34 Foreign Exchange Market and Hedging
35 Part A — The Foreign Exchange Market
35.1 Meaning
The foreign-exchange (forex / FX) market is the worldwide network of banks, corporations, central banks, brokers and retail participants through which currencies are bought, sold and exchanged. It is the largest and most liquid financial market in the world; the Bank for International Settlements Triennial Survey (2022) reports daily turnover of around USD 7.5 trillion (bis2022?; vij2021?; apte2020?).
| Feature | Working content |
|---|---|
| Worldwide and 24-hour | Trades follow the sun across Tokyo, Singapore, London, New York |
| Over-the-counter (OTC) | No single physical exchange |
| Largest and most liquid | Daily turnover ≈ USD 7.5 trillion (BIS 2022) |
| Two-tier structure | Wholesale interbank tier; retail tier |
| Multiple instruments | Spot, forward, swap, futures, options, NDFs |
| Concentration in few currencies | USD on one side of ~88 % of all trades |
35.2 Functions
| Function | Working content |
|---|---|
| Transfer | Moves purchasing power across countries (international payments) |
| Credit | Provides credit through forwards, futures, swaps, NDFs |
| Hedging | Allows participants to manage exchange-rate risk |
A fourth function — price discovery — is implicit: the market continually reveals the consensus price of one currency in terms of another.
35.3 Participants
| Participant | Role |
|---|---|
| Commercial and investment banks | Market makers; quote bid-ask prices |
| Central banks | Manage reserves; intervene to stabilise; conduct monetary policy |
| Corporations / MNCs | Hedge trade and investment exposures |
| Brokers | Match counterparties without taking principal positions |
| Retail investors / Forex traders | Speculative or remittance-driven small participants |
35.4 Spot vs Forward Markets
| Dimension | Spot | Forward |
|---|---|---|
| Settlement | T + 2 (USD/INR is T + 1) | A future date — 1, 3, 6, 12 months or longer |
| Rate | Spot rate | Forward rate |
| Use | Immediate delivery | Hedging future cash flows |
| Counterparty risk | Low | Higher (longer horizon) |
A swap combines a spot and a reverse forward — buy USD spot, sell USD forward (or the other way round) — and is the most common interbank instrument.
35.5 Forex Quotations
35.5.1 Direct vs indirect
A direct quotation states the price of one unit of foreign currency in domestic currency. Example in India: USD 1 = ₹83. An indirect quotation states the price of one unit of domestic currency in foreign currency. Example: ₹100 = USD 1.20.
The two are reciprocals of each other: \(\text{indirect} = 1 / \text{direct}\).
35.5.2 American vs European
In US-based jargon: American terms quote the USD price of one unit of foreign currency (USD 0.012 / INR); European terms quote the foreign-currency price of one US dollar (₹83 / USD).
35.5.3 Bid–Ask spread
A market-maker quotes a bid (price at which it will buy) and an ask / offer (price at which it will sell). The spread (Ask − Bid) is the dealer’s compensation for risk and operating cost. Spread depends on currency pair, market depth, volatility and the counterparty’s relationship.
35.5.4 Cross rate
A cross rate is the implied exchange rate between two currencies derived through a third currency — typically the USD. Example: if USD/INR = 83 and USD/EUR = 0.92, then EUR/INR = 83 / 0.92 ≈ ₹90.22 per EUR.
35.5.5 Worked numerical
Spot bid for USD/INR is 82.95; spot ask is 83.00. The spread is 5 paise. If a Mumbai exporter wants to sell USD 1,00,000, the bank buys at the bid → exporter receives ₹82,95,000.
35.6 Forward Rate, Premium and Discount
The forward rate is the exchange rate quoted today for delivery on a future date. It typically differs from the spot rate, reflecting interest-rate differentials.
A currency is at a forward premium if its forward rate is higher than its spot rate (in domestic-currency terms); at a forward discount if lower. The annualised forward premium / discount is:
\[ \text{Premium / Discount (annualised)} = \dfrac{F - S}{S} \times \dfrac{12}{n} \times 100 \]
where \(F\) is forward rate, \(S\) is spot rate, \(n\) is number of months to forward maturity.
35.7 Theories of Exchange-Rate Determination
Five theoretical building blocks underlie modern exchange-rate analysis (apte2020?; cherunilam2020?).
35.7.1 Purchasing Power Parity (PPP)
Gustav Cassel’s Purchasing Power Parity (1918): in the long run, exchange rates adjust so that the same basket of goods costs the same in different countries when prices are converted at the prevailing rate (the Law of One Price applied to a basket).
| Form | Statement | Formula |
|---|---|---|
| Absolute PPP | Spot exchange rate equals the ratio of price levels | \(S = P_{\text{home}} / P_{\text{foreign}}\) |
| Relative PPP | Change in exchange rate equals the difference in inflation rates | \(\dfrac{\Delta S}{S} \approx \pi_{\text{home}} - \pi_{\text{foreign}}\) |
The Big Mac Index of The Economist (since 1986) is a popular illustration of PPP using the price of a Big Mac across countries.
35.7.2 Interest Rate Parity (IRP)
The Interest Rate Parity condition links spot and forward rates to interest-rate differentials. Covered IRP — the exchange-rate version that uses forward rates — is enforced by arbitrage:
\[ \dfrac{F}{S} = \dfrac{1 + i_{\text{home}}}{1 + i_{\text{foreign}}} \]
The currency of a high-interest-rate country trades at a forward discount against that of a low-interest-rate country.
Uncovered IRP — using expected future spot rate instead of forward rate — assumes investors are risk-neutral.
35.7.3 Fisher Effect and International Fisher Effect
Irving Fisher’s (1930) Fisher Effect: nominal interest rate equals the real interest rate plus expected inflation:
\[ (1 + i) = (1 + r)(1 + \pi^e) \]
The International Fisher Effect extends this internationally: countries with higher expected inflation will have higher nominal interest rates and depreciating currencies.
35.7.4 Balance-of-Payments Approach
The exchange rate adjusts to clear the BoP — currency depreciates if the BoP is in deficit, appreciates if in surplus. Practical, but ignores asset-market and expectational forces.
35.7.5 Asset-Market Approach
Currencies are assets; exchange rates are determined by the relative supply and demand for the stocks of national currencies held in international portfolios. The approach explains short-run volatility better than PPP or BoP.
35.8 The Indian Forex Market
The Indian forex market operates within the framework of the Foreign Exchange Management Act, 1999 (FEMA), administered by the Reserve Bank of India (vij2021?). Key features:
- Interbank market in Mumbai (and major Indian cities); Authorised Dealers (ADs) under FEMA quote rates.
- Foreign Exchange Dealers’ Association of India (FEDAI) — sets market practices and rules.
- RBI — issues guidelines, intervenes through buying or selling USD, manages the managed-float regime.
- Bank holidays, settlement, deal confirmation, dispute resolution and the FBIL (Financial Benchmarks India Ltd) for benchmark reference rates.
36 Part B — Foreign Exchange Risk and Hedging
36.1 Types of Foreign-Exchange Exposure
| Exposure | Working content |
|---|---|
| Transaction exposure | Risk that the value of a contractual future cash flow changes with the exchange rate |
| Translation / Accounting exposure | Risk that consolidated financial statements change when foreign-subsidiary accounts are translated to home currency |
| Economic / Operating exposure | Risk that the firm’s future cash flows and competitive position are affected by exchange-rate moves |
The three are progressively wider: transaction is contractual; translation is accounting; economic is strategic.
36.2 Hedging — Internal Techniques
| Technique | Working content |
|---|---|
| Invoice in home currency | Push the FX risk on to the counterparty |
| Leading and lagging | Pay early (lead) or delay (lag) based on currency-direction view |
| Netting | Bilateral or multilateral offset of receivables and payables |
| Matching | Match a foreign-currency receivable with a foreign-currency payable |
| Choice of plant location and supply chain | Move production / sourcing to dampen currency exposure |
| Risk sharing through contractual clauses | Price-adjustment clauses in long-term contracts |
36.3 Hedging — External Techniques
| Instrument | Working content |
|---|---|
| Forward contract | Lock-in exchange rate for a future date; OTC; customised |
| Currency futures | Exchange-traded standard forwards; daily mark-to-market |
| Currency options | Right (not obligation) to buy (call) or sell (put) at a strike rate |
| Currency swaps | Exchange of principal and interest in different currencies over time |
| Money-market hedge | Borrow/invest in foreign currency to lock the cash flow today |
| Non-Deliverable Forward (NDF) | Cash-settled forward used for non-convertible currencies |
36.3.1 Worked example — money-market hedge
A US importer must pay €1,00,000 in 90 days. Spot EUR/USD = 1.10; 90-day euro interest rate = 4 % p.a.; 90-day dollar interest rate = 6 % p.a.
- Today: borrow USD, convert to EUR, deposit EUR.
- Amount of EUR to deposit = €1,00,000 ÷ (1 + 0.04 × 90/360) = €1,00,000 ÷ 1.01 = €99,010.
- USD needed = 99,010 × 1.10 = USD 1,08,911.
- USD loan repayment in 90 days = 1,08,911 × (1 + 0.06 × 90/360) = USD 1,10,545.
The importer has locked in a USD cost of 1,10,545 — irrespective of what the EUR/USD rate is in 90 days.
36.3.2 Forward vs Option — when to choose which
| Dimension | Forward | Option |
|---|---|---|
| Cost upfront | None | Premium paid upfront |
| Lock-in | Yes — symmetric | One-sided — protect downside, keep upside |
| Best when | Cash flow is certain | Cash flow is probable (e.g. tender bid) |
36.4 Speculation, Hedging and Arbitrage
The three classical uses of forex instruments differ sharply.
| Activity | Position | Risk profile | Profit motive |
|---|---|---|---|
| Hedging | Offsets an existing exposure | Reduces risk | Risk reduction; not profit |
| Speculation | Takes a position based on expected price moves | Increases risk | Profit if forecast right |
| Arbitrage | Simultaneous buy-and-sell across markets | Risk-free | Risk-free profit from mispricing |
36.5 FEMA, 1999 and the Indian Hedging Regime
The Foreign Exchange Management Act, 1999 replaced the earlier FERA 1973 with a liberalised, civil-law framework. Three working ideas (vij2021?):
- FEMA makes management of FX a civil offence (FERA had been criminal).
- Current-account transactions are largely permitted; capital-account transactions require RBI approval.
- Authorised Dealers (ADs) under FEMA effect transactions; RBI and Ministry of Finance set policy; Enforcement Directorate investigates.
Indian residents (corporates, individuals) hedge FX exposure through forwards, options, futures and swaps, subject to RBI guidelines on permitted hedges and underlying exposure requirements. Currency derivatives also trade on Indian exchanges (NSE, BSE) under SEBI’s framework — currency futures and options on USD/INR, EUR/INR, GBP/INR and JPY/INR.
36.6 Exam-Pattern MCQs
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| Theory | Statement | ||
| (i) | Absolute PPP | (a) | Forward / spot ratio equals ratio of (1 + interest rates) |
| (ii) | Relative PPP | (b) | Change in exchange rate equals difference in inflation rates |
| (iii) | Covered Interest Rate Parity | (c) | Spot rate equals ratio of price levels |
| (iv) | International Fisher Effect | (d) | Higher-inflation country has higher nominal rates and a depreciating currency |
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| Exposure | Description | ||
| (i) | Transaction exposure | (a) | Strategic risk to future cash flows and competitive position |
| (ii) | Translation exposure | (b) | Accounting risk on consolidation of foreign-subsidiary statements |
| (iii) | Economic / Operating exposure | (c) | Risk on contractual future cash flows |
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| Element | Content | ||
| (i) | FEMA, 1999 | (a) | Sets benchmark reference rates |
| (ii) | FEDAI | (b) | Civil-law framework for FX management; replaced FERA 1973 |
| (iii) | Authorised Dealers | (c) | Effect FX transactions under FEMA |
| (iv) | FBIL | (d) | Foreign Exchange Dealers' Association of India |
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- Forex market: OTC, 24-hour, USD ≈ 88 % of all trades, ≈ USD 7.5 trillion daily turnover (BIS 2022).
- Three core functions: transfer, credit, hedging (+ price discovery).
- Five participants: banks, central banks, MNCs, brokers, retail.
- Spot settles T+2 (T+1 for USD/INR); forwards beyond.
- Quotation: direct (foreign per domestic) vs indirect (domestic per foreign); American vs European terms; bid (buy) – ask (sell) spread.
- Cross rate = derived rate via a third currency.
- Forward premium / discount (annualised) = \(\dfrac{F - S}{S} \times \dfrac{12}{n} \times 100\).
- Theories: PPP (Cassel 1918) — absolute and relative; IRP — covered and uncovered; Fisher and International Fisher effects; BoP and Asset-Market approaches.
- Three FX exposures: transaction, translation, economic.
- Hedging — internal: invoice in home currency, lead/lag, netting, matching, plant location. External: forwards, futures, options, swaps, money-market hedge, NDF.
- Forward vs option: forward when cash flow is certain; option when probable.
- Three classical uses: hedging (offset), speculation (take risk), arbitrage (risk-free).
- India: FEMA 1999 (replaced FERA 1973); RBI + FEDAI + ADs; FBIL benchmarks; SEBI for exchange-traded currency derivatives.