International Finance - 1

Basics

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Coverage

1. Domestic Currency 2. Exchange Rate 3. Direct Quote 4. Indirect Quote 5. American Term and European Term 6. Bid and Ask 7. Two-way Quote 8. Spread 9. Converting Two-way Quote 10. Cross Rate 11. There is no Single Exchange Rate 12. Spot Rate 13. Forward Rate 14. Appreciation and Depreciation 15. Computing Appreciation and Depreciation Percentage 16. Swap Points 17. Forward Rate, Premium and Discount

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Rules

1. In any transaction involving foreign currency, you are selling one currency and buying another

2. In an exchange rate, two currencies are involved (a pair) 3. Ina direct quote, the price comes first, the commodity comes next 4. In a direct quote, the foreign currency is the commodity which is being

bought and sold. Price comes first, commodity comes next 5. In an indirect quote, the domestic currency is the commodity which is

being bought and sold; commodity comes first, price next 6. How do you convert a direct quote into indirect or vice versa? Divide 1 by given direct quote. The result is indirect quote Rs 53.02 = €1 Re 1 = 1/53.02 = € 0.02 7. The USA Term Direct American Indirect European

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8. The bank’s quote of bid and ask is from the banker’s perspective Bid = Buy Ask = Sell 9. In a numerator denominator format, the denominator currency is bought or sold,

as the case may be, in exchange of numerator currency 10. Direct/Indirect conversion A two way quote; take the inverse of each rate (bid and ask) and switch them

around 11.

i. In a direct quote, since the foreign currency is the commodity, if the forward rate is greater than the spot rate, the foreign currency is appreciating and the home currency is depreciating

ii. In a direct quote, if the forward rate is less than the spot rate, the foreign currency is depreciating and the home currency is appreciating

12. In a direct quote, the foreign currency is the commodity and the home currency is the price

13. Commodity DQ IDQ Appreciate Add Deduct Depreciate Deduct Add 14.

i. If Swap Ask > Swap Bid, the foreign currency is appreciating. Hence, add swap point ii. If Swap Ask < Swap Bid, the foreign currency is depreciating. Hence, deduct swap point

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Formulae

1. Spread = Ask – Bid

2. Bid (Rs/$) = 1/Ask($/Rs)

3. Ask (Rs/$) = 1/Bid ($/Rs)

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Math Rules

1. Bid (A/B) = Bid (A/C) X Bid (C/B)

2. Ask (A/B) = Ask (A/C) X Ask (C/B)

3. Relationship between Bid and Ask

Bid (A/B) = 1/Ask (B/A)

Ask (A/B) = 1/Bid (B/A)

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Note 1

Foreign Market Structure

Layer 3

Layer 2

Layer 1 RBI; FEDAI

Bank to Bank

Bank to Customer

Regulator Sub-regulator

Wholesale Market or IB Marker

Retail Market or Merchant Market

IB Rate

Market Rate

Foreign Exchange Dealers’ Association of India

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Note 2

How to Interpret Forex Transaction in Merchant Deal?

• Always talk w.r.t bank

E.g. If an exporter approaches a bank to sell FC, we will say that bank is buying FC

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Note 3 Cash Flow movement in merchant transactions

‘P’ Type

Bank

FC HC

Exporter

‘S’ Type

Bank

FC HC

Importer

Purchase for Bank

Sell for Bank

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How to interpret forex quote in the IB market? $1 = Rs 40.2030/40.2031 Buy Rate (Bid Rate)/Sell Rate (Ask Rate)

Commodity Price i. In the IB market, market rate is quoted up to 4 places after decimal

except for JPY (Japanese Yen) which is quoted only up to 2 places after decimal

ii. Market Maker – The bank which gives quote in the IB market

Market User – The bank which uses the quote for either buying or selling

The bank can either be Marker Maker or Market User

Note 4

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iii. Interpretation w.r.t. market maker The market maker (or simply market) would always buy at LOW

and sell at HIGH. In the above example, the market is ready to see $1 at Rs 40.2031 and at the same time the market is ready to buy $1 at Rs 40.2030

iv. Interpretation w.r.t. market user The market user can only buy $1 at the market maker’s selling

rate (highest of the quote) and can sell $1 at the market maker’s buying rate (lowest of the rate). The user can do this activity either for its own purpose or on behalf of the customer. When market user does this activity for his own purpose, it is called trading (or speculation) which may result into profit or loss. When this activity is done on behalf of the customer, then the bank will always make profit by loading Exchange Margin [EM].

Note: In exam, the given IB quote is the exchange rate of Market

Maker. And the banker of the customer acts as user bank or market user.

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v. The difference between Bid Rate and Ask Rate is called SPREAD. In the above example Spread is Rs 0.0001 (0.0001 = 1 PIP)

vi. The market convention is to write low rate on the L.H.S. and high rate on R.H.S.

In academic world, the exchange rate may be given in suppressed form. The L.H.S. data will be given in full and we need to interpret R.H.S. This we will do in the light of RHS data. While interpreting this, always ensure that market convention of writing low rate on LHS and high rate on RHS is maintained.

E.g. $1 = Rs 48.3039/43 $1 = Rs 40.25/27 $1 = Rs 40.99/02

Rs 48.3039/48.3043

Rs 40.25/40.27

Rs 40.99/41.02

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Note 5

Live Merchant Deal Pricing

SBI

BOB

Exporter

SBI

BOB

Importer

$1=Rs40.2030/35

Market Maker

Market User

MT BOB is buying FC

BOB = Bank of Baroda MR = Merchant Rate IBT = Inter-bank Trade EM = Exchange Margin MT = Merchant Trade

BOB is selling FC $1=Rs40.2030

$1= Rs40.2030 Less: EM Rs00.1000 MR Rs40.1030

BOB is selling FC

BOB is buying FC

$1=Rs40.2035

$1= Rs40.2035 Add: EM Rs00.1000 MR Rs40.3035

MT

IBT IBT

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Note 6

How to Adjust Exchange Margin in case of Merchant Transactions?

i. For purchase transactions the bank will deduct

exchange margin ii. For sell transactions the bank will add exchange

margin A S Sell Transaction Add

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Note 7

Accounts Required for settlement of forex transactions

Nostro A/c

My A/c with you

Vostro A/c

Your A/c with us

Loro A/c

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BOB Mumbai CITI Bank New York

Opens a current a/c in $

1. For BOB Mumbai this a/c is called Nostro a/c (i.e. my a/c with you) 2. For CITI Bank NY the same a/c would be called Vostro a/c (i.e. your a/c with us)

E.G.

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E.G.

BONY (Bank of New York) opens a Rupee C/A with SBI Mumbai SBI Mumbai will call it what? – BONY will call it what? –

Vostro A/c

Nostro A/c

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Note 8

Common type of forex transactions in IB market

Transactions are classified under

two things

Date of Transaction

Date of Settlement

Transaction Nomenclature DOS = DOT Cash/TT/Ready DOS = DOT+1BWD TOM DOS = DOT+2BWD SPOT DOS = DOT+>2BWD FORWARD BWD=Business working day (Working day should be opened in both places of transactions. Saturday and Sunday is holiday all over the world and in Middle east and other Muslim countries, even Friday is a holiday.

In the inter bank market, transactions are quoted on a spot basis and all other inter bank transactions (Cash, Tom, Frwd) are derived.

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E.G.

DOT DOS Type of transaction(?)

22.06.09 24.06.09

(Monday)

22.06.09 25.06.09

22.06.09 28.08.09

22.06.09 22.06.09

22.06.09 23.06.09 Tom Cash/TT/Ready

Forward

Forward

Spot

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E.G.

DOT DOS for Spot transaction(?)

Thursday

[deal between

India & Dubai]

Tuesday

Logic: Friday is holiday in Dubai, Sat and Sun is holiday both in India and in Dubai. Spot transaction is Transaction day+2 business working days. 2 clear days are Monday and Tuesday. Hence settlement will be on Tuesday.

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Note 9

Forex Quote Style

Direct Quote 1 unit of FC = how many units of HC

e.g. $1 = Rs 48 • Direct quote for India

• Indirect quote for USA

Indirect Quote 1 unit of HC = how many units of FC

e.g. Rs 1 = $0.0208 • Indirect quote for India

• Direct quote for USA

This is a localized definition

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E.G.

What type of quote is this?

£1 = $1.5020

Localized definition fails to categorise this kind of quote where HC is not available

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International Definition

Direct quote 1 unit of $ = how many units of Rest of the world (ROW)

(for ROW)

Indirect quote 1 unit of ROW = how many units of $

(for ROW)

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Take same example as previous E.G. What type of quote is this? £1 = $1.5020

Indirect Quote

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Two Types of Quote

European Style of Quote American Style of Quote

[Europe indicates ROW]

(Currency of ROW will be ($ will be in price side)

in price side)

1unit of $ = how many units 1unit of ROW = how many of ROW units of $

When the name of a country or continent is attached with the name of exchange rate, then the currency of that country or continent will vary (i.e. will be in the price side)

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E.G.

Quote Style(?)

£1 = $1.3020

$1 = €0.9350

American Style

European Style

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E.g.

An Indian Bank wants to fund their Nostro A/c with a US

correspondent bank by $500000 against INR when IB rate is $1=INR 47.20/50. The deal is struck and overseas bank’s Vostro A/c that is being maintained with Indian bank will be credited by how much?

Soln, i)Base Currency (Unit currency) ii)Requirement iii)Given Rate iv)Relevant Rate

Buying $

$1=INR 47.20/47.50 [Always talk w.r.t base currency]

$

The given rate in the question is of the market maker

$1=INR 47.50 ©Anuj G Joshi

Logic:

The $ can be bought at the market selling rate which is highest of the quote.

Answer:

500000 X 47.50 = Rs 23750000

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$1=INR 44.50/44.70

$

Buying Rs

Selling $

Restate the requirement w.r.t to base currency

$1=INR 44.50

E.G.

A NY bank wants to fund their account called Nostro with an Indian bank by Rs 10 million. What $ amount the NY bank would deposit in the Indian Bank’s account called Vostro maintained in NY when IB rate is $1 = INR 44.50/70

Soln,

Expanded form of quote:

Base Currency:

Requirement:

Required Rate:

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Logic:

The $ can be sold at the market buying rate which is lowest of the quote.

Answer:

This amount of $ would be deposited in Indian Bank’s Nostro a/c by the NY bank and in turn Indian bank will deposit Rs. 10 million to the Nostro a/c of NY bank

10 million/44.50 = $ 224719.1011

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E.g.

A Corporate customer of Bank “B” receives an inward remittance of $50000

when IB spot rate is $1=INR 44.40/50 and bank margin is 0.25%. What is the rate the bank will quote to the customer?

Soln,

Relevant Rate:

Answer:

$1=44.40 [Since Inward Remittance is buy transaction for bank, the relevant rate in the IB market would be buy side rate]

Rate 44.40 Less: Margin @ 0.25% 00.11 Market Rate 44.29

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$1=Rs 46.95/47.10

$1=Rs 47.10

[Since Outward Remittance is sell transaction for bank, the relevant rate in the IB market would be sell side rate]

Rate 47.10 Add: Margin @ 0.20% 00.09 Market Rate 47.19

E.g.

Mr. X a valued customer engaged in import business is in spot need to remit

$10 Lacs to a US exporter. What rate you as a banker will quote to Mr. X when IB spot rate is $1 = Rs 46.95/10 and bank margin is 0.20%?

Soln.

Expanded form:

Relevant Rate :

Answer:

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Note 10

CROSS RATE

It is an exchange rate in which neither currency is USD

E.g. £1 = Rs 80.50

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Currencies

• INR = Rs • GBP or STG = £ • EUR = € • AUD = Australian Dollar • SGD = Singapore Dollar • DEM = Deutch Marc • FRF = Franc • ITL = Italian Lira • JPY = Japanese Yen

Now these countries use EURO

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E.G.

Mumbai IB Rate $1 = Rs 43.2550 – 43.2650

London IB Rate $1 = FRF 6.0500 – 6.0550

Case 1: An importer wants to buy FRF against INR what rate bank should quote [Assume EM = 0]

Case 2: At what rate bank should quote an exporter if the exporter wants to sell FRF and buy INR

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Soln.

CASE 1

Step 1 Mumbai IB Market

Action: Sell INR and Buy Dollar

The $ is base currency therefore talk w.r.t $. The $ can be bought at the market selling rate which is highest of the quote.

The relevant rate is $1 = 43.2650 ----(i)

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Step 2 Sell $ and buy FRF

The base currency is $. The $ can be sold at the market buying rate which is lowest of the quote.

The relevant rate is $1 = FRF 6.0500 ----(ii)

From (i) and (ii)

FRF 6.0500 = Rs 43.2650

FRF 1 = Rs 43.2650/6.0500

FRF 1 = Rs 7.1512 (Round off at 4th place)

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CASE 2

Step 1 London IB Market

Action: Sell FRF and Buy $. $ can be bought at the market selling rate which is highest of the quote.

$1 = FRF 6.0550

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Step 2 Mumbai IB Market

$ can be sold at the market buying rate which is lowest of the quote

$1 = Rs 43.2550 ----(ii)

From (i) and (ii)

FRF 6.0550 = Rs 43.2550

FRF 1 = Rs 43.2550/6.0550

FRF 1 = Rs 7.1437 (rounded off at 4th place)

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E.G. May 05 Jan 28, 2005 an importer customer requested a bank to remit

SGD 25 Lacs under an irrevocable LC Points to remember • Merchant Transaction • For bank this is a sale

Due to Strike, the bank effected remittances on Feb 04, 2005 IB Rates Jan 28 Feb 04 Bombay $1 Rs45.85/45.90 45.91/45.97 London £1 $1.7840/1.7850 $1.7765/1.7775 £1 SGD 3.1575/3.1590 SGD 3.1380/3.1390 EM = 0.125%. Customer loss/gain?

Extra Information

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Calculation for Jan

Step 1 Buy Dollar

The $ can be bought at the market selling rate which is highest of the quote

$1 = Rs 45.90

Step 2 Buy Pound

£ can be bought at the market selling rate which is highest of the quote

£1 = $ 1.7850

$1 = £1/1.7850

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Step 3 Sell £

Pound can be sold at the market buying rate which is lowest of the quote

£1 = SGD 3.1575

£1/1.7850 = SGD 3.1575 X (1/1.7850)

Rs 45.90 = SGD 3.1575 X (1/1.7850)

SGD 1 = Rs 45.90/[3.1575 X (1/1.7850)]

= Rs 25.9482

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The Rate to be quoted to the customer SGD 1 Rs 25.9482 Add: EM @ 0.125% Rs 0.0324 Rs 25.9806 Similarly we can calculate Exchange rate (in IB

Market) (45.97 X 1.7775)/3.1380 =26.0394 Add: EM @ 0.125% = 0.0325 26.0719 Loss = (26.0719-25.9806) X 25L = 2.2825 Lacs

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Short-Cut For Cross Rate

• Case 1 Common currency on the base side E.g. $1 = Rs 45.20/45.30 $1 = CHF 1.2030/1.2040 Common Currency is $ Location of Common Currency is on the base side Rule: Divide across by the currency which is going to be the base in the cross rate CHF/Rs = 45.20 45.30 Base/Price 1.2040 1.2030 = 37.5415/37.6559 Rs/CHF = 1.2030 1.2040 Base/Price 45.30 45.20 = 0.02656/0.02664

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Short-Cut For Cross Rate

• Case 2 Common currency on the price side E.g. £1 = $1.5060/70 CHF 1 = $0.8020/30 Common currency = $ Location of $ is on the price side Rule: Divide across by the currency which is going to be the price in the cross rate £/CHF = 1.5060 1.5070 Base/Price 0.8030 0.8020 =1.8755/1.8791 CHF/£ = 0.8020 0.8030 Base/Price 1.5070 1.5060 = 0.5322/0.5332

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Concept of Inverse Rate

E.G a) $1 = Rs 48 Re 1 = $1/48 b)$1 = Rs 48.50/48.60 Re 1 = 1 1 48.60 48.50 = 0.02058/0.02062 Concept: Ask Rate and Bid Rate will be inversed once the

currencies are interchanged from price to base and vice versa

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Short-Cut For Cross Rate

• Case 3 Common currency on the base side as well as price side. We can either go to Case 1 or Case 2 by using Concept of Inverse Rate E.g. $1 = Rs 50.2025/30 £1 = $1.6020/30 Common currency = $ The $ is on the base side as well as price side Applying Inverse Rate Concept $1 = £ 1 1 1.6030 1.6020 £/Rs = 50.2025 50.2030 Base/Price 1/1.6020 1/1.6030 = 80.4244/ 80.4754 Rs/£ = 1/1.6030 1/1.6020 Base/Price 50.2030 50.2025 = 0.012426/0.012434

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Note 11 Base Rate Vs Cover Rate They are essentially IB spot rate. The word covered means exactly opposite transactions in IB market E.G If bank has bought FC in merchant deal, the cover operation would be selling FC Remember, if bank does cover operation first in IB market then the cover rate

and base rate are same [we should assume this unless otherwise specified] If merchant deal is done first, then cover operation is taken, the cover rate and

base rate would be different

BASE RATE

• Base Rate is the IB spot rate which forms the basis for calculation of merchant rate.

COVER RATE

• Cover Rate is IB spot rate at which merchant transactions are covered in the IB market.

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• MAFA Nov 05 Q4(c)

You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at Rs. 5.70 & covered yourself in London market on the same day, when the exchange rates were US$1=H.K.$7.5880 7.5920

Local inter bank market rates for US$ were Spot

US$1=Rs.42.70 42.85

Calculate cover rate & ascertain the profit or loss in the transaction ignore brokerage.

Merchant rate

This must have been calculated using spot rate and EM

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Concepts tested in this question • Cross Rate • Cover Rate • Merchant Rate (Exchange Margin) Given, Merchant Rate HKD 1 = Rs 5.70 Cover Operation What bank will do? Buy HKD in the IB market on spot basis against Rs [because it has sold HKD in the merchant deal.]. Cross Rate Common Currency = $ Location of common currency is on base side HKD/Rs = 42.70 42.85 7.5920 7.5880 = 5.6243/ 5.6471 Not required The bank has to buy HKD in IB market and it can do so at the rate at which the market is ready to sell HKD

which is highest of the quote Gain = (5.70 – 5.6471) X 100 Lacs = (0.0529) x 100 Lacs = 5.29 Lacs

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Note 12 • Appreciation (↑ of value) Revaluation • Depreciation (↓ of value) Devaluation Always talk appreciation or depreciation w.r.t. base currency. o Appreciation Depreciation Market determined [that means

market force (demand and supply) will decide which currency will appreciate or depreciate]

o Revaluation Devaluation This is forced by regulatory authority

% change in value of the currency = New value – Old value Old value

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E.g.

Jan 2007 Sept 2007

$1 = Rs 50 $1 = Rs 39

% decrease in the value of $ = 39 – 50

50

= -22% Per annum decrease in the value of $ = -22% X 12

9

= 29.33%

The $ has depreciated by 22% during 9 month period

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Note 13

Can we say that appreciation of one currency is exactly equal to depreciation of another currency?

No. [But approximately yes]

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E.g.

t = 0 t = 1

£1 = $2.00 £1 = $1.80

% change in the value of £ = 1.80 – 2.00

2.00

= -10%

The £ has depreciated by 10%.

Now we want to check how much $ has appreciated

t = 0 t = 1

$1 = £1/2 $1 = £1/1.80

= £0.5000 = £0.5556

% change in the value of $ = 0.5556 – 0.5000

0.5000

= 11.11%

This difference in the result of appreciation of currency and depreciation of another currency is called Siegel’s Paradox.

We now know that appreciation of one currency is approximately equal to deprecation of another currency but not exactly. In exam, we can do approximation if required but we need to state that we have ignored impact of Siegel’s Paradox. ©Anuj G Joshi

Note 14

What is ACI Convention? ACI Association Combiste International The exchange rate between two currencies are written as

under First Currency and Second Currency are written in three

letters each and they are separated by an oblique (/) The first currency is the base currency and second currency is

the price currency E.g. USD/INR 40.2030/31 First currency/Second currency or Base currency/Price or quote currency

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Note 14

In academic world the ACI convention may not be followed. The possible styles are

i) Style 1 a) $1 = Rs 40.25/26 ↓ ↓ Base Currency Price or quote

b) 120 JPY/USD The Unit currency is the base currency

↓ ↓ Price or quote/Base Currency

ii) Style 2 INR/USD 45.20/45.25 As per ACI convention INR should be the base. However, if we know

the market parity, give preference to market parity over ACI Convention.

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Note 15

How to decide Market Parity?

£1 = Rs 80

€1 = Rs 62

$1 = Rs 50

All other currencies can be

taken as weaker than $

For interpreting exchange rate between $ and € or £, if the value is more than one then $ is the price currency and vice versa

In this case, if the exchange rate value is more than 1 then $ is the base currency and vice versa

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E.g. i) USD/STG 1.6230/31 Base STG Price USD As per ACI convention, USD is the base currency but based on market

parity, STG is the base currency. And the market parity is given preference.

1 STG = 1.6230/31 USD ii) DEM/USD 0.9030/31 Base DEM Price USD Base currency and price currency will be same in both ACI convention

and Market parity

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iii) USD/INR 0.02310/0.02315 Base INR Price USD As per ACI convention, USD is the base currency but

based on market parity, STG is the base currency. And the market parity is given preference.

iv) USD/INR 2.3104/10205 Base INR [base currency with 100 as unit] Price USD v) €/$ €0.9020/21 Base $ Price € [Given in the quote]

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