Foreign Exchange Market

Part - 1

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 What is
Foreign
Exchange
???
 Foreign Exchange

✓ Foreign Exchange is a mechanism by which a currency of one country gets

converted into the currency of another country.

✓ This conversion of currency is done by banks who deals in foreign

exchange.

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 Foreign Exchange

Adam Trade Ram

Exporter Importer
Foreign Exchange Market
 Foreign Exchange Market

Trade
Successful

Bank
 Foreign Exchange Market

Germany
 Foreign Exchange Market

Bank
Germany
 Foreign Exchange Market

A Foreign exchange market is a market in which currencies

are bought and sold.
System of trading in and converting the currency of one country into that of another.
 Foreign Exchange Market
There is no central location of the foreign exchange market.
Over The Counter (OTC) Market

The forex market is situated within the following areas:

•retail forex brokers

•central banks
•commercial businesses
•banks

Open 24 Hours a Day, 5 Days a Week

In the forex market, as one major forex market
24 hours Market closes, another market in a different part of the
world opens for business. The forex market
operates 24 hours daily except on weekends.
 FOREIGN EXCHANGE TRANSACTIONS

bank's point
of view
 Foreign Exchange Rate

1$ = 1 Rs. 1$ = 50 Rs.
1¥ = 40 Rs. 1€ = 55 Rs.
1$=5€
The basis by which the currency unit of one country gets converted into currency
units of another country is known as foreign exchange rate.

The rate of exchange for a currency is known from the quotation in the foreign exchange
market.
 Foreign Exchange Rate
Foreign Exchange Rate refers to the
rate at which one currency is
exchanged for the other

The rate of exchange for a currency is

known from the quotation in the
foreign exchange market.
1 crore Rs.
1$ = 10 Rs. Bank

10 Lakh $
 EXCHANGE QUATATIONS
The exchange rate may be quoted in two ways.

1. Direct quotation or home currency quotation and USD 1= Rs.50

2. Indirect quotation or foreign currency quotation. Rs.100 = USD 2
 EXCHANGE QUATATIONS
The exchange rate may be quoted in two ways. Exchange rate is expressed as the price
per unit of foreign currency in terms of
the home currency.
1. Direct quotation or home currency quotation
2. Indirect quotation or foreign currency quotation.
Method I
USD 1= Rs.50 or USD 1=50
Suppose a bank buys US $ from its customer for Rs. 44 and
sell it to other customer at Rs. 45.
foreign currency is kept constant

USD
USD1= 1=Rs.50
Rs.50may
maybecome
becomeUSD
USD1=
1=Rs.51
Rs.51
ororUSD
USD1=
1=Rs.60
Rs.60, ,etc.
etc.

‘Buy Low, Sell High’

 EXCHANGE QUATATIONS
The exchange rate may be quoted in two ways. Exchange rate is expressed as the price
per unit of foreign currency in terms of
the home currency.
1. Direct quotation or home currency quotation
2. Indirect quotation or foreign currency quotation.
Method I
USD 1= Rs.50 or USD 1=50
Suppose a bank buys US $ from its customer for Rs. 44 and
sell it to other customer at Rs. 45.
foreign currency is kept constant

USD
USD1= 1=Rs.50
Rs.50may
maybecome
becomeUSD
USD1=
1=Rs.51
Rs.51
Buy: ororUSD
USD1=
1=Rs.60
Rs.60, ,etc.
etc.
USD 1= Rs.48

Sell:
USD 1= Rs.51

‘Buy Low, Sell High’

 EXCHANGE QUATATIONS
The exchange rate may be quoted in two ways.

1. Direct quotation or home currency quotation

2. Indirect quotation or foreign currency quotation.

Suppose, for Rs.100 an orange vendor gets 50 oranges from

his supplier and for the same amount of Rs.100 he sells 40
oranges, he would make profit.
Exchange rate is expressed as the price
per unit of home currency in terms of Similarly,
the foreign currency
Method II
Rs.100 = USD 2 or Rs.100 = 2 Buy:
100 Rs. = 2 USD
home currency is kept constant
Sell:
Rs.100=USD 2 may become in due 100 Rs. = 1.5 USD
course Rs.100=USD 2.2 or Buy high and sell low.
Rs.100=USD 2.35, etc.
 EXCHANGE QUATATIONS
The exchange rate may be quoted in two ways. Exchange rate is expressed as the price
per unit of one US dollar in terms of the
home currency.
1. Direct quotation or home currency quotation
2. Indirect quotation or foreign currency quotation.
Method I
USD 1= Rs.50 or USD 1=50

foreign currency is kept constant

Exchange rate is expressed as the price
per unit of home currency in terms of
the foreign currency USD 1= Rs.50 may become USD 1= Rs.51
or USD 1= Rs.60 , etc.
Method II
Rs.100 = USD 2 or Rs.100 = 2

home currency is kept constant

Rs.100=USD 2 may become in due course

Rs.100=USD 2.2 or
Rs.100=USD 2.35, etc.
 EXCHANGE QUATATIONS

➢ The indirect quotation is used in London foreign exchange market

➢ In New York and other foreign exchange markets mostly the direct method is in use.

➢ In India, earlier we had used indirect method. However, from August 2, 1993, India has switched
over to direct method of quotation.
 TWO WAY QUOTATIONS:
➢ Foreign exchange dealers quote two prices, one for selling and the other for buying.

➢ The buying price for bank (at which you sell) is known as the bid price and the selling price for bank (at which you buy) is
known as offer price or ask price.

➢ The difference between the bid rate and the offer is the dealer‘s spread which is one of the potential sources of profit for
dealers.

➢ Whether using the direct quotation method or the indirect quote, the smaller rate is always termed the bid rate and the
higher is called the offer or ask rate.

Ask Price: Bank can sell 1 Euro

for 1.4746 US Dollars

Bid Price: Bank can buy 1 Euro

for 1.4745 US Dollars
 Settlement Mechanism
➢ In foreign exchange transactions the transactions may not completed on the same date.

1. Ready or Cash: Settlement of funds takes place on the same day (date of deal), e.g., if the date
of Ready/Cash deal is 5 October 2009 (Monday), settlement date will also be 5 October 2009. It is
also known as ‘Value today’.

2. Tom: Settlement of funds takes place on the next working day of the date of deal,
e.g., if the date of TOM deal 5 October 2009 (Monday), settlement date would be 6 October 2009
(Tuesday, provided it is a working day for the markets dealing as well as where currency is to be
settled). If Tuesday is a holiday, in any of the 2 countries, the settlement date will be next working day
in both the countries
 Settlement Mechanism
➢ In foreign exchange transactions the transactions may not completed on the same date.

3. Spot: Settlement of funds takes place on the second working day after/following the date of
contract/deal, e.g., if the date of Spot deal is 5 October 2009 (Monday), settlement date will be 7
October 2009. (Presuming all markets are working on 5, 6 and 7 October 2009). If not, it will the
next working day in both the countries

4. Forward: Delivery of funds takes place on any day after Spot date, e.g., if the date of forward deal
is 5 October 2009 (Monday), for value settlement date 30 October 2009 or 30 November 2009, it is a
forward deal.
Generally, settlement takes place on Spot settlement basis in most of the trades
 Settlement Mechanism
4. Forward:

Forward at Par:
When the forward rate is same as the spot rate for the currency, then it is said to be at ‘par’

Forward Premium:
When a currency is costlier in forward, it is said to be at premium.

Forward Discount:
When a currency is cheaper in forward, it is said to be at discount.
Calculation of premium or discount percentage
Settlement Mechanism
Settlement Mechanism
 Cross Rates:
➢ A cross rate may be defined as an exchange rate which is calculated from two (or more) other rates. It is
an exchange rate between two currencies computed by reference to a third currency, usually the US
dollar.

For example, if an exchange rate between the US$ and the Japanese Yen was quoted in an Indian newspaper,
this would be considered a cross rate in this context, because neither the US$ or the yen is the standard
currency of India.

Rs./$ rate
Yen/$ rate obtained from the
INR/Yen from Tokyo INR/Yen
local Indian market

Combination

If an Indian Business firm has imported certain goods from Japan, it needs to pay it in Yen. So the firm needs to
buy Yen from the Bank. But, there is no quote available for INR/Yen. The banker would obtain Yen/$ rate from
Tokyo 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 such a rate as cross
rate.
Factors Affecting the Exchange Rate:
 Factors Affecting the Exchange Rate:

1. International Trade:
Trade of goods and services is the major reason for demand and supply of foreign currencies. If a
country’s imports are high, the demand for foreign currency will be high and vice versa.

2. Capital Movements:
Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII) are important factors
affecting exchange rate. Large capital inflows in the country will result into appreciation of the
domestic country and large capital outflow will result into depreciation of the domestic currency.
 Factors Affecting the Exchange Rate:

3. Speculations:
When people speculate a fall in the value of a currency in the near future, they will sell that currency and start
buying the other currency that they expect to appreciate. The selling will increase the supply of the former
currency and lead to its depreciation and the appreciation of the other currency.

4. Government Policies:
The Central bank of a country plays an important role in case when there is fixed exchange rate system or
managed float. The Central Bank influences the exchange rate by buying and selling of bills and currencies.
 Factors Affecting the Exchange Rate:
5. Political Stability:
If the Political status of a country is uncertain, international investors would stay away from such countries.
Whereas, a stable political environment leads to capital inflows in the country.

6. Balance of Payments:
A surplus in the Balance of payment would lead to a strong currency and a deficit would lead to a weak
currency. A deficit in the current account shows the country is spending more on foreign trade than it is earning,
and that it is borrowing capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand for its products. The excess demand for foreign
currency lowers the country’s exchange rate
 Factors Affecting the Exchange Rate:

7. Inflation:
As per the Purchasing Power Parity theory, high inflation in one country as compared to the other will lead to
depreciation in the currency of that country.

8. Interest Rate Parity:

When interest rates go up in a country, so do yields for assets denominated in that currency; this leads to
increased demand by investors and causes an increase in the value of the currency of this country. If interest
rates go down, this may lead to a flight from that currency to another.
Thanks

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