Assignment of International finance and

Financial derivatives

Topic - Prepare a report on how the international

currency exchange rate system works.

Submitted to – Ms- Taranjeet kaur

Submitted by – Samanpreet kaur(2232259)
Romanpreet kaur (2232255)
International currency rate
Foreign Exchange Rate is defined as the price of the domestic currency with respect
to another currency. The purpose of foreign exchange is to compare one currency
with another for showing their relative values. Most exchange rates are defined as
floating and will rise or fall based on the supply and demand in the market.

An exchange rate has two components namely, the domestic currency and the
foreign currency. Foreign exchange rates are influenced by various factors like
economic conditions, interest rates, geopolitical events, and market speculation.

The main focus of attention in analyzing the role of the exchange rate in the
international adjustment process has been its impact on real variables such as the
trade balance and domestic and foreign levels of output and other macroeconomic
variables. However, in recent years, there has been resurgence in interest in the
balance sheet impact of currency movements. While this valuation channel was
recognized in the portfolio balance literature that was developed during the late
1970s and early 1980s, the increase in the scale of gross holding of foreign assets
and liabilities means that its quantitative importance is larger now than in previous
decades.

The recent literature has two main strands. One focuses on emerging market
economies, which are characterized by large stocks of foreign-currency debt. For
these countries, currency depreciation has a negative valuation impact on the
balance sheets of domestic entities, since the foreign-currency debt increases in
value in terms of domestic currency. This feature has led to a large policy and
academic literature that investigates whether this channel is sufficiently strong to
alter optimal policy decisions.

Methods of exchange rate

There are two methods of quoting the exchange rate.

1. Direct method
2. Indirect method

Direct Method

A given Number of unit local currency for a unit of foreign currency is the Direct
method for Quoting exchange rate . The direct method of foreign exchange rate
quoting involves expressing the value of one unit of the domestic currency in terms
of a foreign currency. For example, if 1 USD = 0.85 EUR, it means 1 US dollar can buy
0.85 Euros.

Indirect method

In the Indirect Method, home currency is variable. In India the direct method of
quotation is used since August 1993. However, certain foreign currencies are quoted
for 100 units, since their one unit value is less than one Rupee e.g. Japanese Yen etc.
In the indirect Method of quotation, the variable is the foreign currency expressed in
a fixed unit of home currency. Indirect method, on the other hand, expresses the
value of one unit of the foreign currency in terms of the domestic currency. Using
the same example, if 1 USD = 0.85 EUR, it means 1 Euro can be bought with 1.18 US
dollars .

PURCHASE AND SALE TRANSACTIONS

In a foreign exchange rate system, a purchase and sale transaction involves buying
and selling one currency in exchange for another. This process occurs in the foreign
exchange market where currencies are traded. Traders typically aim to profit from
fluctuations in exchange rates by buying a currency at a low rate and selling it at a
higher rate, or vice versa. Transactions can involve individuals, businesses, banks, or
governments, and are facilitated through various means such as spot transactions,
forward contracts, options, and futures.

Purchase
a "purchase" refers to the act of acquiring a foreign currency in exchange for the domestic
currency. This transaction can occur for various reasons, such as international trade,
investment, tourism, or speculation.

Example:

Imagine a U.S.-based importer, ABC Electronics, who wants to purchase electronic

components from a Japanese supplier, XYZ Tech. The agreed-upon price for the components
is 1 million Japanese Yen (JPY). However, since ABC Electronics operates in the United
States, they hold U.S. dollars (USD) and need to convert their USD to JPY to pay XYZ Tech.

How its work-

a. ABC Electronics contacts their bank to exchange their USD for JPY.
b. The bank provides a quote for the USD/JPY exchange rate, let's say it's 110.00.
c. ABC Electronics agrees to the exchange rate and purchases 1 million JPY by selling an
equivalent amount of USD.
d. The bank debits ABC Electronics' USD account and credits their JPY account with the
purchased amount.
e. ABC Electronics then transfers the purchased JPY to XYZ Tech's Japanese bank
account to complete the payment for the electronic components.

In this example, ABC Electronics engaged in a purchase transaction in the foreign exchange
market by buying Japanese Yen with U.S. dollars to facilitate an international trade
transaction. The exchange rate between USD and JPY determined the cost of the transaction
for ABC Electronics.

Sale

"sale" refers to the buying and selling of currencies in the foreign exchange market. In a
floating exchange rate system, the value of currencies fluctuates based on supply and
demand dynamics. For example, if the demand for a particular currency increases, its value
will typically rise relative to other currencies. Conversely, if there's a higher supply of a
currency relative to demand, its value may decrease. Example: Imagine you're traveling
from the United States to Europe and need to exchange US dollars for euros. If the exchange
rate is 1 USD = 0.85 EUR, and you exchange $1000, you'll receive €850.

Types of rates
 a. Spot Exchange Rate: The rate at which currencies are exchanged for
immediate delivery, usually within two business days. For example, if the
spot exchange rate between the US dollar and the euro is 1.20, it means 1 US
dollar can be exchanged for 1.20 euros.

b. Forward Exchange Rate: The rate at which currencies are exchanged for
delivery at a future date, typically beyond the spot date. Forward rates are
determined by the spot rate and the interest rate differentials between the
two currencies. For instance, if the one-year forward exchange rate between
the US dollar and the euro is 1.25, it means that in one year, 1 US dollar can
be exchanged for 1.25 euros.

c. Fixed Exchange Rate: A system in which the value of a currency is fixed or

pegged to the value of another currency or a basket of currencies. An
example is the Bretton Woods system, where currencies were fixed to the US
dollar, which was in turn pegged to gold.

d. Floating Exchange Rate: Also known as a flexible exchange rate, it is

determined by market forces of supply and demand without government
intervention. Examples include the exchange rate regimes of the US dollar,
euro, and Japanese yen.

e. Managed Exchange Rate: A system in which governments intervene in the

foreign exchange market to influence the value of their currency. This
intervention can involve buying or selling domestic or foreign currency to
maintain a desired exchange rate. China's exchange rate regime is an
example of managed exchange rates.

COMPUTATION OF RATES

The Bank is a trader in foreign exchange and hence the purchase/sale are not effected at
the same rate. The purchases are made at a lower price and the sale at a higher price, with
the differential being the exchange profit. The maxim practiced by the banks is „Buy Low Sell
High’ for direct quotations. In the foreign exchange market, quotations are always ‘two-way’
i.e. for both buying and selling. The „two way‟ quote for U.S.Dollar would appear as USD 1 =
Rs.61.50/52 where the buying rate is Rs.61.50 and the selling rate is Rs.61.52.. The buying
rate is known as the ‘Bid’ rate and the selling rate as the ‘Offer’ rate. FEDAI has given
freedom to Authorised Dealers for determining their own policy regarding the basisfor
quotation of rates for merchant transactions.
Basis of Exchange Rate quotation:

a) BUYING:- Rate at which Foreign Currency bought from customer can be sold in the
market i.e., market buying rate

b) SELLING:- Rate at which Foreign Currency to be sold to the customers can be bought in
the market i.e., market selling rate.

(a) BASE RATE

Base rate is the rate derived from ongoing market rate, based on which buying / selling
rates are quoted for merchant transactions. The interbank rates are normally for spot
deliveries. Hence, for quoting rates for merchant transaction on cash basis (i.e. value Today),
the base rate will be adjusted to the extent of cash/spot differences.

(B) EXCHANGE MARGIN

The Base Rates, which are derived from the ongoing interbank spot rates, are applied for
arriving at rates for merchant purchase and sale transactions. Banks have been given
freedom to fix the quantum of exchange margin to be loaded to the base rate for quoting
rates for different types of merchant transactions e.g. TT Buying/Selling, Bill Buying/Selling
etc.

(c) SPREAD

Spread is the difference between TT Selling rate and TT Buying rate of a given currency.
FEDAI has stipulated that the spread should not exceed the following limit from the mean
rate:

USD 1%

GBP, EURO, AUD, CHF, JPY 2%

All other currencies Minimum possible spread

Bill buying rate

The bill buying rate refers to the rate at which banks and financial institutions purchase bills
of exchange or promissory notes from customers. It's essentially the discounted rate at
which the bank buys the bill from the customer, providing the customer with immediate
cash in exchange for the bill.

Formula – D = FV × DR ×T/ 365

 BBR = FV - D

Lets take example that we have a bill with face value of $ 10000 a, a discount rate of 6% per
annum and it matures in 90 days.

D = FV × DR ×T/ 365

10000 × 0.06 ×90/ 365 = 540/365 =1.48

BBR = 10000- 1.48= 9998.52

So the bill buying rate would be approximately $ 9,998.52.

CROSS RATE

The U.S.Dollar being the most commonly denominated currency in international trade is the
intervention currency where a quotation in Rupee has to be given for a currency other than
the U.S. Dollar. The cross rate is worked out as follows:

1 USD = Rs.61.50 1 USD = CAD 1.1377

Therefore 1 CAD = Rs.54.05

TC SELLING RATE

This rate is applicable for sale of foreign Traveller Cheques to the customers. Computation
of TC Selling Rate (USD)

i) Base rate isTT Selling rate Rs. 61.62

ii) Add. Margin say 0.50% Rs. 0.30

Rs. 61.92

iii) Rounded off to nearest 5 paise Rs. 61.9

Factor affecting foreign currency exchange rate

Foreign exchange rates play a vital role in the global economy, affecting trade, investment,
and tourism. A currency’s value expressed in terms of another is called an exchange rate. It
is determined by various factors such as economic, political, and social factors. In this article,
we will discuss the five major factors that influence foreign exchange rates.

 Inflation Differential
Inflation differential is the difference in the rate of inflation between two countries. A
country with a higher inflation rate will experience a decrease in the value of its currency
relative to the currency of the country with a lower inflation rate. This is because high
inflation reduces the purchasing power of a currency, causing it to lose value. Therefore,
investors prefer to invest in countries with lower inflation rates to preserve the value of
their investments.

 Interest Rates

Exchange rates are significantly influenced by interest rates. A country with a higher interest
rate attracts more foreign investment, leading to an increase in demand for its currency.
This increase in demand leads to an increase in the value of the currency. On the other
hand, a country with a lower interest rate will experience a decrease in demand for its
currency, leading to a decrease in its value.

 Deficits

A country’s trade balance can also influence its exchange rate. When a country imports
more than it exports, it experiences a trade deficit, leading to a decrease in demand for its
currency. This decrease in demand causes the exchange rate to decline. Therefore,
countries with a trade deficit will experience a decrease in the value of their currency
relative to other currencies.

 Debt

A country’s debt level also influences its exchange rate. Countries with high levels of debt
are perceived as riskier investments, leading to a decrease in demand for their currency. The
value of the currency falls as a result of this decline in demand. Therefore, countries with
high debt levels will experience a decrease in the value of their currency relative to other
currencies.

 Import-Export

International trade also plays a significant role in determining exchange rates. When a
country exports more than it imports, it experiences a trade surplus, leading to an increase
in demand for its currency. This increase in demand causes the exchange rate to rise.
Conversely, when a country imports more than it exports, it experiences a trade deficit,
leading to a decrease in demand for its currency, causing the exchange rate to decline.

These factors impact the demand and supply of currencies, causing exchange rates to
fluctuate. Therefore, individuals and businesses involved in international trade and
investment need to understand the factors affecting foreign exchange rates to make
informed decisions.

Conclusion
Foreign exchange rate system is multifaceted and hinges on its ability to strike a balance
between stability and flexibility within the economy. Fixed exchange rate systems offer
stability but require continuous intervention to uphold, leaving them susceptible to
speculative pressures. Conversely, floating exchange rate systems provide flexibility but can
lead to increased volatility and uncertainty. A managed float exchange rate system attempts
to marry stability with market responsiveness, while pegged exchange rate systems anchor
a currency to another, offering stability but necessitating vigilant oversight and periodic
adjustments. The optimal choice depends on a nation's economic objectives, policy
imperatives, and external economic dynamics. Ultimately, the effectiveness of a foreign
exchange rate system rests on its capacity to facilitate economic growth, foster stability, and
mitigate risks in the face of global economic challenges.