Purchase and Sale Transactions:
The transaction in foreign exchange market is synonymous with commodity market. While a trader has to purchase goods from his suppliers which he sells to his customers, in a similar way the bank which is authorized to deal in foreign exchange purchases as well as sells its commodity—the foreign currency. Therefore, the foreign currency can be considered as a commodity in foreign exchange dealings.
Whenever we talk about foreign exchange two points need to be kept in mind viz., the transaction is always from the bank’s point of view; and the item referred to is the foreign currency. Therefore, when we say a purchase, we imply that the bank has purchased; and it has purchased foreign currency. Similarly, when we say a sale, we imply that the bank has sold; and it has sold foreign currency. In a purchase transaction the bank acquires foreign currency and parts with home currency. In a sale transaction the bank parts with foreign currency and acquires home currency.
Methods of Quotation:
The exchange rate may be quoted in two ways. Direct quotation or home currency quotation and Indirect quotation or foreign currency quotation. For instance, a fruit vendor may express the price of apples in either of the following two ways:
One apple costs Rs.10
For Rs.100, 10 apples
In both the case the value of apple or the rupee is the same though expressed differently .In method I, the price per apple is quoted in rupees. In method II, the unit of rupees kept constant at 100, and the quantity of fruits is varied to reflect their prices.
The same is also true for foreign currency. In foreign exchange also the rate of exchange can be quoted in two ways:
USD 1= Rs.43.20 or USD 1=43.30
Rs.100 = USD 2.3409 or Rs.100 = 2.3200
The quotation under Method I, in which exchange rate is expressed as the price per unit of one US dollar in terms of the home currency is known as ‘Home Currency Quotation’ or ‘Direct Quotation’. It may be noted that under direct quotation the number of units of foreign currency is kept constant and any change in the US dollar quoted at under different values of rupees.
Under Method II, the unit of home currency is kept constant and the exchange rate is expressed as so many units of foreign currency for a fixed unit of home currency is known as ‘Foreign Currency Quotation’ or ‘Indirect Quotation’. Under indirect quotation, any change in exchange rate will be effected by changing the number of units of foreign currency. For instance, the rate Rs.100=USD 2, 3400 may become in due course USD 2.2450 or USD 2.3785, and so on.
The indirect quotation is used in London foreign exchange market. In New York and other foreign exchange markets mostly the direct method is in vogue. In India, earlier we had used indirect method. However, from August 2, 1993, India has switched over to direct method of quotation. The change has been introduced in order to simplify and establish transparency in exchange rates in India.
TRANSACTIONS UNDER DIRECT AND INDIRECT QUOTATIONS:
Under direct quotation the bank buys the foreign currency at lower price and selling it to a customer at a higher price. For instance a bank may buy US dollar at Rs.46 and sell at 46.20 and thus book a profit. Therefore, under direct quotation the maxim is buy low; Sell high.
In the case of indirect quotations, while buying, the bank would acquire more units of foreign currency for a fixed unit of home currency and while selling part with lesser units of foreign currency for more units of home currency. Therefore, the maxim under indirect quotation is buy high and sell low.
TWO WAY QUOTATIONS:
The first area of mystique in foreign exchange quotations arises from the fact that there are two ways of quoting rates; the direct quote and the indirect quote that we already discussed. The former gives the quotation in terms of the number of units of home currency necessary to buy one unit of foreign currency. The latter gives the quotation in terms of the number of units of foreign currency bought with one unit of home currency.
Foreign exchange dealers quote two prices, one for selling and the other for buying. Therefore, in the foreign exchange market; quotations are always for both buying and selling. For instance a bank may quote its rate for dollars as follows:
One US dollar=Rs.46.57- 46.75 or Rs.100=USD 2.2432- 2.2768. While in the case of One US dollar=Rs.46.57- 46.75 the first Rs.46.57 is the buying rate, the second 46.75 is the selling rate. On the other hand in the case of Rs.100=USD 2.2432-2.2768, the bank agrees to sell at the rate of USD 2.2432 for Rs.100, the bank is willing to buy at USD 2.2768 for Rs.100. The buying rate is known as the bid rate and the selling rate is known as offer rate.
Continental European dealers normally quote via the direct method. In London dealers use the indirect method. In the US, both quotation methods are used. When a bank is dealing with a customer within the US direct quotation is given but when dealing with other banks in Europe (except the UK) the indirect quotation is used. Foreign exchange dealers quote two prices: the rate at which they are prepared to sell a currency and that at which they are prepared to buy. The difference between the bid rate and the offer is the dealer’s spread which is one of the potential sources of profit for dealers. Whether using the direct quotation method or the indirect quote, the smaller rate is always termed the bid rate and the higher is called the offer or ask rate.
The size of the bid/offer spread varies according to the depth of the market and its stability at any particular time. Depth of a market refers to the volume of transactions in a particular currency. Deep markets have many deals, shallow markets have a few. High percentage spreads are associated with high uncertainty and low volume s of transactions in a currency. Lower spreads are associated with stable, high volume markets. Deep markets usually have narrower spreads than shallow one.
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