FOREIGN

EXCHANGE
MANAGEMENT
FOREIGN EXCHANGE

RATES & MARKETS

MODULE:2
An international exchange rate, also known as a foreign exchange (FX) rate, is the price of a
nation’s currency in terms of another currency. Foreign exchange rates are determined by
demand and supply. There are three broad categories of exchange rate systems.
 In a free-floating exchange rate system, governments and central banks do not participate
or negligible participation in the market for foreign exchange. Countries are US,UK etc
 A free-floating system has the advantage of being self-regulating. Market forces also restrain
large swings in demand or supply.
 Example: Suppose that a dramatic shift in world preferences led to a sharply increased
demand for goods and services produced in India. This would increase the demand for
Indian Rupee, raise India Rupee’s exchange rate, and make Indian goods and services more
expensive for foreigners to buy. Some of the impact of the swing in foreign demand would
thus be absorbed in a rising exchange rate. Countries are US,UK etc
 In effect, a free-floating exchange rate acts as a buffer to insulate an economy from the
impact of international events.
 The primary difficulty with free-floating exchange rates lies in their unpredictability.
 Fluctuating exchange rates make international transactions riskier and thus increase the cost
DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS
of doing business with other countries.
Managed Float Systems
Government or central bank participation in a floating exchange rate system is called a managed
float system. Exchange rates are still free to float, but governments try to influence in
preventing sudden large swings in the value of a nation’s currency.
Example: Suppose the price of a country’s currency is rising very rapidly.
 The country’s government or central bank might announce that a further increase in its
exchange rate is unacceptable, followed by sales of that country’s currency in order to bring
its exchange rate down.(To protect Exporter)
 Also can sometimes convince other participants in the currency market that the exchange
rate will not rise further. Countries are India , Indonesia, Argentina ,Uriguay etc
That change in expectations could reduce demand for and increase supply of the currency, thus
achieving the goal of holding the exchange rate down.
Fixed Exchange Rates DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS

 Fixed rates of exchange refer to maintenance of external value of the currency at a

predetermined level .
 When the exchange rate differs from the level ,it is corrected through central bank’s
intervention. Example: Bahrain: US Dollar
An exchange rate is the price of a nation’s currency in terms of another
currency. Thus, an exchange rate has two components, the domestic currency
and a foreign currency, and can be quoted either directly or indirectly.
 In a direct quotation, the price of a unit of foreign currency is expressed in
terms of the domestic currency.
Example:USD1.00=INR68.50 would be a direct exchange rate for the United
States Dollar in India.
 In an indirect quotation, the price of a unit of domestic currency is
expressed in terms of the foreign currency.
Example:USD1.4598=Rs100 would be a indirect quotation for the United
States Dollar in India.
 A cross currency transaction is one that consists of a pair of currencies
traded in Forex that does not include the U.S. dollar.
Example: EUR/GBP and EUR/CHF are common cross currency pairs.
DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS
Currency convertibility is the ease with which a Country’s currency can be converted
into another currency as desired by the holder.
The convertibility involves two aspects

1. The rate of exchange should be determined by the market and not by the regulatory
authority and thus the holder does not incur any loss on conversion.
2. There should not be any quantitative restrictions on the repatriation of the currency.

The currency is fully convertible when holder can convert it into any other currency at
rates determined by the forces of demand and supply and without any interference from
the government.
 Remittances on current account represents transactions relating to trade in goods and
services and no reverse flow of funds in future is anticipated (Fully Convertible).
 Remittances on capital account relates to investments , loans etc. These represent the
external debt of the country and reverse flow in the form of interest /dividend and
repatriation of capital is expected.(Not Fully Convertible)
DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS
Current Account Convertibility means that a country's residents can purchase
foreign exchange for the purpose of buying goods and services from abroad without
needing any/minimal permission.
 Current account convertibility implies that the Indian rupee can be converted to
any foreign currency at existing market rates for trade purposes for any
amount.
 It allows easy financial transactions for the export and import of goods and
services.
 Any individual involved in trade can get foreign currency converted at
designated banks or dealers.
 In essence, current account convertibility remains within the trading arena.
 There is easy access to forex for studying or travel abroad
 As a part of liberalization , RBI, enhanced the discretionary powers for
authorized dealers for making various remittances abroad.
DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS
Capital Account Convertibility can be defined as the freedom to convert local financial assets
into foreign financial assets and vice versa at market determined rates of exchange for any
purpose whatsoever without needing any permission from the government.
 CAC is considered to be one of the major features of a developed economy as it helps to
attract foreign investment.
 CAC allows freedom to make investment in foreign equity, extend loans to foreigners and to
buy real estate in foreign lands and vice-versa.
 It results in the most efficient allocation of capital and opens up domestic economy in terms
of capital inflows and out flows.
 Foreign fund flows will be easier thus increasing the availability of large capital stock.
 Offers countries better access to global markets, besides resulting in the emergence of
deeper and more liquid markets.
 CAC brings greater discipline on the part of governments in terms of reducing excess
borrowings and rendering fiscal discipline.
World bank has said that embracing Capital Account Convertibility without necessary
precautions could be absolutely distrusters. DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS

However, the rupee continues to remain capital account non-convertible.

1. Credit rating institutions will play a vital role in decision making by the
investors. The changed view of these institution or changes in the interest/
exchange rate may have a destabilising effect on the portfolio flows.
2. It exposes bank’s liabilities and assets to more price and exchange risks. The
effect of increased volatility of exchange rate will be felt on the bank’s open
foreign currency position.
3. Banks may supplement their domestic deposit base with borrowings from off
shore markets. The volatility in interest and exchange rates can be dangerous to
weak and fragile banks.
4. Fluctuation in interest rate may affect the cost of borrowing for emerging
markets and alter the relative attractiveness of investing in these markets.
5. Real exchange rate volatility may cause currency and maturity mismatches,
creating large losses for bank borrowers.
6. Due to increased competition, the margins for the banks may be reduced.
DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS
The balance of payments(BOP) is an accounting system that records the economic
transactions between the residents and government of a particular country with the
residents and governments of the rest of the world during a certain period of time, usually
a year. Economic transactions include
 Exports and imports of goods and services DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS

 Capital Inflows and outflows

 Gifts and other transfer payments
 Changes in a country’s international reserves

Government: BOP provides valuable information for the conduct of economic policy.
Firms & Individual: BOP provides clues about expectations relating to such matters as the
volume of different types of trade and capital flows , the movement of exchange rates and
the probable course of economic policy.
Externals: Country’s BOP is important to investors, multinational companies , global
business managers, consumers and government officials because it affects the value of its
currency ,its policy towards foreign investments and also influences key macroeconomic
variables like GNP, interest rates, price level, employment scenario and exchange rate.
I. Like other accounting statements, the BOP conforms to the principle of double
entry book keeping. This means that every international transaction should
produce debit or credit entries of equal magnitude.
II. BOP is neither an income statement nor a balance sheet. It is a sources and uses
of funds statement that reflects changes in assets , liabilities and net worth
during a specified period of time.
Rules for Credit & Debit entries:
Credit Entry: An international transaction that leads to a demand for domestic
currency in the foreign exchange market or a transaction that is source of foreign
currency. Exports- US importer purchase Indian currency (Demand for Rupees).

Debit Entry: A transaction that results in the supply of home currency in the
foreign exchange market or a transaction that uses foreign currency .
Imports: Indian importer purchase/make payment i.e. supply of Indian currency
DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS
A. Current Account: The current accounts records all exports and imports of
merchandise, invisible and unilateral transfers.
1.Merchandise: includes agricultural commodities and industrial components.
2. Invisibles: include Services, Income flows
3.Unilateral transfers: Gifts, grants (Both individual and Government)
B. Capital Account: Shows the transactions that involve changes in the foreign
financial assets and liabilities of a country and are three categories,
 Direct Investment: Purchase of stock , acquisition of company, establishment of
new subsidiary.
 Portfolio Investments : Sales and purchases of foreign financial assets such as
stocks and bonds that do not involve a transfer of management control.
 Capital Flows: Claims less than one year like bank deposits , short term loans
etc
C. Reserve Account: (Increase : Debit, Decrease: Credit) Records the transactions
pertaining to reserve or liquid assets such as central bank’s holding of golds,
balances with foreign banks and IMF, Government’s holding of SDRs etc.
DO NOT SHARE THE SLIDES WITH ANYBODY OUTSIDE THE CAMPUS
I. Forex Market provides the physical and institutional structure through which the money of
one country is exchanged for that of another country.
II. Foreign Exchange means the money of foreign country i.e. foreign currency bank balances
, banknotes, checks & drafts.
III. Forex transaction is an agreement between a buyer of one country and a seller of other
country that a fixed amount of one currency will be delivered for some other currency at a
specified rate.
The Foreign Exchange market is a two-tiered market:
I. Interbank Market (Wholesale)
a. About 200 banks worldwide stand ready to make a market in foreign exchange.
b. Nonbank dealers account for about 20% of the market.
c. There are FX brokers who match buy and sell orders but do not carry inventory and
FX specialists.
II. Client Market (Retail)
Participants: Market participants include international banks, their customers, nonbank
dealers, FX brokers, and Central banks.
Currency trading literally extends 24 hours per day. The busiest time of the day, however, is when
New York and London overlap, the world’s most liquid time.
 International commercial banks communicate with one another with:
SWIFT: The Society for Worldwide Interbank Financial Telecommunications.
CHIPS: Clearing House Interbank Payments System
CHAPS: Clearing House Automated Payment System, the first global clearinghouse for
settling interbank FX transactions
Large commercial banks maintain demand deposit accounts with one another which facilitates
the efficient functioning of the FX market.
I. Bank A is in London, Bank B is in New York.
II. The current exchange rate is £1.00 = $2.00.
III. A currency trader employed at Bank A buys £100m from a currency trader at Bank
B for $200m settled using its correspondent relationship.
Bank Bank
$200 M
A B
£100M
London NYC
Today, it is easy to walk into a bank and transfer money anywhere around the globe. But how
does this happen?
SWIFT:(Society for Worldwide Interbank Financial Telecommunications)A system comprising
a vast messaging network used by banks and other Financial Institution to quickly, accurately,
and securely send and receive money transfer instructions, through a standardized code Every
day, nearly 10,000 SWIFT member institutions send approximately 24 million messages on the
network. The member countries are connected to to the centres through regional processor in
each country.
CHIPS UID stands for “Clearing House Interbank Payments System Universal Identifier”, an
electronic clearing house database system, which facilitates the transfer of funds from both
individual consumers and institutions, quickly and accurately. It provides the mechanism for
settlement every day of payment and receipts of numerous dollar transactions among member
banks at New York. The CHIPS UID system has long been the foremost method of moving
U.S. dollars among the world's banks.
CHAPS:(Clearing House Automated Payment System) It is an arrangement similar to CHIPS
that exist in London.
The transactions in the interbank market may place for settlement-
(a) On the same day
Where the agreement to buy and sell is agreed upon and executed on the same date, the
transaction is known as cash or ready transaction. It is also known as value today.
(b) Two days latter
Where the exchange of currencies takes place two working days after the date of the
contract is known as the spot transaction.
(c) Some day late
The transaction in which the exchange of currencies takes place at a specified future
date, subsequent to the spot date, is known as a forward transaction. A forward
contract for delivery one month means the exchange of currencies will take place after
one month from the date of contract.
Spot Rate Quotations: In general, Spot (J/K) will refer to the price of one unit of
currency K in terms of currency J. Spot (Rs /$ = 68.50, mean 1 $ = Rs68.50
I. The Bid (Buy) price is the price a dealer is willing to pay you for
something.(Forex Trader’s Buy Rate-Low)
II. The Ask(Sell) price is the amount the dealer wants you to pay for the
thing. (Forex Trader’s Sell Rate-High)
III. The bid-ask spread is the difference between the bid and ask prices. An
Indian dealer could offer USD 1=68.5025/5035,mean
 bid price of Rs 68.5025 per $
 ask price of Rs 68.5035 per $
IV. The bid-ask spread represents the dealer’s expected profit. If one dollar
bought and sold , the bank make a gross profit of Rs 0.0010.
V. In a foreign exchange quotation, the foreign currency is the commodity
that is being bought and sold.
Cross exchange rate is an exchange rate between a currency pair where neither currency
is the US $.
Example: A Mexican importer imported goods from Japan. He needs Japanese yen to pay.
Both the Mexican peso(MXN) and the Japanese yen (JPY) are commonly quoted against
the US dollar(USD as follows, Japanese yen JPY /USD =112.38
Mexican peso MXN /USD=18.89
The Mexican importer can buy one US dollar for MXN18.89 and with that dollar can buy
JPY112.38. The cross rate calculation would be,
Japanese yen / US dollar 112.38
  JPY / MXN  5.9491
Mexican pesos / US dollar 18.89
The result mean, 1MXN=JPY5.9491
The cross rate could also be calculated as the reciprocal
Mexican pesos / US dollar 18.89
  MXN / JPY  0.1680
Japanese yen / US dollar 112.38

The result mean, 1JPN=MXN0.1680

 A forward contract is an agreement to buy or sell an asset(FX) in the
future at prices agreed upon today.
 When the forward rate and spot rate coincide then it is said to be “At par”.
 But this rarely happens . More often the forward rate for a currency may
be costlier or cheaper than its spot rate.
 The difference between the forward rate and spot rate is known as the
forward margin.
 The forward margin may be either at premium or at discount.
 If the forward margin is at a premium, the foreign currency will be
costlier.
 If discount, the foreign currency will be cheaper.
 In direct quotation, premium is added to spot rate and discount is
deducted from the spot rate.
The market quotation for a currency consists of the spot rate and the forward margin.
For instance, US dollar is quoted as under on 16th July’18
Spot USD 1=Rs68.5000/5200
Spot/August 2000/2100
Spot/Sept 3500/3600

The following points should be noted in interpreting the above quotation,

 The quoting bank’s spot buying rate is Rs 68.5000 and spot selling rate is Rs 68.5200.
 The second and third statements are forward margins for forward delivery during the
months of August and Sept respectively . Spot/August and Spot/Sept rate are valid for
delivery end August and end Sept respectively.
 The margin is expressed in points i.e. 0.0001 of the currency . Therefore the forward
margin for August is 20 paisa for purchase and 21 paisa for sale of foreign currency.
 As the forward margin is in ascending order(2000/2100), it indicates that the forward
currency is at premium.
 The outright forward rates arrived at by adding the forward margin to the spot rate.
The outright forward rates for dollar can be derived from the above quotation,
PARTICULARS BUYING RATE SELLING RATE
August September August September
Spot Rate (16/7/2018) 68.5000 68.5000 68.5200 68.5200
Add: Premium 0.2000 0.3500 0.2100 0.3600
Forward Rates 68.7000 68.8500 68.7300 68.8800

From the above calculation, we arrive at the following outright rates

Particulars Buying Selling
Spot Delivery (USD1) 68.5000 68.5200
Forward delivery August 68.7000 68.7300
Forward delivery Sept 68.8500 68.8800

If forward currency is at a discount, forward margin indicates in the descending order.

Spot(16/7/18) GBP 1 Rs90.6260/6320 Spot Delivery (GBP1) (Buying) 90.6260 (Selling) 90.6320
Spot/August 3800/3600 Forward delivery August 90.6260-0.3800 90.6320-0.3600
Spot/Sept 5700/5400 Forward delivery Sept 90.6260-0.5700 90.6320-0.5400
The difference in rate of interest prevailing at different financial centers(Countries) is a
dominant factor determining forward margin. Other effective factors are demand and
supply of currency, speculation about spot rates and exchange control regulations.
 Rate of Interest: The difference in the rate of interest prevailing at the home center and
the concerned foreign center determines the forward margin.
 Example: Bank has to quote 3 months selling rate to a customer for a Transaction of
US$10,000 when the spot rate for US dollar is Rs68.The interest rate at
Mumbai(MIBOR) is 8%pa and at New York it is 3%.To meet the needs of the customer
, Bank may buy spot $10,000 on spot and deposit them in New York Bank for 3 months
so that he can deliver US$10,000 on due date. The operations involved are
Purchase dollar and invest for 3 months $10,000 Borrow for buying 10k dollar Rs6,80,000
Interest earned @3% for 3 months $75 Interest @6% for 3 months Rs10,200
Amount received after 3 months $10,075 Payment after 3 months Rs6,90,200
Bank Should be able to get Rs 6,90,200 against USD$10,075.Therefore the rate has to be quoted
6,90,200/10,075=68.51. Forward margin can be calculated with the following formula
Spot Rate X Forward Period X Interest Differential / 100 X TIME=68X3X3/100X12=0.51
 Demand and supply:
 If the demand for foreign currency is more than its supply, forward rate would be at
premium.
 If the supply exceeds the demand, the forward rate would be at discount.
 Speculation about spot rates:
 If the foreign exchange dealers anticipate that the spot rate to appreciate(based on a
number of factors), the forward rates would be quoted at premium.
 If they expect the spot rate to depreciate , the forward rates would be quoted at a
discount.
 Exchange Regulations:
 Exchange control regulations may put some conditions on the forward dealings and
may obstruct the influence of the above factors on the forward margin.
 Such restrictions may be with respect to keeping of balances abroad, borrowing
oversea etc.
 Intervention in the forward market by the central bank may also done to influence the
forward margin.
The spot rate of exchange is the outcome of the combined effect of a multiple
of factors constantly at play. The important factors that affect exchange
rates,
Balance of Payments
Inflation
Interest Rates
Money Supply
National Income
Resource Discoveries
Capital Movements
Political Factors
Psychological Factors and Speculation
Technical and Market Factors
 Spot exchange rate (16/4) Rs/$= 68 and three-month forward rate is Rs/$=67.50 (16/7).
Based on your analysis of the exchange rate, you are confident that the spot exchange
rate for Rs/$ on 16/7 will be =67.80 in three months.
Assume that you would like to buy or sell $1,000,000.
A. What actions do you need to take to speculate in the forward market?
B. What is the expected dollar profit from speculation?
C. What would be your speculative profit in Rupee terms if the spot exchange rate
actually turns out to be Rs/$ =67.40?
SOLUTION:
A. Forward cover is the way to mitigate FOREX Risk.
B. If you believe the spot exchange rate will be Rs/$=67.80 in three months, you should
buy $1,000,000 forward for Rs/$=67.50 at a cost, $1,00,000X67.50)= Rs67,50,000
Simultaneously you can sell it at $1,00,000X67.80= Rs67,80,000/
Your expected profit will be:Rs30,000(Rs67,80,000-Rs67,50,000)
C. Instead, if the spot exchange rate actually turns out to be Rs/$=67.40 in three months,
your loss from the position will be: $1,00,000(67.50—67.40) = Rs10,000
 CASE: Shrewsbury Herbal Products, located in central England, is an old-line producer of
herbal teas, seasonings, and medicines. Its products are marketed all over the United Kingdom
and in many parts of continental Europe as well.
Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign
customers in order to guard against adverse exchange rate changes. Nevertheless, it has just
received an order from a large wholesaler in central France for £320,000 of its products,
conditional upon delivery being made in three months’ time and the order invoiced in
euros.
Shrewsbury’s controller, Elton Peters, is concerned with whether the pound will appreciate
versus the euro over the next three months, thus eliminating all or most of the profit when the
euro receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the
firm’s banker for suggestions about hedging the exchange rate exposure.
Mr. Peters learns from the banker that the current spot exchange rate is S(€/£)= 1.4537, thus
the invoice amount should be €465,184. Mr. Peters also learns that the three-month forward
rates for the pound and the euro versus the U.S. dollar are $1.8990/£1.00{F3($/£)=1.8990} and
$1.3154/€1.00{F3($/€)=1.3154}, respectively. The banker offers to set up a forward hedge for
selling the euro receivable for pound sterling based on the €/£ forward cross-exchange rate
implicit in the forward rates against the dollar. What would you do if you were Mr. Peters?
SOLUTION;
I. Suppose Shrewsbury sells at a twenty percent markup. Thus the cost to the
firm of the £320,000 order, is £256,000.
II. Thus, the pound could appreciate to €465,184/£256,000 = €1.8171/£1.00
before all profit was eliminated . This seems rather unlikely.
III. Nevertheless, a ten percent appreciation of the pound (€1.4537 x 1.10) to
€1.5991/£1.00 would only yield a profit of £34,904 (= €465,184/1.5991 -
£256,000).
IV. Shrewsbury can hedge the exposure by selling the euros forward for British
pounds at F3(€/£) = F3($/£) ÷ F3($/€) = 1.8990 ÷ 1.3154 = 1.4437.
V. At this forward exchange rate, Shrewsbury can “lock-in” a price of £322,217
(= €465,184/1.4437) for the sale.
A. The forward exchange rate indicates that the euro is trading at a premium to the
British pound in the forward market. Thus, the forward hedge allows Shrewsbury
to lock-in a greater amount (£2,217) than if the euro receivable was converted into
pounds at the current spot.
B. If the euro was trading at a forward discount or GBP at premium , Shrewsbury
would end up locking-in an amount less than £320,000. Whether that would lead
to a loss for the company would depend upon the extent of the discount and the
amount of profit built into the price of £320,000. Only if the forward exchange
rate is even with the spot rate will Shrewsbury receive exactly £320,000

C. Obviously, Shrewsbury could ensure that it receives exactly £320,000 at the

end of three-month accounts receivable period if it could invoice in £. That,
however, is not acceptable to the French wholesaler. When invoicing in euros,
Shrewsbury could establish the euro invoice amount by use of the forward
exchange rate instead of the current spot rate.

D. The invoice amount in that case would be €461,984 = £320,000 x 1.4437.

Shrewsbury can now lock-in a receipt of £320,000 if it simultaneously hedges its
euro exposure by selling €461,984 at the forward rate of 1.4437. That is,
£320,000 = €461,984/1.4437.
 GOOD
WISHES
TO
ALL