Spot Rates

• When two parties agree to exchange currency

& execute the deal immediately the
transaction is referred to as spot exchange.
• In other words, spot exchange rate is the rate
at which a foreign exchange dealer converts
one currency into another currency on a
particular day.
• When US tourist goes to a bank India to
convert his dollars into Rupees, the exchange
rate is the spot rate for that day.
• An exchange rate can be quoted in two ways:
Direct quotation is where the cost of one unit
of foreign currency is given in units of local
currency, whereas indirect quotation is where
the cost of one unit of local currency is given
in units of foreign currency.
• Your local currency is INR:
- Direct exchange rate: 1USD = 45 INR
- Indirect exchange rate: 1INR = .02222USD
• The value of currency is determined by the
interaction between the demand & supply of
that currency related to the demand & supply
of other currencies.
• If lots of people want US dollar & dollars are in
short supply, and a few people want INR& INR
are in plentiful supply, the spot exchange rate
for converting dollars into INR will change.
• The dollars is likely to appreciate against the
INR/conversely, the INR will depreciate against
the dollar.
• Imagine the spot exchange rate is Rs 45=$1
when the market opens.
• As the day progresses, dealers demand more
dollars and fewer INR and by the end of the
day the spot exchange rate might be Rs 48 =
$1. Thus the dollar appreciated and INR has
depreciated
Operation of Forward Markets
- Importers and Exporters aspect
 IMPORTERS ASPECT
• Suppose an Indian company that import laptop
computers from US knows that in 30 days it must
pay Dollar to US supplier when the shipment
arrives.
• The company will pay US supplier $500 for each
laptop and the current Rupee/ dollar spot
exchange rate is Rs 45= 1$.
• At this rate, each computer costs the Indian
importer Rs 22500(i.e., 500 * 45).
• The importer knows that he can sell the
computer at the day they arrive for Rs 25000
each which yields a gross profit of Rs 2500
( 25000 – 22500 ) on each computer.
• If over the next 30 days the dollar
unexpectedly appreciates against Rupee, say
Rs 55 = 1$, the importer will have to pay US
company Rs 27500 per computer (i.e., 500 *
55) which is more than he can sell the laptop
for.
• Thus, an appreciation in the value of dollar
against Rupee from $1 = Rs 45, to $1 = Rs 55
would transform a profitable deal into
unprofitable for the Indian importer
• To avoid this risk the Indian importer might
engage in a Forward Exchange contract.
• A Forward Exchange contract occurs when two
parties agree to exchange currency and execute
the deal at some specific date in future for a
specific amount.
• Exchange rates governing such Forward
contracts are quoted for 30, 90 and 180 days
into the future.
• Returning to our laptop importer example, let us
assume that a 30 days Forward Exchange rate
for converting dollars into Rupee is $1 = Rs 47
• So, the Indian importer enters into a 30day
forward exchange transaction with a foreign
exchange dealer at this rate and thereby
guarantee is that he will have to pay not more
than Rs 23500 ( 500 * 47 )for each laptop
guaranteeing him a profit of Rs 1500 per
computer.
• Any further appreciation ( > INR47/USD) in the
value of the dollar will be borne by the foreign
exchange dealer
• If on the expiry date, if the dollar depreciates,
for eg., $1=Rs 40, he will lose money in the
forward contract Rs 3500 ( 23500 – 20000),
where 20000 = 500*40.
• But, he will gain in selling the laptop at the
spot rate and will earn a profit of Rs 5000
( 25000 – 20000).
• And, he will end up with a Net profit of 1500
in either way.
 EXPORTERS ASPECT
• Suppose an Indian company that exports
laptop to US knows that in 30 days it will be
paid by the US buyer on delivery.
• The company will be paid by the US buyer
$500 for each laptop and the current Rupee/
dollar spot exchange rate is Rs 45= 1$.
• At this rate, each computer is paid for Rs
22500(i.e., 500 * 45).
• The exporter knows that he can buy laptops
from the local market for Rs 20000 at the day
of export which yields a gross profit of Rs 2000
( 22500 – 20000 ) on each laptops.
• If over the next 30 days the dollar
unexpectedly depreciates against Rupee, say
Rs 35 = 1$, the exporter will be paid only Rs
17500 per computer (i.e., 500 * 35) which is
less than he can buy the laptop from the local
market.
• Thus, a depreciation in the value of dollar
against Rupee from $1 = Rs 45, to $1 = Rs 35
would transform a profitable deal into
unprofitable for the Indian exporter
• To avoid this risk the Indian exporter might
engage in a Forward Exchange contract.
• let us assume that a 30 days Forward
Exchange rate for converting dollars into
Rupee is $1 = Rs 42
• So, the Indian exporter enters into a 30day
forward exchange transaction with a foreign
exchange dealer at this rate and thereby
guarantee is that he will be paid not less than
Rs 21000 ( 500 * 42 )for each laptop computer
guaranteeing him a profit of Rs 1000 per
laptop.
• Any further depreciation ( < INR42/USD) in the
value of the dollar will be borne by the foreign
exchange dealer
• If on the expiry date, if the dollar appreciates,
for eg., $1=Rs 47, he will lose money in the
forward contract Rs 2500 ( 23500 – 21000),
where 23500 = 500*47.
• But, he will gain from the payment from the
buyer of the laptop at the spot rate and will
earn a profit of Rs 3500 in buying the same
from the local( 23500 – 20000).
• And, he will end up with a Net profit of 1000
in either way.
Swap Operations
 Swap Operations
• Commercial banks who conduct forward
exchange business may resort to a swap
operation to adjust their fund position.
• The term swap means simultaneous purchase
of spot currency for the forward sale of the
same currency or the sale of spot for the
forward purchase of the same currency.
 Foreign Exchange Swap Transactions
• Defined: The simultaneous purchase and sale of a
given amount of foreign exchange for two different
dates.
– Both purchase and sale are usually conducted
with the same counterpart (i.e., the same global
bank)
• The most common FX swap is a spot against forward
– A bank buys FX in the spot market and
simultaneously sells the same amount back in the
forward market
– Since the swap transaction is an offset, the bank
incurs NO exchange rate exposure.
• A swap transaction is used to provide bank clients
with needed foreign exchange for a specified period
of time (e.g., a short term loan).
 Example of FX Swap
• Corporate approaches its bank wanting to
borrow 10,00,000 USD for 90 days.
• Bank negotiates in interbank spot market to
purchase 10,00,000 USD’s, which in turn are
lent to the corporate.
• Bank simultaneously sells 10,00,000 USD’s 90 days
forward (i.e., for delivery in 90 days) in the interbank
market.
– When loan matures, bank will receive the
10,00,000 USD from the corporate borrower
which provides it with the USD to be delivered at
that time to complete the forward agreement.
• Thus, the lending bank assumes no exchange risk
during the 90 day period.
• The bank’s return is the interest on the loan, minus
any spot/forward spread not in it’s favor.
Arbitrage Operations
• Arbitrage exploits a price difference between
two or more markets to make money with
zero risk.
• Exchange arbitrage involves the simultaneous
purchase and sale of a currency in different
foreign exchange markets. Thus, arbitragers
take a closed position (No risk).
• Arbitrage becomes profitable whenever the
price of a currency in one market differs from
that in another market.
• Suppose the pound quoted in NY is $1.75, but
pound quoted in London is $1.78.
• It is evident that the exchange rate in both the
markets are mispriced, due to supply and
demand forces; supply for pound is higher in
London with respect to Dollar and the reverse
in New York
• The arbitrager would buy Pounds from NY and
sell the same in London. He earns profit
through the following steps
(a) buy 10 M pounds in NY: cost = $17.5 M
(b) sell 10 M pounds in London: revenue =
$17.8 M
(c) profit = $300,000 less the cost of
telephone, cable transfer.