INTERNATIONAL FINANCE

ASSIGNMENT ON FORWARD EXCHANGE RATES SUBMITTED TO: MISS RABIA SHAKIR SUBMITTED BY: FAHAD AHMED KHAN MEF SEC (A)

This Page Intentionally Left Blank.

CONTENTS

Basic concept of Foreign Exchange Market Financial Markets Major Currencies Symbols Exchange Rates Foreign Exchange Transaction Participants in the Foreign Exchange Markets Component of a Forex Deal Direct and Indirect Quotation Spot Market Bid Ask Spreads of Banks PIP Forward Exchange Rate - USD/PKR - GBP/PKR - AUD/PKR - CAD/PKR - CHF/PKR

FOREIGN EXCHANGE MARKET

1) BASIC CONCEPT:
Foreign Curreny VS Foreign Exchange As per Foreign Exchange Act, (Section 2), 1947. c) "Foreign Currency" means any currency other than Pakistan currency; d) "Foreign Exchange" means includes any instrument drawn, accepted, made or issued under clause (8) of section 17 of the State Bank of Pakistan Act, 1956, all deposits, credits and balance payable in any foreign currency, and any drafts, travelers cheques, letters of credit and bills of exchange expressed or drawn in Pakistan curreny but payab le in other foreign currency.

2) FINANCIAL MARKETS:
Financial market is a place where resources/funds are transferred from those having surplus/excess to those having a deficit/shortage. OR A market in which financial instruments are traded. The financial markets are stock exchanges, commodity exchanges, bonds markets and the foreign exchange markets. OR A financial market is a mechanism that allows people to easily buy and sell financial securities,commodities at low transaction cost. Financial markets facilitates: 1) The raising of capital. 2) The transfer of risk. 3) International trade.

3) FOREIGN EXCHANGE MARKETS:

Just as other prices in the economy are determined by interaction of buyers and sellers, exchange rates are determined by the interaction of the households, firms, and financial institutions that buy and sell foreign currencies to make international payments.The market in which international currency trades takes is called the Foreign Exchange Markets. ( INTERNATIONAL ECONOMICS - KRUGMAN,OBSTFELD,MELITZ)

4) MAJOR CURRENCIES SYMBOLS:

> USD : US DOLLAR > EUR : EURO > JPY : JAPANESE YEN > GBP : BRITISH POUND

> CAD : CANADIAN DOLLAR > AUD : AUSTRALIAN DOLLAR > CHF : SWISS FRANC

5) EXCHANGE RATE:
The price of one currency in terms of another is called exchange rate. ( INTERNATIONAL ECONOMICS KRUGMAN,OBSTFELD,MELITZ) OR The price of one currency expressed in terms of another currency. For example, if the U.S. dollar buys 1.20 Canadian dollars, the exchange rate is 1.2 to 1.Changes in exchange rates have significant effects on the profits of multinational corporations.Exchange rate changes also affect the value of foreign investments held by individual investors. For a U.S. investor owning Japanese securities, a strengthening of the U.S. dollar relative to the yen tends to reduce the value of the Japanese securities because the yen value of the securities is worth fewer dollars. Also called foreign exchange rate.

6) FOREIGN EXCHANGE TRANSACTION:

Any financial transaction that involves more than one currency is a foreign exchange transaction. Foreign exchange trading, which is commonly called forex trading, is the swapping of currencies from different countries. For example, you could trade US Dollars for Euros. In the modern age of computers and digital trading, forex trading has become less dependent on a physical exchange of currencies. These days a trader can make a foreign exchange trade simply by placing an order using a computer. The trade can be held anywhere from minutes to years depending on the intention of the trader.

7) PARTICIPANTS IN THE FOREIGN EXCHANGE MARKETS:

> All commercial banks. ( AUTHORISED DEAERS ONLY) > State Bank of Pakistan. > Corporate Treasuries. > Public Sector/Government. > InterBank Brokerage Houses. > Residents Pakistani. > Non Residents. > Exchange companies. > Money Changers.

8) COMPONENTS OF A FOREX DEAL:

A Forex deal is a contract agreed upon between the trader and the market-maker (i.e. the Currency Trading Platform). The contract is comprised of the following components: > The currency pairs (which currency to buy; which currency to sell) > The principal amount (or "face", or "nominal": the amount of currency involved in the deal) > The rate (the agreed exchange rate between the two currencies). FX trading is always done in currency pairs. For example, imagine that the exchange rate of EUR/USD (euros to US dollars) on a certain day is 1.1999 (this number is also referred to as a 'spot rate', or just 'rate', for short). If an investor had bought

1,000 euros on that date, he would have paid 1,199.00 US dollars. If one year later, the Forex rate was 1.2222, the value of the euro has increased in relation to the US dollar. The investor could now sell the 1,000 euros in order to receive 1222.00 US dollars. The investor would then have USD 23.00 more than when he started a year earlier.

9) METHODS OF QUOTING FOREIGN EXCHANGE RATES:

Currently, domestic banks will determine their exchange rates based on international financial markets. There are two common ways to quote exchange rates, direct and indirect quotation. > Direct Quotation: This is also known as price quotation. The exchange rate of the domestic currency is expressed as equivalent to a certain number of units of a foreign currency. It is usually expressed as the amount of domestic currency that can be exchanged for 1 unit or 100 units of a foreign currency. The more valuable the domestic currency, the smaller the amount of domestic currency needed to exchange for a foreign currency unit and this gives a lower exchange rate.When the domestic currency becomes less valuable, a greater amount is needed to exchange for a foreign currency unit and the exchange rate becomes higher. Under the direct quotation, the variation of the exchange rates are inversely related to the changes in the value of the domestic currency. When the value of the domestic currency rises, the exchange rates fall; and when the value of the domestic currency, the exchange rates rise. Most countries uses direct quotation. Most of the exchange rates in the market such as USD/JPY, USD/HKD and USD/RMD are also quoted using direct quotation. > Indirect Quotation: This is also known as the quantity quotation. The exchange rate of a foreign currency is expressed as equivalent to a certain number of units of the domestic currency. This is usually expressed as the amount of foreign currency needed to exchange for 1 unit or 100 units of domestic currency. The more valuable the domestic currency, the greater the amount of foreign currency it can exchange for and the lower the exchange rate. When the domestic currency becomes less valuable, it can exchange for a smaller amount of foreign currency and the exchange rate drops. Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in value of the domestic currency. When the value of the domestic currency rises, the exchange rates also rise; and when the value of the domestic currency falls, the exchange rates fall as well. Most Commonwealth countries such as the United Kingdom, Australia and New Zealand use indirect quotation. Exchange rates such as GBP/USD and AUD/USD are quoted indirectly. Direct Quotation Indirect Quotation USD/JPY = 134.56/61 EUR/USD = 0.8750/55 USD/HKD = 7.7940/50 GBP/USD = 1.4143/50 USD/CHF = 1.1580/90 AUD/USD = 0.5102/09 There are two implications for the above quotations: (1) Currency A/Currency B means the units of Currency B needed to exchange for 1 unit of Currency A.

(2) Value A/Value B refers to the quoted buy price and sell price. Since the difference between the buy price and sell price is not large, only the last 2 digits of the sell price are shown. The two digits in front are the same as the buy price. 10) SPOT MARKET: The most common type of foreign exchange tranaction is for immediate exchange at the so called spot rate.The market where these transactions occurs is known as spot market.The average daily foreign exchange trading by banks around the world exceeds $1.5 trillion. (JEFF MADURA- INTERNATIONAL FINANCIAL MANAGEMENT) The rate of a foreign-exchange contract for immediate delivery. Also known as "benchmark rates", "straightforward rates" or "outright rates",spot rates represent the price that a buyer expects to pay for a foreign currency in another currency. This is the exchange rate at the present time. The spot rate on FX changes every second and is constantly updating.

11) SPOT MARKET INTERACTION AMONG BANKS:

At any given point in time, the exchange rate between two currencies should be similar across the various banks that provide foreign exchange services. If there is a large discrepancy, customers or other banks will purchase large amounts of a currency from whatever bank quotes a relatively low price and immediately sell it to whatever bank quotes a relatively high price. Such actions cause adjustments in the exchange rate quotations that eliminate any discrepancy.

12) BID/ASK SPREAD OF BANKS:

Commercial banks charge fees for conducting foreign exchange transactions. At any given point in tim e, a banks bid (buy) quote for a foreign currency will be less than its ask (sell) quote. The bid/ask spread represents the differential between the bid and ask quotes and is intended to cover the costs involved in accommodating requests to exchange currencies. The bid/ask spread is normally expressed as a percentage of the ask quote. (JEFF MADURA- INTERNATIONAL FINANCIAL MANAGEMENT)

13 PIP:
Based on the market practice, foreign exchange rates quotation normally consists of 5 significant figures. Starting from right to left, the first digit, is known as the pip. This is the smallest unit of movement in the exchange rate. T he second digit is known as 10 pips, so on and so forth. For example: 1 EUR = 1.1011 USD; 1 USD = JPY 120.55 If EUR/USD changes from 1.1010 to 1.1015, we say that the EUR/USD has risen by 5 pips If USD/JPY changes from 120.50 to 120.00, we say that USD/JPY has dropped by 50 pips.

14 FORWARD EXCHANGE RATE:

In addition to the spot market , a forward market for currencies enables the multi national corporations to lock in the exchange rate called a forward rate at which it will buy or sell currency. A forward contract specifies the amount of a particular currency that will be purchased or sold by the multinational corporation at a specified future point in time and at a specified exchange rate. Commercial banks accommodate the multinational corporations that desire forward contracts. Multinational corporations commonly use the forward market to hedge future payments that they expect to make or receive in a foreign currency. In this way, they do not have to worry about fluctuations in the spot rate until the time of their future payments.

A corporation may make a deal that defers payment until some point in the future. If the transaction requires exchanging currencies, there also must be an agreement of what a fair exchange rate will be at that point in the future. This is called a forward contract; the forward exchange rate is established through combining inflation expectations and the time value of money.

> HOW TO CALCULATE FORWARD EXCHANGE RATE:

1) Determine the spot price of the two currencies to be exchanged. Make sure the base currency is the denominator, and equal to one, when determining the spot price. The numerator will be the foreign currency equivalent to one unit of the base currency. 2) Find the interest rate in the country where the base currency is used. The interest rate is used to account for the time value of money and inflationary expectations in the base country. 3) Find the interest rate in the country where the foreign currency is used. This accounts for the time value of money and inflationary expectations in the foreign country. 4) Plug the numbers into the forward exchange rate equation:

F=Forward Exchange Rate S=Spot Rate rd=Interest rate of domestic country rf=Interest rate of foreign country

FORWARD EXCHANGE RATE OF USD/PKR:

100.0000 90.0000 80.0000

FIGURE 1(A) : SPOT AND FORWARD EXCHANGE RATES (USD/PKR)

SPOT RATE FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

70.0000 60.0000
50.0000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

100.0000 90.0000

FIGURE 1(B) : SPOT AND FORWARD EXCHANGE RATES (USD/PKR)

SPOT RATE
FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

80.0000
70.0000 60.0000

50.0000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FORWARD EXCHANGE RATE OF GBP/PKR:

FIGURE 2(A): SPOT AND FORWARD EXCHANGE RATES (GBP/PKR)

160.00 150.00 SPOT RATE

140.00
130.00 120.00

110.00
100.00 90.00 80.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

FIGURE 2(B): SPOT AND FORWARD EXCHANGE RATES (GBP/PKR)

160.00
150.00 SPOT RATE

140.00
130.00

120.00
110.00

100.00
90.00

FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

80.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FORWARD EXCHANGE RATE OF AUD/PKR:

FIGURE 3(A): SPOT AND FORWARD EXCHANGE RATES (AUD/PKR)

90.00 80.00 70.00 60.00 50.00

SPOT RATE
FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

40.00 30.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FIGURE 3(B): SPOT AND FORWARD EXCHANGE RATES (AUD/PKR)

90.00
80.00 70.00 60.00

SPOT RATE FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

50.00
40.00 30.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FORWARD EXCHANGE RATE OF CAD/PKR:

90.00 80.00 70.00 60.00 50.00 40.00

FIGURE 4(A): SPOT AND FORWARD EXCHANGE RATES (CAD/PKR)

SPOT RATE

FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

30.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

90.00 80.00
70.00 60.00

FIGURE 4(B): SPOT AND FORWARD EXCHANGE RATES (CAD/PKR)

SPOT RATE FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months) FORWARD RATE (12 months)

50.00
40.00 30.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FORWARD EXCHANGE RATE OF CHF/PKR:

100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00

FIGURE 5(A): SPOT AND FORWARD EXCHANGE RATES (CHF/PKR)

SPOT RATE

FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (6 months) FORWARD RATE (12 months)
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00

FIGURE 5(B): SPOT AND FORWARD EXCHANGE RATES (CHF/PKR)

SPOT RATE FORWARD RATE (3 months) FORWARD RATE (6 months) FORWARD RATE (9 months)
FORWARD RATE (12 months) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010