16.

FOREIGN EXCHANGE DEALINGS

1. SPREAD:

This is the difference between the “ask” (buy) price and the
“bid” (sell) price from the foreign exchange dealer’s point of
view.

The buying rate precedes the selling rate, that is the first rate
is the buying rate and selling rate is the second rate.
For example, when a dealer in Mumbai quotes:
1 Pound Sterling = Rs. 78.00 – 78.15 or 78.00 / 78.15
meaning he will buy (bid) 1 Pound @ Rs. 78.00 and
sell (ask) 1 Pound @ Rs. 78.15
(Quotations are normally given upto 4 decimal points.)

Spread is influenced by the currency involved, the volume of

business and the market sentiments/rumours about that currency.
It is like the gross profit of a business firm out of which the
dealer has to meet his establishment expenses.

Spread percent = [(Ask price – Bid Price) / Ask price x

100]
= [(78.15 – 78.00) / 78.15 x 100] =
0.19193%
And
[(Ask price – Bid price) / Bid
Price x 100]
= [(78.15 -78.00) / 78.00 x 100] =
0.19231%
The spread appears very low, but on a daily turnover of
Rs. 1 million, the gross spread is Rs. 1,91,130.

2. SPOT & FORWARD RATES

Example 1: On 1st February, 2010, an Indian firm exports goods of

the value of US$ 100 million on 6 months’ credit.
On that day, the six-month Forward Rate is Rs. 49 per 1US$.
The firm agrees to sell US$ 100 million, 6 months forward at Rs.
49. (i.e.1st August, 2010).
By this, the firm has assured itself of the receipt of US$ 100
million x Rs. 49 = Rs. 4900 million.
a. Suppose the Spot Rate per US$ on 1st August is Rs. 48.50.
The Indian firm has gained Rs. 50 million (Rs. 4900 million
actual receipts (-) Rs. 4,850 million that it would have
otherwise obtained in the absence of a forward contract.
b. If no forward cover had been made and the Spot Rate on 1st
August is Rs. 49.30, he would have gained Rs. 30 million.
c. If 6 months’ forward cover had been made on 1st Feb.,
and the Spot Rate on 1st August is Rs. 49.30, he will suffer
a
loss of Rs. 30 million.
The forward rates are normally for 1, 2, 3, 6, 9 and 12 months.

The forward rates can be a. at a premium or b. at a discount.

In case, the forward rates are higher than the spot rate, it
implies that forward rates are at a premium as more amounts of
domestic currency is required to be paid in future, to buy y
amount of foreign currency.
If the forward rates are lesser than the spot rates, it signals
that the forward rates are at a discount since less amount of
domestic currency is required to buy y amount of foreign
currency.
Forward rate premium / discount is calculated as:
Premium = (Forward rate – Spot rate) / Spot rate
X (12 months / N)
Discount = (Spot rate – Forward rate) / Spot rate
X (12 months / N)
(N refers to the number of months for which forward contract
is to be made)

Example 2: From the data given below, calculate the forward

premium and discount of the Pound in relation to the INR:
Spot Rs. 77.9542 / 78.1255
1 month forward Rs. 78.2111 / .4000
3 months forward Rs. 77.6055 / .7555
6 months forward Rs. 78.8550 / .9650

Premium at Bid Price:

1 month: (Rs.78.2111 – 77.9542) /
77.9542
X (12 / 1) X 100 =
3.95% p.a.
6 months: (Rs.78.8550 – 77.9542) /
77.9542
X (12 / 6) X 100 =
2.31% p.a.
Premium at Ask price:
1 month: (Rs. 78.4000 – 78.1255) /
78.1255
X (12 / 1) X 100 =
4.21% p.a.
6 months: (Rs. 78.9650 – 78.1255) /
78.1255
X (12 / 6) X 100 =
2.15% p.a.
Note: Pound is at a premium and Rs. in discount .

Discount at Bid price:

3 months: (Rs. 77.9542 – 77.6055) /
77.9542
X (12 / 3) X 100 =
1.79% p.a.
 Discount at Ask price:
3 months: (Rs. 78.1255 – 77.7555) /
78.1255
X (12 / 3) X 100
= 1.89% p.a.
Note: Pound is at a discount and Rs. in premium.

Forward premiums for longer time spans tend to be higher in view

of the enhanced risk.

3. CROSS RATES:

When a direct quote of the home currency or any other currency

desired by the dealer/corporate firm bank, is not available in
the forex market, it is computed with reference to other pairs of
currencies.
Cross rates facilitate in determining exchange rates (both sport
and forward) with respect to currencies not having direct quotes.
The US$ is the most actively traded currency in the world forex
markets.
On account of this, exchange rates of most of the currencies are
quoted in relation to the US$. It becomes the benchmark /
intermediate / third currency to calculate the exchange rates of
other currencies.
In fact, the cross rate between any two currencies can be
determined using Pound Sterling, Ff, DM, Japanese yen etc.

Example 3: An Indian importer has to pay to a New Zealand export

firm in NZ$.
Direct quote of INR to NZ$ is not available.
Therefore, he has to use the other two relevant quotes viz:
NZ$ / US$: 1.7908 – 1.8510
INR / US$: 48.0465 – 48.2111
The exchange rate between INR and NZ$ is determined as:
The Indian importer has to buy US$ at the ask rate of
Rs. 48.2111
b. He then sells the US$ to buy NZ $, when the dealer/bank
buys the US$ in exchange for NZ $ at the bid rate of 1.7908.
He gets NZ$ 1.7908 for INR 48.2111.
The INR /NZ$ rate is Rs. 48.2111 /1.7908 which is equal to
Rs. 26.9215 / 1 NZ$ selling / ask rate from the point of view of
the dealer bank.
To complete the quote, the buying/bid rate is also required,
which is computed as below:.
The dealer purchases US$ for Rs. 48.0465
The dealer sells 1US$ in exchange for 1.8510 NZ$.
1,8510 NZ$ are equivalent to Rs. 48.0465 which means
that 1 NZ$ buying rate is Rs. 25.9571.
The complete quote is: INR / NZ$ = Rs. 25.9571 – 26.9215
The term “cross” rate is used literally to determine the bid rate
and the ask rate as:
NZ$ / US$ 1.7908 - 1.8510
INR / US$ 48.0465 - 48.2111
INR / NZ$ 48.2111 / 1.7908 = 25.9571
48.0465 / 1.8510 =
26.9215

Since exchange rates for a third pair of currency can be

derived , given two pairs of exchange rates, cross rates between
B and C can be derived if the rates between currencies A and B as
well as A and C are given, the following formulae can be used:
(B/C)bid = (B/A)bid X (A/C)bid where,
(A/C)bid = 1/
(C/A)ask
(B/C)ask = (B/A)ask X (A/C)ask where,
(A/C)ask = 1/
(C/A)bid

Example 4: From the following rates, determine INR / Can$

exchange rate: INR / US$ = 47.7568 / 47.9675
Can$ / US$ = 1.5412 / 1.5450

(INR/Can$)bid = (INR/US$)bid X (US$/Can$)bid

= 47.7568 X 1/1.5450 = INR
30.9106
(INR/Can$)ask = (INR/US$)ask X (US$/Can$)ask
= 47.9675 X 1/1.5142 = INR
31.6784
Therefore, INR/Can$ rate is = Rs. 30.9106 – 31.6784
In case the actual exchange rates are not in tune with cross
rates, firms as well as dealers/bankers would like to switch over
to markets offering them more favourable rates.
Non-equivalence of the two rates would provide a riskless
arbitrage opportunity to dealers/bankers/arbitrageurs.

4. ARBITRAGE:

In the context of Forex markets, arbitrage means an act of buying

currency in one market (at lower price) and selling it in another
(at higher price). The difference in exchange rates (in a
specified pair of currencies ) in two markets provides an
opportunity to earn profit without risk.
As a result, equilibrium will be restored in the exchange rates
in different markets.

A. Geographical Arbitrage:

This consists of buying currency from a forex market, say London,

where it is cheaper and sell in another forex market, say Tokyo,
where it is costly.
Since forex transactions take place on telephone/fax messages,
geographical distances have no relevance.

Example 5: At two forex centres, the following Rs.-US$ rates are

quoted:
London Rs. 47.5730 - 47.6100

Tokyo (i) Rs. 47.6350 - 47.6675

Tokyo (ii) Rs. 47.6000 - 47.6450
Find out the arbitrage possibilities for an arbitrageur who has
Rs. 100 million.

In the case of Tokyo (i),

He will buy US$ from London market at the rate of 47.6100
as it is cheaper compared to Tokyo rate of 47.6350.
He will obtain Rs. 100 million / 47.6100
= US$
2,100,399.075
He will sell US$ 2,100,399.075 in Tokyo market at the rate of Rs.
47.6350 as it is higher and will obtain Rs. 100,052,509.90
He will earn a profit of Rs. 100,052,509.90 (-) 100 million
= Rs. 52,509.90 without any risk.

In the case of Tokyo (ii),

If he buys US$ from London @ 47.6100, he can sell it in
Tokyo market at the lower rate of 47.6000, he will make
only
a loss. There is no arbitrage opportunity.

B. Triangular Arbitrage:

This takes place when there are three currencies involving three
markets. This arbitrage is also known as three-point arbitrage.

Example 6: The following are three quotes in three forex markets:

US$ 1 = Rs. 48.3011 in Mumbai
Pound 1 = Rs. 77.1125 in London
US$ 1 = Pound 1.6231 in New York
If an arbitrageur has US$ 1 million, is any arbitrage
gains
possible? (assuming no transaction costs)

Arbitrage gains are possible since the cross rates

between
US$ and Pound by using the rates at London and Mumbai
are different.
(Rs. 77.1125/Rs. 48.3011 = US$ 1.5965 per Pound)
He buys Indian Rupees with US$ 1 million in Mumbai
market.
The proceeds will be Rs. 48.3011 X US$ 1 million
= Rs. 48,301,100.
He converts Indian Rupees to Pounds at London market
Rs. 48,301,100 / 77.1125 = Pounds 626,371.8592.
He then converts Pounds at New York Market and gets
626,371.8592 X US$ 1.6231 = US$ 1,016,664.164
d. The arbitrage profit is US$ 1,016,664.164 – 1
Million
= US$ 16,664.164.

The arbitrage process will set in whenever there are significant

differences between quoted rates and cross rates.
This process continues till there is a realignment of the rates.

C. Covered Interest Arbitrage (in Forward Market):

In the case of Spot Markets, a mismatch between cross rates and

quoted rates provides an opportunity for arbitrage.

Similar opportunities exist in Forward Markets also in case the

difference between the forward rate and the spot rates (in terms
of premium or discount) is not matched by the interest rate
differentials of the two currencies.
Since the comparison is to be made with interest rate
differentials, this is also called covered interest arbitrage.

Example 7: Spot rate Rs. 78.10 /

Pound
3 month Forward rate Rs. 78.60 /
Pound
3 month Interest rates: INR:
9%

Pound: 5%
(Assume borrowings of Pounds 200,000)

3 month forward rate of Pound is higher at Rs. 78.60

compared to the Spot rate of Rs. 78.10, which implies
that the
Pound is at a premium.
Premium % = [(Rs.78.60 – 78.10) / Rs.78.60] X (12/3) X
100
= 2.56%.
Interest rate differential = 9.00% - 4.00% = 4.00%
Since Interest rate differential (4%) and
Premium percentage (2.56%) do not match,
there is an arbitrage opportunity.

The arbitrageur borrows Pounds 200,000 at 5% for 3

months (since Pounds carry a lower rate of interest of 5%).
He converts Pounds 200,000 at the rate of Rs. 78.10 in the
Spot market and gets 200,000 X 78.10 = Rs. 15,620,000.
He invests Rs. 15,620,000 in the money market at 9%
p.a. for 3 months and gets an interest of:
Rs. 15,620,000 X (9/100) X (3/12) = Rs. 351,450.
Total sum available three months from now will be
Rs. 15,620,000 + Rs. 351,450 = Rs. 15,971,450.
Since he will get this Rs. 15,971,450 after 3 months, he
will sell forward at the rate of Pound 1 = Rs. 78.60 and
he will get Rs. 15,971,450 / 78.60 = Pounds 203,199.1094.
The interest due on Pounds borrowed will be:
Pounds 200,000 X (3/12) X (5/100) = 2,500.
He refunds the sum borrowed alongwith interest which
amounts to Pounds 200,000 + 2,500 = 202,500
h. His net gain is:
Pounds 203,199.1094 – 202,500 = 699.1094.

These arbitrage gain possibilities will cease to exist:

if the difference in forward rate and spot rates
(in percentage terms)
coincides with the interest rate differential (in percentage)
of the two currencies.

5. THEORIES OF EXCHANGE RATES

Purchasing Power Parity (PPP) Theory

This is the theory according to which goods of equal value in

different countries are equated through an exchange rate.
Example:
Assume the spot rate between the INR and US$ is Rs. 47 in year 1
(base year - 100).
In the first quarter of year 2, the price index in India is 105
and that of US is 102.
Based on this data, the new exchange rate will be:
INR/US$ 1 = Rs. 47 X (105/102) = Rs. 48.3823

Interest rate Parity Theory

This is the theory according to which, the discount/premium of

one currency in relation to another reflects the interest rate
differentials between them.
For instance, if interest rates are relatively higher in US than
in Japan, Japanese funds will be attractive to the
bankers/investors in US.
There will be a flight of capital from Japan to US causing
appreciation of the exchange rate of the US$.
More units of Japanese yen will be required to buy the ssame US$;
there would be arelative decline in the exchange value of
Japanese yen vis-à-vis US$.

According to this theory,

Forward rate = Spot Rate X [(1 + Ib) /(1 + If)
Where,
Ib represents interest rate on home currency and
If represents interest rate on foreign currency.
Therefore, foreign currency is to be at a premium if it has a
lower interest rate and vice versa.

Balance of Payment Position

In the event of a country running a big deficit or persistent

deficit in its BOP, its currency is likely to be under pressure
and the monetary authority has to resort to devaluation of the
currency.
Devaluation is expected to help in reducing imports (as foreign
goods become more costly) and in increasing exports (as the home
currency becomes cheaper and the country’s goods are cheaper
overseas).
In contrast, if the BOP of a country is in a favourable position
with surpluses, the value of the currency is likely to
appreciate.

Volume of International Reserves / Foreign Exchange:

In case the monetary authority feels that its currency is

depreciating in the forex market, it may step in by
releasing/selling foreign exchange out of its reserves.
The monetary authority can ‘prop up’ its currency only if it has
adequate F/E reserves available.

Level of Activity and Employment:

There is likely to be a positive impact on the exchange rates, by

way of a higher level of economic activity and full employment.
Growing economies having a higher level of economic activity and
employment have good potential and prospects of appreciation in
the value of their currencies.
Low level of economic activity and increasing unemployment
enhances the probability of depreciation of its currency.

All the above factors, taken together, have their impact on

exchange rates.