Foreign Exchange Market Dynamics - Types of FX Transactions (Merchant / Cover / IB) Exchange Rate Mechanism (Spot / Cross / Forward)

Foreign Exchange Market Dynamics – Types of
FX transactions (Merchant / Cover / IB)

Exchange Rate Mechanism (spot / cross /
forward)
GOVINDARAJAN RANGACHARY
HEAD-PROFESSIONAL DEVELOPMENT CENTRE,
INDIAN INSTITUTE OF BANKING AND FINANCE,
SOUTH ZONE, CHENNAI.
GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

INDIAN INSTITUTE OF BANKING & FINANCE 1
FOREIGN EXCHANGE DEFINITION
 “Foreign Exchange” means foreign currency and includes—
 (i) deposits, credits and balances payable in any foreign
currency
 (ii) drafts, travellers cheques, letters of credit or bills of
exchange, expressed or drawn in Indian currency but payable
in any foreign currency
 (iii) drafts, travellers cheques, letters of credit or bills of
exchange drawn by banks, institutions or persons outside
India, but payable in Indian currency
 (The above definition is as per Foreign Exchange management
Act 1999)

Session Objectives
 Brief about Indian Foreign Exchange Market
 To learn about Rupee Exchange rate history
 To Know about fundamental concepts about Forex rates
 To know about Foreign exchange terms
 Factors affecting Foreign exchange rates
 To Learn Spot/inter Bank/Merchant rates/Cross Rates
 To know Interest Parity Theorem and Forward rates
 To learn Premium/Discount
 Exercises in calculating Rates and Types of Risks in FX

RESERVE BANK OF INDIA-FOREIGN EXCHANGE MANAGEMENT
Year 1938 - Exchange control was introduced in

India under Defence of India rules.
Year 1966 – Indian Rupee was devalued.
Year 1975 – Rupee Linked to Basket of currencies.
Year 1993 - Exchange rate becomes Market
Determined.
Year 2000 – Foreign exchange management Act
(FEMA) replaces Foreign Exchange regulation Act
(FERA)

RUPEE EXCHANGE RATE-HISTORY
Fixed exchange Rate system with British Pound
Selling and buying Pounds against rupees at fixed
rates
Devaluation of rupee was done to the extent of 57%
in June 1966. Rupee went from Rs. 4.76 to Rs. 7.50
to Dollar.
India’s trade Diversification and Rupee exchange rate
linked to Basket of currencies.
In the First week of July 1991, two step devaluation
of the rupee to the extent of 18% was engineered.
July 12,1991- The balance of payments
reached bottom-line- USD 975 million and Out
of which an amount of USD 600 million was
kept with SBI, New york as contingency
reserve.
Adequate to meet a week import.
Fear of default loomed large for India and
borrowing were ruled out because of Junk
status accorded to Indian bonds by Rating
agencies.
India pledged its Gold stocks with Bank of
England and Bank of France for a short term
loan of USD 405 million. The gold was
redeemed between September and
November 1991.
India applied for assistance with IMF and
conditionalities were told for lending which
led to economic reforms in 1991.
The first major announcement was the
depreciation of Rupees in 2 stages to the
extent of 18%.
There was an urgency to overhaul the

administrated Exchange rate system.
A dual exchange rate system called LERMS
( Liberalized Exchange Rate Management
system) was introduced in March 1992.
60% of the inward remittance will be sold at
Market rates and 40% will be sold to RBI at
official rate to meet import of essential
items like Fertilizers, Essential drugs and Oil.
India moved to unified exchange rate regime
with effect from October 4, 1995 considering
the improvement in forex inflows in the form
remittances and Exports.
India embarked into market determined
exchange rate system paving way for current
account convertibility.
The forex reserves as on 19th Aug 2022 is USD
564.05 Billion ( Picture Next Page)
FOREIGN EXCHANGE TERMS
Fixed Exchange rate refers to a rate which the Government
sets and maintains at the same level.
The rate is determined by the central bank of the country
The change in currency price is carried out by Devaluation
and Revaluation
Flexible Exchange rate is a rate that is varying according to
market forces.
The rate is determined by Demand and Supply.
The changes in currency price is carried out by Depreciation
and appreciation
The exchange rate is not under the control of the
Government or central bank

FUNDAMENTAL CONCEPTS ABOUT RATES
Foreign Exchange is exchanging one currency for another.
All transactions have three key components namely
(1) Purchase (2) Sale (3) Rate of exchange
All rates are quoted from Bank’s point of view
All transactions are also referred from Bank’s Point of
view.
The terms “Purchase” and “Sale” are with reference to
foreign exchange
These standard reference points and conventions must be
remembered at all times.

PARTICIPANTS OF FOREX MARKETS
CUSTOMERS
COMMERCIAL BANKS
CENTRAL BANKS
EXCHANGE BROKERS
OVERSEAS FOREX MARKETS
SPECULATORS
HEDGERS
ARBITRAGEURS
DIRECT AND INDIRECT RATES
 Direct Quotation: In this method, the Home
currency is the variable currency and the Foreign
currency is kept constant. (e.g) USD/INR= Rs.
75.00/75.05
 USD is the base currency and INR is the variable
currency. In India only direct quotations are used.
 Indirect quotation: In this method, the Home
currency is kept constant and the foreign currency
is the variable currency.(e.g) Rs. 100=USD
1.3324/1.3333
 INR is the base currency and USD is the variable
currency.
EXERCISES
 Please find out from the following the base currency and the variable
currency
1. GBP = USD 1.3457
2. EUR = USD 1.1374
3. USD = JPY 114.22
4. USD = CHF 0.9270
5. AUD = USD 0.7338

BASICS OF FOREIGN EXCHANGE
When a Bank quotes USD= Rs. 75.72/75.75, it means that the said
Bank is prepared to deal in USD (i.e) the base currency and the
Bank would buy USD 1 at Rs. 75.72 and sell USD 1 at Rs. 75.75.
The Market maker ( Bank) is willing to buy the Base currency
(USD) by the LHS price and willing to sell the Base currency
(USD) by RHS price.
The difference between the buying rate (Bid rate) and selling rate
( ask rate) is called “Spread”.
In case of direct quote, by convention the First rate is the buying
rate of the Base currency by Market Maker and Second rate is
the selling rate of the base currency by Market Maker.
In case of Indirect quote, the first rate is selling rate of Base
currency by Market Maker and the second rate is the buying rate
of Base currency by Market Maker.

EXERCISES ( which side you will deal)
INTER BANK MARKET SITUATION
 USD = Rs.75.72/75.75 1. Exporter received USD 100,000
 GBP = USD 1.2440/43 2. Importer wants GBP 100,000
 EUR = USD 1.0930/32 3. Exporter received EUR 100,000
 USD = JPY 106.74/77 4. Importer wants USD 1,000,000

ANSWERS TO EARLIER EXERCISES
1. BANK (MARKET MAKER) WILL BUY BASE CURRENCY USD AT
RS. 75.72
2. BANK (MARKET MAKER) WILL SELL THE BASE CURRENCY GBP

AT USD 1.2443
3. BANK (MARKET MAKER) WILL BUY THE BASE CURRENCY EUR

AT USD 1.0930
4. BANK (MARKET MAKER) WILL SELL THE BASE CURRENCY USD

AT JPY 106.77
SPREADS AND PIPS
Spread:
1 USD = Rs. 75.00/75.05
The difference between the Bid rate and ask rate (i.e) 5 paise
is called the Spread.
Pip:
1 GBP = USD 1.2440 rate changes to USD 1.2442 in few seconds
USD has moved by 2 Pips (i.e) .0002 change in the Fourth
Decimal Point.
1USD = JPY 106.74 rate changes to JPY 106.70 then JPY has
moved by 4 pips (i.e) .04. Here the change is in the second
decimal point. Hence Pips definition may vary among
currencies.
EXERCISES
 Please find out which currency has strengthened and
which currency has weakened at the end of the day
 1 USD = Rs. 75.7200 (opening) and Rs. 75. 7650 ( closing)
 2. GBP = USD 1.2440 (opening) and USD 1.2400 (Closing)
 3. EUR = USD 1.0930 (Opening) and USD 1.0920 (closing)
4. USD = JPY 106.74 (opening) and JPY 106.50 (closing)

FACTORS AFFECTING FOREIGN EXCHANGE RATES
Balance of payments
Strength of the Economy
Fiscal Policy
Interest Rates
Monetary Policy
Political Factors
Exchange control and central bank
Intervention
Speculation
VALUE DATE: is the date on which the exchange of
currencies actually takes place. This is irrespective of the
date of deal.
In Foreign exchange markets, it takes some time to process
the transaction and send instructions to the correspondent
bank/branch abroad.
CASH/READY transaction: on the same day
TOM: stands for the next working day
SPOT: stands for the value date falls on the second working
day following the date of the deal.
FORWARD RATE: Settlement on any date beyond Spot date

Nostro account: The account in USD maintained in
the US by a Bank in India is termed as Nostro
account.
Vostro account: Similarly , if a Bank in USA
maintaining an account with an Indian Bank in INR
currency which will be termed us Vostro account.
Loro account: If a Bank in India had to refer to any
US Bank’s account in Thailand, it ( a third party
arrangement) would say “their (US Bank’s) Loro
account with them. (The Thai Bank)

CROSS RATES IN EXCHANGE
US dollar is the intervention currency when USD/Rupee exchange rate is
available in the Indian forex market.
Exchange rate of all other foreign currencies are derived through
crosses.
(e.g.) A export customer has received EURO 100,000. He wants to
convert into Rupees. The rates are as under: 1USD=Rs. 75.72/75.73 at
Mumbai and 1 EURO = USD 1.0930/1.0934 in overseas Market
The customer first sells EURO and buy USD at 1.0930 (the Market maker
at overseas will by at LHS) and these USD will be sold in Mumbai Inter
bank Market. The Market Maker will again buy the Base currency at LHS
(i.e) Rs. 75.72.
From the above, We find that 1 Euro fetches USD 1.0930 and 1 USD
fetches Rs. 75.72 , Hence 1 EURO= 1.0930 * 75.72 (i.e) Rs. 82.7619
say Rs. 82.76. EURO 100000 will fetch Rs. 82,76,000
Find out the rate if the customer has to pay an outward Remittance of
EUR 100,000 ? Ignore exchange Margin.

CROSS RATE EXERCISES
 An importer wants to Buy GBP 100,000 to pay for his imports.
 The rates are quoted as under:
 Mumbai Inter Bank Market: USD = Rs. 75.72/75.75
 In overseas Market : GBP = USD 1.2440/1.2442
 I step: Importer has rupees and wants to buy GBP
 II step: In India Dollar/Rupee is quoted and hence he has to go through
DLR/Rupee route to get the rate for GBP
 III step: Market maker in India ( Bank) will sell Base currency USD at ask rate
(i.e) Rs.75.75
 IV step: By acquiring that dollars, he has to buy GBP. But GBP is quoted in terms
of Dollars. The market Maker in overseas ( Bank) will sell the Base currency GBP
at ask rate (i.e) 1.2442
 V Step: The cost of 1 GBP is Rs. 75.75*1.2442 = Rs. 94.2481 ( say Rs. 94.25)
 To buy GBP 100,000 the importer has to pay Rs. 94,25,000 ( Margins have not
taken into consideration)
Merchant rates
 Reserve Bank of India, being the central bank of the country does not
buy/sell from/to the customers ( exporters and importers and others)
 The importers/exporters/others who are required to buy/sell foreign
exchange are popularly called as “ Merchants”
 RBI has authorised Banks in India to undertake FX transactions with
Merchants
 Foreign exchange Dealers Association of India (FEDAI) acts as a facilitating
body and in consultation with RBI frames rules/regulations for AD
( Authorised dealers) in India, for transactions with merchants, which are
known as “ Merchant rates”
 The rates quoted by Banks for dealing in Inter bank Market are known as
“ Inter Bank rates”
 All Merchant quotation is to be quoted in four decimal places with the
last two digits in the multiple of 25.
 (For example TT buying for 1 USD = Rs. 75.0625)

CARD/COVER/BASE RATES
 Card rates are the rates applied by AD for small value
transactions as to avoid Dealer being disturbed every now
and then. Each Bank is free to fix the limit on the amount to
fix the card rates.
 Cover Rate is the rate at which the AD can cover the
merchant transaction in the inter bank Market without any
profit or loss.
 Base rate is the rate which forms the basis of computation
of both Spot and forward rates and the same is arrived from
the cover rate. This is done by loading some cushion, in the
cover rate, for guarding against any adverse movement in
the exchange rate after committing a rate till the position
is covered.
Computation of Merchant Rates
 Example:
 TT Buying rate  Spot USD = Rs. 75.5050-75.5525
 Step 1:  Find the TT buying rate.
 Select Appropriate Base Rate  Answer:
( Market Buying rate)
 Base rate: Deduct some cushion
 Step 2 : from the cover rate.
 Deduct exchange margin as per your  Cover rate: Rs. 75.5050
bank’s internal guidelines
 Deduct cushion: Rs. 00.1000
 Step 3 :
 Base Rate Rs. 75.4050
 Round off the quote as per FEDAI
 Less Exchange Rs. 00.1000
guidelines in Four Decimal places and
the last two digits should be in the  Margin (Profit)
multiple of 25. (.0025)
 TT buying rate Rs. 75.3050

Computation of Merchant Rates
 Example:
 TT selling rate  Spot USD = Rs. 75.5050-75.5525
 Step 1:  Find the TT selling rate.
 Select Appropriate Base Rate  Answer:
( Market selling rate)
 Base rate: Add some cushion from
 Step 2 : the cover rate.
 Add exchange margin as per your bank’s  Cover rate: Rs. 75.5525
internal guidelines
 Add cushion: Rs. 00.1000
 Step 3 :
 Base Rate Rs. 75.6525
 Round off the quote as per FEDAI guidelines
 Add Exchange Rs. 00.1000
in Four Decimal places and the last two
digits should be in the multiple of 25. Margin (Profit)
(.0025)
 TT selling rate Rs. 75.7525

BILL BUYING RATE
 In case of exports, the exporter send the goods and draws

documents like Bill of exchange(draft) against which the
payment is to be received from abroad as per the agreement
entered by the Buyer and Seller.
 The exporter is not offering FX immediately rather offer
documents for his claim to get the FX in a future date.
 Hence the document is either purchased, discounted
negotiated by the authorised Dealer.
 Hence, the AD can dispose of the FX after receipt of the
same in his NOSTRO account.
 Hence while quoting the Bill buying rate the AD has to take
into consideration the notional due date or already fixed due
date. Accordingly the AD will add forward margin for the
period after adjusting in the SPOT rate.
MERCHANT RATES
Applicable Rate Nature of transaction
TT buying rate 1 Clean Inward remittance TT/MT/DD for which cover has already been provided by credit to the Nostro
account of the Bank
2 conversion of Proceeds of instruments sent on collection basis
3 cancellation of outward TT/MT/DD/PO etc.,
4 Cancellation of forward sale contract
Bill buying rate 1 purchase/discount/negotiation of export bills ( where Bank has to Process the Bill)
TT selling rate 1 Clean outward remittance in foreign currency by TT/MT/DD/PO
2 cancellation of purchase (i.e)

Bill Purchased earlier is returned unpaid
bill Purchased earler transferred to collection account
inward remittance returned to remitting bank
3 Cancellation of forward Purchase contract
4 import documents received directly by the importer
Bill Selling rate 1 Transaction involving remittance for import bill except the 4th point mentioned in TT selling rate

INTEREST PARITY THEOREM EXAMPLE
 Consider a Person wants to Borrow USD 100,000 for one year at the rate of
0.17% p.a and by converting into Indian rupees wants to invest the amount in
Fixed deposit at the rate 4% p.a.
 Suppose the current rate of 1 USD = Rs. 75 and the investor is investing Rs.
75,00,000 for one year in FDR at the rate of 4%
 After one year the dollar borrowing stands at USD 100,170 (including int.) and
rupee investment brings Rs. 78,00,000 ( including int.)
 The parity theorem formula is Spot Price *(1+local interest rate)/ (1+foreign
interest rate) ^1
 This leads to Rs. 75.00 * (1.0400/1.0017)^1 = Rs. 75.00*1.03823= Rs.77.87
 Now rupee forward can also be arrived out by dividing Rs. 78,00,000/USD
100170 which fetches 1 USD = Rs. 77.8676 (say Rs 77.87) at the end of one
year which is the same arrived by the theorem in the earlier step.
 From the above we understand that one year dollar is costlier in forward by
287 paise compared to spot price.

INTEREST PARITY PRINCIPLE
Forward rates are linked to Interest rate differential.
Otherwise, it can provide an arbitrage opportunity to make
risk less profit.
The inference we learnt that the currency carrying a
lower rate of interest will be at Premium, while the
currency carrying a higher rate of interest will be at
Discount.
This relationship is called Interest rate parity.
This Parity will hold good where there are no capital account
controls and capital can move freely across borders.
In India, the forward rate is a function of Demand and supply
rather than interest rate differentials.
GENERAL PRINCIPLES OF FORWARD RATES
Foreign currencies earning higher interest

rates are traded at a forward rate below the
spot rate (i.e) at a discount to their spot
prices.
The forward price of the lower interest rate
currency is always above the spot rate
(i.e., at premium to their spot prices)
The currency which commands higher interest
rate is always at a discount in relation to the
other that commands a lower interest rate.
CALCULATING FORWARD RATE
 The rate of exchange for any date other than spot is a function of Spot
and the relative interest rate in each currency as discussed in interest
parity theorem
 Forward rate has two components:
 Spot rate , and
 Forward points
 Forward points are also called as forward differentials which reflect
the interest rate differentials between the pair of currencies provided
capital flows are freely allowed.
 However in USD/INR rate as there are exchange control regulations
prohibiting free movement of capital from/into India. In India free
convertibility is allowed only in current account transactions.
 Hence in case of USD/INR it is pure demand/supply which determines
the forward differentials.

Premium: When a currency is costlier in future(forward) as
compared to Spot, the currency is said to be at a Premium
vis-à-vis another currency.
In “ Direct Quote” premium is always added to both buying
and selling rate and in “ Indirect Quote” premium is always
deducted from both buying and selling rate.
Discount: When a currency is cheaper in future(forward)as
compared to spot, the currency is said to be at a discount
vis-à-vis another currency.
In “Direct Quote” discount is always deducted from both
buying and selling rate and in “ Indirect Quote” discount is
always added to both buying and selling rate.

FORWARD RATE QUOTATIONS
 Forward rates is quoted in terms of forward differentials also called as forward
margins.
 Mumbai Inter bank Market quotes as under:
 Spot: USD = Rs. 75.70-75.75
 Spot/June = 0.4700/0.4900 ( means 47/49 paise)
 Spot/July = 0.7000/0.7300 (means 70/73 paise)
 Spot/August = 0. 9600/0.9900 (means 96/99 paise)
 Kindly note that the forward differentials are in ascending order in each of
these months. The first figure is lower than the second figure. This means the
base currency (USD) is at Premium. The rupee (INR) is at discount.
 Please also note that if the forward differentials are in descending order,
the base currency is at discount.
 Now calculate the forward rates for USD/INR for all 3 months.

Forward Rates Calculation Examples
 Consider EURO = USD 1.0818/22  Consider USD = JPY 107.02/05
 Spot/June = 2/3  Spot/June = 4/3
 Spot/July = 4/5  Spot/July = 10/9
 Spot/ Aug = 19/22  Spot/ Aug = 15/14
 Spot/ Nov = 49/51  Spot/ Nov = 34/33
 Here the forward points are to be considered as  Here the forward points are to be
under:
considered as under:
 0.0002/0.0003 for June
 0.04/0.03 for June
 0.0004/0.0005 for July
 0.10/0.09 for July
 0.0019/0.0022 for Aug
 0.15/0.14 for Aug
 0.0049/0.0051 for Nov
 0.34/0.33 for Nov
 Please note that the forward points are in
ascending order. Hence the base currency EUR is at  Please note that the forward points
Premium and the other currency USD is at are in descending order. Hence the
discount. Base currency USD is at discount and
the other currency JPY is at Premium.
 Please calculate the forward rates for all months.
 Please Calculate the forward rates
for all months.


GENERAL PRINCIPLES OF FORWARD RATES
 Fixed Date Foreign exchange Forward contract
 Option Foreign exchange Forward contract
 FEMA and FEDAI guidelines
 Contract Amount
 Option of Delivery
 Ready/TOM/Spot/forward
 Place of delivery
 Date of delivery
 Choice of Exercising Option
Calculation of exchange rates for forward exchange contracts
 We see earlier that in case of direct quote, the Premium is

added to spot rate and discount is deducted from the spot
rate.
 If a forward contract is fixed date contract, then it is easy
for the Bank to cover the transaction in the Inter bank
Market.
 But in the case of an option forward contract, the right for
exercising option lies with the purchaser of the contract
(customer). Hence it is difficult for the Bank to know the
date of exact delivery of Foreign exchange and as a Thumb
rule he goes by the “Worst Case Scenario” approach and
takes a very conservative approach while computing the
forward rate in the option forward contract.
Steps in computing forward exchange rate
i. Take the appropriate spot rate;
ii. Arrive at the base rate by deducting or adding to the spot rate the
appropriate forward differentials(margins).
iii. As the period of delivery of foreign exchange is at the option of the
customer, the bank would take a conservative view while charging or
conceding the forward margin.
iv. Generally, the view taken by the bankers is that customer will
give/take delivery of Foreign Exchange at the date which will be most
favourable to the customer and consequently, most unfavourable to
the bank.
v. The Bank will take a conservative view and quote a rate after
ensuring that the Bank will not suffer loss on account of the option
exercised by the customer any time during the currency of the
option period.

Holgate’s rule
 The rule which is applied for arriving at the forward rates is known as Holgate’s
Rule and is summarised as under:
 In case of Direct Rates:
Discount Premium
(Deduct) (Add)
Forward Purchase Maximum discount Minimum Premium

Latest Period Earliest Period
Forward sale Minimum Discount Maximum Premium

Earliest Period Latest Period

Forward rate example-Premium
 Inter Bank Market

 USD = Rs. 75.5025/75.5575
 Forwards
 Spot/June: 24/26
 Spot/July : 46/48
 Spot/Aug : 71/73
 An export customer likely to receive USD
amount in July. What is the AD will quote?

Forward rate example-Premium-Solution
 Base rate: Rs. 75.5025

 (Mind that the customer has the option to deliver the foreign
exchange to the Bank any time in July) een 1st July to 31st)
 Presuming the customer will deliver the FX on 1st July, only
Premium up to June 30th will be added. ( conservative view
by Bank)
 Forward rate= 75.5025+0.2400
 Less appropriate margin as per your Bank’s internal
guidelines.
 Forward rate: 75.7425- 0.1000
 (i.e) Rs. 75.6425

Forward rate example-Discount
 Inter Bank Market  Base rate: Rs. 75.5025
 USD = Rs. 75.5025/75.5575  Deduct July Forward Margin
(Mind that the customer has the
 Forwards option to deliver the foreign
exchange to the Bank any time
 Spot/June: 26/24 between 1st July to 31st July)
 Spot/July : 48/46  Presuming the customer will
deliver the FX on 31st July, only
 Spot/Aug : 73/71 discount up to July 31st will be
deducted. ( conservative view by
 An export customer likely to receive the Bank)
USD amount in July. What is the AD  Forward rate= 75.5025- 0.4800
will quote?
 Less appropriate margin as per
your Bank’s internal guidelines.
 Forward rate: 75.0225-0.1000
 (i.e) Rs. 74.9225

Forward-cross rates
 A customer of your Bank wants to book a forward contract for selling GBP
against rupees for August 30. If the exchange rates as on 1st June 2020 as
follows, what rate you will quote to him. Profit is taken is 5 paise.
 Mumbai Inter Bank quotes are as follows:
 Spot USD = Rs. 77.1000-77.1300
 Spot/June 2500/2700
 Spot/July 5200/5500
 Spot/August 7700/8200
 London Market
 Spot GBP = USD 1.2200/1.2205
 Spot/1 month 2/1
 2 month 3/2
 3 month 5/4

Answer
 Market will buy the Base currency (GBP) and give
dollar as under:
 The customer is having GBP and wants to  1GBP = USD 1.2200
covert into rupees on August 30 ( fixed
date)  Less 0.0005 (Discount)
 1 GBP = USD 1.2195
 Market will take GBP from the customer
and give equivalent dollar to customer.  We are taking 3 months forward points which is at
discount. Hence you have to deduct from the Base
 By selling that dollar in inter Bank market, currency and give less dollars. Base currency (GBP)
is at discount and Variable currency (USD) is at
the Bank will fetch rupees for the Premium.
customer.
 Mumbai inter Bank Market gives rates as under:
 While calculating the forward rates, the  1 USD = Rs. 77.1000
Bank will take into Premium/Discount of
the base currency while quoting the rate.  Add = Rs. 00.7700 (Premium)
 1 USD = Rs. 77.8700
 Here USD at Premium and rupee is at discount.
 Forward rate will be
 1 GBP=USD 1.2195 and I USD= Rs. 77.87
 Hence 1 GBP= 1.2195*77.87= Rs. 94.96246
(say Rs. 94.9625)
 Less: Profit Rs. 00.0500
 Quote to customer is 1GBP= Rs. 94.9125

XYZ COMPANY DOLLAR PAYMENT ON GBP 1 MILLION IN 3 MONTHS USING
DIFFERENT HEDGING TECHNIQUES- A Case study
Technique DOLLAR PAYMENT IN MILLIONS
RATE OF 1 $1.4 $1.5 $1.6 $1.7

GBP = USD1.3
Unhedged 1.3 1.4 1.5 1.6 1.7
Forward GBP 1.5 1.5 1.5 1.5 1.5
purchase @ USD
1.5
Future GBP 1.5 (+/-) 1.5 (+/-) 1.5 (+/-) 1.5 (+/-) 1.5 (+/-)
purchase @USD
1.5
$1.50/GBP call 1.36 1.46 1.56 1.56 1.56
option @ 0.06
per GBP
$1.40/GBP call 1.42 1.52 1.52 1.52 1.52
option @ 0.12
per GBP
$1.60/GBP call 1.32 1.42 1.52 1.62 1.62

option @ 0.06
per GBP

EXPLANATION FOR THE PREVIOUS EXAMPLE
 If the XYZ company does not hedge GBP 1 Million amount payable in 3
months, the dollar cost of the pounds will depend on the spot exchange
prevailing on the settlement day.
 If instead of being unhedged XYZ company decides to buy forward at
$1.50/£, the cost of the pounds is $1.5 million, regardless of what happens
to the spot rate by the time of settlement.
 If XYZ company decides to hedge its pound payables exposure in the
futures market and buys £1 million of futures contracts, it is necessary to
post a margin.
 If subsequent to buying the futures contracts the price of these contracts
declines, it may be necessary to add to the margin account. If the futures
price increases, the margin account is credited by the amount gained.
 This addition or subtraction to the margin account is done on a daily basis
and is called marking to market. The marking to market means is that if, the
pound increases in value more than had been anticipated in the original
price of the futures contract, at the maturity of the contract the margin
account will include the value of the unanticipated increase in the value 50of
INDIAN INSTITUTE OF BANKING & FINANCE
the pounds.
EXPLANATION FOR THE PREVIOUS EXAMPLE- CONTD..
 If ABC company buys call options on pounds at a strike price of $1.50/£, the options
will be exercised if the spot rate for the pound ends up above $1.50/£. The options to
buy pounds will not be exercised if the spot rate for the pound is below $1.50/£,
because it will be cheaper to buy the pounds at the spot rate.
 The above example shows the result of buying £1 million of $1.50/£ strike-price call
options if the option premium, that is, the option price, is $0.06/£. At this option
premium the cost of the option for £1 million is GBP 60,000.
 If the spot rate at the time of payment is $1.30/£, then ABC company will not
exercise the option (out of Money) and directly purchase GBP from the market
paying USD 1.3 million. It addition to the above, the cost of call premium of USD
60,000. Hence the total cost is USD 1.36 Million.
 Similarly, if the spot price is 1 GBP = USD $1.40, the company will buy at
spot and the cost of 1 Million GBP is USD 1.46 Million. At 1 GBP = USD
1.50, the option is at the money and the cost for the company is USD 1.56
Million.
 If the spot price of the GBP exceeds the rate $1.50, as in the cases of $1.60
and $1.70 , the company is in the money and will exercise the option. The
respective cost will be USD 1.56 Million because the company is buying
USD at a cheaper rate. INDIAN INSTITUTE OF BANKING & FINANCE 51
Case study
Consider a situation in which a company anticipates a possible need for foreign currency,
but is not yet certain of that need.
For example, ABC company wants to place a bid in AUG 2022 for project work to be
undertaken in Europe in November 2022. Suppose the company wins the order, it will
require EUR 5 million to purchase raw materials and services to execute the order.
However, the company will not know whether the order will be awarded in their favour
till September 2022. (2 months after placing the order). The company considers four
different strategies to obtain EUROs it may need if it wins the contract and considers
the benefits and risks of each strategy.
First strategy: Purchase Euro 5 million in AUG Spot date while placing the order.
Second Strategy: Purchase Euro 5 million in November Spot date when the order is
won.
Third strategy: Enter into forward purchase in AUG Spot date for the month of
November 2022.
Fourth strategy: Purchase a call option on Euro 5 million in AUG 2022 which will
be expiring in November 2022.
QUESTION BASED ON THE ABOVE EXAMPLE
Question:
 When the order is successful and Euro currency appreciates

 When the order is successful and EURO currency
depreciates
 When the order is unsuccessful and EURO currency
appreciates
 When the order is unsuccessful and EURO currency
depreciates
 And when the risk is unhedged
Please discuss.

SOLUTION TO THE PROBLEM
Analysis of EURO Purchases by ABC Company
Bid Successful Bid Successful Bid Unsuccessful Bid Unsuccessful Unhedged risk
EURO
Strengthens Euro Weakens EURO Strengthens Euro Weakens
Strategy 1 Effective gain Effective loss Sell Euro at Profit Sell Euro at loss Bid Result
Purchase of Euro in Aug Spot Date Spot Purchase
Spot rate
Strategy 2 Effective loss Effective gain Not Applicable Not applicable movement
Purchase of Euro Nov spot date
At contracted Settle forward Settle forward

Strategy 3 rate At contracted Rate contract contract Bid result
Forward contract booked in Aug

2022 Sell Euro at Profit Sell Euro at loss
for November 2022 delivery
Do not exercise Do not exercise

Strategy 4 Exercise option option Exercise Option option
Purchase of call option in Aug

2022 Premium Paid is lost Sell Euro in market at Lose Premium None
for expiry in November 2022 Profit


Foreign Exchange Market Dynamics - Types of FX Transactions (Merchant / Cover / IB) Exchange Rate Mechanism (Spot / Cross / Forward)

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Foreign Exchange Market Dynamics - Types of FX Transactions (Merchant / Cover / IB) Exchange Rate Mechanism (Spot / Cross / Forward)

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Foreign Exchange Market Dynamics – Types of

FX transactions (Merchant / Cover / IB)

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

Year 1938 - Exchange control was introduced in

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

There was an urgency to overhaul the

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

2. EUR = USD 1.1374

3. USD = JPY 114.22

4. USD = CHF 0.9270

5. AUD = USD 0.7338

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

INTER BANK MARKET SITUATION

 USD = Rs.75.72/75.75 1. Exporter received USD 100,000

 GBP = USD 1.2440/43 2. Importer wants GBP 100,000

 EUR = USD 1.0930/32 3. Exporter received EUR 100,000

 USD = JPY 106.74/77 4. Importer wants USD 1,000,000

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

2. BANK (MARKET MAKER) WILL SELL THE BASE CURRENCY GBP

3. BANK (MARKET MAKER) WILL BUY THE BASE CURRENCY EUR

4. BANK (MARKET MAKER) WILL SELL THE BASE CURRENCY USD

 2. GBP = USD 1.2440 (opening) and USD 1.2400 (Closing)

 3. EUR = USD 1.0930 (Opening) and USD 1.0920 (closing)

4. USD = JPY 106.74 (opening) and JPY 106.50 (closing)

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

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GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

 In case of exports, the exporter send the goods and draws

2 conversion of Proceeds of instruments sent on collection basis

3 cancellation of outward TT/MT/DD/PO etc.,

4 Cancellation of forward sale contract

TT selling rate 1 Clean outward remittance in foreign currency by TT/MT/DD/PO

2 cancellation of purchase (i.e)

3 Cancellation of forward Purchase contract

4 import documents received directly by the importer

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

Foreign currencies earning higher interest

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

 We see earlier that in case of direct quote, the Premium is

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

Forward Purchase Maximum discount Minimum Premium

Forward sale Minimum Discount Maximum Premium

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

 Inter Bank Market

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

 Base rate: Rs. 75.5025

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

GOVINDARAJAN RANAGACHARY-CTP-16 09 2022

Technique DOLLAR PAYMENT IN MILLIONS