TFM Session Five FX Management
TFM Session Five FX Management
TFM Session Five FX Management
Szabist Islamabad
By Muhammad Ahmed Khan
Scope of FX Management
Mutual interdependence of countries around the world needs an efficient cross-currency settlement mechanism. Global trade integration underscores the important of smooth international trade regime. Development of international trade owes a lot to free movement of funds from one financial centre to another. However benefits of trade and swift FX movement also bring to fore country, political and exchange rate risks.
Scope of FX Management
USD
SGD/ AUD/ CAD /AED
EUR
Commonly traded Currncies
SFR
GBP
JPY
A currency can be sold or bought in one transaction. Trading is done in pairs of currencies where the currency bought (Top) is mentioned first followed by sold (Bottom) currency. Trading carried out either on Spot or Forward basis.
Scope of FX Management
Typical FX Inflows and Outflows for a country Inflows:
Workers emigrants send foreign exchange back home for family maintenance or savings. Inwards remittances. Receipts of proceeds against exports made. Unfinished goods imported into the country for value addition and re-export at a premium. Receipts from international donors as loan, grants, etc. Foreign investment into the country.
Outflows:
Issuance of foreign currency for personal or business travel to foreign countries. Purchase of foreign books; magazines; or subscriptions to foreign technical, educational & professional bodies Payments for imports into the country Payment of loans with interest to international donors Payment of royalties and dividend. Private Remittances.
Retail Market
Spot Market
Interbank Market
FX Rates
Price of one currency in terms of another.
Rate of USD/ PKR: 99.50 mean that one unit of US Dollar costs PKR: 99.50. Question: What would be the impact if the rate moves to: i. 99.60 ii. 99.40 Why all currencies in the world are not traded against each other? Book keeping and reconciliation issues. Exchange rate complexities and their volatility. Problems in Payment and settlement mechanism
FX Rates
Determinants of Foreign Exchange Rates.
Basic economic and fiscal policies of the host government with regard to: o Fiscal and monitory policy. o Inflation. o Trade policies o Balance of payment position. Countries with a consistently lower inflation rate exhibit a rising currency value, as their purchasing power increases relative to other currencies. Other things remaining same, sound economic policies result in stronger currencies. Political and psychological factors- e.G., US dollar is a safe heaven.
FX Rates
Technical Factors:
Capital movement
Relative inflation rates Exchange rate policy.- Free float or managed Interest rates - By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values.
FX Rates
Exchange Rate Quotations- Direct And Indirect
In a currency pair, the first currency in the pair is called the Base currency and the second the quote or counter currency.
Direct quote:
The domestic currency is the base currency, while the foreign currency is the quote currency. e.g., EUR 0.7210 = USD 1.00 (in the Euro zone).
Direct quotes formula is used by most countries. For a USA dealer the above direct quote would read as USD/EUR: 1.3869 ( $ 1.00 /0.7210)
FX Rates
Indirect quotes:
Just the opposite of a Direct quote. Here: Foreign currency is the base currency. Domestic currency the quote currency. For a dealer in USA, the EUR/USD quote is an indirect one. Indirect quote of 0.7210 EUR/USD means that it takes 0.7210 euros to purchase US$1.00 It is used in UK, Australia, New Zealand & Canada. General Rules. All cross-currency rates contain four decimal points, e.g., USD/ GBP rate would appear as 1.5729. For deals involving JPY, rate will contain two decimal points, e.g., USD/ JPY : 114.14 Spreads in pricing are quoted in pip, i.e., counted from fourth decimal place.
FX Rates
Bid Price:
Rate at which a market maker is ready to buy a unit of currency A, against currency B, or vice versa. It reflects what the trader of currency A will receive for sale (shortening) of a position.
Ask Price:
Rate at which a market player is ready to sell a unit of currency A, against currency B or vice-versa.
FX Rates
Example: Base currency: USD Quote currency: GBP Deal amount: GBP: 100 Bid : 100 x 1.5726 = USD :157.26 Ask: 100 x 1.5729 = USD :157.29 Here a trader pays $ 1.5726 for one GBP bought and receives $ 1.5729 for each unit of GBP sold. Percentage Spread = Ask Bid x100 Ask
FX Rates
Cross Rate
Exchange rate for a currency that is based on exchange rate of two other currencies.
Direct Ask
Indirect Bid
Indirect Ask
GBP
EUR
1.9712
1.4739
1.9717
1.4744
0.5072
0.6783
0.5073
0.6785
Example A.
A bank customer wants to sell 1,000 for EURO. The Bank will sell $ (to buy ) @ $1.9712. The sale yields Bank Customer: 1,000 x 1.9712 = $1,972. The Bank will buy $ (and sell EURO) @ 0.6783. The sale of $ yields Bank Customer: $1,972 x 0.6783 = :1,337. Bank Customer has effectively sold British pounds at / bid price of 1,337/1,000 = 1.3371/1.00.
EUR
1.4739
1.4744
0.6783
0.6785
Example B
A bank customer wants to sell 1,000 for GBP. The Bank will sell $ (to buy ) @ 0.6785. The sale yields Bank Customer: 1,000 .6785 = $1,474. The Bank will buy $ (to sell ) @ $1.9717. The sale of $ yields Bank Customer: $1,474 1.9717 = 747. Here the customer has effectively bought GBP at a / ask price of 1,000,000/747,497 = 1.3378/1.00. Currency against currency bid-ask spread for GBP is 1.3371- 1.3378.
FX Rates
Forward Rate:
A quotation used in forward market to deliver one currency in future against another currency based on the exchange rate determined at the time of conclusion of contract. Delivery is made according to the choice of the customer, e.G., 1,3,6,9 and 12 months. Depending on market trends and future outlook, forward rate may be higher or lower that the spot rate. If forward rate is higher than the spot rate then currency is said to be trading at a premium and vice-versa. Calculation of premium or discount percentage: = (Forward rate- Spot rate) x 12 x100 Spot rate n (Where n is the number of months till maturity)
A currency pegged to a basket of currencies Flexibility limited in terms of a single currency Independent / free float. Managed / Dirty float
Types of Risk: Transaction Exposure: The risk that the domestic cost or
proceeds of a transaction may change, i.e., Rate, Credit or liquidity risk, etc.
contd
Long Position:
A situation where a quote currency is purchased at a price with a motive to sell it afterwards at a profit. Also referred as the notion of Buy low sell high.
contd
Swap Positions Or Mismatched Maturities By definition, a swap involves a simultaneous buy and sale of currency for two different maturities. A swap transaction does not affect the net exchange position. contd
Currency Derivatives
Swap transaction
Currency swap
It enables a company to utilize funds held in one currency towards meeting obligations denominated in another currency, without incurring foreign exchange risk. It is an effective and efficient Cash Management tool for companies that have assets and liabilities denominated in different currencies. contd
Interest rates for the two currencies are not reflected in the two exchanges but are paid separately.
contd
Example
i.
Foreign Currency (FX) options are contracts that give the buyer the right, but not the obligation, to buy or sell one currency against another, at a pre-determined price and on or before a pre-determined date.
Buyer of a call (put) FX option has the right to buy (sell) a currency against another at a specified rate. If this right can only be exercised on a specific date, then the option is said to be European, whereas if the option can be exercised on any date prior to its maturity, the option is said to be American. Maximum tenor of the option may not exceed one year.
contd
Financial Derivatives:
Forward Rate Agreement
A Forward Rate Agreement (FRA) is: An interest rate contract between two parties. It allows an entity to position itself in the interest rate market. Economically. FRA is similar to forward borrowing or lending transactions, however, in case of FRA, the actual lending / borrowing does not take place. contd
Financial Derivatives:
Forward Rate Agreement
The parties enter into a contract at a rate for a Notional Principal amount. On settlement date, the transactions are Net Settled against a pre-determined Benchmark or Reference rate. The party incurring a negative interest rate differential under the transaction settles this by paying the counter-party the difference amount. FRAs are off-balance sheet transactions. contd
Financial Derivatives:
Forward Rate Agreement
The payment of the interest differential is usually settled "upfront", i.e. on settlement date, with the interest differential "discounted back" to the present value. This discount is calculated by using the settlement interest rate. The party quoting the future rate agreement is called the "quoter" and the party receiving the quote is called the "receiver".
contd
Financial Derivatives:
Forward Rate Agreement
The party quoting the future rate agreement is called the "quoter" and the party receiving the quote is called the "receiver". Either party can be called the "seller/ lender" or the "buyer/ borrower". Dealing in FRA is permitted in Pak Rupee only, and while there is no restriction on the minimum tenor, the maximum tenor of the FRA is restricted to twenty four months.
It is a financial contract between two parties exchanging or swapping a stream of interest payments for a `notional principal amount on multiple occasions during a specified period. The principal amount is the same for both sides and not actually exchanged. On each payment date during the swap period, the cash payments, based on the difference in fixed/ floating or floating / floating rates, are exchanged by the parties with one another. The party incurring a negative interest rate differential for that leg pays the other counter-party. Contd
A company typically uses interest rate swap to: Limit or manage its exposure to fluctuations in interest rates. To obtain a marginally lower interest rate than it would have been able to get. While there is no restriction on the minimum or maximum size of notional principal amounts of interest rate swap or tenor, the maximum tenor of the interest rate swap is restricted to 5 years.
Based on the information set used by the forecaster, there are two pure approaches to forecasting foreign exchange rates. Two Approaches for Exch Rate Forecasting:
Fundamental & Technical.
A trading signal can be generated every time there is a significant difference between the model-based expected or forecasted exchange rate and the exchange rate observed in the market.
If the forecaster is happy with the model, he/ she will move to the next step, the generation of forecasts. The final step is the evaluation of the forecast.
Mechanics of FX Trading
On a normal business day:
Trading is done in Retail Market and wholesale market. Dealings are via electronic platforms, SWIFT or telephone. In wholesale dealing pricing for currency pair is quoted as a two way quote, i.e., pricing to buy and sell. If agreeable, deal is concluded and settlement details exchanged. For payment / Receipts communication is channel is SWIFT .
Short position is covered through purchase of the currency & Long position by sale of the currency.
Potential gain or loss from positions depends on the size of position and exchange rate at which transactions are concluded.
In simple words language it means that CAC allows anyone to freely move from local currency into foreign currency and back. Since value of the currencies is established in comparison to each other, the ready trade of currencies potentially offers investors an opportunity for profit.
it means that CAC allows anyone to freely move from local currency into foreign currency and back.
Since value of the currencies is established in comparison to each other, the ready trade of currencies potentially offers investors an opportunity for profit.
In January 1982, an exchange rate regime of managed float was adopted which was based on a basket of currencies.
In 1991, with the onset of financial sector reforms, a liberalized exchange regime was introduced with the objective of achieving current account convertibility of the Pak Rupee, which was realized in 1993. The reform process was finally completed in 2000-2001.
Contd
In Sept, 1949, the decision was taken not to devalue the Rupee in spite of the fact that the current account deficit in 1948-49 was around 2.5% of the countrys GDP.
Fortuitously, the Korean War helped Pakistan to come out of this deficit and in 1950-51 and Pakistan witnessed a surplus in its current account. However, with the end of the Korean War in the latter half of 1953, the tide was reversed and the country was again drowned in the quagmire of current account deficit.
Contd
Positives Developments
During the 10 years the countrys foreign exchange market has Exhibited a degree of maturity. Following SBP sponsored market reforms , close monitoring and occasional market interventions by SBP has reduced the instances of market jitters.