This presentation is a comprehensive presentation of Forex Market. It starts with the history of this market from Pre Gold period, Bretton wood till current floating exchange mechanism and in Indian perspective FERA and FEMA. It then gives you an idea on size, width and extent of this market and post that it covers forex exchange, quotes, and numerical. Finally, it covers few topics like Trade Finance, LIBOR, Balance of Payment & Currency Swaps

1. Forex Market –
a Perspective
ABHIJEET V DESHMUKH
WWW.ABHIJEETDESHMUKH.COM

2. Historical events Forex Market
Pre-Gold Standard System
Countries would commonly use gold and silver as method of international payment. But, the
value of these metals is greatly affected by global supply and demand. For example, the
discovery of a new gold mine would drive gold prices down.
Gold Standard System
This was established in 1875. The basic idea behind the gold standard was that governments
guaranteed the conversion of currency into a specific amount of gold, and vice versa. All of
the major economic countries had pegged an amount of currency to an ounce of gold. Over
time, the difference in price of an ounce of gold between two currencies became the
exchange rate for those two currencies. It was the first official means of currency exchange in
history. But, eventually broke down during the beginning of World War I & later again at the
onset of of World War II. However, gold never stopped being the ultimate form of monetary
value.

3. Historical events Forex Market
Bretton Woods System
Before the end of World War II, the Allied nations felt the need to set up a monetary system as a
replacement of Gold System. In July 1944, more than 700 representatives from the Allies met
in Bretton Woods, New Hampshire.
To simplify, Bretton Woods led to the formation of the following:
 A method of fixed exchange rates;
 The U.S. dollar replacing the gold standard to become a primary reserve currency; and
 The creation of three international agencies to oversee economic activity: the International
Monetary Fund (IMF), International Bank for Reconstruction and Development (now part of the
World Bank), and the General Agreement on Tariffs and Trade (GATT) (which led to the World
Trade Organization WTO).
Furthermore, the U.S. dollar became the only currency in the world that would be backed by gold.
Over the next 25 or so years, the system ran into a number of problems. By the early 1970s, U.S. gold
reserves were so low that the U.S. Treasury did not have enough gold to cover all the U.S. dollars
that foreign central banks had in reserve.
Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, essentially
refusing to exchange U.S. dollars for gold. This event marked the end of Bretton Woods.

4. Historical events Forex Market
Current Exchange Rates
After the Bretton Woods system broke down, the world finally adopted the use of floating
foreign exchange rates during the Jamaica agreement of 1976. Most governments today use
one of the following three exchange rate systems:
 Dollarization : Dollarization occurs when a country decides not to issue its own currency and
uses a foreign currency as its national currency. Upside is that the country is more stable
place for investment, the downside is that the country's central bank can no longer print
money or control the country's monetary policy
 Pegged Rate : Pegging is when one country directly fixes its exchange rate to a foreign
currency so that the country will have somewhat more stability than a normal float. The
currency will only fluctuate when the pegged currencies change. For example, China pegged
its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997 and July 21, 2005.
 Managed floating rate : This type of system is created when a currency's exchange rate is
allowed to freely fluctuate subject to supply and demand. However, the government or
central bank may intervene to stabilize extreme fluctuations in exchange rates.

5. Indian Forex Market Events
 Traditionally Indian forex market has been a highly regulated one. Till about 1992-93,
government exercised absolute control on the exchange rate, export-import policy, FDI
(Foreign Direct Investment) policy via The Foreign Exchange Regulation Act (FERA)
enacted in 1973.
 Post economic liberalization in 1993 FERA was on the verge of becoming redundant as it
did not succeed in restricting activities such as the expansion of transnational
corporations (TNCs). After the amendment of FERA in 1993, it was decided that the act
would become the FEMA.
 The Foreign Exchange Management Act (FEMA) It is an Act of the Parliament of
India which was It was passed in the winter session of Parliament in 1999
"to consolidate and amend the law relating to foreign exchange with the objective of
facilitating external trade and payments and for promoting the orderly development and
maintenance of foreign exchange market in India".
 FEMA is a regulatory mechanism that enables the Reserve Bank of India and the Central
Government to pass regulations and rules relating to foreign exchange in tune with the
Foreign Trade policy of India.

6. FERA vs FEMA
Point FERA FEMA
Emphasis On regulation of foreign exchange On management of foreign exchange
Situation Foreign exchange reserves positions was
not satisfactory for that stringent controls
were required on the use of foreign
exchange
With the improvement in foreign exchange
reserves such stringent controls are not
required now.
Permission Need to take permission of RBI in
connection with remittances involving
external trade
No need for seeking the permission of RBI in
connection with remittances involving external
trade except section3 relates to dealing in
foreign exchange
Restrictions These restrictions on drawals of foreign
exchange for the purpose current account
transactions
Section 5, it removes all the restrictions on
withdrawal's of foreign exchange for the
purposes of current account transactions
Violations of
Rules
Violations of FERA was treated as criminal
offence and burden of proof was on the
guilty
Violations of FEMA treated as civil offence
removes the threat of imprisonment compared
their illegal acts by paying a fine (not too high)

7. Definitions
 Financial market is a place where Resources/funds are transferred from those having
surplus/excess to those having a deficit/shortage. Forex Market is the market where the
commodity traded is Currencies
 As per THE FOREIGN EXCHANGE MANAGEMENT ACT, 1999, Section 2
(m) "foreign currency" means any currency other than Indian currency;
(n) "foreign exchange" means foreign currency and includes,- (i) deposits, credits and
balances payable in any foreign currency,(ii) drafts, travelers cheques, letters of credit or bills of
exchange, expressed or drawn in Indian currency but payable in any foreign currency, (iii) drafts,
travelers cheques, letters of credit or bills of exchange drawn by banks, institutions or persons
outside India, but payable in Indian currency;
 Exchange Rate is the price of one country's currency expressed in another country's currency. In
other words, the rate at which one currency can be exchanged for another.
 Any financial transaction that involves more than one currency is a foreign exchange transaction.
Most important characteristic of a foreign exchange transaction is that it involves Foreign
Exchange Risk.

8. Forex Market – Salient Features
 The Forex market is the largest and most liquid market in the world.
 The US dollar makes up the majority of Forex transactions
 The Forex market’s deep liquidity is advantageous to traders by allowing them to enter
and exit the market instantaneously
 According to the Bank for International Settlements, foreign-exchange trading increased
to an average of $5.3 trillion a day. To put this into perspective, this averages out to be
$220 billion per hour.
 The foreign exchange market is largely made up of institutional investors, corporations,
governments, banks, as well as currency speculators
 Roughly 90% of this volume is generated by currency speculators capitalizing on intraday
price movements.
 In sum, the Forex market size and depth make it the ideal trading market. This liquidity
makes it easy for traders to sell and buy currencies. This is why traders from all different
asset classes are turning to the Forex market.

9. Forex Market - 24 * 7 Market
Unlike the stock and futures
market that are housed in
central physical exchanges,
Forex Market is OTC market
i.e. decentralized market
completely housed
electronically. There is no
physical location where traders
get together to exchange
currencies. Rather traders are
located in the offices of major
commercial banks around the
world and communicate using
Reuters / computer terminals,
telephones, telexes, and other
information channels working
24 * 7.

10. Forex Market - Volume
In the diagram above, it
can be easily seen how
the FX market’s $5.3
trillion per day in trading
volume dwarfs the
equities and futures
markets.
In fact, it would take
thirty days of trading on
the New York stock
exchange to equal one
day of Forex trading!
Indian Stock market daily
volume is $ 2.35 Billion.

11. Forex Market – Top Currencies
Source: https://www4.dailyfx.com
As the most traded currency, the US
dollar makes up 85% of Forex
trading volume. At nearly 40% of
trading volume, the euro is ahead of
the third place Japanese yen that
takes almost 20%.
With volume concentrated mainly in
the US Dollar, Euro and Yen, Forex
traders can focus their attention on
just a handful of major pairs. In
addition, the greater liquidity found
in the Forex market is conducive to
long, well-defined trends that
respond well to technical analysis
and charting methods.

12. Forex Exchange Rate & Quote
 An exchange rate thus has two components, the domestic currency and a foreign currency.
It is generally expressed to four decimal, except for Japanese yen, which are quoted to two
decimal.
 In the forex market rates are always quoted ‘two way’. Two way quote gives both ‘Bid’ and
‘Offer’
e.g. USD/INR = 66.1500/1600
Buy One USD at 66.1500
Sell One USD at 66.1600
Spread (in Pip) 0.0100
 ‘Big Figure’: Term referring to the first digits of an exchange rate. These figures are rarely
change in normal market fluctuations and are usually omitted in dealer quotes. ‘Pips (or
Point): The smallest incremental move an exchange rate can make. Thus Pip/Point is a
measure of Spread
e.g. USD/INR = 66.15/16 ( A trader will quote 15/16 during a deal)
Here the Big Figure is ’66’ & smallest change in value is Pips / Point is 1

13. Forex - Indirect & Direct; Base & Quote
Exchange Rate can be quoted either directly or indirectly.
 In a direct quotation, the price of a unit of foreign currency is expressed in terms of the
domestic currency. Thus, the foreign currency is the base currency and the domestic
currency is the Quote/Counter/Dealt currency
e.g. USD/INR 1 USD = 66.1500/1600
 In an indirect quotation, the price of a unit of domestic currency is expressed in terms of
the foreign currency. Also, here the domestic currency is the base currency and the foreign
currency is the Quote/Counter/Dealt currency. This is an indirect quotation of the INR in
India.
e.g. INR/USD 1 INR =00.0151/07
 Whichever currency is quoted first (the base currency) is always the one in which the
transaction is being conducted. You either buy or sell the base currency.
 When a currency quote is given without the INR as one of its components, India, this is
called a cross currency. The most common cross currency pairs are the USD/EUR EUR/GBP,
EUR/CHF &EUR/JPY in India


15. Forex Forward Rate
 The spread on a forward currency quotation is calculated in the same manner as the spread
for a spot currency quotation.
 The unique factor associated with spreads for forward foreign currency quotations is that
spreads will widen as the length of time until settlement increases.
 Currency exchange rates would be expected to have a higher range of fluctuations over
longer periods of time, which increases dealer risk. Also, as time increases, fewer dealers are
willing to provide quotes, which will also tend to increase the spread.
 Forward currency exchange rates often differ from the spot exchange rate.
 If the forward exchange rate for a currency is higher than the spot rate, there is a premium
on that currency.
 A discount exists when the forward exchange rate is lower than the spot rate. A negative
premium is equivalent to a discount.

16. Forex Forward Rate
 Example: Forward Discount Premium
If 3 month ¥ / $ forward exchange rate is 109.50 and the spot rate is ¥ / $ = 109.38, then The
dollar is considered to be "strong" relative to the yen, as the dollar's forward value exceeds the
spot value. The dollar has a premium of 0.12 yen per dollar. The yen would trade at a discount
because its forward value in terms of dollars is less than its spot rate.
 The annualized rate can be calculated by using the following formula:
Annualized Forward Premium = Forward Price - Spot Price x 12 x 100%
Spot Price # of months
So in the case listed above, the premium would be calculated as:
 Annualized forward premium=
((109.50 - 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%
 Similarly, to calculate the discount for the Japanese yen, we first want to calculate the forward
and spot rates for the Japanese yen in terms of dollars per yen. Those numbers would be
(1/109.50 = 0.0091324) and (1/109.38 = 0.0091424), respectively.
 Annualized forward discount for the Japanese yen, in terms of U.S. dollars, would be:
((0.0091324 - 0.0091424) ÷ 0.0091424) × (12 ÷ 3) × 100% = -0.44%

17. Forex Rate – Interest Rate Parity
 Interest rate parity enforces an essential link between spot exchange currency rates, forward currency
exchange rates and short-term interest.
 It specifies a relationship that must exist between the spot interest rates of two different currencies if
no arbitrage opportunities are to exist.
 To prevent a risk-free arbitrage from occurring , the forward discount rate would have to equal the
difference in interest rates.
 Also note that, if the discount forward rate is greater than the interest rate differential, the arbitrage
will be made in the other direction.
 The relationship depends on the spot and forward exchange rates between the two currencies.
(Forward rate - Spot rate) ÷ Spot rate = (rfc - rdc) ÷ (1 + rdc)
or (F - S) ÷ S = (rfc - rdc) ÷ (1 + rdc)
Where rdc is the risk-free interest rate of the domestic currency, rfc is the risk-free interest rate of the foreign
currency and the exchange rates quoted are indirect quotes expressed as the number of units of the foreign
currency used to obtain one unit of the domestic currency.
 The interest rate parity relationship can also be expressed as:
F × (1+ rdc) = S × (1 + rfc)

18. Forex Rate – Interest Rate Parity
 Example:
Assume the following data for the euro (€) and the U.S. dollar ($):
One-year forward exchange rate €/$ = 0.909; Spot exchange rate € /$ = 0.901;
One-year interest rate, euro 7% & One-year interest rate, dollar 5%
[GAIN] A speculator in US could borrow dollars at 5%, convert them into euros and
invest the euros at 7% for a year. The speculator would be making a profit of 2%.
[RISK] However, at the end of the time period, euros will need to be converted to dollars so
that the initial borrowing can be repaid. The speculator runs the risk that dollars may have
depreciated relative to the euro during that time period.
[HEDGE] The speculator's position can potentially be made into a risk-free one by
purchasing a forward exchange contract Over one year, the speculator would experience
the following exchange rate loss: Annualized forward discount for the euro (€)
(1.10011 - 1.10987 ) / 1.10987 * 12 / 12 * 100 = -0.9%
[ACTUAL GAIN] Because of the 2% interest rate differential, the speculator makes a net
profit of 1.1% for each dollar borrowed.

19. Currency Swaps
 Currency swaps are over the counter derivatives that serve two main purposes.
 First, it can be used to minimize foreign borrowing costs.
 Second, they could be used as tools to hedge exposure to exchange rate risk.
 Currency swaps are an essential financial instrument utilized by banks, multinational
corporations and institutional investors.
 A currency swap involves two parties that exchange a notional principal with one another in
order to gain exposure to a desired currency.
 Following the initial notional exchange, periodic cash flows are exchanged in the
appropriate currency.
 Corporations with international exposure will often utilize these instruments for the former
purpose while institutional investors will typically implement currency swaps as part of a
comprehensive hedging strategy.

20. Currency Swaps - Example

21.  An Appreciation of a
country’s currency makes
its goods more expensive
for foreigners, and makes
foreigners’ goods less
expensive for the country’s
residents.
 An Depreciation of a
country’s currency lowers
the relative price of
domestic goods and raises
the relative price of foreign
goods
Trade Finance

22. LIBOR
 LIBOR (or ICE LIBOR) is the world’s most widely-used benchmark for short-term interest
rates.
 LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s
leading banks charge each other for short-term loans.
 LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five
currencies: U.S. dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss
franc (CHF), and serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12
months.
 There are a total of 35 different LIBOR rates each business day. The most commonly quoted
rate is the three-month U.S. dollar rate.
 LIBOR or ICE LIBOR's primary function is to serve as the benchmark reference rate for debt
instruments, including government and corporate bonds, mortgages, student loans, credit
cards; as well as derivatives such as currency and interest swaps, among many other financial
products.

23. LIBOR

24. Balance of Payment
 The balance of payments measures all financial flows that cross a country's border during a
given period of time, typically a quarter or a year.
 It renders an account of all payments and liabilities to foreigners, and all payments and
obligations received from foreigners.
 For example, when a Indian company sells a product overseas, that export creates a
financial inflow to India, while an Indian citizen purchasing an imported item creates a
negative financial inflow (an outflow).
 By definition, the sum of all the components of the balance of payments must be equal to
zero.
 Balance-of-payments accounts, there are three major types of accounts:
 The Current Account;
 The Capital Account;
 The Official Reserve Account

25. Balance of Payment
The Current Account - This type of account records transactions with foreign countries for all
current transactions that take place as part of normal business. The current account is
specifically made up of:
 Imports and exports (the trade balance or balance of merchandise trade)
 Services, such as accounting and insurance
 Factor payments, such as interest and dividends paid
 Current transfers such as gifts, which do not have an associated exchange factor
The Capital Account - this account covers changes in ownership of financial and real
investments. Parts of this account include:
 Net foreign purchases of long-term domestic assets, such as bonds, stock, real estate
and other business assets, netted against similar purchases of foreign assets made by
the country's citizens

26. Balance of Payment
The Capital Account…..
 Private transfers of financial assets such as cash and other forms of payments made by
domestic entities to foreigners in order to settle balances owed to the foreigners, netted
with similar transfers of financial assets from foreigner to domestic entities.
The Official Reserve Account - This account keeps track of all transactions made by
monetary authorities. The sum of the current and Capital accounts, which is called
the overall balance, should be equal to zero. The central bank can use some of its reserves
when the overall balance is negative. If the overall balance is positive, the central bank can
choose to add to its reserves.

27. Thank You