Chapter11- Foreign Exchange Markets

'Forward Rate' Explanation The forward rate is the price used to determine the price of a futures contract. 'Spot Rate' explanation The spot price reflects market expectations of future price movements for a security or nonperishable commodity (e. It accounts for holding costs. or the currency exchange rate.. The contract will determine the rates to be used along with the termination date and notional value. Definition of 'Spot Rate' The day when a spot transaction is typically settled. An over-the-counter contract between parties that determines the rate of interest. it is only the differential that is paid on the notional amount of the contract.Shivani Sodah – Roll No 51 Definition of 'Forward Rate' Forward rate is the price fixed for an asset for transaction at a future date. The spot date is calculated from the horizon. the spot date for most currency pairs is usually two business days after the date the order is placed. which settles in one business day because this currency pair is commonly traded and its financial centers are in the same time zone. the transaction is settled in advance of the normal spot date. meaning when the funds involved in the transaction are transferred. for example. settlement does not have to occur on the spot date. to be paid or received on an obligation beginning at a future start date. Egs. commodity. On this type of agreement. The contract for a spot . A spot rate in simple terms is the current market price of an asset. For example. In forex.g. the yield on a three-month Treasury bill six months from now is a forward rate. gold). Forward Rate Agreements A forward rate agreement is an agreement between two parties in which one of them contracts to lend to the other a specified amount of funds in a specific currency for a specified period starting at a future date at an interest rate fixed at the time of agreement. It is calculated using the yield curve. which is the date when the transaction is initiated. The forward rate is the future yield on a bond. appreciation and demand for the good. An exception to the usual two-day spot-date guideline is the USD/CAD pair. Furthermore. In a short date forward.

and the way they appear on all computer trading screens worldwide.transaction is processed in two-three working days.INR. The European terms quote shows the number of units of foreign currency needed to purchase one USD: CAD 1. €) Interbank Quotations: The most common way that professional dealers and brokers state foreign exchange quotations.6341 / CAD Direct and Indirect Quotations: A direct quote is a home currency price of a unit of foreign currency.Roll No52 A foreign exchange rate is the price of a foreign currency. Melissa Tiexeria.EUR) Or • Numerically ($ .`.6341 / CAD . The American terms quote shows the number of units of USD needed to purchase one unit of foreign currency: USD 0. In the US. is called European terms. A foreign exchange quotation or quote is a statement of willingness to buy or sell at an announced rate.5770 / USD An alternative method is called the American terms. Quotes can be expressed • Alphabetically ( USD. An indirect quote is a foreign currency price of a unit of home currency. a direct quote for the CAD (Canadian dollar) is USD 0.

a dealer willing to purchase CAD at a price of USD 0.6333/USD is implicitly willing to sell USD at the reciprocal price of CAD 1. A bid is the exchange rate in one currency at which a dealer will buy another currency An ask is the exchange rate at which a dealer will sell the other currency. profiting from the spread between the bid and ask prices: bid < ask.5750 .1. The indirect version of this quote would be CAD 1. .6349/ CAD.5790/USD Clearly.6333/CAD and that the ask price is USD 0. Bid and Ask Quotations: Interbank quotations are given as "bid" and "ask". Dealers buy at the bid price and sell at the ask price.6333 . Transaction costs and dealers as financial intermediaries and 2. Profits.5790/USD. Bid and ask quotations are complicated by the fact that the bid for one currency is the ask for another currency: Example: A dealer provides the following quote: USD 0. The spread between bid and ask prices exist for two reasons: 1.This quote would be an indirect quote in Canada.6349/ CAD. This suggests that the bid price for the CAD is USD 0.0.

The rate is known as the interbank rate.Types of transactions- • Interbank transactions / wholesale transactions These transactions are between banks and financial institutions. This is known as the merchant rate and is the price that is available to individual and corporate customers. • Merchant transactions/ retail transactions While dealing with individual customers banks add a profit margin to the interbank rate. .

e. Sale and Purchase of Securities: Sale and purchase of foreign securities influence the demand for foreign exchange.Shweta tewani-53 Factors that lead to fluctuations in Forex There are a host of factors which influence the supply of and demand for foreign exchange and thus are responsible for the fluctuations in the rate of exchange. When the residents of a country purchase foreign securities. 4. As a consequence. the exchange rate. capital is exported from America for investment in India. . the demand for foreign exchange increases and. the demand for foreign exchange decreases and the rate of exchange rises and moves in favour of the native country. But. for example. at the time of repayment of loan or granting loan to the foreign country. Capital Flow: Capital flow from one country to another brings changes in the rate of exchange. thereby. Granting of Loans: If a country gets loans from some foreign country. and. the supply of the foreign currency will increase. Trade Movements: Changes in the imports and exports cause changes in the demand for and supply of foreign exchange which in turn. the rate of exchange will move in favor of the home currency and against the foreign currency. 3. the rate of exchange moves against the home currency and in favor of foreign currency. the value of home currency falls. if exports exceed imports. the rate of exchange of Indian rupee in terms of American dollar will rise. lead to fluctuations in the rate of exchange. If the imports exceed exports. the rate of exchange of native currency will fall and move against the native country. the demand for India rupee will increase in the foreign exchange market. Important among them are given below: 1. 2. i. the demand for foreign currency Increases. the supply of foreign currency will fall and the rate of exchange will move against the home currency and in favor of the foreign currency. If. as a result.. As a result. As a result. On the other hand.

If the speculators expect the value of foreign currency to rise. As a result. Inflation and Deflation: Changes in the internal value of money also reflect themselves in the similar changes in the external values. As a result. the internal value (or the purchasing power) of home currency falls and there will be outflow of foreign capital from the country to avoid financial losses. On the other hand. Generally. 6. the rate of exchange will move against foreign currency and in favor of home currency. various measures of exchange control involve restrictions on imports which lead to a fall in the demand for foreign currency. and accept foreign bills of exchange. they begin to buy foreign currency in order to sell it in future to earn profit. transfer funds. it increases the supply of home currency in the foreign exchange market. By doing so. the rate of exchange moves in favor of the home currency and against the foreign currency. . 8. Exchange Control: The policy of exchange control also brings about changes in the rate of exchange. During inflation. Banking Operations: Banks are the dealers in foreign exchange. 7. the rate of exchange moves in favor of the home currency and against the foreign currency. When a bank issues drafts or other credit instruments on its foreign branches. Speculation: Speculation (or anticipation about the future changes) in the foreign exchange market also causes variations in the rate of exchange. As a result of this increase in the supply of foreign exchange.5. They sell drafts. 9. they tend to increase the demand for foreign currency and raise its value. As a consequence. it tends to discourage imports from other countries. if the speculators anticipate a fall in the future value of foreign currency. issue letters of credit. the demand for foreign currency will decrease and the rate of exchange will move in favor of the home currency and against the foreign currency. they will sell their foreign exchange holdings. Protection: When the government of a country gives protection to the domestic industries.

12. This reduces the supply of foreign currency and the exchange rate moves in favor of the foreign currency and against the home currency. 13. Peace and Security: The conditions of peace and security in the country attract foreign capital. in a country with inconvertible paper money system. Monetary Standard: If the country is on the gold standard. 10. then the exchange rate will move within the limits set by upper and lower gold points. As a result. the internal value (or the purchasing power) of the home currency rises and there will be inflow of foreign capital to realize financial gains from the relative appreciation of the value of foreign currency and a change in the exchange rate in favor of home currency and against foreign currency. As a result. the supply of foreign exchange will fall and the rate of exchange will turn in favor of foreign currency and against home currency. Bank Rate: Changes in the bank rate cause fluctuations in the exchange rate. 11. during deflation. This increases the supply of foreign currencies in the country and the rate of exchange moves against the foreign currencies and in favor of the home currency. On the contrary. When the central bank of a country raises the bank rate. On the contrary. there will be inflow of foreign capital with a view to earn higher interest income.As a result. there will be an outflow of foreign capital. when the bank rate is reduced. the demand for foreign currency will increase and the external value of home currency will fall. On the other hand. . Financial Policy: Policy of deficit financing leads to inflationary conditions in the country. there is no limit to the fluctuations in the rate exchange. the foreign capital will start leaving the country. the supply of foreign currency increases and the rate of exchange moves against the foreign currency and in favor of home currency.

education abroad etc. As of now. Currency convertibility implies the absence of restrictions on foreign exchange transactions or exchange controls. The Indian rupee became partially convertible. Under the current account convertibility. One is current account convertibility and the other is capital account convertibility Current account convertibility refers to freedom in respect of Payments and transfers for current international transactions. In simple language what this means is that CAC allows anyone to freely move from local currency into foreign currency and back. freezing exchange restrictions could uplift the quality management of balance of payments of the country. 1994. in case of transactions such as trade.e.Devansh Thapar-54 CURRENT AND CAPITAL ACCOUNT CONVERTABILITY The freedom to convert one currency into another internationally accepted currency is known as currency convertibility. In other words. There are 2 types of convertibility. Flexible and realistic approach in exchange rate determination . if Indians are allowed to buy only foreign goods and services but restrictions remain on the purchase of assets abroad. It also provides a signal to the international community that the country intends to manage its affairs without exchange Restrictions which would eventually help to enhance international confidence in the country’s policies. It is compatible with other forms of transactions international transactions in goods services or capital. it is only current account convertibility. Other current businesses include services and nominal short term banking facilities 2) Payment due as interest on loans and as not income from other investments 3) Payment on moderate amount of amortization of loans for depreciation of direct investments 4) Moderate remittances for family living expenses 5) Currency convertibility provides increased capital flows. travel and tourism. Capital Account convertibility is defined as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. there is a freedom to buy or sell foreign exchange for the following purposes: 1) The international transactions consisting of payments due in connection with foreign trade. convertibility of the rupee into foreign currencies is almost wholly free for current account i. India has made the rupee convertible on current account on August 9.

S.S Tarapore. The high rate of interest would serve as an open invitation to the inflow of capital. the full convertibility of the rupee in a phased manner after meeting certain pre conditions. Banks and Financial institutions are not financially strong to grapple with the intricacies of full convertibility. The RBI constituted a committee on capital account convertibility under the chairmanship of Dr. The committee recommended in June 1991. which will result in an appreciation at the rupee and consequent fall in exports .combined with favorable macro economic policies could help to provide a viable of balance of payments. These conditions are as follows: 1) Low fiscal deficit 2) Low inflation 3) Efficient financial system 4) Healthy foreign exchange positions The committee also recommended freedom to banks and financial institutions to operate in the domestic and international gold markets The following are the difficulties and problems in making the Indian rupee fully convertible: 1) Lack of competitive strength of industry 2) Lack of adequate technological base 3) Lack of adequate integration between the different segments of economy 4) Low speed of implementation of reforms 5) Lack of political stability 6) Inadequate banking and financial sector reforms 7) Lack of effective exchange rate mechanism at work In India. It would also worsen our micro economic imbalances due to free movement of foreign capital.

on Friday the government announced further relaxations on the kind and quantum of investments that can be made by residents abroad. It does not preclude the imposition of any monetary/fiscal measures relating to forex transactions that may be warranted from a prudential point of view. many developing countries went in for CAC in the 80s not realising that free mobility of capital leaves countries open to both sudden and huge inflows as well as outflows.How is CAC different from current account convertibility? Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. What is the position in India today? Convertibility of capital for non-residents has been a basic tenet of India’s foreign investment policy all along. we may see further liberalisation and in the not-too-distant future full CAC Can CAC coexist with restrictions? Contrary to general belief. . residents were allowed to invest through the mutual fund route and corporates to invest in companies abroad but within fairly conservative limits. Why is CAC such an emotive issue? CAC is widely regarded as one of the hallmarks of a developed economy. CAC can coexist with restrictions other than on external payments. These relaxations are to be reviewed after six months and if the experience is not adverse. In India. current account convertibility was established with the acceptance of the obligations under Article VIII of the IMF’s Articles of Agreement in August 1994. Buoyed by the very comfortable build-up of forex reserves. subject of course to fairly cumbersome administrative procedures. as part of the liberalisation process the government has over the years been relaxing these controls. it allows residents to make and receive trade-related payments — receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services. a few years ago. access foreign currency for travel. In a bid to attract foreign investment. both of which can be potentially destabilising. studies abroad. More important. Thus. the strong GDP growth figures for the last two quarters and the fact that progressive relaxations on current account transactions have not lead to any flight of capital. However. medical treatment and gifts etc. make sundry remittances. particularly financial institutions. In other words. It is only residents — both individuals as well as corporates — who continue to be subject to capital controls. capable of dealing with such huge flows countries may just not be able to cope as was demonstrated by the East Asian crisis of the late nineties. It is also seen as a major comfort factor for overseas investors since they know that anytime they change their mind they will be able to re-convert local currency back into foreign currency and take out their money. that unless you have the institutions.

in the first quote the common currency is on the bid side and in the second quote it is on the ask side.50 EUR USD 1.21 (quote 2) In cases where the common currency is on opposite sides.2000 . quote 1 and quote 2 both have USD in common).If the base/common currency is on opposite sides: Calculate cross rates from the following data: USD INR 48.Kushal Todi.20/1.50 x 1.Roll No55 Q1.50/49.20/1.20/1.50/49.2 New Bid for the third quote = Bid (quote 1) x Bid (quote 2) = 48. • In addition to that. USD INR 48.50 (quote 1) EUR USD 1.20 = 58. USD INR 48. the formula is as follows: New Bid for the third quote = Bid (quote 1) x Bid (quote 2) New Ask for the third quote = Ask (quote 1) x Ask (quote 2) Third quote (Cross rate)= Lower uncommon currency/ Higher uncommon currency New Bid/New Ask • • Let’s solve it with the above example.21 SOLUTION: • In the above example. the common (base) currency is USD (In other words.50/49.50 EUR USD 1.

8950 Answer: Cross Rate is EUR INR 58. Also.2000/59. please remember to write each step since you get marks for seps) Q2.8950 New Bid = 58.50 x 1.New Ask for the third quote = Ask (quote 1) x Ask (quote 2) = 49.8950 (Note: when we write the answer we have to take the uncommon currency of the lower quote first.2000 and New Ask = 59.If the common currency is on the bid side: .21 = 59.

6350 = 75.6300/0.75 / 0.50 USD GBP 0.9841 Cross Rate = GBP INR 75.1969 New Ask for cross rate = Ask of first quote / bid of second quote = 48.Calculate the cross rates from the following data: USD INR 47.63 = 76.50/0. we use the following formula: New Bid for cross rate = Bid of First quote / Ask of second quote New Ask for cross rate = Ask of first quote / bid of second quote (Answer) : Cross Rate = New Bid/New Ask • USD INR 47.1969/76.9841 Q3 .75/48.50 USD GBP 0.75/48. the common currency is USD • In both quotes it is appearing on the “bid” side • For this kind of cross rate.6300/0.6350 New Bid for cross rate = Bid of First quote / Ask of second quote = 47.6350 SOLUTION: • In the question given above.

If the common currency is on the ask side USD INR 47. You will write the final answer as USD EUR USD INR 47.7804 .50/62.50/48.76 New Ask for cross rate = Ask of first quote / bid of second quote =48.50 =0.50 =0.50/62.00 EUR INR 61.00/61.50 New Bid for cross rate = Bid of First quote / Ask of second quote = 47.50 SOLUTION: Here the common currency is INR and it is on the ask side.50/48.50/62.76/0. the only difference is that in the answer instead of writing EUR USD.00 EUR INR 61. For this you will use the same formula as when common currency is on bid side (example 2) However.7804 Cross Rate= USD EUR 0.

9568 Find INR EUR rate SOLUTION: If 1EUR=USD0.50/1x1=47.50 EUR USD rate=0.9568x49.50 1x0.9568 And USD1=Rs 49.3616 .Q4 CROSS CURRENCY RATE INR USD rate=49.

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