Foreign Exchange Market: Operations for International Trade

Payment Calculation & Uses of Operational Exchange Rates

Foreign Exchange Market is the organizational framework where the various national
currencies are bought and sold. Practically it is a worldwide market, which is made up of
individuals, commercial banks and other authorized agents.
Functions of Foreign Exchange Market The foreign exchange market performs some
important functions:

Foreign Exchange Market transfers funds or purchasing power from one nation and
currency to another
Foreign Exchange Market facilitates financing of International Trade
Foreign Exchange Market facilitates avoiding foreign exchange
Facilities for avoiding foreign exchange risks or hedging.

Foreign Exchange Market

Foreign exchange is the trading of currencies. The foreign exchange market is not a single
place like the NY Stock Exchange (NYSE). It is a widely decentralized 24-hour-a-day
market, made up of banks and traders communicating electronically. The retail market is
between individuals, nonfinancial companies, nonbank financial institutions, and other
customers of banks. The wholesale or interbank market is the trading between banks. This
accounts for 60% or more of the total trading
Scope of the Market
About half the daily foreign exchange trading is done between banks in London and New
York. Most of the trading involves U.S. currency. Sometimes the intent is to trade one foreign
currency for another, and the U.S. currency is only involved as an intermediate step. When
this is done, the dollar is called a vehicle currency.
Market size and liquidity
The foreign exchange market is unique because of
its trading volumes, (2012: some trillion US$ daily)
the extreme liquidity of the market

the large number of, and variety of, traders in the market

its geographical dispersion

its long trading hours: 24 hours a day (except on weekends)

the variety of factors that affect exchange rates

the low margins of profit compared with other markets of fixed income (but
profits can be high due to very large trading volumes)

Major Market Centers

London
Tokyo
New York
Zurich

Frankfurt
Hong Kong

Singapore Paris
Sydney

Exchange Rate: Some Basics

The exchange rate is the price of one countrys money in terms of another countrys money.
This is the rate at which two national currencies are exchanged. The ER is determined by the
intersection of the market dd. curve and supply curves of foreign currency. The dd. for
foreign exchange arises primarily in the course of importing goods and services from abroad
and making foreign investments and loans. The supply of foreign exchange arises in the
course of exporting goods and services and receiving foreign investments and loans.
The spot exchange rate is the price for immediate exchange. (Immediate usually means
within two working days.) This amounts to about 33% of all trading. The forward
exchange rate is the price for exchange to take place at some specific time in the future, often
30, 90, 180 days. This amounts to about 11% of all trading. A swap is a package trade
that includes both a spot exchange of two currencies and a contract to the reverse forward
exchanges a short time later. This is useful when the parties to the swap have only a shortterm need for the currency. This amounts to about 56% of all trading.
Examples of Currencies
Country
US

Currency
Dollar

Symbol
$

ISO Code
USD

UK

Pound

GBP

Canada

Dollar

C$

CAD

Mexico

Peso

Ps

MXP

Japan

Yen

JPY

EU

Euro

EUR

Exchange Rate
The exchange rate can be given as the price of the foreign currency in terms of the domestic
currencythis is the usual way, and the way well use in this session or as the price of the
domestic currency in terms of the foreign currency. Exchange Rate is the rate at which one
currency is exchanged for another or it is the price of one currency in terms of another. Banks
normally quote a two way price in the currency i.e. both Buying (bid) and Selling (ask or
offer) Rates. The maxims for finding out buying and selling rates in two different quotation
systems are different: For Direct: Buy Low, Sell High; and for Indirect: Buy High, Sell Low.
Exchange Rate Quotation
In foreign exchange literature we come across a variety of terminology to indicate methods
of expressing or quoting exchange rates. Sometimes exchange rate spot quotations are
grouped as Direct and Indirect quotations. In case of Direct Quotation domestic currency is
expressed in variable units for a fixed unit of foreign currency; and in Indirect Quotation
foreign currency is expressed in variable units for a fixed unit of the domestic currency.
Quoted Currency means the currency that is variable in an exchange rate quotation. Base

Currency means the currency that is fixed. Thus if 1 = Tk.130.00, sterling is the base
currency and the BDT is the quoted currency.
In Direct Quotation Base Currency is the Foreign Currency and the Quoted Currency is the
Domestic Currency. ($1= Tk.69.50). In Indirect Quotation Base Currency is the Domestic
Currency and the Quoted Currency is the Foreign Currency. (Tk.1= $0.0144).
Quotations sometimes also defined as European Terms and American Terms. European
Quotation is expressed as number of currency units per dollar, and American Quotation is
expressed as number of dollars per currency unit. In American Terms Base Currency is any
Currency other than USD and the Quoted Currency is USD (Tk.1= $0.0144).
In European Terms Base Currency is the USD and the Quoted Currency is any Currency
other than USD ($1= Tk.69.50).
Reciprocal Quotations Currencies can be quoted in terms of the number of units of A per
unit of B or, alternatively, the number of units of B per unit of A. The two rates represent
equal value and are reciprocals of each other. To convert from one method to the other, one
simply divides the number 1 by the rate. Example: USD 1/Tk.69.50 = 1/69.50 BDT/USD
= 0.0143

BDT/USD

Depending upon the time elapsed between the transaction date and the settlement date,
foreign exchange transactions can be categorized into Spot Transactions (spot market) and
Forward Transactions (forward market). A third category called Swap Transaction is
generally a combination of a spot and a forward transaction.
Spot Transaction
Spot transaction generally mean foreign exchange transaction on the spot, and spot exchange
rate is the quotation between two currencies for immediate delivery. However, practically the
situation is different. A foreign exchange trade is an exchange of two currencies. When the
deal has been agreed upon, the parties to the deal arrange settlement. The term settlement
country will refer to the country where the actual transfer of funds is made. Where the deal is
made the dealing center need not be in one of the settlement countries. A spot foreign
exchange deal is one made for settlement in two working days time.
Spot Rate
Exchange rate for spot transaction is known as Spot Rate. While quoting spot rate for
customer, banks consider the exchange rate of the wholesale market, and a margin. The
underlying theory is that the currency sold to (bought from) a customer is simultaneously
bought (sold) in the wholesale market, the margin representing transaction costs (overheads,
brokerage, etc.) and profit for the banks authorized dealers.
Example: Spot Market Transaction
Bangladeshi firm buys a U.S. product from a U.S. firm, which requires payment in U.S.
dollars ($). The Bangladeshi firm contacts its bank, gets a quote on the dollar-taka exchange
rates, and approves it. The Bangladeshi firm instructs its bank to take taka from its checking
account, convert these to dollars, and transfer the amount to the U.S. producer. The

Bangladeshi bank instructs its correspondent bank in New York to take U.S. dollars from
its account and pay the U.S. producer by transferring them to the producers bank.
Spot Market Transaction
USD $ 1= Tk.69.10/15. In this quotation, market maker is willing to buy 1 U.S. dollar at Tk.
69.10 and sell U.S. dollar at Tk. 69.15.
Transactions Costs Bid-Ask Spread: used to calculate the fee charged by the bank
Bid = the price at which the bank is willing to buy
Ask = the price it will sell the currency
Percent Spread Formula (PS)

Ask Bid
PS
x100
Ask
Quoting Spot Rate to Customers - The Basic Principle
Ascertain the going exchange rate in the wholesale market (inter-bank market). Then load a
margin and make a customer quote. Example:
Market Rate: USD1= Tk. 69.50/60
Required margin: 0.10 Tk.
So, the rate will be USD1= Tk.69.40/69.70
Cross Rates A cross-rate may be defined as an exchange rate that is calculated from two
other rates. In practice, cross-rate is the exchange rate between 2 non - US$ currencies.A
cross-rate may be defined as an exchange rate that is calculated from two other rates. The
practice in the world foreign exchange market at present is that currencies are mainly dealt
against the US dollar. If bank A asks bank B for its deutsche mark rate, the rate is quoted
against the US dollar unless otherwise specified. Thus a bank asked to quote GBP/EUR
would normally calculate this rate from the GBP/USD and USD/EUR rates. So some times,
an exchange rate between two currencies, neither of which the US dollar is, referred to as a
cross-rate.
Calculating Cross Rates
In calculating cross rate one has to consider three cases: both exchange rates quoted are
Direct (or American); both Indirect (or European); and the case where one is direct and the
other is indirect (or one is American and another is European). If both currencies involved in
the cross transaction are quoted in the same form (direct or indirect) or terms (American or
European), divide the spot rate of one currency by the spot rate of the other currency. If one
currency is quoted in one form and the other currency is quoted in another form, multiply the
spot rates.

If both currencies involved in the cross transaction are quoted in the same form (American or
European) divide the spot rate of one currency by the spot rate of the other currency.
Calculating Cross Rates: Both European
USD/EUR
0.7828 - 0.7848
Divide by
USD/GBP:
GBP/ EUR :

0.5246

- 0.5266

1.4865-1.4959

Calculating Cross Rates: Both American

EUR/USD 1.2742 1.2774
Divide by
GBP/USD : 1.9042 - 1.9062
EUR/ GBP : 0.6684 - 0.6708
Calculating Cross Rates: One American-One European
EUR/USD: 1.2742 1.2774
Multiply by
USD / GBP: 0.5246 - 0.5251
EUR/ GBP: 0.6684 - 0.6708
Both European
USD1= EUR 0.9230/40
Divide by
USD 1= GBP 0.8110/20

Calculation Procedure of Cross Rate

Both American
One American, One
European
EUR 1 = USD 1.2050/53
Divide by
GBP 1= USD 1.4230/40

EUR = USD 1.2050/53

Multiply by
USD 1= GBP 0.8110/20

Forward Transactions
A forward exchange contract is an agreement between a bank and another party to exchange
one currency for another at some future date. The rate at which the exchange is to be made,
the delivery date, and the amounts involved are fixed at the time of agreement. The rate of
exchange at which such a purchase or sale can be made is known as the Forward Exchange
Rate. Forward rates, i,e, forward prices, are not quoted as such. Dealers only work with
forward differentials (premiums or discounts). Forward transactions are either Out rights" or
"Swaps" An outright is a forward purchase or sale of a currency at a foreign exchange rate
which expresses the actual price of one currency against another for a specific value date. A

Swap is more complicated and is the purchase of one currency against another for one
specific maturity date and the simultaneous reversal of that contract for another, different
maturity date. The difference between the two exchange rates in a swap is called "Swap
Rate." Outright deals are single forward transactions. But Swaps are the combinations of spot
purchase of a currency with its simultaneous forward sale (or vice versa).
The basis of calculation for all forward rates of exchange or Swap Rates is the interest
differential between the two currencies. When a spot rate of exchange depreciates, its Swap
Rate or Forward Premium will normally increase and vice versa. If the interest rates in one
currency increase at a faster rate than another, the interest differential between the two will
widen and so the Swap Rate will also increase. If the interest differential narrows, the Swap
Rate will be reduced. Spot and Forward Rates of Exchange are linked. They move for similar
reasons with the exception that the dominant influence on forward rates of exchange is the
interest differential.
Options are widely used in forward transactions. Option Forward is a forward contract
where the delivery date is at the customers option. It is not like a currency option, where the
customer is paying for the option to deal at a certain price.
Forward rate is quoted either at Premium or at Discount rate over spot rate. In case of direct
quotation, premium will be added to and discount will be subtracted from spot rate. The
reverse is for indirect quotation.
Swap Transactions
In general, a swap is an exchange of one currency for another on one day, matched by a
reverse on a later day. Swaps are generally consisting of a combined spot and forward foreign
exchange deal. A typical swap trade might be the sale of 1 million against US$2.2 million
for spot value, coupled with the purchase of 1 million for delivery in three months against
US$2.17 million. In the example, where the spot trade is done at 2.2000 and the forward at
2.1700, the swap rate is 0.03 or 300 points.
Sometimes swap transactions can be between two forward dates. A one-month forward sale
can be combined with a three-month forward purchase. Such transactions are called
Forward-Forward Swaps.
In most swap deals, the two exchanges are made at the same time with the same counter
party. But this need not be the case. One could buy spot from one counter party and sell
outright forward to another. Such a trade may be called an engineered swap to distinguish
it from the more usual or pure swap.
Traditionally, economic agents involved in the foreign exchange market are divided into
three groups where classifications are distinguished by their motives for participation in the
foreign exchange market:
Arbitrageurs aim to make a risk less profit from purchasing of foreign currency where it's
price is low and selling it where the price is high. This is also called currency arbitrage.

Arbitrage may be due to interest rate differences in two financial centers, which is known as
interest arbitrage.
Hedgers enter the forward exchange market to protect themselves against exchange rate
fluctuations, which entail foreign exchange risk.
Speculators operate in the foreign exchange market with the hope to make profit by
accepting foreign exchange risk.
Forward Rates
It is an ER for the transaction to be happened at some future date, but agreement for the
transaction is to be done today. Forward rate is quoted either at premium (+) or at discount
rate (-) over spot rate. In case of direct quotation, premium will be added to and discount
will be subtracted from spot rate. The reverse is for indirect quotation.
Quotation of Forward Rates
Forward at Premium (pm)
Forward at Discount (dis)
Forward at par meaning the Forward Rate at Parity with the Spot Rate.
Premium and Discount
The quoted currency is said to stand at a premium in the forward market if it is more
expensive in the future than it is now in terms of the base currency. Conversely, the base
currency may be said to stand at a discount relative to the quoted currency.
Example of Forward TransactionSuppose, spot rate is $ I = Tk. 76. Cost to a bank for
borrowing Taka for 90 days is 9% per Annum. Bank can invest in U.S. $ for 90 days at 4%
p.a. So, interest rate differential is 5% p.a If the spot rate of exchange can be adjusted to
reflect this loss of 5% p,a., a forward rate of exchange could be obtained.
Method The amount by which spot rate must be adjusted Spot rate of exchange X interest
rate differential X Period Annualised.
70

5
90

0.875
100
360

The spot rate must be adjusted by 0.875 but is it to be added or subtracted? In the example,
the bank borrows at 9%, but can earn only 4%. So, the bank is losing 5%. If $ I = Tk. 79 for
immediate delivery, it should be more expensive to settle for future delivery in order to
compensate for 5% loss. Therefore, Tk. 70 + 0.875 = $1 = Tk. 70.875 = outright rate of
exchange. If in doubt, whether to subtract or add to forward differential, then first of all see
whether the interest differential constitutes a profit or loss to the bank. If a cost, then forward
rate should be more expensive relative to spot rate; if a profit, then the forward rate should be
cheaper relative to the spot rate.

P x R x N

Calculation of Interest The following formula is used: I 100 x 365

Where I = interest, P = Principal, R = Rate Per Annum and N = No. of Days.

Example: Find the interest on $ 30,500 for 9 days at 4% Per Annum.
I

30 , 500 4 9
$30.08
100 x 365

Alternative Method for Forward/SWAP Points

SWAP Points (Low - High)
USD/EUR 1 Month SWAP 30/40
SWAP Points (High - Low)
USD/EUR 1 Month SWAP 40/30
SWAP Points (Low - High)
Forward Rate at Premium for the base currency
SWAP Points (High - Low)
Forward Rate at Discount for the base currency
Treatment of Forward Margin
High/Low = Subtract
Low/High = Add
Basis for Forward Rate
Forward Points represent the interest Rate Differential between the Two Currencies involved
in the Transaction
Method
Spot Rate Interest Rate Differential Period Annualized

Spot INt .Diff . TimeinDays

100 360

Calculating Forward Rate

Spot Rate: GBP/USD = 1.90
Interest Rate in USA: 8%
Interest Rate in UK: 16%
Forward Points = 1.90 890
100360
=

0.032

So, 90 days forward rate will be

GBP/USD= 1.868
Forward Rate = Spot Rate (both Buying & Selling) Swap/ Forward points Bank
Charges
Spot Rate

Buying Rate

---------

+/-Buying Swap point

- Bank Charges

Selling Rate
+/- Selling Swap point
+ Bank Charges

--------------------- ------------------------------------------------Forward Rate

Buying Rate

---------

Selling Rate

Bank Charges added with the Selling Rate to importers and deducted from the Buying Rate
for the exporters.
Interest Rate Differential = Interest Earned - Interest Paid
The currency with relatively higher interest rate will be cheaper in the forward market and
the currency with relatively lower interest rate will be expensive in the forward market
Spot/ Cash Rate This is the rate at which prevails in the market based on the market demand
& supply & applicable only for spot transaction, where there is not much elapsed time
between the transaction date & settlement date, maximum two working dates. This is the
quotation between two currencies for immediate delivery. This rate is applicable for both
OTC and through the account transactions.
Floating/ Flexible Exchange Rate Regime In the market, the forex rate is determined by the
demand & supply of the foreign currency. Under this regime Banks will be determining own
rate depending on their own demand & supply. Only banks could quote based on their own
demand & supply. No central bank intervention in the market. If there is excess supply/
surplus then bank charges low price & if there is excess demand/ deficit charges high price.

Exchange Rate Quotation It is banks communication process to the customer regarding

the price of forex having two prices one for buying and another one for selling. In the
deposit market bank is the sole buyer & in the credit market bank is the single seller, but in
the forex market bank acts as both buyer & seller. So, bank has got two way quotations, one
for buying & another for selling.
$1 = tk.68.00 ---- tk.70.00
Lower price is the buying price & higher price is the selling price.
Exchange Rate Gain/ Spread or Dealing Margin is the difference between the selling &
buying prices.
Spot/ Cash Rate

Cost of Fund (CoF) = Interbank Buying & selling Rate

Cost of Administration (CoA) = Total Admin Cost/Total Turnover of Forex

Cost of Capital (CoC) = Total Profit Margin / Total Turnover of Forex
CoF is also known as Hurdle Rate/ Interbank Forex Rate. To get the spot rate of a bank we
have to adjust CoA & CoC with the CoF. To get the buying rate we deduct CoA & CoC from
the CoF and for getting the selling rate we add CoA & CoC with the CoF.
IBFR

Buying Rate ------Selling Rate

-CoA

+ CoA

- CoC

+ CoA

--------- CoF

------------------------------------------------Spot/ Cash Rate = Buying Rate -----Selling Rate

TT Clean Rate Adjusting Telegraphic/ Telephonic Transfer/ Swift Charges with the Spot
Rate.
Spot/ Cash Rate = Buying Rate ------ Selling Rate
- Charges

+ Charges

-----------------------------------------------TT Clean Rate

= Buying Rate ------- Selling Rate

TT DOC Rate Adjusting Documentation Charges with the TT Clean Rate.

TT Clean

Rate =

Buying Rate ----- Selling Rate

- Charges

+ Charges

-----------------------------------------------TT DOC Rate

Buying Rate ------ Selling Rate

In Bangladesh there is not any TT DOC Selling Rate, rather TT Clean & TT DOC Selling
Rates are merged together to form TT & OD Selling Rate.
TT (Trade) Rate To maintain profitability a bank should also adjust trade charges. Opening
an L/C& maintaining terms & conditions, scrutinizing/ examining documents for compliant
presentation, overseeing terms & conditions of export & import policy, incoterms and forex
regulation all these requires management cost.
TT DOC Rate

Buying Rate ------- Selling Rate

-Charges

+ Charges

-----------------------------------------------TT Trade Rate

Buying Rate ------ Selling Rate

In Bangladesh, TT Trade Buying Rate is known as OD Sight Rate used for purchasing Sight
Export Bills from the exporter, TT Trade Selling Rate is known as B.C. Selling Rate used in
import payments.
OD Transfer (Buying) Rate For foreign cheque & draft collection outside Dhaka either in
Bangladesh or outside Bangladesh banks use OD Transfer (Buying) Rate after adjusting/
deducting collection & interest charges.
OD Transfer (Buying) Rate = TT Doc Rate - Collection Charges
Usance Rate Purchasing deferred bills means payment after some while at a later date, as
exporter is selling the bill today for meeting the instant demand of cash, but the bill is going
to be matured after 30/60/90/120/180 days (at the end of the tenor). As the banks A/C is
going to be credited later on, so bank charges interest for calculating that. Bangladesh Bank
regulation is that Interest Charges cannot exceed 7%.
Interest Charge/ Amount = Principal Interest Rate Period Annualized
Usance Rate = TT Trade (OD Sight Buying) Rate - Interest Charge/ Amount
References
1. Pilbeam (1998), International Finance, Macmillan.
2. Walmsley, Jullian (1992), The Foreign Exchange and Money Market Guide,
John Wiley & Sons.
3. Rajwade, A V (1994), Foreign Exchange, International Finance and Risk
Management, India.
4. Apte, Prakash G (2002), International Financial Management, Tata McGrawHill, India.

Determination of exchange rate by banks

Developed By Dr. T.A Choudhury.
Spot Cash/Rate ($/Tk.)
Adjust
Adjust

Telex Charges

Cross Rates /Tk.,

/Tk., /Tk.

T.T. Clean Rate

Adjust

with cross
currency

Adjust

Forward Rates

Documentation charges

T.T. (Doc) Rate

Adjust

Trade charges

O.D (Sight) / B.C. (selling)

Adjust

Interest

Usance Rates

with interest
differential/ swap
rates

Adjust Interest and Collection charge

OD Transfer

The flow-chart for calculation of different operational rates by a bank