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
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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

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8. The banks quote of bid and ask is from the bankers 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
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Formulae
1. Spread = Ask Bid
2. Bid (Rs/$) = 1/Ask($/Rs)
3. Ask (Rs/$) = 1/Bid ($/Rs)
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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)
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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
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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
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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
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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
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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 makers selling
rate (highest of the quote) and can sell $1 at the market makers
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.
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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
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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
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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
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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.
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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
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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.
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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
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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.
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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
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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
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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)
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Take same example as previous
E.G.
What type of quote is this?

1 = $1.5020
Indirect Quote

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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)
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E.G.

Quote Style(?)
1 = $1.3020
$1 = 0.9350
American Style
European Style
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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 banks
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
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Logic:
The $ can be bought at the market selling
rate which is highest of the quote.

Answer:

500000 X 47.50 = Rs 23750000
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$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 Banks 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:

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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
Banks 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
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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
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$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:

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Note 10
CROSS RATE

It is an exchange rate in which neither currency
is USD
E.g. 1 = Rs 80.50

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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
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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

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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)


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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 4
th
place)
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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
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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 4
th
place)

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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
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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
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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

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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
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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
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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
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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
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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

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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.
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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
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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

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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
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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
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Note 13
Can we say that appreciation of one currency is
exactly equal to depreciation of another
currency?
No. [But approximately yes]
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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 Siegels 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 Siegels 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
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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.

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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
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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




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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]
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