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Management
(CAIIB)
International Banking
(Module A) – PART-I
Foreign Exchange
Tanushree Mazumdar, IIBF
Contents of Module A
Exchange rates
Risk management and basics of
derivatives
Documentary letters of credit
Facilities for exporters and importers
Correspondent banking and NRI
accounts
RBI and exchange control in India, EXIM
Bank, ECGC
Exchange rates
International transaction in cash requires two
distinct purchases
• Purchase of foreign currency
• Purchase of good/service with the FC
Term foreign exchange is used to denote
foreign currency
Foreign exchange market exists to cater to the
demand for foreign currency/currencies
Foreign Exchange Market
Organisational setting within which
individuals, governments and banks buy
and sell foreign currencies
Only a small fraction of daily transactions
in foreign exchange involve trading of
currency
Most foreign exchange transactions
involve transfer of bank deposits
Definition of foreign exchange
Deposits, credits and balances payable in
foreign currency
Drafts, travellers’ cheques, letter of credit or bill
of exchange expressed or drawn in Indian
currency but payable in foreign currency
Drafts, travellers’ cheques, L/Cs, etc. drawn by
banks, institutions or persons outside India but
payable in Indian currency
The above definition is as per FEMA (1999)
Exchange rate (1)
Denotes the price or the ratio or the
value at which one currency is
exchanged for another
Exchange rate is very dynamic
The foreign exchange market is round-
the-clock market due to different time
zones
Major participants- central banks,
commercial banks, forex brokers,
corporations, individuals
Factors affecting exchange rate
Major banks that act as market-makers
always give two-way quotes; gives depth
and volume to the market
Fundamental reasons
Technical reasons
Speculation
Fundamental reasons
Balance of payments->surplus-
>appreciation
Growth rate of the economy-> higher
growth->depreciation of currency
Fiscal policy-> financing of fiscal deficit
influences exchange rate
Monetary policy->loose monetary policy-
> depreciation of exchange rate
Technical reasons
Freedom or restrictions on capital
movements can affect exchange rates to
a large extent
Among other factors there are:
• Huge trade surpluses of oil exporting
countries
• Capital moving from low-yielding currencies to
high yielding currencies (interest differential)
Speculation
Self-fulfilling prophecies
• Anticipation of depreciation of a currency can
cause dealers to sell that currency
Speculation serves to provide depth and
liquidity to the forex market
Acts as a cushion as well- contrarian
traders exist in the market
Types of exchange rate (1)
Ready/cash- Settlement of funds on the
same day (date of the deal).
Tom- Settlement of funds takes place on
the next working day of the date of the
deal
Spot- Settlement of funds takes place on
the second working day following the
date of the deal
Types of exchange rate (2)
Forward- Delivery takes place on any
day after the date of the deal
In the forex market all rates that are
quoted are generally spot rates
When delivery takes place beyond the
spot date then it is a forward transaction
and the forward rate is applicable
Forward rate = Spot rate + Premium (-
discount)
Forward rate
If the forward value of a currency is higher than
the spot value the currency is said to be at a
premium
If the above is reversed the currency is said to
be at a discount
The forward premium/discount is based on
interest rate differentials of the two currencies
involved
Direct and indirect quotes of exchange rate-
direct quote, local currency is variable
Quotes of Exchange Rate
Cross rates- To obtain rates for a
particular currency pair when they are
not available directly
Bid and offered rates- In USD/INR
39.40/41 the bank is bidding for USD at
Rs. 39.40 and offering to sell USD at Rs.
39.41
Exchange Arithmetic
All foreign exchange calculations have to be
worked with care and accuracy and several
rules have to be kept in mind
Chain rule- is used to attain comparison or
ratio between two quantities which are linked
together through another or other quantities.
Equation in the form of a chain is derived.
Per cent and per mille- Per 100 units/per 1000
units
Example of a Chain Rule (1)
Query: If we have to remit French Francs
to France from India how do we go about
it? (We have to arrive at cross rates
between FRF and INR.)
Mumbai interbank market:
• US $ 1 = Rs. 41.2550/2650
London Market
• US $ 1 = FRF 6.0500/6.0550
Chain rule (2)
At what rate can one buy FRF against rupees?
How many Rs----- = FRF 1?
FRF 6.0500 = US $ 1
US $ 1 = 41.2650, therefore,
FRF 6.0500 = US $ 1 = Rs. 41.2650
Hence, FRF 1 = 41.2650/6.0500
Or FRF 1 = Rs. 6.8206
Forward Rate (1)
Value date: It is customary, in foreign
exchange market, to quote a rate to do the
deal but exchange the currencies not on the
same day but generally afterwards.
Forward rate: Has two components
• Spot rate
• Forward points or forward differentials