The meaning of Foreign Exchange

Foreign Exchange is the system or process of converting one national currency into another and
of transferring the ownership of money from one country to another country

What is the meaning of Exchange Rate?

The rates applied by the Bank for converting foreign currency into Indian rupees and vice versa
are known as exchange rates. In other words, exchange rate is the rate at which one currency can
be exchanged for another.

What are the systems of quoting Exchange Rates?

There are two systems of quoting exchange rates:

i.Direct Quotation: Where the price of foreign currency is quoted in terms of home or local
currency. In this system variable units of home currency equivalent to a fixed unit of foreign
currency is quoted

For Example US Dollar 1 = Rs 43.50

ii. Indirect Quotation: Where exchange rates are quoted in terms of variable units of foreign
currency as equivalent to a fixed number of units of home currency.
For Example US Dollar 2.30 = Rs. 100

Till 01.08.1993 banks in India were required to quote all the rates on indirect basis. From
02.08.1993 banks are quoting rates on direct basis only

Purchase and Sale Transaction – How it Arise?

Its important to have a very clear idea about purchase and sale transaction and how they arise.
From the Banks point of view conversion of foreign currency on behalf of an exporter into
Indian Rupees would involve a Purchase and conversion of domestic currency into foreign
currency on behalf of an importer would be a Sale.

The market in which participants are able to buy, sell, exchange and speculate on
currencies. Foreign exchange markets are made up of banks, commercial companies, central
banks, investment management firms, hedge funds, and retail forex brokers and investors. The
forex market is considered to be the largest financial market in the world.
The primary purpose of the foreign exchange is to assist international trade and investment, by
allowing businesses to convert one currency to another currency. For example, it permits a US
business to import British goods and pay Pound Sterling, even though the business's income is in
US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow
low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been
claimed) may lead to loss of competitiveness in some countries.[2]
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 began forming during the
1970s when countries gradually switched to floating exchange rates from the previous exchange
rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of
• its huge trading volume, leading to high liquidity;
• its geographical dispersion;
• its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT
on Sunday until 22:00 GMT Friday;
• the variety of factors that affect exchange rates;
• the low margins of relative profit compared with other markets of fixed income; and
• the use of leverage to enhance profit margins with respect to account size.

Spot
A spot transaction is a two-day delivery transaction (except in the case of trades between the US
Dollar, Canadian Dollar, Turkish Lira, EURO and Russian Ruble, which settle the next business
day), as opposed to the futures contracts, which are usually three months. This trade represents a
“direct exchange” between two currencies, has the shortest time frame, involves cash rather than
a contract; and interest is not included in the agreed-upon transaction.

[edit] Forward
See also: forward contract

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A buyer
and seller agree on an exchange rate for any date in the future, and the transaction occurs on that
date, regardless of what the market rates are then. The duration of the trade can be one day, a few
days, months or years. Usually the date is decided by both parties. Then the forward contract is
negotiated and agreed upon by both parties.

[edit] Swap
Main article: foreign exchange swap

The most common type of forward transaction is the FX swap. In an FX swap, two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later
date. These are not standardized contracts and are not traded through an exchange.
applicable rate

Definition
Specific scale of numerical progression applied in determining a charge, compensation, fee, tax,
and such.

spread

1. The difference between the current bid and the current ask (in over-the-counter trading) or
offered (in exchange trading) of a given security;

What Does Cross Rate Mean?

The currency exchange rate between two currencies, both of which are not the official currencies
of the country in which the exchange rate quote is given in. This phrase is also sometimes used
to refer to currency quotes which do not involve the U.S. dollar, regardless of which country the
quote is provided in.

What Does Cross multiplication Mean?

It is the mechanism used to derive the exchange rate for a set of currencies, when the exchange
rates for two other sets of currencies are available. E.g. cross multiplication is use to find the
exchange rate between INR & USD when the exchange rate between rupee & pound and that
between pound & USD are available.

Currency depreciation is the loss of value of a country's currency with respect to one or more
foreign reference currencies, typically in a floating exchange rate system

In accounting, appreciation of an asset is an increase in its value. In this sense it is the reverse of
depreciation, which measures the fall in value of assets over their normal life-time. Generally,
the term is reserved for property or, more specifically, land and buildings.

Factors affecting currency trading

What can impact the currency trading?

There are many factors that can contribute to the forming of the exchange rates however such of
them as supply and demand are the major ones. The changes in supply and demand data also
cause the corresponding changes in the price of one currency against another one. The Forex
market provides the most comprehensive information about the current situation in the world.
Usually a complex of several elements can impact the supply, demand for currency as well as its
value. We can divide them into three categories: economic factors, political conditions and
market psychology.

Economic factors
Economic factors imply the economic policy pursued economic conditions that can be estimated
on the basis of economic reports and surveys as well as other important indicators.
Economic policy includes the fiscal policy of the government (budget and spending) and
monetary police (i.e. those methods the Central bank of the country uses to affect the supply and
the “cost” of the currency. The interest rate level shows the “cost” of the currency.)
As for economic conditions, this division comprises following components:
Government budget deficits or surpluses: the broadening of the government budget deficits as
well as it’s narrowing commonly causes negative reaction of the market. And the effect shows
itself in the value of the currency of the country given.
Balance of trade levels and trends: the trade flow between countries reflects the demand for
the services and goods. And this demand reflects the demand for the currency of the country
needed to participate in trading process. The level of the country’s economy competition is
shown in the surpluses and deficits of trade of goods and services. For instance, trade deficits
may cause negative consequences for the currency of the country.
Inflation levels and trends: usually the high or growing inflation leads to the lost of the value
by the nation’s currency. This happens due to the fact that inflation destroys the purchasing
power and the demand for this or that currency consequently. But growing inflation may also
lead to the strengthening of the currency due to forecasts about possible growth of the short-term
interest rates by the national Central bank with an aim to restrain the inflation.
Economic growth and health: the economic growth and the health of the country is reflected by
the data provided in such reports and survey like GDP, the level of employment, retail sales,
capacity utilization and etc. Commonly the healthy economy of the country is accompanied by
the better currency and the demand for it.

Political conditions
The political conditions of any scale (from regional to international ones) can have great impact
on the currency markets. Let’s consider following example, the instability in the political sector
may affect the economy of this country in a wrong way. The strengthening of the political
faction that is usually considered to respond financially may cause quite different consequences.
And the events occurred in the one country may easily affect the neighboring country and
contribute to some changes of its currency.
Market psychology
The market psychology and the way the trader perceives the events may have following impact
on the forex market:
Flights to quality: some groundbreaking events at the international area can cause a “flight to
quality” which is a situation when investors sell the more risky investments and buy those more
safe that are also called a “safe heaven”. So those currencies considered to be stronger will be
more demanded and therefore get higher price for themselves.
Long-term trends: usually currency markets follow long-term trends of their development. And
despite the fact there is no seasonality among the currencies some trends can be seen from the
business cycles. These cycles are considered to provide long-term price trends that can be caused
by economic and political directions.
“Buy the rumor, sell the fact”: this statement is not something surprising when considering
financial markets. The price of the currency usually reflects the possible affect of this or that
event before it has happened, so the matter is that you should do quite opposite actions as soon as
this event has already occurred. This statement also concerns the situations when the market
being oversold or overbought. Moreover the statement also applies to the anchoring – the
situation when investors concentrate only on the reference of the outside events to the price of
the currency.
Economic numbers: the economic indicators can show the condition of the economic policy,
and some reports may have strange effect – the importance of this or that report grows to market
psychology and thus the report may affect some close changes in the market instantly. Over the
last years such indicators as money supply, employment, inflation, and trade balance have
experienced such importance.
Technical trading considerations: the changes of the currency pairs’ prices can be aggregated
into charts and tables for further consideration and use by traders.
interest rate parity theory

Definition
Concept that any disparity in the interest rates of two countries is equalized by the movement in
their currency exchange rates.

Purchasing-power parity theory. A theory which states that the exchange rate between one
currency and another is in equilibrium when their domestic purchasing powers at that rate of
exchange are equivalent.