Forex

Problems in Exchange rate

Domestic Currency & Foreign Currency
Ø Domestic Currency denotes the currency in which the CFO reports company’s performance to the
stakeholders.( Also known as the Home Currency)
o For an entity operating in India, Rupee is the Domestic currency
o Just as is Yen for accompany operating in Japan and Euro for a German Company
Ø Foreign Currency denotes
o For an Indian Company USD is foreign Currency
o For an American Company Rupee is a Foreign Currency
Exchange Rate
Foreign Currency is not only a medium of Exchange but a store of Value, an Asset as well.
As an Asset, Foreign Currency has Purchasing Power, at times greater and at times lesser than
the Domestic currency.
Hence it is necessary to know about its price, also known as the Exchange Rate.
The Price of one currency viewed in relation to another currency is called as Exchange Rate
In other words,Exchange Rate then is the rate at which one currency is exchanged for another
currency.
–Example, $/Rs. 44.76
Note : The Rate is to be understood in terms of the Second of the pair( ie. Rupees in theexample
given above). Thus the example would read as Rs 44.76 equals one dollar.
Exchange rates are normally expressed not beyond 4 decimals
In any Transaction involving foreign exch., you are selling one currency and buying another.
In an Exchange Rate, 2 currencies are involved (“a Pair”)
Direct and Indirect Quote:
A currency quotation is the price of a currency in terms of another currency. For example, $1 =
Rs.44.00, means that one dollar can be exchanged for Rs.44.00. Alternatively, we may pay
Rs.44.00 to buy one dollar. A foreign exchange quotation can be either a direct quotation and or
an indirect quotation, depending upon the home currency of the person concerned. A direct quote
is the home currency price of one unit foreign currency. Thus, in thevaforesaid example, the
quote $1 =Rs.44.00 is a direct-quote for an Indian.
An indirect quote is the foreign currency price of one unit of the home currency. The quote Re.1
=$0.0227 is an indirect quote for an Indian. ($1/Rs. 44.00 =$0.0227 approximately)
Direct and indirect quotes are reciprocals of each other, which can be mathematically expressed
as follows.
Direct quote = 1/indirect quote and vice versa

Problem:
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
 ------------------------------------------------------------------------------------------------------------
1.SEK 5.7500 Rs. Per Kroner
2. Euro 0.0191 Euro per Re
3. SGD 0.0388 SGD per Re
4.AED 12.1500 Rs.per UAE Dhiram

Solution:
Since it is a Mumbai Banker ,the Home Currency is Rupees.
1. SEK/INR is home currency per unit of foreign currency. Hence a direct quote
The Corresponding indirect quoteis 1/dq=1/5.75. That is 0.1739 SEK per INR
2. Euro per INR is foreign currency per unit of home currency. Hence an indirect quote.
The corresponding direct quote is 1/IDQ= 1/0.0191 = Rs 52.36 Per Euro
3. SGD per INR is foreign currency per unitof home currency. Hence an indirect quote
The corresponding direct quote is 1/IDQ = 1/ 0.0388 = INR25.77 per SGD
4. INR/AEDis home currency per unit of foreign currency . Hence a direct quote
The corresponding indirect quote is 1/ DQ= 1/12.15=0.08 AED per INR

Problem:
If indirect quote is $ 0.025/kc. How can this exchange rate be shown under direct quote ?

Solution:
The Direct quote will be the inverse of the Indirect Quote, that is 1/0.025 Kc / $ or 40 kc per $

Problem:
Following are the quotes given by a banker at Mumbai. Identify whether the quote is
direct or an indirect quote. Compute the direct quote for indirect quote and vice versa.
1 USD = Rs 45.85
Rs.100 = GBP 1.2312
Rs.100 = Euro 1.7850
Rs.100 = USD 2.2002
1 Yen = Rs.0.4129

Solution:
1 USD = Rs 45.85 : is a Direct Quote The Indirect Quote is the Inverse of this
figure
That is 1/45.85 or 0.02181
Rs.100 = GBP 1.2312: Is an Indirect Quote. The Direct Quote is the Inverse of this figure
That is 1/0.012312 or 81.22157
Rs.100 = Euro 1.7850: Is an Indirect Quote. The Direct Quote is the Inverse of this figure
That is 1/0.01785 or 56.2241
Rs.100 = USD 2.2002: Is an Indirect Quote. The Direct Quote is the Inverse of this figure
That is 1/0.02202 or 45.41326
1 Yen = Rs.0.4129 : is a Direct Quote The Indirect Quote is the Inverse of this figure
That is 1/0.4129 or 2.4219
 Problem:
Following quotes are given by banker in Mumbai. Identify whether the quote is direct or
indirect quote. Compute the direct quote for indirect quote and vice versa:
Rs. 100= USD 1.9800
Rs. 100=GBP1.2500
1EUR=Rs.55

Solution:
Rs. 100= USD 1.9800: Is an Indirect Quote. The Direct Quote is the Inverse of this figure.
That is 1/0.0198 or Rs 50.5051 Per USD
Rs. 100=GBP1.2500: Is an Indirect Quote. The Direct Quote is the Inverse of this figure.
That is 1/0.0125 or Rs 80 per GBP
1EUR=Rs.55: is a Direct Quote The Indirect Quote is the Inverse of this figure
That is 1/55 or Euro 0.01818 Per Rupee

Bid Price /Offer Price and Spread:

It will not be possible to buy foreign currency from a bank at the same rate at which you can sell
the same currency to it. This is because the bank whose business it is to buy and sell will have to
make a margin to cover costs and make a profit too. For that matter this is normal any other
business too.
An authorized dealer therefore usually gives two types of quote as follows:
- The price at which he is buying the foreign currency called ‘bid‘ price.
- The price at which he is selling a given currency called ‘offer' price.
It is also called ‘ask' price.
The banker does not generally enquire whether you want to buy or to sell. He simply indicates
both quotes. By convention, in the Direct quote the Bid quote precedes the Ask quote. For
example a two-way quote in INR for USD will read: Re/$ 47.00 – 47.80
The difference between bid price and offer price is called ‘spread’. This represents the margin
of foreign exchange dealer as mentioned above.
The following two factors determine the size of the spread.
a) Stability of the exchange rate: The spread will be wider with growing volatility
b) Depth of the market: Depth refers to the volume of transactions. A deep market has a high
volume of transactions with several dealers simultaneously engaged in transacting business. In
this case the spread will be narrower. than for a “thin” market where there is a low volume of
transactions and few dealers.
Problem:
A. At two forex centers, the following Re- US $ rates are quoted:
 London: Rs 47.5730-47.6100
Tokyo: Rs 47.6350- 47.6675
Find out arbitrage possibilities for an arbitrageur who has Rs 100 million.
B. An Indian banker gives the following quotes for USD as INK 50.1125/50.4560.
Calculate percentage spread:

Solution:
A. There is no overlap in these quotes. Hence there is opportunity for arbitrage. For Instance the
Trader could buy USD at the Ask Rate of 47.6100 applicable to Banks sale of USD, in the
London market. He would obtain 21003.99 USD. This he could arbitrage in The Tokyo market
by selling it at the Banks Buying or Bid rate of Rs 47.6350. He would get Rs 1,000,525. Which
would mean he would make a No Risk profit of Rs. 525
.
B. The spread itself is the difference between the Ask and the Bid Price, that is 50.4560-50.1125
The spread is 0.3435 and the percentage spread is 0.3435/50.1125*100 or 0.6855 %

Problem:
Consider the following INR/SGD direct quote of ICICI Mumbai: 26.50 – 26.75
a) What is the cost of buying Rs. 55000 ?
b) How much would we receive by selling Rs. 92,000 ?
c) What is the cost of buying SGD 7,450 ?
d) What is your receipt if you sell SGD 18,340 ?

Solution to a)
Ø This is a direct quote in for singapore dollar Rs.26.50 is the bid rate and Rs 26.75 is the ask rate.
Ø Since it is WE that want to buy Rs 55,000, the Bank will have to sell Rs.55,000. The relevant rate
is the banks’s Ask rate for Rupees.
Ø The quote for Rs. Will be as under
o (INR/SGD) Bid =1/ (SGD/INR) Ask =1/26.75= 0.037383
o (INR/SGD) Ask =1/ (SGD/INR Bid) = 1/26.50= 0.037736
The cost of buying INR 55,000 = Rs 55,0000 * SGD 0.037736, = SGD 2,075.48
Or 55,000/26.50( The Bid Rate for SGD) =SGD 2075.48

Solution to b) Sell Rs. 92,000

Ø We want to sell Rupees. Hence the bank will buy Rupees. The relevant rate is the bid rate for INR
Ø The proceeds of selling Rs 92000 = Rs.92,000 * SGD 0.037383 =SGD3,439.25
Ø Or simply 92000/26.75 ( The Ask Rate for SGD )=SGD 3439.25

Solution to c) Buying SGD 7,450

Ø If we want to buy SGD, the bank has to sell SGD. Hence the relevant rate is the Ask rate for SGD
, which is 26.75
Ø Cost of buying SGD7,450=7,450*26.75=Rs. 1,99,287.50

Solution to d) Receipt if we sell SGD 18,340

Ø If we want to sell SGD, the Bank has to buy SGD. Hence the relevant rate is the Bid rate. Bid rate
is Rs.26.50
Ø Proceeds from selling SGD 18,340 = 18,340 * 26,50 = Rs 4,86,010

Cross Rate & Cross Multiplication

a) Traditionally a Cross rate denotes an exchange that does not involve the home currency:
Thus to the Indian, the following quotes are cross rates:
$ per GBP
Yen per Euro
On the other hand, to the India straight quotes are as follows:
INR per USD
INR per GBP
b) Cross multiplication is different from Cross Rate. It is a mechanism used to derive the
exchange rate for a set of currencies, when the exchange rates for two other sets of currencies are
available. Thus for example , cross multiplication is used to find the exchange rate between
INR & USD when the exchange rate between Rupee & Pound , and Pound & USD are available.

Problem:
One quote is INR/SGD = 0.045 . Another quote is INR/Euro is 0.02
a) Ascertain the quote for SGD in terms of Euro
b) Ascertain the quote for Euro in terms of SGD
Verify the correctness of your answer.
Notes:
1. The quotes are not 2 way quote. We therefore assume that BID and ASK rate are equal, and
convert to direct and indirect when needed.
2. The currency for which the rate is required will be the denominator on the left hand side of the
equation
Solution:
a. Quotes for SGD in terms of Euro is derived by the following formula:
Euro = Euro X INR
SGD INR SGD
INR/SGD is not given, but can be computed as the inverse of SGD/INR
Ie, 1 divided by SGD/INR (1/0.045)
INR/SGD therefore equals 22.22, hence Euro/SGD = 0.02 x 22.22 = 0.444
Euro/SGD = 0.444
b. Quote for Euro in terms of SGD is derived by the following formula
SGD = SGD X INR
Euro INR Euro
INR/Euro is not given but can be computed as the inverse of Euro/INR
That is, 1 divided by / Euro/INR or 1/0.02 and this equals 50
SGD /Euro = 0.045 (Given) X 50 Hence SGD /Euro = 2.25
The result of 2.25 SGD per Euro is verifiable as under
Euro/SGD is 0.444 ( see answer to a. above ). Hence SGD/Euro= 1/(Euro/SGD ) =1/0.444
=2.25
 Problem:
From the following imaginary (Two Way) quotes
I. $0.3302 - 0.3310 per DM
II. $0.1180 – 0.1190 per FF
Derive Bid /Ask rates for one unit of FF.

Solution:
A.Required Bid (FF/DM)
Bid ( FF/DM) = Ask ( $/DM) X Bid (FF/$) = 3.0211 X 0.1180 = 0.3565
WN 1. Bid ( $/DM) = 1/ Ask ( DM/$) = 1/0.3310 = 3.0211
WN. 2 Bid ( FF/$ ) = 0.1180 – Given
B.Required Ask (FF /DM)
Ask ( FF/DM) = Ask (DM /$) X Ask ( $/FF) = 3.0285 X 0.1190 = 0.3604
WN. 3. ASK ( $/DM) = 1/ Bid( DM/$) = 1/0.3302 = 3.0285
WN 4. Ask (FF /$) = 0.1190 – Given

The quote is 0.3565 – 0.3604

Mid Rate
A term used to describe the average rate agreed upon when conducting foreign exchange. The
middle rate is calculated using the median average of the bid and offer rates. The middle rate
intuitively is the rate in the middle of the prices offered by the market makers.

For example: The offer price is 1.5 and the bid price is 2.0. Using the median average, the middle
rate would be 1.75. This rate can also be called the mid-rate, mid-price, etc.

Problem:
On 8th July , a Thursday a menthol exporter in Delhi has received intimation from his
customer in Hamsburg, about a TT remittance of Euro 1,24,000. If the Rupee/ Euro spot
rate is 51.19 – 52.00, How much, and when will the menthol exporter receive the rupees ?

Solution:
Ø The exporter will receive Euro which he will sell to the bank to collect Rs. The Bank buys
Euro Hence the relevant rate is Bid rate for Euro.
Ø The Rupees receipt on sale of Euro would be Rs. 1,24,000 X Rs 51.19 per Euro = 63, 47,560,
subject to deduction of bank charges, if any.
Ø The exporter will get INR on the second working day namely 12th July Monday. ( the banker
also in fact verifies that funds have in fact been received in their account)
Spot and forward exchange rates.
A.Spot Exchange Rate
Exchange rates can be for spot or forward delivery. The foreign exchange market includes both
the spot and forward exchange rates. The spot rate is the rate paid for delivery within two
business days after the day the transaction takes place.
The Forward Exchange Rate: If the rate is quoted for delivery of foreign currency at some
future date, it is called the forward rate. In the forward rate, the exchange rate is established at
the time of the contract, though payment and delivery are not required until maturity. Forward
rates are usually quoted for fixed periods of 30, 60, 90 or 180 days from the day of the
contract.
A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the
currency at some future date. They agree to transact a specific amount of currency at a specific
rate at a specified future date. The forward exchange rate is set and agreed by the parties and
remains fixed for the contract period regardless of the fluctuations in the spot exchange rates in
future. The forward exchange transactions can be understood by an example as follows:
A US exporter of computer peripherals might sell computer peripherals to a German importer
with immediate delivery but not require payment for 60 days. The German importer has an
obligation to pay the required dollars in 60 days, so he may enter into a contract with a trader to
deliver deutsche marks for dollars in 60 days at a forward rate – the rate today for future
delivery.
So, a forward exchange contract implies a forward delivery at specified future date of one
currency for a specified amount of another currency. The exchange rate is agreed today, though
the actual transactions of buying and selling will take place on the specified date only. The
forward rate is not the same as the spot exchange rate that will prevail in future. The actual spot
rate that may prevail on the specified date is not known today and only the forward rate for that
day is known. The actual spot rate on that day will depend upon the supply and demand forces
on that day. The actual spot rate on that day may be lower or higher than the forward rate agreed
today.
What it means for a forward currency to sell at a discount and at a premium.
The forward rate may be at a premium or at a discount on the spot price. This is attributable to
the appreciation or depreciation in the value of one currency against another.
In a Direct quote if the Forward rate > Spot rate , then the foreign currency is appreciating and
the home currency is depreciating. And vice versa.
Forward Exchange rates can be quoted either as :
Outright forward exchange rates or as
Swap points (Difference between Outright Forward rate and the Spot rate)
Example :
Spot rate Rs./Euro 50-52 and Outright Forward rate for the Euro is Rs. 53-56
Swap Bid Point =3 and Swap Ask= 4
To ADD or Deduct ?
The swap points or swap rate do not normally come with Minus or plus Sign. Hence whether we
have to Add or deduct the swap points from the spot rate has to be inferred.
 In a Direct quote if the Forward rate > Spot rate , then the foreign currency is appreciating and
the home currency is depreciating. And vice versa. Hence Add the Swap Points to the Spot to
arrive at the Outright forward rate AND Vice versa
This ‘swap rate’ also termed as ‘forward premium’ or ‘forward discount’.
The difference between the forward and the spot rate is expressed as a percentage change
relative to a spot rate base,i.e.
The difference between the forward and the spot rate is expressed as a percentage change relative
to a spot rate base,i.e.

Problem:
Find the one month forward rate of US dollar if spot rate is Rs. 45/- and forward premium
is 10 %

Solution:
Since the quote is for the Dollar which is said to be trading at a premium, it means that the Value
of the Dollar is appreciating as against the Indian Rupee. It is assumed that the rate of 10 Percent
is the Annualized rate amounting to Rs.4.50. The applicable monthly appreciation would be
4.50/12 =0.375.
M,Hence the One month forward rate of USD would be the Spot rate of Rs. 45/= Plus the One
Month appreciation of 0.375 that is Rs 45.375

Problem:
The following information pertains to exchange rates in India.
Foreign Currency Spot – INR 1 M – Swap points
CAD 34.65- 80 30- 20
NZD 29.85-.05 10- 20
Calculate the Cost or Value in Rs to a customer, who wishes to
a. Buy CAD 25,000 spot
b. `Sell CAD 75,000 One Month Forward
c. Sell NZD 20,000 One Month Forward

Solution:
A. Buy CAD 25,000 Spot
We want to buy CAD in the spot market. The Bank has to sell CAD.
Hence Spot Ask rate is relevant.
CAD X Ask (INR/CAD) that is, 25,000 X 34.80 = Rs. 8,70,000.
B. Sell CAD 75,000 One Month Forward.
WN.1: The Forward rate
This is a Direct quote. Swap Ask(20) < Swap Bid (30).
Hence the Foreign currenct CAD, is depreciating and the Home Currency INR is appreciating.
Since Foreign currency is depreciating – Deduct
 The Bid rate is 34.65 -0.30 = 34.35. The Ask rate is 34.80 – 0.20 = 34.60. The Forward rate is
34.35 – 34.60
WN 2: Value
We want to sell CAD in forward market. The Bank has to buy CAD.
Hence Forward Bid rate is relevant
CAD X Bid (INR/CAD) = 75,000 X 34.35 = Rs. 25,76,250
C. Sell NZD 20,000 One Month Forward
WN 1: The Forward Rate
This is a direct quote. Swap Ask (20) > Swap Bid (10).
Hence the Foreign Currency NZD is appreciating, and the Home currency is depreciating.
Since the foreign currency is appreciating – ADD
Bid rate is 29.85 + 0.10 = 29.95. The Ask rate is 30.05 + 0.20 = 30.25.
The Forward rate is 29.95 – 30.25
WN 2: Value
We want to sell NZD in forward market. The Bank has to buy NZD.
Hence forward Bid rate is relevant.
NZD x Bid ( INR /NZD) = 20,000 X 29.95 = Rs. 599,000

Exchange Rate determination

Fluctuating exchange rate system as opposed to fixed exchange rate system.
In some countries the government fixes the rate of exchange called ‘fixed exchange rate’ for its
own currency. This is called ‘official rate of exchange’. These rates will be fixed by the
respective governments from time to time for the betterment of their economy.
In other countries, the rates move, as in any other market places, depending on the demand and
supply pressures and will be further influenced by market forces and economic conditions of
the respective countries. This rate is called ‘floating exchange rate’.
A currency is freely floating if it has no system of fixed exchange rates and if the central bank
of the country in question does not attempt to influence the value of the currency.

When the central bank of a country engaged in market transaction to influence the exchange
value of its currency, but the rate is basically a loating rate, the policy is called ‘managed float’
or ‘dirty float’.
As opposed to this floating system, number of countries continue to use a pegged float as a
system of exchange rates. The value of one currency might be pegged to the value of another
currency that itself floats.
In a joint float, currencies in a particular group have a fixed exchange value in terms of each
other, but the group of currencies floats in relation to other currencies outside the group.

Merits of flexible exchange rate system as opposed to Fixed Exchange Rate System:
a. Countries can maintain independent monetary and fiscal policies
b. Permits smooth adjustment to external shocks
c. Central banks need not maintain large international reserves to defend a fixed exchangerate

Demerits of flexible exchange rate system as opposed to Fixed Exchange Rate System:
a. Unstable exchange rates can prevent free flow of tradeWhereas Fixed exchange rates simplify
exchange transactions. For multinational firms, a fully functioning fixed exchange rate system
 means that exchange rate fluctuations do not affect accounting income.
b. Inherently inflationary because they remove external discipline. Fixed exchange rates may
constitute a form of discipline for economic policies by participating countries.
Determinants of Foreign Exchange Rates:
i. Interest Rate Differentials - A higher rate of interest can obviously create a demand for that
particular currency, as people buy that currency in order to hold the currency with the higher
rate of interest.
Inflation Rate Differentials - Where countries have different inflation rates, the value of one
country’s currency is reducing in ‘real terms’ in comparison with the other. This will result in a
change in exchange rate.
Balance of Payments Position - Continuous adverse balance of payments position will lead
to depreciation in country’s currency exchange rate due to demand for foreign currencies
increases. This will tend to put buying pressure on the foreign currency against its own
currency. Then the country’s own currency exchange rate will fall.
Government Intervention - Sometimes the governments exerts lot of pressure on exchange
rates by involving in direct selling and buying and impose restrictions on currency dealings,
restrictions on currency movements and by their taxation and monetary policies. All these
will effect the exchange rates.
Market Expectations - The market expectations like changes in government, changes in
policies with respect of taxation, foreign trade, inflation, public sector deficits, industrial and
trade policies will have impact on the supply and demand for currencies which influence the
rates of exchange.
Overseas Investment - Suppose foreign investment in India from US increases, the supply of
U.S. dollars putting downward pressure on U.S. dollars. Investment in India by U.S. individuals
and companies will tend to strengthen the rupee.
Speculation - Speculators, including the treasury managers of international banks, influence
movements exchange rates by buying and selling in the expectation of making positive returns
by correctly forecasting movements in exchange rates, and by exploiting any market
inefficiencies.

Theories of Exchange Rate

Interest Rate Parity Theorem

The interest rates within a country are determined in the money market.The price of money
depends on its supply and demand. Sometimes the government of the country try to manage the
interest rates. The demand for money depends on factors like level of investment, inflation,
government borrowings. The supply of money depends on factors like government policy,
efficiency of financial institutions, customs and habits within the country.
Interest Rate Parity is concerned with the difference between the spot exchange rate and forward
exchange rate between two currencies. There is a strong relationship between the forex market
and money market. When all things being equal, the currency with higher interest rate will sell at
a discount in the forward market against the currency with lower interest rate.
The relative interest rates and expected change in interest rates will influence the exchange
rates. Suppose, if interest rates in India are higher than in U.S., investors will prefer to switch
funds from U.S. to India and the dollars will be used to buy rupees, and the buying pressure
should strengthen the rupee against U.S. dollar.The domestic economic policies influence
domestic interest rates.The domestic interest rates will play an important role influencing
the foreign exchange rates. When currency and money markets are in equilibrium, and
difference in interest rates available through investment in two separate locations should
correspond to the differential between the spot rate and forward rate. The currency with higher
interest rate will be sold at a discount in the forward market against the currency with the lower
rate of interest.
The reason that these relationships hold is that operators in the money market are free to invest
or borrow in the currency that offers them most favourable interest rates. When interest rate
parity exists, the forward rate differ from spot rate by just enough to offset the interest rate
differential between the two currencies.
The interest rate parity condition states that the forward premium or discount for a currency
quoted in terms of another currency is approximately equal to the difference in interest rates
prevailing between the two countries. The theorem states that, in equilibrium the difference in
interest rates between two countries is equal to the difference between the forward and spot
rate of exchange.
The interest rate parity relationship can be expressed in the formula given below:

Purchasing Power Parity Theorem:

The relative inflation rates of different countries will have impact on their currency exchange
rates. The purchasing power parity theorem states that if the rate of inflation of
Country A is greater than the rate of inflation in Country B, the rate of exchange of currency of
Country A will fall against the currency of Country B.
For example, if the rate of inflation in India is higher as compared to U.S., then the relative
exchange rate of Rupees to U.S.dollars is bound to be lower.
The purchasing power parity theorem is based on law of one price. The theorem asserts that the
differences in inflation rates between countries will affect the movements in the exchange rate.

The expected difference in the inflation rate would be expected to approximate to the expected
change in exchange rates. It is assumed that the expected difference in inflation rates between
two countries equals, in equilibrium, the expected movements in spot rates. The exact relative
purchasing power parity relationship is expressed as follows:
Fisher Effect

Irving Fisher (1930) in his book ‘The Theory of Interest’, established that in equilibrium lenders will receive a nominal rate of interest equal to
real interest rate plus an amount sufficient to offset the effects of expected inflation. The real rate of return is the rate at which borrowing and
lending in the financial markets are in equilibrium.
The real rate of return is equal to the real rate of growth in the economy, and it reflects the preference of market participants between present
and future consumption.
The rational lenders will expect compensation not only for waiting for their money, but also for the likely erosion of real purchasing power.
The real and nominal interest rates are connected by Fisher Effect as follows:

The law of one price lead us to the conclusion that the real interest rate (ignoring inflation) should be the same in any country assuming deposits
with a similar level of risk.

Fisher Effect
If investors could move their funds freely from one country to another, they would move towards countries where they could expect to
obtain the highest real rate of interest (nominal rate of interest less the inflation rate) with competition to attract funds, that would mean that the
real rates of interest would move so that they were equal in all countries. An investor would not leave money in a country that was paying lower
real returns than could be obtained elsewhere.
The difference in interest rates between two countries is equal, in equilibrium, to the expected difference in inflation rates between
these countries. This, hypothesis is called ‘Fisher Effect’.
The equation representing Fisher Effect, if real interest rates are equal in all countries, then

This model suggests that countries with high inflation tend to have high nominal rates of interest and countries with high interest rates tend
to have high inflation rates.
The Fisher Effect asserts that, with free movement of capital, the interest rates in a country should be equal to the international real rate of
interest adjusted for the difference in the expected rate of inflation in that country compared with the inflation rate worldwide.
International Fischer Effect
It is also called as ‘Open Fisher Theory’, which asserts that countries with higher rates of
inflation will have higher nominal interest rates to provide adequate return to investors to
combat inflation. The interest rate differentials should reflect the expected movement in
the spot rate of exchange. The interest rate differences between trading partners are offset by
the spot exchange rate changing over time.

The International Fisher Effect relationship is expressed as:

The International Fisher effect implies that the exchange rate is directly linked to nominal
interest rates.
Integrating the Interest Rate Parity (IRP) theorem and Purchasing Power Parity (PPP) theorem,
it can be expressed as follows:

Integrative Approach to International Parity relationship

Role played by various participants in foreign exchange markets.

Introduction:
The foreign exchange market is the market in which currencies of various countries are bought
and sold against each other. The foreign exchange market is an over-the-counter market.
Geographically,the foreign exchange markets span all time zones from New Zealand to the West
Coast of the United States of America.
The retail market for foreign exchange deals with transactions involving travelers and
tourists exchanging one currency for another in the form of currency notes or travelers cheques.
The whole-sale market often referred to as the interbank market is entirely different and the
participants in this market are commercial banks, corporations and central banks.
Participants:
Commercial Banks are commonly known as the “market makers” in this market. In other words,
on demand, they will quote buying and selling rates for one currency against another and express
willingness to take either side of the transaction. They also buy and sell on their own account and
carry inventories of currencies.
Foreign exchange brokers are essentially middlemen providing information to market making
banks about prices and a counter party to transactions. Brokers do not buy or sell on their own
account, instead that they have helped strike between two market making banks.
Central banks also intervene in the markets from time to time in order to move the market in a
particular direction.
Corporations use the foreign exchange markets for many purposes. On the operational front,
they use the foreign exchange markets for payments towards imports, conversion of export
receipts, hedging receivables and payables position and payment of interest on foreign currency
loans which they have taken. Companies that are cash rich tend to also park surplus funds and
take active positions in the foreign exchange market to earn profits from exchange rate
movements. There are others who, as a matter of Company policy, restrict their participation to
producing and selling of goods and servicesand only hedge their exposures.

Influence of Euro currency on the foreign exchange market.

Euro Currency Market:

The Euro currency market refers to funds channelled via financial intermediaries from international
lenders to international borrowers. The Euro currency markets provide the short to medium term
debt required by banks, corporate and government borrowers. The source of these funds is
domestic bank deposits whose ownership is transferred to bank outside the controlled domestic
monetary systems. The deposits are in large denominations, frequently $ 100,000 or more, and the
banks use them to make Euro currency loans to quality borrowers.
The Euro currency deposit rate is usually slightly higher than the rate paid by the domestic banks.

The Euro currency loans in a particular currency are priced according to a ‘LIBOR plus basis’,
with the margin over LIBOR depending on market conditions and the credit quality standing or
riskiness of the borrower. The banks generally arrange syndicated loans in this market. Thus the
risk of a particular borrower are distributed across several banks. The Euro currency market is
not regulated by any government and, therefore, is an international currency. The ‘Euro’ prefix
refers to the high volume of these funds circulating in Europe, mainly through London.
However, this market is world wide, and sectors of the market exist in the Middle East and Far
East (Asia dollar market).

Impact of Functions of Euro Currency Markets

They are extensively used for foreign exchange hedging purposes as the banks seek to balance
out their foreign assets and liabilities. The banks, therefore, take positions in the Euro currency
markets to cover the forward commitments they have made with their customers. Euro currency
markets can at times bypass domestic channels of 'financial intermediation’, especially when
governments impose tight credit policies. For example, US Corporation can acquire Eurodollars
in London. These deposits may be US domestic dollar deposits that have been
transferred abroad during a US domestic credit squeeze.
Function of the markets is the full international intermediation role of channelling surplus liquid
resources from, say, OPEC countries or corporations who need to borrow.
Impact of Japanese Yen and US Dollar.
Many find trading the Japanese yen against the U.S. dollar, USD/JPY, a complicated proposition.
This should not be the case when the Japanese yen is understood in terms of U.S. treasury bonds,
notes and bills. The main driver of this pair is not only treasuries, but interest rates in both Japan
and the U.S. This means that the pair is a measure of risk that determines when to buy or sell the
USD/JPY, in terms of interest rates. Knowing where interest rates are heading will determine the
direction of this pair.

The USD/JPY Relationship

Traditionally, the USD/JPY has been known as a currency pair because of its close correlation
with U.S. treasuries. When treasury bonds, notes and bills rise, USD/JPY prices weaken. This is
a long position. The logic is that the U.S. would never default on its bond obligations, known as
defensive assets, hence its safe haven status is secure. This relationship can be viewed in two
ways: through the U.S. dollar and interest rates. When interest rates are heading higher during
the course of a trading day, or are suspected to head higher in the future, treasury bond prices
will go down. This will send the U.S. dollar higher and, in turn, USD/JPY prices will strengthen.
In this instance, the market is more in search of yields from treasury trades and a lower USD/JPY
price. This is a short position. Yields are the rate of interest paid on a treasury instrument. Yields
and bond prices have an inverse relationship. When yields slump, a flight to liquidity occurs, and
this liquidity must find a home. This relationship is a measure of market risk.

Significance of Integration of Global Financial Markets.

Integrated financial markets assume vital importance for several reasons.
First, integrated markets serve as a conduit for authorities to transmit important price signals .
Second, efficient and integrated financial markets constitute an important vehicle for promoting
domestic savings, investment andconsequently economic growth . Third, financial market
integration fosters the necessary condition for a country’s financial sector to emerge as an
international or a regional financial centre . Fourth, financial market integration, by
enhancing competition and efficiency of intermediaries in their operations and allocation of
resources, contributes tofinancial stability . Fifth, integrated markets lead to innovations and cost
effective intermediation, thereby improving access to financial services for members of the
 public, institutions and companies alike. Sixth, integrated financial markets induce market
discipline and informational efficiency. Seventh, market integration promotes the adoption
ofmodern technology and payment systems to achieve cost effective financial intermediation
services.
An important objective of reforms in India has been to integrate the various segments of the
financial market for bringing about a transformation in the structure of markets, reducing
arbitrage opportunities, achieving higher level of efficiency in market operation of intermediaries
and increasing efficacy of monetary policy in the economy . Efficient allocation of funds across
the financial sector and uniformity in the pricing of various financial productsthrough greater
inter-linkages of financial markets has been the basic emphasis of monetary policy. In the
domestic sphere, integration of markets has been pursued through strengthening
competition, financial deepening with innovative instruments , easing of restrictions on
flows or transactions, lowering of transaction costs and enhancing
liquidity. Financial markets in India have also increasingly integrated with the global financial
system as a resulto f calibrated and gradual capital account liberalization in keeping with
underlying macroeconomic developments, the state of readiness of the domestic financial system
and the dynamics of international financial markets .

Nature & Scope:

It an offshoot of economics. Together with International trade forms the larger branch of International
economics.
Some of the key areas of study are as follows:

1. Exchange rates
2. Foreign investment and their impact on international trade.
3. Analysis of international projects,
4. Overseas investments,
5. Cross border capital flows,
6. Trade deficits,
7. Currency swaps and
8. Global financial markets
Individual investors usually focus on that part of international finance that deals with global
futures and options and the forex market.

Prominent Institutions
There are various global bodies regulating different aspects of international finance. These
include:

 IFC: International Finance Corporation is a prominent entity supporting sustainable investments

in the private sector ofdeveloping countries to stimulate their growth. It is the biggest source of
multilateral loans and equity financing for projects undertaken by the private sector in
developing countries. IFC plays a key role in providing technical assistance to businesses and
governments of developing countries.
 IMF: International Monetary Fund monitors the balance of payments of its member countries. It
is regarded as the lender of last resort for countries facing a financial crisis, such as deficits and
currency crisis. The relief amount is relative to the size of the country’s contribution in the global
trading system.
 World Bank: It funds the development of projects, mainly in developing countries, that are not
financed by the private sector.
Complexities:
(a) Cash flows from foreign projects have to be converted into the currency of the parent
organization.
(b) Parent cash flows are quite different from project cash flows
(c) Profits remitted to the parent firm are subject to tax in the home country as well as the host
country
(d) Effect of foreign exchange risk on the parent firm’s cash flow
(e) Changes in rates of inflation causing a shift in the competitive environment and thereby affecting
cash flows over a specific time period
(f)Restrictions imposed on cash flow distribution generated from foreign projects by the host
country
(g) Initial investment in the host country to benefit from the release of blocked funds
(h) Political risk in the form of changed political events reduce the possibility of expected
cash flows
(i) Concessions/benefits provided by the host country ensures the upsurge in the profitability
position of the foreign project.
 (j) Estimation of the terminal value in multinational capital budgeting is difficult since the buyers
in the parent company have divergent views on acquisition of the project.

Significance of International Finance:

Some of the benefits of international finance (or Integration of Global Financial Markets) are:

 Access to capital markets across the world enables a country to borrow during tough
 times and lend during good times.
 It promotes domestic investment and growth through capital import.
 Worldwide cash flows can exert a corrective force against bad government policies.
 It prevents excessive domestic regulation through global financial institutions.
 The integration of the world economy, shifting from pegged-exchange rate system to floating
exchange rate system, reduced barriers of international trade and investment has led to an
international monetary system in which the foreign exchange rates are frequently fluctuating
under free floating system.
 International finance leads to healthy competition and, hence, a more effective banking system.
 It provides information on the vital areas of investments and leads to effective capital allocation.
International finance promotes the integration of economies, facilitating the easy flow of capital.
The free transfer of funds would eventually result in more equality among countries that are a
part of the global financial system.

Posted 29th November 2012 by Eric S. Morris FCA, DISA(ICA)

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2.
NOV

29

Forex
Domestic Currency & Foreign Currency
Ø Domestic Currency denotes the currency in which the CFO reports company’s performance to the
stakeholders.( Also known as the Home Currency)
o For an entity operating in India, Rupee is the Domestic currency
o Just as is Yen for accompany operating in Japan and Euro for a German Company
Ø Foreign Currency denotes
o For an Indian Company USD is foreign Currency
o For an American Company Rupee is a Foreign Currency
 Exchange Rate
Foreign Currency is not only a medium of Exchange but a store of Value, an Asset as well.
As an Asset, Foreign Currency has Purchasing Power, at times greater and at times lesser than
the Domestic currency.
Hence it is necessary to know about its price, also known as the Exchange Rate.
The Price of one currency viewed in relation to another currency is called as Exchange Rate
In other words,Exchange Rate then is the rate at which one currency is exchanged for another
currency.
–Example, $/Rs. 44.76
Note : The Rate is to be understood in terms of the Second of the pair( ie. Rupees in theexample
given above). Thus the example would read as Rs 44.76 equals one dollar.
Exchange rates are normally expressed not beyond 4 decimals
In any Transaction involving foreign exch., you are selling one currency and buying another.
In an Exchange Rate, 2 currencies are involved (“a Pair”)
Direct and Indirect Quote:
A currency quotation is the price of a currency in terms of another currency. For example, $1 =
Rs.44.00, means that one dollar can be exchanged for Rs.44.00. Alternatively, we may pay
Rs.44.00 to buy one dollar. A foreign exchange quotation can be either a direct quotation and or
an indirect quotation, depending upon the home currency of the person concerned. A direct quote
is the home currency price of one unit foreign currency. Thus, in thevaforesaid example, the
quote $1 =Rs.44.00 is a direct-quote for an Indian.
An indirect quote is the foreign currency price of one unit of the home currency. The quote Re.1
=$0.0227 is an indirect quote for an Indian. ($1/Rs. 44.00 =$0.0227 approximately)
Direct and indirect quotes are reciprocals of each other, which can be mathematically expressed
as follows.
Direct quote = 1/indirect quote and vice versa

Problem:
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
------------------------------------------------------------------------------------------------------------
1.SEK 5.7500 Rs. Per Kroner
2. Euro 0.0191 Euro per Re
3. SGD 0.0388 SGD per Re
4.AED 12.1500 Rs.per UAE Dhiram

Solution:
Since it is a Mumbai Banker ,the Home Currency is Rupees.
1. SEK/INR is home currency per unit of foreign currency. Hence a direct quote
The Corresponding indirect quoteis 1/dq=1/5.75. That is 0.1739 SEK per INR
2. Euro per INR is foreign currency per unit of home currency. Hence an indirect quote.
The corresponding direct quote is 1/IDQ= 1/0.0191 = Rs 52.36 Per Euro
3. SGD per INR is foreign currency per unitof home currency. Hence an indirect quote
 The corresponding direct quote is 1/IDQ = 1/ 0.0388 = INR25.77 per SGD
4. INR/AEDis home currency per unit of foreign currency . Hence a direct quote
The corresponding indirect quote is 1/ DQ= 1/12.15=0.08 AED per INR

Problem:
If indirect quote is $ 0.025/kc. How can this exchange rate be shown under direct quote ?

Solution:
The Direct quote will be the inverse of the Indirect Quote, that is 1/0.025 Kc / $ or 40 kc per $

Problem:
Following are the quotes given by a banker at Mumbai. Identify whether the quote is
direct or an indirect quote. Compute the direct quote for indirect quote and vice versa.
1 USD = Rs 45.85
Rs.100 = GBP 1.2312
Rs.100 = Euro 1.7850
Rs.100 = USD 2.2002
1 Yen = Rs.0.4129

Solution:
1 USD = Rs 45.85 : is a Direct Quote The Indirect Quote is the Inverse of this
figure
That is 1/45.85 or 0.02181
Rs.100 = GBP 1.2312: Is an Indirect Quote. The Direct Quote is the Inverse of this figure
That is 1/0.012312 or 81.22157
Rs.100 = Euro 1.7850: Is an Indirect Quote. The Direct Quote is the Inverse of this figure
That is 1/0.01785 or 56.2241
Rs.100 = USD 2.2002: Is an Indirect Quote. The Direct Quote is the Inverse of this figure
That is 1/0.02202 or 45.41326
1 Yen = Rs.0.4129 : is a Direct Quote The Indirect Quote is the Inverse of this figure
That is 1/0.4129 or 2.4219

Problem:
Following quotes are given by banker in Mumbai. Identify whether the quote is direct or
indirect quote. Compute the direct quote for indirect quote and vice versa:
Rs. 100= USD 1.9800
Rs. 100=GBP1.2500
1EUR=Rs.55

Solution:
Rs. 100= USD 1.9800: Is an Indirect Quote. The Direct Quote is the Inverse of this figure.
That is 1/0.0198 or Rs 50.5051 Per USD
Rs. 100=GBP1.2500: Is an Indirect Quote. The Direct Quote is the Inverse of this figure.
 That is 1/0.0125 or Rs 80 per GBP
1EUR=Rs.55: is a Direct Quote The Indirect Quote is the Inverse of this figure
That is 1/55 or Euro 0.01818 Per Rupee

Bid Price /Offer Price and Spread:

It will not be possible to buy foreign currency from a bank at the same rate at which you can sell
the same currency to it. This is because the bank whose business it is to buy and sell will have to
make a margin to cover costs and make a profit too. For that matter this is normal any other
business too.
An authorized dealer therefore usually gives two types of quote as follows:
- The price at which he is buying the foreign currency called ‘bid‘ price.
- The price at which he is selling a given currency called ‘offer' price.
It is also called ‘ask' price.
The banker does not generally enquire whether you want to buy or to sell. He simply indicates
both quotes. By convention, in the Direct quote the Bid quote precedes the Ask quote. For
example a two-way quote in INR for USD will read: Re/$ 47.00 – 47.80
The difference between bid price and offer price is called ‘spread’. This represents the margin
of foreign exchange dealer as mentioned above.
The following two factors determine the size of the spread.
a) Stability of the exchange rate: The spread will be wider with growing volatility
b) Depth of the market: Depth refers to the volume of transactions. A deep market has a high
volume of transactions with several dealers simultaneously engaged in transacting business. In
this case the spread will be narrower. than for a “thin” market where there is a low volume of
transactions and few dealers.
Problem:
A. At two forex centers, the following Re- US $ rates are quoted:
London: Rs 47.5730-47.6100
Tokyo: Rs 47.6350- 47.6675
Find out arbitrage possibilities for an arbitrageur who has Rs 100 million.
B. An Indian banker gives the following quotes for USD as INK 50.1125/50.4560.
Calculate percentage spread:

Solution:
A. There is no overlap in these quotes. Hence there is opportunity for arbitrage. For Instance the
Trader could buy USD at the Ask Rate of 47.6100 applicable to Banks sale of USD, in the
London market. He would obtain 21003.99 USD. This he could arbitrage in The Tokyo market
by selling it at the Banks Buying or Bid rate of Rs 47.6350. He would get Rs 1,000,525. Which
would mean he would make a No Risk profit of Rs. 525
.
 B. The spread itself is the difference between the Ask and the Bid Price, that is 50.4560-50.1125
The spread is 0.3435 and the percentage spread is 0.3435/50.1125*100 or 0.6855 %

Problem:
Consider the following INR/SGD direct quote of ICICI Mumbai: 26.50 – 26.75
a) What is the cost of buying Rs. 55000 ?
b) How much would we receive by selling Rs. 92,000 ?
c) What is the cost of buying SGD 7,450 ?
d) What is your receipt if you sell SGD 18,340 ?

Solution to a)
Ø This is a direct quote in for singapore dollar Rs.26.50 is the bid rate and Rs 26.75 is the ask rate.
Ø Since it is WE that want to buy Rs 55,000, the Bank will have to sell Rs.55,000. The relevant rate
is the banks’s Ask rate for Rupees.
Ø The quote for Rs. Will be as under
o (INR/SGD) Bid =1/ (SGD/INR) Ask =1/26.75= 0.037383
o (INR/SGD) Ask =1/ (SGD/INR Bid) = 1/26.50= 0.037736
The cost of buying INR 55,000 = Rs 55,0000 * SGD 0.037736, = SGD 2,075.48
Or 55,000/26.50( The Bid Rate for SGD) =SGD 2075.48

Solution to b) Sell Rs. 92,000

Ø We want to sell Rupees. Hence the bank will buy Rupees. The relevant rate is the bid rate for INR
Ø The proceeds of selling Rs 92000 = Rs.92,000 * SGD 0.037383 =SGD3,439.25
Ø Or simply 92000/26.75 ( The Ask Rate for SGD )=SGD 3439.25

Solution to c) Buying SGD 7,450

Ø If we want to buy SGD, the bank has to sell SGD. Hence the relevant rate is the Ask rate for SGD
, which is 26.75
Ø Cost of buying SGD7,450=7,450*26.75=Rs. 1,99,287.50

Solution to d) Receipt if we sell SGD 18,340

Ø If we want to sell SGD, the Bank has to buy SGD. Hence the relevant rate is the Bid rate. Bid rate
is Rs.26.50
Ø Proceeds from selling SGD 18,340 = 18,340 * 26,50 = Rs 4,86,010

Cross Rate & Cross Multiplication

a) Traditionally a Cross rate denotes an exchange that does not involve the home currency:
Thus to the Indian, the following quotes are cross rates:
$ per GBP
Yen per Euro
On the other hand, to the India straight quotes are as follows:
INR per USD
INR per GBP
b) Cross multiplication is different from Cross Rate. It is a mechanism used to derive the
exchange rate for a set of currencies, when the exchange rates for two other sets of currencies are
 available. Thus for example , cross multiplication is used to find the exchange rate between
INR & USD when the exchange rate between Rupee & Pound , and Pound & USD are available.

Problem:
One quote is INR/SGD = 0.045 . Another quote is INR/Euro is 0.02
a) Ascertain the quote for SGD in terms of Euro
b) Ascertain the quote for Euro in terms of SGD
Verify the correctness of your answer.
Notes:
1. The quotes are not 2 way quote. We therefore assume that BID and ASK rate are equal, and
convert to direct and indirect when needed.
2. The currency for which the rate is required will be the denominator on the left hand side of the
equation
Solution:
a. Quotes for SGD in terms of Euro is derived by the following formula:
Euro = Euro X INR
SGD INR SGD
INR/SGD is not given, but can be computed as the inverse of SGD/INR
Ie, 1 divided by SGD/INR (1/0.045)
INR/SGD therefore equals 22.22, hence Euro/SGD = 0.02 x 22.22 = 0.444
Euro/SGD = 0.444
b. Quote for Euro in terms of SGD is derived by the following formula
SGD = SGD X INR
Euro INR Euro
INR/Euro is not given but can be computed as the inverse of Euro/INR
That is, 1 divided by / Euro/INR or 1/0.02 and this equals 50
SGD /Euro = 0.045 (Given) X 50 Hence SGD /Euro = 2.25
The result of 2.25 SGD per Euro is verifiable as under
Euro/SGD is 0.444 ( see answer to a. above ). Hence SGD/Euro= 1/(Euro/SGD ) =1/0.444
=2.25

Problem:
From the following imaginary (Two Way) quotes
I. $0.3302 - 0.3310 per DM
II. $0.1180 – 0.1190 per FF
Derive Bid /Ask rates for one unit of FF.

Solution:
A.Required Bid (FF/DM)
Bid ( FF/DM) = Ask ( $/DM) X Bid (FF/$) = 3.0211 X 0.1180 = 0.3565
WN 1. Bid ( $/DM) = 1/ Ask ( DM/$) = 1/0.3310 = 3.0211
WN. 2 Bid ( FF/$ ) = 0.1180 – Given
B.Required Ask (FF /DM)
Ask ( FF/DM) = Ask (DM /$) X Ask ( $/FF) = 3.0285 X 0.1190 = 0.3604
WN. 3. ASK ( $/DM) = 1/ Bid( DM/$) = 1/0.3302 = 3.0285
WN 4. Ask (FF /$) = 0.1190 – Given

The quote is 0.3565 – 0.3604

Mid Rate
A term used to describe the average rate agreed upon when conducting foreign exchange. The
middle rate is calculated using the median average of the bid and offer rates. The middle rate
intuitively is the rate in the middle of the prices offered by the market makers.

For example: The offer price is 1.5 and the bid price is 2.0. Using the median average, the middle
rate would be 1.75. This rate can also be called the mid-rate, mid-price, etc.

Problem:
On 8th July , a Thursday a menthol exporter in Delhi has received intimation from his
customer in Hamsburg, about a TT remittance of Euro 1,24,000. If the Rupee/ Euro spot
rate is 51.19 – 52.00, How much, and when will the menthol exporter receive the rupees ?

Solution:
Ø The exporter will receive Euro which he will sell to the bank to collect Rs. The Bank buys
Euro Hence the relevant rate is Bid rate for Euro.
Ø The Rupees receipt on sale of Euro would be Rs. 1,24,000 X Rs 51.19 per Euro = 63, 47,560,
subject to deduction of bank charges, if any.
Ø The exporter will get INR on the second working day namely 12th July Monday. ( the banker
also in fact verifies that funds have in fact been received in their account)

Spot and forward exchange rates.

A.Spot Exchange Rate
Exchange rates can be for spot or forward delivery. The foreign exchange market includes both
the spot and forward exchange rates. The spot rate is the rate paid for delivery within two
business days after the day the transaction takes place.
The Forward Exchange Rate: If the rate is quoted for delivery of foreign currency at some
future date, it is called the forward rate. In the forward rate, the exchange rate is established at
the time of the contract, though payment and delivery are not required until maturity. Forward
rates are usually quoted for fixed periods of 30, 60, 90 or 180 days from the day of the
contract.
A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the
currency at some future date. They agree to transact a specific amount of currency at a specific
rate at a specified future date. The forward exchange rate is set and agreed by the parties and
remains fixed for the contract period regardless of the fluctuations in the spot exchange rates in
future. The forward exchange transactions can be understood by an example as follows:
A US exporter of computer peripherals might sell computer peripherals to a German importer
with immediate delivery but not require payment for 60 days. The German importer has an
obligation to pay the required dollars in 60 days, so he may enter into a contract with a trader to
deliver deutsche marks for dollars in 60 days at a forward rate – the rate today for future
delivery.
So, a forward exchange contract implies a forward delivery at specified future date of one
currency for a specified amount of another currency. The exchange rate is agreed today, though
the actual transactions of buying and selling will take place on the specified date only. The
forward rate is not the same as the spot exchange rate that will prevail in future. The actual spot
rate that may prevail on the specified date is not known today and only the forward rate for that
day is known. The actual spot rate on that day will depend upon the supply and demand forces
on that day. The actual spot rate on that day may be lower or higher than the forward rate agreed
today.
What it means for a forward currency to sell at a discount and at a premium.
The forward rate may be at a premium or at a discount on the spot price. This is attributable to
the appreciation or depreciation in the value of one currency against another.
In a Direct quote if the Forward rate > Spot rate , then the foreign currency is appreciating and
the home currency is depreciating. And vice versa.
Forward Exchange rates can be quoted either as :
Outright forward exchange rates or as
Swap points (Difference between Outright Forward rate and the Spot rate)
Example :
Spot rate Rs./Euro 50-52 and Outright Forward rate for the Euro is Rs. 53-56
Swap Bid Point =3 and Swap Ask= 4
To ADD or Deduct ?
The swap points or swap rate do not normally come with Minus or plus Sign. Hence whether we
have to Add or deduct the swap points from the spot rate has to be inferred.
In a Direct quote if the Forward rate > Spot rate , then the foreign currency is appreciating and
the home currency is depreciating. And vice versa. Hence Add the Swap Points to the Spot to
arrive at the Outright forward rate AND Vice versa
This ‘swap rate’ also termed as ‘forward premium’ or ‘forward discount’.
The difference between the forward and the spot rate is expressed as a percentage change
relative to a spot rate base,i.e.
The difference between the forward and the spot rate is expressed as a percentage change relative
to a spot rate base,i.e.

Problem:
Find the one month forward rate of US dollar if spot rate is Rs. 45/- and forward premium
is 10 %

Solution:
Since the quote is for the Dollar which is said to be trading at a premium, it means that the Value
of the Dollar is appreciating as against the Indian Rupee. It is assumed that the rate of 10 Percent
 is the Annualized rate amounting to Rs.4.50. The applicable monthly appreciation would be
4.50/12 =0.375.
M,Hence the One month forward rate of USD would be the Spot rate of Rs. 45/= Plus the One
Month appreciation of 0.375 that is Rs 45.375

Problem:
The following information pertains to exchange rates in India.
Foreign Currency Spot – INR 1 M – Swap points
CAD 34.65- 80 30- 20
NZD 29.85-.05 10- 20
Calculate the Cost or Value in Rs to a customer, who wishes to
a. Buy CAD 25,000 spot
b. `Sell CAD 75,000 One Month Forward
c. Sell NZD 20,000 One Month Forward

Solution:
A. Buy CAD 25,000 Spot
We want to buy CAD in the spot market. The Bank has to sell CAD.
Hence Spot Ask rate is relevant.
CAD X Ask (INR/CAD) that is, 25,000 X 34.80 = Rs. 8,70,000.
B. Sell CAD 75,000 One Month Forward.
WN.1: The Forward rate
This is a Direct quote. Swap Ask(20) < Swap Bid (30).
Hence the Foreign currenct CAD, is depreciating and the Home Currency INR is appreciating.
Since Foreign currency is depreciating – Deduct
The Bid rate is 34.65 -0.30 = 34.35. The Ask rate is 34.80 – 0.20 = 34.60. The Forward rate is
34.35 – 34.60
WN 2: Value
We want to sell CAD in forward market. The Bank has to buy CAD.
Hence Forward Bid rate is relevant
CAD X Bid (INR/CAD) = 75,000 X 34.35 = Rs. 25,76,250
C. Sell NZD 20,000 One Month Forward
WN 1: The Forward Rate
This is a direct quote. Swap Ask (20) > Swap Bid (10).
Hence the Foreign Currency NZD is appreciating, and the Home currency is depreciating.
Since the foreign currency is appreciating – ADD
Bid rate is 29.85 + 0.10 = 29.95. The Ask rate is 30.05 + 0.20 = 30.25.
The Forward rate is 29.95 – 30.25
WN 2: Value
We want to sell NZD in forward market. The Bank has to buy NZD.
Hence forward Bid rate is relevant.
NZD x Bid ( INR /NZD) = 20,000 X 29.95 = Rs. 599,000