Banks undertake foreign exchange transactions for their customers. Foreign exchange is associated with foreign trade. The traders in the foreign exchange market (Authorized Dealers/brokers) rely on the two basic forms of analysis viz. fundamental analysis and technical analysis. The uses of technical analysis in forex are much like the share market where the price is assumed to echo all news, and the charts are the analysis of the objects. Ultimately, the forces of demand and supply in the local forex market drive the day’s exchange rate.
FUNDAMENTALS OF FOREIGN EXCHANGE
There are three fundamental aspects of the foreign exchange mechanism.
- Every country has its currency (legal tender) and the useful possession of the currency, can normally be had only in that country, in which it passes.
- The rate of exchange of currency of one country to currency of another country (like a barter system) depends upon the demand and supply of specific currency at the place of conversion.
- Almost all exchange transactions currencies are routed through banks, which will convert the currency of one country into its equivalent in the currency of another country and transfer the funds from one country to another. Normally currency of the buyer’s country is converted into the currency of the seller’s country. However, many times the funds may be converted into the permitted currency of a third country (like USD, Euro, Sterling Pound, etc. which are accepted in almost all the countries) acceptable to the buyer and the seller/service provider.
FOREX (FOREIGN EXCHANGE) MARKET
The foreign exchange market is described as an OTC (Over counter) market as there is no physical place where the participants meet to execute their deals. It is more of an informal arrangement among the banks and brokers operating in a financing center purchasing and selling currencies, connected by telecommunications like telex, telephone, and a satellite communication network, SWIFT.
The term foreign exchange market refers to the wholesale segment of the market, where the dealings occur among the banks. The retail segment refers to the dealings that take place between banks and their customers.
The leading foreign exchange market in India is Mumbai, Calcutta, Chennai, and Delhi another center accounting for the bulk of the exchange dealings in India. The policy of the Reserve Bank has been to decentralize exchange operations and broader-based exchange markets. As a result of the efforts of Reserve Bank Cochin, Bangalore, Ahmedabad, and Goa have emerged as the new center of the foreign exchange market.
RBI reference exchange rate refers to the benchmark foreign exchange rates for Indian Rupee against major four foreign currencies, published by the Reserve Bank of India daily. The Reserve Bank of India compiles and publishes daily, reference rates for four major currencies i.e. US dollar (USD), British Pound (GBP), Japanese Yen (YEN), and Euro (EUR).
The rate for spot US Dollar against Indian Rupee will be polled from the select list of contributing banks at a randomly chosen five-minute window between 11.30 a.m. and 12.30 p.m. every weekday (excluding Saturdays, Sundays, and Bank Holidays in Mumbai). The other three rates, viz. EUR/INR, GBP/INR, and JPY/INR would be computed by crossing the USD/INR Reference Rate with the ruling EUR/USD, GBP/USD, and USD/JPY rates.
DIRECT AND INDIRECT QUOTATION
Direct Quotation: The direct method of rate quotation is called the direct quote or home currency quotation. In this quote, the home currency is quoted per unit of foreign currency. In the other words, it is a quote where the home currency is the variable unit.
For example: 1 USD = Rs.70.35 is a direct quote for an Indian national.
Indirect Quotation: The indirect method of rate quotation is called indirect quote wherein foreign currency is the variable unit against a fixed amount of home currency.
For example: Rs.100= USD 1.4215
Direct Quote = 1/Indirect Quote and vice versa.
Till 1st August 1993, banks in India were required to quote all rates on an indirect basis. Now, from 2nd August 1993, banks in India began quoting on a direct basis only.
Buy or Sell the Foreign Exchange: Generally, a dealer in the Interbank Market will not reveal whether he is going to buy or sell the foreign exchange. Hence, in the market, the quotation made will be a two-way quotation. This means the market maker will indicate two prices. One price is for buying the currency and the other price is for selling the currency.
For example, a Mumbai bank may quote the rate of dollar as follows;
USD 1 = Rs. 70.1625/1750
It means, the market maker is willing to buy foreign exchange US dollars at the rate of 70.1625 rupees; and he is willing to sell at the rate of 70.1750 rupees per dollar. From this, it is evident that the market maker wants to make a profit of Rs.0.0125 in the deal of buying and selling one dollar. This quotation is a direct quotation, and the bank will apply the rule ― ‘Buy Low; Sell High’.
The buying rate is generally known as Bid Rate, and the selling rate is known as the Offer Rate or Ask Rate. The difference between these two rates, is the gross profit for the bank which is known as the Spread.
SOME BASIC EXCHANGE RATE ARITHMETIC
1. Cross Rates: The exchange rate between two foreign currencies is called the cross rate. When a rate between two currencies is not directly available, it has to be calculated through a 3rd currency which is called cross rate. This is done by using the chain rule.
For example: A dealer in Mumbai sells or buys Euro against US Dollars, he uses cross rates.
Example: US $ 1 = Rs.72.00 and US $ 1 = Euro 0.7500.
Euro 1 = 72 / 0.75 = Rs.96
Example: A bank is offered to purchase an export bill of Pound 100000 and the inter-bank rates are US $ 1 = Rs.70.00/10 and Pound 1 = US $ 1.5000/10.
In this case, the bank will purchase pounds at a given US $ rate of Rs.70 and deliver rupees to the exporter.
Bank will sell pounds in London in the inter-bank market at US $ 1.50. The amount will be worked with the chain rule. Pound 1 = 1.50 x 70 = Rs.105.
2. Chain Rule: The fixing of the rate of exchange between the foreign currency and the Indian rupee through the medium of some other currency is done by a method known as Chain Rule. The rate thus obtained is the Cross rate between these currencies. Calculation of the cross rate is based on a commonsense approach. However, it can be reduced to a rule known as the chain rule with similar steps.
3. Value Date: A value date is a future date used in determining the value of a product that fluctuates in price. The value date is the date on which the exchange of currencies takes place. The exchange rate (Cash, TOM and Spot) is to be used as per the delivery date of currency. Value date can be explained with the following table:
|Date of Contract||Delivery Date / Settlement Date||Rate to be used|
|January 12, 2023||January 12, 2023||Cash / Ready Rate|
|January 12, 2023||January 13, 2023||TOM Rate|
|January 12, 2023||January 14, 2023||Spot Rate|
|January 12, 2023||After January 14, 2023||Forward Rate|
Based on this concept, we have the following types of exchange rates.
(i) Cash/Ready: It is the rate at which an exchange of currencies takes place on the date of the deal. The transaction is to be settled on the same day. It is also known as value today.
(ii) TOM: When the exchange of currencies takes place on the next working day, i.e. tomorrow it is called the TOM rate. The delivery of foreign exchange is to be made on the day next (tomorrow) to the date of the transaction.
(iii) SPOT: When the exchange of currencies takes place on the second working day after the date of the deal, it is called the spot rate.
(iv) Forward Rate: Forward transactions are based on the same principle as TOM and SPOT transactions. If the exchange of currencies takes place after a period of the spot date, it is called the forward rate. Forward rates generally are expressed by indicating a premium/discount for the forward period.
- Premium: When a currency is costlier in forward or say, for a future value date, it is said to be at a premium. In the case of the direct method of quotations, the premium is added to both the selling and buying rates.
- Discount: If a currency is cheaper in the forward or for a future value date, it is said to be at a discount. In the case of a direct quotation, the discount is (deducted) subtracted from both the rates, i.e. buying and selling rates.
The forward rates are quoted in terms of forward margins or forward differentials.
Spot Euro 1 = US$ 1.1480/90
1 month forward 35-32
2 months forward 72-70
3 months forward 110-107
It is understandable that if a currency is at a premium vis-a-vis another currency, the natural consequence is that the latter will be at a discount vis-a-vis the former currency.
In the above exchange rate quotations Euro is at a discount and hence US $ is at a premium. We can buy US $, one month forward at
Euro 1 = US$ 1.1490 (-) 0.0032 = 1.1458
Similarly, we can sell
Euro 1 = US$ 1.1480 (-) 0.0035 = 1.1445
FORWARD FOREX CONTRACT
In a forward contract, both parties enter into a contract on a given day and lock in a fixed rate on a specific future date. In such types of contract, the terms of the purchase (buy or sell) are agreed up front (trade execution date) but the actual exchange take place on a date in the future (maturity date). On the maturity date, both parties exchange the prenegotiated rate.
For example, an Indian company that is likely to earn foreign currency i.e., Euro on account of an export order after one month, may enter into a contract today (trade execution date) to sell Euro and receive Indian Rupees after 1 month (maturity date). The rate is fixed on the trade date and the rate is known as Fwd- 1-month rate.
Suppose on the trade date, the Indian exporter agrees to sell EURO 1000 and receive INR 72450. On the maturity date, he delivers EURO 1000 and receives INR 72450. Such types of forward contracts are known as outright forward contracts (OFTs). The OFT exchange rate is quoted as differentials that are at a premium or discount from the spot rate.
FORWARD EXCHANGE RATE
Since the foreign exchange rate will fluctuation, the spot rate of the currency will not be the same at a future date, i.e., after one month or so. If the forward rate and spot rate happen to be the same, then it is called at par. The difference between the spot rate and the forward rate is known as Forward Margin, otherwise called Swap Points. The forward point may be either at a premium or at discount. This is done for both purchase and sale transactions.
Forward rate calculation: Premium is added to the spot rate to work out the forward rate. Discounted is deducted from the spot rate. This makes the transaction beneficial to the bank.
- The forward premium includes interest differential.
- While calculating the bill’s buying rate, where the forward is at a premium, the bank will round off the transit and usance period to the lower month.
- While calculating the bill’s buying rate, where the forward is at a discount, the bank will round off the transit and usance period to the higher month.
Forward rates are quoted through forward point or forward differentials (which can be either premium or discount).
For example, Euro 1 = US $ 1.2000/10.
One month forward 30-28,
2 months forward 60-55
3 months forward 95-90.
In this case, Euro is at a discount and in that case, the US $ is at a premium.
In this case, the one-month forward US $ can be purchased at the following rate:
Spot Euro 1 =US $ 1.2010—0.0028 = 1.1982
In this case, the one-month forward Euro can be sold at the following rate:
Spot Euro 1 =US $ 1.2000—0.0030 = 1.1970
Premium or discount on forward transactions: The forward rate of a currency is normally either costlier or cheaper than its spot rate. When the forward margin is at a premium the forward rate will be higher/costlier than the spot rate. Similarly, if the forward margin is at a discount, the forward rate shall be lower or cheaper than the spot rate. Under a direct quotation, the premium is added to the spot rate for reaching the forward rate, and a discount is deducted from the spot rate to arrive at the forward rate. If US $ is quoted on a particular day as a spot at US $ 1 = Rs.48.90/49.10, this would be interpreted as buying rate of Rs.48.90 and a selling rate of Rs.49.10.
|Forward Premium||Forward discount|
|Spot Rate 1 US $ = Rs.48.10||Spot Rate 1 US $ = Rs.48.10|
|Forward 1 US $ = Rs.48.30||Forward 1 US $ = Rs.48.00|
Forward Points: Forward rate comprises spot rate and forward points being interest rate differentials. For example, if the spot rate is Euro 1 = US$ 1.4000 and 3 months forward is 1.4300, the difference of 200 points is called a forward point. The forward point is determined by
(a) Supply and demand position of the currency
(b) Market expectation
(c) Interest rate difference between two countries.
How to Calculate Forward Differential:
Example: Euro 1 = US $ 1.40, Euro Interest rate is 6% and US rate is 12%. If a person borrows Euro 100 for a year and by converting this into US$ invests as a deposit for one year, the flow will be as under:
(1) Euro Spot borrowing 100 + interest 6. Total outflow= 106
(2) US $ Gets 140 US$ (for 100 Euro at 1.40) + get interest of 12 for one year = 152
(3) If US $ 152 is converted into Euro at 1.40 = 108.57.
Hence gain (1) – (3) =US$ 2.57
In this case the Euro 106 = US$ 152.
Hence Euro 1 = 1.4340
Here the difference between the spot rate 1.40 and 1.4340 = 0.340 is the forward differential.
How to Calculate Forward Points (or the SWAP cost):
Example: Euro 1 = US $ 1.40, Interest rate differential is 6%. For 90 days forward calculate the forward points. Spot rate = 1.40. Int. differential = 6% Forward period = 90 days (no. in a year to be taken 360 days).
= (1.4000 x 6 x 90) / 360 x 100 = 0.0210
How to Calculate Interest Differential from Forward Points:
In the above example, the calculation can be made with the help of formulae:
= (0.0210 x 360 x 100) / 1.40 x 90 = 6%
How to quote forward rate: The forward can be at a premium or forward can be at a discount. In the case of direct quotation, the premium is added to the spot rate, and the discount is deducted from the spot rate both in the buying or selling rate.
When there is a premium: Let us take an example. Euro/US$ spot rate = 1.3200/20 and forward differential one month 20-25, 2 months 40-45, and 3 months 60-65. This shows that Euro is at a premium here.
2-month Euro buying rate (bid rate) = 1.3200 + 0.0040 = 1.3240 and
Selling rate (offer rate) = 1.3220 + 0.0045 = 1.3265.
Hence, the bid and offer rate would be = 1.3240/65
When there is a discount: Let us take an example. Euro/US$ spot rate = 1.3200/20 and forward differential one month 25-20, 2 months 45-40, and 3 months 65-60. This shows that Euro is at a discount here.
2-month Euro buying rate (bid rate) = 1.3200 – 0.0040 = 1.3160 and
selling rate (offer rate) = 1.3220 – 0.0045 = 1.3175.
Hence, the bid and offer rate would be = 1.3160/75
ARBITRAGE: Arbitrage is the simultaneous buying and selling of foreign currencies or an asset with intention of making profits from the difference between the exchange rate prevailing at the same time in different markets. Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market at a higher price, thus considered to be risk-free profit for the trader.
Example: Assume you begin with $2 million. You see that at three different institutions the following currency exchange rates are immediately available:
- Institution 1: Euros/USD = 0.894
- Institution 2: Euros/British pound = 1.276
- Institution 3: USD/British pound = 1.432
First, you would convert the $2 million to euros at the 0.894 rates, giving you 1,788,000 euros. Next, you would take the 1,788,000 euros and convert them to pounds at the 1.276 rates, giving you 1,401,254 pounds. Next, you would take the pounds and convert them back to U.S. dollars at the 1.432 rates, giving you $2,006,596. Your total risk-free arbitrage profit would be $6,596.
Example: Suppose an asset, gold, is quoted at Rs 27,000 per 10 gm in the Delhi bullion market and at Rs 27,500 in the Mumbai bullion market. A trader may buy 10 gm of gold in Delhi and sell it in Mumbai, making a profit of Rs 500 (Rs 27,500 – Rs 27,000). However, this trade will be profitable only if the cost of transactions is less than Rs 500 per 10 gm of gold. In this example, assuming that the total transaction cost, of executing the trades and physical delivery of gold, is Rs 200 for 10gm, then the net profit for the trader would reduce to Rs 300.
FACTORS DETERMINING FORWARD EXCHANGE RATE
The following factors determine the forward foreign exchange rate:
- Rate of Interest: The prevailing rate of interest at home and also in the foreign country from which we want to get foreign exchange to decide the forward margin.
- Demand and Supply of Foreign Currency: This is similar to the principle of demand and supply of a commodity. If a particular foreign currency is in great demand than its supply, then, naturally, it will be costlier and it will be sold at a premium. If the supply exceeds the demand, the forward rate will be at a discount.
- Investment Activities: Another factor influencing forward margin will be due to the hectic activities of investments, taking advantage of differences in the rate of interest between one center and another. The investor may borrow from low-interest centre and invest the amount in the high-interest centre. For example, the investor may borrow in London at the rate of 4% p.a. and invest the amount in Chennai at 7% p.a. To secure his position, he may cover up his transaction in the forward marker. Then, he will sell spot pound-sterling and buy forward pound-sterling.
- Speculative Activities Regarding Spot Rates: The forward rates are based on spot rates. Any speculation in the movement of spot rates would also influence forward rates. If exchange dealers anticipate the spot rate to appreciate, they will quote the forward rate at a premium. If they expect the spot rate to depreciate, the forward rate would be quoted at a discount.
- Exchange Regulation: Exchange control regulations may also put restrictions or conditions on forward dealing, leading to a change in the forward margin. Such restrictions may be concerning the keeping of balances abroad, borrowing overseas, etc. If the Central Bank of the country intervenes in the forward market, this will influence the forward margin.
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