Foreign Exchange Markets:Instruments, Risks and Derivatives PDF

Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan...

Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Foreign Exchange Markets: An Overview Welcome to this course. In the next few sessions, we will discuss foreign exchange markets. A foreign exchange transaction is an agreement between two parties where one party agrees to pay a fixed amount of one currency in exchange for another currency at an agreed rate. The price of one currency in terms of another currency is called the exchange rate. Currencies are bought and sold in foreign exchange markets. This market provides the institutional, physical, and technological infrastructure to carry out foreign exchange transactions. In this session, we will look at the nature, size, and distribution of the foreign exchange markets. In subsequent sessions, we will look at the type of transactions—spot, forward, swap etc., that's traded in the foreign exchange markets, why are exchange rates important, how are exchange rates quoted, the profile of the participants and the nature of their participation in foreign exchange markets around the globe, the macro-economic theories that underpin fluctuations in exchange rates. First, nature and geographic distribution of the foreign exchange markets. Foreign exchange markets exist all across the globe. Virtually, all currencies of the world are traded in some foreign exchange market or the other. The dominant currencies traded are those obviously of the developed countries including the US Dollar, the Japanese Yen, the Euro, the Pound Sterling, etc. Foreign exchange markets operate 24 by 7, which means currencies are traded, bought, and sold all through the 24 hours, in some market or the other, moving in sync with the rotation of the earth. Hence, when the Tokyo market opens for the day, the US markets would have closed for the previous day. When the Tokyo market closes for the day, the London market would be ready to open for the day, and so on. The foreign exchange market in almost every country is an Over The Counter market, or an OTC market. The predominant OTC nature of the market combined with large number of participants and large trading volumes has resulted in the presence of large number of brokers in foreign exchange markets around the world. These brokers help connect the counter parties who wish to trade in the foreign exchange market. Entities, particularly banks, who trade extensively across markets and across currencies have a very sophisticated technology and telecommunications infrastructure. A) To facilitate 'up-to-the-second' information on exchange rates, and © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 B) To enable screen-based trading in foreign currencies. Active participations by organizations such as Reuters and Bloomberg has entirely changed the landscape of foreign exchange markets and trading patterns across the globe. Let's look at the size of the foreign exchange market. The most recent survey taken up in 2013 by the Bank of International Settlements, or BIS for short, together with the central banks around the world estimated the daily turnover of global FX market to be US dollar 5.3 trillion per day. Let me repeat—US Dollars 5.3 trillion per day. No other segment of the financial markets globally come anywhere near this in terms of volume and value traded. United States, more specifically, New York, and United Kingdom, more specifically, London continue to be the dominant centers for FX trading globally. The volumes traded by leading foreign exchange markets as well as the leading currency pairs, published by the Banker for International Settlements, is given in the table on your screen now. We've included only the top ten currencies in terms of share from the original table. Notice, the Mexican Pesos and Chinese Yuan have emerged in the 2013, which reflects a certain subtle but noticeable change in the foreign exchange marketplace across the globe. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Types of Transactions Traded in the Foreign Exchange Market In this session, we will look at the types of transactions traded in the foreign exchange markets. In order to understand this, we must recognize that there are two distinct activities associated with any foreign exchange transaction— the trading activity and the settlement activity. The trading activity is that activity in which the two counterparties to the transaction agree on the quantum of currencies to be bought and sold and the exchange rate at which it will be executed. This foreign exchange contract is binding on both the counterparties. The date on which the trade is carried out is referred to as the trading date. The settlement activity, on the other hand, relates to when and how the trade that was executed as above on the trading date is settled. That means, how are the currency amounts that is to be paid or received as per the foreign exchange contract, be debited, and credited to the designated bank accounts of the counterparties. The date on which this process takes place is known as the settlement date. So, you have a trading activity and a trading date, and you have a settlement activity and settlement date. The type of transactions traded in foreign exchange markets are classified based on the difference between the trade date and the settlement date. Let us assume ’t’ refers to the 'Trade Date'. The first type of foreign exchange transaction, which is a cash transaction denotes t + 0. That means the trade date and the settlement date are the same. A typical example would be transactions that you undertake at the Money Changer in the airport. TOM transactions denote t + 1. TOM is the short form for tomorrow. t + 1, if trade is done today, settlement will take place tomorrow, or one day hence. TOM transactions globally are very few in number. Spot transactions denotes t + 2. That is, if trade date is today, settlement will take place two days from today. Historically, and even to this day, a vast majority of large value foreign exchange transactions worldwide are settled as spot transactions. Next on our list is a forward contract, or more specifically, an outright forward contract. This denotes a transaction where the difference between the trade date and settlement date is t + n, where n could be any number of days greater than 2. For example, a 90 day forward contract, t + 90, entered into today would mean that funds would be settled between the counterparties 90 days from today. Swap transactions are a little more complex. They comprise actually two foreign exchange transactions entered into simultaneously, both of which are contractually binding on the counterparties. There are two types of Swap transactions traded in the market. One is the Spot and © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 the Forward Swap transaction, and the other is the Forward-Forward Swap transaction. Let's understand the difference between these two. A Spot-Forward Swap transaction involves a Spot transaction and a Forward transaction that are equal and opposite. For instance, a foreign exchange dealer today enters into a Spot transaction with a counterparty to sell 100,000 US Dollars in exchange for Japanese Yen at an agreed exchange rate, and simultaneously enters into a Forward contract with the same counterparty to buy back the 100,000 US Dollars in return for Japanese Yen 30 days into the future. Now this is a Spot-Forward Swap transaction. A Forward-Forward Swap transaction, on the other hand, is in some way similar to the Spot-Forward contract except that both the transactions will be outright forward contracts. For example, a trader today enters into two foreign exchange contracts simultaneously. 1) To buy US Dollars for Japanese Yen, 30 days Forward, from a counterparty at an agreed exchange rate, and B) Sell the same amount of US Dollars for Japanese Yen 90 days Forward to the same counter-party. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Exchange Rates: Importance and Quotation As you would already be aware, the price of one currency in terms of another currency is the exchange rate. Now, why are exchange rate important? Exchange rates are important because they affect the price of domestic goods in foreign countries, and vice versa. When a country's currency appreciate with respect to other currencies, its goods cost more in other countries. Hence, its exports could be adversely impacted. Furthermore, other countries' goods will cost less domestically; hence, imports into that country could become more attractive. The situation would be the exact opposite in case the country's currency depreciates. If left unattended, both those scenarios, rapid appreciation or a rapid depreciation of the domestic currency, could have serious adverse economic ramifications for the country as a whole. The exchange rate volatility could be further exasperated if speculators and arbitragers are allowed to freely trade in that currency in the foreign exchange markets. Hence, the imperative need for governments and central banks of countries to ensure exchange rate stability of the domestic currency, both in the short-term and the long-term. Now let's look at how exchange rates are quoted. All currencies have a unique code allocated to it by the International Standards Organization. For instance, US Dollar is denoted by USD, British Pound by GBP, Japanese Yen by JPY, Euro by EUR, and so on and so forth. Exchange rates are quoted in all markets by currency pairs. For instance, if 1 US Dollar is quoted at a price of 100 Japanese Yen, in other words, 1 US Dollar will fetch you 100 Japanese Yen, or to buy 1 US Dollar, you have to pay 100 Japanese Yen. The quote will be USD/JPY 100. This nomenclature is to be interpreted as the price of one unit of the base currency, which is on the left side of the slash, in our case it was the US Dollar, equal to how many units of the price currency on the right side of the slash, in our case, the Japanese Yen. Here's another example. EUR/USD 1.45 means 1 Euro which is the base currency is quoted at an exchange rate of 1.45 US Dollars, which is the price currency in this quotation. Now we have direct quotes and indirect quotes in the market. Let's understand the difference between the two. A direct quote in foreign exchange markets parlance is the price of one unit of foreign currency in domestic currency units, and an indirect quote is the price of one unit of domestic currency in the foreign currency units. Therefore, in the Tokyo market, USD/JPY 100 is a direct quote, and JPY/USD © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 0.01 or 1 by 100 is an indirect quote because JPY is the domestic currency in the Tokyo market. In the New York market, it would be the exact converse. Now, Bid and Ask rates. Although in our discussion so far, we have looked at exchange rate quotations as a single value, almost always it is a set of two values, normally referred to as a two-way quote. The first value denotes the Bid rate, or the price at which a foreign exchange dealer will buy one unit of the base currency, and the second value denotes the Ask rate or the price at which the foreign exchange dealer will sell one unit of the base currency. Let's look at an example to understand this better. If a foreign exchange dealer in London quotes Euro/USD, 1.2710/80, it is expanded as 1.2710/1.2780 and is interpreted as the dealer is willing to buy Euros and sell US Dollars at 1.2710 Dollar per Euro and is willing to sell Euros and buy USD at 1.2780 Dollars per Euro. Based on the above, his Bid–Ask spread is 1.2780 – 1.2710, which is 0.0070 US Dollars. In foreign exchange parlance, the first two decimals are known as points, and the third and the fourth decimal are known as pips. So, the Bid– Ask spread in this case is 70 pips. In summary, if this dealer buys 100,000 Euros at 1.2710, and immediately, or a little later, sells the 100,000 Euros at 1.2780, you make a profit of 100,000 x (1.2780 – 1.2710), which is, 700 Dollars for the 100,000 Dollars, based on the Bid- Ask spread that he has quoted. Needless to add, the narrower the Bid–Ask spread, the lower will be the profits. Now, let's look at cross rates. Currencies of several countries are not actively traded in the global foreign exchange markets. If the exchange rate is to be determined between two such currencies that are not actively quoted or traded, the market practice is to use the exchange rate quoted for these two currencies, with respect to another widely traded currency. For example, if we wish to determine the exchange rate between Mexican Pesos and Indian Rupees, we use the quotes prevailing for both these currencies with respect to the US Dollar. If USD MXN is 15, that is, one US Dollar equal to 15 Mexican Pesos, and USD INR is 60, i.e., 1 US Dollar is equal to 60 Indian Rupees, then the exchange rate between Mexican Pesos and Indian Rupees would be MXN/INR 60 divided by 15 equal to 4.00. In other words, 1 Mexican Peso is equal to 4 Indian Rupees. Now let's look at how the markets quote Forward rates, i.e., foreign exchange transactions that are to be settled at a date in the future. Forward foreign exchange rates are generally quoted as points to be added or subtracted from the prevailing Spot rates. As a general rule, if the forward points are high © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 low then should be subtracted from the spot rate and if the forward points are low/high then should be added to the spot rate. In the example we have, which is USD/JPY, the quote is 110.50/60. In other words, the Bid rate is 110.50, and the Ask rate is a 110.60. These two are the Spot Bid and Ask rates. Now, if you look at the one-week Forward rates, the table shows you Forward points as 8/7. What this means is the one-week Forward Bid rate is 110.50 – 0.08, which is 110.42, and the Ask rate is 110.60 -.07, which is a 110.53. You can use the same logic to derive the one-month Forward rate, which is 110.22 and 110.33, and the three months' Forward rate. Forward foreign exchange quotations for periods greater than two years, one year in some markets, are called Swap rates because most such transactions effectively involve the purchase of one currency against another on one date and a reversal of that purchase at a future date. We saw those transactions earlier as, if you recall, Spot-Forward Swaps and Forward-Forward Swaps. The Forward points associated with Spot rates are arrived at based on the interest rate differential between the two currencies for the period of the forward contracts, for example, a two year forward points or Swap points for the Bid rate USD JPY should, in theory, reflect the difference in the two year borrowing rates for US Dollar, and two year lending rates for the JPY. Similarly, a two year Forward points or Swap points for the Ask rate USD JPY should reflect the difference in the two year lending rates for USD and the two year borrowing rates for Japanese Yen. As you would have figured out by now, a Swap is a convenient way to effect the transactions in the foreign exchange market rather than borrow in one currency and lend in another currency in the loan market where interest rates are charged based on the period of borrowing, and lending. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Participants in the Foreign Exchange Markets In this session, we will look at the various participants in the foreign exchange markets. Foreign exchange markets around the world comprise a plethora of participants— individuals and firms, banks and non-banks, speculators and arbitrageurs, foreign exchange brokers, and last but not least, central banks. Each of this category of participants come to the foreign exchange market for entirely different reasons and motivations. Let's look at each one of them in some detail. Individuals and firms - This segment includes, tourists, international business travelers, importers, exporters, and investors in international markets, who go to the foreign exchange market to purchase different currencies to meet their personal, commercial and or investment needs. What about banks, and non-banks? Almost all banks and non-banks such as money changers operate in the foreign exchange market to meet the demands of foreign currency by their clients that would include both individuals, and firms. In meeting the requirements of individuals and firms, banks and non-banks make a profit as well. For example, a Japanese bank could buy, say, 100,000 US Dollars in exchange for Japanese Yen at let us say, USD/JPY 102 from a Japanese firm exporting to the United States. At some point in the immediate future, they could sell the same US Dollar 100,000 at let's say, USD/JPY 108 to a Japanese firm importing goods from the United States. By helping the Japanese exporter and the importer with their US Dollar transactions, the Japanese bank, as you would have noticed, has effectively made a profit of 100,000 x (108 -102), which is 600,000 Japanese Yen from just these two transactions. Banks also participate in the inter-bank foreign exchange market, to square off their net overbought or oversold positions or sometimes to simply speculate on the exchange rate, to make a profit. To explain this, let's extend our earlier example. Say, a Japanese bank buys 100,000 from a Japanese firm that has exported goods to the United States at an exchange rate of USD JPY 102. Say, the same Japanese firm sells 200,000 Dollars at an exchange rate of USD/JPY 107 to a Japanese importer who needs to pay a US exporter for goods that he has purchased. As a result of the above two transactions, the Japanese bank has a net oversold position of 200,000 - 100,000, which is 100,000 US Dollars. They are oversold US Dollars 100,000. To cover its oversold position of US Dollars 100,000, the bank purchases US Dollars from another bank at, let us say, 105 Japanese Yen per Dollar. As a result, the Japanese bank's US Dollar position is squared off. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Since it bought a 100,000 at a 102, which is 10,200,000 Yen, it sold 200,000 US Dollars at a 107, which is 21,400,000, and it bought a 100,000 US Dollars at a 105, which is 10,500,000. The net cash flow in US Dollars is 0, and the net cash flow in Japanese Yen is +700,000, which in effect is the bank's profit from these three transactions. Should on the other hand, the Japanese bank be of the view that going forward, that means in the days ahead, the Japanese Yen would strengthen or appreciate with respect to the US Dollar, then it could just hold on to the oversold US Dollar position until say the exchange rate moves in its favor, say, two days later to USD/JPY 100. The map this time would be - Buy a 100,000 at a 102, sell 200,000 at a 107, and buy a further 100,000 at 100 Japanese Yen. The net cash flow in US Dollars would be 0, and the cash flow in JPY would be 1,200,000 Yen, which is again, the bank's profits. As you can see from the above example, by not immediately squaring its position, but carrying the oversold US Dollar position until JPY strengthened, the Japanese bank made an additional profit of 500,000 Yen. In this case, the bank's speculation on the exchange rate movement turned out to be spot on. It was correct. There was an equal probability though that its view on the exchange rate and hence speculation could've gone wrong. For instance, the Japanese Yen would depreciate instead of appreciating. In which case, the bank's profits would have been reduced or even turned into a loss. The next set of participants we look at are speculators and arbitrageurs. Speculators seek profits by predicting or speculating on the future movements in exchange rates, while arbitrageurs’ book riskless profits by trading in the same currency across markets. Let's look at some examples. Speculative first. Based on all the information at his command, let's say, a speculator in USD JPY might be of the view that the Japanese Yen would depreciate in the near term with respect to the US Dollar. Hence, he would, say, buy US Dollars 10 million, i.e., go long in US Dollars today at USD/JPY 105. If his prediction does come true and Japanese Yen depreciates to 108 in the near future, he would sell the 10 million US Dollars and turn it back into Japanese Yen to realize a profit of 10,000,000 x (108 -105), which is 30 million Yen. Needless to add, the exchange rate could've moved in exactly the opposite direction. In which case, the speculator could have lost 30 million Yen or more with equal probability. Speculators, therefore, take huge risks in the foreign exchange markets. However, their presence and their pursuit of market information before placing the bet, as they say, enables better price discovery in the foreign exchange market. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Now let's look at arbitrageurs. Unlike speculators, arbitrageurs look to make a riskless profit by exploiting the price imperfections across markets. For instance, if in the Tokyo market the exchange rate USD/JPY is a 110 and in the New York market it is 109, an arbitrageur would buy US Dollars at 109 Japanese Yen in the New York market and simultaneously sell all of those US Dollars at 110 Japanese Yen in the Tokyo market. Thereby, he can book a profit of 1 Japanese Yen per US Dollar. This arbitrage opportunity, however, would quickly disappear, and the USD JPY exchange rates would equalize across the two markets, New York, and Tokyo in this example, because several arbitrageurs would be doing exactly the same. Which is, buy US Dollars in the New York market, hence US Dollar starts appreciating in the New York market, with respect to the Japanese Yen, and sell it in the Tokyo market. Hence, US Dollar starts depreciating in the Tokyo market. As a result, the arbitrage opportunity would disappear very quickly. In summary, therefore, the presence of speculators facilitate a more efficient exchange rate discovery and a presence of arbitrageurs equalizes exchange rates across markets. In that sense, their presence and participation has an overall stabilizing effect in the foreign exchange markets. There's a very peculiar participant in the foreign exchange market, large in number, called foreign exchange brokers. Worldwide, the foreign exchange market, as we already saw, is predominantly an Over The Counter or an OTC market. The inevitable need, therefore, for the buyers and sellers to identify counterparties in the foreign exchange market with whom they can transact. Foreign exchange brokers worldwide perform this role of bringing the counterparties together very effectively without themselves becoming counterparties to the transaction. Brokers of a competitive two-way quotes from several counterparties at any time but maintain complete anonymity of the counterparties until after the transaction is agreed upon and ready to be closed out. Finally, central banks as participants in the foreign exchange market. Central banks around the world have a very unique role to play in the foreign exchange market. They undertake transactions not to make a profit but to ensure the exchange rate stability of their domestic currency. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 How and Why do Exchange Rates Fluctuate? In this session, we will try and understand how and why exchange rates fluctuate, and a look at some of the very well-established theories that underlie exchange rate fluctuations. First, a look at the factors that impact exchange rate in the long term. Law of one price and purchasing power parity: The Law of One Price states that "If two countries produce an identical good, and exogenous costs are low– that good, in theory, should cost the same in both countries– no matter where it is produced." Let us say that Aluminium produced in the United States costs 2,000 US Dollars per ton, in the United States, and Aluminium produced in Australia costs 3,000 Australian Dollars per ton, in Australia. For the Law of One Price to hold, the USD AUD exchange rate should be 1.50, which is 3,000 AUD divided by 2,000 USD. Should the AUD depreciate for any reason, and let us say, the new exchange rate changes to 2.0, instead of 1.5, the price of Australian Aluminium sold in the United States will fall to US Dollars 1500 per ton, that is, Australian Dollars 3000 divided by the exchange rate 2.00. And US Aluminium will sell for Australian Dollars 4000 per ton in Australia, which is arrived at based on 2000 US Dollars per ton x the exchange rate 2.00. As a result of this, Aluminium produced in the United States becomes more expensive in both countries. And hence, the demand for US Aluminium will go down significantly in both the countries. Ceteris Paribus, i.e., all else remaining constant, this aberration will last until the exchange rate is restored to 1.50 Australian Dollars per US Dollar. This Law of One Price is implicitly manifested in the Theory of Purchasing Power Parity, which states that "Exchange rate between any two currencies will adjust to reflect the change in price levels, in the domicile countries of those two currencies." In other words, if price levels in Australia will rise, by say, 10%, relative to the US price levels then Australian Dollar will depreciate by 10%, vis-a-vis the US Dollar and vice versa. The Theory of Purchasing Power Parity is better explained by considering a basket of goods rather than a single good like Aluminium that we saw in an earlier example, and with that basket of goods determining the price in the two countries. For instance, if a basket of goods cost Pound Sterling 100, in the United Kingdom, and the same basket of goods costs Indian Rupees 8000 in India, then the GBP INR exchange rate based on Purchasing Power Parity should be 80, which is 8000 divided by 100. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 The main intuition or argument underlying the PPP is that, if a country experiences consistently high inflation, then the price of all goods in that country will go up and its currency will therefore demonstrate a depreciating trend. Hence, exports from that country will be less competitive and imports into that country will become more expensive. Do bear in mind, the Theory of Purchasing Power Parity captures the direction in which the value of any country's currency is headed in the long term. But it cannot capture the impact in the near term. The near term is captured very well by the Interest Rate Parity Theorem which we will look at in a later session. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Exchange Rate Pass Through Let's move on to a very interesting concept in the world of foreign exchange markets Exchange Rate Pass Through. The extent to which the prices of exported and imported goods can change as a result of fluctuations in the exchange rate is termed "Exchange Rate Pass Through." While Purchasing Power Parity suggests that all changes in the exchange rates should be passed through in the case of every international trade transaction, it is not always feasible in practice. Let's look at an example to illustrate this phenomenon. Consider an Indian firm that exports denim jeans to the United States. Let’s say, currently, it sells a pair of jeans for US Dollars 20.00 And the current USD INR exchange rate is 65.00. So, the price of each pair of jeans in Indian Rupees would be 20.00x65.00, which will be 1300.00. Say, the cost of producing a pair of jeans is 900 Indian Rupees, and therefore, its operating margin is 1300-900, which will give you 400 rupees. Now, let us say, over the next one-year US inflation is expected to be 5.00% and over the next one-year Indian inflation is expected to be 8.00%. Hence, year-end exchange rate can be expected to be, assuming Purchasing Power Parity holds, it'll be the current exchange rate of 65.00 into the Indian inflation rate of 8.00%, divided by the US inflation rate of 5.00%. Assume, price of jeans can also rise by the US inflation rate. So, it'll be 20 x 1.05, which would be 21 US Dollars. And price in INR would therefore be, 21.00x66.86, which would give you 1404.00 Indian Rupees, per pair of jeans, which is the sales revenue realized. Now, if the cost of manufacturing also goes up, based on the Indian inflation rate of 8%, 900 would become 972.00. With these revised numbers, the operating margins of this company would now be 432, which is 1,404.00-972.00. If you work backwards, last year, the operating margins was 400.00 into the inflation rate of 8%, gives you the 432 Rupees as the operating margin. In other words, all of the change in the exchange rate due to change in inflation has been absorbed in the price. We had some very interesting assumptions here if you think about it. Firstly, the price per denim in US Dollars moves in line with US inflation, and no reduction in sales volume. 2) Increase in operating cost is in line with India's domestic inflation. And 3) The depreciation of INR is proportional to the inflation differential between the US Dollar and Indian Rupees, in other words, Purchasing Power Parity holds. Now, if the change in the above variables is asynchronous, that means they are not in line with the expectations of Purchasing Power Parity. Let's see what happens. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Say, exchange rate quoted in the market is 65.75, not 66.86 as should have been the case, if Purchasing Power Parity holds. Also, let us say, for competitive reasons, price in US Dollars per pair of jeans can only go up to 20.50 instead of 21 US Dollars. Therefore, the price in Indian Rupees at the end of one year would be (20.50 x 65.75), which would be 1347.88. Now, let's assume, the cost of manufacturing does go up by the inflation rate of 8%. In other words, the cost of manufacturing last year was 900, now it'll be 900 x 1.08, which is 972.00. Now, with these challenging numbers that we have, the operating margin would be (1347.88 - 972.00), which is 375.88. As against 432, is what it should have been, now had Purchasing Power Parity impacted the exchange rate as theory would suggest. As we saw in the spreadsheet example, only 87% of the exchange rate impact on the margins could be passed through, and the remaining 13% had to be absorbed by the exporter, as a reduction in his operating margin. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 Foreign Exchange Markets: Concepts, Instruments, Risks and Derivatives Week 01 – Summary Foreign Exchange Markets A foreign exchange transaction is an ‘agreement’ between two parties whereby one partyagree to pay a fixed amount of one currency in ‘exchange’ for another currency at the agreed rate. Foreign exchange markets provide the institutional, physical and technology infrastructure to carry out foreign exchange transactions. Foreign exchange markets operate 24X7 as an ‘over-the-counter’ market, not an exchange traded market. The most recent survey (2013) undertaken by the Bank for International Settlement (BIS) together with the Central Banks around the world estimated daily turnoverof global FX markets to be USD 5.3 trillion per day. Types of Transactions traded in the Foreign Exchange Markets There are two distinct activities associated with any foreign exchange transaction: (a) Trading Activity: The ‘trading’ activity in which the two counterparties to the transaction agree on the quantum of the currencies to be bought/sold and theexchange rate at which it will be executed. (b) Settlement Activity: The ‘settlement’ activity relates to when and how the trade(executed as above on the ‘trading date’) is settled. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 The types of transactions traded in foreign exchange market are classified based on the difference between the trade date and settlement date. How are Exchange Rates Quoted? The price of one currency in terms of another is called the ‘exchange rate’. All currencies have a unique code allocated to it by the international standards organization. Exchange rates are quoted in all markets by ‘currency pairs’. Their nomenclature is to be interpreted as the price of one unit of the ‘base currency’ (on the left of the ‘slash’) equal tohow many units of the ‘price currency’ (on the right side of the ‘slash’). For example: EUR/USD 1.25 means one Euro (base currency) is quoted at an exchange rate of 1.25 US Dollar (the price currency). There are a few terms specific to exchange rate quotations: Direct and Indirect Quote: A ‘direct’ quote, in foreign exchange market parlance, is the price of one unit of foreign currency in domestic currency units and an ‘indirect’quote is the price of one unit of domestic currency in foreign currency units. ‘Bid’ and ‘Ask’ Quote: Exchange rate quotation is a pair of values, normally referred to as a ‘two-way © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 quote’. The first value denotes the ‘bid’ rate or the price at which a foreign exchange dealer will buy one unit of the base currency and the second valuedenotes the ‘ask’ rate or the price at which that foreign exchange dealer will sell oneunit of the base currency. Cross Rate: If the exchange rate is to be determined between two currencies that are not actively quoted or traded, the market practice is to use the exchange rate quoted for these two currencies with respect to another widely traded currency. For example, the exchange rate between Mexican Pesos and Indian Rupees (MXN/INR) isarrived at using the USD/MXN and USD/INR rates. Forward Rate Quotation: Forward foreign exchange rates are generally quoted as points, to be added or subtracted from the prevailing spot rate. Forward foreign exchange quotations for periods greater than two years (one year in some markets)are called ‘SWAP RATES’ because most such transactions effectively involves a ‘purchase’ on one date and ‘reversal’ of that purchase through a ‘sale’ at a future date. Participants in the FX Markets The foreign exchange markets around the world comprise a plethora of participants: Individuals & firms, banks & non-banks, speculators & arbitrageurs, foreign exchange brokers and, last but not the least, Central Banks. Individuals and firms to meet their personal, commercial or investment needs. Banks and non-banks to meet the demand for foreign currency by their clients who include individuals and firms. Banks also participate in the inter-bank foreign exchange market to ‘square-off’ their net ‘over-bought’ or ‘over-sold’ positions (or sometimes to speculate on the exchange rate) to make a profit. Speculators and arbitrageurs: Speculators seek profits by predicting (or speculatingon) the future movements in exchange rates, therefore, takes huge risks in the foreign exchange markets. Arbitrageurs look to make a riskless profit by exploiting the ‘price imperfections’ across markets. Foreign exchange brokers bring together counterparties in the foreign exchangemarket without themselves becoming counterparties to the transaction. Central Banks undertake transactions in the foreign exchange market not to make aprofit but to ensure the exchange rate stability in their domestic currency. They intervene in the FX market (a) © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 1 to protect their home currency from appreciating or depreciating too rapidly in the short term and (b) to arrest excessive volatility in theexchange rate of their domestic currency. How and why do exchange rates fluctuate? The factors that impact exchange rate in the long term are: The law of one price states that if two countries produce an identical good and exogenous costs are low, that good (in theory) should cost the same in both thecountries. The theory of purchasing power parity states that exchange rate between any two currencies will adjust to reflect the change in price levels in the domicile countries ofthose two currencies. The main intuition or argument underlying PPP is that if a country experiences consistently high inflation, then the prices of all goods in that country will go up and its currency will demonstrate a depreciating trend; hence exports from that country will be less competitiveand imports into that country will become more expensive. The theory of purchasing powerparity captures the direction in which the value of any country’s currency is headed in the long term but cannot capture the impact in the near term (the ‘near term’ is captured well by the interest rate parity theorem). Exchange Rate Pass Through is the extent to which the prices of exported and imported goods can change as a result of fluctuation in exchange rate. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 Nominal Vs Real Exchange Rates In this session, we will look at nominal versus real exchange rates. Since most countries have trading relationships with several countries, a well-understood methodology to evaluate if the country's currency is overvalued or undervalued is through the use of nominal exchange rate and real exchange rate and their extensions—nominal effective exchange rate and real effective exchange rate. Nominal Exchange Rate or NER for short, is the price of one currency expressed in number of units of another currency. The prefix "nominal" denotes the numerical exchange value of one currency against another. Say, one unit of US Dollars is equal to 1.35 units of Swiss Francs, or USD/CHF 1.35. Nominal exchange rates does not reflect the Purchasing Power Parity based relationship between the two currencies. The real exchange rate, on the other hand, incorporates the Purchasing Power Parity impact relative to the other currencies as well. Real exchange rate, therefore, is nominal exchange rate multiplied by the price indices prevailing in the domicile country of the two currencies. For example, let's say, the nominal exchange rate of Currency A versus Currency B is 25, and price levels in Country A is higher than price levels in Country B. Then, one unit of Currency A will buy more in Country B, hence, the Real Exchange Rate RER between the two currencies should obviously be greater than 25. If RER is computed using the price level of commonly traded goods between the two countries, it will provide a measure of export competitiveness. Now, let's look at NEER versus REER. Unlike Nominal Exchange Rate, NER, and Real Exchange Rate, RER, Nominal Effective Exchange Rate, NEER, and Real Effective Exchange Rate, REER, are not arrived at separately for each currency pair. Rather, each is a single number—an index to reflect the movement of, say, Currency A against a basket of currencies, the choice of the currency basket being usually based on the countries who are Country A's major trading partners. Nominal effective exchange rate is calculated as the weighted sum of the nominal exchange rate of each currency pair involving Currency A, the weights being based on the share of trade of Country A with each of the countries in its currency basket. By setting a specific base year for NEER equal to 100, the change in Currency A's values can be expressed as a percentage of change over that base year. Real effective exchange rate quite like NEER is an index of the country's real exchange rate. The computation of REER is based on RER and is identical to the computation of NEER. The NEER and the © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 REER measures are very useful benchmarks as to how a country's currency is moving vis-à-vis other currencies. Theory suggests that if the change in exchange rates for Currency A just offsets the differential interest rates vis-à-vis the other currencies in the basket. In other words, Purchasing Power Parity holds, then the REER for that currency will stay at 100 over that period in time. REER above 100 denotes that the currency is overvalued, and below 100 would suggest that it is undervalued with respect to all the currencies in its currency basket. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 Interest Rate Parity In this session, we will look at a very fundamental principle governing foreign exchange rates - Interest Rate Parity. Interest Rate Parity reflects the exchange rate movements for any currency in the short term. Please recall what we saw in an earlier session that Purchasing Power Parity captures the exchange rate movements in the long term. The Interest Rate Parity Theorem states that 'The difference between the spot exchange rate, and the forward exchange rate 'n' days into the future between any two currencies should be explained by the difference in the interest rates for the ‘n’ day period between the two currencies.' Expressed mathematically, Id = Ie.- (F - S) upon S, Id being the domestic currency interest rate for ‘n’ days, Ie being the foreign currency interest rate for ‘n’ days, F is the forward exchange rates n days forward and S is the spot exchange rate. Let's look at an example to illustrate this Interest Rate Parity Theorem. Say, an American investor has the million US Dollars at his disposal. He has an alternative to invest the one million Dollars in the US money market, at 2% per annum for 90 days. So, at the end of the 90 days, he would have a 1,005,000 US Dollars. On the other hand, the investor also has an alternative investment channel, which is to convert the one million US Dollars to Swiss Francs at 1.5, the exchange rate between the US Dollar and Swiss Franc is 1.5, which would immediately give him 1.5 million Swiss Francs. He could take this 1.5 million Swiss Francs, invest it in the Swiss money market at 4%, because the interest rate per annum for Swiss Francs is 4%, for the same 90-day period, which would therefore give him 1,515,000 Swiss Francs at the end of the 90-day period. In order for us to understand the Interest Rate Parity Theorem, if he went through the US money market route, he would have a 1,005,000 at the end of the 90 days. If he went through the Swiss money market route, he would have a 1,515,000. If Interest Rate Parity were to hold, 90 day forward exchange rate should be 1.5075, which is arrived at as 1.515 million Swiss Francs, divided by 1,005,000 US Dollars. This is a case where Interest Rate Parity holds absolutely perfectly. In other words, irrespective of whether the investor chose Alternative A or Alternative B, he gets an effective return of 2% in both cases. In summary, therefore, applying the Interest Rate Parity formula, you should get a result as shown on your screen now. 2%, remember, was the US Dollar interest rates per annum, 4% was the interest rates per annum for the Swiss Francs, so 90 days would be 2% divided by 4, and 4% divided by 4, the forward exchange rates, assuming Interest Rate Parity holds, should be 1.5075, the spot rate is 1.500 © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 divided by the spot rate which is 1.500. So, you get on the left-hand side, 0.005, on the right-hand side, 0.010 - 0.005, which means Left Hand Side is equal to the Right Hand Side. If in the above case, Interest Rate Parity holds, and the 90 day forward exchange rate will be 1.5075. If, for any reason, the forward exchange rate quoted in the market, is different from 1.5075, there will be what we call an arbitrage profit. An arbitrage profit is the opportunity for a riskless profit. Let us see how this transpires in the market. Here's an example. Now, let's say, the exchange rate being quoted in the market is not 1.5075, but it is 1.4975. In this case, if the investor chose Alternative A, he would get the same 1,005,000 as he got in the earlier example that we saw. On the other hand, if he converts it to Swiss Francs, he would get a 1,500,000 invested for 90 days at 4% per annum, he would get a 1,515,000, so far, exactly the same. However, because the exchange rates is 1.4975 that is being quoted in the market, when he converts these 1,515,000 Swiss Francs to US Dollars, he would get a 1,011,686 US Dollars. Now effectively, this is a return of 4.67%. If he had gone this route, this investor would have got a 2% return. But because he took this route, he has managed to get a return of 4.67%. In other words, because the forward exchange rates is not obeying the Interest Rate Parity Theorem, he is able to make a riskless profit, or an arbitrage profit, which is 2.67% more than the return he would have got, if Interest Rate Parity held. Let us say, the exchange rate, the forward exchange rate being quoted in the market, is greater than 1.5075, Option 1 continues to be exactly what it was as we saw earlier, so the investor would get a 1,005,000 US Dollars at the end of 90 days. And Alternative B would give him 1.5 million, invested 4% for 90 days, he would get a 1,515,000. Now, because the forward exchange rates being quoted is greater than 1.5075, let us say, the rate being quoted is 1.5175. When the investor converts this Swiss Francs at the end of 90 days to US Dollars, he would only get 998,353 Dollars, which is less than what he started with, which if you recall was a million dollars. So, in other words, by taking Alternative B and the exchange rate being higher than the exchange rate that prevailed with Interest Rate Parity. This investor is going to book a loss if he took Alternative B, and therefore, he would choose Alternative A. So, just to recap, in the first example, he's indifferent to whether he takes Alternative A or B. In the second example, he is better off going with Alternative B. And, in the third example, he's better off © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 going with Alternative A, because if he went with Alternative B, his effective return would be negative -0.66%. So, in summary, should an arbitrage opportunity exist, due to the absence of Interest Rate Parity, either A) It will be rapidly competed away by the market forces until Interest Rate Parity condition is restored, between the two currencies, or B) The interest rate is changed through policy intervention, by one or both of the monetary authorities, i.e., the central banks involved in the two currencies. The overall direction will therefore be for exchange rates to move in line with Interest Rate Parity Theorem. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 Foreign Exchange Reserves - I We will look at the structure and role of foreign exchange reserves i.e., how are foreign exchange reserves created and why are they necessary for any country. For ease of understanding, we will look at a few examples involving only two countries - United States and India i.e., only exporters, importers and other entities involved in foreign exchange transactions between the United States and India. The same “template” can then be extended to any number of countries, any number of importers and any number of exporters. So, let us consider Company IN1 in India who is exporting manufactured goods to a company say US1 in the United States. Let us further say that IN1’s bank account is with State Bank of India in Delhi and State Bank of India in turn, has its US $ ‘correspondent’ bank account with Bank of America in New York. Furthermore, let’s say the United States importer US1 has its banking relationship with Bank of Utah in the United States. Let us say IN1 and US1 have negotiated and finalized quantity of goods to be exported by IN1 and the corresponding price in US Dollar. Let us also say that IN1 ships the goods worth a million dollars and sends an invoice for a million dollars to US1 towards the value of goods based on the invoice, US1 would instruct its Bankers (Bank of Utah) to transfer USD 1 million by debiting its bank account and transferring the money to Bank of America for the credit of State Bank of India ultimate beneficiary IN1 (remember, the transfer Bank of Utah to Bank of America will be done using payment systems such as Fedwire which is within the United States). On receiving the funds 1 million US Dollars Bank of America will inform State Bank of India that they have credited the latter’s account with USD 1 million, ultimate beneficiary IN1. State Bank of India in turn would credit the account of exporter IN1 in equivalent Indian Rupees at the exchange rate prevailing on that day, which we also refer to as the spot rate. May I mention here that for ease of understanding, we have used an over simplified example: immediate payment based on invoice and spot exchange rate. Do remember most international transactions are governed by a ‘Letter of Credit’, a credit period of up to 60 days or 90 days and foreign exchange instruments such as currency forwards, currency futures etcetera that are used to hedge against volatilities in the exchange rate. We will look at those in detail in other sessions. The transaction we discussed a little earlier will effectively mean that State Bank of India has a credit balance (or a reserve) of USD 1 million in its account with Bank of America. Let us look at a converse © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 transaction where the exporter (i.e., company US2) is domiciled in the United States and the importer (Company IN2) is domiciled in India. The flow of goods and consequently the cash flows in US Dollars therefore be the exact converse of the transaction that we saw just a little while ago. As you can see in the diagram on your screen now, IN2 who is the importer will instruct his bank Union Bank of India to remit USD 500,000 being the value of goods he has imported to the exporter by debiting his account for equivalent Indian Rupees. Union Bank of India after debiting IN2’s account in equivalent Indian Rupees will in turn ask their correspondent bank Citi Bank in the US to debit their account with Citi Bank for USD 500,000 and remit the same to Bank of Alabama, ultimate beneficiary US2. In effect, this means Union Bank of India has a ‘negative reserve’ of US $ 500,000 in its account with Citi bank in New York. If we take the sum of the two transactions that we discussed the first one IN1 exporter US1 importer and the second one US2 is the exporter and IN2 is the importer, the net US dollars ‘reserves’ available with the Indian banking system as a result of these two transactions, will be US dollars US $ 500,000, being the net of one million Dollars USD export from India minus 500,000 US imports into India and in both cases the partner country was the United States. Extending this architecture, we can see that there will be several 100, may be several 1000, export and import transactions between India and the United States which necessitates every Indian Bank to have a US dollar correspondent banking account with a regulated bank in the United States, to facilitate this cross-border flow of funds. Now, based on the above examples that we saw, the net foreign exchange reserve of the Indian financial system in USD will be the sum of the USD balances in the corresponding bank accounts of all Indian Banks. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 Foreign Exchange Reserves - II Based on what we saw in the last session, the net foreign exchange reserve in the Indian financial system in USD would be the sum of the balances in the accounts of all Indian Banks with their USD correspondent banks. Let’s extend the architecture further. Let us say over a period of one year, exports from India to the United States totaled USD 200 Billion and imports into India from the United States totaled USD 100 billion. That means exporters from India have “sold” USD 200 Billion through their bank in India in exchange for equivalent Indian Rupees while importers have “bought” USD 100 billion through their banks in India by exchanging Indian Rupees. Ceteris paribus, i.e., all else remaining constant, the net USD balances of banks in India with their correspondent banks in the United States on account of what we just saw would be USD 100 Billion being USD 200 Billion realized from exports and USD 100 Billion raised for paying towards imports. That results in two eventualities: 1. The Indian financial system has a surplus i.e., a reserve of USD 100 Billion. That means the foreign exchange reserves of India would have increased by USD 100 Billion, being the net of exports and imports. 2. That scenario would in turn have also meant that the Indian rupees bought by the Indian exporters (by “selling” USD 200 Billion) would have been far greater than the Indian rupees “sold” by the Indian importers to buy the USD 100 Billion. In other words, the demand for Indian rupees during that period would have been far greater than the supply, hence Indian Rupee would have appreciated with respect to the US Dollar. Because the Indian Rupee would have appreciated with respect to the US Dollar. Indian exporters will not anymore find it attractive to export to the United States, because an ‘appreciating’ Rupee would reduce INR realization for the Indian exporter. To restore the USD – INR exchange rate to the previous or the more acceptable level, the Reserve Bank of India would “intervene” in the foreign exchange markets in India by buying the excess USD 100 Billion from the Indian banks and selling equivalent INR at the prevailing USD - INR exchange rate. As a result, the banks will be required to remit the USD they ‘sold’ to the Reserve Bank of India by © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 debiting their USD account with their correspondent Banks in the United States and transfer it to the Reserve Bank of India’s ‘correspondent bank’ account that it maintains with the Federal Reserve in the United States. In turn, Indian Banks would receive a credit of equivalent INR into their account with the Reserve Bank of India. This action by the Reserve Bank of India to ‘stabilize’ the exchange rate of INR vis-a-vis USD is referred to as ‘sterilization’ which will restore the appreciating INR vis-à-vis USD to a more acceptable level. Remember, this would not in any way deplete the USD foreign exchange reserve, as the USD reserve would simply have move from the USD correspondent bank account of Indian Banks to the Reserve Bank of India’s USD account with the Federal Reserve. In the final analysis therefore, India’s foreign exchange reserves in USD would go up if (and only if): A. Exports to the United States from India is greater than the imports from the United States into India or what we call positive balance of trade. B. More USD remittance into India, from the Indian work force in the United States who wish to send money to their families back in India. C. More cross-border flow of funds from the United States Investors into India, may be because of the perceived high growth potential in India both by the long-term investors in the United States who called foreign direct investments and investors in India’s financial markets were referred to as foreign institutional investors. Over time, the above scenario should collectively result in an ‘appreciating’ INR, vis-a-vis the USD. On the other hand, INR would depreciate if the opposite were true, that means foreign currency outflows from India exceeds the foreign currency inflows into India. It’s probably an interesting question crossing your mind. Why are foreign exchange reserves necessary for any country? Interesting question. Let’s try and crack that. As you might have gathered from our discussion thus far, any economy that is performing well would have high rates of economic growth that means its GDP would be increasing, and if it can compete effectively in the global market, its exports would exceed its imports resulting in a buildup in its foreign exchange reserves. Those actions in turn result in the country’s currency appreciating with respect to other country’s currencies. Such a buildup of foreign exchange reserve would serve as a cushion, for example, if there is a sudden turn of economic circumstances and foreign investors decide to sell their © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 assets in the host country, where they have invested. Realize cash in the host country’s currency (say INR), convert the proceeds into their home currency (say USD) and remit it back to their home country namely the United States. This action would result in a depletion in the foreign exchange reserves in the host country and a consequent relative depreciation of the currency of the host country. In summary, therefore building up Foreign Exchange Reserves in ‘good times’ should serve as a buffer for potential ‘bad times’ for any country! Economic history of several countries around the world over the last few decades tells us that countries with a low or unstable foreign exchange reserve very vulnerable as it could potentially get into a “balance of payment” and or a “currency crisis” that it might not be able to overcome because of inadequate foreign exchange reserves and that country would then need to be bailed out through funding or loans from multilateral institutions such as the International Monetary Fund. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 Balance of Payments (BoP) – I Balance of Payments (BoP for short) is a summary statement of a country’s inflows and outflows in foreign currency for a specific period, say one year. It is essentially a record of cross-border transactions (debits and credits) between any country and the rest of the world. The Central Bank or the Monetary Authority of that country has the responsibility to prepare and publish the country’s Balance of Payments, either in an internationally accepted currency such as USD or in the country’s own currency. To gain a better understanding of this structure of a BoP statement, let’s look at a sample set of transactions that make up the Balance of Payments of a fictitious country called Utopia, which is going to be reported in US dollars. Firstly, let’s look at transactions that result in foreign exchange inflows into Utopia during a particular year: 1. Companies domiciled in Utopia export goods worth USD 100 Million USD to other countries. 2. Foreign investors bought USD 10 Million worth of equity stock of companies listed in Utopia’s stock exchange (commonly referred to as Foreign Portfolio Investment or FPI) 3. Citizens of Utopia, who have invested in the equity stocks of foreign companies received a dividend worth 2 Million USD 4. Companies domiciled in Utopia borrowed USD 50 Million from banks and financial institutions domiciled outside of Utopia. 5. Companies domiciled in other countries invested USD 25 Million in their subsidiaries and joint ventures located in Utopia. Do remember, such investments are long-term in nature, often referred to as Foreign Direct Investment or FDI, for short. 6. The Government of Utopia receives 15 Million Dollars as aid from another Government. 7. Utopian citizens working overseas remit USD 2 Million to their kith and kin back home in Utopia. So far, we looked at transactions that caused foreign exchange inflows during that particular year into Utopia now let’s look at transactions that caused foreign exchange outflows during the same year: 1. Companies domiciled in Utopia, imported goods worth USD 125 Million from other countries. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 2. Utopian investors bought USD 7 Million worth of equity shares of foreign companies listed on stock exchanges around the world. 3. Companies domiciled in Utopia paid a dividend of USD 6 Million to overseas entities who have invested in the equity shares of the Utopian companies. 4. Utopian banks lent USD 22 Million to companies overseas. 5. Companies domiciled in Utopia invested USD 10 Million in their subsidiaries and joint ventures in other countries, in the form of FDI. 6. Government of Utopia provided aid of USD 2 Million to a South Asian country that let us say has suffered from severe drought. And finally, Utopian citizens gifted USD 1 Million to their kith and kin overseas. All the foreign currency inflows and outflows that we discussed are summarized in the table that is on the screen now: As you can see from that table, the net result of the foreign currency inflows and outflows resulting from all the transactions that we saw earlier is a net increase in foreign exchange reserves of USD 31 Million which is (3+28+15+13+1-25-4) which makes at USD 31 Million. Does it effectively mean that the country has a Balance of Payments surplus of USD 31 Million for the year under consideration? Yes, but with some caveats. Let us explore that in detail. The items listed in the table that we just saw does not distinguishing between trade related items i.e., exports and imports and other items that are short term in nature, which is referred to in BoP parlance as ‘Current Account’ and transactions that are long-term in nature referred to in BoP parlance as ‘Capital Account’ or ‘Financial Account’. In order to ensure consistency in the interpretation of the Balance of Payments reported by countries around the world, the International Monetary Fund has provided guidelines on classifying line items in the BoP statement. Let us look at that classification in some detail. First of all, Current Account: This comprises inflows and outflows the foreign currency that are short- term in nature. These are further divided into visible and invisible items. Cross-border trade involving goods i.e., exports and imports of merchandise are referred to as ‘visible’ items. These form a significant component of the Balance of Payments in any country. The net difference between exports and imports is referred to as Balance of Trade or BoT for short. If the value of exports during the period © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 under consideration is greater than the value of imports, which means there is a net inflow of foreign currency, then the Balance of Trade is considered ‘favorable’ and unfavorable if it is vice-versa, i.e., imports exceeds exports. The invisible component of ‘current account’ include: Services, for example, foreign currency needed when the citizens with the country travel overseas or when citizens of other countries travel to that country. Income: In the form of dividends and interest received from foreign entities by individuals and firms in a country arising from their investments overseas or vice-versa, i.e., payable by entities in that country towards dividends and interest on investments in that country by overseas entities. Royalty and IPR – Royalty and fees for Intellectual Property Rights received by entities in the country or similar payments from that country to entities overseas. Repatriation of profits when subsidiaries of foreign companies, say in Utopia remit some or all of their profit after tax to the overseas parent company i.e., an outflow. Similarly, subsidiaries of Utopian companies overseas remit some or all of their Profit After Tax to the Utopian parent company i.e., an inflow. Next category, reflected in the Balance of Payments, goes by the name Transfers, and it refers to gifts by the citizens or the Government of Utopia in our case to overseas citizens or governments which is an outflow and gifts from citizens or governments overseas to the citizens and/or the Government of Utopia which would be an inflow. Similarly, inward remittances by Utopian citizens working overseas would be an inflow and outward remittances by foreign nationals working in Utopia would be an outflow and all of those fall under the category of Transfers. There was a quick classification of items under Current Account. Now, let us look at the Capital Account or the Financial Account. Capital Account or the Financial Account reflects the inflows and outflows of foreign currency that are essentially long-term in nature. Foreign Direct Investment and Foreign Portfolio Investment overseas entities bring in for instance large value funds in foreign currency, to set up and commission manufacturing facilities in Utopia referred to as Foreign Direct Investment or to invest in the equity and bond market in Utopia referred © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 to as Foreign Portfolio Investments. These result in foreign currency inflows in the Capital and Financial Account segment of Utopia’s Balance of Payments. Similarly, FDI and FPI investments overseas by Utopian entities would result in foreign currency outflows. Next item on the Capital Account is Debt: When entities domiciled in Utopia raise long-term loans or issued long-term bonds overseas, it would result in an increase in the foreign currency inflows. Similarly, Utopian entities giving long-term loans or investing in long-term bonds issued by overseas entities would result in foreign currency outflows. Both these, being long-term in nature, would be reflected in Utopia’s Balance of Payments under the Capital Account or Financial Accounts. Based on the classification that we just discussed, we have re-presented the data that we saw in the earlier table, classified as Current Account and Capital Account. As you can see from that table there is a deficit in the Current Account segment, which is made up by a surplus in the Capital Account segment. Incidentally, this scenario Current Account deficit and Capital Account surplus is not too unfamiliar or uncommon in the BoP positions of several countries, including the United States. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan Week 2 Balance of Payments (BoP) – II The BoP of a country has a significant impact and, in turn, is also impacted by several macroeconomic variables in that country. Let us look at those interactions at some length. First, the relationship between BoP and GDP, which is the Gross Domestic Product. This relationship is best represented by a fairly simple equation GDP = CS + IS + GS + (EX – IM) Where CS denotes consumption spending; IS denotes Investment spending; GS denotes Government spending; EX denotes value of export of goods and services, and IM denotes value of import of goods and services. REMEMBER, (EX – IM) denotes the balance on the current account in the BoP. It would be obvious from that equation that a current account surplus (i.e., EX > IM) improves the GDP and a current account deficit decreases the GDP. There could be other manifestations as well. For instance, the ability of firms in a country to source goods at a lower cost from another country could result in an increase in its imports (IM) and if exports (EX) remain constant, the impact on the GDP could be adverse. However, that could be offset, to an extent for instance, if the sourcing from overseas is backed by ‘export’ of intellectual property (royalty and fees), export of components, etc. Now, let us look at the relationship between BoP and Exchange Rate. This is again represented by a fairly simple equation BoP = (EX-IM) + (CI-CO) + FXR Where BoP denotes, as we already know, Balance of Payment; EX denotes value of export of goods and services; IM denotes value of import of goods and services; CI denotes capital and financial inflows; CO denotes capital and financial outflows and FXR denotes the net monetary reserve such as gold and foreign exchange. If a country is pursuing what is popularly referred to as a fixed exchange rate system, which means the exchange rate will not be allowed to vary on its own. The government of that country therefore has the responsibility to ensure that the BoP is close to zero, i.e., the current account and capital account balances taken together should be very close to zero. If EX is greater than IM, that means exports is greater than imports the demand for domestic currency will increase, since exporters from the country will want to convert their realization in foreign currency to domestic currency. That would inevitably result in an appreciation of the domestic currency vis-à-vis the currencies of countries with whom that country has a trading relationship. As a net result, not only would the currency of the country appreciate, but FXR which is a foreign exchange reserve would also go up. © All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.  Foreign Exchange Markets: Instruments, Risks and Derivatives Prof. P C Narayan