Foreign Exchange

(FX)
Prepared by :
Anjali Pinjani
Aqsa Qamar
Hina Kumari

Contents
INTRODUCTION................................................................................................3
Definition......................................................................................................3
FOREIGN EXCHANGE MARKET OVERVIEW........................................................3
Characteristics of Foreign Exchange Market.................................................5
FOREIGN EXCHANGE RISKS..............................................................................6
Accounting Risk............................................................................................6
Transaction Risk............................................................................................6
Profitability Risk............................................................................................6
DETERMINANTS OF EXCHANGE RATE...............................................................6
Inflation.........................................................................................................6
Interest Rates................................................................................................7
Current-Account Deficits...............................................................................7
PARTICIPANTS IN FOREIGN EXCHANGE MARKET..............................................7
Customers.....................................................................................................8
Commercial Banks..........................................................................................8
Exchange Brokers...........................................................................................8
Overseas Forex Market.................................................................................8
Speculators...................................................................................................9
ROLE OF SBP IN FOREIGN EXCHANGE MARKET................................................9
To manage the exchange rate mechanism...................................................9
Regulate inter-bank Forex transactions......................................................10

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Keep the exchange rate stable...................................................................10

Manage and maintain country's foreign exchange reserves.......................10
FOREIGN EXCHANGE INSTRUMENTS..............................................................10
Spot............................................................................................................10
Forward.......................................................................................................10
Future..........................................................................................................11
Option.........................................................................................................11
FX MARKET PERFORMANCE IN PAKISTAN........................................................11
Highlights of Pakistan economic survey 2013-14.......................................11
FOREX TRADING MECHANISM.........................................................................14
TRADING TERMS............................................................................................15
Base/Quote Currency..................................................................................16
Pip...............................................................................................................16
Spread.........................................................................................................16
Hedging......................................................................................................16
Lot...............................................................................................................16
Rollover/Swap.............................................................................................16
Leverage.....................................................................................................16
Long............................................................................................................16
Short...........................................................................................................16
Margin Call..................................................................................................17
FX USE IN BANK AL-HABIB:............................................................................17
RISK FACTORS................................................................................................17

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INTRODUCTION
Definition
Foreign exchange is the mechanism by which the currency of one country gets converted into the
currency of another country.
The conversion of currency is done by the banks who deal in foreign exchange. These banks
maintain stocks of one currency in the form of balances with banks.
Foreign exchange markets help in:
Facilitating foreign trade
Companies which import or export the product and services need to change
foreign currency into domestic or domestic into foreign currency to avail the
services.
Facilitate raising capital in foreign exchange markets
By purchasing dollars through PKR an individual can invest in foreign security
or stock.
Facilitate transfer of risk between market participants
By fixing the rate of exchange for future transaction a participant can
decrease the risk that it could have faced by buying in future on future rate.
Facilitate speculation in currency values
Anyone interested in making profit by continuous rise and fall of currencies
can keep or sell currencies.
The primary purpose of foreign exchange markets is to assist international
trade and investment by allowing businesses to convert one currency in
another currency.

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FOREIGN EXCHANGE MARKET OVERVIEW

In todays world no economy is self sufficient, so there is need for exchange of goods and
services amongst the different countries. So in this global village, unlike in the primitive age the
exchange of goods and services is no longer carried out on barter basis. Every sovereign country
in the world has a currency that is legal tender in its territory and this currency does not act as
money outside its boundaries. So whenever a country buys or sells goods and services from or to
another country, the residents of two countries have to exchange currencies. So we can imagine
that if all countries have the same currency then there is no need for foreign exchange need for
Foreign Exchange. Let us consider a case where a Pakistani company exports cotton fabrics to
USA and invoices the goods in US dollar. The American importer will pay the amount in US
dollar, as the same is his home currency. However the Pakistani exporter requires rupees means
his home currency for procuring raw materials and for payment to the labor charges etc. Thus he
would need exchanging US dollar for rupee. If the exporters invoice their goods in rupees, then
importer in US will get his dollar converted in rupee and pay the exporter. From the above
example we can infer that in case goods are bought or sold outside the country, exchange
of currency is necessary.
Sometimes it also happens that the transactions between two countries will
be settled in the currency of third country. In that case both the countries
that are transacting will require converting their respective currencies in
the currency of third country. For that also the foreign exchange is required.
Particularly for foreign exchange market there is no market place called the
foreign exchange market. It is mechanism through which one countrys
currency can be exchange i.e. bought or sold for the currency of another
country. The foreign exchange market does not have any geographic
location. Foreign exchange market is describe as an OTC (over the
counter)market as there is no physical place where the participant meet to
execute the deals, as we see in the case of stock exchange.
The largest foreign exchange market is in London, followed by the New York,
Tokyo, Zurich and Frankfurt. The market is situated throughout the different
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time zone of the globe in such a way that one market is closing the other is
beginning its operation. Therefore it is stated that foreign exchange market
is functioning throughout 24 hours a day.
Foreign exchange means foreign currency and includes:
All deposits, credits and balance payable in any foreign currency and
any draft,

travelers

cheques,

letter of credit

and

bills

of

exchange.

Expressed or drawn in Pakistans currency but payable in any foreign

currency.
Any instrument payable, at the option of drawee or holder thereof or any
other party thereto, either in Pakistan currency or in foreign currency
or partly in one and partly in the other. In order to provide facilities to members
of the public and foreigners visiting Pakistan, for exchange of foreign
currency into Pakistan currency and vice-versa. SBP has granted to various
firms and individuals, license to undertake money-changing business at
seas/airport and tourism place of tourist interest. Besides certain authorized
dealers in foreign exchange (banks) have also been permitted to open
exchange bureaus.

Characteristics of Foreign Exchange Market

Foreign exchange market is the oldest and largest financial market in the
world having turnover of more than $3.98 trillion of turnover daily.
FX Has no central trading floor where buyers and sellers meet
Foreign exchange market has no single floor; rather it is an over the counter
market where deals are fixed on telecommunication network throughout the
world.
It is open twenty-four hours a day, except for short gaps on
weekends

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It continues its operations twenty-four hours a day except the weekends i.e.
trading from 20:15 GMT on Sunday until 22:00 GMT Friday.
Global banks account for about two-thirds of the market
volume
Banks throughout the world account for two-third of the market volume
because majority of the foreign exchange transactions take place through
domestic and international banks when we talk about international. Brokers
and dealers only account for 20% of the volume.

FOREIGN EXCHANGE RISKS

Accounting Risk
Accounting risk arises from holding assets or liabilities in foreign currency. If
a Pakistani commercial banks hold $1000 of assets, and exchange rate is
$1=PKR 80. This means firm dollars of PKR 80,000. If, then, dollar
depreciates against PKR e.g. it becomes $1=75, banks asset would decrease
by [5*1000] PKR 5000.

Transaction Risk
When a firm or an individual engages in Export or Import contract involving credit extended for
any period of time. In this case, extension of credit will be measured in terms of single currency.
A firm or an individual who takes the responsibility of currency transaction incurs the transaction
risk e.g. in time of credit, foreign exchange rate may vary and can cause loss to any party. For
example, Textile mill in Pakistan ships fabric to US importer, under an agreement that payment
in dollars will be forthcoming in two weeks taking upon itself the responsibility of converting
dollars into PKR. During this two weeks extension to US importer, Pakistani firm can incur
transaction risk because PKR could appreciate against the PKR during the time; as a result
Pakistani firm can receive less in PKR.

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Profitability Risk
A firm which has significant foreign dealings must take into account its
profitability risk, which is risk that its underlying profitability can be affected
by its foreign exchange transaction.

DETERMINANTS OF EXCHANGE RATE

The following are some of the principal determinants of the exchange rate
between two countries.

Inflation
Country with a constantly lower inflation rate exhibits a rising currency value,
as its purchasing power increases relative to other currencies. Currently
Pakistan is one of the countries having inflation rates and countries like USA
and Switzerland have maintained low inflation rates and high exchange
rates. Those countries with higher inflation typically see depreciation in their
currency in relation to the currencies of their trading partners. Current
inflation rate in Pakistan is 11% and is expected to increase further.

Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, Central Bank exerts influence over both inflation
and exchange rates, and changing interest rates impact inflation and
currency values. Higher interest rates offer lenders in an economy a higher
return relative to other countries. Therefore, higher interest rates attract
foreign investors and cause the exchange rate to rise. The impact of higher
interest rates is diminishes, if inflation in the country is much higher than in
others, or if additional factors like political and economic, serve to drive the
currency down. The opposite relationship exists for decreasing

interest

rates, which means lower interest rates tend to decrease exchange rates. In

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Pakistan, prevailing interest rate is 12%, which may give rise to inflation in
the country, due to increased investments.

Current-Account Deficits
The current account is the balance of trade between a country and its
trading partners, reflecting all payments between countries for goods,
services, interest and dividends. A deficit in the current account shows the
country is spending more on foreign trade than it is earning, and that it is
borrowing funds from foreign sources to offset the deficit. The excess
demand for foreign currency lowers the country's exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign
assets are too expensive to generate sales for domestic interests. Current
account deficit in Pakistan for 1st quarter of 2011 is $1.555 and this deficit is
expected increase further. This is most likely to be influenced by the discount
rate because discount rate has effect on inflation rate and inflation rate will
influence foreign exchange rate.

PARTICIPANTS IN FOREIGN EXCHANGE MARKET

The main players in foreign exchange market areas follow:

Customers
The customers who are engaged in foreign trade participate in foreign exchange market by
availing of the services of banks. Exporters require converting the dollars in to rupee and
importers require converting rupee in to the dollars, as they have to pay in dollars for the
goods/services they have imported.

Commercial Banks
They are most active players in the forex market. Commercial bank dealing with international
transaction offer services for conversion of one currency in to another. They have wide network
of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to
the importers of goods. As every time the foreign exchange bought or oversold position. The

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balance amount is sold or bought from the market. Commercial banks (such as Deutsche Bank
and Barclays) provide liquidity to the Forex market due to the trading volume they handle every
day. Some of this trading represents foreign currency conversions on behalf of customers' needs
while some is carried out by the banks' proprietary trading desk for speculative purpose. A large
part of FX turnover is from banks. Large banks can literally trade billions of dollars daily. This
can take the form of a service to their customers or they themselves speculate on the FX market.
Large banks can trade billions of dollars daily. Central banks have biggest turnover that
exceeding hundreds of millions US dollars a day.

Exchange Brokers
Forex brokers play very important role in the foreign exchange market.
However the extent to which services of foreign brokers are utilized depends
on the tradition and practice prevailing at a particular forex market center..
The brokers are not among that allowed to deal in their own account all over
the world and also in Pakistan. They are agents that bring buyers and sellers
together to carry out conversion transactions. They charge for their work
either by adding a spread or taking commission fee for a lot traded. Daily
turnover of brokers is about 25- 30 Million of US dollars that makes 2% of all FX trading.

Overseas Forex Market

Today the daily global turnover is estimated to be more than US$ 4.9 trillion
a day. The international trade however constitutes hardly 5 to 7 % of
this total turnover. The rest of trading in world forex market is constituted of
financial transaction and speculation. As we know that the forex market is
24-hour market, the day begins with Tokyo and thereafter Singapore opens,
thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York,
Sydney, and back to Tokyo.

Speculators
The speculators are the major players in the forex market.

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 Bank dealing are the major speculators in the forex market with a view to make profit on
account of favorable movement in exchange rate, take position i.e. if they feel that rate of
particular currency is likely to go up in short term. They buy that currency and sell it as
soon as they are able to make quick profit.
Corporations particularly multinational corporation and transnational corporation having
business operation beyond their national frontiers and on account of their cash flows
being large and in multi currencies get in to foreign exchange exposures. With a view to
make advantage of exchange rate movement in their favor they either delay covering
exposures or do not cover until cash flow materialize.
Individual like share dealing also undertake the activity of buying and selling of foreign
exchange for booking short term profits. They also buy foreign currency stocks, bonds
and other assets without covering the foreign exchange exposure risk. This also results in
speculations.
About 70% to 90% of the foreign exchange transactions conducted through hedgers and
speculators.

ROLE OF SBP IN FOREIGN EXCHANGE MARKET

To manage the exchange rate mechanism
SBP plays a major role in managing the exchange rates intervening at the
different steps.

Regulate inter-bank Forex transactions

SBP regulated the transaction of banks in foreign currencies. Disciplinary
arrangement for FX market i.e. Foreign Exchange exposure limit (FEEL)
implemented by the SBP had made the market more flexible and disciplined
to move within some range of banks paid up capital. Previously they were
10% of paid up capital, however recently they have been relaxed to 20%.

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This has made the FX market to arrange their funds by using somewhat
wider space.

Keep the exchange rate stable

SBP sometimes stabilizes the foreign exchange rate in favor of the economy. For example, if the
currency is continuously depreciating, SBP might use its reserves to decrease the supply of
currency from market so that it appreciates in response to increased demand.

Manage and maintain country's foreign exchange reserves

SBP closely monitors the factors that affect the reserve, and from time to
time it keeps certain conditions in market, to manage and maintain the
reserve, which are kept in terms US dollars. To protect the reserves, SBP had
made it necessary that same amount of money going out of the country is
brought back in to country within few days.

FOREIGN EXCHANGE INSTRUMENTS

Spot
A spot describes the immediate delivery of the currency at prevailing rates.
These are usually used for immediate use of the foreign currency by local
citizens.

Forward
Forward transaction is good way to minimize foreign currency risk. In this
transaction, money does not actually change until some agreed upon future
date. A buyer and seller agree on an exchange rate for any date in the
future, and the transaction occurs on that date, regardless of what the
market rates are then. Usually time limit is decided by both the parties.

Future
Futures are standardized forward contracts, which mean that they are traded
on exchange through brokers. The average contract length is roughly 3

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months. In Pakistan, investment in futures has increased. This investment is

done for different commodities and currency is one of them.

Option
A foreign exchange option (commonly shortened to just FX option) is a
derivative where the owner has the right but not the obligation to buy or sell
the currency at pre-agreed rate. The options market is the deepest, largest
and most liquid market for options of any kind in the world. There are two
types of options. In a Put option owner sells the currency whereas in Call
option owner of the option buys the currency from writer of the option at preagreed rate. In Pakistan, Options are not allowed but in other countries there
is a huge business of options.
In April 2010, turnover of spot transactions was $1.5 trillion and $2.5 trillion
was traded in forwards, swaps and other derivatives.

FX MARKET PERFORMANCE IN PAKISTAN

Highlights of Pakistan economic survey 2013-14

Major success of the outgoing fiscal year includes: picking up economic
growth, inflation contained at single digit, improvement in tax collection,
reduction in fiscal deficit, auction of long pending 3G and 4G licenses;
foreign exchange reserves significantly raise, Rupee strengthened and
stock market created new history.
Current fiscal year witnessed significant improvement on account of
contained government borrowings, increase in foreign exchange
reserves and improvement in credit to private sector.
Net Foreign Assets improved and reached to Rs. 236.9 billion during
July-9th May, 2013-14 as compared to a net contraction of Rs. 181.4
billion last year.

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 Foreign investment during Jul-Apr, FY14, increased by 133.3 percent

compared to same period last year due to public investment in debt
securities comprising special US dollar bonds Euro bonds, T-bills and
PIBs.
Pakistans foreign exchange reserves improved substantially and
remained around $13.6 billion as on 21st May, 2014, an improvement
of more than 28 percent.
With increased external inflows, the government was able to reduce
the pressure on domestic resources while strengthening the foreign
exchange reserves vis--vis improving exchange rate parity which also
contributed towards reduction in public external debt.
Foreign exchange reserves and remittances were 45.59%,
6.97% and 3.92% respectively

during

2007-2008.

Economic indicators from 1973-2008

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The table summarizes the following:

Exports form the last 2 decades have been stable, not drastic change
in the numbers
Imports from the last 2 decades have fluctuated, increased in the later
years
Trade balance have fluctuated a lot, increased in the later years
Foreign exchange reserves increased substantially, but decreased in
2008

Table shows the increasing trend of foreign exchange turnover from the year 1988-2007.

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FOREX TRADING MECHANISM

Although currency trading is very much like stock market, and other markets
it has some differences from them, some of the differences are going to be
explained briefly.
Banks and other financial institutions are known as the market makers
because they are the ones that pour billions of dollars in the market and
move it up or down. The benefit of the foreign exchange market is that is not
tied to one countrys economy, but it is a global market and that is why it is
very difficult for these market makers to manipulate the price in their
favor, this is one of the biggest markets in the world, having a volume of up
to 4 trillion dollars a day, which offers a lot of liquidity.
There are very few institutions with the buying (or selling) power to affect the
market. However, there are some big players that are in the market, not
necessarily to make money but to intervene if they feel the value of their
currency is affecting the local economy.
An example of this is the multiple Japanese interventions last year when the
yen was getting too expensive for their liking. Another intervention was the

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Swiss Banks when they decided to peg their currency to the euro in an effort
to control their currency. Other participants are multinationals/corporations
that expand overseas who have to pay wages in different currencies. These
kinds of participants do not really care about making money in the market.
A very important factor that differs the foreign exchange market from other
markets is the risk. This is in most peoples opinion the riskiest trading one
can do because of several reasons.
One of them is that the leverage is greater here. While in the stock market
you may get 20:1 leverage, foreign exchange leverage may go up to 500:1 in
some countries. This means bigger gains, however, if you do not know what
you are doing more likely than not your account will be wiped out in a single
trade. The volatility in the currency market is huge and the price may swing
violently, especially around news times, which is why people recommend to
only investing 10-20 percent of a portfolio in the currency market.
Trading is not for the faint of heart, a trader must realize that this is not
certain science and that he will lose as well, the trick is to minimize those
losses, and maximize the winnings. Having said that, depending on your
objectives, there are various ways one can trade. One of 13 them is doing
technical analysis, reading the charts to forecast the direction of prices
through the study of past market data. Another form of trading is
fundamental analysis; in currency trading is analyzing the financial,
economic or political health of a particular country to determine the value of
their currency. In addition to the two different types of analysis, there are
also diverse styles of trading.
Day trading is one of them and this is what most people that trade for a
living and as a career do. This is trading for relatively short periods of time,
holding positions for several minutes to a couple of hours, in rare occasions
keeping positions open for more than a day.In this type of trading, it is better

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to use technical analysis, because it can help you predict price direction
more accurately than fundamental analysis. Fundamental analysis is for long
term trading, companies placing probably one or two trades per year that
will yield them huge amounts of points. This works because although the
problems for a certain economy may be visible today, its effects may not be
seen weeks or months from now.

TRADING TERMS
For a better understanding of the Forex market a brief explanation on the
most commonly used terms in this market will be given.

Base/Quote Currency
This is the first currency written in a pair. For example, if the currency pair is
EUR/USD, the Euro would be the base currency and the US dollar would be
the quote currency.

Pip
A pip or basis point is the smallest measure of change in a currency. For
example, in the US based pairs it represents one hundredth (1/100) of a cent.

Spread
The spread is the difference between the bid and ask. When you bid, you are
buying and when you ask you are selling. The bid price is always greater
than the ask price.

Hedging
Ability to hold both long and short positions at the same time.

Lot
Standard unit of a transaction. Usually, this is equal to 100,000 units of the
base currency. There is also a mini-lot = 10,000 units and a micro-lot = 1,000
units.

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Rollover/Swap
If you keep a position open for more than one trading day, you would have to
pay/receive interest, depending on the currency pair you are trading. The
rollover price represents the interest rate difference for the two currencies
involved.

Leverage
The used of various financial instruments or borrowed capital, such as
margin, to increase the potential return of an investment.

Long
The buying of a security such as stock, commodity or currency, with the
expectation that the asset will rise in value.

Short
The sale of a borrowed security, commodity or currency with the expectation
that the asset will fall in value.

Margin Call
A brokers demand on an investor using margin to deposit additional money
or securities so that the margin account is brought up to the minimum
maintenance margin. Margin calls occur when your account value depresses
to a value calculated by the brokers particular formula. It is sometimes
called fed call or maintenance call.

FX USE IN BANK AL-HABIB:

The two main ways through which they use the FX in their business are:
Remittances: Buying or selling of currency to a customer for
encashment.
Trade Purposes: To facilitate the import and export.

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o Cross Currency deals: These are directly between banks treasuries. It can be
overnight, forward, ready or spot.
o Dollar/PKR deals: these deals are directed through a broker who in return gets
o
o
o
o

commission. It can only be overnight or ready.

SWAPS: It is a future commitment of buying or selling money.
Borrowing and Placement deals:
Investment in Foreign Bonds
Investments in Nostro

RISK FACTORS
There are many risks associated with the FX trading some of them are listed
below:
Country Risk: The risk associated with the country in which
operations exist.
Exchange Rate Risk: The risk associated with the fluctuations in the
exchange rates of the currency.
Political Risk: The risk associated with the political situation of the
country.
Bank Rating Risk: The risk associated with the default risk of the
other bank which is the other party in the transaction.
Transaction Risk: The risk associated with the wrong or mistaken
transaction that leads to incredible high loss.
Market Risk: The risk associated with the market performance of the
country.
Customer Risk: The risk associated with the reputation of the
customer.
Opportunity Risk: The risk associated with the alternative options of
investment.

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