Unit 2- Forex Markets

K Lubza Nihar
Why Understanding FX Markets and FX Rates?
• Indian companies turn to exotic options to manage hedging costs, risks
• Live Mint, 09 Nov 2022, 01:49 PM IST
• Rated Indian infrastructure firms most exposed to currency risk: S&P
• Business Standard, November 10, 2022 23:26 IST
• Wild Currency Swings Take $34 Billion Bite From Company Profits
• Domino’s Pizza, PepsiCo already warning FX impacts to worsen, Bloomberg, October 18,
2022 at 4:30 PM GMT+5:30
• "Our intervention policy is to prevent excessive volatility in exchange rate, to
anchor expectations around depreciation,"
• Reserve Bank of India (RBI) Governor Shaktikanta Das, at an event organised by the Fixed
Income Money Markets and Derivatives Association of India; Reuters 5/9/22
• Rupee Depreciation: Indian Start-ups and VCs worried as Fed goes hawkish on
the greenback
• Business Today, September 30, 2022 12:34 PM IST
Understanding Exchange Rates helps
• Monetary Authorities
• To frame exchange rate Policy or Monetary Policy
• Business Entities
• To build in a budgeted exchange rate in their export and import transactions
• To strategise currency hedging
• To appreciate the direct and indirect impact on domestic/foreign firms
• Domestic Investors and Financial Market Players
• To time their buy and sell decisions
• To cross hedge their underlying risks
• Foreign Investors
• To time their entry and exit strategies in a country
• To strategise their international arbitrage
 What is Foreign What is Foreign
Exchange? Exchange Rate?
• The number of units of
• As a verb to refer to an Act • one currency agreed to be
exchanged for
• of exchange of currencies between
two entities • a number of units of another
• As a Noun to refer to an Asset currency
• The currency of another country • Like 82.6836 Rs Per 1 US Dollar
• Also means Foreign Currency • Like 10.5527 Swedish Kronas per
• Also means Forex 1 US Dollar
• Also means FX • Like 0.82737 British Pounds per 1
US Dollar
How are Fx Rates Quoted? QUOTING
CONVENTION

• Direct Quote
• As number of units of domestic currency per unit foreign currency
USD / INR
• 75 Rs. Per 1 US Dollar Left side of the
slash is the Base
• Indirect Quote Currency
• As number of units of foreign currency per unit domestic currency
• 0.0134 USD per 1 Indian Rupee Right side of the
slash is the Quote
• Two Way quotes offered by Bankers (Market Makers) Currency
• Rates are always to be interpreted from the Banker’s
Base Currency is
Viewpoint being bought and
• When the Bank Buys it is – BID Rate sold
IN TERMS of
• When the Bank Sells it is – SELL Rate Quote Currency
• Bid Rates are always Lower than Ask Rates
THREE letter Convention- ISO 4217:2015,1978 Symbols
Some Clarity on Terminology

• Depreciation and Appreciation

• Decrease or Increase in value of a currency due to Market Forces, between
today and any date in future
• More prevalent in the Spot FX Markets
• Devaluation and Revaluation
• Decrease or Increase in value of a currency due to an act of the country’s
Government or Central bank to correct mis-valued home currency
• Rarely appears as an announcement from central bank
• Premium and Discount
• When a currency is more valuable in future, then it is referred to be at a
Premium, and when its value declines, then it is referred to be at a Discount
• More Prevalent in the Forward (Derivatives) Market
Some Clarity on Terminology
• Nominal Exchange Rate
• Is what we pay and receive while trading and is what is quoted in the markets
• Nominal Effective Exchange Rate
• Trade weighted average exchange rates of countries expressed as an Index
• Real Exchange Rate
• is the Inflation adjusted nominal exchange Rate -
Reserve Bank of India - RBI Bulletin
• Real Effective Exchange Rate
• Trade weighted average Nominal effective exchange rate adjusted for inflation
• Base Year in India 2015-2016
• Number of countries included is 40
Pointers to Significance of FX Markets
• Around 80% of countries adopt a combination of market determined and
managed exchange rate systems - (IMF, 2021)

• Volatility of Major Currencies and INR is increasing

• “Currency Risk” among top-5 risk management agendas of CFO’s -

HSBC, Corporate Risk Management Survey, 2021

• RBI’s Guidelines (2014, 2015) to Banks to provide upto 0.8% of the total
credit exposure, for currency risk
Average Exchange Rates per 1 unit of USD of Select
Currencies during 2000 -2022

Year GBP JPY EUR AED AUD SGD BRL RUB INR CNY ZAR

2000-05 0.62 114.77 0.96 3.67 1.62 1.73 2.59 29.39 46.05 8.26 7.74

2006-11 0.58 99.80 0.73 3.67 1.18 1.43 1.90 28.19 45.17 7.10 7.51

2012-17 0.67 104.19 0.83 3.67 1.18 1.32 2.75 48.00 61.54 6.38 11.58

2018-22 0.77 114.38 0.89 3.67 1.39 1.36 4.69 67.54 73.51 6.73 15.19
Exchange Rates impact on Foreign Trade

• Indian importers feel the heat as

rupee depreciates over 7%
• Economic Times, Jul 19, 2022, 05:49
PM IST

• Rupee fall to help exports rise by up

to 10%
• Economic Rimes, Mar 09, 2022,
11:53 PM IST

• Why depreciating rupee hasn't

boosted India's exports
• Times of India, Sep 15, 2022, 20:28
What is Foreign
Exchange Market?
• Any
• Physical or Virtual place
• where Buyers and Sellers
• come together
• to exchange
• Foreign Currency
• Today, Tomorrow, or in Future
Clockwise: Global financial centres
Tower Bridge, London;
International Financial Centre, Hong Kong
Tokyo Metropolitan Building, Tokyo
Empire State Building, New York;
 New York 8am to 5pm EST (1pm to 10pm UTC)
A 24 Hours Market Tokyo 7pm to 4am EST (12am to 9am UTC)
Sydney 5pm to 2am EST (10pm to 7am UTC)
London 3am to 12 noon EST (8am to 5pm UTC)
What is the Structure of FX Markets?
• Three Tier
• Central Bank and Authorised Dealers
• Authorised Dealers and Authorised Dealers
• Authorised Dealers and Customers
• Formats
• Electronic Trading through SWIFT and CHIPS between Banks and Dealers
• Over The Counter Market, Electronic Broking Systems for Customers-
Banks
• Exchange Traded for Cash, Tom and Spot Trans-CCIL(India) – since Aug,
2019 – Fx Clear operated by CCIL (Clearing Corporate of India Ltd.)
• Exchange Traded for Derivatives
How a typical Fx transaction takes place?
Dena Bank Purchases 1 Mn US Dollars from
Bank of Baroda, by paying 10 Mn Japanese Yen.
Dena Bank has its Nostro Account (account that a bank holds in a foreign currency at
another bank) with Bank of Japan, in Tokyo and CITI in New York
Bank of Baroda has its Nostro Account with HSBC, New York, and Bank of Japan in
Tokyo
Fragmented FX Market
Who are the Players?

• By their Organisational Structure • By their Motivation

• Commercial and Investment Banks • Hedgers – To cover their
• Financial Institutions underlying risk
• Forex and Securities Dealers and Brokers • Arbitrageurs – To gain on
• Hedge Funds mispricing situations
• Individuals (Travellers, Students) • Speculators – To benefit from a
view about future
• Corporate Entities (Exporters and
Importers)
• Government
• Central Banks of various countries
BIS: Triennial Central Bank Survey, Oct, 2022
What are the types of
Transactions?
• Central Bank Intervention Transactions
• Based on Time of Delivery
• Cash – Delivery Same Day
• Tom – Delivery the next Day
• Spot – Delivery two business days later
• Swap – Exchange between two dates
• Forward – Delivery beyond two business
days later
• Based on Parties to the trade
• Inter-Bank- Between Authorised
Dealers(ADs)
• Merchant – Between ADs and customers
Who are Authorised Dealers? (India)

Category Entities Permitted Activities

Authorised Dealer – Commercial Banks, State Co-op All current and capital account
Category I Banks, Urban Co-op Banks transactions as per RBI directions
issued from time to time

Authorised Dealer- Upgraded FFMCs, Coop Banks, Specified non-trade related current
Category II Regional Rural Banks (RRBs), account transactions and all
others activities permitted to FFMC

Authorised Dealer – Select Financial and other Transactions incidental to the

Category III institutions foreign exchange

Full Fledged Money Changers Department of Post, Urban Co-op Purchase of foreign exchange and
(FFMC) Banks, Other FFMC sale for private and business visits
abroad.
Does anyone Regulate the market?
• Governments through Central Banks of the respective Countries
• No Centralised body worldwide to regulate Forex Market Transactions
• In Europe - Markets In Financial Instruments Directive (MiFID-II)
• In US - The National Futures Association (NFA) Commodities Futures Trading
Commission (CFTC)
• In UK - Financial Conduct Authority (FCA)
• In India
• RBI through FEMA, 1999 – Permitting and Monitoring Forex Transactions
• RBI through RBI Act, 1934 – Printing of Currency and managing the Exchange Rate
• RBI through FCRA, 2010 – Accepting and Utilising Foreign Contribution & Hospitality
• Foreign Exchange Dealers Association of India FEDAI since 1958 – for Interbank
Transactions
• SEBI – to Issue Licenses to Forex Brokers to trade in Indian Exchanges
Trading in Forex in India
• Only permitted to trade in Currency Futures and Currency Options in the
Exchanges
• Allowed in 7 pairs, namely: USD/INR, EUR/INR, JPY/INR, GBP/INR,
EUR/USD, GBP/USD, and USD/JPY.
• Trading on 3 exchanges in India, namely the NSE, BSE, and the
Metropolitan Stock Exchange of India Ltd
• 1000 is the standard lot to trade in USD, GBP, EUR in India, 100000 for
JPY
• A Trading Account with a SEBI registered brokers with KYC completion
• Individuals or entities can undertake forex transactions only with
authorised persons on authorised OTC or Exchanges
Rates in Fx Market? What are Different
• Base Rate or Reference Rate OR Merchant Rates?
Benchmark Rate
• Between Central Bank and Authorised • Based on Day of Delivery
Dealers • Cash – Delivery Same Day
• Quoted based on select banks mean rates, • Tom – Delivery the next Day
adjusted for outliers on volume weighted • Spot – Delivery two business days
average later
• Forward – Delivery beyond two
• Interbank Rate business days later
• Between Authorised Dealers
• Based on the nature of Instrument
• Quoted in 4 decimals rounded off in
multiples of .0025 or 1 quarter of a paise exchanged
• TT Rates – Cash, Cheque, TC, CC,
• Merchant Rate DDs, EFTs, Inward Remittances,
• Between Authorised Dealers and Customers Conversions of Foreign Currency
• Quoted to customers in 2 decimals, rounded A/Cs
off to nearest paise or nearest 5 paise • Bill Rates – Negotiating &
Collecting Export and Import Bills
 Rus-Ukr-War-
US-Inflation
COVID19

US Taper
Tantrum

Sub Prime
Crisis

FIIs Entry
Why do Exchange Rates Move?
• The International Monetary System
• The Exchange Rate Systems

What is International Monetary System?

• A Set of
• Policies, Institutions, Practices
• Regulations, and Mechanisms that
• Determine Trade and Finance settlements between nations
• and hence the Rate at which
• One Currency is to be
• Exchanged for the Other
• Forms part of it
Why is an International Financial System Important?
• To support economic development of the countries

• To bring in discipline in the financial behaviour of countries

• To avoid systemic crisis in the world due to contagion

• To provide adequate independence to countries in pursuing their

economic agendas

• To avoid Trade, Capital, and Resource flow imbalances

• To provide stability to trade and capital flows across the world

What Determines Exchange Rates?

Variable Variable Variable

Foreign Exchange Reserves Openness Indicator Volatility of Capital Flows

Central Bank Intervention Fiscal Deficit International Equity Indices

Foreign Country Interest Rate External Debt Burden Volatility Index (VIX)

Indian Interest Rate Government Bond Yields US Dollar Index

Trade Balance Crude Oil Prices Sovereign Credit Ratings

Trade Balance of Foreign Portfolio Flows Bid & Ask Spread

Country
Terms of Trade Stock Market Indices Number of Transactions
What Determines Exchange Rates?

Variable Variable Variable

Credit Growth Cross Currencies Turnover of Transactions -
Value
Money Supply Capital Flows Order Flow
Inflation Real Effective Exchange Trade Intensity
Rate
Output World Economic Growth Variable

GDP Growth Gold Prices Volatility of Capital Flows

Central Bank Credit to COBs Exchange Rate International Equity Indices

Unemployment Rate Nominal Exchange Rate Volatility Index (VIX)

Post Bretton Woods Exchange Rate
Arrangements
• Fixed Exchange Rate Systems
• Exchange Rate Fixed w.r.t. some currency/currencies/commodity
• Government’s responsibility to maintain the exchange rate
• A Narrow band of fluctuations allowed

• Floating Exchange Rate Systems

• Exchange Rate determined by Demand and Supply in forex markets
• Government’s responsibility to reduce volatility but not a policy rate
• Fluctuations quite wide and bands change with country’s priorities

Currency Peg to a Peg to a Managed

Dollarisation Crawling Peg Free Float
Board Currency Basket Float
Exchange Rate Systems Prevalent
System Type Par Value Central Bank Range Conversion Backup
Intervention Bound
Dollarisation None N.A. None N.A. N.A. N.A.
Currency Boards Fixed w.r.t. Anchor None N.A. Into Anchor 100% of Anchor
Currency Currency Currency
Pegging to a Fixed Policy Rate Direct or +/- 1% N.A. Currencies, Gold
Currency Announced Indirect & SDRs
Pegging to a basked Fixed Policy Rate Direct or +/- 1% N.A. Currencies, Gold
of Currencies Announced Indirect & SDRs
Crawling Peg Semi Fixed Policy Rate Direct or +/- 1% N.A.; Peg value Currencies, Gold
Announced Indirect level adjusted & SDRs
adjusted frequently based
regularly on Macro factors
Managed Float Semi Floating No Policy Rate Direct or Wide N.A.; Focus on Currencies, Gold
Announced Indirect unknown reducing Volatility & SDRs
Free Float Floating No Policy Rate Rare Wide N.A.; Focus on Currencies, Gold
Announced Unknown reducing Volatility & SDRs
Pros and Cons of Fixed Exchange Rate Systems
• Pros
• Almost nil Volatility
• Promotes international trade reducing currency risk
• World economic systems more disciplined and in order
• Global Inflation under control
• Good for Small Economies
• Cons
• Lack of autonomy to countries to pursue their unique development agenda
• Lot of pressure on Leading country’s leadership to be Ethical and Pragmatic
• Long sustaining economic ailments and inefficiencies
• Promotes speculative attacks on currencies
• Need to maintain adequate forex reserves to maintain par value of currency
• Other countries economic troubles contracted through contagion
Pros and Cons of Floating Exchange Rate
Systems
• Pros
• No pressure to maintain forex reserves
• Lot of autonomy to the country to pursue their unique development agenda
• No contagion effects from other countries
• Run on the currencies can be thwarted with timely action
• Good for large developing countries with diverse economic sectors
• No Sharp changes in exchange rates
• Cons
• Exchange Rate Volatility increases tremendously
• Currency Risk Management creates additional cost for business
• World trade imbalances and capital flow imbalances may increase
• Currency Wars may emerge, due to lack of concerted action
Pre-requisites for a Floating Exchange Rate System
• Strong International Trade, preferably Export oriented
• Macro economic policies with both internal and external credibility
• Output and input markets should be flexible enough to adjust and be
resilient to currency shocks
• Strong Financial systems and Institutional network
• Adequate depth, breadth, and liquidity in the Financial Markets
• Credible Governance, and Surveillance with Prudential Norms on Banking
System
• Policy Making to be update with the latest financial products and services
Characteristics of a Good Reserve Currency
• Stable Currency from a Strong Economy
• An economy with a long-running and sustainable Current Account
Deficit
• Currency in which there is strong Bond Market
• Free floating exchange with effective volatility management
• Complete Capital Account Convertibility
• Strength to repay international debt by printing currency
No Target, Allow Flexibility, No Band to adhere to, Keep ability to Intervene, Reduce Volatility,
Prevent Speculation, Maintain Adequate Reserves, Order in Forex Markets
No Target, Allow Flexibility, No Band to adhere to, Keep ability to Intervene, Reduce Volatility,
Prevent Speculation, Maintain Adequate Reserves, Order in Forex Markets
How to Forecast Exchange Rates?
• Fundamental
• Various Macro level fundamentals factors influence exchange rates
• Micro-Structure
• Inventory of Dealers, and Information about Trades influence exchange Rates, and
Mood of the Traders
• Technical
• History Repeats Itself
• Price Patterns, Volume, Breadth, and
• Machine Learning and Artificial Intelligence
• Efficient Market Hypothesis
• Past, Present, Future Information
• Public, Private, and Insider Information
• Is absorbed ACCURATELY and IMMEDIATELY
The Rise of Executing Algorithms
• Started in 2000
• Now around 10-20% of daily spot forex transactions of various currencies
(200-400 Billion US Dollars)
• Rapid Rise of Electronic Trading Platforms
• Risk shifting to the end users or traders
• Post Sub-prime Crises regulatory frameworks stricter on banks’
statements’ transparency
• Rise During a decade of low FX volatility till 2020.
• COVID19 did not change much
BIS: Triennial Central Bank Survey, Oct, 2022
Markets Committee Report, 2020, FX Execution Algorithms and Market Functioning
FX Trading Algorithms
• Executing Algorithms
• Automated Buy and Sell Trading programmes with set instructions to fulfil the
order – Entering or Buying in one direction
• Facilitates aggregating liquidity and place orders where the liquidity is the highest
for faster and low cost execution
• Price is no more a single price but a trade-weighted average and the algorithm
provider Fee
• Monitor, Navigate and Execute in the Fragmented Forex Market
• Market Making Algorithms
• Automated Buy and Sell Trading programmes assisting the Market Makers to
maintain their positions to near neutral or close to neutral
• Opportunistic Algorithms
• Automated Buy and Sell Trading programmes helping Principal Trading Firms
and Hedge Funds to generate Profits
Impact of Execution Algorithms on FX Markets
• Forex Market getting more Fragmented
• Better audit trail in times of investigation, regulatory compliance
• Increased Usage but not very dominant
• Trade offs between Market Risk, Market Impact and Opportunity Cost
• Though Supporting Price Discovery, taking Prices to Dark Pools through
Internalisation
• New measures of FX market liquidity are required
• Shifting risk of execution from dealers to users. Need for Transaction Cost
Analysis (TCA)
• Need for information about liquidity pools, conflict of interest and standardisation
• Controls on operational risks due to errors in coding, human aggression
• Regular Central Bank monitoring and education of market players
In Years to Come...
• Inflation
• War related Uncertainty
• Geo-Political Tensions
• Nationalist and Protectionist Agendas of Countries
• ESG Focus in Forex, w.r.t. Governance of Banks, Countries, Emerging
Markets
• Emerging Market More Vulnerable
• Speculation on Dollar Dominance
• Crisis in Baking sector