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AVERAGE WEIGHTAGE OF CHAPTER 16 MARKS

PRACTICAL WEIGHTAGE 12 MARKS
THEORY WEIGHTAGE 4 MARKS
PART -I
FOREX - THEORY
Had the world been a global village and had there been a single currency in the world, there would have been no need
for foreign exchange. But practically the world is divided into various countries and each and every country has its
own set of rules regulations and has got its own currency.
Now the problem arises when the residents of two different countries enter into any type of business transactions
(called international trade). In these transactions each country functions as a sovereign (supreme) state with its own
set of rules & regulations & currency.
For example an American exporter exports some goods to an Indian importer. Now American exporter would like to
receive payment in US Dollar only because Indian Rupee cannot be used as currency in USA. On the other hand
Indian importer has his savings & borrowings in Indian rupee only hence he cannot make payment in US dollars.
Hence there arises a need of conversion of importers currency into exporter’s currency. And this is done through
FOREIGN EXCHANGE.
Important Definitions-
Foreign exchange: is the mechanism by which the currency of one country gets converted into the currency of
another country.
Exchange rate : is the rate at which one currency is converted into another currency. For example if 1 US dollar can
be exchanged for 45 Indian Rupees then it is said that exchange rate is
1$ = Rs.45
FOREIGN EXCHANGE MARKET - Market where one country’s currency is traded for another’s currency.

EXCHANGE RATE - Rate at which one currency is converted to another.

FOREIGN EXCHANGE RISK - Defined as risk which affects The future cash flow/ profits of an organization due
to fluctuations in exchange rate.

Who determines the exchange rate? (Imp. For theory)

Suppose you want to purchase 1 US Dollar, for that you will have to pay 45 Indian Rupees. Why is it so ? Why not

$1= Re.1? or how come the rate of Exchange of $1 =Rs. 45 ? The rate of exchange is decided by the fiat

(i.e. Government) in a fixed rate regime and by demand and supply for the two currencies in the foreign exchange
market in a floating rate regime. Now the demand and supply is the outcome of the combined effect of multiple
factors constantly at play. Some of the major factors are as follows:

1) Balance of payments: Balance of payments represents the demand for and supply of foreign currencies.

the demand for foreign currency is more than its supply then the domestic currency will depreciate and

foreign currency will appreciate. It means more units of domestic currency will have to be paid for the purpose of
purchase of single unit of foreign currency.

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2) Inflation: inflation in the country is more than foreign country then purchasing power of domestic currency will
reduce as compared to foreign currency. Means one has to pay more units of domestic currency to purchase same.
basket of goods as compared to foreign currency. Hence home currency will depreciate.

3) Interest rates: If interest rate increases in the country then the domestic investors will not invest

foreign countries. At the same time it will attract foreign investors to invest their money. As

a result of this demand for home currency will increase and ultimately home currency will appreciate as compared

to foreign currency.

4) National Income: Increase in national income means increase in living standards of the residents of

country, means increase in consumption. But if the production doesn’t increase in the same proportion

will lead to increased imports. And if imports increases it will depreciate the home currency.

5) Resource Discoveries: If a country is able to discover key resource its currency gains value.

PARTICIPANTS OF FOREIGN EXCHANGE MARKETS

The different participants of foreign exchange markets are:

♦ Importers who pay for goods using foreign currencies

♦ Exporters who receive on foreign currencies and convert to home currency
♦ Portfolio managers who transact in foreign currency when they go to buy or sell foreign
stock.

♦ Foreign Exchange broker who match buy or sell orders.

♦ Traders who make a market in foreign currencies
♦ Speculators who try to profit from changes in exchange rates
CHARACTERISTICS OF FOREIGN EXCHANGE MARKET

Characteristics of foreign exchange market are:

1.OVER THE COUNTER (OTC) MARKET - The participants in Forex Market deal among then directly without any
intervention of any exchange or a clearing house.

2.24 HOURS MARKET - It starts when a business day opens in Sydney, Tokyo, Hong Kong Singapore and then
moves to Middle East to Europe to New York and back to Australia Bahrain and Gulf market also operates on
Saturday and Sunday. Hence this market rename open seven days in a week and 24 hours a day.

3.NO SINGLE LOCATION - Forex Market is global. It is an integration of communication systems.

4.Very large capital and trade flow

5. Exchange rate fluctuation almost every second.

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6. It highly liquid market

List of Major foreign currencies that trade worldwide.

Country Currency Symbol

Australia Australian AUD / A$

EMU Euro €

France Francs FF/FFr

Greece Drachma Dr

India Rupees Rs.

Iran Rial RI

Japan Yen ¥

Kuwait Dinar Dinar

Malaysia Ringitt MR

Mexico Peso Ps

Russia Rouble Rouble

Saudi Arabia Riyal Riyal

South Africa Rand R

Singapore Dollar SD

Sweden Kroner SKr.

USA Dollar $

How to express the exchange rates?

Exchange rates is quotes in one of the following two manner-

DIRECT QUOTE: (Home currency on R.H.S)

A direct quote is a quote where the exchange rate is expressed in terms of number of units of the domestic currency

perunit of foreign currency. Therefore, when we say $1 = 42.50/- , we are expressing one unit of dollar (a foreign
currency for an Indian) in terms of some units of domestic currency. Therefore it is a dollar direct quote for an Indian
in India. It is referred as Rs/$ quote. (Remember that the same quote when quoted in USA is not a direct quote for an
American.)

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Similarly 1£ = $ 1.6650 is a direct quote of pound in USA, where one unit of pound (a foreign currency for an
.American) is quoted in terms of some units of domestic currency($). It is referred as $/£ quote. Again 1MR = £
0.2725 is a direct quote of Malaysian Ringitt in UK. his referred as £/MR. quote.

INDIRECT QUOTE ( Foreign Currency on R.H.S)

A indirect quote is a quote where the exchange rate is expressed in terms of number of units of the foreign currency
per fixed number of units of domestic currency. Therefore, when we say Rs.100 = $02245. we are expressing a
standard unit of rupee (domestic currency for an Indian) in terms of some units of foreign currency (i.e. $).

TYPE OF EXCHANGE RATE:

BID Spread ASK

RATE = BID-ASK RATE

Bid is the price at which the dealer (generally a banker) is willing to buy another currency .If Rs/$ = .42.50/42.55,
here the dealer is willing to buy a $ at 42.50 from you. This is the Bid rate.

Offer rate is the rate at which a dealer is willing to sell another currency. If Rs/$ = 42.50/42.55. Here the dealer is
willing to sell a $ at 42.55 to you. This is the offer rate. Generally the bid and ask are separated by either a slash (/) or
a dash (—). The difference between the bid and ask rate is called the spread. Any quote is always quoted and read
from the point of view of the banker/ dealer.

BID- Rate at which dealer (bank) is ready to buy foreign currency remember ‘B’ for bid and ‘B’ for buying.
ASK- Rate at which dealer (banker) is ready to sell foreign currency. Remember “A S K”, for selling.

SPREAD - It is the difference between BID and ASK. i.e. BID - ASK.

Example-

If Rs / $ = 42.50/42.55

Here the dealer is willing to buy $ at 42.50 from you. This is BID rate.

Here The dealer is willing to sell $ at 42.55 to you.

SPREAD = 42.55 - 42.5

INVERSE QUOTE-
For every quote (A/B) between two currencies there exists an inverse quote (B/A) quote where currency A is being
bought and sold with its price expressed in terms of B

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(B/A) Quote is = 1

GOLDEN RULES FOR SOLVING FOREX PROBLEMS-

Always remember that while solving any question of forex , take quote of that currency in which you want to
Transact. For instance assume that If dollar needs to be purchased than quote of dollar would be needed, if
rupees need to be sold then direct quote of rupee would be needed.
For instance if dollar appreciation is required to be calculated then take direct quote of dollar and lets say
from the same quote if rupee depreciation needs to be calculated then direct quote of rupee.

APPRECIATION AND DEPRECIATION OF CURRENCY -

A currency is said to be appreciated if one is able to purchase more of other currency against it after appreciation. This
if 1$ = 45, changes to 1$ = 46/-. It means one is able to get more of rupees for same value of dollar after appreciation
hence dollar has appreciated.

A currency is said to be depreciated if one is able to purchase less of it after depreciation.

This if 1$ = 45/- changes to 1$ = 44/-. It means one is able to get less of rupees for same value of dollar.

Appreciation/Depreciation(%) = St+1 – St x 100

Where St = spot rate at time “t”

St+1 = spot rate at time “t+1”

PREMIUM AND DISCOUNT -

A Currency is said to be at premium if it is more expensive in forward market than in spot market.

Thus if Rs/$ spot = 44.95/45.00

Rs./$ 3m FWD = 45.20/45.25

We say that $ is said to be at premium because it is quoting higher in forward market.

For direct quote formula for forward premium / discount -

F-S

SWAP POINTS :

For a bank, the underlying principle in any foreign exchange trading is that purchase should be offset by
corresponding sales and vice versa, especially if the bank decides not to take outstanding positions or indulge in
speculation. In an ideal situation a customer purchase is offset by another customer for the same maturity. In practice,
such a situation may not always exist. It is essentially banks to go for cover operations.

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For example, a forward purchase request from a customer to be dealt this way if the corresponding sale of same
maturity is not available in the market. The bank would sell spot and buy forward . By doing this trade a bank has
covered the customer purchase by way of spot sale to another bank. At the same time it has entered into a forward
purchase customer request for future delivery. Obviously this would involve cost for bank as the spot and forward
rates would be different. The bank would charge swap cost over spot rate i.e. it would add this cost to spot rate to
quote forward rate in this manner.

If the swap cost is positive, then the bank has incurred additional to honor customer request and would be promptly
charged. In this case the forward rate would be more than the spot rate. Similarly if the bank is expected to gain in the
process of execution of swap deal, then the benefit would be promptly passed on to customer. In this case the forward
rate would be less the spot rates. Generally this swap cost is denoted as swap points.

.RULE

♦ When the swap cost are LOW / HIGH for A/B quote i.e. in ascending order, add swap points to arrive at
forward rate It means bank has incurred higher cost.

♦ When the swap points the High/ low i.e. in descending order, deduct swap points. It means bank has gained
by swap deal .

♦ The BID is added to BID and ASK to the ASK

Example 1

Rs./$ spot = 42.56/42.58

3Mswap point = 120/126

3MFWD Rate = 42.56+1.20 /42.58 +1.26

= 43.76/43.84

Example 2

Rs./$ spot = 42.56/ 42.6

3M Swap = 4/1

3m FWD = 42.56-.04/42.60-.01

FWD Rate = 42.52/42.59

CROSS - RATE

In India all buy and sell transaction are Routed through us dollars. All Deals other than dollar purchase or dollar sale
with respect to Rupee would Involve transactions Involving dollar. Thus if an Indian importer wishes to purchase yen
than he would have to buy dollars first and then sell these dollars to buy yen.

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The banker would obtain Yen/$ rate from the Tokyo or Singapore Market and then apply the Rs/$ rate obtained from
the local Indian market to arrive at the exact rupees to be given for purchase of Yen. Since this transaction involves
more than two currencies we call it as a cross rate.

Thus a cross rate by definition involves transaction with more than two currencies. For finding the cross rate we need
to remember the following calculations.-

RULE 1 :

Bid ( ) = Bid ( ) x Bid ( )

ASK ( ) = ASK ( ) x ASK ( )

RULE 2 :

Bid ( )=

NOTE:-
This is because when we transact in dollars(say) we use $1 = Rs. 40/44. it means when we want to sell
$ we would get Rs. 40 and when we want to buy a $ we need to give Rs.44.
Now let us assume that we want to transact in rupee. In that case we use Re 1 = $ 0.2273/0.02500. it means
when we want to sell Rs we would get $ 0.02273 and when we want to buy Rs we need to give $ 0.025.
Now is not selling dollars akin to buy rupee and vice versa? From the first quote we get dollar sale rate as $1
Rs. 40. from the second quote we get rupee buying rate at Re.1 = $ 0.025. but both quotes are one and the same
mathematically. Hence we say,
Bid ( ) = and we can say that Ask ( )=

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