Foreign Exchange

Globalization
Germany
Canada

China
USA Japan

Brazil U.K.
India
Some very basic concepts

In which currency will

Smt. Nirmala pay?
Some very basic concepts

In which currency will

Mukesh Ambani pay?
 Foreign Exchange
• Foreign Exchange w.r.t. bank means a general mechanism by which a
bank converts the currency of one country into that of another.

What gives rise to foreign exchange?

• Foreign Trade
 Foreign Trade
• Foreign trade is exchange of goods and services across international
borders or territories.

• It involves 2 parties i.e.:-

1. Importer
2. Exporter
Mukesh Ambani is
Importer
or
Exporter
 Some Basic Definition
• Home Currency/Domestic Currency – Country’s own currency.

• Foreign Currency – Any currency other than home currency is foreign

currency.
 Bid Rate and Ask Rate
1 $ = Rs. 60 (One way)

1 $ = Rs. 60 -65 (Two way)

• Bid Rate – Buying Rate of Bank

• Ask Rate – Selling Rate of Bank

 Direct and Indirect Quote

• Direct Quote – Direct quotation is when the one unit of

foreign currency is expressed in terms of domestic currency.

• Indirect Quote – Indirect quotation is where the cost of one unit of

local currency is given in units of foreign currency.
Two Way Quotations (Bid Rate and Ask Rate)

• Bank in Mumbai Quotes 1$ = 70.4687/70.8791

What does this means?

• Bank is ready to buy at 70.4687 (Bid Price)

• Bank is ready to sell at 70.8791 (Ask Price)

Two Way Quotations (Spread)

Spread = Difference between Bid price and Ask price

• Bank is ready to buy at 70.4687 (Bid Price)

• Bank is ready to sell at 70.8791 (Ask Price)

00.4104

Spread/ Profit of Dealer

Cross Rate

• What if there is no direct quote for a currency in India?

 Currency Pair

• A currency pair is the structure of deciding quotation and Pricing of

the currency traded in the FOREX market.

First Currency/Second Currency = (EUR/USD)

Base Currency

Quote Currency
 Currency Pair

First Currency/Second Currency = (EUR/USD)

EUR/USD = 1.4500

In order to purchase € 1, a buyer must pay $1.45

€ 1 = $ 1.4500
 Cross Rate

Example:- An Indian Importer has to make payment to German export

firm in Euro. The direct quote of Indian rupee and Euro is not available.
Determine exchange rate between Indian rupee and Euro. Given:

US$/Euro = 1.6806-1.6816

US$/INR = 70.148-70.163
 Cross Rate

Example:- An Indian Importer has to make payment to German export firm in Euro. The
direct quote of Indian rupee and Euro is not available. Determine exchange rate between
Indian rupee and Euro. Given: [US$/Euro = 1.6806-1.6816:::US$/INR = 70.148-70.163]

We need Euro/INR

1Euro = Rs. x
 Calculating Cross Rate

Steps:-

1. Indian Importer will first buy US $ @ 70.163

2. The Indian importer will then sell US$ to buy Euro @ 1.6806

3. The importer gets 1.6806 Euro in exchange of Rs. 70.163

 Calculating Cross Rate

Steps:-

4. Therefore we can say € 1.6806 is available for Rs. 70.163 exchange

rate will be 70.163/1.6806 = 41.7488 (Ask Rate).

5. Bid Price = 70.148/1.6816 = 41.7150

Euro/Rupee = 41.7150 -41.7488

 Types of Settlement
Settlement/Exchange
Types of Transactions
of Currency

Cash/Ready Same date

TOM Next Working Day
SPOT 2nd Working day
Forward Any day after Spot

Let’s see an Example

 Types of Settlement

Transactions today (Monday)

Types of Transactions Settlement of Currency
Settlement on

Cash/Ready Same date Monday

TOM Next Working Day Tuesday
SPOT 2nd Working day Wednesday
Forward Any day after Spot Thursday and beyond
 Spot Rate

• It is quoted by bank.
• The rate of exchange of the day on which transaction
has taken place.
• The execution of transaction can occur maximum in
the next two working days.
 Forward Rate

• It is quoted by bank.
• It is applicable on contracts entered today for buying
and selling of currency on some forward date.
• The execution of transaction will occur in some future
date.
 Spot Rate and Forward Rate (Example)

On 1st March, rate provided by bank:

Incase of Today
Spot Rate : € 1 = ₹ 50 • The rate applicable will be € 1 = ₹ 50
3 months forward rate : : € 1 = ₹ 55 • Amount = € 200 x 50 = ₹ 10,000
Mr. Muktesh Ambani is in need of € 200 :
(a) Today
(b) 3 months
Find out the applicable rate for purchasing
€ 200.
 Spot Rate and Forward Rate (Example)

On 1st March, rate provided by bank:

After 3 Months
Spot Rate : € 1 = ₹ 50 • The rate applicable will be € 1 = ₹ 55
3 months forward rate : : € 1 = ₹ 55 • Amount = € 200 x 55 = ₹ 11,000
Mr. Muktesh Ambani is in need of € 200 :
(a) Today
(b) 3 months
Find out the applicable rate.
 Premium and Discount Forward Rate

Premium:
When Forward rate is higher than Spot Rate it is said
to be at premium.
For example:
Spot Rate US$ 1 = Rs. 70.2600
1 Month forward rate US$ 1 = Rs. 70.2800
00.0200 Forward Differential Points
 Premium and Discount Forward Rate

Premium:
When Forward rate is lower than Spot Rate it is said to
be at discount.
For example:
Spot Rate US$ 1 = Rs. 70.2600
1 Month forward rate US$ 1 = Rs. 70.2400
00.0200 Discount
 Premium and Discount Forward Rate

Calculating of forward rate through forward Differential

Spot Rate €1 = Rs. 80.3260/.9230

Given:
1 month forward rate = 75-90
2 months forward rate = 50-20
3 months forward rate = 95-60
Questions

1. When direct rate of foreign currency is not available, the

rate calculated through a common currency, is called
_____.
A. Floating rate
B. Cross rate
C. Fixed rate
D. Direct rate
Questions

2. The chain rule method is used in case of which of the

following types of rates?
A. Floating rate
B. Cross rate
C. Fixed rate
D. Direct rate
Questions

3. When the exchange of currencies takes place on date of

deal, which of the following types of exchange rate will be
applicable?
A. Cash or ready rate
B. TOM Rate
C. Spot rate
D. Forward rate
Questions

4. When the exchange of currencies takes place on next

working day(T+1), which of the following types of exchange
rate will be applicable?
A. Cash or ready rate
B. TOM Rate
C. Spot rate
D. Forward rate
Questions

5. When the exchange of currencies takes place on 2nd

working day (T+2), which of the following types of
exchange rate will be applicable?
A. Cash or ready rate
B. TOM Rate
C. Spot rate
D. Forward rate
Forward Rate

Forward Rates are not given in exam, instead you will find 2
components:
• Spot Rate
Spot Rate €1 = Rs. 80.3260/.9230
• Forward Points
1 month forward rate = 75-90 /2 months forward rate = 50-20
Premium Discount
Forward Differential Points

How/Why differential
point arises?
Why Differential Points arises?

• Supply and Demand of the currency

• Market Expectations for the future

• Interest Rate Differential

How forward Differential Points arises? – Example

Example

• Spot Euro 1 = US$ 1.5000

• Interest Euro @ 3% per annum, US$ @ 6% per annum

Mr. Muktesh Ambani borrows Euro 100 for one year. Find

the gain/loss.
How forward Differential Points arises? – Example
Example
Spot Euro 1 = US$ 1.5000
Interest Euro @3% per annum, US$ @6% per annum
Mr. Muktesh Ambani borrows Euro 100 for one year.

Euro US$
Inflow Outflow Inflow Outflow
Spot Borrowing + 100
Sell Euro (Purchase Dollars @1.500) -100 +150
One year Interest - 3 +9
Total - 103 159
Sells US$ one year +106 -159
Example

Euro 103 = US$ 159

Euro 1 = 159/103
= US$ 1.5436

1 month forward rate = US$ 1.5436

Spot Euro = US$ 1.5000
Forward Differential = 0.0436
 Calculating Forward Points : Example

Spot Exchange Rate = 1.500

Interest Rate Differential = 3% per annum
Forward Period = 90 days
No. of days in an year = 360 days

The formula is :- Spot Rate x Interest Rate Differential x Forward Period

100 x No. of days in the year
 Calculating Forward Points

Spot Exchange Rate = 1.500

Interest Rate Differential = 3% per annum = 1.500 x 3 x 90
100 x 360
Forward Period = 90 days
No. of days in an year = 360 days = 0.01125

Forward Points
The formula is :- Spot Rate x Interest Rate Differential x Forward Period
100 x No. of days in the year
Arbitrage

• Arbitrage is an operation by which

one can make risk free profits by

undertaking off-setting transactions.

• Arbitrage can be in interest rates i.e.

borrow in one centre and lend in

another at a higher rate.

Arbitrage Example

Profit = Rs.
300

Price (Faridabad) ₹ 500 Price (Delhi) ₹ 800

Buy Sell
Arbitrage – Same Example

• Spot Euro 1 = US$ 1.5000

• Interest Euro @ 3% per annum, US$ @ 6% per annum

Mr. Muktesh Ambani borrows Euro 100 for one year. Find

the gain/loss.
 Arbitrage – Same Example

In the above example forward rate Euro 1 = 1.5436

• Principle + Interest (US$) = US$ 1.59
• Principle + Interest (Euro) = Euro 103

Euro 103 = US$ 159, or

Euro 1 = 159/103
= US$ 1.5436
Questions: 1

A currency is said to be at a premium, when:

A. Future rate is lower and spot rate is higher
B. Future rate is higher and spot rate is lower
C. Future rate and spot rate are same
D. None of the above
 Questions: 2

To calculate forward rate in case of direct quote, if there is discount:

A. The discount is added to purchase rate and deducted from selling
rate
B. The discount is deducted from purchase rate and added to selling
rate
C. The discount is added to purchase rate and selling rate
D. The discount is deducted from purchase rate and selling rate
 Questions: 3

Spot exchange rate of Euro/USD = 1.8000 and interest rate

differential is 4%. The forward period is 90 days (no. of days in a
year to be taken 360 days). Calculate the forward points.
A. 0.0360
B. 0.0280
C. 0.0240
D. 0.0180
 Questions: 4

______is an operation by which one can make risk free

profits by undertaking off-setting transactions.
A. Arbitrage
B. Forward
C. Spot
D. Swap
 Questions: 5

The spot rate is Euro 1 = USD 1.3300 and 2 month

forward Euro 1 = USD 1.3400. The forward points are
equal to:
A. 100
B. 200
C. 300
D. 350