Forex in brief – Spot and Forward

Foreign Exchange
I want to go on vacation to London and I need GBP. So I go to the bank and I change my INR into GBP.
A foreign exchange transaction is a contract to exchange funds in one currency for funds in another currency at an agreed rate, and on a agreed date. The agreed rate is the exchange rate, or the price of one currency in terms of the other.
What is a Forex?
A foreign exchange transaction or forex deal exchanges the currency of one country for that of another. It also refers to the actual instruments employed, such as currency, notes, checks and bills of exchange.
Why Forex?
There are several reasons when a forex is used:
· Speculative dealing on mutual currency exchange movements
· International trade
· Repayments on foreign borrowings
· Stabilising domestic currency
The central bank manipulates the economy’s money supply in order to influence the level of economic activity (monetary policy).
When Forex?
Corporate users of the forex markets are normally concerned with covering or “hedging” their foreign currency payables or receivables. However, the great bulk of forex operations is not directly related to international trade or debt rollovers. Most forex deals (about 90 percent) are speculative transactions on behalf of banks. The large profits available through even minor exchange movements are highly attractive.
XYZ BANK acts as intermediary party for its customers and purchases foreign exchange itself. In this XYZ BANK is a market maker in Euro. Besides XYZ BANK hedges its positions in FX options and forwards by buying foreign currency.
Forex types :
Forex spot
A forex spot is a transaction executed at a price agreed today, where one currency is used to buy another currency with settlement in two business days. Another way of expressing this transaction is to see is as a single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) within two business days.
FX refers to Foreign exchange and ‘spot’ refers to the fact that settlement is due two business days after the deal is made. In contrast a Forex forward transaction is settled in more than two days after the conclusion of the transaction.
When a company wants to buy dollars, it turns to its bank and the bank takes care of the transaction done at the foreign exchange market. Banks also turn to the foreign exchange market when they hedge their positions resulting from options trading or forward trading.
Quoting exchange rates
In the spot market, a variable number of units of one currency is quoted per one unit of another currency. The convention is that, e.g. the US dollar/Canadian dollar exchange rate is written as USD/CAD if it refers to the number of Canadian dollars equal to one US dollar. The other way around CAD/USD is used if it refers to the number of US dollars to equal one Canadian dollar. The currency code writ­ten on the left is called the “base” currency. The currency code written on the right is known as the “variable” currency (“counter” or “quoted” currency).
When quoting against the US dollar, it is the common to quote currencies in terms of a vary­ing number of units of currency per one US dollar. This is known as an “indirect” or “European” quotation against the dollar. Rates quoted the other way round are known as “direct” quotations against the dollar.
There are some currencies which are conventionally quoted against the USD “direct” rather than “indirect.” The major ones are sterling, Australian dollar, New Zealand dollar, Irish pound and ECU (European currency unit -to be replaced by the proposed Euro). The direct quotation for the Canadian dollar is known as “Canada cross” and the indirect quotation “Canada funds”. In the currency futures markets, as opposed to the interbank market, all quotations against the US dollar are direct.
As in other markets, a bank normally quotes a two-way price, indicating at what level it buys the base currency for the variable currency (the “bid” for the base currency – a cheaper rate), and at what level it will sell the base currency against the variable cur­rency (the “offer” of the base currency – a more expensive rate). For example, if a bank is prepared to buy dollars for EUR 0.8843, and sell dollars for EUR 0.8852, the USD/EUR rate is quoted: 0.8843/0.8852
The quoting bank buys the base currency (in this case, dollars) on the left and sells the base currency on the right. If the bank quotes such a rate to a company or other counterparty, the counterparty would sell the base cur­rency on the left, and buy the base currency on the right – the opposite of how the bank sees the deal.
In the money market, the order of quotation is not important and it does differ between markets. From a quotation of either 5.80%/5.85% or 5.85%/5.80%, it is always clear to the customer that the higher rate is the offered rate and the lower rate is the bid rate. In foreign exchange, however, the market-maker’s bid for the base currency (the lower number in a spot price) is always on the left. This is particularly important in forward prices. The difference between the two sides of the quotation is known as the “spread.”
As the first three digits of the exchange rate (the “big figure”) do not change in the short term, dealers generally do not mention them when deal­ing in the interbank market. In the example above (0.8843/0.8852), the quotation would therefore be given as simply 43/52. However, when dealers are quoting a rate to a corporate client they will often mention the big figure also. In this case, the quotation would be 0.8843/52.
What factors influence exchange rates?
Government policy :
The current and the expected mix of monetary (interest rates) and fiscal (taxation) policy has a powerful effect on the exchange rate. If the government announces a policy change that no one has anticipated, the exchange rate can move very sharply.
Domestic growth :
Strong domestic growth tends to cause a currency to appreciate in the short term. Robust domestic growth raises expectations of higher inflation, and people start expecting that higher interest rates (tighter money) will be necessary at a later stage. A sluggish economy will often have a depreciating influence on the exchange rate.
Over the longer term, strong growth can have the opposite effect on the exchange rate. Economies which are growing rapidly relative to the rest of the world tend to build up deficits on the current account. This exerts downward pressure on the currency at some point. Slow growth economies build up surpluses, and their currencies tend to appreciate over the long term.
Main factors influencing the exchange rate in the long term are:
Relative inflation performance :
A country with persistently higher inflation than its major trading partners will eventually have a depreciating exchange rate (or will be forced to devaluate under a fixed-rate system). Low inflation countries will have an appreciating or ‘hard’ currency.
Government budget deficits and surpluses :
Countries that run persistent budget deficits have to rely on foreign funds to help finance the deficit if domestic savings are not enough. This will put downward pressure on the domestic currency over time.
Random shocks in the economy :
Unexpected disturbances in the world economy can have a substantial impact on exchange rates. Unexpected and therefore inherently unpredictable events will have the biggest impact on exchange rates.
Speculation :
Speculators actually play a very important role in the foreign exchange markets by providing liquidity to facilitate and smooth the conducting of commercial business. Speculators take a currency position hoping to gain from a sudden rise or fall in the currency concerned.
A spot deal is valued at the price paid for the deal. The price paid is the exchange rate. The exchange rate is determined by the market.
The balance-of-payments situation of a country seems to be the most direct determinant for the external value of its currency. Demand for a currency arises from export of goods and services and from capital inflows (or imports). In turn, a currency is offered in payment for imported goods and services and because of capital outflows (or exports). A surplus on the overall balance-of-payments means a net demand for a currency; creating upward pressure. Since items on the current account of the balance-of-payments are of an irreversible nature, it makes sense to judge the ‘fundamental’ position of a currency according to the country’s current account position. Capital flows, on the other hand, are of a reversible nature. E.g. borrowing abroad creates a temporary demand for the currency when the conversion takes place. The repayments will lead to a corresponding weakening of the currency. While economic factors are of decisive importance for determining exchange rates, certainly in the longer run, non-economic factors too may have an influence. These factors can be political and/or psychological or regulations by central banks etc.
Suppose, the USD/EUR rate is quoted: 0.8843/0.8852 and XYZ BANK concludes two deals.
Deal 1: XYZ BANK buys USD 1,000,000 against EUR 0.8843
Deal 2: XYZ BANK sells USD 1,000,000 against EUR 0.8852
Cash-flow analysis
Deal 1
Inflow USD 1,000,000
Outflow EUR 884,300
Deal 2
Inflow EUR 885,200
Outflow USD 1,000,000
Net result
EUR 900
Now, suppose that a dealer needs to quote to a counterparty a spot rate between the Deutschemark and the Ringgit. XYZ BANK does not have a EUR/MYR trad­ing book. The rate must therefore be constructed from the prices quoted by the bank’s USD/EUR dealer and our bank’s USD/MYR dealer as follows: Spot USD/EUR: 0.8843/0.8852 Spot USD/MYR: 2.4782/2.4792
Consider first the left side of the final EUR/MYR price we are constructing. This is the price at which our bank will buy EUR (the base currency) and sell MYR. We must therefore ask: at which price (0.8843/0.8852) does our USD/EUR dealer buy EUR against USD, and at which price (2.4782 or 2.4792) does our USD/MYR dealer sell MYR against USD? The answers are 0.8852 (on the right) and 2.4782 (on the left) respectively. Effectively, by dealing at these prices, our bank is both selling USD (against EUR) and buying USD (against MYR) simultaneously, with a net zero effect in USD. If we now consider the right side of the final EUR/MYR price we are constructing, this will come from selling EUR against USD (on the left at 0.8843) and buying MYR against USD (on the right at 2.4792). Concluding, since each dollar is worth 0.89 Euro and also 2.47 Ringgits, the EUR/MYR exchange rate must be the ratio between these two.
2.4782+1.6879=1.4682 is how the bank sells MYR and buys EUR
2.4792+1.6874=1.4692 is how the bank buys MYR and sells EUR
Therefore the spot EUR/MYR rate is: 1.4682/ 1.4692.
Risks concerning spot transactions
The greatest potential risk with a spot transaction is that one of the parties of the transaction fails to settle the correct amount in time. There is also a risk that one counterparty goes bankrupt between the time the deal is closed and settled. The remaining counterparty might have to re-arrange the deal with another counterparty. In this respect he is exposed to the risks of exchange rates changing in the meantime. In certain situations, such as selling US Dollars and buying Japanese Yen, one currency may be delivered several hours before the other. This creates the risk that the counterparty may deliver on its side of the deal but won’t receive payment from the counterparty in default.
Risks covered
Þ Issuer risk
Þ Juridical risk
Þ Liquidity
Þ Volatility
Þ Maturity risk
Þ Market risk
Risks exposed
Þ Counterparty risk
Þ Forex Risk
Market information
Spot trades are simple, highly standardised transactions taking place in a very liquid market.
Currencies traded
The US dollar plays an important role in the foreign exchange market. This is because the dollar is used as a vehicle for cross-trading between other currencies. For some currencies, almost all trading takes place in terms of the US dollar, the Canadian dollar, Australian dollar or the Japanese yen. The US dollar figures less prominently, in deals involving European currencies.
The Japanese yen is the most widely traded currency. It is involved in two of the ten most widely traded currency pairs. US dollar/Japanese yen trading tends to be concentrated in Asian centres, the United States and in the United Kingdom.
Geographical patterns
The bulk of foreign exchange market trading takes place in a small number of centres, such as the United Kingdom, United States and Japan. Together they account for more than half of turnover in the foreign exchange market. The next four most important centres are: Singapore, Hong Kong, Switzerland and Germany.
There are considerable differences among centres in the scale and composite of the business. The position of a centre depends both on the role of the home currency itself in the international monetary system and on the importance of the country as a trading centre. For example, centres in which domestic currency business accounts for less than twenty percent of turnover (Singapore, Luxembourg, United Kingdom, Hong Kong) have clearly specialised in global foreign exchange trading. In contrast, in markets where domestic currency business accounts for around seventy percent or more of turnover, partly due to the use of the domestic currency as a vehicle and partly to the greater prominence of transactions driven by cross-border trade and financial flows rather than cross-currency arbitrage and hedging.
Banks and the foreign exchange market
Professional foreign exchange dealing requires advanced technical equipment. Business is done by telephone, telex and computer systems. Spot and forward rates of virtually every currency and money market rates are displayed on several monitors supplied by agencies such as Reuters and Telerate.
Exchange rates are quoted directly or indirectly. A direct quotation shows a variable amount of domestic currency against a fixed amount of foreign currency. An indirect quotation shows a variable amount of foreign currency against a fixed amount of the domestic currency. In dealing circles, a direct quote is a quote in which the US dollar is the base curren­cy, while an indirect quote is one in which the dollar is not the base currency.
Bank for International Settlements: the Basle-based organisation grouping the central banks of the ten most industrial nations.
Cash flow: the cash receipts and payments of a business. This differs from net income after taxes in that non-cash expenses are not included in a cash flow statement. If there is a higher cash income than cash outflow, there is a positive cash flow. If more cash is outgoing than incoming this causes a negative cash flow.
Eurocurrency: certificates of deposit (CDs), bonds, deposits, or any capital market instrument issued outside of the national boundaries in which the instrument is denominated (Eurodollar bonds or Eurodollar CD’s).
Hedging: protecting existing or future securities asset by buying or selling forward contracts, repo’s or options.
Inflation: the creation of money by monetary authorities. In more popular usage, the creation of money that visibly raises goods prices and lowers the purchasing power of money. Inflation may be creeping, trotting, or galloping, depending on the rate of money creation by the authorities. It may take the form of “simple inflation,” in which case the proceeds of the new money issues accrue to the government for deficit spending. Or it may appear as “credit expansion,” in which case the authorities channel the newly created money into the loan market.
Liquid market: is one where selling and buying can be accomplished with ease because there is a large number of interested buyers and sellers willing to trade substantial quantities at small price differences.
Money market: a wholesale financial market in which sovereign states, banks and major corporations raise funds through debt instruments with maturities of up to twelve months.
Outright (forex forward): is a deal whereby two parties agree to exchange currencies on a specific future date.
Over the counter (OTC): a general name for any transaction that does not take place on an exchange. An over-the-counter option is a call or a put whose strike price, expiration, and contract amount premium are negotiated between two parties.
Spot: the market in which commodities are available for immediate delivery. It also refers to the cash market price of a specific commodity.

Next year I want to go on a holiday to Spain, so I need EUROS. The exchange rate of the EURO/INR fluctuates very much. To be sure that I can exchange my INR for a lot of EUROS. I make an agreement with someone. We agree that next year I receive a fixed amount of EUROS in three months for a fixed amount of INR.
Forex forward (outrights) transactions are defined as the exchange of two currencies for settlement more than two business days after the conclusion of the deal. Two parties agree with each other to deliver a certain amount of currency in return for an amount of another currency on a future date. In other words a currency spot in the future.Outright forward deals are structurally similar to spot transactions. Once the exchange rate for a forward deal has been agreed, the confirmation and settlement procedures are the same as in the cash market. However, the longer the forward period, the greater the risk that the creditworthiness of the counterparty could deteriorate. Non-standard amounts or maturities may leave the market-maker with exposure that is difficult to unwind immediately, and the smaller number of participants and lower volumes in this sector imply somewhat less competitive pricing.
Why Ourights?Forward transactions can serve a number of different purposes. First of all, by doing forex forward transactions you can hedge exchange risk resulting from a financial transaction.Currency risks can result from the following financial transactions:· Securities investments, money market deposits, loans extended to subsidiaries abroad, direct investments, etc., if done in foreign currencies all represent foreign currency assets· Borrowing in capital markets abroad, for instance, if done in foreign currencies represent foreign currency liabilitiesWhen you do not have access to the forward market you can replicate on outright deal. Suppose a Dutch importer is due to pay euro 500,000 in three months. He has to take the following actions:1. Buy Euro/sell USD spot2. Deposit USD for three months3. Borrow USD to settle spot dealThese three transactions involve three separate dealers which all want their margins. When you use an outright in stead of the other instruments you replace these separate instruments. This reduces costs because you only have to deal with one dealer spread.Other frequent users of outrights are institutional investors. They use these deals to make or liquidate overseas investments. Equity and bond markets have different settlement periods in different countries. Institutions can match the value date of the currency deal to the settlement of underlying investment transaction using the forward forex market.

The forward rate exchange rate can be calculated from the spot rate rate using the following formula:

Forward rate = spot rate *{[1+(v*N/Bv]/[1+(b*N/Bb)]}

v = variable currency interest rate for the period
b = base currency interest rate for the period
N = number of days in the interest period
Bv = day base for the variable currency
Bb = day base for the base currency
Forward prices can only be calculated where money market rates are known. This limits the maximum possible maturity of forward deals in many markets. For example, where inflation is very high, interest rates may be quoted up to three months only. Forward deals for longer periods can not be hedged or priced.

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