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International Finance - 1
Basics
©Anuj G Joshi
Coverage
1. Domestic Currency 2. Exchange Rate 3. Direct Quote 4. Indirect Quote 5. American Term and European Term 6. Bid and Ask 7. Two-way Quote 8. Spread 9. Converting Two-way Quote 10. Cross Rate 11. There is no Single Exchange Rate 12. Spot Rate 13. Forward Rate 14. Appreciation and Depreciation 15. Computing Appreciation and Depreciation Percentage 16. Swap Points 17. Forward Rate, Premium and Discount
©Anuj G Joshi
Rules
1. In any transaction involving foreign currency, you are selling one currency and buying another
2. In an exchange rate, two currencies are involved (a pair) 3. Ina direct quote, the price comes first, the commodity comes next 4. In a direct quote, the foreign currency is the commodity which is being
bought and sold. Price comes first, commodity comes next 5. In an indirect quote, the domestic currency is the commodity which is
being bought and sold; commodity comes first, price next 6. How do you convert a direct quote into indirect or vice versa? Divide 1 by given direct quote. The result is indirect quote Rs 53.02 = €1 Re 1 = 1/53.02 = € 0.02 7. The USA Term Direct American Indirect European
©Anuj G Joshi
8. The bank’s quote of bid and ask is from the banker’s perspective Bid = Buy Ask = Sell 9. In a numerator denominator format, the denominator currency is bought or sold,
as the case may be, in exchange of numerator currency 10. Direct/Indirect conversion A two way quote; take the inverse of each rate (bid and ask) and switch them
around 11.
i. In a direct quote, since the foreign currency is the commodity, if the forward rate is greater than the spot rate, the foreign currency is appreciating and the home currency is depreciating
ii. In a direct quote, if the forward rate is less than the spot rate, the foreign currency is depreciating and the home currency is appreciating
12. In a direct quote, the foreign currency is the commodity and the home currency is the price
13. Commodity DQ IDQ Appreciate Add Deduct Depreciate Deduct Add 14.
i. If Swap Ask > Swap Bid, the foreign currency is appreciating. Hence, add swap point ii. If Swap Ask < Swap Bid, the foreign currency is depreciating. Hence, deduct swap point
©Anuj G Joshi
Formulae
1. Spread = Ask – Bid
2. Bid (Rs/$) = 1/Ask($/Rs)
3. Ask (Rs/$) = 1/Bid ($/Rs)
©Anuj G Joshi
Math Rules
1. Bid (A/B) = Bid (A/C) X Bid (C/B)
2. Ask (A/B) = Ask (A/C) X Ask (C/B)
3. Relationship between Bid and Ask
Bid (A/B) = 1/Ask (B/A)
Ask (A/B) = 1/Bid (B/A)
©Anuj G Joshi
Note 1
Foreign Market Structure
Layer 3
Layer 2
Layer 1 RBI; FEDAI
Bank to Bank
Bank to Customer
Regulator Sub-regulator
Wholesale Market or IB Marker
Retail Market or Merchant Market
IB Rate
Market Rate
Foreign Exchange Dealers’ Association of India
©Anuj G Joshi
Note 2
How to Interpret Forex Transaction in Merchant Deal?
• Always talk w.r.t bank
E.g. If an exporter approaches a bank to sell FC, we will say that bank is buying FC
©Anuj G Joshi
Note 3 Cash Flow movement in merchant transactions
‘P’ Type
Bank
FC HC
Exporter
‘S’ Type
Bank
FC HC
Importer
Purchase for Bank
Sell for Bank
©Anuj G Joshi
How to interpret forex quote in the IB market? $1 = Rs 40.2030/40.2031 Buy Rate (Bid Rate)/Sell Rate (Ask Rate)
Commodity Price i. In the IB market, market rate is quoted up to 4 places after decimal
except for JPY (Japanese Yen) which is quoted only up to 2 places after decimal
ii. Market Maker – The bank which gives quote in the IB market
Market User – The bank which uses the quote for either buying or selling
The bank can either be Marker Maker or Market User
Note 4
©Anuj G Joshi
iii. Interpretation w.r.t. market maker The market maker (or simply market) would always buy at LOW
and sell at HIGH. In the above example, the market is ready to see $1 at Rs 40.2031 and at the same time the market is ready to buy $1 at Rs 40.2030
iv. Interpretation w.r.t. market user The market user can only buy $1 at the market maker’s selling
rate (highest of the quote) and can sell $1 at the market maker’s buying rate (lowest of the rate). The user can do this activity either for its own purpose or on behalf of the customer. When market user does this activity for his own purpose, it is called trading (or speculation) which may result into profit or loss. When this activity is done on behalf of the customer, then the bank will always make profit by loading Exchange Margin [EM].
Note: In exam, the given IB quote is the exchange rate of Market
Maker. And the banker of the customer acts as user bank or market user.
©Anuj G Joshi
v. The difference between Bid Rate and Ask Rate is called SPREAD. In the above example Spread is Rs 0.0001 (0.0001 = 1 PIP)
vi. The market convention is to write low rate on the L.H.S. and high rate on R.H.S.
In academic world, the exchange rate may be given in suppressed form. The L.H.S. data will be given in full and we need to interpret R.H.S. This we will do in the light of RHS data. While interpreting this, always ensure that market convention of writing low rate on LHS and high rate on RHS is maintained.
E.g. $1 = Rs 48.3039/43 $1 = Rs 40.25/27 $1 = Rs 40.99/02
Rs 48.3039/48.3043
Rs 40.25/40.27
Rs 40.99/41.02
©Anuj G Joshi
Note 5
Live Merchant Deal Pricing
SBI
BOB
Exporter
SBI
BOB
Importer
$1=Rs40.2030/35
Market Maker
Market User
MT BOB is buying FC
BOB = Bank of Baroda MR = Merchant Rate IBT = Inter-bank Trade EM = Exchange Margin MT = Merchant Trade
BOB is selling FC $1=Rs40.2030
$1= Rs40.2030 Less: EM Rs00.1000 MR Rs40.1030
BOB is selling FC
BOB is buying FC
$1=Rs40.2035
$1= Rs40.2035 Add: EM Rs00.1000 MR Rs40.3035
MT
IBT IBT
©Anuj G Joshi
Note 6
How to Adjust Exchange Margin in case of Merchant Transactions?
i. For purchase transactions the bank will deduct
exchange margin ii. For sell transactions the bank will add exchange
margin A S Sell Transaction Add
©Anuj G Joshi
Note 7
Accounts Required for settlement of forex transactions
Nostro A/c
My A/c with you
Vostro A/c
Your A/c with us
Loro A/c
©Anuj G Joshi
BOB Mumbai CITI Bank New York
Opens a current a/c in $
1. For BOB Mumbai this a/c is called Nostro a/c (i.e. my a/c with you) 2. For CITI Bank NY the same a/c would be called Vostro a/c (i.e. your a/c with us)
E.G.
©Anuj G Joshi
E.G.
BONY (Bank of New York) opens a Rupee C/A with SBI Mumbai SBI Mumbai will call it what? – BONY will call it what? –
Vostro A/c
Nostro A/c
©Anuj G Joshi
Note 8
Common type of forex transactions in IB market
Transactions are classified under
two things
Date of Transaction
Date of Settlement
Transaction Nomenclature DOS = DOT Cash/TT/Ready DOS = DOT+1BWD TOM DOS = DOT+2BWD SPOT DOS = DOT+>2BWD FORWARD BWD=Business working day (Working day should be opened in both places of transactions. Saturday and Sunday is holiday all over the world and in Middle east and other Muslim countries, even Friday is a holiday.
In the inter bank market, transactions are quoted on a spot basis and all other inter bank transactions (Cash, Tom, Frwd) are derived.
©Anuj G Joshi
E.G.
DOT DOS Type of transaction(?)
22.06.09 24.06.09
(Monday)
22.06.09 25.06.09
22.06.09 28.08.09
22.06.09 22.06.09
22.06.09 23.06.09 Tom Cash/TT/Ready
Forward
Forward
Spot
©Anuj G Joshi
E.G.
DOT DOS for Spot transaction(?)
Thursday
[deal between
India & Dubai]
Tuesday
Logic: Friday is holiday in Dubai, Sat and Sun is holiday both in India and in Dubai. Spot transaction is Transaction day+2 business working days. 2 clear days are Monday and Tuesday. Hence settlement will be on Tuesday.
©Anuj G Joshi
Note 9
Forex Quote Style
Direct Quote 1 unit of FC = how many units of HC
e.g. $1 = Rs 48 • Direct quote for India
• Indirect quote for USA
Indirect Quote 1 unit of HC = how many units of FC
e.g. Rs 1 = $0.0208 • Indirect quote for India
• Direct quote for USA
This is a localized definition
©Anuj G Joshi
E.G.
What type of quote is this?
£1 = $1.5020
Localized definition fails to categorise this kind of quote where HC is not available
©Anuj G Joshi
International Definition
Direct quote 1 unit of $ = how many units of Rest of the world (ROW)
(for ROW)
Indirect quote 1 unit of ROW = how many units of $
(for ROW)
©Anuj G Joshi
Take same example as previous E.G. What type of quote is this? £1 = $1.5020
Indirect Quote
©Anuj G Joshi
Two Types of Quote
European Style of Quote American Style of Quote
[Europe indicates ROW]
(Currency of ROW will be ($ will be in price side)
in price side)
1unit of $ = how many units 1unit of ROW = how many of ROW units of $
When the name of a country or continent is attached with the name of exchange rate, then the currency of that country or continent will vary (i.e. will be in the price side)
©Anuj G Joshi
E.G.
Quote Style(?)
£1 = $1.3020
$1 = €0.9350
American Style
European Style
©Anuj G Joshi
E.g.
An Indian Bank wants to fund their Nostro A/c with a US
correspondent bank by $500000 against INR when IB rate is $1=INR 47.20/50. The deal is struck and overseas bank’s Vostro A/c that is being maintained with Indian bank will be credited by how much?
Soln, i)Base Currency (Unit currency) ii)Requirement iii)Given Rate iv)Relevant Rate
Buying $
$1=INR 47.20/47.50 [Always talk w.r.t base currency]
$
The given rate in the question is of the market maker
$1=INR 47.50 ©Anuj G Joshi
Logic:
The $ can be bought at the market selling rate which is highest of the quote.
Answer:
500000 X 47.50 = Rs 23750000
©Anuj G Joshi
$1=INR 44.50/44.70
$
Buying Rs
Selling $
Restate the requirement w.r.t to base currency
$1=INR 44.50
E.G.
A NY bank wants to fund their account called Nostro with an Indian bank by Rs 10 million. What $ amount the NY bank would deposit in the Indian Bank’s account called Vostro maintained in NY when IB rate is $1 = INR 44.50/70
Soln,
Expanded form of quote:
Base Currency:
Requirement:
Required Rate:
©Anuj G Joshi
Logic:
The $ can be sold at the market buying rate which is lowest of the quote.
Answer:
This amount of $ would be deposited in Indian Bank’s Nostro a/c by the NY bank and in turn Indian bank will deposit Rs. 10 million to the Nostro a/c of NY bank
10 million/44.50 = $ 224719.1011
©Anuj G Joshi
E.g.
A Corporate customer of Bank “B” receives an inward remittance of $50000
when IB spot rate is $1=INR 44.40/50 and bank margin is 0.25%. What is the rate the bank will quote to the customer?
Soln,
Relevant Rate:
Answer:
$1=44.40 [Since Inward Remittance is buy transaction for bank, the relevant rate in the IB market would be buy side rate]
Rate 44.40 Less: Margin @ 0.25% 00.11 Market Rate 44.29
©Anuj G Joshi
$1=Rs 46.95/47.10
$1=Rs 47.10
[Since Outward Remittance is sell transaction for bank, the relevant rate in the IB market would be sell side rate]
Rate 47.10 Add: Margin @ 0.20% 00.09 Market Rate 47.19
E.g.
Mr. X a valued customer engaged in import business is in spot need to remit
$10 Lacs to a US exporter. What rate you as a banker will quote to Mr. X when IB spot rate is $1 = Rs 46.95/10 and bank margin is 0.20%?
Soln.
Expanded form:
Relevant Rate :
Answer:
©Anuj G Joshi
Note 10
CROSS RATE
It is an exchange rate in which neither currency is USD
E.g. £1 = Rs 80.50
©Anuj G Joshi
Currencies
• INR = Rs • GBP or STG = £ • EUR = € • AUD = Australian Dollar • SGD = Singapore Dollar • DEM = Deutch Marc • FRF = Franc • ITL = Italian Lira • JPY = Japanese Yen
Now these countries use EURO
©Anuj G Joshi
E.G.
Mumbai IB Rate $1 = Rs 43.2550 – 43.2650
London IB Rate $1 = FRF 6.0500 – 6.0550
Case 1: An importer wants to buy FRF against INR what rate bank should quote [Assume EM = 0]
Case 2: At what rate bank should quote an exporter if the exporter wants to sell FRF and buy INR
©Anuj G Joshi
Soln.
CASE 1
Step 1 Mumbai IB Market
Action: Sell INR and Buy Dollar
The $ is base currency therefore talk w.r.t $. The $ can be bought at the market selling rate which is highest of the quote.
The relevant rate is $1 = 43.2650 ----(i)
©Anuj G Joshi
Step 2 Sell $ and buy FRF
The base currency is $. The $ can be sold at the market buying rate which is lowest of the quote.
The relevant rate is $1 = FRF 6.0500 ----(ii)
From (i) and (ii)
FRF 6.0500 = Rs 43.2650
FRF 1 = Rs 43.2650/6.0500
FRF 1 = Rs 7.1512 (Round off at 4th place)
©Anuj G Joshi
CASE 2
Step 1 London IB Market
Action: Sell FRF and Buy $. $ can be bought at the market selling rate which is highest of the quote.
$1 = FRF 6.0550
©Anuj G Joshi
Step 2 Mumbai IB Market
$ can be sold at the market buying rate which is lowest of the quote
$1 = Rs 43.2550 ----(ii)
From (i) and (ii)
FRF 6.0550 = Rs 43.2550
FRF 1 = Rs 43.2550/6.0550
FRF 1 = Rs 7.1437 (rounded off at 4th place)
©Anuj G Joshi
E.G. May 05 Jan 28, 2005 an importer customer requested a bank to remit
SGD 25 Lacs under an irrevocable LC Points to remember • Merchant Transaction • For bank this is a sale
Due to Strike, the bank effected remittances on Feb 04, 2005 IB Rates Jan 28 Feb 04 Bombay $1 Rs45.85/45.90 45.91/45.97 London £1 $1.7840/1.7850 $1.7765/1.7775 £1 SGD 3.1575/3.1590 SGD 3.1380/3.1390 EM = 0.125%. Customer loss/gain?
Extra Information
©Anuj G Joshi
Calculation for Jan
Step 1 Buy Dollar
The $ can be bought at the market selling rate which is highest of the quote
$1 = Rs 45.90
Step 2 Buy Pound
£ can be bought at the market selling rate which is highest of the quote
£1 = $ 1.7850
$1 = £1/1.7850
©Anuj G Joshi
Step 3 Sell £
Pound can be sold at the market buying rate which is lowest of the quote
£1 = SGD 3.1575
£1/1.7850 = SGD 3.1575 X (1/1.7850)
Rs 45.90 = SGD 3.1575 X (1/1.7850)
SGD 1 = Rs 45.90/[3.1575 X (1/1.7850)]
= Rs 25.9482
©Anuj G Joshi
The Rate to be quoted to the customer SGD 1 Rs 25.9482 Add: EM @ 0.125% Rs 0.0324 Rs 25.9806 Similarly we can calculate Exchange rate (in IB
Market) (45.97 X 1.7775)/3.1380 =26.0394 Add: EM @ 0.125% = 0.0325 26.0719 Loss = (26.0719-25.9806) X 25L = 2.2825 Lacs
©Anuj G Joshi
Short-Cut For Cross Rate
• Case 1 Common currency on the base side E.g. $1 = Rs 45.20/45.30 $1 = CHF 1.2030/1.2040 Common Currency is $ Location of Common Currency is on the base side Rule: Divide across by the currency which is going to be the base in the cross rate CHF/Rs = 45.20 45.30 Base/Price 1.2040 1.2030 = 37.5415/37.6559 Rs/CHF = 1.2030 1.2040 Base/Price 45.30 45.20 = 0.02656/0.02664
©Anuj G Joshi
Short-Cut For Cross Rate
• Case 2 Common currency on the price side E.g. £1 = $1.5060/70 CHF 1 = $0.8020/30 Common currency = $ Location of $ is on the price side Rule: Divide across by the currency which is going to be the price in the cross rate £/CHF = 1.5060 1.5070 Base/Price 0.8030 0.8020 =1.8755/1.8791 CHF/£ = 0.8020 0.8030 Base/Price 1.5070 1.5060 = 0.5322/0.5332
©Anuj G Joshi
Concept of Inverse Rate
E.G a) $1 = Rs 48 Re 1 = $1/48 b)$1 = Rs 48.50/48.60 Re 1 = 1 1 48.60 48.50 = 0.02058/0.02062 Concept: Ask Rate and Bid Rate will be inversed once the
currencies are interchanged from price to base and vice versa
©Anuj G Joshi
Short-Cut For Cross Rate
• Case 3 Common currency on the base side as well as price side. We can either go to Case 1 or Case 2 by using Concept of Inverse Rate E.g. $1 = Rs 50.2025/30 £1 = $1.6020/30 Common currency = $ The $ is on the base side as well as price side Applying Inverse Rate Concept $1 = £ 1 1 1.6030 1.6020 £/Rs = 50.2025 50.2030 Base/Price 1/1.6020 1/1.6030 = 80.4244/ 80.4754 Rs/£ = 1/1.6030 1/1.6020 Base/Price 50.2030 50.2025 = 0.012426/0.012434
©Anuj G Joshi
Note 11 Base Rate Vs Cover Rate They are essentially IB spot rate. The word covered means exactly opposite transactions in IB market E.G If bank has bought FC in merchant deal, the cover operation would be selling FC Remember, if bank does cover operation first in IB market then the cover rate
and base rate are same [we should assume this unless otherwise specified] If merchant deal is done first, then cover operation is taken, the cover rate and
base rate would be different
BASE RATE
• Base Rate is the IB spot rate which forms the basis for calculation of merchant rate.
COVER RATE
• Cover Rate is IB spot rate at which merchant transactions are covered in the IB market.
©Anuj G Joshi
• MAFA Nov 05 Q4(c)
You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at Rs. 5.70 & covered yourself in London market on the same day, when the exchange rates were US$1=H.K.$7.5880 7.5920
Local inter bank market rates for US$ were Spot
US$1=Rs.42.70 42.85
Calculate cover rate & ascertain the profit or loss in the transaction ignore brokerage.
Merchant rate
This must have been calculated using spot rate and EM
©Anuj G Joshi
Concepts tested in this question • Cross Rate • Cover Rate • Merchant Rate (Exchange Margin) Given, Merchant Rate HKD 1 = Rs 5.70 Cover Operation What bank will do? Buy HKD in the IB market on spot basis against Rs [because it has sold HKD in the merchant deal.]. Cross Rate Common Currency = $ Location of common currency is on base side HKD/Rs = 42.70 42.85 7.5920 7.5880 = 5.6243/ 5.6471 Not required The bank has to buy HKD in IB market and it can do so at the rate at which the market is ready to sell HKD
which is highest of the quote Gain = (5.70 – 5.6471) X 100 Lacs = (0.0529) x 100 Lacs = 5.29 Lacs
©Anuj G Joshi
Note 12 • Appreciation (↑ of value) Revaluation • Depreciation (↓ of value) Devaluation Always talk appreciation or depreciation w.r.t. base currency. o Appreciation Depreciation Market determined [that means
market force (demand and supply) will decide which currency will appreciate or depreciate]
o Revaluation Devaluation This is forced by regulatory authority
% change in value of the currency = New value – Old value Old value
©Anuj G Joshi
E.g.
Jan 2007 Sept 2007
$1 = Rs 50 $1 = Rs 39
% decrease in the value of $ = 39 – 50
50
= -22% Per annum decrease in the value of $ = -22% X 12
9
= 29.33%
The $ has depreciated by 22% during 9 month period
©Anuj G Joshi
Note 13
Can we say that appreciation of one currency is exactly equal to depreciation of another currency?
No. [But approximately yes]
©Anuj G Joshi
E.g.
t = 0 t = 1
£1 = $2.00 £1 = $1.80
% change in the value of £ = 1.80 – 2.00
2.00
= -10%
The £ has depreciated by 10%.
Now we want to check how much $ has appreciated
t = 0 t = 1
$1 = £1/2 $1 = £1/1.80
= £0.5000 = £0.5556
% change in the value of $ = 0.5556 – 0.5000
0.5000
= 11.11%
This difference in the result of appreciation of currency and depreciation of another currency is called Siegel’s Paradox.
We now know that appreciation of one currency is approximately equal to deprecation of another currency but not exactly. In exam, we can do approximation if required but we need to state that we have ignored impact of Siegel’s Paradox. ©Anuj G Joshi
Note 14
What is ACI Convention? ACI Association Combiste International The exchange rate between two currencies are written as
under First Currency and Second Currency are written in three
letters each and they are separated by an oblique (/) The first currency is the base currency and second currency is
the price currency E.g. USD/INR 40.2030/31 First currency/Second currency or Base currency/Price or quote currency
©Anuj G Joshi
Note 14
In academic world the ACI convention may not be followed. The possible styles are
i) Style 1 a) $1 = Rs 40.25/26 ↓ ↓ Base Currency Price or quote
b) 120 JPY/USD The Unit currency is the base currency
↓ ↓ Price or quote/Base Currency
ii) Style 2 INR/USD 45.20/45.25 As per ACI convention INR should be the base. However, if we know
the market parity, give preference to market parity over ACI Convention.
©Anuj G Joshi
Note 15
How to decide Market Parity?
£1 = Rs 80
€1 = Rs 62
$1 = Rs 50
All other currencies can be
taken as weaker than $
For interpreting exchange rate between $ and € or £, if the value is more than one then $ is the price currency and vice versa
In this case, if the exchange rate value is more than 1 then $ is the base currency and vice versa
©Anuj G Joshi
E.g. i) USD/STG 1.6230/31 Base STG Price USD As per ACI convention, USD is the base currency but based on market
parity, STG is the base currency. And the market parity is given preference.
1 STG = 1.6230/31 USD ii) DEM/USD 0.9030/31 Base DEM Price USD Base currency and price currency will be same in both ACI convention
and Market parity
©Anuj G Joshi
iii) USD/INR 0.02310/0.02315 Base INR Price USD As per ACI convention, USD is the base currency but
based on market parity, STG is the base currency. And the market parity is given preference.
iv) USD/INR 2.3104/10205 Base INR [base currency with 100 as unit] Price USD v) €/$ €0.9020/21 Base $ Price € [Given in the quote]
©Anuj G Joshi