Forex – An Overview

Compiled by: CA Sapna Jain

The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over the counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.

MeaningMeaning-  An expression to denote

foreign currency

-    Also covers the method by which a currency of one country is exchanged for that of another.

Foreign exchange Foreign exchange MarketMarket

In a market there are buyers and sellers who negotiate and agree on the price for the commodity being exchanged.

The foreign exchange market is

no different. However, here the commodity being traded is foreign exchange and the price is the foreign exchange rate.

Foreign exchange Foreign exchange MarketMarket The purpose of the foreign exchange market ‘Forex' is to assist international trade and investment.

It allows businesses to convert one currency to another foreign currency.

For example- It permits a U.S. business to import

European goods and pay Euros, even though the business's income is in US dollars.

Foreign exchange Foreign exchange MarketMarket

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency.

The modern foreign exchange market

started forming during the 1970s when countries gradually switched to floating exchange rate from the previous exchange rate regime, which remained fixed as per the Bretton Woods System.

SOURCES AND USES SOURCES AND USES FOREXFOREXThe main sources of foreign exchange are-

Export earnings from goods and services

Remittances from overseasDirect investment flows Private and official loan inflows.

USES OF USES OF FOREXFOREXThe main users of Foreign exchange are-Individuals and companies – to pay for imports of merchandise,

to make service payments (inclusive of

travel) – to repatriate profits – to repay external debt. The Bank may also purchase foreign

exchange from the market to add the official Net International Reserves.

Types of Exchange Types of Exchange RatesRates Direct Quote It is the number of home currency

units required to buy or sell one unit of foreign currency.

For example- Rs. 44.20 per USD is direct quote

for USD in India.“In a direct quote the price comes

first, the commodity comes next.”

Types of Exchange Types of Exchange RatesRatesIndirect Quote It is the number of units of foreign

currency required to buy or sell one unit of home currency.

For example- Re I = 0.02 USD is an indirect quote

for the Indian. “In an indirect quote, the commodity

being bought and sold is the home currency”.

Q. A Mumbai baker has given the following quotes. Identify whether they are direct of indirect. For each direct quote give the corresponding indirect quote and vice versa.

Currency Rate Quote SEK5.7500 Rs. per Kroner EURO 0.0191 Per Re SGD0.0388 SGD per Re AED 12.1500 Rs per UAE Dirham

Q- Column I give the nature of the quote for the currency named in column 3 in the city named in column 4. Find the quote named in column 5 for the city named in column 6.

1 2 3 4 5 6 Quote Rate For City Quote CityA. Direct 1.694 Sterling New Direct

London YorkB. Direct 52.35 € Chennai Indirect

Rome C. Indirect 13.13 Pound London Indirect

Hong- Kong

D. Indirect 4.726 NZ Auckland Direct Oslo dollar

Bid and Bid and AskAskYou can buy or sell currency from a bank. The rate at which the bank buys a currency

is called the “Bid” rate of that currency. The rate at which the bank sells a currency

is called the “Ask” rate of that currency.For instance- If the bid rate for USD is Rs.45, it means

that the bank is ready to buy 1$ for Rs.45. - If the ask rate for USD is Rs.46, it means

that the bank is (asking if someone will buy) selling 1$ for Rs.46.

Two-way Two-way quotequote A banker gives two-way quote. That

is, a “Bid quote” and an “Ask quote”. When a banker is called about the foreign currency rates, he generally does not enquire whether you want to buy or sell. He simply indicates both quotes. By convention, in the Direct Quote, the Bid quote precedes the Ask quote.

For example A two-way quote in INR for USD will

read: Re/$ - 47.00 – 47.80.

The bank always The bank always winswinsIn a two-way quote, it is easy to

identify the rate you need. The rule: “The bank always wins”. Take Rs. 50-52 = 1. €

You want to buy Rs. You have €. You will get only Rs.50 for each € you part with. You want to sell Rs. and buy € . You part with Rs.52 for each €.

SpreadSpread The different between the bank’s buying rate (bid rate) and the bank’s selling rate (ask rate) is called the “spread”. If the bid rte for € is Rs.50 and the ask rate is 52, spread will be Rs.2.

Q.- INR.47.10 – 47.25 per USD is a direct quote. Another direct quote is ¥/£179-180. Spot

(a) The country where the quote is made. (b) The bid, ask and spread.

(c) For the Ask price (i) Currency being bought by the

bank. (ii) Currency being bought you (d) For the Bid price (i) Currency being bought by the

bank (ii) Currency being bought by you.

Converting two-way Converting two-way quotesquotes Exchange rates can be written in the

numerator denominator format. For example- Bid (Re/$) means the denominator currency, $, is being bought in

exchange for the numerator currency, i.e. Rupees. Ask (Re/$) means the denominator currency, $, is being sold in exchange

for the numerator currency, i.e., Rupees.

Q.-The rate quoted by a Chennai banker is Rs. 70-72 per pound. Compute the relevant pound-per-Re rate.

Q.- Consider the following INR/SGD direct quote of ICICI Mumbai: 26.50 - 75

(a) What is the cost of buying Rs.55, 000?

(b) How much would you receive by selling 92,000 rupees?

(c) What is the cost of buying SGD 7,450?

(d) What is your receipt if you sell SGD 18,340?

Cross Rate and Cross Rate and cross cross multiplicationmultiplication

Rule 1: Bid (A/B) = Bid (A/C) x Bid (C/B) This means that the purchase price of B in relation

to A is the product of the purchase price of C in relation to A and the purchase price of B in relation to C.

Rule 2: Ask (A/B) = Ask (A/C) x Ask (C/B) This means that the selling price of B in relations,

A is the product of the selling price of C in relation to A and the selling price of B in relation to C.

Rule 3: The relationship between bid and Ask is: Bid (A/B) = 1/Ask (B/A)

Ask (A/B) = 1/Bid (B/A) This is to be used when A/B needs to be

computed but B/A is available.

Q.- From the following imaginary quotes

(i)$ 0.3302-0.3310 per DM (ii)$ 0.1180 – 0.1190 per FFDerive Bid/Ask DM rates for one unit

of FF. Note: DM means Deutsche Marks

and FF means French Francs.

There is no single exchange There is no single exchange rate rate An exchange rate is never static or

constant. Consider theses:(a)Inter-day fluctuation(b)Intra-day fluctuation(c)Transaction-based rate – For

instance, there will be one rate if you had over dollar currency to the bank (Bid rate for dollar currency), a different rate if you hand over dollar traveler's cheque to the bank (Bid rate for dollar TC) etc.

Spot RateSpot Rate Exchange rates in the forex market can

be brought under two heads, spot and forward. Spot rate is the most commonly used terms in the context of exchange rates. The spot rate is the rate applicable for immediate settlement.

However, both in India and internationally, by convention spot rates means the exchange rate at which the transaction will be settled on the second working day.

Q.- On 8th July, a Thursday, a menthol exporter in New Delhi has received intimation from his customer in Hamburg about a remittance of € 1,24,000/-. If the Rupee/€ spot rate is 51.19-52.00, how much and when will the menthol exporter receive Rupees?

Forward Forward RateRate The Forward Exchange Rate is the

rate contracted today for exchange of currencies at a specified future date.

Once the rate is contracted, both

parties, namely the customer and the dealer-banker, are obliged to perform on the specified future date irrespective of the exchange rate prevailing on that date.

Swap pointSwap point The difference between the outright

forward rate and the spot rate is called the swap differential or swap points.

For example If the spot rate for the € is Rs.50 and

the forward rate is Rs.53, the difference of Rs. 3 is called the swap points.

The forward quote can be given as Rs. 53 (Called outright forward) or as 3 (called swap quote).

Q.- The spot for € is Rs.50-52. The forward rate is 53-56. Compute swap points, spots and forward spreads.

Q.- Consider the following rates and suggest which currency is quoting at premium and which at discount.

(a)Spot Rs./HK$ is 6.02. 1-month forward = Rs.6.04

(b)Spot Rs./S$ 26.83. 3-month forward = Rs.26.73

  Q.- Consider the following

Euro/USD direct quote: 0.9345 – 0.9375.

(a)What is the cost of buying Euro 1,25,000?

(b)How much would you received by selling 49,300 Euro?

(c)What is the cost of buying USD 78,500?

(d)What is your receipt if you sell USD 63,400?

 

Q.- You propose visiting London. You wish to carry traveler's cheques with you. You go to you local bank. The exchange rate quoted by the bank appear as under;

Travelers’ Cheques Buying–rate Selling–rate GBP – Sterling 72.70 73.25 (a)Explain the quote. (b)Compute the spread?(c)How much would you pay for purchasing £

250 in TC’s? (d)If on your return from London you have a

balance of £ 23 in traveler’s cheques, how many rupees would you receive if the bank in India quotes

73.65 – 73.92? 

Q.- Consider the following quotations in Mumbai Rupee / UAE Dirham (AED) = 12.69 Rupee / Swedish Krone (SEK) = 5.49 Rupee / New Zealand Dollar (NZD) =

25.35 Euro / INR = 0.0198Compute:(a)The quote for SEK/AED(b)Euro / NZD

Q.- Determine the direct quote format, bid and ask rates in dollar terms, for one unit of £. Show the step-by- step approach that you have adopted to derive the rates:

Rupee/$ 47.50 – 62Rupee/£ 75.50 – 60

Q.- The following information pertains to exchange rates quoted in London for spot and forward.

  Spot Swap points Swap

points 1-month 3-months forward forward Canadian 1.8640-8650 40 – 30 c pm 0.90 – 80

pm DollarEuro 1.4468-72 10 – 20 c dis 45 – 55

disUS $ 1.5865-70 20 – 30 dis 25 – 35

disCalculate the cost or value in sterling to a customer, who wishes to- (a)Sell Canadian dollars 19,200 spot.(b)Buy Euro 34,250 one month forward.(c)Sell US $ 93,750 three months forward.

Q.- The United States Dollar is selling in India at Rs.45.50. If the interest rate for a six month borrowing in India is 8% per annum and the corresponding rate in USA is 2%-

(a)Do you expect United States Dollar to be at a discount or at discount in the Indian Forward Market?

(b)What is the expected 6-month forward rate for United States Dollar in India?

(c)What is the rate of forward premium or discount?