Exchange rates

International transaction in cash requires

two distinct purchases
Purchase of foreign currency
Purchase of good/service with the FC

Term foreign exchange is used to denote

foreign currency
Foreign exchange market exists to cater to
the demand for foreign currency/currencies

Foreign Exchange Market

Organisational setting within which
individuals, governments and banks
buy and sell foreign currencies
Only a small fraction of daily
transactions in foreign exchange
involve trading of currency
Most foreign exchange transactions
involve transfer of bank deposits

Definition of foreign
exchange
Deposits, credits and balances payable in
foreign currency
Drafts, travellers cheques, letter of credit or
bill of exchange expressed or drawn in
Indian currency but payable in foreign
currency
Drafts, travellers cheques, L/Cs, etc. drawn
by banks, institutions or persons outside
India but payable in Indian currency
The above definition is as per FEMA (1999)

Exchange rate (1)

Denotes the price or the ratio or the
value at which one currency is
exchanged for another
Exchange rate is very dynamic
The foreign exchange market is roundthe-clock market due to different time
zones
Major participants- central banks,
commercial banks, forex brokers,
corporations, individuals

Factors affecting exchange

rate
Major banks that act as marketmakers always give two-way quotes;
gives depth and volume to the
market
Fundamental reasons
Technical reasons
Speculation

Fundamental reasons
Balance of payments->surplus>appreciation
Growth rate of the economy-> higher
growth->depreciation of currency
Fiscal policy-> financing of fiscal deficit
influences exchange rate
Monetary policy->loose monetary
policy-> depreciation of exchange rate

Technical reasons
Freedom or restrictions on capital
movements can affect exchange
rates to a large extent
Among other factors there are:
Huge trade surpluses of oil exporting
countries
Capital moving from low-yielding
currencies to high yielding currencies
(interest differential)

Speculation
Self-fulfilling prophecies
Anticipation of depreciation of a
currency can cause dealers to sell that
currency

Speculation serves to provide depth

and liquidity to the forex market
Acts as a cushion as well- contrarian
traders exist in the market

Types of exchange rate (1)

Ready/cash- Settlement of funds on
the same day (date of the deal).
Tom- Settlement of funds takes place
on the next working day of the date
of the deal
Spot- Settlement of funds takes
place on the second working day
following the date of the deal

Types of exchange rate (2)

Forward- Delivery takes place on any
day after the date of the deal
In the forex market all rates that are
quoted are generally spot rates
When delivery takes place beyond the
spot date then it is a forward
transaction and the forward rate is
applicable
Forward rate = Spot rate + Premium (discount)

Forward rate
If the forward value of a currency is higher
than the spot value the currency is said to
be at a premium
If the above is reversed the currency is said
to be at a discount
The forward premium/discount is based on
interest rate differentials of the two
currencies involved
Direct and indirect quotes of exchange ratedirect quote, local currency is variable

Quotes of Exchange Rate

Cross rates- To obtain rates for a
particular currency pair when they
are not available directly
Bid and offered rates- In USD/INR
39.40/41 the bank is bidding for USD
at Rs. 39.40 and offering to sell USD
at Rs. 39.41

Exchange Arithmetic
All foreign exchange calculations have to be
worked with care and accuracy and several
rules have to be kept in mind
Chain rule- is used to attain comparison or
ratio between two quantities which are
linked together through another or other
quantities. Equation in the form of a chain is
derived.
Per cent and per mille- Per 100 units/per
1000 units

Example of a Chain Rule (1)

Query: If we have to remit French
Francs to France from India how do
we go about it? (We have to arrive at
cross rates between FRF and INR.)
Mumbai interbank market:
US $ 1 = Rs. 41.2550/2650

London Market
US $ 1 = FRF 6.0500/6.0550

Chain rule (2)

At what rate can one buy FRF against
rupees?
How many Rs----- = FRF 1?
FRF 6.0500 = US $ 1
US $ 1 = 41.2650, therefore,
FRF 6.0500 = US $ 1 = Rs. 41.2650
Hence, FRF 1 = 41.2650/6.0500
Or FRF 1 = Rs. 6.8206

Forward Rate (1)

Value date: It is customary, in foreign
exchange market, to quote a rate to do the
deal but exchange the currencies not on the
same day but generally afterwards.
Forward rate: Has two components
Spot rate
Forward points or forward differentials

Forward rate is the rate when the value of

the deal is fixed beyond the spot date i.e.
beyond the second working day after the
deal

Forward Rate (2)

Forward transactions are necessary in the
foreign exchange market as they serve
number of purposes like:
One can hedge or cover an existing future financial,
commercial or trade related exchange risk
These types of deals, in combination with spot
deals, are used for money market operations
through swap transactions
Taking a view of the market, these can be used for
speculation

Forward rate (3)

When a currency is costlier in the future
(forward) as compared to the spot, the
currency is said to be at a premium vis--vis
another currency
In direct rate premium is added to both the
buying and selling rate whereas discount is
deducted
In indirect rate premium is deducted and
discount is added to the buying and selling
rates

Forward rate (4)

Base currency is the currency which is being
bought and sold and the other currency is
incidental.
Forwards are quoted as follows
Spot/1 month 17/18
Spot/ 2 months 35/37
Spot/ 3 months 53/56

If forward differentials are in the ascending

order (1st figure is lower than the 2nd) the
base currency is at premium

Foreign exchange
transactions (1)
Arbitrage: Is an operation by which
one can make risk free profit by
undertaking offsetting transactions.
Can be in interest rates: borrow in one
centre and lend in another
Can be in exchange rates: Buy a currency
in one market and sell in another

Arbitrage keeps exchange rates

uniform in all markets

Foreign Exchange
Transactions (2)
Merchant rates: Quotes offered to
merchants (importers, exporters) by banks.
Inter-bank rates: The rates quoted by banks
for dealing in the inter-bank market.
Merchant quotations: In India all merchant
quotations for foreign currencies shall be in
so many rupees for one unit of foreign
currency except for Japanese Yen, Italian
Lira and Belgian Franc (Rs/100 units of the
currency)
All quotes are in four decimal places with
the last two digits in the multiple of 25

Modes of remittances (1)

Telegraphic Transfers (TT) of funds are done
from one centre to another by way of
instructions through telex, telegram or SWIFT
(Society for Worldwide Interbank Financial
Transfer). Of late SWIFT is becoming popular
Mail Transfer (MT) of funds is done by way of
instructions sent by mail. An MT is an order in
writing on the correspondent bank/branch
abroad to pay the beneficiary the sum
mentioned

Modes of Remittances (2)

Demand draft (DD): A DD is an order in
writing on the correspondent bank/branch
abroad to pay the beneficiary the sum
mentioned therein.
Fedai prescribed types of rates of merchant
transactions:

TT (buying)- clean inward remittances

Bill (buying)- purchase/discount of export bills
TT (selling) clean outward remittances
Bill (selling) remittance for import bills

RBI/FEDAI Guidelines (1)

RBI has issued Authorised Dealers
(AD) licences to banks, all India
financial institutions and a few cooperative banks to undertake foreign
exchange transactions in India
It has also issued Money Changer
licences to a large number of
established firms, companies, hotels,
shops, etc.

RBI/FEDAI Guidelines (2)

Money changers help facilitate encashment
of foreign currencies of foreign tourists
Entities authorised to buy and sell foreign
currency notes, coins and travellers
cheques are called full fledged money
changers
Those authorised only to buy are called
restricted money changers

RBI/FEDAI Guidelines (3)

FEDAI (Foreign Exchange Dealers
Association of India) is a non-profit making
body formed in 1958 with the approval of
RBI
Its members are authorised dealers and it
prescribes guidelines and rules of the game
for market operations, merchant rates,
quotations, delivery dates, holidays, interest
on defaults, etc.
FEDAI also advises RBI on market related
issues and supplements RBI on
strengthening the market

PART I. INTRODUCTION
I. INTRODUCTION
A. The Currency Market:
where money denominated in
one currency is bought and
sold with money denominated
in another
currency.

INTRODUCTION
B. International Trade and
Capital Transactions:
- facilitated with the ability
to transfer purchasing power
between countries

INTRODUCTION
C. Location
1. OTC-type: no specific location
2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide
Interbank Financial
Telecommunications

PART II.
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET

I . PARTICIPANTS IN THE FOREIGN

EXCHANGE
MARKET
A. Participants at 2 Levels
1. Wholesale Level (95%)
- major banks
2. Retail Level
- business
customers.

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. Two Types of Currency
Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd
business day

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
2.

Forward Market:
- transactions take place at a
specified future date

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
C. Participants by Market
1.
Spot Market
a. commercial banks
b. brokers
c. customers of commercial
and central banks

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
2. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
II. CLEARING SYSTEMS
A. Clearing House Interbank
Payments System
(CHIPS)
- used in U.S. for electronic
fund transfers.

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. FedWire
- operated by the Fed
- used for domestic transfers

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
III. ELECTRONIC TRADING
A. Automated Trading
- genuine screen-based
market

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. Results:
1.

Reduces cost of trading

2.

Threatens traders
oligopoly of information

3.

Provides liquidity

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
IV. SIZE OF THE MARKET
A. Largest in the world
1995: $1.2 trillion daily

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. Market Centers (1995):
London = $464 billion
daily
New York= $244 billion
daily
Tokyo = $161 billion
daily

PART III.
THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have four
different quotes:
a.
b.
c.
d.

spot price
30-day
90-day
180-day

THE SPOT MARKET

B. Method of Quotation
1. For interbank dollar
trades:
a. American terms
example: $.5838/dm

b.

European terms
example: dm1.713/$

THE SPOT MARKET

2. For nonbank customers:
Direct quote
gives the home currency
price of one unit of foreign
currency.

EXAMPLE:

dm0.25/FF

THE SPOT MARKET

C. Transactions Costs
1. Bid-Ask Spread
used to calculate the fee
charged by the bank

Bid = the price at which

the bank is willing to buy
Ask = the price it will sell
the currency

THE SPOT MARKET

4.

Percent Spread Formula (PS):

Ask Bid
PS
x100
Ask

THE SPOT MARKET

D. Cross Rates
1.

The exchange rate

between 2 non - US$
currencies.

THE SPOT MARKET

2. Calculating Cross Rates
When you want to know what
the dm/ cross rate is, and you
know
dm2/US$ and .55/US$
then dm/ = dm2/US$ .55/US$
= dm3.636/

THE SPOT MARKET

E. Currency Arbitrage
1. If cross rates differ from
one financial center to
another, and profit
opportunities exist.

THE SPOT MARKET

2.

Buy cheap in one intl market,

sell at a higher price in
another

3.

Role of Available Information

THE SPOT MARKET

F.Settlement Date Value Date:
1. Date monies are due
2. 2nd Working day after date of
original transaction.

THE SPOT MARKET

G. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverse
exchange rate moves.
b. Increased uncertainty
about future exchange
rate requires

THE SPOT MARKET

1.) Demand for higher risk
premium
2.) Bankers widen bid-ask
spread

PART II.
MECHANICS OF SPOT
TRANSACTIONS

SPOT TRANSACTIONS: An
Example
Step 1. Currency transaction:
verbal agreement, U.S.
importer specifies:
a. Account to debit (his acct)
b. Account to credit (exporter)

MECHANICS OF SPOT
TRANSACTIONS
Step 2. Bank sends importer
contract note including:
- amount of foreign
currency
- agreed exchange rate
- confirmation of Step 1.

MECHANICS OF SPOT
TRANSACTIONS
Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ from
nostro account to exporters.
Value Date.
U.S. bank debits importers
account.

PART III.
THE FORWARD MARKET
I. INTRODUCTION
A. Definition of a Forward
Contract
an agreement between a bank and
a customer to deliver a specified
amount of currency against another
currency at a specified future date
and at a fixed exchange
rate.

THE FORWARD MARKET

2. Purpose of a Forward:
Hedging
the act of reducing exchange
rate risk.

THE FORWARD MARKET

B. Forward Rate Quotations
1.
Two Methods:
a. Outright Rate: quoted to
commercial customers.

b. Swap Rate: quoted in the

interbank market as a
premium.

discount or

THE FORWARD MARKET

CALCULATING THE FORWARD
PREMIUM OR DISCOUNT
= F-S x 12 x 100
S
n
where F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the
forward contract

THE FORWARD MARKET

C. Forward Contract Maturities
1. Contract Terms

2.

a. 30-day
b. 90-day
c. 180-day
d. 360-day
Longer-term Contracts

PART IV.
INTEREST RATE PARITY THEORY
I. INTRODUCTION
A. The Theory states:
the forward rate (F) differs
from
the spot rate (S) at
equilibrium
by an amount
equal to the
interest
differential (rh - rf)
between two countries.

INTEREST RATE PARITY

THEORY
2.

The forward premium or

discount equals the interest
rate differential.
(F - S)/S = (rh - rf)
where

rh = the home rate

rf = the foreign rate

INTEREST RATE PARITY

THEORY
3.

In equilibrium, returns on
currencies will be the same
i. e. No profit will be realized
and interest parity exists
which can be written
(1 + rh) = F
(1 + rf)
S

INTEREST RATE PARITY

THEORY
B. Covered Interest Arbitrage
1. Conditions required:
interest rate differential does
not equal the forward premium or
discount.
2. Funds will move to a country
with a more attractive rate.

INTEREST RATE PARITY

THEORY
3.

Market pressures develop:

a. As one currency is more

demanded spot and sold
forward.
b.

Inflow of fund depresses

interest rates.
c. Parity eventually

reached.

INTEREST RATE PARITY

THEORY
C. Summary:
Interest Rate Parity states:
1. Higher interest rates on a
currency offset by
discounts.

forward

2. Lower interest rates are

offset by forward premiums.