EXCHANGE RATE MECHANISM

By Sudarshana Bhat
Asst General Manager
Corporation Bank
 FOREX RATES

• What is Exchange Rate?

• Exchange Rate is a rate at which one
currency can be exchanged into another
currency.
• Foreign Exchange Deal
• Involves the sale of one currency and the
purchase of another at an agreed
exchange rate.
 Exchange Rate Mechanism

Types of Exchange Rate Quotation

• Direct Quotation: • Indirect Quotation:

• Fixed unit of Foreign • Fixed unit of home
Currency is expressed currency is expressed in
in variable units of variable units of foreign
home currency currency
• (E.g) USD $ 1= INR • (E.g) INR 100 = USD$
54.35 1.83

Direct Quote: Buy Low/Sell High

Indirect Quote: Buy High/Sell Low
 Two way quote
Single Rate Quote:
• Buying and selling rates are quoted simultaneously in same currency
against a foreign currency. The difference between the buy and sell
rate is the spread.
• (E.g.) USD $1 = 54.33/34
Cross Rate Quote:
• When price of one currency is not quoted against other currency,
intermediary currency quote is used in inter forex market.
• E.g. If GBP quote for INR Required: USD $1is quoted as INR 54.35/36
in Indian Market, 1 GBP is quoted as USD $ 1.5980/1.5985 in New
York market.
• Buying Rate: 1 GBP = USD $ 1.5980 & USD $ 1= Rs 54.35 = 86.8513
• Selling Rate : 1 GBP=USD $1.5985 & USD$ 1 = Rs 54.36 =86.8945
Methods of Quotation

• Direct method • Indirect method

• USD 1= Rs 54.35 • Rs 100 = USD 1.83
• GBP 1= Rs 86.80 • Rs 100 = GBP
• EUR 1 = Rs 69.30 1.1520
• Rs 100 = EUR
1.4430
Understanding Two Way Exchange Quotes

USD 1 =INR 54.00/02

INR 54.00 INR 54.02

BUYING RATE SELLING RATE

Understanding two way quotes

USD 1 = CHF 0.9450/55

CHF 0.9450 CHF 0.9455

BID OFFER

LOW FIGURE HIGH FIGURE

Understanding Bid and Offer

USD 1 = CHF 0.9450/55

CHF 0.9450 CHF 0.9455

BID OFFER

LOW FIGURE HIGH FIGURE

Understanding Exchange Rates

• USD/CHF
• Note the order of the
currencies.
• ‘USD’ comes before the
‘CHF’

• The first currency is • The second currency is

the BASE currency. the TERMS/variable
currency.
Understanding Exchange Rates

The reference BASE CURRENCY is very important

because two currencies are actually exchanged.
BID OFFER
0.9450 0.9455

MEANS
Buy USD Sell USD
BUT THAT ALSO MEANS
SELL CHF BUY CHF
ADVANTAGE OF TWO-WAY QUOTES

 Market continuously makes prices available

 Not necessary for any player in the market to

indicate whether he intends to buy or sell

 This ensure that quoting bank cannot take

advantage by manipulating prices

 It automatically ensures alignment of rates with

market rates
 SPREAD

• THE DIFFERENCE BETWEEN THE

BUYING AND THE SELLING RATE (BID
AND OFFER RATES) IS KNOWN AS
SPREAD.
Understanding Exchange quotes

• In the Fx market, Time is of great importance.

• Therefore, there are short forms for everything.
• While quoting, the dealers use only the third & fourth
decimals.
• USD/CHF 0.9440/45
• USD/INR 54.350/36
• GBP/USD 1.5980/85
• BIG FIGURE
• In a live dealing scenario dealers would quote only 40/45,
75/figure, figure/10 and the market assumes that all
players already know the BIG FIGURE
Golden Rules to Remember

• For interpreting or reacting to a quote you need

to know the following three things

• What currency are you trading ?

(Base currency or Terms/variable Currency ?)

• How is it quoted ?
(Is it CHF for 1 Dollar or Dollars for 1 CHF ?)

• Quoting party always wants to

GIVE LESS & GET MORE !!!!
Calculating Cross Rates

• India is a market maker for Indian Rupee

• Dollar/Rupee trading (the first quotes) start in the Mumbai
Market
• BUT WHAT ABOUT OTHER CURRENCIES?
• WHERE DO RATES FOR CHF, GBP, EUR ETC COME FROM?
HOW ARE THEY CALCULATED?
• A CHF/RUPEE RATE IS A CROSS OF DOLLAR/RUPEE &
DOLLAR/CHF
• DOLLAR/RUPEE = 54.35/36

• DOLLAR/CHF = 0.9440/45
• CHF/RUPEE = 57.54/58
• In other words 54.36/0.9440 = 57.58 AND
• 54.35/0.9445 = 57.54
Calculating Cross Rates…2

• FOR GBP (EUR, AUD)/RUPEE RATE

• CROSS RATE IS ARRIVED AT BY MULTIPLICATION

• DOLLAR/RUPEE = 54.35/54.36
X X
• GBP/USD = 1.5980/1.5985

• GBP/RUPEE = 86.85/86.89
Forward Rates

• What is a Forward Rate ?

• Rate agreed for settlement on an agreed date in
the future
• All rates are derived from Spot rates.
• Forward rate is the spot rate adjusted for
premium / discount
• Forward Rate = Spot Rate + / - premium or
discount
• Forward Calculation (examples)
• Is the forward rate, the market’s expectations of
future spot rates?
 Forward Premium/Discount
• Premium are interest rate differential between two
currencies.
• The basic rule is that currency with higher inflation
or interest rate will be always at discount vice versa.
• Premiums are quoted on ascending order & Discounts
are quoted on descending order
• Premiums is added to the Spot & Discount is
deducted from Spot
• Example:
Month Premiums Discounts
January 15/16 16/15
February 30/31 30/28
March 45/46 45/42
April 60/62 50/48
May 70/72 60/58
Determining Forward Rates

Ascending + Add Descending – Deduct

• LOW/HIGH POINTS • HIGH/LOW POINTS

• •
UP DOWN
Determining Forward Rates

• To determine which currency is at a premium/discount to

the other, we need to look at the interest rate hierarchy
• INR 8.00% GBP 4.59%
• USD 0.00-0.25% EUR 1.00%
• CHF 0.73% JPY 0.01%

• As shown above, USD is at premium to INR.

• Once again, the lower yielding currency is at a premium to

the other currency.
FOREX FORWARDS

• CONTRACT BETWEEN TWO PARTIES TO

EXCHANGE CURRENCIES AT AN AGREED RATE ON
AN AGREED DATE

• FOR EXAMPLE :
• Bank A agrees to buyfrom RIL USD 1 mio at
45.10 INR per $ ON 30th June 2011
Determining Forward Rates

• Forward Rates are determined by adding/subtracting the

premium/discount from the spot rates
• Eg The Dollar is at a PREMIUM to the Rupee
• Hence, the Dollar is more expensive to buy at a future date
• If the Spot USD = 54.24
• ADD 3 months fwd Premium = 00.76
• USD/INR 3 MTH FWD = 55.00
• The USD is at a DISCOUNT to the JPY
• Hence, the Dollar is cheaper to buy at a forward date
• If the Spot USD/JPY = 79.80
• DEDUCT 3 months fwd discount = 0.20
• USD/JPY 3 months forward = 79.60
PREMIUM / DISCOUNT

• How do we know if a currency is at a premium or discount

against another?
• In free economies, there is a simple thumb rule:
• IN ANY PAIR OF CURRENCIES, THE CURRENCY WITH THE
LOWER INTEREST RATE IS AT A PREMIUM IN THE
FORWARDS MARKET.

• The logic is simple – the purpose of forward

premium/discount is to negate the interest advantage that
one currency has over another. This is possible only if the
currency with the lower interest is at a premium!
FOREX FORWARDS

• As per FEMA 1999 one of the parties has to be an

AD

• The contract could then be between an AD & its

customer

• OR between two Ads

• The former is the RETAIL segment while the later
is the WHOLESALE segment
FAQ – Forward Rate Quotations

• How are forward premium/discount quoted on

the Reuter screen?
• Is it possible to look at a quote and tell whether
the currency is at premium or discount
• Forward prices are usually quoted in points
• Each point represents 0.0001 pips
• Forward prices are calculated by adding or
substracting the points , to or from the spot rate.
• The addition or subtraction is determined by the
order of the points quoted.
Calculation of forward rates

• SPOT RATE+/- PREMIUM/DISCOUNT =

FORWARD RATE

• E.g. Spot/Dollar Rupee = 54.30/54.35

• 1 month Dollar Premium = 15/17
• 1 month forward $/Rupee = 54.45/54.52

• E.g. Spot USD/CHF = 0.9440/0.9450

• 1month Dollar discount = 20/25
• 1month Fwd USD/CHF = 0.9420/0.9425
 ARITHMETICS

• USD/INR 54.26/54.28
• CASH/SPOT 0.01/0.02
• EXPORTER 54.26-0.02 = 54.24

Pays 0.02(S & B – C/S)

• IMPORTER 54.28-0.01=54.27
Receives 0.01 (B & S – C / S)
MAKE NO MISTAKE!
SWAP PREMIUM DISCOUNT

BUY & SELL RECEIVE PAY

SELL & BUY PAY RECEIVE

• 15/20 = ASCENDING ORDER = PREMIUM =ADD

• 45/40 = DESCENDING ORDER = DISCOUNT =DEDUCT

EXCHANGE MARGIN
DEDUCT FROM BUYING RATE
ADD TO THE SELLING RATE
 Application of Forward Rate incase of Premium/Discount
When the
Nature of When the Forward is at
Forward is at
Transaction Discount
Premium
Pass greatest discount
Pass on lowest assuming delivery date is a
For Exporters
Premium date discounted from the
spot rate

Load Highest Pass on Least Discount on

For Importers
Premium Spot Rate
 EXCHANGE RATES

BUYING RATE SELLING

SPOT FORWARD SPOT FORWARD

 Types of Fx Rates

Foreign Trade

Export Import

Inflow of Foreign Outflow of Foreign

Currency Currency

Buying Rate Selling Rate

• T.T. • T.T.
• B.B. • B.S.
• T.C. • T.C.
• C.B. • C.N.
• Personal Cheque
 Application of Exchange Rates
Selling Rate Transactions
Outward Remittance in Foreign Currency by way of
TT Selling TT/MT/DD/PO
Cancellation of Foreign Purcahses
Bill Purcahsed retured unpaid
Bill Purcahsed transferred to collection account
Earlier Inward remittance is refunded to remitting
Bank
A Forward Purcahse contract is Cancelled

Bill Selling Transactions involving transfer of proceeds of import bills

TC Selling Selling of Travellers cheques
Currency Selling Selling of Currency Notes
Buying Rates
Clean Inward remittance by way of PO/MT/TT/DD for
which foreign exchange cover has already been credited to
TT Buying AD Accounts
Conversion of Proceeds of instruments sent for collection
Cancellation of outward TT/MT/DD etc
Cancellation of Forward Sale Contracts
Purchase/Discounting of Bills & Other Instruments where
Bill Buying bank has to claim cover after payments
TC Buying Buying of Travellers cheques
Currency Buying Buying of Currency Notes
 BUYING RATE

SPOT RATE FORWARD RATE

TT BUYING BILL BUYING TT FORWARD BILL FORWARD

FBC/FCC EBP/EBD FBC/FCC EBP/EBD

 SELLING RATE

SPOT RATE FORWARD RATE

TT SELLING BILL SELLING TT FORWARD BILL FORWARD

OUTWARD TT FBC/L.C OUTWARD TT F.B.C/LC

 Delivery of Foreign Excahnge

Bet ween Banker & Cust omer Bet ween Two Banks

Taking Delivery
Giving Delivery by
by Customer
Customer (Exporter)
(Importer)
Acut al Delivery (Bot h for Buying & Selling)
Notional Actual
Delivery Delivery Actual Delivery CASH TOM SPOT FORWARD
Sport /Ready
Delivery
Forward Delivery Fixed Opt ion

Fixed Option

Delivery & Payment of Foreign Excahnge either in Foreign Currency or in

CASH Indian Rupee Simultaneously Today

Delivery & Payment of Foreign Excahnge either in Foreign Currency or in

TOM Indian Rupee Simultaneously Next Working Day
Delivery & Payment of Foreign Excahnge either in Foreign Currency or in
Indian Rupee would takes place on the 2nd working day from the date of
SPOT contract
Forward
Delivery Beyond Spot
 Settlement of Foreign Exchange

Payments between buyer & selling residing in two different

counmtries are normally settled through Bank accounts in the
respective currency & these accounts are known as

NOSTRO ACCOUNT Our Account with You

VOSTRO ACCOUNT Your Account With Us

Their Account. Indian Bank account

LORO ACCOUNT mainatined with a foreign bank abroad
is referred with relation to a bank
account as a third party
 Value Date
A v alue date for the foreign exchange
transaction is the day on which cash flows are
Spot to take place

Forward rates are quoted for 1,2,3…..Months &

Forward So on, V alue dates are determined as under

Spot V alue is acertained & then Number of months as

required are added to ariv e at forward v alue date (E.g)
Date of Contract 27/12/2006
Spot V alue Date 29/12/2006
Forward V alue Date
1 Month 31/01/2007

2 Month 28/02/2007
3 Month 30/03/2007
VALUE DATE

• In foreign exchange market it takes

some time to process the transaction and
send instruction to the correspondent
bank/ branch abroad.
• Therefore it is customary to quote a rate
to do the deal even though exchange of
the currencies does not take place on the
same day.
 VALUE DATE
• VALUE DATE IS THE DATE ON WHICH
THE EXCHANGE OF CURRENCIES
ACTUALLY TAKES PLACE. THIS IS
IRRESPECTIVE OF THE DATE OF THE
DEAL
THANK YOU

CorpBank Fx Dealing Team