2 Forex-Concept Summary

Chapter - 2
FOREIGN EXCHANGE EXPOSURE AND

RISK MANAGEMENT
Contents
1. REGULATOR OF FOREIGN CURRENCY IN INDIA........................................................................................................................................4

2. MAJOR FOREIGN CURRENCIES ..........................................................................................................................................................................4
3. EXCHANGE RATE ......................................................................................................................................................................................................5
4. APPRECIATION AND DEPRECIATION OF CURRENCY (FORWARD PREMIUM & DISCOUNT) ...............................................5
5. REASON BEHIND APPRECIATION & DEPRECIATION OF CURRENCY ..............................................................................................5
6. RISK ANALYSIS OF FOREIGN CURRENCY TRANSACTION .....................................................................................................................6
OPTION-I [WHEN INVOICE IS IN $] ...............................................................................................................................................................6
OPTION-II [WHEN INVOICE IS IN] .............................................................................................................................................................6
OPTION-III [WHEN INVOICE IS IN THIRD CURRENCY] ........................................................................................................................7
7. EXCHANGE RATE QUOTATION ..........................................................................................................................................................................7
(I) BID, ASK & SPREAD: ..........................................................................................................................................................................................7
(II) ONE WAY QUOTE: ............................................................................................................................................................................................7
(III) TWO WAY QUOTE: .........................................................................................................................................................................................7
INTERPRETATION OF TWO WAY QUOTE: ...........................................................................................................................................8
SELECTION OF BID RATE AND ASK RATE IN CONVERSION OF CURRENCY [MOST IMPORTANT] ...........................8
(IV) PIP (PRICE INTEREST POINT): .................................................................................................................................................................9
(V) ROUNDING OFF OF EXCHANGE RATE: ...................................................................................................................................................9
(VI) INTERPRETATION OF EXCHANGE RATE QUOTED IN COMPRESSED FORM: ......................................................................9
(VII) INTERPRETATION OF EXCHANGE RATE IN SPECIAL CASES: ...................................................................................................9
(VIII) INTERPRETATION OF EXCHANGE RATE QUOTED IN “PAIR OF CURRENCIES”: ......................................................... 10
8. DIRECT QUOTE, INDIRECT QUOTE & ITS CONVERSION ..................................................................................................................... 10
(1.) DIRECT QUOTE .............................................................................................................................................................................................. 10
(2.) INDIRECT QUOTE ......................................................................................................................................................................................... 10
(3.) CONVERSION OF DIRECT QUOTE INTO INDIRECT QUOTE OR VICE-VERSA .................................................................... 10
9. EXCHANGE AND OTC ........................................................................................................................................................................................... 11
10. SPOT TRANSACTION: - ........................................................................................................................................................................................ 11
11. FORWARD/ FUTURE TRANSACTION ........................................................................................................................................................... 11
12. % PREMIUM / DISCOUNT ON A CURRENCY ............................................................................................................................................. 12
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Page 2.2 SFM (CONCEPT SUMMARY)
CONCEPTUAL EXAMPLE FOR CALCULATION OF % INCREASE
`` AND % DECREASE ............................................................... 12
CALCULATION OF FORWARD PREMIUM/DISCOUNT: ......................................................................................................................... 12
CALCULATION OF FORWARD RATE USING % PREMIUM & DISCOUNT RATE ......................................................................... 12
13. LOSS/GAIN AND HEDGING WITH THE HELP OF FORWARD CONTRACT: .................................................................................. 13
14. SHORT CUT TECHNIQUE TO FIND LOSS/GAIN DUE TO CURRENCY APPRECIATION / DEPRECIATION ...................... 14
15. VARIABLE INTEREST RATE (FLOATING INTEREST RATE) ............................................................................................................... 14
16. CONTRIBUTION TO SALES RATIO ................................................................................................................................................................. 14
17. EXPECTED VALUE ................................................................................................................................................................................................. 14
18. SWAP POINT/FORWARD MARGIN/FORWARD POINT/FORWARD PREMIUM OR DISCOUNT ......................................... 14
19. BROKEN PERIOD SWAP POINT/FORWARD RATE ................................................................................................................................. 15
20. MONEY MARKET & CAPITAL MARKET ....................................................................................................................................................... 15
21. MONEY (CASH) MARKET HEDGE ................................................................................................................................................................... 16
(A) FOR AMOUNT RECEIVABLE IN FOREIGN CURRENCY: ................................................................................................................ 16
(B) FOR AMOUNT PAYABLE IN FOREIGN CURRENCY ........................................................................................................................ 17
22. EFFECT OF CONVERSION OF SAME CURRENCY AT SAME TIME BOTH SIDE ............................................................................ 17
23. TAX ON EXCHANGE GAIN / TAX SAVING ON EXCHANGE LOSS OR TAX/TAX SAVING ON INTEREST ........................... 17
24. CROSS RATES OF FOREIGN EXCHANGE ...................................................................................................................................................... 18
CALCULATION OF CROSS RATE: ..................................................................................................................................................................... 18
(A) FOR ONE WAY QUOTE: ....................................................................................................................................................................... 18
(B) FOR TWO WAY QUOTE: ..................................................................................................................................................................... 19
IDENTIFICATION OF CROSS RATE FROM GIVEN RATES: .......................................................................................................... 19
25. INTER-BANK TRANSACTION / MERCHANT TRANSACTION ............................................................................................................. 19
26. EXCHANGE MARGIN ............................................................................................................................................................................................. 20
LOGIC BEHIND ADDITION AND DEDUCTION ........................................................................................................................................... 20
27. EXCHANGE RATE DETERMINATION THEORY ......................................................................................................................................... 21
EXPLANATION-1: IRPT ...................................................................................................................................................................................... 22
EXPLANATION-2: PPPT ...................................................................................................................................................................................... 22
EXPLANATION -3: INTERNATIONAL FISHER’S EFFECT...................................................................................................................... 23
28. RELATIONSHIP BETWEEN HOME CURRENCY RETURN (HCR) & FOREIGN CURRENCY RETURN (FCR) .................... 23
EXPLANATION: ....................................................................................................................................................................................................... 23
29. ARBITRAGE .............................................................................................................................................................................................................. 24
(A) EXPLANATION: GEOGRAPHICAL ARBITRAGE: ................................................................................................................................ 24
(A) DIFFERENT POSSIBLE ROUTES: .................................................................................................................................................... 24
(B) SHORT CUT TO FIND PROFITABLE ROUTES:........................................................................................................................... 25
(B) EXPLANATION (COVER INTEREST ARBITRAGE): .......................................................................................................................... 26
(A) DIFFERENT POSSIBLE ROUTES: .................................................................................................................................................... 26
(B) SHORTCUT TO FIND PROFITABLE ROUTE: .............................................................................................................................. 26
30. NOSTRO A/C, VOSTRO A/C & LORO ACCOUNT ....................................................................................................................................... 27
(1) NOSTRO A/C: [OURS ACCOUNT WITH YOU]: ................................................................................................................................... 27
(2) VOSTRO A/C: [YOURS ACCOUNT WITH US]: ................................................................................................................................... 27
(3) LORO A/C: [OUR ACCOUNT FOR THEIR MONEY WITH YOU]: ................................................................................................ 27
(4) EXCHANGE POSITION & NOSTRO A/C BALANCE ........................................................................................................................... 27
(I) GENERAL INFORMATION:.................................................................................................................................................................. 27

FOREX Page 2.3
(II) EXCHANGE POSITION:........................................................................................................................................................................ 28

(III) CASH POSITION (NOSTRO A/C): .................................................................................................................................................. 28
(IV) EFFECT OF DIFFERENT TRANSACTIONS ON EXCHANGE POSITION & NOSTRO A/C: ........................................ 28
EXPLANATION-1: TRANSACTION THROUGH DEMAND DRAFT (DD) .................................................................................. 28
EXPLANATION-2: TRANSACTION THROUGH BILLS RECEIVABLE (B/R): ......................................................................... 29
31. LETTER OF CREDIT .............................................................................................................................................................................................. 29
32. CANCELLATION OF FORWARD CONTRACT .............................................................................................................................................. 30
33. DIFFERENT RATES APPLICABLE FOR CANCELLATION: ..................................................................................................................... 30
34. EXTENSION OF FORWARD CONTRACT / ROLL OVER OF FORWARD CONTRACT: ................................................................ 30
35. SUMMARY ON EXECUTION, CANELLATION & EXTENSION OF FORWARD CONTRACT ON DIFFERENT DATES: ..... 31
36. EXECUTION OF FORWARD CONTRACT BEFORE DUE DATE (EARLY DELIVERY OF CURRENCY) [DIAGRAM-I] ...... 32
37. EXECUTION, CANCELLATION & EXTENSION OF FORWARD CONTRACT AFTER DUE DATE [DIAGRAM-II] .............. 32
38. LEADING/LAGGING .............................................................................................................................................................................................. 33
39. PARALLEL LOAN / BACK TO BACK LOAN .................................................................................................................................................. 33

REGULATOR OF FOREIGN CURRENCY IN INDIA
All foreign exchange transaction made in India is being regulated either by RBI or FEDAI. In other word, we can say that
a person doing transaction in foreign exchange has to follow RBI rule or FEDAI rule.
Regulator of Forex Market
RBI FEDAI
(Reserve Bank of India) (Foreign Exchange Dealers Association of INDIA)
Established in accordance with the provisions Established under Section-25 of Companies Act
of RBI Act 1934 1956
Manage FEMA Act 1999 & maintain Foreign Regulate Inter-bank foreign exchange business
exchange market  Website: www.fedai.org.in
Website: www.rbi.org.in
MAJOR FOREIGN CURRENCIES

SN Country/Territory Currencies ISO Symbol Fractional Rate in  Regulator
Code* Unit (Approx) (Central Bank)
1. Kuwait Kuwaiti Dinar KWD --- 1000 fils 200 Central Bank of
Kuwait
2. United British pound GBP £ 100 penny 90 Bank of England
Kingdom (UK)
3. Eurozone Euro EUR € 100 Cent 80 European
[19 countries using Central Bank
€] (ECB)
4. Switzerland Swiss Franc CHF Fr 100 75 Swiss National
Rappen Bank
5. USA US dollar USD $ 100 Cent 70 Federal Reserve
Bank (Fed)
6. Canada Canadian CAD $ 100 Cent 55 Bank of Canada
Dollar
7. Australia Australian AUD $ 100 Cent 50 Reserve bank of
Dollar Australia
8. Malaysia Malaysian MYR Rm. 100 Sen 15 Bank Negara
Ringgit Malaysia
9. China Chinese Yuan CNY ¥ 10 Jiao 10 People’s Bank of
Renminbi China
10. India Indian Rupee INR  100 Paisa --- Reserve bank of
India
11. Japan Japanese Yen JPY ¥ 100 Sen 0.65 Bank of Japan
12. Nepal Nepalese NPR Rs. 100 Paisa 0.625 Nepal Rastra
Rupee Bank (NRB)
ISO Code: Internationally Standardized three letter abbreviation.
Note: (i) Earlier Germany was using Deutsche mark (DEM or DM) (Also known as “Mark” or “German Mark”) Currency. But Now
Germany using “Euro” (€) currency
(ii) Earlier France was using French Franc (FRF) currency. But now France is using “Euro” (€) currency. In
question, we still find DEM and FRF currencies.

FOREX Page 2.5
EXCHANGE RATE
Exchange Rate: Relationship between values of two currencies is known as Exchange Rate.
Practically, stronger currencies are quoted for 1 unit of foreign currency and weaker currencies are quoted for 100
units of foreign currency.
How to identify stronger currency & weaker currency?
Stronger Currency Small Quantity Eg: ¥100 = 65
Weaker Currency High Quantity Here, ¥ is weaker &  is stronger.
How does exchange rates decide?

Exchange rate between two countries depends upon price of a product in two countries (i.e. Purchasing Power)
Price in India ABC Price in USA

490 Product $7
In this case, exchange rate should be

$7 = 490
$1 = 490/$7 =70
Purchasing power (Ability to purchase product) depends upon various factors. One main factor is Currency
Circulation in country.
High currency circulation  Weak currency
Low currency circulation  Strong currency
APPRECIATION AND DEPRECIATION OF CURRENCY (FORWARD PREMIUM & DISCOUNT)

Appreciation of Currency (Premium): A currency appreciates when price of that currency increases.
Spot rate: $1 = 70.00;
Appreciation on $ = 2.8 Depreciation on Rupee ≠ 2.8
6M forward rate: $1 = 72.80
Depreciation of Currency (Discount): A currency depreciates when price of that currency decreases.
Spot rate: 1 = ¥1.54;
Depreciation on  = ¥0.04 Appreciation on Yen ≠ ¥0.04
6M forward rate: 1 = ¥ 1.50
REASON BEHIND APPRECIATION & DEPRECIATION OF CURRENCY

There are so many factors due to which currency appreciates or depreciates. Some of them are:
High Currency Depreciate

(i.) Interest Rate
Low Currency Appreciate
(ii) High Currency Depreciate

Inflation Rate
Low Currency Appreciate
Demand of share  Share price 

Good
Supply of $  $ Price 
News for
(iii) Indian
Economy Supply of share  Share price 
Bad
Demand of $  $ Price 
⦿Refer IRPT and PPPT concepts for details.

RISK ANALYSIS OF FOREIGN CURRENCY TRANSACTION

Every person wants to trade and deal in their home currency but the invoice can be made in any one currency only.
Hence invoice can be made in home currency or in foreign currency or in third currency.
Remember that, nobody can hold foreign currency because Government does not allow it. However, one can hold
foreign currency in foreign currency A/C. If someone receive foreign currency, they have to sell it to forex
dealer/bank. Similarly, if they have to pay foreign currency, they have to buy foreign currency from forex dealer/bank.
Let us discuss following three scenarios to understand “how risk generates in foreign currency transaction”
OPTION-I [WHEN INVOICE IS IN $]
Invoice Amount: $100 1

Mr. India () (Credit period 3M) Mr. USA ($)
` 2
3B 3A
Mr. USA has to pay $ 100 at 3
 $ month time.
Indian Bank
[Buy $, sell ]
Mr. India has risk of Low inflow in.

It is possible when $ currency will depreciate
Sequence of Steps: 123A3B

Analysis for Mr. India: When invoice is in foreign currency ($)  Risk to Mr. India  Need to hedge foreign currency
receipt.
Analysis for Mr. USA: When invoice is in home currency ($)  No risk to Mr. USA  No need to hedge home currency
payment hence no need to study FOREX management.
OPTION-II [WHEN INVOICE IS IN]
Mr. India () 1 Mr. USA ($)

Inflow at 3 Month Invoice Amount: 7000 Outflow at 3 Month
(Credit period 3M)
3 2B 2A
 $
Mr. USA has to make payment at 3
month time in ‘’ Currency USA Bank
Buy $ & Sell 
Mr. USA has risk of high outflow in $.

It is possible when will appreciate.
Sequence of Steps: 1⟹2A⟹2B⟹3

Analysis for Mr. India: When invoice is in home currency ()⟹ No risk to Mr. India ⟹ No need to hedge foreign
currency receipt.
Analysis for Mr. USA: When invoice is in foreign currency ()⟹ Risk to Mr. USA ⟹ Mr. USA needs to hedge foreign
currency payment.

FOREX Page 2.7
OPTION-III [WHEN INVOICE IS IN THIRD CURRENCY]
Mr. India () 1 Mr. USA ($)

Inflow at 3 Month Invoice Amount: €87.5 Outflow at 3 Month
(Credit period 3M)
4B 4A 3 2B 2A
 € € $
Mr. USA has to make payment in €
Indian Bank at 3 month time. USA Bank
Buy €, sell  Buy $, sell €
Mr. India has risk of low inflow in . Mr. USA has risk of high outflow in $.
It is possible when € currency will It is possible when € currency will
depreciate. appreciate.
Sequence of steps: 12A2B34A4B

Analysis for Mr. USA: When invoice is in foreign currency (€)  Risk to Mr. USA.  Need to hedge foreign currency
payment.
Analysis for Mr. UK: When invoice is in foreign currency (€)  Risk to Mr. India also  Need to hedge foreign currency
receipt.
Conclusion [Risk Analysis]:

From the above analysis it is cleared that, Hedging is required only when the invoice is being made in foreign
currency. In other word, Hedging is not required when invoice is made in home currency.
If question ask for any measures of hedging, it mean invoice is in foreign currency. Hence, do not get confused to
identify which currency is foreign currency and which currency is home currency. Just identify the currency in which
invoice is being made (or, currency in which amount is payable or receivable), and conclude that invoice currency
is foreign currency. After that, identify that party for whom invoice currency is foreign currency and then take
corrective action to minimize loss.
EXCHANGE RATE QUOTATION

(I) BID, ASK & SPREAD:
Bid Rate: Bid rate is that rate at which bank buys a currency.
Ask rate: Ask rate is that rate at which bank sells a currency.
Spread: The difference between Ask and Bid rate is called the spread.
Mathematically, Spread = Ask rate – Bid rate
𝐀𝐬𝐤 𝐫𝐚𝐭𝐞 – 𝐁𝐢𝐝 𝐫𝐚𝐭𝐞 𝐀𝐬𝐤 𝐫𝐚𝐭𝐞 – 𝐁𝐢𝐝 𝐫𝐚𝐭𝐞
% Spread = × 100 OR % Spread = × 100
𝐁𝐢𝐝 𝐑𝐚𝐭𝐞 𝐀𝐬𝐤 𝐑𝐚𝐭𝐞
(II) ONE WAY QUOTE:

When bid rate (i.e. buying rate) and ask rate (i.e. selling rate) are same, it is called one way quote.
For example: £ 1 = $ 1.50
It means bank will buy £ at $ 1.50 and also sale £ at $ 1.50
(III) TWO WAY QUOTE:

When bid rate (i.e. buying rate) and Ask rate (i.e. selling rate) are different, it is called two way quote.
For example: (a) $1 = 70.2500/71.2500 (b) 1 = $0.01404/0.01423

INTERPRETATION OF TWO WAY QUOTE:
Case-I: When bank quotes rate of $ [Indian Bank] Case-II: When bank quotes rate of  [USA Bank]
Rate: $1 =70.2500 /  71.2500 1 = $0.01404 / $ 0.01423
Buying rate of $ for Selling rate of $ Buying rate of  for Selling rate of 
bank for bank bank for bank
Mr. India Mr. India Mr. India Mr. India

$1 70.25 $1 71.25
1 $ 0.01404 1 $ 0.01423
Bank [Buy $] Bank [Sale $] Bank [Buy ] Bank [Sale ]
Net benefit to bank (Spread) = 1.00 Net benefit to bank (Spread) = $0.00019
SELECTION OF BID RATE AND ASK RATE IN CONVERSION OF CURRENCY [MOST IMPORTANT]
(1.) Identify amount payable or receivable?
(2.) Choose applicable Bid or Ask rate
At same time, bank buys one currency and sells another currency. First, identify the currency which is quoted in per
unit term and then select bid or ask rate.
Mr. India Payable in $10 Receivable in $10

Mr. India
 $
 $
Bank Bank
Buy  and sell $ Buy $ and sell 
Case-I: When bank quotes rate of $ [Indian Bank] Case-I: When bank quotes rate of $ [Indian Bank]
As bank sells $, ask rate of $ is applicable for As bank buys $, bid rate of $ is applicable for
conversion. conversion.
Rate: $ 1 = 70.2500 / 71.2500
Rate: $1 =  70.2500/ 71.2500
Equivalent Rupee = 10 × 71.25 = 712.5 Equivalent Rupee = 10 × 70.2500 = 702.50
Case-II: When bank quotes rate of  [USA Bank] Case-II: When bank quotes rate of  [USA Bank]
As bank buys, bid rate of  is applicable for As bank sells , ask rate of  is applicable for
conversion. calculation.
Rate: 1 = $0.01404 / 0.01423 Rate:  1 = $0.01404 / 0.01423
Equivalent Rupee = 10 × (1/0.01404) Equivalent Rupee = 10 × (1/0.01423)

= 712.5(Approx.) =  702.5(Approx.)

FOREX Page 2.9
(IV) PIP (PRICE INTEREST POINT):

PIP is the smallest value of exchange rate.
If exchange rate is quoted up to 2 digit after decimal, then one PIP value is “0.01”.
If exchange rate is quoted up to 4 digit after decimal, then one PIP value is “0.0001”.
For example: - $1 =  65.25/65.26. Here, spread is 1 PIP.
For example: - £1 = $1.3075/3080. Here, spread is 5 PIP.
Note:
In an exchange (like: NSE), we find exchange rate up to 4 digit after decimal in multiple of “0.0025” (i.e. 25 PIP) (Single
rate. No bid, ask)
Bank deals with customer (i.e. Merchant deal) at a rate up to 2 digits after decimal.
One bank deals with another bank (i.e. Inter-Bank deal) at a rate up to 4 digit after decimal.
(V) ROUNDING OFF OF EXCHANGE RATE:
`
0.0000 0.0012 0.0013 0.0025 0.0037 0.0038 0.0050
0.0001 to 0.0012 0.0013 to 0.0024 0.0026 to 0.0037 0.0038 to 0.0049

= Round off to 0.0000 = Round off to 0.0025 = Round off to 0.0025 = Round off to 0.0050
(VI) INTERPRETATION OF EXCHANGE RATE QUOTED IN COMPRESSED FORM:

Exapmle-1:
Given exchange rate is: $1 = 65.4245/50
It means rate is: $1 = 65.4245/ 65.4250
Example-2:
Given exchange rate is $1 = 65.5189/02
It means rate is: $1 = 65.5189/ 65.5202
(VII) INTERPRETATION OF EXCHANGE RATE IN SPECIAL CASES:

Suppose given exchange rate quotation is:
Spot rate (€ per £): 1.7820 ± 0.0002
1 month forward rate (€ per £): 1.7829 ± 0.0003
It means spot rate: £1 = € (1.7820-0.0002) / (1.7820+0.0002)

= € 1.7818 / 1.7822
1 month forward rate: £1 = € (1.7829-0.0003) / (1.7829+0.0003)
= € 1.7826 / 1.7832

(VIII) INTERPRETATION OF EXCHANGE RATE QUOTED IN “PAIR OF CURRENCIES”:
Pair of currencies
(/$) or (USD/INR)
Interpretation-1 Interpretation-2
When pair of currencies are in symbol When pair of currencies are in ISO code
/$ : XXX USD/INR : XXX
Second currency (i.e. $) is in per unit First currency (i.e. $) is in per unit
term (i.e. $1 = XXX) term (i.e. USD1 = INR XXX)
This is theoretical quotation on the Practically, we find rate quoted in this

basis of following logic: format.
10/kg = 10 per kg
/$ =  per $
Notes:
(i) If exchange rate are among £, €, $ & CHF then ignore strength and apply above interpretation because strength of
these currencies changes time to time.
(ii) If exchange rate are in following currencies “£ with ”, “$ with ”, “€ with ”, “¥ with ” then keep strength in mind
and ignore above interpretation if above interpretation gives illogical rate.
(iii) Use same interpretation (either second currency in per unit or first currency in per unit) in all exchange rate of a
question.
DIRECT QUOTE, INDIRECT QUOTE & ITS CONVERSION

(1.) DIRECT QUOTE
Price in home currency for 1 unit or 100 unit of foreign currency is known as direct quote.
Example: $1 = 70 is a direct quote for $ currency in India
(2.) INDIRECT QUOTE

Price in foreign currency for 1 unit or 100 unit of home currency is known as indirect quote.
Practically, we don’t find indirect quote in bank.
Example: 1 = $ 0.0143 is an indirect quote of $ in India.
(3.) CONVERSION OF DIRECT QUOTE INTO INDIRECT QUOTE OR VICE-VERSA

(A) For one way quote:
Reciprocal of direct quote of one currency is indirect quote of same currency.
1 1
Direct quote = OR Indirect quote =
Indirect quote Direct quote
Example: Direct quote for $: $ 1 =  45
1
Indirect quote for $: 1=$
45
(B) Conversion for two way quote:

Reciprocal of bid rate of one currency becomes ask rate of another currency or vice versa.
Direct quote: $1 =  70.00 / 71.50
1 1
Indirect quote:  1 = / i.e. 1 = 0.0140 / 0.0143 (Bid rate < Ask rate)
71.50 70

FOREX Page 2.11
Logic of above conversion: At same time, bank buys one currency and sales another currency. Hence, bid rate of one
currency becomes ask rate of another currency or vice versa.
Customer Bid rate of $ because

bank buys $
$1 70
Ask rate of 
because bank sells  $1/70 1
Bank Similarly, we can think

$1 = 70.00/71.50 for ask rate too.
EXCHANGE AND OTC

(1.) EXCHANGE:
Market where price negotiation is made publicly among various parties. Here, price of a currency is decided on
the basis of bidding of buyer and seller.
For example: - NSE, BSE, MCX, NCDEX
(2) OTC (OVER THE COUNTER):

OTC transaction are those transactions where price is decided privately between two parties.
For example: Transaction with Bank/Forex dealer.
OTCEI (Over the counter Exchange of India; www.otcei.net),
NASDAQ (National Association of dealers’ Automated quotation system; www.nasdaq.com)
SPOT TRANSACTION: -
SPOT TRANSACTION IN OTC (I.E. IN BANK): Transaction for immediate settlement (i.e. conversion in Bank)
SPOT TRANSACTION ON EXCHANGE (i.e. NSE, MCX, NCDEX): Retailers are not allowed for spot transaction on
exchange. However, big trader (like: Oil Marketing company (IOC, BPCL, HPCL), IT Companies…) can do spot
transactions but settlement takes place in T+2days.
FORWARD/ FUTURE TRANSACTION

FORWARD TRANSACTION/ FORWARD CONTRACT:
Today’s contract for future delivery of currency is known as forward contract.
⦿ In India, forward contracts are available for maximum 1 year period on monthly basis.
⦿ Forward contract is OTC transaction.
⦿ Forward contract rate is normally higher than spot rate due to time value of money.
⦿ We use forward contract to hedge risk as rate for future delivery is decided today in forward contact
FUTURE CONTRACT:
Forward contract entered on exchange (NSE/MCX/NCDEX) is known as future contract.
⦿ Future contracts are also available for maximum 1 year period in monthly basis.
Note:
In all transactions, exchange rate is decided today and settlement being made at different dates. For different time
period, different forward rate is applicable.
Longer Period Forward Rate > Shorter Period Forward Rate > Spot Rate
Normally, we use spot rate transaction for current settlement and forward transaction for future Settlement.

% PREMIUM / DISCOUNT ON A CURRENCY
CONCEPTUAL EXAMPLE FOR CALCULATION OF % INCREASE AND % DECREASE
High price 72.80

2.80 2.80
%increase = ×100 % Decrease = ×100
𝟕𝟎 𝟕𝟐.𝟖𝟎
= 4% = 3.84%
Low price 70.00
If above movement is in 6 month then annual % increase = (4×2) = 8% and Annual % decrease = (3.84%×2) = 7.68%
To calculate % increase, we have to use lower price as base (i.e. 70.00) as price increase from 70 to 72.80
To calculate % decrease, we have to use higher price as base (i.e. 72.80) as price decrease from 72.80 to 70
Hence, % increase and % decrease differ due to different base.
CALCULATION OF FORWARD PREMIUM/DISCOUNT:

First decide on which currency we have to calculate % premium /discount and then use following formula.
Case I: Premium/Discount on a currency using Case II: Premium/Discount on a currency using

exchange rate of same currency: exchange rate of other currency:
Annual % Forward premium/discount = Annual Forward premium/discount =
Forward rate − Spot rate 12 Spot rate − Forward rate 12
× 100 × × 100 ×
Spot rate period Forward rate period
+ve value premium; –ve value Discount +ve value premium; –ve value Discount
Example: SR: $1 = 70.00 Example: SR: $1 = 70.00

6M FR: $1 = 72.80 6M FR: $1 = 72.80
These are rates of $ and going to calculate P/D on $ These are rates on $ and going to calculate P/D on 
Forward rate−Spot rate 12 Spot rate−Forward rate 12
P/D on $ = × 100 × P/D on  = × 100 ×
Spot rate period Forward rate period
(72.80−70.00) 12 (70.00−72.80) 12
= 𝟕𝟎.𝟎𝟎
× 100 × 6 = × 100 × 6
𝟕𝟐.𝟖𝟎
= 8% (Premium.)  Same as above % increase = -7.69% (Discount.)  Same as above % decrease
Notes
At same time, when one currency appreciates, another currency depreciates. But % appreciation and % depreciation
differs due to different bases.
CALCULATION OF FORWARD RATE USING % PREMIUM & DISCOUNT RATE

(i) If there is premium on a currency, increase quantity of another currency by given %.
(ii) If there is discount on a currency, decease quantity of another currency by given %.
Example: €1 = ¥125
Case-I: Premium on € 5% then increase quantity of ¥ by 5%.
Case-II: Discount on € 5% then decrease quantity of ¥ by 5%.
Case-III: Premium on ¥ 5% then decease quantity of € by 5%.
Case-IV: Discount on ¥ 5% then increase quantity of € by 5%.

FOREX Page 2.13
LOSS/GAIN AND HEDGING WITH THE HELP OF FORWARD CONTRACT:

Let us consider following example to understand the entire concept:
Example: Mr. India imported goods from USA at $1. Amount is payable at 6 months end.
Spot rate = 64
Today’s entry in books of Mr. India:
Import A/C-----------Dr 64
To Mr. USA …….. A/C 64
Diagrammatic presentation:
Mr. India Mr. USA

Expected $1 (Payable at 6M)
 68
 65
Forward $1
Bank
(i) Expected Loss/Gain: Payable recorded = 64 (today)
Expected outflow = 68 (On 6M)
Expected loss = (68 – 64) = 4 Not to be recorded in books
(ii) Hedging with forward contract:

Bank quoted 6M FR: $1 = 65 (Say)
Now Mr. India can hedge risk by taking forward contract.
Outflow under forqward contract (if entered) = 65
Not to be recorded in books

Hedge amount = (68-65) = 3
By taking forward contract, expected

outflow of 68 can be reduced to65
Second Alternative:
Expected loss = 4
Recordable in books
Actual loss if entered in forward contract = 1
Hence, hedge amount (4-1) = 3
Payable recorded 64
Loss = 1
Actual outflow 65
(iii) At 6M, Loss/Gain due to Forward Contract if actual rates becomes:

Case-1: $1 =  63 (SR on 6M)
Case-2: $1 =  70 (SR on 6M)
Case-1: Loss due to forward contract = 2
Due to forward contract, actual outflow = 65

If forward contract had not been taken, outflow = 63

Case-2: Gain due to forward contract = 5
Due to forward contract, actual outflow = 65

If forward contract had not been taken, outflow = 70
Note: If question provides actual exchange rate prevailing on due date of forward contract and asks to calculate loss/
gain due to forward contract then compare “Forward rate” with “Spot rate prevailing on due date” to calculate
loss/gain.

SHORT CUT TECHNIQUE TO FIND LOSS/GAIN DUE TO CURRENCY APPRECIATION / DEPRECIATION
(This Is For Decision Making OR To Interpret Question Only)
(i) Payable in foreign currency and foreign currency will appreciate in future ⟹ LOSS (High outflow)
(ii) Payable in foreign currency and foreign currency will depreciate in future ⟹ GAIN (Low outflow)
(iii) Receivable in foreign currency and foreign currency will appreciate in future ⟹ GAIN (High inflow)
(iv) Receivable in foreign currency and foreign currency will depreciate in future ⟹ LOSS (Low inflow)
VARIABLE INTEREST RATE (FLOATING INTEREST RATE)

Interest rate that vary periodically on the basis of market condition is known as variable rate.
 Variable interest rate may be linked with any one of following benchmark:
 LIBOR (London Inter-Bank Offer Rate)
 MIBOR (Mumbai Inter-Bank Offer Rate)
 EURIBOR (Euro Inter-Bank Offer Rate
 BR (Base Rate)
 CP (Commercial Paper)
 T-Bill (Treasury bill)
Note:
 Above Reference rate (excluding BR) are derived from money market.
 Normally, reference rates are quoted in annual term in money market. If question is silent, always assume given
rate is annual rate.
CONTRIBUTION TO SALES RATIO

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Contribution to sale ratio (PV ratio) = × 100 ; where, contribution = sales – variable cost
𝑠𝑎𝑙𝑒𝑠
𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
Average Contribution to sale ratio (PV ratio) = × 𝟏𝟎𝟎
𝑻𝒐𝒕𝒂𝒍 𝒔𝒂𝒍𝒆𝒔
 Higher contribution to sale ratio indicates better position.
 Refer question-2F
EXPECTED VALUE
In statistics, average calculated using probability as weight is known as expected value.
Similarly, we can calculate expected exchange rate if different rates are given with their probabilities.
Expected exchange rate = ∑ (Different exchange rate × Probability)
SWAP POINT/FORWARD MARGIN/FORWARD POINT/FORWARD PREMIUM OR DISCOUNT

The difference between forward rate and spot rate is known as swap points/forward margin /forward premium.
 Increasing order swap points (eg. 6M Swap Point: 20/40) indicate premium.
Hence, add swap point in spot rate to calculate forward rate.
Deceasing order swap points (eg. 6M Swap Point: 30/15) indicate discount.
Hence, deduct from spot rate to calculate forward rate.
Reason: This is because of higher spread in forward rate than spread of spot rate.
Note:
Practically, bank does not quote forward rate. It quotes swap point with spot rate.
DISPUTE:
In one question, ICAI mentioned swap point in deceasing order but specially mentioned it as premium.
ICAI Question: [RTP-Nov-2011] [Nov-2011-8M] [RTP-Nov-2015] [SSM-2016] [PM-2017]
6M Forward premium: 0.60/0.55 Euro Cent
SR: £1 = €1.750/1.770

FOREX Page 2.15
Institute Solution:
RTP 2011  Assumed discount & deducted swap point from SR to calculate FR.
2011 Exam  Assumed premium & added swap point in SR to calculate FR.
SSM-2016  Assumed discount & deducted swap point from SR to calculate FR.
PM-2017  There are two questions: (i) Assumed discount; (ii) Assumed Premium
Recommendation (NS):
Logically it is discount. Hence, Assume discount and deduct from SR to calculate forward rate.
Also write note: Alternatively, we may assume premium also ignoring decreasing order as it specially
mentioned in question.
BROKEN PERIOD SWAP POINT/FORWARD RATE

Practically, bank quotes swap points for one month end, 2 month end and so on….. till 12 month end.
However, sometimes customers need swap point for 2.5 months, 40 days etc. as per requirement.
In this situation, swap points are adjusted for desired period using simple unitary method.
Example:
Swap point for 1M end = 20/35
Swap point for 2M end = 45/60
Customer needs swap point for 50 days to calculate 50 days forward rate.
Particulars For Bid Rate For Ask Rate
30 Days Point 20 35
60 Days Point 40 60
Additional 30 days point 20 25
For additional 20 days point 20
[ ∗ 20] = 13.33
25
[ ∗ 20] = 16.67
30 30
Rounded off 13 17
50 Days swap point (30 Days Point + Additional 20 Days Point (20+13) = 33 (35+17) = 52
Therefore, 50 Days Swap Point: 33/52.
MONEY MARKET & CAPITAL MARKET

CAPITAL MARKET:
Market where long term financial instrument are traded is known as capital market.
For example: Equity share, debenture/bond, preference share are some capital market instruments.
MONEY MARKET:
Market where short term debt instruments are traded is known as money market.
For example: Commercial paper, Treasury bill, Call money, etc. are some money market instruments.

MONEY (CASH) MARKET HEDGE
It is a hedging technique where we use money market instrument to borrow/deposit fund for short period and use spot
rate to convert currency.
(A) FOR AMOUNT RECEIVABLE IN FOREIGN CURRENCY:
1
Indian Supplier US Importer
Inflow at 6 Month Outflow at 6 Month
5
DEPOSIT 6274.56
2
WITHDRAW 6525.5
3
4
Indian MM Indian Bank Convert at SR US MM

Rate: 8% p.a. SR: 1$=64 Rate: 4% p.a.
1 Export today at $100
2 Borrow PV of invoice amount from US money market/bank for 6 months.

= $ 100 / (1+0.02) = $ 98.04
Logic behind borrowing of PV: So that repayment of borrowing should be equal to invoice amount and we can
repay $ borrowing out of receipt from US customer without any conversion.
Convert $ 98.04 into ‘’ @ spot rate.

3
$98.04 =  98.04 × 64 =  6,274.56
4 Deposit  6274.56 today in India for 6 month at Deposit rate of India.

Withdrawal amount after 6 month =  6274.56 X (1+0.04) = 6525.5
Logic behind deposit: Todays inflow can’t be compared with inflow of other hedging option which will be at
6M. Hence deposit today and withdraw at 6M and compare 6M time inflow with other hedging strategy inflow.
Repay $ borrowing out of receipt from foreign customer. Both amount should be $100 (equal to invoice
5
amount).
Hence, Amount receivable under money market operation at 6 month time is equal to  6525.5/-

FOREX Page 2.17
(B) FOR AMOUNT PAYABLE IN FOREIGN CURRENCY
Indian Importer US Supplier

Outflow at 6 Month Inflow at 6 Month
5
R E P A Y () at 6M
B O R R O W ()
4 2
3
6,305.28
6,589.02
Indian MM Indian Bank US MM

Rate: 9% p.a. SR: 1$=64 Convert at SR Deposit Rate: 3%p.a.
1 Import goods
2 Deposit PV of invoice amount @1.5% for 6 month

Amount = $100/ (1+.015) = 98.52
Logic behind borrowing of PV: So that withdrawal of deposit should be equal to invoice amount and we can pay
to US supplier out of withdrawal amount without any conversion.
Convert @SR
3
$98.52 = (64 × 98.52) = 6305.28
Borrow 6305.28 @4.5% for 6 month.

4
Repayment amount = 6305.28 × (1+0.45) = 6589.02
Logic behind borrowing: Todays outflow can’t be compared with outflow of other hedging option which will be
at 6M. Hence borrow today and withdraw at 6M and compare 6M time outflow with other hedging strategy
outflow.
5 Pay to foreign supplier out of withdrawal of $ deposit. Both amount = $100.

Hence, Amount payable under money market operation at 6 month time is equal to  6589.02/-
EFFECT OF CONVERSION OF SAME CURRENCY AT SAME TIME BOTH SIDE

⦿ Never convert same currency on same date both side (i.e. buy & sale) as customer makes loss of spread and
bank/forex dealer earns profit.
⦿ If same currency is receivable from one party and payable to another party on same day then use receipt from one
party to pay another party without any conversion.
TAX ON EXCHANGE GAIN / TAX SAVING ON EXCHANGE LOSS OR TAX/TAX SAVING ON INTEREST
Any expenditure which is allowable under income tax act generates tax saving. Similarly, tax is also payable on any
income.
If information of tax rate is available, then consider income net of tax & Expense net of Tax saving in decision making.
⦿ Net of tax expense (i.e. Exchange loss/ Interest) = Expense × (1-T)
⦿ Net of tax income (i.e. Exchange gain/ Interest) = Income × (1-T)

CROSS RATES OF FOREIGN EXCHANGE
An exchange rate calculated from two or more other exchange rates is known as cross rate.
⦿ We calculate cross rate when desired currencies exchange rates are not quoted by bank.
⦿ Cross rate is only notional calculation to find equivalent amount. We can’t find this rate in market.
For example
Mr. India Mr. Nepal

At 6Month NPR 10,000
 (?) NPR 10,000
Bank
Mr. India has to pay NPR10,000 but exchange

rate of NPR with  is not available in bank.
⦿ Suppose, following two rates are available in different Process to complete transaction
markets/bank:
Mr. India Payable in NPR10,000
Bank-1: $1 = 65
NPR104
Bank-2: $1 = NPR 104 65 $1 $1
` ⦿ Now, we can calculate exchange rate of  with NPR using
above two exchange rates which is known as Cross Rate. But Bank-1 Bank-2
this is only notional calculation to find equivalent amount.
Cross Rate: 65 = NPR 104
CALCULATION OF CROSS RATE:

(A) FOR ONE WAY QUOTE:
METHOD-1 [Prefer this one in exam] METHOD-2

We are going to form LHS/RHS equation by using given rates
Mr. India Payable in NPR10,000
to calculate desired rate.
Given: NPR104
(i) $1 = 65 OR /$ = 65 (i.e.  per $ = 65) 65 $1 $1
(ii) $1 = NPR 104 OR NPR/$= 104 (i.e. NPR per $ = 104)
Alternatively, from (ii) above, Bank Bank
1 1
NPR104 = $1 NPR1 = $ (i.e. $/NPR = )
104 104 Cross Rate: 65 = NPR 104
Desired Rate: NPR1 =  (?) [i.e /NPR = ?] Net Position: 65 = NPR104
Now, we can derive exchange rate of any one
  $ currency from above.
= [ × ]
NPR $ NPR
NPR Rate:  Rate:
NPR1 = 65/104 1 = NPR104/65
Desired LHS Rate of $1 in Rate of NPR1 in
NPR1 = 0.625 1 = NPR1.60
 per NPR  $
 1
Using these rates, we can calculate equivalent 

NPR
= 65 × (104)  NPR1 = 0.625 currency for NPR10,000.
Equivalent  = 10000 × 0.625 = 6,250 Equivalent  = 10000 × 0.625 = 6,250
⦿ Same method can be applied to calculate rate of NPR/ where we get 1 = NPR1.60

FOREX Page 2.19
(B) FOR TWO WAY QUOTE:

Use same method as above from LHS RHS equation for both bid rate & ask rate separately.
Rate quoted by bank is: (i) £ 1 = ¥ 130 / 131 (ii) £ 1 = 72 / 72.5
1 1 1 1
OR, ¥1 = £ / OR, 1 = £ /
131 130 72.5 72
Using these rates, we can calculate any one of following rates:
Calculate required rate using following relationship:
  £  £ 1 1
(i) ¥ = [ £ × ¥] / [ £ × ¥] = [72 × 131] / [72.5 × 130] = 0.5496 / 0.5577
For Bid For Ask
¥ ¥ £ ¥ £ 1 1
(ii)  = [ £ × ] / [£ × ] = [130 × 72.5] / [131 × 72] = ¥1.7931/1.8194
For Bid For Ask
 Hence, required rate: ¥1 = 0.5496 /0.5577 & 1 = ¥1.7931/1.8194.
IDENTIFICATION OF CROSS RATE FROM GIVEN RATES:

Given rates:
Bank-1: £1 = XXX
Bank-2: £1 = $XXX
Bank-3: ¥1 = $XXX
Bank-4: €1 = ¥XXX
 By using Bank-1 & Bank-2, we can calculate cross rate of “$ &”.
 By using Bank-1, 2 & 3 rates, we can calculate cross rate of “ & ¥”.
 By using all bank rates, we can calculate cross rate of “ & €”.
And so on…..
INTER-BANK TRANSACTION / MERCHANT TRANSACTION
Forex Transaction
Inter Bank Transaction Merchant Transaction

[Whole Sale Transaction] [Retail Transaction]
Exchange rate applicable for Exchange rate applicable for transaction between
transaction between two retail customer & bank is known as Merchant rate.
banks/forex dealers is known as In India, merchant rates are quoted upto 2 digit
Inter Bank Rate. after decimal place.
Normally, inter-bank rates are As per FEDAI rule, settlement of all merchant
quoted upto 4 digit after decimal. transactions shall be affected on the principle of
rounding off the Rupee amounts to the nearest
whole Rupee i.e. without paisa.

EXCHANGE MARGIN
Difference between inter-bank rate & merchant rate is known as Exchange Margin. We can calculate merchant rate from
inter-bank rate by adjusting margins.
Exchange Margin Adjustment
For Bid Rate For Ask Rate
Deduct margin from buying rate Add margin to selling rate to get
to get desired exchange rate. desired exchange rate. Hence,
Hence,
Inter Bank Bid Rate XXX Inter Bank Ask Rate XXX
(-) Margin (XXX) (+) Margin XXX
Merchant Bid Rate XXX Merchant Ask Rate XXX
Inter Bank Bid Rate XXX Inter Bank Bid Rate XXX
(-) Margin
LOGIC BEHIND (XXX)
ADDITION AND DEDUCTION (-) Margin (XXX)
Merchant
 For Bid Rate: Bid
Bid rate of Rate XXXof a currency must be lesser than
Merchant Rate Merchant Bid bid
inter-bank Rate XXX bank makes
rate otherwise
loss.
$100L
Customer Bank
(?)
@65.25 $100L
This rate must be lesser than 65.25 otherwise bank
makes loss. Say, exchange margin is 0.25% then
Bid Rate of $: 65.25 - (65.25 ×0.25%) Inter Bank
= 65.09
$1 = 65.25/65.80
65.25/65.8065.25/65.
For Ask Rate: Ask rate of Merchant Rate of a currency must be higher than inter-bank ask rate otherwise bank makes
8065.25/65.80
loss.
$100L
Customer Bank
(?)
@65.80 $100L
This rate must be higher than 65.80 otherwise bank
makes loss. If exchange margin is 0.25% then
Ask Rate of $: 65.80 + (65.80 ×0.25%) Inter Bank
= 65.96
$1 = 65.25/65.80
65.25/65.8065.25/65.
Note: If exchange margin is given in question then assume given exchange rates are inter-bank rate and hence adjust it
8065.25/65.80
to calculate merchant rate.

FOREX Page 2.21
EXCHANGE RATE DETERMINATION THEORY

Following theories are useful to forecast exchange rate and premium/discount of two countries. Forecasted rate may or may not
prevail in market.
Exchange Rate Determination Theory
Interest Rate Parity Theory Purchasing Power Parity Theory International Fishers Effect
(IRTP) (PPPT) (IFE)
According to IRPT, According to PPPT, ⦿ All concepts are same as IRPT.

⦿ Forward rate of two currencies ⦿ Exchange rate of two In addition, it provides
depends upon interest rate of currencies depends upon price of relationship among real interest,
these two currencies. products and inflation rate. inflation rate & risk free rate.
⦿ Currency with high interest ⦿ Currency with high inflation ⦿ Fisher’s Formula:
rate depreciates in future & rate depreciates in future & (1 + Real Interest Rate) × (1+
currency with low interest rate currency with low inflation rate Inflation Rate) = (1+ Risk Free
appreciates in future. appreciates in future. Rate)
⦿ Interest rate differential is ⦿ Inflation rate differential is Where,
approximately equal to approximately equal to Real Interest Rate: Rate at which
premium/discount of a currency. premium/discount of a currency. inflation is not adjusted.
⦿ Fair forward rate is calculated ⦿ Forward/future spot rate can Risk Free Rate: T-Bill rate
using following formula: be calculated using following [Instrument issued by RBI on
1+PIR() n formula: behalf of Gov.]
FR (/$) = SR (/$)× [ ] 𝟏+𝐏𝐈𝐑() 𝐧
1+PIR($)
ER (/$) = SR (/$)× [ ]
𝟏+𝐏𝐈𝐑($)
Where, PIR = Periodic Interest
rate. Where, PIR = Periodic Inflation See: Explanation-3
rate
See: Explanation-1
See: Explanation-2

EXPLANATION-1: IRPT
India (6%) USA (2%)
USA Bank
Borrow in $100 1
Repay $
2
Deposit in Indian Mr. USA/ Borrowing
Bank in 6500 Convert @ SR: $1= 65 India
5
3
4 Convert @ FR
Withdraw deposit At fair rate,
=6500×(1 + 0.6) FR must be: equivalent $ should
= 6890 $102 = 6890 be $102 (i.e. No P/L)
6890
$1 = [ ] 6500 × (1 + 0.06)
102
=67.5490 [ ]
$ 100 × (1 + 0.02)
1+PIR() n
SR (/$)× [ ]
1+PIR($)
Verification: SR: $1= 65;FR: $1 =67.5490
(67.5490−65.00)
Premium on $ = × 100 = 3.92% (Approx. equal to 4% i.e. difference between interest rate)
𝟔𝟓.𝟎𝟎
(65.00−67.5490)
Discount on  = × 100 = -3.77% (Approx. equal to 4% i.e. difference between interest rate)
𝟔𝟕.𝟓𝟒𝟗𝟎
EXPLANATION-2: PPPT
Spot Rate Determination:
Price in India ABC Price in USA
490 Product $7
Current Spot Rate:

$7 = 490
$1 = 70
Exchange Rate after 1 Year:

Inflation in India = 5% (Say)
Inflation in USA = 1.5% (Say)
In this case, $ currency will appreciate by approx. 3.5% (5-1.5) and  currency will depreciate by approx. 3.5%.
Price in India after 1 Year: ABC Price in USA after 1 Year:

=490 × (1+0.05) = 514.5 Product =7 × (1+0.015) = 7.105
ER(Expected Rate) at 1 Year: 490 × (1 + 0.05)

$7.105 = 514.5 [ ]
$7 × (1 + 0.015)
514.5
$1 = [ 7.105 ]
1+PIR() n
= 72.4138 SR (/$)× [ ]
1+PIR($)
Verification: SR: $1= 70;FR : $1 =72.4138
(72.4138−70.00)
Premium on $ = × 100 = 3.45% (Approx. equal to 3.5% i.e. difference between inflation rate)
𝟕𝟎 .𝟎𝟎
(70.00−72.4138)
Discount on  = × 100 = -3.33% (Approx. equal to 3.5% i.e. difference between inflation rate)
72.4138

FOREX Page 2.23
EXPLANATION -3: INTERNATIONAL FISHER’S EFFECT

According to IFE, Risk free rate of a country depends upon inflation rate.
High inflation ⟹ High risk free interest rate
Low inflation ⟹ Low risk free interest rate
Relationship in interest rate as per Fisher [Fisher’s formula]
Risk Free Rate - High

Inflation
Real Interest Rate-Low

Relationship:
(1 + Real rate) × (1+ Inflation rate) = (1+ Risk free rate)
RELATIONSHIP BETWEEN HOME CURRENCY RETURN (HCR) & FOREIGN CURRENCY RETURN (FCR)
(i) (1+ FCR) = {(1+ HCR) × (1+ Premium on HC)} OR {(1+HCR) × (1- Discount on HC)}
(i) (1+ HCR) = {(1+ FCR) × (1+ Premium on FC)} OR {(1+ FCR) × (1- Discount on FC)}
EXPLANATION:
India (6%) USA (2%)
Mr. India has 6500 SR: $1 = 65 Bought share of Apple Inc. @ $100
Equivalent inflow at 1Year end 1Y FR: $1 = 64 After 1 year:

= 7360 Dividend received=$5
Discount on
Price = $110
$ 1.5385%
Return on HC (): Return on FC ($):
(𝐼𝑛𝑓𝑙𝑜𝑤−𝑂𝑢𝑡𝑓𝑙𝑜𝑤)
[(7360−6500)×100] =
= 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
6500 [{(5+110)−100}×100]
= 13.23% =
100
` = 15%
Alternatively, we may calculate Similarly, we may calculate $ return

directly using $ return directly using  return &
premium/discount on. premium/discount on.
(1 +  return) = (1+ $ return) × Premium on  = [(65-64)/64]*100
(1-Discount on $) = 1.1525%
= (1+0.15) × (1-0.015385) (1 + $ return) = (1+ 0.1323) ×
= 1.1323 (1+ 0.015625)
Hence,  return = 1.1323-1
Hence, $ Return = 15%
= 13.23%

ARBITRAGE
Arbitrage is an act or process to earn risk free profit. The act may be:
(i) Sale at high rate & purchase at low rate (Geographical Arbitrage); or
(ii) Borrow at low rate & invest at high rate (Cover interest arbitrage)
Arbitrage
Geographical Arbitrage Cover Interest Arbitrage

⦿ Possible due to mismatch in spot rate of ⦿ Possible due to mismatch in SR, FR & two countries
same currency in different market. interest rate (i.e. not based on IRPT).
⦿ Action: Buy at small rate in one market & ⦿ Action: Borrow from one country & deposit in
sake at high rate in another market. another country.
⦿ For everyone, there are maximum 2 possible ⦿ For everyone, there are maximum 2 possible
routes. In one route, we get profit and in routes. In one route, we get profit & in another route,
another route, we get loss. [See explanation] we get loss. [See Explanation]
⦿ Can we find profitable route directly? ⦿ Can we find profitable route directly?
 Yes, see explanation.  Yes, see explanation.
(A) EXPLANATION: GEOGRAPHICAL ARBITRAGE:

Suppose,
Spot rate in Mumbai: $1 = 65
Spot rate in New York: 100 = $1.55
If there is mismatch in above spot rates then both Mr. India & Mr. USA can earn arbitrage profit.
Both parties have following two possible routes:
(A) DIFFERENT POSSIBLE ROUTES:
(1) For Mr. India: Say, he has 1000 today
Route-1
$1 = 65 100 = $1.55
 $ 
Mumbai New York
1000 $ 15.3846  992.55
Loss = (1000- 992.55) = 7.45. Arbitrage is not possible.
Route-2 100 = $1.55 $1 = 65

 $ 
New York Mumbai
1000 $ 15.50  1007.50
Arbitrage Gain = (1007.50- 1000) = 7.50 Arbitrage is possible.

FOREX Page 2.25
(2) For Mr. USA: Say, he has $1000
Route-1
$1 = 65 100 = $1.55
$  $
Mumbai New York
$1000 65000 $ 1007.50
Arbitrage Gain = $ (1007.50 – 1000) = $7.50
Route-2
100 = $1.55 $1 = 65
$  $
New York Mumbai
$1000  64,516.1290 $ 992.55
Arbitrage Loss = $ (1007.50 – 992.55) = $7.45
(B) SHORT CUT TO FIND PROFITABLE ROUTES:

In arbitrage question, all currencies are quoted for 2 times in different markets. Hence, compare two rates of any one
currency and buy that currency at low rate and sale at high rate to find profitable route.
Example-1:
Given,
Mumbai: $1 = 70
New York: £1 = $1.35
London: £1 = 90
Here, all 3 currencies are quoted for two times. We can compare two routes of anyone currency but comparing $ rate is
less time consuming.
Rate-1: (Mumbai): $1 = 70
Rate-2: (New York & London Cross Rate): $1.35 = 90  $1 = 66.67
Profitable Route: Sale $ in Mumbai & buy $ in New York.
Example-2:
Given,
Mumbai: £1 = 96/98
London: £1 = ¥140/142
Japan: 1 = ¥1.50/1.60
Comparison:
Rate-1: Mumbai: £1 = 96/98
Rate-2: London & Japan Cross rate
 ¥  ¥ 1 1
[/£] = [ × ] /[ × ] =[ × 140] / [ × 142] = 87.50/94.67
¥ £ For Bid ¥ £ For Ask 1.60 1.50
Profitable Route:
Route-1: Buy £ @ 98 in Mumbai & sale £ @ 87.50 in London/Japan.
Arbitrage is not possible as there is loss.
Route-2: Buy £ @ 94.67 in London/Japan & sale £ @ 96 in Mumbai.
Arbitrage is possible as there is gain.
Note:
(i) If face difficulties in finding profitable route, proceed randomly from any one route. If first route provide profit then
no need to check from another route as gain from both routes is not possible. However, if first route provide loss
then again check arbitrage from another route.
(ii) In two way quote, we may find loss in both routes due to spread.

(B) EXPLANATION (COVER INTEREST ARBITRAGE):
Arbitrage may be possible under any one of following two routes:
(A) DIFFERENT POSSIBLE ROUTES:
Route-1 India UK
UK Bank
Borrow in £ 1
Repay £
2
Deposit in Indian Mr. UK/ Borrowing
Bank in  India
Convert @ SR 5
3
4
Withdraw deposit Equivalent £
Convert @ FR
Surplus of 5th step (If any) = Arbitrage
Route-2 India UK
Indian Bank
1 Borrow in 
Repay 
Borrowing 2
Mr. UK/ Deposit in UK Bank
India in £
5 Convert @ SR
3
4
Equivalent  Withdraw £ deposit
Convert @ FR
Surplus of 5th step (If any) = Arbitrage
(B) SHORTCUT TO FIND PROFITABLE ROUTE:

(i) If given rates are one way quote and single interest rate is applicable for both borrowing & deposit in a country
then we can find profitable route directly using following technique:
As per IRPT,
For  per $ rate Derived from IRPT
1+PIR() n
𝐹𝑅 FR (/$) = SR (/$)× [ ]
[1+ PIR ()] =( ) × [1 + PIR ($)] 1+PIR($)
𝑆𝑅
In fact, it is same formula as:

LHS for  RHS for $ [1 + HCR] = [(1 + FCR) × (1+prem/disc]
𝐹𝑅
Because = (1+% Prem/Disc)
Situation-1: LHS < RHS; borrow in  & deposit in $. 𝑆𝑅
Situation-2: LHS> RHS; Borrow in $ & deposit in .

Situation-3: LHS=RHS: Rates are on parity.
Hence arbitrage is not possible.
(ii) If given rates are two way quote or borrowing & depositing rate are different then we can’t use IRPT and hence
can’t find profitable route. Hence proceed randomly from any one route. If first route provide profit then no need
to check from another route. However, if first route provide loss then again check arbitrage from another route.

FOREX Page 2.27
NOSTRO A/C, VOSTRO A/C & LORO ACCOUNT

(1) NOSTRO A/C: [OURS ACCOUNT WITH YOU]:
Current account of domestic bank opened in foreign country in foreign currency is known as Notro Account.
India Switzerland
Indian Bank Swiss Bank

Nostro Account of
Indian bank in CHF
Indian Bank opened a Current Account with
Swiss Bank in CHF currency. This Bank account
is known as Nostro Account for Indian.
(2) VOSTRO A/C: [YOURS ACCOUNT WITH US]:

Current account of foreign bank opened in domestic country in domestic currency is known as Vostro Account.
For example: Account of Swiss bank in India with SBI in Rupee () Currency.
India Switzerland

Vostro Account of
Swiss bank in 
Swiss Bank opened a Current Account with
Indian Bank in  currency. This Bank account
is called Vostro Account by Indian.
(3) LORO A/C: [OUR ACCOUNT FOR THEIR MONEY WITH YOU]:
Current account of one domestic bank opened in foreign bank in foreign currency referred by another domestic bank
for its own transaction is known as Loro Account.
For Example: SBI opened Current Account with Swiss bank. If PNB refers that account of SBI for its own transaction
then it is called Loro Account for PNB and it is Nostro Account for SBI.
India Switzerland
SBI opened a Current Account in
Swiss Bank in CHF currency.
Indian Bank (SBI) Swiss Bank
Nostro Account of
SBI in CHF
Indian Bank (PNB)

PNB refers Account of SBI for its own
transaction. It is Loro Account for PNB
(4) EXCHANGE POSITION & NOSTRO A/C BALANCE

(I) GENERAL INFORMATION:
- Currency of Switzerland is Swiss Franc (CHF)
- “Zurich” is a city of Switzerland
- Telegraphic Transfer or Telex Transfer , often abbreviated to TT, is an electronic means of transferring
funds overseas

(II) EXCHANGE POSITION:

⦿ Foreign currency detail maintained by domestic bank is known as exchange position.
⦿ Over bought exchange position indicates excess of buy over sell. Similarly, over sold exchange position indicates
excess of sale over purchase.
⦿ Objective to maintain exchange position is to find reasons behind difference in foreign currency balance maintained
in Nostro A/C.
(III) CASH POSITION (NOSTRO A/C):

⦿ This balance is maintained by foreign bank.
⦿ Credit balance of Nostro A/C = Positive balance (Deposit)
⦿ Debit balance in Nostro A/C = Negative Balance (Overdraft)
(IV) EFFECT OF DIFFERENT TRANSACTIONS ON EXCHANGE POSITION & NOSTRO A/C:
SN Transaction Effect in Exchange Effect in Nostro A/C

Position
1 Spot purchase of foreign currency (TT) Increase today Increase today
2 Spot sale of foreign currency Decrease today Decrease today
3 Forward Purchase of foreign currency Increase today No effect today but increase on due date
4 Forward sale of foreign currency Decrease today No effect today but decrease on due date
5 Forward purchase contract cancelled Decrease today No effect
6 Forward sale contract cancelled Increase today No effect
7 DD in foreign currency issued Decrease today No effect today but decrease when DD is
(See explanation-1) presented in foreign bank
8 DD in foreign currency cancelled Increase today No effect
9 Bills in Foreign currency purchased Increase today No effect but increase on due date
(See explanation-1)
10 Bill dishonoured Decrease today No effect
11 Foreign currency remitted by TT Decrease Decrease
EXPLANATION-1: TRANSACTION THROUGH DEMAND DRAFT (DD)

At the time of issuing DD Indian Bank decreases its exchange position.
Nostro A/C decreases when DD Presents in Swiss Bank by Swiss Exporter.
If before presenting DD it will cancel, then Indian Bank increases its exchange position.
India Switzerland
Nostro Account of
3 Indian bank
2
DD in CHF 6 5
 1 CHF
Import DD
Indian Importer Swiss Exporter
4
Pay by way of DD

FOREX Page 2.29
After step-3 Indian bank will reduce exchange position.

After step-6 Nostro Account of Indian bank will decrease.
If DD canceled due to some reason the step 6 & 5 will not applicable and Mr Buyer will get money back and
Indian bank will increase Exchange position. No effect on Nostro A/C
EXPLANATION-2: TRANSACTION THROUGH BILLS RECEIVABLE (B/R):

Bank buys bills receivable from Indian Exporter
India Switzerland
Present B/R at Maturity

Indian Bank 5 Swiss Bank
Nostro Account of
4 Indian bank
3
B/R in CHF  Export 6

1 CHF
Invoice in CHF
a
Indian Exporter Swiss Importer
2
Received by way of B/R
 On Step-3 Indian bank increases exchange position.

 On Step-5 & 6, Nostro A/C of Indian bank increases.
 If B/R dishonor, Indian bank decreases exchange position and in this case there will be no effect on Nostro
Account.
LETTER OF CREDIT
➢ Documents issued by banker to foreign supplier which provides assurance of payment of full amount on due date is
known as letter of credit.
➢ Supplier provides credit period to importer only when he transfers LC to supplier.
➢ Bank charges following two commissions for LC:
a. Opening charges payable at beginning on equivalent amount calculated at spot rate
b. Commission payable on due date on equivalent amount calculated at FR.
Types of LC:
1. Revocable LC: Terms & conditions can be changed without permission of supplier. Practically revocable LC is not
in use.
2. Irrevocable LC: Terms & conditions cannot be changed without permission of supplier.
Import with 6 month credit

Indian
US supplier
Importer
LC
 (At 6M)
LC
Enter
Agreement Bank
Today

CANCELLATION OF FORWARD CONTRACT

For cancellation, both parties have to enter opposite transaction / contract for same currency at applicable rate and
settle differential amount which is loss / gain of cancellation.
Receivable $ 100 at 3M
Mr.
Mr India
India Mr. India
 70 $100 X $100
Forward contract
Bank has already been Bank
entered which
3MFR: $1 = 70 Applicable Rate: $1=X
can’t be completed
due to default of
Original Contract foreign customer.
Cancellation Contract
⦿ If X > 70, Loss to Mr. India & gain to Bank (Differential amount payable by Mr. India to Bank)
⦿ If X < 70, Gain to Mr. India & loss to bank (Differential amount payable by Bank to Mr. USA)
In case of Cancellation after due date or automatic cancellation on due date +15 days:
⦿ Loss to customer under cancellation: Payable by customer
⦿ Gain to Customer under cancellation: Bank is not bound to pay
Note: Bank Position after Cancellation:
Bank’s existing position doesn’t change due to cancellation. In other words, gain recorded by bank at the time of
original forward contract with the help of Interbank transaction remains unchanged even customer cancels existing
forward contract.
DIFFERENT RATES APPLICABLE FOR CANCELLATION:

SN Cancellation Date Applicable Rate
1. Before due date FORWARD RATE of remaining period to maturity prevailing on
cancellation date
2. On due date SPOT RATE prevailing on due date
3. After due date or Automatic SPOT RATE prevailing on Approach Date or
cancellation date (DD+15 days) Automatic cancellation date whichever is earlier
EXTENSION OF FORWARD CONTRACT / ROLL OVER OF FORWARD CONTRACT:

Extension of forward contract is not possible.
However, extension objective can be achieved by taking following actions:
SN Extension Date Actions
1. Before due date (i) Cancel original contract at FORWARD RATE of remaining period to
maturity prevailing on Extension date
(ii) Enter New forward Contract for desired period
2. On due date (i) Cancel original contract at SPOT RATE prevailing on due date
(ii) Enter New Forward Contract for desired period
3. After due date or Automatic (i) Cancel original contract at SPOT RATE prevailing on approach date or
cancellation date (DD+15 Automatic cancellation date whichever is earlier.
days) (ii) Enter New forward Contract for desired period
Extension charges = Loss/ Gain under cancellation

FOREX Page 2.31
SUMMARY ON EXECUTION, CANCELLATION & EXTENSION OF FORWARD CONTRACT ON DIFFERENT DATES:
FORWARD CONTRACT- Execution / Cancellation / Extension
BEFORE DUE DATE ON DUE DATE AFTER DUE DATE
Execute Execute Execute
i) Execute at agreed Execute at agreed rate Common cancellation

forward rate charges + Delivery at
ii) Interest on outlay of spot rate
fund www.fmguru.org Refer Diagram-II below
CA Nagendra Sah
iii) Swap difference FCA, B. Sc. (H), CFAL1
Refer diagram-I Below
Cancel Cancel Cancel
Enter opposite contract Opposite transaction at Common cancellation

at forward rate for spot rate charges
remaining period to Refer Diagram-II below
maturity
Extension Extension Extension
A. Cancel original A. Cancel original forward Common cancellation

forward contract at contract at spot rate charges + New forward
Forward rate for B. Enter new forward contract
remaining period to contract desired period Refer Diagram-II below
maturity
B. Enter new forward Common Charges:
contract for desired It includes the following:
www.fmguru.org
period CA Nagendra Sah 1. Swap difference
FCA, B. Sc. (H), CFAL1
2. Interest on outlay of fund
3. Cancellation loss / gain
4.

EXECUTION OF FORWARD CONTRACT BEFORE DUE DATE (EARLY DELIVERY OF CURRENCY) [DIAGRAM-I]
1
Forward contract Exporter US Customer
entered on15-June
for 3M Expiry 4
2
 65 $100
⦿ As per contract: Delivery on 15- Sept
5 ⦿ But Actual: Delivery on 15- Aug (Early Delivery)
Cancellation on Bank
15- Aug @ 1M FR
6 $100 1 2 3 ⟹ On 15-June, 2018
 67 $100
4 5 6 ⟹ On 15-Aug, 2018
3  64
 65.5 $100 www.fmguru.org
CA Nagendra Sah
3M Forward contract FCA, B. Sc. (H), CFAL1
already entered on Inter-Bank-1 Inter-Bank-2
15-June for 3M which
can’t be completed 1M FR on 15- Aug SR on 15- Aug If this is inflow, bank has
due to early delivery $1 =  66.00/67.00 choice to pay interest.
$1 =  64.00/64.50
(i) Bank has to take delivery at agreed rate 65 [Inflow to exporter 6500]
(ii) Outlay of fund to bank on 15-Aug due to early delivery (65-64)×100 = 100
Interest on outlay of fund receivable from exporter @ 12% (say) on 100 for 30 days = 0.986
(iii) Swap loss of bank receivable from exporter = (67 - 64)×100 = 300
EXECUTION, CANCELLATION & EXTENSION OF FORWARD CONTRACT AFTER DUE DATE [DIAGRAM-II]
Cancel original
1
Contract on approach Importer US Supplier
date or (DD+15) @ SR
6
62 $100
Say, Importer approach for Cancellation or
2 extension or execution on 25 Sep (after 10 days)
 65 $100
Forward contract
entered on15-June for www.fmguru.org
⟹ On 15-June, 2018
3M Expiry Bank CA Nagendra Sah 1 2 3
FCA, B. Sc. (H), CFAL1
4 5 ⟹ On 15-Sep, 2018
New 1M forward 5 62.5
contract on 15-Sep to 67 $100 ⟹ On Approach day
6 Or, DD+15Days
hedge uncertainty 4
3 $100
 63.5 $100
3M Forward contract
entered on 15-June
Inter-Bank-1 Inter-Bank-2
for 3M. But it can’t be
executed as customer If this is inflow, bank has
1M FR on 15- Sept SR on 15- Sept
didn’t come choice to pay interest.
$1 =  66/67 $1 =  62.50/63.00
(i) Outlay of fund of bank on 15-Sep to execute forward contract of interbank = (63.5-62.5)×100 = 100
Interest on outlay of fund recoverable from importer @ 12% (say) on 100 for 10 days = 0.329
(ii) Swap loss of bank recoverable from importer = (67 - 62.5)×100 = 450
(iii) Cancellation Charges payable by importer = (65 - 62)×100 = 300; (iv) Common charges = 750.329

FOREX Page 2.33
LEADING/LAGGING
LEADING:
⦿ Payment before due date is known as lead payment or leading.
⦿ No discount is allowed for early payment.
⦿ Lead payment is beneficial when “opportunity benefit of interest during credit period” is lesser than
“exchange loss” in same period.
LAGGING:
⦿ Delaying the payment beyond due date is known as lag payment or lagging.
⦿ Supplier charges interest for late payment.
⦿ Lag payment is beneficial when interest charges by supplier is lesser than “exchange gain & opportunity
saving of interest”.
PARALLEL LOAN / BACK TO BACK LOAN

When multinational corporations operating in various countries could not transfer funds among their subsidiaries
due to restriction in capital flows exercised by various governments, they came out with innovations of back-to-back or
parallel loans among themselves.
Parallel loan involve four parties, two multinational corporations and two subsidiaries in two different countries.
Following arrangement is Parallel loan/back to back loan
India USA
Indian Company US Subsidiary of

Indian company willing to fund Indian Company
its US Subsidiary $1,00,000
Interest in  Loan in  Loan in $

Interest in $
Indian Subsidiary of
US Company US Company
US company willing to fund its
Indian subsidiary in  currency
which is equivalent to $ 1,00,000
Figure showing Parallel loan between two companies

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Chapter - 2

FOREIGN EXCHANGE EXPOSURE AND

1. REGULATOR OF FOREIGN CURRENCY IN INDIA........................................................................................................................................4

// CA NAGENDRA SAH // WWW.FMGURU.ORG

// CA NAGENDRA SAH // WWW.FMGURU.ORG

(II) EXCHANGE POSITION:........................................................................................................................................................................ 28

// CA NAGENDRA SAH // WWW.FMGURU.ORG

Regulator of Forex Market

MAJOR FOREIGN CURRENCIES

// CA NAGENDRA SAH // WWW.FMGURU.ORG

How does exchange rates decide?

Price in India ABC Price in USA

In this case, exchange rate should be

APPRECIATION AND DEPRECIATION OF CURRENCY (FORWARD PREMIUM & DISCOUNT)

REASON BEHIND APPRECIATION & DEPRECIATION OF CURRENCY

High Currency Depreciate

(ii) High Currency Depreciate

Demand of share  Share price 

// CA NAGENDRA SAH // WWW.FMGURU.ORG

RISK ANALYSIS OF FOREIGN CURRENCY TRANSACTION

Invoice Amount: $100 1

Mr. India has risk of Low inflow in.

Sequence of Steps: 123A3B

OPTION-II [WHEN INVOICE IS IN]

Mr. India () 1 Mr. USA ($)

Mr. USA has risk of high outflow in $.

Sequence of Steps: 1⟹2A⟹2B⟹3

// CA NAGENDRA SAH // WWW.FMGURU.ORG

OPTION-III [WHEN INVOICE IS IN THIRD CURRENCY]

Mr. India () 1 Mr. USA ($)

Sequence of steps: 12A2B34A4B

Conclusion [Risk Analysis]:

EXCHANGE RATE QUOTATION

(II) ONE WAY QUOTE:

(III) TWO WAY QUOTE:

// CA NAGENDRA SAH // WWW.FMGURU.ORG

Rate: $1 =70.2500 /  71.2500 1 = $0.01404 / $ 0.01423

Mr. India Mr. India Mr. India Mr. India

Bank [Buy $] Bank [Sale $] Bank [Buy ] Bank [Sale ]

Mr. India Payable in $10 Receivable in $10

Equivalent Rupee = 10 × 71.25 = 712.5 Equivalent Rupee = 10 × 70.2500 = 702.50

Rate: 1 = $0.01404 / 0.01423 Rate:  1 = $0.01404 / 0.01423

Equivalent Rupee = 10 × (1/0.01404) Equivalent Rupee = 10 × (1/0.01423)

// CA NAGENDRA SAH // WWW.FMGURU.ORG

(IV) PIP (PRICE INTEREST POINT):

(V) ROUNDING OFF OF EXCHANGE RATE:

0.0001 to 0.0012 0.0013 to 0.0024 0.0026 to 0.0037 0.0038 to 0.0049

(VI) INTERPRETATION OF EXCHANGE RATE QUOTED IN COMPRESSED FORM:

(VII) INTERPRETATION OF EXCHANGE RATE IN SPECIAL CASES:

It means spot rate: £1 = € (1.7820-0.0002) / (1.7820+0.0002)

// CA NAGENDRA SAH // WWW.FMGURU.ORG

This is theoretical quotation on the Practically, we find rate quoted in this

DIRECT QUOTE, INDIRECT QUOTE & ITS CONVERSION

(2.) INDIRECT QUOTE

(3.) CONVERSION OF DIRECT QUOTE INTO INDIRECT QUOTE OR VICE-VERSA

(B) Conversion for two way quote:

// CA NAGENDRA SAH // WWW.FMGURU.ORG

Customer Bid rate of $ because

Bank Similarly, we can think

EXCHANGE AND OTC

(2) OTC (OVER THE COUNTER):

FORWARD/ FUTURE TRANSACTION

// CA NAGENDRA SAH // WWW.FMGURU.ORG

High price 72.80