Chapter11- Foreign Exchange Markets

Shivani Sodah Roll No 51

Definition of 'Forward Rate' Forward rate is the price fixed for an asset for transaction at a future date. Egs, commodity. 'Forward Rate' Explanation The forward rate is the price used to determine the price of a futures contract. It accounts for holding costs, appreciation and demand for the good. Forward Rate Agreements A forward rate agreement is an agreement between two parties in which one of them contracts to lend to the other a specified amount of funds in a specific currency for a specified period starting at a future date at an interest rate fixed at the time of agreement. An over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. The forward rate is the future yield on a bond. It is calculated using the yield curve. For example, the yield on a three-month Treasury bill six months from now is a forward rate. Definition of 'Spot Rate' The day when a spot transaction is typically settled, meaning when the funds involved in the transaction are transferred. The spot date is calculated from the horizon, which is the date when the transaction is initiated. In forex, the spot date for most currency pairs is usually two business days after the date the order is placed. 'Spot Rate' explanation The spot price reflects market expectations of future price movements for a security or nonperishable commodity (e.g., gold). An exception to the usual two-day spot-date guideline is the USD/CAD pair, which settles in one business day because this currency pair is commonly traded and its financial centers are in the same time zone. Furthermore, settlement does not have to occur on the spot date. In a short date forward, for example, the transaction is settled in advance of the normal spot date. A spot rate in simple terms is the current market price of an asset. The contract for a spot

transaction is processed in two-three working days.

Melissa Tiexeria- Roll No52

A foreign exchange rate is the price of a foreign currency. A foreign exchange quotation or quote is a statement of willingness to buy or sell at an announced rate. Quotes can be expressed Alphabetically ( USD,INR,EUR) Or

Numerically ($ ,`, )

Interbank Quotations:
The most common way that professional dealers and brokers state foreign exchange quotations, and the way they appear on all computer trading screens worldwide, is called European terms. The European terms quote shows the number of units of foreign currency needed to purchase one USD: CAD 1.5770 / USD An alternative method is called the American terms. The American terms quote shows the number of units of USD needed to purchase one unit of foreign currency: USD 0.6341 / CAD

Direct and Indirect Quotations:

A direct quote is a home currency price of a unit of foreign currency. An indirect quote is a foreign currency price of a unit of home currency. In the US, a direct quote for the CAD (Canadian dollar) is USD 0.6341 / CAD

This quote would be an indirect quote in Canada.

Bid and Ask Quotations:

Interbank quotations are given as "bid" and "ask". A bid is the exchange rate in one currency at which a dealer will buy another currency An ask is the exchange rate at which a dealer will sell the other currency. Dealers buy at the bid price and sell at the ask price, profiting from the spread between the bid and ask prices: bid < ask. Bid and ask quotations are complicated by the fact that the bid for one currency is the ask for another currency:

Example: A dealer provides the following quote: USD 0.6333 - 0.6349/ CAD. This suggests that the bid price for the CAD is USD 0.6333/CAD and that the ask price is USD 0.6349/ CAD.

The indirect version of this quote would be CAD 1.5750 - 1.5790/USD

Clearly, a dealer willing to purchase CAD at a price of USD 0.6333/USD is implicitly willing to sell USD at the reciprocal price of CAD 1.5790/USD.

The spread between bid and ask prices exist for two reasons: 1. Transaction costs and dealers as financial intermediaries and 2. Profits.

Types of transactions-

Interbank transactions / wholesale transactions

These transactions are between banks and financial institutions. The rate is known as the interbank rate.

Merchant transactions/ retail transactions While dealing with individual customers banks add a profit margin to the interbank rate. This is known as the merchant rate and is the price that is available to individual and corporate customers.

Shweta tewani-53
Factors that lead to fluctuations in Forex There are a host of factors which influence the supply of and demand for foreign exchange and thus are responsible for the fluctuations in the rate of exchange. Important among them are given below: 1. Trade Movements: Changes in the imports and exports cause changes in the demand for and supply of foreign exchange which in turn, lead to fluctuations in the rate of exchange. If the imports exceed exports, the demand for foreign exchange increases and, as a result, the rate of exchange of native currency will fall and move against the native country. On the other hand, if exports exceed imports, the demand for foreign exchange decreases and the rate of exchange rises and moves in favour of the native country. 2. Capital Flow: Capital flow from one country to another brings changes in the rate of exchange. If, for example, capital is exported from America for investment in India, the demand for India rupee will increase in the foreign exchange market. As a consequence, the rate of exchange of Indian rupee in terms of American dollar will rise. 3. Granting of Loans: If a country gets loans from some foreign country, the supply of the foreign currency will increase. As a result, the rate of exchange will move in favor of the home currency and against the foreign currency. But, at the time of repayment of loan or granting loan to the foreign country, the supply of foreign currency will fall and the rate of exchange will move against the home currency and in favor of the foreign currency. 4. Sale and Purchase of Securities: Sale and purchase of foreign securities influence the demand for foreign exchange, and, thereby, the exchange rate. When the residents of a country purchase foreign securities, the demand for foreign currency Increases. As a result, the value of home currency falls, i.e., the rate of exchange moves against the home currency and in favor of foreign currency.

5. Banking Operations: Banks are the dealers in foreign exchange. They sell drafts, transfer funds, issue letters of credit, and accept foreign bills of exchange. When a bank issues drafts or other credit instruments on its foreign branches, it increases the supply of home currency in the foreign exchange market. As a result, the rate of exchange moves in favor of the home currency and against the foreign currency. 6. Speculation: Speculation (or anticipation about the future changes) in the foreign exchange market also causes variations in the rate of exchange. If the speculators expect the value of foreign currency to rise, they begin to buy foreign currency in order to sell it in future to earn profit. By doing so, they tend to increase the demand for foreign currency and raise its value. On the other hand, if the speculators anticipate a fall in the future value of foreign currency, they will sell their foreign exchange holdings. As a result of this increase in the supply of foreign exchange, the rate of exchange will move against foreign currency and in favor of home currency. 7. Protection: When the government of a country gives protection to the domestic industries, it tends to discourage imports from other countries. As a consequence, the demand for foreign currency will decrease and the rate of exchange will move in favor of the home currency and against the foreign currency. 8. Exchange Control: The policy of exchange control also brings about changes in the rate of exchange. Generally, various measures of exchange control involve restrictions on imports which lead to a fall in the demand for foreign currency. As a result, the rate of exchange moves in favor of the home currency and against the foreign currency. 9. Inflation and Deflation: Changes in the internal value of money also reflect themselves in the similar changes in the external values. During inflation, the internal value (or the purchasing power) of home currency falls and there will be outflow of foreign capital from the country to avoid financial losses.

As a result, the demand for foreign currency will increase and the external value of home currency will fall. On the contrary, during deflation, the internal value (or the purchasing power) of the home currency rises and there will be inflow of foreign capital to realize financial gains from the relative appreciation of the value of foreign currency and a change in the exchange rate in favor of home currency and against foreign currency. 10. Financial Policy: Policy of deficit financing leads to inflationary conditions in the country. As a result, the foreign capital will start leaving the country, the supply of foreign exchange will fall and the rate of exchange will turn in favor of foreign currency and against home currency. 11. Bank Rate: Changes in the bank rate cause fluctuations in the exchange rate. When the central bank of a country raises the bank rate, there will be inflow of foreign capital with a view to earn higher interest income. As a result, the supply of foreign currency increases and the rate of exchange moves against the foreign currency and in favor of home currency. On the other hand, when the bank rate is reduced, there will be an outflow of foreign capital. This reduces the supply of foreign currency and the exchange rate moves in favor of the foreign currency and against the home currency. 12. Monetary Standard: If the country is on the gold standard, then the exchange rate will move within the limits set by upper and lower gold points. On the contrary, in a country with inconvertible paper money system, there is no limit to the fluctuations in the rate exchange. 13. Peace and Security: The conditions of peace and security in the country attract foreign capital. This increases the supply of foreign currencies in the country and the rate of exchange moves against the foreign currencies and in favor of the home currency.

Devansh Thapar-54
CURRENT AND CAPITAL ACCOUNT CONVERTABILITY The freedom to convert one currency into another internationally accepted currency is known as currency convertibility. There are 2 types of convertibility. One is current account convertibility and the other is capital account convertibility Current account convertibility refers to freedom in respect of Payments and transfers for current international transactions. In other words, if Indians are allowed to buy only foreign goods and services but restrictions remain on the purchase of assets abroad, it is only current account convertibility. As of now, convertibility of the rupee into foreign currencies is almost wholly free for current account i.e. in case of transactions such as trade, travel and tourism, education abroad etc. Capital Account convertibility is defined as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. In simple language what this means is that CAC allows anyone to freely move from local currency into foreign currency and back. Currency convertibility implies the absence of restrictions on foreign exchange transactions or exchange controls. It is compatible with other forms of transactions international transactions in goods services or capital. India has made the rupee convertible on current account on August 9, 1994. The Indian rupee became partially convertible. Under the current account convertibility, there is a freedom to buy or sell foreign exchange for the following purposes: 1) The international transactions consisting of payments due in connection with foreign trade. Other current businesses include services and nominal short term banking facilities 2) Payment due as interest on loans and as not income from other investments 3) Payment on moderate amount of amortization of loans for depreciation of direct investments 4) Moderate remittances for family living expenses 5) Currency convertibility provides increased capital flows. It also provides a signal to the international community that the country intends to manage its affairs without exchange Restrictions which would eventually help to enhance international confidence in the countrys policies, freezing exchange restrictions could uplift the quality management of balance of payments of the country. Flexible and realistic approach in exchange rate determination

combined with favorable macro economic policies could help to provide a viable of balance of payments.

The RBI constituted a committee on capital account convertibility under the chairmanship of Dr. S.S Tarapore. The committee recommended in June 1991, the full convertibility of the rupee in a phased manner after meeting certain pre conditions. These conditions are as follows: 1) Low fiscal deficit 2) Low inflation 3) Efficient financial system 4) Healthy foreign exchange positions The committee also recommended freedom to banks and financial institutions to operate in the domestic and international gold markets The following are the difficulties and problems in making the Indian rupee fully convertible: 1) Lack of competitive strength of industry 2) Lack of adequate technological base 3) Lack of adequate integration between the different segments of economy 4) Low speed of implementation of reforms 5) Lack of political stability 6) Inadequate banking and financial sector reforms 7) Lack of effective exchange rate mechanism at work In India, Banks and Financial institutions are not financially strong to grapple with the intricacies of full convertibility. It would also worsen our micro economic imbalances due to free movement of foreign capital. The high rate of interest would serve as an open invitation to the inflow of capital, which will result in an appreciation at the rupee and consequent fall in exports

How is CAC different from current account convertibility? Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts etc. In India, current account convertibility was established with the acceptance of the obligations under Article VIII of the IMFs Articles of Agreement in August 1994. What is the position in India today? Convertibility of capital for non-residents has been a basic tenet of Indias foreign investment policy all along, subject of course to fairly cumbersome administrative procedures. It is only residents both individuals as well as corporates who continue to be subject to capital controls. However, as part of the liberalisation process the government has over the years been relaxing these controls. Thus, a few years ago, residents were allowed to invest through the mutual fund route and corporates to invest in companies abroad but within fairly conservative limits. Buoyed by the very comfortable build-up of forex reserves, the strong GDP growth figures for the last two quarters and the fact that progressive relaxations on current account transactions have not lead to any flight of capital, on Friday the government announced further relaxations on the kind and quantum of investments that can be made by residents abroad. These relaxations are to be reviewed after six months and if the experience is not adverse, we may see further liberalisation and in the not-too-distant future full CAC Can CAC coexist with restrictions? Contrary to general belief, CAC can coexist with restrictions other than on external payments. It does not preclude the imposition of any monetary/fiscal measures relating to forex transactions that may be warranted from a prudential point of view. Why is CAC such an emotive issue? CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen as a major comfort factor for overseas investors since they know that anytime they change their mind they will be able to re-convert local currency back into foreign currency and take out their money. In a bid to attract foreign investment, many developing countries went in for CAC in the 80s not realising that free mobility of capital leaves countries open to both sudden and huge inflows as well as outflows, both of which can be potentially destabilising. More important, that unless you have the institutions, particularly financial institutions, capable of dealing with such huge flows countries may just not be able to cope as was demonstrated by the East Asian crisis of the late nineties.

Kushal Todi- Roll No55

Q1- If the base/common currency is on opposite sides: Calculate cross rates from the following data: USD INR 48.50/49.50 EUR USD 1.20/1.21 SOLUTION: In the above example, the common (base) currency is USD (In other words, quote 1 and quote 2 both have USD in common).

In addition to that, in the first quote the common currency is on the bid side and in the second quote it is on the ask side. USD INR 48.50/49.50 (quote 1) EUR USD 1.20/1.21 (quote 2) In cases where the common currency is on opposite sides, the formula is as follows: New Bid for the third quote = Bid (quote 1) x Bid (quote 2) New Ask for the third quote = Ask (quote 1) x Ask (quote 2) Third quote (Cross rate)= Lower uncommon currency/ Higher uncommon currency New Bid/New Ask

Lets solve it with the above example. USD INR 48.50/49.50 EUR USD 1.20/1.2 New Bid for the third quote = Bid (quote 1) x Bid (quote 2) = 48.50 x 1.20 = 58.2000

New Ask for the third quote = Ask (quote 1) x Ask (quote 2) = 49.50 x 1.21 = 59.8950 New Bid = 58.2000 and New Ask = 59.8950 Answer: Cross Rate is EUR INR 58.2000/59.8950 (Note: when we write the answer we have to take the uncommon currency of the lower quote first. Also, please remember to write each step since you get marks for seps)

Q2- If the common currency is on the bid side:

Calculate the cross rates from the following data: USD INR 47.75/48.50 USD GBP 0.6300/0.6350

SOLUTION: In the question given above, the common currency is USD In both quotes it is appearing on the bid side

For this kind of cross rate, we use the following formula: New Bid for cross rate = Bid of First quote / Ask of second quote New Ask for cross rate = Ask of first quote / bid of second quote (Answer) : Cross Rate = New Bid/New Ask

USD INR 47.75/48.50 USD GBP 0.6300/0.6350 New Bid for cross rate = Bid of First quote / Ask of second quote = 47.75 / 0.6350 = 75.1969 New Ask for cross rate = Ask of first quote / bid of second quote = 48.50/0.63 = 76.9841

Cross Rate = GBP INR 75.1969/76.9841 Q3

If the common currency is on the ask side USD INR 47.50/48.00 EUR INR 61.50/62.50 SOLUTION: Here the common currency is INR and it is on the ask side. For this you will use the same formula as when common currency is on bid side (example 2) However, the only difference is that in the answer instead of writing EUR USD; You will write the final answer as USD EUR USD INR 47.50/48.00 EUR INR 61.50/62.50 New Bid for cross rate = Bid of First quote / Ask of second quote = 47.50/62.50 =0.76 New Ask for cross rate = Ask of first quote / bid of second quote =48.00/61.50 =0.7804 Cross Rate= USD EUR 0.76/0.7804

Q4 CROSS CURRENCY RATE INR USD rate=49.50 EUR USD rate=0.9568 Find INR EUR rate SOLUTION: If 1EUR=USD0.9568 And USD1=Rs 49.50 1x0.9568x49.50/1x1=47.3616