In foreign exchange transactions the transactions are not completed on the same date. The actual exchange of currencies may take place at different time periods For instance let us suppose that there are two banks in the foreign exchange transaction. Bank of India agrees to buy from Bank of Baroda, British pounds one lakh. The actual exchange may take place (1) on the same day or (2) two days later or (3) Some day late say after a month. In case 1.where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as ‘cash transaction’. It is also known as ‘value today’. In case 2, if the settlement takes place, within two days, the rate of exchange effective for the transaction is known as spot rate. In case 3, while the delivery and payment takes place after a month, then the transaction in which the exchange of currencies takes place at a specified future date is known as forward transaction. The forward transaction is an agreement between two parties requiring the delivery of some specified future date of a ?specified amount of foreign currency by one of the parties against payment in domestic currency by the other party at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transaction is known as forward market.
A cross rate may be defined as an exchange rate which is calculated from two (or more) other rates. Thus the rate for the Deutschmark to the Swedish crone will be derived as the cross rate from the US dollar to the Deutschmark and the US dollar to the crone. The practice in world foreign exchange market is that currencies are quoted against the US dollar. If one bank asks another bank for its Deutschmark rate, that rate will be quoted against the US dollar unless otherwise specified. Most dealings are done against the US dollar hence it follows that the market rate for a currency at any moment is most accurately reflected in its exchange rate against the US dollar. A bank that was asked to quote sterling against the Swiss franc would normally do so by calculating this rate from the sterling/dollar rate and the dollar/Swiss franc rate. Thus, the cross rates would be used to determine the quotations.
This could be explained with the help of an illustration. Let us suppose that we require a quote for Swiss francs against the Deutschmark. The quotation which we would receive was derived through the quote of both currencies against US dollar. If these rates against the dollar were $1=Sfr 1.1326/1.1336 and $1=DM1.3750/1.3755, it would be possible to derive the cross rate for the Swiss franc against Deutschmark. Our aim is to derive the selling and buying rates for Swiss francs in terms of Deutschmarks. If we are selling Swiss francs we will be buying Deutschmarks. So we begin with the rate for selling Swiss francs and buying dollars; we then move to selling dollars and buying Deutschmarks. The amalgamation of these two rates gives us the rate for selling Swiss francs and buying Deutschmarks. The rate for selling Swiss francs to the dealer and buying dollars is Sfr 1.1336; the rate for selling Swiss dollars and buying Deutschmarks is DM 1.3750. So selling $0.8822 gives DM1.2120. Thus the rate for selling Swiss francs and buying Deutschmarks is Sfr 1=DM 1.2130, or DM1=Sfr 0.8244.
Example: Let us assume that the inter bank rate for US dollar to Indian rupee is $1=Rs.34.2400 – 34.2600 and the rates in the inter bank for US dollar and French franc are $1=French fr 4.9660 -4.9710. From the above information we can arrive at the rupee franc rate as follows:
In the first instance the customer buys US dollar from the market in India at $1 selling rate of Rs.34.2600.The US dollar thus acquired is disposed off in theLondon market for French franc at the market buying rate $1=French franc4.9660. Therefore the rupee franc rate is:
French franc 1= 34.2600/4.9660=6.8989.
Rounded off to Rs. 6.8990.
Cross rates and Chain rule:
The fixing of rate of exchange between the foreign currency and Indian rupee through the medium of some other currency is done by what it is known as ‘Chain rule’. The rate thus obtained is the ‘Cross rate’ between these currencies. For example, let us assume that in the inter bank market dollar is quoted at Rs.42.50 and at Singapore market dollar is quoted at CHF 1.8000. From this information the rate of exchange of Swiss Franc in terms of rupees may be calculated as follows:
? RS =CHF 1 ………….. (1)
If CHF 1.8000 =USD 1 ………….. (2)
And USD 1 =Rs.42.50 ……… (3)
It should be noted that the currency which appears as the second item (righ]t hand side) in the first equation appears as first item (left hand side) in the next equation. Thus franc appears on the right hand side in the first equation left hand side in the second equation. US dollar which appears on the right hand side in the second equation appears on the left hand side in the third equation. The rate of exchange between Indian rupee and Swiss franc can be calculated by dividing the product of the right hand side by the product of the left hand side.
42.50 x 1 x 1
Ready Rates Based on Cross Rates:
In the international foreign exchange market, the exchange rates for other currencies are quoted in the basis of the rates for the currency in terms of US dollar. They have to be converted into rupee terms before quoting to the customers.
Exchange quotations in international markets:
With a few exceptions, in the international markets, all rates are quoted in against US dollar. For instance, at Singapore Swiss Franc may be quoted at 1.5425/5440 and Japanese Yen at 104.67/70. This should be understood as:
USD 1 = CHF 1.5425 – 1.5440
USD 1 = JPY 104.67 – 104.70
While interpreting an international market quotation, we may do that either from the variable currency or the standard currency, viz., the dollar. In the above quotation, in which Swiss Francs are received in exchange for dollars as: (a) purchase of Swiss Francs against Dollar or (b) sale of Dollar against Swiss Francs. For the sake of uniformity we will assume the standard currency as the currency being bought or sold.
The quotation for Swiss Franc is CHF 1.5425 and CHF 1.5440 per Dollar. While buying dollar the quoting bank would part with fewer francs per dollar and while selling dollars would require as many francs as possible. Thus CHF1.5425 is the dollar buying rate and CHF1.5440 is the dollar selling rate. It may be observed that when viewed from dollar the exchange quotation partakes the character of a direct quotation and the maxim ‘Buy low; Sell high’ is applicable. We will denote such rates as ‘Dollar/Foreign Currency Rates’, implying that dollar is being bought qor sold against foreign currency.
Few currencies such as pound sterling and Euro are quoted in variable units of USD. They are quoted as so many US dollars per unit of foreign currency concerned.
The standard currency here is the foreign currency and will indicate such quotation as ‘Foreign Currency/Dollar Rate’, the quotation for buying and selling of foreign currency against dollars.
Forward Margin/Swap Points
Dollar/Foreign Currency Quotation
At Singapore market dollar may be quoted against Swiss franc and Japanese yen as follows:
Swiss Franc Japanese Yen
Spot 1.5425/40 104.67/70
1 month forward 50/60 17/16
2 months forward 70/80 30/29
The forward margin (also called swap margin or swap points) is quoted in terms of points and a point is the last decimal place in the exchange quotation. It could be in a four digit quotation, a point is 0.0001 or in a two decimal quotation like 0.01.
If the forward margin is ascending order then forward margin is at premium. Premium is added to the spot rate to arrive at the forward rates, both in respect of purchase and sale transactions. The forward margin is given in descending order then forward margin is at discount and deducted from the spot rate to arrive at the forward buying and selling rate.
Using the information already available, the forward rates for dollar against Swiss franc are arrived at as follows:
1 month forward CHF 1.5475 1.5500
2 months forward CHF 1.5495 1.5520
As against Japanese Yen, the forward dollar is at a discount, i.e., the forward margin is in descending order. Therefore, discount is deducted from the spot rate to arrive at the forward rate, both for buying and selling.
The forward rates for dollar against, Japanese Yen based on the data already given are as follows:
1 month forward JPY 104.50 104.54
2 months forward JPY 104.37 104.41
Foreign Currency / Dollar Quotation
Let us assume the following exchange rates are prevailing:
Pound Sterling Euro
Spot 1.4326/48 1.0325/35
1 month forward 50/53 65/62
2 months forward 90/93 84/82
Against dollar, the forward pound sterling is at premium. Premium should be added to the spot rate to arrive at the forward rate.
Thus the forward rates for pound sterling are as follows:
Pound Sterling Pound Sterling
1 month forward USD 1.4371 1.4401
2 months forward USD 1.4416 1.4441
Forward Euro is at discount, since the forward margin is quoted in the descending order. Discount should be deducted from the spot rate to arrive at the forward rate.
Based on the data given, forward rates for Euro can be arrived at as follows:
1 month forward USD 1.0260 1.0273
2 months forward USD 1.0241 1.0253
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