the form of travellers cheques or currency notes, but they are not
allowed to sell. Ex: Five Star Hotels.
17.
18. COMPONENTS OF INDIAN FOREIGN EXCHANGE
MARKET
A. Retail Market: The end-users of foreign currencies are
(individuals, exporters, importers, travellers and tourist) approach
authorized dealers for their requirements. AD’s will provide
merchant rates for them. Total turnover and individual transaction
size is very small in amount and time of maturity. It is governed
by rules and regulations of RBI.
B. Wholesale Market (Interbank Market): The market witness a
bulk foreign exchange transactions. It is in between RBI and
Authorized Delores of Foreign Exchange. The rates are
determined by market and the volume of transactions as stated
above is bulky and standard in lot size. It is also governed by the
rules and regulations of RBI.
The differences between the buying and selling prices is called as bid-
offer spread.
19.
20.
21.
22. The Case Study: How BMW dealt with exchange rate risk
The story. BMW Group, owner of the BMW, Mini and Rolls-Royce
brands, has been based in Munich since its founding in 1916. But by
2011, only 17 per cent of the cars it sold were bought in Germany.
In recent years, China has become BMW’s fastest-growing market,
accounting for 14 per cent of BMW’s global sales volume in 2011.
India, Russia and eastern Europe have also become key markets.
The challenge. Despite rising sales revenues, BMW was conscious
that its profits were often severely eroded by changes in exchange
rates. The company’s own calculations in its annual reports suggest
that the negative effect of exchange rates totalled €2.4bn between
2005 and 2009.
BMW did not want to pass on its exchange rate costs to consumers
through price increases. Its rival Porsche had done this at the end of
the 1980s in the US and sales had plunged.
23. The strategy. BMW took a two-pronged approach to managing its
foreign exchange exposure.
One strategy was to use a “natural hedge” – meaning it would develop
ways to spend money in the same currency as where sales were taking
place, meaning revenues would also be in the local currency.
However, not all exposure could be offset in this way, so BMW
decided it would also use formal financial hedges. To achieve this,
BMW set up regional treasury centres in the US, the UK and
Singapore.
How the strategy was implemented. The natural hedge strategy was
implemented in two ways. The first involved establishing factories in
the markets where it sold its products; the second involved making
more purchases denominated in the currencies of its main markets.
BMW now has production facilities for cars and components in 13
countries. In 2000, its overseas production volume accounted for 20
per cent of the total. By 2011, it had risen to 44 per cent.
24. In the 1990s, BMW had become one of the first premium carmakers
from overseas to set up a plant in the US – in Spartanburg, South
Carolina. In 2008, BMW announced it was investing $750m to
expand its Spartanburg plant. This would create 5,000 jobs in the US
while cutting 8,100 jobs in Germany.
This also had the effect of shortening the supply chain between
Germany and the US market.
The company boosted its purchasing in US dollars generally,
especially in the North American Free Trade Agreement region. Its
office in Mexico City made $615m of purchases of Mexican auto
parts in 2009, expected to rise significantly in following years.
25. A joint venture with Brilliance China Automotive was set up in
Shenyang, China, where half the BMW cars for sale in the country are
now manufactured. The carmaker also set up a local office to help its
group purchasing department to select competitive suppliers in China.
By the end of 2009, Rmb6bn worth of purchases were from local
suppliers. Again, this had the effect of shortening supply chains and
improving customer service.
At the end of 2010, BMW announced it would invest 1.8bn rupees in
its production plant in Chennai, India, and increase production
capacity in India from 6,000 to 10,000 units. It also announced plans
to increase production in Kaliningrad, Russia.
Meanwhile, the overseas regional treasury centers were instructed to
review the exchange rate exposure in their regions on a weekly basis
and report it to a group treasurer, part of the group finance operation,
in Munich. The group treasurer team then consolidates risk figures
globally and recommends actions to mitigate foreign exchange risk.
26. The lessons. By moving production to foreign markets the company
not only reduces its foreign exchange exposure but also benefits from
being close to its customers.
In addition, sourcing parts overseas, and therefore closer to its foreign
markets, also helps to diversify supply chain risks.
Source: The writers are, respectively, professor of economics and
finance and associate dean of research, and a research associate at
CEIBS, reference: The Financial Times Limited 2017.
27. POINTS TO KNOW
1. Meaning of National and International Business.
2. International Business can take three modes: Direct Trade,
Contractual Mode & FDI.
3. Agreements Types – Unilateral, Bilateral, Multilateral
4. Contract Modes: Licensing, Franchising, Management
Control and Turn Key Projects, etc.
5. Current Account and Capital Account in BOP and BOT.
6. Current accounts involve transfer of real income.
7. Capital account involves transfer of funds without affecting
a shift in the real income.
28. FPIs & FDIs
Horizontal − In case of horizontal FDI, the company does all the same
activities abroad as at home. For example, Toyota assembles motor cars
in Japan and the UK.
Vertical − In vertical assignments, different types of activities are carried
out abroad. In case of forward vertical FDI, the FDI brings the
company nearer to a market (for example, Toyota buying a car
distributorship in America). In case of backward Vertical FDI, the
international integration goes back towards raw materials (for example,
Toyota getting majority stake in a tyre manufacturer or a rubber
plantation).
Conglomerate − In this type of investment, the investment is made to
acquire an unrelated business abroad. It is the most surprising form of
FDI, as it requires overcoming two barriers simultaneously – one,
entering a foreign country and two, working in a new industry.
29. The Greenfield project means that a work which is not following a
prior work. In infrastructure the projects on the unused lands where
there is no need to remodel or demolish an existing structure are
called Green Field Projects. The projects which are modified or
upgraded are called brownfield projects.
GREEN FIELD INVESTMENT
• Building new production facilities in a foreign country.
• It refers to investment in a manufacturing, office, or other physical
company-related structure or group of structures in an area where
no previous facilities exist.
BROWNFIELD INVESTMENT
• Used for purchasing or leasing existing production facilities to
launch a new production activity.
FDI Limits as of now in India – Please do refer sources
30. MEANING OF FOREX MARKET:
Foreign Exchange (FOREX) refers to the foreign exchange market.
It is the over-the-counter market in which the foreign currencies of
the world are traded. It is considered the largest and most liquid
market in the world.
Foreign Exchange has no centralized market. Instead, a foreign
exchange market exists wherever the trade of two foreign currencies
are taking place. It is open 24 hours a day, five days a week. This
foreign exchange market exists to ease investment and trade. The
primary trading centers are London, Paris, New York, Tokyo, Zurich,
Frankfurt, Sydney, and Singapore. All levels of traders, from central
banks to speculators, trade currencies with one another.
31. According to the Bank for International Settlements, the preliminary
global results from the 2016 Triennial Central Bank Survey of
Foreign Exchange and OTC Derivatives Markets Activity show that
trading in foreign exchange markets averaged $5.1 trillion per day in
April 2016.
According to the Bank for International Settlements, as of April 2016,
average daily turnover in global foreign exchange markets is
estimated at $5.09 trillion. The $5.09 trillion break-down is as
follows:
$1.654 trillion in spot transactions
$700 billion in outright forwards
$2.383 trillion in foreign exchange swaps
$96 billion currency swaps
$254 billion in options and other products
32. 1. Different countries have different currencies with
different strengths.
2. All the countries in the world are inter dependent.
3. Trade transactions takes place among countries resulting
in exchange of currencies / representing purchasing
power
4. Forex is required to meet import bills of a country.
5. Importers have to pay the bills in currencies at the
choice of the exporters.
NEED FOR FOREIGN EXCHANGE
The foreign exchange market (forex, FX, or currency market) is a
global decentralized market for the trading of currencies. This
includes all aspects of buying, selling and exchanging currencies at
current or determined prices.
DEFINITION OF FOREIGN EXCHANGE MARKET
33. • Individuals
• Firms
• companies (MNCs) exchange forex to meet their imports and exports
commitments, repayment of loans/inflow of forex.
• Banks : major players as major portion of forex transactions are rooted
through banks.
• Banks have to get authorization/permission to deal in forex transaction.
• They are called authorized dealers.
• Speculators: Commercial and investment banks, hedge funds buy and
sell forex to earn profit due to fluctuations in exchange rate
• Arbitragers: firms, companies, investors make profit by buying forex
in a cheaper market and sell the same in markets with higher price
simultaneously. Arbitrage is a risk free transaction.
• Central Banks: The entire forex transactions are controlled by Central
Banks of different countries and in India by the RBI & RBI maintains
forex reserves and intervenes in forex market to stabilize the value of
domestic currency.
PARTICIPANTS IN FOREIGN EXCHANGE MARKET
34. The Foreign Exchange Management Act, 1999 (FEMA) is an Act of
the Parliament of India "to consolidate and amend the law relating to
foreign exchange with the objective of facilitating external trade and
payments and for promoting the orderly development and
maintenance of foreign exchange market in India“
“Foreign Exchange (FOREX) refers to the foreign exchange market.
It is the over-the-counter market in which the foreign currencies of
the world are traded. It is considered the largest and most liquid
market in the world.”
Forex Market concentrated in big cities and is a three tier market
A. Transactions between RBI and Authorized Dealers
B. Commercial Banks
C. Money Changers: A person whose business was the
exchanging of one currency for another.
D. Firms and Individuals
35. 1. RBI buys and sells forex from and to ADs according to exchange
control regulations.
2. RBI intervenes in the market to stabilize the value of rupee.
TIER - I
TIER - II
1. Interbank market where ADs transact business among themselves.
2. It is the wholesale market.
3. The transactions will be within the country & outside the country.
4. Transactions are rooted through banks.
5. Indian banks mainly deal in 2 currencies i.e. USD and pound
sterling.
1. Primary market where ADs transact with the customers.
2. Over the counter transactions.
3. Tourists, exporters, importers, NRIs, exchange currency through
the commercial banks (ADs) and money changers
TIER - III
36. MECHANICS OF CURRENCY TRADING
What is traded in the Forex market?
The instrument traded by Forex traders and investors are currency
pairs. A currency pair is the exchange rate of one currency over
another. The most traded currency pairs are:
EUR/USD: Euro
GBP/USD: Pound
USD/CAD: Canadian dollar
USD/JPY: Yen
USD/CHF: Swiss franc
AUD/USD: Aussie
These currency pairs generate up to 85% of the overall volume
generated in the Forex market.
37. So, for instance, if a trader goes long or buys the Euro
(EUR/USD), she or he is simultaneously buying the EUR and
selling the USD. If the same trader goes short or sells the Aussie
(AUD/USD), she or he is simultaneously selling the AUD and
buying the USD.
The first currency of each currency pair is referred as the base
currency, while second currency is referred as the counter or
quote currency.
Each currency pair is expressed in units of the counter currency
needed to get one unit of the base currency.
If the price or quote of the EUR/USD is 1.2545, it means that
1.2545 US dollars are needed to get one EUR.
38. A. Bid/Ask Spread:
All currency pairs are commonly quoted with a bid and ask price.
The bid (always lower than the ask) is the price your broker is
willing to buy at, thus the trader should sell at this price. The ask is
the price your broker is willing to sell at, thus the trader should buy
at this price.
EUR/USD 1.2545/48 or 1.2545/8
The bid price is 1.2545 (we traders sell at this price)
The ask price is 1.2548 (we traders buy at this price)
B. Pips:
A pip is the minimum incremental move a currency pair can make.
Pip stands for price interest point. A move in the EUR/USD from
1.2545 to 1.2560 equals 15 pips. And a move in the USD/JPY from
112.05 to 113.10 equals 105 pips
39. C. Margin Trading (leverage): In contrast with other financial markets
where you require the full deposit of the amount traded, in the Forex
market you require only a margin deposit. The rest will be granted by
your broker.
The leverage provided by some brokers goes up to 400:1. This means
that you require only 1/400 or .25% in balance to open a position (plus
the floating gains/losses.) Most brokers offer 100:1, where every trader
requires 1% in balance to open a position.
The standard lot size in the Forex market is $100,000 USD.
For instance, a trader wants to get long one lot in EUR/USD and he or
she is using 100:1 leverage.
To open such position, he or she requires 1% in balance or $1,000 USD.
Of course it is not recommended to open a position with such limited
funds in our trading balance. If the trade goes against our trader, the
position is to be closed by the broker. This takes us to our next important
term.
40. D. Margin Call:
A margin call occurs when the balance of the trading account falls
below the maintenance margin (capital required to open one
position, 1% when the leverage used is 100:1, 2% when leverage
used is 50:1, and so on.) At this moment, the broker sells off (or
buys back in the case of short positions) all your trades, leaving the
trader “theoretically” with the maintenance margin.
Most of the time margin calls occur when money management is
not properly applied.
41. FOREX ORDER TYPES - Mechanics of Online Forex Trading
A market order instructs the broker to buy or sell a currency at the
current market price. As such, neither the trader, nor the broker has
any control over where the trade is executed.
a limit order instructs the broker to execute a trade only when a
particular price value is reached. No action will be taken until the
price quote is reached, regardless of the length of time. The
disadvantage of the limit order is that the market may never move in
the desired direction, and the trade may never be executed as a result.
The stop-loss order is a kind of safety mechanism that puts a ceiling
over the losses that a misplaced trade can cause. By entering the stop-
loss order, we’re specifying the maximum amount of unrealized
losses that we are willing to tolerate, beyond which our confidence in
the trade would not be maintained.
42. The trailing-stop order is a relatively uncommon order type. In this
case, the stop-loss order is renewed automatically by the trading
software at intervals specified by the trader. For instance, when we
buy the EUR/USD pair at 1.3500, set our stop-loss order at 1.3400,
and set the period of the trailing stop at 50 pips, the software will
revise our stop-loss order higher at intervals of 50 points as the price
moves and our account shows unrealized profits. When the price
reaches 1.3550, our new stop-loss would be entered automatically at
1.345. When the price reaches 1.36, the new stop-loss would be at
1.35, ensuring a risk-free trade.
The take profit order specifies the price quote at which we would
like our position to be closed, and profits to be realized.
43. DIFFERENT TYPES OF TRANSACTIONS IN THE FOREIGN
EXCHANGE MARKET & SETTLEMENT DATES
Definition: The Foreign Exchange Transactions refers to the sale and
purchase of foreign currencies. Simply, the foreign exchange
transaction is an agreement of exchange of currencies of one country
for another at an agreed exchange rate on a definite date.
44. A. Spot Transaction: The spot transaction is when the buyer and
seller of different currencies settle their payments within the two
days of the deal. It is the fastest way to exchange the currencies.
Here, the currencies are exchanged over a two-day period, which
means no contract is signed between the countries. The exchange
rate at which the currencies are exchanged is called the Spot
Exchange Rate. This rate is often the prevailing exchange rate.
The market in which the spot sale and purchase of currencies is
facilitated is called as a Spot Market.
B & C. Forward & Future Transaction: A forward transaction is
a future transaction where the buyer and seller enter into an
agreement of sale and purchase of currency after 90 days of the
deal at a fixed exchange rate on a definite date in the future. The
rate at which the currency is exchanged is called a Forward
Exchange Rate. Future contract is same as forward except few
points which are discussed.
45. D. Swap Transactions: The Swap Transactions involve a simultaneous
borrowing and lending of two different currencies between two
investors. Here one investor borrows the currency and lends another
currency to the second investor. The obligation to repay the currencies is
used as collateral, and the amount is repaid at a forward rate. The swap
contracts allow the investors to utilize the funds in the currency held by
him/her to pay off the obligations denominated in a different currency
without suffering a foreign exchange risk.
E. Option Transactions: The foreign exchange option gives an investor
the right, but not the obligation to exchange the currency in one
denomination to another at an agreed exchange rate on a pre-defined
date. An option to buy the currency is called as a Call Option, while the
option to sell the currency is called as a Put Option.
Arbitrage: Arbitrage is the simultaneous buying and selling of foreign
currencies with intention of making profits from the difference between
the exchange rate prevailing at the same time in different markets.
46. TYPES OF TRANSACTIONS
A. Cash transaction : settled the same day
B. Spot transaction : settled on t+2 days
C. Forward transaction: settled at a future date
TYPES OF ACCOUNTS MAINTAINED BY BANKS
NOSTRO Account
Italian word 'nostro' means 'ours'. Hence, Nostro account points at -
"Our account with you"
Nostro accounts are generally held in a foreign country (with a foreign
bank), by a domestic bank (from our perspective, our bank). It obviates
that account is maintained in that foreign currency.
For example, SBI account with HSBC in U.K. (may be)
47. VOSTRO Account
Italian word 'vostro' means 'yours'. Hence, Vostro account points at -
"Your account with us"
Vostro accounts are generally held by a foreign bank in our country
(with a domestic bank). It generally maintained in Indian Rupee (if we
consider India)
For example, HSBC account is held with SBI in India. (may be)
LORO Account
Again, Italian word 'loro' means 'theirs'. Therefore, it points at - "Their
account with them"
Loro accounts are generally held by a 3rd party bank, other than the
account maintaining bank or with whom account is maintained.
For example, BOI wants to transact with HSBC, but doesn't have any
account, while SBI maintains an account with HSBC in U.K. Then
BOI could use SBI account. (again may be)
48. EXCHANGE RATE
QUOTATIONS
“A currency quotation in
the foreign exchange
markets that expresses the
amount of foreign
currency required to buy
or sell one unit of the
domestic currency. An
indirect quote is also
known as a “quantity
quotation,” since it
expresses the quantity of
foreign currency required
to buy units of the
domestic currency.”
49. Direct Quote
1. Number of domestic currencies per unit of foreign currency.
2. Foreign currency is fixed and domestic currency varies.
(Example: Rs 66.32 = 1 USD, Rs 73.20 = 1 Euro)
Indirect Quote
1. Home currency is fixed and the foreign currency varies
2. Number of foreign currencies is expressed per unit of domestic
currency.
Indirect quotation: 1 unit of home currency = x Number of foreign
currency units
For example: Tk 1 = $ 0.01193 is an indirect quote in Bangladesh,
Cross Currency Quotes
1. A cross rate is an exchange rate between two currencies, calculated
from their common relationships with a third currency. When cross
rates differ from the direct rates between two currencies, inter-market
arbitrage is possible.
European Quote: The foreign currency price of one dollar.
Example: BDT 75.2525/$, read as BDT 75.2525 per dollar
American Quote: The dollar price of a unit of foreign currency.
Example: $0.0.01329/BDT, read as 0.0.01329 dollars per BDT
52. 1. Hard Peg: Dollarization and currency boards are among the examples of
hard pegs, which severely limit the possibility of an autonomous (independent)
monetary policy in a country. Therefore, sometimes the exchange rate that
stems from a hard peg is referred to as a fixed exchange rate, as in the case of a
metallic standard.
2. Soft pegs: it indicates that monetary policy actions are taken at times and
the peg is adjusted from time to time. Soft pegs are also called crawling pegs.
The central bank guarantees convertibility of domestic currency into the foreign
currency to which it is pegged.
3. Floating Peg: A floating exchange rate or fluctuating exchange or flexible
exchange rate is a type of exchange-rate regime in which a currency's value is
allowed to fluctuate in response to foreign-exchange market mechanisms. A
currency that uses a floating exchange rate is known as a floating currency.
4. Crawling Peg / Bands: The rate is allowed to fluctuate in a band around a
central value, which is adjusted periodically. This is done at an unannounced
rate or in a controlled way following economic indicators.
53. 5. Exchange Arrangements with No Separate Legal Tender: The currency
of another country circulates as the sole legal tender (formal dollarization),
or the member belongs to a monetary or currency union in which the same legal
tender is shared by the members of the union. Adopting such regimes implies
the complete surrender of the monetary authorities' independent control over
domestic monetary policy.
6. Currency Board Arrangements: A monetary regime based on an explicit
legislative commitment to exchange domestic currency for a specified foreign
currency at a fixed exchange rate, combined with restrictions on the issuing
authority to ensure the fulfillment of its legal obligation. This implies that
domestic currency will be issued only against foreign exchange and that it
remains fully backed by foreign assets, eliminating traditional central bank
functions, such as monetary control and lender-of-last-resort, and leaving little
scope for discretionary monetary policy.
7. Independently Floating: The exchange rate is market-determined, with any
official foreign exchange market intervention aimed at moderating the rate of
change and preventing undue fluctuations in the exchange rate, rather than at
establishing a level for it.
54. 8. Pegged Exchange Rates within Horizontal Bands: The value of the
currency is maintained within certain margins of fluctuation of at least ±1
percent around a fixed central rate or the margin between the maximum and
minimum value of the exchange rate exceeds 2 percent. It also includes
arrangements of countries in the exchange rate mechanism (ERM) of the
European Monetary System (EMS) that was replaced with the ERM II on
January 1, 1999. There is a limited degree of monetary policy discretion,
depending on the band width.
9. Exchange Rates within Crawling Bands: The currency is maintained
within certain fluctuation margins of at least ±1 percent around a central rate-or
the margin between the maximum and minimum value of the exchange rate
exceeds 2 percent-and the central rate or margins are adjusted periodically at a
fixed rate or in response to changes in selective quantitative indicators.
10. Managed Floating with No Predetermined Path for the Exchange Rate:
The monetary authority attempts to influence the exchange rate without having
a specific exchange rate path or target. Indicators for managing the rate are
broadly judgmental (e.g., balance of payments position, international reserves,
parallel market developments), and adjustments may not be automatic.
Intervention may be direct or indirect.
55. Foreign Exchange Derivative Instruments in India
Foreign Exchange Forwards: Authorized Dealers (ADs) (Category-I)
are permitted to issue forward contracts to persons resident in India with
crystallized foreign currency/foreign interest rate exposure and based on
past performance/actual import-export turnover, as permitted by the
Reserve Bank and to persons resident outside India with genuine
currency exposure to the rupee, as permitted by the Reserve Bank. The
residents in India generally hedge crystallized foreign currency/ foreign
interest rate exposure or transform exposure from one currency to
another permitted currency. Residents outside India enter into such
contracts to hedge or transform permitted foreign currency exposure to
the rupee, as permitted by the Reserve Bank.
Cross-Currency Swaps: Entities with borrowings in foreign currency
under external commercial borrowing (ECB) are permitted to use cross
currency swaps for transformation of and/or hedging foreign currency
and interest rate risks. Use of this product in a structured product not
conforming to the specific purposes is not permitted.
56. Foreign Currency Rupee Swap: A person resident in India who has a long-
term foreign currency or rupee liability is permitted to enter into such a swap
transaction with ADs (Category-I) to hedge or transform exposure in foreign
currency/foreign interest rate to rupee/rupee interest rate.
Foreign Currency Rupee Options: ADs (Category-I) approved by the
Reserve Bank and ADs (Category-I) who are not market makers are allowed to
sell foreign currency rupee options to their customers on a back-to-back basis,
provided they have a capital to risk-weighted assets ratio (CRAR) of 9 per cent
or above. These options are used by customers who have genuine foreign
currency exposures, as permitted by the Reserve Bank and by ADs (Category-I)
for the purpose of hedging trading books and balance sheet exposures.
Cross-Currency Options: ADs (Category-I) are permitted to issue cross-
currency options to a person resident in India with crystallized foreign currency
exposure, as permitted by the Reserve Bank. The clients use this instrument to
hedge or transform foreign currency exposure arising out of current account
transactions. ADs use this instrument to cover the risks arising out of market-
making in foreign currency rupee options as well as cross currency options, as
permitted by the Reserve Bank.
57. FOREIGN EXCHANGE RESERVES
Foreign Currency Management refers to systematic process of
maintaining adequate foreign exchange reserves which are readily
available with central bank to meet the liabilities and unexpected
payments which may arise in future.
The Reserve Bank of India publishes half-yearly reports on management
of foreign exchange reserves for bringing about more transparency and
enhancing the level of disclosure. These reports are prepared half yearly
with reference to the position as at end-March and end-September each
year.
Reserve management should seek to ensure that: (i) adequate foreign
exchange reserves are available for meeting a defined range of
objectives; (ii) liquidity, market, and credit risks are controlled in a
prudent manner; and (iii) subject to liquidity and other risk constraints,
reasonable earnings are generated over the medium to long term on the
funds invested.
58. 1. support and maintain confidence in the policies for monetary and
exchange rate management including the capacity to intervene in
support of the national or union currency;
2. limit external vulnerability by maintaining foreign currency liquidity
to absorb shocks during times of crisis or when access to borrowing
is curtailed and in doing so;
3. provide a level of confidence to markets that a country can meet its
external obligations;
4. demonstrate the backing of domestic currency by external assets;
5. assist the government in meeting its foreign exchange needs and
external debt obligations; and
6. maintain a reserve for national disasters or emergencies.
OBJECTIVES – RESERVE MANAGEMENT
Foreign Exchange Reserves in India decreased to 362730 USD Million on
February 17 from 362790 USD Million in the previous week. Foreign
Exchange Reserves in India averaged 201080.42 USD Million from 1998
until 2017, reaching an all time high of 383643 USD Million in December
of 2009 and a record low of 29048 USD Million in September of 1998.
59. ROLE OF FEDAI – FOREX MARKET IN INDIA
Authorized Dealers in Foreign Exchange (Ads) have formed an
association called Foreign Exchange Dealers Association of India
(FEDAI) in order to lay down certain terms and conditions for
transactions in Foreign Exchange Business. Ad has to given an
undertaking to Reserve Bank of India to abide by the exchange control
and other terms and conditions introduced by the association for
transactions in foreign exchange business. Accordingly FEDAI has
evolved various rules for various transactions in order to protect the
interest of the exporters, importers general public and also the authorized
in dealers. FEDAI which is a company registered under Section 25 of the
companies Act, 1956 has subscribed to the
1. Uniform customs and practice for documentary credits (UCPDC)
2. Uniform rules for collections(URC)
3. Uniform rules for bank to bank reimbursement.
60. 1. Guidelines and Rules for Forex Business.
2. Training of Bank Personnel in the areas of Foreign Exchange
Business.
3. Accreditation of Forex Brokers.
4. Advising/Assisting member banks in settling issues/matters in their
dealings.
5. Represent member banks on Government/Reserve Bank of
India/Other Bodies.
6. Announcement of daily and periodical rates to member banks.
Due to continuing integration of the global financial markets and increased
pace of de-regulation, the role of self-regulatory organizations like FEDAI
has also transformed. In such an environment, FEDAI plays a catalytic role
for smooth functioning of the markets through closer co-ordination with the
RBI, other organizations like FIMMDA, the Forex Association of India and
various market participants. FEDAI also maximizes the benefits derived
from synergies of member banks through innovation in areas like new
customized products, bench marking against international standards on
accounting, market practices, risk management systems, etc.
61.
62. Arbitrage is the simultaneous purchase and sale of an asset to
profit from a difference in the price. It is a trade that profits by
exploiting the price differences of identical or similar financial
instruments on different markets or in different forms.
Arbitrage exists as a result of market inefficiencies.
Example: Though this is not the most complicated arbitrage
strategy in use, this example of triangular arbitrage is more
difficult than the above example. In triangular arbitrage, a
trader converts one currency to another at one bank, converts
that second currency to another at a second bank, and finally
converts the third currency back to the original at a third bank.
The same bank would have the information efficiency to
ensure all of its currency rates were aligned, requiring the use
of different financial institutions for this strategy.
ARBITRAGE - MEANING
63. For example, assume you begin with $2 million. You see that at three
different institutions the following currency exchange rates are
immediately available: (Cross-Rates and Three-Point Arbitrage)
For example: Infosys is quoting at Rs 2750 on the BSE and Rs 2760 on
the NSE. Hence one can sell the stock on the NSE and buy from the BSE
at the same time. This trade will lead to a profit without any risk. This
process is arbitrage. (Simple Arbitrage)
Institution 1: Euros/USD = 0.894
Institution 2: Euros/British pound = 1.276
Institution 3: USD/British pound = 1.432
First, you would convert the $2 million to euros at the 0.894 rate, giving
you 1,788,000 euros. Next, you would take the 1,788,000 euros and
convert them to pounds at the 1.276 rate, giving you 1,401,254 pounds.
Next, you would take the pounds and convert them back to U.S. dollars
at the 1.432 rate, giving you $2,006,596. Your total risk-free arbitrage
profit would be $6,596.
64. A currency pair is denoted by the 3-letter SWIFT codes for the two currencies
separated by an oblique or a hyphen. EX: USD/CHF – US Dollar – Swiss
Franc
The first currency in the pair is the “Base” currency; the second is the
“Quoted” currency. The exchange rate quotation is given as the amount of the
quoted currency per unit of the base currency. The price shown on the left of
the oblique or hyphen is the “bid” price, the one of the right is the “ask” or
“offer” price. Ex: USD/CHF Spot: 1.1550/1.1560.
The last two digits are called as points or pips. The difference between the
offer rate and the bid rate is called the “bid-offer-spread” or the “bid-ask-
spread”.
The quotations are usually shortened as follows:-
USD/CHF: 1.4550/1.4560 will be given as 1.4550/60
It may be further abbreviated as follows: “50/60”
Remember that the offer rate must always exceed the bid rate.
65. Types of Arbitrage Transactions
A. COVERED INTEREST ARBITRAGE (CIA)
– CIA is one of the segments of interest parity theory.
– If the forward rate differential in two countries is not equal
to interest rate differential, CIA will begin and will
continue till the two differentials become approximately
equal.
– A positive interest rate differential in a country is offset by
annualized forward discount.
– A negative interest rate differential is offset by an
annualized premium.
– Finally the two differentials will be equal.
– If the interest rate differential is higher than the premium or
discount, invest in a country having higher interest rate.
66. • Interest Rate Differential higher than
Premium/Discount
– Borrow funds in Foreign currency in a cheaper market
say at 12% interest
– Convert the foreign currency into rupee at spot rate.
– Invest rupees in India at higher interest rate say 18%
– Sell the rupee forward at forward rate.
– On the due date, repay the foreign currency loan.
– This results in profit.
COVERED INTEREST ARBITRAGE (CIA)
– Steps to be followed
67. B. UNCOVERED INTEREST ARBITRAGE
– Does not involve forward market transaction as interest
rate differential leads to changes in future spot rate.
– If the Interest rate differential = changes in future spot
rate, uncovered interest parity will exist.
– This is represented in the form of the following equation:
• (1+RA)/(1+RB) = (Se+1-S)/S
• Se+1 = expected future spot rate
• RA, RB – Interest rates in two countries
• S – Spot Rate
– So long the above equality is not reached, the arbitragers
will go for uncovered interest arbitrage and reap profits.
Types of Arbitrage Transactions
68. ARBITRAGE – WITHOUT TRANSACTION COSTS
Consider the problem of a British investor in London who is choosing
between a eurodollar deposit and a sterling deposit to place some
surplus funds, the investor does not want to incur ant exchange rate
risk. To begin with, we will assume away all transactions costs. This
means that in the foreign exchange market there are no bid-ask spreads
and in the money market, there is no difference between borrowing and
lending rates.
One-Way Arbitrage: Notice that covered arbitrage involves activities
in four markets, viz. the spot and forward foreign exchange markets
and the two money markets. In case of one way arbitrage the arbitrage
transaction that avoids the use of one of the markets. Ex: A Swiss firm
needs $1 million right now to settle import bill, it can acquire this in the
spot market at cost available or get into Eurodollar market to settle the
import bill and set aside the amount on any dollar loan to earn interest.
69. ARBITRAGE – WITH TRANSACTION COSTS
In the real world there are transaction costs. In the foreign markets,
these are in the form of bid-ask spreads (in addition, there are costs
such as telephone calls, telexes, etc. but there have to be incurred in any
market.) for instance, the rate at which the euro bank will accept a euro
deposit from another bank, its bid rate, is lower than the rate at which it
will lend short term funds to another bank, the ask rate. The relative
magnitudes of these spreads vary between markets depending primarily
upon the volume of business. Also as mentioned above, the interest
rates faced by a particular firm may be different from the eurodollar
market rates. The net result of all this is that different ways of achieving
the same end result can sometimes have different costs or returns.
70. COVERED INTEREST ARBITRAGE IN PRACTICE
We have already examined how transaction costs can create a range of
forward rates which are all consistent with the no riskless profits
condition. given the spot bid-ask rates as well as bid-ask rates in deposit
markets, covered interest parity does not imply a unique pair of forward
bid-ask rates. The one way arbitrage imposes tighter limits on forward
quotes than two way arbitrage. The departures from interest parity
attributable to transaction costs are, therefore, likely to be quite small
since bid-ask spreads in foreign exchange markets as well as deposit
markets are quite small.
Another factor which is said to cause departures from interest parity is
political risk. For an investor resident in country A, home investments
are free from political risks (such as confiscation, temporary freezing of
foreign deposits, etc.) while investment in country B does have a element
of political risk. Another example may be of tax rates which differ from
country to country may cause interest rate differences for arbitrage.
71. Forward Swaps & Swap Positions
A forward swap is a swap agreement created through the synthesis of
two swaps differing in duration for the purpose of fulfilling the specific
time-frame needs of an investor. Also referred to as a "forward start
swap," "delayed start swap," and a "deferred start swap.“
For example, if an investor wants to hedge for a five-year duration
beginning one year from today, this investor can enter into both a one-
year and six-year swap, creating the forward swap that meets the needs
of his or her portfolio. Sometimes swaps don't perfectly match the
needs of investors wishing to hedge certain risks.
A financial institution that acts as an intermediary for interest and
currency swaps. The function of these intermediaries is to find
counterparties for those who want to participate in swap agreements.
The swap bank typically earns a slight premium for facilitating the
swap.
72. A Currency Swap is an agreement between two parties to exchange principal
and fixed rate interest payments on a loan in one currency for principal and
fixed rate interest payments on an equal loan in another currency. The parties
to the contract exchange the principal of two different currencies immediately,
so that each party has the use of the different currency. They also make
interest payments to each other on the principal during the contract term. In
many cases, one of the parties pays a fixed interest rate and the other pays a
floating interest rate, but both could pay fixed or floating rates. When the
contract ends, the parties re-exchange the principal amount of the swap. For
example, two companies in different countries may need to acquire currency
in the opposite denomination. The two companies could arrange to swap
currencies by establishing an interest rate, an agreed-upon amount, and a
common maturity date for the exchange. Currency swap maturities are
negotiable for at least 10 years, making them a very flexible method of
foreign exchange. Currency swaps originally were used to get around
exchange controls and to give each party access to enough foreign currency to
make purchases in foreign markets. Increasingly, parties arrange currency
swaps as a way to enter new capital markets or to provide predictable revenue
streams in another currency, typically as a hedge against currency risk
exposure.
73. How a Forex Swap Transaction Works
In the first leg of a forex swap transaction, a particular quantity of
a currency is bought or sold versus another currency at an agreed
upon rate on an initial date. This is often called the near date since
it is usually the first date to arrive relative to the current date.
In the second leg, the same quantity of currency is then
simultaneously sold or bought versus the other currency at a
second agreed upon rate on another value date, often called the far
date.
This forex swap deal effectively results in no (or very little) net
exposure to the prevailing spot rate, since although the first leg
opens up spot market risk, the second leg of the swap immediately
closes it down.
74. Forex Swap Points and the Cost of Carry
The forex swap points to a particular value date will be determined
mathematically from the overall cost involved when you lend one
currency and borrow another during the time period stretching from the
spot date until the value date.
This is sometimes called the "cost of carry" or simply the "carry" and
will be converted into currency pips in order to be added or subtracted
from the spot rate.
The carry can be computed from the number of days from spot until the
forward date, plus the prevailing interbank deposit rates for the two
currencies to the forward value date.
Generally, the carry will be positive for the party who sells the higher
interest rate currency forward and negative for the party who buys the
higher interest rate currency forward.
75. Why Forex Swaps are Used
A foreign exchange swap will often be used when a trader or hedger needs to
roll an existing open forex position forward to a future date to avoid or delay
the delivery required on the contract. Nevertheless, a forex swap can also be
employed to bring the delivery date closer.
As an example, forex traders will often execute "rollovers", more technically
known as tom/next swaps, to extend the value date of what was formerly a spot
position entered into one day earlier to the current spot value date. Some retail
forex brokers (top list of trusted brokers) will even perform these rollovers
automatically for their clients on positions open after 5pm EST.
On the other hand, a corporation might wish to use a forex swap for hedging
purposes if they found that an anticipated currency cash flow, which had
already been protected with a forward outright contract, was actually going to
be delayed for one additional month. In this case, they could simply roll their
existing forward outright contract hedge out one month. They would do this by
agreeing to a forex swap in which they closed out the existing near date
contract and then opened a new one for the desired date one month further out.
76. Pricing of Swaps
The relationship between spot and forward is known as the interest rate
parity, which states that
77. OPTION FORWARDS
A Standard forward contract calls for delivery on a
specific day, the settlement date for the contract. In
most of the currency markets, banks offer what are
known as Optional Forward Contracts or Option
Forwards. Here the contract is entered into at some
time t0 , with the rate and quantities being fixed at this
time, but the buyer has the option to take or make
delivery on any day between two specified future
dates t1 and t2.
78. a GBPUSD contract could give the owner the right to sell £1,000,000
and buy $2,000,000 on December 31. In this case the pre-agreed
exchange rate, or strike price, is 2.0000 USD per GBP (or GBP/USD
2.00 as it is typically quoted) and the notional amounts (notional’s)
are £1,000,000 and $2,000,000.
This type of contract is both a call on dollars and a put on sterling,
and is typically called a GBPUSD put, as it is a put on the exchange
rate; although it could equally be called a USDGBP call.
If the rate is lower than 2.0000 on December 31 (say 1.9000),
meaning that the dollar is stronger and the pound is weaker, then the
option is exercised, allowing the owner to sell GBP at 2.0000 and
immediately buy it back in the spot market at 1.9000, making a profit
of (2.0000 GBPUSD − 1.9000 GBPUSD) × 1,000,000 GBP =
100,000 USD in the process. If instead they take the profit in GBP (by
selling the USD on the spot market) this amounts to 100,000 / 1.9000
= 52,632 GBP.
79. SWAPS & DEPOSIT MARKETS
FORWARD-FORWARD SWAPS: SWAP POSITIONS
The banks are always arbitrage between foreign exchange swap
markets and the euro deposit markets. What does this mean? It
means that banks will constantly monitor its swap rates so that they
are not out of line with the forwards implied by euro deposit
markets. It is quite similar to a combination of lending a currency
and borrowing another. In fact, a bank can “manufacture” a swap
quote from euro deposit rates or manufacture a euro deposit rate
from swap quotes.
Swap transactions need not be restricted to swaps between spot and
a forward rate. They can be between two forward dates. For
example, a one-month forward sale can be combined with a three
month forward purchase. Such transactions are called forward-
forward swaps. It can be used to take a view on interest rate
differentials with a minimum of exchange rate risk.
80. INTEREST RATE PARITY THEORY
Interest Rate Parity (IPR) theory is used to analyze the relationship
between at the spot rate and a corresponding forward (future) rate
of currencies. The Interest Rate Parity states that the interest rate
difference between two countries is equal to the percentage
difference between the forward exchange rate and the spot
exchange rate.
The IPR theory states interest rate differentials between two
different currencies will be reflected in the premium or discount for
the forward exchange rate on the foreign currency if there is no
arbitrage - the activity of buying shares or currency in one financial
market and selling it at a profit in another.
The theory further states size of the forward premium or discount
on a foreign currency should be equal to the interest rate
differentials between the countries in comparison.
81. The relationship can be seen when you follow the two methods an
investor may take to convert foreign currency into U.S. dollars.
• Option A would be to invest the foreign currency locally at the
risk-free rate for a specific time period. Then convert the proceeds
from the investment into U.S. dollars at the maturity.
Option B would be to invest the same dollars in the (U.S.) market for
the same time period. When no arbitrage opportunities exist, the
cash flows from both options are equal.
In equilibrium, returns on currencies will be the same i. e. No profit
will be realized and interest rate parity exits which can be written as:-
(1 + rh) = F
(1 + rf) S
Rate of return in local
currency
Rate of return in foreign
currency=
82.
83. Case I: Domestic Investment
In the U.S.A., consider the spot exchange rate of $1.2245/€ 1.
So we can exchange our € 1000 @ $1.2245 = $1224.50
Now we can invest $1224.50 @ 3.0% for 1 year which yields $1261.79
at the end of the year.
Case II: Foreign Investment
Likewise we can invest € 1000 in a foreign European market, say at the
rate of 5.0% for 1 year.
But we buy forward 1 year to lock in the future exchange rate at
$1.20025/€ 1 since we need to convert our € 1000 back to the domestic
currency, i.e. the U.S. Dollar.
So € 1000 @ of 5.0% for 1 year = € 1051.27
Then we can convert € 1051.27 @ $1.20025 = $1261.79
Thus, in the absence of arbitrage, the Return on Investment (RoI) is
same regardless of our choice of investment method. Types of IPP are:
84. 1. Covered Interest Rate Parity (CIRP)
Covered Interest Rate theory states that exchange rate forward premiums
(discounts) offset interest rate differentials between two sovereigns. In
another words, covered interest rate theory holds that interest rate
differentials between two countries are offset by the spot/forward
currency premiums as otherwise investors could earn a pure arbitrage
profit.
2. Uncovered Interest Rate Parity (UIP)
Uncovered Interest Rate theory states that expected appreciation
(depreciation) of a currency is offset by lower (higher) interest. In the
above example of covered interest rate, the other method that Google
Inc. can implement is:
Google Inc. can also invest the money in dollars today and change it for
Euro at the end of the month. This method is uncovered because the
exchange rate risks persist in this transaction.
85. Assume Google Inc., the U.S. based multi-national company, needs to
pay it's European employees in Euro in a month's time.
Google Inc. can achieve this in several ways viz:
Buy Euro forward 30 days to lock in the exchange rate. Then Google can
invest in dollars for 30 days until it must convert dollars to Euro in a
month. This is called covering because now Google Inc. has no exchange
rate fluctuation risk.
Convert dollars to Euro today at spot exchange rate. Invest Euro in a
European bond (in Euro) for 30 days (equivalently loan out Euro for 30
days) then pay it's obligation in Euro at the end of the month.
Under this model Google Inc. is sure of the interest rate that it will earn,
so it may convert fewer dollars to Euro today as it's Euro will grow via
interest earned.
This is also called covering because by converting dollars to Euro at the
spot, the risk of exchange rate fluctuation is eliminated.
86. VIOLATION OF IRP
If interest rate parity is violated, then an arbitrage opportunity exists.
The simplest example of this is what would happen if the forward rate
was the same as the spot rate but the interest rates were different, then
investors would:
• borrow in the currency with the lower rate
• convert the cash at spot rates
• enter into a forward contract to convert the cash plus the
expected interest at the same rate
• invest the money at the higher rate
• convert back through the forward contract
• repay the principal and the interest, knowing the latter will be
less than the interest received.
IMPLICATIONS OF IRP
1. If domestic interest rates are less than foreign interest rates, you
will invest in foreign country at higher interest rates.
2. Domestic investors can benefit by investing in the foreign market.
3. If domestic interest rates are more than foreign interest rates, you
will invest in domestic market at higher interest rates
4. Foreign investors can benefit by investing in the domestic market.
Editor's Notes
Square – Offsetting the buy or sell positions. If you are not squaring than u r taking either long position or short position i.e. buyer and seller.
Basket Currencies are: Dollar, Euro, Yen, Renminbi, Pound Sterling – As of Oct 2016. Originally SDR value was 0.888671 grams of gold. (1969)
Reneging: Fail to fulfill a promise or obligation
Foreign Exchange Dealers Association of India: FEDAI
Unified Market Exchange Rate Regime: Full Fledged – Current Account.
Restricted means Govt. or RBI Interventions when the economy is slippery.
SWIFT: Society for Worldwide Interbank Financial Telecommunications – Safer Payment Gateway with International Bank Account Number.
Crystallized: Having become fixed and definite in form