Foreign Exchange Airthmetic

Prof. (Dr.) Paresh Shah,

FCMA., Ph.D.(Finance), F.D.P. (IIMA)

Domestic Currency And Foreign Currency

Domestic Currency denotes the currency in which the Annual Reports prepared. Known as Home Currency Foreign currency denotes any currency other than the domestic currency Foreign currency is a medium of exchange, and also store of value an asset Foreign currency is commodity in terms of commercial life

Exchange rate

Rate at which one currency is exchanged i.e., bought or sold for another currency For any currency, there is an exchange rate for every other traded currency on the foreign exchange market In an exchange rate , two currencies are involved Exchange rate quoted in four decimal places Rs./US$ means Rs. . Per unit US Dollar Rs. / means Rs. .. Per unit Euro currency

Direct Quote

Direct quote - the exchange rate in terms of home currency per unit of foreign currency - used in India

1 = Rs. 35 The price comes first, the commodity next FC is the commodity which is being sold and bought

Indirect Quote

Indirect quote exchange rate in terms of foreign currency per unit of home currency Re. 1 = 0.0286 The currency for which unit is fixed as 1 is the commodity and the currency for which units vary is the price

An indirect quote is the reciprocal of direct quote ( 1/35) = 0.0286

Spot Rate Quotations

Country Argentina (Peso) Australia (Dollar) Brazil (Real) Britain (Pound) 1 Month Forward 3 Months Forward 6 Months Forward Canada (Dollar) 1 Month Forward 3 Months Forward 6 Months Forward USD equiv Friday 0.3309 0.5906 0.2939 1.5627 1.5596 1.5535 1.5445 0.6692 0.6681 0.6658 0.662 USD equiv Thursday 0.3292 0.5934 0.2879 1.566 1.5629 1.5568 1.5477 0.6751 0.6741 0.6717 0.6678 Currency per USD Friday 3.0221 1.6932 3.4025 0.6399 0.6412 0.6437 0.6475 1.4943 1.4968 1.502 1.5106 Currency per USD Thursday 3.0377 1.6852 3.4734 0.6386 0.6398 0.6423 0.6461 1.4813 1.4835 1.4888 1.4975

The direct quote for British pound is: 1 = $1.5627

Spot Rate Quotations

Country
Argentina (Peso) Australia (Dollar) Brazil (Real) Britain (Pound) 1 Month Forward 3 Months Forward 6 Months Forward Canada (Dollar) 1 Month Forward 3 Months Forward 6 Months Forward USD equiv Friday 0.3309 0.5906 0.2939 1.5627 1.5596 1.5535 1.5445 0.6692 0.6681 0.6658 0.662 USD equiv Thursday 0.3292 0.5934 0.2879 1.566 1.5629 1.5568 1.5477 0.6751 0.6741 0.6717 0.6678 Currency per USD Friday 3.0221 1.6932 3.4025 0.6399 0.6412 0.6437 0.6475 1.4943 1.4968 1.502 1.5106 Currency per USD Thursday 3.0377 1.6852 3.4734 0.6386 0.6398 0.6423 0.6461 1.4813 1.4835 1.4888 1.4975

The indirect quote for British pound is:

.6399 = $1

Spot Rate Quotations

Country
Argentina (Peso) Australia (Dollar) Brazil (Real) Britain (Pound) 1 Month Forward 3 Months Forward 6 Months Forward Canada (Dollar) 1 Month Forward 3 Months Forward 6 Months Forward USD equiv Friday 0.3309 0.5906 0.2939 1.5627 1.5596 1.5535 1.5445 0.6692 0.6681 0.6658 0.662 USD equiv Thursday 0.3292 0.5934 0.2879 1.566 1.5629 1.5568 1.5477 0.6751 0.6741 0.6717 0.6678 Currency per USD Friday 3.0221 1.6932 3.4025 0.6399 0.6412 0.6437 0.6475 1.4943 1.4968 1.502 1.5106 Currency per USD Thursday 3.0377 1.6852 3.4734 0.6386 0.6398 0.6423 0.6461 1.4813 1.4835 1.4888 1.4975

Note that the direct quote is the reciprocal of the indirect quote:
1.5627 1 .6399

American quote v/s European term

A quote which is a direct quote for the American is said to be in American quote A quote which is an indirect quote for the American is said to be European quote
The direct quote for British pound is: 1 = $1.5627 The indirect quote for British pound is: .6399 = $1

American quote v/s European term

Since American term and European term are direct and indirect respectively for American, the European term can be said to be reciprocal of the American term International quotes except , NZ $, AU$, SA Rand, and are all expressed in European terms

The Spot Market

Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

The Bid-Ask Spread

The bid price is the price a dealer (Bankers) is willing to pay you for something. The ask price is the amount the dealer (Bankers) wants you to pay for the thing. The bid-ask spread is the difference between the bid and ask prices. Spread will provide a margin to bank to cover costs and make a small profit

Factors determine size of Spread

Stability of exchange rate

If exchange rate stable, the spread will be narrow If exchange rate volatile, the spread will be wider Depth means volume of transactions in the market
market high volume of transactions - spread will be narrow Thin market low volume of transactions spread will be larger
Deep

Depth of the market

Two way quote

Bid and Ask on Foreign Currency

Bid Bank Buys FC Sells LC Customer Buys LC Sells FC

Ask Sells FC Buys LC Sells LC Buys FC

Three tier Architecture

Header: Authorised dealers i.e., Scheduled banks

Full fledged foreign exchange business

Sub-header: Co-operative and commercial banks

Licensed to maintain
Licensed to carry our FOREX transactions by RBI

Bottom level: Money changers

Two way Quotes

In the direct quote: Bid rate < Ask rate

Bank always wants to gain

Ask rate > Bid rate

In the indirect quote: Bid (Rs./$) = 1 / Ask ($/Rs.) Ask (Rs./$) = 1 / Bid ($/Rs.)

Cross rate

Denotes an exchange rate that does not involve the home currency Cross multiplication is the mechanism used to derive the exchange for a set of currencies, when the exchange rates for two other sets of currencies are available A/B = A/C x C/B Bid (A/B) = Bid (A/C ) x Bid (C/B) Ask (A/B) = Ask (A/C ) x Ask (C/B)

Cross Rates

Suppose that S($/) = .50

i.e. $1 = 2
i.e. 1 = 50

and that S(/) = 50

What must the $/ cross rate be?

$ $ since ,

$1 1 $1 S ($ / ) .01or $1 100 2 50 100

Cross rate

Bid (A/B) = 1 / Ask (B/A ) Ask (A/B) = 1 / Bid (B/A )

Fluctuations
Inter day fluctuation intra-day fluctuation Transaction based rates, rate for

Bills - Export / Imports TT Buying / Selling TC Buy / Sell Currency Buy/ sell

Spot v/s Forward Rate

Spot rate- rate applicable for immediate settlement

Transaction will be settled on the second working day

Forward rate rate contracted today for exchange of currencies at a specified future date

Customer and banker - obliged to perform on the specified future date

Spot Foreign Exchange Microstructure

Market Microstructure refers to the mechanics of how a marketplace operates. Bid-Ask spreads in the spot FX market:

increase with FX exchange rate volatility and decrease with dealer competition.

Private information is an important determinant of spot exchange rates.

The Forward Market

Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

The Forward Market

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract. Forward contract to mean a transaction involving delivery, other than cash (delivery of the FX on the day of transaction), or TOM (delivery of FX on a working day next to the day of transaction) or Spot delivery of FX.

Forward Rate Quotations

The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available.

Forward Rate Quotations

Consider the example from above: for US $, the spot rate is $1.5627 = 1.00 While the 180-day forward rate is $1.5445 = 1.00 Whats up with that?

Spot Rate Quotations

Country
Argentina (Peso) Australia (Dollar) Brazil (Real) Britain (Pound) 1 Month Forward 3 Months Forward 6 Months Forward Canada (Dollar) 1 Month Forward 3 Months Forward 6 Months Forward USD equiv Friday 0.3309 0.5906 0.2939 1.5627 1.5596 1.5535 1.5445 0.6692 0.6681 0.6658 0.662 USD equiv Thursday 0.3292 0.5934 0.2879 1.566 1.5629 1.5568 1.5477 0.6751 0.6741 0.6717 0.6678 Currency per USD Friday 3.0221 1.6932 3.4025 0.6399 0.6412 0.6437 0.6475 1.4943 1.4968 1.502 1.5106 Currency per USD Thursday 3.0377 1.6852 3.4734 0.6386 0.6398 0.6423 0.6461 1.4813 1.4835 1.4888 1.4975

Clearly the market participants expect that the pound will be worth less in dollars in six months.

Forward Premium V/s. Discount

Forward premium LC appreciating means LC become expensive and FC loose its value Forward discount LC depreciating means FC become expensive and local currency loose its value RELATIONSHIP (Direct quote) FC > LC FC appreciating; LC depreciating FC < LC LC appreciating; FC

Forward Premium

Its just the interest rate differential implied by forward premium or discount. For example, suppose the is appreciating from S($/) = .5235 to F180($/) = .5307 The forward premium is given by (Direct Quote): Indicates with respect to foreign currency %
f180, v $ F180 ($ / ) S ($ / ) 360 .5307 .5235 .02751 S ($ / ) 180 .5235

Forward premium (Indirect Quote) Indicates with respect to Local currency %

S180 ($ / ) F ($ / ) 360 .5235 .5307 f180,v$ .02713 F ($ / ) 180 .5307

Forward premium or Discount

If the answer is positive as per direct quote it means LC at Discount and FC at premium If the answer is negative as per direct quote it means FC at Discount and LC at premium

FC i.e., commodity Direct quote quote Appreciating (LC Discount) Add Deduct Depreciating (LC Premium) Deduct Add

Indirect

Determination

If swap Ask > Swap Bid, the LC is depreciating, FC is appreciating If Swap Ask < Swap Bid, the LC is appreciating, FC is depreciating Spot Rs./ US $ 45 / 45.20 Swap points 0.10/0.15 means INR depreciate FR 45.10 / 45.35 Swap points 0.15/0.10 means INR appreciating FR 44.85 / 45.10

Forward Cross Exchange Rates

Its just an delayed example of the spot cross rate discussed above. In generic terms FN ($ / k ) FN ( j / k ) FN ($ / j ) and FN ($ / j ) FN (k / j ) FN ($ / k )

SWAPS

A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

Swap points

FX can be quoted as

Outright forward or Adjustment to sport rates (known as swap point)

The difference between the outright forward rate and spot rate known as swap differential or swap points. Spread is difference between Bid and Ask rate

Swap V/s Spread

Term

Bid
A C

Ask
B D

Spread
BA DC

Spot Forward

Swap CA DB Forward Bid : Banks buying rate in the forward market Forward Ask : Banks selling rate in the forward market