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Introduction / Regulator of forex market in India

(a) If any transaction involves foreign currency, then such transaction is known as foreign
exchange transaction.
(b) If any transaction involves foreign currency, then this transaction is regulated by
RBI
FEDAI (Foreign exchange dealers association of India)
(c) RBI established in accordance with the provisions of RBI Act, 1934. RBI manage FEMA
act and maintain foreign exchange market.
(d) FEDAI is established under section 25 of the company act. FEDAI regulate inter
bank foreign currency business.
(e) The foreign exchange market is divided in 3 tiers as shown below:
1. International Bank
2. Bank
3. Customer
Note:
(1) Foreign banks are banks which are licensed by the RBI to deal in foreign exchange.
(2) Only bank can enter into transactions of foreign currency with foreign bank.
(3) The rate at which transaction between foreign bank and bank taken place is known as
Inter bank rate.
(4) The rate at which transaction between bank and customer has taken place is known as
Merchant rate.
(5) For any foreign exchange transaction always think from view point of bank.
(6) Think always view point of base currency / Commodity currency / Currency with 1
attached.
(7) Since bank is always in win win position, hence bank always purchase foreign currency
at lower rate and sell foreign currency at higher rate.
Types of forex market
(1) Wholesale market / Inter bank market
Under inter bank market one bank can deal with another bank.
Exchange rate of inter bank market is known as inter bank rate.
Only bank can deal at inter bank rate.
(2) Retail market
Under retail market bank deal with customer.
Exchange rate of retail market is known as merchant rate.
A customer can buy or sale currency only at merchant rate.
Merchant rate is derived from inter bank rate by adding or deducting exchange
margin.
Types of transactions under forex market
(1) Cash transaction / Ready transaction Transactions entered today for immediate
settlement is known as ready transaction. Ready rate is applicable for this transaction. This
transaction can be entered by one bank with another bank. In other words, we can say that
this is an interbank market transaction.
(2) Value tom transaction Transactions entered today for T + 1 business day settlement
(i.e. next business day settlement) is known as value tom transaction. Applicable rate for this
transaction is value tom rate. This transaction is possible in inter bank market only.
(3) Spot transaction Transactions entered today for T + 2 business day settlement is
known as spot transaction. Applicable rate for this transaction is spot rate.

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(4) Forward transaction Transactions entered today for settlement at a future date is
known as forward transaction. Applicable rate for this transaction is forward rate.
Topic: 4 Exchange rate quotations

Two way

One way quote

quote
When buying rate (Bid rate) and
selling rate (Ask rate) are same,
quotation is known as one way
quote.
Example: Exchange rate = 1$ = `50
It means that 1 $ can be purchased
or sold at `50 only.

When bid rate and ask rate are different then

this is known as two way quote. Bid rate is
always less than ask rate because bank always
purchase foreign currency at lower rate and
sale foreign currency at higher rate.
Example: Exchange rate = 1$ = `50 / 50.50
It means that bank will purchase 1 $ at `50
and sale 1 $ at `50.50.

How to apply two way quote for converting one currency into another currency?
Following steps will be applied for conversion:
1. Step: 1- Identify amount payable / receivable.
2. Step: 2- Select applicable bid rate or ask rate by assuming that what will do bank
for left hand currency i.e. commodity currency.
*Note: If bank has to purchase base currency then applicable rate is bid rate and if
bank has to sell base currency than applicable rate is ask rate. In other words we can
say that bank always purchase foreign currency at lower rate and sale foreign
currency at higher rate.
3. Step: 3- Convert one currency into another currency by using selected rate.
Example: 1 Calculate how many rupees Shri Ras Bihari Ji Ltd., a New Delhi basedfirm,
will receive or pay for its following four foreign currency transactions:
(i) The firm receives dividend amounting to Euro 1,12,000 from its French Associate
Company.
(ii) The firm pays interest amounting to 2,00,000 Yens for its borrowings from a Japanese
Bank.
(iii) The firm exported goods to USA and has just received USD 3,00,000.
(iv) The firm has imported goods from Singapore amounting to Singapore Dollars (SGD)
4,00,000.
Given: 1$ = Rs.40.00/40.05
1 Euro = Rs.56.00/56.04
1 SGD = Rs.24.98/25.00
100 Yens = Rs.44.00/44.10
Solution:
(i) Firm receive Euro = 1,12,000
Applicable exchange rate = 1 Euro = `56.00 / 56.04
Since bank purchase Euro hence applicable rate is bid rate i.e. `56

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Hence firm will receive = 1,12,000 * 56 = `62,72,000

(ii) Payment by firm = 2,00,000
Exchange rate: 100 = `44.00/ 44.10
Since bank sell hence applicable rate is ask rate i.e. `44.10
Payment by firm = 2,00,000 / 100 * 44.10 = `88,200
(iii) Firm receive = 3,00,000 $
Exchange rate: 1 $ = 40.00 / 40.05
Since bank purchase $ and hence applicable rate is bid rate i.e. `40.00
Hence firm receive = 3,00,000 * 40 = `1,20,00,000
(iv) Payment by firm = 4,00,000 SGD
Exchange rate: 1 SGD = `24.98 / 25.00
Since bank sell SGD hence applicable rate is ask rate i.e 1 SGD = `25
Hence firm pays = 4,00,000 * 25 = `1,00,00,000
Example: 2 Calculate how many British pounds a London based firm will receive orpay
for its following four foreign currency transactions:
(i) The firm receives dividend amounting to Euro 1,20,000 from its French Associate
Company.
(ii) The firm pays interest amounting to 2,00,000 Yens for its borrowings from a Japanese
Bank.
(iii) The firm exported goods to USA and has just received USD 3,00,000.
(iv) The firm has imported goods from Singapore amounting to Singapore Dollars (SGD)
4,00,000.
Given: 1$ = 0.50/0.51
1 Euro = 0.60/0.61
1 SGD = 0.39 /0.40
1 Yen = 0.0049 / 0.0050
Answer:
(i) Firm receive = 72,000
(i) Firm pays = 1,000
(iii) Firm receive = 1,50,000
(iv) Firm pays = 1,60,000
example: 3 Calculate how many US$ a New York based firm will receive or pay forits
following four foreign currency transactions:
(i) The firm receives dividend amounting to Euro 1,20,000 from its French Associate
Company.
(ii) The firm pays interest amounting to 3,00,000 Yens for its borrowings from a Japanese
Bank.
(iii) The firm exported goods to UK and has just received 3,00,000.
(iv) The firm has imported goods from Singapore amounting to Singapore Dollars (SGD)
4,00,000.
Given: 1 = $ 2.00/2.01
1 Euro = $ 1.20/1.21
1 SGD = $ 0.49/0.50
100 Yens = $ 0.89/0.90

Answer:
(i) Firm received = 1,44,000 $
(ii) Firm pays = 2,700 $

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(iii) Firm received = 6,00,000 $

(iv) Firm pays = 2,00,000 $
Example: 4 Calculate how many rupees a New Delhi based firm will receive or payfor its
following four foreign currency transactions:
(i) The firm receives dividend amounting to Euro 90,000 from its French Associate
Company.
(ii) The firm pays interest amounting to 2,00,000 Yens for its borrowings from a Japanese
Bank.
(iii) The firm exported goods to USA and has just received USD 3,00,000.
(iv) The firm has imported goods from Singapore amounting to Singapore Dollars (SGD)
4,00,000.
Given:
1 Re = Euro 0.0178/0.0180
1 Re = Yens 2.50/2.51
1 Re. = $ 0.0249/0.0250
1 Re = SGD 0.040 / 0.041
Solution:
(i) Receive dividend = Euro 90,000
Applicable rate: Bank sell` at 0.0180
Firm receive = 90,000 / 0.0180 = `50,00,000
(ii) Payment of interest = 2,00,000
Applicable rate = Bank is buying ` at 2.50
Payment = 2,00,000 / 2.50 = `80,000
(iii) Firm received = 3,00,000 $
Applicable rate = Bank selling ` at 0.0250
Firm receives = 3,00,000 / 0.0250 = `1,20,00,000
(iv) Payment by firm = 4,00,000 SGD
Applicable rate = Bank by ` at 0.040
Hence payment = 4,00,000 / 0.040 = `1,00,00,000

Exchange rate interpretation

Exchange rate would be defined as the price of currency in terms of another. Thus JPY
130.0250 per EUR means that 1 EUR = JPY 130.0250. Here Euro is known as base currency
and JPY is known as the price currency.
In general terms A/B, where
A = Price currency
B = Base currency
`/$implies that 1 $ = `
$/ implies that 1 = $

Direct quote and Indirect quote

(a) Direct quote is the home currency price for 1 unit of foreign currency. Means,
Direct quote: 1 unit of foreign currency = How many units of home currency
(b) Indirect quote is the foreign currency price for 1 unit of home currency. Means,

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Indirect quote: 1 unit of home currency = How many units of foreign currency.
How to convert direct quote into indirect quote or vice versa Direct quote and indirect
quote are reciprocal of each other. Hence,
Direct quote =
OR
Indirect quote =
Note: In two way quote, when we calculate reciprocal then bid rate becomes ask rate and
ask rate becomes bid rate.
Example: 5Identify whether the following is a direct quote in USA. If not, find it.
(i) `46 = 1 $
(ii) 1 $ = S$ 1.60
(iii) 1 GBP = $ 0.639
Answer:
(i) No; 1 ` = 0.0217 $
(ii) No; 1 S$ = 0.6250
(iii) Yes
Example: 6A Mumbai banker has given the following quotes. Identify whether they are
direct or indirect. For each direct quote give the corresponding indirect quote and vice
versa.
Currency
Rate
Quote
SEK
6.16
`per Kroner
Euro
0.0148
per `
SGD
0.0299
SGD per `
AED
13.85
` per UAE Dirham
Solution:
Given quote
` per Kroner
per `
SGD per `
`
per
UAE
Dirhan

Nature
Direct
Indirect
Indirect
Direct

Other quote
Korner per `
` per
` per SED
AED per `

New rate
0.1623
67.5676
33.4448
0.0722

example: 7 Convert the direct quotes into indirect quotes:

(a) 1$ = Rs.40.00 / 40.05
(b) 1 = Rs.82.00/82.07
(c) 1Euro = Rs.56.00/ 56.18

Bid rate, Ask rate and spread

Bid rate is the rate at which bank buys base currency / left hand side currency.
Ask rate is the rate at which bank sell base currency / left hand side currency.
Ask rate will always be greater than bid rate.
Spread is the difference between ask rate and bid rate.

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Spread = Ask rate Bid rate

% of Spread =
X 100
Note: Sometimes, the ask rate may be given in incomplete fashion, and then it should be
interpreted as under:
`/$ = 47.30 / 70 implies 47.30 / 47.70
`/$ = 47.40 / 10 implies 47.40 / 48.10
$/ = 1.3520 / 70 implies 1.3520 / 1.3570
$ / = 1.3260 / 10 implies 1.3260 / 1.3310
Example: 8 Consider the following quotes.
Spot (Euro/Pound) = 1.6543/1.6557
Spot (Pound/NZ$) = 0.2786/0.2800
1. Calculate the % spread on the Euro/Pound Rate
2. Calculate the % spread on the Pound 1 NZ $ Rate
3. The maximum possible % spread on the cross rate between the Euro and the NZ $.

Concept of exchange margin

Exchange margin is the extra amount or % charged by the bank over and above the rate
quoted in inter bank market. With the help of exchange margin we can calculate merchant
rate applicable for customers.
How to calculate exchange rate using exchange margin:
Rule: 1 Deduct margin from buying rate to get desired exchange rate.
Rule: 2 Add margin to selling rate to get desired exchange rate.
Example: 9 Mr. A imported goods worth $ 1,00,000. Exchange rate on that date was 1$ =
`40.80 / 40.90. If bank wants to earn margin of 0.8 %, then what rate should be quoted by the
bank to customer.
SOLUTION:
Bank sell $ at ask rate
Add: Margin @ 0.80 %
Applicable rate for customer

40.90
0.3272
41.2272

Example: 10 - in the inter bank market, we have the following quote:

` /$ = 59.20 / 59.40
TT buying commission = 0.8 %
TT selling commission = 0.90 %.
Calculate merchant / retail rates for customer.
SOLUTION:
Statement of retail rates for customer:
Inter bank rate
Adjustment of margin:
0.80 %
0.90 %

Bid
59.20

Ask
59.40

(0.4736)

0.5346

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Applicable rate

58.7264

59.9346

Example: 11 In the inter-bank market, the DM is quoting Rs.21.50. If the bank charges
0.125%commission for IT selling and 0.15% for TT buying, what rate should it quote?
Answer: Applicable rate: 1 DM = `21.46775 / 21.52688

Concept of spot rate and forward rate

Spot rate Spot rate is the exchange rate at which we can buy or sell currency
now. In other words spot rate is the rate which prevails today.
Forward rate Forward rate is the rate agreed today but settlement takes place
at future date.
Forward premium or discount/ Appreciation or depreciation in currency
Forward premium If currency is costlier in future as compared to spot it is said
to be at premium.
Forward discount If currency is cheaper in future as compared to spot it is said
to be at discount.
Calculation of Annualized forward premium / Discount on currency:
Currency terms = A/B
A = Price currency
B = Base currency
Annualized forward premium on currency B =
X
Annualized forward premium on currency A =
X
Note: A negative answer would imply annualized discount rate.
Example: 12 The exchange rate for Mexican peso was 0.1086 in December 2004, and 0.0913
in November 2004, against dollar. Which currency has depreciated and by how much?
SOLUTION:
Nov. 04: 1 $ = 0.0913 Peso
Dec. 04: 1 $ = 0.1086 peso
Quote is: peso / $
Hence for peso:
X 100
X 100
X 100 = - 15.93 %
Hence, Mexican Peso depreciated 15.93 % against $
Example: 13 The dollar is currently trading at `40. If Rupee depreciates by 10%, what will
be the spot rate? If dollar appreciates by 10% what will be the spot rate?
SOLUTION:
Spot rate: 1 $ = `40
To find depreciation of `, we need to have a quote of `. Since, given quote is in $ and hence
we need to convert it. So, 1` = 1 / 40 = 0.025 $
If ` depreciate by 10 %, then new rate would be
0.025 0.0025 = 0.0225
Hence, 1 $ = 1 / 0.0225 = `44.44
(b) If $ appreciates by 10 %, then we can apply 10 % directly to $ quote.
Hence, new rate would be: 40 + 10 % = 44
Hence, 1 $ = `44

Forex Market Terminology

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Direct quote indicates the number of units of the domestic currency required to buy one
unit of foreign currency.
An indirect quote indicates the number of units of foreign currency that can be exchange
for one unit of the domestic currency.
Ask price is the selling rate or the offer rate and refers to the rate at which the foreign
currency can be purchased from the dealer.
Bid price is the rate at which the dealer is ready to buy the foreign currency in exchange for
the domestic currency:
The ask-bid spread depends upon the breadth and depth of the market for that currency
and the volatility of the currency.
% of Spread = Ask Price- Bid Price X 100
Ask Price
The exchange rate between two currencies calculated on the basis of the rate of these two
currencies in terms of a third currency is known as a cross rate.
The forward rate is a price quotation to deliver the currency in future. The exchange rate is
determined at the time of concluding the contract, but payment and delivery are not required
till maturity.
Transfer Pricing is a mechanism by which profits are transferred through an adjustment of
prices on intra-firm transactions.
Leading implies speeding up collections on receivables if the foreign currency in which
they are invoiced is expected to appreciate.
Lagging implies delaying payments of payables invoiced in a foreign currency that is
expected to depreciate.
Netting implies that all transactions-gross receipts and payments among the parent firm and
subsidiaries should be adjusted and only net amounts should be transferred.
Matching is a process whereby cash inflows in a foreign currency are matched with cash
outflows in the same currency with regard, to as far as possible, amount and maturation
A transaction exposure occurs when a value of a future transaction, through known with
certainty, is denominated in some currency other than the domestic currency.
Translation Exposure is also called the accounting exposure. It refers to and deals with the
probability that the firm may suffer a decrease in assets value due to devaluation of a foreign
currency even if no foreign exchange transaction has occurred during the year.
The economic exposure refers to the probability that the change in foreign exchange rate
will affect the value of the firm.
Capital account convertibility implies the right to transact in financial and other assets
with foreign countries without restrictions.

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