Understanding Foreign Exchange Arithmetic
Forces of demand and supply in the local interbank market drive the exchange rate.
Direct and Indirect Quote
A foreign exchange quotation can be either a direct quotation and or an indirect quotation, depending upon the home currency of the person concerned. For example, $ 1 = Rs. 67.00, means that one dollar can be exchanged for Rs. 67.00. Alternatively, we maypay Rs. 67.00 to buy one dollar. A direct quote is the home currency price of one unit of the foreign currency.
Thus, in the aforesaid example, the quote$ 1 = Rs. 67.00 is a direct quote for an Indian national.
An indirect quote is the foreign currency price of one unit of the home currency. The quote Re. 1 = $ 0.0149 is an indirect quote
Basic Exchange Rate Arithmetic
(a) Cross rate
If a person wants to remit Euros from India, and as a banker, and for argument sake, rupees/Euros are not normally quoted and therefore, we have to first buy dollars against the rupees and the same dollars will be disposed off overseas to acquire the Euros.
(b) Chain rule
Calculation of the cross rate is based on a commonsense approach. However, it can be reduced to a rule known as the chain rule with similar steps.
(c) Value date
The value date is a date on which the exchange of currencies actually takes place. Based on this concept, we have the following types of exchange rates.
(i) Cash/ready: It is the rate when an exchange of currencies takes place on the date of the deal.
(ii) TOM: When the exchange of currencies takes place on the next working day, i.e. tomorrow it is called the TOM rate.
(iii) SPOT: When the exchange of currencies takes place on the second working day after the date of the deal, it is called the spot rate.
(iv) Forward rate: If the exchange of currencies takes place after a period of spot date, it is called the forward rate. Forward rates generally are expressed by indicating a premium/discount for the forward period.
(v) Premium: When a currency is costlier in forward or say, for a future value date, it is said to be at a premium. In the case of the direct method of quotations, the premium is added to both the selling and buying rate.
(vi) Discount: If currency is cheaper in the forward or for a future value date, it is said to be at a discount. In the case of a direct quotation, the discount is (deducted) subtracted from both the rates, i.e. buying and selling rates.
The forward rates are quoted in terms of forward margins or forward differentials. For example:
Spot Euro 1 = US$ 1.3180/90
1 month forward 35-32
2 month forward 72-70
3 month forward 110-107
It is understandable that if a currency is at a premium vis-a-vis another currency, the natural consequence is that the later will be at a discount vis-a-vis the former currency.
In the above exchange rate quotations Euro is at a discount and hence US $ is at a premium. We can buy US $, one month forward at
Euro 1 = US$ 1.3190 (-) 0.0032 = 1.3158
Similarly, we can sell
Euro 1 = US$ 1.3180 (-) 0.0035 = 1.3145
If the rates in Mumbai market are US$ 1 = Rs. 66.8450/545 and rates in London market are US$ 1 = Euros 0.7587 we will get US$ 1 for Rs. 66.8545 and for one US$ we will get Euro 0.7587. Thus, we can form a sort of chain rule as under:
0.7587 Euro = US$ 1
Rs. 66.8545 = US$ 1
1 Euro = Rs. 66.8545 / 0.7587
1 Euro = Rs. 88.1172
If an export customer has a bill for £100,000, the bank has to purchase the £(Pound Sterling) from him and give an equivalent amount in rupees to the customer. Presuming the inter-bank market quotations for spot delivery are as follows:
US$ 1 = Rs. 66.8450/545
The London market is quoting cable (STG/DLR) as
£ 1 = US$ 1.9720/40
The bank has to sell £'s in the London market at US$ 1.9720, i.e. the market's buying rate for £ 1. The US dollars so obtained have to be disposed off in the local inter-bank market at US$ 1 = Rs. 66.8450 (market's buying rate) for US$.
By chain rule, we get:
£ 1 = 1.9720 x 66.8450
= Rs. 131.8183
The precaution which should be taken is that one should know who is the quoting party and who is facing the quote. The thumb rule of the market is that if you ask for a quote, the quoting party will give you a quote and it is for you to do the deal or not to do a deal on the prices quoted. You cannot dictate prices. However, you can ask for a fresh quote.
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