FOREIGN EXCHANGE


INTRODUCTION:

“FOREIGN EXCHANGE” in simplest meaning refers to exchange of one currency for another or the conversion of one currency into another currency. Foreign exchange also refers to the global market where currencies are traded virtually round-the-clock. The term foreign exchange is usually abbreviated as “FOREX” and occasionally as “FX.”

FOREX MARKETS AND FOREX DEALING TECHNIQUES:

What is Market?

A place where selling and buying is taking place is a market. There are various such markets in which different commodities are being traded. e.g.

  • Grain Market – Selling and buying of grains.
  • Stock Market or Exchange – Selling and buying of Shares and Securities.
  • Cattle Market – Selling and buying of cattle.
  • Forex Dealing room – Selling and buying of Foreign exchange.

In all these markets, people deal (Sell or Buy) a specific commodity. In markets mentioned at 1 to 3, people usually face each other at the given physical place. However, in Foreign Exchange Trading Rooms, all transactions conclude via telephones/ telecommunications/ other means throughout the world.

Types of Transactions:

In Foreign exchange dealings, transactions are two types:

  • Merchant Transactions: These are the transactions between a customer and a bank. Say customer selling his export proceeds to the Bank at a quoted rate or customer purchasing Foreign exchange, say, for his import requirement. The rates quoted to the customers by the bank are based on Inter Bank rates after loading appropriate profit margins.
  • Inter Bank Transactions: These are the transactions between two Banks usually for cover operations. The transactions may be with any Bank within the country or with the Banks abroad. The rate quoted by one Bank to another is called Inter Bank rates.

How to quote?

For purchase and sell, quotation may be:

  • In terms of commodity we buy per unit of currency – say for Rs. 1.00 we buy 5 lemons. Here quantity of lemon (Commodity) may change per Rs. 1 in the market.
  • In terms of currency to be paid per unit of commodity – say for 1 Kg lemon we have to pay Rs. 25.00. Here amount you are required to pay, changes for given unit of commodity you deal.

In first example, the currency remains fixed but the units of commodities we buy changes, whereas, in other case the unit of commodity remains fixed but amount of currency changes.

In Foreign exchange quotations, foreign currency is treated as commodity and is quoted accordingly.

Say Rs. 100=USD 1.5873  OR

USD 1 = Rs. 63.00

The first quotation, where foreign currency amount changes with the fixed quantum of home currency, is called INDIRECT QUOTATION. Next one is a DIRECT QUOTATION, where the value of one unit of Foreign currency is given in terms varying quantities of the local or home currency.

In India, prices are quoted as Direct Rates since August 1993.

SPOT AND FORWARD RATES:

A spot transaction is one where the currencies would be exchanged on the second business day after the day of the contract. Foreign Currency Rates are generally quoted on SPOT basis. If it is the intention to effect the exchange of currencies other than on the “SPOT” date, it has to be specifically indicated when a price is asked for. Accordingly, exchange rates can be for:

CASH          –  Currencies are exchanged on the day of the transaction.

TOM           –  Short for Tomorrow. Currencies are exchanged on the next business day.

FORWARD   – Currencies will be exchanged on a future specified date or within a future specified period on a

date at the option of the contracting parties as agreed.

These rates are likely to differ from the SPOT rates. CASH and TOM rates are transactions which results in delivery of currencies prior to the SPOT date. They generally are employed to correct immediate liquidity problems.

Forward rates are used mainly to fix the exchange rate for cash flows expected in future. Generally, only the difference between the forward rate and the spot rate is quoted. This is known as the FORWARD MARGIN or FORWARD DIFFERENTIAL. The forward differences are not volatile as compared to the spot rate and can be readily applied on the spot rates.

The forward difference could make the currency cheaper in the future when currency is said to be at DISCOUNT; or make it costlier when the currency is said to be at PREMIUM. The forward margins are also quoted two way just as the spot rate.

e.g. USD 1 = Rs. 63.01/02

1 Mth =           40/41

The first figure applies to the SELLING PRICE in the INDIRECT quote ( or the BID in the DIRECT quote ) and the second to the BUYING PRICE in the INDIRECT quote ( or the OFFER in the DIRECT quote) for the currencies dealt in. Whether the difference is a premium or discount can be found by looking at the quote itself. For instance, in the given example, the quoting bank is asking for a larger difference on the selling price than the buying price. This indicates that the currency dealt in is at a PREMIUM. When a currency is at premium larger premium will be charged when selling as against conceded when buying. Conversely, if the difference was larger at the buying price side for currency dealt in, DISCOUNT is implicit. Logically, the quoting bank will buy at a higher discount than it is willing to concede when selling.

In the case of Direct quotations, likewise a larger difference on the BID side indicates that the currency dealt in is at a DISCOUNT, where as a larger difference on the OFFER side indicates that the currency dealt in is at a PREMIUM. ( The example given above is for DIRECT quote.)

Distinguishing rates on the basis of the home currency relationship fails on two counts:

  1. When neither is a home currency
  2. In the International Market there is a convention of quoting most currencies as equivalent to USD 1, transactions are denominated in USD. Consequently, the prices which would be an indirect quotation in the USA may seem to be a direct quotation in the other quotation. Theexception to this are Newzealand Dollar, Austarlian Dollar, Cable (STG/USD) and the Euro.

It is therefore preferable to classify rates into DIRECT and INDIRECT on the basis of the currency that is dealt in. Thus in a DIRECT Rate the currency dealt in is expressed as a fixed unit e.g.  USD 1 = INR 63.00.

The deals are done in USD terms and parties contract to buy or sell USD (the consequent exchange of INR is implicit).

Conversely in an INDIRECT rate the currency dealt in is the one whose quantity is variable in the expression e.g. INR 100 = USD 1.5875.

The deals are done in USD terms and parties contract to buy or sell USD whose value in the expression can vary against a constant quantum of INR.

TWO WAY QUOTATIONS:

In foreign exchange markets the bank indicates both the prices at which it is willing to buy and willing to sell a currency. The two price will not generally be the same since any person quoting prices will ensure that some profit margin is available between the buying and selling prices. This manner of quotation of rates is known as TWO WAY QUOTE. The advantages of having two way quotes are:

  1. The Markets constantly have prices for buyers as well as sellers.
  2. The Prices automatically reveals the profit margin the quoting bank is charging. A narrow margin indicates a very fine or competitive pricing.
  3. When inquiring for rates it is not necessary to indicate whether one intends to buy or sell the currency.
  4. Since the quoting bank is not sure of the intention of the inquirer, it cannot afford to make the currency too costly or too cheap and would endeavour to keep prices in alignment with the market.

Conventionally, in the DIRECT quote the first price is the BID on the price at which the quoting bank is willing to buy the currency dealt in and the second price is the OFFER or the price at which the currency is being offered for sell.

Conversely, in the INDIRECT quote the first price is the price at which the currency dealt in is being offered for sale and the second price is the price at which the currency will be purchased by the quoting Bank. e.g.

DIRECT QUOTE:

1 USD = INR 63.01/63.02

Buying  / Selling price  for USD

INDIRECT QUOTE:

INR 100 = USD 1.5875/1.5900

Selling / Buying price  for USD

In two way quotes the first price is indicated in full while the second price is indicated only by the last two digits, since the spreads are such it generally affects only the last two digits.

1 USD = INR 63.01/02

INR 100 = USD 1.5875/00

CROSS RATES:

Since most currencies are quoted against USD, the price relationship between two non USD currencies has to be derived through their respective prices against USD. This is done through “CROSSING” the two sets of rates. Cross rates basically determine the rate of exchange between two currencies when given their individual rates against a common third currency. e.g.

GBP 1 = USD 1.6100

USD 1 = INR 63.00

Therefore GBP 1 = INR 101.43 (1.61 USDx63.00)

In the market where several currencies are being quoted simultaneously, there will be constant endeavour to ensure that the rates are in proper alignment as directed by the cross rate since non alignment can be exploited by the arbitragers.

Cross rate need not necessarily imply multiplication, for instance:

GBP 1 = USD 1.6690

AUD 1 = USD 0.9010

Therefore GBP 1 = 1.6690/0.9010 AUD = 1.8523 AUD