Contents of Module A

Exchange

rates
Risk management and basics of
derivatives
Documentary letters of credit
Facilities for exporters and importers
Correspondent banking and NRI
accounts
RBI and exchange control in India, EXIM
Bank, ECGC

Exchange rates

International transaction in cash requires two

distinct purchases

Purchase of foreign currency

Purchase of good/service with the FC

Term foreign exchange is used to denote

foreign currency
Foreign exchange market exists to cater to the
demand for foreign currency/currencies

Foreign Exchange Market

Organisational

setting within which

individuals, governments and banks buy
and sell foreign currencies
Only a small fraction of daily transactions
in foreign exchange involve trading of
currency
Most foreign exchange transactions
involve transfer of bank deposits

Definition of foreign exchange

Deposits, credits and balances payable in
foreign currency
Drafts, travellers cheques, letter of credit or bill
of exchange expressed or drawn in Indian
currency but payable in foreign currency
Drafts, travellers cheques, L/Cs, etc. drawn by
banks, institutions or persons outside India but
payable in Indian currency
The above definition is as per FEMA (1999)

Exchange rate (1)

Denotes

the price or the ratio or the value

at which one currency is exchanged for
another
Exchange rate is very dynamic
The foreign exchange market is roundthe-clock market due to different time
zones
Major participants- central banks,
commercial banks, forex brokers,
corporations, individuals

Factors affecting exchange rate

Major

banks that act as market-makers

always give two-way quotes; gives depth
and volume to the market
Fundamental reasons
Technical reasons
Speculation

Fundamental reasons
Balance

of payments->surplus>appreciation
Growth rate of the economy-> higher
growth->depreciation of currency
Fiscal policy-> financing of fiscal deficit
influences exchange rate
Monetary policy->loose monetary policy> depreciation of exchange rate

Technical reasons
Freedom

or restrictions on capital
movements can affect exchange rates to
a large extent
Among other factors there are:

Huge trade surpluses of oil exporting

countries
Capital moving from low-yielding currencies to
high yielding currencies (interest differential)

Speculation
Self-fulfilling

prophecies

Anticipation of depreciation of a currency can

cause dealers to sell that currency

Speculation

serves to provide depth and

liquidity to the forex market
Acts as a cushion as well- contrarian
traders exist in the market

Types of exchange rate (1)

Ready/cash-

Settlement of funds on the

same day (date of the deal).
Tom- Settlement of funds takes place on
the next working day of the date of the
deal
Spot- Settlement of funds takes place on
the second working day following the
date of the deal

Types of exchange rate (2)

Forward-

Delivery takes place on any day

after the date of the deal
In the forex market all rates that are
quoted are generally spot rates
When delivery takes place beyond the
spot date then it is a forward transaction
and the forward rate is applicable
Forward rate = Spot rate + Premium (discount)

Forward rate
If the forward value of a currency is higher than
the spot value the currency is said to be at a
premium
If the above is reversed the currency is said to
be at a discount
The forward premium/discount is based on
interest rate differentials of the two currencies
involved
Direct and indirect quotes of exchange ratedirect quote, local currency is variable

Quotes of Exchange Rate

Cross

rates- To obtain rates for a

particular currency pair when they are
not available directly
Bid and offered rates- In USD/INR
39.40/41 the bank is bidding for USD at
Rs. 39.40 and offering to sell USD at Rs.
39.41

Exchange Arithmetic
All foreign exchange calculations have to be
worked with care and accuracy and several
rules have to be kept in mind
Chain rule- is used to attain comparison or
ratio between two quantities which are linked
together through another or other quantities.
Equation in the form of a chain is derived.
Per cent and per mille- Per 100 units/per 1000
units

Example of a Chain Rule (1)

Query:

If we have to remit French Francs

to France from India how do we go about
it? (We have to arrive at cross rates
between FRF and INR.)
Mumbai interbank market:

US $ 1 = Rs. 41.2550/2650
London

Market

US $ 1 = FRF 6.0500/6.0550

Chain rule (2)

At what rate can one buy FRF against rupees?
How many Rs----- = FRF 1?
FRF 6.0500 = US $ 1
US $ 1 = 41.2650, therefore,
FRF 6.0500 = US $ 1 = Rs. 41.2650
Hence, FRF 1 = 41.2650/6.0500
Or FRF 1 = Rs. 6.8206

Forward Rate (1)

Value date: It is customary, in foreign exchange
market, to quote a rate to do the deal but
exchange the currencies not on the same day
but generally afterwards.
Forward rate: Has two components

Spot rate
Forward points or forward differentials

Forward rate is the rate when the value of the

deal is fixed beyond the spot date i.e. beyond
the second working day after the deal

Forward Rate (2)

Forward transactions are necessary in the

foreign exchange market as they serve number
of purposes like:

One can hedge or cover an existing future financial,

commercial or trade related exchange risk
These types of deals, in combination with spot deals,
are used for money market operations through swap
transactions
Taking a view of the market, these can be used for
speculation

Forward rate (3)

When a currency is costlier in the future
(forward) as compared to the spot, the
currency is said to be at a premium vis--vis
another currency
In direct rate premium is added to both the
buying and selling rate whereas discount is
deducted
In indirect rate premium is deducted and
discount is added to the buying and selling
rates

Forward rate (4)

Base currency is the currency which is being
bought and sold and the other currency is
incidental.
Forwards are quoted as follows

Spot/1 month 17/18

Spot/ 2 months 35/37
Spot/ 3 months 53/56

If forward differentials are in the ascending

order (1st figure is lower than the 2nd) the base
currency is at premium

Foreign exchange transactions

(1)
Arbitrage:

Is an operation by which one

can make risk free profit by undertaking
offsetting transactions.

Can be in interest rates: borrow in one centre

and lend in another

Can be in exchange rates: Buy a currency in
one market and sell in another

Arbitrage

keeps exchange rates uniform

in all markets

Foreign Exchange Transactions

(2)
Merchant rates: Quotes offered to merchants
(importers, exporters) by banks.
Inter-bank rates: The rates quoted by banks for
dealing in the inter-bank market.
Merchant quotations: In India all merchant
quotations for foreign currencies shall be in so
many rupees for one unit of foreign currency
except for Japanese Yen, Italian Lira and
Belgian Franc (Rs/100 units of the currency)
All quotes are in four decimal places with the
last two digits in the multiple of 25

Modes of remittances (1)

Telegraphic Transfers (TT) of funds are done
from one centre to another by way of
instructions through telex, telegram or SWIFT
(Society for Worldwide Interbank Financial
Transfer). Of late SWIFT is becoming popular
Mail Transfer (MT) of funds is done by way of
instructions sent by mail. An MT is an order in
writing on the correspondent bank/branch
abroad to pay the beneficiary the sum
mentioned

Modes of Remittances (2)

Demand draft (DD): A DD is an order in writing
on the correspondent bank/branch abroad to
pay the beneficiary the sum mentioned therein.
Fedai prescribed types of rates of merchant
transactions:

TT (buying)- clean inward remittances

Bill (buying)- purchase/discount of export bills
TT (selling) clean outward remittances
Bill (selling) remittance for import bills

RBI/FEDAI Guidelines (1)

RBI

has issued Authorised Dealers (AD)

licences to banks, all India financial
institutions and a few co-operative banks
to undertake foreign exchange
transactions in India
It has also issued Money Changer
licences to a large number of established
firms, companies, hotels, shops, etc.

RBI/FEDAI Guidelines (2)

Money changers help facilitate encashment of
foreign currencies of foreign tourists
Entities authorised to buy and sell foreign
currency notes, coins and travellers cheques
are called full fledged money changers
Those authorised only to buy are called
restricted money changers

RBI/FEDAI Guidelines (3)

FEDAI (Foreign Exchange Dealers Association
of India) is a non-profit making body formed in
1958 with the approval of RBI
Its members are authorised dealers and it
prescribes guidelines and rules of the game for
market operations, merchant rates, quotations,
delivery dates, holidays, interest on defaults,
etc.
FEDAI also advises RBI on market related
issues and supplements RBI on strengthening
the market