International Finance FOREIGN EXCHANGE QUOTATIONS
Learning Objectives After completing this chapter, you should be able to understand:
What do you mean by exchange rate quotations Types of rates in terms of settlement Conceptual understanding of Vehicle Currency Significance of cross rates Mechanism
of
different
types
exchange quotations Foreign Exchange Quotations
of
foreign
Structure 5.1 Meaning of Exchange Rate Quotations 5.2 Foreign Exchange Rate Convention 5.3 Classification of Rates : Direct, Indirect and Cross Currency 5.4 Distinction Between Direct rates and Indirect Rates 5.5 Characteristics of Exchange Rates 5.6 Factors Influencing the Spread 5.7 Significance of Spread
Foreign Exchange Quotations
Structure 5.8
Exchange Rate Quotes
5.9
Direct rates to Indirect or Vice Versa
5.10 Vehicle Currency 5.11 Concept of Cross Rates 5.12 Method of % Spread and Cross Rates 5.13 Arbitrage, Speculation and Trading
Foreign Exchange Quotations
Structure
5.14 Bulls vs. Bears 5.15 Arbitrage and Speculation 5.16 Arbitrage Hunt 5.17 Classification of Rates in Terms of Settlement 5.18 Summary 5.19 Self Assessment Questions
Foreign Exchange Quotations
5.1
Meaning of Exchange Rate Quotations
The Forex market comprises of Banks, brokers and central banks providing financial services; SWIFT, CHIPS, CHAPS etc. providing interbank messaging services; and Bloomberg, Dow Jones Newswires, Thomson Reuters etc. providing information services. Foreign Exchange Quotations
5.1
Meaning of Exchange Rate Quotations
The foreign exchange market provides environment for establishing demand and supply equilibrium among different currencies based on which the rate of conversion gets established. These rates are known as ‘Foreign Exchange Rate’ or just ‘Exchange Rate. Thus the rate of exchange for a currency is known from the quotation in the foreign exchange market, a financial center operating in the banking system through electronic network. Foreign Exchange Quotations
5.1
Meaning of Exchange Rate Quotations
SOME IMPORTANT CURRENCIES REGULARLY QUOTED IN INDIA Country
Currency
Abbreviation
Symbol
USA
US Dollar
USD
UK
Pound sterling
Japan
Japanese Yen
JPY
¥
Euro Area
Euro
EUR
€
India
Indian Rupee
INR
`
Switzerland
Swiss Frank
CHF
$ GBP
£
Foreign Exchange Quotations
SFr
5.1
Meaning of Exchange Rate Quotations
SOME IMPORTANT CURRENCIES REGULARLY QUOTED IN INDIA Country
Currency
Abbreviation
Canada
Canadian Dollar
CAD
C$
Australia
Australian Dollar
AUD
A$
Singapore
Singaporean Dollar SGD
S$
Sweden
Swedish Kroner
SEK
SKr
Germany*
Deutsche Mark
DEM
Dm
France*
French Frank
FRF
FFr
*Not in use now. Foreign Exchange Quotations
Symbol
5.2
Foreign Exchange Rate Convention
A foreign exchange rate is a method which provides a relationship between two currencies, i.e. I USD = INR 46.0675 This is usually written as USD/INR 46.0625; where USD is main currency and INR variable one. A rate, therefore, represents the value of the base currency expressed in terms of the variable currency . Each currency pair, therefore, constitutes an individual product. Foreign Exchange Quotations
5.2
Foreign Exchange Rate Convention
ISO 4217 provides unique three letter abbreviations (codes) for each currency which are internationally used. A rate expressed as EUR/USD is the price of Euro expressed in US Dollars, as in I Euro = 1.2835 US dollars. The LHS (Left Hand Side) currency in the pair is base currency and RHS (Right Hand Side) currency is the counter, quoted or variable currency. Representation of rates in this form is called as the ACI convention. Foreign Exchange Quotations
5.2
Foreign Exchange Rate Convention
Exchange rates are represented under different conventions. Some patterns as follows: INR 56.2750 – 56.3400 = I USD INR 56.2750 – 56.3400 per I USD I USD = INR 56.2750 – 56.3400 INR 56.2750 – 56.3400 / USD In this workshop we shall use ISO 4217 abbreviations for currencies and ACI convention for exchange rates. Foreign Exchange Quotations
5.3 Classification of Rates : Direct, Indirect and Cross Currency
A foreign exchange rate which provides relationship between fixed numbers of units of foreign currency against variable number of units of domestic currency is called a direct rate [ Format of expression operative in India since 1993]. Here foreign currency acts as base currency.
A foreign exchange rate which provides relationship between fixed numbers of units of domestic currency against variable number of units of foreign currency is called an indirect rate [ Format of expression operative in India prior to 1993] Here domestic currency acts as base currency Foreign Exchange Quotations
5.3 Classification of Rates : Direct, Indirect and Cross Currency
A foreign exchange rate which provides a relationship between two nondomestic currencies is called a cross currency rate. Quotation
India
USA
Japan
USD/INR
Direct
Indirect
CrossCurrency
INR/USD
Indirect
Direct
CrossCurrency
Direct, Indirect and Cross Currency rates are, therefore, a function of the location and must always be indicated when classifying rates. Foreign Exchange Quotations
5.4
Distinction Between Direct Rates and Indirect Rates DIRECT RATES
INDIRECT RATES
Foreign exchange rates which represent a relationship between a fixed numbers of units of foreign currency against variable number of units of domestic currency
Foreign exchange rates which represent a relationship between a fixed numbers of units of domestic currency against variable number of units of export currency
An example of a direct rate in India would be I USD = INR 54.3825 – 54.3875
An example of an indirect rate in India would be 100 INR = USD 1.86051.8610
Foreign Exchange Quotations
5.4
Distinction Between Direct Rates and Indirect Rates DIRECT RATES
INDIRECT RATES
Direct rates were introduced Indirect rates were used in in India effective from 2nd India effective from 1971 up August , 1993 to 2nd August , 1993 When trading in foreign currency with use of direct rates , the strategy is ‘Buy low – Sell high’
When trading in foreign currency using indirect rates , the strategy is ‘Buy high– Sell low’
In the US market, direct rates are called ‘Rates on American terms’.
In the US market, indirect rates are called ‘Rates on European terms’.
Foreign Exchange Quotations
5.4
Distinction Between Direct Rates and Indirect Rates
DIRECT RATES INDIRECT RATES Direct rates are generally Indirect rates were expressed to expressed in India to the base the base of 100 INR of one unit of foreign currency except Japanese Yen whose relationship is expressed to the base of 100 units An example of quotation on An example of quotation on American terms would be European terms would be 1USD = CHF 1.4950 1.4960 1GBP = USD 1.6675 1.6685 The base currency is always a The base currency is always a foreign currency while variable domestic currency while currency is always domestic variable currency is always currency foreign currency Foreign Exchange Quotations
5.5
Characteristics of Exchange Rates
Forex rates are quoted by banks on two way basis e.g. USD/INR 54.0625 540.675. The LHS rate in quotation is called BID rate and represents the rate at which the bank would buy one unit of the base currency (USD) The RHS rate in the quotation is called ASK or OFFER rate and represents the rate at which the bank would sell one unit of the base currency. (USD) The difference between the ASK and the BID rates , in a given quotation is called spread. Spread = ASK – BID. Since ASK > BID , spread is always +ve Foreign Exchange Quotations
5.5
Characteristics of Exchange Rates
Forex rates are normally quoted up to two or four decimal places. In India the general practice in the interbank market is to quote rates up to four decimal places. Foreign exchange rates are always expressed to the base of 1, 10, 100 or 1000 units of base currency. In India rates are expressed to the base of 1 unit or 100 units of base currency. Unless otherwise specified , an interbank quotation in India is usually valid for USD one million. Foreign Exchange Quotations
5.5
Characteristics of Exchange Rates
Percentage Spread = spread X 100 mean rate ASK – BID X 100 (ASK + BID) 2 ASK – BID ASK + BID
X 200
Foreign Exchange Quotations
or
or
5.6
Factors Influencing the Spread
Factors that influence the spread are Transaction cost (includes brokerage, operating expenses and correspondent bank charges). Volatility in the market (higher the volatility, wider will be the spread and vice versa) Depth of the market (associated with the volume available for covering the transaction. Greater the depth, narrower will be the spread and vice versa) Exchange control regulations. (no limits specified by RBI) Foreign Exchange Quotations
5.7
Significance of Spread to End Users
For end users the correctness of a foreign exchange quotation decreases when the transaction is undertaken in any currency other than the vehicle currency. The spread represents a level of safety for the person making the quotation whereas it represents cost to the person using the quotation. Thus the spread represents the nominal difference between the ASK and BID rates of a quotation whereas the % spread helps compare the correctness of different quotations. Foreign Exchange Quotations
5.8 Exchange Rate Quotes – in short format Rate Quoted in Short Format
Full Format
USD/INR 54.122575
54.122554.1275
USD/INR 54.122525
54.122554.1325 *
USD/INR 54.127525
54.127554.1325
USD/INR 54.125000
54.125054.1300
Effectively only the ‘ASK’ side of the quote is expressed in short form. The two numbers replace the last two decimal places in the ‘BID’ rate and if the resultant rate is equal or less than the bid rate then 1 is added to the previous decimal place. (see *) Foreign Exchange Quotations
5.9
Conversion of Direct Rates to Indirect or Vice Versa
Consider the quotation USD/INR 54.88508900 This is a direct quotation in India. To convert it to Indirect we need to take the reciprocal of this quotation. a 1 Therefore, = b (b/a) indirect quotation would be INR/USD 0.0182200.018218 If we use the convention of quoting rate up to four decimal places both rates will be identical, hence we increase the base quantity to 100. 100 INR/USD 1.82201.8218 We now find that BID rate > ASK rate, which is not logical, so we interchange them to 100 INR/USD 1.82181.8220 Foreign Exchange Quotations
5.9
Conversion of Direct Rates to Indirect or Vice Versa
Effectively when converting a direct quotation to indirect or vice versa , take the reciprocal and interchange sides. Algebraically it can be represented (USD/)GBP) Quotation: 0.5039 – 0.5042 as 1 1 (A/B)BID (A/B) ASK This is called the Direct/Indirect or Inverse Rule. Direct quotation in New York GBP/USD 1.9835 – 1.9845 1 1 (USD/GBP) BID = = = 0.5039 (GBP/USD)ASK 1.9845 1 1 = 0.5042 (USD/GBP) ASK = = (USD/GBP) BID 1.9835 Foreign Exchange Quotations
5.10 Vehicle Currency The International Foreign Exchange Market is an aggregate of individual markets operating in each country. At start of every trading day, value of domestic currency in each country is locally established against any one major universally accepted, international /foreign currency such as USD, GBP, and EUR. The currency is called the ‘vehicle currency’ for that domestic currency. In India w.e.f. from August 1991, USD is the vehicle currency. Foreign Exchange Quotations
5.10 Vehicle Currency When any quotation is required for a currency other than USD, say EUR/INR, then the domestic market provides the EUR/USD cross currency quotation. These two quotations are crossed so as to eliminate USD and provide the required EUR/INR quotation. Rates obtained in this manner are called ‘Cross Rates’ and the method or mechanism is called ‘Crossing’. In each such calculation the vehicle currency gets eliminated and provides the means to connect the domestic currency with all international currencies. Foreign Exchange Quotations
5.10 Vehicle Currency Sometimes transactions are done in currencies for which the bank may not be maintaining any ‘Nostro’ account. In such instances the vehicle currency is used to pay a correspondent who arranges the required currency for the principal bank. Effectively, if the ‘Nostro’ accounts are not maintained in particular currency, then the vehicle currency is used to pay or receive equivalent amount of that currency. Since, the vehicle currency is normally a universally traded currency ; quotation of this currency against most international currencies is easily available. Foreign Exchange Quotations
5.10 Vehicle Currency The currency, therefore, acts as a vehicle to help establish value of the domestic currency against any desired international currency. The factors which influence the choice of vehicle currency are a) Composition of foreign currency reserves of the country. b) Pattern of invoicing import export trade of the country. c) Ready acceptability of the vehicle currency. d) Ready availability of cross currency quotations against the vehicle currency. e) Proportion of use of vehicle currency in invoicing of international trade. Foreign Exchange Quotations
5.10 Vehicle Currency The vehicle currency mechanism is necessary because if rates for various currencies are established against the domestic currency through market forces , then crossing mechanism could be used to create cross currency quotes in the local market providing arbitrage opportunities against international markets This would defeat the fundamental purpose of the foreign exchange market which is to connect the domestic currency to all international currencies. Foreign Exchange Quotations
5.11 Concept of Cross rates The cross currency rates are used in combination with the vehicle currency rate against the domestic currency to establish the value of domestic currency against all international currencies. The process is known as crossing and the resultant exchange rates are ‘cross rates’. Calculation of cross rate quotation would involve two calculations for establishing the bid and ask rates. If two quotations are a/b and b/c, then cross quotation a/c would be calculated eliminating the common currency ‘b’. Foreign Exchange Quotations
5.11 Concept of Cross rates a/c Bid = a/b Bid x b/c Bid Similarly a/c Ask = a/b Ask x b/c Ask Let us see an example. USD/INR GBP/USD
44.7250  44.7300 1.9675 – 1.9685. Calculate GBP/INR.
(GBP/INR) B = (GBP/USD)B X (USD/INR)B
= 44.7250 x 1.9675 = 87.9964 (GBP/INR) A = (GBP/USD)A X (USD/INR)A = 44.7300 x 1.9685 = 88.0510 Therefore, GBP/INR 87.9964 – 88.0510 Foreign Exchange Quotations
5.12
Method of % Spread and Cross Rates
1. Given : USD/INR 44.7250 – 44.7300 Calculate % Spread ASK – BID % Spread = x 200 ASK + BID =
44.7300 – 44.7250 x 200 44.7300 + 44.7250
0.0050 x 200 89.4550 = 0.0112%
=
Foreign Exchange Quotations
5.12
Method of % Spread and Cross Rates
2. Given : GBP/USD mid rate 1.9697 GBP/USD spread 0.0012 Calculate % Spread Spread % Spread = x 100 Mean Rate =0.0012 x 100 1.9697 = 0.0609% Note : Mean rate = Mid rate = Average rate = Flat rate. Foreign Exchange Quotations
5.12
Method of % Spread and Cross Rates
3. Given :
USD/CHF spread 0.0016
USD/CHF mid rate 1.3996 Calculate (a) % Spread & (b) USD/CHF quotation. Spread % Spread = x 100 Mean Rate =0.0016 x 100 1.3996 = 0.1143% (a)
Foreign Exchange Quotations
5.12
Method of % Spread and Cross Rates
Mean Rate = ASK + BID = 1.3996 2 Thus, ASK + BID= 2.7992  (1) Spread ASK – BID= 0.0016  (2) Therefore, 2 ASK= 2.8008  adding (1) & (2) Therefore, ASK= 1.4004  (A) Substituting in equation (2) , we get 1.4004 – BID= 0.0016 So, BID 1.4004  0.0016 = 1.3998
(B)
(b) USD/CHF quotation 1.3998 – 1.4004 &B
Foreign Exchange Quotations
from A
5.12
Method of % Spread and Cross Rates
Alternate method for (b) Spread 0.0016 BID Rate Mean Rate 1.3996 – = 2 = 2 1.3996  0.0008 = 1.3988  x = Spread 0.0016 ASK Rate Mean Rate +
=
2 1.3996 + 0.0008=
1.3996 + 2 1.4004  y
Therefore Quotation USD/CHF 1.3988 – 1.4404 Foreign Exchange Quotations y
from x and
5.12
Method of % Spread and Cross Rates
4. Given : FRF/SEK spread 40pips FRF/SEK flat rate 1.4030 Calculate a) %spread of FRF/SEK b) FRF/SEK quotation c) SEK/FRF quotation Spread (i) % spread =
x 100
Mean Rate 0.0040 = 1.4030 = 0.2851%
x 100
Foreign Exchange Quotations
(a)
5.12
Method of % Spread and Cross Rates
ii)
ASK + BID Mean Rate = x 1.4030 2 Thus, ASK – BID = 2.8060 (x) Spread =ASK – BID = 0.0040 (y) Therefore, 2 ASK = 2.8100 adding (x) and (y) Therefore, ASK =1.4050 (A) Substituting in equation (ii), we get 1.4050 – BID = 0.0040 Therefore, BID =1.4050 – 0040= 1.4010 (B) FRF/SEK quotation : 1.4010  1.4050  from (A) & (B) Foreign Exchange Quotations
5.12
Method of % Spread and Cross Rates
(SEK/FRF)BID = 0.7117
1
=
(FRF/SEK) ASK
=
(SEK/FRF)ASK 0.7138
1
1 = 1.4050 1=
=
(FRF/SEK) BID
1.4010
Therefore, SEK/FRF quotation : 0.7117 (C)
Foreign Exchange Quotations

0.7138
5.12
Method of % Spread and Cross Rates
5. Identify countries in which following are ‘Direct’ quotations and convert them into ‘Indirect’ form (a) 1 GBP = USD 1.9693 – 1.9708 (b) I USD = CHF 1.3688  1.3698 1 1 (USD/GBP)BID = = = 0.5074 (GBP/USD)ASK 1.9708 1 1 (USD/GBP)ASK = = 0.5078 (GBP/USD)BID 1.9693 Foreign Exchange Quotations
5.12
Method of % Spread and Cross Rates
1
1
(CHF/USD)BID = = 0.7300 (USD/CHF)ASK 1.3698 1 1 (CHF/USD)ASK = 0.7306 (USD/CHF)BID 1.3688 Given Quotation
Country Where Direct
Indirect Form
GBP/USD 1.9693 – 1.9708
USA
USD/GBP 0.5074 – 0.5078
USD/CHF 1.3688  1.3698
Switzerland
CHF/USD 0.7300 – 0.7306
Foreign Exchange Quotations
= =
5.12
Method of % Spread and Cross Rates
NOTE: (a) Identification of a country in ‘Direct’ form is done by identifying country of variable currency. (b) The term ‘PIPS’ and ‘POINTS’ can be interchangeably in the context of exchange They represent the last decimal place conventionally expressed exchange rate. represent the smallest increase / decrease rate. Foreign Exchange Quotations
used rates. of a They in the
5.12
Method of % Spread and Cross Rates
NOTE:. b) In Indian foreign exchange market rates are expressed up to four decimal places. Thus one ‘PIP’ would be 1/100 of the small currency unit and 1/10000 of major currency unit. Therefore. INR 46.3825 can be interpreted as Rupees 48, Paisa 38 and 25 pips. c) A ‘Basis Point’ can be defined as the last decimal of a conventionally written interest rate. Interest rates are quoted up to two decimal places. If rate changes from 2.25% to 2.50% then change is 25 basis points. Foreign Exchange Quotations
5.12
Method of % Spread and Cross Rates
6. Given
USD/CAD 1.1595  1.1605 USD/CHF 1.3690 – 1.3700 Calculate USD/CHF quotation. (CAD/CHF)BID
= (CAD/USD)BID x (USD/CHF)BID
rule
1 (USD/CAD)ASK = x 1.3690 1 1.1605 = 1.1797 Foreign Exchange Quotations
Chain
5.12
Method of % Spread and Cross Rates
(CAD/CHF)ASK rule
= (CAD/USD)ASK x (USD/CHF)ASK =
x (USD/CHF)ASK 1 rule (USD/CAD)BID = x 1.3700 1 1.1595 = 1.1815
(CAD/CHF) quotation 1.1797 – 1.1815 Foreign Exchange Quotations
Chain Inverse
5.12
Method of % Spread and Cross Rates
7. Given
USD/SGD 1.5423 – 1.5433 SGD/GBP 0.3323 – 0.3333 Calculate GBP/USD quotation. (GBP/USD)BID rule
= (GBP/SGD)BID x (SGD/USD)BID =
Chain
x Inverse rule 1 1 (SGD/GBP)ASK (USD/SGD)ASK = x 1 1 0.3333 1.5433 = 1.9441 Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates
(GBP/USD)ASK rule
= (GBP/SGD)ASK x (SGD/USD)ASK Chain = x Inverse rule 1 1 (SGD/GBP)BID (USD/SGD)BID = x 1 1 0.3323 1.5423 = 1.9512
GBP/USD quotation: 1.9441 1.9512 Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates 8. Given USD/FRF 5.9970 – 6.0020 USD/SEK 7.0110 – 7.0160 (a) Calculate FRF/SEK quotation. (b) Establish relation between the given & derived quotation in terms of % spread.
(FRF/SEK)BID = (FRF/USD)BID x (USD/SEK)BID rule
=
Inverse rule
1 (USD/FRF)ASK = x 1 6.0020 = 1.1681
x (USD/SEK)BID 7.0110
Foreign Exchange Quotations
(a)
Chain
5.12 Method of % Spread and Cross Rates (FRF/SEK)ASK Chain rule Inverse rule
= =
(FRF/USD)ASK x (USD/SEK)ASK
1 = (USD/FRF)BID x 1 5.9970 = 1.1699
x (USD/SEK)ASK 7.0160
FRF/SEK quotation : 1.1681 – 1.1699 Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates USD/FRF % spread = ASK – BID x 200 ASK + BID 6.0020 – 5.9970 = x 200 6.0020 + 5.9970 0.0050 = x 200 = 11.9990 0.0833%
ASK – BID USD/SEK % spread = x ASK + BID 200 = 7.0160 – 7.0110 x 200 7.0160 + 7.0110 = 0.0050 x 200 = 14.0270 0.0713% Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates FRF/SEK % spread = ASK – BID x 200 ASK + BID 1.1699 – 1.1681 = x 200 1.1699 – 1.1681 0.0018 = x 200 = 2.3380 0.1540% Therefore, % spread USD/FRF + % spread USD/SEK (Approx.) equal to % spread FRF/SEK. Thus, sum of % spread of given quotation is (approx.) equal to % spread of derived quotation. (b) Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates 9. Identify countries in which the following are ‘Indirect’ quotation and convert them into direct form. (a) 1 USD = CAD 1.1610 – 1.1620 (b) 1 EUR = USD 1.3113 – 1.3123 1 1 (CAD/USD)BID = = = (USD/CAD)ASK 1.1620 0.8606 1 1 = (CAD/USD)ASK = = (USD/CAD)BID 1.1610 0.8613 1 1 = (CAD/USD)BID = = (EUR/USD)ASK 1.3123 0.7620 1 1 (CAD/USD)ASK = = = (EUR/USD)BID 1.3113 0.7626 Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates
Given Quotation
USD/CAD 1.161001620
EUR/USD 1.31133123
Country Where Indirect
Direct Form
USA
CAD/USD 0.8606 – 0.8613
EuroArea
USD/EUR 0.7620 – 0.7626
Identification of country in ‘indirect’ form is done by identifying the country of the base currency. Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates 10. The following quote is given 1 USD = INR 44.3630/80 (a) identify the country in which it is a direct quote. (b) Find the mid rate, spread and spread % (c) Calculate the inverse quote. The given quote reconstructed as per ACI convention: USD/INR 44.3630 – 44.3680 (a) The quote would be classified as direct in India. ASK + BID 44.3680 + 44.3630 (b) Mid rate = = = 2 2 44.3655 Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates (b) Spread = 0.0050
ASK  BID =
% Spread = 200
44.3680  44.3630 =
x 200
ASK – BID ASK + BID = x 44.3680 – 44.3630 44.3680 + 44.3630 = x 200 0.0050 88.7310 = 0.0113% Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates (c) 100INR/USD)BID 2.2539
100 x 1 100 x 1 = = (USD/INR)ASK 44.3680
100INR/USD)ASK = 100 x 1 (USD/INR)BID 2.2541
=
=100 x 1 = 44.3630
Inverse quote : 100INR/USD 2.2539 – 2.2541 Note: When INR is the base currency, base units should be 100. Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates 11. USD/INR mid rate of Bank of India is 44.3825 Required spread = 0.0040 Bank of Baroda quotes : GBP/INR 73.3500/00 (a) Calculate USD/INR quotation of Bank of India (b) Calculate GBP/USD cross rate from quotations of Bank of Baroda and Bank of India. Mid Rate  Spread 0.0040 (a) Bid rate = = 44.3825 – 2 2 = 44.3825 – 0.0020 = 44.3805 Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates Mid 0.0040 (a) ASK rate =
Rate
+
Spread = 44.3825 + 2
2 = 44.3825 + 0.0020 = 44.3845 Therefore, Bank of India USD/INR quotation : 44.3805 – 44.3845
(b) (GBP/USD)BID = (GBP/INR)BID x (INR/USD)BID Chain Rule = (GBP/INR)BID x Inverse Rule 1 (USD/INR)ASK = = 73.3500 x 1.6526Foreign Exchange Quotations 1 44.3845
5.12 Method of % Spread and Cross Rates (b) (GBP/USD)ASK = (GBP/INR)ASK x (INR/USD)ASK Rule
= (GBP/INR)ASK x Rule
= 73.3600 1.6530
x
1 (USD/INR)BID 1 44.3805
Chain Inverse
=
Therefore, cross quotation: GBP/USD 1.6526 – 1.6530
Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates 12. Swiss Bank Corporation, Zurich, offers 100INR at CHF 2.7400  10 whereas Union Bank of Switzerland offers USD at CHF 1.2192 – 02. Calculate the effective USD/INR quote using these two quotations. Given quotations reconstructed as per ACI convention would be 100 INR/CHF 2.7400 – 2.7410 for SBC, Zurich. USD/CHF 1.2192 – 1.2202 for UBS, Zurich Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates (USD/INR)BID = (USD/CHF)BID x (CHF/INR)BID Rule
= (USD/CHF)BID x
Chain
Inverse 1 Rule (INR/CHF)ASK = (USD/CHF)BID x Adjust 1x100 for (100 INR/CHF)ASK Base = 1.2192 x 1 x 100 Units 2.7410 = 44.4801
Foreign Exchange Quotations
5.12 Method of % Spread and Cross Rates (USD/INR)ASK = (USD/CHF)ASK x (CHF/INR)ASK Rule
Chain
= (USD/CHF)ASK x
Inverse 1 Rule (INR/CHF)BID = (USD/CHF)ASK x Adjust 1x100 for (100 INR/CHF)BID Base = 1.2202 x 1 x 100 Units 2.7400 = 44.5328
Therefore, effective USD/ INR quotation: 44.4801 – 44.5328 Foreign Exchange Quotations
5.13 Arbitrage, Speculation and Trading ARBITRAGE Arbitrage can be defined as an operation which involves simultaneous purchase and sale of equal quantity of an asset or currency with intention of deriving riskfree profit out of imperfect quotations in one or more markets. An arbitrageur is an entity who identifies an opportunity for arbitrage and derives profit from it. Arbitrageurs are not market makers and, therefore, do not provide any quotations. They only utilize quotations made by others and profit from them. Foreign Exchange Quotations
5.13 Arbitrage, Speculation and Trading ARBITRAGE Arbitrage operations help to equalize prices and remove imperfections. There are no arbitrage possibilities in a perfect market. The volume and profit of arbitrage transactions is market dependent. The arbitrageur does not use his/her assessment in this operation Factors which lead to arbitrage opportunities are i) sudden imbalance in demand supply equilibrium, ii) time zone factors, iii) information arbitrage and iv) exchange control regulations. Foreign Exchange Quotations
5.13 Arbitrage, Speculation and Trading ARBITRAGE The various types of arbitrage can be classified as Arbitrage
Spot Rates 2 – Point Arbitrage
Forward Rates 3 – Point Arbitrage
Interest Rate Arbitrage
2point arbitrage is also called Geographical Arbitrage–it involves 2 currencies 3point arbitrage is also called Triangular Arbitrage – it involves 3 currencies. Foreign Exchange Quotations
5.13 Arbitrage, Speculation and Trading SPECULATION Speculation can be defined as an operation which involves buying and selling of equal amounts of base currency, security or asset at two different times so as to derive profit from favorable rate movement in the interim period. Speculation involves a deliberate acceptance of risk since the anticipated rate movement may not materialize. Speculation may, therefore, result in either profit or loss depending upon the accuracy of speculators’ view or judgment. Foreign Exchange Quotations
5.13 Arbitrage, Speculation and Trading SPECULATION Entities who undertake such operations are called speculators. These entities normally operate contrary to market views and, therefore, help to provide liquidity in the market when critically needed. While the volume of arbitrage operations depends on the opportunities provided by the market, the volume of speculative transactions depends on the resources of the speculators and conviction of their view on rate movements. Speculation requires high technical knowledge of the asset. Foreign Exchange Quotations
5.13 Arbitrage, Speculation and Trading Trading Trading can be defined as an operation involving buying and selling of currencies, securities and assets etc. through a process of continuously quoting two way prices to provide an instant entryexit opportunity to all other participants in the market. Entities who undertake such operations are called traders or dealers. They are market makers since their presence ensures availability of entryexit prices at all times during market hours. Foreign Exchange Quotations
5.13 Arbitrage, Speculation and Trading Trading These entities help to make the market liquid and generally deliver the largest volume of operations in the market. Traders are, therefore, both buyers and sellers at all times and act as ‘buyer’ for all sellers and ‘seller’ for all buyers coming to the market. They provide continuity to the price discovery process. Foreign Exchange Quotations
5.14 Bulls vs. Bears BULLS
BEARS
Bulls can be described as market participants who are optimistic about the performance of the currency. Bulls always anticipate appreciation in the currency.
Bears can be described as market participants who are pessimist about the performance of the currency.
an Bears always anticipate a fall in the value of currency.
Bulls always initiate trading Bears always initiate trading transactions by first buying transactions by first selling currency and thereafter selling it. currency and thereafter buying it. Bulls require monetary resources Bears require commodity for their activity (to first buy) resources for their activity (to first sell) Foreign Exchange Quotations
5.15 Arbitrage and Speculation Arbitrage
Speculation
It is risk free activity
There is a conscious acceptance of risk
Profit per transaction is normally very small.
Profit / loss per transaction is dependent on takeprofit / stoploss levels set by the speculator.
The volume is market dependent i.e. it depends on the opportunities provided by the market. These transactions cannot be initiated by the arbitrageur.
The volume of transactions is dependent on the risk taking capacity, financial resources and conviction of the speculator regarding rate changes.
Arbitrage operations always result Speculation may or may not result in profit in profit. Foreign Exchange Quotations
5.15 Arbitrage and Speculation Arbitrage
Speculation
Arbitrage transactions remove market imperfections.
Speculative transactions provide critical liquidity to the market and reduce volatility.
Personal analytical skill of the arbitrageur not required.
Personal assessment of the speculator plays an important part in this activity.
Arbitrage operations usually take In most cases speculative place with the flow of the market. operations take place contrary to the market trends. Entities undertaking transactions are ‘Arbitrageur’.
such Entities undertaking called transactions are ‘Speculators’.. Foreign Exchange Quotations
such called
5.16 Arbitrage Hunt 1. Given: SBI Bank quotes USD/INR 40.2350 – 40.2400. ICICI Bank quotes USD/INR 40.2425 – 40.2475. Identify and calculate arbitrage gain. The Bid price of ICICI Bank is more than the Ask price of SBI Bank which means that SBI Bank is selling USD at a rate lower than the buying rate of ICICI Bank. The arbitrageur would exploit this imperfection by using the rate of ICICI Bank. He/she will buy USD from SBI Bank and sell it to ICICI Bank. Foreign Exchange Quotations
5.16 Arbitrage Hunt Arbitrage calculations, therefore, involve two steps: (1) Identifying the rates between which arbitrage is possible and (2) quantifying the arbitrage gain on an assumed or given amount of capital. Bid 40.2425> Ask 40.2400. Therefore arbitrage exists. One can assume ` 1 million also. Assume capital USD I million. (principal x identified Bid rate) Arbitrage gain = Identified Ask rate Principal 1,000,000 x 40.2425 =  1,000,000 40.2400 = USD 62.13 per USD I million. Foreign Exchange Quotations
5.16 Arbitrage Hunt 2. Given: Bank (X) GBP/USD 1.9378 1.9388 Bank (Y) GBP/USD 1.9398 1.9404. Identify and calculate arbitrage gain. Bid 1.9398> Ask 1.9388. Therefore arbitrage exists. Assume capital GBP I million. (principal x identified Bid) Arbitrage profit = Identified Ask Principal 1,000,000 x 1.9398 =  1,000,000 1.9388 = GBP 515.78 per GBP I million. Assumed capital should always be reflected in the answer since the net gain is dependent on it. Foreign Exchange Quotations
5.16 Arbitrage Hunt 3. Given: Bank (X) USD/CHF 1.3725 1.3735 Bank (Y) CHF/USD 0.7215 – 0.7225 Identify and calculate arbitrage gain. When two given quotations are in different forms, it is necessary to convert any one of them to make it comparable with the other. Let us convert quote # 2. 1 1 Derived USD/CHF = = 1.3841 – 0.7225 0.7215 1.3860 Given USD/CHF 1.3725 – 1.3735 Therefore, Bid 1.3841 > Ask 1.3735. Arbitrage exists. Foreign Exchange Quotations
5.16 Arbitrage Hunt Assume capital of CHF 1 million (principal x identified Bid) Arbitrage profit = Identified Ask 1,000,000 x 1.3841 = 1.3735 1,000,000 = 0.7225 x 1.3735
 Principal  1,000,000
 1,000,000
= CHF 7705.17 per CHF I million. Foreign Exchange Quotations
5.16 Arbitrage Hunt Note: An arbitrage operation imperfections in market quotations.
involves
using
The arbitrageur does not quote and derived quotations are to be used only for identifying arbitrage possibilities. Calculation of gain/ profit in such transaction should involve only given market quotations. Hence, it is necessary to substitute the derived rate with the original market rate from which it is derived (1.3841 = 1/0.7225) Foreign Exchange Quotations
5.16 Arbitrage Hunt 4. Given: Bank (A) USD/INR 40.1625 – 40.1665 Bank (B) USD/INR 40.1695 – 40.1735 Identify and calculate arbitrage gain if both quotations are valid for USD 1 million only. In real market conditions quotations are valid for specific base currency amounts. When this fact is specified the formula to be used for calculating the gain is : Arbitrage gain =(principal x identified bid)– (principal x identified ask) Foreign Exchange Quotations
5.16 Arbitrage Hunt Bid 40.1695 > Ask 40.1665. exists.
Therefore arbitrage
Assume capital USD 1 million since quotations are valid for this amount. Arbitrage gain =(principal x identified bid) – (principal x identified ask) = (1,000,000 x 40.1695) – (1,000,000 x 40.1665) = INR 3000 per USD 1 million. Foreign Exchange Quotations
5.16 Arbitrage Hunt Note: The gain is computed in variable currency whereas capital is assumed in base currency. Capital
Gain
Base Currency
Base Currency
Base Currency
Variable Currency Variable Currency Base Currency
Variable Currency Variable Currency
Formula (Principal x Bid) Ask  (Principal) (Principal x Bid)  (Principal x Ask) (Principal x Bid) Ask  (Principal) Principal Principal Ask Bid
Foreign Exchange Quotations
5.16 Arbitrage Hunt 5. Given: USD/CHF 1.3705 1.3715  (1) GBP/USD 1.9355 – 1.9365  (2) GBP/CHF 2.6500 – 2.6510  (3) Identify and calculate triangular arbitrage. In such cases use any two of the given quotations to derive a quotation comparable to the third quotation. Taking quotes (1) and (2), above we can derive a GBP/CHF quotation. This we will compare with given quote (3). Foreign Exchange Quotations
5.16 Arbitrage Hunt Derived (GBP/CHF)BID = (GBP/USD)BID X (USD/CHF)BID = 1.9355 x 1.3705 = 2.6526 Derived (GBP/CHF)ASK = (GBP/USD)ASK X (USD/CHF)ASK = 1.9365 x 1.3715 = 2.6559 Therefore, derived GBP/CHF 2.6526 – 2.6559 and given GBP/CHF 2.6500 – 2.6510 Therefore Bid 2.6526> Ask 2.6510. Therefore arbitrage exists. Foreign Exchange Quotations
5.16 Arbitrage Hunt Assume capital GBP 1 million (Principal x identified Bid) Arbitrage profit = Identified Ask (1,000,000 x 2.6526) = 2.6510
 Principal
 1,000,000
(1,000,000 x 1.9355x1.3705) =  1,000,000 2.6510 = GBP 604.58 per GBP million. The result will be the same irrespective of two quotes chosen. Foreign Exchange Quotations
5.16 Arbitrage Hunt 6. Given: USD/CAD 1.1685 1.1695 USD/CHF 1.3785 – 1.3795 CAD/CHF 1.885 – 1.1895 Identify and calculate triangular arbitrage. Derived (CAD/CHF)BID = (CAD/USD)BID X (USD/CHF)BID =
1 x (USD/CHF)BID (USD/CAD)ASK
1.3785 1.1695 = 1.1787
=
Foreign Exchange Quotations
5.16 Arbitrage Hunt Derived (CAD/CHF)ASK = (CAD/USD)ASK X (USD/CHF)ASK 1 = x (USD/CHF)ASK (USD/CAD)BID 1.3795 = 1.1685 = 1.1806 Derived CAD/CHF 1.1787 – 1.1806 & given quotation 1.1885 – 1.1895 Therefore, bid 1.1885 > 1.1806 Therefore arbitrage exists. Foreign Exchange Quotations
5.16 Arbitrage Hunt Assume capital CAD 1 million Arbitrage gain = (Principal x identified Bid) Identified Ask Principal (1,000,000 x 1.1885) =  1,000,000 1.1806 (1,000,000 x 1.1185x1.1685) = 1.3795 1,000,000 = CAD 6714.21 per CAD 1 million. Foreign Exchange Quotations

5.16 Arbitrage Hunt 7. Given: EUR/USD 1.3132 USD/SGD 1.4733 EUR/SGD 1.9332 Identify if triangular arbitrage exists and if so calculate it. Derived EUR/SGD = EUR/SGD x USD/SGD = 1.3132 x 1.4733 = 1.9347 Given EUR/SGD = 1.9332 When only midrates are given then, as per the identifying mechanism, the arbitrageur would sell at the higher price treating it as the market bid rate and buy at the lower price treating it as the market ask rate. Foreign Exchange Quotations
5.16 Arbitrage Hunt Therefore Bid 1.9347 > ASK1.9332. Thus arbitrage exists. Assume capital EUR 1 million (Principal x identified Bid) Arbitrage gain = Identified Ask Principal = (1,000,000 x 1.9347) 1,000,000 1.9332 (1,000,000 x 1.3132 x 1.4733) = 1.9332 1,000,000 = EUR 795.34 per EUR 1 million. Foreign Exchange Quotations
5.16 Arbitrage Hunt 8. Given: Following quotes are provided by three different traders. Trader A 1.6818 – 28 USD per GBP Trader B 6.0025 – 25 SEK per USD Trade C 10.0800 – 00 SEK per GBP Establish if opportunity for arbitrage exists and if so calculate the profit on capital USD 1 million; using synthetic mechanism. Note: (1) when currency of capital is specified the currency cannot be eliminated while deriving quotation comparable to the third quotation. Foreign Exchange Quotations
5.16 Arbitrage Hunt Note: (2) the establishing of arbitrage opportunity by converting 3currency comparison into 2currency comparison is called “Synthetic Mechanism” and the derived quotation called “Synthetic Quotation” Reconstruction given quotes per ACI conventionTrader A : GBP/USD 1.6818 – 1.6828  [1] Trader B : USD/SEK 6.0025 – 6.0125  [2] Trader C ; GBP/SEK 10.0800 – 10.9000  [3] Using quotations [1] & [3] we can derive USD/SEK quotation comparable to quotation [2] Foreign Exchange Quotations
5.16 Arbitrage Hunt Derived (USD/SEK)BID = (USD/GBP)BID x (GBP/SEK) BID
Chain
rule
= rule
=
x (GBP/SEK)BID 1 (GBP/USD)ASK
1 x 10.0800 1.6828
= 5.9900 Foreign Exchange Quotations
Inverse
5.16 Arbitrage Hunt Derived (USD/SEK)ASK = (USD/GBP)ASK x (GBP/SEK) ASK Chain rule
= rule
x (GBP/SEK)ASK 1 (GBP/USD)BID
=
1 x 10.0900 1.6818 = 5.9995 Therefore Derived USD/SEK 5.9900 – 5.5995 Given USD/SEK 6.0025 – 6.0125 Therefore BID 6.0025 > ASK 5.9995 Foreign Exchange Quotations
Inverse
5.16 Arbitrage Hunt Therefore arbitrage exists. Assume capital of USD 1 million.
Profit = Principal X
 Principal
Bid Ask = 1,000,000 x 6.0025 – 1,000,000 5.9995
= x 1.6818 – 1,000,000 x 6.0025 1,000,000 10.0900 = 496 Therefore, Profit on capital of USD 1 million = USD 496 Foreign Exchange Quotations
5.16 Arbitrage Hunt 9. A dealer in Frankfurt quotes : GBP per EUR 0.7330 – 40 JPY per EUR 102.50  50 What is the expected rate for GBP in terms of JPY in London? If actual quote in London is JPY per GBP 142 143, identify and calculate arbitrage gain, if any. Reconstructing quotations per ACI, we get – EUR/GBP 0.7330 – 0.7341 EUR/JPY 102.50 – 103.50 Foreign Exchange Quotations
5.16 Arbitrage Hunt Estimated (GBP/JPY)BID = (GBP/EUR)BID x (EUR/JPY)BID
Chain
rule
x (EUR/JPY)BID 1 rule (EUR/GBP)ASK = x 102.50 1 =
0.7340 = 139.65 Foreign Exchange Quotations
Inverse
5.16 Arbitrage Hunt (GBP/JPY)ASK = (GBP/EUR)ASK x (EUR/JPY)ASK
Chain
rule
=
1 (EUR/GBP)BID
x (EUR/JPY)ASK
Inverse
rule
x 103.50 1 0.7330 = 141.20 Therefore, Derived GBP/JPY 139.65 – 141.20 =
(Estimated)
Given
GBP/JPY
142.00
(Actual)
Therefore, Bid 142.00> Ask 141.20 Foreign Exchange exists. Quotations Therefore, arbitrage opportunity
–
143.00
5.16 Arbitrage Hunt Assume capital of GBP 1 million.
Identified Bid Profit = Principal X Identified Ask Principal 142.00 = 1,000,000 x – 1,000,000 141.20 = 1,000,000 x 142.00 x 0.7330 – 103.50 1,000,000 = 5662 Therefore, Profit on capital of GBP 1 million = GBP 5662 Foreign Exchange Quotations
5.16 Arbitrage Hunt 10. A bank in Mumbai offers to sell USD against INR at USD/INR 44.3800 whereas a bank in the US offers to sell INR against USD at 100 INR/USD 2.2535. Would you undertake the transaction? Note when comparing rates, base currency should be identical. As per available data, we can buy USD @ 44.3800 and we can sell USD @ 1 / 2.2535 x 100 = 44.3754.. Therefore, by undertaking the transaction we would incur a loss as we’ll have to buy @ 44.38 and sell @ 44.3754, so we’ll not undertake it. Foreign Exchange Quotations
5.16 Arbitrage Hunt 11. A Bank in Mumbai quotes USD/INR 44.6300 – 50 whereas a bank in USA quotes 100INR/USD 2.2410 – 15. Identify if any advantage can be derived from these quotes. Quotation (1) : USD/INR 44.6300 – 44.6350 Quotation (2) : 100INR/USD 2.2410 – 2.2415 Quotation (2) has to be reversed to make it comparable. Foreign Exchange Quotations
5.16 Arbitrage Hunt 1 (INR/USD)ASK 1 = x 100 2.2415 = 44.6130 1 = (INR/USD)BID 1 = x 100 (100INR/USD)BID 1 = x 100 2.2410 = 44.6229
(USD/INR)BID =
(USD/INR)ASK
Foreign Exchange Quotations
5.16 Arbitrage Hunt Therefore derived USD/INR 44.6130 – 44.6229 Given USD/INR 44.6300 – 44.6350 Therefore BID 44.6300 > 44.6229 . Therefore arbitrage exists. Assume capital USD 1 million. Identified Bid Arbitrage gain = Principal X  Principal Identified Ask 44.6300 = 1,000,000 X 44.6229 1,000,000 2.2410 = 1,000,000 X 44.6300 X 100 1,000,000 = USD 158 per USD 1 million Foreign Exchange Quotations
5.16 Arbitrage Hunt 12. The following quotations are available in New York. 1 USD = GBP 0.5880 – 90 1 USD = CAD 1.1003 – 13 Calculate the cross currency quotation for 1 GBP in terms of CAD. Following quotation is available in Toronto 1 GBP = CAD 1.8686  95 Identify if arbitrage opportunity exists. Reconstructing the quotes per ACI convention : USD/GBP 0.5880 – 0.5890 & USD/CAD 1.1003 – 1.1013 Foreign Exchange Quotations
5.16 Arbitrage Hunt Derived (GBP/CAD)BID = (GBP/USD)BID x (USD/CAD)BID
Chain
rule
x (USD/CAD)BID 1 rule (USD/GBP)ASK = =
x 1.1003 1 0.5890
= 1.8681 Foreign Exchange Quotations
Inverse
5.16 Arbitrage Hunt (GBP/CAD)ASK = (GBP/USD)ASK x (USD/CAD)ASK
Chain
rule
x (USD/CAD)ASK Inverse 1 rule (USD/GBP)BID = x 1.1013 1 0.5880 = 1.8730 Therefore Derived GBP/CAD 1.8681  1.8730 Given GBP/CAD 1.8685 – 1.8695 Therefore, arbitrage opportunity does not exist as there is no BID > ASK situation required foe the advantage. =
Foreign Exchange Quotations
5.16 Arbitrage Hunt 13. Following quotations are available at a given time. Bank A: 1.3995 – 05 SGD/USD Bank B : 31.5350 – 00 INR/SGD Bank C : 2.2628 – 33 USD/100INR Identify if triangular arbitrage exists and if so calculate it. Reconstructing quotes as per ACI convention, we get USD/SGD 1.3995 – 1.4005  (1) SGD/INR 31.5350 – 31.5400  (2) 100INR/USD 2.2628 – 2.2633 or INR/USD 0.022628 – 0.022633  (3) Foreign Exchange Quotations
5.16 Arbitrage Hunt Derived (USD/SGD)BID = (USD/INR)BID x (INR/SGD)BID
Chain
rule
x 1 1 rule (INR/USD)ASK (SGD/INR)ASK =
=
x 1 0.022633
1 31.5400
= 1.4009 Foreign Exchange Quotations
Inverse
5.16 Arbitrage Hunt (USD/SGD)ASK = (USD/INR)ASK x (INR/SGD)ASK
Chain
rule
x 1 1 rule (INR/USD)BID (SGD/INR)BID = =
x 1 0.022628
1 31.5350
= 1.4014 Therefore, derived USD/SGD 1.4009 – 1.4014 given USD/SGD 1.3995 – 1.4005 Therefore, BID 1.4009 > ASK 1.4005 Foreign Exchange Quotations
Inverse
5.16 Arbitrage Hunt Arbitrage opportunity exists. Assume capital of USD 1 million.
Profit = Principal X Identified Bid Identified Ask Principal 1.4009 = 1,000,000 x – 1,000,000 1.4005 = 1,000,000 x 1 000,000 1.4005 0.022633
x 1 31.5400
= USD 260 per USD 1 million. Foreign Exchange Quotations
–
5.16 Arbitrage Hunt 14. A Bank in New York is quoting USD/CHF 1.2093 – 03 whereas a Bank in Zurich is quoting CHF/USD 0.8197 – 07 If you are a buyer for CHF, from which Bank will you buy?
Purchase and sale should always be viewed from the perspective of the Base Currency. Since the decision is to be taken for CHF, both quotations should be made comparable with CHF as Base Currency. Foreign Exchange Quotations
5.16 Arbitrage Hunt Therefore derived CHF/USD , using inverse rule 1 1 (CHF/USD)BID = = (USD/CHF)ASK 1.2203 0.8195 1 1 = (CHF/USD)ASK = (USD/CHF)BID 1.2193 0.8201
= =
Therefore, derived CHF/USD 0.8195 – 0.8201 (New York)
Given CHF/USD 0.8197 – 0.8207 (Zurich) The selling rate for CHF is lower in the case of bank in New York, which means we should buy CHF in New York. Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. All the exchange rates indicated so far are those that are exchanged and dealt with between banks and are therefore, called Interbank Rates. Rates quoted by banks to their customers are called Merchant Rates and involve an addition or subtraction of Exchange margin which represents the profit margin, transaction handling commission and overhead expenses.
Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. Interbank contracts are settled at interbank rates. Interbank foreign exchange transactions do not involve any pre/post payment of either currency. In all sale/purchase transactions the two currencies are always exchanged on the same calendar date but at two different times. The time difference is due to time zone factors. This concept is called the Principle of Compensated Value. Contract date – the date on which the two counter parties to a foreign exchange contract agree to the currencies to be bought/sold, the rate of conversion, the amount and the settlement date (represented as C). Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. The settlement of any transaction takes place through transfers of deposits between the two contracting parties. The date on which the actual transfer/exchange of currencies takes place is called the settlement date or the value date. To effect the transfers, the correspondent banks in the countries of two currencies involved must be open for business. The concerned countries are called settlement locations. See table next. The settlement of two principal banks involved in the trade are called dealing locations, which need not be same as settlement locations. Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. Contract date
Settlement date
Classification
C
C+0
Cash
C
C+1
Tom
C
C+2
Spot
or
value
today
C
C+3 onwards
or value tomorrow
Forward
Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. CASH CONTRACTS Foreign exchange contracts which provide for settlement on contract date itself are called ‘cash’ or ‘value today’ contracts and the rate applicable to them are called ‘Cash’ or ‘Ready’ rates. Such contracts are represented as C + 0. The rates for such transactions are derived from ongoing spot rates. It is not possible to deal on ‘cash’ basis in all currencies due to time zone limitations. Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. TOM CONTRACTS Foreign exchange contracts which provide for settlement on the first working day after the contract day are called ‘Tom’ or ‘value tomorrow’ contracts and such contracts are represented as C + 1. The rates applicable for such transactions are called Tom rates. Rates for such transactions are derived from the ongoing Spot rate. It is possible to deal on ‘Tom’ basis in all currencies. Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. SPOT CONTRACTS Foreign exchange contracts which involves settlement of currencies on the second working day after the contract day are called ‘Spot’ contracts and such contracts are represented as C + 2. The rate applicable for such transactions is called Spot rate. The Spot rate represents the standard conversion value between a given pair of currencies which is indicative of their relative strength and weakness. The rates for all other settlement maturities are derived from the spot rate by adding or subtracting swap margins. Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. FORWARD CONTRACTS Foreign exchange contracts in which the counter parties agree to a settlement of currencies beyond the ‘spot date’ are called ‘Forward transactions’ or ‘Forward contracts’. The rates applicable for such transactions are called ‘forward rates’. The ‘forward rates are derived from the spot rates by adding or subtracting a factor called ‘Forward Margin’ ‘Forward Margin’ represents the interest differential between the two currencies for given maturity. It is also known as ‘Swap Points’ or ‘Swap Margin” Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. FORWARD MARGINS They can be classified as either PREMIUMS or DISCOUNTS.
When the interest rate of the variable currency is more than the interest rate of the base currency, the forward margin is added to the spot rate to arrive at the forward rate. Such margins are called PREMIUMS on base currency. When the interest rate of the variable currency is less than the interest rate of the base currency, the forward margin is subtracted from the spot rate to arrive at the forward rate. Such margins are called DISCOUNTS on base currency. Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. FORWARD MARGINS The value of a currency is represented by the spot rate. The forward rate being higher or lower than the corresponding spot rate does not signify appreciation or depreciation of the currency. The difference between the forward and the spot rate signifies the compensation being exchanged between the two parties for the difference in the interest rates for the given forward period. Effectively it compensates net opportunity cost in terms of interest rates. Foreign Exchange Quotations
5.17 Classification of Rates in Terms of Settlement. Holgate’s Principle (1) Premium on base currency is always added whereas discount on base currency is always subtracted from the spot rate to arrive at the corresponding forward rate. (2) Premium on base currency implies discount on variable currency and discount on base currency implies premium on variable currency.
Foreign Exchange Quotations
5.18 Summary. The rates quoted in the foreign exchange markets are described in this chapter. Guidelines followed in the banks while quoting in foreign and local currencies are described. FEDAI has issued guidelines on methods of expressing rates of exchange for certain currencies like sterling pound, US dollars, French francs etc. If equivalent amounts of two currencies are known exchange rate of the currencies is calculated using the rule of three. The buying and selling rates are loaded with interest for the transit period, rediscount charges, bank’s own discount charges plus both banks’ commission while opening documentary letter of credit. Foreign Exchange Quotations
5.19 Self Assessment Questions 1. Define Forward Rates. Explain the concept of premiums and discounts in the context of Holgate’s principle. 2. The term ‘Cash Contracts’ does not refer to currencies in physical cash form. Discuss. 3. A market is imperfect without the presence of market makers. Explain the importance of Foreign Exchange Traders. 4. What is Vehicle Currency? 5. Explain the concept of Arbitrage, Speculation and trading. 6. Bulls vs. Bears – describe their comparative features. Foreign Exchange Quotations
Foreign Exchange Quotations
THANKS